Fiscal and Monetary Policy in the Eurozone

Theoretical Concepts and Empirical Evidence

Rosaria Rita Canale, Rajmund Mirdala

• Publisher: Emerald Publishing Limited
• Year: 2019
• ISBN:
  9781787439818
• Topic: Commerce
• Subtopic: Commerce Général

Following the 2008 financial crisis, the Eurozone faced a major challenge to many of its most widely held beliefs around both short- and long-term economic policy. Contrary to what had been the received wisdom, it suddenly became clear that financial institutions can fail, that low interest rates are often unable to stimulate the economy, that the unemployment gap is still very large, and that external and internal imbalances are becoming more entrenched. Such sudden revelations left economists grasping for answers.
Rosaria Rita Canale and Rajmund Mirdala outline the economic orthodoxies that led to such massive blind spots, and they shed light on the emerging paradigms that continue to struggle to offer convincing frameworks that address what happened and what to do next. They show how dominant economic theories led to a progressive devaluing of the idea that coordinated economic policy offers an effective way of maintaining macroeconomic equilibrium, and they illustrate how the new economic environment calls for a new role for economic policy, one that allows for a more maneuverable monetary policy and a more active fiscal policy. What they ultimately suggest is that this renewed framework of cooperation among policy instruments would require a general rethinking of the political equilibria within the Eurozone, as a stable economic environment cannot be maintained at the expense of particular countries.
For its systematic analyses of the economic policy framework of the Eurozone, and for the rigor of its critiques of current ideas about how to move forward, Fiscal and Monetary Policy in the Eurozone is essential reading for postgraduate students of economics, and it is of keen interest to researchers, policymakers, journalists, and financial strategists.

Chapter 1

The Policy Framework in the Eurozone

Abstract

In this chapter, the historical and theoretical evolution of the policy framework in Europe is presented. It begins from the early steps guided by the general principles of the Keynesian theory in open economies, goes through its revision after the 1970s and the fall of the Bretton Woods agreements, the creation of the European monetary system, and ends with a presentation of the theoretical underpinning that brought to the model on which the European monetary union was built on. The evolution of the economic theory is pieced together, in the light of the main historical and political facts that occurred. A first insight about the flaws of the Eurozone policy framework is provided.

Keywords: Europe; ERM; policy theory; Keynesian theory; New Macroeconomic consensus; Eurozone

1.1. The European Monetary Union: Historical Roots and Recent Events

It is difficult to identify a delimited period leading to the birth of the European Monetary Union (EMU) in 1999 and to the adoption of the single supranational currency, the Euro. The first official acts expressing wills and strategies to pursue concrete forms of integration among European countries date back to the end of World War II. This period was dominated by two conditions, which had far-reaching implications for economic and political configurations in European countries: (1) the hegemony of the United States over Western economies, and (2) the existence of the Soviet bloc, whose political and economic systems were perceived as a destabilizing phenomenon for market economies.

Both these conditions proved to be the driving forces of the initial integration process, guided by the United States, the new leader in the international economic and political arena. With the aim of expanding their sphere of influence in Europe, the United States supported the postwar recovery with the European Recovery Program, known as the “Marshall Plan.” Funds were conditionally assigned to European countries on the basis of mutual cooperation and a gradual liberalization of their trade. In addition, aid was assigned on a continental basis: this circumstance led European countries to create the CEEC, the Commission of the European Economic Cooperation, with the aim of coordinating the granting and use of funds.

The constraints imposed by the United States were favorably received by a stream of thought known as the Union of European Federalists – among whom the best known are Altiero Spinelli and Robert Schumann – which in the end led to the acceptance – unlike what happened after World War I¹– of the principle of economic strengthening of the German nation.

The prevailing economic paradigm, namely federalism, together with the danger deriving from the potential expansion of the Soviet Union, convinced single governments that national interests could converge into the common project of the European integration. These were the first steps toward the liberalization of all the major economic variables: the goods markets, capital flows, and then the abandonment of national currencies.

In 1952, following the proposal of France’s Foreign Minister Robert Schumann and Jean Monnet, the European Coal and Steel Community was created. France, Germany, Italy, the Netherlands, Belgium, and Luxemburg signed the treaty and delegated to a supranational authority the management of European coal and steel production.²

This first step forward lent increasing speed to the process of integration: in 1957 with the Treaty of Rome, the European Community of Atomic Energy and the European Economic Community (EEC) were created. The former would be short lived due to Member State’s unwillingness to finance additional research; the latter, with the abolition of custom duties, was the first tangible step toward the creation of a single market for goods, labor, and services.

The integration process involving currencies and capital markets followed a more circuitous route. In 1944, with the Bretton Woods agreements, many Western countries adopted the Gold Exchange Standard. National currencies were convertible at a fixed parity in respect to the dollar, which in turn was convertible at a given price into gold. As a result, European currencies were linked by cross rates deriving from their parity with the dollar.³ The main goal was to prevent competitive devaluation and promote economic growth in a coordinated policy environment. The Federal Reserve, due to the large amount of gold owned and to the hegemonic role of the dollar, performed the function of a kind of “Central Bank of many countries.” It was also the moment of the birth of the International Monetary Fund, a kind of “global” financial institution created to finance temporary imbalances in the foreign accounts of single countries. Permanent deviations from the fixed parity were only allowed in the presence of changes in the underlying “fundamentals.”

During the life of the Bretton Woods agreements, despite some realignments along the way (in 1967 the British pound was devalued by about 15%, in 1969 the French currency lost more than 10% of its value, while the German mark was revalued correspondingly), the process of integration was never weakened by the existence of asymmetries. In addition, due to reduced capital mobility among countries, the fixed exchange rate regime was maintained, preserving, at the same time, a certain degree of monetary autonomy.

At the end of the 1960s, the European countries had almost completed their commercial union. However, much still had to be done on the financial and currency side.

In 1971 the Bretton Woods agreement collapsed as a consequence of the United States’ unwillingness to preserve parity with gold. The dollar devalued, strongly modifying the international context in which the European integration process was taking off. A wide-ranging debate started on how to steer a common course and harmonize economic policies in the European countries.

The result was the presentation of the Werner Report, from the name of the President of the Commission who drew it up: it contained a policy prescription and institutional recipes to achieve in the subsequent decade the objective of monetary union. According to the Werner Report, a federal-type political organization had to be created, together with a central bank system to manage the common currency.

The proposals of the Werner Report, although formally accepted by the European Council of Economic and Finance ministers (ECOFIN) in 1971, were never implemented: neither new common institutions nor centralized budgetary policy mechanisms emerged. The lack of acceptance was largely due not only to the unavailability of European countries to implement policy measures that can be, even today, considered to be totally “revolutionary,” but especially to the collapse of the international monetary system. The collapse of the Bretton Woods agreements in 1971 led to a generalized flexibility of the exchange rate of the dollar, to a general increase in international capital mobility and hence to the inability to manage internal monetary policy under fixed exchange rates.

An attempt to preserve monetary coordination in Europe was the European monetary snake, a monetary agreement signed in Basel in 1972 by Belgium, France, Germany, Italy, Luxemburg, and the Netherlands, soon after followed by Denmark, the UK, and Norway. Following this agreement, European currencies fluctuated jointly in respect of the dollar. However, the agreement was short lived due to the rapid exit of Italy and the UK, showing the existence of a tradeoff between monetary policy autonomy and the objective of parity with the German mark.

However, European countries continued to pursue the objective of monetary coordination as it was considered a precondition for further steps toward financial and real integration. The fear of diverging inflation rates and increasing external imbalances lay behind the attempt to coordinate currency policy decisions. In 1978, an in-depth discussion started and in March 1979, the European Monetary System (EMS) entered into force. Its main feature was the fixing of bilateral exchange rates, allowed to fluctuate by ±2.5% around a central parity set as a weighted value of all the currencies involved. A virtual currency – the European Currency Unit (ECU) – was established in order to define the benchmark for divergences. Its exchange rate with each national currency was set on the basis of the weight of each country in European trade. The greater the weight, the greater the power to set the value of the ECU. This feature explains why the EMS experienced the primacy of German monetary policy and its target of stable prices. This objective reduced national inflationary pressures but, at the same time, became a factor of deep instability within currency arrangements. During the period 1979–1987, 11 realignments occurred, defined on the basis of systematically higher inflation rates (De Grauwe, 2005)

The year 1992 saw a profound crisis in the EMS. Two out of 10 currencies involved – the British pound and the Italian lira – abandoned the currency agreements, while the Spanish peseta and the Portuguese escudo experienced severe devaluation. German reunification, occurring in 1990, caused massive capital inflows and strong pressure on the other European currencies. Despite the line of credit and the increase in interest rates by the Italian and British Central Banks, investors remained convinced that a greater Germany would assure greater returns, continuously asking for marks in exchange for other currencies. When the increase in interest rates became too costly for the internal equilibrium, the two countries abandoned the EMS and restored their monetary autonomy.⁴

Despite these centripetal forces, in 1988 the European Council nominated a commission with the aim of providing concrete proposals to build up a monetary union. This Commission, coordinated by the president of the European Commission, Jacques Delors, delivered in 1989 a report known as the Delors Report, containing the policy principles of the coming monetary union. These principles were the building block of the Maastricht Treaty.

The most important contribution of the Delors Report was to define the...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of Figures, Tables
• Preface
• Acknowledgements
• Introduction
• Chapter 1 The Policy Framework in the Eurozone
• Chapter 2 Fiscal Policy in the Eurozone
• Chapter 3 Monetary Policy in the Eurozone
• Chapter 4 Policy Coordination in the Eurozone
• Conclusions
• References
• Index