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Paul van den Noord

Economics Department

OECD

xperience to Date

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Monetary union in Europe: progress and headwinds

Exchange risk disappeared, financial markets deepened, interest rates converged, competition strengthened

The euro system weathered major stress tests (911, the introduction of the cash euro)

But growth has been sluggish, fiscal policies fared less well, the Stability and Growth Pact lost credibility

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The beauty contest

Inflation must be close to best performers Fiscal house in order (deficit 3% of GDP, debt 60% of

GDP) Long term interest rates must be low (close to best

inflation performers) Two years in ERMII But convergence stalled when the euro was

created ....

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“Start-up shocks” worked out favourably for the smaller countries

Interest rate shocks (monetary union meant sharply lower interest rates in some countries with high inflation histories)

Exchange rate shocks (initial misallignments, sharp drop in the euro exchange rate in the first two years)

These shocks produced inflation, low real interest rates and housing booms in small economies.

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Macroeconomic management more challenging in euro area if ...

Countries are frequently hit by “asymmetric shocks” Countries differ in their responses to common shocks Market adjustment to shocks is slo and automatic

fiscal stabilsiers weak

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monetary union will reduce asymmetries

Greater integration of product markets means dilution of shocks

Greater integration of financial markets and diversification of portfolios means dilution of shocks

Risk of asymmetric policy shocks diminishes, risk of asymmetric exchange rate shocks vanishes

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Fiscal co-ordination is essential

Spillovers result in high interest rates elsewhere Automatic stabilisers are sorely needed in the face of

asymmetric shocks Fiscal sustainability must be safeguarded

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The longer term: integration will lead to three possible scenarios

Concentration (US model, mobile labour and capital and stong agglomeration effects); implies strong growth but regional disparity of activity (not income)

Dispersion (Mobile capital, immobile labour, flexible real wages); implies weaker growth but even distribution of activity and income

Polarisation (Mobile capital, immobile labour, rigid real wages); implies strong growth but uneven distribution of activity and income (motivates structural funds)

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To sum up

Start up shocks worked out favourable for the smalls Loss of policy sovereignity may be offset by greater

flexibility and integration Investment opportunities open up in a credible low

inflation environment Integration may carry social adjustment cost due to

specialisation Benefits will be higher if policy settings are right

(strong human capital and technology, flexible markets, fiscal prudence)