Week 9 - Currency unions & the Euro Flashcards
European debt crisis
- Banks’ assets grew rapidly in the run-up to the financial crisis. Some grew very large, eg. Bank of Ireland, Banco Santander.
- CREDIT GROWTH fuelled & was in turn fuelled by HOUSING BOOMS
3 .Many European countries also had housing price bubbles which burst, following the US.
(2-way street, interplay between credit growth & house price growth) - When optimism → pessimism, banks made huge losses & faced insolvency.
- Govts had to BAIL THEM OUT as the banks were “too big to fail”. Very expensive to bail out.
- So govts had to increase borrowings by selling more bonds. PUBLIC DEBT INCREASED, extremely high that tax was not enough. Hence, several EU economies were on the brink of default & required bailouts from the ECB, IMF and other EU countries.
2 components of high Economic Integration between joining countries in a currency union + Why is it important that countries in a currency union are highly economically integrated?
- High TRADE INTEGRATION - countries import and export with each other a lot
- increases the efficiency savings from eliminating exchange rate volatility and transaction costs
- The ECONOMIC INSTABILITY COSTS also DECREASE because a recession-hit country can divert production to its booming EXPORT markets instead - High LABOUR MOBILITY - must have high degree of LM between countries in the union
- higher gains from eliminating transaction costs and exchange rate volatility when CONVERTING REPATRIATED EARNINGS back to domestic currency
- Economic instability costs are decreased as, given real wages are inflexible, ADJUSTMENT can occur through MIGRATION instead.
^The countries must be highly open economies with the other countries in the currency union.
GG curve - Why is it upward sloping? Benefits of currency union
Note: axes for GG-LL model are Gains & losses for the joining country vs Degree of economic integration between the joining country and the currency area
The greater degree of economic integration, the larger the EFFICIENCY SAVINGS from ELIMINATING TRANSACTION COSTS & ELIMINATING EXCHANGE RATE UNCERTAINTY
- benefits are increasing in trade integration & labour mobility
What was the ASYMMETRIC SHOCK which led to the euro crisis? Ref. to ECB’s “one size fits all” monetary policy also
Why do asymmetric shocks occur in the first place?
Asymmetric shocks (= hit one country harder than others) happen due to DIFF. INDUSTRIAL MAKE-UPS/STRUCTURES
- The HOUSING BOOM and subsequent BUST were more severe in some countries than others, esp. Ireland & Spain
- Hence the “one size fits all” monetary policy of the ECB (= ECB sets a common interest rate based on the AVERAGE economic conditions across the Eurozone) proved to be lacking
2 key mechanisms that caused the rapid & far-reaching contagion {of the Euro debt crisis} - Self-fulfilling equilibrium
Markets re-assessed country risk in the crisis economies b/c…
1. Greece’s DEFAULT overturned the “TOO RICH TO FAIL” assumption of advanced economies.
- Markets thought Ireland could also default. Therefore, Ireland’s COUNTRY RISK PREMIUM soared → govt bond interest rates increased
- So, cost of servicing the debt increased, Irish govt couldn’t afford it and it pushed them to the brink of default.
- Eurozone economies could not print money to finance govt debt: SEIGNORAGE
- unlike Britain which could
2 key mechanisms that caused the rapid & far-reaching contagion {of the Euro debt crisis} - the Doom Loop + 2 reasons why it induced a “SUDDEN STOP” in capital flows
- BANK INSOLVENCY RISK increases
- and were “too big to fail” so… - Govt bailout required
- Costly so govt had to borrow money by selling bonds
- High DEBT BURDEN put pressure on the public. - Country risk premium increases
- to compensate for high risk of default
- Govts had to pay higher interest rates on their debt to compensate for higher risk. Inverse relationship w/ bond prices - Govt bond prices fall & cycle repeats…
- ERODE BANK CAPITAL & increases insolvency risk
^Banks’ assets in the balance sheet decreased in value. Capital diminished so much that the banks were on the brink of insolvency
Sudden stop in capital flows b/c Investors were concerned that govt borrowing difficulties would constrain
1. bail-out funds
2. deposit insurance commitments
Led to credit crunch, high interest rates, austerity packages which caused affected economies to fall into DEEP RECESSION
The costs of currency union depend on the effectiveness of which 5 adjustment mechanisms for economic stabilisation in the face of asymmetric shocks?
- Trade integration
- If there are strong trade links w/ the currency area, the afflicted country can EXPORT HER WAY OUT OF RECESSION - Real wage flexibility
- A country in currency union can DEVALUE her REAL EXCHANGE RATE by reducing real wages (real wage depreciation)
- However, most EU economies have INFLEXIBLE LABOUR MARKETS, so real wages don’t fall in response to -ve DEMAND SHOCK & high unemployment persists - Labour mobility
- Workers can MIGRATE from recession-hit economies to booming economies (shifts in labour supply).
- but mass migration comes at a price of i) social upheaval; ii) falling real wages & rising living costs in host country; iii) anti-immigration sentiment
- problem of surge in EU migration to Britain in late 2000s - Fiscal federalism
- Fiscal transfers can be used to cushion against asymmetric shocks
- Tax revenues from prospering/booming states are REDISTRIBUTED to depressed states <- done by the US
- Much less scope for fiscal federalism in the EU b/c EU federal budget is only 1% of GDP compared to US’ 20%, ie. not enough money to redistribute to other economies that were suffering during the debt crisis. - Banking union
- Having a COMMON BANK compensates for the loss of SEIGNORAGE implied by monetary union, ie. ECB now has power to bail out banks and the money to recapitalise insolvent banks.
» by setting up a common bailout fund used to rescue any bank on the brink of insolvency in the member states
- This relieves the pressure on national governments to provide bailout cash, hence their debt burden does not increase,
hence the country risk premium does not increase,
hence government bond prices do not fall etc.
» EU’s banking union helped Europe ESCAPE from the DOOM LOOP
LL curve - Why is it downward sloping? Costs of currency union
Note: axes for GG-LL model are Gains & losses for the joining country vs Degree of economic integration between the joining country and the currency area
- Higher trade integration reduces economic instability
- Higher labour mobility reduces economic instability
GG-LL model - Decision to join currency union
- To the RIGHT of theta (countries with high economic integration), benefits > costs of joining currency union ⇒ should JOIN
- To the LEFT of theta (countries with weak EI), costs > benefits. Negative net benefits of joining ⇒ should NOT join
At critical level of integration theta, monetary efficiency gain = economic instability costs.
> DIFFERENT for diff. countries depending on their exposure to ASYMMETRIC SHOCKS!
Why is the Norwegian economy more heavily exposed to asymmetric shocks?
Norway has a different industrial make-up to other EU countries, the only European economy with high OIL production.
Optimal currency area (OCA)
Why is the EU not an OCA? Why is the US an OCA?
*Currency union = common currency, interest rate & exchange rate
An OCA is a group of countries whose economies are sufficiently integrated by trade and labour mobility such that the benefits of forming a currency union [due to elimination of exchange rate volatility and transaction costs] outweigh the costs [due to loss of control over monetary policy for stabilising the effects of asymmetric shocks]
eg. EU, US
- The EU only satisfies the Banking union criterion and fails to meet the rest.
- The US satisfies all 5 criteria: trade integration, real wage flexibility, labour mobility, fiscal federalism, banking union
Why is labour mobility/migration flows low/small in the EU but high in the US?
EU
- language barriers
- cultural differences
- generous WELFARE SAFETY NET -> If lose job, less incentive to move.
US
- descended from immigrants
- no language barriers
- less generous welfare payments
2 reasons for Brexit that are linked to the Euro, Joseph Stiglitz (2016)
- Anti-immigration sentiment in the UK resulting from mass migration from depressed Eurozone economies
- Britain didn’t want both FISCAL FEDERALISM & POLITICAL UNION and the prospect of being ruled by distant and politically unaccountable technocrats.
- These would be required as European leaders realised that monetary union cannot work w/o the INSTITUTIONAL INFRASTRUCTURE that exists in the US, ie. the adjustment provided by fiscal transfers, which distribute tax revenues from rich states to depressed states
Which is more suited to remaining in their respective currency union – Nevada or Ireland?
From PS8 (Krugman, 2011)
Nevada b/c it has stronger adjustment mechanisms than Ireland to cope with asymmetric shocks.
- Trade integration: Ireland trades relatively little with its Eurozone neighbours - its chief export markets are the US and UK
- Real wage flexibility: Real wages are relatively inflexible in Ireland
- Labour mobility: Americans are more mobile than Europeans, due to cultural integration, a common language and a less generous welfare system.
- Fiscal federalism: unlike Ireland, Nevada benefits from a system of FISCAL TRANSFERS from the federal GOVERNMENT
e.g. social security payments are increased during recessionary conditions. - Banking union: US states are bound by a banking union with a common resolution mechanism for dealing with failing banks.
- Hence, Nevada does NOT have to bear the COSTS OF FINANCING BANK BAILOUTS, as these are undertaken by the Federal Reserve.
- Ireland did NOT have a banking union during the euro crisis, which therefore entered the “DOOM LOOP”. However, the Krugman article was published before the Eurozone adopted banking union in 2012.
