xperience to Date Paul van den Noord Economics

xperience to Date Paul van den Noord Economics Department OECD 1

Monetary union in Europe: progress and headwinds n n n 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 2

The beauty contest n n n 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. . 3

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“Start-up shocks” worked out favourably for the smaller countries n n n 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. 5

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Macroeconomic management more challenging in euro area if. . . n n n 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 8

monetary union will reduce asymmetries n n n 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 9

Fiscal co-ordination is essential n n n Spillovers result in high interest rates elsewhere Automatic stabilisers are sorely needed in the face of asymmetric shocks Fiscal sustainability must be safeguarded 10

The longer term: integration will lead to three possible scenarios n n n 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) 11

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To sum up n n n 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) 14