Memorandum by Professor Pedro Schwartz
and Juan Castañeda
Question 1: What contribution has the introduction
of the Euro made to levels of trade within the Euro zone and the
rest of the world?
1.1 Currencies are said to affect trade
in two ways: their number can multiply transaction costs and vice
versa; their volatility can reduce the volume of trade and upset
the balance of payments. But the foreign exchange market is so
large and sophisticated that the costs of using it have fallen
to levels not too removed from money transfers in the same denomination.
Also, a prima facie case can be presented that flexible exchange
rates have not impeded the extraordinary growth of world trade
in the last quarter century. From 1950-71, the Bretton Woods fixed
exchange rate period, world exports corrected for GDP growth multiplied
a mere 1.79 times. But from 1972, when Bretton Woods broke down,
to 1993, they multiplied three times; and from the same 1972-2005,
no less than 14.1 times.
1.2 For trade in goods and services what
matters is the real exchange rate, that is to say, the nominal
rate divided by the price of the goods and services concerned
(E / P). The monetary authorities cannot manage these terms of
trade of the nominal exchange rate, except in the very short run
by means of a "dirty float". The real exchange rate
between two monetary zones cannot be frozen: it moves even if
the money rates are fixed via a currency board. A central bank
that keeps the exchange rate of its currency artificially low
is pricing imports artificially high; quite soon wages and other
production costs will increase; and the bank will find it difficult
to sterilise the reserves it thus accumulates. All this will lead
to rises in the price level that will have the same effect as
a revaluation.
1.3 A full answer to Question 1 would demand
detailed econometric analysis. To our knowledge, one of the most
telling instances of the small effect of nominal exchange rates
on trade is when Eire and the UK broke 150 year monetary union
in 1979. A sharp fall of trade from 1979-82 coincided with a contraction
of the Irish economy and a strong and sustained appreciation of
sterling. But trade soon recovered, showing no sign of being hurt
by the separation between the punt and the pound. (See Graph 1)
Question 2: What effect has the introduction
of the Euro had on the Functioning of European Capital Markets?
2.1 The effect has not been as great as
was hoped. The Treasury Bond Market is still fragmented due to
the insistence of some national Governments such as that of Spain
to force traders to register with the Bank of Spain. However,
mergers between European electronic exchanges are imminent and
they might create Atlantic rather than European Exchanges.
2.2 The Mifid Directive will surely make
for pan-European markets in shares and derivatives, whether within
banks or through Stock Exchange mergers.
2.3 It is ironic that one of the principal
effects of the introduction of the Euro has been the emergence
of London as the premier financial market of the EU and one of
the three world markets, with Tokyo and New York.
Question 3: Are there any lessons to be drawn
from the changes in the Euro exchange rates since 1998?
3.1 Too much political meaning is attached
to the international value of currencies. The exchange rate is
not a symbol but a price.
3.2 There was much misplaced glee at the
early fall of the Euro after its launch and now too much worry
because of its high price in terms of dollars. The dollar has
gone through 30% devaluation since then because of the deficit
in the American basic balance, brought about by low savings rates
and a large Budget deficit. The re-equilibrating mechanism is
working slowly.
3.3 The nominal rate of exchange is not
important in the long term and the real exchange rate is not controllable
by the monetary authorities. (See 1.2 above)
Question 4: Was the recent reform of the
Stability and Growth Pact appropriate?
4.1 In 1997 the Stability and Growth Pact
(SGP) was adopted to prevent Euro zone members from free riding
on a sound Euro to finance large and persistent public deficits
cheaply. Such behaviour would undermine the common currency, especially
when the market knows that errant countries will in the end be
baled out. The 2005 reform weakened the SGP and was not appropriate
with one exception. (See 4.5 below)
4.2 The original SGP imposed a clear limit
(3% GDP) to fiscal deficits in the short run, while aiming at
fiscal balance or even a surplus as the medium term fiscal target
(the preventive arm of the Pact). If the EcoFin Council considered
a deficit as excessive (above 3% GDP), the so-called corrective
arm of the Pact became operative via Council recommendations,
sanctions and, finally, fines (proportionate to the member's GDP)—unless
it was appreciated that the country suffered a "severe economic
downturn" (- 2% or more annually) or an event out of its
control.
4.3 The 2005 reform reduced the effectiveness
of the rule. Regarding the preventive arm, country specific targets
have replaced the single medium term target for all the countries.
Though the reform keeps the 3% maximum for public deficits, the
evaluation of this new country specific target is over the cycle.
This permits a looser fiscal adjustment when output is said to
be under its potential and thus erodes the effectiveness of the
target as an anchor for expectations in markets. Monitoring and
control become more difficult.
4.4 The reform has created such a high degree
of flexibility in the measures to be taken to reduce the deficit
that the effectiveness of the corrective arm has virtually vanished.
The new SGP contains a number of escape clauses to avoid the deficit
procedure (see Morris et al., 2006). The original "severe
economic downturn" clause has been relaxed; now, any negative
GDP growth is taken as severe, "Other relevant factors"
can be taken into account to stay the corrective measures; such
as the existence of an "output gap" in the economy,
or the increased financing of R+D investment, or the implementation
of the Lisbon Agenda. Also, deadlines for excessive deficit procedures
by the Council have been significantly extended.
4.5 A positive aspect of the reform is that
it allows the sustainability of public finances to be taken into
account, such as the structural reforms implemented to achieve
a better fiscal position in the long run.
4.6 A much needed change in the SGP was
passed over: errant members should not be allowed to vote in their
own cause, since they are at present a part the EcoFin Council
that adjudges on their deficit and the correcting measures to
be imposed on them. (Buiter, 2006).
Question 5: What effect has the introduction
of the Euro had on individual member countries' economic development?
5.1 The mere change of the nominal currency
used does not of itself affect the economic development a country.
Economic growth depends on real factors, such as proper institutions,
technological progress and the increase of productive resources
of the economy on a sustainable basis. However, the stability
of the currency does contribute to economic development. Also,
conditions of proper macroeconomic behaviour imposed on the countries
using the Euro contribute indirectly to sustainable growth. The
reduction in transaction costs from using the same currency can
have a sizeable effect as well but it has to be backed by a lowering
of barriers to financial transactions—something still pending
in the Euro zone. In sum, the introduction of the Euro was on
the whole positive for the countries concerned, especially for
those that markets saw as being unreliable.
5.2 The large differences in economic growth
among the nations of the Euro zone indicate that the euro is not
of itself a decisive factor of economic health. At the time of
joining, there will be a marked reduction in the insurance premium
against devaluations included in the interest rates of smaller
countries. There will also be an initial boost in direct investment
coming from the rest of the EU as they are not subject to nominal
exchange rate shocks. However, further sustained growth demands
real reform: Ireland and Spain, for all the aid they received,
took painful but necessary measures; Portugal has done so only
belatedly; France and Italy have not: hence the differences in
growth rates. The case of Germany, where a strong currency has
proved no barrier for industrial exports, is an answer to critics
of "one size fits all" interest and exchange rates:
macroeconomic reforms demanded by a stable currency have positive
returns; countries can adapt to an appreciating currency when
excellence and productivity are pursued.
5.3 These arguments in favour of creating
stable currencies used over a large zone may lead one to overlook
the advantages of monetary competition. The supply of more than
one currency in the EU and the world has its advantages. Central
bankers are not to be trusted. Investors must be able to switch
currencies and combine a portfolio that minimises risk. This consideration
overrules arguments in favour of having Sterling join the Euro.
An advisable step towards increasing monetary competition would
be the total abolition of legal tender.
Question 6: Has the ECB's monetary policy
been too restrictive?
6.1 In the short period of its existence,
the ECB has slowly come to fulfil its main obligation to maintain
price stability in the Euro zone in the medium term. Since monetary
policy cannot be used to smooth the cycle or foster growth, the
policy of the ECB has been just about right.
6.2 The ECB has defined price stability
as increases of the Harmonised Index of Consumer Prices (HICP)
of less than (but close to) 2% yearly; which taking into account
the positive bias of current price indices, virtually amounts
to price stability. After a rocky start the HICP has been kept
around its upper mark throughout from 2003 on. (See graph 2) The
revaluation of the Euro has partly protected the Euro zone from
asset price inflation induced by the lenient behaviour of the
Federal Reserve and the Bank of England.
6.3 Some critics have adduced that monetary
policy can be used as a counter-cyclical instrument. According
to this view, monetary policy can be managed to foster the real
economy by reducing the official nominal interest rate to fit
the economic conditions of a given area. However, both macroeconomic
theory and the analyses of the expansionary policies of previous
decades clearly indicate the undesirable effects of money used
as a demand-managing tool. In the long run, a loose monetary policy
does not contribute to real growth but leads only to increases
in consumer and asset prices (Friedman, 2006). Even in the short
run there is no way to know how much a reduction of the bank rate
will go into inflation and how much into real interest rates and
real growth. Loose monetary policies result in artificial and
temporary output growth, followed by inflationary episodes and
sharp real adjustments.
6.4 Accurate knowledge of economic structure
of the economies in a monetary zone and of the lags associated
with monetary policy-making are even more acute in the case of
the ECB, since it has to conduct a single monetary policy for
a new economic area. Rather than trying to second guess the short
term real effects of its monetary decisions, the ECB has rightly
tried to run a credible price-stabilising policy in the Euro area
and successfully anchored market price expectations. It has thus
inverted the advice of neo-Keynesians and has contributed to better
resource allocation by forcing markets to adapt to stable money
conditions rather than the other way round.
6.5 It is real money, constant value money
(M/P), that individuals find a necessary transaction tool and
an indispensable asset in an uncertain world. But when excessive
issue pushes up P, the price level, the resulting real money supply
may fall and cause stagnation. The object of monetary policy should
be that of the ECB: keeping the value of money as stable as possible
while supplying just enough of it to give the market the real
liquidity it needs.
Question 7: What impact will the expected
enlargement of the Euro zone have on the functioning of the Euro
zone economy?
7.1 Of the 10 countries that joined the
EU in 2004 Slovenia has joined the Euro and the rest still have
to fulfil the Maastricht criteria. When all of them join, the
ECB will have to take monetary policy decisions for a supranational
monetary area of twenty two members. The fulfilment of those criteria
will permit the convergence to the nominal standards of the members
in terms of public finance, as well as a greater stability of
nominal interest rates and exchange rates during the evaluation
period. However, even though necessary these criteria do not guarantee
the proper functioning of the new enlarged monetary area.
7.2 True, these countries will benefit from
the running of a credible non-inflationary monetary policy by
the ECB. But for a multi-country currency area to operate smoothly
the free running of markets is the essential requisite: nominal
exchange rates will have ceased to be policy instruments nor will
country-based monetary policy be possible. In order to overcome
ordinary demand and supply shocks, flexible markets for goods,
services and labour are required, as well as easy labour and capital
movement across countries. Under those conditions transversal
shocks, ie, those affecting the new members singly, would result
in nominal adjustments of local wages and prices rather than in
costly real adjustments of output and employment. The present
performance of the twelve countries of the Euro zone does not
afford much hope of successful avoidance of real adjustment costs,
... and the management of monetary policy in the
Euro zone?
7.3 The management of a new enlarged monetary
area is based on a "one size fits all" policy; that
is, the running of a single monetary policy made based on the
aggregate data of the whole zone. This is the case in the different
regions of nation states, and it has also been the case of the
current heterogeneous multi-country Euro zone. It is sometimes
argued that fiscal transfers are needed in a large monetary area
to soften the cost of reacting to transversal shocks. This is
as may be, but transparent information and timely warnings by
the ECB and more flexibility in the economies of the new Europe
and the whole of the Eurozone will reduce the unwanted effects
of running a monetarist policy such as that of the ECB.
7.4 12 new members of the ECB will pose
the functional difficulties noted by Schwartz (2006) and Berger
et al. (2006). To address these difficulties the Governing Council
of the Bank proposed and the EU Council decreed that the six Executive
Committee members have each one vote and the Central Bank Governors
variously rotate for the other 15 votes. (ECB, 2003)
7 April 2007
REFERENCES
Berger, H, Nitsch, V and Lybeck, T (2006): "Central
Bank Boards around the World. Why does membership size differ?".
International Monetary Fund Working Paper No. 281 (December).
See the IMF website.
Buiter, W (2006): "`The Sense and Nonsense of
Maastricht' Revisited: What have we learnt about stabilization
in EMU?". Journal of Common Market Studies, vol. 44, nr.4,
pgs. 687-710.
ECB (2003): "Adjustment of voting arrangements
in the Governing Council of the ECB", 21 March, <http://europa.eu/scadplus/leg/en/lvb/125065.htm>
Friedman, M (2006): "A Natural Experiment in
Monetary Policy Covering Three Episodes of Growth and Decline
in the Economy and the Stock Market", Journal of Economic
Perspectives, vol. 19, nr. 4, Fall, pgs. 145-150.
HM Treasury (2003): UK Membership of the Single Currency.
An Assessment of the Five Economic Tests. Cmd. 5776.
Morris, R, Ortena, H Schuknecht, L (2006): "The
Reform and Implementation of the Stability and Growth Pact".
ECB Occasional Papers nr. 47 (June).
Schwartz, P (2004): The Euro as Politics. Institute
of Economic Affairs, London. Schwartz, P (2006): "Nomination
of Central Bankers". Expert opinion for the European Parliament
Committee on Economic and Monetary Affairs, Monetary Dialogue
with the ECB, <http://www.europarl.europa.eu/comparl/econ/emu/20060621/schwartz.pdf>
Pedro Schwartz, B.Ll., Dr. Iuris (Madrid), M.Sc.(Econ.),
Ph.D. (London) is Professor Extraordinary in Economics at Universidad
CEU San Pablo in Madrid and Visiting Professor at St. Louis University
Madrid Campus. <pedro@pedroschwartz.com>
Juan Castañeda, Lic. Econ., PhD. is Lecturer
in Economics, Universidad Nacional de Educación a Distancia,
Spain.
Graph 1
IRISH-BRITISH MONETARY SEPARATION AND ITS
EFFECT ON TRADE
Source: HM Treasury Study (2003): EMU and
Trade, pg. 43. Quoted in Schwartz (2004), pg. 132.
Note: After correcting for the continued
fall of UK's share of Irish trade from the 60s, in part due to
the rapid growth of Eire and the trade diversion caused by EU
economic union, the Study asserted that "the estimated impact
of the Anglo-Irish currency regime on trade between the two countries
appears insignificantly different from zero". (Pg. 44)
Graph 2
HARMONISED INDEX OF CONSUMER PRICES, EURO
AREA
Source: Eurostat
Note: Annual rate of change. Neither seasonally
nor working day adjusted.
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