Transcript July 13: Trade and Development II: Economic Reform

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).”
r
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 mediumruns… “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
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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:
THANK YOU
글로벌 KU 프론티어 스피릿 !
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.fa
s.org/sgp/crs
/row/RS2286
0.pdf