one money for europe?: a review essay

Journal of Monetary Economics 25 (1990) 313-322. North-Holland

ONE MONEY FOR EUROPE? A Review Essay

Geoffrey E. WOOD*

City Umuersity Bu.wwss School, London, EC2 Y 8HB, UK

Report on Economic and Monetary Union in the European Community (Delors Report) (Office for Official Publications of the EC, Luxembourg, 1989)

and

A European Central Bank? Perspectives on Monetary UniJication after Ten

Years of the EMS, Marcello De Cecco and Albert0 Giovannini (Cambridge University Press, New York, 1989)

The Delors Report was produced by a committee chaired by Jacques Delors, President of the European Commission, in response to the decision of the Council of the European Communities to consider how to achieve ‘economic and monetary union’. This review focuses on three issues raised in that Report and a very important one which was ignored.

The Report repeatedly emphasizes the necessity for regional policy to prevent some areas being harmed by monetary integration; can this claimed necessity be justified? It is asserted that there must be constraints on the size of national budget deficits. What arguments underlie this? Economic and monetary union is repeatedly described as a ‘single process’ (e.g., p. 24). What meaning of the words economic and monetary union can support this? And finally, not mentioned in the Report, how will price stability be maintained after the union? The Report is considered in sequence. The De Cecco and Giovannini volume is considered subsequently.

1. ‘Past and present developments.. . ’

The Report’s appraisal of the European Monetary System (EMS) is favourable.’ The EMS is said to have been a ‘zone of increasing monetary

*I am greatly indebted for discussions on this subject to Donald Hodgman and Jurgen van Hagen, and for most detailed comments to George J. Benston, Herschel Grossman, and Anna J. Schwartz.

‘A brief outline of the establishment and main features of the EMS can be found in Wood (1989).

0304-3932/90/$3.5001990, Elsevier Science Publishers B.V. (North-Holland)

314 G. E. Wood, One money for Europe?

stability’ (p. 2). These views are not universally held. Vaubel (1989) wrote: ‘ . . . the exchange rate mechanism of the EMS does not seem to have contributed to reducing nominal effective exchange rate variations, inflation, and inflation differences of the member countries, or to increasing intra-ERM trade.. . ‘.2

Von Hagen and Fratianni (1990) support Vaubel’s conclusion on inflation and display evidence which denies that the system has helped high-inflation countries to lower inflation by borrowing credibility from the Bundesbank.3

The Report asserts the ‘need to back up removal of market barriers with a strengthening of common regional policies’; that sounds like replacing a barrier which took the form of a tax with one in the form of a subsidy. The basis for the claim is discussed below. There is concern that ‘external imbalances have become markedly greater in the recent past’ (p. 5); these are described as disequilibria. That is puzzling. External imbalances are a way of transfering capital between countries - regional policy via the market. Why is this bad while government regional policy is good?

All in all, the message is that ‘economic and monetary union implies far more than a single market programme and will require further major steps in all areas of policy making’ (p. 7). These ‘major steps’ are discussed in the next two sections of the Report.4

2. ‘The final stage of economic and monetary union’

This section starts with a definition of economic and monetary union: ‘ . . . complete freedom of movement for persons, goods, services, and capital.. _ and finally, a single currency’ (p. 8). It recognizes (p. 9) that such a union will have to have a ‘single monetary policy . . (and) _. , one decision-making body’. It could not be otherwise if there is a single currency. It is, however, then asserted that there would also have to be ‘. . . an agreed macroeconomic framework . _. (to) . . . avoid unsustainable differences between individual countries in public-sector borrowing requirements’ (p. 9). This claim has attracted great attention [e.g., Goodhart (1989)], but requires further examina- tion.

Before moving to that, one point remains. It is said that ‘economic and monetary union form two integral parts of a single whole’ (p. 9, Report’s

*‘ERM’ stands for ‘Exchange Rate Mechanism’. All countries in the EC are members of the EMS; but not all have joined the set of pegged rates known as the ERM.

3Goodhart (1989) thinks the opposite. He describes the EMS as ‘ functioning as a hegemonic DM block’.

4Before this section of the Report ends, regional policy is mentioned again. The motivation here is plainly political. The Report calls for ‘common policies to help to prevent the emergence or aggravation of regional and sectoral imbalances which could threaten the oiability of an economic and monetary union’ (p. I, emphasis added).

G. E. Wood, One money for Europe? 315

emphasis). This has been asserted in various EC treaties. But is it true? If economic union is a situation where goods, services, and all factors of production can move freely, then economic union could surely be a situation where all barriers to such movement, except currency risk and transport costs, were removed. It is consistent with floating rates. It is slightly harder to see how it is consistent with a Bretton Woods type system; that functioned best when supplemented by exchange controls. But there could certainly be full economic union in an exchange-rate regime modelled on the gold standard. The Report’s assertion that economic and monetary union are inseparable is quite plainly an expression of political intention rather than economic sub- stance.

3. Budgetary constraints

We are told that monetary union would require ‘. . . binding rules governing the size and the financing of national budget deficits’ (p. 16),s to prevent ‘ . . . unto-ordinated and divergent national budgetary policies (which) would un- dermine monetary stability’ (p. 16). It is, however, necessary to ‘establish a fiscal/monetary policy mix appropriate for the preservation of internal bal- ante.. . ’ (p. 16).

These assertions have two parts. National deficits have to be constrained; and, because these must be constrained, a supra-national authority will have to conduct counter-cyclical fiscal policy.

Why cap deficits? Sargent and Wallace’s ‘Unpleasant Monetarist Arith- metic’ (1981) implies that caps are required so that the central bank - the European one in this case - does not ultimately have to monetize the debt of some single member, and thus allow one country to levy the inflation tax on the whole of Europe. If this is the argument, it implies that the authors of the Delors Report do not think highly of either the abilities or judgment of policymakers in EC member states.6

A second situation is where debt does not grow at the rate required to compel monetisation, but leads to residents of one state buying the government debt of another. This is plainly desirable when there is a higher rate of return on capital in one nation than in the other. A classic example of this, on an enormous scale, is lending from the UK to the US in the late 19th century. Both countries gained. [See Cairncross (1953).]

A problem may exist only if capital is borrowed by one country regardless of the rate of return it can earn. In that case, the lending country ends up with a smaller domestic capital stock (although one probably unchanged in total)

‘The Report is somewhat asymmetrical; there is no concern about putting caps on surpluses.

%uch anxieties are nowhere explicit; explicit doubts are expressed only about the efficient functioning of markets.


than it would otherwise have had, while the borrowing country must service more debt with no more capital. This is a problem for the citizens of the borrower only if their government is irresponsible or has different interests from its taxpayers. If the authors of the Report fear this of a national government, why not of a Europe-wide government? Finally on this point, the Report nowhere acknowledges that local governments in many countries are allowed to borrow and to set their own local taxes. This is true of, for example, states in the USA and local governments in Britain. It is nowhere explained why this is not possible in the EC.’

How the Report envisages this Europe-wide fiscal policy being conducted also requires comment. A ‘Community-wide fiscal policy stance’ is to be used for ‘cyclical adjustments’ (p. 16). Although vague, that sounds as if active discretionary fiscal policy is intended. Given the balance of evidence [see Brunner (1989)], this is a strange position.

4. ‘The principal features of monetary union’

In this section it is claimed that, ‘once permanently fixed exchange rates had been adopted, there would be a need for a common monetary policy (Report’s emphasis) . . . The co-ordination of national monetary policies . . . would not be sufficient’ (p. 11). Why not? The gold standard worked with the co-ordination being done a good part of the time by an invisible hand. The statement is true of a common currency, but not for a set of fixed rates.

The Report asserts (p. 11) that the ‘permanent fixing of exchange rates would deprive individual countries of an important instrument . . . for . . . pursuit of price stability’. Not correct. One country in such an area can

pursue price stability - if it is the reserve centre. The others, of course, must passively accommodate. It is claimed that without exchange controls, the ‘effectiveness of national monetary policies will become increasingly depen- dent on co-operation among central banks’.* That is wrong. Policy may become more difficult to implement; money-demand functions may shift, and the relationship between base and other aggregates may change as banks outside a country start to hold some of its base money. But that is not the same as saying that policy becomes less effective.

‘Constraints have very recently been imposed on local government borrowing in the UK. This was done with the explicitly stated objective of preventing sharp rises in local taxes as a result of high debt-service costs.

‘Here the Report describes the absence of exchange controls as a situation where ‘every banking institution in the community is free to accept deposits from, and to grant loans to, any investor in the community and in any of the national currencies’ (p. 11). At no point does it mention whether the authors envisage exchange controls between the EC and the rest of the world.

G. E. Wood, One monqv for Europe? 317

5. ‘The principal features of economic union’

‘ economic union can be described in terms of four basic elements:

(1) - the single market within which persons, goods, services, and capnal can move freely:

(2) - competition policy and other measures aimed at strengthening market mechanisms;

(3) - common policies aimed at structural change and regional development;

and (4) - macro-economic policy co-ordination, including binding rules for bud-

getary policies’ (p. 12, point numbers added).

Taken in order: (1) agreed; (2) excellent, but not obviously relevant to economic union; (3) why?; and (4) already discussed. Points (2) and (3) are now considered.

Why is point (2) included? One reason may be that the authors of the Report recognise how well markets allocate resources. But the Report is elsewhere very critical of the market. The explanation may lie in the urge to centralise policy-making which underlies much of the Report.’

Now to point (3). The Report offers two justifications for such policies: the first is analytical and the second empirical.

First comes the claim that regional problems could arise because of ‘restructuring as set in motion by the removal of barriers’ or because of ‘labour and other cost developments’. Although the report treats these as identical, as Corden (1973) emphasized they are totally distinct.

Restructuring in an area with a common currency could be dealt with by capital flows - for some regions would suddenly have an abundance of labour, making investment desirable. [See Ingram (1959) for discussion of the Puerto Rican experience.] By ‘labour and other cost developments’ are presumably meant ‘cost push’ factors. Grant that these are both common and large. What would be the consequence of alleviating the resulting unemployment by regional policy? It would not cause inflation so long as the policy was not financed by money creation. What it would do is allow some group to levy at will a tax on the rest of the EC. Do the authors of the Report really want that?

It is then asserted that ‘peripheral’ regions generally suffer in a monetary union. Why? If a common currency has any effect on the distribution of prosperity across a region, it does so by reducing the cost of factor mobility,

‘Goodhart (1989, p. 23, fn. 6) writes ‘. the authors of the Report are even more federally minded and centralising than the framers of the U.S. constitution.’


thus moving marginal returns closer together. The Report’s assertion suggests the opposite.”

6. ‘Institutional arrangements’

The Report claims that a ‘new monetary institution would be needed because a monetary policy cannot result from independent decisions and actions by different central banks’ (p. 18). That is arguable; if these central banks all had the same objective, then there might well be no gains from explicit co-operation. l1 It is also beside the point; if there is one money, there can only be one central bank. The Report proposes a federal structure, essentially like the US Federal Reserve System, with current national central banks becoming like district banks, and a board of governors, with staff, in a location yet to be decided.

This bank would have five objectives (p. 19 of the Report): (1) price stability; (2) it should ‘support the general economic policy set at the community level’ (whatever that means); (3) be ‘responsible for the formulation and implementation of monetary policy’ - useful since it has the goal of price stability; (4) provide for ‘the maintenance of a properly functioning payments system’; and (5) ‘would co-ordinate banking supervision policies’.

Why should the new central bank be concerned with the payments system? The US Federal Reserve’s concern arose because it was the only bank legally permitted to engage in interstate banking. There is no such restriction in Europe. It is not clear why banking supervision policies should be ‘co- ordinated’ or even what co-ordination means in this context. Does it mean supervision should be the same throughout the EC? Presumably the motive for this ‘co-ordination’ is to prevent competitive deregulation. That is inconsistent with the earlier-expressed desire (p. 12) to strengthen market mechanisms. [It is also not clear that bank supervision is useful. See Benston (1990).]

The central bank would be independent but accountable. No suggestion is given of how this would be achieved. (The example of New Zealand is instructive. The Reserve Bank of New Zealand has a single objective: price stability. Note the contrast with the five objectives the Delors Report assigns to the proposed European Central Bank. Its decisions on how to attain this objective can be over-ridden by the Minister of Finance making an order in Council. But this order has to be tabled in Parliament, so it can be debated if any member of Parliament wishes, and it lapses automatically after six

“See the paper by Bertola in the De Cecco and Giovannini volume.

“There is some brief discussion of the benefits of policy co-ordination in the Report. This has not been considered in this review. It is a digression from the Report’s main theme; and an excellent discussion can be found in Portes (1989). For the numerous possible meanings of co-ordination, see Corden (1988).


months. In addition, the Governor’s salary is linked to the Bank’s success in

achieving price stability.) The role of the ECU (European Currency Unit) is discussed briefly. The

suggestion that the ECU should cease to be defined as a basket of currencies and should be ‘issued in addition to the existing Community currencies’ (p. 27) was rejected, the Report says, because ‘an additional source of money creation without a precise linkage to economic activity could jeopardize price stability’ (p. 27).

Why the observation that money growth has something to do with inflation is noteworthy emerges below.

The move to full economic and monetary union is seen as taking place in three stages. The interesting stages are 2 and 3. (Stage 1 is just all members of the EC joining the ERM arrangements.) In stage 2, the European Central Bank is set up, and the EC would ‘begin the transition from the co-ordination of independent national monetary policies by the Committee of Central Bank Governors in stage one to the formulation and implementation of a common monetary policy by the ESCB (European System of Central Banks) scheduled to take place in the final stage. The fundamental dificulty inherent in this transition would lie in the organization of a gradual transfer of decision making power from national authorities to a Community institution’ (pp. 33-34, emphasis added). In stage 3, exchange rates would be ‘irrevocably locked’ (p. 35) and ‘over the course of the final stage the national currencies would eventually be replaced by a single Community currency’ (p. 35). That leads directly to the Report’s neglected but important topic.

7. The dog that did not bark12

The new European Central Bank will be operating with a new currency; all existing national moneys will have disappeared. There will be no data whatsoever by which money demand or money supply functions can be estimated. By what procedures could that central bank deliver price stability? What could guide its policy decisions?

It might operate by pegging the exchange rate to a low inflation currency, but there is no hint in the Report that such a peg is planned.r3 Indeed, the Report’s comments on a ‘parallel ECU’ imply that monetary control is to be

“The familiar misquotation from Sir Arthur Conan Doyle’s ‘Silver Blaize’. The precise dialogue is as follows.

‘Is there any point to which you would wish to draw my attention?’ ‘To the curious incident of the dog in the night-time.’ ‘The dog did nothing in the night-time.’ ‘That was the curious incident,’ remarked Sherlock Holmes.

t31f there were a peg, then a case for a budget cap to prevent monetary expansion emerges. Without one, a country could borrow heavily outside the EC, and the resulting inflow would boost the EC money stock so long as the exchange rate were held pegged.


via a monetary aggregate. How this is to be done in the new institutional setting the Report describes is nowhere set out; no possible difficulties are admitted; and no thought is given to an incentive structure appropriate for that objective.

Although the authors of the Report emphasize the goal of price stability, they pay no attention whatsoever to how it is to be achieved. They have ignored a much more fundamental difficulty than that to which they direct our attention.

8. ‘A European Central Bank?’

Nine chapters by ten authors, plus an introductory essay by the editors, consider various aspects of monetary unification in Europe. There are also discussants’ comments on the chapters and a concluding round table discussion on ‘Prospects for a European Central Bank’.

All in all, this is an excellent book. The topics are well chosen and the papers of high quality. The first two papers, by Allan Drazen and Vittorio Grilli, deal with fiscal policy. Greece, Italy, Portugal, and Spain all obtain a substantial portion of government revenue (6% to 12%) from the inflation tax. Eliminating inflation in these countries would entail not only monetary restraint, but also large spending cuts or borrowing or tax increases. (Was the desire to rule out one of these choices an unmentioned argument in the Delors Report for the deficit cap proposal?) Grilli argues that the fiscal position of these countries is such that even a narrowing of the current EMS exchange rate bands is not feasible; and Drazen demonstrates that extensive reliance on the inflation tax is not only inefficient by the usual measure, but also reduces capital accumulation.

Giuseppe Bertola analyses the relationship between factor mobility and exchange-rate behaviour. He finds, not surprisingly, that factors move more readily from country to country in response to relative price signals the smaller is uncertainty about future exchange rates. This reinforces the above noted conclusions of Ingram (op. tit) and further undermines the Report’s insistence on extensive (and no doubt expensive) regional policies as a necessary accom- panyment to monetary union.

Daniel Cohen surveys two past attempts at monetary union - Keynes’s plan for monetary integration, and the European Payments Union - and claims that the failure of these schemes is not a bad omen for a European monetary union. Both his discussants are sceptical; Charles Wyplosz sets out a large research agenda which remains to be tackled before Cohen’s conclusion can be

endorsed. There are three studies of historical episodes. Carl-Ludwig Holtfrerich

examines monetary unification in 19th century Germany; Valeria Sannuci discusses the establishment of a central bank in Italy; and Jeffrey Miron looks


at the consequences of the founding of the Federal Reserve. The last of these papers certainly shows what a European Central Bank, if founded, should not do. The Fed appears to have increased the variance of both the growth rate of output and the inflation rate, lowered the growth rate of output, and increased the variability of stock prices. This all resulted from interest-rate smoothing. There have been few stronger cases for a simple monetary growth rule.

What do the other two papers teach? Contrasting the two points a clear lesson. In the Italian case, political and monetary unification preceded economic integration; in the German, economic integration preceded monetary, and both preceded political centralisation. The German experience was a success, while the Italian was plagued with difficulties. The proposals of the Delors Report seem closer to the Italian than to the German model.

9. Conclusion

The world has by now experienced almost three quarters of a century of monetary instability. Bernholz (1986) aptly summarized this experience:

‘The present age of discretionary monetary policies, which began in 1914, has turned out to be an age of permanent inflation. Inflation rates have ranged from low and moderate to hyper inflationary, but have scarcely anywhere and mainly only during the Great Depression been absent. It is true that countries with rather independent central banks have enjoyed lower rates of inflation [Parkin and Bade (1978)], but the long-term effects in those countries still have been substantial.’

The authors of the Delors Report have devoted no attention to what should be the focus of any plan for monetary reform, devising an institutional structure to deliver price stability. An important opportunity has been missed.

References

Benston, George J., 1990, Does regulation produce stability?, in: Forrest H. Capie and Geoffrey E. Wood, eds., Unregulated banking: Chaos or order? (Macmillan, London).

Bemholz, Peter, 1986, The implementation and maintenance of a monetary constitution, Cato Journal, Autumn, 477-511.

Brunner, Karl, 1989, Fiscal policy in macro theory: A summary and evaluation, in: Karl Brunner and Allan Meltzer, eds., Monetary economics (Basil Blackwell, Oxford).

Caimcross, Sir Alec, 1953, Home and foreign investment, 1870-1913 (Cambridge University Press, Cambridge).

Corden, Max W.. 1973, The adjustment problem, in: Lawrence B. Krause and Walter S. Salant, eds., European monetary integration and its meaning for the United States (Brookings, Washington, DC).

Corden, Max W., 1988, How valid is international Keynesianism?, in: Walter Eltis and Peter Sinclair, eds., Keynes and economic policy (Macmillan, New York, NY).


Goodhart, Charles, 1989, The Delors Report: Was Lawson’s reaction justifiable?, Financial Markets Group working paper, May (London School of Economics, London).

Ingram, James C., 1959, Regional payments mechanisms: The case of Puerto Rico (University of North Carolina Press, Chapel Hill, NC).

Parkin, M. and R. Bade, 1978, Modem macroeconomics (Phillip Allan, Oxford). Portes, Richard, 1989, Macroeconomic policy co-ordination and the European monetary system,

Working paper (Centre for Economic Policy Research, London). Sargent, T. and N. Wallace, 1981, Some unpleasant monetarist arithmetic, Federal Reserve Bank

of Minneapolis Review, Fall, 1-17. Vaubel, Roland, 1989, Comments on Wegner, Manfred: ‘The European monetary system: A

regional Bretton Woods or an institutional innovation’, in: J. Vosgerau, ed., New institutional arrangements for the world economy (Springer-Verlag, Berlin).

Von Hagen, Jurgen and Michelle Fratianm, forthcoming, The European monetary system ten years after, Journal of Monetary Economics.

Wood, Geoffrey E., 1989. Banking and monetary control after 1992: A central bank for Europe?, in: Whose Europe? (Institute of Economic Affairs, London).

one money for europe?: a review essay

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