FYP Ben Murray

To What Extent is the EMU Incomplete

Ben Murray

Economics and Sociology

Ben Murray To What Extent is the EMU Incomplete 11115785

Name: Ben Murray

ID: 11115785

Title: To What Extent is the EMU Incomplete

Supervisor: Declan Dineen

External Examiner: Professor Liam Delaney

Degree Programme: Economics and Sociology

Date: 19th

February 2015


Abstract

The theory and literature suggest that the EMU is deeply flawed from the very beginning. It

fails to meet the necessary criteria as outlined in the theory of Optimum Currency Area,

which is the main justification in establishing such a union. Joining the EMU comes with a

cost, the loss of control over national monetary policy and the adoption of a single ‘one size

fits all’ monetary union. If one economy is out of sync with the rest of the member unions, the

monetary policy can have the opposite effect. Thus alternative stabilization mechanisms must

be sought after in the event of an asymmetric shock. The Maastricht treaty was the beginning

of the transition to the EMU; however it was not a smooth transition as issues soon arose. The

Global Financial Crisis exposed many flaws in the construction of the Euro which was

highlighted through the lack of adherence to the OCA criteria. While the majority of the

issues surrounding the EMU are due to its incompleteness, there are solutions put forward to

rectify these issues and to strengthen the EMU integration process.


Table of Contents

List of Abbreviations ............................................................................................................................. 1

Acknowledgement ................................................................................................................................ 2

Authors Declaration .............................................................................................................................. 3

Chapter 1: Introduction ......................................................................................................................... 4

1.1 Introduction ................................................................................................................................ 4

1.2 Rationale ..................................................................................................................................... 5

1.3 Contribution of the Study ............................................................................................................ 6

1.4 Structure of Thesis ...................................................................................................................... 7

Chapter 2: Literature Review .............................................................................................................. 10

2.1 Introduction .............................................................................................................................. 10

2.2 The Theory of OCA. ................................................................................................................... 11

2.3 Costs of Monetary Union and Alternative Stabilisation Mechanisms........................................ 15

2.3.1 Adjustment Mechanisms to Asymmetric Shocks .................................................................... 16

2.4 Benefits of EMU ........................................................................................................................ 19

2.5 Conclusion ................................................................................................................................. 20

Chapter 3: Establishment and Transition of the EMU – To what extent is the EMU structurally

incomplete. ......................................................................................................................................... 21

3.1 Introduction .............................................................................................................................. 21

3.2 Transition to EMU ..................................................................................................................... 21

3.3 Reasoning behind Convergence criteria. ................................................................................... 23

3.4 Incomplete Monetary Union ..................................................................................................... 25

3.5 Conclusion ................................................................................................................................. 29

Chapter 4 – The Global Financial Crisis 200730

4.1 Introduction .............................................................................................................................. 30

4.2 The Global Financial Crisis in Brief ............................................................................................. 30

4.3 Flaws that came to Light ........................................................................................................... 31

4.4 Conclusion ................................................................................................................................. 35

Chapter 5 – Addressing the Incomplete Monetary Union ................................................................... 36

5.1 Introduction .............................................................................................................................. 36

5.2 How to address the incomplete monetary union. ............................................................... 36


5.3 Integrated Financial Framework................................................................................................ 37

5.4 Integrated Fiscal Policy Framework. .......................................................................................... 38

5.5 Integrated Framework for Economic Governance .................................................................... 39

5.6 Lender of last Resort ................................................................................................................. 40

5.7 Consolidation of Government Budgets and Debts .................................................................... 42

5.8 Transition towards a Political Union .......................................................................................... 42

5.8.1 Consequences of Political Integration ................................................................................ 44

5.9 Conclusion ................................................................................................................................. 45

Chapter 6 Conclusion .......................................................................................................................... 46

Bibliography ........................................................................................................................................ 48


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List of Abbreviations

ECB EUROPEAN CENTRAL BANK

ECU EUROPEAN CURRENY UNIT

EMS EUROPEAN MONETARY SYSTEM

EMU ECONOMIC MONETARY UNION

ESM EUROPEAN STABILITY MECHANISM

EU EUROPEAN UNION

GDP GROSS DOMESTIC PRODUCT

IMF INTERNATIONAL MONETARY FUND

OCA OPTIMUM CURRENCY AREA

OMT OUTRIGHT MONETARY TRANSACTIONS

PIIGS PORTUGAL, ITALY, IRELAND, GREECE, SPAIN

SGP STABILITY AND GROWTH PACT


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Acknowledgement

Firstly I would like to give my supervisor, Declan Dineen a huge thank you for all his

patience and support in the writing of this dissertation. I would also like to thank my three

sisters, Deana, Joelle and Martha-Jayne, for without whom this dissertation would have been

completed a long time ago. I would like to thank my parents for all the moral support and the

amazing chances they’ve given me over the years because without them I would not be the

person I am today. Lastly to all my friends, we made it!


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Authors Declaration

I hereby declare that this project is entirely my own work, in my own words, and that all

sources used in researching it are fully acknowledged and all quotations properly identified. It

has not been submitted, in whole or in part, by me or another person, for the purpose of

obtaining any other credit / grade. I understand the ethical implications of my research, and

this work meets the requirements of the Faculty of Arts, Humanities and Social Sciences

Research Ethics Committee.

Signed: Date:


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Chapter 1: Introduction

1.1 Introduction

The EMU celebrated its 15th

anniversary on the 1st of January 2014. There have been periods

of turbulence during the first ten years, particularly in the latter half through debt crises,

bailouts, emerging liquidity and more recent quantitative easing. The EMU is not well

founded to begin with and is a poor example of a political construct and this is evident

through both theory and literature. While some flaws existed from the beginning through the

poor adherence to the theory of OCA criteria and to the Maastricht Treaty criteria, others

manifested during the Global Financial Crisis and thus revealed more weaknesses in the

construct of the EMU. The EMU can’t correct these flaws by itself and this is where

corrective mechanisms such as lender of last resort and a banking union are needed.

The central focus of this thesis is to uncover the flaws of the EMU from its transition from

EMS to see to what extent the EMU is considered to be incomplete. This paper will look at

the flaws that only came to light during the Global Financial Crisis of 2008 and how to go

about addressing an incomplete monetary union , for example the economic monetary union

in Europe, and to determine if it can be implemented in such a way that it works to its

potential both effectively and efficiently or if the EMU was “doomed” to fail from the very

beginning in 1999 when it was first established.


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1.2 Rationale

This research paper will look at the flaws by firstly looking at the establishment and the

transition of the EMU from Economic Monetary System to identify the extent the monetary

union is considered to be structurally incomplete. The next area of interest will be the Global

Financial Crisis of 2008. The author will be looking at this period in particular because from

2008 to 2012 the EMU was under extreme pressure and the severities of the issues in the

EMU were misdiagnosed. However, the financial problems associated with the global

financial crisis could have been avoided if the correct mechanisms such as a crisis resolution

mechanism and lender of last resort were implemented. The last topic of the researcher’s will

look at is how Europe we address the incompleteness of the monetary union in Europe by

looking at solutions and ideas put forward from various economists and to determine if the

EMU will ever be implemented to its full potential and perform as an OCA.

This research paper is going to address the following questions as outlined below and the

entire paper can be stated simply as the following:

“Identifying the flaws of the incomplete EMU and how can we address the flaws of the

incomplete monetary union”

Through this it gives rise to the author’s key research objective, which is to identify and

examine the flaws in the framework of the EMU. From this, my research questions are as

stated below with the rationale behind them:


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1. “From the establishment and transition of the EMU, to what extent in this monetary

union structurally incomplete, in the sense that how well equipped is it in dealing with

shocks and disturbances?”

The aim of this question is to examine the adherence of the EMU to the OCA

theory criteria as well as to what extent is there functional mechanisms in the event

of an asymmetric disturbance, i.e. wage flexibility, fiscal federalism and labour

mobility.

2. “What flaws came to light in the EMU during the Global Financial Crisis of 2008-

2013?”

The Global Financial Crisis was a particularly turbulent period for many countries in

the EMU. Through this question I investigate the flaws in this period that may or may

not have been visible and the repercussions they had on the EMU.

3. “How would one address the incomplete monetary union in Europe?”

There is no point in writing about the flaws of the EMU without discussing s solutions

put forward. The aim of this question is to discuss the possible resolutions to make the

EMU structurally complete in the event of an asymmetric shock to ensure the

existence of the Euro.

1.3 Contribution of the Study

This research paper investigates the extent to which the EMU is structurally incomplete from

its establishment and transition which includes the Optimum Currency Area Theory and the

loss of a country’s national monetary policy in place of a single monetary policy for all


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monetary union member countries. This paper will also look at the period from 2008 to 2013,

also known as the Global Financial Crisis in which the EMU was almost pushed to the

breaking point as seen with the PIIGS, (Portugal, Ireland, Italy, Greece and Spain) so the

researcher wants to investigate the flaws that slipped through the framework of the EMU and

came to the light and revealed themselves to the public’s eyes. Lastly, this paper will finish

with solutions and ideas put forward by various economists in addressing the incomplete

monetary union in Europe and to determine if any solutions will recover the status of the

EMU to its former glory such as the possible movement towards a political union.

1.4 Structure of Thesis

The remainder of the thesis is as organised as the following; Chapter 2 will present my

Literature Review, Chapter 3 will discuss the establishment and transition of the EMU and

exactly to what extent the EMU is considered to be structurally incomplete, chapter 4 will

look at the Global Financial Crisis, Chapter 5 will examine how to address the incomplete

monetary union in Europe and my last chapter, Chapter 6 will conclude my research.

Chapter 2 sketches the framework for my research as my literature review will provide a

background for my research by using previous research that has been conducted on this topic.

My main focus here will be on the theory of Optimum Currency Area as well as the costs and

benefits of a country joining a monetary union such as the EMU. An optimum currency area

is an economic unit composed of regions affected symmetrically by disturbances and between

which labour and other factors of production flow freely” (Eichengreen 1990) and the OCA

theory is the core set of principles from which a monetary union works efficiently and


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effectively. However upon examination of this theory, the EMU fails to meet three out of the

four criteria, which was highlighted by the Global Financial Crisis. Therefore it shows that the

EMU is not a properly functioning monetary union. Also, this chapter is going to address the

cost and benefits of joining the EMU.

When a country joins the EMU they lose control over their national monetary policy and

instead have to abide by a single monetary policy for all member countries. Therefore they

have no control over inflation, money supply or exchange rate. Furthermore if one single

country is out of sync with the others, the monetary policy may not be appropriate. Corrective

mechanisms such as wage flexibility, labour mobility and fiscal federalism are seen in the US

monetary union and are virtually non-existent in the EMU.

The authors research in Chapter 3 begins with him looking at the transition of the EMS and

the establishment of the EMU to define the extent that the EMU is considered to be

structurally incomplete. The research begins with the transition of the EMU which includes

stating the convergence criteria as set out in the Maastricht Treaty and the reasoning behind

them. He will then go on to examine the incompleteness of the EMU in areas such as issues

with countries joining and the fixing of the exchange rates.

Chapter 4 will look at the Global Financial Crisis of 2008 because, as mentioned before, the

EMU was put under incredible strain and especially with PIIGS. “The global financial and

economic crisis revealed institutional weaknesses and structural problems of particular EMU

countries” (Kowalski 2012 pg. 2) and it was through this crisis that it exposed that the EMU

is far from an OCA. The Global Financial Crisis began in the US with the collapse in

subprime mortgages, but for the EMU it originated from Greek Debt.


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Many of the issues surrounding the EMU are due to its structural incompleteness. Therefore,

Chapter 5 will examine how the EMU can correct for such problems from its establishment to

the Global Financial Crisis. This will include the 3 pillar framework as outlined by the

European Commission.

Chapter 6, the author’s conclusion, will conclude and summarise his research.


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Chapter 2: Literature Review

2.1 Introduction

The foundation of a well-functioning monetary union rests on whether or not it satisfies the

conditions necessary for an OCA; factor mobility, financial integration, openness,

diversification and business cycle harmonisation. The EMU fails to meet the majority of these

conditions required in order to qualify as an OCA. Furthermore, there is an ongoing debate as

to whether the EMU is in fact an OCA.

When evaluating a monetary union it is also essential to look at the cost and benefits. The

benefits gained are exchange rate certainty and the increased usefulness of money as a means

of a unit of account. On the other hand, the costs are less sought after, in particular the loss of

national monetary policy and the adoption of a single monetary policy for all members. The

loss of national monetary policy is significant as depending on the size of the nation and its

economic condition, the single monetary policy can have a different effect and may not be

appropriate. This goes against the theory of OCA which states that all countries in a monetary

union should experience symmetric disturbances, not asymmetric and avoid the need for

exchange rate adjustments. This is where adjustment mechanisms such as wage flexibility,

labour mobility and fiscal federalism come into play, for only they are non-existent in the

EMU. Thus alternative adjustment mechanisms must be sought after.


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2.2 The Theory of OCA.

An Optimum Currency Area , a theory pioneered by Mundel (1961), McKinnon (1963) and

Kenen (1969) is defined as “a group of countries that maintain either a single currency or,

through maintaining separate currencies, have rigidly fixed exchange rates among themselves

and full convertibility of the respective currencies into one another, so that the

macroeconomic goals of internal balance (low inflation and low unemployment) and external

balance (a sustainable balance of payments position) can be achieved” (Mundel 1961). The

OCA theory is the main justification for a country to join a monetary union. For a

geographical area to be considered an OCA it must boast the following conditions; factor

mobility, financial integration, openness, diversification and business cycle harmonisation.

Factor of Mobility is considered to be the core attribute of the OCA theory, as where mobility

exists, there is less need for exchange rate variations as a means of correcting external

imbalances. In regards to financial integration, it is argued that a high degree of financial

integration between two areas can help finance inter-regional payments imbalances.

Openness is defined as “the more open an economy the greater the desirability of fixed

exchange rate arrangements since exchange rate changes in open economies are not likely to

be accompanied by significant effects on real competitiveness”(McKinnon 1963).

Diversification, “the spread of the activities of a firm or a country between different types of

products or different markets” (Black et al 2012 pg. 113), provides some insulation against a

variety of terms-of-trade shocks, avoiding the need for changes in the real exchange rate.

Moreover, countries that possess similar production structures were deemed suitable for

currency areas, since a terms-of-trade shock is likely to affect them symmetrically. Business


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cycle harmonisation or similarities in economic structure is important as the currency unions,

in this case the EMU’s exposure to asymmetric disturbances is reduced if the difference

between each country is small. This is due to the fact that the scale of the shock is easily

compared to other countries and the monetary will serve all member countries to the same

effect (Jager and Hafner 2011).

Relating back to the author’s research question on identifying the flaws of the incomplete

Eurozone monetary union, the EMU is called an OCA yet it fails to meet three out of the four

criteria to be even considered an OCA. The inflexibility of factor mobility is associated with

labour market rigidities and low labour mobility (Jager and Hafner 2011). For example if you

compare the monetary union of the US and the EMU there are many differences. In the US if

someone from California is offered a job in New York they can begin the next day as they

share the same currency but also the same language is spoken. In Europe, if a French man was

offered a job in Spain, or vice versa, it is not as simple. While both share the same currency

the euro, the language and cultural traditions vary tremendously, which would make it

extremely difficult for them to move. The other OCA criteria not met is that there is no risk

sharing system of fiscal transfers to areas negatively by the movement of capital and labour in

the Eurozone. In actual fact the Stability and Growth Pact (SGP) provided no bailout clause,

which hindered fiscal transfers between member nations. However this practice was later

abandoned in April of 2010 only because of an emergency, i.e. the Global Financial Crisis.

Some argue that this happened too late.

As a result, these countries diverged in terms of inflation, growth and fiscal performance with

some placing the blame on the single ‘blanket’ monetary policy imposed by the ECB. There

are wide variances in the business cycles of the member countries with the growth rate


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varying from -7.11% in Greece to 8.28% in Estonia in 2011 as well as quite significant

differences in income distribution ranging from 60% in Slovakia to 115% in Finland (Jager

and Hafner 2011). So in that sense there is very little or no business cycle harmonisation in

the EMU whatsoever.

“One of the Conditions necessary for a single currency area is that

participating countries should be subject to similar shocks and responses to

shocks.” (Hallett and Pistcitelli 1998 pg. 338)

It was global financial crisis that exposed the truth of the EMU OCA in that it failed to meet

the necessary criteria for an effective OCA as mentioned earlier (Baldwin and Wyplosz

2012). This meant that the member countries experienced quite damaging asymmetric shocks

without the necessary resources or mechanisms to cope with them. Once again the Theory of

OCA states that disturbances or shocks should be symmetric not asymmetric, but regardless

of the type of shock, asymmetric or symmetric, the EMU should still have the correct

mechanisms to deal with such occurrences. While mechanisms such as wage flexibility,

labour mobility and fiscal federalism are virtually non-existent in the EMU context. It was

believed that having a common currency would make it easier to do business transaction

across Europe, which it did, but some countries grew faster than others. An example of this

like Germany, as it is a very productive country that benefited from the common currency but

exports from other countries like Greece suffered immensely (Ho 2011).

Research has shown that an OCA in which some countries experience more costs than

benefits that other countries, the EMU OCA is not sustainable in the long run (De Grauwe

2014).


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Fig 1.1

Source: De Grauwe 2006

The above diagram, Fig 1.1, shows the minimum level of flexibility and symmetry required

for and OCA depicted by the downward sloping line. Points along the line show optimal

combinations of flexibility and symmetry in which the costs and benefits are balanced. The

OCA line is downward sloping because at any point to the right, there is more flexibility than

symmetry and to the left the opposite occurs, more symmetry than flexibility (De Grauwe

2014).


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Fig 1.2

Source: De Grauwe 2006

The graph, Fig 1.2, depicts the relationship between symmetry and integration, in which the

benefits and costs of a monetary union are equal. Anything to the right of the OCA line is

where benefits outweigh the costs. However the Eurozone is located to the left of the OCA

line which means that the costs are greater. This shows that the Eurozone is still incomplete

and that some countries are experiencing greater costs than benefits from just being a member

of the monetary union which makes the Eurozone unsustainable in the future (De Grauwe

2014).

2.3 Costs of Monetary Union and Alternative Stabilisation Mechanisms

Looking at the previous graph, Fig 1.2, the cost and benefits should ideally be equal to one

and other but as the author shows here they are not, in actual fact some countries experience

much greater costs than others with little or no benefits gained. The cost-benefit model was


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derived by Scitovsky (1958), Mundel (1961) and McKinnon (1963). The most cited cost in

joining a monetary union is the relinquishment of national monetary policies and the adoption

of a single ‘one for all’ monetary policy. “A disadvantage of EMU is the lack of national

monetary policy to absorb country-specific shocks. The seriousness of this depends on the

availability of alternative adjustment mechanisms…”(Verhoef 2003 pg.4) So therefore if one

country appears out of sync or as an outlier to the rest of the countries, the single monetary

policy may not be appropriate as there are “different effects of a common monetary policy”

(Belke and Baumgartner 2003). This is when adjustment mechanisms come in.

Adjustment Mechanisms to Asymmetric Shocks

For arguments sake let’s say that France and Germany join a monetary union together,

therefore they abandon their own currency in favour of a common currency which is

controlled by a central bank. Now let’s say there is an asymmetric shock in aggregate

demand, consumer preferences shift from French made goods to German made goods.

Therefore the demand curve for the German made products shifts to the right and the demand

curve for French made goods shifts to the left. Both countries experience adjustment

problems, France is plagued with reduced output and higher unemployment, while Germany

experiences a boom, which also leads to upwards pressure on its price levels. There are three

mechanisms that will automatically bring back equilibrium, wage flexibility, labour mobility

and fiscal federalism.


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Wage Flexibility

“Wages that in response to a change in economic adjust instantaneously to balance supply

and demand for labour” (Black et al 2012 pg.159), if wages in France and Germany are

flexible then the following will happen. French workers who are unemployed will reduce their

wage claims and in Germany, the excess demand for labour will push up the wage rate. These

shifts lead to a new equilibrium. In France, the price of output declines, making French

products more competitive and stimulating demand. The opposite occurs in Germany.

Labour Mobility

The second mechanism is labour mobility i.e. the movement of a workforce from one country

to another, in which case the unemployed French workers move to Germany where there is an

excess demand for labour. This movement of labour eliminates the need to let wages decline

in France and increase in Germany. Thus, the French unemployment problem disappears

whereas the inflationary pressures in Germany vanish (De Grauwe 2012). However, it has the

same issues as factor mobility in the sense that a person cannot move to another EMU country

without experiencing similar language and cultural barriers.

Fiscal Federalism

The third and last mechanism is fiscal federalism. Fiscal federalism is “the division of

revenue collection and expenditure responsibilities among different levels of government”

(Black et al 2012 pg.157). The US is a prime example of fiscal federalism in which transfers

take place automatically through the federal budget, in their case, through a tax system that


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lightens the costs coupled with a single currency. These transfers play an integral part in the

insurance role that counteracts the absence of internal exchange rates. In the EMU there is no

fiscal federalism, no system of equivalent insurance. Member countries have no alternative

but to suffer the consequences of asymmetric disturbances.

If we are to implement such a mechanism in the EMU there would be further asymmetry as

the benefits gained by Austria and France would be less than those experienced by Ireland

and the UK. As a result of this asymmetric shocks would make it more difficult to implement

an EU wide fiscal which may not appear attractive to all countries (Fatás 1998). If the EMU

was more federalist it could have prevented the severity of the crisis in a number of ways. It

would have increased the political unity of the euro, provided more scope for greater

redistribution, risk sharing, and a federal counter-cyclical fiscal policy to lessen the effect of

the countries that fell into consolidation back in 2010 as well as helping to strengthen the

banking industry in the euro area in implementing a banking resolution scheme (Darvas

2010).

Alternative Adjustment Mechanisms to Asymmetric Shocks

As of now, the only instrument that can deal with asymmetric shocks is national fiscal policy

therefore the synchronisation of European fiscal policies are important. While it is considered

to be a flexible instrument, in truth it is less flexible due to its delayed reaction. Another such

mechanism is EU budget transfers. These budget transfers absorb the effect of the asymmetric

shock in a number of ways as the transfers take the form of “payments in cash according to a

particular distribution key, as transfers that are connected to particular projects or as loans or

subsidies, which are processed by the European Investment Bank” (Belke and Baumgartner


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2003). Specialisation is stronger in Europe at a regional level than at a national level. So

taking that in to consideration, if we identify a specific region regardless of their nationality

and characterised them, this diversification will dampen the net effects of ‘differentiated

sectorial shocks’ in the economy and reducing the danger of national instability.

2.4 Benefits of EMU

Countries that join the EMU don’t just experience costs but also benefits. The benefits

experienced, depending on how you view them, are mostly visible in the microeconomic level

with the countries relinquishing their national monetary policy, adopting a single monetary

policy and the movement towards a single common currency. The advantages in having a

common currency between large groups of countries is that it can be used as a unit of account

and more importantly it can be used as a means of trade with the rest of the world. In joining a

monetary union and the acceptance of the common currency, the transaction costs associated

with the exchanging of national currencies disappear and according to the European

Commission this gain is estimated to be between 13 to 320 billion euro.

Membership of a monetary union has reduced the exposure to exchange rate volatility which

was especially important for the more open economies that would have surely been worse off

outside of the EMU (Lane 2006). Another reason is because of the increased price

transparency, consumers benefited from increased competition across the Eurozone through

lowered prices and price stability which protects consumer’s purchasing power and the value

of their savings (European Commission 2012).

The global financial crisis, because of its size, compels us to ask new questions and to rethink

the answers to old questions. Everyone knew that the countries who were members of the


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EMU were different in terms of structural differences such as their level of development,

labour market institutions and specialisation as well as variances in inflation and exchange

rate. The EMU is categorized by its degree of asymmetry between member countries and was

able to depend on weaker economic instruments due to the non-existent risk sharing system

and low labour mobility. In the latter part of 2009, the resolution to the crisis was devised in

three parts. The first aspect was being the development of mechanisms such as the crisis

resolution mechanism. The second stage is to redevise the fiscal regime and for the last stage

it has been acknowledged that there is need for systemic reform (Pisani et al 2013). For the

sustained future of the Eurozone, it relies on the efficiency of institutional reforms as the EU-

level and economic reforms in some countries (Bukowski 2011).

2.5 Conclusion

While the OCA theory is the theoretical basis on whether or not countries should join a

monetary union, the EMU itself, is far from an OCA. It fails to meet three out of the four

criteria for an OCA and experiences asymmetric shocks, which contradicts the theory. Factor

mobility is not possible due to barriers such as languages, and from what I can see there is

very little business cycle harmonisation with varying differences in income and growth. This

is not ideal for an OCA, but that is not all. When joining a monetary it comes with costs such

as the relinquishing of sovereignty and national monetary policy. This could be potentially

devastating as the single monetary policy may not be appropriate to use in certain situations.

Then there’s there the matter of the adjustment mechanisms, wage flexibility, labour mobility

and fiscal federalism, none of which exist in the EMU. The only proven mechanisms to

actually work are national fiscal policy and EU Budget Transfers.


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Chapter 3: Establishment and Transition of the EMU – To what extent

is the EMU structurally incomplete.

3.1 Introduction

The Maastricht treaty was the beginning of the EMU. It set out criteria that had to be met in

order for a country to become a member. The criteria were based on inflation, interest rate,

time since last devaluation and government budget deficit. The reasoning behind each of the

criteria is as by only allowing countries who meet the criteria join to ensure the success of the

EMU. However the transition to EMU was not smooth. Issues arose such as the fixing of the

exchange rate and the EMU not being an OCA.

3.2 Transition to EMU

The Maastricht Treaty was signed in December 1991 and was best known for its framework

towards monetary unification in Europe. 12 years of a gradual transition and this monetary

union became reality. Its two core philosophies are that the transition to a collective monetary

union will be gradual and that in order become a member, a country had to meet certain strict

convergence criteria which were described in detail in the Maastricht Treaty:

1. Its inflation rate is not more than 1.5% higher than the average of the three lowest

inflation rates among the EU member states.


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2. Its long-term interest rate is not more than 2% higher than the average observed in

these three low inflation countries.

3. It has joined the exchange rate mechanism of the EMS and has not experienced

devaluation during the two years preceding the entrance of the union.

4. Its government budget deficit is not higher than 3% of its GDP ( if it is, it should be

declining continuously and substantially and come close to the 3% norm, or

alternatively, the deviation from the reference value of 3% should be exceptional and

temporary and remain close to the reference value)

5. Its government debt should not exceed 60% of GDP (If it does, it should diminish

sufficiently and approach the reference value (60%) at a satisfactory pace)

(Bean 1992).

In May 1998, it was agreed that the following 11 EU countries, Austria, Belgium, Finland,

France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain all met the

convergence criteria. And on January 1 2002 the euro was introduced. However three

countries that did meet the criteria but opted to remain outside of the Eurozone were the

United Kingdom, Denmark and Sweden. The United Kingdom remained outside of the

monetary union because it opted for the right not to be included. Denmark subjected its entry

to a national referendum and Sweden decided not to enter because of a loophole in the treaty.

It refused to enter the exchange rate mechanism of the EMS before the start of the third stage,

thereby deliberately failing to satisfy one of the entry conditions (De Grauwe 2012). The 19th

country, Lithuania, joined on 1 January 2015. A peculiarity with the EMU is that, technically

it did not commence until January 1999 when the ECB took over control from the national

central banks. From January 1999 to December 2001 the euro was not in physical form rather


23

it only existed in the banks books and only became a means of currency and payment on 1

January 2002.

3.3 Reasoning behind Convergence criteria.

You may be asking yourself ‘why is there a need for convergence requirements?’ and it is

because in the previous setting up of a monetary union, the decision was made; it was done so

quickly and without the requirements of the Maastricht treaty. Also according to the theory of

OCA, it stresses the importance of labour flexibility, mobility and a budget union, without

which it would be incomplete. So if those conditions are considered to be achieved, why wait

ten years to establish a monetary union. If these conditions are not met even though the

Maastricht conditions are, it is not a good idea to let the country or countries join.

Inflation

To explain the reasoning behind the need for the inflation requirement is due to the concern of

there being inflationary prejudice and to explain the need for this requirement, De Grauwe

(2014) uses Germany and Italy as examples. With both countries being identical expect in

terms of authority, in which the German authorities give a high weight to reducing inflation

while the Italians give it a low weight. Now that a central bank takes over from their national

banks two proposals can be made, one, that Germany, having low inflation can reduce its

welfare by forming a union with a high inflation country. This is because the union’s central

bank is likely to reflect the average preferences of the member countries. The second proposal

that can be made is that Germany, the low inflation country, will lose if Italy, high inflation,


24

joins and it will not want that to happen unless it can force requirements. One requirement is

that the union’s central bank must have the same views as the German Central Bank. Inflation

remained low and stayed low in these countries once the euro was introduced even though

there were rumours that the euro could lead to an acceleration of inflation.

Budgetary Deficit

For the budgetary requirement we’ll use the example of Germany and Italy, in which Italy has

a high debt to GDP ratio. A high government debt creates incentives for the Italian

government to engineer surprise inflation because some of their bonds are long term and their

interest rates are low. By creating ‘surprise Inflation’ the real value of bonds will be less and

the bondholders will get insufficient compensation. Arguments that are in favour and justify

the reduction of debt in order to gain entry to the union are that if a country has a high debt, it

is more likely to default and if they do happen to join it will increase the need for a bailout.

This also explains the no bailout clause that is in the treaty.

Exchange rate

The exchange rate or the no devaluation condition requires that a country cannot have

influenced their exchange rates in order to get entry at a more favourable exchange rate. The

severity of this requirement has changed dramatically since the declaration of the Maastricht

Treaty due to the no-devaluation clause incorporated into the treaty. The treaty states that

exchange rates should be kept within the normal bands of 2 x 2.25%.


25

Interest rate

The validation for this condition is largely due to the excessive differences in the interest rates

before entry could lead to big gains and losses in capital at the moment of entry to the

monetary union. The rule states that the long term government bond level of a country hoping

to join the union should not be above the interest rate of 2%. For the PIIGS countries, their

interest rate was high which led to strong decreases in long term interest rates before the

establishment of the EMU. This also led to higher booms in some of these countries in the

beginning of the EMU (De Grauwe 2014).

3.4 Incomplete Monetary Union

The move to a monetary union such as the EMU was not plain sailing rather there were issues

regarding the convergence criteria. The Maastricht Treaty is based on the understanding that

for a monetary union to be possible and prior to the countries joining, they have to meet the

requirements in their inflation rates, interest rates and fiscal policies. As well as meeting the

criteria mentioned, the level of the fixed exchange rate should be increased at a steady rate so

as to before the establishment of the EMU. The exchange rates should be fixed at the same

level for at least two years. However the convergence criteria are considered to be

contradictory in the sense that all the requirements can only be achieved simultaneously once

the monetary union is established but cannot be achieved simultaneously before the union is

fact. So therefore the Maastricht criteria acts as more of a hindrance to having a monetary

union in Europe by setting out these nominal requirements to meet for entering when in fact

these requirements cannot be met until there is a properly functioning monetary union.


26

A notable fact about the Maastricht Treaty conditions, according to De Grauwe (1994), is that

they have very little to do with economics at all, even more noteworthy is that Maastricht

Treaty had adopted completely different conditions to those outlined in the theory of

monetary union and those of the theory of optimum currency area. The problem here is in the

European community, which consists o twelve member countries, is not considered to be an

OCA nor is it, from an economic perspective, attractive. The reason as to why it is not seen to

be attractive is because asymmetric shocks will still occur in a monetary union and with the

absence of adequate labour market flexibility, labour mobility and automatic fiscal

redistribution. As a result many countries will experience unyielding adjustment problems.

The second reason is more of a political reason rather than an economic. Some countries, like

Germany, do not want a monetary union with twelve members because with that many

members Germany would lose their hegemonic position. With a central bank consisting of

twelve members, Germany could easily be placed in a minority position thereby losing

control over its monetary affairs. However, the danger of this strategy is that since Italy is free

to join, it will always want to be a member of the monetary union because it will gain from

the low inflation and efficiency gains. This makes the union look unappealing for Germany

making it less likely to be part of the union if the loss of welfare is greater than the efficiency

gain of the union.

With the transition to the EMU came many technical problems and even if they are overcome

they are still considered to be important as they can re-surface in the future when other

countries decide to join. The exchange rates of the various national currencies were fixed

permanently on 1 January 1999. The solution, the Treaty decided during the Madrid council

of 1995 that on the 1 January 1999 the ECU would be equal to one euro and adopted by all


27

member states instead of their national currencies. This eliminated the need for conversion

rates between the different currencies in which the commission could have been as high as

7% (Eichengreen 1993). There is also the issue of converting each of the currencies to euro.

The conversion rate for each currency had to be equal to the market rates against the ECU

when the market closed on 31 December 1998. This was because when it was announced that

the market rates before the EMU would be used as a conversion rate that would be

irrevocably fixed. This was to avoid any upwards movement between two currencies before

the conversion date because if not this would allow the exchange rates to diverge in any

direction up until that very date.

This had to be avoided at all costs as this could mean the fixing of the wrong exchange rates

with some being overvalued and others undervalued. The solution, which was put forward by

a number of academic researchers was to publish the conversions rates in advance of the date.

If these conversion rates were credible the market would gently edge the fixed exchange rates

to those conversion rates that were announced. Fortunately enough this is exactly what

happened. The authorities announced the conversion rates in May 1998 and further backed up

these rates by announcing that the central banks of the EMU member countries would help

with monetary policies. They also stated that they would intervene if necessary to bring the

exchange rates close to the announced conversion rates. In fact very little intervention was

needed. As the date grew closer so too did the exchange rates to that of the expected

conversion rates. What makes this even more amazing is that this all happened during a major

financial crisis in the second half of 1998 (De Grauwe 2014).

With the EMUs incompleteness, its integrity is at risk as a lack of confidence can make a

country default. This is challenging as it questions the future sustainability of the monetary


28

union. In the case of the EMU, it has forced extreme austerity measures on some countries

such as PIIGS, and thrust them in to a bad equilibrium threatening their creditworthiness.

While defaulting can have benefits, it also has costs. With defaulting, the government suffers

a loss in their reputation which in turn will make it harder for them to borrow in the future.

Depending on the size of the solvency shock, it may be more beneficial to default, like Greece

did. Investors anticipated this default which meant that the Greek Government will not be

able to locate the funds to finance their budget deficit. Countries that experienced less severe

solvency shocks are better able to sustain a no default equilibrium and by doing so are able to

keep their reputation intact for future borrowing (De Grauwe 2014)

The flaws of the EMU don’t end there as they are also rooted in its construction. The EMU is

not considered to be an OCA because it fails to meet three out of the four convergence

criteria. The OCA theory states that in order for a union to be declared as a monetary union

they have to have labour mobility, capital mobility, and a risk sharing system and similar

business cycles across all member countries. Labour mobility is restricted in Europe due to

different cultures and languages being spoken. For example it would be easier to move from

California to New York than from Spain to France.

The other criteria that the EMU fails to meet is that it does not have a risk sharing system and

as a matter of fact the Stability and Growth Pact specified a no bailout clause, which

prevented the transfer of funds between member states. In addition, while most countries met

the required convergence criteria of the Maastricht Treaty, the dynamics of the economies of

each country varied and over time, they deviated in terms of inflation, fiscal and growth

performance. Thus it is argued that it may have diverged from the optimal monetary policy


29

for the member states. In other words, the members of the EMU may have been worse off

under the single ‘one size fits all’ monetary policy which is regulated by the ECB.

There is a lack of enforcement of penalties in the EMU for when an official transgression has

been committed. It was rare that such penalties were ever enforced and this may have

encouraged more of this outlandish behaviour. In spite of all this the talks held on enforcing

the rules very little has been done and in actual fact some misdemeanours against the Stability

and Growth Pact have never been followed up on. These rules however are not enforceable on

larger countries such as Germany or France because of the influence they have, especially on

the Council of Ministers, who approve such restrictions.

3.5 Conclusion

The Maastricht Treaty was the birth of the EMU. It set out strict convergence criteria that had

to be met in order to join this monetary union. These criteria where put in place to ensure the

success of the EMU. However this is where the flaws begin. For a country to meet these

required criteria, there already has to be a functioning monetary union which is a

contradiction in itself. A notable fact made is that the Maastricht actually has very little to do

with economics and instead adhered to completely different criteria outlined by the theory of

OCA. Due to this lack of adherence, the EMU is far from being considered an OCA. Even

though some flaws were overcome, such as the issues with setting the exchange rate, they are

still considered to be problematic as it can resurface again in the future. With the EMU being

so incomplete, it increases the risk of defaulting which will cause implications for future

borrowing.


30

Chapter 4 – The Global Financial Crisis 2007

4.1 Introduction

Based on the theory and literature, the EMU did not fulfil the criteria for an OCA. Nor did it

have the adjustment mechanisms required to correct itself in the event of an asymmetric

shock. The Global Financial Crisis exposed many of these flaws in the Euro construction.

This chapter is going to analyse the problems and difficulties that occurred in this periods of

turbulence.

4.2 The Global Financial Crisis in Brief

It was argued that it was a result of when a number of economies come together sharing

common currency and monetary policy when everything else is differs such as the business

harmonization cycles of countries. The crisis first came to international attention with the

realisation that the Greek debt was at an unmanageable level. In 2009 the government revised

its budget deficit to be 12.7% rather than the previous 6%. The Greek debt was at an

estimated €216 billion in 2010, 120% of GDP, double that specified in the Maastricht Treaty

criteria. However that was not the only problem. Investors soon realised that this debt was

held by other countries and soon the fear became that other highly leveraged EMU member

countries may experience the same troubles. The countries that soon became the focus of the

crisis were Portugal, Italy, Ireland, Greece and Spain despite the efforts of extensive bailouts

and austerity measures that were taken in 2010, the crisis re-emerged in 2011 (Ho 2011).


31

Ireland left its EU-IMF programme of financial support on 15 December 2013 and is now

being used as a prime example for the success of austerity measures.

According to Ho (2011) one of the most important questions not being asked is ‘how did we

get here?’ The concept of having a common single currency is that it would make it easier to

do business transactions across Europe and that it did. Though some countries grew faster

than others like Germany, a very productive country who benefited from the common

currency but exports from less productive countries like Greece suffered immensely. This is

further evidence of a lack of business cycle harmonisation required for an OCA. As the Greek

economy was collapsing they received less in government revenues and did little to cull their

government spending and as a result, their continued budget deficits added more fuel to the

debt problem (Ho 2011).

4.3 Flaws that came to Light

“The economic crisis exposed the fact that the EMU fails to meet the criteria

required to operate effectively as an OCA” (Baldwin and Wyplosz 2012).

This means that the EMU is subject to potentially damaging asymmetric shocks, what’s more

is that when these shocks hit the EMU, it does not have the adequate resources to deal with it

efficiently and effectively. The theory of OCA states that economic shocks should be

symmetric. In the cases in which they are not symmetric but asymmetric, the EMU should

still have the mechanisms to deal with this type of shock regardless.


32

The EU did not have enough resources to rescue the troubled financial institutions and

member states. The EU’s limited fiscal capacity has proven to be the most critical constraint

in responding to the global financial crisis in a coordinated manner. This leads to

nationalization of rescue operations, which undermines the Single European Market and

requires IMF involvement with respect to its member states in distress. The EU must also

complete the lacking elements of the Single European Market such as the European financial

supervision and help in strengthening global policy and regulatory coordination (Dabrowski

2010).

The Global Financial and the associate ‘Great Recession’ have revealed a whole host of

problems in the EMU, with the future of the euro itself being widely questioned. Elements of

these faults were present from the beginning in the nature of the convergence criteria. The

criteria focussed on nominal rather that real variables, but crucially paid no attention to the

appropriateness of the exchange rates at which countries entered the EMU.

Although the OCA was much discussed in the academic literature and in studies on the

desirability or otherwise for the formation of the Euro, it appears to have had no impact on the

design of the Euro or on the convergence criteria. The OCA literature postulated that in the

absence of the variation of the exchange rate possibility, which is clearly the case for a

country in a currency union. There could be an alternative adjustment processes: those of

price flexibility, of factor of mobility and of fiscal transfers. It is clear that the convergence

criteria made no reference as to whether country possessed sufficient price flexibility. The

SGP limits suffer from a number of shortcomings. First there is a zero budget deficit as

recorded would be surplus of around 1 percent of GDP in real terms. Secondly, a 60 per cent

debt ratio is consistent with a 3 per cent budget deficit on sustainable basis since the


33

relationship between deficit and debt on a sustainable basis is public debt of one-quarter

deficit divided by nominal growth rate. Here a 5 per cent nominal growth rate is taken.

Thirdly and more importantly, the requirements of the SGP are asymmetrical and in the

deflationary conditions-there is an upper limit on surpluses (Arestis and Sawyer 2011).

“As the Crisis unfolded, the problems facing the euro area were initially

misdiagnosed” (Pickford et al 2014, pg. 8).

The EMU learnt valuable lessons from the financial crisis. Probably the most important was

that the EMU needs a sovereign lender of last resort and a banking union. Countries who

joined the EMU found out this the his hard way. They issued debts in a currency that they had

no control and the ECB was set up with the sole purpose to be the central bank for the

monetary union. In actual fact the ECB only had authorization around inflation and is

prohibited in purchasing sovereign debt which means countries that are experiencing

speculative attacks cannot rely on it to stabilize their markets. Another flaw of the EMU was

that there is no lender of last resort, as the ECB had not been given this power of authority

yet.

De Grauwe (2011) further argues this point as a central lender of last resort is needed in the

Eurozone in relation to the government bond markets. If a country has its own currency, its

government can guarantee there is sufficient liquidity in its bond markets. In a monetary

union such as the EMU, the national governments have to rely on the authority that issues the

currency leaving the national governments unable to guarantee adequate liquidity and with

this, issues with liquidity can manifest in to solvency issues. A working monetary union

should have a central bank that appears and is willing to act as a sovereign lender of last

resort. However this may entail a change in the ECBs mandate to allow monetary financing in

extreme situations when such speculative attacks threaten the existence of the euro. Even


34

though it will have its benefits, it would be entering the territory of becoming a political

union.

The second issue that was not foreseen was the need to have a banking union. A banking

union comprises of a common supervisor, a common resolution mechanism and a common

deposit insurance scheme. With the introduction of the euro, it caused the amalgamation of

the member’s financial markets but supervision remained at the national level. As the crisis

progressed, large banks began to experience solvency and liquidity issues, thus more issues

were created. The first issue was the process of financial fragmentation and renationalization

of financial systems which means that the sovereign debt of a country was held in the books

of that country. Secondly, the markets believed that some countries would not be able to cope

with their debt and would increase the likeliness of defaulting, which increased the risk of

national banks becoming insolvent.

This leads to a negative feedback loop in which more problems arose as it distorted the

transmission mechanisms of monetary policy by raising interest rates in countries

experiencing. Thus, the negative feedback loop makes credit more expensive. The point is

that a monetary union requires a core authority to monitor the large banks; it needs a common

resolution authority that has access to fiscal resources to recapitalize the banks without

putting the solvency of other countries at risk. There also needs to be a common insurance

deposit scheme to ensure the people, as well as investors, that deposits are safe regardless

where they are held (Pickfork et al 2014).

Pickfork et al (2014) argue that the EMU needs a crisis resolution mechanism which is

capable of responding in a quick and efficient manner to unexpected shocks such as the global

financial crisis. Since the crisis began there has been work done on this front as the ECB and


35

ESM are now better equipped to deal with such crises, but there is more progress to be made.

During the crisis the euro did not have these mechanisms in place and the decisions by the

leaders on this matter was said to be ‘too little, too late’.

4.4 Conclusion

The Global Financial Crisis was an economically devastating period. Government debt was in

the increase constantly with no sign of falling. The worst affected countries in the EMU were

Portugal, Ireland, Italy, Greece and Spain who were nearly forced to leave the monetary

union. Economists knew the EMU was not an OCA and the Global Financial crisis further

proved their argument. The crisis showed there was no business cycle harmonisation as some

countries grew faster than others, when they should have the same growth trends. The

unforeseen issues were there was neither a lender of last resort nor a banking union in place.

Without either, there were liquidity and solvency issues which ultimately led to more

problems and difficulties in the long run. There were actually no mechanisms in place to deal

with such a devastating crisis. The crisis may have exposed the members of the EMU to the

realisation that ultimately it must accept further and deeper economic reforms if it wants the

EMU to survive.


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Chapter 5 – Addressing the Incomplete Monetary Union

5.1 Introduction

Many of the problems surrounding the EMU are due to the fact that is incomplete. In the

previous chapters the author questioned the incompleteness of the EMU, since its

establishment to the Global Financial Crisis to discover that it is quite incomplete and that the

Euro could be at jeopardy. Having discussed the flaws of the EMU, the aim of this chapter is

to analyse how the EMU can correct for the same issues that came to light from the

establishing of the EMU to the Global Financial Crisis.

5.2 How to address the incomplete monetary union

The report form the president of the European Council identifies three pillars for an integrated

EMU (Ederer and Weingartner 2013):

An integrated financial framework which sets the cornerstones for a European

Banking Union.

An integrated fiscal policy framework.

An integrated economic policy framework

(Ederer and Weingartner 2013)

This framework is to be executed in three stages where closer integration of the EU in these

areas is gradually achieved. The Commission’s proposal included measures that correspond to

these three pillars of an integrated EMU, without however citing them explicitly. These

measures are defined by three times periods; the short-term measures could be implemented


37

within a period of 6 to 18 months without requiring any change to the Maastricht Treaty. The

medium term, 18 months to 5 years, in which these measures are to be fully implemented.

The long term plan stretches beyond 5 years. The Commission’s proposal largely covers the

same ground as the Report of the European Council, partly reaching out further or elaborating

the proposals of the latter (Ederer and Weingarter 2013)

While many of the solutions mentioned are important to some degree to ensure the short to

medium-term survival of the EMU, the solution to its long term survival may lie in the

principles of the OCA. The crises are actually inevitable because the only way it can survive

is to take further steps towards the development of a fulfilled OCA that works to it potential

(De Grauwe 2006). For those thinking of leaving the euro as a solution to the crisis, it is not

really an option as it would defeat the purpose of them joining the monetary union in the first

place. Leaving the euro would mean the reintroduction of significant risk premiums, exchange

rate volatility, poor fiscal discipline and high inflation. Lane (2006) notes that the adaption of

the Euro is a decision that is only reversible at very high costs.

5.3 Integrated Financial Framework

To Van Rompuy (2012), the creation of an integrated financial framework means a closer

banking sector with European wide supervision, an integrated budgetary framework to ensure

sound fiscal policy making across Europe and an integrated economic policy framework to

encourage more even growth rates across Europe. EMU wide supervisory policies would help

to prevent many of the asymmetries that led to the previous financial crisis.

Having a banking union is essential in severing the ‘deadly embrace’ between the banks and

sovereign debt. By having a common bank resolution mechanism, it would allow the cost in


38

resolving the banking crisis to be distributed over the entire union not just faced by a single

country. The United States is a prime example of a common bank resolution mechanism. The

US federal government carried out the resolution of their banking crisis. Nevada has an

economic cycle similar to that of Ireland and experienced a similar credit crunch. The cost of

resolving the Nevada banking crisis was a transfer from the federal government of about 10%

of Nevada’s GDP, because of this transfer, the government spared Nevada from budgetary

implications of this resolution (De Grauwe 2014).

Ireland has no such mechanism in place and therefore the Irish Government had to face the

brunt of the costs of the Irish bank resolution. As a result the Irish Government was forced

into a default crisis, entered a deep depression with harsh austerity measures and the rate of

unemployment rapidly increasing. A must have in establishing such a mechanism is that the

supervision of the banks must be centralised. In actual fact, in 2012 it was decided by the

EMU countries to introduce such a common supervisory structure which should be fully

operational as of the end of 2014 and supervised by the ECB (De Grauwe 2014).

5.4 Integrated Fiscal Policy Framework.

The second pillar of a “comprehensive EMU” as the Report of the Council cites, is an

integrated fiscal policy framework. In the short run, the previously adopted stricter rules of

the “Six-pack”, the “Two-pack” and the Fiscal Compact shall be implemented. The

regulations of the “Two-pack” already provide estimations for the coordination of the annual

budgets of the EU member countries. What is essential here is that it must be a collective

effort at union level where national debt and budgets should be amalgamated to form one


39

‘central component’. With this central component, the EMU can create a communal fiscal

power which has the ability to issue debt in the currency being used, in this case the Euro.

By combining national budgets to form a central budget, a mechanism that protects the

transferring of resources to countries hit with a negative shock, mechanism of automatic

transfers, can be introduced. In the medium term, a European central fiscal capacity along the

lines of the US fiscal federalism is to be created in order to adjust for country-specific shocks

at EU level and thus prevent the transmission of these shocks to other member countries.

5.5 Integrated Framework for Economic Governance

The third pillar of the Council Proposal is an integrated framework for economic governance.

“In an economic union, national policies should be orientated towards strong and sustainable

economic growth and employment while promoting social cohesion.”(Van Rompuy 2012).

Strength in economic integration is needed to promote both convergence and coordination in

different areas of policy amid the Eurozone countries in addressing disparities and in ensuring

the ability to respond to shocks in the global world economy. This framework is key for the

smooth operation of the EMU as well as being core to the previous frameworks, financial and

fiscal. It is important that this framework be easily enforced so as to avoid unsustainable

policies putting the EMU at risk and guide rather important policies such as tax coordination

and labour mobility (Van Rompuy 2012).


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5.6 Lender of last Resort

Liquidity crises are avoided in standalone countries that issue their own debt currencies

mainly because the central bank can be forced to provide all the necessary liquidity to the

sovereign. This creates an implicit guarantee for the bond holders that they will be paid out in

full when the bond matures. This outcome can also be achieved in a monetary union if the

common central bank is willing to provide the necessary liquidity in the different sovereigns’

bond markets. This creates an implicit guarantee for the bond holders that they will always be

paid out once the bond matures and by eliminating the threat of liquidity crises happening, it

can help protect countries by not pushing them towards a bad equilibrium. So in saying that,

there is a need for a lender of last resort in the EMU.

In September 2012, the Eurozone realised they needed a lender of last resort and thus the

ECB took the position and became committed to buying plenty of government bonds in terms

of crises, although the ECB preferred to call this ‘Outright Monetary Transactions’ or OMT.

However just like joining the EMU, the ECB had conditions for OMT, one of which is that

countries should apply for it and dedicate themselves to further programmes of austerity.

However the decision to make the ECB lender of last resort was heavily criticized. In

particular in terms of there being a risk of inflation, fiscal consequences and moral hazard.

The most argued point against a lender of last resort is that it would lead to inflation. This

critique was at its strongest in 2010 when the ECB began to buy the members states

government bonds. With the ECB increasing the stock of money, the risk of inflation grew.

When the government bonds are bought by the central bank it increases the size of the money

base, not the money stock. In other words, in the event of a financial crisis, money is held on


41

to for security reasons. When the central bank refuses to supply the money it quickly turns to

an economic crisis. When the central banks utilises its function as lender of last resort it can

stop the deflationary process. However that’s not to say the central bank is unlikely to

generate inflation, which is a risk once the economy begins flourishing.

The second criticism against the lender of last resort is that there are fiscal consequences

involved in the government bond markets. The central bank make losses when governments

fail to resolve their debts and the taxpayer pay the price. If the central bank does get involved

it is also getting the future taxpayers involved. In reality, the central bank should refrain from

open market operations, as the losses experienced in the open market are no different to those

losses made when buying government bonds. Sometimes losses can be desirable and, in the

case of the central bank, it can make losses without going bankrupt. Why? It has the power to

print money, which no other organisation or institute can do, to cover its losses.

The final criticism against the lender of last resort is that it can encourage the government to

issue too much debt. This is a serious risk of moral hazard. The only way to deal with such

risk is to enforce rules regulating the government’s ability to issue debt. The ideal solution for

the monetary union is to separate moral hazard from liquidity. The common central banks

should be the lender of last resort while another self-governing institution regulates and

supervises the creation of debt by national governments (De Grauwe 2014)


42

5.7 Consolidation of Government Budgets and Debts

Another step that can be taken towards a structurally complete EMU is the consolidation of

government budgets and debts and for this to work it requires a collective effort at a union

level. The theory behind this step is that, firstly, such a combination will create a fiscal

authority that has the power to issue debt in a currency under the control of a supervising

authority. This shields countries from being forced into defaulting by the financial market.

Secondly by centralizing the national government budgets into one single central budget, a

mechanism of automatic transfers can be organised. However this requires a slight degree of

integrating a political union and economists have stressed the importance of a political union

in order to sustain the existence of the euro. However this will require the EMU to closely

resemble a political union.

5.8 Transition towards a Political Union

“A monetary union should be embedded in political union. Almost everybody

will now agree with this. Not so long ago, however, many observers, especially

among the world of officials disagreed and maintained that the Eurozone was

all right and that no significant moves towards a political union were

necessary” (De Grauwe 2014, pg. 119).

It does not require a leap into a political union rather it can be taken in small stages and by

taking it in small steps it will allow the immediate problems to be resolved as well as


43

signalling the significance of European policy-makers in the move towards a political union.

The first small step is the joint issue of common bonds. By issuing joint bonds, the partaking

countries are equally liable for the debt that they have issued together. By combining the

circulation of government bonds, the member countries shield themselves from the

destabilising liquidity crises that can arise from their incapability of controlling the currency

in which their debt is issued. It will also hold benefits for both the weaker and stronger

member countries but this will only happen in there is overall political support. The issuing of

such common joint bonds will strengthen the Euro as a reserve currency by increasing the

potential of the public bond market (Boonstra 2011).

With the distribution of Eurobonds each member state becomes equally liable the debt that

has been issued. This is a quite a restraining guarantee to influence the seriousness of the euro

in the future. By combining the issued government bonds, it shields the monetary union

members from the effects of destabilising liquidity which arises from the incapacity in

controlling the currency in which their debt is issued. Just like the EMU, there are problems

with this mechanism, in particular moral hazard. This expectation causes opposition to those

countries that behave responsibly and therefore it is unlikely that those countries will be less

than enthusiastic to partake in common joint bonds unless the risk of moral hazard is resolved

(De Grauwe 2014).

The next step in the progression towards a political union is the coordination of budgetary and

economic policies. As mentioned earlier when countries join a monetary union lose control

over their national monetary policies and instead abide by a common monetary policy. Yet,

other instruments of economic policies have firmly remained in the hands of the national


44

governments. It is suggested by De Grauwe (2014) that a country should ideally hand over all

their sovereignty over the use of economic instruments yet the enthusiasm over this is weak.

Progress has been made in establishing a new set of rules, a so called ‘six-pack’ of rules and

measures to strengthen the control of budgetary policies. These rules incorporate a tightening

of the mutual control of budgetary policies as well as including a stronger authorising

procedure.

5.8.1 Consequences of Political Integration

While this may sound like a solid plan to complete the shambles of a monetary union, there is

however a weakness. Political integration impinges on the performance of a monetary union

in multiple ways. Firstly, it makes it achievable to manage the systems of automatic fiscal

transfers that provide protection against asymmetric shocks, thus when a country is hit by an

undesirable shock money will automatically be transferred from countries with good

economic conditions to those experiencing particularly bad conditions through the

consolidated unions budget. The result is that the member states will believe that the devotion

to the union is less expensive than with the lack of fiscal transfers.

Secondly, with the consolidation of the national debts to form a jointly issued debt, the

instability of the union diminishes, in turn allowing the unions to endure the movement of

governments with other hidden agendas as they cannot issue their own legal tender. The last

implication political integration is on the performance of a monetary union. A political union

inhibits the risk of asymmetric shocks occurring that have a political source. In the case of the

Eurozone this would be taxation and spending which are firmly in the hands of national


45

governments and with the independent control over whether to inflate or deflate taxes

produces asymmetric shocks.

5.9 Conclusion

There is no shortage of solutions to the incompleteness of the EMU. The European Council

put together a report in which they highlight 3 frameworks for a more integrated monetary

union. An integrated financial framework, integrated fiscal policy framework and an

integrated economic policy framework. Each of which will be gradually implemented over

time. It was during the Global Financial Crisis that it was realised that a lender of last resort

was needed and in 2012 the ECB took that position. The amalgamation of national

government budgets and debts will require a shift towards a political integration. However the

transition towards political integration will affect the performance of the EMU.


46

Chapter 6 Conclusion

The EMU is structurally flawed through both theory and literature. It fails to meet the

majority of criteria required for the theory of OCA which acts as justification for allowing

countries to join. Probably the most significant issue of the OCA is the lack of business cycle

harmonisation which has further implications in the use of the single monetary policy. The

most cited cost in joining a monetary union is the relinquishment of national monetary policy

and the adoption of a single ‘one size fits all’ monetary policy. This is seriously problematic

as depending on the countries size and economic condition, boom or recession, it may not be

appropriate to use. As a result, adjustment mechanisms such as wage flexibility, labour

mobility and fiscal federalism are used. The only problem is, they don’t exist in the EMU.

Instead they abide by alternative adjustment mechanisms such as their national fiscal policy

and EU budget transfers to correct for asymmetric shocks.

The Maastricht Treaty outlined crucial criteria that had to be met in order to for a country to

join the EMU. However, that was a flaw in itself as to meet these criteria, there already had to

be a functioning monetary union in place. As De Grauwe (2014) noted the Maastricht Treaty

had very little to do with economics and nor did it adhere to those conditions outlined in the

theory of monetary unions and those in the theory of OCA. While some issues were overcome

such as the fixing of the exchange rates, they are still considered to be worrying issues as they

can resurface in the future when other countries wish to join the EMU. The Global Financial

Crisis of 2007/08 was a particularly turbulent period in which some of the EMU’s flaws

manifested themselves and revealed weaknesses in the construct of the EMU. First and

foremost the EMU did not have the adequate resources to rescue institutions and member


47

states in financial trouble. It was through this crisis that it was realised that a lender of last

resort and a banking union were needed in the EMU.

The EMU has been structurally incomplete since its establishment in 1999 and the Global

financial crisis only proved this further. However, there are steps that can be taken so the

EMU can correct itself for the same structural issues seen both in its construction and those

during the Global Financial Crisis. The European Council identified three frameworks that

will work towards a better integrated monetary union. An integrated financial framework,

integrated fiscal policy framework and an integrated economic policy framework. Each of

which will be gradually implemented over the short, medium and long term. As realised in the

Global Financial Crisis the need for a lender of last resort, it became a reality in 2012 when

the ECB took up the position. The amalgamation of national government budgets and debts

will require a shift towards a political union but this shift will affect the performance of the

EMU.


48

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