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Michael Bordo and Harold James | Jul 10, 2008
The euro may surpass the dollar in coming decades to become the leading international currency. This column summarises four major challenges that the euro must survive for that to come true.
The European Economic and Monetary Union (EMU) and the euro, the single currency of its members, will be ten years old in 2009. Monetary unions as currency arrangements have been implemented for a few centuries, but the European experiment of embarking on a monetary union without an accompanying full political union is bold and unprecedented. The EMU has precedence in the currency unions of the past (both national and international) but is unique in having a single member bank for all the member states. Historical precedence with fiscal unions is also relevant to the success of the EMU, since the development of fiscal federal arrangements may be of great importance to the successful functioning of the EMU.
The EMU has helped to develop an integrated capital market, as well as providing many obvious consumer benefits in convenience and price transparency for an increasingly mobile European population. Institutions may be conceived of as continually evolving systems of rules whose legitimacy depends on a relatively widely shared consensus that they are not actively dysfunctional. The novelty of a single currency accompanied by divided sovereignty raises a number of problems and potential threats, some of which were anticipated at the time of the institutional preparations for monetary union, while others were not.
Many authors, including Barry Eichengreen (2005) and Menzie Chinn and Jeffrey Frankel (2006), have suggested that, in the light of the continued weakness of the US dollar, the euro will be its successor as the new leading international currency. This sentiment has become more widely shared as a result of the relatively rapid depreciation of the dollar in 2007-8. This means that there is increased sensitivity to the difficulties as well as strength of the governance of the new currency.
The fiscal dilemma
The most obvious threat to the single currency is usually held to arise out of the imperfect control and coordination of national fiscal policies. Some commentators argue as a result that monetary unions produce an inexorable dynamic in the direction of fiscal unions. The stability criteria in the Maastricht Treaty were the subject of immensely protracted and complicated negotiation, and were intended to address this problem. In the aftermath of the recession of 2000-1, and of Europe’s weak growth performance, substantial pressure from the large states led to some loosening of the criteria. When most of the large member states broke the rules, the then-President of the Commission, Romano Prodi, started to refer to the pact as absurd, and a 2005 summit formally modified the rule so as to make it more flexible in the face of cyclical downturns. It has become clear that a formalised system of fiscal federalism would however not necessarily deal with the problems of fiscal indiscipline on the part of member states. On the other hand, some fiscal reforms are needed as in the longer run they might be expected to raise the rate of growth.
Growth rates
The growth rate of the economy will be a central determinant of the likely long run success of the euro. Low growth, or very different rates of growth in different parts of the Euro area, would be likely to raise political questions and produce political tensions around the setting of the common or single monetary policy. Both the ability to comply with the Maastricht criteria and the political tolerance of an autonomous central bank are highly dependent on the overall rate of economic growth. The revival of growth in Europe since 2005 has brought a reduction in the deficits, but they will reappear should there be a renewed faltering. In the longer term (as in other rich industrial countries), the additional costs imposed by increased life expectancy, an ageing demographic structure, and rising health costs are likely to impose a heavy strain. Forecasting long-run developments involves many uncertainties, but almost every contemporary prognosis sees Europe as growing significantly slower than other parts of the world.
There is a political economy reason to worry about the effects of low growth on the euro. In many parts of Europe, globalisation is seen as a major threat to the social order, and these resentments are used by politicians eager to improve their political profile. Workers, especially in manufacturing, are faced with a threat of job losses or radical reductions in income as a consequence of low wage competition from Asia or Eastern Europe. Politically, the backlash against globalisation is associated with the extremes of left and right, which often take their themes and rhetorical engagement from each other. But since the conventional right and the conventional left compete against each other, and need to mobilise as many votes as possible, they are also likely to take up some of the anti-globalisation language in order to maximise their support and prevent a slippage of voters to the extremes. Sometimes they will also experience pressure to transform this rhetoric into policy, and much of the anti-globalisation sentiment may be directed against the euro.
In the 2007 French presidential election, Nicolas Sarkozy derived considerable mileage from criticism of the ECB and then repeated the criticism after the election. The inclusion of the ECB as an institution of the European Union in the slimmed down and revised constitutional treaty raises the possibility that a formal mechanism will evolve for putting pressure on the ECB to make growth as well as price stability an objective of policy.
Regional pressures
Regions with different growth patterns or different political economies are likely to press for different monetary policies, and in a democratic setting the result might be extreme polarisation and conflict. Such polarisation occurred in many gold standard countries in the late nineteenth century, when farming regions believed that they would benefit from the abandonment of a deflationary gold regime and the adoption of a bimetallic standard. In the United States, the agrarian mid-West and the South were pitted against the Northeast; in Germany there was a similar divide between a grain-producing East and the industrial areas of western Germany. Until a general price rise occurred after the discovery of gold in Alaska, Australia and South Africa in the last years of the century, monetary policy was highly politicised. In more extreme settings, federations can even break up.
Financial Stability
In the past, financial sector shocks have played a decisive role in the undermining of monetary regimes and the discrediting of the central banks responsible for their operation. The most dramatic of such episodes occurred in the interwar Great Depression, where banking panics in central Europe and the United States exacerbated the problems of the real economy. Federalism
encouraged the development of a banking system that was regional in character. made for inefficiencies in regulating banks. produced a dispute about the appropriate monetary response of the central banking institutions.All of these problems are likely to be especially acute during the early years of the federation or the central bank.
Europe is an integrated capital market with national bank regulators that respond in different ways to incipient problems. The problem of a bank getting into difficulties because of engagements in a different country is a widely recognised problem, in theoretical discussions. But a unification of banking regulation is still a long way from being realised. The current institutional framework unambiguously limits socially beneficial post-crisis workouts. But it may also limit the capacity to provide efficient preventative or pre-crisis prudential supervision. The consequent limits on the extent to which national regulators were aware of bank problems became highlighted in the credit crunch of the summer of 2007. The ECB supplied general liquidity to the market, and may have been able to avoid some financial distress. But it does not have a responsibility to regulate and thus may not be aware of banking problems until a late stage.
At the same time as finance has become internationalised, each country preserves its own idiosyncratic system of financial supervision and regulation. Though there has been an extensive discussion of the possibility of shifting supervision to the European level, there are practical obstacles to making such a shift (apart from inbuilt bureaucratic resistance from existing regulators). In particular, regulation is often linked to implicit or explicit lender of last resort functions. But such activity has a significant fiscal cost, which at present cannot be assumed at a European level but would remain an issue for national governments and national parliaments.
Conclusions
Low growth will also produce direct challenges to the management of the currency, and a demand for a more politically controlled and for a more expansive monetary policy. Such demands might arise in some parts or regions or countries of the euro area, but not in others. They would lead to a politically highly difficult discussion of monetary governance. This discussion will be more difficult if there is a widespread perception that the international role of the euro is at odds with domestic political demands that the currency should be supportive or sustaining of growth. Financial sector instability, with a potential need for bank bailouts, could also be a source of difficulty. Finally, in addition to all these threats, domestic responses to the challenge of globalisation in markets for goods and services may also be displaced into a discussion of the euro, with the single currency and the central bank that manages it taking the position of fall guy for radicalised and generalised discontent. On the other hand, if all these bumps are overcome and a process of gradual transfer of fiscal responsibility toward greater centralisation occurs, there is the possibility that the euro zone will match the achievement of other late achievers of monetary unification, such as the United States or Germany.
References
Michael Bordo and Harold James, ‘A Long Term Perspective on the Euro’, NBER WP 13815, February 2008
Menzie Chinn and Jeffrey Frankel, ‘Will the Euro Eventually Surpass the Dollar as Leading International Currency?’, NBER WP 11510, August 2005
Barry Eichengreen, ‘Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition’, NBER WP 11336, May 2005
Originally published at
VOX EU and reproduced here with the author’s permission.
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Michael Bordo and Harold James | Jul 8, 2008
The IMF needs a new job. This column makes the case for the bold proposal that the IMF should manage a significant part of the new surplus countries’ sovereign wealth funds.
In the original conception of the 1944 Bretton Woods Conference, the International Monetary Fund (IMF) was created to deal with problems that had afflicted the interwar world, particularly the lopsided distribution of reserves and the deflationary consequences for the international economy – as well as with crisis management. Today the IMF has been almost completely sidelined from many of the major governance issues of the international financial system. In particular, it is much less active as a financial institution. The IMF’s diminished role seems at odds with the world’s need for global governance.
Today’s international financial system is characterised by numerous uncertainties. There are major debates about exchange rates; puzzlement about the large increases in reserves of many emerging market economies; worries about the strategic ambitions associated with the rapid rise to prominence of sovereign wealth funds; and concerns about the capacity of international financial institutions to respond to crises.
Some potential IMF reforms, such as those proposed ten years ago by Jose de Gregorio, Barry Eichengreen, Takatoshi Ito, and Charles Wyplosz1 , sought to make the IMF more relevant by making it less politically dependent. Such reforms, however, have usually been thought of as impractical.
There may be a case for a reform that harks back to the original Bretton Woods conception – although suitably updated for today’s world with its new lopsided distribution of reserves. The IMF could again become a powerful financial stabiliser if it took on a new role as the manager of a significant part of the reserve assets of the new surplus countries.
The reserve debate
Reserves are supposed to facilitate international transactions, in that they help countries deal with unanticipated falls in export revenues, increases in import prices, or sudden withdrawals of foreign credits. Since there are constant local shocks and ups and downs in the international economy, the size of reserves should also be expected to fluctuate (as the length of a cab rank grows and falls as new taxis arrive and lined up taxis are hired).
World reserves have not fluctuated much over the last decade. The negative consequences of not having reserves in the event of a financial shock or crisis are so great that countries (especially poorer countries) are tempted to build additional reserves. Since the millennium, the reserves of Japan, Taiwan, Korea, and Malaysia have all more than doubled, while that of China more than quintupled. Mature industrial countries needed reserves less, while emerging countries wanted them more. In the 1960s, the distinguished international economist Fritz Machlup formulated a different view of reserves, which he called the theory of “Mrs. Machlup’s wardrobe.” Mrs. Machlup apparently always liked to buy new dresses, while resisting giving away old ones: so the stock of dresses went on increasing. Asian reserves now look more like Imelda Marcos’s shoe collection than Mrs. Machlup’s wardrobe.
Because reserves are held mostly in short-dated and very low risk securities (traditionally treasury bills issued by a few industrial countries), the world pile up of assets has driven down short term interest rates and prompted a global expansion of liquidity that then powered asset price bubbles, especially in the housing markets of countries with current account deficits and higher interest rates such as the United States, Australia, and the United Kingdom.
When assets are managed in an alternative way, through sovereign wealth funds (SWFs), there are even greater difficulties. On the receiving end, industrial countries’ governments are increasingly anxious that SWFs will be used strategically rather than simply following the logic of the market. They might be used as a way of gaining control of key sectors of the economy, especially since the credit crunch has made the world’s largest banks look for new injections of capital. For the countries that own SWFs, there is continuous worry about the risk of losing capital (as in the case of China’s investment in Blackstone).
Crisis Management
In the distant past, market expectations were stabilised during panics by the counter-cyclical behavior of very large private institutions. The multinational house of Rothschild made the first half of the nineteenth century stable, not only by lending in crises but also by combining its assistance with a policy conditionality intended to ensure that the credits were more likely to be repaid. In the great panics of 1895-6 and 1907, U.S. financial markets were calmed by J.P. Morgan. At the time of the Great Depression in the 1930s, there was no house of equivalent power.
In 1944 the IMF was envisaged as a public sector provider of the public good of stabilisation. IMF surveillance of individual countries had teeth because the IMF also had financial power and because countries taking its advice were borrowing from the Fund or might need to borrow in the future. Unlike the OECD, it could put its money where its mouth was.
At its most effective moments, the IMF had powerful leverage over countries whose behavior was vital to the health of the international monetary system. In the 1960s, the IMF went well beyond its own quota-based resources, and its financial power was enhanced by a new ability to raise additional resources through the General Arrangements to Borrow. Its ability to give powerful advice to the systemically important countries, such as the United Kingdom, was enhanced by the dependence of those countries on IMF resources.
The IMF as a Reserve Manager
The IMF could again become a very powerful financial stabiliser if it took on a new role as the manager of a significant part of the reserve assets of the new surplus countries. It would be in a powerful position to take bets against speculators. The stabilising action would ultimately benefit both the world economy and the interests of the owners of the reserve assets, who have (simply by the fact of the accumulation of the surpluses) a similar interest in world economic and financial stability. At the same time, the management of reserve assets by an internationally controlled asset manager would remove suspicions and doubts about the use of assets for strategic political purposes.
In the course of developing new functions, it would be important to distinguish between routine day-to-day transactions and crisis management (in the same way as central banks and national regulators do in their management of domestic affairs). The large stock of assets under the routine management of the IMF would in the first place represent a large masse de maneuver that would frighten off speculative attacks or irrational panics. The Fund would be in a situation to intervene preemptively, possibly but not necessarily at the request of the target of the speculative attack; so that the speculation would become impossibly costly.
The enhanced asset base of the IMF would also give it the possibility of switching into crisis mode without long discussions and formal negotiations. There could be very quick responses, and, as the shifting of assets by asset managers, they would also be noiseless. One of the problems of IMF functions in the past – whether it was in trying to define “scarce currencies” in the immediate postwar period or asking whether there was a sufficient world supply of liquidity – was that these determinations had to be made in such a formalised way that there could in practice never be an agreement on the issue. Operating as an asset manager, the IMF would be able to affect currency exchange rates without requiring authorisation through a formal decision.
Institutional Reform
The rise in reserves in many Asian countries was a deliberate response to the 1997 Asia crisis, in which there was a substantial disillusionment with the IMF. A precondition of the IMF acting as a global reserve manager would be a governance reform in which the new surplus countries were able to exercise a substantive influence through the IMF. They would need to feel absolutely secure that they were not being the subject of some politically motivated manipulation. In particular, if the IMF were to be in a position of an asset manager who could shift assets from one market to another, it would need to be at a longer distance from U.S. influence and attempts at control: otherwise, it would be seen as a device for propping up the dollar for political rather than economic reasons.
In a revised approach, votes in the IMF would be allocated or “bought” to a large extent through the assets held at the IMF. The proportion of votes determined in this way might be as high as 50 percent, while the rest would be allocated in the traditional way. There is an analogy to this double determination of voting power in the U.S. Constitution, according to which all states have an equal share of Senate votes, but very different numbers of seats in the House of Representatives, reflecting population differences.
Making a substantial part of Fund voting a reflection of the reserve positions held in the IMF would allow very quick adjustments to new international realities. It would make the IMF more of a market institution, in much the same way as the changing ownership of joint-stock companies can shift quickly and noiselessly. There would be no need for constant and cumbersome processes of quota renegotiation and revision. A revision of the voting system that meant an automatic reflection of reserve assets held in the Fund would at a stroke eliminate political complications and make the IMF appear much more like a market-oriented organisation: in short, the type of credit cooperative that Keynes and the other makers of the postwar monetary settlement envisaged at the 1944 Bretton Woods conference.
Reference
Jose de Gregorio, Barry Eichengreen, Takatoshi Ito and Charles Wyplosz, An Independent and Accountable IMF, Geneva: International Centre for Monetary and Banking Studies, Geneva, 1999.
Footnotes
1 De Gregorio, Eichengreen, Ito and Wyplosz (1999).
Originally published at
VOX EU and reproduced here with the author’s permission.
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