Download 1. Efficiency of the international monetary system means that the

8-6-2005
IMF-Bundesbank Symposium: “The IMF in a changing world”, Frankfurt, June 8, 2005
-----------------------------------------------------------------------------------------------------------Session „Does the international monetary system function efficiently?“
Horst Siebert*
1. Efficiency of the international monetary system means that the
monetary system does not cause important disturbances in the
real side of the economy. In a way, money is neutral in an efficient
international monetary system.1
2. Starting from this definition, we have two problems with the
actual system: The first one is that the international monetary
system is characterized by currency crises brought about by
sudden capital flow reversals and culminating in abrupt
devaluations of about fifty percent of the currency of the crisis
country (Brazil 1999) or even more. Such abrupt devaluations go
hand in hand with a loss of GDP, often in the magnitude of 10
percent over some years, relative to a previous trend. We have
seen quite a few currency crises in the 1990s and also some in this
decade (Sweden in 1992, Mexico in 1994, Thailand, South Korea,
Indonesia and others in 1997, Czechia in 1997, Brazil in 1999,
Turkey in 2001, Argentina in 2001/2002; Siebert 2002). There is
the risk of a systemic crisis developing from such national crises.
*
President-Emeritus of the Kiel Institute for World Economics, Agip Professor in International Economics,
Johns Hopkins University Bologna und Member of the Group of Economic Policy Analysis (GEPA) of the
European Commission advising President José Manuel Barroso.
1
This is a crude definition. Neutral dos not mean perfectly neutral.
2
The second problem is that the exchange rates of the major
currencies overshoot; they temporarily diverge from a long-term
trend, often over a period of several years. Thus, the US-dollar
has depreciated by nearly 50 per cent vis-à-vis the euro in the last
years in nominal terms. Such changes of the nominal exchange
rate affect the allocation of resources, sectorial structure and
imply adjustment costs. Overshooting is due to the fact that the
demand for and supply of currencies is not only determined by
the trade in goods and services, but also by capital flows, among
them the very volatile short-term portfolio flows. These shortterm flows are sensitive to policy failures.
How to solve these two problems? There are two lines of answer,
somewhat related.
3. In order to prevent currency crises – the first problem, mostly
relevant for emerging markets - , the financial sectors of the
national economies need to be robust so that they are not easily
affected by shocks. This is the lesson that we can draw from the
currency crises in the Asian countries. This refers to prudential
supervision of banks and of other financial institutions including
investment
banks,
to
coordination
in
supervision
(Basle
Committee on Banking Supervision), it relates to capital adequacy
requirements for individual financial institutions as requested in
the Basel II Accord, to standards for hedge funds and to the
correct sequencing of financial regulation. (We now know that
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you cannot liberalize the capital account if an appropriate
regulatory framework for the domestic sector is not in place.)
Some standards should also be applied to hedge funds, in order to
prevent excessive damages in case of their brake-down. One
approach is to require them to register onshore; if they instead go
offshore to a regulation heaven, this signals to the customer that a
higher risk is involved and that these funds are not likely to be
bailed out. Another approach is to limit their business to
“informed” clients willing to take large risks. Moreover credits
given to hedge funds and exposure to derivatives should be
adequately reflected in the risk evaluation of banks.2
A second lesson can be drawn from the typical Latin-American
crisis where traditionally the expansion of money and credit has
been an important mechanism for a currency crisis. This lesson
refers to the correct institutional arrangement for the money
supply process, a ban on central banks to print money in order to
finance public deficits, but more relevant these days it requires
the independence of central banks in order to exclude political
pressure for a low interest rate policy, and finally, it mandates
sound fundamentals in the fiscal policy situation.
A third lesson is that is not sufficient to peg the exchange rate, for
instance in a crawling peg or in a currency board, if the real
2
This short section cannot sufficiently deal with Hedge Funds.
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exchange rate appreciates too strongly and a current account
deficit develops. Apparently, conditions must prevail that prevent
a too large divergence between the real and the nominal exchange
rate. This is especially relevant if the currency of country is
pegged to a nominally appreciating currency as in the case of
Argentina.
A fourth lesson relates to the IMF with its twofold role of first
preventing a currency crisis and second mitigating it and helping
a country to get out of the crisis, once it has broken out. These are
conflicting roles between ex ante incentives for solid monetary
stability and the ex post function as a fire brigade.
In its ex-post role, the IMF also has an ex-ante impact by forming
expectations and influencing the behavior of sovereign debtors
and private creditors. It should be careful not to become a funding
agency for countries in self-made trouble, i.e. the troubled
countries' global credit bank. The line must be to improve the
incentives for a stable banking and financial system and to make
these systems robust (now not from the point of view of national
policy but in order to prevent a systemic crisis affecting more than
one country). Apparently, this requires voluntary commitments
by the nation states. In any case, the IMF must be concerned with
the announcement effect of its ex-post behavior. A clear ex-post
rule will be helpful to reduce systemic risk ex-ante. I leave here
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open the question whether more ex-ante conditionality should be
imposed by the IMF.
An explicit early warning system is helpful. It is better to blow the
whistle early, before the train crashes. An important means of
internalizing the social costs of instability is to involve the private
sector in the case of a crisis. ‘Bailing-in' the private sector
requires an arrangement on how to handle private credits when
private debtors and sovereign countries get into trouble. For
bonds and bank credits, sharing clauses, rules on collective
representation and majorities required for the modifications of
the terms of credit represent an institutional mechanism by which
creditors could assume some of the risks. These rules would help
to internalize the credit risks to the creditors, inducing them to be
more cautious in giving credits.
The punch line for this first problem is that we can attempt to
improve the conditions to prevent a currency crisis, but it is quite
likely that we will have to live with such crises.
4. The second problem of the international monetary system is
that exchange rates overshoot, and that nominal exchange rates
may give the wrong price signals for several years. Many ideas
have been put forward to make exchange rates more stable,
including macroeconomic coordination, reference or target zones
and a universal money (Robert Mundell). If one looks more
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closely at the conditions that must be satisfied for these
approaches, it becomes apparent that these ideas are not practical
on a global scale. What are the conditions for stable exchange
rates?
A first condition for exchange rates to be stable is that the price
levels move with the same rate. Since the price level depends on
the money supply, this condition may also be expressed as the
money supplies expanding at about the same speed, correcting for
differences in the expansion of the production potential of the
countries. In inflation targeting, the interest rates must be in line,
albeit not identical.
Exchange rates are not only influenced by commodity arbitrage
and purchasing power parity, but are also by capital flows, and
capital flows are affected by many factors, most importantly by
exchange rate expectations. A second condition for stable
exchange rates is therefore that exchange rate expectations in the
different countries are in line. To harmonize expectations on
exchange rate changes requires to harmonize all the factors
influencing the expectations.
Looking at this condition in more detail, historically it has not
been possible to have a stable money when the fiscal situation of
the state was in disarray. Thus, we have as a third condition that
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the budget situation of the state cannot be in disarray; it should be
in order.
If we want to have stable nominal exchange rates, we put more
adjustment needs on the real exchange rate, i.e. the relative price
between non-tradeables and tradeables or between export goods
and import goods. The nominal exchange rate clears the foreign
exchange market, the real exchange rate brings the current
account and the internal situation into equilibrium. In many
economic conditions it may not be sufficient that we do not have a
strong appreciation as was mentioned for Argentina. It may be
necessary to have a real depreciation. Thus, we have as a fourth
condition: If we want to have stable nominal rates, the real
exchange rate must do the adjustment job. Countries must be
willing and prepared to let the real exchange rate do the job of
adjustment. Such an adjustment of the product and factor
markets (including the labor market) must be politically
acceptable. To put it differently, conditions must be such that the
real exchange rate can sufficiently change.3, 4
3
In a reference zone or a target zone, the exchange rate is allowed to fluctuate within a band. The exchange
rate should only deviate from the (real) equilibrium exchange rate within a limited range. Coordination of
monetary and stabilization policies has to ensure that the limits of the range of fluctuations are not surpassed. As
long as monetary policy and the other fields of economic policy of the countries involved do not contradict the
credibility of the band, the exchange rate can be kept in the target zone. But as soon as the markets doubt the
credibility of the band, such a system has a destabilizing effect. However, as soon the limit of the band is
reached, the central banks have to intervene. The issue is who has to intervene at the limits. If the ECB supplies
euros and has to buy foreign currencies, this means that the money supply of the ECB is de facto steered by a
foreign central bank. If the FED expands its money supply and the foreign currency is threatened with
devaluation, then the ECB would have to supply euros accordingly. But, in the end, this would imply that the
ECB would be heteronomous in its monetary policy. The way out of this dilemma is that the intervention has to
be undertaken by the central bank whose currency is under pressure. The other issue is how to determine the
reference standard of the real equilibrium exchange rate.
4
Looking at the actual imbalances with a US current account deficit of -669.0 bill US-$ in 2004, we have to
admit that we do not have explicit policy instruments to force a major player like the US to reduce its balance of
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5. These conditions hold for a universal money. But they also are
relevant for the euro. Even more so, because it is a common
money. After the stability pact has been softened in this year, I do
not see how in the long run national fiscal policy can prevent an
increase in national debt in the three major continental
economies, Italy, France and Germany. These countries have a
large implicit debt, Germany for instance 240 per cent of GDP.
This implicit debt will become explicit, unless major institutional
changes are made, especially in the level of social absorption.
Thus, the conditions necessary for a stable euro weaken in the
future, and the conflict between the ECB and national politics will
intensify, unless politics solves this conflict by appointing doves to
the ECB Board. The euro area has a Minhas Gerais problem.
Moreover, it is unclear what can be done to prevent a real
appreciation in a member country of the euro area when wage
increases in the non-tradeable spread to the sector of tradeable
where they hamper exports and squeeze profits. Witness the
economic policy problems of Italy.
payments deficit. Such a deficit depresses the US-dollar, depreciates it and makes other currencies appreciate.
This hurts other economies. But at the same time, the US soaks in huge imports thus stimulating exports
elsewhere. This benefits other economies. The advantages and the disadvantages are distributed asymmetrically
among the countries of the world. Looking at China, with its fixed exchange rate China avoids the appreciation
of its currency while at the same time benefiting from the demand stimulus of US imports. But it pays the price
of inflation and the misallocation of resources which eventually have to be corrected.
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6. If we think of global macroeconomic coordination between the
major currencies, the US-dollar, the euro and the Yen, game
theory
tells
us
that
countries
can
have
benefits
from
macroeconomic coordination. However, the political economy of
macroeconomic coordination has its flaws. A theoretical issue with
this approach is to determine the equilibrium real exchange rate,
a practical one is which political influence is exercised to
determine the real exchange rate. A related issue with such an
approach is which type of model we apply. Often, a Keynesian
demand management approach is used, for instance pushing for a
coordinated demand package between the United States, Europe
and Japan as in the second part of the 1980s to get our economies
going again. This seems to be a rather simple or even naive
approach.5 Structural questions such as how countries should
react to an oil price shock, who has to raise energy prices, and
which policy instruments to use against unemployment remain
unanswered (flexible wages as in the US versus an inflexible (or
rigid) labor market as in the European social model of the three
large
continental
countries).
Moreover,
macroeconomic
coordination may be used to put the blame on the other country;
it may also be used to put the burden of adjustment on the other
country.
5
Most of the coordination philosophy is based on extremely simple and naive Keynesian ideas of controlling and
fine-tuning aggregate demand over the cycle; inside and outside lags are neglected. The political process seems
to be unable to smoothen government expenditures over the cycle. While additional spending in a recession is
grabbed wholeheartedly by the political process, reducing demand in a boom is unlikely to take place.
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Thus, I am sceptical on international macroeconomic policy
coordination. The best that governments can do is to follow an
atmospheric coordination, i.e. exchanging information on the
situation and on the paradigm to be used.
7. It may be an economist’s dream to have a global money. But
looking at the conditions that have to be fulfilled for a global
money – this airplane will not fly. We will have to live with
overshooting exchange rates.
--------------------Siebert, H. (2002). The World Economy, 2nd Ed. , Routledge, London und New York.