ECB targets and imbalances
AmazingExpert
Chapter 12
A Common Currency Area
[This is a draft chapter c© Wendy Carlin & David Soskice, 2013]1
[Note to readers: This chapter will be revised and updated closer to publi- cation.]
12.1 Introduction
Among the 34 OECD member countries, 17 have floating exchange rates, Switzer- land moved from floating to a managed exchange rate in September 2011, 15 have chosen to give up their own exchange rate and adopt the euro and one member’s currency is pegged to the euro via ERM II (Denmark)2. In Chapters 9 and 11 we have concentrated attention on countries with independent central banks and floating exchange rates. We now turn our attention to fixed ex- change rates and in particular to the countries of the Eurozone, who collectively accounted for 19% of global GDP in 20103. In this chapter, we
• extend the macro model (3-equation and AD-BT-ERU) to analyze stabi- lization policy under fixed exchange rates and
• provide a set of tools for understanding the origins, successes and failures of the Eurozone – a large-scale experiment in the adoption of irrevocably fixed exchange rates, which began with eleven countries in 1999 and had 17 members by 2011.
1Acknowledgements: David Hope has provided excellent research assistance for this chap- ter. We are grateful to James Cloyne, Christian Dustmann, Liam Graham, Costas Meghir, Jacques Melitz, Luigi Spaventa and David Vines for useful discussions.
2This information is taken from the IMF’s de facto classification of exchange rate arrange- ments (at the end of April 2010), which can be found in Appendix II of the IMF Annual Report 2012.
3Calculated using the IMF World Economic Outlook Database, September 2011
1
2 CHAPTER 12. A COMMON CURRENCY AREA
Common and country-specific shocks In a common currency area, the 3-equation model can be used to model a CCA’s central bank as an inflation- targeting central bank. The CCA central bank responds to shocks to the com- mon currency area as a whole, which are referred to as area-wide or common or symmetric shocks. But there will also be shocks that affect member countries differently. For example, there could be a housing boom in one country but not another: in the Eurozone, there was a housing boom in Spain but house prices fell in Germany during the same period of the 2000s. These are called country-specific or asymmetric shocks.
In this chapter, we show how to use the AD-BT-ERU model and how to adapt the 3-equation model to analyze stabilization problems in countries with a fixed exchange rate. To clarify the analysis we use the ‘extreme’ case of irrevocably fixed exchange rates in a common currency area. This allows us to concentrate on adjustment and set aside the issues of the credibility of the exchange rate peg.
The Eurozone – successes and imbalances Before extending the model, we introduce the Eurozone and look at how it has operated. The Eurozone’s experience illustrates the role played by a CCA central bank and brings out the way the central bank responds to common shocks and how countries are affected by country-specific ones. The Eurozone celebrated its first ten years in 2009 and encountered its first crisis in 2010. The Eurozone’s first decade was during the Great Moderation – a period of tranquility in the international macroeconomic environment. In this period, the European Central Bank functioned successfully, delivering an average inflation rate for the Eurozone just above its target of 2%.
In Chapter 11, we saw how low and stable inflation could be achieved in a global economy in spite of imbalances in the blocs that make it up. In this chapter we shall see another example of this general idea: if we think of the Eurozone as the ‘global’ economy, it achieved low and stable inflation during the 2000s although member countries were experiencing different shocks, and imbalances were building up. Different growth patterns were behind the build- up of imbalances in the Eurozone just as they were in the global economy. Fig. 11.4 in Chapter 11 showed the evolution of current accounts in a number of large economies: two Eurozone economies feature in the chart. On the surplus side is Germany with a rapidly growing surplus in the 2000s and on the deficit side is Spain, with a rapidly growing deficit. We shall see how these different growth patterns arose in the Eurozone.
Fiscal policy Under fixed exchange rates countries do not have independent monetary policy and it is obvious to think of fiscal policy being used to stabilize. But in a common currency area, the use of fiscal policy by one member can have spillover effects for the currency area as a whole. This possibility led the Eurozone to adopt a fiscal policy framework for its members called the Stability and Growth Pact. Sluggish growth in the large member countries in the aftermath of the collapse of the dot com bubble in the early 2000s pushed up
12.1. INTRODUCTION 3
their budget deficits, and Germany and France were guilty of breaching the 3% budget deficit limit of the Stability and Growth Pact. This highlighted problems with the design of the fiscal policy element of European Monetary Union. As growth in the core of the Eurozone picked up from the middle of the decade, these concerns faded – until the Eurozone crisis erupted in 2010.
In the run-up to the global financial crisis, the private sector overheated in Ireland and Spain, and inflation was above the Eurozone average. We will apply the 3-equation model to show how national fiscal policy could have been used to ‘lean against the wind’ and dampen the boom. This was not done. We shall also see that self-stabilizing forces arising from the deteriorating competitiveness of the countries with higher inflation in the Eurozone were not strong enough to counteract the overheating. And just as in the countries with flexible exchange rates like the US and the UK, measures were not taken before the financial crisis to halt the growth of leverage in the financial sector.
Vulnerability to a sovereign debt crisis The Eurozone crisis brought to the fore the need to model the vulnerability of a member of a common currency area to a sovereign debt crisis. This requires an explanation of the relationship between banks, government and the central bank. Although the underlying determinants of the solvency (the ‘fundamentals’) of the British and Spanish governments in 2011 were quite similar, interest rates on government 10-year bonds diverged sharply, reflecting differences in the market perception of sov- ereign default. This divergence demonstrated the vulnerability to a sovereign debt crisis of a country that borrows in a currency it does not issue. For ex- ample, the Spanish government borrows in euros but it is the Eurozone central bank, the ECB, which issues euros.
We summarize the aims of this chapter as follows.
• In Section 12.2, we explain how the Eurozone as a whole and its member countries performed from its formation in 1999 up to the global financial crisis.
• In Section 12.3, we ask how a country chooses an exchange rate regime. We focus on the costs and benefits of giving up exchange rate flexibility and joining a common currency area. There are a set of generic arguments developed under the umbrella of the theory of an optimal currency area. To that we add some colour by relating the OCA to the choice by countries of whether to join the euro. Three countries who were qualified to join (the UK, Sweden and Denmark), chose to remain outside. We summarize how responsibility for economic policy is divided between national and supranational bodies. In the European Monetary Union, this is called the Maastricht policy assignment. We use the 3-equation model to analyze how the ECB should respond to shocks that affect the Eurozone as a whole. National governments remain in control of fiscal policy in EMU. We look at why fiscal rules were introduced in the Eurozone (i.e. the Stability and Growth Pact) and how they worked out.
4 CHAPTER 12. A COMMON CURRENCY AREA
• Section 12.4 explains the issues surrounding stabilization at country level in a common currency area. If a member country is hit by a country- specific shock, how does it respond? Since a member country cannot vary its own nominal interest rate to counteract a shock, two questions arise: Firstly, are there self-stabilizing forces that can be relied upon? To help us answer this question, we introduce the concepts of the real exchange rate and the real interest rate channels of adjustment to shocks. And secondly, should national governments use fiscal policy to stabilize? To help us answer this question, we show how the 3-equation model can be adapted to analyze fiscal stabilization policy under fixed exchange rates.
• In Section 12.5, we show how features of the supply-side affect the opera- tion of a common currency area. This issue is first raised in Section 12.3 in the discussion about an optimal currency area. In Section 12.5, we link that argument to the differences among members of the Eurozone in their labour market institutions as documented in Chapter 15. The Eurozone consists of a group of countries among which the largest, Germany, has a system of coordinated wage-setting. Since changes in the real exchange rate (i.e. competitiveness) among members of a common currency area cannot be achieved by changes in the nominal exchange rate, problems can arise in a CCA if some countries find it easier than others to ori- ent wage increases to the real exchange rate consistent with equilibrium unemployment.
• In the final section (12.6), we investigate the reasons why a sovereign debt crisis can arise for a member country in a common currency area and the implications for a coherent governance structure. A comparison between the Eurozone and the USA is used to highlight the governance problems for when a group of separate countries sharing a common currency.
12.2 The Eurozone’s performance in its first ten years
One way of assessing the Eurozone’s macroeconomic performance in its first decade is to use the same criteria we use for countries like the US or the UK: how close was the Eurozone on average to the inflation target set by the European Central Bank and to an output gap close to zero? Fig.12.1 shows the answer: where the two axes cross shows an average inflation rate of 2% and an output gap of zero. In its first decade and before the global financial crisis, the performance of the Euro area as a whole was close to target. This suggests that the ECB was successful in managing common shocks to the Eurozone.
However, the figure shows very clearly how much variation there was in the performance of Eurozone member countries: at the top are the four Eurozone countries involved in the Eurozone crisis from 2010. These countries all had average inflation rates well above the ECB’s inflation target of 2% and positive
12.2. THE EUROZONE’S PERFORMANCE IN ITS FIRST TEN YEARS 5
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Figure 12.1: Eurozone performance: inflation and output gap, 1999-2008 (average per cent per annum). Source: OECD Economic Outlook Database (2011). Inflation is consumer price
index, harmonized, output gap is for total economy. Greece is from year of entry, 2001.
output gaps during the first decade of the euro. In the opposite corner with inflation below the target and with a negative output gap is Germany. Individual country performance was very diverse.
A second way of capturing the variation in country performance is to look at how real exchange rates and current account balances evolved. We introduced the difference between real and nominal exchange rates in Chapter 9. Figure 12.2 shows indexes for the intra-Eurozone real effective exchange rates (REER) and the current account balances for the four largest member countries (by GDP) between 1999 and 2008. The REER index is set at 100 in 1999 when the Eurozone was formed. The nominal exchange rate for each of the four countries is 100 for the whole period, reflecting the fact that nominal exchange rates are fixed between Eurozone members.
In Fig. 12.2, the current account balances are shown as a percentage of each country’s GDP, where a negative value indicates a current account deficit and vice versa. The real exchange rates are defined in terms of relative unit labour costs and the index rises when the real exchange rate of the economy appreciates. This shows how even when the nominal exchange rate is fixed, real exchange rates can move very differently: Spain’s competitiveness relative to the Eurozone average fell by 26% over the first decade of the Eurozone, whereas Germany’s increased by 17.5%. These divergences in external competitiveness were reflected in the build up of current account imbalances, as shown in Fig. 12.2. We can see that Spain and Italy built up large current account deficits in the first ten years of the single currency, whilst Germany ran a large surplus.
This development was not anticipated when the formation of a common cur- rency area was being discussed. It was assumed that once the nominal exchange rate had been given up – and with it, the opportunity to regain competitive-
6 CHAPTER 12. A COMMON CURRENCY AREA
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Figure 12.2: Current account balances and real effective exchange rates (REER) - France, Germany, Italy and Spain: 1999 to 2008 Source: European Commission, January 2012; OECD Economic Outlook, December
2011
ness through a nominal depreciation – wage and price-setting behaviour would adjust. What would adjustment mean? It would mean nominal wages taking the burden of adjustment to ensure that competitiveness evolved in a manner consistent with stability. To keep the real exchange rate unchanged, for ex- ample, would require that unit labour costs evolve in line with the Eurozone average, which itself would follow closely the inflation target.
Why might divergences in inflation rates and real exchange rates within a currency union matter? To the extent that expected inflation in a member coun- try differs from the currency union average, the member country’s real interest rate is affected. We shall see that this can be destabilizing: a country with higher than union average inflation (like Spain, Ireland, Portugal and Greece as shown in Fig.12.1), has a lower real interest rate. If the higher inflation was the result of a country-specific positive demand shock, a lower real interest rate will reinforce rather than offset this shock.
Movements in the real exchange rate will also affect net exports and the trade balance. A member’s external indebtedness will rise if there are persistent current account deficits. Eventually this is likely to affect the terms on which the country can borrow i.e. their bond yields. In a common currency area, the only
12.2. THE EUROZONE’S PERFORMANCE IN ITS FIRST TEN YEARS 7
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Figure 12.3: Trends in household and public debt to GDP ratios for selected European countries between 1990 and 2010 Source: Oxford Economics
way a country can reverse a deterioration in its real exchange rate is by achieving a combination of slower nominal wage growth and faster productivity growth than the union average. In Section 12.5, we discuss the particular problems in the Eurozone that have arisen because of the differences among the countries in their wage-setting systems.
Public sector and household debt also evolved differently in member coun- tries. The left hand side of Fig.12.3 shows the long-run behaviour of the gov- ernment debt to GDP ratio and the right hand side the household debt to GDP ratio for the large Eurozone countries and for the UK, which remained outside the Eurozone. The big differences across member countries in levels of debt when the Eurozone was formed are clear: Italy’s public debt was very high but its household debt, relatively low. Public debt levels of Germany, France and Spain were similar in 1999 but evolved completely differently in the years before the global crisis: Spain’s public debt ratio fell dramatically and household debt increased. In Germany, public debt increased but household debt fell. Spain’s public debt problem arose only after the crisis.
We shall see that this diversity of performance of member countries reflected policy choices at national level and differences in private sector behaviour, in- cluding the role of labour market institutions.
8 CHAPTER 12. A COMMON CURRENCY AREA
12.3 Choice of exchange rate regime
The theory of an optimal currency area points to the costs and benefits of adopting a common currency. What are the costs to an economy of giving up independent monetary policy (and an independent exchange rate) and what benefits arise from this? We take it for granted that all the states of the USA share a common currency – and, until the recent debate about Scottish in- dependence arose, that England, Scotland, Wales and Northern Ireland all use the pound sterling. But in the Eurozone 17 different countries share the same currency. The economic theory of an optimal currency area focuses on the eco- nomic sources of costs and benefits but we shall see that the political issue of national sovereignty and its role in fiscal policy also plays a role.
From an economic perspective, the key to the optimal size of an area where there is a common currency is the degree of economic integration among the regions. The degree of integration affects both the benefits and costs.
12.3.1 Microeconomic benefits
The microeconomic benefits that arise from using a common currency increase with the degree of economic integration among the countries. Such benefits arise from
• higher trade and investment, due to the fact that adoption of a single currency eliminates foreign exchange rate risk. As we saw in Chapter 10, an unexpected change in the exchange rate affects the profitability of production in different locations. Decisions about location often involve long-lived investment in physical plant and equipment. Where companies would previously have operated in two different countries to hedge the risk of a change in the exchange rate, in a common currency area, they can take advantage of economies of scale and achieve a more efficient allocation of resources by concentrating production in the best location.
• Real resource savings from eliminating transactions costs that are incurred by currency conversion.
• Increased competition in goods and labour markets due to greater ease of price and wage comparisons. More competition would be expected to produce both static and dynamic efficiency gains.
• Increased liquidity of financial markets. This would be of particular benefit for small member countries.
Evidence
A meta-analysis of 34 studies concluded that currency unions boost bilateral trade by between 30% and 90% (Rose and Stanley, 2005). Following the for- mation of the Eurozone, trade within the euro-zone increased more than with non-EMU members (see Micco et al and Barr et al in Economic Policy October
12.3. CHOICE OF EXCHANGE RATE REGIME 9
2003). It is also notable that before EMU, the EU countries that stayed out of the Eurozone (UK, Sweden, Denmark) had lower than average bilateral trade shares with Eurozone members (Barr et al).
In relation to the competition effects, Holland (2007) concluded that
trade liberalization, both on a global and European scale have re- duced mark-ups, and that liberalization has had a clear effect on the sustainable level of employment in European countries. However, it does not appear that the transparency associated with the euro has had a significant impact on the mark-up.
12.3.2 Macroeconomic benefits and costs
To pin down the macroeconomic benefits and costs of choosing to join a common currency area, the comparison is normally with a flexible exchange rate regime. Other exchange rate arrangements such as the Exchange Rate Mechanism of fixed but adjustable exchange rates that operated in the European Union be- tween 1979 and 1999 are viewed as unstable in the presence of highly integrated international capital markets4. Three important macroeconomic issues arise in assessing the costs and benefits of joining a common currency area. How does the choice of regime affect
1. the economy’s ability to respond to shocks? In a CCA, what could sub- stitute for the loss of the nominal exchange rate in adjusting to shocks?
2. the credibility of the medium-run inflation rate?
3. the nature of shocks the economy faces?
Ability to respond to shocks
The theory of an optimal currency area highlights the costs incurred by a switch from a flexible to a fully fixed exchange rate. The basic point is that the ex- change rate can provide stabilization when the economy is affected by some kinds of shocks. The benefit of being able to use monetary policy (and the asso- ciated change in the exchange rate) to adjust to a shock falls with the degree of integration between a country and the rest of the CCA. In particular the more closely is the business cycle of a member correlated with that of other members, the better will be the stabilization performed by the CCA central bank. Taking the example of the Eurozone, the reason is that the ECB stabilizes shocks to the euro area as a whole and the more closely a country’s business cycle moves with the average business cycle for the Eurozone in timing and amplitude, the more stabilization is provided by the interest rate changes made by the ECB.
4The pressures that led to the collapse of the ERM in 1992 are discussed in pp. 698-709 of Chapter 17, Carlin and Soskice, 2006.
10 CHAPTER 12. A COMMON CURRENCY AREA
A B
C
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Figure 12.4: A negative external trade shock: adjustment inside & outside a common currency area
Example of an external trade shock A way of representing the arguments about whether or not the exchange rate is useful as a shock-absorber is to consider a negative external trade shock. For simplicity, we assume the ERU curve is vertical. In Fig.12.4, the country is affected by a negative external trade shock: for example, demand falls for the output of an industry in which it specializes. A negative external trade shock shifts the AD curve and the BT curve to the left (with the new intersection vertically above the initial one (see the Modelling section in Chapter 10)). The new medium-run equilibrium at C is at a depreciated real exchange rate.
In a flexible rate economy, nominal depreciation can help to achieve this: as we saw in Chapter 9 in the 3-equation open economy model, once the shock is recognized, the central bank and forex market will respond. Since home’s interest rate will be kept below that of the world during the adjustment to the new medium-run equilibrium, the exchange rate will jump. There will be a depreciation taking the real exchange rate to a level beyond the new equilibrium level (overshooting), output will rise above equilibrium, and the economy will adjust to equilibrium with inflation rising back to the target level.
Inside a currency union (or more generally under fixed exchange rates), nom- inal depreciation is not possible so the real depreciation that is required must take place through a reduction in domestic wages and prices relative to those in the rest of the world.
Wage and price flexibility A lengthy period with higher unemployment at point B may be necessary if wage and price adjustment is slow. The more flexible are domestic wages and prices, the faster is the adjustment to the new medium-run equilibrium at point C. This is why domestic wage flexibility is regarded as a substitute for a flexible nominal exchange rate. This point can be expressed in another way. It is the failure of wages and prices to adjust immediately under flexible exchange rates to take the economy from point A
12.3. CHOICE OF EXCHANGE RATE REGIME 11
to the new equilibrium at point C that explains the role of the central bank in stabilizing the economy. If wage and price adjustment was instantaneous, the economy would move from A to C irrespective of the exchange rate regime. For a given degree of wage and price stickiness, access to a nominal exchange rate change via an independent monetary policy speeds up the adjustment by operating directly to produce the required real depreciation (in this example)5.
Labourmobility In principle, closer economic integration makes labour more mobile and this provides a shock-absorber that can help substitute for the loss of the exchange rate instrument. The example of labour mobility across states in the USA is often referred to as evidence for the optimality of its currency union. Part of the adjustment to a negative shock to the auto industry in Michigan would be the out-migration of labour to other states where the demand for labour was more buoyant. National differences in language, training and accreditation, and in the flexibility of the housing market are among the reasons for more limited mobility of labour across than within national borders. If the labour market is flexible in the sense that workers leave the country with higher unemployment, then as in the example of Michigan, this is also a substitute for nominal exchange rate adjustment.
Endogeneity of the Optimal Currency Area Optimistic observers of the formation of the Eurozone believed that a combination of adjustment by pri- vate sector agents, reforms to improve flexibility in labour markets by member governments and increased labour mobility across borders would move the Eu- rozone in the direction of an optimal currency area. Although the criteria for an OCA were obviously lacking at the outset, the belief among some economists and policy-makers was that the Eurozone would develop those characteristics endogenously as a consequence of its existence.
A counter-argument asks whether a common currency necessarily reduces the prevalence of country-specific shocks. Paul Krugman (1993) made the ar- gument that closer integration for the microeconomic reasons discussed above that led to co-location of production facilities in a particular industry could have the outcome that asymmetric shocks increase. For example, if the com- mon currency led to the geographical concentration of the automobile industry in southern Germany, this could lead Germany to experience stronger country- specific shocks emanating from shocks to the car industry than was previously the case where there was a car industry in each country.
Fiscal transfers The comparison between a state in the US currency union and a country in a common currency area helps bring out another possible shock-absorber. In the US, the federal government’s tax and transfer regime
5To help with better visualising and understanding these concepts, you can use the Macro- economic Simulator available from the Carlin and Soskice website to model the speed of adjustment to a negative demand shock in fixed and flexible exchange rate economies (see Question 7 in Section 12.8.2).
12 CHAPTER 12. A COMMON CURRENCY AREA
means that a shock to a region is partially offset by the automatic operation of the federal tax and transfer mechanism. A negative shock to Michigan raises unemployment: this increases the inflow of stabilizing demand via the federal element of unemployment benefits and reduces the outflow of demand through lower federal tax receipts from Michigan. This ‘insurance’ or risk-sharing fea- ture of a federal system provides some offset to the effects of region-specific shocks. By contrast, in the Eurozone, the federal budget is tiny and there is no stabilization provided through this route.
Credibility of the medium-run inflation target
In Chapter 10, we saw that the medium-run inflation rate is set by the central bank’s inflation target when there is a credible central bank. We shall see in Chapter 13, that if the central bank’s commitment to its inflation target is not credible – because, for example, it is targeting an unemployment rate lower than the equilibrium – there will be inflation bias. In Chapter 10, we also saw that medium-run inflation for a member of a common currency area will be set by the CCA’s inflation target.
This brings out a potential macroeconomic benefit of CCA membership for a country that found it difficult to establish its own credible low inflation monetary policy regime, it was attractive to ‘tie its hands’ by giving up national monetary policy and entering the Eurozone (refer back to Fig. 10.12 in Chapter 10). This was the case for many countries in Europe. The contrasting experiences of Italy and the UK are interesting in this regard. Both countries were high inflation countries in the 1970s and 1980s. Italy decided to join the Eurozone to take advantage of a low inflation monetary policy regime; the UK government decided to tie its hands by delegating monetary policy to an independent Bank of England. Through these different routes, both countries acquired a credible monetary policy regime.
Exchange rate regime & the nature of shocks
The flip-side of the argument that monetary union imposes a cost by eliminat- ing nominal exchange rate adjustment is that it delivers a benefit by preventing countries from taking advantage of competitive devaluation. Ruling this out was a major selling point of EMU-membership to the German public, who had nothing to gain from moving from credible monetary policy via the Bundesbank to a credible ECB. More broadly it was argued that political support for the project of creating a single market in Europe with its benefits of greater com- petition and dynamism would be threatened if there were sudden exchange rate swings.
In the Chapter 9, we highlighted the potential costs that accompany a flexible exchange rate regime because of the volatility of the real exchange rate. Ex- change rate overshooting is inherent in a flexible exchange rate regime as long as there are wage and price rigidities alongside a forward-looking and rapidly adjusting foreign exchange market. In the example of the adjustment to an
12.3. CHOICE OF EXCHANGE RATE REGIME 13
external trade shock, the real exchange rate jumped – this produced a rapid change in relative prices but the overshooting was larger than required by the new medium-run equilibrium. The second source of exchange rate volatility is the erratic behaviour of the foreign exchange market itself.
12.3.3 Fromoptimal currency area theory to practice: the Maastricht policy assignment
The Maastricht Treaty of 1992 set out the basis for European Monetary Union. The first Chief Economist of the European Central Bank, Otmar Issing, used the term “Maastricht policy assignment” to describe how the responsibility for economic policy was to be divided between the supranational ECB and the national governments.6
• The ECB is responsible for using monetary policy to respond to Eurozone- wide shocks and for delivering low and stable inflation to the euro area.
• National governments are responsible for fiscal sustainability and subject to that, for providing stabilization for country-specific shocks and for the asymmetric effects of common shocks (i.e. for dealing with the fact that common shocks may have different effects in different member countries).
• The aim of the European Union’s Stability and Growth Pact was to pre- vent governments from pursuing policies that might threaten the ECB’s inflation objective.
• National labour and product markets, and national supply-side policies would determine equilibrium unemployment. However, supply-side re- forms would be supported by the European Union’s “Lisbon strategy”. The Lisbon Strategy was a European Union programme for the 10 years from 2000 aimed at making the EU "the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion" (Lisbon European Council, 23-24 March 2000). In 2010, this was replaced by the EU’s ‘Europe 2020’ programme.7
12.3.4 Monetary policy in the Eurozone
The European Central Bank began work as the single monetary policy maker in the Eurozone in 1999. This marked the beginning of an historic experiment. The Eurozone is a unique structure with one central bank, initially eleven and by 2011, seventeen independent national fiscal authorities, and seventeen na- tional labour markets. The ECB is politically independent of governments –
6Otmar Issing (2004) A Framework for Stability in Europe http://www.bis.org/review/r041130h.pdf?frames=0
7For an independent evaluation in 2006, see Pisani-Ferry and Sapir (2006). http://aei.pitt.edu/8387/01/BPC200603_ExitLisbon.pdf
14 CHAPTER 12. A COMMON CURRENCY AREA
its constitution reflects the legacy of the German Bundesbank and as a result it is more independent than either the Federal Reserve in the US or the Bank of England. It sets its own monetary policy in terms of its
• target (price stability, defined as an inflation rate of close to but below 2%),
• strategy, which comprises two pillars (economic and monetary) and
• policy instrument, the interest rate.
The economic pillar makes use of the analysis of forecasts of the output gap and the deviation of inflation from target to inform the interest rate decision. The arguments set out in Chapters 4 and (developed further in Chapter 13) about the credibility of an independent inflation targeting central bank apply to the ECB: it provided member countries with credible monetary policy and for a number of them, it is likely to have delivered a lower inflation bias than they could have achieved with a national monetary policy.
But the interest rate decision also reflects the second pillar of the ECB’s monetary policy strategy. The second, or monetary pillar reflects the influence of the legacy of the German central bank, the Bundesbank. Unlike many central banks, the Bundesbank had considerable success in targeting the growth of the money supply as part of its price stability mandate. This contrasts with the failure of monetary targeting elsewhere.8
In addition to using information from the economic pillar to set the interest rate, the ECB also uses the monetary pillar. For this purpose, it uses a reference growth rate of a broad monetary aggregate. The ECB’s inflation target is a rate below but close to 2%. Its reference for the growth rate of the money supply (the broad monetary aggregate, M3) is 4.5%. This number is consistent with a growth rate of nominal GDP of approximately 4% (e.g. inflation of less than 2% and output growth of 2—2.5%) and with prevailing estimates of a trend decline in the velocity of circulation at a rate of decline of 0.5—1% p.a.9).
Although much of the Anglo-American commentary about the behaviour of independent central banks has been critical of the ECB’s ‘second pillar’, mone- tary economist (and former member of the Bank of England’s Monetary Policy Committee) Charles Goodhart (2006) argued that if inflation expectations come to be more closely anchored to the target, inflation may no longer be a good signal of future inflationary pressure. Under these circumstances, relying only on the economic pillar could be misleading and the growth rate of a money aggregate may be a more relevant indicator of future inflation.
Goodhart picks out two episodes when monetary growth was much faster than 4.5% in the Eurozone. The first was in 2001-3 and the second from 2005. In the first case, the ECB did not respond to the monetary growth outside its target zone. It correctly diagnosed the cause as unusual and temporary monetary
8For a comparison with the UK see CS06 Chapter 8 pp. 273 and 277. 9The calculation uses the so-called Quantity Equation: MV = Py, where V is the velocity
of circulation. Hence ∆M/M = π +∆y/y −∆V/V so we have 2 +2 − (−0.5) = 4.5.
12.3. CHOICE OF EXCHANGE RATE REGIME 15
growth due to a blip in the demand for money arising from the bursting of the high-tech boom in 2001. Higher monetary growth reflected higher demand for money and did not signal inflationary problems.
The second episode of faster than target monetary growth from 2005 was accompanied by higher bank lending (unlike the first time). The ECB viewed this as signalling a potential inflationary problem in the future (a possibility not reflected in the well-anchored inflation expectations) and pointing toward the need to tighten monetary policy. In view of the subsequent credit-related crisis, this is an interesting example of how the ECB’s second pillar could play a useful role. But the need for careful interpretation reinforces the problems with the naive use of a money growth indicator.
To summarize,
• the ECB’s performance has been viewed as broadly successful – inflation was stable and only just above the 2% target on average in its first decade;
• its constitution is viewed as strong on independence but weaker on trans- parency and accountability; and
• its asymmetric target (inflation close to but below 2%) has been criticized because it leaves the Eurozone more vulnerable to deflation (see Chapter 8 for the analysis of a deflation trap) than would be the case with a symmetric target.
12.3.5 Fiscal policy in the Eurozone
Together with the Maastricht Treaty, the Stability and Growth Pact sets the macroeconomic framework for the Eurozone as a whole. The Stability and Growth Pact specified that national budget deficits be kept below 3% and that the ratio of government debt to GDP be kept below 60%. The choice of these particular numbers can be rationalized by noting that a debt ratio of 60% was the average of the EU members in the years preceding the formation of the Eurozone; and with a debt ratio of 60%, the debt to GDP ratio will remain constant if the nominal growth rate is 5% and the budget deficit is 3% of GDP. Using the analysis of Chapter 14,
∆bt = dt +(r−γ)bt−1
= dt +(i−π−γ)bt−1
→ ∆b = 0 when
dt + ibt−1 = (π+γ)bt−1
0.03︸︷︷︸ budget deficit
= (0.02+0.03) 0.6︸︷︷︸ debt ratio
Why should the state of a member country’s deficit and debt levels be of any concern to the EU or the ECB? Is this not simply a matter of national policy? The reason for supra-national concern about the deficits and debt levels
16 CHAPTER 12. A COMMON CURRENCY AREA
in member countries arises because of fears of spillovers from national policy decisions to the Eurozone. There are several arguments about possible spillovers:
1. For any one small country, there may be an incentive to run a budget deficit in order to boost aggregate demand (shift theAD curve to the right) and move along a downward-sloping ERU curve to a lower unemployment rate. Of course if all members of the Eurozone were to do this, and if for simplicity, we think of the Eurozone as a closed economy, then this rightward shift in the IS curve for the Eurozone would lead to higher inflation and the ECB would have to raise the interest rate to dampen demand. The SGP seeks to prevent individual members from behaving like this.
2. A second source of spillover relates directly to government debt. In princi- ple, the market should price any differential risk of default on government debt across Eurozone members into the price of that country’s bonds. Until the Greek crisis of May 2010, the differences in the cost to differ- ent Eurozone governments of borrowing were very small. This is shown in Fig.12.10 below. The problem is that once the risk of default rises in one member, contagion can occur to other members. Although the EU constitution does not make provision for the bailing out of one member government by the union, once a Greek default became a possibility spec- ulation about a bail-out developed. This is clearly a source of spillover from the fiscal policy in one member to others.
According to its own criteria for success, the Eurozone’s record on fiscal policy in the Eurozone’s first decade is not as satisfactory as that of monetary policy. The deficit target of 3% was breached by a number of countries, including France and Germany, and fiscal policy was pro-cyclical, i.e. not stabilizing. Fig.12.5 contrasts the pro-cyclical behaviour of fiscal policy in the Eurozone with the stabilizing counter-cyclical behaviour of the US. For example in the boom from 1999 to 2000, in the Eurozone as the output gap increased, fiscal policy was expansionary (a move to the north-east in the figure) but in the US it was contractionary (a move to the south east).
The SGP was revised in 2005. The aim was to to discourage pro-cyclical fiscal policy by defining the fiscal rule in terms of the cyclically adjusted budget balance. There was greater emphasis on the sustainability of public debt and on structural issues such as the impact of future pension obligations. In addition, country-specific medium-term objectives were introduced, which ranged from a 1% of GDP deficit for countries with low debt and high potential growth to budget balance or surplus for countries with high levels of debt or with low potential for growth. Unlike the original formulation of the SGP, these amendments are consistent with the principle of a prudent fiscal policy rule set out in Chapter 14.
12.4. STABILIZATIONPOLICYFORAMEMBEROFACOMMONCURRENCYAREA17
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Figure 12.5: Fiscal impulse and output gaps for the euro area and the US between 1998 and 2006 Note: Fiscal impulse is defined as the change in cyclically adjusted primary budget
deficit from the previous year. Output gap is for the whole economy
Source: OECD Economic Outlook 89, June 2011
12.4 Stabilization policy for a member of a com- mon currency area
This section can be used in two ways. Some readers will have come directly from Chapter 9 and the introduction to this chapter. Having studied how stabilization policy works in a flexible exchange rate economy, this section addresses the same question for a country operating with fixed exchange rates. Other readers will be thinking about national stabilization policy for a country inside the Eurozone. It turns out that the needs of both sets of readers are similar.
To make clear the comparison between stabilization policy under fixed and flexible exchange rates, it is useful to assume the fixed exchange rate economy is a member of a common currency area. This means that monetary policy is set by the currency area’s central bank and the member has no control over its nominal interest or nominal exchange rate. In other words, the exchange rate is credibly fixed. This means that the terms ‘fixed exchange rate regime’ and ‘common currency area’ can be used interchangeably in this section.
18 CHAPTER 12. A COMMON CURRENCY AREA
To summarize, we have a common currency area where there are two levels at which shocks occur:
1. The first is the level of the common currency area as a whole, where monetary policy is carried out by the central bank of the CCA. It responds to common shocks by choosing the real interest rate, r∗ to achieveπT = π∗. Stars are for the common currency area variables; the home economy, which belongs to the CCA has no stars and in this section, we ignore the rest of the world.
2. At the member country level. We shall look at what happens if there is no intervention by the policy maker and adjustment takes place as discussed above via wage and price adjustment in the home economy. This occurs through two channels: the real exchange rate channel and the real interest rate channel. In a second step, we introduce an optimizing policy maker at the national level who has access to fiscal policy. What would such a policy maker do in response to a shock?
We have seen in Chapter 9 that only under conditions where monetary policy loses traction such as when the economy is in a liquidity trap or the interest rate hits the zero nominal bound, will the government in a flexible exchange rate economy normally choose to stabilize using fiscal rather than monetary policy. Several reasons why monetary policy is the preferred stabilizer when both are available are discussed in Chapters 4, 13 and 14:
1. Monetary policy can be delegated to an independent central bank. By contrast, fiscal policy is inherently political since it involves the use of tax revenues.
2. Changing public expenditure or taxation normally involves lengthy parlia- mentary processes, and the kind of gradual adjustment possible through quarter point changes in the interest rate at a monthly interval is not fea- sible. Of course some stabilization is achieved through the operation of the automatic stabilizers (see Chapter 14).
3. Whereas a lengthy period of low interest rates can be reversed once the economy recovers and it leaves no lasting trace, a lengthy period of high budget deficits to provide the same kind of stimulus leaves a residue of accumulated debt once budget balance is restored.
As discussed in Chapter 4, fiscal policy is much more complex than monetary policy. It is against this background that we look at stabilization in a fixed exchange rate economy.
12.4.1 Is stabilization policy necessary under fixed ex- change rates?
One of the main results about stabilization in the closed economy and in the flexible exchange rate economy (set out in Chapters 4, 9 and 13) is that a
12.4. STABILIZATIONPOLICYFORAMEMBEROFACOMMONCURRENCYAREA19
monetary policy rule in which the central bank responds to forecast inflation by raising the real interest rate is necessary to stabilize the economy. This result was built into the operation of inflation targeting central banks around the world and has been credited with helping to keep inflation low and stable. The comparison of monetary policy and inflation behaviour following the three oil shocks in Chapter 15 highlighted the application of this insight.
To illustrate this, we consider an inflation shock as the simplest example. If inflation rises above the target, then unless the central bank raises the nominal interest rate more than one-for-one (which is referred to as the monetary policy rule incorporating the Taylor Principle), the real interest rate falls and the economy will move further away from equilibrium. Is this true under fixed exchange rates? Not necessarily. The reason is that if inflation goes up, it makes the economy less competitive and this will dampen net exports and pull the economy back toward equilibrium. This is called the ‘real exchange rate’ channel of adjustment. If this mechanism can be relied on, we would need to worry much less about how fiscal policy could be used to stabilize the economy. But can it be relied on? The example in the Box from the recent history of the Eurozone suggests it cannot. [Box De-stabilization in the Eurozone An example of a country-specific
inflation shock comes from the case of Ireland in the initial phase of the Euro- zone. Following the adoption of the euro, the euro depreciated against both the US dollar and the pound sterling. Ireland has much stonger trade relations with the US and the UK than is typical in the Eurozone. The result was that the euro depreciation had a bigger effect in raising inflation in Ireland (as imported goods increased in price, which in turn triggered domestic wage increases) than was the case in other members. This represented a country-specific inflation shock for Ireland.
The Irish example highlights that there is another channel that can oper- ate under fixed exchange rates to destabilize the economy and may prevent the ‘no intervention’ strategy from working. This is the ‘real interest rate’ channel. When home’s inflation is above the Eurozone average, this may affect expected inflation in the home economy. If expected inflation rises, then home’s real in- terest rate falls and this boosts output, putting additional upward pressure on inflation as output rises above equilibrium. Instead of moving back to equilib- rium as happens through the real exchange rate channel, the economy will move further away from equilibrium with rising output and rising inflation.
This helps explain what happened in Ireland and Spain in their post-euro property booms: the combination of the low nominal interest rate set by the ECB with high domestic inflation (relative to the Eurozone average) pushed down the real interest rate and stimulated investment in construction projects and consumption in those economies. It is said that 60% of Europe’s concrete was being used in Spain in 2006. The real interest rate in Ireland and Spain was actually negative for much of the period from euro entry until 2007.
Under these circumstances, the government must intervene with a sufficiently contractionary fiscal policy to ensure the economy returns to equilibrium. As noted above, the failure to do so fuelled the house price bubbles and construction
20 CHAPTER 12. A COMMON CURRENCY AREA
booms in Spain and Ireland before the crash of 2007-8. Box ends]
The Taylor principle and stabilization
• In a flexible exchange rate regime, the Taylor principle refers to the need to raise the nominal interest rate sufficiently that the real interest rate rises when stabilization requires policy tightening. This is built into the 3-equation model.
• Under fixed exchange rates, unless a similar principle is applied so that the required negative output gap is created to dampen inflation (through the combination of tighter fiscal policy and the operation of the real exchange rate channel), instability can arise. This is referred to as the Walters’ critique. British economist Alan Walters argued against UK membership of the euro on the grounds of this kind of instability.
In the analysis of stabilization under flexible exchange rates, we did not mention the government’s financial balance, i.e. whether it was in budget deficit or surplus. This is because under normal conditions, stabilization against a private sector shock is carried out by the central bank using the interest rate and once the economy has returned to medium-run equilibrium, the government’s primary balance will be back at its initial level.
We shall see that the result is different when fiscal policy is used as the stabilization policy in a fixed exchange rate regime. This draws attention to whether fiscal policy is a good substitute for monetary policy in stabilizing against shocks. In general, we find that fiscal policy is not a perfect substitute for monetary policy: concern about the consequences for the budget balance of stabilization make its use considerably more difficult than the use of monetary policy under flexible exchange rates.
Fig.12.6 summarizes the stabilization issues that arise for a member of a CCA or for a fixed exchange rate economy where the home country does not have its own monetary policy. The government can choose to do nothing in response to a shock (the left hand side of Fig.12.6) or to use fiscal policy (the right hand panel). We look at the real exchange rate and real interest rate channels in turn, and then show why fiscal policy is not a perfect substitute for monetary policy in stabilization.
12.4.2 The real exchange rate (competitiveness) channel
As noted above, if the government decides not to use policy to respond to a shock, two adjustment processes arise automatically. These are the real ex- change rate and real interest rate channels. Inflation in medium-run equilibrium in a fixed exchange rate economy is pinned down by inflation in the country to which home’s exchange rate is tied, i.e. πMRE = [π∗]. In a common currency area, π∗ = πT , where πT is the inflation target of the currency area’s central bank. In the Eurozone, this is the ECB’s inflation target. In this chapter, when
12.4. STABILIZATIONPOLICYFORAMEMBEROFACOMMONCURRENCYAREA21
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Figure 12.6: Stabilization policy options under fixed exchange rates
we refer to the ‘world’ inflation rate or the ‘world’ interest rate, this is the Euro- zone inflation and interest rates when we are thinking about stabilization policy for member countries.
The simplest way of explaining the two channels is by making an assumption about how inflation expectations are formed. In Chapter 9, we saw that in a fixed exchange rate economy, home’s nominal interest rate is equal to the world nominal interest rate (i = i∗). If inflation expectations in the home economy are firmly anchored to world inflation, i.e. πE = [π∗] then from the Fisher equation, the real interest rate remains constant at the world interest rate throughout:
r = i−πE (Fisher equation)
If πE = π∗ and since i = i∗
then r = i∗ −π∗ = r∗.
Using the definition of the real exchange rate, Q ≡ P∗e/P and taking logs, we have q = p∗ +loge−p. Under fixed exchange rates, we can see that home’s competitiveness improves (its real exchange rate depreciates) when home infla- tion is below world inflation and vice versa.
∆q = π∗ −π.
The real exchange rate channel works like this: if we take the case of a pos- itive inflation shock as our example, a rise in home inflation reduces home’s
22 CHAPTER 12. A COMMON CURRENCY AREA
competitiveness and depresses output via the IS relation
yt = A−art−1 +bqt−1.
The causal chain for the real exchange rate channel is:
↑ π →↓ q →↓ y →↓ π... until π <π∗when ↑ q →↑ y.
Eventually, y = ye and π = π ∗.
In Fig.12.7a the upward shift in the Phillips curve due to the inflation shock is shown. As a consequence of the impact of this in reducing home’s competi- tiveness, the IS curve shifts to the left and the economy is at lower output (at point C on the r = r∗ line because of our assumption that πE = π∗). What happens to inflation? As usual, this depends on inflation expectations. Because of our assumption that inflation expectations are firmly tied down to the world inflation rate, in the period after the inflation shock, the Phillips curve reverts to the one indexed by π∗ (Fig.12.7a). The fall in output caused by home’s loss of competitiveness pushes inflation below π∗ and as we can see from the definition of the real exchange rate, this boosts home’s competitiveness. The following period, the IS curve therefore shifts to the right (IS(q1)) and the economy begins to recover. Eventually, it is back at equilibrium with the initial real exchange rate. Nothing has happened to government spending or taxation so the economy remains in fiscal balance.
In Section 12.5, we look at how Germany’s wage-setting system allows the real exchange rate channel to operate there.
12.4.3 The real interest rate channel
Let us now see what happens when inflation expectations are not firmly anchored to world inflation. When there is a backward-looking element in inflation expec- tations, the Fisher equation indicates that home’s real interest rate can deviate from the world real interest rate. This will be the case if agents believe that inflation will continue to behave as it has in the past. To make the explanation of this channel as clear as possible, we assume the IS curve does not shift with a change in the real exchange rate. Fig.12.7b illustrates how the real interest rate channel works. Inflation expectations are formed in a backward-looking way with πE = π−1. The inflation shock shifts the Phillips curve up as usual. This now raises expected inflation, which reduces home’s real interest rate (to r1). This leads to a rise in output and inflation (point C). Inflation expectations are updated and the Phillips curve shifts up again. Output rises further.
The causal chain for the real interest rate channel works like this:
↑ π →↑ πE →↓ r →↑ y →↑ π... destabilizing.
In a more realistic model, the real exchange rate effect will operate alongside the real interest rate effect. But as long as the real interest rate effect is stronger,
12.4. STABILIZATIONPOLICYFORAMEMBEROFACOMMONCURRENCYAREA23
( )IS q
*π
( *)EPC π π=
ey
0( )IS q
y
y
π
1π ey
*r
r
1( )IS q
0q∆ >
1y 2y
C
C
A,Z
A,Z
0π (inflation shock)PC
B
( )IS q
*π
( *)EPC π π=
ey y
y
π
*r
r
2y 3y
C
A
0π
(inflation shock)PC
B C
1( ) EPC π π −=D
1π
ey
C
A
1r D 2r
a. Real exchange rate channel: stabilizing b. Real interest rate channel: destabilizing
Figure 12.7: Inflation shock: the exchange rate & interest rate channels
the problem of instability identified by Walters exists.10 11
12.4.4 Using fiscal policy to stabilize
Why might the government in a common currency area or in a fixed exchange rate economy use fiscal policy for stabilization? Since it has no access to mon- etary policy to offset country-specific shocks, the government might reach for fiscal policy as a substitute for two reasons:
1. It may be necessary in order to prevent the instability of the Walters’ critique effect.
2. Sluggish wage and price adjustment may make the real exchange rate channel slow and costly.
Even in an economy where the exchange rate channel dominates the interest rate channel, inflation expectations may adjust only slowly to world inflation. Looking at Fig.12.7a, if instead of jumping back to its original position in the
10See T. Kirsanova, D. Vines and S. Wren-Lewis (2006), "Fiscal Policy and Macroeconomic Stability within a Monetary Union" CEPR DP 5584. 11The Macroeconomic Simulator available from the Carlin and Soskice website can be used
to show the destabilising real interest rate channel in action (see Question 6 in Section 12.8.2)
24 CHAPTER 12. A COMMON CURRENCY AREA
period after the inflation shock, the Phillips curve shifts downward only a little, then inflation will remain above world inflation and home’s competitiveness will continue to deteriorate. The process will be stabilizing in the end because eventually, the combination of the downward drift of the Phillips curve and the rise in the output gap will push home’s inflation below world inflation, and its competitiveness will begin to improve. In such a case, relying on the competitiveness channel may impose heavy costs on the economy in the form of inflation and output deviations from πE and ye respectively
12.
Inflation shock
It is important to examine carefully the use of fiscal policy for stabilization. A good place to start is to assume the policy maker in a fixed rate economy has the same utility (i.e. loss) function as in the flexible rate (or closed economy) and faces the same constraints. In other words, the policy maker minimizes its losses subject to the constraint of the Phillips curve. To make the comparison with the flexible rate economy as direct as possible, we use the same loss function and the same Phillips curve:
The central bank is modelled as minimizing this loss function:
Lt = (yt −ye) 2 +β(πt −π
∗ )2, (Government loss function)
where β > 1 characterizes a government that places less weight on output fluc- tuations than on deviations in inflation, and vice versa. The only difference from the flexible rate economy is that the government wants to minimize deviations from world inflation rather than from the inflation target.
The Phillips curve is the same as in the flexible rate closed economy:
πt = πt−1 +α(yt −ye). (Phillips Curve, PC)
The government optimizes by minimizing its loss function subject to the Phillips curve. This produces the policy rule equation (thePR curve), which differs from the MR curve only in the replacement of πT by π∗:
(yt−ye) = −αβ(πt −π ∗). (Policy Rule, PR)
Fig.12.8 provides a direct comparison between the use of fiscal and monetary policy in the fixed and flexible rate economies in response to an inflation shock. We see immediately that because of our assumptions about the policy-maker’s loss function and the Phillips curve, the lower panel is virtually identical in each economy – the only differences are in the labelling of the policy rule curve, and the fact that at equilibrium, inflation is equal to world inflation in the fixed and equal to target inflation in the flexible rate economy.
12The Macroeconomic Simulator available from the Carlin and Soskice website can be used to model the speed of adjustment to a negative demand shock in fixed and flexible exchange rate economies (see Question 7 in Section 12.8.2). This highlights the costs imposed when fiscal policy is not used to stabilise in a fixed exchange rate economy.
12.4. STABILIZATIONPOLICYFORAMEMBEROFACOMMONCURRENCYAREA25
Flexible exchange rate economy
( , , ),
( , , )
IS A G q
IS A G q″ ″
*r
*π
PR
( )TPC π
ey
r
y
y
π (inflation shock)PC ( )tPC π
2π
1y
0r
1π
1r A,Z
A,Z
C
C
B
D
D 1( )tPC π +
*r
Tπ
MR
*( )PC π
r
y
y
π (inflation shock)PC ( )tPC π
2π
1y
0r
1π
1r
A,Z
B
D
D
( , )IS A q
A,Z
C
RX
1( )tPC π +
2y 2y
( , , )IS A G q′ ′
ey
ey ey
C
( , )IS A q′
Member of a CCA
Figure 12.8: Inflation shock: comparison between the use of fiscal policy (fixed exchange rates) and monetary policy (flexible exchange rates)
The lower panels show that the optimizing policy maker in each type of economy chooses the same sequence of output gaps on the path back to equi- librium. However how policy is used to implement those output gaps differs. The central bank in the flexible rate economy gets the economy on the path back to equilibrium by raising home’s interest rate and taking advantage of the exchange rate appreciation that will accompany it (right upper panel). The IS curve is shifted to the left by the appreciation and goes through point C.
Under fixed exchange rates, the government will decide on its initial fiscal policy stance, G′, (to achieve the output gap at point C) taking into account the fact that higher expected inflation reduces the real interest rate to r0 and higher actual inflation reduces competitiveness to q′.
The crucial point to note is that once the fixed exchange rate economy is back at equilibrium with inflation at target, home’s real exchange rate will have ap- preciated. The reason is clear from the left hand lower panel of Fig.12.8: home’s inflation is above world’s throughout the inflation shock episode. Hence, home’s price level will have risen relative to world’s and therefore home’s real exchange rate will have appreciated. This is not the case in the flexible rate economy, where the real exchange rate is back to its initial level q. The appreciated real exchange rate (q′′) at equilibrium in the fixed rate economy means that net ex- ports are lower and therefore for the level of demand to be sufficient for output
26 CHAPTER 12. A COMMON CURRENCY AREA
of ye, government spending must be higher (G ′′).
Table 12.1 shows the characteristics of the initial and new equilibria for the case of an inflation shock. Under flexible exchange rates, monetary policy is used to stabilize and under fixed exchange rates, fiscal policy is used.
Table 12.1: Characteristics of the initial and new equilibria in the case of an inflation shock in fixed and flexible exchange rate economies
Fixed exchange rates Flexible exchange rates Initial equilibrium π = π∗;y = ye;q = q,G = G π = π
T ;y = ye;q = q;G = G New equilibrium π = π∗;y = ye;q = q
′′;G = G′′ π = πT ;y = ye;q = q;G = G
Summary
In a flexible rate economy following an inflation shock, the central bank uses changes in the nominal interest rate to stabilize and it leaves no trace once the economy is back at equilibrium. However, in a fixed rate economy if fiscal policy has to be used to stabilize (because the real exchange rate channel is insufficiently effective), there is a fiscal deficit when the economy is back at equilibrium. Indeed because net exports are lower and government spending is higher, the economy is characterized by twin deficits, a budget deficit and an external trade deficit.
In an AD-ERU diagram (not shown, see Question 9 in Section 12.8.1), the flexible exchange rate economy returns to its starting point with budget balance. But the fixed rate economy in which fiscal policy has been used to stabilize, will be at a medium run equilibrium with an appreciated real exchange rate and on a new AD curve indexed by the higher level of government spending. There is a budget deficit at the new medium-run equilibrium.
Aggregate demand shock
If the economy is hit by a country-specific negative aggregate demand shock, the central bank in a flexible exchange rate economy will cut home’s interest rate. The exchange rate will depreciate and the economy will move on to the MR line at point B in the right hand panel of Fig. 12.9. At the new equilibrium at point Z, the flexible exchange rate economy is characterized by r = r∗ with a depreciated real exchange rate (q′′) and unchanged government expenditure. The primary fiscal deficit is unchanged.
In a common currency area, the PR line in the left hand panel of Fig. 12.9 shows the output gap the government has to choose in order for the economy to move back to equilibrium following the same path as the flexible rate economy. It raises G to G′ at point B taking into account the fact that the real interest rate in the home economy has been pushed up by its lower inflation. To shift
12.4. STABILIZATIONPOLICYFORAMEMBEROFACOMMONCURRENCYAREA27
Fixed exchange rate Permanent aggregate demand shock Flexible exchange rate
( ) ( , , );
, ,
IS A q G
IS A q G′ ′ ″
*r
*π
PR
( )TPC π
y
( , )IS A G′ ′( , )IS A q′
( )tPC π
y
y
π
tπ y
A,Z B
A′
A,Z
1y0y
A′ B
2y
( ) ( , , );
, ,
IS A q G
IS A q G′ ″
*r
Tπ MR
( )TPC π
y
( , )IS A q′ ′( , )IS A q′
( )tPC π
y
y
π
tπ y
A,Z
B
A′
A,Z
1y0y
A′ B
RX 2y
rr
Figure 12.9: Permanent negative aggregate demand shock: comparison between the use of fiscal policy (fixed exchange rates) and monetary policy (flexible exchange rates)
the economy to the new equilibrium at Z, the government adjusts government expenditure each period. Once the economy is at Z, the real exchange rate is depreciated (to q′). The depreciation is not as large as in the flexible rate economy because it only reflects the cumulative inflation differential vis-a-vis the rest of the world: in the flexible exchange rate case, the depreciation consists of the same cumulative inflation differential plus some nominal depreciation. Hence once the member of the common currency area is at the new equilibrium at Z , r = r∗, q′ <q′′ and G′ >G.
The bottom line is that in the face of a permanent negative demand shock, a fixed exchange rate economy that uses exactly the same policy rule as in the flexible exchange rate economy to return inflation to the CCA inflation target – but implements the desired output gaps by using fiscal rather than monetary policy – ends up with a primary budget deficit when it is back in equilibrium, whereas the flexible exchange rate economy does not.
28 CHAPTER 12. A COMMON CURRENCY AREA
12.4.5 Conclusions about stabilization policy under fixed exchange rates or in a common currency area
In response to country-specific shocks, policy-makers in a common currency area or a fixed exchange rate regime
• can choose not to intervene and rather, to rely on the stabilizing mecha- nism of the real exchange rate channel.
• But this may not produce rapid stabilization because of the countervailing operation of the destabilizing real interest rate channel and / or because the operation of the real exchange rate channel is sluggish.
• Hence, the government may use fiscal policy to stabilize.
Our results show that
1. stabilization policy – if it has to be used – is more difficult to manage in a fixed as compared with a flexible exchange rate regime.
2. A fiscal policy rule can be used to stabilize in a fixed exchange rate regime. However, although using the same loss function as in the flexible rate econ- omy will return the economy to a medium-run equilibrium with inflation at world inflation, the economy will not in general return to budget balance.
3. If the government wishes to ensure budget balance at medium-run equi- librium, then its stabilization task is more complex.
For example, in the case of a temporary inflation shock, the government must target the price level rather than the inflation rate. In order for the econ- omy to end up at its initial medium-run equilibrium with budget balance, the government will have to use fiscal policy to push inflation below world inflation for some time so that when the economy is back at equilibrium, the impact of the inflation shock on the real exchange rate has been eliminated. This is what is meant by targeting the price level rather than the inflation rate. To get in- flation below world inflation, a larger drop in output below equilibrium will be required. Similarly in the case of a negative aggregate demand shock, the fiscal policy maker must ensure that the real exchange rate at the new equilibrium is consistent with fiscal balance.
12.5 The supply-side & the operation of a CCA
12.5.1 The role of differences in wage-setting systems in the Eurozone
The role fiscal policy plays in macroeconomic stabilization in a currency union could be shared with or substituted by wages policy or by the kind of coordi- nated wage-setting behaviour discussed in Chapter 15. This possibility depends
12.5. THE SUPPLY-SIDE & THE OPERATION OF A CCA 29
on institutional arrangements for collective bargaining and is relevant in the Eurozone because of the use made of it by the largest economy in the Euro- zone, Germany. In particular, we shall see that Germany’s wage-setting system means that the real exchange rate channel explained in Section 12.4 operates there. This poses particular difficulties for some other member countries in which the real exchange rate channel does not operate as effectively.
As we have seen in Section 12.3, from a macroeconomic perspective, one attraction for a country to join a common currency area with Germany was to acquire a credible commitment to low inflation. However, as noted above, one outcome has been divergent real exchange rates because inflation rates or, more specifically, growth rates of unit labour costs, did not converge rapidly to the ECB’s target and Germany’s inflation was below the target.
Fig. 12.2 shows that from 2000, Germany experienced a substantial real depreciation within the Eurozone. This took place through a combination of restraint in nominal wage growth and more rapid productivity growth than many other member countries. Although this partly reflected the recovery of Germany’s competitiveness, which had been depressed by the consequences of German reunification in the early 1990s, more importantly, it demonstrated the country’s ability to engineer a real depreciation inside the Eurozone when required.
German wage coordination Whilst it does not have a classical flexible labour market, Germany, like some other northern Eurozone members (and some EU countries outside the Eurozone like Sweden and Denmark), has wage- setting institutions that enable it to coordinate nominal wage growth. The role of wage-setting institutions in affecting the WS curve and hence, equilibrium unemployment is discussed in Chapter 3 and extended in Chapter 15. In the 2000s, unions agreed to modest nominal wage increases in multi-year deals, and works councils in large companies negotiated over wage and hours flexibility in exchange for investment by firms in fixed capital and training (e.g. Carlin and Soskice, 2008).
Germany’s model of export-led growth relies on skilled workers in its core manufacturing industries. This places such workers in a strong bargaining po- sition. As a result, unions and employers’ associations in the export sector are important in wage-setting. They play two roles in keeping the export sector competitive. First, agreements between unions and employers’ associations are important in restraining the bargaining power of skilled workers in those indus- tries. Second, they lead the wage-setting round in the economy as a whole so as to ensure that the pace of wage increases is pinned down by the competi- tiveness requirements of the export sector and not by the wage bargains in the non-tradeables parts of the economy, where external pressure to contain cost increases is absent. Coordinated wage-setting in Germany is the outcome of private sector behaviour – it is not the result of government policy.
The German model allows coordinated wage restraint to substitute for the use of stabilizing fiscal policy. To see how coordinated wage-setting works, we
30 CHAPTER 12. A COMMON CURRENCY AREA
can use the example shown in Fig.12.7. The left hand panel can be thought of as representing Germany and the right hand panel, other member countries such as those in the periphery, where inflation expectations are not anchored to the ECB’s inflation target. If there is an inflation shock to each country, the response in Germany is a reduction in wage increases below the ECB’s inflation target in order to restore the real exchange rate to its initial level. This restores competitiveness and the economy returns to equilibrium. Coordinated wage setting can make the real exchange rate channel work.
A country without this kind of wage behaviour may experience destabiliza- tion as shown in the right hand panel of Fig.12.7. To return to equilibrium at the initial real exchange rate, it would have to use tight fiscal policy to imple- ment the large negative output gap associated with the relevant Phillips curve (labelled ‘inflation shock’) sufficient to bring inflation below the target.
To take another example, in the face of a negative aggregate demand shock, Germany is able to achieve a response similar to that under flexible exchange rates whereby demand is stabilized by a real depreciation achieved via wage restraint. Under flexible exchange rates, the real depreciation takes place via a nominal depreciation triggered by a cut in the interest rate. By contrast, as we saw in Fig. 12.9, a Eurozone member without wage coordination can use fiscal policy to stabilize but will need to manage the consequences that arise for the government deficit.
For countries like Germany where the export sector is the dynamic part of the economy, it can be argued that it is important to limit the use of discretionary fiscal policy for stabilization since it weakens the incentive of wage-setters to exercise restraint.
Living in the Eurozone with Germany For other Eurozone members that do not have similar or substitute unit cost control mechanisms, there are serious problems with achieving satisfactory macroeconomic performance. For example, a country entering the Eurozone with a higher growth rate of unit labour costs than the average will suffer from falling competitiveness. An attempt to offset the effects of this on aggregate demand by using expansionary fiscal policy will produce problems of fiscal imbalance. The divergence of real exchange rates that characterized the Eurozone in its first decade reflects both
• the failure of domestic unit cost growth to adjust to the Eurozone inflation average of just above 2% and
• the success of Germany in achieving unit cost growth below 2% p.a.
Given the variation in institutional characteristics among members and Ger- many’s export-oriented growth strategy, this problem is likely to remain a source of tension for the Eurozone.
12.6. WHYISACOUNTRYINACCAVULNERABLETOASOVEREIGNDEBTCRISIS?31
12.6 Why is a country in a CCA vulnerable to a sovereign debt crisis?
In this chapter, we have seen that a country with a fixed exchange rate loses access to the nominal exchange rate as a mechanism for adjustment to shocks and that neither adjustment via domestic wages and prices (the real exchange rate channel) nor via the use of fiscal policy is problem-free. On the other hand, as long as the exchange rate peg is credible as it is by definition in a common currency area, such an economy is free of the disturbances that can come from the foreign exchange market itself. Until 2010, this was a reasonable summary of the issues facing a country deciding whether to adopt a fixed exchange rate, and in particular, whether to join the euro.
The new issue that emerged was familiar to observers of emerging economies but not to those whose expertise was limited to developed countries, like those in the Eurozone. The new issue was the possibility of sovereign default – the inability of the government to honour the repayment of bonds it has issued. The first market signal that there was a problem of sovereign debt in the Eurozone came from the emergence of large interest rate differentials between bonds issued by Germany (and France) and those issued by the periphery countries. This was a new development and followed the collapse of Lehman Brothers in 2008 (see Chapter 8).
During the Eurozone’s first decade, interest rate spreads on government bonds among Eurozone members shrank dramatically. Prior to the formation of the Eurozone, the interest rate differentials reflected both the exchange rate risk and the government default risk. Once inside the Eurozone, the exchange rate risk (e.g. the risk that the Italian lira would depreciate against the German D-Mark) vanished since all members used the euro, leaving only differences in government default risk to account for the variation in interest rates on long- term (e.g. ten year) government bonds.
Extending the uncovered interest parity condition (UIP) to include the risk of a government defaulting on its debt highlights the exchange rate and default risk:
i = i∗ + ( logeE
t+1 − loget
) (UIP condition)
i = i∗ + ( logeE
t+1 − loget
) ︸ ︷︷ ︸ exchange rate risk
+ ρt︸︷︷︸ default risk
, (UIP condition with default risk)
whereρt is the default risk on government debt. The risk-adjusted UIP condition says that home’s interest rate will have to be above the world interest rate to reflect both the expected depreciation of home’s exchange rate and any higher default risk on home’s government debt as compared with the bonds issued by ‘world’. In the Eurozone, the bench-mark government debt is that issued by Germany (so-called German Bunds) and exchange rate risk is zero. Hence the difference between German and e.g. Greek interest rates on 10-year bonds reflects the difference in default risk.
32 CHAPTER 12. A COMMON CURRENCY AREA
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Figure 12.10: Long term interest rate differentials on 10-year government bonds vis-a-vis Germany between 1990 and 2011 Source: OECD (accessed 23rd August 2011)
Fig.12.10 shows the differential between the interest rate on long-term gov- ernment bonds issued by a number of European countries and the German Bund rate. The data include the period before the Eurozone was formed (in 1999). The countries shown include those caught up in the Eurozone crisis of 2010 in addition to France and the UK. The UK is not a member of the Eurozone: its interest differential therefore reflects both the exchange rate and the default premium throughout the period. For the countries (i.e. excluding Greece) who joined the Eurozone when it began, the sharp fall in the interest differential with Germany when the exchange rate parities with the euro were announced in 1998 is clear. The same happened with Greece prior to its entry in 2001.
During the Eurozone’s first decade, interest differentials with Germany on long-term government bonds were very small. How can this be explained?
1. The markets viewed the likelihood of a default by a Eurozone government as being very low. For example, they considered the risk of a systemic banking crisis in a Eurozone member that would require a government rescue of banks as a very low probability event.
2. The markets did not connect the divergent performance among Eurozone members with its possible implications for government solvency.
12.6. WHYISACOUNTRYINACCAVULNERABLETOASOVEREIGNDEBTCRISIS?33
3. The markets did not believe the Eurozone’s ‘no bail-out clause’ and took the view that any problem in one member government’s ability to service its debts would be solved by the ECB and / or by the other Eurozone governments.
When the global financial crisis took hold in 2008 and large banks in small countries (like Ireland) began to fail, this market perception changed dramat- ically. Knowing that governments would rescue solvent but illiquid banks and would bear the burden of restructuring insolvent ones, the markets suddenly began to differentiate between the bonds issued by different Eurozone member governments.
12.6.1 Governancearrangements: banks, governmentsand central bank
At the root of the Eurozone’s vulnerability to a sovereign debt crisis are the relationships among banks, national governments and the ECB. When the Eu- rozone was created, a coherent set of relationships among these three groups that was robust to a financial crisis was not put in place. In discussing the Maastricht policy assignment in Section 12.3.3, we did not mention banks. This was a key omission. In terms of the relationship among member governments and between them and the ECB, the central elements were:
1. Government to government: the ‘no bail out’ clause stated that other member governments could not be called upon to bail out a government in trouble.
2. ECB to government: the ‘no monetary financing’ clause stated that the ECB would not provide credit to governments (it would not be the lender of last resort to governments).
3. The fiscal rules: the entry rules on deficits and debt and the Stability and Growth Pact, which were designed to support (1) and (2).
This governance structure was believed to be sufficient. In particular, it was believed to make a supra-national government redundant. To highlight the problems that have arisen, it is useful to review the relationships among banks, government and central bank in a nation state with an independent central bank.
Fig. 12.11 illustrates the relationships among commercial banks, the gov- ernment and the central bank in a nation state. We begin with the commer- cial banks. In Fig. 12.11, the central bank’s role of lender of last resort (LOLR) to the banking system is represented by the dashed arrows labelled ‘liquidity’. As we have seen in Chapter 6, a key role of the central bank is to provide liquidity in a situation where a bad shock to the economy has raised the possibility that banks may be insolvent (i.e. that their assets are worth less than their liabilities). Under such circumstances, there can be a run on banks
34 CHAPTER 12. A COMMON CURRENCY AREA
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Figure 12.11: Governance arrangements in a nation state Source: adapted from Winckler 2011
as depositors do not want to be the last in line to turn their potentially risky deposits into safe cash.
The institutional response to this source of fragility in the banking system was to create a lender of last resort to the banking system in the form of a central bank. The central bank’s LOLR role to the banking system rests on its judgement that the panic in the market is misplaced: i.e. that the problem is indeed one of liquidity and not of solvency. In the case where a bank is insolvent, the central bank and government work together. The central bank controls the panic by providing liquidity and the government, with its access to tax revenue (current and future), is responsible for the restructuring, recapitalization or orderly closure of the bank. This role is captured in Fig. 12.11 by the solid arrows labelled solvency.
We turn now to the role of the government as borrower. Households and firms make use of banks and the bond market to finance long-term investment projects using shorter-term loans. Governments also borrow shorter-term in the bond market to finance long-term projects. The service provided by banks and the bond markets that allows this is called maturity transformation and whether the borrower can service the debt is called rollover risk. When the government is the borrower, it is relying on its ability to raise tax revenue to provide confidence to the bond market that it will service its debts. It is clear
12.6. WHYISACOUNTRYINACCAVULNERABLETOASOVEREIGNDEBTCRISIS?35
that if the government is being called upon to use tax revenue to support failing banks (or there is a possibility it will have to do so), its ability to service its debt via tax revenue is reduced. This highlights the interconnection between the banks, the government and the bond market. We can see the parallel with the ‘last in line’ liquidity problem for banks: if fear emerges that the government will not be able to service its debts, holders of bonds will sell them, prices will fall and, reflecting the rise in the risk premium, interest rates will rise.
How can this be prevented? If the central bank is the lender of last resort to the government, it can be relied on to step in and buy government bonds. How is this possible and why would the central bank do this? The parallel with the case of banks is again useful. If we assume that the flight from government bonds is inconsistent with the underlying ability of the government to service its debts (i.e. the government is solvent) then the government is suffering from a liquidity problem. The central bank can step in by printing money (just as it does in the case of dealing with the liquidity problem of the banking system) and buy government bonds. The central bank would end up with more government bonds on its balance sheet and the counterpart on the liability side is an increase in high-powered money. The mutual support of the government and central bank for each other – the taxpayer base is the ultimate guarantee of the solvency of the government and of the central bank’s ability to buy government bonds in unlimited quantities (LOLR) – is shown by the double-ended arrow in the diagram. This means that even when the market has doubts about the solvency of the government, the existence of the LOLR prevents runs on government bonds. When this structure of mutual confidence breaks down, the economy can plunge into hyperinflation as discussed in Chapter 14.
Comparison between a country with an independent central bank and a Eurozone member
We can now compare the situation of a country with an independent central bank with that of a member of the Eurozone. Fig. 12.12 illustrates this case. Once again, we begin with the banks. Once the financial crisis began, the ECB played the role of lender of last resort to the banks of member countries. Just like the Bank of England and the Federal Reserve, the ECB made liquidity available to banks in unlimited amounts, as highlighted by (then President of the ECB) Jean-Claude Trichet in a speech in April 2009 (at the nadir of the global financial crisis)13:
Our primary concern was to maintain the availability of credit for households and companies at accessible rates. We significantly adapted our regular operations in the crisis. Since then, we have followed a new “fixed rate full allotment” tender procedure and we have signif- icantly expanded the maturity of our operations. This means that
13Excerpt taken from. Jean-Claude Trichet, 27th April 2009, The financial crisis and our response so far, keynote address at the Chatham House Global Financial Forum
36 CHAPTER 12. A COMMON CURRENCY AREA
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banks have been granted access to essentially unlimited liquidity at our policy interest rate at maturities of up to six months.
In the Eurozone, responsibility for dealing with insolvent banks rests with member country governments. This meant that governments had to use national borrowing to pay for the recapitalization of banks headquartered in their country during the global financial crisis. The burden on governments increased (just as it did in the US and the UK, for example). However, the big difference is that for a Eurozone member, it could not rely on a lender of last resort to support its bond sales if required. There was no central bank that would – in extremis – purchase its bonds. There are two aspects to this: first, the member country issues bonds in a currency (the euro) that it does not control and second, the central bank that issues the euros (the ECB) is prevented by its mandate from acting as lender of last resort to the governments of member states.
This created the fear of the illiquidity of the government, i.e. that it would not be able to rollover its debts as they came due. As a result, interest rates on government bonds increased. We can see the same element of self-fulfilling prophecy here as arises in the case of a bank run: even if the bank is solvent, once doubts emerge, fears about liquidity arise, panic begins and depositor behaviour can produce insolvency. The circuit can be interrupted by the existence of a
12.6. WHYISACOUNTRYINACCAVULNERABLETOASOVEREIGNDEBTCRISIS?37
LOLR quashing liquidity fears. Similarly, in the bond market, a LOLR to the government can prevent the negative feedback loop from taking hold. [Box - Spain and the UK: To highlight the difference between the risk of sovereign default between a
country inside and outside the common currency area it is useful to compare Spain and the UK. In this box, we show that on the basis of the determinants of government solvency, there was little to separate these two countries. However, interest rates on 10-year government bonds in Spain at the end of November 2011 were 6.5% whilst they were 2.3% in the UK.
Table 12.2 compares the two countries and shows that the UK government was more indebted than Spain in 2010. GDP growth forecasts in the two coun- tries are broadly similar, with Spain expected to grow slightly more slowly in 2012 and 2013.
Table 12.2: Macroeconomic and government finance indicators for the UK and Spain Source: OECD Economic Outlook, December 2011
Variable Year Spain UK General government underlying primary balances (as a % of poten- tial GDP)
2010 -5.6 -5.5
Maastricht definition of general government gross public debt (as a % of nominal GDP)
2010 61 79.9
Real GDP growth (%, forecast) 2012f 0.3 0.5 Real GDP growth (%, forecast) 2013f 1.3 1.8 10-year government bond yields (%) 2010 4.3 3.6 10-year government bond yields (%, forecast) 2011f 5.4 3.1
Given these figures, we would expect both countries to have similar 10-year government bond yields (i.e. default risks), but this is not the case. We can see from Table 12.2, that Spanish bond yields were higher than the UK’s for 2010. We can also see that the UK’s cost of borrowing fell in 2011, whilst the Spain’s continued to rise, culminating in interest rates on Spanish bonds being 2.3 percentage points higher than those on UK bonds (on average) over 2011. This apparent inconsistency between government solvency and perceived sovereign default risk is summed up by Pisani-Ferry (2012):
"This comparison is prima facie evidence that the fiscal situation per se fails to explain tension in the euro-area government bond markets. Or, to put it slightly differently, although their levels of deficit and public debt are the same, euro-area countries seem to be more vulnerable to fiscal crises than non-euro area countries."
As we saw in Chapter 10, in the 1990s Spain and the UK both solved their high inflation problem by adopting a new monetary policy regime: the UK
38 CHAPTER 12. A COMMON CURRENCY AREA
chose to establish a credible monetary policy through inflation-targeting and an independent central bank and Spain chose to borrow credible monetary policy by giving up its exchange rate and joining the Eurozone. Both countries enjoyed buoyant domestic economies in the 2000s and both suffered bank failures and the subsequent deterioration of the public finances in the global financial crisis. Yet Spain faced much higher interest rates on government borrowing than the UK and was identified in 2011 as one of the so-called PIIGS, a Eurozone economy threatened by a sovereign debt crisis.
In Paul De Grauwe’s 2011 paper, he suggests that this is a consequence of Spain entering the European Monetary Union and the UK not doing so. The argument follows that when Spain adopted the euro, it lost control over the currency it issued debt in, which meant that the financial markets could force the Spanish sovereign into default (or at least cause a sovereign liquidity crisis). De Grauwe highlights two important factors that make the UK less vulnerable to being forced into default by financial markets than a eurozone country (in a similar fiscal situation). Firstly, the UK has a freely floating exchange rate, which will depreciate if government bonds are sold off. This should help to raise growth and increase inflation, both of which are positive for debt dynamics. Secondly, if the UK cannot roll over its debts at a reasonable interest rate, then it could force the Bank of England (in its role as LOLR) to buy government securities. In summary, De Grauwe places a lot of emphasis on the governance structure of the Eurozone (and particularly the lack of a credible LOLR to member governments) as the reason for seemingly solvent Eurozone governments (e.g. Spain and Italy) ending up in liquidity crises. Box ends]
12.6.2 Comparison between the Eurozone and USA
Both for understanding the problems in the Eurozone and for thinking about reforms, it is helpful to compare the governance arrangements in the USA and in the Eurozone. The US is a federal system and parallels can be drawn between the US states and the member countries of the Eurozone. In the USA,
• the Federal Reserve stabilizes common shocks, is responsible for financial stability and is the lender of last resort to the federal government and to the banking system.
• The federal budget provides stabilization to the states in the face of asym- metric shocks through the federal budget (e.g. federal contributions to unemployment benefit and federal taxes). In the US, stabilization of state- specific aggregate demand shocks through federal taxes and transfers lies between 10 and 20% (Melitz and Zumer, 2002).
• The states have balanced budget rules.
• The failure of a bank headquartered in a state is not the responsibility of the state but of the federal regulators and the federal government.
12.6. WHYISACOUNTRYINACCAVULNERABLETOASOVEREIGNDEBTCRISIS?39
• The federal government does not bail out delinquent states – they are allowed to default.
In the Eurozone,
• the ECB stabilizes common shocks and, as has been demonstrated by its actions in the financial crisis, is the lender of last resort to the banking system (although this was not explicitly part of the Maastricht Treaty). However, it is not responsible for financial stability and is not the lender of last resort to member governments.
• There is no federal government and no stabilization through the EU budget (it is too small).
• Member countries have national fiscal autonomy subject to rules (i.e. the SGP).
• The failure of a bank headquartered in a member country is the responsi- bility of the country and not of Eurozone federal regulators or a Eurozone government (there is no Eurozone government)
• Member governments are bailed out (e.g. bailouts were provided for Greece, Ireland and Portugal).
In conjunction with Figs. 12.11 and 12.12, this comparison between the US and the Eurozone highlights the incoherence of the Eurozone governance structure. In addition, the analysis presented in this section so far suggests that the problems brought to the fore by the financial crisis involve three key parties: banks, governments and the central bank.
Bank problems Given its mandate, the ECB concentrated on supporting the European banking system during the global financial crisis (and more recently during the sovereign debt crisis). This approach is helpful to the extent that the problems of European banks are ones of liquidity and not solvency. But if it postpones the required cleaning up of insolvent banks, it is only a holding mechanism. The delicate balancing act reflects the close relationship between the health of the banks and of governments in the Eurozone.
In the Eurozone, banks are major holders of government bonds. For example, the percentage of national government bonds that were held by domestic banks in Spain, Italy and Germany were 28.3%, 27.3% and 22.9% respectively in mid- 2011. The equivalent figure for the UK was 10.7% and for the US was just 2%. The close ties between the governments and the banks in the Eurozone adds to the vulnerability of the system. When government bond prices fall, bank solvency is in question; in turn, when banks are more likely to be insolvent, the contingent liabilities of the government (to recapitalize and restructure them) rise and government solvency comes into question.
The absence of a pan-European or Eurozone bank resolution scheme meant countries were faced with dealing with bank solvency on their own. The fact
40 CHAPTER 12. A COMMON CURRENCY AREA
that banks were often large relative to the size of the country helped turn the bank solvency issue into a sovereign debt problem. For example, the Irish com- mercial bank, Bank of Ireland had total assets that were equal to 99% of Irish GDP in 2007. This can be compared to Bank of America that had total assets that were equal to only 12% of US GDP in the same year. This meant that the US government could bail out Bank of America (BoA) and other financial institutions without the government finances becoming unsustainable, this was not the case in Ireland and would not have been the case had North Carolina (the US state where BoA is headquartered) been responsible for bailing out BoA – BoA had total assets equal to 431% of North Carolina’s GDP in 200714.
A second difficulty faced in the Eurozone arises because of the presence of cross-border banks, where two (or more) national governments are responsible for dealing with solvency issues. This is illustrated by the inclusion of a cross- border bank in Fig. 12.12. We can see from the figure, that two member governments are jointly responsible for the restructuring, recapitalisation or orderly closure of the cross-border bank (as indicated by the solid ‘solvency’ arrows).
In the US, the federal government’s responsibility for the solvency of banks meant that although the liquidity support to the banks from the Fed quelled the panic, the government moved swiftly to recapitalize the banks through the TARP schemes (see Chapter 8 for a more detailed discussion of the government response to the bank solvency crisis).
Government problems Governments of Eurozone countries have high levels of debt as compared with states in the US. This reflects the fact that the US is a federal system. The nation is the major fiscal policy player in both cases: the federal government in the US and the member countries in the Eurozone. The upper panel of Fig. 12.13 compares the debt to GDP ratios of the US and the Eurozone member countries as a whole in 2010. In contrast, the lower panel shows how the debts of the individual Eurozone countries compare to Eurozone GDP and how the debts of the individual US states compare to US GDP just before the onset of the financial crisis.
From the upper panel of Fig. 12.13, we see that the aggregate public debt burden of the US is comparable to that of the Eurozone. The key difference is that this is federal debt in the USA and member country debt in the Eurozone. This has major consequences for the resilience of the governance mechanism. If a state – even a large one like California – in the US defaults, this represents a small shock to US GDP. As the lower panel of Fig. 12.13 shows, this is not the case in the Eurozone.
14These figures were calculated by the authors in March 2012 using data from the 2007 annual reports of Bank of Ireland (BoI) and Bank of America (BoA), the IMF World Economic Outlook Database and the US BEA. The figures for total assets for BoI are as of March 31st 2007 and for BoA are as of December 31st 2007. GDP data for all regions are in current prices and for 2007.
12.6. WHYISACOUNTRYINACCAVULNERABLETOASOVEREIGNDEBTCRISIS?41
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2012), US Census Bureau, 2007 Census of Governments
12.6.3 Governance solutions
Creating a coherent governance structure for a common currency area requires addressing the interconnection among banks, governments and the central bank. The distance between the existing governance arrangements in the Eurozone and in the USA suggests that adoption of the US arrangements would be very diffi- cult. The fact that the Eurozone is a set of independent nations raises important political obstacles to a number of elements of the US structure – most obvi- ously, the role of the large federal budget in buttressing the US set-up. In the US, national solidarity lies behind the large federal budget and the commitment of the federal government to deal with insolvent banks. Limits on the extent to which states can inflict damage on other states through fiscal profligacy are re- flected in the balanced budget laws in most states, in the correspondingly small levels of state debt and in the credible commitment of the federal government not to bail out a state.
42 CHAPTER 12. A COMMON CURRENCY AREA
The US states balance their budgets for current expenditure and issue bonds to finance investment projects. There has been a long tradition of the federal government not bailing out individual states when they are in fiscal distress. The ‘no bail out’ began with the state fiscal crises of the 1840s and continued with the famous refusal of President Ford to rescue New York City and New York State in 1974. In fact, in most cases where individual states have got into fiscal distress, the federal government did not bail them out (Melitz, 2010).
In the Eurozone, there is no natural solidarity across member countries com- parable to that in a nation state. There is wide variation in political traditions and in the role of the state among member countries. There is no basis for pan- Eurozone solidarity that would permit a large federal budget (with transfers stabilizing member country shocks), federal responsibility for banks and a fed- eral lender of last resort. The Eurozone requires a different governance solution from that of a federal country.
In the absence of pan-Eurozone solidarity, at the heart of the Eurozone’s governance problem is a concern about moral hazard. Although mechanisms to ensure coherent governance might prevent financial crisis, they will invite behaviour that makes crisis more likely. (This is a version of the moral hazard problem we discussed in relation to bank regulation in Chapter 7). Citizens of one country are worried that they will be required to foot the bill because of lack of discipline (the operation of moral hazard) in another part of the CCA. The restrictions that prevent the ECB from being the lender of last resort to governments stem from this fear, as do the original ‘no bail out’ restrictions on transfers between countries. Opposition to the issuing of Eurobonds guaranteed by the collective of Eurozone members arises from exactly the same fear.
The response of the Eurozone governments to the need for a coherent gover- nance structure has focused on one of the many interconnected issues: namely, imposing constraints on government deficits and debt with external (i.e. supra- national) surveillance. The approach concentrates on government budgets in the belief that if the fear of insolvency can be removed, the pressure on government bonds will dissipate. It rests on the success
• with which the ECB’s provision of liquidity to the banking system keeps banks from failing, and
• of the bail-out countries in meeting the conditions imposed on them and eventually returning to self-sustaining growth.
12.7 Conclusions
In this chapter, the successes and failures of the Eurozone as a common currency area have been explained. The successful creation of an independent inflation- targeting central bank was illustrated in its performance in the period up to the crisis; the ECB has also steered the eurozone through the much more challenging period of the global financial crisis.
12.7. CONCLUSIONS 43
The ECB’s success in achieving low and stable inflation during the Euro- zone’s first ten years did, however, disguise the build up of dangerous imbal- ances. The economic performance and external competitiveness of the member economies diverged during this period, culminating in the accumulation of large current account imbalances. The Southern European economies and Ireland built up large current account deficits, whilst Germany and the Northern Euro- pean economies ran persistent surpluses. A current account deficit means that a country is borrowing from the rest of the world. This borrowing can take place through the government, the private sector, or both. In Spain and Ireland, the deficits reflected a credit-induced private sector boom, whereas the Greek and Italian deficits reflected government profligacy.
These current account deficits were not the benign reflection of intertem- poral optimization of the kind discussed in Chapter 11 and made Ireland and the Southern European countries vulnerable to a sovereign debt crisis, through their effects on the fiscal position of member governments. This was both di- rectly, through excessive government spending putting government debt on an unsustainable path (e.g. Greece), or indirectly, as sovereigns were forced to take on the debts of their banks following the bursting of the private sector (espe- cially property) bubble (e.g. Ireland). In contrast, in Germany, large current account surpluses in the 2000s reflected low growth accompanied by substantial restructuring in the core export sector and the associated significant real de- preciation. The latter was aided by the high level of wage coordination in the German tradeables sector, which helped to hold down nominal wage growth.
Although it was widely agreed that the Eurozone was not an optimal cur- rency area at its formation, some observers thought it would evolve towards one. This was not the case in the first decade. Neither labour mobility nor wage- flexibility responded sufficiently to the new ‘no exchange rate depreciation’ envi- ronment. Deep-seated differences in language and professional accreditation, as well as in the functioning of labour and housing markets inhibited adjustment.
Stabilization policy is more difficult to implement in a common currency area because it requires the use of fiscal rather than monetary policy. The use of fiscal policy to stabilise country-specific economic shocks (e.g. positive inflation or negative demand shocks) imposes a larger cost on the economy than using monetary policy, due to the build up of budget deficits.
In an attempt to avoid the spillovers to the monetary union of potentially destabilising budget deficits, the European Commission required all euro area countries to sign up to the Stability and Growth Pact. Almost since its incep- tion, the Eurozone economies failed to operate within the fiscal rules set out in the Pact.
In the first ten years of the Eurozone, fiscal policy was not used actively to cool overheating economies (e.g. Ireland). Without stabilization policy, the real interest rate channel was destabilizing. Bubbles developed and the pre- conditions for a banking crisis were put in place.
The governance structure of the Eurozone also makes it more susceptible to sovereign debt crises. In contrast to a nation state with an independent inflation-targeting central bank, there is no lender of last resort to member
44 CHAPTER 12. A COMMON CURRENCY AREA
governments in the Eurozone. In joining the euro, member countries necessarily give up control over the currency they issue their debt in. This means that the financial markets can more easily force them into default (or at least induce a liquidity crisis). There is at present no easy solution for resolving the governance problem in the Eurozone. One potential solution would be move towards a closer political and fiscal union, such as that in place in the United States. However, the comparison with the US highlights the challenges the Eurozone faces: the gap between current arrangements and those of a political and fiscal union is large.
The management and regulation of the Eurozone’s banking system also needs to be reassessed in the wake of the global financial crisis. At present, member governments are responsible for the solvency of banks headquartered in their country, even if they are cross-border. This leaves the health of sovereigns very intertwined with that of their banks. This systemic weakness could potentially be alleviated through the creation of a credible pan-European or Eurozone bank resolution scheme.
The imbalances that built up in the first ten years of the single currency contributed to the sovereign debt crisis of 2010-11, as did the governance struc- ture of the EMU. We return to the Eurozone crisis in Chapter 19, but at this stage, we can see that the currency union faces serious problems in both the short-term and the long-term, such as:
• creating fiscal rules that prevent spillovers to other members, but allow for stabilization,
• the management of the banking sector,
• the lack of a credible lender of last resort to member governments; and
• the longer term problems of re-establishing and then sustaining the com- petitiveness of some of its members.
12.8 Questions
12.8.1 Checklist questions
1. Explain the factors that contributed to the difference in inflation rates between Germany and Spain between 1999 and 2008. What effect did this differential have on the external competitiveness of these two economies?
2. What are the microeconomic benefits of a currency union?
3. Use the mathematical relationship between the government budget deficit and debt ratios from Section 12.3.5 to find the level of real GDP growth that is required to keep debt constant if a country is at the maximum level of debt and deficit allowed under the Stability and Growth pact.
12.8. QUESTIONS 45
4. Use your knowledge of common currency areas (CCAs) to assess whether the following statements (S1 and S2) are both true or whether only one of them is true. Justify your answer:
S1. If country A in a common currency area undertakes an expansionary fiscal policy then they can reduce the unemployment rate.
S2. The rate of unemployment in country A will be reduced even more should the other countries in the union also undertake expansionary fiscal policy.
5. How could the 2-bloc model from Chapter 11 be used to shed light on the economic divergence between the Northern and Southern European countries during the first ten years of the single currency? Explain in words.
6. What is the Walters’ critique and why was it used as an argument for the UK not joining the single currency?
7. Explain the difference between the real exchange rate channel and the real interest rate channel. Which of these channels has to dominate for the economy to revert to equilibrium after a shock without any active policy response?
8. Use the three equation model to show how fiscal policy can be used to stabilize the economy after a positive demand shock in a country that is a member of a CCA. What affect does this have on the budget balance?
9. Use an AD − ERU diagram to show the new medium run equilibrium of a fixed exchange rate and a flexible exchange rate economy following a negative demand shock. Assume that the fixed exchange rate economy uses fiscal policy as a stabilization tool. What are the differences in y, q and G between the two economies in the new medium run equilibrium?
10. What are the key differences in the fiscal design of the Euro area and the United States? Does the US federal government or the European parliament play the largest role in stabilizing their respective economies through the use of fiscal policy?
11. What are the costs and benefits for a government under stress in bond markets of defaulting on their sovereign debt?
12.8.2 Problems and questions for discussion
1. ‘The ECB’s success in achieving low and stable inflation during the Euro- zone’s first decade disguised the build-up of dangerous imbalances among the members.’
Provide an explanation and assessment of the claims in this statement.
Use the models presented in Chapters 9-12 to
46 CHAPTER 12. A COMMON CURRENCY AREA
a) Discuss reasons why countries that wish to achieve low inflation may join a common currency area. Discuss how the ECB achieved its inflation objective.
b) Explain what could be meant by ‘dangerous imbalances’ among the members.
c) Use the AD−BT−ERU model to explain how imbalances could occur consistent with the ECB achieving its inflation target. Relate this to the performance of specific countries.
2. For this question use the national accounts data available from Eurostat.
a) Compare the composition of GDP (in current prices) in the PIGS (i.e. Portugal, Ireland, Greece and Spain). [TIP: Use current price GDP data to find the following types of expenditure as a percentage of GDP for each of the four countries: C = household consumption, I = gross fixed capital formation, G = government spending, X = exports and M = imports.]
b) Does the above have any bearing on the argument for any of these countries leaving the single European currency?
c) In the years preceding the recession, how much of PIGS economic output came from the construction industry?
d) How much did this change after the recession (i.e. 2010) and what were the macroeconomic consequences of this shift?
3. For this question use data from the European Commission on the Stability and Growth pact. Pick a Eurozone country.
a) Has this country breached the fiscal rules of the euro area? If so, how many times?
b) What were the reasons given for the breaches and what were the con- sequences?
c) Do you agree with the actions taken by the EC? Were the punishments severe enough to stop further breaches?
4. When joining a common currency area each country relinquishes the use of monetary policy.
a) Explain how fiscal policy can be used as a substitute when undertaking stabilization policy. Use the 3 equation model to provide an example.
b) Are there any drawbacks to stabilizing using fiscal policy?
c) What advantages have euro area economies gained by having an inde- pendent monetary authority? Give an example of a country where this has been particularly important.
5. The Euro cannot survive without a closer political and fiscal union. Dis- cuss.
12.8. QUESTIONS 47
6. This question uses the Macroeconomic Simulator available from the Carlin and Soskice website [insert web address] to show the destabilising real in- terest rate channel. Begin by opening the simulator and selecting the open economy (fixed exchange rates without endogenous fiscal policy) version. Then reset all shocks by pressing the appropriate button on the left hand side of the main page. Use the simulator and the content of this chapter to work through the following questions:
a. Apply a 2% inflation shock.
b. Use the impulse response functions to describe the path of the economy after the shock.
c. Is the economy self-stabilising in this scenario?
d. Use the 3-equation model to explain how the real interest rate channel can lead to this outcome.
7. This question uses the Macroeconomic Simulator available from the Car- lin and Soskice website [insert web address] to compare the effects of a negative demand shock in two economies; one with a fixed exchange rate regime and one with a flexible exchange rate regime. Begin by opening the simulator and selecting the open economy (flexible exchange rate) version. Then reset all shocks by pressing the appropriate button on the left hand side of the main page. Use the simulator and the content of Chapters 9-12 to work through the following questions:
a. Apply a 2% negative demand shock (i.e. -2%). Save your data.
b. Switch to the open economy (fixed exchange rates without endogenous fiscal policy) version of the simulator by pressing the relevant button on the left of the main page. Set the degree of inflation inertia to 0.2. Apply a 2% negative demand shock (i.e. -2%). Save your data.
c. How long does it take for the economy to return to medium-run equilibrium in each case? Why is the speed of adjustment different?
d. Can fiscal policy be used in the fixed exchange rate case to speed up the adjustment? Are there any disadvantages of doing this? Suggest a real world setting in which you could you apply this analysis? (Hint: what happens to the adjustment of the economy in the simulator if public expenditure is permanently increased by 1.5%?)