EUROPEAN MONETARY SYSTEM 1. Bretton Woods 2. Exchange rate determination Fixed v flexible exchange rates 3. Breakdown of Bretton Woods: Werner Report Snake in the tunnel 4. European Monetary System (EMS) 5. Crisis in EMS 1. Bretton Woods End of the Second World War, 1944, international agreement set up world trading community linked by fixed exchange rates with the American Dollar being the main international currency. Countries allowed to adjust value of their exchange rate only after periods of fundamental disequilibrium in balance of payments. Restrictions on international capital flows fair degree of certainty with respect to international economic transactions. The $US international currency America ran trade deficits provide $US to the world + the expansion of the American economy international engine of growth + export market. Problems: no mechanism resolved balance of payments problems accentuated OPEC price rises and subsequent crises 1
2. Exchange rate determination The demand for foreign currency: 1) To pay for the purchase of imports 2) For net income and transfers 3) Capital outflows- ie. local investment abroad. Value of currency (ie. depreciation/devaluation) Domestic price of imports (M) or M [this depends on the nature of imports. Some do not respond to changes in price, especially intermediate goods, eg. capital but manufactures do] For foreign debt and transfers depends on the currency in which they are denominated. Also makes overseas investment more expensive and so is likely to capital outflows Supply of foreign currency: 1. Export sales 2. Net capital inflows. Value of currency (ie. depreciation/devaluation) Foreign price of exports (X) X [this depends on the nature of exports. Some do not respond to changes in price, especially raw materials, but manufactures do] Capital flows will depend on expectations of exchange rate changes. Fixed v flexible exchange rates Flexible or floating exchange rate: free market, supply and demand determine the value of the exchange rate, no official regulations or government intervention. Fixed exchange rate regime: value of the exchange rate determined [usually] by the central bank, as a policy variable foreign reserves. 2
3. Breakdown of Bretton Woods: Werner Report 1970s increased international exchange rate instability, huge international monetary flows: oil dollars and Eurodollar market European Community disunited: West Germany and Italy float, France two-tiered regime current account regulated but the capital account determined by the market. Internal and external factors, loss of control over monetary affairs for internal stabilization pressure for economic and monetary union. The increased monetary instability lead the Werner Report 1971 which advocated the movement toward economic and monetary union by 1980. It proposed an EMU in three stages. There was a clear view of what monetary union entails: "A monetary union implies inside its boundaries the total and irreversible convertibility of currencies, the elimination of margins of fluctuation in exchange rates, the irrevocable fixing of parity rates and the complete liberation of movements of capital... monetary union. may be accompanied by the maintenance of national monetary symbols or the establishment of a sole Community currency. From the technical point of view the choice between these two solutions may seem immaterial, but consideration of a psychological and political nature militate in favour of the adoption of a sole currency which would confirm the irreversibility of the venture" (Werner Report, 1970, p. 5) According to the report: Stage 1: 1971 to 1973: getting economic underpinning right preparing the ground for institutional development to facilitate coordinated policy-making. Stage 2: consolidated economic and institutional progress. Exchange rate changes could only be made with the explicit agreement of members. During these stages policy co-ordination convergence, common policy on government budgeting, and progressive narrowing of currency fluctuation bands. Stage 3: exchange rates irrevocably fixed and a community central bank created to centralise monetary policy. Opposition to these particularly from France institutional consolidation would 3
have to be evolutionary and cautious - France would only assent to a managed currency arrangement, also dispute over which strategy to adopt to achieve economic and monetary union. One group, [France, Belgium and Luxembourg] wanted to lock into irrevocably fixed exchange rate parities as soon as possible. West Germany and the Netherlands, wished to establish system of economic policy co-ordination before eventually progressing to a fixed exchange rate. Snake in the tunnel 1971 Smithsonian negotiations official renunciation of gold/dollar convertibility + unilateral devaluation of the US dollar by nine per cent. Modified version of fixed exchange rates with managed, adjustable parities. Werner Report compromise developed strategy of parallelism for economic policy co-ordination and for monetary union. In March 1971 EMU agreed on, only stage 1 was elaborated. Mechanisms for closer co-operation among central banks agreed. Opt-out clause included. Notion of irrevocably locking exchange rates together without any margin of fluctuation abandoned in favour of mechanism to reduce margin of fluctuation around the central parities. Intra-EEC exchanges confined to a narrower band of fluctuation than was permitted in respect of EEC currencies against the dollar (the snake in the tunnel ). Initial European accord on exchange rate system beginning of European Union s movement towards stronger monetary union. The three main motives: 1. Increase Europe s role in the international monetary system. Partly due to decline of $USA as international currency, and to achieve economic power by union. 2. To achieve economic union creating a zone of monetary stability. 3. To avoid problems with the Common Agricultural Policy. The Basle Agreement, March 1972 reduced intra-eec exchange rate fluctuations to 2.25 per cent the snake in the tunnel. Tunnel set at 4.5 per cent, snake 4
confined to a margin of 2.25 per cent. European currencies used as means of central bank intervention while dollar deployed to prevent the snake from leaving the tunnel. The six original members of the currency bloc joined by Ireland, the UK, Denmark and Norway Speculative waves engulfed international currency markets in February-March and June-July, 1972. June speculative attack against the British pound due to worsening UK balance of payments. Despite major intervention by the Bank of England, Banque de France and Brussels monetary authorities British withdrawal from the snake mechanism. Exposed the institutional weakness and limited resources devoted to defend the snake regime speculators targeted other European currencies. Quadrupling of oil prices by OPEC in mid 1973. Table 5.1 Estimated change in the current account of selected EEC countries in 1974 as a result of the increase in oil prices (including secondary effects) Country $US Billion Percentage of GNP West Germany -5.8-1.6 France -5.3-2.1 Belgium/Luxembourg -1.2-2.5 Netherlands -0.9-1.5 Denmark -0.9-2.8 United Kingdom -4.7-2.7 Italy -4.2-3.0 Ireland -0.2-3.3 Lucarelli p. 87 Stagflation underlying tensions surfacing. German fear of inflation, France worried about growth. Table 5.2 Comparative Economic Indicators between France and Germany, 1972-74 Inflation Economic Growth 1972 1973 1974 1972 1973 1974 France 5.9 7.2 14.0 5.6 6.6 4.7 Germany 5.7 7.2 7.0 3.0 5.5 0.5 5
Lucarelli p. 89. France withdraw from snake. 4. European Monetary System (EMS) 1979 all ten EU members participated in the European Monetary system (EMS). Eight in a formal system of mutually fixed Exchange rates setting exchange rates relative to each other, and float jointly against the dollar: Exchange rate mechanism (ERM).. [UK and Greece not included. UK joined in 1990 The bilateral exchange rates allowed to fluctuate within bands of an assigned par value with each of the other currencies. Called margins. Each currency has a central parity in terms of ECUs - European currency units, basket of member currencies, of all members of EMS. Use central parities to determine what bilateral central rates are. Initially each bilateral rate was only allowed to deviate from this by 2.25% above or below, with a couple of exceptions. Initially capital controls limited the ability of private citizens to trade in foreign currencies: relaxed in 1987 1978 to 1982 strong convergence of critical economic indicators between the main countries of Europe success of EMS. 1987-1992 no changes in parities. 5. Crisis in EMS German Dominance Germany dominance: reputation for low inflation Other countries wanted to import Germany s reputation for low inflation used DM as main reserve currency,, monetary policy mimic Germany like Bretton Woods system, with Germany at centre. Domestic problems German domestic interests ahead of international role. Economic shock caused by German Unification: 6
July 1992 East Germans traded f East German currency for DM as rush to buy the modern consumer goods consumption Also fiscal expenditures on East Germany as: 1) unemployment in East: demanded same wages as in west, without modern equipment or training so less productive. Enterprises could not produce goods of competitive quality or price bankruptcy and need to pay for training and support of the unemployed 2) Need to rebuild infrastructure in East - roads, etc, and to clean up the polluted environment. huge demand and in inflationary pressure. Government fear economy overheating and generating inflation main German economic fear tight monetary policy to lower inflation r interest rates demand for deutch marks Results in Currency Crisis To stay within bands relative to the DM rest of EMS had to implement tight monetary policy and interest rates output levels unemployment speculation Pressure on the Lira devalue in September 11 1992 speculators made profit: EMS could indeed be cracked. September 16, Black Wednesday Continued pressure for Lira to be devalued more and pressure on UK, costly draining of reserves. Ended up taking Lira and Pound out of the EMS system and allowed currencies to float. France also attacked, but managed to hang on Many other currencies had to be devalued: Spanish peseta, Irish punt, Portuguese Escuda. 7
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