EMU

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EMU

• Professor Joseph McCahery

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IS the EU An Optimal Currency Area?

• OCA economic unit composed of regions affected
  symmetrically by distrubances and between which
  labor (and other factors) flow freely (Mundell,
  1961)
• Movement toward OCA facilitated by
• Real exchange rate change to enhance adjustment
  between regions experiencing change in relative
  prices

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OCA

• 2nd factor real security prices the more
  closely share prices move across regions, more
  symmetrical the disturbances and more rapid the
  allocation of factors across regions
• 3rd factor labor mobility the more mobile the
  factors, more likely the region will constitute
  an OCA

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US v. EU with reference to harmonization of policy

• Labor market response not same as US (per capita
  income in 1990 terms 50 higher than Europe)
• degree of openness is comparable (if intra EC
  trade netted out) degree of unemployment higher
  in EU share of agric labor employment higher
• Monetary Policymaking Institutional framework
  resembles US system (differences in experience )
• Fiscal federalism states and national govts in
  US redistrubute due to effects of cross-border
  externalities (matching block grants fiscal
  insur)

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Benefits/Costs

• Benefits
• lower transaction costs (0.1 to 1.0 of GDP
  source EC 1994)
• price stability in EU, Art 105(1)
• gains from trade because of exchange rate
  stability
• increased capital formation

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Costs

• Loss of exchange rate flexibility to deal with
  asymmetric, country specific shocks
• Moral hazard problems stemming from decentralized
  policies for managing unemployment risk
• high country-specific fiscal costs due to absence
  of EU-wide system of unemployment insurance

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Responses private control at country level

• Out-migration of labor (very little evidence due
  to linguistic, professional and other barriers)
• Private insurance to cover excessive risk due to
  unemployment (some evidence of increased take up
  in UK, NL, etc)
• Labor Market coordination (wage coordination
  under further strain in NL, D)

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Institutional Issues

• The existing policy instruments to deal with
  political or economic disturbances
• level of government expenditure is narrowly
  contrained by convergence criteria (Art 109j)
  (1) Stage 3 criteria inflation not more than
  1.5 higher than the average of the three lowest
  rates in EMU long term interest rate not higher
  than 2 higher than average observed in three low
  inflation cts no devaluation gt budget deficit
  is not higher than 3 GDP govt debt not exceed
  60 GDP

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Critique of Convergence

• Maastricht approach may be cause of
• limited economic growth in 90s across EU caused
  by pursuit of simultaneous pursuit of budget and
  inflation reductions which created some
  deflation there is some evidence
• US v. EU 81-90 2.5 v. 2.4
• 91-96 1.5 v. 2.3 (EC 1997)
• Inflation policy based restrictive monetary
  policy
• US rates dropped in early 90s in contrast with EU

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Convergence Critique II

• Limited coherence as standards, but have utility
  in that they provide screening device for entry
  (price stability, economic convergence,
  commitment)
• Not effective as operating rules for EMU
• No specific mechanisms to guide policy
• Does not provide means for exit.

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Excessive Debt Critique

• Art. 104c(1) requires MSs to avoid excessive
  government debt (Commission is monitor)MSs will
  not exceed 3 for debt to GDP at Market prices
  60 for ratio of debt to GDP at market prices
• Contains ambiguity Council confirms MSs to
  qualify according to 109j(1) with regard to
  excessive debt, Art 104c(6) states Council by QMV
  may recommend after an overall assessment whether
  an excessive debt exists (bargaining)

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DeGrauwe

• De Grauwe (2000) claims that for countries
  following budget and inflation strategy may have
  been self-deating in that the combination reduced
  ability of policymakers to achieve budget deficit
  targets and could have been reasons for increase
  in deficits (around 70 GDP in 1996)
• contrast with US strong budget deficit reduction
  combined with eased monetary restriction explains
  reason for high growth

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Transition Issues

• Conflict over monetary and budget policy led to
  emergence of countries that chose to opt out
• Opportunistic conduct by certain countries with
  regard to convergence criteria (unreal numbers by
  France, Italy but monetary officials concede in
  order to maintain political cohension)
• No serious incentives to comply since there were
  no fines under stability pact hence countries
  with very different rates of success joined at
  Stage 3

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3rd Stage January 1, 1999

• Progress initial launch went without hitch
• Eurosystem ECB and 11 NCBs has responsibility
  for Euroland monetary policy
• Governing Council (11 NCBs 6 ECB BMs) sets
  monetary policy (akin to Feds Monetary Rate
  Board)
• policy is not accountable to European
  parliaments
• lack of transparency (although this may change
  over time)
• asymmetries in budget making policy lack of
  fiscal and budgetary integration
• limited input by EP (but now require regular
  testimony from ECB president (similar to
  Congresss requirement of FRB)

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ECB

• Art 105 sets forth primary objectives for the ECB

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Measures of Progress

• Eurosystem distribution of liquidity to EU
  banking system
• 1) through weekly main refinancing operations
  (fixed rate rationed auctioned with a maturity of
  two weeks--banks can bid for a share if they
  pledge collateral if bids exceed liquidity, then
  distributed on pro rata share of liquidity)
• some initial overbidding by banks during initial
  phase
• allows better collateralized banks to overbid
  successfully
• hence more costly for weaker banks to obtain
  liquidity in unsecured markets (overnight rate 10
  BP above main refinancing rate

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Transition Problems

• To avoid distortions, ECB changed from fixed
  rated to variable rate tenders (based on what
  they needed)
• choice between fixed and flexible is a question
  of sending clear interest rate signal
• choice between American style and Euro style
  flexible rate tenders turns on their impact on
  banks revenues

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TARGET

• TARGET payment systems transfers liquidity
  between countries
• competing systems European Bankers Association
  European Access Frankfurt French Paris Net
  Settlement
• many systems for cross-border payments within
  Europe reflects preferences of different groups
  of banks
• problem--no priority rules receiving bank not
  certain whether it would receive funds via TARGET
  (now common rules)
• timing of payments late payments in day TARGET
  settles in day v. EBA which settles next day

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Integration of Markets

• Money markets very little change in cross-border
  interbank flows
• interest rates are aligned across unsecured
  interbank market little volatility around rates
  but there is some difference in bid-ask spreads
• Still 11 money markets little problem with
  cross-border flows and interest rates
• few cross-border deposits and loans
• single system could have encouraged this better

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Repo Market

• Private repurchase market may converge due to
• convergence of overnight repo rates across
  markets
• Problem absence of efficient links between
  national securities settlement sytems (which is
  limiting cross-border use of collateral)
• securities deposited in 31 national depositories
  and some international systems (Cedel and
  Euroclear)
• difficult to create single platform from existing
  systems
• problems subject to credit loss and some
  liquidity risk

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ECB Correspondent Central Bank Model

• For cross-border use of collateral in monetary
  operations and intraday trading operations in
  TARGET (non euroland NCBs can participate)
• network of accounts through which securities
  deposited by bank can be used by another bank as
  collateral in a repo operation
• Problem temporary (not real time hence slow)
  use other operations (bridge finance)

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Corporate Bond Market

• Eurobond market lead managers are local in UK,
  GR domestic currency provides access to a home
  investor base which is essential to competition
  (secondary trading)
• book runner correlation between nationality of
  issuer and book runner
• US dominates this market (large US companies)
• Corporate Bonds Single currency could provide
  basis for competitive advantage in this field

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Pan European Capital Markets

• Some consolidation is necessary 25 derivatives
  exchanges20 derivatives clearing houses and 15
  exchanges
• obstacles to creation of pan Euro exchange
• securities settlement system (like with bonds)
• could be limited if there were linkages between
  exchanges
• back office functions would need to be
  coordinated as well

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Other Policy Problems

• Limitations in ISDs ability to encourage more
  cross-border transactions (remote membership)
• ETN alternatives EASDAQ AIM EURO.NM
• End of Alliance
• Derivatives
• DTB and Soffex merger (Eurex)
• Eurex forced Liffe to change trading system
• MATIF alliance

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