The Euro:The Euro:ConsiderationsConsiderations

The Feldstein Thesis The Feldstein Thesis

Turning over monetary authority to the Turning over monetary authority to the ECB removes an important component ECB removes an important component of macroeconomic policy from of macroeconomic policy from individual European governments.individual European governments.

If a recession comes in Italy (but not in If a recession comes in Italy (but not in the EU generally), the Italians cannot the EU generally), the Italians cannot run deficits (EU rules) and cannot run deficits (EU rules) and cannot increase the money supply to stimulate increase the money supply to stimulate the economy. What will happen when a the economy. What will happen when a serious recession hits in part of the EU serious recession hits in part of the EU countries?countries?

The Feldstein Thesis The Feldstein Thesis

Feldstein thought the EU would Feldstein thought the EU would unravel.unravel.

The Maastricht rules. (No excessive The Maastricht rules. (No excessive deficits, debt or inflation.)deficits, debt or inflation.)

Krugman thought they made no Krugman thought they made no sense. They’re like hazing to get into sense. They’re like hazing to get into a fraternity at some local university.a fraternity at some local university.

Did they have any purpose?Did they have any purpose?

The ECB transparency issue.The ECB transparency issue.

Why doesn’t the ECB publish its Why doesn’t the ECB publish its minutes?minutes?

So individual countries can’t get upset So individual countries can’t get upset when their central bank representative when their central bank representative votes in the interest of the community votes in the interest of the community rather than their particular, narrow rather than their particular, narrow national interest.national interest.

So is transparency sufficient in the ECB?So is transparency sufficient in the ECB?

Chinese And Japanese Chinese And Japanese Purchases of US BondsPurchases of US Bonds(Shifting from the US (Shifting from the US

Dollar to the Euro as a Dollar to the Euro as a country’s reserve country’s reserve

currency)currency)The value of Yuan, The value of Yuan,

Yen, US$ and the EuroYen, US$ and the Euro

What are China’s trade policy What are China’s trade policy objectives?objectives?

Keep the value of the Yuan low to Keep the value of the Yuan low to promote exports.promote exports.

Keep the U.S. export market open.Keep the U.S. export market open.

China has 50 million jobs dedicated China has 50 million jobs dedicated to its U.S. trade, and rural Chinese to its U.S. trade, and rural Chinese continue to pour into manufacturing continue to pour into manufacturing areas seeking work.areas seeking work.

How has China kept the Yuan price How has China kept the Yuan price low? low?

Sell Yuan in foreign currency Sell Yuan in foreign currency markets.markets.

Buy dollars. Buy dollars.

Dollars become foreign currency Dollars become foreign currency reserves. How can you make money reserves. How can you make money

on reserve holdings? on reserve holdings?

Purchase U.S. treasury bonds.Purchase U.S. treasury bonds.

Why do we sell so many bonds? Why do we sell so many bonds?

To finance the war in Iraq, to fund To finance the war in Iraq, to fund Katrina-related projects, to fund Katrina-related projects, to fund medicare prescription benefits, medicare prescription benefits,

Etc.,Etc.,Etc.,Etc.,Etc.Etc.

In purchasing our bonds, China supports In purchasing our bonds, China supports the maintenance of the U.S. trade-finance the maintenance of the U.S. trade-finance system. We need the foreign funds to system. We need the foreign funds to sustain our import deficits.sustain our import deficits.

Why does China want to sustain our Why does China want to sustain our system by purchasing treasury bonds?system by purchasing treasury bonds?

The Chinese have around two hundred The Chinese have around two hundred billion dollars invested in it. They want to billion dollars invested in it. They want to retain our export markets. U.S. bond retain our export markets. U.S. bond yields, somewhat low by historical yields, somewhat low by historical standards, are still higher than those of standards, are still higher than those of the other major countries. the other major countries.

What happens if China were to sell off What happens if China were to sell off their bond holdings?their bond holdings?

The increase in supply would drive the price The increase in supply would drive the price down. down.

$96

$92

S1

S2

So the interest raterises from 4% to 8%.

When China unpegged the Yuan, they When China unpegged the Yuan, they purchased Euros to support their new purchased Euros to support their new

market basket pegging. market basket pegging.

Interest rates rose immediately as Interest rates rose immediately as bond prices fell (although only a bond prices fell (although only a little.)little.)

We panicked. China restructuring it’s We panicked. China restructuring it’s reserve portfolio?reserve portfolio?

A cutback can do the same job A cutback can do the same job as a selloff in the Treasury bond as a selloff in the Treasury bond

market!market! Cutback SelloffCutback Selloff

Japan has been doing the same Japan has been doing the same thing, only they’ve got a lot thing, only they’ve got a lot

more bonds!more bonds! Why do they buy bonds?Why do they buy bonds? They want to sell Yen, so they buy dollars They want to sell Yen, so they buy dollars

with them in the foreign exchange with them in the foreign exchange markets.markets.

With the huge dollar reserves, they buy With the huge dollar reserves, they buy U.S. bonds. 3-4% interest is better than U.S. bonds. 3-4% interest is better than just sitting on the dollars. They have c. just sitting on the dollars. They have c. $740 billion in our bonds and have lost c. $740 billion in our bonds and have lost c. $110 billion in value with decline of the $110 billion in value with decline of the dollar.dollar.

Japan’s Interest in the DollarJapan’s Interest in the Dollar

To maintain the bond market is to To maintain the bond market is to defend the dollar. If the bonds sell defend the dollar. If the bonds sell big time, the value of the dollar big time, the value of the dollar would fall. Even if China stopped would fall. Even if China stopped buying U.S. securities, Japan's central buying U.S. securities, Japan's central bank probably would step in and bank probably would step in and defend the dollar to protect its own defend the dollar to protect its own huge export trade with the United huge export trade with the United States.States.

Is a selloff likely?Is a selloff likely?

Nobody thinks so at the moment, but Nobody thinks so at the moment, but would it take a selloff to drop bond would it take a selloff to drop bond prices and raise interest rates?prices and raise interest rates?

No, the cutback would do the job No, the cutback would do the job fine.fine.

Could we raise the funds by Could we raise the funds by selling additional bonds to other selling additional bonds to other

parties?parties?Of course. How can we get other Of course. How can we get other

investors to buy more than they investors to buy more than they currently want?currently want?

Raise the interest earnings (drop the Raise the interest earnings (drop the costs of the bonds). costs of the bonds).

Could we raise the funds by Could we raise the funds by selling additional bonds to other selling additional bonds to other

parties?parties?Of course. But when these interest Of course. But when these interest

rates go up, what else happens?rates go up, what else happens?

Other interest rates in investment Other interest rates in investment markets rise. Crowding-out occurs in markets rise. Crowding-out occurs in private sector investments.private sector investments.

Interest rates on housing go up, so Interest rates on housing go up, so the housing boom ends.the housing boom ends.

What happens if the housing What happens if the housing boom ends and all i rates boom ends and all i rates

skyrocket?skyrocket?

Fini Fini (The End)(The End)

Europe’s Labor MarketsEurope’s Labor Markets

““European Labor Markets and EMU European Labor Markets and EMU Challenges Ahead,” Soltwedel, Challenges Ahead,” Soltwedel, Dohse, and Krieter-Boden.Dohse, and Krieter-Boden.

Members of the EMU must give upMembers of the EMU must give up1. Monetary policy1. Monetary policy2. Currency devaluations2. Currency devaluations

Europe’s Labor MarketsEurope’s Labor Markets

With different regional structures, some With different regional structures, some based on divergent development from based on divergent development from scale economies and specialization, scale economies and specialization, regions are subject to different asymmetric regions are subject to different asymmetric (region-specific) shocks, those whose (region-specific) shocks, those whose macro impacts affect some regions more macro impacts affect some regions more than others.than others.

Such shocks are more pronounced in the Such shocks are more pronounced in the EU at the regional than at the national EU at the regional than at the national level.level.

Europe’s Labor MarketsEurope’s Labor Markets

Unemployment also has a regional Unemployment also has a regional dimension. The dispersion of regional dimension. The dispersion of regional unemployment rates across the EU unemployment rates across the EU was three times higher in 1995 than in was three times higher in 1995 than in the late 1970s. Unemployment in the late 1970s. Unemployment in economically troubled regions was economically troubled regions was three times higher in 1995 than in the three times higher in 1995 than in the late 1970s.late 1970s.

Europe’s Labor MarketsEurope’s Labor Markets

Unemployment is largely a result of Unemployment is largely a result of the inflexible labor markets in Europe.the inflexible labor markets in Europe.Workers once hired are more or less Workers once hired are more or less

permanent acquisitions. (Legal, permanent acquisitions. (Legal, institutional impediments to down-sizing.) institutional impediments to down-sizing.)

West European workers are costlyWest European workers are costly(e.g., high, union-encouraged wages, (e.g., high, union-encouraged wages,

payroll taxes in Germany. Minimum payroll taxes in Germany. Minimum standards for working conditions in the standards for working conditions in the EU’s social charter of 1989.)EU’s social charter of 1989.)

Europe’s Labor MarketsEurope’s Labor Markets

Conclude by discussing the quote on Conclude by discussing the quote on p. 348.p. 348.