by Sara Eisen
The potential role of the SDR should not, however, be overestimated. The stability of the international monetary system depends primarily on strengthening macroeconomic policies, economic governance, financial regulation, and supervisory frameworks at the level of the respective currency areas and countries. This is necessary in order to reduce and prevent a renewed buildup of global imbalances. It remains to be seen to what extent an enhanced role for the SDR could complement these tasks.
Sustaining the Euro as a Key Player in the Multipolar Currency System
Europe has a strategic interest in supporting an emerging multipolar currency system in which there are multiple reserve currencies. The underlying shift toward a multipolar system is reinforced by the present trend, in which major central banks may wish to hold a more diversified portfolio of multiple reserve currencies (Ghosh, Ostry, and Tsangarides, 2010). The diversification of reserve assets may be induced by different factors, namely, the availability of high-quality assets, liquidity and size of the market, network effects, trade patterns, and the currency denomination of trade. Ghosh, Ostry, and Tsangarides (2010) argue that central banks “will want to diversify risk in order to preserve the ‘real value’ of their reserve portfolios.” Indeed, the share of the euro in global currency reserves has increased constantly (see Figure 3-6). In terms of the composition of foreign exchange reserves, the euro is already an important anchor currency for many Eastern European and African economies (Lim, 2006).
Figure 3-6 Share of Global Currency Reserves
Source: IMF COFER database; only allocated reserves (78 percent, 66 percent, and 55 percent of total global reserves, respectively)
Sharing the responsibility for providing the main currencies among different countries and regions should help to increase the stability of the international monetary system (World Bank, 2011). The supply of liquidity by different central banks and the augmented supply and diversity of global traded assets should improve capital allocation and risk sharing, thus enhancing the system’s resilience to (idiosyncratic) shocks. Having more international main currencies in use should also help to increase the legitimacy of the international monetary system by having a fair distribution of costs and benefits and creating a widening of international cooperation, which would reduce the risks of protectionism and competitive devaluations (or “currency wars”).
However, the future of the euro and its contribution to the stability of the international monetary system will primarily be assessed against economic performance in the euro area itself, namely, the euro area’s success in safeguarding financial stability and augmenting potential growth, reforming entitlement systems, and meeting the demographic challenge, as well as in fostering the efficiency and openness of capital markets and the stability of the exchange rate.
Despite the euro area’s current challenges in dealing with sovereign debt and competitiveness issues, there are grounds for optimism. The euro’s positive role in accompanying a transition toward a multipolar currency system can be illustrated by the large external position of the euro area in terms of its share of world trade and the rise of net foreign capital inflows (see Figure 3-7). Even before the formal adoption of the euro, a steady increase in the inflow of foreign direct investment (FDI) into the euro area (and its predecessor countries) can be observed from 1989 onward, capped by two positive outliers in 2000 and 2007. A similar development can be observed for portfolio investments (see Figure 3-8), the trend being broken only by a sharp decrease during the recent financial crisis. In fact, when the euro was introduced in 1999, there were shifts in official investors’ foreign exchange holdings (Lim, 2006).
Figure 3-7 Net Foreign Capital Inflows into the Euro Area
Source: World Bank database
Figure 3-8 Market Capitalization of Listed Companies
Source: World Bank database
The Next 20 Years
The enormous market size and financial depth of the euro area are properties that make the euro a credible candidate for an increased international role. Despite its more moderate outlook in terms of demographic developments, the dimensions of the euro area can still be expected to grow with the entry of new countries into the common currency area (Eichengreen, 2009). Low and stable levels of inflation, credible government policies, and open and deep financial markets will pave the way for the euro to remain a strong global reserve currency. The consequent response to the current crisis is to strengthen policy fundamentals and stability, as well as to foster further economic and financial integration in the single European market.
Furthermore, the euro’s reserve role, as well as its policies, will help other nations integrate into a multipolar reserve system. For instance, going forward, the rise of emerging-market economies, especially Brazil, India, and China, will continue in a dynamic manner. In 2020–2030, many more financial and trade transactions will be conducted in the currencies of these countries, serving as a benchmark for the growth of the real economies in emerging markets. Concerns over volatility in capital flows and a cost-benefit analysis of artificially lowering the value of their currencies will perhaps be reassessed more neutrally. The cost to China of not allowing the yuan to appreciate is financial repression and a continuously closed capital account. As Prasad (2011) indicates, current account balances may, in the future, be dominated less by trade flows and more by net factor income flows and their effects on the capital account. Both for the U.S. dollar and for the euro, this means that securing policy credibility on the basis of strong economic fundamentals will become much more important.
For the time being, advanced countries are still much more financially integrated into the global economy than emerging-market economies. Prasad (2011) explains that the median level of the ratio of gross stocks of external assets and liabilities to GDP more than doubled over the last decade in advanced economies; but the ratio is also on the rise for Brazil, India, China, and Russia. The main point here is that after the financial crisis, the world will still be dominated by increased global financial integration. And this crisis has shown that financial spillovers can carry risks around the globe.
Given these trends, global cooperation and policy coordination are key factors. It could be argued that the main advantage of a more multipolar currency system is that it contributes to enhancing policy discipline among the reserve-issuing countries in the form of peer pressure that arises from potential substitutability (IMF, 2010). With credible alternatives to the U.S. dollar as an international reserve asset, issuers “will feel market discipline earlier and more consistently” (Eichengreen, 2011). Such a possible gain in stability in terms of major currencies could also lead to lower global reserve holdings. Furthermore, the current incongruence in the system that leads to the building up of enormous precautionary reserves can be overcome by a more multipolar system because currencies would be held primarily for transaction purposes (Mateos y Lago et al., 2009).
Conclusion
For the euro area, the key question is whether it can put its house back in order and assimilate the divergent economies into a zone of stability. At the same time, the euro area must succeed in inducing a renewed impetus for integration with more competitive, closely linked markets, especially where financial services are concerned (Lim, 2006). The euro can reinforce its role as a global reserve currency only once the euro area succeeds in reestablishing policy credibility. In order to secure this role, the euro area must advance with a much deeper degree of fiscal integration and solve the questions of its governance by means of more political integration. In the end, domestic factors will determine whether the euro will be a successful international reserve currency, shaped by the success of fiscal consolidation, structural reforms, and monetary policy making by the ECB (Prati and Schinasi, 1997).
The benefits from further economic and financial integration are still substantial. Despite the current challenges facing the euro area, the IMF has also been upbeat in stating that “executing the structural reform agenda w
ith more emphasis on ensuring contestability and competition will greatly bolster growth prospects” for the euro area (IMF, 2011c).
There has not been consensus on an overall concept of how to repair the damage done by the crisis in a way that creates a sound and stable international monetary system in the future. The G-20’s close cooperation on policy during the crisis and beyond will not remain an exception; global superpowers will need to continue to work closely together. A challenge will be to address the medium- to long-term issues. Sovereign debt problems in some countries in the euro area have been looming for too long, as has now become clear. At this current juncture, public policy is still preoccupied with the immediate management of the fallout from the crisis. Nonetheless, the next decade will be decisive because major changes will come to the fore—especially in terms of the further rise of emerging markets and their financial systems and currencies.
The reform of the international monetary system is not just an issue for a single G-20 summit, but one of the strategic issues for the next 20 years. Instabilities in the current system are not disputed. The move toward a multipolar currency system is well founded for economic reasons and will foster international financial stability. It is a long-term challenge. The fallout from the present crisis has reminded us of the underlying currents in the global economy that have been far from sound. These risks justify a reevaluation of past trends in the international monetary system as we move ahead. The euro can lead the way to reform if Europe is ready to assume a key leadership role internationally and if Europe is able to establish a consensus in terms of reforming and strengthening its governance further internally.
The objectives and plans for European integration, shaped by differing national traditions and experiences, have often varied considerably over the last 50 years, both among nations and within individual countries. And to some extent they still do—despite all of the efforts and progress made in integration. On the one hand, this diverse range of objectives is part of Europe’s cultural wealth. On the other hand, this diversity sometimes impedes the commonality needed to achieve the objective of the process of integration. This is especially true when trying to develop and implement joint ideas for specific political objectives, action plans, and essential institutional structures, which are particularly important in a permanent currency union.
In spite of all the advantages and benefits for all of us, there is the danger that because of the almost permanent state of crisis, Europe’s citizens may lose confidence in Europe and the euro. Therefore, answers to fundamental questions are needed. The euro area today is faced with a fundamental political dilemma: we cannot simultaneously pursue the three goals of democracy, national self-determination, and economic integration. We must opt for two of these three things, or at least place them in a clearly defined relationship (see also Rodrik, 2011).
Today’s basic consensus on monetary policy is the result of a long and, at times, very painful learning process that has also often created critical situations. But the benefit of hindsight also shows that most of the currency-related crises were caused largely by inconsistent or completely incompatible national policies. Overcoming them, however, has also often led to the discovery of new approaches and ways forward that have largely advanced political and economic integration in Europe. That is because, as a rule, crises offer potential for new progress as well—at least if the correct conclusions are drawn from them.
In view of the process of globalization, and faced with emerging powers such as China, India, and Brazil, European countries will be able to exert influence at the global level only if they act together. Wall (2008) argues that the “future is too unpredictable to say with confidence that this will be the Asian century. What is sure, however, is that we will be part of a multi-polar world and there is no single European country that can, by itself, constitute one of the poles. Only Europe united, politically and economically, can do so. And that is impossible while we run our economic and fiscal policies on the present national bases.” Clearly, we need further bold steps to improve the governance of the euro area as a whole.
CHAPTER 4
WHAT HISTORY TELLS US ABOUT THE EURO’S FUTURE
JOHN TAYLOR
“What we should grasp, however, from the lessons of European history is that, first, there is nothing necessarily benevolent about programmes of European integration; second, the desire to achieve grand utopian plans often poses a grave threat to freedom; and third, European unity has been tried before, and the outcome was far from happy.”
—Margaret Thatcher, Stagecraft, 2002
In the last few decades, more than a few fashionable writers have followed the lead of Francis Fukuyama in The End of History and the Last Man (1992), treating his thesis as a given and implying that the world has advanced—or at least changed—so much that any analysis of previous historical events and relationships is a waste of time. Accordingly, if any research were to be carried out, the hypotheses generated from it would only lead to erroneous conclusions.
Although Fukuyama’s concept has been challenged by many mainstream political and social historians, his “end of history” attitude seems to have become the dominant paradigm for the financial world. And, even if this paradigm isn’t often stated, the impression is that the world of finance has changed so much that any inferences drawn from the past have to be treated with great care. Putting it bluntly, if a market event occurred before the end of World War II, it doesn’t count; ignore it. Analyses of prices, earnings, yield curves, credit spreads, and how these relate to and interact with the underlying economy or political events almost always start with the end of the war.
Those economists and economic historians who look at the whole span of history and draw modern conclusions from them have been few and far between. Notable among them were Charles Kindleberger (Mania, Panics, and Crashes, 1978) and Hyman Minsky (Stabilizing an Unstable Economy, 1986). Although many great minds have studied the Depression era, including Milton Friedman, Anna Schwartz, and Ben Bernanke, it could be argued that their analyses and conclusions were rooted in that time and have not been as effectively applied to the problems of today. The work on the Depression actually seems to illuminate the differences between the prewar system and that of today, rather than helping to unearth new similarities that would allow us to manage current failings. Perhaps Kindleberger and Minsky’s success in analyzing the whole of economic time, resulting in a deeper understanding of today’s issues, is a sign that the study of the capitalist system’s repeated failings would be a more effective way to pinpoint and analyze the universal—including the modern—qualities of that system.
When analyzing currency movements and valuations, the division between significance and not-worth-looking-at is even more rigidly demarcated. The date when history begins is late February 1973, when the last vestige of the Bretton Woods system was finally swept away and floating rates began. Reading modern currency analysis, one would be convinced that history began less than 40 years ago. Before that, the world was dark and primeval. I am not aware of any recent (post–1990) academic or serious institutional studies that attempt to tie currency movements in the Bretton Woods era or the pre–World War II era with modern currency issues. The chasm is so wide that the data we use to dissect the markets and their movements today were not even available during the Bretton Woods period, as we now approach the analytical process so differently from the way we did back then. The data that we so love to load into computer systems and pore over for hours either were discarded in the trash or did not even exist back then.
Focusing on the mountain of data that describes the currency markets and relationships over the last decade or two and ignoring the past because it cannot be sliced and diced the way that our modern machinery allows is a major blind spot that has led today’s investors, traders, and government authorities to pursue ill-chosen paths. We must see currency relationships as part of the ongoing political interplay among countries, something that has n
ot changed dramatically in the past 300 or 400 years.
To think of currencies in this way, we must understand financial markets as being more than the modern places where we raise capital, invest, and transact business on a day-to-day or year-to-year basis. Markets do not actually depend on capitalism, as they have underpinned civilization from the very beginning. They can be seen as nothing less than the monetary and transaction-based expression of the underlying social and political structure. Feudal markets were very different from the markets of the Roman Empire, and markets can be thought of as a good way to quantitatively measure the reality of the society as a whole—how it actually functions and how well it may be doing at any given time. The foreign exchange market is a particular subset of markets, as it measures the relationship among coherent social systems organized into nation-states.
In the past 200 years, capitalism and the Industrial Revolution brought markets to the forefront, sharpening their relationship to the average person and developing a more structurally intact process for global trade and exchange. The intersocietal measures of valuation and credit quality or trust have developed as the global system has grown and changed, but the basics are unaltered—can I trade with that country; if I invest there, will I make a decent return; and will I get my money back?
As the foreign exchange valuation of an individual country, and the rate of change of that valuation in relation to its trading partners, is an integral part of the economic and social fabric of each of the countries involved, one must consider and understand much more than the week-to-week, or even year-to-year, movements in the currency market to divine how the currencies will move in the very long term. Considering that the currency markets have been floating for 39 years as this is being written and that the Bretton Woods system controlled the currency markets for only 25 years before collapsing, the post–World War II experience does not really tell us much about the long-term nature of the foreign exchange market and in what direction it might be moving.