Societal Interest in Monetary System: European Monetary Union

Question 1

Road to economic and monetary union

Answer 1

1979-1999: European Monetary System with the European Exchange Rate Mechanism
1992: Maastricht Treaty, convergence criteria or Maastricht criteria
1997: Stability and Growth Pact, two rules on fiscal discipline:
- Annual budgetary deficits should not exceed 3% of national GDP
- Government debt should be no more than 60% of GDP
1st January 1998: European Central Bank (ECB)
1st January 1999: Adoption of the euro and of a single monetary policy under the ECB

Question 2

Why give up control of monetary policy?

Answer 2

• A single currency makes:
  – Trade easier between members
  – Countries independent
• Mundell’s unholy trinity
• The role of ideas: the triumph of monetarism over Keynesianism

Question 3

Key characteristics of the European Central Bank

Answer 3

• The ECB’s primary objective is to maintain price stability
• Inflation target: 2% over the medium term
• The ECB is an independent institutions (EU institutions and member states have no influence)

Question 4

Governance of the ECB

Answer 4

• The governing council is the main decision-making body of the ECB, it is formed by:
  – 6 members of the Executive board
  – The 20 governors of the national central banks of the euro area countries

Question 5

The Eurozone crisis trigger

Answer 5

2009: The newly elected Greek government revealed a much higher budget deficit than previously declared

Question 6

The Eurozone crisis structural causes

Answer 6

• Balance of Payment (BoP) imbalances
• The architecture of the Eurozone itself
  – No lender of last resort
  – Monetary union without a fiscal union
  – “Doom loop” between national banks and governments

Question 7

The Eurozone crisis as a BoP crisis (structural causes of Eurozone crisis)

Answer 7

With the adoption of the single currency, countries in the periphery were able to borrow at very low rates
- Banks in Europe’s core invested in faster-growing countries in the periphery
– Capital Flows: core -> periphery
- Borrowed capital mainly fed current consumption -> economic boom -> bubble -> burst and sudden stop -> inability to repay debts

Question 8

The Eurozone’s architecture (structural causes of Eurozone crisis)

Answer 8

• The fragility of the Eurozone
  – Eurozone countries issue debt in a currency over which they have no control
  – It means that countries cannot force their national central bank to provide liquidity (no lender of last resort)
  – As a result, countries are more exposed to self-fulfilling market sentiments
• The Eurozone is a monetary union without a fiscal union, necessary to offset the distributional consequences of monetary policy or provide a safety net and bailout troubled states
• The Eurozone is a monetary union without a banking union, necessary to prevent the “doom loop” between national governments and banks (governments allow public debt to increase to save national banks, which, in turn, hold their own government’s debt)

Question 9

Eurozone crisis resolution options, deficit countries (periphery)

Answer 9

External adjustment:
- Exchange-rate devaluation
Internal adjustment:
- Austerity (public spending cuts and/or tax increases) and structural reforms to restore the competitiveness of exports (typically associated with increased unemployment, lower wages, recession, etc)
Financing:
- Cover funding gap through external funding

Question 10

Eurozone crisis resolution options, surplus countries (core)

Answer 10

External adjustment:
- Exchange-rate appreciation
Internal adjustment:
- Reforms aimed at boosting domestic demand, letting inflation increase and competitiveness of exports decrease
Financing:
- Providing financing for deficit countries with BoP problems

Question 11

Eurozone crisis resolution options, implications for the Eurozone

Answer 11

External adjustment:
- Eurozone breakup
Internal adjustment:
- Convergence of deficits and surplus countries (burden sharing among creditors and debtors)
Financing:
- Permanent financing structures (eg. fiscal federalism, automatic stabilizers)

Question 12

Eurozone crisis resolution chosen option

Answer 12

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

Question 13

Internal adjustment and temporary financing (Eurozone crisis resolution)

Answer 13

• To avoid default, Greece was granted loans by the Troika (IMF, European Commission, and the ECB) in exchange for austerity measures (tax increases, reforms to enhance competitiveness and public spending cuts in categories such as pensions, unemployment benefits, health and education)
  – Ireland and Portugal’s bailout followed soon
• However confidence among creditors was not restored and sovereign spreads kept increasing, with Italy looking like a mortal threat to the euro

Question 14

Monetary policy (Eurozone crisis resolution)

Answer 14

• In July 2012, ECB’s President Mario Draghi announced to be ready to buy government’s bonds in the secondary market
• Financial markets believed in Draghi’s “Whatever it takes” and borrowing costs returned to pre-crisis level
• The ECB implemented several other unconventional measures to keep interest rates down

Question 15

Austerity measures continued in all of the debtor countries, at what cost? (Eurozone crisis)

Answer 15

• 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, GDP has fallen and the debt-to-GDP ratio has increased
• Inequality has risen, together with poverty and homelessness, while mental illnesses and suicides have increased
• Economic hardship has fueled populism and anti-EU feelings

Question 16

Changes in economic governance (Eurozone crisis)

Answer 16

Fiscal discipline
- European Semester (ex-ante coordination of fiscal policy)
- Fiscal Compact (2012) to foster budget discipline in the EU
- Creation of a permanent fund, the European Stability Mechanism (ESM)
Banking Union
- Created in 2014, with a Single Supervisory Mechanism and a Single Resolution Mechanism (SRM) with a Single Resolution Fund for effective and efficient resolution of non-viable credit institutions

Question 17

How is the “pandemic pressure” different from the Eurozone crisis?

Answer 17

• Public debt increased to face the economic downturn -> Suspension of the SGP rules and agreement among Eurozone leaders on mutualized debt
• The European Commission borrows money (at a more favorable rate than most Member States) to fund the NextGenerationEU, the “largest fiscal stimuli package ever”

Question 18

Why is the “pandemic pressure” different than the Eurozone crisis?

Answer 18

• No risk of moral hazard, as the pandemic was an exogenous and not endogenous shock
• Past austerity showed the need for countercyclical policies, for both social and economic benefits
• Temporary or sustained? remains to be seen