Economics and European Integration

Snake in the tunnel

Created in 1972. Tried to limit the amount of fluctuations among European currencies by comparing them to the US dollar. Given +_ 2.25% fluctuations. In 1973 it became a joint float of currencies linked to the German D-mark against the dollar.

Governance of the Euro and Eurozone

European Central Bank (ECB) as central monetary authority, with the following key aspects about its governance: (instruments and goals, forbidden activities, governance and decision making, accountability and independence). Rules of the club: 1) Membership rules (Convergence Criteria, when a country can join the Eurozone and stay in) 2) Conduct rules: the Stability and Growth Pact (SGP, fiscal conduct expected of members, to keep the eurozone in tact)

Overall enlargement process

European conference started in 1998 1) Enhanced pre-accession strategy 2) accession negotiations 3) "Screening of EU-Legislation" 4) Review Procedure Also includes Acquis Communautaire and Transitional arrangements

Exceptional Budget Deficits

Excess deficit over reference value is result of "unusual event outside the control of MS" -Major impact on financial position of the gov't. GDP reduction of more than 2% GDP reduction between .75 and 2% could also suffice in case further supporting evidence is submitted

Temporary Budget Deficits

Excess of deficit over reference value should disappear in year following recession

From symmetry to DM Zone

-First: A flexible arrangement (different inflation rates: long run monetary policy independence, frequent realignments) -Second: Realignments (barely compensated accumulated inflation differences. Were easy to guess by markets. Put weak currency/high inflation countries on the spot: Continuing current account deficits. Speculative attacks) The symmetry was broken de facto. The Bundesbank became the example to follow. -Third: The DM zone. (What shadowing the Bundesbank required: 1) Giving up much what was left of monetary policy independence. 2) Aiming at a low German-style inflation rate. 3) avoiding realignments to gain credibility.

Economic and Monetary Union (EMU)

1 Jan 2002, 12 EU countries replaced national currencies with euro notes and coins. Only UK, Denmark, and Sweden remained out at the time. Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009) and Estonia (2011) joined later. European Central Bank came into effect in Frankfurt. Countries of the eurozone adopted a common interest rate, and at least in theory, close coordination of their fiscal policies.

Four Periods of EMS

1) 1979-1983: Frequent and large currency realignments between EMS members. 2) 1983-1987: Relatively few realignments, and when these occurred few currencies were involved and the changes in central rates tended to be small. 3) 1987-1992: the "hard" EMS was characterized by great stability if not rigidity of exchange rates. 4) After the currency crisis of Sept. 1992, Aug. 1993, most ERM margins were widened to +/- 15%

Cures to the Eurozone Crisis

1) 3-year bail-out program for Greece amounting to 110 bn euros (first bail-out) which could be raised to 180 bn euros for second bail-out (still being negotiated) 2) Creation of European Financial Stability Facility (EFSF) until 2013 3) Amounting to 440 bn euros 4) Supplemented by IMF lending of 250 bn euro 5) Design of EFSF with 6% interest rate vs. 3% for core countries signals to investors a default risk that becomes self-fulfilling 6) European Stability mechanism (ESM) to replace EFSF later (still under discussion) 7) Bail-out implies that taxpayers in core countries are shouldering the costs instead of the banks who lent money imprudently. 8) Involvement by ECB through debt buyback 9) ECB buying Greek Bonds from the secondary market through rediscounting and repurchasing windows with the banks of crisis countries at a discount called a haircut (comprises of >40% of loan portfolio) 10) ECB was forced politically to get compromising its independence- adherents say ECB should done this earlier in the game to prevent contagion

EMS 1 Key Features

1) A parity grid (bilateral central parities, associated margins of fluctuations 2) Mutual unlimited support (Exchange market interventions, short-term loans) 3) Realignments (tolerated, if not encouraged, require unanimity agreement) 4) The ECU (not a currency, just a unit of account, took some life on private markets)

Benefits of EMU

1) A saving in transaction costs 2) increased transparency in comparing prices 3) encouraging the creation of deeper and wider capital markets 4) increased trade 5) possible economies of scale in holding international reserves 6) use of the euro as an international reserve could yield seigniorage (difference between the value of the money and the cost to produce and distribute it) 7) Introduction of a common monetary policy which may permit countries to "borrow credibility" 8) improved location of industry 9) neo-funcionalist spillover into other integration 10) increased weight of the member countries at a world level

Proposals for more sustainable debt management

1) Active involvement of ECB 2) Requires a lender-of-last-resort 3) Requires more quantitative easing 4) "No bail-out provision" has to be amended 5) Lender of last resort reinforces moral hazard and compromised independence, 6) Lender of last resort is a function of a central bank, price stability vs. defending euro zone 7) The ECB should prevent short-term liquidity problems of banks/gov'ts to turn into long-term solvency problems 8) Capitalizing of ECB from national central banks should be raised (burden sharing) 9) ECB involvement will make debt fall under eurozone control 10) Creation of a European Monetary Fund 11) Issuance of eurozone bonds to replace national gov't bonds 12) Debt restructuring 13) Debt conversions or swaps

Breakdown of the DM zone

1) Bad design (Full capital mobility established in 1990 as part of the Single Act: EMS in contradiction with impossible trinity unless all monetary independence relinquished.) 2) Bad Luck (German unification: a big shock that called for very tight monetary policy. The Danish referendum on the Maastricht Treaty.) 3) A wave of speculative attacks in 1992-93 (The Bundesbank sets limits to unlimited support)

Typology of Crisis

1) Banking Crisis (Bank runs and closures - Liquidity based: bank runs, bank borrowings- Solvency-based: bank closures, bank receiverships) 2) Balance of payments crisis (Trade and current account deficits) 3) Fiscal crisis (Huge gov't deficit spending and larger public sector debt) 4) Debt crisis (Debt moratoriums and bankruptcies) 5) Currency crisis (Drastic devaluation of currencies) 6) Growth crisis (Recession, depression and huge unemployment) 7) Financial crisis (capital flight and withdrawals, loss of confidence)

Self-fulfilling prophecies

1) Behavior of economic agents lead to self-fulfilling expectations. 2) investors who expect likely devaluation will charge higher risk premiums leading to higher costs of borrowing and debt servicing, cost of maintaining peg also rises leading to eventual devaluation. 3) Investors who do not expect devaluation will not charge risk premiums so that exchange rate peg could be maintained. 4) Possibility for economic fundamentals not to play a key role, hence, matter of pure speculation based on asymmetric information.

External Strategy Tax

1) Commission identifies a set of third countries that may need to be screened using a neutral scoreboard of indicators. 2) Member States decide which of those third countries should be screened. Constructive dialouge takes place with those countries selected for screening. 3) Commisssion recommends which countries should be listed. Member States take the final decision. As soon as the third country meets jointly agreed standards, it is de-listed.

5 Tests for the UK to adopt the euro

1) Convergence (Are business cycles and economic structures compatible so that Britain can live comfortably with common euroland interest rates on a permanent basis. 2) Flexibility (If problems emerge is there sufficient flexibility to deal with them?) 3) Investment (Would adopting the euro create better conditions for firms taking long-term decisions to invest in the UK?) 4) The City of London (How would adopting the Euro affect UK financial services?) 5) Stability, growth, and employment: (Would adopting the euro help to promote higher growth, stability, and a lasting increase in jobs?)

Criticisms of the SGP

1) Convergence rules ineffective (Deficit limit rules eliminate the automatic stabilizer associated with fiscal politics; Criteria have no theoretical & empirical underpinning; Rules are post-ante, so difficult to observe & in conflict with political reality) 2) Surveillance failed because countries concealed their true fiscal situation. 3) Punishment weak and peer pressure ineffective 4) Once countries joined the Eurozone, most stopped observing the fiscal rules. 5) The largest countries, France and Germany, violated the rules in 2003 with no consequences.

Key Problems of Taxation in EU

1) Double Taxation 2) Tax avoidance/ tax evasion 3) Transfer pricing 4) CCTB 5) Fiscal Union as a solution for the present EMU-discussion

Key Points of Accession of New Member States

1) Econ and political transformation in CEEC has progressed a long way in a relatively short time. 2) Transition and enlargement are interdependent: Both depend on the emergence of a strong private sector. 3) Levels of FDI in CEEC have been disappointing and foreign investors find life difficult. 4) Copenhagen Criteria provide a valuable framework for assessing the readiness of applicant states. 5) Enlargement will have a profound effect on most EU policies and on the EU economy with significant knock-on effects for the European business community.

EU and Central & Eastern Europe Reforms

1) Economic Stabilization (prices, credit, money supply, wages) 2) Institutional reform (restoration of private property & reform, bankruptcy legislation) 3) Capacity Restructuring 4) Shift from primary and machine building industries to consumer goods and high-tech products

Common Regulations of free circulation lead to:

1) Enlarged business opportunities 2) Facilitate exchanges 3) Prolong life cycles 4) New risks and uncertainties 5) New obligations and costs

EU External policy instruments

1) European Development Fund (EDF; 77 African, Caribbean, and Pacific countries (ACP) and 20 Overseas Territories (OCT); Programming on the basis on partnership approach and "demand" expressed by the beneficiaries; Newly introduced "incentive allocation" related to gov't commitments) 2) Economic Partnership Agreements (EPAs; 6 regions of ACP countries; Follow up to Cotonou-Agreement, market access at stake) 3) Partnership and Cooperation Agreements (PCAs) linked to Free Trade Agreements (FTAs) 4) Association Agreements 5) European Neighborhood Policy (ENP) 6) Savings Agreements (Bilateral and multilateral; Various agreements with Switzerland, Liechestein, Monaco, San Marino, Andorra, Overseas Countries and Territories, etc.; Frequently benefits accorded in terms of market access

The EC Treaty

1) Free movement of goods (Article 28) 2) Freedom to provide services (Article 49) 3) Free movement of persons (free movement of workers (Article 39) and freedom of establishment (Article 43)) 4) Free movement of capital (Article 56) 5) State aid rules (Article 87)

Challenges of national tax systems

1) Global Business and National Tax Systems must coexist 2) Difficulties in taxing income from mobile activities 3) New opportunities for international tax evasion

Does the Likelihood of asymmetric shocks increases or decreases with the level of integrations

1) Higher level of integration may lead to some convergence of consumer tastes and preferences, so on the demand side, there would be fewer asymmetric shocks. 2) If integration leads to specialization, the economies of the member states will become less similar and more vulnerable to asymmetric shocks. 3) But most trade within the EU is the intra-industry so shocks would be likely to affect all the member states. 4) If the integration implies centrifugal forces leading to the concentration of industry, asymmetric shocks may not necessarily respect national boundaries and may transgress one or more border.

Challenges of Marketization

1) Inflation 2) Unemployment 3) Deindustrialization 4) Real wages dropped by 25-30% 5) Discrimination against state-owned enterprises

Challenges encountered with external policies

1) Limited Political awareness (no systematic quantitative data on "revenue leakage", Citizens not conscious of problem) 2) International standards in the tax field less firmly established than in other areas (Ex. No international convention like in the case of corruption) 3) EU tax policy decisions have to be taken unanimously (Some EU Member States have economic interests that are to some extent similar to those of "tax havens" 4) Distinction between acceptable tax comp. and harmful preferential regimes not always straightforward and difficult to maintain. 5) Debate about "Community competence" vs. "Member State Competence"

Article 104-104.b (Golden rules of deficit financing)

1) No monetary financing of deficits (104) 2) No privileged access by public authorities to financial institutions (104.a) 3) No bail-out rule (104.b) To make these rules effective, two further "golden"rules would be required: A) Markets should have full info on the public finances of a member state. B) Maturity of gov't debt should not be too short.

Criteria to decide whether a country should form part of a currency area

1) Openness (the McKinnon Criteria) 2) The degree of similarity of the structure of production and trade (the Kenen criterion) 3) Existence of alternative adjustment mechanisms such as labor movement (the Mundell criterion) or the possibility of transfers 4) The extent to which high inflation countries can borrow credibility. Consensus that neither the EU(15) nor the EU(25) should form monetary union.

Tax policy in the EU

1) Pragmatic and evolutionary approach based on the subsidiarity principle 2) No need for an across the board harmonization- different taxes require a different degree of harmonization/coordination 3) Unanimity requirement for taking decisions on tax matters

Main costs of EMU

1) Problem of "one size fits all" arising with a single interest rate and loss of the possibility of exchange rate changes between member states. The role of the exchange rate mechanism is to compensate asymmetric shocks (shocks that affect the countries involved in different ways) 2) More trade openness, the cost of giving up an independent currency is less. 3) The psychological cost of losing a national currency 4) The technical costs of changeover 5) Loss of seigniorage for some memberstates

Rationale for Sustainability and Growth Pact (SGP)

1) Protect euro-stabilization policies by defining the aggregate fiscal stance to complement the monetary policies of the ECB. 2) Instrument to sanction free-riders who might destabilize the EU economy by deviating policies to pursue narrow national interests 3) Avoid tax and spending competition where benefits and costs of public goods easily spill over from one country to another, it has generally been found necessary to: A) Either assign the provision of such goods to a higher level of gov't according to the principles of "fiscal federalism" or B) To coordinate taxation and expenditure (e.g. minimum standards of provision of public goods; grants/subsidies from central revenue)

Internal challenges for SMEs (Small and Medium sized enterprises)

1) Reach critical size 2) Transform development and diversification opportunities 3) Develop and implement innovation strategies 4) Recruit or access specific competencies 5) Benchmark ambitions, performances, and results

Benefits of national tax systems

1) Reducing tax rates and broadening the tax base 2) Gov'ts search for new efficiencies/better service 3) A reassessment of fiscal climate for investment

Consequences of Agenda 2000

1) Reform of institutional frame-work of EU 2) More effective use of structural funds 3) Further reform of Common Agricultural Practices (CAP) 4) Improvement of R&D policies

External challenges for SMEs (Small and Medium sized enterprises)

1) Resist market internationalization and globalization impacts (econ of scales, strong competition and pressure on markets, etc.) 2) Adapt to large companies' tendency towards offshore production and services 3) Access to financial markets, ensure long-term/reliable financing and cash mgmt

Maastricht Convergence Criteria

1) Successful candidates must have inflation rates no more than 1.5% above the average of the three countries with the lowest inflation rate in the Community. 2) Long-Term interest rates should be no more that 2% above the average of that of the three lowest inflation countries. The exchange rate of the country should remain within the "normal" band of the ERM without tension and without initiating depreciation for 2 years. 3) The public debt of the country must be no more than 60% of GDP 4) The national budget deficit must be no more than 3% of GDP

OECD (Organization for Economic Cooperation and Development) Objectives

1) Sufficient transparency for tax audits 2) Effective exchange of info 3) No ring-fencing

Contradictory Lessons from 1993

1) The two-corner view (Even the cohesive EMS did not survive. Go to one of the corners, gotta pick one) 2) The EMS should be made even more cohesive (The monetary union is the way to go) 3) The EMS was a bad idea (float is the future) 4) Unlimited interventions can't be unlimited (need more discipline and less support) 5) The Bundesbank's selection of countries to be supported (Left scars, e.g. Britain; raises question on who decided what) 6) Speculative attacks can hit even robust systems and properly valued currencies (suggesting self-fulfilling crises) 7) Both facts strengthen the two-corner, providing arguments for each corner.

Enlargement Triangle

1) Transition process: conversion of plan-economy to a free-market economy 2) Corporate Response: Foreign Direct Investment 3) Enlargement Process: 28 Member States

SGP In Trouble

1)Excessive deficit procedure (EDP) was invoked for the first time in the monetary union in 2002, when it was applied to Portugal. 2) In 2003, The SGP was thrown into a crisis when the Ecofin Council did not follow the stipulated procedure for Germany and France, which both had begun to run deficits above 3% of GDP in the preceding year. This led to a situation where it was unclear what rules did in effect apply. 3) Root of enforcement problem with the EU fiscal rules is the strong incentive of finance ministers in the Ecofin Council to act strategically and collude to avoid sanctions for violators of the fiscal rules. This has partly been the result of several countries running large deficits at the same time. But also finance ministers in countries without deficit problems have a strong incentive of treating colleagues in countries with such problems in a lenient way: this can be regarded as an investment, raising the probability that they run themselves will be treated in a similar lenient way if they, too, to run large deficits in the future.

Origin of Eurozone debt crisis

1)Neglect of the Rules (convergence criteria) of the EMU, adherence was too lax, no credibility 2) France and Germany breached the SGP rules but were never sanctioned. 3) Greece (previous gov't) presented false budget figures but no sanction given. 4) Financial markets ignored the "no bail-out clause" of the ECB governance and continued extending loans to peripheral eurozone member states at same interest rates as core countries even though they entailed more risks (moral hazard problem)

EMU Program 1 Key Dates

1989: Delors Report on EMU 1990: Beginning of Stage 1 and abolition of capital controls in July for most member states. 1993: Maastricht Treaty. 1994: Stage 2 of EMU begins with the creation of the EMI. 1995: The Madrid European Council announced that the third stage would be launched from 1999, and adopted the name "euro" for the single currency. 1996: Stability and Growth Pact agreed at the Dublin European Council.

EMU Program 2 Key Dates

1998: The European Council of May decided on the euro members and fixed the exchange rates between the currencies of the participating countries irrevocably. May/June 1998: The President and Executive Board of the ECB were chosen and it came into operation in June. 1999: The ECU is converted into the euro, and the third stage of EMU began. 2001: Greece joins. 2002: Euro notes and currencies introduced and national currencies withdrawn. 2005: Reform of the Stability and Growth Pact. 2007: Slovenia joins. 2008: Cyprus and Malta join. 2009: Slovakia joins. 2011: Estonia joins.

60/40 Rule

40% lost in transaction costs because of exchanging, 50% increase in prices

Dream Scenario

A potential scenario The rescue plans succeed in making debt dynamics more sustainable. Everything returns to normal, no debt restructuring or default takes place.

International Monetary Fund (IMF)

Analyze the roots of the financial crisis. Compulsory policy advice. Conditional Loan. Introduce national reforms, rigid system with no flexibility.

Article 94 of EC Treaty

Approximation of domestic laws directly affecting the establishment of the functioning of the Common Market - legal base used for direct taxes

The exchange rate criterion

At the time of the Maastricht treaty, the "Normal" band referred to the margins of +/- 2.25%, but from August 1993, it was taken to refer to +/- 15%. The new member states that joined the EU in 2004 and 2007 were told that they have to respect the margin of +/- 2.25%. The new member states could only join the EMS2 after EU accession and would to wait at least 2 further years before adopting the euro.

Sustainability and Growth Pact (SGP)

Basic elements include: 1) Preventative arm (Member states must submit annual stability and convergence programs showing fiscal positions in the medium term) 2) Dissuasive or Corrective arm (Governs excessive deficits procedure (EDP). The EDP is triggered by the deficit breaching 3% of GDP threshold of the Maastricht Treaty. If deficit is found excessive, the Council gives reccommendations to concerned member state to correct the excessive deficit and gives a time frame doing so) SGP sets time limits to various steps of excessive deficits procedure (10 months) More clearly defines the exceptionality and temporariness conditions. Specifies the conditions in which sanctions will be applied and their scale.

Hybrids

Before: A group with operations in two EU countries sets up a new entity in one of the countries. This entity borrows money on behalf of the group and pays interest on the loan. The two Member States treat this hybrid entity differently for tax purposes- there is a mismatch of treatment. Because of this mismatch, both Member States allow a tax deduction for the interest payment. After: With the hybrid rules the mismatch is eliminated and the tax deduction will be allowed in only one Member State- ensuring effective taxation.

The Switchover

Before: An EU-based company invests in another company based in a low-tax country outside the EU. Dividends are in turn paid back to the EU-based company where Member States treat them as having already been properly taxed in the third country, but this is often not the case. After: Switchover rules would mean the Member States would have to tax dividends coming into the EU if they have not already been properly taxed.

Theory of Optimum Currency Areas

By Robert Mundell. A group of countries that maintain their separate currencies but fix the exchange rate between themselves permanently. Also maintain full convertibility among their currencies and flexible exchange rates towards third countries. Problem is determining the optimum size of the currency area, and more specifically, deciding whether it is to the advantage of a particular country to enter or remain in a currency area.

Each time a new member state joins, it reinforces:

Competitiveness Trade and investment flows Shared know how Innovation and tech advancements Job creation Standards and norms on a European level (regulations, econ of scale, tax revenue gains) European voice in multilateral trade negotiations

EMS

Concieved as the solution to the end of the Bretton Woods System. Became a D-mark area, with the Bundesbank in command Made the Monetary union option attractive

Impossible Trinity

Contradictory quartet (included liberalized trade) by Padoa Schioppa in 1988. No international monetary arrangement has been able to reconcile simultaneously: 1) Free capital movements 2) Fixed exchange rates 3) Autonomy of monetary policy

Alternative instruments to the exchange rate mechanism

Cost of foregoing the exchange rate mechanism will be less if other instruments such as wage/price flexibility and factor mobility (the Mundell criterion) or budget transfers can replace it. In the EU, labor mobility is rather low, and the EU budget is probably to small to carry out an effective stabilizing role.

Pessimistic Scenario

Disintegration A potential scenario No political support to extend and expend rescue plans and accept stronger ECB involvement. A default occurs and exit procedures from the eurozone are implemented. Contagion continues and affects other member states. The euro devalues.

Race to the Bottom Theory

Doomsday Scenario 1) Taxes on capital income to spiral to zero 2) Taxes shift to labor, consumption and property. Low tax/No tax is legit choice. Key issue is Process vs. Outcome

EU countries and the Impossible Trinity from 1979-1987

During first period of EMS (1979-1983), participating countries maintained controls on capital movements and there were frequent realignments of exchange rates. After '83, Italy and France managed to acquire exchange rate stability but only through losing autonomy for monetary policy and recourse to capital controls. Britain realized free capital movements during the '80s, but only at the cost of exchange rate stability.

Objective of EMU was revived:

During the late 1980's. 1)Exchange rate uncertainty between the EC currencies was another obstacle to trade that should be eliminated in the internal market. 2) The aim was to take the relatively successful experience of cooperating in the EMS one step further. 3) The boom of the late 1980's was beginning to flag so methods of prolonging business confidence were needed. 4) EMU could push the integration process further towards political union. 5) The EC Commission (and Delors in particular) and the French and German gov'ts (despite the hesitancy of the Bundesbank) were active in re-launching the initiative.

Game Change Scenario

ECB intervention with a QE succeeds in designing burden sharing among member states through greater capitalization. Greater fiscal coordination through decision to move towards a federal budget or fiscal union.

EMS-2

EMS-1 died on 1 January 1999 with the launch of the euro. Created to: 1) Host currencies of existing EU members who can't/don't want to join Euro area (Denmark and the UK have an exemption, but Denmark has adopted the new ERM.; Sweden has no exemption but has declined to adopt the new ERM) 2) Host currencies of new EU members before they are admitted into euro (Potentially ten new members)

Condor Sanitaire

EU gives financial and econ aid to CEEC in exchange for effective border control.

Tax Harmonization

Exists when taxpayers face similar, perhaps even identical, tax rates regardless of where they work, shop, save, or invest. Form of capital control/exit tax. Two types : Direct (when nations agree to implement similar tax rate structures. Minimum 15% VAT in EU) Indirect ("residence-based" or "worldwide" since a taxpayer faces home country tax rates regardless of where they work, saves, shops, or invests)

Contagion

Financial panic and creditor race to collect ahead of others. Transmission channels: 1) Trade (One country's devaluation of its currency triggers its neighbors to also devalue their currencies if they are competing for same export markets. 2) Financial (Investors reevaluate their positions to countries of a region when one country in the region is hit by a crisis) 3) Neighborhood or pure contagion (Change in market sentiment of investors due to a country-specific shock causing them to look for weaknesses)

Acquis Communautaire

Full body of laws and regulations governing the EU. The chapters include free circulation of goods, services, capital and people, competition, of rights and rules

Monetarist View

Generally held by countries such as France, Belgium and Italy. Exchange rate is an ineffective corrective mechanism. Monetary integration is the best way to commit national gov'ts to reducing inflation. Once a monetary union is formed, the credibility of the common central bank will shape expectations and will deliver low inflation to all member states. The cost of reducing inflation is assumed high before joining the monetary union, but almost negligible afterwards. Many countries would gain by giving up their national currencies and joining a monetary union. Emphasis should be on building strong institutions rather than having demanding criteria and a lengthy convergence period before creating EMU.

The Economist View

Generally held by countries such as Germany. A high level of coordination of economic policies and integration is necessary before creating a monetary union. View stresses rigidities (wages and prices and labor, considered immobile), arguing that the exchange rate is an effective instrument. The assumption that inflation is sticky means that countries with a history of high inflation will not support tight monetary policy once they have a representative in the common central bank. Low inflation countries may import higher inflation from non-converged countries. Sometimes called the coronation theory as monetary union is regarded as the final step in a long process, occurring only when monetary policies have become fully aligned and national currencies are indistinguishable.

EU Policy towards third countries/jurisdiction

Give and Take approach Give: Where appropriate, the EU is willing to provide tech assistance, financial assistance for econ adjustment or trade facilitation/access to the EU market. Take: The EU expects third countries to respect internationally recognized standards of good governance in the field of taxation (transparency and exchange of info) The EU and its Member States are committed to promoting the adoption of the principles of the Code of Conduct in Third countries

Article 93 of EC Treaty

Harmonization of indirect taxes (VAT and excise duties) in so far as is necessary for the establishment and functoning of the Internal market

Fair vs. Harmful Comp

High Road: Compete on overall levels of tax, balance of taxes, general structure of tax rates. Preferential Regimes that are non-discriminatory and transparent. Low Road: Compete with measures that lack transparency, secrecy provisions and ring-fenced regimes.

Agenda 2000

Hungary, Poland, Estonia, Czech Republic, and Slovenia fulfill Copenhagen criteria. Challenges include: 1) Reforming EU policies (create conditions for sustainable growth, high employment, improving the standard of living) 2) Preparation of all applicant countries for their future membership 3) Reforming EU internal policies (enlargement does not result in financial, budgetary problems)

European Central Bank (ECB)

In Frankfurt. -Instrument: Interbank lending rate. -Goals: similar to those of other central banks, but with a inflationary bias; Primary is "maintain price stability"; Secondary is "support the general economic policies in the Community with a view to contributing the achievement of the objectives of the Community" -Forbidden activities: 1) Can't finance member states' fiscal deficits 2) Can't provide bailouts to member gov'ts or national public bodies 3) No mandate to serve as lender of last resort (Can provide general liquidity support to the market, but the ECB can't serve as lender of last resort to make deals that prop up individual banks. -Governance and Decision making: 1) Decisions are made at the governing council, with Central bank governors of Eurozone national central banks and ECB executive board. 2) Decisions made by consensus, not majority vote 3) Meetings twice a month -Accountability and independence 1) Responsible for monetary policy in Eurozone 2) complete autonomy from all other EU bodies 3) ECB is not required to release minutes from meetings and has independence over decisions about instrument

Revival of the EMS?

In principle, ERM membership is compulsory for all the new member states. They must stay at least two years in the ERM before joining the euro area. They must also eliminate all capital controls. The impossible trinity says that they will have to fully give up monetary policy. The risk of self-fulfilling crises says that may not be enough to avoid trouble.

CFC Rule

Income tax system designed to limit artificial deferral of tax using a low tax off shore entities Before: Companies are able to shift their profits to dependent companies in low-tax countries reducing the taxable profits in the EU. After: With CFC rules in place, companies can still shift their profits but those profits will now be taxable in the EU

Excise Duties

Indirect taxes on the consumption of certain products. Harmonization of structures and approximation of rates.

Problem of asymmetry of EMS

Initially envisaged as a symmetrical system, with intervention by both the authorities responsible for strong and week currencies. However, Germany dominated and the system began to operate in an asymmetrical way. Germany provided the anchor for the system, using money supply to control German inflation

Central European Free Trade Agreement (CEFTA)

Integration exercise, managed trade, cheap labor; 1) Anti-dumping duties (WTO anti-dumping) 2) Safeguard measures 3) VERs (Voluntary Export Restraint)

Competitive strategies in the enlarged market

Internationalization is crucial to maintain competitiveness 1) Strategic approach 2) Optimizing or reducing costs 3) Getting new opportunities for growth 4) Developing new strategic strengths 5) Choice of location 6) Implementation 7) Entry modes 8) Geographic approach 9) Risk approach, Info 10) FDI (Poland, Slovakia, Romania)

Copenhagen Criteria

June 1993 1) Stable and democratic institutions with the rule of law and respect and protection for minorities. 2) Establishment of a functioning market economy with the capacity to compete inside the EU. 3) The ability to adhere to the obligations of membership including the political, economic and monetary union.

Fight against Tax Avoidance and Evasion

Key Problem: Lack of transparency and lack of cooperation/exchange of information (key concerns: individuals, but also transfer pricing and corporate malpractice) EU Objectives: Bilateral exchange of info (on request, spontaneously or automatically) Mutual assistance Intra-EU instruments: Mutual Assistance directive and directive on Mutual assistance in recovery. Directive on the taxation of saving income

First-generation models

Krugman (1979), Flood and Garber (1984), Calvo (1987), Edwards (1989). 1) Expansionary monetary or fiscal policies inconsistent with fixed exchange rate. 2) Money expansion or expansion of loans triggered by budget deficit leads gov'ts to print money 3) Growth of money supply exceeds demand for local currency leading to preference for foreign currency or foreign denominated assets. 4) Leads pressure on exchange rates, gradual run on international reserves because of exchange rate commitment; depletion of reserves lead to collapse of fixed exchange rate regime.

European Monetary System (EMS)

Launched in 1979. Pegged but adjustable system. Forerunner of the euro, and the European Monetary Institute provided the institutional basis on which to build the future European Central Bank. Included: 1) the exchange rate mechanism 2) introduction of the ECU 3) a divergence indicator 4) monetary cooperation.

EU framework for general policy on tax competition

Member states are free to adopt their policies towards "tax havens" provided they respect community law. Certain types of preferential tax regimes are considered to be "harmful" and should therefore not be used. EU Policy focuses on: Establishing certain ground rules with respect to tax evasion and avoidance within EU. Trying to avoid the jurisdictions outside the EU undermine these intra-EU efforts

Nominal integration vs. Real integration

Nominal (ECU, currency of accounts) Real (Euro)

Muddle Through Scenario

Potential Scenario Rescue plans continue to be provided until the core (wealthier) members grow tired. Eventually a default occurs, contagion spreads, and the break-up of eurozone eventually happens.

Tax Competition

Pressure put on politicians to lower tax rates and be more fiscally responsible so FDI comes in

Each time a new member state joins, it also results in:

Rising unemployment in less competitive sectors, Rethinking of social policy, Reshuffle of important factor conditions (labor and capital)

Moral hazard and banking and financial crisis

Role of moral hazard in driving over-lending provided a hidden subsidy to investments which lead to crisis when visible losses lead to the withdrawal of these implicit guarantees or when the gov'ts limited willingness or ability to honor these guarantees lead to a credibility problem. Self-fulfilling expectations by foreign banks that gov'ts will renege on its promises will cause them to raise interest rates leading to a collapse of real output and capital flight. Decline in capital flows and the real exchange rate adversely affect the balance sheets of domestic firms, reducing their ability to borrow which feeds back into more reduced capital flow

Functions of a Central Bank

The Banker's Bank 1) Issue currency 2)Formulate and implement monetary policy 3) manage monetary aggregates (money supply, interest rates) 4) Repository of foreign exchange reserves 5) Custodian of cash reserves of banks 6) Manage external debt 7) Allocates credit or loans 8) Supervise and regulate commercial banks and financial institutions 9) Serve as lender of last resort during crisis 10) Fiscal agent of the gov't

The Maastricht Treaty

The main provisions regarding to EMU were: 1) Convergence criteria a country has to meet before it could participate in EMU, though allowance was made for certain countries opting out. 2) A timetable for the three stages in introduction of a single currency. 3) The main institutional features of EMU and, in particular, of the European Central Bank

EU countries and the Impossible Trinity after 1987

The single market and EMS implied a commitment to free capital movement with fixed exchange rates. This system could survive only as long as the other ERM countries were prepared to sacrifice monetary autonomy and accept German policy leadership. After reunification, this was no longer the case and the system broke down. EC countries regained a degree of monetary autonomy, but at the price of sacrificing fixed exchange rates from August 1993. The way forward proposed by the Treaty of Maastricht was to combine the first two elements of the list with a common monetary policy for the euro area.

Could the EU become an optimal currency area?

Though the EU is not a OCA, the mere creation of EMU could help progress in this direction. Joining a monetary union encourages rapid growth of trade, speeding up the integration process. Some authors have found empirical evidence for increased integration reducing the likelihood of asymmetric shocks. The decision to join a monetary union may therefore lower the costs relative to the benefits, so it is possible that the criteria for joining an optimal currency area assume an endogenous nature. However, there is debate about this issue and with the eurozone crisis divergences appear to have increased.