The Euro Symposium: Is the Euro an Optimum Currency Area

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The Euro Symposium Is the Euro an Optimum
Currency Area?

• Presented by
• Nell Williams, Kevin Bradford, Alvaro Berti,
  Shelly Suzuki, and William Sun

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Overview of Presentation

• What is an Optimum Currency Area?
• History Behind the Formation of the EU
• The GG-LL Schedules
• The EU Today and Tomorrow
• Is the EU an Optimum Currency Area?

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Definitions

• Optimum Currency Zone
• Theory of Optimum Currency Areas

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• Belgium
• Germany
• Greece
• Spain
• France
• Ireland
• Italy
• Luxembourg
• The Netherlands
• Austria
• Portugal
• Finland

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Currency Was Accomplished in Three Stages

• Removal of restrictions on capital
• Treaty of European Union (Maastricht Treaty)
• January 1, 1999, when 11 countries fixed their
  exchange rates to the Euro.

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Removal of restrictions on capital

• 1969 meeting in The Hague initiated drive towards
  monetary unification
• By 1971, European National Central Banks
  established a federated system of banks

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Decline in US Confidence

• European confidence declined in the Bretton Woods
  system of pegged US exchange rate by the early
  1970s.
• Created desire of European independence of
  monetary responsibility.
• This desire forced European leaders to cooperate
  in establishing both a market and monetary
  unification process.

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European Monetary System

• The European Monetary System included France,
  Italy, Belgium, Denmark, Germany,Ireland,
  Luxembourg, and the Netherlands.
• These countries agreed to a pegged exchange rate
  within the European community.
• Although a fixed exchanged rate seemed bleak at
  first, it was established until some set backs in
  1992.

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German Reunification Creditability Theory

• 1989, Germany reunites with East Germany.
• Because of passed history after WWI, Germans are
  very hesitant of increased inflation rates.
• This leads to a dependence on the Credibility
  Theory of The Economic Monetary System.
• EMS equals the political cost of violating an
  international exchange rate restrains governments
  from depreciating their currencies to gain the
  short term advantages of an economic boom at the
  long term cost of higher inflation rates.

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Maastricht Treaty

• December 10th, 1991.
• The leaders of EU countries meet to propose for
  national ratification of far reaching amendments
  of the Treaty of Rome.
• This lead to the adoption to the EU currency The
  Euro European leaders believed the Euro would
  produce a greater degree of European market
  integration.

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Stability and Growth Pact

• In 1997, leaders of European countries agree to
  tightened fiscal restraints
• This included inflation
• This particular issue forced legitimacy of
  economic polices between European countries.

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European Central Banks

• Headcorterd are located in Frankfurt Germany, but
  every county has their own central bank.
• These central banks act simalerly as the federal
  reserve bank in the US, i.e.. Control inflation
  rates and other economic regulations.

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Conclusion

• Since the inception of the ideology of the
  European Commission in the early 1950s, to the
  establishment of the Euro as a standard currency
  in1999, the Euro has proved itself as both a
  political and, more importantly an economic
  juggernaut to world economic policies.

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• 1 - WatermarkWhen the banknote is held up to the
  light, a picture and the value of the banknote
  become visible.2 - Security threadWhen the
  banknote is held up to the light, a dark line
  becomes visible.3 - Foil hologramOn the front
  (right-hand side) of the low-value banknotes (EUR
  5, 10 and 20) there is a hologram foil stripe.
  When the banknote is tilted, the euro symbol and
  the value of the banknote appear.4 - Iridescent
  stripeThe EUR 5, 10 and 20 banknotes have an
  iridescent stripe. It only appears on the reverse
  side of the banknote. When the banknote is tilted
  under a bright light, the iridescent stripe
  shines and changes colour slightly

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Euro symbol design

• to be a highly recognizable symbol of Europe
• to be easy to write by hand
• to have an aesthetically pleasing design.

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History Behind the EU

• 3 Stages to Convergence

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The GG Schedule

• G Gains from joining a fixed exchange rate
  system
• Monetary Efficiency Gains when
• Trade is extensive
• Factors of production can migrate

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The GG Schedule

• Monetary efficiency
• gain for the joining country

Degree of economic integration between the
joining country and the exchange rate area
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The LL Schedule

• L Losses from joining a fixed
• exchange rate area
• Cannot use the exchange rate and monetary policy
  to stabilize output and employment

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The LL Schedule
Economic stability loss for the joining country

LL
Degree of economic integration between the
joining country and the exchange rate area
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GG-LL Schedules
Gains and losses for the joining country

GG
Losses exceed gains
Gains exceed losses
LL
Degree of economic integration between the
joining country and the exchange rate area
?1
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Increase in Market Output Variability
Gains and losses for the joining country
GG
LL2
LL1
?1
?2
Degree of economic integration between the
joining country and the exchange rate area
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Charting a Course Toward Successful Euro Adoption

• Susan Schadler
• Pros and Cons of Currency Union
• Preparing for the EMU
• Strategies for the approach to euro adoption

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Pros and Cons of Currency Union
PROS

• Research suggests a currency union may result in
  gains over the long term (20-30 years)
• Andrew Rose (2003)
• Tested to see whether a currency union induces
  trade using 1970-1990 data from 186 countries,
  dependencies, territories, and colonies.
• Found that
• A currency union creates trade, increasing it
  between members by amounts ranging from 10-100
• Two countries in a trade union will trade
  three-times more than countries that do not share
  a currency
• These increases in trade also increase income
• Raising GDP anywhere from 10-25 in Europe
• Other recent research
• Looked at actual experience of EMU ion its first
  four years
• Found that even during this short time, it has
  had positive effects on trade and growth for the
  existing members.

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Pros and Cons of Currency Union
PROS

• Studies on the causes of increased trade provide
  ambiguous answers.
• Studies have looked at the effects of
• Foreign exchange risk
• Presence or absence of a trade barrier
• Both provide ambiguous answers
• Thus it is thought that Euro adoption should also
  produce some other less well researched benefits
  including things such as
• Lower risk premiums on interest rates in member
  countries
• Stronger framework for policy discipline

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Pros and Cons of Currency Union
CONS

• Members must follow the same monetary policy,
  whether or not it is appropriate for their
  country at the time
• Member countries cannot use monetary policy as a
  tool for stabilizing their economy
• Relative prices between member countries become
  transparent

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DO PROS OUTWEIGH CONS?

• According to Optimum Currency Literature, this
  depends on two thing
• How susceptible a country is to real shocks
  ideally fixed by monetary policy
• How able a country is to adapt to shocks in the
  absence of monetary policy
• Also, may depend on
• How effective is monetary policy as a shock
  absorber?
• Do countries have fiscal, wage, and structural
  policies, which not only help absorb shocks, but
  do not create them?

Do pros outweigh cons? It is a matter of
judgment.
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In order to obtain successful Euro Adoption, new
members must prepare for the EMU

• Remember that
• The theory of optimum currency areas predicts
  that fixed exchange rates are most appropriate
  for areas closely integrated through
  international trade and factor movements.

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New members include Czech Republic Poland Sloveni
a Hungary Slovak Republic
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There are five specific risks in their present
state that stand out
Preparing for the EMU

• These countries continue to attract large and
  possibly volatile net capital inflows
• Increased productivity among countries may cause
  inflation
• Balassa-Samuelson Effect
• Increased productivity in traded goods
• Should lead to
• Appreciation in the Real Exchange Rate
• HOWEVER
• Because the exchange rate is fixed, real
  appreciation will have to occur through slightly
  higher inflation in central European countries
• Bank Credit Booms are likely
• Rapid credit growth could create risks for asset
  price bubbles and overheating

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Five specific risks in their present state that
stand out
Preparing for the EMU

• Although declining, Inflation in most of these
  countries is above the optimal rate, and even if
  lower, it is unclear whether low inflation will
  be sustained

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Preparing for the EMU
Five specific risks in their present state that
stand out

• General government deficits are large

This means that the requirements for a successful
experience in the euro are demanding
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Preparing for the EMU Three Elements to consider
Preparing for the EMU

• Fiscal deficits and rigidities from subsidies and
  formula-driven social transfers must be low
• Financial market supervision must be strong
• Competitiveness must be robust

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• Is the EU an Optimum Currency Area?