July 28: The European Monetary Union

READING ASSIGNMENT: McNamara, Kathleen R. 2008. A rivalry in the making? The Euro and

international monetary power. Review of International Political Economy 15 (3):439-459.

글로벌 KU 프론티어 스피릿 !!!

• The story of the contemporary international monetary system is the story about the search for the elusive ideal balance between domestic economic autonomy and exchange rate stability

The Unholy Trinity

• Fixed Exchange Rate

• Autonomy of Monetary Policy

• Capital Mobility

Mundell-Fleming: Only 2 out of 3 are possible

The point of the unholy trinity – you can’t have it all…

• 1999: Paul Krugman http://slate.com/id/36764

• “The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).”

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A note on “capital controls”

• Governments can restrict the flows of foreign direct investment, portfolio investment, changes in holdings in loans, bank accounts, and currencies (at least in the short- and medium-runs… “for a while”)

• Controls on outflows can prevent a run on the currency

• Controls on inflows can prevent going into too much debt

• Such controls can allow a country to maintain a fixed XR and have monetary autonomy… at least for a while…

Trade & international capital flows lead to imbalances

• How do governments deal with these imbalances?

1. Fixed exchange rate monetary policy

OR:

1. Floating exchange rate

• Trade-off between exchange rate stability – or – domestic price stability with monetary policy autonomy

Why are there imbalances?

• These days, foreign exchange markets conduct between $1 trillion and $1.5 trillion worth of business… PER DAY!!

Exchange rate volatility! Exchange rate misalignments

Consequences of XR volatility?

• Uncertainty may hurt international transactions

Fixed XR• A kind of commitment

• To avoid SPECULATATION governments try to make a credible commitment to a fixed XR

• If the commitment is not credible, speculation can be disastrous

• Argentine Currency Board (1991-2002)– Pegged the Argentine peso to the U.S. dollar in an attempt to

eliminate hyperinflation

– Credibility? Required legislative vote to change the value of the currency (public discussion undermines the point of a devaluation!)

– But deficit spending ultimately undermined confidence– And tied hands prevented the government from acting– Run on the currency in 2002 disaster!!

The Euro

• The ultimate commitment

• So, if it’s credible, will it overtake the dollar as the international reserve currency?

Euro-Zone• Austria (1999)• Belgium (1999)• Cyprus (2008)• Finland (1999)• France (1999)• Germany (1999)• Greece (2001)• Ireland (1999)• Italy (1999)• Luxembourg (1999)• Malta (2008)• Netherlands (1999)• Portugal (1999)• Slovakia (2009)• Slovenia (2007)• Spain (1999)

• EU members not using the Euro:– United Kingdom (float)– Poland (float)– Sweden (float)– Denmark (fixed)– Czech Rep (managed float

(Oatley) Nov 2009 set to join)

– Bulgaria– Estonia– Hungary– Latvia– Lithuania– Romania

The European Monetary System

• 1979

• Fixed but adjustable

• The Bundesbank (Germany) used monetary policy to keep inflation low, and other countries engaged in foreign exchange market intervention to fix their currencies to the German mark

French-German fight in 1981-3

• Mitterand – socialist president – believed German monetary policy was strangling

• Expansionist monetary policy (e.g., lowered interest rates)

• French inflation began to rise

• Called on Germany to lower their interest rates

• 18 month stand-off… the French backed down

1988-2002: Monetary Union

• 1988: Planning begins

• Gradually moved towards fixing their currency XR’s (1999 – “permanently” fixed)

• Jan 2002: The Euro!

• Why union?

• High degree of economic openness across Europe

• Sacrificed monetary autonomy for XR stability

Cocktail party phrases:

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Overvaluation of the Dollar

• International reserve currency

• Early 1980s: Reagan’s fiscal expansion – cut taxes, increased spending

• Current account deficit

• Increased interest rates and capital inflows (from, e.g., Japan)

• Value of the dollar goes up!

• Plaza Accord (fall 1985): G5 agreed to reduce the value of the dollar against the yen & mark by 10-12% – sell dollars if it appeared the value was going to increase

• By early 1987, dollar had depreciated 40%

Similar situation today

• US current account deficit

• Japan, Europe, China, current account surpluses

• Finance the American deficit– US absorbs about 6% of the world’s savings

• US international investment position:– foreign-owned assets in 2007: $17.8 trillion– US residents’ foreign assets in 2007: $15.4 trillion– international investment position: –$2.4 trillion

Worry?

• Catastrophe!

• Doubts about the solvency of American financial institutions & American assets

• Foreign lenders reluctant to continue to accumulate dollar-denominated assets

• Trigger massive sales of current holdings?

• http://www.youtube.com/watch?v=MJJN9qwhkkE

Hope• Cooperation amongst G5?

– (G5??? p255... China?)

1. US needs to reduce its budget deficit

2. Countries with surpluses need to expand demand in their own countries

• Macroeconomic coordination along these lines would reduce American imports & expand consumption in surplus countries

• Cooperation could also guide a gradual decline of the $, rather than a fast catastrophic drop

• Problem for China: adjustment moving from the US market to the domestic market would create economic dislocation, winners & losers… political instability?

• This is a reality that the Chinese government must deal with and therefore the American government must also!

• But a catastrophic drop would hurt the export-oriented sectors of all countries with current account surpluses with the US!

Source: http://www.fas.org/sgp/crs/row/RS22860.pdf