THE EUROPEAN MONETARY UNION

For more than twenty years, the European Union has been attempting to achieve the degree of exchange rate stability within Europe that the old Bretton Woods system had. As trade barriers fell in Europe and trade increased, the instability of exchange rates became increasingly important as a deterrent to both trade and investment. This led the EU to seek some form of an exchange rate regime that would promote more exchange rate stability. Over the past several years a new word—the euro—has entered the jargon of international economics and business. The origins of the euro can be traced back to the mid-1970s. With the breakdown of the Bretton Woods system, a number of members of the EU joined a system informally called “the snake.” Essentially, this system was one in which a number of countries pegged their nominal exchange rates to the German mark. In 1979, this rather informal arrangement turned into the more formal European Monetary System (EMS). Countries could keep their nominal exchange rates fixed only by keeping their inflation rates and real interest rates close to those of Germany. This effectively meant that the German central bank (the Bundesbank) was setting monetary policy for all countries in the EMS. Discomfort among some EU members over this “German dominance of the EMS” was what led to negotiations for a single currency.

The initial negotiations for the single currency were held during 1987-1988. The EU issued the Delors report in June 1989 that recommended the creation of a new single currency. In the meantime, EU leaders abolished capital controls within the EU in July 1990. This was a necessary step in preparing European capital markets for a single currency and was considered the first step in a three-step process. The second step was the opening of the European Monetary Institute in Frankfurt, Germany, as a forerunner to a European Central Bank. In December 1995, EU leaders decided that the new currency, the euro, would be launched in January 1999. It was further decided that the euro would be valued in relation to the European Currency Unit (ECU), which was a synthetic currency tied to the value of a number of existing European currencies. All countries would not necessarily be part of the EMU. First, countries could “opt out” of the system, as did the U.K., Sweden, and Denmark. Second, countries were required to meet several “convergence criteria” in order to qualify for membership. Of the twelve remaining EU members, only Greece did not meet the convergence criteria. The third step of the process started with the initial launch of the euro on January 1, 1999. In the interim, the conversion rates between the euro and all eleven national currencies (barring some emergency) were irrevocably fixed. Also, the European Monetary Institute became the European Central Bank.

The euro could be used for financial transactions, and companies were allowed to keep their books in euros. The euro has been used for all transactions within the eleven countries of the EMU since January 2002. There are benefits as well as costs for the EMU countries in choosing to abolish national currencies. The euro is projected to save 0.5 percent of GDP per year, or approximately $40 billion in transaction costs alone. The currency should boost the rate of growth of GDP in nineteen countries that now use the euro, but by how much is uncertain. In any case, lower transaction costs and a higher growth rate of GDP must seem to the governments involved worth the price of the partial loss of sovereignty in monetary policy. For the rest of the world, the euro’s effects are expected to be negligible. The major impact could potentially be on the U.S. First, the euro may lead international investors to diversify more into euro assets. Second, central banks may choose to hold more of their reserves in euros and less in dollars. Third, the dollar has been the currency of choice for invoicing trade and the pricing of some commodities. The euro may reduce the demand for dollars. The bottom line is that the creation of the euro may lead to a somewhat “weaker” dollar as the demand for dollars falls over time. These types of effects may take years to work out.

BOX 18.3 THE EUROZONE CRISIS

Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.

Milton Friedman

One of the motivations for countries to become part of the Eurozone is that borrowing costs denominated in euros are substantially less than borrowing in the former domestic currencies. Lenders correctly assume that the exchange rate risk of a bond denominated in euros will be considerably less than bonds denominated in, for instance, the Italian lira. Unfortunately, there was another side to this pleasant effect

for the residents of countries joining the euro. As borrowing costs fell, the borrowing costs for governments also fell.These low borrowing costs led many governments in Southern Europe to rapidly increase their level of debt.This effect was much smaller in Northern Europe as joining the euro with a national currency that was considered strong, such as the Dutch guilder, produced a much smaller effect on borrowing costs. In Southern Europe, it suddenly became very tempting for political leaders to increase government spending without increasing taxes to pay for the extra spending. As members of the Eurozone, these countries were able to borrow at

BOX 18.3 (CONTINUED)

rates similar to the rates paid by countries such as Germany or France. The result was an explosion of government debt in Greece, Ireland, Portugal, Italy, and Spain. However, this increase in debt did not seem to be a problem until the advent of the global financial crisis.The crisis caused a global slowdown in economic growth which greatly reduced tax revenues in virtually all countries. At the same time, the slowdown in growth led to large increases in transfer payments. The net result is that countries that were already heavily indebted were rapidly becoming even more so.The problem became a crisis in later 2009.The Greek government reported that their national debt was, in fact, much larger than was previously reported and that scheduled payments on the debt could not be made.

As investors became more focused on the fiscal situation in Europe, it became apparent that the situation in Greece was going to be difficult but that Greece merely was the worst case among a group of countries. Understandably, investors were selling Greek government debt but this reaction also spread to Ireland, Portugal, Spain, and eventually Italy. Given the usual inverse relationship between bond prices and interest rates, the prices of government bonds for these countries fell dramatically and interest rates increased. For governments already struggling with large debts, the increase in interest rates was increasingly making it even more difficult for these countries to manage their public finances. The problem for the rest of the EU was that this public finance crisis quickly was becoming a banking crisis. By nature, banks are highly leveraged institutions. Part of the usual operations of banks is the holding of bank reserves in what are deemed to be risk-free assets such as government bonds. Unfortunately in this case many banks in Europe were holding government bonds issued by countries that were now having extreme public finance problems. The EU and the Eurozone countries now faced a very uncomfortable choice. Some countries would default on their debts. If this occurred, the result would be major losses for European banks with the possibility of a major banking crisis. Under the circumstances, the choice was either to bail out the countries involved or risk having to bail out the European banking system. The initial response was money was provided to the relevant governments through the EU,the European Central Bank, and the I MF. This initial round of money was insufficient to resolve the crisis and in 2011 the ECB began large-scale buying of the relevant government bonds in order to keep rates of these bonds affordable for the countries involved. In addition, private-sector holders of the bonds took a loss on their holdings.

The price the indebted countries have paid for the assistance in managing their debt problems has been mandated fiscal austerity. Across the region, taxes have been increased and public spending has been reduced. This has slowly improved the public finances in the countries but the price has been high. The global economic slowdown has reduced aggregate demand almost everywhere and Southern Europe is no exception. However, in most countries governments have reacted with a mixture of fiscal and monetary stimulus. In these countries, fiscal policy has become much tighter at a time when aggregate demand already was weak. Further, as part of a currency union, none of these countries have the option of pursuing a looser monetary policy. In Greece, the situation is reminiscent of the Great Depression. Since 2009, GDP in Greece has fallen by 25 percent. While not as extreme there were declines in GDP for all of the indebted countries. These declines were directly attributable to the austerity measures that were imposed as the price of continued support. These austerity plans were supposed to be accompanied by structural reforms in the economies that would eventually lead to higher economic growth. Unfortunately, in many of these countries the structural reforms that are needed also are politically difficult to either pass or implement.

BOX 18.3 (CONTINUED)

Even under the best of circumstances, structural reforms in any country are difficult and frequently do not contribute to growth in the short run.

Amidst all of this turmoil has been the persistent fear that one or more countries would leave the Eurozone. Any such move would put the entire euro project in jeopardy. In the short run the support coming from Northern Europe has stabilized the economies of Southern Europe but the prospect of a return to normal economic growth still seems to be a distant prospect. While the crisis has seemingly passed, the underlying problem is that the austerity plans are still ongoing and the populations of the effected countries are growing weary of years of negative, or at best, slow growth. It is difficult to predict when growth will return. The indebted countries are not alone in facing structural problems. The crisis has highlighted structural problems within the EU. For example, the European Central Bank runs monetary policy for the region, but they do not regulate the banking systems. A much deeper problem is that there is no official way to transfer money among the different regions of the EU. In a large country with a unified tax and transfer payment system, the public finance system automatically transfers money from faster growth to lower growth regions within the country. As the EU has no such system, such transfers have to be done on an ad hoc basis. The euro crisis has exposed a fundamental weakness within the EU. In some senses, the EU is moving toward an ever tighter economic relationship. However, important parts of the system are not unified and are unlikely to be in the foreseeable future. This crisis is thus not just a crisis of the euro but potentially a broader crisis for the EU.¹¹