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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Gold standard Classic gold standard period 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Neutrality of money and current account equilbrium gold money price level P0P0 M1M1 M0M0 A current account deficit current account surplus

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Neutrality of money and current account equilbrium gold money price level P0P0 M1M1 M0M0 A current account deficit current account surplus Money determines the price level (in the long run)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Neutrality of money and current account equilbrium gold money price level P0P0 M1M1 M0M0 A current account deficit current account surplus 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Neutrality of money and current account equilbrium gold money price level P0P0 M1M1 M0M0 A current account deficit current account surplus Trade balance is achieved when the stock of money is M1

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Balance of payment equilbrium gold money price level 0 M0M0 A C B‘ B outflow of money inflow of money

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Balance of payment equilbrium gold money price level 0 M0M0 A C B‘ B outflow of money inflow 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Financial account equilbrium gold money interest rate i* M2M2 M0M0 A financial account surplus financial account deficit

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Financial account equilbrium gold money interest rate i* M2M2 M0M0 A financial account surplus financial 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Monetary equilbrium under gold standard Money in excess of M 0 translates into external deficits and gold outflows If money is in short supply (left of A = M 0 ), 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)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Lessons from history Gold standard Inter- war Bretton Woods EMSEMU Long-lasting alignment must be avoided Yes Systems must be built coherently Yes Policy misbehaviour must be ruled out Yes Systems must be robust Yes Needs a conductorYes

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Three basic principles 1Long term: neutrality of money 2Short term non-neutrality of money 3Interest parity condition

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets The long-term neutrality of money: theory A B C AD long-term AS short-term AS output gap Inflation rate 0 The AS-AD model output gap (Actual – Trend GDP)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Monetary policy in the IS-LM model A C B D IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Fixed exchange rate: no independent monetary policy Money is endogenous

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Fiscal policy in the IS-LM model A B C IS IS‘ LM LM‘ Output-gap (Actual-Trend GDP) Foreign level Flexible exchange rate: no effect of fiscal policy The exchange rate offets fiscal policy effects

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Exchange rate regimes and policy effectiveness Monetary policy Fiscal policy Fixed exchange rate IneffectiveEffective Flexible exchange rate EffectiveIneffective

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets What’s on the menu? Free floating Managed floating Target zones Crawling pegs Fixed and adjustable Currency boards Dollarization/Euroization Monetary union

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets Fear of floating

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets 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

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Integration of Labour Markets NEXT LECTURE Optimum Currency Areas Reading: Baldwin/Wyplosz (2006, Ch. 16)