Monetary Policy - Coursework Example

? The last two centuries have seen multiple efforts by countries to fix exchange rates or create monetary unions because of a desire for more predictability in international trade patterns and need for greater ease in transacting and settling accounts across borders. The latest of these efforts is the establishment of the Economic and Monetary Union (EMU) in Europe in 1999. However, almost all of the efforts in the past have had to be abandoned within a period of time for a variety of reasons, and it is tempting to conclude that the sovereign debt crisis in Europe will lead the Euro Zone down the same road. While there are certainly several similarities between these experiences, the European experiment must be viewed in its broader political and administrative context to see that such pessimism is not entirely warranted. The failure of monetary cooperation was partly due to the loss of autonomy countries face when they agree to fix exchange rates or participate in a union. This loss of autonomy means that a country has fewer tools at its disposal to reach its internal and external balance. Different countries define the term “balance” differently with respect to their internal and external balance goals – for instance, the German Bundesbank has historically been considered very inflation-averse, while the central bank of Italy has generally seemed comfortable with higher inflation rates1. In normal economic times, this divergence in goals is not a problem and countries find their fiscal tools sufficient to address short- and medium- term deviations from their internal and external balance goals. In times of crises, however, countries with a lower tolerance for deviation from goals may find that they require more than just their fiscal tools to address the crisis. This is particularly true under fixed exchange rate regimes. When a country is facing unemployment, in addition to fiscal measures, monetary authorities might want to stimulate investment by increasing the money supply and lowering interest rates. However, the Mundell-Fleming model shows us that under a fixed exchange rate regime (unless the nation imposes restrictions on capital mobility, such as China did until recently)2, such a move would be ineffective because a lower interest rate would cause a capital outflow, which in turn would apply depreciating pressures on the domestic currency. To maintain the exchange rate, the central bank would then be obliged to buy back the very same currency that it initially supplied to the economy to encourage investment.3 Where the costs are deemed to outweigh the benefits, countries are left with three options: (i) Continue to remain within the arrangement, but act autonomously (ii) Continue to remain within the arrangement, but renegotiate the terms to address the crisis, or (iii) Cease to remain within the arrangement Examples of these options being exercised are numerous. For example, under the Gold Standard, which was a fixed exchange regime between 1870 and 1914, central banks were required to adhere to the “rules of the game,” when there were disturbances in the price-specie flow mechanism that held the Gold Standard in place4. These “rules” meant that central banks would sell domestic assets while experiencing a current account deficit and buy domestic assets while experiencing a surplus. However, the urgency to bring about an external balance was felt more sharply by countries facing deficits, so countries often exercised the first option - which meant that the “rules” were frequently violated or ignored5 although to all appearances, the system was not overthrown. The second option, often takes a form that either returns a degree of autonomy to the member countries or enhances the power of a third body to address the crisis. Examples of the second option being exercised can be found in both the history of the Bretton Woods System as well as the European Monetary System (EMS). Under the Bretton Woods System, countries were required to peg their currencies to the U.S. dollar while the U.S. was responsible for maintaining the dollar price of gold at $35 per ounce, convertible on demand. However, in the 1960s and 1970s, countries within the system faced a number of balance of payments crises brought on by speculative attacks. Britain, France and Germany had to devalue or revalue their currencies in 1964, 1967 and 1969 respectively to keep the system afloat6. Even under the EMS, currencies pegged to each other were allowed to float within a band of ± 2.25%7. However, the member countries renegotiated capital controls and currency realignments numerous 11 times between 1979 and 19878. The eventual abandonment of the various fixed exchange mechanisms, the Bretton Woods System, the Gold Standard and other systems shows that countries have often resorted to the third option also. Often, this is done under great duress, such as the recent collapse of the Argentinian economy in 2000. In this case, the inability of the central bank to maintain the fixed exchange rate, compounded by a loss of confidence in the Peso, led to abandonment of the fixed exchange regime and severe austerity measures imposed by the IMF. The Euro Area (EA) shares several similarities with previous international monetary arrangements. However, the EA experiment is necessarily broader in scope than any similar attempt in the past for a number of reasons. One, the union is not just as a currency union, but as an economic and monetary union, where cooperation is pursued over a wide range of economic policy. Secondly, the central banks of the member states have not only ceded the power to maintain their external balances, but have also somewhat ceded the power to affect their internal balances. Monetary policy for the entire Euro Zone is the sole responsibility of the European Central Bank. The Euro was successfully introduced in so many countries despite not being an “Optimal Currency Area”9, is because of the political will to do so – the principle of limiting their annual deficits and public debt were not always followed, and this (as an example of countries following option 1) in turn has some role to play in the current crisis. However, in order to truly understand if history is merely repeating itself in the case of the Euro Zone crisis, it is worth looking at all of the potential causes for the crisis first. Broadly speaking, there are three immediate causes for the Euro Crisis: The first being, unsustainable levels of debt taken on by some governments: The adoption of the common Euro by all EA member states resulted in countries of different credit-worthiness receiving loans at similarly low interest rates. This “Credibility Effect” has long been studied10, and indeed, was foreseen as a potential problem of adopting a single currency. However, it was seen more as an advantage for the so-called “peripheral nations,” and seen as the mechanism by which the economies of the various nations would converge11. However, this reflected credibility was in some cases used to bail out banks burdened by the subprime mortgage crisis12, and in other cases used imprudently towards unproductive welfare schemes. With the overall economy in decline, the ability of the governments to repay the debt became questionable. Another cause was the unstable external balances. Differences in the productivity of workers in Germany and the workers in other parts of Europe led to an unbalanced current account situation between the nations, with Germany experiencing high trade surpluses13, and the peripheral nations seeing significant deficits. And the third cause was structural issues within the EA. The EA has so far been conceived only as a monetary union, with the fiscal powers vested in the member nations itself. This means, however, that the EA cannot use any fiscal measures to attend to a union wide problem without large scale cooperation. For example, Krugman points out that although the economies of Spain and Florida were in similar situations in 2010, the fiscal federalism of the United States allowed the federal government to pump in roughly $31 billion into the state to revive its economy14. In the absence of any body to undertake similar fiscal pump-priming, the EA is more vulnerable to recessions. Reviewing the current Euro Zone crisis, several similarities become immediately apparent between the current crisis and crises of the past. There are significant asymmetries between the various countries of the Euro Zone, and the current system tends to propagate the asymmetries further. Countries like Germany have significantly stronger economies than countries like Greece; the unification of the European market has meant that capital flows to the stronger regions, thus benefiting strong economies like Germany more15. Such asymmetries have several parallels in past monetary arrangements. For example, under the Bretton Woods System, the position of the U.S. as the issuer of the reserve currency allowed the U.S. to accrue great asymmetric power. Likewise, the Gold Standard system allowed nations running current account surpluses to flout the “rules of the game” and placed the burden of bringing the payments balances of all countries into equilibrium on the deficit running countries16. Secondly, the current crisis has partly been brought about by several countries within the Euro Zone (such as Italy and Greece)17 that exercised the first option described above when it seemed more convenient for them. Similarly, the current crisis has lead economists from several countries arguing that ceasing cooperation (exercising the third option described above), returning to a national currency and devaluing the currency would resolve their current predicament. No country in the EA has yet exercised this option because the Maastricht treaty does not have any clause that deals with leaving the union, and the experience of the Great Depression indicates that international cooperation helps overcome crises better and faster than trying to disengage with the world. But there have been a few dissimilarities observed also. Firstly, the primary cause of the crisis did not happen because of an inability to maintain member states’ external balance objectives – the roots of the problem lay in the subprime mortgage crisis, which affected the internal balance objectives of the various member nations. In the case of the Bretton Woods System, the final abandonment of the system came about when the external balance problem of the U.S. led to the fundamental “confidence problem.”18 By adopting a single currency, the problem of external balance was successfully outsourced to the European Central Bank. Secondly, while all previous systems carried inbuilt structural weaknesses, there is a fundamental difference with that of the EA. The Gold Standard and the Bretton Woods system took away the ability of central banks to address economic problems through monetary policy. The fundamental problem was that central banks were left with too little autonomy. In the EA crisis, the problem is that member states have been left with too much autonomy on the fiscal and political fronts. The EMU has encouraged a very high degree of economic and monetary cooperation, but has failed to foster an equal degree of political and fiscal cooperation. The EA is one of the boldest experiments in monetary cooperation in recent history, and its future has far-reaching consequences for the member states of this arrangement. While it is true that monetary arrangements generally fail if they seek to limit the autonomy of member states, it would be premature to apply to predict the fate of the EA. Given the scope of this experiment and the progress made so far, the current crisis may only further strengthen the continent’s tendency towards greater cooperation and integration. References: Bloomfield, A. I. (1959), “Monetary Policy under the International Gold Standard: 1880-1914”, Federal Reserve Bank of New York, New York. Chambers, A, (2005), How Europe's Governments have Enronized their Debts, . Available from: http://www.euromoney.com/Article/1000384/BackIssue/50007/How-Europes-governments-have-enronized-their-debts.html [Accessed: Dec 4, 2012]. Giavazzi, F. Pagano, M. , (Jun 1988), "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility", European Economic Review, vol. 32. , pp.1055-1082. Higgins, B, (1993), "Was the ERM crisis inevitable?", Federal Reserve Bank of Kansas City Economic Review, fourth quarter, pp. 27-40. Johnson, S, (2012), "The End of the Euro is not about Austerity", New York Times, Jun 21. Krugman, P, (2012), "Florida versus Spain", The New York Times, Jun 2. Krugman, P. Obstfeld, M. , (2009), International Economics: Theory and Policy, 5th ed, Pearson Education Inc., Boston. Lewis, M, (2011), Boomerang – Travels in the New Third World, Norton, New York. Mundell, R, (1963), "Capital mobility and stabilization policy under fixed and flexible exchange rates", Canadian Journal of Economic and Political Science, vol. 29. 4, pp.475-485. Norris, F, (2011), "Euro Benefits Germany More Than Others in Zone", The New York Times, Apr 22, p.B3. Norris, F, (2012), "Outside Europe, German Trade Surplus Soars", The New York Times, May 11. Towards a single currency: a brief history of EMU. Available from: European Union, European Commission: http://europa.eu/legislation_summaries/economic_and_monetary_affairs/ introducing_euro_practical_aspects/l25007_en.htm. [Accessed: Dec 4, 2012]. Triffin, R, (1960), Gold and the dollar crisis, Yale University Press, New Haven. Read More