The Economics of Monetary Unions

Past Experiences and the Eurozone

Juan E. Castañeda, Alessandro Roselli, Geoffrey E. Wood, Juan E. Castañeda, Alessandro Roselli, Geoffrey E. Wood

• Publisher: Routledge
• Year: 2020
• ISBN:
  9781000036855
• Edition: 1
• Topic: Economía
• Subtopic: Política monetaria

In this book, a historical analysis of the precedents of the euro is examined within the context of the current issues affecting the Eurozone and the long-term effects of the institutional changes implemented since 2010.

The book begins by placing the Eurozone challenges in the historical context of previous monetary unions, drawing on the experience of the gold standard. It then specifically focuses on the problems arising from the running of permanent trade imbalances within the Eurozone. The authors explore the advantages and disadvantages of being a member of the Eurozone and attempt to measure the optimality of a currency area by the calculation of an index on internal macroeconomic asymmetries. They address the proposals recently made in favour of a fiscal union in the Euro zone; including the economic and political feasibility of fiscal transfers in the Eurozone. The final two papers discuss whether the monetary union is in fact more than just that, and whether it will lead inevitably to some form of political union if it is to survive.

With chapters by leading experts from both Europe and the UK, this book will appeal to students in Economics, Finance, Politics, EU integration and European studies; as well as academics and professional economists doing research in EU integration, the Euro zone, monetary history and monetary and banking unions in Europe, the UK and elsewhere.

1
Introduction

Juan E. Castañeda, Alessandro Roselli and Geoffrey E. Wood

The creation of the euro divided economists. Some thought it would have major favourable effects, promoting trade and growth across the eurozone. Others thought it a bad idea, inevitably damaging to the diverse economies of the eurozone. And there were some who thought it desirable in principle, but a good idea needing work to achieve anything like its full possibilities. In particular, fiscal union and even political union were seen to be necessary to complete the monetary union.

The creation of the euro can be thus seen from a double perspective. The economic perspective, that it followed previous unsuccessful attempts by European countries to stabilize the exchange rates of their currencies, through a coordination of their economic policies, within the floating rates regime that had prevailed after the Bretton Woods system’s collapse. Alternately, from a political perspective, as a monetary arrangement that would promote political union in Europe in response to what seemed a series of never-ending wars.

The year 1992 saw the failure of the Exchange Rate Mechanism (ERM), the last of those attempts to stabilize the exchange rates of European currencies, which prompted Milton Friedman’s appropriate comment, titled “Déjà vu?”: “How many more fiascos will it take before responsible people … are finally convinced that a system of pegged exchange rates is not a satisfactory financial arrangement for a group of large countries with independent political systems and independent national policies?”¹

The second perspective, with its broadly political background, brings us to the French–German bargain of the unification of Germany within a unified Europe. In the same year as the ERM’s failure, 1992, the Maastricht Treaty was signed by the European Council to create a single market and a monetary union, by introducing the euro at the end of a convergence period.²

An interesting perspective on these two views is provided in Chapters 13–16 of Living the Cold War (2017), in which Christopher Mallaby gives an account of his years as British Ambassador to West Germany (as it was when he started in post there).

In many public speeches I made in Germany, European affairs were a frequent theme. When the Maastricht agreement was being negotiated, I thought that the British objections to a European single currency were unanswerable. How could it be sensible to have a single currency with one interest rate and one exchange rate for countries with different levels of development and rates of growth? … Business audiences understood my strictures, but some others, including politicians enthusiastic about the EU, did not want to know about economic objections; they wanted the single currency because they wanted progress in building a united Europe.

(p. 189)

He then goes on:

At this time the Federal Government had doubts about the single currency and the Bundesbank was dead against it. Mitterand (President of France, 1981 to 1995) later persuaded Kohl (Chancellor of Germany, 1982 to 1993) to commit to it in return for French agreement to German reunification.

Kohl was the more susceptible to this pressure because he had realised there was need for total economic transformation in East Germany as soon as possible to prevent economic collapse, and he believed the then government of East Germany was not competent to carry that out. Further, he feared that Gorbachev’s position in the USSR was not secure, and wanted reunification to be achieved as rapidly as possible lest someone hostile to reunification replace Gorbachev (p. 225).³

The issue of whether the eurozone can be seen as an optimum currency area is an economic question, but it should not be forgotten that there is another perspective, a political one that for better or worse has accompanied the launch of the euro since its very inception.⁴

Robert Mundell published two papers on monetary unions, one providing support to the first view and one to the second (1961 and 1973). His two papers are part of the literature on “optimum currency areas”, which many scholars have sought to apply to study of the euro. This literature is recent in its origins. The question of whether the chosen domain of a currency is optimal, or at least sensible, is important. In this regard, Peter Kenen argued that a fiscal redistribution scheme should take the place of any missing exchange rate flexibility.⁵ But nonetheless the optimal area currency concept developed relatively recently. Bennett McCallum (2003, p. 8) advances an explanation:

The optimal currency area concept was introduced, as is well known, by Mun-dell (1961). Despite appearances, the foregoing should be regarded as a striking statement because it is surprising that such a basic idea would not have been developed previously.

McCallum (2003, p. 10) explains this late development as follows:

Prior to the 1950s, the predominant position among international and monetary economists was that some metallic monetary standard should be adopted by all countries. The most common position was that the same monetary standard, typically the gold standard, should prevail everywhere.⁶

This orthodoxy was, McCallum suggests, ended by the publication of Friedman’s “The Case for Flexible Exchange Rates” together with other papers in favour of floating, such as Lutz (1954), Sohmen (1957) and Yeager (1959). In combination with acceptance of the belief that monetary policy could be used to offset temporary adverse demand shocks, there was clearly now a case for floating exchange rates as well as for the other extreme, a single worldwide currency. Hence, McCallum argues, since the concept of a monetary area other than the whole world was now of interest, economic arguments were relevant in discussion of the creation of the euro.⁷ Did the euro area at least approximate to an optimum currency area (OCA)?

There can be few doubts that, at its beginning, it could not be considered as having the features of an optimum currency area, given the huge economic and social discrepancies existing between its potential members. The issue is therefore not so much to ask whether an OCA was already there, but to question whether the necessary steps towards it have been, or are going to be, taken. As observed by Capie and Wood (2002) whether the eurozone becomes as an optimum currency area is, eventually, an issue of political feasibility.

Another important issue affecting any type of fixed exchange rate system, and the eurozone is an example of it as member states have irrevocably fixed the exchange rate of their national currencies to the euro, is the issue of preserving symmetry in the running of a monetary union. The main difficulty is perhaps that any movement towards making the eurozone a more optimal currency area and indeed more symmetric has to proceed through two different economic philosophies:⁸ a “northern vision” mainly based on the application of rigorous and consistent rules (mostly focussed on “supply side” measures) versus a “southern vision” that favours more flexibility in the application of the rules and more room to exert discretion; the former mostly relying on preserving price stability as the ultimate policy goal, the latter on “demand management policies” that focus more on stabilisation policies.

But relevant or not to its creation, economics is relevant to evaluating its performance, and in considering how that performance could be improved. At the same time, politics cannot be neglected; they, after all, influence what is done at least as much (certainly in the short term) as economics. That need for joint economic and political consideration brings us to the contents of this volume, a set of papers given initially at the University of Buckingham in 2019, in a conference co-hosted by the Institute of International Monetary Research. This introduction first surveys these papers, and then concludes by seeing what themes emerge from them.

The papers themselves are in five groups. This review of them starts with the papers that contain pure historical comparison, drawing on the experience of the gold standard. These two are then followed by two papers that consider the inevitable financial imbalances within a monetary union, and their possible financial consequences – a difficulty increased by the imbalances being between countries each with their own fiscal policies, in contrast to the handling of imbalances within a monetary union such as the US.⁹ Discussion of imbalances of course starts discussion of threats to the union’s survival. The next section, “When may unions fail?”, considers some of those, and leads to a discussion of political factors which may affect the survival of a union, to possible debt market operations which can help survival, and in the last paper of this section to plans which fall short of full fiscal union but go sufficiently far towards it to stabilise the union. The final two papers discuss whether the monetary union is in fact more than just a monetary union, and whether it will lead inevitably to some form of political union if it is to survive.

1 The papers

1.1 Lessons from previous currency and monetary unions

The first two papers constitute attempts to learn from a previous union, the gold standard.¹⁰ The authors of the first paper (Guillaume Bazot, Eric Monnet and Matthias Morys) remark on similarities between the eurozone and the gold standard: fixed exchange rates and free capital movements, with a consequent lack of autonomous monetary policies. However, under the gold standard these conditions did not prevent central banks from acting as a buffer to preserve financial stability, a role carried out today by the European Central Bank (ECB) through a range of measures.

Central banks avoided symmetrical behaviour through managing their balance sheets, and sometimes using international loans. They reacted to asymmetric shocks, offsetting them by producing negative correlation between the domestic and foreign components of the balance sheet, and by restrictions to banknotes’ convertibility into gold (a form of capital control). The gold standard “rules of the game” – gold convertibility, changes in the money supply in the same direction as changes in the international reserves – were not rigidly followed.

The effects of these policies are measured by observing the central banks’ reaction to changes in the discount rate of the Bank of England, the system’s pivot.¹¹

In particular, the core countries (Germany, France) adopted systematic sterilization policies, opposite to what the rules of the game would have suggested (for instance, by expanding the domestic “portfolio” in case of contraction of the foreign reserves), in this way stabilizing the money supply; while peripheral countries (such as Italy) relied on capital controls through convertibility restrictions (again, not following the rules of the game). In addition, as mentioned earlier, central bank cooperation acted through international loans (as that of the Banque de France to the Bank of England during the Barings crisis of 1890). This flexibility can explain the stability of the classical – pre-WWI – gold standard.

In today’s eurozone, the ECB uses versions of these operations to maintain financial stability, countering a very asymmetric distribution of loans and trying to stabilize interest rates, through macroprudential measures such as long-term refinancing operations or Emergency Liquidity Assistance, or – as a last resort – temporary capital controls. All measures, however, that cannot solve chronic current account imbalances. The authors conclude that lessons have plainly been learned from the gold standard, but that whether they are sufficient is for discussion.

The next paper, by Juan E. Castañeda, Alessandro Roselli and Simeng He, further pursues comparisons with the gold standard. The recent (2010–2012) crisis in the eurozone has revived discussions on the adoption of policies symmetric between creditors and debtors and aimed at preventing fundamental disequilibria within systems characterized by fixed exchange rates among different currencies, or in a monetary union where a single currency has replaced the system’s national currencies, as in the case of the eurozone itself. In monetary history this debate has often been focussed on previous systems having these features, and in particular on the working of the gold standard: on whether its members pursued, in fact and to what extent, symmetric policies to preserve the system’s stability. In this paper the authors briefly survey the features of international monetary systems that have in common symmetry as a balancing factor, and then explore the meaning and consequences of asymmetric monetary policies under the gold standard. They offer a new measure of asymmetry in the running of the gold standard for the biggest five European economies in the pre-WWI period (UK, Italy, France, Germany and Spain) and use this measure to draw policy implications deriving from the gold standard constraints. Did central banks act symmetrically? The results show that the UK was the country which followed most closely the symmetry rule of the game; at the other extreme was Italy. The common pattern of behaviour was an under-issue of currency (minimal, in the case of Britain).

Was policy affected by the observance of the legal conversion ratio, or were there other criteria? Italy, Germany France and Spain seemed to have paid attention to the deviations of the coverage ratio from a (high) safety ratio in order to maintain convertibility. Achieving a safety ratio of 35% seemed to have been taken as a pre-condition to be able to abide by symmetry in the running of the gold standard.

These two chapters, and other work using comparisons with the gold standard, are the bedrock of work on the euro, for the gold standard is the clearest previous example of several countries agreeing to use a common money, and one issued by none of them individually, but rather by all collectively.

1.2 Financing imbalances in a single monetary area. An assessment of Target2

In Chapter 4 Uwe Schollmeyer addresses one of the most contentious issues affecting the eurozone in the last few years, one which has received an increased attention in the financial media and particularly in Germany: the accumulation of TARGET2 (im)balances...