Comment: Some Thoughts on the Papers Presented by Kenen, Fratianni, and Pollard

4 Colum. J. Eur. L. 421 (1998)

James T. Little. Professor, John M. Olin School of Business, Washington University, St Louis.

For economists, the most interesting of the questions regarding monetary union is whether it should be undertaken at all. By now, however, this is a moot issue. Monetary union will happen whether or not economists agree it is a good thing. While slogans such as “one market, one money” were employed by the supporters of economic and monetary union (EMU), the motivation for EMU had more to do with politics than economics in the first place. However, even if the economic consequences of monetary union are less important than political considerations in the decision to proceed, the economic consequences will still remain. Through the three papers presented in this session, we are to identify some of the near-term consequences. The Kenen and Fratianni papers deal with the questions of who will be in the European Central Bank and how membership will affect the decisions made by that body. Dr. Pollard’s paper considers the closely related question of the role of the euro as an international currency.

Before commenting on the individual papers, it may be useful to review the economic tradeoffs that monetary union involves. Monetary union brings with it intra-European exchange rate certainty. Exchange rate certainty is not a necessary condition to accomplish the goals of a single market in the European Union any more than fixed exchange rates are necessary to realize the benefits of free trade within a regional trade area such as NAFTA. Nevertheless, as Eddie George, the Governor of the Bank of England has put it: “Exchange rate certainty is a very considerable prize.” The economic benefits come in the form of increased competition and improved resource allocation resulting from increased price transparency and lower transaction costs. But it is worth noting that the transaction costs savings are much smaller than most laymen perceive. For most major trading currencies, the foreign exchange markets are highly efficient with very narrow spreads. It is also worth noting that most business people prefer fixed rates until confronted with the possible consequences, as happened in the United Kingdom prior to that country’s forced exit from the European Monetary System. The tradeoff for having certainty in exchange rates is that with a single currency comes a single monetary policy. At times, the policy will be different from that which would be appropriate for the domestic economies of the member countries or for different regions within the currency area. The greater the asymmetry in the impact of economic shocks on these “sub-economies,” the greater the potential cost of monetary union. When the costs of the economic dislocations caused by the depth and duration of economic dislocations resulting from inappropriate monetary policies outweigh the benefits of exchange rate certainty, then the grouping of countries is not an optimal currency area.

As Fratianni points out in his paper, the weight of the evidence suggests that the EU-15, taken together, would not create an optimal currency area. Correlations between business cycles provide a crude measure of the asymmetries that are at the root of the problem. Over the period of 1980 through 1996, for example, the correlation between the Dutch and Austrian business cycles and that of Germany were each in the neighborhood of 0.8, suggesting a high degree of symmetry between these economies. However, for France and the United Kingdom, the correlations with Germany are 0.5 and 0.2 respectively, implying that for significant periods the cycles in these countries were out of phase with German cycles. It can be argued that these asymmetries are a product of the special circumstances of German reunification. However, the 1970s showed a similar pattern, this time in reaction to oil price shocks. Convergence under the terms established by the Maastricht Treaty does not eliminate the asymmetries. So they are part of the economic landscape in which the ECB will operate.

The fact that the EU-15 do not comprise an optimal currency area is the reason that membership of the monetary union could matter so much. In a “narrow” monetary union, the chances of asymmetries arising are lower than in a “broad” union. In the narrow union, conflicting policy needs are unlikely to arise. However, in the broad union that both Kenen and Fratianni see emerging, conflicts are likely. To put this issue in stark terms we need to ask how the ECB will behave when confronted with a recession in Italy and a rapid expansion in Germany. Here, Kenen and Fratianni disagree. Fratianni concludes that membership will significantly affect the policy stance of the ECB. He sees the national central bank governors dividing into factions which, together with the incentives of ECB Executive members, will result in the inflation “doves” carrying the day in some circumstances, the “hawks” in others. This, in turn, will lead to problems of credibility and inconsistent monetary policy and will result in the embedding of an expected inflation premium.

Kenen argues that the combination of the safeguards of ECB independence built into the Maastricht Treaty combined with the likely appointment of inflation “hawks” to both the Executive Board of the ECB and as governors of national central banks, will lead to price stability as the overriding goal of the ECB. In other words, ECB policy will be largely immune from political pressures of one or a small group of member countries. Given that he expects political considerations to dominate economic factors in determining membership of the union, this may seem inconsistent. However, Professor Kenen knows  central bankers better than any of us do. Nevertheless, as Kenen points out, a conservative posture is not necessarily a good thing. Without monetary policy as an option and with reduced fiscal discretion, the rigidities in European labor markets have consequences that are much more serious than they would otherwise be. The final sentence of his paper is almost chilling: “If indeed we have reason to worry about the life expectancy of the European monetary union, it is not because we have reasons for concern about the objectives or governance of the ECB but because individual countries may have much trouble adjusting to its monetary policy.” This is an important point. The cost of asymmetries depends not only on the frequency and severity of the shocks but also on the speed with which the affected regions can respond to these shocks without monetary intervention.

Neither Fratianni’s nor Kenen’s conclusions are at all sanguine. However, it has been asserted that such arguments neglect an important outcome of monetary union, namely, the benefits of the euro playing a major role as an international currency. Pollard’s paper addresses these issues and her analysis suggests that these benefits will be modest at best and, during infancy and adolescence of the euro, possibly not exist at all. She points out that, in the short run, the emergence of the euro is likely to increase the dollar’s role in international markets. Elimination of the individual currencies of EMU members will eliminate the use of such currencies as reserves for EMU members and eliminate foreign currency transactions in the EMU currencies. Moreover, the uncertainty that will surely exist regarding the euro will likely favor the dollar.

Actually, the euro’s international role may be even less significant than Pollard projects. Here again, membership may matter, but in this case it is the “outs” rather the “ins” that are important. With the U.K. as a non-member, as is virtually certain for the euro’s first round, sterling will continue to have an independent role as an international currency. Moreover, assets that are now sterling-denominated will remain sterling-denominated, which will mean a considerable reduction in the potential stock of euro-denominated financial assets. This by itself will reduce the depth and liquidity of the markets for euro assets. Potentially even more important in this regard is that the London markets, which are the deepest and most liquid of the European financial markets, will be outside the euro-zone, at least initially. Participants in the London markets take great pride in their willingness to engage in any transaction in any currency, so that ironically, London could very possibly be the major trading center for euro instruments even while the U.K. is not a member of the monetary union. But having London on the outside will certainly not enhance the prospects for the rapid development of deep and efficient euro-denominated markets.

So, these three papers have removed the question mark from the conference title. There will be a euro in 1999. Yet, the papers raise the equally important questions of what kind of euro it will be and whether it will be successful
however that is judged in economic terms. To the questions the papers raise, I would like to add one more: has the development of the single currency diverted attention away from concern with operation of the European financial system at a micro level? Here I have in mind particularly the apparent inadequacy of the system in providing finance to start-ups and smaller businesses.

As we learn more about the role of labor market flexibility, it is becoming increasingly apparent that wage flexibility alone cannot explain the difference in performance of the United States and the European economies over the past few years. The United States has a very efficient system for providing capital for start-up businesses. This of course accelerates adjustment to changes in patterns of demand. The recent experience of southern California provides a compelling example of this. The last U.S. recession hit this region harder than any other, in large part because of cuts in military spending. Unemployment rose more and was moie persistent than elsewhere in the country. Yet, in a remarkably short period the southern California economy transformed itself and by 1994-1995 had not only replaced all the jobs lost during the recession but was adding jobs faster than any other U.S. region. This happened without the Federal Reserve Bank compromising any policy goals and without special assistance such as “structural funds.” The job growth occurred in new businesses, not only in high-tech sectors such as software and biotech but also in low-tech sectors such as clothing manufacturing. A critical factor was the availability of finance and the counsel and oversight that came along with it.

It certainly appears that the monetary union project has for the time being stopped any fundamental restructuring of financial services within the EU. This is not to say that there have been no changes, especially at the wholesale level. However, at the retail finance level little has really changed. This is hardly surprising-a grand project such as developing a new currency is heady stuff. There are few conferences on providing finance and business advice to an entrepreneur who wants to expand a small chain of taco stands. But, perhaps that is what we, and the European Union Member States, should be talking about.