EUROPE, THE EURO, AND THE REFORM OF THE GLOBAL

RESERVE SYSTEMJoseph E. Stiglitz

September 2005

THE MIXED RECORD OF THE EURO

• FEW DOUBTED THAT IT WOULD BE ACCEPTED AS A CURENCY– AND EVEN BECOME A “STRONG” CURRENCY– ITS SUCCESS IN THAT REGARD IS THUS NO

SURPRISE• THE WORRY WAS WHETHER MACRO-

ECONOMIC PERFORMANCE OF EUROPE WOULD BE IMPAIRED– AS A RESULT OF THE LOSS OF EXTRA DEGREES

OF “POLICY” FREEDOM– ESPECIALLY SINCE IT WAS NOT CLEAR THAT

EUROPE WAS AN “OPTIMAL” CURRENCY AREA

THE EURO AS NON-OPTIMAL CURRENCY AREA

• WITH LIMITED LABOR MOBILITY• WITH LIMITED FISCAL RESOURCES TO

STIMULATE WEAK REGION• PROBLEM EXACERBATED BY MISGUIDED

POLICY FRAMEWORK– CENTRAL BANK FOCUSING EXCLUSIVELY ON

INFLATION• IN CONTRAST TO US, WITH GROWTH AND

EMPLOYMENT OBJECTIVES, AND GREATER POLITICAL SENSITIVITIES

– GROWTH AND STABILITY PACT • IN CONTRAST TO US, WHICH EXPLICITLY REJECTED

CONSTITUTIONAL AMENDMENT

EUROPE’S MACRO-PERFORMANCE HAS NOT BEEN

STELLAR• CENTRAL BANKERS ALWAYS BLAME

OTHERS– MICRO-POLICIES (LABOR MARKET

FLEXIBILITY)– BUT, IF ANYTHING, LABOR MARKETS

HAVE BECOME MORE FLEXIBLE

PART OF PROBLEM…..

• EUROPE’S WISH TO BE STRONG, RESERVE CURRENCY COMING TRUE– WITH ALL THE COSTS, DISADVANTAGES– WHICH FAR OUTWEIGH SLIGHT BENEFITS FROM

SEIGNORAGE• EUROPE IS EXPORTING “PAPER”, NOT

GOODS – EXPORTING IOU’S DOES NOT CREATE JOBS– ESPECIALLY WHEN ONE HAS FISCAL

CONSTRAINTS (GROWTH AND STABILITY PACT)• EUROPE IS CATCHING AMERICA’S DISEASE

– WITHOUT THE MEANS TO DEAL WITH IT

THE UNDERLYING PROBLEM…GLOBAL RESERVE SYSTEM

• Essential for global stability

• But it has not been working well—growing dissatisfaction– Stability– Equity– Deflationary bias

Deflationary Bias

• Every year, several hundred billion dollars of “purchasing power” are buried in ground

• Under gold system, gold buried in ground gave rise to employment—though hardly productive

• Previously, profligate governments and lose monetary policies made up for deflationary bias

• Now US has played the role of “consumer of last resort”– Offsets deflationary bias– But causes problems of its own

Inequity

• Allows U.S. to have access to cheap credit

• Net transfer from developing countries

• Adversely affecting their growth

Instability

• Reserve currencies need to be good store of value

• Which is why inflation has always been viewed so negatively by central bankers

• But the credibility of a currency as a reserve currency depends also on exchange rates

• For foreign holders of dollars, weakening of the exchange rate is as bad as an increase in inflation

• Even true for domestic wealth holders, because of opportunity costs

DOLLARS HAVE BEEN USED AS RESERVE CURRENCY

• But can the current system continue?• Negative dynamics—as IOU’s mount, confidence erodes• As confidence erodes, people move out of currency,

weakens currency• Now there are alternatives to dollar• Problem is partly inherent—reserve currency country

gets increasingly in debt as others hold its currency; ease of selling debt entices borrowing; but eventually, debt gets so large that credibility is questioned

• Is this happening today?

Major shift in thinking among central banks

– Don’t need dollar as reserves– What matters is value of reserves– Reserves have to be managed like any other

portfolio– With due attention to risk– With multiple hard currencies, prudent to hold

reserves in multiple currencies– And as dollar appears more risky, to shift out

of dollar– This process is already well under way

INSTABILITY—ANOTHER PERSPECTIVE

• The Hot Potato of Global Deficits• Deficits long recognized as contributing to instability• But sum of trade deficits must equal sum of trade

surpluses• Surpluses are as much a part of the problem as deficits• But it is in the interests of each country to run surplus—

to avoid consequences of crisis– Especially evident in East Asia crisis

• And well managed countries actually succeed in doing so

• But if there are some countries that persist (prudentially) in having a surplus, the rest of the world must have a deficit

• If some country succeeds in eliminating its deficit, the deficit will appear somewhere else in the system (hence the term, deficits as hot potatoes)

• The current system “works” because the US has been willing to be “deficit of last resort”

• But even the United States has a problem in being “the deficit of last resort”– With imports exceeding exports, creates deflationary

bias in U.S.– Requires huge fiscal deficits to offset

• It is not a solution for there to be a two-reserve currency system– Europe too would then face a deflationary bias– Given its institutional structure, Europe would not be

able to respond effectively– Europe should not wish to become a global reserve

currency

Implications for medium and long run

• During transition an extra source of weakness for the dollar—posing problems for Europe

• Increased potential instability, as changes in expectations can lead to more shifting in portfolios

A Simple Proposal: Reforming the Global Reserve System

• Annual issue of global greenbacks (SDR’s, bancor)

• In amounts equal to amount of additions of reserves

• Would not be inflationary—would just undo deflationary bias of current system

• Simplest system—allocating SDR’s to countries on basis of formula

Enhancing Stability

• Now, each country could run deficit equal to its allocation of SDR’s without its reserves being diminished– Reducing fragility of the global economic

system

Enhancing Equity

• Allocation could be done in ways which promote global equity, help finance global public goods

• But still according to simple formula• Enhance stability would facilitate countries

borrowing in their own or related currencies– Addressing one of major global market failures– Poorest countries have to bear risk of interest rate

and exchange rate volatility– Because they borrow in “hard currencies”

Global Reserve System

• There is a worry that the current global reserve system is not working well, that it is contributing to high level of exchange rate volatility, that this volatility has adverse effects on the global economic system

• It is essential for the functioning of the global economic system that the global financial system function well

• The global financial system and the global reserve system are changing rapidly

• But are they changing in ways which will enhance global economic stability?

• Europe’s bid to be a “second” reserve currency is neither good for Europe or for the global economy

• Europe should be working for a more fundamental reform in the global financial system

• This is essential if we are to make globalization work• Both for the developed and the developing world