ems - piigs

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The Euro, European Monetary system, & Debt Crisis.

With an Emphasis on the PIIGS countries.

German University In CairoMBA Program

Spring 2010

Finance MajorInternational Financial Management

FINC802


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The European Monetary System (EMS) was founded in December 1978 with the

intention to replace the earlier Snake system - mentioned later on in this article - which had

failed to stabilize the European currencies. The EMS started its operations in March 1979 with

the objective of fostering economic growth through economic integration and greater exchange

rate stability.

Stability was to be achieved in the short run through ironing out excessive fluctuations, and in

the long run through promoting greater convergence of the member economies.

The initial members were Belgium, Denmark, France, West Germany, Ireland, Italy,

Luxembourg and the Netherlands. Spain joined on 19 June 1989 and Portugal on 6 April 1992.

The United Kingdom entered the system on 8 October 1990 and dropped out along with Italy on

17 September 1992 due to heavy speculative pressure. Greece has not yet joined the system.

Through a set of monitoring mechanisms based on such economic variables as interest rates and

inflation, the EMS authority tracks the convergence of the member economies and enforce a

target zone on their exchange rates. The zone was initially set at 2.25% (6% for the Italian lira)

around the central parity rates but after the foreign exchange market crisis of August 1993, the

zone became 15%.

The band is enforced through a divergence indicator which alerts the monetary authorities

whenever a bilateral exchange rate moves too close to the floor or the ceiling of the zone

(Lieberman, 1992). Fundamental disequilibriums are usually fixed through realignments.

Notwithstanding the efforts in stabilizing currency movements, there were 12 realignments

between 1979 and 1987. That is to say, fluctuations of exchange rates often exceeded the

margins and the central parity rates had to be reset. Compulsory interventions by central banks

were required to keep currencies within the target zone. To further strengthen the credibility of

the EMS, the BasleNyborg agreement of the European Union (EU) central bankers signed in

September 1987 provided, for the first time, credit facilities for intramarginal (within-the-band)

intervention.

With a well-functioning credit mechanism, it is expected that central banks would be more

determined to intervene in the foreign exchange market before the need for realignment arises.

The limited available research on the subject shows that the proportion of marginal (at-the


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margin) intervention increased from 11% in the period 19791981 to 15.2% in 19861987

(Mastropasqua et al., 1988). After the signing of the BasleNyborg agreement, this proportion

decreased significantly due to the popularity of the credit facilities made available by the

agreement (Bini-Smaghi and Micossi, 1990).

The academic literature has largely ignored the impact of the BasleNyborg agreement on the

EMS exchange rates.

Previous studies have used an event approach to examine the impact of the establishment of the

EMS on a number of economic variables ranging from inflation and interest rates to exchange

rate volatility (Artis, 1990; Edison and Kole, 1995). Regarding exchange rates, most previous

research has focused on what Williamson (1983, 1985) calls high-frequency instability, that is,

daily exchange rate volatility. After some progress on the theoretical front (Krugman, 1987;

Miller and Weller, 1989), more attention was paid to the exchange rate realignments or low-

frequency instability (Rose and Svensson, 1994). The distinction between high- and low-

frequency instability is important because they have different trade effects (Williamson, 1985).

The European Community monetary integration has received periodic attention often as a result

of financial crises but has now evolved into its major aim. To achieve this goal the European

Monetary System was established in 1978. It was designed to provide a tool, the Exchange Rate

Mechanism, for exchange rate stabilization and convergence of economic and monetary policies.

To give further impetus to monetary integration the Maastricht Treaty was approved in

December 1991. Experiences with the operation of the European Monetary System show that

there is no conclusive evidence that it has disciplined the monetary and fiscal policies of all its

members. More recently, Germany's insistence on a tight monetary policy, to fight the inflation

that resulted from unification costs, has brought turmoil in European financial markets and has

dealt a serious blow to the system. Furthermore, the ensuing recession and its impact on the

European economies make improbable that the timetable of the Maastricht Treaty will be met.

According to the Single European Act, the legal document formalizing the Single Market

Program, the European Community (EC) shall adopt measures with the aim of progressively

establishing an integrated internal market in which the free movement of goods, persons,

services and capital will be ensured. Furthermore, the establishment of this single, integrated


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market, targeted to be a reality by December 31, 1992, has for all practical purposes been

accomplished.

What is the Single European Act? First, in a technical sense, it is an amendment of the 1957

Treaty of Rome that created the EC. In a broader sense, it firmly reaffirms a commitment of the

EC to accelerate its economic integration. However, although the Single European Act deals

with economics, it remains primarily a political act and, as such, it expresses the desires,

aspirations and hopes of at least three broad groups of European political players.

The "Euro-idealists" view the Single European Act as an important step towards a European

political union patterned after the United States. The "Euro-pragmatists" realize that

technological progress, world economic competitiveness, the integration of world financial

markets, among other factors, demand an economically integrated Europe. Finally, the "Euro-

skeptics" view this accelerated process towards integration as an effort to suppress nationhood

and concentrate enormous political powers in the bureaucracy of EC.

Thus, it is logical to argue that Europe 1992 is both a political compromise and an economic

process. It is a compromise because the governments who wished rapid economic and political

union but did not get it in the Single European Act, and those governments that wished to

preserve major home government rights and responsibilities but ended up losing some of these

rights to the EC bureaucracy. On the other hand, Europe 1992 is a process because economic

reality constitutes a dynamic flow and it will take several years to establish the institutional

framework necessary for a complete economic and monetary union.

History of Monetary Integration

MONETARY INTEGRATION, remarkably was not listed as one of the primary goals of the

Treaty of Rome that established the EC. Actually, Europeanmonetary integration, rather than

being a persistent priority, has been a vague objective of the EC and only received attention

periodically, often as a result of financial crises of certain magnitudes.

The first move towards monetary cooperation occurred during the early period of 1958-61 and

was caused by the reality of persistent balance of payments surpluses in the original six members

of the EC. During this period the EC established the Committee of Governors of the Central

Banks to coordinate issues of exchange rate management and international monetary policy.
http://web.ebscohost.com/ehost/detail?vid=5&hid=4&sid=c7fa11d5-115e-49f1-9c9d-405fa69e33c4%40sessionmgr13&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d%3d#tochttp://web.ebscohost.com/ehost/detail?vid=5&hid=4&sid=c7fa11d5-115e-49f1-9c9d-405fa69e33c4%40sessionmgr13&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d%3d#toc


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The increasing monetary instability of the late 1960s, created primarily by the inflationary

pressures of the Vietnam war, generated financial dangers that appeared to threaten the existence

of the European customs union. These concerns were expressed in the Barre Report which

recommended the setting up of a machinery for monetary coordination. At the December 1969

Hague summit, the Barre Report motivated a detailed discussion on the issue of a coordinated

Europeanmonetary policy. However, differences of opinion existed among the finance ministers

and as a compromise solution, it was suggested that a study group be formed to review these

issues carefully. The chairmanship of this group was assigned to M. Pierre Werner, the then

Prime Minister of Luxembourg.

The Werner Report, published in 1970, has become a significant document on the topic of

monetary integration. It recommended the development of theEuropean Currency Unit (ECU), a

centralized European credit policy, a unified capital market policy, a common policy on

government budgeting and the gradual narrowing of exchange-rate fluctuations.

The monetary crises of the early 1970s that led to the rescinding of the gold convertibility of the

dollar on August 15, 1971 and the floating of the guilder and mark created great pressures for

finding an alternative solution to the abandoned Bretton Woods system of fixed exchange rates.

The major economic powers, the U.S.A., the United Kingdom, Japan, Germany, Italy, Canada

and France, known as G-7, in their Smithsonian Accord agreed to allow their participatingcurrencies to fluctuate within a 4.5% band visa vis the U.S. dollar and EC currencies to vary as

much as 9% against each other. It was agreed that if a participating country's currency moved

outside such a band that country's central bank was responsible for sufficient intervention to

move its rate back within the acceptable range.

EC countries concerned about the difficulties that such a wide variation in their exchange rates

implied for their Common Agricultural Policy, proposed a more limited exchange-rate

mechanism which was called the snake. Such a snake allowed a maximum total band of 2.25%against the EC currencies. However, because EC countries were unable to maintain such a

narrow band, Denmark, France, Ireland, Italy and the U.K. left the arrangement at various times

during 1973 and 1974.


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In October 1977, Roy Jenkins of the United Kingdom, president of the European Commission

reactivated the EC's efforts at establishing an European monetary union. His efforts were

supported by the French-German alliance and led to the birth of the EuropeanMonetarySystem

(EMS) which became operational in March 1979. At the time all EC members joined in the EMS

with the exception of Italy, and the U.K. which did not become an active participant partly

because of various concerns including national sovereignty.

Actually the EMS is a supersnake that imposes less strict exchange-rate conditions on the

participating currencies because it is founded on the European Currency Unit (ECU). As such

the EMS does not attempt to maintain direct parity with currencies outside the EC, specifically

the U.S. dollar or the Japanese yen. The details of the EMS and a brief evaluation of its

performance will be presented in the next section. Here the historical account of the evolution

towards aEuropeanmonetary integration must deal with two additional events: the Delors Plan

and the Maastricht meeting.

At the Hanover summit of June 1988, the Council agreed that in adopting the Single European

Act, an implicit objective was monetary integration. The task for making such a goal explicit was

assigned to the M. Jacques Delors Committee and the analysis, findings and recommendations of

this committee are known as the Delors Report. This Report contains three major stages.

Stage One was unanimously adopted by the EC members at the June 1989 Madrid summit. It

addresses the issue of the non-participating member states in the exchange-rate mechanism of the

EMS and the expansion of the role of the Committee of Central Bank Governors in coordinating

monetary policy. The second stage would create a EuropeanSystem of Central Banks (ESCB)

much in the spirit of the U.S. Federal Reserve System. The Euro-Fed would be responsible for

price stability, exchange-rate and reserve management, banking and monetary policies and

general support of macroeconomic policies agreed upon at the EC level. Finally, the third stage

of the Euro-Fed would be to transfer the authority of monetary policies to an EC central bankand establish such a narrow band for the existing exchange rate fluctuations of the 12 currencies

that effectively a convergence would occur to one ECU.

Although the Delors Report outlined the process towards monetary integration, it was in the

December 1991 Maastricht summit that EC addressed a little more specifically the timetable of


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Mechanisms

The Aim of the Ems is to establish closer monetary cooperation leading to a zone ofmonetary

stability in Europe. Stability applies to exchange rates between EC currencies and is part of a

wider strategy that involves overcoming inflation and promoting economic growth. The

achievement of both external and internal stability is considered essential for the operation of a

long term growth policy.

The EMS facilitates the interdependence ofEuropean economies by providing a tool for

exchange rate stabilization and for encouraging convergence of economic and monetary policies.

This tool is called the Exchange Rate Mechanism (ERM) and it consists of four major

components: the ECU, the parity grid, the divergence indicator and the credit facilities. These

will be dealt with in turn.

The ECU is a monetary unit based on a basket of all EC currencies. The number of units of each

currency in the ECU is fixed, the weights of the various currencies change over time, as intra-

European exchange rates fluctuate.

The ECU also functions as a reserve instrument. It is issued by the EuropeanMonetary

Cooperation Fund to the EMS central banks, in exchange for 20% of their gold reserves and U.S.

dollar reserves. The amount of ECU created as a result is adjusted every three months to take

account of changes in the level and variation of gold and dollar reserves.

The parity grid consists of the central rate, the bicentral rate and marginal intervention. Subject

to agreement of all ERM participants, each member has a central rate. The central rate is

expressed as the amount of that nation's currency equal to one ECU. The central rates are fixed

and are revised only with a realignment. These rates are used in the parity grid to monitor

currency fluctuations relative to each other. The ratio of one country's central rate to another's

forms the bicentral rate. From this bicentral rate, the value of this ratio is allowed to fluctuate up

or down 2.25% (for Italy 6%). When the ratio reaches the allowable "margin," action must be

taken by both countries. This is called marginal intervention. The weaker currency's central bank

must sell the stronger currency, and the stronger currency's central bank must buy the weaker

currency.


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The divergence indicator was designed to give a country a warning when its currency is nearing

the divergence of the ECU central rate. When the divergence indicator crosses a threshold, a

country is expected to act through diversified intervention, measures of domestic monetary

policy, changes in central parity, or other measures of economic policy.

The final component of the ERM is the availability of credit financing. There are three financing

facilities in the EMS: the Very Short Term Financing Facility (VSTF); the Short Term Monetary

Support (STMS) and the Medium Term Financial Assistance (MTFA). The first two are

administered by central banks; the third is administered by the EC Council of Ministers.

The purpose of VSTF is to finance obligatory intervention in EC currencies. VSTF consists of an

unlimited credit line that central banks participating in ERM open to each other, in their own

currencies. The amounts drawn are expressed in ECU's and carry interest. This financing is of

very short duration (45 days after the end of the month), but it can be extended for three months

subject to certain conditions and limits. With the consent of the creditors a second extension of

three months may be obtained.

The Short TermMonetary Support is a system of mutual credit for all the central banks of the

EC. It was increased in volume and in duration on the creation of the EMS. The initial loan

period is three months, but can be extended to a total duration of nine months. Finally, the

Medium Term Financial Assistance is a system of mutual credit that EC member states can grant

each other for a period of two to five years.

From this brief description of the EMS, it seems safe to conclude that it is an elaborate system,

quite unique in the history of economic cooperation between countries. It is therefore appropriate

to raise the rhetorical question: how well has the EMS done in achieving exchange rate stability

and economic convergence, both fiscal and monetary, within the EC?

The EMS Experience

The Variability of Exchange Rates before and after the implementation of the EMS is examined

by Deravi and Metghalchi (1988). They compute an indicator of exchange rate variability for


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alternative measures of exchange rates. The measure they illustrated in their paper was monthly

average absolute percent change (AAPC). For all the countries participating in the ERM, the

AAPC dropped from 1.3% to 0.5%--a decrease of more than 50%. This evidence suggests that

the bilateral exchange rate variability had been reduced since March 1979.

The authors also compare the effective exchange rates of EC countries. The monthly AAPC for

France, Italy and the Netherlands dropped by 10%, 30%, and 20% respectively. Also worth

noting is the fact that the measure for the British pound sterling, which was outside the system,

increased by 45%. Thus, by comparing the increased volatility of the pound sterling to the more

stable rates of the participating countries, strong evidence in support of the EMS was provided.

For all participating countries in the EMS, the AAPC dropped by almost 20%. Thus Deravi and

Metghalchi (1988) concluded that the EMS had successfully reduced the variability of the

exchange rates of the EC countries.

The results coincided with an earlier study by Horst Ungerer et al (1986). These authors give

detailed evidence about exchange rate variability within EMS countries, within the non-EMS

countries and between them. Their results show that intra-EMS exchange rate variability, both

nominal and real, declined after the creation of the EMS. In contrast the non-EMS exchange rate

variability went up after the creation of the EMS.

Several studies have investigated the important issue of convergence of monetary and fiscal

policies. For evidence of such convergence, researchers often design measures of policy input

and evidence of economic performance using either simple descriptive statistics or more

advanced methods. For example, Artis (1987) measures policy input, such as OECD's

calculations of the structural budget balance (deficit or surplus) as a percent of potential GDP

and for monetary policy, he uses rates of growth of M3. His results suggest that there is

convergence for fiscal policy among EMS countries contrasted to a control group who had

differences between U.S.'s expansion and the contraction in Japan and the U.K. On the otherhand, Artis (1987) finds mixed results for monetary policy: there is some convergence but the

dispersion ofmonetary growth rates remains very high.

Coffey (1990) argues that the goal of monetary stability has been served satisfactorily by the

EMS. At the beginning of the operation of the system the rates of inflation tended to rise but


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more recently they have tended to fall. Moreover, there has been an expansion in the commercial

use of the ECU. Businessmen view the ECU as a model of stability and a risk spreader. It is now

among the top 5 currencies used for international loans.

Fratianni (1988) argues that the EMS has been successful in reducing nominal and real exchange

rate variability. On the other hand, she says, the facts about inflation are more ambiguous. The

achieved reduction in inflation rates turns out to be modest. The reduction in inflation among

non-EMS countries was more significant when the entire post-EMS period is considered.

Our look at available data suggests that there are still major problems of convergence that must

be addressed. This is particularly the case in countries which are not participants of the ERM,

e.g., Greece, but also in countries which have joined recently, e.g., U.K. Spain and Portugal and

in some original participants, e.g., Italy. The rates of inflation were quite high in Greece and

Portugal in 1991, 18 per cent and 11.5 per cent respectively, and substantial differences have

characterized the public finances of the EC members. For instance, in 1991 net borrowing in

Greece was more than 15% of GDP and in Italy about 10% of GDP. In 1991 the debt/GDP ratio

was 128% in Belgium, 86% in Greece, 97.4% in Ireland, 103.3% in Italy and 63.8% in Portugal.

Greece also had a serious current account imbalance.

The above studies and data do not offer conclusive evidence that the EMS has disciplined the

monetary and fiscal policies of all its members. Although it is true that inflation rates and interest

rates have dropped in countries of the EMS, the same can be observed worldwide during the

same period. Furthermore, the decline in exchange-rate volatility among EMS countries cannot

be declared as being only positive: surely it reduces uncertainty and promotes stability but fixed

exchange rates may create trade distortions and also, as Willett (1988) points out, are just not

workable among countries that insist on maintaining highly divergent monetary and fiscal

policies.

Finally, because among the 12 EC countries, Spain and the United Kingdom joined the ERM

later than others, on June 20, 1989 and on October 8, 1990 respectively and Portugal on April 6,

1991 and Greece has remained outside the ERM, whatever results exist can only be viewed as

tentative and certainly not all inclusive.


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An uncertain picture has also characterized the implementation of the Maastricht treaty. Between

December 1991 when the Maastricht summit was held and September 1993 several important

developments have taken place. First, the Danes on June 2, 1992 narrowly rejected the Treaty

while the Irish approved it on June 18, 1992. In France, renewed populism induced the French

President to hold a referendum which turned out in support of the Treaty by a very narrow

margin. In May 1993, the Danes tried again and this time approved the Treaty. To date a total of

eleven countries have ratified the Treaty. These are Belgium, France, Greece, Luxembourg,

Ireland, Italy, Portugal, Spain, United Kingdom, Netherlands and Denmark. Germany is the only

country which, because of constitutional objections, has not ratified the Treaty yet.

Moreover, Germany's insistence on tight monetary policies to fight inflation resulting from

unification costs has brought major turmoil inEuropean financial markets and has dealt a serious

blow to theEuropeanmonetarysystem in general, and the British, Spanish and Italian currencies

in particular. As a result, the British pound and the Italian lira have been driven out of the ERM

and the Spanish peseta has been devalued. It must also be noted that in 1993 the EC has

experienced its worst recession in many years. Because of this recession, countries with large

debts will be unable to meet the Maastricht Treaty criteria.

Most recently, the widening of the fluctuation of bands in the ERM from 2.25% to 15% either

way has been interpreted by the Euro-skeptics as the abandonment of the ERM and of the goalfor a single currency. Waiters (1988) also argues that if the ultimate objective is the monetary

integration of Europe through anEuropean Central Bank in a single currency area, then the EMS

seems to be hardly a step in the right direction. It creates too many tensions, both economic and

political. On the other hand, the Euro-idealists claim that recent developments are only

temporary and that a drop in German interest rates will bring about a return to the narrow bands

soon. Finally, another view by Kondonassis (1989) suggests that "Europe, notwithstanding its

dynamism and the progress it has made toward integration, may have to be satisfied with a half

loaf rather than a full one."

Monetary Integration was not listed as one of the primary goals of the Treaty of Rome, which

established the European Community in 1958. Since then monetary integration has received


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periodic attention often as a result of financial crises. In recent years, it has evolved into a major

aim of the EC.

To achieve this goal, the European Monetary System (EMS) was established in 1979. The EMS

facilitates the interdependence of European economies by providing a tool for exchange rate

stabilization and for encouraging convergence of economic and monetary policies. This tool is

the Exchange Rate Mechanism (ERM). To give further impetus to the goal of monetary

integration the Maastricht Treaty was approved in December 1991, It provides for fixed

exchange rates and a single currency by January 1, 1999.

Experiences with the operation of the EMS to date show that there is no conclusive evidence that

the EMS has disciplined the monetary and fiscal policies of all its members. More recently,

Germany's insistence on tight monetary policies to fight inflation resulting from unification costs

has brought major turmoil in European financial markets and has dealt a serious blow to the

EMS. Furthermore, the ensuing recession and its impact on the European economies make

improbable that the timetable of the Maastricht Treaty will be met. A two-speed Europe is a

possibility.

Conclusive Summary: EMU: Theory, History and Consequences

Four Levels of Economic Integration:

1. Preferential trade arrangements in which member countries accord each other low tariffrates for imports while all others (outside the agreement) continue to face higher tariffs.

2. A free trade area (FTA). This abolishes tariffs between member countries while stillmaintaining a tariff vis--vis all third member countries.

3. Harmonization of external tariffs (to third party countries) while still maintaining theirFTA amongst themselves

4. A common market amongst member states which combines market integration withabsolute factor mobility (capital and labor mobility). This stage may additionally include

monetary union to ensure complete factor mobility (some argue that this last stage is

essential for the completion of a true single market)


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Costs and Benefits of EMU

Costs:

Loss of national sovereignty (including much national symbolism) Monetary Union may promote further political integration as well as economic

integration and thus constitutes still a further loss of national sovereignty and stronger

supranational institutions.

Loss of control over monetary policy means member states will be unable to usemonetary policy as a means to control internal or divergent economic difficulties (high

inflation or unemployment).

Benefits:

Lower transaction costs between member states. No longer a need to exchangecurrencies, no exchange rate commissions and no need to insure against currency

fluctuations.

A more efficient market. Reduces the possibility for price inequalities of same goods,minimizes need for monitoring of price inequalities. Promotes market integration.

Greater economic certainty. Prices and revenues are more stable and this improves thequality of production, investment and consumption decisions.

Lower interest rates. Exchange rate stability is assured and this leads to lower interestrates overall (because no need for risk premiums).

The History of economic integration in the EU leading to the EMU

European Coal and Steel Community (ECSC)-1951 European Economic Community (EEC)-1957 Warner Plan-1970 The Snake-1971 The European Monetary System (EMS) and The Exchange Rate

Mechanism (ERM)-1979


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Single European Act (SEA) and the Single Market-1985 Delors Committee - Completing the Single Market-1989 Maastricht Treaty-1992

European Monetary Union

The Three Stages to EMU:

Stage 1 began in July 1990 and called for the elimination of exchange controls and most

restrictions on capital movement. It also called for better coordination of national economic

policies and the intensification of central ban coordination among the Member States. It was

during this first stage that the Maastricht Treaty was signed and the criteria for entry into

stage 3 were set.

Stage 2 was devised as a transition step between stage 1 and the irrevocable locking of exchange

rates (full EMU). It began as scheduled in July 1994. The main elements of stage 2 were to

create closer policy cooperation and devise multi-annual programs to reduce inflation and

budget deficits. To this end the European Monetary Institute (EMI) was created.

Stage 3 initiated the irrevocable fixing of exchange rates and the establishment of anindependent European Central Bank with the primary goal of maintaining price stability among

the Member States.

The Convergence Criteria

1. Price Stability: An average inflation rate not exceeding by more than 1.5% that of thethree best-performing Member States.

2. Budgetary Discipline: A budget deficit of less than 3% of GDP and a public debt ratio notexceeding 60% of GDP.

3. Currency Stability: Respect for normal fluctuation margins of the ERM without severetensions for at least two years with no devaluations.


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4. Interest Rate Convergence: An average nominal long-term interest rate not exceeding bymore than 2% that of the three best performing Member States.

The Institutions of EMU

The European Monetary Institute (EMI):

The predecessor to the European Central Bank. It was established by the Treaty on European

Union (Maastricht Treaty) to assist the member states in moving from stage 2 to stage three on

the road towards monetary union. It was formally established on January 1 1994 at the beginning

of stage 2 in Frankfurt

The European Central Bank (ECB) and European System of Central Banks (ESCB):

These are the primary independent economic institutions of European Monetary Union. The over

arching goal of both institutions is the maintenance of price stability.

The Council of Economic and Finance Ministers (EcoFin):

Consists of all of the Economic and Finance ministers of the EU Member States (regardless of

membership in the Euro-zone).

The Euro-X committee:

Refers to the meeting of the Ministers of the Economy and Finance of the Euro-Zone countries

only.

Ins and Outs

Ins

On January 1, 1999 11 Member States successfully joined the Euro-zone: France, Italy,

Germany, Belgium, The Netherlands, Luxembourg, Ireland, Portugal, Spain, Austria and

Finland.

Outs


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Denmark and Great Britain decided to make use of their opt -outs as specified in the Maastricht

Treaty and did not attempt to join the Eurozone. Greece tried to join but fell short of the

convergence criteria. Greece was then admitted officially as of January 1, 2001. Sweden fell

short of the convergence criteria but only because there has been no real attempt on the part of

the Swedish government to meet them. Since they were not members of the EU when the

Maastricht Treaty was created they did not have specific opt-out options and chose instead to

simply wait by not achieving the criteria.

---

The impact of the 2008 crisis on the Euro Zone Economy & the debt

crisis theory:

With the Eurozone having moved into recession faster than elsewhere and some member

countries severely hit by the impact of the credit crunch, there are mounting concerns about a

possible debt default by one or more member states, which in turn might threaten the existence

of the Eurozone. This article examines the current economic strains within the Euro area and

considers whether these factors, which might deter some EU members from joining, could

ultimately lead to a breakdown in the euro.

Recession revives longstanding tension points

Ten years after the euro was introduced, the onset of deep recession in the Eurozone has

triggered concern that the single currency might impose intolerable strains upon some members,

leading to speculation that default is possible in one or more states and that some may ultimately

consider exiting the euro. Use of the common currency meant that more vulnerable members

such as Ireland and Greece were spared the run on their currencies that hit countries like Iceland

during the financial crisis. But despite absence of exchange rate risk, the deepening recession is

bringing to the surface the economic tensions that some had predicted would inevitably arise at

some stage from the one-size-fits-all constraint of monetary and fiscal policy under a single

currency. This in turn has resulted in mounting social tensions in some countries, leading to

downward pressure on the euro as investors speculate about a possible fracture in the Eurozone.


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With the Eurozone economy now forecast to contract by 3.1% this year and only a very sluggish

recovery seen in 2010, unemployment is set to climb steeply and fiscal deficits will soar, partly

as a result of higher social spending in the downturn and partly because of the large banking

bailouts and fiscal stimulus packages that are being implemented by member states. This

pressure on public spending has raised concerns about deteriorating public finances in a number

of countriesin particular the southern states such as Greece, Spain, Portugal and Italy, together

with Ireland. In turn, this has led to credit rating downgrades for Greece (to A), Spain (to AA+)

and Portugal (to A+), with Ireland probably facing a similar fate soon. Standard & Poors has

suggested that the global economic crisis has highlighted structural weaknesses that are

inconsistent with the near triple-A rating accorded to Eurozone economies. Government bond

spreads in these countries have widened sharply in recent months Greek 10-year bond yields

rose to 308 basis points over German bunds in February, the highest since the launch of the euro,

before easing somewhat, while Irish bond yields are 270 basis points over bunds.

As economies weaken and inflation rapidly heads towards zero, with deflation possible in the

coming months, governments in some countries face a very difficult period. Under the Stability

and Growth Pact, countries are able to run fiscal deficits of over 3% of GDP in exceptional

circumstances and most of them are likely to exceed this target in the next two years. Butpolitical pressures demand stronger action, and hence higher deficits. Single currency rules do

not permit the printing of money, so governments in some countries now face the prospect of

having to pay high real rates of interest on new borrowing to fund the extra spending, which in

turn will exacerbate the pressures on public finances. This has raised fears of possible default by

one or more member states, also raising question marks about whether some might exit the euro


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either of these eventualities would cast considerable doubt over the credibility of the single

currency. This in turn has led to a sharp widening of credit default swap premia the price

investors have to pay to insure against the risk of default on a countrys debt. These have risen

steeply for those Eurozone countries most exposed, such as Ireland and Greece, but the most

striking change has been shown by Austria, where CDS spreads have risen to 230bp compared

with just 100bp in mid-January and around 10bp a year ago as a result of its banks exposure to

increasingly troubled countries in Central and Eastern Europe.

But although the situation is worrying, it is worth remembering that changes in bond yields were

always intended to be the mechanism that would limit public spending in the more profligate

countries. The fact that bond yields in most countries in 2003-07 had converged to (or in some

cases like Ireland gone below) German bunds, the benchmark for the Eurozone, did not reflect

economic reality given the relative economic strengths of the member states. The markets had

become increasingly complacent about potential problems in recent years, but the depth of the

downturn now under way has highlighted the underlying weaknesses of some economies. And

these problems are being exacerbated by the deepening crisis in Central and Eastern Europe

(CEE), which have been hit by the downturn in demand for their exports to the main Eurozone

economies and the drying up of credit lines, in turn making it difficult to roll over short-term

debt falling due. It seems very likely that the deepening problems in the CEE region will have a

major impact on banks in some Eurozone countries, with Austria in particular (with its banks

exposure to the CEE equal to 75% of GDP), Belgium, Sweden and the Netherlands the most

vulnerable.


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20

The cornerstone of the Eurozone against which all other countries have to be judged is, of

course, Germany. And being the largest member, the German economy, along with that of

France, tends to dictate the course of both fiscal and monetary policy, as well as the speed of

policy response to economic developments. One result of this was that, as recently as July last

year the ECB was still raising interest rates in order to combat above-target inflation, almost a

year after the US had started its easing policy this probably contributed to the surprising speed

of the Eurozones descent into recession. The question now is whether the Eurozone economies

can withstand the strains that the period of deep recession will impose, or whether some will

succumb to the pressure and move towards default or be tempted to withdraw from the euro in

order to regain the option of currency devaluation the method of combating downturns

traditionally used by countries such as Italy, Spain and Greece (and of course the UK) that have

suffered a serious loss of competitiveness. At the heart of this debate will be the strengths and

structures of the member states economies, their fiscal and current account balances and their

levels of indebtedness. These relative strengths will have a major bearing on which countries are

best able to both withstand the fiscal squeeze that is coming and adopt credible medium-term

spending plans. Yet equally importantly, the need for fiscal stringency will test political

commitment to the single currency, especially in Greece and Ireland, where there have beenpolitical tensions in recent months. A protracted slump would inevitably undermine the currently

strong public support for the euro.

Sharply higher deficits and debt ratios


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21

The period of slower growth will inevitably mean lower tax revenues and higher spending on

social welfare. At the same time, most governments are implementing rescue packages for the

banks and introducing fiscal stimulus programs to mitigate the impact of recession. As a result,

budget deficits are set to rise above the Maastricht target of 3% of GDP in some cases well

above the target. Ireland, for example, will see its deficit in double digits as a % of GDP, perhaps

as high as 13% and for several years, as its revenues are falling by around 20% on a year ago,

and Spain is likely to run a deficit of over 6.5% of GDP. Italys deficit is heading above 5.5%

and, given their weak economies, deficits in Greece and Portugal will be rising towards 5%.

Even Germany is now expected to post a deficit of just 4.5% in 2010, after exceeding the 3%

target this year. Rising fiscal deficits will in turn result in higher levels of debt, which in some

countries has remained well above the Eurozone target of 60% of GDP for many years. Italys

debt, for example, could be equal to 110% of GDP this year, Belgiums is likely to be back up to

around 90% of GDP and Greece could see a ratio of close to 100% of GDP. All these levels

would be well above the Eurozone average of about 70%. In contrast, Germanys debt/GDP level

is significantly lower, albeit it is forecast to rise towards 70% of GDP this year from 65% in

2008, while France is expected to be posting slightly higher levels of close to 70%. Interestingly,

Irelands debt/GDP ratio was only around 30% in 2008, but this is likely to climb steeply to well

over 40% in the next few years.

At the same time, a number of Eurozone countries are running very large current account

deficits, which are a reflection of years of loss of competitiveness. Spain, for example, posted

deficits of around 10% of GDP in the last two years, the third highest deficit in the world in cash


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22

terms after the US and the UK, and Greeces deficit is close to 15% of GDP. Although the

adoption of the single currency eliminated any immediate currency risk for those member states

running large external deficits, there are clear medium- to long-term risks from falling exports,

heavy job losses and shifting patterns of investment, in turn leading to mounting social and

political pressures.

There have already been protests about the mounting economic problems on a significant scale in

Greece and Ireland, and these can be expected to escalate as the problems intensify over the next

year. A weaker euro would help, but only with regard to exports to non-Eurozone countries

competitiveness of these countries would still lag within the Eurozone, making it a difficult and

slow process for them to restore positive growth. With the previous option of currency

depreciation no longer available, the way to improve competitiveness for countries such as

Spain, Greece, Portugal and Ireland is either via faster productivity growth, which will probably

take many years to achieve, or lower nominal wages, which will be politically hazardous.

Which countries are most at risk? The biggest debtor countries (as a % of GDP) are Italy and

Greece (both expected to be around 100% of GDP in 2009), and Belgium, followed by France,

Portugal and Germany. Those with the largest current account deficits (again as a % of GDP) are

Greece, Portugal, Spain, Ireland, Belgium and Italy. And in terms of the fiscal accounts, Ireland

(at 13% of GDP in 2009), Spain, France, Italy, Greece and Portugal are expected to run theheaviest budget deficits. Although other factors clearly come into play, on these three measures

alone the countries most at risk are Greece, Ireland, Portugal, Spain and Italy.

The deepening recession will place an even greater focus on these strains over the next year, with

most Eurozone countries facing the depressing prospect of falling GDP, rising public sector

deficits and worsening balance of payments positions. The collapse in growth that is projected

for the period 2008-2011, compared with the preceding four-year period, will put an increasing

strain on government finances, with tax revenues plunging and unemployment and socialspending climbing, thereby further pushing up deficits in the absence of new measures to boost

revenues.


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23

With monetary policy in the hands of the ECB and hence unable to match the needs of all zone

members, the recent sharp rise in international borrowing costs facing some governments will

exacerbate fears of possible default given their inability to inflate away public debt or to finance

budget deficits via the issue of additional currency. In these circumstances, the strong political

commitment to the euro that has been evident for the past decade will inevitably come under

scrutiny in some countries, especially as levels of unemployment start to climb more rapidly and

long-term borrowing rates remain high.

However, although the situation appears bleak, it is important to put recent events into

perspective. The market response to the rising tensions has seen bond spreads widen quite

sharply, but in historical terms the move has been quite small. Back in the mid-1990s, when

there were fears that the Italian lira would break from the European Monetary System because of

its domestic problems, the spread on Italian bonds over German bunds rose to some 600-700

basis points, way in excess of current spreads even for Greek bonds. And as noted earlier, rising

bond spreads were always intended to be the main method by which Eurozone governments

would be punished forfailing to consolidate their public finances during the years of favorable

economic performance. Moreover, long- term rates are still relatively low in an historical context

for example, the current yield on Spanish 10-years bonds is around 4.2%, compared with the

average of 4.4% for the last ten yearsand nor are they yet at particularly onerous levels in real

terms. Belgian 10-year yields are significantly lower than they were back in the 1990s, when its

government was striving to bring down its deficit and debt levels in order to qualify for the

single currency.


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24

As a result, the current situation is not as dire as some commentators have suggested the real

issue is whether the current economic downturn proves to be prolonged. In the near term, even

the worst hit of the peripheral Eurozone members such as Greece and Ireland should be able to

withstand the pressures of higher borrowing costs, as long as the EU Commission accepts that

the current situation will lead to members overshooting the Maastricht targets by quite a large

margin and for quite some years. In the near term, no country appears to be in any danger of

imminent default indeed, any default would more likely be the result of a loss of market

confidence following a political decision to leave the single currency. Yet there is no evidence of

any move in this direction. Any move by a member country to exit the currency zone would be

seen by the markets as a sign of serious weakness, which in turn would accelerate and exacerbate

the problems that the move was designed to avoid.

and the Eurozone remains united for now

Furthermore, rather than Eurozone numbers dwindling, the EBRD has indicated that some of the

recent EU entrants are likely to want to join the euro soon, as inflation moves rapidly lower

despite recent sharp plunges in their currencies. Notwithstanding the outward signs of stresswithin the Eurozone, those countries that have fixed their currencies against the euro under the

ERM-II arrangement are anxious to join as soon possible in these states, there has been

substantial external borrowing in Euros and the threat of a forced currency devaluation could

spell real trouble, in terms of debt servicing, for both the public and private sectors. But given the


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25

signs of potential financial problems with existing members, it is questionable whether the

Eurozone would welcome new participants until the situation settles.

At this stage, talk of countries defaulting or a break-up of the euro appears alarmist and well

wide of the mark. Any country that was in any real danger of default would certainly not even

contemplate exiting the euro in addition to a debt crisis, such a move would almost inevitably

result in a currency slide and a banking sector crisis as Euros shift out of the country. One of the

underlying reasons for joining the single currency in the first place was to benefit from the

stability offered by currency union one of these benefits would be the support of other

members at times of crisis. And this is what would happen in the unlikely event of one or a

number of the smaller countries threatening to default on its debt; other member states would

step in to bail out the potential defaulter. For example, it would cost just 0.6% of German GDP

to cover Irelands projected 2009 budget deficit.

Even though the core members such as Germany, France and the Netherlands might be reluctant

to go down this path, failure to do so would inevitably lead to contagion, spreading default to

other countries and bringing down banks and financial institutions throughout Europe, wreaking

incalculable havoc. Inaction would not be an option in such circumstances. But Germany has

made it clear that any EU bailouts of member states facing difficulty would be only as a last

resort and would come attached with tough conditions, along the lines of previous IMF packages.

For example, Ireland might be forced to raise its currently low corporate tax rates, which in the

past attracted large inflows of foreign investment. There is a strong feeling in Germany that some

countries now facing difficulties have been living beyond their means in recent years, relying

upon the growth of credit and borrowing to finance GDP growth rather than solid expansion of

productive capacity. The German government is clearly very reluctant to ask its taxpayers to foot

the bill to help such countries unless more prudent policies are adopted.

with more policy action likely

What form might this support action take? Firstly, there is likely to be greater coordinated fiscal

measures to try to get the economy going again. The fiscal packages announced so far equal to

about 1.7% of GDP are well below of the scale of programs announced in the US and

elsewhere. And there is also scope for further monetary easing by the ECB. Although the ECB


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26

was slow to start cutting ratesand even slower to recognize the scale of the mounting threats to

the Eurozone economy its benchmark refine rate is now down to 1.5%. The ECB has been

wary about bringing rates down too rapidly (although they are now below the 2% seen in the

aftermath of the dotcom bust), but further cuts seem likely as the recession bites; we expect rates

to fall to 1% later this year. And there is increasing talk of a need for quantitative easing

essentially expanding the money supply by creating money to buy assets which is already

under way in the US and appears likely in the UK and Japan. Yet the ECB will be cautious about

proceeding down this route. One such unconventional method of monetary stimulus would be

for the ECB to buy up government bonds of member countries, specifically those facing

financial problems.

Although the Maastricht Treaty appears to prevent the ECB from making direct purchase of

member government debt, it is allowed to operate freely in the financial markets, buying or

selling assets or by lending or borrowing claims and marketable instruments. And the possibility

of financial losses incurred by the ECB resulting from possible monetary policy stimulus is

explicitly covered by the treaty in this event, the ECBs general reserve fund can be tapped

and, if this is insufficient, then national central banks have to step in. Eurozone member central

banks are ECB shareholders, and profits, as well as losses, are distributed according to a scale

based on GDP and population. In any event, national governments can be lenders of last resort

through their ownership of national central banks, or they can back the ECB against losses by

direct capital injections.

Although some ECB governing council members may have some misgivings about such a course

of action, there are others who favor more aggressive policy measures in order to try to ward off

the risks. Acquisition of private sector debt by the ECB could be more contentious, given the

potential losses for the ECB in holding such debt.

Unlike the US, the UK and Japan, where the national governments stand behind the centralbanks, the ultimate financial backing for any ECB losses is less clear. These issues highlight the

complex nature of the Eurozone, in terms of control over fiscal and monetary policy and the

independence of individual member states.


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27

The response of Germany, France and other core Eurozone members to the threat of default in

other countries will obviously be critical. But, as argued above, there can be little doubt that they

would respond to crises in a number of the smaller countries that threatened the euro. And in

financial terms, the larger countries would certainly be able to bail out the smaller members, with

the IMF also likely to weigh in with its support.

But what would happen in the event that the recession proves much more prolonged than

currently envisaged and the threat of default spreads to a number of larger Eurozone countries

such as Italy and Spain? In this situation, the ability and, more importantly, the willingness of the

major countries to stave off default would be called into question. But prior to this, it is very

likely that there would have been further developments affecting the operation of the single

currency. Indeed, if the situation appeared to pose a risk to the whole of the Eurozone, then it

seems likely that the single currency could begin to unravel. This in turn would spark widespread

panic in financial markets, depreciation of newly reissued national currencies, sharply higher

spreads among the weaker European countries and a further flight of capital to the US dollar,

adding to the woes facing Europe. The chances of this happening are slim, but given the train of

events over the past 18 months it cannot be ruled out completely.

and Germanys role will be key

And there remains an underlying concern about the role of Germany within the monetary union,

given its inability/unwillingness to boost domestic demand sufficiently to curb its large current

account surplus, which in effect is exporting unemployment to other less competitive Eurozone

countries. Although it is prepared to tolerate a budget deficit for now, it is talking of returning to

a surplus as soon as possible. While its surplus is still perhaps not perceived to be a problem in

Germany itself, it nevertheless poses one of the fundamental strains for the weaker members that

will continue to cast a shadow over the Eurozones long -term viability. However, in return for

more expansive domestic policy in order to assist with rebalancing the Eurozone economy,Germany would probably demand more prudent fiscal policy from other member states in the

future. This would involve countries running higher budget surpluses in the good times in order

to leave them in a better state to handle crisis periods such as is being experienced at the

moment. It is clear that the improvement in public finances during the 1990s, which entailed


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tough policy decisions by a number of countries, have not really been followed through during

the easier years of the last decade.

In the current situation, for those countries facing the worst problems, such as Greece, Portugal

and Spain, stabilizing GDP growth will mean much bigger public deficits as an offset to the

expected retrenchment as the private sector tries to move back into financial surplus. One

solution to this would be for Germany to run asignificantly higher public deficit, which in turn

would mean a lower current account surplus, as this would allow other Eurozone countries to see

an improvement in their net trade positions. Germanys reluctance to go down this route, while

understandable from a domestic standpoint, is less tenable given its lead role in the Eurozone as

it makes other member countries growth rates lower than they need to be and aggravates

tensions noted above.

Using the Oxford Economics model, the following table shows the scale of additional public

spending, and hence the size of budget deficit, that Germany might be faced with if it were to

boost its domestic demand growth sufficient to offset the lower growth rates elsewhere implied

by other smaller member countries reining back their public spending. The Eurozone GDP

growth rate is broadly unchanged from our base forecast, but German GDP falls only slightly in

2009 before recovering quite strongly in 2010-11 as it expands government spending by 5% of

GDP. But its growth prospects for 2012 onwards are weakened as it then has to tighten fiscal

policy sharply to bring its budget deficit under control. Under this scenario, the fiscal expansion

required to support Eurozone growth and enable other members to bring down their deficits

closer to the Maastricht goal of 3% of GDP would see the German budget deficit rise to about


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29

8% of GDP in 2010-11. At the same time, less expansionary fiscal policy in other countries

would see much weaker GDP results, with Ireland for example posting a double-digit GDP

decline this year and Italys GDP contracting by just over 6.5% although the subsequent

recoveries would be stronger.

But it seems highly unlikely that the German government would be willing to countenance

budget deficits as high as 8% of GDP in order to support growth in the Eurozone and help othermember countries run lower fiscal deficits. The memories of the cost of German re-unification

and pledges not to repeat this burden on taxpayers will make the government reluctant to run a

deficit much higher than the level of around 4.5% of GDP that is currently expected for 2010.

Equally, it is difficult to envisage governments in countries such as Ireland and Italy agreeing to

curb public spending to get their deficits back down towards 3% of GDP if this were to result in

such steep declines in GDP and accompanying hefty rises in unemployment.

Slower growth over the next 10 years

In conclusion, the current situation facing the Eurozone is undoubtedly severe, but our forecasts

showing growth beginning to recover in 2010 should mean that the deficit and debt problems

should remain manageable for most member countries. The more robust the recovery, when it

comes, the lower the risks facing the Eurozone economies, although at this stage there is an

increasing danger that the recovery may take longer to emerge than we currently expect.

But even if the recovery does start later this year, the combination of banking bailouts, fiscal

packages and possible financial support for troubled member states will impose a heavy fiscal

burden for the next four or five years. This implies a long hard slog for many countries as they

try to return to the path of fiscal rectitude. And monetary policy is almost certainly going to have

to be tighter than currently envisaged as the authorities reverse the recent and ongoing sharp

monetary relaxation in order to ward off the threat of a possible pick-up in inflation in the years


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30

ahead. Together with slower growth in the emerging markets over the next couple of years, this

almost certainly means that trend GDP growth in the Eurozone is going to be below the pace

seen in the last ten years or so.

In the event that the recession proves more prolonged than we expect, with GDP falling for next

two years and deflation threatening to take hold, which could jeopardize the prospects of some of

the larger Eurozone countries, then the implications for the euro would be much more fraught.

The political commitment to the euro project would be called into doubt and, even if there were

to be a move to a narrower currency union based around the core countries where deficits, debt

and debt spreads are more closely correlated, it is questionable whether a new arrangement could

survive given the likely political, economic and financial pressures that would ensue.

In these circumstances, one alternative to the threat of a break-up of the single currency area

might be a move to fiscal federalismcentralized fiscal policywhich would reduce the risk of

member countries going into default. The head of the IMF has suggested that the euro could

prove unworkable unless member states surrender some control over fiscal policy. Currently, this

is clearly not politically acceptable to most countries, but the concept may gain support if the

next few years prove increasingly difficult. Indeed, it can readily be argued that this is a natural

progression from centralized monetary policy control.

====================


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2. Artis, Michael J. (1987), "The EuropeanMonetarySystem: An Evaluation," Journal of Policy Making, 9,175-98.

3. Coffey, Peter, ed. (1991), Main Economic Policy Areas of the EEC Toward 1992, Third Revised Edition,Kluwer Academic Publishers, Dordrecht, Netherlands.

4. Deravi, M. Keivan and Massoud Metghalchi, (1988), "The EuropeanMonetarySystem: A Note", Journalof Banking & Finance, 12, 505-12.

5. Fratianni, Michele (1988), "The EuropeanMonetarySystem: How well Has it Worked?", Cato Journal,8, 477-501.

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7. Ungerer, H., et at., (1986), The EuropeanMonetarySystem: Recent Developments, IMF OccasionalPaper #48, Dec.

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10.The volatility impact of the European monetary system on member and non-member currenciesMICHAEL Y. HU*, CHRISTINE X. JIANGz and CHRISTOS TSOUKALAS Graduate School ofManagement, College of Business Administration, Kent State University, Kent, Ohio 44242-0001, USA,Department of Finance, Insurance and Real Estate, Fogelman College of Business and Economics,University of Memphis Memphis, TN 38152, USA, and m-Tier Consulting, Inc. 6 Linden Street, PortChester New York 10573, USA.

11.European Monetary Union: Theory, History and Consequences Prof. Amie Kreppel Dept. PoliticalScience, University of Florida, Box 117325, Gainesville Fl. 32611-7325

12. Euro Zone Unity Under Threat Oxford Economics website.http://docs.google.com/viewer?a=v&q=cache:KgTPebnDFiEJ:www.ciaonet.org/wps/oef/0017692/f_0017692_15171.pdf+

The+impact+of+the+2008+crisis+on+the+Euro+Zone+Economy&hl=en&gl=eg&pid=bl&srcid=ADGEESjN-sERe4YklRQKVfyrTGJDFiak2e9sMUjpA-QjtaXYv3TNBxHcVc2Hx3XxNzm0Gub2-yHoIytWdUDPnChFOP_5fX_ld0R5idTsTCLTW2MtRe7G5zN44rLYnkPCyDLbQkeolSrW&sig=AHIEtbQDJj1WRNG_DnAXOfny6

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