Euro and Euro Crisis
Euro and Euro Crisis
Lecture 12
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FINC5090 Finance in The Global Economy
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Lecture 12 Euro and euro crisis
The European Union and the European Monetary System
Theory of optimal currency areas
Is the EU an optimal currency area?
Other considerations of an economic and monetary union
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1. The EU and EMS (EMU)
What is the EU?
The European Union is a system of international institutions, the first of which originated in 1957, which now represents 27 European countries through the following bodies:
European Parliament: elected by citizens of member countries
Council of the European Union: appointed by governments
of the member countries
European Commission: executive body
Court of Justice: interprets EU law
European Central Bank, which conducts monetary policy through a system of member country banks called the European System of Central Banks
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1. The EU and EMS (EMU)
What is the EMS?
The European Monetary System was originally a system of fixed exchange rates implemented in 1979 through an exchange rate mechanism (ERM).
The EMS has since developed into an economic and monetary union (EMU), a more extensive system of coordinated economic and monetary policies.
The EMS has replaced the exchange rate mechanism for most members with a common currency under the economic and monetary union.
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1. The EU and EMS (EMU): membership of the EMU
To be part of the economic and monetary union, EMS members must
adhere to the ERM: exchange rates were fixed in specified bands around a target exchange rate.
follow restrained fiscal and monetary policies as determined by Council of the European Union and the European Central Bank.
replace the national currency with the euro, whose circulation is determined by the European System of Central Banks.
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Which countries use the euro in 2020?
https://www.polgeonow.com/2014/08/map-which-countries-use-euro-plus-this.html
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1. The EU and EMS (EMU): the EMS between 1979 and 1998
From 1979 to 1993, the EMS defined the exchange rate mechanism to allow most currencies to fluctuate +/−2.25% around target exchange rates.
But because of differences in monetary and fiscal policies across the EMS, market participants began buying German assets (because of high German interest rates) and selling other EMS assets.
As a result, the exchange rate mechanism was redefined in 1993 to allow for bands of +/−15% of the target value in order devalue many currencies relative to the deutschemark.
Eventually, each EMS member adopted similarly restrained fiscal and monetary policies, and the inflation rates in the EMS eventually converged (and speculation slowed or stopped).
In effect, EMS members were following the restrained monetary policies of Germany, which has traditionally had low inflation.
Under the EMS exchange rate mechanism of fixed bands, Germany was “exporting” its monetary policy.
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Inflation convergence for six original EMS members 1978-2015
Shown are the differences between domestic inflation and German inflation for six of the original EMS members: Belgium, Denmark, France, Ireland, Italy, and the Netherlands.
Source: CPI inflation rates from International Monetary Fund, International Financial Statistics, and BLS.
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1. The EU and EMS (EMU): the Maastricht Treaty
The Maastricht Treaty, proposed in 1991, required the 3 provisions to transform the EMS into an economic and monetary union.
attain exchange rate stability defined by the ERM before adopting the euro.
attain price stability: a maximum inflation rate of
1.5% above the average of the three lowest national inflation rates among EU members.
maintain a restrictive fiscal policy:
a maximum ratio of government deficit to GDP of 3%.
a maximum ratio of government debt to GDP of 60%.
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1. The EU and EMS (EMU): the Euro
The euro was adopted in 1999, and the previous exchange rate mechanism became obsolete.
But a new exchange rate mechanism—ERM 2—was established between the economic and monetary union and outside countries.
It allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union in the future to maintain stable exchange rates before doing so.
It allowed EU members outside of the economic and monetary union to maintain fixed exchange rates if desired.
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1. Theory of optimal currency areas
The theory of optimum currency areas argues that the optimal area for a system of fixed exchange rates, or a common currency, is one that is highly economically integrated.
economic integration means free flows of
goods and services (trade)
financial capital (assets) and physical capital
workers/labor (immigration and emigration)
The theory was developed by in 1961.
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2. Theory of optimal currency areas
Fixed exchange rates have costs and benefits for countries deciding whether to adhere to them.
Benefits of fixed exchange rates are that they avoid the uncertainty and international transaction costs that floating exchange rates involve.
The gain that would occur if a country joined a fixed exchange rate system is called the monetary efficiency gain.
Costs of fixed exchange rates are that they require the loss of monetary policy for stabilizing output and employment, and the loss of automatic adjustment of exchange rates to changes in aggregate demand.
Define this loss that would occur if a country joined a fixed exchange rate system as the economic stability loss.
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2. Theory of optimal currency areas: monetary efficiency gain
Joining fixed exchange rate system would be beneficial for a country if
trade is extensive between it and member countries, because transaction costs would be greatly reduced.
financial assets flow freely between it and member countries, because the uncertainty about rates of return would be greatly reduced.
people migrate freely between it and member countries, because the uncertainty about the purchasing power of wages would be greatly reduced.
In general, as the degree of economic integration increases, the monetary efficiency gain increases.
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2. Theory of optimal currency areas: economic stability loss
The economic stability loss of joining a fixed exchange rate system also depends on the amount of economic integration.
After joining a fixed exchange rate system, if the new member faces a fall in aggregate demand:
Relative prices will tend to fall, which will lead other members to increase aggregate demand greatly if economic integration is extensive, so that the economic loss is not as great.
Financial assets or labor will migrate to areas with higher returns or wages if economic integration is extensive, so that the economic loss is not as great.
The loss of the automatic adjustment of flexible exchange rates is not as great if goods and services markets are integrated*.
In general, as the degree of economic integration increases, the economic stability loss decreases.
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*Consider what would have happened if the country did not join the fixed exchange rate system:
the automatic adjustment would have caused a depreciation of the domestic currency and an appreciation of foreign currencies, which would have caused an increase in many prices for domestic consumers when goods and services markets are integrated.
2. A model of money market: deciding when to peg the exchange rate
The upward-sloping GG schedule shows that a country’s monetary efficiency gain from joining a fixed exchange rate area rises as the country’s economic integration with the area rises.
The downward-sloping LL schedule shows that a country’s economic stability loss from joining a fixed exchange rate area falls as the country’s economic integration with the area rises.
The intersection of GG and LL at point 1 determines a critical level of economic integration, 1, between a fixed exchange rate area and a country considering whether to join. At any level of integration above 1, the decision to join yields positive net economic benefits to the joining country.
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3. Is the EU an optimal currency area?
If the EU/EMS/EMU can be expected to benefit members, we expect that its members have a high degree of economic integration:
large trade volumes as a fraction of GDP
a large amount of foreign financial investment and foreign direct investment relative to total investment
a large amount of migration across borders as a fraction of total labor force
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3. Is the EU an optimal currency area?
Widely divergent unemployment rates moved closer together after the euro’s launch in 1999 but since the late 2000s have moved sharply apart.
Source: International Monetary Fund, World Economic Outlook database, April 2016. Numbers for 2016 are IMF forecasts.
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3. Is the EU an optimal currency area?
Deviations from the law of one price also occur in many EU markets.
If EU markets were greatly integrated, then the (currency-adjusted) prices of goods and services should be nearly the same across markets.
The price of the same BMW car varies 29.5% between British and Dutch markets.
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3. Is the EU an optimal currency area?
Regional migration is not extensive in the EU.
Europe has many languages and cultures, which hinder migration and labor mobility.
Unions and regulations also impede labor movements between industries and countries.
Differences of U.S. unemployment rates across regions are smaller and less persistent than differences of national unemployment rates in the EU, indicating a lack of EU labor mobility.
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3. Is the EU an optimal currency area?
There is evidence that financial assets were able to move more freely within the EU after 1992 and 1999.
But capital mobility without labor mobility can make the economic stability loss greater.
After a reduction of aggregate demand in a particular EU country, financial assets could be easily transferred elsewhere while labor is stuck.
The loss of financial assets could further reduce production and employment.
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3. Is the EU an optimal currency area?
Europe is not an optimum currency area. Therefore, asymmetric economic developments within different countries of the euro zone – developments that might well call for different national interest rates under a regime of individual national currencies – will remain hard to handle through monetary policy.
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4. The Euro crisis： the tinder
Late in 2009, the euro zone entered a new crisis so severe as to threaten its continuing existence.
The tinder:
Banks in the euro zone expanded their balance sheets through purchases of U.S credit-backed products and through lending to other euro zone countries: taking greater risk in searching for profits.
Individual banks had become “too large to save”.
Spread between the government judged most creditworthy (e.g. Germany) by rating agencies and the least creditworthy (e.g. Greece) became very small, encouraging more spending and borrowing in countries including Greece, Portugal and Spain.
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4. The Euro crisis： the tinder (cont.)
Higher spending also resulted in higher inflation in the euro zone periphery (e.g. Ireland, Portugal, Spain and Greece) relative to the German level. With higher inflation than Germany’s, but essentially equal bond rates, these countries had lower real interest rates during the mid-2000s, a factor that spurred spending and inflation even further.
The low real interest rates caused the currencies of these countries to appreciate in real terms, resulting in current account deficit, higher foreign debts, deteriorating the debt serving ability of the governments.
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4. The Euro crisis： the spark
The fiscal problem of Greek government: a fiscal deficit around 12.7% of GDP was uncovered by the new government in 2009, double the size announced by the previous government.
The downgrading of Greek government debt made investors to worry that other deficit countries might face similar problems. World stock markets plunged as the prospect of a much wider crisis in Europe grew.
Countries using the euro cannot print money (a function of ECB) to pay off their debts. If these countries are unable to raise taxes or cut spending sufficiently, they will default.
During the GFC, many European banks fell in trouble due to their exposure to the US real estate markets. The fiscal crisis of European countries and the consequential decrease in the value of their government bonds caused the bank assets and capital to reduce.
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4. The Euro crisis： the spark
The doom loop: the perilous state of each government’s credit weakened the solvency of domestic banks and the weakened state of the banks strongly reinforced the likelihood of government default (e.g. governments have to borrow more money to support the local banks).
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Figure 21.8 Nominal Government Borrowing Spreads over Germany
Euro countries’ long-term government bond yields converged to Germany’s level as they prepared to join the euro. The yields began to diverge again with the global financial crisis of 2007–2009 and moved sharply apart after the euro crisis broke out late in 2009.
Source: Datastream. Ten-year government bond interest rates.
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Table 21.4 Current Account Balances of Euro Zone Countries, 2005–2009 (percent of GDP)
blank Greece Ireland Italy Portugal Spain Germany
2005 −7.5 −3.5 −1.7 −9.4 −7.4 5.1
2006 −11.2 −4.1 −2.6 −9.9 −9.0 6.5
2007 −14.4 −5.3 −2.4 −9.4 −10.0 7.6
2008 −14.6 −5.3 −2.6 −12.0 −9.8 6.7
2009 −11.2 −2.9 −3.1 −10.3 −5.4 5.0
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Figure 21.11 Gross Public Debt to GDP Ratios in the Euro Area
Source: International Monetary Fund.
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5. The future of EMU
In most EU countries, labor markets remain highly unionized and subject to employment taxes and regulations that impede labor mobility between industries and regions. The result has been persistently high levels of unemployment. Unless labor markets become much more flexible, individual euro zone countries will have a hard time adjusting toward full employment and competitive real exchange rates. Other structural problems also abound.
Thus, the euro faces significant challenges in the years ahead
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The influence of Brexit
Brexit does not have immediate implications for the size of the euro area or for its trade and foreign investment flows. Since investment and trade with the UK are much less important for the euro area than vice versa, powerful implications for the euro area’s rate of economic growth are unlikely.
there were worries in 2016 that Brexit would unleash a cascade of exits from the EU, undermining confidence in and the stability of the latter. This scenario has not come to pass. If anything, the difficulty of Britain’s exit negotiations serves as a deterrent. Insofar as this has reduced rather than amplifying worries about the integrity and stability of the euro area, it may have modestly enhanced the euro’s attractions as an international currency.
(Eichengreen, 2019 https://link.springer.com/article/10.1007/s10368-018-0422-x)
5. The future of EMU
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Final examination
Type: ProctorU Review+ online open-book exam (restricted open-book, an A4 size double-sided cheat sheet is allowed to be used during the exam)
Duration: 2 hours+10 minutes reading time
Time: 22 June 2021, Tuesday 13:00 (please confirm in your student system)
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Final examination
Permitted materials:
Calculators (all types)
Excel (open after the exam starts)
An A4 size double sided cheat sheet with handwritten/typed/mixed notes
Multiple sheets of scratch paper
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Final examination
Exam structure
Three parts:
Part A Multiple choice questions (20 questions, 1 mark each, 20 marks total)
Part B Graph analysis (2-3 questions, 15 marks total)
Part C Short answer questions (2 questions, 15 marks total)
The total mark of this exam is 50. Around 20-30% of the questions require calculation.
All materials covered in Topic 5 to Topic 12 are examinable.
A practice exam is provided in Canvas. Answers will be provided and discussed in Week 13 tutorials.
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Final examination
Other requirements:
The exam will be proctored (record+), make sure not to use any material (online and/or hard copies) except the cheat sheet;
Do not communicate with any people during the exam unless you are experiencing a technical problem. In this case you can contact the technical support staffs;
You are required to type your answers in the space provided in Canvas. You are not required to type formulas (you can use Math equation editor in Canvas if you want to). There will be no penalty if you show the workings directly without providing the formulas. Check the solution to the practice exam for the example answers (available in Week 13 Thursday at 7pm).
Follow the instruction in Canvas announcement (to be made in Week 13) to set up your computer and perform a tech-check on the examination day. Contact Canvas support / support if you encounter any technical problem.
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Final examination
Learning support during the StuVac period.
Ed discussion board is monitored daily.
Contact your tutors by email if you have any question.
Wei will be available for consultation on:
Mondays 7pm to 8pm between 7 June and 22 June. No appointment is needed and feel free to drop in via the Zoom link in Canvas.
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When you complete your USS survey (https://student-surveys.sydney.edu.au),
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Thank you and Good Luck!
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