May 08, 2003
Monetary union and economic flexibility

The question whether the euro will in the long term benefit Europe or harm it cannot be answered at this point with any certainty. I have been skeptical about monetary union in Europe as it is constituted now, as there are serious divergences undermining EMU. There is no agreement between economists (is there ever?) on whether even in theory it is better to have fixed exchanged rates or floating ones. And the split goes right down the middle of the free market camp too, with both views represented by the Big Names of Economics.

So I was very interested to find a discussion between Milton Friedman and Robert Mundell on this very issue. (I came across it via Arnold Kling, whom I found through this post at Asymmetrical Information). The discussion goes around in circles to a certain extent, but in the end it boils down to the issue of economic flexibility. As exchange rates are prices, they convey information on supply and demand of currencies, which again is based on numerous other factors in the real economy. By shutting down a mode of expression for the information by fixing currency prices, you can't make the information go away. It will have to express itself by other means, and that's where economic flexibility comes into play.

Mundell argues that having a sound monetary policy is of vital importance, and that economic benefits will follow if only there's stable money. In fact, he takes the argument to its logical conclusion and advocates having a world currency. The larger an area a currency covers, the greater the stability will be. Mundell does say he does not advocate a single world currency, but just a world currency; the difference though seems to be semantic rather than substantive. He says:

My ideal and equilibrium solution would be a world currency (but not single world currency) in which each country would produce its own unit that exchanges at par with the world unit. We could call it the international dollar or, to avoid the parochial national connotation, the intor, contraction of “international” and the French word for gold. Everything would be priced in terms of intors, and a committee—in my view, say, open market committee designated by the Board of Governors of the International Monetary Fund—would determine how many intors produced each year would be consistent with price stability. Every country would its currency to the intor following currency-board system principles.
This is different from having a single world currency only in that it retains the option of re-floating national currencies, which would be harder if they were abolished altogether. And the practical difficulties are enormous too, as its ultimate viability would depend on the proposed "G3 Open Market Committee" being able to determine the right amount of intors to issue. In effect, this creates a single fiat currency for the whole world. I get nervous with three fiat currencies being dominant. The art of central banking has not evolved to the point where one would wish to bet the world's economic future on central bankers getting it right.

Friedman argues for flexible exchange rates, arguing that they provide an important escape valve for the adjustment of prices within an economy. Mundell counters that the same adjustment can take place by changing domestic price levels, and that it can be done more effectively that way. In theory, Mundell is right, but in practice it does not work that way, and this is what Friedman argues too. The case of Argentina is instructive in this regard, as it had a fairly orthodox currency board which ultimately failed. The discussion between Friedman and Mundell took place before the Argentinian currency board collapsed in late 2001, so there are no port-mortems of this event, nor do they spend much time discussion the Argentinian situation.

By tying the peso at parity to the US dollar, Argentina did get the immediate benefit of vastly improved monetary policy in 1991, just as Mundell argues. It also introduced thitherto unheard-of macroeconomic stability, and the Argentinian economy prospered. But Argentina was pricing itself slowly out of the market by maintaining convertibility with the dollar. It simply wasn't producing enough economic added value to justify charging the prices in a convertible peso, nor did it have the productivity gains that would allow the economy to remain competitive internationally. The 2001 collapse in Argentina came after Brazil had unpegged the real from the dollar in 1999, which added to the competitive pressures on Argentina. At this point, Argentina had the choice of adjusting its domestic price level downward, or achieve a similar result by devaluing the peso and thus breaking the currency board. In a very messy process that exacerbated the outcome manifold, it ultimately defaulted on its debt and devalued the peso. It sank from parity with the dollar to 4, essentially wiping out 75% of Argentina's wealth if measured in dollars.

The key again is economic flexibility here. Had Argentina possessed an economy flexible enough to adapt quickly to competitive pressures by improving productivity and reducing the domestic price level, it would have been able to keep the peso convertible to the dollar at parity. Looking at a single dimension of productivity, it might have had to reduce aggregate labor costs by, say, 25% in the mid-1990s. Firing 25% of all workers is one way of doing that, or by all workers taking a 25% pay cut. Neither is very appealing.

One of the architects of the Argentinian currency board, Steve Hanke, defended the currency board against the critics (such as Paul Krugman):

And how did the Argentine economy fare during the Menem decade? As Table 1 shows, Argentina responded with a growth spurt that left its neighbours in the dust. All this is not an anomaly. Since 1950, countries with currency boards have realized average GDP growth per capita that is 54% higher than comparable countries that had central banks with discretionary monetary powers.

This is not to say that a sound currency is everything. Indeed, Argentina desperately needs a good dose of supply-side economics. Unemployment is high because labour market regulations are burdensome and taxes are too high and complex. Bring on deregulation and a flat tax. Clone Hong Kong, please. And that's not all. The government apparatus needs a complete overhaul. The only way to attack the endemic corruption spawned by the state is to shrink it. Those reforms, on top of its sound money, would put Argentina back on a high-growth track.

The table at the bottom of his article shows that Argentina's economy grew by 230% in the years 1989-1999 in US dollar terms. The devaluation of the peso (now trading at about 3 to the US dollar) means that all that growth and then some has been wiped out if measured in dollars. In fact, in dollar terms the Argentinian economy contracted about 25% in the period of 1989-2002. Hanke actually sees the seeds of demise for the currency board when he argues for structural reforms. (As an aside, the picture for the Asian economies he mentions would now be different, as some floating-rate countries like South Korea have done pretty well since the crisis of 1997.)

Using the currency board as both the carrot and the stick in Argentina failed to get the necessary structural reforms get implemented. The members of the European Monetary Union are no Argentinas, but there are a number similarities. Structural problems are contributing greatly to the current economic weakness in the entire Eurozone. The problems are the same as in Argentina, although probably not as severe: rigid labor markets and high non-wage costs are preventing European companies from adjusting to the weak global economic environment (and the strong euro too). Mundell's argument is that the single currency will be a driver of reforms, making it more likely that these structural problems will finally get tackled. Are reforms a necessary precursor for monetary union, or is monetary union a catalyst to bring these changes about?

There has been some progress in Europe on structural reforms, but overall far too little has been achieved. While there is a reasonable single market now in goods, the services sector is still highly fragmented. And even the European directives establishing the single market for goods are poorly implemented, with France being one of the biggest offenders. Not very surprising, that. It does show that there is a difference between the Single Market on paper and the reality on the ground. But the intentions here of the EU are good for a change, and Brussels will be trying to create a true single market for services. It's not going to be easy:

A commission report published last year listed 92 barriers encountered by businesses wishing to offer their services in more than one EU country.

The report found problems began with the founding of businesses, which can be hindered by local and national requests for several authorisations.

The distribution of services was also made difficult by laws forcing the provider to have a physical base in the country.

The advertising industry was hampered by a maze of different national regulations.

Belgian electricians have to pay three times the Belgian rate to register with the authorities in neighbouring Luxembourg for a one-day job. And Austrian bakers need eight different licences if they want to set up in Italy.

If the euro is to become successful, it is vital that the internal market be as free as possible. This still does not address the issue of structural reforms within member countries, though. Eurosclerosis is a problem that won't go away easily. Having a true single internal market will make cross-border competition more intense in many more areas than is possible now. This could be one of the great strengths of the European Union, by allowing countries to experiment with their domestic economic policies by competing against one another. Competition is an essential tool in the economic discovery mechanism of what works and what doesn't. But competition is scary to those who like the status quo, and especially those who like the power they wield in their own countries. So plans are afoot to stifle competition between countries, because it's so unfair:
Plans to scrap the national veto on tax to eliminate "unfair" tax competition in Europe will this month be proposed by Valéry Giscard d'Estaing, the man drawing up a new EU treaty.

His plan, designed to stop some EU members poaching inward investment and savings by setting very low tax rates, has the backing of most member states, including France and Germany.

According to aides, Mr Giscard d'Estaing is determined to press the issue, even though Britain and Ireland are opposed to deciding any EU tax issues on the basis of majority voting.

The former French president believes that without reform, the EU's single market will be distorted as countries embark on a damaging race to undercut one another's company tax rates.

It's the same old argument against capitalism and competition, but transported into a different context. It shows that the European elites still don't understand why an economy works and prospers. It's not a new insight, but it's the statists of d'Estaing's ilk who are drawing up the new EU constitution. That does not bode well for the future, but that's not news either.

There is some evidence that the euro has indeed spurred greater economic integration and flexibility in Europe. But this enforced discipline has not extended very far, nor is it making much of a difference in the discussions about structural reforms. My view remains that European Monetary Union is currently doing more harm than good.

Meanwhile, in Latin America, the idea of monetary union seems to be catching on. Brazil and Argentina have floated the idea of moving to a joint currency. Coordinating economic policy is one thing, but moving to a joint currency at this stage seems foolhardy in the extreme. Moreover, one report quotes deputy foreign minister Martin Redrado as saying:

"The currencies are worth almost exactly the same, this is the time,"

Yes, the exchange rate between the real and the peso happens to be close to one at the moment, but that is utterly meaningless. You could multiply either currency's nominal value by a constant and it would not change underlying economic reality one bit. If they're going to base a single Latin American currency on this kind of reasoning, it's doomed before they even start.

Posted by qsi at May 08, 2003 12:17 AM | TrackBack (0)
Read More on European Union , Finance & Economics , Latin America , Monetary Matters

Thank you for these 'briefings'. I find them very informative since I have managed to avoid thinking deeply about economic theories after my one semester bout. Keep on producing, please.


Posted by: J.M. Heinrichs on May 9, 2003 03:26 AM

Hanke is wrong. First, only a fraction of Argentina's economy (~4%) reflected trade with the US while Hong Kong's was over 40%. In addition, the regulatory and labor structures are very different between the US and Argentina. The two economic systems were completely unaligned and often out of sync with each other. It's foolish to think a peg would have any validity to it before long.

I'm sure that their economy grew in the short term and you don't need a Ph.D. to know why. I'm also sure that the peg would never be sustainable. Unless you have full convertibility like Hong Kong does, currency board just serve to delay the inevitable. And when the fall comes, it will be harder and last longer than it would have if the currency reflected its true worth. Currency raiders have no incentive to attack a truly free floating currency but definitely have a free rider incentive to attack pegs. That, and the fact that they have the iron law of economics on their side.

Posted by: Erik on May 10, 2003 08:52 AM

One of my Chinese counterparts from Shenzhen told me that their RMB is pegged to the dollar. Pegging to the currency of an economy that is growing more slowly actually seems to make sense, if you can do it politically. It keeps the cost of imports up and cost of exports down.
It's a de facto tariff, really. The result is that the government ends up with foreign currency that it can use for buying all sorts of toys.. like diesel subs..

Posted by: Dishman on May 10, 2003 07:32 PM
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