Week 11 Deck

Question 1

Define the eurozone? (4)

Answer 1

1. Group of countries deciding to adopt a common currency, thereby fixing the countries exchanges rates in relation to one another
2. Eurozone is referred to as the European Monetary Union (EMU)
3. Consists of 19 members
4. Monetary policy is an open economy under fixed exchange rate

Question 2

Explain the theory of an optimum currency area (Mundell, 1961)

Answer 2

Points to the cost and benefits of a country giving up independent monetary policy and an independent exchange rate

Question 3

Explain the microeconomic benefits of joining CCA (4)

Answer 3

1. Higher trade and investment due to elimination of foreign exchange rate risk
2. Resource Savings
3. Increased competition
4. Increased liquidity in financial markets

Question 4

Explain the Macroeconomic benefits of joining the CCA (3)

Answer 4

1. Reduction of exchange rate volatility
2. Delegation authority for monetary policy: importation of stable inflation
3. Avoidance of competitive devaluation by members of a CCA

Question 5

Costs of joining a CCA (1)

Answer 5

1. Giving up an independent monetary policy and exchange rate regime

Question 6

Explain the Eurozone’s performance in its first 10 years (monetary, fiscal, individual performance)

Answer 6

1. Eurozone’s performance as a whole prior to the GFC was good
2. Monetary policy: ECB’s performance was broadly successful (stable inflation just above 2% target)
3. Fiscal policy: Compared to monetary policy, fiscal policy was less successful
4. Member countries individual performance pre-GFC was heterogenous
   - Indicators of imbalances

• The Real exchange rate
• Current account balances
• Public sector debt
• Private sector debt
• Variation in inflation in member countries

Question 7

The Eurozone policy regime

Explain the Maastricht Treaty 1992:

Answer 7

• Monetary policy - ECB responsible for:
• Responding to Euro-area wide (common) shock
• Delivering low and stable inflation in the Eurozone (Euro area)

Question 8

The Eurozone policy regime

Explain Fiscal policy - National governments responsible for:

Answer 8

• Fiscal sustainability and stabilising country-specific asymmetric shocks
• The stability growth pact (SGP) - specifies limit on national budget deficits (<3%) and on government debt-to-GDP ration (<60%)
• SGP aims to prevent policies that threaten the ECB’s inflation objectives

Question 9

The Eurozone policy regime

explain in terms of Supply-side policy

Answer 9

• National labour product markets and supply-side policies determine equilibrium unemployment
• Supply side reforms supported by EU’s ‘Lisbon Strategy’

Question 10

Interest rate Differentials

Write out the expected rate of return on bonds

Answer 10

SEE NOTES

Question 11

Write out the UIP condition written in logs in week 10 and include a risk premium

Answer 11

SEE NOTES

Question 12

Write out the Eurozone equation:

where p is seen as the risk of a government defaulting on its debt

Answer 12

SEE NOTES

Question 13

Explain how stabilisation works in the Eurozone (4)

Answer 13

Two levels of stabilisation:

1. At the Eurozone level (supra-national)
2. At the country-specific level (national)

ECB works as a single monetary policy maker in the Eurozone and members states have no control of their own nominal interest or exchange rates

ECB responds to common shocks: shocks that affects all members.
By choosing the real interest rate to achieve its inflation rate

Question 14

Draw out the ‘country specific shocks - options available’ diagram

Answer 14

SEE NOTES

Question 15

Why is a country in the Eurozone (CCA) vulnerable to a sovereign debt crisis? (2)

Answer 15

1. Member countries issue debt in a currency they do not control
2. Member countries do not have their own central banks

Question 16

Compare and contrast the governance arrangement of nation states or the US and Eurozone pre sovereign debt crisis

Answer 16

DRAW DIAGRAM (SEE NOTES)

Question 17

What are the symptoms of a sovereign debt crisis? (2)

Answer 17

1. An increase in a government’s default risk
2. In the Eurozone, this is reflected by a spread between the I on a members country’s government bonds and that of the German government bonds

Question 18

The sovereign-bank doom loop in the Eurozone - the panic

What are the two types of vulnerabilities to debt crisis in the Eurozone:

Answer 18

1. Private sector debt

2. Excess government defecit pre-GFC => sovereign debt crisis

Question 19

Explain the issue of private sector debt in terms of sovereign bank doom loop?

Answer 19

Banking crisis => fiscal crisis => sovereign debt crisis

- Bailout costs hits sovereigns balance sheet => debt rises
- Recession further worsens fiscal position

Evidence is Ireland and Spain when their house bubble burst even though fiscal position was good

Question 20

Explain the fiscal crisis in terms of sovereign banking doom loop?

Answer 20

Fiscal crisis = exacerbates banking crisis when banks hold lots of their government’s debt

Incentives for banks to buy stressed sovereign debt due to sovereign debt as very low risk

Question 21

What are the Possible governance solutions to the Eurozone sovereign debt crisis? (draw diagram and name the 3)

Answer 21

1. Fiscal Union
2. Economic and political Union
3. Banking Union

Question 22

Explain the logic of a banking union as a reform proposal for governance in the Eurozone?

Answer 22

Supporters of a banking union: a banking union’s objective is to avoid banking crises and will provide arrangements for the resolution of failing banks

• To deal with the doom loop problem
• To free member governments to be able to stabilise country specific shocks
• Single Resolution Mechanism - member countries are jointly responsible for bank solvency
• Ensures national governments remain intact

Question 23

Explain the logic of a fiscal union as a reform proposal for governance in the Eurozone?

Answer 23

Supporters of a fiscal union: objective is to have a central government to allow for automatic stabilisation of country specific shocks through automatic stabilisers

• To provide adequate stabilisation at the supra-national level
• To deal with the threat to the sovereign banking crises

Question 24

Possible governance solutions to the Eurozone sovereign debt crisis

Explain the policy steps to monetary policy

Answer 24

• ECB - massive injection of liquidity to support the banks
• Draghi statement -> panic receded and the risk premia fell this solvency of governments improved
• But weak growth and fear of deflation
• QE (2015 to 2020)
• The spectre of deflation again in 2020!
• A Eurozone banking union requires banking reform.
• Otherwise banking union could mutualise the implicit government guarantee to banks
• Banking reform is needed whether or not there is banking
  
  • Break the doom loop by incentivising banks to diversify
    
    • Create a European deposit insurance system (supra nations)

Question 25

Possible governance solutions to the Eurozone sovereign debt crisis

Explain the policy steps for fiscal policy?

Answer 25

• Eurozone bailouts for Greece, Ireland, Portugal, Cyprus
  · Accompanied by harsh fiscal austerity condition
• Eurozone fiscal compact
  · SGP but more stringent
  · Ineffective in reducing public debt
• Reform is required - some proposals that try to avoid a fiscal union.
  · Create a euro-area fund to stabilise large shocks but with incentive to minimize drawing from it
  · Create euro-bonds from a portfolio of national bonds as an alternative to national bonds
• Fiscal union proposals go further: centralising fiscal policy through stabilising fiscal flows like a national government

Question 26

What are the current problems affecting the future of the Eurozone?

Answer 26

• Cyclical recovery - then stalled revealing underlying problems remain
• Heterogeneity across countries
  · Germany has fiscal space but is at high employment
  · The countries that need to generate domestic demand such as Italy don’t have fiscal space (pro-cyclical rules)
  · Where will growth come from?
  · How will union deal with the Greek and Italian government debt levels?
• Over reliance on blunt and weak common instrument of monetary policy

Question 27

What was agreed at the December 2018 European Summit? (3)

Answer 27

• Create Eurozone deposit insurance system BUT only after successful banking reform - Italy’s non-performing loans resolved
• Create euro area fiscal capacity BUT only after high government debt levels brought down - Italy
• Give European Stability Mechanism (rescue fund established in 2012) more resources BUT only after the non-performing loans problems are resolved