Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 7 The EURO and Optimal Currency Area Theory Fiscal Policy and the Stability

Theorie und Politik der Europäischen Integration

Prof. Dr. Herbert Brücker

Lecture 7

The EURO and Optimal Currency Area TheoryFiscal Policy and the Stability Pact

Theory and Politics of European Integration

Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker

Theory and Politics of European Integration Fiscal Policy and Stability Pact

The last Lecture

• A Monetary History of Europe· The Gold Standard· Hume‘s Mechanism: Monetary Equilbrium under the Gold Standard· The Interwar Period· The Bretton Woods System· The Snake and the Super-Snake· The EURO

• The Choice of an Exchange Rate System· The long-term neutrality of money in the AS-AD Diagram· Fiscal Policy in the IS-LM Diagram· Monetary Policy in the IS-LM Diagram· The trade-off between fiscal and monetary policies



This Lecture

Optimum Currency Area (OCA) Theory • What are the trade-offs?• Asymmetric shocks and currency areas• Criteria for an optimal currency area

The European Monetary Union (EMU)• Maastricht Treaty and History• The Eurosystem• Objectives, instruments and strategy• The record during the first years



This Lecture

Fiscal Policy and the Stability Pact• Fiscal policy in the monetary union

· More and more important?· Borrowing instead of transfers· Automatic stabilizers and discretionary policy actions

• Fiscal policy externalities· Spillovers and coordination· Cyclical income spillovers· Borrowing cost spillovers· Excessive deficit and the no-bailout clause· Collective discipline



Reading

Richard Baldwin/Charles Wyplosz, The Economics of European Integration, 3rd Edition, 2009, Ch. 11 (Optimum Currency Areas) and Ch. 18 (Fiscal and Stability Pact)



Exam

Topics• Microeconomics of Trade• Preferential Trade Liberalization• Scale Economies (BECOMP diagram)• Trade and Competition Policies• Dynamics of integration• Capital and labour mobility• Macroeconomics of monetary integration• Optimum Currency Area Theory• European Monetary Union and Eurocrisis (next lecture)


Theory and Politics of European Integration Optimal Currency Areas

A good question, no simple answer

• Should curreny area borders coincide with national borders?

• If not, how best to delineate currency areas?

• What economic criteria should be used?



The economic toolkit

•There must be benefits and costs involved in adopting a common currency

•The solution has to involve trading off

these benefits



In a nutshell

•The benefits• Money exhibits increasing returns to scale

(network externalities)· E.g. you save transaction costs for money exchange the

people use your currency

• The world is the way to maximize these benefits•The costs

• Loss of monetary and exchange rate instruments• Matters in presence of:

· Price and wage stickiness· Asymmetric shocks



Focusing on costs

•Start with the idea that benefits argue for one worldwide currency•Ask why not•Look at the costs•No precise way of estimating costs and benefits so, in the end, a matter of judgement•Look at asymmetric costs

• How they create trouble• What makes them more likely• What makes them less painful



Asymmetric shocks

•Simplest example: an adverse demand shock: how can the exchange rate help?• Assumption: sticky prices and wages• Definition of exchange rate:

• EP/P*

or in terms of wages:• E W/W*



Asymmetric shocks

• Simplest example: an adverse demand

shock: how can the exchange rate help?

If domestic prices and wages are sticky, adverse demand shock will reduce production to C if exchange rate does not adjust



Asymmetric shocks

•Simplest example: an adverse demand shock: how can the exchange rate help?

If exchange rate adjusts, production

declines to D.



Asymmetric shocks: adverse demand shock in 2 country CU




No currency union case:Real exchange rate declines in country A to λ1, production declines to B, country B remains unaffected.

What would happen if exchange rate stays at λ0?




No currency union case:Real exchange rate declines in country A to λ1, production declines to B, country B remains unaffected.

What would happen if exchange rate stays at λ0?



Asymmetric shocks: adverse demand shock in 2 country CUCurrency union case:Central Bank let currency decline to λ2. production declines in country A to C, in country B to D, and excess demand creates inflationary pressure D-D‘.



Asymmetric shocks: adverse demand shock in 2 country CUDisequilbria don‘t last forever. In country A wages and prices decline, such that production moves to equilibrium point B. In country B wages and prices will increase, until economy is back to point A as well.



Implications of asymmetric shocks

• Thus, both countries are hurt when they share the same

currency

• Also the case when a symmetric shock creates asymmetric effects

• This is an unavoidable cost of a currency area



Six critieria for a optimal currency area

• Next questions:• What reduces the incidence of asymmetric shocks?• What makes it easier to cope with shocks when they occur

• The analysis develops six criteria for an optimal currency area (OCA)• Three economic

· labour mobility· diversion· trade openness

• Three political· transfers· homogeneous preferences· Common destiny



Criterion 1 (Mundell): Labour mobility

•In an OCA labour moves easily across national borders.

•Caveats• Labour mobility is easy within national borders (culture, language, legislation,

welfare, etc…), but much less so across national borders

• Capital mobility: difference between financial and physical capital

• In case of country specialization, skills also matter and hinder labour mobility




What happens with labour mobility?

• Assume exchange rate declines to λ2 and production is at B in country 1 and D in country 2.




Labour mobility shifts supply curve leftwards in country 1 to S‘ and rightswards in country 2 to S‘.

• New equilbrium ar C and D‘.

• Output gap is zero.



Criterion 2 (Kenen): Production diversification

•Countries whose production and exports are widely diversified and of similar structure form an OCA.

•Indeed, in that case, there are few asymmetric shocks and each of them is likely to be of small concern



Criterion 3 (McKinnon): Openness

•Countries which are very open to trade and trade heavily with each other form an OCA.

•Distinguish between traded and non-traded goods• Traded good prices are set worldwide• A small economy is price-taker, so the exchange rate

does not affect competitiveness

•In the limit, if all goods are traded, domestic good prices must be flexible and the exchange rate does not matter for competitiveness



Criterion 4: Fiscal transfers

•Countries that agree to compensate each other for adverse shock form an OCA.

•Transfers can act as an insurance that mitigates the costs of an asymmetric shock

•Transfers exist within national borders• Implicitly through the welfare system (e.g.

unemployment benefits)• Explicitly in federal states



Criterion 5: Homogeneous preferences

•Countries that share a wide consensus on the way to deal with shocks form an OCA.

•Matters primarily for symmetric shocks• Prevalent when the Kenen criterion is satisfied• Do countries agree how to adress symmetric shocks?

Should we favour exporters (currency depreciation) or consumers (currency appreciation)? How much?

•May also help for asymmetric shocks• Better understanding of partners’ actions• Encourages transfers



Criterion 6: Commonality of destiny

•Countries that view themselves as sharing a common destiny better accept the costs of operating an OCA.

•A common currency will always face occasional asymmetric shocks that result in temporary conflicts of interests

• This calls for accepting such economic costs in the name of a higher purpose

• Solidarity vs. Nationalism



Is Europe an OCA?

•A synthetic OCA index:

How much of a currency appreciation/devaluation vis-à-vis the DM is needed to keep economic conditions unchanged?A ten year period is considered.Indicator for the relevance of adjustment pressures from asymmetric shocks.



Is Europe an OCA?

•Asymmetric effects of symmetric shocks: effects on GDP and prices of a change of the common interest rate (increasing the interest rate by 1 per cent)



Inside the OCA index: Openness

•Most EU countries are very open: The McKinnon criterion is broadly satisfied



Inside the OCA index: Diversification

•Most EU countries have a diversified production structure (intra-industry trade dominates)

•The Kenen criterion is broadly satisfied and well explains which countries joined the euro area



Inside the OCA index: Labour mobility (1)

•The labour mobility criterion cannot be black-and-white

•The migration response to economic incentives must consider many costs:

• Moving costs• Risk of becoming unemployed• Longer run career opportunities• Family prospects• Eligibility to welfare• Taxation• Cultural/linguistic differences• National attachment




•An international comparison suggests that labour mobility is low in Europe

• Across countries

• Even within countries




•Low labour mobility implies that unemployment bears much of the burden of adjustment to shocks•An US-EU comparison:• How much of an initial employment shock is absorbed by labour mobility?



Inside the OCA index: Transfers

•The EU does not satisfy the transfer criterion•The overall EU budget

• is low, capped at 1.27% of EU GDP• entirely used for administration, CAP,

regional and structural funds• These funds do not vary with the business

cycle and are not earmarked to address asymmetric shocks

•This changes with the ESM/ESRM facilities in the course of the Eurocrisis



Inside the OCA index: Homogeneity of preferences

•Preferences could affect the role of monetary and fiscal policies to address external shocks•Little is known about this criterion• Eurbaometer survey suggest that people agree on common decisionmaking for defence (64%), but 67% reject decisionmaking in the area of social affairs• Eurocrisis show increasing tensions across nations and their populations and disagreement e.g. on fiscal transfers and macroeconomic policies



Inside the OCA index: Commonality of destiny

•Little is known about this criterion•Public opinion polls do not reveal deep opposition to EU institutions



Summarizing

Criterion Satisfied?

Labour mobility No

Trade openness Yes

Product Diversification Yes

Fiscal transfers No (but tend to increase)

Homogeneity of preferences Partly (eroding?)

Commonality of destiny ?



Overall

• Is the OCA glass half full or half empty?



History never ends: the endogeneity of OCA criteria

•Living in a monetary union may help fulfill the OCA criteria over time

•Would the US be an OCA without a single common currency?

•Will the existence of the EURO area change matters too ?• Will the Eurocrisis create further integration e.g. via fiscal transfers and common fiscal policies or further disintegration? Split between the South and the North?• Will no-Eurozone members leave EU, e.g. UK?



Will trade deepen?

• Little evidence that reducing exchange rate volatiliy increases trade

• Mounting evidence that eliminating exchange rate volatility by adopting a common currency raises trade a lot

• Estimates range from 50% to 100%• The “border effect” provides similar estimates



Will diversification grow or decline?

•Argument 1: intra-industry trade will grow

•Argument 2: specialization will increase

•No firm conclusion so far



EMU and labour markets

•Mobility may not change much, but wages could become less sticky•Two views:

• The virtuous circle: labour markets respond to enhanced competition by becoming more flexible

• The hardening view: labour markets respond to enhanced competition by increasing protective measures that raise stickiness

•The jury is still out: EURO crisis has not much increased labour mobility in 2010, but in 1st half year of 2012

• E.g. Greek migration in Germany: + 80%.• But: Substantial diversion of migration flows from NMS

equilbriate labour supply between crisis and non-crisis countries



Are the other criteria endogenous?

Transfers• No support for more taxes fo finance transfers at beginning

of EMU• But: Meanwhile 50% of German population support at least

some transfers to bailout Greece

Homogeneity of preferences• No presumption that it will change soon, but EURO crisis my

force countries to do so (e.g. zero debt ceiling)

Commonality of destiny• No presumption that it will change soon



In the end

•Monetary union is not only about economics

•The OCA criteria do not send a clear signal• The EU is not a perfect OCA• A monetary union may function, at cost

•The OCA criteria tell us only partly where the costs will arise:• Labour markets and unemployment• Political tensions in presence of deep asymmetric shocks• Fiscal shocks and imbalances like real estate bubble remain

largely unadressed



Fiscal Policy and the Stability Pact

Fiscal Policy and the Stability Pact• Fiscal policy in the monetary union

· More and more important?· Borrowing instead of transfers· Automatic stabilizers and discretionary policy actions

• Fiscal policy externalities· Spillovers and coordination· Cyclical income spillovers· Borrowing cost spillovers· Excessive deficit and the no-bailout clause· Collective discipline



The fiscal policy instrument

• In a monetary union, the fiscal instrument assumes greater importance

· The only macroeconomic policy instrument left at the national level

· Its effectiveness is increased (a result from the Mundell-Fleming model)

· Heavily used in 2008 financial crisis and subsequent period

• A subsitute to transfers

• Yet, many questions arise regarding its effectiveness and use



Limits on effectiveness

• The crucial role of private expectations· A deficit today but a debt tomorrow: who will pay?· A tax cut, but how permanent?

• Slow implementation· Agreement within government· Agreement within parliament· Spending carried out by bureaucracy· Taxes not retroactive

• Result: countercyclical moves can become procyclical actions and in extreme cases create fiscal crisis (default of government bonds)



A crucial distinction: automatic vs. discretionary

• Automatic stabilizers· Tax receipts decline when the economy slows down,

and conversely· Welfare spending rise when the economy slows down,

and conversely· No decision, so no lag: nicely countercyclical· Rule of thumb: deficit worsen by 0.5% of GDP when

GDP growth declines by 1%



Public debt and automatic stabilizers in Europe



A crucial distinction : automatic vs. discretionary

• Discretionary actions: a voluntary decision to

change tax rates or spending

• Technically: a change in the structural budget

balance

• But no automatic correction of deficits, so a

problem of discipline



Should instrument be subject to some form of collective control?

• Yes, if national fiscal policies are a source of several externalities

• (Positive) income externalities via trade• Important and strengthened by monetary union• A case for some coordination

• Borrowing cost externalities• One common interest rate• But EURO area integrated in world financial markets

• Sovereign debt default risk put other EMU members or ECB under bail-out pressure



Income spillovers, 1972 -2005



What is the problem with the deficit bias?

• The track record is not really good (2005 – 2013):

Quelle: OECD STAT Database, 2013; eigene Berechnungen.




• The track record is not really good (2005 – 2013):

Quelle: OECD STAT Database, 2013; eigene Berechnungen.




• Fiscal indiscipline in parts of the EURO area might concern financial markets and:• Raise borrowing costs for all countries:

unlikely, markets can distinguish among countries

• More serious is the risk of sovereign debt default in one member country• capital outflows and a weak EURO

• pressure on other governments to help out

• pressure on the Eurosystem (European Central Bank) to help out



The answer to default risk: the no bailout clause

• The no-bailout clause:Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments. (Art. 101)



The answer to default risk: the no bailout clause

• The no-bailout clause: Question of credibility

(ex post the world looks different)

• Thus, fears remain

• Informal pressure

• Impact on EURO

• Prevention is better, especially given a tradition of

indiscipline



In the end, should fiscal policy independence be limited?

• The arguments for:• Serious externalities

• A bad track record, anyway

• The arguments against:• The only remaining macroeconomic instrument

• National governments know better the home scene



The general principles

• Two general arguments for collective action• Externalities• Increasing returns

• Two general arguments against collective action• Heterogeneity of preferences• Information asymmetries

• And a caveat• Governments may pursue own interests



How to restrain fiscal policies?

• Distinction No.1• Micro/structural aspects (tax and spending levels and

structure)

• Macro aspects (the balance between tax revenues and spending)

• Distinction No.2• Coordination: voluntary and flexible efforts at taking into

account each other’s action

• Binding commitments or rules



The Stability and Growth Pact

• Formally, the implementation of the Excessive Deficit Procedure (EDP) mandated by the Maastricht Treaty

• The EDP aims at preventing a relapse into fiscal indiscipline following entry in euro area

• The EDP makes permanent the 3% deficit and 60% debt ceilings and foresees fines

• The Pact codifies and formalizes the EDP



How the Pact works

• Emphasis on the 3% deficit ceiling

• Recognition that the budget balance worsens with recessions:• Exceptional circumstances when GDP falls by 2% or more:

automatic suspension of the EDP

• When GDP falls by more than 0.75%, country may apply for suspension

• Precise procedure that goes from warnings to fining



The procedure

• When the 3% ceiling is not respected• The Commission submits a report to ECOFIN• ECOFIN decides whether the deficit is excessive• If so, ECOFIN issues recommendations with an associated

deadline• The country must then take corrective action• Failure to do so and return the deficit below 3% triggers a

recommendation by the Commission• ECOFIN decides whether to impose a fine• The whole procedure takes about two years



The fine schedule

• The fine starts at 0.2% of GDP and rises by 0.1% for each 1% of excess deficit



How is the fine levied

• The sum is retained from payments from the EU to the country (CAP, Structural and Cohesion Funds)

• The fine is imposed every year when the deficit exceeds 3%

• The fine is initially considered as a deposit• If the deficit is corrected within two years, the deposit is

returned• If it is not corrected within two years, the deposit is

considered as a fine



The Broad Economic Policy Guidelines (BEPG)

• Emphasis on precautionary measures to avoid warnings and fines

• The stability programmes are embedded in the wider BEPG, a peer-monitoring process that includes the Lisbon strategy

• Each year, each country presents its planned budget for the next three years, along with its growth assumptions

• The Commission evaluates whether the submission is compatible with the Pact



Issues raised by the Pact (1)

• The BEPG shift the focus to ex ante commitments• Led to the Irish warning (2001)

• Decisions are taken by the ECOFIN, a political grouping• France and Germany treated leniently in 2003-4

• Imposition of a fine can trigger deep resentment• Are fines credible? • If not, what is left?




• Does the Pact impose procyclical fiscal policies?• Budgets deteriorate during economic slowdowns• Reducing the deficit in a slowdown may further deepen

the slowdown• A fine both worsens the deficit and has a procyclical effect

• The solution: a budget close to balance or in surplus in normal years




• What room left for fiscal policy?• If budget in balance in normal years, plenty of room left

for automatic stabilizers




• What room left for fiscal policy?• If budget in balance in normal years, plenty of room left

for automatic stabilizers




• What room left for fiscal policy?• If budget in balance or surplus in normal years, plenty of

room left for automatic stabilizers• Some limited room left for discretion action

• In practice, the Pact encourages• Aiming at surpluses• Giving up discretionary policy

• At first glance, the early years seems to be hardest• Takes time to bring budgets to surplus

• Today we know, it is even harder after a shock



The early years (before slowdown)

-6 -4 -2 0 2 4 6 8

Spain

Portugal

Netherlands

Luxembourg

Italy

Ireland

Greece

Germany

France

Finland

Belgium

Austria

2001 1998



Further controversies

• Discipline imposed from outside· A further erosion of sovereignty?

• Arbitrary limits· Why 3%?· What about the debt celing of 60%?

• Asymmetry• The Pact binds in bad years only• A budget forever close to balance or in surplus

would drive debt/GDP ratio to 0



Next Lecture

February 6, 2014

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Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 7 The EURO and Optimal Currency Area Theory Fiscal Policy and the Stability