International Monetary System and European Monetary Economics April 9, 2013 European Monetary Union (EMU) Elisabeth Pereira University of Aveiro (Portugal) 1

2 LESSON I : General Overview of Money, Brief Monetary History, International Monetary System Background and European Monetary System LESSON II : Organizational Structure, Main Functions and Tasks of the ECB, European Monetary Policy

Monetary Union is the controversial end of a long process. History helps to understand it. Since paper money was invented, Europe’s monetary history has been agitated. Each bad episode carries important lessons. Before paper money, Europe was a de facto monetary union. Understand how it worked helps to understand how the new union works.

 A long time ago, there was no money. People didn’t need any. They lived, gathering or hunting their food. They built their own houses and made their own clothes. Sometimes people had things that others wanted. A woman who made beautiful pots might want an animal skin hunted by a tribe of hunters. So, they would barter, with each other.

5 Specialization in production and trade expansion (e.g. farmers versus shepherds) (Barter Economy - Double coincidence of needs) Need for exchange goods and services Establishment of a reference unit (cattle, salt, shells, coffee, etc) Indirect exchange (Indirect exchange ) “Commodities reference”:manageable goods, transportable, divisible, durable scarce ex: copper, iron, silver, gold handle ability, conservation, beauty, religious connotation, Functions of Money as Exchange Instrument Growing acceptance Stamp (sovereign right to coin in Antiquity and Middle Age ) Multiplicity of sovereign and currencies Scalpers (burghs, fairs) time

6 Development of Trade (Jews) Exchange of Letters (letters, notes) cabalistic signatures London Goldensmiths (century XVII) Standardization of the value of the notes (goldsmiths notes) Bank of Stockholm (century XVII) (first banknotes) Industrial Revolution and World War I and II, progress of century XX Development of the banking system Monetary Economies (Monetary Economies) time

Shells Precious stones Salt Pearls Feathers Wheat Cattle Coffee Copper Brass Silver Gold Paper money Plastic money

Money – originally based on metals Costly and dangerous to engage in long distant trade. Problems with quantity and divisibility Even then no guarantee that value is ‘true’ Emergence of bills of exchange

10-9 ● International Monetary System ● International Monetary System refers to the institutional arrangements that countries adopt to govern exchange rates  A f loating exchange rate system exists when a country allows the foreign exchange market to determine the relative value of a currency  a dirty float exists when a country tries to hold the value of its currency within some range of a reference currency  A fixed exchange rate system exists when countries fix their currencies against each other  European Monetary System (EMS)  A pegged exchange rate system exists when a country fixes the value of its currency relative to a reference currency

Gold Standard System: 1870 – 1914 Interwar years: 1918 – 1939 Bretton Woods System: 1944 – 1973 European Post War Arrangements: Monetary Snake European Monetary System (EMS) European Union

Gold Standard Gold Standard refers to a system in which countries peg currencies to gold value and guarantee their convertibility the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value payment for imports was made in gold or silver later, payment was made in paper currency which was linked to gold at a fixed rate  $1 = grains of “fine” (pure) gold  the gold par value refers to the amount of a currency needed to purchase one ounce of gold balance of trade equilibrium for all countries Value of exports should equal value of imports Flow of gold used to make up differences abandoned in 1914 Failed resumption after WWI Great Depression

The workings of the gold standard are described by David Hume’s price-specie mechanism Depends on (i) long-run neutrality of money and (ii) the effect of money on interest rates Money and the balance of payments are linked by trade flows Hume’s mechanism implies an automatic change in the money stock to achieve balance of payments equilibrium Balance of payments = net increase in money supply    0 C A B Gold money 0 C A B

 Money determines the price level (in the long run). Gold money Price level  The price level affects the trade balance:  if domestic prices are high relative to foreign prices, we have a deficit  conversely, relatively low domestic prices lead to a trade surplus. Price level Trade deficit Trade surplus Gold money

 Trade balance is achieved when the stock of money is M 1  Hume’s mechanism: return to balance is automatic  if we start with deficit (point A, high money stock M 0 ),  money flows out until we get back to balance.   Price level Current account deficit Current account surplus Gold money A M0M0 M1M1 P1P1

● Much the same story applies to the financial account: if the domestic interest rate is high (low), capital flows in (out) and the return to balance is automatic. The balance payments adds the current and financial accounts.  Interest rate Financial account surplus Financial account deficit Gold money i* M0M0 M2M2 A 0

● Paper money starts circulating widely ● The authorities attempt to carry on with the gold standard but: ● no agreement on how to set exchange rates between paper monies ● an imbalanced starting point with war legacies ● high inflation ● high public debts.

1. The British case: a refusal to devalue an overvalued currency breeds economic decline. 2. The French case: devaluation, under-valuation and beggar- thy-neighbour policies, until others retaliate and the currency becomes overvalued. 3. The German case: hyperinflation, devaluation and, finally, evading the choice of an appropriate exchange rate by resorting to ever-widening non-market controls.

In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth Fixed ex rate system imposes restriction on monetary policy of countries. Floating ex rates were regarded as a cause of speculative instability. Under the new agreement  a fixed exchange rate system was established  all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold  devaluations could not to be used for competitive purposes  a country could not devalue its currency by more than 10% without IMF approval  The Bretton Woods agreement also established two multinational institutions: International Monetary Fund(IMF) and the World Bank

 International Monetary Fund (IMF) and World Bank: IMF: maintain order in international monetary system through a combination of discipline and flexibility World Bank: promote general economic development Fixed exchange rates pegged to the US Dollar US Dollar pegged to gold at $35 per ounce Countries maintained their currencies ± 1% of the fixed rate; buy/sell own currency to maintain level

10-21  Today, the IMF focuses on lending money to countries in financial crisis ● A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates ● A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits ● A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt

● : Private capital outflows from US ● : Johnson Administration : bad US macroeconomic policy Involvement in the Vietnam conflict “Great Society” program  G   Deficit   M S   P  & CA  (stagflation) ● August 1, 1971: Nixon’s announcement ends the gold convertibility Stop to sell gold for dollars to foreign central banks 10% tax on all imports until revaluation of each country’s currency against the dollars Freeze prices and wages. ● December 1971: Smithsonian agreement The dollar was devalued against foreign currencies by about 8% ($38 per ounce of gold). The currencies of the surplus countries were revalued. Maintain the ex rate within ±2.25% of the stated parity. ● : Speculative attacks and currencies floating. central banks frequently intervene

 Initial divergence.

 Fixed ex rates works like a gold standard. To keep their prices fixed, countries have to buy or sell their currencies in foreign exchange market (FX market intervention).  Floating (Flexible) ex rates the exchange rates are determined by the market forces of demand and supply. No intervention takes place.

Managed Floating: MA influences ex rates through active FX market intervention (Independently) Floating: the ex rate is market determined. No FX intervention. Currency Board: A legislative commitment to exchange domestic currency for a specified foreign currency at a fixed ex rate. Fixed Peg: The ex rate is fixed against a major currency. Active intervention needed. Crawling Peg: The ex rate is adjusted periodically in small amounts at a fixed, preannounced rate. Dollarization: The dollar circulates as the legal tender.

● Advantages: Each country can produce independent macroeconomic policies. Countries can choose different inflation rates. ● Disadvanges: The system is subject to destabilizing speculation Increase the variability of ex rates Self-fulfilling prophecy “evening out” swings in ex rates

● Advantages: Stable exchange rates Each country’s inflation rate is “anchored” to the inflation rate in the US.  price stability ● Disadvanges: A country cannot follow macroeconomic policies independent of those of other countries. To maintain the fixed rates, countries need to share a common inflation experience.

● Agreeing on stabilizing intra-European bilateral parities. ● No enforcement mechanism: too fragile to survive.

O Exchange rate No intervention Central bank buys domestic currency No intervention Central bank sells domestic currency No intervention Time +4.50% -4.50% +2.25% %  The first attempt by the EC to deal with the exchange rate turbulence that followed both of these events, the so-called “snake,” rapidly collapsed to an arrangement involving only a few of the Member States. Upper limit Lower limit

 1973 – First Oil Crisis  Snake outside the ‘tunnel’ link with dollar broken  Governments responded by trying to deflate economies spending and issuing (‘forging’) money –expansionary fiscal and monetary policy  Collapsed, and then revived in 1979

10-31  more volatile less predictable  more volatile and less predictable, in part because of: the 1973 oil crisis the loss of confidence in the dollar after U.S. inflation in the 1979 oil crisis the rise in the dollar between 1980 and 1985 the partial collapse of the European Monetary System in 1992 the 1997 Asian currency crisis

 An overriding desire for exchange rate stability –Initially provided by the Bretton Woods system –The US dollar as anchor and the IMF as conductor  After Bretton Woods collapse, the Europeans were left on their own –The Snake arrangement (Basileia Agreement, March 1972) –The European Monetary System (EMS) (1978) Main elements: Exchange Rate Mechanism + ECU –The Economic and Monetary Union (1990)

● Complements bilateral exchange rate commitments with a support mechanism. ● Allows for prompt realignments to avoid misalignments. ● Emergence of the Deutschemark as the system’s anchor.  The EMS had as main elements: Exchange Rate Mechanism + ECU  The Treaty did three things to further monetary integration in Europe: 1.It set out a timetable for the establishment of monetary union. 2. It laid down the criteria by which the fitness of countries to join in monetary union would be determined. 3.It established the institutional framework for the conduct of monetary policy under EMU.

 The EMS was originally conceived as the solution to the end of the Bretton Woods System.  This, and the speculative crisis of 1993, made the monetary union option attractive.  Now the EMS is mostly the entry point for future monetary union members.

 EMU is the latest step toward the greater integration in Europe  Monetary Union in the European Community (EC) was proposed in 1970 in the Werner Report to take place in the 1980s  However, two events in the international sphere derailed this first attempt: 1. The breakdown of the Bretton Woods system of fixed exchange rates in August 1971, and 2. The 1973 oil crisis

● In June 1988 the European Council confirmed the objective of the progressive realisation of Economic and Monetary Union (EMU) ● Discussed in Maastricht in 1991 : propose of a single currency ● A single currency would make European markets more efficient and Europe's economies more dynamic ● A single currency leads to a more intense political cooperation between EU nations ● The criteria for nations to be part of the single currency: ● Low government debt ● Low inflation rates ● Low interest rates ● Greece initially failed to qualify on economic grounds and the UK and Sweden opted to remain outside the euro zone

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38  Stage1 : Maastricht Treaty  Stage 2 : Establishment of the EMU 1. 1 January 1994: The establishment of the European Monetary Institute (EMI)The EMI had no responsibility for the conduct of monetary policy in the European Union 2. December 1995: the European Council agreed to name the European currency unit to be introduced "euro", and confirmed that Stage Three of EMU would start on 1 January December 1996: EMI presented to the European Council, and to the public, the selected design series for the euro banknotes to be put into circulation on 1 January May 1998: the governments of the 11 participating Member States (Austria, Belgium, France, Finland, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain) appointed the President, the Vice-President and the four other members of the Executive Board of the ECB. 1 June 1998: Establishment of the ECB. ( EMI ended with the establishment of the ECB).  Stage 3 : Irrevocable fixing of exchange rates 1 January 1999: the irrevocable fixing of the exchange rates of the currencies of the 11 Member States initially participating in Monetary Union was commenced along with the conduct of a single monetary policy under the responsibility of the ECB. 1 January 2001: Greece joined the EMU, making the number of participating Member States increased to 12.

Stage Three: January 1, o Eleven countries fixed their exchange rates. o The national currencies of the eleven were replaced by the euro. o The ECB took over responsibility for monetary policy in the euro area.  January 1, 2002: Begins with the introduction of euro notes and coins and the withdrawal of national currencies on.  July 1, 2002: the old national currencies ceased to have legal tender status

● A system is needed ● The gold standard –monetary unions–delivers automatic return to equilibrium, but with the cost of booms and recessions. ● No agreement leads to misalignments, competitive devaluations and trade wars. ● Any monetary system agreement require rules and implies a conductor.

● May 9, proposed in a speech by the French Foreign Minister Robert Schuman. (Europe day) ● 1951 – Founded in 1952 (Treaty of Paris) purpose : reduce potential conflict between member states by pooling vital resources ● European Economic Community (EEC) – or Common Market (Treaty of Rome) ● 1980s - European Community (EC) created (1986: Single European Act is signed) ● 1993 – name changed to European Union (EU) (Treaty of Maastricht) ● Europe has been able to achieve political cooperation and even unify by using economics as a political tool

► 1957 six founding members: Belgium, France, Germany, Italy, Luxembourg and the Netherlands. The EU has now undergone six successive enlargements: ► 1973 Denmark, Ireland and United Kingdom ► 1981 Greece ► 1986 Portugal and Spain ► 1995 Austria, Finland and Sweden ► 2004 The Czech Republic, Cyprus, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia ► 2007 Bulgaria, Romania

44 1.Primary objective : to maintain price stability, as defined in Article 2 of the Statute of the ESCB and of the ECB. 2.Price stability : a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%. To be maintained over the medium term. The Governing Council announced that, in the pursuit of price stability, it would aim to maintain inflation rates close to 2% over the medium term.

45 BALDWIN Richard, WYPLOSZ Charles (2012). The Economics of European Integration. Maidenhead McGraw-Hill Higher Education. (Chapters 11) Hill, Charles (2011), Global Business Today, McGraw-Hill,6th Edition. (Chapter 5 : The International Monetary System)

46 o Why did fiscal and monetary indiscipline in the US lead to the collapse of the Bretton Woods system? o Why did growing inflation differentials create a problem for exchange rate stability in Europe? o During the interwar era, misalignments led to competitive devaluations, which then prompter a tariff war. Explain the links from one step to the next. o How can the Hume mechanism be applied to the flows of euros within the euro area?

10-47 A ________ exchange rate system exists when the foreign exchange market determines the relative value of a currency. a) Fixed b) Floating c) Pegged d) Market

10-48 What type of exchange rates system was the gold standard? a) Fixed b) Floating c) Pegged d) Market

10-49 A _________ is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt. a) currency crisis b) banking crisis c) foreign debt crisis d) foreign exchange crisis

10-50 Which type of exchange rate system do most IMF countries follow today? a) Free float b) Managed float c) Fixed peg d) Adjustable peg