Desirability of currency internationalisation Jeffrey Frankel Harpel Professor of Capital Formation & Growth Harvard University 7th Policy Roundtable of the European Central Bank The international role of the euro: past, present and prospects ___________ ECB, Wednesday, 24 June 2015, Frankfurt

Questions 1) What are the benefits & costs of internationalisation – i) from a euro area perspective? – ii) from a global perspective? 2) What concrete steps can be taken to foster the international role of the euro? – Are there lessons from the US dollar experience? – What are the implications for the ECB's monetary policy?

1) The benefits & costs of internationalisation i) from the perspective of the home region Benefits – Makes international transactions easier for residents, analogously to the advantage of doing business in English. Currency mismatches become somebody else’s problem. – More business for its banks. – Exorbitant privilege Could the US have run 33 years of CA deficits otherwise? Includes also more seigniorage for the central bank. – Security dimension: More power/prestige for region. Not overwhelming, in the case of the euro-zone – But there is one more to come…

1) The benefits & costs of internationalisation i) from the perspective of the home region Costs – A possible rise in volatility of total demand for the currency. – An increase in average world demand for the currency, leading to appreciation and lost competitiveness for industry. This is why internationalization lacked domestic support – in the US, after World War I; – in Germany, in the 1970s; and – in Japan, in the 1980s. – Unwanted burden of responsibility, e.g., when other countries adopt the currency. Is this why the ECB opposes unilateral adoption of the euro in Eastern Europe?

5 Cost – A multiple reserve currency system is inefficient, in the same sense that barter is inefficient: money was invented in the first place to cut down on the transactions costs of exchange. Benefit – Nevertheless, if sound macro policies in the leader country cannot be presumed, the existence of competitor currencies gives the rest of the world protection against the leader exploiting its position by running up too much debt and then inflating/depreciating it away or by excessive extraterritoriality. 1) The benefit & cost of internationalisation ii) from a global perspective

2) What concrete steps can be taken to foster the international role of the euro? The “traditional” list of criteria for determining international currency status: – Historical inertia – Size of the home economy – Reputation for retaining value – Depth/liquidity/openness of home financial market. I think I was missing (in 2007): – a deep, liquid, integrated government bond market. – That is, the euro is missing one.

2) What concrete step can be taken to foster the international role of the euro? Should the euro area try to develop a government bond market just to facilitate internationalization? No. But there are other more important reasons to develop a euro bond anyway: – to help the ECB conduct monetary policy, by offering an asset to buy in QE, in place of national bonds; but also in normal times, before the crisis, – so that national bonds don’t appear to be backed by the ECB.

How could a euro bond be established without the current moral hazard of letting national governments issue them? (I) The US precedent: Shift some government activities to the federal level, – undertaken by Brussels institutions, – with power to borrow and tax. Or (II) A version of the “blue bonds” solution: – The ECB accepts as collateral euro bonds issued by national governments, up to an explicit limit = 60% of GDP. – If countries borrow beyond that, they face market penalties for default risk. – Proposal is intended for after the euro crisis is well past.

10 Eichengreen, Chitu & Mehlo, April 2014 Appendix: Central bank holdings of FX Reserves, The US $ passed ₤ by 1955 and has been #1 ever since.

11 Determinants of Reserve Currency Shares Pre-euro Panel Regression, (182 observations) Coefficient estimates Standard errors GDP ratio [0.049] Inflation differential [0.063] Ex. rate variability [0.032] FX turnover [0.016] GDP leader [0.014] Lagged share [0.029] Source: Chinn & Frankel (2007). Notes: Figures in bold face are significant at the 10% level. Adj. R 2: 0.99 Dependent variable is shares in logit form. Estimated using OLS, no constant. All variables are in decimal form. GDP at market terms.