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In identifying the macroeconomic impact of EMU, it is important to take note of the fact that European monetary union occurred in the context of other structural changes in the world economy over the last decade. This chapter begins with an overview of these developments. Against this background, developments in the euro area are interpreted. The role of balance of payments deficits and internal euro-area imbalances are examined in Sections 5.2 and 5.3 respectively. The role of EU financial regulation is discussed in Section 5.4 while Section 5.5 reviews the performance of the Stability and Growth Pact (SGP) in guiding fiscal policy in the EU. The critical role of structural reform in addressing the challenges of the European economy is discussed in Section 5.6. The impact of the euro on European identity is considered in Section 5.7, while finally Section 5.8 examines the issue of intra-EU exchange rate policy.
5.1 Structural Change in the World Economy
Structural changes in the world financial system are described by Lane (2010b). Key developments in the world economy in the decade prior to EMU include the growth in world trade and a massive increase in cross-border financial positions, the emerging market economies’ increased share in world trade and output, the integration of Central and Eastern European economies into the EU and major global shocks such as the collapse of the technology bubble in 2000-2001, the attacks of 9/11, sharp fluctuations in commodity prices (around an upwards trend) and, more recently, the global financial crisis.
It is useful to divide the period since the formation of EMU in 1999 into three distinct phases. First, the transition from multiple currencies to a monetary union represented a major macroeconomic shift and this played out over 1999-2002. In addition, that period included the collapse of the technology bubble, the recession brought on by 9/11 and the major depreciation of the euro against the dollar. The second phase, from 2003 to 2007 was marked by highly-liquid conditions in global financial markets, generating rapid growth in the balance sheets of many financial intermediaries, a surge in cross-border capital flows and significant downward pressure on long-term real interest rates. World capital markets were awash with liquidity during this period. Financial intermediaries searched for yield by taking on additional risk in areas such as sub-prime mortgages, low-grade corporate debt and sovereign debt. In addition, it was believed that innovations in the securitisation process enabled a superior re-allocation of risk, thereby expanding the range of eligible borrowers and target leverage ratios for financial intermediaries.
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The shift in financial markets contributed to increased dispersion and persistence in current account balances. Most obviously, the US current account deficit expanded, with an increase share of the funding sourced from emerging Asia and oil exporters. While Europe collectively did not run a significant external imbalance, very large surpluses in countries such as Germany, Switzerland and Sweden were offset by large deficits in the periphery of the euro area (Ireland, Spain, Portugal, and Greece), Central and Eastern Europe and financial innovators such as Iceland and the United Kingdom.
The third phase began in summer 2007 and is still ongoing. This phase has been dominated by the global financial crisis and the onset of a major global recession. With the global recession there has been a reduction in global financial imbalances. If a global economic recovery is to be sustainable there is a need to finds ways of preventing the re-emergence of comparable global financial imbalances and more effective regulation of global finance. This is a huge challenge as the global institutional arrangements to address these issues on a global scale are fragile (see Chapter 8).
5.2 The Role of Balance of Payments Deficits
While much of the current focus is centred on public debt, the current problems only partly have their origins in the public finances. There are many differences across the peripheral European countries that now have public finance problems, but a common feature of these economies during the years prior to the economic crisis was high capital inflows and associated high current account deficits (see Figure 4.4). In the case of both Ireland and Spain, the current account deficits were essentially due to private financial deficits (i.e., a high level of private investment well in excess of savings) with the public finances close to balance or in surplus. These large private financial deficits for Ireland and Spain in 2007 are shown in Figure 5.1. Greece and Portugal had both government deficits and balance of payments deficits; indeed, the balance of payments deficits were substantially higher than the government deficits, signifying that these economies also had private financial deficits. All of these countries experienced reductions in interest rates on joining EMU and the ease of financing in the euro area facilitated both private and public borrowing. These economies all experienced a loss of cost competitiveness over the past decade.
A country’s balance of payments is equal to the gap between national savings (comprehensively defined to include government, corporate and household savings) and investment (private and public). In the case of both Ireland and Spain, national savings have been at similar rates to the euro-area average. The balance of payments deficits arose in these countries on account of exceptionally high levels of investment, particularly in construction (see Table 5.1). By contrast, in the case of Greece and Portugal, investment rates were comparable to the euro-area average. The balance of payments deficits arose because of below average rates of saving. An analysis by the OECD examined the factors behind the increase in the balance of payments deficits in Greece and Portugal between the periods 1990- 98 and 2007-08. In both cases the analysis found that the rise in the deficit was mainly due to a fall in transfers, both EU transfers and emigrant remittances.
Figure5.1