Which countries were European Union members as of 2003?

• France• Belgium• Netherlands• Luxembourg• Italy• Spain• Portugal• Greece• United Kingdom• Ireland

• Denmark

• Sweden

• Norway

• Finland

• Germany

• Switzerland

• Austria

• Cyprus

• Turkey

Which countries became EU members in 2004?

• Turkey

• Cyprus

• Malta

• Hungary

• Poland

• Czech Republic

• Slovakia

• Romania

• Latvia

• Estonia

• Lithuania

• Bulgaria

• Slovenia

Forms of Economic Integration• free trade area - free movement of goods and services

between member countries• Example: NAFTA

• customs union = free trade area + common external trade barriers

• Example: Mercosur (Brazil, Argentina, Paraguay, Uruguay)

• common market = customs union + free movement of labor and capital

• Example: European Union after Single Market Program

• economic union = common market + common currency ( common monetary policy and coordinated fiscal policies)

• Example: European Union after Maastricht Treaty

Forms of Economic Integration• free trade area - free movement of goods and services

between member countries• Example: NAFTA

• customs union = free trade area + common external trade barriers

• Example: Mercosur (Brazil, Argentina, Paraguay, Uruguay)

• common market = customs union + free movement of labor and capital

• Example: European Union after Single Market Program

• economic union = common market + common currency ( common monetary policy and coordinated fiscal policies)

• Example: European Union after Maastricht Treaty

Chronology of European Integration

• 2 problems after WWII:– Economic reconstruction– History of German-French hostility

• Technical cooperation: European Coal & Steel Community (1951)

• Free trade area: Treaties of Rome (1957)

• Customs Union (1967)

Legacy of segmented markets (pre-Single Market Program)

Markets segmented by protection - technical, physical and fiscal barriers - leading to:

• Pattern of “national champions”• Lack of economies of scale (high unit costs)• Overcapacity, overstaffing• Low incentive to innovate, invest• Unresponsive to customers & market changes

Not globally competitive, so seek protection…A vicious cycle...

that can be broken bythe dynamic benefits of economic integration

Common market: the Single Market Program• “Eurosclerosis” of early 1980s

– Lack of global competitiveness– Lack of progress towards higher level of integration– Euro-standards mentality

• 1987 Single European Act– Mutual recognition– 1992 target date

• Philosophy – dynamic benefits:– Economies of scale– More competitioncut costs, innovate,

respond to market

Result: increased global competitiveness

Broadening of membership

• Original Six: France, Germany, Italy, Belgium, Netherlands, Luxembourg

• 1973 - U.K., Ireland, Denmark• 1981 - Greece• 1986 - Spain, Portugal• 1995 - Austria, Sweden, Finland• 2004 – 10 new members from Eastern

Europe and the Mediterranean

Note: geographic alternation between richer (northern) and poorer (southern, eastern) countries

Rationale for a single currency in Europe

• Logical extension of the 1992 Single Market Program – Exchange rate fluctuations as barriers to a

single market– Growing percentages of intra-Community trade– Further increase global competitiveness by

reducing costs faced by European firms

Background: post-WWII European exchange rate

arrangements

• Bretton Woods: gold-dollar fixed exchange rate system

• Werner Report (1970)• Breakdown of Bretton Woods System• Snake (1974)

– “snake in the tunnel”– “snake in the lake”

EMS - European Monetary System (1979)

• Fixed exchange rate system• Components of EMS

– European Currency Unit (ECU)– Exchange Rate Mechanism (ERM)– Intervention funds

• EMS track record – Realignments (devaluations and revaluations)– Macroeconomic convergence

Rationale for a single currency (cont’d)

• Apparent success of EMS: stable exchange rates, converging economic performance

• Fixed exchange rates w/o capital controls are vulnerable to speculation

• Public enthusiasm for Single Market

• Politics - bind unified Germany to western Europe

Maastricht plan for EMU (Economic and Monetary Union)

• 1991 Maastricht Treaty criteria– Government deficit 3% of GDP

– Government debt 60% of GDP

– Inflation 3% per year

– Convergence of long term interest rates

– Everyone in ERM, no realignments for 2 years

• Original timetable for single currency:– All countries meeting the criteria join in 1997

– All other countries join in 1999

Exchange rate crises

• September, 1992 crisis– Precipitating factors: French referendum on

Maastricht, high German interest rates– Outcome: UK, Italy left ERM

• July-August, 1993 crisis– Precipitating factors: European recession, high German

interest rates– Outcome: bands of fluctuation widened from 2.25%

to 15%

• Lesson: EMS vulnerable w/o capital controls

Revised timetable for EMU• 1992, 1993 currency crises pushed back timetable• 1998 conference to determine which countries qualified,

set conversion rates– Creation of European Central Bank (ECB)

• Choice of head of ECB: Wim Duisenberg• France preferred Jean-Claude Trichet

• January 1, 1999 - start of EMU C– Exchange rates with euro irrevocably fixed– Euro is introduced and co-exists with legacy currencies

• Jan. 1, 2002 - euro notes and coins circulate• Early 2002 - national currencies disappear

Euro-zone: who’s in, who’s out

Countries that are inAustriaBelgiumFinlandFranceGermanyGreeceIrelandItalyLuxembourgNetherlandsPortugalSpain

Countries that are out

Denmark

Sweden

U.K.Referendum in September 2003; No’s won

5 tests show UK not ready; future referendum in doubt

Rejected euro in 2000 referendum; polls show support but no new referendum yet

Joined 1/1/01

Technically, the launch of the euro was a great success

• European Central Bank

• Contracts

• Stock and bond markets

• Public acceptance

But the euro lost a lot of value in the first 2 ½ years:

Explanations for the euro’s fall

• Rates of return in US vs. euro-zone– Interest rates– Stock markets

• Rates of economic growth and productivity

• Central bank credibility

Then the euro reversed direction:

Sep 2004

Explanations for the rise in the euro

• Rates of return in US vs. euro-zone– Interest rates– Stock markets

• Rates of economic growth and productivity

• Central bank credibility

US and Euro-zone 3-month interest rates (interbank)

0

1

2

3

4

5

6

7

8

07/24/1998 12/06/1999 04/19/2001 09/01/2002 01/14/2004 05/28/2005

pe

rce

nt

pe

r a

nn

um

Euro-zone interest rate US interest rate

Source: Datastream

Monetary policy – Euro-zone and US compared

• Who makes monetary policy decisions?

• How are these decisions communicated?

• What is the central bank’s mandate?

• How are monetary and fiscal policy coordinated?

ECB’s policy challenges• Balancing European and national economic needs

– Divergent economic performance• Have seen higher inflation in peripheral countries like Ireland

and Spain since euro launch• Growth has been slow in core countries like Germany

– Critics: over-emphasis on fighting inflation neglects economic growth effects of monetary policy

• Consensus decision-making– Critics: decisions are made too slowly– ECB: we don’t fine-tune as much as US; we realize

policy takes a long time to have an effect

ECB’s policy challenges (2)

• Communicating monetary policy – getting the “code” right– Credibility– Consistency– Transparency

• Critics: too secretive, should publish minutes

• ECB: we do not want policy to be interpreted as politically motivated

ECB’s policy challenges (3)• ECB Succession – Jean-Claude Trichet took over

November 1, 2003– Cleared in Credit Lyonnais scandal

• Will Trichet make a difference?– Trichet a “more forceful” personality– May be better communicator

• Duisenberg “too blunt”, Trichet “chooses his words more carefully”

– Analysts disagree about whether Trichet will alter strategy of 2% inflation target

• He was tough on inflation at Banque de France• Well-connected with central bankers who believe best practice is

to support economic growth + fight inflation

Fiscal policy in the euro-zone

• Fiscal policy governed by “Stability Pact” – Fiscal policy coordination necessary in order to

have a single monetary policy– Pact: budget deficits cannot exceed 3% of GDP

• Punishment for violations: public reprimand, fines (of up to 0.5% of GDP)

• Exceptions in cases of recession

– Germany was biggest supporter of pact

Stability Pact in practice

• Expected that smaller, “weak currency” countries would have most trouble with the stability pact– But it’s France and Germany whose budget deficits

have been too big the last few years

• France has resisted deficit reduction, citing slow growth– Undermines credibility of Stability Pact; – Looks like big countries are treated differently

• When Portugal breached limit in 2001, it was forced to reduce its deficit

Stability Pact in practice (2)

• European Commission and ECB urged Stability Pact compliance for France & Germany

• Nov 2003: finance ministers agreed France & Germany could cut less than Commission wanted– Gave France, Germany until 2005 to meet 3% limit

– Effectively suspended Stability Pact

– Ministers were split: Spain, Austria, Finland, Netherlands opposed agreement

Stability Pact in practice (3)

• Commission challenged ministers’ agreement in court– In July 2004 European Court of Justice ruled:

• Council of Ministers may not suspend the Pact• However, Council may reject Commission’s recommendations

and interpret the Pact its own way

• 6 countries likely to go over deficit limit in 2004– Germany says it’s likely to breach limit in 2005, too (4th

consecutive year)

• Looks like Pact will be revised; Commission has proposed some ideas (see below)

Revising the Stability Pact• General principle:

– Cannot reduce fiscal policy to a single variable (budget deficit) and a single number (3%)

• Ideas proposed by Commission in Sept. 2004– Relate rules to business cycle: can run bigger deficits in recession but

must run surpluses during expansion– Look at medium/long term debt sustainability

• Relate to economic growth, future pension liabilities, etc.

– Rely more on consultation, peer pressure than rules

• Differences of opinion– Germany opposes weakening pact, sees fiscal prudence as necessary

to avoid inflation– ECB opposes changing pact