Assignment 1999-2000 in

European Integration and Economic Policy Coordination(2000)

For

Dr. Valerio Lintner

Title: 'HVFULEH WKH IHDWXUHV RI D FRPSOHWH PRQHWDU\ XQLRQ +RZ

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Written by Konstantinos Kostoulas 9910284

Msc in International Banking and Finance (F/T)

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Features of a monetary union:The case of EMU

A monetary union entails a single market for goods, services, capital and labour,
complemented by common policies and coordination in several structural, micro- and
macro-economic domains. A monetary union can exist in either a strong, or a weak
version. In its weak version, the members of the monetary union agree to irrevocably
fix their bilateral exchange rates while at the same time allowing the national
monetary authorities to undertake the necessary monetary policy in order to defend
this exchange rate. In its strong version, monetary union implies that the individual
national currencies are replaced by a single currency which will be in use throughout
the Union, and national monetary authorities are replaced by a single central monetary
authority.

Economic and monetary union in Europe implies a complete freedom of movement

for persons, goods, services and capital, as well as a single currency. This, in turn,
would imply a common monetary policy and require a high degree of compatibility of
economic policies and consistency in a number of policy areas, particularly the fiscal
field. These policies should be geared to price stability, balanced growth, converging
standards achieving higher employment and external equilibrium. Economic and
monetary union would represent the final resort of the process of progressive
economic integration in Europe.

The first and one of the most significant discussions of the economics of monetary
integration was by Mundell1, who pioneered the so-called theory of optimum currency
areas. This theory focuses attention upon the costs and benefits of forming a monetary
union. The former arise largely as a result of the loss of monetary policy as an
instrument of adjustment. The main concern here lies in whether the costs of losing
this instrument for the individual member country outweigh the economic benefits of
monetary union. If the economic benefits exceed the economic costs, then the
countries taking part in the monetary union are said to be within an " optimum
currency area ".

What monetary union is for (according to the strong version described earlier), the
Central Bank of that union has control over the monetary policy instrument for that
Union as a whole; National monetary authorities cannot conduct their own individual
monetary policy operations. The main potential cost of EMU is that represented by
the loss of monetary and exchange rate policy as an instrument of economic
adjustment at the national level.

Whether or not the situation is beneficial for the countries in a monetary union
depends upon three distinct considerations. The first of these is concerned with labour
mobility. Let us consider a two-country model (Greece and Germany): An
asymmetric demand shock will result in a decline in demand for Greek goods which
will exactly offset an increase in demand of German goods (so that the Greek balance
of payments deficit is matched by a German balance of payments surplus). If labour is
mobile within the two countries, unemployed Greek workers could migrate to
Germany where there is excess demand for labour (to meet the increase in demand

1
Watson M.S Alison (1998):” Aspects of European Monetary Integration: The politics of
convergence”, Macmillan Press Ltd
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for German goods). Such labour mobility reduces unemployment in Greece, reduces
the inflationary pressures which have been caused by the increase in demand in
Germany and reduces the current account disequilibria in both countries. If, however,
countries within a monetary union have less mobile labour forces, which find it less
easy to move between countries, then losing the instrument of exchange rate
adjustments will be more costly for the members of that union. Thus, for example,
Greece's unemployment problems will remain, as will the inflationary pressures in
Germany.

The second consideration to be made when deciding whether a monetary union is

beneficial or not amongst the member countries, concerns wage flexibility. If wages
are flexible, then, in terms of our previous example, unemployment in Greece should
bid down wages, while the increased demand for labour in Germany should bid up
wages - in other words, for firms in Greece wage costs will be lower, whereas for
firms in German wage costs will be higher. Greek competitiveness is improved (since
output prices had fallen) which stimulates world demand for Greek goods , and
German competitiveness is reduced (since output prices have increased), suppressing
demand for German goods. Both countries should therefore find their economies
returning towards the previous equilibrium. If, however, wages do not move easily
(that is, if they are sticky - particularly in a downwards direction) then countries who
take part in a monetary union will find that it is more difficult to adjust to changes in
demand than it is for other countries who have maintained their national monetary
authorities and can thus adjust their currencies in order to bring the forces of supply
and demand into balance once more.

There is also the consideration of whether or not fiscal policy can be used as an
alternative monetary policy when instituting macro-economic adjustments. How
much national authorities can use fiscal policy as an adjustment mechanism is
dependent upon the degree to which countries are willing to trade-off inflation against
unemployment. For example, if shocks to demand are random then the Greek
government can increase its budget deficit (thus causing inflationary pressures) in
order to finance an increase in government spending. This would increase demand in
Greece, thereby reducing unemployment. However, if shocks are not random or are
long lasting, or if governments cannot borrow sufficient funds from financial markets,
governments may then find it difficult to reduce government budget deficits. One
solution to this problem is to allow for a fiscal transfer, as in this example between
Germany and Greece. After the demand shock, the German authorities would increase
the tax rate, reducing demand. These tax revenues would then be donated to the Greek
government (monetary authority) where they would be spent, resulting in an increase
in Greek demand and a reduction in Greek unemployment. The use of fiscal policy
does not correct for the imbalances in the Greek and German current accounts but,
under monetary Union, they would be less visible.

There is one further point to consider when examining the costs of joining a monetary
Union - loss of seignorage2 revenue. Seignorage is usually taken to be the command

2
Emerson Michael et al.(1998): “One Market, One Money:An evaluation of the Potential Benefits and
Costs of Forming an Economic and Monetary Union”, Oxford University Press
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over real resources which the government can obtain by printing money. The
seignorage derived from note issue can be an important source of revenue for
countries, especially in times of war or in other crises, when revenue from taxes or
bond issues is difficult or impossible to raise. In addition, when countries have an
inefficient tax system, they find it more beneficial to raise revenue by means of
inflation.

This is because, for a country with an underdeveloped fiscal system, raising revenue
by increasing tax rates is costly. On the other hand, it is less costly to increase
government revenue by means of inflation. However joining a monetary union (with
low inflation commitment) means forfeiting the source of revenue because national
monetary authorities are no longer free to institute inflation as a means of creating
government income.

Price stability is a generally accepted objective and beneficial economically. The

problem is that of retaining price stability at least cost, and then maintaining it. The
European Union has the opportunity of being able to build its monetary union on the
basis of the reputation for monetary stability of its least inflationary member states.
Given the paramount importance of credibility and expectations in winning the
continuous fight against inflation at least cost, this is a great advantage.

A new framework of incentives and constraints will condition national budgetary

policies, for which the key words will be autonomy (to respond to country specific
problems) discipline (to avoid excessive deficits) and co-ordination (to ensure an
appropriate overall policy mix in the European Union). European monetary union will
also bring valuable gains for many countries' national budgets through reductions in
interest rates, as inflation and exchange risk premiums are eliminated. These benefits
will probably outweigh the loss of seignorage revenue to be experienced by some
countries.

Importance of the single currency

The single currency eliminates the present cost associated with converting one
European Union currency into another. The resulting savings can be estimated at
more than fifteen billion euro per annum or about zero 0.4% of the euroland GDP.
The larger parts of these gains are financial consisting of the disappearance of the
exchange margin and commission fees paid to banks. The other gains take the form of
reductions in costs and inefficiencies inside firms.

Transaction costs differ strongly from country to country. The gains for the larger
member states whose currency is extensively used as a means of international
payments may be of the order of between 0.1% and 0.2% of national GDP.

Significant improvements in the costs and timing of cross-border settlements are to be

expected in Europe as the banking system becomes more integrated and better links
are constructed between national payments systems, and smaller firms will benefit
considerably from this.

The single currency would eliminate nominal exchange rate variability among EU
currencies. However, some variability in national price levels might remain. In any
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case, the EMU should lead to a sharp reduction in real exchange rate variability. This
is particularly important. Theory suggests that risk-averse agents will reduce their
activity if there is variability in the expected rate of return, and the lags between
contracting and payment in international trade are a common source of risk if interest
rates are flexible.

Since a single currency eliminates all exchange-rate risk between the countries in the
EMU, it therefore increases trade and the benefits associated with it. These benefits
include a greater variety of products and lower prices due to competition and
economies of scale from producing for a larger market. In fact, many economists
believe that one of the greatest benefits of a single currency comes from its favourable
effect on trade from increased competition.

Between world wars I and II3, European countries engaged in what are known as
competitive devaluations: one country would devalue its currency to boost its export
sector, and its trading partners would retaliate by devaluing their currencies as well.
Reducing the value of currency is inflationary, so competitive devaluations caused an
inflationary spiral during that period.
Although the current European exchange-rate arrangement is designed to limit the
threat of competitive devaluations, such devaluations remain possible so long as there
are multiple currencies whose exchange rates are set by policy makers, rather than
determined by the market as in a floating exchange-rate system.
As trade between European countries has increased, the costs to one’s trading partners
from using a competitive devaluation have increased but so have the potential gains to
any one country. However, the effect of competitive devaluations on the world’s
economic welfare is clearly negative, and it can be disastrous if retaliation leads to a
devaluation spiral. A single currency eliminates the threat of this type of competition.

Because it allows large, though infrequent, exchange-rate adjustments, the current

European exchange-rate mechanism is vulnerable to speculative attacks: if speculators
believe the value of a currency will be reduced (devalued relative to other European
currencies), they will sell their holdings. If enough speculators believe this,
confidence in the value of the currency may collapse and may force the government to
devalue even if that had never been its intent.
Although a government can try to thwart speculators by raising interest rates and
thereby the return to holding money-market instruments denominated in that
currency, there’s a downside to doing so: higher interest rates mean that business
firms face higher borrowing costs, so they’ll do less borrowing and investing in new
plant and equipment, which, in turn, will lead to slower economic growth.
Since much of the speculative activity within Europe has occurred when speculators
have bet that one European currency would be devalued relative to another, moving to
a single currency would eliminate such activity. Moreover, since investors will not
have to be compensated for uncertainty about exchange rates, interest rates will fall,
thereby stimulating investment and growth within the EMU. Although interest rates
will fall more in those countries that are now subject to the most speculation, all
countries will probably benefit from lower rates as the world economic environment
becomes less risky.

3
Moss H.Bernard (1998):”The single European currency in national perspective: A Community in
Crisis?”, Macmillan Press Ltd
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The elimination of exchange rate uncertainty and transaction costs, and further
refinements to the single market are sure to yield gains in efficiency. Through
improving the risk-adjusted rate of return on capital and the business climate more
generally they are good chances that the credible commitment to achieving EMU will
help further strengthen the trend of investment and growth.

For investors, there are three key benefits: One, the single currency brings about a
wave of merger activity, which will result in stronger and more profitable companies.
Two, it creates bigger and more efficient capital markets. Three, it allows European
investors to construct more balanced portfolios. In other words, Eurozone investors
can diversify their portfolios more effectively. Pension funds and insurance
companies can now match their domestic liabilities with assets from anywhere in the
Eurozone, not just their home market. These benefits will be maintained whether or
not the single currency turns out to be a political or economic success.

Reducing the costs and preserving the benefits

Although a single currency should lessen fiscal and monetary sources of asymmetry,
there are, at the same time, reasons to suspect that adoption of a single currency may
increase asymmetry within the EMU. By reducing transaction costs, adopting a single
currency may increase trade. Trade tends to encourage regional specialization in the
production of goods.

If regions specialize in the types of goods they produce, shocks to demand or to the
production of any particular good will affect regions differently. Faced with
asymmetric shocks, members of the EMU may have to rely more heavily on fiscal
policy to compensate for the lack of independence in setting monetary policy.

Whatever the costs of EMU, mechanisms other than domestic monetary or exchange
rate policy will have to bear the burden of economic adjustment after adoption of the
single currency. Barriers to movements of labour have been removed, which
encourages that adjustment process. Further labour-market reforms may be necessary
to increase labour markets’ speed of adjustment.

In general, member countries may find it necessary to institute international tax and
redistribution policies through growth of the European Union’s budget to allow for
regional differences in policy stimulus or restraint. Taxation and redistribution across
EMU countries may be a promising approach. But the European Union’s budget is
currently much too small for such a task; however, it may increase to meet the
demands of post-monetary-union Europe in the next century.
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References

Bishop Graham, Salomon Smith Barney, 10th January 2000(handout):”Delivering the

Benefits of EMU”

CIB in Scotland:” EMU-The Impact of the Euro”, 1998

Duisenberg W(1998):”Economic and Monetary Union in Europe: The challenges

ahead”, Working Paper, Journal of Common Market Studies

Emerson Michael et al.(1998): “One Market, One Money:An evaluation of the

Potential Benefits and Costs of Forming an Economic and Monetary Union”, Oxford
University Press

The Euro Web site: www.euro.com, and the EU web site www.europa.eu.int/

The European Central Bank Web Page: www.ecb.com

Giddy Ian, Saunders Anthony, Walter Ingo, Working Paper Series, New York
University, Salomon Center, July 15,1995:”European Financial Market Integration:
Clearance and Settlement Issues”

Moss H.Bernard (1998) :”The single European currency in national perspective: A

Community in Crisis?”, Macmillan Press Ltd

The International Monetary Fund Web Page: www.imf.org

The WOPEC web site: www.wopec.com

Porter R.and Rey H., Economic Policy, April 1998:”The Emergence of the Euro as an
International Currency”

R.B Johnston, Macmillan Press, London: ”The Economics of the Euro-

Market,History,Theory and Policy”

Taylor Cristopher (1997): “EMU 2000? Prospects for European Monetary

Union”,Royal Institute of International Affairs

Watson M.S Alison(1998):” Aspects of European Monetary Integration: The politics

of convergence”, Macmillan Press Ltd