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Stagnation, Crisis, and RevivalEurope, 1973-Today
The Bretton Woods Exchange Rate System, 1945-1973
• Bretton Woods: Fixed Exchange Rate Regime• What reserves? Gold and U.S. $ where and
what parity? One ounce of gold = $35. U.S. had most of the world’s monetary gold.
• Countries peg their currencies to gold. It was effectively a “dollar-gold standard.”
• Benefit is that countries could earn interest on dollar deposits or U.S. dollar securities.
• Dollar balances are also easier to transfer than gold.
• High powered money not tied to gold mining
Bretton-Woods $-Gold Standard• US
• [V = constant]• ΔM/M + ΔV/V =
ΔP/P + ΔQ/Q• EX - IM = 0• Trade is in balance• -------------------------• Now ΔM/M rises
ΔP/P risesU.S. goods less competitive
• EX-IM<0$ to France
• FRANCE• [V = constant]• ΔM/M + ΔV/V =
ΔP/P + ΔQ/Q • EX - IM = 0• Trade is in balance• ------------------------
Inflation makes U.S. goods less competitive
• US [V = constant]• EX - IM < 0• Trade is in deficit• EX – IM = ΔM($) <0• ΔP/P = ΔM/M - ΔQ/Q, so • BUT NO ΔP < 0, ΔP =0
because no loss of goldship $ to France, asymmetry in corrective mechanism
• Trade deficit dissipates and US has exported inflation
• France [V = constant]• EX - IM > 0• Trade is in surplus• EX – IM = ΔM($) >0• ΔP/P = ΔM/M - ΔQ/Q, so
$ add to French reservesmoney growth
• ΔP > 0• Inflation and France loses
some competitive advantage and trade surplus dissipates.
• Burden of adjustment on France--asymmetry
Rules of the Game?
• Classical Gold Standard• Central bank losing reserves (gold) from a trade
deficit would raise interest ratesconsumption & investment fallimports fall. Also attracts foreign short-term capital. Balance of payments improves.
• Does the Fed have to raise interest rates when there is a trade deficit? No. No reserves are lost if deficits paid in $. Surplus countries see reserves risehigh-powered moneyinterest rates fallinflation.
The Collapse of the Bretton Woods System of Fixed Exchange Rates
• U.S. Runs Large Trade Deficits
• Asymmetric adjustment---U.S. trade deficitspaid for by $, which add to other countries reserves.
• Reserves are high-powered money, creating a multiplier effect; no effect in U.S. as payment in dollars, no contraction. Inflationary bias and impulse from the U.S. to Europe
The Collapse of the Bretton Woods System of Fixed Exchange Rates
• Continued U.S. trade deficits force NO adjustment on U.S.---it swells the dollar reserves of other countries.
• The “Triffin Problem:” Dollars held as reserves in foreign central banks exceed U.S. gold reserves by 1961. (named after Yale economist, Robert Triffin).
• Triffin Problem raises the possibility of a run on the dollar----like interwar currency problems.
The Collapse of the Bretton Woods System of Fixed Exchange Rates
• German’s try to fix problem---the mark is revalued twice. But the U.S. trade deficit reappears because of continued inflation.
• Vietnamese War and “Great Society” programs in the U.S. add to the budget deficit and inflation.
• By the 1960s, there is more capital movement---an increase in short-term investments (speculative capital) sensitive to interest rate changes and fear! A country can lose money faster than just by trade deficit. Less and less breathing room to make adjustments.
Inflationary Pressures Build in the 1960s:Vietnam War and Great Society spending
Inflation 1950-2005(GDP Deflator)
0
1
2
3
4
5
6
7
8
9
10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Perc
ent
The Role of the French
• The French want Bretton Woods to move to a more orthodox gold standard where the U.S. would have to make symmetric adjustments.
• De Gaulle threatens to convert France’s U.S. dollars to gold---aimed at forcing U.S. change policies—leads U.S. to abandon its fixed exchange rate in 1973.
• Other countries also find it difficult to maintain fixed/pegged exchange rates.
• World moves towards floating exchange rates and thus “monetary independence”
Oil Price Shocks--Inflation
• 1973 (Arab-Israeli War) and 1979 (Iranian Revolution) produce sharp rises in oil prices.
• Western Europe’s has large trade deficits with oil producing countries. With fixed exchange rates—implies that they should lose gold, $ and other currencies.
• According to “rules” of fixed exchange rates, they should pursue contractionary policies to force adjustment on their economies.
Oil Price Shocks--Inflation
• Europe (and the U.S.) fail to do so. Instead, they pursue “accommodative” policies. There is easy credit to business and others to help with higher oil prices. Result? Inflation surges in all countries.
• Further loss of reserves. Speculative capital flees and facing loss of reserves, countries all abandon fixed exchange rates for floating exchange rates in the 1970s.
The “Snake” and other critters• When the U.S. abandons the $ peg to
gold, the European try to preserve their own fixed exchange rates. Some forced to float but repeated efforts to return to fixed exchange rates.
• In the 1970s, the “European Snake” permitted currencies to be “pegged” but fluctuate in a narrow band of 2 ¼ % around the pegged rate. It fails with 1979 oil shock.
• Inconsistent policies—some countries money supplies grow faster.
DM/Lira
Quantity of £s
Supply
Demand
Depreciation of the Italian Lira vs. DM in 1980s
1980 1985
Pegged Rate +/- 2.5%
The “Snake” and other critters• In the 1980s, the European Monetary
System or EMS, sets similar bands for fluctuation.
• Two problems: – Countries with strong currencies (Germany)
refuse to provide assistance to countries with weak currencies (France or Italy)
– Once there is a problem ---budget deficit or inflation, “orderly” changes in parities are impossible---once a currency looks weak, no time for adjustment because “hot capital” precipitates a run on the currency because of the loss in confidence.
Crisis of the early 1990s
• European countries have inconsistent policies: the Bundesbank pursues a low inflation policy, while the Banque de France/Banca d’Italia pursues a higher inflation more stimulus
• Implies that currencies are not falling in value evenly---so hard to stay within bands of exchange rate mechanism
• These are inconsistent with a fixed exchange rate, as conservative-policy countries gain reserves and easy-policy countries lose reserves.
• EMS is forced to widen “bands” from 2 ¼% to 15%. • Crises hit U.K. Ireland, Sweden, Norway, Spain, which
abandon pegged exchange rates
Example: the Swedish Crisis(the Interwar Crises Redux)
• Swedish krona is pegged to the deutschemark---a fixed exchange rate.
• Swedish banks borrow from German banks (in DM) to fund expansion of lending to mortgage market. A real estate boom and economic boom begins.
• Increased foreign investmentmore DM and $ flow inMoney Supply. Inflation rises.
• Sweden begins to run a balance of payments deficit.
• Huge government budget deficit also.
Example: the Swedish Crisis(the Interwar Crises Redux)
• Government consider a devaluation of currency. BUT, banks repayment would be much more costly in DM.
• When this is discovered there is a DUAL crisis---a run on the banks and a run on the krona.
• The Riksbank—the Swedish central bank---raises the discount rate to 500% to try to stop run. It fails.
• Result----krona abandons peg and floats and depreciates and the banking system collapses with government rescuing the failed institutions.
The Choice: Float or Permanent Fix• Bretton Woods, Snake and EMS
adjustable pegged exchange rates seem to invite trouble, especially when there is high capital mobility. Response?
• Maastricht Treaty of 1991: EEC now EC decides to become the EU---an economic union1. Single European Market by 1992---free trade
in goods, services, capital and labor.2. Establish the Euro, a single currency by
1999. There would be a new European Central Bank (ECB)
European Industry1950-2000
What Happened to British (European) Industry?
The American Challenge
Henry Ford (1863-1947)
• Mass Production on an Assembly Line
• Standardization and interchangeable parts. Higher volume lower price.
• Model T—1908 $850/1924 $290.
• 10 million produced by 1925. Has 60% of market.
• Why did Ford introduce the $5 day in 1914?
• Mass consumption
Morris Motor Company• Founded in 1910 by bicycle manufacturer, William Morris. • First vehicle was 2 seat “Bullnose” with all major components were
purchased. Engines and other key components for early vehicles purchased from Detroit manufacturers for standard “Morris Cowley” of 1915, MG in 1924
• High-quality cars, reduction of pricing and a policy of cutting prices, Morris Motor Company beats out Ford to obtain 51% of UK market.
• Purchases local suppliers• But only in 1932 is a proper assembly line introduced.• Shutdown of all private production during World War II• 1952 merger with Austin produces the British Motor Corporation
(BMC)
British Motor Vehicle Industry
• Protected by high tariffs during 1930s and World War II
• Post-World War II—export led initially until U.S. industry recovers from World War II and Korea
• UK share of world exports 15% in 1937, 52% in 1950, 19% in 1967
• 1950—fragmentation of market, more models than all U.S. producers
• Continued concentration on Empire markets---few competitors
• Faces multiple craft unions any one of which can halt production
Tariff Rates (Duties to Total Imports, %)UK US Germany
1820 24 43
1850 22 25
1870 7 45
1890 5 30 9
1910 5 28 8
1920 8 6 5
1935 25 18 30
1950 31 6 5
1960 30 7 7
1970 34 6 2
1980 12 3 1
1990 3 1
Unionization (% of Labor Force)
UK US Germany
1892 9.4 1.8 1.5
1910 15.4 5.9 3.3
1920 33.0 11.2 20.3
1930 23.2 7.0 24.1
1950 39.3 23.6 26.8
1960 39.1 23.2 28.5
1970 44.2 25.1 29.7
1980 48.3 21.2 33.1
1990 35.0 14.1 31.8
Comparative Labor Productivity UK=100
1907 1935 1968
US/UK
Total Manuf 209 218 276
Motor Vehicles 435 294 438
Germany/UK
Total Manuf 102 119
Motor Vehicles 141 141
Attempts to Americanize Technology
• WWII followed by high tariffs (>30%) protect British industry, productivity lags, and allow unions to bid up wages.
• During World War II, British industrialists visit U.S. to learn American methods to increase productivity
• Postwar attempts to adopt American mass production techniques not successful– Skilled craft workers opposed erosion of the
value of their skills– Unpopular with managers who were not
used to exercising strong shop floor control.
Attempts to Americanize Technology
• American techniques with British craft unions---no UAW but a large number of firms.
• In 1970s British Leyland had to deal with 36 unions and British Ford with 22 unions.
• Inter-union and intra-union struggles as change production
• Shift from piece rates, where incentive is to ensure that the plant ran smoothly, parts were available, machinery kept going…….is lost as shift to fixed day rates under the American system---managers do not step in to provide strong coordination.
• Result: Frequent, disruptive strikes---productivity falls and quality falls
Government Intervention• Labour Government: industrialization reorganization
program to improve British competitiveness.• British Leyland Motor Corporation was created in
1968 by the merger of British Motor Holdings and the Leyland Motor Corporation. LMC was successful, BMH close to collapse. Government hope LMC will revive BMH.
• Merger combined almost all remaining independent British car manufacturing companies and included car, bus and truck manufacturers plus construction equipment, refrigerators, metal casting companies, road surface manufacturers--100 different companies.
Government Intervention• British Leyland offered a range of dated
vehicles, nothing in new line of development to compete with popular Ford Escort and Cortina. New products unsuccessful.
• Plagued by strikes.• 40 different manufacturing plants.• One division competes with another---Rover
competed with Jaguar at the expensive end of the market and the Triumph with Austin, Morris and MG. The result was a product range which was incoherent and full of duplication.
British Motor Vehicle Industry• Result bitter labor relations—Strikes rise sharply
in 1970s peak 1979• Exacerbated by entry into EEC in 1973—tariffs
eliminated for Europe• Difficult to shift from Empire to European markets• Exacerbated by First Oil Price Shock (1973) —
inputs more costly• Exacerbated by Second Oil Shock (1973)—UK is
oil exporter—the pound appreciates• British Leyland—huge losses. December 1974
government nationalizes firms and injects capital. • No improvement
A Change in Regime• Bitter winter of 1978-1979• Public believes unions have privileged place• Election: Victory of Margaret Thatcher in 1979• Further Losses at BL—further government
injections of funds • Privatize nationalized industries, slow break-up
of BL• Eliminate minimum-wage floors in specific
industries, Suspend rules extending union scales to non-union employers
Recent Economic Performance
• Movement away from U.S. style mass production technology and revival of flexible production, a traditional British strength.
• Post-1980 return to more use of skilled labor and European “flexible production technology” Emphasis on skilled labor.
• Adjustment to European markets is complete.
Recent Economic Performance
• Germany dominant manufacturing country.– Giant Corporations– Mittelstand—aggressive medium sized firms.
• Volkswagen produces mass scale but it relies on unskilled labor from the countryside and overseas while BMW and Mercedes focus on higher end vehicles with skilled labor.
• British industry revives in 1980s with investments from Japan—Nissan, Toyota & Honda establish plants.
• But it is a niche success for luxury cars and 4-wheel drive vehicles.
The Choice: Float or Permanent Fix• Bretton Woods, Snake and EMS
adjustable pegged exchange rates seem to invite trouble, especially when there is high capital mobility. Response?
• Maastricht Treaty of 1991: EEC now EC decides to become the EU---an economic union1. Single European Market by 1992---free trade
in goods, services, capital and labor.2. Establish the Euro, a single currency by
1999. There would be a new European Central Bank (ECB)
How to move from DM, FF, Lira, Peseta to Euro if each country has different monetary policy---money growing at different rates, different interest rates, etc.?
Maastricht Treaty Requirements for Harmonization of Macroeconomic Policy
• Each country’s inflation must at maximum be 1.5% of 3 best performing members (i.e. if average is 2%, each country must have 3.5% inflation.)
• Each country’s nominal interest rate on government bonds must at maximum be 2% > 3 best performing members
• Annual budget deficit no greater than 3% of GDP
• Debt/GDP < 60%
The European Union
• By 1997, 11 members of the EU meet the criteria---but Belgium and Italy do not (big violation of Debt/GDP ratios). They are allowed to join anyway, and Greece finally allowed in 2001 (it fudges its numbers)
• BUT……• Result of criteria is that countries follow stricter
policy and interest rates fall.• “Eurosceptics:” the British accept the single
market but not the monetary union of the Euro.
Does Harmonization Work?
Some Price Convergence
Some Price Convergence
Policy Implications of the Euro
• Previously: if two countries had different circumstances their central banks could react differently: – If a country had unemployment and a recession, its
central bank could lower interest rates– If a country had inflation, its central bank could raise
interest rates.• Now, there is only one European Central Bank---
its policy is “one size fits all” – If ECB sets low rates that may cure recession in some
countries but cause inflation in others. – If ECB sets high rates that stop inflation in some
countries, it may cause a recession in others.• True for the USA too but….
Policy Implications of the Euro• In the U.S. there is a high degree of labor mobility• Unemployment in one region can be cured if there
is migration from there to a booming region.• But there is less in Europe---language and cultural
differences, plus differences in pension and social security benefits. Fears of migration, e.g. Turkey, Africa, Asia
• Implies that adjustment policies will be more painful.
• Will countries be tempted to opt out? Were the British wise?
!!!!
Looking to the Future
• Lagging Productivity Growth in Manufacturing– EU/US 1986-1995: 2.8%/3.2% (HiTech: 3.1%/5.1%)– EU/US 1996-2003: 2.7%/5.6% (HiTech: 3.6%/11.1%)
• Lagging Productivity Growth in Business Services– EU/US 1986-1995: 1.4%/1.1%– EU/US 1996-2003: 0.9%/4.2%
The Bargain Gets Expensive
Reduced Work IncentivesEmployment Rates as % of Population
• EU 1970---80% of men and 39% of women are in labor force.
• US 1970---83% of men and 46% of women are in the labor force
• EU 2003---73% of men and 56% of women are in labor force.
• US 2003---77% of men and 66% of women are in the labor force.
Unemployment RatesProblem of Labor Market Rigidities---
especially in Spain, France, Italy
Expansion of the EU
Income Disparities of New Member StatesAverage = 100
• Average of EU-15 = 102, range Ireland 136 and Portugal 69 [France 101, Germany 104, UK 105]
• Average of new member states = 54, range Slovenia 73 and Latvia 43 [Poland 44]
• Large social welfare programs and ageing populations
• Common Agricultural Policy.• General problem of giving
benefits equal to developed economies
That is in 2000 but by 2005
• Things look very good.
• Economies are booming
• Low Inflation
• Falling unemployment
• The Euro is a great success…..
How did the EU get into trouble?[Everything “looked good” in even 2008]
• In the Upswing of a business cycle• Combine in a monetary union
– High-wage/high labor productivity economies (Germany, France) with low wage/low productivity economies (Greece, Spain, Portugal, Ireland).
– Monetary union forced so that some countries are undervalued (guess) and others overvalued (guess)
– Undervalued boom---import cheaply. • Increased social welfare state as economic conditions
look good.– Early retirement—age 60 for men (France and
Greece) (55 for women in Greece)
How did the EU get into trouble?[Everything “looked good” in even 2008]
• In the Upswing of a business cycle• Combine countries with divergent debts
– Traditionally high (Greece, Spain, Belgium, Italy) and low (Germany) debt/GDP ratios.
– Common interest rates permits heavy borrowing. – Large capital inflows (Greece, Spain, Portugal) lead to
real estate booms, huge mortgage portfolios of banks.
How did the EU get into trouble?[Everything “looked good” in 2008]
• Combine countries that have lots and little of tax avoidance, tax evasion and corruption.
• Countries borrow heavily to maintain high level of government and consumer spending.
• Economic slowdown. Housing prices collapse—banks collapse. Banks are bailed out by national governments adding to national debt. Debt/GDP ratios rise. Default by governments appears imminent. Capital flight, can’t pay!
• Double Crisis: Banking and “Currency” Crisis
Whose in trouble?
What to do?• But this happened in Sweden---Sweden devalued.
– Result? Banks built on foreign debt fail. They are closed---some stakeholders take losses, government raises taxes to pay the remainder.
– Kroner is devalued. Imports drop and Exports boom---recovery in a few years.
• But in a monetary union, can’t devalue– Can force a deflation (tried in Ireland and Greece) prices
and wages fall but there is no incentive to cut exports and imports like a devaluation.
• U.S. unemployment benefits maintain expeditures, labor migrates and the dollar can depreciate and improve the trade balance.
• Europe is stuck: How to help? Provide loans to troubled countries and force them to contract. Political trouble. How to share out pain? No easy answers.
• Stay tuned.
