Why Do States Occasionally Cooperate and Try to Realign Exchange Rates - Coursework Example

Why Do States (And Central Banks) Occasionally Cooperate and Try to Realign Exchange Rates Name: Course: Instructor: Date: Introduction European countries have used several approaches to ensure political and economic order before and during 19th Century. The order has been through a series of challenges many of which decisions have to be made. The advocates of the order suggested that the order would be only achieved if there were an established system among the European countries to take care of their national and international economic issues. This paper tries to explain the economic reason for the union and cooperation among European countries and their central banks in the period between 1930 and 1980. What British Columbia experiences just before the economic recession of 1930 In Columbia after the First World War, there appears to be a remarkable spread in pure hybrid bulls for fertilisation and dehorning of cattle to avoid spoilage of the meat packers during shipment. There is an economic boom as from 1920 to 1929, and the market of beef grows strong as expressed by the price. Ranching is highly profitable in October but in 1929, the stock market crashes. A cow initially costing 100$ goes for 21$ and beef farmers are incapable of paying back their expenses and debts. The income of beef eaters drops and the demand for beef drops too (Mather, 2006). The already bad economy precedes a calamity of grasshoppers and mites which make ranching almost entirely impossible. An economy that has been having a producer surplus in cattle is now facing a shortage with importing the cattle being the only option. The importation itself brings another challenge in the British Columbia. There is widespread of diseases in the 1930s leading to more losses. Cattle rustling became prevalent by use of trucks during this period of the global recession (Mather, 2006). The establishment of protectionism policies before the recession The global recession causes trade and financial crises arise and call for regulation of mass immigration of people and capital movements within Europe. This raises the tension amongst the European countries (Britain, France and Germany). The globalization causes attempts to regulate the control of capital movements especially when their volatility produces regular and massive financial crises (James, 2001). Each state sets up measures for protection of goods, labour markets and capital markets. The protection set stage for the great depression of 1907. The same economic reaction causes the recession of 1930 (James, 2001). The recession tragedy strikes again The prestige of central banks and the myth that surrounds their power does not arise untouched from the financial tragedy of 1931-1933. The tragedy leads to loss of freedom of each European country together with their international bargaining power. As in many cases a great deal of that independence is derived from central banks standing with the banking community and the public opinion rather than from the explicit legal provisions. Third, the very aim of cooperation is blurred (James, 2001). Before 1931, there is clarity in the ultimate purpose of central bank preserving stable exchange rates under the anchor of gold. The clarity of the objective loses its significance afterwards when recession stroke in 1930 (James, 2001). Finally, the end of the gold standard affords the individual states more freedom in pursuing their own distinctive monetary policies. The recession causes inflation and countering it becomes a private goal for each of the countries. In theory, the co-ordination of economic policies is still essential for the overall recovery of the world economy. However, with the state of recession it starts to become irrelevant to individual, countries (James, 2001). The European countries take reaction measures to curb recession Countries pursue foreign exchange policies to achieve domestic deflation through artificially low interest rates and import substitution (Friedman & Schwartz, 2008). An option of currency devaluation can succeed if other countries. Forming an international union becomes a long-term measure to counter inflation for Europe With the introduction concept of the international union, they are brought to an agreement on the importance of avoiding a self-defeating race of competitive devaluations. Cooperation was, therefore, desirable even in minimal rates. Small countries that pegged their currencies to that of a leader in their monetary area would take advantage from mutual coordination and understanding from the larger player (Friedman & Schwartz, 2008). Finally, the few countries that remain on the gold system after 1933 are bound to achieve effective cooperation amongst themselves and with the largest capital markets outside the bloc (Friedman & Schwartz, 2008). As policies differ, so does the need for coordination and the forms it is supposed to take. In the current world, international cooperation policy is under classification of a one-size-fits-all that is clarified implicitly during creation of the Bank of International Settlements (BIS) would no longer apply (Goodhart & Mizen, 2003) Measures to enhance economic recovery of Germany by the union Germany becomes the country in which the greatest impact of the recession falls on. Failing to find a reasonable compromise at London conference in 1931, the seven government representatives issue a declaration that Germany's financial crisis comes as a result of lack of confidence (Kaiser, 2000). The crisis is not justified by the economic and budgetary situation of the country and that they are ready to cooperate as it was within the power to restore the confidence. The recommendations measure though amount to nothing (Kaiser, 2000). There is renewal of the debt of 100 million dollars to the Reischbank and measures that aim at maintaining the volume of short-term credits already granted by private financial institutions are set to Germany (Goodhart & Mizen, 2003).There is no need for further action till there is issuing of deliberation by committee of experts set up by the BIS. The deliberations included inquiring into immediate further credit needs and study of possibilities of converting the short-term credit to long-term (Goodhart & Mizen, 2003). Members of the committee come from the private banking sector. The appointed chair is Robert Wigin, the chairman of the board of Chase Bank based in New York. The committee delivers its report in 18th august 1933. The Germany representative, Melchior is adamant to state that there is no need for short-term credit (Goodhart & Mizen, 2003). Melchior and The recovery of Germany’s economy The balance of trade is in equilibrium temporarily due to slack domestic demand, as were the public finances courtesy of the drastic methods adopted by the Germany government. There is also no need for increasing foreign exchange reserves of the Reichsbank (Goodhart & Mizen, 2003). According to Melchior, there are strong psychological reasons for maintaining large reserves in foreign balances. The acute crisis of the country is now over and increase of these balances obtained as a result of rediscount credit from abroad can have any particular effect (Goodhart & Mizen, 2003). On the contrary to this, he thinks that any short term rediscount credit can create embarrassment to the bank when it falls due. The representative fails to mention that the situation has been improved significantly by exchange controls that have just begun to bite. Germany finds its way out of the financial crisis once it becomes apparent that the international co-operation is a failure (Goodhart & Mizen, 2003). One of the county's bankers claims that the country needs long-term credit to enable industrialists to give orders and so increase employment. In the debate, it is stated that it is detrimental for Germany to make an international borrowing to meet payments of credit that. Melchior replies to this by saying that the situation of Germany is not healthy, and it is impossible to obtain internal credits. It is not a prior concern of the committee to determine the ability of Germany to finance its future economic development after living beyond their budget capacity for at least seven years. With consideration that the net withdrawals as from 1931 were 2.5 billion RM, not replacing it raises a question (Goodhart & Mizen, 2003). How the central banks help in shaping the behaviour of the economy and its agents Monetary control takes course with the goal of influencing the behaviour of economic agents and financial intermediaries with the aim of achieving policy objectives of financial and monetary stability. The achievement of the policy depends on the credibility of the monetary and regulatory authority (Goodhart & Mizen, 2003). The reliability also depends on the ability of the power to track the record of the monetary and financial discipline. The behaviour of the regulator and the regulated occurs as a series of games between the parties involved. The policy objective of the monetary regulatory authority is to maximise social welfare through monetary and financial stability and to minimise social costs through regulation of, market misconduct (Goodhart & Mizen, 2003). If their rules are unclear or the incentives encourage moral hazard, some private sector participants may exploit these opportunities. The private sector attempts to maximise individual gains and minimising enforcement costs and sanctions (Goodhart & Mizen, 2003).The credibility of the authority depends on its ability to reinforce monetary and fiscal discipline through undertaking surveillance, investigation and enforcing action. A transparent and credible series of independent professional and regulatory action that is free of political and vested interests can enhance the reputation of the market and command the respect of the market participant especially the investors. Such interaction influences market behaviour and hence the development markets rely on the standards or quality of relationships based on trust, honesty and consultation transparency, accountancy, good reputation for fairness of the regulator results in better information disclosure and cooperation by market players. Trust is the drive towards adequate (Goodhart& Mizen, 2003). Monetary, macroeconomic and financial stability are two sides of the same coin and obtaining one objective cannot be isolated from the other. It is essential for central banks and regulatory policies to coordinate and share information of their policies and actions Central banks need enough and timely information on health of the banks to determine their liquidity and solvency. Raising interest rates when corporate sector is excessively leveraged can undermine the stability of the banking system. Illiquidity can cause insolvency problem for the market participants (Goodhart & Mizen, 2003). The role of the Central Banks in Regulation of Macroeconomic stability The central banks need to understand the micro aspects of the monetary actions and the regulators need to know that soundness of individual institutions has a larger implications on macroeconomic and systemic stability. Information disclosure helps to manage risks effectively, improve performance and increase transparency of actions. The quality of the information depends on existence and implementation of accounting and auditing standards. To attain these, they need to be clear, transparent and explicit (Smits, 2003). Secondly they need to be legitimate, that is, have public consultation and approval; they should improve market efficiency and level playing filthily. They should also have regard to the regulatory burden on market participants such consumers and investors. And they need have transparency and due process in enforcement. The markets are changing fast through innovation and technology, and this change requires excessive regulatory costs by the regulators (Smits, 2003). For markets to do sound work, they require three sets of disciplines; Self-discipline, market discipline and regulatory discipline. Self-discipline encompasses provision of the best defence against imprudent or improper exposures and measures for efficiency. Regulatory discipline on the other hand reinforces self-discipline through enforcement to promote compliance and good governance through fairness, consistency and credibility of the playing fields. Finally, there is market discipline which separates the weak from the strong through transparency, healthy competition and accountability (Smits, 2003). Markets are driven by expectations and investors have a tendency of using reason to make decisions. However, behavioural researchers object to this notion because it, usually, leads to inefficiency. They claim that the resultant decisions are mental shortcuts to make quick decisions from the masses of information (Smits, 2003). The information can be misleading because of an overemphasis of information that is unimportant and minimising use of relevant information. Worse investors confuse short term cycles with long term trends and predict the future from the past. Reliance on average opinion is better because the view is typically stable for an extended period. A sudden shift in average opinion or sentiment results in over adjustments that can intensively interrupt the performance of the real economy (Smits, 2003). The European Central bank fulfils the objective of the EU The statistical tasks of European Central Bank (ECB) are to issue coins and consultative functioning respect to the legislation at the community and national as defined. It is the community that acts similar to a legal person with distinct features to adopt a single currency. The institutions of the member states prepare for the transition. The community's monetary authority to perform the central banking functions for the member states participating in the single currency area (Smits, 2003). The pillars are union activity, common foreign and security policy and cooperation in the fields of justice and home affairs. Initially, the currencies of the members have a link with a fixed relationship. Their fluctuation bears a narrow band around the dollar parity. The link with the US currency results in stable exchange rates. The US dollar has a firm connection with gold. The BrettonWoods provide currencies with a stable semi-gold standard against which the economic expansion of 1950s and 1960s could take place. There is no reason for the negotiators of EEC treaty to include treaties on monetary affairs (Smits, 2003). The Rome treaty requires that the member states co-ordinate their economic policies and regard their exchange rate policy (ERP) same as matters of combined concern. Each member is required to respect four objectives of the policy, equilibrium in the balance of payments confidence in its currency, a high degree of employment and stable prices. The agreement includes measures to support the balance of payments of member states. There is assurance of convertibility of currencies of the member states to enhance current transactions in the ordinary market. Coordination of the economic policies of each of the member states is one of the two means besides the establishment of the common market through which the European community was to achieve its objectives. The co-ordination calls for the establishment of tearing of tariff walls tariffs across borders to coordinate cross-border economic activities, with central bankers being given a mandate to discuss the economic policies. The council requires the member states to consult each other over the context of the monetary support operations for the third countries. In 1964, the member states undertook to consult each other prior to any changes of parity on their currencies. The BrettonWoods monetary order failed in 1968 after introduction of the Barre plan by the council (Smits, 2003). The essence of the European Monetary Union for fulfilling cooperation objective The monetary disturbances that occur from the 1970s onwards lead to general floating of the major currencies. They have divergent influences on the currencies of the member states. Some appreciate while others depreciate on the foreign exchange markets (Smits, 2007). The monetary disturbances affect farm produce differently in various member states. Appreciation effects to the farmers' income in the member states create a concern that is unacceptable politically. Depreciation leads to an increase in income to the farmers but leads to inflation hence undermining the confidence in the currency. The strains almost lead to the collapse of EEC (European Economic Community) agricultural policy. It is agreed to solve the problem by introducing levies and rebates at the community internal frontiers called monetary compensatory amounts. Other schemes and measures that rely on a shared value for all member states are affected too by the monetary disturbance as well (Vaitilingam, 2010). The dangers of the common market occur as a result of felt effects of negative consequences of monetary disturbances. The situation becomes acute, and the economic boundaries vanish. Then an official decision to achieve economic and monetary union by the end of the next decade in 1969 is made (Vaitilingam, 2010). At a meeting in Hague in 1971, the heads of states and government decided to proceed with the European Monetary Union (EMU). Under the Werner report, there is adoption of the resolution of the council and representatives of the governments of the member states. The terms of the resolution include completion of the new market where there is free movement of commodities and services without distortion in competition of structural or regional balances, currencies to be irreversibly and totally convertible with their parities irrevocably locked (Moussis, 2004). A single currency requires a creation and the community organization of central banks. A single currency within an international system is established to enable the community to possess powers and responsibilities in economic and monetary matters to enable its institutions to administer the union (Moussis, 2004). Pursue of the coordination of economic policies gets an increase by medium-term economic policies. In 1973, there was an oil shock that causes a disturbance of the process of materializing of the economic policy which calls for national rather than international response to the shocks. High inflation plus the high unemployment rates in 1970s acted as setbacks to the union. The shock leads to non-transition to the next stage as the financial difficulties led to national rather than international responses to situations (Shojai, 2002) The Operation of the Union The economic policies are further strengthening towards 1974 (Moussis, 2004). A convergence decisions to co-ordinate the procedures are laid down. The approach requires the member states to have their disposal of certain instruments of economic policy, which is to lead to the mentioning of establishment of the economic policy committee. Smithsonian agreement is set up as an effort by the G-10, grouping of 11 industrial nations to reinstate the exchange rate stability by adopting wider margins (Council On Foreign Relations, 2002). The joint float against the US dollar of several nation or community currencies makes a symbol of a snake due to the fluctuations of the exchange rates of the participating currencies against the dollar when depicted graphically. There is an establishment of a system of fixed but adjustable exchange rates so as to alleviate from the community the adverse effect of the exchange rate volatility existing internationally. However, regardless of the exchange rate stability, currency stability is to remain a feature of the community's economic order for a long period (Council On Foreign Relations, 2002) More Challenges to the European Union Lack of progress on the financial front is brought to an end and initiatives to bring more currencies into the exchange rate agreement and monetary stability in Europe. There is creation of European Monetary Union (EMU) in Bremen by the European council (Smits 2007). The aims have three features namely; the exchange rate mechanism between the participating currencies, the creation of European currency Unit (ECU)s against the deposit of foreign reserves of all member states and the mechanisms to provide credit to the participating central banks. The tools help to maintain the primary rates agreed and coordination of the economic and financial policies to underpin the currency arrangement (Smits 2007). The exchange rate mechanism There is a creation of parity grid of bilateral exchange rates. With interventions to limit swings in currency, prices between pronounced floors and ceilings, the maximum permissible band of swinging is 2.25% in either side of their central rates. The exchange rates can be adjusted depending on the current economic circumstances or thrust of market forces. These rates are adjustable from the central rates (Smits, 2007). EMM introduces ECUM which serves as a new unit of account in the community affairs and as means of payment between the community's monetary policies. In 1979, European Multilateral Clearing Facility (EMCF) was given the responsibility of issuing ECU against the deposit of the part of member states holdings of gold and US dollar under the EMS. The member states deposit 20 percent of their gold holdings and US dollar assets with the EMCEF and get recognition with the counter value in ECU (Smits, 2007). The ECU serves as the basis of the parity grid with each community currency having an ECU central rate The ECU serves the basis for divergence threshold. The mechanism is meant to measure the inconsistency of a single participating currency exchange rates and the average of the other currencies (Smits, 2007). ECU is a basket of currencies with each participating currency having a relative weight. It serves as a weighted average of the participating currencies. It works to balance the adjustment requirements on the member states participating in the ERM and is better than the snake by enhancing the use of divergent threshold (Smits, 2007). The Plaza Accord Recent inflation points at fluctuations in the value American dollar value due the oil shock and freezing of the Iranian assets held in the Unites States of America as its causes. The value of the dollar remained high when (OPEC) made preference for it as the primary currency. However, because of having high value, there has been an observed trade deficit. The deficit causes capital outflows whereby investors opt to venture elsewhere where there is an expectation of high returns to investments. The capital outflow leads to a remarkable decline in confidence of the dollar as a trading currency. Systems developed created expectations for occurrence of a lower inflation in USA that makes the investments in USA eye-catching. Small interest rates were part of the policies established in 1978 to attract investors. Despite running a huge balance of payments deficit between 1981 and 1985, there is an observed appreciation of the US dollar. Political stability, fall in price of oil, reinvestment of funds by major commercial banks in the US market, speculative a purchase by investors in foreign exchange market makes it a haven to investments. However, US exports become expensive as imports become cheap bringing in the balance of payments deficit .external borrowings are used to finance the deficit. There is a loss in attractiveness in foreign investments of the dollar assets. One of the remedies for the balance of payments deficit is reducing interest rates, concerted effort to devalue the dollar by monetary authorities of major industrialized countries. Application of the measure led to success in 1985. At this time Japan, USA, France, West Germany, and United Kingdom jointly acted to bring about the corrective action (Grieco 1996). Ministers and Central Bank governors collaborated to devalue the US dollar. The joint action to bring down the value of the dollar is referred to as the plaza accord However, records show that by 1987, the value is considered too weak, and United Kingdom, West Germany, France Canada and Italy agree to control the rate the reduction of the value under Louvre accord. However, it is observed that it takes a longer period to do so than the plaza accord. The policy of china depreciating the RMB currency became a matter of concern for many in the congress. The concern arose because the RMB devaluation is a way of conveying unfair competitive advantage to Chinese producers and exporters through being a distortive trade policy. The system created a scenario where China's exports became less expensive and imports expensive. The RMB is significantly undervalued against the dollar a situation that contributes to US trade deficits with china and decrease of manufacturing jobs of USA. By 1994. The dollar was worth 8.28 of the Japanese Yuan, and it remained till 2005. However, from 2005 to 2008, it appreciated by 34% against the dollar on a nominal basis (Lardy 2005). The appreciation halted because of global economic crisis which made global demand of Chinese products to reduce. The halting led to a reduction of china current account surplus and slowing of accumulation of foreign exchange reserves. These facts nullify the claim that the RMB is not much below the dollar in value as it once was. The devaluation makes it appear as an indirect export subsidy to USA and other countries. The prices of the Chinese imports lower, a benefit to consumers of Chinese [products in USA but causes unfair competition for firms that produce substitute commodities in the USA. (Morrison& Wayne 2011). Exporting to china is likely to reduce in volume under a floating rate of exchange system. China starts purchasing a significant amount of US Treasury securities. China accumulates a lot of exchange reserves of US dollars that it uses to purchase US debt. Thence e the appreciation is both beneficial and with a negative effete to sectors. Manipulation of the currency aims at gaining an unfair advantage. Economists suggest that a reduction of global imbalances in savings, investment and trade about china and USA needs a reduction in order to lower chances of future global financial crises as those that have occurred recently. And instead divert dependency on exports as drivers of economic growth to increment of domestic demand to increase imports. The goal is attainable through setting of a market-based currency policy (Feldstein 2008). The need for the financial reform stands to be the reason for introducing of bills seeking to induce china to change currency system Conclusion Struggle to cushion itself from the negative effects of inflation has been a journey full of successes and failures for Europe. However, it has made progress in terms of establishing a union to take care of the members monetary and economic interests. From the above, article, it can be established that the major reason for the cooperation among the European countries is working to ensure economic stability through stable exchange and interest rates. References Feldstein, M. S. (2008). Resolving the global imbalance: The dollar and the US saving rate (No. w13952). National Bureau of Economic Research. Friedman, M., & Schwartz, A. J. (2008). The great contraction, 1929-1933. Princeton, Princeton University Press. Grieco, J. M. (1996). State interests and institutional rule trajectories: a neorealist interpretation of the Maastricht Treaty and European economic and monetary union. Security Studies, 5(3), 261-306. Council on Foreign Relations. (2002). The Smithsonian Agreement. View on the Aftermath New York, Council on Foreign Relations. James, H. (2001). End of globalization: Lessons Learnt from Great Depression. Cambridge, Mass, Harvard University Press. Kaiser, D. E. (2000). 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