Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 11 A Monetary History of Europe and the Choice of Exchange Rate Systems.

Theorie und Politik der Europäischen Integration

Prof. Dr. Herbert Brücker

Lecture 11

A Monetary History of Europe and the Choice of Exchange Rate Systems

Theory and Politics of Eropean Integration

Theory and Politics of European Integration Integration of Labour Markets

Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker

Last Lecture

• EU Competition and State Aid Policy· Economics of anticompetitive behaviour and state aid policy

– Collusion in the BECOMP framework– Horizontal anti-competitive practices

» cartels (e.g. the ‘Vitamin’-cartel) » abuse of domninant position (e.g. Microsoft)

– Merger control– State aid in the BECOMP diagram

· EU competition policy– EC competencies and EU law (Treaty of Rome)– Merger control



This lecture

• A monetary history of Europe• Metallic money• The gold standard• The interwar period• The post-war period: from Bretton Woods to the EMU

• Choice of an exchange rate regime• Exchange rate and monetary policy• The range of exchange rate policies• Choices

· Criteria· Fix or float?· Regional arrangements



Why studying history?

• Monetary union is the controversial end of a long process. History helps understand.

• Since paper money was invented, Europe’s monetary history has been agitated. Each bad episode carries important lessons.

• Before paper money, Europe was a de facto monetary union. Understand how it worked helps understand how the new union works.



Metallic Money

• Under metallic money (overlooking the difference between gold and silver) the whole world was really a monetary union

• Seignorage as key source of public finance -> ‘shaving’

• Multiplicity of money• Previous explicit unions only agreed on the

metal content of coins to simplify everyday trading



Metallic money (cont.)

• From immemorial until 19th century metallic money (gold or silver)

• Monetary unions as a tool of nation-building• Germany: before 1871 different monetary standards

• Bimetallism (gold and silver) with fluctuating exchange rates depending on discoveries

• Two historical monetary unions• Latin Monetary Union (BE, FR, IT) to preserve bimetallism• Scandinavian Monetary Union ceased WWI



Gold standard

• Classic gold standard period 1880-1914• Frequent financial crises, armed conficts and

depressions• Working of the gold standard: Hume’s “price-

specie-mechanism”• (“specie” = money/gold)

• Key assumptions• long-run neutrality of money• effect of money on interest rates

• Helps to understand working of EMU



Neutrality of money and current account equilbrium

gold money

price level

P0

M1 M0

A

current account deficit

current account surplus




gold money

price level

P0

M1 M0

A



Money determines the price level (in the long run)




gold money

price level

P0

M1 M0

A



The price level affects the trade balance

• If domestic prices are

high relative to foreign

prices, we have a deficit

• Conversely, relatively low domestic prices lead to a trade surplus




gold money

price level

P0

M1 M0

A



• Trade balance is achieved when the stock of money is M1



Balance of payment equilbrium

gold money

price level

0M0

A

C

B‘

B

outflow of moneyinflow of money



Balance of payment equilbrium

gold money

price level

0M0

A

C

B‘

B

outflow of moneyinflow of money

Hume’s mechanism: return to balance is automatic. If we start with deficit • (point A, high money stock M0), money flows out until we get back to balance



Financial account equilbrium

gold money

interest rate

i*

M2M0

A

financial account surplusfinancial account deficit



Financial account equilbrium

gold money

interest rate

i*

M2M0

A

financial account surplusfinancial account deficit

•Much the same story applies to the financial account: •if the domestic interest rate is high (low), •capital flows in (out) and the return to balance is automatic



Monetary equilbrium under gold standard

• Money in excess of M0 translates into external deficits and gold outflows

• If money is in short supply (left of A = M0), balance of payments is in surplus and gold flows in

• Point A may correspond to a point with imbalances in current and capital account, e.g. current account deficit and capital account surplus in our example

• Financial markets support equilibrium: if money supply delines, interest rate increases, which attracts capital

• Over time, money sluppy stringency creates growth slow-down, higher unemployment, downward pressure on prices and wages

• All markets contribute to eliminate external imbalance, no need for government intervention (in theory)



Rules of the game and problems

• Full gold convertibility at fixed price of all banknotes• Full backing. Central Bank holds same amount of gold as

notes issued• Complete freedom of trade and capital mobility

• Problems:• Sticky prices and wages (short-term disequilbria)• World money supply driven by discoveries and money

demand driven by economic growth go not hand in hand• Governments facing deficits tend to opt out of gold

standard



Similarities to the EMU

• EURO replaces gold (no national money supply)• Balance of payments surplus translates into EURO

inflows• Balance of payments deficit translates into EURO

outflows• Exchange rate cannot be used to equilibrate

external deficits• Adjustment has to work via prices and wages



The interwar period: the worst of all worlds

• Paper money starts circulating widely• Yet the authorities attempt to carry on with the

gold standard but:• No agreement on how to set exchange rates between

paper monies• An imbalanced starting point with war legacies

· High inflation· High public debts



The interwar period: three case studies

The British case: a refusal to devalue an overvalued currency breeds economic decline

The French case: devaluation, undervaluation and beggar-thy-neighbour policies, until others retaliate and the currency becomes overvalued

• The German case: hyperinflation, devaluation and, finally, evading the choice of an appropriate exchange rate by resorting to ever-widening non-market controls



Lessons so far

We need a system, one way or another

• The gold standard – monetary unions – delivers automatic return to equilibrium, but at the cost of booms and recessions

• No agreement leads to misalignments, competitive devaluations and trade wars

• Agreements require “rules of the game”, including a conductor



European postwar arrangements

An overriding desire for exchange rate stability• Initially provided by the Bretton Woods system• The US dollar as anchor and the IMF as conductor

• Once Bretton Woods collapsed, the Europeans were left on their own• The timid Snake arrangement• The European Monetary System• The monetary union



European postwar arrangements (cont.)

The Bretton Wood collapse• Financing the Vietnam war• Diverging inflation rates and real appreciation pressures• The realignment 1971• The collapse 1973

• The Snake arrangement• Agreeing on stabilizing intra-European bilateral parities• No enforcement mechanism: too fragile to survive



The EMS: Super Snake

Complements bilateral exchange rate commitments with a support mechanism

• Allows for prompt realignments to avoid misalignments

• Emergence of the DM as the system’s anchor



Lessons from history

Goldstandard

Inter-war

BrettonWoods

EMS EMU

Long-lasting alignment must be avoided

Yes Yes Yes

Systems must be built coherently

Yes Yes Yes Yes

Policy misbehaviour must be ruled out

Yes

Systems must be robust Yes Yes

Needs a conductor Yes Yes Yes Yes



The choice of an exchange rate regime

An question and the answer

• The question: what to do with the exchange rates• Viewpoint of an individual country, in contrast with

Chapter 10 which looks at systems• Underlines the principles to evaluate the merits of a

monetary union

• The answer: there is no best arrangement• A matter of trade-offs



Three basic principles

1 Long term: neutrality of money

2 Short term non-neutrality of money

3 Interest parity condition



The long-term neutrality of money: theory

A

B

C

ADADlong-term AS short-term AS

output gap

Inflationrate

0

The AS-AD model output gap (Actual – Trend GDP)



Long term neutrality implication: PPP

• The real exchange rate• Defined as = EP/P*• PPP: E offsets changes in P/P*• So is constant

• Many caveats, though



Short term non-neutrality of money

• From AD-AS: the short-run AS schedule• So monetary policy matters in the short run• Channels of monetary policy

• The interest rate channel• The credit channel• The stock market channel• The exchange rate channel



Monetary policy in the IS-LM model

A

CB

D

IS

IS‘

LM LM‘

Output-gap(Actual-Trend GDP)

Foreignlevel

Fixed exchange rate: no independent monetary policy

Money is endogenous



Fiscal policy in the IS-LM model

A

B

C

IS

IS‘

LM LM‘

Output-gap(Actual-Trend GDP)

Foreignlevel

Flexible exchange rate: no effect of fiscal policy

The exchange rate offets fiscal policy effects



Exchange rate regimes and policy effectiveness

Monetary policy

Fiscal policy

Fixed exchange rate

Ineffective Effective

Flexible exchange rate

Effective Ineffective



When does the regime matter?

• In the short run, changes in E are mirrored in changes in = EP/P*: P and P* are sticky

• In the long run, is independent of E: P adjusts• If P is fully flexible, the long run comes about

immediately and the nominal exchange rate does not affect the real economy

• Put differently, the choice of an exchange rate regime has mostly short-run effects because prices are sticky



What’s on the menu?

• Free floating• Managed floating• Target zones• Crawling pegs• Fixed and adjustable• Currency boards• Dollarization/Euroization• Monetary union



The choice of an exchange rate regime

• The monetary policy instrument• Can be useful to deal with cyclical disturbances• Can be misused (inflation)

• The fiscal policy instrument• Can also deal with cycles but is often politicized• Can be misused (public debts, political cycles)

• Exchange rate stability• Freely floating exchange rates move “too much” • Fixed exchange rates eventually become misaligned



The old debate: fixed vs. float

• The case for flexible rates• With sticky prices, need exchange rate flexibility to deal

with shocks• Remove the exchange rate from politicization• Monetary policy is too useful to be jettisoned

• The case for fixed rates• Flexible rates move too much (financial markets are often

hectic)• Exchange rate volatility: a source of uncertainty• A way of disciplining monetary policy• In presence of shocks, always possible to realign



The new debate: the two-corners solution

• Only pure floats or hard pegs are robust• Intermediate arrangements (soft pegs) invite government

manipulations, over or under valuations and speculative attacks

• Pure floats remove the exchange rate from the policy domain

• Hard pegs are unassailable (well, until Argentina’s currency board collapsed…)

• In line with theory• Soft pegs are half-hearted monetary policy commitments,

so they ultimately fail



The two-corners solution and the real world

• Fear of floating• Many countries officially float but in fact

intervene quite a bit• Fear of fixing

• Many countries declare a peg but let the exchange rate move out of official bounds



Fear of floating

80.00

90.00

100.00

110.00

120.00

130.00

140.00

1999M1 1999M7 2000M1 2000M7 2001M1 2001M7 2002M1 2002M7 2003M1 2003M7

Denmark (vis a vis €)Sweden (vis a vis €)Switzerland (vis a vis €)Korea (vis a vis $)



The two-corners solution and the real world

• Fear of floating is deeply ingrained in many

European countries

• Fear of fixing partly explains the disenchantment

with the EMS and some reluctance towards

monetary union



Conclusions

• A menu hard to pick from: trade-offs are everywhere

• All of this takes the view from a single country• Systems involve many countries and rest on agreed

upon rules, including mutual support• Since the end of Bretton Woods, there is no world

monetary system• This leaves room for regional monetary systems.

Enters Europe’s experience



NEXT LECTURE

• Optimum Currency Areas• Reading: Baldwin/Wyplosz (2006, Ch. 16)

Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 11 A Monetary History of Europe and the Choice of Exchange Rate Systems.

Documents

europischen integration

paper money

century metallic money

monetary policy

herbert brcker lecture

monetary union seignorage

emu folie

silver monetary unions