European Monetary Union

Question 1

Why is a monetary union without fiscal union inherently fragile?

Answer 1

Budgetary union = countries in a monetary union that share tax revenue, have common automatic stabilisers and social security systems
Optimum currency area theory argues for centralised FP if there is a currency union
No authority has direct control over the euro, which causes fragility.
CAUSE OF DEFAULT: ECB cannot fund govs in the monetary union if a country is about to default. Govs must fund the deficit themselves by issuing bonds (here bonds=debt). But what if investors don’t want to buy these bonds? This gives rise to multiple equilibria as investors must look at the gov’s calculus.

BENEFITS OF DEFAULT=not having to pay debts, although have to impose austerity
Less austerity is needed as the gov won’t have to honour interest payments on their debt (don’t have to raise as much revenue)
A country would consider defaulting if the gov has problems raising revenue
Benefit of defaulting will increase with size of shock

COST OF DEFAULT
Loss of reputation makes borrowing more expensive
Cost of default line is horizontal (cost doesn’t vary with size of shock)
Implications on the banking system:
-when investors pull out of domestic markets, the price of gov bonds falls, and as domestic banks are the main holders of these bonds, they make a loss
-domestic banks now viewed as riskier, and therefore have difficulty with funding, hence lending will reduce
Solution=banking union so the crisis is spread across the union
Implications on automatic stabilisers:
-supposed to reduce the likelihood that an economy will crash when a shock occurs
-bad equi creates solvency and liquidity crisis, which leads to austerity
-in midst of recession, gov is unable to use automatic stabilisers to increase GDP

look at graph

DEBT DYNAMICS

Question 2

What are the solutions to prevent defaulting?

Answer 2

• Allow ECB to lend to govs, which would provide the gov with liquidity -> less need for austerity -> can honour interest payments on debt -> won’t default
• Raise cost of defaulting (e.g. by threatening to throw the defaulter out of the euro)
• BUDGETARY UNION. Consolidate the national debt of the eurozone. But would these transfers be politically acceptable?

EUROZONE WILL REMAIN FRAGILE WITHOUT A BUDGETARY UNION

Question 3

Problems caused by asymmetric shocks

Answer 3

At the same time, France experiences an AD expansion, whilst Germany experiences an AD contraction.
Clearly each country needs a different MP. Germany needs a reduction in the interest rate to increase AD back to equi. France needs an increase in the interest rate to reduce AD back to equi. But the ECB can only set one interest rate. ECB is paralysed, it has one instrument to deal with 2 problems