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International Atlantic Economic Society Madrid, April 2014

P. Schwartz Universidad San Pablo CEU J. Castañeda University of Buckingham Research assistants : Sam Burton, Jordan Taylor, and Lucia Novak University of Buckingham “ Optimal Monetary Zones: Why is There No Single World Money? ”. International Atlantic Economic Society Madrid, April 2014.

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International Atlantic Economic Society Madrid, April 2014

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  1. P. SchwartzUniversidad San Pablo CEU J. CastañedaUniversity of BuckinghamResearch assistants: Sam Burton, Jordan Taylor, and Lucia Novak University of Buckingham“Optimal Monetary Zones: Why is There No Single World Money?” International Atlantic Economic Society Madrid, April 2014

  2. The problem • Milton Friedman and Bob Mundell clashed on flexible and fixed exchange rates • If flexible exchanges are optimal, why is there a single monetary zone in the US? • If fixed exchange rates are optimal, why is there no single world money? Ours is a positive, not a normative analysis

  3. Monetary second best First best. The use of a single currency markedly reduces transaction costs Why has a single world currency not emerged displacing all other means of payment? In the presence of restrictions: the costs of dealing in a single world currency too high (Functional) Second best. Fact: the world today deals in a number of currencies, separated by flexible exchange rates. 3

  4. Coasian analysis Static Coase: institutional limitations make the first best unattainable and multiple moneys preferred (Friedman) Dynamic Coase: Network effects will promote one single safe currency to role of principal transactions instrument Unrestricted monetary and commercial competition May lead to a single world currency (Mundell?) 4

  5. The case for flexible exchange rates (1953-1) Milton Friedman Basic economic objective: “The achievement and maintenance of a free and prosperous world community engaging in unrestricted multilateral trade” Much easier to achieve “in a world of flexible exchange rates and its corollary, free convertibility of currencies” (1953, 1987, pg. 462) 5

  6. Why are flexible rates better attuned to the modern world (1953-2) “If internal prices were as flexible as exchange rates, I would make little economic difference whether adjustments were brought about by changes in ex-change rates or by equivalent changes internal prices.” “In the modern world, internal prices are highly inflexible.” “Wage rates tend to be among the less flexible prices.” “Permitting or forcing prices to decline is is likely to produce unemployment rather than, or in addition to, wage decreases.” (1987, pg. 467) 6

  7. Friedman’s mixed system (1953-3) “In principle there is no objection to a mixed system of fixed exchange rates within […] and freely flexible rates between […], provided that the fixed rates within […] can be maintained without trade restrictions. (1987, pg. 487) “Any flexible exchange system is […] a mixed system, since there are rigid rates between the different sections of one nation […] all effectively responding to a single central fiscal and monetary authority. […] And the [states]have effectively surrendered the right to impose restrictions on the movements of goods, people, or capital between one another.” (497-8, n. 16) 7

  8. The case for Fixed Exchange Rates Mundell (1961-1) Bob Mundell “The question then arises whether all existing national currencies should be flexible.” “What constitutes an optimum currency area.” “The theory of optimum currency areas can elucidate if the national currency area does not coincide with the optimum currency area.” 8

  9. Mundell and mixed exchange system (1961-2) • Mundell (1961) “advanced the argument that stabilization policy would be more difficult under fixed exchange rates if short-term capital were immobile than if it were mobile, and more difficult under flexible exchange rates if capital were mobile than if it were immobile”. • The hypothesis of his paper [is] that “the fixed-exchange-rate system is better within areas where factors are mobile and the flexible-exchange-rate system is better for areas between which factors are immobile”. • In another paper he presents: “an additional argument against increasing the number of currencies”. 9

  10. Mundell’s plan for a European currency (1969-1) “The balance of payments is a monetary phenomenon and its correction implies monetary policies”. Two monetary means of bringing about equilibrium. “One is to change the price of money – the flexible exchange rate solution”. “The other is to change the quantity of money – the flexible money solution”. 10

  11. Mundell’s plan for a European currency (1969-2) “We live in a world composed of a super-state, a few large powers, and many smaller states”. “There is an inherent tendency for a common international money to develop based on economies of scale in the production of information”. “Historically this is seen in the use of gold. […] No one invented the gold standard”. 11

  12. Mundell’s plan for a European currency (1969-3) “Only by creating a substitute for the dollar can Europe free itself from dependence on it”. “And only through this means can the U.S. correct its balance of payments”. Does not seem to think structural reforms to be much of an obstacle 12

  13. Mundell’s Politics (1969-4) Understands the mixed system but his goals are different “The case for a European money must be made primarily on political grounds, just because politics in the widest sense of the word has to override economics.” (1969) His aims are that the State must preserve its sovereignty over economic policy, or Europeans should be able to limit the $ hegemony 13

  14. Mundell: Gold standard redux? (2013) Mundell (2013)’s volte-face: suddenly sees no need for anti-hegemon politics Maybe the effect of the 2007-2010 Great Recession Flexible exchange rate experiment, a failure An intl. monetary system should avoid unnecessary changes in real exchange rates Exchange rates consistently overshoot equilibrium The solution: creating an international currency that can be used by all countries for international trade purposes the new world currency, to be called the INTOR, possibly in conjunction possibly with gold 14

  15. Back to positive economics 15

  16. The Trade-OffThe model (a) Minimize TCM (Total Costs of Monetary arrangements) · · · Min TCM = f [Mj, σ2{Ui,Pi ,GDPi ,Ulci,Rxi, Defi /GDPi, Debti/GDPi}] Mj being the number of currencies in a zone, i the countries or states in the zone; Ui, Pi , GDPi with dots, the rates of unemployment, of real inflation, and real growth; Ulci, the unit labour costs in each country; Rxi,the real exchange rate of each country in the zone; and Defi /GDPiand Debti/GDPithe relative deficits and total public debt of each country. 16

  17. The model (b) Subject to → d TCM / d f > 0 (1) → M j = (σ2i{.} ) – φ(2) → 1≤ (a σ2i{.}) ≤ M j ≤ ∑ (Mi) (3) i → if {σ2Uj ≤ Z; σ2 Pj ≤ W; (XRi) ≤ S; (4) σ2(Defi/GDPi) ≤ Q; σ2(Debti/GDPi) ≤ N} where Z, W, S, Q, N… are the same variables in the US, then a σ2i{.} = 1 17

  18. The Model applied TCM will be minimized by reducing the number of currencies and increased by the variance of the rate of unemployment, of the rate of inflation; and by the variance of unit labour costs, of the real depreciation, of the relative deficit and the relative amount of debt. The upper bound of an OTC could be empirically set at the variance of each argument compared with that of a country that is happy with its single currency, such as the US or Germany. 18

  19. Graphical results 19

  20. Euro USA Notes: Euro data from Eurostat, 2005=100 (Euro zone-17). US data from the Bureau of Labor Statistics (1982-84=100), covering four major regions: North East, Mid West, West, South

  21. Euro US Notes: Euro data from Eurostat, 2005 euros (Euro zone-17). US data from the Bureau of Economic Analysis (2005 US dollars), covering 51 States

  22. Euro US Notes: Own calculations; Real exchange rate = Nominal exchange rate x (P State/P whole area) Based on HICP Euro data from Eurostat, 2005=100 (Euro zone-17) and US CPI data from the Bureau of Labor Statistics (1982-84=100), covering four major regions: North East, Mid West, West, South

  23. Euro US Notes: Unemployment rate in the Euro zone from Eurostat (Euro zone -17 countries, seasonally adjusted) and in the US from the Bureau of Labor Statistics, covering 52 States (not seasonally adjusted)

  24. Euro US Notes: Unit Labor Cost index for the Euro zone, from Eurostat (Euro zone -17 countries) and the Employment Cost Index for the US, from the Bureau of Labor Statistics, covering 13 regions: North East, New England, Middle Atlantic, South, South Atlantic, East South Central, West South Central, Midwest, East North Central, West North Central, West, Mountain, Pacific

  25. Notes: Total government deficit for the Euro zone Member States, from Eurostat (Euro zone -17 countries). For the US total deficit of the States (no Federal nor Local deficit included), from the US Census Bureau 2011 Survey.

  26. Notes on the data • For the euro zone, the calculation of the variance has included the 17 Member State countries data • As to 2013, data has been updated from the OECD and IMF datasets when needed • Variance calculated against the average of the Eurozone • For the US, the calculation of the variance has included: • The State level data as to the public deficit, public debt, unemployment rate and the GDP • Four major regions as to the Consumer Price Index • Thirteen regions as to the Employment Cost Index • Variance calculated against the average of the States or the regions, as needed.

  27. The model extended An Optimality Index Proxied by an Index of dispersion of the rates of unemployment, GDP growth, real exchange, unit labor costs, government deficit, and government debt Dispersion measured by Total Variance (σ 2i , covi) Fano factor = σ 2 j/ mean σ 2 On going calculations of the total variance show a much lower value in the US than in the EU (subject to confirmation) 27

  28. Ongoing research We will extend the analysis to compare the functional optimality of the current monetary arrangements in the US and the EU with some historical precedents The UK under the gold standard The US and other European countries under the gold standard 28

  29. References Friedman, Milton (1953, 1987): The Case for Flexible Exchange Rates”; in Kurt E. Leube, ed.: The Essence of Friedman. Stanford. Mundell, Robert A. (1960): "The Monetary Dynamics of International Adjustment under Fixed and Flexible Exchange Rates," Quarterly Journal of Economics, (74), 227-57 May. - (1961): “A Theory of Optimum Currency Areas, American Economic Review, LI (4) September. - (1969, 2012): Typescript: “A Plan for a European Currency”. MS for the American Management Association Conference on Future of the International Monetary System”. December 8. New York. - (2012): “The Case for a World Currency”, Journal of Policy Modeling (34), 568–578. Elsevier. At <www.sciencedirect.com> 29

  30. www.pedroschwartz.com pedro@pedroschwartz.com juan.castaneda@buckingham.ac.uk

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