"ASYMMETRY IN THE EMS; INTENTIONAL OR SYSTEMIC ?" by Charles WYPLOSZ N° 88 / 41 Charles Wyplosz, Professor of Economics, INSEAD, Fontainebleau Director of Publication : Charles WYPLOSZ, Associate Dean for Research and Development Printed at INSEAD, Fontainebleau, France ASYHHETRY IN THE EMS: INTENTIONAL OR SYSTEMIC ? Charles Wyplosz INSEAD, Fontainebleau, Ecole des Hautes Etudes en Sciences Sociales, and CEPR August 1988 ABSTRACT: Why has Germany emerged as the center country in the EMS? Most explanations consider that this is an outcome desired by all (or most) member countries. This paper offers an alternative view. Given a policy conflict the higher inflation countries face stronger pressure from the EMS than the lower inflation ones. Thus asymmetry may be systemic, an implication of fixed exchange rates. Paper presented at the Third Congress of the European Economic Association in Bologna. I have benefited from useful discussions with Jacques Melitz, Francesco Giavazzi, and Vittorio Grilli. - 1 - I - INTRODUCTION Germany has apparently become the de-facto center country of the European Monetary System (EMS). 1 This asymmetry is quite surprising given that the EMS was apparently designed to deliver full symmetry. Other previous experiences with fixed exchange rate systems seem to have also resulted in the emergence of a center country. The existence of such hegemonic tendencies, as reported by Eichengreen (1987), is usually explained by the size of the center country, either measured by its GNP - as the US under the Bretton-Woods system - or by the relative development of its financial markets - as the UK under the Gold Exchange Standard. In the case of the EMS, the size argument is a priori unlikely to be a good explanation, since other countries such as France or 2 Italy are not significantly smaller than Germany. The purpose of this paper is to consider other possible sources of asymmetry. The current literature mostly views the asymmetry as desired by the EMS member countries. Yet, it might be that the asymmetry is systemic, merely the inevitable outcome of a fixed exchange rates regime. The reasons why this might occur are presented in Section 3. The existence of a fundamental asymmetry, if demonstrated, would be of importance. It could lead to a reassessment of the costs and benefits from EMS membership and possibly suggest possible reforms. More generally, it would have implications for any potential reconstruction of the international monetary system. 1. For a detailed exposition of this view, see Giavazzi and Giovanini (1988). Evidence based on interventions data is produced by Mastropasqua et.al. (1987). 2. It has been noted that Germanys exports are significantly larger than those from any other EMS country. This is not, however, a powerful argument given that trade related exchange rate transactions represent a very small fraction of exchange market activity. Any explanation must concern chiefly financial transactions, and we return to the size argument in this context. -2- 2 - ASYMHETRY BY INTENT 2.1. Credibility The literature on credibility (see Persson (1988)) has shown how monetary policy may lead to inefficient outcomes because the authorities incentive to create inflation surprises is understood by the public. It is rational for the public to push prices up to the threshold point where the central bank sees further price increases as too costly to warrant a (temporary) expansionary effect. The key here is Rogoffs (1985) observation that the inefficiency is reduced if the central bank is known to be more adverse to inflation than the public at large, because the inflationary threshold is lowered, and credibly so. When applied to the EMS, this argument implies that the Bundesbank plays the role of the conservative central banker. EMS membership amounts to borrowing the Bundesbanks credibility. This interpretation, while intuitively appealing, is not entirely convincing for at least three reasons. First, devaluations become the signal that a country does not strictly adhere to the Bundesbanks stance. However, to act as a deterrent devaluations must be costly. One solution is to assume such costs: the public sees devaluations as a failure of the government (Melitz (1988)); but as any exchange rate change implies income and wealth transfers, revaluations are equally disliked in Germany. It is not clear, therefore, that assuming asymmetric costs brings much insight. An alternative is to make devaluations costly by preventing a return to a competitive level (Giavazzi and Pagano (1988)). This threat is both implausible and unrealistic. It is implausible because, if carried out, it would mean continuous and permanent losses of competitiveness so that the system is dynamically unstable. It is unrealistic because such has not been the case with the EMS (with the exception of Italy between 1982 and 1983). Second, we may imagine that all EMS inflation rates converge to the point where realignments are ruled out. The resulting credible disciplinary effect must however be weighed against a serious signal extraction effect. While the no-realignment rule may be optimal in face of domestic demand disturbances, a devaluation may be the best response to adverse supply shocks. If the public cannot distinguish among disturbances, the authorities face the choice between a loss of credibility and an inferior policy response. Finally, it is relatively easy to design institutions which - 3 deliver domestic conservative central bankers (strong independence, rewards, surveillance, disindexation, etc...). Why then adopt a foreign one? 2.2. Disinflation Another possible interpretation is that the EMS experience so far has been one of a successful joint disinflation. In such a disinflationary context, there exist conditions under which an EMS, centered around the lowest inflation country, Pareto dominates the Nash outcome under free float (Begg and Wyplosz (1987)). This possibility calls for two brief comments. First, it implies that Germanys leadership need not be sustained in a context where priorities shift away from inflation. Second, game theoretic results appear to be very sensitive to model specifications and the assumptions made about inter-country spillover effects: welfare implications of ambiguous policy linkages are far from convincing. 2.3. Portfolio preferences Asymmetric portfolio preferences may translate a dollar weakness into a DM strength, leaving most other currencies in an intermediate position, therefore weak relatively to the DM. Such an asymmetry, however, which looks systemic, cannot be simply assumed, it must be explained. (It has been shown to violate the traditional theory of portfolio optimization, see Frankel (1986)). Portfolio asymmetry may be a consequence of exchange controls in devaluation- prone countries, whose currencies become poor substitutes to the dollar. If, as argued in section 3, exchange controls are a systemic implication of the EMS, we still need to work out the corresponding portfolio theory. A more readily acceptable view (see e.g. Cohen et al. (1988)) is that the portfolio asymmetry reflects markets expectations about policy responses. This view then boils down to the credibility argument of the previous section. 3 - A SYSTEMIC ASYMMETRY ? It has long been believed (see, e.g. Nurkse (1945)) that a fixed exchange rate regime exerts more pressure on high than on low inflation countries because - 4 - the former see their exchange reserves fall. The long run inflation rate, while a policy choice, is constrained by a number of country characteristics such as the tax system, the degree of social consensus, specific markets structures, etc... Assuming that such constraints are exogenous and lead different countries to different steady state inflation rates, I sketch two arguments which suggest that this situation leads to a fundamental asymmetry. 3.1. Framework: a fixed exchange rate model The discussion is organized around a simple fixed exchange rate model adapted from Obstfeld (1988). Except for interest rates, all variables are expressed as deviations of their logs from the initial equilibrium (x . log X - log X0). The money base market equilibrium is (with obvious notations): (1) m - p ay - i/b In the absence of exchange controls, interest parity prevails: (2) i i + è, where é de/dt. Demand for the domestic good is: (3) d - a (i-p) + e (e+p-p) + g where dp/dt and p is the log of the foreign price level. The first part in (3) is interpreted as real absorption, the second part as the current 3 account and the last term g is a fiscal policy shift parameter. For simplicity it is assumed that y, i and p are constant (no inflation in the EMS partner country) and therefore y = p i O. The domestic good price is sticky and evolves as: (4) p = Y (d-Y) 3. Using upper-case letters for the level of variables (e.g. x log X), D = A + CA . A(1+CA/A) so that d a + log (1+CA/A) = a + CA/A. - 5 - where q is the shadow price which would be observed under PPP: (5) q e + p If the exchange rate is credibly fixed, è.0 and (1) to (5) reduce to: (6) (1-ay)f -erre + yg The money base is endogenously determined via (1) so that the only available instrument is fiscal policy. 3.2. Crises and Exchange Controls The model is first used to illustrate speculative crises in a fixed but adjustable exchange rate system. The literature on balance of payments crises has shown how an anticipated devaluation must eventually lead to a temporary period of floating. Thus pure realignments (i.e. without a temporary float) are impossible unless devaluing countries use exchange controls. To see this, we consider the balance sheet of the central bank: (7) m log M log (E0R + D) where R and D are, respectively, foreign currency holdings and domestic credit, E 0 being the reference exchange rate used for valuation of exchange 4 reserves. The evolution of R is governed by the balance of payments identity linking the current account (CA) and the capital account (KA): • E R CA + KA (8) o With no trend growth and perfect substitutability (see (2)), capital movements need not Lake place except when a realignment is imminent: as é goes to 4.