The European Monetary Union

1
The European Monetary Union

• READING ASSIGNMENT
• McNamara, Kathleen R. 2008. A rivalry in the
  making? The Euro and international monetary
  power. International Political Economy 15
  (3)439-459.

2
Plan

• Eurozone
• Solving Addressing an old problem
• International Reserve Currency

3
The Euro represents an ultimate commitment

• unless they really figure out a way to kick out
  Greece Cyprus
• I doubt it but the discussion is raging
• http//www.ft.com/intl/cms/s/0/3b617900-d92a-11e4-
  b907-00144feab7de.html?ftcampcrm/email/201549/nbe
  /USMorningHeadlines/productsiteeditionintlaxzz3
  WouEvhxu
• The Euro solution to the TRILEMMA ?

4
Fixed Exchange Rate
The Trilemma
Open Capital Flows
Sovereign Monetary Policy
5
Imbalances are a fact of global life

• These days, foreign exchange markets conduct
  between 1 trillion and 1.5 trillion worth of
  business PER???
• Per year?
• Per month?
• Per day?
• Per hour?
• ?
• ? Exchange rate volatility!
• ? Exchange rate misalignments

6
How do governments deal with these imbalances?

• Avoid them? ? Capital controls!
• Fixed exchange rate? ? Sacrifice monetary policy!
• OR
• Floating exchange rate
• Trade-off exchange rate stability or
• domestic price stability with monetary policy
  autonomy

7
The Eurozone
8
(No Transcript)
9
http//en.wikipedia.org/wiki/EurozoneEnlargement
10
http//en.wikipedia.org/wiki/Eurozone
11
Membership

• Some countries, the Eurozone doesnt want
  (yet/ever?)
• Must do the 2 year European Exchange Rate
  Mechanism
• Some countries dont want the Eurozone
  (yet/ever?)
• Opt out Denmark, UK, Sweden (de facto)
• Why?
• A real commitment
• To understand
• how its a strong commitment
• and why some countries want it,
• lets go back

12
A puzzleWhy were countries able to maintain
fixed exchange rates with high capital mobility
in the late 19th century?
Fixed exchange rates Open capital flows
Degree of global capital mobility
Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1870
Interwar period
1944
13
Why?
14
Answer Democracy
Growing s of democracies
Few democracies
Fixed exchange rates Open capital flows
Degree of global capital mobility
Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1870
Interwar period
1944
15
The international collective action problem

• How can we allow for the free flow of goods,
  service, and capital without
• Imbalances leading to beggar-thy-neighbor policies

16
One solution

• IMF to the rescue!
• Soften the blow of adjustment
• Moral hazard?
• Conditionality?
• Bretton Woods just falls apart
• The IMF never really worked as intended

17
Maybe not an impossible mission?

• 1979 The European Monetary System
• 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

18
French-German fight in 1981-3
19
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

20
1988-2002 Monetary Union

• 1988 Planning begins
• Gradually moved towards fixing their currency
  XRs (1999 permanently fixed)
• Jan 2002 The Euro!
• Why union?
• High degree of economic openness across Europe ?
• Sacrificed monetary autonomy for XR stability

21
Why sacrifice autonomy? Are XR fluctuations
really such a problem?
22
Brazilian President Dilma Rousseff referred to
unstable capital flows as a "liquidity tsunami"
11 Apr 2012 http//www.aljazeera.com/indepth/opin
ion/2012/04/20124894553253392.html
23
Brazilian exports getting crushed by currency
appreciation
24
Do trilemma solutions need to be compatible
across countries?

• Brazil is complaining now
• Used to have a fixed XR
• Then East Asian Financial Crisis hit
• Currency value collapses under speculation (Dec
  1998/ Jan 1999)
• MERCOSUR?
• Argentinas exports become uncompetitive over
  night
• Argentinas currency collapses in 2002

25
Commitment mechanisms

• 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!)
• Then current account deficit widens (after
  Brazils 1998/9 crisis)
• And deficit spending ultimately undermined
  confidence
• Tied hands prevented the government from acting
• Commitment was, perhaps, too strong
• Run on the currency in 2002 ? disaster!!

26
What does a run look like?

• https//www.youtube.com/watch?viPkJH6BT7dM

27
Do the worlds 2 largest economies have
compatible solutions to the trilemma?

• US shock absorber
• Floating exchange rate
• China opts for
• restrictions on capital flows
• fixes its currency to the dollar
• How can the dollar adjust if China fixes to it?
• This is the current monetary system
• And its doomed

28
Exchange rates protectionism

• Currency manipulator ??
• Should the WTO be involved in regulating the
  exchange rate?

29
What can China do?

• Gradual appreciation?
• A one-way road to hot money and a scary bubble
• A one-off revaluation?
• Catastrophic economic dislocation
• Politically possible given the export-oriented
  sector strength?
• Status quo?
• Unsustainable in the long-run

30
http//www.ft.com/intl/cms/s/0/7e010a5a-8324-11e1-
9f9a-00144feab49a.htmlaxzz1rjqaPoVT
31
(No Transcript)
32

• Complaints from Mexico about Chinese currency
• But even as their currency appreciated, it was
  far below where it was before the crisis

33
http//www.bea.gov/newsreleases/international/tran
sactions/transnewsrelease.htm
34
So, are global imbalances the fault of the United
States?

• How can the US get away with running Current
  Account deficits year after year?
• Capital Account surpluses
• Why?
• Are we really a great place to invest?
• International Reserve Currency
• The world has coordinated on the dollar

35
Battle of the sexes
Her
Him Football Ballet
Football 4,3 2,2
Ballet 1,1 3,4
4gt3gt2gt1
36
There are 2 equilibria! This is a game with
multiple solutions This is a game with multiple
equilibria!
Which side of the street?
Korea
Japan Left Right
Left 4,3 2,2
Right 1,1 3,4
4gt3gt2gt1
37
(No Transcript)
38
Good Will Hunting

• (around min 21)
• SKYLAR Maybe we could go out for coffee
  sometime?
• WILL Great, or maybe we could go somewhere and
  just eat a bunch of caramels.
• SKYLAR What?
• WILL When you think about it, it's just as
  arbitrary as drinking coffee.
• SKYLAR (laughs) Okay, sounds good.
• http//www.imsdb.com/scripts/Good-Will-Hunting.htm
  l

39
Is the euro an alternative?

• Coordination game
• Present distribution of reserve currencies
• Dollar 60
• Euro 25
• Pound 4
• Yen 4
• Swiss franc 0.1
• Other 5

40
Obstacles

• A focal point The more people who use an
  international currency, the more effective it is
  (increasing returns to scale)
• No equivalent to the US treasury bill _at_ the EU
  level
• Leadership who bails you out?
• US track record v. EU (Greece?)

41
Is the renminbi an alternative?
42
Be careful what you wish for

• Benefits of international reserve currency
• finance fiscal deficits
• enhance international prestige
• debt denoted in your own currency
• Costs of international reserve currency
• Monetary policy autonomy is hindered - vast
  quantities of your currency held abroad
• Overvaluation leads to uncompetitive
  export-oriented/import-competing sectors

43
Is the SDR an alternative?
44
In CRYPTOGRAPHY we trust?
45
(No Transcript)
46
Take-homes on Euro

• Solves the old problem that the IMF failed to
  solve
• Still limited as a currency
• No EU level bond
• Will it become the new international reserve
  currency?
• Probably not any time soon
• Coordination game
• The Dollar is still noon, Grand Central
  information booth

47
Thank youWE ARE GLOBAL GEORGETOWN!
48
Keynes 1919 quote

• The inhabitant of London could order by
  telephone, sipping his morning tea in bed, the
  various products of the whole earth, in such
  quantity as he might see fit, and reasonably
  expect their early delivery on his doorstep he
  could at the same moment and by the same means
  adventure his wealth in the natural resources and
  new enterprise of any quarter of the world. He
  could secure forthwith, if he wished it, cheap
  and comfortable means of transport to any country
  or climate without passport or other formality.
  He regarded this state of affairs as normal,
  certain, and permanent.

49
My personal idea a market solution

• Competition for natural resources
• Marginal benefit of protecting exporters
• Meets
• Marginal benefit of cheaper oil
• ? Currency appreciation
• Addresses imbalances but prices in the US will
  go up
• Good for the global economy but hard times ahead
  for the United States
• Alternative?
• Global catastrophe