Euro

On the way to the Euro

Can Hungary learn from the Irish example?

Intro to Macroeconomics

Professor Istvan Magas

Central European University

Business School

Weekend MBA

Fall Semester, 2006

The free trade area called European Community was founded by six countries Ð'- West-Germany, France, Italy, The Netherlands, Belgium and Luxemburg. At the end of 2006, when this essay is written there are 25 member states of the European Union. Romania and Bulgaria will join by 1 January, 2007.

The first step on the way to the single European currency was taken only in 1979, when the European Monetary System was set up. The EMS was designed to lessen variations in the exchange rates between the currencies of the member countries. The system allowed the member states fluctuation margins of between 2.25 % and 6 %. But the system was weakened by several crises caused by the instability of the USD and the weakness of some currencies.

The plan about the economic and monetary union (EMU) Ð'- submitted in June, 1989, by Jacques Delors - was involved in the Maastricht Treaty, signed in February, 1992. The set of criteria laid down were all about economic and financial discipline:

Ð'* inflation rate: no more than 1.5 % above the average of the inflation rate of the lowest 3 countries in the EMS

Ð'* long-term interest rate: no more than 2 % above the average of the lowest 3 EMS countries

Ð'* exchange rate: in the narrow band of ERM for 2 years

Ð'* budget deficit: no larger than 3 % of GDP

Ð'* national debt: no greater than 60 % of GDP

An independent European Central Bank (ECB) was set up, and given the task of setting interest rates to maintain the value of the Euro.

In June, 1997, in Amsterdam, the European Council adopted two important decisions (Treaty of Amsterdam). The "stability and growth pact" committed the countries concerned to maintain their budgetary discipline. They would all keep eye on one another and not allow any of them to run up excessive deficits. The second decision was about economic growth. It states that the member countries and the Commission were firmly committed to making sure employment remained at the top of the EU's agenda.

The single monetary policy is led and controlled by the European Central Bank (ECB). The ECB's first duty is to ensure price stability. ECB adopted two intermediate targets, the so-called "twin pillars" of their monetary strategy. The first pillar is a monetary target, the growth rate of the M3 measure of nominal money. The second pillar is expected inflation. The ECB claims that it takes both pillars into account in setting interest rates in the euro area.

Changes in interest rates impact both consumption and investment demand. A lower interest rate increases household wealth and makes borrowing cheaper. Together, these effects increase consumption demand by increasing the present value of expected future labor income.

Given the cost of new capital goods and expected stream of future profits, a lower interest rate increases investment demand.

In an integrated market such as the Euro area, inflation differentials across countries arise as an integral part of catching up and adjustment mechanisms to shocks. Policymakers' main concern is that inflation differentials are more than just temporary deviations from the Euro-zone average. Consequently, in EMU monetary policy has real effects because monetary policy affects the real interest rate which in turn affects aggregate spending decisions. With a uniform nominal interest rate, the domestic real interest rates will be lower in high inflation regions, discouraging savings and stimulating consumption and investment. In comparison to a monetary policy, within a monetary union the real interest rate channel no longer acts as a brake on the cycle but instead may accelerate regional economic developments. This effect may be further amplified by wealth effects, as low interest rates may inflate share and real estate prices.

Consumers in small member states expect much more change in the direction of price development than consumers in the largest member states. Consumers in the larger countries are apparently more confident in the ability of the ECB to keep prices stable in their country than consumers in smaller countries.

Inflation shocks in small EMU countries have a smaller effect on EMU inflation than those in large member states, because of their smaller weight in the aggregate data. As a result, the ECB interest rates will react more strongly in setting interest rates to stabilize inflation in large countries compared to small ones. Before EMU, national central banks could still use the interest rate instrument to manage national inflation expectations and national inflation uncertainty. Since EMU, this management is no longer possible.

Ireland's entering EMU is one of the economic success stories. Average growth in the 90's has been over 6 percent, the strongest growth rate in Europe. A major reason for that strong performance is that Ireland has been very attractive to business investment from abroad. The attraction is based not just on an English-speaking work force, but also on the relatively low labor costs and relatively low real estate prices.

Ireland's relatively low cost of production has also helped Irish companies increase growth through exports to the rest of the world. Ireland's trade surplus was at the end of 90's 15 percent of GDP, also the highest in Europe.

But the economic boom has become a super boom that is threatening to push up both wages and real estate prices at a pace would weaken Ireland's international competitiveness. So it's not surprising that Irish government officials and central bankers would have liked to cool the economy down to maintain Ireland's competitiveness and to sustain its prospects for long-term economic growth.

The traditional remedy would be to hike up short-term interest rates until the period of heightened excitement had calmed. That would have reduced the excess demand and allowed Ireland both to continue attracting outside investors and to maintain competitive export.

That was where the problem with EMU came in. A central feature of the monetary