General Essay on Optimum currency areas

General Essay on Optimum currency areas - /4 THE ANDREW...

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Unformatted text preview: /4 THE ANDREW WELLINGTON CORDIER ESSAY OPTIMUM CURRENCY AREAS AND THE INTERNATIONAL MONETARY SYSTEM by Robert A. Ogrodnick The Andrew Wellington Cordier Essay is selected on a competitive basis from among articles submitted to the Journal by students at the School of International and Public Afi‘airs. This essay is named in memory of Andrew W. Cordier, who served as Dean of the School of International Afl'airs (1962-1972) and President of Columbia University (1968-1970), in addition to having a distinguished diplomatic career. A fundamental issue for virtually all countries within the international monetary system concerns the choice of an optimal exchange rate regime. The United States and J apan, for example, must decide whether to stabilize their exchange rates within agreed upon reference ranges as under the Louvre Accord, or whether it would be preferable to allow the exchange rate to float, largely independent of central bank intervention. Similarly, is it optimal for the European Monetary System to operate under a regime of limited exchange rate flexibility? And should East and West Germany undertake monetary union through the adoption of a common currency? One approach to answering these questions is to utilize the theory of optimum currency areas. A currency area is defined as “a domain within which exchange rates are fixed.”1 Hence an optimum currency area is simply the optimum zone or region of fixed exchange rates. Presumably then, if a region does not constitute an optimum currency area it would be desirable for that region to have a more flexible exchange rate system. The first section of the article lays the theoretical foundation by delineating the potential determinants or characteristics of an optimum currency area. In the second section the theory is reconsidered in light of a number of m ajor trends that affecting the world economy. The objective 1. Robert A. Mundell. “A Theory of Optimum Currency Areas," International Economics, ch. 12 (New York: Macmillan, 1968) p. 177. Journal of International Mairs 241 Robert Ogrodm'ck of both sections is to establish the criteria for assessing the optimality of alternative exchange rate regimes for different countries. In the third section the theory is applied to assess the optimality of the current exchange rate arrangements within the European Monetary System, and between the United States, Japan and West Germany, three of the Group of Seven signatories of the Louvre Accord. At the outset, two points should be noted. First, it is important to understand the similarities and distinctions between a currency area and a common currency area. While the former is a zone of fixed exchange rates between two or more different currencies, the latter implies the existence or establishment of a single, common currency. Both entail a fixed rate of exchange and a loss of monetary independence; however, a common currency area necessarily implies that the exchange rate is immutany fixed whereas a currency area represents a fixed exchange rate agreement that can be broken. This article discusses currency areas, and does not explore the question of establishing a single currency with a common central bank, the final stage of monetary integration. How— ever, given the fact that the exchange rate is fixed in both cases, the theory of optimum currency areas may also be applied to common currency areas. If the criteria for a currency area are not satisfied, those for a common currency area will also remain unsatisfied. Second, there are, in reality, a wide array of exchange rate regimes from which to choose. The rigidly fixed and freely flexible options are but opposite ends of a wide continuum. In between there are an assort- ment of regimes ranging from adjustable pegs to reference ranges to managed floats. The terms “fixed” and “flexible” exchange rates are used in the paper as theoretical benchmarks, and should not be construed as the only exchange rate options available. The theory of optimum curren- cy areas provides one with the broad criteria for determining whether a specific exchange rate system is appropriate for a particular country, or whether one group of nations should optimally adopt more orless flexible exchange rates than a second group. Determinants of an Optimum Currency Area The choice between fixed and flexible exchange rates should not be made in a vacuum. Instead, the decision should take into account the underlying economic characteristics of the countries in question. This section delineates what those characteristics or determinants are. Factor Mobility In a classic and seminal article first published in 1961, Robert A. Mundell described an optimum currency area as a region in which factors of production are mobile internally (within the region) but immobile 242 Journal of International Affairs M5 The Andrew Wellington Cordier Essay externally or internationally (between regions).2 In other words, he argued that the exchange rate should, optimally, be fixed within areas in which factors are mobile, and flexible between areas in which factors are immobile. To illustrate, suppose there is inflation and a balance of payments surplus in country A, and unemployment and a balance of payments deficit in country B. Also assume that factors of production are immobile between countries A and B. If these two countries have flexible exchange rates, the currency of country A will tend to appreciate relative to that of country B. This will lower the demand for country A’s goods and increase the demand for country B ’s goods, which, in turn, will tend to eliminate the balance of payments surplus and inflation in country A, and the balance of payments deficit and unemployment in country B. Hence, in this simple case, flexible exchange rates successfully restore the two countries to full employment with stable prices and balance of payments equilibrium. Now, suppose instead that factors of production are mobile between countries A and B. Unemployed factors will move from country B to where they are needed in inflationary country A, thus tending to eliminate the unemployment in country B and the inflation in country A. At the same time, as unemployed labor moves from country B to country A, country B ’s imports will fall and country A’s imports will rise, thereby tending to restore balance of payments equilibrium. Hence, in this simple case, factor mobility between countries A and B is able to restore internal and external balance without any change in the exchange rate. The essence of Mundell ’s argument is that if factors of production are immobile across regions, in this case countries, then flexible exchange rates should be helpful in restoring and maintaining internal and external balance. In contrast, if factors of production are mobile across regions, then flexible exchange rates are unnecessary or, in a sense, redundant. In other words, factor mobility provides the additional degree of freedom needed to fix the exchange rate. Openness of the Economy In a follow-up article to Mundell, Ronald I. McKirmon argued that the critical determinant of an optimum currency area is the openness of the economy. McKinnon defined openness as “the ratio of tradeable to 2. Ibid., p. 181. Journal of International Afiairs 243 Robert Ogrodnick non-tradeable goods."3 More simply, one could also define openness as the ratio of total imports or total exports to Gross Domestic Product (GDP). The opemiess criteria states that the more open the economy the more optimal it is to fix the exchange rate.“ This result can be explained by illustrating the dynamics of flexible exchange rates in closed and open economies. The standard argument for flexible exchange rates is that a depreciation of the domestic currency will result in expenditure switch- ing from relatively more expensive foreign goods to domestic goods, thereby leading to an improvement in the balance of trade and an increase in employment. But suppose the economy is very open, i.e., has a high ratio of imports to GDP. In this case a depreciation of the domestic currency may primarily result in a rising price level because imports are now higher priced in terms of the domestic currency, and the economy has, by definition, a high propensity to import. If this rising price level then initiates a general inflation, depreciation will not be successful in stimulating exports. Furthermore. if the economy is heavily dependent on imports because domestic equivalents or substitutes are not available (i.e., imports are highly price inelastic), then the depreciation is unlikely to diminish imports. The openness criteria is closely connected to the concept of exchange- rate illusion. Workers and firms are said to suffer from money illusion when they fail to take into account the effect of changes in the price level (inflation) on their real wages and profits. Similarly, one can define exchange-rate illusion to mean that “...participants act as if they are unaware of the effect of exchange-rate change on the purchasing power of domestic currency.” Most economists do not believe that workers or firms suffer from money illusion. It is also unlikely that economic agents suffer any more from exchange-rate illusion than they do from money illusion. For example, a worker whose real income is falling because of a rising price level probably does not distinguish, or even care, whether this is strictly the result of domestically induced factors, or is due to a decline in the foreign exchange value of the domestic currency. In either case he will attempt to compensate by demanding higher wages. 3. Ronald I. McKinnon, “Optimum Currency Areas," American Economic Review 53 $83ternber 1963) p. 717. b' , p. 719. Edward Tower and Thomas D. Willem, The Theory of Optimum Currency Areas and Exchange-Rate Flexibility, Special Papers in International Economics, Princeton University, no. 11, May 1976, p. 17. PH“ 244 Journal of International Affairs The Andrew Wellington Cordier Essay Nevertheless, assuming some exchange-rate illusion does exist be- cause of lags or institutional and contractual rigidities, this illusion is more likely to occur in a closed economy than in an open economy. This is so because in an open economy where imports are a large percentage of GDP. a devaluation (rise in the domestic currency price of imports) will tend to have a very large effect on domestic inflation, such that economic agents are unlikely to be “fooled” into passively accepting the same nominal income. ’ In summary, for a devaluation to be successful it must result primarily in expenditure switching from foreign to domestic goods and only secondarily in domestic inflation. This is most likely to be the case in closed economies and in circumstances where workers and firms suffer from exchange-rate illusion. If the economy is very open and economic agents do not suffer from exchange-rate illusion, as they especially should not in an open economy, then a depreciation is less likely to be successful. Hence, openness points in the direction of fixing the exchange rate, whereas more closed economies may benefit from allowing their exchange rates to fluctuate. Diversflication of Output In 1969 another contribution to the theory was made by Peter B. Kenen who argued that diversification of output (including exports) is an important criteria in the determination of optimum currency areas. He maintains that fixed exchange rates are most appropriate for well-diver- sified economies, the reason being that diversification tends to average out the effect of external shocks, thus forestalling the need for frequent changes in exchange rates. He therefore suggests, in a similar vein, that less well-diversified economies should rely more heavily on flexible rates for their insulation-from-extemal-shock properties.‘5 However, while itis sometimes true that diversified economies should fix their exchange rates, it does not follow that less well-diversified economies should maintain flexible rates. The less well-diversified an economy (in the extreme a country producing and exporting only one product such as coffee or copper), the more open that economy is likely to be since consumers may have little choice but to import many types of goods. As already noted, flexible exchange rates are least likely to be 6. Peter B. Kenen, “The Theory of Optimum Chimney Areas: An 13nd View," in Robert A. Mundell and Alexander K. Swoboda, eds., Monetary Problem of the International Economy (Chicago: University of Que-go Press, 1969) pp. 49, 54. Journal of International Aflairs 245 Robert Ogrodnick effective in such an economy because devaluation will simply lead to increases in prices, wages and inflation. In contrast, a well-diversified economy could conceivably be either relatively closed or relatively open. For example, the United States and West Germany, which both have well-diversified economies, have import to GDP ratios of 11 percent (relatively closed) and 27 percent (relatively open) respectively. Hence a well-diversified economy could optimally utilize either fixed or flexible exchange rates depending upon its relative degree of openness or closedness. However, contrary to Kenen, a severe lack of diversifica- tion would seem to invalidate the effectiveness of flexible rates, and thus at least suggest the need for a larger currency area (fixed exchange rates). Size of the Economy It has also been reported that “Small economies are said to be more inclined to join currency unions because, in the absence of such monetary integration, their effective economic size would be suboptimal.”8 The logic of this argument is not entirely clear. In fact, it would appear to be correct only if joining a currency union also implies that the small, suboptimally—sized economy gains access to largermarkets. However, it is possible for two countries to fix their exchange rates and effectively create a currency area, while still maintaining their trade barriers such that each economy continues to remain suboptimal in size. It may be useful and not unreasonable to define a small economy in terms of the two previous criteria, i.e., as tending to be open and undiversified. Then, based on the results of those criteria, one could argue that small economies should form larger currency areas by fixing their exchange rates. Similarly, if an economy is large in the sense of being closed and well-diversified, it can probably best afford to have flexible exchange rates. Inflationary Preferences A fifth determining factor when contemplating an optimum currency area is whether the countries involved have similar preferences for inflation, or would at least be willing to accept the same rate. To see the importance of this, consider the following simple example. Assume country A has a significantly higher inflation rate than country B. Under a system of fixed exchange rates, country A will tend to run a balance of 7. All import to GDP ratios are calculated from Intemuional Monetary Fund, International Financial Statistics XLHI. no. 2 (February 1990). 8. Jacob A. Frankel and Morris Goldstein, “A Guide To Target Zones," International Monetary Fund Stafl' Papers 33. no. 4 (December 1986) p. 661 . 246 Journal of International Afl'airs The Andrew Wellington Cordier Essay payments deficit and country B a balance of payments surplus. Eventual- ly country A will run out of the gold and foreign exchange reserves needed to finance its deficit. At that point, in order to keep the exchange rate fixed, country B will have to be willing to hold increasing reserves of country A’s currency which will, in tum, increase country B ’s domes- tic money supply and hence also its inflation rate. Although in the short run country B’s central bank may be able to sterilize part or all of the induced increase in the domestic money supply by selling bonds to the public. presumably there is a limit to the amount of bonds the public is willing to hold. Hence, at some point, country B will have to decide to either accept country A’s inflation rate as its own, or allow its currency to appreciate. In other words, a fixed exchange rate may cause a central bank to lose control over its domestic monetary policy, since the decision to fix the exchange rate at a particular level to a large degree predeter- mines policy options. Three additional points should be noted. First, to successfully negotiate a fixed exchange rate it may also be necessary to have similar preferences regarding other important variables such as unemployment and growth.9 Second, large countries may have more influence than small countries in determining what the “common preference” should be. And third, preferences can change over time and so too, therefore, can the optimality of a given potential currency area. Existence of a Hegemonic Power Closely related to the determinant of convergent or divergent infla- tionary preferences is the question of whether a hegemonic power exists. A world or regional hegemon that is both willing and able to exercise its power (for example the United States during the Bretton Woods System or West Germany in the European Monetary System) may be able to sufficiently set the tone for monetary policy amongst all the members of the system such that a currency area or zone of fixed exchange rates can be established. According to the theory of hegemonic stability, cooperation will be more difficult “in the absence of active leadership by a hegemonic power," or“among many states of approximately equal power.”1°Hence, this determinant requires that one examine the underlying distribution of economic, political and even military power amongst the countries of the potential currency area. In the presence of an effective hegemonic power, 9. Tower and Willem, op. cit. pp. 15-16. 10. Robert D. Putnam and Nicholas Bayne, Hanging Together: Cooperation and Conflict in the Seven-Power Summit: (Camridge: Harvard University Press, 1987) pp. 6-7. Journal of International Afiairs 247 Robert Ogrodm'ck the resulting cooperation, stability and convergence will tend to make a currency area both feasible and desirable. In contrast, in the absence of such a power a system of flexible exchange rates will tend to be preferable. Source of Shocks A final factor relates to the source of shocks or disturbances to the domestic economy. Floating exchange rates tend to insulate an economy from external disturbances. By the same token, however, they also tend to bottle-up an internal shock. In contrast, within a currency area or zone of fixed exchange rates, the effects of shocks within one country will tend to be spread out over the other countries as well.11 To take the example of an inflation-prone country, floating rates will tend to bottle- up the inflation within that country whereas fixed rates may allow the country to export part of its inflation abroad. Similarly, an inflation-shy country can, to some extent, insulate itself from external inflation by floating, but may have to import inflation if it fixes its exchange rate. On the basis of this criteria “...countries that typically suffer from external disturbances should adopt floating rates, while countries that are victims of intemal disturbances should join currency areas.”12 Hence, in this case, because an internal shock to one country can be an external shock to a second country, the determination of the optimum currency area depends on the perspective of each of the countries in question. If, however, the shocks of each country are random and less than perfectly positively correlated then currency union should increase price stability.13 The following table on the determinants of optimum currency areas summarizes the characteristics which indicate whether countries should either form currency areas (zones of fixed exchange rates) or allow their exchange rates to float. Note that well-diversified economies can, depending on their relative degree of openness of closedness, either fix their exchange rates or allow them to float. 11. Tower and Willett, op. cit., p. 51. 12. Ibid., p. 51. 13. Herbert G. Grubel, “The Theory of Optimum Currency Areas," Canadian Journal of Economics 3, no. 2 (May 1970) p. 320. 248 Journal of International Afi‘airs Md The Andrew Wellington Cordier Essay Determinants of Optimum Currency Areas Currency Area Determinant (Fixed Rates) Flexible Rates Factor Mobility Mobile lmmobile Openness of Economy More Open More Closed Diversification of Output Well-Diversified Well-Diversified Not Diversified Size of Economy Small Large Inflationary Preferences Convergent Divergent Existence of a Hegemon Yes No Source of Shocks lntemal External The Changing World Economy Significant events are having a large impact on the world economy. This section delineates some of those changes and attempts to assess their impact on the choice between adopting relatively more fixed or more flexible exchange rates. Declining Importance of Labor Peter F. Drucker has written about what he describes as the “uncou- pling of manufacturing production from manufacturing employment.”M By this he means that while manufacturing production has been rising. manufacturing employment has been declining. Although this is not a new trend, it has accelerated in the recent past. As well, we are witnessing an acceleration in the substitution of knowledge and capital for labor, and a shifi from labor-intensive to knowledge-intensive industries.” The consequence of these developments is that labor costs are becoming increasingly less important in the total production process. Essentially there are four factors of production: capital, technology, raw materials or natural resources and labor. Capital and technology are frequently the most mobile. And even natural resources can be extracted and cost-effectively transported around the globe. For personal, cultural, political and many other reasons, however, labor has often not been very mobile. In general, this is true today notwithstanding the fact that during the 19605 and 1970s literally millions of guest workers migrated from the poorer countries of Southern Europe to the more affluent regions of 14. Peter F. Drucker, “The Changed World Economy." Foreign Afi’airs 64. no. 4 (Spring 1986) . 775-76. 15. Ericka, op. cit, pp. 777-78. Journal of International Affairs 249 Robert Ogrodnick Western Europe. It is still typically the case that restrictions on immigra- tion and guest workers significantly inhibit labor mobility. As was indicated earlier, factor immobility seems to necessitate the use of flexible exchange rates. Labor is probably the single most im- mobile factor of production. However, with the declining importance of labor relative to capital, technology and perhaps even raw materials, this immobility is becoming increasingly less significant. The mobility of capital and technology combined with the declining importance of labor, and therefore also labor immobility. would seem to indicate that com- pared to the past it is becoming relatively more optimal to form currency areas. Movement Toward Free Trade Areas Many areas of the world are forming regional free trade and common market groupings, leading to increasing economic integration. It is necessary to relate this development to the theory of optimum currency areas and the international monetary system. This section discusses free trade areas using the U.S.-Canada Free Trade Agreement as an example. The following section considers common markets, and uses the Single European Act of the European Community as an illustration. A free trade area is an area in which tariffs and other trade restrictions have largely been eliminated. The U.S.-Canada Free Trade Agreement will, over time, eliminate all tariffs and reduce or eliminate other non- tariff baniers such as quotas. However, the Agreement does not allow for the free movement of all factors of production, particularly labor. In essence then. the Agreement stipulates that goods may move freely, but not all factors. Mundell has argued that international trade is, at least to some degree, a substitute for factor movements. More specifically, he states “...that an increase in trade impediments stimulates factor movements and that an increase in restrictions to factor movements stimulates trade.””’ If one accepts this conclusion, then it is also reasonable to argue that a decrease in trade impediments or a movement toward a free trade area should discourage, or at least obviate the need for, factor movements. Earlier it was argued that factor mobility can be thought of as a substitute for exchange rate flexibility, i.e., if factors are mobile one has the luxury of fixing the exchange rate. In contrast, if factors are immobile there is an a priori need for flexible exchange rates. In the paragraph 16. Robert A. Mundell, “International Trade and Factor Mobility." American Economic Review 47 (1957) p. 321. 250 Journal of International Afiairs The Andrew Wellington Cordier Essay above it is argued that free trade discourages, or at least obviates the need for, factor movements. In other words, free trade should make factors more immobile. But if factors become more immobile there is a greater need for flexible exchange rates. Hence, on the basis of the theory of factor mobility and using trade as a substitute for factor movements, the trend toward free trade areas should increase the need for, or desirability of. flexible exchange rates. One could also argue that it is particularly important for free trade areas to adopt flexible exchange rates during their formative years. Take the U.S.-Canada free trade area as an example. The average Canadian tariff on dutiable imports from the United States is 9 to 10 percent, approximately twice the US. average tariff rate of 4 to 5 percent.17 In addition, suppose Canadian firms face a significant cost disadvantage relative to their US. counterparts as a result of higher interest rates. taxes and construction costs, lower productivity or other reasons. Under these circumstances, how will Canada be able to compete against the United States once the remaining tariff barriers and other trade restrictions are removed? The standard intemational trade argument is that higher absolute costs are not a problem as long as the exchange rate is flexible. This is so because trade depends on comparative, not absolute advantage. High- cost countries can trade with low-cost countries because the exchange rate will adjust. Hence if, for example, higher taxes in Canada mean that absolute costs are greater than those in the United States, it does not imply that Canada will not be able to compete. Instead, the Canadian dollar will depreciate relative to the US. dollar until Canada’s competitiveness is restored.1s However, in the following sections it will be shown that this argument depends upon the existence of factor, and in particular capital, immobility. Movement Toward Common Markets A common market is a free trade area combined with common external tariffs against non—member countries and an agreement for the free movement of factors of production among member countries. The agen- da of the Single European Act is to complete the internal market of the European Community by the end of 1992. Since tariffs among member 17. United States Department of Commerce, International Trade Administration, Smary of the US.-Canada Free Trade reement, (February 1988) p. 14. 18. Richard G. Lipsey, “'Ihe Cam a-U.S. Free Trade Agreement and the Great Free Trade Debate," Trade Monitor. C.D. Howe Institute, no. 1. (November 1987) pp. 9-10. Journal of International Affairs 251 Robert Ogrodm'ck countries have already been eliminated. the intent of the Act is to remove other non-tariff baniers such as those relating to border controls, public procurement policies, and divergent regulations and technical standards. To create what is truly a common market, the remaining restrictions on the free movement of labor and capital will be removed as well.19 In contrast to a strictly defined free trade area, a common market eliminates restrictions on the free movement of labor and capital among member nations, i.e., not only goods but also factors of production are allowed to move freely. An absence of restrictions on the movement of factors should enhance their inherent mobility which, according to the theory of factor mobility, may provide the additional degree of freedom needed to fix the exchange rate. In summary. while a free trade area would seem to indicate that exchange rates should be flexible. the additional factor mobility provided by a common market may enable one to fix the exchange rate. While this is true theoretically, in the case of our specific example, the European Community, the result needs to be qualified because the Single European Act not only increases factor mobility but also eliminates remaining trade barriers. The elimination of trade barriers on goods should discourage factor mobility. If this decrease in factor mobility is large enough to outweigh the increase in mobility from the elimination of restrictions on factors, then the exchange rate should remain more flexible. Nevertheless, based on the above theoretical construct, flexible ex- change rates are most appropriate for free trade areas, but once the additional step is taken to form a common market, implying the free movement of factors of production, a currency area may be optimal. In practice either more flexible or more fixed rates may be optimal for a common market, depending upon the relative degree to which trade is truly free and factors of production are truly mobile. Increasing Importance of Capital Flows Another significant trend has been the enormous increase in the volume of foreign exchange trading. From 1980 to 1989 the volume of trading in the US. foreign exchange market increased from $15 billion 19. See Michael Calingaen, The I 992 Challenge From Europe: Development of the European Community’s Internal Market, National Planning Association, 1988. 252 Journal of International Affairs The Andrew Wellington Cordier Essay per day” to $129 billion per day.21 The most current estimate (1989) by central banks indicates that the daily turnover in the world-wide foreign exchange market is now over $500 billion, which amounts to over $125 trillion on an annual basis.22 Trading in the foreign exchange market has increased far more rapidly than can be accounted for by the growth in world trade. Total world merchandise trade is currently estimated at $3 trillion per year, or less than 3 percent of the total world-wide volume of foreign exchange trading, a virtually insignificant amount.23 The implication of these statistics is that exchange rates are predominately driven not by trade flows but by capital flows, which include not only investment capital but also shifts in asset portfolios. The increasing importance of capital flows relative to trade flows has potentially significant implications for some of our previous results. In an earlier section, the U.S.-Canada Free Trade Agreement and the standard argument of comparative advantage were used to illustrate that free trade areas should optimally adopt flexible exchange rates. But suppose capital flows are now introduced into the model, i.e., all foreign exchange trading and not just that associated with trade flows are taken into account, a consideration that is conspicuously absent in the pure theory of international trade. Furthermore, suppose that as is the case in the real world, trade flows account for less than 3 percent of the total volume of foreign exchange trading. Assuming, once again, that Canada has higher absolute production costs than the United States, will Canada still be able to compete once the remaining tariff barriers and other trade restrictions are removed? Previously it was argued that the Canadian dollar would depreciate until Canada’s international competitiveness was restored. However, suppose that once the Canadian dollar has depreciated, capital begins to flow into the country because Canada now has a new comparative advantage in investment opportunities in certain sectors of the economy such as natural resources. The resulting capital account surplus will lead to upward pressure on the Canadian dollar, a reduction in Canada’s manufacturing competitiveness and a corresponding balance of trade deficit. 20. Roger M. Kubarydr, Foreign Exchange Market: in the United States, (Revised Edition), Federal Reserve Bank of New York. 1983. p. 4. . 21. Bear, Steam: & Co. Inc. The Global Spectator, Economics Department, New York, 6 November 1989, p.1. 2?. Bear, Steams, op. cit, p.2. 23. lbid.. p. 2. ‘ Journal of International Afi'airs 253 Robert Ogrodm'ck Hence, in the presence of large capital flows and an exchange rate that is virtually unaffected by trade flows, one cannot definitively conclude that Canada’s balance of trade will remain unchanged by the movement toward a free trade area. If there were no capital flows and the exchange rate was the equilibrating mechanism for the balance of trade alone, one could predict that the Canadian dollar would depreciate and Canada’s balance of trade position with the United States would be restored to neither a deficit nor a surplus position. However, as indicated. the exchange rate is in reality the equilibrating mechanism for the entire balance of payments which includes not only the balance of trade but also the capital account. Presumably capital would flow into those industries in which Canada is competitive. Other industries, which were relying on a depreciation in the Canadian dollar to remain competitive, would need to be restructured to lower their costs relative to US. firms, or else they would go out of business. In other words, new investment capital would flow into some industries while simultaneously other firms or even entire industries could be forced into a state of decline. The upshot of this argument is that in contrast to the implied results of the comparative cost ad- vantage/flexible exchange rate theory. a flexible exchange rate is not a panacea or license for inefficiency and high costs. Fundamental restruc— turing of the economy may still need to take place either with or without flexible exchange rates. In conclusion, once we introduce capital flows and a “real world” foreign exchange market, one can think of scenarios in which flexible exchange rates become potentially less effective as an adjustment mechanism or saving grace for sectors of the real economy. Furthermore, with the globalization of capital markets, capital is becoming increasing- ly more mobile. Based on Mundell’s theory of factor mobility, this increased mobility may partially substitute for flexible exchange rates, thereby providing the additional degree of freedom needed to form a currency area or zone of fixed exchange rates. Greater Volatility of Exchange Rates Since the collapse of the Bretton Woods system in 1973, a common criticism has been that exchange rates have become increasingly volatile. Others allege that exchange rates are often seriously misaligned as evidenced, for example, by persistent current account deficits in the United States and surpluses in Japan. This is sometimes described at Group of Seven summits in terms of a currency or exchange rate being inconsistent with longer-term economic fundamentals. 254 Journal of International Affairs MD The Andrew Wellington Cordier Essay Excessive volatility in the foreign exchange market would seem to call for increasing intervention by central banks. However, their capacity for direct intervention is limited. For example, in May, June and July 1989, the Federal Reserve spent a record $12 billion to blunt the rise in the foreign exchange value of the US. dollar.24 This amounts to an average of approximately $200 million of intervention per day over that three month period, a mere pittance compared to the $129 billion that surges through the US. foreign exchange market each day. Hence, while central banks may be able to iron out short-term fluctuations, it is virtually impossible for them to stand in the way of a long-term trend using the technique of foreign exchange market intervention alone. However, one should not conclude that central banks are unable to influence the foreign exchange value of their currencies. If the interven- tion provides the foreign exchange market with new information, for example, if it signals a change in monetary policy, then it will affect the exchange rate. Moreover, by running an accommodating monetary policy and coordinating other macroeconomic policies, central banks can set exchange rates at whatever level they choose. Whether exchange rate volatility is sufficiently excessive to warrant instituting more fixed exchange rates, with their accompanying loss of monetary independence, is another question. Nevertheless, if this volatility is deemed to be sufficiently excessive, one solution would be to move in the direction of greater market intervention. The following table summarizes the effects that current trends in the world economy may be having on the choice between currency areas and flexible exchange rates. It is important to remember that the polar opposites of fixed and flexible rates are being used as theoretical benchmarks in this analysis. Hence, an “X” indicates whether exchange rates should be relatively or marginally more fixed or flexible compared to circumstances in which the trend in question does not exist. The table should not be interpreted as meaning that exchange rates should be fixed or flexible per se. 24. Alan Mumy and Peter Trudl. “6-7. Facing Another Day, Another Dollar. Seeks Way: to Curb Greenback in leged Marketplace," Wall Street Journal, 22 September 1989, p. A 14. Journal of International Afiairs 255 Robert Ogrodnick The Changing World Economy Currency Area Trends (Fixed Rates) Flexible Rates Declining Importance of Labor X Movement Toward Free Trade Areas X Movement Toward Common Markets X Increased Importance of Capital Flows X Greater Volatility of Exchange Rates X Applications Of The Theory In this section the theory of optimum currency areas is applied in an attempt to assess, at least on a preliminary basis, the optimality of the exchange rate arrangements first within the European Monetary System, and second between the Big Three, namely the United States, Japan and West Germany. European Monetary System Under the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS), European Community (BC) currencies are allowed to fluctuate within narrow margins around central parities estab- lished between each combination of two currencies. MostE. C. currencies are allowed to fluctuate 2.25 percent above and below their central panties. With the addition of Spain in June 1989, only three of the 12 EC. countries remain outside the ERM (Great Britain, Greece and Por- tugal). Although exchange rate flexibility is limited, the EMS is not a system of rigidly fixed rates in that each currency may fluctuate within its permissible margins and, more importantly, exchange rate realign- ments are accepted and have been fairly common. In fact, from 1979 to 1989 there were “eleven realignments involving one or more curren- cies."25 Hence the ERM could perhaps be best described as a system of limited flexibility or realignable fixed margins. A detailed analysis of all the determinants and trends discussed in this paper would require extensive research. However, some preliminary observations can easily be made. To begin with, the EC. economies are more accurately described as being open rather than closed. Import to GDP ratios range from approximately 20 percent for France, Italy and Spain to varying amounts over 50 percent for the Netherlands, Ireland, 25. Horst Ungerer, “The European Monetary System and the Intematimal Monetary System," Journal ofCommon Market Studies 27, no. 3 (March 1989) p. 233. 256 Journal of International Affairs The Andrew Wellington Cordier Essay Belgium and Luxembourg. In addition, six of the nine ERM economies are easily classified as small, and of the three larger countries (West Germany, France and Italy) only West Germany can be thought of as comparable in size to the United States or Japan. Moreover, depending upon how long each country has been a member, most of the EC. economies are closely integrated through their common market arrange- ments. And, as already discussed, the Single European Act is attempting to eliminate over time the remaining barriers to labor and capital mobility. Interestingly enough, all of these factors point in the direction of forming a currency area. In the past, the differences in inflation rates between the individual countries have been substantial. In 1979, the year the EMS was estab- lished, annual inflation rates ranged from 7.2 percent in West Germany to 23.9 percent in Italy.“ Presumably this is one of the reasons the ERM was structured not rigidly, but flexibly in terms of allowing for both frequent exchange rate realignments and permissible deviations around central panties, with larger deviations being permitted for countries with inflationary problems. However, Over time the inflation rate differentials have declined considerably. The most currently available information indicates that inflation rates range from 1.2 and 2.8 percent in the Netherlands and West Germany to 6.5 and 7.0 percent in Italy and Spain. The deutsche mark is the key currency within the EMS, and Germany is the economically predominant country within the European Com- munity. German hegemonic leadership can enhance the feasibility of creating a currency area. As already noted, inflation-rate differentials have declined since the late 1970s. Although inflation rates have also converged in non-EMS nations, Germany is unquestionably an inflation- shy country, and its dominance within the EMS may have allowed it to set the tone for monetary policy. It is important to remember that the EC. is integrated not only economically but also, to some extent, politically. The institutional framework of the EC. includes a Council of Ministers, the European Commission and a European Parliament.28 N otwithstanding the fact that power still ultimately resides within the member states (since the Mini- sters in the dominant E.C. decision-making unit, the Council of Mini- 26. International Monetary Fund, International Financial Statiytics 37, no. 1 (Janna 1985). 27. All current inflation rates are from, International Monetary Fund, International inancial Statistics 37. no. 1 (February 1990). 28. Leon Hurwitz, The European Community and the Management oflnternatr'onal Cooperation (New York: Greenwood Press, 1987) p. 64. Journal of International Afi'airs 25 7 Robert Ogrodnick sters, are responsible to, and represent the interests of, their national governments), this institutional framework cannot help but be a stabiliz- ing force in the convergence of national macroeconomic policies and in the deepening of the common market. Once again this points to the feasibility and desirability of establishing a currency area in Europe. Based on the theory of optimum currency areas, one can at least tentatively conclude that the EMS exchange rate arrangements of limited flexibility or realignable fixed margins are close to optimal for the European Community. As an aside, it is interesting to consider whether the theory of optimum currency areas can provide any insights into why Great Britain has been reluctant to join the ERM. First of all, Britain’s current inflation rate (7.6 percent) is higher than the rates of all the ERM member countries. Also, one should not discount the importance of the English Channel. Britain has always been separate from the continent—geographically, culturally and in terms of her own uniqueness (or aloofness) as the former head of a world empire. Her interests have never been confined to the Continent alone. Moreover, Great Britain choose to not become involved in the early stages of the European integrative process, and was later vetoed from becoming a member. For all these reasons, one could hypothesize that the British economy is probably less integrated into the E. C. than are the continental European countries. Finally, as a former hegemonic power in her own right, Britain may be reluctant to submit herself to the possible hegemonic dictates of German monetary policy. United States, Japan and West Germany The major events that signalled the final demise of the Bretton Woods System (an adjustable peg, gold exchange standard) include the 1971 suspension of US. dollar convertibility into gold, the Smithsonian and subsequent exchange rate realignments, and finally the general adoption of floating rates in 1973. The industrialized world then entered a period of largely freely floating exchange rates. Similarly, it has been argued that the beginning of the end of the flexible exchange rate system occurred in September 1985 with the signing of the G-5 Plaza Accord.” The intent of this Accord, in large part a response to concerns over the growing US. trade deficit, was to lower the external value of the US. dollar through coordinated central bank intervention in the foreign ex- 29. John Williamson and Marcus H. Miller, Targets and Indicators: A Blueprinrfor the International Coordination of Economic Policy, Institute for International Economics, (September 1987) p. 40. 258 Journal of International Afi‘airs The Andrew Wellington Cordier Essay change market. There is a common belief amongst policy makers that large trade imbalances are an indication of exchange rate misalignments, that is, the over or undervaluation of a currency. However, this would seem to overlook the fact that trade flows now account for less than 3 percent of the total volume of foreign exchange transactions. Hence one can legitimately question whether a trade imbalance is the appropriate parameter to signal a currency misalignment. The Louvre Accord of February 1987 represents an attemptto stabilize exchange rates within agreed-upon reference ranges. Although these ranges have not been publicly announced, as late as September 1989 they were widely believed to be 120 to 140 Yen to the U.S. dollar and 1.70 to 1.90 deutche marks to the U.S. dollar"o It is difficult to clearly determine what the current exchange rate policy of the Big Three is. On the one hand, since 1985 there has been a movement toward coordinated inter- vention, the stabilization of exchange rates, and since 1987, the fixing of reference ranges. On the other hand, it is not publicly known with absolute certainty what these reference ranges are, or how rigidly fixed they are intended to be. In September 1989. for example, the Yen was trading outside its assumed upper bound of 140 yen to the U.S. dollar. This lack of public information makes it difficult to assess the optimality of the current exchange rate regime. Nevertheless, there are a few observations that can be made, especially if one uses the EMS as a point of reference. To begin with, factors of production, particularly labor, are more immobile between the United States, Japan and Germany than they are within the EC. nations. This reflects not only the more pronounced cultural and historical differences between the Big Three but also sheer geographic distance. As well, compared to other countries, the Big Three have large well—diversified economies. Because they produce a wide array of products, they have less need for imports (ie. can afford to be more closed) than most other nations. There are exceptions to this generalization; for example, Japan must import most of its raw materials, but is virtually self-sufficient in terms of consumer and industrial goods. Note that while Germany with an import to GDP ratio of 27 percent is relatively open compared to the United States and Japan who have ratios of 1 l and 9 percent respectively, outside the walls of the EC, that is, vis-d-vis the non-EC. world, Germany is also relatively closed. Furthermore, compared to the Bretton Woods era, the hegemonic power of the United States has declined relative to the growing economic power of Japan and West Germany. 30. Murray and Truell, op. cit. p. A14. Journal of International Aflairs 259 Robert Ogrodnick thus potentially making policy coordination and convergence more dif- ficult. Finally, trade barriers have also been falling over time, indicating a movement toward a more fully free trade area. These characteristics (the immobility of some factors, the large, well-diversifiednature of theireconomies,the self-sufficiency or relative closedness of their economies, the absence of a clear hegemonic power and falling trade barriers) point in the direction of adopting more flexible rather than more fixed exchange rates. Working in the opposite direction, there has been a convergence in inflation rates. The rates for Japan, West Germany and the United States are currently 2.7. 2.8 and 4.7 percent respectively. This is a narrower range of inflation rates than currently exist for the countries that par- ticipate in the ERM of the EMS (the Netherlands has the lowest rate at 1.2 percent and Spain the highest rate at 7.0 percent). In addition, some factors of production are becoming more mobile over time. A good example of capital and technology transfer (factor mobility) is the growing extent of Japanese automobile production within the United States. Both of these factors (the convergence of inflation rates and greater factor mobility) should make it easier for the Big Three to stabilize or fix their exchange rates. In summary, while there are forces working in both directions, the preponderance of factors would seem to indicate that the Big Three are less closely integrated and more dissimilar than the European Com- munity. As such, their exchange rate system should, optimally, be more flexible than the ERM of the EMS. This has typically been the case since the final demise of the Bretton Woods system in 1973. However, a decision of the Big Three to interpret the reference ranges of the Louvre Accord as being steadfast or rigidly fixed would clearly be suboptimal based on the theory of optimum currency areas. Given the lack of a clearly defined policy, it would be premature, if not impossible, to provide a final judgement on the optimality of the current (Louvre) exchange rate arrangements. However, one can conclude that too rigid an interpretation of the reference ranges of the Louvre Accord, i.e., a movement too far in the direction of forming a currency area, would, relative to more flexible exchange rates, be sub-optimal. Conclusions Based on the theory of optimum currency areas, the Exchange Rate Mechanism of the European Monetary System would appear to be a reasonably appropriate exchange rate system for the European Com- munity of nations. A clear determination of, and therefore reasoned judgement on, the current exchange rate policy between the United 260 Journal of International Afiairs #5 I f The Andrew Wellington Cordier Essay 19‘ States. Japan and West Germany is more difficult at this time. However, one can conclude that there are danger signs in the Louvre Accord in that reference ranges, especially if rigidly fixed. are not appropriate for these three nations. The international monetary system consists of a multiplicity of ex- change rate regimes. A second conclusion is that this diversity, what could almost be called a nonsystem, is in fact a desirable feature. Given the range of nations which compose the world economy, a single uniform exchange rate system is extremely unlikely to be optimal. The interna- tional monetary system must be sufficiently flexible to accommodate the diverse and heterogeneous character of the nations which make it up. A third related conclusion is that success of a particular exchange rate regime, for example the EMS. does not imply that this system could uniformly and successfully be applied elsewhere, let alone on a world- wide scale. Clearly the potential for success is a function of the extent to which the exchange rate mechanism is appropriate for the underlying characteristics or determinants of the countries in question. It is unlikely that the ERM of the EMS could be applied with equal success to the United States, Japan and West Germany. A fourth conclusion is that as nations become increasingly integrated (economically, financially and politically), the likelihood of currency area success increases. The European Community is perhaps the best example of a trend toward greater economic and political integration increasing the success of monetary integration. It could also be noted that the majority of the trends described in this paper are pushing the world economy, or at least regions of it, in a direction that makes currency areas and greater monetary integration increasingly desirable. Finally, one should not expect the international monetary system to remain constant over time. As the underlying characteristics of individual state economies—the determinants of optimum currency areas—change, and as new trends in the world economy develop, the optimal mix of fixed versus flexible exchange rates will change as well. This is anatural, evolutionary process that has occurred in the past, and that can be expected to continue in the future. Journal of International Affairs 261 Copyright© 2003 EBSCO Publishing ...
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General Essay on Optimum currency areas - /4 THE ANDREW...

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