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Integration in the EU and Monetary Policy

by
Alexandra Aranda
 

 

The creation of the European Union (EU) is a great political and economic feat.  For it is the ultimate sign of cooperation between nations that had been in constant rivalry before.  Nevertheless, the ideals of such a union cannot stand alone without having a strong foundation and continuos rational decision making by all of the actors involved.  If we assume the the European Central Bank’s (ECB) principle role is to guarantee the well-being of all EU members, then policy making becomes a very complex issue since it must consider such a large and diverse area.  I believe there needs to be more economic integration between EU countries for monetary [and fiscal] policy of the ECB to be beneficial to all participants.

Even before World War II, the dream of a unified Europe existed.  This ideal emerged from the desire to guarantee peace, for a common political and economic system would, in theory, lower the chances of war.  This is because by slowly erasing countries’ borders and making them intra-dependent, states are forced to work with each other rather than oppose one another.  A unified economy would also turn Europe into one market and increase the continent’s role in the international monetary system.  In March of 1979, eight countries officially participated in the European Monetary System (EMS) by pegging their currency to the German mark.  By tying their monetary policy to the Bundesbank’s well known monetary targeting policy, they were able to import German credibility to reduce their own inflation.  Indeed, EMS members considerably reduced their inflation by exchange-rate targeting, making Germany the anchor country.  France reduced inflation from about 5% in 1987 to 2% in 1992, while the United Kingdom reduced from 10% to 3% in two years.[1]  The system worked well until 1992 when political events caused the German government to fiscally expand.  At the same time an increase in consumption in Germany caused inflation.  The Bundesbank reacted by raising its interest rates to fight their inflation.  Subsequently, EMS partner countries were transmitted the pressure of raising their own interest rates, but because not all were simultaneously experiencing a boom, it cost them recession.  This is a perfect example of how countries have different needs because of internal dissimilarities, therefore the same monetary policy can benefit one state while hurting another.  The strain of contradicting needs between EMS members and the desire to continue toward a common currency caused a series of speculative attacks.  Eventually the EMS was forced to widen its exchange rate “bands” to ±15%.[2]  


[1] Mishkin, Frederic S.  The economics of Money, Banking, and Financial Markets.  Sixth Edition.  Boston:Addison Wesley.  p.509

[2] Krugman, Paul and Obstfeld, Maurice.  International economics.  Reading, Mass.: Addison Wesley Longman, 5th Ed.  2000.  pp. 611-618

 

Not only was there an interest in fixing their currencies, but initiatives to eliminate trade, capital, and labor barriers began.  The Maastricht Treaty of 1991 gave a time line aiming toward a common currency for EMS members.  It was thought that a single coin for all EMS countries had many benefits.  First, there would be greater incentives and less costs in integrating the European market.  Second, it would permit freedom of capital movement while keeping a fixed exchange rate.  Third, It would lessen Germany’s power over exchange rates.  To facilitate the transition into a common currency, the treaty set macroeconomic goals, or convergence requirements,  for the countries to follow.  For example, inflation could not be 1.5 % above the average lowest member states’ inflation, and a limit was set on public-sector deficit and public debt.  By 1998, eleven countries satisfied the criteria and became the European Monetary Union (EMU).  Finally on January 1st of 1999, the Euro was adopted by the EMU members.

The “Eurosystem,” or European System of Central Banks, refers to the ECB and the fifteen National Central Banks (NCB) of EU members (the countries that are not part of the Euro area have special status.)  The principle objectives of the Eurosystem is to define and implement monetary policy, hold member states’ reserves, and smooth the payment system operation.  The Eurosystem works very similar to the American Federal Reserve because the ECB works together with members of all the NCBs to decide on policy.  For example decisions of the Eurosystem are made by votes of the Governing Council which is made up of 6 members of the Executive board (from the ECB) and the governors of the NCBs.  One of the most important qualities of the Eurosystem is its autonomy, making it the most independent central bank in the world.  In other words, the ECB inherited Germany’s conservative monetary policy, making price stability its ultimate goal.[1]   This, of course, restrains individual countries more since they are no longer able to use monetary policy to alleviate domestic pressures. According the theory of Optimum Currency Area, “fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements.”[2]


[1] European Central Bank - http://www.ecb.int/

[2] Krugman, Paul and Obstfeld, Maurice.  International economics.  Reading, Mass.: Addison Wesley Longman, 5th Ed.  2000.  pp. 623

 

Therefore, it is necessary to measure the costs and benefits of joining a fixed exchange rate, which is related to how well integrated economies are and the “monetary efficiency gain for the joining country.”  This theory concludes, that when countries are more economically integrated with the fixed exchange rate countries, output market shocks will cause less general disturbances.  This theory is supported by a game theory designed by CESifo, where it shows that members in the EMU have an increase need of macroeconomic policy cooperation.  Nevertheless, the authors admit that the CEB should remain independent, so it is up to the European governments to promote this cooperation.[1]      Is the European Union a Optimum Currency Area?  The answer lies in the amount of trade, mobility of labor and capital, and similarities in economic structures.  Trade between EMU did not sharply increase, as some expected, as trade restrictions were pulled down in 1992.  Intra-EU trade has remained between 10 and 20% of GDP.[2]   Although it is considerably larger than in the 1980’s, it is not enough to justify a monetary union.  Some trade barriers still remain, such as agricultural products that are protected by some governments.  Despite the same currency being used throughout the EU, the law of one price does not apply for all items.  For example, Portugal is still considerably cheaper than Germany.


[1] van Aarle, Bas, Jacob Engwerda, and Joseph Plasmanas.  “Monetary and Fiscal Policy Interaction in the EMU: A Dynamic Game Approach”  Munich:  Center for Economic Studies & Ifo Institute for Economic Research.  March 2001.[

2] Krugman, Paul and Obstfeld, Maurice.  International economics.

 

The labor market is currently one of the least flexible inputs needed for economic integration in Europe.  There are many barriers, such as language, culture, trade unions, and employment regulations and taxes.  Just because two countries have the same currency, it does not mean emigrating a from one to another is a simple matter.  It is hard to imagine a Spaniard fully assimilated in Finland, and having the same productivity as he did in Spain.  We can see these bottlenecks in the labor mismatch that currently exists in the EU.  Unemployment is at about 8%, yet, at the same time firms complain about not finding workers.[1]  This shows how the labor supply and demand are not in equilibrium.  Further proof of this is seen in the drastic differences in unemployment, when Ireland and Austria have an unemployment rate at about 4%, while Greece is at 11%.  In addition, the skill of labor varies tremendously throughout the continent, where lower-skill workers concentrate in the South and higher-skill in the North.  The lack of labor mobility is a problem because it limits the growth of the economy and shows the inflexibility of the labor market.  This in turn raises inflation, which affects the monetary goal of price stability.  Even though the Euro countries have made great improvements as shown by the decrease of unemployment between 1997 and 2001.  There is still plenty that can be done to improve labor mobility and matching efficiency such as increase the flexibility of wages, and decrease employment protections and restrictions.    


[1] European Central Bank  “Labor market Mismatches in Euro Area Countries”   March 2002

 

Unlike with trade and labor mobility, there has been a considerate increase in capital migration within the EU.  This is because of the removal of previews capital movement restrictions.  Now investors have a much larger playing field to find the highest rate of returns.  But this can create a problem when considering the limited flexibility of the labor market.  Suppose there is a country that is suffering from a slow down and unemployment is increasing, investors will surely find better returns outside.  The capital flight worsens unemployment and because there is little labor mobility, few people will venture off to look for jobs.  Nevertheless, there are other benefits the Euro brought to Europe when looking at business.  According to the Economist, the Euro has simplified life for many transnational businesses and provided more accurate information between regions.  Although the change of currency did bring many logistic problems in some sectors, mainly small businesses.[1]   Yet the IMF still prescribes further integration of the European financial sector.  In a report published in 2001, it found that the banking sector, in the face of the introduction of the Euro and consolidation of a financial market in the IMU area, there was the need for a “stronger cross-border coordination among supervisory authorities.”[2]  


[1] “Survey: European Business and the Euro - Work in Progress”  The Economist.  November 29, 2001

2] Belaisch, Agnes, Laura Kodres, Joaquim Levy, and Angel Ubide.  “Euro-Area Banking at the Crossroads”   International Monetary Fund.  March 2001.

 

The year 2000 was the beginning of a downward trend for the world economy, high oil prices caused inflation.  By 2001, the three economic giants (US, Japan, and Europe) were in recession.  Yet there was one policy tool two of the countries enjoyed, but the EU did not, that was fiscal policy.  The EU could only react by reducing interest rates, while the US and Japan could stimulate their economy by fiscally expanding.  In the EU fiscal policy is not centralized, rather it is decided within each country individually; making it closer to a federation than a pure monetary union.  The IMF recommends eventual fiscal policy centralization, and therefore encourages fiscal policy coordination.[1]


[1] Cangiano, Marco and Eric Mottu,  “Will Fiscal policy Be Effective Under EMU?”  International Monetary Fund.  December 1998

 

In a study done by the Bank of Italy, it was found that when national information is taken into consideration, rather than only area-wide variables, “performance of a central bank that chooses the nominal interest rate to minimize a standard quadratic loss function of area-wide inflation and output gap significantly improves.”[1]  By assuming that monetary policy should exclusively rely on area-wide information implies that events that happen in individual countries are entirely negligible because they do not differ from each other enough to matter.  Yet, this study proves the opposite, variables from individual countries are relevant enough to make a difference in policy outcome.  Although the study showed that these differences, when taken into consideration, make monetary policy decisions more beneficial.  We return to the problem of contradictory interests as there was in 1992.  Where a monetary policy does not affect all countries evenly because of internal distinctions.  For example, inflation rates in early 2000 in Ireland were between 3% and 4%, while in the Netherlands, it was between 0% to 0.5%.  Clearly, the same monetary policy for both countries had drastically different effects.


[1] Angelini, Paolo, Del Giovane, Paolo, Siviero, Sefano, and Terlizzase, Saniele.  “Monetary Policy Rules for the Area: What Role For National Information?”  Banca d’Italia-CIDE.  2002

 

Another study done by the University of Leuven addresses the issue of different interests between countries and the decision making process when determining monetary policy at the ECB.  The study argues that if an euro-wide perspective is not taken within the ECB when there are diverging monetary goals (because of asymmetric shocks) between member state, then divergent views can cause distorted choices.[1]  According to this theory, smaller countries would find themselves less satisfied with ECB policy, since they would account for less of the Euro area.  Therefore, it would be to their interest to be more persuasive when participating in the decision-making process.  However, instead of distorting the EU choices because of their own interests, they should try their best to align themselves with the larger countries.  Although at first glance it seems as if these two last studies contradict themselves, but in reality, they address two completely different issues.  The first acknowledges the importance of taking into consideration state-specific information, while the second simply warns of the danger of political interests that can influences monetary policy makers.  Nevertheless, both studies reaffirm the fact that it is in the best interests of the European Union, especially for small countries, to integrate their economies with the rest of the EU members.


[1] Aksoy, Yunus, Paul De Grauwe, and Hans Dewachter.  “Do Asymmetries Matter for European Monetary Policy?”  University of Leuven: Center for Economic Studies.  April 2002

 

It is clearly beneficial for the well-being of the EU for there to be greater cooperation between members.  If borders truly want to be erased, intra-EU trade and labor mobility needs to increase substantially.  Also, fiscal policy needs to be increasingly coordinated so the European government can use it as a tool.  Although, with enough fiscal room granted to individual countries so they can use it against domestic shocks.  In conclusion, political and economic integration should be the ultimate goals of the EU, because by making Europe more uniform, at least in numerical terms, ECB policies will be most effective and beneficial for each country.

 

 

 

 

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