marco - the economics of the monetary union and the eurozone crisis (2014)

11 2 The Economic Rationale of Fiscal Rules in OCAs: The Stability and Growth Pact and the Excessive Deficit Procedure.. in order to reduce the demand for imports from A, and to divert p

Manuel Sanchis i Marco

The Economics

of the Monetary Union and the

Eurozone Crisis

SpringerBriefs in Economics

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Manuel Sanchis i Marco

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The Economics of

the Monetary Union and the Eurozone Crisis

Manuel Sanchis i Marco

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The ECB decided in September 2012 to act as a lender of last resort in the government bond markets of the Eurozone In doing so, it prevented panic from undermining the stability of the Eurozone It was a necessary move to eliminate the existential fear that was destroying the Eurozone

While necessary, the ECB decision is insufficient to save the euro in the longer run The greatest threat for the Eurozone today does not come from financial instability, but from the potential social and political instability resulting from the economic depression Southern European countries have been pushed into and that has led to increases in unemployment not seen since the Great Depression This state of affairs is the result of a dramatic failure of macroeconomic management in the Eurozone

Under the leadership of the European Commission and the ECB, tight austerity was imposed on the debtor countries while the creditor countries continued to follow policies aimed at balancing the budget This has led to an asymmetric adjustment process where most of the adjustment has been done by the debtor nations The lat-ter countries have been forced to reduce wages and prices relative to the creditor countries (an “internal devaluation”) without compensating wage and price increases

in the creditor countries (“internal revaluations”)

These internal devaluations have come at a great cost in terms of lost output and employment in the debtor countries As these internal devaluations are not yet completed (except possibly in Ireland), more losses in output and employment are

to be expected

Thus, the burden of the adjustments to the imbalances in the Eurozone between the surplus and the deficit countries is borne almost exclusively by the deficit countries in the periphery This creates a deflationary bias that explains why 5 years after the start of the financial crisis the Eurozone still has not recovered and threatens to return into a recession

The risk is real that citizens in Southern European countries that are subjected

to prolonged deep economic downturns revolt and reject a system that was ised to them to be economic heaven

prom-In order to understand these dramatic economic developments that grip the Eurozone, the book of Manuel Sanchis i Marco is the right one coming at the right

Foreword

time The theory of optimal currency areas remains the essential framework to understand the design failures of the Eurozone Professor Sanchis i Marco does a superb job in explaining this theory and in making it relevant for our understand-ing of the problems faced by the Eurozone.

The last two chapters of the book turn towards an analysis of the crisis of the euro and how to get out of this crisis Spain is used as the prototype country to explain how the crisis unfolded This is the country that in the beginning of the Eurozone seemed to do everything right Few saw how the imbalances were build-ing up; even fewer predicted that this would lead to disaster This book produces the best analysis I have seen of why things have gone wrong so badly in Spain By suggesting a path out of the crisis, Professor Sanchis i Marco leaves us with some hope for the future for Spain and other Eurozone countries

Paul De GrauweLondon School of EconomicsJanuary 2013

Early in July 2012, Professors Esther Versluis, Director of Studies of the MA in European Public Affairs of the University of Maastricht, and Christine Arnold from the Department of Political Science of that University, invited me to partici-pate in the MA programme on European Studies as a Guest Speaker They pro-

posed that in autumn I give a set of six Guest Lectures on The Economics of the

Monetary Union and the Eurozone Crisis

Over the summer, I was very engaged with the preparation of the teaching material for this set of six lectures, now transformed into the six chapters of this book It was a great honour to participate in the University of Maastricht‘s MA program on European Studies, and I would like to thank both professors for giv-ing me the opportunity to do so I also wish to thank Professor Vicent Almenar who assisted me in the preparation of the graphs and tables Thanks are also due to Sallie Russell, responsible for the final version of the text in English

Finally, I would like to express my gratitude to my beloved wife, Yvonne, who

as always, showed exceptional patience and indulgence with me during the long summer days when I was typing the manuscript

La Canyada, January 2013 Manuel Sanchis i Marco

Preface

Disclaimer: The author asserts that the views expressed in this book are his own and do not represent the official position of the European Commission or any of the European Institutions

1 The Economics of Monetary Union: The Theory of Optimum

Currency Areas 1

1.1 Introduction to the Analytical Framework 2

1.2 The Theory of OCAs: The Costs of Having a Common Currency 3

1.2.1 Mundell: Factor Mobility 3

1.2.2 McKinnon: Openness of the Economy 5

1.2.3 Kenen: Product Diversification 6

1.2.4 Magnifico: “National Propensity to Inflation” 7

1.2.5 Ingram: Degree of Financial Integration 7

1.2.6 Vaubel: Real Exchange-Rate Changes 8

1.3 The Benefits and Costs of a Common Currency 9

1.3.1 Benefits 9

1.3.2 Costs 11

References 11

2 The Economic Rationale of Fiscal Rules in OCAs: The Stability and Growth Pact and the Excessive Deficit Procedure 13

2.1 Why Don’t Regions Leave Currency Areas When they Experience Asymmetric Shocks? 13

2.2 The Economic Rationale of Fiscal Rules in a Monetary Union 18

2.3 The Stability and Growth Pact 20

2.3.1 The Preventive Arm 20

2.3.2 The Dissuasive Arm: The Excessive Deficit Procedure 20

2.3.3 The Long-Term Sustainability of Public Finances 23

2.4 An Assessment of the Revised Stability and Growth Pact 25

2.5 The Six Pack : Scoreboard for the Surveillance of Macroeconomic Imbalance Procedure 27

References 28

Contents

Contents xii

3 Coping with Asymmetric Shocks in the EMU:

The Role of Labour Market Flexibility 29

3.1 Conditions for Success 30

3.2 Nominal and Real Wage Growth: The Experience from the 1970–1997 Period 31

3.3 Coping with Asymmetric Trans-European Shocks 33

3.4 Adjustment to Shocks 35

3.5 Behavioural Changes of Economic Agents and Institutions 36

3.6 Wage Negotiations Within Member States from a European Perspective 37

3.7 Price Setting and Wage Bargaining Behaviour 38

References 40

4 The Concept of Labour Market Flexicurity in the Eurozone 41

4.1 A Tentative Proposal for the Concept of Flexicurity 41

4.2 The Concept of Labour Market Flexibility 43

4.3 The EU Policy Approach to the Flexibility-Security Nexus 43

4.4 Definition of Labour Market Adaptability 44

4.5 How the European Commission Understands Flexicurity 46

4.6 Wilthagen’s Definition of Flexicurity: The Dutch Approach 47

4.7 Madsen’s Definition of Flexicurity: The Danish Approach 48

4.8 The Flexicurity Approach in Austria 50

4.9 The Flexicurity Approach in Spain 50

4.9.1 Elements of Flexicurity in the Spanish Labour Market Reforms (1984–1997) 51

4.9.2 New Reforms During the 1997–06 Period 51

4.9.3 Latest Reforms During the 2010–12 Period 52

References 53

5 The Spanish Case: The Housing Market Bubble and External Disequilibria 55

5.1 Gliding Economics Did Not Solve the Spanish Meltdown 56

5.2 Spain’s Major Macroeconomic Imbalances and Weaknesses 60

5.3 A Huge Current Account Deficit, Though Now Close to Balance 61

5.4 Over-Dimensioned Sectors and Structural Reforms 62

5.4.1 The Housing Market 62

5.4.2 The Financial Sector 69

5.4.3 Labour Market Reforms 70

5.4.4 Changes in the Fiscal and Budgetary Scenarios 71

5.5 Is Spain a Heavily Indebted Economy? 71

References 74

6 The Global Crisis and Alternative Scenarios to Save the Euro:

A Spanish Perspective 75

6.1 Origins of the Great Recession 76

6.2 Lessons That Can be Learned 78

6.3 How the European Union Reacted 80

6.4 From Financial to Debt Crisis: The Weaknesses of the Euro at Sight 83

6.5 Some Institutional Responses 87

6.6 The Euro Project: The Economic and Political Rationales are Conflicting 90

6.7 What Does Fiscal Union Mean So Far? 92

6.8 Alternative Scenarios to Save the Euro 95

6.9 The January 2012 European Summit: The Need for a European Approach 96

6.10 A Sort of Epilogue: The EU at the Crossroads 100

References 102

Appendix: Ideology and Economics in the Failure of Lehman Brothers 105

Abstract In the 1960s, the theory of Optimum Currency Areas (OCAs) emerged

as a by-product of the theoretical debate between fixed and flexible exchange

rates The OCAs approach singles out an economic characteristic to define

an economic domain where there is exchange rate fixity erga intra, while there

is exchange rate flexibility erga extra In an optimum currency area, exchange

rates fixity prevails internally without any type of internal or external rium Each single characteristic ensures that floating or regular adjustments in

disequilib-nominal exchange rates are neither necessary, efficient nor desirable for

stabili-sation purposes The literature proposes several economic criteria: factor ity (Mundell); openness of the economy (McKinnon); product diversification (Kenen); national propensity to inflate (Magnifico); financial integration (Ingram);

mobil-real exchange-rate changes (Vaubel) While the cost-benefit approach considers

OCAs criteria for guaranteeing long-term equilibrium, this approach is operational and focuses on the political commitment of countries to form a monetary union assessing the resulting costs and benefits Benefits are associated with efficiency and price stability gains, reduction of risks arising from exchange rate uncertainty, and gains from using the euro as a reserve currency; while costs relate to the loss

of monetary independence, diverging preferences in national ment relationships, and worsening regional disequilibrium

inflation-unemploy-Keywords  Optimum  currency  area  •  OCAs  •  Monetary  union  •  Monetary 

integration  •  Cost-benefit approach  •  One money, one market  •  Exchange rate fixity  •

Exchange rate flexibility

Chapter 1

The Economics of Monetary Union: The

Theory of Optimum Currency Areas

M Sanchis i Marco, The Economics of the Monetary Union and the Eurozone Crisis,

SpringerBriefs in Economics, DOI: 10.1007/978-3-319-00020-6_1, © The Author(s) 2014

1.1 Introduction to the Analytical Framework

The theory of optimum currency areas1 (OCAs) emerged in the early 1960s, as a by-product of the theoretical debate between those who favoured fixed and those who favoured flexible exchange rates According to this theory, we understand a currency area as a “domain within which exchange rates are fixed” (Mundell

1961) This means that a currency area is a territory, composed by either regional

or national entities, with one or several currencies whose values are permanently fixed, but whose external value is determined in markets free from official inter-ventions (Grubel 1970, p 318)

A problem arises when defining the domain within which exchange rates are fixed, and when selecting the economic criteria that would qualify a domain as

optimum to form a currency area What would be the single economic istic that would define the appropriate domain of a currency area? It is important

character-to keep in mind that, in this context, the boundaries of a national currency area

do not necessarily correspond with those of so-called optimum currency areas In

other words, if Europeans assumed that EU Member States would increase their welfare when they abolished their currencies and adopted a single one of a wider area, the issue at stake would be “What is the appropriate domain of a currency areas?” (Ishiyama 1975, p 344), or “Where do they stop then? Should they have one money for the Benelux, or for the EC, or for the whole of Europe, or maybe for the whole world? This problem leads us to raise the question of what consti-tutes an optimal currency area” (De Grauwe 1997)

There are two main approaches to answering these questions First, the

tradi-tional approach , called optimum currency areas (OCAs)—which may not

nec-essarily correspond with national boundaries—tries to single out one economic

or financial characteristic that an economic region or space has to fulfil in order

to draw a line within which fixed exchange rates could be maintained internally without tension Each single characteristic has to ensure that floating or discreet

adjustments in nominal exchange rates are neither necessary nor efficient nor

desirable for stabilisation purposes The alternative approach is called the cost

benefit approach It takes a more realistic and useful view as it tries to evaluate the costs and benefits of partner countries, which have taken a political decision

to participate in a currency union Although this approach takes into tion the previous single criteria of OCAs for guaranteeing long-term equilibrium,

considera-it focuses on the polconsidera-itical commconsidera-itment of a group of countries, which find considera-it able to form a currency area when the final balance of costs and benefits favours participation in the institutional frame of such a currency unification

desir-1 For surveys on this issue see Tower and Willet ( 1970 ), Fernández de Castro ( 1973 ), Ishiyama ( 1975 ), Presley and Dennis ( 1976 ), Molina ( 1982 ), and Sanchis i Marco ( 1984a , , 1988a , and b ).

3 1.2 The Theory of OCAs: The Costs of Having a Common Currency

1.2 The Theory of OCAs: The Costs of Having a Common

Currency

1.2.1 Mundell: Factor Mobility

Robert Mundell, inspired by the Ricardian assumption that factors of production are mobile internally but immobile internationally, proposed the concept of factor mobility By this he meant that the free movement of labour and capital are the

key conditions to define a geographic area as an optimum currency area (Mundell

1961) Optimality in Mundell’s article means the ability to stabilise national employment and price levels Mundell's definition of an optimum currency area

consists of a geographical region that exhibits characteristics, which lead to an

automatic removal of unemployment and balance-of-payments disequilibria In his

seminal paper automatic means that no intervention from fiscal or monetary

poli-cies is required to restore both internal and external equilibrium

Mundell considered a simple model of two entities, whether regions or tries, and assumed that such entities pursue both internal and external balance, that is, full employment and payments equilibrium These entities were initially

coun-in full employment and balance-of-payments equilibrium He also assumed that money wages and prices were rigid in the short run, so we could not reduce them without producing output forgone and job losses and that monetary author-ities would react to prevent inflation Then, he supposed that both entities, whether regions or countries, were unexpectedly disturbed by a shift in aggre-gate demand from B to A, that is, a fall in the demand for goods in entity B, and

an increase in the demand for goods in entity A In this case he proposed three alternative scenarios

1.2.1.1 Scenario A: Countries with National Currencies

A shift in demand from country B to country A, provided import and export demands are sufficiently elastic, will cause in B an increase in unemployment and

a balance-of-payments deficit; whereas, it will cause in A an over full-employment situation, inflation and a balance of payments surplus As long as country A does not resist the price increase, price pressures in A will translate into a change into the terms-of-trade and will introduce some relief in B, so the burden of adjustment will be distributed between B and A However, if country A tightens monetary pol-icy to prevent prices from rising, then B will suffer the entire adjustment burden (Mundell 1961, p 658)

Country B needs to reduce its real income level However, if this cannot be done through a change in the terms-of-trade—because B cannot lower money wages and prices in the short run, while A cannot raise prices because of credit restrictions—then the reduction of country B’s real income will take place through output forgone and job losses The latter would imply higher unemployment levels

in order to reduce the demand for imports from A, and to divert production to exports and to stabilise or reduce prices to improve the foreign trade balance or make it more balanced.

Therefore, under a fixed exchange rates regime or a common currency, a restrictive monetary policy in A (the surplus country) to contain price pressures, will cause a deflationary bias, or recessive pressure, in B (the deficit country)

In other words, in the absence of exchange rate adjustments, disequilibria would require deflation (internal devaluation) in B and reflation (internal revaluation) in

A As said above, if we allow prices to rise in country A, then the terms of trade will improve for B and will relieve B for some of the adjustment burdens In addi-tion, if the deflationary bias works, prices will fall in B and we will restore the balance-of-payments equilibrium

To avoid a deflationary bias—and the resulting recession—and restore both the external and the internal equilibrium, there must be a free-floating exchange rate regime between the two countries B and A In this case, the exchange rate would depreciate in the deficit country with respect to the surplus country or, conversely, the exchange rate in the surplus country would appreciate with respect to the deficit country

1.2.1.2 Scenario B: Regions with a Common Currency

In contrast with the previous situation, consider now a closed economy with regions that share a common currency, and assume that the government pur-sues a full employment policy In this context, the shift in demand from B to A causes unemployment and a balance-of-payments deficit in region B, and infla-tionary pressures and a balance-of-payments surplus in region A To correct for the unemployment in B, the monetary authorities could expand the money stock This monetary expansion, however, would be at the expense of higher prices in A, aggravating the inflationary pressure in A and turning the terms-of-trade against A.Therefore, a monetary policy pursuing full employment in region B causes an inflationary bias in the multiregional economy, or in the whole area sharing a com-

mon currency Similarly, in a currency area made up of different countries with

national currencies, the willingness of surplus countries to inflate determines the pace

of employment in the deficit countries However, in a currency area comprising many

regions and a single currency, the pace of inflation is set by the willingness of the central bank to allow unemployment in deficit regions (Mundell 1961, pp 658–659)

1.2.1.3 Scenario C: Regions of both Different Countries and Currencies

Mundell assumes that the whole world area consists of two countries, Canada and the United States, with separate currencies, but also that this world is divided into two separate regions, East and West, which do not correspond with the national bounda-ries The East produces cars and the West, lumber products An increase in productiv-ity in the car industry (in the East) will produce an excess supply of cars and an excess

5 1.2 The Theory of OCAs: The Costs of Having a Common Currency

demand for lumber products As a result, this shift in demand will cause ment in the East and inflationary pressures in the West (Mundell 1961, p 659)

unemploy-Both central banks (North and South) will have to choose between relieving

unemployment in the East by relaxing their monetary policies; or, preventing

infla-tion in the West by tightening both monetary policies Therefore, both countries will share the burden of adjustment between East and West with some unemploy-ment in the East and some inflation in the West However, each single country has

to face both unemployment and inflation

With flexible exchange rates the situation between the two countries will be rected, but not between the two regions Therefore, it will be preferable for those regions to have their own common currency or fixed exchange rates internally This would favour the use of regional currencies (Eastern and Western dollars, respec-tively) and the abandonment of national ones (Canadian and US dollars)

cor-To sum up, Mundell argued in favour of dividing the monetary world into rency areas This is because the stabilization argument which favours flexible

cur-exchange rates does not apply when the currency area has full factor mobility erga

intra and factor immobility erga extra, that is, “[…] If the world can be divided

into regions within each of which there is factor mobility and between which there

is factor immobility, then each of these regions should have a separate currency which fluctuates relative to all other currencies” (Mundell 1961, p 663) In these cases, regional currency areas can be created because the use of flexible exchange rates for stabilisation purposes becomes ineffective, unnecessary or undesirable

To reorganise the world in such a way is not, however, very realistic since a region is an economic entity, while a currency domain is mostly an expression of national sovereignty Therefore, it is not feasible to give up monetary sovereignty unless the political domain coincides with the economic criteria of having both internal factor mobility and external immobility Otherwise, in these cases, cur-rency flexibility will not fulfil its stabilisation function, and the result will be vary-ing rates of unemployment and prices in the different regions of the country If this is the case, why would the different regions in a country, which show diverg-ing trends in unemployment, prices, and productivity, have an interest in sharing a common currency? We will come back to this issue in Chap 2

1.2.2 McKinnon: Openness of the Economy

Ronald McKinnon proposed a second criteria for a group of countries or economic regions to qualify for constituting a optimum currency area (McKinnon 1963)

For McKinnon for whom, as for Mundell, optimality is defined as the capacity to

achieve automatic internal and external balance, or, more precisely: “‘Optimum’ is used here to describe a single area within which monetary-fiscal policy and flex-ible external exchange rates can be used to give the best resolution of three (some-times conflicting) objectives: (1) the maintenance of full employment; (2) the maintenance of balanced international payments; (3) the maintenance of a stable internal average price level” (McKinnon 1963, p 717)

McKinnon proposes that a group of regions or countries could comply with the definition of optimum currency area provided they are highly open econo-mies, as for him “‘The ratio of tradable to non-tradable goods’ is a simplifying concept which assumes all goods can be classified into those that could enter into foreign trade and those that do not because transportation is not feasible for them” (McKinnon 1963, p 717) When a group of regions/countries forms an optimum currency area, McKinnon puts more emphasis on the need to minimise the costs of achieving these three objectives, than on the possible benefits of forming such an area, on which there are few references.

McKinnon’s criteria rely implicitly on the so-called ‘vicious circle esis’ in such a way that the higher the degree of openness, the lesser the degree of money illusion of a country, the less effective will be exchange rate depreciation to lower real wages and restore the external equilibrium The more open an economy

hypoth-is, the less effective flexible exchange rates to both correct external imbalances and stabilise prices will be because “[…] A devaluation would be associated with

a large domestic price-level increase and hence money illusion would not be much help in getting labor to accept a cut in real wages” (McKinnon 1963, p 723)

1.2.3 Kenen: Product Diversification

The third contribution to the theory of optimum currency areas is from Kenen who proposed the degree of diversification of national production as the key economic criterion which prompts a group of regions or countries to form a successful opti-mum currency area (Kenen 1969) The more diversified a national economy is, the fewer the variations in the terms of trade because variations in the prices of some goods, produced by an external shock will be compensated for by variations in others In addition, this would maintain the exchange rate and the level of employ-ment more steadily than in the case of a partially diversified economy

Kenen states that “[…] diversity in a nation’s product mix, the number of single-product regions contained in a single country, may be more relevant than factor mobility” (Kenen 1969, p 49), and makes three claims: “(1) That a well-diversified national economy will not have to undergo changes in the terms of trade as often as a single-product national economy (2) That when, in fact, it does confront a drop in the demand for its principal exports, unemployment will not rise as sharply as it would in a less-diversified national economy (3) That the links between external and domestic demand, especially the link between exports and investment, will be weaker in diversified economies” (Kenen 1969, p 49)

McKinnon's and Kenen's approaches are contradictory as they use as starting points different assumptions For McKinnon domestic economic forces produce the external disequilibrium; for Kenen the origin of the disturbance is external For McKinnon economies that are more open should maintain internal exchange rate fixity but external flexibility Surprisingly, if these more open economies joined in

a new currency area they would become more diversified In this case, according

to Kenen's criteria, they should establish a regime of fixed exchange rates between

7 1.2 The Theory of OCAs: The Costs of Having a Common Currency

them, whereas, according to McKinnon, they should have exchange rate flexibility between them Furthermore, one would expect that the more diversified an economy

is the less it will rely on trade and, therefore, the smaller its external sector will be

1.2.4 Magnifico: “National Propensity to Inflation”

Magnifico introduces the concept of “national propensity to inflation” as the relevant criteria to determine whether a group of countries should form a currency area An optimum currency area is one that is formed by countries with similar national pro-pensities to inflation This “propensity” is a function of the inflation-unemployment trade-off existing in each country, with some countries having a stronger preference for inflation than others do Assuming only two countries A and B, different prefer-ences concerning inflation and unemployment imply that both countries will pay

a cost when forming a currency area To maintain monetary union is costly for both countries because both will have to choose a less preferred point in their respective Phillips curves Therefore, if country A had a higher preference for inflation it will be subject to a deficit with country B, which has a lower preference for inflation

Magnifico’s concept of “national propensity to inflation” opens many vistas when compared to the concept of inflation rates, because it refers to a set of struc-tural and institutional elements which constitute building blocks of national eco-nomic sensibilities From this perspective, the formation of a currency area is not directly derived from maintaining equal inflation rates but, mostly, from the con-vergence of the economic structures of the member countries, as well as from the structural adjustments needed for these economies to converge

In 1971, Magnifico stated that “[…] differences in the NPI would seem to

depend inter alia on historical and social factors, on the system of industrial

rela-tions and the militancy of trade unions, on the structure of industry and its regional deployment, as well as, on the building into the general psychology of expecta-tions of inflation or price stability generated by demand-management policies, which in the past consistently may, or may not, have aimed at guaranteeing the full-employment level of monetary demand, with little regard to changes in exter-nal competitiveness and payments balance In other words, historical patterns may not tell us what level of unemployment would be necessary for a given country to attain the desired degree of price stability, but they would indicate that, in order

to prevent prices from rising faster than at a specified rate, higher unemployment would be needed in certain countries, less of it in others.” (Magnifico 1971, p 12)

1.2.5 Ingram: Degree of Financial Integration

The above four criteria focus on the real side of the economies, and leave little room for the analysis of financial and monetary issues Indeed, the models pro-posed by Mundell, McKinnon, Kenen and Magnifico put the stress on real

variables, since prices are expressed in real terms of trade and the external ment takes place on the current account, leaving aside the compensating financial flows Instead, Ingram considers that what matters to determine the optimum size

adjust-of a currency area are not the real but the financial characteristics adjust-of the concerned economies (Ingram 1959)

The Ingram criterion to define a currency area considers that the higher the degree of financial integration the lower the need for exchange rate changes among partner countries, because changes in interest rates would provoke com-pensating capital flows across national frontiers In other words, “[…] Integration

of capital markets in the several partner countries, plus removal of restrictions on the movements of claims, will enable equilibrating movements to perform their vital role.” (Ingram 1959, p 631)

1.2.6 Vaubel: Real Exchange-Rate Changes

Roland Vaubel states that a group of EC countries should form a monetary union when they have no need to modify their real exchange rates through changes in nominal exchange rates Vaubel looks for “[…] a comprehensive and operational criterion for the desirability of currency unification [and] it is the thesis of [his] paper that the concept of real exchange rate variation can fill the gap” (Vaubel

1976, p 440) Vaubel starts with the existence of a group of specific nations, which show both the political will and the commitment to merge into a separate currency area Consequently, he raises the following question: “Is the European Community (already) a desirable ‘currency area’?” (Vaubel 1976, p 432)

Vaubel explores the two reasons why it may not be The first reason is that

“national propensities to inflate”, the term coined by Magnifico, might be too different within the EC to allow for the abandonment of nominal exchange rate changes as a tool to correct the external imbalances While the first argument is essentially political in nature, the second reason is of purely economic nature, as it

is concerned with the need for real exchange-rate changes The EC members may

be willing and able to agree to a common rate of inflation for the whole monetary union, but still find it harmful to adjust if diverging economic structures between them require major real exchange rate adjustments

Indeed, real exchange rates change when the commodity ‘terms of trade’ or the financial ‘terms of finance’ change The terms of trade shift when supply condi-tions, notably labour costs and productivity increases, and/or demand condi-tions change between members countries The terms of finance shift in response

to changes in currency preferences and in risk, which may affect expected asset yields (e.g default risk) Therefore, as Vaubel states “[…] while the formation of

a currency union […] puts an end to all shifts of currency preferences within the union, changes in the terms of trade and in lending risk will continue to occur and produce real exchange-rate changes between the members of the union.” (Vaubel

1976, p 434)

9 1.2 The Theory of OCAs: The Costs of Having a Common Currency

Therefore, a group of countries may prefer not to form a monetary union because: (i) if flexibility in nominal exchange rates is not allowed, adjustment will take the form of inflation or deflation between member countries; and (ii) if, for example, productivity increases are faster in central areas than in the peripheral ones, but trade unions of peripheral areas claim and obtain increases in wages equal to those of the central areas, the monetary union (equivalent to rigidity in nominal exchange rates) will lead to a rise in unemployment in peripheral areas

As Vaubel clearly states, “If trade unions do not allow […] for the rise in import prices which currency depreciation would produce, nominal exchange-rate adjust-ment may be an effective means of bringing about a real exchange-rate depreciation and hence of reducing real wages without a cut in nominal wages The outcome depends largely on the existence of exchange rate illusion […] But even if labour

is fully aware of the purchasing power of its wages, exchange-rate depreciation is likely to be a more effective means of inducing labour to accept downward adjust-ments of real wages and of real wage increases for the sake of reductions in unem-ployment than contractive demand management (and incomes policy) because exchange-rate adjustment—unlike domestic demand management—does not require transitory changes in relative wage positions of different trades and profes-sions as successive wage bargains are concluded.” (Vaubel 1976, pp 435–436).Finally, Vaubel puts forward a summary of the main costs and benefits which could be derived from currency unification, because it “[…] is likely to reduce the monetary efficiency of domestic transactions, but it will increase the monetary effi-ciency of international intra-union transactions by eliminating exchange rate risk, exchange control risk, the cost of money changing and the cost of information about foreign prices, exchange market conditions and foreign-exchange regulations Since real exchange-rate changes reflect the degree of openness they will—indirectly—also indicate the efficiency gains or losses to be had from currency unification.” (Vaubel 1976, p 439) This brings us to the following point

1.3 The Benefits and Costs of a Common Currency

1.3.1 Benefits

The economic literature on both the traditional and the alternative approaches to optimum currency areas has singled out the above six main economic criteria by means of which a group of regions can minimise the costs of maintaining inter-nally fixed exchange rates or a common currency Of course, there are others but they can be included, to some extent, in the previous ones As seen above, the opti-mum currency areas approach puts the stress on the macroeconomic costs, which

a group of countries (or regions) has to face when abandoning the use of nominal exchange rate changes to restore external disequilibria Little attention has been paid, however, to the advantages—mostly of a microeconomic nature—of having

a common currency This is one of its major drawbacks

Bearing in mind all the above, the European Commission launched a study (European Commission 1990) to assess the potential costs and benefits of hav-

ing currency unification within member states in the context of the 1992 Single

Market Programme (SMP) From this study and other economic literature, we can distinguish at least seven main benefits:

(i) reduction or suppression of risks associated with both the volatility and the uncertainty of unexpected movements in nominal exchange rates Indeed, when the variability of exchange rates is not perfectly foreseeable and the cost of covering the risks of unexpected exchange rate movements is high, the maintenance of separate currencies, and the associated variability, is an obstacle to reaping the efficiency gains arising from a better allocation of resources in a single market;

(ii) efficiency gains Highlighted by the European Commission (Emerson

1992), but somewhat oversold as most studies show a relatively weak impact of the reduction of exchange rate volatility on the rates of invest-ment, trade and economic growth Moreover, lower exchange rate uncer-tainty does not necessarily reduce systemic risks, as it may be compensated for by higher uncertainty on sovereign debt, for instance, and therefore induce higher risk premiums, as is the case today in the Eurozone

(iii) direct and indirect efficiency gains obtained from the elimination of the

transaction costs related to money changing and costs associated with information on foreign prices, and foreign-exchange market conditions and regulations The use of a common currency as the medium of exchange is directly proportional to the size of the monetary area to which it applies Therefore, the saving of resources resulting from this efficiency gain would

be devoted to uses that are more productive Furthermore, the suppression

of transaction costs will benefit EU consumers as it will increase ket transparency, thus, increasing the difficulties for price discrimination between national markets;

mar-(iv) benefits of price stability The adoption of a common currency could tribute to maintaining inflation under control, provided the monetary authorities build up a reputation and credibility by means of an independent central bank (De Grauwe 1997);

con-(v) reduction of uncertainty positively influences capital movements, foreign direct investments, trade and growth Consumption, saving and investment decisions might be distorted because the economic agents cannot fully exploit the advantages of having access to the single market as the exist-ence of several currencies acts as a barrier to access to the market and cre-ates segmentation in economic and financial transactions Further, there are

potential indirect and dynamic efficiency gains arising from the positive

impact that direct productivity gains might have on the increase of the stock

of capital over time, in response to efficiency gains;

(vi) economic gains from the use of the euro as a reserve and vehicle currency for payments in international trade A source of potential benefits arises

11 1.3 The Benefits and Costs of a Common Currency

from the demand for euros as a reserve currency (Wyplosz 1997) This, together with the possibility to denominate payments in euros, eliminates the uncertainty of future payments denominated in US dollars, or other reserves or vehicle currencies for Eurozone countries Achieving this will rely heavily on the political will of more international hegemony for the EU because “[…] the impact of EMU in the world cannot be fully understood outside the framework of international political considerations The ques-tion of size is all-important in international monetary relations Big powers with stable currencies lead or dominate their currency areas Great powers have great currencies.” (Mundell 1993, p 10) This puts the political ration-ale of monetary union on the spot; and,

(vii) foster political integration within the EU countries, since monetary union was conceived and launched as a step forward in the building of Europe

1.3.2 Costs

Most of the costs are implicit in the macroeconomic analysis of optimum currency

areas discussed above, and can be summarised as follows:

(i) loss of autonomy of a country's monetary policy, both in terms of domestic

(interest rate) and external (exchange rate) aspects, which limits the capacity

of these instruments to correct external desequilibria when facing asymmetric macroeconomic shocks

(ii) reduced possibility to use seigniorage (or the inflation tax), something that

despite its inflationary consequences is very effective to escape from sive debt problems;

exces-(iii) diverging country preferences on the inflation-unemployment relationship (or

Phillips curve) As Corden (1972) and Giersch (1973) pointed out, the main characteristic of a monetary union is the setting of a common monetary policy and, therefore, the convergence in inflation rates of member countries; and,

(iv) worsening of regional disequilibria, as there is the risk that the tation of the 1992 Single Market Programme (SMP) would exacerbate eco-

implemen-nomic activity and would concentrate investment in the already affluent areas

of the EU Consequently, the EU regional imbalances would deteriorate as the material conditions of production in the less productive areas would worsen in relative terms (Krugman 1991)

De Grauwe P (1997) The economics of monetary integration Oxford University Press, Oxford,

228 pp

Emerson M et al (1992) One market, one money An evaluation of the potential benefits and costs

of forming economic and Monetary Union Oxford University Press, Oxford, 354 pp

European Commission (1990) One market, one money European Economy, no 44, Brussels,

347 pp

Fernández de Castro J (1973) Las Áreas Monetarias Óptimas: Hacia una Teoría General Facultad de Ciencias Económicas y Empresariales, Universidad de Barcelona, Barcelona, Feb, Tesis Doctoral, 420 pp

Giersch H (1973) On the desirable degree of flexibility of exchange rates Weltwirschaftliches Archiv 109, Kiel:191–213

Grubel HG (1970) The theory of optimum currency areas Can J Econ 3:318–324

Ingram JC (1959) State and regional payments mechanism Q J Econ 13:619–632

Ishiyama Y (1975) The theory of optimum currency areas: a survey IMF Staff Papers, vol XXII, Washington, D.C., pp 344–383

Kenen P (1969) The theory of optimum currency areas: an eclectic view In: Mundell RA, Swoboda AK (eds) Monetary problems of the international economy The University of Chicago Press, Chicago, pp 40–41

Krugman P (1991) Geography and trade The MIT Press, Cambridge, 142 pp

Magnifico G (1971) European monetary unification for balanced growth: a new approach Essays

in International Finance, no 88, Princeton University, Princeton, 39 pp

Molina Requena MJ (1982) Unión Monetaria Europea Pirámide, Madrid, 140 pp

Mundell RA (1961) A theory of optimum currency areas Am Econ Rev 51:657–665

Mundell RA (1993) EMU and the International Monetary System: a transatlantic perspective Austrian National Bank Working Paper, no 13, Austrian National Bank, July, 41 pp

McKinnon RI (1963) Optimum currency areas Am Econ Rev 53:717–725

Presley JR, Dennis GEJ (1976) Currency areas: theory and practice Macmillan, London,114 pp Sanchis M (1984a) La integración monetaria de España en el sistema monetario europeo Facultad de Ciencias Económicas y Empresariales, Universidad de Valencia, Valencia, May, Tesis Doctoral, 458 pp

Sanchis M (1984b) The European monetary experience and the Spanish entry into the EMS Research work undertaken with the financial help of a grant awarded by the Commission

of the European Communities, Faculty of Economics and Business Sciences, University of Valencia, Valencia, 255 pp

Sanchis M (1988a) La peseta ante el sistema monetario europeo Alfons el Magnánim, València,

283 pp

Sanchis M (1988b) The implications of the enlargement of the EEC on the monetary questions: the Spanish case, vol 5 SUERF Papers on Monetary Policy and Financial Systems, 41 pp Tower E, Willett ThD (1970) The concept of optimum currency areas and the choice between fixed and flexible exchange rates In: Halm GN (ed) Approaches to greater flexibility of exchange rates: the Bürgenstock Papers Princeton University Press, Princeton, pp 407–415 Vaubel R (1976) Real exchange-rate changes in the European community: the empirical evi- dence and its implications for European currency unification Weltwirschaftliches Archiv 112(3):429–470

Wyplosz C (1997) EMU: Why and how it might happen J Econ Perspect 11:3–22

Abstract This chapter examines the case of different regions within a single

coun-try that wish to share a common currency, even though they have divergent trends

in unemployment, inflation, wages, non-wage costs and productivity This situation compares with the case of a group of EU countries, each with its own decentralised national budget, that have established a monetary union and that are facing asymmet-ric shocks As such an economic context requires fiscal commitments from national governments, we analyse the economic rationale of setting fiscal rules for a common

currency area and the resulting EU institutional frame for the Stability and Growth

Pact (SGP) and the Excessive Deficit Procedure (EDP) We discuss the legal basis for

the EDP and the relevant accounting definitions We also provide the initial settings

of the SGP, as well as a summary of the contents and the related assessment of the revised SPG in March 2005 The chapter concludes with a brief comment on the so-

called “Six Pack” adopted by the EU in December 2011, which provides a wide range

of macroeconomic indicators to improve the governance of EMU within Eurozone

countries, through the Surveillance of Macroeconomic Imbalance Procedure.

Keywords  Fiscal federalism  •  Fiscal rules  •  Excessive Deficit Procedure (EDP)  •

Stability  and  Growth  Pact  (SGP)  •  Six  Pack  •  Surveillance  of  Macroeconomic   

Imbalance Procedure

2.1 Why Don’t Regions Leave Currency Areas When they

Experience Asymmetric Shocks?

We have presented above an overview of the economic rationale for a group of countries to share a common currency I would like to start this second chapter

by examining the case of regions that in spite of showing diverging trends in both unemployment and inflation rates, as well as in wages, non-wages costs and productivity, still consider it advantageous to be part of a wider country with a common currency

Chapter 2

The Economic Rationale of Fiscal Rules in

OCAs: The Stability and Growth Pact and

the Excessive Deficit Procedure

M Sanchis i Marco, The Economics of the Monetary Union and the Eurozone Crisis,

SpringerBriefs in Economics, DOI: 10.1007/978-3-319-00020-6_2, © The Author(s) 2014

Consider, for instance, the effect that the oil crisis of 1973–75 had on Spain At the time, the Spanish economy had embarked on a public investment programme engineered through the National Institute for Industry (INI) In Leviathan fashion, the government had decided to invest the bulk of Spain's national savings in the shipyard and steel industries It turns out that the State chose the wrong sectors, in

a situation that has been repeated today in the construction sector after it received massive flows of private funds between 1999–2007

What happened in 1973–75? Some regions in Spain like Cadiz or Valencia suffered a negative productivity shock as their respective shipyards and steel industries lost competitiveness Subsequently, these regions experienced an excess of productive capacity which resulted in a fall in industrial output and a sharp increase in unemployment Both regions undertook a process of industrial restructuring which lasted nine years The negative supply shock had an asymmet-ric impact throughout the whole country, and the Bank of Spain implemented an accommodating monetary policy to support growth However, whereas some parts

of Spain were slowly recovering, the very lax monetary stance was unable to ulate the severely damaged areas of Cadiz and Valencia

stim-Had these depressed areas had the opportunity to separate from the monetary union with the rest of Spain, they would have experienced a sharp devaluation, which would have stimulated exports and fuelled a strong growth recovery in the short-run This was not, however, a politically feasible option Why didn’t these damaged regions choose to quit the currency area? Had these areas exited the monetary union, they would have incurred huge losses as compared to short-term competitive gains What happened instead?

(i) investment opportunities remained in the chemical, textile, construction, and other sectoral economic activities, which were concentrated in the north-ern areas of Spain As a result, physical capital flowed to areas in economic expansion and absorbed the redundant employment, which was coming from the depressed areas in the South (Cadiz) and the East (Valencia) Thanks to factor mobility, workers from Cadiz and Valencia moved freely to those Spanish areas which were experiencing both a moderate economic expansion, and the corresponding increase in the demand for labour;

(ii) because most of these workers remained within the country, the savings that Spanish society had previously used to invest in training and retraining this human capital were not lost but fully exploited within Spain, thus contributing

to the financial sustainability of the Spanish pension system;

(iii) those workers who had fewer job opportunities in the Northern industries and those who remained unemployed in the Southern/Eastern regions, received financial sup-port from the national unemployment benefits schemes funded through the Spanish

national social security fund which, in turn, was mostly funded with the social

security contributions from people working in the North/Centre and North/East areas in expansion;

(iv) to correct for the regional imbalances, which had been exacerbated by the asymmetric negative shock, the central government set up a plan to

provide incentives for establishing companies in the damaged regions The plan included direct investment by the public sector, financial incentives and tax rebates for private companies—State aid policies which are prohibited in the EU—and a training policy to fill the skills gap between the new skills required

by the companies and the old skills of the labour force (Box 1) Again, as with the social security funds, all this support was funded through taxes collected by

the central government budget whose main contributors were people and

com-panies in the more flourishing Northern regions; finally

(v) the country increased its foreign indebtedness and, although part of the foreign debt was in dollars, the bulk was denominated in the national currency The fact that Spain at that time had its own currency mitigated any insolvency prospects

2.1 Why Don’t Regions Leave Currency Areas

Box 1: Success Story of the Industrial Restructuring of the Altos Hornos del Mediterráneo Steel Company

The case of the Altos Hornos del Mediterráneo (AHM) Steel Company in

Sagunto constitutes the first traumatic industrial restructuring of such an

industrial concern in Spain and one of the few examples of a successful re-industrialisation of an old industrialised area This is a case of a com-munity with a single industrial concern that was retrofitted in its entirety

In 1975, Sagunto had more than 52,000 inhabitants and the economic base

of the area was predominantly agricultural with the exception of the steel industry From 1978–91, 800 industrial jobs were lost in the economic area around Sagunto, while the steel industry alone lost more than 4,000 The AHM Steel company went from 5,569 employees in 1976 to fewer than 1,000 in 1991, and the Sagunto area showed the highest unemployment rate in the region of Valencia In 1996, in contrast, the population of the municipality of Sagunto was 60,000, and the city's unemployment rate was below the regional average What is more, jobs were concentrated in the tertiary sector More importantly still, the industrial sector boasted impres-sive employment dynamics

The industrial decline of the area of Sagunto started in the second half of

the 1970s with the decrease in the demand for steel and the resulting capacity of the steel sector at national level In 1983, the Spanish govern-ment passed a law to close the AHM steel company, a process that was fully accomplished in 1984 The announcement of the closure was met with mass mobilisations led by the trade unions These influenced the government to devise compensation schemes for the redundant workers and to reach agree-

over-ments with the regional government to re-industrialse the whole area Early

retirement measures (from 55 years onwards) were offered to 1,013 workers, while the Employment Promotion Fund (FPE, for the Spanish Fondo para la Promoción del Empleo) guaranteed to financially support the other redundant

workers for three years Furthermore, the Regional Government together with

the municipality and the unions reached a political agreement in April 1984

to find new jobs for redundant workers under the age of 52 and those with temporary contracts and to provide them with the required training, funded

by the FPE The agreement also guaranteed that workers would make at least 80% of the income they had previously earned at AHM The objective of the agreement was to create at least 1,700 new jobs for this type of redundancies

in three years, the time span of the validity of this policy

• The legal and institutional framework set up to implement the

re-industri-alising policy was the following:

– Creation of the Fund for the Promotion of Employment (FPE) to give financial support to the workers made redundant by the steel company while these workers were waiting to be re-allocated in other companies

or to be eligible for early retirement The FPE also subsidised ment in companies recruiting redundant workers from AHM

employ-– Two laws declared the area around Sagunto as a “Zone for Preferential Industrial Location” (ZPLI) and “Zone for Preferential Industrial and Agroalimentary Location” (ZPLIA) and provided the legal basis for the policy of re-industrialisation This implied that companies planning on expanding projects and investing in the area would enjoy such perks as subsidies to stimulate investments and employment, fiscal bonuses, etc.– Creation of the Commission for the Economic Promotion of Sagunto (CEPS) in charge of the management of the policy of re-industrialisa-tion The objectives of the CEPS were to promote and attract investments from abroad into the area and to increase the attractiveness of the area from a location viewpoint by ameliorating public infrastructures (retro-fitting the harbour of Sagunto and opening it to general maritime traffic and improving accessibility, providing industrial infrastucture etc.) and providing public industrial land at political prices The regional govern-ment played a major role in influencing the final decision of the Italian multinational glass company SIVESA (Società Italiana del Vetro, S.A.)

to locate its important investment in the area of Sagunto

• The instruments to stimulate the installation of new activities in the area

or the expansion of those activities already existing were as follows:

– Direct investment by the public sector, which materialised in the above supply of infrastructures, and direct creation of employment through public companies The state holding INI (Institute for National Industry) accepted the engagement to generate at least 500 new jobs either through new companies or by means of the plan for the enlarge-ment of the state-owned steel company SIDMED that was expected to create around 2,000 new jobs However, the public sector was unable

to honour its commitments The INI was able to bring the national

fertilisers company, ENFERSA, to Sagunto, originally planned for building in Cartagena, and generate 209 jobs But the expansion of SIDMED ultimately resulted in the net loss of 300 jobs between 1985–87

– Financial and tax incentives, which consisted in: (i) subsidies to ment, with a maximum limit up to 30% of investment in fixed capital; (ii) preferential access to official credit, up to 70% of the non-subsi-dised investment; (iii) several tax rebates; and (iv) the possibility to benefit from special depreciation plans

invest-– A training policy, through the Plan for Professional Occupational Training (funded by the FPE) which trained 1,404 people to fill the gap between the type of workers required by the new companies and the skills of the labour force SIVESA and ENFERSA were the main beneficiaries

During the 1984–89 period, the regional and national authorities took the lead of the re-industrialisation strategy In early 1989, between the new companies set up and the expansion of existing ones, 54 projects received subsidies amounting to more than 35 billion pesetas (around 211 million euros), and 2,053 new jobs were created The objective of finding new jobs for the workers made redundant by the steel company AHM was, therefore, reached Furthermore, the improvements in public infrastructures and the location advantages of the area paved the way for a robust diversification

of the industrial structure Beyond the traditional industrial sectors such as metal working, new industries making chemical, glass, plastics, and aux-iliary car products become a permanent feature of the industrial area of Sagunto

Despite the successful results above the re-industrialisation strategy implemented by the various public authorities cannot by itself explain the flourishing economy the zone enjoys today It did, however, pave the way for a radical change in the area’s industrial dynamics Despite the fact that many of the companies created with public support disappeared in the fol-lowing years, the industrial base of the area continued to expand and diver-sify after the implementation of the official re-industrialisation programme

During the second phase of re-industrialisation (1988–92), numerous small

companies were set up on the Sagunto Industrial Estate They represent more the 30% of the new jobs created From 1988 onwards, two thirds of the new companies were created without any subsidies or financial or tax benefits In this second phase of “free” re-industrialisation, factors such as improved public infrastructures and communications, proximity to custom-ers, availability of industrial land at competitive prices, the existence of a skilled and well-trained labour force, were major determinants for attracting new companies

2.1 Why Don’t Regions Leave Currency Areas

Large transfers of savings from the less affected to the more severely damaged regions took place This flow of funds took place without any regions having to pay any interest rate for the funding provided, as we shall discuss more in depth below The above five elements are missing today in the analytical framework of the Eurozone and we will come back to them later in the chapters of this book Let

me underline, however, the relevance of five elements right from the beginning It

is important to keep them in mind during the coming chapters, as they are key ments challenging today’s future of the Eurozone:

ele-(i) factor mobility (labour and capital, physical investment) within the currency area;

(ii) sustainability of the pension systems;

(iii) common budget funding;

(iv) common social security funds; and,

(v) sovereign debt funding, with a single currency which is not a country’s own currency

2.2 The Economic Rationale of Fiscal Rules

in a Monetary Union

As we have seen in the previous chapter as well as in the previous point, in the

ideal world of optimum currency areas (OCAs), and within the framework of

a unified and centralised State, the economic consequences that an ric shock has on different geographical areas will be absorbed through a cen-tralised budget (De Grauwe 1997; Sanchis i Marco 1998, 2011, pp 201–221) Different areas will feel the shock with different intensity, some negatively, some positively Residents of regions with difficulties will receive savings from residents in those regions that, thanks to the positive influence of the macroeco-nomic shock, are now in expansion Savings from these more prosperous areas will be channelled to the residents of the regions adversely affected by the shock through the fiscal and the social protection systems by means of public trans-fers, in the form of either current or capital transfers Savings flows that will be sent to residents in the regions with difficulties will be generous, because they will be channelled, by means of taxes and social security contributions, through both the centralised budget and the social security fund As a result, the social protection benefits received in the regions in difficulties will not be accompa-nied by the request of interest payments for the transfer of savings from the regions in expansion

asymmet-However, in the real world, such as in a monetary union among countries that all have their own decentralised national budgets, when one country is negatively

affected by a shock, good economics advises the flexible use of fiscal policies

That means that the public deficit should be allowed to increase and automatic bilisers must come freely into play This country’s debt can be financed by its

neighbours with surplus savings as long as the capital markets are efficient and frictionless Its government can increase its public deficit without having to face problems of solvency or fiscal sustainability

However, the “real world situation” introduces several differences compared to

the unitary State or the ideal world of optimum currency areas First, the transfer

of savings is not free, as the country in difficulties will have to pay the interest and principal of the loans received from the country of the monetary union experienc-ing an economic expansion More importantly, the higher payments necessary to service the debt reduce the margin of manoeuvre of the country negatively affected

by the shock This happens at the very moment when the country needs to adjust

to the shock in a flexible way and looks for a wider margin for manoeuvre of its fiscal policy Moreover, the rapid accumulation of public deficit and debt puts

upward pressure on real (inflation-adjusted ex post) long-term interest rates This

acts as a deadweight for growth and sets the debt/GDP ratio on a path of trolled escalation, putting the country's financial stability in jeopardy

uncon-A major weakness of the previous argument lies on the implicit hypothesis that governments would incur public deficit repeatedly without having to face solvency

or fiscal policy sustainability problems Experience of the European economies during the 1980s shows how fast public deficits and the stock of debt accumulated

As the rate of growth was lower than real interest rates, the debt/GDP ratio entered

an explosive path undermining the sustainability of public finances

The economic literature points out that for a monetary area to function erly, fiscal rules must be put in place This is to prevent negative externalities in the less virtuous countries from affecting the more virtuous ones Unsound finan-cial policies would put heavy pressure on interest rates That would increase interest payments of other members of the area obliging them to adopt more restrictive fiscal policies than otherwise, in order to face higher interest pay-ments Indeed, during the 1980s, expansionary fiscal policies interfered with the monetary policy of central banks as they could not free themselves from the high stocks of public debt when they wanted to tighten monetary and credit condi-tions The same concern emerged when the European Central Bank would have limited power to tighten its monetary policy and would resist, for instance, rais-ing the intervention rate

prop-Because of all the above reasons, the Treaty of Maastricht (Council of European Communities, Commission of European Communities 1992) set up certain rules to limit the size of public deficits (3%) and the stock of public debt (60%) with respect to a country’s GDP The aim was to preserve the autonomy of the future European Central Bank from eventual pressures of unsustainable levels

of deficit and debts which might prevent it from eventually tightening its tary policy when needed These arguments, however, have been criticised because their underlying assumption is that capital markets are inefficient because they are

mone-unable to allocate different risk premia to the public debt of each area member

according to the specific situation of each country’s public finances If capital kets worked efficiently and were frictionless, negative externalities would not take place

mar-2.2 The Economic Rationale of Fiscal Rules in a Monetary Union

2.3 The Stability and Growth Pact

In spite of the safeguards described above, when assigning risk premia to tries with less sound public finances, financial markets may take into account the impact of one country's declaration of bankruptcy on others of the area's members

coun-To mitigate this effect, Article 104B of the Treaty prohibits the Community or any member state from taking on the debt of another country

However, without setting up rigorous fiscal rules concerning the size of the deficit allowed within the union, the problem of credibility in implementing this clause would continue to be open Therefore, and in view of the difficulties to

apply those rules, the Treaty replaced this idea by the Excessive Deficit Procedure (EDP) in article 104C, according to which recommendations to Member States are

to make their public finances comply with the Maastricht criteria

The Stability and Growth Pact (SGP) is a rule-based framework for the

coor-dination of national fiscal policies in the EMU, which was set up to ensure sound public finances The SGP consists of two arms: One preventive and the other dissuasive, along with an assessment of the long-term sustainability of public finances In December 2011, a new set of indicators was announced to guarantee a correct monitoring of the cyclical macroeconomic imbalances within the Eurozone member countries

2.3.1 The Preventive Arm

Under the provisions of the preventive arm, Member States must submit annual stability or convergence programmes, in which they show how they intend to achieve or safeguard sound fiscal positions in the medium-term, taking into account the impending budgetary impact of the aging of the population The Commission assesses these programmes and the Council gives its Opinion on

them This preventive arm includes two policy instruments:

(i) the Council, on the basis of a proposal by the Commission, can address an

early warning to prevent the occurrence of an excessive deficit; and,

(ii) using the policy advice, the Commission can directly address policy

recom-mendations to a Member State as regards the broad implications of its fiscal policies

2.3.2 The Dissuasive Arm: The Excessive Deficit Procedure

The dissuasive part of the Pact governs the Excessive Deficit Procedure (EDP)

The EDP is triggered should a country surpass the Treaty’s deficit ceiling of 3% of GDP If it is deemed that a country’s deficit exceeds the limit as expressed in the

spirit of the Treaty, the Council issues recommendations to the member state cerned This country is given a period of time to curtail its deficit Non compliance with the recommendations triggers further steps in the procedures, including the possibility of sanctions for euro-area member states

con-2.3.2.1 Legal Basis and Accounting Definitions

The Excessive Deficit Procedure is detailed in article 104C of the Treaty of Maastricht, as well as in its associated legislation, that is, in the Protocol on the

excessive deficit procedure, and in Council Regulation (CE) no 3605/93 on the application of the Protocol (European Council 1993) In this article, it is stated that fiscal deficit and debt figures must comply with the methodology of the European System of Integrated Economic Accounts (ESA) Each country has to notify the European Commission twice a year of its expected and real deficit, as well as of its debt level

Article 2 of the Protocol on the excessive deficit procedure of the Treaty of

Maastricht states the following:

• “government means general government, that is central government, regional

or local government and social security funds, to the exclusion of commercial paper, as defined in the European System of Integrated Economic Accounts;

• deficit means net borrowing as defined in the European System of Integrated

Economic Accounts;

• debt means total gross debt at nominal value at the end of the year and

consoli-dated between and within the sectors of general government as defined in the first indent”

However, before we discuss the economic rationale of the Stability and Growth

Pact and the Excessive Deficit Procedure, we need to keep in mind a few basic

concepts concerning public deficit and fiscal effort In terms of accounting, there are four definitions of public deficit depending of the breadth of economic oper-ations and the size of the public sector considered The two first refer to public accounting because of the government budget, whereas the third and fourth defini-tions refer to national accounts in the domain of the national statistical office

(i) Deficit in cash terms (State non-financial): indicates the balance between

receipts and spending for non-financial operations of the central government

(State) expressed in terms of Public Accounts (Cash criteria).

(ii) Deficit in accruals terms: indicates the balance between recognised rights and

obligations of the non-financial operations of the central government (State)

expressed in terms of Public Accounts (Accruals criteria).

(iii) Deficit in national accounts terms: this differs from deficits in terms of Public

Accounts as far as it also includes extra-budget operations such as interest rate swaps, exchange rate, insurance of motorways, etc This is the definition of deficit used by Member States when they have to deliver the required statistics

2.3 The Stability and Growth Pact

to the European Commission to comply with the convergence criteria of

Maastricht (Maastricht criteria).

(iv) Deficit in economic and patrimonial terms: this includes both financial and

non-financial operations and is similar to the profit and loss account of the

State public sector (Public sector criteria).

2.3.2.2 A Few More Economic Definitions

The concept of deficit as expressed in the Maastricht criteria and the Excessive

Deficit Procedure is defined in the European System of Integrated Accounts To grasp the economic meaning of public deficit and fiscal effort, we need to add a few more definitions:

(i) Actual deficit of general government: according to the ESA95 definition, it is

the volume of net indebtedness of the General government sector (S.13), and includes the sub-sectors of Central government (S.1311), State government (S.1312), Local government (S.1313), and Social security funds (S.1314)

(ii) Cyclically-adjusted general government deficit: is obtained by subtracting the

cyclical component from the actual budget The determination of the cal component is obtained by multiplying the output gap with the marginal rate of change of both receipts and expenditure, respectively, with respect to

cycli-GDP Therefore, when the output gap is positive the cyclically-adjusted

defi-cit figure will be greater (worse) than the actual defidefi-cit figure, as the tion of the cyclical component will worsen (increase) the actual deficit figure

extrac-Conversely, a negative output gap will adjust the cyclically-adjusted deficit

figure favourably, as it will correct (improve) the previous figure of actual icit making the adjusted deficit smaller

def-(iii) Fiscal effort of general government: there are several definitions for this concept, but the most established is the one that considers fiscal effort as

the annual change of the cyclically-adjusted budget balance It is important

to consider the evolution of the actual public deficit and the figures of fiscal

effort from a dynamic perspective to undertake sound economic analysis on

public finance as we will see Moreover, it is important to underline that not all of the amount of the deficit has the same impact on growth in the long

term, and this is why the quality of public spending matters for growth The

crucial distinction is between consumption and investment expenditure, not between private and public expenditure

Commissioner Mario Monti, in a Letter addressed to the College of Commissioners in 1998, underlined that Art 104c, paragraph 3, of the Maastricht Treaty stated “If a Member State does not fulfil the requirements under one or both of these criteria, the Commission shall prepare a report The report of the Commission shall also take into account whether the government deficit exceeds government investment expenditure and take into account all other relevant factors, including the medium term economic and budgetary position of the Member State”

econ-to cover government investment, not current expenditure During the early stages

of the Maastricht negotiations, the German delegation suggested that the “golden rule” should be introduced as the criterion for public finance Although a numeric criterion (3%) was finally introduced, the “golden rule” was indirectly recognized through Art 104c.3 (Bulletin Quotidien Europe 1998, pp 1–2)

2.3.3 The Long-Term Sustainability of Public Finances

EU Member States face the challenge of ensuring the long-term sustainability of public finances in the light of the impending budgetary impact arising from both the ageing of the European population—as people live longer and have fewer chil-dren—and lower employment rates in the EU compared to the US and Japan To meet this challenge and taking into account the focus put on long-term sustain-

ability by the 2005 reform of the Stability and Growth Pact, common long-term

budgetary projections are today established at the EU level and each individual Member States’ situation is assessed and monitored A comprehensive analysis can be found in the sustainability report The long-term sustainability of public finances is also taken into consideration in the assessment of the stability and con-vergence programmes

2.3.3.1 The Initial Setting of the Stability and Growth Pact (SGP)

The Stability and Growth Pact originally stated that a country with a deficit of

more than 3% of its GDP would have to pay a penalty 0.25% of its GDP for every percentage point beyond the 3% limit No ceiling was placed on the penalties imposed Only a country whose GDP had dropped by 2% would be exempt In December 1996, however, the Dublin European Council agreed that there would

be a grey zone for those countries whose GDP fell between 0.75 and 2% The

pen-alties were rounded out with a fixed component of 0.2% of GDP for deficits above 3%, increasing by 0.1 percentage points of GDP per each additional percentage point of deficit There would also be a linear penalty of 0.2% of GDP for debt ratios above 60% However, the maximum penalty would never exceed 0.5% of a country’s GDP when the deficit penalty was combined with the debt penalty

2.3 The Stability and Growth Pact

In June 1997, the Amsterdam European Council established the payment of

a deposit without interests amounting to 0.1% of GDP if a country’s deficit was higher than 3% of its GDP A further penalty of 0.1% of the country’s GDP would

be added for each additional percentage point of deficit beyond the 3% limit, up

to a maximum of 0.5% The amount was blocked and, after two years, it would become a penalty for the profit of virtuous countries, which had respected the con-vergence criteria Until the revision of the Stability and Growth Pact in 2005, the possible situations were the following:

(i) if a country’s GDP had fallen by 2% or more, no penalty would be imposed, but the country had to take urgent measures;

(ii) if a country's GDP fell between 0.75 and 2%, the case could be presented for the consideration of the ECOFIN1 Council; and,

(iii) if a country's GDP dropped by less than 0.75%, it could be sanctioned if its deficit had not met the 3% criteria

2.3.3.2 The Revision of the Stability and Growth Pact

In March 2005, the Brussels European Council approved a reform of the Stability

and Growth Pact making it less stringent, considering more closely the stances of each case The sanctions were no longer imposed automatically and more room was made for “relevant factors” in public spending, such as R&D, German reunification costs, international solidarity, etc This reform was consist-ent with the lines previously established in the Commission Communication COM (2004) 581 on “Strengthening economic governance and clarifying the implemen-tation of the Stability and Growth pact” (European Commission 2004) The major new elements of the Commission Communication were the following:

circum-(i) surveillance of the budgetary positions will focus more on government debt

and debt sustainability In particular, a reference rate for the satisfactory pace

of debt reduction will be set up for highly indebted countries It will take into account country-specific circumstances like the impact of ageing and contingent liabilities, the initial debt level and the potential output growth conditions;

(ii) when defining the medium-term deficit objective of ‘close to balance or in

surplus’ or the path to achieve it, greater consideration will be given to try-specific circumstances Deviations from its achievement will be assessed

coun-in light of national debt levels, potential output growth, coun-inflation, existcoun-ing bilities related to ageing populations, the impact of structural reforms carried out The need for additional net investment could be considered;

lia-1 The ECOFIN is the Economic and Financial Affairs Council, one of the oldest of the EU It

is composed of the Finance Ministers of the 27 Member States and of their Budgets Authorities when the budget is discussed.

(iii) country-specific circumstances will also be taken into consideration for the

defi-nition of the adjustment path to correct excessive deficits, the related deadlines

will be fixed according to the cyclical position and debt levels of the economy

under scrutiny Moreover, the exceptional circumstances clause will be

modi-fied in order to include protracted periods of sluggish economic growth;

(iv) the preventive side of the action to avoid budgetary imbalances will be strengthened implying: a) running symmetric fiscal policies over the cycle

to both prepare for the ageing of the population, and create sufficient room

of manoeuvre for the full working of automatic stabilisers; and, b) using the

Broad Economic Policy Guidelines (BEPG) more effectively to prevent cyclical policy in good times; and

pro-(v) the surveillance of fiscal policies will be encompassed in a broader perspective

in the sense that economic and budgetary policies need to set the right priorities towards economic reforms, innovation, competitiveness and strengthening of

private investment and consumption linking them to the wider macroeconomic

goals of the EU, including the Lisbon strategy Therefore, more emphasis will

be put on the growth and employment enhancing role of public finances This calls for a better coordination between the BEPGs, the SGP and the national budgetary processes, and for a revision of the economic calendar

The revised 2005 Stability and Growth Pact calls for the use of more judgement

and greater discretion in the implementation of the fiscal rules as they are intended

to be consistent with economic theory This is likely to enhance the legitimacy and

enforceability of those rules In particular, the higher weight given to debt with

respect to deficit makes is likely to reduce the moral hazard that might tempt ber states, by providing fewer incentives for one -off or cosmetic operations just

mem-meant to bring the deficit below 3%

However, the partial shift from rules to discretion is no guarantee for greater consideration of policy concerns in the reshaping of the fiscal framework There is not necessarily an equivalence between rules and stringency, on the one hand, and discretion and loosening, on the other Early in the 1990s, Manuel Guitián already underlined (Guitián 1992) that the dilemma between strict observance of rules and reasoned exercise of discretion is more apparent than real: (i) rigid adherence to rules in circumstances that call for the use of judgement and some discretion is inim-ical to the very existence of the rules themselves; and (ii) the longevity of rules in economic policy depends on the ability to adapt them when conditions warrant

2 The author would like to thank Ralf Jacob, a former colleague in DG EMPL, for the fruitful exchange of views that we maintained on these issues Such conversations made my own previ- ous ideas change Any remaining error is my sole responsibility.

2.3 The Stability and Growth Pact

The stronger emphasis on the growth enhancing role of public spending, term sustainability and country specificities advocates considering, within the imple-

long-mentation of budgetary surveillance, the total amount of human capital-enhancing

spending.3 Here we refer to education, training and Active Labour Market Policies

(ALMPs), which improve a country's future macroeconomic performance in terms of productivity, growth and employment thereby helping to cope with the ageing issue

If those policies are properly targeted to older workers they delay the actual exit age from the labour market, leading to a direct relief for pension systems Moreover, they help to prevent a skills mismatch in the labour markets Higher flexibility in the close to balanced budget target, or in the path for excessive deficit correction—if not even in the threshold relevant for the latter—could be allowed when a significant share of GDP devoted to government expenditure—namely capital formation, including human capital—falls under the above items

One should ask for a different approach in the assessment of the quality of lic expenditure under which social expenditure is no longer regarded as unproductive Looking at spending aggregates, which are arbitrarily defined as productive or unpro-ductive, is inappropriate Therefore, one should stress that every type of public expend-iture can be more or less productive, depending on whether it meets real needs in the most cost effective way Moreover, one should recognize the social returns of policies against poverty in terms of, for instance, lower criminality and health care costs

pub-In the area of social expenditure, incentive effects are particularly important This touches upon the issue of making work pay (European Commission 2003) and the degree to which tax-benefit systems provide the right incentives for unem-ployed people to take up even low-paid jobs, for workers to progress towards better paid jobs—through the right level of marginal effective tax rate—or for workers to remain in the labour market longer

An interesting example of the complexity of the issue is the size of ment benefits, which is negatively correlated with employment protection legisla-tion in the Western countries Higher spending on such benefits appears to be more efficient than employment protection legislation in facilitating structural change, enhancing economic performance and raising employment Clearly, the emphasis between the two policy tools is also a matter of Member States’ preferences and traditions and there is no national model that should be systematically adopted by the other countries Still, this evidence shows that an approach relying on suppos-edly unproductive expenditure can be more efficient than an approach which does not show up in public expenditure at all

unemploy-Regarding future liabilities linked to ageing, it is important to avoid too narrow a view Considering only the total amount of implicit liabilities (present value of the future stream of pension payments that would be due according to current legislation)

is not sufficient This will be high for some countries, which rely primarily on public

3 We must avoid any approach that looks at the share of such spending in overall public ture, as this will be distorted by the choice between public and private pension and health care provision However, it would make more sense to look at the share of GDP devoted to capital formation, including human capital.

pension provision, but these countries are generally also able to raise more revenue for such schemes (need to consider acceptance of contributions/taxes for financing public pension schemes) Therefore, the revenue side also needs to be considered

It is also important to take into account the adequacy situation: countries with generous pension systems (high replacement rates available at a relatively young age) have room to manoeuvre and can reduce future liabilities more than countries where benefits are already low (two contrasting examples could be Greece and the UK) Finally, room for manoeuvre might come from the increase in employment rate, as long as a country is willing to carry out the necessary policies to prompt

it Similar considerations can be applied to the area of health and long-term care where ageing is also expected to lead to expenditure, although this is even more difficult to quantify than pension expenditures

A more sophisticated analysis of a country’s ability to cope with the impact of

ageing is required in the framework of the revised Stability and Growth Pact In

the previous SGP, the assessment was too much based on simple projections of public spending without taking into account any of the considerations mentioned above The Open Method of Coordination (OMC) on pensions and health/long-term care plays an important role in developing a more comprehensive assessment

of the long-term sustainability of the social protection systems

2.5 The Six Pack: Scoreboard for the Surveillance

of Macroeconomic Imbalance Procedure

Despite the above strict procedures involved in the surveillance of the economic and budgetary situations of Member States, the current financial crisis revealed weaknesses in the governance framework of the EMU As a result, the EU adopted

the so-called Six Pack, that is, a set of legislative proposals to enhance economic

governance The legislative package entered into force on 13 December 2011, and introduced a new surveillance procedure for the prevention and correction of

macroeconomic imbalances, the so-called, Macroeconomic Imbalance Procedure (MIP) built around a ‘two-step’ approach: the first step is an alert mechanism consisting in a scoreboard with early warning indicators put in place by the

Commission to focus attention on risks; in a second step, a more in-depth analysis

is undertaken in those countries identified in the Alert Mechanism Report (AMR).

As stated in the Commission report, the indicators and thresholds of the board aim at providing “[…] a reliable signalling device for potentially harmful imbalances and competitiveness losses at an early stage of their emergence […] The scoreboard consists of the following ten indicators and indicative thresholds:

score-• three-year backward moving average of the current account balance in percent

of GDP, with a threshold of +6% of GDP and −4% of GDP;

• net international investment position in percent of GDP, with a threshold of

−35% of GDP;

2.4 An Assessment of the Revised Programme

• five-year percentage change of export market shares measured in values, with a

threshold of −6%;

• three-year percentage change in nominal unit labour cost, with

thresh-olds of +9% for euro-area countries and +12% for non-euro-area countries, respectively;

• three-year percentage change of the real effective exchange rates based on

HICP/CPI deflators, relative to 35 other industrial countries, with olds of ∓ 5% for euro-area countries and ∓ 11% for non-euro-area countries, respectively;

thresh-• private sector debt in percent of GDP with a threshold of 160%;

• private sector credit flow in percent of GDP with a threshold of 15%;

• year-on-year changes in the house price index relative to a Eurostat

consump-tion deflator, with a threshold of 6%;

• general government sector debt in percent of GDP with a threshold of 60%;

• three-year back moving average of the unemployment rate, with a threshold of

Council of the European Communities, Commission of the European Communities (1992) Treaty on European Union Office for official publications of the European Communities, Brussels, 253 pp Guitián M (1992) Rules and discretion in international economic policy IMF Occasional Paper,

no 97, IMF, Washington, June, 50 pp

Sanchis i Marco M (2011) Falacias, Dilemas y Paradojas La Economía de España: 1980–2010

Publicacions de la Universitat de València, Colección Educació Materials, Valencia, Chap

8, pp 201–221

Sanchis i Marco M (1998) Aspectos fiscales de la unión monetaria el ‘procedimiento de déficit excesivos’: su racionalidad económica Colegio de Economistas de Valencia, Valencia, p 19

Abstract The chapter discusses the economic conditions for the success of EMU

when there is still a need for structural reforms in the markets of goods and vices, and factors of production In view of asymmetric shocks, experience shows that behaviour in nominal and real wage growth resulted in increased unemploy-ment throughout the EU15 Fiscal policy, on the other hand, could mitigate to some extent the burden of wage adjustment, and could play an important role in improving productivity In general, however, smooth shock-absorption requires

ser-a flexible wser-age formser-ation process to circumvent low employment levels, but the risk of hysteresis would remain To avoid the accumulation of wage and labour cost differentials, which finally result in a widening external cost-competitiveness divergence among Eurozone countries, wage bargaining behaviour should respect

at least several rules These norms for wage developments are the following: (i) maintain overall nominal wage developments consistent with the goal of price stability; (ii) keep real wage developments in line with productivity increases; (iii) keep wage demands from converging upwards and catching up with wage increases in neighbouring countries; and, (iv) wage agreements should also better take into account productivity differentials according to qualifications, skills and geographical areas

Keywords  Structural  reforms  •  Asymmetric  shocks  •  Labour  costs  trends  • 

Productivity trends  •  Labour market adjustment  •  Price setting  •  Wage bargaining  •  Social agreement  •  Wage agreement

Chapter 3

Coping with Asymmetric Shocks in

the EMU: The Role of Labour Market

Flexibility

M Sanchis i Marco, The Economics of the Monetary Union and the Eurozone Crisis,

SpringerBriefs in Economics, DOI: 10.1007/978-3-319-00020-6_3, © The Author(s) 2014

The author would like to thank Karl Pichelman, a former colleague in DG ECFIN, for the fruitful exchange of views that we maintained on these issues Such conversations made my own previ- ous ideas change Any remaining error is my sole responsibility.