The Eurozone

Question 1

The Eurozone

Answer 1

The Eurozone is a common currency area or a monetary union.

» Eurozone also referred to as the European Monetary Union (EMU).

The Eurozone is a variant of a fixed exchange rate regime. Therefore, when looking at the Eurozone:
» monetary policy in an open economy under fixed exchange rates.

Question 2

The theory of the optimum currency area

Answer 2

The theory of an optimum currency area (Mundell, 1961):

» points to the costs and benefits of a country giving up independent
monetary policy and an independent exchange rate. Considerations of joining a common currency area.

For example, why did the following countries join the Eurozone?
» Germany:
‘Level playing field’ where other European countries could not gain a competitive advantage.
» Italy, Spain and Greece: Low and stable inflation.

Question 3

Microeconomic benefits of joining a common currency area

Answer 3

higher trade and investment due to elimination of foreign exchange rate risk

resource savings

increased competition

increased liquidity in financial markets

1. it is argued that monetary integration stimulates higher trade and investment, due to the fact that adoption of a single currency eliminates foreign exchange rate risk.
2. Real resource savings arise from eliminating transactions costs that are incurred by cur- rency conversion.
3. Competition in goods and labour markets would be expected to increase due to greater ease of price and wage comparisons. More competition, in turn, would be expected to produce both static and dynamic efficiency gains
4. Monetary union is expected to increase the liquidity of financial markets. This is of par- ticular benefit for small member countries. More liquid financial markets can also bring dangers of resource misallocation

Question 4

Macroeconomic benefits of joining a common currency area

Answer 4

reduction in exchange rate volatility

delegation authority for monetary policy: importation of stable inflation

avoidance of competitive devaluation by members of a CCA

Question 5

costs joining a common currency area

Answer 5

giving up an independent monetary policy and exchange rate regime

Question 6

The Eurozone’s performance in its first 10 years

Answer 6

Eurozone’s performance as a whole prior to the GFC was good. Monetary policy:
» ECB’s performance was broadly successful. Fiscal policy: less successful.
Member countries individual performance pre-GFC was heterogeneous.

Question 7

Indicators of imbalances

Answer 7

The real exchange rate.
Current account balances.
Public sector debt.
Private sector debt.
Variation in inflation in member countries.

Question 8

The Eurozone policy regime

Answer 8

Maastricht Treaty 1992.
» Monetary policy - ECB responsible for:
responding to Euro-area wide (common) shocks.
delivering low and stable inflation in the Eurozone (Euro area).

» Fiscal policy - National governments responsible for:

fiscal sustainability and stabilising country-specific & asymmetric
shocks.

the Stability & Growth Pact (SGP) - specifies limit on national budget deficits (< 3%) and on government debt–to–GDP ratio (< 60%). SGP aims to prevent policies that threaten the ECB’s inflation objectives.

» Supply-side policy
National labour & product markets and supply-side policies determine equilibrium unemployment.

Question 8

The Eurozone policy regime

Answer 8

Maastricht Treaty 1992.
» Monetary policy - ECB responsible for:
responding to Euro-area wide (common) shocks.
delivering low and stable inflation in the Eurozone (Euro area).

» Fiscal policy - National governments responsible for:

fiscal sustainability and stabilising country-specific & asymmetric
shocks.

the Stability & Growth Pact (SGP) - specifies limit on national budget deficits (< 3%) and on government debt–to–GDP ratio (< 60%). SGP aims to prevent policies that threaten the ECB’s inflation objectives.

» Supply-side policy
National labour & product markets and supply-side policies determine equilibrium unemployment.

Question 9

Interest rate differentials

Answer 9

Question 10

UIP condition with default risk

Answer 10

he risk-adjusted UIP condition says that a CCA member’s interest rate will be above the CCA interest rate to the extent that its nominal exchange rate is expected to depreciate and its risk of default on government debt exceeds that of the benchmark CCA government.

ln the Eurozone, the benchmark government debt is that issued by Germany (so-called German Bunds) and exchange rate risk is zero (as exchange rates are fixed between members). Hence, the difference between German and, for example, Greek interest rates on ten-year bonds reflects only the difference in default risk.

Question 11

During the Eurozone’s first decade, interest differentials with Germany on long-term gov- ernment bonds were very small. How can this be explained?

Answer 11

1. The markets viewed the likelihood of a default by a Eurozone government as being very low. For example, they considered the risk of a systemic banking crisis in a Eurozone member that would require a government rescue of banks as a very low probability event.
2. The markets did not connect the divergent performance among Eurozone members with the possible implications for government solvency.
3. The markets did not believe the Eurozone’s ‘no bail-out clause’ and took the view that any problem in one member government’s ability to service its debts would be solved by the ECB and/or by the other Eurozone governments.

Question 12

In terms of the relationships among member governments and between them and the ECB, the central elements were:

Answer 12

1. Government to government: the ‘no bail-out’ clause stated that other member govern- ments could not be called upon to bail out a government in trouble.
2. ECB to government: the ‘no monetary financing’ clause stated that the ECB would not provide credit to governments {i.e. it would not be the lender of last resort to govern- ments).
3. The fiscal rules: the entry rules for deficits and debt and the Stability and Growth Pact, which were designed to support {1) and (2).

Question 13

Stabilisation in the Eurozone: common shocks

Answer 13

Two levels of stabilisation
1. At the Eurozone level (supra-national).
2. At the country-specific level (national).

ECB works as a single monetary policy maker in the Eurozone. ECB responds to common shocks: shocks that affects all members.
» By choosing the real interest rate to achieve its inflation target.

Question 14

Stabilisation in the Eurozone: country-specific shocks - options available

Answer 14

Question 15

Eurozone membership & vulnerability to a sovereign debt crisis

Why is a country in the Eurozone (CCA) vulnerable to a sovereign debt crisis?

Answer 15

Question 16

No need for a fiscal union pre sovereign debt crisis.
What is the problem with this view?

Answer 16

When the government is the borrower, it is relying on its ability to raise tax revenue to provide confidence to the bond market that it will service its debts. it is clear that if the government is being called upon to use tax revenue to support failing banks (or there is a possibility it will have to do so), its ability to service its debt via tax revenue is reduced. This highlights the interconnection between the banks, the government and the bond market. We can see the parallel with the ‘last in line’ liquidity problem for banks (Chapter 5): if fear emerges that the government will not be able to service its debts, holders of bonds will sell them, prices will fall and, reflecting the rise in the risk premium, interest rates will rise.

Question 17

How can this be prevented?

Answer 17

If the central bank is the lender of last resort to the government, it can be relied upon to step in and buy government bonds.

assume that the flight from government bonds is inconsistent with the underlying ability of the government to service its debts (i.e. the government is solvent) then the government is suffering from a liquidity problem. The central bank can step in by printing money Uust as it does in the case of dealing with the liquidity problem of the banking system) and buying government bonds. The central bank would end up with more government bonds on its balance sheet and the counterpart on the liability side is an increase in high-powered money.

The mutual support of the government and central bank for each other-the taxpayer base is the ultimate guarantee of the solvency of the government and of the central bank’s ability to buy government bonds in unlimited quantities {LOLR)-is shown by the double-ended arrow in Fig. 12.11.

Question 18

Symptoms of a sovereign debt crisis

Answer 18

» An increase in a government’s default risk.

there are two aspects to this:

first, the member countries were issuing bonds in a currency (the euro) that they did not control and second, the central bank that issues the euros (the ECB) was pre- vented by its mandate from acting as lender of last resort to the governments of member states.

This created the fear of illiquidity of the government, i.e. that it would not be able to rollover its debts as they became due. As a result, interest rates on government bonds increased.

Question 19

The sovereign-bank doom loop in the Eurozone – the panic

Answer 19

Two types of vulnerabilities to debt crisis in the Eurozone.
1. 1 Private sector debt.
2. 2 Excess government deficits pre-GFC ⇒ sovereign debt crisis.
Private sector debt
» Banking crisis ⇒ fiscal crisis ⇒ sovereign debt crisis.
Evidence is Ireland and Spain when their house bubble burst even though fiscal position was good.
» Fiscal crisis ⇒ exacerbates banking crisis when banks hold lots of their government’s debt.

Question 20

Possible governance solutions to the Eurozone sovereign debt crisis

Answer 20

1. Supporters of a banking union: a banking union’s objective is to avoid banking crises and will provide arrangements for the resolution of failing banks.
   o » To deal with the doom loop problem.
   o » Single Resolution Mechanism - member countries are jointly responsible for bank solvency.
   o » Ensures national governments remain intact.
2. Supporters of a fiscal union: objective is to have a central government to allow for automatic stabilisation of country specific shocks through automatic stabilisers.
   » To provide adequate stabilisation at the supra-national level.
   » To deal with the threat to the sovereign banking crises.
3. Economic and Political Union

Question 21

The Eurozone crisis – policy steps – monetary policy

Answer 21

» ECB – massive injection of liquidity to support the banks.
» Draghi statement.
» But weak growth and fear of deflation.
» QE (2015 to 2020).
» A Eurozone banking union requires banking reform.
» Banking reform is needed whether or not there is banking union.
Break the doom loop by incentivising banks to diversify. Create a European deposit insurance system (supra national).

Question 22

Why policy steps were ineffective in reducing public debt

Answer 22

• » Reform is required - some proposals that try to avoid a fiscal union. Create a euro-area fund to stabilise large shocks but with incentives to minimize drawing from it.

Create euro-bonds from a portfolio of national bonds as an alternative to national bonds
.
* » Fiscal union proposals go further: centralising fiscal policy with stabilising fiscal flows like a national government.

» EU recovery fund deal revives hopes for Eurozone banking union.

Question 23

Current problems affecting the future of the eurozone

Answer 23

» Cyclical recovery - then stalled revealing underlying problems remain.
» Heterogeneity across countries.

Germany has fiscal space but is at high employment.
The countries that need to generate domestic demand such as Italy don’t have fiscal space (pro-cyclical rules).

» Over reliance on blunt and weak common instrument of monetary policy.

Question 23

Current problems affecting the future of the eurozone

Answer 23

» Cyclical recovery - then stalled revealing underlying problems remain.
» Heterogeneity across countries.

Germany has fiscal space but is at high employment.
The countries that need to generate domestic demand such as Italy don’t have fiscal space (pro-cyclical rules).

» Over reliance on blunt and weak common instrument of monetary policy.

Question 24

December 2018 European Union Summit

Answer 24

• » Create Eurozone deposit insurance system BUT only after successful banking reform.
• » Create euro area fiscal capacity BUT only after high government debt levels brought down.
• » Give European Stability Mechanism (rescue fund established in 2012) more resources BUT only after the non-performing loans problems are resolved.
• Meanwhile, a crisis is looming unless underlying issues are resolved.
• Banking union still unfinished business and progress is slow.

Question 25

Summary

Answer 25

The Eurozone is a common currency area but individual member countries are heterogeneous thus it is not yet an optimum currency area.

The Eurozone’s performance in its first 10 years was broadly successful but there were major imbalances in member countries individually. Private sector indebtedness:
» the banking crisis which contributed to the fiscal crisis. » consequently the Eurozone sovereign debt crisis.

Policy steps have been made since the Eurozone crisis but are insufficient to avoid a similar crisis.

Question 26

Governance solutions to the Eurozone

Answer 26

1. Banking union.
2. Fiscal union.

Banking union aim is to prevent banking crises but allow fiscal policy to remain national, a major source of fiscal conflict among members of Eurozone.

Fiscal union aim is to centralize fiscal policy to enable stabilization of country-specific shocks via automatic stabilizers and lend credibility to banking union.

Among Eurozone members, there is political opposition to full economic and political union – as in the US.

Question 27

Common and country specific shocks

Answer 27

Countries in the Eurozone do not have independent monetary policy and it is obvious to think of fiscal policy being used as an alternative stabilization policy instrument. But in a common currency area, the use of fiscal policy by one member can have spillover effects for the currency area as a whole.

This possibility led the Eurozone to adopt a fiscal policy framework for its members called the Stability and Growth Pact.

Question 28

Vulnerability to a sovereign debt crisis

Answer 28

The Eurozone crisis brought to the fore the need to model the vulnerability of a member of a common currency area to a sovereign debt crisis, where financial markets attach very different risk premia to the government bonds issued by different member country governments.

This requires an explanation of the relationship between banks, government and the central bank

The role of Eurozone membership is highlighted by the contrasting experiences of Spain and the UK. Although the underlying determinants ofthe solvency (the ‘fundamentals’) faced by the British and Spanish governments in 2011 were quite similar, interest rates on 10-year government bonds diverged sharply, reflecting differences in the market perception of the risk of sovereign default.

This divergence demonstrated the vulnerability to a sovereign debt crisis of a country that borrows in a currency it does not issue. As a member of the Eurozone, the Spanish government borrows in euros, but it is the Eurozone central bank, the ECB, which issues euros.

Question 29

Origins of the Eurozone and the theory of an optimal currency area

Answer 29

The political impetus for creating a common currency area in Europe was increased as a consequence of German reunification in 1990.

In economic terms, German industry favoured monetary union as a way of preventing its competitors in France, Italy and Spain from using exchange rate depreciation as a tool to regain competitiveness, as had happened under previous exchange rate arrangements. The private sector and policy makers in France, Italy and Spain saw Economic and Monetary Union as a means of acquiring a credible low inflation policy regime through a German-style inflation targeting central bank at the level of the common currency area.

The themes of competitiveness and the behaviour of wage and price setters under the new rules of the game of a currency union play a big role in this chapter.

The theory of an optimal currency area points to the costs and benefits of a country giving up independent monetary policy (and an independent exchange rate).

Question 30

Macroeconomic benefits of CCA explained

Answer 30

The theory of an optimal currency area highlights the main macroeconomic cost incurred byjoining a common currency area: the policy maker is no longer able to use monetary policy (and the associated change in the nominal exchange rate) to adjust to country-specific shocks. This cost falls with the degree of integration between a country and the rest of the CCA. The more closely the business cycle of a member is correlated with that of other members, the better will be the stabilization performed by the CCA central bank.

1. The degree of wage and price flexibility: domestic wage flexibility can substitute for a flexible nominal exchange rate since changes in prices influence the real exchange rate. For example, a period of wage and price growth below that of the other CCA members will make a country more competitive and boost net exports.
2. The mobility of labour: in principle, closer economic integration makes labour more mobile and this provides a shock absorber that can help substitute for the loss of the ex- change rate instrument. This channel works particularly well in the US, where the movement of workers across state borders is fluid. National differences in language, training and ac- creditation, and in the flexibility of housing markets are among the reasons for the limited mobility of labour across national borders in the Eurozone
3. The size of fiscal transfers: the bigger the central (i.e. Eurozone level) tax and transfer system, the more automatic stabilization there is for country-specific shocks). This channel does not operate well in the Eurozone, as the EU budget is tiny. In comparison, in the United States, the federal tax and transfer system is much more substantial.

Question 31

Benefits of a CCA explained

Answer 31

1. The reduction in exchange rate volatility and the removal of exchange rate overshooting from economic adjustment.
2. By giving up control of monetary policy to the ECB, countries which could not successfully manage inflation through their own central bank could ‘tie their hands’ and establish a low inflation monetary policy regime. This was a key reason for the southern European economies to join the euro.
3. The other countries in the CCA can no longer competitively devalue. Ruling this out was a major selling point of EMU membership to the German public, who already had a credible low inflation monetary policy regime before joining the euro (i.e. the Bundesbank).

Question 32

First decade of Eurozone performance explained

Answer 32

In its first decade and before the global financial crisis, the performance of the Euro area as a whole was close to target for inflation
Most countries displaying a small positive output gap. This suggests that the ECB was successful in managing shocks common to the Eurozone.
However, Fig. 12.1 shows very clearly how much variation there was in the performance of Eurozone member countries: at the top are the four Eurozone countries involved in the Eurozone crisis from 2010, Greece, Spain, Ireland and Portugal. These countries all had average inflation rates well above the ECB’s inflation target of 2% and positive output gaps during the first decade of the euro. In the opposite corner with inflation below the target and with a negative output gap is Germany. Individual country performance was very diverse.
how even when the nominal exchange rate is fixed, real exchange rates can move very differently: Spain’s competitiveness relative to the Eurozone average fell by 26% over the first decade of the Eurozone, whereas Germany’s improved by 17.5%. These divergences in external competitiveness were reflected in the build-up of current account imbalances, as shown in Fig. 12.2. We can see that Spain and Italy built up large current account deficits in the first ten years of the single currency, whilst Germany ran a large surplus.

Question 33

Eurozone policy regime explained

Answer 33

The Maastricht policy assignment
1. The ECB is responsible for using monetary policy to respond to Eurozone-wide shocks and for delivering low and stable inflation in the euro area.

2. National governments are responsible for fiscal sustainability and subject to that, for providing stabilization for country-specific shocks and for the asymmetric effects of common shocks (i.e. for dealing with the fact that common shocks may have different effects in different member countries).
3. The aim of the European Union’s Stability and Growth Pact was to prevent governments from pursuing policies that might threaten the ECB’s inflation objective.
4. National labour and product markets, and national supply-side policies would deter- mine equilibrium unemployment. However, supply-side reforms would be supported by the European Union’s ‘Lisbon strategy’. The Lisbon strategy was a European Union pro- gramme for the 10 years from 2000 aimed at making the EU ‘the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion’

Question 34

Monetary policy in the Eurozone

Answer 34

The ECB is politically independent of governments-its constitution reflects the legacy of the German central bank, the Bundesbank, and as a result it is more independent than either the Federal Reserve in the US or the Bank of England. it sets its own monetary policy in terms of its target (price stability, defined as an inflation rate of close to but below 2%). it uses its policy instrument, the interest rate, to achieve this target, considering both economic and monetary ‘pillars’

The economic pillar uses forecasts of the output gap and the deviation of inflation from target to inform the interest rate decision.
In contrast to most other independent central banks (e.g. the Bank of England), the ECB has an asymmetric inflation target. The target impi ies that the ECB wou Id be happier with inflation 1% below target than 1% above target. The target has been criticized on the grounds that it leaves the Eurozone more vulnerable to deflation than would be the case with a symmetric target.
The interest rate decision also reflects the second pillar of the ECB’s monetary policy strategy.

The second, or monetary pillar reflects the influence of the legacy of the German central bank, the Bundesbank. Unlike many central banks, the Bundesbank had considerable success in targeting the growth of the money supply as part of its price stability mandate. This contrasts with the failure of monetary targeting elsewhere n addition to using information from the economic pillar to set the interest rate, the ECB also uses the monetary pillar. For this purpose, it uses a reference growth rate of a broad monetary aggregate. The ECB’s inflation target is a rate below but close to 2%

Question 35

Fiscal policy in the Eurozone

Answer 35

The Stability and Growth Pact (SGP} specified that national budget deficits be kept below 3% and that the ratio of government debt to GDP be kept below 60%. The choice of these particular numbers can be rationalized by noting that a debt ratio of 60% was the average of the EU members in the years preceding the formation of the Eurozone; and with a debt ratio of 60%, the debt to GDP ratio will remain constant if the nominal growth rate is 5% and the budget deficit is 3% of GDP.1

concern about the deficits and debt levels in member countries arises because of fears of spillovers from national policy decisions to the Eurozone.

Question 36

There are several arguments about possible spillovers: