Dollarization: Lessons from Europe for the America (Routledge International Studies in Money and Banking, 22)

Dollarization

For many years now, the US dollar has been used for domestic monetary transactions outside the USA – Panama in 1904 being the earliest example. Since the advent of the euro, the debate over the benefits of monetary integration has warmed up, particularly for NAFTA countries. This collection, with contributions from experts such as Philip Arestis, Malcolm Sawyer and John Smithin, examines the various problems and benefits involved in monetary integration and covers such themes as: ● ● ● ●

the causes of euro instability monetary policy in non-optimal currency unions financial openness and dollarization the question of dollarization in Canada.

Dollarization addresses one of the burning policy issues in Europe and America: is monetary union worthwhile? The readable yet comprehensive style of this book will make it of interest not only to academics and students involved in European integration, financial liberalization, and dollarization, but also to policymakers at intergovernmental level. Louis-Philippe Rochon is the Stephen B. Monroe Assistant Professor of Economics and Banking at Kalamazoo College, USA, where he is also Director of the Center for Policy Studies. Mario Seccareccia is Full Professor of Economics at the University of Ottawa, Canada.

Routledge International Studies in Money and Banking

1 Private Banking in Europe Lynn Bicker 2 Bank Deregulation and Monetary Order George Selgin 3 Money in Islam A study in Islamic political economy Masudul Alam Choudhury 4 The Future of European Financial Centres Kirsten Bindemann 5 Payment Systems in Global Perspective Maxwell J. Fry, Isaak Kilato, Sandra Roger, Krzysztof Senderowicz, David Sheppard, Francisco Solis and John Trundle 6 What is Money? John Smithin 7 Finance A characteristics approach Edited by David Blake 8 Organisational Change and Retail Finance An ethnographic perspective Richard Harper, Dave Randall and Mark Rouncefield 9 The History of the Bundesbank Lessons for the European Central Bank Jakob de Haan 10 The Euro A challenge and opportunity for financial markets Published on behalf of Société Universitaire Européenne de Recherches Financières (SUERF) Edited by Michael Artis, Axel Weber and Elizabeth Hennessy 11 Central Banking in Eastern Europe Nigel Healey 12 Money, Credit and Prices Stability Paul Dalziel

13 Monetary Policy, Capital Flows and Exchange Rates Essays in memory of Maxwell Fry Edited by William Allen and David Dickinson 14 Adapting to Financial Globalisation Published on behalf of Société Universitaire Européenne de Recherches Financières (SUERF) Edited by Morten Balling, Eduard H. Hochreiter and Elizabeth Hennessy 15 Monetary Macroeconomics A new approach Alvaro Cencini 16 Monetary Stability in Europe Stefan Collignon 17 Technology and Finance Challenges for financial markets, business strategies and policy makers Published on behalf of Société Universitaire Européenne de Recherches Financières (SUERF) Edited by Morten Balling, Frank Lierman, and Andrew Mullineux 18 Monetary Unions Theory, history, public choice Edited by Forrest H. Capie and Geoffrey E. Wood 19 HRM and Occupational Health and Safety Carol Boyd 20 Central Banking Systems Compared The ECB, the pre-euro Bundesbank and the Federal Reserve System Emmanuel Apel 21 A History of Monetary Unions John Chown 22 Dollarization Lessons from Europe and the Americas Edited by Louis-Philippe Rochon and Mario Seccareccia

Dollarization Lessons from Europe and the Americas

Edited by Louis-Philippe Rochon and Mario Seccareccia

First published 2003 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 Routledge is an imprint of the Taylor & Francis Group

This edition published in the Taylor and Francis e-Library, 2005. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” © 2003 Selection and editorial matter, Louis-Philippe Rochon and Mario Seccareccia; individual chapters, the contributors All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Dollarization : lessons from Europe and the Americas / [edited by] Louis-Philippe Rochon & Mario Seccareccia. p. cm. – (Routledge international studies in money and banking ; 22) Includes bibliographical references and index. 1. Monetary policy–European Union countries. 2. Monetary policy–America. 3. Dollar, American. I. Rochon, Louis-Philippe. II. Seccareccia, Mario. II. Series. HG925.D64 2003 332.4⬘94–dc21

ISBN 0-203-98774-8 Master e-book ISBN

ISBN 0-415-29878-4 (Print Edition)

2002037065

Contents

List of illustrations List of contributors Acknowledgments 1 Introduction

vii ix xi 1

LOUIS-PHILIPPE ROCHON AND MARIO SECCARECCIA

PART I

The European experience 2 The decline of the euro in its first two years: is there a satisfactory explanation?

13

15

PHILIP ARESTIS, IRIS BIEFANG-FRISANCHO MARISCAL, ANDREW BROWN, AND MALCOLM SAWYER

3 The European Monetary Union: a preliminary assessment

30

MARCELLO DE CECCO

4 The theory and practice of European monetary integration: lessons for North America

48

ALAIN PARGUEZ, MARIO SECCARECCIA, AND CLAUDE GNOS

5 Common currency lessons from Europe: have member states forsaken their economic steering wheels?

70

STEPHANIE BELL

6 Monetary policy in a non-optimal currency union: lessons for the European Central Bank THOMAS PALLEY

92

vi

Contents

7 The “balanced budget multiplier” for the small open economy in a currency union or for a province in a federal state

101

MARKUS MARTERBAUER AND JOHN SMITHIN

PART II

Lessons for the Americas 8 Electronic payments and exchange rate regimes: industry changes and the question of a single North American currency

113

115

BRENDA SPOTTON VISANO

9 Financial openness and dollarization: a skeptical view

129

LOUIS-PHILIPPE ROCHON AND MATIAS VERNENGO

10 Dollarization as a tight rein on the fiscal stance

143

ALEX IZURIETA

11 Why Ecuador was ripe for dollarization, but Canada is not

165

JAMES W. DEAN

Index

176

Illustrations

Figures 2.1 2.2a 2.2b 2.3 2.4 4.1 4.2 4.3 4.4 4.5 5.1 5.2 6.1 6.2

6.3 6.4 6.5 7.1 7.2

Daily exchange rates: US dollars per euro US/euro area real, short-term interest rate differential US/euro area real, long-term interest rate differential Dollar/euro exchange rate and revisions to GDP growth forecasts Euro area, US, and Japanese growth rates Evolution of real prime rates in two core euro countries and the United States, 1979–99 Unemployment rate performances of two core euro countries and the United States, 1979–99 Share of deficit (–)/surplus (+) to GDP of two core euro countries and the United States, 1979–99 Share of primary deficit (–)/surplus (+) to GDP of two euro countries and the United States, 1983–99 Unemployment rate performances of two core euro countries and the United Kingdom, 1979–99 Decision-making bodies of the ESCB EUR-11 deficit-to-GDP (1999) Price and output impact in two countries subject to synchronized positive demand shocks of the same magnitude Price and output impact in two countries when country A is subject to a negative demand shock, and country B is subject to a positive demand shock Price and output impact of an expansion in aggregate nominal demand in a two-country currency union The long-run Phillips curve The impact of an imperfect currency on the Phillips curve The effects of an expansionary fiscal policy The effects of an expansionary fiscal policy with variable income distribution

16 20 20 22 25 62 63 64 65 66 77 86 94

95 96 97 98 107 109

viii Illustrations 10.1 Fiscal deficit and current account balance of the South after the shock 10.2 Financing of the deficit in the South 10.3 Interest rates in the South and the North 10.4 Fiscal and current account balances of the South by fiscal tightening 10.5 Fiscal stance, and current expenditure and tax revenue 10.6 Fiscal tightening and global recession

155 156 156 158 158 159

Tables 2.1 4.1 5.1 5.2 9.1 10.1

Investment in the euro area and current account surplus Stages of the Mengerian plan for European monetary integration Predecessors of the 1992 Treaty on Monetary Union (Maastricht) Stage 3 of the Treaty on Monetary Union (Maastricht) Foreign ownership of banking assets (%) – 1994–8 The flow/stock transaction and balance sheet matrices

26 54 72 73 138 146

Contributors

Philip Arestis is Professor of Economics at the Levy Economics Institute of Bard College, New York, USA. Stephanie Bell is Assistant Professor of Economics at the University of MissouriKansas City, USA and Research Scholar with the university’s Center for Full Employment and Price Stability. Iris Biefang-Frisancho Mariscal is Senior Lecturer at the University of the West of England, Bristol. Andrew Brown is Lecturer at Leeds University, England. James W. Dean is Professor of Economics, Simon Fraser University, British Columbia, Canada. Marcello de Cecco is Professor of Monetary Economics at the University of Rome “La Sapienza,” Italy. Claude Gnos is Maître de conférences at the University of Burgundy, Dijon, France, where he is the Director of the Centre d’études monétaires et financières. Alex Izurieta is a former Research Fellow at the Levy Economics Institute of Bard College, New York. He is currently Senior Research Fellow, Cambridge Endowment for Research in Finance, University of Cambridge, England. Markus Marterbauer is an economist at the Austrian Institute of Economic Research (WIFO), Vienna, Austria. Thomas Palley is Director of the Globalization Reform Project at the Open Society Institute, Washington DC, USA Alain Parguez is Professor of Economics at the University of Franche-Comté, in Besançon, France, and adjunct professor at the University of Ottawa, Canada.

x Contributors Louis-Philippe Rochon is the Stephen B. Monroe Assistant Professor of Economics and Banking, Kalamazoo College; and the Director of the Center for Policy Studies, Kalamazoo, Michigan, USA. Malcolm Sawyer is Professor of Economics at Leeds University, England. Mario Seccareccia is Full Professor of Economics, University of Ottawa, Canada. John Smithin is Professor of Economics in the Department of Economics and the Schulich School of Business, York University, Toronto. He holds a Ph.D. degree from McMaster University and has previously taught at the University of Calgary and Lanchester Polytechnic (now Coventry University) in England. His main research interests are in the fields of monetary economics, international finance and macroeconomics. He is the author or editor of Macroeconomic Policy and the Future of Capitalism (1996), Money, Financial Institutions and Macroeconomics (1997), What is Money? (2000), and Controversies in Monetary Economics: Revised Edition (2003). Brenda Spotton Visano is Associate Professor of Economics, School of Analytic Studies and Information Technology/Atkinson, York University, Toronto, Canada. Matias Vernengo is Assistant Professor of Economics at the University of Utah, Salt Lake City, Utah, USA.

Acknowledgments

This book is the result of a conference hosted by the Department of Economics, University of Ottawa, Canada and the Center for Policy Studies, Kalamazoo College, Michigan, on 6 October 2000. The editors would like to acknowledge the financial support of the International Council of Canadian Studies, and the Canadian Studies Program of the Canadian Embassy in Washington. The editors would also like to thank all those who participated in the conference either as a presenter, a commentator or otherwise. These include, in addition to the authors, Emmanuel Apel (University of Ottawa), Ronald Bodkin (University of Ottawa), Duncan Cameron (University of Ottawa), Jane D’Arista (Financial Markets Center), Thomas Ferguson (University of Massachusetts), Marc Lavoie (University of Ottawa), Jean-Guy Loranger (University of Montréal), Warren Mosler (Adams, Viner, and Mosler, Ltd), Henri Sader (House of Commons, Ottawa) and Thomas K. Rymes (Carleton University). The editors are especially grateful to Professor Chad Gaffield, Director of the Institute of Canadian Studies at the University of Ottawa, for his strong and continued support of our research project, and to Mathew Forstater (University of Missouri – Kansas City) for his valuable comments to all the chapters to this volume. Finally, a warm thanks to two students at Kalamazoo College, Erin Lee and Scott Petz, who worked tirelessly and diligently on preparing the book for publication.

1

Introduction Louis-Philippe Rochon and Mario Seccareccia

Dollarization has emerged in the last few years as a serious policy issue. Two events contributed to its policy relevance. On the one hand, the string of financial crises in the late 1990s in Asia, Russia, and Brazil – and most recently in Argentina – has triggered a revision of the conventional wisdom about the ways emerging market economies deal with the increased worldwide capital mobility. The central issue is one of policy possibilities: faced with a financial crisis, what can a country do? Devaluation is a possibility, although flexible exchange rate solutions have come under increased scrutiny and criticism, especially when applied to emerging economies (Hausmann, 1999). Some sort of fixed exchange rate system becomes, once again, a policy option. Second, the relative success of the euro (at the time of writing this, the euro has regained much of its decline against the US dollar) has led many to argue in favor of currency blocks. Moreover, Courchene and Harris (1999) have argued that the success of the euro may represent a threat to the hegemonic role of the US dollar as an international reserve currency that American citizens desire to hold. The US should therefore promote dollarization in order to maintain this role. If dollarization is increasingly a policy issue, we must differentiate between full and partial dollarization. In the latter case, also known as de facto dollarization, local currencies exist and circulate alongside the US dollar. Partial dollarization is fairly widespread, as many countries today have a significant proportion of bank assets or liabilities in US dollars. The US dollar can be used as a means of payment (medium of exchange), in addition to the local currency, which is known as currency substitution (see Calvo, 1996, Chapter 8), or can be used as a store of wealth (asset substitution). Full dollarization, however, is a situation by which countries fully abandon the local currency. Only the US dollar would exist and all assets and liabilities would be denominated in US dollars. In this way, exchange rate risk is eliminated for good, although country risk may remain. However, de facto or partial dollarization, if irreversible (see Dean, 2000), represents for some a potential problem. For Eichengreen and Hausmann (1999), for instance, the use of a local currency mixed with the inability of that country to

2 Louis-Philippe Rochon and Mario Seccareccia issue debt in its own currency leads to a currency mismatch: what they call “original sin.” The solution, therefore, appears to be full dollarization. Dollarization, in this sense, is a form of currency union; and while there are similarities between a dollarized regime and a monetary union such as the euro, there are striking and important differences as well. Perhaps the most important one is the fact that, in a monetary union, all countries abandon their own currency and institutions in order to create a new currency supported by new institutions. The euro and the European Central Bank are good examples. In this sense, these new institutions are created that cater to no one specific country, at least in principle. These new institutions typically are governed by a body consisting of representatives from all countries. Monetary and interest rate policies, in turn, are based on the prevailing economic condition in the union rather than in any particular member country and are imposed on all countries: European monetary policy is aimed at Europe. In a dollarized regime, however, things could not be more strikingly different. First, there is no creation of a new currency. Rather, countries accept the existing US dollar. Second, member countries must accept the existing American institutions. In this sense, the Federal Reserve would remain unaffected. Member countries would not be represented on the powerful Federal Open-Market Committee, for instance, and therefore have no say in shaping monetary and interest rate policies. Of course, these institutions could always be amended to reflect the new monetary reality, but this would require the consent of the American government and central bank, which is, in our opinion, a virtual impossibility. If dollarization appears to be a policy option for some countries, it remains a fact that it has primarily been championed by those countries with a history of economic and financial problems, although ironically some economists in Canada have also defended this possibility. Dollarization, thus, is seen as a solution of last resort, once all other solutions have been considered. This was the case in 1999–2000 in Ecuador, shortly after the inflation crisis led to the collapse of the sucre. The reasoning appears to be that, after all, nothing else can be worse, so why not? The adoption of the US dollar is thought to restore hope and confidence in the local economy. Yet, if dollarization is mainly being considered by crises-prone countries, where does that leave countries like Canada, for instance? Moreover, as McCallum (2000) has argued, using the European model as a guideline for dollarization in the Americas may be inappropriate given the vastly different economic and political traditions. Two questions therefore need to be asked and answered. First, what are the costs and benefits of dollarization for the dollarized economy? Second, what are the implications for the US dollar and the US economy? There appears to be a large consensus in the literature concerning the pros and cons of dollarization for the dollarized country. Among the advantages (see for instance Berg and Borensztein, 2000a), economists claim that dollarization leads to the elimination of exchange rate risk, lower inflation, lower interest rates (at quasi-

Introduction

3

US levels, except for country risk, which could also be correlated with exchange rate risk), the elimination of transaction costs, an increase in trade and thus a closer integration with the US and global economies. Local governments would benefit fiscally since they would now be able to sell bonds at lower interest rates (given a reduction in the interest rate spread relative to the US). Moreover, international investors would show increased levels of confidence and invest more in the local, dollarized economy. Hence the principal attraction of dollarization rests in the expectation that the elimination of exchange rate risk will lead to more stable international capital movement, trade and growth. Dollarization would therefore bring stability, both economic and political (see Grubel, 1999). As for the disadvantages, the literature usually points to the loss of control over monetary and interest rate policies, the loss of seigniorage, and the loss of the central bank role of lender-of-last-resort. The loss of seigniorage is considered by some as rather substantial (Chang, 2000). Countries that unilaterally dollarize lose seigniorage revenue although, from the US perspective, dollarization would lead to increased revenues, since dollarization would imply increased circulation of US dollars. This forms the basis for Senator Connie Mack’s plan, proposed in 1999 in the US Senate, to recommend sharing seigniorage revenues with dollarized countries as a way to entice countries to dollarize. The loss of the central bank and its role as lender-of-last-resort is often cited in the literature as an obvious problem. Under dollarization, the local central bank ceases to exist and hence there is no mechanism by which it could intervene to prevent a collapse of the banking system during a financial crisis, for instance. This is a major difference between dollarization and a common currency regime where the lender-of-last-resort role of the newly created central bank would still remain in effect. However, although the loss of a lender of last resort is an important argument, some economists – see for instance Calvo (2000) – have shown that in emerging economies central banks’ function as lender-of-last-resort has actually worsened already fragile economies. Finally, the ability to set monetary policy and interest rates is linked to national sovereignty. A country able to set policy is a country that is able to influence the future course of its economy. It is thus essential for national economic policy. Giving up monetary policy, within the context of dollarization, is essentially tying its hands to the whims of the Federal Reserve, which sets policy according to the US business cycle and inflationary expectations. Moreover, fiscal policy may itself be constrained by monetary conditions, thereby creating further obstacles for a dollarized economy to conduct independent macroeconomic policy. Proponents of dollarization, however, do not necessarily see the loss of monetary sovereignty as a disadvantage. They argue that if business cycles in the US and dollarized economies are more or less synchronized, then abandoning monetary policy is really not an issue. They argue that with increased economic integration,

4 Louis-Philippe Rochon and Mario Seccareccia business cycles are more likely to be synchronized. US interest rates would correspond, or should, to interest rates that would have been set in the dollarized country. Moreover, since dollarized countries are usually prone to currency and financial crises, the adoption of US monetary policy will simply impose on them policy discipline. Given their history of inflation, US monetary policy would restore a sense of stability. Dollarization leads to “better policies” (Powell, 2000). However, the synchronicity of cycles is not really the issue. Even synchronized economies can benefit from national monetary and interest rate policies, since their economies can respond differently to a given external shock. In this sense, economists should consider the composition of output. Canada’s economy, for instance, is more resource-based than the United States’ economy. Moreover, it becomes problematic if countries differ on their respective economic goal. While the US may want to fight inflation, other countries may want to fight unemployment (see De Grauwe, 1997). The above discussion focused mainly on the pros and cons of dollarization on dollarized economies. It rests, however, on a very specific assumption. It implicitly suggests that dollarization, on its own, will bring about these positive changes: that is, dollarization, through the graces of perfectly flexible markets, will bring about the positive gains. Not all economists agree, however. Eichengreen (2000), for instance, suggests that before a country chooses to dollarize, it must undertake a number of significant market-friendly reforms; otherwise dollarization may worsen the situation. Instead of asking whether a country should dollarize, Eichengreen asks when should a country dollarize. Hence, he writes: Dollarization, to work smoothly and yield more benefits than costs, must wait on the completion of complementary reforms. The banking system must first be strengthened, so that the authorities’ more limited capacity to provide lender-of-last-resort services does not expose the country to financial instability. The fiscal position must first be strengthened and the term structure of the public debt lengthened so that the absence of a domestic monetary authority able to absorb new issues does not expose the government to a funding crisis. Provisions must first be made, through the negotiation of commercial or intergovernmental credit lines, for obtaining the liquidity needed to finance intervention if a crisis nonetheless occurs. The labor market must first be reformed, so that the absence of the exchange rate as an instrument of adjustment does not leave the country without a mechanism for accommodating asymmetric shocks. And the economy must first be restructured, perhaps through the negotiation of a free-trade agreement, to ensure that cyclical fluctuations and appropriate monetary conditions coincide with those in the United States. This view is certainly consistent with Gruben, Wynne and Zarazaga (2002), who

Introduction

5

claim that dollarization ought to be an “integral process of institutional, political and economic reforms,” although the authors are silent on the specific sequence of the reforms. However, the debate over whether or when to dollarize, or what Gruben, Wynne and Zarazaga (2002) call the division between the “just-do-it” and the “coronation” approaches to dollarization, rests largely on the same arguments: that is, it rests on the need for perfectly flexible markets to receive eventually the benefits from dollarizing. Fiscal, financial and political reforms, as well as labor market reforms are all tied to dollarization. Further, the above discussion is largely focused on the pros and cons of dollarization for the dollarizing country. Indeed, there is virtually no debate on the pros and cons of dollarizing for the United States, perhaps reflecting the (official) ambivalence of Washington on the issue. Yet, this does not mean that there are no costs and benefits to the US. In fact, perhaps the most important argument that needs to be made is the direct benefit the US would gain from opening money and financial markets in dollarized countries, an argument made by Rochon and Vernengo (see this volume). It should therefore come as no surprise that the debate over dollarization is often tied to schemes of privatization and financial liberalization. At the time of the Ottawa conference on dollarization, little evidence was available to support the argument – or rather the allegation – that dollarization would eventually lead to the increased presence of American banks and credit financing of American firms in dollarized countries. Since then, however, there seems to be some evidence to this effect. Of course, the World Bank (2002) position is that the presence of foreign banks will add to the stability of the financial markets in emerging economies, and Berg and Borensztein (2000b) have claimed that this would lead to fewer financial crises. However, there is increasing evidence, or at least strong theoretical arguments, that this may not be the case. For instance, the presence of American banks in dollarized economies may lead to a greater number of residents moving their savings outside of the dollarized country to the US, hence hurting the local financial system (D’Arista, 2000). Moreover, if dollarization does lead to an increased presence of American banks in dollarized countries, then it is conceivable that they would prefer lending to American firms rather than local firms. How would American banks feel about lending to local firms, farmers and various local arms of the government? In other words, how would dollarization affect the overall supply of credit and the composition of that supply? These are certainly interesting questions to pursue. If post-Keynesians link the creation of money and output to the supply of credit within the framework of endogenous money, how then will dollarization affect the growth of dollarized economies? How will dollarization and the penetration of foreign banks affect local economies? Will this prove destabilizing rather than stabilizing? Already, the 1999 Economic Report of the President had indicated that

6 Louis-Philippe Rochon and Mario Seccareccia dollarization would lead to an important increase in the number of American banks and financial institutions. Dollarization is thus an invitation for expanding American presence in emerging markets. What impact that would have on local economies is certainly a question that needs to be addressed carefully. Although their paper is not directly on dollarization, Weller and Hersh (2002, p. 3) argue that many crisis-prone countries tend to have a greater number of foreign banks. The authors also present evidence showing that foreign banks’ “clients are usually MNCs [multinational corporations] or large domestic corporations engaged in international transactions,” usually export-oriented. They further argue that “it is quite clear that MNBs [multinational banks] do not serve the majority of low- and middle-income households or even small- and medium-sized enterprises and startups,” a point also made by D’Arista (2000).

Structure of the book As the authors had made already these points forcefully at the conference held in Ottawa in October, 2000, many of the contributions in this book address these points, in a rather critical perspective. Most authors would be deemed heterodox, with the possible exception of one, James Dean, who nonetheless is critical of dollarization for a country like Canada, but certainly does not reject it for other countries, like Ecuador. Yet the overwhelming position on this point is against dollarization, and perhaps even against monetary unions. Each author in this book has made an important contribution to the ongoing debate on dollarization and monetary unions. The overwhelming conclusion is that dollarization and monetary unions should not be pursued as a serious policy issue, as they impose too many constraints, as seen in the previous section. The book is divided into two overall parts. The first part, containing six chapters, deals more specifically with the European experience, while the second part, containing the remaining four chapters, is more specific to the debate on dollarization. In Chapter 2, Philip Arestis, Iris Biefang-Frisancho Mariscal, Andrew Brown, and Malcolm Sawyer examine the causes of the general decline in the value of the euro following its adoption. The various explanations offered in the literature are assessed. And although the authors’ critical assessment draws on a number of papers in the literature, they focus on their own research and published output. The authors carefully review the decline in the value of the euro and examine two obvious explanations. They conclude that neither “bad luck” nor fundamentals such as interest rate differentials or measures of long run equilibrium magnitudes explain the decline. They then proceed to construct a more satisfactory explanation. The argument, prevalent in the literature, that the decline in value of the euro is due to “US strength,” rather than to any inherent difficulties with its imposition, is thought to be rather undeveloped. They suggest that US strength is an important but partial factor in euro decline.

Introduction

7

The following chapter, by Marcello de Cecco, also looks at the initial weakness of the euro. The author begins his analysis by identifying the conditions under which a currency becomes an international currency. The author looks at issues of trade and spot market transactions, and to other more complex financial arrangements, such as forward contracts used for arbitrage and hedging. The author then proceeds to explain why the mark and the yen never made the transition to international currencies, and carries his analysis to the newly created euro. Chapter 4, by Alain Parguez, Mario Seccareccia, and Claude Gnos, takes a careful look at the European monetary union and draws specific lessons for the proposed North American union. They begin by outlining the neoclassical or Mengerian foundations of what they call “European economics”: that is, the basis of arguments for monetary union in Europe. They then look at three required policy rules for implementation: the role of the central bank, the need for restrictive fiscal policy and, finally, the need that employment and welfare programs no longer ought to constrain the economic policy behavior of the member states. Combined, these rules should ensure that narrow national interests do not dismantle the new supranational monetary order. From there, the authors look at the North American situation. Chapter 5 also looks carefully at the European case. Stephanie Bell correctly asks whether member countries have forsaken their economic “steering wheel.” The chapter examines the prospects for macroeconomic policy under a currency union. Although the focus is on European monetary union, implications of such a currency union between Canada and the United States, for example, can also be drawn. The paper focuses on Abba Lerner’s theory of Functional Finance, which essentially describes the ultimate form of policy flexibility, and the extent to which his proposal is tenable under the institutional arrangements that now govern the eurozone. Tom Palley’s argument, in Chapter 6, revolves around an examination of how monetary policy should be conducted in a non-optimal currency area. The author argues that optimal policy requires a slightly higher rate of equilibrium inflation to avoid higher unemployment. Formation of a non-optimal currency area shifts the Phillips curve right and worsens the inflation–unemployment tradeoff. This has important implications for the ECB, since it is widely agreed that the euro area is not an optimal currency area. By carrying over the old Bundesbank’s 2 percent inflation target, the ECB is setting policy as if the euro were an optimal currency area. The euro area therefore stands to have higher unemployment. Finally, the analysis in the paper has important implications for plans to enlarge the euro area. To the extent that enlargement worsens the non-optimality of the euro area, it further worsens the ECB’s inflation–unemployment tradeoff. Preventing unemployment from rising will require an even higher inflation target. In Chapter 7, Markus Marterbauer and John Smithin try to show that there are certain circumstances and conditions in which a balanced budget fiscal expansion by a political jurisdiction lacking a sovereign currency can “work,” in the sense of

8 Louis-Philippe Rochon and Mario Seccareccia promoting increased growth and employment. They also show the general limits to such a policy initiative. In a more specific context, they do not believe that this strengthens the case for a country such as Canada, which currently has a floating exchange rate and a sovereign currency, to negotiate a North American monetary union (NAMU) or simply to accept “dollarization.” The authors argue that, under such arrangements, the implied restrictions on the freedom to maneuver in policymaking, not only in interest rate or monetary policy, but also in fiscal policy and other areas, remain so onerous that this should be one of the main considerations in the debate. Finally, there is a major caveat in the case of jurisdictions in existing currency unions such as the eurozone of the EU, or provincial jurisdictions in federations. This is simply that explicit legal/negotiated measures for coordinated reductions in both taxes and public expenditures could easily remove whatever loopholes remain for an independent policy. In Chapter 8, Brenda Spotton Visano argues that the economic debate around the question of greater monetary integration hinges critically on the importance or not of retaining Canadian autonomy over monetary policy, and that it is a question regarding the ability of the Canadian central bank to influence independently and effectively the Canadian economy. By whichever means the central bank may influence the macroeconomy, consensus opinion holds that this influence, in Canada as elsewhere, derives fundamentally from a central bank monopoly over the ultimate and final means of payment. The author argues that the primary question is to what extent might financial innovations in the payments system be eroding the central bank’s monopoly control over final settlements balances and liquidity services both directly and indirectly through innovation facilitating “dollarization”? The author does not offer any objectively verifiable or quantifiable answers. Rather, questions together with opinion are offered as an observationally grounded way of thinking about what the future might hold. The exercise presumes that the future may look significantly different from the past – based on the observable fact that technological innovations in information communications are revolutionizing the financial services sector. Louis-Philippe Rochon and Matias Vernengo, in Chapter 9, examine some of the arguments of this debate from an American perspective. They begin by exploring the differences between dollarization and monetary union, where the arguments rest on the mismatching of markets and regulators, and then move to a discussion of what they consider to be the standard arguments in the debate, namely the elimination of transaction costs and the benefits to trade, and seigniorage. They argue that the arguments presented by proponents of dollarization are not definitive, and that increased trade may not result necessarily in increased output and growth. Finally, they consider two arguments for dollarization that have been neglected in the literature. First, dollarization, by allowing the use of the US dollar only, allows American banks to have a stronger presence in local economies, while simultaneously leading to a decrease in the number of local banks. In other words,

Introduction

9

American banks gain a competitive edge over local banks. Second, American multinational firms who have connections with US banks gain greater access to local economies and local markets, given their established access to US banks. These effects lead to the question of who benefits from dollarization and who bears the costs. This is the crucial question to be analyzed from the political economy perspective. The benefits from dollarization for American banks and multinational firms would not be the case in a common currency arrangement. Therefore the differences between a monetary union and dollarization are of particular importance. More importantly, the increase in the number of American banks and firms extends the American brand of capitalism to other regions, and with that the advantages and costs of this particular institutional arrangement. Dollarization seems to export one of the main problems of the American system to other economies, namely: the disproportional influence of financial interests. As a result, dollarization may very well intensify the problems generated by the increasing volatility of capital flows. Chapter 10 begins with the assertion that theoretical and empirical studies over exchange rate policy informing the debates around the European economic and monetary union and currency boards have, for the most part, overlooked a critical shortcoming of these systems: namely, monetary union agreements broadly remove major sources of deficit financing, virtually inhibiting macroeconomic management by governments. Alex Izurieta further claims that by not putting in place a system of transfers and fiscal stimuli, which would compensate for interstate disparities or help recovery after exogenous shocks, monetary unions would lead to polarization rather than convergence. The author believes that experience seems to suggest that countries under tight exchange rate and monetary agreements are more prone to suffer from chronic unemployment or financial weakness in the aftermath of exogenous shocks. In order to investigate this proposition, the author takes the case of a formally dollarized economy – the most radical amongst common currency settings – in which there is no exchange rate flexibility or monetary policy at all. Yet, it could be argued, fiscal policy may perhaps be sufficient to “do the trick.” Cautioned by the Tinbergenian principle that for each policy goal one instrument is required, the author hypothesizes that fiscal policy alone is not capable of helping an economy recover after an external shock and ensure, at the same time, financial stability. Furthermore, by constructing an inherently consistent, axiomatic, macroeconomic model, the author concludes that fiscal policy is not only inadequate, but also left with fewer financial sources to operate. The alternative, namely tightening the fiscal stance along with the financial constraints, would rather exacerbate the adverse effects on income and employment of the initial shock. In the final chapter, James Dean examines the case for dollarization in Latin America and in Canada. While accepting many of the arguments put forth by the supporters of dollarization, the author concludes that dollarization is good for Latin

10 Louis-Philippe Rochon and Mario Seccareccia America, but should be rejected for Canada. The author believes that the case for dollarizing Latin America rests on six grounds: (1) dangerous exposure of both banks’ and firms’ balance sheets to currency risk; (2) related currency and country risk premiums on Latin American interest rates; (3) weakened monetary control due to substitution of US for domestic currency; (4) probable dominance of nominal over real external shocks; (5) high pass-through from exchange rates to wages and domestic prices; and (6) probable irreversibility of currency substitution. The author then argues that the case for dollarizing Canada fails on all six of these grounds. This book is meant to offer a general discussion of the benefits and costs of dollarization and of other forms of monetary integration. This is of particular importance in the western hemisphere where the question is being posed, and more so since the successful adoption of the euro within the countries of the European economic and monetary union.

References Berg, A. and E. Borensztein (2000a), “The Pros and Cons of Full Dollarization,” International Monetary Fund, Washington DC, Working Paper 00/50. Berg, A. and E. Borensztein (2000b), “The Dollarization Debate,” Finance and Development, International Monetary Fund, Washington DC, March. Calvo, G. (1996), Money, Exchange Rates, and Output, Cambridge, MA: MIT Press. Calvo, G. (2000), “The Case for Hard Pegs,” paper presented at the North–South Institute Conference on Dollarization, 4–5 October, Ottawa. Chang, R. (2000), “Dollarization: A Scoreboard,” Federal Reserve Bank of Atlanta, Economic Review, Vol. 85 (third quarter), pp. 1–11. Chriszt, M. (2000), “Perspectives on a Potential North American Monetary Union,” Federal Reserve Bank of Atlanta, Economic Review (fourth quarter), pp. 29–39. Courchene, T. and R. Harris (1999), “From Fixing to Monetary Union: Options for North American Currency Integration,” C.D. Howe Institute Commentary, 127, June, Toronto. D’Arista, J. (2000), “Dollarization: Critical US Views”, paper presented at the North-South Institute Conference on Dollarization, 4–5 October, Ottawa. Dean, J. (2000), “De Facto Dollarization,” paper presented at the North-South Institute Conference on Dollarization, 4–5 October, Ottawa. De Grauwe, P. (1997), The Economics of Monetary Integration, Third Edition, Oxford: Oxford University Press. Eichengreen, B. (2000), “When to Dollarize,” paper presented at the Federal Reserve Bank of Dallas Conference, 6–7 March. Eichengreen, B. and R. Hausmann (1999), “Exchange Rates and Financial Fragility,” NBER Working Paper 7418, Washington DC. Grubel, H. (1999), “The Case for the Amero: The Economics and Politics of a North American Monetary Union,” Critical Issues Bulletin, The Fraser Institute, September, Vancouver.

Introduction

11

Gruben, C., M. A. Wynne and C. Zarazaga (2002), “Dollarization and Monetary Unions: Implementation Guidelines,” Federal Reserve Bank of Dallas, unpublished paper. Hausmann, R. (1999) “Should There Be Five Currencies or One Hundred and Five?” Foreign Policy, Vol. 116 (Fall), pp. 65–79. McCallum, J. (2000), “Engaging the Debate: Costs and Benefits of a North American Common Currency,” Royal Bank of Canada, Current Analysis, April. Powell, A. (2000), “Dollarization: The Link Between Devaluation and Default Risk,” paper presented at the Federal Reserve Bank of Dallas, March. Weller, C. and A. Hersh (2002), “Banking on Multinationals: Increased Competition from Large Foreign Lenders Threatens Domestic Banks, Raises Financial Instability,” Economic Policy Institute Issue Brief 178, April, Washington DC. World Bank (2002), Global Development Finance: Financing the Poorest Countries, Washington DC: World Bank.

Part I

The European experience

2

The decline of the euro in its first two years Is there a satisfactory explanation? Philip Arestis, Iris Biefang-Frisancho Mariscal, Andrew Brown, and Malcolm Sawyer

Introduction The euro was formally launched in January 1999 and, at the time of writing (January 2001), the euro’s value against the dollar is substantially below its initial level. There was a general decline throughout the first two years of the euro, with a low reached in May 2000, and again in September 2000. A further, all-time low was reached in October 2000, but the euro has recovered somewhat since then. However, it still remains lower than its initial value. Figure 2.1 provides the details. The purpose of this chapter is to examine the causes of this general decline in the value of the euro. The various explanations offered in the literature are assessed. The introduction of the euro and the associated operation of the euro system, that is the European Central Bank (ECB) and the National Central Banks (NCBs), has been under considerable scrutiny. This is reflected in a relatively large number of scholarly papers providing a detailed assessment of the performance of the euro, the ECB and of the euro area macroeconomy more generally (for a recent example see OECD, 2000). Although our assessment draws on these papers in a critical manner, we also focus on our own research and published output (see, for example, Arestis, Brown, and Sawyer, forthcoming). The second section reviews the decline in the value of the euro. The third section examines two obvious explanations, and argues that neither mere “bad luck,” nor fundamentals such as interest rate differentials or measures of long run equilibrium magnitudes explain the decline. The fourth section of the chapter attempts to construct a more satisfactory explanation. The argument, prevalent in the literature, is that the decline in the value of the euro is due to “US strength,” rather than to any inherent difficulties with its imposition. We believe this argument to be rather undeveloped. We suggest that US strength is an important but partial factor in euro decline. The fifth section summarizes and concludes the chapter.

16 Philip Arestis et al. 1.19

1.14

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7/4/1999

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1/4/1999

0.84

Source: Pacific Exchange Rate Service © 2000 Prof. Werner Antweiler. Time period: 4 Jan 1999 – 22 Sept 2000.

Figure 2.1 Daily exchange rates: US dollars per euro.

The decline in value of the euro Contrary to the predictions of its proponents the euro declined in value by over 25 percent against the dollar in the first two years of its life (see Figure 2.1), 30 percent against the yen, and 13 percent against the pound sterling since its inception in January 1999. Furthermore, the euro declined by 20 percent on the (narrow) ECB measure of its effective rate (ECB, 2000). Several possible explanations are reviewed and found wanting below. Before we embark upon them, we ask the question of whether the euro is in fact “undervalued.” The answer to the question about whether the euro is undervalued requires some discussion of the notion of the “right” value of the euro. We suggest two types of benchmark as appropriate measures, namely the value of the currency that would correspond to a trade balance, and a purchasing power parity level. The euro area maintains a trade surplus (in 2000, quarter 1, the surplus of exports over imports, as a percentage of GDP, was 2.1 percent). On the face of it this would suggest that the euro was undervalued relative to the exchange rate that would generate a balance of trade. Chinn (2000), Coppel et al. (2000) and Deutsche Bank Research (2000) provide some of the most recent attempts to gauge the “real” value of the euro. Chinn (2000) estimates an econometric “monetary model,” augmented by the relative price of non-tradeables using the value of the synthetic euro; Coppel et al. (2000) prefer more direct indexes of the real “longrun” or

The decline of the euro in its first two years 17 “equilibrium” effective exchange rates, such as relative unit labor costs, manufacturing prices, and consumer prices, and indicate that there has been a divergence between such indices and the movement of the exchange rate. Both papers also survey recent attempts to estimate the equilibrium exchange rate (see also the review of PricewaterhouseCoopers, 2000, Chapter 3). The striking feature of their own and other such estimates is that the level of the euro was, with few exceptions, found to be way below its supposed “real” level, by a magnitude of 15 percent or more, no matter what method is employed. Thus Deutsche Bank Research (2000) shows that the euro moved more than 15 percent away from its PPP measure of the real exchange rate in late 1999 and onwards. Consequently, Duisenberg’s comments in 2000, on announcing increases in euro area interest rates, that the euro is clearly undervalued,1 are well supported by relevant empirical work. It would seem then that the low value of the euro cannot be explained by appeal to any notion of its “fundamental” value, whether that value is deemed to be purchasing power parity, fundamental equilibrium exchange rate or similar. We now proceed to discuss a number of explanations of the fall in the value of the euro.

Obvious explanations A number of explanations of the fall in the value of the euro suggest themselves. This section deals with the most obvious ones, which are the “just bad luck” argument and interest rate differentials. We discuss both in this section and we find them not persuasive enough. We begin with the first. Just bad luck? It is widely recognized that a host of contingencies affect the short run movements of the exchange rate, including the vagaries of market sentiment. Thus it can be argued strongly that the fall in the value of the euro based simply on “bad luck” has little underlying significance. This point of view can be coupled with the argument that, in historical perspective, the decline is not dramatic and the current level is not unusually low (Buiter, 1999b; Coppell et al., 2000; Corsetti and Pesenti, 2000). It can start from the observation that the decline in the euro (say during the year of 1999) is not unprecedented. We have reported elsewhere (Arestis and Sawyer, 1996) that over the period 1980 to 1995 the average ratio of the maximum level of sterling relative to the mark minimum level during a year was 1.13, and the corresponding figure for the dollar relative to the yen was 1.17 (with a figure of 1.28 in 1985 and 1.30 in 1986). The pound, for example, fell by around 25 percent from 1984 to 1985 and by roughly the same percentage in the winter of 1992–3; similar or greater volatility is displayed by other comparable exchange rate series. This lends some weight to the view of Favero et al. (2000) that “lamenting a weak

18 Philip Arestis et al. euro is patently unjustified.” This can be further supported by the idea that the value of the euro was relatively high on its introduction. Hence a decline from a relatively high level may have been anticipated.2 The interesting question, though, is how should this fall in value, even if there are precedents for the extent of its fall, be interpreted? A first possibility is that this decline is indeed “bad luck.” We may bet on the toss of a coin, and let us say that tails represents a loss and heads a win. A string of tails arising from repeated tossing of a coin may represent “bad luck” for us as the gambler, but may not be unprecedented. If we regard the movement of the exchange rate as a “random” event, then, on occasions, there will be “runs” of generally negative movements in the exchange rate, and at other times positive “runs.” Although the decline in the euro is by no means unprecedented, many of the large movements in exchange rates do appear to have some underlying cause. For example, the rise and then fall of the dollar during the 1980s can be ascribed to tight monetary policies and then the impact of the Plaza agreement, or at least those events were the “trigger” for large movements in the exchange rate. A related possibility is that these declines in the value of the euro could be seen as an example of a self-perpetuating “bubble” in financial markets in which expectations of price rises (falls) fuel those price rises (falls). A variant of the “bubble” argument has been put forward recently by De Grauwe (2000). This contribution attempts to explain the apparent lack of a relationship between fundamentals and the falling euro by resorting to the uncertainty of the impact of fundamentals on the exchange rate and of the precise equilibrium value of the euro/dollar exchange rate. This uncertainty promotes “beliefs” about the exchange rate that have nothing to do with fundamentals. Under these conditions exchange rate movements themselves become the focus and a signal to search for those fundamentals might explain the given exchange rate movement. Hence, when in early 1999 the euro began to fall against the dollar, it was interpreted as a signal that the US economy was strong and the euro area weak. Given the conflicting evidence of underlying strengths and weaknesses, such a search for some fundamentals is normally successful. Those “beliefs” have reinforced the euro fall since then. Nonetheless, treating the decline of the euro as a “bubble” may still raise the question of the cause of the start of the “bubble” even if there are mechanisms by which the “bubble” is perpetuated. We would argue that the “bad luck” argument captures an important but partial truth. The bulk of the literature is right to eschew the straightforward argument that the falling euro, per se, undermines the case of the euro’s proponents. However, it is also correct to stress that, if the proximate causes of exchange rate movements are the beliefs of market participants, and such beliefs have a random component, then, equally, beliefs are not purely contingent. Neither pure truth, nor pure whimsy, market beliefs do have some connection with economic reality. Thus, the historical and comparative precedents for the fall in the euro were not always a matter of “luck.” On the contrary, in many cases, they have an underlying economic logic, as

The decline of the euro in its first two years 19 suggested above. It is significant that proponents of the euro had predicted that its value would rise from January 1999 (Buiter, 1999 admits that he was one such proponent). Such predictions stemmed, not only from the relatively buoyant economic outlook at that time, but also from the view that the inception of the euro would contribute to the rosy economic future of the euro area. It is in this context that the decline in the value of the euro should be appraised. Whilst it is true that the decline provides prima facie evidence against proponents of the euro, it is the underlying causes of the decline that provide the critical evidence for any assessment of the exchange rate debate. If the decline in value is most plausibly attributed to a change in the economic conjuncture that is external to the euro’s inception, then the decline does not, after all, count against the euro. If, on the other hand, such external causes are not sufficient to explain the decline, then the spotlight must fall on factors endogenous to the euro and its accompanying euro system institutions and the Stability and Growth Pact. Real interest rate differentials The effects of interest rate differentials on the exchange rate appear at first sight paradoxical. A general presumption would be that raising the (domestic) interest rate would raise the exchange rate. The mechanism is quite simple: the higher interest rate makes acquiring financial assets in that currency more attractive, and wealth-holders acquire the currency in order to be able to acquire the financial assets. But uncovered interest rate parity indicates that the nominal interest rate differential is equal to the expected decline in the exchange rate. Thus a high interest rate differential foretells a declining exchange rate. These two ideas can be reconciled with an argument that is reminiscent of the “overshooting” theories. The immediate impact of an (unexpected) increase in the domestic interest rate is a sharp rise in the exchange rate, and the persistence of the interest rate differential is associated with a declining exchange rate. The extent of the initial rise in the exchange rate could be seen to depend on the expectations of the time period for which the interest rate differential persists. An interest rate differential of, say, 2 percent expected to persist for five years would signify a cumulative decline in the exchange rate over those five years of (just over) 10 percent. The measure of interest rate differential depends, not surprisingly, on the interest rate chosen for the comparison, and it cannot be assumed that the different interest rate differentials tell the same story. In terms of short-term interest rates, the differential between the US and the euro area has been positive, fluctuating around 1.5 percentage points: the month by month movements in this differential are given in Figure 2.2a. But the differential in terms of long-term interest rates has generally fluctuated between negative values, particularly over the 12 months to April 2000, as shown in Figure 2.2b. Consequently, the picture over the sign and size of the interest rate differential between the US and the euro area is a confused

20 Philip Arestis et al. 2.5 2 1.5 1 0.5

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Figure 2.2a US/euro area real, short-term interest rate differential. 0.4 0.2 0 –0.2

Jan- Feb- Mar- Apr- May- Jun- Jul-99 Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr99 99 99 99 99 99 99 99 99 99 99 00 00 00 00

–0.4 –0.6 –0.8 –1 Source: ECB (2000).

Figure 2.2b US/euro area real, long-term interest rate differential.

one. But the size of the differential is clearly not large enough to explain the rate of change in the value of the euro over this time period in terms of uncovered interest rate differentials. With the US interest rate moving generally in parallel with euro rates, and inflation rates likewise moving in rough parallel, there has been little change in the real interest rate differential between the USA and the euro area since January 1999. This is true of both short-term (Figure 2.2a) and long-term real interest rates (Figure 2.2b). Thus Gros et al. (2000) report that the clear negative correlation between long-term interest rates and exchange rate movements, empirically robust in the past (as confirmed also by Coppel et al., 2000), has broken down since mid1999. In the case of Japan, the real long-term interest rate differential was at the same level in April 2000 as it was in January 1999, with a “hump shape” in between. Real short-term interest rates did drift against the euro area during 1999 (from 2

The decline of the euro in its first two years 21 percent to below 0.5 percent), but they drifted in the opposite direction during 2000 (moving back up above 1 percent), with no reversal in the exchange rate decline (ECB, 2000). Clearly, interest rate differentials do not explain the decline in the value of the euro.

US strength There has been much focus on the euro/dollar exchange rates in general and also in this chapter. Clearly from that perspective the weakness of the euro can be treated as the other side of the coin of a strong dollar. The euro, however, has also declined against sterling and against the yen. In the case of sterling, the decline of the value of the euro has been less pronounced. It is also the case that many of the arguments which have been applied to explaining the weakness of the euro against the dollar can be carried over to explaining the weakness of the euro against sterling. The UK economy has experienced relatively strong growth, and interest rates have been similar to American rates. Turning to the yen, its strength against the euro is more difficult to fit in with the explanations of the euro/dollar rates. The Japanese economy has experienced sluggish growth (zero in the second half of 1999 and in fact for most of the period under scrutiny) and interest rates have been low. Although the explanation of the relationship between the euro and the yen is not the focus of this chapter, these observations are relevant to the arguments advanced below. Indeed, they contribute towards undermining the “US strength” explanation in accounting for the euro’s weakness. In this section we concentrate on explanations for the weakness of the euro by looking at the strength of the dollar, and in turn we account for the perceived strengths of the US economy. Expected and actual growth rate differentials Eichengreen (forthcoming), Buiter (1999), Corsetti and Pesenti (1999, 2000), Von Hagen (1999), Favero et al. (2000), Coppell et al. (2000), OECD (2000) and Deutsche Bank Research (2000) all point to the strong performance of the US as the fundamental cause of the decline in the value of the euro. The continuing strength of the US in 1999 coincided with a rather slower growth than had been expected in the euro area during the first half of 1999. During the four quarters of 1999, the US GDP growth rate was, expressed at an annual rate, 3.9 percent, 3.8 percent, 4.3 percent, and 4.6 percent. The corresponding figures for the euro area are 1.8 percent, 2 percent, 2.5 percent and 3.1 percent. In addition to the actual GDP figures, these authors offer striking graphical evidence (a graph first presented by Corsetti and Pesenti, 1999) for the “strong US” explanation. A very close fit obtains between the graph of the daily dollar/euro exchange rate and the graph of the difference between consensus 1999 GDP growth projections for the euro area and the US; as can be seen (Figure 2.3), the fit holds very well through 1999. Thus, it is argued, the

22 Philip Arestis et al.

Source: Consensus Economics, European Central Bank. (Reproduced from Corsetti (2000). We should like to thank Professor Giancarlo Corsetti for permission to reproduce this figure.)

Figure 2.3 Dollar/euro exchange rate and revisions to GDP growth forecasts.

“fundamentals,” as expressed in actual and/or expected growth rate differentials, explain the decline in the value of the euro. However, difficulties remain in explaining the precise significance of the graph for this decline. So much so that Corsetti (2000, p. 32) the co-originator of the graph, remarked recently that “To be honest, it is hard to find a convincing interpretation of the recent evolution of the euro.” Eichengreen (2000, p. 2) interprets the differing expected, and actual, growth rate performance as follows: “With demand growing relatively slowly and excess capacity pervasive in Europe, a weak Euro was the market’s way of pricing European goods into international markets.” Yet Eichengreen offers no explanation as to why international currency markets should behave in the way he postulates. If

The decline of the euro in its first two years 23 trade in international goods is the key, then the euro area’s trade surplus would lead to an appreciation rather than a depreciation of the euro. Buiter (1999) provides a different interpretation. According to him, growth differentials affect the exchange rate through (1) money demand and (2) the anticipated future path of short-term interest rates. On the first point, Buiter does not spell out the mechanism he has in mind, but we would interpret it as follows. Given the amount of money in existence and the level of prices, an acceleration in the rate of growth should cause an increase in the demand for money, which in turn causes interest rates to rise (so that interest rates in the US are expected to be higher than in the euro area). However, this view relies on the money supply being regarded as exogenously given. In the (to our mind) more realistic case of endogenous money, an increased demand for money would lead to an increase in its stock without interest rates necessarily rising. With reference to Buiter’s second point, interest rates may be anticipated to be higher in the future, but how does that lead to a rising exchange rate? In so far as financial assets are held in the form of bonds, then the anticipation of higher future interest rates is an anticipation of lower bond prices. Hence the anticipation of higher US interest rates would make US bonds less attractive now (than otherwise) and tend to generate a capital outflow rather than inflow. But financial assets may be held in the form of interest-bearing deposits. With low transaction costs, there is little reason to shift financial assets from one currency to another in this period for the prospects of higher future interest rates, but rather to shift when those higher interest rates materialize. Thus we are unconvinced that anticipated higher future interest rates can explain a rise in the value of the dollar (and hence a decline in the value of the euro). In any case, and as noted above, it is clear that the actual interest rate differential has not moved substantially in favor of the US (see above, and Figures 2.2a and 2.2b) at any time since the inception of the euro, nor is it currently expected it to do so in the future (e.g. Deutsche Bank Research, 2000). Coppel et al. (2000) and Corsetti and Pesenti (1999) invoke the strong correlation of expected growth rate differentials and the dollar/euro exchange rate, but they do not explain, in detail, just how the growth differential translates into a declining euro. Two explanations may be in order. First, there is a vague notion of “market confidence” whereby low growth prospects entail low “confidence” and a movement of speculative capital to the strong US – a possible “self-fulfilling prophecy.” Second, there is also the view that a relatively stagnant eurozone cannot match the prospective earnings potential of the buoyant US, which led to direct, and possibly portfolio, investment capital flows from the euro area to the US. Despite being vague, these explanations tied in well only with the situation in the second half of 1999, when the decline in the value of the euro appeared as little more than a reversal of a previous rise and when the recent growth performance of the euro was disappointing, especially relative to US strength. They have the effect of “absolving” the euro, and its accompanying institutional structure, from blame. For they suggest that the decline in value is a purely cyclical phenomenon that will naturally reverse,

24 Philip Arestis et al. in tandem with a future reversal of the relative cyclical positions of the US and the euro. Thus, by focusing upon the growth rate differential, it is possible to justify remaining sanguine about the fall in value of the euro. However, recent developments have served to cast doubt upon the cyclical explanation, and have led to a search for a clearer articulation of the relation between the expected US/euro area growth rate differential and the exchange rate. In fact, as noted above, the growth performance of the euro area started to pick up in the second half of 1999 and continued on this upward path in the first quarter of 2000 (growing at 3.4 percent p.a.). At the time of writing a growth at over 3 percent was forecast for the euro area in 2001 (OECD, Economic Outlook, June 2000). In any event, the value of the euro did not rise in tandem with the growth acceleration. On the contrary, it continued to decline and only began its (minor and short-lived) recovery in mid-May, which was followed again by severe falls. However, in the first week of December 2000 the euro exchange rate with respect to the dollar increased, prompting commentators to declare that the euro was well on course to rise. A few statistics suggested that the assessment may have had a grain of truth. The US GDP growth rate was 2.4 percent in the third quarter of 2000 – the lowest for more than a year – against an expected 2.7 percent. US consumer confidence in November was the lowest for more than a year, as a result of which durable goods orders were 5.5 percent lower in October, when in September they had been up by 2.4 percent. These figures should have pushed the euro, in relation to the dollar, well above the level it actually reached at the time (it was at 0.8898 on 7 December, up from its lowest ever at 0.8828 on 26 October 2000). By the end of December 2000, however, the euro did increase more, allegedly following further weak US economic performance and expectations of a possible recession there (see, for example, The Economist, 6–12 January 2001). The euro area appears to have been doing better than at any other time previously since 1 January 1999. In fact, the forecast that the growth differential between the euro area countries and the US would disappear in 2001 was so adverse for the US that the small increase in the value of the euro towards the end of 2000 is hard to justify on this explanation alone. In any case, it is still well below its value at its inception. On the other hand, the US growth performance has matched the euro area quarterly increases (growing at 5.1 percent p.a. in 2000, quarter 1), so that the actual growth differential has remained relatively stable in the five quarters since the inception of the euro (Figure 2.4). The point we would like to stress is that the “cyclical” explanation is more convincing when the euro area is clearly sluggish, as was apparent during the first half of 1999. The subsequent pickup in the euro area should, ceteris paribus, have led to profitable investment opportunities. There is no reason to suppose that the parallel growth increase in the US indicates a parallel increase in the earnings potential of direct investment. Indeed the cheap euro should have provided the euro area with an advantage in this regard, now that the euro area recovery is well under way (Gros et al., 2000). These considerations are all the more pertinent for the case of Japan, given its below zero growth in quarter 4 of

The decline of the euro in its first two years 25 6 ▲

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Figure 2.4 Euro area, US, and Japanese growth rates.

1999 (Figure 2.4). This may be one reason why, in the light of developments, Corsetti (2000) has considerably modified his explanation from that provided in Corsetti and Pesenti (1999). Now, the author (Corsetti, 2000, p. 7) stresses that, “a growth-concentrated perspective of the euro–dollar exchange rate is far from being ‘cyclical.’” His more detailed explanations are considered next. Corsetti (2000) even shows that the consensus expected growth differential between the US and the euro area in 2000 has displayed a similar pattern to that of 1999 (see Figure 2.3). The relationship with the yen broke down in 2000, however, confirming that the expected or actual growth differential cannot be the main explanation of the euro’s slide against the yen. If, given the argument of the above paragraph, Figure 2.3 cannot be interpreted to support a purely cyclical explanation of exchange rate decline, how, then, is it to be interpreted? Corsetti (2000) suggests that the high domestic US demand can explain the graph, and as a result the exchange rate movement. In view of the fact that US domestic demand growth outstrips US output growth (US consumption demand grew by 7.5 percent in the first quarter of 2000), Corsetti argues that domestic US producers will export fewer products abroad, in order to satisfy domestic demand. For such a relative fall in exports to occur, the real price of US goods vis-à-vis foreign goods needs to rise, on this view (causing non-US consumers to substitute non-US products for US products). This is no more than to say that the real exchange rate must appreciate. At the same time the current account will move (further) into deficit. By definition such an appreciation can occur through nominal exchange rate appreciation or through higher US inflation, or both. Thus this explanation focuses entirely upon the US side, irrespective of the situation in the euro area, and so, like the explanations considered above, it has the effect of “absolving the euro from blame” (though the explanation may be complementary to, rather than excluding, explanations that focus on the euro area). In itself, Corsetti’s theoretical argument is highly questionable. It relies upon the idea that US output is determined fully on the supply side, and that it will be sold

26 Philip Arestis et al. domestically, until domestic demand is saturated. We would argue, however, that aggregate demand is a spur to the growth of output. It may be that such demand has, instead, “sucked in” foreign direct investment. This would provide one alternative explanation for Corsetti’s (2000) graphs showing a strong and positive correlation between the exchange rate and both the expected US–euro area consumption demand differential and the expected investment demand differential (though the strong association between growth expectations and demand expectations may, in any case, be a sufficient explanation). This alternative is focused upon below. Investment flows Evidence on investment flows from the euro area highlights its potential importance in explaining the decline in value of the euro against the dollar (see Table 2.1). Table 2.1 provides evidence that one proximate cause of the decline in the value of the euro is an outflow of direct and portfolio investment far in excess of the current account surplus (a number of recent publications concur with this view: Gros et al., 2000; PricewaterhouseCoopers, 2000; ABN-AMRO Bank, 2000). But what explains the net outflow of investment? A widely discussed possibility is that the outflow is due to the strong US equity market. However, as both Corsetti (2000) and Gros et. al. (2000) note, the evidence from BIS (2000) is that “the appreciation of the dollar coincided with the sell off in the US equity market, defying the view that US stock prices drive the dollar” (cited in Gros et al., 2000, p. 51). The negative correlation has continued to the present. We now have US equity “downgrades” outstripping “upgrades” supporting the pessimistic view about US equities which, nonetheless, has not affected the euro favorably (Financial Times, 4 October 2000). Interestingly enough, NASDAQ (the US high-technology stock market) reached its lowest value for more than a year in the last week of November 2000, hardly affecting the euro– dollar exchange rate. However, it ought to be noted that by the end of December 2000, when NASDAQ lost more than 50 percent from its 10 March 2000 high and other unfavorable US statistics emerged, the dollar took a plunge with the euro appreciating, but not as much as the adverse statistics might suggest. In fact, the statistics for foreign direct investment for the fourth quarter of 2000 clearly indicate that if anything FDI increased in the US but slowed down substantially in the euro Table 2.1 Investment in the euro area and current account surplus (in billions of euros)

1997 1998 1999

Direct investments

Portfolio investments

Current account surplus

–48.1 –102.6 –147.3

–22.8 –85.3 –21.3

76.2 63.4 24.3

Source: ECB (2000).

The decline of the euro in its first two years 27 area (see, for example, Financial Times, 19 December 2000). This should have increased the euro and the dollar at the same time! Moreover, the interest rate influence on the stock market and on the exchange rate provides the economic logic for such a correlation (an actual or expected interest rate increase could depress the stock market and raise the exchange rate simultaneously). Gros et al. (2000) also noted that net capital outflow cannot be explained by the selling of euro-denominated equity by investors outside of the euro area. The figures show that euro area investors purchased (around 60 billion euros) more foreign-denominated equity than euro-denominated equity in 1999. Gros et al. (2000) suggest, therefore, that the outflow of capital might stem from a structural (the outflow started before the inception of the euro) economic imbalance of long-term investment capital, rather than from more speculative sources. They suggest that the latter type of explanation may explain the portfolio investment outflow: the rise in the ECU prior to 1999 being attributed to a “euphoria” that served to mask the underlying structural imbalance so that “many wrong-footed investors who over-invested in the euro at the beginning of 1999 have had to ‘capitulate’ since then, which may go a long way towards explaining the downward trend of the euro over the past fifteen months” (pp. 52–3). Gros et al. (2000) thus provide, in our view, a more convincing argument than Corsetti (2000) as to just why relative US strength, as expressed in actual and expected growth differentials, should contribute to the decline in value of the euro. However, in this case, US strength can be only half the story. A buoyant US economy will only attract foreign direct investment from the euro area if equally profitable opportunities for investment in the euro area are perceived to be unavailable. As argued above, the actual growth pickup of the euro area would, ceteris paribus, suggest that suitable investment opportunities in the euro area are growing. It is true that the continual slide in the expected growth differential might be taken to suggest a growing lack of investor confidence in the euro area, but why should investors perceive the euro area to be weak? The import of this latter question is suggested also by a very different consideration: the validity of strong US growth figures have been the subject of significant doubt. Gordon’s (1999, 2000) widely discussed analysis suggests that (1) strong US productivity growth is largely confined to just the IT sector; (2) it is a normal, cyclical acceleration of productivity as the economy expands above trend; and (3) in that sector changes in the statistical estimation of price declines, and quality improvements, serve to inflate greatly the true productivity growth, the implication being that productivity revival is not the result of the massive investment in IT throughout the IT-using economy. In conclusion, if Gros et al. (2000) are right, then the next important question to ask in order to get to the bottom of the decline in the value of the euro is, why has the euro area been perceived by investors to be weak? The timing of the investment outflow, which began about a year before the inception of the euro, is clearly consonant with the view that the inception of the euro itself has played a significant

28 Philip Arestis et al. role in harming investor perceptions of the euro area. Indeed, this view is plausible even if a more cautious stance towards the interpretation of Gros et al. (2000) is adopted, and not taking the net outflow of direct investment as necessarily fundamental. For it remains pertinent to ask just what market and speculative perceptions of the euro area have existed, for nearly a year and a half, and therefore helped to force down a range of currencies other than the US dollar.

Summary and conclusions The US economy has been growing faster than the euro area in the past few years, and the general perception of the strength of the US economy relative to the euro area economies is likely to have contributed to the strength of the dollar and the weakness of the euro. However, there is no consensus as to just how US strength causes the value of the euro to fall. US strength cannot, of course, explain euro weakness against other currencies such as the yen. We have suggested that the most plausible explanation concerns long-term investment flows and (following Gros et al., 2000) shorter-term post-“euphoria” flows of portfolio investment. Both approaches, though, can only offer a partial explanation of the euro’s instability. We would suggest that it may very well be that a more satisfactory explanation should also look at the euro’s weakness. This view would stress that the other side of the coin of US strength is euro area weakness. This, however, should be the main thrust of another paper.

Notes 1 Duisenberg (2000a) states that the euro has “clearly overshot a level which could be regarded as being in line with the fundamentals.” Duisenberg (2000b) also admitted that the euro exchange rate was “a cause for concern” and reiterated that it had been out of line with fundamentals “for a prolonged period of time.” 2 Relevant time series are available, beginning in the early 1990s on both narrow and broad measures of the effective rate, and, beginning in 1979, on a “synthetic” euro construct (see, ECB, 2000; OECD, 2000). The narrow ECB measure includes only the thirteen main trading partners with the eurozone, whereas the broad measure includes thirty countries (ECB, July 2000). The synthetic euro is based upon a weighted average of the respective exchange rates of the eleven euro area countries (with the dollar, for example), where the weights used are the country share in euro-wide GDP. It is calculated as a chain-linked index, taking the same value as the euro on 4 January 1999. The data show that the “historical perspective” argument on the level of the euro was more persuasive in mid-October 1999 than now. Since mid-October 1999 the value of the euro has declined by more than 10 percent.

References ABN-AMRO Bank (2000), “Euro Suffers from Capital Outflows,” Euroland Economics Update, Economics Department, April, Netherlands.

The decline of the euro in its first two years 29 Arestis, P. and M. Sawyer (1996), “The Tobin Financial Transactions Tax: Its Potential and Feasibility,” International Papers in Political Economy, Vol. 3, No. 3. Reprinted in P. Arestis and M. Sawyer (1998) (eds), The Political Economy of Economic Policies, London: Macmillan. Arestis, P., A. Brown, and M. Sawyer (forthcoming), The Euro: Evolution and Prospects, Aldershot: Edward Elgar. BIS (2000), International Banking and Financial Market Developments, February, Basle. Buiter, W. H. (1999), “Six Months in the Life of the Euro: What Have We Learnt?,” remarks prepared for a seminar on monetary and budgetary policy in the Economic and Monetary Union, held at the Rabobank, 25 June 1999, London. Chinn, M. D. (2000), “The Empirical Determinants of the Euro: Short and Long Run Perspectives,” paper prepared for the Deutsche Bundesbank conference, Equilibrium Exchange Rates of the euro, 27–8 March. Coppel, J., M. Durand, and I. Visco (2000), “EMU, the Euro and the European Policy Mix,” OECD Economics Department Working Papers 232. Corsetti, G. (2000), “A Perspective on the Euro,” CESifo Forum, Vol. 1, No. 2 (Summer), pp. 30–6. Corsetti, G. and P. Pesenti (1999), “Stability, Asymmetry and Discontinuity: The Outset of European Monetary Union,” Brookings Papers on Economic Activity, Vol. 2 (December), pp. 295–372. Corsetti, G. and P. Pesenti (2000), “The (Past and) Future of European Currencies,” Cuadernos de Economia, April. De Grauwe, P. (2000), “The Euro/Dollar Exchange Rate: In Search of Fundamentals”, mimeo, University of Louven and CEPR, June. Deutsche Bank Research (2000), Economic and Financial Outlook, 15 May. Duisenberg, W. (2000a), ECB Press Conference, Question and Answer Session, Frankfurt am Main, 8 June. Duisenberg, W. (2000b), ECB Press Conference, Question and Answer Session, Frankfurt am Main, 23 December. ECB (2000), Monthly Bulletin, various issues, augmented by data available on the ECB website, at http://www.ecb.int Eichengreen, B. (forthcoming), “The Euro One Year On”, Journal of Policy Modelling. Favero, C., X. Freixas, T. Persson, and C. Wyplosz (2000), “One Money, Many Countries”, Monitoring the European Central Bank Volume, Vol. 2, London: CEPR. Gordon, R. J. (1999), “Has the ‘New Economy’ rendered the Productivity Slowdown Obsolete?,” at http://faculty-web.at.nwu/economics/gordon/334.pdf. Gordon, R. J. (2000), “Does the ‘New Economy’ Measure Up to the Great Inventions of the Past?,” Journal of Economic Perspectives, Vol. 14, No. 4 (Fall), pp. 49–74. Gros, D., O. Davanne, M. Emerson, T. Mayer, G. Tabellini, and N. Thygesen (2000), “Quo Vadis Euro? The Cost of Muddling Through,” Centre for European Policy Studies Macroeconomic Policy Group, Second Report, Brussels. OECD (2000), EMU One Year On, Paris: OECD. PricewaterhouseCoopers (2000), European Economic Outlook, May, New York. Von Hagen, J. (1999), “The First Year of EMU,” mimeo, Centre for European Integration Studies, University of Bonn.

3

The European Monetary Union A preliminary assessment Marcello de Cecco

Introduction In spite of repeated last-minute attempts to the contrary, European Monetary Union started on schedule with eleven countries participating in it. The self-exclusion of Great Britain made the task of monetary unification much easier, as the special requirements of an intensely financial currency did not have to be looked after, and neither did the British economy’s cyclical co-movement with the US economy. Repeated financial crises notwithstanding – first Russia and Brazil, then the US (with the LTCM affair, which recalls to monetary historians the Baring crisis of 1891) – the new European currency was definitively launched on 1 January 1999. Many well-considered experts predicted at the time of its inception that the euro would be a strong currency. They did so on theoretical grounds, which already appeared then, and do even more so now, rather shallow, as can be said of so much contemporary theory. In a paper presented at a conference convened in Buenos Aires in June 1998, by the then president of the Argentine Republic, I predicted that the euro would start weak and that it would stay weak for quite a long time. Looking back, I can afford to be rather amused by the mistakes of the experts and smile at their attempts to justify their wrong predictions. There are no real historical precedents for the present EMU. The only comparable example history offers is that of the Latin Monetary Union. German and Italian unification in the second half of the nineteenth century did not perpetuate the component states as far as full sovereignty was concerned. The Latin Monetary Union, on the other hand, was started by an international treaty among sovereign states, but it was a metallic currency inter-circulation agreement. It did not have a central bank as the present EMU does, and did not cover all aspects of monetary creation; in particular it was not concerned with bank money. It did not have a stability pact, regulating fiscal policy, as strict (formally, at least) as the one the eleven countries of the European Union have signed. The Latin Monetary Union was based on a central power which was France, whose economic and financial power was larger than that of the other member countries put together. In the present EMU, it will be enough for Italy and France to move together to represent a

European Monetary Union: a preliminary assessment 31 joint economic and financial power at least as large as that of the EMU’s central power, Germany. There is no disputing the fact that European Monetary Union is centered on the new Germany, in a way that the European Union, based on the Common Market of forty years ago, was not. The EMS was not based on Germany either, although it became centered on the DM in a way that made its smooth functioning impossible. After the Maastricht Treaty, the progress to monetary union was seriously impaired by the crises of 1992–3, and the actual achievement of a single currency for Europe was seen to be possible only by allowing a temporary widening of the fluctuation bands and the suspension from the ERM of some countries, which could be allowed back in only if their convergence to the Maastricht parameters looked realistic. Everybody knows the most recent installments of the story. Appropriate precedents for multinational currencies not being available, we must look at cases of international currencies which were the currencies of national states, even if they were very large ones, like the US, or of formal empires, like the British Empire.

How can we identify an international currency? Usual answers to this question underline the functions a currency performs in the international exchange of goods and services. Normally, a currency becomes international when it is adopted as a vehicle currency in a sufficiently large number of international transactions. Historically, this has happened as the country in question has grown in importance in international trade, i.e. when it trades more and more and with a larger and larger number of different countries. When a deep and wide network of international economic relations comes into being, an ever increasing number of international economic transactions begin to take place, with the currency of one of the two countries involved being used as a counterpart to the transactions. This helps to make the market for the currency in question deep, wide, and resilient to shocks. Furthermore, the currency in question thus becomes more liquid than other currencies. It then becomes convenient for people who want to go from one currency to another to do so by using the widely exchanged currency. For instance, if I want to exchange Italian lire for Argentine pesos, it is preferable to sell lire against US dollars and then buy the pesos with the dollars that are obtained, for the simple reason that the lire–dollar exchange rate and the peso– dollar exchange rate will probably yield a better rate than the lire–pesos rate I would get if I went directly from the Italian currency into the Argentine currency. The two dollar markets are in fact more liquid, as the US is a prime trade and services partner of both Italy and Argentina. As a result, transaction costs are lower and rates are more stable and predictable. We can proceed from this case of a simple spot transaction to much more complex ones involving forward contracts used for arbitrage and hedging. Each of

32 Marcello de Cecco them will turn out to be more convenient and easier to facilitate if we use the large dollar market than if we go directly from lire into pesos, two currencies used only for national transactions. The same applies to lending and borrowing outside our national financial market. Whoever the lender or borrower may be, a loan will be easier to enter, service, and repay if we denominate it in the international, rather than in one purely nationally used, currency. Again for the same reasons, national central banks will find it more convenient to place their foreign exchange reserves in the financial market of the international currency and to conduct their international intervention operations, aimed at influencing the exchange rate of their own national currencies, on the exchange market of the international currency. The main features an international currency possesses ought to be clear by now. It is a currency used as a vehicle, to lend, and as a reserve. These features can be conferred upon a currency only by the international markets. It is possible that international agreements reached by sovereign states formally recognize the international role of a currency, as happened to the dollar at Bretton Woods. But such agreements are purely a formal recognition of something that the markets have already decreed. International values can be set by decree only if the will to do it is backed by sufficient military and political power: in this case we may speak of imperialism, whether it is formal or informal. The hegemonic country will rule only as far as its economic, political, and military power reaches. Beyond that, markets re-acquire their functions, and the hegemonic country’s currency will be traded at rates fixed only by the meeting of demand and supply. When discussing these matters, it is advisable to avoid being over-deterministic. There are currencies which belong to states whose economies have become over time large and heavily involved in international transactions, and which, in spite of that, have never become full-fledged international currencies. The two best-known cases are those of the German mark and the Japanese yen. They are two currencies which never acquired the essential features that make a real reserve currency. They are not widely used as vehicle currencies, except in limited geographical areas around those countries, and they are not often used as reserve and intervention currencies (the mark was used for those two purposes inside the now defunct EMS). This is in spite of the fact that both Germany and Japan have large shares of total international trade. However, Germany and Japan’s shares of world trade at no point in history have ever been over 50 percent of total trade, as was the case with Britain and the United States at one time, even if that time is far gone.

Why the mark and the yen never made the full transition Leaving aside more distant history, we can say that after having been defeated in the Second World War, Germany and Japan were allowed to re-acquire an important

European Monetary Union: a preliminary assessment 33 position in the world economy as exporting countries, with exchange rates which were punitively low at the start and therefore compelled them to export a lot in order to import enough to survive and prosper, neither of them being well endowed with raw materials and liquid fuel. Having a relatively low exchange rate then became a virtue rather than a curse, and both countries learned to govern their economies in a way that would not allow the relative depreciation of their currencies to seep into their domestic economies in the form of high prices. For more than a crucial early decade, the US opened its market to imports from both countries, in order to wean them from their prewar protectionism, autarky, and organized trade practices. It also gave additional viability to free trade by Marshall Aid and by providing liquidity through the European Payments Union. The Bretton Woods rules, as long as they lasted, discouraged both countries from revaluing. And the values of their currencies lasted twenty-five years. After the demise of Bretton Woods, caused by US withdrawal, both countries were able to govern their economies to couple currency revaluation with domestic macroeconomic stability, obtained by lingering corporatism, transformed into neocorporatism because of the democratic framework imposed by the winning Allies, and to discourage international capital flows by investing most of their external surpluses abroad, as direct and portfolio investments, or as reserves held in US Treasury bonds. By keeping the international value of their respective currencies quite low compared to the domestic cost situation, Germany and Japan have managed to keep the industrial core of their economies virtually intact, and it is in both cases a core producing mainly investment goods and automobiles (and electronic products, in the case of Japan) of which a good many are exported. The strategic sectors have been kept internationally competitive by being mercilessly rationalized, and by sacking workers, who became redundant because of continuous high productivity gains. Germany prefers to keep these millions of workers idle by giving them high unemployment benefits. Japan redistributes redundant workers in the inefficient and labor-intensive tertiary sector of its economy. The net result of these activities, which involve the joint action of the government, central bank, the banking system, entrepreneurs, and labor unions, has been that the mark and the yen have never acquired the status of full-fledged international currencies. The benefits accruing from such status have evidently been considered by those two countries’ leaderships to be less than the costs and dangers. And the costs are those represented by a loss of control over the neocorporatist macroeconomy, because of international capital flows going in and out of the country, influencing interest rates and through them the economic structure which it is deemed desirable to keep unchanged for as long as possible. Another cost Germany and Japan have not wanted to face is that of the likely enmity of the US, which has repeatedly and openly shown the desire to remain the only monetary hegemony for as long as possible. The US want to keep the dollar’s role as the real sole international currency not only because of seigniorage, but also

34 Marcello de Cecco because of a preference for high-value service and financial activities vis-à-vis traditional industrial activities, for foreign direct investment, which directly helps their large companies to achieve a global reach, and, of late, for the so-called new economy, where they are confident of maintaining a long-lived monopoly power. It goes without saying that the US does not seem to have been discouraged by the costs involved in keeping the dollar as the main international currency. However, there are countries that have tried to keep an international role for their currency long after they had ceased to be the political, economic, and military hegemony. Britain, for instance, chose to keep the pound overvalued every time it had a chance to do so, in the hope that this would lure foreigners into using it for their trade and especially for financial transactions. These efforts notwithstanding, the day the pound ceased to be an international currency did finally arrive. The City has kept its role as a prime international financial center, but international transactions in London do not use the pound, and most of them are conducted by financial firms that have been sold to foreigners.

Germany at the center of the euro area It is interesting to note that the European Monetary Union that came into being on 1 January 1999 has as its center one of the two countries that, after the war, refused to see their currencies acquire a full-fledged international status. We refer, of course, to Germany, which preferred its destiny to be a great “workshop of the world,” specializing in the production and export of complex investment goods. Germany can still be described as an export economy, one of the few that have remained in the world and the only one among large European countries. Recent research by the Bundesbank has shown that German GNP was and still is more profoundly and rapidly influenced by the mark exchange rate dynamics than it is by interest rate dynamics. German monetary authorities have thus, understandably, focused their policy moves on the mark exchange rate, with the money supply (M3) used as an instrumental variable. A very important part of German exports has thus been directed towards other European countries, and recently also towards those countries of the former Soviet bloc. The exchange rate target, though nominally still the mark/dollar rate, in reality has been that linking the mark to other European currencies, which are the main competitors and main markets for German goods. It is not too risky a statement to say that Germany agreed to be part of the EMU because a common currency would eliminate intra-European exchange rates, where the currencies of countries like Italy and France tended to fluctuate with the dollar when the US currency was weak, thus making it difficult for Germany to remain competitive. It was thought that by creating a new currency that would be the expression of most European economies, it would shield German producers from competitive devaluations in Europe and excessive dollar devaluations. The main interest of Germany in the EMU was that the euro would not have the same structural strength of the mark.

European Monetary Union: a preliminary assessment 35

One money for Europe The euro is the official currency of an array of very affluent countries, which have taken the relatively untrodden path of starting out toward political federation by first of all uniting their monies into a single currency. They have no common foreign policy, in spite of having created the post of “Mister Europe” (the first incumbent, Professor Solanas, is the former general secretary of NATO, and thus guarantees the special relations between the EU and the US). Nor do they have a common military policy, in spite of the recent crusade against Milosevic, fought under the NATO flag, and the creation of joint brigades by Germany and France and of a Southern European Force headquartered in Florence and commanded by another Spaniard. They are still informally subjected to the hegemony of the only remaining superpower, the United States. A policy of benign neglect towards the external consequences of monetary policy, and a single-minded concentration on domestic macroeconomic policy targets, are only imaginable as long as the objective is to depreciate the common currency in order to maximize exports outside the euro area and thus obtain from outside the demand for European goods which cannot be created directly by fiscal stimulus. This is because of the unfortunate adherence to the Stability Pact, a fiscal rule imposed on their euro partners by German Christian Democratic politicians before the 1998 elections to calm down their fractious Bavarian Social-Christian allies. As long as the central power of the Monetary Union, that over-industrialized area which includes Germany, part of France and the northern part of Italy, suffers from structurally insufficient internal demand, the interest rates of the European Central Bank, mirroring the old Bundesbank strategy, will stay lower than their US equivalents. Low domestic demand is thus replaced by exports, which, combined with the other ten countries of the Union exporting to the rest of the world, thereby generating a high level of demand for German investment goods, automobiles, and trucks, would reduce unemployment in many countries of the Union, even if it stays at a level deemed high by US standards. Let us, however, imagine the opposite situation. The US enters a recessive phase, stocks fall on Wall Street, and the dollar loses part of its high value vis-à-vis the euro. Can we think that the ECB will keep the same nonchalant attitude of benign neglect towards the dollar/euro rate that the Fed has been keeping with respect to the same rate since January 1999? I strongly doubt it! The EMU has at its center an area of great exporters, particularly German ones. European domestic demand is structurally unable to absorb all the productive capacity of that area. The ECB will thus behave exactly like the old Bundesbank, which gave strength to its currency by sitting tight on domestic costs (especially wages) in order to prevent it from dangerous up-valuation vis-à-vis the dollar and the yen. It is therefore the structure of the European economy, particularly of its industrial heart, to dictate depreciation and fight appreciation of the euro with

36 Marcello de Cecco respect to the other two major currencies. Relative appreciation of the currency will be combated by keeping a negative gap between euro interest rates and those of the US, in order to favor the export of European capital towards the US and emerging countries’ financial markets, especially in the form of portfolio investments by European institutional investors. European direct investments by European companies, which have, since the inception of the euro, been very large, especially in the direction of the US, are motivated mostly by productive and commercial strategies (to be present as producers in the most innovative area of the world, at the same time benefiting from the, allegedly stable, non-correlation of European and US business cycles). This is made easier by the fact that Europe is a demographically old area and by definition its pension funds need to invest in demographically younger areas. But the financial markets of the really young countries are not yet developed enough to absorb all European savings potential. European savings thus goes to countries like the US, which have a developed financial market and have generated a supply of new shares and financial and housing asset inflation brisk enough to absorb European spare funds. If Russia picks itself up politically, it will also renew its demand for foreign funds, and European (especially German) savings will find their way there. This last point has been the permanent dream of German industrialists and geo-politicians for two centuries. The dream is currently being revived by the joint efforts of Romano Prodi and Gerhard Schroeder, in the time-honored form of an exchange of European investment goods and knowhow, to rehabilitate and develop the Russian raw material industries (oil, in particular) and be rewarded by a number of long-term raw material supply contracts. If the asymmetric behavior that was typical of the Bundesbank until the inception of the ECB were inherited by the latter (and we can largely count on this, especially as long as Britain stays out of the EMU), the United States will be able to have one large payments deficit after another, as they have done for two decades, and as the structure of their domestic demand now requires, since private saving has virtually disappeared there. It is thus probable that the European economic policymakers will try to generate a domestic rate of growth capable of absorbing the non-structural part of European unemployment by even more radical rationalization of European productive structures, to capture the obvious economies of scale made available by the demise of national currencies, which were managed to segment national markets and keep national producers alive. It is altogether possible, indeed likely, that in this grand rationalization activity by large US multinational corporations will play a very important role. They have for years considered Europe as one large economic area, of a size comparable to that of the US – one single market in which they can operate better than any European competitor, through their long experience of uniting and running as a single market the huge American economic area. European firms have remained tied for too long to their national production base and are still new to world-based production, as they still mostly export from their home base. This is,

European Monetary Union: a preliminary assessment 37 of course, changing rapidly, but it will take time until the large European companies achieve the stage at which their US competitors have been for some time. All this implies a reversal of the direction of direct investment flows that we have seen in more recent months between Europe and the US. When the US economy finally slows down, large US corporations will want to concentrate on Europe if the latter inherits the phase of new-economy fervor that the US is in today, and which cannot last indefinitely. It is, however, not the goods markets but the financial and service markets that will receive the greatest boost by the EMU. They are the ones that have been, hitherto, kept unnaturally separated from each other. This is because of the relative unimportance of the European stock markets as markets for corporate control and the superior role of banks as providers of funds to European industry (second only to reinvested profits). The national ownership of banks has been jealously guarded in all countries of continental Europe. This is about to finish, and we can confidently expect a wave of intra-European mergers and acquisitions to sweep the European banking world. Whether it will be strong enough to overpower the concomitant drive to transform more and more banking transactions into off-balance-sheet ones, and to transfer them to markets directly linking lenders and borrowers, is not clear. Both trends will probably manifest themselves in Europe, because both of them are coming into relief in the huge American financial market. The creation of huge onestop banks, capable of serving a client’s every need, is cited as the ultimate reason for the giant mergers taking place in the US recently. This goes against the expectations of those who had detected in the United States an unequivocal trend toward securitizing all transactions, to bring them to the market, and toward the extreme specialization of individual financial institutions. Will the department store or the shopping mall prevail in finance? Whatever trend prevails, we cannot refrain from noting that the unification of the continental European financial market, which the euro will bring in its wake, must result in a much larger private and public European bond market. All European banks, for instance, will be euro banks. This is extremely important for enterprising bankers in countries like Italy or Spain, who have been smarting under the negative impact of a balance sheet written in a structurally weak (or just a small) currency. That is now gone, and enterprising bankers will be able to prove their worth wherever they are located in Europe, on a level playing ground. The same must be said of corporation managers on the periphery of Europe. They will be able to devise finance strategies for their firms without being penalized by the consequences of writing their own balance sheet in a weak currency. The whole of Europe will be potentially able to compete to finance them. They will be able to reap previously non-existent economies of scale, by tapping a pan-European commercial bills market, which already exists but is now reserved only to very large corporations. All EMU countries, moreover, redenominated their public debt in euros on 1 January 1999 and, as a consequence, public debt managers, like their

38 Marcello de Cecco private counterparts, will be able to devise debt management strategies that see the whole euro financial market as their natural environment. It is certainly true that, after the inception of the single currency, national public debts are in the peculiar state of no longer being sovereign, if sovereign means that they can be reclaimed by unlimited issue of national currency. Each national debt has its quotation, and a premium or discount is and will be attached to individual national debt instruments. But this has gone on for a very long time in the US and other federal countries. It must be contrasted with national debt managers who can rely on the whole big European market when managing their debt. Small countries already find their issues much easier to place than when they had to rely on national markets, and national debt instruments already have and will further become much more liquid. The EUR-11 already has the largest amount of public bonds extant in the world. Its chances of becoming not only the largest but also the first public bond market for depth, width and resiliency are accordingly high, and it is to be expected that its private bond market, which is now considerably smaller than that of the US, will grow to rival the latter, especially as the one-currency advantages start to kick in. Before the inception of the euro, the issuance of third country bonds was still much larger in the US than in all the eleven countries of the euro. As the euro financial market really develops, new issues by third countries will flock to it. This has been helped in no small way by the relative surplus of investable funds that the euro countries have experienced in the first two years of the euro. As I have already noted above, the euro covers an economic area inhabited by a fast-aging population, who have thus far relied on state pension systems. However, they seem destined to rely more and more on capitalized pensions. Since viable capitalised pension schemes must also rely on young populations being able to pay older people’s pensions, it is to be expected that capitalized pension funds will invest outside the euro area much more than they have hitherto. This has made and will make the euro financial market very attractive to issuers from third countries, as the euro area will in all probability have to deal with a continuous flow of internally generated financial funds to invest. Consequently, it will be much more attractive than the United States. If one looks at the valuations of all EUR-11 equity markets, and compares them with the US equivalent, the difference in favor of the US is glaring. The US equity market is almost three times the size of the sum of all euro equity markets. It is, however, too simple to infer that the gap will be filled, in euroland, in the not too distant future. The way company finance works in Europe, in fact, is too radically different from that of the United States to expect a rapid growth of euro equity markets. A long and painful process of unification of euro stock exchanges has begun, and recent debacles are evidence of how difficult it will be. In addition to that, European small and medium-sized companies, of which there are a very large number (indeed they are the core of the whole euro industrial system), repeat, every time their CEOs are polled, that they see no advantage in going public. In the

European Monetary Union: a preliminary assessment 39 near future this may change to some extent, but it is altogether unlikely that there will, first of all, be one stock exchange for the whole of euroland, and that it will top its US equivalent. Attempts to replicate NASDAQ in Europe seem to have had great difficulty taking off too. This is a field where US experience does not seem to be a useful guideline to future European developments. Before the inception of the euro, commentators reserved a good deal of space for the treatment of one particular issue, namely the future of the international reserves owned by the central banks that have become members of the European System of Central Banks (ESCB). The decision to pool reserves was taken some time ago, and it was agreed to assemble an ECB reserve of 45 billion dollars in non-European currencies. This leaves a total of 175 billion dollars in the coffers of national central banks, with Germany and Spain having, respectively, 55 and 41 billion dollars in spare reserves, and Italy 24 billion. A good part of the currency composition of European countries’ present national reserves consists of marks and ECUs, the bulk of the contribution to the ECB coffers having to be gold and dollars (though it could also be yen and Swiss francs). Remaining national reserves will consist of gold and non-euro currencies. This required that some of the marks soon had to be exchanged for dollars, and the dollar accordingly received a boost – one it did not really need under the circumstances of its explosive strength. The remaining reserves could also be used to acquire a much larger share in the IMF and the World Bank, and to impose the creation of an international institution to oversee financial markets, which might pool the intellectual resources of BIS, the World Bank, the OECD, the IMF and the European Commission, to play the part of a giant rating agency which would vet would-be private and sovereign borrowers before being allowed to borrow on the main financial markets of the world, and which ought also to supervise the private lending institutions in the member countries. We did hear some rumors about that happening, but then everything calmed down, as the international financial crises of 1997 and 1998 abated and financial markets in 1999 and 2000 were relatively calm. As marginal debt and securities, both in developed and emerging markets, have again started accumulating and spreads started shrinking again, we may in the near future hear about these reform projects again. Everything we have said so far seems to point in the direction of the euro becoming a full-fledged international currency in the future, it will present a challenge to the dollar much greater than either the mark or the yen have been in recent years. Commentators thought that this was imminent, and fretted when it seemed not to come about in the first two years of the new currency. As I correctly forecasted in June 1998, the fundamental reasons for the euro’s weakness vis-à-vis its competitors have prevailed and the structural reasons why the European capital market is taking time to become really integrated are not disappearing all that fast. Attentive readers will remember a debate that took place between economists before January 1999. How fast – some commentators asked – will owners of dollars

40 Marcello de Cecco restructure their existing portfolios in favor of the euro? Will there, in other words, be an adjustment of stocks in addition to the changed structure of new flows? Given the size of privately held foreign exchange stocks, this was no idle question. Most of them are easily liquefiable and therefore can be easily switched from one currency into another. It is not difficult to see that, if even a small percentage of existing dollar stocks had been switched soon after the inception of the euro, exchange rates between the two currencies would have fluctuated wildly. A strong destabilization of the foreign assets market might thus have occurred, starting in the foreign exchange market and spreading to other asset markets via arbitrage, hedging, and swaps. Imagine what would happen if only 10 percent of foreign-held Treasury bonds were to be switched into euro public debt. Five hundred billion dollars of US government bonds are currently in the hands of foreigners. If fifty billion were switched the impact would be quite large, especially if it is done rapidly. But to this one must add a similar amount switched from private dollar bonds and from Wall Street. How likely is such a movement? And, more crucially, how rapid would the movement be? Some commentators did not refrain from betting on a quick drawdown of dollardenominated assets in favor of euro-denominated ones. This is the case, in particular, of Portes-Rey and of C. Fred Bergsten, who wrote papers foreseeing such an event as realistic and even imminent. Initial conditions prevailing in the exchange markets immediately before and after 1 January 1999 seemed to prove this prophecy. The euro entered the world with a bang. But the bang turned into a whimper soon afterwards, and there things seem to have remained since then. The prophecy of the strong euro was, as I repeatedly said, strongly flawed for fundamental reasons. The core of the European economy was mired in slow growth and got restarted only after the euro became weak, and because of that weakness. The European financial market is not yet united, and is struggling to achieve the further integration necessary to compete with the US financial market. But there were other and more ephemeral reasons why the euro became weak. People have already forgotten the war in Kosovo. Yet only a little more than two years ago, fishermen in the Adriatic were picking up spent uranium grenades dropped into the sea by US planes returning from bombing missions over Yugoslavia, and mothers and girlfriends in Germany received their first postcards from German soldiers on the front line in a foreign country since 1945. The foreign country is, however, in the heart of Europe. The unthinkable had occurred. The intra-European civil war had started again right after the fanfare for the start of EMU had stopped playing. A pall of sadness, uncertainty, and straightforward pain fell over Europe. It certainly could not be dispelled by the warlike shrieks being issued from NATO Headquarters in Brussels, the Pentagon, and other usual and novel war-mongering circles. Consumers in continental Europe, and especially in

European Monetary Union: a preliminary assessment 41 Germany and Italy, reacted by drawing in their horns, tourism in southeast Europe fell like a stone, the core of the European economy stalled and the European Central Bank, invented to defend Europe against the ever-falling dollar and the southern European spendthrifts, found itself making its first uncertain moves as a pump primer, rather than a firefighter. It is really remarkable how the media have managed to exorcise the memory of these events less than a year after they took place. The bridges on the Danube bombed by NATO planes are still in ruins, but only the people of Belgrade see them as a reminder of what happened. The rest of the world has forgotten the Balkan War, the last European war of the old millennium, and the first of the New Age. But, if we want to understand why prophecies about the euro turned out to be so wide of the mark, we have to take the war into account. The collapse of consumption in the core European economies, that were formed by Germany, its satellites, and northern Italy, prolonged much more than could be initially foreseen the accommodative stance the ECB was compelled to take, with the result that the negative differential between euro interest rates and dollar rates remained open and is still open as we write. Consumers’ ebullience, and asset inflation on the other side of the Atlantic, was meanwhile stoked by a Federal Reserve which did not want to be seen to root openly for the Republicans by squeezing the economy and puncturing asset inflation too drastically. The result was a longer weakness for the euro, one which was also fostered by Fed behavior, which finally managed to stimulate European exports to non-euro countries and in this way to get the core economies of Europe finally moving, as true export economies do. Now the oil crisis threatens to send timid central-European consumers back to their agonizing about the future. German and Italian car producers, for instance, have already seen unpleasant omens of this in their recent sales reports. The investment goods industry, geared for exports inside and outside the euro area, seems in better shape. For how long, we do not know. How hard and long the process of European capital market integration will be has been shown by the Frankfurt–London stock exchange merger saga, which ended in failure and has, for the time being, been shelved. A careful study of the failed attempt might yield interesting lessons in the political economy of the new Europe, but I am not going to cover that here. The attempted merger is in itself evidence of the preoccupation of German political and economic leaders for the need to create new job opportunities for young Germans in the service sector, after decades, indeed centuries, of seeing industry as the manifest destiny of the German nation. The service sector in Germany even today employs fewer people than does its counterparts in other developed countries. After twenty years of job destruction in industry, it has dawned on German leaders that the future is in services even for young unemployed Germans. After this epiphany, German leaders in government and in industry have started promoting the growth of a modern service sector. It goes without saying that a large part of that effort has been directed towards getting

42 Marcello de Cecco German financial institutions a bigger share of the world financial services market. This is exemplified by the foreign offensive of the German Grossbanken. Hence the attempted merger between Frankfurt and London, which was in reality a takeover of the London stock exchange by Frankfurt, even if the venue of the new merged financial market would have been in London. The new institution would have been chaired by a German and the digital platform used would have been the one developed for the Deutsche Boerse. New-economy shares would have been transacted in Frankfurt. As I just said, the project has been shelved for the time being. But it is going to be taken up again in the not too distant future, because German leaders think a larger share in world high-value services is the only way to give a structural solution to the German employment problem, and generally to the problems of the German economy. It is to be hoped that it will be a European, and not just a national, solution that the Germans will seek to remedy its problems. This is the fear that pro-Europeans have, when they look into the future. European economic integration preceded European monetary integration; the latter was introduced when it was thought that economies could not integrate further without political integration. The common currency would be the first step of political integration according to a federalist blueprint. Money is an appurtenance of national sovereignty, and to cede that to Europe represented for the member countries a loss of national sovereignty which would create an imbalance so deep that only further concessions of sovereignty would adjust it, through the creation of a higher balance, with a European federal government, a full-fledged parliament, and a constitution. All these new institutions have to be created from scratch, by European leaders who cannot, however, move too far from the actual will of their own citizens. And the actual will of the European citizenry today seems to falter in view of the decisive steps that have to be taken. The forces of European conservatism have felt that, in this uncertain phase, they stand a chance, after being defeated in most countries by social democratic parties and coalitions. It is ironic that European conservatives have now turned to anti-Europeanism, after fifty years of professed proEuropeanism (with the exception of the British Tories, who were the ones who took Britain into Europe) directly inspired and favored by the US government, when Europe was seen as anti-communist idea, and a reply to the COMECON and to Soviet expansionism. After the demise of communism, the US has turned neutral towards the European idea, and its government often behaves as if Europe might be its rival, in a novel foreign economic and even military policy “à tous azimuts.” And the mostly idle cant of European fringe politicians can be perceived by US observers to be anti-American, and therefore to justify their neo-Gaullist stance. The incisive steps that Europe now has to take, on the road to a European federation, requires that citizens feel they have no viable alternative to that course. This is in fact correct! No European national government is strong enough to promote a national solution which will keep its full sovereignty.

European Monetary Union: a preliminary assessment 43 But some small European countries might think they stand a better chance anchoring themselves to the US, a country large enough to afford a national solution to the problem of maintaining sovereignty in a globalized environment, than by sticking to Europe, a would-be federal state most of whose institutions do not exist and will have to be hastily constructed, with the many risks attendant upon this. The same temptation might be indulged in by medium-sized European countries like Spain, which negotiated their place in the European Union before they started on a very dynamic economic phase and now feel that they were not given the vital space in European institutions that their later growth record justifies. Finally, centrifugal forces might also arise because a large country like Germany might feel that it can create its own little Europe around its borders, a reproduction of the ill-fated Mitteleuropa of pre-1914 decades. Conservative forces are thus taking the chance offered by the euro’s weakness to describe it as a sign of the weakness of the European Monetary Union, a proof that it is not a viable construction. They play on the asset-holders, tourists to distant lands, the souls of every German, Austrian, Belgian, and Dutch person, and make them feel that the EMU has ruined them, and that they have exchanged a strong currency for a mongrel infected by the weak currency smell of the “Club Méditerranée” member countries: Greece, Italy, Spain, Portugal, even France. It takes the former countries a good deal of character and rationalism to remember that it was only thanks to the weak euro that the industrial core of Europe, Germany, and the parts of Italy and France that share its industrial destiny, picked themselves up from the domestic demand slowdown that coincided with and followed the Kosovo War. The recent Danish referendum results are evidence of that, but the real danger lies in the countries I have mentioned, Austria representing the crucial test, because it is a relative newcomer to the EU and because of its cultural proximity to Germany.

The European Central Bank It is within this complex context that we have to place the conduct of the ECB in these past 22 months of its operations. First of all, it is necessary to stress the fact that the bank was not only created with the Bundesbank model clearly in mind, but that it received, in addition, a command structure that reflected the fear that European national central bankers had of losing control of the new institution. This is clearly shown by its two-tier control structure, with a board and a council, the first formed by former national central bankers who work full time at the head of the new institution, and the second composed of “reigning” national central bank governors, who look over the shoulder of the first organ and, in these days on fast physical and electronic communications have proved that they can exercise “handson” control of the new institution even while remaining in their national capitals and making fast and frequent trips to Frankfurt. The lack of trust in the new institution by the national central banks is also shown by the appointment of its first governor,

44 Marcello de Cecco who certainly cannot be called a new Jacques Delors. The net result of all this crossmaneuvering is that the ECB has sailed rather uncertainly through the troubled waters of the weak Euro, sometimes giving the impression that too many people take turns at its helm, or even that all of them try to run it at the same time. Too many voices have, in these early months of its operations, spoken on its behalf on matters of monetary and exchange rate policy. And, remember, the Maastricht Treaty rules that the exchange rate policy of the EMU is set by the Finance Ministers’ Council, a further cause for uncertainty. To make things even more complicated, a theoretical contrast has been noticeable in the official utterances of the ECB, between the followers of traditional monetary analysis, who set great store by the control of the money supply – more precisely, of M3 – and those who think that inflation-targeting is the only method left to any central bank compelled to deal with a huge and powerful, private financial market. Things were not made easy, purposely, for the new bank managers by the Maastricht Treaty, which stipulates that the control of inflation must respect a fixed target for prices set at a sharp 2 percent. To know why that target was written in stone in the Treaty is to know the internal politics of the German Federal Republic, and especially the disputes between its Northern and Southern Christian parties and the internecine warfare going on within the CSU. It was, however, written in the Treaty, and transferred to the brains of the world financial market operators, who see it as a trigger around which clever expectation games can be organized and have, indeed, been organized. As we just said, the ECB has rendered its own life even more difficult by publishing research papers in which it seems to sponsor both traditional monetarism and inflation-targeting at the same time – a balancing-act which has won the new bank very few friends in the markets and elsewhere. The ECB was, in its early life, also subjected to a rather unpleasant shouting match to which it could not reply by Oskar Lafontaine, the former German Finance Minister who, having to deal with a laggard domestic demand in his own country in the early months of the Schroeder government, decided to make the ECB a scapegoat for the fiscal stalemate into which the opposition had cornered the new SPD–Green coalition government (stealing a leaf from Lafontaine’s own book, who had himself played that game with the Christian Democrats and probably defeated them in the elections with it). In the end, it was Lafontaine who succumbed, as happened to another minister, Karl Schiller, many years before. But in the intervening period the ECB succumbed and lowered their interest rate, further widening the negative spread between the euro and the dollar, a move which was largely ineffective from the point of view of wanting directly to boost domestic demand in the Union, and only useful in starting the euro slide, which soon changed into an overshooting which is not yet over. The bank, since its inception, has raised its rates by a full 2 percent, against the Fed’s

European Monetary Union: a preliminary assessment 45 three-quarters of a percentage point. European rates had been pushed very low by slumping world rates and by the deflation of domestic demand in Europe, so the negative spread against dollar rates remains wide to this day and goes a long way in explaining why international capital has shunned the Euro, while Europe has become the main source of world finance, especially for US balance of payments financing purposes. The original sins of the management of the new European central bank include: too many announcements made by too many people, a detectable unsteadiness under the Lafontaine attacks and an even more readily detectable unsteadiness in its stance over flexible versus managed exchange rates, exemplified by a final resort to the giant episode of market intervention on the eve of the Danish referendum. Or at least, they are the sins of which the bank stands accused by the financial markets. I personally think that they must be viewed as growing pains, and one has to remember the first twenty years of the Fed to obtain plenty of solace. But, what if Friedman was right, and the Fed had really started the Great Depression with its unwise behavior? A sobering thought that, and one we cannot entirely exorcise. Thus far, however, the ECB cannot be accused of excessively hard conduct towards its own interest rates. Rather, the markets accuse it of the opposite, not without reason. Market observers keep accusing the ECB of continuously “falling behind the curve.” They also corroborate their indictment with technical remarks, to the effect that the ECB, by adopting the money market management methods dictated to the Bundesbank by the German Grossbanken, has persisted in fixing both prices and quantities by letting banks compete for its funds by making excessive quantitative requests for funds given at fixed rates. This method has finally been discontinued, but the ECB kept it going for too long just because the German market was used to it. One thing, incidentally, that comes clearly out of the EMU experience, is the relative backwardness in which the German money market has lingered, compared to the refinement of other markets, like the French, the Dutch, the Italian, and the Spanish ones. Cosy, non-transparent methods popular in the 1960s in all European countries but largely overcome since then have lingered on in Germany, a country where banking and local politics are intertwined even more than in the provincial United States. The profound dualism of the German financial market, where very old-fashioned institutions live side by side with, and often politically prevail over, world financial giants like the Deutsche Bank, go a long way in explaining the recent hard landing of the Frankfurt–London stock exchange merger. It might bring even greater trouble to the Monetary Union. An interesting last point to make before closing this short assessment of the euro’s early life concerns the techniques, which have been perfected to bring about the European Payments System, TARGET. Here an early squabble with the British, who wanted to impose a cheaper net payment system, was won by an Italo-German alliance that imposed the creation of a gross payments network, more expensive in terms of reserves, but certainly the only method which could decently be introduced

46 Marcello de Cecco in an age of massive computer power and to overcome the initial mutual distrust of the participants in the scheme. In this field, moreover, the Bundesbank has been able to rely on its unique experience, as the sole European central bank with a long experience of running a federal network of regional central banks, to perfect an electronic system of integrated payments with several central banks of Mitteleuropa, which made the transition from socialism under the auspices and with the aid of the Bundesbank. The German system will certainly be chosen even after the enlargement of the EMU, and in any case the Europe of monetary payments is now wider than the official EMU borders, and the Bundesbank is firmly at its center, which must be seen as a small consolation prize for the loss of the Deutschmark as the pivotal European currency.

Envoi In the first months of its existence, the ECB has earned more criticism than praise, especially, but not exclusively, with reference to the euro/dollar exchange rate. But it is worth remembering that by definition an exchange rate is a relative price, and the institution that issues one of the currencies is totally unable to influence the supply of the other currency. At the same time as the ECB has been criticized, much praise has been bestowed upon the behavior of the Fed and, in particular, of its chairman. The fact that, by three successive interest rate cuts, he had to leave the American boom running unfettered, while he had seemed set, by his immediately previous actions, to curb it with higher interest rates, just because first Russia and Brazil, and then the US financial market (with the LTCM affair) were threatening to explode, and then that he backtracked by three successive rate rises which exactly matched the previous cuts, is considered the height of technical ability, although I would prefer to consider them a demonstration of great political cunning at the expense of world financial equilibrium. The ECB has had to adjust to the environment changes continually and unpredictably brought about by the Fed’s policy actions. The Fed pays minimal regard to the world financial environment when it acts, and the spillover of its actions has to be dealt with by the ECB and by the Bank of Japan. I have for the last two years repeatedly advised that, in order to make the Fed clean up its act, the ECB ought to adopt the same disregard of the environment shown by the Fed. This means not paying any attention to the euro/dollar exchange rate and concentrating on domestic economic conditions in the ECB area. If, by its repeated rate changes in a predictable direction, the Fed creates an environment that directly induces an excessive depreciation of the euro, which is what has actually happened since early 1999, the ECB ought to show benign neglect of the euro exchange rate until the US starts becoming worried about its depreciation and actually asks for a joint intervention operation to redress the euro/dollar rate. This is in fact what the ECB has done in the last 12 months, but it has always looked as if it was not really convinced of what it was doing, and was only doing it because of

European Monetary Union: a preliminary assessment 47 political pressure, especially from the German government which was worried about the modest pickup of its economy. Even the intervention operation, although agreed with Japan and the US, has looked like something the ECB begged from the US, so much so that Lawrence Summers, with his customary arrogance, stated they had intervened because the ECB had asked them to, and reasserted the interest of the US government in a strong dollar. Recent falls on the NASDAQ, however, were directly attributed by the companies whose shares had fallen (INTEL, for instance) to the low euro exchange rate, which had reduced their profits either because products, where European competition does not exist, had yielded lower dollar returns from their European sales, or because US competitiveness had been sapped by the strong dollar, as, for instance, in the case of chips and DRAM memories, which Europe produces, and certain sorts of business software, where EU firms also show a marked capacity to compete. A little more benign neglect on the part of the ECB would have made the euro so low in terms of dollars that it would have been the US Treasury, pushed by New Economy firms, which would have suggested joint intervention to the ECB. These are, however, the problems stemming from the unfinished work of European unification. There is one ECB looking the Fed in the eye, but eleven European Treasuries still used to fifty years of each vying for a special relationship with their US sister to boast about to the other ten. We still need to see, after the European Summit in Nice, whether the EMU has actually given European political integration the big push it was intended to.

4

The theory and practice of European monetary integration Lessons for North America Alain Parguez, Mario Seccareccia, and Claude Gnos 1

Introduction With the advent of the euro, have national currencies now become obsolete? It is commonly agreed that the international monetary system is a hierarchical system dominated by a few key currencies, such as the dollar, the euro and the yen. However, some economists, especially those whose research has been influenced by the work of the 1999 Nobel Prize winner in economics, Robert Mundell, have tended to go a step further. These Mundellian writers generally espouse a geodeterministic logic and argue that there exists an ineluctable tendency towards a tripolar world made up of three major currency blocs: the dollar bloc for the Americas, the euro bloc for the European continent and its satellite regions, and the yen bloc for Asia. Indeed, to paraphrase Mundell (2000), with the possible exception of these three major currencies, most of the other 175-odd currencies in the world today should be classified as mere “junk” currencies without long-term viability. While the case for a single world currency is not usually embraced because of the benefits that may arise from the existence of some competing currencies à la Hayek (cf. Hayek, 1976), for the advocates of optimal currency areas, regional currency blocs are presumed to be welfare enhancing to its constituents. Given the alleged rapid pace of market dollarization, particularly on the American continent, national governments must by force majeure abandon their sovereign currencies. In its place, they ought to seek to negotiate alternative currency arrangements that would allow Canada and other countries of the Americas to improve their economic welfare within a North American Monetary Union (NAMU) specifically patterned on the European Economic and Monetary Union (EMU). One has only to quote the wellknown paper by Courchene and Harris (1999) to deduce this deterministic logic: While a NAMU is not on the immediate horizon, there is nonetheless an urgent need to place the currency union issue on the public policy agenda. Policy developments within the NAFTA and elsewhere in the Americas appear to be moving quickly in the direction of dollarization. Since widespread dollarization could preclude the emergence of the NAMU by reducing the advantages the

European monetary integration 49 United States would garner from it and since . . . a NAMU would be preferable to dollarization from a Canadian perspective; Canada must become engaged on this issue with its NAFTA and hemispheric partners – and sooner rather than later. (Courchene and Harris, 1999, pp. 3–4) Much like the debate over the original Canada–US Free Trade Agreement during the 1980s, the argument in favor of a monetary union is not dissimilar. Given the spread of regional currency blocs, one must acquiesce to the logic of monetary globalization. Hence, one must endeavor to negotiate a monetary union with the United States under more advantageous terms than the more rigid ones that would ultimately be imposed by default on Canada and its other NAFTA partner, Mexico, via either the market or unilateral policy dollarization. In the case of the latter policy of dollarization, this could take several routes. It could entail either the Panamanian route with the outright loss of seigniorage, the Argentine model of retained seigniorage with its currency board structure or, perhaps, the model of shared seigniorage revenues along the lines proposed by Senator Connie Mack’s “International Monetary Stability Act” recently proposed to the American Senate and US House of Representatives. While no one could seriously question the significance of dominant currencies in the world economy, the inescapable trend in favor of such regional currency melting pots is less clear. For instance, from the information provided in a recent study by Bogetic (2000) of the International Monetary Fund, the number of either fully “dollarized” countries or countries with official bi-monetary systems are significant but still few. They generally tend to be either former colonies that had adopted another country’s currency long ago or geographically tiny protectorates or vassal states incapable of having their own viable currencies (such as Puerto Rico, the Virgin Islands, Panama, Liechtenstein, Monaco, and more recently, among others, the Republic of Montenegro). Moreover, if one takes a longer-term perspective, since the collapse of Bretton Woods the general tendency internationally has been towards the adoption of flexible exchange rate regimes. The obvious exception to what appears otherwise to be an international monetary landscape somewhat at variance with the views of those who profess this Mundellian geo-deterministic logic in favor of regional currency blocs are, of course, the member countries of the EMU. The countries of the EMU have joined together not to adopt any one dominant currency but to create a new one – the euro. To the defenders of this regional determinism, the creation of the euro in 1999 represents an endorsement of immense proportion which has put a strong burst of political wind into the sails of all those who envisage hemispheric dollarization in the Americas. Indeed, the advent of the euro, at the end of a turbulent decade plagued by significant currency crises in the world economy, such as those in Asia, Russia, and Latin America, has spurred interest in the European project of monetary

50 Alain Parguez, Mario Seccareccia, and Claude Gnos integration. This is not only for the euro’s much-talked-about “stabilizing” role in world currency markets, due to the supposed narrowing of the foreign exchange space within which to speculate internationally, but primarily for the presumed material benefits that would accrue to those nations that would follow the route of monetary integration. Indeed, alternative currency arrangements, such as fixed exchange rates, currency boards, and policy dollarization, have been put forth by partisans of this Mundellian logic as possible short-term half-way houses towards greater North American monetary integration. However, it is the EMU that remains the model of choice for those advocates who favor the abandonment of national currencies in North America. For instance, in extolling the virtues of the EMU, Grubel (1999) imagines: On the day the North American Monetary Union is created – perhaps on January 1, 2010 – Canada, the United States, and Mexico will replace their national currencies with the amero . . . In all three countries, the prices of goods and services, wages, assets, and liabilities will be simultaneously converted into ameros at the rates at which currency notes are exchanged. At the same time, the national central banks of the three countries will be replaced by the North American Central Bank. The operations of that bank will be governed by a constitution like that of the European Central Bank, which makes it responsible solely for maintaining price stability. It is not required to pursue full employment or maintain certain exchange rates. Its personnel policies will be free from political influences, in particular those arising out of partisan national politics in member countries . . . As in Europe, membership in the union will require that countries do not incur persistent budget deficits. The amero notes and coins will have in common abstract designs on one side. Notes and coins will be produced in each of the three countries according to their own demand and show national symbols on the other side. (Grubel, 1999, p. 5) This long quotation from Grubel sketching out the basic institutional structure of the proposed NAMU is also highly representative of the views of most other partisans of the monetary union. For instance, Courchene and Harris (1999) view the NAMU as “the North American equivalent of the European Monetary Union (EMU) and, by extension, the euro” (1999, p. 22). This model of a currency union based on the European engineering blueprint for monetary integration would bring forth numerous presumed benefits to the three countries of the NAMU. These benefits would be the traditional static gains in terms of lower transactions costs, as well as lower interest rates that would supposedly arise from the elimination of exchange rate variability, including further dynamic gains in terms of lower inflation rates, expansion of trade, increased labor market discipline, and higher productivity. Interestingly these were also the type of

European monetary integration 51 benefits that would supposedly accrue to the members of the EMU which were stated repeatedly in the latter’s construction and monetary design. However, as we shall discuss below, the European engineering blueprint, with its assumed cornucopia of welfare benefits, is based on a specific view of money and the current monetary system that does not square very well with reality. Founded on this view of the monetary system, we believe that the EMU’s derived institutional structure has, in turn, placed its member states in an untenable policy straitjacket.

The underlying Mengerian economics of a monetary union The structure of the EMU stemming from the treaties of Maastricht (1991) and Amsterdam (1997) are the logical consequence of its underlying economics. A careful reading of the quasi-official literature – of particular interest are the Emerson Report (1990) and the Fitoussi Report (1998) – suggests that what could be dubbed “Euro Economics” has two major theoretical foundations. On the one hand, it is deeply rooted in the traditional theory of a monetary union, which had been spelled out in the 1960s by Robert Mundell. As pointed out by Goodhart (1998), however, Mundell has done little more than extend the question of a currency union, which Karl Menger’s neoclassical theory of money first put forth at the end of the nineteenth century. Indeed, Menger (1892) wished to demonstrate why a monetary economy evolved out of a barter system, as the free choice of individual agents seeking to maximize their wealth. By a similar reasoning, following Mundell it ensues that a common currency must itself also evolve out of a multicurrency transaction space in accordance with the Mengerian methodology. On the other hand, this neo-Mengerian project has materialized at the institutional level in Europe in large part because of the influence of a powerful group of French (and some German) economists and technocrats on the historical process leading to the establishment of the euro. What Parguez (2000) has dubbed the “techno-classical” group transcribed the abstract Mengerian theory into a set of economic principles that would constitute the infrastructure of a European monetary union. However, this techno-classical group could not succeed without the undaunted support that was offered by European political leaders. In fact, from the very inception of the euro project in the late 1930s, the project of monetary unification was seen by Europe’s political elite as the path to an enlightened new order that would protect economic management from the narrow interests of the elected representatives. Mengerian monetary economics Menger’s (1892) original theory of money attempted to explain how the emergence of money was the logical outcome of a tâtonnement process of indirect barter

52 Alain Parguez, Mario Seccareccia, and Claude Gnos exchanges. Menger assumed that individual agents across a given transaction space sought to minimize costs by ultimately choosing a unique commodity that would serve as a medium of exchange. Consequently, a monetary economy evolving as the “spontaneous outcome” of bartering created commodities that were progressively discriminated by economic agents according to their “different degrees of saleableness” (Menger, 1892, p. 250). As long as rational wealth-maximizing individuals seek to minimize their losses via indirect exchange, they will ultimately adopt the most “saleable” of commodities as a circulating medium. Assuming that all individuals can have access to the same information set regarding what Menger called the objective “saleableness” of commodities, there would be only one commodity that would best objectify the intrinsic characteristics needed to minimize transaction costs. Moreover, since money is the endogenous outcome of a market process, it cannot be generated by law and thereby emerge from the exogenous actions of the state along chartalist lines. Indeed, much like later Austrian economists, the state and money were natural adversaries since the former seeks arbitrarily to constrain the behavior of economic agents by tinkering with the latter by means of monetary debasement. The neo-Mengerian theory of a monetary union The modern neo-Mengerian theory of a monetary union, as best elaborated by Mundell (1961, 1968, 1971) and Mundell and Swoboda (1969), simply extended the earlier Mengerian analytics to a multicurrency economic space. Hence, instead of going from bartering to a single-currency monetary economy, Mundell employed the same Mengerian methodology of minimizing transaction costs to explain why a multicurrency economy spontaneously evolves into an optimal common currency of one. Complying with Menger’s theory of intrinsic “saleability,” Mundell referred to two fundamental characteristics of existing currencies: their specific transaction spaces and the “quality of management” of their respective economies. The transaction space of a currency reflects the number of transactions involving this currency that each agent can expect to undertake to reach an optimum under the constraint of cost minimization. This optimum space is determined by the respective size of the underlying economy in terms of real income, trade balance, and available savings. The quality of management, on the other hand, is reflected by the long-run behavior of the inflation rate, which depends primarily on the size of the budget deficit and its degree of monetization. Much like Menger himself, neo-Mengerians believe that, since money arises spontaneously from the activities of market participants, inflation would arise primarily from the deficit spending of the state in its attempt to exact seigniorage revenues. When applying this neo-Mengerian theory to a highly integrated economic space such as North America, the ensuing solution would be obvious – a single currency would be welfare-enhancing and the currency to be adopted should be the US dollar.

European monetary integration 53 This is because the latter’s own transaction set is of such a magnitude that it is incommensurate with the Canadian dollar and the Mexican peso transaction sets; while, in terms of sound management, it may be argued that the US economy has succeeded in out-performing the Mexican and Canadian ones. When this theory is applied to the European economic space, however, the solution becomes somewhat indeterminate. Neither of the major European currencies, such as those of France or Germany, has a transaction set incommensurate relative to the other. Moreover, none can be considered significantly “better managed” in relation to one another. Under such circumstances, no one currency can come to dominate and it ensues that rational wealth-maximizing agents, seeking to minimize transaction costs, must choose a distinct composite commodity to serve as the new money – the euro. However, the Mundellian analysis is quite analogous to the earlier Mengerian methodology applied to a given economic space. Within the Mundellian logic, the adoption of the euro among the European states of the monetary union is conceived as the implicit outcome of a tâtonnement process with the action of some Walrasian auctioneer merely finalizing this underlying optimizing procedure.

The Mengerian plan for an effective European monetary union This Mengerian theory was successfully implemented in Europe because it became the key element of a long-term plan spanning over sixty years from the late 1930s to its finalization in the treaties of Maastricht (1991) and Amsterdam (1997). This European plan for monetary integration was carefully promoted by a powerful lobby of both politicians and economists. In the case of distinguished French economists, this began with François Perroux and Jacques Rueff during the war and the early postwar years, and it went all the way to modern players such as Michel Aglietta and Jean-Paul Fitoussi. The importance of the European “technoclassical” school is discussed in great detail by Parguez (2000). However, it will suffice to say that it was the activities of this group, principally in France, but in later years also in Germany, that prepared the ground for the political implementation of what we would like to describe as the Mengerian plan for European monetary integration. As shown in Table 4.1, this plan was implemented in four stages, with the final outcome being the expected monetary union. The first stage was implemented according to three guiding principles. The first was the free market rule. With the creation of the European common market and its enlargement, the European Union, all individuals can freely engage in economic transactions, namely commodity, financial, and foreign exchange transactions, without any institutional impediments that would obstruct the workings of the free market. The second principle can be described as the market order rule, which, according to the techno-classical elite,

54 Alain Parguez, Mario Seccareccia, and Claude Gnos Table 4.1 Stages of the Mengerian plan for European monetary integration Stage 1

Stage 2

Building the → The determination transactions space of equilibrium for relative prices of currencies European common market → European Union

→ The fixed exchange rate system of the European Monetary System (EMS)

Stage 3 → Single composite currency

1979–90

→ Improving the transaction space

→ Maastricht Treaty → New European (1991), order Amsterdam Treaty (1997) → Growth and Stability Pact (1997)

1957–90

Stage 4

1991–9

→

1999–

would be the first step towards the “New European order.” Laws can now be enforced by a set of dominant institutions that would largely escape local government control. Indeed, with the legislative powers in the control of the European Council and the executive and legal powers bestowed on the European Commission and the European Supreme Court, decisions taken by the democratically elected national governments can now be nullified if they contradict European laws and decrees. The third principle can be described as the enlargement adjustment rule, in which the effective integration of countries into the European Union would depend, in Mengerian terms, on the objective “saleability” characteristics of the respective countries; but which in practice would guarantee the spatial hegemony of the Franco-German axis. The second stage, with the establishment of the European Monetary System (EMS), was a transitory phase during which the long-run “equilibrium” of relative prices for respective national currencies would be determined, to lead eventually to a monetary union (cf. de Cecco and Giovannini, 1989, p. 2). Once established, these equilibrium exchange rates would then be the anchors upon which the national currencies could be converted into a new supranational composite currency. The EMS followed a Walrasian tâtonnement process in which the two main players were the European central banks and the currency markets. Central banks first agreed on a band, with maximum and minimum values, within which the relative price of the respective currencies could fluctuate. As early as the late 1970s and early 1980s, all members of the EMS then pledged to undertake domestic policies aimed at convincing the financial markets of the sustainability of the targeted exchange rates.

European monetary integration 55 The policy requirements included fiscal restraint and high real interest rates so as to attain low inflation. If the targeted set of relative currency prices were not to be endorsed by the markets, thereby leading to excessive volatility, two alternatives were open to the member countries during this stage. Either they would impose more severe monetary and fiscal austerity, or a downward (or upward) adjustment of the currency rates would take place to satisfy the financial markets. By the mid1990s, this tâtonnement led to the establishment of a set of relative exchange rates that were deemed to be the “long-run equilibrium levels” consistent with market expectations of low inflation and fiscal soundness. As discussed by Parguez (1998), during the 1980s and 1990s all EMS countries had sufficiently deflated their economies, with the respective countries’ inflation rates converging to the rather low German inflation rate (see Bleaney and Mizen, 1997), to convince the financial markets of the long-run stability of these targeted exchange rates. The final two stages pertain to the advent of the euro. Indeed, once the relative equilibrium prices of currencies were established, the time was ripe for monetary union with the new currency to be created as a composite commodity. Given the established long-run values of the exchange rates, the conversion of assets denominated in former national currencies into assets denominated in the euro conversions could now be achieved without any asset holder suffering a windfall gain or loss from the conversion process. The new composite currency is recognized by the Maastricht Treaty as well as the followup Growth and Stability Pact that instituted the mandatory rules of the new European Monetary Union, whose objective was to convince the markets of the desirable intrinsic value of the new composite commodity money. The new currency would not survive unless there could materialize a permanent demand that would arise from the choices of individual agents seeking transactions. According to the architects of the euro, the latter would remain unscathed in the long run if it could be protected institutionally against the narrow domestic policies of national governments. Once achieved, the markets’ endorsement of the new currency would provide clear economic benefits in the form of more efficient resource allocation and market flexibility while, henceforth, the new European Union would evolve into a leading world power whose currency – the euro – would supplant the US dollar as the world’s premier currency (Wyplosz, 1997, p. 15).

Implementing the European plan: the effective rules of the European monetary union The structural design of the European plan for monetary integration is based on three sets of rules. The first set defines the role and power of the supreme guardian of the currency, the European Central Bank (ECB). A second set of rules pertains to the limitations imposed on the fiscal policy behavior of the member states. Finally, a last set of rules ensures that employment and welfare programs will no longer

56 Alain Parguez, Mario Seccareccia, and Claude Gnos constrain the economic policy behavior of the member states. These policy rules should remain unaltered over time so as to prevent narrow national interests from dismantling the new supranational monetary order. The supreme stewardship of the European Central Bank The underlying theory of the euro is premised on well-known neoclassical postulates regarding the exogeneity of the money stock. The ECB is presumed to fix at will the supply of euros, with the commercial banks being understood to play no role in its creation. For instance, in the first section of the Maastricht Treaty, the role of the banking sector is not even addressed because of the traditional presupposition that banks are mere intermediaries that recycle savings for the purpose of investment. At the same time, the ECB has to use its discretionary power over the supply of the euro to ensure that, in the long run, all rational transactors can expect price stability. Although this commitment to a permanent zero expected inflation had not characterized the behavior of the former national central banks, zero inflation is to be achieved when the ECB creates just enough money to meet the public’s estimated long-run portfolio demand for money. To attain this goal the central bank must thereby fix short-term rates of interest. In particular, the ECB must increase interest rates when it fears that the exuberant expectations of commercial banks have led them to supply loans in excess of their deposits, which reflects an excess of ex ante investment over ex ante saving. On the other hand, the underlying economics of the Monetary Union rejects the notion of exogenous interest rates set by the Central Bank that is postulated by many critics of Mengerian orthodoxy, going back to the work of post-Keynesian writers such as Nicholas Kaldor (1980). In the Wicksellian sense, when the ECB has to increase interest rates, it is because existing rates are too low to maintain equilibrium in the capital markets, i.e. the market for savings (cf. Seccareccia, 1998). The role of the Central Bank is to curb the profligacy of commercial banks in supplying loans in excess of savings by forcing upon them the natural rate of interest – a purely endogenous variable. Finally, the ECB is ultimately also responsible for setting the normal relative price of the new currency vis-à-vis the US dollar, the UK pound, the yen, and other important international currencies. In its leadership role, it must seek to guide participants in the foreign exchange markets and encourage them to hold euros rather than other currencies. As long as participants in the foreign exchange markets are convinced of the ability of the ECB to achieve price stability (their faith being reinforced by relatively higher rates of interest), this would ultimately lead them to perceive the euro, in Rueffian terms, as the “quintessential gold” (Parguez, 1999). From this vision, it ensues that the euro should come to replace the US dollar as an important reserve currency. In accordance with Rueffian logic, the United States would lose its hegemonic power and Europe would reap seigniorage rewards from

European monetary integration 57 the euro’s status as an international reserve currency (even though, as argued by Alogoskoufis and Portes (1992), such benefits would not be very large). Protecting the ECB stewardship: the subordination of fiscal policy The ECB is forbidden to create money at the request of member states and the European authorities. While this prohibition has never been an explicit element of the constitution of its member states, it is now enshrined in the constitution of the European Union. It undoubtedly fits well under the Mengerian logic that comprises the basic structure of the European Union. It prevents the creation of money to finance state outlays in excess of tax revenues. However, to understand the harshness of the fiscal constraints accompanying this prohibition, we have to integrate the Maastricht rules and the Growth and Stability Pact into a consistent framework germane to the underlying economics. The fundamental principle is that, in the medium term, each member state must de facto target a fiscal surplus. If in the short term the economy goes into a slump, the government can, of course, allow “automatic stabilizers” to follow their course and generate a budget deficit, as long as the accounting deficit does not exceed 3 per cent of GDP. At the same time, three other conditions must be met by each member state incurring a deficit. First, the deficit ought not to be a structural one resulting from a persistent expansionary fiscal stance. Second, the resulting increase in the public debt must not exceed the threshold level of 60 percent of GDP. Finally, the government must ensure that there will be future surpluses high enough to permit the state to exact a cumulative net budgetary balance over the cycle. Indeed, according to the Growth and Stability Pact (interpreted by the European Commission and the European Central Bank), the initial slump must be of “abnormal magnitude.” In particular, it must have occurred while the national government was undertaking a policy of “fiscal responsibility,” that is to say, targeting at least a balanced budget. However, since future surpluses cannot be guaranteed, prudent policy would advise that governments target budget surpluses. Therefore, much as in Canada, since budget deficits are assumed to impact negatively on growth in accordance with neoclassical theory, for contingency reasons all member states must permanently target surpluses since one cannot be sure that fully offsetting future surpluses will evolve out of destabilizing deficits. Based on this neoclassical logic, a sound fiscal policy is one approach that consequently targets a permanent surplus as insurance against disequilibrating shocks. However, unlike in Canada, failure to respect these criteria could result in serious penalties for the guilty member states. The implications of this provision are quite startling, since the constitution of the European Union now bestows absolute supremacy to neoclassical economics as the ultimate source of law. Hence, any state can be indicted for excessive deficits before the European Council in its capacity as Supreme Court can condemn a state to pay a fine equal to 0.5 percent of its GDP per year of excessive deficits!

58 Alain Parguez, Mario Seccareccia, and Claude Gnos Removing employment and welfare from macroeoconomic policy This major aspect of the European Monetary Union is dealt with in Appendix II of the Growth and Stability Pact largely at the request of France. Much like the early doctrines of Rueff and of current neoclassical orthodoxy, unemployment is a supply-side phenomenon due to the absence of flexibility in the labor market. The solution, in Appendix II, is that unemployment is purely a social problem, which must be addressed directly by removing the causes of the supply-side constraints. It includes an agenda of reforms, which is strongly advocated by both the European Commission and the ECB. Since high unemployment could encourage politicians to adopt “misguided” Keynesian policies, over the long term, the monetary union would be jeopardized if labour-market flexibility is not achieved (Fitoussi, 1999). Reforms could include lower minimum wages, the replacement of welfare programs that create labor-market disincentives by job training programs, the more efficient organization of work, and the suppression of all such obstacles that restrain employers’ rights to dismiss inefficient employees. The effect would be to reduce the equilibrium level of unemployment, or what Parguez (1999) has termed the “non-expected inflation rate of unemployment” (NEIRU), that would be critical to the success of the monetary union. The NEIRU is not explicitly mentioned in the Growth and Stability Pact but it is the logical consequence of its underlying economics. In a sense, the NEIRU can be conceived of as that rate of unemployment that removes any Keynesian temptation to engage in more activist fiscal and monetary policies. By combating unemployment via supply-side policies, it is thus deemed by the architects of the euro as the best route to a sustainable noninflationary state of full employment. The protective institutional structure Given the concerns of the European political elites, EMU institutions have been shrewdly built to remove any damaging intervention by the elected representatives. Money must thus be protected from the perils of democracy! It is for this reason that the ECB is independent of both member states and European institutions. While the ECB is obliged to present reports to the European Commission and the European Parliament, this obligation conflicts with the rule of absolute secrecy that forbids the ECB to explain its policy. To guarantee its independence, the Maastricht Treaty carefully shaped the organization of the bank. The president, the Directory (the Board) including the vice-president, and four other members exercise supreme authority. All are appointed for eight years by the European Council and are selected from those who are “perfectly known within the financial community for their outstanding expertise” (paragraph 109A of the Treaty of Maastricht). They cannot be dismissed during a mandate even by a unanimous decision of the European Council. While the

European monetary integration 59 last of these regulations is common for central bankers, the first is crucial because it is the guarantee that the president and the board must be either former central bankers or presidents of private commercial banks. Moreover, national central banks form a part of the European Monetary System of central banks, regulated by the ECB (paragraph 8 of the Maastricht Protocol on the ECB). Since the ECB enjoys complete independence in relation to member states, national central banks must enjoy the same independence relative to its respective countries (paragraph 14–3 of the Maastricht Protocol on the ECB). National central banks are merely the national branches of the ECB. Member states as such do not participate in the Council of Governors, which is a purely technocratic assembly. Indeed, national governors are sworn to ignore the special interests of their respective countries (paragraphs 14-3 and 14-4 of the Maastricht Protocol on the ECB). At the same time, rules governing fiscal policy cannot be amended. They are monitored and interpreted by the European Commission and the ECB. According to paragraph 4 of the Maastricht Protocol on the European Central Bank, the ECB “has the power to issue advisories on all matters related to its mission.” Since the bank monitors fiscal as well as social policy in the member states, if some domestic legislation is seen to jeopardize the value of the currency, according to its own sovereign “judgment,” it issues an advisory requiring the repeal of this piece of legislation. It is also required to issue advisories on domestic budgets when they are not explicitly targeting surpluses. Such advisories are not mandatory regulations, but no member state can choose to ignore them. This is because the bank has the right to ask the Commission to issue mandatory directives that would impose the required change. Since all European institutions must help the ECB to fulfill its mission, the Commission is obliged to issue the desired directives. Finally, the European Parliament is deprived of any powers over the ECB. It does not participate in the appointment of the president, the board, or the council of governors of the ECB. The bank has to present regularly a report to the European Parliament. However, this report cannot be discussed and, in any case, cannot include any material that could inform the parliament of its policy because of the secrecy provision. Moreover, if members have some disagreement with the bank’s policy, the European Parliament is obviously forbidden to issue directives to the bank.

The lessons of European monetary union for North America We have shown thus far that the Mengerian theory of money offers a logical explanation for an optimal currency area or monetary union. Since its inception, the European plan has been rooted in Mengerian theory. A composite commodity currency that fits the fundamental principles of Mengerian theory has necessitated a precise institutional structure which, over the course of the sixty years of unfolding, the European plan has gone from the abstract Mengerian theory to the economic

60 Alain Parguez, Mario Seccareccia, and Claude Gnos and institutional rules of the new European monetary order. How would a similar structure be fashioned in North America? Although there does not exist a long-run political process in North America in favor of a single currency, it has already been shown that, on the basis of Mundellian economic logic, the common North America currency would be the US dollar. However, establishing the US dollar as a common currency requires the determination of the rates of conversion of assets and liabilities denominated in Canadian dollars and Mexican pesos. As we saw in Europe, it was through the long tâtonnement process of the EMS that such equilibrium exchange rates were finally worked out. Presumably, within the North American integrated economic space (NAFTA), a similar trajectory would be followed. As many have advocated (see, among others, Courchene and Harris, 1999), the first stage of this process of monetary integration ought to be the setting-up of a fixed exchange rate structure that would solidify the long-term depreciation of the Canadian dollar and the Mexican peso relative to the US dollar. Only after a certain process of realignment of these exchange rates until a desired “equilibrium” is struck in accordance with EMS-type arrangements (and convergence criteria) would a fully fledged monetary union have been achieved. Once the new North American Monetary Union is in place, however, a slightly revamped US Federal Reserve would play the part of the ECB with a similar strong commitment to a zero expected inflation via its control of the rate of growth of the money supply. Like its sister union, the NAMU would be logically committed to a strong version of the exogeneity of money as a mere consequence of the Mengerian analytics. Since euro economics postulates that banks cannot create money, the architects of the NAMU are poised to rely on a similar postulate, without which the whole economics of monetary union would unravel. This strong exogeneity theory of money explains why debates over monetary union in North America ignore the role of banks and only address the supply of “legal tender” by the Federal Reserve (see von Furstenberg, 2000; Laidler, 1999; and McCallum, 2000). For the same reason as in Europe, however, the Federal Reserve can indirectly control the money supply only via interest rate policy, by setting the level of interest rates that would adjust ex ante saving to ex ante investments – the supposed prerequisite of a sound currency characterized by zero inflation. However, money supply targeting via the setting of interest rates could prove to be more difficult in North America than in Europe because of a long-run discrepancy in inflation rates among the three presumed members of the NAMU. In fact, unlike stage I of the European plan of monetary integration, there has not been the same structural longterm preparatory adjustment in North America. Furthermore, in the European system the ECB is sovereign in relation to its member states, and the same absolute independence would have to be bestowed on the new Federal Reserve. Indeed, since the ECB is not a central bank dependent on its member states, then neither would the new Federal Reserve be the central bank of the NAMU members. Hence, Canada and Mexico would lose their national

European monetary integration 61 central banks and would be integrated into the American system under the supreme authority of the new Federal Reserve. The new Federal Reserve would be granted constitutional independence in relation to all member states, including the US government, and the former central banks of Canada and Mexico would become mere domestic branches or districts of the new Federal Reserve (see Courchene and Harris, 1999; and Grubel, 1999). At the same time, the new Federal Reserve would probably have to be protected by more stringent fiscal rules than in Europe. This is because neither Mexico nor Canada has passed through the same degree of fiscal austerity as in Europe during the twenty years prior to the official implementation of the single currency. This would mean that any financing of state outlays by the new Federal Reserve would be prohibited and Canada, Mexico, and the United States would have to commit themselves to achieving permanent budget surpluses (including social security) in accordance with EMU-type fiscal rules. Given its past fiscal excesses, required surpluses would have to be higher for Mexico and Canada than for the United States. These fiscal constraints would be enshrined in the NAMU, and there would be sanctions imposed on countries running insufficient surpluses. Finally, since such fiscal surpluses would probably be exacted primarily from the social program envelopes of government budgets, North American fiscal deflation would help to suppress obstacles to market flexibility, especially in the labour market. It would also help create a highly flexible and single North American labour market. The obvious problem is that politically there would be strong pressures, particularly from the United States, not to eliminate in the short or medium term certain barriers to labor mobility, because of fears of a mass exodus of workers from Mexico into the neighboring American regions to the north.

The consequences of establishing a North American Monetary Union The impact of the exogeneity of money postulate The vast majority of the discussions over either a NAMU or outright dollarization along the lines proposed by US Senator Connie Mack have focused on the question of regulation of the stock of legal-tender-based money. The unbridled faith in the postulate of exogenous money explains why Canadian advocates of the NAMU (such as Courchene and Harris, 1999; and Grubel, 1999) never address the role of banks. In modern monetary economies like Mexico and Canada, money is an endogenous variable. Canadian and Mexican banks will now create NAMU dollars to finance their loans. This is because banks are not mere intermediaries between savers and investors, but are active creators of deposit money. Since the new Federal Reserve will be committed to maintaining the stability of the North American financial system, it will provide new reserves to the system through open-market

62 Alain Parguez, Mario Seccareccia, and Claude Gnos operations. Such a commitment would conflict, however, with the Mengerian principle to which the new Federal Reserve ought to subscribe. For instance, let us assume some profligacy of Mexican banks in their loans policy. The new Federal Reserve will detect an unexpected increase in monetary velocity that it believes could jeopardize the value of the NAMU dollar and its target of zero inflation. For this reason, it will start to raise interest rates in order to impose a fall in the demand for loans until they are again presumed equal to ex ante deposits. In the process, both Canadians and Americans will suffer the same credit squeeze as the Mexicans, even though the former may have been cautious in their credit-worthiness rules. The more the new Fed is committed to this Wicksellian rule, the more it will react to the endogeneity of money by raising interest rates as a preemptive strike against the expected inflation. This was exactly the interest rate policy adopted under the EMS which led to a successful disinflation (cf. Bleaney and Mizen, 1997) and which was subsequently followed under the EMU. In the name of defending the European fixed exchange rate system and now the euro, European countries have consistently followed over the last two decades a policy of high real interest rates in relation to the United States. For instance, Figure 4.1 presents real prime interest rate series (as well as their underlying trends) for the United States and the average for the two core countries of the EMS, France and Germany, for the period 1979 to 1999. 12

10

Percent

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Euroreal Real Prime Euro prime rateRate HPeuro Euroreal Real HP rateRate trendTrend

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USreal Real Prime US prime rateRate HPUS USreal Real Prime HP prime rateRate trendTrend

Source: IMF.

Figure 4.1 Evolution of real prime rates in two core euro countries and the United States, 1979–99 (nominal prime rates less CPI inflation rates).

European monetary integration 63 From this simple statistical evidence, we can infer that the institutional framework of the European system has generated much more restrictive monetary policy than in the United States and with disastrous consequences over the same period in terms of unemployment and growth (see Figure 4.2 for the unemployment experience of the two regions). Moreover since the central bank is now forbidden to finance any government expenditures of the member states, national governments are forced to rely exclusively on private banks as a source of short-term financing. In the name of combating inflation that supposedly ensues from the process of acquiring seigniorage revenues via the “monetization of deficits,” the EMU arrangements have become a real cornucopia for private banks and have imposed an amazing burden on any member state, since they have to both pay interest to the banks on their borrowings and comply with their creditworthiness criteria. With interest rates being ultimately decreed by the supranational ECB they can at the same time increase at will the public debt burden in the member countries. These same financial constraints will apply to all members of the NAMU. All member states of the NAMU will find themselves in the same relation to the new Fed as Canadian provinces are presently with respect to the Bank of Canada. The Canadian government will have no choice but to meet its short-term financing requirements by borrowing from private financial institutions. Moreover, any 13 12 11

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Source: OECD.

Figure 4.2 Unemployment rate performances of two core euro countries and the United States, 1979–99.

64 Alain Parguez, Mario Seccareccia, and Claude Gnos interest rate hike decreed by the new Federal Reserve to tame overspeculation, say, in Mexico will automatically increase the debt burden in Canada. The impact of fiscal rules Fiscal austerity is a twin of the exogeneity of the money principle. The belief in balanced budgets and fiscal surpluses is rooted deeply in neoclassical thought, with its rejection of the Keynesian principle of effective demand. Converting to the Mengerian principles of the monetary union entails the abandoning of Keynes and his legacy. Unfortunately, modern monetary economies are no longer governed by Say’s law and supply-side neoclassical economics as in Keynes’s times. The stringent fiscal rules of a monetary union, as we saw under the Maastricht Treaty, led to a permanent reduction of aggregate demand and an increasing long-term problem of involuntary unemployment (as is displayed in Figure 4.2). Such has been the case for Europe for at least the past two decades prior to the official launching of the euro on 1 January 1999. Figures 4.3 and 4.4 present indicators of the fiscal stance of the core euro countries (France and Germany) vis-à-vis the United States, and are quite suggestive of the importance of the policies of fiscal austerity in Europe during the past two decades. Indeed, in the early 1980s the sole member of the European Union that refused to enter into a monetary union by rejecting the European monetary 2 1 0

Percent

–1 –2 –3 –4 –5 –6 78

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Euro deficit/GDP Deficit/G DP HP euro Eurodeficit/GDP Deficit/G DP T rend trend Source: OECD.

S

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O C

Figure 4.3 Share of deficit (–)/surplus (+) to GDP of two core euro countries and the United States, 1979–99 (all levels of government).

European monetary integration 65 4

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–1

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–3 78

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US Pimary deficit/GDP Deficit/G DP US primary HP US primary Primary Deficit T rend HP US deficit trend

Source: OECD.

Figure 4.4 Share of primary deficit (–)/surplus (+) to GDP of two core euro countries and the United States, 1983–99 (all levels of government).

tâtonnement was the United Kingdom; and it is the only major European country to have enjoyed a significant decline in the unemployment rate since the mid-1980s (see Figure 4.5). If Canada, Mexico, and the United States were to agree on a monetary union along the lines of the EMU, they would have to deflate their economies significantly and accept a higher long-term rate of unemployment. Some may wish to invoke the miracle of the new economy of the late 1990s when, especially in the United States, rising budget surpluses were matched by strong growth and quasi-full employment without inflation. However, as has been discussed elsewhere (see Seccareccia 2000), in both the United States and Canada, the deflationary impact of fiscal surpluses has been mitigated largely by the accompanying dramatic growth of private debt. Neither the US Federal Reserve nor the Bank of Canada has shown much concern with explosive household debt ratios. This has largely been because of rising private debt with the use of company stocks as collateral, the values of which have been inflated by excessive speculation in the stock market via credit financing. There is no doubt, however, that a more cautious supranational Federal Reserve would engineer a credit crunch by significantly raising interest rates. In fact, the deflationary “success” of the monetary union would be linked to the destruction of the compensating role of household indebtedness. While the US economy would suffer from such a deflationary policy, the bulk of the credit crunch will be borne by Mexico and

66 Alain Parguez, Mario Seccareccia, and Claude Gnos 13 12 11

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Euro Unemploymentrate Rate Euro unemployment HP Eurounemployment Unemployment T rend HP euro trend

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UK Unemploymentrate Rate US unemployment HP UK UK unemployment Unemployment Trend trend

Source: OECD.

Figure 4.5 Unemployment rate performances of two core euro countries and the United Kingdom, 1979–99.

Canada, where the rise in real income upon which borrowing can be sustained has been lower than in the United States.

Concluding remarks To the question that was posed at the very beginning of this paper, as to whether national currencies in North America are destined to disappear, the answer can be only an ambiguous one. If one subscribes to neo-Mengerian theory of optimum currency areas, a monetary union in North America should have long preceded the European Monetary Union (see, inter alia, Eichengreen 1997, p. 52). Canada and the United States are economies that are more integrated as trading partners than any of the major partners of the European Union with, for example, over 85 percent of Canada’s foreign trade being done with the United States. Moreover, the Canadian and American economies are structurally more homogeneous than most of the members of the EMU. If Mundellian logic prevailed, these two countries of NAFTA should have integrated monetarily long before the Europeans. Yet, to the dismay of the neo-Mengerians, this has not happened. Indeed, despite the much greater economic integration between Canada and the United States, it is only since the launching of the euro in 1999 that concern with the issue of a common North

European monetary integration 67 American currency has actually surfaced among politicians and the public at large. However, this appetite by some for greater monetary integration has not been based on any prior political plan to which the European political class had subscribed for sixty years prior to the launching of the euro. Rather, in North America, with the possible exception of some pro-NAMU sovereigntists in Quebec, it is based primarily on what may be described as Veblenesque desires of “keeping up with the (European) Joneses.” The European governments have chosen to move in the direction of monetary union not because of any underlying Mundellian logic but because of a strong political and ideological commitment on the part of the European “techno-classical” group who, throughout the early postwar period, had promoted a course of greater political, economic, and monetary integration. Thus, there was nothing inevitable about the path and, indeed, as we have argued, the European member states have given themselves an institutional structure that, despite the political rhetoric to the contrary, has ironically weakened their economies since the advent of the EMS in 1979 (cf. Feldstein, 1997). In many ways, as argued by Parguez (1999), the European states are virtually repeating the old mistakes of the gold zone during the 1930s. Since their restrictive monetary and fiscal policies have had the effect of compressing aggregate demand and employment on the European continent, the consequence has been to weaken and accelerate the depreciation of the euro and to trigger deflationary pressures in the world economy. The European states, by applying further doses of fiscal restraint to an otherwise ailing European economy, have further weakened the real economy and, accompanying it, the euro. Some may argue that a downward spiraling euro would ultimately stimulate exports from the euro region. While this may be true, the effect would also be to further increase the American trade deficit and, paradoxically, to further reinforce the holdings of US dollars internationally. Instead of being the quintessential gold which international transactors would wish to hold, the euro is more likely to become what the original advocates of the European plan least desired – perhaps just another one of the growing number of international “junk” currencies described by Mundell (2000). Is this really the model of a new monetary system for the twenty-first century that North Americans would wish to adopt? Are North Americans better off with their existing national currencies? Or, to paraphrase former Governor Gordon Thiessen of the Bank of Canada, why would anyone want to give up their national currencies for, to all intents and purposes, a more constraining supranational monetary order (Thiessen, 1998, p. 123)?

Note 1 The authors would like to thank Thomas Ferguson for his helpful comments. The usual disclaimer applies.

68 Alain Parguez, Mario Seccareccia, and Claude Gnos

References Alogoskoufis, George and Richard Portes (1992), “European Monetary Union and International Currencies in a Tripolar Word,” in Mathew B. Canzoneri, Vittorio Grilli, and Paul R. Masson (eds), Establishing a Central Bank: Issues in Europe and Lessons from the U.S., Cambridge: Cambridge University Press, pp. 273–302. Bleaney, Michael and Paul Mizen (1997), “Credibility and Disinflation in the European Monetary System,” Economic Journal, Vol. 107, No. 445 (November), pp. 1751–67. Bogetic, Zeljko (2000), “Full Dollarization: Fad or Future?,” Challenge, Vol. 43, No. 2 (March–April), pp. 17–48. Courchene, Thomas J., and Richard G. Harris (1999), “From Fixing to Monetary Union: Options for North American Currency Integration,” C.D. Howe Institute Commentary, 127 (June). de Cecco, Marcello and Alberto Giovannini (1989), “Does Europe Need its own Central Bank?”, in Marcello de Cecco and Alberto Giovannini (eds), A European Central Bank? Perspectives on Monetary Unification after Ten Years of the EMS, Cambridge: Cambridge University Press, pp. 1–12. Eichengreen, Barry (1997), European Monetary Unification: Theory, Practice, and Analysis, Cambridge, MA: MIT Press. Emerson, Walter et al. (1990), Single Market, Single Currency: An Evaluation of Potential Gains and Cost Stemming from the Creation of an Economic and Monetary Union, Brussels: Direction générale des affaires économiques et financières, European Commission. Feldstein, Martin (1997), “The Political Economy of the European Economic and Monetary Union: Political Sources of an Economic Liability,” Journal of Economic Perspectives, Vol. 11, No. 4 (Fall), pp. 23–42. Fitoussi, Jean-Paul (1999), Rapport sur l’état de l’union européenne, Paris: Presses des universités de France/Fayard. Furstenberg, George von (2000), “A Case Against U.S. Dollarization,” Challenge, Vol. 43, No. 4 (July–August), pp. 108–20. Goodhart, Charles A. E. (1998), “The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas,” European Journal of Political Economy, Vol. 14, pp. 407–32. Grubel, Herbert G. (1999), “The Case for the Amero: The Economics and Politics of a North American Monetary Union,” Critical Issues Bulletin, Fraser Institute, September. Hayek, Friederich von (1976), Choice in Currency: A Way to Stop Inflation, London: Institute of Economic Affairs. Kaldor, Nicholas (1980), “Monetarism and U.K. Monetary Policy,” Cambridge Journal of Economics (December), pp. 293–318. Laidler, David (1999), “What Do the Fixers Want to Fix?,” C.D. Howe Institute Commentary, 131 (December). McCallum, John (2000), “Engaging the Debate: Costs and Benefits of a North American Common Currency,” Current Analysis, Royal Bank of Canada Reports (April). Menger, Karl (1892), “On the Origin of Money,” Economic Journal, Vol. 2, No. 6 (June), pp. 239–55. Mundell, Robert A. (1961), “The Theory of Optimum Currency Areas,” American Economic Review, Vol. 51, pp. 657–64.

European monetary integration 69 Mundell, Robert A. (1968), International Economics, London: Macmillan. Mundell, Robert A. (1971), Monetary Theory: Inflation, Growth and Interest in the World Economy, New York: Goodyear Publishing. Mundell, Robert A. (2000), “Interview on ‘The euro Revolution,’” The National Post, 13 December. Mundell, Robert A. and Alexander K. Swoboda (1969) (eds), Monetary Problems of the International Economy, Papers and Discussions, Chicago: University of Chicago Press. Parguez, Alain (1998), “The Roots of Austerity in France,” in Joseph Halevi and Jean-Marc Fontaine (eds), Restoring Demand in the World Economy, Cheltenham, UK: Edward Elgar. Parguez, Alain (1999), “The Expected Failure of the European Economic and Monetary Union: A False Money against the Real Economy”, Eastern Economic Journal, Vol. 25, No. 1, pp. 63–76. Parguez, Alain (2000), “For Whom Tolls the Monetary Union: The Three Lessons of the European Monetary Union,” mimeo, University of Besançon (January–March). Seccareccia, Mario (1998), “Wicksellian Norm, Central Bank Real Interest Rate Targeting and Macroeconomic Performance,” in P. Arestis and M. C. Sawyer (eds), The Political Economy of Central Banking, Cheltenham, UK: Edward Elgar, pp. 180–98. Seccareccia, Mario (2000), “Rising Consumer Debt and Declining Household Saving: What Are the Public Policy Concerns?,” brief presented to the Standing Committee on Finance, House of Commons, Ottawa, Ontario, Canada (May). Thiessen, Gordon (1998), “The Euro: Its Economic Implications and its Lessons for Canada,” Bank of Canada Review (Winter), pp. 117–23. Wyplosz, Charles (1997), “EMU: Why and How it Might Happen,” Journal of Economic Perspectives, Vol. 11, No. 4 (Fall), pp. 3–21.

5

Common currency lessons from Europe Have member states forsaken their economic steering wheels? Stephanie Bell

Introduction In 1941, Abba Lerner wrote an essay entitled “The Economics of the Steering Wheel.” In the opening paragraph, he invited the reader to enter a fantasy world, where mad motorists on Mars perpetually flirted with death by submitting themselves to the mercy of an unconventional interplanetary highway system. In the scenario he described, automobiles were guided by a high-tech system of specialized braking devices and cleverly crafted roads rather than by living beings (Martians) who could skillfully direct their vehicles by employing the use of a steering wheel. Instead, these motorists relied on high curbs that were designed to maneuver wayward vehicles back onto the road. Most autos would bounce erratically from curb to curb, their passengers averting disaster despite having forsaken the power to control their own destiny.1 Likening this state of affairs to a bad dream, Lerner suggested that Earthlings should be grateful that their fate is governed by more sensible (if less sophisticated) methods. While the transportation system on Earth was deemed preferable, Lerner maintained that “when it comes to maintaining their economic system,” humans are as reckless as the mad Martians, because they allow “their economic automobile to bounce from the curb of depression to the curb of inflation in wide and uncontrolled arcs” (1941, p. 271). Specifically, he indicted the human race for failing to devise a mechanism capable of systematically regulating the level of employment. Lerner’s approach was generally consistent with Keynes’s. Most importantly, he maintained that the level of output and employment (i.e. effective demand) was determined by the amount of total spending, and, like Keynes, he believed that capitalist economies were inherently demand-constrained. Thus, Lerner viewed unemployment as the result of insufficient aggregate demand, which, he believed, could be eliminated by adopting a “functional” approach to public policy. Lerner explained this approach in his 1943 article “Functional Finance and the Federal Debt.” He said:

Common currency lessons from Europe 71 The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions and not to any established traditional doctrine about what is sound or unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science as opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance. (Lerner, 1943, p. 39; emphasis in original) Thus, if full employment was to be achieved, the government would have to abandon any preexisting bias toward “sound” finance and grip hold of the steering wheel of Functional Finance. Like a motorist with the ability to control the speed and direction of its automobile, Lerner suggested that policymakers could guide the pace of economic activity, steering the economy away from danger (recession) and toward prosperity by implementing policy according to two fundamental principles (or “laws”). The first law of Functional Finance placed upon the government was the responsibility for maintaining the total rate of spending on goods and services at the level necessary to purchase all of the output that a fully employed labor force could produce. In elucidating this law, Lerner explained that when spending was at the requisite level, it would prevent both inflation and unemployment (i.e. there would be full employment and price stability). In order to increase total spending, he suggested that the government should increase its own expenditures or reduce taxes so that private spending would increase. Similarly, the government could cut its spending or raise taxes in order to reduce the total rate of spending. The second law of Functional Finance decreed the specific manner in which the shortfall in total spending was to be eliminated. Specifically, Lerner proposed that the government borrow only in the event that private spending would otherwise generate excessive aggregate demand. Since he believed that there would ordinarily be insufficient aggregate demand, he felt that under ordinary circumstances it would be unnecessary for the government to offer bonds in exchange for existing funds. Instead, he believed that bonds should be sold to the central bank or to private banks “on conditions which permit the banks to issue new credit money based on their additional holdings of government securities, [which] must be considered for our purposes as printing money” (Lerner, 1943, p. 41). In Lerner’s view, policymakers were not taking full advantage of the economic steering wheel. Too much of the time the economic auto was allowed to stray from a full employment path. But, said Lerner, the government could prevent this by keeping its hands on the wheel so that it could react appropriately to unforeseen obstructions in the road. Thus, by adjusting its taxing/spending, purchase/sale of

72 Stephanie Bell bonds, and creation/destruction of money, the government could keep the economy on a path toward full employment. Although Lerner’s approach appeared to be tenable regardless of the monetary system in place, it will be argued in this chapter that a nation can undertake Functional Finance only under certain specific monetary arrangements. Since I have already demonstrated that the US monetary system is amenable to Functional Finance (see Bell, 2000), my objective here is to consider the prospects for Functional Finance under an alternative monetary system. If Functional Finance represents the ultimate in policy freedom, then it is instructive to inquire whether countries that adopt alternative monetary arrangements retain this degree of freedom. Although we could apply our analysis to a variety of monetary arrangements (i.e. currency boards, a gold standard, or other systems of fixed exchange rates), our focus here will be on the monetary system that now governs the Eurozone.2

Why a currency union but not political union? Monetary union was considered a logical and necessary counterpart to establishing a economic union.3 Indeed, EMU stands for “economic and monetary union,” not “European monetary union,” as it is often mistakenly translated. Moreover, because Europe had been moving toward an economic union for some time, plans to introduce a single currency began well before the Treaty on European Union (or Maastricht Treaty) was drafted. Indeed, as Coffey notes, “a full economic and monetary union (EMU) was agreed upon by the Heads of Government of the original six founder Member States of the European Economic Community (EEC) in Den Haag at the end of 1969” (1993, p. 1). Table 5.1 illustrates that a broad process of integration actually began even before 1969. It is not coincidental that it began just after the Second World War. Indeed, economic and political cohesion became important after the war; however, the idea of a United States of Europe, which was revived by Churchill in 1946, had to be abandoned due to resistance from the communist bloc.4 Thus, Europe’s integration plans were limited to Western Europe, where a number of post-WWII treaties and agreements helped to pave the way for economic and monetary union. But it was Table 5.1 Predecessors of the 1992 Treaty on Monetary Union (Maastricht) ● ● ● ●

● ●

1951: Union of coal- and steel-producing industries 1957: Treaties of Rome – established a European common market 1965: Treaty on European economic union 1973: Alignment of European currencies – adopted after the end of the Bretton Woods system 1979: European Monetary System (EMS) 1990: Delors proposals – suggested a program for future monetary integration

Common currency lessons from Europe 73 the Maastricht Treaty, agreed upon by the European Community (EC) heads of government in December 1991 and signed on 7 February 1992, which actually laid out the process by which the euro was to be gradually implemented. Today, eleven of the fifteen countries in the European Union (EU) have relinquished control of their domestic monetary policies and abandoned their individual currencies. Table 5.2 shows the three-phase process by which this change has been taking place. With the completion of stage 3, sovereign currencies, which have been gradually withdrawn from circulation, have ceased to carry the status of legal tender, and the introduction of the euro as the common currency of the eleven participating countries has been completed. As the heading indicates, the purpose of this section is to explain both the reasons for adopting a single currency and the rationale for stopping short of full political union. A general answer to the first part of this question has already been given: a single currency was believed to be a logical and necessary counterpart to economic union, something Europe has been moving toward since the mid-twentieth century. More specific support for the single currency often focuses on two (related) benefits – the reduction of transaction costs and the elimination of exchange rate risks. The former is considered by Eudey to be “the most important” benefit of moving to a single currency (1998, p. 14). The benefit, of course, is that a single currency makes it possible to move within a single monetary area “without having to exchange money every hundred kilometers” (Vaclav, 1997, p. 1). In other words, a French citizen bound for Italy need not exchange francs for lire in order to purchase goods and services while in Italy, since the euro will circulate in both regions. The other oft-cited benefit – the elimination of exchange rate risks – means that this same traveler will not become a Table 5.2 Stage 3 of the Treaty on Monetary Union (Maastricht) Phase 1 – 1 January 1999 ● Conversion rates between national currencies and the euro become irrevocably fixed. ● Legislation on the euro comes into force. ● Foreign-exchange and money markets switch over. Phase 2 – 1 January 1999 to December 2001 ● The ECB begins to operate. ● All new issues of public debt are denominated in euros. ● Financial markets switch over. Phase 3 – 1 January to July 2002 ● Euro notes and coins are brought into circulation. ● National currency notes and coins are gradually withdrawn. ● All bank accounts are euro-denominated. ● The euro is used for salaries, welfare services and retail trade.

74 Stephanie Bell victim of an unexpected devaluation or revaluation. Additionally, it is often believed that monetary union will strengthen the single market, promote convergence of national economies, and encourage investment in the eurozone. Against these benefits, a host of costs have also been identified. The loss of independent monetary policy (i.e. the ability to control interest and exchange rates) and the resulting constraints imposed upon fiscal flexibility typically rank high when inventorying the costs of monetary union. The EUR-11, having chosen to adopt the euro, must have believed that the benefits of monetary union outweighed the (nontrivial) costs of moving to a single currency. This belief was based on the Optimum Currency Area (OCA) theory, which suggests that the benefits of monetary union should be balanced against the costs of forfeiting interest and exchange rates as adjustment mechanisms. The most notable contributions to the study of optimum currency areas have been made by Mundell (1961), McKinnon (1963), Kenen (1969), Fleming (1971), Onida (1972), Corden (1972), Magnifico (1973), and Presley and Dennis (1976). For Mundell, an optimum currency area “is precisely a region in which there exists factor mobility” (Coffey, 1977, p. 43). According to Mundell, exchange rates would fluctuate to equilibrate conditions between different currency areas, but factor (labor) movement would equilibrate conditions within a particular currency area.5 McKinnon (1963), while not rejecting the role of factor mobility, tended to emphasize the degree of “openness” of the economy as a criterion which should be used to define an OCA. The idea seems logical, as Coffey notes, “since these countries – whose economies are open or very open ones – were conducting half of their trade with each other” (1993, p. 1). Kenen (1969), in contrast, focused on the degree of “complementarity” as a crucial characteristic. Magnifico (1973), like Kenen, also emphasized complementarity, arguing that it was important for nations to exhibit a similar propensity to inflate. In sum, Mundell originally maintained that as long as labor was highly mobile, it would not be risky to relinquish monetary sovereignty in favor of a common currency. Since then, others have extended this criterion to include openness to trade, capital mobility, and wage/price flexibility. Together, these criteria form what many economists today use to determine the feasibility of an OCA. Thus, in its modern form, a currency union is considered advantageous if goods and services, capital, labor, and prices move in the appropriate directions following asymmetric shocks.6 Assuming these adjustments take place as required, the regions would become self-stabilizing, and the loss of monetary sovereignty would become irrelevant. As the OCA theory is frequently used to justify European Monetary Union, an expectation that the EUR-11 satisfied the OCA criteria could be listed as a final reason for the adoption of the euro. Now that we have some understanding of the various forces that influenced the decision to adopt the euro, we must inquire as to why the EUR-11 decided to stop short of full (i.e. political) union. As Eric Helleiner notes, “most nation-states in the

Common currency lessons from Europe 75 contemporary world have attempted to maintain a distinct currency which is both homogenous and exclusive within their territorial boundaries” (1997, p. 2). However, in the case of European Monetary Union, the currency union spans “a set of sovereign states with relatively little federal centralisation of either political powers or of fiscal competences” (Goodhart, 1996c, p. 1083). Our objective is to understand why, in an environment where “all separate nation states larger than Panama, Liberia or Liechtenstein have a single currency” (Goodhart, 1996c, p. 1084), the consensus became “one market, one money,” rather than “one nation, one money.” Along with the argument that “one market needs one money” (European Commission, 1990), the EUR-11 conceded to the idea that a single federal authority should have the exclusive right to manage this money (Treaty, Article 105a). However, they did not demand an analogous transference of power with respect to fiscal authority. In fact, says Wilhelm Nolling, “the political intention of the Treaty is to subordinate the Community’s economic and fiscal policies” (1993, p. 143). Thus, fiscal authority remains the responsibility of individual member states, while monetary policy, which is primary, is now the responsibility of the European Central Bank (ECB). This separation has created an unprecedented divorce between the monetary and fiscal authorities, a divorce motivated by a desire to establish a monetary authority with “absolute independence from government” (Goodhart, 1998, p. 409). Arestis and Sawyer (1998) argue that the monetarist theory underlies the desire for strict central bank independence. Godley also sees the monetarist influence, suggesting that “it took a group largely composed of bankers” (the Delors Committee) to decide that “governments are unable, and therefore should not try, to achieve any of the traditional goals of economic policy, such as growth and full employment” (1992, p. 39). All that can legitimately be done, according to this view, is to “control the money supply and balance the budget” (ibid.). Both of these beliefs – that the central bank can control the rate of inflation and that the levels of output and employment are set on the supply side of the economy – are central tenets of monetarism. Under the monetarist view, the economy is naturally driven toward equilibrium by a set of highly efficient and fast-acting forces so that activist policies are both unnecessary and unwise. Thus, at least part of the reason for the “divorce” has to do with the fact that monetarists do not believe there is a role for fiscal policy.7 A compatible motivation is given by Jerry Jordan, who argues that “Europe’s move to a single market for capital, goods, and labor is part of a worldwide trend toward greater reliance on unfettered markets for the allocation of productive resources” (1997, p. 1).8

The terms of the divorce In a very real sense, the Maastricht Treaty is like a divorce contract; it allocates various rights and responsibilities among the “divorcing” fiscal and monetary

76 Stephanie Bell institutions. By submitting to the conditions laid out in the Treaty, member states have agreed to hand over certain powers and to abstain from certain behaviors. As Ramon Torrent notes, “one does not need to be a specialist to understand the extraordinary importance and implications [of this] not only in terms of the institutional equilibrium and balance of powers within the European Union but also in terms of economic policy” (1999, p. 1229). The purpose of this section is to describe the institutional framework within which fiscal and monetary policies are to be conducted and to explain the terms (i.e. the rules and conditions) under which they must be carried out. The establishment of the European System of Central Banks (ESCB) marks the most important institutional modification to have occurred on the monetary side. Comprised of the European Central Bank (ECB) and the National Central Banks (NCBs) of all fifteen countries within the European Union (EU), the ESCB is controlled by the Governing Council and the Executive Board, the decision-making bodies of the ECB.9 The Executive Board consists of the President, the vice-president and four other members, while the Governing Council includes the members of the Executive Board and the governors of the national central banks (NCBs). Under Title II, the Treaty states that “the primary objective of the ESCB shall be to maintain price stability” (Article 105).10 This objective is to be pursued indirectly, through control of the money supply. In addition, the Treaty specifies a number of secondary responsibilities, which include:11 ● ●

● ●

defining and implementing monetary policy within the Community conducting foreign exchange operations consistent with the provisions of Article 109 holding and managing the official foreign reserves of the member states promoting the smooth operation of the payments systems.

Under the new framework, NCBs – like the Bundesbank and the Banque de France – have been relieved of their authority to conduct independent monetary policy. Under current arrangements, the Governing Council formulates monetary policy for the entire Eurozone, while the Executive Board is charged with the implementation of the Community’s monetary policy (Article 109a). The NCBs, having lost the power to conduct independent monetary policy, are primarily operating arms of the ECB.12 Figure 5.1 depicts these relations. In order to achieve its objectives, the ESCB has a variety of policy instruments at its disposal. First, it has the power to conduct open market operations. In addition to initiating these operations, the ESCB also decides on the instrument to be used and the terms and conditions under which the operation will be executed.13 The General Documentation on ESCB Monetary Policy Instruments and Procedures (1998), specifies four kinds of open market operations:

Common currency lessons from Europe 77 ●

●

●

●

main refinancing operations – regular liquidity-providing reverse transactions with a weekly frequency and a maturity of two weeks longer-term refinancing operations – liquidity-providing reverse transactions with a monthly frequency and a maturity of three months fine-tuning operations – executed on an ad hoc basis in order to smooth the effects on interest rates caused by unexpected liquidity fluctuations in the market structural operations – executed whenever the ECB wishes to adjust the structural position of the ESCB vis-à-vis the financial sector.

A second instrument of monetary policy, the short-term interest rate, follows from the ESCB’s willingness to provide or absorb overnight liquidity at marginal lending/deposit facilities, known as standing facilities. Two standing facilities are available to eligible counterparties on their own initiative:14 ●

●

borrowing facility – counterparties can use the marginal lending facility to obtain overnight liquidity from the national central banks against eligible assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate lending facility – counterparties can use the deposit facility to make overnight deposits with the national central banks. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.

The third instrument is control over minimum reserve requirements on accounts with the ESCB.15 The ESCB’s minimum reserve system applies to credit institutions in the euro area and is based on a system of lagged reserve accounting (LRA) similar to the US system.16 These three things – open market operations, overnight lending/borrowing rates, and minimum reserve requirements – make up the set of

GOVERNING COUNCIL formulates monetary policy

EXECUTIVE BOARD implements monetary policy

ESCB

ECB

NCBs Monetary policy is administered through these channels.

Figure 5.1 Decision-making bodies of the ESCB

78 Stephanie Bell instruments through which the Treaty grants the ECB power to conduct monetary policy. While the Treaty clearly describes the manner in which monetary policy is to be implemented, it does not include such a precise blueprint for the implementation of fiscal policy. This is not only because fiscal policy remains the responsibility of member states but also, as argued above, because the Delors Committee was comprised primarily of monetarists, who tend to view the economic system as inherently stable and who consider fiscal policy a fairly impotent and unreliable tool. Thus, rather than sketching out a program for the implementation of countercyclical fiscal policy, the Treaty imposes a set of rules and guidelines that are designed to constrain the use of discretionary fiscal policy. Specifically, by agreeing to the terms set out in the Maastricht Treaty, member states have subjected themselves to three distinct fiscal constraints. First, member states have agreed to exercise a certain degree of self-restraint when it comes to matters of fiscal policy. The Treaty encourages “close coordination of Member States’ economic policies” (Article 3a), asking member states to “regard their economic policies as a matter of common concern and … [to] coordinate them within the Council, in accordance with the provisions of Article 102a” (Article 103). To be convinced that member states have responded to this plea for self-restraint, one need only consider the position of the French government.17 At the close of 1998, French officials published a document titled Multi-annual Public Finance Program to the Year 2002: A Strategy for Growth and Employment. In it, officials laid out the principles that they believed should govern public policy over the following three years. With respect to fiscal policy, they openly committed themselves to the principles of “sound” finance, stating that “larger deficits occurring in years of low growth are [to be] offset by smaller deficits in years of high growth” (French Republic, 1998, p. 9).18 For the period 2000 to 2002, the officials set targets for real expenditure for the general government. The targets were set in line with what the officials believed represented a desirable trend in the government debt ratio over a full economic cycle. Assuming their targets would be met, general government expenditures in France would grow at just 1 percent per year (in real terms) over the three years of the program.19 The government’s budget policy follows from the conventional wisdom that government deficits, by raising prices and interest rates, will “crowd out” privatesector activity. Two controversial elements are central to this view. The first is the (positive) correlation that is supposed to exist between budget deficits and prices. The problem with this argument is that deficit spending, like additional spending by households or firms, should put upward pressure on prices only if the additional demand is borne by an already fully employed industry or economy, hardly a concern of the present-day EUR-11. Second, the conventional view requires a (negative) correlation between investment and the rate of interest. But this too is

Common currency lessons from Europe 79 problematic, as demonstrated by the capital critiques and by Fazzari (1993). Nevertheless, the French position is consistent with the ideological bias embedded in the Treaty and, hence, with the monetarist/sound finance perspective that favors fiscal discipline rather than Functional Finance. The second constraint on fiscal policy derives from the Stability and Growth Pact. Proposed by former German Finance Minister Waigel, the pact makes more explicit the budgetary limits and financial penalties for non-compliance with Maastricht rules regarding fiscal discipline. The pact, which was ratified at the June 1997 Amsterdam Summit, strengthens the surveillance of member states by forbidding countries from running deficits in excess of 3 percent of GDP and requires that debt-to-GDP ratios be maintained below 60 percent. One reason for these limits is the European Council’s belief that they mark “an essential condition for sustainable and non-inflationary growth and a high level of employment” (quoted in Spiegel, 1997, p. 1).20 Both Issing (1997) and Semmler (1999) recognize that member states are not encouraged to take advantage of the “freedom” to persistently run small deficits but, instead, are to offset deficits by running surpluses in subsequent periods in order to generate balanced budgets over the business cycle. Issing, who is the chief economist of the ECB, notes: If, for instance, the 3 percent criterion for the budget deficit were prescribed as a statutory upper limit for national governments having joined the monetary union, the authorities in each country would be responsible for ensuring the necessary leeway. In buoyant economic conditions, the budget deficit would thus have to be much lower in order to provide fiscal policy makers with the appropriate scope for running up higher deficits in periods of recession. (Issing, 1997, p. 11)21 As Parguez (1999) contends, encouraging balanced budgets is related to the fear of negative spillover effects (i.e. externality effects), which are thought to occur as one country’s budget deficit, working through its impact on interest rates, affects economic conditions in other EU nations. In the event that a country does not fulfill the two fiscal criteria – for the budget deficit and public indebtedness – the excessive deficit procedure pursuant to Article 104(c) will apply. Under the Excessive Deficit Procedure, deficits exceeding 3 percent of GDP are subject to a fine as declared by the European Council upon a report by the European Commission and a judgment by the Monetary Committee. Specifically, the Growth and Stability Pact commits EMU members to government budget positions that are close to balance, and the Excessive Deficit Procedure allows the Council to: ●

demand that recalcitrant governments “publish additional information, to be specified by the Council, before issuing bonds and securities; to invite

80 Stephanie Bell

●

●

the European Investment Bank to reconsider its lending policy towards the Member State concerned; require the Member State concerned to make a non-interest-bearing deposit of an appropriate size with the Community until the excessive deficit has, in view of the Council, been corrected; impose fines of an appropriate size. (Article 104c)

There is strong disagreement regarding the severity of the deficit-to-GDP and debt-to-GDP constraints. For example, Pasinetti argues that “the ‘pact’ may entail severe costs on two counts: because it prevents expansionary policies in periods of recession and mass unemployment . . . and because, on top of that, it even imposes heavy fines” (1997, p. 9). Arestis and Sawyer (1998, p. 2) concur, suggesting that the objective deficit-to-GDP “constraint on the budget deficit clearly limits the use of national fiscal policy for demand management purposes.” DeGrauwe (1996) and Eichengreen and von Hagen (1995) also oppose the objective constraint, arguing that member states should be free to pursue independent fiscal policy without arbitrary limits or penalties.22 In contrast, Mosler (1999) suggests that the objective constraints are relatively unimportant, since member states are unlikely to be able to secure financing for deficits in excess of 3 percent of GDP except, perhaps, over relatively short periods of time.23 The final constraint on fiscal freedom, mandated under Article 104 of the Maastricht Treaty, is the requirement that central governments abandon the use of “overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States” (Article 104). Article 104 forbids both the ECB and the NCBs from lending directly to member states or buying securities directly from them. Moreover, it states that the ECB should be mindful of this rule when carrying out monetary policy so that it does not engage in operations that would amount to the indirect monetization of debt.24 Additionally, Article 104 includes a provision that neither the Community nor any other member state shall be “liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies’ government by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project” (Article 104b). This provision is often referred to as the no-bailout clause, because it implies that even if a member state finds itself unable to service its debt commitments, the ECB is not permitted to assist it by purchasing a portion of its outstanding bonds. Since NCBs are now forbidden to issue Treasury bonds on behalf of the government and the ECB is forbidden to monetize (directly or indirectly) government debt, governments wishing to deficit spend must now float bonds on the capital market, where they must compete with the financing needs of private borrowers. It

Common currency lessons from Europe 81 is for this reason that Mosler (1999) wonders whether the Stability and Growth Pact and the Excessive Deficit Procedure are even needed in order to constrain government spending. It may well be that financial markets – if they can price risk correctly – will be able to impose discipline by constraining public spending without the need for penalties for fiscal violations (Eichengreen and von Hagen, 1997). Focusing on the role of the Excessive Deficits Procedure, Eichengreen and von Hagen (1995, p. 224) contend that it exists because the Treaty’s no-bailout provision is not considered credible. If it were, it would be sufficient, they maintain, to warn member states that the ECB will not step in to stave off a crisis that might result from a scenario such as the one described below: The scenario the framers of the treaty had in mind presumably runs as follows . . . Imagine that a government of a member state – call it Italy for illustrative purposes – experiences a revenue shortfall. It finds it difficult to service its debt. Bondholders concerned about the interruption of debt service begin to sell their bonds, depressing their price and forcing the Italian government to raise the interest rate it offers when it attempts to roll over maturing issues. The rise in interest rates further widens the gap between government revenues and expenditures, exacerbating the fiscal problem. Problems in the bond market threaten to spill over to other financial markets, because, for example, higher interest rates depress equity prices. In the worst-case scenario, the collapse of asset prices and the impact of higher interest rates on corporate profitability and the performance of outstanding loans can threaten the stability of the banking system. (Eichengreen and von Hagen, 1995) Kenen (1995, p. 70) argues that the purpose of the financing constraint is either intended to “reinforce the ban on ‘excessive’ budget deficits” or to “reinforce the independence of the ECB by giving it better control over the money supply.” In sum, the Maastricht Treaty specifies the responsibilities and limitations of the newly created ESCB and the individual member states. The decision-making bodies of the ESCB are responsible for the formulation and implementation of a single monetary policy within the eurozone. Thus, NCBs can no longer alter interest or exchange rates in response to changing domestic conditions. Rather, they must accept the policy that is formulated by the Governing Council and implemented throughout the eurozone. In addition to assenting to the loss of monetary autonomy, member states have consented to a variety of constraints that limit their fiscal autonomy. They have agreed to pursue fiscal policy in accordance with the guidelines established by the European Council and to implement it without recourse to overdraft accounts or financial assistance from any central bank.

82 Stephanie Bell

Implications for Functional Finance The purpose of this section is to demonstrate that despite the attention that critics have paid to the second constraint – the 3 percent deficit-to-GDP limitation – the third constraint – the one imposed by financial markets – actually results in a far more serious limitation of policy choice. Specifically, by forsaking their monetary independence and agreeing to the terms set out in Article 104 of the Maastricht Treaty, the national fiscal authorities of the EUR-11 voluntarily relinquished the power to conduct fiscal policy according to the principles of Functional Finance. Godley (1992, p. 39) recognizes the significance of this, arguing that the abdication of monetary authority has brought “an end to the sovereignty of its component nations and their power to take independent action on major issues.” Sawyer (1999) also appreciates the relationship between sovereignty over policy choice and sovereignty over money. He recognizes that, by severing this relationship, “national governments will no longer have the ability to ‘print money’ to pay interest on bonds, and their ability to pay depends on their ability to levy the necessary taxation” (Sawyer, 1999, p. 11). This means that member states must (ultimately) rely on tax revenues in order to finance spending and/or validate past spending (i.e. service debt). Thus, unlike the US government, which really faces no external budget constraint, the EUR-11 governments truly do face financing constraints. Two important implications follow from this. First, member states must secure the funds required to spend in excess of current receipts before they can engage in deficit spending. Although the US government could spend first and drain reserves later (by selling bonds), EUR-11 governments must sell bonds first. Thus, their ability to deficit-spend depends upon the willingness of private banks to extend credit in advance. Second, unlike the bonds issued by the US government, the obligations that are now issued by EUR-11 governments are no longer default-risk-free. As Parguez recognizes, this means that markets will make lending decisions on the basis of their perception of member states’ creditworthiness, which is based on a state’s ability to “pledge to balance its budget, to get a zero ex post deficit, so as to protect the banks against the risk of accumulating public debt” (1999, p. 72). Since markets will perceive some members of the EUR-11 as more creditworthy than others, financial markets will not view bonds issued by different nations as perfect substitutes. Therefore, high-debt countries may be unable to secure funding on the same terms as their low-debt competitors. This was recognized by Lemmen and Goodhart (1999, p. 77), who suggest that “governments with above-average deficits and debt will find that they have less financial flexibility within EMU than [was previously] the case.” Suppose, for example, that Italy or Belgium – with debt-to-GDP ratios of 115.1 and 116.1, respectively, at the close of 1999 – decided to pursue an expansionary fiscal policy in order to stimulate GDP and combat high domestic unemployment. If

Common currency lessons from Europe 83 capital markets demand high rates of interest in order to hold Italian or Belgian government debt, then it is easy to see how these governments could be forced to abandon expansionary policy. As Kregel (1999, p. 40) notes, an attempt by Italy to expand domestic demand would lead to a deterioration of the Italian fiscal deficit and, hence, “credit risks rising on Italian securities.” Jordan (1997, p. 3) states the implications succinctly: The risk for the fiscal authorities of any member country is that the “dismal arithmetic” of the budget constraint leaves few palatable alternatives. If the yield on government securities demanded by markets exceeds a country’s nominal income growth, then interest expense on the outstanding debt must become a relatively larger burden. Again, the “burden” can persist because EUR-11 governments cannot create spendable deposits internally (i.e. “print” money) in order to meet rising interest costs. Thus, unlike the US government, which can always meet any dollardenominated commitment as it comes due, the EUR-11 governments must finance their excess spending by selling bonds. Looking at the budget constraint G – T = ∆B + ∆M, then, we see that deficits must be covered by borrowing (i.e. ∆M = 0 for purposes of government finance). But if interest payments are becoming a significant portion of a member state’s total outlays, it may be difficult to convince financial markets to accept new issues in order to service the growing debt.25 While some (e.g. Eichengreen and von Hagen, 1995) have argued that member states can still service higher debt levels because they retain the power to alter tax rates, others recognize that EUR-11 governments are seriously constrained in this regard. Jordan (1997, p. 3), for example, argues that “the prospect of higher taxes would cause the factors of production to migrate . . . [so that] . . . higher tax rates could, eventually, shrink the tax base.”26 Taylor also disagrees with Eichengreen and von Hagen (1995, p. 16), suggesting that, despite “their substantial revenue-raising powers,” member states will “be increasingly constrained by the pressure of ‘fiscal competition’ operating” under EMU. Again, this “fiscal competition” is the direct result of Article 104. Because member states can no longer create spendable deposits internally (i.e. “print” money), they must compete for euros by selling bonds to private investors (including private banks) who will not view the various obligations as perfect substitutes. Thus, governments must float bonds on the capital market, where they must compete with debt instruments offered by other (government and non-government) entities. The result, as Taylor (1999, p. 16) recognizes, is that “debt issuance by euroland’s governments [will] take place in a new environment of market discipline.” The ability of financial markets to impose discipline on member states depends upon two important factors. First, the no-bailout rule must be seen as reasonably credible. If it is, then markets will “treat lending to EMU governments in much the

84 Stephanie Bell same way that they approach lending to the regional governments of existing federal monetary unions” (Taylor, 1999, p. 16). Second, markets must be well informed and efficient in their pricing of credit risk. If they are, they will be able to “exert effective new safeguards against persistently high borrowing” (ibid.). To the extent that these conditions are met, lenders may assign different quality or risk premiums to the obligations of member governments “whose ability to service debt seems less assured than other nations” (Stevens, 1999, p. 5). Thus, even though the ECB, through its willingness to provide (absorb) liquidity at marginal lending (deposit) facilities, will set the short-term interest rate, “bonds issued by different national governments, denominated in euros, may attract different credit ratings and hence different interest rates” (Sawyer, 1999, p. 11). As Lemmen and Goodhart (1999, p. 77) note, this means that “credit risks will replace market risks . . . as the principal source of relative risk in government debt markets in EMU.” As a consequence, obligations issued by EUR-11 governments begin to resemble those issued by state and local governments in the United States, where risk premiums “rise sharply with the ratio of state debt to state product. States with high debt-to-output ratios can become effectively rationed out of the market” (Jordan, 1997, p. 3). Thus, the traditional (institutional) link between the Treasury and the Central Bank has been severed under the new monetary arrangements, which means that, unlike currencies that are “creatures” of their issuing states, “the euro will be a pureprivate money, created at the sole request of private agents by banks obliged to comply with the targets set by the Central Bank, [and] sustained by the expectations of the financial markets!” (Parguez, 1999, p. 66). Whereas the franc, the mark, the lira, etc. used to derive their legitimacy from the state (i.e. from their acceptance in payment of taxes), financial markets are now “the ultimate source of legitimacy for the [euro]” (ibid., p. 72). Having broken the (chartalist) link between sovereignty over currency and sovereignty over public policy, member states must rely on the willingness of commercial banks or other financial institutions when floating new issues; they cannot create spendable balances the way the US Treasury can. Therefore, government debt issued by the EUR-11 countries is forced to compete with other forms of debt (e.g. commercial paper, bonds issued by private firms, the debt of other member states, etc.). In the event that a member state finds itself unable to locate sufficient funding, it will be forced to run a balanced budget. Imposing fiscal constraints on member governments in order to encourage discipline is, of course, wholly inconsistent with the idea of Functional Finance.

Concluding remarks Before entering the currency union, NCBs had command over their own currencies and could alter interest and/or exchange rates in an attempt to stabilize their

Common currency lessons from Europe 85 economies. Now, however, they must accept the monetary and exchange rate policies that are handed down by the ESCB. Moreover, member states have agreed to allow the ESCB to make the pursuit of price stability its overriding objective in implementing monetary and exchange rate policies. They did not, however, insist that a federal agency be made responsible for stabilizing output and employment in times of crises. Currently, “the federal budget for the European Union is not used as a tool to address recessions or overheating, either in particular countries or in Europe as a whole” (Eudey, 1998, p. 17). It is as if policymakers decided to set the economic speedometer at 55 mph, even though it might be wise to speed up (or slow down), depending on current (economic) driving conditions. Although some groups (e.g. monetarists) probably find this limited role for fiscal policy comforting, others have been critical of the lack of attention it has received. Godley (1992, p. 40), for example, states that “the incredible lacuna in the Maastricht program is that, while it contains a blueprint for the establishment and modus operandi of an independent central bank, there is no blueprint whatever of the analogue, in Community terms, of a central government.” This is significant because, as Jordan (1997, p. 40) notes, “the sustainability of any monetary regime depends on the fiscal regime in which it operates.” The reader will recall that the fiscal regime in which the EUR-11 must operate is characterized by three distinct constraints that have been imposed as part of the currency union. However, as Hughes-Hallet and Scott (1993, p. 72) note, “empirical research has shown that monetary union is particularly dependent on its supporting fiscal policies in that, in the absence of sufficiently larger or frequent interventions, economic performance will rapidly deteriorate in the union’s constituent economies.” Because of the deficit-to-GDP constraint, many critics of the European currency union have concluded that it will be impossible for the constituent governments to provide the kind of large-scale intervention that would be needed to stimulate depressed economies. These critics do not seem to be objecting to the existence of fiscal discipline in general, but to the particular upper limit – 3 percent deficit-toGDP – that has been imposed under the Stability and Growth Pact. This view begs the question: is the upper limit the primary obstruction to flexible policy? If it were, then raising it (or lifting it all together) should renew significant fiscal flexibility. But it is not clear that the 3 percent limit is really constraining deficit spending in the EUR-11. Indeed, one might conclude, given that the unemployment rate in the euro area averaged 10 percent in 1999, that many member states would have at least exercised their right to run deficits equal to 3 percent of GDP. As shown in Figure 5.2, however, none of the EUR-11 governments have even come close to running up against the 3 percent deficit-to-GDP limit. We cannot know for sure whether each member state’s budgetary position reflects its preferred stance or whether larger deficits would have been run in the absence of financial market discipline. It seems clear, however, that even if member

86 Stephanie Bell Deficit/surplus as a % of GDP

66 44 22 00 –2 2 –4 4 BE

DE

ES

FR

IE

IT

LU

NL

AT

PT

FI

Source: Monthly Bulletin (September), http:www.ecb.int

Figure 5.2 EUR-11 deficit-to-GDP (1999).

states were able to jettison the objective deficit-to-GDP limit and to abandon any self-imposed fiscal restraints that stem from a bias for “sound” finance, no member of the EUR-11 would be capable of conducting policy according to the principles of Functional Finance. The reader will recall that Lerner proposed that the government undertake two functions. First, it was to ensure that the level of total spending was sufficient to purchase all of the goods and services that a fully employed system could produce. Now, if spending by households, firms and foreigners typically generated a spending gap of no more than 3 percent of GDP and governments were able to borrow enough to close this gap, then it would be possible for the EUR-11 governments to implement Lerner’s first law. However, Article 104 prevents member states from closing the gap in accordance with his second law, which precludes borrowing unless the private sector would otherwise spend enough to bring about full employment. Implementing policy according to the principles of Functional Finance means using taxes and bonds “simply as instruments, and not as magic charms that will cause mysterious hurt if they are manipulated by the wrong people or without due reverence for tradition” (Lerner, 1943, p. 51). It means deciding whether to tax/ spend, buy/sell bonds, create/destroy money, etc. by considering which operation is likely to yield the most desirable effects on the macroeconomy. In other words, policymakers should decide on a policy objective – for Lerner this was full employment and price stability – and then use whatever means are deemed most constructive, given the goal. As the EUR-11 “possess none of the instruments of macro-economic policy, their political choice is confined to relatively minor matters of emphasis – a bit more education here, a bit less infrastructure there” (Godley, 1992, p. 39). There are, perhaps, only two ways to regain control of the economic steering wheel.27 First, the institutional arrangements could be reformed. For example, the ECB (or a newly established lending institution) could be required to aid member states in their pursuit of a broad set of policy objectives by assisting in the coordination of monetary and fiscal policy. This has been proposed by Arestis et al. (2000), Sawyer (1999), and Kregel (1999). The crucial point is that member states

Common currency lessons from Europe 87 need to be able to avert the financial constraint imposed under Article 104. This would enable them to regain control over their individual steering wheels. Second, the EUR-11 could unite politically. As Godley suggests “the counterpart of giving up sovereignty should be that the component nations are constituted into a federation to whom their sovereignty is entrusted” (1992, p. 40). Under political union, the power to tax would be transferred to the EU, and its budget could be used to coordinate policy according to the principles of Functional Finance. This, essentially, means allowing a federated European government to control the economic steering wheel on behalf of the entire EUR-11. Either way, it seems that the link between control over money and control over policy must be reestablished if nations are to recapture control of their economic steering wheels. Countries considering a currency union of their own should study the European experiment carefully, so as not to find themselves unable to steer their economies in the future.

Notes 1 I say ‘most’ because the system tended to fail about 10 percent of the time. Burned vehicles and dead motorists were efficiently deposited in nearby fields. 2 The “eurozone” (or EUR-11) refers to the geographic territory throughout which the euro has been adopted. This geographic area includes Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. The countries within the European Union that opted out of EMU – Sweden, Denmark, Norway, and the UK – retain the power to conduct independent monetary policy. 3 For an alternative perspective, see Goodhart (1996a), in which it is argued that a single currency is not a necessary consequence of a single market. 4 Although eleven countries have adopted the euro, Alan Meltzer argues that it is not really Europe (as a whole) but France and Germany (in particular) that are important. Specifically, he calls EMU “a way to bind France to Germany and Germany to France” (1997, p. 17). 5 Mundell received the Nobel Prize in Economics, in part for his 1961 article on “optimum currency areas.” 6 Although our purpose is to provide insight into the decision to adopt a common currency (i.e. a monetary union), this also sheds light on the decision to adopt a common economic policy. The idea of a one-size-fits-all policy follows from the idea of factor mobility. Thus, as long as factors are viewed as sufficiently mobile, there is a symbiotic relationship between an OCA and an EMU. Peter Coffey, who is critical of this conclusion, points out that an optimum currency area is different from an economic and monetary union. The former implies the linking of individual currencies through fixed exchange rates, while the latter implies “common economic, fiscal and monetary policies as well as a common currency” (1977, p. 41). In Coffey’s view, it does not necessarily follow that an optimum currency is conducive to a full economic and monetary union. 7 As Meltzer notes, another reason for maintaining fiscal power at the national level may have to do with the fact that “Europe, or even Germany and France, are unwilling to mention political union or federation as a feasible near-term prospect” (1997, p. 17). 8 Both views are incompatible with Functional Finance, which views the reliance on

88 Stephanie Bell

9

10 11

12 13 14 15

16

17 18

19 20 21 22

unfettered markets and the opposition to discretionary fiscal policy as conceptually similar to the removal one’s hands from an automobile’s steering wheel. The ESCB “denotes all the central banks in the European Union that have access to Target, and includes not only the European Central Bank and the 11 euro-area central banks, but also the central banks of England, Sweden, Denmark and Greece” (Weller, 1999, p. 43). In October 1998, price stability was defined as “a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below 2%” (ECB). Among the more conspicuous duties often conferred upon governments, but for which the ESCB bears no responsibility, are the pursuit of high rates of growth and employment and a responsibility to act as “lender-of-last-resort” in times of crises. For this reason, many economists (Arestis and Sawyer, 1998; Zaretsky, 1998; Kregel, 1999; Parguez, 1999; Lemmen and Goodhart, 1999) have been critical of the duties with which the ESCB has been charged. The NCBs will continue to perform many of their original functions, but they “now engage in monetary policy operations only when and as instructed by the ECB” (Stevens, 1999, p. 1). Unlike the Federal Reserve, Stevens argues that the ECB lacks “a deep market for securities in which to conduct policy operations,” requiring it to operate in a variety of public and private debts (1999, p. 2). Use of the standing facilities is subject to the fulfillment of certain access criteria. The reserve requirement went into effect at the beginning of stage 3. The requirement has been set at 2 percent of the individual credit institution’s liabilities. The liabilities against which credit institutions must hold reserves include: overnight deposits, deposits with an agreed maturity or period of notice of up to two years, debt securities issued with an agreed maturity of up to two years and money market paper ([email protected]). A lump-sum allowance of 100,000 euros can be deducted from this amount in order to determine the final reserve requirement. Under the ESCB’s requirements, “compliance with reserve requirements is determined on the basis the average of the end-of-calendar-day balances on the counterparties’ reserve accounts over a one-month maintenance period” (http://www.ect.int/pub/ pdf/gedo98eu.pdf). France was chosen because official documents (in English) were easily obtainable, not because the French government is unique in its commitment to fiscal restraint. The French, then, are pursuing a balanced budget over the course of the business cycle. Interested readers are encouraged to consult a paper on the Australian experience by George Argyrous (1998), in which it is argued that “trying to eliminate a deficit and force a surplus through outlay reductions biases the business cycle downward so that on average a deficit persists” (p. 9). Currently, public spending is over 50 percent of GDP. Despite the Council’s stated objectives, Kregel (1999) maintains that the Stability Pact ensures that priority is given to wage and price stability over high growth and employment. Parguez actually argues that the Stability and Growth Pact “leads to the conclusion that fiscal surpluses should be the rule to enhance the value of the currency” (1999, p. 66). The limits are referred to as arbitrary because there was no technical (or even theoretical) reason for choosing 3 percent and 60 percent as the upper limits for the deficit-to-GDP and debt-to-GDP ratios. Indeed, as Bean (1992) notes, the limits were chosen primarily because 3 percent and 60 percent happened to be close to the average that prevailed when the Treaty was signed.

Common currency lessons from Europe 89 23 As we will see, Mosler’s position derives from the relative importance he places on the third form of fiscal constraint – the one imposed by financial markets. 24 Parguez calls the suppression of any interference in the process of money creation the “sine qua non condition for the ability of the ECB to impose the Euro” (1999, p. 65). 25 Governments can attempt to match these rising expenditures by raising tax rates or by permanently reducing their non-interest outlays (or some combination of these). 26 Jordan’s scenario is perhaps highly implausible since it is widely recognized that labor has been extremely immobile within the eurozone. 27 Abandoning the euro is not considered an option, since Europe’s rules bar any country from doing so.

References Argyrous, George (1998), “Can Expenditure Cuts Eliminate a Budget Deficit? The Australian Experience.” Levy Institute, Working Paper 248, pp. 1–11. Arestis, Philip and Malcolm Sawyer (1998), “Prospects for the Single European Currency and Some Proposals for a New Maastricht,” draft manuscript. Arestis, Philip, Kevin McCauley, and Malcolm Sawyer (2000), “An Alternative Stability Pact for the European Union,” Jerome Levy Economics Institute, Working Paper 296. Bean, Charles (1992), “Economic and Monetary Union in Europe,” Journal of Economic Perspectives, Vol. 6 (Fall), pp. 31–52. Bell, Stephanie (2000), “Do Taxes and Bonds Finance Government Spending?” Journal of Economic Issues, Vol. 19, No. 3, pp. 603–20. Coffey, Peter (1977), Europe and Money, London: Macmillan. Coffey, Peter (1993), “The European Monetary System and Economic and Monetary Union,” in Peter Coffey (ed.), Main Economic Policy Areas of the EC – After 1992, Fourth Revised Edition, Dordrecht: Kluwer Academic Publishers. Corden, W. M. (1972), “Monetary Integration,” in Essays in International Finance, Princeton, NJ: Princeton University Press. Eichengreen, Barry and Jurgen von Hagen (1995), “Fiscal Policy and Monetary Union: Federalism, Fiscal Restrictions, and the No-Bailout Rule,” in Horst Siebert (ed.), Monetary Policy in an Integrated World Economy, Ann Arbor: University of Michigan Press. Eudey, Gwen (1998), “Why is Europe Forming a Monetary Union?”, Business Review (November/December). http://www.phil.frb.org/files/br/brnd98ge.pdf European Central Bank (1998), “The Quantitative Reference Value for Monetary Growth,” press release, 13 October 1998. European Central Bank (1999), Monthly Bulletin, July 1999 European Commission (1990), European Economy 44, Brussels. Fazzari, Steven (1993), “Investment and U.S. Fiscal Policy in the 1990s.” Jerome Levy Economics Institute, Working Paper 98. Fleming, J. M. (1971), “On Exchange Rate Unification,” Economic Journal (September). Fleming, J. M. (1999), “Functional Finance and Full Employment: Lessons from Lerner for Today,” Journal of Economic Issues. Vol. 33, No. 2, pp. 475–82. French Republic (1998), “Multi-annual Public Finance Program to the Year 2002: A Strategy for Growth and Employment,” at ftp://ftp.oat.finances.gouv.fr/pub/ 2002us.pdf

90 Stephanie Bell Godley, Wynne (1992), “Maastricht And All That: Letter from Europe,” London Review of Books, Vol. 14, No. 19 (October). Godley, Wynne (1997), “Curried EMU – the Meal that Fails to Nourish,” The Observer, 31 August. Goodhart, Charles (1996a), “The Two Concepts of Money and the Future of Europe,” unpublished paper. Goodhart, Charles (1996b), “The Approach To EMU,” in Peter Kenen (ed.), Making EMU Happen. Problems and Proposals: A Symposium, Princeton, NJ: Princeton University International Finance. Goodhart, Charles (1996c), “European Monetary Integration,” European Economic Review, Vol. 40, pp. 1083–90. Goodhart, Charles (1998), “The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas,” European Journal of Political Economy, Vol. 14, pp. 407–32. Helleiner, Eric (1997), “One Nation, One Money: Territorial Currencies and the Nation State,” at http://www.sv.uio.no/arena/publications/wp97–17.htm Hughes-Hallet, Andres and Andrew Scott (1993), “The Fiscal Policy Dilemmas of Monetary Union,” in Peter Coffey (ed.), Main Economic Policy Areas of the EC – After 1992, Fourth Revised Edition, Dordrecht: Kluwer Academic Publishers, pp. 65–101. Issing, Otmar (1997), “A German Perspective on Monetary Union,” in A Single European Currency?, Washington DC: AEI Press, pp. 7–12. Jordan, Jerry L. (1997), “Money, Fiscal Discipline, and Growth,” Federal Reserve Bank of Cleveland, 1 September. Kenen, Peter B. (1969), “The Theory of Optimum Currency Areas,” in R. A. Mundell and A. K. Swoboda (eds), Monetary Problems of the International Economy, Chicago: Chicago University Press. Kenen, Peter B. (1995), Economic and Monetary Union in Europe: Moving Beyond Maastricht, Cambridge: Cambridge University Press. Kregel, Jan (1999), “Currency Stabilization Through Full Employment: Can EMU Combine Price Stability With Employment and Income Growth?,” Eastern Economic Journal, Vol. 25, pp. 35–47. Lemmen, Jan J. G. and Charles A. E. Goodhart (1999), “Credit Risks and European Government Bond Markets: A Panel Data Econometric Analysis,” Eastern Economic Journal, Vol. 25, No. 1 (Winter), pp. 77–107. Lerner, Abba P. (1941), “The Economics of the Steering Wheel,” The University Review, June, pp. 2–8. Lerner, Abba P. (1943), “Functional Finance and the Federal Debt,” Social Research, Vol. 10, pp. 38–51. Magnifico, G. (1973), European Monetary Unification. London: Macmillan. McKinnon, R. I. (1963), “Optimum Currency Areas,” American Economic Review, Vol. 53. Meltzer, Alan H. (1997), “An American Perspective on Monetary Union,” in A Single European Currency?, Washington DC: AEI Press, pp. 13–21. Meltzer, Alan H. (1999), The Launching of the Euro: A Conference on the European and Monetary Union, Annandale-on-Hudson, The Bard Center. Mosler, Warren (1999), The Launching of the Euro: A Conference on the European and Monetary Union, Annandale-on-Hudson, The Bard Center.

Common currency lessons from Europe 91 Mundell, R. A. (1961), “A Theory of Optimum Currency Areas,” American Economic Review, Vol. 51, pp. 657–65. Nolling, Wilhelm (1993), Monetary Policy in Europe after Maastricht, New York: St. Martin’s Press. Onida, F. (1972), The Theory and Policy of Optimum Currency Areas and their Implications for the European Monetary Union, St. Louis: SUERF. Parguez, Alain (1999), “The Expected Failure of the European Economic and Monetary Union: A False Money Against the Real Economy,” Eastern Economic Journal, Vol. 25, pp. 63–76. Pasinetti, Luigi L.(1997), “The Myth (or Folly) of the 3% Deficit/GNP Maastricht ‘Parameter’,” unpublished paper. Presley, J. R. and C. E. J. Dennis (1976), Currency Areas: Theory and Practice, London: Macmillan. Sawyer, Malcolm (1999), “Minsky’s Analysis, the European Single Currency, and the Global Financial System,” The Jerome Levy Economics Institute, Working Paper 266, pp. 1–18. Semmler, Willi (1999), “The European Monetary Union: Success or Failure in Practice?” January, draft. Spiegel, Mark M. (1997), “Fiscal Constraints in the EMU.” Federal Reserve Bank of San Francisco, Economic Letter, No. 97–23, 15 August, at ttp://www.frbsf.org/econsrch/ wklyltr/e197–23.htm Stevens, Ed. (1999), “The Euro,” Federal Reserve Bank of Cleveland, 1 January, at http:// www.clev.frb.org/Research/com99/0101.pdf Taylor, Christopher (1999), “Payments Imbalances, Secession Risk and Potential Financial Traumas in Europe’s Monetary Union,” draft manuscript. Torrent, Ramon (1999), “Whom is the European Central Bank the Central Bank of?: Reaction to Zilioli and Selmayr,” Common Market Law Review, Vol. 36, pp. 1229–41. Vaclav, Klaus (1997), “European Monetary Union and its Systemic and Fiscal Consequences,” in A Single European Currency? Washington DC: AEI Press, pp. 1–6. Weller, Benedict (1999), “Special Feature: The Euro in the World Economy,” Central Banking, Vol. 9, No. 3, pp. 39–45. Zaretsky, Adam M. (1998), “Yes, This EMU Will Fly, But Will it Stay Aloft?” Federal Reserve Bank of St. Louis, at http://www.stls.frb.org/publications/re/1998/c/rel1998c3.htm

6

Monetary policy in a non-optimal currency union Lessons for the European Central Bank Thomas Palley

Introduction Does not being an optimum currency area matter for monetary policy?1 Since January 1999 eleven countries in Europe (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Portugal, Spain, and the Netherlands) have shared a common currency. Prior to the formation of this union, there was extensive debate over whether the eleven constituted an optimal currency area. The general consensus was that by the standards laid out in the Mundell (1961) – McKinnon (1963) – Kenen (1969) literature on optimum currency areas, they did not.2 However, despite this, European politicians still concluded that a currency union was worthwhile because of the political benefits it stood to confer. With currency union now in place, debate over whether or not the euro region is an optimum currency area has receded. The thinking is that a currency union is now in place, there will be problems from not being an optimum currency area, but Europe will just have to live with this fact and move on. This attitude is reflected at the new European Central Bank (ECB) where policy debate has moved on to the issue of building policy credibility. Thus, much attention has been paid to institutional design issues concerned with establishing policy accountability and the desired extent of policy transparency. In addition, there has been debate over whether the ECB should adopt a policy of inflation targeting, and if so what that target should be. The outcome has been the adoption of an inflation target for the euro area “harmonized index of consumer prices” (HICP) of below 2 percent – a target that is very similar to that earlier adopted by the Bundesbank. In the debate over what the inflation target should be, no mention has been made of the fact that the euro region is not an optimum currency area.3 In effect, the debate has been conducted as if the issue of whether or not euroland is an optimum currency area does not matter. The implicit assumption has been that once a currency union is in place, monetary policy should be conducted without regard to this question. Consequently, the concerns and practices of the ECB should be the same as those of a monetary authority operating in an optimum currency area. This view is directly reflected in the ECB’s willingness to adopt an inflation target that

Monetary policy in a non-optimal currency union 93 was earlier used by the Bundesbank for just Germany, despite the fact that the euro now encompasses eleven economies. This chapter challenges this assumption, and argues that monetary policy in a non-optimum currency area must differ significantly from monetary policy in an optimum currency area. Formation of a non-optimal currency area shifts the Phillips curve right and worsens the inflation–unemployment tradeoff confronting the monetary authority. This in turn implies that the inflation target in a nonoptimum area must be set at a higher level to avoid higher unemployment. In terms of the ECB’s current operational practice, it implies that the target of less than 2 percent inflation is too low. Whereas such a target might have been appropriate for Germany alone, it is not appropriate for the euro area and will likely consign the euro region to permanently excessive unemployment. Lastly, the chapter has important implications for discussions regarding enlargement of the euro area. To the extent that enlargement worsens the non-optimality of the euro as a currency area, it further worsens the ECB’s inflation–unemployment tradeoff. Preventing unemployment from rising will therefore require an even higher inflation target.

The economics of optimum currency areas revisited The traditional approach to optimum currency areas has focused on microeconomic concerns. On the supply side, attention has focused on factor markets and the mobility of factors across geographic regions. The more geographically mobile factors are, the more regions correspond to an optimum currency area. The argument is that if factors move between regions in response to regional imbalances, there is no need for an exchange rate to perform the function of ensuring full employment by adjusting relative regional prices. Instead, full employment is achieved by factors moving to where demand is, rather than by exchange rate adjustment that brings demand to where the factors are. On the demand side, regions correspond more closely to an optimum currency area the greater the extent of interregional trade and the greater the degree of product market integration. In this case, there is no need for exchange rate adjustment to bring demand to producers, since producers follow market demand of their own will. The force behind this process is profit maximization. When demand is stronger and prices are higher in one market, this presents profit opportunities that induce firms to redirect output to that market with higher prices. Thus, the combination of the price system and the profit motive ensures that producers find demand, so that there is no need for relative price adjustment via exchange rates to create demand for producers in the low demand region. Indeed, the existence of different currencies could even impede this process by introducing currency conversion costs that make it more difficult to sell across regions, thereby reducing product market integration.

94 Thomas Palley

Price A

>

>

In addition to these microeconomic factors there are also macroeconomic factors that matter for whether a set of countries constitutes an optimum currency area. In an optimum currency area countries should experience broadly similar business cycles, with expansions and contractions occurring simultaneously across the regions. Moreover, not only must the “timing” of cycles be similar, but so too must the “amplitude.” Currency unions involve countries giving up their own interest and exchange rates, so that they cannot use these variables to offset demand shocks. If a currency union is to work, demand shocks in the member countries should therefore be of similar timing, magnitude, and direction so that there is no need for country-specific adjustment of interest and exchange rates. The problem of demand shocks in a currency union is illustrated in Figures 6.1 and 6.2. Consider two economies in which the aggregate supply schedules are Lshaped, becoming vertical at the full employment level of output. In Figure 6.1, countries A and B are subject to synchronized positive demand shocks of the same magnitude, and a common monetary policy can therefore be used to offset the shock. This contrasts with Figure 6.2 in which country A is subject to a negative demand shock, while country B is subject to a positive demand shock. In this situation, if the monetary authority seeks to offset the negative shock in A, it amplifies the inflationary shock in B. Conversely, if it seeks to offset the expansionary shock in B, it amplifies the contractionary shock in A. No economy is ever a perfect optimum currency area since there always exist local differences in demand conditions, and markets are imperfectly integrated owing to factor mobility frictions and goods transportation costs. That said, some economies are closer to being optimum currency areas than others. Thus, the US is widely viewed as an optimum currency area, while euroland is not. Over time, euroland can expect to become more integrated owing to increased factor mobility, increased financial and product market integration, and elimination of foreign SA

Price B

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Figure 6.1 Price and output impact in two countries subject to synchronized positive demand shocks of the same magnitude.

Price A

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Monetary policy in a non-optimal currency union 95 SA

Price B

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Figure 6.2 Price and output impact in two countries when country A is subject to a negative demand shock, and country B is subject to a positive demand shock.

exchange uncertainty.4 However, in the meantime there is the question of how Europe should conduct monetary policy given that it is not an optimum currency area. On this issue there is little theoretical guidance.

Monetary policy in currency unions that are not optimal currency areas The above construction of the problem of macroeconomic management in a currency union has important implications for central bank behavior. In an earlier paper (Palley, 1994), I presented a model of a multisector economy in which there is a long-run negatively sloped Phillips curve that offers policymakers a permanent tradeoff between inflation and unemployment.5 This model can be applied to analyze monetary policy in a currency union; only different sectors are now identified as countries. The logic of the inflation–unemployment tradeoff is as follows. A currency union consists of many countries. Each country is characterized by a degree of downward nominal wage rigidity, and countries are also subject to random demand shocks.6 In countries with unemployment, nominal demand is too low. Restoration of full employment therefore calls for price and nominal wage reductions, but this process is slow and contested so that unemployment will persist.7 An alternative to countryspecific nominal wage reduction is to increase aggregate nominal demand, but this increases nominal demand in all countries. As a result, employment increases in those countries with unemployment, but prices and nominal wages rise in those countries at full employment. This adjustment process is illustrated in Figure 6.3. Initially, country A is short of demand and has excess capacity and unemployment, but country B is at full

>

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96 Thomas Palley Price A

Price B SA

DA

Sa

Da

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Figure 6.3 Price and output impact of an expansion in aggregate nominal demand in a two-country currency union.

employment. Expanding aggregate nominal demand increases demand in both countries, and shifts both countries’ demand schedules to the right. In country A the increase in nominal demand translates into a pure output and employment gain; in country B it translates into price and nominal wage increases, and the increase in nominal wages raises the floor of the supply curve.8 Figure 6.3 provides a static glimpse into the microfoundations of the Phillips curve. If there were no further shocks to the two economies, the monetary authority could simply expand nominal demand until both were at full employment. However, in reality there are ongoing demand shocks, and this means that unemployment is constantly reemerging. Countries that were at full employment suffer negative shocks so that they have unemployment, and dealing with this requires new demand injections. By having nominal demand grow at a steady pace, the monetary authority can offset the impact of new demand shocks. In effect, it introduces a “nominal demand drift” that has each country’s demand curve steadily drift up. This drift offsets the impact of each period’s negative demand shocks and reduces unemployment. But it also amplifies the impact of each period’s positive demand shocks, which increases inflation in countries at full employment. Faster nominal demand growth strengthens this drift factor, offsetting more of the unemployment impact of negative demand shocks, and further amplifying the inflation impact in countries at full employment, hence the existence of a long-run negatively sloped Phillips curve as shown in Figure 6.4. Each point on the Phillips curve corresponds to a different rate of aggregate nominal demand growth, with points of higher inflation corresponding to higher rates of nominal demand growth. The long-run rate of unemployment depends on the rate of nominal demand growth, and the long-run rate of inflation is equal to the rate of nominal demand growth minus the average rate of productivity growth.9 The location of the Phillips curve in Figure 6.4 depends on the variance of demand

>

Monetary policy in a non-optimal currency union 97

Price A

Unemployment rate

>

Figure 6.4 The long-run Phillips curve.

shocks across countries. As the variance of these shocks increases, the Phillips curve will shift to the right, so that there will be a higher rate of unemployment for any given rate of inflation. The logic of this shift is readily understandable in terms of the reverse L-shaped supply diagrams shown in Figure 6.3. If the variance of crosscountry demand shocks is small, the two countries’ demand curves will tend to be close together. Consequently, a low growth of nominal demand will be sufficient to offset negative country demand shocks and keep both economies close to full employment (i.e. low unemployment). It also means that inflation will be low since low nominal demand growth means there will be little additional inflation pressure in the economy at full employment. Conversely, if the variance of demand shocks is large, then one economy will have high unemployment and the low rate of nominal demand growth will do little to offset this. Consequently, there will be more unemployment for each rate of inflation. The above construction of the Phillips curve has important implications for the conduct of monetary policy in a currency union. The bottom line is that monetary policy in a currency union needs to take account of the structural factors impacting the optimality of the currency area. The critical parameter is the variance of country demand shocks. An optimum currency area can be thought of as a group of countries in which the cross-country variance of demand shocks is small. A non-optimal currency area is one in which the variance of cross-country demand shocks is large. The fact that the euro area is likely not an optimum currency area suggests that its formation has increased the variance of country demand shocks. The impact of this is shown in Figure 6.5. Prior to the formation of the euro, the representative country monetary authority confronted a Phillips curve denoted PC1. After the formation of the euro, which merged eleven different economies into one currency area, the new European Central Bank confronts a euro-area Phillips curve denoted by PC2.

>

98 Thomas Palley

2% PC2

PC1

UGER

UEURO

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Unemployment rate

Figure 6.5 The impact of an imperfect currency on the Phillips curve.

The policy implications of this changed circumstance are clear. When the Bundesbank pursued an inflation target of 2 percent, the resulting unemployment rate was UGER. If the ECB persists with this same inflation target, the resulting euro area unemployment rate will be UEURO. Consequently, if the ECB is to prevent an increase in the euro area’s equilibrium unemployment rate, it will need to adjust its inflation target upward. Whether this increase needs to be temporary or permanent depends on how economic relations and practices within the euro area change as a result of the creation of the euro. If they change in a manner that has the euro area more closely resemble an optimum currency area, then the Phillips curve will shift back to the left. In this event, the ECB will be able to lower its inflation target without negative consequences. However, such structural changes will take years, and this argues for an inflation target above the current 2 percent level for the foreseeable future. Last, the above analysis has implications for discussions concerning enlargement of the euro area to incorporate the UK, Greece and the Scandinavian economies (Denmark, Sweden, Norway). To the extent that such enlargement worsens the non-optimality of the euro as a currency area, it will further worsen the inflation– unemployment tradeoff facing the ECB.10 If enlargement occurs under this condition, it would argue for an even higher inflation target to keep the equilibrium unemployment rate from rising further.

Conclusion This chapter has focused on the question of how monetary policy should be conducted in a non-optimal currency area, and argued that this requires higher

Monetary policy in a non-optimal currency union 99 inflation to avoid higher unemployment. This finding has important implications for the ECB’s conduct of monetary policy, since it is widely agreed that the euro area is not currently an optimum currency area. Yet the ECB is conducting policy as if the euro area were an optimum currency area, as reflected in its 2 percent inflation target which corresponds roughly to the target used by the old Bundesbank when it set policy for just Germany. The chapter also has implications for plans to enlarge the euro to include the UK, Greece, and Scandinavia (Denmark, Sweden, Norway). To the extent that these economies march to a drum that differs from that of the euro economy, this will aggravate the non-optimality of the euro area. To prevent unemployment from rising further, the ECB will have to increase its inflation target even more.

Notes 1 This paper is based upon a longer paper (Palley 2000) that presents a formal theoretical model deriving a long-run negatively sloped Phillips curve. The paper shows how an imperfect currency union, which widens the dispersion of country demand shocks, will worsen the inflation–unemployment tradeoff. It also presents empirical evidence showing that expanding the euro area to include all European Union countries would widen the dispersion of country demand shocks. 2 See Bayoumi and Eichengreen (1993). They report that the group of eleven does not constitute an optimum currency area, but there is also a group of countries centered around Germany that could plausibly constitute an optimum currency area. 3 See Angeloni, Gaspar, and Tristani (1999) who provide an insider’s account of the monetary policy strategy of the ECB. Gaspar is the Director General of Research at the ECB, and their article contains no mention of optimum currency area considerations. This absence is likely furthered by understandable institutional considerations whereby the ECB has a political vested interest in denying that the euro is not an optimal currency area. 4 See Rose (1999) for evidence that the creation of a currency union leads to greatly increased cross-country trade, thereby endogenously contributing to the creation of an optimum currency area. 5 This model is a formalization of a descriptive model outlined by Tobin (1972) in his presidential address to the American Economics Association. Akerlof, Dickens, and Perry (1996) have presented a similar model of the Phillips curve. The principal difference is that instead of describing the economy in terms of sectors, they describe it in terms of monopolistically competitive firms. In their model the allocation of demand across firms also depends on relative prices. 6 There is no need for complete downward rigidity of nominal wages. All that is needed is that the adjustment process in response to unemployment be sluggish (see Palley, 1994). 7 Even if nominal wages were perfectly flexible downward, it is still possible that this might be unable to restore full employment owing to adverse debt effects (Palley, 1999). 8 This type of analysis applies to national economies as well. For instance, in the US there is considerable variation of unemployment rates by state, and within each state there is variation by county. Attempts by the Federal Reserve to expand economic activity

100 Thomas Palley through monetary policy confront the problem of causing inflation in some regions and output gains in others. The same problems also confront the Bank of Canada. 9 A formal derivation of this proposition is provided in Palley (1996, Chapter 12). 10 Palley (2000) presents evidence that suggests having the UK join the euro would worsen it as an optimal currency area, but this is not the case for the Scandinavian countries.

References Akerlof, G. A., W. T. Dickens, and G. L. Perry (1996), “The Macroeconomics of Low Inflation,” Brookings Papers on Economic Activity, Vol. 1, pp. 1–76. Angeloni, I., V. Gaspar, and O. Tristani (1999), “The Monetary Policy Strategy of the ECB,” in D. Cogham and G. Zis (eds), From EMS to EMU, London: Macmillan. Bayoumi, T., and B. Eichengreen (1993), “Shocking Aspects of European Monetary Union,” in F. Torres, and Francisco Giavazzi (eds), The Transition to Economic and Monetary Union, Cambridge: Cambridge University Press, pp. 193–240. Kenen, P. (1969), “The Theory of Optimum Currency Areas: An Eclectic View,” in R. Mundell and A. Swoboda (eds), Monetary Problems of the International Economy, Chicago: University of Chicago Press, pp. 41–60. McKinnon, R. (1963), “Optimum Currency Areas,” American Economic Review, Vol. 53, pp. 717–25. Mundell, R. (1961), “The Theory of Optimum Currency Areas,” American Economic Review, Vol. 53, pp. 657–65. Palley, T. I. (1994), “Escalators and Elevators: A Phillips Curve for Keynesians,” Scandinavian Journal of Economics, Vol. 96, pp. 111–16. Palley, T. I. (1996), Debt, Distribution and the Macro Economy: Post Keynesian Economics, London: Macmillan. Palley, T. I. (1999), “General Disequilibrium Analysis with Inside Debt,” Journal of Macroeconomics, Vol. 21 (Fall ), pp. 785–804. Palley, T. I. (2000), “Monetary Policy in Imperfect Currency Unions: Lessons for the European Central Bank,” AFL-CIO Public Policy Department Technical Working Paper T032, Washington DC. Rose, A. K. (1999), “One Money, One Market: Estimating the Effect of Common Currencies on Trade,” NBER Working Paper 7432, December. Tobin, J. (1972), “Inflation and Unemployment,” American Economic Review, Vol. 62, Nos. 1/2, pp. 1–18.

7

The “balanced budget multiplier” for the small open economy in a currency union or for a province in a federal state Markus Marterbauer and John Smithin1

Introduction The purpose of this chapter is to develop further work originally reported in Marterbauer and Smithin (2000). The issues raised in that paper had to do with the restrictions on, and remaining scope for, nationally based fiscal policy initiatives for a small open economy (SOE) within the framework of a currency union. Similar questions, of course, have also traditionally arisen in the context of existing federal states with a common currency, under the general rubric of fiscal federalism. In Marterbauer and Smithin (2000) and Marterbauer (2000a) much of the discussion revolved around both the implicit as well as the explicit constraints on fiscal policy, which are entailed in such arrangements. The former have to do with the greatly increased market pressures for equalization of tax rates, which arise when product and capital markets become integrated, and the possibility of exchange rate adjustment is lost. The latter, on the other hand, seem frequently to be tied in to the treaties and protocols governing the political arrangements. The obvious example in the case of the European Economic and Monetary Union (EMU) is the so-called Pact for Stability and Growth, and subsequent developments. Marterbauer and Smithin (2000) interpret this as virtually imposing a balanced budget requirement on fiscal policy initiatives, thus (perhaps ironically) creating an environment similar to that described in the “old Keynesian” textbooks regarding the “balanced budget multiplier” (cf. Ackley 1978, pp. 195–7). In this chapter, we show that there are in fact certain circumstances and conditions in which a balanced budget fiscal expansion by a political jurisdiction lacking a sovereign currency can “work,” in the sense of promoting increased growth and employment. We are also able to show the general limits to such a policy initiative. We do not believe, however, that this in any way strengthens the case for a country such as Canada, which currently has a floating exchange rate and a sovereign currency, to negotiate a North American monetary union (NAMU) or

102 Markus Marterbauer and John Smithin simply to accept “dollarization.”2 Under such arrangements, the implied restrictions on the freedom to maneuver in policymaking, not only in interest rate or monetary policy, but also in fiscal policy and other areas, remain so onerous that this should be one of the main considerations in the debate. There is a major caveat also in the case of jurisdictions in existing currency unions such the eurozone of the EU, or provincial jurisdictions in federations. This is simply that explicit legal/negotiated measures for coordinated reductions in both taxes and public expenditures could easily remove whatever loopholes remain for an independent policy.3

Simple national income accounting for the “domestic” and “foreign” economy The analysis relies on a simple macroeconomic production function, which we take to exist in two economies, the domestic economy and the foreign economy. The “foreign economy,” of course, may well simply be a partner in some form of commercial union, or the “rest of the union.” For the domestic economy, the production function is: Y(t) = A(t)N(t)

(7.1)

where Y(t) is aggregate output, A(t) is the average product of labor, and N(t) is aggregate labor input. However, the output actually available for sale in period t is assumed only to be that produced in the previous period (t – 1). This is intended to illustrate the fact that production and finance inevitably take time (Smithin 2001a), which must be a basic feature of any model of monetary production. Output is produced currently on the basis of expectations of future sales receipts, and the cost of financing must be adequately taken into account in any calculation of total costs. Under these assumptions, the income-based breakdown of current GDP for the domestic economy can be written as: P(t)Y(t – 1) = [1 + k(t – 1)][1 + i(t – 1)][W(t – 1)N(t – 1)][1 + T(t – 1)] (7.2) where k(t – 1) is the rate of profit generated by economic activity in the previous period (actually realized in the current period), i(t – 1) is the nominal interest rate prevailing in the last period, and W(t – 1) is the nominal wage rate in that period. All incomes are after tax, and T(t – 1) is the average tax rate. We therefore differentiate between three types of income in the functional distribution. These are profits, which are the rate of return to entrepreneurial capital, interest rates, or the rate of return to financial capital, and the wages of labor. Notice that the rate of interest is treated as an entirely different concept from the rate of profit (Smithin 2001a). Interest is the rate of return for lending financial resources, and is basically determined by the monetary authority. Profits are the return to entrepreneurs and are

The “balanced budget multiplier” 103 the outcome of economic activity. Interest rates and profits are competitive with each other in terms of income distribution. If we now use a forward-looking version of equation (7.2), take logarithms, and use equation (7.1) we obtain: p(t + 1) = k(t) + i(t) + T(t) + w(t) – a(t)

(7.3)

In this expression, lower-case symbols stand for the logarithm of the corresponding upper case variables (e.g. w = ln W), k(t) is the expected rate of profit, and p(t + 1) is the logarithm of the nominal price level expected in period (t + 1). A similar expression must also hold true for the foreign economy, where an asterisk (*) represents a foreign variable: p*(t + 1) = k*(t) + i*(t) + T*(t) + w*(t) – a*(t).

(7.4)

Subtracting equation (7.4) from equation (7.3) and rearranging will then yield a general expression illustrating the “room for maneuver” for tax policy, or the differential between domestic and foreign tax rates: T(t) – T*(t) = [a(t) – a*(t)] + [p(t + 1) – p*(t + 1)] – [k(t) – k*(t)] – [i(t) – i*(t)] – [w(t) – w*(t)]. (7.5) Equation (7.5) is true by definition, but it gains theoretical significance when it is realized that the tendency within neoclassical economics would be to appeal to various “factor price equalization” theorems, which would reduce or eliminate most of the differentials on the right-hand side of the expression. To the extent that this does not happen there would be scope for a different tax/fiscal policy. From this point of view, in fact, most of the political arrangements under discussion can themselves be seen precisely as deliberate attempts to close down these differentials, if this process was not occurring “naturally” via market forces. In general, we therefore conclude that relatively higher tax rates in the domestic economy are possible if productivity is higher than abroad, if the expected price level is higher (because this implies higher expected nominal income), or if after-tax profit rates, nominal interest rates, and after-tax wage rates are all lower than in the foreign economy (Marterbauer and Smithin 2000).

Effective demand, output, and employment Turning now to the demand side of the model, we take a fundamentally Keynesian view of the determinants of both output and employment in the domestic and foreign economies. An increase in effective demand will increase output and employment, and vice versa for a decrease in effective demand. We do not,

104 Markus Marterbauer and John Smithin however, accept that a demand expansion would necessarily only have temporary or short-run effects, as is assumed in the macroeconomics of the neoclassical synthesis. There is an impact in the long period also. In other words, it is argued that the growth of demand is one of the main prerequisites for GDP growth in both the short run and the long run. Some of the theoretical underpinnings for this view for the SOE are to be found in Smithin (2001a, 2001b). To illustrate, note that the usual demand-orientated breakdown of GDP is: Y(t) = C(t) + I(t) + G(t) + NX(t)

(7.6)

where the symbols have familiar meanings (with NX standing for net exports). The subscript t is used throughout to illustrate the point that this is the demand for output produced in t. Recall, however, that given the production/marketing lag, the actual consumption must take place in (t + 1). Now assume simple textbook forms for the consumption function, import function, etc., and use the symbols c, m, τ, to stand for the marginal propensity to consume (MPC), the marginal propensity to import (MPI), and the marginal tax rate, respectively. Suppressing intercepts, the demand-side representation therefore becomes: Y(t)[1 – (1 – τ)(c – m)] = I(t) + G(t).

(7.7)

Now divide through by Y(t – 1), and, for notational simplicity, use a composite coefficient, c⬘, to stand for (1 – τ)(c – m): [Y(t)/Y(t – 1)](1 – c⬘) = I(t)/Y(t – 1) + G(t)/Y(t – 1)

(7.8)

Now assume that investment is a function of profitability, e.g. I(t)/Y(t – 1) = ek(t), and define government expenditure (as a ratio of GDP) as G(t)/Y(t) = θ. Also note that Y(t)/Y(t – 1) = 1 + g(t), where g(t) is the real growth rate. After some rearrangement this gives: k(t) = (1 – c⬘ – θ)/e + [(1 – c⬘ – θ)/e]g(t).

(7.9)

Equation (7.9) therefore stands as a summary representation of the demand side of the model in one jurisdiction. It is upward-sloping in k,g space because the positive impact of an increase in profitability on investment is assumed to outweigh any negative impact on consumption due to a lower propensity to consume out of profits.4 There is a positive relationship between increased government expenditure and demand growth, although the same increase would tend to reduce the rate of profit for a given growth rate. The actual impact of an expansionary fiscal policy, of course, can only be inferred in the complete model.

The “balanced budget multiplier” 105

The scope for differences in tax rates between jurisdictions Now, returning to equation (7.5), we can rearrange again as follows: T(t) – T*(t) = [a(t) – a*(t)] – [k(t) – k*(t)] – [w(t) – p(t)] + [w*(t) – p*(t)] – [r(t) – r*(t)]. (7.10) This gives the result that differences in tax rates may be allowed for by differences in productivity, profit rates, real wages, and real interest rates, where relatively lower real interest rates allow for higher tax rates. In Smithin (1999) this observation was used to suggest that if technology transfer were genuinely to equalize productivity, and, also, the various factor price equalization pressures eliminated differences in after-tax profit rates and real wage rates, then the only scope left for differences in average tax rates would be difference in real interest rates. In other words (7.10) would reduce to: T – T* = r* – r.

(7.11)

Obviously in a monetary union nominal interest rate differentials vanish (Marterbauer and Smithin 2000), though real interest differentials can persist in the short term as long as inflation differentials persist.5 Relatively higher inflation in an economy within a monetary union can therefore increase the room for maneuver for fiscal policy, because it can account for differences in real interest rates, even though nominal rates are the same. In the somewhat longer term, however, inflation rates in a monetary union will presumably tend to be roughly equalized. Therefore a continuing substantial difference in inflation rates is not a factor which can be relied upon into the indefinite future. In the hypothesized conditions, exchange rate flexibility would then be the only regime in which the market pressures for equalization of tax rates could be resisted. We can see this by introducing the following definition of the (logarithm of) real exchange rate, q: q(t) = s(t) + p*(t) – p(t)

(7.12)

where s(t) is the (logarithm of) the spot exchange rate. Then, also using the basic definitions of domestic and foreign nominal interest rates, we can obtain the following expression for real interest rate differentials: r(t) – r*(t) = q⬘(t + 1) – q(t) + z(t)

(7.13)

where z(t) is a currency risk premium. Obviously z(t) is zero in a currency union or

106 Markus Marterbauer and John Smithin in a federal state, and if real exchange rates are also not expected to change (certainly nominal exchange rates cannot) the tax differential in equation (7.13) will vanish: T = T *.

(7.14)

The argument in Marterbauer and Smithin (2000), however, began from the other end of the problem, so to speak, and ruling out exchange rate flexibility (as is the case internally within EMU or a federal state) questioned whether or not, as a practical matter, the other elements in the expression for tax differentials would themselves always be equal to zero. In other words, apart from the interest differentials the difference in tax rates would be given by: T(t) – T*(t) = [a(t) – a*(t)] – [k(t) – k*(t)] – {[w(t) – p(t)] – [w*(t) – p*(t)]}.

(7.15)

So, besides nominal and real interest rates, and inflation rates, there are three other factors, namely, productivity, the rate of entrepreneurial profit, and real wages, which can potentially allow tax rates to differ, and allow for equilibrium changes in the terms of trade (1/q). From the practical point of view, the question is whether the rate of profit, real wages, and productivity can be expected to differ very much between the member states of a currency union or partner jurisdictions in a federal state. A number of arguments on these questions were put forward by Marterbauer and Smithin (2000). It was argued that productivity can be enhanced by demand-side policy measures which improve economic growth, and also by supply-side measures. In fact, it is the case that there remain substantial productivity differences between regions in a common currency area, and even in federal states, which seem to exhibit substantial persistence over fairly long periods. We also argued that there is a definite hierarchy in factor mobility, which may also allow for differences in tax policy. Financial capital is extremely mobile (we have already ruled out interest rates differentials), entrepreneurial capital is perhaps less so (and therefore more susceptible to implicit or explicit taxation), and labor arguably the least mobile. There are clearly also mobility differences within each of the categories. We did not thereby argue that the bulk of the tax burden should fall on the least mobile elements of the labor force through regressive taxation, but we did suggest that there might sometimes be a policy choice to be made in this respect. For example, wage earners who prefer an extended and high-quality general welfare system may be prepared to face relatively lower after-tax wage levels. The most important issue though, is improvement in productivity, as will be illustrated in the argument which follows.

The “balanced budget multiplier” 107

Expansionary fiscal policy in a single jurisdiction Using equations (7.3) and (7.9), the simplest version of the steady state of our model, from the point of view of the domestic jurisdiction, is given by: k = a – r – (w – p) – T

(7.16)

k = (1 – c⬘ – θ)/e + [(1 – c⬘ – θ)]/e]g.

(7.17)

In this case, we assume a given after-tax real wage rate (real wage resistance) and a given level of productivity. These loci are illustrated in Figure 7.1. Point a represents an equilibrium between the supply (or distribution) side of the economy and the demand side, with a specific combination of growth and profits. Figure 7.1 also shows the impact of an expansionary fiscal policy, which is assumed to be an increase in the parameter, θ, or the ratio of government spending to GDP. Note that because of the balanced budget requirement we must also have: dT = dθ.

(7.18)

>

However, to avoid any more complications than necessary in the graphical exposition we will assume that marginal tax rates, τ, do not change, so that equation (7.18) must be satisfied by changes in the lump-sum component of taxes, changes in tax allowances, etc. This also implies that the shifts in the schedules illustrated in Figure 7.1 are net of any demand-depressing effects of these tax changes. k

(17)

k⬘

a (16)

k⬙

b

g⬘

g⬙

g

>

Figure 7.1 The effects of an expansionary fiscal policy.

108 Markus Marterbauer and John Smithin In terms of the graphical exposition, the balanced budget expansion will reduce the intercept of equation (7.17) and flatten the slope. It will also shift equation (7.16) downwards, because of the overall increase in taxation. The upshot is a higher rate of growth, much as traditional Keynesian economics would predict. Note, however, that this also requires a fall in the after-tax rate of profit (in effect the incidence of the tax is on profits). So this result would depend, as discussed earlier, on being able to sustain a lower rate of profit in the domestic economy than elsewhere, which leads on to a number of difficult questions of political economy.

Endogenous productivity growth From the Keynesian point of view matters would be much improved if the increases in economic growth fueled by demand growth also endogenously increase productivity via economies of scale, dynamic effects, learning-by-doing, etc. It would therefore be possible to gain higher levels of productivity and GDP, and to “afford” higher tax rates than the competing economies. A sort of virtuous circle may be established as the higher tax rates themselves provide resources for improving the relevant determinants of productivity. Based on some of the empirical evidence, a reasonable specification in the present context would be the following: a(t) = a0 + vg(t – 1), v > 0.

(7.19)

This allows for exogenous “productivity shocks” and also an endogenous component whereby current productivity depends on past growth. As pointed out by Marterbauer (2000b) this is a version of Verdoorn’s law, named after Verdoorn (1949), which was also investigated by Kaldor (1966) in the 1960s.6 Symmetrically we should also allow for the possibility that growth will increase real wage demands by improving the bargaining power of labor (Smithin 2001a, 2001b). For example: [w(t) – p(t)] = w0 + hg(t), h > 0.

(7.20)

With the above modifications, the steady state of the more complex version of the model will now be: k = (a0 – w0) – r – T + (v – h)g

(7.21)

k = (1 – c⬘ – θ)/e + [(1 – c⬘ – θ)]/e]g.

(7.22)

These loci are illustrated in Figure 7.2. The most interesting case for present purposes will be v > h. Now the locus relating to income distribution (the supply

>

The “balanced budget multiplier” 109 k (22) (21)

a

b

g⬘

g⬙

>

g

Figure 7.2 The effects of an expansionary fiscal policy with variable income distribution.

side of the model) is upward sloping rather than a horizontal line. However, as drawn, it still has a flatter slope than the demand-side schedule. The main importance of this case is that an increase in growth caused by a balanced-budget demand expansion is now consistent with an increase in both real wages and the rate of profit, because productivity improves sufficiently to allow for this. The rentier share falls, although the absolute level of rentier incomes remains constant, the wage share increases, the before-tax profit share increases, and the after-tax profit share may also increase. Hence, the “political economy” of this case may be favorable to allowing the expansion to continue. Other potential scenarios, such as h < v, would also be consistent with a demand-led increase in growth, but would continue to raise difficulties in terms of the political economy of income distribution, as discussed above. Note also that once we allow for induced productivity increases, the framework would also be able to accommodate an extreme version of the “factor price equalization” case with k = k* and (w – p) = (w* – p*). In that case we would have: T – T* = a – a*

(7.22)

and the best interpretation of this in practical terms would presumably be a situation in which all of the “proceeds” of the productivity increases would be devoted to social services, public infrastructure, etc. The question obviously arises as to what, if any, are the potential limits to a balanced budget fiscal expansion in the high productivity case. The public sector cannot absorb more than 100 percent of output, for example. One way of

110 Markus Marterbauer and John Smithin determining this limit is to notice that if the slope of equation (7.21) becomes greater than that of (7.22) further increases in the ratio of public spending to GDP become counterproductive, and lead to reductions rather than increases in the rate of growth.7 Therefore, it can be argued that the limit in the more complicated of our two cases is defined by: v – h > (1 – c⬘ – θ)/e

(7.23)

which, recalling the definition of c⬘, can be expressed as: θ < 1 – (1 – τ)(c – m) + e(h – v).

(7.24)

Meanwhile, in the simpler case illustrated in Figure 7.1, the limit will be: θ < 1 – (1–τ)(c – m)

(7.25)

which involves the MPC, the MPI, and the marginal tax rate, etc. Interestingly enough, and perhaps contrary to contemporary conventional wisdom, textbooktype numbers from “Economics 101” for these magnitudes would not rule out a ratio of the public sector to GDP which is considerably higher than current norms in (say) Western Europe and North America.

Conclusion This chapter has investigated the conditions under which a balanced budget fiscal expansion is a workable policy tool for a small open economy that does not issue a sovereign currency. The obvious examples, currently, would be those member states of the EU who have adopted the euro, or provincial legislatures with tax and spending powers in federal states. The reason for focusing on the balanced budget case is that this situation is often explicitly mandated in such circumstances. In fact, a fiscal expansion can “work,” particularly if the demand-led expansion enhances domestic productivity growth. We would not, however, use this as an argument for any jurisdiction to voluntarily surrender existing monetary sovereignty, as the constraints on domestic policy initiatives remain severe. Also, we note that formal proposals for upper limits to tax and expenditure rates, in addition to restrictions on budget deficits, may rule out such initiatives in any event.

Notes 1 The authors would like to thank Jean-Guy Loranger, Warren Mosler and other participants at the Ottawa conference on North American Monetary Union, October 2000, for helpful comments and suggestions on an earlier draft of this chapter.

The “balanced budget multiplier” 111 2 A number of economists in Canada have recently advocated such as change. See, for example, Courchene and Harris (1999, 2000) and Grubel (2000). 3 In the European case, while the negotiations on tax harmonization, that is minimum standards for some tax rates and tax bases, have not shown many signs of success, the discussion on upper limits for expenditure rates and on expenditure structures has started. This shows very clearly that the political arrangements are implicitly oriented against state influence in the economy in general, and the role of social policy in particular. 4 On this issue, see the discussion by Gordon (1995). 5 In fact, in the first two years of the eurozone inflation differentials between the members did increase: e.g. to 2.5 percentage points between France and Ireland in 2000 (Marterbauer and Smithin 2000). 6 According to the evidence presented by Marterbauer (2000b), in the European case the best specification on empirical grounds for equation (7.19) would involve both lagged and contemporaneous growth terms. Clearly, however, adding an extra coefficient would not alter the qualitative results worked out below. Similar remarks would apply to the wage behavior specified in equation (7.20). 7 Actually, this case would not only be “perverse,” but also unstable. See Smithin (forthcoming).

References Ackley, G. (1978), Macroeconomics: Theory and Policy, New York: Macmillan. Courchene, T. J. and R. G. Harris (1999), “From Fixing to Monetary Union: Options for North American Currency Integration,” C.D. Howe Institute Economic Commentary, 127, June. Courchene, T. J. and R. G. Harris (2000), “North American Monetary Union: Analytical Principles and Operational Procedures,” North American Journal of Economics and Finance, Vol. 11, pp. 3–18. Gordon, D. M. (1995), “Growth, Distribution and the Rules of the Game: Social Structuralist Macro Foundations for a Democratic Economic Policy,” in G. A. Epstein and H. M. Gintis (eds), Macroeconomic Policy after the Conservative Era: Cambridge: Cambridge University Press. Grubel, H. G. (2000), “The Merit of a Canada–US Monetary Union,” North American Journal of Economics and Finance, Vol. 11, pp. 19–29. Kaldor, N. (1966) Causes of the Slow Rate of Growth in the United Kingdom, Cambridge: Cambridge University Press. Marterbauer, M. (2000a), “Fiscal Policy and the European Economic and Monetary Union,” paper presented to the GRIG conference on Public Surplus and Deficit in Federal States, Quebec City, August. Marterbauer, M. (2000b), “Economic Growth and Unemployment in Europe: Old Questions, Some New Answers,” unpublished paper, York University, Toronto. Marterbauer, M. and J. Smithin (2000), “Fiscal Policy for the Small Open Economy Within the Framework of Monetary Union,” WIFO Working Paper 137/2000, Vienna, November. Smithin, J. (1999), “Money and National Sovereignty in the Global Economy,” Eastern Economic Journal, Vol. 25, pp. 49–61.

112 Markus Marterbauer and John Smithin Smithin, J. (2001a), “Interest Rates, Profits and Economic Growth,” in E. J. Nell (ed.), Reinventing Functional Finance: Transformational Growth and Full Employment, Cheltenham: Edward Elgar. Smithin, J. (2001b), “Aggregate Demand, Effective Demand, and Aggregate Supply in the Open Economy,” in P. Arestis, M. Desai, and S. C. Dow (eds) Methodology, Microeconomics and Keynes: Essays in honour of Victoria Chick, London: Routledge. Smithin, J. (forthcoming), “The Rate of Profit, Interest, and ‘Entrepreneurship’ in Contemporary Capitalism,” Kurswechsel. Verdoorn, P. J. (1949), “Fattori che regolano lo sviluppo della produttività del lavoro,” L’Industria, Vol. 1, pp. S.3–10.

Part II

Lessons for the Americas

8

Electronic payments and exchange rate regimes Industry changes and the question of a single North American currency Brenda Spotton Visano1

Introduction Greater integration of Canadian and American markets is rendering more onerous the distributional consequences of exchange rate volatility. There exists debate around the relative significance of destabilizing currency speculation. Many are considering the benefits of greater exchange rate stability and thus seeking a solution to the problems inherent in maintaining the status quo. A single North American currency is the extreme solution. The initial successes of the euro have set the first precedent and reduced some of the associated uncertainty of this method of gaining exchange rate stability.2 The economic debate around the question of greater monetary integration hinges critically on the importance or not of retaining Canadian autonomy over monetary policy. Otherwise stated, it is a question regarding the ability of the Canadian central bank to influence independently and effectively the Canadian economy. Canadian proponents of an independent monetary regime adhere strongly to the belief that Bank of Canada actions have mattered in the past, matter in the present, and will continue to matter in the foreseeable future. Belief that a flexible (or managed) exchange rate regime is necessary to insulate the Canadian economy grounds this position. Unsurprisingly, the strongest of proponents of this position include representatives of, and those closely associated with, the bank itself. Recourse to claims of the traditional textbook benefits accruing to economies with flexible exchange rates support these arguments. (See Laidler, 1999a; Thiessen, 1999; Murray, 1999a, 1999b; Poloz, 1999; and McCallum, 1999a, 1999b, 2000; for example.) On the other side of the debate stand advocates of a single currency for Canada and the US; researchers supported by and affiliated with pro-business organizations such as the Fraser Institute argue the net benefits of monetary unification in terms of efficiency and higher aggregate welfare from greater exchange rate stability (see Grubel, 1999, for example). Courchene and Harris (1999a, 1999b, 2000) continue the logic further and suggest such integration is inevitable.

116 Brenda Spotton Visano The precise means by which the Canadian central bank influences the Canadian economy is unclear. Not yet satisfactorily validated or quantified are claims that recent financial market developments have left unaltered the traditional transmission mechanism. The central bank’s influence over expectations of future asset values and commodity prices, via its public relations activities and announcements, is very possibly significant. However, these too remain incompletely specified. By whichever means the central bank may be influencing the macroeconomy, consensus opinion holds that central bank influence, in Canada as elsewhere, derives fundamentally from a central bank monopoly over the ultimate and final means of payment.3 The primary question for this paper is to what extent might financial innovation in the payments system be eroding the bank’s monopoly control over final settlements balances, and liquidity services both directly and indirectly through facilitating “dollarization”? This chapter offers no objectively verifiable or quantifiable answers. Instead, it offers questions together with opinion as an observationally grounded way of thinking about what the future might hold. The exercise presumes that the future may well look significantly different from the past – based on the observable fact that technological innovation in information communications is revolutionizing the financial services sector. Its industry impact is unprecedented – never before in the history of financial capitalism has innovation affected at once the structure, the process, and the content of the financial industry. The remainder of the chapter proceeds as follows. The second section describes recent innovation as it affects the nature of the payments system. The third section outlines briefly some of the issues for Canada related to the transmission of central bank influence in light of technological developments. It includes a discussion of the European Central Bank’s position on related issues. The fourth section draws into the argument the question of informal “dollarization.” The last section offers a summary and concluding opinion.

Electronic payments Advances in technologies affecting information communication have altered and continue to alter the delivery of information.4 With the possibility of transmitting electronically information in digital form, everything can change – from the manner in which people conduct business, through the organization of related industries, to the very structure of the economy and its operation. Most importantly, information communication technologies (ICTs) have altered product economies and the comparative efficiency of different financial distribution channels. In the credit and capital markets, the electronic and remote delivery of new financial products and services continue to erode the economic advantages of traditional financial institutions. Increasingly, the process of transferring funds is becoming smoother and faster with less reliance on the services of specialized

Electronic payments and exchange rate regimes 117 intermediaries and more reliance on the direct automated matching processes afforded by ICTs. An explosion in the number of new credit instruments and the relative increases in value and volatility of the associated “new economy” mark recent changes in financial market content. Payments systems Three layers of fund transfer systems comprise the payments system. The retail payments system operates to transfer funds between households and businesses. A commercial payments system encompasses the network of arrangements transferring funds from businesses to businesses. Finally, interbank payment systems operate behind the scenes to clear and settle interbank accounts. Together, these layers comprise a combination of products, processes, and networks of institutions. Typical products or media of exchange include cash, checking and checkable savings deposit balances at banks, as well as all other comparable instruments offered by non-bank, deposit-taking institutions. Payments system processes include the clearing and settlement of checks and account balances. Networks of institutions designed to transfer purchasing power have been, historically, networks of deposittaking institutions, primarily banks. Technological innovations have spawned a host of financial innovations that affect all strata of the payments system including: (1) the recent introduction of direct cash substitutes such as electronic money or “digital cash,” stored on either a “smart card” or some other electronic storage facility; (2) the small value retail payments substitutes for cash and checks afforded by the electronic funds transfer system at the point of sale (EFTS-POS); and (3) alternative, electronic means of conducting traditional retail banking activities such as those alternatives offered by automated banking machines and the internet banking options. Commercial and interbank payments systems are employing the electronic data interchange technology in the management of accounts and image processing systems technology as a means of processing those fund transfer orders initiated by checks. And financial decisions amenable to codification (such as the processing of standard loan applications) benefit from the introduction of expert system technology. The potential for competition from non-financial companies in the spheres affected by both the EDI and expert systems technologies is especially significant. (For early discussions of this possibility, see Steiner and Teixeira, 1990; Science Council of Canada, 1992.) The interbank payments system is the system designed to clear and settle accounts between different branches of the same institution, between different deposit-taking institutions within Canada, and between different deposit-taking institutions around the globe. Most core functions in this network of clearing and settlement systems are electronic, with the introduction of the automated clearinghouse system (ACHS), the large value transfer systems (LVTS), and the

118 Brenda Spotton Visano Society for World-wide Inter-bank Financial Telecommunications (SWIFT), for example. The restructuring of the financial industry that these technologies have promoted is apparent. The demand for intermediated financial services is declining as larger corporations find it possible and cost-effective to access directly financial markets and clearinghouse processes. The suppliers of monetary products and processes are increasingly non-financial companies. As the preferred monetary instruments and methods of exchanging value become increasingly electronic, non-financial suppliers of electronic products and services gain importance in those spheres traditionally monopolized by banks. Our imagination need not be limited, however, to an evolution defined simply by the straightforward replacement of the traditional payments system with its electronic twin. Nor should our imagination be limited to this if economies are witnessing any reconfiguration of the network of production and distribution channels – especially if the reconfiguration involves a greater international integration of the core economic functions that generate the need for payment. Following a brief discussion of the domestic monetary transmission process, we turn to the question of a single North American currency.

Monetary transmission mechanisms and central bank influence It is widely accepted that no central bank of a contemporary market economy controls the aggregate amount of domestic credit. Rather, it can only attempt to exert influence indirectly through its manipulation of the funds available for final settlement balances. Theoretically, there are three avenues by which central bank action influences credit conditions and real spending. One avenue relies on adjustments in the quantity of credit; a second avenue relies on adjustments in the price or cost of credit; and a third works through altering agents’ inflation expectations. Majority opinion maintains that it is the second avenue – the price linkage – that operates most effectively in contemporary developed economies such as Canada, Europe, and the United States. Through this second avenue, it is the cost of credit that influences spending decisions. Under the twin assumptions of competitive asset markets and asset substitutability, central-bank-induced changes in the shortest of money market rates (e.g. the call loan or overnight rate) induce portfolio adjustments by a wide range of investors (assuming no offsetting changes in inflation expectations). The term structure, the debt-to-equity instrument ratio, and the foreign content of investor portfolios may all be affected. Assuming these portfolio shifts are large enough to influence asset prices, the exchange rate and lending rates in the longer-term debt markets will change. Agents’ spending and investment decisions – taken in the mix between domestic and foreign-produced goods and services, and in the mix of capital versus consumption spending – will be affected.

Electronic payments and exchange rate regimes 119 If intertemporal arbitrage conditions hold across the maturity spectrum, central bank intentions may be, by themselves, important in affecting real economic activity via longer-term interest rate adjustments. If media coverage is an adequate measure of the attentions paid to central bankers, signals from Governors Dodge or Greenspan (and former Governor Thiessen) appear to be sufficient to move rates further out of the maturity spectrum. Some argue that central bank announcements to raise or lower interest rates in the future may affect longer-term rates in the present. And the Bank of Canada argues that the same applies to inflation expectations. A widely held belief that the central bank will hit its inflation targets will itself support attainment of the target inflation rate. But beliefs must be based on an independent ability to achieve the stated objective. The validity of any independent mechanism by which the Canadian central bank transmits its influence through asset markets over macroeconomic variables remains, however, unsatisfactorily demonstrated. Fictional stories about Canadian transmission mechanisms, it seems, are just that (see Spotton and Rowley, 1997). Similar challenges still face US researchers of American monetary policy.5 This says, to be clear, only that if a transmission mechanism exists, we have been incapable of validating and quantifying it to the satisfaction of some. Several problems confound the exercise. The postulated linkages are simple, linear, with causality uni-directional. In reality, it may well be that the series of links are nonlinear, evolutionary (in the sense of exhibiting path-dependencies), and complex. For example, the Bank of Canada representatives argue in support of a strict monetary interpretation of exchange rate changes only reflecting fundamental differences between Canada and the United States. In contrast, McCallum (1999b) for example, suggests a depreciating Canadian dollar may instead be the cause of a relative decline in Canadian productivity. Or it may well be that the true influence runs in both directions. More fundamentally, an identification problem challenges us: money–output correlations “conflate the effects of money on output and output on money” (see Eichengreen, 1993, p. 1331, fn25). Are financial developments eroding central bank influence? The majority of studies in Canada and elsewhere examining developments in electronic finance and the payments system restrict attention to the implications for payments risks. Consumer protection and financial stability are the two targeted policy concerns (see, for example, Payments System Advisory Committee, 1997a, 1997b, and 1997c; Group of 10, 1997; Bank for International Settlements, 1996; and Basle Committee on Banking Supervision, 1998). The Bank of Canada merely states that it “continues to monitor the pilot projects for stored-value cards that are currently under way in Canada” (Bank of Canada, 1997). Yet there may be a much larger threat to monetary arrangements, as we know them, looming from these developments.6

120 Brenda Spotton Visano Arguably, domestic disintermediation increased access to global capital markets, and the dramatic increase in foreign exchange trading have rendered impotent the actions of any one central bank in spite of a flexible or managed exchange rate policy. For the price linkage in the monetary transmission mechanism to operate successfully, the change in the yield of any one instrument (overnight loans, for example) must induce portfolio changes large enough to alter the return on financial contracts entering a given spending decision. As the relative importance or financial market share of a given financial instrument decreases, so too must the wider impact of any change in its relative price decline. And with a central bank’s influence restricted to only one or at most a handful of the shortest-term financial instruments, a decrease in the impact of a change in its relative price means a decrease in central bank influence. At a minimum, integrated financial markets have complicated the transmission mechanism immeasurably with traditional commodity trade effects of exchange rate changes interacting with asset price and debt service effects to produce unknown and unpredictable outcomes (see White, 1999). Further attenuation of isolated central bank influence is promoted by the increasing number of financial transactions escaping regulation and central authority influence. As technological advance continues to render regulated processes and products obsolete, regulation becomes increasingly outdated and sooner. With ineffective, outdated regulation, a central bank’s ability to monitor and influence financial activity is eroded. Yet some measure of influence may remain so long as the central bank can control liquidity in the system. A monopoly over final settlement balances will yield such control and exists so long as there is a need (by law or by economy or both) to clear final payment through the central bank. It is clear that central banks assume they will retain such monopoly. For example, Stuber (1996) addresses the substitution possibilities of electronic money for cash and its implications. In a very brief statement about the monetary policy implications, he states simply: “Gradual shifts in the demand for currency arising from such innovations as the electronic purse could be offset by the Bank of Canada through its control over the supply of settlements balances held by the direct clearers in the Canadian Payments Association” (Stuber, 1996, p. 30). The question is how likely it is that central banks will retain this monopoly in the future. Until recently, there has been little by way of effective alternatives to the present networks for clearing final settlement balances. The benefit of ICT innovation in the clearing and settlements processes is already evident. As mentioned above, ACHS, LVTS and the like are innovations already in place. The question then translates into how likely it is that these processes will gravitate outside of the traditional bank network and outside of central bank control. Any detailed examination of the issue will have to address specific cost and savings benefits as well as the host of non-economic influences that would impinge on any such decision.

Electronic payments and exchange rate regimes 121 Conjecturing such possibilities, there are a couple of ways a private payments and clearing system might develop. In a forthcoming paper, I contemplate the possibility of an independent transnational corporate payments system. Friedman (1999) speculates on straightforward extensions of private money schemes currently operating in Japan and the US. Finally, the Scandinavian developments in mobile phone technology – where goods and non-communication services may be purchased by electronically debiting consumers’ telephone accounts – is one significant step closer to a completely separate and closed payments system. In all possibility, firms in the network of a private money scheme would simply accept and swap balances on the books of the non-financial issuer, thus bypassing the central bank entirely. Such developments would make the traditional monetary policy debate irrelevant. For a development in the payments system to become widespread, we would need the computing power and services offered by a private-sector supplier. Culturally, perhaps motivated by cost savings, we would need a willingness on the part of financial agencies (existing or newly established) to circumvent the central bank, opting instead for electronic, privately owned, clearinghouse substitutes. As the current deputy governor of the Bank of England states: “There is no reason, in principle, why final settlements could not be carried out by the private sector without the need for clearing through the central bank” (King, 1999, p. 48). Such a development would diminish the need to clear final payment balances through the central bank and, with it, erode whatever influence the central bank now exerts. Perspective of the European Central Bank (ECB) Consideration of the ECB’s position is especially appropriate. First, by most measures, adoption and operation of electronic payments schemes is more advanced in Europe than in either Canada or the United States. Second, the ECB is the only bank I am aware of that has not swept aside the fundamental challenges potentially presented by alternative electronic payment and finance schemes. The ECB report begins from the premise that “the issuance of electronic money is likely to have significant implications for monetary policy in the future. Above all, it must be ensured that price stability and the unit of account function of money are not endangered. A significant development of electronic money could also have implications for the monetary policy strategy and the control of the operational target” (ECB, 1998, p. 1). The report considers in detail the potential for the variety of electronic means of payment and access products to develop into close substitutes for central-bankissued media of exchange. The authors consider the implications for velocity of any such developments. And finally considered is the possibility where: if electronic money were to bear interest and/or if electronic access products were to facilitate the use of interest-bearing financial assets for transaction

122 Brenda Spotton Visano purposes and were to replace non-interest-bearing assets to a large extent – in this case, the wedge between the interest paid on components of “money” and non-monetary assets would fall, thereby reducing the interest elasticity of money demand, as witnessed in previous episodes of financial innovation. (ECB, 1998, pp. 17–18) The ECB limits their interpretation of the possibilities to these potential substitute media of exchange in retail payments. They conclude that: the ECB is of the opinion that as long as there is a demand for central bank money and as long as the central bank has the position of a monopoly supplier, it will be possible for it to control a money market interest rate. On this issue, the ECB is of the opinion that there are reasons to assume that the confidence factor of central bank money and the absence of credit risk are likely to ensure that central bank money will continue to be used as the medium for interbank settlements. (ECB, 1998, p.19) An earlier report included the recommendation that only credit institutions be allowed to issue multipurpose prepaid cards or other e-money instruments. The combination of this restriction with the above perspective suggests the focus of the ECB remains on the possibility of new instruments primarily. As such, it is unsurprising that the primary concern of the ECB is with the potential future need to redefine operational monetary aggregates and targets. This is a straightforward extension of the challenge facing the Bank of Canada back in the 1980s when financial innovation (in that case the rise in the exchange importance of dailyinterest checkable savings accounts) eroded the operational importance and information value of M1. Such substitutions are an important operational issue. Yet this assumes that with appropriate redefinition of the relevant monetary aggregate, everything will work as it did before the innovation. With the possibility of both emoney schemes and the clearinghouse functions moving outside of central bank purview, to what extent will e-money substitutes for cash be wholly irrelevant?

Drifting toward market “dollarization”? As a byproduct of the large and growing integration of North American markets – goods, financial and non-financial services – McKinnon (2000, p. 110) argues that Canada is now, in effect, part of a common monetary standard dominated by the United States. “The Canadian authorities have little scope for departing significantly from this standard, which can be approximated by a credible rule for targeting Canadian domestic inflation similar to the rule used by the US Federal Reserve for targeting price inflation in the United States” (McKinnon, 2000, p. 110).

Electronic payments and exchange rate regimes 123 Courchene and Harris (1999a, 1999b, 2000) argue further (and along slightly different lines) for the inevitability of adopting explicitly the US dollar as Canada’s unit of account and medium of exchange. “Market dollarization” – the independent, individual decision by Canadian-based firms to transact using the US dollar as the unit of account – is, they claim, “alive and well.” Introducing a formal policy of adopting the US dollar (where establishment of a single currency is assumed synonymous with Canada adopting the US dollar) is then only a formal recognition of the inevitable. Moving ahead with a policy of adopting the US dollar would reduce the risk capital losses imposed on holders of C dollar-denominated assets that will eventually occur. Although Courchene and Harris leave their claim of de facto “dollarization” unsupported by any example, we need not look far to see preliminary evidence. To the chagrin of many Canadian nationalists, it is the Canadian culture industry that appears to be moving most rapidly in this direction; for example, all North American professional sports contracts are now negotiated in US dollar.7 Further, the Bank of Canada itself issues US dollar-denominated debt and the number of US dollar-denominated bank balances held by Canadians is significant. Countering this last anecdotal example, Laidler and Poschmann (2000, p. 9) claim that the degree of “dollarization” is now approximately the same as it was thirty years ago. “If we measure the degree of dollarization using data that include interbank holdings of foreign-currency deposits, the degree of dollarization in Canada now is roughly where it was in the 1970s, following a decline in the interim.” Yet such a measure will uncover only those Canadian agents (persons and businesses) who opt to negotiate in US dollar and hold deposits in a Canadian financial institution. Financial innovation makes this latter requirement, however, increasingly unnecessary and remote. A more rigorous study might entail surveying industry and firm payments operations to establish the extent of the “dollarization” phenomenon. We would be wise to resist such summary dismissals of the possibility of “dollarization.” Recourse to arguments that rely on any traditional understanding of the operation of the payments system supports potentially nothing. Innovation can render traditional statistical measures obsolete and thus conclusions derived from such statistics suspect. Financial innovation can and has radically altered cost structures. The financial system is evolving in ways and with a speed never before imaginable. As the Canadian economy becomes increasingly more integrated with the American economy and the introduction of new payments products and processes continues to alter product and scale economies in the payments system, the market “dollarization” hypothesis might best be explored further.

Conclusion Recent financial developments stemming from advances in ICTs suggest the potential of a real threat to central bank monopoly over the clearing of final settlements

124 Brenda Spotton Visano balances – a monopoly that is critical to any known story of monetary authority influence. The ECB is one central bank that has not swept aside the possibility of any real threat. It has tabled recommendations to prevent the erosion of its monopoly insofar as the creation and use of e-monies may threaten this means of ultimate settlement. Yet even it has not made, to my knowledge, comparable efforts on the clearinghouse side of its operations. What these financial developments – actual and potential – mean for the “inevitability” of “market dollarization” is even more speculative. There is evidence that “dollarization” exists. Advances in electronic finance generally, and the electronic payments system specifically, suggest that the incentives to “dollarize” may be rising. For a given exchange risk inherent in transacting in two currencies of fluctuating relative value, ICTs have introduced alternative and potentially cheaper media of exchange and clearing processes. In default of legislative action controlling and restraining some aspects of these developments, the possibility these alternatives are denominated in only one currency is real, as is the possibility that the denomination of these alternatives is the US$. The status quo, in other words, may be unsustainable. Indeed, the impact, actual and potential, of financial innovation casts doubt on any argument that presumes we will be able to maintain the status quo and would thus continue to derive the benefits the status quo has traditionally offered. Thus it follows that the traditional textbook benefits of flexible exchange rates may be increasingly doubtful as well. Is any further move toward a single North American currency desirable? Economics can contribute only a small part of the answer of this question.8 Probusiness forces are advocating the benefits of a single currency with appeals to competitive efficiencies guided by a faith in the ability of deregulated financial markets to act as an impartial and effective regulator of agents, institutions, and government. Yet financial markets are no more internally logical, rational, and free from temptations of power than the humans who comprise it. If adopting the American currency is undesirable, the implication of the above is that we may have to do more than resist policy proposals to create a single currency. If the outcome is undesirable yet potentially inevitable, then we might be well advised to turn our attentions to the question of how best to reverse this trend. The challenge before us appears to be the need to reinvent the regulations and constraints necessary to achieve socially desired outcomes in a world that has been transformed by technological innovation in information communications. Assuming no structural transformations of significance to monetary policy, defending the appearance of a status quo based on traditional concepts and models leaves us blind, and thus vulnerable to missing opportunities to manage our future. We might want to explore actively ways in which to manage financial developments to Canadian community advantage. We may want to resist further pressures to disengage in a way that serves the interests of the already powerful privileged.

Electronic payments and exchange rate regimes 125 Practically speaking, we might revisit the notion of capital controls and we might explore more openly the possibility of regulating closely electronic media of exchange and payments processes. In this era of electronic and “global” finance, the challenge to regulate anything financial is significant; yet, success would promote the restoration of that which is Canadian and with it a diminished drift toward “dollarization.”

Notes 1 An earlier version of this paper was presented at the International Conference on “The Political Economy of Monetary Integration: Lessons from Europe for Canada,” University of Ottawa, 6 October 2000. Detailed comments by Tom Rymes and discussions with Tom Palley, Robin Rowley, Tom Rymes, and Livy Visano, as well as several other conference participants, helped considerably in clarifying some of the issues. The opinions, along with any remaining ambiguities, errors of fact or argument, are mine alone. For their support, encouragement, and patience, I thank Mario Seccareccia and Louis-Philippe Rochon. 2 “But there are no precedents for Europe’s current course, in which countries with histories of monetary sovereignty and long-standing central banks establish a common central bank accountable to them jointly with control of their national monetary policies, including the power to issue a common currency. Monetary unification in Europe is thus a leap in the dark” (Eichengreen, 1993, p. 1322). 3 From a monetarist perspective, the ultimate means of payment are central-bankcontrolled bank reserves. Forming the monetary base, these reserves anchor aggregate credit and thus exert influence over its price. For an alternative, Keynesian interpretation of an anchorless banking system in which it is not the stock of base money but the flow of liquidity services that grounds prices, see Rymes (1998). If the bank rate is viewed as “the price of the services of liquidity that the central bank is providing” where the bank rate is the instrument of monetary policy, then “the price level is determined by the fact that central banks set the relative price of liquidity” (Rymes, 1998, p. 81). 4 Technological changes promoting the development and evolution of telecommunications services involve mutually enhancing advances in communications, information, computer hardware and software, and networking technologies. Advances in communication technology enhance the speed with which larger and larger volumes of data may be transferred between physically distinct parties. Information technologies give those with access to information increasingly better ways to organize, store, and retrieve data. These advances, together with advances in computer hardware and software technologies, enable increasingly larger numbers of people access to electronically communicated information. Finally, networking technology, by enabling separate systems with specialized functions to be interconnected, enhances the raw volume of information that can be processed as well as the sheer numbers of people who can have access to any one information database (see Vanasse, 1990). 5 “Today expressions of intentions by leaders of the world’s major central banks typically have immediate repercussions in financial markets, and perhaps more broadly as well . . . Central bankers’ public utterances and other, more subtle signals on such questions regularly move prices and yields in the financial markets, and these financial variables in turn affect non-financial activity in a variety of ways . . . The problem is rather that each story, while plausible enough at first or even second thought, turns out to depend on one or another of a series of by now familiar fictions . . . this central mystery notwithstanding,

126 Brenda Spotton Visano at the practical level there is today little doubt that a country’s monetary policy not only can but does largely determine the evolution of its general price level over the medium to longer run, and almost as little doubt that monetary policy exerts significant influence over aspects of real economic activity, like output and employment, over the short to medium run” (Friedman, 1999, p. 322). 6 All e-moneys are currently denominated in units of the national currency. Denominating e-money in the national unit of account is, however, merely a means to promote the initial acceptance of a new medium of exchange. There is nothing to prevent the development of distinct currency units for the purpose of effecting transactions within a community of local retailers perhaps. Whatever its denomination, e-money and emoney schemes require some form of interinstitution or intercompany clearing and settlement arrangement when trading outside the firm issuing the money. To date, most schemes have relied on existing interbank clearing and settlement arrangements to service this need. The potential for e-money to operate outside of the existing and recognized financial networks is high. In some form it does so already. Current suppliers of these e-services include vendors of specialized software and computer network operators. And the current issuers of e-money are, again, not all chartered financial institutions, but include software and internet companies. Freedman and Goodlet (1998, p. 15) raise the issue of non-financial suppliers of electronic payments and service delivery: “One big issue here is whether the software providers will create strategic alliances with the financial institutions or whether they will try to provide alternatives to them.” Their subsequent discussion of the holding company option foreshadows the proposed legislation currently before the Canadian parliament. It alludes to a belief that a holding company option will, if not encourage an outright alliance of financial with non-financial companies, at least position banks well enough to compete with unregulated commercial suppliers of payments services. 7 I thank Anthony Visano for drawing my attention to this. Crowley and Rowley (2000) address the question of dollarization from the point of view that the creation of the euro may, in time, effectively challenge US hegemony in the financial arena. 8 Georgetti (1999) and Harris (1999), for example, present political arguments opposing the adoption of the US$.

References Bank for International Settlements (1996), Implications for Central Banks of the Development of Electronic Money, Basle. Bank of Canada (1997), Annual Report, http://www.bankofcanada.ca/en/annual/ar975.pdf Basle Committee on Banking Supervision (1998), Risk Management for Electronic Banking and Electronic Money Activities, Basle: Bank for International Settlements. Courchene, T. J. and R. G. Harris (1999a), “Canada and a North American Monetary Union,” Canadian Business Economics, Vol. 7, No. 4, pp. 5–14. Courchene, T. J. and R. G. Harris (1999b), “From Fixing to Monetary union: Options for North American Currency Integration,” CD Howe Institute Commentary, 127. Courchene, T. J. and R. G. Harris (2000), “North American Monetary Union: Analytical Principles and Operational Guidelines,” North American Journal of Economics and Finance Vol. 11, No. 1, pp. 3–18.

Electronic payments and exchange rate regimes 127 Crowley, P. and R. Rowley (2000), “Battle of the Giants? The International Monetary System Post-EMU: Some Thoughts and Observations,” in C. Paraskevopoulos, A. Kintis, and T. Georgakopoulos (eds), Global Financial Markets and Economic Development, Toronto: APF Press. Eichengreen, B. (1993), “European Monetary Unification,” Journal of Economic Literature, Vol. 31, No. 3, pp. 1321–57. European Central Bank (1998), Report on Electronic Money, Frankfurt am Main: ECB. Freedman, C. and C. Goodlet (1998), “The Financial Services Sector: Past Changes and Future Prospects,” Bank of Canada Technical Report 82, March. Friedman, B. (1999), “The Future of Monetary Policy: The Central Bank as an Army with Only a Signal Corps?,” International Finance, Vol. 2, No. 3, pp. 321–38. Georgetti, K. (1999) “It Would be Folly to Adopt the U.S. Dollar,” Globe and Mail: Commentary, 2 July, p. A13. Group of 10 (1997), “Electronic Money: Consumer Protection, Law Enforcement, Supervisory and Cross Border Issues,” report of the Working Party on Electronic Money. Grubel, H. G. (1999), “The Case for the Amero: The Merit of Creating a North American Monetary Union,” Critical Issues Bulletin, Fraser Institute, September. Harris, S. L. (1999), “The Political Costs of a Common Currency,” Canadian Business Economics, Vol. 7, No. 4, pp. 31–3. King, M. (1999), “Challenges for Monetary Policy: New and Old,” in New Challenges for Monetary Policy, a symposium sponsored by the Federal Reserve Bank of Kansas, Jackson Hole, Wyoming, at http://www.kc.frb.org/publicat/sympos/1999/sym99prg.htm Laidler, D. (1999a), “The Exchange Rate Regime and Canada’s Monetary Order,” Bank of Canada Working Paper 99–7. Laidler, D. (1999b), “What do the Fixers Want to Fix? The Debate About Canada’s Exchange Rate Regime,” CD Howe Institute Commentary, 131. Laidler, D. and F. Poschmann (2000), “Leaving Well Enough Alone: Canada’s Monetary Order in a Changing International Environment,” CD Howe Institute Commentary, 142. McCallum, J. (1999a) “Canada, the euro, and the Exchange Rate Fixity,” in Current Analysis, Toronto: Royal Bank, at http://www.royalbank.com/economics/market/pdf/ current13.pdf McCallum, J. (1999b), “Seven Issues in the Choice of Exchange Rate Regime for Canada,” Current Analysis, Toronto: Royal Bank, at http://www.royalbank.com/economics/ market/pdf/current14.pdf McCallum, J. (2000), “Engaging the Debate: Costs and Benefits of a North American Common Currency,” in Current Analysis, Toronto: Royal Bank, at http://www. royalbank.com/economics/market/pdf/namoney.pdf McKinnon, R. I. (2000), “On the Periphery on the International Dollar Standard: Canada, Latin America, and East Asia,” North American Journal of Economics and Finance, Vol. 11, No. 2, pp. 105–21. Murray, John (1999a), “Going with the Flow: The Benefits of a Floating Canadian $,” Canadian Business Economics, Vol. 7, No. 4, pp. 15–25. Murray, John (1999b), “Why Canada Needs a Flexible Exchange Rate,” Bank of Canada Working Paper 99–12.

128 Brenda Spotton Visano Payments System Advisory Committee (1997a), “The Payments System in Canada: An Overview of Concepts and Structures,” background discussion paper prepared by Bank of Canada and Department of Finance, Ottawa, Canada. Payments System Advisory Committee (1997b), “The Canadian Payments System: Public Policy Objectives and Approaches,” background discussion paper prepared by Bank of Canada and Department of Finance, Ottawa, Canada. Payments System Advisory Committee (1997c), “Access to Payment Networks in the Canadian Payment System,” background discussion paper prepared by Bank of Canada and Department of Finance, Ottawa, Canada. Poloz, S. (1999), “Currency Options for Canada: The Elusive Dream,” Canadian Business Economics, Vol. 7, No. 4, pp. 27–30. Rymes, T. K. (1998), “Keynes and Anchorless Banking,” Journal of the History of Economic Thought, Vol. 20, No. 1, pp. 71–82. Science Council of Canada. (1992), The Canadian Banking Sector, Sectoral Technology Strategy Series 7, Ottawa. Spotton, B. and R. Rowley (1997), “Monetary Dialogue and Dogma in Canada: The Inside Evidence,” unpublished manuscript. Steiner, T. D. and D. B. Teixeira (1990), Technology in Banking, Creating Value and Destroying Profits, Homewood, IL: Dow Jones-Irwin. Stuber, G. (1996), “The Electronic Purse: An Overview of Recent Developments and Policy Issues,” Bank of Canada Technical Report 74. Thiessen, G. (1999), “The Euro: Its Economic Implications and Lessons for Canada,” in Speeches and Statements by the Governor: speech to the Canadian Club of Ottawa (20 January 1999), at http://www.bankofcanada.ca/en/speeches/sp99–1.htm Vanasse, P. (1990), Technology and Financial Services: Challenges for Financial Institutions and Policy Makers, Ottawa: Conference Board of Canada. Visano, B. (Spotton) (2001), “Financial Innovation in Contemporary Capital Markets: Revolutionary Changes in Structure, Process and Content,” unpublished manuscript. Visano, B. (Spotton) (forthcoming), “Electronic Banking and Trans-national Corporate Activity: Conjectural Implications for National Monetary Policy and Future Monetary Arrangements,” in B. Batavia, N. Lash, and A. Malliaris (eds), Asymmetries in Financial Globalization, Toronto: APF Press. White, W. R. (1999), “Evolving International Financial Markets: Some Implications for Central Banks,” BIS Working Papers 66, Basle: Bank for International Settlements.

9

Financial openness and dollarization A skeptical view Louis-Philippe Rochon and Matias Vernengo

Introduction The introduction of the euro and the increasing economic convergence and integration of the NAFTA member countries have stimulated a debate on the feasibility of adopting a common currency among Canada, the United States and Mexico.1 The Mexican president-elect Vicente Fox, on a recent visit to Ottawa proposed a North American equivalent to the European integration project, with open borders, common currency, and an equivalent to the social cohesion funds to finance schools, roads, and infrastructure in Mexico. The creation of such a monetary union would certainly be the most ambitious, and controversial, project in many decades. The project would certainly be that much more contentious since it is difficult to believe that the US will abandon the dollar and embrace a common currency. In this sense, the NAMU – the North American Monetary Union – implies a process of dollarization, which is more similar to the German unification process than to the European Monetary Union. In fact, Vicente Fox did not propose a common currency, but simply dollarization. Either way, whether the US dollar is adopted as sole currency or there is the creation of a new currency, it raises serious questions that go beyond the strict technical economic problems, since it implies that Canada and Mexico would have to abandon their domestic currencies. The conventional arguments for monetary union are based on the notion that eliminating national currencies and moving to a common one leads to gains in economic efficiency arising from the elimination of transaction costs, and the reduction of risk arising from uncertain movements in exchange rates (De Grauwe, 1997, p. 52). The costs of a monetary union, on the other hand, are associated with the loss of national sovereignty in conducting monetary policy (De Grauwe, 1997, p. 5). This chapter will examine some of the arguments of this debate from an American perspective. The second section will explore the differences between dollarization and monetary union where the arguments rest on the mismatching of markets and regulators.2 The third section will then move to a discussion of what we consider to be the standard arguments in this debate, namely the elimination of transaction

130 Louis-Philippe Rochon and Matias Vernengo costs and the benefits to trade, and seigniorage. We suggest that the arguments presented by proponents of dollarization are not definitive, and that increased trade may not result necessarily in increased output and growth. Finally, the last section will look at two arguments concerning dollarization that we believe have been neglected in the literature. First, it will be argued that dollarization, by allowing the use of the US dollar only, allows American banks to have a stronger presence in local economies,3 while simultaneously leading to a decrease in the number of local banks. In other words, American banks gain a competitive edge over local banks. Second, American multinational firms who have connections with US banks gain greater access to local economies and local markets given their established access to US banks. These effects lead to the question of who benefits from dollarization and who bears the costs. This is the crucial question to be analyzed from the political economy perspective. The benefits for American banks and multinational firms under dollarization would not necessarily be present under common currency arrangements. Therefore the differences between a monetary union and dollarization are of particular importance for the purposes of this work. More importantly, the increase in the numbers of American banks and firms would extend the American brand of capitalism to other regions, and with that the advantages and costs of this particular institutional arrangement. Dollarization seems to export one of the main problems of the American system to other economies, namely: the disproportional influence of financial interests. As a result, dollarization may very well intensify the problems generated by the increasing volatility of capital flows.

Monetary union versus dollarization The differences between an official dollarized regime and the creation of a monetary union are not trivial. Dollarization refers to the adoption of the US dollar by countries other than the US who must then abandon their respective national currencies. In contradistinction, a monetary union would require the creation and subsequent adoption of a new currency by all member countries, as in the EMU. In this situation, the NAMU would require the abandonment of the US dollar and its related institutions for a new currency and new institutions with shared responsibilities for all member countries. The problems of establishing the NAMU would be overwhelming. It is virtually inconceivable that the United States would agree to the dismantling of its monetary and financial institutions, and then accept shared responsibility in setting monetary policy in a new, refurbished, and non-dollar-based institution. Moreover, the United States has good reasons for wanting to keep the dollar. The position of the dollar as the international reserve currency brings considerable advantages to the US economy.4 Finally, as noted by Buiter (1999), even if the creation of a supranational central bank were to be discussed by American authorities, the transfer of national

Financial openness and dollarization 131 sovereignty to a North American Central Bank would lack political legitimacy in the absence of a political union. As Buiter (1999, pp. 29–36) writes, Unless this transfer of power is received as legitimate by NAMU residents, the authority of the NAMUFed will be challenged by those who perceive themselves to be adversely affected by it . . . In an open, democratic society the delegation of policy-making powers to unelected officials will only be accepted as legitimate by the citizens, if the independent central bank is accountable to the elected representatives. Accountability requires openness and transparency . . . The need for openness and transparency also applies to the procedures of the central bank . . . In North America, there is no parliament that could enforce effective accountability of the NAMUFed. Even if Canada were to get a seat on the NAMUFed Council, the Canadian parliament would only be able to call its single representative to account. The non-Canadian majority on the NAMUFed Council would be under no obligation to answer to the elected representatives of the citizens of Canada. The creation of a supranational bank requires the pre-establishment of a supranational political institution. One might argue that the euro was created without the previous development of an European state. However, there are at least European institutions that are supposed to regulate the European market. The question of whether the experience of a currency without a state will work or not goes beyond the scope of this chapter. Dollarization would imply also that complete loss of monetary sovereignty for Canada and Mexico. This would be unprecedented in countries of this size and complexity, countries whose monetary authorities would be redundant if dollarization were effectively pursued. However, it is not clear if or how American institutions would act in foreign territory. An institutional void is one of the consequences of dollarization. This is more visible in the problems that the absence of a lender-of-last-resort would create for Canadian and Mexican financial institutions. A most important difference between dollarization and monetary union resides in the fact that dollarization creates by definition a mismatch between domestic markets and regulators. Whereas a currency union might lead, as in the case of EMU, to the development of supranational institutions that regulate the supranational market, in a dollarized economy the national regulatory agencies lose their power. A foreign regulatory agency, the Federal Reserve Board in particular, will have the power, even if it does not have the political will, to formulate monetary policy beyond the US frontier. It is well known that the development of the capitalist system involved, since the early phases of the industrial revolution, the development of a banking system (Cameron, 1967). However, the history of banking is rich in stories of crises provoked by lack of information, speculative behavior, and eventually criminal

132 Louis-Philippe Rochon and Matias Vernengo activity (Kindleberger, 1978). It is for this reason that, alongside the development of banking systems, governments developed national regulatory systems to better control and supervise the activities of the national banking systems for the purpose of reducing financial crises. Among the functions performed by a central bank is that of providing liquidity to the banking sector. In regular times, it does this mostly through open market operations; while in periods of crisis, it falls back on its role as lender-of-last-resort. In the absence of a national monetary authority in Canada and Mexico, many problems can arise as a result. First, the Federal Reserve Board (Fed) may refuse to act as a lender-of-last-resort to banks outside American territory. In fact, the bill once proposed by Senator Connie Mack explicitly stated that the Fed would not be obliged to act as a lender-of-last-resort to dollarized countries, or have supervisory responsibility over banks outside the US, or to consider foreign economic conditions in formulating monetary policy. Moreover, Canadian and Mexican households that keep deposits in dollars in their countries after dollarization might not be covered by deposit insurance. In that sense, the risks associated with the normal functioning of an economy will be exacerbated. The countries that dollarize are basically thrown back to the institutional framework of an earlier stage of the development of market economies. More problematic is the fact that any discussion of institutional governance will leave out Canadians and Mexicans. After all American institutions respond only to their American constituency. On the other hand, it is also not clear what would be the reaction of the American institutions once confronted with a crisis outside US territory. Recent experience shows that with the increased integration associated with globalization, the American administration would react promptly. The Mexican Tequila crisis of December 1994 is a relevant example. The Mexican crisis worried American policymakers in no uncertain terms, first by affecting directly Americans with investments in Mexico, and second by threatening the stability of NAFTA and beyond the plans for a Free Trade Area of the Americas (FTAA). Furthermore, there was the real fear that immigration of Mexicans to the US would increase, thereby creating fears of increasing competition for American workers. To counteract these possible threats, the Clinton administration planned a rescue plan that included bond issues and guarantees from the American government for ten years. The plan, however, lacked the support needed for approval in Congress. The likelihood of a Mexican default led the administration, under the leadership of then secretary of the Treasury, Robert Rubin, to decide not to send the bill to Congress. Rather, the Treasury extended a direct line of credit (up to $20 billion) from the Exchange Stabilization Fund, which remains outside the control of Congress (Henning, 1999, p. 64). The Treasury pursued this line of action because it was assumed that a Mexican default would have dire consequences for the US

Financial openness and dollarization 133 economy, in particular for the investors in Wall Street who were overextended in peso-denominated assets.5 The importance of the Mexican crisis from our perspective is that it shows that American institutions might be willing to act beyond its frontiers, in a voluntary effort to create stability. However, the process is driven by interest groups and lacks transparency or accountability. Foreigners are excluded from the decision process that affects their own destiny. In addition, American civil society is also left out of the decision process. Whereas the Fed is accountable to Congress for the rescue of a domestic bank, the Treasury is not accountable for the rescue of the Mexican economy. It is quite true that there is a strong case for the delegation of congressional power to the executive in periods of crisis, as noted by Henning (1999, p. 43), and the rescue proved to be efficient in avoiding a systemic crisis. However, it also highlighted the weaknesses of the current lack of institutions to deal with supranational crises. In the hypothetical case in which a NAMU takes place, and a North American Central Bank (NACB) is created, one would expect that the NACB would be accountable to a supranational congress, if transparency and accountability are to be taken seriously. However, the costs involved in the construction of the new institutions seem to be too high. Although the advantages of NAMU over dollarization would be considerable for all the parties involved, the costs of forgoing its own currency are much bigger in the case of the US, than for Canada or Mexico. This asymmetry and the overwhelming importance of the American economy in world markets, leads us to believe that coercive power rather than cooperation would be the driving force of a monetary union in the Americas, and that dollarization has more, if any, future than NAMU.

Standard arguments for and against dollarization Mundell’s (1961) discussion of an optimum currency area is still the main reference in the literature on the adoption of a common currency. According to the theory a monetary union is optimal if the economies are subjected to similar shocks, so that the depreciation or appreciation of the common currency solves the problems of all the countries. If shocks have asymmetric effects on the economies, an optimal currency area implies that there is either sufficient wage flexibility or sufficient labor mobility for countries to adjust without resorting to variations of the exchange rate. It is assumed that the costs of monetary union in an optimal currency area would be very small. On the other hand, the gains in economic efficiency arising from elimination of transaction costs, and the reduction of risk coming from uncertain movements of exchange rates are seen to be very high. Also, an additional advantage for the US in the case of dollarization is the increase revenues from seigniorage. The first question posed by the optimal currency literature is whether countries – in the case at hand Canada, Mexico, and the US – are subjected to symmetric

134 Louis-Philippe Rochon and Matias Vernengo shocks. That is, if the economic cycles converged in the three economies, then the lack of independent monetary policy is of secondary importance. Frankel and Rose (1996) make the case that closer trade links between countries are consistently related to higher cyclical correlations between the countries involved. Be that as it may, this fails to consider that a correlated cycle might not be sufficient to guarantee that the absence of independent monetary policies will have no effects. In particular, countries that are at different stages in the process of development might need different monetary policies. Amsden (1989) argues that some degree of financial repression is necessary for underdeveloped countries. That is, in the case of South Korea the use of interest rate limits, of subsidized credit, and of discretionary allocation of credit were all-important parts of the system.6 In such an instance, dollarization in less-developed countries like Mexico may be more problematic than in developed countries like Canada. On the other hand, many developed countries have welfare systems that are far more extensive than the American welfare state, as is the case in Canada. In this situation, dollarization may impose monetary policies that are too restrictive and incompatible with the maintenance of broad social policy programs. For instance, Canada has an extensive national health care system and a broad social safety net. A restrictive monetary policy in the United States in a dollarized regime may impose interest burdens on Canada that may jeopardize these social programs.7 That is, under these circumstances, dollarization in less-developed countries like Mexico may be less problematic than in developed countries like Canada. The conclusion is that dollarization is problematic for both developed and lessdeveloped countries. However, in order to decide whether to dollarize or not one has to weigh the costs and benefits associated with dollarization. On the benefit side, it is generally assumed that a currency union reduces transaction costs, and also eliminates foreign exchange risk. As a result of these two advantages, trade flows between the countries of the union increase dramatically.8 Rose (2000, p. 11) argues that “countries that share a common currency engage in substantially higher international trade.” The most important gains from higher trade, in turn, are the higher rates of growth. This has been a dominant theme in the literature on development in the last twenty-five years. The contrasting experiences of the relatively closed Latin American economies and the relatively open East Asian countries led many authors (e.g. Dollar, 1992; World Bank, 1993) to argue that outward-oriented development strategies are more conducive to growth. However, the literature on the advantages of economic openness is far from being consensual. Measures of openness do not seem to be consistent across studies (Pritchett, 1996). Taylor (1991a, p. 100) argues that structuralist models of both commodity and capital flows suggest that “openness or a hands-off policy in either market will not necessarily lead to faster growth or less costly adjustment to external shocks.” Further, Rodriguez and Rodrik (1999) find little evidence that

Financial openness and dollarization 135 open trade policies are significantly associated with higher growth. In their recent study on the effects of the structural adjustment reforms in Latin America, Stallings and Peres (2000), find that capital and current account liberalization had a significant but small effect on growth. The weakness of the link between trade and growth suggests that any decision to dollarize based on the effects of the reduction of transaction costs on trade, and hence on growth, should not be overemphasized. Thus, from an American perspective, the main advantage according to the standard arguments for dollarization would be the increase in seigniorage revenues. The standard arguments surrounding seigniorage can be divided neatly into two arguments. First, there is a discussion of how to measure the precise value of revenues accruing to a government out of seigniorage. Second, the debate then concerns itself on how much the United States should repatriate back to any given country that chooses to dollarize: that is, the precise nature of the sharing rule. Seigniorage arises because currencies are worth more than their printing costs. Printing money, therefore, generates revenues, since it allows the government to finance real purchases. The more a country prints money, the more revenue it accrues up to a certain point. In general the literature assumes that a seigniorage Laffer curve (or inflation-tax Laffer curve) exists. The existence of this curve is justified as follows. The quantity of real spending financed through money creation is equal to the nominal increase of the money stock over the price level (seigniorage). It is easily shown that in steady state, when the real stock of money is constant, seigniorage will equal the tax rate (the rate of depreciation of the real value of money) times the amount being taxed, that is, the real money balances (Agénor and Montiel, 1996). As a result, the government can increase its revenues by printing money and generating inflation, since a higher rate of inflation represents a higher tax on money holders. However, beyond a certain inflation level, agents will substitute money for interest-bearing assets, so a rise in the tax rate (inflation) is accompanied by a decrease of the tax base (real money balances). Hausmann (1999, p. 76) estimates seigniorage to be roughly 0.5 percent of a country’s GDP, although others have reached different conclusions.9 SchmittGrohé and Uribe (1999), on the other hand, conclude that most estimates are “enormously underestimated” and misleading because they do not consider that the monetary base increases through time. Their conclusion is that the estimate of seigniorage revenues can be as much as “five times as large as the incorrect one.” Despite these considerable divergences in the actual size of seigniorage revenues, there is no doubt that dollarization represents a windfall gain for the United States. This brings us to the second issue: the nature of the sharing rule. Most economists in this field believe the United States should, on an annual basis, compensate dollarized countries for the loss of seigniorage revenues. Perhaps standing alone is Barro (1999) who claims the United States should agree to exchange local currencies for US dollars, but then offer no annual seigniorage repatriation. Many endorse some

136 Louis-Philippe Rochon and Matias Vernengo version of the proposal advocated by Senator Connie Mack (Florida) who suggests repatriating 85 percent of the seigniorage revenues a nation loses to the US as a result of dollarization.10 In other words, although the loss of seigniorage is a real loss for dollarizing countries and a gain for the US, it is clear that some degree of revenue sharing would take place if dollarization was actually pursued. It is still true that discussion of revenue sharing would only take place in the US, leaving the other countries involved without any vote in the discussion of their own future. Additionally, many authors argue that losing seigniorage revenues is good for countries that have a history of hyperinflation, since it forces fiscal discipline upon populist governments. Dollarized countries would then enjoy price stability compatible with US standards. Two sets of problems are posed by the view that dollarization leads to lower inflation rates. On the one hand, it is quite possible to have inflationary processes even if governments do not have any seigniorage revenues. Supply shocks, increased labor bargaining power with pressures for higher wages, indexation rules, and other mechanisms could lead to higher inflation (Taylor, 1991b). On the other hand, this argument can hardly be used to defend dollarization in the case of Canada, which does not have a record of high inflation.11 Furthermore, the argument of seigniorage brings into question the finance of public spending. Under a dollarized economy, Canada and Mexico would have to issue bonds in dollars. Given the incapacity to print dollars, one would expect that Canadian and Mexican bonds would pay a premium over American bonds. The higher interest rates in Canada and Mexico would in turn make government spending more costly, creating a permanent deflationary fiscal stance. This would lead to a reduction in social spending in Canada, and to the impossibility of increasing spending in social programs in Mexico. This is probably the most important cost of any dollarization attempt. All in all, the conventional arguments for dollarization seem to build a rather fragile case. Transaction cost reductions and increasing trade might not lead to higher growth. Price stability might not be enhanced. Finally, the loss of seigniorage, even if redistributed, reduces the attractiveness of dollarization and creates serious problems for financing government spending. However, even if one assumes that those benefits outweigh the losses there is room for skepticism about dollarization.

Financial openness and dollarization In the previous sections we discussed the relative merits of the NAMU and dollarization, and the standard arguments for and against dollarization. We have seen that, despite the advantages of NAMU, dollarization is a more probable outcome, and that the advantages of dollarization are dubious since the positive effects of reduced transaction costs on trade and on growth are somewhat limited. Finally the advantages for the US of increasing seigniorage revenues are considerable, but

Financial openness and dollarization 137 the majority in the US seems to be willing to share those revenues. In this section we discuss the specific consequences of dollarization on the domestic financial markets of the countries that dollarize. As is well known, common currencies and dollarization are part of a more general movement towards greater financial openness. Since the breakdown of the Bretton Woods system financial markets have experienced an explosive expansion. The process was intensified by the deregulation of financial markets in several underdeveloped countries during the 1990s. The US government has encouraged the process of financial deregulation, and more recently a consensus has emerged within the IMF decisionmaking circles that the Fund should promote freer movement of capital (Mohammed, 1998, p. 211). One of the arguments for financial deregulation is that it would lead to lower rates of interest and higher rates of growth (Eatwell, 1996). In the case of developing countries the expectations were that a higher proportion of capital flows would be composed of long-term, stable foreign direct investment (FDI). FDI, in turn, would lead to higher rates of domestic investment and higher rates of growth. Experience has not yet vindicated the confidence that free global capital markets are the keys to stability and growth worldwide. In the case of Latin America there is considerable evidence that capital inflows in the 1990s led to excessive exchange rate appreciation and unsustainable current account deficits leading to balance of payments crises (Agosin and Ffrench-Davis, 1996; Taylor, 2000). Also, Agosin and Mayer (2000) argue that in the case of Latin America FDI tends to crowd out domestic investment, thus having a negative impact on the rate of growth. The increasing number of financial flows to developing countries in the 1990s was also accompanied by an increasing number of balance of payments crises. In fact, given the recurrence of financial crisis, several proposals to reform the socalled international financial architecture, including Tobin taxes, creating world regulatory agencies, and re-imposing capital controls, have been developed in the last couple of years.12 Dollarization can be said to be one alternative to cope with the increasing volatility of financial flows. The standard arguments for and against dollarization were reviewed in the previous section. It is our view that even if one accepts the conventional arguments showing that dollarization would be beneficial for all parties involved – a very contentious position none the less – it is still possible to argue that other effects make dollarization problematic. In particular, dollarization seems to export one of the main problems of the American system to other economies, namely: the disproportional influence of financial interests. It is clear that in dollarized countries banks will take deposits and provide credit in dollars.13 It is also true that American banks have a comparative advantage in operations that involve dollars and dollar-denominated assets. As a result, it is reasonable to expect that American banks would have an increasing role in dollarized countries. If this hypothesis is correct, the effects are far-reaching.

138 Louis-Philippe Rochon and Matias Vernengo In the first place, American firms that have long-term ties with the banking sector will also be in a privileged position. This implies that dollarization would increase the relative dominance of American interests abroad. It is not difficult to understand why Senator Mack, who comes from the banking sector, is proposing a bill on dollarization (Mack, 2000). Further, Treasury Secretary Lawrence Summers recently argued that “to the extent that dollarization helped to consolidate or expand our large role in Latin American markets, it might help to ensure that we continued to benefit disproportionately from their future growth” (Summers, 1999). Also, one would expect that the American financial framework, based on stock markets with its emphasis on short-term profitability, would become the point of reference for future developments in financial markets in dollarized economies. These institutional changes might lead to higher financial instability. Further, there seems to be some evidence to support this hypothesis. Table 9.1 shows the increase of foreign ownership in the national banking sectors of Argentina, Brazil, and Mexico. As can be seen, in Argentina and Mexico ownership was already near 40 percent in the late 1990s, while in Brazil the ratio was still around 20 percent. According to Freitas and Prates (2000) the different ownership ratios are related to the differences in the domestic regulatory environments. In fact, both Argentinian and Mexican financial sectors are more open to foreign competition than the Brazilian financial sector. In Argentina and Mexico banks are allowed to take deposits and lend in dollars, and in Argentina since 1991 a currency board has guaranteed that the nominal exchange rate is fixed to the dollar. Mexico does not have formal dollarization, but since the 1980s informal dollarization has characterized the Mexican economy as much as it has in Argentina. In contrast, the Brazilian economy does not allow deposits and lending in foreign currencies. A tax on financial transactions is still in place, which might have a discouraging impact on foreign capital inflows.14 Further, the extensive and efficient indexation of financial assets during the 1980s, up to the Real Plan of July 1994, implied that informal dollarization was never widespread in Brazil (Freitas and Prates, 2000, p. 56).15 In other words, we have three countries, one officially dollarized, one informally dollarized, and one not dollarized. Although foreign ownership increased in all three during the 1990s as part of the process of opening the capital account, it is clear that higher levels of foreign participation are to be found in dollarized economies. Table 9.1 Foreign ownership of banking assets (%) – 1994–8

Argentina Brazil Mexico

1994

1997

1998

21.7 11.0 1.2

45.0 21.1 19.9

N/A 22.5 40.0

Source: Freitas and Prates (2000).

Financial openness and dollarization 139 An increasing role of foreign banks and of lending in foreign currency increases the mismatch between the domestic market and the regulator of that market. By giving a competitive advantage to foreign banks, dollarization increases the problems of regulating financial markets. The consequences might be a higher number of financial panics, with negative effects on employment and growth levels.16 One must conclude that there is no guarantee that dollarization is the best way, or even a sensible way for that matter, to cope with the problems of increased financial inflows from a perspective of the dollarized countries. From the American perspective dollarization gives competitive advantage to American banks, but it creates the additional burden of regulating and supervising foreign markets, a task that is not on the agenda of the main political parties in the US.

Concluding remarks This chapter attempted to do two things. First, it tries to show that the standard arguments over dollarization are less important issues than generally assumed. While the conclusions reached by these theoretical arguments seem to paint dollarization in a positive light, the empirical evidence in favor seems to be limited. In particular, the argument that the elimination of transaction costs leads to more trade and that in turn increased trade leads automatically to increased growth does not seem to find support in the data. The conclusions are far from definitive, and, if anything, one is left with the view that the benefits from dollarization are highly uncertain and relatively small. Second, we tried to introduce two key arguments that we think have been overlooked in this debate – arguments that we think are at the heart of the issue. The debate over dollarization needs to be refocused, we believe, to allow discussion over the role of foreign – read US – banks and multinational corporations. We argued that dollarization may lead to an increased presence of American banks, as can be seen in Latin America. American banks stand to gain a comparative advantage over local banks. Moreover, to the extent that investment is financed through bank loans, the path to higher growth may go through American multinational corporations that enjoy existing ties with American banks. This process can lead to an institutional structure that emphasizes short-term financial profits over long-term growth. In that case, dollarization might not lead to reduce financial volatility as expected, but might very well increase the financial fragility of the domestic economic system. Overall, though, there appears to be a need to deflate the rhetoric of the debate. One should not make claims that cannot be substantiated. And most importantly one should note that dollarization is no panacea, and will not solve all the problems associated with the volatility of capital flows. In particular, we believe that the idea that dollarization strengthens democratic values is difficult to defend. Senator Mack (2000, pp. 2, 7) argues that dollarization will

140 Louis-Philippe Rochon and Matias Vernengo export [American] principles as well – principles like freedom, justice, democracy and the protection of basic human rights . . . We’ll see more social harmony. We’ll see less social conflict – less of the strife and uncertainty that’s led to upheaval in the past, creating friction within and between countries. In contradistinction to these great expectations we believe that if dollarization proves to be a good solution for a limited set of macroeconomic problems, it will have done more than expected.

Notes 1 The debate actually extends to Latin America with the idea of forming a monetary union between North and South American countries. We deal minimally here with Latin American countries. 2 Eatwell and Taylor (2000) argue that there should be a match between markets and regulators. Hence, a global market requires a global regulator. 3 By local economies, we mean the economies of countries other than the United States. 4 Vernengo (2000) argues that the ability to maintain the trade deficit for almost twenty years results from the international position of the dollar. 5 The increasing importance of Wall Street’s views on policymaking led Bhagwati (1998) to create the term Wall Street–Treasury complex. Smithin (1996) refers to the dominance of financial interests as the revenge of the rentiers, in a more Keynesian vein. 6 The argument is not that credit markets are imperfect, since they are subject to asymmetric information or other imperfections, which may very well be true. The point is that imperfections had to be created in order to promote growth. In other words, the state took deliberate action in getting prices wrong. 7 This argument also raises the issue of taxes. Canada requires higher taxes to fund the programs. Dollarization may eventually lead to the need for tax harmonization (a topic of great debate in Europe at the moment) that would eventually lead to drastic changes in Canada’s social programs. 8 However, given that by all reasonable estimates transaction costs involved in dealing with more than one currency are fairly small, one tends to believe that increasing trade is related to trade liberalization, that is, the elimination of quotas and the reduction of tariffs. 9 See also Berg and Borensztein (2000) for alternative estimates of seigniorage. 10 See Schuler and Stein (2000) for other possible sharing rules. 11 In the case of Canada, however, the existence of different structures of social spending may very well be a relevant argument against dollarization. 12 See Eatwell and Taylor (2000) for a discussion of the World Financial Authority, D’Arista (1999) for a proposal of an International Clearing System, and Vernengo and Rochon (2000) for an argument for capital controls. 13 In fact, banks also take deposits and lend in dollars in countries that adopted a currency board, which implies a fixed peg to the dollar, such as Argentina. 14 In fact, since 1995 foreign direct investment (FDI) inflows are larger than portfolio inflows in the case of Brazil. 15 One must note that in his study Rose (2000, p. 20) assumes incorrectly that Brazil is “informally or unofficially dollarized.”

Financial openness and dollarization 141 16 Bergsten (1999) suggests that countries that dollarize could adopt “the Fed itself (which is unlikely, although Argentina has raised the issue) or by turning most of the financial system over to American banks.”

References Agénor, P. and P. Montiel (1996), Development Macroeconomics. Princeton, NJ: Princeton University Press. Agosin, M. and R. Ffrench-Davis (1996), “Managing Capital Inflows in Latin America,” UNDP, Office of Development Studies, Discussion Paper Series 8. Agosin, M. and R. Mayer (2000), “Foreign Direct Investment in Developing Countries: Does it Crowd in Domestic Investment?,” UNCTAD, Discussion Paper 146. Amsden, A. (1989), Asia’s Next Giant, New York: Oxford University Press. Barro, R. (1999), “Let the Dollar Reign from Seattle to Santiago,” Wall Street Journal, 8 March, p. A18. Berg, A. and E. Borensztein (2000), “The Pros and Cons of Full Dollarization,” IMF Working Paper 00/50, Washington DC. Bergsten, F. (1999), “Dollarization in Emerging-Market Economies and its Policy Implications for the United States,” memorandum to the Joint Hearing of the Subcommittee on Economic Policy and the Subcommittee on International Trade and Finance Committee on Banking, Housing, and Urban Affairs, United States Senate, 22 April, Washington DC. Bhagwati, J. (1998), “The Capital Myth,” Foreign Affairs, Vol. 77, No. 3, pp. 7–12. Buiter, W. (1999), “The EMU and the NAMU: What is the Case for North American Monetary Union?,” Douglas Purvis Memorial Lecture, Canadian Economic Association, Toronto, May. Cameron, R. (1967), Banking in the Early Stages of Industrialization: a Study in Comparative Economic History, New York: Oxford University Press. D’Arista, J. (1999), “Reforming the Privatized International Monetary and Financial Architecture,” Financial Markets and Society, Financial Markets Center, November. De Grauwe, P. (1997), The Economics of Monetary Integration. Oxford: Oxford University Press. Dollar, D. (1992), “Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976–1985,” Economic Development and Cultural Change, Vol. 40, No. 3. Eatwell, J. (1996), “International Capital Liberalization: The Record,” CEPA, Working Paper Series I, No. 1, New York. Eatwell, J. and L. Taylor (2000), Global Finance at Risk: The case for International Regulation, New York: The New Press. Frankel, J. and A. Rose (1996), “The Endogeneity of the Optimum Currency Area Criteria,” NBER Discussion Paper 5700, Washington DC. Freitas, M. and D. Prates (2000), “La experiencia de apertura financiera en Argentina, Brasil y Mexico,” Revista de la CEPAL, vol. 70 (April), pp. 53–69. Hausmann, R. (1999), “Should there be Five Currencies or One Hundred and Five?,” Foreign Policy, Vol. 116 (Fall), pp. 65–79.

142 Louis-Philippe Rochon and Matias Vernengo Henning, C. R. (1999), The Exchange Stabilization Fund: Slush Money or War Chest?, Washington DC: Institute for International Economics. Kindleberger, C. (1978), Manias, Panics, and Crashes: A History of Financial Crises, New York: Basic Books. Mack, C. (2000), “Dollarization and Cooperation: Achieving Sound Money,” paper presented at the Federal Reserve Board Dallas conference, 6 March. Mohammed, A. (1998), “Issues Relating to the Treatment of Capital Movements in the IMF,” in G. Helleiner (ed.), Capital Account Regimes and the Developing Countries, London: Macmillan. Mundell, R. (1961), “A Theory of Optimal Currency Areas,” American Economic Review, Vol. 51, pp. 657–64. Pritchett, L. (1996), “Measuring Outward Orientation in LDCs: Can It Be Done?,” Journal of Developing Economics, Vol. 49, pp. 307–35. Rodriguez, F. and D. Rodrik (1999), “Trade Policy and Economic Growth: A Skeptic’s Guide to the Cross-National Evidence,” NBER Discussion Paper 7081, Washington DC. Rose, A. (2000), “Does a Currency Union Boost International Trade?,” paper presented at the Federal Reserve Board of Dallas conference, 6 March. Sachs, J. and F. Larrain (1999), “Why Dollarization is More Straightjacket than Salvation,” Foreign Policy, Vol. 116 (Fall), 80–92. Schmitt-Grohé, S. and M. Uribe (1999), “Dollarization and Seigniorage: How Much is at Stake?,” mimeo. Schuler, K. and R. Stein (2000), “The Mack Dollarization Plan: An Analysis,” paper presented at the Federal Reserve Bank of Dallas conference, 6 March. Smithin, J. (1996), Macroeconomic Policy and the Future of Capitalism, Aldershot: Edward Elgar. Stallings, B. and W. Peres (2000), Growth, Employment, and Equity: The Impacts of the Economic Reforms in Latin America and the Caribbean, Washington DC: Brookings. Summers, Lawrence (1999), “Prepared Testimony,” memorandum to the Joint Hearing of the Subcommittee on Economic Policy and the Subcommittee on International Trade and Finance Committee on Banking, Housing, and Urban Affairs, United States Senate, 22 April, Washington DC. Taylor, L. (1991a), “Economic Openness: Problems to the Century’s End”, in T. Banuri (ed.), Economic Liberalization: No Panacea, Oxford: Clarendon Press. Taylor, L. (1991b), Income Distribution, Inflation and Growth: Lectures on Structuralist Macroeconomic Theory, Cambridge, MA: MIT Press. Taylor, L. (2000), “The Consequences of Capital Liberalization,” Challenge, Vol. 43, No. 6 (November–December). Vernengo, M. (2000), “Trade Elasticities, the Trade Deficit and the Dollar,” CEPA Working Paper in Economic Policy Analysis 13, October. Vernengo, M. and L.-P. Rochon (2000), “Exchange Rates and Capital Controls,” Challenge, Vol. 43, No. 6 (November–December). World Bank (1993), The East Asian Miracle: Economic Growth and Public Policy, Washington DC: Oxford University Press.

10 Dollarization as a tight rein on the fiscal stance Alex Izurieta1

Introduction Theoretical and empirical studies over exchange rate policy informing the debates around the European Monetary Union and currency boards have, for the most part, overlooked a critical shortcoming of these systems, as put forward by W. Godley (1991, 1992, 1997b, c). Namely, monetary union agreements would broadly remove major sources of deficit financing, virtually inhibiting macroeconomic management by governments. In particular, Godley argues, “the incredible lacuna in the Maastricht program is that there is no blueprint whatever of the analogue, in Community terms, of a central government.” Moreover, by not putting in place a system of transfers and fiscal stimuli which would compensate for interstate disparities or help recovery after exogenous shocks, monetary unions would lead to polarization rather than convergence.2 Godley’s original insights seemed to have been disregarded by the perhaps unfortunate coincidence of an uncritical adherence to the mainstream in academia during the past two decades and the partisan grounds on which the Maastricht Treaty was defined. Common to all was the trust that economies are self-righting organisms which never under any circumstances need management at all. However, experience seems to suggest that countries under tight exchange rate and monetary agreements are more prone to suffer from chronic unemployment or financial weakness in the aftermath of exogenous shocks. In order to investigate this proposition we take the case of a formally dollarized economy – the most radical amongst common currency settings3 – in which there is no exchange rate flexibility or monetary policy at all. Yet, it could be argued, fiscal policy may perhaps be sufficient to “do the trick.” Cautioned by the Tinbergenian principle that for each policy goal one instrument is required, we would indeed hypothesize that fiscal policy alone is not capable of helping an economy to recover after an external shock and assure, at the same time, financial stability. Furthermore, by constructing an inherently consistent, axiomatic, macroeconomic model4 we will conclude that fiscal policy is not only inadequate, but is also left with fewer financial resources to operate. The alternative, namely tightening the fiscal stance along with the financial

144 Alex Izurieta constraints, would exacerbate the adverse effects on income and employment of the initial shock. In the next section we explain our model. Care will be taken to emphasize its flow/stock balance consistency and to make our assumptions explicit before going into the technical description of macroeconomic relations and adjustment. Subsequently we explain our main results (baseline, and two alternative scenarios), on which we base our conclusions, in the last section.

Description of the model A list of the notation used in this section can be found at the end of the chapter. Economic structure and underlying flow/stock accounting framework Our model is inspired in the tradition of empirical models that link money with aggregate demand, the generation of income and the allocation of wealth (Godley and Cripps, 1976; Lavoie 1984; Minsky 1989; Godley 1996, 1999). Underpinning the model is the accounting structure deployed in Table 10.1.5 There are no “black holes”; all flows are fully accounted for, and generate, sequentially, the financial balances of each sector. These ex post balances reflect macroeconomic constraints and how sectors adjust vis-à-vis each other. They are, therefore, incorporated in the behavioral relations of the model (as in Godley, 1997a; Lavoie and Godley, 2000; and Lavoie, 2001). Our “world,” as implied by Table 10.1, consists of two countries (“North” and “South,” denoted by suffixes n and s). Both share a currency – the dollar – issued by the common central bank (CB).6 Households (HH) in each country earn the GDP (Y), resulting from production generated by each country’s enterprise sector (ENT). The national product is either consumed by governments (G), by households (C), or traded (exports, X, and imports, M). There are (foreign) interest payments on bonds (B) issued by the partner country, but there are no other transfers.7 Each government’s source of revenue consists of taxes (T ), paid out by households, which, in turn, earn interest on government bonds. Net saving, the balance of each sector’s primary operation, is mapped into financial allocations, as shown in the flow-of-funds system. Considering that the central bank does not earn an operating surplus, and assuming, for simplicity, that enterprises spend all their receipts from sales on production, net changes of assets and liabilities are between households and governments. The corollary is that deficits of governments (PSBR) create wealth (FA) for households (by issuing debt that is acquired by them), while government surpluses would bleed the circular flow of income and destroy wealth. According to our simplified flow-of-funds, financial choices open to households of each country are changes in dollar balances, and net acquisitions of perpetuity bonds

Dollarization as a tight rein on the fiscal stance 145 (of both North and South). Governments’ financial needs are satisfied by issuing these bonds at a market-determined price (the inverse of the interest rate), and bills to be acquired by the central bank – at no cost, but subject to a balance sheet constraint. Namely, total changes of bills (CB assets, government debts) will match total changes of money held by households (central bank liability against household wealth). Financial balance sheets represent the stock accumulation of flows, plus holding gains due to changes in the price of government bonds outstanding at the beginning of the period. Thus, households’ wealth comprises the stock of money and governments’ bonds at current prices, while government debt is equal to the stock of bonds and CB bills. The balance of the central bank assures the consistency of the system by equaling money with bills. Working assumptions and central hypothesis It is worth making explicit the assumptions and restrictions that we choose to impose on this axiomatic framework and to unveil our working hypothesis. This way the reader will be able to verify that our conclusions are not vitiated by the methodological flaw of prefabricating results in hidden assumptions. First, our world is restricted to two countries sharing the common currency, with no rest-of-the-world outside this bloc. It could perhaps be argued that such a restriction determines our finding that countries which dollarize do not have room to freely implement fiscal policies. In other words, if there exists a big pool of countries sharing the dollar, and countries outside the pool are trading with it, then, it could be said, external constraints would be smoothed, and would perhaps not be binding at all. In aggregate this may be right, but experience shows that there are countries that are more prone to external constraints than others, or more vulnerable to shocks. These are generally the countries which are now facing the dilemma of whether to dollarize or not, if they have not already done it. Besides, if imbalances between the two countries of our model arise, a positive performance of the bloc vis-à-vis the rest-of-the-world would not invalidate the fact that disparities internal to a common currency bloc would tend to be perpetuated. Second, we have narrowed down the available sources of financing currentaccount and fiscal deficits to that of borrowing from wealthy institutions abroad (in our model, bonds acquired by households of the country across the border). Yet foreign grants, loans from international institutions, commercial credits, foreign direct investment, or even the sale of public-sector enterprises to multinational corporations might well be realistic options. It could be disputed whether these sources of finance alleviate trade shocks (or do it at no cost). But even if they did, they could not go on forever. At a certain point, grants are stopped, loans from international institutions are made conditional upon politically unfeasible criteria, foreign investment moves out quickly in the pursuit of higher profits or more

Holding gains

Sum of transactions

Flow of funds: financial allocations of institutions

0 +∆pbnBnn–1 +∆pbsBns–1

–∆Hn

+∆FAn –∆Bnn.pbn –∆Bns.pbs

Flow balances

Interest on government bonds

+Yn (= Wn) –Tn +Bnn–1 +Bns–1

–Cn

Output/Income Tax

External trade

Consumption Govt. expenditure

NORTH HHn GOVn

0

0

0 –∆pbnBnn–1 –∆pbnBsn–1

+∆Bcn

+∆Bsn.pbn

–PSBRn +∆Bnn.pbn

–Bsn–1

+Cn +Gn –Gn +Xn (= Ms) –Mn (= –Xs) –Yn +Tn –Bnn–1

ENTn

Table 10.1 The flow/stock transaction and balance sheet matrices

–∆Hs 0 +∆pbsBss–1 +∆pbnBsn–1

–∆Bsn.pbn –∆Bss.pbs

+Bsn–1 +Bss–1 +∆FAs

0

0

0 –∆pbsBss–1 –∆pbsBns–1

+∆Bcs

+∆Bss.pbs

+∆Bns.pbs

–Bss–1 –PSBRs

–Bns–1

+Ts

–Ms (= –Xn) Xs (= Mn) +Ys (= Ws) –Ys –Ts

GOVs –Gs

ENTs +Cs +Gs

–Cs

SOUTH HHs

–∆Bcn –∆Bcs +∆Hn +∆Hs 0

CB

0 0

0 0 0 0 0 0 0 0

0 0 0 0 0 0

0

0 0

Row sum

Stock balances

Govt. Treasury bills

Stock of money

Stock of bonds

Balance sheets

Vn

+Hn

+Bnn.pbn +Bns.pbs

NORTH HHn

ENTn

DebtGn

–Bcn

–Bsn.pbn

–Bnn.pbn

GOVn

Vs

+Hs

+Bsn.pbn +Bss.pbs

SOUTH HHs ENTs

DebtGs

–Bcs

–Bss.pbs

–Bns.pbs

GOVs

0

–Hn –Hs +Bcn +Bcs

CB 0 0 0 0 0 0 0 0

Row sum

148 Alex Izurieta political stability elsewhere, and there is no more room for privatizations. Besides, all of this often happens at once. Thus, the previously contained financial imbalances, which these sources may have served to postpone, arise more dramatically at one coup. In this view, our simplified set of options highlights the underlying structural problem and avoids relying on misleading or temporary solutions. Third, commercial banks are absent, so that financing takes place directly between households, firms, governments, and the common central bank. We are aware that institutions in financial distress may have direct recourse to banks, leading to the creation of “inside money.” This would have been an unnecessary complication, since the purpose of our study is to explain the consequences of fiscal imbalances resulting from an external shock impinging on a dollarized economy. Besides, we are assuming that private firms are balanced, and that households enjoy net saving positions.8 Thus, by omitting banks we have only made more transparent the flow/stock process and avoided other possible (if not likely) sources of instability, such as those originating in money banks and non-performing private agents. Other assumptions worth mentioning are the absence of relative price changes, the existence of excess capacity (thus allowing an effective working of the demand multiplier), and a stationary steady-state baseline. Price changes could serve momentarily to alleviate trade deficits, but prices would eventually become uniform in a common currency setting. Full capacity utilization is not the normal way in which economies operate. By allowing positively growing steady states, we would not have been able to eradicate trade imbalances, which are at the core of our analysis. Restrictive as it may be, our analytical framework will suffice to outline the implications of a balance of payments shock. Our central hypothesis can be summarized as follows. A shortage of export demand would affect both the current account and fiscal balances, forcing the need for additional finance. Since, in a dollarization setting, there is no exchange rate mechanism to circumvent (at least to some extent) trade imbalances, and the public sector cannot obtain liquidity from a domestic central bank ready to issue money, there remain two alternatives only. One, the public sector has to resort to issuing debt, at a cost. Debt servicing costs will exacerbate the fiscal imbalance, and also the current account (since part of the debt would be “external,” i.e. acquired by agents of the partner country). As a consequence, the interest rate offered on government bonds in distress would keep increasing, thus increasing debt service payments. Alternatively, the fiscal stance could be adjusted, in a more or less automatic fashion. By endogenizing public spending the public sector will stay in balance, but then aggregate income and demand will be depressed. The economic depression will bring the current account into balance again, leading to a stable solution. But this solution will take place at lower levels of income and employment in both countries. Since this is not a desirable solution either, we would be inclined to suggest staying away from the dollarization scheme altogether.

Dollarization as a tight rein on the fiscal stance 149 How the system works: description of the model Our model is rooted in the accounting structure depicted in Table 10.1. Hence, the set of identities resulting from the column sums of the matrix can (and should) be found through the model, assuring full flow/stock consistency. The first block of equations for the model are those which define national income and the balance of payments. The only behavioral relations in this block are the import functions relating trade to income in a standard fashion. Imports become, by symmetry, exports of the partner country. As noted earlier, there are no factor payments across the border other than net interest payments on perpetuity bonds; i.e. for country n we have Bns(–1) – Bsn(–1). The relation between the interest rate and the inverse of the price of bonds (below) allows us to write, say, rbn. [pbn.Bns(–1)] in the simpler form Bns(–1). Yn = Cn + Gn + Xn – Mn

(10.1)

Ys = Cs + Gs + Xs – Ms

(10.2)

Mn = µnYn

(10.3)

Ms = µsYs

(10.4)

Xn = Ms

(10.5)

Xs = Mn

(10.6)

s s – Bsn–1 BPn = Xn – Mn + BNs–1

(10.7)

s s – Bns–1 BPs = Xs – Ms + Bsn–1

(10.8)

From these sets of relations is possible to infer the balances of the private sector, considering that their disposable income results from wage earnings and interest receipts less tax payments: d d + Bnn–1 – Tn YDn = Yn + Bns–1 d d + Bss–1 – Ts YDs = Ys + Bsn–1

(10.9) (10.10)

Behavioral equations (10.11) and (10.12) relate private expenditure with income and wealth (long-term stability in an undisturbed system is assured under the condition that the sum of the two propensities is smaller than unity). Net saving in each period (equations (10.13) and (10.14)) is defined as the net acquisition of financial assets.

150 Alex Izurieta Cn = α1nYDn + α2nVn–1

(10.11)

Cs = α1sYDs + α2sVs–1

(10.12)

∆FAn = YDn – Cn

(10.13)

∆FAs = YDs – Cs

(10.14)

Financial wealth is generated after including holding gains due to changes of prices of the stock of bonds. d d + ∆pbs · Bns–1 Vn = Vn–1 + ∆FAn + ∆pbn · Bnn–1

(10.15)

d d + ∆pbn · Bsn–1 Vs = Vs–1 + ∆FAs + ∆pbs · Bss–1

(10.16)

Public sector balances are obtained after the standard assumption of tax receipts as a proportion of national income (which could be further expressed, as below, in relation to disposable income of the private sector). Needless to say, interest payments on bonds add to public sector borrowing requirements (PSBR). Note that in this case we are making government spending exogenous. This is consistent with our first hypothesized alternative, in which the public sector is allowed to run deficits when it is affected by exogenous shocks. θn Tn = –––––– · YDn (1 – θn )

(10.17)

s s + Bsn–1 PSBRn = Gn – Tn + Bnn–1

(10.18)

θs Ts = –––––– · YDs (1 – θs )

(10.19)

s s PSBRs = Gs – Ts + Bss–1 + Bns–1

(10.20)

The alternative would be to make the public sector balance a policy-determined, a priori, variable (typically equal to zero in dollarized economies or a small percentage of GDP). Assuming, as we will do in the next section, that it is the South which is forced to adjust to an external shock, the analytical representation of the alternative to equation (10.20) would be: Gs = PSBRs + Ts – (Bss–1s + Bns–1s ).

(10.21)

Dollarization as a tight rein on the fiscal stance 151 In passing, note that the link between a current account shock and the public sector balance is implicit through equations (10.2), (10.19), and (10.20), or (10.21). The feedback, from fiscal imbalances to the balance of payments can be traced after bringing the demand and supply of bonds into equivalence (below), noticing that debt services across the border are incorporated in equation (10.8). The demand for financial assets expressed by households follows the (implicitly Tobinesque) structure advanced by Godley (1999), extended below to the case in which households in each country are allowed to choose between bonds of either government and the dollar issued by the single CB:9 Bsnd · pbn –––––– = γ0 + γ1rbn – γ1rbs Vs

(10.22)

Bssd · pbs –––––– = γ0 + γ1rbs – γ1rbn Vs

(10.23)

Bnsd · p ––––––bs = γ0 + γ1rbs – γ1rbn Vn

(10.24)

Bnnd · pbn –––––– = γ0 + γ1rbn – γ1rbs Vn

(10.25)

1 rbn = ––– pbn

(10.26)

1 rbs = ––– pbs

(10.27)

Hsd = Vs – pbn · Bsnd – pbs · Bssd

(10.28)

Hs d = 1 – 2γ In practice ––– 0 Vs Hnd = Vn – pbs · Bnsd – pbn · Bnnd

(10.29)

d In practice Hn ––– = 1 – 2γ0 Vn

By using perpetuity bonds (which makes it possible to define prices being the inverse of the interest rate), the demand for money may be expressed as a residual after wealth is allocated to bonds, or as a fixed proportion of wealth. Either way, the conditions that the sum of the constants must be unity and the sum of the propensities for each financial asset must be zero is satisfied.

152 Alex Izurieta Critical to the model solution is the determination of the amount of government bills that can be accepted by the CB. Intuitively, equation (10.30) tells that the government of the North (which we will assume is not affected by a shock) would issue bills in order to satisfy public sector borrowing requirements after households have expressed the demand for bonds at the market price. There is a restriction, defined in (10.31), denoting that government Treasury bills cannot be negative (a negative government bill would mean a loan from the government to the central bank). Obviously, there is no point for a government to lend to the central bank (and not expecting to earn interest from such a loan) when at the same time it still holds debt vis-à-vis households for which it has to pay interest. Unless the CB forces a government to do so, it would not be reasonable for a government to lend to the CB without earning interest. This is particularly the case if the government in question could first withdraw bonds for which it is actually paying interest. s Bcns = Zc · (Bcn–1s + PSBRn – pbn · (∆Bnnd + ∆Bsnd )) + (1 – Zc) · Bcn–1 (10.30) s s · Bcs–1 ) > 0; 〈0|(Bcn–1s · Bcs–1s ) ≤ 0 Zc = 〈1|(Bcn–1

(10.31)

Bcs s = Bcsd

(10.32)

The model structure as a whole would assure the symmetry of allocation of bills between both governments and the CB. In practice, however, we could straightforwardly write the amount supplied by the South as a constraint imposed by the amount that the CB is willing to take, as in equation (10.32). The above becomes clearer after defining the demand functions and noticing that the CB is constrained by the accounting balance derived from Table 10.1, wherein the sum of the last column is zero. That is, by allowing the CB to satisfy the supply of government bills expressed by, say, the North (equation (10.33)), the other demand becomes a residual after demand for money has been expressed (equation (10.34)). This constraint is, in turn, imposed on the supply of bills expressed by the South (equation (10.32), above). Bcnd = Bcns

(10.33)

Bcsd = Hnd + Hsd – Bcnd

(10.34)

In a dollarized regime, the CB will not lend to governments beyond what households are prepared to hold in money (which is proportional to wealth). From an accounting point of view, this restriction cannot be overcome, but could be made more binding if the CB imposes “politically determined” quotas for each country, or keeps a reserve of high-powered money.

Dollarization as a tight rein on the fiscal stance 153 Thus, since there is a limit to the extent governments can borrow from the CB, they have to satisfy additional borrowing requirements by supplying bonds at attractive interest rates, which in turn would imply higher costs in the future, leading to instability. This is the core of the adjustment process in this model. The supply functions below make this explicit. Bsns = Bsnd

(10.35)

Bnns = Bnnd

(10.36)

Bsss = Bssd

(10.37)

1 (p · Bns s + PSBRs – ∆Bcs s – p · ∆Bss s) Bns s = –– bs –1 pbs bs

(10.38)

Bnsd = Bns s

(10.39)

Of all the supply functions, which we can take as being responsive to the demands defined above, there is one that serves to determine the interest rate (or the price of bonds), in a standard manner. Since we have only two prices (bonds of the North and bonds of the South) we could fix one (as if it was a numéraire) and let the other fluctuate according to expressed demand and supply. We have taken pbn as our numéraire, and the system will solve for pbs. Indeed, this is done by expressing in equation (10.38) the condition which “forces” the government of the South to assure the resources needed to make up for its deficit. Finally, another relevant characteristic of this model is the finding, expressed analytically below, that money supply cannot be different from money demand, with no need for an additional equation to bring this equilibrium about. This has been sufficiently discussed in Godley (1999), and is further expanded, in the context of common currency scenarios, in Izurieta (2001) and in Godley and Lavoie (2003). Hn s = Hn–1s + ∆Hnd

(10.40)

Hs s = Hs–1s – ∆Hn s + ∆Bcsd + ∆Bcnd

(10.41)

It may be worth noting that both equations refer to a single money supply function, of which part is held in the South and part in the North, according to demands expressed above. We have included equations for fluctuations of employment (below, assuming standard elasticities), to be able to gather some insights about the likely implications

154 Alex Izurieta of recessionary model solutions on unemployment. These equations would not have feedback into the model solution (this would happen if we were to assign unemployment benefits paid by the governments, but this would have only exacerbated, perhaps unnecessarily, our results). En = En–1 + εn · ∆ln (Yn)

(10.42)

Es = Es–1 + εs · ∆log (Ys)

(10.43)

Baseline and simulations after an exogenous shock As usual, we first solve the model in order to further verify its internal consistency and obtain a steady-state baseline.10 Data sets of the two economies are hypothetical, and are constructed by matching two conditions: (i) they are consistent with the accounting structure set out in Table 10.1; and (ii) both economies are relatively similar to each other, neither showing anomalies such as a high debt burden or noticeable imbalances. We then experiment with initial conditions until we reach a quick convergence to the steady-state solution.11 Interpretation of some of the results plotted below requires considering that the unit of measure is such that GDP of each country is around 115, the balance of the central bank is around 65, and the net worth of the private sectors is around 120. Without exogenous disturbances, the public sector, the private sector and the external sector of each country would be in balance. As we have simplified the system to be stationary in real terms, government expenditure, the (endogenous) adjustment of money supply to demand (levels and differences), and employment ratios are horizontal in the baseline. We have chosen to inflict an exogenous shock upon the South by changing the import propensity of the North. This will produce a trade imbalance in the South, further transmitted into the fiscal balance (lower GDP will erode tax receipts). We explore its implications according to two alternative scenarios. The first scenario assumes fiscal self-determination: government spending and tax rates are fully determined by policymakers, and the model has to solve for public sector borrowing requirement arising from lack of tax revenue. In the second scenario, conversely, the fiscal stance will be tightened to ensure public sector balance. The model will show the pace of convergence towards a current account balance, and the implications on aggregate income and employment. Scenario 1: financial instability with fiscal self-determination Public spending is taken to be a domestic policy variable, independent of the cycle, short-term fluctuations, and policy decisions in the neighboring country. Considering that tax revenue is proportional to GDP, and that interest payments depend on

Dollarization as a tight rein on the fiscal stance 155 the stock of debt, PSBR would be fully endogenous. Indeed, PSBR of the South will rise once the shock (lower imports of the North) leads to lower aggregate demand and thus lower tax revenues in the South. In order to finance the deficit the government will initially draw from CB bills. At a certain point, access by the South to CB bills will reach its limit. The government will attempt to sell bonds in domestic and world markets (households of the South and of the North respectively), at ever increasing interest rates. This sequence is represented graphically in Figure 10.1, which shows that, due to the shock inflicted in 1955, the current account of the South falls from zero to a deficit of nearly 1.5 percent of GDP. Similarly, the public sector experiences a deficit of less than 1 percent of national income. This situation turns out to be relative stable until the mid-1970s, when both deficits start to show a tendency to explode. The apparent instability is consistent with the patterns observed in Figure 10.2, which represent the sources of financing for the government in the South. Up to the mid-1970s the government relies on increasing access to CB bills, until it faces a restriction.12 From that point onwards it places bonds in the market, which are purchased domestically and abroad.13 It goes without saying that these bonds carry additional costs for the government of the South in the successive periods, aggravating the deficit and triggering an ever increasing need to place more bonds on the market. This unleashes financial instability, which can be represented by an explosion of interest rates of the bonds issued by the South, plotted in Figure 10.3, compared with initial values and the interest rate in the North. 15%

10%

% (DEFs/Ys) (DEFs/Ys) % 5%

0%

BPs/Ys) % ((BPs/Ys)

–5%

06

10

02

98

90

94

86

82

78

70

74

66

62

54

58

50

–10%

Figure 10.1 Fiscal deficit and current account balance of the South after the shock.

156 Alex Izurieta 70

Bns*pbs Bns*pbs 60

50

Bss*pbs Bss*pbs

40

Bcs Bcs 30

20 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Figure 10.2 Financing of the deficit in the South. 16% 14% 12%

rbs rbs 10% 8% 6% 4%

rbn rbn

2% 0%

50 53 56 59 62 65 6 8 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Figure 10.3 Interest rates in the South and the North.

Scenario 2: sluggishness by tightening the fiscal stance Given the instability and potential financial crisis yielded by a dollarized system facing a shock, policymakers would be inclined to set automatic controls on the PSBR (curbing the fiscal stance by contracting spending or raising tax rates). We have adopted here the norm of a zero deficit, typically imposed on developing economies, stigmatized as lacking fiscal discipline. Yet the tight rein on the public sector would weaken demand and lead to an increasing deterioration of income of the system of the two countries as a whole.14

Dollarization as a tight rein on the fiscal stance 157 The notion of the fiscal stance serves to assess the extent to which government expenditures align with the overall tax rate in such a way as to assure the structural contribution of the public sector to aggregate demand. As explained in Godley and McCarthy (1998), the “real fiscal stance” (RFS), defined as a ratio of deflated general government outflows to the average rate of taxation, would be, if the fiscal budget is balanced, exactly equal to real GDP.15 In our framework, the contribution of the fiscal stance to aggregate demand is partially weakened by net interest payments abroad16 (which is consistent with our findings above: namely, even if the RFS remains unchanged, GDP would deteriorate in the event of a exogenous shock involving larger debt service burdens). But the direction of the impact, from the fiscal stance to aggregate income, remains the same; thus, the strain on the fiscal stance as a policy response to the external shock will be recessionary. The external shock will, as above, initially affect the balance of payments, leading to lower GDP and lower tax revenue. By adjusting spending the forces of the demand multiplier will weaken. Thus, it is expected that the initial drop of exports will be compensated by lowering imports. The current account imbalance will disappear, with time. A new problem arises, since the country initially unaffected by the shock will start experiencing a similar type of shortage in its external sector, its income will deteriorate, and with it imports from the South. Due to the adjustment from the spending side in both countries, all financial balances will tend to zero and the system will be, in this respect, stable. Yet lower aggregate demand and income will affect both countries, feeding each other some time in the future. The system will continuously generate unemployment. This sequence is fully reproduced by the simulation obtained after having inflicted the same shock experimented by the South above. This is represented graphically in Figure 10.4. The fiscal sector stays in balance, while the initial balance of payments deficit caused by the shock in 1955 tends to disappear smoothly. The public sector was required to maintain its balance by reducing spending at par with the lower tax revenue. The contraction is relatively drastic in the initial period, but the slide-down continues all the way through, though at a different pace. In Figure 10.5 we have plotted the lines corresponding to public sector tax income and current spending17 (left-hand side scale). The other line, using the right-hand side scale, is our RFS (Gs/θs). This trend would be proportional to that of government spending since the tax rate is unchanged. Besides, it hints at the expected shape of aggregate demand and income, as explained above. Figure 10.6 conveys clearly the notion that by tightening the fiscal stance in one country aggregate income of the system as a whole deteriorates dramatically. The dotted line is our RFS of the South as a ratio to “full-employment GDP” (which is the level before the shock). Both its initially sharp decline and the decreasing trend thereafter are matched by a “global” recession at a similar pace. Of the two countries, the South experiences a more drastic recession since it is

158 Alex Izurieta 0.3%

% (DEFs/Ys)

% (DEFs/Ys) %

0.0%

–0.3%

(BPs/Ys) %%(BPs/Ys)

–0.5%

–0.8%

–1.0%

50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Figure 10.4 Fiscal and current account balances of the South by fiscal tightening.

40

110

100

RFS RFS = Gs/"theta's" = Gs/θs 90

80 30

Ts

Gs Gs

70

60

50

20

40 50 53 56 59 62 65 6 8 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Figure 10.5 Fiscal stance, and current expenditure and tax revenue.

the import propensity of the North which has affected its revenue in the first place. The impact in the North, and its feedback onto the neighboring country, depend on the size of the multiplier as much as on the application of restrictive fiscal policies. By standard assumptions about employment elasticities, it seems self-evident that the system expels an increasing number of workers from their economies, in both countries.

Dollarization as a tight rein on the fiscal stance 159 230

1.00 0.98

228

0.96 226 0.94

Ys + Yn 224

0.92 0.90

222

0.88

220

0.86 218

Ratio RFS on Full Empl. Ys 216

0.84 0.82 0.80

214

50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Figure 10.6 Fiscal tightening and global recession.

Conclusion We have seen that a dollarized economy, by dismantling exchange rate and monetary policy, is left with only two options after an exogenous shock. In one it could stick to the previously determined priorities which have structured the patterns of demand, employment, income, and distribution, while leaving to “the market” the task of financial consolidation. The alternative is to adjust to the shock by tightening the fiscal stance, thus achieving – by contraction – financial consolidation, disregarding the fact that the structural patterns of demand might be altered, perhaps irreversibly. In order to explore these alternatives, we constructed a theoretical, inherently consistent, flow/stock model, based on the accounting principle that all flows have a counterpart, and accumulate over time feeding into the balance sheets of the system. This allowed us to determine, for given macroeconomic relations, how exogenously generated imbalances are absorbed by each sector. Indeed, by provoking a fall of export demand affecting the South, two clearly distinguished scenarios resulted. The first scenario assumes that the fiscal stance is exogenous, which we would see as a desirable characteristic of economic policy. However, the lack of export demand affects net foreign earnings, which in turn translates into meager tax revenue by eroding national income in the South. The result is deficits in both external and fiscal accounts. To a limited extent, either reserves or some form of direct financing from the central bank may help. Yet at a certain point the government in distress would require additional financing, that is, debt. In order to place

160 Alex Izurieta bonds the interest rate has to rise. Debt services mount, aggravating the fiscal burden, thus necessitating more bonds to be issued, etc. We find that the model yields an inherently unstable solution, since the interest rate rises indefinitely. The second scenario did not allow fiscal deficits at all; i.e. instead of a policydetermined fiscal stance the goal is fiscal balance. Thus, the public sector would adjust spending automatically. By achieving fiscal stability via contraction, domestic income was affected. The trade imbalance would tend to correct itself due to fewer imports. Now the initially “unaffected” country would also experience a slow-down because of lack of export demand. Though stable from a finance point of view, this scenario was recessionary, generating unemployment. This exercise dramatically simplifies the complex process of economic adjustment of countries in the real world facing real shocks. More comprehensive analytical frameworks, by allowing for the inclusion of a third bloc representing the rest-of-the-world, by defining production functions constrained by imports, or by specifying relative price changes, etc. may shed additional light on the problems typically faced by countries which have dollarized. We would not expect, however, that more complex analytical frameworks would reverse our conclusions. Rather, by streamlining the analytics we have unveiled how the external balance is linked with the financial system and the fiscal sector in a formally dollarized regime. The framework set out above, even if purely axiomatic, yields results sufficiently informative for policymaking. In a nutshell, by dismantling exchange rate and monetary policy, fiscal policy must be given up if the financial stability of the system is to be guarded. But, then, policymaking is completely deprived of ways of generating income and protecting employment. If none of these is a sensible option, neither is dollarization.

Notation BCn, BCs Bij Cn, Cs En, Es FAn, FAs Gn, Gs Hn, Hs Mn, Ms pbj PSBRn, PSBRs Rbj Tn, Ts Vn, Vs Wn, Ws

Government treasury bills Bonds issued by country j, held by households in country i. Consumption Employment levels Financial assets owed by households Government expenditure Money, issued by the CB, held in either country Imports Price of bonds issued by country j Public sector borrowing requirements Rate of interest on bonds issued by country j Tax income Financial wealth of households Wage bill

Dollarization as a tight rein on the fiscal stance 161 Xn, Xs YDn, YDs Yn, Ys Zc γ1, γ2 α1, α2 εn, εs µn, µs θn, θs

Exports Disposable income of households GDP Discrete variable denoting conditional constraints Parameters of the demands for financial assets Propensity to consume out of income and wealth, respectively Elasticities of the employment function Import propensities Tax rates

Notes i. Suffix “n” denotes North and “s” South. ii. When two suffixes are used, the first one denotes the country that holds the asset position and the second one the country that honors the liability.

Notes 1 The theoretical insights of Wynne Godley are entrenched throughout this paper, and his support was invaluable in reaching this stage. The author has also benefited from fruitful discussions with Marc Lavoie, Jörg Bibow and John Eatwell. The usual disclaimer applies. 2 The controversy on “polarization rather than convergence” is discussed in Godley (2001, 1988), Godley and Christodoulakis (1987), Godley and Coutts (1990), Godley and Cripps (1978) and Godley and May (1977). The core argument is consistent with that of Kaldor (1980), who points to the fact that the modern theory of international trade misleadingly assumes perfect competition and aggregate production functions with constant returns to scale. In reality, however, dynamically increasing returns to scale, and far from perfect competitive markets lead to “a process of polarization in which success in competitive performance feeds into itself and losers become immiserated by trade.” Godley and Cripps (1978) advance a proposition towards nonselective, non-discriminatory and coordinated import controls to raise output between partners. 3 The European Monetary Union, at least theoretically, would have available the creation of a “common fiscal institution,” which could eventually serve to compensate balance of trade deficiencies by interstate transfers; and the Currency Board System would have available the choice of adjusting the convertibility rate, in a way similar to, though perhaps not as frequently as, fixed exchange rate systems. 4 This model is a variation of the one presented in Izurieta (2001), which was, in turn, a special case of the more general analytical framework proposed in Godley (1999). The present version has been enriched by fruitful discussions with, notably, M. Lavoie and J. Bibow. In particular it was noticed that, because that model intended to tackle all cases of “common currency” (i.e. the EMU, CBS, and dollarization), it required an underlying accounting structure that was too artificial and thus of little practical use. 5 The emphasis on accounting consistency, and especially the incorporation of financial accounts (both flows and stocks) into the system of production and distribution accounts (à la Meade and Stone, 1941), is owed to Denizet (1963), Tobin (1969), and Roe (1973).

162 Alex Izurieta

6

7

8

9

10 11

12

13 14

15

Notable developments of this methodology can be found in the traditions of the “Cambridge Economic Policy Group Models” (see Godley and Cripps, 1978) and models based on “Social Accounting Matrices” (Pyatt and Round, 1977). Properly speaking, the “dollar” should be issued by, say, the “Treasury” of the North country, rather than by a “neutral” central bank. We chose the latter to emphasize that our results are symmetrical, i.e. independent of which country holds the central bank prerogative. The exclusion of transfers across the border is not only a simplifying assumption. It is meant to emphasize the main difference with respect to a federal system. If it existed, an automatic compensatory mechanism from surplus states to deficit states then sharing a common currency and a central bank would not lead to the trap of fiscal repression or instability, we hypothesize, because, in some ways at least, governments would compensate each other via those types of transfers. It may not have been sufficiently emphasized that the conventional wisdom that macroeconomic imbalances result from public sector financial failures, while assuming that the private sector is balanced, has led, quite often, to catastrophic financial and systemic crises around the globe. Moreover, it is also the case, as in Ecuador and elsewhere (Izurieta, 2000) that it was private sector financial failures, in the first place, which unleashed crises leading to dollarization or currency boards systems. Thus, in considering that the entrepreneurial sector is in balance and that there is no banking sector (or that it exists but that its role is purely intermediary, thus balanced), we are – generously – omitting one more possible cause of economic instability. We have chosen to use the same values of the coefficients for both countries in order to rule out the argument, made in other studies, by which the inherent instability of common currency settings is due to differences in economic structures and portfolio behavior within the common currency bloc. The software we use is Modler, from Alphametrics (www.modler.com). Notionally, the model would eventually reach a steady-state solution independently of the baseline used. In practice, however, convergence to the steady state would depend on numerical algorithms, and would, in any case, involve a longer period if the baseline is too far from a steady state. In passing, it can be noticed that the total amount of CB bills available to the South tends to slide down, moderately. This is because the total amount of CB bills that can be issued are to be equal to the total amount of money demanded by the system of the two countries. Since money demand in each country is proportional to wealth, and wealth declines when income declines, then total money demand decreases. Notice that bonds sold domestically are fewer than those sold abroad although our propensities were equal and the interest rate is the same because income in the South is lower than that of the North, due to the shock itself. It should perhaps be emphasized that such a solution, which implies financial stability with stagnation, is not an issue of the level of desired PSBR chosen (as put forward by economists who question the specific parameters of the Maastricht Treaty) but of the nature of the adjustment per se. Assuming that there are no factor payments across the border, deriving from (10.21) we have: Gs = PSBRs + Ts, where now PSBRs → 0. Considering that Ts = θs.GDPs in the standard macro model, replacing and rearranging above we get:

Dollarization as a tight rein on the fiscal stance 163 Gs

= GDPs. θs 16 Using the full expression in (10.21) and considering that the relation between tax revenue and national income can be rewritten as Ts = θs. (Ys + Bsn–1 + Bss–1), we will obtain, after rearranging, an expression such as: Gs 1 1–θ –– = Ys – –– Bns–1 + ––––s Bss–1 – Bsn–1 θs θs θs 17 Government current spending is systematically lower than tax revenue because of debt payments (at the baseline level). The novelty of this scenario is that, since the public sector deficit is contained, there are no additional financing requirements, and thus neither the debt stock nor the interest rate needs to rise. Thus, debt service payments are stable through the entire period.

References Denizet, J. (1967), Monnaie et financement. Essai de théorie dans un cadre de comptabilité économique, Paris: Dunod. Godley, W. (1988), “Manufacturing and the Future of the British Economy,” in T. Baker and P. Dunne (eds), The British Economy after Oil: Manufacturing or Services?, London, New York and Sydney: Croom Helm in association with Methuen. Godley, W. (1991), “Britain and the Danger of EMU,” Cambridge DAE Working Paper 911. Godley, W. (1992), “Maastricht and All That,” London Review of Books, Vol. 14, p. 19. Godley, W. (1996), “Money, Finance, and National Income Determination: An Integrated Approach,” Jerome Levy Economics Institute of Bard College Working Paper Series 167, June. Godley, W. (1997a), “Macroeconomics Without Equilibrium or Disequilibrium,” Jerome Levy Economics Institute of Bard College Working Paper Series 205, August. Godley, W. (1997b), “The Hole in the Treaty,” in P. Gowan and P. Anderson (eds), The Question of Europe, London: Verso, pp. 173–7. Godley, W. (1997c), “Curried EMU: The Meal that Fails to Nourish”, The Observer, 31 August. Godley, W. (1999), “Money and Credit in a Keynesian Model of Income Determination,” Cambridge Journal of Economics, Vol. 23 (July), p. 4. Godley, W. (2001), “Wynne Godley,” in P. Arestis and M. Sawyer (eds), A Biographical Dictionary of Dissenting Economists, Second Edition, Cheltenham: Edward Elgar. Godley, W. and N. Christodoulakis (1987), “Macroeconomic Consequences of Alternative Trade Policy Options,” Journal of Policy Modelling, Vol. 9, No. 3 (Fall), pp. 405–36. Godley, W. and K. J. Coutts (1990), “Prosperity and Foreign Trade in the 1990s: Britain’s Strategic Problem,” Oxford Review of Economic Policy, Vol. 6, No. 3 (Autumn), pp. 82–92. Godley, W. and F. Cripps (1976), “A Formal Analysis of the Cambridge Economic Policy Group Model,” Economica, Vol. 43, No. 172 (November), pp. 335–48. Godley, W. and F. Cripps (1978), “Control of Imports as a Means to Full Employment and the Expansion of World Trade: The UK’s Case: Comment,” Cambridge Journal of Economics, Vol. 2, No. 3 (September), pp. 327–34.

164 Alex Izurieta Godley, W. and M. Lavoie (2003), Monetary Economics: An Integrated Approach to Credit, Money, Income, Production, and Wealth. Godley, W. and R. May (1977), “The Macroeconomic Implications of Devaluation and Import Restriction,” Economic Policy Review, Vol. 3, No. 1 (March), pp. 32–42. Godley, W. and G. McCarthy (1998), “Fiscal Policy Will Matter,” Challenge, Vol. 41, No. 1, (January–February), pp. 38–54. Izurieta, A. (2000), “Crowding-out or Bailing-out? Fiscal Deficits and Private Wealth in Ecuador, 1971–99,” Ph.D. thesis, The Hague: Institute of Social Studies. Izurieta, A. (2001), “Can Countries Under a Common Currency Conduct Their Own Fiscal Policies?,” Jerome Levy Economics Institute of Bard College Working Paper Series 337, August. Kaldor, N. (1980), “The Foundations of Free Trade and Recent Experiences,” In E. Malinvaud and J. P. Fitoussi (eds), Unemployment in Western Countries: Proceedings of a Conference Held by the International Economic Association at Bischenberg, London: Macmillan. Lavoie, M. (1984), “The Endogenous Flow of Credit and the Post Keynesian Theory of Money,” Journal of Economic Issues, Vol. 18, No. 3 (September), pp. 77 1–97. Lavoie, M. (2001), “Endogenous Money in a Coherent Stock-Flow Framework,” Working Paper 325, Annandale-on-Hudson, NY: Levy Economics Institute. Lavoie, M. and W. Godley (2000), “Kaleckian Models of Growth in a Stock-Flow Monetary Framework: A Neo-Kaldorian Model,” Working Paper 302, Annandale-on-Hudson, NY: Levy Economics Institute. Meade J. and R. Stone (1941), “The Construction of Tables of National Income, Expenditure, Savings and Investment,” Economic Journal, Vol. 51, Nos. 202/203 (June– Sept.), pp. 216–33. Minsky, H. (1989), “Financial Structures: Indebtedness and Credit,” in A. Barrere (ed.), Money, Credit and Prices in Keynesian Perspective, New York: St. Martin’s Press. Pyatt, G. and J. Round (1977), “Social Accounting Matrices for Development Planning,” Review of Income and Wealth, Vol. 23, No. 4 (December), pp. 339–63. Roe, A. (1973), “The Case for Flow of Funds and National Balance Sheet Accounts,” Economic Journal, Vol. 83, No. 330 (June), pp. 399–420. Tobin, J. (1969), “A General Equilibrium Approach to Monetary Theory,” Journal of Money, Credit and Banking, Vol. 1, No. 1 (February), pp. 15–29.

11 Why Ecuador was ripe for dollarization, but Canada is not James W. Dean

Introduction Questions of which exchange rate regimes might be appropriate for countries, and regions larger than countries, have long been central to the concerns of internationally oriented economists, politicians and policymakers. Although the issue seemed to be settled after 1945, when most free-market countries signed up to the Bretton Woods regime of fixed exchange rates, by 1953 the wisdom of that regime was being challenged in a now-classic essay by Milton Friedman. By 1973 the Bretton Woods regime had collapsed and major countries were using flexible rates more or less by default. But by 1979, the core countries of Western Europe had adopted fixed rates with one another, and in 1999, despite widespread skepticism among economists (see Dean, 1997), they went one step further and adopted a common currency. Meanwhile, debate and experiment in countries outside Western Europe intensified. By the mid-1980s, a consensus had been formed at the IMF and other Washington institutions that emerging economies were best served by fixed, or at least “managed,” exchange rates, primarily because this would serve to discipline their central banks and keep inflation at single-digit levels. By the mid-1990s, this “Washington consensus” had been terminally undermined, notably by the Mexican currency crisis of late 1994. A new and radically different consensus began to evolve. The new consensus was that in a post-Bretton Woods world of highly mobile capital, only “automaticity” could avert currency crisis. By this was meant regimes that adjusted automatically to market forces, without government intervention: either fully flexible exchange rate regimes, or fixed-rate regimes constitutionally bound by so-called “currency boards.” Hence by 1999, after the Asian, Russian, and Brazilian crises of 1997, 1998, and 1999, several eminent economists were advocating fully flexible exchange rates for major emerging economies such as Indonesia, Russia, and Brazil, whereas other, equally eminent economists were recommending fully fixed rates, “guaranteed” by currency boards, for the same emerging economies. Even more dramatically, a

166 James W. Dean growing group of analysts and advisors now propose common currencies, modeled loosely on the European euro, for regions as diverse as Belarus and Russia, the Mercosur free trade region of South America, and Canada and the United States. And in Latin America, proponents of “dollarization” are advocating outright adoption of the US dollar, with implications for both Latin America and the US that run well beyond even a common currency. In fact several prominent economists have begun to argue that essentially all developing countries should dollarize (notably, Calvo and Reinhart, 2000).

Latin America In Ecuador, inflation – which threatened to spiral out of control 18 months ago – slowed to a monthly rate of 2.5% in December [after dollarization] from 14.3% in January 2000 [before dollarization]. Interest rates are plummeting and banks are out of intensive care. President Gustavo Noboa described the move as a rabbit pulled from a magician’s hat to save the economy from ruin. El Salvador needed no such rabbit. It has long been a star pupil of Washington’s free-trade gospel and enjoyed a steady currency and low inflation. But the country wanted to grow faster and believed that adopting the dollar would eliminate foreign-exchange risk and allow interest rates in the country to fall. That, in turn, would make it possible for businesses to expand faster and would make buying a home affordable for more consumers. Even before the dollar officially made its debut at the start of January, interest rates fell. Asian Wall Street Journal, 16 January 2001 As this newspaper extract illustrates, official, “de jure” dollarization has just now begun in Ecuador and El Salvador, two of Latin America’s smallest and poorest countries. With the exception of Panama, which has used the US dollar as its sole official currency since 1904, and a few minor territories of the US, these two countries are the first in the world to dollarize officially. But they will not be the last. Guatemala scheduled official dollarization for 1 May 2001, and Costa Rica, Honduras, Nicaragua, and Argentina are seriously discussing the possibility. In Mexico, where it was a hot topic in 2000, popular opinion has swung contra, but some form of monetary cooperation with the US is still in the air. Informal or “de facto” dollarization is already well established all over Latin America, not least in some of its largest and richest countries. According to data compiled by Feige et al. (forthcoming), the most highly de facto dollarized Latin American countries are Bolivia, Nicaragua, Argentina, Peru, Venezuela, and Costa Rica. This chapter will argue that de facto dollarization may be irreversible. It will also report evidence and arguments that, in many Latin American countries, de facto dollarization has rendered monetary policy relatively impotent, and active exchange rate policy downright dangerous. Hence full de jure dollarization might be the only

Dollarization in Ecuador and Canada 167 sensible course left to such countries, whatever the putative benefits of alternative regimes might have been were de facto dollarization not already in place. These arguments are not conclusive, nor do they necessarily apply to all Latin American economies.1 For example the largest of them all, Brazil, is not heavily dollarized in terms of currency use or bank deposits, although it does have large dollar liabilities. But in Argentina, Bolivia, Peru, and Uruguay, the value of dollardenominated bank deposits is higher than those in local currency. Citizens and firms in all Latin American countries also hold huge dollar deposits offshore. And in all Latin American countries, governments, firms, and banks have huge dollar liabilities. Not one Latin American country is able to issue external debt in its own currency. In fact, as Eichengreen and Hausmann (1999) point out, virtually no nonOECD countries can borrow abroad in their own currency: part of a pervasive developing-country problem of mismatched balanced sheets they call “original sin.” Hausmann et al. (2000) studied eleven Latin American countries during the troubled period between October 1997 and April 1998. Three “stylized facts” emerge. In response to negative external shocks: ● ●

●

most countries lowered their exchange rates very sparingly most countries raised their interest rates very aggressively to defend their exchange rates interest rates were hiked least in countries with fixed exchange rate regimes.

These results seem to run against conventional theory and merit closer attention. Over and above the much-debated costs associated with fixed exchange rates (notably, loss of monetary sovereignty), the two main costs of full dollarization would be loss of seigniorage revenue and loss of the option to “exit” to domestic currency in case devaluation (or revaluation) became desirable. Loss of seigniorage can cost a country upwards of 1 percent of its annual GDP. However, the additional loss associated with fully dollarizing countries that are already partially dollarized would be proportionately less. Moreover, the US might agree to share seigniorage with countries that officially dollarize. A US Senate bill to facilitate seigniorage sharing failed in 1999, but could be revived. Recently, various plans for how this might work in practice have been proposed (see, for example, Hanke and Schuler, 1999; and Hausmann and Powell, 2000).

Causes of de facto dollarization When you get right down to it, the benefits of having your own currency are much smaller than we used to think, especially for countries that already to a considerable extent are using the dollar. Stanley Fischer, speaking in the context of Ecuador’s dollarization, quoted in the Wall Street Journal, 17 May 2000

168 James W. Dean If individuals and firms in one country choose to use the dollar without any requirement or even authorization to do so by law, the phenomenon can be called “de facto dollarization.” De facto dollarization is by private rather than public choice; the latter, where use of the foreign currency is legislated, is called “official” or “de jure” dollarization. De facto dollarization has typically occurred in response to high inflation, and, relatedly, a rapidly depreciating exchange rate.2 A secondary motive has been to hedge against losses in the event of a banking crisis. Whereas losses of purchasing power due to inflation or losses of exchange value due to depreciation can be averted by holding either foreign currency bank deposits or foreign cash, losses from a domestic banking collapse can be averted only by holding foreign cash or bank deposits in a foreign bank. In short, de facto dollarization has typically been a response to actual or expected financial turmoil (Hausmann et al., 2000). But while financial turmoil typically explains an initial flight to foreign currency, it cannot explain the persistence of dollarization after turmoil ceases. Such persistence is documented by Kamin and Ericsson (1993). Although the flight to foreign currency was substantially reversed in, for example, Israel and the transition countries of Eastern Europe after their macroeconomies were to some extent stabilized, dollarization has persisted in the Americas despite stabilization (Sahay and Vegh, 1995). Whereas initial dollarization is typically motivated by asset substitution so as to preserve value, persistent dollarization is motivated by sufficient currency substitution that foreign currency is in widespread use as a medium of exchange. The most cogent explanation for persistence is that once foreign currency comes to be widely used as a medium of exchange, so-called “network effects” begin to raise the cost of reverting to the domestic currency.3 At some point, de facto dollarization may become irreversible, except by de jure means.

The case for de jure dollarization4 Perhaps the most prominent advocate of de jure dollarization for Latin America has been Ricardo Hausmann, notably when he was chief economist of the InterAmerican Development Bank (Hausmann, 1999; Hausmann et al., 2000; Fernando-Arias and Hausmann, 2000).5 The argument has several strands: Dangers of liability dollarization According to Hausmann, nominal exchange rate depreciation has become too dangerous to permit because of de facto liability dollarization. When a country’s firms, banks, and government have borrowed in a foreign currency such as the US dollar, sharp depreciation of the domestic currency leads to an equally sharp increase in the domestic currency value of foreign currency debt obligations. This in

Dollarization in Ecuador and Canada 169 turn sharply increases the demand for foreign currency and can lead to a downward spiral in the price of domestic currency. And not only does an x percent depreciation increase the local-currency debt burden by an equal x percent, it increases the likelihood of default on such debt. Hence banks, which are both borrowers and lenders, are doubly exposed, to currency risk as well as default risk. Episodes such as Mexico’s attempt at a moderate devaluation in 1994 led to uncontrolled depreciation that had to be countered by crippling increases in interest rates. Recently, most Latin American countries have, in practice, ruled out any exchange rate policy other than nominal targeting, and monetary policy has in effect become passive. In other words, liability dollarization has become a strong deterrent to depreciation, a phenomenon that Calvo and Reinhart (2000) term “fear of floating.” Currency and default risk premiums on interest rates De facto liability dollarization acts to increase the currency risk premium on Latin American interest rates, because of the dangers alluded to above. It also acts to increase default risk. De jure dollarization would eliminate currency risk premiums, and probably reduce country (default) risk premiums as well. This would likely stimulate investment and growth. Even Argentina, which enforces a rigidly fixed rate against the US dollar under its currency board arrangements, may be well advised to dollarize because of the currency risk premium on peso-denominated debt that persists because of the perceived risk that the currency board may be compromised or collapse (Berg and Borenzstein, 2000b). Less predictable control of the domestic money supply De facto substitution of the US dollar for local currencies has reinforced the impotence of monetary policy because on the margin it weakens the ability of central banks to control the stock of domestic money predictably (Balino et al., 1999). Stronger monetary than real shocks Currency substitution also increases the relative importance of the monetary as against real shocks that buffet an economy, and hence reduces the relative desirability of a flexible exchange rate as a buffer against such shocks (Berg and Borenzstein, 2000a). Irreversibility Informal use of US cash – currency substitution – has now become so widespread in Latin America that it may be irreversible due to exponentially growing network

170 James W. Dean externalities. This conjecture is untested and probably untestable, but models of network externalities in currency use, such as Dowd and Greenaway (1993), identify indicative parameters that, for Latin America, are within ranges that suggest irreversibility. Impotence Although most of Latin America operates under putatively flexible exchange rate regimes, real exchange rate depreciation is difficult to achieve because of the high pass-through to domestic prices that is a lingering legacy of recent high inflation. Hence exchange rate policy has become impotent (Hausmann et al., 2000).

Though Ecuador was ripe for dollarization, Canada is not De facto dollarization is also well underway in Canada. Over the last three years, the case for de jure dollarization has been made in both government and academic circles (see, for example, Courchene and Harris, forthcoming), and lively debate has ensued. But the case for Canada is not as strong as the case for Latin America. In fact I am on record as being against dollarizing Canada (Dean, 1999). Here, I will contrast the Canadian case with that of Latin America. The case for dollarizing Latin America rests on six grounds: dangerous exposure of both banks’ and firms’ balance sheets to currency risk, related currency and country risk premiums on Latin American interest rates, weakened monetary control due to substitution of US for domestic currency, probable dominance of nominal over real external shocks, high pass-through from exchange rates to wages and domestic prices, and probable irreversibility of currency substitution. The case for dollarizing Canada fails on all six of these grounds. Consider each in turn: Dangers of liability dollarization Unlike Latin America, Canada is capable of issuing debt, both domestic and foreign, in its own currency. While Canadian banks and firms do issue lots of US dollar debt (about one-third of Canadian bank deposits are in US dollars), banks also hold substantial US dollar assets and firms enjoy extensive US dollar revenues. And while on balance the net liability exposure of both banks and firms is still in US dollars, the extent of the exposure is not nearly as large as in most Latin American countries. Equally importantly, Canadian banks, unlike many in Latin America, are prudentially sound with adequate loan loss reserves to cover any likely currency losses. It is simply not plausible to argue that Canada should dollarize because rapid depreciation of the Canadian dollar might cause a banking crisis.

Dollarization in Ecuador and Canada 171 Currency and default risk premiums on interest rates Currency risk premiums against the US dollar are not only absent in Canada, they have been apparently negative for most of the past few years! Canadian interest rates, both short- and long-term, have been well below American ones. The easy explanation for this is that the markets have generally expected the Canadian dollar to rise against the American, due to lower inflation and inflationary expectations in Canada, notwithstanding that this expectation has been consistently and palpably wrong. A more paranoiac explanation – one to which I do not subscribe – is that the Bank of Canada in conspiracy with the Department of Finance deliberately held Canadian rates lower than American ones in order to depreciate the Canadian dollar and hence the external value of Canadian-dollar-denominated debt. Given that the bulk of Canada’s external debt, except for the federal government’s, is US dollar denominated, this implies a fantastic conspiracy by the Finance Department against provincial, local, and municipal, not to mention corporate, debtors, as well as Canadian travelers and consumers of all other imports. But the bottom line is that, for whatever reason, Canadian interest rates have been lower than American ones, not higher, and it is hard to argue they would have been even lower had Canada adopted the US dollar. Less predictable control of the domestic money supply Does currency substitution weaken Canada’s control over its money supply? In Latin America, currency substitution – holding US cash – is, at bottom, motivated by a store of value considerations: the need to hedge against inflation, exchange rate depreciation, or banking crises. Asset substitution – holding US-dollar-denominated bank deposits – is even more directly motivated by such considerations.6 As a result, major injections or withdrawals of domestic money by Latin American central banks often prompt large and unpredictable movements into or out of US dollars. Currency substitution in Canada, by contrast, is relatively minor and stable, motivated largely by tourist transactions. Asset substitution in Canada is admittedly more substantial, and motivated by a mixture of hedging as well as transactions motives. But asset substitution in Canada is also more predicable than in Latin America, simply because inflation and (even!) exchange rate movements are more predictable. This relative predictability extends to marginal movements in response to money supply management by the Bank of Canada. Hence currency and asset substitution are not serious impediments to monetary control. Stronger monetary than real shocks Other things being equal, an economy is better buffered from monetary shocks by a fixed rate and from real shocks by a flexible rate. In Latin America, currency

172 James W. Dean substitution is sufficiently substantial that monetary shocks are likely to dominate, due to unpredictable internal shifts between domestic and foreign cash. Moreover, Latin America is vulnerable to substantial shocks on its external capital account: capital inflows and outflows are volatile. And, finally, unless these external shocks are sterilized, they translate into internal monetary shocks because exchange rates are, in practice, heavily managed. Canada, by contrast, has relatively little currency substitution: US cash in circulation is low by Latin American standards, and (as in Latin America) US dollar bank checks are not legal tender. Furthermore, Canada is not subject to such sharp shocks to its external capital account as Latin America, and when capital does flow in or out the exchange rate is usually allowed to adjust sufficiently so that the domestic money supply is not forced to respond. Canada still is, however, dependent on resource exports relative to the US; hence its flexible nominal exchange rate does provide a useful buffer against real terms of trade shocks. This flexibility proved particularly valuable in 1997–8, when resource prices plummeted in the wake of East Asia’s financial crisis.7 Irreversibility Some suggest that currency substitution in Latin America may now be irreversible, short of draconian legislation and its enforcement. According to the Dowd and Greenaway (1993) model of network externalities, whether domestic monetary expansion induces currency substitution depends upon the sensitivity of the exchange rate to money, the sensitivity to exchange rate changes of the number of people using foreign currency, and the extent to which the broad money supply is not covered by foreign exchange reserves. In Latin America, these two sensitivities are relatively high and the coverage ratio is typically low. Moreover the monetary “slippage” effect increases exponentially as levels of cash dollarization increase, due to network externalities in the use of foreign currency. In Canada, the two sensitivities are relatively low, the coverage ratio is relatively high and the level of cash dollarization is relatively low. Hence the case for de jure dollarization is correspondingly weaker. Impotence In Latin America, exchange rate depreciation is often quickly matched by domestic wage and price inflation, leaving the real exchange rate unchanged. Hence depreciation or devaluation as a tactic to stimulate real output is bound to prove futile. Latin America’s pervasive and persistent wage indexation and short-period contracting is a legacy of its recent rampant inflation. Canada does not have such a legacy. More fundamentally, Canada has a long history of responsible – some would say excessively restrictive – monetary growth. Particularly over the past twelve years, the Bank of Canada has earned a reputation as a consistent inflation-fighter.

Dollarization in Ecuador and Canada 173 No central bank in Latin America – with the exception of Argentina’s which is bound by a currency board, and possibly Chile’s which has worked the inflation rate down – can match this reputation. As a result, Canada’s real exchange rate can and does depreciate markedly, and, as a further result, nominal exchange rate targeting is not at all necessary to control inflationary expectations or to discipline the central bank. A final reason for dollarizing Latin America – one that I have not emphasized here but that is emphasized by many advocates – is to promote tighter trade and investment ties with the United States, presumably because both exchange rate uncertainty and currency conversion costs would be eliminated. But surely explicit free trade and investment pacts are a more straightforward way to go about this, and indeed the North American Free Trade Agreement has been accompanied by a burgeoning of cross-border trade and investment between both Mexico and the US and Canada and the US. While it may be that direct investment into Mexico would be further encouraged by dollarizing, it is not at all clear that cross-border trade needs such encouragement. It is even less clear for Canada, which now sends some 85 percent of its exports to the US.

Notes 1 For strong counter-arguments, see Willett (2001) and Williamson (2000, forthcoming). 2 Ize and Levy-Yeyati (1998) present a model of bank dollarization in which currencies are chosen on the basis of hedging decisions. For a broad sample of countries, they are able to approximate actual dollarization closely as a result of minimum variance portfolio allocations. Moreover, they show that dollarization hysteresis (irreversibility) occurs when the expected volatility of the inflation rate is high relative to that of the real exchange rate. 3 As the transaction use of foreign currency increases, its utility value rises non-linearly with the number of users. This phenomenon has been captured by Dowd and Greenaway (1993) in a model of network externalities; for a secondary exposition, see Dean (2000), Feige et al. (forthcoming) and Feige (forthcoming). 4 For elaborations of the arguments outlined in this section, see Dean (2000, forthcoming). 5 An excellent critique of Hausmann’s (1999, 2000) arguments and evidence in favor of de jure dollarization can be found in Willett (2001). Interestingly, Hausmann’s strong advocacy of dollarization was disavowed by the bank’s president, and even more interestingly, Hausmann resigned from the bank in mid-2000 to take up a professorship at Harvard. 6 Following Feige (forthcoming), a currency substitution index, CSI, can be defined as the fraction of a country’s total currency supply that is made up of foreign currency: CSI = FCC/(FCC + LCC), where FCC is foreign currency in circulation, and LCC is local. An asset substitution index, ASI, can be defined (for bank deposits) as the ratio of foreigncurrency-denominated monetary deposits to domestic-plus-foreign-currencydenominated deposits: ASI = FCD/(DCD + FCD). 7 According to the Bank of Canada’s amazing econometric model, which consistently “explains” movements in the Canada/US exchange rate, Canada’s continued low dollar is due to continued low resource prices – of agricultural products including pulp and paper,

174 James W. Dean and of non-oil and gas mineral products. Surprisingly to some, Canada is a net importer of oil and petroleum products, when intermediate goods are taken into account.

References Balino, T. J. T., A. Bennett, E. Borensztein, et al. (1999), “Monetary Policy in Dollarized Economies,” Occasional Paper 171, Washington DC: International Monetary Fund. Berg, Andrew and Eduardo Borensztein (2000a), “The Choice of Exchange Rate Regime and Monetary Target in Highly Dollarized Economies,” Working Paper WP/00/29, Washington DC: International Monetary Fund, February. Berg, Andrew and Eduardo Borensztein (2000b), “The Pros and Cons of Full Dollarization,” Working Paper, Washington DC: International Monetary Fund, March. Calvo, G. A. and C. A. Vegh (1992), “Currency Substitution in Developing Countries – An Introduction,” Working Paper WP/92/40, Washington DC: International Monetary Fund. Calvo, G. A. and Eduardo Fernandez-Arias (2000), “The New Features of Financial Crises in Emerging Markets,” in Eduardo Fernando-Arias and Ricardo Hausmann (eds). Calvo, G. A. and Carmen M. Reinhart (2000), “Fear of Floating,” NBER Working Paper 7993, Washington DC: National Bureau of Economic Research. Courchene, Thomas J. and Richard G. Harris (forthcoming), “North American Currency Integration: A Canadian Perspective,” in Dean et al. (eds) (to appear). Dean, James W. (1997), “Is the European Common Currency Worth It?,” Challenge, Vol. 40, No. 3 (May/June), pp. 57–74. Dean, James W. (1999), “Our Money or Theirs?,” National Post Magazine, September. Dean, James W. (2000), “De Facto Dollarization in Latin America,” prepared for a conference, To Dollarize or not to Dollarize: Exchange-Rate Choices for the Western Hemisphere, sponsored by the North–South Institute, Ottawa, Canada, 4–5 October 2000. Dean, James W. (2001), “Should Common Law Marriages to the US Dollar be Legalized?,” Journal of Policy Modeling, May. Dean, James W., Dominick Salvatore, and Thomas D. Willett (eds) (forthcoming), Dollarization in the Americas?, New York: Westview Press. Dowd, Kevin and David Greenaway (1993), “Currency Competition, Network Externalities and Switching Costs: Towards an Alternative View of Optimum Currency Areas,” Economic Journal, Vol. 103 (September), pp. 1180–9. Eichengreen, Barry and Ricardo Hausmann (1999), “Exchange Rates and Financial Fragility,” NBER Working Paper 7418, Washington DC, November. Feige, Edgar L. (forthcoming), “Unofficial Dollarization and Network Externalities: Where is America’s Currency?,” in Dean et al. (eds) (to appear). Feige, Edgar L., Michael Faulend, Velimir Sonje, and Vedran Sosic (forthcoming), “Currency Substitution, Unofficial Dollarization and Estimates of Foreign Currency Held Abroad: The Case of Croatia,” paper prepared for the Sixth Dubrovnik Economic Conference, Dubrovnik, 28–29 June, 2000 in conference proceedings, Markus Skreb and Mario Bleijer (eds) (to appear).

Dollarization in Ecuador and Canada 175 Fernando-Arias, Eduardo and Ricardo Hausmann (eds) (2000), Wanted: World Financial Stability, Washington DC: Inter-American Development Bank. Hanke, Steve H. and Kurt Schuler (1999), “A Monetary Constitution for Argentina: Rules for Dollarization,” Cato Journal, Vol. 18, No. 3 (Winter), pp. 405–19. Hausmann, Ricardo (1999), “Should There Be Five Currencies or One Hundred and Five?,” Foreign Policy (Fall), pp. 65–78. Hausmann, Ricardo and Andrew Powell (2000), “Dollarization: How to Go About It,” Working Paper, Washington DC: Inter-American Development Bank. Hausmann, Ricardo, Michael Gavin, Carmen Pages-Serra, and Ernesto Stein (2000), “Financial Turmoil and the Choice of Exchange Rate Regime,” in Eduardo FernandoArias and Ricardo Hausmann (eds). Ize, Alain and Eduardo Levy-Yeyati (1998), “Dollarization of Financial Intermediation: Causes and Policy Implications,” Working Paper WP/98/28, Washington DC: International Monetary Fund. Kamin, Steven B. and Neil R. Ericsson (1993), “Dollarization in Argentina,” International Finance Discussion Paper 460, Washington DC: Board of Governors of the Federal Reserve System, November. Sahay, R. and C. A. Vegh (1995), “Dollarization in Transition Economies: Evidence and Policy Implications,” Working Paper WP/95/96, Washington DC: International Monetary Fund. Willett, Thomas D. (2001), “Truth in Advertising and the Great Dollarization Scam,” Journal of Policy Modeling, May. Williamson, John (2000), “Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option,” Washington DC: Institute for International Economics. Williamson, John (forthcoming), “Dollarization Does Not Make Sense Everywhere,” in Dean et al. (eds) (to appear).

Index

This index is in alphabetical, word by word order. It does not cover the introductory pages, content or illustration lists, contributors or acknowledgements . Location references are to page number. Abbreviations: ECB = European Central Bank; EMU = European Monetary Union; Fig = Figure; NAMU = North American Monetary Union; Tab = Table; US = United States of America. advantages of dollarization: for dollarizing countries 2–3; for US 5, 130; see also dollarization Amsterdam Treaty (1997) 53, 79; see also Treaties Argentina, foreign ownership of banking assets 138(Tab 9.1) assets, conversion from national currencies to euro 55 balanced budget fiscal expansion 101–2; demand, output and employment 103–4; expansionary fiscal policy 107–8; national income accounting 102–3; productivity growth 108–10; tax rates 105–6 Bank of Canada, influence: over Canadian economy 115–16; over credit conditions 118–19; see also Canada banks: Bank of Canada, influence 115–16, 118–19; effect of EMU on 37; foreign ownership of Latin American banking assets 138(Tab 9.1); increased role of US banks in foreign countries 137–9; interbank payment system, Canada 117–18; loss of local central banks 3; see also European Central Bank (ECB); European System of Central Banks (ESCB); national central banks

bonds: Canada and Mexico, issue of after dollarization 136; EUR-11 38, 80–4 Brazil, foreign ownership of banking assets 138(Tab 9.1) Bretton Woods 32–3, 49, 137, 165; see also exchange rates “bubbles” in financial markets 18; see also euro, decline in value budget deficits, EMU countries 57, 79–80; GDP share v. US 64(Fig 4.3), 65(Fig 4.4) Buiter, W., quote 131 business cycles, synchronization 3–4 Canada; adoption of common currency 60, 129–30; arguments against dollarization 170–3; central bank influence 115–16, 118–19; de facto dollarization 122–3; demand shocks 133–4; disadvantages of dollarization 134–6; interbank payment systems 117–18; monetary sovereignty, loss of under NAMU 131; regulatory control, loss of under NAMU 131–2; seignorage revenues, loss of 135–6 central banks see local central banks, loss of; national central banks Courchene, T. J. 50, 123; quote 48 credit, central bank influence over 118–19 currencies: international 31–4, 39; regional

Index 177 blocs 48–9; single 73–4; see also euro; euro, decline in value de facto dollarization 1; Canada 122–3; causes 167–8; Latin America 166–7; see also dollarization debt: growth of private debt under monetary union 65–6; re-denomination of public debt in euros 37–8 demand, effect of increased on output and employment 103–5 demand shocks: Canada/Mexico/US 133–4; non-optimum currency areas 95–8; optimum currency areas 93–5 deutschmark, failure to become international currency 32–4 disadvantages of dollarization: for dollarizing countries 3–4; for US 5; see also dollarization dollarization: acceptance of US institutions 2; advantages 2–3, 5, 130; Canada 170–3; differences from monetary union 2, 130–3; disadvantages 3–5; financial openness 137–9; increases in US seigniorage revenues 135–6; Latin America 166–70, 173; policy relevance 1; reduction in transaction costs 134–5, 139; solution of last resort 2; see also de facto dollarization; fiscal stance, model showing effects of dollarization; North American Monetary Union (NAMU) Domingo Solans, E. (“Mister Europe”) 35 The Economics of the Steering Wheel (Lerner, A.) 70–2 economies in a monetary union, fiscal policy 101–2; demand, output and employment 103–5; expansionary fiscal policy 107–8; national income accounting 102–3; productivity growth 108–10; tax rates 105–6; see also European Monetary Union (EMU); North American Monetary Union (NAMU) Ecuador, adoption of US dollar 2, 166–7 Eichengreen, B., quotes 4, 81 El Salvador, adoption of US dollar 166–7 electronic payments 116–17, 123–5; ECB perspective 121–2; erosion of central bank influence 119–21; payments systems 45–6, 117–18

emergent economies, exchange rates 165 Emerson Report 51 enlargement adjustment rule 54; see also European Monetary Union (EMU) equity markets 38–9; see also bonds EUR-11 countries: adoption of single currency 73–4; bonds 38, 80–4; budget deficits 79, 85–6; deficit spending 57, 82–3; Excessive Deficit Procedure 79–80; financial sovereignty, loss of 82–4; monetary policy 74–5; overdraft facilities 80; political union 87; self-restraint in fiscal policy 78–9 euro: as international currency 39; benefits 55; conversion of national currency assets 55; creation 55; daily exchange rates US$/€ 16(Fig 2.1); redenomination of public debt 37–8; “right value” benchmarks 16–17; stabilising role 50; US/euro area interest rate differentials 20 (Figs 2.2a–b); weakness 40–1, 67 euro, decline in value: against other currencies 15–16; “bad luck” argument 17–19; cyclical phenomenen 23–5; growth rate differentials 21–6; interest rate differentials 19–21; investment flows 26–8 euro area: perception of weakness by investors 27–8; trade surplus 16 European Central Bank (ECB) 15; command structure 43–4; co-ordination of monetary and fiscal policy 86; credit facilities, EMU countries 80–1; electronic payments, views on 121–2, 124; euro/dollar exchange rates 46–7; exchange rate setting 56–7; fiscal policy 57, 59; independence 58; inflation targets 98; interest rate strategy 35, 56; lowering of interest rates 44–5; Maastricht Treaty stipulations 44; management errors 45; money creation 57; money supply 56; organization 58–9; reports to European Parliament 59; see also banks; European System of Central Banks (ESCB); national central banks European Monetary System (EMS) 54 European Monetary Union (EMU): banking market 37–8; budget deficits of member countries 57; creation of new currency 49–50; economic policy 36; employment

178 Index and welfare concerns 58; equity markets 38–9; financial and service markets 37; German desire for 34; goods markets 36–7; Growth and Stability Pact 35, 55, 57–8, 79; historical aspects 72–3; historical precedent 30–1; impact of fiscal rules 64–6; implementation 53–5; international reserves 39; lack of common policies between countries 35; launch 30–1; lessons learnt 59–61; monetary policy 74–5, 85–7; public bonds 38; rules 55–9; theoretical foundations 51; see also economies in a monetary union, fiscal policy European Payments System (TARGET) 45–6; see also electronic payments European System of Central Banks (ESCB); composition 76, 77(Fig 5.1); international reserves 39; policy instruments 76–8; primary objective 76; responsibilities 76, 81; see also banks; European Central Bank (ECB); national central banks Excessive Deficit Procedure 79–81; see also EUR-ll countries; European Monetary Union (EMU); Maastricht Treaty (1992) exchange rate movements 17–19 exchange rates: countries in European Monetary System 54–5; emergent economies 165; Latin America 168–9; role of ECB 46–7; setting of by ECB 56–7; US$/€ 16(Fig 2.1), 22(Fig 2.3); see also Bretton Woods Federal Open-Market Committee 2; see also dollarization Federal Reserve: as lender of last resort 132; role in NAMU 60–1; see also United States of America finance market, effect of EMU on 37 fiscal stance, model showing effects of dollarization 143–4, 159–60; balance sheets 147(Tab 10.1); description of model 149–54; economic structure and underlying flow/stock accounting framework 144–5; financial instability with fiscal self-determination 154–6; flow-stock transactions 146(Tab 10.1); sluggishness by tightening fiscal stance

156–8; working assumptions and central hypothesis 145–8; see also dollarization Fischer, S., quote 167 Fitoussi Report 51 foreign direct investment 137–8; foreign ownership of banking assets in Latin America 138(Tab 9.1) Fox, V. 129 free market role 53; see also European Monetary Union (EMU) functional finance: fiscal policy in EUR-11 countries 82–4; fundamental principles 71–2; implementing policy in accordance with 86–7 Functional Finance and the Federal Debt (Lerner, A.) 70–2 Germany: backwardness of money market 45; desire for EMU 34; export economy 34; post-WWII economy 32–4; promotion of service sector 41–2 gross domestic product: effect of demand growth on 104; fiscal constraints on EMU countries 79–80, 85–6; growth forecasts 22(Fig 2.3); seigniorage percentage 135; US 1999 21; US 2000 24 Growth and Stability Pact 35, 55, 57–8, 79; see also European Monetary Union (EMU); Maastricht Treaty 1992 growth rate differentials, US$/€ 21–6 growth rates: European policy 36–7; Euro area, US, Japan 25(Fig 2.4); US 27 Grubel, H. G., quote 50 Hagen, J. von, quote 81 Harris, R. G. 50, 123; quote 48 Hausmann, R. 135, 168 inflation, effect on unemployment in nonoptimum currency areas 95–9 interest rate differentials 19–21; US/euro area 20(Figs 2.2a–b) interest rates: ability of countries to set own 3; Canada 171; ECB strategy 35, 56; effect on exchange rates 23, 27; European policy 62–3; Latin America 169; lowering of by ECB 44–5; US$/€ 35–6, 62(Fig 4.1)

Index 179 international currencies: definition 31–2; euro 39; failure of mark and yen to become 32–4; main features 32 international monetary system 48 investment flows 37; effect on euro 26–8 Issing, O., quote 79 Japan: post-WWII economy 32–4; strength of yen against euro 21, 25 Jordan, J., quotes 75, 83 Latin America: case for full dollarization 168–70, 173; de facto dollarization 166–7; foreign ownership of banking assets 138 (Tab 9.1) Latin Monetary Union 30; see also European Monetary Union (EMU) lender of last resort 3, 132 Lerner, A.: Functional Finance and the Federal Debt 70–2; The Economics of the Steering Wheel 70 local central banks, loss of 3; see also banks; national central banks local economies, effect of dollarization on 5–6 Maastricht Treaty (1992) 31, 53, 55, 57; control of inflation 44; fiscal constraints 78–81, 84–7; organisation of ECB 58; pre-Maastricht Treaties 72(Tab 5.1); role of banking sector 56; stage 3 73(Tab 5.2) Mack, C. 3, 49, 132, 136; quote 140 “market dollarization” 123–5; see also Canada; North American Monetary Union (NAMU) market order rule 53; see also European Monetary Union (EMU) Menger K., money theory 51–2; plan for European monetary integration 53–5 Mexico: adoption of common currency 60, 129–30; demand shocks 133–4; disadvantages of dollarization 134–6; foreign ownership of banking assets 138(Tab 9.1); loss of monetary sovereignty under NAMU 131; loss of regulatory control under NAMU 131–2; loss of seigniorage revenues 135–6; Tequila crisis (1994) 132–3, 169 monetary economies, evolution 51–2 monetary policy, ability of countries to set own 3

monetary union, neo-Mengerian theory 52–3; see also European Monetary Union (EMU); North American Monetary Union (NAMU) Mundell, R. A. 48, 51–3 NASDAQ (US high-technology stock market) 26, 39, 47 national central banks 15, 59, 76, 81; creation of North American Central Bank 130–1, 133; erosion of influence by electronic finance 119–21; influence over credit conditions 118–19; loss of under NAMU 60–1; monopoly over final settlement balances 120, 123; reserves held by 39; see also banks; European Central Bank (ECB); European System of Central Banks (ESCB) national debts, re-denomination in euros 37–8 NEIRU 58 neo-Mengerian theory of monetary union 52–3 non-expected inflation rate of unemployment (NEIRU) 58 non-optimum currency areas, monetary policy 95–9; see also optimum currency areas North American Monetary Union (NAMU) 48, 66–7; application of neo-Mengerian theory 51–2; benefits 50; central bank, creation 130–1, 133; common currency 60; consequences 61–4; creation, quote from H. G. Grubel 50; differences from dollarization 130–3; fiscal constraints 61, 63–4; impact of fiscal rules 64–6; lender of last resort 132; lessons learnt from European Monetary Union 59–61; loss of regulatory systems 131–2; “market dollarization” 123–5; problems foreseen 130–1; US Federal Reserve 60–1; see also dollarization optimum currency areas 74, 133–4; economic factors determining 93–5; eurozone 92–3; see also non-optimum currency areas Ottawa Conference 5 overdraft facilities, EMU countries 80–1 overview of text 6–10

180 Index Parguez, A. 53, 55, 58, 67, 79 partial dollarization see de facto dollarization pension funds 36, 38 “Phillips curve” 95–8 political integration in Europe 42–3 private debt, growth under monetary union 65–6 productivity growth, economies in a monetary union 108–10 public debt, redenomination in euros 37–8 regional currency blocs 48–9 reserves held by national central banks 39; see also national central banks Russia, investment in by European countries 36 seigniorage: definition 135; loss of 3, 167; US post-dollarization 135–6 single currency: benefits 73–4; costs 74; see also euro; European Monetary Union (EMU) solution of last resort 2; see also dollarization Stability Pact see Growth and Stability Pact stock exchanges: London/Frankfurt merger 41–2; NASDAQ 26, 39, 47 stocks, movement from $ to € 40 structure of book 6–10 Swoboda, A. K. 52 TARGET (European Payments System) 45–6; see also electronic payments

tax rates, economies in a monetary union 105–6 “techno-classical” group 51, 53, 67; see also European Monetary Union (EMU) Tequila crisis (1994) 132–3, 169; see also Mexico Thiessen, G. 67 transaction costs under dollarization 134–5, 139 treaties: Amsterdam 53, 79; European, preMaastricht 72(Tab 5.1); Maastricht see Maastricht Treaty (1992) unemployment 58, 63; comparison US/euro countries 63(Fig 4.2); in non-optimum currency areas 93, 95–8; United Kingdom 65 United States of America: adoption of common currency 60, 129–30; banks, increased role in dollarized countries 137–9; demand shocks 133–4; equity markets 38–9; Federal Reserve, as lender of last resort 132; Federal Reserve, role in NAMU 60–1; reaction to foreign crises 132–3; seigniorage revenues 135–6; see also dollarization; North American Monetary Union (NAMU) yen: failure to become international currency 32–4; strength against euro 21, 25