Chapter 20: European Monetary Arrangements

Topics: European Monetary System EMS Crisis European Monetary Union European Central Bank

1. European Monetary System (EMS)

After the collapse of the Bretton Woods system, several European countries attempt various mechanisms to fix their exchange rates to each other.

a) Mechanics

In 1979, eight created a formal system of mutually fixed exchange rates, called the European Monetary system (EMS). This set E relative to each other, and these currencies floated jointly against the dollar.

The bilateral exchange rates were not held exactly fixed. They were allowed to fluctuate within bands (margins) of an assigned par value with each of the other currencies.

These were set in this manner: Each currency has a central parity in terms of ECUs (European Currency Units, a basket of member currencies). Central parities were used to determine the bilateral central rates. When this was first set up, each bilateral rate was only allowed to deviate by 2.25% above or below the established parity.

So, if the French franc depreciates to its lower limit relative to the DM, it is obligated to sell DM reserves to make the Franc appreciate. The German central bank is obligated to loan DM to France. If the pressures of misalignment are strong, and it seems that a country can’t defend the set exchange rate, there are provisions for currencies to be realigned if necessary.

Initially, there were capital controls that limited the ability of private citizens to trade in foreign currencies. This helped to prevent speculators from starting a currency crisis. These restrictions were relaxed in 1987.

Initially, the system worked better than most expected, and more countries joined along the way.

b) German Dominance

The system was designed to be symmetric, but it evolved with Germany having the dominant position.

Germany had a reputation for low inflation, likely due to memories of the severe hyperinflation in the inter-war years. When the Bundesbank (German central bank) was created, its primary goal was said to be to keep inflation low and keep the value of the DM high. And it was designed to be independent of the government, so as to be insulated from political pressures to expand money supply and raise output.

Other countries wanted to import Germany’s reputation for low inflation. So they willingly used the DM as their main reserve currency, and let their monetary policy mimic what Germany was doing. This evolved so that it looked like the Bretton Woods system, with Germany as the hub rather than the U.S.

However, this once again led to problems when Germany put its domestic interests ahead of its international role, just as Bretton Woods got into trouble when the U.S. pursued its policy of the 1960s. This led to a currency crisis in the fall of 1992, which almost wrecked the EMS.

2. EMS Crisis

a) German Unification

Recall that Bretton Woods and the gold standard ran into trouble because they couldn’t adjust well to economic shocks. This was true here as well; the shock was German Unification.

The economic reunification of East and West Germany began in July 1990, when East Germans traded their holding of East German currency for DM. One result was a rush to buy the modern consumer goods had been unavailable earlier. The result was that the DD curve shifted to the right, due to an increase in the consumption component of aggregate demand.

This also marked the beginning of large fiscal expenditures on the East.

There was a surge in unemployment in the East; people demanded the same wages as in the West, but they did not have the modern equipment or the training to be as productive. Enterprises could not produce goods of competitive quality or price, so they went out of business. The government needed to pay for the training and support of the unemployed.

This was also caused by the need to rebuild the infrastructure in East - roads, etc. - and to clean up the polluted environment. This caused an even bigger rightward shift in DD.

The government feared that the economy was overheating, with a big increase in aggregate demand, and generating inflation, which Germans have feared ever since hyperinflation. So in 1992, it cut the money supply to lower inflation. This produced a left shift in the AA curve. This would lead to the DM appreciating (draw graph).

b) Currency Crisis However, recall that Germany is part of a fixed exchange rate regime with other European countries. This policy put them in a difficult position. To stay within the bands relative to the DM, they also had to cut their money supplies. But this was no fun for them, because they had not been part of the output boom Germany had been experiencing. (Instead, they had the problem of large budget deficits.) So output levels fell and unemployment rose substantially in France, the U.K., Italy.

The EMS had not had to change parities since 1987, no changes in 5 years. People had thought it was working well, but the shocks simply had not been that big.

Now speculators in currency markets began to doubt whether these countries would be able to bear the recession they were inducing. They would need to revise their central parities against the DM. But this expectation set off speculative attacks and a currency crisis of the same type that undid Bretton Woods.

Pressure on the Lira caused it to devalue on September 11, 1992. So some speculators made profits, and showed that the EMS could indeed be cracked.

September 16, Black Wednesday. There was continued pressure for the Lira to be devalued even more, and pressure on the Pound as well, with costly draining of reserves. The Lira and Pound ended up being taken out of the EMS system, and these currencies were allowed to float. France was also attacked, but managed to hang on. Many other currencies had to be devalued: Spanish peseta, Irish punt, Portuguese Escuda.

Even for those currencies still in the system, the bands were widened considerably, from 2.25% to 15%. It’s not clear that was much of a restriction, but the internal European E-rates seem to have settled down again for the most part at their new levels. c) Aftermath

Perhaps France was the unlucky/unwise one. France has continued in recession with very high unemployment. But the U.K. and Italy did better, In part due to a depreciated currency that made their goods more competitive, so the CA improved. The Lira dropped in value almost 50%, CA went from negative (over the 10 years prior to 1992) to positive in 1993. This was also true for the U.K., Sweden, and Ireland, and helped most of these countries to see improved output levels in 1993.

Note that this came at cost of their European trading partners, especially France, who kept currency high and goods non-competitively priced. Output fell substantially in France and unemployment rose. There are accounts of firms that closed up shop in France and moved across English Channel to use cheaper British labor, worsening unemployment in France.

This led to calls for protection, and threatened to undermine the free-trade agreements within the EU. It’s also an example of the“beggar-thy-neighbor” policy mentioned in Chapter 19. 3. European Monetary Union

a) Introduction

The Maastricht treaty of 1994 was the first step in adopting a common currency, or monetary union. It is novel in that there are distinct countries with own governments, but with a single currency controlled by a single European Central Bank in Frankfurt Germany.

Countries had to satisfy various macroeconomic convergence criteria with respect to inflation and debt. It was determined in May, 1998 that 12 (of 15) EU countries had satisfied these, and 11 of these (not the U.K.) joined the monetary union.

In January, 1999 each national currency was redefined as a fixed number of euros. No physical euros yet, but euros are used for electronic transactions and accounting purposes: stock and bond trades denominated entirely in euros, all transactions between banks, bank customers can write checks in euros. Euro notes were introduced in January, 2002, with time limits on using/converting the old national notes.

This is an extreme version of fixed exchange rates, as it is irrevocable (in principle). It’s very different from the U.S., where 50 states are part of one country, with a strong central government. European countries retain national sovereignty over most things, but give up national sovereignty with respect to money.

b) Theory: Gains from monetary union

There is less uncertainty and a lower (zero) transaction cost for cross-border trade.

d) There are transaction costs of exchanging currency. Imagine if California had its own currency, and everyone else had to convert dollars (or whatever) to buy its products and services.

1. Uncertainty is even a bigger issue. Example: It is risky for an electronics store to order a shipment of Japanese televisions if its not sure what the $ price will be when they are delivered.

 This is compounded for investment (although this can be used as a hedge. Here the payoff is far in the future.

The size of all these gains depend on the extent of cross-border trade (integration).

Another issue is that this change is “irrevocable”. In EMS, as long as there is some chance E parities can be realigned, this invites speculative attacks to undermine the system. The way to maintain fixed E is by selling reserves of foreign currencies and buying own currency from anyone who wishes to sell it at the official rate. If the government runs out of reserves, it must let the value of the currency fall.

So speculators can make money: borrow a bunch of FF, go to the central bank and sell for large # DM (FF overvalued), when reserves of DM depleted, bank allows value of FF to fall, then sell back your DM for large number of FF. Repay loan and have profit.

This possibility is eliminated if is only one currency. c) Theory: Costs of monetary union

Of course the main cost is the inability to use independent monetary policy (as with the fixed exchange rate regime). But how great is this cost and what does it depend on? Consider a recession in Spain alone: high unemployment and falling output. Previously Spain could use its monetary policy: increase money supply to lower interest rates, making it cheaper to borrow to buy car or build new factories, and so stimulating demand for investment projects and consumption. This increased demand causes factories to produce more and hire more workers. So this raises GDP and lowers unemployment. But now Spain can’t do this on own, as the ECB decides on common monetary policy to suit diverse interests of all the EU 11.

Here are some features that determine size of this cost:

1. Symmetry of shocks: suppose the rest of the EMU countries are all experiencing the same shock - fall in tastes for all European goods. In that case, the monetary union as a whole could increase money supply to restore full-employment output. But suppose Spain is the only one in this boat. Then it is stuck. So this is a question of how asymmetric the shock is. If it hits one country more than others, we would want to use a country-specific policy if possible. Shocks will tend to be more symmetric if the national economies are more similar, producing the same sorts of things in similar ways. 2. Integrated factors markets: If the unemployed workers in Spain can move to Denmark if there are more jobs there, then this helps alleviate the stress of asymmetric shocks. 3. Fiscal Federalism: Suppose there is a mechanism whereby if Spain is hurt by a shock, income would be transferred from Denmark to Spain to compensate for lost welfare of higher unemployment. An example would be a federal system of taxation and welfare payments, where more taxes are collected from where income is higher and more benefits are dispensed to where income is lower, in similar economies.

It appears that costs are low and benefits high if economies are highly integrated: a high level of trade in goods, flow of labor, integrated fiscal administration. These are characteristics of an optimal currency area, where the costs are lower than gains.

d) Evidence We can compare this situation to the U.S., a functioning common currency area.

1. Extent of trade: If there is more trade, the effects (gains) of lower transaction costs will be larger. Most European countries trade 10-20 percent of their GDP with other European countries. This is larger than trade between Europe and the U.S., but not as large as trade between regions within the U.S. However, there is a trend of increasing trade between European. 2. Symmetry of Shocks: Studies have tended to find that shocks are more asymmetric in Europe, partially due to the fact that Northern Europe tends to produce more goods that require capital and skilled labor than do southern European countries. But can also see some asymmetric shocks in the U.S. Consider the recession in 1990- 91. It hit Californian harder and longer than most of the rest of country, because it was partly due to cutbacks in defense spending, and many defense contractors were based in California. 3. Integration of Labor markets: Labor mobility is low in Europe, despite the fact that they have removed passport checks within Europe. Main reason is that countries have distinct cultures, making people less willing to relocate to find employment. Further, even within each European country there is less mobility than in the U.S. One study showed that in 1986, 3% of U.S. citizens changed state of residency, while in Germany only 1.1% changed from one German region to another German region; Italy was 0.6%. Labor mobility is an important means for U.S. regions to adjust to asymmetric shocks. When California went through bigger recession, there was outflow of migration to states where unemployment was lower. 4. Fiscal Federalism: Not highly developed in Europe - individual governments have not given up their separate authority over taxing and spending. There is a highly developed fiscal federal system in U.S. - national income tax and welfare system. This can transfer much income to areas hit by an asymmetric shock. For example, for every dollar California lost in income relative to rest of country, 25 cents less was paid to the federal government, and 10 cents more was received from the federal government. So perhaps 35% of an asymmetric output shock is offset. (Some studies dispute these amounts, estimating 17 cents cushion on the dollar)

The clear conclusion seems to be that Europe is not an optimal currency area, as the costs appear to outweigh the benefits. So why move forward? e) Political benefits of EMU:

1. Joint decision making. Germany was the leader in the EMS, deciding monetary policy; the other countries were followers. But if there is one common central bank deciding monetary policy, Germans will just be one among many members, others will also have a voice in deciding policy. What then is in it for Germany - why join?

2. The next step toward political integration. This financial integration is seen as a necessary step toward political integration, allowing more influence in international affairs. This is something Germany has a hard time doing now because of its history. 3. Prevent political opposition to free trade. There are large gains to free trade in goods. If we allow fluctuations in the exchange rate to hurt export sectors in one country or another, there will be an organized political force to demand protectionism and undo free trade in goods.

This raises the question of whether the U.S. is really an optimal currency area. We have mechanisms to help deal with asymmetric shocks, like California recession in early 1990s (or the recent electricity fiasco, but that’s a political economy question). But perhaps California would have been better off if it had its own currency. It could have used monetary policy to make the California currency depreciate --California goods become cheaper, improving California’s CA component of aggregate demand, raising California’s output level toward full employment.

4. European Central Bank

a) ECB design

The ECB is based in Frankfurt. It is similar in some ways to the Federal Reserve and Bundesbank. A governing council, with representatives from each member country, determines monetary policy.

It is d esigned to keep inflation low.

Theory: if you increase money supply, you may lower unemployment in the short run, but you will increase inflation in long run. There is more money chasing after the same number of goods, bidding up their price.

There are natural tendencies to make politicians vote for too much money supply increase, because low unemployment causes more favorable votes for incumbents. So we tend to get too much inflation.

Inflation is disliked, because it generates uncertainty, similar to changes in the exchange rate. We don’t know how much a nominal payment is worth in real terms.

At the time the ECB charter was written, most governments in Europe were conservative and thought it was more important to keep inflation low than worry about unemployment. So they argued for design features to help ECB keep inflation low and not worry about unemployment. Design features 1. ECB charter states that inflation control is its primary objective. 2. Independence: The representatives on the governing council are prohibited from taking instructions from governments. The president has an 8-year term, and is (supposedly) immune from politics. 3. Stability pact: Keep deficits low, below 3%.

Of course, now that the system is in place, some governments regret the design. Some of these governments are now more “left”, and place a higher priority on unemployment. Germany in particular has a problematic economy and has pressured Duisenberg to increase the money supply. It’s unclear whether the design will stand up to pressure. b) Implications for the U.S.

The European economy is little more efficient. They will be able to sell us cheaper goods, and be richer and buy more of our goods.

It should be easier for our firms to conduct business there.

The Euro will compete with the dollar as an international reserve asset. Currently the dollar is 60% of foreign reserves (European currencies only 1/4 of that). We get benefit because people want to hold US dollar. The Euro may get some of this business.