5.1 Societal interests in the monetary system + European Monetary Union

Question 1

pros and cons of pegging your currency to the USD

Answer 1

pros =

• much easier trade and investment with the US, including US tourism (relying on tourism from the US)
• monetary policy discipline: peg requires monetary policy that monitors US (good if your institutions (CB) are not very trustworthy)

cons =

• no monetary policy autonomy - e.g. if US raises interest rates, you raise interest rates

Question 2

“society centered” approach to monetary politics - policy choices along two axes

Answer 2

strong - weak currency (vertical axis)

domestic economic autonomy - XR stability (horizontal axis)

Question 3

“society centered” approach to monetary politics - why do govs choose diff paths?

Answer 3

society centered approach = take into consideration domestic interests

• domestic politics, shapes monetary policy
• interests and institutions

3 models:

1. electoral models
2. partisan models
3. sectoral models

Question 4

“society centered” approach to monetary politics - electoral models

Answer 4

only helps explain one dimension: Help explain choice between fixed and floating exchange rate (so not strong vs weak currency)

Politicians have two major ways to influence the state of the economy

• Fiscal policy (taxes & spending)
• Monetary policy (adjust interest rates, if available)

Monetary policy is determined by a leader’s desire to control their own fate

Assumption: Policymakers want monetary policy autonomy, only maintain fixed XR if compatible with MP they want to implement
- diff on actual slides

Regime Type:

• Democracies are more sensitive to the state of the domestic economy…
• Therefore, monetary policy autonomy is more important (but not irrelevant in non-democracies).

Institutional heterogeneity:

• Electoral rules in different democracies (or non-democracies) might alter these incentives.
• Veto players: veto players make fiscal policy difficult
  The more fiscal constraints, the more monetary policy autonomy is valued Ex. Obama and the Republican Congress: both chambers have to approve, difficult when it is diff party dominated)

Institutions and Credibility:

• Fixed XR requires a commitment to uphold the peg…
• Democracies might not be the best at upholding commitments…
  lower credibility bc of elections -> more speculation about the peg/currency
• Why? Elections…: politicians often have incentives to focus on the next election, not long-term commitments.

democracy = less likely to maintain fixed XR bc you want to keep the public happy + markets don’t trust you will keep the peg

Question 5

“society centered” approach to monetary politics - partisan models

Answer 5

(looks like factor model trade)

people are economic voters

XR policy is determined by the ruling party’s ideology/interests (left-right wing)

Remember the short-run Phillips Curve: There is a trade-off between inflation and employment

• Left-wing parties are “pro-employment” : Tend to represent labor organizations, poor folks -> want monetary policy autonomy
• Right-wing parties are “anti-inflation”: Tend to represent business interests, rich folks (scared of inflation)

predictions of this model =

1. right-wing govs are more likely than left-wing govs to establish and maintain a fixed XR
2. right-wing govs are more likely than left-wing govs to promote a “strong currency” (because it requires taming inflation)

connection with electoral model = voters choose left-wing parties during recessions (high unemployment) and right wing parties under inflation

Question 6

“society centered” approach to monetary politics - sector models + 4 interest groups

Answer 6

interest groups have diff preferences towards the trade off

sector of employment determines preferences: policy autonomy vs XR stability

4 interest groups:

1. export-oriented producers
2. import competing producers
3. nontraded-goods producers (e.g. universities)
4. financial services industry

export-oriented producers: want fixed XR + weak currency

• fixed XR: stability for int’l transaction
• weak XR: lowers price of products abroad

import-competing producers =

• floating XR: prefer monetary policy to address recessions/inflation
• weak XR: keep imports high, they are more competitive
  *week Euro: cheaper to buy domestic

nontraded-goods producers:

• floating XR: prefer monetary policy to address recession/inflation, we don’t care about XR fluctuations bc we don’t trade
• strong XR: more traded goods, travel more, pay for tuition, we buy imports (we only consume, don’t compete)
  *stronger Euro -> cheap shit in the action store

financial services industry:

• XR stability for int’l transaction (leads to more trade)
• but XR volatility can also be profitable: foreign exchange trading (currency trade)
• monetary policy autonomy maintains stable domestic banking system
• WEAK preferences for floating XR (bc they can also benefit from stability)
• no preference for strength of currency: benefit from currency trading no matter how much your own currency is worth

so: allies and adverseries:
XR stability: non-tradeable and import competing want flexibility, but export oriented wants stability

XR strength: export oriented and import-competing want a weak currency, but non-tradeables want strong currency

Question 7

“society centered” approach to monetary politics - criticism of each model

Answer 7

electoral model =

• limited in explanation: tells us only why a gov might abandon a fixed XR
• some govs don’t abandon fixed XRs according to its predictions (sometimes even democracies are willing to take on the pain of a fixed XR)

partisan model =

• monetary policy preferences aren’t always neatly distributed across parties, other issues matter
• leftists sometimes pursue contradictory measures, rightists are sometimes expansionary (both parties rise to the biggest challenge of the day -> leftists can contract econ to fight inflation, right can be expansionary when high unemployment)
• can’t explain situations where monetary policy is separated from politics (independent central banks)

sector model =

• overestimates importance of fixed XR to export interests: they have ability to purchase insurance
• weak currency also increases production costs, eliminating some gains to traded-goods sector (remember supply chains: you are often both importer and exporter)
  they also use imported imports, which rise in cost as a currency weakens
• can’t tell us much about which sector will prevail in political competition

Question 8

NL fixed or floating currency?

Answer 8

EU-internally = fixed

(nothing to do with this but: tarrifs bring inflation up)

Question 9

road to European Economic and Monetary Union

Answer 9

1979-1999: European Monetary System with the European Exchange Rate Mechanism (ERM: all tried to fix their XR to each other)

• 1971 countries abandon Bretton Woods peg to the dollar -> chaos
• Europe decides to have more XR stability
• Europe-internal fixed XR regime, but all had seperate currency

1992: Maastricht Treaty: convergence criteria or Maastricht criteria (start road toward having EU currency): e.g. have low inflation rate, mirror interest rates to most succesful country

1997: Stability and Growth Pact: two main rules on fiscal discipline

1. annual budgetary deficits should not exceed 3% of national GDP
2. gov debt should be no more than 60% of GDP

1st January 1998: European Central Bank (ECB)

1st January 1999: adoption of euro and of a single monetary policy under the ECB

Question 10

European Economic and Monetary Union - why?

Answer 10

European countries had to give up monetary policy autonomy bc they wanted free capital flow and fixed XR

All were democracies -> why did they gave up monetary policy autonomy?

1. trade: most EU countries are highly dependent on trade and investment flows within the EU
2. Monetarism (eco idea Milton Friedman): believes that Keynesian stimulus is ineffective at solving crises
   - Central Bank should just focus on keeping inflation at a steady, low level (let market do the rest)
   - no need for expansionary policy in crises (or do at least a lot less) -> giving up sovereignty over MP is less costly
   - in 2008 we all became Keynesian again

Question 11

pre- Euro : the EMS

Answer 11

late 1970s: all european countries wanted to restrict inflation

• common policy objective = fixed exchange rate less costly

from 1979: system of fixed but adjustable exchange rates in Europe
- normal times all are fixed

in practice: Germany set monetary policy for the European community, everyone else had to follow what Germany was doing to maintain the peg

• Bundesbank worried about having to use inflation to support weaker currencies -> didn’t want to have to mirror those policies and risk inflation (historic meaning: hyperinflation destroyed the econ in the 20s)
• solution: to keep the Bundesbank on board, let Bundesbank set monetary policy that controls inflation, everyone else has to converge to maintain peg to Mark

not everyone happy with this (France)

Question 12

European Economic and Monetary Union - Euro replaces EMS

Answer 12

European countries wanted a say in monetary policy (once inflation down?)

Germany & Bundesbank opposed (inflation worries)

France makes EMU condition of supporting German reunification -> Germany acquiesces (reunification seen as more important politically)

BUT compromise: Bundesbank writes most of the rules for ECB
- to avoid inflationary pressures

Question 13

the ECB

Answer 13

mainly mirrors the Bundesbank

key characteristics:

• ECB one mandate: maintain price stability
  diff from Federal Reserve US that also mandated to boost employment by inflating the econ
• inflation target: 2% over the medium term
• ECB is an independent institution
• ECB not allowed to buy government debt

governance: Governing Council (main decision-making body) formed by 6 members of the Executive Board + 20 governors of the national central banks of the euro area countries

Question 14

EMU before the eurozonecrisis

Answer 14

a monetary union without fiscal and banking union

(banking union would mean the ECB oversees all other European banks (that they have enough reserves) + that they can rescue the banks)

Question 15

from the great recession to the Eurozone crisis: private debt or public debt crisis?

Answer 15

2007 housing bubble burst in the US

banking crisis and sudden reduction of availability of credit

gov’s bailout (financial assistance) of financial institutions in the US and Europe -> private debt became public debt

increasing sovereign spreads (diff in interest rates on gov bonds) as trust in the solvency of gov decreased

Gneral gov debts: they are breaking debt/GDP ratio (e.g. Ireland), starting 2008/9 much higher gov debt that led to Eurozone crisis

Question 16

eurozone crisis - causes

Answer 16

trigger = 2009
newly elected Greek gov revealed a much higher budget deficit than previously declared

structural causes =

• balance of payment imbalances
• architecture of the Eurozone: no lender of last resort, monetary union without a fiscal or banking union

Question 17

structural causes: the eurozone crisis as a BOP crisis

Answer 17

after Euro was introduced macroeco conditions diverge (before they were all battling inflation): Northern Europe experiences much slower economic and wage growth than Southern Europe

+ banks thought that the ECB or other countries’ banks WOULD bail them out

single currency -> periphery countries could borrow at low rates -> banks in European core invested in fastergrowing countries in the periphery

northern Europe

• slow growth
• very low inflation and wage growth
• exports more competitive

southern Europe

• faster growth
• higher inflation and wage growth
• exports less competitive (become more expansive)

same central bank -> same monetary policy -> ECB not expansionary enough for northern Europe + not enough inflation-fighting for southern Europe

capital flows from core (Germany, Benelux, France) to periphery (Greece, Italy, Spain, Ireland)= increasing debt-financed consumption

big current account surpluses/deficits (and no XR adjustments possible) = trade imbalances

Question 18

structural causes Eurocrisis: Eurozone’s architecture

Answer 18

fragility of the Eurozone:

• Eurozone countries issue debt in a currency over which they have no control (if you are indebted, you can’t just print more of your currency)
• it means that countries can’t force their national central bank to provide liquidity (no lender of last resort when they can’t pay their debt)

-> countries are more exposed to market panicks

• other states have higher gov debt, but they are indebted to their own central banks, they will not force them to pay it off quickly

Eurozone is monetary union without a fiscal union -> no coordination that could have counteracted the imbalances:

• northern europe could’ve used fiscal expansion, southern europe contraction
• stability and growth pact rules regularly ignored by all

Eurozone is monetary union without a banking union necessary to prevent the “doom loop” between national govs and banks

• gov increase public debt to save national banks
• gov debt becomes unsustainable
• domestic banks hold gov debt now at risk of default
• Ireland held a lot of banks -> they had to bail them out, if there was a banking union, not all the burden would fall on Ireland
• doomloop: banks and govs both get more and more debt, bailing each other out

Question 19

possible solutions to the Eurozone crisis

Answer 19

1. external adjustment: exchange rates adjust: deficit countries devalue, surplus countries appreciate -> implies breaking up the Eurozone
2. internal adjustment: austerity and/or expansionary policies: deficits need to bring prices down with austerity (cuts in public spending or tax increase) + surplus countries should expand gov spending and cut taxes (decreasing competitiveness exports) -> convergence of deficits and surplus countries (burden sharing among creditors and debtors)
3. financing: cover funding gap through external funding: surplus countries finance for deficit countries -> implies: permanent financing structures (e.g. fiscal federalism)

northern countries don’t adjust by boosting demand

Question 20

Eurozone crisis resolution: the chosen option

Answer 20

internal adjustment in debtor states, temporary financing and expansionary monetary policy

internal adjustment and temporary financing:

• to avoid default, Greece was granted loans by Troika (IMF, European Commission, ECB) in exchange for austerity measures: tax increases, reforms to enhance competitiveness and public spending cuts (pensions, unemployment benefits, health and education)
• Ireland and Portugal bailout followed soon
• problem: austerity led to economic contractions -> debt/GDP ratio worsened

confidence among creditors was not restored and sovereign spreads kept increasing, with Italy looking like a mortal threat to the euro

-> 2012 ECB president Draghi started buying gov bonds in the secondary market (buy debt held by private banks, not by the gov) = lender of last resort

• financial markets believed Draghi’s “whatever it takes” and borrowing costs returned to pre-crisis level
• ECB implemented several other unconventional measures to keep interest rates down

austerity measures continued in all of the debtor countries -> painful adjustment:

• despite some limited debt restructuring , the burden of adjustment has almost exclusively fallen on debtor countries, especially on the youth
• in Ireland, Italy, Spain, Portugal and Greece unemployment has soared, gross domestic product (GDP) has fallen and the debt-to-GDP ratio has increased
• inequality has risen + poverty + homelessness
• increase mental illnesses and suicides
• eco hardship has fueled populism + anti-EU feelings

Question 21

changes to avoid future (eurozone) crises

Answer 21

more fiscal discipline

• European Semester (ex-ante coordination of fiscal policy): need to coordinate on fiscal policy….
• Fiscal Compact (2012) to foster budget discipline in the EU
• creation of permanent fund, European Stability Mechanism (ESM)

banking union

• created in 2014
• single supervisory mechanism
• single resolution mechanism (SRM) with a single resolution fund for effective and efficient resolution of non-viable credit institutions