1. Mr. Massimo M Beber Fellow in Economics Sidney Sussex College Cambridge CB2 3HU mb65@cam.ac.uk www.cus.cam.ac.uk/~mb65/mpes European Economics Lecture 7 MONETARY UNION (Provisional Version: last updated 19 th November 2007) M.Phil. in Contemporary European Studies 2007/8 ©Massimo M Beber 2007

3. Landmarks en route to EMU Jul-50The European Payments Union begins its operation, facilitating clearing of intra-European payments Dec-59With the generalized introduction of "external convertibility", the Bretton Woods system of fixed exchange rates begins to operate. Dec-69At the first European Summit in The Hague, the heads of state and government commission the "Werner Report" on a possible European Monetary Union (George Pompidou and Willi Brandt as French President and German Chancellor respectively). Dec-71The Smithsonian Agreements effectively signal the demise of the international monetary order based on the "dollar standard".The Agreements included (1) a devaluation of the US $ against other currencies; (2) the abolition of the fixed link between dollar and gold, substituted by one with the SDR; (3) wider fluctuation bands (4.5%). Dec-72After 9 months of operation of the "snake in the tunnel", European Summit adopts the goal of economic and monetary union. Dec-78European Council's resolution on "creating a zone of monetary stability in Europe". Mar-79The European Monetary System (EMS) begins to operate on the basis of an agreement between central banks. Britain does not join the Exchange Rate System (ERM) of the EMS, and remains a floating currency. Jul-85Palermo Agreement between Central Bank Governors: the ERM "hardens". Jun-89The Madrid European Council endorses the Delors Report commissioned a year earlier at the Hanover Council. Jun-90Dublin European Council establishes two ICGs (on political as well as economic and monetary union), with the aim of having new treaties ratified by December 1992. Oct-90The UK joins the ERM weeks before Mrs Thatcher's removal from office. Sep-92"Black Wednesday": Britain, Italy and France suspend their membership of the narrow-band ERM Feb-92Following political agreement in Rome (11-12th December 1991), the Maastricht Treaty on Economic and Monetary Union is signed and ratified in all member countries during the rest of the year. Jan-93Stages One of the Convergence to EMU begins, leading through Stage Two to the choice of irrevocable parities and the 1998 Convergence Report, leading to the approval of 11 member countries for initial EMU membership. Jan-99EMU Stage Three launched: national currencies remain in circulation at their irrevocably fixed exchange rate against the euro - effectively, as non-rounded denominations of the same monetary unit. Jan-02Conversion of national currencies into Euro notes and coins.

4. EMU MK I By the mid-1960s, the global monetary architecture of Bretton Woods was cracking. “Triffin Dilemma”: growth in world trade  growing world demand for forex reserves  chronic US balance of payments deficit  falling gold cover ratio; “exhorbitant privilege” of US seignorage The Hague summit (1969): monetary union between the EEC’s members by 1980: –Werner Report (1970) on monetary policy (a “centre of decision for economic policy”) –Macdougall Report (1977) on fiscal policy (a large federal budget – at least 5-7% of the union’s GDP – needed for stablisation purposes)

5. Stagflation and Monetary Disunion Deepening conflict over income distribution –productivity slow-down –price- and wage-setting leap-frogging –growing fiscal pressure of the welfare state –adverse move in industrial countries terms of trade (commodities, first and second oil shock) Inflation as a safety valve for conflict The sharper the conflict (and less effective corporatism), the higher inflation

6. THE CHOICE OF EXCHANGE RATE REGIME II: A “NON-SYSTEM” OF NATIONAL MONIES Monetary and Macroeconomic Sovereignty Stable Real Exchange Rate Free Mobility of Capital B C’, D C B: the Bretton Woods compromise C, C’: the (old) Keynesians’ Last Hurrah (Mitterrand experiment) D: the German model, Msrs Thatcher’s and Volcker’s monetarist experiment

7. Monetarism and National Monies The 1970’s and the “breakdown of the Phillips Curve” (stagflation); Unemployment as an equilibrium phenomenon, and therefore “voluntary”; “Only money matters”: central banks and only central banks can control inflation; moreover, only unexpected inflation has real consequences for the macroeconomy; Consequence: the schizophrenia of the “monetarist experiments” (Volcker Turn, the UK’s Medium Term Financial Strategy) Disinflation, credibility, and the “advantages of tying one’s hands” - the EMS as a “discipline device”

8. Inflation A SHORT TERM TRADE-OFF Unemployment “German” (very surprised) “Club Med” (once bitten, twice shy)

9. “Club Med” (employment oriented) Inflation p SOCIETY’S PREFERENCES “German” (stability oriented) Unemployment ΔU Δp’ Δp ΔU’ ΔU Δp

10. Price stability, no surprises, and the (“natural”, “non-accelerating inflation”) rate of unemployment... Inflation A “CLUB MED” FALSE CHOICE? Unemployment No surprises, still the “natural” rate of unemployment, but worse off by the “inflationary bias” UU UU* UU’ A B C D

11. Δe 1 Δi h Δe 0 THE PROBLEM WITH FLOATING RATES If total expected returns are quickly equalised by arbitrage... …any change in the exchange rate expected to prevail in the future will generate an immediate change in today’s interest rate and/or exchange rate: expected depreciation causes either an immediate monetary contraction or immediate depreciation

12. THE CHOICE OF EXCHANGE RATE REGIME III: FROM MONETARY ANARCHY TO MAASTRICHT Monetary and Macroeconomic Sovereignty Stable Real Exchange Rate Free Mobility of Capital EC’, D C’: the (old) Keynesians’ Last Hurrah (Mitterrand experiment) D: the German model, Msrs Thatcher’s and Volcker’s monetarist experiment E:back to the anchor: EMU, currency boards, dollarisation...

13. Bretton Woods StagflationERM disinflation Transition to EMU

15. Fewer Monies, Better Monies? The “Monetarist Revolution” undermined confidence in the use of monetary policy –for stabilisation (“long and variable lags” in the transmission mechanism make it unworkable) –for “riding the Phillips Curve” (you can only fool all of the people some of the time – or never, if they are “rational”; The other elements of OCA were also downplayed: –Differences in labour markets –Differences in financial structures –Differences in growth rates –Differences in the efficiency of tax systems

16. Source: Rowthorn and Martin (2004).

17. PRODUCTIVITY SLOWDOWN AND RECOVERY Source: The Kok Report (2004)

18. INCOMPLETE CONVERGENCE? Source: Kok Report (2004)

19. NAIRU AND HYSTERESIS The disappointing 1980’s: disinflation, but high and rising unemployment; The disappointing 1990’s: price stability, but chronic high unemployment; Updating Keynes: the “New Keynesian Macroeconomics” –Micro-foundations: imperfect competition in product and labour markets, and unemployment as a discipline device; –a “inexorable and mysterious trade-off”: the Phillips curve lives on –Hysteresis: long-term unemployment, insider power, capital scrapping as examples of persistence mechanisms Equilibrium unemployment –a political economy concept –requiring action in both product and labour markets –but also supporting macroeconomic policy

20. There is a short run in which, for various and complex reasons, inflation and economic activity move in the same direction (and, therefore, unemployment and inflation in the same direction).- in principle, providing monetary and macroeconomic policy with a useful role in offsetting any volatility in expenditure. The problem has always been how to prevent abuse of this power, while allowing its proper use to control the business cycle - from Ricardo to Friedman, many influential economists have thought the danger too great; but others (from Ricardo’s contemporary Harry Thornton, to the Keynesian tradition up to Greg Mankiw) have been more optimistic: as this President of the CEA (2001) put it “The inflation unemployment trade-off is, at heart, a statement about the effect of monetary policy. It is the claim that changes in monetary policy push these two variables in opposite directions. Monetary policy-makers face a short term trade-off between inflation and unemployment.” [Mankiw, Gregory N (2000) The Inexorable and Mysterious Tradeoff between Inflation and Unemployment, New York, National Bureau of Economic Research: p. 5, 7] The “New” Phillips Curve

21. Source: HM Treasury (2003) Government Policy on EMU and the Five Economic Tests, Ch. 1. The Labour Government’s Euro Policy since October 1997

22. Source: HM Treasury (2003) Government Policy on EMU and the Five Economic Tests, Ch. 1. Gordon Brown’s economic tests for British Membership

23. Despite the progress made since 1997, the lack of sustainable and durable convergence means that, for the UK, macroeconomic stability would be harder to maintain inside EMU than outside, were the UK to make a decision to join at the present time. The potential uncertainty created by the price stability objective of the European Central Bank (ECB) and the potential constraints on the use of fiscal policy for stabilisation under the current interpretation of the Stability and Growth Pact (SGP) increase the chances that output and employment would be less stable inside EMU. The Government supports the direction in which the EU macroeconomic framework is evolving. Enhancing the flexibility and dynamism of the European economy, building on the achievements of the economic reform programme agreed at Lisbon, will also be important if the full benefits of EMU are to be realised. Source: HM Treasury (2003) Government Policy on EMU and the Five Economic Tests, Ch. 6. No Euro, Please - We Are British (June 2003)

24. Source: Gordon Brown’s Budget Speech, 17th March 2004. REPORTS OF THE “DEATH OF (KEYNESIAN) ECONOMICS” HAVE BEEN GREATLY EXAGGERATED…

25. CONCLUSIONS The exchange rate is a powerful but dangerous substitute for price flexibility, labour and capital mobility, an integrated fiscal system; the historical anomaly is national monetary sovereignty: from the Gold Standard, to Bretton Woods, to the ERM, “zones of monetary stability” have been the norm. Given the current universal consensus on price stability as the primary goal of monetary and fiscal policy, only a high probability of asymmetric shocks recommends retaining the use of the exchange rate instrument. The Treasury criteria appear more relevant to the competitiveness of the EU (a real concept) than to its currency and monetary arrangements (a nominal concept, reflected in the nominal Maastricht criteria and GSP).