International Economics: European

economy and policies

L2 (2023-2024)
Julieta Peveri (Université Paris 1)

1
➢ CHAPTER 2 – THE ROAD TO MAASTRICHT :
EXPLAINING THE ECONOMIC AND MONETARY UNION

2
Main sources for this
chapter

➢ Baldwin R., Wyploz V. (2020), The economics of

European Integration, London, McGraw-Hill Higher
Education Sixth edtion: chapters 13, 14, 15, and
16
➢ De Grauwe P. (2018), Economics of Monetary Union,
Oxford University Press, 14th edition, chap. 1 to 4.

3 3
The Treaty of Maastricht (1992): Toward the
European Monetary Union

➢ The adoption of a single currency: a long process for Europe.

➢ The process that led to the creation of a single European currency

(the euro) and a European Central Bank (the ECB): both an
economic and a political phenomenon.
✓ Monetary unification has far-reaching consequences for

economic policy and performance Europe-wide. Economic

implications of this choice.
✓ Content of the Treaty: not a social-welfare-maximizing

planner, but the results of EU governments interacting

through treaty negotiations and interaction of interest groups
domestically.

4 4
The Treaty of Maastricht (1992): Toward the
European Monetary Union

➢ Why was this monetary union decided? In which

context? How were the member states of the Monetary
Union selected?
➢ Which way was chosen towards the single currency?
➢ What are the main contents of the Maastricht Treaty?
➢ What are the main economic consequences of the
implementation of this single currency?
➢ Did they form a so called “Optimum Currency Area”? If
not, how can the Monetary union be explained?

5
 .

CHAPTER 2 – EXPLAINING THE

ECONOMIC AND MONETARY UNION

2.1 The path towards a monetary union.

2.1.1 Macroeconomic tools
2.1.2 The road to Maastrich
2.1.3 Negotiations and outcome of the Treaty of
Maastricht

2.2 The theory of Optimal Currency Area

6
 Three principles: interest rate parity
• A trader deciding on investing anywhere in the world:
-Compare real interest rates;
-Consider exchange rate fluctuations

What would you do if

A) Foreign interest rate > Domestic interest rate and fixed exchange rate
B) Foreign interest rate > Domestic interest rate and foreign currency
will appreciate
C) Foreign interest rate > Domestic interest rate and foreign currency
will depreciate

7
 Three principles: interest rate parity
• If we are in A or B, you would want to invest broad, but also every other
trader! So?

• Huge outflow of domestic currency → depreciation

• But in one year everybody will want to sell foreign currency → appreciation

• Thus, financial markets are in equilibrium (without capital controls) when:

→ Interest rate parity condition. 8

 Three principles: interest rate parity

➢ Does the interest rate parity condition work?

➢ Interest parity condition interpreted as revealing market

expectations:

But on top of exchange rate fluctuations there is also risk:

Interest rate of risky asset = Interest rate of safe asset + Risk premium
 Three principles: interest rate parity

Government bond interest rates:

© The McGraw-Hill Companies, 2012

 Three principles: purchasing power parity
➢ The purchasing power parity (PPP) principle asserts that:

(Nominal) Exchange rate appreciation = Foreign inflation rate –

Domestic inflation rate.

➢ So, if inflation at home is durably lower than abroad,

domestic currency should appreciate (and conversely).

➢ Real exchange rate (measure of competitiveness): E × P/P*, where

E is nominal exchange rate; P and P* are prices of basket of goods
at home and abroad.

➢ When real exchange rate appreciates, competitiveness declines as

more baskets of foreign goods would need to be traded for 1 basket
of domestic goods.
 Three principles: purchasing power parity
E and prices are nominal variables. The money neutrality principle
asserts that nominal variables do not affect real variables in the long
run. PPP implies that the real exchange rate is constant.

Nominal and real exchange rates: Germany vs. UK, 1950–2010:

 Three principles: purchasing power parity

Developing countries: tendency to appreciate

 Three principles: the impossible trinity

Review of monetary policy:

Money neutrality in the long run but monetary policy can

affect the real economy in the short run, as explained by
IS-LM:
-IS curve represents the conditions under which the market for
goods and services is in equilibrium (with sticky prices);

-LM curve assumes that the central bank controls money supply to
affect interest rate.

with financial openness, interest rate parity condition must hold. Foreign
interest rate is given. If expected exchange rate change is also given,
the interest rate parity condition imposes our own interest rate: IRP line.
 Three principles: the impossible trinity

IRP does not necessarily go through point A (i.e., interest rate chosen
by the central bank): central bank must either accept being at B or
‘do something’ about the exchange rate.
• Consider 2 possibilities:

1) Fixed exchange rate:

In A, domestic i >i*: capital inflows → tendency to appreciation → CB buys foreign
currency →capital inflows continue → CB buys more → not sostainable

If domestic i < i*: capital outflows → tendency to depreciation → CB sells foreign

currency → capital outflows continue → CB cells more (limit to reserves!)

2) Flexible exchange rate:

In A, domestic i >i*: capital inflows → appreciation → X are more expensive →
decline in aggregated demand → IS shift left → equilibrium point B

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 Three principles: the impossible trinity

➢ Impossible trinity principle: only two of the three following features

are compatible with each other:
- full capital mobility;
- fixed exchange rates;
- autonomous monetary policy.
 Three principles: the impossible trinity

➢ The impossible trinity principle is central to European integration: fixing

the exchange rate means adopting the foreign interest rate;
conversely, maintaining the ability to choose the domestic interest rate
requires allowing the exchange rate to float freely.

➢ Since the EU adopted in 1992 the principle of open capital markets,

the choice has been circumscribed to the left or bottom sides of the
triangle. One way of escaping the choice between exchange rate
stability and monetary policy autonomy is to restrict capital
movements

➢ This is one reason why many European countries operated

extensive capital controls until the early 1990s when full capital
mobility was made compulsory. Likewise, many of the new EU
members only abandoned capital controls upon accession.
 Three principles: the impossible trinity
There are examples for each side of the impossibility triangle:
- Full capital mobility, autonomous monetary policy, flexible
exchange rate: Eurozone as a whole, USA, Japan, UK,
Switzerland, Sweden:
• exchange rate can be quite volatile;
• ability to conduct short-run stabilization.
Three principles: the impossible trinity
- Full capital mobility and fixed exchange rate: Exchange
Rate Mechanism:
• shallow distinction between such a policy and euro membership.
 Three principles: the impossible trinity

- Fixed exchange rate, monetary policy autonomy, capital

controls: many developing and emerging countries (e.g.,
Brazil, China):
people try to evade the restrictions;
negative effects on investment and growth.

➢ What happens when one tries to violate the impossible trinity?

A currency crisis: sooner or later a speculative attack wipes out the
fixed exchange rate arrangement.

Ex: Argentina 2001, Russia and South East Asia 1997, Europe 1993
 In a nutshell - What is possible:
➢ Full capital mobility and monetary policy autonomy (without fixed exchange
rate)
Monetary policy is effective but the central bank must give up any
preference to steer the exchange rate. The Eurozone as a whole, the US,
the Japan, follow this approach.

➢ Full capital mobility and fixed exchange rate (without monetary policy
autonomy)
The loss of monetary policy as a policy instrument: the central bank must
abandon the fixed exchange rate commitment (member states of the
Eurozone have given up monetary policy autonomy by transferring the
responsibility for monetary policy to a supranational body, namely the ECB).

➢ Fixed exchange rate and monetary policy autonomy (without full capital
mobility)
Capital controls block the interest parity principle. This combination was
widespread under the Bretton Woods system. Nowadays, some developing 22
countries, like China.
The point is that you can’t have it all: A
country must pick two out of three.

Paul Krugman (1999)

23
 .

CHAPTER 2 – EXPLAINING THE

ECONOMIC AND MONETARY UNION
1. The path towards a monetary union.
1. Macroeconomic tools
[Link] road to Maastrich
[Link] and outcome of the Treaty of
Maastricht

2. The theory of Optimal Currency Area

24
2. The road to Maastrich

2.1 Before paper money

2.2 Bretton Woods System and the “snake”
2.3 The Werner Plan (1970): the forerunner of the EMU.
2.4 The European Monetary System.
2.5 Main phases of the ESM.
2.6 From the ESM to Maastricht.
 Prehistory: before paper money
➢ Until end of 19th century, money was metallic and many currencies
were circulating: exchange rates corresponded to the different contents
of precious metal (silver and gold).

➢ During 19th century people started to identify money and country and
efforts were developed to put order: this led to the gold standard.

➢ The world was one big monetary union.

➢ The gold standard automatically restored a country’s external balance:

Hume’s price–specie mechanism, which applies to the internal working of
a monetary union:
➢ a country whose prices are too high is uncompetitive (real exchange
rate is overvalued) and runs a trade deficit → importers spend more
gold money than exporters receive from abroad → stock of money
declines → long-run monetary neutrality implies that prices will decline
and the process will automatically go on until competitiveness is
restored (real exchange rate in equilibrium level).
 Prehistory: before paper money
➢ Thus, gold standard was inherently stable. No capital control (although
slow gold movements). Capital traveling for trade but also for saving and
borrowing.
➢ No monetary policy autonomy (No CBs) since the stock of gold money
is determined by trade and gold mouvements
➢ i determined according to supply and demand.

➢ But prices highly unstables → affect wages → unemployment

➢ By the late 19th century, paper money started to exist: gold exchange standard
where paper money could circulate internationally, but each banknote was
representing right to obtain some amount of gold (= Gold exchange standard)

➢ The continuing automaticity of the gold exchange standard relied on adherence

to three principles, known as the ‘rules of the game’ (i.e., contemporaries tried
to implement the impossible trinity principle):
❖ full gold convertibility at fixed price of banknotes (i.e., fixed exchange rate);
❖ full backing where central bank holds at least as much gold as it has issued
banknotes (i.e., no monetary policy autonomy);
❖ freedom in trade and capital movements (i.e., full capital mobility).
 Prehistory: before paper money

➢ Gold exchange standard was suspended in 1914: disrupted gold

shipments and the ability to pay for international trade.

➢ Because of war expenditures, governments issued debt and printed

money. During the war, prices were kept artificially stable through
rationing schemes; when war was ended and prices were freed, the
accumulated inflationary pressure burst: Germany, Hungary and
Greece faced monthly inflation rates of 1000% or more in the early
1920s.

➢ Post-war policymakers committed to return to gold exchange

standard as soon as practical: at which exchange rate? European
countries adopted different strategies, which ended up tearing them
apart, economically and politically.
 Prehistory: before paper money
➢ UK: return to a much-depreciated sterling to its pre-war gold parity, ‘to
look the dollar in the face’, which forced appreciation: a landmark policy
mistake that led to overvaluation. Restoring competitiveness required
deflation through a lengthy and painful process. The Bank of England
withdrew from the gold standard in 1931.

➢ France: intended to return to its pre-war gold parity, but soon lost
control of inflation for several years due to high level of public debt. It
return in 1928 with 1/5 of pre-war gold exchange rate, which led to
surpluses. It had to devalue once UK and USA abandoned the gold
standard.

➢ Germany: never considered returning to its pre-war level. It suffered one

of history’s most violent hyperinflations. The German economy started to pick
up just when it was hit by the Great Depression. In the end, it stopped
conversion of marks into gold and foreign currencies – an extreme form of
capital controls by the Nazis– and imposed ever-widening state controls on
imports and exports.
Prehistory: before paper money
 Prehistory: before paper money
➢ When gold standard collapsed, exchange rates were left to float. Each
country (except Germany) sought relief by letting its exchange rate
depreciate to boost exports: tit-for-tat depreciations, which led to
protectionist measures.

➢ The result was political instability, leading to war.

➢ Among the many lessons learnt, two are relevant for the
monetary integration process:
❖ freely floating exchange rates result in misalignments that breed
trade barriers and eventually undermine prosperity;
❖ management of exchange rate parities cannot be left to each
country’s discretion: need of a ‘system’.
2. The road to Maastrich

2.1 Before paper money

2.2 Bretton Woods System and the “snake”
2.3 The Werner Plan (1970): the forerunner of the EMU.
2.4 The European Monetary System.
2.5 Main phases of the ESM.
2.6 From the ESM to Maastricht.
 Bretton Woods
➢ Bretton Woods conference established an international
monetary system based on paper currencies:
❖ gold as ultimate source of value, but the dollar as the anchor of the
system (with US government guarantying its value in terms of gold
= US$35/ounce );
❖ all other currencies defined in terms of the dollar = fixed but
adjustable +/- 1%;
❖ IMF supervising compliance and providing emergency assistance;
❖ most countries made abundant use of capital controls.

➢ System unravelled with lifting of capital controls in the 1960s:

exchange rates had to be freed or authorities had to give up
monetary policy autonomy. Most governments (except Canada)
refused to make such a choice. Monetary policy lead to inflation
and the dollar gradually became overvalued
 Bretton Woods

➢ Collapse in 1971: disequilibrium that led to the break-down = the

massive accumulation of dollars in the hands of US trading partner
countries with trade surpluses. US lost progressively its gold
reserves.

➢ Smithsonian agreement of December 1971: the dollar was devalued

by 8.6%, the major currencies appreciated and the margin of
exchange rate fluctuation vis-à-vis the US dollar was set at +/-
2.25%

➢ 1973: BW system abandonned

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The collapse of the Bretton Woods System and the
“snake”
➢ Fluctuation between currencies could lead to a maximum
spread of 4.5%.
➢ To solve this problem, the EEC members decided to
reduce intra-Community currency fluctuation margins.
➢ Beginning of the European monetary integration. On 24
April 1972, EEC central-bank governors concluded the
'Basel Agreement', creating a mechanism called the
‘Snake in the tunnel’.
➢ Member States' currencies could fluctuate (like a snake)
within narrow limits against the dollar (the tunnel) and
central banks could buy and sell European currencies,
provided that they remained within the fluctuation margin
of 2.25%.
The « snake » in the tunnel.
The Snake was meant to be ‘an island of stability in an ocean of
instability’

36
 Europe’s snake
➢ ‘European Snake’ = regional version of the Bretton Woods system to
limit intra-European exchange rate fluctuations.

➢ It was a very loose arrangement and when inflation rose due to the
first oil shock of 1973–74, divergent monetary policies led several
countries to leave the Snake.

➢ In spite of its failure, the Snake brought about two innovations:

❖ determination to keep intra-European rates fixed, irrespective of
what happened elsewhere in the world;
❖ European currencies needed to be defined vis-à-vis each other.
The Snake was meant to be ‘an island of stability in an ocean of
instability’.

➢ The next move was the European Monetary System (EMS).

Decades of attempts to achieve a monetary
union
The Werner Plan (1970): the forerunner of
the EMU.
➢ Werner Committee report in 1970: a monetary union was
feasible by 1980, in 10 years.

➢ Influential role on the Delors’ report (1989), which later

paved the way to the Euro.

➢ Five principles:
✓ 1/ economic convergence prior to monetary union,
✓ 2/ the liberalisation of capital movements,
✓ 3/ the irrevocable fixing of parities between currencies,
✓ 4/ a transfer of national sovereignty to Community bodies for
the main aspects of the economic policy and
✓ 5/ three phases to get there.
39
The Werner Plan (1970): the forerunner of
the EMU.
➢ The three stages of the Werner Plan:
➢ (1) coordination of monetary and fiscal policies by the
EC governments to reduce exchange rate fluctuations;
➢ (2) creation of the European Monetary Cooperation Fund
(EMCF) to help governments stabilize the exchange
rates if necessary; and
➢ (3) the EMCF would be transformed into the Central
European Bank and the exchange rates would be
irrevocably fixed.

➢ The Werner plan: never adopted by the EC (collapse

of the Bretton Woods system, enlargement of the EC in
1973, 1974 oil crisis…).
40
 The European Monetary System.

➢ March 1979, French President Valery Giscard D’Estaing and German

Chancellor Helmut Schmidt launched the European Monetary System
(with the participation of 8 Member states), which lasted a period of
almost 20 years until the end of December 1998.

➢ The EMS consisted of two major components:

➢ (1) The European Currency Unit (ECU),
✓ European Currency Unit (ECU): used as a unit of account and for a

variety of transaction, based on the size of the economy and the intra-EC
trade shares of the member countries. It’s virtual.
✓ Value of an ECU: a weighted average of the value of all the currencies

that were members of the EMS.

➢ (2) The Exchange Rate Mechanism (ERM).
(2) The Exchange Rate Mechanism
(ERM)
❖ Cours plancher/plafond=upper and lower intervention levels.
fluctuation bandwidths’ (marges de fluctuation) of ±2.25.
❖ If 75% of the possible fluctuation margin was reached, central
bank should intervene
❖ Until when? If marked don’t react → realignment

42
The European Monetary System
 The European Monetary System

No fewer than 12 realignments during 1979-1987 due to different

inflation rates:
 The European Monetary System
➢ As capital controls were lifted, realignments became increasingly
destabilizing. Thus, high-inflation and depreciation-prone countries
tried to reduce inflation to converge to the lowest rate:

➢ Germany became the standard to emulate (i.e., German monetary

policy became the ERM standard and other countries de facto
surrendered monetary policy independence) and inflation rates
started to converge.

➢ No realignment between 1987 to September 1992; a system

designed to be symmetric became perfectly asymmetric. Two
implications:
❖ countries resented the Bundesbank leadership;
❖ Germany was unwilling to give up leadership but accepted a
political deal in 1991: monetary union in exchange for
reunification with the former East Germany.
 The European Monetary System
❖ But inflation differentials persisted (Italy, Spain and Portugal started
from too far away) → exchange rate kept appreciating → loss of
competitivness

❖ German reunification was costly and became inflationary, which led

to contractionary German monetary policy (increase i). When other
countries did not follow and referendum in Denmark rejected the
Maastricth Treaty and negative polls in France → speculative
attacks targeted countries that were less competitive:
❖ Banca d’Italia and Bank of England intervened to
support their currencies;
❖ attacks became so massive that Bundesbank stopped its
support
❖ the lira and the pound withdrew from the ERM;
❖ speculation shifted to the currencies of Ireland, Portugal and
Spain; contagion then spread to Belgium, Denmark and France;
❖ monetary authorities adopted new ultra-large (±15 per cent)
bands of fluctuation: tight ERM was dead.
 The European Monetary System

Post-crisis ERM agreed in 1993 differed little from a floating exchange

rate regime (i.e., bilateral parities could move by 30%).

One condition in Maastricht Treaty for joining the monetary union: at

least two years of ERM membership: ERM is still in use as a
temporary gateway but it has been re-engineered:
- parities defined vis-à-vis the euro;
- margin of fluctuation less precisely defined;
- interventions automatic and unlimited, but ECB may stop them.
•It was the 1992 EMS crisis that provided the
immediate impetus for monetary unification.

Barry Eichengreen (2002)

48
2. The road to Maastrich

2.1. The collapse of the Bretton Woods System and the

“snake”
2.2. The Werner Plan (1970): the forerunner of the EMU.
2.3. The European Monetary System.
2.4. Main phases of the ESM.
2.5. From the ESM to Maastricht.
50
CHAPTER 2 – EXPLAINING THE
ECONOMIC AND MONETARY UNION

1. The path towards a monetary union.

[Link] Monetary integration following the
Collapse of the Bretton Woods System
2. Negotiations and outcome of the Treaty of
Maastricht

2. The theory of Optimal Currency Area

51
 The Maastricht Treaty

➢ The Maastricht Treaty (1991) established the monetary union:

o it described in great detail how the system would work, including
the statutes of the ECB;
o it set the conditions under which monetary union would start;
o it specified entry conditions (mostly at German request);
o fulfillment of these criteria to be evaluated by late 1997, a full year
before the euro would replace the national currencies. In the end,
all the countries that wanted to adopt the euro qualified, with the
exception of Greece, which had to wait for another two years.

➢ On 4 January 1999, the exchange rates of 11 countries were

‘irrevocably’ frozen and the power to conduct monetary policy was
transferred to the European System of Central Banks (ESCB),
under the aegis of the European Central Bank (ECB). Euro
banknotes and coins were introduced in January 2002.
 The Maastricht Treaty

➢ Monetary union is the outcome of a deal between Germany and

the other countries. As part of it, the Maastricht Treaty included:

❖ a firm commitment to launch the single currency by January 1999 at

the latest;
❖ a list of five criteria for admission to the monetary union;
❖ a precise specification of central banking institutions;
❖ additional conditions mentioned (e.g. the excessive deficit
procedure).

➢ Maastricht Treaty introduced, for the first time, the idea that a major
integration move could leave some countries out. It specifies that all
countries are expected to join as soon as practical (Denmark and UK
were given an exemption; Sweden does not have an exemption but
acts as if it did).
53
 The Maastricht Treaty: three principles

3 principles

1. Price stability: main objective of the Eurosystem.

2. Central bank independence: free to operate without interference

3. Fiscal discipline: to accomplish 1 and 2

54
 The Maastricht Treaty: five entry conditions
A selection process to certify which countries had adopted a ‘culture of price
stability’ (i.e., German-style low inflation): countries have to fulfill five
convergence criteria:
1. inflation: not to exceed by more than 1.5 percentage points the
average of the 3 lowest inflation rates among EU countries;

55
The Maastricht Treaty: five entry conditions

2. Long-term nominal interest rate: not to exceed by more than 2

percentage points the average interest rate in the 3 lowest inflation
countries (long-term interest rates mostly reflect markets’
assessment of long-term inflation = Fisher principle);
Otherwise inflation objective can be reached with short-term
sacrifices

3. ERM membership: at least 2 years in ERM without being forced

to devaluate;

4. budget deficit: deficit less than 3% of GDP. Historically, all big

inflation episodes born out of runaway public deficits and debts!

5. public debt: debt less than 60% of GDP (average of countries

when Maastricht treaty signed).
56
Understanding the thresholds: Why a 3% and
60%?
➢Two stories on why the bound on deficit was set at 3% and the
debt to GDP at 60%: (i) German Golden Rule, (ii) Estimates of
growth and inflation within the Euro Area

➢According to the first story, it was Germany which imposed the

German view of an acceptable budget deficit, based on the so-
called “Golden rule of public finance”.

➢According to the first Golden rule, a deficit is acceptable if it is due

to public investment (e.g. road, telecommunications, other
infrastructures) and not to current expenditure (e.g. salaries of
employees of the public sector).

➢Only the part of the budget deficit which can be traced back to
public investment should be finance
57
Understanding the thresholds: Why a 3% and
60%?
➢This rule is based on the assumption that public investment is a source
of growth and therefore is capable to generate a social or economic
return which can compensate for the cost of borrowing in order to
finance deficit.
➢According to the German Golden rule, roughly 3% of the deficit is due
to public investment. Hence the threshold should be 3%. Notice
however, that the Golden rule was not incorporated in the convergence
criterion.
➢The idea behind these criteria is then that high public indebtedness of
an EMU country can be problematic because a country that cannot pay
its public debt would most likely request assistance from the ECB.
Therefore, a country could fulfill the criterion even if public investment
were less than 3% of the budget.
➢Italy succeeded in making the budget deficit shrink from 7% of GDP in
1997 to 3% in 1998.
➢Italy, Germany, France and Spain engaged in some window dressing
and creative accounting to hide some of the deficit by 1998 58
Made in Germany?

➢ Several factors contributed to the fact that the

Maastricht regime was ‘largely a “made in Germany”
product’ :
✓ the asymmetric functioning of the EMS and the strong
negotiating position of Germany, which in turn resulted
from the lack of an attractive alternative to the agreement;
✓ the position of the Bundesbank, which was able to dictate
the conditions of its own abdication of power;
✓ strong theoretical support, based on Germany
vision of how Economics work
✓ and the success story of German monetary policy
 2nd view: Constant debt ratio
➢The second story explaining the upper bound on the deficit/GDP ratio is the
following. European leaders agreed that in a satisfactory scenario over the
long run EMU would be characterized by real growth of 3% and inflation of
2%.

➢ Combining this with a constant debt to gdp ratio of 60%:

➢Therefore, in order to keep the debt/GDP ratio constant at 60% with real
growth at 3% and inflation at 2% it is necessary a constant deficit/GDP ratio
around 3%

60
Two speed Europe

61
Four main elements of the Treaty

➢ 1. Open market, which secures the four fundamental

freedoms of the single market.
➢ 2. Primacy of monetary policy by subordinating the
functioning of the eurozone to an inflation target
defined by the European Central Bank.
➢ [Link] role of national budget policies is limited to
smoothing out business-cycle fluctuations.
➢ 4. Fourth, the interdiction made to the ECB to
monetarize sovereign debt and the ‘no bailout’ clause
between member states in the case of crises of solvency
affecting one member.

47
Performance of EU member states in relation
to the Maastricht convergence criteria, 1997–
1998.

51
Convergence Criteria

➢ Of the 15 evaluated candidate EMU members, 11 met 4

criteria, but not the government debt-to-GDP ratio.
Because it was difficult for the countries to meet the
required public debt-to-GDP ratio, the European Council
waived this criterion.

52
Government budget deficits as a percentage
of GDP in the EU, 1995–1997.

53
 The Eurosystem

❖ N countries with N National Central Banks (NCBs) and a new

central bank at the centre: the European Central Bank (ECB).

❖ The European System of Central Banks (ESCB): the ECB and all
EU NCBs. The Eurosystem: the ECB and the NCBs of euro area
member countries.

66
Objectives

“The primary objective of the ESCB shall be to maintain price stability.

Without prejudice to that objective, it shall support the general
economic policies in the Union in order to contribute to the
achievement of the latter’s objectives.”
(Article 282-2)

Eurosystem has chosen to interpret it as follows: ‘Price stability is

defined as a year-on-year increase in the Harmonized Index of
Consumer Prices (HICP) for the Eurozone of below 2 per cent.
Price stability is to be maintained over the medium term.’
 commonly understood as between 1.5 and 2%;
 commonly understood to refer to a 2–3 year horizon.

67
 Instruments

Eurosystem uses the short-term interest rate: its changes have a

knock-on effect on longer-term interest rates (and thus on the cost
of credit), on asset prices (and thus on capital costs of firms) and on
the exchange rate (and thus on foreign demand for domestic goods
and services).

The Eurosystem focuses on the overnight rate EONIA (European Over

Night Index Average, a weighted average of overnight lending
transactions in the Eurozone’s interbank market):
- The Eurosystem creates a ceiling and a floor for EONIA by
maintaining open lending and deposit facilities at pre-announced
interest rates;
- The Eurosystem conducts, usually weekly, auctions at a rate that it
chooses, thus providing liquidity to the banking system and the
chosen interest rate serves as a precise guide for EONIA.
68
Instruments

69
 Strategy

Strategy relies on three main elements:

1. definition of price stability;

and two ‘pillars’ to identify risks to price stability:

1. first pillar = ‘economic analysis’. It consists of a broad review of
recent evolution and likely prospects of economic conditions (e.g.,
growth, employment, prices, exchange rates, foreign conditions);
2. second pillar = ‘monetary analysis’. It studies the evolution of
monetary aggregates (M3, in particular) and credit.
 Independence and accountability
Independence
➢ Institutional arrangements: the treaty of functioning of the EU
stipulates that NCBs and ECB are protected from political influence

➢ Status of the Eurosystem officials: personal independence is

guaranteed. Elected for 8 years without reelection

➢ Policy objectives and instruments: vague enough to allow

Eurosystem to decide (except if it’s threats price stability).

➢ Financial independence: Own budget

 Independence and accountability

Accountability

➢ In democracies, delegation to unelected (also elected) officials

must be counterbalanced by accountability.

➢ 2 ways: reporting and transparency

➢ Reporting: Annual report to the Parliament, the Council and the

Comission. But beyond formal requirements, the European
Parliament never really challenged the ECB.

➢ Transparency: refers to the communication of deliberations,

policies, voting, etc. to the public
73
 Independence and accountability
Independence and transparency indices:

© The McGraw-Hill Companies, 2012

 The first years (until the Great Crisis)

A difficult period:
- oil shock in 2000;
- September 11 in 2001;
- oil prices to record level and US financial crisis start in mid-2007

Result: inflation almost always above 2% but close to target (until

2007) and lower than perceived.

Growth has been generally slow in the Eurozone, prompting criticism

of the ECB, including by some member governments.
The first years (until the Great Crisis)
Inflation in the Eurozone (%), 1999Q1–2008:
The first years (until the Great Crisis)

Average annual GDP growth rate (%), 1999–2008:

© The McGraw-Hill Companies, 2012

 The first years (until the Great Crisis)
➢ Exchange rate: from too weak to too strong? But Eurosystem does
not manage exchange rate: the euro is a freely floating currency
 The first years (until the Great Crisis)
Asymmetries:
 The first years (until the Great Crisis)

Still, large inflation differentials have occurred:

- lower than average: Germany, France and Finland;
- higher than average: Ireland, Spain, Portugal, Netherlands and
Italy.

Possible causes:
- catching up in productivity levels;
- wrong initial conversion rates;
- autonomous wage and price setting;
- policy mistakes, such as fiscal expansion;
- asymmetric shocks, such as oil price effects.
 The first years (until the Great Crisis)
Asymmetries:
 New EU members and EMU
➢ New EU members do not have an opt-out so they are formally
required to join the Eurozone ‘as soon as possible’.

➢ They must meet the five convergence criteria, assessed

by ‘Convergence Reports’.

➢ The latest extensive report was issued in May 2008 and included
the ten countries with a derogation (Bulgaria, the Czech Republic,
Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Slovakia
and Sweden): only Slovakia met the conditions to join the euro area
in January 2009 (for Sweden, this is intentional since it does not
want to join the ERM).

➢ Estonia joined in 2011, Latvia in 2014, Lithuania in 2015 and

Croatia in 2023.
 .

CHAPTER 2 – EXPLAINING THE

ECONOMIC AND MONETARY UNION

1. The path towards a monetary union.

1. Macroeconomic tools
[Link] road to Maastrich
3. Negotiations and outcome of the Treaty of
Maastricht

2. The theory of Optimal Currency Area

83
1. The path towards a monetary union.

2. The theory of Optimal Currency Area

➢ 2.1 Benefits and costs of a monetary Union: theory of
Optimal Currency Area

➢ 2.2 The optimum currency area criteria

➢ 2.3 Is the Eurozone an Optimum Currency Area?

Optimum Currency Area

• “The European countries could agree on a common piece of paper, . . .

they could then set up a European monetary authority or central bank. . . .
This is a possible solution, perhaps it is even an ideal solution. But it is
politically very complicated, almost utopian.” Robert Mundell (1973)

85
Should currency area borders coincide with
national borders?
• Money makes transactions immensely easier: the more people accept a
currency, the more useful it is;

but as a currency area grows larger, it becomes more diverse, which

means more costly.

• The solution has to involve trading off these costs and benefits

86
2.1.1 Benefits of monetary Unions

➢ Whereas the costs of a common currency have much to

do with the macroeconomic management of the
economy, the benefits are mostly situated at the
microeconomic level arsing from efficiency gains and
therefore not always easy to evaluate

56
2.1.1 Benefits of monetary Unions
➢ Direct gains from the elimination of transaction costs:: if you
started with one EU currency and exchanged it successively in all
the currencies of the EU (before the Euro) and than exchanged it
back into the initial currency, you would get less than 50% of the
initial amount!

➢ Indirect gains from the elimination of transaction costs: price

transparency.

➢ Welfare gains from less uncertainty (Elimination of exchange rate

risk for transactions and FDI)

➢ Trade: less transaction costs + less uncertainty → more trade

➢ Quality of monetary policy: More independent central bank and

better quality of monetary policy.
61
2.1.1 Benefits of monetary Unions

➢ Benefits of an international currency

• First, when a currency is used internationally, the issuer of that

currency obtains additional revenues.

• A second source of benefits: an international currency is also one

that held as international reserve by foreign central banks.

• A third benefit: an international currency will boost activity for

domestic financial markets.

• What is the situation of the Euro regarding its international

performance?

89
90
91
2.1.1 Benefits of monetary unions

➢ Benefits are sizeable but difficult to quantify.

➢ Some of them are controversial: as the increase in

competition

➢ Benefits increase with size of monetary union (marginal

benefits are decreasing but always positice)

➢ Usufulness and convenience of a currency depends on

the number of people who use it

64
2.1.2 Costs of monetary unions

➢Costs are mainly due to the macroeconomic side of the economy

➢Diversity in a currency area is costly because a common currency makes

it impossible to react to each and every local particularity.

➢Analysis is based on celebrated contribution of Robert Mundell (1961)

➢Assume two countries, France and Germany

➢Asymmetric shock in demand

• Decline in aggregate demand in France
• Increase in aggregate demand in Germany
• Need to distinguish between permanent and temporary shock
 Figure 1.1: Aggregate demand and supply in
France and Germany
France Germany

PF P SG
SF G

DF DG

YF YG
2.1.2 Costs of monetary unions

Assymetric shock outside a monetary union

What if France and Germany have their own currency and national central
bank?

Then national interest rate and/or exchange rate can be used:

France can devaluate the franc against the mark → increase competitiveness
of French products → increase demand in France coming from Germany

France can reduce interest rate → stimulate demand

Opposite reasoning for Germany

95
 Figure 1.3: Effects of monetary expansion in France and monetary contraction in
Germany

France Germany

PF P
G

YF YG
2.1.2 Costs of monetary unions

• How can France and Germany deal with this shock if they form a
monetary union?

• If both countries are hit by the same adverse shock, solution: real
depreciation vis-à-vis the rest of the world.

• But under an asymmetric shock, France cannot stimulate demand

using monetary policy; nor can Germany restrict aggregate demand
using monetary policy

• Do there exist alternative adjustment mechanisms in monetary

union?
1. The path towards a monetary union.

2. The theory of Optimal Currency Area

➢ 2.1 Benefits and costs of a monetary Union: theory of
Optimal Currency Area

➢ 2.2 The optimum currency area criteria

➢ 2.3 Is the Eurozone an Optimum Currency Area?

55
 2.2 The optimum currency area criteria

- The notion of “optimum currency areas” was introduced by Robert Mundell

in 1961 and then further elaborated by Ronald McKinnon (1963) and Peter
Kenen (1969) and others.

- Main idea: the choice between fixed and flexible rates should not be
independent of the economic characteristics of the countries . The
optimum currency area (OCA) theory derive practical criteria to understand
which countries should share the same currency.

- Three classic (economic) criteria:

- Mundell: labour mobility
- Kenen: diversification
- McKinnon: openness
- Three political criteria:
- fiscal transfers;
- homogeneous preferences;
99
- solidarity vs. nationalism.
 Criterion 1 (Mundell): labour mobility
Optimum currency areas are those within which people move
easily:
unemployment in A and inflationary pressures in B could be solved by
moving production factors from A to B.
PF P
G

YF YG
France
Germany
➢ Mundell proposed two other criteria
to judge optimality:

Wages and prices flexibility:

wages decreased in France; and in Germany, the excess
demand for labour will push up the wage rate . The
reduction of the wage rate in France shifts the aggregate
supply curve downwards, whereas the wage increases in
Germany shift the aggregate supply curve upwards.

✓ in the absence of labour mobility and/or wage-price

flexibility, the frequency and incidence of
asymmetric shock should be a criterion for
assessing optimality.

78
 Figure 1.2: The automatic adjustment process

France Germany

PF P
G

YF YG
 Criterion 1 (Mundell): labour mobility
Caveats:
- labour mobility is easier within national borders (culture, language,
legislation, welfare, etc.) than across countries;
- in presence of country specialization, skills also matter (time to
train workers);
- capital mobility: difference between financial and physical capital.

103
Criterion 2 (Kenen): production diversification
Countries whose production and exports are widely diversified
and of similar structure form an optimum currency area:
indeed, in that case, there are few asymmetric shocks and each of
them is likely to be of small concern.

Caveat:
- a very broad statement: How much diversification and
production similarity is enough?

104
 Criterion 3 (McKinnon): openness

Countries that are very open to trade and trade heavily with each
other form an optimum currency area:
- traded good prices are set worldwide;
- if all goods are traded, domestic good prices must be flexible and
the exchange rate does not matter for competitiveness.

Caveat:
- exchange rate can affect profits for exporters
- True, but consider case when goods incorporate parts produced in
other countries. If profits rises (declines) because of depreciation
(appreciation) , it can be compensated by increase (decreased) in the
imported components

105
 Criterion 4: fiscal transfers

Countries that agree to compensate each other for adverse

shocks form an optimum currency area:
- transfers can act as an insurance that mitigates the costs of an
asymmetric shocks;
- transfers exist within national borders;

Caveat:
- the debt crisis has brought forward the issue of transfers (i.e.,
moral hazard = if you know than in case of a bad shock, you’ll
receive transfers → less incentives to avoid those shocks).

106
 Criterion 5: homogeneous preferences
Currency union member countries must share a wide consensus on
how to use collective instruments (i.e monetary policy) and how to
deal with shocks

➢ Habeler (1970) and Tower and Willett (1976) stressed the importance
of sharing common collective preferences in terms of growth,
inflation,unemployment and public finances.

➢ Collective preferences , which shapes the policy response, thus

depends on domestic politics and there is no reason for all the
countries of a currency area toshare the same balance of political
forces.

➢ This criterion states that these differences should not be too wide. So
currency union member countries must share a consensus on the way
to deal with shocks.

Caveat: - a very broad statement

107
 Criterion 6: solidarity vs. nationalism

When the common monetary policy gives rise to conflicts of

national interests, the countries that form a currency area need to
accept the costs in the name of a common destiny:

it is unavoidable that there will be times when there will be

disagreements and that these disagreements may follow national lines:
people must accept that they will be living together and extend their
sense of solidarity to the whole union.

➢ Argument often used to say that a political union should come

before a monetary union. Eurozone challenges this view betting that
solidarity across nations is possible.

108
1. The path towards a monetary union.

2. The theory of Optimal Currency Area

➢ 2.1 Benefits and costs of a monetary Union: theory of

Optimal Currency Area

➢ 2.2 The optimum currency area criteria

➢ 2.3 Is the Eurozone an Optimum Currency Area?

55
 2.3 Is Europe an optimum currency area?
Assymetric shocks in the UE

• The nature of shocks in the eurozone: empirical evidence (De

Grauwe & Ji, 2016).

• In order to gain insights into the nature of booms and busts in the
Eurozone we can first have a look at the cyclical movements of the
GDP in the Eurozone countries from the mid-90s to 2014.

• The cyclical component is obtained by subtracting the trend

component from the observed GDP (by using a Hodrick-Prescott
filter).

110
111
112
 2.3 Is Europe an optimum currency area?
Assymetric shocks in the UE

• First, we observe for all eurozone countries (except for Germany) a

decline in the long-term growth rate of GDP. This decline is
particularly significant in Greece, Ireland, Finland, Spain, Portugal and
Italy.

• Second, there is great variability in the business cycle (temporary)

component of GDP growth.
• In order to asses the relative importance of cyclical and

113
114
 2.3 Is Europe an optimum currency area?
Assymetric shocks in the UE

• For the core countries (Austria, Belgium, Germany, and the Netherlands)
the cyclical growth and trend growth components are of similar
magnitudes, although the cyclical component is systematically larger
than the trend component.

• It appears that the cyclical movements of GDP are highly correlated in

the eurozone. This is made clear by the following table, which shows the
correlations in the cyclical components of GDP growth across the
eurozone.

• We observe high correlation coefficients of bilateral cyclical components

of GDP growth, typically 0.8 or more. It is interesting to note that the
country with the lowest correlation coefficients is Germany.

115
 2.3 Is Europe an optimum currency area?
Assymetric shocks in the UE

• In sum, concerning the asymmetry between the Eurozone countries:

Eurozone countries’ business cycles seem to have been relatively well
correlated.

• Yet, countries in the periphery experienced much more higher variance

in business cycle than others; the core countries.

• As a result, the main asymmetry between member countries is to be

found in the variance of the business cycle.

116
117
 2.3 Is Europe an optimum currency area?
Assymetric shocks in the UE

Policy implications (Delattre, 2019)

• Large idiosyncratic shocks in the European countries strengthen the case
for policy autonomy made the EMU more difficult.

• Strong distinction between a core of EC members with highly-correlated

aggregate supply and periphery with larger and more idiosyncratic
disturbances ; two-speed Monetary Union

• Germany and its immediate EU neighbours come much closer than the
Euro area as a whole to represent a workable monetary union along
American lines.

118
 2.3 Is Europe an optimum currency area?
Labour mobility: Europeans move little!

119
 The effects of asymetric shocks in Europe
and the USA: labour market responses.

• Fatas (2000) looks at 51 regions in the USA and at 54 regions in Europe (a

decomposition of 14 EU countries) at the turn of the century.
• He asks what happens when an adverse asymmetric shock occurs, i.e,
when it affects just one region.

• Results: Employment declines and, for the same shock size, the effect is
quantitatively similar in Europe and in the USA;

In the USA, most of the drop in employment is met by regional

emigration; people move to more fortunate parts of the country. In
Europe, instead, most of the drop in employment is met by a fall in the
participation rate; people withdraw from the labour force.

120
 Labour mobility

➢ Why Europeans move little?

• Cost of moving
• Career opportunities
• Family career prospects
• Social benefits
• Taxation
• Non-economic incentives: cultural differences, family and friends ties, nationalism)

➢ But also little migration within countries (culture and welfare

protection).

138
 2.3 Is Europe an optimum currency area?
Diversification and trade dissimilarity = trade dissimilarity index:

*Latvia is a member since 2014! 122

 2.3 Is Europe an optimum currency area?
Openness = openness to trade:

123
 2.3 Is Europe an optimum currency area?

Fiscal transfers:
-In the USA, for instance, it has been estimated that any shortfall of
income in a state is compensated by federal transfers that amount to
between 10 and 40 percent of the loss. There is no such system at work
in the ED.

- up until the debt crisis, there was no transfer system in the EU;
- EU budget is small (slightly above 1% of GDP) and almost entirely
spent on operating expenses, CAP, and Structural Funds;
- crisis led to the creation of the European Financial Stability Fund
(EFSF), which recognizes that monetary union needs transfers.

124
Krugman (2013) “The Revenge of the Optimum
Currency Area” (text available on the EPI).

• “Kenen has turned out to dominate Mundell: lack of

labor mobility has not played a major role in euro’s
difficulties, at least so far, but the lack of fiscal
integration has had an enormous impact, arguably
making the difference between the merely bad
condition of America’s “sand states,” where the
housing bubble was concentrated, and the acute
crises facing Europe’s periphery”.

125
 2.3 Is Europe an optimum currency area?
Homogeneity of collective preferences

➢ European countries did non seem to share homogeneous

collective preferences regarding the economic policy:

✓ Low inflation in Germany and relative high inflation rates in

southern countries.
✓ looking at public debts, they are huge differences which
separate European countries' approaches to fiscal policy.

➢ Why has the quality of macroeconomic policies been so

diverse in Europe?
political incentives, institutions, political competition,
ideologies..
94
 2.3 Is Europe an optimum currency area?

Homogeneity of collective preferences

➢ Solution: commun institutions

➢ In fact, one-reason why the inflation-prone countries have been eager to

join the monetary union is that it provides for a degree of monetary policy
discipline.

➢ Still, although all countries are increasingly operating under common

institutions, they do not fully share the same views on each and every
issue that arises. The result is frictions among governments regarding
fiscal policy and the Maastricht criteria.

➢ There remains some heterogeneity among national preferences as the

Eurozone crisis will show.

95
 2.3 Is Europe an optimum currency area?
Solidarity vs. nationalism = feeling European? (2006)

128
 2.3 Is Europe an optimum currency area?

So, is Europe an optimum currency area? Mixed performance:

→ The single currency project has been and remains controversial.

→ The partial fulfillment of the OCA criteria implies that, given that the
decision to go ahead has been taken, there will be costs.
129
Maastricht from the OCA perspective

➢Not immune to critiques:

➢The Economist, Maastricht follies (1998)

➢Not connected with OCA criteria

➢Too tight on fiscal rules based on two “unsure” risks:

High debt might be a problem for a currency, and Moral
Hazard

➢Might limit the functioning of automatic stabilizers and

fiscal policy in time of crisis
130
 Are the six criteria endogenous?

- The six criteria presented above refer to country characteristics, but

these characteristics may change over time.

- A puzzling question is whether they can change because of

membership of a currency area.

- Put differently, can an area that is not an optimum currency area

become one as a consequence of being one?

- This possibility is called the endogeneity of the OCA criteria.

131
 Are the six criteria endogenous?
• The fact that the single currency exists can change the situation:

1) Effects on labour markets:

-With crisis, within EU labor mobility increased (but mostly for

qualified professions)
-Few expect labour mobility to increase dramatically in the near
future
-Alternative to mobility: increase in labour flexibility.

➢ The single market may encourage reforms to make European

labour markets more flexible or the opposite!
➢ The OECD index of employment protection, shows how the
eurozone has significantly reduced its employment protection,
especially since the sovereign debt crisis in 2008
132
133
 Are the six criteria endogenous?

• The fact that the single currency exists can change the situation:

2) Effects on trade: Monetary union (MU) can affect trade flows and intensify
trade integration: There is a positive linkage between trade integration and
income correlation (Frankel and Rose, 1998).

➢ Baldwin et al. (2008) conclude that, so far, the euro has probably increased
trade by some 5%;

➢ “Krugman specialisation hypothesis”: With a MU, countries become more

integrated: they will specialize in the production of those goods and services
for which they have a comparative advantage (hypothesis rooted in the new
trade theory based on increasing returns to scale);*

➢ Members of a currency area become less diversified and more

vulnerable to supply shocks. Correspondingly their incomes will become
less correlated 134
 Are the six criteria endogenous?

• The fact that the single currency exists can change the
situation:

3) Fiscal transfers: The crisis increased fiscal transfers.

. A country hit by a shock gets automatically transfers
from the centralized budget. As a result, this member
State will perceive the adherend to the union to be more
advantageous.

“disciplining effect” on participating countries regarding

the fiscal policy;

135
• 4) Politics: preferences and common destiny: Animosity across
countries after the crisis (transfers debate, migration crisis)

136
137
138
• « Le débat engendré par le refus de l’Allemagne de livrer des missiles Taurus
et la phrase d’Emmanuel Macron sur la possibilité que soient envoyées des
troupes terrestres occidentales en Ukraine ont une fois de plus porté un coup
dur aux relations franco-allemandes. Alors que l’Europe aurait
besoin de présenter un front uni dans son soutien à l’Ukraine et sa défense
contre la guerre hybride menée par la Russie, les deux plus importants Etats
européens se trouvent plongés dans une profonde crise de confiance
et de leadership.

(…) La déclaration de M. Macron disant que l’on ne pouvait exclure l’envoi de

troupes de l’OTAN en Ukraine a été, à Berlin, la goutte d’eau qui a fait déborder le
vase. Elle a mis à mal l’approche du chancelier allemand, qui consiste à ne pas
provoquer la Russie et à ne pas laisser s’engager de troupes allemandes ou
occidentales dans ce conflit. Cette prudence a des fondements historiques
: l’Allemagne n’a encore jamais gagné une guerre contre la Russie, et la population
allemande, de plus en plus lassée par ce conflit, a tendance à privilégier une
solution diplomatique. Il ne fait aucun doute que ces divergences reflètent les
faiblesses tant du côté de Scholz que de Macron en matière de politique
intérieure. Mais, in fine, et comme sur beaucoup d’autres points, l’enjeu
reste l’image que les deux pays ont d’eux-mêmes et leur relation avec les Etats-
Unis. On trouve là des différences fondamentales qui n’ont rien à voir
avec la personnalité des deux dirigeants.

139
 OCA criteria contradictions and limits
• The pioneering authors initiated a debate on the benefits and costs
from adopting a single currency, that is continuing.

• Several properties are difficult to measure unambiguously and

evaluate against each other. Tavlas (1994) calls this the “problem of
inconclusiveness,” as OCA properties may point in different directions.

1) An economy that is small and open (pegged exchange rates) but

might also possess a low degree of labour mobility (implying the
desirability of flexible exchange rates).

2) A small open economy relatively undiversified

140
The logic of the optimum currency area
criteria

141