The European Monetary Union READING ASSIGNMENT: McNamara, Kathleen R A rivalry in the making? The Euro and international monetary power. International Political Economy 15 (3):

2 The Trilemma Fixed Exchange Rate Open Capital Flows Sovereign Monetary Policy Switzerland PRC Eurozone countries 2

Recall why a country might want: Free Capital Flow? –Draw on the savings of the rest of the world –Investment opportunities abroad Fixed Exchange Rate? –Reduce uncertainty in trade Sovereign Monetary Policy? –Address inflation/unemployment 3

Plan 1.Euro area 2. Solving Addressing an old problem 3.International Reserve Currency 4

International Cooperation Throughout the semester… disappointment –Little substantial sacrifice of sovereignty –IOs not really fulfilling their stated goals –“dirty work,” “resolve” Is real cooperation with genuine sacrifice possible? YES! The Euro represents an ultimate* commitment –*unless they really figure out a way to kick out Greece –(I doubt it) 5

2010 6

Current (2014) From 7

The EU 8

The Euro area 9

Membership Some countries, the “Eurozone” doesn’t want (yet/ever?) –Must do the 2 year European Exchange Rate Mechanism Some countries don’t want the Eurozone (yet/ever?) –Opt out – Denmark, UK, Sweden (de facto) Why? A real commitment To understand –how it’s a strong commitment –and why some countries want it, –let’s go back… 10

A puzzle: Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19 th century? 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870Interwar period Fixed exchange rates + Open capital flows 11

Why? 12

Answer: Democracy 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870Interwar period Fixed exchange rates + Open capital flows Growing #’s of democracies Few democracies 13

The international collective action problem: How can we allow for the free flow of goods, services, and capital without: –Imbalances leading to beggar-thy-neighbor policies 14

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 15

Maybe not an impossible mission? 1979: The European Monetary System Fixed but adjustable How did it work? –Essentially, the Bundesbank (Germany) used monetary policy to keep inflation low, and the rest of EMS members fixed to the German mark 16

French-German fight in

Or: François tests the Adele-hypothesis Is the trilemma wrong? Can we have it all? 18

French-German fight in 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 19

: 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 20

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. 21

The point of the unholy trinity – you can’t have it all… 1999: Paul Krugman “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).” 22

Sacrifice In the pursuit of free-flowing goods & services, and capital across the borders of Europe… Eurozone countries have completely surrendered monetary policy Germany’s inflation concerns threatened by Portugal, Italy, Greece, & Spain Portugal, Italy, Greece, & Spain’s employment concerns threatened by Germany A genuine sacrifice of sovereignty has taken place 23

Trade & international capital flows lead to imbalances How do governments deal with these imbalances? 1. Avoid them? (Capital controls?) 2. Fixed exchange rate  sacrifice monetary policy OR: 3. Floating exchange rate Most advanced countries make a trade-off between (2) exchange rate stability – and – (3) domestic price stability with monetary policy autonomy 24

Why are there imbalances? 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 25

Consequences of XR volatility? Uncertainty may hurt international transactions 26

The Euro The ultimate commitment So, if it’s credible, will it overtake the dollar as the international reserve currency? 27

28

Good Will Hunting 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. 29

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% SDR? 30

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 31

Obstacles to the euro 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 the EU level Leadership – who bails you out? –US track record v. EU (…Greece?) 32

Is the renminbi an alternative? 33

Is the SDR an alternative? 34

Is the bitcoin an alternative?? 35

Status quo US “shock absorber”: –Floating exchange rate China opts for: –restrictions on capital flows How can the dollar adjust if China fixes to it? This is the current monetary system… And it’s doomed 36

Exchange rates & protectionism “Currency manipulator” ?? Should the WTO be involved in regulating the exchange rate? 37

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 38

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” 39

Thank you WE ARE GLOBAL GEORGETOWN! 40

A puzzle 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 41

Conclusion: Cannot maintain (global) fixed exchange rates in the presence of high capital mobility…? 42

A puzzle 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 * 43

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.” 44

A puzzle: Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19 th century? 1944 Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870Interwar period Fixed exchange rates + Open capital flows 45

Eurozone Austria (1999) Belgium (1999) Cyprus (2008) Estonia (2011) 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 –Denmark –Sweden –Czech Rep  Was set to join Nov 2009… but things changed –Poland –Bulgaria –Hungary –Latvia –Lithuania –Romania –Legal loophole: Required to join the eurozone after meeting the convergence criteria (including ERM II for two years). But joining ERM II is voluntary. 46

47

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 48