European economics notes part 2 PDF

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European economics notes Epiphany term – European Monetary Union Lecture 1: The current climate in the EU: - Rise of nationalism e.g. increasing tension between fiscally prudent northern member states and their southern counterparts - Brexit – there is significant trade between the UK and the Eurozone, what will the implications be – uncertainty - Divergence in trade competitiveness and productivity - Divergence in income per capita between northern and southern countries, and the catchup of Central and Eastern European countries Good things: - ¾ of people in the euro area are in favour of the euro - The euro has become the second most important currency in the world - 4 freedoms - Reduced transaction costs, elimination of currency risk, greater transparency and possibly greater competition because prices are easier to compare (given the same currency) A common currency: Costs: - Loss of a country’s independent monetary policy used to stabilize the economy (as well as loss of national currency) - ECB sets the interest rate for the whole area since there is a single currency - Member countries lose both interest rate and exchange rate instruments to stabilize national business cycles – this is extremely costly when asymmetric shocks occur - Theory of ‘optimum currency areas’ by Mundell (1961) – it suggests serious concerns about the euro project Benefits: - Reduced transaction costs - Higher transparency - Pro-competitive effect possibly in place Mundell model (1961): Assume 2 countries When there is an asymmetric shock in demand i.e. a decline in AD in France and an increase in AD in Germany, which we assume is permanent, we can carry out the analysis of this shock in two regimes: 1. Monetary independence 2. Single currency area Shift in demand leads to increase in UE in France and upward pressure on wage inflation in Germany

1. Monetary policy dependence - If the 2 countries maintained their own currencies and national central banks, then national interest rate and/or exchange rate can be used - Lower interest rate in France can stimulate domestic demand and lead to a depreciation in the Franc (WPIDEC), this also increases international demand for France-produced goods - If France and Germany have decided to peg their exchange rate, France would devalue the Franc against the Deutschmark 2. Single currency area - France cannot stimulate demand using MP; nor can Germany restrict AD using MP - There are 2 mechanisms which can automatically bring back equilibrium – one is based on wage flexibility and the other is labour mobility Wage flexibility: - French workers agree to accept lower wages to avoid being laid off work; thus, AS in France shifts downwards - Wages go up in Germany due to upward pressures in the labour market; AS in Germany shifts upwards Labour mobility: - Excess French workers will move to Germany – wage does not need to fall in France or rise in Germany - The UE problem is removed from France and rising inflationary wage pressure is removed from Germany - Just the AS curve shifts to keep price level constant (as labour moves) However, labour mobility is very limited in Europe, especially for low skilled workers  If wages and prices are not flexible, and labour is not mobile, monetary union will be costly – when asymmetric shocks occur and there are a lot of rigidities, France will experience sustained UE and the adjustment process in Germany will lead to higher inflation Monetary independence and government budgets: - The increase in the debt to GDP ratios since 2007 is significantly faster in the US and the UK than in the Eurozone - However, it is the Eurozone that has experienced severe sovereign debt crisis and not the other two countries When countries join a MU they lose their monetary independence This fundamentally changes the capacity of governments to finance their budget deficits Member countries now issue debt in euros National governments/CBs do not have direct control of the currency (the ECB does) Financial markets have the power to force default on the euro area countries Spanish example: If investors fear default of Spanish government then: - They sell Spanish government bonds (yields increase)

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The money received is re-invested in other euro area assets Spanish money stock declines; pool of liquidity for investing in Spanish government bonds shrinks ECB provides liquidity to the euro area as a whole (not controlled by Spain) Liquidity crisis possible: Spanish government cannot fund bond issues at reasonable interest rate Can be forced to default Investors know this and will be tempted to try

Self-fulfilling prophecy: When investors distrust a member’s government, they will sell the bonds, thereby raising the interest rate and potentially triggering a liquidity crisis - With a higher interest rate, the government debt burden increases - This forces the government to reduce spending and increase taxation - Such budgetary austerity is politically costly and may lead the government to stop servicing the debt and to declare default Stand-alone countries issue debt in their own currencies, and thus they can always create liquidity to pay out the bondholders – however, creating additional liquidity to finance debt by money creation is inflationary Asymmetric shocks and debt dynamics: - Important interactions between asymmetric shocks and debt dynamics - Negative shock in France increase budget deficit in France (due to automatic stabilizers) - If markets lose trust in French government then the effect of the asymmetric shock is amplified - Investors sell French government bonds and this leads to an increase in the interest rate and a liquidity crisis in France - With a higher interest rate, the country’s AD curve shifts further to the left - Also, when investors sell French bonds they are likely to purchase Germany government bonds (trustworthy) - German government bond yield declines - AD curve in Germany shifts outwards - Intensifying the boom in Germany - Thus, the interest rate changes that occur tend to destabilize the system instead of stabilizing it - The divergence in long-term government rates reflects the fact that investors attach different risks of holding government bonds of different euro area members Other sources of asymmetry: Different labour market institutions: - Centralized versus non-centralized wage bargaining - Symmetric shocks are transmitted differently and lead to wage and price divergence

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In countries with centralized wage bargaining, labour unions take into account the inflationary effect of wage increases - therefore, wage increase is moderate

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In countries with decentralized wage bargaining, labour union bargaining leads to higher wage inflation The same shock shifts supply curve upwards more in one country than others

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Conclusions: When shocks are asymmetric: - MU creates costs compared to monetary independence - Flexible wages and labour market mobility reduce the adjustment costs of members MU changes a government’s capacity to finance its debt – distrust of investors can cause liquidity crises and force default in a euro area country Debt dynamics can amplify asymmetric shocks through the trust of investors The revenge of the OCA – Paul Krugman: - The euro has become an economic trap and Europe a nest of squabbling nations - Dire economic conditions create a favourable environment for political extremism - The common European currency has not led to an explosion in intra-European trade however, trade has risen modestly - A currency area is limited to a one-size-fits-all monetary policy – Loss of a mechanism for adjustment - “Asymmetric shocks” are evident in the Eurozone - Mundell (1961) argued that a single currency would be successful if the regions sharing that currency were characterized by high mutual labour mobility (factor mobility) - Kenen’s argument (1969) about fiscal integration – a large federal component to spending at the regional of local level – can help a lot in dealing with asymmetric shocks too Why did they believe it would work then? - Adoption of sound fiscal policies to reduce the incidence of asymmetric shocks - Countries would engage in structural reforms to make labour markets more mobile and wages more flexible to cope with these shocks Exchange rates were locked in 1999 The euro crisis: - The creation of the euro led to a perception on the part of many investors that the big risks associated with cross-border investment within Europe had been eliminated - Massive capital movements from Europe’s core to the periphery (after euro’s creation), leading to an economic boom in the periphery and significantly higher inflation rates in southern countries – this movement was itself an asymmetric shock (although a gradual one) - When private capital flows from the core to the periphery came to a stop, leaving the periphery with higher prices and unit labour costs relative to the core – suddenly there was an adjustment problem - “Internal devaluation” proved extremely hard

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Nobody foresaw that countries hit by adverse asymmetric shocks would face fiscal burdens so large as to call government solvency into question (a series of fiscal emergencies) - Traditional OCA theory paid little attention to banking issues; in Europe, bank bailouts have helped cause sudden jumps in government debt (Ireland) - Concerns about sovereign debt and the absence of federal bank backing => “doom loops” [Fears of sovereign default undermine confidence in the private banks that hold much sovereign debt, forcing these banks to contract their balance sheets, driving the price of sovereign debt still lower] - Lender of last resort issue as well – DeGrauwe (2011) pointed out that national CBs are potentially crucial LOLR to governments as well as private financial institutions - Members of a currency area, it turns out, should have high integration of bank guarantees and a system of lender of last resort provisions for governments as well as the traditional Mundell criterion of high labor mobility and the Kenen criterion of fiscal integration -> The euro area has none of these Making the euro workable: - Full integration (American-style) or at least a “transfer union” with much more in the way of automatic compensation for troubled nations/regions - Europe-wide backing of banks: this would involve both some kind of federalized deposit insurance and a willingness to do TARP-type (Troubled asset relief program) rescues at EU level - The ECB as a LOLR in the same way that national CBs already are (complaints amount moral hazard need to be addressed) - A higher inflation target – internal devaluation via deflation is extremely difficult and likely to fail politically if not economically Krugman believes that the euro project increasingly looks like it was a mistake and the main reason of not breaking it up is political – it would amount to a huge defeat for the broader European project Draghi launches defence of EU and euro against rising nationalism: - Fight the rising tide of nationalism and meet the challenges of globalisation through deeper integration - The introduction of the euro had been an “exceptional response” to centuries of dictatorship and misery - In Europe, there are tensions over rising wealth inequality - The president of the ECB recognized that the gains of membership of the single currency area had not been evenly spread

Lecture 2: The theory of optimum currency areas: A critique: A critique of OCA theory can be formulated at 3 different levels: - How relevant are the differences between countries? - Will some of the differences disappear when countries join EMU? - Is national MP effective? EMU and Economic convergence: - Appropriate setting of MP and FP, internal EU market with 4 freedoms -> economic convergence in the euro area, even though cross-country structural differences prevailed in the beginning (consensus) ECB was established with a strict mandate to maintain price stability (main focus of MP) In terms of FP we have the Stability and Growth Pact which set binding constraints on each member’s fiscal policy i.e. deficit/GDP wage and price divergence in a MU - Differences in legal systems and financial markets High inflation countries issue short-term government debt/ Low inflation countries issue more long-term government debt Some of these differences disappeared following MU: - Centralized MP places a consistent trade-off on UE and inflation across all countries - There is a reduction of inflation differentials - Convergence in nominal and real interest rates (ECB) - Convergence of maturity structures and yields of government bonds Some differences remain and some have even grown:

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Divergence in C/A balances Divergence in productivity and competitiveness Differences remain in inflation rates and real interest rates

Current account composition: C/A is the result of savings and investment decisions of the private and public sectors C/A= net public savings + net private savings 3 major components: C/A= Trade balance + Net factor income + Net transfers [Trade balance is positive for northern countries and negative for southern countries Net factor income follows the same pattern Net current transfers are positive and falling for the South and negative and steady for the North (kind of reverse pattern of above observations)] C/A imbalances and economic convergence: - Different levels of economic development -> diverging C/As, in the process of country convergence - A country with lower income/capita would be expected to attract domestic and foreign investment, since higher productivity and economic growth rates promise higher rates of return - Such countries, should consume more and consequently save less in anticipation of higher income growth in the future (expectations) - Thus, higher investment and lower savings in the South accumulates net foreign liabilities by running C/A deficits - However, total factor productivity in the South fell relative to Northern countries over the years 1992-2007 (Positive correlation between Real GDP/capita and Relative TFP) C/A imbalances and sovereign risk: - Private savings and investment can lead to large external deficits without generating sufficient economic growth and productivity gains - Excessive borrowing in southern Europe can also be explained by excessive risk-taking by European banks in both north and south due to elimination of exchange rate risk and the pro-cyclical effect of the common MP - Banking risk can easily be converted to sovereign risk, since a country’s government will ultimately need to provide the banking system’s safety net - Fiscal policy will be forced to step in to address unsustainable C/A imbalances Divergence in competitiveness: - Higher inflation in the South leads to loss of international competitiveness relative to the North (as exchange rates became fixed and interest rates converged) - Divergences in unit labour costs lead to additional adjustment problems

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Loss of competitiveness has led to reductions in wage levels relative to other countries (if productivity cannot be raised) This is likely to be a slow and painful process (internal devaluation)

Currency depreciation and deflationary policies (2 adjustment mechanisms) compared Summary: - Critique of OCA theory suggests that Mundell’s old OCA theory is too pessimistic about euro projects and EMU itself should lead to economic convergence and lower costs - Empirical evidence finds large divergence in current accounts and competitiveness in euro area countries - Large external imbalances have strong negative consequences for fiscal policy - Independent MP can sometimes make the dynamics towards new equilibrium less costly than alternative policy strategies The crisis and the Euro – Barry Eichengreen: - Most Europeans will insist that the credit crisis of 2008 originated in other parts of the world, in most initial events Europe was just a bystander with relatively positive features before the credit crunch - European financial institutions took substantial losses on mortgage-based and related derivative securities, indicating that the shortcomings of internal controls and risk management were not exclusively an American problem – European banks were more highly leveraged than U.S banks, so when losses were incurred and deleveraging resulted, financial distress was at least as severe - Between 1999-2005 housing prices in the euro area rose as strongly as in the US - Associated with these booms were sharp increases in labour costs – more generous labour compensation meant more income with which to purchase real estate – higher wages also meant higher export prices and larger C/A deficits - As demand for exports fell, not only did countries in question develop large external deficits but the demand for domestic merchandise softened and domestic inflation slowed - The problem was not so much monetary union as it was a rigid application of the doctrine of inflation targeting, pro-cyclical fiscal policy and the failure to use supervision and regulation to limit excesses and financial and property markets - The crisis of 2008/9 is precisely the kind of asymmetric shock warned of by early eurosceptics and highlighted by the theory of OCA - Large losses for banks with larger losses in some countries than others – rising UE throughout euro area but some countries suffered more – deflationary pressures – higher strains on the public finances of some euro-area countries -

Policy makers in the countries where domestic demand is weakest can imagine how, if they still possessed a national currency, they might push it down in order to encourage exports A country that unilaterally abandoned the euro in order to steal a competitive advantage would jeopardize its status as an EU member in good standing – reputation consequences

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Eichengreen (2007) documents the same greater sensitivity outside the euro area of sovereign credit ratings. Evidently investors and the rating agencies informing their decisions take comfort in the fact the conduct of fiscal policy in the euro area is overseen by the mutual surveillance and sanctions of the Stability and Growth Pact and by the fact that the European Central Bank operates under a no-bailout rule that prohibits it from buying bonds directly from governments. It might make it easier for a government to fund its deficit in the short-run but this will come at a cost in terms of more expensive funding down the road – greater short-run flexibility compared to longer-run costs in the calculations of policy makers The case for reintroducing the euro is probably more compelling in Ireland, where the problem is mainly high wages, rather than Greece, where it is heavy debts. It is that with currency depreciation a grinding deflation and high unemployment can be avoided. Revealingly, the main cases where participants have left monetary unions are of countries that were relatively closed to trade and financial flows and when the banking and financial system was underdeveloped or tightly regulated, leaving only limited scope for capital flight when preparations were underway. Countries such as Denmark, Sweden and the eastern European countries, despite all being euro-sceptical to some degree, have concluded that coping with a financially-volatile world is easier inside than outside the euro area Having automatic access to emergency liquidity facilities of the ECB was attractive in a situation where small non-euro countries incur euro-denominated liabilities – the ECB did extent a one-time E12 billion swap to Denmark to help that country defend its currency (however, this kind of cooperation is not guaranteed) Hungary and Poland both have indicated that they may speed up the transition to the euro in response to the crisis The displeasure of the ECB is significant, since it suggests that countries unilaterally adopting the euro would not receive emergency liquidity from the central bank at times of distress, vitiating the main argument for unilateral ...