320.326: Monetary Economics and the European Union Lecture 8 Instructor: Prof Robert Hill The Costs and Benefits of Monetary Union II De Grauwe Chapters 3, 4, 5 1
1. Countries in Trouble in the Eurozone That Followed Irresponsible Fiscal Policies Leading Up to the Crisis Greece s debt-to-gdp ratio: 1990 79.6 percent 2000 114.9 percent 2007 103.8 percent 2011 166 percent Italy s debt-to-gdp ratio: 1990 97.3 percent 2000 121.6 percent 2007 116.9 percent 2011 122 percent 2
2. Countries in Trouble in the Eurozone that Did Not Follow Irresponsible Fiscal Policies Leading Up to the Crisis Ireland s debt-to-gdp ratio: 1990 93.3 percent 2000 37.8 percent 2007 29.2 percent 2011 110 percent Spain s debt-to-gdp ratio: 1990 47.7 percent 2000 66.5 percent 2007 42.8 percent 2011 68 percent 3
Gross Public Debt, 1970-2010 (% of GDP) 1970 1980 1990 2000 2010 Austria 18.5 35.8 57.2 69.4 72.3 Belgium 61.9 74.5 125.8 113.4 96.7 Denmark n.a. 43.7 66.4 57.1 43.6 Finland n.a. 13.6 16.3 52.3 48.4 France 40.0 29.7 38.6 65.2 81.6 Germany 17.5 30.2 40.4 60.4 83.4 Greece 18.8 22.8 79.6 114.9 142.8 Ireland n.a. 69.5 93.3 37.8 96.2 Italy 55.1 86.6 97.3 121.6 119.1 Japan 12.0 55.0 68.6 136.7 199.7 Netherlands 65.5 59.1 87.8 63.9 62.7 Norway 41.7 39.7 29.4 34.1 49.5 Spain n.a. 19.9 47.7 66.5 60.1 Sweden 29.1 47.2 46.7 65.7 39.8 UK 80.9 55.9 32.9 45.6 80.0 USA 46.3 41.7 63.0 55.2 93.6 Source: OECD Economic Outlook
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3. Why Did the Debt-to-GDP Ratios in Ireland and Spain Rise So Much with the Onset of the Crisis? Both countries had real estate booms that were financed by loans from banks and other financial institutions. Banks make money by lending long-term and borrowing short-term. This is because the yield curve is usually upward sloping. The interest banks charge on mortgages is higher than the interest they pay on their short-term borrowing. In the years before the crisis there was a big increase in the amount of short-term debt held by banks and other financial institutions in Ireland and Spain. 6
With the start of the financial crisis liquidity in the short-term credit market dried up (due to a big increase in perceived counterparty default risk). Banks were no longer able to rollover their debts. The Irish and Spanish governments were forced to lend to the banks to prevent them defaulting. The banks debts were more or less taken over by the government. At the same time the housing markets fell in Ireland and Spain, and mortgage holders started to default on their loans. The value of the banks assets fell. 7
Note: if the bank loans are still sound then the banks are facing a liquidity problem. If enough mortgage holders default and the value of the houses falls below the value of the mortgages, then the banks may become insolvent. This is a key difference between countries that experienced housing booms and busts and those that did not. In most other countries the financial crisis created a temporary liquidity crisis for banks. In countries that had housing busts, the banks may have also become insolvent. The government was forced to bail them out. If not, one bank collapsing can then trigger collapses at other banks endangering the whole financial system. 8
A similar thing happened in Iceland, except that it was aggressive international expansion of the banking sector rather than a housing bust that caused the problem. The combination of the financial crisis and housing bust triggered bad recessions in Ireland and Spain. (i) Banks stopped lending, causing a credit crunch. Hence investment fell. (ii) The fall in house prices reduced household wealth and hence consumption fell. 9
(iii) Government debt rose dramatically as a result of bailing out banks, and due to the fall in tax revenue from rising unemployment and falling house purchases. Lenders became concerned about the Government s ability to service its debt, forcing a tightening of fiscal policy. Tightening fiscal policy made the recession worse. The combination of (i), (ii) and (iii) caused a big fall in aggregate demand which sent both economies into recession. This in turn acted to further reduce tax revenue and increase government expenditure (as unemployment rose) putting still more pressure on the government budget. 10
As GDP fell this also worsened the debt-to-gdp ratio. During the boom, Ireland and Spain were also becoming less competitive since wages were rising too fast. This helped make the recession even worse when the boom ended. 4. How Did Greece and Italy Accumulate So Much Debt Before the Crisis? Entry into the Eurozone allowed member countries to issue Euro denominated bonds. The market decided that Greek/Italian bonds denominated in Euros were less risky than Greek/Italian bonds denominated in Drachma/Lira. 11
Hence Greece and Italy were able to borrow more and at a lower interest rate than they would have been otherwise able to. The markets ignored two risks associated with buying Greek bonds. (i) The Government could default on its bonds. (ii) It could be forced out of the Eurozone and then convert these bonds into Drachma at a very devalued rate. 12
5. The Benefits of a Common Currency (i) Elimination of transaction costs These are the costs incurred buying and selling foreign exchange. The EU Commission has estimated that the elimination of transaction costs as a result of monetary union save firms and households about 13 to 20 billion Euros a year This is between 0.25 and 0.5 percent of EU GDP. Banks lose out about 5 percent of bank revenue prior to monetary union came from fees charged for foreign exchange transactions. 13
Even with monetary union, bank transfers between Euro-zone countries are more expensive than within country transfers. The European Commission is pressuring the banks to eliminate these differences. (ii) Greater price transparency Differences in prices across Eurozone countries are more transparent after monetary union. This might stimulate greater competition and hence lower prices. In 2000, the differences across countries were much larger than within countries See Table 3.1. 14
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According to Wolszczak-Derlacz (2006), this gap has not narrowed since 2000 see Figure 3.1. This may be because retail markets across Euro-zone countries are still quite segmented. For example, a few supermarket chains dominate in each country. It can be difficult for a new chain to establish itself. Also transport costs make it hard for consumers to exploit arbitrage opportunities. (iii) Reduced uncertainty Uncertainty about future real exchange rates may discourage investment and attempts by firms to establish market share in other countries. 16
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A significant appreciation of the domestic currency can impose large costs on exporters. The large appreciation of the US dollar from 1980-5 hurt a number of exporting US firms, and led to some closures. Example: Suppose exchange rate changed from 1 dollar = 1 Euro to 1 dollar = 1.5 Euros. If a US firm wants to receive $100 for each unit of a good sold in Europe, after the appreciation of the dollar it must raise its Euro price from 100 to 150. This will cause it to lose market share, which will reduce profits. If it keeps the price at 100 Euros, then the firm will only receive $67 for each unit sold. This will also reduce profits. 18
Monetary union however does not necessarily reduce systemic risk. A reduction in exchange rate risk could be countered by increased volatility in domestic output (since monetary policy can no longer be used to respond to country specific shocks). These shocks could hit either the goods or money market. The former (i.e., shocks to the goods market) are considered in Figure B6.1. Under monetary union, a rightward shift of the IS curve causes an increased demand for goods. More money flows into the country from the rest of the union to meet this demand. This shifts the LM curve to the right. 19
With a freely floating exchange rate, the rightward shift of the IS curve exerts upward pressure on the interest rate. The rise in output is dampened by the fall in investment and appreciation of the currency triggered by the rise in interest rates. Conclusion: fluctuations in output are bigger under monetary union. 20
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The latter (i.e., shocks to the money market) are considered in Figure B6.2. Under monetary union, a rightward shift of the LM curve causes an outflow of money, since the amount of money circulating exceeds the demand for goods. This shifts the LM curve back to the left. With a freely floating exchange rate, the rightward shift of the LM curve causes the interest rate to fall, which stimulates investment and causes the currency to depreciate increasing net exports. Conclusion: fluctuations in output are smaller under monetary union. 22
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(iv) Increased trade between the member countries Monetary union has stimulated greater integration of financial markets and institutions across the member countries. This should help increase trade between the member countries. Current estimates are that monetary union has boosted trade between member countries by between 5 and 20 percent. Increased trade allows each country to exploit its comparative advantages. This should benefit all countries in the union. 24
(v) Monetary union helps create an environment conducive to monetary union Frankel and Rose have argued that monetary union stimulates trade between the member countries which tends to harmonize their business cycles and make them less likely to be hit by asymmetric shocks. 25
7. Comparing Costs and Benefits The benefits of monetary union tend to rise with the level of trade with other countries in the union. Assuming that increased trade causes increased symmetry (see Figure 2.1), then the costs of monetary union decrease with the level of within union trade. In this case, whether monetary union is desirable for a particular country may depend on the level of within union trade that results (if more trade implies more symmetry). See Figure 4.1. 26
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The benefits of monetary union (through lower transaction costs and lower exchange rate uncertainty) increase with the amount of trade between countries in the union. Hence the benefit curve is upward sloping. The costs of monetary union decrease with more trade (assuming trade makes the countries more symmetric). Hence the cost curve is downward sloping. 28
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Estimates of within union trade for the EU countries are provided in Table 4.1. The results suggest that monetary union is desirable for Belgium, the Czech Republic, and the Netherlands, but less so for Italy, Spain, the UK and Greece. Note: there are other advantages of monetary union, such as tapping into the ECB s inflation fighting credibility. This alone at the time seemed like a sufficient justification for Italy and Greece to join the monetary union. The gains though are illusory if wages continue rising. In this case the country becomes gradually less competitive leading to recession and unemployment. 30
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Figure 4.4 provides an alternative way of comparing the desirability of monetary union. The desirability of monetary union is an increasing function of: (a) the symmetry of the member countries (since this reduces the likelihood of the countries being hit by asymmetric shocks). (b) the flexibility of the labour markets of the member countries (e.g. wage flexibility and mobility of labour). Greater flexibility reduces the impact of asymmetric shocks. It follows that we can construct a downward sloping frontier in flexibility-symmetry space, such that groups of countries above the frontier are optimal currency areas, while those below the frontier are not. 32
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Figure 4.4 implies that a lack of symmetry can be compensated for by greater labour market flexibility. The current consensus is that a subset of the EU (e.g., Germany, France, Belgium, the Netherlands, Luxembourg and Austria) are an optimal currency area (OCA), the EU-25 countries are not an OCA. Further eastward expansion of the EU will move it further away from an OCA. Most economists believe that the US is an OCA, although this is more due to labour market flexibility than symmetry. For example, car production is centred on Michigan. This is due to economies of scale (as argued by Krugman). 34
The OPEC oil shocks of the 1970s caused recessions in the US. In both cases, Michigan was hit worse than the rest of the US (see Figure 4.5). A major part of Michigan s recovery (relative to the rest of the US) was driven by emigration from Michigan to the rest of the US (see Figure 4.7). By contrast, Belgium s recovery from recession over the same period (relative to the rest of the EU) was driven by a depreciation of the Belgian franc (see Figures 4.6 and 4.8). 35
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We can also measure the desirability of monetary union as a function of trade integration and symmetry. The desirability of monetary union is an increasing function of: (a) the symmetry of the member countries (since this reduces the likelihood of the countries being hit by asymmetric shocks). (b) the extent of trade integration. This is because greater integration increases the gains from lower transaction costs and avoiding exchange rate uncertainty. The OCA frontier is again downward sloping. Groups of countries above the frontier are OCAs (see Figure 4.9). 40
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If increased integration leads to increased symmetry, then the Eurozone countries will move to the right over time in Figure 4.9. hence even if they are not an OCA to begin with, they may become so over time. If instead the Krugman view is correct, then trade integration will cause the Eurozone to diverge from an OCA over time (see Figure 4.10). 42
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8. Other Monetary Unions (i) Enlargement of the EU Most of the new entrants to the EU are more integrated with it than are Denmark, Sweden and the UK (the three older members not in the Eurozone) see Figure 4.11. Figure 4.12 plots the correlation between demand and supply shocks for various countries relative to the Eurozone. The low or negative demand shock correlations for Slovakia, Slovenia, the Czech Republic, the UK, Latvia and Lithuania may be attributable to each country following its own monetary policy. 44
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These demand shock correlations could well change sign if these countries joined the Eurozone. (ii) Monetary union in Latin America Within region exports as a share of GDP in Latin America are compared with the Euro-zone in Figure 4.16. The very low within region trade levels suggest that monetary union would not be a good idea. 47
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Also, there can be no presumption that a Latin American central bank would have any more inflation-fighting credibility than the existing central banks in the region. There is no equivalent of Germany in the region. Monetary union in Latin America does not look like a good idea. Some Latin American countries have considered monetary union with the US in the form of dollarization (i.e., unilateral adoption of the US dollar). 49
(iii) Monetary union in East Asia The within region trade in East Asia is comparable with that in the Euro-zone (see Figure 4.17). The symmetry of the shocks hitting East Asian countries are also comparable to those hitting the Eurozone countries (see Figures 4.18 and 4.19). East Asia does look like a potential candidate for monetary union. Increasingly, the countries in the region however would fear domination by China. Hence monetary union is unlikely in the near future. 50
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