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The euro debt crisis, exchange rate instability and the problem of global recovery robert mundell, global hr forum 2010.pdf, seoul, korea

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The global shock that began with the sub-prime mortgage crisis in 2007 continues. The massive central bank infusion of funds in August 2007 solved the liquidity problem of the crisis but a year later …

The global shock that began with the sub-prime mortgage crisis in 2007 continues. The massive central bank infusion of funds in August 2007 solved the liquidity problem of the crisis but a year later the soaring dollar (against the euro) brought on disinflation and the greatest financial crisis since the great depression. Quantitative easing in March 2009 brought on a recovery but it was aborted when the dollar was allowed to soar again against the euro in the wake of the European debt crisis aborting the US recovery. A second round of quantitative easing in September-October of 2010 brought the dollar down and created the monetary conditions for US recovery.
In its wake, however, the quantitative easing and depreciating dollar has created problems of imported inflation for countries with currencies tied to the dollar and currency appreciation of countries practicing inflation targeting,

Quantitative easing has created problems for countries tending toward surplus with the U.S. The Japanese Yen has hit record highs (since 1995) and slowed recovery there. The euro, which has appreciated by more than 15% in the fall of 2010 is bound to exacerbate solvency problems in the euro area.
China s surplus has given it bulging reserves of more than $2.65 trillion.

Japan was correct to intervene in the foreign exchange market to prevent a further appreciation of the yen. Japan s sluggish economic performance has been aggravated by a strong yen in a world which has typical signs of deflation. Japan s policy mix of tight money and large budget deficits is not in the long run viable.

The European fiscal crisis created shock waves through the European community and much of the world. It was initially a Greek fiscal problem, but it threatened to turn into a euro problem. The euro had the effect of relaxing fiscal discipline in some of the countries, since it removed the fear of a currency crisis. The entry of poorer countries into the eurozone removed the risk of currency depreciation and led to higher government spending until the second barrier of fiscal solvency was reached. The euro crisis arose when the richer countries of the north balked at bailing out the debt-ridden countries of the south. In new monetary union like that of EMU, a formula must be found for achieving solvency without undermining fiscal responsibility. The Growth and Stability Pact set up along with EMU failed because it lacked the political strength to enforce its directives.
The long-term future of EMU will depend on a move toward economic federalism.

The Korea-EU FTA will come into effect in July 2011. The free trade area should be a great benefit to Korea especially to the automobile and electronic industries. It will be more profitable the healthier is the European economy and the better Europe can cope with its debt problems.
Korea will have to determine how it wants to let its exchange rate policy regarding the euro be affected by the free trade area.

Global imbalances represent a problem in the world economy and there are some who see these imbalances at the heart of the current fiscal crisis. The Obama administration has been pressuring China to revalue its Yuan against the US dollar and recently China has returned to its policy over 2005-8 of slow appreciation. But appreciation is not the only and it is hardly ever the best way to deal with imbalances. First of all, imbalances, are never the problem of only one country. China and the United States must both take action to reduce excessive trade imbalances. Exchange rate appreciation is not the best way for dealing with imbalances. Throughout history exchange rate appreciation has hardly ever been forced upon a country. The U.S. had large surpluses for sixty years (from 1915 to 1975). It never appreciated its currency. There was widespread discussion at the Bretton Woods negotiations to apply restrictions against a country with a scarce currency (it was aimed at the dollar), but it

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  • 1. The Euro Debt Crisis, Exchange Rate Instability and the Problem of Global Recovery Robert Mundell Columbia University October 27, 2010 Seoul, Korea
  • 2. Outline • Three Great Booms • 3 Phases of the Crisis • The Lehman Fiasco • The Euro and the Greek Problem • High Cost of Instability of the $-€ Rate • Stabilizing the $-€ rate. • Reform of the International Monetary System
  • 3. The Context: Three Great Booms • The first was 1982-90, the “Seven Fat Years” of the Reagan administration. • The second, in 1991-2001, was the longest expansion in American History. • The third great boom was the Bush expansion of 2002-08.
  • 4. The 2007-10 Financial Shock: A Play in Four Acts
  • 5. Four Acts • 1. The sub-prime mortgage crisis crystallized on Aug 9-10, 2007. • 2. The Sept 15, 2008 bankruptcy of Lehman Bros, AIG and its aftermath. • 3.The economic contraction that occurred from 2008(3) to 2009(1). • 4. The Euro deficit-debt fallout of 2010
  • 6. Why the Lehman Crisis of 2008? • The sub-prime mortgage crisis had been managed with the unprecedented $300 billion central bank bailouts of August 9-10, 2007. • What detonated the Lehman crash more than a year later. • The answer is a mistake by the Federal Reserve Board after June 2008.
  • 7. The Fed’s Shift to Tightness • In June 2008 the Fed listened to inflation hawks. • They saw the huge balance sheet as an inflationary threat. • The money multiplier had fallen in half, from 8 to 4. • They thought when the money multiplier reverted to normal, the system would explode in inflation.
  • 8. Symptoms of Monetary Tightness in 2008(3) • Soaring Dollar • Plummeting Gold • Plummeting commodity prices • Plummeting inflation rate to negative
  • 9. Record of Tight Money in last half of 2008 • Soaring Dollar—30% appreciation against euro • Falling Price of Gold—30% fall • Collapsing Oil prices—70% fall • Monthly Inflation Rate (annualized) lowered from 5.5% in June 08 to negative in early 2009.
  • 10. The Dollar in Euros and the Price of Gold in Dollars in July and November 2008 Euros per Dollars per Gold ounce Dollar Euro per Dollar July 15, 0.63 1.60 980 2008 Oct 27, 0.80 1.25 720 2008
  • 11. 0.85 1200 Euro-Dollar Exchange Rate 0.8 1100 Gold Price per US Dollar 0.75 1000 0.7 900 0.65 800 0.6 700 0.55 0.5 600 4-Jan-08 4-Apr-08 4-Jul-08 4-Oct-08 4-Jan-09
  • 12. USA CPI YOY% 6 5.6 5.4 5 5 4.9 4.3 4.3 4.2 4.1 4 4 4 3.9 3.7 3.5 3 2.8 2.8 2.6 2.7 2.7 2.4 2.4 2 2.1 2 1 1.1 0.2 0 0.1 0 -0.4 -0.7 -1 -1.3-1.4 -1.5 -2 -2.1 USA CPI YOY% -3 Se 7 Se 8 9 M 8 8 M 9 7 7 07 08 M 9 7 8 9 08 07 l- 0 l- 0 l- 0 -0 -0 -0 -0 -0 0 -0 -0 -0 n- n- n- p- p- ov ov ar ar ar ay ay ay Ju Ju Ju Ja Ja Ja M M N N M
  • 13. Two Failures • Lehman and others brought down by dollar appreciation in 2008 (3). • KDB backed away from buying Lehman • Paulsen-Bernanke decided not to save Lehman. • But Lehman was too big to fail.
  • 14. New Policies
  • 15. Quantitative Easing in 2009 • Fed did not acknowledge its mistake in 2008. • In March 2009 it started “Quantitative Easing” • This brought down the dollar and the lower dollar helped to spur the economic recovery in 2009.
  • 16. The Euro Debt Shock
  • 17. Europe Debt in the Age of Bretton Woods • Western Europe had achieve budget discipline under the Bretton Woods fixed exchange rate system. • Debt levels were around 35%. • The breakdown of Bretton Woods opened the way to fiscal indiscipline.
  • 18. No Extra Degree of Freedom • The shift to flexible exchange rates at first led to monetary indiscipline as leaders thought the flexible exchange rate gave them an additional degree of freedom. • But this was true only if monetary stability was abandoned.
  • 19. Soaring Debt Levels • When countries went back to monetary discipline through exchange rate or inflation targeting, they relaxed their fiscal discipline. • Debt levels of countries like Italy and Greece ran huge budget deficits and ran Debt/GDP levels above 100%.
  • 20. Treaty of Maastricht and the EU • After the Cold War ended, Germany was reunited and the Economic Union came into being with the Maastricht Treaty, with its plan for monetary and political union.
  • 21. Deficit and Debt Levels • Conditions for entry included Price and exchange rate stability, budget deficit below 3% and debt levels below 60% of GDP. • No country but Luxembourg met the Debt/GDP condition for entry, but 11 countries nevertheless entered in 1999.
  • 22. Political Urgency of Monetary Union • Strict Maastricht conditions were waived because of the political priority attached to tying German into Western Europe. • Greece didn’t make the first cut, but was allowed to enter in 2002—despite misgivings.
  • 23. The Stability and Growth Pact • The risk in allowing countries like Greece and Italy into the monetary union was their ability or discipline for achieving budget balance. • To enforce the budgetary rules the Stability and Growth Pact was formed was established, at the suggestion of Theo Waigel, German Minister in 1997.
  • 24. Weak SGP • The SGP was only weakly enforced, largely because even the stronger members like Germany and France were also in deficit.
  • 25. Free Rider Problem • An individual country with its own currency is inhibited from excessive budget deficits because of the threat to confidence and convertibility of its currency. • When, however, it joins a monetary union, it can risk larger budget deficits because the risk of exchange stability is taken away. • This is the FRB.
  • 26. National vs Federal Accountability • In a monetary union where a member country cannot be allowed to default, accountability is shifted from the individual member to the collectivity. Any member can pollute the pool of national debts and risk currency devaluation or fiscal insolvency to the union.
  • 27. Debt Pollution • The situation of countries in a monetary union is in this respect like residents sharing a lake. If there are no controls there will be overfishing. • The solution is to treat debt as a pollution and establish global debt pollution rights, to be distributed among members.
  • 28. Debt Centralization • One solution, and perhaps the best, would be to centralize the national debts, as Alexander Hamilton did in the U.S. in the 1790s. • Countries could pay interest in proportion to their relative debt levels. • Centralization of debts would equalize the risk factors of weak and strong countries.
  • 29. Closer Political Integration • There would have to be centralized control over the overall debt level of the monetary union. • The junior government would be restricted to a limited discretionary deficit level. • It would involve a step up toward political integration.
  • 30. Great Advantages • There would be great advantages to debt unification. • The mass of euro-area debt would be almost as large as that of the of the U.S. and therefore have the same liquidity premium, at a considerable interest cost to all members.
  • 31. Restoring Fiscal Policy • The amalgamation of debts would restore fiscal policy to the EMU as an active economic variable to add to monetary policy, giving the EMU policy makers the same flexibility as the U.S. policy makers.
  • 32. The EMU/EU Problem • Debt amalgamation of the EMU runs into the awkward problem that the EU is the appropriate governing institution for debt.
  • 33. The $/€ Exchange Rate Problem
  • 34. Strong Euro, Fiscal Problems • Europe’s fiscal debt situation got worse with the depreciating dollar and appreciating euro in the fall of 2007 and spring of 2008. • The strong euro rose to $1.64 in June 08 aggravating the downturn in Europe and its fiscal difficulties.
  • 35. QE-1 • The strong dollar in the last half of 2008 gave Europe some respite from its fiscal difficulties. • But in March 09, the FED began its first venture in quantitative easing. • The dollar sank and the euro soared. • US recovery got under way while budget deficits in Europe widened.
  • 36. Risks of Insolvency • By the fall of 2009, the weak economy and strong euro created fiscal deficits in a number of countries: Portugal, Ireland, Italy, Greece and Spain. – the PIIGS. • Greece was in the forefront of the crisis with a hug deficit and a debt-GDP ratio over 100%.
  • 37. Should Europe Bail out Greece? • Greece was on the brink of bankruptcy. Could Europe and the euro stand it? • French banks had huge creditor positions in Greek bonds; German banks had a lesser position. France led the charge to save Greece.
  • 38. Strong Dollar Cuts off Recovery • As the euro fell to a long-term low of $1.18, the strong dollar began to cut off the recovery in the United States. • The weak euro began to ease conditions in Europe and incrase optimism about a solution.
  • 39. Resolution • Resolution of the crisis took place in the late spring of 2010, with huge fund put up by Europe and by the IMF. • With the resolution of the crisis the euro began to recover. • It was too late to save the recovery. In the U.S. unemployment got stuck just below 10%.
  • 40. QE-II • Quantitative easing in the U.S. should have the effect of depreciating the dollar against the euro in the absence of new monetary actions by other central banks. • With the dollar bumping against the level of $1.40, however, the ECB may find ways to intervene to support the dollar and prevent a further deterioration of the Euro fiscal system.
  • 41. Stabilizing the Dollar- Euro Rate
  • 42. Dollar-Euro Swings • The history of the last three years shows compellingly that the dollar-euro rate plays a fundamental role in the macroeconomic and fiscal positions of the U.S. and Europe. • Both currency areas make big mistakes when they allow excessive appreciation of their currencies in a state of recession.
  • 43. Stabilize $-€ Exchange Rate • To avoid competitive devaluation, U.S. and Europe should cooperate on exchange rates and coordinate monetary policies. • E.g., choose a central parity like $1.30 with lower limits on the euro of $1.20 and lower limits on the dollar of $1.40
  • 44. Mechanism of Fixing • Cooperative System. • Each country intervenes at the lower limit of the other currency. US intervenes to buy euros at $1.20, and ECB intervenes to buy dollars at $1.40.
  • 45. Details • Over time these margins could be reduced. • The two banks should cooperate on the total levels of changes in the money bases. • The intervention should not be sterilized. • It is possible also to intervene in the forward market.
  • 46. $-€-C¥ Currency Triangle
  • 47. Devaluation in 1994 • China’s currency has been closely related to the US dollar. • The 1994 devaluation was excessive. • It created an inflation spike of 25% in 1994 and 15% in 1995. • Then the price level caught up with the excess devaluation and inflation ended.
  • 48. Dollar-Euro-RMB Triangle • In the 1990s the US experienced a ten- year boom, the longest in its history. • The Silicon Valley IT revolution (spurred by the Reagan tax-rate cuts of the 1980s) created a surge in American productivity (especially in internationally-traded goods). • US growth nearly doubled and adjustment required a real appreciation of the dollar against all currencies.
  • 49. Real $ Appreciation • The dollar appreciated against currencies that were flexible against the dollar, such as most of those in Europe and elsewhere. • But in those countries whose currencies were fixed to the dollar, the real appreciation had to be effected by a higher inflation rate in the U.S. than in those countries whose currencies were fixed.
  • 50. Deflation in Fixed • US inflation rate rose in the late 1990s to about 3%. • Inflation rates in countries fixed to the dollar fell considerably below that and most had negative inflation. • China, for the first time in 65 years, had deflation.
  • 51. Deflation to let the $ Appreciate • The deflation was not very severe, but it was unique in China’s modern history. • Toward the end of the 1990s other countries with currencies fixed to the dollar had a unique experience of deflation: this occurred in Panama, several Gulf States, and some countries in Asia.. • The U.S. inflation rate increased to about the Fed limit of 3%
  • 52. 2008 • China allowed about a 20% appreciation of the RMB in 2005-8. • But when the dollar soared against the euro in the summer of 2008, it was the correct move to stop the appreciation. • Good to resume appreciation against the dollar only when the dollar is depreciating or low against the euro.
  • 53. $-€-C¥ Tangle • Strong dollar appreciation against the euro hurts China’s export markets. • China imported the financial crisis only when the dollar was soaring against the euro in the summer of 2008.
  • 54. International Monetary Reform
  • 55. The International Monetary System Today ¥ Russia Canada Korea ₤ Sweden RMB $ Malaysia Taiwan India € Hong Kong Indonesia Malaysia Mexico Australia Brazil Gulf Latin American & Caribbean Countries CFA
  • 56. International Monetary Reform • China should continue to assert some leadership in the field of international monetary reform. • Most important issue is to reduce the instability of major exchange rates. • Secondary issue: to reduce reliance on the dollar.
  • 57. Proposals • Cooperation and proposals to the G- 20 to create an improved international monetary system. • First step: Add Chinese Yuan to the SDR to take effect in 2011.
  • 58. Sarkozy’s Speech on August 25 • President Sarkozy of France makes three categories of proposals. • 1. Reform of the international monetary system to reduce the instability of exchange rates. • 2. Controlling/reducing the volatility of raw material prices. • 3. Reform of Global Governance.
  • 59. 20 after Seoul meeting and Chairman of G-20 in January 2011 • Sarkozy’s proposals especially important because of the position of France as 2010 Chairman of G-20 and G-8. • Sarkozy proposes a seminar on the subject of international monetary reform, perhaps in China!
  • 60. The INTOR • The revised SDR could be made the active component of a generalized global currency in which all members of the SDR have a stake in relation to their quotas in the IMF. • Such a generalized INTOR could be a embryo of a genuine supranational global currency.
  • 61. Quotas in IMF Be lgium 2% Unite d State s Canada 17% 3% China, P.R. Mainland 3% Unite d Kingdom France 5% 5% Switz e rland Ge rmany 2% 6% India Saudi Arabia 2% 3% Russia Italy 3% 3% Japan Nethe rlands 6% 2%
  • 62. World Map with the INTOR: ¥ $ India RMB € ₤ Latin Dollar Russia Arab Bloc Africa
  • 63. Thank You