A 2 Economics Power Point Briefings 2009 The

A 2 Economics Power. Point Briefings 2009 The Single European Currency tutor 2 u™

Key Issues • Which countries have joined the Euro Zone? • Why have convergence criteria? • What are the basic effects of a single currency? • What are the motivations for joining the Euro? • The case for UK entry • The case against UK entry • Optimal currency areas • Tensions for the single currency in 2009 -2010 tutor 2 u™

Britain and the Euro – The Current Position (2009) • Britain is outside of the Euro Zone • It has an opt out from the single currency • No entry likely in the coming years • Important point: Even though the UK is outside of the Euro Zone, the UK cannot be isolated from the static and dynamic effects of the Single European Currency tutor 2 u™

Back to Basics on the Euro • A single currency requires a common interest rate for the Euro Zone – i. e. a common monetary policy • 16 member nations are inside the Euro Area • The European Central Bank (ECB) sets official interest rates to meet an inflation target of 2% • The approach of ECB is different to that of the USA Federal Reserve (dual target) • The US Federal Reserve tends to set interest rates to maintain growth and avoid deflation tutor 2 u™

Central Bankers Bernard Bernanke Chairman of the Federal Reserve Mervyn King Jean-Claude Trichet Governor of the President of the Bank of European England Central Bank tutor 2 u™

Euro Zone Interest Rates tutor 2 u™

Judging the Success of the Euro • The Euro project should be judged according to whether it achieves its long term aims – (1) Sustained non-inflationary growth – (2) Lower long-term interest rates and higher rates of investment – (3) Lower unemployment – (4) Expansion of the EU single market • The Euro on its own in insufficient to achieve these – structural economic reforms in Europe are also required and many are taking place tutor 2 u™

Convergence Criteria – Joining the Euro • Flexibly applied for original Euro members – but more strictly applied in the case of new member states • Inflation: – Average inflation over previous year must not exceed by more than 1. 5% that of the three lowest inflation countries • Government Finances – Budget deficit must not exceed 3% of GDP – Gross government debt must not exceed 60% of GDP • Interest Rates: – Average yield on govt bonds must not exceed by more than 2% bond yields of three lowest inflation countries • Exchange Rate Stability: – Currency must have adhered to fluctuation margins of the ERM II in two previous years without severe tension tutor 2 u™

Inflation convergence – Slovakia tutor 2 u™

Nominal v Real (Structural) Convergence Nominal Economic Indicators • (Those required under the Maastricht Treaty) • Consumer price inflation • Short term interest rates • Fiscal (Budget) deficit • Gross government debt • Exchange rate stability tutor 2 u™

Nominal v Real (Structural) Convergence Nominal Economic Indicators Real Economic Indicators • (Those required under the Maastricht Treaty) • (Important in the long term) • Consumer price inflation • Labour market performance • Short term interest rates • Fiscal (Budget) deficit • Gross government debt • Exchange rate stability • Trend growth of GDP • Trend growth of labour productivity • Trade balances in goods and services • Investment/GDP ratios • Housing market structure tutor 2 u™

A 2 Economics Power. Point Briefings 2009 Optimal Currency Areas (OCA) • Is the Euro Zone an optimal currency area?

Is the Euro an Optimal Currency Zone? • An optimal currency zone occurs when: – (1) Countries have achieved real convergence – (2) They respond in similar ways to external economic shocks or macro policy changes – (3) They have sufficient flexibility in both their product markets and labour markets to deal with these shocks • High geographical mobility of labour • High occupational mobility of labour • Wage and price flexibility in factor markets – (4) Countries are prepared to use fiscal transfers to even out some of the regional economic imbalances within the European currency union tutor 2 u™

Optimal Currency Zones (2) • By most criteria, the current Euro Zone does not come close to an optimal currency zone! – The core group of EU countries are broadly similar (Germany + France + Netherlands + Belgium) – But peripheral countries have big structural differences – And there are barriers to the mobility of labour – Little wonder that tensions are rising in the Euro Area as recession bites tutor 2 u™

Optimal Currency Zones Highly Flexible Labour Market Flexibility Inflexible Divergent Real Economic Convergence Convergent tutor 2 u™

Optimal Currency Zones Highly Flexible Labour Market Flexibility High risk currency union Inflexible Divergent Real Economic Convergence Convergent tutor 2 u™

Optimal Currency Zones Highly Flexible Monetary Union Works Labour Market Flexibility High risk currency union Inflexible Divergent Real Economic Convergence Convergent tutor 2 u™

Is the Euro an Optimal Currency Zone? Professor Robert Mundell The 1999 Nobel Prize Winner "for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas" tutor 2 u™

Tensions in the Euro Area (2) • Recession in Euro Area as a whole (-2% in 2009) • Riots and protests – Fears of deep cuts in real wages – Rising unemployment – Strong Euro making life very tough for exporters – Many peripheral Euro Area countries are struggling e. g. Greece, Ireland, Italy, Portugal and Spain – Huge divergence in competitiveness showing up in massive trade imbalances – But no chance of nominal exchange rate adjustment – So downward pressure on wages and jobs tutor 2 u™

Tensions in the Euro Area (1) • Fiscal policy is coming under pressure: – Bail outs for financial institutions – But smaller EU states have little chance of doing this – Cross-border contamination e. g. heavy investment into CEEC’s by Austrian banks – Downgrading of credit rating for several Euro Area countries including Spain and Greece – Makes it more expensive for companies and the government to finance borrowing – Think of consequences for investment and growth What happens if one or more countries leave and devalue their way to an economic recovery? tutor 2 u™

A 2 Economics Power. Point Briefings 2009 Case for Entry into the Euro

Microeconomic Benefits of Entry • The Euro is important in realising some of the gains from a functioning single market • (1) Potential Gains for consumers – Lower prices because of increased competition/ greater price transparency (this is more likely with easily transportable goods) – Reduction in the transactions costs of travelling within Europe (e. g. costs of currency exchange) – Easier to live and work in different EU countries tutor 2 u™

Microeconomic Benefits of UK Entry (2) Potential gains for businesses • Invoicing can be done with one currency • Lower transactions costs – some people argue that staying out of the Euro is equivalent to exporters facing a tariff when they trade inside the EU • Gains for the tourist industry in attracting overseas visitors • Businesses might be able to fund their capital investment at lower real interest rates tutor 2 u™

A 2 Economics Power. Point Briefings 2009 The Case for Staying Outside the Euro Zone

Microeconomic Disadvantages (1) Changeover Costs from joining the Euro: – Costs of changing accounting systems – Menu Costs (vending machines, catalogues, franking machines, postage – Installation of new payments systems – Customer confusion (imperfect information) (2) Higher prices – Potential loss of consumer welfare if suppliers increase prices when converting from sterling to euro (3) The vast majority of consumers will continue to buy locally – what matters more is the effectiveness of competition policy in targeting anti-competitive behaviour tutor 2 u™

Macroeconomic Case Against Entry (1) Entering the Euro means losing an instrument of policy adjustment – A “one-size fits all” monetary policy may work against a country if their cycle is not convergent with Euro Zone – Retaining the option of making an exchange rate adjustment is useful (2) Fiscal Policy constraints – The EU Growth and Fiscal Stability Pact – Limits on government borrowing – But now largely ignored – especially with the effects of the credit crunch / fiscal bail-outs etc tutor 2 u™

Expansion of the Euro Zone • Slovenia joined in 2007 • Cyprus and Malta joined in January 2008 • Slovakia joined in January 2009 • Latvia narrowly missed out on the convergence criteria • Other countries have delayed their entry • What are the arguments for the new member states entering the single currency? tutor 2 u™

Converging on the Euro Area tutor 2 u™

Fixing the currency ahead of the switch tutor 2 u™