EMU and the International Monetary System

Jean-Pierre Patat

Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
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These two papers have addressed the main issues of the future international monetary system. They have provided us with insightful ideas about the consequences of the creation of the euro. I will briefly add a few points. First, I will focus on the cooperation that could occur in such a world. Second, I will make some comments about the likely evolution of the euro rate, as it is described in these two papers.

Obviously, the international monetary system will be progressively completely transformed by the introduction of the euro, for the euro is likely to become a major international reserve currency.

International monetary cooperation would be strengthened because of EMU. The euro will rapidly become a major currency in the world for settlements and transactions, whatever the size of the monetary union at the outset.

Things could be much more progressive as far as the status of the major reserve currency is concerned. A reserve currency needs a large, safe, and liquid financial market. It is precisely one of the objectives of the Stability and Growth Pact in assessing financial convergence to promote a situation of total substitutability of public debt bonds issued by the European countries and thus to create the conditions for a large and unified financial market. That is a first reason why I do not share the view that the European decision makers will be inclined toward a benign neglect: vigilance will prevail over carelessness in the transition period as well as in the steady state.

Furthermore, from a central bank point of view, benign neglect is impossible because the ECB objective will be to deserve the highest confidence of national and international savers with a view to securing the best possible financial conditions for the development of our economies and the limitation of social imbalance. The stability of the internal value of the euro will be the primary objective of the ECB. Therefore, obviously, ensuring the external value of the euro will also be a key issue. It is misleading to believe that the management of a currency can be divided into two separate purposes, one being to maintain the internal value of the currency, and the other concerning its external value. The primary objective of the ECB will clearly be price stability. And this is entirely consistent with exchange rate stability. This is why Europe will make its best efforts to avoid and, if needed, correct the misalignments that might endanger the world economy (trade difficulties) and world finance. In this context, the United States will surely be prepared to make similar efforts.

For all these reasons, the scope of international monetary cooperation is likely to be broadened by EMU. The international monetary system will most likely be a tripolar one, before perhaps becoming multipolar later on; I therefore do not concur with Fred Bergsten’s expectations that the system will be a bipolar one.

The system will be tripolar insofar as it would not make sense to exchange views and, if needed, take any decision to maintain an orderly exchange rate environment without the active participation of the world’s largest creditor country, namely, Japan. I see no reason why the creation of a unified European area would oust Japan from the cooperation forums (with an acceptable stake in the debate).

Therefore, I do not think that Japan will just play a “minor key currency role.” No other country in Asia is likely to outweigh Japan from a monetary point of view in the near future. From a global perspective, a bipolar system is indeed preferable to a “hegemonic system,” and a tripolar system is certainly preferable to a bipolar one.

Therefore, in such a tripolar system, Europe is unlikely to adopt a “benign neglect” behavior concerning its exchange rate. The two papers provide most of the reasons why there is a solid common interest in international cooperation, and why carelessness would be collectively dangerous.

These two papers already anticipate the future changes of the euro exchange rate. However, their scenarios are questionable. According to Bergsten, the European countries would try to reach a deliberate depreciation of their currencies (competitive depreciation, as he terms it) in the pretransition period because they know that in the transition period, the euro has to be appreciated to gain credibility. Such a scenario draws too much on an alleged capacity and deliberate willingness of European decision makers to “tailor” the process. Moreover, two elements are missing: first, the rest of the world, and more precisely, the United States. There is no reason why the U.S. authorities would agree to play such a game; and second, more fundamentally, the market itself: such a scenario gives too much weight to the opinion that governments can lead the exchange market wherever they judge it useful. This opinion is obviously untrue.

The recent fluctuations in the dollar have just helped to smooth out the cyclical divergences of the world‘s three main economies, which is the desirable role of the exchange rate in a flexible system, provided that these movements remain orderly.

Both papers foresee an appreciation of the euro during the “transition period” that will follow its creation. They argue that portfolio adjustments will make the euro appreciate because of an increasing demand for assets in euros. I am very skeptical about this because the supply of euros will also increase, as there will be more borrowers in euros. Therefore, the portfolio effects on the exchange rate are likely to be mixed between demand and supply effects.

This supply effect is mentioned in the Alogoskoufis and Portes paper, but the authors consider it will be very slow. It is questionable that this will be so. I am also doubtful about this appreciation due to portfolio effects for an another reason. Even if investors’ demand for euro-denominated assets increases more than the supply of liabilities in euros, the balance will not necessarily be restored by an appreciation of the euro. It could also be achieved by a decrease in interest rates in Europe, which would be more profitable for the European economies.

Fiscal consolidation is a necessary condition for economic stability. Its impact on the exchange rate as presented in Bergsten’s paper is questionable. The connection between fiscal policy and the exchange rate is arguably not obvious from the experiences of a number of industrial countries.

Bergsten advocates the idea that fiscal consolidation in Europe would lead to a depreciation of the exchange rate. I would reply that the U.S. “balancing the budget” process will lead to a depreciation of the dollar (prompted by the decline in interest rates). And as fiscal consolidation is also implemented in Japan as well as nearly everywhere else in the world, the argument is invalidated. (If the euro, the dollar, and the yen are simultaneously depreciated, there will be no depreciation at all.)

I totally disagree with the scenario according to which “an ‘ effective’ Stability and Growth Pact could… produce much more severe international risks than a more permissive [fiscal policy]” (Bergsten, p. 34). According to the author, the Stability and Growth Pact would suppress any flexibility in the use of macroeconomic policies, so that the two solutions to counter European unemployment problems would be competitive depreciation and/or trade protection. This is obviously very unlikely.

Generally speaking, I do not agree with the idea that fiscal consolidation in Europe will lead to further depreciation of the European currency1 for three reasons.

First, it is true that fiscal consolidation contributes to lower interest rates and therefore possibly to a lower exchange rate. However, as the European fiscal consolidation has been announced for a long time, this decrease in the interest rate is expected by the markets. Therefore, the current exchange rate already includes the effects of fiscal consolidation. The further evolution of the European exchange rates will not be affected by this expected fiscal policy, for it is already discounted in the present exchange rates. More generally, the exchange rate of a country is driven not only by its interest rates but also by its net external assets. As fiscal consolidation improves domestic savings, the country will accumulate net foreign assets or will reduce its foreign debt.

Second, fiscal consolidation provides healthier conditions for the whole economy. The decrease in interest rates that it allows does not mean that the monetary policy stance is looser.

Third, Bergsten assumes that European monetary policy may become easier in order to fight unemployment, as fiscal policy will be tighter. That would be totally inefficient since, according to the IMF, 80 percent of European unemployment is structural. European unemployment certainly ought to be solved, but with suitable structural reforms, and not with monetary or fiscal stimuli. It would also be counterproductive for sustainable growth. The main purpose of the ECB will be to design and implement a policy of credibility and to provide the European economies with the best financing conditions, that is, with very low market interest rates. That would not be the case if the market had the feeling that the ECB’s objective was not monetary and price stability, but some magic recipe for managing interest rates to improve employment. Any loosening of monetary policy will result in an increase in the expected inflation and in long-term rates, which will affect only economic growth adversely. In the long run, a stable monetary policy will provide better conditions for growth, by lowering the interest rates for all maturities.

A stable monetary policy could be expected for the euro. A stable exchange rate is also likely. There is no benign neglect of the international impact of EMU (even though it is true that the debate has so far been subdued), and there will be no European benign neglect of the future evolution of the euro. As has been frequently stressed (and sometimes criticized) on this side of the Atlantic, exchange rate issues do matter for European decision makers. There is no reason to think that the monetary policy of the ECB will be different from what can be described as an optimization of the yield curve in an orderly exchange rate environment, which is presently the aim of monetary policy in the European countries.

See the; IMF’s October 1995 World Economic Outlook, which concluded that if he short-run effect of fiscal consolidation is to depreciate the real exchange rate, “for the long run, there is a more general presumption that a sustained reduction in the government deficit that raises national saving […] will eventually Lead to a real exchange rate appreciation” (p. 80).

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