Reforming the International Monetary and Financial System

3 The Euro, Yen, and Dollar: Making the Case Against Benign Neglect

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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International discussions on the damage done by exchange rate instability and possible cures started with the demise of the Bretton Woods regime and have remained on the agenda, more or less continuously, for the past 25 years. From time to time, they have been followed by action to deal with specific situations, such as the dollar appreciation in 1985 and the yen appreciation in 1995, or by more durable commitments, as in the case of the Plaza and Louvre accords of 1985 and 1987. There is a widespread consensus, however, that arrangements aimed at stabilizing major currencies have not fulfilled the expectations of the 1980s, and that governments should not waste scarce resources on activism in foreign exchange markets.

Two recent series of events, however, have led us to reconsider the pros and cons of arrangements that could help moderate exchange rate fluctuations between the dollar, the euro, and the yen. The first was the succession of exchange crises in emerging economies, which some observers have traced back to the effect of the strong dollar on currencies that were formally or informally pegged to the U.S. currency. The second was the creation of the euro, whose impact on the international monetary system has given rise to considerable speculation as well as some proposals for reforming international monetary arrangements.

In this chapter, we take a new look at the issue of exchange rate stabilization and put forward some modest proposals for improving upon existing arrangements. The first section is devoted to assessing the evidence: it examines the consequences of the euro, the costs of exchange rate instability, and the lessons that can be drawn from previous attempts at stabilizing exchange rates. We conclude that the euro could lead to some additional instability, especially in the early period after its introduction; that excessive exchange rate fluctuations entail significant costs, both for the countries directly involved and for the rest of the world; and also that any attempt to mitigate instability can no longer rely on the Plaza-Louvre scheme, which has a mixed record and no longer corresponds to the present state of the world economy.

In the second section we explore some avenues for exchange rate cooperation. We first look at policy coordination after the euro: the case for it, the obstacles it may be facing, and possible principles around which it could be organized. We then turn to the monitoring of foreign exchange markets in the context of highly developed financial markets. Finally, we outline the implementation of a possible arrangement within the framework of the new currency regime initiated by the introduction of the euro.

The Evidence

International Monetary Stability After the Euro

There are three reasons why some additional exchange rate instability was to be expected from the introduction of the euro: because a multicurrency system could be inherently less stable than a hegemonic one (the hegemonic stability argument); because the advent of a new currency would give rise to shocks to the demand for and the supply of international currencies (the portfolio shift argument); and because the euro area will be a more closed, and thus a more inward-looking, economy than its constituent member states (the openness argument). A significant body of research has been devoted to discussing these elements and to assessing the impact of the euro on exchange markets. We briefly discuss the findings and weigh whether they lead to firm conclusions we can build on.

Before entering this discussion, it is worth clarifying what we mean by exchange rate instability. The more readily available approaches focus either on the ex ante, short-run volatility (as measured by the implicit volatility derived from option prices) or on the ex post volatility (of which historical volatility is the most usual measure). In this respect, the volatility of the euro in the first months following its introduction was low in comparison with that of its constituent currencies. However, research tends to suggest that the welfare cost of moderate short-run fluctuations of the exchange rate is limited, if only because they can be hedged. What matters are abrupt changes that can disrupt financial markets because of the loss they imply on unhedged positions, and significant departures from equilibrium exchange rates over longer horizons, which are generally not hedged against and may distort the allocation of resources. This is what we mean by exchange rate instability.

The hegemonic stability argument basically holds that only monetary hegemony is able to provide the public good of international monetary stability. A two-currency system would thus be inherently less stable, as illustrated by the comparison between the interwar episode and the stability that followed World War II. Because the euro would challenge the international role of the dollar, this could be a significant cause of instability.

The hegemonic stability argument needs to be assessed carefully. Its basic weakness is that it overlooks the fact that monetary arrangements need to correspond, to some extent, with the structure of the real economy if they are to contribute to international stability. Despite its brilliant economic performance, the U.S. economy is bound to represent a declining share of the world economy in the long run, and it is questionable whether a system in which a country representing one-fifth of world GDP is the sole provider of international money is a sound basis for international stability. Europe and the United States represent roughly equal shares in the world economy and, together with Japan as it regains its economic strength, should remain the dominant players. A monetary arrangement that reflects this reality should provide a more solid basis for world trade and growth, provided that the major players cooperate and share the burden of leadership.1

It is true, however, that the creation of a unified, highly liquid, European financial market will increase the substitutability between European and U.S. assets and thereby provide an international alternative to the holding of dollar assets for international investors. This could increase the potential for largescale portfolio reallocations in response to shocks (Artus, 1999). In Portes and Rey (1998), this view is supported by empirical evidence that the introduction of the euro could lower transaction costs and increase liquidity.

Whether a two- or three-currency regime would result in additional exchange rate instability thus depends on the nature of shocks affecting the world economy. Because liquidity and substitutability between currencies would increase, financial shocks could be accommodated without large exchange rate fluctuations. However, the building up of unsustainable foreign positions would result in more pronounced exchange rate changes than in a one-currency regime, because official and private asset holders would be offered an alternative to the accumulation of dollar balances. Furthermore, this new regime cannot be expected to be put into place without trial and error, and the transition to it will probably involve some exchange rate volatility.

The course of events since January 1, 1999, has apparently refuted the main conjecture of the portfolio shift argument—that there would be a tendency for the euro to appreciate. This is certainly a spectacular rebuttal of the most outspoken versions of the argument (Bergsten, 1997), but with two important qualifications. First, it is far too early to conclude on the issue because preliminary evidence suggests that portfolio diversification into the euro has barely begun. (For example, most Asian central banks are willing, in principle, to rebalance their reserves, but they have yet to start the process, and the Hong Kong Monetary Authority, which did so, has since reversed its position.) Indeed, careful analysts had suggested that the diversification process could be spread out over several years. Second, analysts had already speculated that portfolio shift effects would affect the supply of euros as well as the demand (Bénassy-Quéré, Mojon, and Schor, 1998; Portes and Rey, 1998). Here again, early evidence tends to show that supply shifts have been taking place, especially in the international bonds market, where euro-denominated securities represented 44 percent of total issues in January-April 1999, roughly the same share as the dollar (46 percent), compared with 35 percent for the euro and 48 percent for the dollar on average in 1998. It would thus be premature to dismiss the argument. One could even be tempted to conclude from the experience of the past few months that, while exchange rate predictions based on a one-sided view of the issue have been dashed, the evidence, so far, reinforces the view that unsynchronized shocks to the demand for and the supply of euros could create a significant potential for instability.

The openness argument has a permanent character. It holds that because the euro area’s openness rate (measured by the ratio of trade in goods and services to GDP) is about 14 percent, compared with some 25 percent for large member states like Germany or France, the European Central Bank (ECB) will care less about the exchange rate. A more elaborate version of that argument, based on three-country models, combines a size/openness effect with the automatic coordination effect provided by European monetary unification. This literature has apparently come up with contradictory results, since some scholars (Martin, 1997) conclude that the euro will lower exchange rate volatility while others (Bénassy-Quéré, Mojon, and Pisani-Ferry, 1997) argue that it will increase it. Furthermore, some papers (Bénassy-Quéré, Mojon, and Pisani-Ferry, 1997) argue that the exchange rate impact of demand shocks will increase and that of supply shocks decrease, while others (Cohen, 1997) offer the opposite conclusion. Créel and Sterdyniak (1998) provide a synthesis and conclude that there should be a modest addition to the response of the exchange rate to demand shocks affecting the euro area and the United States asymmetrically, while asymmetric supply shocks should result in lower volatility.2 However, most of these results originate in models with optimizing policymakers, and the increase in volatility they predict should therefore be regarded as welfare-improving. As EMU removes intra-European externalities that previously constrained national central banks to pay excessive attention to the exchange rate vis-à-vis the dollar, the greater volatility produced by EMU may be deemed to reflect an increase in the freedom to pursue optimal policies and should thus be welcomed.

In summing up, we find reasons to expect some instability of the euro exchange rate vis-à-vis non-European currencies in comparison with that of its constituent currencies in the past. Although additional volatility could remain modest in the long run and, at least part of it, should not be resisted, we are more worried about the next few years, as several factors of instability will interact: the policy learning process in Europe and its perception by market participants; international adjustment to a new multicurrency regime; and shocks to the demand for and the supply of euros arising from portfolio rebalancing effects on the asset and the liability sides of private and official sectors. Furthermore, these factors enter into play in a rather disturbed monetary environment, where the U.S. current account imbalance represents a threat to the stability of the dollar, the yen suffers from deeply rooted domestic weaknesses, and many emerging market currencies are just starting to recover from exceptionally severe crises.

Pitfalls of Instability

Assessing the potential costs from exchange rate instability involves making a judgment on the performance of exchange markets and the economic consequences of currency misalignments. We have no intention of expanding on the already rich literature of the lessons from 25 years of floating exchange rates. Our reading of this literature is that the instability of floating exchange rates is well documented, and that while moderate currency fluctuations can be accommodated without major difficulties, the economic costs of misalignments are significant, especially for owners of physical and human capital who cannot hedge against the consequences of large currency fluctuations (see, for example, Obstfeld, 1995). What we would like to stress is that excessive exchange rate instability between the major currencies would be especially harmful after the introduction of the euro, for two reasons.

First, exchange rates between major currencies have the character of public goods for the world economy. Bilateral trade among the euro area, the United States, and Japan is a relatively minor fraction of world trade, but since trade with these three blocs represents a significant fraction of total exports for a large number of countries, wide fluctuations of the dollar-euro and dollar-yen exchange rates can have a destabilizing impact on third countries. This effect was apparent in 1997, when the appreciation of the dollar contributed to the collapse of Asian currencies, which maintained links to the dollar, and again in June 1998 when interventions took place to support the yen to avoid a new spiral of depreciation in Asia and a devaluation of the renminbi.

One might argue that this is just another illustration of Milton Friedman’s famous “cat’s tail” argument: rather than fixing the euro-dollar exchange rate, the appropriate response would be for third countries to float their currencies or at least to adopt a basket peg in which the dollar and the euro are weighted according to their relative shares in the country’s trade. However desirable they may be, it is uncertain that emerging countries and countries in transition will, in fact, adopt such alternative strategies. In the Asian case, the prevalence of unilateral pegs to the dollar prior to the 1997-98 crisis was not justified on trade-shares grounds. Instead, these pegs were a de facto device for implicitly coordinating exchange rate policies. The shortcoming of the theoretically superior “band-basket-crawl” solution advocated by Williamson (1999) and endorsed by Dornbusch and Park (1999), was that it implied some kind of explicitly coordinated decision by Asian countries. Furthermore, as exemplified by the countries with currency boards, authorities may prefer to peg to a specific currency because the transparency, and thereby the credibility, of the currency board are enhanced by the choice of a single anchor currency.

Europe and the United States therefore have reasons to care about external effects of fluctuations in the euro-dollar exchange rate. While the significance of this externality might decrease as a consequence of the extension of floating-rate regimes following the currency crises of 1997-98, it would certainly be premature to disregard it altogether.

The second reason why exchange rates instability among the major currencies would be harmful arises from domestic considerations. We see reasons why exchange rate misalignments could be a cause of concern for both the United States and Europe. The United States remains sensitive to excessive fluctuations in the exchange rate, as misalignments generally trigger conflicts between domestic interest groups and ultimately fuel protectionist pressures. Furthermore, higher substitutability between dollar and euro assets, combined with the permanent need to finance the U.S. current account deficit, should increase the potential for abrupt portfolio shifts and thereby make U.S. debt issuers and policymakers more sensitive to exchange rate developments (see above).

Europeans may become less sensitive to the dollar exchange rate than they were before the euro, but wide exchange rate variations would probably give rise to domestic conflicts there also as all governments are not equally responsive to the demands of the traded-goods sector. There is also a risk that misalignments would cause difficulties in the management of EMU because they would trigger different reactions in the participating countries. Some governments might insist on making use of the exchange rate policy instruments provided by the Maastricht Treaty, while others might resist because, in their view, the use of these instruments would threaten the independence of the ECB. With only partially tested economic policy institutions, a misalignment might give rise to a dispute over the constitution of EMU. The euro area may acquire a U.S.-style indifference to small exchange rate fluctuations, but it has good reasons to avoid being caught in a currency misalignment trap during its early years.

In summing up, there could be some kind of convergence in the U.S. and European attitudes vis-à-vis exchange rate fluctuations in the coming years. Europe’s indifference to limited fluctuations could increase, as would U.S. sensitivity to large fluctuations.

What Have We Learned from the Post-Bretton Woods Era?

Exchange rate coordination in the post-Bretton Woods era has been a process of trial and error. The consensus on exchange rate management has evolved only under the pressure of events, when uncoordinated economic policies resulted in severe exchange rate misalignments and triggered domestic tensions or, on the contrary, when attempts at exchange rate stabilization resulted in dead ends.3 In the process, the coordination instruments that were refined along the way have remained in the international policy toolbox.

This trial-and-error process is best illustrated by the well-known policy shift of the mid-1980s, when the appreciation of the dollar eventually became unbearable. The first Reagan administration had stuck to a laissez-faire policy on foreign exchange markets. By February 1985, the dollar had soared so high and the U.S. trade deficit had grown so large as by-products of fiscal expansion, that the United States decided to bring the exchange rate down and, in the process, recognized the virtue of international coordination. Although the initial reversal of the dollar was not policy-induced, a policy change was engineered by Treasury Secretary Baker and embodied in the Plaza Agreement of September 22, 1985, when Group of Five ministers and governors agreed to talk the dollar down further and to “cooperate more closely when to do so would be helpful,” meaning coordinated interventions on foreign exchange markets. This represented a marked shift from the prevailing skepticism about the effectiveness of intervention, which still had been apparent in the Jurgensen (1983) report commissioned by the heads of state and government at the Versailles Summit in 1982.

Foreign exchange intervention was complemented in May 1986 by an agreement at the Tokyo Summit to reinforce economic policy cooperation. Finance ministers were given the goal of working together more closely and more frequently and were asked to review their economic objectives and forecasts collectively. To this purpose, a list of indicators was drawn “with a particular view to examining their mutual compatibility” (Group of Seven, 1986). These indicators included GNP growth rates, inflation rates, interest rates, unemployment rates, fiscal deficit ratios, current account and trade balances, monetary growth rates, reserves, and exchange rates too. The toolbox of coordination was then ready, and it was formalized as the surveillance section in the G-7 meetings. It has not been much improved upon since then.

By the end of 1986, the reversal of the dollar had been completed and the United States and Japan agreed to stabilize the dollar-yen rate around current levels. This was formalized in a multilateral framework by the first Louvre Accord of February 21-22, 1987, which secretly established a narrow intervention grid for the G-7 currencies. The agreement worked reasonably well for some time, insofar as bilateral rates were contained in much narrower margins than in the preceding years. Central banks intervened repeatedly, for instance, in January 1988 to support the dollar or in September 1989 to stop the dollar rally. However, subsequent episodes revealed a progressive erosion of the international commitment to the Louvre mechanisms. From 1990 onward, German interest rates had to rise in the wake of unification while the U.S. Federal Reserve was easing its monetary policy to counteract declining activity. The resultant widening of the interest rate differential between the United States and Europe triggered an appreciation of the deutsche mark and other ERM currencies, without giving rise to G-7 reactions. Similarly, the G-7 did not try to halt the depreciation of the yen in 1990. By 1993, the Louvre Accord was virtually dead, because all major players had decided to give domestic objectives priority over internationally agreed targets.

It is still debatable whether the most elaborate attempt ever made to stabilize major currencies was technically a failure. The fluctuations of the dollar since 1987 have been sizable against the deutsche mark (roughly ±20 percent, between 1.37 and 1.98 deutsche mark per dollar) and very large against the yen (±45 percent, between 84 and 159 yen per dollar). It may be argued that the diverging trends of the mark and the yen imply that the Louvre System was not flexible enough to accommodate them. But the parity grid could have been adjusted to accommodate changes in equilibrium exchange rates. Instead, the attention of central bankers and politicians turned progressively away from international cooperation to focus on domestic issues, as illustrated on the European side by the interest rate rises of the early 1990s, which revealed a deliberate preference for regional stability in the perspective of monetary union.4

Following these events, the consensus within the G-7 in recent years has evolved from “high-frequency” activism to “low-frequency” action, with ad hoc interventions in cases of extreme misalignments only. More attention has also been given to the volatility of exchange rates than to their levels. As an example, the yen was allowed to soar toward unprecedented levels before an “orderly reversal” signal was eventually delivered in spring 1995, followed by concerted intervention on August 15. There was no other coordinated intervention until the bilateral U.S.-Japan intervention on June 17, 1998 to support the yen, after the Japanese currency had depreciated 70 percent to a level of 145 yen per dollar. The G-7 did not even verbally intervene to smooth the yen purchases on October 6-8, 1998, by hedge funds and Japanese investors, which pushed the yen from 134 up to 115 yen per dollar in a three-day period. The underlying philosophy was made explicit by the European Council when it was asked to interpret Article 109.2 of the Maastricht Treaty (Article 111.2 of the new Amsterdam Treaty) operationally. This article authorizes the issuance of so-called “general orientations of exchange rate policy.” The European Council (1997) stated that such a possibility should be exercised only in case of “major misalignments or excessive volatility.”

We draw two conclusions from these episodes. First, fine-tuning exchange rates is neither feasible nor desirable, if only because the exchange rate is an important instrument for market-driven macroeconomic adjustment. The rise and fall of the U.S. current account deficit in the 1980s demonstrated that a flexible exchange rate could play a significant role in the adjustment process (Kenen, 1991), and the sharp depreciation of the yen in the second half of the 1990s illustrated the need for flexibility in coping with severe domestic shocks.5 Second, the Plaza-Louvre regime was based on shaky foundations, since policy coordination was meant to derive from the commitment to exchange rate stability. This is too demanding for large, relatively closed economies because it is politically impossible to maintain a constituency for external stability.

There is, therefore, no room for another Bretton Woods system in today’s economic and political environment. We believe for the same reasons that target zones, which have often been advocated as an intermediate regime (see Williamson, 1998; or Bergsten and Henning, 1996) are not a practical alternative. Target zones consist of (1) fluctuation ranges of about ±10 percent around real equilibrium exchange rates; (2) public announcement of the target zones; (3) constant reappraisal of their appropriateness to accommodate inflation differentials and structural change; and (4) a commitment to defend the zones through concerted intervention in the markets, changes in domestic economic policies, or both.

Target zones may be valuable for emerging economies as a complement to some kind of real exchange rate peg. However, the experience of large economies, namely the Louvre Accord and the European Monetary System, has revealed a fundamental dilemma. On the one hand, intervention margins need to be narrow in order to make full effective use of stabilizing speculation—that is, to trigger Krugman’s (1991) honeymoon effect whenever exchange rates stray far from their central rates. On the other hand, large asymmetric shocks or market tensions may still occur, and it is then politically costly either to change one’s own central rate or to defend it (not mentioning the cost of defending the exchange rate of other participants). Sustaining narrow margins thus requires a strong and permanent political commitment, both domestically and internationally. To survive, target zones need relatively wide bands and can then be described as mere variants of floating exchange rates, with preannounced midpoints aimed at coordinating market expectations. While the European ERM operated successfully from 1993 until end-1998, it can be argued that its effectiveness owed less to its technical virtues than to the political commitment of governments and central banks to European monetary union. Indeed, the devaluation of the Spanish peseta in 1995 proved that even economically sensible central rates and a ±15 percent fluctuation band could not be defended against market pressure in the absence of commitment from other participants.

Changes in the Environment

The above arguments cast doubt on the effectiveness of arrangements based on numerical targets for exchange rates, such as target zones. In addition, changes in both the international consensus on monetary policy and the functioning of foreign exchange markets reinforce skepticism vis-à-vis such arrangements.

Target zone systems usually rely on the assumption that monetary policy bears primary responsibility for making the domestic adjustments required to defend the bands. The corresponding implicit instrument assignment, however, is questionable, since it does not align with the recommendations arising from most models of real exchange rate determination. Nor does it address the indeterminacy of the overall monetary stance of the zone—the so-called (n-l) problem. Furthermore, a new consensus recently emerged in all of the major economies in favor of an independent, single-objective monetary policy that puts the priority on internal price stability. This is especially true in Europe, where the statute enshrined in the European Union (EU) Treaty gives the ECB the overriding objective of maintaining domestic price stability. The bank has repeatedly indicated that the exchange rate would be given only a marginal weight in the conduct of monetary policy, and insofar as it affects domestic price stability. Moreover, Article 111.2 of the EU Treaty on general orientations for exchange rate policy states that “these general orientations shall be without prejudice for the primary objective of the European system of central banks to maintain price stability,” and Article 105 gives the ECB the sole responsibility for conducting foreign exchange intervention. Taken jointly, these two articles give the ECB a de facto veto on an activist exchange rate policy. While implementation differs, the same price stability objective has been assigned to the Bank of England, and the new culture of transparency that characterizes the U.K. monetary constitution could hardly accommodate obfuscating the strategy by adopting an additional external objective. Finally, while carefully avoiding public statements on exchange rate policy, the U.S. Federal Reserve Board has always been reluctant to base its decisions on external considerations, and after its unsuccessful experience of exchange rate management, the Bank of Japan is now focusing on domestic monetary developments, intervention being the responsibility of the government.

Thus, the role of instruments has changed, and monetary policy can be used in an international coordination framework if, and only if, external objectives are coherent with the domestic monetary strategy. Put simply, the ECB would be prepared to raise interest rates to counteract a depreciation of the euro if this were perceived as a threat to monetary stability, but the central bank would probably not be willing to lower rates in the case of an appreciation of the exchange rate associated with fiscal expansion. This suggests that the burden of any kind of ex ante coordination would now have to be borne primarily by fiscal policies.

The second change arises from structural transformations in foreign exchange markets. Most commonly held views on exchange rate management rest on the experience of the 1980s and the early 1990s. It is increasingly recognized, however, that foreign exchange markets have changed since then as a result of three trends: deepening, concentration, and the development of new instruments.

  • Deepening can readily be observed. The turnover in global foreign exchange markets, including derivatives, roughly tripled between 1989 and 1998, reaching $1.5 trillion a day (Figure 1),6 while world exports increased by only 80 percent in nominal terms over the same period. Besides, the introduction of the euro created an integrated market for bonds and monetary instruments comparable in size with the U.S. market giving scope for further development of transactions (as witnessed by the explosion of intra-European, cross-border transactions in bonds and bank loans in the first months of 1999).

  • Concentration among markets and within markets has been taking place. London and New York now account for 50 percent of global turnover compared to 42 percent in 1989, and the combined market share of the top 10 dealers has risen from 44 percent to 50 percent in London and from 48 percent to 51 percent in New York.

  • New instruments have developed as the share of the spot market in total transactions has shrunk to 40 percent from 59 percent 10 years ago, with the development of the forward and derivatives markets.

Figure 1.Foreign Exchange Market Turnover

(Daily averages; in billions of U.S. dollars)

Concentration, turnover, and the development of new instruments are important because larger markets enable agents to diversify risk better (Martin and Rey, 1999), thus contributing to macroeconomic stability. At the same time, these tendencies also increase the risk of destabilizing movements, especially as market transparency has not made significant progress—the institutional structure of the spot market for major currencies is still different from that of equity or futures markets, characterized by a more fragmented dealership and the absence of disclosure of transactions. The order flow is not observed and common-knowledge information is limited to the final clearing price, thus conveying less information than in other markets about the structure of supply and demand (Lyons, forthcoming), while information about macroeconomic “fundamentals,” although easily available, is of little help in the short run because of the poor fit of empirical exchange rate models at this horizon.

The characteristic of this market is that because of transaction costs, information can easily remain trapped in some segment of the market until it is revealed by some participant, triggering a large number of operations. The increase in the number of participants and in the size of transactions, therefore, raises the probability of sudden portfolio shifts, which may or may not be related to macroeconomic news and which may result in large exchange rate swings (Davanne, 1999).

The previously mentioned episode of October 6-8, 1998 is an illustration of such swings. Highly leveraged hedge funds and investment houses had built up large short positions in yen in previous months in an effort to take advantage of the low Japanese interest rates (the so-called yen carry trades). As stated by the Bank for International Settlements (BIS) (1999b),

In early October, market participants seem to have reconsidered their expectations regarding yen/dollar movements in the short term. The sudden change of views on the yen/dollar rate may have induced investors to close their yen carry trade positions, thereby pushing the dollar down further. A massive unwinding of these positions may have contributed to the intensity of the yen/dollar movements on 7 and 8 October 1998. Figure 2, which is taken from the BIS report, illustrates the shift in sentiment toward a stronger yen on October 7 and 8. While this information was present to some extent in the market and particularly in option prices (from which the density functions in Figure 2 were extracted), it was probably not available immediately to every trader, not to mention policymakers.

Figure 2.Probability Distributions of the Yen Against the Dollar

Note: The calculation assumes risk neutrality and is based on data posted at the beginning of the days shown.

Source: Bank for International Settlements (1999b).

This bears important consequences for exchange rate analysis and management. First, views on exchange rate determination are changing. It has always been recognized that floating exchange rates can, in some instances, depart lastingly from macroeconomic fundamentals, even though they revert to their equilibrium in the long run.7 There is now a growing feeling among scholars that Milton Friedman’s seminal view that “… instability of exchange rates is a symptom of instability in the underlying economic structure” no longer holds, at least in the short term, and that macroeconomics matters little in understanding high frequency behavior of the exchange rate (Flood and Rose, 1998). Recent research on exchange rates has thus evolved along two complementary lines: representative agent models of exchange rate determination now include explicit intertemporal optimizing behavior as in Obstfeld and Rogoff (1995), and growing attention is being paid to microstructure issues such as the heterogeneity of expectations, the link between prices and order flows, the impact of nonpublicly shared information, and, generally speaking, the way information is aggregated by the market (Lyons, forthcoming). Both lines of research should be built into new approaches toward exchange rate management.

Second, it can be inferred from these developments that intervention can still be effective, but requires reliance on increased amounts of reserves and careful preparation, and has to be supplemented by public statements. It can no longer be used as a routine technique of exchange rate management, and should primarily be seen as a way of conveying information to market participants and, in so doing, coordinating their expectations. Recent research (Dominguez, 1998) suggests that overt intervention has been more effective than secret intervention in reducing exchange rate volatility. In short, the emphasis has moved from traditional balancing to the signaling channel of foreign exchange intervention.

A Two-Handed Approach to Cooperation

There are two lessons from the previous section. First, something ought to be done to avoid excessive exchange rate instability, and second, schemes like the Plaza-Louvre suffer from significant shortcomings—they overestimate the national policymakers’ willingness to deviate from domestic objectives for the sake of exchange rate stability; they underestimate changes that have taken place virtually everywhere in the monetary policy doctrine; and they rely on an (implicit) model of exchange rate determination that does not hold anymore.

Those who are not content with a Panglossian view should thus offer alternative approaches. Our belief is that a renewed international arrangement should dissociate the two objectives that target zone schemes closely associate—policy coordination and exchange rate surveillance. There is still a case for coordinating the policy responses of the major players to common shocks, and it would contribute to stabilizing exchange rates, but commitments toward coordination should not be formulated as deriving from an exchange rate objective. There is also a case for monitoring foreign exchange market developments, but not for targeting specific values for nominal exchange rates.

In this section, we explore an arrangement for cooperation that would be based on a two-handed approach: (1) a renewed commitment to ex ante coordination that would put the emphasis on responding to macroeconomic shocks in a cooperative way rather than on stabilizing exchange rates per se, and (2) a monitoring of foreign exchange developments that would put the emphasis on avoiding excessive fluctuations by providing information to market participants that would trigger stabilizing speculation. Finally, we discuss issues of implementation.

The Case for Coordination

In most models of exchange rate determination, uncertainty regarding the future course of monetary and fiscal policy can be a significant cause of instability. Empirically, this has been illustrated in several instances in which markets formed divergent expectations about the reactions of U.S., European, or Japanese policymakers, or of all three to common shocks. The most recent example of such behavior was the reaction to the Russian shock in the summer of 1998. Within a few weeks, the currencies of the future euro zone appreciated by more than 10 percent against the U.S. dollar, as markets expected the U.S. Federal Reserve to react aggressively to the slowdown in growth and the emergence of financial distress, while European central banks were expected to keep interest rates on hold (Figure 3). Eventually, European central banks and the ECB signaled a willingness to support growth in the euro area and engineered two cuts in interest rates on December 3, 1998, and April 8, 1999. This contributed to a reversal of the depreciation of the U.S. dollar vis-à-vis the euro, and in early spring 1999, the euro-dollar exchange rate was back to its summer 1998 level. It can be argued that the appreciation and the depreciation of the euro vis-à-vis the dollar did not result in any major disturbance, which is true. However, these exchange rate movements generated some unnecessary shakiness in a period when the euro had to build up its credibility. It would have been preferable to have avoided them by letting the markets know that the reactions to the crisis would eventually be symmetric.

Figure 3.Forward Interest Rates in 1998

(3-month rates, 3 months ahead)

This episode illustrates that reducing policy uncertainty would help prevent exchange rate instability. In principle, this could be done either through discretionary coordination within the G-7 or by adopting policy rules. The difficulty is that discretionary coordination is problematic for Europe, whereas predetermined rules have little appeal for the United States.

For Europe, the problem with coordination starts at home; achieving an appropriate policy mix requires coordination and dialogue between 11 governments and the independent central bank. This is not a problem of principle. Although some member states initially feared that policy coordination would conflict with the independence of the ECB, the requirements of fiscal discipline, or both, it is no longer the subject of significant disputes. On the contrary, it has been convincingly argued that developing an economic pillar alongside the monetary one could, in fact, protect the independence of the central bank (von Hagen, 1999). But economic policy coordination is an entirely new kind of model for Europe, which has thus far relied on legislative harmonization (for the single European market), policy delegation (for example, with the common agricultural policy and regional policies), and convergence toward the best performer or toward specified performance indicators (especially in the run-up to monetary union), but has no experience in coordinating decisions between independent policy players.

The Euro-11 was created on the model of the G-7 as an informal forum to facilitate mutual economic assessment and to foster informal policy dialogue between the ministers and with the central bank. Meetings are held about once a month, and attended by ministers of finance from the euro area and, on most occasions, the ECB.8 This new institution has made a promising start, and it has certainly been instrumental in building a consensus on the need to respond to the financial crisis through a tight budget/supportive monetary policy mix. The Euro-11 has the potential to develop further, and suggestions have already been made for making it more effective.

Whatever the merits and the potential of the Euro-11, there are, nevertheless, well-known limits to what informal discussions can deliver, especially with a large number of participants. This also hampers European coordination with the United States and Japan. In spite of the euro area’s increased integration, only the President of the ECB is, in his field, able to speak for the zone; neither the Commission nor the President of the Euro-11 alone has the authority to speak for the member states on fiscal or structural policies.

This is why rules-based coordination has a distinctive appeal for Europe. Recent thinking on economic policy has put significant emphasis on the concepts of transparency and predictability. In the EMU context, policy transparency and predictability would be instrumental in improving coordination because of the large number of independent players and the diversity of national institutions and procedures (Muet and Pisani-Ferry, 1999).

The Stability and Growth Pact, which sets numerical ceilings for public deficits and requires governments to issue medium-term public finance programs annually, already provides some information on fiscal policy objectives, but more could be done. It would be advisable for governments and the central bank to agree on some broad principles for the use of policy instruments, which would help determine what the respective roles of fiscal and monetary policy are in responding to a particular shock. The ECB should make further progress in defining a well-formulated and transparent policy strategy that would make its reactions more predictable. And governments should make use of the medium-term public finance programs, prepared in the context of the Stability and Growth Pact, to improve the predictability of fiscal policies.

These steps would require all players to forsake some of their discretionary leeway; for example, the ECB would have to make its inflation target narrower and publish its inflation forecasts. It would also have to clarify the purpose of having an additional monetary target. Moreover, governments would have to set for themselves rules of conduct for fiscal policy. For example, it has been proposed that governments adopt medium-term public spending objectives that do not change with output fluctuations and specify aggregate tax policy rules, if they choose not to allow automatic stabilizers to play their role without restriction. Other rules could be considered. But only the adoption of predetermined principles for fiscal and monetary policy could cut information and negotiation costs to an acceptable level.

The situation in the United States is significantly different, because the U.S. Federal Reserve has deliberately and successfully adopted a discretionary approach to monetary policy and the U.S. Congress is not willing to set rules that would constrain its fiscal policy decisions. While what Frederic Mishkin (1999) calls the “just do it” approach to monetary policy has been criticized for its lack of transparency and the excessive personalization it implies, the U.S. Federal Reserve has not signaled any intention of forsaking an approach that has proved successful. Moreover, European countries can adopt a rules-based approach to fiscal policy because they have parliamentary systems in which the budget prepared by the government has a reasonable chance of being adopted by the legislature, whereas, in the United States, the authority on fiscal policy is divided between the executive branch and the congress.9 Therefore, while a rules-based approach to macroeconomic policy is consistent with Europe’s domestic institutions and policymaking procedures, the same hardly applies to the United States, and the basic problem with transatlantic cooperation is how to ensure that significantly different domestic institutions do not hamper coordination.

From a game-theory standpoint, the logical outcome of such a combination should be a Stackelberg leadership equilibrium in which the United States plays the leader and Europe the follower—European policy players would follow predetermined policy rules and the United States would optimize, taking into account the likely European reaction. Although standard models show that such an equilibrium would already improve upon a situation with no cooperation, it would hardly be acceptable either economically or politically for the following reasons:

  • As previously argued, relative GDP weights are not such that a hegemonic stability model can be advocated on economic grounds.

  • The United States might make policy changes to which Europe could not respond within its rules-based framework without enduring excessive inflation, unemployment, or a large exchange rate swing.

  • The rationale for G-7 coordination does not stem solely from exchange rate concerns. As the 1997-98 crisis in emerging market countries demonstrated, major industrial countries share responsibility for delivering an appropriate global policy mix for the world economy.

  • For European leaders (and especially the French), EMU was meant to result in a more assertive Europe, more able to speak “with one voice” on world economic and financial issues. Although Europe has in fact been a follower in several instances, it still has the ambition to act as a global player.

  • U.S. policymakers have made it equally clear that they want Europe to play its part in elaborating collective responses to world economic and financial turbulence and in sharing the corresponding burden (Truman, 1999).

The question thus is how to find a middle way between a discretionary model, which does not appeal to Europe, and a rules-based model, which does not align with the U.S. philosophy. Our opinion is that such a middle way should be based on joint endorsement by the United States, Japan, and Europe of what could be called a core set of broad macroeconomic policy principles.

The basis for such convergence already exists, since G-7 members have gone a long way toward developing a common economic policy philosophy. While in the early years of Ronald Reagan and Francois Mitterrand, focusing on exchange rates was an elegant way to avoid highlighting policy divergence, this is no longer the case. No one challenges the objective of price stability or the need to avoid accumulating unsustainable public debt anymore. There is, therefore, a foundation we can build on.

The next step could be to develop commonly agreed principles for deciding on the respective responses of fiscal and monetary policy to shocks. As previously emphasized in the case of the 1998 shock, uncertainty about the respective roles of monetary and fiscal policy when the economy has been hit by a shock can significantly aggravate exchange rate instability. It is thus difficult to find convincing reasons why the United States and Europe should adopt an opposite policy mix to respond to a common demand shock. Recognizing that the burden of responding to such shocks should, in principle, fall on monetary policy, rather than on fiscal policy, would already help to reduce uncertainty. As the price and quantity impacts of demand shocks are positively correlated, such an assignment of roles would not contravene the central banks’ mandate to aim toward price stability. It would also improve the transparency of policymaking within G-7 members, and would help to stabilize the world economy, since major policy players would adhere to commonly defined policy principles. In a way, this approach could be regarded as a weak version of McKinnon’s (1984) global monetary rule.

Adopting common assignment principles would not challenge the autonomy of national policy institutions either, since implementation could take different routes, depending on the domestic institutions. In some countries, such as the United Kingdom, the government has already set forth principles for monetary and fiscal policy (including an explicit inflation targeting strategy), and our approach would agree with its basic philosophy perfectly. France has moved in the same direction; its latest medium-term public finance program includes some explicit fiscal policy principles. More generally, it can be argued that developing such principles is precisely what is needed for Europe to increase internal policy transparency and to facilitate intra-European coordination, as well as the dialogue between the governments and the ECB. And the United States would certainly not object to clarifying the instrument assignment philosophy it has been following consistently for years now, as long as it does not imply adherence to a rigid rule. Some degree of subsidiarity in implementing common principles could thus be appropriate to accommodate different national institutions and approaches. The only condition is that both monetary and fiscal policy remain valid instruments of economic policy, which would not be the case, for example, if either Europe or the United States were to adopt the dogma of a balanced budget.

The real difficulty is the case of Japan, since standard assignment principles are of no use in a country caught in a liquidity trap. However, situations like that of Japan’s should, in our view, be dealt with through explicit or implicit escape clauses, because even the most sophisticated contingency rules cannot envisage situations that appear every half-century. More generally, there will certainly be instances when national governments will wish to depart from preannounced targets or principles. Our view is that they ought to be allowed to do so, but that their departure from previously agreed principles or rules should be used as an opportunity to make their choice more transparent.

Another possible objection is that defining the appropriate response to common shocks can be relatively easy, but that this may be much more difficult for asymmetric shocks. From a European perspective, demand shocks that hit European countries in a symmetric way (but affect the United States and Europe asymmetrically) would also be best dealt with through monetary policy, and the same applies to the United States (or Japan). But this would necessarily imply some degree of volatility in exchange rates, since monetary policy reactions would amplify the exchange rate effect of shocks. We cannot decide in advance whether or not this would be an acceptable consequence—while there is no reason why exchange rate adjustment should not be allowed to play its part in stabilization, large-scale fluctuations might not be desirable. In such cases, however, the consequence would not be that monetary policy is given the role of counteracting fluctuations—as it would be under the implicit Plaza-Louvre assignment—but rather that fiscal policy enters into play. Policymakers should be aware that the logical consequence of having a preference for exchange rate stability is that the policy mix would have to be altered if it generates excessive fluctuations.

Thus, developing common principles for macroeconomic policy would not make discretionary coordination useless, but it would help focus discussions. It has long been known that obstacles to coordination frequently arise from disagreements about the true model of the economy (Frankel and Rockett, 1988). By limiting the scope for ad hoc coordination and providing some guidance on basic policy linkages, our proposal would reduce the transaction costs inherent in the discretionary approach and correct the tendency to let monetary policy bear the burden of exchange rate stabilization.

Monitoring Foreign Exchange Markets

The changing nature of foreign exchange markets points to an increased need for monitoring, especially after the launch of a new currency changed the landmarks of market participants. Such monitoring should not interfere with the market but should be aimed at improving the way information is processed and, when necessary, at providing new information to market participants. It should be a useful complement to exchange rate assessment at the macroeconomic level so as to fulfill two objectives: limiting market-induced volatility and preventing microeconomic phenomena from amplifying movements in exchange rates driven by fundamentals.

There is no need here for radical reform. The discussion on the new architecture of the international financial and monetary system has already produced robust recommendations aimed at improving the functioning of financial markets along two major lines: increased transparency requirements for governments, as well as public and private market participants; and a sound prudential framework and supervision of financial institutions (Interim Committee, 1999).

These recommendations should fully apply to foreign exchange markets. The issue of transparency especially deserves a detailed discussion in light of the idiosyncrasies of the foreign exchange markets. As mentioned above, there is little information available in the market because order flows are not disclosed and information about fundamentals is usually unhelpful in the short run. Market participants do not have access to data that may help explain the timing and magnitude of portfolio shifts, such as outstanding foreign asset positions, expectations on international returns and corresponding correlations, and the overall risk exposure of financial institutions. As an example, the extent to which a major hedge fund relied on yen carry trades may be illustrated by the fall in its net asset value in early October 1998 (Figure 4). Conversely, given the existence of destabilizing mechanisms such as those described above, information on net foreign exchange positions, even at an aggregate level, may provide an indication of the probability of such exchange rate shifts.

Figure 4.Yen Carry Trade and the Yen/Dollar Exchange Rate in 1998

These data are known at the individual level, at least in the case of international banks with modern risk management systems. They are treated as private information and are not reported to other participants, but there is no reason why corresponding statistics should not be made available. More work should be done on how such information can be reported to central banks or market regulators, aggregated, and disclosed to the markets, as is already the case for international bank loans and credit risk.

Work of this sort has already been undertaken by the central banks of the Group of Ten countries and should lead to the provision of additional data to the market, under the aegis of the newly created Financial Stability Forum. Aggregate information on foreign exchange positions and expectations on asset returns would be released to the markets as early as possible on a regular basis. When appropriate, the chairman of the Financial Stability Forum should also be able to signal confidentially to the G-7 the existence of abnormal risk exposure on certain segments of the markets so that ministers and governors can issue the appropriate warnings to the market. Recent episodes of liquidity shortages or accumulating open positions on global markets suggest that providing information to the market cannot be left to the market alone, and that statistical knowledge has the character of a public good, whose provision should be the responsibility of public authorities (Davanne, 1999). The direct usefulness of such data should not be overstated, but we believe it could help reduce the likelihood of abrupt price movements such as the October 1998 episode, or at least smooth such movements.

This “micro” approach is an obvious complement to the previously outlined “macro” approach toward ex ante coordination. At the intersection between the two approaches is the need to distinguish, on an empirical basis, between exchange rate movements that are due to present or future macroeconomic events and those that appear to be unrelated to fundamentals, and which may be explained either by herd behavior or by microlevel phenomena of the type described above.

Would it also be useful to provide some guidance to national and supranational authorities, as well as to market participants, regarding the appropriateness of current exchange rate levels? It has long been claimed, on the basis of Meese and Rogoff’s (1983) celebrated paper, that empirical research on exchange rates was doomed. This is probably true in the short run (Flood and Rose, 1998), but there is now a sizable body of empirical research yielding reasonably robust models of medium-run exchange rate determination, either building on the Williamson (1994) fundamental equilibrium exchange rate concept or using larger sets of explanatory variables. These estimates are known to be rather imprecise because of the difficulty in defining mediumterm current account targets and computing output gaps, and because of their sensitiveness to point estimates of income and price elasticities. They have the merit, however, of providing a rational (as opposed to political) basis for discussion on exchange rates, and they still make it possible to issue warnings in case of large exchange rate movements. At any rate, such estimates would be valuable for structuring G-7 discussions on exchange rate developments and for providing some guidance on market assessment.

As part of its surveillance exercise, the IMF could thus be asked to build on its long-standing experience of exchange rate assessment (IMF, 1998) and examine, on a regular basis, whether prevailing market exchange rates and the implied current account positions are broadly consistent with medium-term fundamentals. This analysis would take into account the equilibrium exchange rates and the departures from these equilibrium rates that can be explained by current and expected macroeconomic policies. As a first step, this information could be supplied confidentially to G-7 countries and would enable ministers and governors to identify the buildup of exchange rate misalignments and, as it is already the case, to issue appropriate signals to the markets through their statements, through coordinated intervention, or both. After a trial period, the IMF could then begin to make these analyses public. Another solution would be for the IMF to publish the main “building blocks” underlying its assessment (including output gaps, current account targets, and trade elasticities), without committing to specific values for equilibrium exchange rates.

Whether or not these concrete steps would contribute to limiting exchange rate instability is obviously a matter for discussion. Our view is that they would represent a significant improvement upon the existing coordination and surveillance practice, which has evolved under the pressure of events without giving rise to a clear redefinition of its purpose and modus operandi. Rather than continue relying on an implicit soft target zone model, which has lost its credibility, we consider that the G-7 would gain from implementing an apparently less ambitious, but more precisely defined and transparent approach. This, in turn, could contribute to stabilizing exchange rate expectations and help prevent misalignments.

Practical Implementation

Implementing the framework outlined in this chapter does not require radical institutional change. It can be embodied in the traditional G-7 surveillance exercise and rely on the technical expertise and advice of existing bodies such as the IMF and the BIS. Practical implementation could involve the following steps.

Implementing effective arrangements for coordination within Europe and for the representation of the euro area at the G-7. In our opinion, transforming the G-7 into a G-3 as envisaged by some scholars would result in paralysis of the institution, at least in the current state of political integration, since the representative of the euro area would be bound to express preagreed views, without being able to participate in substantive discussions, negotiations that could result in any kind of commitment, or both. Thus, representation of the euro area has to combine ministers from major individual member states (Germany, France, and Italy jointly account for 70 percent of the euro area’s GDP) with representation of the area as a whole. A first step in this direction is the proposal made by G-7 finance ministers in June 1999 that the first section of the G-7 talks, which focuses on the world economic situation and exchange rate issues, would be attended by the finance minister currently holding the chair of the Euro-11 group and the ECB president.

Agreeing within the G-7 on common principles for the respective responses of monetary and fiscal policy to a given shock. Such principles should take account of the particular features of domestic policymaking institutions. They should not include the exchange rate as an autonomous policy tool, nor should they be derived from numerical exchange rate targets, but they should take account of the impact of a given set of policies on the exchange rate. The principles should not contradict central banks’ primary objective of domestic price stability, but, rather, imply that the natural policy mix would have to be altered if it is likely to generate excessive exchange rate fluctuations. They should be backed up by an effort toward greater transparency of policy objectives and medium-term forecasts on the part of governments and central banks. Lastly, they should not be defined as a set of binding rules but rather as a way of cutting transaction costs and providing more structure in policy discussions.

Asking the IMF to assess, on a regular basis, the appropriateness of exchange rates among major currencies. Such an exercise should be backed up by sensitivity analyses and discussed by the IMF as a part of the existing surveillance process. This should enable the G-7 to identify exchange rate misalignments at an earlier stage. These estimates, or at least their main building blocks, could be released to the public after a trial period.

The Financial Stability Forum should be asked to organize collection and reporting of information on foreign exchange markets with the aim of identifying excessive risk exposure. Aggregate information on positions and return expectations would be released to the markets on a regular basis. When appropriate, the chairman of the Financial Stability Forum should also be able to warn the G-7 confidentially of the existence of abnormal risk exposure on certain segments on the markets so that ministers and governors can issue appropriate warnings to the market.


The authors are grateful to Alan Blinder, Virginie Coudert, Ricardo Hausmann, Pierre Jaillet, Peter Kenen, Ronald McKinnon, Richard Portes, Horst Siebert, and Alexander Swoboda for detailed remarks and comments.

The history of European monetary integration underscores our point. As the currency crises of 1992–93 illustrated, the ERM’s inherent weak point was that a permanent German monetary hegemony could not be sustained without the perspective of a more symmetric arrangement: after countries like Britain, Italy, and France had converged on the German inflation level, they were too large to continue acquiescing to the policy of the German central bank, especially when facing asymmetric shocks. Hence, Economic and Monetary Union (EMU) is a more stable system than the ERM.

Créel and Sterdyniak (1998) demonstrate that these results hold except if the interest rate elasticity of demand is low and the price elasticity of intra-area trade is higher than the price elasticity of trade with the rest of the world. In the latter case, all results are reversed.

See Dominguez and Frankel (1993, Chapter 1) for a history of foreign exchange intervention.

It is fair to recognize, however, that the blame cannot entirely be cast on insufficient efforts to adjust policies. Political shocks (such as German unification or the invasion of Kuwait) and stubborn economic facts (such as the resilience of the Japanese current account surplus in spite of a strong yen) played an important role.

The parallel rise of the Japanese surplus proved that this role must not be overstated.

All figures are taken from the latest report of the Bank for International Settlements (1999a). Trading on foreign exchange markets has decreased somewhat as of January 1, 1999 due to the suppression of most European cross rates and the narrowness of the euro/yen spot market relative to the former mark/yen.

The overvaluation of the dollar in the mid-1980s is widely considered as an example of such a departure, which was driven by the rational herd behavior of individual market participants.

The difference between the Council of the Ministers of the Economy and Finances (ECOFIN) and the Euro-11 is not just one of membership. It is also a difference of purpose, as the more formal ECOFIN fulfils the legislative function of the council, while the Euro-11 devotes itself to macroeconomic policymaking and structural issues that are specifically related to the single currency.

This point was made to us by Peter Kenen.

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