There is a huge literature about fixed exchange
rates. Since the effective break-up in 1970 of Bretton Woods (the
post-war international agreement to fix exchange rates), the general
consensus among economists has been that major economies were
better off under floating exchange rates (we ignore here the discussion
of what is right for small, especially developing, economies where
there may be a case for fixing exchange rates under the tough
conditions of a 'currency board'). This was underlined in a major
study of the international economy using all available World Models-
Bryant et al (1993); this found that monetary policy conducted
with a fixed exchange rate target was distinctly inferior to that
using domestic targets- whether for money supply, inflation or
output. Within that volume work on the Exchange Rate Mechanism
(Hughes Hallett et al) found that this particular fixed exchange
rate regime gave extremely poor results- the UK's difficulties
are well known (see Walters, 1990 and 1992).
Bryant, Ralph C., Peter Hooper and Catherine
L. Mann (eds.) (1993) Evaluating Policy Regimes- new research
in empirical macroeconomics, Brookings Institution, Washington
DC.
Hughes Hallett, Andrew, Patrick Minford
and Anupam Rastogi (1993) 'The European Exchange Rate Mechanism',
in Bryant et al (1993).
Walters, A. A. (1990) Sterling in danger:
the economic consequences of pegged exchange rates, Collins (Fontana)
with the Institute of Economic Affairs, London.
(1992) 'Britain and the exchange rate mechanism',
in The Cost of Europe (P. Minford ed.), Manchester University
Press, Manchester, pp. 119-124.
Monetary Union- general
Monetary Union involves fixing exchange
rates 'indefinitely'; of course nothing is really for ever and
what is meant is that undoing a currency union is much more costly
than leaving a fixed exchange rate arrangement, since under monetary
union a country actually gives up the right to print its own currency
hence in order to leave the union it must issue a new currency.
This higher cost reduces the probability of departure substantially,
hence the 'indefinitely'. But when participating nations remain
sovereign, they can always decide to leave; thus the possibility
remains open in principle at all times. As is noted in our 'encyclopaedia'
section, there are many examples of monetary unions that failed
because of the departure of one or more members.
Good general guides to the issues raised
by monetary union are:
De Grauwe, Paul (1994) The Economics of
Monetary Union, Oxford University Press.
Kawai, Masahiro (1992) 'Optimum currency
areas', in New Palgrave Dictionary of Money and Finance (Peter
Newman, Murray Milgate and John Eatwell, eds), Macmillan.
Minford, Patrick (1993) 'The Path to Monetary
Union in Europe', The World Economy, Vol. 16, No. 1, January 1993,
pp. 17-27.
They are organised around the original ideas
of Robert Mundell, Ronald McKinnon and others dating back to the
1960s of an 'optimal currency area'. The basic idea is simple.
There are gains in principle from having a common money, these
being the reduction in 'transactions costs', a general term for
the costs of having to change money to do business. But economic
conditions in different countries are likely to differ because
of 'asymmetries' (these can come about because the primary shocks
are different or because the 'transmission mechanisms'- i.e. the
effects of any given shock in each economy- differ); to deal with
this different interest rates and exchange rates are required.
The two go together: if interest rates differ this creates an
incentive to move money from the low-interest-rate country to
the other, and in order to stop this flow of money (which would
deplete reserves) the exchange rate between the two must move
until the expected capital loss due to the exchange rate movement
just offsets the interest rate differential. The inability of
a country to set its own interest rates and exchange rate will
in general make its economy more unstable- unemployment will be
larger in slumps and overheating worse in booms. Thus we have
a prima facie comparison of the benefits from lower transactions
costs with the costs from asymmetries. This is an empirical matter
for investigation: it is assumed that the more cross-country transactions
there are ('integration') the higher the transactions costs and
the less the asymmetries. Hence union is recommended for regions
that have already achieved a high degree of integration: in practice
this has coincided with the boundaries of states.
Andrew K Rose, in his CEPR discussion paper
No 2329 'One Money, One Market: Estimating the Effect of Common
Currencies on Trade', uses a gravity model to assess the separate
effects of exchange rate volatility and currency unions on international
trade. We examine his paper here.
The argument does not stop there: a country
may substitute other mechanisms to deal with its own asymmetries.
These consist of:
(a) labour mobility: people in ar eas in
a recession can move to those in an upswing.
(b) wage flexibility: the real wages ( and
so labour costs) in depressed areas can fall relative to those
in prospering areas.
(c) fiscal transfers: the central government
in the Union can transfer money from the prospering areas to the
depressed areas, either through taxes or benefits.
However, one notes at once that (a) and
(c) are intimately connected with being part of a state; labour
mobility is assisted by being within a common jurisdiction, so
that legal rights are preserved and fiscal transfers require a
central budget. (b) can occur regardless of jurisdiction; it merely
requires a flexible labour market without intervention by the
state or by state-legitimised unions to stop real wages adjusting
to equate desired labour supply with firms' demand for labour.
In this discussion much depends on the rapidity of these responses;
noone today argues that asymmetric shocks or responses will prevent
a region adjusting ultimately to a permanent change in its circumstances
under a monetary union as under floating exchange rates- in principle
it should in both cases reach the same ultimate situation. The
issue is whether the adjustment is more painful and involves greater
volatility, especially of unemployment, under monetary union because
the responses from these alternative mechanisms are slower than
those of interest rates and exchange rates.
De Grauwe also discusses at some length
the 'new monetary union' argument: that countries can acquire
monetary credibility in the fight against inflation by transferring
their monetary sovereignty away from home politicians to an independent
(foreign) central bank. However, this argument has been sidelined
by the obvious capacity of a country to generate its own domestic
monetary credibility by suitable policies and institutions. The
clearest recent demonstrations are from the UK, New Zealand, Canada
and the USA.
There is another economic concern about
monetary union: sharing a single currency means that all countries
issue their debt denominated in it and consequently when one country
threatens to default the others may be called upon to 'bail it
out'. Why? There is a common concern for the reputation of the
currency- in other words lenders may require a higher interest
rate from all if one debt-issuer defaults, because lenders have
inadequate information to distinguish between borrowers in fine
detail. Another reason is that under monetary union there is more
coordination and so the crisis created by the default is relevant
to the collective decision; there is then political pressure to
help a member of the collective (even if in fact the Maastricht
Treaty explicitly states that each government must deal with its
own obligations without help). The fear of pressure to bail out
governments with poor public finances led directly to the Maastricht
Treaty conditions for ceilings on debt and deficits, as well as
to the Stability Pact setting targets for deficits to be eliminated.
To many people the key argument is political:
they either do or do not want political union and see monetary
union as a means to advance that political aim. At first sight
it is obscure why monetary union should be seen as such a step
to political union. But the above economic arguments reveal why.
The need to find alternative mechanisms to deal with regional
difficulties strengthens the case for a central state with fiscal
powers and jurisdiction over the 'single market in labour'. The
fear of bail-out is another reason for stronger central controls
over member governments in fiscal policy. Finally, one may note
that the test of a union is in the end its acceptability to the
member peoples; the stronger the central institutions the harder
it is for dissatisfied peoples to withdraw. Plainly the case for
'co-ordination' now being pressed by Germany in particular can
be seen as justified by the need to advance political union.
De Grauwe (1994) contains the essential
arguments and also many supporting references. His own conclusion
is that a narrow group of countries consisting of the old DM-bloc
of Germany, Benelux and Austria, plus France- because of their
demonstrated commitment to pegging to the DM over a long period
of time- represent an 'optimal currency area'; in other words
the costs for this bloc are probably smaller than the benefits.
But that any wider group would not constitute such an optimal
currency area. However, the inclusion of France in the narrow
group can certainly be queried; as a large economy with a history
of very different behaviour from Germany since the war, it remains
to be seen whether its economy can be managed within the union
in a way its citizens ultimately agree with.
Monetary Union- detailed topics
Transaction cost benefits
EEC Commission (1990) 'One market, one money:
an evaluation of the potential benefits and costs of forming an
economic and monetary union', European Economy, no.44, October.
Finds that costs of intra-EU currency exchange for country with
advanced banking system are about 0.1% of GDP (this is the only
estimate of the transactions cost gain available). Suggests but
cannot quantify risk-premium reduction on borrowing costs because
of union. Carries out 'stochastic simulation' (see below under
'asymmetric' for criticisms) which purports to show that EMU produces
more stability in output and inflation than floating- the reason
being that it eliminates the volatility in intra-EU-currencies
risk-premia.
One symptom of transactions costs is foreign
trade: there should be some effect of exchange rate volatility
on the volume of trade or the pricing behaviour of traders. The
consensus of studies is that such effects are not significant.
A typical one is:
Bailey, M., G.S. Tavlas and M. Ulan (1987)
'The impact of exchange rate volatility on export growth: some
theoretical considerations and empirical results' Journal of Policy
Modelling, 9, pp. 225-243.
Where there is an increase in medium term
real exchange rate volatility (ie when there are long swings in
competitiveness as opposed to fluctuations in exchange rates as
part of the business cycle) researchers have found evidence of
effects on trade volumes. But such swings are not in principle
connected with floating rates- competitiveness in the medium term
should be unaffected by the type of exchange rate regime because
over that time-scale relative wages and prices will adjust one
way or the other as much as they can. Examples of these findings
are:
De Grauwe, P. (1987) 'International trade
and economic growth in the European Monetary System', European
Economic Review, 31, pp. 389-398.
Peree, E. and A. Steinherr (1989) 'Exchange
rate uncertainty and foreign trade', European Economic Review,
33, pp. 1241-1264.
Recent studies have looked at 'pricing to
market' where firms absorb exchange rate fluctuations into their
profit margins, keeping import prices stable in the domestic currency
of consumers; if this was a factor and was costly there should
be an effect on the rate at which import costs are 'passed-through'
to the consumer and a riskpremium in the import price mark-ups.
However, again not much has been found e.g.:
Sapir, Andre, and Khalid Sekkat (1990) 'Exchange
rate volatility and international trade' in The European Monetary
System in the 1990s, Paul De Grauwe and Lucas Papademos (eds),
Longman, pp. 182-198.
Asymmetric shocks and transmission mechanisms
The consensus of a variety of studies is
that the regional shocks in EU countries are highly asymmetric,
at least as much as and possibly somewhat more than those in the
regions of the USA. The latest such studies are:
Duarte, Agustin and Ken Holden (2000) 'The
Business Cycle in the G7 Economies', in which the authors decompose
real GDP for the G7 countries into cyclical and trend components.
They find that since 1990 two seperate cycles have developed:
one for Germany, France and Italy; and one for the US, UK and
Canada. This paper is available as an Acrobat PDF file here.
Horvath, Michael (1999) 'Empirical Evidence
on Common Money and Uncommon Regions in the United States' and
Carlino, Gerald A. and Robert DeFina (1999)
'Monetary Policy and the U.S. States and Regions: Some Implications
for Common Currency Areas'; both in Jurgen von Hagen and Christopher
Waller (eds.) Common Money, Uncommon Regions, forthcoming Kluwer.
A number of previous studies include:
Eichengreen, Barry (1990) 'One money for
Europe? Lessons from the US currency union' Economic Policy 10,
Blackwell.
Neumann, Manfred, and Jurgen von Hagen (1991)
'Real exchange rates within and between currency areas: how far
away is EMU?' discussion paper, Indiana University.
Bayoumi, Tamim, and Barry Eichengreen (1993)
'Shocking aspects of European Monetary Integration', in F. Torres
and F. Giavazzi (eds.) Adjustment and growth in the European Monetary
Union, Cambridge University Press (for CEPR, London).
De Grauwe, P., and H. Heens (1993) 'Real
exchange rate variability in monetary unions', Recherches Economiques
de Louvain, 59.
De Grauwe, P., and W. Vanhaverbeke (1993)
'Is Europe an optimum currency area?: evidence from Regional data',
in P.R. Masson and M.P. Taylor (eds.) Policy Issues in the operation
of currency unions, Cambridge University Press.
A further argument, documented by Krugman
(1993), is that greater specialisation by region occurs with greater
integration and reduction of regulative barriers (also possibly
encouraged by monetary union); this has been visible in the USA
(eg Silicon Valley in California, automobile production in Pittsburgh,
defence in New England) and in the EEC would worsen the asymmetries
already visible as it proceeded further:
Krugman, Paul (1993) 'Lessons of Massachusetts
for EMU', in F. Torres and F. Giavazzi (eds.) Adjustment and growth
in the European Monetary Union, Cambridge University Press (for
CEPR, London).
Studies comparing stability under floating
and EMU, using World models and stochastic simulation:
The first two of these find that EMU generally
causes substantially more instability in the member economies
than floating exchange rates; the EEC study finds the opposite
but the reason, explored by the first two, is that it has entered
a special class of shocks (to intra-EEC interest rate risk-premia)
whose volatility it has arbitrarily assessed and very likely over-estimated.
Minford, Patrick, Anupam Rastogi and Andrew
Hughes Hallett (1993) 'The price of EMU revisited', Greek Economic
Review, 15 (1), pp.191-226.
Masson P. and S. Symansky (1992) 'Evaluating
the EMS and EMU Using Stochastic Simulations: Some Issues', in
'Macroeconomic Policy Coordination in Europe, the ERM and Monetary
Union', R. Barrell and J. Whitely (eds.) London, NIESR, 1992
EEC Commission (1990) 'One market, one money:
an evaluation of the potential benefits and costs of forming an
economic and monetary union', European Economy, no.44, October.
Labour mobility
The studies following have found that labour
migration in the USA between regions is very high compared with
that between countries of the EU and even compared with that between
regions of the same countries within the EU.
Eichengreen, Barry (1993a) 'European Monetary
Unification', Journal of Economic Literature, 31, pp. 1321-1357.
(1993b) 'Labour markets and European monetary
unification' in Paul Masson and Mark Taylor (eds.) Policy Issues
in the operation of currency unions, Cambridge University Press,
pp. 130-162.
Decressin, Jorg, and Antonio Fatas (1995)
'Regional labour market dynamics in Europe', European Economic
Review, 39, pp. 1627-1655.
Obstfeld, Maurice, and Giovanni Peri (1998)
'Regional non-adjustment and fiscal policy', Economic Policy,
26, April 1998, pp.207-259.
De Grauwe, P., and W. Vanhaverbeke (1993)
'Is Europe an optimum currency area?: evidence from Regional data',
in P.R. Masson and M.P. taylor (eds.) Policy Issues in the operation
of currency unions, Cambridge University Press.
Wage flexibility
A wide variety of studies dating back to
the late 1970s have shown western labour markets generally to
have a low response of regional real wages to regional unemployment.
In the USA this is generally interpreted as reflecting high labour
migration (see above)- rather than take a wage cut workers move
to other regions. At the aggregate level of the whole USA US wages
appear to be highly flexible whereas those in Europe are not;
the reason appears to lie in the social support of wages in Europe
either through unemployment benefits, minimum wages, unions or
a combination of all three; this is consistent with estimates
of structural unemployment (also termed 'the natural rate' of
unemployment, the rate at which inflation can be stabilised, and
the 'non-accelerating-inflation rate of unemployment or NAIRU)-
high, perhaps double digit on the European continent compared
with low, around 4.5%, in the USA.
Grubb, D., R. Jackman and R. Layard (1983)
'Wage rigidity and unemployment in OECD countries', European Economic
Review.
Bruno, M., and J. Sachs (1985) Economics
of worldwide stagflation, Blackwell.
Layard, Richard, Steven Nickell and Richard
Jackman (1992) Unemployment: macroeconomic performance and the
labour market, Oxford University Press.
Blanchflower, David G., and Andrew J. Oswald
(1994) The Wage Curve, MIT University Press.
Kincaid, R. G., W. Lee, A. Jaeger, B. Drees,
W. Merz, V. Valdivia, H. Faruquee (1997) 'Germany- selected issues',
IMF Staff Country Report No. 97/101, 8/8/1997.
McMorrow, Kieran (1996) 'The wage formation
process and labour market flexibility in the Community, the US
and Japan', European Commission Economic Papers, No. 118, Brussels.
Blanchard, Olivier J., and Lawrence F. Katz
(1992) 'Regional evolutions', Brookings Papers on Economic Activity,
1992 (1), pp. 1-75.
Fiscal transfers
Early estimates of the extent to which a
fall in a US region's GDP would generate extra net revenue from
the Federal Budget were of the order of 0.3 (Sala-i-Martin and
Sachs, 1989). However, the later research listed has reduced this
to some half of this. Nevertheless, it is substantial set beside
the obviously negligible figure in the EU- the regional funds
are irrelevant in this context because they do not react to cyclical
or other marginal changes in regional GDP.
Sala-i-Martin, Xavier, and Jeffrey Sachs
(1992) 'Fiscal federalism and optimum currency areas: evidence
for Europe form the United States', in Mathew Canzoneri, Vittorio
Grilli and Paul Masson (eds.) Establishing a central bank: issues
in Europe and lessons from the US, Cambridge University Press.
Pp. 195-227.
Von Hagen, Jurgen (1991) 'Fiscal arrangements
in a monetary union- evidence from the US' in D. Fair and C. de
Boissieux (eds) Fiscal policy, taxes and the finacial system in
an increasingly integrated Europe, Kluwer.
Fatas, Antonio (1998) 'Does EMU need a fiscal
federation?' Economic Policy, 26, April 1998, pp. 165-203.
Bayoumi, Tamim, and Paul R. Masson (1995)
' Fiscal flows in the United States and Canada: lessons for monetary
union in Europe', European Economic Review, 39, pp.253-274.
Bail-out
The recent Mexican, Asian and Brazilian
crises have illustrated the pressures for bail-out. The following
discuss these, with varying opinions about the likelihood of bail-out
in Europe.
Eichengreen, Barry, and Charles Wyplosz
(1998) 'The stability Pact: more than a minor nuisance?' Economic
Policy, 26, April 1998, pp. 67-113.
Crawford, Malcolm (1993) One Money for Europe?,
Macmillan.
Buiter , Willem, Giancarlo Corsetti, Noriel
Roubini (1993) 'Excessive deficits: sense and nonsense in the
Treaty of Maastricht', Economic Policy 16, pp. 58-100.
Harmonisation
The costs of harmonisation for low cost
members of the EU such as the UK is evaluated as of significant
size in:
Minford, Patrick (1998) 'Europe and the
new world order' chapter 8 of Markets Not Stakes, Orion, London.
Layard, R, S. Nickell and R. Jackman
(1990) Unemployment- macroeconomic performance and the labour
market, Oxford University Press, bring together evidence on labour
markets around the world and find that state interventions which
increase real wage inflexibility and raise labour costs (e.g.
by subsidising long-term unemployment) also raise unemployment.
In the conditions of general wage rigidity prevailing in continental
Europe harmonisation as a levelling-up of taxes and social charges
would raise unemployment both in countries where these rise and
so overall.
