The Euro Crisis From the Perspective of the Preceding Debates on Fixed versus Flexible Exchange Rates and the European Currency Union

Richter, Rudolf Article The Euro Crisis From the Perspective of the Preceding Debates on Fixed versus Flexible Exchange Rates and the European Currency Union Credit and Capital Markets – Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Richter, Rudolf (2013) : The Euro Crisis From the Perspective of the Preceding Debates on Fixed versus Flexible Exchange Rates and the European Currency Union, Credit and Capital Markets – Kredit und Kapital, ISSN 2199-1235, Duncker & Humblot, Berlin, Vol. 46, Iss. 1, pp. 13-27, https://doi.org/10.3790/ccm.46.1.13 This Version is available at: https://hdl.handle.net/10419/293698 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Preliminary Remarks To clarify right from the outset: The introduction of flexible exchange rates and the establishment of European Monetary Union are not the consequences of applying economic expertise. The first is a consequence of the normative power of facts: the breakdown of the Bretton Woods System in 1973; the latter a consequence of political wisdom or shrewdness: the Maastricht Treaty of 1992. All economists did was to provide the arguments to rationalize flexible exchange rates (after the breakdown of the Bretton Woods System) and its opposite (absolutely fixed rates) in the European Monetary Union. Both should be seen together. The debate on fixed versus flexible exchange rates had its impetus in Milton Friedman’s critique of the Bretton Woods System (Friedman (1953)). He argued that a system of flexible exchange rates would be “absolutely essential for the fulfilment of our basic economic objective: The achievement and maintenance of a free and prosperous world community engaging in unrestricted multilateral trade.” ((1953), 157) That was a revolutionary proposal at a time of foreign exchange control, of import restrictions, and of people still thinking in categories of the gold standard. To many, paper money seemed to be “unsuitable in the service of world trade”1 (v. Wieser (1927), 684). It was feared that flexible exchange rates would cause enormous exchange rate fluctuations – considerable over and under shootings of purchasing power parities (PPP). By con- * Revised and translated version of a paper presented in German at the Economic Research Colloquium of Professor Dinko Dimitrov at the Faculty of Law and Economics of the University of Saarland Feb. 27th 2012. I wish to thank Professor Kenneth E. Scott at Stanford Law School for his critical comments and corrections. 1 Own translation from the German. Credit and Capital Markets, 46. Jahrgang, Heft 1, Seiten 13–27 Abhandlungen OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 14 Rudolf Richter Credit and Capital Markets 1 / 2013 trast, Friedman was convinced that exchange rate speculation would limit exchange rate deviations from PPP (Friedman (1953), 175 ff.). II. Basic Arguments of the German Debate on Foreign Exchange Rates2 The three main German protagonists of the exchange rate debate were members of the Saarbrücken Department of Economics: Egon Sohmen (1961 / 1969) and Herbert Giersch fought vigorously for the introduction of flexible exchange rates, while Wolfgang Stützel (1960a) defended fixed exchange rates. The debate was driven by the concern of a further rise in West German inflation rates (it had more than doubled in 1960–1963 as against 1952–1959 (2.8 % compared with 1.26 %). The German Council of Economic Experts, of which Giersch was a member, supported flexible exchange rates and maintained3 that without a central authority fixed exchange rates would have disintegrating effects. Two years later, after Stützel had become a member, the Council of Experts published in its annual report Stützel’s idea of a “hardened foreign exchange standard” as part of his argument for absolutely fixed exchange rates.4 Yet different from the Bretton Woods Agreement, fixed exchange rates would have to have absolutely fixed upper and lower points of intervention and participating states would have to guarantee, without reservation, to exchange their money into as many units of foreign exchange (read US dollars) as corresponded to an absolutely fixed upper point of intervention. Moreover, member states would not be liable for the liabilities of other members – a no bail-out-clause as that of the later Maastricht Treaty. The no bail-out-clause together with the guarantee of full convertibility of national money into foreign exchange at a fixed rate would secure fiscal discipline among member states.5 As Stützel put it, his “hardened foreign exchange standard” would serve as “taskmaster of governments,”6 while flexible exchange rates would accelerate rather than decelerate the creeping inflation in Germany and possibly lead to an exchange rate war as in the 1930’s that resulted in a serious decline of international trade. Not surprisingly, Stützel argued early on for a common European cur- 2 Following Richter ((1999), 537). 3 SR JG 1964 / 65, 179. 4 SR JG 1966 / 67, 147. 5 SR JG 1966 / 67, 149. 6 Stützel ((1960, 1973), 95). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 The Euro Crisis 15 Credit and Capital Markets 1 / 2013 rency, so did also the German Council of Economic Experts (SR JG 1971 / 72). III. What Happened to the DM / $ Rate After its Release March 3rd 1973? Given imperfect foresight and the influence of a few great political players, and given transaction costs, the markets for foreign exchange deviate strongly from the classical ideal of perfect markets. Thus, what we observe are the results of a market whose forces are heavily polluted by effect of sunk costs of exporting firms,7 herd behaviour of investors,8 interventions of central banks,9 political manoeuvres of governments,10 etc. As a consequence, the control effect of purchasing power parity (PPP) on exchange rates – based on the law of one price – is considerably loosened, and the hoped-for stabilizing effect of exchange rate speculation may be impaired. The following graph shows development of DM / $ exchange rates during the first 14 years after the freeing of the DM / US$ rate on March 19th 1973. An appreciation of the DM was expected after the freeing of the DM / $ exchange rate in March 19th 1973 but not its heavily fluctuating downward movement to 1.71 DM / $ in Jan. 3rd 1980, followed by a steep increase up to 3.47DM / $ in Feb. 26th 1985, and then by a fast decline. The cause of the latter was the American pressure on major central banks to help reverse the enormous appreciation of the US Dollar: In their “Plaza Accord” the governments of France, West Germany, Japan, the United Kingdom had agreed with the United States to depreciate the US$ in relation to the Japanese Yen and Deutsche Mark by intervening accordingly in foreign exchange markets. The following decline of the DM / $ rate 7 Example: “… the foreign firms that entered the U.S. market when the dollar appreciated did not exit when the dollar fell back to its original levels.” (Dixit (1989), 620 on hysteresis of investments by foreign firms). 8 Shiller (2000); Stützel (1960, 1973) argued early on that exchange rates are to be seen as asset prices. 9 For a list of agreed upon Bundesbank exchange rate interventions (until May 1983), see the Annual Report of the Deutsche Bundesbank ((1983), 76–77). 10 Such as in the “Plaza Agreement” of September 22nd 1985 between the United States, France, West Germany, Japan, and the United Kingdom – or the “Louvre Accord” of Feb. 22nd 1987 between the G6. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 16 Rudolf Richter Credit and Capital Markets 1 / 2013 was stopped by the Louvre Accord of Feb. 22nd 1987 among the G 116.12 From then on the US dollar rate was roughly stabilized within the range of 1.40 to 1.80DM / $ until the end of the Deutsche Mark in Jan. 1st 1999 (its final mean value was 1.66DM / $)13. With the establishment of the European Monetary Union, foreign exchange movements lost much of its public interest. After the first five years of adaptive movements, the $ / € rate fluctuated within the range of 1.20–1.50$ / €, baring some outliers in 2008 (monthly average in Feb. 2012 = 1,32 $ / €). Agreements between main players may have continued to play a role. However, there was no currency war after the collapse of the Bretton Woods Agreement (as opponents of flexible exchange rates had feared), no worldwide inflation (so far at least), no downturn of world 11 Calculated by the West German Statistische Bundesamt, in relation to the American and the German commodity basket. 12 Group of the six leading industrial nations (Germany, France, Italy, Japan, USA, GB). 13 From Richter ((1999), 146). Source: Richter (1989, 276). The figure shows the daily averages of the spot DM / $ rate and the monthly averages of consumer price parity (Verbrauchergeldparitäten) between West Germany and the USA.11 In addition it shows the average value of these two parities. To simplify matters, take the average consumer price parity as a measure of purchasing power parity between the two countries. The actual exchange rate differs for long periods considerably from this “PPP”. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 The Euro Crisis 17 Credit and Capital Markets 1 / 2013 trade. Thus, flexible exchange rates did not cause the gloom and doom predicted by their opponents, probably not least because of the cooperative attitude among major Western industrial nations as compared with the period between the two Great Wars. IV. Contractual Preparations of the European Monetary Union (EMU) and Preceding Debate Between German Economists The debate on flexible versus fixed exchange rates was replaced by the debate on the pros and cons of a European Monetary Union (EMU), though the idea of introducing a common European currency was discussed more or less seriously within the European Economic Union since 1962. Yet after the official freeing of the US-dollar rate in 1973, the need arose for a stable accounting unit as basis for the annually renegotiated transfer payments within the European Economic Union. In 1988 Jaques Delors, the energetic president of the European Commission undertook to develop a much wider plan of a European Economic and Monetary Union.14 The plan was outlined in the Delors Report (Delors (1989)); it was soon elaborated in detail and passed by all EU member states, except Denmark and the United Kingdom, at Maastricht in February 1992. The European Monetary Union (EMU), as part of the Maastricht Treaty, was to be realized by 1999 at the latest. The Treaty was submitted to the national parliaments (the German Bundestag adopted it overwhelmingly in December 1992, the Bundesrat passed it unanimously), and entered into force on November 1st 1993. The euro [€] was introduced in January 1st 1999 as book money, and three years later in the form of cash (coins and banknotes). The preceding German debate among economists was much less analytically oriented than the earlier exchange rate controversy – an amazing fact given the seriousness of the planned enterprise. Among leading German economists favouring EMU were Peter Bofinger15 (Würzburg), Olaf Sievert (Saarbrücken), Rüdiger Pohl (Halle). Also the German Council of Experts supported EMU – albeit only “as a long-term goal” (SR JG 1989, 15). The scientific advisory council at the German Federal Ministry for Economics rejected the concern of various governments that EMU’s 14 The goal was a combination of European Union member states into a cohesive economic system, most notably represented with the adoption of the euro as the national currency of participating members. 15 A former student of Stützel. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 18 Rudolf Richter Credit and Capital Markets 1 / 2013 rules would infringe on their financial autonomy. The council argued that it would suffice to clarify that there was no joint liability of member states. The council followed Olaf Sievert who argued in the style of German “system policy” (Ordnungspolitik)16 that “fiscal policy of member states will be disciplined through the all-important fact that states have to pay back their debt with money, which they cannot produce themselves” (1997, 2; own translation).17 Thus, for Sievert the no-bailout rule of the Maastricht Treaty is essential and so argued De Grauwe (1996). Among leading German Euro sceptics or opponents were Manfred J. M. Neumann (Bonn), Renate Ohr (Stuttgart-Hohenheim, now Göttingen), Joachim Starbatty (Tübingen), Roland Vaubel (Mannheim), Rudolf Richter (Saarbrücken). Joachim Starbatty together with Wilhelm Hankel, Wilhelm Nölling and Karl Albrecht Schachtschneider submitted, albeit with no avail, a constitutional appeal against EMU at the German Constitutional Court (Frankfurter Allgemeine Zeitung, Jan. 13th 1998, 13). 60 leading German economists published a Memorandum on the planned European Monetary Union on June 11th, 1992.18 They questioned not only the effectiveness of the Maastricht criteria and the assurance of the independence of the planned European Central Bank, but also expressed their concern regarding the regional differences in productivity and competitiveness which could result in increasing unemployment.19 The significance of this memorandum was directly downplayed by two opinions: one by the chief economists of three major German banks (see Hrbek (1992), 161–164), the other by a group of European economists initiated by the European Investment Bank (loc.cit., 169–170). However, the “ideal” counterargument had been provided already by Delors (1989b). He simply compared the still rather loose European Union with already existing federal States like the USA or Switzerland: i. e., with political structures that had solved the problem of controlling the individual policies of their states or cantons. In fact, Delors’s paper is a rhetoric masterpiece that overshadows the very clear contribution (and correct predictions) by 16 In a speech of 1997; reproduced in Deutsche Bundesbank, Auszüge aus Presseartikeln Nr. 49, 3. Sept. 1997. 17 Note the similarities and differences to the above described Stützel’s “hardened foreign exchange standard.” 18 Published in Frankfurter Allgemeine Zeitung of June 11th 1992; see also Hrbeck ((1993), 159–161). 19 “As so far no agreement exists on the structure of a political union there is also no sufficient democratically legitimated regulatory system.” (Hrbek (1993), 160, own translation). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 The Euro Crisis 19 Credit and Capital Markets 1 / 2013 Doyle (1989) published in the same “Collection of papers submitted to the Committee for the Study of Economic and Monetary Union”20 of the material underlying the Maastricht Treaty. Shortly before its implementation 50 German professors of economics (among them the German Nobel Prize winner Reinhardt Selten) advocated the introduction of the euro. The central message of their appeal was: “The Euro must not fail on the deficit threshold” (of the Maastricht Agreement, see Manager Magazine, Sept. 1997). A couple of months later some 150professors of economics warned, “The Euro comes too early!” (Frankfurter Allgemeine Zeitung, Feb. 9th 1998, 15). Their main objection was that the Maastricht criteria for acquiring EMU membership and the control of fiscal discipline would be unconvincing. Apart from that, doubts were raised again as to whether all EMU member states would be able to cope with the sudden loss of the policy instrument of national currency depreciation. That would become a great problem for states with relative low labour productivity like Greece whose labour productivity is less than half that of the Federal Republic of Germany. The problem is best illustrated by the “disastrous results” (Karl Otto Pöhl) of German reunification, which drastically shows what “convergence” actually means.21 So much for the German debate. American economists criticized in particular that the territory of the planned Euro zone would not be an optimal currency area (Eichengreen (1990, 1993); Krugman (1993); Feldstein (1997); Mussa (1997); Friedman (1997)).22 Feldstein (1997b) questioned also the claimed peace-guaran- teeing function of the euro.23 On the other hand, Mundell (1997) ignored “his own” problem and favoured the establishment of EMU, as did Dornbusch (1997) and Kenen (1995, 1997).24 As for the British, Ralf Dahrendorf, in an interview with Der Spiegel (Dec. 11th 1995),25 expressed seri- 20 Thus Doyle ((1989), 74) writes: “For EMU to be sustainable, the economies of the countries forming the union must be similarly competitive or else some countries would be faced with the equivalent of a constant balance-of-payments-defi- cit which, in EMU, would be reflected in terms of stagnation and unemployment.” 21 See The Wall Street Journal, March 20th 1991, p. 11. 22 How right these authors were is confirmed by the economic experiences of the years 1999–2011 as Wynne / Koech ((2012), 2) show. 23 “Instead of increasing intra-European harmony and global peace, the shift to EMU and political integration that would follow it would be more likely to lead to increased conflicts within Europe…” Feldstein (1997b). 24 On this point and more see also Richter (1991b). 25 http: / / www.spiegel.de / spiegel / print / d-9247341.html OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 20 Rudolf Richter Credit and Capital Markets 1 / 2013 ous doubts about the viability of EMU, saying, i.a., “The European Currency Union is a great mistake, an adventurous and failed objective that will not unite but divide Europe.” (Own translation). There was no serious debate on the stability of financial markets in the EMU,26 and no debate at all on the national default of a member state and its possible effect on co-members. The analytical shallowness of the debate is amazing from the German perspective, because of Germany’s high specific investments in the brand name capital of its currency, the deutschmark, in comparison to the low international regard of some other EMU members’ former currencies (Richter (1991), 97). As argued above, the debate on EMU can be seen as an offshoot of the debate on fixed versus flexible exchange rates. Friedman, the leading protagonist of flexible exchange rates, admited that permanently fixed exchange rates, combined with unmitigated freedom of international payments, might be an attractive system – provided all countries submited their internal policy to external control. Really effective ‘coordination’ would require essentially either that nations adopt a common monetary standard like gold and agree to submit unwaveringly to its discipline or that some international body control the supply of money in each country, which in turn implies control over at least interest-rate policy and budgetary policy. … [He continues to ask] is it desirable that such far-reaching powers be surrendered to any authority other than an effective government democratically elected and responsible to the electorate? (Friedman (1953), 199) In other words, Friedman put his finger on the sore spot of any currency community. Amazingly, his name and arguments can hardly be found in the debate on EMU during the ’90s.27 A different way to look at EMU is from the perspective of New Institutional Economics as described by Williamson (1985) in his transaction cost approach. Following Trachtman ((2008), 17), it may be also applied to international contracts such as the European Union or EMU. 26 Apart from two IMF economists, Prati / Schinasi (1999), who studied the allocation of lender-of-last-resort and banking supervision responsibilities among the European Central Bank and the national central banks, the national supervisors, and national treasuries of the (at that time) eleven member countries. 27 See, e. g., the contributions published in Hrbek (1993). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12 The Euro Crisis 27 Credit and Capital Markets 1 / 2013 Zusammenfassung Die Euro-Krise aus der Perspektive der Debatten über feste versus flexible Wechselkurse und über die Europäische Währungsunion Die Entwicklung der Europäischen Währungsunion ist im Zusammenhang mit der vorausgegangenen Kritik von Milton Friedmans am Bretton Woods System zu sehen, die eine lebhafte Debatte zum Thema „feste versus flexible Wechselkurse“ auslöste. Die Debatte wurde kurz nach Zusammenbruch des Bretton Woods Systems von der Diskussion über die Wünschbarkeit und Realisierung einer Zone fester Wechselkurse innerhalb Europas fortgesetzt. Beide Debatten werden von uns skizziert und gezeigt, dass der Übergang zu einer internationalen Währungsgemeinschaft vertragsspezifische Investitionen erfordert, die einzelne Vertragspartei- en zu opportunistischem Verhalten einladen können. Genau das ist ein zentrales Problem der Neuen Institutionenökonomik vom Typ der Transaktionskostenökonomik von Oliver Williamson. Seine Antwort lautet: Zum Schutz gegen ex-post opportunistisches Verhalten von Vertragspartnern sollen sich die Parteien zu einer Union unter einheitlicher Führung zusammenschließen – zu „unified governance“. Für souveräne Staaten ist dieser Schritt jedoch problematischer als für Einzelpersonen oder Unternehmungen, deren Verträge nationalem Rechtszwang unterliegen. Die Europäische Währungsunion – ein internationaler Vertrag – muss dagegen selbstdurchsetzend sein. Das erfordert mehr als nur die Übertragung nationaler Souveränitätsrechte an eine europäische Zentralstelle. Es verlangt dazu die Entwicklung gegenseitigen Einvernehmens der Bürger aller Mitgliedsstaaten hinsichtlich ihrer wirtschaftspolitischen Vorstellungen – sozusagen als zeitgemäße Antwort auf das jahrhundertalte Problem des europäischen Gleichgewichts – ein Ziel das weder leicht noch im Eilverfahren erreicht werden kann. (B52, F15, F31, F33, F34) OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/kuk.46.1.13 | Generated on 2023-01-16 13:35:12