Macroeconomic Performances of European Monetary Union Members

Transcription

1 International Conference on Applied Economics ICOAE Macroeconomic Performances of European Monetary Union Members Andreea-Maria Ciobanu 1 Abstract The article is aimed to examine both one-off and permanent benefits and costs from participating in the single European currency arrangement. Correspondingly, particular attention is being paid to the impact, which the formation of a monetary union might have on the macroeconomic performance of members' economies. Proponents of monetary integration point to a positive combination of greater exchange rate stability, reduced transactions costs, enhanced competition deriving from price transparency and low real interest rates resulting from a successful anti-inflation strategy pursued by the joint central bank. However, opponents of monetary union posit that it will result in adjustment costs, together with the loss of monetary and exchange rate policy instruments which is likely to increase instability amongst countries which are incompletely converged, resulting in exposure to asymmetric external shocks beyond the capability of a central bank using only one policy instrument: interest rates. The main conclusion of the study is that most benefits and costs can take a different profile across participating countries such as between large and small countries or for countries with a track record of relatively high inflation in the past. Key Words: monetary agreements, single currency, economic performance JEL codes: E200, E420, E Introduction The European monetary integration is not a single and simple event taking place at one moment in time, but a long lasting evolutionary process with many ups and downs (Jones: 1996 and Swann: 1996). The road towards the EMU has been full of obstacles (Alders et al.: 1996). The EMS system with the European Currency Unit (ECU) as a central accounting unit has shown various tidal movements, and it has lasted until the Maastricht Treaty (1991) before a decision was taken by the European member countries to pave the road towards the EMU. In contrast to the EMS, the countries did not only commit themselves to a stable exchange rate, but more importantly also to full monetary integration. The creation of a single currency in Europe on January 4, 1999 represents by far the most significant change in the international monetary system since the end of World War II. Never in the past has a group of sovereign nations voluntarily given up their national currency for a common currency (Fink and Salvatore: 1999, pp. 187); yet fifteen members of the European Union are now participating in this new currency, the euro and another nine are making preparations for its adoption, as they did not have the right to opt at the moment of EU entrance. Since 1999 the European Monetary Union (EMU) has extremely changed Europe s economic, social and political structure. Before the introduction of the euro two different points of view dominated the macroeconomic debate. According to the first one, the EMU countries are considered so dissimilar that a common monetary policy would, without doubt, lead to adverse effects. The second viewpoint underlined that the adoption of a single currency would increase trade and financial integration of markets, which in turn would lead to business cycles more synchronized across the EMU member states, increasing the likelihood that a one size fits all monetary policy would be adequate for the euro area as a whole (Frankel and Rose: 1996). After nine years from the euro creation, the macroeconomic debate still focuses on the trade-off between costs and benefits of the common currency. The purpose of this paper is to verify the fulfilment of such theoretical criteria in EMU, especially after the 2004 and 2007 enlargements. It focuses on the inflation rates, trade linkages and fiscal behaviour of the member countries as key elements for ensuring deeper economic, monetary and political integration across the euro zone. The main questions to be answered are whether the European Monetary Union (EMU) has led to greater economic integration, with increased trade and financial linkages, decreased inflation differentials and enhanced more fiscal discipline between member countries. Or, by contrast, whether the EMU member states are too different for benefit from a common currency. The paper is structured as follows. Section 2 gives a brief insight into OCA theory. Section 3 verifies the fulfilment of theoretical criteria among the oldest members of the EU. Section 4 discusses, from the same perspective, the opportunity of the new members participation at euro zone, as well as the dangers of an early euro adoption. Section 5 concludes. 2. The Costs and Benefits of EMU Membership The move to a common currency for all EMU members had both positive and negative consequences. Clearly the benefits outweighed the costs, or the EMU would not have adopted the euro Benefits of a Single Currency The introduction of the single European currency reduced or even removed transaction costs such as exchange fees. Furthermore, companies Have faced lower costs e.g. in the field of multi currency book keeping (Fenton and Murray: 1992, pp. 489). In addition, further positive effects occurred from holding reduced foreign currency reserves and from a lesser number of goods prices (Cohen: 1998, pp ). Alesina and Barro (2000, pp. 5-12) showed that reduced transaction costs have lead to higher output and consumption gains, thereby improving welfare. Along with eliminating the need to exchange currencies, the problems with exchange rate volatility were also eliminated between member nations. That only left fluctuations between the euro, the dollar, the yen, and any other important national currencies from outside the European Monetary Union (The Euro, the European, pp. 154). Exchange rate fluctuations were another form of transaction cost, because they made trading between firms from different countries more risky. If a manufacturer in one country and an importer in another make a deal for the products of the manufacturer, the volatility of the exchange rate can pose a major problem in the trade. If one currency falls in value in relation to the other, then the manufacturer could end up getting far less for his product then he should have, or 1 Assistant Professor, Ph. D. Candidate, Faculty of Economy and Business Administration, andreeaenea2005@yahoo.fr University of Craiova, Romania,

2 208 International Conference on Applied Economics ICOAE 2008 the importer could pay much more than was originally agreed upon (Eudey: 1998, pp ). The elimination of this risk will help international trade, therefore, giving advantages to all EMU countries (Portone: 2004, pp. 1). To put it in other words, a major attraction of monetary integration is its trade-creating potential within and beyond the constituent states by removing some of the payments obstacles to trade. As the costs of money conversion and forward cover required in a flexible exchange system are eliminated, the common currency constitutes a reliable anchor for businessmen in their trade contracts and position taking on trade issues generally (Itsede: 2002, pp. 45). Two other major benefits of switching to the euro deal with the prevention of competitive devaluations and speculation. A competitive devaluation is when one country devalues its currency in order to export more goods. In response, the trading partners of that country would do the same thing, resulting in a downward spiral regarding currency value, as well as an increase in inflation (Eudey: 1998, pp.15). Since the goal of the EMU was to keep inflation rates low, the switch to a single currency made sense. In terms of speculation, a single currency for the group of nations eliminates speculation between member nations. Speculation occurred regularly throughout Europe because whenever people thought that a currency was going to drop in value, they would sell all of their holdings in that type of currency. Others would follow and the trend was self matriculating. In order to control speculation European countries had to keep interest rates high. High interest rates hinder economies and that was the result in Europe for a large part of the early nineties (Eudey: 1998, pp ). By eliminating speculation, the economies of member countries are allowed to grow much more easily than when unnaturally high interest rates were necessary to ward off speculation (Portone: 2004, pp. 2). Given the fixity of exchange rate under a monetary union arrangement, speculative capital flows would be eliminated, thereby relieving the authorities of frustration in their monetary control. (Mundell: 1973). All things being equal, a monetary zone with a supranational currency would be more stable and safer for capital mobility. Long-term interest rates would decline and be less volatile. This was the experience of Europe where interest rates declined in a number of countries notably, Ireland, Italy, Portugal and Spain. This development made it easier to reduce fiscal deficits and promote growth. Monetary union involving a common currency is tantamount to the unification of the national capital markets of the integrating countries. This promotes market deepening, greater competition and more investment opportunities for institutional and individual investors. Banks, brokerage firms, issuing houses and other capital market operators can expand their operations rapidly for investible funds held by savers in crossborder accounts. Private firms and public entities issuing debt instruments would have a larger pool to tap into. The combined effect of increased competition and an enlarged market could result in a fall in long-run interest rates which is a critical condition for sustained economic growth. In fact, the viability and growth of some domestic capital markets would be somewhat limited without opening their doors to the regional possibilities. In order to ensure a safe, level and viable playing turf, a unified capital market should have a common regulatory framework with common rules, standards and ethics that would guide cross-border investments within the integrating zone (Itsede: 2002, pp ). Cutting out speculation and the risk of competitive devaluation, capital market gains as well as the need to convert from one currency to another, are all benefits that the European Monetary Union counted on when switching to a single currency. But not all the authors share these ideas. Floating exchange rates are said to provide insulation, and to be an additional tool of monetary policy. In practice, they just as often introduce shocks that have to be offset through other tools of economic policy. Rather than being part of the solution, they are frequently part of the problem. That s why so many countries seem to have a fear of floating. No one knows why floating exchange rates seem to be so volatile. Indeed, it is accurate to describe this problem as possibly the most important problem in international finance. But no one denies it. Exchange rates at least of those low-inflation developed countries seem to fluctuate in a way that is disconnected from macroeconomic fundamentals (money, income, prices, etc.) for significant periods of time; this is the famous finding of Meese and Rogoff (1983). Further, when the exchange rate is fixed especially in a hard fix this volatility vanishes from the exchange rate and does not reappear elsewhere in macroeconomic fundamentals, as Flood. As a result, thinking about the exchange rate as an extra tool for macro management is starting to seem unworldly. There are exceptions of course (Rose: 2001, pp. 2). Further benefits of currency unification may result from enhanced central bank credibility (cf. Alesina and Barro: 2000, pp and Bofinger: 1994, pp ) and from stronger market integration (Eichengreen and Frieden: 2000, pp and Eichengreen: 1993, p. 1329). Besides economic reasoning, political considerations may be taken into account additionally when deciding about currency unification (Karmann: 2001, pp ) Costs of a Single Currency Costs may arise on the macro level because while relinquishing floating exchange rates a country loses an instrument of reacting to upcoming disequilibria. Assuming that exchange rates respond sufficiently fast and exactly to fundamental changes, the policy decisionmakers will lose an important instrument of stabilisation (Weimann: 2002, pp. 4). The establishment of a European Central Bank and the euro creation involves how economic and monetary union member nations will respond to asymmetric demand or supply shocks. It is practically inevitable that a large and diverse single-currency area, such as the European Union, will face periodic asymmetric shocks that will affect various member nations differently and drive economies out of alignment. In such a case, there is little that a nation so adversely affected can do. It is clear that a nation would not be able to change the exchange rate or use monetary policy to overcome its particular problem because of the single currency. Moreover, fiscal discipline will also prevent using this policy to deal with the problem. While exchange rate adjustments generally are easy to handle, the only substitute in a monetary union would be direct downward wage adjustment. Since wages are rigid, this instrument has never been used and would meet with strong resistance from trade unions. A single currency works well in the United States because if a region suffers an asymmetric shock, workers move quickly and in great numbers out of the region toward areas of the nation with greater employment opportunities. This escape hatch is not generally available in Europe to the same extent. In fact, the Organization for Economic Cooperation and Development and the European Commission found that labor mobility among EU member states is two to three times lower than among U.S. regions. The main reasons for lower labor mobility among EU members are language barriers, inflexible housing markets, and the short-time period in which free labor movement has been possible i.e., since the single market was established. Whether the twenty-seven member states of the EU are more alike than the fifty U.S. states should not be a question. When considering the breakdown by the German Lander or the Italian regione, regions in the EU may be as different as U.S. states. In addition to much greater regional and occupational labor mobility, there is, in the United States, a great deal of federal fiscal redistribution that favors adversely affected regions.

3 International Conference on Applied Economics ICOAE Facing an asymmetric shock, the United Kingdom and Italy opted to leave the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in September 1992 and, by allowing their currencies to depreciate, were able to move out of the deep recession in which they found themselves. However, with a single currency this would have been impossible. It is true that the establishment of a single currency prevents such speculative attacks, but this also means that with a single currency the nation has almost no policy choice available. Rather, it will have to wait out for the recession to cure itself (Fink and Salvatore: 1999, pp ). The theory, however, is that by creating a single currency economy throughout Europe, the economies will be tied together, and the business cycles will slowly come together. If the business cycles of all the countries were in sync, then there would be no fear of one country being in a recession, while the others were economically stable. There are other ways of dealing with economic problems in individual countries. Even though a country gives up its right to change monetary policy, it still retains the right to change its fiscal policies. This means that EMU countries will still be able to change how much they tax the people (Eudey: 1998, pp. 20). If only one EMU country is having economic problems, then the other countries can raise taxes in order to increase the purchasing power from those countries. The extra money can then be used to help bail out the country that is having problems. There has also been talk of the European Union budget increasing, so they would also be able to help countries in the union that undergo economic problems in the future (Portone: 2004, pp. 4). Another potential cost factor concerns the public budget due to reduced seignorage. For a country with a history of high inflation joining currency union with more price-stable economies may reduce revenues derived from printing money. This is especially relevant for economies with an underdeveloped tax system that makes an inflation tax desirable. The resulting reduction of revenues will -under the assumption of no cuts in public spending - entail the need for higher budget deficits or for compensation paid by the union. Costs may also be due to the Balassa-Samuelson-effect. Divergent growth rates in the member states of a currency union may lead to persistent imbalances in national inflation rates. In the case of a monetary union of less and higher developed countries, the formers will - due to trade liberalisation and foreign competitive pressure - presumably experience higher inflation than the latters. It is assumed that in such a situation productivity grows primarily in the sector of tradeables. Resulting wage increases will nevertheless, due to reasons of competition, be comparable in the non-tradeables sector as well (cf. Halpern and Wyplosz: 2001, pp. 9-11). As the production of nontradeables is not characterised by marginal products growing in the course of time, the price level in this sector will increase. For tradeables, the prices grow with a rate similar to the one abroad because of international competition. Thus, the overall CPI increases faster in the formerly poorer economies than in the other ones (Balassa-Samuelson-effect). Sell (2001: pp. 3) notes that currency unification of countries with different inflation rates may be counterproductive as those with higher price level growth would tie up liquidity which would force the central bank to push money growth in order to avoid deflation in the higher developed countries (Weimann: 2002, pp. 5-6). 3. EMU an Ex-Post Evaluation of Costs and Benefits Nine years after the creation of the common currency in Europe, there are still main issues worthy to be deeper examined. For example, one criterion contained in the Stability and Growth Pact focuses on inflation rates convergence across the euro zone members. Indeed, a common monetary policy requires similar inflationary conditions throughout the euro area, otherwise resulting too tight or too loose in different regions. The period between the Maastricht Treaty in 1992 and the creation of the euro in 1999 saw a remarkable convergence of inflation rates across EMU countries. Surprisingly, inflation dispersion has increased since then. In 2000, inflation ranged from a minimum 1.5% in Germany to a maximum 5.5% in Ireland. Inflation differentials have been persistent too, with a cumulative inflation differential of about twice the differential across US states. One explanation for this persistence is that poorer euro-zone countries are still catching up, and, consequently, increasing their price levels during the process. However this does not account for the whole story; Italy, for example, grew no faster than Germany, but Italian inflation was 5.5% higher than German inflation. The introduction of the euro itself, maybe, can be quoted as cause of these inflation differentials. Peripheral EMU countries traditionally experienced both high inflation and high nominal interest rates. With a common nominal interest rate for all members, real interest rates in high-inflation countries declined significantly, stimulating growth for consumption, housing, and credit, thus accelerating the pace of inflation further. There is reason to believe, however, that widening inflation is only a temporary phenomenon brought by the adjustment to a common currency, rather than by fundamental differences across euro-zone countries. In fact, the European Central Bank has been remarkably successful in maintaining inflation expectations at 2%, suggesting long-run stability. Second, according to the main theoretical literature in the field of the economics of European integration, the EMU should enhance trade intensity among member countries. Stronger trade linkages, mostly intra-industry, beside a relatively high degree of production diversification should reduce ex-ante the probability of country-specific shocks and, at the same time, uniform the standards of life among member countries. While the euro has not yet delivered on its promise of price stability, it has been successful in promoting trade and financial integration. Conventional estimates suggest that the adoption of the euro increased trade between EMU countries by 7 to 20% - a large increase, considering that these countries were already part of a customs union. At the same time, trade with the rest of the world increased at a similar pace, so that the share of trade among EMU countries on their total trade remained roughly constant. Furthermore, the pattern of external trade varies across EMU countries, suggesting that an external shock would have different effects across the euro area. Moreover, due to the common monetary policy implemented by the European Central Bank (ECB), the way how to implement the national fiscal policies is a matter of common concern because inevitably affect the economic conditions in the entire euro zone. If the EMU implies a common monetary policy, the discretionary national fiscal policy should be subject to coordination to avoid free rider behaviour. The results are more modest here, largely because the euro has little power on non-financial policies. Although joining the EMU places limits on budget deficits, these limits have been exceeded by the euro-zone s largest economies. Consequently large differences in government spending or tax rates might create imbalances in the euro zone, representing a potential instability factor. Finally, another important issue underline that labour mobility across the EMU member countries might accelerate economic convergence in the whole euro area. Labour mobility could increase the possibility of dealing with regional shocks, but labour mobility in Europe is still relatively low. However, high rates of immigration towards Ireland and Spain indicate that labour mobility might finally be picking up (Raguseo: 2006).

4 210 International Conference on Applied Economics ICOAE New Member States and Euro Adoption The accession in 2004 and 2007 of ten Central and Eastern European countries (CEECs) along with Cyprus and Malta to the European Union (EU) marks the end of the first phase of the integration of these economies with Western Europe. These countries have travelled a long road since the beginning, just over a decade ago, of their transition to market economy status. In many respects the macroeconomic similarities to Western Europe have grown: borders are open to trade and capital, the role of the state in production is far smaller than during the period of central planning, inflation rates are generally low and stable, and monetary and fiscal policy are for the most part transparent. Reasonably strong recoveries from immediate posttransition drops in output have been the reward for reform, and the bold step of taking these countries into the EU promises to further boost their growth prospects (Schadler, 2005, 1). The next step for these countries in European integration euro adoption is both an obligation under the acquis communautaire and an opportunity to expand the benefits of EU accession. The new member states have not been granted an opt-out clause, a provision which allowed Denmark and Great Britain to stay out. In fact, they are already members of the European Monetary Union (EMU) with derogation ie, they will join the eurozone as soon as they fulfill the Maastricht criteria, in particular the membership of the ERM II for at least two years. From among them, only Slovenia, Cyprus and Malta succeeded by now in adoption of the single European currency. Some of the CEE countries probably do not meet the optimum currency area criteria as well currently as do the existing members of EMU. An argument for going ahead and joining anyway is the endogeneity of the OCA criteria. By adopting the euro, they will eventually promote trade with the rest of euroland, and increase the cyclical correlation. The increased trade will in turn further increase the advantages of a common currency, while the increased correlation will reduce the disadvantages of a common currency. Thus the CEE countries may eventually qualify ex post even if they do not ex ante. On the other hand the risks of asymmetric shocks in the meantime are substantial (Frankel, 2004, 13). For the new EU members, also Maastricht criteria may prove particularly painful: low inflation may be hard to achieve because poor and fast growing countries tend to have higher inflation rates due to the Balassa-Samuelson effect, which is estimated to add 1-2 points to consumer-price inflation (Kovács et al., 2002). To compensate this effect, monetary policy must be tougher probably causing unemployment in the short run. Limiting fiscal deficit may create additional tensions for basically three reasons. First, the new members might want to spend more in order to upgrade infrastructure, education facilities, and institutions to Western European standards. Limiting the state s ability to borrow against future revenues may postpone these investments and reduce growth (Wagner, 2002). Second, low taxes are used to attract foreign investments in the private sector, although many old members decry this as unfair competition. Anyway, the loss in tax revenues will at least temporarily boost the deficit. Third, adjusting to a monetary union is not always a smooth and frictionless process. Potential losers may need compensation in order to keep political and social stability: the trade creation delivered by monetary union increases economic efficiency by boosting specialization and division of labour but it also means that industries without comparative advantage will perish. This can result in economic hardship for affected workers and regions where these industries are concentrated, and governments may want to accommodate this process with transfers and (hopefully) temporary subsidies to allow for a gradual rather than abrupt adjustment (Meyer and Jacobsen, 2005, 10). The Balassa-Samuelson effect also predicts that as a consequence of rapid productivity growth in Central and Eastern Europe, these countries will experience increases in their relative prices of nontraded goods and services, such as housing, and thus will experience real appreciation of their currencies. If they retain their own currencies, and this trend in relative prices continues, it will probably show up partly as nominal appreciation of their currencies. But if they have joined EMU before income convergence is achieved, the trend will show up entirely as a higher inflation rate in the new member countries than in the rest of euroland. One issue is the parity at which they enter EMU. But even assuming these countries are able to adjust their parities to the right competitive level before entering EMU, or more precisely, before entering the two-year probationary period, the Balassa-Samuelson effect predicts that there will continue to be upward pressure on their price levels in the future. Once they have joined EMU there will be no good way to address it. Full convergence of real incomes can be expected to take a very long time. No country should be expected to wait this long to join EMU, if joining is otherwise attractive. But the absence of income-convergence suggests that the ECB would have to take into account the Balassa-Samuelson effect. After the expansion of EMU, it might be appropriate for the ECB to allow countries that experience the Balassa-Samuelson effect to run inflation rates above the union-wide target, so as to avoid imposing deflation on the original core members. 5. Conclusions Summing up, after nine years of euro, its economic impact is not yet clearly defined. Of course, increased trade has been one of the most obvious benefits. Trade within the euro zone increased by 7-20%. There has been also a significant integration of financial markets. Inflation differentials across EMU countries however, have widened particularly in peripheral countries. The euro has also had little effect on fiscal discipline and labour mobility. Nevertheless, we can mainly attribute the observed imbalances in the euro zone to the necessary adjustments to a common currency rather than to strong structural differences between EMU countries. If this is true, such imbalances will weaken soon, although they shall come back each time a new country joins the EMU. Regarding euro adoption in CEEC, although the costs may seem substantial, one has to bear in mind two things. First, the probability that these costs will have to be incurred is relatively low. Second, their magnitude depends crucially on domestic policy prudent banking sector supervision, labour market reforms and sound fiscal policies to name a few. In my view, given the evidence that reforms have been halted in many countries after entering the eurozone, these measures should be taken before the euro area accession (Rybinski, 2007, 7). To conclude, it seems too early for a final judgement on the suitability of the EMU. As suggests the mixed evidence present in this article, at the moment, it is quite difficult also to strike a balance. Generally speaking, the euro can be positively judged, especially if the asymmetries it created will turn out to be temporary consequences of the adjustment process (Raguseo: 2006). References Alders, K., K. Koedijk, C. Kool and C. Winder (1996), Monetary Policy in a Converging Europe, Kluwer, Dordrecht Alesina, A. and R. J. Barro (2000), Currency unions, NBER Working Paper 7927, Cambridge Bofinger, P. 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