Barry Eichengreen at the MWP on monetary unions and the impact of new technology on foreign exchange markets

A briefing by MW Fellow Gary Winslett (RSC)

Barry Eichengreen (University of California, Berkeley) is one of the world’s foremost scholars on international finance, currency markets, and the history of the international monetary system. He visited the EUI and gave both a Master Class and a Max Weber Lecture. He was at the EUI on 15 February 2017 to deliver at the Max Weber Programme a Master Class and a Max Weber Lecture.

Master Class

His Master Class was on a National Bureau of Economic Research (NBER) Working Paper that he is co-authoring with Arnuad Mehl and Romain Lafarguette. It is titled Cables, Sharks, and Servers: Technology and the Geography of the Foreign Exchange Market. His presentation on the paper examined the connection and between technological connection involving underwater cables and financial transactions and the geographical implications of that connection. The main research question of the paper is what impact did the laying of submarine cables have on foreign exchange markets. In other words, there are a number of dynamics that create friction in foreign exchanges across distances such as time zones, local market liquidity, and capital controls. How did technological innovation interact with those? Specifically, did the exogenous shock of new cables augment these centripetal agglomerative effects that promote geographic consolidation or did they weaken those effects and thus promote geographic dispersion?

This question could thus provide one point of leverage for adjudicating between two very different views of the financial world. The first view is that that distance is still really important, that there remain significant costs to offshoring, and that proximity to the main hubs of the financial markets have grown more, not less, important. This view might be called the Flash Boys view after Michael Lewis’ book about high frequency trading. The other view is that technological innovation shrinks the effects of distance. This view might be called the Flat World hypothesis after Thomas Friedman’s famous book The World is Flat.

Professor Eichengreen and his colleagues found some evidence for the idea that these cables strengthened geographic frictions (which would thus support the Flash Boys view of foreign exchange markets) but much greater evidence for the latter (which would support the Flat World view.) For example, they find that the overall effect of the cables was that it reduced the power of the main spatial frictions (time zone, liquidity of the local market, and capital controls) by roughly 80 percent. They also found that whereas the introduction of cables did not have a great effect on currencies that faced few spatial frictions, like the Canadian dollar and the South Korean won, they had much greater effect on currencies that faced stronger versions of these frictions such as the Indian rupee. Thus, their main research finding is that cheap information and communication technology (ICT) attenuates the effect of distance.

An additional implication of his work that Professor Eichengreen discussed is the impact high- speed communication cables have on market volatility. Counter-intuitively, he argues that high-speed communication actually reduces rather than accelerates market volatility. One of the discussants, Richard Portes (RSC), added that high frequency trading in general tends to do this in normal times but in some ways shuts down in times of exogenous shocks.

Max Weber Lecture

His Max Weber Lecture was titled “Minimal Conditions of the Survival of the Euro.” He divided his discussion into two parts. The first examined why the euro area continues to problems emanating from its common currency and the second advanced his ideas of what is done to be done to alleviate those problems.

Part I: Why the euro continues to have problems?

Professor Eichengreen began by discussing his most cited publication, a paper from 1992 that argued that a currency union in Europe would be a mistake. In it, he asserted that currency unions effectively required the members to have a high degree of symmetry of macroeconomic shocks and the speed of adjustment to those shocks. The problem was that this correlation was a lot weaker in the European Union than in the United States. That was still true even after the introduction of the Euro.

This meant that when a positive supply shock led the Southern European to be on the receiving end of a significant lending boom, and then higher output and thus higher prices, it ultimately produced a severe loss of long-term competitiveness. Once global financial conditions became less expansionary, the process went into reverse in which those same Southern European countries experienced negative supply shock, which led to an acute lending drought, which produced lower output, i.e. recession and deflation, which then made existing debt unserviceable which in turn worsened the recession and created a vicious downward economic spiral. There was then insufficient political will to implement a robust enough response to fully stop the spiral.

Part II: What is to be done?

It is obvious that Europe needs monetary, financial, and fiscal stability. What is less obvious is how to get there. Professor Eichengreen began his second half by laying three macro-level solutions. The first would be to create a single fiscal policy. The second would be to have a true single labor market. The third would be to create a political union. As he noted, this is basically the set of ideas, for which the political backing is nowhere near sufficient, outlined in the Five Presidents Report which he wryly termed ‘social science fiction.’

Given this lack of sufficient political will for those macro-solutions, what more limited steps could be taken then? Professor Eichengreen outlined four. First, the euro area could establish a normal central bank. This is necessary because a sound banking system stability is a public good with strongly increasing returns and powerful spillovers. Moreover, it was lax regulations on German and French banks that set the stage for Southern Europe’s problems. Second, Europe now has half a banking union that lacks a single supervisor and has no harmonisation of deposit insurance with a common financial backstop. Third, Europe needs to renationalise fiscal policy because spillovers of budget deficits are small and countries have heterogeneous spending tastes, but importantly that requires a no bailout rule and, the fourth policy prescription, removing debt overhangs. Doing that in turn requires disconnecting banks and government bond markets. So in sum then, Professor Eichengreen’s proposals assert that the Euro area needs both more and less integration.