and Social Review,
Vol. 20, No. 2, January
T h e European Monetary System Lessons from Europe and Perspectives in Europe FRANCESCO G I A V A Z Z I * Universita' di Bologna, Italy Centre for Economic Policy Research, National Bureau of Economic Research,
Abstract: I n the debate that surrounds the proposals for a reform of the international monetary system the EMS experience is often referenced. These frequent references to the EMS have lacked so far a review o f the system aimed at identifying which lessons — i f any — one can draw from this experi ment at l i m i t i n g exchange rate flexibility. Analyses o f the EMS have been limited to Europe, and have never been brought to bear on the wider question of world monetary arrangements. This is the aim of the first part o f the paper. The second part looks at what lies ahead i n Europe, asking whether the EMS can survive the current process o f rapid financial integration, and what are the prospects for monetary unification. I first discuss the effect o f financial integration on public finances, and then I analyse the major development i n Europe since the beginning o f the EMS: the plan to create a unified financial market. The paper ends w i t h a word o f caution on the "financial integration strategy": financial inte gration and further progress toward monetary unification will not succeed unless they are accompanied by sweeping fiscal reforms.
hen the EMS was launched i n 1978 the new plan for exchange rate Y Y stability i n Europe was accepted w i t h m u c h skepticism. Policy-makers still were influenced b y the collapse o f B r e t t o n Woods, and concentrated o n learning h o w to live w i t h flexible exchange rates. Because economists were also a t t e m p t i n g t o understand the w o r k i n g o f flexible exchange rates, there was no analysis o f the EMS u n t i l the mid-1980s. N o w the situation is quite different. The conventional w i s d o m is that the EMS has been a success, and the debate i n Europe has moved o n t o the issue o f monetary unification and the European central bank. Outside Europe, the r e f o r m o f the international monetary system is no longer an unfashionable t o p i c : "target zones", and the simple r e t u r n to fixed exchange rates, have taken centrestage i n p o l i c y discus sions and, to some extent, in economic analysis. 1
* I am especially indebted to Alberto Giovannini, for I draw freely i n this paper o n material contained in our forthcoming book (1989a). 1. See for instance Krugman (1988a).
There are three views on the future o f the international monetary system. T w o o f t h e m advocate reforms w h i c h w o u l d l i m i t the degree o f exchange rate f l e x i b i l i t y , a t h i r d concentrates o n "fundamentals", and rules o u t the active management o f exchange rates. Ronald M c K i n n o n (1988) is responsible for the first set o f proposals. He argues for fixed nominal exchange rates. The system he envisages is very similar t o a symmetric gold standard: central banks w o u l d use domestic credit policies to peg the price o f a c o m m o n basket of internationally traded goods. Fiscal policy w o u l d target external balance: deficits and surpluses w o u l d be corrected b y changes i n the level o f spending in the various countries, at given relative prices. The second proposal, "target zones", was originally formulated b y J o h n Williamson ( 1 9 8 5 ) , and later elaborated i n Miller and Williamson ( 1 9 8 8 ) , Croham C o m m i t t e e ( 1 9 8 8 ) . The central p o i n t o f the plan is the assignment of monetary policy to a real exchange rate target: interest rate differences among countries keep the real effective exchange rate o f each c o u n t r y w i t h i n a pre-assigned band. N o m i n a l variables (nominal GDP) are controlled b y the average level o f w o r l d real interest rates, and b y domestic fiscal policy i n each country. A radically different view seems to be favoured b y the staff o f the Inter national M o n e t a r y F u n d . I t begins w i t h the premise that "a reform o f the international monetary system should be viewed as a constitutional change that should n o t be taken lightly, [. . . and] not viewed as an instrument for crisis management." (Frenkel, 1987, p. 11.) Policy-makers should concen trate o n eliminating the " f u n d a m e n t a l " sources o f imbalance i n the w o r l d e c o n o m y : "the use o f monetary policy to sustain exchange rate stability has definite drawbacks as a longer-term strategy, and that monetary policy is no more than a temporary substitute for changes in underlying fiscal positions." ( I M F , 1987, p. 17.) I n the debate that surrounds these proposals, the EMS experience is often referenced. Some — M c K i n n o n , for instance — p o i n t t o the success o f the system at l i m i t i n g exchange rate v o l a t i l i t y . Others — Miller and Williamson — p o i n t to the evidence indicating that the EMS has operated as a Deutsche mark zone demonstrating how difficult it is t o b u i l d symmetric exchange rate regimes. S t i l l others — Fischer (1987a) — p o i n t to the apparently crucial role played b y capital controls i n keeping the system together. These frequent references to the EMS have lacked so far a review o f the system aimed at identifying w h i c h lessons — i f any — one can draw from this experiment at l i m i t i n g exchange rate f l e x i b i l i t y . Analyses o f the EMS have been l i m i t e d t o Europe, and have never been brought to bear on the wider question o f w o r l d monetary arrangements. This is one o f the aims o f the pre sent paper. T w o issues seem o f particular relevance. First is the issue o f symmetry,
that is the formal resolution o f the so-called N - l p r o b l e m . M u n d e l l (1968, p . 195) p o i n t e d out the importance o f this p r o b l e m i n any plan for the reform o f the international monetary system, and Frenkel (1987) has recently reminded us: " i t is essential to ask h o w the various proposals, including those for target zones, deal w i t h the extra degree o f freedom." The second issue is the constraints — i f any — that the exchange rate system imposes u p o n domestic policies, and u p o n inflation i n particular. The issue o f " d i s c i p l i n e " was central in discussions over the r e f o r m o f the B r e t t o n Woods system i n the 1960s, and has been raised recently b y Fischer (1988). This paper is divided i n t w o parts. I n the first I ask what lessons can we draw f r o m the EMS experience that may be relevant for the r e f o r m o f the international monetary system. Sections 2.1 and 2.2 discuss s y m m e t r y and discipline, respectively; Section 2.3 draws the main conclusions. The second part o f the paper looks at the prospects i n Europe. I n Section 3.1 I discuss European p u b l i c finances; i n Section 3.2 I analyse the effects o f the t w o major developments i n Europe since the beginning o f the E M S : the enlarge ment o f the C o m m u n i t y and the Single European A c t .
I I C A N T H E EMS S E R V E A S A B L U E P R I N T F O R T H E R E F O R M O F T H E I N T E R N A T I O N A L M O N E T A R Y SYSTEM? 2.1 The Gold Standard, Bretton Woods and the EMS A central feature o f any operational monetary system must be a solution of the N - l p r o b l e m — namely a solution for the p r o b l e m that in a system o f N interdependent countries (and N currencies), o n l y N - l policies can be set independently, and therefore one policy instrument is redundant. The pro blem has a symmetric and an asymmetric solution. The symmetric solution "par excellence" is flexible exchange rates: each country sets its o w n monetary policy independently, and exchange rates are endogenous. Whenever countries actively manage their exchange rates, the consistency between the N - l targets and the N instruments can be achieved symmetrically or asymmetri cally. I n the symmetric solution, each central bank uses domestic credit policies to peg the price o f a basket o f goods i n units o f domestic currency, and it abstains f r o m sterilising reserve flows. I f exchange rates are fixed, central banks must peg similar baskets, ideally t o the price of a single good — for example, gold. I n an asymmetric system, the centre c o u n t r y pegs the price o f a good (or a basket) i n units of its o w n currency: all other countries peg the bilateral exchange rate vis-a-vis the centre c o u n t r y . I f exchange rates are fixed, the peripheral countries relinquish a l l monetary a u t o n o m y . I n a managed exchange rate system, the possibility o f changing the bilateral exchange rate vis-a-vis
the central c o u n t r y gives the others some leeway in the pursuit o f independent monetary p o l i c y . The current proposals for reform o f the international monetary system all envisage symmetric solutions t o the N - l p r o b l e m . The M c K i n n o n plan resembles a symmetric gold standard. The "target zones" proposal also calls for symmetry i n the management o f w o r l d monetary p o l i c y : "We reject b o t h the idea t h a t any one c o u n t r y should in effect use the level o f w o r l d interest rates solely for its o w n purposes, or that the latter should emerge as a result of a set o f decentralized decisions b y separate countries." (Croham C o m mittee, 1988, p . 50.) These blueprints o f symmetric exchange rate systems contrast sharply w i t h the historical experience. 2
Bretton Woods I n the B r e t t o n Woods system the N - l problem was solved asymmetrically. A l t h o u g h the numeraire o f the system was gold, and thus there was the theoretical possibility o f affecting all countries' exchange rates independently b y changing their gold price, the dollar price o f gold was very m u c h regarded as the cornerstone o f the system. A change in the dollar/gold parity was con sidered a de fac to abandonment o f the system. The role o f the dollar contrasted w i t h the ability that countries other than the U n i t e d States had t o change their exchange rates. A f t e r the abandonment o f the "gold p o o l " , in 1968, the B r e t t o n Woods system evolved into a dollar standard: a system i n w h i c h the U n i t e d States w o u l d choose domestic policies w i t h a view t o domestic objectives, while the other countries pegged to the dollar, retaining the right to change their peg. The International Gold Standard The gold standard that operated from the late 1870s t o World War I also w o r k e d asymmetrically. T r i f f i n ( 1 9 4 7 , p p . 58-64) argues that the system was less similar to the classical gold standard t h a n it was to a sterling-exchange standard managed b y the Bank o f England — at least in the years from 1870 to 1890. The 1931 C o m m i t t e e o n Finance and I n d u s t r y concluded that Britain could " b y operation o f her bank rate almost immediately adjust her reserve p o s i t i o n . Other countries had, therefore, i n the main to adjust their conditions to hers." I n an econometric study o f the international gold stan dard Giovannini (1986) also shows that the data are not consistent w i t h the
2. I f countries retain some policy independence, as in the case of flexible and managed rates, the shortage of independent instruments gives rise to policy conflicts. I n the managed exchange rate regime, the possibility o f international conflicts can make the regime unstable, because managed rates give the peripheral countries the ability to control the exchange rate i n their own interest — and thus against the interest of the central country (see for example Giavazzi and Giovannini, 1988b).
hypothesis that the Bank o f England followed the "rules o f the game" b y using domestic credit policies to minimise the v o l a t i l i t y o f international gold flows. I n the case o f the Reichsbank, on the contrary, the hypothesis that it f o l l o w e d the rules o f the game cannot be rejected. The European Monetary System The EMS provides one more example o f a managed exchange rate regime that has w o r k e d asymmetrically. A l t h o u g h " s y m m e t r y " was the w o r d most frequently pronounced at the Bremen and Brussels summits o f June and December 1978 where EMS was created, and n o t w i t h s t a n d i n g rules designed w i t h the explicit purpose o f "sharing the burden o f adjustment", the system has w o r k e d effectively as a DM-zone. Germany b y and large has retained the a b i l i t y to set monetary p o l i c y independently; the other countries have pegged to the Deutsche mark. The conclusion that the EMS has w o r k e d as a D M zone is supported b y four empirical observations: 3
(i) The i n s t i t u t i o n a l features that were designed to achieve symmetry i n the exchange-rate mechanism o f the EMS d i d not w o r k appropriately. The divergence indicator is unbalanced, contains currencies outside the EMS and, most i m p o r t a n t l y , i t does not b i n d member central banks t o any a c t i o n . 4
(ii) The rules for exchange market intervention were designed w i t h the explicit purpose o f "sharing the burden o f adjustment": intervention at the margin — when t w o currencies reach the l i m i t o f the bilateral f l u c t u a t i o n band — is compulsory, i t has to be carried o u t b y b o t h central banks involved, using each other's currency, and is supported b y the V e r y Short T e r m Financ ing Facility. Table 1 reports cumulative intervention figures as percentages o f t o t a l i n t e r v e n t i o n b y all countries i n the period f r o m January 1983 t o A p r i l 1986. F r o m January 1983 to March 1985, there was a general appreci ation o f the dollar o n an effective basis. I n the second period, f r o m A p r i l 1985 t o A p r i l 1986, there was a d o w n w a r d t r e n d o f the dollar effective exchange rate i n d e x . T h e three panels o f the table contain data on inter vention at the margin o f bilateral f l u c t u a t i o n bands ( w h i c h is carried o u t i n EMS currencies), o n intra-marginal intervention i n EMS currencies, and o n dollar intervention, respectively. The table shows that the t w o countries most involved i n i n t e r v e n t i o n at the margin were Belgium and France. The negative 5
3. This evidence is presented i n Giavazzi and Giovannini (1987, and 1989a, chapter 4). 4. For a discussion of the properties o f the divergence indicator see Spaventa (1982);Masera (1987). 5. During that interval there was one EMS realignment which took place i n March 1983 and involved a revaluation of the Deutsche mark vis-a-vis all EMS partners. 6. I n that period there were t w o realignments: J u l y 1985 (lira devalued) and A p r i l 1986 (general Deutsche mark revaluation).
signs i n Table 1 indicate a sale o f foreign exchange b y the central bank: for example, the first figure for Belgium ( ( - ) 0 . 5 5 4 ) indicates that the Belgian central bank undertook 55.4 per cent o f all marginal interventions carried out between January 1983 and M a r c h 1985. T h e sign is negative, indicating that d u r i n g this period the Belgian franc frequently h i t the b o t t o m o f the band relative t o another currency i n the system. This currency was often the French franc: over the same period the Banque de France was responsible for sizeable interventions (31.3% of the total) in the opposite direction. N o t i c e that the Bank o f I t a l y , w h i c h enjoys a wider f l u c t u a t i o n band, never intervened at the margin.
T a b l e 1: Central Interve
Marginal Intervention Germany
in the EMS Apr.
currencies) (-)0.093 (-)0.039
Belgium Summary I n t e r v e n t i o n at Margin Intra-Margin I n t e r v e n t i o n Dollar Intervention
Source: Giavazzi and Giovannini (1989a, Chapter 4). Notes: T h e d a t a used to c o n s t r u c t this table are cumulative intervention figures expressed in U S dollars. Negative signs indicate foreign exchange sales b y the central bank of the corresponding c o u n t r y . E a c h entry represents the share of intervention of that c o u n t r y in the total v o l u m e o f i n t e r v e n t i o n during the given interval, that is i n the s u m of the absolute values of the entries of that c o l u m n .
The second panel reports data on intra-marginal intervention. I t shows that on average Germany — at least during the years reported i n our table — has kept no positions in other EMS currencies for the purpose o f interven t i o n . This strongly suggests that Germany might not intervene i n the EMS w h e n the Deutsche mark is w i t h i n the bilateral f l u c t u a t i o n bands of its partner currencies. The other i m p o r t a n t piece o f evidence o n intra-marginal intervention comes f r o m the b o t t o m panel o f the table: intra-marginal intervention is as signifi cant in v o l u m e as intervention at the margin, and intervention vis-a-vis the dollar. I n the second panel, we can see that the d i r e c t i o n o f intra-marginal intervention changed between the first and the second period. The strength o f the dollar between 1983 and 1985 was associated w i t h a weak Deutsche mark w i t h i n the E M S : the table shows that all the other central banks in the system were purchasing Deutsche marks. A f t e r A p r i l 1985, when the dollar started falling, the signs in the table change: a weak dollar was associated w i t h a strong D M inside the E M S ; all other central banks ( w i t h the exception of the Netherlands) intervened selling Deutsche marks. 7
The t h i r d panel o f the table reports dollar intervention. The large dollar sales b y the Bundesbank, especially during the period o f dollar appreciation, might have been motivated b y the objective o f avoiding the strains w i t h i n the EMS associated w i t h fluctuations o f the dollar exchange r a t e . W i t h the data in Table 1, however, we cannot determine whether dollar intervention b y the Bundesbank was motivated b y the desire to avoid exchange rate strains i n the EMS or b y the desire to avoid big fluctuations in relative prices w i t h a large trading partner — the U n i t e d States — along w i t h the assumption that other European authorities w o u l d accommodate. 8
The i m p o r t a n t lesson f r o m Table 1 is that the burden of EMS-related inter vention was shared very unevenly among EMS countries: most o f the intramarginal intervention was carried o u t b y countries other than Germany, while Germany intervened o n l y w h e n bilateral f l u c t u a t i o n margins were reached. (iii) The strongest evidence in support o f the hypothesis that the EMS actually w o r k e d as a Deutsche mark area comes f r o m the study o f interest rates. West German interest rates are unaffected b y most intra-EMS shocks, like the expectations o f p a r i t y realignments, w h i l e interest rates denominated 7. For another discussion of the growing importance of intra-marginal intervention, see Ungerer et al. (1986). 8. Notice that the dollar interventions by the other central banks are generally consistent w i t h their intra-marginal interventions. When the dollar starts falling, for example France sells Deutsche marks and buys dollars: the D M sale supports the franc inside the EMS, and the dollar purchase is an attempt at slowing d o w n the fall i n the dollar that is ultimately responsible for the weakness of the French franc relative to the D M . Italy is an exception: when the dollar starts falling, the Bank of Italy inter venes, selling both dollars and EMS currencies (presumably Deutsche marks and D u t c h guilders).
i n other currencies are those that suffer the full impact o f intra-EMS port folio disturbances. Countries like I t a l y and France have prevented the wide fluctuations in their o w n interest rates observed in the (unregulated) Euro markets f r o m affecting their domestic economies b y imposing capital controls. This evidence is similar to that o f the gold standard and the B r e t t o n Woods period, w h e n countries other than Great Britain and the U n i t e d States, res pectively, sought to defend their policies f r o m the influence o f the " c e n t r e " c o u n t r y b y imposing various forms o f regulatory hurdles on the international transmission o f monetary policies. (iv) The data o n exchange rate movements around EMS realignments show that at the t i m e o f a realignment the Deutsche mark appreciates vis-a-vis its EMS partners in the majority o f cases. However, the Deutsche mark value outside o f the EMS is hardly affected b y what happens w i t h i n Europe. This is consistent w i t h the view that EMS realignments — to the extent that they affect spot exchange rates — are centred around the Deutsche mark. 2.2 Inflation and the Exchange Rate Regime A n international monetary system may w o r k asymmetrically because o f the efficiency o f solving the overdeterminacy associated w i t h the N - l pro blem b y allocating to one c o u n t r y the task o f providing the " n o m i n a l anchor" for the w h o l e system. The centre c o u n t r y should be chosen f r o m those whose monetary authorities have the highest "anti-inflationary r e p u t a t i o n " . This often is referred to as the " d i s c i p l i n e " argument for fixed exchange rates. The " d i s c i p l i n e " argument dates back to Mundell's (1968) " o p t i m a l burden of adjustment" argument. More recently, it has acquired new fame — along w i t h the emergence o f a new and influential view o f the inflation process. I n f l a t i o n is simply the inefficient outcome o f a non-cooperative "game" between the p u b l i c and the monetary authorities. I f inflation is just a source of inefficiency, then the inflation standard in an international monetary system should be set b y the c o u n t r y where the "game" produces the least inefficiency: that is the lowest equilibrium rate of inflation. Thus there is an incentive to b u i l d monetary areas centred around l o w inflation countries. 9
The view rests o n the assumption that the exchange rate system can influ ence inflationary expectations, because exchange rate targets are more credible than monetary targets. This remains an empirical question. Professional views of the role o f the exchange rate regime in a disinflation, and the actual experiences, differ w i d e l y . On one hand, experiences such as the SouthernCone "new style" I M F plans, where the exchange rate was used to stop very 9. There is also an influential view maintaining that the Bretton Woods system collapsed when the United States stopped providingprice stability to the world economy. See, for example, Johnson (1973).
high i n f l a t i o n rates, were viewed as negative. Critics (for example, Dornbusch, 1982) p o i n t e d to the disruptive effects o f the large appreciation in the real exchange rate, that was eventually unsustainable, and t o the lack o f credibility of the exchange rate targets. O n the other hand, B r u n o (1986) suggests that exchange rate policy might have had an i m p o r t a n t role i n the successful Israeli stabilisation. The positive role o f exchange rate p o l i c y i n the Bolivian stabili sation is also stressed b y Sachs ( 1 9 8 6 ) . I n the case of the EMS experience, the general perception is that the exchange rate regime helped the high inflation countries. Fischer (1987b) describes the EMS as "an arrangement for France and I t a l y to purchase a c o m m i t m e n t t o l o w i n f l a t i o n b y accepting German monetary p o l i c y . " Even i n countries considering EMS membership, the main advantages o f member ship are associated w i t h Germany's r e p u t a t i o n . The Economist [September 2 1 , 1985] writes: I f sterling does j o i n , the biggest change w i l l be the transfer o f respon sibility for Britain's monetary p o l i c y from the Bank o f England to the Bundesbank w h i c h , as the central bank keenest o n sound m o n e y , sets the pace for others to f o l l o w . This w o u l d be a blessing: T o r y govern ments may like appointing C i t y gents as governors o f the Bank, b u t M r . K a r l O t t o Poehl w o u l d do a better j o b . The Financial
Times [September 28, 1987] writes:
I n place o f money supply targetry, long since discredited, we w o u l d have t h a K i n f l i n c h i n g guardian o f monetary rectitude, the Bundesbank, standing as guarantor against Britain's endemic propensity t o generate double-figure rates o f i n f l a t i o n . What is the evidence? T h e EMS has w o r k e d as a DM-zone: according to the "discipline v i e w " we w o u l d expect the l o w inflation propensity o f the Bundesbank to have shifted inflation expectations d o w n w a r d i n the other countries. Table 2 compares inflation rates o f various European countries at the start o f the EMS w i t h the present. The table suggests b o t h the presence of significant convergence o f European inflation rates towards the West German levels, and a general decrease of i n f l a t i o n , w h i c h is not l i m i t e d t o the countries belonging to the EMS. Since the conclusion o f the preceding section is that West Germany's monetary policy has been at the centre o f the EMS, and since West German authorities b u i l t a wide reputation as " i n f l a t i o n fighters" i n the second post-war p e r i o d , the natural question raised b y this experience is whether the structure and w o r k i n g of the EMS, and i n particular the central role played b y the German monetary authorities, have played any role i n the disinflation experience o f countries as different as Denmark, France and I t a l y . I n Giavazzi and Giovannini (1989a, Chapter 5) we have a t t e m p t e d
to measure empirically the effects o f the EMS on the dynamics o f inflation i n member countries. T h e results appear to broadly agree w i t h the popular presumptions, b u t the evidence o f a shift i n expectations associated w i t h the i n s t i t u t i o n o f the EMS is very weak. Inflationary expectations seem t o have adjusted w i t h a long lag: 2-3 years. One explanation might be that learning takes t i m e . A n o t h e r and more appealing explanation is that some European governments used the EMS to j u s t i f y unpopular domestic policies. These policies, i n t u r n , shifted expectations.
T a b l e 2: The European
( G D P deflator: a n n u a l growth, per cent)
Netherlands United Kingdom
Using the exchange rate regime t o j u s t i f y being tough is an indirect, albeit effective, way to impose discipline. I f i t w o r k e d in Europe — and our evidence suggests that i t might have — then i t d i d so under t w o very special circum stances. First, the EMS is just one element o f a m u c h richer set o f agreements among European countries i n the trade, industrial, and agricultural areas. A s I discuss in Section 3.2 these agreements rest o n exchange rate stability, and thus lend credibility to exchange rate targets. T h e other reason w h y the EMS may have shifted inflationary expectations is capital controls. B y allowing "weak-currency" countries to fend o f f specu lative attacks against the reserves o f the central bank, capital controls have performed t w o i m p o r t a n t functions i n the EMS. T h e y have avoided realign ments d u r i n g periods o f crisis in the system — for example, when the dollar falls. Episodes o f dollar weakness are often associated w i t h a crisis i n the EMS: in the absence o f capital controls, it w o u l d be difficult to sustain existing parities. Second, capital controls have enabled central banks to delay p a r i t y realignments d u r i n g the disinflation. This has been a crucial factor i n forcing i n f l a t i o n convergence, because the discipline that the EMS imposes u p o n its high inflation members, depends crucially on the interval between successive
realignments being sufficiently long. I f high inflation countries had been forced to realign as soon as higher-than-average inflation (combined w i t h the r i g i d i t y o f the n o m i n a l exchange rate) started h u r t i n g competitiveness, then the system w o u l d have been indistinguisable from a crawling-peg: a l l discipline gains w o u l d have v a n i s h e d . We conclude that despite its p o p u l a r i t y , the view that European countries may have j o i n e d the EMS simply t o b u y the anti-inflationary reputation o f the Bundesbank is quite narrow. First o f all, the discipline argument certainly was not p r o m i n e n t when the EMS was designed. B y neglecting the incentives to stabilise intra-European exchange rates, the r e p u t a t i o n view overlooks the main motivations that brought about the establishment o f the EMS. 10
Moreover, the reputation view fails to explain Germany's incentives. What d i d Germany gain f r o m the discipline i t provided to the rest o f Europe? There is no general explanation for the incentives o f the central c o u n t r y . Models of credibility and r e p u t a t i o n are suggestive o f the reasons w h y inflation-prone countries may want t o belong to a monetary area centred around a lowi n f l a t i o n c o u n t r y , b u t do not explain the incentives o f the centre c o u n t r y . A tentative explanation for w h y Germany might have accepted this role is suggested b y the observation o f real exchange rates. B y j o i n i n g the E M S , Germany seems t o have achieved more stability i n its real effective exchange rate. EMS membership has dampened the effects o n the German economy o f extreme d o l l a r - D M fluctuations. This has happened because, since the begin ning of the EMS, European currencies o n average have kept closer t o the Deutsche mark, thus c o n t r i b u t i n g to stabilisation of Germany's global com petitiveness. This is the opposite o f what happened i n the early 1970s, w h e n the fall o f B r e t t o n Woods was accompanied b y an appreciation o f the Deutsche mark both i n Europe and vis-a-vis the U n i t e d States. This evidence provides some support for the "European A l l i a n c e " view o f the EMS: the interest that Germany had i n the creation o f the system was " t o l i m i t the detrimental effects of dollar disturbances" (Thiel, 1987, p . 17). 2.3 Summing Up: Is the EMS Exportable? I n this section I have reviewed the experience o f the EMS t o identify the lessons that this experiment in monetary co-ordination could provide t o those w h o are considering a r e f o r m o f the international monetary system. Policy co-ordination, and the successful a t t e m p t at making exchange rate targets credible, are sometimes hailed as i m p o r t a n t European achievements and examples for experiments outside o f Europe as w e l l . This view should be taken w i t h caution: 10. For an analysis of the role o f capital controls i n the European disinflation see'Giavazzi and Pagano (1988a, 1988b). For an analysis o f the effects of dollar fluctuations on intra-European exchange rates, see Giavazzi and Giovannini (1986).
(1) T h e degree o f policy co-ordination probably has been higher i n the EMS than under B r e t t o n Woods, particularly d u r i n g realignments. However, co-ordination has never been extended t o the area o f monetary p o l i c y tar gets. As a result, the EMS operates essentially a Deutsche mark zone, in a w a y that is not very different f r o m the B r e t t o n Woods system. (2) The credibility of exchange rate targets has been enhanced under t w o very special conditions, u n l i k e l y to be reproduced outside Europe: (i) intra-European agreements, and the EC c o m m o n agricultural policy i n particular, rely o n the stability o f intra-European exchange rates. Leaving the EMS is perceived i n Europe as a move that w o u l d question the survival o f other EC institutions as w e l l . These institutions have played an i m p o r t a n t part i n lending credibility t o exchange rate targets; (ii) capital controls also have played a major role in making exchange rate targets credible, b y severely l i m i t i n g the possibility of speculative attacks against central banks' reserves. I n order to survive, the EMS has become addicted to a mechanism that precludes further financial integration. This is a major p r o b l e m i n view o f the fact that item number one on the p o l i c y agenda in Europe is the c o m p l e t i o n o f a unified market b y 1992, the date set b y the Single European A c t . W i l l the EMS survive the removal o f exchange controls? This is a controversial issue that I take up in the second part of the paper. I l l W H A T N E X T FOR EUROPE? 3.1 European Public Finances and the Exchange Rate Regime The i m p o r t e d r e p u t a t i o n argument discussed i n Section 2.2 relies o n the assumption that inflation is o n l y a source o f inefficiency, arising f r o m the i n f o r m a t i o n costs o f n o m i n a l price v o l a t i l i t y . However, there are other i m p o r t a n t aspects o f the cost-benefit analysis o f inflation. One is the role o f i n f l a t i o n i n public finance, w h i c h might be particularly relevant for European countries. I n f l a t i o n is an i m p o r t a n t source o f government revenue. I t should thus be thought o f as just one element i n an o p t i m a l tax p r o b l e m , namely the pro blem o f raising a given amount o f revenue at the lowest cost in terms o f wel fare. I n solving this p r o b l e m , the distortions induced b y inflation should be traded o f f w i t h those induced b y regular taxes. 11
T h e extent t o w h i c h governments generate revenue through the seignorage attached to m o n e y creation varies across Europe. Table 3 documents the 11. Dornbusch (1988a, b) and Giavazzi (1988) point to the public finance role of inflation as an important factor i n choosing an exchange rate regime for Europe. Seignorage and fixed exchange rates are discussed i n Fischer (1983).
importance o f seignorage among the sources o f government revenue in the EC. T h e data show that the countries where seignorage revenue is the highest are also the countries where the revenue f r o m other forms o f t a x a t i o n is the lowest. Seignorage still accounts for 7 per cent o f t o t a l government revenue i n Greece, 5 per cent i n Spain, around 4 per cent i n I t a l y and Portugal; these are also the countries where the share o f tax revenue (net o f seignorage) in GDP is the lowest. I n many southern European countries seignorage has recently fallen along w i t h the fall i n i n f l a t i o n — in Portugal, for example, f r o m 16 per cent o f t o t a l revenues i n 1982, to 4 per cent i n 1986; the loss o f seignorage, however, has n o t always been accompanied b y a corresponding increase i n tax revenues — the result being an increase i n public debt ( i n Por tugal, for example, f r o m 40 per cent o f GDP in 1980 to 72 per cent i n 1987).
T a b l e 3 : The Importance
Seignorage plus total (% of seignorage tax revenues)
(% GDP) 1979
31.2 40.2 37.7
Sources and Definitions: Seignorage is the change i n the m o n e t a r y base (line 14 f r o m : I n t e r n a t i o n a l M o n e t a r y F u n d , International Financial Statistics), as i n F i s c h e r ( 1 9 8 3 ) . Tax revenues are f r o m O E C D : Revenue Statistics of OECD Member Countries, Paris, O E C D , 1 9 8 8 . T h e y refer to total tax revenues, i n c l u d i n g taxes o n personal and corpora t i o n i n c o m e , e m p l o y e r s ' a n d e m p l o y e e s ' S o c i a l S e c u r i t y c o n t r i b u t i o n s , p r o p e r t y taxes, c o n s u m p t i o n taxes, and excises.
L o w tax revenues often reflect the structure o f the economy; it is n o t clear that they could be raised very fast. T h e y are often associated w i t h a narrow tax base, rather t h a n w i t h lower-than-average tax rates. I n discussing the Greek economy, for example, the O E C D writes:
There is [ i n Greece] a relatively heavy tax burden on incomes and transactions that are easily taxable (wages and salaries, purchases o f cars and some consumer durables, real estate and inheritance trans actions). T a x evasion and avoidance are p a r t l y responsible, b u t the most i m p o r t a n t factor is the structure o f the economy characterized b y a large share o f agriculture in GDP (18%), and o f self-employment in the non-agricultural labour force (33%). (OECD, Economic Survey of Greece, 1987). The case o f Portugal is similar: " L o w tax yield is attributable t o the narrow ness o f the tax-base, w h i c h is not unrelated t o the high marginal tax-rates." ( O E C D , Economic Survey of Portugal, 1986). The inflation tax may also be the o n l y w a y o f taxing economic activity in the underground economy. I n some countries a substitution o f seignorage for other forms o f t a x a t i o n may n o t be possible w i t h o u t further adding t o the distortions o f the tax system. Differences i n fiscal structures thus j u s t i f y differences i n the " o p t i m a l " revenue f r o m seignorage. I t is u n l i k e l y that w i t h an unchanged fiscal structure and i n the absence o f fiscal redistributions, the " o p t i m a l " i n f l a t i o n rate may be the same across Europe. 3.2 Which Exchange Rate Regime for the Single European Financial Market? The major development i n Europe since the EMS began was the decision — made in 1985 — to "complete the internal m a r k e t " : that is t o eliminate b y 1992 a variety o f practices that cause frontiers to matter still in the EC. The plan (as set o u t i n the Single European Act o f 1986, see EC ( 1 9 8 5 , 1987)) w o u l d create a t r u l y unified market, comparable to that w h i c h exists in the U n i t e d States. Its m o t i v a t i o n is the widespread impression that notwithstand ing the EC, European markets remain less than fully integrated in ways that may n o t be explained b y visible obstacles. Market segmentation is par ticularly evident in the b a n k i n g and insurance industries: in fact, the high p o i n t o f the Single European A c t is the establishment o f a c o m m o n market for financial services. However, the plan for integrating European financial markets comes up against the inconsistency between f u l l financial integration and the current w o r k i n g o f the EMS. 12
The recent experiences o f liberalisation have had mixed outcomes. N o sooner had the Italian monetary authorities removed controls on "leads and lags" (in M a y 1987) than they were faced w i t h a severe speculative attack. Because o f the level and m a t u r i t y structure o f the Italian public debt, the authorities could not accept a rise in domestic interest rates large enough to
12 For a discussion of market segmantation in the EC, see Krugman (1988b) and Smith and Venables (1988).
stop the capital o u t f l o w . The Bank o f I t a l y was thus forced to decide between giving i n , and accepting a realignment that i t viewed as unwarranted b y "fundamentals", or reintroducing administrative controls. A n d so w e n t (at least t e m p o r a r i l y ) the attempted liberalisation o f leads and lags. The French experience has been more successful so far, n o t w i t h s t a n d i n g a sequence o f attacks o n the French franc. There are t w o l i k e l y explanations for such suc cess. The first is that France does n o t have a public debt p r o b l e m , so that the French authorities have been more prepared than the Italian t o let domestic interest rates bear the burden o f adjustment. The other i m p o r t a n t reason is that foreign lending i n domestic currency is still controlled, so that the volume o f funds that can be mobilised to stage an attack is l i m i t e d . I f f u l l financial integration remains the p r i m a r y p o l i t i c a l objective i n Europe, and if the current system o f fixed b u t adjustable parities cannot survive f u l l financial liberalisation, the choice is between allowing greater exchange rate f l e x i b i l i t y , or giving up realignments altogether, m o v i n g t o w a r d a system of credible, and thus irrevocably fixed rates — that is a monetary u n i o n . I believe that greater exchange rate f l e x i b i l i t y is n o t a viable o p t i o n i n Europe t o d a y . Since the mid-1950s Europeans have attempted to l i m i t intra-EEC exchange rate fluctuations, for three main reasons. First, European countries are all relatively open. Second, many i n Europe hold the floating rates o f the 1920s and 1930s responsible for the ensuing collapse o f national economies and o f the international trading and monetary systems. T h i r d , post-war Euro pean i n s t i t u t i o n s — particularly the c o m m o n agricultural market — depend for their survival o n exchange rate s t a b i l i t y . 13
Analysing the exchange rate question i n Europe w i t h o u t considering w h y Europeans are particularly averse to exchange rate fluctuations w o u l d n o t give a clear picture o f the p r o b l e m . The EMS is j u s t one element o f a m u c h richer set o f agreements among European countries i n the trade, industrial and agricultural areas. These agreements rest o n exchange rate stability. I n Europe financial integration thus calls for more — rather than less — exchange rate stability. T h i s explains w h y the v i a b i l i t y o f irrevocably fixed exchange rates, reserve pooling and the setting o f monetary targets b y a supernational i n s t i t u t i o n have become p r o m i n e n t issues o n the European agenda. 14
13. I n Giavazzi and Giovannini (1989a, Chapter 1) we describe in detail the effects of exchange rate realignments on European institutions and i n particular on the common agricultural market and on the EC budget. 14. The issue of a "European Central Bank" is analysed in Cohen (1989), and Thygesen (1987). The prospects of the EMS after financial liberalisation are discussed in Padoa-Schioppa (1988).
3.3 Financial Integration and Fiscal Reform The risk o f the financial integration cum monetary unification strategy is that i t w i l l not w o r k in the absence o f a fiscal r e f o r m . There are t w o reasons w h y fiscal r e f o r m is a. prerequisite for financial integration: (i) Fiscal structures, as documented in Section 3 . 1 , differ across Europe: tax systems are less efficient i n the southern countries, and, as a consequence, governments there " o p t i m a l l y " rely more o n the inflation tax than n o r t h e r n countries d o ; (ii) A monetary u n i o n implies giving up exchange rate realignments as a t o o l o f economic p o l i c y . The loss o f the exchange rate instrument must be compensated either b y fiscal transfers across countries (centralising some revenues and redistributing t h e m t h r o u g h o u t Europe, along the example o f the US Federal government), or b y an active use o f differentiated fiscal poli cies. One o p t i o n requires building new fiscal institutions in Europe. The other may not be easy since i n an integrated market the o n l y transactions and the o n l y factors that can be taxed differently across countries are those that cannot be relocated at l o w cost. A note o f caution o n the "financial integration strategy" is also suggested b y the situation o f some current members o f the EMS. The three OECD countries characterised b y the highest ratio o f p u b l i c debt-to-GDP ( I t a l y , Belgium and Ireland) are also members o f the EMS. I n these countries, the debt p r o b l e m has emerged d u r i n g the EMS years and is far from being solved. F r o m 1981 to 1988, the ratio of public sector debt-to-GDP has increased from 61 to 97 per cent i n I t a l y , from 88 to 130 per cent in Belgium, and f r o m 90 t o 145 per cent i n Ireland. While Belgium and Ireland have a p r i m a r y budget surplus, I t a l y still has a p r i m a r y deficit equal to 3.5 per cent o f GDP. U n e m p l o y m e n t , however, is close to 20 per cent in Ireland, 12 per cent in Belgium, 10 per cent in I t a l y . Is the inflation rate consistent w i t h fiscal stability the same i n Ireland, I t a l y , Belgium and Germany? Once again, further steps t o w a r d financial integration and monetary unification i n Europe are closely linked t o the issue o f fiscal r e f o r m .
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