The EURO and Financial Markets

International Economic RelationsMetropolitan University PragueMartin Kolmhofer2011/2012

The Problem

• Why not one world currency?• Why not a currency for every city?

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The Problem• A currency becomes more useful as it is used in a

wider economic area - but having a one-size-fits-all monetary policy typically becomes more problematic in a wider economic area; this is the key trade off in optimum currency area theory.

The Problem• Diversity (different competitiveness) translates into asymmetric

shocks and the exchange rate is very useful for dealing with these shocks

• Possible Scenario: One country will sell everything to the other country and demand nothing in return (save money), leading to prosperity for the exporting nation and massive unemployment and depression in the importing country.

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Self Correcting Mechanism• Normally trade deficits tend to be self-correcting:• A country with a trade surplus, in that it sells more abroad than it buys,

will create an international demand for its currency. (If you want its stuff, you need its currency). As a result, strong trading positions tend to strengthen a country’s currency. The opposite is true with countries with weak trading positions. If no one wants your stuff no one really needs your currency.

• But when a country’s currency rises, its products become more expensive. This gives a competitive opportunity to countries with weak currencies to start selling some of their products into that market. When they sell more demand for their currency rises

• This currency counterweight should keep runaway trade imbalances in

check.

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Self Correcting Mechanism

• Own Currency acts as a “buffer”“Compensates” for different levels of competitiveness

Big Mac IndexInformal way of measuring the purchasing power parity (PPP) between two currencies

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PPP - says that a currency’s price should reflect the amount of goods and services it can buy.

Tendencially developed countries currencies are highly valued, developing nations currencies are less valued

Big Mac Index

• Why/How can differences persist?

1) It takes time to adjust2) Tradable vs Non-tradable goods (even a Big Mac includes

cost like real estate, local taxes…)3) PPP assumes free trade is in place (no tariffs, taxes,

transportation costs, other restrictions…)4) Demand for currency is not only determined by trade of

goods (also investment purposes: financial assets, real estate…)

Video: Exchange Rates• How do currency values rise and fall? Why

would a country want to manipulate the value of its own currency?

Competitive Devaluation• “Keeping your currency cheap”• When a country tries to devalue its currency to increase its international

competitiveness. “Beggar thy neighbor”• The idea is that by devaluing our currency, our exports become more competitive

which reduces unemployment.• Our devaluation is another country’s appreciation. This means we are effectively

just shipping our unemployment overseas. Other countries don’t like that, so they devalue their currency in turn. This leads to cycles of competitive devaluation.

• But: Devaluing also means defaulting on a portion of your debt. (= no access to Debt Capital (Bond) Markets in the future.)

• How to devalue a currency?Increasing the supplyIncreasing the demand for competing currency (Example China – buying US government debt / bonds)

What happens without exchange rate “buffer”?• In the case of an overvalued currency:

Competitiveness needs to be restored in other ways

• Prices (Wages) need to fall – but are sticky• Unemployment • Government Debt

Low demand – what to do?:• Opinion 1:

"If consumers are not spending the best way to increase demand is to allow prices to fall to more affordable levels“

• Opinion 2: "If you believe that wages and prices are not perfectly flexible and there are many that are not, then the economy can get pushed away from full employment“ (Ben Bernanke)

What happens without exchange rate “buffer”?

If competitiveness cannot be achieved via lower prices (either via exchange rate or lower wages or increased productivity) it will result in lower quantity demanded – Result: unemployment

In a Nutshell• The benefits:

– A currency becomes more useful as it is used in a wider economic area

• The costs:

– loss of monetary and exchange rate instruments– matters in presence of:

• price and wage stickiness• asymmetric shocks (a recession which only affects some members of

a group of trading countries)

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History of the EURO / ECB

The Long Road to Maastricht and to the Euro

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At the Hague summit of 1969, European leaders committed themselves to the policy objective of establishing economic and monetary union. The summit led to the creation of a committee, chaired by Luxembourg Prime Minister Pierre Werner, to produce a multi-stage plan for achieving EMU. Maastricht Treaty 1991: A firm commitment to launch the single currency by January 1999 at the latest (Monetary union started in 1999, just as scheduled -Britain, Denmark, Sweden and Greece did not participate in the Euro when it was launched in 1999)

A Tour of the Acronyms• A new central bank at the centre: the European Central Bank (ECB).

• The European System of Central Banks (ESCB): the ECB and all EU NCBs (N=27).

• The Eurosystem: the ECB and the NCBs of euro area member countries (N=17).

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The System

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The ECB is run by the Governing Council which is made up of an Executive Board of six members, appointed by the heads of states or governments of the countries which have joined the monetary union + the governors of the national central banks of EU members in the Eurozone.(Executive Board: Appointed for 8 years, not reappointed)

ECB Governing Council 2011

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Independence and Accountability• The ECB is quite independent in two senses: It can

define its objectives and it can decide how to conduct monetary policy

• Arguments for central bank independence:– governments tend not to resist to the ‘printing press’

temptation– the Bundesbank has set an example.

• But misbehaving governments are eventually punished by voters.

• Independence removes central banks from such pressure.

• A democratic deficit?19

New EU members and EMU

• In order to enter the monetary union, the new EU members must satisfy the same 5 convergence criteria that the older members did.

• Yearly publication of ‘Convergence Reports’ to assess how they meet the convergence criteria

• Whilst Slovenia, Malta, Cyprus and Slovakia are members, Lithuania was rejected and the rest are still to meet criteria

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