Box 2.1 The European Monetary System

sure, language barriers do play a role, as does the lack of portability of pensions and healthcare benefits. Moreover, qualification requirements and certification procedures create an additional constraint. In particular in services, making up over 70 percent of euro area GDP47, entry and conduct regulations are often overly restrictive. The 2016 EU Regular Economic Report No. 3 focused on this largely unfinished reform agenda of creating a single market for services48 .

As a result, population movements within the EU contribute little to economic convergence, even over longer periods. The economic convergence or catching-up process can be decomposed into two components: the first capturing population movement to lower and higher income countries and regions, and the second capturing catching-up growth in GDP per capita. Between 2000 and 2016, only 5 percent of the observed catching-up process could be attributed to population movements49. Population movement accounted also for only 7 percent of the decline in the coefficient of variation (i.e. the standard deviation divided by the mean—a measure of variability) between 2000 and 2008 (Figure 2.2).

Figure 2.2 Population movements contribute little to economic convergence

Decomposition of the decline in coefficient of variation into that due to changes in population compared to changes in GDP per capita

Note: World Bank estimates using purchasing power standard (PPS) per inhabitant at the national and NUTS-2 level (dataset identifier: nama_10r_3gdp). The decomposition is conducted by comparing the coefficient of variation using yearly population weights compared to holding population weights fixed at the beginning of the period (2000 or 2008). The comparison of these figures gives an estimate of the amount of dispersion that could be linked to population movement. Note that this estimate can be considered to be a lower bound since population shifts contribute to changes in GDP and also feed through directly to GDP per capita. Source: World Bank calculations.

Decline in coefficient of variation 0.10

0.08

0.06

0.04

0.02

0

–0.02

2000–2008

National 2008–2016 2000–2008

NUTS-2 2008–2016

Change due to population movements Change due to GDP convergence

Is labor migration in response to economic shocks an optimal short run economic response? Within the EU, a recent study shows, large emigration of talent can have a negative impact on the “sending” member states and depress economic growth by reducing the productivity of the smaller and less-skilled workforce50. Given its costs, only the adjustment to a permanent change in the national (or regional) economic perspectives could justify migration on a larger scale. Even then, this would imply running the risk of depleting a nation (or region) of its labor force, often particularly high-skilled labor, which would limit future regional growth opportunities.

The eurozone’s institutional architecture was significantly strengthened as a result of the crises of the last decade. The crisis triggered reforms in key areas of the EMU. For instance, it became clear that the EMU needed a centralized, discretionary, fiscal backstop (but with strong conditionality), and stronger banking supervision under a single supervisory mechanism, complementing the centralized rule-setting (already in existence before the crisis) with centralized implementation. The current institutional set up is summarized in Box 2.3.

Box 2.3 Eurozone institutional “architecture”

• Prevention of the need for fiscal transfers between member states (Stability and Growth Pact) • European Stability Mechanism provides budget support for countries in financial difficulty, but with strict conditionality and not automatically

• Centralized supervision of large banks, underwriting safety and soundness • No fully backed single resolution fund (to manage failing institutions) • No common deposit insurance

• Freedom of movement of labor… • But subject to several barriers (language, portability of social insurance, “guild-like” entry and conduct restrictions in many professions)

• Freedom of movement of capital… • But cross-border stock and corporate bond market investments constrained by lack of a common regulatory, taxation and insolvency framework and supervisory authority

In response to the euro crisis, the eurozone now benefits from the European Stability Mechanism (ESM)—a budget support facility for member states in serious financial difficulties. In case of a shock that affects only a particular country or affects countries unevenly, fiscal transfers to the affected countries can be an effective substitute for independent monetary policy51. The ESM built on the experience of the support given by the EU, the ECB and the IMF (the “troika”) to Greece, Ireland, Portugal and Cyprus during the crisis5253. The ESM can give fiscal support in case one of its member states risks losing access to financial markets, that is, if it is threatened with a “sudden stop”54. However, ESM support is conditional, not automatic. Conditional means that it comes with a strict macroeconomic adjustment program that would first need to be negotiated and agreed to between the stakeholders. It is not intended to serve as a counter-cyclical fiscal policy instrument.

The current institutional set up could still leave eurozone members individually exposed to potentially large exogenous, idiosyncratic and asymmetric shocks. When fiscal space is limited, and banks own large amounts of debt of their sovereign, the risk of the “doom loop” looms, materializing in negative feedback from banks to sovereigns and back from sovereigns to banks. With deeply integrated banking and capital markets (an objective of the union), the spillovers of such shocks could be severe555657 .

However, cross-border capital flows are now better regulated through centralizing the supervision of systemic banks within the new banking union, which has centralized the supervision of systemic banks58 . In 2014, the ECB, charged by the EU Council, established the Single Supervisory Mechanism (SSM)59. Under the SSM, the ECB, together with the national authorities, directly supervises the 125 significant banks of all euro area countries, covering about four fifths of euro area bank assets. Participation in the SSM is now automatic for all euro area members, including new ones, but not part of the formal criteria for euro adoption, simply because it did not exist at the time of the Maastricht Treaty (the treaty did not foresee the types of banking sector issues that would arise)60 .

The banking union and the single capital market are work in progress. Today, most observers agree that a monetary union without a banking union and capital markets union would be vulnerable, at least in times of crises with cross-border repercussions. This marks a substantial shift in policy consensus within a matter of years. Going forward, other institutional elements under discussion include the shared

underwriting of retail deposits, for instance through a euro area wide deposit insurance scheme61. This could also include reaching agreement on a mutualized backstop to the Single Resolution Fund62 —like the Federal Deposit Insurance Corporation in the US, which is “backstopped” by the U.S. Treasury—or another, comparable reinsurance mechanism. Finally, a single capital market would be buttressed by a uniform regulatory, taxation and insolvency framework and a single capital market supervisor.

Given the architectural incompleteness of the European Monetary Union, resilience is mainly determined by the institutions that govern the real exchange rate. The absorption relies on how these institutions translate the shock into movements of the national and regional prices relative to international prices and how the impact is distributed across incomes and regions. The rebound is determined by how the institutions shape the pattern of income and jobs growth after the recession.

What institutions could improve the speed of adjustment and the pattern of economic growth created during the economic rebound? In the following, the institutions that could improve resilience are identified based on recent experience63. The report also assesses whether they are amenable to change in the short and medium run. In this way, the report focuses on what eurozone members can change and control through implementing structural and institutional reforms.

Absorption and rebound played out differently across the EU’s members states depending on the institutional set-up of each country. Different growth patterns emerged, characterized by differences in the depth of the shock, the speed of the rebound, the extent to which growth was shared among income groups and whether households, most notably the poor and vulnerable, are protected. When hit by an exogenous shock, the common “one-size-fits-all” monetary policy of the eurozone created adjustment challenges for individual countries. Given the current institutional “architecture” at the EU level, meeting these challenges mostly fell on national adjustments of the real exchange rate.

However, the real exchange rate is not a policy instrument: it is a market outcome, representing the relative price of “domestic” (non-traded) and “foreign” (traded) goods and services. It defines the competitiveness of a country (or a region within a country) vis-à-vis the rest of the world (or the rest of the country). It is set in thousands of markets. After euro adoption, member states face exogenous shocks without having recourse to a devaluation of the nominal exchange rate. The nominal exchange rate, if market-based and flexible, can function as a short-term “shock absorber”. However, if the shock persists, the real exchange rate will adjust, regardless64. This is because the influence of the central bank’s policy rate or direct interventions in the foreign exchange market on the prices and quantities in these markets is limited at best65. The (extreme) case of Zimbabwe illustrates this point vividly (Box 2.4).

Box 2.4 Zimbabwe’s attempts to control the real exchange rate

Zimbabwe, starting in the late 1990s, attempted to prevent depreciation of the nominal exchange rate, while extremely loose monetary and fiscal policies were put in place. It resulted in widespread parallel market activity, where the “real” prices of goods and money were set, as goods at official prices were severely rationed. Even a series of nominal devaluations were unable to keep up with the much larger adjustments of the real exchange rate in these parallel markets, until the domestic currency was entirely abandoned in favor of a multitude of foreign currencies in 2009. The case of Zimbabwe illustrates that the real exchange rate is ultimately set in markets, not by the central bank.