The EMU Debate
EMU: economic and monetary union
(i.e. establishment of the euro)
• ‘Long-run neutrality of money’ means that the
value of the exchange rate doesn’t matter in
the long run
• BUT, “in the long run we are all dead!”
• In the short run, exchange rate fluctuations
can lead to large changes in a country’s
international competitiveness
The Timing of EMU
• EU Single Market programme (c1992) had abolished capital
controls
• Danish electorate rejects Maastricht Treaty (to establish the
euro) in June 1992
– Massive currency turmoil incl. speculative attack on sterling:
• Fixed exchange rate (and no capital controls) means Bank of England
guarantees to sell or buy any amount of sterling at this fixed rate
• Speculators borrow sterling and sell it in vast quantities to Bank of
England and hence deplete the Bank’s foreign exchange reserves
• (When the Bank runs out of foreign exchange reserves it can no
longer defend the currency and has no option but to float or devalue)
– (Unless other Central Banks are willing to support it adequately)
• Sterling forced out of ‘tight exchange rate band’ in September
• Supporters of EMU argued that the evidence
pointed to:
– (i) inherent instability of fixed-exchange-rate
arrangements when there are no capital controls
(because of the possibility of speculative attacks) and
– (ii) undesirability of flexible exchange rates, because
of fluctuations in a country’s international
competitiveness
• EU decides in 1995 to proceed to currency union
in 1999
• Is the EU an "optimal currency area“?
• Compare Europe with how the US functions as
a single-currency area
The "Optimal Currency Area" Question
• Adverse region-specific shock will generate
high unemployment
– But painful recession (and demand for exchange
rate devaluation) is avoided if labour migrates
from the region
• An alternative to labour mobility is a high
degree of wage flexibility
– Generally agreed that both labour mobility and
wage flexibility far lower in Europe than in US
• Question then turned to likelihood of
‘asymmetric’ (i.e. region-specific) shocks
• Proponents of EMU argued that region-specific shocks
are caused primarily by uncoordinated macro policies
• HOWEVER, Barry Eichengreen (UC Berkeley) found
that of the 15 Western European EU countries, only
Austria, Denmark, France, the Netherlands, Belgium
and Luxembourg were suitable for monetary union
with Germany
– Only in these countries were shocks (other than those
caused by policy) symmetric
Single Currency/Monetary Union
• Optimal currency area analysis (Canadian
economist Robert Mundell):
– Having a regional/national currency is less important
• if there is inter-regional/international labour mobility
• And/or if wages are very flexible
– Also if ‘asymmetric’ (i.e. regional or nation-specific)
shocks are infrequent or unlikely
• Which basically means: are your business cycles in synch?
• Remember that both the Gold Standard and
the Bretton Woods System of Fixed Exchange
Rates were like Single Currency Systems for
most of the world (though without the benefit
of the savings in transactions costs)
BUT: US also has “fiscal federalism”
• Even the US has neither instantaneous nor complete labour
mobility. It has another instrument, however, which substitutes
for not having an internal exchange rate
• US federal spending and taxation (i.e. the Washington federal
budget) respond to region-specific shocks;
– for every $1 decline in regional income relative to the national average,
federal tax liabilities fall by 25 cents while inward transfers rise by 10
cents.
• Thus over one-third of a fall in regional income is offset by the
federal system in the US. The equivalent figure for Canada is
around one-fifth.
• The conventional wisdom in Europe up to the
1990s had been as expressed in the
MacDougall Report (1977): The Role of Public
Finance in European Integration
• “Public finance in existing economic unions plays a
major role in cushioning short-term and cyclical
fluctuations”
• “If only because the Community budget is so
relatively very small there is no such mechanism in
operation on any significant scale as between
member countries, and this is an important reason
why in present circumstances monetary union is
impracticable”
One Market, One Money
• “To the extent that aggregate fiscal policy measures
are required, most if not all of this policy will have to
be implemented through coordination among
Member States”
– Offered no suggestions as to how this
coordination would be ensured
Krugman (1987)
• “Achieving co-ordination of fiscal policies is probably
even harder politically than co-ordination of monetary
policies. There is not even temporarily a natural central
player whose actions can solve the co-ordination
problem.
• In surveying the problems of European integration, it is
hard to avoid the conclusion that this is the systemic
change most needed in the near future”
• 1987 !
What was going on in European leaders’
heads?
• Monnet collaborator George Ball on the
Monnet (“chain reaction”) method
• Wim Duisenberg, first President of the European Central Bank:
– “EMU is, and was always meant to be, a stepping stone on the way to
a united Europe”
• Helmut Kohl, contemporary Chancellor of Germany:
– “it is absurd to expect in the long run that you can maintain economic
and monetary union without political union”
• The Four Presidents’ Report of 2012 and the Five Presidents’
Report of 2015 propose such a route in seeking to rectify the
design flaws in the project
– as is currently advocated by French President Macron
Issues raised in the Irish debate
• Ireland a clear example of an ‘asymmetric’ region, because
of importance of UK & sterling and the US & dollar
• Agreement between the two sides of the debate on the
savings in transactions costs, though less significant if the
UK remained outside
• Disagreement on benefits of lower interest rates when
country’s business cycle is out of synch with that of the
eurozone core
Nor would interest rates necessarily
fall to German levels
• Experience of Canadian provinces and US
states shows that their debts can command a
risk premium even within a monetary union
• American economists were almost entirely
unconvinced by the arguments in favour of
EMU
• James Tobin: “the absence of an authority for
centralized fiscal redistribution, sticky wages,
and a monetary policy objective that took no
account of employment, production or
growth”
• Precise fault lines to appear in Europe were
not generally foreseen
• No discussion of importance of banking union
and very little on financial regulation in any of
the debates across Europe
• “IMF economists tended to hold in highest
regard macro models that proved inadequate
for analyzing macro-financial linkages”
– IMF Internal Evaluation Office
• There was one incredibly prescient
contribution:
Paul de Grauwe
(Financial Times, 20 February 1998)
• “Suppose a country, which we arbitrarily call Spain, experiences a
boom which is stronger than in the rest of the euro-area. As a result of
the boom, output and prices grow faster in Spain than in the other
euro-countries. This also leads to a real estate boom and a general
asset inflation in Spain. Since the ECB looks at euro-wide data, it cannot
do anything to restrain the booming conditions in Spain...
• Unhindered by exchange risk, vast amounts of capital are attracted
from the rest of the euro-area. Spanish banks, that still dominate the
Spanish markets, are pulled into the game and increase their lending.
They are driven by the high rates of return produced by ever increasing
Spanish asset prices, and by the fact that in a monetary union, they can
borrow funds at the same interest rate as banks in Germany, France
etc.
• After the boom comes the bust. Asset prices collapse, creating a crisis
• Both sides of the Irish debate agreed on need
for more careful conduct of fiscal policy within
EMU
– Barry and FitzGerald (2001) Report of the Swedish
Committee on Stabilization Policy in EMU
• A possible alternative to fiscal union is a
complete banking union where banking losses
are borne at the federal rather than at the
member-state level
• Importance of banking union has increasingly come to be
recognised
• Debate continues over whether it can completely
substitute for fiscal union
• Banking union is another form of federal insurance policy
– Daniel Gros (2012): Banking Union: Ireland vs. Nevada, an
illustration of the importance of an integrated banking system
– Daniel Gros (18 October 2012); www.ceps.be
• The key difference between Nevada and Ireland is
that banking problems in the US are taken care of at
the federal level (the US is a banking union),
whereas in the euro area, responsibility for banking
losses remained national
• Nevada banks were bailed out by Washington
rather than by Nevada itself, while lots of US banks
(rather than purely Nevada banks) took the hit from
the Nevada crash
Supplementary slide 1
• Local banks in Nevada experienced huge losses (just like in
Ireland) and many of them became insolvent, but this did
not lead to any disruption of the local banking system as
these banks were seized by the Federal Deposit Insurance
Corporation (FDIC), which covered the losses and transferred
the operations to other stronger banks.
• In 2008-09, the FDIC closed 11 banks headquartered in the
state, with assets of over $40 billion, or about 30% of state
GDP.
Supplementary slide 2
• Other losses were borne at the federal level when
residents of Nevada defaulted in large numbers on their
home mortgages. The two federal institutions that re-
finance mortgages lost substantially since 2008.
• The federal institutions of the US banking union thus
provided Nevada with a ‘shock’ absorber
• Of course, a lot of the banking business in Nevada is
conducted by ‘foreign’ (i.e. out-of-state) banks, which just
took the losses from their Nevada operations on their
books and could set them against profits made elsewhere.
This is another way in which an integrated banking market
can provide insurance against local financial shocks
• The comparison between Nevada and Ireland
illustrates the shock-absorbing capacity of an
integrated banking system and a banking
union
• For Nevada, the banking union resulted in a
transfer worth more than 10% and possibly up
to 20% of its GDP
The Counterfactual
• Would the eurozone periphery states have fared better
or worse had they not been in the eurozone?
• General agreement that imbalances would have been
lower when the global crisis struck
– Periphery states would have been unable to borrow as much
because exchange rate risk would have forced up their
interest rates
• Would adjustment to the crisis have been easier or
harder outside the currency union?
Philip Lane
(former Governor of Irish Central Bank;
now chief economist with the ECB)
• In the crisis, Irish banks relied heavily on ECB
• And debtors benefitted from the eventual
“whatever it takes” policy of Draghi
Kevin O’Rourke
(TCD/Oxford economic historian: now at NYU, Abu Dhabi)
• Small crisis-ridden countries much more vulnerable
inside the eurozone than out
– “Outside, you will deal with the IMF on its own, and
they have a standard policy template: debts will be
written down, currencies will be devalued, and yes,
there will also be austerity
– Inside, the Eurozone creditor countries will sit alongside
the IMF at the table and you may find that neither of the
first two policies will be feasible, which will make the
austerity far more harmful than it would otherwise
be, both economically and politically”
Would strict adherence to the new
European fiscal criteria substitute for fiscal
federalism?
• Some say “yes”, because governments with low debt and low
deficits should always be able to borrow easily on world capital
markets
• The logic of this, though, is based on the assumption that markets
are efficient, which the global financial crisis has challenged
• Those who say “no” point to the contagion seen in the Asian
financial crisis of 1997
– Behavioural economics / ‘Narrative Economics: How Stories Go
Viral and Drive Major Economic Events’, by Robert Shiller,
Princeton Univ Press, 2019)
