Stagnation, Crisis, and Revival Europe, 1973-Today

1. Stagnation, Crisis, and RevivalEurope, 1973-Today

2. The Bretton Woods Exchange Rate System, 1945-1973 • Bretton Woods: Fixed Exchange Rate Regime • What reserves? Gold and U.S. $ where and what parity? One ounce of gold = $35. U.S. had most of the world’s monetary gold. • Countries peg their currencies to gold. It was effectively a “dollar-gold standard.” • Benefit is that countries could earn interest on dollar deposits or U.S. dollar securities. • Dollar balances are also easier to transfer than gold. • High powered money not tied to gold mining

3. US [V = constant] ΔM/M + ΔV/V = ΔP/P + ΔQ/Q EX - IM = 0 Trade is in balance ------------------------- Now ΔM/M rises ΔP/P risesU.S. goods less competitive EX-IM<0$ to France FRANCE [V = constant] ΔM/M + ΔV/V = ΔP/P + ΔQ/Q EX - IM = 0 Trade is in balance ------------------------ Bretton-Woods $-Gold Standard

4. US [V = constant] EX - IM < 0 Trade is in deficit EX – IM = ΔM($) <0 ΔP/P = ΔM/M - ΔQ/Q, so BUT NO ΔP < 0, ΔP =0 because no loss of goldship $ to France, asymmetry in corrective mechanism Trade deficit dissipates and US has exported inflation France [V = constant] EX - IM > 0 Trade is in surplus EX – IM = ΔM($) >0 ΔP/P = ΔM/M - ΔQ/Q, so $ add to French reservesmoney growth ΔP > 0 Inflation and France loses some competitive advantage and trade surplus dissipates. Burden of adjustment on France--asymmetry Inflation makes U.S. goods less competitive

5. Rules of the Game? • Classical Gold Standard • Central bank losing reserves (gold) from a trade deficit would raise interest ratesconsumption & investment fallimports fall. Also attracts foreign short-term capital. Balance of payments improves. • Does the Fed have to raise interest rates when there is a trade deficit? No. No reserves are lost if deficits paid in $. Surplus countries see reserves risehigh-powered moneyinterest rates fallinflation.

6. The Collapse of the Bretton Woods System of Fixed Exchange Rates • U.S. Runs Large Trade Deficits • Asymmetric adjustment---U.S. trade deficitspaid for by $, which add to other countries reserves. • Reserves are high-powered money, creating a multiplier effect; no effect in U.S. as payment in dollars, no contraction. Inflationary bias and impulse from the U.S. to Europe

7. The Collapse of the Bretton Woods System of Fixed Exchange Rates • Continued U.S. trade deficits force NO adjustment on U.S.---it swells the dollar reserves of other countries. • The “Triffin Problem:” Dollars held as reserves in foreign central banks exceed U.S. gold reserves by 1961. (named after Yale economist, Robert Triffin). • Triffin Problem raises the possibility of a run on the dollar----like interwar currency problems.

8. The Collapse of the Bretton Woods System of Fixed Exchange Rates • German’s try to fix problem---the mark is revalued twice. But the U.S. trade deficit reappears because of continued inflation. • Vietnamese War and “Great Society” programs in the U.S. add to the budget deficit and inflation. • By the 1960s, there is more capital movement---an increase in short-term investments (speculative capital) sensitive to interest rate changes and fear! A country can lose money faster than just by trade deficit. Less and less breathing room to make adjustments.

9. Inflationary Pressures Build in the 1960s:Vietnam War and Great Society spending

10. The Role of the French • The French want Bretton Woods to move to a more orthodox gold standard where the U.S. would have to make symmetric adjustments. • De Gaulle threatens to convert France’s U.S. dollars to gold---aimed at forcing U.S. change policies—leads U.S. to abandon its fixed exchange rate in 1973. • Other countries also find it difficult to maintain fixed/pegged exchange rates. • World moves towards floating exchange rates and thus “monetary independence”

11. Oil Price Shocks--Inflation • 1973 (Arab-Israeli War) and 1979 (Iranian Revolution) produce sharp rises in oil prices. • Western Europe’s has large trade deficits with oil producing countries. With fixed exchange rates—implies that they should lose gold, $ and other currencies. • According to “rules” of fixed exchange rates, they should pursue contractionary policies to force adjustment on their economies.

12. Oil Price Shocks--Inflation • Europe (and the U.S.) fail to do so. Instead, they pursue “accommodative” policies. There is easy credit to business and others to help with higher oil prices. Result? Inflation surges in all countries. • Further loss of reserves. Speculative capital flees and facing loss of reserves, countries all abandon fixed exchange rates for floating exchange rates in the 1970s.

13. The “Snake” and other critters • When the U.S. abandons the $ peg to gold, the European try to preserve their own fixed exchange rates. Some forced to float but repeated efforts to return to fixed exchange rates. • In the 1970s, the “European Snake” permitted currencies to be “pegged” but fluctuate in a narrow band of 2 ¼ % around the pegged rate. It fails with 1979 oil shock. • Inconsistent policies—some countries money supplies grow faster.

14. Depreciation of the Italian Lira vs. DM in 1980s Supply DM/Lira Pegged Rate +/- 2.5% Demand 1985 1980 Quantity of £s

15. The “Snake” and other critters • In the 1980s, the European Monetary System or EMS, sets similar bands for fluctuation. • Two problems: • Countries with strong currencies (Germany) refuse to provide assistance to countries with weak currencies (France or Italy) • Once there is a problem ---budget deficit or inflation, “orderly” changes in parities are impossible---once a currency looks weak, no time for adjustment because “hot capital” precipitates a run on the currency because of the loss in confidence.

17. Crisis of the early 1990s • European countries have inconsistent policies: the Bundesbank pursues a low inflation policy, while the Banque de France/Banca d’Italia pursues a higher inflation more stimulus • Implies that currencies are not falling in value evenly---so hard to stay within bands of exchange rate mechanism • These are inconsistent with a fixed exchange rate, as conservative-policy countries gain reserves and easy-policy countries lose reserves. • EMS is forced to widen “bands” from 2 ¼% to 15%. • Crises hit U.K. Ireland, Sweden, Norway, Spain, which abandon pegged exchange rates

18. Example: the Swedish Crisis(the Interwar Crises Redux) • Swedish krona is pegged to the deutschemark---a fixed exchange rate. • Swedish banks borrow from German banks (in DM) to fund expansion of lending to mortgage market. A real estate boom and economic boom begins. • Increased foreign investmentmore DM and $ flow inMoney Supply. Inflation rises. • Sweden begins to run a balance of payments deficit. • Huge government budget deficit also.

19. Example: the Swedish Crisis(the Interwar Crises Redux) • Government consider a devaluation of currency. BUT, banks repayment would be much more costly in DM. • When this is discovered there is a DUAL crisis---a run on the banks and a run on the krona. • The Riksbank—the Swedish central bank---raises the discount rate to 500% to try to stop run. It fails. • Result----krona abandons peg and floats and depreciates and the banking system collapses with government rescuing the failed institutions.

20. The Choice: Float or Permanent Fix • Bretton Woods, Snake and EMS adjustable pegged exchange rates seem to invite trouble, especially when there is high capital mobility. Response? • Maastricht Treaty of 1991: EEC now EC decides to become the EU---an economic union • Single European Market by 1992---free trade in goods, services, capital and labor. • Establish the Euro, a single currency by 1999. There would be a new European Central Bank (ECB)

21. European Industry1950-2000What Happened to British (European) Industry?The American Challenge

22. Henry Ford (1863-1947) • Mass Production on an Assembly Line • Standardization and interchangeable parts. Higher volume lower price. • Model T—1908 $850/1924 $290. • 10 million produced by 1925. Has 60% of market. • Why did Ford introduce the $5 day in 1914? • Mass consumption

23. Morris Motor Company • Founded in 1910 by bicycle manufacturer, William Morris. • First vehicle was 2 seat “Bullnose” with all major components were purchased. Engines and other key components for early vehicles purchased from Detroit manufacturers for standard “Morris Cowley” of 1915, MG in 1924 • High-quality cars, reduction of pricing and a policy of cutting prices, Morris Motor Company beats out Ford to obtain 51% of UK market. • Purchases local suppliers • But only in 1932 is a proper assembly line introduced. • Shutdown of all private production during World War II • 1952 merger with Austin produces the British Motor Corporation (BMC)

24. British Motor Vehicle Industry • Protected by high tariffs during 1930s and World War II • Post-World War II—export led initially until U.S. industry recovers from World War II and Korea • UK share of world exports 15% in 1937, 52% in 1950, 19% in 1967 • 1950—fragmentation of market, more models than all U.S. producers • Continued concentration on Empire markets---few competitors • Faces multiple craft unions any one of which can halt production

25. Tariff Rates (Duties to Total Imports, %)

26. Unionization (% of Labor Force)

27. Comparative Labor Productivity UK=100

28. Attempts to Americanize Technology • WWII followed by high tariffs (>30%) protect British industry, productivity lags, and allow unions to bid up wages. • During World War II, British industrialists visit U.S. to learn American methods to increase productivity • Postwar attempts to adopt American mass production techniques not successful • Skilled craft workers opposed erosion of the value of their skills • Unpopular with managers who were not used to exercising strong shop floor control.

29. Attempts to Americanize Technology • American techniques with British craft unions---no UAW but a large number of firms. • In 1970s British Leyland had to deal with 36 unions and British Ford with 22 unions. • Inter-union and intra-union struggles as change production • Shift from piece rates, where incentive is to ensure that the plant ran smoothly, parts were available, machinery kept going…….is lost as shift to fixed day rates under the American system---managers do not step in to provide strong coordination. • Result: Frequent, disruptive strikes---productivity falls and quality falls

30. Government Intervention • Labour Government: industrialization reorganization program to improve British competitiveness. • British Leyland Motor Corporation was created in 1968 by the merger of British Motor Holdings and the Leyland Motor Corporation. LMC was successful, BMH close to collapse. Government hope LMC will revive BMH. • Merger combined almost all remaining independent British car manufacturing companies and included car, bus and truck manufacturers plus construction equipment, refrigerators, metal casting companies, road surface manufacturers--100 different companies.

31. Government Intervention • British Leyland offered a range of dated vehicles, nothing in new line of development to compete with popular Ford Escort and Cortina. New products unsuccessful. • Plagued by strikes. • 40 different manufacturing plants. • One division competes with another---Rover competed with Jaguar at the expensive end of the market and the Triumph with Austin, Morris and MG. The result was a product range which was incoherent and full of duplication.

33. British Motor Vehicle Industry • Result bitter labor relations—Strikes rise sharply in 1970s peak 1979 • Exacerbated by entry into EEC in 1973—tariffs eliminated for Europe • Difficult to shift from Empire to European markets • Exacerbated by First Oil Price Shock (1973) —inputs more costly • Exacerbated by Second Oil Shock (1973)—UK is oil exporter—the pound appreciates • British Leyland—huge losses. December 1974 government nationalizes firms and injects capital. • No improvement

34. A Change in Regime • Bitter winter of 1978-1979 • Public believes unions have privileged place • Election: Victory of Margaret Thatcher in 1979 • Further Losses at BL—further government injections of funds • Privatize nationalized industries, slow break-up of BL • Eliminate minimum-wage floors in specific industries, Suspend rules extending union scales to non-union employers

38. Recent Economic Performance • Movement away from U.S. style mass production technology and revival of flexible production, a traditional British strength. • Post-1980 return to more use of skilled labor and European “flexible production technology” Emphasis on skilled labor. • Adjustment to European markets is complete.

39. Recent Economic Performance • Germany dominant manufacturing country. • Giant Corporations • Mittelstand—aggressive medium sized firms. • Volkswagen produces mass scale but it relies on unskilled labor from the countryside and overseas while BMW and Mercedes focus on higher end vehicles with skilled labor. • British industry revives in 1980s with investments from Japan—Nissan, Toyota & Honda establish plants. • But it is a niche success for luxury cars and 4-wheel drive vehicles.

40. The Choice: Float or Permanent Fix • Bretton Woods, Snake and EMS adjustable pegged exchange rates seem to invite trouble, especially when there is high capital mobility. Response? • Maastricht Treaty of 1991: EEC now EC decides to become the EU---an economic union • Single European Market by 1992---free trade in goods, services, capital and labor. • Establish the Euro, a single currency by 1999. There would be a new European Central Bank (ECB)

41. How to move from DM, FF, Lira, Peseta to Euro if each country has different monetary policy---money growing at different rates, different interest rates, etc.?

42. Maastricht Treaty Requirements for Harmonization of Macroeconomic Policy • Each country’s inflation must at maximum be 1.5% of 3 best performing members (i.e. if average is 2%, each country must have 3.5% inflation.) • Each country’s nominal interest rate on government bonds must at maximum be 2% > 3 best performing members • Annual budget deficit no greater than 3% of GDP • Debt/GDP < 60%

43. The European Union • By 1997, 11 members of the EU meet the criteria---but Belgium and Italy do not (big violation of Debt/GDP ratios). They are allowed to join anyway, and Greece finally allowed in 2001 (it fudges its numbers) • BUT…… • Result of criteria is that countries follow stricter policy and interest rates fall. • “Eurosceptics:” the British accept the single market but not the monetary union of the Euro.

44. Does Harmonization Work?

45. Some Price Convergence

46. Some Price Convergence

47. Policy Implications of the Euro • Previously: if two countries had different circumstances their central banks could react differently: • If a country had unemployment and a recession, its central bank could lower interest rates • If a country had inflation, its central bank could raise interest rates. • Now, there is only one European Central Bank---its policy is “one size fits all” • If ECB sets low rates that may cure recession in some countries but cause inflation in others. • If ECB sets high rates that stop inflation in some countries, it may cause a recession in others. • True for the USA too but….

48. Policy Implications of the Euro • In the U.S. there is a high degree of labor mobility • Unemployment in one region can be cured if there is migration from there to a booming region. • But there is less in Europe---language and cultural differences, plus differences in pension and social security benefits. Fears of migration, e.g. Turkey, Africa, Asia • Implies that adjustment policies will be more painful. • Will countries be tempted to opt out? Were the British wise?

49. !!!!

50. Looking to the Future • Lagging Productivity Growth in Manufacturing • EU/US 1986-1995: 2.8%/3.2% (HiTech: 3.1%/5.1%) • EU/US 1996-2003: 2.7%/5.6% (HiTech: 3.6%/11.1%) • Lagging Productivity Growth in Business Services • EU/US 1986-1995: 1.4%/1.1% • EU/US 1996-2003: 0.9%/4.2%