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The European Monetary Union

The European Monetary Union. READING ASSIGNMENT: McNamara, Kathleen R. 2008. A rivalry in the making? The Euro and international monetary power. International Political Economy 15 (3):439-459. Fixed Exchange Rate. Eurozone countries. Switzerland. PRC. The Trilemma. 2.

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The European Monetary Union

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  1. The European Monetary Union READING ASSIGNMENT: McNamara, Kathleen R. 2008. A rivalry in the making? The Euro and international monetary power. International Political Economy 15 (3):439-459.

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

  3. 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

  4. Plan • Euro area • Solving Addressing an old problem • International Reserve Currency

  5. 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)

  6. 2010

  7. Current (2013)From http://en.wikipedia.org/wiki/Template:Supranational_European_Bodies

  8. The EU

  9. The Euro area

  10. 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…

  11. A puzzle:Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19th century? Fixed exchange rates + Open capital flows Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 Interwar period 1971-3 1944

  12. Why?

  13. Answer: Democracy Growing #’s of democracies Few democracies Fixed exchange rates + Open capital flows Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 Interwar period 1971-3 1944

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

  15. The 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

  16. The European Monetary System • 1979 • Fixed but adjustable • The Bundesbank (Germany) used monetary policy to keep inflation low, and other countries engaged in foreign exchange market intervention to fix their currencies to the German mark

  17. French-German fight in 1981-3 • 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

  18. 1988-2002: 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

  19. 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.

  20. The point of the unholy trinity – you can’t have it all… 1999: Paul Krugman http://slate.com/id/36764 “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).”

  21. 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

  22. 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

  23. 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

  24. Consequences of XR volatility? • Uncertainty may hurt international transactions

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

  26. 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. • http://www.imsdb.com/scripts/Good-Will-Hunting.html

  27. 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?

  28. 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

  29. 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 bill @ the EU level • Leadership – who bails you out? • US track record v. EU (…Greece?)

  30. Is the renminbi an alternative?

  31. Is the SDR an alternative?

  32. Is the bitcoin an alternative??

  33. 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

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

  35. 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

  36. 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”

  37. Thank youWE ARE GLOBAL GEORGETOWN!

  38. A puzzle Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1971-3 1944

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

  40. A puzzle Degree of global capital mobility * Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1971-3 1870 1944

  41. 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.”

  42. A puzzle:Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19th century? Fixed exchange rates + Open capital flows Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 Interwar period 1971-3 1944

  43. 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. Eurozone

  44. 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

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