The Role of Tradables vs. Non-tradables for the Adjustment Process in Europe

Table of contents

Introduction

I. Fixed exchange rates systems prior to EMU and resemblances
1. The Gold Standard
2. The new Gold Standard and the Great Depression
3. The Bretton Woods System

II. The generation of European current account imbalances
1. Diverging competitiveness through price and wage growth differentials
2. Diverging non-price competitiveness
3. The role of tradables vs. non-tradables for the generation of imbalances About non-tradables
The role of non-tradables for current account imbalances

III. The size of the non-tradable sector and the current account balance
1. Tradability according to actual trade
2. Geographical concentration as a tradability indicator
3. Identification of countries relevant for the analysis

IV. The adjustment process in the euro area
1. Policy alternatives for deficit countries
2. Short-run adjustment and the importance of the external sector
3. Long-run adjustment and the importance of market flexibility
Flexible labor markets
Flexible product markets
4. The role of non-tradables for the adjustment process, a graphical analysis
Outline of ultimate results and critical appraisal

Conclusions

References

List of figures

1. Structure of the paper

2. World trade desintegration during the Great Depression

3. Gold price in the private market during Bretton Woods

4. Inflation for selected group of countries during Bretton Woods

5. Current account balances of Northern and Southern euro area

6. Reasons behind current account imbalances

7. Evolution of nominal unit labor costs

8. Cumulated inflation vs. cumulated growth of nominal ULC

9. Labor productivity measured as GDP per hour worked

10. Labor productivity growth measured as GDP per hour worked

11. Relative use of capital, labor productivity and growth of ULC

12. Relationship between productivity, labor intensity and non-tradable sector size

13. Non-tradable sector size and current account balance, De Gregorio et al. (1994)

14. Non-tradable sector size and current account balance, Jensen and Kletzer (2005)

15. Relative sectoral production

16. Countries identification

17. External and internal balance

18. Adjustment process and the role of the non-tradable sector size

19. The case of a negligible tradable sectors size.

List of tables

1. Sectors classification according to their export share in total production

2. Sector size according to De Gregorio et al. (1994)

3. Sector size according to Jensen and Kletzer (2005) and De Gregorio et al. (1994)

4. Policy alternatives at choice for deficit countries

“ This is a nightmare, which will pass away with the morning. For the resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life — high, I mean, compared with, say, twenty

years ago — and will soon learn to afford a standard higher still. ”

- John Maynard Keynes (1930)

Introduction

In view of the extremely tough situation some countries of the euro area are going through, many people wonder why it is so difficult to overcome the impact of a financial crisis that started already four years ago. They ask themselves why there are countries that have already recovered while others are performing so much differently. A fundamental reason is that countries are very diverse regarding their economic structure, and so were their levels of development at the time of joining the euro. Supported by this heterogeneity, macroeconomic imbalances began to grow even before the European Monetary Union was introduced. As long as economies grew and people became wealthier, imbalances did not seem as critical as to be addressed imperatively. Not until the outburst of the financial crisis did European leaders effectively agree upon reducing imbalances, along with other policy measures aimed at recovering from the slowdown and ensuring future stability.

In this context, we look at the European Commission’s Assessment of Spain’s national reform and stability program. Properly speaking, such judgment ultimately comes from the Council, but insofar it relies on previous analysis and policy recommendations from the Commission, we will be referring to the Commission’s recommendations. In addition, the International Monetary Fund also monitors the economic development of its member countries and advises them in case of economic instabilities under the Article IV of its Articles of Agreement (surveillance). We also consider its 2012 Article IV Consultation for Spain, which we choose as representative for countries going through a period of severe economic slowdown whose external indebtedness, whether public or private, has been steadily increasing for the last two decades. Spain’s condition as the fourth largest economy of the euro justifies taking its particular circumstances as anchor point.

Surely, there are many propositions for structural reforms, the most common of which are ensuring a larger degree of labor and market flexibility. They sound familiar to many people because they have been suggested for quite a long time prior to the crisis, both by experts and international institutions. However, we focus on a different aspect addressed by both the Commission’s and the IMF’s latest documents for policy recommendations: the need to shift resources from the non-tradable to the tradable sector.

In this paper, we intend to explain the reason why the Commission and the IMF are concerned about this issue in countries with large current account imbalances and low competitiveness. Inferring that not accomplishing such a reallocation of resources will yield a major ‘pain of adjustment’, we investigate the role of the non-tradable sector size in the European adjustment process. In the first instance, we need to make clear that the ‘adjustment process’ we refer to concerns the correction of intra-euro area imbalances, although it is closely related to the process of recovering from the financial crisis. ‘Pain of adjustment’ is here understood as the time and/or the contraction required for reaching a certain level of external balance in terms of social costs, most notably unemployment.

The unique nature of the European Monetary Union demands covering several aspects in order to contextualize the leading question presented above. This explains the wide scope we have given to our analysis, whose structure is depicted in the following illustration:

Source of the map: European Commission. Dark blue: euro area; pale blue: non-euro area in the process of adopting the euro; beige: non-euro area with ‘opt-out’ not obliged to introduce the euro.

The illustration represents how our main assertions rely on two main pillars and a historical background, essential for the full understanding of the adjustment process in Europe.

In the first part, we compare the two most relevant former systems of fixed exchange rates, the Gold Standard and Bretton Woods, in order to draw resemblances to the euro. We specifically regard their rigidities and failures, which can be resumed as the impossibility of dealing with external and internal imbalances at the same time.

The next part covers the driving factors of current account imbalances in the euro zone that began to grow in the mid-90s. We find that diverging competitiveness driven by a too large growth of unit labor costs in Southern European countries, together with market imperfections, were the main source of imbalances, while the size of the non-tradable sector played a reinforcing role. For this purpose, we basically rely on previous analysis by Blanchard and Giavazzi (2002), Zemanek, Belke and Schnabl (2009) and Berger and Nitsch (2010), among other authors referred to along the text.

Third, we compare the current account balances of euro area countries during the period 2000-2010 with their size of the non-tradable sector, which we calculate according to different methods by De Gregorio, Giovannini and Wolf (1994), Helpman and Krugman (1985) and Jensen and Klezter (2005). It comes out that almost all core euro countries with large current account imbalances exhibit either a surplus or a deficit depending on the size of the non-tradable sector. Hence, Germany and Finland have a relatively small non- tradable sector and a large current account surplus, while countries with a greater non- tradable sector run especially high deficits, like Spain, Greece and Portugal.

The last part ultimately addresses the adjustment process in Europe. We first describe the policy alternatives available for countries in difficulties, which, given the current circumstances, are confined to complying with the austerity measures decided by European leaders. Next, we analyze both short- and long-run adjustment of current account imbalances and identify ‘internal devaluation’ and structural reforms as the key aspects. In order to illustrate the role that the non-tradable sector size has for the adjustment process, we draw upon a model of Krugman and Obstfeld (2006) conceived for explaining the rigidities of the Bretton Woods system of fixed exchange rates. We slightly modify the model’s setup and perform and extended graphical analysis that includes the size of the non-tradable sector. Our modification of the model predicts that deficit countries with underemployment attempting to reach external and internal balance can reduce the ‘pain of adjustment’ by fostering the tradable sector to the detriment of an oversized, uncompetitive and low productive non-tradable sector.

I. Fixed exchange rates systems prior to EMU and resemblances

In many aspects, the current debate on the euro crisis shows great resemblances to bygone economic policy discussions arisen from of global imbalances and major disturbances of international monetary systems. The euro crisis itself may arouse a feeling of ‘déjà vu’ for anybody with a notion of economic history, and economists surely think back on the Gold Standard or Bretton Woods. Of course, the unique nature of the European Monetary Union (EMU) makes a big difference to past monetary systems. The disputes then were concentrated on exchange rates and troubles occasioned by maintaining them, yielding excessive in- and outflows of gold and/or currency reserves. Today nobody talks about currency reserves or gold in Europe,¹ and discussions are focused on fiscal issues and costs of financing instead. Yet these past conflicts have something critical in common with the ones European leaders have been worrying about during the last years, namely that they originated for a quite similar reason: the problem of maintaining external and internal balance without exchange rate policy as an adjustment tool. In this paper, internal balance primarily stands for full employment but also for price stability, where the former is the employment level whithout deviations from potential production and the latter means predictable inflation. For simplification, external balance connotes current account balance.

Before turning to the imbalances attributed to the introduction of the European common currency (second part), the following sections provide a historical background about the mentioned fixed exchange rate regimes that existed prior to EMU: the Gold Standard (1879-1914) and the Bretton Woods system (1958-1971)². Each of them stands for a different system of international fixed exchange rates: one is a gold and the other a reserve currency standard. These two predecessors are not just independent examples of former fixed exchange rate systems and can be considered as one single process in the history of EMU. In other words, all three systems are related and, regardless of their names, represent a single development. The Bretton Woods system tried to resemble the monetary order of Fixed exchange rates systems prior to EMU and resemblances the Gold Standard and the virtues attributed to it during the years it worked well: fast industrialization and wide expansion of international trade. Later, the European Monetary System (EMS) was designed to deepen economic integration and was driven by the inertia of Bretton Woods, despite its failure during the end of the 60s and early 70s. Having had their currencies pegged to each other first, and fluctuating within a margin later, had shown European countries the way toward a future monetary and political union (by now, only the first has been brought to fruition).

In what follows, the Gold Standard and the Bretton Woods system are described with a focus on the rigidities that arose in the face of particular disruptions of the equilibrium during both periods. The costs of dealing with these rigidities in terms of output losses and unemployment were the main cause for giving up the international monetary arrangements. A historical perspective with respect to the flaws of the systems may provide some insights about potential problems in the functioning of EMU and the adjustment process.

1. The Gold Standard

The Gold Standard can be described as the sequel of Bimetallism, a system where gold and silver were used for transactions under a fixed parity between both metals, also called ‘mint parity’. Bimetallism was abandoned during the nineteenth century, when Britain chose gold to the detriment of silver because alterations of the mint parity were a source of trouble and gold had a higher value.³ First Canada and later Germany, Japan, the ‘Latin Monetary Union’ (comprising France, Belgium, Italy and Switzerland), and the U.S. followed Britain in the adoption of the Gold Standard by the end of the 1870s. By then, Britain was already the leading nation and had the largest share of world trade (Officer 2008a, 2008b). London became the monetary center of the industrializing world, although a leading country and a reference currency are not necessary under a gold standard (Krugman and Obstfeld 2006). Indeed, the fact that the pound sterling actually became a reserve currency beside gold wrecked the automatic mechanisms of the system, as will be explained below (Burda and Wyplosz 2001).

Under the Gold Standard, each country tied its currency to gold setting fixed conversion parities, and their central banks issued coins and banknotes that represented the property of a certain amount of gold for the bearer. Conversion of issued money into gold and vice versa was unhindered to the parity adopted. Hence, a central bank had to hold (almost) the same quantity of gold reserves as the value of the paper money it issued in order to guarantee the parity. As long as gold parities remained unchanged, cross rates, the relative price of a currency in terms of another, could slightly fluctuate, but not as much as to cause arbitrage opportunities. Gains from arbitrage consisted of buying gold at the fixed parity in a country whose currency had lost value in terms of another currency; shipping the gold to the country whose currency had appreciated against the first; buying the appreciated currency with the gold; and finally, selling the newly acquired currency for a larger amount of the first currency (larger than the initial ‘investment’).⁴ Unless transportation and other transaction costs were less than gains from arbitrage, cross rates could fluctuate by a margin about one percent (Burda and Wyplosz 2001). If they deviated much more, arbitrage gains exceeded transportation costs, and buying and selling currencies generated depreciation and appreciation pressures, counteracting the initial deviations.

Automatic adjustment mechanisms of the Gold Standard did not just confine to holding exchange rates fixed, but also ensured external balance. Nowadays external balance stands for preventing excessive surpluses and deficits in international payments. Since international payments imply multilateral transactions (bilateral in the simplest case), a country’s external balance depends on other countries’ positions. Back in times of the Gold Standard, an external imbalance meant too large in- or outflows of gold, for these were the counterpart of trade surpluses and deficits (this is why monetary authorities had to hold sufficient gold reserves). The forces that automatically led multinational transactions toward a balanced position were outlined by David Hume in his ‘price-specie-flow mechanism’ (Hume 1752). This principle described how a country’s gold-financed trade deficit implied a shrinking money supply that would raise interest rates and reduce price levels in that country (due to the depressing effect of higher interest rates on economic activity). Lower prices and higher interest rates had two consequences: a gain in competitiveness and a capital inflow, respectively. Higher competitiveness tended to reduce the trade deficit, while the capital account surplus financed part of it, so that less gold shipments were needed. A country with a trade or a current account surplus encountered the opposite situation and thus tended toward balance in a quite automatic way as well.

Although the system was supposed to operate well in theory, there were three important failures that are relevant for our argumentation. First, the problem of the pound sterling becoming a reserve currency is closely related to the one faced by the U.S. dollar during the Bretton Woods years. Another dysfunction is attributed to a lack of international policy coordination and could be very well applied to the imbalances of the euro zone today. The third flaw is the most important of all three and was already mentioned at the beginning of this part: the costs of maintaining external balance in terms of internal disruptions, especially amid economic slowdowns. It seems historically evident that this has become a ‘chronic pathology’ of fixed exchange rate systems, since it manifested itself again during the Bretton Woods period and is actually a central topic of discussion in the euro crisis.

Regarding the first isssue, the leading role of the pound gave Britain the power to issue sterling-denominated debt, so it did not have to ship all gold reserves it should and thus escaped the price-specie-flow mechanism. Foreign countries’ desire to hold sterling assets meant that Britain could finance increasing balance of payments deficits through liabilities; liabilities that eventually exceeded gold reserves (Burda and Wyplosz 2001). One might guess that this would have inevitably led to a massive confidence problem, and that fear of a pound devaluation against gold (and thus against all currencies) would have triggered a balance of payments crisis similar to those during the 60s and early 70s, which are addressed later. In fact, economic intuition suggests that such a crisis would have occurred sooner or later if it had not been for something worse: World War I.

The second issue bears upon a term which was referred to by Keynes as “the rules of the game” (McKinnon 1993). Following these ‘rules’ meant that countries losing too much gold had to sell assets in order to reduce their money supply and raise interest rates. This led, just as explained above, to capital inflows. In theory, countries running surpluses and receiving gold would have done the contrary: buying assets with higher profitability than gold and experiencing a capital outflow due to lower interest rates. In practice, and here is the imperfection, surplus countries did not have as many incentives as deficit countries to follow the ‘rules’, since large gold inflows were not as bad as shrinking reserves.⁵ As Krugman and Obstfeld (2006, p. 493) explain: “By not always taking actions to reduce gold inflows, the surplus countries worsened a problem of international policy coordination”. The problem was a ‘run for gold’ by deficit countries to the detriment of internal objectives, since the only way to cut gold outflows was using contractionary fiscal and monetary policies. These policies curtailed inflation but were detrimental to employment. In the fourth part, this issue is compared to claims for higher inflation in Northern Europe so as to partly relieve deficit countries of output and employment losses.

This leads back to the above-mentioned main flaw of the system: the major pain of adjustment for deficit countries within a monetary system where devaluation is not an option (unless they leave it). In the following, while the Bretton Woods system is outlined, it can be kept in mind that in the Gold Standard “it was the deficit countries that bore the burden of bringing the payments balances of all countries into equilibrium.” (Krugman and Obstfeld 2006, p. 493) This asymmetry is a key insight, for it recurs in the Bretton Woods system, but is also perfectly applicable to the current debate on the euro crisis. However, before discussing Bretton Woods, the Interwar Period (1919-1939) is briefly outlined.⁶

2. The new Gold Standard and the Great Depression

The period between the two World Wars was important for setting the international monetary system after 1945, for it drove the will to consolidate international monetary policy cooperation. The experience had shown how merciless ‘beggar-thy-neighbor policies’ could be for all economies.⁷ These policies were a result of countries desperately trying to hang on to the new Gold Standard while going through economic stagnation.

After World War I and some years of free floating exchange rates, industrialized countries gradually adhered to the new Gold Standard, but not without difficulties. Due to price increases during and after the war (e.g., hyperinflations in Germany and France) practically all nations undertook deflationary policies in order to return to the pre-war gold parity. Yet the old parity was not truly determined by fundamentals and currencies like the pound sterling were overvalued.⁸ In practice, such a misalignment meant “a depressed export sector and chronic balance-of-payments difficulties” (Officer 2008b), not to forget additional contractionary policies for holding the gold parity that harmed employment.

The new Gold Standard was deprived of its automatisms. Convertibility to gold was not always guaranteed and minor countries increasingly held pound and dollar reserves. At the same time, gold hoarding and sterilization practices like those prior to the war were very common. Given this setting, a widespread severe economic downt urn like the Great Depression, starting at the end of 1929 and lasting several years, represented the ‘coup de grâce’ for a world economy that was already going through a period of slow economic growth. Bank failures soon prompted confidence loss and holders of sterling-denominated assets quickly tried to convert them into gold (not only investors, but also central banks). Britain suffered an important gold drain before suspending convertibility in 1931. The pound was allowed to float freely and to depreciate. Since a depreciation implies an appreciation elsewhere (in this case practically everywhere), many countries devalued, in order to protect their currency from appreciating. The U.S. even enforced a gold embargo on gold exports in 1933. ‘Beggar-thy-neighbor’ policies in the form of competitive devaluations triggered a tariff war, which yielded an enormous detraction of international trade, shown in Kindleberger (1973)’s famous illustration.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2. World trade desintegration during the Great Depression (1929-1933)

Source: Kindleberger (1973). Numbers expressed in millions of US dollars.

The gold standard was definitely over in 1935, when the last ‘resistant’ countries of the monetary system, the ‘gold bloc’ (Belgium, France, Italy, the Netherlands, Switzerland and Poland, among others), abandoned it. Autarky had become the ‘least bad’ option for dealing with the trade-off between external and internal balance.

The important lesson of this period complies with the one of the previous section: the negative effects of giving priority to external balance over internal objectives. It becomes evident by comparing the countries that first abandoned the Gold Standard with those that obstinately tried to keep the gold parity. Contrasting their recovery performance regarding the stagnation after the Great Depression shows that the majority of the ‘gold bloc’ suffered much greater inflation and output losses (Eichengreen 1992; Bernanke 1993).

3. The Bretton Woods System

More than a year before the end of World War II, experiences from the Gold Standard encouraged world leading nations in the Bretton Woods conference (July, 1944) to settle the mainstays of the new international economic and monetary framework that would follow after World War II. This framework was supposed to overcome the main flaw of the preceding monetary system and enable the preservation of “external balance and financial stability without sacrificing internal policy goals” (Krugman and Obstfeld 2006, p.497). At the end of 1945, 29 member countries formally constituted the International Monetary Fund (IMF) as the institution on which the monetary system would center.⁹

The monetary system was a ‘reserve currency standard’, where the U.S. dollar was fixed to gold and the rest of the currencies were fixed to the dollar. This meant implicit gold exchange parities for all currencies and cross rates between them. There was an automatic mechanism equivalent to the Gold Standard with regard to the role of arbitrage as a market force making sure that deviations in cross parities rapidly returned to their initial values. Designating the dollar as reserve currency was partly because the U.S. held about 70% of global gold reserves (Burda and Wyplosz 2001). As a consequence, reserves of all other central banks did not primarily consist of gold any more, but mainly of dollar balances.

Regarding the ‘engine’ that should make the whole system operate optimally, the IMF as a supranational institution represented both discipline and flexibility, for it was precisely the lack of these two principles that had led the world economy to the brink of ruin. The former should keep countries from ‘beggar-thy-neighbor’ behaviors, while the latter had to ensure countries that had excessive difficulties in achieving external balance an alternative way of adjustment other than paying with unemployment. Concisely, simultaneous achievement of both principles was brought about as follows: countries that had financially contributed a fund (therefore the name), could not alter the exchange rate without the IMF’s approval, while in cases of ‘fundamental disequilibria’ (structural), parities could be realigned and funds could be provided as financial support if necessary.

As before, the purpose of this section is to draw conclusions about the collapse of the system in order to identify inherent flaws of fixed exchange rate regimes, rather than expounding its whole ‘modus operandi’. Still, the collapse of the Bretton Woods system deserves an expanded view at the main drivers for its failure so as to be able to understand the nature of the system’s drawbacks and find connections to the euro. It becomes evident that those drivers were interconnected and reinforced each other’s effects, while the underlying dilemma between external and internal balance remained.

The major flaw of Bretton Woods was so obvious that it was already foreseen in 1960 by Robert Triffin, who noted that foreign central banks’ dollar holdings growing faster than U.S. gold reserves would inevitably outgrow these (reserves). At this point, mass conversions of those assets to gold would be unleashed as soon as asset holders became aware that the U.S. was no longer able to redeem all claims into gold at the fixed parity (Triffin 1960). Indeed, liabilities outgrew U.S. gold reserves by 1964 (Burda and Wyplosz 2001) and Triffin’s predicted run for gold was a latent risk that, in principle, should have constrained U.S. external policy from the beginning. However, the only way that the Federal Reserve could provide foreign central banks with their demands for liquidity was persistently running balance of payments deficits, which paradoxically should have undermined confidence in the dollar as the anchor currency of the system (Frank 2003).¹⁰

At the same time, the mechanism ensuring external balance was a ‘double-edged’ feature. On the one hand, countries tried not to exhibit too large current account imbalances, so that the IMF did not suspect a ‘fundamental disequilibrium’ and urged for currency de-

/revaluation. On the other hand, even cyclical deficits (rather than surpluses) were enough to fuel speculation about a possible intervention of the IMF, currency devaluation and hence losses of deposits’ value in that currency. Capital outflows consonant with these expectations would then require selling of foreign reserves, making it increasingly difficult for monetary authorities to maintain the parity pegged to the anchor currency and eventually forcing devaluation. Balance of payments crises (an example of self-fulfilling expectations) were continually present during the 60s and 70s; the most severe hit Britain between 1964 and 1967 after a “record British trade balance deficit” in early 1964. (Krugman and Obstfeld 2006, p. 501) After Britain had tried to hold the parity and to oppose devaluation, again at the expense of employment and deflationary policies, the pound was finally devalued (followed by a devaluation of the French franc and a revaluation of the German mark). As a result, even more pressure was put on the dollar (partially shared with the mark), i.e., more dollar balances were demanded as a ‘safe haven’ despite Triffin’s insight.

Not only were the two theoretical solutions for curtailing the dollar’s pressure unfeasible (either discovering more gold or reducing foreign demand for dollar balances), U.S. policy during the 60s aggravated the situation and is commonly viewed as the main responsible for the collapse of Bretton Woods (Garber 1993). First, fiscal expansion chiefly due to the Vietnam War and social programs (‘Great Society’) not only yielded economic growth, but also higher inflation and a steady deterioration of the current account surplus. Furthermore, in order to foster the construction industry, the Federal Reserve took “a much more expansionary monetary course in 1967 and 1968.” (Krugman and Obstfeld 2006, p. 507)

But if the U.S. was part of a fixed exchange system, why could it conduct monetary expansion? Actually, any other country within the system attempting to increase its money supply at a higher rate than the rest would have found it to be ineffective. The interest rate differential would have led to a currency depreciation and the central bank would have had to sell foreign reserves (thus decreasing the monetary base) in order to maintain the exchange rate. Yet, the U.S. had a privileged position by virtue of the dollar as the ‘Nth currency’.¹¹ So when the U.S. expanded its monetary base, all exchange rates based on the dollar tended toward appreciation (again via interest rate differentials), and countries had to expand their monetary supplies as well in order to detain those trends.¹² Inflation was imported as a consequence of renouncing monetary policy, which is necessary in fixed exchange systems. This, together with other political actions irrelevant for the exposition, induced protests against Bretton Woods and the ‘privilège exorbitant’ of the U.S.¹³ Perhaps partially as a protest gesture, France persistently purchased massive amounts of gold from the U.S. during several years in the mid-60s (Obstfeld and Rogoff 2005).

Not surprisingly, speculators anticipated a rise of the gold price and began to redeem dollars for gold as well. In order to prevent U.S. gold reserves from evaporating, countries from the ‘Gold Pool’ (U.S., U.K., West Germany, Italy, Belgium, Switzerland and the Netherlands) agreed on trading gold among themselves at the official parity and on allowing the gold price in the private market to fluctuate. The result was a sky-rocketing gold price in the private market, as can be observed from the next figure.

Abbildung in dieser Leseprobe nicht enthalten

Figure 3. Gold price in the private market during Bretton Woods (1960-1975)

Source: Garber (1993). Numbers expressed in US dollars per ounce of gold.

In theory, one of the virtues of the Bretton Woods system was that it naturally constrained global monetary growth. However, first U.S. policies and later the separation of official and private gold markets substantially eliminated this natural constraint, so that inflation started to grow. The economic downturn of 1970 temporarily prevented inflation from soaring excessively, but the outburst of the ‘Oil Crisis’ in 1973 released the consequences of a too loose monetary policy, as can be realized from the following illustration.

Figure 4. Inflation for selected group of countries during Bretton Woods (1960-1975)

Abbildung in dieser Leseprobe nicht enthalten

Source: OECD, Key Short-Term Econ. indicators, own construction. Average annual growth of CPI.

The mentioned recession of 1970 and rising unemployment in the U.S. placed American leaders in a dilemma. One option was to lower prices at home combined with higher inflation abroad, meaning the ‘usual’ submission of internal balance. The other was to devalue the dollar against all other currencies.¹⁴ The first would have been too painful in terms of additional unemployment, not to mention the probable unwillingness of other countries to suffer higher inflation (since that would have hurt their trade balance).¹⁵ Consequently, the second option was chosen but implied negotiating new parities with each country. Again, speculators anticipated this and begun to sell dollars on a large scale.¹⁶ Partly for stopping the gold drain, partly for exerting pressure on countries reluctant to revalue their currency against the dollar, the U.S. suspended convertibility of the dollar to gold during the summer of 1971; an event that became to be known as ‘the Nixon Shock’. Furthermore, the U.S. imposed restrictions to trade until the international community agreed to revalue their respective currencies against the dollar in the Smithsonian Agreement (1971), whereas gold convertibility was never again resumed.

The realignment only lasted a little more than a year and further speculative attacks on the dollar during the first months of 1973 yielded an additional devaluation of the American currency. By March of the same year, all major currencies were floating against each other with the exception of European currencies, which were mutually pegged to each other under the ‘Snake’. This arrangement allowed for a 2.25 percent fluctuation margin and later evolved into the Exchange Rate Mechanism (ERM) when the EMS was established in 1979.

The scope of this paper does not cover the whole creation process of EMU, the third step toward European monetary unification; nevertheless the previous stages should be outlined. In the early 90s, financial liberalization culminated in the creation of the common market that had started with the European Coal and Steal Community in 1951. From then on until the introduction of the euro in 1999, convergence took place with regard to macroeconomic policies and exchange rates in accordance with the ‘Maastricht criteria’ for joining the euro.¹⁷ Although there was convergence in many aspects, even before the introduction of the euro other macroeconomic imbalances arose, specifically in the trade and the current account. Berger and Nitsch (2010) show how trade imbalances reemerged in the mid-90s after having grown during the Bretton Woods era and then having declined once the system was abandoned.¹⁸ It is these imbalances that are of particular concern and therefore addressed in the next part. The last part of the paper covers their correction.

II. The generation of European current account imbalances

Since the mid-90s, current account imbalances have grown in the euro area (EC 2009), coinciding with the years previous to the adoption of the euro. It can be inferred from the previous part that this kind of external maladjustment is characteristic of fixed exchange rate systems, a view supported by Berger and Nitsch (2010). The following figure shows the steadily diverging current accounts of three groups of countries within the euro area and indicates the years of the different stages of EMU at the end of the first part.

Abbildung in dieser Leseprobe nicht enthalten

Figure 5. Current account balances of Northern and Southern euro area (1976-2008)

Source: Jaumotte and Sodsriwiboon (2010). Northern euro area (NEA) comprises: Austria, Belgium, Finland, France, Germany, Ireland, Luxembourg and the Netherlands. Southern euro area (SEA) comprises: Greece, Italy, Portugal and Spain (SEA-4) and Cyprus, Malta and Slovenia (SEA-3).

The monetary union has had a double effect on diverging current accounts. On one side, similar to the rapid integration of financial markets during Bretton Woods, free capital movements provided easy access to financing (in the form of lower interest rates) for catching-up Southern European countries (Jaumotte and Sodsriwiboon 2010).¹⁹

[...]

---

¹ Barring concerns about actual Germany’s gold reserves, brought about by the German deputy Peter Gauweiler (CDU/CSU), who in November 2010 formally asked Parliament to count the country’s gold stocks (Bundestag 2010). A week before, former World Bank President, Robert Zoellik, had argued for a new gold standard in an article written for the Financial Times (Zoellik 2010).

² 1958 and 1971 are taken as references. The Bretton Woods conference took place in July 1944, but convertibility in most European countries was not restored until 1958. 1971 is taken as reference ending year because of the ‘Nixon Shock’ (August 15th, 1971) referred to later. There is no official ending date, since countries gradually left the arrangement while others made efforts to maintain the exchange rate.

³ Troubles refer to Gresham’s Law, which states that if the price of one metal in terms of the other increases above its mint parity, the more valuable metal, here gold, tends to disappear from circulation (Officer 2008a).

⁴ Note that the essential principle behind the business is buying cheap and selling expensive.

⁵ Surplus countries sometimes tried to accumulate even more gold by selling assets instead of buying them just as the ‘rules’ dictated, an operation that ‘sterilized’ gold flows. See Bloomfield (1959).

⁶ Certainly, the Interwar Period begins in 1918, but the new monetary order begins with the elimination of the U.S. gold embargo and its effective return to gold in 1919.

⁷ The term ‘beggar-thy-neighbor’ was coined during the years after the market crash in October 1929 by the press, plausibly named after the British card game ‘Beggar-My-Neighbour’ (Gower 1932).

⁸ Instead of a realistic calculation, Churchill argued for a pre-war parity aimed at reinforcing “world confidence in the stability of Britain’s financial institutions”. (Krugman and Obstfeld 2006, p. 497)

⁹ The World Bank and the General Agreement on Tariffs and Trade (GATT) were two further institutions that emerged from the cooperation movement (the GATT in 1947). The former had the goal of restoring warruined territories and the latter aimed at reducing barriers to trade built up before the war.

¹⁰ ‘Triffin’s Paradox ’ reflects that central banks kept demanding and accumulating dollar balances due to growing balance sheet needs, apparently without anticipating eventual non-convertibility in the medium run.

¹¹ In a system with N currencies, N-1 currencies are pegged to the Nth, which in turn is only coupled to gold.

¹² Note that the U.S. was in fact only responsible for the gold-dollar parity, for which there were no direct effects of a monetary expansion for the remaining exchange rates

¹³ According to Obstfeld and Rogoff (2005), the term “privilège exorbitant” is commonly but wrongly attributed to the former President of the French Republic, Charles de Gaulle.

¹⁴ Both are ways of restoring external balance via competitiveness gains, which are in turn achieved through depreciation of the real exchange rate, which is defined as domestic prices in terms of foreign prices.

¹⁵ Note the similarity to the current debate concerning adjustment in the euro area specified in the fourth part.

¹⁶ Note the clear parallelism to the gold drain faced by Britain before suspending convertibility in 1931.

¹⁷ These criteria imposed maximum levels of government deficit, public debt, inflation and long-term nominal interest rate, as well as exchange rate stability.

¹⁸ Berger and Nitsch (2010) measure trade imbalance as the difference between a country’s exports and its imports over its total bilateral trade against relevant trade partners and calculate the average.

¹⁹ As noted by Jaumotte and Sodsriwiboon (2010), talking about Southern or Northern Europe is of course a simplification. Exceptions are Southern countries with moderate deficits like Italy, Malta or Slovenia, and Northern countries like Ireland, which showed large current account deficits before the 2008 crisis outburst.