Monetary Policy and Free Trade Part II

The 1973 Oil Crisis was a consequence of a series of events that illustrate the downfall of free trade whenever the governments take on expansionary monetary policies to tackle a deficit on the balance of payments, without having a strong monetary reserve to adjust parity purchase power between currencies.

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In the light of the Smithsonian Agreements, the European Economic Community (EEC) decides to self regulate, based on the Werner report of 1970.

Nicknamed by economists as the snake in the tunnel model, basically this meant pegging all EEC currencies to one other, through the coordination of macro-economic policies of the Member States. This trading model proposed a much larger bandwith than Bretton Woods, thus allowing currencies to go up or down 4.5% to the dollar. This allowed that one currency could go up 9% relative to the other.

It was then seen as necessary to improve on the permissive nature of the snake in the tunnel. The Basle Agreements of 1972 take place  on the background negotiations for the Rome Treaty with its 6 Member States.

The new model of the snake in the tunnel limited the bilateral margins between European currencies to 2.5% with a maximum turn over of 4.5% and with all moving together against the dollar. This model killed the sterling pound monetary area, but eventually also collapsed when the U.S. dollar started floating freely. in 1977 the Deutsche Mark led as the reserve currency but only with Benelux and Danemark on its tail.

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The 1973 Oil Crisis had strong effects on the Monetary Policy.

The OAPEC proclaimed an oil embargo to sanction the U.S. support to the Israeli on the Yom Kippur war. Europe and Japan disassociated themselves from the U.S. and Kissinger had to negotiate an Israeli retreat from the Golan Heights and the Sinai Peninsula right after the end of hostilities.

Right after Bretton Woods fall, started the free floating of the U.S. dollar, and most industrialized nations increased their reserves by printing more money , which resulted in a depreciation of the dollar and because oil price was indexed in dollars, oil producers were getting less value for the petro dollars, which made them issue the statement of pegging the oil barrel prices to the gold. OPEC/OAPEC were not ready to make the institutional adjustments from the volatility of the dollar after 1967.

With the Middle East hostilities, the West was increasing their energy bill by 5% per year and selling inflation priced goods back to the oil-producers countries in the Third-World. That led to the declaration of the Shah of Iran in 1973: “You  increased the price of wheat you sell us by 300%, and the same for sugar and cement…; You buy our crude oil and sell it back to us, refined as petrochemicals, at a hundred times the price you’ve paid to us…; It’s only fair that, from now on, you should pay more for oil. Let’s say ten times more.”

With the demise of Bretton Woods, the world financial system fell into a recession of inflationary prices until the 1980s, while the oil prices continued to rise up until 1986.

The 73 oil crisis marked for that same reason the very beginning of  alternative energy sources research, so popular in our days.

The Oil Producers immediately started accumulating a vast wealth and pipe lined some of  those monies in the form of aid to other under developed or developing countries. The International Monetary Fund also created the “Oil Facility” instrument (1974-76) destined to help most affected nations to tackle their balance of payments deficit. The IMF loans were subject to one of two pre-conditions:  a petro-dollar international payment deficit or a general balance of payments deficit.

in 1975 the European Economic Community also joint efforts and approved a regulation (law) on European Community loans.

The International community first instinct was to provide support first to the industrialized countries, those who supported Liberal Capitalism in the form of free trade and financial cooperation. The other support was made available, in the form of a special line of credit, to the Developing countries, whose economies had been caught between higher prices of oil and lower prices for their own export commodities and raw materials amid shrinking Western demand for their goods.

Those Non Alignment countries more often than not, with the exception of a few remarkable cases, ended up appropriating that structural adjustment financial loans and deviating it to their ideological programs, such as rearmament and cosmetic public spending infrastructures.

That meant that the credit institutions loans, like the IMF, The Paris Club of Creditors, the London Club of Creditors,  were never repaid in full, while in debt nations spiraled into consecutive loans, that were granted simply to pay for accumulated interests in the short run, in the long run they could never fully regain international confidence, simultaneously degrading their future access to credit line. A few of the final consequences over this matter were moratoriums over the payments, regime nationalizations of oil wells and even civil wars. On the other side, International Creditors even went as far as forgiving outstanding multi-billion dollars debts just to prevent another collapse of the status quo, but unwillingly legitimizing corrupted regimes in the process and preventing reform.

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in 1979 is born the European Monetary System, in the veils of the II oil shock crisis. Back then, the dollar was floating freely and the Deutsche Mark had limited adhesion from other European currencies. The European Monetary System created a central reserve currency, called the ECU (European Currency Unit). With the ECU it was also created an European Exchange Rate Mechanism (ERM), an extension of European credit facilities and the European Monetary Cooperation Fund (precursor of the European Central Bank: that allocated ECUs to Member States in exchange for Gold and U.S. dollar deposits).

The European Exchange Rate Mechanism created a `Parity Grid` of  bilateral exchange rates based on the fixed currency exchange rate margins of the ECU (a semi pegged system where fluctuations were contained within a margin of 2.25% on either side of the bilateral rates, 6% to Italy and enlarging to 15% in 1993 to sustain speculation against the french franc). The ECU fixed exchange rate was based on a weighted average of the participating currencies.

There were two ECU’s: The Official ECU (mostly an accounting unit for reference, circulating among banking institutions), and the `private` ECU (used in international financial transactions). The ECU was regulated by the European Monetary Cooperation Fund (Brussels Resolution of 1978), that would manage the `snake in the tunnel` trends, issuing currency against the deposit of 20% of gold/dollar reserves of the Central Banks of the Member States, with a trimester review of the divergence indicator.

In the 1980’s most economists began to stand for a nation’s central bank independence from the executive to ensure a smoother monetary policy (avoid its manipulation over party politics and electoral fault moves).

The debate over the European Economic Monetary Union, was again launched by the Delors Committee in 1988 (The Member States Central Banks Governors met around the President of the European Commission). And in 1989 the Delors Report set up a 3 stage plan to roll out the EMU, including the creation of The ESCB (European System of Central Banks):

-Stage 1 (1990-93)- exchange controls were abolished, thus capital movements were completely liberalised in the European Economic Community

-Stage 2 (1994-98)- The European Monetary Institute replaces European Monetary Cooperation Fund and is later baptised European Central Bank, setting up the conversion rate for the 11 participating currencies to the EURO; The Stability Pact gets approved at the European Council of Amsterdam to ensure budgetary discipline after rolling out of the euro, and a new exchange rate mechanism (ERM II) is set up to provide stability above the euro and the national currencies of countries that haven’t yet entered the eurozone.

-Stage 3- (1999)- single monetary policy is introduced under the authority of the ECB. A three-year transition period begins before the introduction of actual EURO cash.

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In the 1990s, central banks started to adopt formal, public inflation targets with the goal of making the outcomes, if not even the process, of monetary policy more transparent. This is to say if a targeted inflation is not achieved then the central bank will typically have to submit an explanation.

The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% Retail Prices Index (now 2% of Consumer Prices Index).

The underlying point is about whether monetary policy can soften up business cycles or not. Keynes principle is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded.

Nowadays most economies in the world have an inflation targeting (Conumer Price Index) type of monetary policy. These include the U.S. ( a mix model), the European Union and the single currency (EURO), Australia, Brazil, Canada and India, UK. The great exception is China.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate (ex: EURIBOR) at which banks lend to each other overnight for cash flow purposes.

To achieve inflation targets, Central Banks resort to open market operations (sales and purchases of second hand government debt or changing reserve requirements: If the central bank desires to lower interest rates, it purchases government debt, therefore increasing the amount of cash in circulation; A central bank can only operate a truly independent monetary policy when the exchange rate is floating. If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange).

Changes to the interest rate target are made in reaction to many market indicators in an tentative to forecast economic trends and thus keeping the market on track towards achieving the defined inflation target.

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in 1998 the ECU exchange rates of the Eurozone countries were frozen and the value of the EURO, which then superseded the ECU at site, was therefore established. In 1999 the ERM II replaced the first ERM. A currency in ERM II is allowed to float within a range of plus or minus 15% with respect to a central rate against the euro.

The characteristics of an Economic Monetary Union are free circulation of capitals in a free market area , where member states join in  common commercial policy (competition), adopting a series of convergence criteria in the macro economic sphere (budget, fiscal, monetary). Within the monetary union, there is an assurance of absolute convertibility of the currencies between each other in a fully integrated banking and financial unitarian system. Elimination of fluctuation margins and an irrevocable determination of parities.