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Volume XXXIII No. 2 (April-June 1998)
The Impact of the Euro on the International Monetary System
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By Robert A. Mundell
The European Council met in London on the first of May 1998 to announce the final decisions regarding the countries that are eligible to proceed to European Monetary Union (EMU). The next day, the selected countries met in Brussels to make the decisions required to implement the decisions. The six executive directors of the European Central Bank (ECB) were appointed, including the president and vice president, and the designated countries will lock exchange rates by 1 July at the latest, and the ECU will become the euro on 1 January 1999. On this date, the process of replacing national currencies by euros within banks will begin. On 1 January 2002, the circulation of euro banknotes and coins will begin, to be completed within six months, when the legal tender status of national banknotes and coins will end.
By the middle of 2002, the technical transition will be complete. By this time a substantial degree of centralisation of foreign exchange reserves will have taken place and monetary policy will be governed by the ECB, on behalf of the European System of Central Banks. The national central banks will then be relegated to much the same position as the twelve Federal Reserve District Banks of the Federal Reserve System of the United States. From that date hence, the monetary histories of the member European states will end and the history of the core of the European Union as a single monetary entity will begin.
Eleven countries out of the fifteen members of the EU will proceed to EMU. The UK, Sweden and Denmark have exercised their right to opt out or delay entry. Of the other twelve, all have achieved the crucial deficit convergence condition of 3 percent of GDP except Greece. Of a total EU population of 375 million, the EU-11 will total 293 million; of an EU GDP of $8.4 trillion, the EU-11 GDP will be $6.6 trillion. 1 When, as can be forecast, all members of the EU have joined EMU, it will represent a single-currency area that is fully the equal of the United States, and as the EU expands to the south and east, it will become substantially larger.
The introduction of the euro will mark an important turning point in the international monetary system. It will certainly be the most important change in it since the advent of flexible rates in 1973 and since President Richard Nixon took the dollar off gold in August 1971. But its significance is even deeper. The collapse of the Bretton Woods arrangements altered the modus operandi of the exchange system, but it did not change the power configuration of the international system: both before and after 1971, the dollar was the dominant currency. The introduction of the euro, on the other hand, will change the status of the dollar in the international monetary system and alter the power configuration of the world monetary system. In this sense it will be the most important development since the dollar replaced the pound sterling as the dominant currency in the First World War.
The euro will create an alternative to the dollar as the main standard of value in the international monetary system and vie with the dollar for seigniorage in the reserve currency market. It will also become a viable alternative to the dollar as an anchor currency. A decade from now the international monetary system will look very different. This article will try to assess the long-run effects of the euro on the international monetary system and its impact on financial markets during the transition.
The Pound and the Dollar
Epochal events such as the introduction of the euro must be appreciated in the panorama of monetary history. The world economy has always been in need of a currency for international transactions and in the absence of an official world currency, the void has usually been filled by the currencies of the greatest powers in the period of their ascendancy. Two main factors operate to make a currency dominant: its stability and the size of its transactions area. Shekels of Babylon, darics of Persia, drachmas of Athens, staters of Macedon, denarii or aureii of Rome, dinars or dirhems of Islam, maravedis of Spain, deniers of the Carolingian, florins, ducats and sequins of the Italian states, scudos of Spain, thalers of Austria, livres and francs of France, pounds of England and dollars of the United States have each successively been widely used as international currencies. In our own times, the pound sterling and the dollar have been great international currencies. For future reference, it is important to note that all these important international currencies were either metallic or backed by gold or silver.
The pound sterling goes back to early England, but it was in the reign of William III that the Bank of England was established and gave English finance that flexibility that made it the dominant international currency when Britain reached its ascendancy in the nineteenth century. The pound, however suffered a jolt with World War I, at a time when its successor, the dollar, was waiting in the wings. After World War II, the Bank of England was nationalised, Britain’s empire fell away and monetary policy fell victim to the Phillip’s Curve. 2 Elizabeth I had a more stable monetary policy than Elizabeth II.
Both size and stability factors made the dollar dominant. Already by the 1870s, the US was the largest economy in the world, and by the outbreak of the First World War, its GDP was more than thrice its nearest economic rivals, Britain and Germany. The inter-war weakness and instability of the pound reinforced reliance on the dollar. After the Second World War, the transition had become complete and in the postwar decades, the dollar achieved a position in world finance unrivalled in monetary history.
Anchored to gold, the dollar presided over an era of remarkably low unemployment, high growth and price stability, a great period that stands out in its performance characteristics far above the preceding period in the 1930s or succeeding period in the 1970s. Nevertheless, fault signs began to appear in the international monetary structure as early as the 1950s. Although the architects of Bretton Woods had tried to create a symmetrical structure, in reality it was dramatically asymmetrical with respect to the role of the dollar: other currencies were linked to the dollar and only the dollar was linked to gold. Equilibrium in the system required a correct relationship between gold and the dollar. But wartime price increases had made gold, the price of which had been set in the 1930s, undervalued. It was just a matter of time before the United States would no longer be able to convert dollars into gold at $35 an ounce for foreign monetary authorities. By the early 1960s, the United States had lost half its gold reserves to European countries. Inevitably, the dollar became inconvertible: when the dollar left gold in 1971 other currencies left the dollar.
US and World Inflation
The severing of the link to gold and the movement to flexible exchange rates did not prove to be a forward step for the world economy; contrary to the predictions of its advocates, 3 flexible exchange rates did not reduce the need for international reserves, lead to the elimination of controls, reduce unemployment, or preserve price stability. In the 1970s, the world economy moved toward stagflation, with high and rising unemployment, and an outbreak of inflation unprecedented in world history.
Freed from the “albatross” of gold, US monetary policy became more inflationary. Freed from the discipline of convertibility into the dollar, the other countries also inflated. Left untended, the Eurodollar market exploded: from less than $10 billion in 1968, it would top $10 trillion three decades later. 4 Gold and oil prices soared, huge oil deficits were financed through the Eurodollar market, and inflation, acting on progressive tax schedules, shifted taxpayers into higher brackets, increasing unemployment. High inflation and the falling dollar in the late 1970s drove Europeans into the creation of the European Monetary System (EMS) as a defence against the dollar.
A major objection to the dollar as an international currency had been that it gave the United States a power and income that other countries did not have. Even in the absence of inflation, the larger European countries were vexed under what General Charles De Gaulle, in his prickly attacks on the dollar in the 1960s, called that “exorbitant privilege” by which dollar balances were used as international reserves, enabling the United States to finance what his advisor, Jacques Rueff termed a “deficit without tears”. Whereas other countries had to settle their deficits with owned reserves, the United States was enabled to settle its deficits with its own currency, an IOU of the United States, which, instead of being returned for payment, was added to foreign reserves. The gain the United States acquired from the use of the dollar as an international currency was a form of seigniorage or money tax.
Inflation aggravated the problem. When the US inflation rate went up, the real value of dollar balances went down. In order to keep the same real value of reserves or the same proportion of reserves to imports, countries would have to augment their dollar holdings just to stay level with inflation. The more US inflation, the more the rest of the world had to pay in seigniorage.
The problem could have been avoided if flexible exchange rates had made international reserves unnecessary, as—to repeat—its advocates had predicted. The seigniorage argument against the dollar would not have applied. But in fact world reserves exploded with flexible exchange rates and countries that did not maintain sufficient reserves suffered repeated crises and loss of sovereignty to the international organisation. It is no accident that the four Asian developing countries that escaped the worst of the current Asian crisis—China, Singapore, Hong Kong and Taiwan—had massive exchange reserves.
US Inflation, Debts and EMU
Not surprisingly, then, the impetus for a European currency to replace the dollar has been strongest when the dollar is in excess supply. Rising inflation and the weak dollar in the late 1960s led to the 1969 Hague Summit, which established formally the goal of monetary union; the weak dollar in the late 1970s provoked the Bremen Summit and the European Monetary System; and the weak dollar in the late 1980s led to the Delors Report, the substance of which was implemented by the Maastricht Treaty. By contrast, not much was heard about monetary union when the dollar was comparatively strong in the middle 1960s, the middle 1970s, and the early 1980s. If the strong dollar today weakens the argument for EMU, it nevertheless has the compensating benefit of helping the weaker European countries satisfy more easily their Maastricht convergence requirements.
Forces similar to those at work to undermine the dollar under the Bretton Woods arrangements act today to threaten the dollar in the future. In the postwar system, growing countries bought dollars to add to their reserves imposing on the US a balance of payments deficit. Despite flexible exchange rates the same tendencies persist in the present system but in expanded form. If, because of growth of outputs, countries want to add to their dollars or dollar assets every year, and buy these assets in the New York capital market, the capital inflow increases expenditure in the United States relative to its income and imposes a trade deficit on the United States. Since the late 1970s and early 1980s, the US trade deficit has continued to mount, building up a pile of international indebtedness that is unique not just in America’s history but in the history of the world.
The United States can take pride in recent economic performance. With the exception of a nine-month recession in 1990-91, the fifteen years between 1982 and 1998 have seen low inflation rates and continuous expansion producing no fewer than 38 million new jobs. This is more than the entire labour force of Germany! But it would be a mistake to ignore the downside of this period. In the same fifteen years current account deficits have exceeded $1.5 trillion, turning the United States from the world’s biggest creditor to its biggest debtor. When it ends, the Clinton-Gore administration alone will have presided over cumulative trade deficits of more than a trillion dollars.
Fundamental changes have occurred in the US economy in the past half century. In the 1940s, the United States accounted for over a third of the world’s output, was a large net capital exporter with a strong trade surplus, had an overwhelmingly strong reserve position with two-thirds of the world’s gold stock, and was by far the world’s largest creditor nation. A half century later, the United States accounts for less than a quarter of the world’s GDP, is the largest capital importer with a huge and seemingly chronic trade deficit, has negative net reserves, and is the world’s largest international debtor nation. Although more favourable demographics in the United States than in Europe or Japan may provide a temporary respite, the debt problems will one day come home to roost.
The Peter Principle, by which in a hierarchy every employee tends to rise to his level of incompetence, applies to the hierarchy of currencies. Like its predecessor the pound, the use of the dollar will increase until it is extended beyond the point of its utility. The time will arrive when the pile-up of international indebtedness—in itself a consequence of faith in the dollar—will make increased reliance on the dollar as the world’s only main international currency untenable. It would be rash to predict instability of monetary policy in the United States in this spectacular fifteen-year boom and while it is under the watch of Alan Greenspan, the chairman of the Board of Directors of the US Federal Reserve System. But the boom will not go on forever and when it ends, there could be a spectacular run on the dollar. The huge stock of international reserves held in dollars makes that currency a sitting duck in a currency crisis. It was no accident that the dollar fell to 79 yen in 1995 at the peak of the fallout from the Mexican crisis, wrecking havoc with Japan’s already distressed economy. The position of the United States as a the great debtor will eventually undermine the stability of the dollar as an international reserve currency.
A dollar-based system was inevitable in the early postwar years, when the rest of the world was still in a wreck and racked by instability. But with the soaring strength of Europe and Japan, sole reliance on the dollar as the main reserve, invoice and intervention currency presents risks that are no longer necessary. While the dollar will continue to be an important part of the international monetary system—and perhaps remain the most important part of it for years to come—it is no longer necessary or even healthy for the United States or the rest of the world to rely solely upon the dollar.
Four Options
What should other countries do in the world of a potentially unstable dollar? There are several options.
Historically, international monetary reform in the direction of a world currency is blocked by the presiding superpower. Nothing is more inevitable than self-interest. Britain in the nineteenth century rejected the reform plans put forward by France, a descending power, and the United States, an ascending power, mainly on the self-interested grounds that it would challenge the world role of the pound. Similarly, the United States in the twentieth century—in 1933, 1944 and 1973—blocked proposals for an international monetary reform that would clip the wings of the dollar. When the Special Drawing Right (SDR) was established, it had a gold guarantee; when the price of gold soared, the US and its allies insisted that the gold guarantee be removed.
Today, there is no prospect at all for a world currency. Any proposal for the establishment of, say the SDR as an international currency would in the past have been blocked by the United States. Now that the euro seems to be a viable option, it would be blocked by Europe. Europe would look upon a proposal for basic international monetary reform today as a mere ploy to undermine or pre-empt the euro.
Unfortunately, it would not have the multilateral patina of the IMF that the postwar system had. It would be rejected by many of the larger countries unless the US committed itself to some form of convertibility—which, judging from recent decades, the US would reject. Unless the United States could develop institutions for internationalising a dollar-centred currency area—with a commitment not to block funds for political reasons—a dollar standard would be unacceptable to many countries.
A system of currency areas—optimal or not—is the likely outlook for the world economy in the next few decades. There is and will always be for the foreseeable future a dollar area. Nearly a fait accompli is the euro area. It is also likely, however, that additional currency areas will develop on the other continents. A Japan-led currency area in Asia is a distinct and imminent possibility when or if the United States withdraws its objections to it. In the long run, however, the inefficiency of these arrangements will make themselves felt and there will be a return of interest in a global international unit of account.
A Dollar-Euro-Yen World
While other smaller countries might accept a fix to the dollar, such a solution has proved to be unacceptable to Europe. Unlike most of the other countries, Europe has an alternative. With the road to economic integration already paved, Europe needs only to put the finishing touches on its common market with a common currency. With eleven countries set to join, the stage will be set for a single currency area that can be a worthy alternative to the dollar.
The introduction of the euro would at once make it the reserve currency of choice for a large number of countries connected in trade and finance with Europe. Diversification from the dollar to the euro would begin once confidence in the policies of the new European Central Bank have been established.
This attractive new option would be of enormous advantage to other countries in the event that the dollar again becomes unstable, and especially for countries where political difficulties made a dollar fix unworkable. At first glance, the international monetary system would seem to be dominated by relations between the dollar and euro. Certainly these will be the two most important currencies, followed by the yen. The dollar-euro would surely be the most important exchange rate in the world, followed by the yen-dollar and euro-yen rates. 6
How such a tri-currency world would work out depends largely on relative market sizes. The size of a single currency area determines its liquidity. Obviously a currency that is money for 100 million people is much more liquid than a currency that is money for 1 million. Size is also important for a different reason. The larger the single currency area, the better it can act as a cushion against shocks. 7 If a shock such as German unification, manifested in a debt-financed increase in annual government spending and transfers of more than 150 billion DM, came close to destabilising the German economy, think of the effect of the same shock on a smaller economy. Alternatively, think how much more easily the shock would have been handled had there been a stable European currency in 1992!
From the standpoint of size, the outlook for the euro is very favourable. The EU-15 has a population of 375 million, and the EU-11, which includes those countries slated to enter EMU, contains 292 million people, somewhat larger than the United States; by comparison, Japan has a population of 125 million. At current exchange rates, the GDP of the EU-15 is running at the rate of $8.4 trillion, that of the EU-11, at $6.6 trillion. These compare to US GDP running at 8.5 trillion and Japanese GDP at 4.1 trillion. 8 All of a sudden, with or without the four countries that will not proceed to the first round, the EU becomes a player on the same scale as the United States. Over time, as the other countries join, as the per capita incomes of the poorer members of EU catch up, and as the EU expands into the rest of Central Europe, the EU will have a substantially larger GDP than the US.
The Big Three economies are about equally open, as measured by the ratios of exports or imports to GDP. Of course Europe is the most open economy if judged by the ratio of total exports or imports; the ratio of exports is around 30 percent. But for purposes of international comparison, it is necessary to net out intra-EU exports and imports. When that is done, the openness figures are remarkably similar, after making allowance for the large trade deficit in the US and trade surplus in Japan and the EU-15. The US ratio of imports to GDP is the highest, at nearly 11 percent; the EU-15 and Japan’s import ratios are substantially lower, at around 8 percent. With openness measured by exports, on the other hand, Japan’s and the EU-15’s ratios are around 9 percent, while the US’s is a little over 8 percent. 9 What emerges from these numbers is the significant fact that the three giant economies are all relatively closed, a fact that might lead to increased instability of exchange rates if any of the three regarded their exchange rates with benign neglect.
ECB Monetary Policy
The monetary policy planned for the EMU countries is clearly important. No currency could ever survive as an international currency with a high rate of inflation. The lower the rate of inflation, the lower the cost of holding money balances, and the more of them that will be held. In addition to a low rate of inflation, a stable rate is also desirable; since inflation and variance go hand in hand; much of the problem, however, is avoided if inflation is kept low.
Additional considerations are predictability and consistency in monetary policy. In a democracy, both are abetted by transparency. If the monetary authorities openly state their targets and their strategies for achieving them, the market and the critical public will be able to make their own judgements about inflation outcomes.
From the standpoint of sound monetary policy, the outlook for the euro is also very favorable. The Maastricht Treaty is unambiguous in making price stability the target of monetary policy; while the European System of Central Banks (ESCB) can and should assist the monetary union in carrying out its other objectives, it is forbidden to do so if such assistance would conflict with price stability. Monetary policy will not be used to reduce unemployment by “surprise inflation” or to inflate away embarrassing public debts.
There remains considerable discretion for the independent ECB. It will have to determine how price stability can best be achieved. The problem is complicated by lags in the effect of monetary policy. The best approach for a large economy like the EU is to target the inflation rate, formulating monetary policy actions on forecasts of inflationary pressures. Leading indicators that should always be taken into account include gold prices, other commodity prices, rates of change in the different monetary aggregates, the growth rate and bond prices. The most successful central bankers have been pragmatists. But there is no reason why an independent ECB cannot be as effective a body as the Federal Reserve System in the United States or the Bundesbank in Germany.
The Security Factor
Political stability is a sine qua non of monetary stability. That is why strong international currencies have always been linked to strong central states in their ascendancy. The EU cannot be considered a strong, central state. Indeed, it is hardly a state at all. Monetary union will change that somewhat, and will be a catalyst for greater political union, but political union is a long way down the road. In the meantime, will the fact that the EU is not a strong central state be a fatal weakness for the euro?
The answer is no—or at least, probably not. The state is needed to prevent civil war and inhibit invasion. Europe has already had more than its shares of civil wars, and one of the motives for European integration has always been to make intra-European war impossible. At the same time, the Cold War has ended, reducing drastically the external threat to Europe. Even so, the security of Europe is well attended to by NATO, the most successful military alliance in history. Allied with the military superpower, the prospects for peace in the next few decades are excellent. These factors greatly mitigate what would otherwise be a fatal defect.
The Fallback Factor
Historical analogies can be treacherous. Modern currencies differ from the great currencies of the past, which were all either gold or silver, or convertible into one or both of those metals. Unlike paper currencies, they had a fallback value if the state collapsed. If any of the Italian city-states coining the sequins, florins or ducats of the Middle Ages collapsed, the 3.5 gram gold content would always have a fallback value in metal. That does not hold for a paper currency. When, for example, the Confederacy collapsed in 1864, its notes became worthless. Until the advent of the dollar, there is no historical record of any fiat currency achieving international significance. But the dollar is the exception that makes the rule: it is itself a ghost of gold.
There is in this a lesson for the euro. In the event of a great war scare, and especially one that threatened the durability of the EU, there would be a run on the euro that would not be mitigated by any fallback value. A run would have a devastating impact on the bond market. Even the possibility of a run would make it difficult to float really long-term securities in euros.
It might be argued against this, that economies like Germany’s thrived even when it was on the front line of the Cold War. Yet two factors need to be understood. The first was the existence of NATO, which kept Germany under the security umbrella of the United States. The second was that Germany, like most of the other countries on the European continent, did not—or only rarely—issued debt exceeding 10-15 years. The substantial issues of long-term securities have been a phenomenon of the post-Cold War world.
Of course, the same qualification of the strength of the euro could be used to point up a potential weakness for the dollar as well. Total political and military security can never be assumed. Nevertheless, the US situation differs for several reasons: its currency has an old tradition; it is a military superpower; and, though a federation, it has a strong central government. The lesson in this for the euro is that the ESCB will need larger holdings of external reserves than otherwise or than the United States. Fortunately, the EU countries have dollars and gold in abundance and will therefore be able to meet any foreseeable contingency.
Debt and the Money Multiplier
Reference has already been made to the liquidity of the euro in connection with the size factor and the ability of the euro area to insulate itself against shocks. But there are other liquidity effects to consider. Monetary policy will have to take into account several liquidity effects associated with the introduction of the euro. First, there will be a once-off liquidity effect associated with the replacement of national currencies by euros. The replacement of the total stock of national currencies by euros will increase total liquidity. This is because a euro, with a larger transactions domain, will be more liquid than any of its component currencies. When, say 500 billion euros worth of national currencies are replaced by 500 billion euros, European liquidity will be increased just as if there had been a sudden increase in the European money supply. On this account, ECB monetary policy at the outset will have to be tight.
A similar effect will be experienced in the bond market. Like all assets, bonds have a liquidity dimension. Liquidity is measured by the ease with which an asset can be turned into cash without loss; it is inversely related to the cost of turning a bond into cash and then re-acquiring it. Bonds with a large market are more liquid than bonds with a small market. The re-denomination of national debts and corporate bonds from local currencies to euros will all of a sudden create a vast single market in Euro-denominated bonds, a bond market of the same massive scale as that of the United States. The liquidity of this debt will be much larger than the liquidity of the combined public and corporate debts now denominated in national currencies. The re-denomination of these national debts is bound to create a revolution in European and world capital markets.
How important is this liquidity effect likely to be? Some indication can be had by comparing the degree of securitisation in Europe with that in the United States and Japan, the two countries in the world with the largest bond market. Outstanding government and corporate bonds in the Big Three markets—taking the EU-15 as a single entity—amounted to just short of $40 trillion in 1995. Of this total, $12.5 trillion was accounted for by the EU-15, and the remainder of $27 trillion by the US and Japan together. 10 The liquidity of the EU-15 debt will be greatly enhanced by the adoption of the single currency.
There is a related issue. The superiority of the new facility—the ability to issue euro-denominated debt—will make larger issues cheaper and more attractive. But by how much would the market expand? One heroic (or crude!) way to estimate the potential increase is to compare ratios of outstanding bonds to GDP—securitisation ratios—in different countries. Using the outstanding-debt figures cited above for 1995, and taking the 1995 GDPs of the EU-15, the US and Japan as $8422 trillion, $7265 trillion and $5135 trillion respectively (remember these are translated into dollars at 1995 exchange rates), the securitisation ratios in the EU and the US + Japan come to, respectively, 1.5 and 2.18. 11 This is a remarkable difference and at least part of it can be attributed to the disadvantage the EU countries have up until now faced in their national currency bond markets. No doubt there will be some shift from the other markets to the European markets and also an increase in total outstanding issues in Europe. Outstanding bonds in the EU-15 in 1995 would have had to have been $6 trillion more to equal the ratio in the United States and Japan. The euro will create magnificent new openings until the market reaches maturity.
Another liquidity effect concerns the money multiplier. The money multiplier is the EU-15 money supply divided by the supply of euro currency outstanding. Obviously a considerable coordination problem is likely to arise because of different legal or practical reserve ratios in the different member countries. But a more serious problem is the creation of euro substitutes. Because the replacement of a national currency by the euro transfers seigniorage to the ECB, each country has an incentive to minimise the need for euros. This incentive exists even though it is weakened by the redistribution of ECB profits to the national central banks (NCBs). 12 What if the NCBs created a lender-of-last resort facility that enabled the banks to get by on a far smaller ratio of euros to deposit liabilities? The incentive for NCBs to do so may be eliminated for the most part by the provision by which their money incomes are earmarked for the general account and then “allocated to the national central banks in proportion to their paid-up shares in the capital of the ECB”. 13 There nevertheless remain opportunities for the private sector or another branch of the government to perform functions previously performed by the NCBs. The EU’s money multiplier will have to be watched closely!
Redundant International Reserves
Much more well-known liquidity effects will arise from the centralisation of international reserves. It is convenient to divide these reserves into three types: (a) foreign exchange held in European currencies, ECUs, IMF reserve positions and SDRs; (b) foreign exchange held in non-European currencies; and (c) gold. Foreign exchange held in European currency “may” be held and managed by the ECB. The ECB will also receive “up to an amount equivalent to” ECU 50 billion. The contributions of each member state will be fixed in proportion to its share in the subscribed capital of the ECB. 14
Reserve needs in Europe will be lower on two counts. First, once EMU is formed, intra-Union deficits and surpluses will be netted out and reserve needs for the Union as a whole will be considerably smaller than the sum of the reserve needs of individual members. If external (mainly dollar) reserves were at an appropriate level before the Union, they will be excessive after it. The same holds for gold reserves, of which the EU countries hold almost half the world’s monetary reserves—although here gold reserves could partially compensate for the absence of the strong central state. Any immediate action to dispose of the part of these reserves that is considered excessive would be damaging to exchange rate stability
Second, and in the long run much more important, the ESCB’s need for foreign exchange reserves will decline drastically once the euro is successfully launched. The euro will then become a reserve currency of choice for many countries around the world. Reserve currency countries have less need for reserves—especially if there is confidence in their monetary policy—because their own currency is liquid internationally; reserve currency status is a widow’s curse that keeps the owner in perpetual liquidity.
Apart from IMF positions and SDRs, EU-15 reserves at the end of 1996 amounted to 350.6 million ounces of gold (to which could be added 92.0 million held by the EMI). The other big holders were the United States with 261.7 million ounces, Switzerland with 83.3 million ounces, and the IMF with 103.4 million. These countries and institutions thus hold 891 million ounces or 80 per cent of the world total of 1,108.1 million ounces. Pooling all foreign exchange would give the ECB $387 billion, or 25.9 per cent of the world total of $1,498 at the end of 1996. This compares with the holdings of $209 billion in foreign exchange in Japan or about $300 billion in “Greater China” (China, Taiwan and Hong Kong). 15
The foreign exchange reserves would not seem so excessive (at least compared to the Asian holdings) were it not for the fact that the euro, as already mentioned, will itself become a widely-used international currency, conferring on the EU the “exorbitant privilege” of running a “deficit without tears”. China, for one, has already said it will hold part of its reserves in euros. Judging by the past experience of reserve centres, which have frequently got by on negative net reserves, Europe will be able to float its own IOU’s to pay for future deficits as they might arise. (At the end of 1996 the United States held only $36 billion in foreign exchange, hardly 2.5 per cent of the world’s foreign exchange reserves). It is therefore more than likely that there will be a glut of dollars that will have to be managed once the euro gets established. 16
To conclude, the liquidity factors suggest that monetary policy will have to cope with conditions of excess liquidity in the early years of the euro. Reserves of the ESCB will be more than ample; the liquidity of the euro will be greater than the liquidity of the national currencies it replaces; there will be a tendency for the money multiplier to increase; and the liquidity of bonds will be higher. To offset these factors the ESCB will have to plan on a slower rate of euro growth than would otherwise be necessary.
There is a danger for the United States as well. Any of the excess reserves held by the EU that get spent will create renewed dangers of inflation and currency depreciation in the United States, aggravating the exchange rate effects of the inevitable swing from the dollar to the euro. To the extent that the dollars come back home, the US will have to prevent them from causing renewed dangers of inflation.
The liquidity factors suggest that there will be excess liquidity in the transition phase that could lead to inflation. Over the longer run, however, this danger of inflation has to be set against the demand for euro reserves on the part of the rest of the world. There is bound to be a large and growing demand for euros to hold in central bank accounts that will eventually more than make up for inflationary liquidity factors inside Europe. Because the external demand will come at a later date, immediate policy will have to be conservative.
Transition Problems in the System
Although the euro will contribute to the stability of the international monetary system in the long run, it could present problems in the transition. A number of the effects that have to be considered have already been discussed: the once-off liquidity effect associated with the replacement of national currencies by euros; the increase in liquidity due to the replacement of national currencies by euros; the greater liquidity of euro bonds; the increase in the money multiplier; the extra liquidity associated with reserve pooling; redundant reserves of the ECB; and the use of the euro itself to finance deficits. Judging from the past experience of reserve centres, which have frequently got by on negative net reserves, Europe will be able to float its own IOU’s to pay for future deficits as they might arise. The liquidity factors suggest that there will be excess liquidity in the transition phase that could lead to inflation if these effects are not offset by restrictive monetary policies of the ECB.
Over the longer run, however, this danger of inflation will be mitigated by the demand for euro reserves on the part of the rest of the world. There is bound to be a large and growing demand for euros to hold in central bank accounts that will eventually more than make up for inflationary liquidity factors inside Europe. The new euro will create changes in currency preferences of central banks and other portfolio managers. Diversification effects are inevitable. Imagine the impact on exchange rates if new currency preferences were such that countries wanted to keep their official reserves divided equally between dollars and euros! The problem is magnified by the likelihood of a massive diversification into euro-denominated deposits in the off-shore currency markets and in the bond markets.
Both the EU and the United States would need to take strong defensive action to ease the transition. It may be necessary to create an institutional framework for dealing with the problem. A “Conversion Account” could be set up under the auspices of the IMF, authorised to accept deposits of gold or dollars or euros in return for credit balances denominated, perhaps, in Special Drawing Rights. With the replacement of the mark and franc, and eventually perhaps the pound by the euro, the SDR, of course, will have to be redesigned. It is at present a basket of five currencies with weights of 39 percent for the US dollar, 21 percent for the DM, 18 percent for the yen, and 11 percent each for the French franc and pound sterling. If the existing country weights were retained, the new SDR, assuming all three European countries entered the EMU, would have weights of 43 per cent for the euro, 39 per cent for the dollar, and 18 per cent for the yen.
The view advanced here is that a well-run monetary union encompassing most of the members of the EU today, and most of Europe in the future, will be of enormous benefit to the people of Europe and also to the people of the rest of the world, not excluding the United States. Members of the EMU will get not just a currency on a par with the dollar and the right to a share in international seigniorage, but also greater influence in the running of the international monetary system—much needed, if the fallout from the Asian crisis is a prevision of the future. The rest of the world will get an alternative asset to the dollar to use in international reserves and a new and stable currency that could be used as the focus for stable exchange rates or currency boards. The United States will get a needed respite from the eventually debilitating overuse of the dollar as an international currency and will find itself faced with a single currency continent that vastly simplifies trade and investment, as well as a strong partner in Europe with an equal stake in constructing an international monetary system suitable for the twenty-first century.
Robert A. Mundell is Professor of Economics at Columbia University and the 1997-98 AGIP Professor of Economics at the Johns Hopkins SAIS Bologna Center.
Endnotes
*: his article is a revised version of a paper presented at the conference on “The Euro and its Consequences for Europe, the International System and Italy”, organised by the IAI with the sponsorship of the Ligurian Regional Administration and the Cassa di Risparmio di Genova e Imperia, and held in Genoa on 20-21 March 1998. Back.
Note 1: GDP figures expressed in a common currency are subject to variation due to changes in exchange rates. The data used here have been drawn from IMF sources and converted at current exchange rates. They are intended to serve as representative approximations only, subject to revision. Back.
Note 2: The Phillips Curve, which portrayed the alleged trade-off between inflation and unemployment, became widely endorsed in policy-making in the United States and Britain in the 1970s until it came to be realised that it was unstable. Back.
Note 3: Milton Friedman, James Meade and Harry G. Johnson are only some of the important economists who advocated flexible exchange rates in the decades before the breakdown of the system. Back.
Note 4: “Eurodollar” deposits were until recently reported in the IMF International Financial Statistics under the category of Deposit Money Banks International Liability. Back.
Note 5: See J. J. Polak, “The Contribution of the International Monetary Fund” in A. W. Coats (ed.) The Post-1945 Internationalization of Economics, Annual Supplement to Volume 28, History of Political Economics (Durham, N.C. and London: Duke University Press, 1996) p. 221. Back.
Note 6: It would be a mistake, however, to neglect the role of gold. Gold is now the second most important reserve asset. Total above-ground gold stocks amount to, say, 110,000 tons, worth at $10 million a ton, $1.1 trillion. Financial authorities hold about a third of this—more exactly 1.1 billion ounces—worth $330 billion at $300 an ounce. EU countries hold 365.9 million ounces or 457.9 million ounces, counting gold held by the European Monetary Institute on their behalf. By comparison, the United States holds 261.7 million ounces. Soon enough, however, reserves held in euros may displace reserves held in gold. The future of gold reserves will depend crucially on the attitude taken by Europe, which will have a strong voice in determining the role played by gold in the future of the international monetary system. For original holdings of gold, see IMF International Financial Statistics Yearbook 1997 ; non-official holdings are estimates based on industry sources and personal estimates. Back.
Note 7: This idea can be seen in a formal model by examining how the slope of a national money demand curve changes when population and output are increased. The larger the country the flatter the slope and the smaller the change in the marginal utility of money corresponding to any given size of shock. Back.
Note 8: See, for example , WEFA Economic Outlook, February 1998. Back.
Note 9: Authors calculations. See IMF International Financial Statistics Yearbook 1997 for the basis. Back.
Note 10: For these figures, see W.Duisenberg, “EMU and the Financial Sector”. Inaugural lecture to the Leerstoel Generale Bank a the Katholieke Universiteit van Leuven, 5 February 1998. Back.
Note 12: Article 33 (1.b) of the Protocols and Declarations annexed to the Maastricht Treaty provides for the transfer of ECB’s net profits (except for a maximum of 20 percent transferred to the general reserve fund) to the shareholders of the ECB (i.e. the NCBs) in proportion to their paid-up shares. Back.
Note 13: rticle 32.5 of Protocols and Declarations.[http://europa.eu.int/euro/en/pap7/pap716.asp?nav=en]. Back.
Note 14: See Compilation of Community Legislation. [http://europa.eu.int/euro/en/pag716.asp?nav=en]. Back.
Note 15: See IMF International Statistics Yearbook 1997. Back.
Note 16: In this connection, a prominent member of the European Commission, Yves-Thibault de Silguy, after noting the large stock of European reserves, has commented as follows: “Some commentators have confidently asserted that the reserve markets will be flooded with surplus dollars. This is hardly a rational expectation! Central banks have just as much common sense as the markets. Who can seriously think they are unaware of the impact of their transactions on foreign exchange markets? If there indeed turns out to be a dollar surplus in European central bank coffers, that surplus will be absorbed in an orderly and gradual fashion so as to prevent any disruption of the markets.” Speech delivered at the Institution of International Finance, Washington, DC, on 29 April 1997 [http://europa.eu.int/euro/en/silguy3/silg3.asp]. Back.