Better Than the Euro? The European Monetary System (1979–1998)

ABSTRACT

The euro crisis has provoked a debate on the pros and cons of adjustable exchange rate regimes that enable their participants to negotiate nominal de- and revaluations. To evaluate the functioning of such regimes, we revisit the EMU’s predecessor, the European Monetary System (EMS). We show that in the EMS, devaluations did indeed help more than revaluations did hurt. Assuming that the political-economic heterogeneity of the Eurozone will not vanish in the foreseeable future, the move to a more flexible exchange rate regime might therefore be economically advantageous. However, a purely economic view ignores the huge political ‘maintenance costs’ of negotiable realignments, costs that the EMS members aimed at overcoming when they opted for the euro. The re-politicization of nominal exchange rate policy in today’s Eurozone would therefore not end transnational political conflicts in the Eurozone but fuel new ones.     

The Euro: An Italian perspective

The adoption of Euro as a common currency of twelve European countries has meant a considerable change in the Italian exchange rate policy. In the past, before Italy entered the EMS and again in 1992-96 when Italy temporarily left the EMS, the Italian monetary authorities enacted a policy of managed exchange rates, aiming at keeping the dollar rate stable, while letting the Italian lira depreciate vis-à-vis the German mark. By so doing, the danger of imported inflation was reduced (the dollar area was then a major import area) and at the same time the Italian exports to Europe were made easier. In the presence of a regime of fixed exchange rates in the European area, Italian industry is trying to make its exports more competitive by means of a reduction in costs. This means moving segments of production to small or middle-size firms, located in Italy as well as in developing countries. A further help is coming from the gradual but consistent depreciation of the Euro against the US dollar. The relevance of the dollar area in Italian exports has been correspondingly increasing.     

Nonfundamental FX trading and excess volatility in credible target zones Theory and empirical evidence

This paper presents a target zone model with imperfect asset substitutability in which exchange rates are driven both by expectations regarding the credible defense of the currency band and foreign exchange traders' stop-loss trading strategies. The model generates excess volatility and nonuniqueness in the density function of the exchange rate. These results obtain independently of whether the stop-loss strategies are known to the market. In an empirical section, the authors find support for the existence of excess volatility for selected countries of the European monetary system (EMS) during the stable EMS period.     

Does exchange rate pegging enhance credibility? Evidence from the European Monetary System

The European Monetary System (EMS) has been credited with immediately enhancing the credibility of onetary policy among its member countries. However, there is little empirical evidence to support this view. This study provides evidence from exchange rate data that political actions taken to support the EMS enhanced rate arangement. Further, empirical results were sensitive to the specification of the estimating equations, and varied dramatically if risk premia (discounts) were absent from estimating equations.     

Imperfect credibility and risk premia in the European Monetary System

The paper deals with the estiamation of models for the expected rate of depreciation within the currency bands of the French franc and the Italian lira against the deutshmark, both unconditional and conditional upon no realignment, as well as the estimastion of models for risk premia. Using these estimates,estimates are constructed for the expected rate of depreciation, the expected rate of realignment and the expected rate of devaluation of these exchange rates during their EMS period by appropriate adjustment of interest rate differentials. It is found that these adjustments are of non-trivial magnitude.     

Trade integration and synchronization of shocks*

According to the European Commission (1990 ), closer integration leads to less frequent asymmetric shocks and to more synchronized business cycles between countries. However, for Krugman (1993 ) closer integration implies higher specialization and, thus, higher risks of idiosyncratic shocks. Drawing on the evidence from a group of transition countries, this paper tries to determine whose argument is supported by the data. This is done by confronting estimated time‐varying coefficients of supply and demand shock asymmetry with indicators of trade intensity and exchange rates. We find that (i) an increase in trade intensity leads to higher symmetry of demand shocks: the effect of integration on supply shock asymmetry varies from country to country; and (ii) a decrease in exchange rate volatility has a positive effect on demand shock convergence. The results confirm ‘The European Commission view’ and also the argument by Kenen (2001 ) according to which the impact of trade integration on shock asymmetry depends on the type of shock.     

Trade Costs and the Open Macroeconomy

Trade costs are known to be a major obstacle to international economic integration. Following the approach of New Open Economy Macroeconomics, this paper explores the effects of international trade costs in a micro‐founded general equilibrium model that allows for different degrees of exchange rate pass‐through. Trade costs are shown to create an endogenous home bias in consumption and the model performs well in matching empirical trade shares for OECD countries. In addition, trade costs reduce cross‐country output and consumption correlations, and they magnify exchange rate volatility. Trade costs turn a monetary expansion into a beggar‐thy‐neighbor policy.     

THE POLITICS OF MAASTRICHT

The Economic and Monetary Union (EMU) treaty signed at Maastricht does not guarantee the recreation of German-style economic policies and outcomes at the European Community (EC) level. Membership was not limited to countries that mimic the German commitment to price stability. National representatives may outvote inflation-averse EC central bankers in monetary policy decisions. The Council of Ministers has the power to set exchange rate policy vis-à-vis third currencies. The treaty does not provide binding constraints against fiscal profligacy in member states. The German government agreed to this suboptimal outcome because in the wake of the demise of the Soviet Union and German unification it had broader political interests in maintaining the pace of European integration at Maastricht. The Bundesbank's policy of high interest rates in 1992, however, has effectively guaranteed a two-speed monetary union, in which the first group of members will be limited to a narrow deutschemark zone. Given the waning enthusiasm for integration across the EC, the German government has no incentive to alter this outcome.     

The Eurozone Sovereign Debt Problem: What It Means for U.S. Exports

The European sovereign debt problem became the focus of world attention in 2010, when the interest rates on Greek government bonds rose dramatically, requiring immediate action by the European Union to avoid an imminent default. It has become clear that the problem is not limited to Greece, but a more general problem of the fundamental imbalances and underlying inconsistencies in the Eurozone economic system of using a single currency for a set of countries that lack a unified economic and political system. Financial markets reacted to the debt offering of the other deficit countries in the Eurozone by increasing interest rates on their sovereign debt as well. The major consequences are likely to be largely felt by the Eurozone countries themselves, some of whom will be forced to go through significant structural adjustments over the coming years. The adjustment process could generate a range of alternative macroeconomic outcomes for affected countries??including differences in growth, exchange rates, and investment??which could have significant implications for U.S. trade. This paper attempts to allay some of that uncertainty by exploring a wide range of alternative global macroeconomic outcomes and their potential impact on U.S. exports. The analysis extends the work done in a previous paper which focused on U.S. agricultural exports and its major components. While U.S. exports vary across the scenarios, continued strong economic growth in developing countries supports demand for U.S. exports. Because the EU has represented a declining share of U.S. exports, the direct impact of changes in European demand affects U.S. exports less than the secondary effects of changes in exchange rates and global investment patterns associated with alternative EU outcomes.     

Exchange rates and food in the European Community

The workings of the agri-monetary system in the European Community are not widely understood and seldom analyzed. This paper provides a simple theoretical framework that highlights the main features of the system and explains the policy options and potential costs and benefits that accrue to agricultural producers within the Community as exchange rates continue to fluctuate.     

Trade,foreign direct investment or acquisition: Optimal entry modes for multinationals

We examine multinationals' optimal entry modes into foreign markets as a function of market size, FDI fixed costs, tariffs and transport costs. Our results highlight why large countries are more likely to attract acquisition investment, while intermediate sized countries may be served predominantly through trade, even in the presence of high tariffs. Small countries are most likely to experience either FDI or no entry. We also show how these results vary with the competition intensity in the host country.FDI fixed costs, tariffs and transport costs are crucial not only in determining whether to engage in FDI or trade, but they are also shown to influence the acquisition choice as trade and FDI threats influence the acquisition price. Finally, we explore the welfare implications of tariff reductions for both the local firm and the multinational and investigate political motives to impose endogenous tariffs that influence not only the welfare of a local firm, but also the entry mode of the multinational.     

Exchange Controls,Political Risk and the Eurocurrency Market: New Evidence from Tests of Covered Interest Rate Parity

This study employs daily data to examine the effects on Eurocurrency and onshore returns of the May 21, 1981 imposition of exchange controls by French President Mitterand. Prior to this time, transaction costs explain the average onshore deviations from covered parity; however, these averages ignore short-lived political risk premia which emerged just before the imposition of controls. As expected, there is no evidence of political risk of Eurocurrency markets. Yet when exchange controls were in effect, premia in excess of transaction costs surfaced on nonfranc Eurocurrency deposits at the time of devaluations of the franc within the EMS. [431]     

Does the quality of political institutions affect intra-industry trade within trade blocs? The ASEAN perspective

There has been a renewed resolve for deeper integration and cooperation within ASEAN. Intra-industry trade (IIT) is often viewed as a way of achieving economic as well as political integration. This article tests for the effect that political regime and governance may have on the intensity of IIT. We particularly examine if quality of political institutions which includes corruption and democracy indices as well as economic factors comprising corporate tax rate, regional FDI flow, flexibility of exchange rate regime, size of the market, economic distance affect the intensity of horizontal and vertical IIT. The study finds that control of corruption and good governance both increase the vertical IIT but not the horizontal IIT. The study further finds that intra-economy FDI flow, stable exchange rate regime, market size and proximity positively affect IIT within the trade bloc. However the negative effect of corporate tax rate suggests that if countries were to coordinate their tax policies, they could avoid harmful tax competition and promote IIT across their borders. The findings regarding the effect those economic and political factors have on the intensity of IIT certainly warrants the attention of policy makers and researchers alike.     

On the Aggregate Impact of Exchange Rate Variability on EU Trade

The paper assesses the aggregate impact of exchange rate variability on EU trade. A small econometric model is constructed and estimated for five countries: France, Italy, Germany, the UK and Belgium. The results show that there exists a long-term relationship between trade variables and relative costs, demand, exchange rates and expected exchange rates. No such relation exists with respect to volatility. It is also found that while the most important determinants of trade variables are relative wages and demand, variability is also responsible for a decrease in the growth rate of these variables.     

Real exchange rates,economic performance,and trade balances in the central european free trade association

The relationships between real exchange rates dynamics, domestic economic growth, and external economic positions are examined for four East European countries: Poland, Hungary, Slovakia, and the Czech Republic. Results show that in Poland the dynamic of the trade balance is independent of both the real exchange rate and industrial production. In both Hungary and Slovakia, trade balances appear to have strong autonomous components, albeit in circumstances where the influence of real exchange rates and industrial production dynamics cannot be entirely denied. The Czech Republic's situation is, however, substantially different from its Central European Free Trade Assocation partners. The growing trade balance deficit appears to be determined by both the continuing real appreciation of the Czech currency and a mildly accelerating industrial production growth. Both are the consequence of accelerating capital inflow.     

Trade,finance or policies: What drives the cross-border spill-over of business cycles?

In this paper we investigate how income growth rates in one country are affected by growth rates in partner countries, testing for the importance of pairwise country links as well as characteristics of the receiving country (trade and financial openness, exchange rate regime, fiscal variables). We find that trade integration fosters the spill-over of business cycles, both bilaterally and as a country characteristic (trade openness). Results for financial integration are mixed; financial links as pairwise country characteristic are either insignificant or negatively signed (indicating a dampening of cross country spill-overs), but financial openness as characteristic of the receiving country amplifies spill-overs. We find no evidence for a role of the exchange rate regime. Finally, we find that higher government spending and debt reduces countries’ vulnerability to foreign business cycles, presumably through the effect of automatic stabilizers.     

Inflation,interest and exchange rates in the transition1

Central and Eastern European economies have made extraordinary progress in their trade and exchange regimes. Surprisingly, instant convertibility was established for a great variety of exchange rate regimes. In spite of diversity, all these countries have followed a common pattern: severe initial undervaluation - the cost of speed and unrestricted trade - followed by rapid real revaluation and incipient protectionism. Since 1994 in many cases an embarrass de richesse has appeared: high capital inflows which are either inflationary or costly to sterilize. A major cause of these flows - or at any rate of the high cost of sterilization - is the presence of significant interest rate differentials higher than required to cover the risk of devaluation. These are the necessary consequence of a policy of positive real interest rates and of real revaluation from excessively undervalued exchange rates. Lower interest rates are recommended, both to stem financial capital inflows and to reduce the cost of their sterilization.     

SEIGNORAGE AND EUROPEAN MONETARY UNION

Inflation differentials in Europe have narrowed substantially since the inception of the European Monetary System in 1979. However, their persistence after more than a decade raises the question of why these differentials are so difficult to eliminate. Some European Community countries systematically use seignorage—financing government expenditures with money creation—while others do not. This increases the difficulty of achieving the convergence of monetary policies and inflation rates required for irrevocably fixed exchange rates in Europe. This paper, utilizing a model of government finance that minimizes the social cost of financing government expenditures, examines monetary finance in the European Community. It rejects soundly the social cost minimization model of seignorage collection.     

Factor Endowments,Democracy, and Trade Policy Divergence

We develop a stochastic model of electoral competition in order to study the economic and political determinants of trade policy. We model a small open economy with two tradable goods, each of which is produced using a sector‐specific factor (e.g., land and capital) and another factor that is mobile between these tradable sectors (labor); one nontradable good, which is also produced using a specific factor (skilled labor), and an elected government with the mandate to tax trade flows. The tax revenue is used to provide local public goods that increase the economic agents’ utility. We use this general equilibrium model to explicitly derive the ideal policies of the different socioeconomic groups in society (landlords, industrialists, labor, and skilled workers). We then use those ideal policies to model the individual probabilistic voting behavior of the members of each of these socioeconomic groups. We use this model to shed light on how differences in the comparative advantages of countries explain trade policy divergence between countries as well as trade policy instability within countries. We regard trade policy instability to mean that, in equilibrium, political parties diverge in terms of the political platforms they adopt. We show that in natural resource (land)–abundant economies with very little capital, or in economies that specializes in the production of manufactures, parties tend to converge to the same policy platform, and trade policy is likely to be stable and relatively close to free trade. In contrast, in a natural resource–abundant economy with an important domestic industry that competes with the imports, parties tend to diverge, and trade policy is likely to be more protectionist and unstable.     

SEIGNORAGE AND EUROPEAN MONETARY UNION

Inflation differentials in Europe have narrowed substantially since the inception of the European Monetary System in 1979. However, their persistence after more than a decade raises the question of why these differentials are so difficult to eliminate. Some European Community countries systematically use seignorage—financing government expenditures with money creation—while others do not. This increases the difficulty of achieving the convergence of monetary policies and inflation rates required for irrevocably fixed exchange rates in Europe. This paper, utilizing a model of government finance that minimizes the social cost of financing government expenditures, examines monetary finance in the European Community. It rejects soundly the social cost minimization model of seignorage collection.