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Limiting exchange rate flexibility: The European Monetary System
Journal
of International
Economics
29 (1990) 385-396.
BOOK
North-Holland
REVIEWS
Francesco Giavazzi and Albert0 Giovannini, Limiting Exchange Rate Flexibility: The European Monetary System (The MIT Press, Cambridge, Mass., 1989) pp. xi + 230, $27.50. This book should become a standard reference for economists interested in the performance of the European Monetary System (EMS) during its first decade of operation. It is written by two economists who previously had published several influential papers on the EMS. Now they have provided readers with a comprehensive analysis of this system, which highlights both its strengths and weaknesses. The book focuses on several key characteristics of the EMS: (1) The primary objective of the EMS is to stabilize European exchange rates. The authors provide an interesting historical discussion of why exchange rate stability is so important to European countries, rightly emphasizing the need to stabilize the exchange rates used for agricultural trade within the European Economic Community. In a later chapter they present evidence on exchange rate variability. (2) Germany occupies a central position within this system, much like the position held by the United States under Bretton Woods. In the Bretton Woods system, the United States tied its currency to gold, while other countries tied to the dollar. In the EMS, Germany focuses its intervention operations on the dollar market, while its partners in the EMS conduct most of the intra-European intervention required to fix rates within the EMS. When exchange rate crises occur, DM interest rates are largely unaffected, while franc and lira interest rates, at least those in the Eurocurrency markets, respond sharply to the resulting speculation. (3) One important advantage of membership in the EMS is that countries can tie their monetary policy to that of the Bundesbank, an institution with a solid reputation for fighting inflation. The authors present evidence showing that the EMS has led to a convergence of inflation rates in Europe. By joining the system, members of the EMS, other than Germany, gain credibility for their monetary policies. The authors explore Barr+Gordon type models to show the gain in credibility attained when fixed exchange 0022-1996/90/$03.50
0
1990-Elsevier
Science Publishers
B.V. (North-Holland)
386
Book reciews
rates replace discretionary monetary policy under flexible rates or a managed float. (4) The EMS is not truly a fixed exchange rate system since periodic realignments of parities occur, so the success of the system depends partly on how frequently such realignments occur. Capital controls have played a role in helping the partner countries to avoid realignments by limiting speculation against a currency. The authors present evidence showing the effects of controls on the interest rate differentials between national markets (which are behind the control barriers) and Eurocurrency markets in the same currencies. The authors provide a variety of theoretical models and empirical evidence on these and other questions. Not all of their analyses are successful in resolving the questions at hand, but researchers can learn almost as much from their unsuccessful explorations as from their successful ones. Chapters 3-5 provide the heart of this analysis. Chapter 3 presents tests to determine whether the EMS has stabilized exchange rates. The first two sets of tests examine the conditional variances of changes in nominal and real exchange rates between the DM and other EMS currencies. Variances of the exchange rates for the guilder, French franc, and lira all have declined in the EMS period, although the variance of the Belgian franc has not. Variances of the real exchange rates for the franc and lira have also declined, but, curiously enough, not the variances of the Belgian franc and guilder. A similar test applied to real effective exchange rates, however, finds that only one EMS currency, the lira, has experienced a decline in variance in the EMS period. So it appears that the EMS has stabilized many bilateral rates between the DM and other EMS currencies, but has not succeeded in stabilizing multilateral rates, despite the large weight of intra-European trade in the effective exchange rate indexes. First differencing the data obscures low-frequency movements in real exchange rates, which have been termed ‘misalignments’ by John Williamson and others, so the authors also examine the standard deviations of the levels of real effective exchange rates. Germany alone experiences a decline in standard deviation over the EMS period, while at the other extreme Belgium experiences a large increase in the standard deviation of its real effective exchange rate. We have to be careful in interpreting these results because, as the authors point out, we do not know whether these differences are statistically significant (we know little about the small sample properties of these statistics). But if these results are taken at face value, we can understand one motivation for Germany to join the EMS: prior to the EMS, Germany found its European and non-European exchange rates highly correlated. After 1979, Germany was able to stabilize its exchange rates with other European currencies and therefore was able to reduce the variability of its real effective exchange rate. Other EMS countries were not able to reduce
Book reviews
387
the variability of their real effective rates, so we must look to other motivations for their membership. In chapter 4, the authors investigate whether the DM occupies a central position in the EMS akin to that of the dollar in the Bretton Woods System. They use a simple model of the money markets in two countries to show how foreign exchange intervention and sterilization behavior can allow one country to follow a domestic monetary policy while the other country plays follow the leader. They provide three types of evidence bearing on this question. First, intervention data suggest that Germany is much more active in intervening in the dollar market than other EMS countries, but largely refrains from intervention in the markets for EMS currencies, leaving such intervention to countries like France and Belgium. Second, French and Italian interest rates, at least in the Eurocurrency markets, respond to exchange market crises, while German interest rates are largely insulated from such crises. In the third investigation, the authors estimate reaction functions for three countries, but are unable to obtain definitive results. Of the three empirical studies, the second, showing different interest rate behavior in Germany, is the most interesting. One drawback of this investigation is that the model of interest rates leaves no room for capital controls that are crucial in explaining interest differentials between the national interest rates in France and Italy and their Eurocurrency counterparts. As the authors have emphasized in earlier work, capital controls help to insulate national markets from speculation about realignments by diverting pressure to the Eurocurrency markets. So we are not sure whether the asymmetric behavior of Euro rates is due to different monetary policies in France and Italy compared with Germany, or to the presence of controls in the former two countries. As discussed above, one theme of the book is that the EMS has been successful in lowering the inflation rates of its member countries. The evidence presented by the authors in chapter 5 is not decisive on this point. The authors show that inflation has fallen dramatically in the EMS countries they examine and that in all cases the gap between the inflation rates in Germany and other countries has narrowed just as dramatically. One of the four countries compared with Germany, however, is the United Kingdom, which has kept flexible exchange rates throughout the period even though it is a nominal member of the EMS. An examination of inflation performances in the United States and Japan, moreover, shows that these countries’ inflation rates also fell dramatically and converged with German inflation. The same chapter, on the other hand, presents an insightful discussion of how exchange rate regimes should affect inflation performance. Using a simple two-country model due to Canzoneri and Henderson, they show that a country with a poor reputation for fighting inflation may gain by joining forces with a country with a tough reputation for inflation-fighting (visualize
388
Book reviews
Germany). But what if periodic realignments are possible? The authors show that the costs of inflation in the periods between realignments, arising from the real appreciation that accompanies the inflation, are high enough to reduce the inflationary bias of such a regime below that of a purely flexible regime. They then estimate reduced-form equations for prices, wages, and output over the period since 1960, and test to see whether there is a structural break in 1979 at the start of the EMS. Only in France is a break statistically significant. When they simulate the models, they find that German inflation is higher than predicted after 1979, while French and Danish inflation is underpredicted. This pattern is consistent with a model where the EMS represents a compromise for the monetary policies of both Germany and its partners. But the simulations also show that British inflation is below that predicted by the model, so the causal link from EMS membership to inflation performance remains unclear here as well. Chapters 6 and 7 address more specialized issues, i.e. dollar-DM ‘polarization’ and capital controls. The polarization involves the tendency for the DM to weaken vis-a-vis other European currencies when the dollar is strong in foreign exchange markets. The authors present empirical evidence establishing the importance of polarization, then develop a dynamic portfolio model to explain the polarization. As in other studies, the dynamic model is not very successful in explaining the data, even when the model is modified to include capital controls. The chapter on capital controls presents very interesting evidence on the effects of capital controls in France and Italy. The authors distinguish between the effects of controls on portfolio investments and trade credits, then analyze the pattern of national and Eurocurrency interest rates in terms of expectations about realignments of parities. The authors manage to address most of the important features of the EMS. (One topic not addressed concerns the System’s possible evolution into a monetary union with a single central bank.) They are sufficiently critical of some of these features to provide a balanced perspective on the system as a whole. The System has not necessarily performed as its architects intended, particularly in allowing Germany such a central role, but most observers join Giavazzi and Giovannini in pronouncing the EMS an overall success. Richard C. Marston University of Pennsylvania Edward M. Graham and Paul R. Krugman, the United States (Institute for International 1989) pp. xiii+ 161, $11.95.
Foreign Direct Investment in Economics, Washington, DC,
This volume provides an effective rebuttal to frequently heard calls for greater restrictions against foreign direct investment (FDI) in the United
of International
Economics
29 (1990) 385-396.
BOOK
North-Holland
REVIEWS
Francesco Giavazzi and Albert0 Giovannini, Limiting Exchange Rate Flexibility: The European Monetary System (The MIT Press, Cambridge, Mass., 1989) pp. xi + 230, $27.50. This book should become a standard reference for economists interested in the performance of the European Monetary System (EMS) during its first decade of operation. It is written by two economists who previously had published several influential papers on the EMS. Now they have provided readers with a comprehensive analysis of this system, which highlights both its strengths and weaknesses. The book focuses on several key characteristics of the EMS: (1) The primary objective of the EMS is to stabilize European exchange rates. The authors provide an interesting historical discussion of why exchange rate stability is so important to European countries, rightly emphasizing the need to stabilize the exchange rates used for agricultural trade within the European Economic Community. In a later chapter they present evidence on exchange rate variability. (2) Germany occupies a central position within this system, much like the position held by the United States under Bretton Woods. In the Bretton Woods system, the United States tied its currency to gold, while other countries tied to the dollar. In the EMS, Germany focuses its intervention operations on the dollar market, while its partners in the EMS conduct most of the intra-European intervention required to fix rates within the EMS. When exchange rate crises occur, DM interest rates are largely unaffected, while franc and lira interest rates, at least those in the Eurocurrency markets, respond sharply to the resulting speculation. (3) One important advantage of membership in the EMS is that countries can tie their monetary policy to that of the Bundesbank, an institution with a solid reputation for fighting inflation. The authors present evidence showing that the EMS has led to a convergence of inflation rates in Europe. By joining the system, members of the EMS, other than Germany, gain credibility for their monetary policies. The authors explore Barr+Gordon type models to show the gain in credibility attained when fixed exchange 0022-1996/90/$03.50
0
1990-Elsevier
Science Publishers
B.V. (North-Holland)
386
Book reciews
rates replace discretionary monetary policy under flexible rates or a managed float. (4) The EMS is not truly a fixed exchange rate system since periodic realignments of parities occur, so the success of the system depends partly on how frequently such realignments occur. Capital controls have played a role in helping the partner countries to avoid realignments by limiting speculation against a currency. The authors present evidence showing the effects of controls on the interest rate differentials between national markets (which are behind the control barriers) and Eurocurrency markets in the same currencies. The authors provide a variety of theoretical models and empirical evidence on these and other questions. Not all of their analyses are successful in resolving the questions at hand, but researchers can learn almost as much from their unsuccessful explorations as from their successful ones. Chapters 3-5 provide the heart of this analysis. Chapter 3 presents tests to determine whether the EMS has stabilized exchange rates. The first two sets of tests examine the conditional variances of changes in nominal and real exchange rates between the DM and other EMS currencies. Variances of the exchange rates for the guilder, French franc, and lira all have declined in the EMS period, although the variance of the Belgian franc has not. Variances of the real exchange rates for the franc and lira have also declined, but, curiously enough, not the variances of the Belgian franc and guilder. A similar test applied to real effective exchange rates, however, finds that only one EMS currency, the lira, has experienced a decline in variance in the EMS period. So it appears that the EMS has stabilized many bilateral rates between the DM and other EMS currencies, but has not succeeded in stabilizing multilateral rates, despite the large weight of intra-European trade in the effective exchange rate indexes. First differencing the data obscures low-frequency movements in real exchange rates, which have been termed ‘misalignments’ by John Williamson and others, so the authors also examine the standard deviations of the levels of real effective exchange rates. Germany alone experiences a decline in standard deviation over the EMS period, while at the other extreme Belgium experiences a large increase in the standard deviation of its real effective exchange rate. We have to be careful in interpreting these results because, as the authors point out, we do not know whether these differences are statistically significant (we know little about the small sample properties of these statistics). But if these results are taken at face value, we can understand one motivation for Germany to join the EMS: prior to the EMS, Germany found its European and non-European exchange rates highly correlated. After 1979, Germany was able to stabilize its exchange rates with other European currencies and therefore was able to reduce the variability of its real effective exchange rate. Other EMS countries were not able to reduce
Book reviews
387
the variability of their real effective rates, so we must look to other motivations for their membership. In chapter 4, the authors investigate whether the DM occupies a central position in the EMS akin to that of the dollar in the Bretton Woods System. They use a simple model of the money markets in two countries to show how foreign exchange intervention and sterilization behavior can allow one country to follow a domestic monetary policy while the other country plays follow the leader. They provide three types of evidence bearing on this question. First, intervention data suggest that Germany is much more active in intervening in the dollar market than other EMS countries, but largely refrains from intervention in the markets for EMS currencies, leaving such intervention to countries like France and Belgium. Second, French and Italian interest rates, at least in the Eurocurrency markets, respond to exchange market crises, while German interest rates are largely insulated from such crises. In the third investigation, the authors estimate reaction functions for three countries, but are unable to obtain definitive results. Of the three empirical studies, the second, showing different interest rate behavior in Germany, is the most interesting. One drawback of this investigation is that the model of interest rates leaves no room for capital controls that are crucial in explaining interest differentials between the national interest rates in France and Italy and their Eurocurrency counterparts. As the authors have emphasized in earlier work, capital controls help to insulate national markets from speculation about realignments by diverting pressure to the Eurocurrency markets. So we are not sure whether the asymmetric behavior of Euro rates is due to different monetary policies in France and Italy compared with Germany, or to the presence of controls in the former two countries. As discussed above, one theme of the book is that the EMS has been successful in lowering the inflation rates of its member countries. The evidence presented by the authors in chapter 5 is not decisive on this point. The authors show that inflation has fallen dramatically in the EMS countries they examine and that in all cases the gap between the inflation rates in Germany and other countries has narrowed just as dramatically. One of the four countries compared with Germany, however, is the United Kingdom, which has kept flexible exchange rates throughout the period even though it is a nominal member of the EMS. An examination of inflation performances in the United States and Japan, moreover, shows that these countries’ inflation rates also fell dramatically and converged with German inflation. The same chapter, on the other hand, presents an insightful discussion of how exchange rate regimes should affect inflation performance. Using a simple two-country model due to Canzoneri and Henderson, they show that a country with a poor reputation for fighting inflation may gain by joining forces with a country with a tough reputation for inflation-fighting (visualize
388
Book reviews
Germany). But what if periodic realignments are possible? The authors show that the costs of inflation in the periods between realignments, arising from the real appreciation that accompanies the inflation, are high enough to reduce the inflationary bias of such a regime below that of a purely flexible regime. They then estimate reduced-form equations for prices, wages, and output over the period since 1960, and test to see whether there is a structural break in 1979 at the start of the EMS. Only in France is a break statistically significant. When they simulate the models, they find that German inflation is higher than predicted after 1979, while French and Danish inflation is underpredicted. This pattern is consistent with a model where the EMS represents a compromise for the monetary policies of both Germany and its partners. But the simulations also show that British inflation is below that predicted by the model, so the causal link from EMS membership to inflation performance remains unclear here as well. Chapters 6 and 7 address more specialized issues, i.e. dollar-DM ‘polarization’ and capital controls. The polarization involves the tendency for the DM to weaken vis-a-vis other European currencies when the dollar is strong in foreign exchange markets. The authors present empirical evidence establishing the importance of polarization, then develop a dynamic portfolio model to explain the polarization. As in other studies, the dynamic model is not very successful in explaining the data, even when the model is modified to include capital controls. The chapter on capital controls presents very interesting evidence on the effects of capital controls in France and Italy. The authors distinguish between the effects of controls on portfolio investments and trade credits, then analyze the pattern of national and Eurocurrency interest rates in terms of expectations about realignments of parities. The authors manage to address most of the important features of the EMS. (One topic not addressed concerns the System’s possible evolution into a monetary union with a single central bank.) They are sufficiently critical of some of these features to provide a balanced perspective on the system as a whole. The System has not necessarily performed as its architects intended, particularly in allowing Germany such a central role, but most observers join Giavazzi and Giovannini in pronouncing the EMS an overall success. Richard C. Marston University of Pennsylvania Edward M. Graham and Paul R. Krugman, the United States (Institute for International 1989) pp. xiii+ 161, $11.95.
Foreign Direct Investment in Economics, Washington, DC,
This volume provides an effective rebuttal to frequently heard calls for greater restrictions against foreign direct investment (FDI) in the United