1. EC120 Spring 2016: Week 23, Topic 18, Slide 0 EC120: The World Economy in Historical Perspective Topics Week 23: The Elusive Search for Global Monetary Stability after Bretton Woods 1. The disruptive, generally inflationary, oil price shocks after 1972. 2. Widespread policy moves to control inflation in the late 1970s. 3. Policy constraints (especially in Europe) and the International Trilemma. 4. Only limited global co-ordination to manage exchange rates after 1973; does it matter? 5. Is Europe an Optimal Currency Area? Why the answer matters. 6. The European experience with exchange rate co-ordination after 1987: German reunification, the crisis in the European Monetary System, 1992-93, and its aftermath. 7. The (flawed?) creation of the euro.

2. EC120 Spring 2016: Week 23, Topic 18, Slide 1 EC120: The World Economy in Historical Perspective 1. The Disruptive Oil-Price Shocks after 1972. Note that the oil shocks occurred after inflation had begun to accelerate in the 1960s. Given the pervasive use of oil throughout advanced economies for both transportation and electrical power generation, it is clear that a sharp increase in oil prices, ceteris paribus, will lower aggregate output. The inflationary impact is much harder to determine a priori, for it depends heavily upon the policy response to the decline in output and rise in unemployment (see Diagram 1). It took time to adjust the capital stock to the new reality

3. EC120 Spring 2016: Week 23, Topic 18, Slide 2 EC120: The World Economy in Historical Perspective 1a. The Disruptive Oil-Price Shocks of the 1970s [con’t.] As Diagram 1 indicates, it is not hard to imagine a situation where an adverse oil price shock reduces the level of both output and prices for an oil-importing country. However, the actual experience of the oil shocks of the 1970s on the economy-wide price levels of OECD countries was unambiguously highly inflationary. This suggests that both the economic environment in which the oil shocks occurred and the subsequent policy responses deserve closer attention.

4. EC120 Spring 2016: Week 23, Topic 18, Slide 3 EC120: The World Economy in Historical Perspective 2. Widespread policy moves to control inflation starting in the late 1970s The long struggle to suppress inflation – an overview: ̶ In Europe, steps towards closer economic integration and monetary union were only possible with converging (or at least stable) rates of inflation, a task not easily accomplished (for an indication of the consequences of differential inflation in foreign exchange markets, see Baldwin & Wyplosz (2004), Fig. 10-4). ̶ In the U.S., the “Volcker squeeze”, starting in late 1979 and following an abrupt change in policy, brought inflation (CPI) down to 3.2% by 1983, from an average of 7.1% over the preceding eight years, albeit at the cost of two sharp but brief recessions (see again Barsky & Kilian (2001), Table 1). ̶ Eventually interest rates, both real and nominal, also eventually came down (see Blanchard (2003), Figs. 1 & 2).

5. EC120 Spring 2016: Week 23, Topic 18, Slide 4 EC120: The World Economy in Historical Perspective 3.Policy Constraints (especially in Europe) and the International Monetary Trilemma (again). The particular problems of differential inflation rates for European economic integration in the context of generalized floating: –either the country with a higher rate of inflation accepts the loss of export market share that pegged exchange rates imply and the loss of reserves that follow (not a sustainable policy, but then what?); –or it devalues (or markets force it to devalue) and thereby perhaps gains a temporary cost advantage in export markets (i.e. a competitive devaluation, the scourge of the 1930s); – or it imposes exchange and/or trade controls; – in any case, unequal rates of inflation tend to disrupt trade.

6. EC120 Spring 2016: Week 23, Topic 18, Slide 5 EC120: The World Economy in Historical Perspective 4. Only Limited International Co-ordination to Manage Exchange Rates The broader international environment of floating rates: “benign neglect” by the US (dictated by the primacy of domestic objectives and the international trilemma) broken only occasionally by limited concerted intervention: the Plaza (September, 1985) and Louvre (February, 1987) “accords”. International monetary co-operation has been an intensely political process – only when all the main actors can agree on a particular course of action is effective co-ordinated policy likely to occur. Inflation targeting by central banks may be a means by which effective co-ordination can occur without requiring comprehensive, detailed agreement, much as the classical Gold Standard operated with only occasional central bank co-operation.

7. EC120 Spring 2016: Week 23, Topic 18, Slide 6 EC120: The World Economy in Historical Perspective 5. A Note on Optimal Currency Areas (OCA). The concept of an OCA was devised as a means of assessing whether a particular group of regions or countries would be better off sharing a single currency or having separate currencies with floating exchange rates. The characteristics of OCAs fall in two broad categories: − Economic factors. − Political factors. Europe does not currently meet the normal criteria of an Optimal Currency Area. The political question is whether it can either become one or contain adequately the costs of sub-optimality.

8. EC120 Spring 2016: Week 23, Topic 18, Slide 7 EC120: The World Economy in Historical Perspective 6. The European Experience with Exchange Rate Co-ordination after the Launch of the Single Market Programme in 1986. After four years of stability, the shock of German reunification led to atypical German inflation, to which the Bundesbank responded by raising interest rates, creating serious problems for countries facing weaker domestic demand, flagging exports, and higher unemployment. The Berlin Wall, c.10 November 1989

9. EC120: The World Economy in Historical Perspective EC120 Spring 2016: Week 23, Topic 18, Slide 8 6a. Europe’s Experience with Exchange Rate Co-ordination: Crisis in the EMS, 1992-93 Britain and Italy were forced out of the ERM in September 1992, unable to hold the peg to the DM without unacceptable costs. Pressure continued, and in August 1993, the normal ERM bands were widened from 2.25% to 15%, greater than they had ever been during Bretton Woods, the ‘Snake’, or the EMS previously. The policy choices after 1992: monetary union vs. wide-band floating. Norman Lamont, British Chancellor of the Exchequer George Soros, c. 1992 and aide, September 1992

10. EC120 Spring 2016: Week 23, Topic 18, Slide 9 EC120: The World Economy in Historical Perspective 6b. Europe’s Experience with Exchange Rate Co-ordination: After the Crisis After a turbulent period in 1992-93, stability returned to the EMS and plans were made for the ultimate in exchange rate co- ordination – the move by some countries to a single currency, the euro. Criteria for euro eligibility: − low inflation (reinforced by the market test of low long-term interest rates); − government budget deficits capped at 3% of GDP; − the total nominal amount of government debt capped at 60% of GDP.

11. EC120 Spring 2016: Week 23, Topic 18, Slide 10 EC120: The World Economy in Historical Perspective 7.The (flawed?) creation of the euro. Britain’s exit from the ERM removed from the ranks of euro candidates a large economy arguably unusually prone to asymmetric shocks. A favourable growth environment made euro-entry criteria easier to meet. Euro-fudge: countries with high (over 100%) levels of government debt (Belgium, Italy, Greece) were allowed to enter the euro on grounds of (slow) movement towards the 60% cap, with budget deficits (allegedly) well under 3%. Emerging problems − The difficulty of fitting a single interest rate to the entire euro-zone. − Trade imbalances. Can the euro-zone cope?

12. EC120 Spring 2016: Week 23, Topic 18, Slide 11a EC120: The World Economy in Historical Perspective The problems the euro faced before the global financial crisis broke in 2008 were minor compared with those that were to come (considered in more detail in the remaining lectures). However, a consistent response to those problems has been to find some sort of resolution, even if only temporarily before attempting another one. Given that a search for monetary union in Europe has now been going on for more than forty years and many obstacles overcome, involving a wide range of compromises and experiments, such an experience would suggest (but by no means guarantees) that Europe will continue to muddle along until a more durable monetary system is finally achieved (probably involving the European Central Bank acting as a recognized lender-of-last-resort, supported by regulatory oversight of the euro-zone banking system; some system of support for countries facing asymmetric shocks; and at least some issue by nation states of eurobonds whose creditworthiness would be backed by the eurozone as a whole rather than by individual governments as at present). Whenever that time comes, it is unlikely to bear much resemblance to the system that currently exists and may not necessarily include all current members of the eurozone.

13. EC120 Spring 2016: Week 23, Topic 18, Slide 12 EC120: The World Economy in Historical Perspective Summing Up: Interpretation and Assessment As the “Golden Age” came to a close, inflationary pressures grew, becoming much more pervasive with the first oil shock in 1973. Gradually, in the context of a global regime of floating exchange rates, inflationary pressures were subdued, albeit at the cost of slower growth and high levels of unemployment. High and varying rates of inflation created obstacles to European monetary integration; these obstacles were gradually overcome as inflation rates came down and new impetus was given to the creation of a unified European market. The EMS, after a period of stability in the late 1980s, succumbed to the shock of German unification. Following the EMS crises of 1992-93, most of the EU elected to strive for an extremely tight form of monetary unification, a single currency, trusting that the entry criteria were sufficient to ensure that member states would constitute an acceptable, if not perfect, currency area.