Monetary integration

European Economic Integration
Monetary integration
Giovanni Di Bartolomeo
Sapienza University of Rome
European Economic Integration
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Growth of the Gold Standard
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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 £15.58333 per
ounce
• The pound trades for $2.64 (10% higher than the ratio of the
gold parities - $2.40)
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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 £15.58333 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 £15.58333
– 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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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).
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The end of the Gold Exchange Standard
• Gold Exchange Standard was suspended in 1914.
• 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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Choices between the wars
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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 1931.
• 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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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.”
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Performance during the Great Depression
• Economic performance and Degree of Exchange Rate
Depreciation During the Great Depression
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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 1973.
• Since then, the exchange rates of the major industrial powers
have been floating exchange rates
– Fluctuate according to supply and demand
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The Bretton Woods collapse
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
Europe’s snake
European Economic Integration
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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 1973–74, 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).
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
The European Monetary System
• No fewer than 12 realignments during 1979-1987 due to different
inflation rates.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Equilibrium
• The real exchange rate, long-run expectations, and interest rate
differentials
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Tensions
• Domestic interest rates are set by foreign-exchange speculators
and the exchange rate target
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Effect of foreign shocks
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
The European Currency Crisis of 1992
European Economic Integration
• War in Europe: Late September, 1992
Central Banks
vs
Sell: Deutsche Mark
Buy: British Pound
Italian Lira
Investors
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
German fiscal policy in the early 1990s
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Effect on other European countries
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
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.
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)
European Economic Integration
Decades of attempts to achieve the EMU
Prof. Giovanni Di Bartolomeo (Sapienza University of Rome)