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

A Monetary History of Europe 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

Optimum Currency Area (OCA) Theory What are the trade-offs? Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

Fiscal Policy and the Stability Pact Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

Theory and Politics of European Integration Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

Microeconomics of Trade Preferential Trade Liberalization Theory and Politics of European Integration Fiscal Policy 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)

A good question, no simple answer 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 solution has to involve trading off these benefits Theory and Politics of European Integration Optimal Currency Areas The economic toolkit There must be benefits and costs involved in adopting a common currency The solution has to involve trading off these benefits

Money exhibits increasing returns to scale (network externalities) Theory and Politics of European Integration Optimal Currency Areas 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

Start with the idea that benefits argue for one worldwide currency Theory and Politics of European Integration Optimal Currency Areas 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

Assumption: sticky prices and wages Definition of exchange rate: EP/P* Theory and Politics of European Integration Optimal Currency Areas 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*

Theory and Politics of European Integration Optimal Currency Areas 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

If exchange rate adjusts, production declines to D. Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas 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?

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas 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?

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU Currency 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 CU Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU Disequilbria 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 Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas 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

Asymmetric shocks: adverse demand shock in 2 country CU Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU What happens with labour mobility? Assume exchange rate declines to λ2 and production is at B in country 1 and D in country 2.

Asymmetric shocks: adverse demand shock in 2 country CU 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. Theory and Politics of European Integration Optimal Currency Areas Asymmetric shocks: adverse demand shock in 2 country CU

Criterion 2 (Kenen): Production diversification Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas 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: Theory and Politics of European Integration Optimal Currency Areas 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.

Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Openness Most EU countries are very open: The McKinnon criterion is broadly satisfied

Inside the OCA index: Diversification Theory and Politics of European Integration Optimal Currency Areas 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) Theory and Politics of European Integration Optimal Currency Areas 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

Inside the OCA index: Labour mobility (2) Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Labour mobility (2) An international comparison suggests that labour mobility is low in Europe Across countries Even within countries

Inside the OCA index: Labour mobility (3) Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Labour mobility (3) 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 Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Optimal Currency Areas Inside the OCA index: Commonality of destiny Little is known about this criterion Public opinion polls do not reveal deep opposition to EU institutions

Product Diversification Fiscal transfers No (but tend to increase) Theory and Politics of European Integration Optimal Currency Areas Summarizing Criterion Satisfied? Labour mobility No Trade openness Yes Product Diversification Fiscal transfers No (but tend to increase) Homogeneity of preferences Partly (eroding?) Commonality of destiny ?

Is the OCA glass half full or half empty? Theory and Politics of European Integration Optimal Currency Areas Overall Is the OCA glass half full or half empty?

History never ends: the endogeneity of OCA criteria Theory and Politics of European Integration Optimal Currency Areas 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?

Little evidence that reducing exchange rate volatiliy increases trade Theory and Politics of European Integration Optimal Currency Areas 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? Theory and Politics of European Integration Optimal Currency Areas Will diversification grow or decline? Argument 1: intra-industry trade will grow Argument 2: specialization will increase No firm conclusion so far

Mobility may not change much, but wages could become less sticky Theory and Politics of European Integration Optimal Currency Areas 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? Theory and Politics of European Integration Optimal Currency Areas 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

Monetary union is not only about economics Theory and Politics of European Integration Optimal Currency Areas 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact Public debt and automatic stabilizers in Europe

A crucial distinction : automatic vs. discretionary Theory and Politics of European Integration Fiscal Policy and Stability Pact 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? Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

Theory and Politics of European Integration Theory and Politics of European Integration Fiscal Policy and Stability Pact Income spillovers, 1972 -2005

What is the problem with the deficit bias? Theory and Politics of European Integration Fiscal Policy and Stability Pact What is the problem with the deficit bias? The track record is not really good (2005 – 2013): Quelle: OECD STAT Database, 2013; eigene Berechnungen.

What is the problem with the deficit bias? Theory and Politics of European Integration Fiscal Policy and Stability Pact What is the problem with the deficit bias? The track record is not really good (2005 – 2013): Quelle: OECD STAT Database, 2013; eigene Berechnungen.

What is the problem with the deficit bias? Theory and Politics of European Integration Fiscal Policy and Stability Pact What is the problem with the deficit bias? 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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? Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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? Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

Emphasis on the 3% deficit ceiling Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

When the 3% ceiling is not respected Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

Theory and Politics of European Integration Theory and Politics of European Integration Fiscal Policy and Stability Pact The fine schedule The fine starts at 0.2% of GDP and rises by 0.1% for each 1% of excess deficit

The fine is imposed every year when the deficit exceeds 3% Theory and Politics of European Integration Fiscal Policy and Stability Pact 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) Theory and Politics of European Integration Fiscal Policy and Stability Pact 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) Theory and Politics of European Integration Fiscal Policy and Stability 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?

Issues raised by the Pact (2) Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (2) 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

Issues raised by the Pact (3) Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (3) What room left for fiscal policy? If budget in balance in normal years, plenty of room left for automatic stabilizers

Issues raised by the Pact (3) Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (3) What room left for fiscal policy? If budget in balance in normal years, plenty of room left for automatic stabilizers

Issues raised by the Pact (3) Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (3) 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) Theory and Politics of European Integration Fiscal Policy and Stability Pact The early years (before slowdown)

Further controversies Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

Theory and Politics of European Integration Theory and Politics of European Integration Fiscal Policy and Stability Pact Next Lecture February 6, 2014