Chapter 7: The Transition to a Monetary Union

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Chapter 7The Transition to a Monetary Union

• De Grauwe
• Economics of Monetary Union

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The Maastricht Treaty

• The Maastricht Treaty was signed in 1991
• It is the blueprint for progress towards monetary
  unification in Europe
• It is based on two principles
• Gradualism the transition towards monetary union
  in Europe is seen as a gradual one
• Convergence criteria entry into the union is
  made conditional on satisfying convergence
  criteria

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Convergence criteria'

• For each candidate country
• (1) Inflation rate ? average of three lowest
  inflation rates in the group of candidate
  countries 1.5
• (2) Long-term interest rate ? average observed in
  the three low-inflation countries 2
• (3) Joined the exchange rate mechanism of the EMS
  and did not experience a devaluation during the
  two years preceding the entrance into EMU

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• (4) Government budget deficit ? 3 of its GDP
• If this condition is not satisfied
• budget deficit should be declining continuously
  and substantially and come close to the 3norm
• or the deviation from the reference value (3)
  'should be exceptional and temporary and remain
  close to the reference value', art. 104c(a))

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• (5) Government debt ? 60of GDP
• If this condition is not satisfied
• government debt should 'diminish sufficiently
  and approach the reference value (60) at a
  satisfactory pace', art. 104c(b))

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Why convergence requirements?

• The OCA theory stresses micro-economic conditions
  for a successful monetary union
• Symmetry of shocks
• Labour market flexibility
• Labour mobility
• The Treaty stresses macro-economic convergence
• Inflation
• Interest rates
• Budgetary policies

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1. Inflation convergence

• Future monetary union could have an inflationary
  bias
• The analysis is embedded in the Barro - Gordon
  model

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The inflation bias in a monetary union

• Before EMU Germany has low inflation Italy has
  high inflation
• Differences are due to different preferences
  concerning inflation and unemployment
• Once in the union, Germany and Italy will decide
  together
• Inflation will reflect average preferences and
  will be located between EI and EG
• Germany looses welfare Italy gains welfare
• Germany wants evidence from Italy that it has
  the same strong preference for price stability
• Germany also wants ECB to be clone of Bundesbank

Italy
EI
Inflation
Germany
EG
Un
Unemployment
U
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2. Budgetary convergence

• Deficit and debt criteria can be rationalized in
  a similar way
• A country with a high debt-to-GDP ratio has an
  incentive to create surprise inflation
• The low debt country stands to lose and will
  insist that the debt-to-GDP ratio of the highly
  indebted country be reduced prior to entry into
  the monetary union
• The high debt country must also reduce its
  government budget deficit

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• In addition, countries with a large debt face a
  higher default risk
• Once in the union, this will increase the
  pressure for a bailout in the event of a default
  crisis
• No-bailout clause was incorporated into the
  Maastricht Treaty
• But is this clause credible?

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Numerical precision of budgetary requirements is
difficult to rationalize

• 3 and 60 budgetary norms have been derived from
  formula determining budget deficit needed to
  stabilize government debt
• d gb
• b (steady state) level at which the government
  debt is to be stabilized (in per cent of GDP)
• g growth rate of nominal GDP
• d government budget deficit (in per cent of
  GDP)
• In order to stabilize the government debt at 60
  of GDP the budget deficit must be brought to 3
  of GDP if and only if the nominal growth rate of
  GDP is 5 (0.03 0.05 x 0.6)

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Arbitrary nature of the rule

• The rule is quite arbitrary on two counts
• Why should the debt be stabilized at 60?
• The only reason was that at the time of
  Maastricht Treaty negotiation this was the
  average debt-to-GDP ratio in the European Union
• The rule is conditioned on the future nominal
  growth rate of GDP
• If the nominal growth of GDP increases above
  (declines below) 5, the budget deficit that
  stabilizes the government debt at 60 increases
  above (declines below) 3

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3. Exchange rate convergence (no-devaluation
requirement)

• It prevents countries from manipulating their
  exchange rates
• e.g. so as to have more favorable (depreciated)
  exchange rate in the union
• Note
• According to the Treaty, countries should
  maintain their exchange rates within the 'normal'
  band of fluctuation (without changing that band)
  during the two years preceding their entry into
  the EMU
• Since August 1993, the 'normal' band within the
  EMS was 2 x 15
• The exchange rate arrangements for the newcomers
  (Denmark, Sweden, UK and accession countries) are
  similar but not identical

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4. Interest rate convergence

• Excessively large differences in the interest
  rates prior to entry could lead to large capital
  gains and losses at the moment of entry into EMU
  
• However, these gains and losses are likely to
  occur prior to entry because the market will
  automatically lead to a convergence of long term
  interest rates as soon as the political decision
  is made to allow entry of the candidate member
  country

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How to fix the conversion rates during the
transition

• Madrid Council of 1995 implied that on 1 January
  1999 one ECU would be converted into one Euro
• At the same time the conversion rates of the
  national currencies into the Euro had to be equal
  to the market rates of these currencies against
  the ECU at the close of the market on 31 December
  1998
• This created potential for self-fulfilling
  speculative movements of the exchange rates prior
  to 31 December 1998

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• The effect of such speculative movements could be
  to permanently fix the wrong values of the
  exchange rates
• In order to avoid this, the fixed rates at which
  the currencies would be converted into each other
  at the start of EMU were announced in advance
• If these announcements were credible, the market
  would smoothly drive the market rates towards the
  announced fixed conversion rates

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• This is exactly what happened. The authorities
  announced the fixed bilateral conversion rates in
  May 1998
• Transition was very smooth with minimal turbulence

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How to organize relations between the 'ins' and
the 'outs' main principles

• Main principles decided in ECOFIN meeting in June
  1996
• A new exchange rate mechanism (the so-called
  ERM-II) has replaced the old Exchange Rate
  Mechanism (ERM) since 1 January 1999
• Adherence to the mechanism is voluntary
• Its operating procedures are determined in
  agreement between the ECB and the central banks
  of the 'outs'
• ERM-II is based on central rates around which
  relatively wide margins of fluctuations are set.
  Countries may choose different margins

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• The anchor of the system is the Euro
• When the exchange rates reach the limit of the
  fluctuation margin, intervention is obligatory
• This obligation will be dropped if the
  interventions conflict with the objectives of
  price stability in the Eurozone or in the outside
  country

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• The ECB has the power to initiate a procedure
  aimed at changing the central rates
• At this moment Denmark and some Central European
  countries have adhered to the ERM-II
• The UK does not want to be constrained by an
  ERM-type of arrangement
• The second EU-country which has not adhered to
  the ERM-II is Sweden

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Convergence of new member countries

• When the new member states of the EU signed the
  accession Treaty they also committed themselves
  to enter the Eurozone some time in the future
• The exact moment at which this will happen
  depends on the fulfillment of the Maastricht
  convergence criteria
• These are the same criteria that the present
  Eurozone member countries had to satisfy (equal
  treatment)
• On 1 January 1 2007 Slovenia was the first of the
  new member countries to join

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Balassa-Samuelson again

• Potential for conflict between the inflation
  criterion and the requirement for joining the
  ERM-II
• Central European countries experience high
  productivity growth in the tradable sector. This
  is part of their catch-up process with Western
  Europe

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• Thus, structurally higher inflation (measured by
  the consumption price index)
• There is really nothing to worry about in this.
  When these countries are in the Eurozone they
  will show a higher inflation rate that is part of
  their catching up process and that should be
  considered to be an equilibrating process

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• During the transition process this could be a
  problem
• Rate of inflation must be close to the Eurozone
  inflation until entry into the monetary union
• Entry into the ERM II also reduces scope to use
  the exchange rate as an instrument to lower the
  inflationary dynamics coming from high
  productivity growth

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Balassa-Samuelson model

• pcE ? pE (1 - ?)wE (1)
• pcN ? pN (1 - ?)wN (2)
• During the transition process the exchange rate
  of the new member state can change relative to
  the Euro we introduce the purchasing power
  parity as follows
• e pE pN (3)
• Where pE and pN are the rates of price increases
  in the tradable sectors of the Eurozone and the
  new member state respectively and e is the rate
  of depreciation of the Euro relative to the
  currency of the new member state

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• We now subtract (2) from (1) and use (3). This
  yields
• pcE pcN e (1 - ?)(wE wN)
• or assuming as before that the wage increases
  arise form productivity growth
• pcE pcN e (1 - ?)(qE qN)
• which can be rewritten as
• (pcE pcN ) - e (1 - ?)(qE qN)

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• The convergence criteria impose constraints
• The inflation criterion forces the inflation
  differential (pcE pcN) to be less than 1.5 (in
  absolute value).
• If the exchange rate is not allowed to change (e
  0) then the inflation criterion cannot be
  realized if the productivity growth differential
  (qE qN) is higher (in absolute value) than 1.5
  /(1 - ?). Assuming that the share of
  non-tradables is 0.7, we obtain the conditions
  that this productivity differential should not be
  larger than 2.1.

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• There is some evidence that yearly productivity
  growth differentials between the new member
  countries and the Eurozone have been higher than
  2.1.
• The problem described here is a little over
  dramatized because the requirement to join the
  ERM-II does not prevent the exchange rate from
  moving somewhat within a given band of
  fluctuation
• If the wide band (2 x 15) is chosen there is no
  problem
• Problem arises if the smaller band (2 x 2.25) is
  selected

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• Final remark countries cannot devalue prior to
  entry they can revalue though
• Thus even if the narrow band is selected counties
  would still have the option to revalue their
  currency
• However, this option would be difficult to
  implement systematically because the knowledge
  that the authorities could do this could lead to
  speculative pressure and volatility in the market

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Is the UK ready to enter the Eurozone?

• UK satisfies most convergence criteria
• Two economic sources of UK hesitation to join
• a) There is evidence that UK may not form an
  optimal currency union with the rest of the EU
• b) The pound may be overvalued relative to the
  Euro
• Thus, if the UK enters the Eurozone at too
  high an exchange rate it might be saddled with
  low competitiveness for years to come, putting
  downward pressure on economic growth in the UK

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Figure 7.2 Europound exchange rate (19902006)
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Figure 7.3 Real effective exchange rate pound
sterling, 1991 100
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Conclusion

• The transition towards EMU was based on two
  principles
• Gradualism
• Macro-economic convergence
• These principles will continue to be important
  for the central European countries, the UK,
  Denmark and Sweden when these countries decide to
  join the Eurozone
• The technical problems associated with the start
  of EMU were solved remarkably well