Economics Honours Thesis 2002

The Euro and Beyond

This thesis investigates the background and reasoning for the introduction of the euro. It employs
qualitative and quantitative analysis to determine whether or not monetary unions are economically
efficient and highlights the impact that the euro has had on the international financial structure.

by: Andrew du Boulay

 Front cover

Presently there are 12 member states of the European Union participating in a common currency.

They are:

Austria Belgium Finland France

Germany Greece Ireland Italy
Luxembourg Spain The Netherlands Portugal

Denmark, Sweden and the United Kingdom are members of the European Union but are not
currently participating in the single currency. Denmark is a participating member of the Exchange
Rate Mechanism II (ERM II), which means that the Danish krone is linked to the euro, although the
exchange rate is not fixed.

As of March 2002, there were another thirteen countries that had made application to join the
European Union. The countries participating in the enlargement process are :

Bulgaria Cyprus Czech Republic Estonia

Hungary Latvia Lithuania Malta
Poland Romania Slovakia Slovenia
Turkey

It is expected by 2008 that there will be at least twenty five countries participating in the European
Union all having a common currency, with monetary policy being managed by the European
Central Bank in Frankfurt, Germany under the directive of the European Parliament.
 The euro and beyond
This thesis investigates the background and reasoning for the introduction of the euro. It
employs qualitative and quantitative analysis to determine whether or not monetary unions are
economically efficient and highlights the impact that the euro has had on the international
financial structure.

Thesis submitted by

Andrew du Boulay

November 2002

In partial fulfilment of the requirements for the

Degree of Bachelor of Economics with Honours
from the School of Business,
James Cook University, Townsville.
 Statement on access to thesis

I, Andrew du Boulay the undersigned and author of this thesis, understand that James Cook
University will make this thesis available for use within the university library in hard copy as
well as microfilm or other photographic or electronic means as they so desire. I also
acknowledge that the James Cook University Library will also allow access to users in other
approved libraries, both national and international. I do not place any restrictions on access to
this thesis.

----------------------------------

Andrew du Boulay

4th November 2002

II
 Declaration

I, Andrew du Boulay, declare this thesis is my own work and has not been submitted in any form
for another degree or diploma at any university or other institution of tertiary education.
Information derived from the published or unpublished work of others has been acknowledged
in the text with references given.

---------------------------------

Andrew du Boulay

4th November 2002

III
 Acknowledgements

I wish to express my sincere gratitude to the James Cook University staff. A special thank you is
extended to the School of Business and the Economics Department.

On a personal note I would like express my appreciation to the Head of School, Associate
Professor Owen Stanley and Associate Professor Richard Monypenny, for having the insight,
courage and determination to ensure the survival and longevity of the Economics Degree within
James Cook University. If it were not for your efforts the economics students of 2002 would
have surely had to settle for second best. The economics students of 2002 acknowledge and
sincerely appreciate your efforts. Personally and on behalf of my student peers I would also like
to thank you for your guidance. You inspired the thirst for learning and directed that to fruition.
Thank you both very much.

It must also be acknowledged that the tremendous wealth of knowledge adjunct Professor
Wolfgang Fischer contributes to the Economics Faculty, is truly appreciated. Sir, the Degree of
Economics is not complete without your input. I would also like to thank Professor Fischer for
the initial guidance extended to me in the conceptual stages of this thesis. I would also like to
thank Mr Ian Fleming for keeping the spark of interest alive in the pursuit of economics. Your
wisdom of macroeconomics crystallized and clarified the importance of the big picture
perspective. My thanks is also extended to Ms Vera Girgenti and Dr Paul Kim who carved
through rock an impressionable course on the virtues of statistics and mathematics and its
relationship in economics. I also extend with the warmest of appreciations, a big thank you to Dr
Rabiul Alam Beg, not only for your valuable help in guiding the technical portion of this thesis
but also for making the pice de rsistance of economics, econometrics, the crowning
achievement of this degree. Dr Beg you made learning rewarding, it was an honour to be one of
your students. A special thank you must be given to Dr Marianne Phillips for her valuable
assistance in proof reading and improvement suggestions on the finer details of this thesis.
Marianne thank you very much!

Not forgetting the motley crew that made up the 2002 honours class: Aiva Viri; Joel Thomas;
Bruce Ferrett; John Cain; Luke Galloway; Cameron Stuart and Graham Vickery, thank you all
for putting up with me. Thank you for your positive and constructive feedback throughout this
programme. Most of all, thank you for sharing and being there for one another. You guys are the
best!

This thesis draws on the wisdom and education that all of you have synergistically instilled upon
me. I thank every one of you from the inner depths of my heart.

IV
 I have studyd the advancement and encrease of knowledge
for those that read, and shall be as glad to make them wise,
as to make them merry; yet I hope they will not find the
story so ill told, or so dull as to tyre them too soon, or so
barren as to put them to sleep over it.
Daniel Defoe (1727)1

Likewise!
Andrew du Boulay (2002)

1
Defoe, D. (1727) A tour thro the Whole Island of Great Britain, (G.D. Cole ed. 1968) Kelly Publishers, New
York.

V
 Abstract

The Question: Are currency unions economically efficient and is this phenomenon something
that is likely to perpetuate?

This thesis is about monetary unions and the impact that they are having on the evolution of
global financial architecture. But first, what is a currency union and how is it determined? This
thesis explores the options and provides a comprehensive overview of recent literature on this
subject. A currency union can be defined as any cooperation between two or more sovereign
states who reach agreement on a number of economic relationships. These relationships can
include free trade movement, capital and or labour between participating member states
combined with fixed exchange rates. This usually involves abdicating national sovereignty with
respect to monetary policy to a central banking system. To do this it is necessary that political
integration also becomes an active ingredient in the make up of a currency union. The ultimate
currency union exists when all of the above criteria are fulfilled and the economic zone
implements a single currency. The adoption of the single currency by an economic union can be
viewed as a defining step in the intricate process of integration. Europe recently implemented a
single currency, the euro. To date this has been the largest currency change over in the history of
mankind. The euro is changing economic, social and political traditions. This then raises the next
question; Is the adoption of a single currency the final step in the formation of a currency union
or is it merely the catalyst for further political, social and economic change?

The Euro
In order to discover what impact currency unions might have on economic and social cohesion
between sovereign states, this thesis focuses on an examination of the implementation of the
euro. To help explain some of the concepts, challenges, paradoxes and strategies encountered
during the process of implementing the euro, this thesis employs the useful assistance of Mr
Robinson Crusoe who allows the reader to experience the human perspective to what could
otherwise be dull and barren topic. This thesis looks at the history of the European Union (EU)
and the reasoning behind the euros conception through to its currency release in January 2002;
What economic benefits were realised by the exercise? What drawbacks surfaced and what
further development do those drawbacks demand? This thesis employs qualitative and
quantitative analysis to critically examine whether monetary unions are economically efficient or

VI
inefficient compared to Robinson Crusoe independent national currencies operating in the global
market alone.

This thesis monitors the euros progress by means of quantitative analysis using the Efficient
Market Hypothesis (EMH). A comprehensive review details the development of EMH and puts
in plain English what criterion is required for markets to be deemed efficient. The thesis employs
statistical and econometric calculations to prove and disprove any arguments. It also pays
particular attention to the euros strengths and weaknesses and summarizes these findings.
Supported by empirical evidence, this thesis highlights the positive aspects of the euro. The
benefits being; There are efficiency gains to channelling international transactions through a
single currency through the elimination of commission charged on foreign exchange
transactions. Another much boasted benefit of the changeover is price transparency. Having one
currency exposes price differentials between countries, this helps consumers and firms compare
prices and forces suppliers to be more competitive. More important than conducting cash
transactions with the euro are the benefits and risks associated with the long-term process of
monetary integration, especially the elimination of exchange rate fluctuations. Another long-
term benefit of the euro often claimed by fervent supporters is that the single currency ought to
become a more important international reserve currency than the sum of its legacy currencies.
This would bring greater immunity from international financial fluctuations, as well as a more
prominent role for Europe in designing the international financial systems architecture.

This thesis reinforces the notion that larger unified economic blocks working in the free open
market are subject to fewer speculative attacks, show more financial stability and thus are more
economically efficient compared to countries that choose to go it alone.

And Beyond

To justify the Beyond part of the title of this thesis, a detailed report is presented on the snowball
effect that the euro is having throughout Europe and explains why so many other countries are
lining up to be part of this phenomenon. It also explains why other economic zones such as Asia,
Africa and South America are likely to copy the European example and provides a valuable
insight into the future of what global economic changes may be anticipated in the twenty first
century. The reality is; Currency unions are altering global financial architecture by creating
powerful economic alliances. These alliances enhance efficiency in an ever-shrinking world.
Extrapolating this trend forward, economic logic would suggest that the concept of a single
global currency may have merit.

VII
 Contents

Title Page I

Statement on access to thesis II

Declaration III

Acknowledgements IV

Abstract VI

List of Figures and Tables XI

Abbreviations XII

Chapter 1 Introduction
1.1 Introducing Mr Robinson Crusoe 1
1.2 Currency unions and the euro 3
1.3 Definition of a currency union 4
1.4 Relevance of the topic 4
1.5 Purpose of the study 7
1.6 Thesis outline 8

Chapter 2 The hostile international monetary scene

2.1 The perils of the international financial system 9
2.2 Exchange rate speculation and price determination 9
2.3 An Australian example 10
2.4 Foreign exchange trading 12
2.5 The winners and the losers 13
2.6 Advantages of a monetary union with respect to
foreign exchange speculation 15

Chapter 3 History of the euro

3.1 Reason and passion 17
3.2 Rebuilding Europe 18
3.3 Schuman Declaration 19
3.4 Creation of the European Economic Community 19
3.5 The Werner Report 21
3.6 The Delors Report 23
3.7 Stage One of EMU - price stability 23
3.8 The Maastricht Treaty 23
3.9 Stage Two of EMU - establishment of the EMI and the ECB 24
3.10 The euro 25
3.11 Stage Three of EMU - introducing the euro 26

VIII
Chapter 4 Literature Review
4.1 The advancement of knowledge 29
4.2 Andrew Roses work 30
4.3 Charles Wyploszs work 35
4.4 Robert Mundells work 40
4.5 Summary of literature review 44

Chapter 5 The euro in the international monetary system

5.1 The intrinsic value of money 45
5.2 Implications for the euro 45
5.3 The role of an international currency 46
5.4 The euro as an international player 50
5.5 New businesses opportunities 53
5.6 The euro and international monetary cooperation 54

Chapter 6 Is the euro a success? The qualitative approach

6.1 The homogenous union of man and society 56
6.2 The process of monetary integration 57
6.3 Benefits and risks of integration 58
6.4 The euro as a reserve currency 59
6.5 The political consequences of the euro 60

Chapter 7 Is the euro a success? The quantitative approach

7.1 The art of econometrics 64
7.2 Efficient Market Hypothesis (EMH) 65
7.3 The Econometric model 72
7.4 Foreign Exchange Market Efficiency 75
7.5 A simple alternative 84
7.6 Conclusion of empirical evidence 86

Chapter 8 And Beyond: One Planet, One people, One currency

8.1 Patience, diligence and resolution 89
8.2 The matter of sovereignty 89
8.3 The currency of a superpower 90
8.4 Bretton Woods revisited 92
8.5 The euro as a model 95
8.6 The lack of an international monetary system 96
8.7 The changing face of international money 97
8.8 The third player 98
8.9 The likelihood of a global monetary union 100

Chapter 9 Conclusion
9.1 Destinys child 102
9.2 Summary 102
9.3 The value of tradition 104

IX
Bibliography 106

Appendices

Appendix A Rats Computer Software Instructions 114

Appendix B Econometric Printouts 116
Appendix C Sample of Econometric Reasoning 125
Appendix D Big Mac Index 129

Glossary of terms 132

X
 List of Figures

Figure 1.1 Inflation rates 1970 - 2000 5

Figure 7.1 Random walk with constant mean of Y variable 67
Figure 7.2 Random walk with upward trend 68
Figure 7.3 Exploitable profit opportunities when a0 0 79
Figure 7. 4 Possibility of profit 1987 1990 81
Figure 7. 5 Possibility of profit 1987 1990 with Japan excluded 81
Figure 7.6 Converging efficiency of euro with pound 86
Figure 8.1 World Bank GDP Figures for major currencies 1982 to 2001 98
Figure 8.2 IMF forecast of changing percentages of the global economy 99

List of Tables

Table 7.1 Descriptive statistics January 1987 to January 1990 78

Table 7.2 Coefficients of variables 1987 1990 78
Table 7.3 Return to Forward Speculation 1987 1990 79
Table 7.4 Dickey-Fuller and Phillip-Perron tau values 1987 1990 80
Table 7.5 Descriptive statistics January 1999 to October 2002 82
Table 7.6 Coefficients of variables 1999 2002 82
Table 7.7 Return to Forward Speculation 1999 2002 83
Table 7.8 Dickey-Fuller and Phillip-Perron tau values 1999 2002 83
Table 7. 9 The descriptive statistics of exchange rate data sets to 1999 - 2002 84
Table 7. 1 0 The descriptive statistics of exchange rate data sets to 1987 1990 85
Table 8.1 Inflation Rates Among the Big Four 101

XI
 Abbreviations

ATM Automatic Teller Machine

BIS Bank for International Settlements
CNY Chinese Yuan
EBRD European Bank for Reconstruction and Development
EC European Council
ECB European Central Bank
ECU European Currency Unit
EEC European Economic Community
EIB European Investment Bank
EMI European Monetary Institute
EMU Economic and Monetary Union
EONIA Euro Overnight Index Average
ERM Exchange Rate Mechanism
ESCB European System of Central Banks
EU European Union
EUR Euro (the currency)
GATT General Agreement on Tariffs and Trade
GB Great Britain
GDP Gross Domestic Product
HLI Highly Leveraged Institution
IBRD International Bank for Reconstruction and Development
IFMS International Financial and Monetary System
IMF International Monetary Fund
JPY Japanese Yen
M1 Narrow Money
M2 Intermediate Money
M3 Broad Money

XII
MFN Most Favoured Nation
MSE Mean Square Error
NCB National Central Bank
OECD Organisation for Economic Cooperation and Development
OEEC Organisation for European Economic Cooperation
OTC Over-the-Counter
SDR Special Drawing Right
UK United Kingdom
UKP The British Pound
UN United Nations
US United States of America
USD US dollar

XIII
 Chapter 1

Introduction

1.1 Introducing Mr Robinson Crusoe

The central enterprise of The Life and Strange Surprizing Adventures of Robinson Crusoe, is
to extend a tension between mobility and stability, between jeopardy and security, between
abundance and scarcity, and between pleasure and pain. In simple terms Robinson Crusoe is the
story of a young adventurer who leaves his home in York England in 1651 and sets sail into the
perils of life. The core of his ordeal comes when he is shipwrecked on a deserted island and
spends the next twenty eight years learning through survival the lessons of life. In that time he is
confronted with scarcity, treasures, wild animals, cannibals and pirates. He is finally rescued
when he helps the deposed captain of a mutiny, recapture his ship. Symbolically it is a story of
the nature of things and mans position within the world. The tale encompasses the adventures of
a free spirit who repeats the same mistakes many times over before he awakens to his own
identity and adjusts his life accordingly. Not only does Mr Crusoe have to find his way in the
hostile world, he has to struggle with his own personal relationship with God and fellow man.
The notion of peril is central to all Daniel Defoes fiction, as it is with most popular adventure
tales. In Robinson Crusoe, jeopardy arises from a volatile world, fraught with dangers of
tempest, slavery, savage beasts, shipwrecks, earthquakes, hostile natives and mutineers. The
theme is explored by means of a robust central figure, speaking as the first person, whose own
wandering inclination is the biggest hazard he has to face. The oscillation between adventure and
prudence throughout the tale mirrors life itself. Without having to postulate anything as precise
as allegory, Mr Crusoe and life in general share a sense of the worlds stubbornness. Through the
trials and tribulations, human civilisation, like Robinson Crusoe, may awaken to the futility of
conflict and rejoice at the triumphant conquering of adversity. But what has Mr Robinson Crusoe
got to do with an economics thesis?

Robinson Crusoe was written by Daniel Defoe in 1719, the early part of the eighteenth century.
By the end of the nineteenth century there were many references made to a Crusoe economy to
illustrate the principles of supply and demand theory. Robinson Crusoe thus became a
representative rational economic individual, allocating his available but scarce resources to

1
obtain maximum satisfaction for either present or future consumption. He would calculate
resource allocation according to the relative amounts of pleasure and pain immediately or
ultimately involved with each of his activities. The role of the Crusoe economy was not simply
to illustrate the various components of supply and demand theory, it was also employed to
support claims that the principles of rational behaviour could be applied to any type of economy,
from the isolated individual stuck on a desolate island to the most sophisticated industrialised
nations on the planet.

The notable scholars who have employed Daniel Defoes character to illustrate economic
concepts include; Karl Marx (1857-8)1, William Jevon (1871)2, Carl Menger (1871)3, Philip
Wicksteed (1888)4, Alfred Marshall (1891)5, Francis Edgeworth (1881)6, Ronald Meek (1976)7,
Stephen Hymer (1980)8, Marther White (1982)9 and James Tobin (1986)10 just to name a few.
Not only does Mr Crusoe add a humorous under tone of the frailties of humanity, he turns what
could normally be a dry and barren thesis into an enjoyable piece of literature. Using this genre,
this thesis will also employ Mr Crusoe to help illustrate in parable fashion the trials and
tribulations of economic evolution and show how this has contributed to the design of complex
financial structures of the twenty-first century. In tandem with a story about some new European
money, I invite you to enjoy Mr Robinson Crusoes classic adventure!

1
Marx, K. (1857-8) Grundrisse, (1973) Penguin, Harmondsworth.
2
Jevons, W.S. (1876) The future of political economy, In The Principles of Economics and Other Papers, ed. H.
Higgs, (1905) Macmillan, London.
3
Menger, C. (1871) Principles of economics, New York University Press, New York.
4
Wicksteed, P. (1888) Alphabet of Economic Science, (1935 ed.) Routledge, London.
5
Marshall, A. (1891) Principles of economics: an introductory volume, (1920 8th ed.) Macmillan, London.
6
Edgeworth, F.Y. (1881) Mathematical Physics, (1967) Augustus M. Kelly, New York.
7
Meek, R.L. (1976) Social Science and the Ignoble Savage, Cambridge University Press, Cambridge.
8
Hymer, S. (1980) Robinson Crusoe and the secret of primitive accumulation, In Growth, Profits and Property, ed.
Nell, E.J. (1980) Cambridge University Press, New York.
9
White, M.V. (1982) The production of an economic Robinson Crusoe, Reading and rewriting, Southern Review,
15(2).
10
Tobin, J. (1986) The future of Keynesian economics, Eastern Economic Journal, Oct Dec 1986, 12 (4), p 347
356.

2
1.2 Currency unions and the euro

Toward the latter part of the twentieth century, the traditional economic model of Europe was
partially flawed and in need of structural change and reform. Europe suffered chronic
unemployment rates, restrictions on international trade, currency fluctuations and speculative
attacks. There were only very limited reforms in the direction of reducing the role and size of the
welfare state. Privatisation of public enterprises was slow in coming to fruition. Deregulation in
all sectors of the economy was required and demanded major economic restructuring. Increased
global trade and lower tariffs led to global competition and the need for industrial restructuring.
Europe was relatively open to trade but followed trade policies that were overall more protective,
- particularly in respect to agriculture - than other Western economies.

The 1992 Single Market Project and the Economic and Monetary Union (EMU) eventually lead
to the elimination of barriers to trade in goods, services and factors of production11 within
Europe. The successful development of the single euro currency was central to the realisation of
a Europe in which people, services, capital and goods could move freely. The European Central
Bank (ECB) successfully brought about what is so far, the largest currency union in the history
of the world. If currency unions are successful, is there any reason why that success wont be
repeated? If currency unions are economically efficient and conserve resources, would
economics and rational maximizing behaviour promote further expansion? Maximizing the
benefit to society by employing scarce resources in the most efficient manner is what has shaped
civilizations from time immemorial. Logic reasoning would suggest that if the European
currency union is successful at preserving resources, this phenomenon is likely to be repeated.

The prehistoric evolution and dispersion of humans over the globe, coupled with genetic
idiosyncrasies, cultural habits, religious diversity and ethnic barriers meant that societies had to
run their own race and fend for themselves in order to survive. In the twenty first century
however, with international organisations, international travel, instant communications,
international financial architecture, global markets and homogenization, it becomes believable
that all societies are part of the same human race. If all societies are participating in the global
economy and seeking economic efficiency, it stands to reason that a single global currency is
distantly possible if not inevitable. The euro represents one such development that is changing
the world not only from an economic perspective but also from a socio-political perspective as
well. This thesis explores the recent economic evolution, by means of an investigation into the
European currency union.
11
Capital and labour.

3
1.3 Definition of a currency union

A currency union can be defined as any cooperation between two or more sovereign states who
reach agreement on a number of economic relationships. These relationships can include free
trade movement - capital and or labour - between participating member states who also adhere to
fixed exchange rates. This usually involves abdicating national sovereignty with respect to
monetary policy to a central banking system. To do this it is necessary that political integration
also becomes an active ingredient in the make up of a currency union. The ultimate currency
union exists when all of the above criteria are fulfilled and the economic zone implements a
single currency. According to the Delors Report12, four rather arbitrary conditions were laid
down as forming the core economic dimension of monetary unification. These included: the
single market within which persons, goods, services and capital could move freely; competition
policy and other measures aimed at strengthening market mechanisms; common policies aimed
at structural change and regional development; and macroeconomic policy coordination,
including binding guidelines for budgetary policy. According to the Delors definition, a
common currency was not essential. By adopting a common currency the Economic Monetary
Union actually went a step further than this definition demanded. However for this thesis and for
simplicitys sake, think of the essence of a currency union as the agreement to use a common
currency, in this case the euro, under a common monetary policy conducted through the
European System of Central Banks (ESCB). The euro represents one of the most outstanding
developments in recent economic history, but it is by no means the only development.

1.4 Relevance of the topic

There have been several outstanding developments with regard to economic evolution in the
national and international arena over the past few decades. A major development is the
mechanism of inflation targeting being employed by many central banks internationally,
especially in the more technologically and economically advanced societies. Once central banks
mastered the art of inflation targeting, this provided the financial impetus that governments
sought to manipulate economic factors that then allowed strategic political goals and policies to
be implemented. Inflation targeting methodology unequivocally demonstrated the ability of
central banks to maintain inflation within prescribed bands usually between 1 to 3 per cent.

12
The Delors Report was named after Jacques Delors, the 1988 President of the European Commission, who studied
and proposed concrete stages leading to European unity. The full title of the report is Report on Economic and
Monetary Union in the European Community, and was submitted to the European Council on 12 th April 1989.

4
This had the most profound effect of stabilising economies. This phenomenon had not been
achieved since the time prior to the break down of the Bretton Woods Agreement 13 in the early
1970s when the US dollar was tied to gold and the rest of the world aligned its currencies to that
dollar. To give a graphical representation of this, Figure 1.1 shows the volatility of inflation from
1970 to 2000. Because of external shocks experienced in the 70s due to the adoption of flexible
exchange rates and the consequences of OPECs increased oil prices, inflation started to soar.

Figure 1.1 Inflation rates 1970 - 2000

Effect of inflation targeting on

inflation rates

30
25
Inflation rate

20 Australia
France
15 Germany
10 Italy
Netherlands
5 United Kingdom
0 United States

-5
1970 1980 1990 2000

Source: World Bank database and graphed in Microsoft Excel

After much anguish, there arose a need for crisis prevention. Academic and political debate
abounded until finally strategies were developed to tackle the inflationary curse. Inflation
targeting was adopted by most advanced economies through the 1990s. The results can be seen
in the stability of inflation rates starting in the early 1990s. Out of the countries examined, all
have managed to maintain inflation well below 5 per cent and usually within a band of less than
two per cent movement.

In the absence of the Bretton Woods gold standard, inflation targeting thus became a powerful
tool that allowed central banks to control economic activity with incredible precision. This in
turn allowed national governments the ability to align their currencies to the value of other

13
The Bretton Woods Conference took place in July 1944, at Bretton Woods, New Hampshire, USA. Its purpose
was to reach agreement on procedures and protocols for the international financial system.

5
currencies, with which they chose to do so, without the uncertainty that had existed before.
Europe capitalised on these developments and employed this stratagem to further advance the
move towards full economic integration.

The withdrawal of the Soviet Union in 1989 from Eastern Europe made unification of Germany
possible and brought with it renewed impetus for European monetary and political integration.
The fiscal spending associated with German spending on its new states gave a jolt to the
exchange-rate mechanism (ERM) of the European Monetary System (EMS). A few countries left
the exchange rate mechanism, while others opted for devaluation within it. Nevertheless, by 1st
January 1994, the European Monetary Institute (EMI) was formed, and by the middle of 1998 its
successor, the European Central Bank (ECB) was established. On 1st January 1999, the euro was
launched with eleven members. A new era in the international monetary system was unfolding.
On 1st January 2002 the euro notes and coinage made their debut into the global economy. The
introduction of the euro redrew the international monetary landscape. This challenged the long
time dominance of the US dollar as being the most used currency on the planet. With the
introduction of the euro, currently the second most important currency in the world, a tri-polar
currency world involving the US dollar, euro, and yen came into being. The exchange rates
between these islands of stability thus became the most important prices in the global economy.
But that is not where the story ends. Like Robinson Crusoes adventures, one development
always leads to several more.

The creation of the euro has led to its widespread adoption in Central and Eastern Europe as well
as the former Central French African franc zone and along the rim of the Mediterranean.
Expansion of the wider euro area, counting not only countries entering with the enlargement of
the European Union, but also currencies fixed to the euro, will eventually give it a transactions
area larger than that of the United States. This will inevitably provoke countervailing expansion
of the US dollar in Latin America and parts of Asia. Other currency unions are likely to form,
adapting the European example to suit their own local economic and social needs.

What the world is witnessing by observing the expansion of monetary unions, is a process
similar to what the oil industry experienced in its short life. To clarify this, in the early part of the
twentieth century there existed over 100 reasonably sized oil companies dotted around the planet,
but in an effort to maximise efficiency and capitalise on economies of scale, through a process of
corporate takeovers, buyouts and closures, the number whittled down. Today, the oil industry
encompasses six multi-national companies. The Six Sisters, as they are known include: Exxon;

6
Chevron; Mobil; Texaco; British Petroleum and Royal Dutch Shell. These companies are bound
together in consortia or joint enterprises throughout the world and rely heavily upon one another
to maintain the price stability of oil14. Likewise the evolution of monetary unions may follow a
similar path leading to a few major economic zones that dominate world finances. This thesis
attempts to highlight this process by studying the history, formation, implementation and
progress of the European currency union. With a better understanding of what currency unions
entail, this thesis then directs the readers imagination into the future towards the possibility of
the successful implementation of a single global currency. While the latter may be somewhat
optimistic the former definitely represents a topic that is relevant to todays world. The relevance
of currency unions is a topic of much discussion and debate and is made convincingly evident, in
the literature reviews of Chapter 4. However relevance is of no consequence unless there is a
purpose, which the next section now explains.

1.5 Purpose of the study

An underlying objective of this thesis is to promote the idea of further expansion in the realm of
economic and financial integration between nations and perhaps guide the imagination to the
possibility of a single global currency. While this may sound ambitious and perhaps a little ahead
of its time, the rapid expansion and integration of the global economy throughout the latter part
of the twentieth century has already modified the genetic make up of the international financial
system and simultaneously proved that the world is prepared to change. National and
international financial structures have thus given way to the new financial architecture.

Through the process of technology and globalisation, international economics has evolved to the
point where global trade and the world currency market now continually operate, twenty four
hours a day, seven days a week, three hundred and sixty-five days a year. Capital flows, equity
investments, foreign loans, trade relations and merchandise stretch into every corner of the
planet. During this process, the weakness and frailties of the international money market have
been detected, exposed and exploited. Fuelled by the desire of profits, investor speculation and
hedge funds have planned highly strategic attacks on most currencies via the exchange rate
mechanism. These funds profit at the expense of the less sophisticated economic regimes without
giving or producing anything. In simple terms this relates to a form of theft conducted through
sophisticated information and banking mechanisms. This not only builds resentment but also

14
Nossiter, B. D. (1987) The Global Struggle for More, A Twentieth Century Fund Essay, Harper & Row
Publishers, New York. p 55.

7
destroys the bridges of international cooperation. By promoting the idea of more currency unions
within regional economic zones, the profiteering effect on exchange rate variations is minimised,
the opportunities diminish and therefore speculation no longer becomes viable. This in turn
would create a more stable economic environment for the majority of the worlds inhabitants. If
the global economic environment is equitable, stable, integrated and harmonised, the entire
world benefits. If the world can become a better place for all the worlds people, then that is a
good purpose.

1.6 Thesis outline

Currency unions deliver many benefits. This thesis will investigate those possibilities. In order to
discover what impact currency unions might have on economic and social cohesion between
sovereign states, this thesis focuses on an examination of the implementation of the euro. To help
explain some of the concepts, challenges, paradoxes and strategies encountered during the
process of implementing the euro, this thesis employs the useful assistance of Mr Robinson
Crusoe. But the starting point must be the history of the European Union and the reasoning
behind the euros conception through to its currency release in January 2002; What economic
benefits were realised by the exercise? What drawbacks surfaced and what further development
do those drawbacks demand? In order to answer these questions, Chapter 3 sets the scene and
gives a comprehensive background for the euros existence. Chapter 4s literature review makes
evident what advantages and disadvantages prominent academics envision, Chapter 5 examines
the euro in the international monetary system focusing on the implications for the euro and its
role as an international currency. Chapter 6 questions whether the euro is a success via the
qualitative approach while Chapter 7 answers the same question from the quantitative
econometric perspective. Having provided evidence of the economic feasibility of currency
unions, Chapter 8 then investigates the possibility of further expansion into the realm of a global
currency union. Chapter 9 summarises the arguments and hopefully leaves the reader with the
thought that a single global currency is not such a bad idea. But why the need? There is an
odious underlying reason why the world needs currency unions. The following Chapter
highlights the necessity as to why the world needs currency unions. It does this by exposing just
how hostile the existing international monetary scene really is.

8
 Chapter 2

The hostile international monetary scene

2.1 The perils of the international financial system

Robinson Crusoes realisation that man is surrounded by the terrible perils of life is an essential
element to the organisation of Defoes famous book. In one adventure, Crusoe on his torturous
journey across the Pyrenees from Spain to France, was attacked by ravenous wolves. The
analogy of wolves being representative of the perils of life - not only from a wild animal
perspective but also from mans own deceptive nature - mirrors the competitive nature of mans
existence, solidifying the selfishness of humankind. This chapter exposes these characteristics
within the existing framework of the international financial system.

2.2 Exchange rate speculation and price determination

History demonstrates, currency exchange rates are necessarily volatile due to the highly
competitive nature of foreign exchange markets. With the event of real time electronic commerce
operating 24 hours per day throughout the world, currency values are determined instantaneously
15
by the invisible hand of market forces driven by animal spirits 16. Provided of course, central
banks refrain from intervening, the free market equilibrium exchange rate occurs at the point at
which the natural quantity demanded of a particular currency is equal to the natural quantity
supplied of that currency.

In flexible exchange rate systems, to maintain equilibrium in the foreign exchange market, it is
necessary for the Balance of Payments to equal zero. That is; these currencies must adjust their
exchange rate value to accommodate for any imbalance away from zero in the overall balance of
payments. The exchange rate is consequently sensitive to all of the influences that typically
affect trade and investment decisions, especially expectations about future asset prices, including
expectations about the exchange rate itself. These expectations can dominate in the short term

15
The invisible hand was a term coined by one of the Grand Fathers of economics, Adam Smith in 1776 in his
classical work An inquiry into the nature and causes of the Wealth of Nations and alludes to the guiding force of
market outcomes.
16
Animal spirits is a term often used to describe the optimism or pessimism of investors and originates in the work
of John Maynard Keynes (1936) The General Theory of Employment, Interest and Money, Macmillan, London, p
149-150.

9
and can change quickly in response to such things as changing news about the economy,
changing prospects for the current account, changing perceptions about policy or even to
political events and terrorists attacks.

The volatility that can be caused by sudden changes in these expectations can be exacerbated by
the behaviour of market traders, who often exhibit herd-like behaviour and can sometimes adopt
trading strategies which tend to be destabilising. In this situation, exchange rates are prone to
overshooting by being forced to accommodate detrimental strategic investment. Any prolonged
significant departure of the exchange rate from its equilibrium level can, in turn, produce
imbalances in the domestic economy as well as on the external accounts and therefore becomes a
matter of serious concern for politicians and policy makers.

2.3 An Australian example

In his address to The Reinventing Bretton Woods Committee Conference, in Canberra, 15th July
1999, RBA Deputy Governor Dr S.A. Grenville, exposed mankinds selfishness through the
negative effects exchange rate speculation had had on the Australian economy. His talk titled,
International Capital Mobility and Domestic Economic Stability, outlined foreign exchange
investment tactics that had been employed by speculators to damage the value of Australias
dollar.

The Deputy Governor speaking of overshooting said;

the recent episode (coinciding with the Asian crisis), saw a variant on the
overshooting theme. That is, speculators who believe that they could make money
by attacking an exchange rate which has already overshot, so that it overshoots
even further. The tactic is straightforward enough, simply take a short position17
in the currency which is already a bit undervalued, and then, by a mixture of
highly public additional short selling and vigorous orchestration of market and
press opinion, get the exchange rate to move down quite a bit further. As it does,
a bandwagon forms, with market players anxious to sell the currency as it
becomes cheaper, in the belief that it will become cheaper still. As the herd moves
in, the original speculators can square up their position, at a profit.

This is the world that we saw in operation in the middle of 1998.

17
A short position is one in which the speculator borrows or sells forward, a foreign currency with the anticipation
of purchasing it at a future lower price to repay the foreign-exchange loan or fulfil the forward sale contract ( that is,
they are agreeing to sell something that they do not presently have).

10
 The most disturbing element of this is that it was part of a concerted effort at
market destabilisation. Some of the players18 themselves told us, at the time, that
their objective was to push down the Japanese yen to the stage where the Chinese
renminbi was under irresistible pressure to devalue, which would have broken the
Hong Kong dollar peg. The Australian dollar was a minor secondary target
collateral damage for these Masters of the Universe.

we carry from this experience a strong viewpoint into the debate on

international financial architecture concerning the hedge funds (or, as they are
known in that context, the highly leveraged institutions) .There are those who
deny, even now, that the hedge funds played any significant role. For these
pundits, it may be enough simply to observe that the hedge funds themselves do
not deny their actions19

The movement of exchange rate values through the 1997 1999 period, including large
currencies such as the yen, provided more evidence that hedging was being played out in the
global market with some drastic results. As the hedge funds cut their short positions in yen to
cover their disasters in the Russian rouble, the yen fell 11 per cent in a week20, driven by events
unrelated to any Japanese internal influence. Hong Kong, South Africa, Malaysia, Korea,
Indonesia and Thailand all pointed to their similar stories. These currencies were systematically
attacked, all suffered depreciation of their currency which basically resulted in: lower purchasing
power in the global market; increased value of any foreign debt; a shift in the national
community indifference curve and ultimately to a drop in national utility21.

18
Dr Grenville referred to these players as being the Masters of the Universe. It is unlikely that these players were
individuals or corporations. The stock of capital required to influence the value of a nations currency would more
than likely originate from countries that had a vested interest in disrupting exchange rate stability of a competing
nation so that they could in turn maintain their superior position. Also what organisation would reveal its intentions
and motives to the RBA? It is subjective to assume that the RBA is privy to information and strategies enacted by
friendly nations in order to gang up on opposing teams.
19
George Soros has written a best-selling book about the existence and benefits of Hedging. Soros, G. (1998) The
Crisis of Global Capitalism, Little, Brown and Company (UK), London.
20
See Reserve Bank of Australias Exchange rate data base, www.rba.gov.au for the first week October 1998.

21
Microeconomic theory uses utility as a measure of satisfaction by a consumer. The higher the utility means the
consumer is better off. Utility can be represented in graph form either as an indifference curve for the individual or
as an isoquant for the firm. The further away the convex curve is from the X,Y origin, the higher the utility and the
better off consumer will be. Katz, M. Rosen, H. (1998) Microeconomics 3rd ed, Irwin/ McGraw-Hill Companies,
Inc. United States of America. San Francisco. p 34-36, 49-50, 88,187-192,237-238,317-318.

11
2.4 Foreign exchange trading

Foreign exchange trading is the simultaneous buying of one currency and selling of another
currency. Daily volume in the foreign currency market exceeds $1.2 trillion22 per day, making it
the largest and most liquid market in the world. Unlike other financial markets, the Forex market
has no physical location or central exchange. It is an over-the-counter market where buyers and
sellers including banks, corporations, and private investors conduct business. Foreign exchange
trading takes place in financial trading centres all over the world, including New York, London,
and Tokyo creating one cohesive, international market. The huge number and diversity of
players involved make it difficult for even governments to control the direction of the market.
The unmatched liquidity and around-the-clock global activity make foreign exchange the ideal
market for active traders.

The foreign exchange market is one of the most popular markets for speculation, due to its
enormous size, liquidity, and tendency for currencies to move in strong trends. An enticing
aspect of trading currencies is the high degree of leverage available. Most foreign exchange
brokers allow positions to be leveraged up to 100:1. Although the Forex market is incredibly
huge, rightly no individual can manipulate prices, but private individuals who correctly identify
and anticipate price trends can make large profits by depositing only a 1 per cent margin upfront.
When expectations are ripe and herd like behaviour comes into play, en mass movements
leveraged at 100:1 can have detrimental effects on the value of a targeted currency.

Throughout the 1990s there evolved a growing interest in the causes of speculative pressures on
currencies. This became evident, stimulated by the attack on the exchange rate mechanism
(ERM) of the European Monetary System in September 1992, followed by the devaluation and
float of the Mexican peso in December 1994, and culminated with the Asian meltdown through
1997 - 98. In international debate it was argued that short-term capital movements were at the
root of financial and economic crises, hampering development and nourishing poverty in many
developing countries. While it is true that weaker economies feel the pressure more intently, this
practice had never been restricted to the developing economies. One day in October 1992,
American financier George Soros correctly judged that the British pound was indefensibly

22
This thesis uses the new Australian version of a trillion as being a million million 1,000,000,000,000 or 10, it
does however acknowledge that a trillion was formally a million million million or 10.

12
overpriced. He fearlessly sold sterling against the US dollar and made 2 billion dollars profit
within a few hours23.

2.5 The winners and the losers

Well may you ask, how is it possible to make 2 billion dollars profit in a few hours? More
importantly the question is, where does that 2 billion dollars come from and who pays for it? In
the case of the British pound, all of Britain paid for it. The lowered value of the pound meant that
all British exports would be cheaper on the world market thus lowering British income.
Additional to this, British imports would cost more from that point onwards. The nation as a
whole loses out. This then raises the question why was the pound overvalued to start with? The
pound increased in value over a period of time due to the increased demand for that currency.
Because brokers allow 100:1 leverage in the Forex market, US$1 did not only buy 55 pence, it
bought 55. This leverage when multiplied by billions of investor dollars created an artificial
demand for the pound thus raising its price. Once the market grew complacent about the
increased value of the pound, the investors unloaded their portfolios of pounds selling at the
higher price and realised a profit. The flood of selling caught the uninitiated unaware and pushed
the value of the pound down below its correct value thus allowing speculators to move back in

buying at the lower price. Even if the speculator made a profit of just a cent per dollar,
leveraged at 100:1 they make a 25 per cent profit on investment. The sophisticated techniques of
foreign exchange speculation and the ease with which experienced players profited contributed
to the radical increase in activity in the international money market.

Over the last thirty years, international monetary flows have experienced incredible expansion.
In the early 1970s, the daily turnover in foreign exchange markets was $18 billion24. Transaction
volume increased more than fourfold between 1977 and 1980 and fourfold again between1980
and 1983. Trading doubled between 1983 and 1986, and tripled between 1986 and 1989, when it
reached the sum of $590 billion. It increased by almost 40 per cent between 1989 and 1992,
when it amounted to $820 billion a day. In April 1995, the average daily turnover associated
with foreign exchange contracts was $1.2 trillion, an increase of 45 per cent on that for 1992. In

23
Soros, G. (1998) The Crisis of Global Capitalism , Little, Brown and Company (UK), London.

24
The financial figures in this section are derived from the Bank for International Settlements 1996 Annual Report
and paper titled Settlement Risk in Foreign Exchange Transactions. Report prepared by the Committee on
Payments and Settlement Systems of the Central Banks of the Group of Ten Countries.

13
April 1998 this figure reached a staggering $1,490 billion turnover per day. That was more than
double the size of the market in 1989, and more than 82 times the size in 1973. The massive
increase in the volume of trade was due to the break up in the early 1970s of the Bretton Woods
system of fixed parities among major currencies and a move to floating exchange rates. It was
also due to the growing liberalisation of financial markets, and the introduction of electronic
trading, which made it possible to deal with a greater volume of trade.

The extent to which this massive increase in the volume of foreign exchange trading can be
accounted for by speculative activity is surmised by comparing the figures for the volume of
world trade, which revealed no equivalent increase. In comparison to the average daily turnover
of US$1.2 trillion in foreign exchange activity, the annual global turnover in equity markets in
1995 was only $21 trillion while the annual global trade in merchandise exports and commercial
services in 1998 was $6.5 trillion, equivalent to a mere 4.3 days of trading in the foreign
exchange market. Total foreign exchange trading in 1998, approximately $360 trillion, amounted
to approximately 55 times the world trade in merchandise exports and commercial services.
According to Bank for International Settlements (BIS)25, the worlds total official foreign
reserves in 1998 amounted only to $1.6 trillion, or just over a days trading on the traditional
foreign exchange markets. On the London Stock Exchange in the financial year 1998-99,
equities to the value of $5.7 trillion were traded in contrast to the $152.8 trillion in foreign
exchange that changed hands.

The last tri-annual report on Forex figures from the Bank for International Settlements26
indicated that turnover in traditional foreign exchange markets declined substantially between
1998 and 2001. In April 2001, average daily turnover had returned to the 1995 level of $1,200
billion, compared to $1,490 billion in 1998, a 19 per cent decline at current exchange rates and a
14 per cent fall when volumes were measured at constant exchange rates. Turnover did not
decline uniformly across instruments. Trading volumes fell sharply in spot markets and, to a
lesser extent, foreign exchange swaps. By contrast, trading in outright forwards increased
slightly. The reduction in turnover can be attributed to several things: the decrease in risk
tolerance that followed the financial market turbulence in the third quarter of 1998; the ability of
central banks to maintain price stability and therefore ease pressure on exchange rate

25
Derived from the Bank for International Settlements 1997 & 1998 Annual Reports.
26
Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2001, released 18th March 2002.

14
differentials; more countries adopting floating exchange rate regimes; George Soross retirement
from the market; and the introduction of the euro.

Although it is impossible to attribute the exact cause for this decline, market confidence and
reduced returns to investors would be the main contributing factor. The introduction of the euro
would logically be the next largest influence. As of January 1999 all currencies within the EMU
were irrevocably locked into one another. As the EU represents the worlds second largest
economy, it necessarily dictates that shoring up a major proportion of the global economy
reduced considerably the room for speculative behaviour.

2.6 Advantages of a monetary union with respect to foreign exchange speculation

Michael Dooley (1996)27 reviewed the theory and evidence supporting the argument that
restrictions on access to capital markets can change trading opportunities for private investors
and, in turn, alter the nature of speculative attacks, their probability of success and their
consequences. Capital controls limit access to national credit markets. Monetary unions by
contrast enhance access to national credit markets but alter terms under which contracts are
expected to be enforced. A full monetary union limits the trading opportunities of private
investors but does so in a fundamentally different and more effective manner by making all
contracts enforceable with a single currency. A monetary union is therefore more effective in
neutralizing private expectations than a perfectly effective capital control program. This Dooley
believed, made monetary unions much more desirable.

The introduction of the euro created one of the worlds major economic areas. The euro zone is
an important economic power, with a population of around 305 million people, having
considerable purchasing power, which is only exceeded by the United States. The member states
of the euro area together represent some 15 per cent of world GDP, which is about 5 per cent less
than the United States but twice as much as Japan28. By way of comparison, the biggest country
of the euro area, Germany, by itself is estimated to represent only 4.5 per cent of world GDP.
The monetary union implied that exchange rates within the union would no longer exist, for
instance, the rate of the French franc against the German mark or the Italian lira. Focusing back

27
Dooley, M.P. (1996) A Survey of Literature on Controls Over International Capital Transactions, IMF Staff
Papers, 43, December, p 639 687.
28
Quaden, G. (2002) The Euro - a milestone on the path of European integration and a contribution to world
economy stability, keynote address by Mr Guy Quaden, Governor of the National Bank of Belgium, at the OECD
Forum, Paris, 14 May 2002.

15
to the ERM-crises in 1992 and 1993, the volatility of these exchange rates had been most
harmful to the closely interdependent national economies of the European common market. The
euro has completely removed exchange rate risks for exporters and importers, as well as debtors
and creditors across the 12 countries of the euro area and has thus eliminated the costs of
hedging exchange rate risks vis--vis to other euro area countries.

It can be observed, that a monetary union or the adoption of a single currency between nations
plainly has economic benefits. But was this discovered by accident or was this a planned
strategy? What made the currency union possible in the first place and why did Europe end up
with a single currency? To comprehend how the euro came about, Chapter 3 reveals the history
of European integration since World War II and shows how forward vision, patience and
determination molded the European financial system of the twenty first century.

16
 Chapter 3
History of the euro

3.1 Reason and passion

One of the lessons Robinson Crusoe had to learn was that reason, although necessary to subdue
his unruly passion, was by itself, insufficient as a guide for all human activity. Crusoe was quite
prone of failing to follow reason and of being led by his inane fancy. One of the best examples in
the book was when he decided to cut down a large tree and hack out a boat. After months of
work the boat was finished, unfortunately the boat was far too heavy to move to the water.
Needless to say the boat stayed where it was made and eventually rotted away. Twenty years
later he repeated the exercise, but this time he had Friday to help him. The second boat was also
large and heavy. Passion had to devise a strategy to achieve the goal of getting the boat to water.
It was a most preposterous method but the eagerness of my fancy prevailed. It took near a
fortnights time to get her along, as it were, inch by inch, upon great rollers into the water. It is
part of the human condition for man, as the life of Crusoe illustrates, to suffer terrible and
unexpected turns of fortune because of his limited sight. At the same time however, his blindness
preserves him from the unbearable vision of his true state. The double image of the island as an
opportunity for deliverance as well as prison helps to express and highlight this eternal paradox
of the human condition. Europe had been destroyed by war. Europe needed solutions. If unruly
passion had destroyed Europe, a preposterous method coupled with reason and eager fancy was
needed to rebuild it. What was that preposterous method and how fanciful was that reason?

This chapter presents the chronology of important events and accomplishments that built the
European Union which led to the euro. This encompasses a selection of events starting in 1946
and carries us through to the present. Understandably 1946 was by no means the very beginning.
A united Europe had been discussed in the nineteenth century but talk cooled toward the latter
part of that century and froze completely with the arrival of the twentieth century. World War I
jeopardised what little chance existed but the Treaty of Versailles quenched it completely. Adolf
Hitler wanted a union of sorts, but his objective was that he wanted it by conquering Europe.
World War II helped form an alliance against Germany, but the big three equally guilty, Russia,
Britain and the US wanted to carve up the spoils of victory. The imperceptible union lay buried
beneath the rubble of Europe. Somewhere, somehow, the power of unity struggled to resurface.
Robinson Crusoe had been shipwrecked and needed to be rescued.

17
3.2 Rebuilding Europe

The aftermath of the Second World War, saw Europe in ruins. It was imperative to find some
fanciful way of securing a lasting peace. Rebuilding Europe required a paradigm shift in
international relations based on real equality between states and the willingness to take concrete
action together. A radically new way of building friendship and cooperation between European
nations and their respective people was needed. In September 1946 Winston Churchill called for
a kind of United States of Europe in a speech he gave at the Zurich University29. Fostered by
Churchills vision, the United Europe Movement was created. It was hostile to supranational
organs but in favour of intergovernmental cooperation. June Ren Courtin created the French
Council for a United Europe that was later absorbed by the European Movement in 1953.
Fostered by Christian Democrats, the Nouvelles Equipes Internationales, (later known as
European Union of Christian Democrats), was also created. The Socialist United States of
Europe Movement was created, being renamed European Left in 1961.

In early 1947 policymakers concluded that Western Europe would require substantial economic
aid in order to attain political stability. The European Recovery Program, announced by US
Secretary of State George Marshall in an address at Harvard University on 5th June 1947
proposed that the European countries draw up a unified plan for economic reconstruction to be
funded by the recently formed World Bank and International Monetary Fund. In 1948 the
Organisation for European Economic Cooperation (OEEC) was created to coordinate the
Marshall Plan. Fostered by the International Coordination of Movements for the Unification of
Europe Committee, the European Congress met in The Hague. It was chaired by Winston
Churchill and attended by 800 delegates. Participants recommended that a European Deliberative
Assembly and a European Special Council, in charge of preparing political and economic
integration of European countries, be created. They also advised the adoption of a Human Rights
Charter and, to ensure the respect of that charter, the creation of a Court of Justice. In 1949
France, Great Britain and the Benelux countries decided to set in place a Council of Europe and
asked Denmark, Ireland, Italy, Norway and Switzerland to help them prepare a statute for the
Council. The Statute of the Council of Europe was signed in London and entered into force. The
first session of the Consultative Assembly of the Council of Europe was held in Strasbourg,
France. Federalist members of parliament requested the initiation of a European political
authority.

29
Information in this Chapter is derived from History of the European Union, the Bulletin of the European Union,
and the annual General Report on the Activities of the European Union, plus European Reports, Legislation and
Treaties as per references at page 112 of this Thesis. Available at www.europa.eu.int

18
3.3 Schuman Declaration

Delivering a speech, inspired by Jean Monnet, French Foreign Minister Robert Schuman
proposed that France and Germany and any other European country wishing to join them, pool
their Coal and Steel resources (Schuman Declaration). Schuman did not specify the depth or
breadth of unity he had in mind. But clearly, although the nature of the cooperation was to be
economic, the objectives and motivation were highly political. The purpose was to devise a new
way in which states could live together. A new supranational political system began the process
of European integration. Belgium, France, Germany, Italy, Luxembourg and the Netherlands
subscribed to the Schuman Declaration and the Council of European Assembly approved the
plan in 1950. By April the following year, The Six (Belgium, France, Germany, Italy,
Luxembourg and Netherlands) signed the Treaty of Paris establishing the European Coal and
Steel Community (ECSC). In 1952 The Six signed the European Defence Community (EDC)
Treaty. The ECSC Treaty entered into force and Luxembourg was chosen as the temporary
headquarters. In November of the same year, the General Agreement on Tariffs and Trade
(GATT) decided to grant to The Six leniency from the most-favoured-nation treatment, to allow
them to fulfil their ECSC obligations. Early in 1953 the Common Market for coal and iron ore
was set in place. The Six removed custom duties and quantitative restrictions on these raw
materials and the ECSC levy (the first European tax) came into force.

3.4 Creation of the European Economic Community

In March 1953 Paul-Henri Spaak, the Belgian Minister for Foreign Affairs and President of the
ad hoc Assembly created the year before, handed to G. Bidault, President of the ECSC Council,
a draft treaty instituting a political European Community. This community would aim: at
safeguarding human rights and fundamental rights; at guaranteeing security of member states
against aggression; at ensuring the coordination of member states external policy and at
progressively establishing the Common Market. Five institutions were foreseen in the draft
treaty: a European Executive Council; a two-chamber Parliament; a Council of National
Ministers; a Court of Justice and; an Economic and Social Committee. At a meeting in Messina,
Italy in 1955, the Foreign Ministers of The Six agreed to aim for the integration of their countries
on an economic front. Meanwhile, The Council of Ministers of the Council of Europe,
employing symbolic reasoning, adopted as it emblem the blue flag hosting 12 golden stars thus
giving visual identity to an entity of significant importance.

19
Paul-Henri Spaaks proposal, foresaw the creation of a European Economic Community (EEC)
and a European Atomic Energy Community (Euratom). In 1956 the Spaak Report was approved
allowing negotiations for the drafting of the instituting texts for the EEC and Euratom to
commence in Brussels. The following year, the Treaties establishing the EEC and Euratom were
signed by The Six in Rome and henceforth became known as the Treaties of Rome.

The European Parliamentary Assembly in 1958 elected Robert Schuman as President of the
Assembly and sat for the first time according to political groups rather than nationality. By 1959
the first steps were taken in the progressive abolition of custom duties and quotas within the
EEC. The Stockholm Convention establishing the European Free Trade Association (EFTA)
entered into force. The Council adopted the European Social Fund promoting mobility of
workers within the Community and the Organisation for European Economic Cooperation
(OEEC) changed its name to become the Organisation for Economic Cooperation and
Development (OECD).

At the 1961 European Summit meeting in Germany, The Six voiced their wish to set up a
political union. Also in 1961 Ireland, United Kingdom and Denmark formally applied to join the
European Community. In 1962 the Parliamentary Assembly decided to change its name to the
European Parliament.

In 1966 a joint meeting of the European Institutions was held to discuss the progress of the EEC
towards economic union and future prospects. A year later, the EEC Council of Ministers
decided to harmonise indirect taxes in the Community and adopt an added-value tax system.
They also approved the first medium-term economic policy programme clarifying and setting the
aims of economic policy for the Community. The Merger Treaty of 1967 fused the Executives of
the European Communities (ECSC, EEC, Euratom) into a single Commission with a single
Council.

In 1968 the Common Customs Tariff (CCT) entered into force. Any remaining duties in intra-
community trade were abolished. The European Council, the Parliament and the Commission
held an exchange of views on the prospects of the ECSC, EEC and the Euratom Communities. It
gave rise to discussions on the need to democratise the institutional machinery of the
Communities and institute closer cooperation in the monetary field. The 1969 heads of
government summit meeting in The Hague, confirmed their willingness to maintain the gradual
advance towards a genuine economic and monetary union with close alignment of social policies

20
and reaffirmed their agreement on the principles of the Communitys enlargement. In 1970 the
European Court of Justice clarified the idea of fundamental rights in Community law. It declared
that protection of those rights, although inspired by the constitutional traditions common to the
member states, must be secured within the framework of the Communitys structure and
objectives.

3.5 The Werner Report

Probably the most outstanding development of 1970 was the Werner Report. The European
Council assigned a committee of experts presided by Pierre Werner, to deliver proposals for
achieving economic and monetary union. It outlined a staged process culminating in a single
currency within ten years. The objectives of the report were for a greater role for Europe in
international monetary affairs and increased exchange rate stability relative to the Bretton Woods
system. In 1971 the Council adopted the Werner Plan to strengthen coordination of economic
policies, however the timing was not quite right. The 15th August 1971 saw US President
Richard Nixon announce his economic emergency package which included a wage and price
freeze in the US, a 10 per cent import surcharge and the suspension of US dollar convertibility
into gold. Unquestionably, the closing of the gold window was a seismic shock that unleashed
financial reverberations that were felt even a decade later. By December 1971, it was obvious
that the imbalances created and pent up by fixed exchange rates were about to erupt. The death
of the Bretton Woods Agreement ended the system of fixed exchange rates. President Nixons
economic measures were only one of those effects and were immediately followed by a number
of joint international actions and pious pronouncements which, for the most part, turned out to be
futile30. The Werner Plan meant that member states now had to take measures to harmonise their
budgetary policies and reduce the margins of fluctuation between their own currencies.
Subsequently the magical currency snake31 was invented whereby The Six signed the agreement
(in Basle) to limit the margin of fluctuation between their currencies to 2.25 per cent.

30
The Smithsonian Agreements proposed currency realignments as well as dollar devaluation. These attempts at a
new foreign exchange value standard were doomed from the outset since they were not much more than a reshaping
of Bretton Woods in a slightly more flexible form. Its name stemmed from the place, the Smithsonian Institution in
Washington DC, where on 17th and 18th December 1971, the Group of Ten ministers met in an attempt to resolve
the international financial crisis but to no avail.

31
A system established by the EEC countries on 24 th April 1972, for the narrowing of the margins of fluctuation
between EEC currencies to plus or minus 2.25per cent. The six original participating countries included Belgium,
France, Germany, Italy, Luxembourg and the Netherlands.

21
In September 1972 the Ministers of Finance of The Six and of The Four32 countries that applied
for membership met in Rome, they agreed that in the first stage of economic and monetary union
it would be necessary to set up a European Monetary Cooperation Fund. However, by October
Egyptian armed forces caught Israel unaware during their Yom Kippur religious rituals and war
broke out. Simultaneously the Organisation of Arabic Petroleum Exporting Countries (OAPEC)
decided to reduce or ban exports towards some Western countries while the Organisation of
Petrol Exporting Countries (OPEC) decided to massively increase petroleum prices. Along with
the break down of the Bretton Woods Agreement, these events lit the fuse of inflation. What
followed was an era of financial turmoil that tested the very foundations of Western society; the
value of the US dollar plunged; unemployment rose; oil prices skyrocketed to US$39 a barrel;
stock-market indices fell; gold reached US$800 an ounce; inflation exploded; and interest rates
followed suit.

January 1973 saw Denmark, Ireland and the United Kingdom joining the European
Communities. The Community Free Trade Agreement with Austria, Switzerland, Portugal and
Sweden also came into force. The earlier success were however starting to recede. The Werner
plan fell apart under mounting pressure, there would be no economic union by 1980. European
countries continued to peg their exchange rates under the snake arrangement, but the system
proved to be highly unstable.

By 1979 dissatisfaction with the exchange rate volatility under post-Bretton Woods floating led
to the formation of the European Monetary System (EMS). EEC members pegged their currency
to a basket of European currencies called the European Currency Unit (ECU) within bands of
2.25per cent and agreed to jointly intervene to support currencies that reached the limits of
their band. The objectives of the EMS were to reduce exchange rate volatility and further the
drive towards European integration. West Germany dominated the system with the de facto
Deutsche Mark peg. This allowed other member states the chance to free ride on West
Germanys reputation for price stability and avoided costly disinflations. The system was subject
to frequent realignments in its early years, but convergence of inflation rates toward low German
levels did occur. The Single European Act (1986) built on this as countries set themselves the
target of eliminating almost 300 non-tariff barriers on intra-European trade by the end of 1992.

32 The Four refers to the four countries that made application to join the original six countries that made up the
original European Communities. The four countries were: Denmark, Ireland, Norway and the United Kingdom.

22
3.6 The Delors Report

In June 1988 the European Council confirmed the objective of the progressive realisation of
economic union and mandated a Committee chaired by Jacques Delors, the then President of the
European Commission, to study and propose concrete stages leading to European unity. The
Committee was composed of the governors of the EC national central banks plus; Alexandre
Lamfalussy, the then General Manager of the Bank for International Settlements; Niels
Thygesen, Professor of Economics, Copenhagen; and Miguel Boyer, the then President of the
Banco Exterior de Espaa. Jacques Delors presented the committees findings to the European
Council on 12th April 1989. The Report on Economic and Monetary Union in the European
Community - which later became known as Delors Report - proposed that economic and
monetary union (EMU) should be achieved in three discrete but evolutionary steps.

3.7 Stage One of EMU - price stability

On the basis of the Delors Report, the European Council decided in June 1989 that the first stage
of the realisation of economic and monetary union should begin on 1st July 1990 - the date on
which, in principle, all restrictions on the movement of capital between member states were to be
abolished. At this time, the Committee of Governors of the Central Banks of the member states of
the European Economic Community, which had played an increasingly important role in
monetary cooperation since its creation in May 1964, was given additional responsibilities. These
were laid down in a Council Decision dated 12th March 1990 and included holding consultations -
on and promoting the coordination of, the monetary policies of the member states - with the aim
of achieving price stability. In view of the relatively short time available and the complexity of
the tasks involved, the preparatory work for Stage Three of EMU was also initiated by the
Committee of Governors.

3.8 The Maastricht Treaty

For the realisation of Stages Two and Three of the Delors Report to come to fruition, it was
necessary to revise the Treaty establishing the European Economic Community (one of the
Treaties of Rome) in order to establish the required institutional structure. To this end, an
Intergovernmental Conference on EMU was convened and held in 1991 in parallel with the
Intergovernmental Conference on political union. The negotiations resulted in the Treaty on
European Union, which was agreed to in December 1991 and signed in Maastricht The
Netherlands, on 7th February 1992. However, owing to delays in the ratification process, the

23
Treaty33 did not come into force until 1st November 1993. From that point forward the Treaty on
European Union also became known as the Maastricht Treaty.

The Maastricht Treaty was one of the most important and visionary legal texts in the history of
European integration. It delivered tangible proof of the vision and ambition of the founding
fathers of the European integration process and brought the people of Europe closer together by
fostering economic integration. The Maastricht Treaty rightly described it as an ever-closer
union among the peoples of Europe34.

The European Community was built up around three institutions that carried out certain key
functions vis--vis legislative, executive and judicial matters. With the introduction of new
decision-making procedures and the advent of direct elections to the European Parliament, the
Community system became even more unique.

Harmonization was implicit in the Maastricht Treaty. The Treatys much discussed convergence
criteria conditioned entry into the European monetary union with national budget deficits of no
more than 3 per cent of gross domestic product and government debt of 60 per cent or less.
Inflation rates had to be within 1.5 per cent of the average of the three lowest inflation countries
and long-term interest rates also within 2 per cent of the average of the three lowest.

3.9 Stage Two of EMU - establishment of the EMI and the ECB

The establishment of the European Monetary Institute (EMI) on 1st January 1994 marked the start
of the second stage of EMU and with this the Committee of Governors ceased to exist. The
EMIs transitory existence also mirrored the state of monetary integration within the Community.
The EMI had no responsibility for the conduct of monetary policy in the European Union - this
remained the preserve of the national authorities - nor had it any competence for carrying out
foreign exchange intervention. However, two main tasks of the EMI were: to strengthen central
bank cooperation and monetary policy coordination; and to prepare the requirements for the
establishment of the European System of Central Banks (ESCB), for the conduct of the single
monetary policy and for the creation of a single currency in the third stage. To this end, the EMI

33
The Maastricht Treaty amended the Treaty establishing the European Economic Community - changing its name
to the Treaty establishing the European Community - and introduced, inter alia, the Protocols on the Statute of the
European System of Central Banks and of the European Central Bank and the Protocol on the Statute of the
European Monetary Institute.

34
The Treaty on European Union Preamble p10.

24
provided a forum for consultation and for the exchange of views and information on policy
issues. It specified the regulatory, organisational and logistical framework necessary for the
ESCB to perform its tasks in Stage Three.

3.10 The euro

In December 1995 the European Council agreed to name the European currency unit to be
introduced at the start of Stage Three, the euro, and confirmed that Stage Three of EMU would
start on 1st January 1999. A sequence of events was pre announced for the changeover to the
euro. This scenario was mainly based on detailed proposals elaborated by the EMI. At the same
time, the EMI was given the task of carrying out preparatory work on the future monetary and
exchange rate relationships between the euro area and other EU countries. In December 1996 the
EMI presented its report to the European Council, which formed the basis of a Resolution of the
European Council on the principles and fundamental elements of the new exchange rate
mechanism (ERM II). Also in December 1996, the EMI presented to the European Council, and
subsequently to the public, the selected design series for the euro banknotes to be put into
circulation on 1st January 2002.

In order to complement and to specify the Treaty provisions on EMU, the European Council
adopted the Stability and Growth Pact in June 1997. On 2nd May 1998 the Council of the
European Union, in the composition of Heads of State or Government, unanimously decided that
11 member states (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the
Netherlands, Austria, Portugal and Finland) had fulfilled the necessary conditions for the
adoption of the single currency. These countries were ready to participate in the third stage of
EMU. The Heads of State or Government also reached a political understanding on the persons
to be recommended for appointment as members of the Executive Board of the European Central
Bank (ECB).

At the same time, the Ministers of Finance along with the Governors of the national central
banks of the participating member states agreed with the European Commission and the EMI,
that the existing ERM bilateral central rates of the currencies of the participants would be used in
determining the irrevocable conversion rates for the euro.

On 25th May 1998 the governments of the 11 participating member states appointed the
President, the Vice-President and the four other members of the Executive Board of the ECB.
Their appointment took effect from 1st June 1998 and marked the establishment of the ECB. The

25
ECB and the national central banks of the participating member states constituted the
Eurosystem, which formulated and defined the single monetary policy for Stage Three of EMU.

With the establishment of the ECB, the EMI had completed its tasks. In accordance with the
Maastricht Treaty the EMI was dissolved. All the preparatory work entrusted to the EMI was
concluded in good time and the rest of 1998 was devoted by the ECB to the final testing of
systems and procedures.

In order to fulfil the clearly defined mandate of maintaining price stability, the Treaty accorded
the Eurosystem a considerable degree of institutional independence, albeit supplemented by
extensive obligations concerning transparency and accountability. On 13th October 1998 the
Governing Council of the ECB announced the Eurosystems stability-oriented monetary policy
strategy to guide its monetary policy decisions in Stage Three of EMU. The primary objective of
the ESCB was to maintain price stability. In pursuing its objectives, the ESCB acts in accordance
with the principle of an open market economy with free competition, favouring an efficient
allocation of resources.

3.11 Stage Three of EMU - introducing the euro

On 1st January 1999 the third and final stage of EMU commenced with the irrevocable fixing of
the exchange rates of the currencies of the 11 participating member states under the
responsibility of the ECB. The number of members increased to 12 on 1st January 2001, when
Greece entered the third stage. From that day the Bank of Greece was part of the Eurosystem and
the Greek drachma became a sub-denomination of the euro. On the 1st January 2002, the world
witnessed an historic moment - the euro having been successfully used for non-cash operations
both within the euro area and on international financial markets for three years, became tangible
reality. 2002 saw the euro banknotes and coins become legal tender in the euro area. The euro
thus became a visible symbol of European identity. This was an achievement of historic
proportions, involving in the 12 euro area countries alone, more than 305 million people. The
completion of the changeover was complex, ambitious and an unprecedented undertaking.

In addition to the EU institutions, the Eurosystem and national authorities, it was essential to
closely involve the banking sector, security carriers, retailers and the cash-operated vending
machine industry, in the preparations at an early stage. A smooth changeover, in a short period
of time, could only be achieved through a systematic and coordinated interaction on the part of
all leading actors. This required organisational, logistical, technical and economic efforts by all

26
parties in the use and handling of banknotes and coins. At the end of the day, however, the
success of the euro cash changeover also depended heavily on a favourable attitude of and swift
acceptance by all citizens. As it turned out, the European citizens accepted their new currency
rapidly with enthusiasm.

By the end of 2001, more than 6.5 billion euro banknotes worth some 133 billion amounting to
almost 50 per cent of national banknote circulation had been frontloaded. With regard to the euro
coins, more than 37.5 billion coins with a total value of around 12.4 billion had been
frontloaded. Overall, citizens acquired more than 150 million coin starter kits. By the third week
of the eight week change over, around 8.1 billion euro banknotes were in circulation, which was
more than 90 per cent of the number of euro banknotes that had initially been estimated for the
end of February 2002. In terms of value, this corresponded to approximately 209 billion, which
was equivalent to 77 per cent of all national banknotes in circulation at the end of 2001.

In terms of transactions, around 70 per cent of all banknotes were put into circulation via
automated teller machines (ATMs). The quick adaptation of these machines was one of the key
factors for a smooth changeover. In total, more than 200,000 ATMs had to be converted. In
virtually all euro area countries, 100 per cent of the ATMs were converted within less than one
week. As a result, on average, 75 per cent of all cash transactions were already effected in euro
after only one week. On the whole, the euro banknotes and coins were introduced considerably
faster than originally foreseen. 10 million vending machines had to be adapted for the new
currency. Some counterfeiting was reported, but it was of very poor quality.

Not only was the change over smooth within the euro zone but changeover was also smooth and
progressed well outside the euro area. The euro banknotes were received positively, especially in
the accession countries of the UK and Denmark. Euro banknotes became readily available in
banks and bureaux de changes around the globe. With regard to the frontloading of banks
outside the euro area, 26 central banks, mainly in Central and Eastern Europe, the Mediterranean
area and in Africa, requested to be frontloaded with euro cash. The total value of the euro
banknotes provided to these central banks and to wholesale banks outside the euro area
amounted to some 4 billion.

With the introduction of euro banknotes and coins, the process of rebuilding Europe was
complete, proving that a preposterous idea coupled with eager fancy could succeed where reason
by itself could fail. Monetary integration and capitalist enterprise forged the vessel that allowed
Europe to sail into the twenty-first century. Like Crusoes boat, the European Union with its

27
single currency thus became the physical manifestation of the preposterous and eager fancy that
drives humanity. Now the main task is to analyze by reason the ramifications, the successes and
potential inadequacies of the euro and relate this back to the general question of this thesis of
whether currency unions are or are not economically efficient and if efficient, whether this
phenomenon is likely to provide a workable model for the formation of other currency unions or
help promote the concept of a global currency. The next chapter reviews the thoughts of a few
prominent academics to assertain the value of the euro and the benefits of currency unions.

28
 Chapter 4

Literature Review

4.1 The advancement of knowledge

His fever and delirious dream about an angel with a flaming sword leads Crusoe to ask a
profound and significantly broad question, What is this Earth and Sea of which I have seen so
much, whence is it producd, and what am I, and all other creatures, wild and tame, humane and
brutal, whence are we? Crusoe has stopped thinking of himself alone; soon his conscience
awakens. He decides to learn the virtue and goodness of the fruits and plants of the island.
Suddenly the island abounds with food as he masters his environment. The island becomes a new
Eden for it looks in a constant verdure or flourish of Spring it looked like a planted garden.
Crusoe looked over that delicious vale and his thoughts prefigure the pleasure he imagines any
English king would have experienced on surveying his country. Through experience and the
seeking of knowledge, Crusoe awoke to the realities of his beautiful world. The following
authors have already asked the questions and sought the knowledge. They have studyd the
advancement and encrease of knowledge for those that read, and shall be as glad to make them
wise.

The focus of this section is to draw the readers attention to a snippet of the current literature that
abounds at present about the positive and negative aspects of currency unions. This thesis has
endeavoured to track down and report on some of the more prominent views concerning the
economic efficiency, or lack there of, of currency unions. It has done this by specifically
targeting a small number of leading academics who have demonstrated intellectual wisdom far
beyond that of ordinary folk, forward vision that is seldom matched even by hindsight and
passion that only few can achieve. It has been an honour for this author to have gained from their
wisdom. Hopefully this thesis will convey their message with the same clarity for which these
economists are famous. Any misinterpretation of their work would be due truly to the
inefficiencies of this author.

There are several authors work that will be examined, these include: An acceptance speech
titled A Reconsideration of the Twentieth Century by Professor of Economics at Columbia
University Robert A. Mundell delivered in Stockholm in 1999, when he received the Bank of
Sweden Prize in Economic Sciences in Memory of Alfred Nobel; A paper presented at the

29
Reserve Bank of Australias conference35 on Future directions for Monetary Policies in East
Asia titled A Monetary Union in Asia? Some European Lessons, by Charles Wyplosz,
Professor of International Economics at the Graduate Institute in Geneva and Director of the
International Centre for Money and Banking Studies and; An examination of a leading
econometricians work, which includes among others, a paper titled One Money, One Market:
The Effect of Common Currencies on International Trade authored by Andrew Rose Jr.
Professor of International Trade and Business in the Economic Analysis and Policy Group at the
Haas School of Business Administration, at the University of California at Berkeley.

Although there are some slight variations of view, these authors share the common belief that
currency unions enhance price stability and promote trade within unified economic zones. Unlike
Robinson Crusoes isolated existence, the modern world demands that no man live as an island.
This applies proportionately to nations. Apart from the economic concept, the idea of a Crusoe
economy existing in the modern world is preposterous. Because all nations participate in the
global economy, it is imperative that international financial structures cater for all the worlds
people and not just the rich and powerful. I trust that you will find the following reviews
enjoyable.

4.2 Andrew Roses work

Presently, Andrew Rose is one of the more active econometricians researching the effects of
monetary unions. He has published and co-published in the vicinity of ninety works in recent
years. His credentials place him firmly as a leader in this field of research. This section examines
but one proportion of his work.

In his One Money, One Market (2000) article, Rose employed a gravitational econometric
model36 to assess the separate effects of exchange rate volatility and currency unions on
international trade. To initiate his research Rose posed the question: What is the effect of a
common currency on international trade? His answer was a single word - Large. For this thesis
one word may be a little inappropriate therefore to summarize his paper more technically, Rose

35
Reserve Bank of Australias conference held at the H.C. Coombs Centre for Financial Studies, Kirribilli, NSW on
the 24th July 2001.
36
In the bare-bones gravity equation, trade between a pair of countries is modeled as an increasing function of their
sizes and a decreasing function of the distance between the two countries. The framework is one of the more
successful empirical models in economics - typically a reasonable proportion of the variation in trade is explained
with an equation where the coefficients are economically sensible, and well-determined statistically. The gravity
model is used for trade - Andrew Rose applied the principles to currency unions.

30
used a large cross-country panel data set to show that two countries with the same currency
traded more than comparable countries with their own currencies. The effect was statistically
significant as well as being economically large. While reducing exchange rate volatility also
increases trade, the effect of a common currency appeared to be an order of magnitude larger
than that of eliminating exchange rate volatility but retaining separate currencies. The effect took
into account a variety of other factors, and was extremely robust37. The panel data set included
bilateral observations in five year periods, spanning 1970 through to 1990 for 186 countries. In
this data set, there were over one hundred pairings and three hundred observations, in which both
countries used the same currency. Rose found a large positive effect of a currency union on
international trade, and a small negative effect of exchange rate volatility, even after controlling
for a host of features, including the endogenous nature of the exchange rate regime. These effects
implied that two countries sharing the same currency would trade three times as much as they
would with different currencies. Countries within currency unions, like the EMU, may thus
experience a large increase in intra-zonal trade.

The effect of a common currency on trade is an important issue. The increase in trade stemming
from the common currency is one of the few undisputed gains from the European monetary
union. Even EMU-skeptics agree that substituting a single currency for several national
currencies reduces the transactions costs of trade within that group of countries. That effect had
not been quantified until Rose conducted the econometric tests. Instead, economists used the
much smaller effect on trade of eliminating exchange rate volatility. As a result, the consensus
was that currency unions had hardly any effect on trade. The case for a common currency was
weaker accordingly.

Roses paper contended that such skepticism was unwarranted, so that a potent argument in
favour of currency unions had been under-stated in the literature. Logically it is cheaper to trade
between two countries that use the same currency than between countries with their own monies.
The question was; By how much? Skeptics and most economists believed that intra-EU trade
would only rise a little because of the euro. According to Rose, this line of thought seemed
reasonable as exchange rate volatility was low before the EMU anyway, and whatever volatility
remained could be inexpensively hedged through the use of forward contracts and other
derivatives.

37
Robust; is used in econometrics to mean that the model stands up to vigorous examination and passes the Tests
convincingly.

31
Euro supporters in contrast, thought that sharing a common currency would lead to an increase in
the depth of trading relations, while precluding the beggar thy neighbour38 competitive
devaluations that usually destroy common markets. They conveyed that a common currency
could have a larger effect on trade than even a radical reduction in exchange rate volatility. The
primary objective of Roses paper was to resolve the argument by estimating the separate effects
of exchange rate volatility and common currencies on trade.

The reasoning behind Roses investigation was that if a common currency did substantially
increase trade, there would be important repercussions. First, there would be an increase in trade
disputes and frictions simply because the volume of international trade rises within the union.
Second, if greater international competition leads to layoffs and associated labour market
pressures, there could be an increase in pleas for continuation or enlargement of the social
security safety net. Third, higher levels of trade could lead to more synchronization of business
cycles across countries. More generally, closer economic integration was likely to lead to greater
political integration. Fourth, other countries like the UK, Sweden and Denmark in Europe, but
also Argentina, Canada and others could find it more worthwhile to join a common currency
area, leading to a further increase in global integration. Fifth, and most importantly, a big
increase in trade would lead to substantial extra gains from trade for consumers inside the
currency union.

With such important and interesting issues at hand, it was no surprise that economists worked
hard to quantify the effects of reduced exchange rate volatility on trade. Sadly, there was almost
no consensus in the area, save that the effect (if any) was difficult to estimate, even with high-
tech time-series econometrics. In any case, having even a very stable exchange rate may not be
the same as being a member of a common currency area. Sharing a common currency is a much
more serious and durable commitment than a fixed exchange rate regime. This is manifest
empirically in much more intense trade inside countries than between countries, a phenomenon
known as home bias in international trade. John McCallum (1995)39 quantified the size of the
intra-national bias at more than twenty to one. Part of this home bias effect, McCallum believes,
stems from the fact that a single currency was used inside a country.

38
Beggar thy neighbour principle implies that a political state would adjust currency values to enhance its terms of
trade with its trading partners. This has the effect of profiteering at the neighbours expense, hence they become
beggars.

39
McCallum, J. (1995) National Borders Matter: Canada-US Regional Trade Patterns, American Economic
Review 85, no.3 June, p 615-623.

32
One might imagine that trying to measure the effects of a common currency on trade is a purely
academic exercise. The only countries that have adopted a common currency of late are the
EMU-12, for whom there is necessarily few data due to the euros brevity. True enough, but
Rose perceived that there was no reason to rely on before and after differences to estimate the
effect of currency unions on trade, just as one need not use time-series variation to discern the
effects of exchange rate volatility on trade. Roses paper exploited cross-sectional variation
using evidence across countries to trace the effects of currency unions and exchange rate
volatility on trade. Is a cross-country approach to investigating currency unions doomed to
failure since there are so few of them? Not at all said Rose. One need not go back to the
nineteenth century precedents of the Latin and Scandinavian Monetary Unions to find examples
of countries with common currencies. Above and beyond the twelve current members of the euro
zone, ninety-one countries are currently in some sort of official common currency scheme
(thirty-two of these areas are official dependencies or territories). Roses empirical work hinged
on exploiting these linkages.

The most important consequence of increased trade was increased gains from trade. As the
deadweight loss of using different currencies vanished, competitive pressures increased and
consumers gained static Harberger triangles40. There could also be dynamic gains if economic
growth rates increase. If the euro causes radically increased intra-European trade and the benefits
associated with that, other countries may well take the plunge of joining a monetary union,
spreading these gains even further.

A large increase in trade precipitated for whatever reason (including the introduction of a
common currency) brings benefits but also tensions. Certainly there may be an increase in trade
disputes. These will occur inside Europe as competitive pressures lead special interest groups to
cry for protectionism in the usual timeworn fashion. There may also be an increase in trade
tensions between Europe and the rest of the world if the European market size increases
dramatically. As a result, there may be pressures to retain (or even increase) the social security
safety net both inside and outside Europe. An increase in trade also affects the very sustainability
of the currency union. As trade increases, business cycles can in principle move either more
asynchronously (as countries specialize to take advantage of comparative advantage) or more

40
Harberger triangles are used to calculate the efficiency costs of taxes, government regulations, monopolistic
practices, and various other market distortions. Prior to the publication of Arnold Harbergers papers, economists
very rarely estimated deadweight losses. The empirical deadweight loss literature expanded greatly since the 1960s
and is now quite common. Meanwhile, critical evaluation of deadweight loss estimates led to new theories of rent-
seeking and other inefficiencies of economies with multiple distortions.

33
closely together (if most shocks are monetary or most trade is intra-industry trade). An increase
in intra-European trade precipitated by the EMU, could make the euro itself more sustainable by
increasing the synchronization of European business cycles.

Torsten Persson (2001)41 used non-parametric matching techniques on the data set that Rose
(2000) used and found that the effect of currency union on trade was smaller than Roses tripling
estimate, and that it was less precisely estimated, though still positive and usually significant. In
response to this, Rose (2001)42, exploited a larger data set to try to address the possible
endogeneity of the decision to leave or join a currency union (using linear, matching and panel
fixed-effect techniques) and once again Rose found that the effect on trade was large, positive
and significant.

Andrew Roses work with Reuven Glick (Glick and Rose 2001)43 examined the 130 exits from
currency unions in the 19481997 period using a large panel of International Monetary Fund
(IMF) bilateral trade data. Using only data on the countries that left or joined currency unions,
they found that a pair of countries that dissolve a currency union experience a halving of trade.
This was true even after controlling for a number of other things such as preferential trade
agreements and income, which also affected trade.

A more recent study44 that Andrew Rose participated in was with Professor Jeffrey A. Frankel,
Director of the NBER program in International Finance and Macroeconomics. To quantify the
implications of common currencies for trade and income, they used data for over 200 countries
and dependencies. In their two-stage approach, estimates at the first stage suggested that
belonging to a currency union/board triples trade with other currency union members. Moreover,
there was no evidence of trade-diversion. Their estimates at the second stage suggested that
every one per cent increase in a countrys overall trade (relative to GDP) raised income per
capita by at least one third of a per cent. They combined the two estimates to quantify the effect
of common currencies on output but found no evidence that currency unions per se have a
positive significant effect on output. There was of course a caveat associated with this work.
41
Persson, T. (2001) Currency Unions and Trade: How Large is the Treatment Effect?, Economic Policy,
forthcoming.
42
Rose, A. (2001) Currency Unions and Trade: The Effect is Large, http://haas.berkeley.edu/~arose
43
Glick, R. and Rose, A. (2001) Does a Currency Union affect trade? The time series evidence, NBER Working
Paper No 7857.
44
Frankel, J. and Rose, A. (2002) An estimate of the effect of common currencies on trade and income.
http://www.haas.berkeley.edu/~arose

34
It was based on actual currency unions that typically involved small and or poor countries, thus
any extrapolation to large rich countries was or remains anextrapolation. They did however,
find it reassuring that the currency union had a positive effect on income when included directly
in the income equation, if and only if it was weighted by the importance of trading partners. This
suggested that the benefit did not come directly from monetary stability. Their results therefore
supported the hypothesis that important beneficial effects of currency unions come through the
promotion of trade that is attributed to the use of a common currency.

4.3 Charles Wyploszs work.

This section presents a brief outline of a paper presented at the conference45 on Future
directions for Monetary Policies in East Asia. The conference, had five leading economists
presenting their papers on various considerations, which holistically outlined the significance of
exchange rate stability and contributed to the notion of implementing a monetary union within
the East Asian region. The author that is reviewed in this section is Charles Wyplosz, Professor
of International Economics at the Graduate Institute in Geneva and Director of the International
Centre for Money and Banking Studies. Professor Wyplosz presented his paper A Monetary
Union in Asia? Some European Lessons at the conference. The following is an abridged
interpretation of his work.

Professor Wyplosz reminded us that it was not so long ago that the idea of a country ceding its
monetary policy to another country, or to a supra-national authority, was a curiosity fit only for
special cases. But the advent of monetary union in Europe, as well as a re-assessment of the
relative merits of floating exchange rates and monetary unions, has seen a change in attitudes
about the desirability of monetary unions. Wyplosz used his paper to draw lessons for Asia from
the European journey to monetary union. He made the interesting point that, given relative sizes
and distances between countries, there is much more trade among East Asian countries than
among European countries, even despite the existence for more than forty years of the Common
Market in Europe.

Wyplosz made a compelling case for the importance of building collective institutions towards
the implementation of monetary unions. He stated that collective institutions become the
advocates of integration. They move the debate from the purely political sphere to the technical
level, allowing for professional assessments, which helps to minimize costly mistakes. Collective

45
Reserve Bank of Australias conference held at the H.C. Coombs Centre for Financial Studies, Kirribilli, NSW on
the 24th July 2001.

35
institutions provide analyses that would not be carried out otherwise. These institutions can
prepare blueprints that can be readily put to use when critical occasions arise.

The message of Charles Wyploszs paper was that an East Asian monetary union is a long way
down the path of time and can only come to fruition through the gradual increase of cooperation
between countries. Europe started with trade agreements among a small number of like-minded
countries striving to restore trade links in order to replace political and military competition with
common economic interests. Financial integration, and therefore exchange rate stability and
ultimately monetary union, was the means to an end of trade integration, not an objective in
itself.

Achieving a high degree of exchange rate stability in Europe was made relatively easy by
extensive use of internal and external financial repression. Once the commitment to full capital
mobility was made, and set in concrete in the Single European Act (1988) being implemented in
1992, the authorities gradually realised the full implication of the hollowing-out principle46.
Unique political conditions made it possible to quickly take the step and cement the by-then
shaky European Monetary System. Looking first at the role of exchange rate stability and
secondly at the irrelevance of optimum currency area criteria in the European debate, Wyplosz
then presented some comparative evidence based on Europe for East Asia.

Wyplosz directed us towards the political economy and proposed the view that Europe had
followed a unique path of institution-building. Exchange rate stability within Europe was
identified early on as a prerequisite to trade integration, and was maintained with the help of
capital controls. When the controls were lifted, the monetary union emerged as the next logical
step. Exchange rate stability was the paramount objective among countries seeking to achieve
and maintain the high degree of trade integration. Fear of competitive devaluations and the
protectionist reactions that they create had always been a key concern and the incentive for a
cooperative approach to European interdependence. Wyplosz suggested that truly free floating
regimes were the exception, not the rule, as convincingly shown by Calvo and Reinhart (2000)47.
Wyplosz also stated that most floats are dirty floats, he then raised the following question; Why

46
The hollowing-out principle refers to the extremities associated with mutually exclusive scenarios, ie no middle
ground.
47
Calvo GA and CM Reinhart (2000) Fear of Floating, NBER Working Paper No 7993.

36
agree on detailed trade agreements if relative prices can be freely changed by large amounts? He
continued48:

When the exchange rate can be manipulated it is inevitable that trade partners become
suspicious of each other, thus threatening the best-crafted trade agreements. Once the
option of some degree of exchange rate management is rehabilitated, we need to consider
the various ways of achieving it.

Wyploszs informed us of a new wisdom that states the only sustainable fixed exchange rate
regime is a hard peg dollarisation or a currency board. Barry Eichengreen (1999) 49 observed,
normal pegs (fixed-but-adjustable exchange rates, crawling bands) had never lasted very long.
On the other side, the hard pegs currently in vogue are a recent phenomenon and it is far too
early to conclude that their endurance significantly exceeds that of previous peg arrangements. It
can be noted that the closest equivalent to modern currency boards, the gold standard, did not
last for very long either. In fact, its abandonment is often considered as a major step forward. In
the case of Europe, soft pegs had been an important transition step and a period of learning how
to deepen cooperation towards hard pegs (ie. the monetary union).

Wyplosz proved graphically50 that by adopting an explicit system of fixed-but-adjustable rates,

the European countries had achieved more stability than other countries, the standard deviation
of their effective exchange rate was on average half of that observed in countries with fully
floating rates. Before the final integration step in 1999 which fixed exchange rates permanently
within the euro zone, the rates in European countries were about 50 per cent less volatile than
those of the AsiaOceania region. Secondly, the euro zone had 90 per cent lower frequency in
volatility.

Exchange rate stability is increasingly found to enhance trade, the choice between soft and hard
pegs is less of a foregone conclusion than recent fashion suggested. Fixed-but-adjustable rates
deliver exchange rate stability. While their shelf-life is undoubtedly limited, they can be an
efficient arrangement during a transition period. The Bretton Woods Agreement can be seen, in
retrospect, as a transitional arrangement set up to last until the largest economies were ready to
float. After having restored trade links between countries and built adequate institutions for

48
Economic Group, Reserve Bank of Australia, Conference paper (2001) Future Directions for Monetary Policies
in East Asia, p 127.
49
Eichengreen B (1999) Toward a New Financial International Architecture: A Practical Post-Asia Agenda,
Institute for International Economics, Washington DC.
50
Ibid p 128.

37
financial management, the European Monetary System achieved its aims of exchange rate
stability right up until the euro zone was ready for a single currency. Wyplosz firmly subscribes
that fixed but adjustable exchange rates do deliver stability. By adopting this system the
European countries achieved more stability than purely floating regimes and suffered less at the
speculators hands.

Wyplosz expressed that the European Monetary Union was sometimes seen as a long-planned
step in the unfinished process that ultimately aimed at creating the United States of Europe.
Wyplosz did however say that this was not quite accurate and that divergence of opinions about
the ultimate aim of European integration ran deep, cutting across countries and traditional party
lines. For that reason, each step had always been discussed on its own merits. Any attempt to
link any step to a broad master plan would have most likely triggered lethal opposition.
Pragmatism, Wyplosz states, was the first ingredient of Europes successful integration progress.
The second ingredient was institution building. Wyplosz then drew attention towards this most
critical component and expanded upon the European example of fiduciary control mechanisms.

The evolution of these control mechanisms demonstrates how complex the notion of a currency
union is to implement. A myriad of considerations need to be addressed. The simple common
Basket Band Crawl (BBC)51 regime presents a good starting point but the politically sensitive
issues of financial integration and institution building present the largest hurdle. Wyplosz
informed us that the main European fiduciary institutions today are the European Commission
and the European Central Bank (ECB). The Commission was created along with the Common
Market. With limited powers initially, it had been the repository of each abandonment of
national sovereignty, in trade matters initially, progressively extending its role to industrial and
antitrust policies, agriculture, research, diplomacy, etc. The Commissions natural role was to be
the main advocate of the integration process, which often brought it into conflict with its member
governments. The European Commissions arcane functioning was often derided, but it reflected
the inherent difficulty of its mission: it represented the common interest which often came at the
expense of national or corporate interests. It used the powers grudgingly given up by member
countries to try and force them to act in a way that was collectively desirable. Its legitimacy was
devolved by member governments, which were prompt to call it into question when they felt
threatened. Its task was thankless but essential.

51
BBC represents a basket of currencies operating within prescribed bands to one another while their exchange rate
values crawl together.

38
The ECBs structure also reflected the fundamental ambiguity in relinquishing national
sovereignty. The policy decisions were taken by the European System of Central Banks (ESCB)
Council which included the 12 central bank Governors and the six members of the ECBs Board.
Wyplosz says that52;

the Council is clearly too large to be efficient, and its size is designed to increase with
each new admission.

Officially the ESCB is prevented from taking into account national interests which regularly
causes antagonism between participating member nations and the central authority (that Wyplosz
describes as sometimes adrift and slow to move).

The European Parliament is the only pan-European elected body. Yet, elections are conducted at
the national level, the candidates are appointed by national parties, and the issues debated at
election times always refer to national politics with lip service paid to European issues. The
Parliaments powers are mostly advisory and jealously restricted by the national parliaments. But
it exists and is likely to see its role grow whenever it is politically expedient.

For all their shortcomings, the mere existence of common European political and fiduciary
institutions had been undeniably crucial. They embodied the principles of a common good with
common aims which transcended national interests and objectives. Importantly, their staff
developed analyses and proposals that matched those carried out by national governments. They
provided neutral grounds for dealing with conflicts among member countries and most
importantly they gave integration forces a name and a face. Europes integration had always
been characterised by a process of muddling-through, two steps forward and one step backward,
with deep and lingering divergences as to what the end objective would be. But each integration
step made the next one more likely. The existence of institutions ready to transform projects into
reality had been essential.

In Europe in the 1980s, the desirability of adopting a monetary union was being discussed and
studied, but it was staunchly opposed by Germany, Britain and a few other countries. What made
a crucial difference was that the project was available on the shelf when the Berlin Wall fell and
Germany was ready for an historic political deal in return for support for its unification. The
European Commission had done all the preparatory background work and was in a position to
carry the plan to the next step. That was the Delors Commissions recommendation of adopting a

52
Economic Group, Reserve Bank of Australia, Conference paper (2001) Future Directions for Monetary Policies
in East Asia, p 140.

39
monetary union for the European zone. Integration can be thus seen as a dynamic process, but
one that was not predetermined, at least in policy-makers eyes. It made bold, unplanned moves
possible when the occasion arose unexpectedly. As Wyplosz masterfully put it,53 Crusoe would
have surely agreed:

Time is not of the essence, opportunities are.

4.4 Robert Mundells work.

The theme of Professor Mundells acceptance speech on winning the Nobel Prize for Economics,
was the role of the United States in the twentieth century and the role of the monetary factor as a
determinant of political events. Specifically, he argued that many of the political changes in the
twentieth century were caused by little-understood perturbations in the international monetary
system, while these in turn were a consequence of the rise in economic power of the United
States and the mistakes of its financial arm, the Federal Reserve System. Mundell took us full
circle to arrive at the understanding that the twentieth century ended with an international
monetary system inferior to that with which it began. He said it remains to be seen where
leadership will come from and whether a restoration of the international monetary system will be
compatible with the power configuration of the world economy. He indicated that the restoration
of the international monetary system would certainly make a contribution to world harmony.
Today, the dollar, the euro and yen have established three islands of monetary stability, which
Mundell says, is a great improvement over the 1970s and 1980s, but stated, there are two pieces
of unfinished business, the most important is the dysfunctional volatility of exchange rates that
could sour international relations in times of crisis and the other is the absence of an international
currency. As an international currency would be the physical manifestation of the ultimate
currency union, which is exactly what this thesis is trying to promote, it stands to reason, this
author values the wisdom of one of the great economic gurus of the twentieth century.

Mundell opened his dialogue recalling the financial history of the twentieth century. He informed
us that the twentieth century began with a highly efficient international monetary system in place
that was destroyed during World War I, and that its bungled recreation in the inter-war period
brought on the great depression, Hitler and World War II. The new arrangements that succeeded
it depended more on the dollar policies of the US Federal Reserve System than on the discipline

53
Ibid at p 141.

40
of gold itself. When the link to gold was finally severed in 1971, the Federal Reserve System was
implicated in the greatest inflation the United States had known, at least since the days of the
Revolutionary War of 1776. Even so, as the twentieth century ended, a relearning process had
created an entirely new framework for capturing some of the advantages of the system with
which the century began.

Mundell divided the century into three distinct, almost equal parts. The first third, 1900 - 33, was
dominated by the confrontation of the Federal Reserve System with the gold standard. The
international gold standard at the beginning of the twentieth century operated smoothly to
facilitate trade, payments and capital movements. Balance of payments were kept in equilibrium
at fixed exchange rates by an adjustment mechanism that had a high degree of automatic
adjustment. The world price level may have been subject to long-term trends but annual inflation
or deflation rates were low, or tended to cancel out and preserve the value of money in the long
run. Mundell said the system gave the world a high degree of monetary integration and economic
stability. The efficiency and stability of the gold standard came to be increasingly dependent on
the discretionary policies of a few significant central banks. This tendency was amplified
substantially with the creation of the Federal Reserve System in the United States in 1913. The
Federal Reserve Board, which ran the system, centralized the power of an economy that had
become three times larger than either of its nearest rivals, Britain and Germany. The story of the
gold standard therefore became increasingly the story of the Federal Reserve System and its
policies.

World War I made gold unstable. The instability began when deficit spending pushed the
European belligerents off the gold standard, and gold came to the United States, where the newly-
created Federal Reserve System monetised it, doubling the dollar price level and halving the real
value of gold. The instability continued when, after the war, the Federal Reserve engineered a
dramatic deflation in the recession of 1920 - 21, bringing the dollar (and gold) price level 60 per
cent of the way back toward the pre-war equilibrium, a level at which the Federal Reserve kept it
until 1929. This created the deflationary pressures of the 1930s. Federal Reserve economists
blamed the gold standard instead of their mishandling of it and turned away from international
monetary consensus to national management.

Passing verdict on the first part of the century, Mundell explained that the Federal Reserve
System was guilty of inconsistency at critical times. It held onto the gold standard between 1914
and 1921 when gold had become unstable. It shifted over to a policy of price stability in the

41
1920s that was successful. But it shifted back to the gold standard at the worst time imaginable,
when gold had again become unstable. The unfortunate fact was that the least experienced of the
important central banks, the new Federal Reserve, had the awesome power to make or break the
system by itself. Mundell ambitiously pointed out that had the price of gold been raised in the late
1920s, or, alternatively, had the major central banks pursued policies of price stability instead of
adhering to the gold standard, there would have been no Great Depression, no Nazi revolution
and no World War II.

The second third of the twentieth century, 1934 -71, was dominated by the contradiction between
national macroeconomic management and the new international monetary system. In April 1934,
after a year of flexible exchange rates, the United States went back to gold after a devaluation of
the dollar. This decreased the gold value of the dollar by 40.94 per cent, raising the official price
of gold 69.33 per cent to $35 an ounce. France held onto its gold parity until 1936, when it
devalued the franc. Two other far-reaching events occurred in that year. One was the publication
of John Maynard Keynes General Theory, the other being the signing of the Tripartite Accord
among the United States, Britain and France. One ushered in a new theory of policy management
for a closed economy, the other, a precursor of the Bretton Woods Agreement, established some
rules for exchange rate management in the new international monetary system. The contradiction
between the two could hardly be more ironic. At a time when Keynesian policies of national
economic management were becoming increasingly accepted by economists, the world economy
had adopted a new fixed exchange rate system that was incompatible with those policies.

In the new arrangements, which were ratified at Bretton Woods in 1944, countries were required
to establish parities fixed in gold and maintain fixed exchange rates to one another. The new
system, however, differed greatly from the old gold standard. For one thing, the role of the United
States in the system was asymmetric. A special clause allowed any country the option of fixing
the price of gold instead of keeping the exchange rates of other members fixed. Because the US
dollar was the only currency tied to gold it was the only country in a position to exercise the gold
option. There thus came into being the asymmetrical arrangements in which the United States
fixed the price of gold whereas other countries fixed their currencies to the US dollar. Another
difference of the new system from the old was that not even the United States was on anything
that could be called a full gold standard. The dollar was no longer in the old sense anchored to
gold; it was rather that the world price level, and therefore the real price of gold, was heavily
influenced by the United States. Gold had become a passenger in the system. National
macroeconomic management precluded the operation of the international adjustment mechanism

42
and the system broke down. On 15th August 1971, confronted by requests for conversion of
dollars into gold by the United Kingdom and other countries, President Nixon took the dollar off
gold, closing the gold window at which dollars were exchanged for gold with foreign central
banks. The other countries then took their currencies off the dollar and a period of floating began.

The third part of the century 1972 - 1999, as Mundell put it, started with the destruction of the
Bretton Woods Agreement as other nations adopted flexible exchange rates. The old system was
one way of handling the inflation problem multilaterally. The collapse of the international
monetary system and the subsequent vacuum it created, the outbreak of massive inflation and
stagnation in the 1970s sent officials and academics in search for the new international monetary
order. Inflation was the initial result but a steep learning curve educated a generation of monetary
officials on the advantages of stability and by the end of the century fiscal prudence and inflation
control had again become the watchword in all the rich and many of the poor countries. The
blossoming of supply-side economics in the 1980s, the return to monetary stability and the birth
of the euro in the 1990s, signified if not the arrival of the new international financial architecture,
the willingness for governments to at least enter into dialogue on the subject and improve the
system already in place.

Winding up his speech Mundell summarised the economic performance of the 1990s and said
that it compared well with the first decade of the century. Prudent financial management, then as
now, produce similar effects, but in two respects he said, our modern arrangements compare
unfavourably with the earlier system, these being the current volatility of exchange rates and the
absence of a global currency. The volatility of exchange rates is especially disturbing among
countries that have achieved price stability. The volatility therefore measures real exchange rate
changes and involves dysfunctional shifting between the domestic and the international-goods
industries and aggravates instability in the financial markets. Mundell then focused on the
economic lessons of the last third of the twentieth century. One was that flexible exchange rates,
at least initially, did not provide the same discipline as fixed rates. A second was that the cost of
inflation is much higher in a world with progressive income tax rates. A third was supply-side
economics pointed to one of the mechanisms for strapping down ministers of finance and that the
need for, and means of, attaining monetary stability could be learnt. A fourth was that the proper
combination of policy mix of monetary tightening and government spending could shift the
Phillips Curve54. Professor Mundell concluded his speech with the advise, that flexible exchange

54
British economist A.W. Phillips identified the relationship between unemployment and the inflation rate and
represented it in graphical form in the shape of a curve.

43
rates are an unnecessary evil in a world where each country has achieved price stability, any
gambit by one country in its exchange rate would effect the entire play, this he said could sour
international relations. But saying that he then pointed to another piece of unfinished business,
that being the absence of an international currency. Mundell believed the adoption of a single
global currency could be a solution for all exchange rate problems.

4.5 Summary of literature review

From this literature, one gets the reasonable view that monetary unions have both costs and
benefits but generally the benefits outweigh the costs. More importantly, the literature today is
now more empirical than it has been in years gone by. It uses data on actual monetary unions to
get some sense of their effects. For instance, Andrew Rose employed a gravitational econometric
model to assess the separate effects of exchange rate volatility and currency unions on
international trade. He found a large positive effect of a currency union on international trade,
and a small negative effect of exchange rate volatility. These effects were statistically significant
and implied that two countries sharing the same currency trade three times as much as they
would with different currencies. Countries within currency unions, like the EMU, will
experience a large increase in international trade in the coming years. As a result of such work,
monetary unions are now viewed under a much more favourable light. Charles Wyplosz
informed us of the advantages and hurdles of forming currency unions by relating the European
example. Wyplosz also indicated that this phenomenon is likely to be repeated as other nations
adopt similar strategies to maximize economic efficiency. Professor Mundell took us one step
further and outright proclaimed that a single global currency would be the most efficient scenario
because that system would eliminate totally any room for speculative pressure, increase price
transparency and promote economic integration on an unprecedented scale. With such views
being expressed by the leading academics, it is only a matter of time before such reasoning
becomes universally accepted by society in general and consequently enters into the political
arena as well. The idea of a single global currency thus becomes more believable.

The next step is to view the euro in the international setting. By doing this the reader may
appreciate just how significant the euro has become over the last few years and monitor how
dramatically it has - and is - changing the design of global finances.

44
 Chapter 5

The euro in the international monetary system

5.1 The intrinsic value of money

The relationship between the island economy and the real world is suggested subtly by Mr
Crusoes changing attitude towards money. Within the first fortnight of being trapped on the
island Crusoe visited the wreck of the ship and found foreign coin, pieces of eight, gold, silver
and English pounds. Being trapped on an island by himself there was little use for money. I
smild to my self at the sight of this money, Oh Drudge, said I aloud, what art thou good for?
Thou art not worth to me, no, not the taking off the ground. Upon second thoughts, he picked it
up and took it with him anyway, the paper money went moldy and rotted in the dampness of his
cave. Years later a Spanish galleon was also destroyed on the reef leaving no survivors. Again
Mr Crusoe salvaged the wreck. To his discovery he came across three great bags of pieces of
eight, which had about eleven hundred pieces in all. In one of them, wrapped in paper, six
doubloons and some small bars of gold. Again he lamented, as to the money, I had no manner
of occasion for it; Twas to me as dirt under my feet. None the less Crusoe lugged this money
home to his cave. These events were part preparation of Crusoes gradual return to the real world
economy. Crusoe was not only concerned about securing the money, but began thinking about
his return to the world and the value of the money there. Figuratively, Crusoes acceptance of the
intrinsic value of money as a means of trade is representative of humankinds inherent need to
symbolize the process of exchange. The euro, is one such medium.

5.2 Implications for the euro

On 1st January 2002, euro notes and coins began to circulate for the first time. After 40 years of
dreaming and 20 years of concerted planning, the euro finally became part of economic reality
throughout the euro zone and hence around the rest of the world. Abandoning their historic
currencies and forging a new currency was both costly and risky for the euro zone nations. The
costs covered everything from the establishment of a new system of central banks and a new
system for clearing and settlement among EMU banks to the re-denomination of all financial
claims and instruments and of course, the design, manufacture and issuance of the new euro

45
notes and coins. In addition, there was the political cost of ceding national monetary policy to a
collective European Central Bank of unproven competence and uncertain political legitimacy.
Despite the daunting magnitude of these changeover costs, European policymakers employing
rational maximizing behaviour, concluded that the costs would be paid but once - where the
benefits would be perpetual.

Since the launch of the euro, the complications have gone well beyond locking exchange rates
and using a single currency across a large market. A single currency means a single one size fits
all monetary policy for the EMU countries. The European Central Bank worked hard to
articulate a clear statement of policy to persuade the market that it was on a disciplined course,
but not an overly restrictive one. The introduction of the euro affected the nature of trading
arrangements in all financial markets including currency, fixed-income and equity markets.
These new arrangements impacted upon the competitiveness of financial institutions and raised
related questions concerning the design of European corporate funding and investment strategies,
as well as the design and implementation of coherent systems of prudential and financial market
regulation. Broadening the investor base for European companies has further impacted upon the
nature of corporate governance and managerial policies as European firms consolidated in
response to the larger marketplace. These are only some of the issues that related to the internal
workings and governance within the EMU, but the euro also effected the international economic
scene as well.

As we can see, there are an incredible amount of implications associated with the new currency.
Because the international scene relates to everyone, this now becomes the topic for discussion.
Remembering that the international status of a currency involves a number of different functions
that correspond generally to the classic uses of money as a medium of exchange, a unit of
account, a standard of deferred payment and a store of value, this section addresses some of the
basic considerations that confront the euro in its emergence as a key international currency;
firstly, the role of an international currency and the pros and cons of being a hegemonic
currency; secondly, the euro as an international player and likelihood that the euro will displace
the US dollar in the not too distant future; and thirdly, the influence of the euro on international
monetary cooperation.

5.3 The role of an international currency

An international currency emerges because it is a solution to an economic problem. In a world of

multiple currencies and multilateral trade, those engaged in cross border transactions face a

46
problem of coordinating purchases and sales of currencies. Because a sale of a given currency to
a customer is unlikely to be matched by a nearly simultaneous purchase of the same currency
from another customer, foreign exchange traders must make their customers wait or must hold
costly inventories of currencies.

When the volume of transactions in a given currency is large, the waiting time between buy and
sell orders for the currency will typically be shorter, and smaller stocks of the currency can be
held. Thus, there are efficiency gains to channelling international transactions through a single
currency, passing demands and supplies for other currencies through trades involving a so-called
vehicle. In addition, as more and more transactions work through the vehicle currency, the
currency becomes increasingly acceptable in international transactions because bid-ask spreads
narrow and liquidity increases. Because the attractiveness of any vehicle currency grows as its
liquidity increases, a powerful international currency has a tendency to become a natural
monopoly.

If the underlying demand for one of two competing vehicle currencies falters for a reason not
clearly perceived to be transitory, and its bid ask spreads, accordingly, increasing relative to its
competition, demand will shift to the competitor. That shift in turn will widen the bid ask spread
of the faltering competitor still more - inducing a further shift of transactions to the alternative
currency. This process ends with the demise of the weaker currency as a competing vehicle and
the stronger of the two becomes the sole surviving vehicle.

However, even when an emerging international currency is displacing another, the transition can
be drawn out, resulting in two vehicle currencies existing side by side for a protracted period.
Between the two World Wars, for example, pound sterling and the US dollar were both active as
international currencies. This period was clearly transitional, and the US dollar subsequently
became the dominant currency.

But the most important factor inhibiting the emergence and persistence of a single vehicle
currency throughout the world is the attraction of portfolio diversification. This can be a
powerful counterforce, especially because currencies offer far greater opportunities for
diversification and extremely short periods for return compared to other assets. The average price
of all currencies, by construction, is trendless, tending to decrease the positive covariance within
a portfolio of currencies. In contrast, debt and equity prices often move together in the same
direction.

47
This point brings us to the question: How does a currency become an international currency? The
question is particularly intriguing because, in the reign of fiat currencies, its answer is unlike the
explanation of how a currency becomes dominant within a country.

In years gone by when gold, silver, or other commodities were the normal means of exchange,
units of currency were defined by commonly understood weights of the commodities that
circulated. The pound sterling was originally a pound of sterling silver. The US dollar was
originally defined for legal purposes in the US Coinage Act of 1792 as either 0.05 ounces of gold
or 0.77 ounces of silver55. Soon the equivalent of warehouse receipts for precious metals
circulated as currency. Under the commodity standard the value of paper currency or any other
financial claim was derived from the value of that standard. Contracts were written in terms of
ounces of gold or, more conveniently, in terms of a unit of exchange.

In todays world of government-issued monies, the unit of currency is not, and need not be,
defined. Printed paper circulates as legal tender under government fiat. Its value can be inferred
only from the values of the present and future goods and services it can command. However, in
the international arena, no overarching sovereign exists to decree what is money. Instead, a
myriad of private agents must somehow reach agreement on which currency to use as an
international currency. In the modern world of fiat currencies, a number of factors can enhance
the attractiveness of a currency to private agents, making it easier for them to settle on an
international currency. First and foremost, an international currency must be perceived as being
sound. To be acceptable, market participants must be willing to hold it as a store of value. A
necessary condition of that willingness is that a currencys future value in terms of goods and
services be viewed as predictable. Losses in purchasing power will tend to discourage the use of
a currency, but so will any excessive price fluctuation that raises the risk of holding it. In
addition, if a currency is seen as a viable store of value in times of general uncertainty, it will
attract investors even when times are certain. Clearly, many currencies meet this test - yet few
emerge as international currencies.

Other factors will govern the selection of an international currency from the body of sound
currencies. One is a strong competitive economy open to - and active in - international trade and
finance. Such an economy will naturally generate a large quantity of foreign exchange
transactions with at least one leg in the home currency to support its wide-ranging business

55
Taken from, Remarks by Chairman Alan Greenspan, The euro as an international currency, Before the Euro 50
Group Roundtable, Washington, D.C. November 30, 2001

48
activity. This factor evidently goes a long way toward explaining the dominance of the Dutch
guilder in the seventeenth and eighteenth centuries, the British pound in the nineteenth and early
twentieth centuries, the US dollar today and perhaps the euro or the Chinese yuan tomorrow. But
is the dominant position the best?

Hegemonic currency has its pluses and minuses, it is not an unmitigated free ride, as some may
think. There is a burden that accompanies having a leading international currency. Policy
changes that are undertaken for domestic purposes can have important effects on others. These
effects are magnified when the country is not only a large part of the world, in terms of goods
production and trade, but also a large part of the global financial system and an anchor for the
international monetary system.

For example, US Federal Reserve policy in the early years of Paul Volckers chairmanship56
involved a large increase in short-term interest rates designed to reign-in high domestic inflation.
For countries in Latin America that had borrowed heavily in US dollars at floating interest rates,
the change in US monetary policy had enormous consequences. Thus, when a countrys currency
is widely used internationally, the international spill-overs to domestic policy actions can be
intensified, so that domestic policy actions quickly seem to become everyones business and can
generate criticism in international circles. The ECB will have to wrestle with the same issues as
the euro becomes a major player in the international monetary system.

On the other hand, having an international currency can provide substantial benefits. The most
direct benefit is seigniorage57 revenue. With about $350 billion of US currency notes in the
hands of foreigners, the United States earns roughly $15 billion per year (less than 0.2 per cent of
GDP) 58 in seigniorage. With the euro as another major currency in the worlds economy and, in
light of the potential attractiveness of euro to countries in Eastern Europe and former Soviet
States, the US is likely to lose a considerable proportion of the profit that the rest of the world
provides them.

56
Paul Volcker, b. 1927, served as chairman of the Federal Reserve Board from 1979 to 1987.
57
Seigniorage is the process of making a profit by issuing currency. Historically this was done when a government
issued coins rated above their intrinsic value. The Roman Empire financed their expansion using this method for
over eight hundred years.

58
Remarks by US Federal Reserve Governor Laurence H. Meyer at the European Institutes Conference Challenges
to the European Millennium, Four Seasons Hotel, Washington, D.C. 26 April, 1999.

49
Some believe that the major benefit from the United States having the premier international
currency and the broadest and most liquid financial markets is that they are able to finance their
large current account deficit more cheaply than would otherwise be the case. That is true only to
the extent that the international status of the dollar brings lower interest rates on dollar liabilities.
This suggests that international currency status might affect a countrys (or in the case of the
euro, the regions) equilibrium real exchange rate and real interest rate. But looking at exactly
the same phenomenon in another way, those who seek international currency status should not
forget that an appreciating currency - and one that is very often a safe haven in times of
economic and political crisis - implies a reduction in competitiveness and a drag on economic
growth through a declining current account balance. In years gone by with less sophisticated
systems this did pose a problem but today, this of course can be rectified by a closely monitored
financial system that can act to supply additional currency as demand permits.

As the international role of the euro increases, the demand for euros will increase, both directly
as currency and indirectly via euro-denominated assets, potentially leading to an appreciation of
the euro with increased demand. A stronger euro will in turn encourage an increase in both the
issuance of euro-denominated liabilities as well as in the demand for euro-denominated assets.
As a result, there may be some uncertainty about the effect of portfolio decisions on the price of
the euro. But even if the euro appreciates, the magnitude of the appreciation may not be very
large.

The effect of a large reallocation of portfolios away from the US dollar and dollar-denominated
assets into the euro and euro-denominated assets would imply a swing from current account
surplus to deficit for the euro area as investors acquire net claims on the region. Certainly, the
appreciation of the euro would be the cause of the euro zones move from surplus to deficit. But
such an appreciation of the euro could bring a reduction in competitiveness that may provide
additional pressure for structural reform in continental European product and labour markets.
The counterpart to this from the US perspective would be a reduction in net claims on the United
States.

5.4 The euro as an international player

A necessary factor for a strong competitive open economy is the presence of an open and well-
developed financial system. A well-developed financial system increases the attractiveness of
doing business in a currency for at least two reasons. First, such a system offers a number of
ancillary services to participants in international markets, who may want to borrow or invest in a

50
currency or to hedge foreign currency positions. To the extent that these activities can be
accomplished efficiently in a particular currency, will be more appealing for business conduct.
Secondly, deep and liquid financial markets that offer a full array of instruments and services
will attract business from abroad that might otherwise have stayed at home because of financial
market constraints at home or other barriers to efficiency. For example; borrowing or investing
abroad in an international currency and exchanging the proceeds for domestic currency, might be
cheaper than conducting the transactions directly in the home currency. Thus, a currency
supported by a well-developed financial system is likely to encourage greater international use,
above and beyond the needs associated directly with international business activity. As a
consequence, the volume of gross international capital flows denominated in the currency are
likely to be high, adding to its desirability, regardless of whether or not these capital flows are
positive or negative at any point in time.

Strong financial systems tend to develop in strong economies, and well-developed financial
systems tend to enhance economic development. The development of both the economic and the
financial systems supports the soundness of the domestic currency, which in turn feeds back to
economic and financial activity. To some extent, both elements are clearly intertwined.
Ultimately however, a currencys success in the international arena requires success at home
because the strength and efficiency of the home economy and home financial system will be a
source of the strength for the currency.

At the international level, the euro has become the second most widely used currency as a result
of the overall weight of the euro area economy in the world and the legacy of the national
currencies that preceded the euro. Looking at official international uses, the euro is second only
to the US dollar among the worlds official reserve currencies. The gap between the two
currencies is wide but decreasing. According to data59, at the end of 1999 the euro accounted for
around 13 per cent of the worlds official foreign currency holdings, compared with a US dollar
share of around 70 per cent. By the first three quarters of 2001 gross international debt issuance
denominated in US dollars came to $732 billion compared with only some $535 billion in euros -
a relatively significant increase to 30 per cent60. Although official figures have not yet been
released for subsequent quarters this percentage should have continued to expand. Experience
has shown however, that there is a considerable time lag before the importance of a currency is
reflected in its use as an official reserve currency.

59
World Bank database, www.worldbank.org
60
Bank for International Settlements publication and statistics database, www.bis.org

51
Europe now has relations with more than 56 countries61 in the world, which use the euro to some
extent as an anchor currency. These countries represent about 20 per cent of world population,
but barely represent 5 per cent of world GDP. There are a number of relations with those
countries through the euro or through association arrangements. Basically, in all cases Europe is
the largest creditor to those countries - this applies to the European banking system, and also to
its status as an official creditor. In some of those countries the euro is only used as a private
means for transactions, mainly as an investment currency. In some other countries the link exists
through exchange rate policy. In other countries, the euro has been introduced as a de facto
currency (euroisation).

The euro readily meets all the key qualifications for a major international currency. Indeed, there
can be little doubt that the euro is a sound currency62. The mandate of the European Central Bank
to maintain a stable purchasing power of the currency is doubtlessly firmer than that of the US
Federal Reserve or any other major central bank63. The economy of the twelve countries
embracing the euro is roughly the size of the US economy, and its financial system matches the
magnitude of the United States. Continuing advances in European telecommunications and
payment systems have resulted in financial systems that now have the potential to be highly
integrated not only within the euro zone but also capable of expanding internationally.

The introduction of the euro and the successful implementation of the TARGET 64 payment
system has also contributed to this potential, by linking more firmly the financial markets of the
continental European countries. The tremendous growth of bond markets in the euro area since
1999, shows how such potential can be employed successfully. In addition, the greater depth and
liquidity of financial markets in the euro area have facilitated the development of financial
instruments, such as mutual funds and commercial paper. But in its brief history, the euro zone
financial system has had its difficulties as well. Expansion across national borders of important

61
Yves Mersch: In the run-up to an enlarged Europe, Speech by Mr Yves Mersch, Governor of the Central Bank
of Luxembourg, at the 6th European Congress of the Association des Cambistes dInternationaux (ACI) (Financial
Markets Association), Luxembourg, 25th May 2002.
62
Refer to Chapter 7.
63
Greenspan, A. (2001) The euro as an international currency, Speech to the Euro 50 Group Roundtable,
Washington, D.C., 30th November 2001.

64
TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer system and is an
EU-wide system for euro payments. TARGET only processes euro. The Real Time Gross Settlements system and
the ECB payment mechanism is interconnected according to common infrastructures and procedures (the
Interlinking system), to allow payment orders denominated in euro to move from one system to another.

52
financial markets, such as equity trading and securities lending, is being restrained by difficult
negotiations over regulatory and legal differences. A resolution of these differences would add to
the attractiveness and stature of the euro in the international arena.

Many of the concerns about the euro, however, have little to do with the euro itself but pertain to
certain European economic conditions that have affected the value of the currency. Following its
inception in 1999, the euros exchange rate declined by close to 25 per cent in US dollar terms.
The consensus seemed to be that the euros depreciation resulted largely from a slowing in
growth relative to expectations in the euro zone, while at the same time, growth in the US had
been stronger than expected. If this was the case, then the movement of the euro simply mirrored
what would have occurred in the currencies of the euro area in the absence of monetary union.
The evident strengthened demand for the US dollar relative to the euro, reflected a market
expectation that productive growth in the United States was likely to be greater than that in
continental Europe. The international economy experienced a steady flow of capital from Europe
to the United States throughout 1999 early 2000, presumably reflecting the consequence of
lack of faith in the new currency and of Europeans finding many investments in the United
States persistently more attractive than those at home. The persistent strength of the dollar in the
face of the United States unsustainable current account deficit underscored this illogical
propensity to accumulate dollar investments, relative to those denominated in euros. This
outcome may well have resulted to an important degree from the particular legal structures and
customs that governed labour relations in much of Europe65. However, as the US economy
slowed down between 2001 and 2002, the euro steadily regained its earlier losses. In July 2002,
the euro finally had the upper hand with respect to the US dollar. Since then the euro has
managed to maintain at least 98 99 per cent of its value against its US competitor thus equating
to almost one US dollar for one euro66.

5.5 New businesses opportunities

Within the euro area, the elimination of exchange rate risks and the lower transaction costs which
followed, together with the far more transparent markets the euro brought with it, created new

65
For example, over the decades, Europe has sought to protect its workers from some of the presumed harsher
aspects of free-market competition. To discourage layoffs, discharging employees was made difficult and costly
compared with doing so in the United States.

66
Reserve Bank of Australia, exchange rate database as at August 2002. www.rba.gov.au

53
opportunities for businesses and forced firms to attain higher levels of efficiency and
competitiveness. A large, liquid and integrated money market was rapidly created after 1st
January 1999. This in turn triggered a significant growth of interest bearing instruments
denominated in euro. On the unsecured money market, the euro overnight index average
(EONIA) reference rate, an interbank overnight interest rate index compiled by the ECB,
established itself as one of the most important reference rates. The EONIA swap market is now
considered the largest overnight swap market in the world. In the bond market, too, the euro
played a crucial role in fostering the deeper and more liquid euro area bond market that is
evident today. As early as 1999, the total amount outstanding of euro-denominated debt
securities made the euro bond market the second largest bond market in the world, with the
international issuance of the euro-denominated bonds outpacing the US dollar-denominated
bonds several times67.

5.6 The euro and international monetary cooperation

It was predicted before its introduction in January 1999, that the euro would rapidly displace part
of the dollar holdings in many portfolios, including in particular official holdings of reserves.
These expectations were probably too ambitious. History has shown that once currencies achieve
the status of an international vehicle currency, as the Dutch guilder and the English pound did in
previous centuries, the established infrastructure of deep and liquid markets favours their
continuing use. Inertia and so-called network externalities are a key to explaining why a shift
away from the US dollar will not occur overnight. Inertia explains why until relatively recently, a
number of traded commodities were still quoted and priced in pound sterling. If the euro is used
in enough different ways in the international arena, then it becomes cheaper to use the euro
rather than some alternative. With the euro being so new, with its implementation as a tangible
currency in January 2002, it remains a very short period of time by standards of international
monetary history and provides ample reason not to get too impatient about the slow pace of the
euros growing international role.

The question remains, of how the international role of the euro will unfold? The attraction of
investing in dollar-denominated assets depends upon relative rates of return. To the extent that
the capital flows from Europe to the United States were a critical piece of the story, the future
will be determined, at least in part, by the success in Europe of matching the expected rates of

67
Speech by C. Noyer, Vice-President of the European Central Bank, at the symposium World Economic Climate
after the Introduction of the Euro, organised by Japan Center for International Financeand Sumitomo-Life
Research Institute, Tokyo, 13 February 2002.

54
return to US returns. But market pressures toward portfolio diversification are also going to play
a major role in the future relative positions of the dollar and the euro. Whatever the outcome, the
world can only benefit from the increased competition.

The instability of the euro in its initial stages should indicate that the evolution of the euro for
international financial relationships is likely to evolve over some period of time. The
consequences might include: a more competitive and healthier euro-wide economy; a greater role
for the euro as an international currency; a growing role for euro-denominated assets in global
portfolios more generally; and changes in the global pattern of exchange rates and current
account balances. If economic policies in Europe are sound, the US dollars international status
would likely diminish somewhat and the euros international status would increase, reflecting the
prosperity of the euro zones economy and its role in the global marketplace. A growing and
ultimately significant international role for the euro is not automatic. Instead, the euro area will
have to earn its place in the international financial system by pursuing policies that produce a
healthier economy. By improving price transparency within the euro zone, the euro itself may
increase competitiveness across Europe and thereby benefit low-cost producers, enhance trade
competitiveness and give European consumers cheaper products. But the key to the success in
the euro zone would still appear to be the same set of policies that would have been essential in
France, Germany, and other euro countries in the absence of the union anyway - structural
reforms, especially those related to reducing the rigidities in European labour markets, and
disciplined monetary and fiscal policies. The structural reforms and monetary and fiscal policies
that are making the euro area stronger and more competitive will certainly enhance the strength
of the world economy as well. Whenever the world economy is strengthened, humankind
benefits.

55
 Chapter 6

Is the euro a success? The qualitative approach

6.1 The homogenous union of man and society

Robinson Crusoe offers a vision of the life of one man in which the unaided individual is
continually threatened by both moral and physical dangers. Not least of these is his own weak
nature. By the providential intervention of a shipwreck, Crusoe is for many years set free from
such dangers and temptations of society. But his story is not complete until he returns from the
islands safe haven to the daunting realities of the ubiquitous outside world. The imagery of
Robinson Crusoe reinforces the structural contrast between the island and the world, giving form
to the nature of man in society. This pattern is reinforced by the theme of rationality, which calls
attention to the differences of both existences. The introduction of euro cash had important
symbolic and political dimensions for all the people of Europe. In Europe, it is no longer
possible to interpret the individual nation as an island. The European Union was the realisation
of a dream that had long been expressed by political visionaries. Victor Hugo68 spoke about the
United States of Europe halfway through the nineteenth century. This concept was a key
ingredient in the reconstruction of Europe as articulated by politicians such as Jean Monnet,
Altiero Spinelli, Konrad Adenauer, Robert Schuman and more recently, Jacques Delors. As the
bridges displayed on all euro notes suggest, the single currency is expected to link people and
countries from Ireland to Greece more closely together. Building bridges allows access to islands
and enhances the condition of human society. Once barriers are eliminated, societies become
homogenised. If societies are homogenised, they are no longer different, they are one. The euro
notes also display windows and gates that symbolise the passage to a new era. An era where all
the people of Europe are linked more closely together through a homogenous economic union.

68
Victor Hugo (1802 1885) French poet, dramatist, novelist and political statesman, was a champion of
republican ideals. Hugo was also a believer in European integration, and as an illustration of this, on the 14 th July
1870, he planted in the garden of Hauteville House (on the island of Guernsey, where he lived in exile for 15 years)
an oak - which still flourishes today - predicting that when the tree was mature The United States of Europe, uniting
all European nations, would have become a reality.

56
6.2 The process of monetary integration

The circulation of euro notes and coins in reality, was not the final step of monetary union but
merely another goal in the long process of integration. The most important step in that process
was made in 1998, when exchange rates between the euro zones member currencies were
irrevocably locked. This established the final framework of Europes monetary union, with
major changes, not least of which was the elimination of currency fluctuations within the euro
area and the introduction of a single monetary policy. The bulk of non-cash financial instruments
(shares, bonds, mutual funds, time deposits and bank accounts) were converted in 1999 or
shortly thereafter. By comparison, the recent substitution of notes and coins, which constituted
only 7 per cent of M2 money supply, had more limited economic implications.

Nevertheless, the logistics of the switch were formidable: 50 billion new coins were minted and
14.5 billion new banknotes printed, all of which had to be delivered to the right place at the right
time, for a total value of 664 billion. Cash dispensing machines had to be adjusted, computers
reprogrammed and soft-drink vendors and pay phones adapted. The overall cost of the
changeover (transportation, security, training, software adjustments and so on) is estimated to
have run into the several billions euros, although no precise estimate is available.

The cost was also borne by retailers and customers, who had to post prices in the single currency
and grapple with new monetary symbols. Although banknotes are identical throughout the euro
zone, coins have a common side, the flip side of the coins is minted with symbols specific to
each country, adding to initial confusion as the money spread across borders. Some 120 different
types of coins are in circulation at the same time (12 series of eight coins issued by each member
state, plus the Vatican, San Marino and Monaco), enough to cause headaches for at least some of
the 305 million inhabitants of the euro zone. A temporary jump in prices also happened, with
retailers taking the opportunity to round up prices on conversion.

For all their effort in getting use to new prices, notes and coins, what benefit can Europeans
expect to draw from the changeover? One gain often highlighted is the elimination of
commission charged on foreign exchange transactions. The new coins and notes will mostly be
welcomed by tourists who no longer have to change their money to visit different member
countries. However the single currency does not mean a single banking system and although the
European Commission has compelled banks to bring fees for intra-euro zone transfers into line
with those for domestic transfers, cross-border bank transfers still incur costly handling charges.

57
Another much boasted benefit of the changeover is more price transparency. Having one
currency exposes price differentials between countries, helping consumers and firms compare
prices and forcing suppliers to be more competitive. The shortcomings of the single market have
so far limited price convergence. According to the William M. Mercer Global Information
Service69, the price of the same litre of milk ranges from 0.67 in Portugal to 1.22 in Italy,
while the price of the same colour TV ranges from 543 in Finland to 1049 in Luxembourg.
Taxes may explain some of these differences, but insufficient market competition is also
responsible. The greater transparency brought by the single currency should help narrow the gap.
Indeed, several magazines and newspapers already post the same price everywhere in the euro
zone. For convergence to happen more generally, further regulatory reforms will be needed to
remove blockages in cross-border trade within the euro zone, for instance, in the automotive
industry, where buying a car in another country is still discouraged.

6.3 Benefits and risks of integration

More important than conducting cash transactions with the euro are the benefits and risks
associated with the long-term process of monetary integration, especially the intra-zone
elimination of exchange rate fluctuations since 1st January 1999. Stability is important in a
continent that was often struck by currency market turbulence. The sharp economic slowdown in
the US - experienced from early 2001 and the terrorist attacks of 11th September left the
European currency relatively unscathed; one can but imagine the monetary tensions that might
have occurred without the single currency. By contrast, those European currencies outside the
euro zone, including the British pound, the Swedish krona and the Swiss franc, are still subject to
fluctuations.

But there were risks to monetary integration too. Monetary union brought its sacrifices, including
the loss of national autonomy with respect to exchange rate and monetary policies. To outweigh
such costs, the economies sharing the same currency should not be too dissimilar, otherwise, it
would be better to retain autonomous policy instruments. As matters stand, there is some
evidence that euro zone economies react differently to common shocks (such as oil price hikes or
world trade slumps), in no small part because uneven progress has been made towards labour
market flexibility. Also, euro zone economies often appear to react differently to interest rate
changes, and ECB decisions may therefore have different impacts on different countries. This
may improve over time as economies adapt to the new monetary regime.
69
Evans, D. and Padilla J.A. (2002) European Competition Policy :Issues and Perspectives, NERA Economic
Journal, Mercer Management Consultants, www.mercermc.com.

58
Specific shocks tend to affect the euro area in an asymmetric fashion, hurting some regions or
countries more than others. This may lead to divergence rather than convergence. Although the
European Central Bank began controlling monetary policy for the euro zone in 1999, consumer
inflation rates still ranged from 1.3 per cent in France and close to 5 per cent in The Netherlands
at the end of 200170. Output growth also diverged during 1999-2001, with cumulative growth of
8.5 per cent in France, but only 5.5 per cent in Germany. Several small economies, like Ireland,
had been through periods of overheating, and could not raise interest rates to cool domestic
demand growth or inflation. The recent bursting of the Internet bubble was an asymmetric shock,
affecting Finland that specialised in information and telecommunication products more so than
the larger diversified economies.

These dissimilarities are not an insurmountable obstacle to monetary union, but they require that
member economies become more adaptable and adjust to shocks without relying on help from
policy intervention. Budgetary policy remains in the realm of national government and can be
used to respond to adverse developments, but safeguards enshrined in the Maastricht Treaty to
prevent excessive fiscal deficits, restrict the margin to manoeuvre. All this implies that Europe
will reap the full benefit of the euro only if it removes outstanding obstacles to the free flow of
goods, services, capital and workers.

Unfortunately, economic integration has so far lagged behind monetary integration. Even in the
much vaunted single market, important sectors are still protected by national barriers - banking
and energy being just two. Large public subsidies continue to distort competition - not least in
agriculture - and public procurement still favours national suppliers. The lack of labour mobility
is also a problem. Whether for cultural, linguistic or institutional reasons, countries affected by
adverse asymmetric shocks may suffer high unemployment, even if neighbours have a healthy
labour market. Clearly, Europe needs to implement the structural reform agenda to which the
European heads of state have expressly agreed. Todays currency union under the euro simply
makes the objective of completing the single market more desirable than ever.

6.4 The euro as a reserve currency

Another long-term benefit of the euro often claimed by fervent supporters is that the single
currency ought to become a more important international reserve currency than the sum of its
legacy currencies. This would bring greater immunity from international financial fluctuations,

70
Eurostat - the Statistical Office of the European Commission. www.europa.eu.int/comm/eurostat.

59
as well as a more prominent role for Europe in designing the international financial systems
architecture.

But the euros performance in international market has so far been surprising. Remembering that
shortly after its launch in 1999, the euros exchange rate declined by close to 25 per cent in US
dollar terms before rebounding to match the US dollar by mid 2002. According to the Bank for
International Settlements71, balance of payments data indicated that during the early stages after
its launch, residents in the euro zone made more portfolio and direct investment outside the area
than non-residents made inside it. Euro-denominated issues on the international market for bonds
and notes lagged well behind those denominated in US dollars. During the first three quarters of
2001 gross international debt issuance denominated in US dollars came to $732 billion compared
with only some $535 billion in euros. About half of the outstanding amounts of international
debt securities were still denominated in US dollars, compared to a relatively modest 30 per cent
in euros.

How to achieve a more internationally attractive euro was not clear, though making Europe a
more attractive place to invest proved a helpful start. Surveys and business reports72 indicated
that most of the euro zone remained stifled by cumbersome administrative regulations, rigid
labour markets and high operating costs even though some progress had been made to address
those issues. Investor caution also reflected the problems of building political cohesion across
Europe. Despite the fact that Europe has one currency and a European Parliament, it is still
represented by separate nations in international financial organisations like the IMF and the
World Bank. It also sends separate delegations to international economic forums, such as those
of the Group of Seven. Europe will have to overcome these national prerogatives and speak with
one voice in the international monetary arena. It will take work, but if achieved, and if the single
market reforms are pursued with the same determination and vision, then the new currency will
not only bring Europeans together, it will also become a mechanism for greater prosperity.

6.5 The political consequences of the euro

The fact that the euros introduction was a success is little denied, however what ramifications
either positive or negative exist because of it? This section examines the link between European

71
Bank for International Settlements publication and statistics database, www.bis.org
72
Quarterly Review: International Banking and Financial Market Developments, Bank for International
Settlements publication. www.bis.org

60
integration and the euro, and then argues why an increasingly competitive and dynamic society
raises the need for further structural reforms. It is necessary to assess the progress that has been
made with the structural reforms so far and discuss how the single currency has already benefited
the zones economy by acting as a catalyst for integration and competition.

The move to Economic and Monetary Union was profoundly a political act, despite the fact that
the underlying rationale was predominantly economic, namely that a single market required a
single currency. Understanding that point, the EMU itself is a political consequence of even
earlier decisions, a product of a functionalist approach to European integration. Successfully
applied by the founding fathers of the European Community, the Union led the people of Europe
from a limited pooling of sovereignty in the coal and steel sectors back in the 1950s to todays
modern European Union. Not forgetting the hurdles in arriving at this point, the process of
integration has been driven forward by the inherent dynamics of the market. This included the
opening up of national markets, the deepening of economic interdependence and the continuous
political engagement within common institutions. With the introduction of the euro, the network
of interrelations and mutual dependencies between member nations undoubtedly acquired a new
quality. The European economies thus became inextricably tied together so national policy
decisions of one country became a matter of concern for all member nations. These nations have
a legitimate interest in developments and political actions in other EU countries, since they are
affected by them.

A revelation of the One money, one Euregion Conference73 was that the introduction of the euro
might precipitate further European integration in other policy areas. There are several reasons for
this. One is: the introduction of the euro has increased the transparency of prices between
countries and regions, not only to the prices of goods and services, but also to other nominal
factors which influence the price-setting process, such as taxes. This increased price transparency
has triggered increased cross-border trade and commerce and hence competition. However,
people then realised that the Single Market is not yet perfect. For instance, even if people in
Holland see that it is cheaper to buy a car in Germany, they are not allowed to do so without
paying taxes to the Dutch authorities. In this regard the Single Market still has room for
improvement. Regulatory, administrative and legal impediments to trade, commerce and the
mobility of labour, still exist. Different tax regimes and so-called exclusive distribution

73Euregion; the name coined by the University of Maastricht and promoted at their conference One money, one
Euregional market, Maastricht University, 6th February 2002.

61
agreements, are still allowed under the Maastricht Treaty. These impediments surface especially
in cross-border trade and commerce between the border regions within the euro area. It is
reassuring to note that one reason for the introduction of the euro; being to crown the
establishment of the Single Market, has helped to identify those areas in which the Single Market
has not yet been completed. Will citizens then start asking themselves; Why is it possible to have
a single currency, yet still have other barriers that hinder trade within the euro zone? This
means the elimination of more obstacles to cross border activities, and at the same time, either
harmonisation or mutual recognition of standards in order to avoid undesirable competition
between regions and countries. Could the push for full economic equality within the euro zone
and hence reform, be initiated by the citizens of Europe and less by politicians and experts -
which has been the case so far? In addition, completing the Single Market would be a welcome
contribution to structural reform in solidifying the European Union

Another reason, why the introduction of the euro might precipitate further European integration
is that a currency is a very important symbol of national sovereignty. Because the governments
of the euro zone complied to the Maastricht Treaty and gave up their national currencies and
adopted the euro, citizens have subsequently acknowledged the economic benefits of using a
single currency in an enlarged economic area.Will this acceptance of economic unity lead to
social unity and further still to complete political unity through increased structural reform?

Policy refinements are needed to shore up the success of the single currency and to ensure that
the benefits of complementing a single market with a single currency are reaped in full. They are
the logical consequence of the euro, derived from the same functional logic of building an even
closer economic union. The possible political implications of the euro on the other hand
represents uncharted territory, but they are fundamental questions about the future of Europe that
need to be addressed. Dr Willem Duisenberg, President of the European Central Bank touched
on some of the issues when he addressed the Karlspreis-Europa-Forum, in Aachen on the 8th
May 2002. His questions included; Is the euro, a currency without a state a viable construct? Can
the European monetary union function properly without some form of political union? What
political reform is necessary and what pressure will instigate that reform? Indeed, the question of
whether a single currency requires, or inevitably leads to a single state is hotly debated, not only
among Europeans, but also and especially in the three EU member states (UK, Denmark and
Sweden) where the citizens and policy-makers still have to make up their minds about adopting
the euro. One of the reasons for this confused state of affairs is that political union is a rather
abstract concept. It can mean different things to different people. On one hand, a political union

62
can be broadly understood as a dense network of integrated policies, common rules and
established procedures. This gives the Union with strong and active supranational institutions
common symbols and a common identity. Measured against this definition, the EU already
exhibits many of these features. However on the other hand, if Europeans interpret a political
union as the establishment of an entity that resembles the traditional nation state, then the
European Union may still have some way to go. Todays European Union is not as yet a
European Federation, nor can it be regarded as the United States of Europe, with a constitution
and a single executive, playing an active role in international affairs. So will the euro lead to a
European constitution? The euro marks the achievement of integration in the monetary field. In
purely functional terms, it is therefore an endpoint, rather than an intermediate step. But to think
that the job is complete could also be a faux pas, because to stand still in a world that is ever
moving forward means that you will inevitably be left behind.

Although the euro will probably act as a catalyst for further European integration, this does not
necessarily imply that further European integration is a prerequisite for a well functioning
monetary union. The current framework, laid down in the Maastricht Treaty, has so far proved to
work well and should continue to do so in future. However, speeding up the process of
equalisation across boarders by deepening economic and social reform is a key challenge facing
the European Union. Only through reforms aimed at improving the functioning of the market
mechanism will it be possible to bring the potential level of economic growth and political
cohesion within the Union to a structurally higher level.

63
 Chapter 7

Is the euro a success? The quantitative approach

7.1 The art of econometrics

The central shaping theme of Robinson Crusoe is deliverance. Defoes vision of the human
predicament is rendered and supported by a related theme - that of reason and passion - which
helps to define the difference between Crusoes life in the world and his life on the island. Being
a creature of whimsical fancy, his pre-island days were subject to always losing the internal
struggle to conquer his passions. His ruinous wanderings predominate over his reason and
subsequently he slides further and further into the depths of despair. The time on the island in
solitude is a time for reflection and personal growth. The deliverance comes to Mr Crusoe when
he masters his own frailties and providence allows events to transpire that permits his re-entrance
into the civilized world. Not without a touch of pride Mr Crusoe tells the reader of his discovery,
as reason is the substance and original of the mathematicks, so by stating and squaring
everything by reason, and by making the most rational judgment of things, every man may be in
time, master of every mechanick art. Since econometrics is the intellectual manifestation of
quantitative economic reasoning, mastering the mathematicks and other mechanick art of
econometrics is a necessary condition to squaring the argument of the euro currency union being
economically efficient. This chapter explains the process of this art.

Business economics endeavours to understand the structure of an economy, specifically how it

works and more importantly, how to forecast it. It is an unenviable task because the future, is
essentially unpredictable and cannot be foretold. The best economists can do is to construct
probabilistic models that can inform the decisions of business executives and, of course,
economic policymakers who should not, by rights, be making their decisions armed with
incomplete information anyway.

For a while in the 1960s, economists were increasingly mesmerized by the possibilities of
econometric models being crystal balls or magical predictors of the future. However, history was
not entirely kind to this endeavour. For one thing, especially against the backdrop of the inflation
of the following decade, it soon became apparent that economic theories of the macroeconomy
were woefully inadequate. For another, even leaving aside the shortcomings of those theories,

64
economists soon learnt that the economic structure did not hold still long enough to capture its
key relationships. Its changing structure frustrated efforts to isolate a reasonably fixed set of
coefficients that could be used to model the economy more accurately. In turn, the absence of
fixed coefficients undermined the usefulness of models as a basis for predicting the future.

Econometricians recognized many of these difficulties, and so developed a vast and elegant
literature in support of this research programme, covering a spectrum of topics ranging from
maximum-likelihood-estimation techniques to tests for coefficient stability and more tests about
diagnostics for detecting undesirable properties of the errors in numerous equations. The
creativity that was applied to this effort was all the more impressive because it took place in the
context of a computing environment that was, by todays standards, truly primitive.

In time it became increasingly clear that, for all their theoretical advantages, these sophisticated
models did not reliably outperform a number of simple and far less costly reduced-form models,
based on the money supply models and the structural vector autoregression models that worked
on a handful of lagged variables - which are still employed today.

Certainly, the intricate econometric models have been refined, incorporating the fruits of later
theoretical developments, guided perhaps most importantly by the insight, that nothing stays the
same and all models sooner or later can be improved upon or discarded. Throughout this period
of development a larger role was given to a range of financial and expectational variables that
earlier practitioners raised on orthodox Keynesian income determination tended to avoid. One
such model is the Efficient Market Hypothesis and represents the foundation of this thesis
argument. The next section explains the rationale behind this model.

7.2 Efficient Market Hypothesis (EMH)

A rational expectation is an expectation that uses all the available information that is relevant for
forecasting a future price. Since the actual price of a stock or currency is equal to the rational
expectation of the future price, the current price should also embody all relevant information that
is available. A market in which the actual price embodies all currently available information is
called an efficient market. In an efficient market, it is impossible to forecast changes in price
for the following reason. If the forecast is that the price of a stock or currency is going to rise in
the next period, it is more than likely that an investor would purchase the item now, since the
price would be low today compared with what the predicted price would be in the future. The
action of buying today acts as an increase in demand today and increases todays price. It is true

65
that the action of a single small time investor will not make much difference to a large
international market, but if traders in general expect a higher price in the next period and they all
act today on the basis of that expectation, then todays price will rise due to the increased
demand. The price will continue to rise until it reaches the expected future price. At that price,
traders no longer envision making a profit and subsequently demand settles at the higher price.
There is an apparent paradox about efficient markets. Markets are efficient because people try to
make a profit. They seek a profit by buying at a low price and selling at a high price, but the very
act of buying and selling to make a profit means that the market price moves towards its
expected future value. Once the expected future price is reached, no one - not even those who are
seeking to profit - can predictably make a profit. Every profit opportunity seen by a trader leads
to an action that produces a price change that removes the profit opportunity for the other
investors that follow. Thus an efficient market has two features: its price equals the expected
future price and embodies all the available information; and secondly, there are no forecastable
profit opportunities left in the market. Similarly, the foreign exchange monetary market is said to
be efficient if it fully and correctly reflects all relevant information in determining future
currency prices.

Formally, the market is said to be efficient with respect to some information set, {Yt}, if security
prices would be unaffected by revealing that information to all participants. The New Palgrave
Dictionary of Economics informs us that it has been customary to distinguish three levels of
market efficiency by considering three different types of information sets74. Firstly, the weak
form of the Efficient Market Hypothesis asserts that prices fully reflect the information contained
in the historical sequences of prices. Thus, investors cannot devise an investment strategy to
yield abnormal profits on the basis of an analysis of past price patterns (a technique known as
technical analysis). It is this form of efficiency that is associated with the term Random Walk
Hypothesis which scrutinises the movements of specified prices over time.

Secondly, the semi strong form of EMH asserts that current stock prices reflect not only
historical information but also publicly available information relevant to a particular security. If
markets are efficient in this sense, then an analysis of balance sheets, income statements,
announcements of dividend changes or stock splits or any other public information about a
company (the technique of fundamental analysis) will not yield abnormal economic profits.
Thirdly, the strong form of EMH asserts that all information that is known to any market

74
The New Palgrave Dictionary of Economics (1988) Volume 2 E-J, p 120.

66
participant about a security is fully reflected in its market price. Hence, not even those with
privileged information can make use of it to secure superior investment results. There is perfect
revelation of all private information in market prices.

Digressing for a short moment, the term random walk has been used loosely in finance literature
to characterise a price series where all subsequent price changes represented a random departure
from previous prices. This meant that changes in the price of a commodity or security would be
unrelated to its past price changes. Formally, the random walk model states that investment
returns are serially independent and that their probability distributions are constant through time.
Palgrave75 states that the term was first used in an exchange of correspondence appearing in
Nature magazine in 1905. The problem considered in the correspondence was the optimal search
procedure for finding a drunk who had been left in the middle of a field. The answer was to start
exactly where the drunk had been placed. That starting point represented an unbiased estimate of
the drunks future position since he would presumably stagger away from that point in an
unpredictable and random fashion. In graphic terms random walk can be shown as;

Figure 7.1 Random walk with constant mean of Y variable

Y value

0 time

In this instance the value of the Y coefficient rises and falls over time, however if the average
value of Y was calculated for any two cycles it would be similar to any other cycle.

75
The New Palgrave: A Dictionary of Economics, (1987) The Macmillan Press Limited, London, Volume 2, E-J, p
120.

67
It is also possible to have a random walk situation with an upward or downward trend.

Figure 7.2 Random walk with upward trend

Y value

0 time

In Figure 7.1 the series exhibits a random walk process but the average value of Yt remains
constant, the series is said to be nonstationary. In Figure 7.2 the average value of Yt increases
with time. In the situation where the average value of Yt changes over time, the series is said to
be nonstationary with drift. In econometrics, the different mean values of Yt represents a
Moving Average (MA).

The earliest empirical work on the random walk hypothesis was performed by Louis Bachelier
(1900)76. He concluded that commodity prices followed a random walk, although he did not use
that term. Supporting evidence from other economists was provided by: Working (1934) 77 when
he investigated various time series; Cowles and Jones (1937)78 using US stock prices and;
Kendall (1953)79 testing UK stock and commodity prices. These studies generally found that the

76
Bachelier, L. (1900) Thorie de la speculation, Annales de lEcole normale Suprieure, 3rd series, 17, 21 86.
Translation by A.J. Boness (1967) in The Random Character of Stock Market Prices, ed. P.H. Cootner, MIT Press
Cambridge, Mass.
77
Working, H. (1934) A random difference series for use in the analysis of time series, Journal of the American
Statistical Association, vol. 29, March, p 11 24.
78
Cowles, A. and Jones, H. (1937) Some posteriori probabilities in stock market action, Econometrica, 5(3), July,
p 201 213.
79
Kendall, M. (1953) The analysis of economic time series, Part 1: Prices, Journal of the Royal Statistical Society,
96(1), p 11 25.

68
serial correlation between successive price changes was essentially zero. Roberts (1959)80 found
that a time series generated from a sequence of random numbers had the same appearance as a
time series of US stock prices. Osborne (1959)81 found that stock price movements were very
similar to the random Brownian motion82 of physical particles. Osborne found that the
logarithms of price changes were independent of each other. More recent empirical work has
employed alternative techniques and data sets to search for more complicated patterns in the
sequence of prices in speculative markets. Clive Granger and Oskar Morgenstern (1963)83 used
the powerful technique of spectral analysis but were unable to find any dependably repeatable
patterns in stock price movements.

The weak form of EMH is employed in this thesis and requires the following expansion to
appreciate the intricacies of this methodology. If markets are efficient, the technical analysis of
past price patterns to predict the future will be useless because any information from such an
analysis will already have been impounded into current market prices. To illustrate this, suppose
market participants were confident that a commodity price would double next week. The price
will not gradually approach its new equilibrium value. Unless the price adjusted immediately, a
profitable arbitrage opportunity would exist and would be expected to be exploited immediately
in an efficient market. Similarly, if a reliable and profitable seasonal pattern for equity prices
exists (e.g. a substantial Christmas rally), speculators will bid up prices sufficiently prior to
Christmas so as to eliminate any unexploited arbitrage possibility. Paul Samuelson (1965) 84 and
Benoit Mandelbrot (1966)85 proved rigorously that if the flow of information is unimpeded and if
there are no transaction costs, then tomorrows price change in speculative markets will reflect

80
Roberts, H. (1959) Stock market patterns and financial analysis: methological suggestions, Journal of
Finance, 14(1), March, p 1 10.
81
Osborne, M. (1959) Brownian motions in the stock market, Operations Research, 7(2), March/April, p 145
173.
82
Brownian motion is an erratic, zigzag motion of microscopic particles. It was first noted in 1827 by the English
botanist Robert Brown, who was observing microscopic particles suspended in tiny pockets of fluid inside pollen
grains. The effect was observed even in pollen samples that had been dead for more than 100 years. Brownian
motion was investigated further by Brown and others during the 19th century. Experiments showed that the motion
became more rapid and the particles moved farther in a given time interval when the temperature was raised, when
the viscosity of the fluid was lowered, or when the average particle size was reduced.
83
Granger, C. and Morgenstern, O. (1963) Spectral analysis of New York Stock Market prices, Kyklos 16, January,
p 1 27.
84
Samualson, P. (1965) Proof that properly anticipated prices fluctuate randomly, Industrial Management Review,
6(2), Spring, p 41 49.
85
Mandelbrot, B. (1966) Forecasts of future prices, unbiased markets and martingale models, Security Prices: A
Supplement, Journal of Business, 39(1), January, p 242 255.

69
only tomorrows news and will be independent of the price change today. But tomorrows news
by definition is unpredictable and thus the resulting price changes - following the drunks
predicament - will also be unpredictable and random. Eugene Fama (1965)86 not only looked at
serial correlation coefficients, which were close to zero, but also backed up his investigation by
examining a series of lagged price changes as well as by performing a number of nonparametric
runs tests. Eugene Fama and Marshal Blume (1966)87 examined a variety of filter techniques
where purchasing (selling) market signals were generated by some upward (downward) price
movements from previous troughs (peaks) and found they could not produce abnormal profits.
Other investigators have done computer simulations of more complicated techniques of stock
price patterns and found that profitable trading strategies could not be employed on the basis of
those techniques.

With President Nixons abandonment of the Bretton Woods Agreement and the gold standard in
1971 and the destabilising strategies of the OPEC cartel, the early 1970s saw dramatic changes
in currency valuations around the planet. In 1972 the Chicago Mercantile Exchange launched the
International Monetary Market, this in turn drew attention to foreign exchange rate differentials
and subsequently speculation in the foreign currency market took off. Bruno Solnik (1973)88
measured serial correlation coefficients for daily, weekly and monthly price changes in nine
countries and also concluded that profitable investment strategies could not be formulated on the
basis of the extremely small dependencies found. While the empirical data was remarkably
consistent in their general finding of randomness, equity markets did not however conform
perfectly to the statisticians ideal of a random walk. Although serial correlation coefficients
were always found to be small, there were some small dependencies that had been isolated.
While runs tests found only minute departures from randomness, there was a slight tendency for
runs in daily price changes to persist. Robert Merton (1980)89 showed that by noting changes in
the variance of a stocks return, its price could be predicted by using its variance from the past.
Such departures from a pure random walk do not violate the weak form EMH, which states only
that unexploited trading opportunities should not exist in an efficient market. David Dickey and

86
Fama, E. (1965) The behaviour of stock market prices, Journal of Business, 38(1), January, p 34 105.
87
Fama, E. and Blume, M. (1966) Filter rules and stock market trading, Security Prices: A Supplement, Journal of
Business, 39(1), January, p 226 241.
88
Solnik, B. (1973) Note on the validity of the random walk for European stock prices, Journal of Finance, 28(5),
December, p 1151 1159.
89
Merton, R. (1980) On estimating the expected return on the market: an exploratory investigation, Journal of
Financial Economics, 8(4), December, p 323 361.

70
Wayne Fuller (1979)90 developed specific tests for detecting the presence of random walk in data
series. This then allowed the primitive computers that existed at that time to examine a multitude
of models that sought to find answers for the Efficient Market Hypothesis. Computerised
empirical studies have since abounded.

In general the empirical evidence in favour of EMH is extremely strong. As Palgrave 91 informs
us, probably no other hypothesis in either economics or finance has been more extensively
tested. There have been scattered instances of the inefficiencies of EMH that have been duly
summarised by economists such as Robert Ball (1978)92 and Michael Jensen (1979)93 but the
facts remain that if there is some area of pricing inefficiency that can be discovered by the
market and dependably exploited, then profit maximising investors will eventually - through
their purchases and sales - bring market prices in line so as to eliminate the possibility of
acquiring extraordinary returns. Pricing irregularities may well exist and even persist for periods
of time. As well as this, markets can at times be dominated by fads and fashions, but eventually
any excesses in market valuations will be corrected. With the passage of time, the growing
sophistication of the worlds data bases and improved information systems, econometricians of
tomorrow should be able to monitor any departure from market efficiency and better understand
the causes more fully.

Having briefly reviewed the history and the reasoning behind the growing interest in
econometrics and the EMH, the next section will focus specifically on the methodology
employed in this thesis. From this point onwards it becomes necessary to delve into the world of
econometrics even further. This has to be done so that an understanding of the process and
reasoning behind the economic efficiency of currency unions can be fully appreciated.

90
Dickey, D.A. and Fuller, W.A. (1979) Distribution of the estimators for autoregressive time series with a unit
root, Journal of the American Statistical Association, 74, p 427 431.
91
The New Palgrave Dictionary of Economics,(1988) Volume 2 E-J, p 121.
92
Ball, R. (1978) The Relationship between securities yields and yield surrogates. Journal of Financial
Economics, 6 (2-3) 103-26, June September, 1981.
93
Jensen, M. (1978) Some anomalous evidence regarding market efficiency, Journal of Financial Economics, 6(2-
3), June September, p 95 101.

71
7.3 The Econometric model

In discrete time series, the value of variable y will change when time t changes. The pattern of
change can be represented by

y/t

The change in y from ( t ) to ( t - 1 ) is y= yt - y t-1

And the change in t from ( t ) to ( t - 1 ) is t= t - ( t 1) = 1

The variable yt = yt - yt-1 is called the first difference of the series yt . A series yt that is not
stationary, (ie, random walk), can be made stationary by differencing the series. A data series
that is made stationary by taking the first difference is said to be integrated of order 1, denoted
as Y~ I (1). A level stationary series is said to be integrated of order zero and is denoted by Y~
I (0). If a series must be differenced d times to be made stationary, it is said to be integrated of
order d, or I (d).

To test whether a data series is stationary over time, that is; it does not demonstrate a random
walk, it can be tested directly by the Dickey and Fuller (1979) 94 unit root test. Various
extensions of the Dickey-Fuller test can also be used; see Dickey and Fuller (1981)95.

Consider the following auto-regressive AR (1) model for the time series variable yt

yt = yt-1 + t (1)

Assume that t is a random disturbance with zero mean and constant variance . In this

model, if = 1 then yt is nonstationary, ie: yt = 1yt-1 + t and is said to have a unit root

because the coefficient = 1.

A stochastic process yt is stationary if its mean and variance are constant over time, and the
covariance between two values from the series depends only on the length of time separating the

94
Dickey, D.A. and Fuller, W.A. (1979) Distribution of the estimators for autoregressive time series with a unit
root, Journal of the American Statistical Association, 74, p 427 431.
95
Dickey, D.A. and Fuller, W.A. (1981) Likelihood ratio statistics for autoregressive time series with a unit root,
Econometrica, 49, p 1057 - 1072.

72
two values, and not on the actual times at which the variables are observed. That is, the time
series is stationary if for all values it is true that:

E (yt) = t ie: constant mean

var (yt) = ie: constant variance

cov (yt , y t+s ) = cov (yt , y t-s ) = s

The random walk process yt = yt-1 + t can be tested for nonstationarity. Since this model and

the AR (1) model (see equation (1)) are identical if = 1 , a test for nonstationarity can be

performed by testing the null hypothesis that = 1 against the alternative that < 1 or

simply < 1. This test can be put into a convenient form by subtracting yt-1 from both sides of
equation (1) to obtain

yt - yt-1 = yt-1 - yt-1 + t

or yt = ( 1)yt-1 + t

or yt = yt-1 + t (2)

Where yt = yt - yt-1 and = ( 1)

We test for nonstationarity by testing the null hypothesis that = 1

That is the null hypothesis Ho : = 1

Against the alternative H1 : < 1

This is equivalent to testing Ho : = 0

Against the alternative H1 : < 0 in model (2)

If yt follows a random walk ie. nonstationary, then = 0 and yt = yt - yt-1 = t

If we reject the hypothesis Ho : = 0 we can conclude that the data series yt is stationary.

To test the hypothesis Ho : = 0 we estimate equation (2) by the least squares method and
examine the t-statistic. The t-statistic no longer has the usual t-distribution under this null
hypothesis. Consequently this statistic must be compared to the specially constructed (tau)

73
critical values. Originally these critical values were tabulated by Fuller (1976)96 when he tested
for the presence of a unit root in a time series process. Dickey and Fuller (1981) 97 latter applied
the unit root test in the presence of a drift (ie: a time series showing an upward or downward
trend in the data) using a time trend as in model (2) and expanded the (tau) tables. These tests

are usually defined by (tau mue) and t (tau t) respectively.

The empirical studies that have tested for unit roots in foreign exchange rate data have assumed
independent and identically distributed errors (iid error) in order to apply Dickey-Fuller test
procedures. However, as outlined by Hansen and Hodrick (1980)98 as well as Krasker (1980)99,
this assumption ignored the temporal dependence of the error sequence present in many simple
efficient markets models. An asymptotically equivalent procedure to Dickey-Fuller, for testing
the presence of a unit root was proposed by Peter Phillips (1985a)100 and later extended by Peter
Phillips and Pierre Perron (1986)101 to models with a fitted drift and time trend. Unlike the
conditions imposed by Phillips and Perron on the error sequence, the strict iid error assumption
of Dickey-Fuller, were weak as they allowed for weakly dependent and heterogeneously
distributed innovations. Dean Corbae and Sam Ouliaris (1986)102, using the Phillips-Perron test
procedure, contrasted their results to those of Richard Meese and Kenneth Singleton (1982)103
who employed the Dickey-Fuller method, to deduce that the Phillips-Perron statistics were a
more powerful test for the unit root hypothesis. Corbae and Ouliariss findings suggested that
Dickey-Fuller tests of the simple efficient markets model based on regressions of the future spot
rate on the forward rate could be inappropriate since the asymptotic distribution theory was
invalid due to non-stationarity. This gave stronger evidence than Meese and Singleton, that

96
Fuller, W.A. (1976) Introduction to statistical time series, Wiley, New York, p 373.
97
Dickey, D.A. and Fuller, W.A. (1981) Likelihood ratio statistics for autoregressive time series with a unit root,
Econometrica, 49, p 1057 - 1072.
98
Hansen, L.P. and Hodrick, R.J. (1980) Forward exchange rates as optimal predictors of future spot rates: An
econometric analysis, Journal of Political Economy, 88, p 829 853.

Krasker, W.S. (1980) The peso problem in testing the efficiency of forward exchange markets, Journal of
99

Monetary Economics, 6, p 269 276.

100
Phillips, P.C.B. (1985a) Time series regression with unit roots, Cowles Foundation Discussion paper no. 740.
101
Phillips, P.C.B. and Perron, P. (1986) Testing for a unit root in time series regression, Cowles Foundation
Discussion paper no. 795. And latter in Biometrica 75 June 1988, p 335 346.
102
Corbae, D. and Ouliaris, S. (1986) Robust tests for unit roots in the foreign exchange market, Economic Letters
22, p 375 380.
103
Meese, R.A. and Singleton, K.J. (1982) On unit roots and the empirical modelling of exchange rates, Journal of
Finance, 37, p 1029 1035.

74
efficient market studies using the Phillips-Perron three-month return to speculation as the
regressor satisfied the stationarity assumptions that were necessary to invoke conventional
asymptotic theory.

7.4 Foreign Exchange Market Efficiency

Applying Corbae and Ouliariss (1986) reasoning this thesis will now examine the Efficient
Market Hypothesis using the Dickey-Fuller and Phillips-Perron tests to determine whether the
return on forward exchange market speculation contains a unit root. Unlike Corbae and Ouliaris
however, this procedure will be conducted several times using different currencies to determine
whether or not a currency union, in this case the euro, out performs the Robinson Crusoe
currencies. The results will be tabulated for comparison to determine the presence of a unit root.
This will in turn determine stationarity. Estimating the stationary model for each currency will
produce the minimum Mean Square Error (MSE). The MSE criterion can be used to diagnose the
stability of each currency and the least amount of random walk. The currency that proves to be
most stable allows the least amount of expected profit and represents the market that is most
efficient.

Denoting the spot price of foreign exchange on day t, as st , an investor at time t, may buy or sell
foreign exchange forward. A 90-day forward contract requires that on day t + 90, the investor
takes delivery of a specified amount of foreign currency in exchange for a specified amount of
money.

If we let t denote the 90-day forward market price of foreign exchange purchased on day t, and
a speculator wanted to buy forward 100,000 euro at the price of t = A$1.40/euro, in 90 days
time the speculator would be obliged to provide A$140,000 in return for the 100,000.
Pretending that there were no transaction costs involved, and provided that both currencies
maintained their value, the speculator could choose to sell the euros on the spot market to break
even.

However, if on day t + 90 the spot price for euro happened to be s t + 90 = A$1.50/euro, the
speculator could sell the 100,000 for A$150,000. Without taking transaction costs into
account, the speculator earns a profit of A$10,000.

75
In general, the profit on such a transaction will be s t + 90 - t multiplied by the number of euros

transacted. Note that the profits could have been negative had s t + 90 < t . This process works two
ways of course, it is also possible to speculate by selling forward euro. A speculator operating
from a short position who purchases the right to sell 90-day forward euro on day t will be able to
buy them on the spot market at s t + 90 . In this case profits would be t - s t + 90 multiplied by the
number of euros transacted.

The efficient market hypothesis maintains that the Expected profit or loss from such speculative
behaviour must equal zero. Letting Et st+90 denote the Expectation of the spot rate for day t + 90
conditioned on the information available on day t , and since we actually know t on day t, the
efficient market hypothesis for forward exchange market speculation can be written as either

Et st+90 = t or st+90 - t = pt (4)

where pt = per unit profit on speculation and Ept = 0

Here, the efficient market hypothesis requires that for any time period t, the 90-day forward rate
(i.e., t ) will be an unbiased estimator of the spot rate 90 days from t. Supposing weekly data
was collected of the spot and forward exchange rates, the data would consist of the forward rates
t , t+7 , t+14 , t+21, t+28 , and the spot rates st , st+7 , st+14 , st+21 , st+28 , . By using these exchange

rates, it is possible to construct the sequence st+90 - t = pt , st+7+90 - t=7 = pt+7 , st+14+90 - t=14 = pt+14 ,

st+21+90 - t=21 = pt+21 ,.Then normalising the time period to 1 week, so that y1 = pt , y2 = pt +7 , y3 =
pt +14 , y4 = pt +21 , and consider the regression equation

yt= 0 + 1 y t-1 + 2 t + t (5)

The efficient market hypothesis asserts that ex ante expected profit must equal zero - hence with

quarterly data, it should be the case that 0 = 1 = 2 = 0. The way in which this data set is
constructed means that the residuals will be correlated. Supposing that there is relevant exchange
market news at time t, speculators will incorporate this news into all forward contracts signed
subsequent to t. However, the realised returns for all pre-existing contracts will be affected by

the news. Since there are approximately 13 weeks in a 90-day period, we can expect the t
sequence to be a moving average MA (12) process. Although ex ante expected returns may be

76
zero, the ex post facto returns from speculation a t will be correlated with the returns from those
engaging forward contracts at weeks t + 1 through to t + 12.

The data sets were compiled from an Australian perspective. Because Australia has very little
influence on the global economy, a currency that does not affect the outcome or distort the
findings presents an unbiased view of the major currencies in action - those being: the US dollar
(USD), British pound (UKP), Japanese yen (JPY) and the EMU euro (EUR). The Chicago
Mercantile Exchange developed the concept of buying foreign currencies on a futures market
basis in the early 1970s. Their International Monetary Market quickly became the worlds largest
futures market for foreign currencies, henceforth their end of day prices for purchasing 90 day
forward currencies is used in this thesis. The historical pricing information was purchased from
Paritech Australia Pty Ltd 104
and covered the years from the early 1980s through to the
present. While the prices were given in US dollars, the relevant Australian / US exchange rate
was employed to convert the US currency prices into Australian dollars. This would have been
the procedure and prices paid had an Australian speculator chosen to participate in the futures
market at those times. The spot price data for the currencies in Australian dollars was obtained,
free of charge, courtesy of the Reserve Bank of Australia at their web site
www.rba.gov.au/exchangerates . By constructing the weekly sequence st+90 - t = pt , st+7+90 - t=7 =

pt+7 , st+14+90 - t=14 = pt+14 , st+21+90 - t=21 = pt+21 , and calculating the Expected profit from speculation
for two periods for each currency - the first period being January 1987 through to January 1990
when the European Currency Unit (ECU)* existed and secondly from January 1999 through to
October 2002, the period in which the euro has existed it allows for a comparative before and
after situation to be examined. N.B. * The European Currency Unit was heavily influenced by
the stability and value of the Deutsche mark.

The Rats computer software programme was employed to process the data and calculate the
descriptive statistics. The computer instructions for the Rats programme are given in Appendix
A. The Dickey-Fuller and Phillips-Perron test procedures were carried out. The computation
printouts are given in Appendix B. An explanation of the econometric reasoning is given in
Appendix C. The Tests gave the following results, which can now be used to analyse foreign
exchange market efficiency.

104
Paritech Australia Pty Ltd, phone: 1 300 652 511 or www.paritech.com.au

77
Compiled Printouts placed in descending order: taken from Appendix B

Table 7.1 Descriptive statistics January 1987 to January 1990

Series Obs Mean Std Error Minimum Maximum

UKP 155 -0.0054864516 0.0085587813 -0.0244000000 0.0153000000

USD 155 0.0260567742 0.0312318207 -0.0364000000 0.0919000000

ECU 155 -0.1135341935 0.0199419171 -0.1527000000 -0.0672000000

JPY 155 1.7375561290 1.8948348319 -2.5261000000 6.6866000000

Table 7.1 shows that for the 1987 1990 period the UKP had the smallest variation in expected
profit opportunities between its minimum and maximum values while the JPY had the largest
variation. The ECU allowed greater expected profit opportunities than did the UKP and USD.
This meant that currency fluctuations for the individual European countries were more
pronounced than the UKP and USD. The advantages of participating in the currency union in
terms of EMH efficiency should be made evident by comparing the before and after situations.

Table 7.2 Coefficients of variables 1987 1990

Variable Coeff Std Error T-Stat P-Value

UKP
1. Constant -0.002374999 0.001370435 -1.73303 0.08513271
2. Y{1} 0.265823208 0.078088664 3.40412 0.00085024
3. TREND -0.000020153 0.000015020 -1.34176 0.18168750

USD
1. Constant 0.002884829 0.001783368 1.61763 0.10782948
2. Y{1} 0.938228032 0.025863264 36.27647 0.00000000
3. TREND -0.000009984 0.000018143 -0.55032 0.58291068

ECU
1. Constant -0.007133087 0.002937372 -2.42839 0.01634122
2. Y{1} 0.944952130 0.024091584 39.22333 0.00000000
3. TREND 0.000007973 0.000010803 0.73796 0.46168360

JPY
1. Constant 1.620851933 0.346870421 4.67279 0.00000653
2. Y{1} 0.225760769 0.079191807 2.85081 0.00497117
3. TREND -0.003638704 0.003375331 -1.07803 0.28274001

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Table 7.3 Return to Forward Speculation 1987 1990
Constant Y{1} TREND
0 1 2
yt UKP -0.002374999 0.265823208 -0.000020153

yt USD 0.002884829 0.938228032 -0.000009984

yt ECU -0.007133087 0.944952130 0.000007973

yt JPY 1.620851933 0.225760769 -0.003638704

A necessary condition for the efficient market hypothesis to hold is that the intercept term 0
must equal zero. A non zero intercept term suggests a predictable gap between the forward rate

and the spot rate in the future. In the equation yt = 0 + 1 y t-1 if 0 0, on average,

there will be exploitable profit opportunities. In our case, the JPY 0 coefficient is 1.6208. This
clearly places the yen in a vulnerable position and excludes it from being considered efficient.
The yens predicament can be represented in graph form in the Figure below.

Figure 7.3 Exploitable profit opportunities when a0 0

Y = a0 + a1 x

profit

Y = 0 + a1 x

Opportunity gap

0 time

Remembering that if 1 < 1 the process is stationary, it allows us to test for nonstationarity

by testing the null hypothesis that 1 = 1 against the alternative that 1 < 1. Observing the test

for the unit root hypothesis (i.e. 1 = 1), all estimated values of 1 are less than one, however
while the UKP and JPY are close to zero, the US dollar and the ECU are precariously close to 1.

79
To accurately determine whether we can accept the probability of the information being relevant,
we have to examine the significance of the T-Stat.

The T-Stat values in this case are: UKP 3.40412, USD 36.27647, ECU 39.22333 and JPY
105
2.85081. As all the P-Values are less than .05 significance we cannot reject the hypothesis

that 1 = 1. This implies that these currencies were nonstationary for the period between 1987
through to 1990. It is now necessary to confirm this by applying the Dickey-Fuller and the
Phillip-Perron tests. The Dickey-Fuller and Phillip-Perron Tests gave the following results from
Appendix B.

Table 7.4 Dickey-Fuller and Phillip-Perron tau values 1987 - 1990

Test UKP ECU USD JPY

Dickey-Fuller with 0 lags -9.28161 -2.25821 -2.37959 -9.71291

Dickey-Fuller with 4 lags -3.79763 -2.20058 -2.56361 -3.82154

Dickey-Fuller with trend, 0 lags -9.40184 -2.28494 -2.38841 -9.77676

Dickey-Fuller with trend, 4 lags -4.01294 -2.20493 -2.59152 -3.87318

Phillips-Perron Test with 0 Lags -9.28161 -2.25821 -2.37959 -9.71291

Phillips-Perron Test with 4 Lags -9.61633 -2.38995 -2.45298 -9.96332

Phillips-Perron Test with Trend & 0 Lags -9.40184 -2.28494 -2.38841 -9.77676
Phillips-Perron Test with Trend & 4 Lags -9.70616 -2.40511 -2.45544 -10.0356

At the 5 per cent significance level, the critical value for a test of Ho : = 0, is 2.89, this being
the Dickey-Fuller statistic for 100 observations. Both the Dickey-Fuller and Phillip-Perron
statistics reinforce one another. This means we can be confident about the results. In this instant
the ECU and the USD fall within the acceptance region, implying both demonstrate
nonstationarity and similarly allow speculative opportunities. The UKP statistics fall outside of
the critical value, which implies that we do not accept that it is nonstationary. The JPY has
already been eliminated, but it is not accepted as being non stationary because the volatility of
the yen did not allow sufficient predictability for nonstationarity over this short time period. As
volatility increases ~ predictive ability decreases.

105
P-Value refers to the probability value and determines whether the T-Stat can be accepted or rejected.

80
Figure 7. 4 Possibility of profit 1987 1990

Source: World Bank Database graphed in Microsoft Excel

Figure 7.4 shows the variation in profit opportunities between the four currencies, the USD,
UKP, ECU and the JPY for the period January 1987 through to January 1990. Because the yen
was the most volatile it has been excluded in Figure 7.5 below to allow for closer examination.

Figure 7. 5 Possibility of profit 1987 1990 with Japan excluded

Source: World Bank Database graphed in Microsoft Excel

It can be seen that the UKP demonstrated the least amount of random walk. The profit
opportunities for the UKP from speculation on the 90 day futures market hovered close to zero

81
for the entire period. The USD allowed some positive gains from forward speculation while the
ECU showed continual losses for the same period. The reasoning behind this from an Australian
perspective could have been the gradual devaluation of the ECU with respect to the Australian
dollar over this period and the USDs gradual appreciation in value vis--vis the Australian
dollars depreciation. Having discovered that the ECU faired poorly in the 1980s, we will now
examine the euros performance since 1st January 1999. Similarly the EUR will be compared to
the UKP, USD and JPY.

Compiled Printouts placed in descending order: taken from Appendix B

Table 7.5 Descriptive statistics January 1999 to October 2002

Series Obs Mean Std Error Minimum Maximum

UKP 193 -0.0012689119 0.0045994301 -0.0169000000 0.0133000000

EUR 193 0.0029243523 0.0071501222 -0.0148000000 0.0268000000

USD 193 0.56863989637 0.05483385810 0.48480000000 0.6662000000

JPY 193 1.5035077720 1.0746201438 -0.3214000000 4.5698000000

The UKP again had the smallest variation in its expected profit opportunities between its
minimum and maximum values for the 1999 2002 period while the JPY still had the largest
variation. Unlike the ECU in the 1987 period, the EUR demonstrated smaller variations in its
expected profit opportunities than did the USD - bettering its performance.

Table 7.6 Coefficients of variables 1999 - 2002

Variable Coeff Std Error T-Stat P-Value

UKP
1. Constant 3.2007e-004 6.4384e-004 0.49712 0.61968195
2. Y{1} 0.0202 0.0700 0.28853 0.77325515
3. TREND -1.5203e-005 5.8058e-006 -2.61850 0.00954802

EUR
1. Constant 5.9046e-003 1.0132e-003 5.82745 0.00000002
2. Y{1} 0.4464 0.0651 6.85652 0.00000000
3. TREND -4.4863e-005 8.3374e-006 -5.38092 0.00000022

UDS
1. Constant 0.020784765 0.013273892 1.56584 0.11905932
2. Y{1} 0.966557309 0.020344260 47.51007 0.00000000
3. TREND -0.000022813 0.000020112 -1.13429 0.25811096

JPY
1. Constant 0.557845842 0.143118490 3.89779 0.00013472

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2. Y{1} 0.766245386 0.046784147 16.37831 0.00000000
3. TREND -0.002203192 0.000903531 -2.43842 0.01567591

Table 7.7 Return to Forward Speculation 1999 2002

Constant Y{1} TREND
0 1 2
yt UKP 0.000032007 0.0202 -0.000001520

yt EUR 0.00059046 0.4464 -0.000004486

yt USD 0.020784765 0.966557309 -0.000022813

yt JPY 0.557845842 0.766245386 -0.002203192

The T-Stat values in this case are: UKP 0.28853, EUR 6.85652, USD 47.51007, and JPY
16.37831. Except for the UKP with a Y {1} P-Value of 0.7732 all other P-Values are less

than .05 significant. Excluding the UKP, we cannot reject the hypothesis that 1 = 1. This
suggests that the EUR, USD and JPY were nonstationary for the period between 1999 through to
2002. The Dickey-Fuller and the Phillip-Perron tests were applied.

Table 7.8 Dickey-Fuller and Phillip-Perron tau values 1999 - 2002

Test UKP EUR USD JPY

Dickey-Fuller with 0 lags -13.54346 -6.14773 -1.27123 -4.3077

Dickey-Fuller with 4 lags -4.53398 -1.93327 -1.26001 -2.88064

Dickey-Fuller with trend, 0 lags -13.98749 -8.5035 -1.64384 -4.99645

Dickey-Fuller with trend, 4 lags -4.95035 -3.25322 -1.75962 -3.40997

Phillips-Perron Test with 0 Lags -13.54346 -6.14773 -1.27123 -4.30771

Phillips-Perron Test with 4 Lags -13.66266 -5.96527 -1.28431 -4.02809

Phillips-Perron Test with Trend & 0 Lags -13.98749 -8.50352 -1.64384 -4.99645
Phillips-Perron Test with Trend & 4 Lags -14.00531 -8.79046 -1.72988 -4.85721

The Critical test for 200 observations at .05 significance level is -2.88. The Phillip-Perron
Test is the more powerful test. That test shows that the UKP, EUR and JPY values fall
outside of the critical value. We can therefore reject the null hypothesis of Ho : = 0, which
implies that we do not accept that those currencies are nonstationary. In other words it indicates
that they may be stationary, but Hypothesis Testing protocol forbids us to say it that way because

83
it could still be false. Truthfully when we examine the volatility of the JPY it would suggest
otherwise. In terms of the EMH, we can conclude that the UKP remained the most efficient for
both periods. It was also demonstrated that the efficiency of the European currencies improved
from the 1987 period to the 2002 period. Unfortunately this finding does not suggest why or how
it improved - only just that it did. The USD definitely fell into the nonstationary category, more
so in the latter time period. The USD allowed constant opportunities for expected profits (and
losses). In terms of EMH the USD became less efficient. The JPY isnt worth talking about
except to advise that there could be quite large exploitable profit opportunities to capture but also
equally large losses.

7.5 A simple alternative

The simplest way to determine currency stability is to calculate the descriptive statistics of the
different exchange rate data and compare the standard deviation between the currencies. The
currency with the smallest standard deviation has the least amount of variation in its value. This
implies that that currency is most stable and therefore is deemed to be more efficient. The
Chinese yuan has been included for interest. Table 7.9 places them in descending order from left
to right.

Table 7. 9 The descriptive statistics of exchange rate data sets to Jan 1999 - Sep 2002

Statistics Pound Euro US$ Yuan Yen

Mean 0.377497 0.60287632 0.574179 4.7530816 66.08395

Standard Error 0.003364 0.00477902 0.009669 0.080086 0.98545
Median 0.37785 0.60725 0.57415 4.75285 63.74
Mode #N/A 0.6161 #N/A #N/A #N/A
Standard Deviation 0.020735 0.02945984 0.059603 0.493683 6.074719
Sample Variance 0.00043 0.00086788 0.003552 0.2437229 36.90221
Kurtosis -0.84925 -0.6839881 -1.64517 -1.645321 -0.12339
Skewness -0.06124 -0.2707867 0.089426 0.0887594 0.781735
Range 0.0843 0.1126 0.1708 1.4148 23.55
Minimum 0.3345 0.5383 0.489 4.0479 56.11
Maximum 0.4188 0.6509 0.6598 5.4627 79.66

Using this method it can again be noted that the UKP has the smallest Standard deviation and
smallest sample variance. This means the UKP is the most stable of all currencies tested thus
reinforcing the econometric results of the Efficient Market Hypothesis.

To support the argument that the European currency union has improved the economic efficiency
of the pre-EMU countries, exchange rate data series were taken of the major currencies that

84
made up the euro zone prior to harmonisation. The period examined extended from January 1987
to December 1990. The currencies tested in this instant were the German mark, French franc,
Italian lira and Dutch guilder, compared to the same basket of currencies as before. The standard
deviations of the major European currencies show considerably more variation. They are placed
in order of stability from left to right in Figure 7.10.

Table 7. 1 0 The descriptive statistics of exchange rate data sets to Jan 1987 - Dec 1990

British German Dutch France Chinese Japanese

pound US dollar mark guilder franc yuan yen Italian lira
UK P US$ DMK NGL FRF CNY JPY ITL
Mean 0.44810609 0.764848673 1.341778389 1.51825118 4.5482342 3.060188172 106.0109625 987.880012
Standard
Error 0.000997478 0.0015743 0.004036624 0.00447851 0.0138561 0.013887932 0.240904147 2.90297028
Median 0.45036104 0.7677 1.3069 1.4738 4.3896609 2.925012285 105.960219 957.871475
Mode 0.4333 0.7665 1.3193 1.4134 4.0350623 2.67544548 106.6 879.3495
Standard
Deviation 0.031825636 0.050205126 0.128792966 0.14289188 0.4420931 0.443109905 7.686314747 92.6224957
Sample
Variance 0.001012871 0.002520555 0.016587628 0.02041809 0.1954463 0.196346388 59.07943438 8578.92672
Kurtosis -0.83660801 -0.31737207 -0.96109492 -0.93793815 -1.0030518 -0.797957953 -0.372568001 -1.0429623
Skewness -0.33895596 0.063082924 0.280007312 0.28084338 0.3346357 0.702670337 -0.104459032 0.30671228
Range 0.13317392 0.2512 0.5477 0.6205 1.8968478 1.66090035 35.19056 389.9844
Minimum 0.37822008 0.6425 1.1232 1.2662 3.7919996 2.39144925 88.09944 831.25665
Maximum 0.511394 0.8937 1.6709 1.8867 5.6888474 4.0523496 123.29 1221.24105

All tests demonstrated that the UKP was in fact the more stable and EMH efficient currency.
This may explain why the British were hesitant about adopting the euro. According to the
Efficient Market Hypothesis, they already had the most efficient currency on the planet. But it is
necessary to understand that the euro is less than 4 years in existence and the initial introduction
placed considerable pressure and expectations on that infant currency. Another major point was
that from 1999 to 2002 the infant euro co-existed with the national currencies that operated
within the monetary union. This period of duel currency allowed some arbitrage opportunities to
be exploited whenever the national EMU currencies fluctuated away from the euro. During the
transition period in the EMU, the national central banks faced constraints and private speculators
enjoyed opportunities very similar to those associated with conventional fixed exchange rate
regimes. At the same time, commercial banks were free to denominate assets and liabilities in the
new unit of account and the old currency unit. These contracts were the vehicles for profitable
speculation. A relatively simple but unconventional policy initiative of euroization106

106
Euroization was the procedure whereby the European Parliament and the ECB wanted to achieve a credible
commitment not to debase the new currency, and so proposed a completely euro-based system through law,

85
considerably reduced the vulnerability of currency boards and the transitional arrangements to
speculative attacks. Taking the initial shocks and expectations out of the equation by allowing
the new currency to settle in - give the euro another twelve months - it would be more than likely
that the euros efficiency will be equal to, if not better than, the pounds. Figure 7.6 shows how
the euro has converged with the pounds efficiency as time progresses.

Figure 7.6 Converging efficiency of euro with pound

Possibility of profit 1999 - 02

0.0300
Value of possible profit

0.0200

0.0100 UKP
0.0000 EUR

-0.0100

-0.0200
Jan 1999 to Oct 2002

Source: World Bank Database graphed in Microsoft Excel

7.6 Conclusion of empirical evidence

In all cases the British pound out performed stability expectations. I didnt expect that result but
it was reassuring to find the euro was not far behind at being the second best performer
especially in more recent times. The euro - though only young at 4 years - has demonstrated
stability only marginally less than the pound. Both the pound and the euro out performed the US
dollar in efficiency. If anything, this shows how well advanced and tightly managed both central
banking systems are - it is a credit to both management teams. Not wishing to discredit the
pound, after all it proved the most reliable over both periods that were examined, but I will
highlight two points: the first one is that the pound has been around for hundreds of years and is

enforcing the complete linking of banks assets and liabilities to the euro, discouraging the use of national currencies
as a unit of account for banks, which thus eliminated conversion risk during the transition.

86
well established in the market and did not undergo the dramatic upheaval that the EMU went
through in giving birth to the euro; and secondly, the British while being one of the major
players in the European Union, opted out of the single currency, undermining the euros
credibility right from the start. This allowed British speculators to add to the euros instability in
the first eighteen months after its launch in 1999 prior to euroization. Had the British
participated in the single currency as an obligation to the EU, the British contribution would
have added more stability and efficiency to the entire euro equation. It seems as if the British
wanted their share of the cake but didnt want to contribute to its making.

Remarkably, the euro has shown exceptional performance within such a short period. While this
thesis could not rank the euro as the best performer in terms of the Efficient Market Hypothesis,
it still proved that the monetary union did succeed in improving the monetary stability of the
individual countries that made up the euro zone to start with. This thesis has shown how the
European currency union and the countries that participated in it, are now economically more
efficient, more so than they would have been, if they had not adopted the single currency.
Having a stable efficient currency is one thing - having the largest economy is another. The UKs
GDP equates to 145 Billion107. The EMUs GDP is 610 Billion108, roughly four times larger.
Taking into consideration the euros brevity and its quick convergence towards stability, the
shear size of the euro zone economy coupled with its increasing efficiency must place the euro as
the overall best performer. The European monetary union represents a magnificent dichotomy,
where both factors - of size and stability - combined, should make the euro the most
economically preferred currency on the planet.

By creating the EMU and unifying the European monetary system, implementing the single
currency and creating one of the worlds largest economic blocs109 in the process, the euro has
made a grand entrance into the global economy. Because of rational maximising behaviour, this
economic experiment will more than likely be repeated as other cultural, ethnic and political
blocs realise the economic benefits of joining a currency union. In the modern international
financial arena of the twenty first century, the euro was the first tangible currency unit to be
adopted by the people of twelve sovereign states. These countries did this because they perceived
economic benefits by doing so. In 2004 another ten countries hope to join the economic union

107
World Bank Database, www.worldbank.org
108
Ibid.
109
At present the US still has the largest GDP. However in 2004 when the other applicant countries come on line
the euro zone will be the largest.

87
and adopt the euro as their currency - enhancing their own efficiency. Extra countries are lined
up to follow. Observing that monetary unions enhance efficiency, is it possible to have a single
global monetary union where all nations reap benefits? Is it possible to have a single global
currency? The next chapter explores this opportunity.

88
 Chapter 8

And Beyond: One Planet, One people, One currency

8.1 Patience, diligence and resolution

After Crusoe returned to England, he searched for his family only to discover most had already
died, while the survivors had all but forgotten him. He also discovered that his money had been
working for him during his absence and that he had unwittingly become a rather wealthy man.
Coupled with his island treasures this made him an extremely wealthy man.

A secondary theme, hidden between the lines of Robinson Crusoe, is the correlation with the
Biblical story of Job. At the end of the book, Defoe refers to the Book of Job twice as Crusoes
prosperity is restored and increased beyond imagination. Similar to Job, Crusoe neither entirely
understood why he had suffered as he did nor understood what the entire experience meant.
Patience, diligence and resolution held firm long after most would have given up, but above all,
the power of the mind to transform destruction to deliverance or captivity to reign, is
exemplified in the resiliency of Defoes character. Robinson Crusoe returned to England a
wealthy and respected man. Employing the same stratagem of patience, diligence and resolution
the new international financial architecture could also prove to be unwittingly prosperous. If
providence, or more correctly Adam Smiths invisible hand, can guide human affairs towards the
most efficient allocation of economic resources, it becomes conspicuously evident that through
patience, diligence and resolution, a single global currency is ultimately achievable. This chapter
explores this opportunity.

8.2 The matter of sovereignty

Fred Hirsch (1969)110 recognized the intimate connection between sovereignty and the right to
issue money. One of the hallmarks of national sovereignty throughout the ages has been the right
to create money. That right allowed the sovereign to lay down through law what was or was not
legal tender. It also enforced the requirement that the legal tender would be accepted in
settlement of debt within the countrys borders and maintained the sole right of issuing all
national money. No sovereign power controlled the way in which individuals chose to use their

110
Hirsch, Fred. (1969) Money international. Doubleday, New York, p 22.

89
money, that depended on the quality of the money itself, on its real worth in relation to the goods
it bought and on the choices of the free market. The ability to create its own domestic currency
was the key financial distinction of a sovereign state.

In the middle of the nineteenth century, John Stuart Mill recognized but deplored the sentiment
that made nations so attached to their own currencies, so much so that he wrote111:

So much barbarism still remains in the transactions of the most civilized nations, that
almost all independent countries choose to assert their nationality by having, to their
own inconvenience and that of their neighbours a peculiar currency of their own.

The euro has proved to the world that national populations are now prepared to scrap those
hallmarks of sovereignty that have existed for thousands of years. What was the nature of the
sentiment that made national currencies so easy to give up? Could it have been the realization of
the inconvenience with respect to international trade? Was it the fact that the nations of the world
no longer see their neighbours as barbarians? Are patience, diligence and resolution virtues that
the international political arena now accept as appropriate behaviour and does the world truly
believe that economic unification could also prove to be unwittingly prosperous? If the euro was
achievable, how is a single global currency achievable? If the world is as Robinson Crusoe
suggests, so stubborn that it allows history to repeat itself, then the invisible hand of providence
is bound to come into play. But before a single international currency becomes reality, many
hurdles need to be overcome. The hurdles are not a problem, they are an opportunity for
humanity to achieve its best. One challenging hurdle is to encourage the existing superpower to
relinquish its strangle hold on the international market.

8.3 The currency of a superpower

There is a constant phase relationship in the global financial structure due to the configuration of
dynamics in the world economy and the special role played by the currency of the superpower.
When one country has a super-economy, its currency often fulfils many of the functions of an
international currency. Historically, whenever there has been a superpower in the world, the
currency of the superpower plays a central role in the international monetary system. This has
been as true for the Babylonian shekel, the Persian daric, the Greek tetradrachma, the
Macedonian stater, the Roman denarius, the Islamic dinar, the Italian ducat, the Spanish
doubloon and Dutch guilder, as it has for the more familiar pounds sterling of the nineteenth
century and the US dollar of the twentieth century. The superpower typically has a veto over the

111
Mill, John Stuart. (1848) (1909 Ashley ed.). Principles of political economy. Longmans, Green, London. p 615.

90
international monetary system. Because it benefits from the international use of its currency, the
superpowers interest is usually in vetoing any kind of global collaboration that would replace its
own currency with an independent international currency.

In the 1870s, the United States and France were campaigning for international monetary reform
in the sense of an international return to bimetallism and the development of a standard
international unit of account. Which country was saying no to this reform? It was Britain, the
leading world power in the nineteenth century. Having the largest economy, Britain said no to
international monetary reform and no to an alternative to the pound as a unit of account and the
sterling bill as a means of payment. But when Britains star faded and Americas rose, the
positions were reversed, with Britain wanting international monetary reform and the United
States, the new superpower, rejecting it.

The international monetary system in the twentieth century saw the United States outstrip the
other countries and cause a new framework. This occurred when the dollar domain expanded and
became allied to the prestige of gold with the anchored US dollar standard from 1915 to 1924.
Britain went off the gold standard in 1931, and America followed in 1933. At the world gold
conference in 1933, France wanted international monetary reform. France wanted the United
States and Britain to go back to fixing of the price of gold. President Roosevelt said no, and the
US dollar continued to float until the US devalued the dollar, raising the price of gold from
$20.67 per ounce to $35. The United States did not want to move back to an international
monetary system, except under terms that gave it leadership. America then went back to gold
after devaluing the dollar in 1934. France was still on gold, but in 1936, France had to devalue
and was the last country to leave the Reformed Gold Standard of the post First World War
period. 1936 was also the year of the Tripartite Monetary Agreement, which established a new
form of international monetary system. This equated to a dollar standard where the US dollar
was the only currency anchored to gold. All other countries in that system kept their respective
currencies pegged to the US dollar.

The US dollar became the centre of the system and the world started to base its reckoning on the
dollar rather than on gold as the international unit of account. In the early 1940s, President
Roosevelt told US Treasury Secretary Henry Morgenthau to make plans for an international
currency for after the war. Harry Dexter White and the staff at the US Treasury made a plan that
involved the creation of a world currency to be called the unitas. John Maynard Keynes, in
London, made a comparable plan for reform that included a world currency called the bancor.

91
Initially both the White and Keynes plans endorsed the idea of an international currency having
legal tender throughout the world. But what happened to these two currencies and why arent
they around today? To answer that question it is necessary to go back to Bretton Woods.

8.4 Bretton Woods revisited

Bretton Woods could probably be regarded as the most successful economic conference held in
the twentieth century112. One of the main reasons for its success was the years of planning that
went into it. By January 1944, three years of intensive drafting and redrafting by US and UK
officials had taken place. These officials had met often to exchange ideas and drafts and to
negotiate their positions. It was in the 1930s that US Treasury officials began thinking about an
institution for international monetary cooperation with regard to international currency exchange
rates. About that time, Henry Morgenthau Jr., Secretary of the US Treasury, appointed a group
of international economists, including Jacob Viner and Harry Dexter White to work on
exchange-rate stabilization. Further momentum toward international monetary arrangements
took place in February 1940. An Inter-American Committee, assisted by a group of experts,
including Harry White, recommended the establishment of the Inter-American Bank. The
intensive planning that eventually led to Bretton Woods, really began in the early part of 1941,
when White and his associates in the US Treasury started thinking in earnest about a
comprehensive international monetary agreement. They had in mind two possible organizations:
one to stabilize exchange rates and another to help provide the long-term capital that would be
needed for European reconstruction once World War II was over. By mid-1941, the time was
ripe for serious thinking about monetary plans. In August, President Roosevelt and Prime
Minister Churchill, met in the Atlantic and agreed to the Atlantic Charter, which, among other
provisions, emphasized British commitment to post-war international cooperation, including help
in forming a United Nations. Six months later, in February 1942, under the Mutual Aid
Agreement (Lend-Lease), the British agreed to a post-war multilateral payments system in
exchange for a US commitment to help Britain financially after the war.

John Keynes, working with Lionel Robbins, James Meade, and others, had gone through several
drafts of a currency plan. On 11th February 1942, Keynes circulated his Proposals for an
International Currency (or Clearing) Union. The International Union was to keep accounts for
national central banks in the same way as national central banks kept accounts for commercial
banks in each country. The accounts were to be denominated in a new international currency to
be known as bancor. Exchange rates were to be fixed in terms of bancor and could not be
112
Information in this section is derived from Eckes (1975), Garritsen de Vries (1986), and Horsefield (1967).

92
changed without permission of a governing board. Within limits, member countries could run up
debit balances with the Union. The Union would charge interest on both debit and credit
balances, a provision that was interpreted by creditors (that is, by the US planners) to mean that
both creditor countries and debtor countries would share the burden of balance-of-payments
adjustment.

Two months later, in April 1942, the White plan, entitled Preliminary Draft Proposal for a
United Nations Stabilization Fund and a Bank for Reconstruction and Development of the
United and Associated Nations, was circulated. The plan covered not only what eventually
became the International Monetary Fund but the World Bank as well. Eager to move ahead as
fast as possible, a few weeks later in mid-May, Morgenthau sent to President Roosevelt the
preamble of Whites plan with a proposal for an international conference to consider the plan. He
also suggested that an interdepartmental committee be set up to coordinate action within the US
government. Roosevelt agreed to the suggestion on the same day. Now that preliminary versions
of both the Keynes and the White plan had been circulated, it was time for reshaping. This
started in August 1942 and consumed most of the next eight months.

A fifth draft of the Keynes plan was given to the US Treasury. Its differences from, and
similarities to, the White plan were intently studied by the Treasury and the interdepartmental
committee. The two plans had many features in common, but vital differences existed. One
crucial difference was that Whites Stabilization Fund was now based on a mixed bag of national
currencies rather than his original unitas, while the Clearing Union still favoured its new
international currency. Also, being astutely aware of Britains need for economic support after
the war, Keyness Union had less strict rules than did the Fund for its use by countries with
balance-of-payments deficits. The US committee was concerned about the potential financial
liability of the United States and about the rights of creditor countries, that is, countries with
balance-of-payments surpluses. Hence, the committee had serious reservations about the Keynes
plan, which had generous liquidity provisions and easy access to liquidity for countries in deficit.
Keynes obviously had British interests at heart but expected the US to foot the bill. The White
plan contemplated the abolition of exchange rate controls, an important feature for the United
States, whereas the Union did not put much emphasis on the abolition of exchange controls and
even advocated the use of capital controls.

White and Keynes and other officials of both governments were keenly aware that any monetary
agreement would have to have the support of their legislatures. Various versions of the White

93
plan had been sent regularly to members of the US Congress. To help gain the support of the US
Congress and of the British Parliament, it was necessary also to have wide spread public support.
Criticism had begun to surface in both countries. In the United States, many congressmen,
especially those who had long preferred that the United States play an isolationist rather than an
internationalist role, were concerned about binding international commitments. Some economists
and many businessmen objected to government institutions that would regulate, or at least
interfere with, the free operation of foreign currency markets. Some bankers feared a
government-sponsored and subsidized competitive institution that could lend money to
governments below commercial rates. Meanwhile, the experts on both sides of the Atlantic
continued to work on their plans. By March 1943, White had sent a revised version of his plan to
Keynes, who had come to realize that the major objectives of the Clearing Union could equally
be achieved under the Stabilization Fund and that the eventual draft would have to be based on
the Stabilization Fund. In April, both plans were published and the public debate became
vigorous in both countries.

It was now time to get the support of other countries. White sent his revised version to thirty-
seven countries, with an invitation to an informal conference to discuss the plan. By September
1943, it was imperative for the United States and the United Kingdom to reconcile their
differences in order to come up with an agreed plan. A consensus was now emerging. The major
remaining difference concerned the nature and use of a proposed international currency: whether
the bancor, as under the Keynes plan, would be a currency to be issued by the Fund; or whether
the mixed bag of currencies as then discussed in the White plan would be used. Both these
proposals were rejected by the United States, undoubtedly because it would have involved a loss
of monetary sovereignty to the largest power. When the British delegation arrived at the Bretton
Woods conference, it kept bringing up the question of a world currency, but the Americans now
had second thoughts and kept silent. Thus academic internationalist idealism fell prey to
economic national self-interest. As a result, the wised-up self-centred superpower backed away
not only from Keynes bancor plan, but from its own unitas plan.

The global currency did not come to fruition. Bretton Woods did not succeed in creating a new
international monetary system, it merely kept the system that had been in place since 1936.
However, it did create two new international institutions. The IMF and the World Bank were set
up to manage international interdependence within the global financial system and provide a
supranational veneer for the anchored dollar standard. That system lasted to 1971. The
international monetary system was supposed to enhance equality among countries, but the US

94
dollar was still used as the unit of account. That system broke down due to, as always, the
perennial problem of disciplining the major power. It appears that the more powerful a
superpower becomes, the more it is tempted to expand beyond its international monetary
potential and exact seigniorage from the rest of the world.

8.5 The euro as a model

Members of the European Community signed the Treaty of Maastricht that formed the EU and
developed a plan for the euro to begin in 1999. This plan involved the sudden sacrifice of
national independence and transferred monetary sovereignty and future policy to the European
Parliament in which, of course, all members shared control. It remains to be seen however,
whether other countries in a similar situation would be willing to completely scrap their legal
sovereignty in the way prescribed or in a manner in which Europe did. History has
demonstrated113 that political federations where the states have diverse cultural backgrounds,
religious beliefs and racial differences have difficulty in surviving. The choices made at the time
of Maastricht will remain one of the most intriguing questions for historians, but certainly this
step in human development will prove positive. The fact that the Maastricht Plan followed
Delorss recommendations is well known. But the Delors Report said, The adoption of a single
currency, while not strictly necessary for the creation of a monetary union . . . would clearly
demonstrate the irreversibility of the ...union114 As it has turned out, the adoption of the Delors-
Maastricht approach seems to have had unparalleled success. It is quite another question,
however, whether the European model will travel well with other economic zones.

What has worked for Europe is not necessarily the best model for other areas considering closer
monetary integration or even monetary unions. It has been proved that the euro is on the same
scale of importance as the US dollar and already far surpasses the yen. Moreover, it is an
expanding monetary area that will increase in importance over time. The creation of the euro
cannot fail to have a demonstration effect leading to the formation of economic unions
elsewhere. One reason for this is that the creation of a huge and expanding monetary bloc in
Europe will lead competing areas to reconsider their international currency arrangements. As the
European monetary area expands into Central and Eastern Europe, the coastal states of the
Mediterranean, and Africa, it seems likely that there will be renewed interest in the idea of

113
Blackshield, T. and Williams, G. (1998) Australian Constitutional Law and Theory, The Federation Press,
Leichhardt, NSW, Chapters 1 6.
114
The Delors Report or the Report on Economic and Monetary Union in the European Community, p 10.

95
monetary integration in the Western Hemisphere as well as the Asian and Pacific areas. A
contagious effect at long last that will have positive results perhaps?

However the majority of smaller less developed trading areas lack the political and economic
prerequisites for a single currency - but would nevertheless benefit from the economics of a large
stable currency. There is no doubt that a single currency offers important advantages over an area
in which multiple currencies remain. The single currency disposes of the necessity for quick
adjustment day in and day out. It does not allow for large imbalances between currencies to build
up and it rules out speculation about exchange rate changes. It is also true that the single
currency approach, compared to the multiple currency mix of an economic union, is harder to
reverse. Moreover, transactions costs and information costs of trade in a single-currency area are
much less than in a multiple currency situation. But without complementary development of
deeper political integration, other emerging currency areas would be better advised to exploit the
advantages of credible currency board arrangements centred around a hegemonic leader or else a
parallel currency arrangement linked firmly to one or more of the larger currencies. The question
is; which large currency? Presently the world has a choice, the US dollar, the euro or the?

8.6 The lack of an international monetary system

An international monetary system in the strict sense of the word does not presently exist. Apart
from the euro zone, every other country on the planet has it own system. Most people do not
comprehend how unconventional the current system is. For thousands of years countries
anchored their currencies to one of the precious metals or to another currency. But since 1973,
countries have been on their own - a phenomenon that has no historical precedence in
international finance. When the international monetary system was linked to gold, gold managed
the interdependence of the currency system. It established an anchor for fixed exchange rates and
stabilized inflation. When the gold standard broke down, these valuable functions were no longer
performed and the world moved into a regime of erratic inflation. From its beginning in 1946 to
1971, the IMF gave countries a coherent philosophy of macroeconomic management based on
the rudder of fixed exchange rates. Being established to defend and manage the anchored dollar
system of fixed exchange rates, the IMF lost its sense of purpose as guardian of the international
monetary system in 1971 when President Nixon took the US dollar off gold. This led to the
events of 1973 when the entire international monetary system was scrapped for flexible
exchange rates. The Fund was then shifted from its role at the centre of the international
monetary system to a new role of ad hoc macroeconomic consultant and debt monitor.

96
The international monetary system that existed for the last quarter of the twentieth century
neither managed the interdependence of currencies nor stabilized prices. Instead of relying on the
equilibrium produced by automatic adjustments of gold, the US resorted to bashing its trading
partners which it treated as enemies115.

8.7 The changing face of international money

The US dollar was the most widely used currency in the world through a major proportion of the
twentieth century. The euro has rushed to the forefront as a major international currency and all
indicators point towards further expansion as the increasing list of applicant countries confirms.
It is more than likely that it will take a few more years of growing pains while participating
countries get use to the new procedures associated with the euro. Examining the euros dramatic
rise as an international currency and extrapolating forward, by the year 2010, the euro will most
probably surpass the US dollar as the preferred currency for international trade.

Had the United States talked about international monetary reform back in the early 1990s,
Europeans would have interpreted it as an attempt on the part of the US to break up their strategy
for the euro. Back then, the United States didnt talk about international monetary reform
because as the economic superpower it didnt need or want reform. Remembering Bretton
Woods, the US saw reform as a threat to break up its own hegemony. The dollar liabilities of the
United States had been rising astronomically. From a national standpoint, the United States was
never going to suggest an alternative to its own system because it was already a system where
the United States maximized the benefits of its position.

By not actively participating in the global arena in a somewhat fairer manner than it has, the US
appears to have alienated itself. But on the other hand, underestimating Americas competitive
nature would undoubtedly be a mistake. Obviously the US would be willing to pursue a course
of action that would at least maintain them some influence in the global economy. So not
wishing to miss an opportunity, it is more than likely that the US will invest considerable effort
to promote its economic superiority, but its bungled administration of global finances throughout
the twentieth century and its bullying tactics may have already cost them dearly. It was certainly
one of the reasons why the European economies united in the first place, not only to enhance

115
Professor Mundells words, not mine. Mundell, R. A. (1997) The International Monetary System in the 21st
Century: Could Gold Make a Comeback? Lecture delivered at St. Vincent College, Letrobe, Pennsylvania, March
1997.

97
stability within their own boundaries, but also to provide a powerful viable alternative other than
the US dollar for global trade.

8.8 The third player

Apart from the European EMU the other great power emerging is China. Current statistics place
Chinas economic status within the big three. For centuries China has stood as a leading
civilization, outpacing the rest of the world in the arts and sciences. But for several hundred
years and for a larger part of the twentieth century, China was beset by major famines, civil
unrest, military defeats, and foreign occupation. After World War II, the Communists under Mao
Zedong established a dictatorship that, while ensuring Chinas sovereignty, imposed strict
controls over everyday life and cost the lives of tens of millions of people. After 1978, Maos
successor Deng Xiaoping gradually introduced market oriented reforms and decentralized
economic decision making. Output quadrupled in the next 20 years to the point where China now
has the worlds third largest GDP (purchasing power parity US $5.3 trillion 2001). Although
considerably less than the size of the EMU or US economies at present, Chinas rapid rise in
performance is to be admired.

Figure 8.1 World Bank GDP Figures for major currencies 1982 to 2001

Source: World Bank Database graphed in Microsoft Excel

Figure 8.1 shows the GDP for the major economies from 1982 to 2001. The GDPs of the
counties that made up the EMU 12 were totaled to arrive at the GDP for the euro zone. Chinas

98
GDP has demonstrated significant growth. The US has the largest GPD in US dollar terms. The
other countries GDPs were converted into US dollars based on purchasing power parities.

Although the US had a significant track record in productivity and economic superiority through
most of the twentieth century, it may not always be that way. As the euro and the yuan
strengthen and expand as vehicle currencies for international trade, the US dollar may be forced
to revert to its proper value. According to McDonalds 2001 Big Mac Index, the US dollar was
overvalued by 28 per cent in relation to most currencies116. Admittedly the Big Mac Index is
only regarded as a light-hearted comparison of currency values, but many a true word has been
spoken in jest. If an official international study was conducted using an identical baskets of
goods on the same scale as the Big Mac Index, it could be expected that it would reveal similar
findings. If this was true, the competitive pressure of the euro and the yuan could force the US
from the top position.

In terms of percentages of the value of global trade activity, as the percentage of Chinas share
increases - ceteris paribus other economies share will decline. The changing percentages of
global GDP are shown in Figure 8.2 below.

Figure 8.2 IMF forecast of changing percentages of the global economy

Source: IMF forecasts Oct 1997

On the bottom axis of the graph is the year, on the right is the percentage of the world economy
that the country accounts for. The graph shows the economic growth prediction by the
International Monetary Fund (IMF) calculated in 1997. In 1997 the IMF predicted China - with
over one fifth of the worlds population and economic growth averaging around 9 per cent

116
For a full explanation of this see Appendix D.

99
since 1980 - would overtake the United States and Europe to become the worlds largest
economy by 2007 (Of course, Chinas GDP per capita would still be very low compared to most
other economic zones ~ China only wins because of the shear size of its population). However, if
other Asian countries adopt the currency union mentality and form economic alliances with
China, it could make the Chinese yuan one of the most powerful currencies on the planet117.

In 1997 however, it was uncertain exactly how the European EMU would fair. At that time it
was not known thirteen other countries would apply to be part of the EU or that 58 other
countries would align their currency to the euro. Two weeks after the launch of the euro currency
in January 2002, British Prime Minister Tony Blair lamented118[First] we said that it wouldn't
happen. Then we said it wouldn't work. Then we said we didn't need it. But it did happen. And
Britain was left behind. It seems as if Britain may be having second thoughts about joining the
EMU. Denmark, Sweden and the United Kingdom still have the option of adopting the euro. If
this scenario unfolds, coupled with the ten new applicant members coming online in 2004, it
will catapult the euro to the forefront as being the worlds most used currency.

If the US fails to compete by not forming strategic economic relationships with Latin America
through the formation of fixed exchange rates or currency unions, its period of dominance in the
global economy could be short lived. The show down will not be between the US dollar, yen or
euro, it will be between the euro and the yuan.

8.9 The likelihood of a global monetary union

From the early planning, Bretton Woods was expected to be the catalyst for a global currency.
The British and American plans both contained provisions for a world currency. But these
forward looking ideas were soon buried. No doubt the Americans came to believe that a single
world currency would restrict the potential profit opportunities of the US dollar. There was not
therefore a new monetary system but rather a Bretton Woods order outlining the charter of a
system that already existed. Apart from the euro zone, the twentieth century did not see fixed
exchange rates develop between any of the major currencies. The US dollar, the euro, the yen
and the yuan all maintained their own independence. But it is entirely possible that a new

117
The Association of South East Asian Nations (ASEAN) is presently discussing the benefits of forming economic
unions. ASEAN seeks to promote economic growth, cultural development, and social progress as well as stability
and peace in the region. Investigate its programs and projects at www.aseansec.org

118
Related in a speech by Romano Prodi President of the European Commission 2002, titled A tremendous year
for Europe. Bocconi's University Milan, 28th January 2002.

100
international monetary system will emerge in the twenty-first century. As it was pointed out at
the beginning of this thesis, convergence of inflation rates has become a precise art comparable
to the stability of the gold standard of the early part of the twentieth century. Table 8.1 shows
how the inflation rates of the four largest economies compare.

Table 8.1 Inflation Rates Among the Big Four

Country 1995 1996 1997 1998 1999 2000 2001

US 2.8 2.9 2.3 1.6 2.1 3.37 2.8
Eurozone* 1.8 1.8 1.5 1.8 1.0 2.4 2.6
China 16.8 8.3 2.8 -.84 -1.4 0.25 1.0
Japan -0.1 0.1 1.7 0.6 0.15 -.7 -.7

Source: OECD database, October 2002. Harmonised Index of Consumer Prices * Germany cost-of-living index for
1995-98, the European Monetary Union Index of Consumer Prices from 1999 onwards.

It may seem a long way off, but given the degree of inflation convergence some sort of monetary
union of the four areas would not be impossible. The condition would result from a four-way
fixed currency exchange rate system with agreement over a common inflation rate and a fair
distribution of seigniorage. If a single currency arrangement among countries that had converged
is conceivable - as it was in the case with the European Economic and Monetary Union then it
could be a reasonable assumption to expect an international monetary system with a single
global currency of the kind initially proposed back in the days of Bretton Woods.

If patience, diligence and resolution brought about the euro, and if the world is - as Robinson
Crusoe suggests - so stubborn that it allows history to repeat itself, and supposing that the US
behaves rationally and copies what Britain did when its fortunes were reversed in the 1930s, the
US would find itself promoting international monetary reform. Because the US may perceive
that it is dipping-out as it loses its hegemonic position to the euro and the yuan, it could be the
one nation that promotes the new international financial architecture and the adoption of a single
global currency more so than any one else. Similar to the introduction of the euro, - if patience,
diligence and resolution are employed - the new international financial architecture or New
World Order derived through an international monetary union and subsequent single global
currency must also be inevitably achievable.

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 Chapter 9

Conclusion

9.1 Destinys child

By helping the deposed captain to quell the mutiny and recapture his ship, Robinson Crusoe was
given free passage to England - of course he took Friday and his island treasures with him. It was
through helping others that it was possible for Robinson Crusoe to return to the real world.
Through participation and interaction with his fellow man, Robinson Crusoe realised his fortune
and fulfilled his destiny. If nations participate, interact and help other nations as they did with
the European EMU - what destiny awaits humankind? This thesis with the aid of Mr Crusoe and
other preposterous methods has demonstrated with eager fancy and unruly passion that the old
idea of implementing a single global currency could be a worthwhile objective for economists
and political leaders of the twenty-first century. It did this by placing the euro under the
microscope to deduce the positive effects currency unions offer participating member states.
Because humanity, like Robinson Crusoe, acts in a rational economic manner allocating their
available but scarce resources to obtain maximum satisfaction, humanity will seek out the best
balance of pleasure and pain. If the idea of a single global currency offers the most pleasure with
the least amount of pain, Adam Smiths invisible hand will direct humanity towards that destiny.

9.2 Summary
A consequence of the breakdown of Bretton Woods was that it sped up the EECs planning for a
monetary union. After the suspension of US dollar convertibility and the ensuing currency
storms of the early 1970s, Germany realized that defending the fixed exchange rate was futile. In
April 1972 the Basle Agreement for the European Economic Community established the so-
called snake for EEC currencies. This regime was novel in that it allowed EEC currencies to
jointly float against the US dollar while the movement between each currency was restricted to a
predetermined band. The establishment of the European Monetary System in 1979 proved to be
more important. This system was intended to bring exchange rate stability to Europe by setting
up an exchange rate regime in which the currencies of participating European states would adjust
against one another within a fixed range rather than simply floating. The logic of European
monetary union had been seriously discussed since the early 1960s. After the creation of the

102
EMS that logic drew increasing support, particularly from the influential French policy-makers
who saw monetary union as a way of breaking free of the hegemony of Germanys central bank.
Under the Presidency of Jacques Delors, the EC devised a three-stage plan for European
monetary union.

At a meeting in Maastricht in 1991, European states entrenched in treaty form a timetable and set
of conditions for monetary union. Essentially, states wishing to be part of the union had to
commit themselves to the prevailing principles of macroeconomic orthodoxy; a low inflation
rate, reduced government deficits and the stabilization of their currency. The monetary union
would inevitably involve the creation of a single monetary authority for Europe and the
introduction of a single currency. On 1st January 1999 eleven countries participated in stage 3 of
the economic and monetary union by adopting the euro as their currency. As of November 2002,
there were another thirteen countries that had made application to join the European Union. Most
of these countries are on track to be admitted by 2004. It is expected by 2008 that there will be at
least thirty countries participating in the European Union all having a common currency, with
monetary policy being managed by the European Central Bank in Frankfurt, under the directive
of the European Parliament.

This thesis has identified some of the reasons why the European currency union has proved to be
so popular. The formation of a strong economic bloc has a stabilising effect. It does this by
eliminating room for speculative behaviour that has a tendency to encourage exchange rate
differentials. Additional to this is price transparency. People throughout Europe can now easily
compare the price of goods and services with their neighbours. This contributes to the efficient
use of resources, consumers are better off. The free market area allowed trade between nations to
flourish. It was shown empirically that the euro improved the economic condition of EU
members. Recalling Andrew Roses literature review of Chapter 4, he had already proved that
fact anyway, but this thesis looked at the same question from the different perspective of the
Efficient Market Hypothesis to come to the same conclusion. Charles Wyplosz subscribed that
by adopting the EMU the European countries achieved more stability than purely floating
regimes and suffered less at the speculators hands. Because price stability enhances economic
growth by minimising the uncertainty of investment decisions, the free market acting through
rational maximising behaviour optimises its output. Optimum output equates to the most
efficient allocation of scarce resources, if this can be achieved, social utility is maximised.
Pleasure is increased while pain is reduced. Tension becomes stability, scarcity gives way to

103
abundance and security over powers jeopardy. If society functions at its most productive and
efficient level, social utility is maximised and as such people should be most content.

The manner in which the euro has joined the countries of Europe is more than just living under
the same roof, it is about sharing a common vision and managing life together in a new free
market economic zone where national boarders no longer restrict the movement of labour or
capital. In parallel to the establishment of the Monetary Union, a move towards deeper political
integration is also occurring. Throughout the 1990s, the political and constitutional edifice of the
Union consolidated its power base. Today, the EU is faced with the challenge of devising a
viable, transparent and democratic structure for a political community that encompasses almost
the entire European continent, a job that is by no means a small task. Although some of the
fundamental regional issues still need to be resolved, there are conditions that stand out as
interesting, and eminently researchable. To the economist these areas provide ample room to
investigate the opportunities yet to be discovered beneath the opaque surface that could become
the tidal wave that sweeps the globe. Adopting a global currency is merely another step towards
humans realizing that they are all one species, living on one planet, running one race.

9.3 The value of tradition

The nations and generations who sow the seeds of progress do not always gather in the harvest,
but sooner or later the human race, as a whole enjoys and profits by what has been planted with
the blood and tears of a few. The assumption must be that those who can see value only in
tradition, or versions of it, deny humanitys ability to adapt to changing circumstances. In the
events of human affairs, 50 or 100 years is not a long time. If the process of international
financial integration, global economic stability and a single world currency is at all a remote
possibility - because empirical evidence shows that it is the most economically efficient
condition - then rational maximising behaviour would suggest that this course of action would
eventually be adopted. The question that needs to be answered is not how long it is going to take
but what plans and institutions can be created today to further such a cause? This thesis with the
help of such notables as John Stuart Mill, Harry Dexter White, John Maynard Keynes, Robert
Mundell, Charles Wyplosz and Andrew Rose suggests a starting point and directs us to the
challenges ahead. By being pro-active towards the implementation of economically efficient
goals, the development of the worlds international financial architecture for monetary policy
and financial stability for all the worlds people, will not be left to the whims of time, it shall be
something economists and political leaders can be instrumental in creating today for the world of
tomorrow.

104
105
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The Treaty of Rome establishing the European Atomic Energy Community (1957)

The Treaty of Rome establishing the European Economic Community (1957)

The Merger Treaty (1967)

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112
Electronic Journals

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OECD: Euro Area, Economic Survey series, Paris, 2001.

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International Monetary Fund, www.imf.org

Organisation for Economic Cooperation and Development, www.oecd.org

Reserve Bank of Australia, www.rba.gov.au

United Nations, www.un.org

United States of Americas Federal Reserve Board, www.federalreserve.gov

United States of Americas Central Intelligence Agency, www.cia.gov

World Bank, www.worldbank.org

World Trade Organisation web, www.wto.org

113
 Appendix A

114
Rats computer programme instructions

allocate 155
open data c:\andy\profit87.txt
data(format=free, org=obsn) / USD EUR UKP JPY
set y = USD
table / y
set trend = t
linreg y /
# constant y{1} trend

source(noecho) c:\rats\dfunit.src
source(noecho) c:\rats\ppunit.src

@dfunit(ttest,lags=0) y
@dfunit(ttest,lags=4) y
@dfunit(ttest,lags=8) y
@dfunit(ttest,lags=12) y

@dfunit(trend,lags=0,ttest) y 1 155
@dfunit(trend,lags=4,ttest) y 1 155
@dfunit(trend,lags=8,ttest) y 1 155

@ppunit(ttest,lags=0) y 1 155
@ppunit(ttest,lags=4) y 1 155
@ppunit(ttest,lags=8) y 1 155
@ppunit(ttest,lags=12) y 1 155

@ppunit(ttest,lags=0,trend) y
@ppunit(ttest,lags=4,trend) y
@ppunit(ttest,lags=8,trend) y

end stop

115
 Appendix B

116
Computer printouts of econometric results
European Currency Unit 1987 - 1990

Series Obs Mean Std Error Minimum Maximum

Y 155 -0.1135341935 0.0199419171 -0.1527000000 -0.0672000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 154 Degrees of Freedom 151
Centered R**2 0.910941 R Bar **2 0.909761
Uncentered R**2 0.997392 T x R**2 153.598
Mean of Dependent Variable -0.113751948
Std Error of Dependent Variable 0.019821241
Standard Error of Estimate 0.005954258
Sum of Squared Residuals 0.0053534308
Regression F(2,151) 772.2501
Significance Level of F 0.00000000
Durbin-Watson Statistic 2.118949

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant -0.007133087 0.002937372 -2.42839 0.01634122
2. Y{1} 0.944952130 0.024091584 39.22333 0.0000000
3. TREND 0.000007973 0.000010803 0.73796 0.46168360

Dickey-Fuller Test with 0 Lags = -2.25821

Dickey-Fuller Test with 4 Lags = -2.20058
Dickey-Fuller Test with 8 Lags = -2.10157
Dickey-Fuller Test with 12 Lags = -2.34314

Dickey-Fuller Test with 0 Lags = -2.28494

Dickey-Fuller Test with 4 Lags = -2.20493
Dickey-Fuller Test with 8 Lags = -2.14079

Phillips-Perron Test with 0 Lags = -2.25821

Phillips-Perron Test with 4 Lags = -2.38995
Phillips-Perron Test with 8 Lags = -2.43338
Phillips-Perron Test with 12 Lags = -2.46500

Phillips-Perron Test with 0 Lags = -2.28494

Phillips-Perron Test with 4 Lags = -2.40510
Phillips-Perron Test with 8 Lags = -2.43788

117
Computer printouts of econometric results
UK Pound 1987 1990

Series Obs Mean Std Error Minimum Maximum

Y 155 -0.0054864516 0.0085587813 -0.0244000000 0.0153000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 154 Degrees of Freedom 151
Centered R**2 0.089662 R Bar **2 0.077605
Uncentered R**2 0.352044 T x R**2 54.215
Mean of Dependent Variable -0.005423377
Std Error of Dependent Variable 0.008550487
Standard Error of Estimate 0.008212007
Sum of Squared Residuals 0.0101829967
Regression F(2,151) 7.4363
Significance Level of F 0.00083136
Durbin-Watson Statistic 2.084465

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant -0.002374999 0.001370435 -1.73303 0.08513271
2. Y{1} 0.265823208 0.078088664 3.40412 0.00085024
3. TREND -0.000020153 0.000015020 -1.34176 0.18168750

Dickey-Fuller Test with 0 Lags = -9.28161

Dickey-Fuller Test with 4 Lags = -3.79763
Dickey-Fuller Test with 8 Lags = -2.86335
Dickey-Fuller Test with 12 Lags = -2.57666

Dickey-Fuller Test with 0 Lags = -9.40184

Dickey-Fuller Test with 4 Lags = -4.01294
Dickey-Fuller Test with 8 Lags = -2.99618

Phillips-Perron Test with 0 Lags = -9.28161

Phillips-Perron Test with 4 Lags = -9.61633
Phillips-Perron Test with 8 Lags = -10.06714
Phillips-Perron Test with 12 Lags = -10.37607

Phillips-Perron Test with 0 Lags = -9.40184

Phillips-Perron Test with 4 Lags = -9.70616
Phillips-Perron Test with 8 Lags = -10.06119

118
Computer printouts of econometric results
US Dollar 1987 1990

Series Obs Mean Std Error Minimum Maximum

Y 155 0.0260567742 0.0312318207 -0.0364000000 0.0919000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 154 Degrees of Freedom 151
Centered R**2 0.897236 R Bar **2 0.895875
Uncentered R**2 0.940625 T x R**2 144.856
Mean of Dependent Variable 0.0264188312
Std Error of Dependent Variable 0.0310056600
Standard Error of Estimate 0.0100050221
Sum of Squared Residuals 0.0151151705
Regression F(2,151) 659.1954
Significance Level of F 0.00000000
Durbin-Watson Statistic 2.108848

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant 0.002884829 0.001783368 1.61763 0.10782948
2. Y{1} 0.938228032 0.025863264 36.27647 0.00000000
3. TREND -0.000009984 0.000018143 -0.55032 0.58291068

Dickey-Fuller Test with 0 Lags = -2.37959

Dickey-Fuller Test with 4 Lags = -2.56361
Dickey-Fuller Test with 8 Lags = -2.29152
Dickey-Fuller Test with 12 Lags = -2.33238

Dickey-Fuller Test with 0 Lags = -2.38841

Dickey-Fuller Test with 4 Lags = -2.59150
Dickey-Fuller Test with 8 Lags = -2.34254

Phillips-Perron Test with 0 Lags = -2.37959

Phillips-Perron Test with 4 Lags = -2.45298
Phillips-Perron Test with 8 Lags = -2.51951
Phillips-Perron Test with 12 Lags = -2.52768

Phillips-Perron Test with 0 Lags = -2.38841

Phillips-Perron Test with 4 Lags = -2.45544
Phillips-Perron Test with 8 Lags = -2.51181

119
Computer printouts of econometric results
Japanese Yen 1987 1990

Series Obs Mean Std Error Minimum Maximum

Y 155 1.7375561290 1.8948348319 -2.5261000000 6.6866000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 154 Degrees of Freedom 151
Centered R**2 0.063326 R Bar **2 0.050920
Uncentered R**2 0.489483 T x R**2 75.380
Mean of Dependent Variable 1.7272064935
Std Error of Dependent Variable 1.8966165578
Standard Error of Estimate 1.8476981962
Sum of Squared Residuals 515.51228227
Regression F(2,151) 5.1043
Significance Level of F 0.00716032
Durbin-Watson Statistic 2.062900

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant 1.620851933 0.346870421 4.67279 0.00000653
2. Y{1} 0.225760769 0.079191807 2.85081 0.00497117
3. TREND -0.003638704 0.003375331 -1.07803 0.28274001

Dickey-Fuller Test with 0 Lags = -9.71291

Dickey-Fuller Test with 4 Lags = -3.82154
Dickey-Fuller Test with 8 Lags = -2.77975
Dickey-Fuller Test with 12 Lags = -2.19703

Dickey-Fuller Test with 0 Lags = -9.77676

Dickey-Fuller Test with 4 Lags = -3.87318
Dickey-Fuller Test with 8 Lags = -2.82738

Phillips-Perron Test with 0 Lags = -9.71291

Phillips-Perron Test with 4 Lags = -9.96330
Phillips-Perron Test with 8 Lags = -10.33137
Phillips-Perron Test with 12 Lags = -10.65782

Phillips-Perron Test with 0 Lags = -9.77676

Phillips-Perron Test with 4 Lags = -10.03556
Phillips-Perron Test with 8 Lags = -10.39782

120
Computer printouts of econometric results
EMU Euro 1999 2002

Series Obs Mean Std Error Minimum Maximum

Y 193 0.0029243523 0.0071501222 -0.0148000000 0.0268000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 192 Degrees of Freedom 189
Centered R**2 0.519398 R Bar **2 0.514312
Uncentered R**2 0.586637 T x R**2 112.634
Mean of Dependent Variable 0.0028635417
Std Error of Dependent Variable 0.0071186007
Standard Error of Estimate 0.0049610442
Sum of Squared Residuals 0.0046516604
Regression F(2,189) 102.1285
Significance Level of F 0.00000000
Durbin-Watson Statistic 2.134576

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant 5.9046e-003 1.0132e-003 5.82745 0.00000002
2. Y{1} 0.4464 0.0651 6.85652 0.00000000
3. TREND -4.4863e-005 8.3374e-006 -5.38092 0.00000022

Dickey-Fuller Test with 0 Lags = -6.14773

Dickey-Fuller Test with 4 Lags = -1.93327
Dickey-Fuller Test with 8 Lags = -1.32353
Dickey-Fuller Test with 12 Lags = -1.36364

Dickey-Fuller Test with 0 Lags = -8.50350

Dickey-Fuller Test with 4 Lags = -3.25322
Dickey-Fuller Test with 8 Lags = -2.44604

Phillips-Perron Test with 0 Lags = -6.14773

Phillips-Perron Test with 4 Lags = -5.96527
Phillips-Perron Test with 8 Lags = -6.74972
Phillips-Perron Test with 12 Lags = -7.49533

Phillips-Perron Test with 0 Lags = -8.50350

Phillips-Perron Test with 4 Lags = -8.79046
Phillips-Perron Test with 8 Lags = -9.61813

121
Computer printouts of econometric results
UK Pound 1999 2002

Series Obs Mean Std Error Minimum Maximum

Y 193 -0.0012689119 0.0045994301 -0.0169000000 0.0133000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 192 Degrees of Freedom 189
Centered R**2 0.037331 R Bar **2 0.027144
Uncentered R**2 0.101107 T x R**2 19.412
Mean of Dependent Variable -0.001187500
Std Error of Dependent Variable 0.004469858
Standard Error of Estimate 0.004408777
Sum of Squared Residuals 0.0036736517
Regression F(2,189) 3.6646
Significance Level of F 0.02745270
Durbin-Watson Statistic 2.028771

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant 3.2007e-004 6.4384e-004 0.49712 0.61968195
2. Y{1} 0.0202 0.0700 0.28853 0.77325515
3. TREND -1.5203e-005 5.8058e-006 -2.61850 0.00954802

Dickey-Fuller Test with 0 Lags = -13.54346

Dickey-Fuller Test with 4 Lags = -4.53398
Dickey-Fuller Test with 8 Lags = -3.73027
Dickey-Fuller Test with 12 Lags = -3.21407

Dickey-Fuller Test with 0 Lags = -13.98749

Dickey-Fuller Test with 4 Lags = -4.95035
Dickey-Fuller Test with 8 Lags = -4.28373

Phillips-Perron Test with 0 Lags = -13.54346

Phillips-Perron Test with 4 Lags = -13.66266
Phillips-Perron Test with 8 Lags = -13.89547
Phillips-Perron Test with 12 Lags = -14.01337

Phillips-Perron Test with 0 Lags = -13.98749

Phillips-Perron Test with 4 Lags = -14.00530
Phillips-Perron Test with 8 Lags = -14.08872

122
Computer printouts of econometric results
US Dollar 1999 2002

Series Obs Mean Std Error Minimum Maximum

Y 193 0.56863989637 0.05483385810 0.48480000000 0.66620000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 192 Degrees of Freedom 189
Centered R**2 0.976741 R Bar **2 0.976495
Uncentered R**2 0.999787 T x R**2 191.959
Mean of Dependent Variable 0.5683307292
Std Error of Dependent Variable 0.0548083003
Standard Error of Estimate 0.0084027826
Sum of Squared Residuals 0.0133446769
Regression F(2,189) 3968.5277
Significance Level of F 0.00000000
Durbin-Watson Statistic 2.061712

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant 0.020784765 0.013273892 1.56584 0.11905932
2. Y{1} 0.966557309 0.020344260 47.51007 0.00000000
3. TREND -0.000022813 0.000020112 -1.13429 0.25811096

Dickey-Fuller Test with 0 Lags = -1.27123

Dickey-Fuller Test with 4 Lags = -1.26001
Dickey-Fuller Test with 8 Lags = -1.07412
Dickey-Fuller Test with 12 Lags = -1.14008

Dickey-Fuller Test with 0 Lags = -1.64384

Dickey-Fuller Test with 4 Lags = -1.75960
Dickey-Fuller Test with 8 Lags = -1.38779

Phillips-Perron Test with 0 Lags = -1.27123

Phillips-Perron Test with 4 Lags = -1.28430
Phillips-Perron Test with 8 Lags = -1.26099
Phillips-Perron Test with 12 Lags = -1.20298

Phillips-Perron Test with 0 Lags = -1.64384

Phillips-Perron Test with 4 Lags = -1.72988
Phillips-Perron Test with 8 Lags = -1.71777

123
Computer printouts of econometric results
Japanese Yen 1999 2002

Series Obs Mean Std Error Minimum Maximum

Y 193 1.5035077720 1.0746201438 -0.3214000000 4.5698000000

Dependent Variable Y - Estimation by Least Squares

Usable Observations 192 Degrees of Freedom 189
Centered R**2 0.676816 R Bar **2 0.673396
Uncentered R**2 0.890540 T x R**2 170.984
Mean of Dependent Variable 1.5003333333
Std Error of Dependent Variable 1.0765219532
Standard Error of Estimate 0.6152242874
Sum of Squared Residuals 71.536674610
Regression F(2,189) 197.9033
Significance Level of F 0.00000000
Durbin-Watson Statistic 2.237478

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant 0.557845842 0.143118490 3.89779 0.00013472
2. Y{1} 0.766245386 0.046784147 16.37831 0.00000000
3. TREND -0.002203192 0.000903531 -2.43842 0.01567591

Dickey-Fuller Test with 0 Lags = -4.30770

Dickey-Fuller Test with 4 Lags = -2.88064
Dickey-Fuller Test with 8 Lags = -3.07203
Dickey-Fuller Test with 12 Lags = -2.59784

Dickey-Fuller Test with 0 Lags = -4.99645

Dickey-Fuller Test with 4 Lags = -3.40997
Dickey-Fuller Test with 8 Lags = -3.52609

Phillips-Perron Test with 0 Lags = -4.30770

Phillips-Perron Test with 4 Lags = -4.02809
Phillips-Perron Test with 8 Lags = -4.27833
Phillips-Perron Test with 12 Lags = -4.45433

Phillips-Perron Test with 0 Lags = -4.99645

Phillips-Perron Test with 4 Lags = -4.85720
Phillips-Perron Test with 8 Lags = -5.15103

124
 Appendix C

125
Sample of Econometric Reasoning
US Dollar 1987 - 1990

allocate 155
open data c:\andy\profit87.txt
data(format=free, org=obsn) / USD EUR UKP JPY
set y = USD
table / y

Series Obs Mean Std Error Minimum Maximum

Y 155 0.0260567742 0.0312318207 -0.0364000000 0.0919000000

*Unit Root Test

we do Ho: nonstationary testing

H1: stationary

* Augmented Dickey-Fuller Test, tests constant & trend ie; ao and a1 in;

Yt = ao + a1Yt-1 + a2t + et

Ho: a1 = a2 = 0

If a1 < 1 the y series is stationary. The ADF test allows us to test for
nonstationarity by testing the null hypothesis that a1 = 1 against the
alternative that a1 < 1.

Ho: a1 = 1 means if a1 is equal to 1 the data exhibits random walk.

This test can be put into a convenient form by subtracting yt-1 from both
sides of equation (1) to obtain
yt - yt-1 = a yt-1 - yt-1 + et
yt = (a - 1)yt-1 + et
yt = L yt-1 + et

Where yt = yt - yt-1 and L = a - 1.

We test for nonstationarity by testing the null hypothesis that a1 = 1

The hypothesis Ho : a1 = 1 thus becomes Ho : L = 0 and
The alternative H1 : a1 < 1 thus becomes H1 : L < 0

If yt follows a random walk ie. nonstationary, then L = 0 and

yt = yt - yt-1 = et.

The decision rule is if we reject the hypothesis Ho : L = 0 we can assume

that the data is stationary.

To test the hypothesis Ho : L = 0 we estimate by least squares

and examine the t-statistic. However, if the null hypothesis is true,
ie Ho : L = 0 meaning that the yt series follows a random walk,

126
then the t-statistic no longer has a t-distribution.

Consequently this statistic must be compared to the specially constructed

T(tau) critical values.

set trend = t
linreg y /
# constant y{1} trend

Dependent Variable Y - Estimation by Least Squares

Usable Observations 154 Degrees of Freedom 151
Centered R**2 0.897236 R Bar **2 0.895875
Uncentered R**2 0.940625 T x R**2 144.856
Mean of Dependent Variable 0.0264188312
Std Error of Dependent Variable 0.0310056600
Standard Error of Estimate 0.0100050221
Sum of Squared Residuals 0.0151151705
Regression F(2,151) 659.1954
Significance Level of F 0.00000000
Durbin-Watson Statistic 2.108848

Variable Coeff Std Error T-Stat Signif

*****************************************************************************
1. Constant 0.002884829 0.001783368 1.61763 0.10782948
2. Y{1} 0.938228032 0.025863264 36.27647 0.00000000
3. TREND -0.000009984 0.000018143 -0.55032 0.58291068

Where Constant = a0
Y{1} = a1
TREND = a2

Substituting these values into the original equation

Yt = ao + a1Yt-1 + a2t + et

Yt = 0.00288 + 0.93822Yt-1 + -0.00000t + et

s.e. (0.00178) (0.02586) (0.00001)

source(noecho) c:\rats\dfunit.src
source(noecho) c:\rats\ppunit.src
@dfunit(ttest,lags=0) y
Dickey-Fuller Test with 0 Lags = -2.37959
@dfunit(ttest,lags=4) y
Dickey-Fuller Test with 4 Lags = -2.56361
@dfunit(ttest,lags=8) y
Dickey-Fuller Test with 8 Lags = -2.29152
@dfunit(ttest,lags=12) y
Dickey-Fuller Test with 12 Lags = -2.33238
@dfunit(trend,lags=0,ttest) y 1 155

127
Dickey-Fuller Test with 0 Lags = -2.38841
@dfunit(trend,lags=4,ttest) y 1 155
Dickey-Fuller Test with 4 Lags = -2.59150
@dfunit(trend,lags=8,ttest) y 1 155
Dickey-Fuller Test with 8 Lags = -2.34254

@ppunit(ttest,lags=0) y 1 155
Phillips-Perron Test with 0 Lags = -2.37959
@ppunit(ttest,lags=4) y 1 155
Phillips-Perron Test with 4 Lags = -2.45298
@ppunit(ttest,lags=8) y 1 155
Phillips-Perron Test with 8 Lags = -2.51951
@ppunit(ttest,lags=12) y 1 155
Phillips-Perron Test with 12 Lags = -2.52768

@ppunit(ttest,lags=0,trend) y
Phillips-Perron Test with 0 Lags = -2.38841
@ppunit(ttest,lags=4,trend) y
Phillips-Perron Test with 4 Lags = -2.45544
@ppunit(ttest,lags=8,trend) y
Phillips-Perron Test with 8 Lags = -2.51181

** Phillips-Perron Test

does not care if the errors are correlated

ie; this series is more powerfull than D-F
when heteroskedastisity is present.

* The Critical tau-test for sample size 200 at 10% sig = -2.88
* As all values fall inside the critical value, we accept the Ho:L=0
* This means that the US dollar data for the 1987 - 90 period
is nonstationary. This is indicated by the coefficient value of y{1} being almost 1

By using the D-F test and the Phillips-Perron test we came to the same result.
The results were similar giving the same conclusion. This suggested that the data
was not heteroskedastic. If it was the Phillips-Perron test would have been different.

end xxx

128
 Appendix D

129
130
The Big Mac Index

The Economists Big Mac index was first launched in 1986 as a gastronomes guide to whether
currencies were at their correct exchange rate. It was never intended to be a precise predictor of
currency movements, but simply a way to make exchange-rate theory a bit more digestible.

Burgernomics is based upon one of the oldest concepts in international economics: the theory of
purchasing-power parity (PPP). This argues that the exchange rate between two currencies
should in the long run move towards the rate that equalises the prices of identical bundles of
traded goods and services in each country. In other words, a dollar should buy the same amount
everywhere.

Our bundle is a McDonalds Big Mac, which is produced to more or less the same recipe in
about 120 countries. The Big Mac PPP is the exchange rate that would leave hamburgers costing
the same in each country. Comparing a currencys actual exchange rate with its PPP is one test
of whether the currency is undervalued or overvalued.

The first column of the table shows local-currency prices of a Big Mac; the second converts them
into dollars. The average price of a Big Mac in America is $2.54 (including sales tax). In China,
Big Mac scoffers have to pay Yuan 9.90, or $1.20 at 2001 exchange rates. The third column
calculates PPPs. Dividing the Yuan price by the dollar price gives a Big Mac PPP of Yuan3.90.
Comparing that with the exchange rate of Yuan 8.28 implies that the Yuan is 53 per cent
undervalued comparable to Australias own situation of being 40 per cent undervalued.

Judging by the number of countries that have a negative sign in front of them in the last column,
that is 28 out of 31, it would tend to suggest that the US dollar is grossly overvalued when
compared to the majority of the worlds currencies.

Given that on average the US dollar is overvalued by 28 per cent in relation to other currencies,
this adjustment would decrease the value of the US dollar. If the US currency was devalued by
28 per cent US GDP would drop from US$10.374 Trillion to US$7.45 Trillion.

Conclusion: The US may be living with a false sense of their currencys value.

131
 Glossary of terms

Arbitrage
The buying or selling of stocks or bills of exchange to take advantage of varying prices in
different markets.

Basis
The local cash market price minus the price of the nearby futures contract.

Basis contract
A forward contract in which the cash price is based on the basis relating to a specified futures
contract.

Bid
The price that the market participants are willing to pay.

Bid ask spread

The price that the market participants are willing to pay minus the price that sellers ask.

Breakaway gap
A gap in prices that signals the end of a price pattern and the beginning of an important market
move.

Call
An option to buy a commodity, security or futures contract at a specified price any time between
now and the expiration date of the option contract.

Call value
At expiration, the call value is equal to the futures price minus the strike price of the call.

Cash price
Current market price of the actual physical commodity. Also called the spot price.

Cash settlement
Final disposition of open positions on the last trading day of a contract month. Occurs in markets
where there is no actual delivery.

Contract
The smallest unit of an instrument that can be traded. A future is specified by its contract month.
An option is specified by its contract month, strike price and whether it is a put or a call.

Deferred pricing agreement

A cash sale in which you deliver the commodity and agree with the buyer to price it at a later
time.

Delivery
The tender and receipt of an actual commodity of financial instrument in settlement of a futures
contract.

132
Demand
The quantity of a commodity that buyers are willing to purchase from the market at a given
price.

Economic and Monetary Union (EMU)

The Treaty establishing the European Community set out the process of achieving Economic and
Monetary Union in the European Union in three stages.

Stage One of EMU started in July 1990 and ended on 31st December 1993. It was
mainly characterised by the dismantling of all internal barriers to the free
movement of capital within the European Union.

Stage Two began on 1st January 1994. It provided for, inter alia, the establishment
of the European Monetary Institute (the forerunner of the European Central
Bank), the prohibition of financing of the public sector by the central banks and of
privileged access to financial institutions for the public sector, and the avoidance
of excessive deficits.

Stage Three started on 1st January 1999 with the transfer of monetary competence
to the Eurosystem and the introduction of the euro.

Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis asserts that the current price of an asset should embody all
relevant information that is available. A market in which the actual price embodies all currently
available information is called an efficient market. In an efficient market, it is impossible to
forecast changes in price.

End-of-day balance
End-of-day balance means the balance at the point in time when the finalisation of payment
activities and entries related to possible access to the standing facilities of the European System
of Central Banks (ESCB) has taken place.

Euro
The euro is the single European currency used instead of the ECU (see below). The euro was
launched on 1st January 1999 in 11 EU member states: Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, Portugal, Spain and the Netherlands. The twelfth country
Greece, adopted the euro on 1st January 2001.The tangible currency went into circulation
throughout the euro zone on the 1st January 2002.

Euro area euro zone

The euro area encompasses those Member States of the European Union in which the euro has
been adopted as the single currency and in which a single monetary policy, in accordance with
the Maastricht Treaty, is conducted under the responsibility of the decision-making bodies of the
European Central Bank. The euro area currently comprises Austria, Belgium, Finland, France,
Germany, Greece, Ireland, Italy, Luxembourg, Portugal, Spain and the Netherlands.

Euro overnight index average (EONIA)

EONIA is an interbank overnight interest rate index compiled by the ECB. The EONIA swap
market is considered the largest overnight swap market in the world.

133
Euro symbol ()
The graphic symbol for the euro was inspired by the Greek letter epsilon and refers to the first
letter of the word Europe. The parallel lines represent the stability of the euro. The official
abbreviation for the euro is EUR, which has been registered with the International Organization
for Standardization (ISO) and is used for business, financial and commercial purposes.

Euroization
During the transition period from 1st January 1999 to 1st January 2002 when the euro co-existed
with the existing European currencies, profit opportunities were being exploited on the differing
values of the currencies. Euroization was the 2001 procedure whereby the European Parliament
and the ECB wanted to achieve a credible commitment not to debase the new currency, and so
proposed a completely euro-based system through law, enforcing the complete linking of banks
assets and liabilities to the euro and not to the individual currencies.

European Central Bank (ECB)

The European Central Bank was established on 1st June 1998 and is situated in Frankfurt am
Main, Germany. It ensures that the tasks conferred upon the Eurosystem and the European
System of Central Banks (ESCB) are implemented either by its own activities pursuant to the
Statute of the ESCB or through the national central banks.

European Central Bank Decision Making Board

Governing Council
The Governing Council comprises all the members of the
Executive Board and the Governors of the national central
banks of the member states which have adopted the euro.

Executive Board
The Executive Board comprises the President and the Vice-
President of the ECB and four other members appointed by
the Heads of State or Government of the member states
which have adopted the euro.

General Council
The General Council comprises the President and the Vice-
President of the ECB and the governors of all the national
central banks of the member states of the European Union.

European Currency Unit (ECU)

The European Currency Unit was the precursor of the euro. The ECU was a basket currency
made up of the sum of fixed amounts of 12 (Belgium, Denmark, France, Germany, Greece,
Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain and United Kingdom) of the 15
currencies of the European Union (EU) member states. The value of the ECU was calculated as a
weighted average of the value of its component currencies. The ECU was replaced by the euro
on a one-for-one basis on 1st January 1999.

European Investment Bank (EIB)

The European Investment Bank finances capital investment projects which further the European
Union (EU) policy objectives. It also participates in the implementation of the EUs cooperation

134
policy towards third countries. In South-East Europe, the EIB operates under the Mandate for
Central and Eastern Europe agreed by the Council of Ministers. Under its i2i programme, EIB
is to lend up to EUR 12-15 billion over the years 2000-2003. EIB Group contributed to this
objective through its long-term loans and the strengthened capacity of the European Investment
Fund to support investment helping to reinforce the capital base of innovative SMEs. The EIB
plays an active role in the preparation of the reconstruction investment programme, in
cooperation with the European Commission and the other multilateral financing institutions.

European System of Central Banks (ESCB)

The European System of Central Banks (ESCB) comprises the ECB and the national central
banks of all 15 member states of the European Union. It includes, in addition to the members of
the Eurosystem, the national central banks of the member states which have not adopted the
euro. The ESCB is governed by the Governing Council, the Executive Board and the General
Council of the ECB. Its primary objective is to maintain price stability but tasks also include;

to define and implement the monetary policy of the Community;

to conduct foreign exchange operations;
to hold and manage the official foreign reserves of the member states;
to promote the smooth operation of payment systems.

Eurosystem
The Eurosystem comprises the European Central Bank (ECB) and the national central banks of
the member states which have adopted the euro in Stage Three of Economic and Monetary
Union (EMU). There are currently 12 national central banks in the Eurosystem. The Eurosystem
is governed by the Governing Council and the Executive Board of the ECB and has assumed the
task of conducting the single monetary policy for the euro area since 1 January 1999.

Fiat money
Fiat money is an intrinsically worthless or almost worthless commodity that serves the function
of being an accepted medium of exchange. Example; paper with pictures and numbers printed on
it.

Forward contract
A private agreement between buyer and seller for the future delivery of a commodity at an
agreed price.

Fundamental analysis
The study of supply and demand information to help project futures prices.

Futures
A term used to designate all contracts covering the purchase and sale of financial instruments or
physical commodities for future delivery, at a specified price, on a specified date conducted
through a commodity futures exchange.

Futures contract
A standardized agreement, traded on a futures exchange, to buy or sell a commodity at a
specified price at a date in the future. Specifies the commodity, quality, quantity, delivery date
and delivery point or cash settlement.

135
General Agreement on Tariffs and Trade (GATT)
GATT was established in the wake of the Second World War and first signed in 1947 by
participating UN member nations. The agreement was designed to provide an international
forum that encouraged free trade between member states by regulating and reducing tariffs on
traded goods and by providing a common mechanism for resolving trade disputes. GATT
membership reached more than 110 countries in 1993 before being superseded by the World
Trade Organization in 1995.

Gross Domestic Product (GDP)

Gross Domestic Product, or GDP for short, measures the value of a nations output of goods and
services for some period of time, usually a year. It is not the only measure of output - but the
GDP has become a favourite among economists because it is the most comprehensive of output
measures. In arriving at GDP, the Australian Bureau of Statistics is careful not to double count
transactions. If it counted the sale of steel to General Motors Holden from BHP and also the
value of the cars that GMH produced, it would count the steel twice, once in an unfinished form,
and once in a finished form. In practice it avoids double counting by only including the value
added at each stage of production. Value added is sales minus the cost of raw materials and
unfinished goods.

Hedge
The purchase or sale of a futures contract as a temporary substitute for a cash market transaction
to be made at a later date. Usually it involves opposite positions in the cash market and futures
market at the same time.

Hedging
The purchase or sale of a futures contract as a temporary substitute for a cash market transaction
to be made at a later date.

Institution
Institution is any entity in a participating member state which the ECB, under the terms of
Article 19.1 of the Statute, may require to hold minimum reserves.

Intra-area trade
Flows of exports and imports within a given region or group of countries.

Irrevocable conversion rates

The irrevocable euro/ national currency conversion rates used to define the euro on 1 January
1999 (2001 for Greece) were the following:

Austrian schilling 13.7603 Belgian franc 40.3399

Finish markka 5.94573 French franc 6.55957
Deutsche mark 1.95583 Greece drachma 340.750
Irish pound 0.787564 Italian lira 1936.27
Luxembourg franc 40.3399 Netherlands guilder 2.20371
Portuguese escudo 200.482 Spanish peseta 166.386

Least Squares Method

The Least Squares Method, or linear regression, is the most accurate of all the equation
determination methods. The least squares parameter estimation method is a variation of the
probability plotting methodology in which one mathematically fits a straight line to a set of

136
points in an attempt to estimate the parameters. The method of least squares requires that a
straight line be fitted to a set of data points such that the sum of the squares of the vertical
deviations from the points to the line is minimized, if the regression is on Y, or the line be fitted
to a set of data points such that the sum of the squares of the horizontal deviations from the
points to the line is minimized, if the regression is on X.

Leverage
The use of a small amount of assets to control a greater amount of assets.

Long
One who has bought a futures or options on futures contract to establish a market position and
who has not yet closed out this position through an offsetting procedure. The opposite of short.

Maintenance period
Maintenance period is the period over which compliance with reserve requirements is calculated
and for which such minimum reserves must be held on reserve accounts.

Money
Money encompasses a number of different functions that correspond generally to the classic uses
of money as a medium of exchange, a unit of account, a standard of deferred payment and a store
of value. Money can have various meanings so it is important to distinguish between each type.

Narrow money (M1)

Narrow money includes currency, i.e. banknotes and coins, as well as balances
which can immediately be converted into currency or used for cashless payments,
i.e. overnight deposits.

Intermediate money (M2)

Intermediate money comprises narrow money (M1) and, in addition, deposits
with a maturity of up to two years and deposits redeemable at a period of notice
of up to three months. Depending on their degree of moneyness, such deposits can
be converted into components of narrow money, but in some cases there may be
restrictions involved, such as the need for advance notification, delays, penalties
or fees. The definition of M2 reflects the particular interest in analysing and
monitoring a monetary aggregate that, in addition to currency, consists of deposits
which are liquid.

Broad money (M3)

M3 comprises M2 and marketable instruments issued by the MFI sector. Certain
money market instruments, in particular money market fund (MMF) shares/units
and money market paper, and repurchase agreements are included in this
aggregate. A high degree of liquidity and price certainty make these instruments
close substitutes for deposits. As a result of their inclusion, M3 is less affected by
substitution between various liquid asset categories than narrower definitions of
money, and is therefore more stable.

Optimal Currency Area

The optimal currency area theory defines a set of mechanisms that might be set in motion when a
participating country or region, in a monetary union, is hit by an asymmetric shock. First,
adjustment to the shock might come from domestic price or wage changes, thereby altering the
real exchange rate without changing the nominal exchange rate. Secondly, migration of

137
production factors might act as an adjustment channel. These flows of labour and capital are
facilitated by a high degree of economic and financial integration of the countries participating in
the union. In addition to this, the theory of optimal currency areas has also something to say on
the similarity of shocks affecting countries or regions in a monetary union. In this respect, the
degree of trade and financial integration are often considered. Trade and financial integration
may tend to lead to more similar economic developments in the respective countries or regions in
a monetary union, reducing the likelihood of asymmetric shocks and increasing the economies
abilities to adjust to these shocks.

Offer
Indicates a willingness to sell a futures contract at a given price.

Offset
Selling if one has bought, or buying if one has sold, a futures or options on futures contract.

Offsetting a hedge
For a short hedger, to buy back futures and sell a commodity. For a long hedger, to sell back
futures and buy a commodity.

Offsetting a long option

Offset a put by selling a put with the same strike price. Offset a call by selling a call with the
same strike price.

Option
The right, but not the obligation, to sell or buy the underlying (in this case, a futures contract) at
a specified price within a specified time.

Organization for Economic Cooperation and Development (OECD)

The Organization for Economic Cooperation and Development is an international organization
set up to attain the highest possible sustainable rate of growth among its member countries
consistent with maintaining financial stability, to expand world trade on a multilateral, non-
discriminatory basis, and to contribute via development to the expansion of employment and
living standards everywhere.

Originally set up as the Organization for European Economic Cooperation (OEEC) to coordinate
Marshall Plan aid in 1948, the OECD took on its present form in 1961, once the task of
reconstruction was accomplished. Today the membership includes 25 countries: Australia,
Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy,
Japan, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden,
Switzerland, Turkey, the United Kingdom, and the United States.

Out-of-the-money
An option with no intrinsic value. A call option with a strike price greater than the underlying
futures price. A put option with a strike price less than the underlying futures price.

Participating Member State

Participating member state means an EU member state which has adopted the single currency in
accordance with the Treaty.

138
Participating National Central Bank
Participating national central bank (participating NCB) is the national central bank of a
participating member state.

Premium
The amount agreed upon between the buyer and seller for the purchase or sale of a futures option
the buyer pays the premium and the seller receives the premium. The excess of one futures
contract price over that of another or over the cash market price.

Purchasing Power Parities (PPPs)

Rates of currency conversion that equalize the purchasing power of different currencies by
eliminating the differences in price levels between countries. In their simplest form, PPPs are
simply price relatives which show the ratio of the prices in national currencies of the same good
or service in different countries. The major use of PPPs is as a first step in making inter-country
comparisons in real terms of gross domestic product (GDP) and its component expenditures.

Put option
An option granting the right, but not the obligation, to sell a futures contract at the stated price
prior to the expiration of the option.

Random walk
Random walk is the term given to the path of an asset price that demonstrates a random
stochastic movement over time.

Random walk hypothesis

The random walk hypothesis is a variant of the efficient market hypothesis and scrutinises the
movements of specified prices over time. It holds that stock prices follow a random walk pattern
and, consequently, historic prices are of no value in forecasting future prices.

Reserve account
Reserve account is an institutions account with a participating NCB, the end-of-day balance of
which counts towards fulfilment of the institutions reserve requirement.

Reserve ratio
Reserve ratio is the percentage specified in Article 4 for any particular item in the reserve base.

Reserve requirement
Reserve requirement is the requirement for institutions to hold minimum reserves on reserve
accounts with participating NCBs.

Scalp
To trade for small gains. Scalping normally involves establishing and liquidating a position
quickly, usually within the same day, hour or even just a few minutes.

Security
Property which is pledged as collateral for a loan. Or an investment instrument, other than an
insurance policy or fixed annuity, issued by a corporation, government, or other organization
which offers evidence of debt or equity. These include any note, stock, treasury stock, bond,
debenture, certificate of interest or participation in any profit-sharing agreement, transferable
share, investment contract, voting-trust certificate, certificate of deposit, or any put, call,
straddle, option, or privilege entered into on a national securities exchange relating to foreign

139
currency. but shall not include currency or any note, draft, bill of exchange exceeding nine
months.

Seigniorage
Seigniorage is the process of making a profit by issuing currency. Historically this was done
when a government issued coins rated above their intrinsic value. Today fiat money is employed
to achieve the same result.

Selective hedger
A person who hedges only when he or she believes that prices are likely to move against him or
her.

Selling climax
An extraordinarily high volume occurring suddenly in a downtrend signalling the end of the
trend.

Settlement price
A figure determined by the closing range that is used to calculate gains and losses in futures
market accounts, performance bond calls and invoice prices for deliveries.

Short
One who has sold a futures contract to establish a market position and who has not yet closed out
this position through an offsetting procedure. The opposite of long.

Short hedge
The sale of a futures contract in anticipation of a later cash market sale. Used to eliminate or
lessen the possible decline in value of ownership of an approximately equal amount of the cash
financial instrument or physical commodity.

Speculator
One who attempts to anticipate price changes and, through buying and selling futures contracts,
aims to make profits. Does not use the futures market in connection with the production,
processing, marketing or handling of a product. The speculator has no interest in taking delivery.

Spot Price
Current market price of the actual physical commodity. Also called the cash price.

Spread
The price difference between two contracts. Holding a long and a short position in two related
futures or options on futures contracts, with the objective of profiting from a changing price
relationship.

System transaction
An instruction to a computer system to take an action once a specified price is attained.
Examples of system transactions include an order to buy or sell a contract, to cancel an order, or
to modify an order. For electronic trading systems, a key measure of performance capacity is the
number of transactions per second (TPS) i.e., the number of bids and offers the system can
process.

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Target price
An expected selling or buying price. For long and short hedges with futures: Futures Price +
Expected Basis. For puts: Futures Price - Premium + Expected Basis. For calls: Futures Price +
Premium + Expected Basis.

The Four
Refers to the four countries that made application to join the original six countries that made up
the original European Communities. The four countries were: Denmark, Ireland, Norway and the
United Kingdom.

The Six
Refers to the six countries that signed the Treaty of Paris establishing the European Coal and
Steel Community (ECSC) in 1951. The countries were: Belgium, France, Germany, Italy,
Luxembourg and Netherlands.

Time series
A time series is a set of values recorded over time. The values can relate to any set of data and
can be represented in graphical form plotted on the Y vertical axis. Time is plotted on the X
horizontal axis.

Treaty on European Union

The Treaty on European Union, was agreed to in December 1991 and signed in Maastricht, The
Netherlands, on 7th February 1992. This treaty became known as the Maastricht Treaty.

Unit root
A unit root is a mathematical representation of a time series coefficient having a value equal to 1.
In the time series equation yt = yt-1 + t if = 1 the series is said to have a unit root because
the coefficient = 1. In econometrics the presence of a unit root in a model signifies that the
series follows a random stochastic movement, meaning it is nonstationary.

United Nations (UN)

The United Nations was established on 24th October 1945 by 51 countries committed to
preserving peace through international cooperation and collective security. Today, nearly every
nation in the world belongs to the UN: membership now totals 189 countries. UN member States
are independent sovereign nations and while each nation maintains its own identity, most nations
collectively participate in principle with each UN directive. The United Nations is central to
global efforts to solve problems, which challenge humanity. Cooperating in this effort are more
than 30 affiliated organizations, known together as the UN system. At present, the UN does not
make compulsory binding laws by which member nations must comply, but it has exerted its
power on numerous occasions especially with the use of military force to ensure regional peace
keeping initiatives are implemented.

Volatility
An annualised measure of the fluctuation in the price of a futures contract. Historical volatility is
the actual measure of futures price movement from the past. Implied volatility is a measure of
what the market implies it is, as reflected in the options price.

Volume index
Most commonly presented as a weighted average of the proportionate changes in the quantities
of a specified set of goods or services between two periods of time; volume indices may also
compare the relative levels of activity in different countries.

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World Trade Organization (WTO)
The WTO came into being in 1995 and is the successor to the General Agreement on Tariffs and
Trade. While the WTO is still relatively young, the multilateral trading system that was
originally set up under GATT had already operated for 54 years. GATT and the WTO have
helped to create a strong and prosperous trading system contributing to unprecedented economic
growth throughout the world. Merchandise exports grew on average by 6% annually. Total trade
in 1997 was 14-times the level of 1950. The system was developed through a series of trade
negotiations, or rounds, held under GATT. The first rounds dealt mainly with tariff reductions
but later negotiations included other areas such as anti-dumping and non-tariff measures. The
last round between 198694 called the Uruguay Round led to the WTOs creation.

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