Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 12 THE INTERNATIONAL FINANCIAL SYSTEM (2)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main2 The ECU and the ERM The ECU was a weighted average of the currencies of all (initially 9, then 12) member states of the (now) European Union. The ERM (“exchange-rate mechanism”) was an arrangement that compelled governments to keep the exchange rate of their currencies within predetermined corridors (± 2.25% or ± 6%) relative to the ECU rate. Participation in the ERM was voluntary.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main3 The composition of the ECU (1989)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main4 The exchange-rate mechanism (ERM) The national currency is fixed to the ECU. A variation of the exchange rate within the pre-defined “corridor” is allowable. Once the exchange rate tends toward the margins of the “corridor”, the central bank is encouraged to intervene (“infra-marginal interventions”). Once the exchange rate moves out of the “corridor”, a central bank intervention is mandatory to bring it back into the “corridor”.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main5 The “dual solution” to the ERM There could be an alternative to the ERM whereby the central bank is relieved from exchange-rate interventions. This would protect its foreign reserves and allow it to concentrate on its primary role: combating inflation. The mechanism is basically the same as for the ERM, but instead of sustaining markets by supplying international reserves, deviations from the corridor are penalized by a tax: the ERND (exchange-rate normalization duty).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main6 The dual solution to the ERM
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main7 The ERM is a fixed-exchange-rate regime based on an average (the ECU-rate) as a fixed target within a well-defined „corridor“. The ERND works –also with a „corridor“, but –with moving averages (of bilateral exchange rates) as a flexible target (“crawling peg”). It is an automatic, rules-based policy that can be anticipated by market participants. It activates fiscal (not monetary) policies, with built-in (and not discretionary) stabilizers. Differences with the ERM
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main8 not solve structural problems of a currency zone not sustain a policy of „leaning against the wind“, i.a. an exchange rate. It is suitable for smaller countries that intend to „anchor“ their currencies. The concept is suitable, in principle, also for the dollar-euro market, but there might be an alternative: policy coordination. The tax can not
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main9 International monetary policy coordination There were two (failed) attempts to coordinate exchange-rate policies to stabilize the US dollar in the 1980s: the “Plaza” and the “Louvre” accords.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main10 Capital controls Capital controls (particularly those on outflows) are typically rejected by economists. Controls on capital inflows receive some support and have also been used rather successfully in some countries (Chile and Colombia). Reason: Capital inflows can cause an excessive lending boom, … entailing a painful reversal. But controls of capital inflows could also block funds for economic development. It calls for differential treatment according to maturity.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main11 The international policy focus is now on ….. improving banking regulation and supervision, and on greater transparency.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main12 The role of a nominal anchor Adherence to a nominal anchor forces a monetary authority to conduct “disciplined” monetary policy. A priori publicized self-binding rules –imply a strong auto-commitment; –can relieve from short-term political pressures; –contribute to the predictability of policy and hence stabilize economic behavior; –foster confidence building in monetary authorities.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main13 The time-consistency problem Economic behavior is influenced by what economic agents expect monetary authorities to do in the future. If expectations were to remain unchanged there is the temptation to abuse this fact by attempting to boost the economy through discretionary expansionary monetary policy. If expectations will incorporate the expected outcome of such a policy, output will not be higher, but inflation will! A monetary anchor acts as self-binding rule.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main14 Exchange-rate targeting Exchange-rate targeting has a long history, including the fixing of the exchange rate to the price of gold. Exchange-rate targeting has clear advantages –it links the price of traded goods to that found in the anchor country; this might contain inflation; –time-inconsistent monetary becomes less of an option; this stabilizes price expectations; –it is a simple and transparent rule (“franc fort”); Exchange-rate targeting has been widely used in Europe and world-wide.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main15 Disadvantages of exchange-rate targeting Exchange-rate targeting might be create serious problems because –the country tying its currency to that of an anchor currency can no longer respond to shocks to its own economy; –there could also be shocks applying to the anchor country; these are fully transmitted (the case of Germany after unification); –if the anchor country opts for inflation, countries with pegged currencies will “import inflation” –it may present opportunities of a one-way bet for speculators (crisis of the EMS of September 1992).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main16 The 1992 ERM crisis: the UK and France France did not! The UK did devalue
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main17 The “cost” of pegging The UK had higher growth and less unemployment But its inflation rate increased France had lower growth and more unemployment But its inflation rate was lower
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main18 Exchange-rate targeting: For whom? Industrialized countries might have more to lose by exchange-rate targeting than to win. In some industrialized countries the central banks is subject to political pressure. In this case exchange-rate targeting may prove to be beneficial. It also encourages economic integration. Contrary to industrialized countries, emerging market countries may not lose much by giving up an independent monetary policy, but it leaves them open to speculative attacks.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main19 Can speculation be averted? The currency-board approach: One approach is to back the domestic currency by 100% by a foreign currency (euros, dollars). It means –the money supply can only expand when international reserves of a country increase. –a strong commitment of monetary policy, which may therefore work instantly in controlling inflation. Currency boards are however not immune against speculation.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main20 Currency boards: Examples Recent examples of currency boards include –Hong Kong (1983) –Argentina (1991) –Estonia (1992) and Lithuania (1994) –Bulgaria (1997) –Bosnia and Herzegovina (1998) Argentina had to abandon the scheme in December 2001 -- with painful social and economic repercussions.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main21 The CFA-zone The CFA franc is the common currency of 14 countries in West and Central Africa, 12 of which are former French colonies. The CFA franc has been pegged to the French franc since 1948. Only one devaluation has occurred during the history of the currency peg (January 1994). The French Treasury has the sole responsibility for guaranteeing convertibility of CFA francs into euros, without any monetary policy implication for the ECB.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main22 CFA-zone: operations While the two (regional) CFA central banks maintain an overdraft facility with the French Treasury, the amount that can be withdrawn is limited. Each CFA central bank must –keep at least 65 per cent of its foreign assets in its operations account with the French Treasury; –provide for foreign exchange cover of at least 20 per cent for demand deposits (sight liabilities); –and impose a cap on credit extended to each member country equivalent to 20 per cent of that country's public revenue in the preceding year.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main23 Can speculation be averted? Dollarization: Another approach is to abandon a national currency altogether and to adopt a foreign currency (e.g. US dollars) instead. It means –a euro or dollar remains a euro or dollar, whether inside or outside the respective currency area. –that the country adopting a foreign currency loses potential income through seignorage. However a reversal to a domestic currency always remains an option.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main24 “Dollarization”: Examples of countries
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main25 “Dollarization”: Exits Even dollarization does not guarantee a permanent monetary anchoring. There is need to a continuing inflow of foreign denominated capital to satisfy domestic demand for money. This puts severe strains on the economy. There is a large number of exits from a currency zone during recent years: –Numerous exits from the ruble zone after the breakdown of the Soviet Union –the secession of Slovakia from Czechoslovakia –the breakdown of Yugoslavia.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main26 Monetary targeting As already discussed, monetary targeting became fashionable in major industrialized countries during the 1970s (Germany, Switzerland, Canada, Japan, the UK, and the United States). It allows to focus on domestic considerations without regard to exchange-rate developments. Different aggregates were chosen –“central bank money” (Germany 1974-88) –M1 (Canada, the United States) –M2 + CDs (Japan) –M3 (UK, Germany from 1988)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main27 Monetary targeting Monetary targeting proved to be problematical because of –unreliable indicators due to shifts in the demand for money and the introduction of new technologies (financial innovations); –a weak relationship between monetary indicators and inflation; –prevalence of foreign-exchange rate considerations; –speculative bubbles of stock and housing prices (Japan, the United States); and –occasionally moral hazard and banking crises. Monetary targeting was thus suspended, strongly de-emphasized, if not abandoned altogether.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main28 Inflation targeting A number of countries has adopted inflation tar- geting following the lead of New Zealand (1990). –Canada (from 1991) –the UK (from 1992) –Australia (1994) –Brazil (1995) In 1990 the Reserve Bank of NZ became fully independent and was committed to the sole objective of price stability. The governor of the central bank is held accoun- table for achieving a predefined inflation goal.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main29 Inflation targeting: strategy The strategy consists of –publicly announcing a medium-term numerical target for inflation that is well defined; –committing the central bank to price stability as the primary (if not sole) policy goal; –an information strategy that includes several indicators, not just monetary aggregates –increased communication with the public to render monetary policy more transparent; and –an increased accountability of the central bank for attaining its inflation target.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main30 Inflation targeting: advantages Inflation targeting –enables the central bank to focus on domestic policy objectives, but a stable relationship between money and the price level is not critical for its success; –is highly transparent and easily understood; –increases the accountability of the central bank because of a numerical target as a benchmark; –seems to ameliorate the effects of inflationary shocks (introduction of a GST in Canada; exit of the British pound from the ERM in 1992). There was a one-time price adjustment, but no spiraling up of inflation.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main31 Inflation targeting: disadvantages Inflation targeting is not without problems because –inflation cannot be controlled directly and policy outcomes occur only with a time lag; –therefore the policy cannot send immediate signals to economic agents; –may be too rigid and limit the policy discretion to respond to unforeseen events; –it will even out inflation, but might increase output fluctuations.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main32 The two pillar strategy of the ECB The strategy of the ECB appears to reconcile monetary targeting with inflation targeting by scrutinizing both monetary growth and a bundle of economic indicators to assess the medium-term impact on the HICP. Contrary to the NZ approach, the ECB may be criticized as being less responsive to public demands for information. Less transparency goes hand in hand with less accountability.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main33 Thank you for attending this course I hope you enjoyed it All the best for you private and professional future, and … … good luck for the final exam ! That’s it !