After more than a decade of experience with the European Monetary System (EMS), the 12 member countries of the European Community are now engaged in important discussions and negotiations about the path to economic and monetary union (EMU). This article takes a look at key issues relating to the design and implementation of monetary policy in the emerging EMU, without endorsing or dismissing specific institutional proposals for transition to EMU. The emphasis is on the interrelationships among price stability, current account equilibrium, and exchange rate stability, as well as the questions of the degree of coordination and rules versus discretion. Also considered are the critical implications of fiscal policy for the conduct of monetary policy, along with alternative ways of encouraging fiscal discipline.
Monetary policy goals
Progress toward EMU necessarily requires a consensus to be reached among participating countries on the goals of monetary policy. During the 1960s and the 1970s, monetary policies in the major industrial nations typically embraced a number of objectives, notably price stability, full employment, and sustainable economic growth (and for some, exchange rate stability and stability of the financial system). But in the last decade or so, governments have concentrated on the objective of controlling inflation, with price stability being regarded—appropriately in our view—as a necessary (albeit not sufficient) condition for achieving other economic goals, including sustainable economic growth.
Consistent with this tendency, there appears to be broad agreement that a European System of Central Banks, or “EuroFed,” should have an explicit mandate to pursue price stability (see “Europe: The Quest for Monetary Integration,” by Horst Ungerer in Finance & Development, December 1990, for a discussion of the institutional aspects of EMU). To give “teeth” to this commitment, some have proposed giving the “EuroFed” substantial independence, while prohibiting it from granting credit to the public sector. What is less clear is how policy-making authorities should respond to developments in current accounts and frame their exchange rate objectives.
Historically, not all potential EMU members have placed the same emphasis on the current account balance relative to other goals. But the further liberalization of European capital markets might increase the importance of any differences among countries in the importance attached to current account objectives, by making it easier to finance intra-European external imbalances. There is also the matter of Europe’s aggregate current account position, which could well influence a future ECU/US dollar or ECU/yen exchange rate. (ECU stands for European Currency Unit, a composite basket of the EC currencies.)
What then should the authorities’ attitude be on current account imbalances? Several analysts—ourselves included—believe that such imbalances are not inherently good or bad, but must be assessed on a case-by-case basis. For example, imbalances that arise from temporary differences among countries in the age distribution of the population—which in turn yield differences in private saving patterns—are likely to be benign, whereas an imbalance that reflects unsustainable borrowing abroad to finance a consumption spree should surely be placed in the malign category.
We see merit in a framework that would consider at least the following factors:
• whether the fiscal position is appropriate (in terms of both the level and composition of government spending, as well as the structure of taxes and borrowing used to finance the budget);
• whether increased investment associated with the external imbalance can be expected to provide a rate of return that exceeds the cost of borrowing (including externalities); and
• whether any increased consumption associated with the imbalance is temporary and desirable for purposes of smoothing movements in consumption over time.
One needs to know the origin of an imbalance before one can decide both if the imbalance needs correcting and how that can best be accomplished.
As for the role of exchange rate objectives, several issues arise: the management of the union’s exchange rate vis-â-vis non-EMU currencies; the loss of the nominal exchange rate as a policy instrument; and the choice between rapid and gradual approaches to EMU, with “hard” and “soft” exchange rate commitments, respectively.
Exchange rate management in a tri-polar system. In recent years, we have increasingly felt that a tri-polar exchange rate system, in which exchange rate commitments are “looser” and “quieter” across the poles than within regional currency areas, represents a feasible and desirable evolution of the international monetary system. By tri-polar, we mean a regime where many currencies are linked either to the US dollar, the Japanese yen, or a European currency (e.g., the deutsche mark or the ECU). “Loose” exchange rate commitments imply that exchange rate targets are altered more frequently and are subject to wider margins than with “tighter” commitments. “Quiet” and “loud” commitments are merely a shorthand for distinguishing between confidential and publicly announced exchange rate targets.
Several of the arguments for such a system are directly relevant to how an evolving EMU might react to exchange rate movements outside the union. First, an exchange rate system that has as its regional nominal anchors, three relatively independent central banks—each committed to price stability—is not conducive to policy “blueprints” that require monetary policy in the anchor countries to give first priority to keeping exchange rates within loud target zones. Second, real exchange rates across the three poles need some flexibility to be able to reflect changes in real economic conditions over time. Third, better disciplined monetary and fiscal policy within each of the currency areas would go a long way toward establishing more disciplined exchange markets across the poles. Fourth, intervention to manage exchange rates across the poles (i.e., $/ECU, $/yen, ECU/yen) should be saved for cases where there is strong evidence of bubbles or large misalignments in exchange rates.
This should not be interpreted as a call for return to “benign neglect” in the management of major currency exchange rates. Quite the contrary, as we regard a reasonable degree of exchange rate stability for key currencies as a public good for the system. Our argument instead is that the stabilizing effect of any official exchange rate commitment on expectations depends on its credibility. A looser commitment across the poles—wherein authorities “keep their powder dry” for large, clear-call misalignments and do not claim that the primary assignment of monetary policy is for external balance—should be more credible than a (nominally) tighter and louder commitment But the same logic also points to tight, loud exchange rate commitments within currency areas, one of which is an emerging EMU. Here, the incentives for stabilizing exchange rates are greater—because these economies are more open, because trade flows among union members account for a large share of members’ total trade, because exchange rate stability is closely linked to larger, regional integration objectives, and because there are larger gains in anti-inflationary credibility to be had by “tying one’s hands” on monetary policy via exchange rate fixity.
Nominal exchange rates within the union. What about the pressing issue of managing exchange rates within, and on the way to, monetary union? One key issue relates to the consequences of losing the nominal exchange rate as a policy instrument. Economic theory suggests that the types of shocks hitting an economy (monetary or real) should be an important factor in the choice of an exchange rate regime. The potential problem of a monetary union is adjusting to country-specific real shocks. Here, three questions need to be addressed.
• Are the real economic shocks that typically hit European economies industry-specific rather than country-specific? If they are industry-specific and if potential EMU members have well-diversified industrial structures, then it is possible that these shocks largely cancel out at the country level; but if shocks are predominantly country-specific, potential difficulties are obviously greater.
• Will the increased competition in goods and factors markets associated with 1992 increase the downward flexibility of money wages and prices in Europe? If so—and we do not discount this possibility—it will be less costly to achieve needed changes in real exchange rates via changes in internal wages and prices.
• Is there in operation a federal fiscal authority that could automatically adjust a country’s tax and transfer payments in the event of country-specific real shocks—and in a roughly budget-neutral fashion for the union as a whole? As is well known, this kind of tax and transfer system operates as a cushioning device in the United States.
The more confident one can be that the answers to these questions are “yes,” the less concerned can monetary authorities afford to be in embracing greater (nominal) exchange rate fixity on the path to EMU.
The exchange rate regime in the transition to EMU. Assume, in keeping with the spirit of EMU, that a judgment has been made to make use of the nominal exchange rate as a policy instrument only in “exceptional” circumstances. This still leaves unanswered whether the transition should be rapid or gradual and whether exchange rate commitments should be absolute or conditional.
One option would be to move rapidly to EMU itself, that is, to a common currency (e.g., the ECU) and to a central monetary authority (e.g., the EuroFed). This would carry a number of attractions. First, it gives maximum credibility to exchange rate stability by eliminating exchange rates within the union. A common currency is harder to “undo” than a commitment to “irrevocably fixed” exchange rates, and market participants presumably know it. Second, a common currency allows EMU participants to obtain more of the efficiency gains associated with moving closer to one money than do fixed exchange rates. Third, a central monetary authority can in principle avoid the negative externalities associated with beggar-thy-neighbor policies taken by competing national monetary authorities. Fourth, a central monetary authority may be able to implement monetary control more effectively than individual national central banks—because the demand for money in the wider area may be more stable under open capital markets and full financial liberalization than are individual-country money demands.
On the negative side, two concerns arise about a rapid move to EMU. One is that the participating countries will not be “ready” for a common currency or a common monetary policy, be it because of inadequate convergence of economic performance (particularly of inflation), inadequate consensus on the goals or framework for monetary policy, or inadequate experience with common institutions. To some observers, this lack of readiness calls either for a two-track approach—where the fast track is limited to a subset of potential members who already are ready in terms of convergence of economic performance—or for waiting together until a wider group of members is ready. A second objection is that an administrative, centralized approach to currency and monetary management will result in average—or even worse, collusive, below-average—performance; in contrast, a “competitive” approach—so the argument goes—would allow the market to converge on “the best in the Community.”
Another option would be to pursue a slower transition to EMU, characterized by the coexistence of a federal monetary authority and national central banks, and by a looser commitment to fixed exchange rates. This option clearly provides more scope for learning by doing and for making monetary policy more accountable to national governments. But as critics point out, such a strategy cannot escape the constraint that only two of the following three objectives can be obtained simultaneously: open capital markets, fixed exchange rates, and independent monetary policy. With capital controls all but gone and with increased opportunities for diversification of currency portfolios, a commitment to truly fixed exchange rates will be credible only if monetary policy coordination—ex ante and ex post—is tighter than in the past. In fact, the very liberalization processes that give rise to increased currency substitution, along with any destabilizing speculation, may well call for more frequent recourse to coordinated interest rate adjustments; otherwise, national monetary control is apt to be rendered less effective.
A related challenge thrown up by the coexistence of central and national monetary authorities and by a desire to introduce more symmetry of adjustment into the system, is that the rules of the game may become more difficult to define than in the existing EMS. Not only does the assignment of responsibilities have to be clearly understood, but also that assignment has to respect the primacy of price stability as a goal of EMU.
Carrying out monetary policy
During the transition to EMU, EC member governments will also have to come to terms with at least two important issues relating to the implementation of monetary policy: the degree of coordination, and rules versus discretion.
We see the current process of financial liberalization, innovation, globalization, and securitization as strengthening the case for closer coordination of monetary policy on at least three counts.
• The shift away from credit rationing and quantitative lending restrictions means that the transmission mechanism of monetary policy falls more heavily on interest rates and exchange rates—the “competitive” variables most often the subject of beggar-thy-neighbor complaints. Coordination is a way of discouraging such practices. The degree of conflict that exists in the transition to EMU is not irrelevant for prospects of actually achieving EMU.
• When there is a sudden, large increase in currency substitution, it may become more difficult to implement reliable monetary control at the national level without stronger coordination among monetary authorities.
… when fiscal policy is undisciplined and works in a direction opposite to that of monetary policy, efforts to promote price stability, effective external adjustment, and exchange market stability will be seriously handicapped.
• The problem of systemic risk does not lend itself easily to an autonomous, competitive approach, and this is of particular rele-vance to the Europe of 1992 and beyond. In an environment where there are increasing competitive pressures in financial services, universal banking throughout the region, equity prices moving more closely across countries, and a desire on the part of monetary authorities to establish or maintain anti-inflationary credibility, it would not be surprising if some financial institutions experienced difficulties. A national monetary authority might act to contain such difficulties by providing emergency liquidity support or by activating official or private deposit insurance schemes. However, official safety nets, as with other types of insurance, raise moral hazard issues; in this case, the encouragement to undertake an unduly high share of risky activities, giving rise to unfavorable consequences for the public sector’s liability.
This problem could be reduced if financial institutions maintained adequate capital requirements, or if access to deposit insurance went hand-in-hand with restrictions on institutions’ activities. But in a world of financial liberalization, any single country’s attempt to impose stiffer regulatory standards could result merely in firms fleeing to countries with more lax standards (resulting in a form of regulatory arbitrage). A coordinated approach to regulation can accomplish what a competitive approach cannot. The recently concluded Basle Agreement on risk-weighted capital standards for commercial banks in the Group of Ten countries is a case in point.
This brings us to the familiar issue of rules versus discretion, which would need to be addressed whether a coordinated or competitive approach to monetary policy was selected. Those who favor policy rules make essentially three arguments. First, rules are a viable mechanism for imposing discipline on economic policymakers who might otherwise manipulate the instruments of policy for their own objectives and to the detriment of the public. Second, rules can reduce the cost of negotiations and burden-sharing conflicts. Third, rules are regarded as enhancing the predictability of policy actions, thereby improving the private sector’s ability to make informed resource allocation decisions.
These arguments in favor of policy rules are powerful, but their immediate operational attractiveness is blunted by two considerations—both of which are relevant to an emerging EMU. One is that rules that do not adapt to major changes in the operating environment run the risk of worsening policy performance. The weakening in many countries of the link between narrow monetary aggregates and the ultimate goals of monetary policy in the face of large-scale financial innovation and institutional change is a leading case in point. In recognition of these changes in the operating environment, several prominent supporters of policy rules have incorporated trend changes in velocity into their money supply or national-income rules (what we might call “evolutionary” rules)—while several monetary authorities have indicated that they now employ a more eclectic approach to monetary policy (where the behavior of monetary aggregates is taken into account along with a set of other variables). A second consideration is that rules will impart greater discipline to policy only to the extent that penalties for breaking the rules are significant enough to ensure that the rules are followed. The sanctions available against sovereign nations for breach of economic policy commitments should not be exaggerated.
Search for fiscal discipline
A striking lesson of the 1980s is that when fiscal policy is undisciplined and works in a direction opposite to that of monetary policy, efforts to promote price stability, effective external adjustment, and exchange market stability will be seriously handicapped. Basically, there are three potential mechanisms for encouraging greater fiscal discipline.
The exchange rate regime. Experience is not kind to the view that the exchange rate regime by itself can enforce discipline on fiscal policy. Thus after more than ten years of operation—and with a clear progression toward greater fixity of exchange rates—there is little evidence of fiscal policy convergence in the EMS. Monetary policy convergence, yes—but not fiscal policy convergence. In a similar vein, the North American experience with much greater exchange rate flexibility hardly suggests that this exchange rate regime can consistently rein in fiscal policies. It is not difficult to construct theoretical examples where the exchange rate regime sends either a false signal, or no signal at all, about the need for fiscal adjustment. Typically, this comes about because the higher interest rate associated with fiscal expansion induces a capital inflow that either prompts a loosening of monetary policy (to keep the exchange rate within its target), or simply makes the fiscal deficit easier to finance.
The market. What then about the discipline imposed by “the market?” Such market discipline is usually said to operate via two channels. The first is the higher cost of borrowing associated with consistent fiscal imprudence—as the markets exact an increasing risk premium to reflect lower expected repayment At some point, markets could even impose their ultimate sanction, by refusing to lend altogether to the unrepentant borrower. The second is via pressures for tax harmonization. In short, a government that spends a lot will eventually have to tax a lot, but high taxes will, in turn, induce firms and individuals to move to jurisdictions with lower taxes. Declining tax revenues will then force tax harmonization, and finally, a halt to excessive spending.
For market discipline to work, the following conditions need to be satisfied.
• The market must have accurate and comprehensive information on the size and composition of the debtor’s obligations, so that it can make a valid assessment of debt-servicing obligations relative to ability-to-pay. Credit-rating agencies can of course assist in this information processing task, but they need to be cautious since a rating change can become a self-fulfilling prophecy. In addition, debtors may not have incentives to reveal unfavorable information before mandated reporting dates.
• There must not be any implicit or explicit guarantee of a bail out. For if there is the expectation of a bail out, then the interest rate charged will reflect the creditworthiness of the guarantor—not that of the debtor. The market’s perception of a bail out is sometimes cited as a reason why in the 1970s interest rate spreads on bank loans to developing countries were so slow to rise. It is of course possible for the overseeing fiscal authority to issue a no bail-out pledge. The problem is that it may be difficult to make this pledge credible if troubled debtors were in the past bailed out.
• The financial system must be strong enough for any given debtor not to be regarded as too large to fail; if other financial institutions are large holders of the troubled debtor’s obligations, it will be harder to exercise discipline.
• The borrower’s debt must not be monetized by central bank purchases—that is, be allowed to be translated into an expansion of the money supply. This is because the resulting erosion of the real value of the debt will make it difficult for the market to price it accurately.
• There must be neither high costs of mobility nor the provision of public services that compensate for tax differentials (this condition applies specifically to tax harmonization). If mobility costs are high, individuals and firms are less likely to “vote with their feet” when taxes are raised. If better public services are offered in high tax districts, then high taxes do not provide an incentive to leave.
The empirical evidence on market discipline is quite limited. From the viewpoint of an emerging EMU, perhaps the most relevant work is that dealing with common currency areas that have federal fiscal systems (such as the United States and Canada), and where there is no explicit or implicit guarantee of a bail out for fiscal adventurism at the local level. A recent analysis of whether US states with higher debt burdens actually paid higher interest rates on their debt was undertaken by Professor Barry Eichengreen of the University of California at Berkeley. He found only a weak, positive relationship between debt burdens and the cost of borrowing, and no evidence that borrowing costs accelerate at very high debt levels. Moreover, even if stronger empirical evidence linking borrowing costs to fiscal irresponsibility were available, it would give us only half the picture. Still missing is evidence that higher borrowing costs actually induce governments to correct fiscal policy excesses; to our knowledge, no such tests are yet available.
Peer group surveillance. This would offer still another mean of encouraging fiscal discipline. One possibility would be a fiscal policy rule that put a ceiling on each participant’s fiscal deficit. The main difficulty with rigid fiscal policy rules is that they may not take adequate account of relevant differences between countries—in private savings rates, outstanding debt stocks, the uses to which government expenditures are put, past credit histories, etc. In addition, there may be few sanctions that can be imposed on noncomplying members. For these reasons, peer group surveillance typically takes place in a voluntary, discretionary format. But this mode of operation faces its own obstacles: fiscal policy is inflexible (at least relative to monetary policy); it operates with long and variable lags that depend in good measure on the pace of legislative actions; and the effects of fiscal policy on macro-variables of interest hinge on what kind of fiscal action is taken (taxes versus expenditures, expenditures on tradables versus nontradables, taxes on saving versus investment, etc.). Then, too, surveillance exercises invariably employ multi-indicator methods, where the tendency of different indicators to point in different directions gives considerable scope for discretion in policy diagnosis and prescription.
The likelihood that no single mechanism can be relied upon to yield fiscal discipline means that a broad-based approach that leans both on markets and on surveillance will be called for. The transition to EMU will proceed a lot smoother if fiscal policy can be made to work with monetary policy in achieving EMU’s basic economic goals.