Mr Meyer discusses the euro in the international financial system  (Central Bank Articles and Speeches, 26 Apr 1999)
Central bank: fed | Type: speech | Date: 1999-04-26

## Mr Meyer discusses the euro in the international financial systemRemarks by Mr Laurence H Meyer, a member of the Board of Governors of the US Federal Reser System,

at the European Institute's Conference 'Challenges to the European Millennium Washington, DC on 26 April 1999.I am very pleased to be here today with such a distinguished group of European officials about the monetary adventure that commenced in Europe earlier this year.

These are challeng for policymakers, with or without a new currency to worry about.Our task today is to celebrate and speculate.

We celebrate an important international creation of the European Economic and Monetary Union, and with it the birth of a new curre euro, and a new supra-national central bank, the ECB.

We recognize the leadership this s Germany as President of the European Union.

And we speculate about the implications of mon union and the euro - for the euro area, for the United States, for the world economy, and for the international monetary system.In my remarks today, I would like to touch on four issues.

First, the role of an internati and the likelihood that the euro could displace the dollar to some extent over the years ah the pros and cons associated with having a preeminent international currency; third, the r exchange rate plays in monetary policy formulation; and, finally, the implications of th international monetary cooperation.Today marks the 81st trading day of the euro since its debut on January 4.

Since its in Europe's single currency has depreciated against the U.S. dollar by nearly 9 percent.

The seems to be that the euro's depreciation has resulted largely from a slowing in growth expectations in the euro zone, while, at the same time, growth in the U.S. has been str expected.

If this is the case, and I believe it is, then the movement of the euro has si what would have occurred in the currencies of the euro area in the absence of monetary unionIt also stands in sharp contrast to the speculation, in the years leading up to the euro's d might be a massive and rapid reallocation of investor portfolios out of dollars and into E currency.

Some experts estimated that such a reallocation of official and private portfolio in the range of $500 billion to $1 trillion.

Such a massive reallocation would, of course, in an appreciating euro and depreciating dollar in the early stages of monetary union.

We that, at least in this initial period, rapid portfolio reallocation does not seem to have euro's exchange value relative to the dollar has moved exactly contrary to what some had p The macroeconomic factors - the outlook for growth and interest rates - so far have dominat new currency's movements, just as macroeconomic factors were the driving force behind movem in the euro's chief predecessor currency, the German mark.But the absence of dramatic near-term consequences should not lead us to conclude that t adventure will have negligible consequences for the euro area, for the global economy o United States.

Rather it should remind us that the consequences of the euro for internation relationships are likely to evolve over some considerable period of time.

The consequenc include a more competitive and healthy euro-wide economy, a greater role for the euro international currency, a growing role for euro-denominated assets in global portfol generally, and changes in the global pattern of exchange rates and current account balances.For example, if economic policies in Europe are sound, the dollar's international status w diminish somewhat and the euro's international status would increase, reflecting the prospe euro-area economy and its role in the global marketplace.

The international status of a involves a number of different functions that correspond generally to the classic uses ofunit of account, a means of payment, and a store of value.

Since the end of the Second World War, dollar has been preeminent in the global financial system in terms of the currency in which con are denominated and paid, official reserves are held, and financial instruments are issued.

But, the German mark increased in international importance and eroded slightly the dollar's status, the euro likely to continue this trend.Inertia and so-called network externalities are key to explaining why a shift away from the d would not occur overnight.

Inertia probably explains why it is that until relatively recently a of traded commodities were quoted and priced in sterling.

If the dollar is used in enough dif ways in the international arena, then it is cheaper to use the dollar rather than some alterna will use the dollar simply because you and everyone I do business with uses the dollar - that is, is a network externality associated with using the dollar.But the international financial consequences of the euro will be driven most importantly to the euro-denominated assets play a growing role in global portfolios, displacing to some degree the of dollar-denominated assets.

Such an expanded role for euro-denominated assets would depend upo and follow from the development of a broad, liquid euro securities market to rival the dollar sec markets.But I am talking only of potential.

A growing and ultimately significant international role for is not automatic.

Instead, the euro area will have to earn its place in the international financ and earn it the old fashioned way - by pursuing policies that produce a healthy euro-area econo By improving price discovery within the euro zone, the euro itself may increase competitiven across Europe, and thereby benefit low-cost producers, trade competitiveness, and Europea consumers.

But the key to the success of the euro area would still appear to be the same set of p that would have been essential in France, Germany, and other euro countries in the absence of euro: structural reforms, especially those related to reducing the rigidities in European labor and disciplined monetary and fiscal policies.

Does the euro make structural reforms and discip policy more or less likely?

Frankly, I do not know the answer to that question.Fortunately, we do not live in a zero sum world.

The structural reforms and monetary and fi policies that would make the euro area stronger and more competitive would certainly enhance t strength of the world economy as well.

Whenever the world economy is strengthened, the U.S. benefits.

However, this should not lead us to understate or neglect the significant changes i flows, current account balances, and exchange rates that might be part of the transition to an in international role of the euro, and the importance of careful management of this transition.It is only fair, however, to warn my euro friends that having a preeminent international curren its pluses and minuses - it is not an unmitigated free ride, as some of the discussion has sugg There is a burden that accompanies having an international currency.

Policy changes that undertaken for domestic purposes can have important effects on others, effects that are magni when a country or region is not only a large part of the world, in terms of goods production and but also a large part of the global financial system and a foundation of the international mo system.For example, Federal Reserve policy in the early years of Paul Volcker's chairmanship involved large increase in short-term interest rates designed to reign-in high domestic inflation.

For cou Latin America that had borrowed heavily in dollars at floating interest rates, the change i monetary policy had enormous consequences.

Thus, when a country's currency is widely used internationally, the international spillovers to domestic policy actions can be intensified, domestic policy actions quickly seem to become everyone's business and can generate criticism international circles.I might note that we at the Federal Reserve steadfastly resist the call to be the world's We are the central bank of the U.S. and Congress has given us a quite specific and narrow promote price stability and full employment at home, period.

While their mandate is not id that of the Federal Reserve, the ECB will have to wrestle with the same issues, and increas the euro becomes a major player in the international monetary system.On the other hand, having an international currency can provide substantial benefits.

The benefit is seignorage revenue.

With about $300 billion of U.S.

currency notes in the foreigners, the United States earns roughly $15 billion per year (less than 0.2 percent seignorage.

With the euro as another major currency in the world's economy - and, in ligh potential attractiveness of euro notes when they are introduced in 2002 to countries in eas and former Soviet states - we could stand to lose a considerable fraction of the interest-f the rest of the world provides to us.

This will, obviously, not be a major event for us and it is not the major benefit for the euro countries of the birth of the euro!Some believe that the major benefit from the United States having the premier international and the broadest and most liquid financial markets is that we are able to finance our l account deficit more cheaply than would otherwise be the case.

That is true only to the ext international status of the dollar brings lower interest rates on dollar liabilities.

Th international currency status might affect a country's (or in the case of the euro, t equilibrium real exchange rate and real interest rate.

But looking at exactly the same phe another way, those who seek international currency status should not forget that an ap currency - and one that is very often a safe haven in times of economic and political implies a reduction in competitiveness and a drag on economic growth through a declining account balance.As the international role of the euro increases, the demand for euros will increase - both currency and indirectly via euro-denominated assets - potentially leading to an appreciati euro.

I say potentially because we all know that the price of anything, including the euro by supply as well as demand.

And the euro will encourage an increase in both the issuance denominated liabilities as well as in the demand for euro-denominated assets.

As a resul some uncertainty about the effect of portfolio decisions on the price of the euro.

Even appreciates, this consideration suggests, the magnitude of the appreciation may not be veryBut let us nevertheless explore the implications of a net increase in the demand for euros appreciation of the euro over time, given that this is the result many have emphasized an particularly important implications for the international financial system.

The effect reallocation of portfolios away from the dollar and dollar-denominated assets and into th euro-denominated assets would, by definition, imply a swing from current account surplus t for the euro area as investors acquire net claims on the region.

Indeed, the appreciation would be the cause of the euro-area's move from surplus to deficit.

But such an appreciat euro would bring a reduction in competitiveness that could provide additional pressure for reform in continental European product and labor markets.

And the counterpart to this from would be a reduction in net claims on the United States, and might be just the medicine ordered to help us move to a more sustainable external position.I'd like to say a few words about how monetary policymakers think about the exchange rat judging the appropriate level for domestic short-term interest rates.

As you know, the economy is relatively closed when compared with individual European countries - U.S. expo goods and services, for example, are only 14 percent of our GDP, compared with Germany w exports are 31 percent of GDP.

With monetary union, the euro area's openness to trade with outside the single currency region becomes more similar to the United States.

For U.S. officials, the dollar through its implications for U.S. net exports and the growth of real for inflation is one of many important economic variables that is input into policymaking.is not, in-and-of itself an explicit goal for policy:

The dollar and its performance are ve important for the United States.

But the Federal Reserve sets its target for the Fed funds rat into account all the performance variables in the economy and does not try to target the exchangeThe European Central Bank now confronts a similar situation relative to the euro's value. depreciation of the euro since its introduction should provide a boost to net exports and put upward pressure on inflation in the euro zone.

The ECB must weigh the effects of the euro depreciation along with many other factors affecting the region's economy in judging the appropr policy stance.Some experts have alleged that the Federal Reserve - and now the ECB - treat the exchange value of their currency with benign neglect.

I have some problems with this characterization.

In the States, we have had a system of flexible exchange rates since the breakdown of the Bretton Woo system in the early 1970s.

By definition, a flexible exchange rate system is one in which policym have complete discretion over monetary policy.

That is, we do not devote monetary policy to maintenance of a particular value for the exchange rate.

That is not benign neglect.

That i implication of a system in which we retain total flexibility for monetary policy actions in order stabilize the domestic economy, of which the international sector is an important component.The importance of maintaining the focus of monetary policy on domestic objectives has clea implications for the suggestion that international monetary cooperation be directed toward maintenance of target zones for exchange rates.

Some have suggested that now that we have thr major currencies - the dollar, the euro, and the yen - it may be easier to achieve such coopera The importance of maintaining monetary policy focused on domestic objectives, however, rules ou in my view, assigning monetary policy the objective of maintaining exchange rates within tar zones.

Frankly, given the volatility of international capital flows, I doubt we could accomplis an objective even if we assigned monetary policy with the responsibility to enforce such agreement.

And, as I said, we should not even want to try to do so.What we should want is a system that permits the United States, the euro area, and Japan to pu policies to achieve domestic objectives, without generating wide and unsustainable swings exchange rates.

But cyclical swings in exchange rates and trade deficits that naturally aris cyclical divergences across the countries should neither be avoided nor regretted.

These moveme are potentially stabilizing and part of the benefits of a flexible exchange rate regime.

We ha that very clearly recently.

Monetary policy responses to cyclical developments tend to reinforc cyclical swings in exchange rates, and these exchange rate movements are very much part of t stabilizing power of monetary policy.

So, in general, these movements should not be avoided regretted.However, when cyclical swings are of longer duration or deeper than normal, fiscal policy must c into play.

Fiscal policy adjustments allow a country to meet its stabilization objective mo bolstering domestic demand and correspondingly less by encouraging external demand at the expens of other countries.

In addition, in times of global economic stress, relying on cyclical swing exchange rates to stabilize individual countries amounts to relying on a redistribution of d across the countries rather than on policies which raise global demand.Changes in structural fiscal deficits - bringing changes in national saving rates and in relat interest rates around the world - are a major contributor to non-cyclical swings in exchange and current account balances.

Divergent fiscal policies may generate movements in exchange rat and current account balances that are large and unsustainable, subjecting the global economy not to an inevitable reversal of these movements, but to the threat of a disorderly correction. dialogue among the dollar, euro and yen countries might have produced a set of policy mixes acr these countries that avoided some of the wider swings in exchange rates that we have witnesduring the past 25 years.

We have learned much from this period, and will all work toward pu knowledge to good use.Let me conclude once again by congratulating the euro area on a remarkably smooth birth new currency and new central bank.

I personally wish the euro area great success with t initiative.