1. Introduction
This article first addresses very briefly some basic issues of regional economic cooperation and global imbalances. Second, it will show that EMU not only shelters its member states against international shocks but also contributes to international monetary stability. Third it will draw some policy conclusions.
2. Regional Economic Cooperation
Balassa (1962) set out a logical roadmap for the steps of regional economic cooperation and integration: In his view, countries decide first to create a free trade area. This could then lead to a common external tariff, thereby producing a customs union. Efficiencies would be further generated by the formation of a genuine internal market amongst member countries. The gains of the internal market could be best achieved through further ‘deepening’ of integration. Therefore, monetary integration – the use of a common currency – would be the next stage. This in turn would generate incentives for further political integration. How much political integration is required, is still an open question. In my view at least some pooling of economic policy sovereignty seems to be necessary.
The economic case when and if monetary integration should take place is based on the optimum currency area (OCA) theory, which postulates that lower transaction costs, reduced need for reserve holdings, reduction in regional price discrimination, elimination of costs due to interregional exchange rate uncertainty must outweigh the costs of the loss of monetary policy autonomy (Mundell, 1961). In principle, the chances for making monetary union a success, are the better, if you have a high degree of convergence in business cycle, flexible labour and product markets, and a high mobility of labour and capital.
Of course, by reducing transactions and information costs, a single currency itself facilitates trade and financial flows amongst members. There is a large body of evidence suggesting that a common currency stimulates trade. Rose and Engel (2002) argue that a common currency area significantly increases international business cycle correlations. Frankel and Rose (2002) and others conclude that a common currency is especially trade-stimulating. Corsetti and Pesenti (2002) formalize the theory behind this catalyzing role of monetary unions and the possibility of OCA criteria being satisfied ex-post even if they fail ex-ante. In other words, OCA criteria may be endogenous since the structure of the economy is endogenous to economic policy (Frankel and Rose, 1998).
It is clear that a common currency, as well as convergence in macro policies and micro-prudential statutes and regulations, will deepen and broaden regional financial markets and shelters to some extent from exogenous shocks. The terrible events of September 11, would have shocked Europe as a whole much more, if the monetary union would not have existed at that time. This property of shelter is especially important for smaller economies and, as I said, this certainly holds true for smaller European economies that have joined EMU.
By definition, global current account imbalances are related to savings and investment decisions taken by the private and public sectors. The savings glut hypothesis brought forward by Bernanke (2005) suggests that especially Asian countries save more than they invest. If Asian market participants would spend more on domestic demand, global imbalances, i.e. the US current account deficit would be significantly reduced.
In this respect two further aspects have to be pointed out: First, one has to look at the other part of the equation as well: The U.S.A. with its budget deficit and declining household savings obviously explains partly the global imbalances issue. Second, available data suggest that unusually low investment rates for this stage of the business cycle have resulted in excess savings, which – by the way – contribute to strong asset prices and low long term interest rates. In other words, the “savings glut” is rather a kind of “global corporate investment gap”.
3. EMU´s Contribution to International Stability
3.1 Price Stability: Spreading the Zone of Monetary Stability
Since the beginning of EMU, the euro-area has achieved low inflation as well as stable and low inflation expectations. As a result, inflation risk premia and interest rates have been very low. The Governing Council of the Eurosystem has made its decisions with a view to maintaining price stability, which is the primary objective of the Eurosystem according to the EU Treaty.
Price stability is defined as "year-on-year increases in the HICP for the euro area of close to but below 2%" and it is a medium term goal. The maintenance of price stability helps to allocate resources efficiently both across uses and across time. In order to maintain price stability, the Eurosystem has designed a monetary policy strategy whereby risks to price stability are assessed on the basis of two pillars. The fist pillar is a broadly based assessment of a wide range of economic and financial indicators, including various forecasts. Its aim is to identify short- to medium term prospects for price stability from the demand side of the economy and from various shocks. The second pillar assigns a prominent role to monetary developments, reflecting the theoretical and empirical findings that excessive money and credit growth over the long run result in higher inflation. The monetary pillar thus has a medium to long term time horizon. It also serves to cross-check the findings of the first pillar.
3.2 Fiscal Stability as a Precondition for a Sustainable Macroeconomic Savings-Investment Balance
Sound fiscal policies are a corner stone of the euro area´s stability architecture. The macroeconomic policies pursued in the euro area at present are – although by far not perfect – on the whole more conducive to price stability, fiscal prudence and structural changes than at any time in the 1970s, 1980s or early 1990s.
The Maastricht fiscal convergence criteria have also set a kind of standard beyond the euro area, above all in the EU Member States which have not yet adopted the euro, including the New Member States, many of which already participate in the ERM II. The fact that the developments of all Member States’ public finances are continuously checked and discussed in detail by the ECOFIN Council implies transparency, accountability and peer pressure.
The fiscal rules can act as a commitment device to prevent short-sighted political considerations leading to excessive spending and deficits and to limit discretionary fiscal policy. In a monetary union, undisciplined fiscal policies may impede a stability-oriented single monetary policy and would lead to negative spillovers. Fiscal rules are an important issue for the long-run sustainability of a monetary union (Christl 2003). Fiscal rules also matter because monetary union membership could give rise to moral hazard and free-rider problems: Moral hazard because a member country might expect to be bailed out by others when faced with unsustainable debt levels; free-riding because fiscal laxity in one country can drive up the union-wide interest rate and can induce others to relax fiscal rules.
Since market interest rate spreads have not acted as an effective deterrent against excessive deficits, fiscal rules are a necessary complement to achieve sound fiscal policies for a credible and successful monetary union. That is why strict adherence to the revised rules of the SGP is paramount to safeguarding its credibility. Fiscal rules also help to reduce fiscal profligacy in other countries in world and would in this way help to avoid or to reduce global imbalances.
3.3 Structural Reforms: Creating Positive Growth and Employment Spillovers for the Rest of the World
In the long run, structural reforms are the only way to enhance the growth potential and improve the resilience of economies against shocks. Therefore, structural reforms summarized in the Lisbon Agenda are a key priority for policy-makers in Europe and also for the Austrian Presidency. The main rationale for structural reforms is to create dynamic growth and jobs, be it at the level of the EU in the context of the Lisbon Agenda, be it at the level of the WTO at the world level.
Having said that, structural reforms and liberalisation may also affect current account balances. But it should be clear that the mechanisms at work are complex and by no means unambiguous with respect to the effects to be expected. The impact of structural reforms on international current account balances depends on three key factors:
- the type of reforms,
- the time horizon and
- whether the reforms mainly affect the tradable or non-tradable sector.
With respect to the first two aspects an OECD study (Kennedy et al, 2005) argues that reforms of product and financial markets may imply a worsening of the current account over the medium term, whereas labour market reforms might possibly have the opposite effect. In particular, the OECD study argues that product market reforms should increase the income elasticity of demand for imports, which will tend to worsen the current account, at least in the medium term. Financial market reforms tend to stimulate the inflow of foreign capital, thereby also weakening the current account. Equilibrium can be restored if capital inflows improve productivity, and hence competitiveness in the long run. Conversely, labour market reforms primarily have an impact on the effective labour supply, thereby reducing wages and prices in the medium term while improving the profitability of domestic capital in the long run. Labor market reforms would thus tend to improve current accounts in the short and medium term because of the improved international competitiveness of the tradable sectors.
Moreover and as pointed out by Obstfeld and Rogoff (2004), a welcome increase in the productivity of the EU would help to adjust the U.S. current account deficit only if it were to occur primarily in the non-tradable sector. If structural reforms induce a significant productivity improvement in the tradable sector, then current account positions may improve as exports become more competitive and imports less competitive. The policy implication is that structural reforms in Europe and Japan will contribute to a reduction in the U.S. trade deficit only if, in relative terms, productivity increases in the tradable sector in the United States and in the non-tradable sector in the euro area and Japan.
Most European countries, and in particular the euro area, have a current account that is in balance or even have a small current account surplus, which is fully in line with Europe’s economic fundamentals of having a relatively wealthy and ageing economy. Further progress with structural reform in the euro area is desirable in its own right, as it will have a beneficial effect on economic growth and resilience to shocks in Europe. Whether and to what extent structural reforms would affect the current account is far from clear and, in my view, also not a first priority.
3.4 The Euro Area as a Stability Anchor
EMU and the euro are an anchor for stability for neighbouring regions. A more detailed analysis shows that the euro has become particularly important as a unit of account in international goods and service trade not only in the New Member States but also in other Eastern European, Central Asian and African countries. The trade orientation of many of these countries and their desire to anchor inflation expectations has led to the euro playing a vital role in the monetary policy and exchange rate strategies of these countries. Even if the euro is not a formal or informal intermediate target, it serves as an important monetary policy indicator affecting, e.g., overall monetary conditions. Thus, the zone of stability of the euro area is extended to other countries – within the ERM2, within the EU and beyond.
The euro also provides an anchor of stability to the international community. The ECB’s mandate to focus on price stability and credibility increases the euro´s attractiveness for central banks to diversify parts of their foreign reserve holdings into euro denominated assets. The euro forms one of the main component of the Russian and Chinese reference basket. According to IMF figures, the euro captures about 25 percent of foreign reserve assets, although many important foreign reserve accumulators are not covered by the IMF statistics. As an intervention currency, the euro naturally features very prominently in some of the New Member States. It should be noted though, that the Eurosystem does not actively promote the international use of the euro but sees this process as entirely market-driven.
4. Conclusions
Economic theory and practical experience demonstrate that regional integration can shelter member countries to a certain extent from internationally transmitted shocks because of the risk sharing and consumption smoothing properties of regional integration. A regional monetary arrangement seems to be superior in this respect to a free trade arrangement.
It is evident from the OCA literature, that a high degree of business cycle correlation within a currency area is certainly of advantage. It is also quite obvious that the degree of economic development within a unified currency area should be fairly homogeneous, since significant differences in economic development and economic growth cannot be adjusted through exchange rate fluctuations or devaluations any longer.
But, as the more recent extensions to the literature have shown, optimal currency conditions are endogenous and can be shaped by economic policy and by the formation of a currency union itself. In particular, structural policies should aim at making markets more flexible such that they can cushion asymmetric shocks – which will always occur – more effectively without the need for government interference. This need for market flexibility extends to goods, labor and capital markets. Therefore structural reforms and in particular the Lisbon Agenda are so important for EMU.
As a second line of defence against asymmetric shocks, national fiscal policies can play a useful role. For this to happen, they need to be in good shape in the first place. Therefore, the Maastricht fiscal convergence criteria, the Stability and Growth Pact, and its aim of structurally balanced budgets is central.
The EU´s single market program, the formation of the euro area and the structural reforms undertaken under the Lisbon Agenda are important and useful in their own respect and for Europe. They do have positive repercussions on other countries, for instance by extending the area of monetary and financial stability in which foreign exporters can do business or to which foreign governments can orient their monetary and exchange rate policies. They may also affect current account developments, but these effects are complex, hard to predict and are thus by themselves hardly suitable to motivate any specific course of action of European policies. By combining stability-oriented and sustainable macroeconomic policies with structural reforms aimed at increasing European potential growth and employment Europe makes its best possible contribution to the development of a prosperous world economy.
References
Bernanke, B. (2005), “The Global Saving Glut and the U.S. Current Account Deficit”, speech at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia.
Christl, J. (2003), “Why We Need Fiscal Rules in a Monetary Union”. http://www.oenb.at/de/presse_pub/reden/re_20031113_why_we_need_fiscal_rules.
Corsetti, G. And P. Pesenti (2002), “Self-Validating Optimum Currency Areas”, mimeo.
Eichengreen, B. And Y.C. Park (2003), “Financial Liberalization and Capital Market Integration in East Asia”, mimeo.
Frankel, J. A. and A. K. Rose (1998), “The Endogeneity of the Optimum Currency Area Criteria,” Economic Journal, 108:449, pp. 1009-25.
Kalemli-Ozcan, Sebnem and Bent E. Sorensen & Oved Yosha (2003), "Risk Sharing and Industrial Specialization: Regional and International Evidence," American Economic Review, American Economic Association, vol. 93(3), pages 903-918.
Kenen, P. (1969), “The Theory of Optimum Currency Areas: An Eclectic View”, in r. Mundell and A. Swoboda (eds.), Monetary Problems of the International Economy, Chicago: University of Chicago Press.
Kennedy, M. and T. Sløk (2005), Structural policy reforms and external imbalances, OECD Economics Department Working Paper 415.
Krugman, P. (1993), “Lessons from Massachusetts for EMU” in F. Torres and F. Giavazzi (eds.) Adjustment and Growth in the European Monetary Union, Cambridge: Cambridge University Press.
McKinnon, R. (1963), “Optimum Currency Areas”. American Economic Review, 53, pp. 717-725.
Mundell, R. A. (1961), "A Theory of Optimum Currency Areas." The American Economic Review, Volume 51, No. 4 (September 1961), pp. 657-665.
Mundell, R. (1973), “Uncommon Arguments for Common Currencies”, in H. Johnson and A. Swoboda (eds.), The Economics of Common Currencies, London: Allen and Unwin.
Obstfeld, M. and K. Rogoff (2004), “The Unsustainable US Current Account Position Revisited”, Working Paper 10869, NBER.
