Monetary integration. Giovanni Di Bartolomeo Sapienza University of Rome

Transcription

1 Monetary integration Giovanni Di Bartolomeo Sapienza University of Rome

2 The Gold Standard Before World War I, nearly all of the world economy was on the gold standard A government would define a unit of its currency as worth a particular amount of gold The currency was convertible could be converted into gold freely The currency s price in terms of gold was its parity When two countries were on the gold standard, their nominal exchange rate was fixed at the ratio of their gold parities

3 Prehistory: Before paper money Until end of 19th century, money was metallic and many currencies were circulating: exchange rates corresponded to the different contents of precious metal. During 19th century people started to identify money and country and efforts were developed to put order: this led to the gold standard. The Gold Standard automatically restored a country s external balance: Hume s price specie mechanism, which applies to the internal working of a monetary union: A country whose prices are too high is uncompetitive and runs a trade deficit importers spend more gold money than importers receive from abroad stock of money declines long-run monetary neutrality implies that prices will decline and the process will automatically go on until competitiveness is restored.

4 Growth of the Gold Standard

5 Example of currency arbitrage The U.S. government is willing to buy gold at $35 per ounce The British government is willing to buy gold at per ounce The pound trades for $2.64 (10% higher than the ratio of the gold parities - $2.40)

6 Example of currency arbitrage The U.S. government is willing to buy gold at $35 per ounce The British government is willing to buy gold at per ounce The pound trades for $2.64 (10% higher than the ratio of the gold parities - $2.40) Someone with an ounce of gold could trade it to the British Treasury for trade those pounds for dollars in the foreign exchange market and get $38.50 trade the $38.50 to the U.S. Treasury for 1.1 ounces of gold repeat the process as quickly as possible, making a 10% profit each time the circle is completed

7 Gold Exchange Standard Gold standard was inherently stable. No monetary policy autonomy since the stock of gold is determined by balance of payments. By the late 19th century, paper money started to exist: Gold Exchange Standard where paper money could circulate internationally, but each banknote was representing some amount of gold. The continuing automaticity of the gold exchange standard relied on adherence to three principles, known as the rules of the game (i.e., contemporaries tried to implement the impossible trinity principle): 1. Full gold convertibility at fixed price of banknotes (i.e., fixed exchange rate); 2. Full backing where central bank holds at least as much gold as it has issued banknotes (i.e., no monetary policy autonomy); 3. Freedom in trade and capital movements (i.e., full capital mobility).

8 The end of the Gold Exchange Standard Gold Exchange Standard was suspended in Because of war expenditures, governments issued debt and printed money. During the war, prices were kept artificially stable through rationing schemes; when war was ended and prices were freed, the accumulated inflationary pressure burst: Germany, Hungary and Greece faced monthly inflation rates of 1000% or more in the early 1920s. Post-war policymakers committed to return to gold exchange standard as soon as practical: at which exchange rate? European countries adopted different strategies, which ended up tearing them apart, economically and politically.

9 Choices between the wars

10 Choices between the wars UK: return to a much-depreciated sterling to its pre-war gold parity, to look the dollar in the face, which forced appreciation: a landmark policy mistake that led to overvaluation. Restoring competitiveness required deflation through a lengthy and painful process. The Bank of England withdrew from the gold standard in France: intended to return to its pre-war gold parity, but soon lost control of inflation for several years. It did in 1928 with an undervalued exchange rate, which led to surpluses. It had to devalue once UK and USA abandoned the gold standard. Germany: never considered returning to its pre-war level. It suffered one of history s most violent hyperinflations. The German economy started to pick up just when it was hit by the Great Depression. In the end, it stopped conversion of marks into gold and foreign currencies an extreme form of capital controls and imposed ever-widening state controls on imports and exports.

11 Choices between the wars: Lessons When gold standard collapsed, exchange rates were left to float. Each country (except Germany) sought relief by letting its exchange rate depreciate to boost exports: tit-for-tat depreciations, which led to protectionist measures. The result was political instability, leading to war. Among the many lessons learnt, two are relevant for the monetary integration process: - Freely floating exchange rates result in misalignments that breed trade barriers and eventually undermine prosperity; - Management of exchange rate parities cannot be left to each country s discretion: need of a system.

12 Collapse of the Gold Exchange Standard Four factors made the system a less secure Everyone knew that governments could abandon their gold parities in an emergency Everyone knew that governments were trying to keep interest rates low enough to produce full employment After World War I, countries held their reserves in foreign currencies rather than gold The post-war surplus economies did not lower interest rates as gold flowed in As soon as a recession hit, governments found themselves under pressure to raise interest rates and lower output Could either stay on the gold standard and face a deep depression or abandon the gold standard The further countries moved away from their gold-standard rates, the faster they recovered from the Great Depression

13 Performance during the Great Depression Economic performance and Degree of Exchange Rate Depreciation During the Great Depression

14 The Bretton Woods System The Bretton Woods System was the result of an international monetary conference that took place in 1944 Three principles guided this system In ordinary times, exchange rates should be fixed In extraordinary times, exchange rates should be changed An institution was needed to watch over the international financial system: the International Monetary Fund (IMF) The Bretton Woods System broke down in the early 1970s The U.S. found itself with a large trade deficit and sought to devalue its currency - USA suspended the dollar s convertibility into gold in 1971; - Fixed but adjustable principle officially abandoned in Since then, the exchange rates of the major industrial powers have been floating exchange rates Fluctuate according to supply and demand

15 The Bretton Woods collapse

16 Europe s snake First European response to the collapse of Bretton Woods: European Snake = regional version of the Bretton Woods system to limit intra-european exchange rate fluctuations. It was a very loose arrangement and when inflation rose due to the first oil shock of , divergent monetary policies led several countries to leave the Snake. In spite of its failure, the Snake brought about two innovations: determination to keep intra-european rates fixed, irrespective of what happened elsewhere in the world; European currencies needed to be defined vis-à-vis each other. The Snake was meant to be an island of stability in an ocean of instability. The next move was the European Monetary System (EMS).

17 The European Monetary System Heart of EMS is the Exchange Rate Mechanism (ERM): grid of agreed bilateral exchange rates, mutual support, joint realignment decisions, ECU.

18 The European Monetary System No fewer than 12 realignments during due to different inflation rates.

19 The European Monetary System II As capital controls were lifted, realignments became increasingly destabilizing. Thus, high-inflation and depreciation-prone countries tried to reduce inflation to converge to the lowest rate: Germany became the standard to emulate. German monetary policy became the ERM standard and other countries de facto surrendered monetary policy independence) and inflation rates started to converge. Deutsche Mark became the de facto "anchor" in the European Monetary System (EMS). No realignment between 1987 to September 1992; a system designed to be symmetric became perfectly asymmetric. Two implications: - Countries resented the Bundesbank leadership; - Germany was unwilling to give up leadership but accepted a political deal in 1991: monetary union in exchange for reunification with the former East Germany.

20 The European Monetary System But inflation differentials persisted. German reunification was costly and became inflationary, which led to contractionary German monetary policy. When other countries did not follow and referendum in Denmark rejected the Maastricth Treaty, speculative attacks targeted countries that were less competitive: - Banca d Italia and Bank of England intervened to support their currencies; - Attacks became so massive that Bundesbank stopped its support the lira and the pound withdrew from the ERM; - Speculation shifted to the currencies of Ireland, Portugal and Spain; contagion then spread to Belgium, Denmark and France; - Monetary authorities adopted new ultra-large (±15 per cent) bands of fluctuation: tight ERM was dead.

21 How a fixed exchange rate system works A fixed exchange rate is a commitment by a country to buy and sell its currency at fixed, unchanging prices (in terms of other currencies) The central bank or Treasury must maintain foreign exchange reserves These reserves are limited

22 Equilibrium The real exchange rate, long-run expectations, and interest rate differentials

23 Tensions Domestic interest rates are set by foreign-exchange speculators and the exchange rate target

24 Effect of foreign shocks

25 The European Currency Crisis of 1992 War in Europe: Late September, 1992 Central Banks vs Investors Sell: Deutsche Mark Buy: British Pound Italian Lira Sell: British Pound Italian Lira Buy: Deutsche Mark Aim: To maintain/destroy the exchange rates between Mark/Pound and Mark/Lira Result: Pound and Lira were forced to be withdrawn from ERM

26 The impossible trinity Impossible trinity principle: only two of the three following features are compatible with each other: 1) full capital mobility; 2) fixed exchange rates; 3) autonomous monetary policy. ERM 1992 Common market German unification vs. other countries needs

27 The catalyst of the crisis Germany: Economic strength increased Concerned about domestic inflation, set high interest rate The counties in recession: Want more expansionary policies to lift their economies out of sluggish growth But Those countries must keep their own rates high to maintain the value of their currencies against the Deutsche Mark The contradiction led to the crisis

28 German fiscal policy in the early 1990s

29 Effect on other European countries

30 The European Currency Crisis of 1992 After reunification with East Germany, the West German government undertook a program of massive public investment This shifted the IS curve out The German central bank raised interest rates to keep inflation under control The increase in interest rates generated a rise in the German exchange rate vis-à-vis the dollar and the yen Exports fell Other countries in western Europe had fixed their exchange rates to the German mark as part of the European ERM The rise in German interest rates meant that these western European countries were required to raise interest rates as well The required interest rate increase threatened to send the other European countries into a recession

31 The European Currency Crisis of 1992 Foreign exchange speculators did not believe that these western European governments would keep this promise to maintain the fixed exchange rate parity when unemployment began to rise The equilibrium long run rate rose which caused an additional rise in the domestic real interest rate required to maintain exchange rate parity Different governments in western Europe undertook different strategies Some spent reserves in the hope that it demonstrated their commitment to maintaining the exchange rate parity Some tried to demonstrate that they would defend the parity no matter how high the interest rate needed to be Some abandoned the fixed exchange rate and let their currencies float The end result was the formation of the European Monetary Union

32 The European Monetary System Post-crisis ERM agreed in 1993 differed little from a floating exchange rate regime (i.e., bilateral parities could move by 30%). One condition in Maastricht Treaty for joining the monetary union: at least two years of ERM membership ERM is still in use as a temporary gateway but it has been re-engineered: - Parities defined vis-à-vis the euro; - Margin of fluctuation less precisely defined; - Interventions automatic and unlimited, but ECB may stop them.

33 The Maastricht Treaty The Maastricht Treaty (1991) established the monetary union: - It described in great detail how the system would work, including the statutes of the ECB; - It set the conditions under which monetary union would start; - It specified entry conditions (mostly at German request); - Fulfillment of these criteria to be evaluated by late 1997, a full year before the euro would replace the national currencies. In the end, all the countries that wanted to adopt the euro qualified, with the exception of Greece, which had to wait for another two years. On 4 January 1999, the exchange rates of 11 countries were irrevocably frozen and the power to conduct monetary policy was transferred to the European System of Central Banks (ESCB), under the aegis of the European Central Bank (ECB). Euro banknotes and coins were introduced in January 2002.

34 Decades of attempts to achieve the EMU