ECONOMIC AND MONETARY UNION (EMU)

1. ECONOMIC AND MONETARY UNION (EMU)

2. Rationale for EMU • Advances European integration • Market integration – finishes the SEM? • political integration - a key symbol of such integration? • Builds on EMS • German unification - lessons • Strengthens position of EU in global economy

3. What is EMU? • Achieved when: • Bilateral exchange rates are permanently fixed or a common currency (EU – the latter) • Free movement of capital

4. EMU’s technocratic requirements: • Single Central Bank • Common monetary policy – i.e. one central rate and common exchange policy • Some pooling of foreign reserves • Common policies to remove obstacles to factor mobility (i.e. to a single market) • Some common ground - macroeconomics

5. Broader EMU requirements • Possible interstate transfers to offset negative aspects of EMU? • Political and economic commitment • Some limits to/pooling of sovereignty • Domestic reform

6. Optimal currency areas require: • An absence of asymmetric shocks • A high degree of labour mobility and wage flexibility • Centralised fiscal policy to aid redistribution Key question: is the EU an OCA?

7. Road to EMU • Not new – e.g. Rome, Napoleon, etc I want the whole of Europe to have one currency; it will make trading much easier Napoleon in a letter to his brother, Louis, 1807

8. Emergence of modern EMU • Werner Report – proposes EMU by 1980 • 1979 European Monetary System - ERM, ECU • 1989 Delors Report – 3 stage approach to EMU • 1993 Maastricht Treaty – EMU framework and timetable • 1992-3 ERM crises • 1.1.99 - fixing of exchange rates • 1.1.02 – notes and coins in circulation

9. Convergence criteria (EMU entry requirements) • Convergence criteria remain important • Operation of EMU - Stability and Growth Pact • For countries hoping to join EMU • Fiscal criteria • National budget deficit less than 3% GDP • National debt less than 60% of GDP – or heading in the right direction

10. Convergence criteria • Monetary criteria • Inflation no more than 1.5 percentage points above the average of the 3 countries with the lowest rates • Long term interest rates no more than 2 percentage points above the average of the 3 countries with the lowest rates • Exchange rate – within normal band of ERM for previous 2 years

11. “Euroland” in 2006 • 12 member states form the Euro-zone – all pre-2004 member states • UK and Denmark ‘opt-out’ • Danish referendum: February 2000 – 53% against • Sweden remains out: September 2003 ‘no’ vote • May 2004 – enlargement • All 2004 accession states new members committed to membership – timing the issue • First likely - 2007.

12. European Central Bank • Independent and supranational • Primary objective is price stability • Responsibility for monetary policy – i.e. interest and exchange rate policy. • Fiscal policy – remains national – but Growth and Stability Pact to stop member states undermining ECB

13. Economic benefits of EMU • Removes exchange rate uncertainty on intra-EMU trade • Avoids competitive devaluations • Eliminates transaction costs • Increases price transparency • Low and stable inflation and interest rates • Promotes international specialisation and improves EU competitiveness • Boosts the EU’s international economic profile

14. Economic risks of EMU • Short term deflation • Can ‘one monetary policy fit all’? • Loss of economic sovereignty? • Asymmetric shocks? – especially if SEM and EMU lead to specialisation. • Lack of real economic convergence • Burden of adjustment on wages and prices - flexible enough?

15. EMU and the Business Environment • More predictable trade and investment environment • Initial transition costs • Harder for SMEs to adjust? • Intensified competition • greater cost and price transparency • some price convergence? • Clusters • Impact on external economic environment

16. EMU: The early years

17. €/S rate: Jan 1999 - July 2006 Source: European Central Bank

18. Stability and Growth Pact • Fiscal convergence criteria continue after 1.1.02 • Why? • Germany keen • Avoid free riders • Impact of budget indiscipline spreads in EMU → higher interest rates all round • Excessive deficit - Sanctions? • 4 months to correct • No correction - non-interest bearing deposit with Commission up to 0.5% GDP becomes a fine after 2 years.

19. But tight budget constraints unsustainable in economic downturn? → Commission President Prodi describe SGP as ‘stupid’ • Portugal, France, Germany broke SGP rules • By 2004, France and Germany on 3rd year • November 2003 effective suspension of SGP with agreement of members (except Sp, Nl, Aust and Belgium) • Commission takes Finance Ministers to European Court of Justice and wins case in July 2004 • In reality, difficult to impose SGP if member states do not agree to comply

20. Impact of SGP problems • Large-small country divide • Austria and Netherlands furious as they have striven to comply • Undermines credibility of system • Implications for absorption of new members

21. March 2005 – SGP reforms • 3% budget deficit/60% debt thresholds remain • ‘relevant factors’ to enable member states to avoid ‘excessive deficit’ procedures • e.g. economic cycle, structural reform, research and development, public investment, etc • Countries have longer to correct ‘excessive deficit’ – 2 years. Can be extended further.

22. SGP reform • Has increased flexibility – has it gone too far? • Lack of clarity re ‘relevant factors’ • Weakens pact via exceptions • Short term – reduces political rows but how workable in long term?

23. Other problems for eurozone • Flexibility – member states need new ways to adjust to economic imbalances - especially labour markets • Reform proving elusive in ‘Big 3’ – France, Germany and Italy • National economic reform essential for long term health of Eurozone

24. EMU and EU non-members 1. The old ‘outsiders’

25. Support for the single currency, 1998-2004

26. €/£ rate: Jan 1999-July 2006 £ Source: European Central Bank

27. UK - not on the agenda in short or medium term • Political parties • Labour in favour ‘in principle’ but some dissenters • Conservatives – mostly Eurosceptic – some pro • Liberal Democrats – the most ‘pro’ • Businesses – divided • Foreign investors – more pro • Big companies – more pro than anti • Small companies – more anti than pro • Public opinion • Heavily anti – how deeply held?

28. Pooling of sovereignty – gains influence Left behind in EU Economic gains Commitment to integration Loss of sovereignty Managing OK outside One policy fits all flawed Misconceived and too risky Identity concerns Europhile and Eurosceptic views

29. Five economic tests • UK government has own entry tests • Sustainable convergence between UK & EU • Enough flexibility to absorb economic change • Effect on investment in UK • Impact on financial services • Impact on employment • June 2003 – Chancellor Brown says progress made – but only one test passed.

30. Impact on City – no evidence that non-membership causes problems • FDI shift • UK main destination for EU FDI inflows for many years • 2002: several EU countries attract more inward FDI than UK. € effect? • 2004: UK and Ireland recover – other factors at play?

32. Sweden and Denmark • Referenda defeat pushed membership back • Some more positive attitudes to membership emerging but: • Politicians wary of further defeats • Difficult to justify given consistently better performance of outsider economies in recent years

33. Economic performance – inside and outside the eurozone

34. EMU and EU non-members 1. The new ‘outsiders’

35. The 2004 accession states • Commitment to adopt euro – condition of EU membership • Many said as soon as possible • 1st wave – smaller countries – 2007-09? • 2nd wave – larger countries – 2010 plus? • Have to comply with convergence criteria – varies across countries • 2004: Estonia, Lithuania, Slovenia → ERM 2 • 2005: Cyprus, Latvia, Malta, Slovakia → ERM 2 • 1.1.2007 – Slovenia to enter eurozone (Lithuania turned back because of inflation)

36. Membership – technical and political • Convergence criteria – vary over time • 2004 – inflation deterioration – temporary as adjust indirect taxes on accession • Clash between stability and growth initiatives? • Bigger countries – target entry dates receding, especially Hungary

37. Convergence criteria - 2003

38. Convergence criteria - 2004

39. Convergence criteria - 2005 Source: national governments and Eurostat: X = above threshold value

40. Poland - example • Legally compliant • Technical issues: • ERM II – Polish concerned about speculative attacks/volatility of zloty • Public expenditure – budget deficit in 2004 over 5.0% but technical adjustment in 2005 brought it within threshold

41. Public opinion in 2004 accession states • Generally pro-EU (honeymoon period) but declining • Political elites in favour – little public discussion of euro issue • EU – more about jobs/ending poverty etc

44. Final comments and questions • Strong commitment to EMU of its members • Economic benefits/costs - too early to assess. • Political motivation • Modification of Stability and Growth pact? • Expanding the remit of the ECB? • Does true EMU require fiscal federalism? • Need for increased labour market flexibility • Challenge of Enlargement