Monetary Unions: Institutions and Policies (Springer Texts in Business and Economics) 3030932311, 9783030932312

Table of contents :
Preface
References
Structure of the Book
Terminology matters
Contents
Part I Monetary Issues
1 Monetary Unions: Between International Trade and National Sovereignty
1.1 Monetary Sovereignty
1.1.1 The Circulation of Currency
1.1.2 Monetary Unions
1.1.3 Monetary Sovereignty in Monetary Unions
1.1.4 Monetary Unions in History
1.1.4.1 Monetary Unions Before and After Bretton Woods
1.1.4.2 National Unions
1.1.4.3 Multi-National Monetary Unions
1.1.4.4 Dollarization
1.2 Currencies, Foreign Exchange and International Payments
1.2.1 Currency Plurality and External Constraints
1.2.1.1 International Trade and External Constraints
1.2.1.2 The External Constraint and the Role of Exchange Rates
1.2.1.3 The Balance of Payments and the External Constraint
1.2.2 Monetary Union and the External Constraint
1.2.2.1 Price Adjustments in the Absence of an Exchange Rate
1.2.2.2 The Case of a Monetary Union Open to the World
1.2.2.3 The Balances of Payments of the Monetary Union
1.2.3 Currency Area and Monetary Union: What Is the Difference?
1.3 The Rules of the Game of a Monetary Union
1.3.1 International Monetary Systems
1.3.1.1 What Is the Purpose of an International Monetary System?
1.3.1.2 A Brief Overview of the International Monetary Systems. The Role of Exchange Rates
1.3.2 Multi-National Monetary Union as an International Monetary System
1.4 Conclusion
References
2 Why a Monetary Union?
2.1 Assessing a Monetary Union
2.1.1 Methodological Preliminaries
2.1.2 The Theory of Optimal Currency Areas
2.1.3 Subsequent Contributions
2.1.3.1 The Issue of Finance
2.1.3.2 The Issue of Openness and Diversification
2.1.3.3 Fiscal Policies
2.1.4 Monetary Union, Expectations, and Credibility
2.2 The Membership of a Monetary Union
2.2.1 Why Joining a Monetary Union?
2.2.2 Why Accepting a New Entrant?
2.2.3 The Special Case of Dollarization
2.3 Changes Induced by a Monetary Union
2.3.1 Microeconomic Effects
2.3.1.1 International Trade
2.3.1.2 Productive Specialization
2.3.2 Macroeconomic Effects
2.3.2.1 Shocks, Cycles
2.3.2.2 Prices and Inflation
2.3.2.3 Risk Sharing
2.3.2.4 Labour Markets: The Issue of Mobility
2.3.3 Financial Effects
2.4 Conclusion
References
3 Monetary Policy in a Monetary Union: Lessonsfrom Simple Models
3.1 Monetary Policy
3.1.1 Monetary Policy in a Unified Economy
3.1.2 Monetary Instruments
3.2 Monetary Policy in a Monetary Union
3.2.1 Preference Functions of the Central Bank
3.2.2 Heterogeneity and Monetary Policy
3.2.3 Monetary Policy and Nominal Rigidities in the Monetary Union
3.2.4 Taylor Rule and Indicators of Misalignment
3.2.5 Misalignment Indicators in the European Case
3.3 A Simple Model of Monetary Union
3.3.1 A Monetary Union
3.3.2 Central Bank Preferences
3.3.3 The Monetary Policy Decision
3.3.3.1 With the Union Loss Function
3.3.3.2 With an Aggregation Loss Function
3.4 Traded Goods, Terms of Trade and Monetary Policy
3.4.1 With a Union-Wide Loss Function
3.4.2 With a Summation Loss Function
3.4.3 With Asymmetry
3.5 Non-conventional Monetary Policy in a Monetary Union
3.5.1 From Conventional to Non-conventional Policy
3.5.2 Non-conventional Policy in Monetary Union
3.5.2.1 The Transition to Non-conventional Policy
3.5.2.2 Which Policy Should Be Pursued?
3.5.2.3 The Effectiveness of Non-conventional Policy
3.6 Conclusion
A Simple Model of a Monetary Union
Solution for 3.3.3.1 (With the Union Loss Function)
Solution of 3.3.3.2 (With an Aggregation Loss Function)
Solution for 3.4.1 (With a Union-Wide Loss Function)
Solution for 3.4.2 (With a Summation Loss Function)
References
4 Institutions and Monetary Policy
4.1 Rule or Discretion in a Monetary Union
4.1.1 Expectations and Monetary Policyin a Simple Economy
4.1.2 Rule or Discretion?
4.1.2.1 Discretionary Policy
4.1.2.2 Rule-Based Policy
4.1.3 Monetary Policy in a Monetary Union with Direct Negotiation
4.1.3.1 Discretionary Policy
4.1.3.2 Rule-Based Policy
4.1.4 A Variant with Asymmetric Anchoring
4.1.4.1 Independent Monetary Policies
4.1.4.2 Asymmetric Anchorage or Monetary Union?
4.2 Central Bank Independence
4.2.1 What Is Meant by Independence?
4.2.2 Central Bank Independence in a Monetary Union
4.2.3 Delegation in a Monetary Union
4.2.3.1 Delegation in a Simple Economy
4.2.3.2 Choosing the Central Banker in a Monetary Union
4.3 The Collegiality of the Monetary Decision
4.3.1 The Monetary Policy Committee
4.3.2 The Monetary Policy Committee in a MonetaryUnion
4.3.2.1 How to Supra-Nationalize the Common Monetary Policy?
4.3.2.2 Appointing Members to the Monetary Policy Committee
4.4 Communication and Accountability
4.4.1 Between Transparency and Opacity
4.4.2 Accountability
4.4.2.1 What Is Meant by Accountability?
4.4.2.2 Accountability in a Monetary Union
4.5 Financial Crises and the Lender-of-Last-Resort Function
4.6 Conclusion
Solution for 4.1.4. (A Variant with Asymmetric Anchoring)
Proof of Proposition 4.1
Proof of Proposition 4.2
References
Part II Fiscal Issues
5 Government Deficits, Transfers and Debts
5.1 Government Deficits and Public Debts in a Monetary Union
5.1.1 The Budget Constraint of a Member State of a Monetary Union
5.1.2 The Constraint of the Federal Treasury
5.1.3 Central Bank Accounts
5.1.4 Public Accounts and Monetary Union
5.1.5 Budget Constraints in Real Terms
5.2 The Sustainability of Public Debts in a Monetary Union
5.2.1 The Sustainability of a Member Country's Debt
5.2.2 Sustainability of the Federal Treasury Debt
5.2.3 The Consolidated Sustainability of a Monetary Union
5.3 Debt Sustainability and Sovereign Default in a MonetaryUnion
5.3.1 Default and Renegotiation of the Public Debt
5.3.2 Budget Constraints Including Default Possibility
5.3.3 Sovereign Default in a Monetary Union
5.4 Market and Institutional Disciplines
5.4.1 Market Discipline
5.4.2 Institutional Discipline in a Monetary Union
5.4.3 Separating Disciplines?
5.5 Conclusion
References
6 Fiscal Policies in a Monetary Union
6.1 Fiscal Effects in a Monetary Union
6.1.1 The International Effects of Fiscal Impulses
6.1.1.1 Direct Macroeconomic Effects
6.1.1.2 Financial Effects
6.1.2 Cross-Border Effects of Fiscal Impulses in Monetary Union
6.1.2.1 In the Short Term
6.1.2.2 In the Long Term
6.1.2.3 Financial Flows
6.2 Stabilization Policies in a Monetary Union
6.2.1 The Functions of Fiscal Policy
6.2.2 The Conduct of Fiscal Policies
6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union
6.3.1 Fiscal Multipliers
6.3.2 The Macroeconomic Impact of Fiscal Policies
6.3.2.1 The Case of a Union with Flexible Prices
6.3.2.2 What Do the Empirical Studies Tell Us?
6.3.3 Macroeconomic Stabilization and Transfers
6.3.3.1 The (Non-)coordination of Fiscal Policies
6.4 Fiscal Policies and External Balances
6.4.1 Fiscal Devaluations
6.4.2 National Fiscal Policies and Tax Competition
6.5 Fiscal Rules
6.5.1 The Properties of a ``Good'' Fiscal Rule
6.5.2 Types of Rules
6.5.3 Fiscal Rules in a Monetary Union
6.6 Conclusion
References
7 The Policy Mix
7.1 The Policy Mix in a Monetary Union
7.1.1 Is an Optimal Monetary Union Possible?
7.1.2 Is Insulation Within a Monetary Union Possible?
7.1.3 The Issue of Dominant Policy
7.1.3.1 Policy Dominance in a Monetary Union
7.1.3.2 Policy Dominance, Default and Transfers
7.1.4 The Policy Trilemma of a Monetary Union
7.2 Lessons from a Simple Model
7.2.1 Modelling the Policy Mix
7.2.2 Institutional Options
7.2.3 Calculation of Expected Losses
7.2.3.1 Very Tightly Constrained Fiscal Policies (FU 1)
7.2.3.2 Autonomous Fiscal Policies (FU 3)
7.2.3.3 Very Weakly Constrained Fiscal Policies (FU 5)
7.2.4 Comparison of Options
7.3 Conclusion
Solution for 7.2.3 (Calculation of Expected Losses)
Very Tightly Constrained Fiscal Policies (FU 1)
Autonomous Fiscal Policies (FU 3)
Very Weakly Constrained Fiscal Policies (FU 5)
References
Part III Toward an Ever Closer Union
8 Structural Adjustments and Reforms
8.1 Understanding Structural Reforms
8.1.1 Market Reforms
8.1.1.1 Goods Markets
8.1.1.2 Labour Markets
8.1.1.3 Financial Markets
8.1.2 Public Sector Reforms
8.1.3 Structural Reforms and External Constraints
8.1.3.1 Redistributive Effects
8.1.4 The Macroeconomic Impact of Structural Reforms
8.1.5 Structural Reforms and Macroeconomic Policy
8.2 The Challenge of Structural Reforms in a Monetary Union
8.2.1 External Constraint in a Monetary Union
8.2.2 The Macroeconomics of Structural Reforms in a Monetary Union
8.2.2.1 In Normal Times
8.2.2.2 In the Liquidity Trap
8.3 Implementing Structural Reforms
8.3.1 National Structural Reforms
8.3.2 Multi-National Structural Reforms
8.4 A Simple Model for Structural Reforms in a Monetary Union
8.4.1 Demand and Monopolistic Competition
8.4.2 Labour Markets
8.4.3 The Structural Configuration of Monetary Union
8.4.4 Equilibria
8.4.4.1 Internal Equilibrium
8.4.4.2 External Equilibrium
8.4.5 Domestic Structural Reforms and the ExternalBalance
8.4.5.1 National Structural Reforms
8.4.5.2 The Possibility of Multiple Non-cooperative Equilibria
8.4.6 Structural Reforms at the Union Level
8.4.7 Additional Remarks
8.5 Conclusion
References
9 Fiscal Union
9.1 What Is a Fiscal Union?
9.1.1 Why a Fiscal Union?
9.1.2 Fiscal Union Between Integration and Differentiation
9.1.3 Sovereignty and Fiscal Union
9.1.4 International Transfers
9.1.5 Policy Dominance
9.2 International Fiscal Cooperation
9.3 Fiscal Federalism
9.3.1 Macroeconomic Analysis of Fiscal Federalism
9.3.2 Fiscal Federalism in Practice
9.3.2.1 The American Case
9.3.2.2 The German Case
9.3.2.3 The Case of Argentina
9.4 Fiscal Federalism or Inter-Governmental Cooperation?
9.5 Opportunistic Behaviour and Fiscal Union
9.6 Fiscal Union and Public Debt
9.6.1 Mutualization of Public Debt
9.6.2 The Economics of Mutual Bonds
9.6.2.1 Advantages of Mutual Bonds
9.6.2.2 Disadvantages of Mutual Bonds
9.6.2.3 Mutual Bonds and Inter-Governmental Transfers
9.6.2.4 Fundamental Dilemma
9.6.2.5 Mutual Bonds and Monetary Union
9.6.3 Implementing Mutual Bonds
9.6.3.1 Agreeing on Mutual Bonds
9.6.3.2 Managing Mutual Bonds
9.7 Assessing a Fiscal Union
9.7.1 Financial Solvency
9.7.2 Economic Cohesion
9.7.3 Political Consensus
9.7.4 Creating a Fiscal Union
9.8 Conclusion
References
10 Banking Union
10.1 Why a Banking Union?
10.2 Banking Fragility
10.2.1 Bank Failures and the Notion of Lender of LastResort
10.2.2 Banking Panics and Deposit Insurance
10.3 Banking Regulation
10.4 Banking Integration in a Monetary Union
10.4.1 The Stability of the Payment System in a Monetary Union
10.4.2 International Finance and Monetary Union
10.4.3 Structural Heterogeneity and Banking Fragility
10.4.4 Banking Panics in a Monetary Union
10.4.5 Home Bias
10.4.6 The Triangle of Financial Impossibility in a Monetary Union
10.5 Banking Union and Regulation
10.5.1 Going Beyond Banking Sovereignty
10.5.2 Supervision
10.5.3 Resolution
10.5.4 Deposit Insurance
10.6 Establishing a Banking Union
10.6.1 Regulatory Federalism or Cooperation
10.6.2 The Banking Union Between Integration andSubsidiarity
10.6.2.1 Supervisory Institutions
10.6.2.2 Resolution Institutions
10.6.2.3 Deposit Insurance Institutions
10.6.3 Banking Union Politics
10.7 Banking Union and Central Banking
10.7.1 Banking Union and Monetary Policy
10.7.2 The Role of the Central Bank in Supervision
10.7.3 The Role of the Central Bank in Resolving the Crisis
10.7.4 The Role of the Central Bank in Deposit Insurance
10.7.5 Monetary Policy Versus Macroprudential Policy?
10.8 Conclusion
References
11 The Fate of a Monetary Union
11.1 Creating a Monetary Union
11.1.1 Why Creating a Monetary Union?
11.1.2 When and How Forming a Monetary Union?
11.1.2.1 What Economic Theory Tells Us
11.1.2.2 What History Tells Us
11.1.2.3 Immediate or Conditional Creation?
11.2 The Transformation of a Monetary Union
11.2.1 Economic Transformation
11.2.2 Social Transformation
11.2.3 Institutional Transformation
11.2.4 The American Example
11.3 Joining a Monetary Union
11.4 Exiting a Monetary Union
11.4.1 Causes of Exit from a Monetary Union
11.4.2 The Consequences of Exit
11.4.3 How to Leave?
11.5 Death of a Monetary Union
11.5.1 The Causes of the End of a Monetary Union
11.5.2 How a Monetary Union Ends
11.5.3 Post-monetary Union for Member Countries
11.6 Conclusion
References
12 General Conclusion
12.1 What Have We Learned?
12.2 Monetary Union, a Total Economic Fact
12.3 Collective Choices in a Monetary Union
12.4 Monetary Union and Politics: Between Sovereignty and Cooperation
References
Index

Citation preview

Springer Texts in Business and Economics

Hubert Kempf

Monetary Unions Institutions and Policies

Springer Texts in Business and Economics

Springer Texts in Business and Economics (STBE) delivers high-quality instructional content for undergraduates and graduates in all areas of Business/Management Science and Economics. The series is comprised of selfcontained books with a broad and comprehensive coverage that are suitable for class as well as for individual self-study. All texts are authored by established experts in their fields and offer a solid methodological background, often accompanied by problems and exercises.

More information about this series at https://link.springer.com/bookseries/10099

Hubert Kempf

Monetary Unions Institutions and Policies

Hubert Kempf École Normale Supérieure Paris-Saclay Paris, France NRU Higher School of Economics Moscow, Russian Federation

ISSN 2192-4333 ISSN 2192-4341 (electronic) Springer Texts in Business and Economics ISBN 978-3-030-93231-2 ISBN 978-3-030-93232-9 (eBook) https://doi.org/10.1007/978-3-030-93232-9 Translation from the French language edition: Economie des unions monétaires: Institutions et politiques by Hubert Kempf, © Economica 2019. Published by Economica. All Rights Reserved. © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

To Anne, for what she knows.

Preface

The creation of the European Monetary Union (hereafter EMU), within the framework of the European Union, was a major event at the end of the last century. A key political event for the European nations involved, with far-reaching international consequences, gradually emerged. It was also a bold economic event: advanced economies decided—after decades of deliberation in confidential circles—to give up their monetary sovereignties, create a single, common currency, unify their payment systems and entrust the management of the area of monetary circulation thus created, including monetary policy, to a supranational institution, the European Central Bank (ECB).1 Politicians were ahead of economists: academic thinking on the concept of monetary union was barely sketched out when Jacques Delors, then President of the European Commission, launched in 1988 the institutional reflection that was to lead to the euro.2 Economists have since caught up: scholarly (and less scholarly) literature on the subject has exploded. From the most theoretical writing to the most empirical, from the scientific article to the expert report, from the most timeless considerations to the most elaborate empirical analyses, all the analytical capacities of economics have been put to use. The still limited history of the European Monetary Union has been rich in developments and lessons learned. The period of preparation for this undertaking, from the publication of the Delors Report to the actual creation of the European and Monetary Union, the official name of the European Monetary Union, has been a period of great change and learning.3 European governments, having been through complicated negotiations and determined to achieve a successful outcome, were able to produce without too much difficulty an international treaty

1

The institutional reality of the euro area is more complex than the creation of the European Central Bank alone. For the sake of simplicity, we shall refer to it as such. 2 This report [1], which was submitted to the European authorities in 1989, was drawn up by the “Delors Committee” made up of the Governors of the then 12 Member States of the European Community (the international organization that preceded the European Union, created in 1993 by the Maastricht Treaty) and the President of the European Commission, Jacques Delors. 3 The Delors Report here refers to the report of the “Delors Committee”, officially presented to the European Commission the 17 April 1989. See [2], Chap. 7. In this book we use the acronym EMU to refer to the European monetary union. vii

viii

Preface

laying the foundations—among other things—for European monetary union, which was adopted in December 1991 at the European Council meeting in Maastricht (hence the common name “Maastricht Treaty”). Yet the process of ratification by individual countries was difficult. In particular, French ratification by referendum (20 September 1992) was only obtained by a narrow majority of the electorate (51% “yes”). The agreement on the membership to the EMU within the European Union, i.e. the list of countries meeting the admission criteria and/or retained by the European governments deciding unanimously, was hard to reach and only made at the last hour, just before the deadline set by the Treaty for the creation of this union, 1 January 1999. But the launch of the euro, buoyed by a favourable world economic situation, was a resounding success, to the surprise of many observers. The integrated payment system functioned smoothly; the European Central Bank maintained its credibility, conducted a sound monetary policy and largely achieved its objectives, especially in the area of inflation. The gamble seemed to have been won. The successive financial crises of 2007 (the “subprime” crisis) and 2008 (following the bankruptcy of the financial firm Lehman Brothers in the United States, which the US government decided not to bail out in order to set an example and convince financiers that they will suffer the negative consequences of their risktaking) put an end to this fine optimism [3]. The 2008 crisis in particular quickly turned into a global financial crisis that led to the most severe recession—for developed countries—since the end of the Second World War. It forced central banks to resort to non-conventional monetary policies, as the manipulation of interbank market interest rates proved to be ineffective. The European Central Bank followed suit, which forced it to the limits of its mandate.4 Worse, this global financial crisis exposed the structural weaknesses of some countries and their inability to meet their financial commitments. In the case of the EMU, the weakest link was Greece, who was forced to acknowledge publicly in 2009 the catastrophic and hitherto hidden state of its public finances. The so called “sovereign debt crisis”, confined to the EMU, was thus opening up. Confidence in the solidity of this union was followed by a period of widespread doubt, with some even going so far as to predict the end of the adventure.5 From the point of view of economic analysis, it became clear that the proper functioning of a monetary union implied more than the conduct of a common and unique monetary policy according to a few simple principles or rules. In other words, a monetary union, particularly in the economic conditions prevailing in the twenty-first century—globalization, the ever-increasing digitalization of monetary and financial transactions, the speed of exchanges of all kinds, and the primacy

4

Some, particularly in Germany, even feel that it has exceeded its mandate. A good example of this view can be found in the interview of Nobel Prize winner for economics Joseph Stiglitz in Fortune magazine on 8 September, 2016 (http://fortune.com/2016/09/08/stiglitzeuro-doomed-nobel/). See also [4].

5

Preface

ix

of information technology, even in industrial matters—is an institution of hitherto unsuspected complexity. The purpose of this book is to expose and understand, on the basis of our knowledge and the tools currently mastered and utilised by economists, this complexity. Economists may have been surprised or caught off guard by the vicissitudes encountered by the EMU. But these difficulties have led them to propose new analyses, to continue their research on the issue of monetary unions. Motivated by the observation of the European case, often conducted by comparison with other monetary unions, past or present, this research has considerably renewed our understanding of the institutional mechanisms of a monetary union. The time has come to offer a synthesis of this research: it is the justification and ambition of this book. Let us immediately remove any ambiguity that may have arisen from the previous pages. This book is not focused on the EMU even though it refers to it, as well as to other monetary unions: the euro area is a case rich in lessons to be learnt and on the observation of which many reflections are based. It would be regrettable not to mention the European enterprise when it can support some specific reasoning. But the EMU is unique and complex. Born within the very particular framework of the European Union, a political union of sovereign States still in the making, which is neither a State in its own right nor a mere international organization, this monetary union reflects its ambiguities. Thus, because it is sui generis, understanding the EMU requires a detailed exposition of its history as well as its institutions and policies, which is beyond the scope of this book. We must not forget other monetary unions with an equally turbulent and questionable history, such as the Francophone monetary unions, UEMOA6 and CEMAC7 , or the dollarization experiences. In view of this diversity, the logic of this book is not to focus on one case of monetary union deemed particularly interesting. Its ambition is to understand the general principles and dilemmas that any monetary union encounters. The application of these principles and the resolution of these dilemmas depend on the configurations in which a given monetary union was born and has evolved, as well as on the circumstances it is going through. But understanding the solutions— good or bad—found in any given historical configuration implies understanding the principles from which the problems arise and as well as their solutions. To say this is to emphasize the pedagogical dimension of this book. It is primarily intended for economics students as part of the macroeconomics, monetary economics and international monetary relations courses they receive during their training. It presupposes knowledge of the principles of economic analysis, both microeconomic and macroeconomic. In this respect, it is aimed at students at the end of their bachelor’s or master’s degree. However, it is not primarily a book aimed at researchers wishing to take stock of the very active research on the notion of monetary union. Some chapters use a formalized exposition and are based on

6 7

In French, “Union Économique et Monétaire de l’Ouest Africain”. In French, “Communauté Économique et Monétaire de l’Afrique Centrale”.

x

Preface

economic models. But these models are deliberately designed to be very simple: they are static models, without explicit and detailed microeconomic foundations, and in particular without intertemporal perspectives. No knowledge of dynamic optimization is required. To put it simply, the formal tools needed to read this book profitably are those acquired in an intermediate macroeconomics course. This book may also be of interest to experienced economists concerned with the issue of monetary unions, in one capacity or another: working in a central bank, in a ministerial department or a large international organization, in a financial or banking institution, or in a company. Here, they can find some answers or clarifications to the questions they ask themselves daily in their work. It is naive to believe that a monetary union simply consists in sharing a few monetary signs in order to facilitate the exchanges of agents residing in their welldefined area of circulation. Of course, the sharing of an immediate and perfectly liberating means of payment (which is the very definition of a currency) is the most obvious feature of a monetary union. But it has radical implications for the functioning of such a union, involving the adjustment mechanisms of the markets and the way agents, including public institutions, cover their financing needs. This is where a monetary union is complex, and understanding this complexity involves detailed developments. There are two reasons why this complexity did not become apparent until recently to economists, apart from the fact that they did not feel the urgency to respond to pending issues. 1. The first is that monetary discussions are dominated by the question of the neutrality of money, which stems from the quantitative or neo-quantitativist theory of money. The primacy of this issue has led economists to focus on issues related to the money supply and its circulation, implicitly suggesting that monetary arrangements were without major structural or macroeconomic consequences. 2. The second reason is that the demands of academic research tend to segment the fields of research. As a compulsory mode of operation for making significant advances (in the primary sense of the term), this segmentation has the disadvantage of failing to grasp phenomena crossing several fields. However the study of monetary unions relates as much to international economics, banking economics, macroeconomics as to monetary economics. It requires the use of tools and concepts from these different fields. In other words, the reader should be aware that reading this book requires some continuing effort. Paris, France

Hubert Kempf

Preface

xi

References 1. Committee for the study of economic and monetary union (1989) Report on economic and monetary union in the European community. http://aei.pitt.edu/ 1007/1/monetary_delors.pdf 2. James H (2012). Making the European Monetary Union. Belknap Press, Cambridge 3. Tooze A (2018) Crashed. How a decade of financial crises changed the world. Allen Lane, London 4. Stiglitz J (2016). Euro. Blackwell, London

Structure of the Book

This book consists of three parts. Part I deals with the strictly monetary dimension of a monetary union and consists of four chapters. The first chapter is devoted to a discussion of the concept and forms of monetary union. After explaining the diversity of institutional configurations of a monetary union, we address the theoretical question of its analysis. We show that a monetary union is a particular form of international monetary system (confined to the economic area it covers) and, as such, faces the dilemmas of any international monetary system, which are not limited to currency conversion problems alone. Chapter 2 seeks to understand what is at stake in a monetary union, the reasons that may explain its establishment and, more broadly, the various points of view that must be taken into account in its assessment. After summarizing Robert Mundell’s theory of optimal currency areas, we show both the innovation it represented and its inadequacy for a proper analysis of a monetary union. We also discuss the question of its stability and the effects of a monetary union. The next two chapters are devoted to the monetary issues themselves. The conduct of monetary policy in a monetary union is discussed in Chap. 3, based on some very simple models. Chapter 4 examines the institutional issues associated with the monetary union, in particular the status of the central bank in the union. Part II deals with the fiscal issues that arise in a monetary union. It is an illusion to believe that a monetary union only concerns money and its circulation: because it profoundly changes the financing conditions of the agents residing in the union and because money affects so closely the prerogatives of the member states (in the case of a union made up of sovereign states). The creation or existence of a monetary union modifies the fiscal choices of the public entities that compose it, provided they have significant fiscal autonomy. If proof were required, one need only look at the sovereign debt crisis in the EMU, which began in 2009 when the newly elected Greek government acknowledged that public accounts were falsified and the public deficit was significantly higher than previously announced. This crisis has shown that public expenditure management is a critical element in the functioning of a monetary union, both because it can lead to a new kind of crisis and because the contribution of fiscal policies to exit the crisis cannot be thought of in the same way as in a situation of monetary sovereignty. Following the ratification of the Maastricht Treaty, fiscal issues were already the concern (not to say the obsession) of the then German xiii

xiv

Structure of the Book

Finance Minister, Theo Waigel.1 He played a crucial role in the design of a “stability2 was to prevent the public finances of the Member States from drifting out of control”. This part is made up of three chapters. Chapter 5 is devoted to the fiscal dimension of a monetary union, in particular the issue of transfers and public debt. Chapter 6 focuses on fiscal policies in a monetary union. The link between monetary and fiscal policies is the subject of Chap. 7. Here, again, we use a variant of the model already used in Chap. 3. Finally, Part III continues the exploration of the complexity of a monetary union and focuses on the structural issues of the monetary union. Chapter 8 is devoted to the issue of structural adjustment, another term in economists’ jargon that needs to be explained. An exchange rate system is a simple and possibly effective mechanism for adjusting a country’s foreign trade. Its removal requires finding and implementing alternative modes of adjustment. Consequently, a country joining a monetary union cannot hope that its regulation by the markets or by the public sector can remain unchanged: it must find new structural arrangements that modify its regulation and ensure its external equilibrium. How the problem arises, and how to judge the relevance of the adjustments and structural reforms implemented in the union and in the different components of the union, these questions will be dealt with in this chapter. Chapter 9 deals with the question of fiscal union. Many politicians and economists alike explain the current difficulties of the EMU by the absence of a “fiscal union” linking the Member States, unlike in the United States where the existence and massive intervention of the federal Treasury would do much to make the American monetary union more solid. The various proposals of fiscal union schemes differ markedly and there is (as yet) no consensus on the form such a union should take. This is an issue that merits investigation, highlighting the dilemmas associated with a fiscal union, and in particular the idea of a common debt in the union. In particular, we return to the question of fiscal federalism, asking whether such an institution is required in a monetary union. Finally, Chap. 10 deals with banking union. This is a neologism formed during the sovereign debt crisis. What is meant by this term? Why should a monetary union be linked to a system of prudential rules that uniformly governs the banks registered in the union or to intervention mechanisms in the event of a financial crisis affecting all or part of the union? If so, which ones should they be? These are the questions addressed in this chapter. After reading these chapters surveying the challenges faced by a monetary union, the reader should be convinced that such a union (effective or putative) cannot be an institutional arrangement that is imposed with the force of evidence, nor can

1

Theo Waigel was minister from 1989 to 1998 and played a fundamental role in the creation of the euro area. 2 It became the “Stability and Growth Pact” at the insistence of the then French Prime Minister Lionel Jospin.

Structure of the Book

xv

it be sustained by the mere merit of its existence. A monetary union encounters numerous difficulties linked to its development and to changes in the economic and political environment in which it operates. In other words, the evolution of a monetary union—how and under what conditions it is created, how it evolves and, in particular, how it expands or shrinks, and how it can be brought to an end—is an important subject for analysis. This is the subject of Chap. 11. The conclusion, finally, summarizes the main points dealt with in the various chapters and addresses the issue of collective decision-making in a monetary union. There are two reasons why a monetary union—both at its inception and in its management—is an institutional system whose management is complex. On the one hand, a monetary union is a “total economic fact”; on the other hand, by reasoning from the notion of the collective good, we show that the collective problems it poses are diverse and of different natures, and therefore the mechanisms for resolving the difficulties encountered are themselves differentiated. A final conclusion cannot fail to be drawn from the progressive exposure of the complexity of a monetary union: contrary to certain irenic or superficial discourses, monetary unification cannot fail to create winners and losers, that is, to generate distributional conflicts. In other words, a monetary union raises questions of equity. These questions are dealt with by political economy, or by economic analysis of the political decision-making mechanisms by which conflicts of interest are decided for a time. It is possible, and probably necessary, to design a political economy of monetary unions. We will not address this field, which implies the use of other theoretical and analytical tools than those used here.3 This book has benefited from recent research on monetary union. As this research continues, new results and even new problems will gradually refine or challenge some of the proposals and conclusions put forward here. This book will have achieved its objective if, despite its fragility and its shortcomings, which will become apparent sooner or later, it has been able to clarify for a while the complexity and stakes of a monetary union. This book is the result of the research I conducted on the subject of monetary unions, with various co-authors. In particular, Russell Cooper, who taught me as much about economics as he did about monetary unions in a particularly rewarding companionship for me: may he find here an expression of my gratitude. This book is also the fruit of the reflections that I had started on another project, devoted to the European Monetary Union, with Jean-Pierre Vidal, economist at the European Central Bank. Unfortunately, Jean-Pierre was unable to work on it as planned, being devoured by his immediate and eminent responsibilities, and we had to abandon this collaborative project. But his intimate knowledge of the EMU was invaluable to me and the discussions we had on the subject, and I thank him very much for that. I would like to thank Bastien Alvarez, Antoine Camous, Édouard Challe, Laurent Clerc, François Écalle, Samuel Guérineau, Olivier Loisel, Jean-Stéphane

3

The calculations leading to the propositions contained in Chaps. 3, 4 and 7 can be found at https:// hubertkempf.wixsite.com/homepage/eum.

xvi

Structure of the Book

Mésonnier, Cullen Coty O’Neil, Alain Paquet, Cord Phelps, Stéphane Rossignol and Caroline Vincensini who read all or part of a first draft of this book and whose comments and remarks were extremely useful to me in finalizing the manuscript. Parts of the book have been used as teaching aids in courses given at the École Normale Supérieure Paris Saclay, the University of Bologna, Birkbeck University of London and the Moscow School of Economics. I would like to thank the students who attended these courses for their remarks and the discussions we had on these occasions. Finally, the book is dedicated to my wife Anne. The dedication says it all, adding anything to it is not needed.

Terminology matters

The hybrid nature of a monetary union, both as part of the international economy and as an integrated system, makes it necessary to use appropriate terminology. In this book, we made several terminology choices that we need to present now. When a monetary union binds countries that retain their sovereignty in the legal sense, we speak of a multi-national union. If its limits correspond to the borders of a sovereign state under international law (e.g. the Indian Union and the United States), we speak of a national union. A cross-border effect refers to the impact of an event or decision occurring in one component of a monetary union on all or part of the other components of the union. In contrast to a monetary union, we speak of a single or unitary economy to refer to a country detaining its monetary sovereign with its own currency and for which its macroeconomic analysis does not require its multi-jurisdictional organization (if it exists). We use the adjective inter-national to refer to trade or flows between nations in an inter-national monetary union, i.e. within the union itself. We use the adjective international in the usual sense of the term, to refer to the exchanges or flows with the rest of the world of a given economy, which may be a monetary union. We refer to the components or entities of a monetary union to denote the public jurisdictions within the union. A national monetary union is a federation.1 In a federation, the federated components have significant autonomy in fiscal and regulatory (legislative) decision-making and have significant macroeconomic responsibilities.2 An multi-national monetary union is formed of Member States.

1

At this point, we do not distinguish between “federation” and “confederation”. In some national unions, such as the United States, Brazil, the Federal Republic of Germany or the Indian Union, these subdivisions are “states”, in others, they are “provinces”, as in Canada or Argentina, or even “cantons”, as in the Swiss Confederation. In a multi-national monetary union, these components are the Member States.

2

xvii

Contents

Part I 1

2

Monetary Issues

Monetary Unions: Between International Trade and National Sovereignty . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.1 Monetary Sovereignty .. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.1.1 The Circulation of Currency . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.1.2 Monetary Unions . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.1.3 Monetary Sovereignty in Monetary Unions .. . . . . . . . . . . . . . 1.1.4 Monetary Unions in History . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.2 Currencies, Foreign Exchange and International Payments .. . . . . . . 1.2.1 Currency Plurality and External Constraints . . . . . . . . . . . . . . 1.2.2 Monetary Union and the External Constraint . . . . . . . . . . . . . 1.2.3 Currency Area and Monetary Union: What Is the Difference? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.3 The Rules of the Game of a Monetary Union .. .. . . . . . . . . . . . . . . . . . . . 1.3.1 International Monetary Systems . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.3.2 Multi-National Monetary Union as an International Monetary System . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 1.4 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . Why a Monetary Union?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.1 Assessing a Monetary Union . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.1.1 Methodological Preliminaries .. . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.1.2 The Theory of Optimal Currency Areas . . . . . . . . . . . . . . . . . . . 2.1.3 Subsequent Contributions . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.1.4 Monetary Union, Expectations, and Credibility.. . . . . . . . . . 2.2 The Membership of a Monetary Union . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.2.1 Why Joining a Monetary Union? . . . . . .. . . . . . . . . . . . . . . . . . . . 2.2.2 Why Accepting a New Entrant? . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.2.3 The Special Case of Dollarization . . . . .. . . . . . . . . . . . . . . . . . . .

3 4 4 6 10 11 17 17 23 28 30 30 32 36 36 39 40 40 41 44 50 55 56 58 59

xix

xx

Contents

2.3

Changes Induced by a Monetary Union .. . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.3.1 Microeconomic Effects .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.3.2 Macroeconomic Effects . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.3.3 Financial Effects .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2.4 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3

4

Monetary Policy in a Monetary Union: Lessons from Simple Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.1 Monetary Policy .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.1.1 Monetary Policy in a Unified Economy . . . . . . . . . . . . . . . . . . . 3.1.2 Monetary Instruments . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.2 Monetary Policy in a Monetary Union . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.2.1 Preference Functions of the Central Bank .. . . . . . . . . . . . . . . . 3.2.2 Heterogeneity and Monetary Policy . . .. . . . . . . . . . . . . . . . . . . . 3.2.3 Monetary Policy and Nominal Rigidities in the Monetary Union . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.2.4 Taylor Rule and Indicators of Misalignment . . . . . . . . . . . . . . 3.2.5 Misalignment Indicators in the European Case . . . . . . . . . . . 3.3 A Simple Model of Monetary Union .. . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.3.1 A Monetary Union.. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.3.2 Central Bank Preferences . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.3.3 The Monetary Policy Decision .. . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.4 Traded Goods, Terms of Trade and Monetary Policy . . . . . . . . . . . . . . 3.4.1 With a Union-Wide Loss Function . . . .. . . . . . . . . . . . . . . . . . . . 3.4.2 With a Summation Loss Function . . . . .. . . . . . . . . . . . . . . . . . . . 3.4.3 With Asymmetry . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3.5 Non-conventional Monetary Policy in a Monetary Union . . . . . . . . . 3.5.1 From Conventional to Non-conventional Policy . . . . . . . . . . 3.5.2 Non-conventional Policy in Monetary Union . . . . . . . . . . . . . 3.6 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . Institutions and Monetary Policy . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.1 Rule or Discretion in a Monetary Union . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.1.1 Expectations and Monetary Policy in a Simple Economy .. . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.1.2 Rule or Discretion? . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.1.3 Monetary Policy in a Monetary Union with Direct Negotiation .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.1.4 A Variant with Asymmetric Anchoring . . . . . . . . . . . . . . . . . . . 4.2 Central Bank Independence.. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.2.1 What Is Meant by Independence? . . . . .. . . . . . . . . . . . . . . . . . . . 4.2.2 Central Bank Independence in a Monetary Union . . . . . . . . 4.2.3 Delegation in a Monetary Union .. . . . . .. . . . . . . . . . . . . . . . . . . .

60 61 63 69 71 73 77 79 79 81 84 85 88 90 91 93 96 96 97 99 102 103 104 105 106 106 108 111 119 121 122 123 124 128 130 134 135 136 137

Contents

xxi

4.3

144 144

The Collegiality of the Monetary Decision . . . . .. . . . . . . . . . . . . . . . . . . . 4.3.1 The Monetary Policy Committee . . . . . .. . . . . . . . . . . . . . . . . . . . 4.3.2 The Monetary Policy Committee in a Monetary Union .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.4 Communication and Accountability .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.4.1 Between Transparency and Opacity . . .. . . . . . . . . . . . . . . . . . . . 4.4.2 Accountability . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 4.5 Financial Crises and the Lender-of-Last-Resort Function.. . . . . . . . . 4.6 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . Part II 5

6

146 151 151 154 156 158 163

Fiscal Issues

Government Deficits, Transfers and Debts . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5.1 Government Deficits and Public Debts in a Monetary Union .. . . . . 5.1.1 The Budget Constraint of a Member State of a Monetary Union . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5.1.2 The Constraint of the Federal Treasury .. . . . . . . . . . . . . . . . . . . 5.1.3 Central Bank Accounts .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5.1.4 Public Accounts and Monetary Union .. . . . . . . . . . . . . . . . . . . . 5.1.5 Budget Constraints in Real Terms . . . . .. . . . . . . . . . . . . . . . . . . . 5.2 The Sustainability of Public Debts in a Monetary Union . . . . . . . . . . 5.2.1 The Sustainability of a Member Country’s Debt .. . . . . . . . . 5.2.2 Sustainability of the Federal Treasury Debt .. . . . . . . . . . . . . . 5.2.3 The Consolidated Sustainability of a Monetary Union . . . 5.3 Debt Sustainability and Sovereign Default in a Monetary Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5.3.1 Default and Renegotiation of the Public Debt.. . . . . . . . . . . . 5.3.2 Budget Constraints Including Default Possibility . . . . . . . . . 5.3.3 Sovereign Default in a Monetary Union .. . . . . . . . . . . . . . . . . . 5.4 Market and Institutional Disciplines . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5.4.1 Market Discipline. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5.4.2 Institutional Discipline in a Monetary Union . . . . . . . . . . . . . 5.4.3 Separating Disciplines? . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 5.5 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . Fiscal Policies in a Monetary Union . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.1 Fiscal Effects in a Monetary Union . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.1.1 The International Effects of Fiscal Impulses . . . . . . . . . . . . . . 6.1.2 Cross-Border Effects of Fiscal Impulses in Monetary Union . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.2 Stabilization Policies in a Monetary Union . . . . .. . . . . . . . . . . . . . . . . . . . 6.2.1 The Functions of Fiscal Policy .. . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.2.2 The Conduct of Fiscal Policies. . . . . . . . .. . . . . . . . . . . . . . . . . . . .

167 168 169 171 172 173 175 178 178 180 181 182 183 183 185 187 188 190 193 194 195 197 198 198 199 201 201 204

xxii

Contents

6.3

7

Fiscal Impulses and Transmission Mechanisms in a Monetary Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.3.1 Fiscal Multipliers . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.3.2 The Macroeconomic Impact of Fiscal Policies. . . . . . . . . . . . 6.3.3 Macroeconomic Stabilization and Transfers . . . . . . . . . . . . . . 6.4 Fiscal Policies and External Balances . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.4.1 Fiscal Devaluations .. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.4.2 National Fiscal Policies and Tax Competition . . . . . . . . . . . . 6.5 Fiscal Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.5.1 The Properties of a “Good” Fiscal Rule . . . . . . . . . . . . . . . . . . . 6.5.2 Types of Rules . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 6.5.3 Fiscal Rules in a Monetary Union . . . . .. . . . . . . . . . . . . . . . . . . . 6.6 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

205 206 208 218 220 220 223 225 225 226 228 230 230

The Policy Mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.1 The Policy Mix in a Monetary Union . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.1.1 Is an Optimal Monetary Union Possible? . . . . . . . . . . . . . . . . . 7.1.2 Is Insulation Within a Monetary Union Possible? . . . . . . . . 7.1.3 The Issue of Dominant Policy . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.1.4 The Policy Trilemma of a Monetary Union . . . . . . . . . . . . . . . 7.2 Lessons from a Simple Model . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.2.1 Modelling the Policy Mix . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.2.2 Institutional Options .. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.2.3 Calculation of Expected Losses . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.2.4 Comparison of Options .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 7.3 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

233 234 234 237 239 242 243 243 245 246 251 253 271

Part III 8

Toward an Ever Closer Union

Structural Adjustments and Reforms . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.1 Understanding Structural Reforms . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.1.1 Market Reforms . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.1.2 Public Sector Reforms.. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.1.3 Structural Reforms and External Constraints . . . . . . . . . . . . . 8.1.4 The Macroeconomic Impact of Structural Reforms . . . . . . 8.1.5 Structural Reforms and Macroeconomic Policy . . . . . . . . . . 8.2 The Challenge of Structural Reforms in a Monetary Union . . . . . . . 8.2.1 External Constraint in a Monetary Union . . . . . . . . . . . . . . . . . 8.2.2 The Macroeconomics of Structural Reforms in a Monetary Union . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.3 Implementing Structural Reforms . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.3.1 National Structural Reforms . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.3.2 Multi-National Structural Reforms . . . .. . . . . . . . . . . . . . . . . . . .

275 276 279 281 282 287 288 289 289 291 293 294 295

Contents

xxiii

8.4

A Simple Model for Structural Reforms in a Monetary Union . . . . 8.4.1 Demand and Monopolistic Competition.. . . . . . . . . . . . . . . . . . 8.4.2 Labour Markets . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.4.3 The Structural Configuration of Monetary Union.. . . . . . . . 8.4.4 Equilibria.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.4.5 Domestic Structural Reforms and the External Balance .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.4.6 Structural Reforms at the Union Level . . . . . . . . . . . . . . . . . . . . 8.4.7 Additional Remarks . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 8.5 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

297 298 299 301 302

Fiscal Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.1 What Is a Fiscal Union?.. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.1.1 Why a Fiscal Union? . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.1.2 Fiscal Union Between Integration and Differentiation . . . 9.1.3 Sovereignty and Fiscal Union .. . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.1.4 International Transfers . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.1.5 Policy Dominance . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.2 International Fiscal Cooperation.. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.3 Fiscal Federalism .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.3.1 Macroeconomic Analysis of Fiscal Federalism . . . . . . . . . . . 9.3.2 Fiscal Federalism in Practice. . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.4 Fiscal Federalism or Inter-Governmental Cooperation?.. . . . . . . . . . . 9.5 Opportunistic Behaviour and Fiscal Union . . . . .. . . . . . . . . . . . . . . . . . . . 9.6 Fiscal Union and Public Debt. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.6.1 Mutualization of Public Debt . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.6.2 The Economics of Mutual Bonds .. . . . .. . . . . . . . . . . . . . . . . . . . 9.6.3 Implementing Mutual Bonds .. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.7 Assessing a Fiscal Union . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.7.1 Financial Solvency . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.7.2 Economic Cohesion . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.7.3 Political Consensus . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.7.4 Creating a Fiscal Union . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 9.8 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

319 320 320 321 322 323 323 324 327 328 329 332 334 339 339 340 345 347 347 349 350 351 353 354

10 Banking Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.1 Why a Banking Union? . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.2 Banking Fragility .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.2.1 Bank Failures and the Notion of Lender of Last Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.2.2 Banking Panics and Deposit Insurance .. . . . . . . . . . . . . . . . . . . 10.3 Banking Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

355 356 359

9

305 313 313 314 316

359 360 361

xxiv

Contents

10.4 Banking Integration in a Monetary Union . . . . . .. . . . . . . . . . . . . . . . . . . . 10.4.1 The Stability of the Payment System in a Monetary Union .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.4.2 International Finance and Monetary Union . . . . . . . . . . . . . . . 10.4.3 Structural Heterogeneity and Banking Fragility . . . . . . . . . . 10.4.4 Banking Panics in a Monetary Union... . . . . . . . . . . . . . . . . . . . 10.4.5 Home Bias . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.4.6 The Triangle of Financial Impossibility in a Monetary Union . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.5 Banking Union and Regulation .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.5.1 Going Beyond Banking Sovereignty . .. . . . . . . . . . . . . . . . . . . . 10.5.2 Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.5.3 Resolution .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.5.4 Deposit Insurance.. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.6 Establishing a Banking Union . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.6.1 Regulatory Federalism or Cooperation . . . . . . . . . . . . . . . . . . . . 10.6.2 The Banking Union Between Integration and Subsidiarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.6.3 Banking Union Politics . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.7 Banking Union and Central Banking .. . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10.7.1 Banking Union and Monetary Policy . .. . . . . . . . . . . . . . . . . . . . 10.7.2 The Role of the Central Bank in Supervision . . . . . . . . . . . . . 10.7.3 The Role of the Central Bank in Resolving the Crisis . . . . 10.7.4 The Role of the Central Bank in Deposit Insurance . . . . . . 10.7.5 Monetary Policy Versus Macroprudential Policy? . . . . . . . . 10.8 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

364

380 382 384 384 386 387 389 389 391 393

11 The Fate of a Monetary Union . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.1 Creating a Monetary Union .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.1.1 Why Creating a Monetary Union? .. . . .. . . . . . . . . . . . . . . . . . . . 11.1.2 When and How Forming a Monetary Union? .. . . . . . . . . . . . 11.2 The Transformation of a Monetary Union . . . . . .. . . . . . . . . . . . . . . . . . . . 11.2.1 Economic Transformation .. . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.2.2 Social Transformation .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.2.3 Institutional Transformation . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.2.4 The American Example . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.3 Joining a Monetary Union . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.4 Exiting a Monetary Union . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.4.1 Causes of Exit from a Monetary Union . . . . . . . . . . . . . . . . . . . 11.4.2 The Consequences of Exit. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.4.3 How to Leave? .. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

395 396 396 399 405 406 408 409 410 412 414 414 416 420

365 366 368 369 370 372 373 373 375 375 378 379 379

Contents

xxv

11.5 Death of a Monetary Union .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.5.1 The Causes of the End of a Monetary Union .. . . . . . . . . . . . . 11.5.2 How a Monetary Union Ends . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 11.5.3 Post-monetary Union for Member Countries . . . . . . . . . . . . . 11.6 Conclusion .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

422 422 424 424 425 427

12 General Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 12.1 What Have We Learned?.. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 12.2 Monetary Union, a Total Economic Fact . . . . . . . .. . . . . . . . . . . . . . . . . . . . 12.3 Collective Choices in a Monetary Union .. . . . . . .. . . . . . . . . . . . . . . . . . . . 12.4 Monetary Union and Politics: Between Sovereignty and Cooperation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . References .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . .

429 429 432 434 438 440

Index . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 441

Part I Monetary Issues

1

Monetary Unions: Between International Trade and National Sovereignty

Abstract

This chapter presents the main issues to be associated with the design of a monetary union. It shows that it results from a tension between the necessity to open economies to trade and exchanges and the requests implied by monetary sovereignty. Monetary sovereignty can be shared among different policy-makers, either in a national or in an international context, creating a monetary union. The consequences of the suppression of exchange rates due to monetary unification are discussed. Finally, it is shown how a monetary union can be conceived as a particular type of international monetary system.

The first chapter defines a monetary union as an institutional design attempting to combine the need to trade goods, services, and financial flows between different economies with the constraint of sharing a unique currency and monetary institutions common to these economies. A monetary union can be national or international, symmetrical, or asymmetrical. The implications of the absence of exchange rates are thoroughly discussed. A monetary union can be seen as an international monetary system where the need to balance external accounts is still to be faced and requires new types of economic adjustments. The evidence that market exchanges as well as the fiscal flows of public institutions are monetized raises the question of how these exchanges are regulated when the currencies are different. In a world economy marked by international trade and different payment media, the plurality of currencies used by economic agents makes it necessary to convert these currencies through the foreign exchange markets where the exchange ratios of these currencies, also called exchange rates or “currency parities,” are set. In this context, the question arises as to whether States must assume their monetary sovereignty and impose the use of a national currency or whether they must resort to the use of another national currency or a currency common to several States. In the latter option, States resort to some form of monetary union. © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_1

3

4

1 Monetary Unions: Between International Trade and National Sovereignty

In this first chapter, we will define what a monetary union is, detail its variants, and explain how a country’s foreign trade regulatory mechanisms are modified by its integration into a monetary union. Section 1.1 is devoted to the discussion of the concept of monetary union, seen as a particular modality for the exercise of monetary sovereignty by a member State. Section 1.2 deals with the changes in the external constraint for member countries resulting from monetary unification. Section 1.3 presents monetary union as a specific international monetary system. The conclusion is contained in Sect. 1.4.1

1.1

Monetary Sovereignty

1.1.1

The Circulation of Currency

The development of merchant exchanges over the centuries has made it necessary to use convenient means of payment common to swindlers, called “currencies.” The use of monetary technology to carry out exchanges between economic agents logically poses three problems: 1. The first is that of extending the area in which a currency can be used. Given that traders are geographically located, what explains why a common currency is used or not by them? In other words, what is the magnitude of the set of agents using the same currency? This raises the question of the area of circulation of a currency and its extension. 2. The second problem is that of the coexistence of currencies. The plurality of the means of payment being used raises the question of their conversion. Without ways for currency conversion, two agents belonging to different currency areas will not be able to exchange, which represents a loss of welfare. How can the plurality of currencies be explained? How to organize this conversion of currencies? Is it possible that agents all use the same currency? Can there be several currencies circulating in the same geographical or political space? Is it possible to use a common currency so as to avoid these difficulties? 3. Finally, the third problem is to understand the relative properties of currencies and the circumstances in which economic agents use one currency rather than another. These problems are interdependent and cannot be solved independently of each other. It is convenient to look at them through the lenses of monetary history. The development of the use of currencies has gone hand in hand with the emergence of States as organized forms of transmission, devolution, and exercise of political power. States, sovereign over a given territory, historically sought to conquer the

1

I am very grateful to Stéphane Rossignol for the development of the notation used in this chapter and his remarks on the writing of the equations.

1.1 Monetary Sovereignty

5

monopoly of control over the means of payment circulating in the territory and have gradually acquired monetary sovereignty. Monetary sovereignty is defined by four elements (Steil and Hinds [31]): 1. The presence of an authority that asserts its sovereignty in monetary matters in a given area. 2. The definition by this authority of a unit of account, specifying its denomination and numerical properties. 3. The exclusive control of the issuance of the quantities of means of payment denominated in this unit of account and authorized to circulate in the zone of monetary sovereignty, as well as the conditions of their circulation. 4. The establishment and dissemination within the sovereign’s territory of a monetary symbol constituting the marks of sovereignty. In particular, a State may decree the “legal tender” of the currency it controls, i.e. the obligation for agents residing in its territory to accept it as a means of payment and exchange. This has the considerable advantage of providing additional resources through the issuance of money, which in common parlance is known as the “banknote plate/printing press” and in the lexicon of economists as “seigniorage”. The acquisition of monetary sovereignty by States has been gradual and, above all, incomplete. There are several reasons for this. On the one hand, a fraction (never null) of trade in a territory is done in a foreign currency or out of the currency, due to the ability of residents to invent “private” payment methods using the financial markets. On the other hand, the State itself may allow its residents to use the currency of another State for certain transactions, particularly financial transactions. Finally, the monetary sovereignty of a State is limited by the need or desire of its residents to contract with agents located in another currency area. This obliges the State to ensure the conversion of its own currency; otherwise, it will be living in autarky or depending on difficult to manage and expensive barter agreements for these exchanges with the outside world. Under these conditions, the question of the coexistence of different currencies leads to the “international monetary system”, i.e. the set of collective rules organizing and managing the conversion of currencies. The legal declaration of monetary sovereignty must thus be completed by the actual exercise of this sovereignty, i.e. by the latitude of action in the management of the currency and the conditions of its circulation. A first pillar of this effective sovereignty is the “completeness” of all the monetary instruments available to a State, which are necessary to cover the monetary practices of its residents. The effective monetary sovereignty of a State is never complete, since the payment instruments available to residents considerably exceed the national currencies alone, particularly in financially developed economies. The second pillar of effective sovereignty is monetary policy, broadly understood as all the actions of the State aimed at ensuring that its currency circulates in accordance with its objectives.

6

1 Monetary Unions: Between International Trade and National Sovereignty

However, the effectiveness of monetary policy depends on the ability and willingness of agents to circumvent the holding and use of the national currency. Monetary policy is therefore limited by these conditions of acceptance. It cannot free itself from market constraints, particularly financial constraints, which are the basis for exchanges between agents. The long-term trends in the economy, namely the development of trade between different monetary zones and the growing complexity of banking and financial operations, are increasingly constraining the monetary sovereignty of States. The international opening and the plurality of currencies reveal the disjunction between the spaces of circulation of currencies between private agents and the spaces of public management of currencies. In other words, the gap between legal monetary sovereignty and effective sovereignty continues to widen. The plurality of currencies can be approached from two different perspectives: 1. In an international economic logic, the question is to understand which zone a currency covers, knowing that it coexists with others and that it is always possible to compensate for the narrowness of a zone in relation to the international economy by converting currencies. More specifically, it is a question of understanding what is the desirable extension of a currency zone, knowing that the foreign exchange markets make all transactions between all agents possible (including higher or lower transaction costs). 2. From a political economy perspective, the question is how monetary sovereignties are combined. The question naturally arises of whether it is desirable or not to modify monetary sovereignties, that is to adjust the conditions under which they are exercised, given the constraints they face. This is what is at stake in the construction (or reconstruction) of an international monetary system. These two perspectives can be dissociated. If political sovereignty is overlooked, the first will focus on the question of the conversion of currencies by foreign exchange and the possibility of escaping from it, and will thus lead to a theory of optimal currency circulation zones. If the question of the exchange rate system is neglected and the question of political sovereignties placed in the foreground, the second will give us a theory of the organization of monetary sovereignties and the conditions under which the union of monetary sovereignties can be thought out.

1.1.2

Monetary Unions

How can we address the issue of monetary unification in a global economy characterized by a plurality of currencies?

1.1 Monetary Sovereignty

7

In the case of a plurality of currencies in circulation, sovereign States can set up “monetary agreements”: A monetary agreement is an agreement between sovereign states, with a legal monopoly on the issue of a national currency, on the conditions for the exchange of these currencies.

Agreements on the international monetary system are of this type. A monetary union goes beyond such agreements since it does not deal with the exchange of currencies but with the conditions for the circulation and use of the same currency. A monetary union can be defined as follows: A monetary union allows the circulation of a currency in a national or multi-national political space, establishing the conditions for the use of this currency in this space, imposing, if necessary, the circulation monopoly given to this currency, and defines the exercise of monetary sovereignty by the sovereign political authorities in this political space.

For example, consistently with this definition, Keynes was able to propose, at the international discussions held at Bretton Woods in 19442 the creation of an “international monetary union” to manage the fixed exchange rate system (Skidelsky [29], pp. 202–204), linked to a world currency, named the bancor. In the face of opposition from the chief American negotiator, Harry Dexter White, Keynes proposed that the international institution responsible for managing the system be called the International Monetary Fund. The term was accepted by the American delegation and has remained (Steil [30], p. 176). In this book, we are only interested in monetary unions understood in the narrow sense of a single currency with a forced circulation in the area of circulation concerned with the monetary union. As a general rule, we reason within the monetary framework of today’s economies, based on a completely dematerialized currency.3 The circulation space in question can exist in two political forms: 1. It is occupied by a sovereign State in the sense of a single international law that groups together, in the form of a federation, a plurality of public jurisdictions. 2. It is occupied by a plurality of sovereign States within the meaning of international law.

2

Bretton Woods is a small town located in the state of New Hampshire, USA. A hybrid form of monetary union consists of defining a common but not a single currency. This raises the question of the coexistence of currencies within a given national territory. Such coexistence is common, especially in countries with weak and underdeveloped institutions. It is most often tolerated by the public authorities. The problem of the coexistence of legal tender currencies has arisen in the context of metallic currencies, mainly in connection with silver–gold bi-metallism. This book does not deal with this configuration, which is not very topical. 3

8

1 Monetary Unions: Between International Trade and National Sovereignty

Two types of union may be distinguished, depending on whether the political space covers one or more sovereign States. The preceding definition may then be replaced by the following two definitions: A national monetary union defines the conditions for the exercise of monetary sovereignty by a sovereign State based on a federal principle. A multi-national monetary union is an international agreement between sovereign States that decide on the exclusive use of a common currency on their territories, delegate the exercise of monetary sovereignty to a supranational institution, and define the operating conditions of this institution.

The first definition calls for a clarification of what is meant by the “federal principle,” so as to remove an ambiguity: since all States, except microstates, are based on a hierarchy of interlocking public jurisdictions, what is the difference between a national monetary union and a singular economy, as we defined this term at the end of the introduction? In a federation, sub-national jurisdictions, which are not recognized as entities under international law, have a constitutional singularity, are in charge of a wide range of fields of intervention (non-regalian, i.e. not affecting national sovereignty), and have fiscal resources or the capacity to mobilize significant fiscal resources. From this perspective, France was not a national monetary union in the time of the franc, given the limited and controlled macroeconomic role played by the regions and departments, contrarily to the Federal Republic of Germany in the time of the Deutschmark since the Länder are constitutionally, politically, and economically fundamental entities in the overall functioning of the republic. Although sovereignty is exercised by the “federal” state, political fragmentation is sufficiently important in a national monetary union that the same issues of economic heterogeneity and plurality of political bodies arise as in multi-national monetary unions. In a multi-national monetary union, the components of the union are sovereign States under international law. These States decide to unify their monetary payment areas and to create a single issuing institution responsible for regulating this payment area and defining and conducting monetary policy. In so doing, they share monetary sovereignty. However, because of their sovereignty, they retain their legislative, executive, and judicial capacities. The political heterogeneity of a multinational union is therefore increased by an additional degree compared to what it is in a national monetary union, due to the institutional heterogeneity of the nations that make it up. A monetary union has three characteristics (Allen [1]): 1. A single currency. This currency may take different forms but these different monetary means of payment must be perfectly substitutable at zero cost. If these means of payment take the form of “internal currencies,” these currencies must have a single and definitive conversion into the single currency.4

4

The EMU was established in 1999, but the national currencies of the member countries disappeared from the monetary circuits and ceased to be used by non-financial agents only in

1.1 Monetary Sovereignty

9

2. A single monetary policy. This implies a single central bank, the sole issuer of the “monetary base,” i.e. the money circulating between commercial banks to settle their accounts on a daily basis.5 But also the unification of the conditions of competition between the banks in terms of credit creation and therefore of monetary issues. This unification requires a single and identical regulatory framework for all commercial banks in terms of bank refinancing and a single and integrated system of interbank payments, treating all banks in the union in an undifferentiated manner, regardless of the country in which they are legally established. 3. A single system for the convertibility of this currency into the other currencies used in the world economy. This uniqueness ensures that all exporters and importers active in the union are treated in the same way and form their future parity expectations (and therefore their economic calculations) on the basis of the same information. This has two consequences in the case of a multinational monetary union. The first is that the currency reserves of the union are consolidated at the central bank, thus preventing member States from having the means—through the reserves they would have held—to manipulate the exchange rate unilaterally and uncooperatively. The second is that they must also lose the means to change the terms of trade of their exporters and importers through a system of customs duties over which they would have retained control.6 Thus a logical prerequisite for monetary union is the common market (the disappearance of customs duties within the union) and the customs union, i.e. the definition by the member States of a single system of custom duties vis-à-vis the rest of the world.7 It can be seen that the creation of a multi-national monetary union goes beyond monetary policy alone and implies a strong economic integration of the Member States. This is obviously the case in a national monetary union. However, the two types of monetary union cannot be confused. Indeed, the plurality of sovereignties considerably changes the behaviour of Member States in a multi-national monetary union. On the one hand, there is no a priori common

2002. From 1999 to 2001, these national currencies had lost their status as international currencies, no longer circulated outside the euro area, and were therefore only different forms of the euro. This is why the creation of the euro dates back to 1999. 5 The institution issuing the currency of the Union, commonly referred to as the “central bank,” may consist of a more or less complicated system of different institutions, adapted to the legal and economic diversity of the Union, and in particular rely on national central banks. This is the case in the euro area, where the monetary organization is based on a “European System of Central Banks,” one of which is the European Central Bank” itself. Similarly, the “Reserve Bank of India” has four regional “subsidiaries” whose directors are members of the bank’s “Central Board of Directors.” 6 States retain the possibility, however, of modifying the terms of trade through tax provisions. This will be dealt with in Chap. 6. 7 From this point of view, the African monetary unions, UEMOA and CEMAC, are atypical since monetary unification preceded the common market by 30 years.

10

1 Monetary Unions: Between International Trade and National Sovereignty

legislative and regulatory framework governing the different States. In particular, since banks are subject to the regulations in force in the country in which they are registered, the banking system is heterogeneous in multi-national unions but integrated into national unions. On the other hand, the modes of operation of public Treasuries differ in the two types of union. In a multi-national union, the tax collection capacities of the national tax authorities differ. As States retain their fiscal sovereignty, they practice autonomous fiscal policies and face different financial conditions. For this reason, the borrowing and default conditions of national Treasuries differ. In a national monetary union, on the contrary, the functioning of tax administrations is homogenized and fiscal policy is by single consolidation. In other words, the management of economic and financial risks is posed in different terms in the two types of union.8

1.1.3

Monetary Sovereignty in Monetary Unions

A monetary union implies a unity of monetary sovereignty. It remains to be seen how this will be exercised. In the case of a national monetary union, there is no ambiguity. Monetary sovereignty is exercised by the national central bank. It conducts its monetary policy according to a logic identical to that which prevails in a simple economy. In fiscal matters, its natural interlocutor is the Federal Treasury; in financial and banking matters, its interlocutors are the national prudential regulatory agencies. In the case of a multi-national monetary union, an important new distinction is introduced into the analysis. Monetary sovereignty can be shared between the Member States of the union or not. In the latter case, monetary sovereignty is exercised by a single Member State, usually in its own national interest. This situation is known as “dollarization”. The sharing of monetary sovereignty in the case of a multi-national union is provided for in the agreement creating the monetary union, which is legally an international treaty since it is an agreement between sovereign States. In concrete terms, the agreement lays down the conditions under which the Member States are represented in the central bank in conjunction with the way in which central policy is conducted. Similarly, it provides for the central bank’s relationship with the national Treasuries and banking and financial regulatory agencies in place in the union. If a parallel agreement deals with the relations between the public Treasuries, it is referred to as a “fiscal union”. Similarly, if the Member States set up a common organization of regulatory powers in financial and banking matters, it is referred to as a “banking union”. It is reasonable to think that this agreement will be based on the principle of “equal” treatment of countries (weighted by their population and

8

Empirical studies of monetary unions often amalgamate the two types of monetary unions, often without explicitly stating which type of union they are interested in.

1.1 Monetary Sovereignty

11

economic weight). Thus, the surrender of national sovereignty by a Member State is compensated by participation in collective monetary sovereignty. The term “dollarization” comes from the fact that some countries use de facto or de jure the dollar, the currency issued by the United States. By generalization, it applies in all cases where countries use a currency issued by another country (or a monetary union to which they do not belong, as is the case with the euro, which is used in some European countries that are not members of the euro zone). Let us restrict ourselves to cases where a country decides that the currency officially used to settle nominal transactions is a foreign currency issued by a single country. Such a monetary union is asymmetric. The country whose currency is used is called the “anchor country,” the country using its currency is called the “dollarized country.” The important point is that dollarization is not the subject of an international agreement between the two countries. The anchor country does not share its monetary sovereignty while the dollarized country has completely abandoned its own. Monetary policy is entirely controlled by the anchor country according to its own imperatives or objectives and its own economic situation. It is undergone by the dollarized country, regardless of its conjuncture and its possible needs. For the dollarized country, the consequence is threefold: 1. It is totally unable to accomodate by means of monetary policy the idiosyncratic shocks (the shocks that are specific to it) which it experiences. 2. On the contrary, it is totally exposed to the management by the anchor country of its idiosyncratic shocks. 3. It has no seigniorage resources to limit public borrowing. The dollarized country is thus extremely exposed to external risks. On the other hand, the anchor country benefits from a broader basis for its own seigniorage and a deeper financial market to finance its public and/or external deficits. Since the aggregate demand function of its currency is displaced (for a given interest rate, the demand for money is greater), all other things being equal, the cost of its external debt is reduced.

1.1.4

Monetary Unions in History

It is interesting to look at the history of monetary unions for two reasons. On the one hand, the historical perspective allows us to take the measure of the phenomenon, its frequency, and its avatars. On the other hand, it allows us to identify stylized facts about these monetary arrangements. Reflecting on the difficulties that historical monetary unions have encountered, the solutions they have found to overcome them or tried to implement, their dynamics and how they have or have not been able to survive are instructive for thinking about existing, potential, or future monetary

12

1 Monetary Unions: Between International Trade and National Sovereignty

unions.9 Monetary unification is a massive phenomenon in history. It has gone hand in hand with two phenomena: the constitution of States, and in particular nationStates, and the slow dematerialization of monetary signs, abandoning gold, this “barbaric relic” to use Keynes’s famous formula [20, p. 172].10

1.1.4.1 Monetary Unions Before and After Bretton Woods A monetary union depends on the international monetary environment in which it operates. Until the early 1970s, currencies were exchanged within a system that relied partly on stocks of metals, gold, and silver, held by central banks. The anchoring of the international monetary system on gold and silver reserves provided for currency conversions and limited the use of monetary policy instruments for macroeconomic stabilization. Monetary unions operating under the gold standard regime (the Latin Union, the Austro-Hungarian Union) had the main objective of facilitating currency circulation by avoiding currency conversions. The Bretton Woods system was designed to compensate for the inadequacy and low elasticity of the world gold stock by using the dollar as the international conversion currency. The gold peg disappeared completely with the collapse of the Bretton Woods gold exchange standard system. The international monetary environment changed dramatically at the end of the twentieth century. In the post-Bretton Woods system, both monetary unions and unitary economies are faced with the objective of conducting macroeconomic stabilization. Current dollarized economies (such as Panama, pegged to the dollar, or Kosovo, pegged to the euro) have given up the possibility of conducting an autonomous monetary policy; instead, symmetric monetary unions (such as the EMU) have to assume the same monetary policy responsibilities as simple economies. 1.1.4.2 National Unions Bordo and Jonung [4] examine three national monetary unions: the United States, Italy and Germany. Others include Switzerland, Canada, India and Argentina, for example. More generally, all sovereign monetary federations are monetary unions. Let us focus on the American and German cases, both because of the importance of these economies and because their monetary sovereignty was acquired very early on. The first significant monetary union is undoubtedly the union of the American states. Bordo and Jonung classify it as a national monetary union. This is true nowadays but it should be noted that its “national” nature developed very slowly (Friedman and Schwartz [12]). Indeed, it took almost a century and a half for this national union to be firmly established as such. Its legal creation dates back to 1789 when the Constitution drafted in Philadelphia gave the US Congress a monopoly on

9 These questions are the subject of the article by Bordo and Jonung (Bordo and Jonung [4]). We draw much inspiration from this article in this section. 10 In the case of metallic coins, unification concerned the conditions of circulation of a particular form. We are neglecting this question, which is of interest to numismatic historians.

1.1 Monetary Sovereignty

13

the minting of money and the “regulation” of its value. It is reasonable to argue that it acquired all the characteristics of a modern monetary union with the Banking Acts of 1933 and 1935 which statutorily unified the American banking system and finally allowed the Federal Reserve System, the Union’s central bank created in 1914, to fully exercise a nationally consistent monetary policy. At that time, the internal payment system of the American Union was unified and the costs of converting payments within the United States were eliminated. The monetary history of the United States is marked by a succession of crises that have been overcome, rarely without major difficulties. The most important of these crises was, of course, the Civil War, during which the secessionist states created their own currency. German monetary unification is also rich in lessons (Holtferich [15]). It too was built up gradually. The German customs union was established on the initiative of Prussia in 1834. One of its articles provided for the unification of “coinage,” or the issue of metallic means of payment. It was not until after the Prussian victory in the French–Prussian war of 1870 that a unified coinage system was established and the Reichsmark instituted, thanks in particular to the war indemnity paid by defeated France. The next logical but difficult step was the establishment of the Reichsbank in 1876, which gradually gained a monopoly on the issue of banknotes. It should be noted that German monetary unification experienced three major shocks during the twentieth century: the hyperinflation crisis in 1923, which saw the replacement of the Reichsbank by the Bundesbank; the post-war crisis when the dismantling of Germany was envisaged by some of the victorious allies and the secession of the Soviet-controlled eastern part, effective in 1948; finally, the reunification shock of 1990, which ended with the absorption of the Ostmark by the deutsche mark, on the basis of a 1:1 parity.

1.1.4.3 Multi-National Monetary Unions The significant multi-national monetary unions of the nineteenth century are the Latin Union (Flandreau [9], [10]), the Scandinavian Monetary Union (Bergman [3]) and the Austro-Hungarian Union (Flandreau [11]). But these monetary unions, operating under the gold standard, are mainly monetary unions regulating the circulation of cash. The Austro-Hungarian Union is an exception insofar as the banking system and the sharing of seigniorage were effectively concerned (Table 1.1). In the post-war period, i.e. in the period when currencies were dematerialized and converted through currency markets, new multi-national monetary unions emerged. The “European Payments Union” was created in 1950 in order to avoid the use of the dollar among European countries, as their dollar reserves were low and their trade needs were high because these countries were in the process of reconstruction (Kaplan and Schleiminger [18]). It ended in 1958. It was one of the first steps in European monetary unification. This process began in earnest in 1957 with the Treaty of Rome, signed by six European countries, one of whose articles (Article 105(2)) provides for the creation of a “Monetary Committee of the European Community” responsible for coordinating the monetary policies of the member States. However, it was not until 1992 that the member countries of what became the European Union

14

1 Monetary Unions: Between International Trade and National Sovereignty

Table 1.1 Monetary unions before Bretton Woods Name of the union German custom union Austro-Hungarian union Latin monetary Union

Countries States belonging to the German Empire Austro-Hungarian Empire France, Belgium, Italy, Switzerland, Greece (1868) Scandinavian Union Denmark, Sweden, Norway Belgium–Luxembourg economic union Belgium, Luxembourg

Duration 1833–1919 1867–1918 1865–1927 1873–1914 1921–...

Sources: Central banks, IMF, Chown [5]

created the “Economic and Monetary Union,” the real name of the euro area, by the Maastricht Treaty. This union became effective on 1 January 1999 when the national currencies of the eleven countries admitted to the Union were replaced by the euro.11 It only began to circulate in current transactions between residents of member countries on 1st January 2002 (James [17], Marsh [21]). The European Union has experienced two major crises in its short history: the global financial crisis linked to the bankruptcy of the financial giant Lehman Brothers in 2008, and the so-called sovereign debt crisis which began in 2009 when the newly elected Greek Prime Minister, G. Papandreou, announced that the previous government had seriously and deliberately underestimated the size of the Greek public deficit. These crises have been difficult to overcome and show the unfinished nature of European monetary union. Contrary to what has often been argued, economists had long since recognized its shortcomings without being heard by European politicians (Begg et al. [2], Eichengreen [8]). The question is open as to whether these are youth crises or crises highlighting more structural shortcomings. In contrast to the patient European monetary construction, the French-speaking monetary unions were born suddenly and clearly for political motives: to maintain a link between France and the new African States, created in the wake of the dismantling of the French colonial empire. Monetary stability in the newly independent countries is ensured by means of a monetary union based on a common currency linked to the French franc, which provided a financial guarantee but implied supervision by the former colonial power. The West African Monetary Union was created in 196212 and the Central African Customs and Economic Union in 1965, which became the CEMAC in 1994 (Table 1.2).

11 These

11 countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain and Finland. Greece joined the euro area in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, Latvia in 2014 and Lithuania in 2015. 12 It became WAEMU (West African Economic and Monetary Union) in 1994.

1.1 Monetary Sovereignty

15

Table 1.2 Monetary unions after Bretton Woods Name of the union United States of America Switzerland Canada Indian Union European Union of payments

West-African economic and monetary union (UEMOA) Common Monetary Area Organisation of the Oriental Caribbean Countries Central Africa Economic Community (CEMAC)

Countries United States of America Switzerland, Liechtenstein Canada Indian Union Autria, Belgium, Denmark, France, West-Germany, Greece, Ireland, Iceland, Italy, Luxembourg, Norway, Netherlands, Portugal, United Kingdom, Sweden, Switzerland, Turkey Benin, Burkina-Faso, Ivory Coast, Guinea-Bissau, Mali, Niger, Senegal, Togo South Africa, Lesotho, Swaziland Antigua-and-B., Dominique, Grenade, St Christophe, St Vincent, Ste Lucie Cameroun, Central-African Rep., Rep. Congo, Gabon, Equat. Guinea, Tchad

Duration 1790–... 1905–... 1935–... 1935–... 1950–1962

1962–...

1986–... 1965–...

1995–...

Sources: Central Banks, IMF

1.1.4.4 Dollarization As we have seen, dollarization poses particular sovereignty problems and the conditions under which a country uses it are different. It is the most prevalent form of monetary union in recent monetary history. The simplest explanation for this is linked to the multiplication of States in the second half of the twentieth century following the demise of the colonial empires formed by European nations. There are nearly two hundred independent States, 193 of which are members of the United Nations. Many of these new States are small or sparsely populated, have weak resources, or reduced administrative capacity. The option of dollarization enables them to avoid the costs and risks of a national currency.13 Dollarization may or may not be recognized by the issuing country. At present, some forty sovereign States legally use the currency issued by another country. To give only a quantitative indication, Rose [26] has compiled a database of trade data for 186 countries over the period 1970–1990. He was able to observe more than 300 5-year episodes during which two countries were linked by currency use. In most cases, these were episodes of dollarization. 13 We

will come back to this in more detail in the next chapter.

16

1 Monetary Unions: Between International Trade and National Sovereignty

The most exemplary case is that of Panama. Created by secession from Colombia (with the support of the United States, anxious to ensure its control over the Panama Canal) in 1903, granting the same year the sovereignty of the United States over the canal zone, Panama decided to dollarize itself as early as 1905, thus putting itself completely dependent on the United States. The recovery of Panama’s sovereignty over the canal zone on 31 December 1999 did not call into question the choice of dollarization. In another symptomatic case, Ecuador opted for dollarization in 2000 following a serious financial crisis combined with an extremely violent episode of hyperinflation. It should be noted that a country can de facto be “dollarized” when it has not de jure renounced its sovereignty. This is the case when a foreign currency (“the dollar”) assumes a significant share of transactions in the country, alongside the national currency. Or when a country strictly and permanently follows the monetary policy of another country in order to stabilize the exchange rate between its currency and the currency of the country to which it is anchored. Denmark, for example, which is not formally a member of the European Monetary Union, is euroized because the monetary policy of the Danish Central Bank is strictly aligned with that of the euro area (Tables 1.3 and 1.4). In fine, by crossing the two criteria of symmetry and nationality, it is possible to order the varieties of monetary union in a double-entry table (Table 1.5). Table 1.3 Dollarized economies (since 1970) Anchor currency US Dollar Euro Australian Dollar Majulah Singapura Neo-Zealand Dollar

Countries Ecuador, Liberia, Marshall islands, Micronesia, Palau, Panama, Salvador, Timor oriental, Zimbabwe Andora, Montenegro, Kosovo, Monaco, San Marino, Vatican City Kiribati, Nauru, Tuvalu, Tonga Brunei Cook islands

Sources: Rose [26], Pomfret [25], Nitzsch [23] Table 1.4 Anchored economies Anchor currency US Dollar

Indian rupee Euro

Countries Aruba, Bahamas, Bahrain, Barbados, Belize, Djibouti, EAU, Guyana, Caïmans islands, Hong Kong, Oman, Eastern Caribbean States Bhutan, Nepal Bosnie-Herz., Cabo-Verde, Comores, Georgia, North Macedonia, Morocco, San Tome-and-Principe

Sources: Rose [26], Pomfret [25], Nitzsch [23]

1.2 Currencies, Foreign Exchange and International Payments Table 1.5 Varieties of currency unions

17

Symmetrical Union Asymmetrical Union National union × USA Multi-national union EMU P anama

1.2

Currencies, Foreign Exchange and International Payments

1.2.1

Currency Plurality and External Constraints

To understand what is at stake in international trade and payments, particularly within a monetary union, some simple formalization is necessary. Let us consider an international economy composed of J countries, which we indicate by j, j = 1, ..., J . We therefore speak of “country j .” Each country has its own currency, and nominal prices are denominated in this currency. Let us assume a world without uncertainty. All the products of a country are internationally tradable,14 and all consumers in all countries wish to consume all goods. There are K goods produced in the global economy. The set of products is denoted K = {1, ..., K}. We assume that a good is produced in a single country.15 Goods indexed from 1 to k1 are produced in country 1, goods indexed from k1+1 to k2 are produced in country 2, and more generally goods produced in country j are indexed from kj −1 + 1 to kj (with k0 = 0). The set of products of country j is    denoted Kj = kj−1 + 1, . . . , kj . We have: K = Jj=1 Kj . Let us denote by pk the price of the good denominated in the national currency of country j where the good k is produced. This price is a “nominal” price, measured in the currency of the country. There are nj goods produced in country j . Let Pj be the vector of the  prices of the goods of country j expressed in the currency of country j : Pj = pkj−1 +1 , ..., pkj . Let the direct exchange rate express the exchange ratio of a unit of the currency of country j in the currency of another country j  . Let us denote it ej  ,j .16 This exchange rate is used to convert nominal prices from one currency into another, or  to change currency.   The price of a good k expressed in the currency of a country j  j j is noted pk pk = pk si k ∈ Kj . The exchange rate makes it possible to convert j

the price of a good produced in country j into the currency of country j  : pk = j ej  ,j pk = ej  ,j pk .17 Consumers in each country can thus compare the prices of all the goods they wish to consume once expressed in the national currency. The set of

14 These goods are referred to as “tradable goods.” Goods that are not traded internationally are referred to as “non-tradable goods.” 15 This assumption is easy to relax. 16 An increase in this ratio represents an appreciation of the national currency, a decrease a depreciation. 17 We disregard transaction costs, including international transport costs.

18

1 Monetary Unions: Between International Trade and National Sovereignty

  exchange rates in the currency of country j is a vector ej ≡ e1,j , ..., eJ,j where ej,j = 1. The nominal prices of the products of   country j expressed in the currency of country j  are given by a vector ej  ,j pk k∈K according to the conversion rule we j have just defined. By generalization, the vector of all the prices of goods produced in the world economy in the currency of country j  , noted PjW , is defined as follows from the original prices pk , k = 1, ..., K:  PjW ≡ ej  ,1 p1 , ..., ej  ,1 pk1 , ej  ,2 pk1 1 , ..., ej  ,2 pk2 , ..., pkj  −1 +1 , ...,  pkj  , ... , ∀j  = 1, ..., J. The demand for the good k produced in j expressed by consumers in country j  depends on this vector. A change in ej  ,j leads to a change in the price of good k denominated in the currency of country j  , on which consumers in that country make their purchasing decisions. It also leads to a change in the prices of the products of country j expressed in the currency of country j  (assuming, of course, that nominal prices do not change). If it is a decrease, all the prices of products of country j fall in country j  and all the prices of products of country j  rise in country j (assuming that no prices denominated in the currency of its home country change): products of country j gain in competitiveness and those of country j  lose in competitiveness.

1.2.1.1 International Trade and External Constraints Because all the goods in the world are in demand by all consumers, country j is both an exporter and an importer. Note Dj,k is the demand of consumers in country j for good k. This demand is a function of the world price vector PjW denominated   in currency j : Dj,k = Dj,k PjW . Specifically, we assume that demand depends on relative prices of goods and not on nominal prices. The nominal value of country j exports (due to demand for its goods by consumers in the rest of the world)—expressed in its currency—is equal to ⎛ ⎞ kj J   ⎝ pk · Dj  ,k PjM ⎠ . j  =1,j  =j

Note that

k=kj−1 +1

  j W corresponds to the total value of the demands  P p ·D  j ,k k=kj−1 +1 k j

kj

made by country j  to country j , denominated in the currency of country j  . To convert this sum into its equivalent in the currency of country j , the conversion rule j using ej,j  implies: pk = ej,j  pk . Similarly, the value of country j imports (due to its consumers’ demand for goods from the rest of the world)—denominated in its

1.2 Currencies, Foreign Exchange and International Payments

19

currency—is equal to

  j pk · Dj,k PjM .

k=kj−1 +1,..,kj

The balance of trade of country j with the rest of the world expressed in the currency j , which we note Sj,j , is given by the following expression: Sj,j ≡

J j  =1,j  =j

⎛ ⎝

kj

pk · Dj  ,k

k=kj−1 +1



⎞  P M ⎠ −



j

  j pk · Dj,k PjM .

k=kj−1 +1,..,kj

(1.1) Trade for country j is balanced when this balance is zero, in surplus when it is positive and in deficit when it is negative. This balance is the equivalent in our highly simplified world of the current account balance recorded in a given country’s balance of payments. It can also be converted into the currency of country 1 and become the external balance of country j expressed in the currency of country 1, S1,j , defined as: S1,j ≡ e1,j Sj,j .

1.2.1.2 The External Constraint and the Role of Exchange Rates The “external constraint” is a country’s obligation to balance its trade with the rest of the world. It is an inescapable and universal obligation that results from the fact that any market purchase must be matched by an equivalent value and, in a monetary economy, be balanced by a flow of money. The equilibrium of the external balance of country j is defined as follows:   Definition 1.1. For a given world price vector P1 , ..., Pj , ..., PJ , an exchange rate vector ej satisfying the condition Sj,j = 0 is an equilibrium of the external balance of country j . By extension, we can define the equilibrium of all international trade. Such an equilibrium formally corresponds to the following condition: Sj,j = 0,

∀j = 1, ..., J.

(1.2)

  Definition 1.2. of world prices P1 , ..., Pj , ..., PJ , an exchange  For a given vector  rate vector e1 , ..., ej , ..., eJ satisfying condition (1.2) is an equilibrium of all international trade. The balancing of international trade, that is the fact that the external current accounts of all countries are all zero, is obtained by price adjustments and in particular by those particular prices that are the exchange rates. Let us focus on exchange rates. Definition 1.1 implies that, for given prices, exchange rates

20

1 Monetary Unions: Between International Trade and National Sovereignty

must adjust so as to ensure the general equilibrium of the external balances of the countries participating in international trade. This is because a change in an exchange rate, ej  ,j , changes the relative prices of traded goods in the two countries concerned. An decrease in ej  ,j raises the relative prices in country j of goods produced in country j  relative to goods produced in country j but lowers the relative prices in country j  of goods produced in country j . This leads to a shift in the relative demands in the two countries for the different goods. Under conventional assumptions,18 when the demand functions for a good are decreasing in the (relative) prices of goods, the balance of trade between j and j  changes in favour of j and against j  . Country j improves its external balance, while the external balance for country j  deteriorates. The conversion of currencies can go through an intermediate stage: to change a sum in the currency of country j into a sum in the currency of country j  , it is possible to proceed indirectly by a conversion into the currency of country 1 and then to convert this sum into a sum in the currency of country j  . Formally, we can write: ej  ,j = ej  ,1 · e1,j . If we assume that the costs related to these conversions are zero, the two ways of proceeding are equivalent. It can be argued that some conversions involve exorbitant transaction costs. It will then be preferable to carry out an indirect exchange involving a currency that can be converted into any other currency and for which these transaction costs are the lowest. Let us then call the currency of country 1 a “universal” currency (in the sense that it is tradable worldwide) or a “reserve” currency (in the sense that all national central banks hold it in order to be able to convert their national currency). The external balance equation (1.1) can be written as follows: ⎛

J

kj

j  =1,j  =j

k=kj−1 +1

S1,j = e1,j ·⎝ ⎛ =⎝

J

kj

j  =1,j  =j k=kj−1 +1







pk · Dj  ,k PjM −

  pk1 · Dj  ,k PjM −

j pk

⎞   · Dj,k PjM ⎠

k=kj−1 +1,..,kj



⎞   pk1 · Dj,k PjM ⎠ .

k=kj−1 +1,..,kj

This equation teaches us one thing: if the parity of the currency of country j with the universal currency e1.j changes, while the other parities remain constant, the external balance of country j is modified. In fact, this change alters all the prices

18 That is to say, under assumptions usually made about supply and demand behaviour. This is equivalent to assuming that the substitution effects outweigh the income effects of a change in exchange rates.

1.2 Currencies, Foreign Exchange and International Payments

21

of goods imported by j denominated in the national currency and all the prices of goods exported by j to other countries, once converted into the national currencies. This change alone alters all price ratios of goods traded by country j with the rest of the world. Importantly, the change in the external parity does not change the relative price of two goods produced in country j . In other words, the conditions of internal competition are not (directly) affected by a change in the exchange rate, whereas the conditions of external competition (of goods from country j with goods from the rest of the world) are affected by a change in the exchange rate.19 This has an important consequence. A fall in the exchange rate (depreciation of the domestic currency) raises the prices of foreign goods imported by country j . This is referred to as “imported inflation”. This is the only direct redistributive effect this decline creates and it is with respect to the rest of the world. There is no direct redistributive effect within country j .20 Since the price ratios between producers in country j remain identical, there is no relative change in their positions and remuneration. In brief, the variation in parities is a powerful instrument for varying the relative competitiveness of traded goods in the world economy.21

1.2.1.3 The Balance of Payments and the External Constraint The previous reasoning has shown that the exchange rate system plays an important role in the balance of a country’s external accounts. Yet international trade is complex. On the one hand, these exchanges occur over time and in a world where financial markets operate. On the other hand, these exchanges are affected by shocks and uncertainty must be taken into account in the study of the current account balance. These two elements considerably modify the analysis. The time dimension of the economy means that investment—both private and public—must be taken into account. Moreover, it is possible for a country—taken as a consolidated whole—to use debt to finance its external balance. This debt is an international debt: collectively the rest of the world lends the monetary resources that make trade possible. This loan is an “incoming” financial flow (from the rest of the world), in return for a real “outgoing” flow (exports of goods and services from the country concerned).22

19 This

reasoning refers to the immediate effects of exchange rate changes. There are indirect effects that should not be overlooked for a complete analysis. 20 We are neglecting the indirect effects that this decline may create. 21 It is not the only instrument. Moreover, there is no evidence that unilateral manipulation of the exchange rate is sufficient to ensure external equilibrium. Lastly, this manipulation can only be effective in the short term, since the fundamentals of the economy (productivity, mobilization of factors, innovations) tend to determine an economy’s competitiveness. 22 We disregard the precise forms that the financing of an international transaction takes, speaking without further precision of “loan.”

22

1 Monetary Unions: Between International Trade and National Sovereignty

Table 1.6 Simplified balance of payments Current transactions Capital flows

Credit Exports of goods and services Capital inflows

Debit Imports of goods and services Capital outflows

All of these gross flows—related to financial transactions and transactions in goods and services—are summarized in the “balance of payments”. The balance of payments is the accounting document that records in a synthetic way all the transactions carried out by the residents of a given country with the rest of the world during a given period (generally the year).

Exports of goods and services and outward financial flows are recorded as credits, while imports and inward financial flows are recorded as debits. The balance of payments has two parts: the current account and the financial account. The first records exports and imports of goods and services (at their current prices, in national currency); the second records financial inflows and outflows. By construction, the balance of payments reports the total of inflows and outflows as equal since it is an accounting document. However, the current account is not necessarily balanced and can be compensated by an imbalance in the opposite direction of the financial account. In other words, the current account for a given period is not necessarily zero and corresponds to an inverse financial balance (Table 1.6). Trade flows vary over time because of shocks of all kinds that hit the economy. We must therefore expect the current account to vary over time. It will be considered “balanced” if, over time, external surpluses offset external deficits. Let us use macroeconomic notations so as to understand what is meant by the external balance of country j . The fundamental macroeconomic accounting identity in the open economy is that the expenditures—consolidated, hence aggregated— made in a given period are equal to the resources produced in the same period. The total expenditure is the sum of aggregate private consumption Ci net of taxes Ti , public consumption Gi , aggregate investment and exports Xi ; the total resources are equal to domestic production Yi and imports Mi . The fundamental identity is written: Yj + Mj = Cj − Tj + Gj + Ij + Xj . All these terms are nominal quantities, expressed in national  The terms  currency. of this identity can be reordered by defining the difference Yj − Cj as aggregate “savings” Sj leading to a more meaningful accounting equilibrium condition:       Sj − Ij + Tj − Gj = Xj − Mj .

(1.3)

The  latter expression can be interpreted as follows: the sum of net private savings Sj − Ij and public savings (the difference between tax receipts Ti and public

1.2 Currencies, Foreign Exchange and International Payments

23

  expenditures Gi ) is equal to the external surplus, or the current account Xj − Mj . A country with a surplus in its current trade in goods and services has a financing (lending) capacity vis-à-vis the rest of the world. Conversely, a country with a deficit has a financing need vis-à-vis the rest of the world. This is the mirror result of the one obtained from looking at the balance of payments. The external constraint can be loosened “temporarily” through international financial flows. However, the question then arises as to how a country’s external accounts return to equilibrium or how a country repays its debts. This is the “most pressing world economic problem of our time” (Rueff [27]). It is logical to think that exchange rate adjustments should play a privileged role in solving this problem.

1.2.2

Monetary Union and the External Constraint

What does it change to switch to a monetary union? What is the external constraint for a country when it is part of a monetary union? Having unified the legal tender currency does not change the need to balance the external accounts of each country because monetary unification does not imply political unification and therefore national sovereignty, and in particular the regulatory and fiscal arrangements. The abolition of exchange rates between member countries of a multi-national monetary union does not remove the obligation to balance the external accounts of these countries. This is the essential difference with national monetary union. In this case, the unification of national sovereignty removes this obligation. If there are non-zero balances of trade in goods and services produced by the regions of a country (the states of a federation), these balances are covered by transfers within the federal country.

1.2.2.1 Price Adjustments in the Absence of an Exchange Rate Let us reason in the case of a multi-national monetary union. We first assume that the J countries of the economy unify their monetary sovereignty. Formally, we can write: ej  ,j = 1

∀j = 1, .., J, j  = 1, ...J.

Let us note Sj,U the total external balance of country j (belonging to the union) denominated in the currency of the union. The balance of j within the union is equal to Sj,U = Sj,U =

J j  =j

⎛ ⎝

kj

k=kj−1 +1

pk · Dj  ,k



⎞  PW ⎠ −



  pk · Dj,k P W

k=kj−1 +1,..,kj

(1.4)

24

1 Monetary Unions: Between International Trade and National Sovereignty

in application of (1.1), the vector of world prices being denominated in the currency of the union, the sole currency of this economy and thus being the same for all buyers regardless of their country of residence. By construction, exchange rates have disappeared. The need to balance the external accounts leads us to modify the previous definitions. The balance of the external balance of country j in monetary union is defined as follows:   Definition 1.3. For a given vector of world prices P1 , ..., Pj −1 , Pj +1 , ..., PJ , the price vector Pj satisfying the condition Sj,U = 0 is an equilibrium of the external balance of country j in the monetary union. By extension, we can define the equilibrium of all international trade in monetary union. Such an equilibrium formally corresponds to the following condition: Sj,U = 0,

∀j = 1, ..., J.

(1.5)

  Definition 1.4. The vector of world prices P1 , ..., Pj , ..., PJ satisfying condition (1.5) is an equilibrium of all international trade in the monetary union. The relative prices on which the demand for goods in the union depends no longer integrate on exchange rates. However, their variations are supposed to restore the competitiveness of countries in order to ensure external equilibria. It follows that the adjustment of external balances in a monetary union is necessarily carried out by nominal prices, without exchange rate mediation. Two observations can be made on the basis of these expressions: 1. A country’s external balance within the union does not depend directly on any exchange rate. The producers and consumers of country j are in direct competition with those of the other member countries: the primary effect of monetary union is to homogenize the functioning of markets. 2. The removal of exchange rates through monetary union removes the property that all the relative prices of goods traded by a country with the rest of the world are changed by rate adjustments (whether in a fixed exchange rate system or in a flexible exchange rate system), without the relative prices within a particular country being changed, as discussed above. If the external deficit balance of a member country needs to be corrected in order to return to equilibrium,23 the weight of the adjustment is borne in a differentiated way by the producers of this country, via the adjustment of their prices. Some producers with high market power will be able to protect their prices while others will have to adjust their prices significantly. As internal price relations are potentially modified by the adjustment of the external balance, this implies redistributive effects

23 For

example, through a decrease in public spending or an increase in taxes, i.e. a reduction in the public deficit.

1.2 Currencies, Foreign Exchange and International Payments

25

within and between member countries. The transition to a single and common currency radically changes the adjustment modes of a member country’s external constraint. Relative price positions (and by extension income positions) are no longer maintained within the member country when the need to balance accounts is clearly felt, as is the case in a multi-currency world. The conditions for adjusting external balances in a monetary union are therefore clearly complicated and politically sensitive: conflicts of interest between social groups or between productive sectors in a member country are increased in a monetary union. This is what happened in Greece, after the crisis that began in 2009, where the reforms imposed in return for external financial support were borne in a differentiated manner by the Greeks: some being better protected than others from the measures taken to balance the external accounts, this exacerbated internal political tensions.

1.2.2.2 The Case of a Monetary Union Open to the World Now suppose that N of the J countries that make up the world economy unify their monetary sovereignty. For the sake of simplicity, using the formalization used above, let us assume that these are the first N countries in the world economy: the countries indexed from 1 to N < J . As the same currency circulates between these countries, it is as if the parity between the currencies used by these countries is set at 1. Formally, we can write: ej  ,j = 1

∀j = 1, .., N, j  = 1, ...N.

Let us note Sj,U the total external balance of country j (belonging to the union) denominated in the currency of the union, and let us note eU,j  the parity between the currency of the union and the currency of country j  not belonging to the union (j  > N). The balance of a country of the union—expressed in the currency of the union—is equal to the sum of its balance vis-à-vis the countries of the union, which U R : we note SU,j and its balance vis-à-vis the rest of the world, which we note SU,j U R + Sj,U . Sj,U = Sj,U

We can define the external balance of the union, which we note SU,U , as the sum of the external balances of the member countries: SU,U =

N

SU,j .

j =1

The balance of j within the union is equal to: U Sj,U =

N j  =1,j  =j

⎛ ⎝

kj

k=kj−1 +1

⎞ ⎞ ⎛ N     ⎝ pk · Dj  ,k PjM ⎠ − pk · Dl,k PlM ⎠ . l=1,l=j

k∈Kl

(1.6)

26

1 Monetary Unions: Between International Trade and National Sovereignty

Similarly, the balance of j with the rest of the world is equal to: R Sj,U =

J j  =N+1

⎛ ⎝

⎛ ⎞ ⎞ J     j ⎝ pk · Dj  ,k PjM ⎠ − pk · Dl,k PlM ⎠ .

kj

k=kj−1 +1

l=N+1

k∈Kl

(1.7) U cannot depend on The balance of country j with its partners in the union Sj,U the variation of an exchange rate between their currencies but its balance with the R depends on the exchange rates of the currency of the union rest of the world Sj,U with other currencies. Only the exchange rates between the union currency and the other currencies are taken into account in the expression of the general price level, and thus in aggregate demand. Finally, let us look at the question of the external constraint from an aggregate point of view. The sum of the external balances of the J countries taking part in international trade, expressed in the same currency, is by construction zero. Let us use the currency of the union as the numéraire. We obtain J j =1

SU,j =

N j =1

SU,j +

J j =N+1

SU,j = SU,U +

J

SU,j = 0.

j =N+1

  If all the balances of the member countries are zero SU,j = 0, ∀j = 1, ..., N , the balance of the union SU,U is zero. But the opposite  is not true.  The conditions that ensure the external equilibrium of the union SU,U = 0 do not automatically ensure the external equilibrium of all the member countries of this union  SU,j = 0, ∀j = 1, ..., N . Two additional observations can be made from these expressions: 1. The external balance of a country in the union with the rest of the world depends on the exchange rates of the union with the rest of the world. These exchange rates depend on the aggregate conditions of the union vis-à-vis the rest of the world, and in particular on the competitiveness of the other countries. A member country’s external balance is thus affected by a parity over which it has little or no control. Indeed, it may be thought that the parities of the union’s currency depend on the overall external balance of the union, not on the external balances of the individual member countries. A country’s deficit position may therefore not lead to a change in these parities, for example if the overall external balance is in balance. It can therefore only be improved by a change in nominal prices themselves, which directly leads to a gain in competitiveness. 2. A monetary union thus has two sides, internal and external. And the question of balancing trade is twofold: – In the absence of an exchange rate system, how is trade between countries (or jurisdictions) sharing the same currency regulated? How can the internal macroeconomic balance of the union be defined? What adjustments and what

1.2 Currencies, Foreign Exchange and International Payments

27

institutions are needed to ensure it? If so, under what conditions is such a balance impossible? – How does the monetary union ensure its integration into the global monetary economy? Assuming that the exchange rate of its currency is fixed in accordance with the rules of the international monetary system, how does its determination affect the relative situation of the countries that are part of it?

1.2.2.3 The Balances of Payments of the Monetary Union We find this duality in the balance of payments. We have to distinguish between the balance of payments of a member country and the balance of payments of the union as a whole. Starting from Eq. (1.3), we can determine the fundamental accounting equilibrium for country j : 

     Sj − Ij + Tj − Gj = Xj − Mj .

  The term Xj − Mj corresponds to the external balance. It is the sum of the external balance vis-à-vis its partners in the union XjU − MjU and the external   balance vis-à-vis the rest of the world XjR − MjR . Let us sum all these equations to obtain the fundamental equilibrium of the union: N 



Sj − Ij +

j

N 

 Tj − Gj ≡ (SU − IU ) + (TU − GU ) = (XU − MU )

j

≡

N 

 Xj − Mj .

j

We can write: (XU − MU ) =

N  j

N    XjU − MjU + XjR − MjR . j

By construction, the sum of the external balances within the union is zero: the bilateral deficits of a member country imply the bilateral surpluses of its partners. We deduce that: (XU − MU ) =

N  j

N    XjU − MjU + XjR − MjR . j

28

1 Monetary Unions: Between International Trade and National Sovereignty

  A member country may be indebted to its external partners Xj − Mj < 0 , whereas the union as a whole is not (XU − MU = 0). In this case, a country is indebted to the other member countries. This is the current situation in the euro area where trade with the rest of the world is (almost) balanced, whereas the foreign trade position of other member countries is not. Germany is recording considerable surpluses year after year. In recent years, the crisis in the eurozone, which was caused by the external debt of Greece due to a persistent negative external balance, is a good example of the problems of external debt in a monetary union. But it is not the only example. The chronic insolvency of the African monetary unions linking French-speaking countries does not lead to the same crisis because of the transfers made by the French State to ensure the solvency of these unions as a whole. Further back in time, the American monetary union was shaken in the nineteenth century by insolvency crises of certain American states. In particular, in 1837, President Von Buren refused to allow the federal Treasury to come to the rescue of insolvent states, which precipitated their bankruptcy. As these historical examples show, these are important issues: both the external indebtedness of a union and the indebtedness of its member countries determine its internal coherence, the degree of compatibility between its components, and thus the viability of the union.

1.2.3

Currency Area and Monetary Union: What Is the Difference?

A final distinction remains to be made: between a monetary union (defined as based on a single currency) and fixed exchange rate agreements. In such an agreement, a group of countries agree to intervene in the foreign exchange markets so that the parities between their currencies fixed on the foreign exchange markets are equal— within very small fluctuation margins—to predefined values. These countries form a “currency area”.24 As we have seen, a monetary union can be thought of as having set a 1 : 1 parity between the means of payment exchanged in the member countries (one dollar circulating in Alabama is worth one dollar circulating in California). It would therefore be possible to equate a monetary union with a currency area. This is confusing and Kenen [19] rightly and forcefully insists on the necessary distinction between a currency area and a monetary union. The difference is marked in times of financial crisis. In a fixed exchange rate system, member countries have accepted that their monetary sovereignty is constrained by the agreement but they have not renounced it. The plurality of currencies is maintained. Admittedly, in such a system, the balance of foreign trade of a given country may prove to be impossible in the fixed parities. There comes a time when the monetary authorities no longer have sufficient foreign exchange reserves to defend that parity. Government officials, having retained monetary sovereignty, must then negotiate with their partners— 24 This

is the original meaning of the term used by Mundell [22].

1.2 Currencies, Foreign Exchange and International Payments

29

and most often obtain—a change in the reference parities: the country currency is devalued against other currencies. In other words, the parity grid is changed but the country remains a member of the currency zone. The agreement is modified, it is not called into question. In a monetary union, things are quite different. In such a configuration, a country with a deficit does not have foreign exchange reserves to intervene. If a country is unable to overcome its external imbalances, if necessary with the help of its partners, its external indebtedness will continue to grow. There comes a time when the debt burden is unsustainable. Since no change in parity is possible, the only solution for this country to regain room for manoeuvre—when it finds itself in a situation of deep financial crisis, it goes without saying—is to leave the union itself and (re)introduce its own currency. The union is broken. There are other financial crises: those caused or initiated in a country or countries outside the monetary union or the currency area. In a financially open world, and depending on the degree of openness, member countries are affected differently depending on whether they belong to a monetary union or a currency area. In the first case, trade-offs by financial actors and short-term capital movements affect the currency of the union. All member countries are also affected. Monetary union means that the member countries assume the same external risk: the monetary union unifies in the face of external financial risks. In the second case, international tradeoffs differentiate between countries bound by a fixed exchange rate agreement and favour investments in some, deemed safer, rather than in others, seen as financially fragile. The consequence of these arbitrages is often a realignment of parities, even if the member countries do not leave the currency area. A currency area means that member countries do not bear international financial risk in the same way, unlike the monetary union. Finally, the two types of monetary arrangement are potential targets for different speculative attacks. Speculative attacks are the major weakness of currency zones: they relate to the realignment of parities within the zone (Sarno and Taylor [28], chapter 8). Such attacks are clearly impossible in a monetary union. This does not mean that such a union cannot be subject to speculative attacks, but they are more complicated to analyse and of a different nature from those that are common in monetary zones. Three consequences follow from these observations: 1. The conditions for risk sharing are very different in a monetary union and in a currency area. 2. Agents’ behaviour is necessarily different in the two configurations. For example, an investor conceives his investment plans in a given country differently depending on whether he anticipates that the prices of his products may be caused by a realignment of the parity of the country concerned or not. As a result, it is to be expected that the macroeconomic dynamics of the countries concerned will be different in the two types of monetary arrangement. 3. Finally, the conditions for the exercise of a country’s sovereignty are different in the two configurations. The analysis of the adjustment mechanisms used

30

1 Monetary Unions: Between International Trade and National Sovereignty

in the two configurations cannot be identical. Confusion between the two configurations is impossible. A distinction must be made between the concepts of monetary union and currency area.

1.3

The Rules of the Game of a Monetary Union

Comparing an international monetary system based on a plurality of currencies with a monetary union, we argue that a monetary union is logically an international (sub)monetary system. It is therefore useful to reflect on the “rules of the game,” both legal and implicit, that govern the functioning of a monetary union.

1.3.1

International Monetary Systems

1.3.1.1 What Is the Purpose of an International Monetary System? In a world of sovereign but not self-sufficient States, international trade generates cross-border flows of goods and services but also of capital, the counterparts of which are monetary flows. An international monetary system is a set of private arrangements valid in international law and inter-governmental agreements according to which these flows are made. At the forefront of these agreements, agreements on the terms and conditions of the international exchange of currency play a key role in characterizing such a system. An international monetary system has four purposes: 1. Ensuring the easiest and cheapest convertibility of the currencies of countries engaged in international trade so as to facilitate it; 2. Ensuring their access to the financial markets in order to secure at the lowest cost their indebtedness to external creditors, private or public, necessary to finance their economic development and their external deficit; 3. Permitting the gradual elimination of balance of payments imbalances, if necessary by manipulation of the exchange rate system; 4. In the event of a serious balance of payments crisis leading to an actual sovereign default or a high risk of imminent sovereign default, addressing the resolution of the crisis between the borrowing country and its creditors and facilitating the return of the country in crisis to the financial markets. The first purpose—to define the terms and conditions under which exchange rates are set and managed—is the most obvious. But it only makes sense as a balance of payments management modality and insofar as a country is not required to balance its current account at all times and is therefore able to borrow internationally. Indeed, the major problem facing any architect of an international monetary system is to find a mechanism to regulate international indebtedness, so that no participating country takes advantage of the system to go into endless or unconstrained debt, or on the contrary suffers disproportionate constraints as a result

1.3 The Rules of the Game of a Monetary Union

31

of trade adjustment, or is excluded from international financial markets. It is on the basis of this dual requirement that international financial crises must be avoided or, if they do occur, resolved at the lowest possible cost to the system as a whole.

1.3.1.2 A Brief Overview of the International Monetary Systems. The Role of Exchange Rates Limiting ourselves to the modern period, which saw the rise of international capitalism coupled with unceasing technical progress, from the beginning of the nineteenth century onwards, we are used to distinguish three major international monetary systems (Eichengreen [7]). The first is that of the gold standard that goes from the end of the Napoleonic period (1815) to the outbreak of the First World War. A gold price for each national currency was strictly defined, gold circulated freely (not physically: property rights over gold stocks changed hands) and external deficits resulted in international gold flows. Finally, Britain (in the late nineteenth century) ensured the liquidity of the system by exporting capital. The second international monetary system is the dollar exchange standard, negotiated at Bretton Woods. It lasted from 1944 to 1973.25 It is a system based on “fixed but adjustable” parities, currencies being convertible into dollars at that parity, the dollar itself being convertible into gold at a given parity. This system was aimed at overcoming the inadequacy of the gold stock in relation to the needs of international trade. Currency market prices could fluctuate within a range centred around the official parity. The parities with the dollar could be changed by international agreement. The system was supervised by the International Monetary Fund, which was able to intervene in the event of an imminent payment crisis for a given country. Finally, since 1973, the world has (gradually) entered into a flexible exchange rate system in which official parities are no longer defined and in which gold no longer plays the role of an anchor in exchange rate adjustments. Currency prices are determined in foreign exchange markets and fluctuate according to net excess demand for foreign exchange. This system does not preclude countries from seeking to fix the parity of their currency against another currency, or a basket of currencies. Nor does it preclude the existence of a few pre-eminent or “global” currencies (mainly the dollar and, to a lesser extent, the euro, the pound sterling and the Swiss franc).

25 The

period between the two world wars was a transition period, during which the main countries tried to return to the gold standard, but were unsuccessful on a lasting basis.

32

1.3.2

1 Monetary Unions: Between International Trade and National Sovereignty

Multi-National Monetary Union as an International Monetary System

Let us summarize the previous developments regarding a multi-national monetary union: forming a multi-national monetary union rather than a multi-currency system based on exchange rates does not remove the obligation to balance its external accounts for each of the sovereign member countries, but changes the modes of adjustment; these are no longer based on exchange rates. With this difference— admittedly a major one—a multi-national monetary union is an international monetary system, since it faces the same challenge of regulating misalignments in the balance of payments of the member countries. It is therefore faced with the four tasks that an international monetary system must fulfil, as mentioned above. It is a special international monetary system because monetary unicity and the irreversible impossibility of changing parities—which have disappeared with the currencies of the member countries—drastically change the modus operandi within the union. Let us reason for simplifying on a monetary union gathering all the countries (N = J ). As this union has no outside, the deficits of some member countries are the counterpart of the surpluses of the other countries. In this union, there is a single, universally accepted means of settling international trade: a fiat money, managed by the banking system and controlled by a single central bank that applies a monetary policy covering the entire union. Without a plurality of currencies and therefore without a foreign exchange market, exchange risk is eliminated and it is no longer necessary to “defend” any parity. However, sovereign countries must always ensure the balance of their current accounts. The consequences of monetary union in terms of adjustment of the external balance are as follows: 1. The elimination of exchange rate risk between member countries allows for greater financial integration between them, thus facilitating and potentially increasing cross-border financial flows. This implies that, other things being equal, countries (considered as a whole, i.e. by aggregating private and public agents) are able to borrow more easily. Alternatively, larger current account deficits can be expected. Moreover, a monetary union leads to greater productive specialization of the various countries, and hence exposure to more idiosyncratic or even less correlated shocks. This too tends to increase external imbalances. Finally, if the member countries are at different levels of development and monetary union makes it easier for “poor,” “lagging” countries to grow by importing productive capital, it also contributes to the indebtedness of these countries towards “rich” countries: financial integration facilitates cross-border

1.3 The Rules of the Game of a Monetary Union

33

investment flows to lagging countries, where (potential) productivity gains are high.26 2. Unlike fixed exchange rate systems and the gold standard system, a monetary union does not create a problem of insufficient liquidity or asymmetry in the production of the multi-national liquidity available to member countries.27 The central bank in fact has an unlimited issuing capacity for the single, dematerialized liquidity used in the union. 3. The strategic asymmetry between surplus and deficit countries, a major problem in a fixed exchange rate system, does not disappear in a monetary union even if it does not involve the defence of fixed parities. Indeed, surplus countries may find advantages, from a neo-mercantilist perspective, in maintaining their capacity to generate surpluses insofar as export activity supports aggregate employment and avoids the social and political problems that (often) result from a rise in nonemployment. Deficit countries, on the other hand, are constrained by financial markets and face rising lending rates with their external debt. In order not to jeopardize their financial position, they are led to restrict their aggregate activity so as to reduce their imports if they are unable to redirect their productive apparatus towards exports in the short term. 4. In a monetary union, the adjustment mechanisms put in place in a country to restore its external accounts are more difficult to mobilize. Indeed, the “rest of the world” and in particular creditors can no longer carry out a targeted attack on the deficit country to force it to take the decision to devalue or change its economic policy regime: there is no longer an exchange rate and monetary policy is no longer constrained by it. Symmetrically, that country cannot rely on a change in the exchange rate to restore its competitiveness, as we saw in the previous section. Nor can it freely use provisions for controlling financial flows or “financial repression”: these provisions are the responsibility of the union as a whole or are governed by the rules of the monetary union. It is through the mechanisms of price formation and productive specialization in favour of tradable products that this adjustment must take place. These mechanisms are decentralized in nature, less dependent on the government than the definition of a parity or financial repression procedures. To sum up, monetary union potentially tends to increase the external current account deficits of the member countries, whereas the adjustment mechanisms seem much less effective and quick to apply and, above all, less easily controlled by the public authorities. A sovereign country with its own currency can intervene on the parity of this currency, either by devaluing in a fixed exchange rate regime, or

26 As

Ingram [16] pointed out, current indebtedness in a monetary union, as in any other system, is not a problem as long as it is the counterpart of greater productive efficiency or is framed by unfailing financial discipline where debt repayment is not questionable. 27 This problem, known as “Triffin’s dilemma” after the Belgian economist who highlighted it in the international system that emerged from Bretton Woods, has been eliminated (Triffin [32]).

34

1 Monetary Unions: Between International Trade and National Sovereignty

by supporting or depreciating this parity through interventions on the markets in a flexible exchange rate regime. This is no longer possible in a monetary union. And a State’s ability to intervene on prices and wages in a decentralized economy is limited. It is enlightening at this stage to draw a parallel between a monetary union and the gold standard. The way the latter system works is an illuminating historical precedent for understanding what is at stake in a monetary union.28 The gold standard system became widespread in the world economy from the second half of the nineteenth century and disintegrated in the 1930s with the Great Depression. The major question facing economists is to understand why it worked well until the First World War and not after, despite attempts to return to this system after the end of the war. Polanyi [24] provided an answer to this question in his major book on the transformations of capitalism. In the gold standard system, a country’s current account deficit implies a fall in the gold reserve held by its central bank, thus a risk that it will no longer be able to convert its currency into gold or that it will be excluded from the international system. Restoring the desired level of the gold stock implies that the country regains a surplus position in its foreign trade, thus restoring its export capacity and competitiveness. This is done by tightening monetary policy, raising interest rates and seeking to lower the prices of tradable goods, or by lowering real wages and production costs.29 In other words, the gold standard works when internal objectives (inflation, unemployment, purchasing power, control of cyclical fluctuations) are subordinated to the objective of external equilibrium. Polanyi argues that such subordination was possible in the first period of the gold standard. Central banks were protected from political pressures and the political system itself made it difficult for social demands to be expressed. The right to vote and electoral participation of the working classes were limited, trade unions were non-existent or very weak, and social law was rudimentary and unprotective. The social and political configurations were favourable to the functioning of market mechanisms and to the flexibility of prices and real wages. Thus, the conditions were met for the gold standard to work. Things changed gradually, particularly because the return to peace after WWI made major social and political reforms necessary. The rise of socialist or labour parties, trade union recognition and concessions to workers meant that workers were able to resist foreign trade pressures and defend their purchasing power. Adjustment mechanisms gradually seized up, and the gold standard was gradually challenged until it was abandoned (Eichengreen, [6, 7]).

28 Under the gold standard, currencies are perfectly substitutable for each other via their convertibility to gold. It is therefore as if there were only one means of payment, as in monetary union. The major difference is that in a monetary union there are coordinating bodies, starting with a single central bank that pursues an active monetary policy. 29 In the days of the gold standard, there was no fiscal policy. The use of fiscal instruments for macroeconomic stabilization is an invention that dates back to the Keynesian revolution.

1.3 The Rules of the Game of a Monetary Union

35

This analysis is enlightening for understanding the rules of the game of a multinational monetary union. Such a union is confronted with the tension between the internal objectives of the member countries and the external objectives that require that their current accounts be balanced over the medium term. However, there may be a conflict between the two requirements, as was the case in the gold standard regime (Holmes [14]). The absorption of a country’s current account deficits requires a restoration of national competitiveness and a reorientation of production towards tradable goods. This may involve adjustments in production costs and, where appropriate, downward pressure on purchasing power for some or all social categories. The perspective opened by Polanyi, applied to a multi-national monetary union, leads us to the following proposition: a monetary union can only be assured of its durability if the social and political conditions, in each of the member countries and in the union as a whole, allow for the collective management of international current account imbalances. Following Polanyi’s reasoning, it can be argued that social conditions in the countries of a contemporary monetary union make it difficult to adjust remunerations—and in particular to reduce real wages in a given country or sector—which could rapidly ensure a return to balanced external accounts. It is essential to think simultaneously and jointly about the internal and external balances of the member countries of the union. Not thinking about these problems is perilous. In particular, neglecting a member country’s balance of payments problems may lead it to accumulate unsustainable debt that could trigger a major financial crisis within the monetary union, bringing a risk to the union itself. This is the major challenge of a monetary union. A monetary union entails much more than the unicity of the currency, the harmonization of payment conditions and the conduct of a single monetary policy. Because it radically transforms the processes of adjustment of payments and trade, the rules by which agents and States must conduct themselves are radically transformed compared with those prevailing in a State that has retained its monetary sovereignty. The rest of the book will explore these rules of the game, which can lead to a questioning of the foundations of the social pact. The case of the EMU, in view of the difficulties it has faced since 2008, is enlightening in this respect. Let us follow the analysis made by Giavazzi and Spaventa [13] in 2011. They begin by pointing out that: “The external payments situation of member countries has always been neglected, both in the academic and political debate on the design and implementation of the single currency project. It has found no place either in the convergence criteria of the Maastricht Treaty or in the European Commission’s assessment of the macroeconomic situations of the member countries. (...) Symptomatically, according to Article 143 of the Treaty on the Functioning of the European Union, only member States that have not adopted the euro may receive balance-of-payments financial assistance” (p. 4).

And Giavazzi and Spaventa conclude: “This reflects weaknesses in the way the EMU was designed” (p. 14). The aftermath, the sovereign debt crisis, confirmed this diagnosis. It forced the European Union to change its structures and institutions

36

1 Monetary Unions: Between International Trade and National Sovereignty

from 2012 onwards.30 Despite these initial reforms, it is clear that the process of rebuilding the EMU is not yet complete.

1.4

Conclusion

A monetary union is defined as the use of a common (and single) currency by a set of public jurisdictions, grouped in a federation, or by a set of sovereign states. In all cases, it implies the unification and homogenization of payment mechanisms within the union, as well as a common and unique monetary and exchange rate policy (with the rest of the world). For the (responsible) Member States, the exercise of their monetary sovereignties is radically transformed in the case of a multi-national monetary union. It is either shared or simply abandoned in the case of the choice of “dollarization”. The conditions of this sharing are the central object of the international treaty creating the union. The fact that a national economy belongs to a monetary union considerably modifies the modalities of its functioning and its regulation, in particular in the expression of the external constraint. For the agents residing in the union, they face both an extension and a homogenization of the markets in which they operate as producers or consumers. For countries taken as consolidated entities, the external constraint becomes more complicated. Moreover, the external constraint of the union as a whole must be taken into account since it is likely to affect the exchange rates of the union currency with other currencies and, in turn, to affect the external constraint of each country. The regulation of a national monetary union is facilitated by the political and legal unity of the nation: the social pact underlying the adjustment mechanisms is unique. The matter is more complicated for an multi-national monetary union, which must be analysed as an international monetary system in which the search for external equilibria within the union is essential to the viability of the union. In the end, it is clear that being part of a monetary union profoundly alters the operating and regulatory conditions of a member economy. This raises the question of why sovereign countries choose to establish or join a monetary union. It puts to the fore the assessment of its institutions, the economic policy arrangements and the functioning of a monetary union. We address this question in the next chapter.

References 1. Allen P (1976) Organization and administration of a Monetary Union. Princeton University Press, New York 2. Begg D, De Grauwe P, Giavazzi F, Uhlig H, Wyplosz C (1999) The ECB: Safe at any speed? CEPR Monitoring the ECB 1

30 These

changes involved a redefinition of fiscal rules and the implementation of multi-national agreements on the prudential regulation of banks operating in the Union.

References

37

3. Bergman M (1999) Do monetary unions make economic sense? Evidence from the Scandinavian Currency Union, 1873–1913. Scand J Econ 101:363–377 4. Bordo M, Jonung L (1999) The future of EMU: what does the history of monetary unions tell us? In: NBER Working Paper w7365 5. Chown J (2003) A history of monetary unions. Routledge, London 6. Eichengreen B (1992) Golden fetters. Oxford University Press, New York 7. Eichengreen B (2019) Globalizing capital: a history of the international monetary system. Princeton University Press, New York 8. Eichengreen B, Wyplosz C (1998) The Stability Pact: more than a minor nuisance? Econ Policy 13:66–113 9. Flandreau M (1993) On the inflationary bias of common currencies: The Latin Union puzzle. Eur Econ Rev 37:501–506 10. Flandreau M (2000) The economics and politics of monetary unions: a reassessment of the Latin Monetary Union, 1865-71. Financ Hist Rev 7:25–44 11. Flandreau M (2006) The logic of compromise: monetary bargaining in Austria-Hungary, 18671913. Eur Rev Econ Hist 10:3–33 12. Friedman M, Schwartz (1963) A monetary history of the United States, 1867–1960. University of Chicago Press, Chicago 13. Giavazzi F, Spaventa L (2011) Why the current account matters in a monetary union: lessons from the financial crisis in the euro area. In: Beblavý M, Cobham D, Ódor L, (eds) The Euro area and the financial crisis. Oxford University Press, Oxford 14. Holmes Ch (2014) ‘Whatever it takes’: Polanyian perspectives on the eurozone crisis and the gold standard. Econ Soc 43:582–602 15. Holtferich C-L (1993) Did monetary unification precede or follow political unification of Germany in the 19th century? Eur Econ Rev 37:518–524 16. Ingram J (1973) The Case for European Monetary Integration. Princeton Essays in International Finance 98 17. James H (2012) Making the European Monetary Union. Belknap Press, Cambridge, MA 18. Kaplan J, Schleiminger G (1989) The European payments union: Financial diplomacy in the 1950s. Oxford University Press, Oxford 19. Kenen, P (1997) Preferences, domains, and sustainability. Am Econ Rev 87:211–213 20. Keynes J (1923) A tract on monetary reform. Macmillan, London 21. Marsh D (2012) The Euro. The battle of the new global currency. Yale University Press, New Haven, NJ 22. Mundell R (1961) A theory of optimal monetary areas. Amer Econ Rev 51:657–665 23. Nitzsch V (2006) How to Enter a Currency Union? Lessons from the Past. mimeo 24. Polanyi K (1944) The great transformation: Economic and political origins of our time. Rinehart, New York 25. Pomfret R (2005) Currency areas in theory and practice. Econ Rec 81:166–176 26. Rose A (2000) One money, one market: the effect of common currencies on trade. Econ Policy 15:8–45 27. Rueff J (1967) Balance of payments: proposals for the resolution of the most pressing world economic problem of our time. Macmillan, New York 28. Sarno L, Taylor M (2003) The economics of exchange rates. Cambridge University Press, Cambridge 29. Skidelsky R (2000) John Maynard Keynes, Fighting for Britain, 1937–1946. Macmillan, Londres 30. Steil B (2013) The battle of Bretton Woods. Princeton University Press, New York 31. Steil B, Hinds M (2009) Money, markets, and sovereignty. Yale University Press, New Haven, NJ 32. Triffin R (1961) Gold and the dollar crisis: the future of convertibility. Yale University Press, New Haven, NJ

2

Why a Monetary Union?

Abstract

This chapter focuses on the properties of a monetary union, the desirability of its membership both from the point of view of an economy considering entering a monetary union and from the point of view of its actual member countries (or regions). It explores the various theories offered by economists to answer these questions. Starting with a discussion of the optimal currency area theory developed by Mundell, it then addresses the issue of credibility of a monetary union. The extend of a monetary union, that is its membership, is discussed as well as the most significant changes induced by the creation of a monetary union.

The question of the desirability of a monetary union has become a very active area of academic research since the 1990s following the creation of the European Monetary Union. Similarly, there has been no shortage of opportunities for symposia, expert reports, and practical analyses by international financial and monetary institutions. This has led to a great deal of work that has significantly advanced the understanding of what a monetary union is and the problems it poses. However, this collective effort has been accompanied by some confusion and a proliferation of opposing views. In this chapter, we attempt to clarify the questions posed and the concepts used. Section 2.1 focuses on some methodological prerequisites necessary to analyse a monetary union. Section 2.2 is devoted to the optimal currency area theory developed by Mundell and its extensions. In particular it addresses the desirability of a monetary union from the point of view of credibility. Section 2.3 analyses the changes induced by a monetary union. Section 2.4 concludes.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_2

39

40

2 Why a Monetary Union?

2.1

Assessing a Monetary Union

2.1.1

Methodological Preliminaries

Assessing the merits of a monetary union means answering the following questions: What is the desirable extension of a monetary union? What is its scope? Which countries should be part of which monetary union? What benefits can they expect? What disadvantages should they have to bear? Some methodological preliminaries to moving forward are necessary: 1. This assessment is needed in the context of the alternative between monetary union and recourse to a plurality of currencies and exchange rate mechanisms. Systems based on the plurality of currencies have their own shortcomings. To summarize them briefly, flexible exchange rates have the disadvantage of extreme volatility, which makes it difficult to forecast and determine a macroeconomic strategy: this explains the “fear of floating” (Calvo and Reinhart [16]). Fixed exchange rates, on the other hand, open up the possibility of speculative crises, which may be self-fulfilling. The assessment consists in understanding the merits of a monetary union in relation to an alternative exchange rate regime that needs to be clarified. 2. The evaluation of a monetary union is broken down into two sets of questions. (a) The evaluation can be done for a constituted monetary union of a given size and composition. How does it work? What are the (relative) benefits to its members? What costs (including opportunity costs) do they bear? (b) The evaluation may focus on the relevance of its composition. The question arises as to the stability of its perimeter, i.e. its optimal size. When issues related to the sharing or not of monetary sovereignty are taken into account, the question becomes which countries derive what benefits from joining a union, and what benefits do other countries derive from a given country’s membership (or entry into the union). Are some member countries not better off leaving? Others to enter? 3. These two sets of questions differ in the perspective that they implicitly assign to the analyst. The first set requires an ex post retrospective judgement since it assumes a constituted union that needs to be understood. The second requires a prospective ex ante judgement: the union is not yet constituted or, in any case, stabilized, its perimeter may still vary according to the benefits and costs that can be expected from the decision of the countries that are considering joining it, and of the countries that are considering leaving it. Frankel and Rose [29] were the first to argue that a union should be evaluated ex post. In their words, the “evaluation criteria are endogenous.” The expression is awkward: criteria are necessarily given a priori to carry out an evaluation exercise and cannot be endogenous. What Frankel and Rose meant was that monetary unification

2.1 Assessing a Monetary Union

41

changes the behaviour of agents and the mechanisms at play are “endogenous” to unification. Under these conditions, the indicators chosen as a basis for assessing a monetary union, such as the scale of international trade or the degree of synchronization of the economic cycles followed by the various countries, must be assessed on the basis of the functioning of the union and not on the basis of what the countries experienced before joining the union. In the same vein, Krugman [39] pointed out that the productive structures of the member countries were logically modified by membership of the union. 4. This brings us to the question of the criteria on which to base an assessment, ex ante or ex post. We can assess the properties of a monetary union, in other words, adopt a positive approach. Alternatively, we can assess the welfare that a union brings to its members, in other words adopt a normative approach. As we can see, the evaluation of a monetary union does not lend itself to oversimplification.

2.1.2

The Theory of Optimal Currency Areas

The question of the perimeter of a monetary zone was given priority in the context of the reflections on the properties of exchange rate regimes that accompanied (quite naturally) the slow exit from the gold standard during the twentieth century. When questions of monetary union arose at the end of the previous century in the context of European economic integration, economists favoured this approach to the organization of international trade. The question of the sharing of sovereignty and the conditions for its exercise, without being neglected, received less attention than would certainly have been desirable. Indeed, the first attempts to assess monetary unions were based on Mundell’s “optimal currency area” theory in the 1961 article mentioned above [46]. Let us stress at the outset the remarkable nature of this contribution and its ability to avoid the methodological difficulties we have just raised. Mundell’s criterion for judging the optimality of a currency area is the (general) equilibrium of markets, which is the simplest and easiest criterion to use and defend. If it is possible to define what makes a currency area optimal, there is no need to compare it with any other option. If optimal, the analysed area is considered to be the best arrangement, preferable to any other configuration. The comparison is simplified. In particular, the optimal size of a currency zone means that each participant is satisfied with the zone and does not wish to see it change. The question of the stability of the union is settled ipso facto. Finally, Mundell’s (short) article is more a general and abstract methodological reflection than an accurate analysis based on a formally developed model.

42

2 Why a Monetary Union?

It is through an unfortunate confusion that this article on currency zones has been seen as answering the question of what constitutes an optimal monetary union. This is clearly stated by Kenen [38] (p. 211): “It should be (...) clear that the theory of optimal currency areas cannot be used to compare currency areas and monetary unions. It is concerned with the choice between floating and fixed exchange rates, not between narrowly-pegged rates and a common currency.”

Kenen goes on to say: “Rarely so many good papers have been written about the wrong question.” When Mundell published his article, the Bretton Woods system had just been definitively established and the period of reconstruction of European economies was coming to an end.1 At the same time, macroeconomic analysis, which was dominated by Keynesian theory, was turning its attention to the issue of the openness of economies. It was therefore appropriate to try to understand the conditions under which it is possible to function efficiently or at least properly without the instrument of exchange rate flexibility, i.e. the variation in the conditions for converting the means of payment used by agents, without this undermining the functioning of an economy subject to fixed exchange rates. This is the question that interests Mundell. Limiting his reasoning to the monetary sphere alone, he completely disregards issues of sovereignty and does not reason on the disappearance of currencies but on their insertion in a fixed exchange rate system. Mundell’s thinking on the fixed exchange rate system led two years later to the more elaborate theory known as the “Mundell-Fleming model”, the cornerstone of open macroeconomics. For Kenen, a monetary union should not be confused with a fixed exchange rate zone, which is what Mundell is interested in. The reason is that the realignments of parity, which are always possible in a flexible exchange rate zone, show that the States have not abandoned their monetary sovereignty but have decided to subject it to an international commitment on their exchange rate policy, contrary to what happens in a monetary union. However, in spite of its focus on exchange rates, its use as a basis for thinking about monetary unions was as much due to the quality and coherence of Mundell’s reasoning as to the opportunity to have a theoretical framework for understanding European unification when, relaunched with the Delors Report [57], it reached the stage of implementation. In any event, this contribution has played such an important role in the debate on the concept of monetary union that it is necessary to go into more detail. Let us consider the case of two “regions,” i.e. two sets of agents. Each region is likely to have its own currency, and trade between regions is done through a conversion of currencies in the foreign exchange market. But another arrangement would be for exchange rates to be fixed. What is lost by moving to fixed exchange rates? Let us disregard issues of sovereignty. And formally, we refer indifferently to 1

On the origin of the theory of optimal currency areas, see Cesarano [19]. On its evolution, see Mongelli [45] and Masini [41]. The latter two works emphasize the interaction between theoretical thinking on the concept of the optimal currency area and the European monetary construction. On this point, see also de Grauwe [25].

2.1 Assessing a Monetary Union

43

a monetary union or a currency area despite Kenen’s warnings, without any further precision. The (weakly defined) “optimality” referred to by Mundell is a macroeconomic optimality: a configuration in which the “currency area” has low inflation, full employment, and balanced trade with the rest of the world (zero current account balance). We saw in the previous chapter that, under ideal conditions, exchange rates ensure market equilibrium and therefore the optimum, while respecting the autonomy of monetary policies: the exchange rate ensures monetary isolation without sacrificing economic efficiency. The disappearance of the exchange rate mechanism in the currency area represents a deterioration in the operating capacity of the whole: such a disappearance represents a “cost” for the acceding countries. A currency area, because it removes degrees of freedom, is potentially costly because it offers less capacity to respond to shocks. What interests Mundell is whether this disadvantage can be reversed. That is, whether it is possible to achieve the same macroeconomic efficiency as with a flexible exchange rate when the two regions form the same currency zone and render the foreign exchange market inoperative. If this is the case, the meeting of the two regions will form an “optimal currency area” since the removal of the flexibility of the exchange rate mechanism does not deteriorate the quality of trade and thus the overall efficiency. Mundell’s answer to this question is very simple and makes perfect sense, without using a significant formal apparatus. His reasoning is progressive. The first question to be asked concerns the characteristics of shocks. If shocks are global,2 in the absence of exchange rate adjustment, they will not cause relative disturbances, the optimal relative price structure will remain unchanged, and the absence of exchange rate adjustment will be inconsequential, since the exchange rate has the very purpose of modifying the terms of trade or relative prices between regions. The interesting case is one where the shocks are asymmetric.3 In the absence of flexible exchange rates, is it possible that the situation is as good as it would be if exchange rates allowed trade adjustment? The answer commonly derived from Mundell’s reasoning is positive. If prices, including factor prices, are perfectly flexible, markets are balanced and functioning optimally. So there is no cost to do without flexible exchange rates. Mundell explicitly envisages that this price flexibility can be linked to countercyclical monetary policies in both regions. The important point of Mundell’s analysis is to insist on the need for an adjustment of relative wages, and hence, real wages, between the two regions in order to restore their relative competitiveness. If region A is penalized by the asymmetric shock while region B benefits relatively, 2

...and the two regions respond identically. Mundell omits to ask the question of the channels of transmission of shocks in the two economies. This is because his article is a very short note that focuses on the essentials. Moreover, at the time Mundell wrote, macroeconomics had not yet begun to make the transition to dynamic analysis and attention to the lagged effects of shocks was not yet a central tenet for macroeconomic reasoning. 3 By this expression, we must understand a differentiated impact of the shocks on the two regions that makes it necessary to adjust relative prices.

44

2 Why a Monetary Union?

A’s current account will deteriorate, reflecting a loss of competitiveness for that region. The relative competitiveness of the region can be restored, and the current account returns to equilibrium if the production cost of goods produced in the region falls. This will be the case, the mark-up rate being assumed to remain constant, if wages in the region fall relative to what is happening in the other region. Let us now assume that this is not the case. There is another way to adjust. Balance can be restored within the currency area if production factors are mobile within the area, or between sectors. What is at stake is the mobility of workers (capital is mobile, or at least mobile enough to move to the most competitive region). The reduced competitiveness of region A, which is implicitly due to the lack of wage flexibility, will cause companies to make people redundant and unemployment in A will increase while the opposite will happen in B, where companies will seek to hire. If workers from region A migrate to B, unemployment will fall in A, while its overall competitiveness is restored by the disappearance of the least competitive firms. In the end, the current accounts return to equilibrium despite the lack of exchange rate flexibility. Mundell’s conclusion is that a currency area is optimal, in the sense that it reproduces the configuration of flexible exchange rates, when it covers a group of agents affected in the same way by exogenous shocks or endowed with a strong adjustment capacity, by prices or by quantities (the mobility of internal factors). Mundell’s reasoning has the advantage of simplicity, which allows him to focus on shocks and adjustments. The framework and the mode of analysis thus put in place are sufficiently general to allow discussions around the notion of monetary union. This explains the posterity of Mundell’s article. The implicit consequence of Mundell’s reasoning is clearly against the creation of too large currency areas and the fragility of a fixed exchange rate system. Indeed, an increase in size generates an increase in the sources of heterogeneity, in terms of shocks, structures or rigidities in international adjustments. Mundell’s article was thus as much appreciated by the Keynesians of the 1960s, since it was in line with the Mundell–Fleming model of Keynesianism at the time, as it was by the monetarists who advocated monetary independence and exchange rate flexibility (McKinnon [44], p. 693).

2.1.3

Subsequent Contributions

Mundell in his 1961 article reflected on the criteria on the basis of which to assess the desirability of a currency area, but without dwelling too much on the structural conditions of the economies to which to apply them. Further research on optimal currency areas has in fact focused on this question. Are labour markets flexible enough? What are the conditions for macroeconomic policies to assume their share of macroeconomic adjustment within the zone? Are shocks asymmetric?

2.1 Assessing a Monetary Union

45

Mundell’s reflection was first discussed and amended to take into account a more complex economic reality, and then almost forgotten. Niehans [48] (p. 294) can write: “Optimal currency areas are always a concept in search of a theory.”4 It is in the process of reflection on the single European currency that it regained the interest of researchers. However, it is an incomplete theory for several reasons: – First, it neglects the financial dimension linked to the coexistence of currencies. Currencies are not just means of payment and exchange rates are not there just to ensure the equilibrium of trade in goods and services, or to restore the relative competitiveness of differentiated economic areas. They also record financial flows and are supposed to eventually allow external positions to be balanced. Monetary unification cannot therefore be assessed by analysing trade flows alone. – Second, the question of productive diversification within a monetary area is central because it can give rise to divergent expectations about external openness and thus to conflicts of interest developing within a member economy. – Lastly, since it is only interested in the conditions that cancel out the costs associated with the absence of an exchange rate, it tells us nothing about the effective functioning of a monetary area, and in particular about the conduct of monetary policy in an economy that is heterogeneous in terms of exposure to shocks and the transmission mechanisms of these shocks.

2.1.3.1 The Issue of Finance A few years after his first contribution, Mundell [47] developed a new argument in favour of currency areas: the extension of a currency area makes it possible to enlarge financial markets. Said differently, economies of scale in financial matters make it possible to better protect risks. Moreover, thanks to lower costs, the currency area allows for better financial diversification through the creation of new financial products.5 Here again, Mundell’s intuition was full of promise. But his reasoning is elliptical or, to put it bluntly, rapid. Mundell implicitly assumes that the monetary unification of an economic area leads to its financial integration, from which the benefits he mentions derive. However, there is no guarantee that this integration will take place or, if it does, that it will not also generate costs such that it cannot be taken for granted that it is desirable. The concept itself is unclear. In the context of a monetary union, let us distinguish between regulatory financial integration and effective integration. Regulatory finan-

4

Quoted by Masini, art. cit., p. 1028. Mundell was thus led to join the group of economists in favour of European monetary integration. The question of Mundell’s “turnaround” is studied by McKinnon [44].

5

46

2 Why a Monetary Union?

cial integration refers to the institutional framework of the banking and financial sector and can be defined by three properties: 1. The rules and institutions governing financial products and services are identical throughout the union or, at the very least, harmonized.6 2. Identical economic agents (with the same economic and legal characteristics) have the same access to the same financial products and services wherever they are located in the union. 3. There is no discrimination on financial markets based on the origin and location of the economic agents involved. Effective financial integration depends on the structure of the banking and financial sector and concerns the effective functioning of financial markets in the union. 1. Transaction costs are the same for all agents, irrespective of their location in the union. 2. Financial information concerning products, services, and transactions is the same for all agents located in the union. 3. Arbitrage opportunities, given the structure of transaction costs, result in a single price throughout the union for identical financial products and services, regardless of the location of their issuers and buyers (Pagano [49], Baltzer et al. [7]). The two concepts of integration are linked: regulatory integration aims to make effective integration possible and is a necessary condition for it, since no significant financial activity is possible without a regulatory framework. This regulatory framework can be more or less developed and underpinned by very diverse, even opposing, principles. Let us make two additional remarks about regulatory financial integration. 1. It facilitates effective integration but does not guarantee it. Indeed, banks and financial intermediaries may not uniformly and equally cover the whole area of monetary union. Some regions may be less “banked” or “financialised” than others, due to their physical or economic characteristics.

6

The simplest case is full integration and therefore uniform regulation. But optimal harmonization does not necessarily mean identical regulatory frameworks. Canada is characterized by a very high degree of harmonization in the area of securities regulation, even though it falls under provincial jurisdiction (passport system) without uniformity. Differences at the margin may make it possible to better respond to local specificities. Moreover, by avoiding a concentration of regulatory power in a single place, it makes it more difficult for large financial firms with converging interests to “capture” the regulatory agencies. I would like to thank Alain Paquet for providing me with this example.

2.1 Assessing a Monetary Union

47

2. It is not synonymous with the absence of financial frictions. In particular, it does not ensure the disappearance of dysfunctions and financial crises in the union. This leads us to differentiate between forms of financial integration. Regulatory integration can be “complete” (leading to a complete homogenization or harmonization of the regulatory conditions for financing agents) or “incomplete.” Effective integration may be “perfect” (leading to the disappearance of rents linked to market segmentation) or “imperfect.” Let us assume that effective integration is perfect. What benefits or costs can be expected, still in the context of a monetary union? The benefits of financial integration are due to wider markets (economies of scale) and greater diversification of financial products and services (economies of scope). Enlargement makes markets “deeper” (there are more buyers and sellers), and therefore more liquid: agents can enter (buy) or exit (sell) markets without risking a sharp price change. Thanks to product diversification, agents can find products that are better suited to their specific needs. The beneficial consequences of this broadening and diversification are better risk sharing and better capital allocation. Individually and for a given risk aversion, the saver is more inclined to enter a financial market at a given interest rate. Conversely, a borrower needing to finance a risky project or in need of liquidity following a negative shock to its activity is able to find the necessary financing at a lower cost: he has been able to share the risk with a larger number of lenders at a lower cost (the aggregate loanable funds supply curve has flattened). Macroeconomically, this risk sharing is a good thing in a monetary union: it represents a market adjustment to the asymmetric shocks that hit the union. If a region (a country) or an economic sector in the union is hit by a negative shock, integration allows private savings from the rest of the union to be drawn on and mitigated, thereby reducing the need for government intervention. Conversely, in the event of a positive shock, the induced increase in savings can be channelled to other regions of the union, facilitating the lowering of interest rates borne by borrowers in those regions and promoting macroeconomic adjustment within the union. It should be noted that financial integration allows both a better sharing of intertemporal risk by agents and of macroeconomic risk. Financial integration also leads to a better allocation of capital within the union. All other things being equal, the enlargement of markets and financial product diversification mean that interest rates at any term are reduced: the cost of external financing of a capital-intensive project carried by an entrepreneur is reduced, which is favourable to capital formation. Moreover, the competition for investment projects throughout the union means that projects that are relatively more profitable, but which are not financed in the event of financial segmentation due to high interest rates, find their financing rather than others. This improves the allocation of capital.7

7

It is to these risk sharing and specialization mechanisms that Mundell refers in his 1973 article. But it is immediately obvious that this raises the question of structural adjustments within the union.

48

2 Why a Monetary Union?

The costs of financial integration are linked to the structure of the banking and financial sector, financial distortions and the contagion effects or mimetic behaviour of financial intermediaries. More specifically, these costs result from imperfections in financial market adjustments, from impediments to free competition that may exist in financial markets and from very specific informational problems that arise in these markets. Economies of scale and scope are deviations from the standard conditions of pure and perfect competition. They can lead to dominant positions acquired by a few financial intermediaries and to an oligopolistic market configuration. The concentration of financial flows in a few markets or productive sectors may provide oligopolistic rent to dominant financial intermediaries. Certain sectors or regions of the union may then be neglected. Macroeconomically, the counter-cyclical effects of financial flows between regions of the union can be questioned. Moreover, financial intermediaries and market participants do not make decisions solely on the basis of the fundamentals with which they are familiar. They cannot be assumed to have perfect information or a logic of autonomous and rational behaviour. They may misunderstand the real situation of the economy, react to intrinsically non-fundamental news, anticipating an upward trend and thus validating it, or they may behave in a herd and flock manner, merely reproducing aggregate behaviour. In the case of financial integration, bubbles or contagion can spread throughout the union without being constrained by segmentation barriers. Finally, financial markets imperfectly regulate financial behaviour. Financial intermediaries, and particularly banks, take advantage of the asymmetry in their balance sheets.8 In periods of high activity (cyclical or trend), they will tend to increase this asymmetry, either by borrowing short term (banks) or lending long term (intermediaries). In doing so, their exposure to the risk of reversal is increased. In the event of a turnaround in activity (cyclical downturn or lower growth trend), the willingness of intermediaries and banks to rapidly adjust their balance sheet structure will lead to a sudden and massive tightening of credit offers and, more generally, a sharp rise in interest rate spreads, due to the rise in risk premiums that are a component of this. Financial integration in a monetary union will have the effect of amplifying these emergency adjustment behaviours throughout the union, whereas financial segmentation on the contrary makes it possible to contain these cross-border effects between countries or regions. It is therefore impossible, in view of these potential benefits and costs, to share Mundell’s convictions on the merits of financial integration in a monetary union. But it should be noted that these benefits and costs are closely related to the financial and banking regulations in force in the union, i.e. the quality of regulatory integration. To assess the financial dimension of a monetary union, we need to look closely at the modalities of this integration and the questions it raises.

8

Balance sheet mismatch refers to the fact that the time profile of assets differs from that of liabilities. It is measured, for example, by comparing the average maturities of the assets shown on the assets side with those shown on the liabilities side.

2.1 Assessing a Monetary Union

49

2.1.3.2 The Issue of Openness and Diversification What productive structures are conducive to the construction of a currency area? McKinnon [43] extended Mundell’s thinking, in line with the same question about the macroeconomic optimality for a given country of the monetary union, and quite naturally—since, after all, Mundell’s thinking is about the type of exchange rate regime that regulates international trade—looked at trade openness. He argued that monetary unification for a country with its trading partners is all the more desirable—moving closer to Mundell’s macroeconomic optimality—when it is open in the following sense: a large part of its production is made up of exportable products and a large part of its consumption is made up of importable products. Indeed, in the event of an imbalance in the trade balance that needs to be corrected, the extent of the exchange rate adjustment necessary for domestic consumption to shift to non-tradable products and allow an increase in exports will be all the greater the smaller the share of non-tradables. This will result in a strong price adjustment or a high rate of inflation due to the consequent increase in the price of imports. In the case of wage indexation to inflation, it is doubtful whether the country will ultimately gain in competitiveness and restore its external balance. On the other hand, for countries open to international trade, fiscal instruments will see their action strengthened in the option of a single currency shared between trading countries, both to redirect demand and to control prices. If price control is one of the macroeconomic objectives of the union, two countries that are very open to each other must choose monetary unification because inflation control simplifies the calculation of relative prices and use fiscal policy for macroeconomic stabilization. One of the consequences of this reasoning is that the size of the currency area matters because it is known that the larger an economic area is, the less open it tends to be. Kenen [37] suggests that diversification of economies is a factor in favour of monetary unification. The reason is that diversification makes economies less exposed to aggregate shocks or more capable of coping with them through sectorally differentiated transmission channels. In other words, local shocks become more important and the economic and social costs of negative global shocks are lower because of differentiated responses. Labour mobility within the national (regional) economy between differentiated sectors is also an adjustment mechanism that reduces the usefulness of exchange rate adjustment. Dellas and Tavlas [26] point out that the argument can be reversed: countries with very low levels of diversification may not benefit much from exchange rate flexibility since it is a major source of macroeconomic variability. These contributions reveal an ambiguity in Mundell’s reasoning. As Kenen points out, Mundell implicitly equates region and productive sector or amalgamates the geographic and economic dimensions. Actually this is questionable, especially when the regions are large. When it comes to nations, apart from micro-nations, it must be admitted that their productive structures are differentiated. The distinction between global shocks and idiosyncratic, nation-specific shocks, is therefore too rudimentary.

50

2 Why a Monetary Union?

2.1.3.3 Fiscal Policies As early as 1969, Kenen [37] drew attention to the role of fiscal policies as a means of stabilizing a monetary union. For him, fiscal policy, through taxes and spending, must counterbalance the cyclical differences between the entities in a monetary union, as measured, for example, by unemployment rates or per capita income. The original point in this argument is that the objective is not a reduction in the gaps between individuals (between the unemployed and employed workers) as in the case of a simple economy, but the reduction of gaps between regions or countries.9 Fiscal policy is indeed an important modality of public intervention, particularly for macroeconomic stabilization purposes. It is therefore logical to think that the importance of fiscal policies is increased in a monetary union to the extent that monetary policies can no longer play a role. A division of roles is emerging: the monetary policy of the union must aim at stabilizing the union as a whole, while the fiscal policy of a member entity of the union must aim at stabilizing that entity. We shall see in Part Two that such a vision is too simple and far from sufficient to grasp the complexity of fiscal policies in a monetary union. All in all, the first attempts to evaluate monetary unification, envisaged in relation to exchange rate flexibility, appear to be methodologically interesting because they put forward a rich and useful conceptual framework, even though it is not fully satisfactory. For two reasons, on the one hand, these reflections did not sufficiently distantiate from the discussion on the relative merits of exchange rate regimes and, in particular, did not focus on the issue of sovereignty. The distinction between a currency area and a monetary union has only gradually become established. On the other hand, they have not been sufficiently supported by a formal apparatus in which the channels for the transmission of shocks and policy impulses are clearly identified and discussed. This has led to ambiguous and partly contradictory results. Neither the merit of the pioneers nor the need to pursue research along other paths can be denied.

2.1.4

Monetary Union, Expectations, and Credibility

The process of creating a monetary union in Europe, which began in the late 1980s, has renewed the interest of researchers in monetary unions. A large body of applied research has examined whether the euro area is an optimal currency area in the sense of Mundell [12]. Simultaneously, theoretical reflections have been pursued, based on developments in macroeconomic analysis since the 1970s, particularly on the role of agents’ expectations and the design of economic policy. Since the article by Kydland and Prescott [40], economic policy analysis has been dominated by the debate between

9

“It is a chief function of fiscal policy, using both sides of the budget, to offset or compensate for regional differences, whether in earned income or in unemployment rates. The large-scale transfer payments built into fiscal systems are interregional, not just interpersonal.” (p. 47).

2.1 Assessing a Monetary Union

51

credibility and flexibility or between rule and discretion. Once it is accepted that agents’ expectations strongly condition their behaviour, the impact of economic policy via expectations becomes a central issue. If the economic policy-maker is able to announce what his decision will be in a credible manner, i.e. by means of a pre-commitment technology that prevents him from deviating, agents will base their expectations on that announcement (on that decision). The solution will then be said to be the “rule-based” solution. Otherwise, since the decision-maker does not bind his hands, agents must calculate what his optimal decision is, knowing that it is based on their own expectations. The solution to this problem is defined as the “discretionary” solution. Barro and Gordon [8] formally study the two options in a very simple variant of the New Classical model and show the macroeconomic superiority of credibility over discretion to the extent that discretion leads to an “inflation bias”, i.e. a higher rate of inflation than under the rule, regardless of the impact of shocks. Discussions then focused on the question of whether policy-makers are able to implement a precommitment technology, and if so, which one. A particularly important contribution in this literature was Rogoff’s paper [50], which shows how, in the absence of a precommitment on the monetary decision, delegating it to an “independent” central banker (chosen by the policy-maker but able to make a discretionary decision based on personal preferences) reduces the inflation bias. The interest of the article is to show formally how institutional arrangements are of major importance for monetary policy, and for economic policy in general. The debate between credibility and flexibility can shed light on the question of monetary unification. The choice by a country to join a multi-national monetary union, implying the renunciation of monetary sovereignty and its delegation to a supra-national monetary authority, can be likened to a pre-commitment technology. It has the disadvantage of renouncing to the national monetary instrument and, as such, some form of flexibility. But the credibility associated with monetary unification may have advantages that more than compensate for these disadvantages. Let two countries A and B. Country A is characterized by a high credibility of its monetary policy when it benefits from its own currency, or a low inflationary bias, while country B has low credibility, thus producing a high inflationary bias. Apart from this difference in pre-commitment capacity, the two countries are identical in terms of their exposure to shocks and the transmission channels of monetary policy. If the two countries form a monetary union and are able to implement the precommitment technology of country A, the monetary union will be characterized by a low inflation bias, possibly equal to that of A when it exerts its monetary sovereignty. In the latter case, let us reason why this is the most favourable. Since nothing else is changed (i.e. by focusing only on the behaviour of inflation), country A loses nothing in the monetary union, while country B gains a reduction in the inflation bias: through the monetary union with A, it has “imported” its credibility. Implicitly, this country is unable to change its own institutions or the pre-commitment technology at its disposal by itself, for reasons of opposition from its population or for an unspecified political difficulty. Forming a monetary union

52

2 Why a Monetary Union?

with country A gives it the capacity to overcome these difficulties and achieve a low inflation regime. In other words, countries with high average inflation have an interest in monetary unification with countries with low inflation if the monetary policy of the union is organized according to the arrangements put in place in the latter. It remains to be understood in this intellectual construction why it is easier to have a change of institution accepted indirectly through monetary union than directly. Or why interest groups or the political coalition that defends a weak pre-commitment capacity of sovereign institutions do not oppose monetary unification. Reciprocally, we need to understand what low inflation countries gain from joining high inflation countries in a common monetary union. As Dellas and Tavlas [26] note, in this analysis, the loss of monetary sovereignty is now considered a benefit (for the credibility importing country), whereas in the previous, “mundellian” approach, it was considered a cost since it implied the abandonment of an economic policy instrument. In the credibility approach, the imposition of a constraint is a way of resisting the problem of temporal inconsistency uncovered by Kydland and Prescott. What distinguishes this “strategic” approach from the Mundellian approach is that the latter implicitly assumes that the conduct of monetary policy is unaffected by the move to monetary union, whereas the former bases its reasoning on the opposite assumption: monetary unification allows for a change in the mode of monetary policy, and this change represents its main advantage. In the strategic approach, it is not a question of knowing what are the structural (and real) conditions that justify the use of the same monetary means of payment, but of understanding what is at stake in the transition from national monetary policies to a single supranational monetary policy. The question of monetary sovereignty is at the heart of the reflection: what is at stake is indeed a monetary union in the sense we gave to this term, and no longer a zone of monetary circulation. Giavazzi and Pagano [32], forerunners to this approach, had already addressed the issues of monetary unification (focusing at the time on the case of the European Monetary System, the EMS) in terms of credibility and showed that a country could reduce its inflationary bias by giving up its sovereignty and joining a monetary union (such as the EMS) characterized by high credibility (a low inflationary bias). Alesina and Barro [1] study two variants of a two-country model based on Barro and Gordon. In the first, the two countries are monetarily independent and each controls a monetary instrument. In the second, one country gives up its monetary sovereignty and anchors its currency to that of the other country. This abandonment is all the more interesting as the country is small, very open to the country it is anchoring to and has an economic cycle that is highly correlated with the latter’s cycle. Cooley and Quadrini [22] study the same problem but use a dynamic stochastic general equilibrium model (“DSGE model”) with flexible prices. The advantage of such a model is that it allows social welfare functions to be used as criteria for evaluating economic policies and, in this case, different institutional configurations. These functions, which have microeconomic foundations in the preferences of agents, appear to be more robust than the rather imprecise criteria used in the first generation of work.

2.1 Assessing a Monetary Union

53

However, the hypothesis of perfect price flexibility is unrealistic. Clerc et al. [21] pursued this path by using a variant of the “neo-Keynesian” model commonly used in macroeconomics to analyse economic policy issues, i.e. a model with nominal price rigidities adapted to the case of a monetary union. The question posed in this article is what does a given country gain by joining a monetary union in which the central bank is pre-committed and credible while, independently, it conducts discretionary policy in a world of flexible exchange rates. The presence of shocks means that discretionary policy, even if it leads to an inflation bias, is able to stabilize the economy. It may be thought that nominal rigidities make macroeconomic stabilization more difficult and that this is an argument against monetary union, since it makes it more desirable to mobilize a large number of instruments capable of managing as closely as possible the national peculiarities due to these rigidities, which have their source in the country. This is a renewed dilemma between credibility and flexibility. Entering monetary union implies gaining in credibility (the inflation bias decreases) but potentially losing in flexibility. The model used is based on the monetary union model developed by Gali and Monacelli [30]. This model provides an objective function for the conduct of monetary policy and a social welfare criterion with a coherent microeconomic foundation. The result reached by Clerc et al. is that, even if the reduction in the inflation bias is small (and hence the gain in credibility low), the transition to monetary union is beneficial if the various shocks are sufficiently correlated or, if that is not the case, if the labour cost shocks are relatively strong. Chari et al. [20] add significantly to the credibility approach. Following the same model logic as Dellas et al., they too address simultaneously the interaction between credibility and the nature of the shocks. They study a multi-country economy under two configurations: the flexible exchange rate regime and the monetary union. To eliminate one source of difference, they assume that central banks cooperate under a flexible exchange rate regime. The differences obtained for the two configurations cannot be due to cooperation or non-cooperation. In concrete terms, therefore, in both configurations, central banks respond to the sum of the shocks to which they can respond. The main point of their analysis is to assume that economies are affected by two types of shocks. The first ones are shocks the impact of which on the economy does not depend on the credibility of monetary policy, unlike the second ones that create an incentive for the monetary authorities to be inconsistent over time, or tempted to deviate from an announced decision. For example, the shock studied in Barro and Gordon’s model, on the output gap, creates the temptation for the central bank in the discretionary configuration to deviate from an announced measure in order to surprise agents’ expectations. On the other hand, a shock to the level of the natural product cannot create such a temptation if it is assumed that the central bank seeks to reduce the output gap and not to act on the natural level. Chari et al. call the former “Mundellian shocks” because they are the ones Mundell had in mind, and the latter “temptation shocks” because they are the ones that create the temptation for the central bank to play surprise and deviate from an announced measure.

54

2 Why a Monetary Union?

To simplify, suppose that the distribution laws of Mundellian shocks are the same in both countries (same expectation and variance), as well as the laws of temptation shocks. Domestic Mundellian shocks can be correlated, as can domestic temptation shocks. Mundellian shocks are by construction independent of temptation shocks. The covariances between national shocks are important for the analysis. Note CovMun and CovT ent these two covariances, respectively. Let us reason in the case where a central bank follows a discretionary policy, whether national or union policy. It can respond to both types of shocks. To simplify the reasoning, let us assume that a central bank responds after observing Mundellian and temptation shocks (to which it can therefore respond). Let us compare the two monetary configurations in this case. In the case of flexible exchange rates, the lower the sum of the temptation shocks, or the lower the covariance of the temptation shocks, the less temptation there is for (cooperating) central banks to respond. The less tempted they are to act, the lower the inflationary bias. But, with two instruments at their disposal, they can respond effectively to the heterogeneity of Mundellian shocks. In the monetary union configuration, the central bank has only one instrument. It responds ineffectively to temptation shocks, and therefore the higher the sum of these shocks, the more favourable this option is, because the inflation bias is smaller than in the case of flexible exchange rates. On the other hand, the disadvantage of having only one instrument to respond to Mundellian shocks is all the smaller the higher is their covariance. Now suppose that a central bank follows a rule-based policy. It can respond to Mundellian shocks on the basis of available information but by construction, it does not react to temptation shocks. Let us assume that a central bank reacts after observing Mundellian shocks but before observing temptation shocks. In both monetary configurations, the correlation between the temptation does not matter: neither the national banks nor the union bank can respond to them. This is in line with Mundell’s reasoning. The flexible exchange rate regime is preferable to the monetary union because it has more capacity (i.e. more instruments) to respond to Mundellian shocks. The monetary union can be justified (assuming that it has other advantages not described by the model) only if the correlation of these shocks is high. In the end, the comparative advantages of a monetary union and fixed exchange rates are not the same in a rule-based and discretionary situation. They depend differentially on the correlations between shocks. Table 2.1 summarizes the above reasoning. Table 2.1 Impact of shocks

With commitment High CovMun CovT ent indifferent Flexible Changes Low CovMun CovT ent indifferent Monetary Union

Without commitment Low CovMun High CovT ent High CovMun Low CovT ent

2.2 The Membership of a Monetary Union

55

The time inconsistency approach to the assessment of a monetary union, exemplified by these contributions, has the advantage of placing the question of the institutional arrangements of a monetary union at the centre of the analysis and of showing its importance. It focuses on the conduct of economic policies and provides an opportunity to reflect on the sovereignty issue raised by monetary unification through the dilemma between credibility and flexibility. But the models used are very rudimentary. Too much is left out of the analytical framework, starting with what was the central focus of the first generation, the question of international trade and external equilibrium. More generally, the microeconomic dimension of the analysis is omitted. Exposure to shocks and the channels of transmission of economic policies depend on the microeconomic arrangements of agents, be it the mobility of factors or their ability to insure against different risks. Similarly, these models are too rudimentary to address financial issues. Lastly, distributional considerations are by construction absent from macroeconomic models that assume the existence of identical individuals.10

2.2

The Membership of a Monetary Union

There are at least two points of view for analysing the membership of a monetary union. 1. It may be as given. A monetary union is evaluated given its scope and composition. 2. It can be assessed when the scope and composition of a monetary union vary. For example, from the point of view of a country assessing the interest of entering or leaving a monetary union (existing or potential). Mundell’s masterstroke is to have linked the two problems by formulating the question in terms of the optimality of a currency area. Since he does not use a formal analysis, it is impossible to understand precisely what is meant by the optimum.11 Let us leave this difficulty aside. If membership of a monetary union is optimal for each of the countries concerned, this gives the answer to the two questions posed: the country has an interest in entering and the composition and perimeter of the monetary zone are optimal. Discussions based on Mundell’s contribution sought to

10 Groll

and Monacelli [34] also focus on the time inconsistency issue in a monetary union in a New Keynesian framework of a two-country economy where the dynamics of terms of trade is explicitly obtained in the presence of nominal rigidity. They prove whereas under monetary policy commitment a flexible exchange rate regime dominates a monetary union (a fixed exchange rate regime), this is not necessarily true when monetary policy is discretionary. This is because under discretion, the inertia of terms of trade acts as a surrogate to commitment and allows to anchor price expectations and thus control inflation. 11 As we have seen, the criteria of optimality that Mundell uses are linked to the internal and external equilibria of each country.

56

2 Why a Monetary Union?

understand both the merits of a monetary union and the benefits of entering it. When referring to Mundell’s views, particularly in the context of European monetary integration, analysists have sought arguments to judge the merits of a monetary union as well as to judge the opportunity for a non-member country to join.12 But we have to recognize that this normative assessment exercise of a monetary union is indeed impossible, as we saw in the previous section. Not only the factors to be taken into consideration are numerous and difficult to quantify but a monetary union depends on the institutions that structure it. These institutions are a priori indeterminate and marked by political and historical factors that make the economist’s normative analysis if not questionable, at least partial. Finally, monetary unification modifies economic behaviour and structures, leading to major redistributive effects between and within member countries that render the usual criteria of optimism of economists inoperative. More important than the optimality of a monetary union (or zone) is its stability in the sense of game theory. A monetary union is generically a “coalition,” a group of agents (here, sovereign states) pooling instruments and constraints and managing them according to a common interest. The stability of the composition of a coalition is the result of two sets of decisions: the first, for a given country, is to want to join it; the second, for the other countries in the coalition, is to accept the newcomer. A coalition is stable when each of its members is better off inside than outside and when its membership is accepted by all.13 Applying this stability-oriented reasoning to monetary union thus implies asking what motivates a country to want to join a coalition (existing or potential) and to accept its partners. The configuration and functioning of a monetary union depend on the answers to these two questions.

2.2.1

Why Joining a Monetary Union?

What are the reasons why a sovereign country wishes to join a multi-national monetary union or, which amounts to the same thing, why a region wishes to remain in the (possibly national) monetary union to which it belongs rather than secede (assuming that this choice is open to it)? Giving some elements of answer will be a way of taking up the achievements of the previous section. Answering this question

12 Perfectly

representative of this effort, the volume edited by Calmfors [15] sought to answer the question of whether it was in Sweden’s interest to join EMU in 1997. Similarly, the article by Clerc et al. [21] focuses on the desirability of joining an existing monetary union. 13 Various stability criteria are proposed and studied in the specialized literature. For an introduction to coalition theory and its use in economics, see Demange and Wooders [27].

2.2 The Membership of a Monetary Union

57

means weighing up the broad pros and cons of a given monetary union: 1. There are considerations related to trade between countries. The more two countries have actual or potential trade in goods and services, the more willing they are to share the same currency. More broadly, a country may wish to enter a monetary union in order to benefit from an international currency and save on transaction costs. The relative size of countries matters, but not exclusively: Switzerland, a small European country, did not join the euro zone. One of the reasons for this is that the Swiss franc is indeed a widely used international currency. 2. Microeconomically, membership of the monetary union can potentially change the productive structure of the candidate country. Changes in the structure of costs and competition, but also the differing management of shocks, labour mobility and the possible existence of economies of scale may in fact change a country’s productive specialization to a greater or lesser extent once it has joined the union. If the aggregate gains associated with this change outweigh the costs, particularly social costs associated with the decline in certain activities, this transformation is beneficial overall. The difficulty is that the costs of destruction usually occur before the gains of specialization. 3. Macroeconomically, the discussion is dominated by the question of shocks and risk sharing. It emerges from the elements of the previous section that it is difficult to know whether a country should wish to enter into monetary alliances with countries exposed to the same types of shocks or, on the contrary, prefer countries experiencing idiosyncratic shocks with little correlation with its own. Even more awkwardly, it is reasonable to think that membership of a monetary union changes the characteristics of the shocks to which a national economy is exposed. Finally, a monetary union may allow for better risk sharing if financial integration leads to economies of scale in the collection and management of savings within the union. But this cannot be regarded as guaranteed. 4. Financially, integration in a union implies a change in banking and financial structures, through the establishment of a single interbank payment system. It is therefore reasonable to believe that monetary union promotes financial integration in the sense we have defined it above. The conclusion of the previous section was that financial risks were modified but not eliminated by monetary unification. Again, it is difficult to decide a priori between the gains and drawbacks of entry. It should simply be noted that these gains and drawbacks are felt only very gradually and therefore refer to long-term considerations. 5. Institutionally, a country can hope to import credibility if the monetary union has stronger institutions than its own. Credibility gains are related to significant reduction in risk premiums and the reduced productive distortions generated by fragile institutions. The reduction in the inflation bias discussed in the previous section is one example of these gains. What is at stake, therefore, is the

58

2 Why a Monetary Union?

institutional quality of the monetary union.14 This desire to import credibility can go as far as accepting an asymmetric monetary union, as we saw when discussing dollarization. 6. The abandonment of monetary sovereignty or the loss of the monetary instrument is a cost, which is only partially compensated for by the fact that the entering country can weigh on this policy, depending on the degree of asymmetry of the union it wants to enter and the institutional arrangements regulating the monetary policy of the union. But the advantage of having control over an instrument could be more apparent than effective. In any case, it must be assessed in relation to the constraints that the country accepts or not in the international monetary system.

2.2.2

Why Accepting a New Entrant?

Let us now ask the reciprocal question: knowing that a country wants to enter a union, do its potential partners—which constitute the union in question—accept this request? To simplify the reasoning, let us consider this union as a whole, which must give a single answer to this question.15 The answer to this question depends on the benefits and costs to this union of the enlargement represented by the admission of the country in question. They are symmetrical to the benefits and costs for the potential entrant that we have just detailed. 1. In trade terms, the gains are the same for the countries of the union and for the entering country. The higher the trade flows with the entering country, the greater the gains for the receiving countries. 2. Microeconomically, depending on the size of the entering country and its productive structure, this entry may generate shifts in the productive specializations of the union. They will generate the benefits linked to a better allocation of factors and economies of scale, but also the costs linked to this reallocation of factors, particularly in terms of employment. 3. Macroeconomically, enlargement changes the structure of the shocks facing the union, in particular because it probably implies more heterogeneity in that structure. It is difficult to answer with certainty whether or not this makes the union stronger and less cyclical. It can be taken for granted that the transmission mechanisms of economic policy are changed. Similarly, enlargement may allow for a better sharing of risks for the host countries, subject to conducive financial integration.

14 We will see in subsequent chapters that the discussion goes beyond monetary institutions alone but highlights problems related to fiscal and financial institutions. 15 The simplest case is to assume a single country B to which country A asks to form a monetary union consisting of the two countries.

2.2 The Membership of a Monetary Union

59

4. Financially, enlargement is not unequivocally a good thing for the union: financial risks are always present and not necessarily diminished as a result of monetary unification. 5. Institutionally, enlargement is also ambiguous. It can take place with unchanged institutions of the union, or on the contrary, it can involve a transformation of those institutions. Even in the first case, enlargement may represent a cost for the union because it may imply a weakening of its capacity to withstand and manage shocks, and more broadly its credibility, as the institutions prove insufficient for the new union. In the event of institutional transformation, host countries will be careful that it does not lead to such a weakening. 6. Finally, the enlargement of the union may imply a dilution of the influence that the host countries have on its monetary policy, which may represent a cost, more or less important depending on the institutional arrangements in place and the weight they have on the conduct of monetary policy. By construction, the stakeholders—the incoming and host countries in the case of a multi-national monetary union—answer these questions autonomously and, most likely, uncooperatively. It is therefore less the optimality of a monetary union that needs to be studied than the decentralized balance resulting from these answers, or the stability of the union. In a second step, it is possible to move on to a normative assessment of the union thus formed.

2.2.3

The Special Case of Dollarization

So far, we have implicitly assumed that the partners in the monetary union are on an equal footing in the management of the monetary union and, in particular, of monetary policy. What about asymmetric monetary unions? Let us look at the extreme case of “dollarization”, or the complete renunciation of monetary sovereignty. We will use the terminology proposed by Alesina et al. [2] and refer to the “client country” as the country giving up sovereignty and the “anchor country” as the country whose currency is adopted. How can we justify a sovereign country adopting the status of “client”? First, there are objective considerations related to the structure of the dollarized economy. From a Mundellian perspective, giving up monetary sovereignty involves two types of costs. On the one hand, monetary policy does not respond to the specific needs of the client country, but only to those of the anchor country: idiosyncratic shocks to the client country are no longer managed by monetary policy. On the other hand, the client country loses its ability to manage severe crises, either by acting as a lender of last resort in the event of a banking crisis, or by providing assistance to the government (seigniorage revenue) in the event of a serious economic crisis whose treatment exceeds the government’s financial capacity. A dollarized country can be expected to experience high cyclical variability (the difficulty is that this variability has to be measured against what it would be if it were sovereign).

60

2 Why a Monetary Union?

But dollarization has advantages. First, it provides access to deeper financial markets. Second, it allows to benefit from the same level of protection with respect to the consequences of international crises as the anchor country (supposedly high: one anchors oneself to a powerful country). It also eliminates the quasifixed costs associated with the management of monetary sovereignty (approximated by the amount of reserves in the central bank’s balance sheet). There are also considerations related to temporal inconsistency and credibility. Dollarization, as a counterpart to the renunciation of sovereignty, allows the client country to import the credibility of the anchor country. The question is why a country might not be able to have strong credibility. Cooper and Kempf [23] have shown that this could be due to social “segmentation” or to economic and social conflicts specific to the client country, which the latter can only respond to through hyperinflation. Under these conditions, social division justifies dollarization as a way of resisting temptation and inflationary pressures. On the whole, it is logical to think that a small country whose economy is highly integrated with (or even dependent on) the economy of a large country (for example for reasons of neighbourhood) adopts its currency. Small size means that the fixed and transaction costs involved in monetary sovereignty are relatively high, while strong integration means that the shocks experienced by the two countries are relatively similar. Similarly, countries with a history of high average and volatile inflation, and possibly episodes of hyperinflation, are inclined to give up their monetary sovereignty. For the anchor country, the adoption of its currency by other countries has almost only advantages. There are no added constraints, while the area in which the currency is used is widening. This increases its seigniorage income, widens the financial markets denominated in this currency, and thus increases the power of its banking and financial sector.

2.3

Changes Induced by a Monetary Union

The previous analyses do not provide the formal tools and models useful or necessary to assess the transition to a monetary union. Let us simply investigate what monetary union changes, without wanting to weigh its benefits and costs, and assess the net merits of monetary unification. Comparative empirical studies would be desirable for this exercise. But these are few in number for obvious reasons: monetary unions are heterogeneous, sometimes distant in time, and data on historical processes of monetary unification are insufficient. Numerous studies have been devoted to the effects of the euro on the economies of member countries. But the euro area economy is still undergoing significant adjustments and the institutional arrangements of the euro area are bound to change. The results of these interesting studies should therefore be taken with caution: the

2.3 Changes Induced by a Monetary Union

61

changes due to European unification are far from being fully felt.16 In any case, this is the most recent and best documented of the monetary unification processes and we will refer to it.

2.3.1

Microeconomic Effects

Krugman [39] pointed out that most of the literature on optimal currency areas has focused on macroeconomic issues, particularly adjustment mechanisms, while microeconomic effects have tended to be minimized or ignored. However, the reduction in transaction costs and the economies of scale and scope made possible by monetary unification can induce changes in the behaviour of private and public agents. In other words, unification implies that economic agents—including States—face a different system of incentives and prices.

2.3.1.1 International Trade The effect of monetary unification in Europe on international trade has been the subject of numerous studies. Rose [51] published an article on the subject with surprising ... and fragile results. Based on a database of nearly 200 countries and territories, he introduced a dummy variable when two countries share a common currency into an equation that is commonly used to study the volume of international trade between two countries.17 In his paper, Rose argued that trade between two countries in a currency union is three times higher than trade between two countries using different currencies (all else being equal). Rose’s study has been the subject of considerable scientific controversy and many studies have been devoted to the subject, often with highly contrasting results, due as much to different databases as to different econometric methods or the correction of biases. However, Rose and Stanley [52], based on a meta-analysis of 34 studies on the subject, concluded that a monetary union between two countries leads to an increase in bilateral trade of between 30% and 90%. With respect to the euro, the current consensus is that the growth in trade due to the euro over the period 1999–2009 is between 5% and 20%. Studies on the effect of the euro on the “extensive margin”18 estimate this effect to be between 2% and 19%. The study by Fontagné et al. [28], based on microeconomic data (at the firm level), gives a much lower result, however. These studies are fragile insofar as the extensive margin may have increased as a result of monetary unification but before the creation of the euro, through an anticipation effect, as shown by Bergin and Lin [13]. Gil-Pareja et al. [33] studied the effects of monetary agreements between

16 See

Corsetti et al. [24] for an example of ongoing reflections on the eurozone. is called a “gravity equation.” 18 In international trade, the extensive margin is defined as the ratio between exports from country i to country j by products, weighted by the weights of these products in world exports, and total world exports to country j . In simpler terms, it is a measure of “export market share to country j .” 17 This

62

2 Why a Monetary Union?

OECD countries over the period 1950–2004, including in particular the creation of EMU. These agreements increased trade within participating countries as well as trade with other countries. But the euro has a separate effect, stronger than the other agreements. A recent study by Mayer et al. [42] revisited the “cost of non-Europe,” actually the trade-related gains obtained by EU countries since 1986. Admittedly, it is not strictly the date of the creation of the EMU but it gives us a useful benchmark estimation of the impact of economic integration in Europe, consistent with the previous results just mentioned. Using standard methods in empirical trade economics, they show that since 1986, trade between EU countries has on average doubled and is responsible for an increase of real GDP estimated to 4.4%. Given these results, the challenge is to understand how the removal of currency conversion costs, which are low in absolute terms and relative to production costs, can have significant effects on trade and the productive orientation of firms in member countries. Baldwin and Taglioni [5] and Baldwin et al. [6] have developed a theoretical model to justify the impact of monetary unification on trade between the countries involved. Their argumentation is based on models of international trade with monopolistic competition and the fact that monetary unification leads, even more than the reduction of transaction costs, to a reduction in exchange rate volatility and therefore in relative prices. Monopolistic competition is linked to the existence of fixed and unrecoverable costs of entry into external markets. These costs are relatively higher for small firms than for large ones. Moreover, the higher the volatility of a firm’s relative price, the more fragile it is because it is likely to lose market share, thereby jeopardizing its profitability. The critical size at which a firm can enter a foreign market (export) is all the higher the higher the volatility of exchange rates, at given fixed costs. Under these conditions, monetary unification, which cancels out exchange rate volatility and reduces the volatility of relative prices, has two consequences on trade. On the one hand, it reduces the critical size of entry into foreign markets: the number of exporting firms increases. On the other hand, as smaller firms are more exposed to price variability, small firms that are already exporting increase their exports proportionally more than large ones. These two factors lead to an increase in international trade. Underlying this is the fact that the volume of international trade is a decreasing and non-linear function of price volatility, fuelled in part by exchange rate volatility.

2.3.1.2 Productive Specialization The microeconomic impact of monetary unification is not limited to an increase in the volume of trade between the countries or regions concerned. It also concerns the productive structure itself. The reasoning of Baldwin and his co-authors can be extended using a simple analysis of international trade based on comparative advantage. The increase in trade due to unification is of the same nature as trade openness: it implies an increase in competition. Firms in member countries will respond by improving their productive efficiency, specializing more, or locating themselves according to the available factor endowments. A member country’s

2.3 Changes Induced by a Monetary Union

63

productive specialization will (tend to) increase so as to make the best use of factor endowments according to its comparative advantage. Economies of agglomeration can also be used to amplify the scale and scope effects associated with monetary unification. Krugman [39] concluded from such an analysis that increased productive differentiation within a monetary union was to be expected, contrary to the idea that there is convergence between the economies of the member countries and casting doubt on the reality of this convergence. This increased productive differentiation should lead to an increase in the asymmetry of shocks and in the transmission channels of economic policy impulses. Krugman took the example of the state of Massachusetts, which in the 1980s specialized in the advanced military and computer industries but experienced a sharp recession in the early 1990s with the end of the Cold War and the resulting slowdown in military orders. Its economy then successfully switched to the high tech and bio tech sectors. His prognosis at that time was that the EMU would be affected by growing international disparities and marked national crises. Developments in the EMU since 2008 have not proved him wrong. But there is no guarantee that the borders of specialization, even reconfigured under the impact of monetary unification, will coincide with the institutional borders of the member countries or regions of the union. Krugman reasons on Massachusetts and not California, a populated state that is much more differentiated than Massachusetts. Moreover, the intensification of trade is also a factor of increased interdependence that mitigates, or even reverses, the effects of differentiation.

2.3.2

Macroeconomic Effects

The macroeconomic effects—or rather the macroeconomic manifestations of the changes brought about by monetary unification—are also important to understand. Some of them, particularly the credibility effects, are difficult to measure.

2.3.2.1 Shocks, Cycles The impact of monetary unification on cycles can be broken down into two parts: 1. The first concerns the dynamic analysis, and in particular the cyclical properties, of the union’s economy taken as a whole. First, a macroeconomic diagnosis of the functioning of the union is necessary. Then, in a comparative perspective, it is necessary to know whether integration has made the consolidated economy of the member countries more or less stable, what is the nature of the shocks affecting it, what are the transmission mechanisms of these shocks and of the economic policy impulses. 2. The second part asks the same questions at the level of the member countries or regions of the union. One is naturally induced to address the question of the degree of synchrony or asynchrony between country (or regional) cycles. Studies on these questions do so with reference to the theory of optimal currency areas that suggests that the heterogeneity of shocks and transmission channels is

64

2 Why a Monetary Union?

harmful for the union and its components. Here again, recent empirical studies using sophisticated econometric methods have been prompted by European unification and mostly refer to the euro area. Macroeconomic and comparative analysis of national monetary unions is not yet carried out. As regards the first question, the study by Giannone and Reichlin [31] has provided valuable information. The authors compared (on the basis of the available macroeconomic data, covering the period 1970–2004) the “European” cycle19 and the cycle in the United States. Their conclusions are as follows. A common shock to the two currency areas is predominant in their dynamics but the propagation mechanisms of this common shock are different. On the contrary, idiosyncratic country- and state-specific shocks have contributed little to the volatility of these currency areas and have been persistent. The European cycle is more persistent but less volatile than the US cycle. After the occurrence of a common shock, it takes five years for the European economy to return to its stationary state while the US economy recovers in less than a year. Concerning the second set of questions, Bayoumi and Eichengreen [10] conducted the first empirical studies on the group of countries that was to become the euro area in 1999 by comparing the degree of macroeconomic heterogeneity between European countries and American states.20,21 Their conclusion, based on a study of the correlation of shocks, is that European countries are characterized (before the changeover to the euro) by greater heterogeneity than the American states.22 Alesina et al. [2] study aggregate product co-movements between countries sharing the same currency.23 Their database covers annual data over the period 1960–1997 for 207 countries. Under these conditions, the currency unions under consideration are mainly dollarization phenomena, involving anchor countries and client countries. Three anchor countries are emerging: the United States, Japan, and the Euro-12 (the twelve European countries that will be the first members of the euro area, taken collectively). The fact that two countries belong to the same currency area (measured by the joint probability of adopting the same anchor currency) has no impact on the turnover of their aggregate products. Using the same methodology, Barro and Tenreyro [9] conclude that the common use of the same currency reduces the correlation between shocks to real product. This last point therefore tends to

19 That

is, the cycle observed in the euro area as a whole. is, the (non-sovereign) States forming the United States of America. 21 See also Bayoumi and Prasad [11]. 22 Campos and Macchiarelli [17] replicated Bayoumi and Eichengreen’s study over the period 1989–2015 (not 1963–1988). They conclude that heterogeneity within the euro area has declined. 23 The correlation between aggregate outputs is measured by the square root of the Root-MeanSquare Errorobtained of theratio of  aggregate products between two  from an estimated regression   j j j i i /Yt−1 and ln Yt−2 /Yt−2 . countries ln Yti /Yt to its lagged values ln Yt−1 20 That

2.3 Changes Induced by a Monetary Union

65

support the proposition that sharing the same currency increases the asymmetry between two countries, via productive specialization effects. In the same perspective, Canova et al. [18] studied the effect of three major events in European monetary integration, namely the Maastricht Treaty, the creation of the European Central Bank and the creation of the euro, on the cycles of European countries. Their study is based on a VAR system using panel data covering ten European countries, seven of which belong to the euro area. Their general conclusion is twofold: a world-wide convergence phenomenon is at work; the changes observed in the transmission of shocks preceded these events and seem to be related to this common convergence movement rather than to monetary integration.

2.3.2.2 Prices and Inflation What can we expect in terms of prices and inflation from a monetary union? Here again, several questions need to be distinguished, depending on whether one looks at the union as a whole or at its components. In good macroeconomic logic, the price trend characterizing the union is assessed on the basis of price indices calculated for the union as a whole. The two main ones will be a general price index, calculated on the basis of the goods and services produced in the union, and a consumer price index, calculated on the basis of the goods consumed in the union. The central bank of the union, according to its mandate and the tasks entrusted to it, seeks to control the inflationary process in the union. The credibility of monetary policy—which we discussed in Sect. 2.1.4—is measured both by its ability to set a lower or higher inflation target and by its ability to achieve it. It is normal for monetary policy to be conducted on the basis of inflation for the union as a whole. It is possible, and even necessary in the case of a multi-national monetary union, to define price indexes valid for the components of the union from which to measure the inflation rates characterizing those components. The question then arises as to whether the national or regional inflation rates are equal or not, whether they converge (when inflation differentials tending to disappear), and whether any heterogeneity is evidence of a malfunctioning monetary union. In terms of monetary policy, it is logical to ask whether the central bank should be concerned about these inflation differentials. Empirically, statisticians almost always record different national and regional inflation rates and not necessarily a process of convergence of inflation differentials. Is this cause for alarm? Not necessarily. Non-convergence can be explained by the Balassa–Samuelson effect (Balassa [4], Samuelson [53]) and be consistent with efficient market adjustment processes. The reasoning, in the context of a twocountry international economy, is as follows. Each of the two countries produces the same tradable (internationally) good and a non-tradable good. Two assumptions are made: (1) “purchasing power parity” or more precisely the “law of one price” applies to the tradable good; (2) the labour markets in both countries are perfectly competitive, leading to the equalization in each country of the unit wage in the two production sectors.

66

2 Why a Monetary Union? j

Let us indicate by j, j = 1, 2 the two countries, QT the quantity produced of j the traded good, and QN the quantity produced of the non-traded good in country j . Production is a linear function of the quantity worked in the sector: j

j

j

(2.1)

j

j

(2.2)

QT = aT LT j

QN = aN LN . j

j

aT and aN represent the unit labour productivities in the tradable and non-tradable good sectors in country j . The price of the traded good is the same in both countries: pT (assuming a 1:1 exchange rate of the national currencies, or a monetary union). i The prices of non-traded goods are denoted by pN . By maximizing their profit, firms in a sector are led to equalize the wage in relation to the selling price with the marginal productivity in this sector: Wj j = aT , pT

Wj j pN

j

= aN .

(2.3)

From this, various equations can be deduced: j

j

a1 W1 = T2 , 2 W aT

pN a = Tj , pT aN

1 pN 2 pN

=

aT1 1 aN

 ·

aT2

−1

2 aN

.

(2.4)

In a given country, the ratio of prices is equal to the productivity ratios; the ratio of wages in the two countries is equal to the ratio of productivity in the tradable goods sectors, and finally the ratio of prices of non-tradable goods is given by the ratio of productivity ratios. Let us now turn to changes over time. Let us indicate the various variables by the j time index t. Consumption patterns are such that the price index Pt in country j at time t is defined by the following equality:  1−α j j . Pt = (pT t )α pNt j

j

(2.5)

j

Let us note πt , πT t , and πNt , respectively, the inflation rate, the growth rate of the price of the traded good, and the growth rate of the non-traded good in country j at j j period t. Note ρT t and ρNt the growth rates of productivity in the traded and nontraded goods sector in country j at period t. From these equations, we can deduce the following:24 j

j

j

πt = απT t + (1 − α) πNt 24 Using

the following approximation: log (1 + x) = x for x small enough.

(2.6)

2.3 Changes Induced by a Monetary Union

67

and thus: πt1 − πt2 = (1 − α)



   1 2 ρT1 t − ρT2 t − ρNt . − ρNt

(2.7)

The differential in inflation rates between the two countries is given by the difference in productivity gains in the two sectors between the two countries. This result justifies the fact that inflation rates are not the same at any period for all countries: this is due to the divergent productivity developments both between sectors and between countries. In particular, when the least developed member countries are those where, in a catching-up logic, productivity growth rates are the highest, they experience higher inflation rates than the more advanced member countries. However, this reasoning does not justify ignoring the inflation differential in a monetary union. It may be that this differential is due to factors other than the Balassa–Samuelson effect, and instead corresponds to a deterioration of relative competitiveness. Monitoring and understanding the inflation differentials and the inflation rate of the union are essential for a macroeconomic diagnosis of the functioning of the union. From an empirical point of view, Alesina et al. [2] have studied the co-movements of price indexes, measured by the square root of the Root-Mean-Square-Error obtained from regression of the ratio of price  an estimated   indicesbetween two  j j j i i countries ln Pt /Pt to its lagged values ln Pt −1 /Pt −1 and ln Pti−2 /Pt −2 , using the same database as in 2.3.2.1. It turns out that the fact that two countries use the same currency significantly increases the correlation between changes in price (indices of prices). This is consistent with the proposition that the suppression of exchange rates ipso facto leads to a source of variation in the real terms of trade and relative prices between two countries and increases their correlation. More recently, Whitten [58] conducted an analysis of co-movements in price (indices of prices) in currency unions based on statistical methods of cointegration. He finds that most of the studied currency unions, though not all, possess a cointegrating vector among their members. More interestingly, in order to investigate whether this is due to the sharing of a currency, he looks at bilateral cointegration between pairs of countries, either belonging to a common monetary union or not. His conclusion is that currency union pairs are cointegrated far more frequently than are non-currency union pairs. This is consistent with the idea that there is a “currency union effect.” All together, divergent results are obtained on these macroeconomic issues, depending on the dataset available, the time period studied, the methods used, etc. This confirms the diagnosis of the complexity of a monetary unification process, especially when it concerns economies such as those of European countries. Simple ideas about monetary unification are not appropriate.

2.3.2.3 Risk Sharing Risk sharing is an important measure for assessing a monetary union since institutions are supposed to allow individuals, who are generally risk-averse, to insure

68

2 Why a Monetary Union?

themselves through markets or public insurance schemes. Indeed, it gives a closer indication of collective well-being than aggregate macroeconomic indicators. The few studies devoted to the issue are therefore worth mentioning. In a federal country, perfect risk sharing occurs when aggregate consumption in a state is perfectly correlated with the aggregate product of the federation regardless of the shocks affecting it, and hence the state’s level of production. The weaker the correlation, the more imperfect the risk sharing within the federation. The article by Asdrubali et al. [3] was one of the first to be devoted to this question, applying an original and rigorous statistical methodology to the United States over the period 1963–1990, based on this definition of risk sharing. This study was highly commented on in connection with the European unification underway at the time of its publication. Asdrubali et al. look at the variance of aggregate state products over the period and show how it can be decomposed into three sources: via financial markets, via government transfers from the federal government, and via the credit market. The result they arrive at is that 40 per cent of the variance is “smoothed” by financial markets, 13 per cent by federal transfers, and 23 per cent by bank credits. This first study was followed by many others, but the qualitative conclusion drawn is that federal transfers play a significant stabilizing role in the functioning of the US currency area. Comparing the United States and Europe and using the same methodology, Sorensen and Yosha [55] find less risk sharing in Europe25 than in the United States. In particular, international transfers within the European area can only absorb 3% of shocks. As the study covers the period 1966–1990, i.e. before the actual creation of the euro area, it tells us nothing about European unification: it compares two economic groupings, one of which is a national monetary union and the other is not. Kalemli-Ozcan et al. [35] studied risk sharing in the European monetary union over the period 1973–2000 and showed that risk sharing in the European Union26 had increased in the last decade of the twentieth century, thanks to the growth of cross-border asset acquisitions, and that the asymmetry of aggregate fluctuations between European countries had decreased markedly since 1980. Finally, Giannone and Reichlin [31] replicated the study of Asdrubali et al. on European data27 over the period 1970–2003. According to their results, risk sharing within the euro area increased markedly in the last sub-period 1990–2003. The extent of risk sharing is therefore an important dimension of a monetary union. The first existing studies confirm that risk sharing depends on the monetary arrangements and institutions that structure a monetary union.

25 Defined

as what was then the “European Community.” Union, established by the Maastricht Treaty in 2003, took over from the European Community. 27 That is, the euro zone countries minus Luxembourg. 26 The European

2.3 Changes Induced by a Monetary Union

69

2.3.2.4 Labour Markets: The Issue of Mobility We saw earlier that Mundell emphasized labour mobility (that is, the geographic mobility of workers themselves) as an adjustment mechanism within a monetary union. The mobility of capital is less discussed: it is accepted that capital, at least in its financial form, is internationally mobile and that monetary unification plays a marginal role in this mobility. Two empirical questions arise. How important is labour mobility within monetary unions? Does it evolve in connection with monetary unification? Bayoumi and Prasad [11] were the first to examine this question from a comparative perspective. They studied data decomposed into major productive sectors (8) for eight European countries and regions of comparable size in the United States over the period 1970–1989. Once again, the data cover a period prior to European unification but, since labour mobility is a slowly evolving structural phenomenon, the indications they obtained appeared to shed light on the differences between the two economic groupings. Their conclusion is that the United States (not surprisingly) had a much more integrated labour market than was the case in Europe as a whole and that the reallocation of work was much more within sectors in Europe than in the United States, where a significant part of this reallocation was between regions. Since then, many studies have been devoted to the subject. We shall refer to one recent study that appears particularly significant. Beyer and Smets [14] used a very comprehensive database covering the labour markets of the United States and the euro area countries, broken down by region and recording in particular inter-regional and international mobility flows. The time series used are particularly long, covering the period 1976–2013. The main results obtained are as follows. In the two areas studied, labour mobility accounts for roughly half of the long-term adjustment to regional labour demand shocks. The other half is due to the reallocation of the jobs themselves. But the adjustment is slower in Europe (10 years instead of 5 years), probably due to greater labour market rigidity. This leads to a stronger response from unemployment. Lastly, as might be expected, labour mobility in Europe plays a less important role in the response to national shocks than to regional shocks. These various empirical results are often interpreted in the light of the theory of optimal currency areas. We have seen that this framework is too crude to allow a satisfactory assessment of a monetary unification process. Moreover, the consensus among empirical economists is that the fluctuation processes have gradually changed over time, independently of any institutional and monetary considerations (Stock and Watson [56], Canova et al. [18]). This makes a firm diagnosis on the basis of currently available work risky, particularly with regard to the euro area.

2.3.3

Financial Effects

Monetary unification cannot be without consequences for the functioning of financial markets and the risk-sharing mechanisms used by economic agents, as

70

2 Why a Monetary Union?

it increases financial integration. By eliminating exchange rate risk, financial integration leads to wider and deeper, and therefore more liquid, markets and increased international financial flows. On the positive side, this should lead to a better sharing of risk for agents and less variability in consumption, i.e. less vulnerability to idiosyncratic shocks. But, in a more subtle way, it is also a displacement of risks due to greater economic integration. Financial crises are always possible and spread more directly and perhaps more easily than in the presence of flexible exchange rates. In addition to the econometric difficulties inherent in this type of exercise, the question of the precise definition of financial integration is a delicate one. Even more so than in the case of goods and services, the concept covers a wide range of phenomena and can be measured in many ways. Moreover, the question of causality arises. It may be that financial integration is indirectly linked to monetary unification through economic integration and, in particular, through the growth of international trade flows in goods and services. We have few comparative studies on this subject, similar to those available on trade in goods and services. Existing studies focus on European unification (Pagano [49]). There is insufficient time span to draw firm conclusions. Overall, it seems possible to draw two conclusions from the studies conducted on aggregate data. On the one hand, the euro did induce financial integration, as the government securities market showed a rapid decline in spreads on national government securities until the onset of the financial crisis in 2008, and there was a growth in international financial flows, as suggested by the economic analysis. Financial flows between two euro area member countries in terms of holdings of government securities increased relative to similar flows between non-euro area countries (Silva and Tenreyro [54]). A similar but smaller and statistically more fragile effect occurred for equity holdings. However, such a phenomenon does not seem to have occurred for direct investment. The study by Kalemli-Ozcan et al. [36] is based on a database of microeconomic banking data over the period 1977–2007, thus covering European unification and covering 20 OECD countries, including the 12 largest members of the euro area. It is accompanied by a survey of the changes in banking regulations that took place in the countries concerned in connection with the process of European unification, particularly with regard to the harmonization of banking procedures. In this study, financial integration is limited to banking integration and is assessed alternately by interbank international flows calculated on the basis of banks’ balance sheets. Three main conclusions emerge from the study of this statistical base: 1. The introduction of the euro had a significant impact on financial integration through the reduction of exchange rate risk, the most immediate consequence of European unification. This is in line with the analysis and parallel to what we have observed in terms of international trade flows. 2. The regulatory harmonization linked to the introduction of the euro has played a significant role in European banking integration, i.e. the increase in international interbank flows. This is consistent with the idea that such harmonization leads to broader and more liquid financial markets (level playing field effect).

2.4 Conclusion

71

3. Trade integration alone cannot explain the financial integration that has taken place in the euro area. These results are important but need to be complemented by other studies covering other areas and periods in order to better assess quantitatively the financial integration implied by monetary unification, and in particular by studies on the impact of financial crises.

2.4

Conclusion

There can be no simple answer to the question of why a monetary union exists and how it works. On the one hand, the diversity of monetary unions is great, particularly with regard to the relationships between the components of a union. An asymmetrical monetary union between anchor and client countries is in every respect, institutional, political and macroeconomic, very different from a symmetrical monetary union or a hierarchical one, coupled with a political federation. On the other hand, there are many elements that need to be taken into account and can only lead to a complex response. Answering these questions implies clarifying delicate methodological points, in particular the relevant criteria for judging the functioning of a monetary union and assessing the net benefits for the components of the union. Moreover, the question of the stability of a monetary union, which is linked to the question of whether it is appropriate to enter or leave it, cannot be neglected as it conditions the overall functioning of the union. In any case, we can confidently make three claims: 1. A monetary union changes the conditions under which markets clear. In particular, individual markets benefit from economies of scale and scope, are larger, more diversified, and deeper. But it cannot be argued that market instability is reduced. Monetary unification changes the causes and workings of crises but does not eliminate them. 2. It changes access to the various markets for all agents resident in the union. 3. In particular, a monetary union modifies the financing conditions of agents and thus the conditions for risk sharing. But it is difficult to go beyond these claims that are admittedly vague. In particular, it is impossible to know whether monetary unification leads to more convergence between the components or not. Empirical observation of monetary unions is not a very reliable guide to general and precise conclusions. The distinction between multi-national and national monetary unions is of extreme analytical importance. The empirical evidence we currently have on the functioning of monetary unions does not allow us to distinguish a preferred form of monetary union architecture. Three analytical items must be mobilized in order to understand the functioning of a monetary union: the analysis of the shocks to which the components of the union are exposed and the adjustment mechanisms in the various markets to those shocks; the analysis of the external imbalances of those components (in the case of a multi-national monetary

72

2 Why a Monetary Union?

union); the analysis of the institutions that guarantee the solidity of the union and ensure its internal and external credibility (vis-à-vis the rest of the world). Ultimately, issues of financial integration and stability, institutions, and the conduct of economic policy are essential to understanding the functioning of a monetary union and its viability. From this perspective, the theory of optimal currency areas initiated by Mundell more than half a century ago, although very fruitful from a methodological point of view, cannot be a sufficient guide to understanding the dilemmas, strengths and weaknesses of a monetary union, as it neglects essential elements such as the question of financial links between the components of the union, the articulation of economic policies, and the importance of institutional arrangements. In terms of economic policies, the degree of economic interaction between the countries of the union means that the consequences of the decisions of one authority depend on what is decided by the other authorities. Formally, the transmission channels for economic policy impulses are interdependent. Consequently, the effectiveness of an economic policy measure depends on what is done by the authorities in charge of the other economic policy instruments: 1. The Central Bank and the Treasuries have joint responsibilities in the macroeconomic functioning of the union. Their macroeconomic objectives may differ from one authority to another or be weighted differently. There may therefore be a “conflict of objectives” between authorities, particularly fiscal authorities, because they have different constituencies. The central bank, being unique, is concerned about the overall functioning of the monetary union. It is reasonable to assume that its objectives are linked to the macroeconomic situation of the union. On the other hand, a national Treasury, levying taxes on residents in a given country, managing a national budget, is accountable to its national electorate. Its objectives will be linked to the macroeconomy of the country in question. 2. The monetary policy practised by the central bank determines the way in which a government finances its indebtedness. Either because it affects the range of interest rates charged on the financial markets or because it can assume part of this financing. 3. Finally, public authorities are jointly responsible for the functioning of the financial system and, more specifically, the union’s banking system. The financial markets depend on the conditions under which financial contracts are settled and on access to interbank liquidity, which is a prime responsibility of the issuing institution. But they also depend on the financing needs of States which can weaken or stabilize them. More specifically, the banking system, insofar as it handles the transactions of private agents, must have its operation guaranteed by the public authorities and banking crises necessarily call for the intervention of public authorities. It is impossible to understand the functioning of a monetary union without understanding the institutional architecture that structures the responsibilities and capabilities of the different monetary and fiscal authorities in a given union. The

References

73

number of member countries is a crucial first element of this architecture. But also the links that the central bank has with the fiscal authorities, and more broadly with the political powers that operate in the union. The rest of this book therefore naturally focuses on issues of policy and institutional design.

References 1. Alesina A, Barro R (2002) Currency unions. Q J Econ 117:409–436 2. Alesina A, Barro R, Tenreyro S (2002) Optimal currency areas. NBER Macroecon Annu 17:301–345. Cambridge, MA: MIT Press 3. Asdrubali P, Sorensen B, Yosha O (1996) Channels of interstate risk sharing: United States 1963-1990. Q J Econ 111:1081–1110 4. Balassa B (1964) The purchasing-power parity doctrine: a reappraisal. J Polit Econ 72:584–596 5. Baldwin R, Taglioni D (2004) Positive OCA Criteria: Microfoundations for the Rose Effect. In: COE/RES Discussion Paper Series 34 6. Baldwin R, Skudelny F, Taglioni D (2005) Trade effects of the euro: evidence from sectoral data. In: European Central Bank Working Paper 446 7. Baltzer M, Cappiello L, De Santis R, Manganelli S (2008) Measuring financial integration in new EU member states. In: European Central Bank Occasional Paper 81 8. Barro R, Gordon D (1983) Rules, discretion and reputation in a model of monetary policy. J Monetary Econ 12:101–121 9. Barro R, Tenreyro S (2007) Economic effects of currency unions. Econ Inquiry 45:1–23 10. Bayoumi T, Eichengreen B (1992) Shocking aspects of European monetary unification. In: National Bureau of Economic Research Working Paper w3949 11. Bayoumi T, Prasad E (1997) Currency unions, economic fluctuations, and adjustment: some new empirical evidence. IMF Staff Papers 44:36–58 12. Beetsma R, Giuliodori M (2010) The macroeconomic costs and benefits of the EMU and other monetary unions: An overview of recent research. J Econ Literature 48:603–641 13. Bergin P, Ching-Yi L (2012) The dynamic effects of a currency union on trade. J Int Econ 87:191–204 14. Beyer R, Smets F (2015) Labour market adjustments and migration in Europe and the United States: how different? Econ Policy 30:643–682 15. Calmfors L (ed) (1997) EMU – A Swedish Perspective. Kluwer Academic Publishers, Amsterdam 16. Calvo G, Reinhart C (2002) Fear of floating. Q J Econ 117:379–408 17. Campos N, Macchiarelli C (2016) Core and periphery in the European Monetary Union: Bayoumi and Eichengreen 25 years later. Econ Lett 147:127–130 18. Canova F, Ciccarelli M, Ortega E (2007) Similarities and convergence in G-7 cycles. J Monetary Econ 54:850–878 19. Cesarano F (2006) The origins of the theory of optimum currency area. Hist Polit Econ 38:711– 731 20. Chari V, Dovis A, Kehoe P (2019) Rethinking optimal currency areas. J Monetary Econ 111:80–94 21. Clerc L, Dellas H, Loisel O (2011) To be or not to be in monetary union: A synthesis. J Int Econ 83:154–167 22. Cooley T, Quadrini V (2003) Common currencies vs. monetary independence. Rev Econ Stud 70:785–806 23. Cooper R, Kempf H (2001) Dollarization and the conquest of hyperinflation in divided societies. Q Rev Federal Reserve Bank Minneapolis 25:3–17

74

2 Why a Monetary Union?

24. Corsetti G, Feld L, Lane P, Reichlin Lucrezia and Rey H, Vayanos D, di Mauro B (2015) A new start for the Eurozone: Dealing with debt. CEPR, Monitoring the Eurozone 1 25. De Grauwe P (2006) What have we learnt about monetary integration since the Maastricht Treaty. J Common Mark Stud 44:711–730 26. Dellas H, Tavlas G (2009) An optimum-currency-area odyssey. J Int Money Finance 28:1117– 1137 27. Demange G, Wooders M (eds) (2005) Group formation in economics: networks, clubs, and coalitions. Cambridge University Press, Cambridge 28. Fontagné L, Mayer T, Ottaviano G (2009) Of markets, products and prices: The effects of the euro on European firms. Intereconomics 44:149–158 29. Frankel J, Rose A (1998) The endogeneity of the optimum currency area criteria. Econ J 108:1009–1025 30. Gali J, Monacelli T (2008) Optimal monetary and fiscal policy in a currency union. J Int Econ 76:116–132 31. Giannone D, Reichlin L (2006) Trends and cycles in the euro area: how much heterogeneity and should we worry about it? In: European Central Bank Working Paper 595 32. Giavazzi F, Pagano M (1988) The advantage of tying one’s hands: EMS discipline and central bank credibility. Eur Econ Rev 32:1055–1075 33. Gil-Pareja S, Llorca-Vivero R, Martinez-Serrano A (2008) Trade effects of monetary agreements: evidence for OECD countries. Eur Econ Rev 52:733–755 34. Groll D, Monacelli T (2020) The inherent benefit of monetary unions. J Monetary Econ 111:63–79 35. Kalemli-Ozcan S, Sorensen B, Yosha O (2004) Asymmetric shocks and risk sharing in a monetary union: Updated evidence and policy implications for Europe. In: CEPR Discussion Paper Series 4463 36. Kalemli-Ozcan S, Papaioannou E, Peydro J-L (2010) What lies beneath the euro’s effect on financial integration? Currency risk, legal harmonization, or trade? J Int Econ 81:75–88 37. Kenen P (1969) The theory of optimum currency areas: an eclectic view. In: Mundell R and Swoboda A (eds) Monetary Problems of the International Economy, The University of Chicago Press, Chicago, 41–60 38. Kenen P (1997) Preferences, domains, and sustainability. Am Econ Rev 87:211–213 39. Krugman P (1993) Lessons of Massachusetts for EMU. In: Giavazzi F, Torres F (eds) Adjustment and growth in the European Monetary Union. Cambridge University Press, Cambridge 40. Kydland F, Prescott E (1977) Rules rather than discretion: The inconsistency of optimal plans. J Polit Econ 85:473–491 41. Masini F (2014) A history of the theories on optimum currency areas. Eur J Hist Econ Thought 21:1015–1038 42. Mayer T, Vicard, V, Zignago S (2019) The cost of non-Europe, revisited. Econ Policy 34:145– 199 43. McKinnon R (1963) Optimum currency areas. Am Econ Rev 53:717–725 44. McKinnon R (2004) Optimum currency areas and key currencies: Mundell I versus Mundell II. J Common Mark Stud 42:689–715 45. Mongelli F (2002) ‘New’ views on the optimum currency area theory: What is EMU telling us? In: ECB Working Paper 138 46. Mundell R (1961) A theory of optimum currency areas. Am Econ Rev 51:657–665 47. Mundell R (1973) Uncommon arguments for common currencies. In Johnson H, Swoboda A (eds) The Economics of Common Currencies. Allen and Unwin, London 48. Niehans J (1978) The theory of money. Johns Hopkins University Press, Baltimore 49. Pagano M (2010) Financial Market Integration Under EMU. In: Buti M, Deroose S, Gaspar V, Nogueira M (eds) The Euro: the First Decade. Cambridge University Press, Cambridge 50. Rogoff K (1985) The optimal degree of commitment to an intermediate monetary target. Q J Econ 18:1169–1189

References

75

51. Rose A (2000) One money, one market: the effect of common currencies on trade. Econ Policy 15:8–45 52. Rose A, Stanley T (2005) A meta-analysis of the effect of common currencies on international trade. J Econ Surv 19:347–365 53. Samuelson P (1964) Theoretical notes on trade problems. Rev Econ Stat 31:145–154 54. Silva J, Tenreyro S (2010) Currency unions in prospect and retrospect. Annu Rev Econ 2:51–74 55. Sorensen B, Yosha O (1998) International risk sharing and European monetary unification. J Int Econ 45:211–238 56. Stock J, Watson M (2005) Understanding changes in international business cycle dynamics. J Eur Econ Assoc 3:968–1006 57. Thygesen N (1989) The Delors Report and European economic and monetary union. Int Affairs 65:637–652 58. Whitten G (2018) Price-level co-movements within currency unions: An alternative integration metric. World Econ 41:2414–2438

Monetary Policy in a Monetary Union: Lessons from Simple Models

Abstract

This chapter analyses the most prominent issue facing a monetary union, the conduct of a unique and common monetary policy despite the structural heterogeneity of the union. It discusses the various possible objectives of this central bank that shape its policy. It illuminates how the heterogeneity of the union appears as a major challenge through some simple indicators. It develops a simple model of a monetary union that serves to exemplify the main problems addressed in this chapter. It is enriched by the distinction of traded versus non-traded goods and its impact on the conduct of monetary policy. Lastly, nonconventional monetary policy in a monetary union is discussed.

Reasoning about a monetary union does not require a different framework for monetary policy analysis than the one used in a simple economy. Both the instruments of the union’s central bank and its modus operandi are identical in the two economies. Similarly, individual behaviour with respect to the holding of financial and monetary assets is, if not identical, at least similar. The principles of monetary analysis are therefore unchanged. The purpose of this chapter is to understand how to apply these principles to the case of a monetary union. For the sake of simplicity, we will reason in the context of a multi-national monetary union. It is in the implementation of monetary policy—the institutions and, first and foremost, the central bank—and in its effectiveness that the differences with a simple economy are introduced. A monetary union implies a single and common monetary policy, exercised by a single central bank, acting by delegation of the public authorities of the union.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_3

77

3

78

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

More specifically, the concept of monetary union leads to an emphasis on the structural heterogeneity of the economic area covered by the union. This heterogeneity is threefold: 1. The first heterogeneity is that of the structures of the economies of the member entities (countries) and the shocks affecting them. It is logical to think that the structures are differentiated. In the case of shocks, it is convenient to distinguish between global shocks, affecting the union as a whole, and idiosyncratic shocks, affecting the member countries in a differentiated manner, particularly because of their productive specialization. 2. The second heterogeneity—stemming from the first—relates to the transmission channels of monetary policy. The monetary policy impulse, decided by the central bank, affects the behaviour of financial and non-financial agents differently, resulting in quantitatively different macroeconomic effects in the member countries. As a result, monetary policy has different consequences in the member countries. 3. Finally, the last heterogeneity is political. The member countries, or more precisely the political authorities that govern them, logically have different macroeconomic objectives because they are placed in different macroeconomic configurations or because the political expectations expressed more or less openly by civil societies (depending on the degree of democracy of the member countries) are diverse, or even opposed. From this perspective, two major questions arise: 1. The first focuses on the monetary policy practised in a monetary union. Given these different forms of heterogeneity, what does it imply for the monetary policy of the union and how should it be conducted? 2. The second is more precisely that of the institution and governance of the central bank of a monetary union. What should be the legal and operational framework for the central bank? The first question is the subject of this chapter, the next chapter being devoted to the second. In these two chapters, we will leave aside fiscal issues and their interaction with monetary policy, which we will deal with in Part Two. Section 3.1 is devoted to a brief review of the principles of monetary policy. Section 3.2 outlines the specific challenges of monetary policy in a monetary union. In Sect. 3.3, we will develop a very simple model of a monetary union that will allow us to discuss the different options faced by the central bank of the union through a discussion of the different possible specifications of its objective function. In Sect. 3.4, we will enrich the model by introducing differentiated goods produced and traded in the union. Considerations of competitiveness within the union and of the terms of trade are

3.1 Monetary Policy

79

then introduced, which monetary policy may or may not take into account. Finally, in a penultimate section, we will address the issue of non-conventional policy in a monetary union, before concluding.

3.1

Monetary Policy

Let us start with some generalities about monetary policy (Benassy-Quéré et al. [1], Walsh [11]). Let us reason in the context of an economy where liquidity— money in the strict sense—is totally dematerialized, created and managed by commercial banks in return for their credit operations. The regulation of money creation is assumed by a central bank through its transactions with commercial banks, particularly on the money market, also known as the interbank market, since this is the market where commercial banks obtain the very short-term liquidity needed to meet their daily net liquidity requirements. This regulation is the essence of monetary policy. It is traditionally based on the distinction between the central bank’s objectives and the instruments at its disposal.

3.1.1

Monetary Policy in a Unified Economy

The problem of monetary policy for a simple, closed economy can be set as follows. The economic constraints on the central bank are represented by a macroeconomic model that formalizes the economic relationships within the economy. We reason on a simple macroeconomic model: we assume it is static and based on relationships between linear variables. Such a model is written in matrix form as follows: X = X × (Z, θ, ) ,

(3.1)

where X is a vector of macroeconomic variables synthesizing the macroeconomic state of the economy. Z is a vector of explanatory variables for X;  is a vector of shocks hitting the economy; θ is the monetary policy instrument manipulated by the central bank. Finally, X is a matrix of adequate dimension: schematically, it incorporates the transmission channels of monetary policy, i.e. the causal relationship between θ and X. Given this formal representation of the economy, monetary policy can be approached in two ways: 1. The monetary policy decision can be the result of an optimal choice made by the central bank. This choice is formalized as the resolution of a constrained objective function optimization problem through manipulation of the monetary instrument θ .

80

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

The objective function summarizes the objectives that are important to the central bank, its “preferences,” and is written as follows: L = L (ω1 , ..., ωm , ...) , where ωm is the m-th objective of the central bank. These objectives are most often numerical values and relate to variables belonging to the X vector and represent the levels desired by the central bank for these variables. Typically, the objective function takes the form of a loss function, which is minimized. A quadratic specification of the loss function is often used: the loss function is a weighted sum of squared deviations between the actual values taken by macroeconomic variables and the desired “target” values for those variables. The weights represent the relative importance of the different deviations for the central bank. Here is a simple example:  2 2  L = y − y∗ + λ π − π ∗ , where y is the aggregate output (GNP), y ∗ is the aggregate output target, π is the inflation rate, and π ∗ is the inflation target. The central bank focuses exclusively on two objectives: the gap between actual inflation and a target value and the gap between aggregate output and a target value; λ expresses the relative importance that the central bank attaches to reducing the inflation gap relatively to the output gap. The monetary policy optimal decision is the value of θ that minimizes the aggregate value of the loss L, where the variables in question are linked by the relation (3.1). It is important to understand that a central bank always acts by delegation from the political authorities of the country in question. Its preferences are therefore always determined by the preferences of these political authorities. They may be identical. 2. The central bank follows a monetary rule functionally linking the monetary policy instrument to a vector of economic variables: θ = (ζ1 , .., ζl , ..) ,

(3.2)

where ζl is the l-th economic variable taken into account by the central bank in its rule. Equation (3.2) represents the monetary policy “rule” followed by the central bank. (·) is most often expressed as a linear relationship. The arguments ζl are the macroeconomic indicators to which the central bank responds via the rule it follows. The Taylor rule is the most famous and most widely used example (particularly by central banks) of a monetary rule in economics. Taylor [10] sought to synthesize US monetary policy followed over the period 1984–1992 by a very simple relationship linking interest rates, inflation and aggregate output.

3.1 Monetary Policy

81

In Taylor’s rule, the instrument of monetary policy is the very short-term interest rate it . The central bank sets it with reference to both inflation and the product gap according to the formula:     it = r + πt + απ πt − πt∗ + ϕy yt − y t ,

(3.3)

where r is the “natural” real interest rate (or a target value for the real interest rate), y t  a reference value for the aggregate product for period t, such that  yt − y t is the output gap, and πt∗ the inflation rate desired for period t by the central bank. απ and αy are the coefficients attached    to thetwo macroeconomic indicators used by the central bank, πt − πt∗ and yt − y t . In Taylor’s original estimate, απ is equal to 0.5 as αy , while πt∗ is equal to 2.

3.1.2

Monetary Instruments

In advanced economies, the dematerialization of money is complete and the calculation of the quantity of means of payment in circulation is becoming increasingly difficult and arbitrary as a result of technological innovations, the growing digitization of trade and the ensuing financial liberalization. From this point of view, a monetary union is placed on the same level as a single economy: monetary policy is conducted through the relations between the central bank and the commercial banks, which are privileged providers of credit, and hence liquidity, to non-financial agents, and with the same instruments. 1. Some are instruments aimed at directly regulating the reserves of commercial banks with the central bank. This is mainly due to the reserve requirement ratio and the deposit or lending facilities that commercial banks have with the central bank. 2. Other instruments are price instruments. This is essentially the very short-term central bank intervention rate around which the market rate at which financial institutions lend to each other normally fluctuates. 3. Finally, a central bank may provide collateral for operations to financial institutions in exceptional circumstances, mainly in crisis situations. In normal times, monetary policy does not imply the use of such tools. We will return to these exceptional circumstances, as opposed to “normal times,” in Sect. 3.6. Under these circumstances, the conduct of conventional monetary policy consists in manipulating interest rates, and more precisely in defining a corridor within which the market interest rate moves. The following chart shows the “interest rate corridor” for the euro area since 2000, where the EONIA (Euro Overnight Interest Average) represents the market rate. It should be noted that the trend in interest rates has been downwards, to the point where rates are very close to 0 at the end of the period,

82

3 Monetary Policy in a Monetary Union: Lessons from Simple Models %

6

5

4

3

2

1

0

–1 1999

2001

EONIA

2003

2005

2007

Deposit Facility

2009

2011

2013

Marginal Lending Facility

2015

2017

2019

Main Refinancing Operartion

Fig. 3.1 EONIA. Source Renton et al. [9]

when it is impossible to conduct a “conventional” monetary policy by changing rates (Fig. 3.1). A central bank conducts its monetary policy through transactions involving the acquisition or disposal of assets with financial institutions. Its balance sheet records these transactions. On the liabilities side of the balance sheet, the capital of the central bank is recorded. In the case of a national monetary union, the capital is contributed by the State alone; in the case of an international monetary union, it is contributed by the Member States of the union, according to an allocation rule that reflects the historical circumstances of its creation and, where appropriate, of its mutations.1 The asset side of the balance sheet records the “counterparts” of monetary creation by the central bank, i.e. the operations to which the monetary creation gave rise. Table 3.1 shows the components of the simplified balance sheet of the European Central Bank: A monetary policy operation of interest rate manipulation has the effect of triggering transactions between the central bank and its financial correspondents that result in a change in its balance sheet. The understanding of this operation is not complete without studying the consequences of this change. For example, a “sterilization” policy consists in keeping the total size of the central bank’s balance

1

The case of the European Central Bank is singular since it is an institution of the European Union, whereas it manages a currency whose area of legal circulation is more restricted than the European Union itself. As a European institution, part of its capital is thus contributed by States that are not members of the European Monetary Union.

3.1 Monetary Policy

83

Table 3.1 Simplified ECB balance sheet 31 December 2020 Assets Gold Claims on non-EA residents in foreign currencies Claims on EA residents in foreign currencies Claims on non-EA residents in euro Claims on EA residents in euro Lending to EA credit institutions in euro Other claims on EA credit institutions in euro Securities of EA residents in euro General government debt in euro Other assets Liabilities Bank notes in circulation Liabilities to euro area credit institutions related to monetary policy Other liabilities to euro area credit institutions Debt certificates Liabilities to other EA residents in euro Liabilities to non-EA residents in euro Liabilities to EA residents in foreign currency Liabilities to non-EA residents in foreign currency Counterpart to SDR allocated by the IMF Other liabilities Revaluation accounts Capital and reserves

e millions 6,979,324 536,542 347,179 23,437 14,337 435,581 1,793,194 25,328 3,890,916 22,676 325,715 6,979,324 1,434,512 3,489,194 23,563 0 611,304 431,145 7816 3895 54,799 301,414 512,884 108,797

% 100

100

Source [7]. EA: Euro area. Revaluation accounts correspond to changes in value due to price changes

sheet constant when monetary policy causes a change in a particular balance sheet item. More generally, the central bank must jointly ensure that commercial banks have “adequate” liquidity and that interest rates are consistent with macroeconomic stabilization requirements. On the articulation of the central bank’s monetary policy and financial policy, a “separation principle” has long been accepted. This principle states that the central bank must separate its monetary policy (the manipulation of key interest rates) from its policy on credit or the financing of financial institutions in the event of shocks to the demand for liquidity. This means that it must separate its interest rate policy from its policy for providing liquidity to banks, eventhough both are made interdependent via the central bank’s balance sheet (Bordes and Clerc [3]).

84

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

3.2

Monetary Policy in a Monetary Union

Let us now look at a monetary union and see how the issue of monetary policy arises. We assume, for the sake of simplicity, that the monetary union is closed, that is, does not exchange with the rest of the world. It is made up of J countries, indexed by j .2 Finally, we maintain the same modelling assumptions as above: 1. The economy of a country j that is a member of the monetary union can be represented by a simple, static, linear macroeconomic model. We can write it in matrix form as follows:   Xj = Xj × Zj , Z−j , ZU , j , U , θ ,

(3.4)

where Xj is the vector of macroeconomic variables for country j , θ the monetary policy instrument common to all countries in the union, Zj is the vector of explanatory variables related to country j , Z−j is the vector of explanatory macroeconomic variables from countries other than j , ZU is the vector of explanatory variables from the union as a whole, j is the vector of countryspecific shocks j , and U is the vector of shocks affecting the union. Xj is a matrix of adequate size. The monetary policy instrument is manipulated by the union’s central bank. 2. The union economy is defined by aggregating the national components: XU =

J

μj .Xj ,

(3.5)

j =1

where XU is the vector of macroeconomic variables summarizing the macroeconomic state of the union. μj represents the diagonal matrix of the country weights in the union (generally a weight related to its relative demographic size in the union). There is heterogeneity of shocks when the realizations of the shocks differ: j = j  ,

j = j  .

Similarly, there is heterogeneity of transmission channels when the matrices of equations (3.4) differ: Xj = Xj  ,

2

j = j  .

We leave aside the fiscal issues that will be dealt with in the second part. The interaction between monetary policy and fiscal policy will be discussed in Chap. 7.

3.2 Monetary Policy in a Monetary Union

3.2.1

85

Preference Functions of the Central Bank

In a monetary union, monetary policy depends both on the specification of the preference function assigned to its central bank and on the model used to represent its economy. There are three options for describing and evaluating monetary policy: 1. The central bank may have (set) the overall objectives (valid for the union as a whole) and respond to aggregate indicators. Following the two options presented in the previous section, we can write: (a) The loss incurred by the central bank depends only on macroeconomic arguments about the union:   U LU = L ω1U , ..., ωm ,ζU ,

(3.6)

U is the m-th objective of the central bank, defined for the area as where ωm   a whole, and ζU is a vector ζ1U , ..., ζlU , ... , ζlU being the l-th indicator, calculated for the area as a whole. (b) Similarly, the monetary rule followed is based on the indicators calculated for the economy of the union as a whole:

  θ = ζU .

(3.7)

2. The central bank may have global objectives and respond to a combination of global and national indicators. Formally: (a) The objective function is unchanged, given by (3.6). (b) The monetary rule followed is based on indicators calculated for the economy of the union as a whole and indicators specific to the different countries:   θ = ζ U , ζ 1 , ..., ζ j , ..., ζ J ,

(3.8)

  j j j where ζ j is a vector ζ1 , ..., ζl , ... made up of indicators ζl , calculated for the country j that is a member of the monetary union (with j = 1, ..., J ). 3. Finally, the central bank may have both global and national objectives and react to a combination of global and national indicators. Formally: (a) The loss incurred depends on macroeconomic arguments relating to the union and macroeconomic arguments specific to the different countries of the union.   (3.9) LU = L U , 1 , ..., j , ..., J ,

86

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

  j j j where j is a vector ω1 , ..., ωl , ... consisting of objectives ωl , defined for   country j (with j = 1, ..., J ) and U is the vector ω1U , ..., ωlU , ... . (b) The monetary rule is given by (3.8). In a monetary union, discussing these options is unavoidable.3 Which is “the best” option for approaching monetary policy in a monetary union? It is impossible to answer this question without a detailed analysis of the characteristics of the union under consideration, and in particular the expectations of the political authorities of the member countries. However, a few remarks help to circumscribe the problem: 1. A monetary policy must be simple and easily understood by economic agents. It must be based on a limited number of indicators. Similarly, the central bank’s objectives must be few in number, again to make it possible to assess the effectiveness of the measures adopted. 2. When the components of the union are all identical, the problem of monetary policy is the same as in a unified economy. This refers to Mundell’s reflections on what constitutes an optimal currency area. Implicitly, Mundell recognized that if the shocks were identical (by extension, the transmission channels in member countries), monetary unification was not a problem. 3. The divergences caused by the different configurations depend on the extent of friction and dysfunction in the union. If they are small or negligible, monetary policy has no other purpose than to fix the currency and to anchor nominal quantities in such a way as to make the relative prices on which agents base their economic calculations more easily interpretable. Again, this refers to Mundell’s reflections on the crucial role of price flexibility in a monetary circulation area. There is a tension between the complexity of the monetary union (a function of its structural and political heterogeneity) and the requirement of simplicity or “conciseness” (synthetic construction) that monetary policy must satisfy in order to be interpreted and evaluated by economic agents and public authorities. The first option, “comprehensive,” favours the second requirement (assuming, of course, that few objectives and indicators are chosen). However, the question arises whether this option is satisfactory, since it neglects the factors of heterogeneity: designed for the union as a whole, monetary policy may not be adapted to any of its components, thus becoming an unsatisfactory rating. It cannot be ruled out that monetary policy could lead to increased heterogeneity, thereby weakening the union itself.

3

A fourth option, combining global and regional objectives and a rule defined only with global indicators, is difficult to justify analytically and we do not discuss it.

3.2 Monetary Policy in a Monetary Union

87

The other two options are justified by the desire not to neglect the heterogeneity of the union. In doing so, they come up against the opposite difficulty: how can the heterogeneity of the union be captured in a synthetic way by a small number of indicators or objectives? Clearly, it is impossible to include in the definition of the rule a number of indicators at least equal to N, or even equal to or greater than 2N (if we take the example of the Taylor rule), especially if N is a fairly large integer. One possible compromise is to include in the policy rule indicators of variance (the variance of inflation rates and/or growth rates of the components of the union) that are supposed to capture the heterogeneity of the union. Similarly, one of the central bank’s objectives (included in its objective function) could be considered to be to minimize the variance of a macroeconomic variable, such as the inflation rate or the growth rate, calculated for the union. The central bank may then be faced with a dilemma: the reduction of a variance objective, interpreted as the fact that the heterogeneity of the area is contained, may be paid for by poor performance with respect to an aggregate level-related objective. For example, low heterogeneity in the variation of the aggregate product may be associated with poor performance for the aggregate product of the union or with a high inflation rate for the union. A final note is in order. To the extent that the central bank is a supra-national institution acting by delegation, it is politically expedient to avoid having it preoccupied with strictly national considerations. These would logically lead it to make almost explicit trade-offs between national components within the union. However, such arbitration is not easy and may not satisfy any of the parties involved. For example, to prevent inflation in country j from spiralling out of control, thereby increasing the variance of inflation in the union, the central bank raises its interest rate when a large number of countries in the union are at the bottom of the cycle and would need to lower their key interest rate. The trade-off between the interest of country j (wishing to keep domestic inflation under control) and the interest of other countries (wishing to see economic activity supported) that the central bank makes is clear. It is doubtful that it will be accepted without discussion or recriminations. The political controversies generated by the central bank’s decision logically lead to a questioning of the soundness of its policy, or even its operation, which is more or less widely shared. The political fragility of the central bank, which can lead to a questioning of the union, is a major risk when the central bank takes into account national objectives or indicators. Both for reasons of operational simplicity and for political reasons, let us assume that monetary policy in a monetary union follows the first option, i.e. that the central bank is subject to economic objectives capturing the current state of the union and bases its policy on aggregate indicators relating to the union. The consequence is that monetary policy will not react to the centrifugal stresses arising from the structural heterogeneity of the union, which may be reinforced by the monetary decisions taken. These tensions are the expression of macroeconomic dysfunctions that need to be remedied because they are costly in terms of collective welfare (or, more crudely put, involve social costs that public policy-makers have to deal with). They may be the result of economic cycles that differ from one country to

88

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

another, both in amplitude and in frequency, or of divergent nominal developments that may feed external imbalances within the union, which we studied in Chap. 1 and which cannot be sustained without endangering the union itself. One conclusion must be drawn: The regulation of imbalances within a monetary union cannot depend on monetary policy alone. Other adjustment mechanisms must make it possible to manage structural heterogeneity and ensure the overall cohesion of the union.

This principle is in line with the third criterion developed by Mundell as a condition for an optimal monetary area, that of labour mobility within the union. This mobility can be extended to the various factors of production. What Mundell points out through this condition is precisely the inadequacy of strictly monetary measures to effectively manage a monetary union. In particular, he insists on the need for real mechanisms, such as factor mobility, to balance production conditions in the components of the monetary area and thus ensure its viability and efficiency.

3.2.2

Heterogeneity and Monetary Policy

The structural heterogeneity of a monetary union raises the following questions. 1. Is the business cycle uniform or differentiated according to the components of the union? It is possible to track fluctuations in the aggregate product of the union. In this way, it is possible to study the cyclical characteristics of the union. But the same is true for the aggregate products of the member countries, which also fluctuate and therefore experience cycles. This raises the question of how the cycles of the union and the member countries compare. Let us assume, which is reasonable in view of what we said above, that the union central bank seeks to stabilize the union cycle, practising a counter-cyclical policy and acting restrictively at the top of the cycle (when the union product is above its long-term trend) and accomodating at the bottom of the cycle (when the union product is below its trend). More precisely, the first question is whether the cycle of country j is synchronous with the union-wide cycle or not.4 If it is synchronous, the monetary policy of the union is appropriate for country j . Since it is likely that, for at least a group of union countries (perhaps all of them!), the cycle is not synchronous with the union cycle, monetary policy cannot satisfy the needs of each, even if it is tailored to average needs, as expressed by the union cycle.

4

Technically, two cycles are synchronous when their frequencies are the same and the turning points occur on the same dates.

3.2 Monetary Policy in a Monetary Union

89

The next step is to look at the amplitude of the cycle.5 Let us assume, for the sake of argument, that all the country-specific (national) cycles are synchronous. Some national cycles have a greater amplitude than others, due to the structural heterogeneity of the union. The monetary policy decision is adopted on the basis of the amplitude of the union cycle, i.e. an average of the amplitudes of the cycles of the member countries. It will therefore be too low in view of the needs of countries with a large cyclical amplitude (higher than the average) and too high for the others. Under these conditions, one of the concerns of those responsible for the union’s monetary policy must be to make the cycles, both in frequency and amplitude, of the union’s member countries converge, so as to make the union’s monetary policy as satisfactory as possible for the union as a whole. 2. The inflationary process in the union. A major concern of a central bank is the control of nominal developments, i.e. the rate of inflation. One could reproduce for inflation the previous analysis concerning the cycle and consider that the ultimate objective of the central bank of the union is to ensure the same rate of inflation in the various countries of the union. Structurally, if inflation rates are the same in all member countries and perfectly controlled by the central bank, the terms of trade between member countries are independent of monetary policy. International trade imbalances, and their evolution over time, are then clearly dependent solely on the structural conditions of international competitiveness, and the monetary authority is not involved in resolving these imbalances, whose persistence, as we saw in Chap. 1, raises the problem of the viability of the monetary union. The conduct of monetary policy is simplified in this case since the heterogeneity of inflation rates is eliminated. However, it is not possible to think that this convergence of inflation rates is a preferable configuration to a situation where inflation rates diverge. Certain economic sequences justify a monetary union being characterized by divergences in the nominal developments of the member countries, as our analysis of the terms of trade within the union demonstrates (Sect. 3.4). In the end, inflation rates cannot be expected to be the same in the different countries of the union, either for structural reasons related to their productivity levels or to net financial flows to those countries, or for cyclical reasons, since those countries are at different phases of the cycle. Two consequences follow from this observation: (a) It is difficult to easily diagnose the causes of an inflation differential within the union. This differential may be linked either to a relative deterioration in the productivity of a country that has poor control over the development of its production costs or, to the contrary, to high productivity due to a catchingup process from which that country is benefiting. It can also be due to

5

Technically, the amplitude of the cycle is measured by the standard deviation of the time series under consideration.

90

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

external factors such as capital inflows. However, this difficulty complicates the conduct of the union’s monetary policy, since it makes its action difficult for economic agents to understand, and thus to anchor expectations. (b) It is impossible to assess a country’s relative performance in the union or even the appropriateness of its entry into the union, by means of its inflation differential. A high inflation differential can in fact be explained by the high growth pattern that the union would enjoy once the country has joined. 3. The inflation–unemployment dilemma. Under these conditions, the inflation–unemployment dilemma cannot be expected to be the same in member countries, nor can it be expected to be the same as the inflation–unemployment dilemma when assessed at the union level. However, it depends in all countries on the anchoring of expectations, and this gives the central bank an eminent responsibility. This is one of its key responsibilities. Indeed, the dynamics of inflation differentials, and therefore of inflation–unemployment dilemmas, are conditioned by relative price ratios or terms of trade. These require a nominal anchor that only the central bank of the union can provide. From this perspective, the very heterogeneity of the union requires the central bank to provide a clear and credible monetary policy, allowing in particular an anchoring of the expectations of all the agents operating in the union.

3.2.3

Monetary Policy and Nominal Rigidities in the Monetary Union

Benigno [2] offers important results about this issue. Benigno reasons in a twocountry model, representative of the New Keynesian macroeconomy and characterized by the assumptions of a representative agent with an infinite horizon, monopolistic competition, nominal rigidities and the immobility of residents (immobility of the labour factor). Both countries are characterized by the same forms of nominal rigidity but the degrees of this rigidity may differ between the two countries. Following Woodford [12], Benigno investigates the union central bank’s loss function, whose minimization allows it to be as close as possible to the Paretian optimum based on the individual utilities of the union’s member agents. In other words, Benigno seeks to provide a convincing microeconomic foundation for the welfare criterion (the central bank’s loss function) by which monetary policy is conducted. In particular, the question is whether this function should be based on macroeconomic variables (product and price level) that relate to the union as a whole, or should take into account the dispersion of these variables measured at the regional level. Benigno shows that the answer depends crucially on the degrees of price rigidity existing in the two countries. The inflation target for the central

3.2 Monetary Policy in a Monetary Union

91

bank must be a weighted sum of the inflation rates of the two countries. If the degrees of rigidity are the same in both countries, the weights must be the sizes of the two countries. If they differ, the weight given to a country’s inflation should be an increasing function of its degree of rigidity. In other words, the central bank must give greater weight to the inflation of the country with the highest degree of rigidity.

3.2.4

Taylor Rule and Indicators of Misalignment

In the presence of heterogeneity, the needs of the member countries differ. Monetary policy can be adapted to the aggregate conditions of the union but not to the specific conditions of individual countries. We saw in the previous section that monetary policy is at first sight based on aggregate indicators and may not meet the specific needs of member countries. How can we know whether the common monetary policy is generating tensions within the area or not? To answer this question, let us try to construct “misalignment indicators” of monetary policy, by country.6 We assume that the central bank follows a Taylor rule based on aggregate indicators. The commonly estimated variant of (3.3) is   it = (1 − ρ) ψ + ϕπ πt + ϕy yt + ρit −1 + εt ,   where ψ represents the composite constant term r¯ − απ π ∗ − ϕy y¯ and εt represents an error term (not autocorrelated, identically distributed, i.i.d.). The introduction of the lagged term ρit −1 is intended to capture the inertia of monetary policy and improve the statistical quality of the estimate. The variant applied to the case of a monetary union, assuming that the central bank uses only aggregate indicators, is written as follows:   it = (1 − ρ) ψ U + ϕπ πtU + ϕy ytU + ρit −1 + εtU , U where πtU denotes theinflation rate of  the union, yt denotes the product level of the union, and ψ U ≡ r ∗U + ϕ ∗ π ∗U . εtU is a defined random term for the union, or an aggregate shock. Let us denote ρ, ˆ ψˆ U , ϕˆ π , ϕˆy the estimated values of these coefficients. The (estimated) monetary rule followed by the central bank is written:

   it = 1 − ρˆ ψ U + ϕˆ π πtU + ϕˆy ytU + ρi ˆ t −1 .

6

We are following the study by Quint [8]. Quint refers to “stress indicators.”

(3.10)

92

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

The Construction of a Misalignment Indicator Let us calculate, on the basis of this rule (3.10), the level of the interest rate suitable for a member country j , given its product level and inflation rate. This rate is equal to    j j j j ˆ t −1 , it = 1 − ρˆ ψ j + ϕˆπ πt + ϕˆy yt + ρi j

j

πt denotes the inflation rate of country j , yt its product level and cj ≡  where ∗j ∗ ∗U . Note that the natural interest rate of country j , r ∗j , is not r +ϕ π necessarily equal to the natural interest rate valid for the union. This level of interest rate is not equal to it since inflation rates and product levels differ: there is a “mismatch” for country j . Quint [8] proposes the following misalignment indicator for country j : j

j

st = itU − it .

(3.11)

A zero value of this indicator indicates that the interest rate charged by the central bank corresponds to what the rule followed by the bank would indicate as adequate for country j . A positive value means that the bank’s policy is too restrictive for the needs of country j , a negative value means that it is too accomodative. Finally, the higher the value in absolute terms, the greater the mismatch. It is possible to calculate the average of this indicator over a given period: sj =

1 j s . n t t

(3.12)

This provides an indicator of average misalignment for country j . In the same logic, it is possible to calculate the standard deviation of this indicator over the period:  DtU =

2 n j μ sj,t − stU . (n − 1)

(3.13)

j

This indicator is a measure of the magnitude of misalignments for country j during a given period. It is also possible to construct aggregate indicators of monetary policy misalignments. The first one is defined as the weighted average of the misalignment indicators: sU t =

1 j j μ st , n j

(3.14)

3.2 Monetary Policy in a Monetary Union

93

where μj represents the weight of country j in the union (usually a weight related to its relative demographic size in the union). When these coefficients are equal to 1, the average is unweighted and all countries have the same weight in the indicator. The second one is the standard deviation of these indicators:  2 n j U Dt = μ sj,t − stU . (3.15) (n − 1) j

Calculated for a given date, this last indicator measures the extent to which the monetary policy of the union is inadequate to the idiosyncratic needs of the member countries of the union. A value of zero would indicate that the monetary policy decision, although calculated on aggregate quantities, perfectly corresponds to the decisions that would be taken if they were calculated on country magnitudes. These misalignment indicators are empirical measures that have the advantage of being easily computable and provide information on the consequences of a monetary policy based on union-wide indicators, neglecting by construction country-specific data and considerations. Put another way, they represent a measure of the degree of heterogeneity of a monetary union from a monetary policy perspective. Despite the ease of use of these indicators, they should be analysed or interpreted with caution. On the one hand, these indicators are based on a questionable assumption. They assume that the monetary policy rule is based on a given monetary rule, the central bank’s rule for the union. There is no evidence that this rule should be followed for country j . On the other hand, they are not based on any theory and are difficult to interpret. Lastly, they do not allow any normative analysis of the functioning of a monetary union. They do not measure the impacts of monetary policy on the various countries in the union. They are not derived from a welfare analysis and cannot be interpreted as indicators of the sub-optimality of monetary policy for country j , or of the magnitude of welfare losses in the union because of the central bank’s neglect of the heterogeneity of the union. In short, these indicators, which are debatable in their construction and limited in the interpretation that can be made of them, are rough empirical indicators of the heterogeneity of a union from the point of view of monetary policy. They merely provide a (fragile) answer to the question of whether the monetary policy decision is suited to the heterogeneous macroeconomic conditions of the union.

3.2.5

Misalignment Indicators in the European Case

Quint applied his methodology to the EMU case. Its results are summarized in Figs. 3.2 and 3.3. Figure 3.2 shows the misalignment indicators of by member country. Note that, as expected, the structural heterogeneity of the euro area leads to non-zero indicators of monetary policy misalignment. Second, these indicators

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

Fig. 3.2 Misalignment indicators. Source: Quint [8]

94

Fig. 3.3 Misalignment averages. Source: Quint [8]

3.2 Monetary Policy in a Monetary Union 95

96

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

are persistent: that is consistent with the autocorrelated nature of macroeconomic dynamics. Third, misalignment appears to be particularly strong (and negative, meaning that monetary policy was too accomodating in view of the macroeconomic situation in these countries) for countries on the periphery at the creation of the area, but it has tended to diminish and converge towards zero. For the three main countries of the zone, the misalignment is small and positive (indicating a rather restrictive policy, especially for Germany), while for the small non-peripheral countries, it is small, rather negative and converging towards 0. From 2009 onwards, the shift to a zero-lower-bound policy implies an indicator of zero misalignment for all countries, indicating that this policy is in line with the macroeconomic situation of all countries. Figure 3.3 gives indications of the overall misalignment of monetary policy, as calculated from indicators (3.14) and (3.15). The euro area’s monetary policy seems to have been too restrictive on average, but that overall misalignment has gradually receded, according to the average misalignment indicator (weighted or unweighted). Similarly, the aggregate absolute misalignment indicator given by (3.15) shows a trend towards convergence towards 0, implying a trend towards greater homogeneity of the area. The switch to a zero interest rate policy from 2009 onwards sharply reinforces this homogeneity.

3.3

A Simple Model of Monetary Union

3.3.1

A Monetary Union

Consider a monetary union with J member countries. The model that we study is formed, for each country in the union, on a pair of aggregate supply and aggregate demand functions. We do not consider fiscal issues. For the sake of simplicity, we assume that the countries have an identical economic structure. The relative weight  of country j in the union is nj , assuming Jj=1 nj = 1. There are no lagged variables or expectations in this model, and we omit the time indexes of the different variables. The aggregate product in country j is given by the following equation:   Yj = Yˆ + b m − πj + εj

∀j = 1, ..., J,

(3.16)

where Yj is the aggregate product in country j (logarithmic), Yˆ is the natural aggregate product in country j (logarithmic, assumed to be the same in all countries), πj is the inflation rate in country j and m is the instrument of monetary policy in the monetary union. Defining m as the growth rate of the available money   supply in the economy, m − πj is interpreted as the change in the real money supply in country j .

3.3 A Simple Model of Monetary Union

97

εj is the (real) shock affecting country j ; it is an identically distributed and independent (i.i.d.) random variable of zero expectation and variance σε2 . The real shocks in the different countries come from the same distribution but the realizations in the different countries differ (a priori). The product of the union Yu is defined as the average of national products: Yu = Jj=1 nj Yj . Let us reason in the simplest case: assume that inflation is identical in all the countries of the union: πj = πu . The aggregate good is produced indifferently in any country of the union, it is fully tradable and the law of the single price is valid (no friction in trade between countries). There is a uniform Phillips curve for the union as a whole: the union-wide inflation depends on the aggregate product of the union as well as on a monetary shock ν. ν is an i.i.d. random variable of zero expectation and variance σν2 . Formally, inflation is given by the following equation: πu = π0 + γ Yu + ν.

(3.17)

The endogenous variables in the model are functions of current shocks, instruments and objectives of the monetary authorities. Combining (30) and (31), we obtain Yu =

Yˆ − bπ0 bm − bν + εu Yˆ − bπ0 + bm − bν + εu = + 1 + γb 1 + γb 1 + γb

(3.18)

from which we derive  πu =

π0 + γ Yˆ 1 + γb

 +

bγ m + ν + γ εu 1 + γb

(3.19)

 ˆ −bπ0 defining εu = Jj=1 nj εj . The term Y1+γ b is interpreted as the natural level of the product, obtained in the absence of a shock and εu as the real aggregate shock to the union as a whole.

3.3.2

Central Bank Preferences

The question of the preferences of the union’s central bank cannot be addressed independently of the preferences of the political authorities that govern the member countries, since the central bank acts by delegation from these authorities. Following the logic developed above, we can formalize the preferences of a member country (or its governing authority) by a loss function:     Lj = Lj ω1j , ..., ωmj , ..., ζ j , ... = Lj j , ζ j

∀j = 1, ..., J

98

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

  by defining j ≡ ω1j , ..., ωmj , ... the different arguments ωmj of which are specific to country j . There is political heterogeneity when the functions Lj (·) differ. What about the central bank? We can express its preferences through a loss function. We note LU is the central bank’s loss. Following Sect. 3.3, two options are open for these preferences, that is for constructing the loss function: 1. The central bank can make its decisions with concern for the conditions of the union as a whole. The central bank’s objectives focus on macroeconomic variables in the union: the loss incurred depends solely on macroeconomic arguments about the union. Thus, we have   Lcb = L U , ζ U

(3.20)

defining ζ U ≡ (ζ1U , ..., ζlU , ...). A simple example of this option is the following. The central bank of the union has two objectives: an output objective and an inflation objective. The output objective is denoted Y ∗ . As shown in (3.16), a monetary stimulus varies aggregate output and brings it closer to Y ∗ . But this is at the price of an increase in inflation, following (3.17). Inflation creats distortions and represents a loss of purchasing power on non-inflation-indexed assets, in the first place money. The central bank therefore seeks to reduce it: its objective is πu∗ , which is set at 0 for simplicity. The central bank’s loss function is given by the following formula: Luw =

 2 1  Yu − Yu∗ + λM πu2 , 2

(3.21)

where Yu is defined by (3.18). 2. It may also take its decisions by looking at macroeconomic variables characterizing the member countries. The loss incurred then depends on macroeconomic arguments relating to the union and macroeconomic arguments specific to the different countries of the union. A specification of this option is particularly interesting: the central bank preference function is a weighted average of the preference functions of the political authorities of the member countries. Formally, it is defined as follows: Lcb =

J

ωj Lj .

(3.22)

j =1

Implicitly, the central bank is concerned about the distribution of losses incurred as a result of its policy by member countries. Let us give an example.

3.3 A Simple Model of Monetary Union

99

The government of country j has the following loss function: Lj =

  2 1  Yj − Yj∗ + λj πu2 . 2

(3.23)

The central bank’s loss function is therefore written as follows: Lna =

J

nj Lj =

j =1

  J 2 1 Yj − Yj∗ + λj πu2 . nj 2

(3.24)

j =1

In the first option, the central bank appears as a fully supra-national institution, not only because it controls an instrument7 that is binding on the whole union but also because it is only interested in the overall functioning of the union, disregarding the member countries and their relative situations. In the second option, the central bank appears instead to be dependent on national considerations. As the central bank is the delegate of monetary policy, its objectives are stated in the constitutional texts of the union by the member countries themselves. Their monetary governance choices express their vision of monetary union. The central bank seeks to respond to shocks, once they have occurred, in such a way as to minimize its loss.

3.3.3

The Monetary Policy Decision

To focus the discussion on the importance of whether or not the central bank has an aggregate view of the operation of the monetary union, we assume that the output targets of all policy-makers are identical: Yj∗ = Yu∗ = Y ∗ , ∀j = 1, ..., J .

3.3.3.1 With the Union Loss Function The central bank programme is written: min Luw = mu

7

Or a set of instruments.

 2 1  Yu − Y ∗ + λu πu2 2

100

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

under constraints (3.18) and (3.19). The solution, which we note muw , is8 muw

  Yˆ 1 + λu γ 2 − Y ∗ (1 + γ b) (b − λu γ )    π0 −  =− 2 b 1 + λu γ b 1 + λu γ 2 +

b − λu γ 1  ν − εu .  2 b b 1 + λu γ

(3.25)

Since we are interested in the central bank’s response to shocks to the economy, let us ignore the constants by posing Yˆu = Yu∗ , and π0 = 0. We obtain muw =

1 b − λu γ  ν − εu ,  2 b b 1 + λu γ

(3.26)

and, consequently, the aggregate output is equal to λu γ (1 − γ )  ν. εu −  (1 + γ b) 1 + λu γ 2

Yuw = Yˆ +

(3.27)

Let us calculate the reaction of the monetary decision to the monetary shock ν ∂muw b − λu γ , =  ∂ν b 1 + λu γ 2 which is positive if b > λu γ . When we study the sensitivity of this reaction to the weight λu , we obtain  ∂

∂muw ∂ν



∂λu

=−

γ b (1 + bγ )  2 < 0. b2 1 + λu γ 2

Similarly, we obtain that ∂Yuw λu γ  ν < 0, = − ∂ν 1 + λu γ 2 which is always negative. When we study the sensitivity of this reaction to the weight λu , we obtain  ∂

∂Yuw ∂ν

∂λu

8

 γ = − 2 < 0. 1 + λu γ 2

The calculations are detailed in the Appendix to Chap. 3.

3.3 A Simple Model of Monetary Union

101

The higher the relative weight of inflation, the less the central bank reacts to the monetary shock. The consequence is that inflation reacts less to that shock and, as a result, the aggregate output is less stabilized. Finally, the reaction of the monetary decision to the real shock εu ∂muw 1 =− ∂εu b is independent of the relative weight of inflation.

3.3.3.2 With an Aggregation Loss Function Now consider that the central bank’s loss function is the sum of the government’s loss functions, given by (3.24). The central bank programme is written:  2 1  = nj Yj − Y ∗ + λj πu2 2 J

min Lna mu

j =1

under constraints (3.18) and (3.19). The solution, which we note mna , is given by the following equality

mna

      b − λ¯¯ γ − Yˆ − Y ∗ (1 + γ b) − λ¯¯ γ π0 + γ Yˆ 1    ν − εu +  = ¯ ¯ b 2 2 b 1 + λ¯ γ b 1 + λ¯ γ

(3.28)

J defining λ¯¯ = j =1 nj λj . By comparing (3.25) and (3.28), two differences can be noted: the constant terms differ and so do the coefficients of the nominal shock, which are affected by the relative weights of inflation. The two expressions are equal (muw equals mna ) if λ¯¯ = λu . This is satisfied if λj = λ, ∀j = 1, ..., J , i.e. when there is strict structural similarity between the economies of the union countries. We would find an equivalent qualitative result if we had reasoned about differences in constant terms Yˆj , output targets Yj∗ and Yu∗ , or inflation targets πj∗ (targets that we have so far assumed to be zero for all countries and for the central bank reasoning about the union as a whole). The conclusion we draw from this small model is that the definition of the mandate of the union central bank is essential and has a strong impact on the monetary policy it conducts. In particular, as announced in the previous chapter, a central bank that takes its decision on the basis of the functioning of the union economy as a whole will have a different policy from that based on the preferences of the public authorities in the union countries.

102

3.4

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

Traded Goods, Terms of Trade and Monetary Policy

The previous model fails to take into account trade between member countries, or what is known as the relative “competitiveness” of these countries, a problem whose importance we stressed in the first chapter. Let us develop a variant of the model which includes the terms of trade and show how this affects the monetary policy of the union. We consider a monetary union with two countries of the same size and disregard the constants in the various equations of the model. The economies of the member countries are made up of two production sectors, one producing goods that are traded throughout the union and thus subject to competition, and the other producing goods that are not traded and are not subject to competition, and are not priced according to demand from the union. Formally, inflation in country j , j = 1, 2, is given by the following equation: πj = μtj + (1 − μ) hj + νj ,

(3.29)

where tj represents inflation of goods exchanged for (sold by) j , and hj the domestic inflation specific to j , relating to non-traded goods. The country-specific monetary shock, νj , is a white noise, an i.i.d. random variable of zero expectation and variance σν2 . The terms of trade for country 1 are defined by q1 = t1 − t2 and identically for country 2: q2 = t2 − t1 . μ represents the degree of openness of the member countries, assumed to be identical for both countries, or equivalently the relative share of the traded goods sector. We assume that, in the “non-traded” sector, domestic inflation is indexed to the total inflation: hj = πj . We obtain πj = tj +

νj μ

πu = tu +

νu μ

from which we deduce that

with tu = 12 (t1 + t2 ) and νu = following equation:

1 2

(3.30)

(ν1 + ν 2 ). Country j output is given by the

Yj = b (m − πu ) − qj + εj ,

(3.31)

where the real shock of country j , εj , is an i.i.d. random variable of zero expectation and variance σε2 . Since the sum of the terms of trade is zero, we get Yu = b (m − πu ) + εu with εu =

1 2

(ε1 + ε2 ).

(3.32)

3.4 Traded Goods, Terms of Trade and Monetary Policy

103

The traded goods inflation of country j is given by tj = γ Yj − ρj ,

(3.33)

where ρj represents the change in productivity in country j , which we treat as a random shock, i.i.d., of zero expectation and variance σρ2 . Inflation of traded goods increases with the product of country j and decreases with productivity gains.

3.4.1

With a Union-Wide Loss Function

Suppose the central bank is concerned about the state of the monetary union. Formally, the central bank’s loss function is given by (35). The central bank’s programme is min Luw = mu

 2 1  Yu − Y ∗ + λu πu2 2

(3.34)

under constraints (3.30), (3.32) and (3.33). The optimal solution denoted by muwt is given by the following equality muwt =

1 b − λu γ νu b + λu γ   ρu  − εu −  2 b b 1 + λu γ μ b 1 + λu γ 2

(3.35)

with ρu = 12 (ρ1 + ρ2 ). The similarity between (3.25) and (3.35) is clear: both solutions have the same linear form. The differences are twofold: on the one hand, the impact of the monetary shock is affected by the degree of openness μ; on the other hand, an aggregate productivity shock term, ρu , appears. Monetary policy is affected by the degree of openness of the monetary union economies μ. However, the terms of trade are not affected by monetary policy. According to (3.30), (3.31) and (3.33):        νj Yj = b m + ρj − − γ Yj − Y−j − ρj − ρ−j + εj . μ   We deduce that Yj − Y−j is not affected by monetary policy, nor are the terms of trade affected by monetary policy, since according to (3.33):     qj ≡ tj − t−j = γ Yj − Y−j − ρj − ρ−j . This result is due to the strict symmetry assumed between the two countries. This strict symmetry allows us to disregard the external balances of the member countries, which are implicitly assumed to balance over time.

104

3.4.2

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

With a Summation Loss Function

Now consider that the central bank’s loss function is the sum of the government’s loss functions, given by (3.24). The central bank programme is: min Lna = mu

 1  2 2  1  nj Yj − Y ∗ + λj πu2 = nj Yj − Y ∗ + λu πu2 2 2 J

J

j =1

j =1

under constraints (3.30), (3.31) and (3.33) and here λu ≡ We get: Yj =

1 1 + (1 + b) γ

1 2

J

j =1 (λu

+ λu )2 .

  νj bmu + γ Y−j + (1 + b) ρj − ρ−j + εj − b μ

and πu =

γ γ γ 1 νu bmu − ρu − εu + . 1 + bγ 1 + bγ 1 + bγ 1 + bγ μ

The optimal solution is given by the following formula: mnat

  νu 1 (b − λu γ )  ρu − =γ  − εu . 2 μ b b 1 + λu γ

(3.36)

It differs from the one obtained in the previous subsection by the presence of the parameter γ in the first term of the right-hand side of the equation. Note that aggregate output of country j depends on the output of country −j . By taking into account the national loss functions, the monetary authority reacts indirectly to crossborder effects (via the parameter γ , which relates to the inflation of the traded good). This explains the differences in the response to shocks between monetary policy and monetary policy for the union as a whole. Here again, the terms of trade are not affected by monetary policy because of the assumption of symmetry between the two countries. A more complicated model, in which the methods of price determination in the two sectors would be more detailed, the competitiveness effects better micro-founded, and the external constraint on the two countries taken into account, would make it possible to reverse this result and show that the terms of trade, a simple indicator of the competitiveness of the member countries, are a function of monetary policy. This makes sense. In a multi-currency world, where financial flows are neglected because they are considered to have no impact on exchange rates, a flexible exchange rate system is traditionally credited with the quality of making the monetary policies of the various countries independent of the external balance. The suppression of exchange rates ipso facto restores the link between monetary policy and external trade within the union. The lesson is clear: the central bank of

3.4 Traded Goods, Terms of Trade and Monetary Policy

105

a monetary union cannot abstract itself from trade and thus from the terms of trade within the union.

3.4.3

With Asymmetry

Let us show that the terms of trade, or the competitiveness of member countries, are a function of monetary policy in an asymmetric union. We remove the assumption of symmetry of countries, specifically the assumption of the same size. Assume that country j is of relative size nj , where n1 + n2 = 19 and n1 = n2 . We ignore the shocks (ρ1 = ρ2 = υ1 = υ2 = 0) for simplicity. Union inflation is now written: πu = n1 π1 + n2 π2

(3.37)

instead of (3.30). From (3.33) we obtain πu = γ (n1 Y1 + n2 Y2 ) . Using (3.31), we obtain Yu ≡ (n1 Y1 + n2 Y2 ) = b (m − πu ) − (n1 − n2 ) q1

(3.38)

from which Yu (1 + bγ ) = bm − (n1 − n2 ) q1 , which implies q1 =

bm − Yu (1 + bγ ) . (n1 − n2 )

(3.39)

The terms of trade, given by q1 for country 1, are not zero, except if m = Yu (1 + bγ ) /b. They are affected by the monetary policy measure m. This result is consistent with simple macroeconomic reasoning. Suppose that, in each of the union economies, the inflation–unemployment trade-off is given by a simple Phillips curve: wages are a non-linear decreasing function of unemployment and there is a price–wage loop through costs. Suppose that the large economy is in recession while the small economy is expanding. Through a trade-off between inflation and unemployment at the union level, the union’s monetary policy is accomodative. This has a pro-cyclical effect on the small economy in which wages rise more sharply than in the large economy: the terms of trade deteriorate in favour of the large economy as a result of the monetary policy action. In this model, this

9

We normalize the union size to 1.

106

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

deterioration plays a balancing role between the two economies: the small economy is held back and the large economy is stimulated.

3.5

Non-conventional Monetary Policy in a Monetary Union

3.5.1

From Conventional to Non-conventional Policy

The 2007 financial crisis in the United States caused a major global economic and financial crisis in September 2008 and led to a major shift in monetary policy in the major currency areas of the world economy: central banks moved to a nonconventional form of monetary policy. Banks were unable to continue to influence short-term interest rates through free intervention in the very short-term liquidity markets, which is the conventional and usual form of monetary policy. Such a policy has a logical limit: the so-called zero-lower-bound. It has long been recognized that there is a lower limit below which the nominal interest rate cannot fall since agents at some point prefer to hold all their assets in the form of cash. This configuration is referred to as a “liquidity trap.” Such a limit was reached in Japan in 1999, and the short-term interest rate has remained close to zero since then, without the Japanese economy emerging from the anaemia that began in 1990. The zero-lower-bound not only renders monetary policy inoperative, it changes the transmission channels for shocks. Assuming that monetary policy is neutralized, a phase of deflation can no longer be countered by monetary policy. Under these conditions, it raises the real interest rate and slows investment and consumption in durable goods, which feeds deflation itself. A vicious circle is set in motion. Actually, things are not that simple. There is not a single interest rate but a range of rates, depending on the characteristics of the assets being traded, in particular their maturity and the risks they bear. By arbitrage, these rates are interdependent and this interdependence constitutes the term structure of interest rates. The very short-term interest rate makes it possible to situate the other rates according to this structure (this is known as the “sloping-up” of the yield curve). Conventional monetary policy consists, by varying the very short-term rate, in getting all rates to move, thus influencing investment and consumption decisions and the dynamics of aggregate demand. For the sake of simplicity, it is customary to think in terms of a single rate (considering the consequences of this variation on the term structure of interest rates as given and known). The nullity of this rate does not imply the nullity of all the other rates but their reduction. Monetary policy remains operative provided that it is able to act on these rates. It is described as “non-conventional” insofar as it is based on instruments other than the short-term interest rate. A first non-conventional policy consists in compensating for the inefficiency of central bank action through the (very short-term) money market interest rate by acting on long-term rate expectations. This action consists of “forward guidance.” It is a communication policy that seeks to credibly establish the future path of short-

3.5 Non-conventional Monetary Policy in a Monetary Union

107

term interest rates, in a generally very accomodative direction, via the term structure of interest rates. Other non-conventional monetary policies increase (and decrease) the size or composition of the central bank’s balance sheet. In doing so, they increase (or seek to increase) monetary liquidity (as assessed by the various money supply aggregates) by increasing the liquidity provided to the banking system. “Quantitative easing” consists in increasing the reserves of commercial banks with the central bank and therefore relates to the liability side of the central bank’s balance sheet. “Credit easing”, on the other hand, focuses on the asset side of the central bank’s balance sheet and seeks to change the relative shares of commercial securities and bonds (especially Treasury bills) with the aim of facilitating the supply of credit to firms and investors. It is therefore possible to conduct monetary policy even when the zero-lowerbound has been reached. The risks posed by non-conventional monetary policies should not be underestimated: 1. Logically, a non-conventional policy is accomodative because it seeks to revive the economy and eradicate the risk of deflation. The recovery of the economy and the resumption of inflation that is supposed to follow should allow the zero interest rate limit to be lifted in the long term and allow a return to a conventional policy. 2. This accomodating character is linked to a lowering and flattening of the yield curve. The support of monetary policy is therefore no longer liquidity. The logic of arbitrage on the financial markets implies that this action durably constrains the central bank’s commitments. This represents a loss of monetary policy flexibility since the central bank’s hands are tied. In technical terms, it can be shown that the temporal impact of a non-conventional policy exceeds the nominal duration of the assets on which the bank intervenes. However, if a shock occurs later inducing a change in policy, the central bank would put itself in a situation of temporal inconsistency. This has a cost: the credibility of the central bank. To sum up, a non-conventional policy makes it more difficult to conduct a flexible monetary policy that is responsive to shocks, and credibility is at risk. 3. A non-conventional policy calls into question the separation principle since macroeconomic stabilization policy involves inflating the central bank’s balance sheet and, implicitly, manipulating its components, thus directly intervening in the method of financing institutions, non-financial agents, and State. 4. A (quasi-)liquid asset is by and large a risk-free asset, in particular one without nominal risk. This is not the case with an asset with a longer maturity. By purchasing such an asset, the central bank de facto assumes the risk of default by its issuer. By implementing a non-conventional policy, a central bank changes its management logic, accepting risks transferred by financial agents. 5. Finally, a non-conventional policy is less neutral vis-à-vis the economy. The central bank is not just modifying the operating conditions of the market by intervening minimally and rapidly in the least exposed financial market, i.e. the liquidity market, but is taking durable market positions. Non-conventional

108

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

policy represents greater interference with the banking system (in the case of credit easing) and with fiscal policy (in the case of quantitative easing).10 For an institution acting by delegation and often under conditions of great independence, this is an uncomfortable situation, to say the least. What these options have in common is that they all involve monetary issuance, usually on a lasting basis. This issue is supposed to contribute to the resumption of inflation, or to allow a revival of activity via monetary depreciation. This is logical and desirable if the objective is to counter agents’ appetite for liquidity or to escape the liquidity trap.

3.5.2

Non-conventional Policy in Monetary Union

Reasoning in a monetary union makes it considerably more difficult to set up and conduct non-conventional policy.

3.5.2.1 The Transition to Non-conventional Policy The first question is whether, once the zero rate limit is reached, the shift to a nonstandard policy is appropriate for all components of the union. Heterogeneity factors, coupled with cross-border effects, are at work in the shift to non-conventional policy. The structural heterogeneity of the components may relate to financial behaviour. Residents of different countries may have different attitudes to holding money and, more generally, to saving choices (in terms of quantity and portfolio choices). This may be explained by history, technological arrangements for investments and transactions, or sociological habits with regard to the use of money. Similarly, if the attainment of the zero interest rate limit is the result of sudden changes in risk behaviour (which occurred from 2008 onwards), these changes may not be identical in the member countries. Even if the union as a whole is in a depressed state that justifies lowering the policy rate to its lowest limit, some components may be in a relatively favourable situation for which a non-conventional policy is not required. Let us assume that this is unlikely to be the case. The zero bound occurs in a severely and persistently deteriorated situation. It is unlikely that any component of the union can escape this very bad situation. On the other hand, the very poor economic situation logically accentuates the differences between the components of the union, some of which suffer more than others by virtue of a property of the “weakest link”: the difficulties tend to concentrate on the structurally most fragile component of the union. 3.5.2.2 Which Policy Should Be Pursued? Once the zero rate limit has been reached, the question arises as to which nonconventional policy to adopt. A major difficulty immediately arises. It is logical to wish the non-conventional policy to share in monetary union with the conventional policy the property of 10 On

this point, see Buiter [4].

3.5 Non-conventional Monetary Policy in a Monetary Union

109

globality (in objectives and instruments). In concrete terms, the central bank a priori treats banking systems and public securities of the components of the union in an equivalent manner. However, some components have worse financial situations than others. Non-conventional policy cannot ignore these situations and thus run the risk of appearing to be biased and taking sides in the conflicts of interest that are always likely to arise in a monetary union. This difficulty does not arise in the same way depending on the options chosen: 1. As we have seen, the forward guidance policy is the least radical of the nonconventional policies. However, since it implies a rigid interest rate structure, in a monetary union it represents a risk of increasing and rendering more persistent the heterogeneity of the components in terms of monetary needs. 2. Credit easing aims to relieve banks’ balance sheets so that they can resume the distribution of credit to non-financial agents. Banks in a fragile situation benefit relatively more than others. Thus, this policy contributes to distorting competition among banks. Moreover, it runs the risk of postponing until later the consolidation of the financial environment in which economic agents operate. The unhealthy nature of this environment may well be one of the major causes of the very poor economic situation in the union. 3. Quantitative easing poses similar problems. The purchase of public securities by the central bank amounts to substituting in the private portfolios (of financial institutions or non-financial agents) a security yielding a positive nominal interest but with a risk of sovereign default by money implying a zero nominal rate but opening the risk of a nominal depreciation by inflation. This amounts to allowing a transfer of risk from bondholders to liquidity holders throughout the union. Depending on the allocation of these securities, this risk transfer leads to a crossborder allocation effect. Then the question arises as to which government securities the central bank should buy. If there is a federal structure supported by the monetary union, the simplest and politically painless solution is to buy federal bonds. If such a structure does not exist, the central bank must buy securities issued by member States, the public financial situations of which are more or less sound. These purchases are particularly useful for States with a fragile financial situation (highly indebted and for which rates are high). In addition, the central bank assumes fiscal risks and bears the consequences for the whole of the union, including “virtuous” countries with sound public finances. Again, there is a crossborder redistributive effect in the event of a sovereign default, via the losses incurred by the central bank and borne by all residents of the union. This is a politically sensitive issue. In the case of the euro area, such a concern explains, in the case of the euro area, the desire of the German political authorities since 1995 to make it impossible for certain member countries to be lax in their fiscal policies. The problem of the heterogeneity of member States’ financial positions is a major source of fragility in the euro zone. In a monetary union, it should be noted that the redistributive effect depends on the composition of the “basket” of public securities of the member countries

110

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

purchased by the central bank. This opens up the possibility of defining rules for the composition of this basket such that any transfers are either zero or reduced to a minimum (De Grauwe and Ji [5]). 4. In any event, the questioning of the principle of separation implied by nonconventional policy places the central bank at the heart of the financing arrangements for agents, and in particular for States. In a monetary union, especially a multi-national one, this means influencing the political balance between jurisdictions.

3.5.2.3 The Effectiveness of Non-conventional Policy The rationale for a non-conventional policy is to reduce the attractiveness of liquidity and induce agents to change their attitudes to risk (make them less riskaverse). This is done through two channels: 1. Greater predictability of the future, leading to a reduction in the uncertainty premiums included in interest rates. Lower interest rates should, as in the case of conventional policy, contribute to economic recovery. 2. The transfer of risk from financial (mainly banks) and non-financial agents to the central bank, with the hope that the restoration of the balance sheet positions of these agents will allow the recovery of aggregate investment and consumption of durable goods, in particular thanks to a less restrictive bank credit policy. But the central bank must be vigilant because this transfer must be such that the increase in idiosyncratic risks assumed by the central bank (due to the increase in its balance sheet) will not materialize (or will be insignificant). The forward-looking guidance policy is an example of a policy aimed exclusively at the first channel. Other non-conventional policies seek to activate both channels simultaneously. Under these conditions, economic logic dictates that the central bank of a monetary union should come to the rescue of the most fragile banks and the most indebted member States, since these are the ones that pose the greatest risk to the union. The danger is obvious: if the political conditions are such that this aid generates significant and widespread moral hazard effects, it leads to a situation contrary to what is sought. It can be analysed by agents as evidence of the intrinsic weakness of the central bank and its inability to significantly reduce global and sectoral risks. The non-conventional policy becomes inoperative and may even aggravate the situation it is supposed to combat. Thus the segmentation of a monetary union makes a non-conventional monetary strategy more riskier than in the case of a unified economy. Moreover, non-conventional policy is less effective when it coincides with structural policies that aim to increase the risk-taking behaviour, particularly through investment (Eggertsson et al. [6]). This is the difficulty that the euro area has encountered since 2008, when the first non-conventional measures were taken by the European Central Bank.

3.6 Conclusion

111

A non-conventional policy is more difficult to define and implement in a monetary union, especially a multi-national one, than in a unified economy. 1. The dilemma between the need for flexibility and monetary policy rigidity is more acute here, complicated by the structural heterogeneity of the union, which means that its components have different cyclical needs. 2. The risk management issues that are at the heart of non-conventional policies are more difficult to disentangle and deal with in a monetary union, particularly a multi-national one. The transfer of risk to the central bank is more delicate and may give rise to conflicts of interest between member countries. The central bank may become involved in these conflicts because the measures it is called upon to take may amount to support for certain components of the union, the weakest and most exposed to deteriorating economic conditions. Thus, non-conventional monetary policy poses new problems of implementation and conduct, linked to the heterogeneity of the productive structures and the fiscal differentiation of the union. It is likely to increase the union’s internal heterogeneity. But these problems are of the second order in relation to the need to conduct an effective monetary policy in the event of a liquidity trap, or in the event of excessively risk-averse behaviour leading to an overvaluation of liquidity and nonrisky assets at the aggregate level.

3.6

Conclusion

Monetary policy is always the result of trade-offs: between objectives, between the desire to wait for better and more complete information and the fear of intervening too late and too little, between the need for the decision to be easily understood and therefore simple and the inadequacy of instruments in the face of the complexity of the economic situation. In a monetary union, these different trade-offs are made more complex by the heterogeneity of the union. The monetary policy conducted by the central bank in a monetary union is therefore more complicated to conduct, explain and decipher than in a unified economy. Moreover, the more asymmetric a monetary union is, either in its structures or in its exposure to exogenous shocks, the more asymmetric are the effects generated by monetary policy. Monetary policy can manage them, and it cannot eliminate them. More importantly, it can generate new forms of heterogeneity. Indicators of misalignment in monetary policy give a rough but telling indication of the inadequacy of monetary policy to the economic conditions of a component of the union. It is reasonable to assume that monetary policy will be conducted with reference to the union as a whole, in terms of both objectives and instruments, primarily for reasons of readability. A policy, which focuses on the aggregate functioning of the union but not on its parts, cannot escape the fact that it generates redistributive or sectoral effects in the union, which often cut across the borders of the member countries, particularly if the union is multi-national.

112

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

Similarly, the introduction of non-conventional monetary measures is confronted with equally clear redistributive effects. Through the counterparts to the monetary base that it chooses to accept, the central bank is likely to give a relative advantage to a particular country or region in the union. Similarly, the financial stability concerns that legitimize the bank’s intervention as lender of last resort in the event of a banking crisis lead to cross-border reallocation effects. These effects should not be exaggerated in the case of normal economic conditions. But they are certainly magnified in the case of a crisis configuration. These cross-border reallocation (redistributive) effects of monetary policy explain the importance of the governance (institutions) of the central bank of the Union. The various modelling cases of a monetary union, centred on the optimal monetary policy decision, that we have just studied, have enabled us to put forward the following results: 1. The definition of the objectives assigned to the central bank plays a major role in the monetary policy decision. In particular, a central bank with objectives for the union as a whole conducts a monetary policy that is significantly different from that of a central bank that bases its decision on the aggregation of the preferences of the political authorities of the member countries. 2. The monetary policy decision takes into account the terms of trade between the member countries of the union when there is productive heterogeneity within the union, even if its objectives—output and inflation—are defined at the level of the union as a whole. Conversely, the terms of trade are affected by monetary policy. It is not possible to dissociate monetary policy and the analysis of cross-border flows within the union. Put another way, monetary policy affects the distribution of productive activities in the union. These qualitative results, even if they have been obtained through very simple models, characterize any monetary union. They are themselves an expression of the heterogeneity of the member countries of the union, whether it concerns the preferences expressed by the political authorities of these countries or the very structure of their economies.

A Simple Model of a Monetary Union • Equation for the aggregate product in country j :   Yj = Yˆ + b m − πj + εj

Yu =

J j =1

nj Yj

∀j = 1, ..., J

(3.40)

(3.41)

3.6 Conclusion

113

• Equation for the union aggregate product: Yu =

Yˆ − bπ0 bm − bν + εu Yˆ − bπ0 + bm − bν + εu = + 1 + γb 1 + γb 1 + γb

(3.42)

• Equation for inflation:  πu = defining εu =

π0 + γ Yˆ 1 + γb

 +

bγ m + ν + γ εu 1 + γb

(3.43)

J

j =1 nj εj .

Solution for 3.3.3.1 (With the Union Loss Function) Here we study the case of a union-based loss function: Luw =

 2 1  Yu − Yu∗ + λM πu2 2

(3.44)

The first-order condition is   ∂Luw bγ b + λu πu = 0 = Yu − Y ∗ · ∂mu 1 + bγ 1 + bγ

(3.45)

equivalently: 

 Yu − Y ∗ = −λu γ πu

which implies 

Yˆ − bπ0 bm − bν + εu − Y∗ + 1 + γb 1 + γb



 = −λu γ

π0 + γ Yˆ 1 + γb



 bγ m + ν + γ εu + 1 + γb (3.46)

Hence: 

b + λu bγ 2 m 1 + γb

 =−

  Yˆ − bπ0 − Y ∗ (1 + γ b) − bν + εu 

− λu γ

1 + γb   π0 + γ Yˆ ν + γ εu + 1 + γb 1 + γb

114

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

We derive the solution denoted by muw :

muw

muw

  π0 + γ Yˆ + ν + γ εu Yˆ − bπ0 − Y ∗ (1 + γ b) − bν + εu =− − λu γ b + λu bγ 2 b + λu bγ 2   Yˆ 1 + λu γ 2 − Y ∗ (1 + γ b) (b − λu γ ) π0 b − λu γ   +  ν +  =− 2 2 b 1 + λu γ b 1 + λu γ b 1 + λu γ 2 −

1 + λu γ 2  εu  b 1 + λu γ 2

    We neglect the constant term (assuming Yˆ 1 + λγ 2 − Y ∗ (1 + γ b) = π0 = 0). We get muw =

1 b − λu γ  ν − εu  2 b b 1 + λu γ

Since : Yu = Yˆ +

bm − bν + εu , 1 + γb

the solution for this case which we denote by Yuw is equal to:  Yuw = Yˆ +

b

(b−λu γ ) ν b(1+λu γ 2 )

 − b1 εu − bν + εu

1 + γb

(b−λu γ ) −b λu γ λu γ (1+λu γ 2 ) ˆ  ν = Yˆ −  ν ν = Yˆ −  =Y+ 1 + γb 1 + λu γ 2 1 + λu γ 2

Solution of 3.3.3.2 (With an Aggregation Loss Function) Here we study the case of a summation loss function: Lna =

J j =1

nj Lj =

  J 2 1 Yj − Yj∗ + λj πu2 nj 2 j =1

(3.47)

3.6 Conclusion

115

The first-order condition is   N N   ∂Luw bγ bγ ∗ = ni Yi − Y · b 1 − λi + πu ∂m 1 + bγ 1 + bγ i=1

=

N

i=1

  ni Yi − Y ∗ ·

i=1

denoting λ¯¯ =

N 



b 1 + bγ



+ λ¯¯ πu

bγ 1 + bγ

λi .

i=1

  = Yu − Y ∗ ·

b bγ ¯¯ + λπ =0 u 1 + bγ 1 + bγ

(3.48)

Hence:   Yu − Y ∗ = −λ¯¯ γ πu   π0 + γ Yˆ + bγ m + ν + γ εu bm − bν + εu − Y ∗ = −λ¯¯ γ Yˆ + 1 + γb 1 + γb Equivalently: 

   Yˆ − Y ∗ (1 + γ b) + bm − bν + εu = −λ¯¯ γ π0 + γ Yˆ + bγ m + ν + γ εu

which gives

mna

        ¯¯ ν − 1 + λγ ¯¯ ¯¯ 2 ε − Yˆ − Y ∗ (1 + γ b) − λγ b − λγ π0 + γ Yˆ u     = + ¯¯ 2 ¯¯ 2 b 1 + λγ b 1 + λγ

Solution for 3.4.1 (With a Union-Wide Loss Function) (Constants are omitted for sake of simplicity.) Inflation in country i is given by πi = μti + (1 − μ) hi + νi

(3.49)

Terms of trade for country 1 is q1 = t1 −t2 and identically for country 2: q2 = t2 −t1 . As it is assumed that hi = πi , we get: πi = ti +

νi μ

116

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

hence: πu = tu +

νu μ

(3.50)

with tu = 12 (t1 + t2 ) and νu = 12 (ν1 + ν 2 ). Inflation for traded goods for country i is given by ti = γ Yi − ρi

(3.51)

and aggregate output in country i : Yi = b (m − πi ) − qi + εi hence Yu = b (m − πu ) + εu since the sum of terms of trade is null. Therefore:   νu + εu Yu = b m − γ Yu + ρu − μ with ρu =

1 2

(ρ1 + ρ 2 ). We get Yu = =

b 1 b b νu m+ ρu − + εu 1 + bγ 1 + bγ 1 + bγ μ 1 + bγ

b νu 1 b m− + (εu + bρu ) 1 + bγ 1 + bγ μ 1 + bγ

(3.52)

Using this equation in (3.50) we get  πu = γ =

 b νu 1 b νu m− + (εu + bρu ) − ρu + 1 + bγ 1 + bγ μ 1 + bγ μ

1 νu γ γb 1 m+ + εu + ρu 1 + bγ 1 + bγ μ 1 + bγ 1 + bγ

The CB’s programme is min Luw = mu

 2 1  Yu − Y ∗ + λu πu2 2

(3.53)

3.6 Conclusion

117

such that (3.52) and (3.53). We assume Y ∗ = 0. The first-order condition is bγ b ∂Luw + λu πu = 0 = Yu · ∂mu 1 + bγ 1 + bγ

(3.54)

equivalently: Yu = −λu γ πu The following equality obtains b νu 1 b mu − + (εu + bρu ) = 1 + bγ 1 + bγ μ 1 + bγ  = −λu γ

γ γb 1 νu 1 mu + + εu + ρu 1 + bγ 1 + bγ μ 1 + bγ 1 + bγ



equivalently:   b 1 + λu γ 2 b − λu γ νu b + λu γ 1 + λu γ 2 mu = − εu − ρu 1 + bγ 1 + bγ μ 1 + bγ 1 + bγ The optimal decision is denoted by muwt and is equal to: muwt =

1 b − λu γ νu b + λu γ   ρu  − εu −  2 b b 1 + λu γ μ b 1 + λu γ 2

Let us now assume that hi = ξ m: domestic inflation is indexed on the growth of money supply. We get πi = μti + (1 − μ) ξ m + νi

(3.55)

Hence: πu = μtu + (1 − μ) ξ m + νu = μγ (Yu − ρu ) + (1 − μ) ξ m + νu

(3.56)

Aggregate output in country i is given by the following equation: Yi = b (m − πi ) − qi + εi which implies Yu = b (m − πu ) + εu

(3.57)

118

3 Monetary Policy in a Monetary Union: Lessons from Simple Models

We get πu = μtu + (1 − μ) ξ m + νu = μγ (Yu − ρu ) + (1 − μ) ξ m + νu = μγ ((b (m − πu ) + εu ) − ρu ) + (1 − μ) ξ m + νu equivalently: πu =

(μγ b + (1 − μ) ξ ) m + μγ εu + νu − μγρu (1 + μγ b)

Since the first-order condition is not modified, we get m=

1 (b − λu γ ) πu − ε u b b

and the solution is muwt b =

(b − λu γ ) (μγ εu + νu − μγρu ) − (1 + μγ b) εu     b b 1 + λu γ 2 μ − (b − λu γ ) ((1 − μ) ξ )

Solution for 3.4.2 (With a Summation Loss Function) The programme of the central bank is  2 1  nj Yj − Y ∗ + λj πu2 2 2

min Lna = mu

j =1

2  1  nj Yj − Y ∗ + λu πu2 2 2

=

j =1

such that (3.56), (3.57) and (3.51). We define λu ≡

1 2

simplicity we assume Y ∗ = 0. Combining the various equations of the model we get Yj =

1 1 + (1 + b) γ

2  j =1

(λ1 + λ2 )2 . Again for

  νj bmu + γ Y−j + (1 + b) ρj − ρ−j + εj − b μ

and πu =

γ γ γ 1 νu bmu − ρu − εu + 1 + bγ 1 + bγ 1 + bγ 1 + bγ μ

References

119

The first-order condition, using the above equations, is b γb ∂Lna + λu πu = 0 = Yu ∂mu 1 + bγ 1 + bγ As:  Yu =

1 1 + bγ

  νu bmu + bρu − b + εu μ

the optimal decision denoted by mnat is equal to: mnat

  νu 1 (b − λu γ )  =γ ρu − − εu 2 μ b 1 + λu γ b

References 1. Bénassy-Quéré A, Pisani-Ferry J, Jacquet P, Coeuré B (2010) Economic policy: Theory and practice. Oxford University Press, Oxford 2. Benigno P (2004) Optimal monetary policy in a currency area. J Int Econ 63:293–320 3. Bordes C, Clerc L (2013) The ECB’s separation principle: does it ‘rule OK’? From policy rule to stop-and-go. Oxford Econ Pap 65:i66–i91 4. Buiter W (2015) Remarks. In ECB Forum on Central Banking, Unemployment and inflation in the euro area: why has demand management failed so badly?, Sintra, 22 mai 2015 5. De Grauwe P, Ji Y (2016) How to reboot the Eurozone and ensure its long-term survival. In Baldwin R, Giavazzi F (eds) How to fix Europe’s monetary union. VoxEU, pp 137–150 6. Eggertsson G, Ferrero A, Raffo A (2014) Can structural reforms help Europe? J Monetary Econ 61:2–22 7. European Central Bank (2020) Consolidated balance sheet of the Eurosystem as at 31 December 2020. https://www.ecb.europa.eu/pub/annual/balance/html/ecb.eurosystembalancesheet2020~ 0da47a656b.en.html 8. Quint D (2014) Is it really more dispersed? Measuring and comparing the stress from the common monetary policy in the euro area. Freie Universität Berlin, School of Business and Economics: Economics, Discussion Paper n◦ 2014/13 9. Renton C, Patiño R, Yang S, Wang A (2020) A Primer on the European Central Bank. LSE SU Central Bank Society. https://lsecentralbanking.medium.com/a-primer-on-the-europeancentral-bank-d6b63bc827f1 10. Taylor J (2006) Discretion versus policy rules in practice. In: Carnegie-Rochester Conference Series on Public Policy, vol 39, pp 195–214 11. Walsh C (2019). Monetary theory and policy. MIT Press, Cambridge, MA 12. Woodford M (2003) Interest and prices. Princeton University Press, New York

4

Institutions and Monetary Policy

Abstract

This chapter is devoted to the monetary institutional design of a monetary union. The argument that a monetary union allows an incoming country to import credibility is discussed. Centred on the inflation bias issue, it shows that the results obtained in a simple economy do not apply straightforwardly in a monetary union. Delegating monetary policy to an independent central banker does not necessarily reduce the inflation bias as the nomination procedures based on bargaining introduce new strategic channels. The issues of nomination of a monetary policy committee, accountability and transparency are also addressed in this chapter.

In this chapter, the second question mentioned in the introduction to the previous chapter is addressed: once the importance and complexity of monetary policy in a monetary union have been recognized, what should be the legal and operational framework for the central bank? What should its governance be? What should its tasks be? How should monetary policy and its response to macroeconomic disturbances be designed? Central bank governance is an issue that became increasingly important as the responsibilities of this institution have grown in modern economies where liquidity is largely dematerialized. In particular, the question of its independence from political powers arose both practically and theoretically. This is particularly relevant in the context of a monetary union, especially if it is multi-national since the political powers involved are by construction multi-national. But new questions arise, particularly in relation to the collegiality of decision-making. The aim of this chapter is to see how the major issues currently being discussed with regard to central bank governance and the conduct of monetary policy arise and are amended in monetary union. We shall reason in a multi-national monetary union since the plurality of national political powers makes the problem complex. Indeed, © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_4

121

122

4 Institutions and Monetary Policy

the various aspects of central bank governance are complicated by the fact that a negotiation process between the national political actors of the member countries necessarily takes place. We shall see that taking these negotiations into account clearly modifies the conclusions that can be drawn both on the consequences of a discretionary policy and on the advantages of delegation, that is, of central bank independence, compared to the usually studied case of a simple economy. In Sect. 4.1, we shall see how the debate between rule and discretion arises in a monetary union. In particular, we evaluate the argument put forward to justify the creation or entry into a monetary union that it allows “importing credibility”. In Sect. 4.2, we address the issue of central bank independence and the delegation of monetary decision-making to a central banker. This phase implies that the political authorities negotiate on the choice of this policymaker and the question is whether the negotiation process affects the appropriateness of delegation. However, in most central banks and, in any case, in those of advanced countries, the monetary policy decision is the result of a collegial consultation, held in a “monetary policy committee” made up of several members. In a monetary union, appointments to this committee come from the member countries. The issue of collegiality in a monetary union is discussed in Sect. 4.3. Finally, in Sect. 4.4, we discuss issues of transparency and accountability of the central bank of the union.

4.1

Rule or Discretion in a Monetary Union

In the previous chapter, we developed very simple models not taking into account the expectations of economic agents. However expectations impact economic dynamics. More specifically they play a key role in the credibility of economic policy decisions, particularly monetary policy decisions. There is perfect credibility when an announced decision is based on a precommitment technology such that agents anticipate that it will be applied.1 Conversely, there is zero credibility when the announcements are not underpinned by such a technology since agents do not believe the authorities’ announcements will be necessarily applied. In monetary policy, a policy rule is seen as a precommitment mechanism (or underpinned by such a mechanism, so that it will be applied). An opposite case is a “discretionary” decision, taken on the basis of events and not by applying a rule determined before those events. The debate between rule and discretion, renewed with the introduction of rational expectations in macroeconomics, is central to the understanding of monetary. In this section we will see how this debate arises in monetary union.

1

See Sect. 2.1.4.

4.1 Rule or Discretion in a Monetary Union

4.1.1

123

Expectations and Monetary Policy in a Simple Economy

Let us recall the credibility problem by first addressing it in the case of a simple economy, before transposing it to a monetary union. We develop a model that is still simple but incorporates anticipation effects, based on the canonical model of Barro and Gordon [3]. The expectations in question are assumed to be rational. The model is static and the expectations do not relate to future variables. Despite these limitations, using a model with rational expectations allows us to address the question of the respective strategies of monetary policy-makers and private agents. Consider an economy with J countries. We first assume that they are all monetarily sovereign, totally independent of each other. The aggregate output of country j is given by the following equation:2   Yj = Y + aj πj − πje + εj ,

(4.1)

where πj denotes the inflation rate and πie the rational expectation of this rate. εj is a real shock affecting the product. This shock is an i.i.d. shock of zero expectation and variance σε2 . Y represents the “natural output”, derived from the fundamental characteristics of the economy and assumed to be the same for all countries. According to (4.1), Yj can deviate from this level depending on the inflation surprise (the difference between actual inflation and inflation expected by agents). A common explanation for this impact is that the unexpected component of inflation weighs on the real wage and makes employment more profitable, which stimulates output. In country j , the government is responsible for inflation and is able to manipulate it. In other words, we assume that the central bank is completely in the hands of the political authorities. πi is the variable on which monetary policy is based. Its manipulation can allow the government to support economic activity and vary the output gap. It is viewed in terms of achieving an output target, denoted by Y ∗ . Y ∗ is higher than Y : the government believes that the “natural” level is too low relative to what it considers desirable. Moreover, inflation is damaging, creating distortions and representing a loss of purchasing power on assets that are not indexed to inflation, in the first place money holdings. The government therefore seeks to reduce it as much as possible. In total, the government’s monetary policy objectives are represented by a “loss function” given by the following formula: Lj =

2

 2 1  Yj − Y ∗ + λj πj2 , 2

(4.2)

The indexes are maintained, although not needed in this subsection, to facilitate comparison with the currency union configurations studied later.

124

4 Institutions and Monetary Policy

where λj is the relative weight of the inflation control objective in relation to the objective of supporting activity. The higher λj is, the more the decision-maker is opposed to a given change in inflation, for a given product gap.

4.1.2

Rule or Discretion?

The question that arises is how monetary policy accomodates agents’ expectations. There are two options: the monetary policy-maker takes the expectations of private agents as given, or, on the contrary, he determines a monetary rule, on which private agents base their expectations. The difference between the two options lies in the fact that, in the second option, the policy-maker takes into account the impact of his decision on the expectations of private agents. The first option is referred to as “discretionary policy” and the second as “rule-based policy”. The question that arises is how inflation depends on the option chosen. In other words, it is a question of comparing the inflation levels resulting from these two policy options.

4.1.2.1 Discretionary Policy In the discretionary option, saying that the monetary policy-maker takes agents’ expectations as given is equivalent to saying that his instrument, here πj , is determined for a given value of πje . Since agents form their expectations rationally, they react to πj . The decision that emerges is the solution of an noncooperative game between the monetary policy-maker and private agents. Here, the game in question is a sequential game whose stages are as follows: 1. Private agents form their expectations in a rational manner.3 2. The shock is realized. 3. The government sets the inflation rate in a discretionary manner. The equilibrium of this game is obtained by backward induction reasoning, i.e. the last steps must be resolved first, since their solutions condition the resolution of the steps upstream. Let us start by solving stage 3, the stage at which the government makes its decision, once the shock is known to have occurred. Formally, it resolves the following optimization programme: min Lj = πj

3

  2 1  Yj − Yj∗ + λj πj2 2

We assume that expectations are formed on the basis of knowledge of the structure of the model and the information available on shocks at the time of their formation.

4.1 Rule or Discretion in a Monetary Union

125

under the constraints:   Yj = Y + aj πj − πje + εj

(4.3)

and πie given. The first-order condition is        ∂Lj = aj Y − Y ∗ + aj πj − πje + εj + λj πj = 0 ∂πj

(4.4)

or:     πj λj + aj2 = −aj Y − Y ∗ + aj2 πje − aj εj .

(4.5)

Let us now move on to the stage of forming expectations, before the shock occurs. As E (εi ) = 0, we deduce from (4.5) that     πje λj + aj2 = −aj Y − Y ∗ + aj2 πje , which implies πje =

 aj  ∗ Y −Y . λj

(4.6)

Using (4.5), the discretionary solution obtains πjA =

 aj  ∗ aj  εj . Y −Y −  λj λj + aj2

(4.7)

The reason for the presence of the constant term in this equation is that private agents anticipate that the government, playing after them, has an incentive to surprise them, i.e. to choose an inflation rate higher than their expectation so as to reduce the gap between actual output and their target output, even if this increase itself has a cost. But this surprise is unfavourable to private agents (implicitly because of a falling real wage, which is not formalized in the model). They seek to reduce this surprise (by implication of the rational expectations principle). By raising their expectations, they increase the marginal cost for the government of high inflation. At equilibrium, the rate of inflation is high enough to discourage the government from pursuing a positive surprise policy since the marginal cost in terms of higher inflation is equal to the marginal benefit of increasing output. The level of output is equal to:  Yj = Y + 1 −

aj2 λj + aj2

 εj = Y +

λj λj + aj2

εj

(4.8)

126

4 Institutions and Monetary Policy

  and so E Yj = Y . The anticipated product is equal to the natural product and not to the target of the government product. The government responds to the shock the stronger the relative cost of inflation since: 



∂ −

aj λj +aj2

∂λj



> 0.

The actual product depends on whether the shock is realized: the stronger the relative cost of inflation, the more sensitive it is to the shock. In other words, the higher this cost is, the more the government reacts to limit the impact of the shock on inflation, letting it then impact on output.

4.1.2.2 Rule-Based Policy In the case of a rule-based policy, the monetary policy-maker acts independently of events (here, shocks) and incorporates into his calculation the consequences of his decision on the rational expectations of agents. In other words, the policy-maker acts before agents form their expectations. The sequential game is modified as follows: 1. The government of country j sets the rule by which the inflation rate is determined. 2. Private agents form their expectations in a rational way. 3. The shock occurs and the rule determines the rate of inflation that is practised by the government. In the first step, the policy-maker must define how his decision depends on the realization of the shock. This involves defining a monetary policy rule that determines the rate of inflation as a function of the shock, εj . Formally, we assume a linear rule:   πj = hj . Y − Y ∗ + fj .εj . The definition of the optimal rule involves the government choosing the coefficients hj and fj before the shock is realized. To do so, it must rely on the anticipation of the shock and seek to minimize its expected loss E (Li ) by choosing the  optimal coefficients hj , fj . Since he plays before agents determine their inflation   expectations, he knows that πie = E (πi ) = hi Y − Y ∗ . The government’s programme is   min E Lj

hj ,fj

(4.9)

4.1 Rule or Discretion in a Monetary Union

127

  under the constraint given by (4.1) and πje = hj Y − Y ∗ . The expected loss is equal to:   2    2  1  E Y + aj fj .εj + εj − Y ∗ + λj hj Y − Y ∗ + fj .εj 2 =

    2  2 1  1 + λj h2j + aj fj + 1 + λj fj2 σε2 . Y − Y∗ 2

The first-order condition for hj is    2 ∂E Lj = hj Y − Y ∗ = 0, ∂hj

(4.10)

which results in hj = 0. The first-order condition for fj is      ∂E Lj = σε2 aj fj + 1 aj + λj fj = 0, ∂fj

(4.11)

  which results in: fj = −aj / λj + aj2 . The rule solution is therefore π˜ jA = −

aj λj + aj2

εj .

(4.12)

Thus, a rule policy results in reacting only to the real shock. The government anticipates that it cannot surprise private agents since        E πj − E πj = E πj − E πj = 0. Private agents do not have to dissuade it from trying to surprise inflation with an inflation rate high enough to make such an attempt too costly: the constant term disappears in the inflation equation. Let us return to the question of comparing the levels of inflation obtained in these two policy options. The difference between the two solutions is equal to  aj  ∗ λj Y − Y . Discretionary policy results in an increase in inflation by a fixed amount, independent of the realization of the shock. This is what is known as the “inflation bias”, i.e. formally:  a    j ρjA ≡ E πjA − π˜ jA = Y∗ − Y . λj

(4.13)

Note that the inflation bias decreases with the relative weight of inflation in the monetary policy-maker’s loss function. It measures the cost of the lack of “credibility”, the impossibility of pursuing a rule-based policy.

128

4.1.3

4 Institutions and Monetary Policy

Monetary Policy in a Monetary Union with Direct Negotiation

Let us now turn to the case of a monetary union made up of the J countries, all assumed to be of the same size. By construction, the inflation rate in the union is noted πu and is the same for all countries. The expectation formed by the agents in the union is noted πue .4 According to (4.1), the aggregate product in country j is given by the following equation:   Yj = Y + aj πu − πue + εj .

(4.14)

Countries differ in their sensitivity to unanticipated inflation (the coefficients aj ) as well as in the realization of their real shocks. But they are characterized by the same natural product. Governments are still characterized by the loss functions given by (4.2). Being in a monetary union, they jointly determine the monetary policy of the union, i.e. πu , by consultation, seeking to minimize a loss defined as a weighted sum of their individual losses. Here we assume that all countries are given equal weight in the decision and that the weight assigned to each country’s loss is 1/J . Thus the loss function in a monetary union, which characterizes the collective of decision-makers, is defined as: ⎫ ⎧ J ⎬ ⎨ 1 Lj Lu = (4.15) ⎭ 2J ⎩ j =1

or again: ⎫ ⎧ J ⎬    1 ⎨  2 Y + aj πu − πue + εj − Y ∗ + λu πu2 Lu = ⎭ 2J ⎩

(4.16)

j =1

with λu =

1 J

J

j =1 λi .

4.1.3.1 Discretionary Policy Consider that the monetary policy of the union is conducted on a discretionary basis. This means that the game is played as in the case studied above, with the only difference that in step 3, the inflation rate is set by the collective of governments

4

We assume that the agents in the union are all the same, and in particular all have the same information.

4.1 Rule or Discretion in a Monetary Union

129

seeking to minimize (4.16), πue given. The first-order condition is ⎡ ⎤ J       ∂Lu aj2 πu − πue + aj εj ⎦ = 0 = ⎣au Y − Y ∗ + λu πu + ∂πu

(4.17)

j =1

 with au = J1 Jj=1 aj .   Since E εj = 0, we deduce that πue =

 au  ∗ Y −Y . λu

The discretionary solution is therefore πU =

J  aj au  ∗   εi . Y −Y − λu λu + a 2 j =1

(4.18)

j

If the coefficients aj are all equal, we get πU =

J   a  ∗ a a  ∗ a   εu , Y −Y − Y −Y − εj = 2 λu λu λu + a λu + a 2

(4.19)

j =1

i.e. the same formula as in the autarkic case, except that it depends on λu and not on λj . This is logical: the model is extremely simple and does not allow for any cross-border effects. The optimization problem is therefore formally identical in both configurations.

4.1.3.2 Rule-Based Policy If governments follow a rule-based policy, again the game is played as above, with the difference that in Step 1, governments jointly choose the coefficients of the rule to minimize the expected loss E (Lu ) with Lu given by (4.16). Reasoning as above, we obtain the following result π˜ U = −

J j =1

aj   εj . λu + aj2

(4.20)

In this configuration, given (4.18), the inflationary bias is equal to   a   u ρ U ≡ E π U − π˜ U = Y∗ − Y . λu

(4.21)

130

4 Institutions and Monetary Policy

Suppose that J = 2 and

a1 λ1

≤

a2 λ2 .

We then observe that: a1 au a2 ≤ ≤ . λ1 λu λ2

We observe that the inflationary bias in a monetary union has an intermediate value between the inflationary biases obtained in autarky. The country with the lower inflation bias sees its inflation bias increased in the case where it is a partner in a monetary union with a country with a higher inflation bias. Conversely, the latter sees its bias decreased. In sum, one country gains credibility thanks to the monetary union, the other loses credibility. This conclusion depends on the model from which it was obtained. It is conceivable that the transition to the monetary union implies structural changes and the introduction of procedures which generate credibility gains for all members. But the important thing to keep in mind is that a monetary union is not in itself, because it has a single monetary policy, a guarantee of credibility and an anti-inflationary mechanism for all the members of the union.

4.1.4

A Variant with Asymmetric Anchoring

We pursue this investigation and show that forming a monetary union is not necessarily the best way to gain credibility, even for the country with the highest inflationary bias. To further simplify our exposure, we now reason about only two countries and assume that the coefficients aj are equal (aj = a) and the target levels are the same (Y1∗ = Y2∗ = Y ∗ ). Contrary to what we assumed above, the loss functions of the two governments differ. They are given by the following equations: L1 =

 2 1  Y1 − Y ∗ + λ1 π12 + ς (π1 − π2 )2 , 2

(4.22)

 2 1  Y2 − Y ∗ + λ2 π12 . 2

(4.23)

L2 =

We assume that country 1 is less opposed to inflation than country 2: λ1 < λ2 . But its nominal target has two components: not only does it aim to contain its own inflation (π1 ) but it also seeks not to deviate too far from the inflation of country 2 equivalently to reduce the inflation gap: |π1 − π2 |. Country 1 thus seeks to “anchor” its monetary policy to the monetary policy of country 2, which is less inclined to tolerate inflation. The higher ς , the tighter the external anchor. Country 2 does not feel the need for such an anchor. Remark that if the two countries form a monetary union, the inflation rate being the same, the inflation differential term disappears in (4.22) and the formulas obtained in the previous section apply. We have just seen that monetary union allows country 1 to reduce its inflation bias. The question now is whether membership in a

4.1 Rule or Discretion in a Monetary Union

131

monetary union is, from the point of view of country 1, preferable to this asymmetric anchoring policy, i.e. leads to a lower inflation bias. We will proceed as before and calculate the inflation bias in the case of monetary independence of the two countries, one with a nominal anchor on the other.

4.1.4.1 Independent Monetary Policies The optimization problems of the government of country 2 are the same as those given above. The problem of government 1 is modified because this government must now take into account the choice of country 2, in addition to the anticipation formed by its own residents. We will assume that both countries are in a discretionary or rule-based situation.5 Discretionary Policies The government 2’s optimization programme is unchanged from that given above. The solution, which we note π2AA , is therefore the same, given by (4.7). It generates  ∗  an inflationary bias ρ2AA = λ−1 2 · a Y − Y . The government 1’s optimization programme is modified since it must take into account the inflation rate of country 2. It is now min L1 = π1

 2 1  Y1 − Y ∗ + λ1 π12 + ς (π1 − π2 )2 2

(4.24)

under the constraints:   Y1 = Y + a π1 − π1e + ε1 π2AA =

 a  ∗ a Y −Y − ε2 λ2 λ2 + a 2

(4.25)

and π1e given. The first-order condition is         ∂L1 = a Y − Y ∗ + a π1 − π1e + ε1 + λ1 π1 + ς π1 − π2AA = 0 ∂π1 which implies       π1 λ1 + ς + a 2 = ς π2AA − a Y − Y ∗ + a 2 π1e − aε1 .

5

We do not study hybrid cases.

(4.26)

132

4 Institutions and Monetary Policy

Therefore       π1e λ1 + ς + a 2 = ς E π2AA − a Y − Y ∗ + a 2π1e from where we draw, using (4.25)  ∗  ∗     AA   ∗ a Y a Y − Y + ς − Y − Y + ς E π a Y λ 2 2 π1e = = λ1 + ς λ1 + ς   λ2 + ς = a Y∗ − Y . (λ1 + ς ) λ2

(4.27)

The solution is π1AA =

  λ2 + ς a a ε1 − ς 2 a Y∗ − Y − 2 ε2 . a + λ1 + ς a + λ2 (λ1 + ς ) λ2

(4.28)

The inflation expectation in country 1 is positive. It is lower, the higher the weight ς of the anchor. Discretionary inflation depends on the two exogenous shocks. Its dependence on the anchor country (country 2) shock can be explained precisely by the link between the inflation rate of country 1 and that of country 2. Rule-Based Policies The optimisation programme of government 2 again provides the same solution as in the case studied above, since its problem is unchanged. This solution, which we a note π˜ 2AA , is equal to: π˜ 2AA = − λ +a 2 ε2 . 2 Moving on to the optimisation programme of government 1, we write the monetary policy rule as follows:   π1 = h1 Y − Y ∗ + f1 .ε1 + f2 .ε2 . The presence of ε2 in this rule is explained by the fact that inflation in country 1 depends on it a priori through its monetary policy anchor. The programme is therefore written min E (L1 )

h1 ,f1 ,f2

  aλ2 e ∗ . By under the constraint given by (4.1), π˜ 2AA = − 1+a 2 λ ε2 , and π1 = h1 Y − Y 2

solving this problem, we obtain the following solution6 π˜ 1AA = −

6

a ς λ +a 2 a 2 − .ε .ε2 . 1 2 2 a + λ1 + ς a + λ1 + ς

A proof of this result is provided in the appendix to this chapter.

(4.29)

4.1 Rule or Discretion in a Monetary Union

133

The expectation of the rule-based inflation is zero in country 1 but the monetary rule leads to a response to both exogenous shocks. This reaction is weaker, the higher the anchor weight ς . Note also that rule inflation in country 1 responds less to the external shock ε2 than does discretionary inflation if ς is sufficiently large. The inflation biases in the two countries are given by the following equations    a  ∗ Y − Y = ρ2A , ρ2AA ≡ E π2AA − π˜ 2AA = λ2   ρ1AA ≡ E π1AA − π˜ 1AA =

  λ2 + ς a Y∗ − Y . (λ1 + ς ) λ2

(4.30)

(4.31)

Note that λ2 + ς 1 < ⇔ λ1 < λ2 . λ1 (λ1 + ς ) λ2

(4.32)

Assuming λ1 < λ2 , we deduce from (4.13) and (4.31) that ρ1AA < ρ1A .

(4.33)

Thus anchoring on a country that is less favourable to inflation allows a country to reduce its inflationary bias, that is, to import credibility. But we also note that the inflation bias in country 2 is always higher than the inflation bias in country 1. It is close to it when country 2 has only one objective: to have the same inflation as country 1.

4.1.4.2 Asymmetric Anchorage or Monetary Union? Under these conditions, is it better for country 1 to go through a monetary union or to anchor itself to country 2? Let us reason in the case of a monetary union. We start from the same definition of the loss function that the governors of the two countries in the union seek to minimize, given by (4.15); the components of this loss function are given by (4.22) and (4.23). Since we are in a monetary union where inflation is the same in both countries, it is clear that π1 = π2 = πu . Under these conditions, the anchoring argument disappears from the loss function of country 1. The inflation bias is identical in the two countries and given by (4.21). Let us compare the inflation bias obtained by country 1 in asymmetric  anchoring  and in monetary union. We have seen from (4.21) that ρ U = λauu Y ∗ − Y . Is it possible that this bias is greater than the bias obtained by country 1 under asymmetric anchoring? This is true if ρU =

     a  ∗ 2 λ2 + ς Y −Y = a Y ∗ − Y > ρ1AA = a Y∗ − Y . λu λ1 + λ2 (λ1 + ς ) λ2

134

4 Institutions and Monetary Policy

This inequality is satisfied when ζ > λ2 . Thus, when the relative inflation weight of the anchor country in relation to the output gap target (λ2 ) is lower than the weight of inflation differential (ς ), the asymmetric anchoring arrangement results in a lower inflation bias for the anchoring country than the inflation bias if it forms a monetary union with the anchor country. That is, if the anchoring motive is sufficiently strong, the anchoring country reduces the inflation bias, compared with what it obtains in a monetary union. The reason for this is simple: in a monetary union, discretionary policy depends on an equal-weight-negotiation and the country with a low inflation concern is heard, which has an impact on the inflation bias. In the asymmetric peg, the high inflation country has no influence on the policy followed in the anchor country. The autonomous monetary policy conducted by the anchoring on the other hand is quite severe because of the strong desire to limit the inflation differential. Monetary union is therefore not systematically the best way of acquiring credibility for a country characterized by low resistance to inflation (λ1 weak). In other words, the credibility advantage of monetary union is not guaranteed for any member of the union: there may be other institutional arrangements that do better.

4.2

Central Bank Independence

In a given country, the central bank is a public institution acting by delegation from the political authorities of that country and exercising the prerogatives of monetary sovereignty. The management of a payment system and the exercise of monetary sovereignty are indeed delicate. They require a high degree of technicality and expertise in financial and monetary matters and it is no insult to politicians to recognize that their competence in these matters is generally limited with respect to what is necessary. Moreover, the conduct of monetary policy and supervision of financial stability are daily and painstaking activities since they involve constant observation of economic conditions and financial markets. Lastly, it involves constant interaction with financial institutions and banks, which appears incompatible with political responsibility. These reasons justify delegation of monetary policy. The principle of delegation raises two fundamental questions with regard to the monetary policy decision-making process: 1. The first is to know what responsibility should be given to the central bank. This is the question of “central bank independence”. The two extreme options are zero independence, with the central bank being solely responsible for implementing monetary and financial decisions taken by the government, and complete independence, with the government delegating all decisions together with their implementation to the central bank’s officials. In practice, the reality is always one of incomplete independence, with the political authorities retaining a greater or lesser capacity to influence monetary policy. 2. The second is to know how to implement this delegation and specifically who to appoint at the head of the central bank and under what conditions.

4.2 Central Bank Independence

135

How do these two questions arise in the case of a monetary union? From the perspective opened up in the first chapter, the novelty lies in the plurality of political authorities in a monetary union, especially if it is multi-national. Independence must be conceived in relation to the political authorities that may a priori have different views on how to conceive and implement this independence.

4.2.1

What Is Meant by Independence?

The term “independence” is confusing, as central bank independence from politicians can never be complete. A central bank is a public institution and as such, it is subject to legal arrangements intended by the legislature and guaranteed by the judiciary. These arrangements limit to a greater or lesser extent the capacity of the executive branch (“the government”) to interfere legally or practically in the operation of the central bank and its monetary policy decision-making. It is possible to define markers of such interference and to develop “indicators of central bank independence”. The main markers concern the conditions for appointing members of the bank’s steering committee (in particular its governor), the relations between the bank and the public authorities in the implementation and monitoring of monetary policy, the limits on the bank’s financial assistance to the Treasury and lastly the conditions for amending the text establishing the bank and providing for its mode of operation. Various indices of independence, based on these markers, have been proposed since Cukierman [5].7 Grilli et al. [11] distinguish between “political” markers, linked to the legal modalities of appointment and ties with the government, and “economic” markers, linked to constraints coming from the government and limiting the determination of monetary policy. Practically, an independent central bank is able to withstand the demands of the public Treasury and is neither obliged to finance it nor to follow its recommendations or economic policy requirements. These indicators (debatable as any synthetic indicator of a complex reality) thus make it possible to rank central banks according to their degree of independence. In addition, it is important to distinguish objective independence from operational independence. 1. A central bank is independent in its objectives when it is free to choose the macroeconomic objectives on the basis of which it conducts monetary policy. The government does not assign an objective to the central banker but chooses the central banker (whose preferences it knows) who is legally free to make his choices. In the case of the theoretical model developed above, the union central bank is independent in its objectives.

7 The Cukierman index is an unweighted average of sixteen markers, while Cukierman et al. [6] propose a weighted sum of sixteen indicators as an index. Other indices have been proposed by Bade and Parkin [13], Alesina and Summers [2], Grilli et al. [11] and Eijffinger et al. [10].

136

4 Institutions and Monetary Policy

2. A central bank is independent in its instruments when it can freely choose and manipulate the instruments with which it conducts monetary policy. In practice, these two independences may be incomplete and the central bank’s latitude in defining its objectives and instruments may vary. Operational autonomy is easier to be granted by the government, given the expertise and information available to the central banker, than autonomy of objectives.

4.2.2

Central Bank Independence in a Monetary Union

In the case of a multi-national monetary union, there is not one government trying to influence or direct monetary policy, but several. And there is no guarantee that the wishes of these governments coincide: the structural heterogeneity of the union necessarily leads to its political heterogeneity. Different governments (and, implicitly, the electorates of which they are constituents) have different expectations of monetary policy and very likely different objectives. 1. The political independence of the central bank in a multi-national monetary union has the effect of putting an end to disputes and bickering between governments. It can be argued that government-to-government discussions on monetary matters create a deleterious climate in the monetary union, cause the central bank to lose credibility and thus weaken the union. Independence means that government interference in monetary matters is limited to the appointment of the central banker (or members of the bank’s management committee). There is, of course, haggling and bargaining over the identity and characteristics of the central banker. In the case of a national monetary union, the argument of dissension between national public authorities does not hold. However, insofar as this union is heterogeneous, this heterogeneity feeds different political expectations, which are expressed by pressure on political power from interest groups with divergent interests. Central bank independence is a means of cutting off any overbidding or disagreements that would again, albeit with less force, increase the inflationary bias. 2. The economic independence (when it is complete) of the central bank of the union prohibits the monetary financing of public deficits, making it impossible for each government in the union to be tempted to behave in an improper manner, inconsistent with the soundness of the union. Similarly, it ensures that monetary policy is not linked to the political contingencies created by electoral competition or circumstantial pressures and does not contribute to political and economic cycles. This does not mean that the central bank cannot come indirectly to the rescue of the States of the union, but that it does not do so out of constraint. Independence makes the central bank not subject to the financial needs of the States.

4.2 Central Bank Independence

137

Table 4.1 Independence indicators Country Canada EMU Japan New Zealand Sweden Switzerland United-Kingdom United States

Alesina 2 4 3 1 2 4 2 3

GMT political ind. 4 6 1 2 – 5 1 5

GMT economical ind. 7 7 5 3 – 7 5 7

LVAU 0,46 0,81 0,36 0,69 0,47 0,68 0,53 0,51

Eijffinger–Schaling 1 5 3 3 2 5 2 3

Source: [16]

3. Finally, central bank independence is an important element of central bank credibility. But it is not the only one that must be taken into account in assessing the credibility of monetary policy. It also depends on the confidence of the public opinions in the union, which can be highly heterogeneous. In practice, it is to be expected that the central bank of a multi-national monetary union will be more independent than that of a national monetary union, which is itself more independent than the bank of a single economy. The comparison of central bank independence indicators points in this direction: the European Central Bank is one of the most independent central banks, more so than the US Federal Reserve, which is significantly more independent than the Bank of England, as shown in Table 4.1.

4.2.3

Delegation in a Monetary Union

The issue of central bank independence has dominated debates in monetary economics since the 1970s and has represented, in line with the macroeconomics of rational expectations, a paradigm shift. Until then, monetary policy had been treated as the manipulation of an instrument for controlling a given economic system that could be steered (more or less effectively depending on the quality of the understanding of that system) in the same way as a machine is steered. But a series of important theoretical works, based on the concepts of rational expectations and time inconsistency, have renewed the theory of monetary policy, in a different analytical framework derived from game theory. Rogoff’s article [15] theoretically justified central bank independence. Rogoff, reasoning within the Barro–Gordon model, shows how delegating monetary policy to an independent central banker, i.e. one who is completely free to make his own decisions, leads to the appointment of a central banker who is more eager to fight inflation than the government appointing her, and that this appointment lowers

138

4 Institutions and Monetary Policy

average inflation compared to the rate that would prevail if the government conducts monetary policy directly. Formally, the government chooses a central banker who is more “conservative” than itself, i.e. characterized by a higher relative weight given to inflation in its loss function than its own. The delegation to an independent central banker, appointed by the government with no possibility of going back, thus appeared and was defended as a means of lowering the rate of inflation without affecting the level of output.8 We shall show how monetary union changes the question of the delegation of monetary policy: Rogoff’s conclusions on the superiority of central bank independence do not apply in such an institutional framework. The model developed in the previous section will allow us to tackle the question of central bank independence in a monetary union. Let us reason in the case of a multi-national monetary union. In order to take into account the diversity of interests and points of view that emerge in the union, the solution of the monetary committee is natural: the members of the committee are delegated by the governments of the union. But it is necessary to keep at bay the risks of too much disharmony within the committee, leading to no decision. The choice of the chairperson is therefore central. The governments must collectively choose the composition of the committee and the appointment of the chairperson. Let us distinguish between the two decisions by means of two different configurations for the sake of simplicity: 1. In the first configuration, the monetary policy decision is taken by a committee, without a chairperson. Governments appoint their delegates to this committee, and these delegates decide by negotiation. 2. In the second configuration, there is a single monetary policy decision-maker and there is no collective decision taken by a committee. Governments negotiate directly on the person of this decision-maker, the “central banker”. Once appointed, the central banker is independent. The theoretical point is whether Rogoff’s result still stands. In which of the two selected configurations does the delegation of the decision result in the reduction of the inflationary bias? Let us simplify the problem to avoid cumbersome calculations: assume that the output targets are the same for all governments (Yi∗ = Y ∗ ) and the coefficient associated with the inflation surprise (ai = a).

8

The amalgam between the central banker’s conservatism and his independence has been criticized by Eijffinger and Hoeberichts [10]. Similarly, the benefit of delegation has been qualified when the factors creating the distortions that monetary policy seeks to contain are endogenized. Here we will limit our discussion to the simple framework studied by Rogoff, adapted to a monetary union.

4.2 Central Bank Independence

139

4.2.3.1 Delegation in a Simple Economy Let us begin by presenting the problem of delegation in its canonical version, the one studied by Rogoff, i.e. in the configuration studied in Sect. 4.1.2, monetary policy in a single economy with no external links. The economy is formalized by the model developed in Sect. 4.1.2. The determination of monetary policy is the outcome of a sequential game whose steps are as follows: 1. The government of country j 9 chooses the central banker before observing the shock. 2. Private agents form their expectations in a rational manner. 3. The shock is realized. 4. The central banker sets the inflation rate in a discretionary manner. Does this organization lead to a lower inflation bias than that obtained by the government when it acts directly in a discretionary manner? Notice that the central banker also acts in a discretionary manner. What does the choice of the central banker by the political authority mean in such a framework? Formally, the government (identified with the political authority) is characterized by a loss function. It chooses as central banker an agent characterized by a similar loss function but parameters of which are a priori different. Assuming that the latter has two arguments as in Eq. (4.2), the output gap and inflation, the government, characterized by a relative weight of inflation λj , must appoint as central banker an agent characterized by a coefficient λcb j , a priori different from λj . Suppose that there is a continuum of candidates for this position, each characterized by a relative weight of inflation, covering all possible values of weight from 0 to ∞. The choice of a central banker amounts to choosing a value of λcb j in the interval (0, ∞[. Let us solve the game by backward induction. The central banker’s programme in country j , characterized by a relative weight λcb j , is min Lj = πj

 2 1  2 Yj − Y ∗ + λcb j πj 2

under the constraints   Yj = Y + a πj − πje + εj

9

(4.34)

The indexes are maintained, although not needed in this subsection, to facilitate comparison with the monetary union configurations studied later.

140

4 Institutions and Monetary Policy

and πje given. The solution is given by (4.7) and we note it  a  ∗ a a  εj = πje −   εj Y −Y −  cb cb 2 2 λj λcb λ + a + a j j !   ! = π Y ∗ , Y , εj !λcb j

πjDA =

(4.35)

and thus Yj = Y . The inflation bias is equal to    a  ρjDA ≡ E πjDA − π˜ jDA = cb Y ∗ − Y . λj When the government of country j , characterized by a relative weight λj , chooses the central banker, it anticipates that its decision will be determined by (4.35). But it has to make its decision before knowing the realisation of the shock. It cannot seek to minimize its effective loss (Li ), but the anticipation of its loss (E (Li )). Its programme is   2   1 ∗ 2 E Y + λj πj min E Lj = j − Yj 2 λcb j under the constraint !   ! πj = π Y ∗ , Y , !λcb . j Under these conditions, we have "  #    1  ∗ 2 2 Yj − Y E Lj = E + λj πj 2 ⎧ ⎛  2 ⎞ ⎛  2 ⎞ ⎫ ⎪ ⎪ cb cb 2 2λ ⎬ ⎨ + λ a + a λ λ j j  j 1  ⎟ ⎜ j ⎟ 2 ∗ 2⎜ . + σ Y −Y = ⎝ ⎠ ⎝ ⎠     ε 2 2 ⎪ 2⎪ cb ⎭ ⎩ 2 λcb λ + a j j The government programme is being rewritten   min E Lj = λcb j

⎧ ⎪ 1 ⎨ 2⎪ ⎩

⎛ Y − Y∗

2 ⎜ ⎝

λcb j

2



+ λj 2

λcb j

a2

⎛  2 ⎞ ⎫ ⎪ cb 2 ⎬ λ + a λj ⎟ ⎜ j ⎟ 2 + σ ⎠ ⎝  2 ⎠ ε ⎪ . ⎭ 2 λcb + a j ⎞

4.2 Central Bank Independence

141

The solution is given by the first-order condition 

∂E Lj ∂λcb j



⎛ ⎞   2 λcb − λ 2 a j   j 2 ⎜ −λj a ⎟ 2 = Y − Y ∗ ⎝  3 ⎠ +  3 σε = 0, 2 λcb λcb j j +a

which implies ⎛

⎞

  cb − λ λ j 2 ⎜ λj ⎟  j 2 Y − Y ∗ ⎝  3 ⎠ =  3 σε . cb cb 2 λj λj + a

(4.36)

This equality calls for four remarks. 1. As the left-hand side of this equality is positive, it implies that λcb i > λi . A government will appoint a central banker who is more anti-inflationary than itself. Her aversion to inflation is higher than the aversion of the government appointing her. This is what has been referred to as the “conservatism” of the independent central banker. 2. The delegation procedure makes it possible to appoint a central banker who is very much opposed to inflation, more so than the government itself. This has the consequence of reducing the inflationary bias. Indeed, we obtain ρjDA =

  a  ∗ a  ∗ Y − Y < ρjA = Y −Y . cb λj λj

(4.37)

3. λcb j is an increasing function of λj . 4. In the absence of a shock (σε2 = 0), we obtain λcb j = ∞.

(4.38)

Under these conditions, the inflationary bias, which we note ρiDA , is equal to:   ρjDA = E πjDA − π˜ jA = 0.

(4.39)

Delegation removes the inflationary bias. The solution of delegation in a simple economy will serve as a benchmark against which to compare the solutions obtained in a monetary union.

4.2.3.2 Choosing the Central Banker in a Monetary Union Let us now consider delegation in a monetary union. The monetary policy decision is taken by a single central banker whose appointment is a matter for negotiation among the governors of the member countries of the union (Aaron-Cureau and

142

4 Institutions and Monetary Policy

Kempf [1]). Our reasoning is based for simplicity in the context of a monetary union with two countries of the same size, whose economy is represented by the model developed in Sect. 4.1.3. The institutional configuration is as follows: the two governments jointly choose the central banker; the central banker makes the monetary decision on a discretionary basis. Formally, monetary policy is the outcome of a sequential game whose steps are as follows: 1. The governments of the monetary union choose the central banker of the union to whom monetary policy is entrusted, through a negotiation in which the government of country j has relative weight γi . At this stage, acting before the shocks materialize, governments seek to minimize an objective function that is the weighted sum of their expected losses, with the weights reflecting the relative weight of governments in the bargaining.10 Here we assume equal weights.11 2. Private agents form their expectations rationally. 3. Shocks are realized. 4. The central banker of the union sets the inflation rate in a discretionary manner. Reasoning by backward induction, we first solve the central banker’s programme, characterized by a relative weight λDB u min Lu = πu

 2 1  2 Yu − Y ∗ + λDB π u u 2

under the constraints   Yu = Y + a πu − πue and πje given. The solution of this programme is given by (4.7) and we note it πuDB  a  ∗ a a  εu = πue −   εu Y −Y −  C 2 C λu + a λu + a 2 !   ! = π Y ∗ , Y , ε1 , ε2 !λDB u

πuDB =

λDB u

(4.40)

and thus Yu = Y . The inflation bias is ρuDB =

10 Aaron-Cureau

 a  ∗ Y −Y . λDB u

and Kempf use a form of negotiation given by the Nash criterion. different weights would not change the result we will get but would make the calculations and formulas heavier. 11 Assuming

4.2 Central Bank Independence

143

The appointment of the central banker is the result of the following maximization programme ⎧ ⎫ 2 1 ⎨  ⎬ min E Lj ⎭ 2⎩ λDB u j =1

with 

E Lj



⎧ ⎡ 2 ⎨1 a2 ∗ ⎣  εu + εj =E Y − Y −  DB ⎩2 λu + a 2  +λj

2 ⎤⎫ ⎬  a a  ∗ ⎦   Y − Y − ε j 2 ⎭ λC λC u u +a

  2      ( ' 2  λC ξ λC + λj a 2 1  u u + a λj ∗ 2 + σε2 Y −Y =  2  2 2 λC λC + a 2 u

u

and Yj given by (4.34) and πuDB given by (4.40). The first-order condition is written 1∂ 2

*

) 2

j =1 E (Li )

∂λDB u

⎞ ⎛     DB 2  DB 3 − 2 λDB 2 2 λ λ + λ a i  2 u u u 1 ⎠ = Y − Y∗ ⎝  4 DB 2 λ u j =1 " 2

    C 2    # 2 ξ  λDB λu + a 2 − 2 ξ λDB + a 2 λi λDB u u u +a − σε2 = 0   2 4 λDB + a u that we rewrite as 

 DB 3 λu 2 λDB u +a

3

2ξ − a 2

2



 j =1 λi − ξ  a 2 2j =1 λi

2 λDB u +a



 2 Y − Y∗ = . σε2

(4.41)

The solution of the game is the value of λDB u that satisfies this equality. We are now able to compare the inflationary bias for a single economy with delegation ρjDA (given by (4.37)) and for a monetary union with appointment of a central banker ρuDB . Given the definition of inflationary bias, this means comparing

144

4 Institutions and Monetary Policy

cb DA < ρ DB . λDB u and λj . In particular, we want to know whether it is possible that ρj u The answer is positive, as the following proposition shows12

  Proposition 4.1. There are parameter values σε2 , a, λ1 , λ2 , Y , Y ∗ such as ρ2DA < ρ1DA < ρuDB . At the appointment stage, the two governments cooperate. They take into account that the central banker reacts to the average shock and, cooperating, they internalize the cross-border effects that this introduces between the two countries and their impact on each other’s situation. If the variance of the shocks is sufficiently high, they may have a common interest in appointing a central bank with low inflation aversion because in this way they will obtain, albeit in return for a high inflation bias, a better consideration of idiosyncratic shocks in the monetary policy decision. The result for some parameter configurations is a higher inflation bias than if each of the two governments had appointed their own central banker autarkically. In this configuration, the monetary union does not represent a gain in credibility for any of the member countries.

4.3

The Collegiality of the Monetary Decision

4.3.1

The Monetary Policy Committee

Diagnosing the current macroeconomic situation and forecasting the future is no easy task, given the complexity of a modern economy and the scale of the factors of uncertainty that affect it. The risk of being wrong is large. The way to deal with this danger is through a confrontation of points of view and consultation, assuming that the resulting decision is probably correct. But there is more: the monetary policy decision affects multiple interests in different ways. This raises the problem of potential conflicts of interest related to monetary policy, which must be resolved at the lowest political and economic cost. Applied to the conduct of monetary policy, the solution is for it to be conducted by a committee of a few confirmed experts under the direction of a “governor”, the ultimate head of the central bank, who is able to make a consensual diagnosis and have the decisions taken accepted as legitimate. Thus, the interest of a collegial decision on monetary (and financial) policy is twofold: 1. On the one hand, it makes it possible to draw up a macroeconomic diagnosis that is made more adequate through discussion between experts within the committee and the consensus that emerges.

12 A

proof of this result is provided in the appendix to this chapter.

4.3 The Collegiality of the Monetary Decision

145

2. On the other hand, it makes it possible to represent the various interests concerned and to legitimize the decision taken as being the result of a compromise. In a single economy, the monetary decision is most often taken by a committee, headed by a chairperson. The latter has an eminent position within the monetary committee: she sets the agenda, directs the central bank’s administration and thus guides the preparatory work for the monetary policy decision, represents the central bank and is therefore responsible for communicating on monetary policy, which nowadays plays a major role. The question of setting up this committee in a monetary union is more complicated than in a simple economy because the economy is by construction more fragmented. This raises a twofold question: 1. How are the members of this “monetary policy committee” selected? 2. How are decisions taken within this committee? The selection of the members of the committee is made by the political authorities, through an institutional process that aims to ensure that the members are competent in monetary and financial matters and guarantee that the committee makes decisions in line with the general interest. In the case of a multi-national monetary union, the principle of the committee is almost automatically applicable. By adopting the rule that each member country appoints a representative to the committee, the member countries are assured of being represented at the highest level of the bank and of having at least one privileged channel of information on monetary policy, or even a channel of influence. The choice of a country’s representative is the sole responsibility of its political authorities, according to its institutions and the rules of the union: it is a decision that we can describe as non-cooperative. The membership selection process is thus complex and can lead to counter-intuitive results. To illustrate this point, let us assume that the monetary policy decision relates to the inflation rate of the union. Anticipating a bit on what will be developed below, suppose that this rate is chosen through a process of negotiation among the members of the committee in which each member is given a certain political weight. The composition of the committee and the resulting monetary policy decision can be considered theoretically as the outcome of the three-stage nomination game: 1. National governments choose their representatives on the committee in an uncooperative manner. 2. The committee, once constituted, chooses the inflation rate according to a defined negotiating procedure. 3. The inflation rate is applied and exogenous shocks occur. The values taken by endogenous macroeconomic variables, in particular output levels, are realized.

146

4 Institutions and Monetary Policy

Consider the case of the pro-inflation government of country j : it is characterized by a low coefficient λj in its loss function given by Eq. (4.2) and has a preference for higher inflation on average than other governments (its coefficient λj  is lower than the average of the coefficients of member countries λj < λ ≡ 1/J · k λk ). This government will be tempted to appoint a representative even more accomodating towards inflation than itself, so as to compensate in the negotiation process for the fact that its partners are less accomodating. Other governments will reason similarly. In particular, a country that is very hostile to inflation will seek to appoint a representative even more hostile to inflation than itself, for the same reason: to compensate in the negotiating process for the fact that its partners are more accomodating. The above development is not a prediction. It has the merit of highlighting that the selection process for committee members is a delicate matter in monetary union. Once the committee is formed, its members decide on monetary policy after discussion. The decision-making rules are logically based on a voting procedure, defined by the central bank’s statutes.13 Economic theory approaches this decisionmaking process from the perspective of bargaining between national delegates. It may be thought that, in the case of a national monetary union, this negotiation is easier than in the case of a multi-national monetary union: being less heterogeneous than the latter, there are fewer differences of opinion, and even fewer conflicts of interest expressed by the delegates.

4.3.2

The Monetary Policy Committee in a Monetary Union

Let us assume that the public authorities responsible for appointments choose their delegates with a view to defending their national or sectoral interests. Let us also assume that it is preferable (Pareto-superior) to pursue a supra-national monetary policy. A double dilemma arises: 1. There is a contradiction between the objective of credibility of the monetary decision and the fact that it is the result of a negotiation, i.e. the outcome of a political compromise between sectoral interests. 2. There is a contradiction between the principle of appointments on national (in the case of a multi-national monetary union) or sectoral (in the case of a national monetary union) bases and the idea that monetary policy must take account of the overall conditions of the union for the reasons given above. How can these dilemmas be resolved and ensure that monetary policy is credible and “supra-nationalized”?

13 In practice, the monetary policy decision is often presented as a consensus decision rather than a vote since consensus has the advantage of enhancing the credibility of the decision with public opinion.

4.3 The Collegiality of the Monetary Decision

147

4.3.2.1 How to Supra-Nationalize the Common Monetary Policy? A first solution is to include in the monetary policy committee personalities appointed by means of a supra-national arrangement. A second solution is to set up a mechanism for rotating national (or sectoral) delegates, so as to reduce the extent of bargaining. This, together with the gradual establishment of a “supra-national” culture in the central bank, is supposed to mitigate these dilemmas and, if necessary, render them inoperative. But these concerns cannot be eliminated from the study of the actual functioning of a monetary union, particularly a multi-national one. In any case, this discussion leads us to make the following points: 1. Central bank independence—political and economic—is a way of making monetary policy less dependent on the structural and political heterogeneities of the union, but not of freeing the central bank and its officials from such heterogeneities. It is felt indirectly via the conditions of appointment (or confirmation), which cannot escape political considerations. 2. It facilitates the adoption by central bank officials of an integrated view of monetary union and, as such, contributes to the credibility of the union’s monetary policy since it is the result of a global and politically neutral analysis (with regard to national considerations) of the macroeconomy of the union. 3. However, the terms of the monetary negotiations between the union’s political authorities are modified, not abolished by the independence of the bank. The complexity of the monetary union can thus counterbalance the interest in terms of simplicity and readability of entrusting monetary policy to an expert without political motivations.

4.3.2.2 Appointing Members to the Monetary Policy Committee Focusing again on the issue of the inflation bias, let us consider (for simplicity) a two-country monetary union. Its economy is represented by the model developed in Sect. 4.1.3. The institutional set-up is as follows: the two governments choose delegates to sit on the monetary policy committee; these delegates make the monetary decision by consultation. Formally, monetary policy is the outcome of a sequential game whose stages are as follows: 1. Each of the governments in the monetary union chooses its delegate in a noncooperative manner. 2. Private agents form their expectations in a rational manner. 3. The shock is realized. 4. The monetary policy committee, made up of the two delegates, sets the inflation rate in a discretionary manner, through a negotiation in which the delegate of country j has a relative weight γj . As in the previous game, the choice of the delegate by the government of country j , characterized by a relative weight of inflation λj , should be understood as the choice of an agent whose loss function will be characterized by a relative weight

148

4 Institutions and Monetary Policy

of inflation λC j . The monetary policy committee is thus made up of two delegates, C identified by their relative weights λC 1 and λ2 . The differences, due to the plurality of actors linked to the very fact of monetary union, with the previous game appear in steps 1 and 4. In step 1, the governments act in a non-cooperative way; in step 4, on the contrary, the committee acts in a cooperative way since negotiation is a cooperative way of playing. We again assume that the relative weights of the two delegates in the negotiation are the same. In this institutional arrangement, is the inflationary bias lower than the one obtained in the case of a simple economy? As before, we reason by backward induction to solve this game. The objective function of the monetary policy committee is to minimize the weighted sum of the losses incurred by the delegates, with the weights reflecting the relative weight of the delegates in the bargaining.14 The programme of the monetary policy committee is written  2 1 1  2 Yj − Y ∗ + λD j πu 2 2 2

min Lu = πu

j =1

under the constraints   Yj = Y + a πu − πue + εj , ∀j and πue given. The solution of this programme is taken from the following first-order condition  "  ∂ (Y1 − Y ∗ ) 1  ∂Lu Y1 − Y ∗ = + λC π 1 u ∂πu 2 ∂πu #   ∂ (Y2 − Y ∗ )  . + Y2 − Y ∗ + λC π 2 u ∂πu Using this equality to calculate πue , the final solution we note πuDC is given by the following equality πuDC =

 a  ∗ a a  εu = πue −   εu Y −Y −  C C 2 C λu λu + a λu + a 2

(4.42)

14 We could use a more sophisticated form of negotiation, such as Nash bargaining. Again, this would complicate the calculations without changing much the answer we are going to give to the question posed.

4.3 The Collegiality of the Monetary Decision

and, furthermore, Yj = Y −

a2 2 εu λC u +a

ρuC =

149

+ εj . The inflation bias ρuC is equal to  a  ∗ Y −Y . λC u

(4.43)

At the delegate selection stage, governments,   acting before the shocks occur, seek to minimize the expectation of their loss E Lj . According to the previous formula, this expected loss is equal to "  # 2   1  Yj − Y ∗ + λj πu2 E Lj = E 2   2      ( ' 2  λC + λj a 2 ξ λC 1  u u + a λj ∗ 2 Y −Y + σε2 . =  2  2 2 λC λC + a 2 u

u

The programme of the government of country j , characterized by a weight λj , is 

min E Lj



λC j

  2      ( ' 2  λC ξ λC + λj a 2 1  u u + a λj ∗ 2 + σε2 = Y −Y  2  2 2 λC λC + a 2 u

u

under constraints (4.1), (4.42) and λ−j given. The first-order condition is   ∂E Lj ∂λC j

  + 2  1  ∗ 2 −2λj a = Y −Y  3 2 λC u

+

ξ

 C  C      , 2 λu λu + a 2 − 2 ξ λC u + a λj σε2 = 0.   2 4 λC + a u

Therefore   2    C   C  2 −2 Y − Y ∗ ξ  λC 2σε2 u · λu + a − 2ξ λu λj + σε2 = 0.  3 4 −  4 C C 2 2 C 2 a λu + a λu λu + a (4.44) The reaction functions of governments j at the appointment stage are written as follows !   C ! 2 ∗ λC ∀j = 1, 2. (4.45) j = N λ−j !λj , σε , a, Y , Y The equilibrium of the game is defined by the two previous equations as well as by the definition of λC u.

150

4 Institutions and Monetary Policy

We are now able to compare the inflationary biases of a simple economy ρiA and a monetary union with committee ρuC . Given the definition of inflationary bias, this cb cb is equivalent to comparing λC u and λj . λj is given by the following equation ⎛

⎞

  cb − λ λ j  2 ⎜ λj ⎟ j 2 Y − Y ∗ ⎝  3 ⎠ =  3 σε . cb cb 2 λj λj + a In particular, we want to know whether it is possible that the inflationary bias in autarky for country j is smaller than the inflationary bias in monetary union (ρiA < ρuC ). The answer is positive, as the following proposal shows15   Proposition 4.2. There are parameter values σε2 , a, λ1 , λ2 , Y , Y ∗ such as ρ2A < ρ1A < ρuC . For some parameter values, the inflationary bias obtained in monetary union by a monetary committee is higher than the inflationary bias obtained in autarky by each of the countries. The reason is as follows: monetary union causes national aggregate outputs to be affected by the inflation of the union, and hence by all the idiosyncratic shocks. Delegates playing cooperatively and reasoning about average inflation, even if they weigh it differently, take this into account. But the delegate nomination process introduces an noncooperative element. Each government can expect the delegate of the other government to control inflation sufficiently so as to influence discretionary policy at the margin by appointing a more “lax” delegate. This temptation is strong when the variance of the shocks is high and thus the gains from monetary surprise are strong. But, in doing so, this noncooperative behaviour may ultimately lead to an equilibrium where the two delegates prove to be lax and thus to a high inflationary bias, higher than the inflationary biases that would be experienced by the two countries if in autarky. The monetary union does not represent a gain in credibility for any of the member countries. The result is similar to the one obtained by reflecting on the asymmetric anchorage or the negotiated delegation to an independent central banker. Delegation is presented as a solution to the credibility problem affecting monetary policy: by giving up the task of conducting monetary policy itself and delegating it to an independent central banker, the government reduces the inflationary bias. Applying this reasoning to the case of a monetary union, it is often assumed as delivering a credibility gain insofar as the central bank of the union is established as a “supra-national” institution, independent from national governments and political pressure. Actually, this argument does not hold in all circumstances for the simple reason that delegation in a monetary union triggers strategic effects that can work against the intrinsic advantage of delegation, namely to play indirectly on agents’ 15 A

proof of this result is provided in the appendix to this chapter.

4.4 Communication and Accountability

151

expectations. This may be due to the non-cooperative appointments of delegates to a monetary committee or to collusive behaviours, as in the case of concerted and negotiated appointment of an independent central banker. It is difficult to specify exactly for which parameter values the union leads to a deterioration in the credibility of monetary policy (compared to a situation of autarky) but this happens when the variance of the shocks is high or when the direct benefits of delegation are small.

4.4

Communication and Accountability

The policy conducted by a central bank cannot be reduced to the mere taking of a monetary decision. Indeed, the simple game-theoretical paradigm we use to analyse the conduct of monetary policy shows that communication and accountability are key to the success of monetary policy by the central bank, which are essential elements of this policy. Let us study these two dimensions of monetary policy in the context of a monetary union.

4.4.1

Between Transparency and Opacity

The methodological advance represented by the rational expectations hypothesis led macroeconomists to explicitly take into account the information available to agents to form their expectations.16 In these circumstances, the available information sets, since they condition the decisions taken via the formation of expectations, play a major role in macroeconomic dynamics. Moreover, the actions of the players themselves constitute information and implicitly convey some of the information available to the players. It is indeed possible for a player to use inference or signal extraction procedures and apply them to the decisions made by another player: he will interpret them better and thus increase his own set of information. In the same logic, providing information or accompanying a decision with a comment or signal becomes a means of action. Applied to the case of monetary policy, this principle tells us that central bank communication is a tool of economic policy. This is all the more true since, as we have seen above, a central bank’s responsibility is to anchor nominal expectations and make a path for the general price level in the future legible and credible. Communicating about the central bank’s analysis of the business cycle and the implications of that analysis for future decisions becomes an essential ingredient of this anchoring policy and of the bank’s search for credibility (Blinder et al. [4], Ehrmann [8]).

16 The

assumption that agents know the true model of the economy and have incomplete or imperfect information about shocks is subsidiary to this methodological principle.

152

4 Institutions and Monetary Policy

Table 4.2 Impact on market of FOMC’s communication

Speeches Testimonies Minutes Discourses

Mean impact Rate of future eurodollar 4,5 6,7 1,9 0,3

2-year rate 5,6 6,8 2,5 0,4

Cumulated impact 2001–2005 Rate of future eurodollar 2-year rate 103 14 28 33 41 71 75 119

Source: [14]

The communication tools available to a central bank are multiple. They can be written texts: they are the reports and business surveys that the bank publishes, or the minutes of the monetary committee meetings, which make it possible to decipher the monetary policy decisions taken at these meetings. Or oral interventions: speeches by members of the monetary policy committee to various audiences and likely to be picked up by the press, depositions before parliamentary committees, and above all statements to the press commenting on monetary policy decisions. A study by Reinhart and Sack [14] shows that these different modes of communication have a definite effect on financial markets and are essential monetary policy tools in contemporary hyper-informed societies (Table 4.2). The central bank thus oscillates between transparency and opacity. Does it have to say everything it knows, filter its information, or even blur or distort it? The amount of information that the central bank should reveal depends on its perception of both shocks and the reactions of agents to the information. There are two key dimensions that are important in determining how a central bank communicates: 1. The first is fairly easy to understand. What matters in the effectiveness of a communication is less its volume than the processing capacity of the recipients of this communication. Too much information may saturate these capacities, disorient the recipients and paradoxically lead to increasing the opacity of monetary policy. An information policy on monetary policy is necessarily synthetic and conditioned by the channels through which the information is disseminated and processed. Moreover, this policy must be differentiated. There are different types of addressees of this communication: monetary economy specialists (the academic world in the broadest sense), financial operators (operating in banks and financial institutions), non-financial agents, both consumers and investors. As their technical skills and expectations differ, the central banker must communicate specifically with each of these categories of agents. 2. The second, more theoretical, dimension refers to the dilemma between credibility and flexibility. Giving information ties hands, which contributes to credibility since it reinforces pre-commitment arrangements; not revealing information that

4.4 Communication and Accountability

153

is available means giving oneself informational superiority and increasing one’s discretionary room for manoeuvre in order to better manage unexpected events. In a monetary union, the communication tools available to the central bank are no different from those available to any central bank. But the preceding remarks allow us to measure the difficulties of defining a communication policy (concerning the use of these tools) given the heterogeneity of the union. 1. The synthesis of the information to be transmitted is made more difficult. The central banker has to decide how much importance he should give to the existing asymmetries in the union, resulting both from its structural heterogeneity and from monetary policy itself. Moreover the central banker has to be careful about the reactions to his communication. There is no guarantee that they will be homogeneous throughout the union. In the case of a multi-national union, the anchoring of expectations is made more difficult by the fact that audiences are segmented along national lines. Public opinion is sensitive to the national inflation rate, at least as much as to the inflation rate of the union. The duality of the inflation rates to which agents pay attention carries a risk of confusion and misinterpretation of signals. The challenge of a communication policy is to ensure that the anchoring of expectations concerning the union’s inflation rate takes precedence over the anchoring of expectations concerning the national rate. 2. The dilemma between credibility and flexibility is made more complex in a monetary union. The central banker of the union has to be alert not only to shocks affecting the union but also to their cross-border effects and to the risks of destabilisation or contagion, which they may cause. 3. The heterogeneity of the union makes communication policy more difficult. The union’s central banker must be careful not to fuel international controversies and give the impression that his policy creating distributional conflicts within the union, favouring some to the detriment of others. But this very heterogeneity feeds the different expectations of economic agents according to their location, in the case of a multi-national monetary union. It is possible that a differentiated communication according to the target audiences is desirable, at the risk of equivocation or contradiction. To sum up, communication policy is even more necessary in a monetary union because it plays a key role in the monetary homogenisation of the union. But it is more delicate. It is logical to argue that the temptation of opacity is greater there than in a unitary economy. A central bank must therefore seek to communicate in an optimal way, sorting out the essential from the trivial or the insignificant, and sometimes playing with opacity: there is no full transparency. This has led economists to develop indicators of transparency, just as there are indicators of independence. The most widely used indicator is the one developed by Eijffinger and Geraats [9]. These authors distinguish five areas of transparency: political transparency (degree of information

154

4 Institutions and Monetary Policy

Table 4.3 Transparency indicators of central banks Indicator Australia Canada EU (1999) Japan New Zealand Sweden Switzerland UK USA

Political 3 3 3 1,5 3 2 1 3 1

Economic 1 2,5 1 1 2,5 1,5 1 1,5 2,5

Procedural 1 1 1 2 3 2 1 3 2

Policy 1,5 2 1,5 1,5 1 1,5 2 1,5 1,5

Operational 1,5 2 2 2 1 2 1 2 1,5

Total 8 10,5 8,5 8 10,5 9 6 11 8,5

Source: [9]

on economic policy objectives), economic transparency (degree of information on data, the economic models used by the central bank, and the forecasts made by the bank’s staff), procedural transparency (degree of information on decision-making), policy transparency (degree of information on the decision taken, including its timeliness, and explanations of the decision), and operational transparency (degree of information on the implementation of the decision and its effects). The synthetic indicator of transparency they develop is based on quantified assessments in these five areas. The results for nine central banks are shown in Table 4.3.17 On reading this table, it does not appear that the central banks of monetary unions (USA, European Monetary Union, Canada) are systematically more or less transparent than the central banks of unitary economies (Japan, Sweden, Australia).

4.4.2

Accountability

4.4.2.1 What Is Meant by Accountability? The merit of central bank independence is that it removes political pressure from policy-makers and ensures the credibility of monetary policy. This credibility depends on other factors, in particular on the assurance that the central banker and the institution he or she leads are honest, competent and serving the public interest. We have seen that the conduct of monetary policy is a complex activity that is difficult to decipher from the outside because it is highly technical. This technicality makes it possible to conceal the true motivations for the decisions taken, or even the decisions themselves and their beneficiaries. Under these conditions, the ethics of central bank officials, which conditions the process of processing monetary and financial information, is a critical element in the confidence that economic agents can place in the institution and thus in the credibility of monetary policy.

17 The

initial work of Eijffinger and Geraats was generalized by Dincer and Eichengreen [7].

4.4 Communication and Accountability

155

The honesty of the central banker and, more generally, of the institution itself is understood by economists in a larger sense than pecuniary honesty strictly speaking. It may refer to intellectual honesty or professional integrity. It encompasses the idea that the central banker, the experts on whom she relies and the institution do not pursue their personal interests in the conduct of monetary policy. Similarly, the collective and individual competence of economists and central bankers is also an important dimension of the quality of a central bank. It is essential that the integrity and competence of the officials to whom the task of conducting monetary policy in the general interest of the economy is delegated be regularly verified. This means that managers must be accountable for their actions, not only explaining them but also justifying them and providing the means for them to be evaluated. Accountability can only take place before a political authority, which can sanction or redress the situation if necessary. The difficulty is clear: accountability is the counterpart of delegation to a non-political authority, which is intended to be independent of political pressure. It is convenient to understand the relationship between independence and accountability by conceiving independence as an ex ante measure and accountability, logically its opposite, as ex post. But the key point is that both independance accountability, should be jointly designed in such a way as to minimize opportunistic pressures from political leaders. This should ensure, if not an absolute trust in the relevance of monetary decisions, that at least a strong confidence in the public opinion in their soundness, which is a prerequisite for efficient monetary policy. Accountability implies that a qualified representative of the monetary institution, generally the chairperson of the monetary policy committee, regularly informs a political assembly of the community, explains and takes responsibility for their past decisions. In contrast to communication as such, it concerns past decisions and the assessment that can be made of them. It logically leads to the possibility of sanctions. A gradation of possible responses to accountability can be envisaged: 1. The first stage is to record and ensure the public and wide dissemination of the explanations given. 2. The second stage is to comment on and criticize the decisions taken. 3. The third stage is the actual punishment, if the record of those responsible is judged to be poor. The process itself and its specificities are linked to the charter under which the central bank operates. In particular, the extent of punishment is the crucial point in the articulation between delegation and accountability. The risk is to practically void independence of content if the punishment for deviations from announcements or errors is extremely strong. Too much accountability kills independence; too little accountability renders it untrustworthy and inoperative.

4.4.2.2 Accountability in a Monetary Union Accountability is based on specific institutional procedures that are determined by the political environment in which the central bank operates.

156

4 Institutions and Monetary Policy

From this perspective, accountability is arguably easier in the case of a national monetary union than in a multi-national monetary union, where the constitutional arrangements are necessarily more complex and the central bank’s constituencies are more numerous. Specifically, each national government will demand a record of the impact of monetary policy in its country. Monetary policy assessments may therefore differ according to the structural and political heterogeneity of the area. Let us assume that the accountability is to a college of national constituencies of the central bank of the union. We consider the most difficult case, where the impacts of monetary policy are not only differentiated, but opposed, with some countries benefiting from the policy pursued while others suffer from it. Two options are then possible: 1. If some governments do not accept the merits of the monetary decision or strategy followed, the disagreement between the central bank’s constituents leads to the impossibility of a joint commentary. 2. If governments, after discussion, accept the merits of the decision and agree on a common assessment of monetary policy, disagreement is avoided. But they may find it difficult to explain it to the public. They face the risk of a political crisis within the union. In both cases, accountability to the college of national constituencies is very difficult to establish. The logical solution is for the central bank to be accountable to an institution that is supra-national but representative of the diversity of the union, since the single monetary policy concerns the whole area.

4.5

Financial Crises and the Lender-of-Last-Resort Function

A central bank is a hybrid institution. It is given by delegation the responsability of ensuring the adequate circulation of means of payment. However, as it has to intervene on a day-to-day basis in the financial markets and deal with financial institutions of all kinds, it is not a government department, but a bank, with a balance sheet and its own funds. Its specificity lies in the operations it carries out, the partners with whom it contracts, its motivations and, lastly, its owner. At the end of a long historical evolution, the State now provides the central bank with the capital with which it operates. As a result of its market operations, it is likely to incur losses and it has to absorb them through its capital. In the opposite direction, the profits from its operations accrue to its shareholder, the State. In the case of a monetary union, the central bank belongs collectively to the member States. For example, the European Central Bank became a European institution under the Treaty of Lisbon and its capital is held indirectly by the EU States through their national central banks. The objective of a central bank is not to maximize profit but to ensure the smooth monetary functioning of the economy. This objective is twofold. The first is the provision of liquidity to the financial markets and banking institutions in accordance

4.5 Financial Crises and the Lender-of-Last-Resort Function

157

with the macroeconomic objectives set by the central. This is what is commonly referred to as monetary policy and which we have just been discussing. This concern manifests itself on a daily basis, in the normal functioning of a market economy. The second, less apparent but equally important, aspect is to manage the banking and financial crises that regularly, though infrequently, shake market economies. These crises have a long history (Kindleberger [12]). The central bank is mainly concerned with banking crises since banks directly manage the means of payment of non-financial agents. The first form of crisis hits a banking institution in isolation. As the failure of this bank harms its customers, the public authorities may wonder whether it is appropriate to intervene, through the central bank, as a “lender of last resort”. The second form of crisis hits the banking system as a whole: it is referred to as a “systemic crisis”. This crisis may be caused by widespread panic among non-financial agents or by the contagion effects of a crisis originally limited to one bank. Under these conditions, the central bank must intervene to curb the crisis, or rather the risk of such a crisis. By coming to the aid of a banking or financial institution or group of institutions, the central bank intervenes in the allocation of resources and assumes a quasifiscal responsibility. It intervenes because it has the means for immediate action, an informational advantage since it deals intimately with the banks day after day, and its operation through a delegation scheme allows it to do so without the political constraints, particularly democratic constraints, that weigh on the usual fiscal interventions of the State. This can be seen in the bank’s balance sheet. A central bank’s crisis intervention potentially generates significant losses on its operations. If this is the case, it will be provisioned and its capital will be reduced. If it does not suffice, the State has to recapitalize the central bank and this represents a fiscal outflow. The State can also directly assume the consequences of a banking crisis and ensure the rescue of a bank, often through recourse to nationalisation. These events are rare but important in the dynamics of market economies. In such cases, public intervention in banking matters necessarily involves a close cooperation between monetary and fiscal authorities. These principles remain valid in a monetary union. But the management of a banking crisis is made more complex for two reasons: 1. The banking crisis has every reason to affect the member countries differently. However, they are all financially interdependent since they are collectively responsible for the central bank of the union. In fact, this will lead to aid from some countries to other countries. Logical in terms of risk-sharing, this aid is politically sensitive because national public opinions may resent it. 2. Any weakness in the banking sector, and more broadly in the financial sector, sets in motion contagion phenomena. This is, for example, what happened during the 1997 financial crisis in Southeast Asia, when the banking difficulties encountered in Thailand very quickly spread to all the countries in the zone (except Hong Kong), with international investors suddenly withdrawing their funds from these countries. This is true in an economy with different currencies. It is even

158

4 Institutions and Monetary Policy

more true in a monetary union where the absence of exchange rate filters, the interconnection of national payment systems and the prohibition of exchange controls do not allow a country to protect its banking system. In short, a banking crisis in a monetary union is a domain where monetary and fiscal responsibilities intertwine in a technically complex and politically perilous manner.

4.6

Conclusion

Three major conclusions can be drawn from the developments contained in this chapter: 1. The heterogeneity of a union and the fact that the tutelary authorities of the central bank of the union have to negotiate the institutional arrangements governing it clearly alter the conclusions on institutional matters put forward by monetary theory in the context of a simple economy. By focusing on the issue of inflationary bias, we have seen that the benefit of delegation to a single central banker is no longer guaranteed. Similarly, the appointment of the monetary policy committee may lead to a higher inflationary bias in a monetary union than would be the case in an autarky. One implication of this methodological principle is that there is no institutional arrangement that uniformly imposes itself as the best for any monetary union. Comparing two different institutional frameworks designed for any monetary union would show that one never systematically prevails over the other. Simple governance recommendations for a monetary union are not appropriate. The reallocative (redistributive) cross-border effects implicit in monetary policy explain the importance of the governance (institutions) of the central bank of the union. The adequate institutions of a monetary union depend on its structural configuration as well as on its political foundations. 2. If a country’s objective is to import credibility, joining a symmetrical monetary union is not necessarily the best institutional arrangement. An asymmetrical anchoring on a country’s monetary policy controlling its inflation may be preferable. 3. Because of the heterogeneity that makes up a monetary union, the monetary policy of the union may generate losers and winners among the member countries. For example, the inflationary bias of the union is intermediate between the inflationary biases obtained by two different countries in their appreciation of the costs of inflation. Even if monetary policy is conducted with reference to the union as a whole, both in terms of objectives and instruments, it generates redistributive or sectoral effects in the union, which often cut across the borders of member jurisdictions, especially if the union is multi-national. These effects should not be exaggerated in the case of normal economic conditions. But these effects are certainly magnified in the case of a crisis configuration. The principle of delegation is unavoidable due to the complexity of monetary policy in a monetary union. If delegation leads to a significant degree of indepen-

4.6 Conclusion

159

dence in terms of instruments or even objectives, it has the advantage of making monetary policy better founded and less debatable but it weakens the political support that the central bank receives and subjects it to the criticism of being nondemocratic. Rigorous accountability can counterbalance this effect and enhance the public confidence without which a central bank cannot conduct effective monetary policy in a complex economy such as a monetary union.

Solution for 4.1.4. (A Variant with Asymmetric Anchoring) It is assumed that both countries follow a monetary policy rule. The inflation rate in country 2 is equal to: π˜ 2AA == −

a ε2 λ2 + a 2

(46)

The loss L1 is + 2 ,       2 1  a ∗ e 2 L1 = Y − Y + a π1 − π1 + ε1 + λ1 π1 + ς π1 + ε2 2 λ2 + a 2     with π1 = h1 Y − Y ∗ + f1 .ε1 + f2 .ε2 and π1e = h1 Y − Y ∗ . We get    2 1 E (L1 ) = E Y − Y ∗ + a (f1 .ε1 + f2 .ε2 ) + ε1 + λ1 π12 2    2    a + ς h1 Y − Y ∗ + f1 .ε1 + f2 + ε2 λ2 + a 2

=

 2  1 Y − Y∗ 1 + (λ1 + ς ) h21 2  +  2 , 1 a + σε2 (af1 + 1)2 + (λ1 + ς ) f12 + (af2 )2 + λ1 f22 + ς f2 + 2 λ2 + a 2 The first-order conditions are 2 ∂E (L1 )  = Y − Y ∗ (λ1 + ς ) h1 = 0 ∂h1 ∂E (L1 ) = (af1 + 1) a + (λ1 + ς ) f1 = 0 ∂f1   a ∂E (L1 ) = a 2 f2 + λ1 f2 + +ς f2 + =0 ∂f2 λ2 + a 2

160

4 Institutions and Monetary Policy

The optimal values for the coefficients in the rule followed by country 1 obtain ςλ

a  f1 = −  2 a + λ1 + ς

h1 = 0

a

2 +a

2

 f2 = −  2 a + λ1 + ς

Proof of Proposition 4.1 cb We want to compare λDB u with λi given by



Y

2 − Y∗

=

σε2

 DB 3 λu λDB u

2ξ − a 2

  2 λi − ξ  λDB u +a

2  i=1

3 + a2

a2

2 

λi

i=1

 cb 3  cb  2  λi λi − λi Y − Y∗ =   λi σε2 2 3 λcb i +a

(47)

Hence:  

λcb  cb i  λi +a 2 λDB u

2ξ +a 2

3

2  i=1

  2 λi −ξ  λDB u +a 2 

a2

3 =

2 (λDB u +a )

λi

i=1

 cb  λi −λi λi

 2ξ

2 

+ a2

λi

− ξ

  DB  2 λu + a λ λi

i=1

=



2   2 λcb λi i − λi a i=1

  This ratio may be bigger than 1 when λcb − λi is sufficiently low, that is, when the variance is sufficiently large. This may be true for both countries.

Proof of Proposition 4.2 C Let us assume λi = λ. Given symmetry, λC i = λu . We get



Y − Y∗ σε2

2



λcb = λ

 3  cb λ −λ  3 λcb + a 2

4.6 Conclusion

161

and  σε2

     2 ∗ 2 + a Y − Y 2λa 2 + 2ξ − ξ  λC u = 2λ    3 2 4 + a λC λC u u

Hence:    2  2 λC 3 2λa 2 + 2ξ − ξ  λC Y − Y∗ u +a u =   2 4 2λ σε2 λC u +a equivalently:  cb 3  cb     2 λC 3 λ λ −λ 2λa 2 + 2ξ − ξ  λC u +a u  3 =  4 cb 2 C 2 λ 2λ λ +a λ +a u

 cb 3 λ ⇒  3 = λC u

 

2λa 2 +2ξ −ξ λC u +a 2 2 (λ C u +a )

 2

4

=

(λcb −λi ) (λcb +a 2 )3

   2 λcb + a 2 3 2λa 2 + 2ξ − ξ  λC u +a     2 4 λcb − λ 2 λC u +a

We get  C 2  2 2λu + a 2 + a 2 ξ=   2 2 4 λC u +a          C 2 λC + a 2 2 − 8 2λC + a 2 2 + a 2 2 λu + a 2 16 2λC + a u u u ξ =   2 4 16 λC u +a     C     2 λC + a 2 − 2 2 + a2 2 2 2λC 2λ + a + a u u u =  3 C 2 2 λu + a    2 2  C 2 C 2 2λu + a 2 2λC λC a 2 u + 2a − 2λu − a − a = =  u 3   2 2 3 4 λC 2 λC u +a u +a Hence: 2λa 2

ξ



+ 2ξ −  2 λC u +a

λC u  2 4

+ a2

 =

2λa 2 + 2

 C 2 2  2 2 2λu +a + a 2 4 (λ C u +a )

2

−

  2 4 2 λC u +a

2 λC ua 2 2(λC u +a )

2

162

4 Institutions and Monetary Policy

      2 2 + 2λC + a 2 2 + a 2 2 − λC a 2 4λa 2 λC u +a u u =  6 C 2 4 λu + a =

4λa 2

       2 4 + 2λC a 2 + 4 λC 2 + a 4 + 2λC a 2 + a 2 2 − λC a 2 λC + a u u u u u  6 C 2 4 λu + a 4λa 2

=

     2 4 + 2λC a 2 + 4 λC 2 + 2a 4 + λC a 2 λC + a u u u u  6 2 4 λC u +a

Using this equality we get      2 3 3 2 + 4 λC 2 + 2a 4 + λC a 2  cb 4λa 2 λC + a 4 + 2λC u ua u u λcb λ + a2     3 =  2 6 λcb − λ 4 λC λC u u +a



=

4λa 2



λC u

2

   3 2 + 4 λC 2 + 2a 4 + λC a 2  cb + a 4 + 2λC ua u u λ + a2       2 3 λcb − λ 2 3 λC 4 λC u +a u +a

equivalently:  

3

λcb

(

λcb +a 2

)

3 λC u C 2 (λu +a )

=

4λa 2

     2 4 + 2λC a 2 + 4 λC 2 + 2a 4 + λC a 2 λC + a u u u u 3    C 2 cb λ −λ 4 λu + a

(48)

ofthis equality is bigger than 1. This is consistent If λcb > λC u , the left-hand-side  with the equality (48) if λcb − λ is sufficiently low, that is, if σε2 is sufficiently large. This proof can be generalize this proof and show that parameter sets such that DC λcb 1 > λ1

lead to: cb DC λcb 2 > λ1 > λu

References

163

References 1. Aaron-Cureau C, Kempf H (2006) Bargaining over monetary policy in a monetary union and the case for appointing an independent central banker. Oxford Econ Pap 58:1–27 2. Alesina A, Summers L (1993) Central bank independence and macroeconomic performance: some comparative evidence. J Money Credit Bank 25:151–162 3. Barro R, Gordon D (1983) Rules, discretion and reputation in a model of monetary policy. J Monetary Econ 12:101–121 4. Blinder A, Ehrmann M, Fratzscher M, De Haan J, Jansen D-J (2008) Central bank communication and monetary policy: A survey of theory and evidence. J Econ Literature 46:910–945 5. Cukierman A (1992) Central bank strategy, credibility, and independence: Theory and evidence. MIT Press, Cambridge, MA 6. Cukierman A, Web S, Neyapti B (1992) Measuring the independence of central banks and its effect on policy outcomes. World Bank Econ Rev 6:353–398 7. Dincer N, Eichengreen B (2014) Central bank transparency and independence: Updates and New Measures. Int J Central Bank 10:189–259 8. Ehrmann M (2006) Central bank communication. Eur Central Bank Res Bull 5:2–5 9. Eijffinger S, Geraats P (2006) How transparent are central banks? Eur J Polit Econ 22:1–21 10. Eijffinger S, Hoeberichts M (1998) The trade off between central bank independence and conservativeness. Oxford Econ Pap 50:397–411 11. Grilli V, Masciandaro D, Tabellini G (1991) Political and monetary institutions and public financial policies in the industrial countries. Econ Policy 6:341–392 12. Kindleberger C (1978) (sixth edition 2011) Manias, panics and crashes. A history of financial crises. Palgrave Macmillan, London 13. Parkin M (2013) Central bank laws and monetary policy outcomes: A three decade perspective. In: EPRI Working Paper 2013–1 14. Reinhart V, Sack B (2006) Grading the federal open market committee’s communications. Federal Reserve Board of Governors, mimeo 15. Rogoff K (1985) The optimal degree of commitment to an intermediate monetary target. Q J Econ 18:1169–1189 16. Weber C, Forschner B (2014) ECB: Independence at risk? Intereconomics 49:45–62

Part II Fiscal Issues

5

Government Deficits, Transfers and Debts

Abstract

Chapter 5 develops a public finance view on monetary unions. Focusing on multinational unions, it analyses the impact of monetary unification on governmental budgets and deficits. Fiscal constraints can be assessed both at the country level and at the union level. Based on explicit formulas for the government budget constraints of member countries, it proves that the constraints due to the sharing of a common currency implies that transfers are unavoidable except under very stringent conditions. This affects the conditions for public debt sustainability. This chapter ends with a discussion of the two ways to discipline fiscal profligacy within a monetary union, through markets or through restricting institutions.

The fiscal dimension is inherent to a monetary union, particularly between sovereign States. The structural links created by a common currency impinge on the fiscal positions of each member country (or region). This chapter is devoted to the public finances of member countries of a monetary union and their interdependence. Unless there is an explicit exception, we reason within the framework of a multinational monetary union and we reason on national budgets. But our developments apply without difficulty to the case of a national monetary union: we then refer to the budgets of sub-national public entities. Section 5.1 is devoted to the budget constraints of States in a monetary union and their indebtedness. The sustainability of public debt will be dealt with in Sect. 5.2 and (sovereign) default in Sect. 5.3. Finally, Sect. 5.4 deals with the roles of markets and institutions in the regulation of public debt in a monetary union.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_5

167

168

5.1

5 Government Deficits, Transfers and Debts

Government Deficits and Public Debts in a Monetary Union

The financing of government deficits is of such importance that it deserves a specific and detailed treatment in any macroeconomics textbook. Economists have been studying the subject for a long time, but in view of the general and permanent nature of public deficits, policy-makers seem to have a pragmatic view on the subject: government deficit is a normal modality of fiscal policy and the public debt. Since the sudden, sharp and significant growth of public debts in the period post-2008, followed by an even larger leap due to the Covid-19-related downturn, the issue has become a major concern. Public debt is costly in financial terms since borrowing on the financial markets involves the payment of an interest rate. A loan whose repayment is certain without loss of real value is said to be “risk-free”. If its repayment is uncertain, either because it may not happen or because it may imply a loss in real value, it is “risky” and lenders include in the interest rate an additional cost that allows them to cover their anticipated risk. This extra cost includes an “inflation premium” to compensate for the erosion of the value of the loan due to inflation and a “default risk premium” to compensate for the possibility that the borrower may not repay the loan itself. These mechanisms are at work in the case of loans made by a public authority, in particular a government. A government must be in a position to repay its loans, i.e. to assume the burden of its outstanding debt (payment of interest and repayment of maturing loans) so that it can continue to borrow on the financial markets. If it is unable to do so, its debt is said to be “unsustainable” and the government is (sooner or later) in a situation of “sovereign default”. The financial default of a government is different from the bankruptcy of an individual or company in that it is not possible for aggrieved borrowers to turn to the courts of justice to obtain compensation or to force the lender to repay to the maximum of its ability. The State is sovereign and there is no supranational judicial system that can compel it to meet its contractual obligations. The only option left to the lenders is to renegotiate expired contracts.1 From an economic point of view, it leads to a reduction in the debt burden and a loss for the lenders. This loss is referred as a “haircut”. The extent of the haircut is the subject of renegotiation. The defaulting State is subject to sanctions that effectively make it difficult or impossible to raise new loans on the international financial markets. A sovereign default is a sign of the failure of a country’s economic policies over a long period of time and plunges the country in question into a major economic crisis. Therefore this phenomenon should be extremely rare. Surprisingly, this is not the case. Reinhard and Rogoff [10] identify 219 episodes of sovereign default around the world from 1800 to 2008. Approximately one per year worldwide. This

1

The sybilline terms “debt rescheduling”, “revision of contractual clauses” or “private sector involvement” refer to this renegotiation.

5.1 Government Deficits and Public Debts in a Monetary Union

169

problem cannot be neglected on the pretext that it may only be of interest to lovers of logic puzzles and textbook cases, cut off from the world. The difficulty is that it is impossible to assess the financial sustainability of a State by an objective and undisputable measure. It is all a matter of circumstances. The economy is prone to sudden downturns, sudden and unanticipated crises, and the fiscal mobilization capacities of governments are not testable ex ante. Lastly, we may qualify as “variable”, with a certain sense of understatement, the financial expertise of governing political teams and their ability to build a national consensus on fiscal discipline. In a monetary union, the question of public debt and its sustainability is raised in terms that are made more difficult by the multiplication of actors and, in particular, of States in the case of a multi-national monetary union. The link between public deficit and public debt is of an accounting nature. The debt of a public institution on a given date is the total gross outstanding amount of public debt issued in the past by that institution that has not matured and been repaid in full. Since a government comprises a wide variety of public institutions, it is useful to consolidate the debts of these public institutions to obtain “public debt”. Moreover a State may use institutions that are not public administrations in the legal sense of the term to achieve part of its objectives, particularly in the area of social protection, while guaranteeing their indebtedness. It is reasonable to include the debts of these institutions in the public debt.2 Let us therefore reason about the consolidated debt of a member State of a monetary union, without trying to distinguish between the debts of the components of this State. Furthermore, we are giving ourselves the possibility of having a supra-national “federal” Treasury in this union. This Treasury may incur deficits and issue “federal” debt. The link between deficit and debt is given by the State’s budget constraint which we will detail and discuss in this section.

5.1.1

The Budget Constraint of a Member State of a Monetary Union

Let us reason in current nominal (monetary) values and record the government’s expenditure and revenue flows in a given period (it makes sense to reason in terms of a fiscal year) in the unit of account that characterizes the union (its “currency”). This record constitutes the budget constraint of a State in nominal terms. It is an essential prerequisite for economic analysis.

2

It is in this logic that the debts of the member States of the European Union are defined.

170

5 Government Deficits, Transfers and Debts

We make the following simplifying assumptions: 1. There is only one type of public debt security. It is a Treasury “bond” with a nominal value of 1, redeemable in the period following its issue (maturity of one period) and bearing interest. 2. The financial markets do not discriminate between borrowers and apply the same interest rate for all member countries of the union, as well as for the federal Treasury. Implicitly, based on what we have just said, this means that the risk of default is the same for everyone and that the inflationary premium is the same throughout the union. 3. The monetary union is made up of J member countries, indexed by j . The government’s inflows consist of its own resources, tax receipts from its residents, transfers from other public authorities, including the central bank, and the loans it takes out during the period. Its outflows consist of government expenditures, transfers to other public authorities and repayments, including interest, of its previous borrowings. ˜ j t the non-financial public expenditure of j in t, T˜ j t the fiscal resources of Note G j in t and Bj t the number of securities issued by j in t. All these sums are recorded at current value, i.e. at market prices for period t. Finally, r˜t represents the nominal interest rate per security, on the matured debt in t (issued in t − 1). Flows (without counterpart) between different government institutions are posj sible: these are transfers. Note φ˜ i the transfers from country j to country i, φ˜ jt

Ft

the transfer from the federal Treasury (if it exists) to country j , φ˜ jFt the transfer j from country j to the federal Treasury and ψ˜ t the transfer from the central bank to country j . Logically, we can posit that country j does not make a transfer to itself: j φ˜ j t = 0, ∀j = 1, ..., J. Define the net transfer from j to i, ˜ ji t as the difference between gross transfers ˜ ji t = φ˜ ji t − φ˜ ji t . j ˜ ji t can be negative or positive (and of course ˜ j t = 0, ∀j, ∀t ). If it is negative, this corresponds to a positive net transfer from i to j . Logically, we have j ˜ ji t = −˜ it .

(5.1)

Similarly the net transfer from the federal Treasury to country j , denoted byF˜t , is defined as j

j j F˜t = φ˜F t − φ˜ jFt .

5.1 Government Deficits and Public Debts in a Monetary Union

171

˜ jt defined as Country j receives a total net transfer (of fiscal origin)  ˜ jt 

⎛ ⎞ J j j ˜ it + F˜t ⎠ . =⎝

(5.2)

j =1

The budget constraint for the j -th member State for the period t is therefore written as follows ˜ j t + (1 + r˜t ) Bj t −1 = T˜j t + Bj t +  ˜ jt + ψ˜ tj . G

(5.3)

Public deficits are easily defined from (5.3). For country j , the net debt (the change in debt during period t) is given by the following equality ˜ j t + r˜t Bj t −1 − T˜j t −  ˜ jt − ψ˜ tj . Bj t − Bj t −1 = G

(5.4)

If the deficit is negative, it corresponds to a surplus situation: inflows are greater than outflows and the government has the capacity to pay down debt since the change in debt is negative. The stock of debt may itself be negative. In this case, the government in question is a lender since it invests its surpluses on the financial market.3 Finally, it is also possible to define the primary deficit as the remainder of nonfinancial expenditure (excluding financial charges) not financed by own resources, i.e. by tax ˜ j t − T˜j t = Bj t − (1 + r˜t ) Bj t −1 +  ˜ jt + ψ˜ ti . G

5.1.2

(5.5)

The Constraint of the Federal Treasury

The federal Treasury can play two distinct roles, depending on whether it has fiscal autonomy, i.e. the ability to raise taxes, have its own resources and spend directly within the union. If it has this capacity, it can make transfers to the States out of its own resources; otherwise, its only resources are the transfers it receives from the States and distributes to States. In the first case, the federal Treasury a priori has greater freedom of manoeuvre. In the second case, it is a fund through which transfers between States transit. In this case, it plays an indirect redistributive role in the taxes levied on taxpayers of the union. Behind this accounting point lies the extremely important problem of the decision-making capacities of the federal Treasury and the supranational institutions of the monetary union. Finally, this Treasury may or may not have the capacity to take on debt.

3

International lending by sovereign States is often done through “sovereign wealth funds”.

172

5 Government Deficits, Transfers and Debts

It should be noted that, from an accounting point of view, the federal Treasury ˜ F t its non-financial expenditures in t, T˜ F t is similar to a national Treasury. Note G F its (own) tax resources in t and Bt the number of securities it issues in t. All these sums are recorded at current value, i.e. at market prices for the period t. The net j federal transfer F˜t to country j can be positive or negative. We can write the budget constraint of the federal Treasury for the period t as: J

j ˜ F t = BF t + ψ˜ F t + T˜F t , F˜t + (1 + r˜t ) BF t −1 + G

(5.6)

j =1

where ψ˜ F t represents the transfer from the central bank to the federal Treasury. If the Treasury does not have the capacity to tax and spend directly, this implies that ˜ F t = T˜F t = 0. If it does not have the capacity to incur debt, this implies that G ˜ BF t = 0 for any value of t. If it only has the possibility of distributing transfers received from the States among them, the budget constraint becomes J

j F˜t = ψ˜ F t .

(5.7)

j =1

In other words, the sum of net federal transfers is equal to the transfer received by the federal Treasury from the central bank of the union.

5.1.3

Central Bank Accounts

The central bank of the union is an economic agent with its own constraints. Its activities are recorded in two documents: a balance sheet and an operations account, which could be compared to the operating account of a private agent. The balance sheet of a central bank is of great importance for economic policy since it is the ultimate guarantor of the macro-financial stability of an economy. Since this chapter does not focus on the banking and financial system but on the financing of public deficits, we will do with a minimum accounting representation of the central bank. We make the following assumptions: 1. We abstract from the banking system and assume that the central bank is the only money-creating institution in the entire union. 2. The central bank may be allowed to make transfers to Treasuries alone through the money creation generated by its interventions. Recording flows in period t allows us to define money creation as: Mt ≡ Mt − Mt −1 ,

(5.8)

5.1 Government Deficits and Public Debts in a Monetary Union

173

where Mt denotes the money supply in circulation (at the end) of period t and  is the operator indicating a difference. The problem is to understand how these transfers are made. Two options are worth being explored. According to the first, money creation is the immediate counterpart of transfers to the Treasuries of the union. According to the second option, money is created during the operations carried out by the central bank on the financial markets. Here we have assumed a single financial market. In both cases, money creation is redistributed in the form of transfers to the Treasuries Mt = ψ˜ tF +

J

j ψ˜ t .

(5.9)

j =1

The distribution, except in exceptional cases, is defined by an institutionally fixed scale, which does not depend on a discretionary decision by the central bank. Note χj the share of monetary creation received by country j and χF the share of monetary creation received by the federal Treasury. Under these conditions, we can rewrite the previous equation as ⎛ Mt = ⎝χF +

J

⎞ χj ⎠ Mt ,

(5.10)

j =1

   which implies that χF + Jj=1 χj is equal to 1.

5.1.4

Public Accounts and Monetary Union

The budget constraint of a sovereign State exists in all circumstances but it is written differently depending on the institutional environment, particularly monetary, in which this State operates. Let us look at the impact of belonging to a monetary union on the constraint of a member State, based on the equations we have just detailed: 1. The first point is that they are all written in the same numéraire, the monetary unit common to all. This means, in line with what we saw in Chap. 1, that no exchange rate variation alters a member State’s resources and expenditure. In particular, the debt burden is not abruptly altered by a change in exchange rates. This is both the removal of a source of risk and an additional rigidity, as the exchange rate cannot be used to loosen the budget constraint in certain circumstances. 2. Second, note that we have included in these constraints international transfers. To understand why, let us recall the equation:       Yj t − Cj t − Ij t = Sj t − Ij t + Ej t = Xj t − Mj t ,

(5.11)

174

5 Government Deficits, Transfers and Debts

where Ej t represents the public net position of country j at period t.4 Consider a monetary union of two countries, 1 and 2, and that it is closed: the only international trade is between 1 and 2. Equation (5.11) applies to j = 1, 2. We know that the sum of the external balances is zero (X1t − M1t ) + (X2t − M2t ) = 0.

(5.12)

Let us assume that for a given period t country 1 is in deficit and country 2 is in surplus: (X1t − M1t ) < 0 < (X2t − M2t ). Let us now make a succession of assumptions: (a) net private savings are zero in both countries: (S1t − I1t ) = (S2t − I2t ) = 0; (b) public debts are zero; (c) there is no net issuance   of money ˜ j t − T˜j t , and (d) there is no federal Treasury. Under these conditions Ej t = G Eq. (5.5) becomes 

 ˜ j t − T˜j t =  ˜ jt . G

(5.13)

Since the external balance of country 1 is negative, the public deficit is positive:   ˜ j t − T˜j t . The opposite is true for country 2. By combining these three G equations, we obtain 1 ˜ 2t > 0.

(5.14)

For country 1 to balance its public and external accounts, country 2 must make a positive transfer to it. If it does not do so, country 1 is in default5 and a crisis opens up in the monetary union: it is doubtful that country 2 will not suffer from it. In a multi-currency economy, countries have no obligations to each other, exchange rates adjust to ensure external balance and participants in international financial markets assume their risk if they decide to lend to a government. As discussed in Chap. 1, the absence of exchange rate adjustment means that the current accounts are not balanced by the exchange rate. One possible adjustment mechanism comes from the interdependence of the public accounts, as the previous example shows. Let us now loosen the very restrictive assumptions we have just made. Potentially at least, international transfers are mobilized to ensure the resolution of the international payments of the member countries of a monetary union. This is why some economists refer to a monetary union as a “transfer union” [7]. Indeed, what was at stake in the Greek debt crisis that began in 2010 was the size of the transfers to be granted (or not to be granted, depending on the analysis of the

4

It generalizes Eq. (1.3) from Chap. 1, which ignored the government’s financial expenses. Strictly speaking, there is no “default” since we assume that there is no public debt. In the present configuration, Country 1 cannot close its public accounts, which we equate to default.

5

5.1 Government Deficits and Public Debts in a Monetary Union

175

situation and the responsibilities of each party in the outbreak of the crisis) to the Greek State, which was unable to meet its financial obligations. 3. The sum of net transfers between governments is logically zero: ⎛ ⎞ J J ⎝ ˜ ji t ⎠ = 0. i=1

(5.15)

j =1

If, in addition, the federal Treasury has no fiscal autonomy and receives no transfers from the central bank, we have, according to (5.7) ⎛ ⎞ J J ⎝ ˜ ji t + F˜ti ⎠ = 0. i=1

(5.16)

j =1

These equations represent constraints imposed on States and, more generally, on the monetary union as a whole: it is not possible to free oneself neither from the first nor from the second. They have the merit of showing another channel of interdependence existing between the States of a monetary union, an accounting constraint. However, it is clear that these equations are also valid in a multi-currency economy in which each country retains its monetary sovereignty (when the variables are expressed in the same numeraire, i.e. through exchange rates). What is special about the monetary union? In a multi-currency economy, countries have at their disposal the instrument of exchange rates to balance their foreign trade. In a monetary union, this instrument has disappeared. There is no other way to balance external accounts, in case the price system is not sufficient, than to resort to international transfers. 4. What the purely accounting approach cannot tell us is how transfers between jurisdictions in a monetary union are decided (or not). A national monetary union is easier to manage than a multi-national monetary union. Insofar as the former is based on a federal organization and a regulatory unit, transfers are logically provided by the federal government and legal provisions are imposed on the member jurisdictions to govern the management of their public finances and, if necessary, impose a more or less strict budget balance. On the contrary, in a multi-national union, transfers are made between States that have retained full fiscal sovereignty. They are caught in a dilemma between international interdependence and sovereignty.

5.1.5

Budget Constraints in Real Terms

We have reasoned for the moment in nominal terms, i.e. we have recorded the transactions of the various public institutions in monetary units. However prices change from period to period, and it is necessary to take this into account in

176

5 Government Deficits, Transfers and Debts

order to make things comparable and understand what public institutions have “really” collected, spent and redistributed. To do this, we assume, as is common in macroeconomics, that only one good is produced in the economy in each period. This good will serve as a unit of account, or even as cash. Instead of counting in a monetary unit, which may lose over time in purchasing power, we will reason in a unit of good, by definition invariable over time. A nominal variable is the product of the price and the corresponding quantity of the good: X˜ t = pt Xt , where pt is the nominal price of a unit of the good exchanged in t and Xt denotes a real quantity. Macroeconomists have the practice of identifying the good in question with a basket of goods that is representative of aggregate consumption and thus qualify pt at the “general price level”. Its (relative) change then becomes the (net) inflation rate. We will follow this usage. Using this definition, we can rewrite Eqs. (5.5) and (5.6)  pt Gj t + (1 + r˜t ) Bj t −1 = pt

j Tj t + Ft

+

J

 ji t

+ χj (Mt − Mt −1 ) + Bj t

i=1

(5.17) and J

j

pt Ft + (1 + r˜t ) BF t −1 + pt GF t = BF t + χF (Mt − Mt −1 ) + pt TFFt .

(5.18)

j =1 B

We can switch to real terms by dividing by the price level. Let us define bj t ≡ pjtt . bj t is the purchasing power in goods at period t of a unit of debt issued by country j in t. It is the quantity of goods that the Treasury of country j must repay to its creditors (in the form of monetary repayment). We define in the same way btF . It is the “real debt” of j in t. mt ≡ Mptt corresponds to the purchasing power of the stock of money issued in t. We will call it “aggregate real balances”. Finally, we define the t t−1 gross inflation rate πt as πt ≡ ppt−1 = 1 + ptp−p . The previous equations become t−1     J mt −1 (1 + r˜t ) i i pt −1 bj t −1 = Tj t + Ft + j t + φj mt − Gj t + + bj t pt πt i=1

(5.19)

5.1 Government Deficits and Public Debts in a Monetary Union

177

and J i=1

Fti

(1 + r˜t ) + pt −1 bF t −1 + GF t = btF + φF pt

  mt −1 mt − + TF t . πt

(5.20)

We know that   (1 + r˜t ) = (1 + rt ) 1 + πte , where rt denotes the real interest rate in the economy and πte denotes the inflation rate from t − 1 to t expected in t − 1 in financial markets by market participants. The nominal interest rate   differs from the real interest rate by an “inflation” premium, given by 1 + πte and linked to the expected inflation rate. If expected inflation is the same throughout the union, it is normal that all interest rates charged in the monetary union are the same (for the same category of securities). The government’s budget constraint j in real terms (5.19) can be rewritten and expressed by the following formula     J 1 + πte mt −1 j i + φ m + bj t . bj t −1 = Tj t + Ft + j t Gj t + (1 + rt ) j t − 1 + πt πt i=1

(5.21) Similarly, the budget constraint of the federal Treasury is written as follows J

Fti +GF t +(1 + rt )

i=1

1 + πte bF t −1 = TF t +φF 1 + πt

  mt −1 mt − +bF t . πt

(5.22)

The comparison between (5.3) and (5.21) shows the impact of inflation on the accounts of a State (as of any agent).   1+πt e 6 1. The ratio 1+π e , which can be approximated by πt − πt , is the unanticipated t component of inflation. It comes into play via the holding of an interest-bearing asset. “Surprise” inflation makes it possible to reduce an agent’s debt. Why does it do so? Because, as we have seen, the nominal interest rate contains an “inflation premium”, which protects the purchasing power of the sum lent according to the inflation expectation. An error in anticipations makes the inflation premium inappropriate, so the unanticipated component affects the public accounts. The real debt is reduced if the anticipated inflation is lower than the actual inflation, and increased otherwise.

6

For low values of πt and πte .

178

5 Government Deficits, Transfers and Debts

2. Total inflation also matters as it generates a loss of purchasing power of the money held in the economy in t − 1 and transferred in t. This loss of purchasing power is borne by all the agents in the union insofar as they hold nominal balances. We can speak of an “inflation tax” insofar as inflation is positive. These two effects are present at the level of the union, i.e. they concern a priori all agents resident in the union. They represent quasi-fiscal levies. Depending on the distribution key for monetary creation, these levies add to the available resources of the States. There is indeed cross-border redistribution within the union. It  is also a channel of fiscal and monetary interdependence since φj mt − mπt−1 t represents the (real) transfer of seigniorage to j .

5.2

The Sustainability of Public Debts in a Monetary Union

Equation (5.21) allows us to study the dynamics of real debt as it can be rewritten ⎛ ⎞   J m 1 + πte t −1 ⎠ j bj t = (1 + rt ) bj t −1 + Gj t − ⎝Tj t + Ft + ji t + φj mt − . 1 + πt πt j =1

(5.23)     represents the real public deficit, Gj t − Tj t + Fti + Ji=1 ji t + φj mt − mπt−1 t excluding financial charges but including transfers received, of country j . Let us denote it Dj t . So we can rewrite the previous equation Dj t = bj t − (1 + rt )

1 + πte b.j t −1 . 1 + πt

(5.24)

From (5.22), under the same assumptions, we obtain

DF t ≡ GF t +

J j =1

   mt −1 1 + πte j Ft − TF t + φF mt − bF t −1 . = bF t − (1 + rt ) πt 1 + πt (5.25)

5.2.1

The Sustainability of a Member Country’s Debt

Public debt is sustainable when the public institution that issued it is able to repay the debt when it falls due. How can this sustainability be rigorously defined? Under what conditions is this ownership verified? Analyses of sustainability are familiar to economists (D’Erasmo, Mendoza and Zhang [4]). To what extent does reasoning in a monetary union change the analysis of the sustainability of public debt issuance?

5.2 The Sustainability of Public Debts in a Monetary Union

179

To answer this question, let us take the case of a member country and consider an extremely simplified configuration. We will make a quadruple assumption:7 1. Inflation is perfectly anticipated in any period: πte = πt . 2. The central bank does not create money and does not distribute seigniorage resources to the national and federal Treasuries. 3. The interest rate at any period for any debt contract is constant. Let us also maintain the assumption of no sovereign default. 4. There is no shock and perfect foresight applies: the sequence of future flows is known by all. (5.24) is valid at any period t. By using it to successively replace bj t +1, ..., bj t +s , ..., we obtain bj t −1 =

∞ Dj t +s bj t +s . s + lims→∞ (1 + r) (1 + r)s

(5.26)

s=0

The last term in this equation represents the present value of real government debt calculated at infinity in the future. It is logical to think that the government must settle its accounts “at the end of time”. It cannot push the debt burden into the future, let alone grow it indefinitely. Formally, this requirement takes the form of a constraint, known as the “transversality condition” lims→∞

bj t +s = 0. (1 + r)s

(5.27)

Applying it to Eq. (5.26), we obtain the definition of a sustainable debt issued in t −1 bj t −1 =

∞ Dj t +s . (1 + r)s

(5.28)

s=0

According to (5.28), a real debt is sustainable if its value is equal to the sum of discounted future deficits, using the interest rate as the discount rate. If the initial debt (bj t −1 ) is zero, the sum of the discounted future deficits is zero. Three observations are useful: 1. Equation (5.28) shows the need to run surpluses (i.e. a negative deficit) at some point in time in the absence of growth and unanticipated inflation. A member country cannot neglect controlling its deficits without calling into question the sustainability of its debt and thus the viability of the union or the sustainability of its membership. 7

These assumptions can be relaxed at the cost of increased complexity, unnecessary at this stage of reasoning.

180

5 Government Deficits, Transfers and Debts

2. Transfers received by a member State, including monetary transfers, contribute to the sustainability (or otherwise) of its debt. Equation (5.28) is defined on the basis of the deficit including transfers, not on the basis of primary deficits as is the case in a closed economy with a single government. A received transfer contributes to the sustainability of a country’s public accounts but a given transfer contributes to its deterioration. 3. The consequence of this condition of sustainability is that the public debt is not equal to the sum of the discounted primary surpluses bj t −1 =

∞ Tj t +s − Gj t +s (1 + r)s s=0

except in the case where the transfers are systematically zero or if the sum of the discounted transfers is itself zero. If we assume that the discounted sum of the net transfers received by a member State j is positive, it can bear, thanks to these transfers, a debt greater than the tax resources it will mobilize in the future. In other words, transfers make the debts of the member States sustainable. We can put forward the following proposition: Proposition 5.1. In a monetary union, a member country’s sustainable debt is not equal to the sum of its discounted primary surpluses but to the sum of its real surpluses, including the net transfers received. Since the sum of net transfers within the union is zero, this implies that some countries receiving net transfers can bear a higher debt than if they were in a flexible exchange rate and without the capacity to receive transfers (assuming that the induced monetary change has no impact on the way they finance their deficit) while others, paying net transfers, face a lower debt ceiling than in a flexible exchange rate system. In other words, part of their discounted net fiscal effort is used to repay the debt of other countries. This represents a potentially large redistributive effect within the monetary union. The fact that it occurs over time and via complex and obscure financial mechanisms does not alter the strategic importance of this solidarity between member States. It is easy to sense that this fact is fraught with political difficulties.

5.2.2

Sustainability of the Federal Treasury Debt

We can apply the same reasoning to ensure the sustainability of the federal debt. Starting from (5.25) and imposing the following cross-cutting condition lims→∞

bF t +s = 0, (1 + r)s

(5.29)

5.2 The Sustainability of Public Debts in a Monetary Union

181

we obtain for the existing real debt of the federal Treasury the following sustainability condition bF t −1 =

∞ DF t +s . (1 + r)s

(5.30)

s=0

It is interpreted as the condition relating to the public debt of a member State: the existing real federal debt is sustainable if its value is equal to the sum of the discounted future real federal deficits, taking the interest rate as the discount rate. Net transfers are here the transfers paid by the federal Treasury. If the original federal debt (at period t = 0, denoted bF −1 ) is zero, the sum of discounted future deficits is zero.

5.2.3

The Consolidated Sustainability of a Monetary Union

The debt sustainability of one member country is insufficient to ensure the sustainability of the whole since the conditions of sustainability are linked through transfers between public institutions: the sustainability of one may be due to transfers that make the debt of another institution unsustainable. It is therefore simultaneously that these conditions must be satisfied. How to ensure overall sustainability? As we have seen, the jurisdictions of the union have their sovereignty, i.e. their decision-making autonomy. The decisions of these authorities are a priori uncoordinated by the very definition of their autonomy. At the same time, each institution has resources at its disposal, which may be internal, coming from the economic space it controls, or external, transfers coming from economic spaces it does not control. Thus, what emerges from the previous equations is the interdependence of public debt, in connection with the monetary process steered by the central bank of the union. In other words, a de facto interdependence ensures the sustainability of an institution within a monetary union. One way of dealing with this problem is to define the overall sustainability of a monetary union, defined as the sustainability of the total debt of the member institutions, after consolidation of flows between institutions. Let us assume, to simplify, that there are no transfers from the central bank (no monetization of deficits) for the benefit of the States so as to keep the central bank out of the problem. We can sum up the budget constraints of the various Treasuries (in nominal terms): J j =1

 ˜ j t − T˜j t − G



J

 ˜ ji t

˜ F t − T˜F t + F˜ti = BU t − (1 + r˜t ) BU t −1 +G

i=1

(5.31) noting BU t the sum of the debts issued at period t

J

j =1 Bj t

+ BF t .

182

5 Government Deficits, Transfers and Debts

The real consolidated debt of the monetary union that we note bU t is defined as the sum of the debts at a given time t and, by repeated substitutions, we obtain bU t ≡

J

bj t + bF t =

j =1

∞ s=0

 J

j =1 Dj t +s

+ DF t +s

(1 + r)s

 + lims→∞

bU t +s = 0. (1 + r)s (5.32)

Let us apply the transversality condition and use the fact that the sum of transfers between public institutions is zero (Eqs. (5.15) and (5.16)). We can then rewrite the previous equation as follows bU t =

∞ s=0

 J

j =1



  Gj t +s − Tj t +s + GF t +s − TF t +s (1 + r)s

.

(5.33)

This equation is similar to the usual equation obtained for the Treasury of a unitary economy. We obtain the following proposition: Proposition 5.2. In a monetary union, the consolidated sustainable debt of the union is equal to the consolidated sum of the discounted primary surpluses of the member countries, net of transfers. How should this proposition be interpreted? It expresses at the global level the compulsory financial solidarity between the members of a monetary union that we had already noted when we looked at the sustainability of a member country. The public surpluses of some compensate for the public deficits of others. The overall financial sustainability of a monetary union implies a collective effort that may involve fiscal redistribution between member countries, possibly through the federal Treasury. The decision-making and governance mechanisms for this redistribution represent a major issue in a monetary union and are eminently political.

5.3

Debt Sustainability and Sovereign Default in a Monetary Union

We have so far reasoned by excluding the possibility of a sovereign default by a member State, i.e. by imposing the sustainability of public debt: a State must in all circumstances assume the repayment of its financial obligations. If we abolish this obligation and the matured debt is not repaid in full, the issuing public institution defaults. If it is part of a monetary union, this means that its partners did not want to assume financial solidarity for its benefit and the transfer efforts that would have prevented its default.

5.3 Debt Sustainability and Sovereign Default in a Monetary Union

5.3.1

183

Default and Renegotiation of the Public Debt

How does the default manifest itself and why? In a market economy, the debt of a public institution is issued on a financial market and purchased according to the judgements of potential lenders about its sustainability. These judgements depend on the lenders’ expectations of future developments in tax revenues and government expenditure. Lenders (purchasers of debt instruments) have the possibility to hedge against the prospect of a possible default by raising interest rates. The latter includes a “(sovereign default) risk premium”, which makes it possible to compensate for the failure to meet contractual obligations, i.e. to default, by increasing the remuneration in the event of noncompliance with these obligations. The calculation of this risk premium is complex and depends on the probability that lenders attribute to such a default. The complexity of this calculation stems in particular from the fact that the risk premium increasing the debt burden increases the probability of default. There may come a time when there is unanimity in the financial market about the unsustainability of a government institution’s debt. For no lender, there is a credible prospect of future repayment at any level of interest rates and any value of the risk premium. As no one would then buy the debt, no debt issuance is possible. However, part of the issued debt is used to repay the matured debt. The public institution is unable to meet its repayments today: it defaults. Unlike the bankruptcy of a private agent, there is no possibility of liquidation of assets used as collateral for loans, no possibility of seizure of assets to compensate creditors and of course no possibility of appealing to a supra-national judicial system that could force the institution in question to repay its debt in one way or another since it is sovereign. In the event of a sovereign default, the lenders and the public borrower in question must seek, through direct negotiations and a subtle mix of pressure and sanctions, a reshaping of the prospects for repayment of the existing debt. Formally, after the default, a “debt renegotiation procedure” is set up, leading to a change in the public institution’s budget constraint and specifying new terms for repayment of matured debt, enabling this institution to return to the financial markets and re-issue public debt.

5.3.2

Budget Constraints Including Default Possibility

To understand the sovereign default and its consequences in a monetary union, it is convenient to return to the writing of a member State’s budget constraint in nominal terms given by Eq. (5.3). Speaking of sovereign default means that the debt actually repaid, resulting from the renegotiation of the contractual conditions attached to the matured debt, is not equal to the latter: it is lower since the public institution has proved unable to meet its primary obligations. Let us neglect the circumstances of the renegotiation, which is long and difficult. On the contrary, let us imagine that it is immediate and straight: in case of default, the haircut rate is equal to (1 − δ) < 1.

184

5 Government Deficits, Transfers and Debts

The repaid debt is equal to δt Bj t −1 with "

δt = δ < 1 if default δt = 1 if not.

Default is a loss for the creditors. As we have seen, they have the capacity to protect themselves from it through the interest rate paid in case of non-default. This involves incorporating a (default) risk premium into the interest rate, which varies from period to period according to the estimate of the probability of default. Even if inflation in the union is the same, member countries have different probabilities of default because they face different shocks and because their spending patterns and fiscal structures, and in particular their ability to tax residents, differ. The nominal interest rates they obtain in the financial market (for similar securities) differ accordingly. Note r˜j t the interest rate that country j bears on the debt it issues in t − 1. We reason in terms of the probability of default: if default were anticipated with certainty, there would never be a possibility for a government to issue debt.8 One must reason in an uncertain framework and write the government’s budget constraint in anticipated terms. Given what we have just said, the budget constraint of country j (in nominal terms) at time t anticipated at time t − 1 when the debt matured in t is issued is now written + , J     j i i ˜ j t + 1 + r˜t δt Bj t −1 = Et −1 T˜j t + Bj t + F˜t + Et −1 G ˜ + S˜j t , jt

i=1

(5.34) where Et [Xt +s ] is the anticipation at date t of the value taken in t +s of the variable X. This equation replaces (5.3). The differences between (5.3) and (5.34) come from the presence of δt and r˜j t instead of r˜t . What are the consequences of this rewriting from a macroeconomic point of view? The first one is that the taking into account of sovereign default (even virtual and never realized) modifies the writing of the intertemporal budget constraint and therefore the debt dynamics. The second one is that in the event of an actual default, a break occurs in this dynamic. Formally, the debt trajectory is discontinuous. Of course, what has just been developed for the case of a member country applies immediately to the case of the federal Treasury. It is possible that the latter may default. If that happens, the renegotiation of its debt leads to a recovery rate that we note δ F , and the anticipation of its possible default leads borrowers to apply an

8 Suppose it is known in period 0 that the government will default in period T on a debt with a maturity of one period. In period T − 1, the issued government debt will not find a buyer since investors know that they will not be repaid. The government will go bankrupt in T − 1. Going back to period 0, the government can never issue debt. The reasoning is generalized to a plurality of government debt securities of different maturities.

5.3 Debt Sustainability and Sovereign Default in a Monetary Union

185

interest rate rtF to the debt issued at period t − 1. Using these ratings, the budget constraint (5.6) must be modified to give an expression similar to (5.34). Let us conclude this discussion with four important remarks: 1. We have assumed the same default rule in the union. This is implicitly assuming a legal or political homogeneity in the union, which may not be true. More generally, the legal conditions for the issue of public securities have an important impact that we can only mention here. 2. The inclusion of a risk premium in the interest rate increases the debt burden. This increase reinforces the possibility of default since it becomes more difficult for the Treasury of country j to repay its debt. A cumulative phenomenon is set up where the increase in debt feeds the default risk, which contributes to the increase in the debt burden. But this is not the only channel: this increase in the cost of borrowing for the public borrower is spread to the interest rates charged to private borrowers and slows down investment or the consumption of durable consumer goods. As this deceleration slows down tax revenues, it makes it more difficult to close the loop on the government’s budget constraint and can also fuel debt growth. Even if we can (and must) discuss empirically the ratio of public debt/aggregate product at which there is a “turnaround”, there comes a point when the weight of debt relative to aggregate product weighs negatively on the dynamics of growth. The “debt overhang” discussed by Reinhart et al. [11] cannot be denied and sovereign default is a serious matter that cannot be treated lightly. 3. The interest rate spreads obtained by the Treasuries reflect different default risk premiums. The size of these spreads gives us information on the assessment of countries’ default probabilities. An increase in this spread means that financial markets believe that the default risk for one country increases relative to another. All else being equal, spreads lead to different dynamics for sovereign debt. 4. We have seen that what matters is the expectation of default since it conditions the interest rate at which new debt is issued by a public institution and thus the dynamics of the debt itself. Until now, we have reasoned on the assumption that these expectations are linked to the effective fiscal capacity of a government, or to the “fundamental” data that determine the repayment of the debt. But the anticipation of a default can be a self-fulfilling mechanism, in the sense that the anticipation of default itself leads to default (Ayres, Nicolini and Teles [1]).

5.3.3

Sovereign Default in a Monetary Union

Sovereign default is a threat to all countries. What is added by reasoning in a monetary union? Two things: 1. The exchange rate cannot be part of the renegotiation, assuming of course that the insolvent country does not leave the union.

186

5 Government Deficits, Transfers and Debts

2. Default is on a debt that depends on the net transfers received by the defaulting state. In other words, the conditions of financial solidarity within the union are a determining factor in the default. When calculating risk premiums, and therefore interest rates r˜ti and r˜tF , lenders assess this solidarity. If this solidarity is total, it means that all the national Treasuries and, where applicable, the federal Treasury, are ready to mobilize all their resources to help a member country in difficulty, at the risk of all defaulting simultaneously. Under these conditions, it is clear that the risk premium is the same for all and the spreads are zero. On the other hand, if these spreads are not zero, this means that solidarity is not total: the prospects of default differ since not all the fiscal resources of the union will be mobilized to avoid the default of certain member countries. We can put forward the following proposal: Proposition 5.3. The size and dynamics of credit spreads on government securities of the same type issued by public institutions belonging to the same monetary union reflect the financial solidarity between these institutions. Credit spreads not only reflect the extent of financial solidarity between institutions, they also contribute significantly to it. Different debt dynamics within the union result from different interest rates as we have seen. However, since the member countries of the union are de facto tied together, these dynamics cannot be studied separately from each other. There are at least three reasons for this. The first, and most obvious, is immediate: interdependence takes place through transfers between institutions within the union. But a country in financial difficulty may question its transfer policy. A chain of difficulties can therefore spread from one country to other countries, increasing their own risk of insolvency in the countries. This is a contamination effect. The second is related to the distribution of debt instruments within the union. In a monetary union, if financial integration is deeper than in the rest of the world, creditors of country j are likely to be in the union. They will suffer losses as a result of the default of a member country. The deterioration of their financial situation logically translates into a deterioration of their country’s fiscal situation. More generally, these patrimonial consequences may lead the government of a member country to modify its fiscal policy. They may also lead the central bank of the union to change its monetary policy. Cooper et al. [2, 3] have shown how the federal Treasury, if it exists, or the central bank can be led to bail out a State on the verge of default so as to avoid the financial losses of its debt holders when they are sufficiently distributed within the union, i.e. outside the country in difficulty. These losses would indeed have led to contrasting situations depending on whether or not the agents hold these securities and are therefore unequally affected by the risk of default. The central bank intervenes out of risk sharing concerns. But, in doing so, the central bank creates money and generates an inflation tax paid by all for the benefit of a country dependent on money creation to avoid its insolvency.

5.4 Market and Institutional Disciplines

187

Finally, a contagion effect may occur, linked to the self-fulfilling mechanism mentioned above. It is easy for financial market operators to adopt sheep-like or mimetic behaviour, without really questioning the economic merits of their position. When lenders see the default or rising risk of default of a member country, they may start to doubt the financial soundness of other member countries and thus trigger a self-fulfilling mechanism even though nothing has changed in the fiscal situation of these countries. As we have seen, increasing the default risk premium may be sufficient to lead to default. This “contagion” effect is not specific to countries belonging to a monetary union but it is particularly easy to trigger in a union, insofar as the absence of exchange rates means that a barrier to contagion has disappeared (Eijfinger, Kobielarz and Uras [5]).

5.4

Market and Institutional Disciplines

We have just seen the political and economic sensitivity of public deficits. This is particularly true in a monetary union since the issues of nominal and real transfers are more complex. The question arises as to how to control them or ensure their sustainability. In a monetary union, the search for the right way to control deficits must take into account the necessary interdependence of national public finances, both in terms of financing and in terms of the induced effects on the economy. There are two opposing, but possibly combined, ways of looking at controlling debt dynamics. Public deficits can be “disciplined” by markets or by institutional arrangements. Market discipline is based on the incentive role of interest rates. When talking about public transfers, the role of markets as arbitrage instances between different institutions cannot be neglected. We saw in the previous section that the interest rate applied to securities issued by a government authorized to do so incorporates a default risk premium. An increase in this risk (as perceived in the markets) raises the interest rate. Under normal conditions, it is to be expected that this makes it less attractive to finance public expenditure through debt than other means of financing such as taxation. The government is likely to have less recourse to debt. Institutional discipline is achieved through the imposition of rules governing the ability to issue debt instruments for (primary) deficit financing. The simplest rule one can think of is an outright ban on running a current budget deficit. But there are many others, as we shall see in the next chapter. This set of constraints must be of a legislative or constitutional nature, as it limits the power of the administration or the sovereign parliament in fiscal matters. In the case of a monetary union between sovereign States, it is included in the legal texts that organize this union, particularly in international treaties between sovereign States. It limits the autonomy of the public Treasuries and the supranational bodies provided for in these texts (central bank and, where applicable, the federal Treasury).

188

5.4.1

5 Government Deficits, Transfers and Debts

Market Discipline

Market discipline consists in letting the markets assess the risks of insolvency and, if necessary, assume the consequences of this insolvency by triggering or organizing the default. Its logic is to rely on price signals. The rise in risk premiums and the increase in the cost of the public debt borne by the public finances of the country concerned should make it possible to penalize the fiscal authorities, as they are under pressure from their voting taxpayers. Of course, market discipline is based on the assumption that default is a credible option. In this case, the direct costs of putting a public institution’s finances in order are borne by those who have made unsustainable public deficits possible through their financing. In the end, the advantage of market discipline would be to make public authorities and investors accountable and to encourage them to limit the rise in deficits and keep them within sustainable limits. However this discipline can only work if certain conditions relating to the functioning of the market are met. More specifically, its effectiveness is conditioned by the efficiency of the markets and will be maximum under the following conditions: 1. There must be perfect mobility of capital flows and, in particular, no capital controls. If there are frictions in the markets, such as barriers to entry and exit in the market where an institution’s debt is traded, the interest rate is affected by these frictions and may reflect the small number of participants requesting securities at any given time. Market illiquidity implies additional risk and the interest rate will incorporate an illiquidity premium and not just the default risk premium. 2. Investors must have all available information on the indebted public institution, which implies having the same information as the indebted public institution on the actual implementation of budgets and forecasts of future budgets. In other words, an institution’s fiscal policy must be perfectly transparent to observers and no accounting bookkeeping trick should conceal the state of tax receipts and expenditure borne by the budget. 3. All implicit or explicit financial commitments given or received by a public institution must be fully known and valued by all investors. In corporate finance, these are referred to as off-balance sheet commitments. Here, these are all the promises that a public institution can make to other public or private institutions of potential support in the event of temporary or temporary difficulties. It is not a question of assuming that everything is known: on the contrary, the notion of guarantee implies uncertainty. But the risk of potential expenditure due to the granted guarantees must be assessed in accordance with the actual probabilities that these guarantees will be mobilized. 4. In the event of a default of a public entity, and therefore of losses suffered by some investors, this must not jeopardize the functioning of the financial markets. Otherwise, through contamination phenomena, other public institutions could in

5.4 Market and Institutional Disciplines

189

turn default and the situation would become one of a systemic public debt crisis. The financial markets in which public securities are traded must be sufficiently deep and liquid so that the disappearance of one issuer does not destabilize the entire market. These conditions tend to point to the difficulty of relying on market discipline in the case of a monetary union, or rather to doubt whether it is sufficient to ensure optimal management of the debt of a public institution belonging to the union. 1. The condition of perfect capital mobility is probably not in question. A monetary union, based on the free movement of means of payment in all countries of the union via the banking systems, cannot admit barriers to the movement of capital, which, in turn, would call into question the possibility of freely transferring liquidity within the union. 2. The condition of transparency of public budgets applies to an institution irrespective of whether it belongs to a monetary union or not. This membership has an ambivalent impact on its implementation. The formation of a monetary union can be expected to go hand in hand with an effort to standardize public accounting entries which increases the readability of the public accounts and thus their comparability. But, to the extent that it involves new actual or potential transfer flows, it increases the incentive for an institution to disguise or conceal its accounting entries in order to take better advantage of these transfers. 3. The soundness and credibility of guarantees given or received by a public institution are logically more difficult to assess in a monetary union. This follows directly from the propositions put forward above on the sustainability of public debt in monetary unions. We have seen that it potentially relies on transfers between jurisdictions. The interdependence of fiscal constraints in a union implies that the condition relates to the overall transparency of all fiscal policies. The level of the requirement is seriously raised and the transparency condition tightened. 4. Finally, the last condition on the depth of financial markets is more delicate in the case of a monetary union. Indeed, what is at stake is a question of size: the volume of the issuer’s debt defaulting relative to the aggregate volume of debt of comparable characteristics circulating on the financial markets. It is likely that, for the reasons of interdependence detailed above, the impact of one member country’s default will be felt on the financial terms met by all public (and private) issuers in the union. To the extent that the union aggregates several countries, its relative importance in the financial market is greater. The financial market turbulence has a greater likelihood of testing the resilience of financial markets. If financial markets are potentially severely affected by the turmoil, it undermines the effectiveness of market discipline. Ultimately, the discipline of financial markets depends on their allocative efficiency. Are financial markets functioning rationally and reliably? No, far from it, even if the various usual conditions for the efficiency of a market, i.e. the conditions we have

190

5 Government Deficits, Transfers and Debts

just recalled, are verified. Financial markets are in fact marked by a fundamental indeterminacy, due to the fact that they are “forward-looking” and admit different self-fulfilling trajectories, not all of which are sustainable. There may be phenomena of “financial bubbles”, fuelled by speculation or mimetic behaviour. The fact that the support for these self-perpetuating phenomena is the security issued by the Treasury of a member country of a monetary union does not change their characteristics. It is certainly in the sovereign debt securities segment that these speculative phenomena are least likely to occur. But belonging to a monetary union brings a new motive for speculation. Financial markets can speculate on the exit of a country from the monetary union to which it belongs as a consequence of its inability to issue sovereign debt in a sustainable manner within a monetary union. Exiting from the union implies the setting of a new parity, which leads to a revaluation of existing debt and therefore a gain for speculators who have taken forward positions to buy back sovereign debt denominated in the currency of the union at low prices on the secondary market, which will be revalued in the event of exit. The likelihood of unsustainability is increased by the increase in risk premiums that speculators coordinate on, triggering a “snowball” effect. Finally, it cannot be assumed that the rise in interest rates will result in a slowdown in the issuance of public securities. Rising interest rates on government securities lead to higher debt. Not only because the burden of public debt is heavier at constant volume, but also because it may call into question the logic of deficit reduction. It can be transmitted to all rates by arbitrage. This can lead to a slowdown in private investment (by a logic comparable to that of the classic crowding out effect). The ensuing economic slowdown can then feed the public deficit through automatic stabilizers and lead to an increase in debt. In a monetary union, this mechanism can feed a contamination process via the cross-border fiscal externalities mentioned previously. Assuming that the rise in the interest rate on the country’s debt j commits it to reducing its debt, via a smaller deficit, this may lead to a reduction in opportunities for the other member countries, thus aggravating their indebtedness and increasing their sovereign debt. If market discipline is applied, this will lead to a generalized rise in interest rates, whose signal property will then be diminished. The country initiating the reduction of its deficit may thus end up with a larger debt at a higher interest rate. The opposite of what was intended. To sum up, in view of these arguments, it is reasonable to argue that Market discipline does not fully ensure the sustainability of the debt of a public issuer belonging to a monetary union, as is the case for a private borrower.

5.4.2

Institutional Discipline in a Monetary Union

Is it possible under these conditions to rely on institutional discipline to achieve this sustainability? We understand “institutional discipline” to mean the existence of

5.4 Market and Institutional Disciplines

191

rules of fiscal commitment that limit the fiscal sovereignty of a country belonging to a monetary union. A preliminary remark is in order. Any budget of a public institution is drawn up and applied in accordance with rules laid down by law. Every public authority is thus constrained by institutional arrangements. When we speak of the institutional discipline applying to public institutions in countries belonging to a multi-national monetary union, we are referring to rules drawn up at the level of the monetary union, approved by the governing bodies of this union, which constrain the way in which budgets are drawn up and executed. They are binding and limit the fiscal sovereignty of member State, which is at the heart of the political dilemmas of a monetary union. Not all public institutions need to be subject to supra-national rules. A principle of subsidiarity can apply and these rules may only apply to the national state and not to lower level public institutions. But they aim at making it responsible for the conditions for drawing up and implementing the budgets of the latter. If the union is a “union of equals”, of member States equal in rights and duties, if not equal in terms of economic power, it is logical to postulate that these supranational rules apply uniformly and homogeneously throughout the territory of the union. This does not imply that all public institutions are treated indiscriminately in the same way but that institutions of similar political status are treated similarly. The question is what are the “right” institutional constraints, applying to all public institutions of comparable status, which it makes sense to impose in a monetary union and, above all, what constraints are made desirable by the existence of the monetary union. Such rules have the well-known advantages and disadvantages of rules. Generally speaking, a rule is a way of establishing the credibility of a policy. But this presupposes that it itself is supported by a pre-commitment technology that makes it credible. The credibility of a rule is an inverse function of the costs incurred in the event of non-compliance. It is these costs that are modulated by a pre-commitment technology. The advantage of a fiscal rule is twofold. On the one hand, it makes it possible to mitigate the undesirable effects of non-cooperation between actors, whether they are responsible for economic policy or private agents.9 It therefore has an interest in terms of macroeconomic stabilization. On the other hand, a fiscal rule makes it possible to limit undue pressure on the fiscal authorities or strengthen their capacity to resist interest groups. It also makes it possible to limit recourse to debt and to reduce market pressure, which we have seen could be inefficient and potentially destabilizing. A fiscal rule also has a redistributive interest by limiting the possibility

9

In the classic example of monetary policy, following a rule eliminates the inflationary bias, or the component of inflation due to the non-cooperation between the central bank and private agents setting the level of nominal wages with the objective of stabilizing their real wages.

192

5 Government Deficits, Transfers and Debts

that taxpayers collectively finance public spending for the benefit of a fraction of the population.10 The disadvantages of a fiscal rule are also well known. To be effective and easily enforceable, a rule must be simple. However, the economic situation is complex and can give rise to varied, sometimes unexpected, macroeconomic configurations, which call for differentiated responses. A simple rule may make an optimal response impossible because it would imply action on a scale prohibited by the rule. In other words, the rule generates opportunity costs associated with foregone flexibility. Credibility gains must be compared with these costs (Lohmann [8]). These gains and costs are not only related to the lack of macroeconomic stabilization but also to the redistributive effects of fiscal policies. A rule may make it impossible to repair the adverse consequences of the economic situation on a particular segment of society or the economy. The brakes on the use of fiscal instruments can thus limit the sharing of risk within a community. However the major peculiarity of a fiscal rule governing the capacity to take on debt is that it must be voluntarily accepted by the sovereign since by definition nothing is imposed on the sovereign other than what it accepts. The fiscal rule is intimately linked to politics. This is perhaps what makes the credibility of a fiscal rule doubtful or limits it drastically. What a national parliament once accepted, it is always in a position to reject later. Similarly, constitutions are being revised and international treaties denounced. And the rules that these texts lay down fall. How do these considerations apply to the case of fiscal discipline in a monetary union? The balance sheet of costs and benefits is of the same order, but we must now consider that the “factions” of society or the “segments” of the economy are the States themselves. The aim is to restrict the freedom of action of States, via the budget, in order to limit the unintended effects of non-cooperative fiscal policies, as we saw in the previous chapter. At the same time, this may limit the ability to act effectively against economic fluctuations, especially recessions since deficits are macroeconomically effective in these phases of the economic cycle, both in individual countries and in the union as a whole. The distributional dimension cannot be forgotten. A rule limiting national deficits in one way or another has the advantage of making it more difficult to shift part of the immediate or deferred burden to other partner countries, or other public institutions, or to make cross-border transfers less necessary or obligatory. But this can be paid for at the price of a reduced capacity of public budgets to redistribute within a country or between countries. Without going into the discussion of the fiscal rules applied or discussed in the framework of monetary unions, we must accept the principle that fiscal discipline in monetary union is not a panacea, or the optimal way to control public deficits. The question of its credibility remains. To the extent that a fiscal rule is imposed on sovereign States, it must be freely accepted by them, individually and collectively.

10 A

fiscal rule may also have an allocative interest in that it would limit the use of distortionary taxes.

5.4 Market and Institutional Disciplines

193

It is therefore dependent on their collective willingness to have such a rule imposed on them. Two observations flow from this: 1. Since fiscal discipline is established by consensus, it has every reason to be nonbinding or to reflect the views of the least demanding State in the matter. 2. Sovereign States will remain in control of its application as it stands or of its modification. What has collectively been decided can be changed at a later date. In brief, we may argue that The credibility of the fiscal discipline applied to the member countries of a monetary union depends on its supra-national cohesion over time.

5.4.3

Separating Disciplines?

The two modes of deficit regulation or discipline clearly differ. But are they opposed? This is a common way of looking at things, and it was in particular the view of the drafters of the Delors Report. They wrote: “The constraints imposed by market forces may be too weak or too slow or too sudden and destabilising. Thus countries should recognise that sharing a single currency or currency area implies constraints” (Delors Report, p. 17). They considered that it was not possible to rely on the market and that constraints and institutional discipline should make up for its shortcomings. Implicitly, the constraints would be strong, quickly implemented and stabilizing because they were perfectly anticipated by all. Such a conception is based on a double fallacy. In reality, markets are instituted and the institutions of a society are the result of negotiations between the stakeholders in that society. This is not to say that the two concepts are indistinguishable but that they are interrelated and it is futile to try to set them against each other. Markets are instituted because what is exchanged on a market is logically a contract and this contract is of a legal nature: it is the law that specifies the properties of an exchange, even if it does not provide for its strictly economic terms (the price). Markets depend on the law and the institutions that define it. These institutions result from the contradictory demands of the components of a divided society. The unity of society is expressed through the institutions that make it viable and perennial. These institutions are established by the interplay of transactions and exchanges negotiated on the basis of their relative positional advantages. It is therefore not surprising that, in a decentralized economy, where the positional advantages of the members of society are partly materialized by markets, institutions take into account and rely on the functioning of markets. These general remarks apply to the fiscal problem in a monetary union. The two disciplines are logically combined and must be thought out together. The institutional discipline organizes the management of deficits through the limits placed on it and the transfers between public jurisdictions that it can organize. Market discipline depends on institutions in two main ways. On the one hand, it

194

5 Government Deficits, Transfers and Debts

depends on the efficiency of markets, and therefore on the legal framework in force. On the other hand, market operators take their positions to buy or sell a government’s public debt securities according to their perception of the pattern of deficit financing and the potential and anticipated transfers that this government may receive from its partners. Conversely, institutional discipline takes note of the markets and depends on them in two ways. On the one hand, their effectiveness in managing public debt may lead, depending on the institutional arrangements of a union, to transfers between institutions. On the other hand, fiscal discipline per se is more broadly dependent on the organization and functioning of markets within and across the monetary union itself. It is impossible to dissociate fiscal discipline from the institutions that oversee the markets. Public authorities in a monetary union are therefore faced with a dual institutional responsibility. From this perspective, the sentence quoted in the Delors report justifying the imposition of constraints on the grounds of market inefficiency is the result of an optimistic at best, or inconsistent at worst, view of the interrelationships between the markets. On the contrary, we may conclude that The functioning of a monetary union depends on whether or not these two disciplines are successfully combined in the regulation of public deficits.

Finally, the last problem is even more thorny because it concerns fiscal policies themselves. There are no natural and objective criteria for drawing up a budget that would be binding on everyone. There is a contingency or a degree of freedom in fiscal matters that cannot be eliminated, despite efforts at commensurability and homogenization. It is within this margin that the fiscal sovereignty of a State can be exercised and allow it to take opportunistic measures, aimed at disguising the fiscal reality either to take advantage of existing rules or to hide their political incapacity or administrative incompetence to contain the deficit. The list of ways in which fiscal constraint can be loosened is endless and covered by the term “creative accounting” (Milesi-Ferreti [9], Von Hagen and Wollf [12]). This trend is not specific to countries that are members of a monetary union but it is certainly stronger in this case. Indeed, institutional discipline in the union creates the temptation for the managers of a public institution to free themselves as much as possible from the constraints that it implies in terms of fiscal matters, and to take advantage as much as possible of the fiscal interdependence between institutions.

5.5

Conclusion

Far from simplifying fiscal issues, monetary union introduces additional complications because of the forced interdependence it creates between the fiscal arrangements tying the member States or jurisdictions. The transmission channels for fiscal impulses are affected by the increased cross-border effects. It is difficult a priori to determine whether or not spending and fiscal instruments are made more potent. The financing of public deficits is also affected by monetary unification.

References

195

Monetary unification creates increased financial interdependence, linked to the mobility of capital within the union and the banking integration implied by the union. Savings flows between member countries are potentially greater. This makes risk sharing within the union more efficient but it also increases the exposure of all to the difficulties of a particular member country. This raises the question of the discipline to be applied to national fiscal policies to ensure the sustainability of national public debt or its orderly default, with a view to preserving the sustainability of the union: should it be based on financial markets or on institutional procedures? No simple answer can be given to this question. This increased economic and financial interdependence leads to a paradox in fiscal matters. The loss of monetary policy instruments implied by the monetary unification of several countries reinforces the interest of fiscal policy instruments left in the hands of national public authorities. These instruments appear to be the only ones capable of dealing with the idiosyncratic shocks which affect the member countries in different ways. There is reason to believe that the regulation of the monetary union in the short term and the support of the growth process in the long term must be based on greater use of these instruments. At the same time, however, monetary union increases the constraints on public fiscal authorities, be they national or federal. Increased economic interdependence means that they have to be concerned about what is happening in other member States of the union and about the overall economic situation in the union. But, above all, financial interdependence means that all are collectively responsible through their policies for guaranteeing the sustainability of public debt within the union. Under these circumstances, it is understandable that the conduct of fiscal policies is made more difficult in a monetary union. This is what we will analyse in more detail in the next chapter.

References 1. Ayres J, Navarro G, Nicolini J, Teles P (2018) Sovereign default: the role of expectations. J Econ Theory 175:803–812 2. Cooper R, Kempf H, Peled D (2008) Is it is or is it ain’t my obligation? Regional debt in a fiscal federation. Int Econ Rev 49:1469–1504 3. Cooper R, Kempf H, Peled D (2010) Regional debt in monetary unions: Is it inflationary? Eur Econ Rev 54:345–358 4. D’Erasmo P, Mendoza E, Zhang J (2016) What is a sustainable public debt? Handb Macroecon 2:2493–2597. North-Holland 5. Eijffinger S, Kobielarz M, Uras B (2018) Sovereign default, exit and contagion in a monetary union. J Int Econ 113:1–19 6. Frankel J (2016) International coordination. In: National Bureau of Economic Research Working Paper w21878 7. Glienicker Group (2014) Towards a Euro Union. http://bruegel.org/2014/08/towards-a-eurounion 8. Lohmann S (1992) Optimal commitment in monetary policy: credibility versus flexibility. Am Econ Rev 82:273–286 9. Milesi-Ferretti G (2004) Good, bad or ugly? On the effects of fiscal rules with creative accounting. J Public Econ 88:377–394

196

5 Government Deficits, Transfers and Debts

10. Reinhart C, Rogoff K (2009) This time is different: Eight centuries of financial folly. Princeton University, New York 11. Reinhart C, Reinhart V, Rogoff K (2012) Public debt overhangs: advanced-economy episodes since 1800. J Econ Perspect 26:69–86 12. Von Hagen J, Wollf G (2006) What do deficits tell us about debt? Empirical evidence on creative accounting with fiscal rules in the EU. J Bank Financ 30:3259–3279

6

Fiscal Policies in a Monetary Union

Abstract

Chapter 6 deals with fiscal policies in a monetary union, including those of a federal Treasury. The macroeconomic impacts of national or union-wide fiscal measures are discussed in particular by means of a variant of the IS-LMBP model adapted to a monetary union. Monetary and fiscal policies interact. Crucially fiscal policies impact the external position of each member country (or region) and must therefore be checked as they have the potential to jeopardize the union. This makes clear that some form of fiscal discipline must be put in place in a monetary union.

What to expect from fiscal policy in a monetary union? How does it contribute to the stabilization and adjustment mechanisms of the union? Should it be regulated and how? This chapter deals with these questions. Section 6.1 offers a broad overview of fiscal effects in a monetary union. Section 6.2 is devoted to the conduct of a member State’s fiscal policy. Section 6.2 deals with the analysis of the impact of fiscal impulses in a monetary union. The link between fiscal policy and the external balance is discussed in Sect. 6.3. Finally, Sect. 6.4 deals with the fiscal discipline to be imposed in a monetary union. In this chapter, we restrict ourselves to the analysis of fiscal policies conducted autonomously by the member States of a multi-national monetary union, or to the analysis of the fiscal policy of the federal Treasury in the case of a national monetary union.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_6

197

198

6.1

6 Fiscal Policies in a Monetary Union

Fiscal Effects in a Monetary Union

A country’s fiscal policy is made up of any tax and spending measures adopted by its government. A large part of the measures taken in period t results from decisions taken earlier, such as the payment of civil servants previously recruited. In order to focus on the fiscal and tax innovations taken in period t by the state and to study their impact, economists use the concept of “fiscal impulse.” A fiscal impulse is an unanticipated shock to a fiscal or tax variable. To the extent that it is a shock, it is independent of the economic circumstances in which it occurs, and studying the consequences of this shock makes it possible to understand the transmission channels of fiscal policy. More specifically, a fiscal impulse is the truly discretionary component of fiscal policy and we will consider it as such in this chapter. The conduct of fiscal policy in a monetary union will be discussed in the next section.

6.1.1

The International Effects of Fiscal Impulses

Let us begin with a review of the main lessons regarding the macroeconomic and financial effects of fiscal policy and identify, from a macroeconomic perspective, the main international spillover effects that it create. We focus on the direct effects, as we cannot develop a general equilibrium model that would take into account all effects, both direct and indirect.

6.1.1.1 Direct Macroeconomic Effects Macroeconomic analysis distinguishes between cross-border effects according to their term. In the short term, demand effects predominate. In a standard framework, based on real and nominal rigidities, known as “Keynesian” or “neo-Keynesian,” macroeconomic fluctuations are sensitive to the size of effective aggregate demand. Fiscal policy is counter-cyclical insofar as the public deficit (positive or negative) is a component of aggregate demand. The effectiveness of fiscal policy is measured through a range of multipliers. If the national economy is open, part of the demand generated by public expenditure will benefit foreign economies through imports. A reduced multiplier is to be expected for the national economy and a positive one for trading partner economies. Moreover, the increase in public deficits generates an increase in the national interest rate due to the increase in activity (an effect well identified in the IS-LM model), which is called the “crowding-out effect.” To the extent that capital markets are open, this increase is transmitted internationally and has a counter-cyclical effect on foreign economies, depending on the exchange rate regime, the relative size of economies and the policies pursued by central banks.

6.1 Fiscal Effects in a Monetary Union

199

In the long run, domestic discretionary fiscal policy has potential supplyside effects and affects the growth process of the economy. Two effects can be distinguished. On the one hand, public spending on productive public investment (education, infrastructure, health spending, etc.) can affect the productive capacity of the economy. On the other hand, fiscal policy affects the incentives to produce agents (labour supply, savings and savings modalities) and, to the extent that this policy creates distortions, it has misallocative and therefore negative effects on growth.

6.1.1.2 Financial Effects National public policy has financial effects. The public deficit is financed by a call for savings. In a financially open world (in which countries do not live in financial autarky), the providers of funds are international. Public borrowers compete with each other and the strength of this competition depends on the degree of global financial integration (the degree of friction in financial markets). It is reflected in arbitrage processes from which all interest rates are derived. The interest rate differentials observed on public securities with similar characteristics (maturity, collateral, etc.) depend on the assessment of the risks associated with public borrowers (mainly default risk and inflationary risk). Global financial integration thus creates an interdependence between the financial policies of governments and, as a result, between their fiscal policies. The extent of these effects depends on the effective mobility of international capital flows and savings. This raises questions about the relationship between investment and savings. Under the assumption of perfectly integrated, i.e. frictionless, global financial markets, one should expect an equalization of interest rates for assets with comparable properties and a disconnection between the origin of the supply of these assets and the origin of demand. However, this result is empirically invalidated: there is a positive correlation between national investment and national savings. This is known as the Feldstein–Horioka paradox. Applied to public debt, this means that the correlation between the issuance of public securities and national savings is positive: public securities are more readily subscribed to by national savers than by savers in the rest of the world, and the former are more than proportionally represented among holders of national public debt. This fact reflects first and foremost national tax policies that may favour investment in domestic securities, and also imperfections in the international arbitrage arrangements open to savers, as well as the differentials in the information packages available to savers.

6.1.2

Cross-Border Effects of Fiscal Impulses in Monetary Union

How does reasoning on the case of a monetary union change the understanding of these cross-border spillover effects? How does the abolition of the exchange rate system radically change the ways in which fiscal policies are interdependent?

200

6 Fiscal Policies in a Monetary Union

Exchange rates act as a shock absorber for fiscal externalities. With fixed exchange rates (assuming fiscal shocks are small enough not to require a parity adjustment), the induced changes in foreign interest rates are stronger than with flexible exchange rates and the effects on partner economies are also stronger. In a monetary union, since these shock absorbers have disappeared, the externalities generated by national fiscal policies are a priori greater (Fahri and Werning [15]). Let us discuss the cross-border effects on the basis of this principle. We reason on the basis of a monetary union made up of two countries, one called the “source” country where the fiscal impulse takes place, and the other called the “partner” country.

6.1.2.1 In the Short Term There are two reasons for a lower fiscal impulse multiplier effect in the source economy: one is the disappearance of exchange rates and their dampening role; the other is that monetary union (once stabilized) induces greater interdependence of economies, both because production processes are more integrated and because there can be greater differentiation in the production of the goods demanded. These two channels, on the other hand, work in favour of higher induced multipliers in the partner country. But one channel works in the opposite direction. Since monetary unification is linked to greater financial integration, the pool of savings is larger, or that the increase in interest rates is lower than in a country that is monetary self-sufficient. In other words, the crowding out effect is smaller. 6.1.2.2 In the Long Term We have seen (Chap. 2) that a monetary union has potentially important microeconomic effects of reallocating productive resources over the long term. As production factors are made more mobile by monetary unification, the cross-border effects on factor mobility of these growth policies are reinforced. This applies to both physical capital and labour. The effects of international equalization and international adjustments are stronger. In particular, it can be expected that, other things being equal, migration of different types of work, regardless of their level of qualification, will increase within the area concerned by monetary unification. Similarly, national fiscal and redistributive policies may generate externalities between member countries. Residents in the monetary union, depending on their capacity for mobility, may migrate to countries that are more generous in terms of benefits or out of countries that are more demanding in terms of taxation. These externalities can be significant from a macroeconomic point of view depending on the degree of mobility of residents and factors of production. 6.1.2.3 Financial Flows We mentioned earlier that monetary union has the potential to change savings behaviour within the union. What effect does this have on the financial transmission

6.2 Stabilization Policies in a Monetary Union

201

channel for fiscal impulses? Monetary union can work in two opposite ways, depending on whether or not it reduces the financial risks faced by savers: 1. To the extent that it reduces financial adjustment costs (currency conversion costs are eliminated and risk premia associated with uncertainty about exchange rates are cancelled out), harmonizes and simplifies financial information, thereby reducing international financial asymmetry and contributing to financial integration, monetary unification reduces the causes of the Feldstein–Horioka paradox: the multi-national mobilization of savings is facilitated since risks and their perception by savers are reduced. This reduced financial segmentation within the union represents an increase in financial competition and the opportunity for better international risk sharing. This is conducive to more international financing of public deficits and lower interest rates compared to what they would be in the same zone in a situation of multiple currencies. 2. But a monetary union is potentially a source of specific risks, particularly of a financial nature, as we saw in Chaps. 2 and 5: risks of contagion and risk of partial or total dismantling of the union. Savers are therefore tempted to limit their exposure to the risk of the union and prefer investments in their home country. The consequences of monetary unification on the correlation between national investment and savings resulting from these two effects are ambiguous. The Feldstein–Horioka paradox may in unfavourable cases be reinforced in monetary union. In any case, monetary unification implies an increase in financial interdependence through greater exposure of the residents of the monetary union to the financial circumstances of a member country, and in particular to the fiscal policies of the member countries.

6.2

Stabilization Policies in a Monetary Union

We have drawn two important conclusions from the previous chapter and the previous section: the first one is the increased constraints on the member States of a monetary union, in particular in ensuring the sustainability of national public debt; the second one is the importance of cross-border fiscal and financial effects in the economic dynamics of a monetary union and its components. Assessing fiscal policies in a monetary union implies paying close attention to these external effects and constraints in the conduct of national fiscal policies.

6.2.1

The Functions of Fiscal Policy

Musgrave [34] proposed a typology of fiscal policy functions that has become standard. For Musgrave, the price system alone cannot ensure economic optimality,

202

6 Fiscal Policies in a Monetary Union

and the state has a responsibility to correct market imperfections. He distinguished three functions of fiscal policy: 1. The allocation function: The State must contribute to improving the allocation of resources through the use of the fiscal instruments (taxes and subsidies). 2. The redistribution function: The State is responsible for social equity and must fight against inequalities deemed undesirable. Here again, the system of compulsory levies is used to redistribute income and wealth. 3. The stabilization function: Since the market does not by itself ensure the elimination of economic cycles, as Keynes showed, the State must intervene through macroeconomic policy to limit fluctuations and hasten the return to the growth path. A typology focusing on the random nature of the economy and risk management can be proposed, distinguishing three functions inspired by Musgrave’s typology. 1. The State contributes to the optimization of risk-taking by economic agents. This is a microeconomic function. Regulation, which seeks to optimize risktaking by agents by prohibiting, encouraging and standardizing production and consumption conditions, is the preferred instrument of this function. But taxation can play a penalizing or incentive role. 2. It helps to manage collective risk, i.e. to make it shared by all residents. This is a macroeconomic function. The stabilization of the cycle can be analysed from this point of view since it involves managing macroeconomic risk and smoothing it over time, if necessary by means of debt. The tools of macroeconomic fiscal policy are favoured for this purpose, along monetary policy. 3. It compensates for the adverse consequences of the risk incurred (ex post) through redistribution between agents. The ideal instrument is the public or parapublic transfer, controlled by the public authorities. In a monetary union, the objective of fiscal policies can be defined as optimal risk management at the level of the union. Risk exists first at the level of the components of the union and it is conventional to treat it as an idiosyncratic random “shock,” i.e. specific to one component. This idiosyncratic risk is diffused to all the partners, and therefore to the union as a whole, through cross-border effects. Second, there is a risk at the level of the union itself. Not only a global risk, in the form of a shock affecting all the components of the union, but also a “strategic risk,” linked to the way in which shocks and their international transmission are managed within the union. If the management of these risks is collectively inefficient to the point of being disastrous, it can lead to the dismantling of the union, the sanction of a structural inability to manage shocks and have the different components of the union sharing the risks in a way that is satisfactory for all. Another reason for the complexity of risk analysis stems from the fact that, as far as economic stabilization is concerned, the economic cycle is at two levels in a monetary union. It can be observed at the level of a member State as well as at

6.2 Stabilization Policies in a Monetary Union

203

the level of the union as a whole. A counter-cyclical policy can be analysed at both levels: 1. Optimizing risk-taking is difficult to implement in a differentiated grouping of several countries that are structurally different, potentially competing and probably characterized by different levels of development.1 Is it necessary to homogenize the productive apparatus of the union or, on the contrary, to increase its national differentiation in order to take advantage of comparative advantages? To what extent does public intervention inhibit the risk-taking that it seeks to optimize? Lastly, can conflicts of interest in risk management between stakeholders in the union be ruled out? If not, how can institutions be arranged to resolve these conflicts of interest? 2. The macroeconomic risk-sharing function, or the stabilization function, is probably the most important function for a monetary union. It is frequently argued that the reduction of monetary instruments gives a greater role to national fiscal policies in managing shocks and stabilizing national economies. Implicit in this thesis is the assumption of the effectiveness of fiscal policy: it would be sufficient to use more of them to compensate for the lower effectiveness of monetary policy. We have seen that the suppression of exchange rates changes the transmission channels of fiscal impulses but it does not necessarily make them more potent, while at the same time constraints are increased. All in all, it cannot be taken for granted that the national fiscal authorities have a greater stabilizing capacity in monetary union. Moreover, the national point of view cannot be the only one used to assess a national fiscal policy since it has an impact on the union as a whole. This amounts to ignoring the question of the interdependence of economic cycles and neglecting the spread of idiosyncratic risks within the union. Second, the question of the nature of the risks to be shared is essential. It is not equivalent to counterbalance a shock specific to a country or a sector of that country, or a shock affecting the union as a whole. The question is whether national fiscal policies alone are sufficient to manage the overall risk affecting the monetary union. 3. The last function, redistribution or compensation of the risk to one of the components, is the most difficult. Is it the compensation of a lasting asymmetry or not? Is there a risk of moving from a temporary redistribution, designed to repair the consequences of a non-permanent shock, to a permanent or irreversible redistribution, designed to compensate for lower structural efficiency and lower living standards in a given country? Can this redistribution perspective handicap the aim of improving the productive specialization within the union? Can it interfere with the stabilization function by making a country more inert and therefore more sensitive to economic hazards? Actually, behind the economic

1

At first sight, the level of development will be captured by average national income and its trend by the growth rate of aggregate output.

204

6 Fiscal Policies in a Monetary Union

stakes, there is indeed a political problem, the type of solidarity accepted by the member parties of the monetary union. In order to consider the interdependence of economic policies, it is necessary to adopt the point of view of the union as a whole. Which level should be favoured? The question also arises in the case of a national monetary union or a federation. The consensus in fiscal federalism is to favour the federal level (Oates [36], Boadway and Shah [4]), given the importance of cross-border effects. Moreover, it is difficult to coordinate the actions of the components. On the contrary, the federal level has an overview of the needs of the union and has instruments covering the whole union through transfers between jurisdictions.

6.2.2

The Conduct of Fiscal Policies

The conduct of fiscal policy encompasses decision-making, its determinants and the choice of instruments, as well as its procedures and implementation over time. Here we leave aside the procedural issues that are unique to each monetary union and its components. Fiscal policy concerns the two sides of the government budget: expenditure (government spending and transfers) and tax revenues. Fiscal policy consists in defining the compulsory levies, in particular taxes, on economic agents taking into account the degree of progressiveness of these levies (Kaplow [23], Hindriks and Myles [19]). A large part of the budget of a public jurisdiction is insensitive or lowly sensitive to the economic cycle, either because of the nature of expenditures and taxes or because the public authority has preferred to set up rules of engagement. Examples include military spending, regalian functions or public servants’ salary costs. Only a fraction of the budget and the tax system is likely to be affected by a decision taken by the public authorities in response to the economic cycle and which can be modified in line with that cycle. This is referred to as a “discretionary decision” and “discretionary policy” (Leith and Wren-Lewis [32]). Counter-cyclical fiscal policy can also rely on “automatic stabilisers.” Automatic stabilizers refer to the automatic responses (due to laws and regulations governing the state budget) of the components of the State budget. Automatic stabilizers may relate to expenditure items or taxes. As a rule, automatic stabilizers are countercyclical. Public expenditures on social protection, such as unemployment benefits, increase automatically when economic activity declines and unemployment rises (through the application of unchanged benefit scales); similarly, tax revenues are linked to the business cycle, again through the application of tax provisions that (as a general rule and unless there are special provisions) do not vary with the business cycle and are counter-cyclical: direct and indirect taxes fall when economic activity is depressed. All in all, leaving aside discretionary decisions, the public deficit is logically counter-cyclical. In a monetary union, both types of fiscal policy remain possible and available to the country member authorities. The question is which one is more conducive to managing both global and specific risks to the national economy, that is, which one

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

205

is more likely to take account of cross-border effects or result from a cooperative effort between member States. From this point of view, automatic stabilizers are certainly more effective and convenient in a monetary union than discretionary policies. There are three reasons for this: 1. The first is operational: it is (relatively) easy when designing automatic stabilizers to take into account the externalities they create on other member countries by means of reliable and monitored statistical indicators. On the contrary, a discretionary fiscal decision results from a complex and time-consuming deliberation as depends on the levels reached by indicators which may be known too late or may be subject to corrections in subsequent periods. 2. The second is political: the definition and implementation of a discretionary policy to be adopted in a given member country take time because they are subject to political hazards, being discussed by political bodies (the government and the parties that support it) and validated by a vote in parliament. It is unlikely that these bodies are very sensitive in their discussions and negotiations to the conjunctures of the partner countries or that they have reliable and detailed information on these circumstances. Moreover, they may anticipate that their partners will not reciprocate and may prefer to behave in an non-cooperative manner. 3. Finally, the third is related to international cooperation on stabilization policies (Canzoneri, Cumby and Diba [8]) needed to overcome these difficulties. Again, it is all about negotiation. Cooperation cannot be decreed and takes time. It is therefore preferable to devote the resources necessary for successful negotiation to an agreement that is valid over time, as in the case of an automatic stabilizer arrangement, and not for a given conjuncture, as in the case of the definition of discretionary policies.

6.3

Fiscal Impulses and Transmission Mechanisms in a Monetary Union

The formal analysis of a fiscal policy is carried out by singularizing an impulse on a fiscal instrument and analysing its transmission mechanism in the economy under consideration. In an international context, the aim is to identify the international transmission channels of a fiscal impulse taken in a given country in order to understand the international effects of national fiscal policies. In this section, we discuss how the existence of a monetary union affects these cross-border spillover effects created by the fiscal policies of member countries. We focus on the direct effects, as we cannot develop a general equilibrium model that would take into account all cross-border interactions. In a monetary union, as these shock absorbers have disappeared, the externalities generated by national fiscal policies are a priori greater as discussed in Sect. 6.5.1.

206

6.3.1

6 Fiscal Policies in a Monetary Union

Fiscal Multipliers

The quantitative assessment of a fiscal policy measure is made using the concept of the fiscal multiplier. A fiscal multiplier measures the impact of a fiscal impulse applied to a given fiscal instrument on the aggregate output. Since the impact of a measure (identified as a fiscal impulse) is felt gradually (depending on the channels through which the impulse is transmitted), the dynamics of the multipliers needs to be defined and measured. Formally, the multiplier mt,t +1 can be defined as an elasticity.2 It is the ratio between a relative fiscal impulse taken at date t and the relative change in aggregate output at date t + τ : mt,t +τ

  yt +τ gt −1 = . yt +τ −1 gt −1

τ = 0, ....,

where gt denotes the level at period t of the fiscal instrument used, gt measures the fiscal impulse taken at date t, yt +τ is the aggregate output at period t + τ , and yt +τ its change (from t + τ − 1 to t + τ ). In the context of a multi-national monetary union, we need to distinguish between two levels of decision-making, the national and the supra-national levels3 and two levels of analysis, the national economy and the economy of the union as a whole.4 Let us assume that there is a supra-national fiscal policy authority that can control a fiscal instrument rated gU t , while the fiscal authority of the member country j controls an instrument rated gj t . At this stage, we remain vague on the characterization of this supra-national body: we can think of a federal authority or a fiscal policy concerted among all the member countries. We will therefore speak of the fiscal policy “of the union” or a “union-wide fiscal policy.” Having made these distinctions, several types of “fiscal” multiplier may be defined.5 1. The overall multiplier of a global impulse applied to gU t : U mU t,t +1 =

U ytU+τ U ytU+τ

 .

gtU gtU

−1 τ = 0, ...

This multiplier measures the impact on the economy of the union of the instrument “of the union.”

2

Reasoning in terms of elasticity makes it possible to ignore size effects and makes comparisons between multipliers easier. 3 “Regional” and “national” in the case of a national monetary union. 4 The “regional” economy and the “national” economy in a national monetary union. 5 Without more precision at this stage, since we have not precisely defined the fiscal instrument being manipulated.

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

207

2. The local multiplier of a local impulse applied to gj t : 

j

jj mt,t +1

=

yt +τ j

.

j

gt

−1 τ = 0, ...

j

yt +τ

gt

This multiplier measures the impact on the economy of country j of the fiscal instrument manipulated by the fiscal authority of that country. 3. The local multiplier of a global impulse applied to gU t : 

j

jU

mt,t +1 =

yt +τ j

.

gtU

−1 τ = 0, ...

gtU

yt +τ

This multiplier measures the impact on the economy of country j of the instrument “of the union.” 4. Moreover, it is necessary to measure the cross-border effects of a fiscal impulse made in country j . The cross-border multiplier on the economy of country k of the local impulse applied to gj t decided by the fiscal authority of country j can be defined as follows: kj mt,t +1

=

ytk+τ ytk+τ

 .

j

gt j

gt

−1 τ = 0, ...

At this stage, a few remarks are useful: 1. If the trans-border effects are negligible, with the same transmission channel identity and for the same manipulation of an instrument, local multipliers are identical. There is no advantage in favouring the policy taken at the level of the union over national fiscal policy. 2. The consensus on fiscal federalism mentioned above starts from the assumption that cross-border effects are not negligible. This justifies that fiscal policy “of the union” should be favoured because it allows these effects to be taken into account in the fiscal decision.6 3. The cross-border effects generated by a member country are (presumably) all the higher the more open and important (either because of size, political influence or economic role) the country is with respect to its partners. 4. The cross-border effects generated by country j may be positive in country k and negative in country k  .

6

Assuming a set of assumptions about information, ease of implementation and the motivations of the authorities “at the level of the union” that may in practice not be met.

208

6.3.2

6 Fiscal Policies in a Monetary Union

The Macroeconomic Impact of Fiscal Policies

The understanding of the macroeconomic effects of fiscal policies depends very much on the analytical framework chosen and the macroeconomic model used. The diversity of views and macroeconomic approaches being what it is, it is illusory to attempt to present a consensus synthesis of results obtained on the effectiveness of fiscal policies in a monetary union. Rather, the most important question is what does monetary unification do to the transmission mechanisms of fiscal impulses? To answer this question, we can theoretically reason within the framework of various simple models and empirically take into account studies that have tried to measure these effects in a union. The IS-LM-BP Fixed-Price Model Let us use the IS-LM model applied to a (small) open economy, namely the ISLM-BP model.7 It is based on the assumption that the general price level is fixed (implicitly, goods prices are fixed) over the model’s short-run horizon. Its simplicity makes it unsatisfactory in many respects, but it is an advantage for an initial analysis of macroeconomic interdependencies, disregarding dynamic linkages. This model seeks to account for the functioning of a small open economy (referred to as the “Home country”) in different exchange rate and external balance adjustment configurations. It is based on a triple equilibrium: the equilibrium of the goods market, the equilibrium of the money market and the external equilibrium. The adjustment variables—in the absence of price adjustment—are the interest rate, the aggregate product and, possibly, the exchange rate. Denote by y and y ∗ , respectively, the activity levels in the Home country and in the rest of the world treated as a unique “Foreign” country, π and π ∗ the inflation rates. In an open economy, foreign trade is regulated by the nominal interest rates of the country and the rest of the world, respectively, i and i ∗ , s the effective exchange rate, i.e. the exchange ratio of one unit of the rest of the world currency to the currency units of the Home country and s e the anticipated change in the exchange rate.8 More precisely, the interest rate differential, adjusted for the expected change in the exchange rate, has an impact on international investment flows.9 In the logic of the IS-LM model, the equilibrium of the goods market is characterized by equality between investment and savings. In an open economy, investment is a decreasing function of the interest rate and an increasing function of the interest rate differential i ∗ +s e − i; savings is an increasing function of the product (in a strictly Keynesian perspective). The equilibrium is formally written by means of the following equation:   I i, i ∗ + s e − i = S (y) . 7

For a detailed discussion of the model, see Wickens [42], Chap. 12. Denoting s  the future exchange rate, s e ≡ s  − s. 9 If the expected exchange rate varies, the expected profit of an investment made from one country to another varies. 8

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

209

Using a linear formulation, we get   y = −ηi + ν i ∗ + s e − i

(6.1)

represented by a decreasing IS curve. Let us look at the impact of fiscal policy. To do this, let us denote by g the instrument of the Home country’s fiscal authority. It is such that it positively affects the aggregate output. We can think of an increase in public expenditure or a reduction in taxes, or an increase in the deficit. Let us modify Eq. (6.1) accordingly:   y = −ηi + ν i ∗ + s e − i + g.

(6.2)

The equilibrium on the money market is characterized by the equality between the supply (exogenous, as determined by monetary policy) and the demand for money, knowing that real balances (m − p), with m the log of the quantity of money and p the log of the price level normalized to 0, are an increasing function of the aggregate product and a decreasing function of the Home country’s interest rate. We therefore have m = y − ζi

(6.3)

represented by an increasing LM curve. The balance of foreign trade (assimilated in this simple economy to the balance of trade in goods and services) is noted f : it is the balance between the variation of the Home country’s holding of assets of the rest of the world and the variation of the rest of the world’s holding of the country’s assets. This balance depends on the differential between nominal interest rates in the rest of the world and in the country, expressed in the same currency, the inflation differential and the activity differential, measured by the difference between the aggregate demands made on producers in the rest of the world and on producers in the country. A linear version10 of this relation is written as11     f = α ∗ y ∗ − αy + β π ∗ + s − π + γ i ∗ + s e − i .

(6.4)

Assuming as fixed prices, effective and expected exchange rates and the variables of the rest of the world (the assumption of a “small” open economy means that the macroeconomic situation of the country has no impact on that of the rest of the world and on exchange rates), the external equilibrium equation (f = 0) corresponds to a pair (y, i). Graphically, in a (y, i) graph, this relationship is expressed by a BP curve which can be increasing or decreasing.

10 It

is log-linear if y, y *, π, π * and s are expressed in logarithms. various parameters of the equation are assumed to be positive.

11 The

210

6 Fiscal Policies in a Monetary Union

Fig. 6.1 Equilibrium

Let us assume perfect international mobility of financial flows. Under these conditions, a rise in interest rate i leads to a depreciation of the external balance: the interest rate differential causes financial arbitrage and non-zero net financial flows. To ensure external equilibrium, it is necessary that12 i ∗ + s e − i = 0.

(6.5)

If exchange rates are fixed, s e is equal to zero and the interest rate of the country is equal to the interest rate prevailing in the rest of the world. The interest rate is thus fixed and independent of the Home country’s macroeconomic situation. The BP curve is a horizontal line. In the configuration of interest to us (fixed prices and fixed exchange rates), the equilibrium is represented by the three curves in Fig. 6.1. It is the configuration studied by Mundell and Fleming who concomitantly proposed this extension of the IS-LM model. An increase of g causes the IS curve to move to the right (from I S to IS’). The new intersection with the LM curve is incompatible with the external equilibrium given in Fig. 6.1. To restore the equilibrium, two options are possible: 1. The central bank is inflexible and does not change the money supply. The LM curve does not move. Under these conditions, the tensions due to the rise in interest rates, via pressures on the exchange rate (the country’s currency tends to appreciate: s e tends to rise), discourage investment and the IS curve returns to its initial place. The macroeconomic balance is not modified and the fiscal policy is in this case ineffective (Fig. 6.2).

12 This

condition is the uncovered interest rate parity condition. See Sarno and Taylor [40, Chapter 3].

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

211

Fig. 6.2 Shifting IS. Non-accomodating monetary policy

Fig. 6.3 Shifting IS. Accomodating monetary policy

2. The central bank is accomodating and modifies its money supply to defend the parity of the country’s currency. The curve LM moves (from LM to LM’) so that the equilibrium is located at the intersection between IS’ and the horizontal line BP. The fiscal policy is fully effective (Fig. 6.3). Comparing these two options, it is reasonable to think that the second is more plausible: a country that has committed itself to a fixed exchange rate system has implicitly committed itself to defending its parity and subordinating its internal monetary objectives to the objective of ensuring the sustainability of the system. In the IS-LM-BP model, there is an “incompatibility triangle”: it is impossible to reconcile simultaneously the independence of monetary policy, exchange rate fixity and the perfect circulation of financial capital. In a Fixed-Price Monetary Union Now, let us reason in the context of a closed (not trading with a “rest of the world”) monetary union with J countries. All countries are structurally identical and of the same size. Each is an open economy. We maintain the assumption of fixed prices.

212

6 Fiscal Policies in a Monetary Union

Monetary union implies that the “exchange rate” is fixed logically equal to 1. Hence terms of trade are fixed. We maintain the assumption of perfect mobility of financial and monetary flows within the union. This configuration is close to the one studied by Mundell–Fleming. In a monetary union, the central bank is unique. It has the power to set the interest rate and the money supply in circulation in the union. This is the crucial difference with Mundell–Fleming’s reasoning. The uncovered interest rate parity applies because of the mobility of monetary and financial capital, but the interest rate is no longer given by the rest of the world. Similarly, the central bank should not make its monetary policy conditional on defending the parity and the interest rate. In this context, let us assume that the central bank sets the interest rate at a ˆ The perfect mobility of financial flows means that, in both countries, the BP level i. line is horizontal: in each country, whatever its level of activity, the interest rate is ˆ equal to i. For reasons of representation, suppose that the union is made up of two countries (J = 2). The IS-LM-BP model in this framework is written for country j (j = 1, 2): yj = −ηiˆ + gj ˆ M = yu − ζ i, where the lower index j refers to country j , M is the money supply in circulation in the union: M = 12 (m1 + m2 ), mj is the money supply in circulation in country j and yu is the product of the union: yu = 12 (y1 + y2 ).13 The impact of the interest rate differential has disappeared since there is no exchange rate (the union is closed). But we have not returned to a simple economy since there are still two separate countries. We assume for the sake of simplicity that there is no cross-border fiscal effect. Figure 6.4 shows the macroeconomic balance (point A ) in each of the two countries, which are strictly identical since structures and settings are the same. Impact of a National Fiscal Policy Let us start by studying the impact in the union of a fiscal stimulus (g1 > 0 ) practiced in the country 1. We assume that monetary policy is not accomodating: not only does it set the interest rate but it also keeps the quantity of money in circulation at a level M, independent of the fiscal policies practised in the member countries. Since it does not have to defend a parity, this is conceivable: it follows a rule and can resist pressure from member countries. Let us first assume that the variation in public expenditures in one country has no direct cross-border effect on output in the other country. Moving the I S1 curve to the right leads to upward pressure on the interest rate. Given the perfect mobility of financial flows in the economy, this tension leads to an international capital flow; hence a shift of the LM1 curve to the right: the money supply in circulation in 13 i ∗

is set to zero because we are in a closed monetary union with no rest of the world.

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

213

Fig. 6.4 Equilibrium in a monetary union

country 1 increases. A new equilibrium is established in country 1, leading to an increase in output y1 (point C1 in Fig. 6.5a). In country 2, the I S2 curve has not moved in the absence of direct cross-border effects. But the LM2 curve shifted to the left since there were money transfers from 2 to 1, and the total quantity of money did not increase because of the inflexibility of the central bank. This shift implies upward pressure on the interest rate in country 2. This tension, all other things being equal, pushes investment downwards: the I S2 curve shifts to the left in order to restore macroeconomic equilibrium in country 2 ˆ In other words, the expansive fiscal policy of compatible with the interest rate i. country 1 has a depressing effect in country 2 through a cross-border crowding out effect: investment is discouraged to be compatible with the scarcity of available liquidity in country 2. The traditional domestic crowding out effect in a closed economy does not occur in a monetary union because the central bank controls the interest rate but a cross-border crowding out effect does occur. Ultimately, as a result of these curve shifts, the new equilibrium in country 2 is characterized by a fall in output y2 (point C2 in Fig. 6.5b). Now let us assume that there are direct cross-border effects of increased government spending within a country. The I S2 curve shifts, to the right if these effects are positive, to the left if they are negative. In the first case, the net change in output (resulting from the joint movements of I S2 and LM2 ) may be positive in country 2. These results are thus different from those obtained for a small open economy that retains monetary sovereignty. We have seen that if monetary policy is nonaccomodative, fiscal policy is ineffective. In a monetary union, on the other hand, under the same hypothesis on monetary policy, national fiscal policy is effective in both countries. More precisely, it creates redistributive effects between the two countries of the union, favouring the country that initiates it and disadvantaging the other.

214

6 Fiscal Policies in a Monetary Union

Fig. 6.5 Shifting IS. Non-accomodating monetary policy

Fig. 6.6 Shifting IS. Accomodating monetary policy

Let us now relax the assumption that the central bank maintains the money supply equal to M. Instead, assume that the central bank provides liquidity directly to countries according to their demand for it.14 Under these conditions, following the variation g1 , the curve LM1 moves to the right, but without the curve LM2 moving. Eventually, fiscal policy is operating in country 1 (Fig. 6.6a), but not in country 2, whose macroeconomic balance is not altered (Fig. 6.6b). This is the closest configuration to that obtained in a small open economy.

14 It is reasonable to assume that this is done through national banking systems or through partial financing of public expenditure. We do not detail the means by which this inflow of liquidity into countries takes place.

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

215

Impact of Fiscal Policy at the Union Level We now turn our attention to the impact of an overall fiscal policy, carried out at the union level. Let us consider that this policy amounts to an equal variation in public expenditures in the two member countries (g1 = g2 > 0). The central bank of the union applies an interest rate iˆ and a constant money supply, M. Under these conditions, since the two countries are symmetrical, the pressures on interest rates being identical in both countries, the monetary transfers cancel each other out and the LM1 and LM2 curves do not shift. Only the I S1 and I S2 curves shift. Let us return to the hypothesis of a non-accomodative central bank, applying a constant money supply, M. In this case, the pressure on investment financing conditions resulting from the shift in the I S curves makes this shift unsustainable. There is a complete intranational crowding out effect or a return of these curves to their initial position. The situation is represented by Fig. 6.1, applied to each of the two countries. This return does not take place, as in the case of a small open economy, through an appreciation of the exchange rate and a fall in exports but through a reduction in private investment in each country. In this configuration, there is no cross-border crowding out effect but a total internal crowding out effect in each country. If the central bank is now accomodating, it provides the necessary liquidity consistent with the rise in domestic products and the maintenance of the interest rate. This increase in liquidity is the same in both countries. As a result, the LM curves move in the same proportions. There is an increase in aggregate products without any internal or cross-border crowding out effects. The situation is represented by Fig. 6.2, applied to each of the two countries. Once again, we are in a configuration fairly close to that of a small open economy, but through very different adjustment mechanisms since they do not involve upward pressure on the exchange rate.

6.3.2.1 The Case of a Union with Flexible Prices What if prices are flexible? Let us continue our comparison of a small economy with monetary sovereignty or, alternatively, part of a monetary union. Let us begin by looking at the case of a single closed economy with control over its monetary policy (Farhi and Werning [14]). Specifically, suppose that the nominal interest rate is set by the central bank. In this configuration, the increase in public spending implying an increase in aggregate demand leads to a rise in prices and thus a fall in the real interest rate. That decline itself helps to stimulate investment and consumption, hence an indirect effect reinforcing the direct effect due to the increase in public spending.15 The impact of fiscal policy is amplified—assuming unchanged monetary policy—by price flexibility. By generalizing the reasoning, it can be argued that the impact of fiscal policy is an increasing function of price

15 This

sequence is plausible and reasonable. Under certain conditions (relating to the aggregated supply and demand functions), it may not occur.

216

6 Fiscal Policies in a Monetary Union

flexibility. Formally, it is to be expected that the multiplier will increase with the degree of price flexibility. If the economy is open and trades with the rest of the world, the increase in the price of its product degrading its competitiveness leads to a decrease of the parity of its currency in a flexible exchange rate. This devaluation cancels out the external effect of (indirect) loss of competitiveness of the fiscal impulse, or even has a positive impact on the external demand addressed to national production (according to the breakdown of world demand and assuming that the conditions on the usual price elasticities of world demand are verified). The real interest rate remains unchanged, with the impact of the exchange rate depreciation offsetting the impact of the price increase. Let us now consider an economy belonging to a monetary union and open to its union partners. The exchange rate effect disappears. For the sake of convenience, consider that there are two countries, 1 and 2. Each country produces one good, but its consumers consume both goods. Apart from this difference, the two countries are symmetrical and of the same size. Again, suppose that the central bank has an inactive monetary policy and that the nominal interest rate is fixed. Then the indirect effect through price flexibility is negative. Why is this? Let us make the— reasonable—assumption that national public spending is on the nationally produced good. A positive fiscal impulse in country 1 (g1 > 0) causes an increase in its relative price. The resulting loss of competitiveness depresses the aggregate demand for domestic production, an indirect effect going in the opposite direction to the initial direct effect. The increase in the price of the national good contributes to the rise in the general price level in the union, depending on the relative size of country 1, and therefore the real interest rate falls in proportion to the size of this economy. The indirect stimulus effect through the fall in the real interest rate is smaller than in the case of a monetarily sovereign country. It should be noted that, here again, significant cross-border effects occur: the loss of competitiveness not compensated by the variation in the exchange rate leads to an increase in demand in the partner country. These are no longer crowding out effects, but demand displacement effects. A fiscal policy “at the level of the union,” implying the same increase in public expenditure in both countries, would cancel out relative price changes and these demand displacement effects. The situation is then identical to that of a closed economy: the local multipliers of a global impulse are reinforced, higher than the local multipliers of a local impulse since the effects of loss of competitiveness do not appear. All in all, the positive direct effect on aggregate demand of an expansive national fiscal policy in a monetary union is offset by indirect effects going in the opposite direction, which is the opposite of what happens in the case of an open but monetarily sovereign economy. Farhi and Werning [14] sought to quantify these differences, using a neo-Keynesian model (with a Calvo pricing assumption for firms) in which monetary policy is absent (inactive). Their results show that government expenditure multipliers increase over time, are high in a liquidity trap and can reach very high levels, but that the local multipliers of a local impulse jj (mt,t +1) are low and always below unity.

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

217

We can draw some general conclusions from the analysis of these different macroeconomic configurations of a monetary union: 1. The transition to monetary union changes the transmission channels for fiscal policy, whether it is practised at the national or union level. 2. In particular, there are cross-border effects that may take the form of crowding out effects or demand-shifting effects. 3. These cross-frontier effects justify a fiscal policy at the level of the union. 4. The way in which monetary policy responds to national fiscal policies is crucial to their effectiveness. 5. Fiscal multipliers can be expected to be weaker in a monetary union than they would be if countries retained monetary sovereignty. In any event, the multipliers are dependent on the transmission channels and hence on the economic structure of the monetary union, particularly as regards price and wage flexibility and the mobility of factors in real or financial form.

6.3.2.2 What Do the Empirical Studies Tell Us? The difficulty in measuring fiscal multipliers stems from the fact that it is difficult to distinguish fiscal impulses from changes in public expenditure, levies or the deficit, as noted above. The latter aggregates are in fact largely the result of macroeconomic activity and do not correctly measure fiscal or tax policy decisions. One way of resolving this difficulty is to study natural experiments in which changes in government spending are exogenous to the business cycle and generate sufficient data so as to apply econometric treatment to them. It is in this perspective that recent empirical studies have exploited data on the effect of government spending that is made locally but decided at an aggregate level, most often in the context of a national monetary union. Thinking within the framework of a national monetary union has the dual advantage of having a large amount of data, but also of taking advantage of an economic (particularly monetary) environment that is the same for all jurisdictions, which makes it possible to attribute the causes of the variations observed to fiscal impulses made at the local level. A study by Serrato and Wingender [41] focused on the United States and exploited the fact that some of the federal transfers received by the 3144 U.S. counties depend on the demographic data available for each county. Censuses are conducted every 10 years, and in the interim, the federal government uses projections to calculate transfers to the counties. The censuses are therefore an opportunity for significant corrections in the available data and result in significant variations in the transfers received by local jurisdictions. These changes are independent of the economic conjuncture in the state at the time of the correction and can be assimilated to fiscal impulses, specific to each county. The authors’ main result is that the federal–local multiplier of public expenditure is in a range between 1.7 and 2. Since the consensus is that the federal public expenditure multiplier is

218

6 Fiscal Policies in a Monetary Union

in the order of 1,16 that is a high number. An important point is that the authors are unable to find any significant cross-border effects of these changes in federal spending. Another study on the same subject using a similar approach is that of Nakamura and Steinsson [35], which examines US military spending over the period 1966– 2006. Taking advantage of the fact that these expenditures are made locally in a highly differentiated manner depending on the American states and regardless of the economic situation there, these authors obtain results that are consistent with those of Serrato and Wingender: the local multiplier17 is of the order of 1.5. Carlino and Inman [9] studied the effect of US state government deficits on employment, both within a given state and in neighbouring states, using data over the period 1973–2009.18 They do find an effect of a state’s deficit on employment in the state as well as the presence of cross-border effects (measured by correlated changes in employment in neighbouring states). In the case of large states, these cross-border effects account for approximately two-thirds of employment growth in these states. Carlino and Inman [10] also examine the effect of federal fiscal policies in the United States over the period 1960–2010 using an SVAR analysis.19 The lessons learned are that tax cuts and federal transfers to states in favour of poor households generate high 1- and 2-year multipliers of over 2%. These few empirical studies show the difficulty of measuring multipliers in monetary unions. Not surprisingly, the results on multipliers in a single economy are already fragile, difficult to interpret and controversial.20 The difficulties are compounded by taking into account the fiscal heterogeneity of a monetary union. But it cannot be denied that multiplicative effects of fiscal impulses, whether national or supra-national, exist and the cross-border effects may be significant.

6.3.3

Macroeconomic Stabilization and Transfers

A fiscal policy decision, whether it concerns taxes or public expenditure, always involves transfers. We mentioned in Chap. 2 the study by Asdrubali et al. [2],

16 The measurement of multipliers has been the subject of numerous studies with very mixed results, depending on the methods and data used. Ramey [39] concludes her review by writing: “The aggregate multiplier in the United States corresponding to a temporary increase in debtfinanced public spending (with no impact on productive capacity) is probably between 0.8 and 1.5. But serious studies do not reject values of 0.5 or 2.” 17 Nakamura and Steinsson speak of the “relative multiplier in an open economy.” 18 The statistical measurement of a government deficit is delicate everywhere. Particularly in the United States, where many states are under a constitutional obligation to balance their budgets, as we will see in Sect. 6.4. Carlino and Inman consider, in addition to government budget balances, “off-budget” deficits, such as pension liabilities. Their focus is on the employment consequences, not on measuring a multiplier per se. 19 “Structural vector auto-regressive analysis.” 20 Leeper et al. [31] discuss the “morass” of the budget multiplier.

6.3 Fiscal Impulses and Transmission Mechanisms in a Monetary Union

219

which shows the role played by federal transfers in the U.S.A. In the previous chapter, we discussed fiscal policy in a monetary union through the international transfers it generates. But we have dealt only with the accounting aspect, neglecting their macroeconomic dimension and the role they play in the macroeconomic stabilization of the union. The issue was addressed in a very enlightening way by Farhi and Werning [15], whom we follow here. In the international economy, international trade in goods (and services) means that transfers smoothing agents’ consumption have cross-border effects (since they affect the supply and demand of imported or exported goods). The private valuation of these transfers differs from their collective utility, which would take these cross-border effects into account. Economic agents tend to under-insure themselves compared to what would be optimal because they do not internalize the macroeconomic consequences of their private insurance decisions.21 This therefore constitutes a justification for public intervention, or the establishment of national public transfers. This is true regardless of the efficiency of financial markets. If the exchange rate regime is a flexible exchange rate regime, Farhi and Werning show that the independent monetary policy of a given country can solve the problem and make the private valuation of insured transfers equal to the collective valuation. In a monetary union (and more generally in a fixed exchange rate system, disregarding the ability to modify the exchange rate system), by contrast, public intervention through public transfers is justified: there are too few monetary instruments to ensure optimal stabilization in the presence of idiosyncratic shocks. Farhi and Werning formally study the problem in a macroeconomic model of an international economy in the presence of nominal price and wage rigidities. In each economy, traded and non-traded goods are produced. This model can be implemented in a monetary union or with flexible exchange rates. They show how a system of public transfers makes it possible to achieve optimal stabilization of the monetary union. This justifies the formation of a fiscal union—a transfer union—within a monetary union. In the model studied, the greater the gains from this arrangement, the higher the idiosyncratic shocks (low correlation and high variance), the more persistent they are, and the less open the member economies are. In any case, the stabilization of the monetary union requires fiscal policies whose effectiveness depends on international transfers. On the basis of this result, the question arises as to the effects of fiscal policies and the usefulness of a given transfer rule. On this subject, two articles representative of current research are worth mentioning. Evers [13] considers two international transfer rules that redistribute funds between member countries of a monetary union in the presence of idiosyncratic shocks. The first targets national budget deficits. Such a rule reduces fluctuations in private consumption, reinforces

21 This

problem is related to the problem of international transfers addressed by Keynes [26] and Ohlin [37] in the 1920s, in the context of the payment of reparations owed by the defeated powers (mainly Germany) to the victorious countries that suffered the destruction of the First World War (mainly France and Belgium).

220

6 Fiscal Policies in a Monetary Union

the international smoothing of private consumption, but on the whole generates a fall in collective well-being due to the distortions created by the transfers. A second rule targets international differences in labour income. This rule leads to a gain in collective well-being but causes greater fluctuations in consumption and national aggregate products. Engler and Voigts [12] propose an international transfer rule that reduces the volatility of consumption and unemployment. This mechanism ensures a better stabilization of the union for the same level of distortions as the uncoordinated combination of national fiscal policies. They show that this mechanism is equivalent to a unique fiscal policy covering the whole union.

6.3.3.1 The (Non-)coordination of Fiscal Policies National fiscal policies are interdependent for macroeconomic and financial reasons. Since there are international spillover effects, policies designed from a strictly national perspective are sub-optimal from both a global and even a national perspective, since governments neglect both the consequences of their decisions on the economies of their partners and the feedback effect on the national economy. More broadly, non-cooperative fiscal policies lead to a probably sub-optimal outcome for each of the economies under consideration. This theme is at the heart of international macroeconomics thinking and gives rise to debates on the extent of the gains from international cooperation.22

6.4

Fiscal Policies and External Balances

How can fiscal policies influence and, if necessary, redress the external balances of those member countries that we have seen are central to a multi-national monetary union?

6.4.1

Fiscal Devaluations

In the light of the preceding chapters, the first question that arises is whether national fiscal policies are capable of ensuring that the external positions of the member countries of a monetary union are balanced. To the extent that the fiscal weapon can be used to restore competitiveness, it is logical to assume that it can also be used to restore external imbalances within a monetary union, or to play the exchange rate game in a multi-currency world. The idea of using taxation to offset exchange rate rigidity and ensure external balance is not new. It dates back to the days of the gold

22 For

a recent discussion of these issues, see Frankel [6].

6.4 Fiscal Policies and External Balances

221

exchange standard, based on fixed parities.23 Keynes [27] had already argued that fiscal instruments could balance a country’s external accounts insofar as they affect the terms of trade. The tax instruments in question are multiple. One can first think of tariffs and export subsidies, fiscal instruments that directly affect the terms of international trade. Another example is taxes levied directly on goods produced and consumed or on factors of production, which indirectly influence the terms of trade through the pricing of exported and imported goods. To the extent that a monetary union is logically associated with a customs union, the first instruments are inapplicable. That leaves indirect fiscal instruments. Let us consider taxation policy on imperfectly mobile factors of production such as labour. Let us assume that labour (we reason on the basis of a single type of qualification) is perfectly immobile, disregarding migration within the union. Direct taxation consists of all the levies that weigh on the remuneration of labour, such as payroll taxes and social security contributions.24 Indirect taxation consists of levies, mainly on consumption, which affect the purchasing power of wages, such as VAT. The reduction of taxes on wages and, more broadly, on the wage bill can, under certain conditions, lead to a drop in the prices of produced and exported goods and thus to a gain in competitiveness. Under certain conditions: this is true if the firm passes on the reduction in charges in full to its price, without seeking to increase its profit margins. The effect is temporary since the greater profitability of labour gradually pushes up wages. This effect is likely to last only a few years and gradually disappears in the medium term. Lowering consumption taxes (such as VAT) is not likely to improve national competitiveness as it increases purchasing power and will limit export capacity, benefit imports and push prices up. An increase in these taxes would have the opposite effect: the increase in VAT would weigh on goods sold on the territory, including imports, and not on goods sold abroad, exports (Kaufmann [24]). Finally, a change in the tax system could be considered, based on the assumption of constant tax revenues; for example, a reduction in social security contributions offset by an increase in VAT. Such a policy consists in shifting the tax burden to agents other than employees: consumers of the goods produced (which includes the inactive and the self-employed) partly rely on the import of goods from abroad. Here again, this shift is effective if firms do not pass on the full VAT increase in their selling prices, and it is effective only in the medium term, since it is likely that the increase in nominal wages will gradually reduce it until it is cancelled out. To sum up this discussion, the gain in competitiveness through the reduction of taxes on immobile factors is a realistic option in monetary union. But neither the effectiveness nor the availability of the weapon of fiscal devaluation should

23 The

gold exchange standard system was introduced in 1922 and replaced the gold standard system. It provided for two currencies, the pound sterling and the dollar, to be convertible into gold, with the parity of the other currencies to gold being fixed. Pound sterling and dollar were accepted as international reserves by central banks. 24 We treat social security contributions as taxes.

222

6 Fiscal Policies in a Monetary Union

be exaggerated. The effectiveness of such a fiscal policy is rapidly declining and cannot be practised indiscriminately without jeopardizing the sustainability of public finances. Its use is limited and the restoration of external accounts requires other policies. On a theoretical level, it can be conjectured that if the government of a member country of a monetary union has sufficient fiscal instruments at its disposal, it is able to ensure the balance of its external accounts, for a given productive structure (Adao, Correia and Teles [1]). But two questions then arise. The first is whether this equilibrium can be achieved with a limited number of fiscal instruments. The second is whether all countries can simultaneously balance their external accounts through their fiscal manipulations. The article by Farhi et al. [16] focuses on the first question. These authors show that simple fiscal policies practised by a country open to the rest of the world make it possible to obtain the same allocation of resources as the one obtained by a change in the exchange rate in a flexible exchange rate regime. Remarkably, the characteristics of these effective policies remain valid for very different environments or different values of economic parameters. The model on which they are based is a macroeconomic model of an open economy based on standard microeconomic foundations (monopolistic competition) and assumptions of nominal price or wage rigidities. Each country is specialized in the production of a good that is consumed internationally. Financial markets are open and different specifications of financial openness are explored. The policy of fiscal devaluation is based on the simultaneous manipulation of a few fiscal instruments: customs duties that modify the terms of trade and consumption taxes, as well as taxes on wage income, which are necessary to compensate for the macroeconomic consequences of this variation. Hohberger and Kraus [21] pursue the approach of Farhi et al. by examining the normative consequences of a fiscal devaluation practised by a small open economy whose exchange rate with its trading partners is fixed (possibly because it belongs to a monetary union). They show that, if fiscal devaluation does indeed lead to the restoration of the external balance as would an exchange rate adjustment, it generates welfare losses for households greater than those caused by the exchange rate adjustment because the volatilities of aggregate output and household consumption are increased by fiscal manipulation, while they are reduced by monetary manipulation. It is important to notice that, in these studies, only one country is fiscally active. The other country (the rest of the world) is assumed to be entirely passive in both monetary and fiscal terms. The consequences of fiscal devaluation policy on this passive country are not studied, nor are the effects of non-cooperative fiscal devaluation policies that would be conducted simultaneously. This work therefore does not answer the second question posed above. From this point of view, the pressing questions raised by the issue of fiscal manipulations for stabilization purposes in monetary union are avoided: what cross-border effects do they generate? Can they ensure the equilibrium of the external balances of the member countries of the union?

6.4 Fiscal Policies and External Balances

223

Hjortso [20] addressed the latter question by means of a two-country monetary union model. She shows that the optimal fiscal policy from the point of view of the monetary union as a whole practised by a benevolent planner “à la Ramsey,” i.e. manipulating fiscal instruments in both member countries, together with interest rate manipulation, is to stabilize the external balances of both countries. But this policy creates fiscal distortions that create internal inefficiencies in each country. The optimal fiscal policy from the point of view of the union thus consists in allowing an international sharing of risks through transfers that in the long run balance each other out, rather than ensuring macroeconomic stabilization of each country taken in isolation. Implicitly, there is a contradiction between the optimal fiscal policy from the point of view of the union and the optimal policy from the point of view of a member country. Moreover, national fiscal policies are the responsibility of national political authorities and not of a benevolent supra-national authority. It is unlikely that non-cooperative fiscal manipulation policies of the type proposed by Farhi et al., when conducted in a world of fixed exchange rates and particularly in a monetary union, would result in the same allocation as the one resulting from non-cooperative monetary policies in flexible exchange rates. The manipulation of different instruments generates monetary and technological externalities (given nominal rigidities) of different natures and magnitudes.

6.4.2

National Fiscal Policies and Tax Competition

As we have seen, fiscal policy is also conceived in a long-term perspective, with the dual aim of supporting the growth process and providing public amenities (in particular efficient public services) that meet needs not or poorly served by markets. There are cross-border effects in these matters. The most important of these structural effects is the tax competition between governments to attract mobile factors of production and increase their growth potential: 1. In an economy that is open to the rest of the world, governments are tempted to use fiscal and tax instruments to give their domestic producers competitive advantages: by lowering the tax rates on factors of production or on the income derived from these factors, they can hope to lower the relative cost of domestic products and improve their competitiveness. 2. Moreover, lower tax rates can bring internationally “mobile” factors of production into the country, i.e. factors that are likely to migrate from one country to another. The interest is twofold: by increasing the productive base located in the country, growth is sustained and tax revenues are increased. Let us focus on the latter effect. By lowering taxes on capital,25 a country can hope to attract productive capital. This is only possible if other countries in the rest of 25 Excluding

real estate capital, which is by definition non-mobile.

224

6 Fiscal Policies in a Monetary Union

the world do not react to this aggressive policy. Unless there are special reasons (such as the interest in having “tax havens” for more or less avowable reasons), they have every reason to react to a policy that reduces their own productive bases and tax revenues. This is known as “tax competition” or tax race to the bottom (Wilson [43], Keen and Konrad [25]). The canonical result of this competition is what specialists call the “race to the bottom”: the desire of each country to be fiscally less demanding and to lower its tax rates results in all countries setting the rate on tradable goods or mobile factors at the lowest level, leading to a sub-optimal situation, and in particular an insufficient provision of public services in relation to collective needs. As capital26 is the most mobile of the factors of production, tax rates on capital tend to decrease.27 Reasoning in a monetary union rather than in an international economy characterized by a flexible exchange rate regime changes the modalities of tax competition. On the one hand, exchange rate adjustment alters the relative returns on factors of production invested in different countries. It is plausible that the currency of a country to which capital flows are directed in order to benefit from relatively low taxes appreciates and this reduces the profitability of the operation. On the other hand, one of the consequences of monetary unification is to lower the costs of crossborder adjustment within the union (due to the disappearance of exchange rates and regulatory harmonization) and to increase factor mobility accordingly. Tax competition is enhanced within a monetary union. The resource implications are important and are likely to have a significant macroeconomic impact in a monetary union: 1. When a member country secures a competitive advantage by lowering its tax rates on mobile factors (as we have said, typically capital), its partners in the union may decide, by consensus or consultation, not to retaliate. This country will see its relative productive situation improve. If initially its level of development (conventionally measured by GNP per capita) is lower than that of its partners, it will experience a catch-up situation. This is the “Irish” scenario: once Ireland joined what was then the European Economic Community (which became the European Union in 1993) in 1973, its growth was stimulated by very low tax rates on capital relative to those applied by its partners. There is clearly a dimension of trans-national redistribution to the benefit of the lowest cost country. This raises the question of the extent to which these redistributive effects are collectively accepted within the union. 2. The other option is for the partners to react to this reduction, particularly under pressure from their public opinion, by making a downward adjustment to their tax burden. In this case, we are in a race-to-the-bottom configuration. The result

26 That

is to say, financial capital to finance the purchase of productive assets. canonical result is widely discussed in the scientific literature. In addition, other modes of tax competition have been identified and studied. We focus on this one because it is the most emblematic and probably the most prevalent. 27 This

6.5 Fiscal Rules

225

is not a displacement of the factors of production, but a reduction in tax revenues for all the States in the union and consequently lower public amenities.

6.5

Fiscal Rules

Given the possible negative cross-border effects of national fiscal policies and the undesirable consequences of non-cooperation by national authorities, we have seen that institutional discipline may be applied in a monetary union.28 Such a discipline implies that the strict independence of national fiscal policies must be limited through rules that limit the fiscal leeway of member countries.

6.5.1

The Properties of a “Good” Fiscal Rule

The notion of “fiscal rule” is not limited to monetary unions. It stems from the thinking of macroeconomists (and more broadly economists) concerned about the difficulty of curbing public deficits (Kopits and Symansky [29], Wyplosz [44]). The difficulty of such a rule is to reconcile the stabilizing function of fiscal policy with the sustainability of public debt, which implies not doing “too much” at the wrong time. The search for the ”right” framing rule therefore amounts to seeking a compromise between fiscal discipline and flexibility. From this perspective, an “ideal” framing fiscal rule fulfils the following properties [5, 29]: 1. Focus on an indicator or series of indicators of the discretionary stance of fiscal policy. 2. Be analytically sound, especially if it refers to quantitative targets or thresholds. 3. Be consistent with the stabilization function of fiscal policy. 4. Ensure the sustainability of public debt. 5. Be simple and easily understandable. 6. Allow for an easy assessment of its implementation and enforcement. 7. Be credible: the conditions for its application must be implemented in a transparent manner and without being manipulated according to economic or political circumstances. Properties 1, 2, 3, 4 are economic properties. They relate to the statistical and analytical apparatus with which fiscal policy is, in the current state of our knowledge, approached and practised. Properties 5, 6 and 7 relate to the conditions for the political acceptance of a rule. These properties are general and apply to any fiscal rule. In addition, the evaluation property 6 should be understood as relating to the

28 See

Sect. 5.4 of the previous chapter.

226

6 Fiscal Policies in a Monetary Union

evaluation of a country’s fiscal policy, both its impact on its internal situation and that of its partners and on the dynamics of the union as a whole. The purpose of applying a framing rule in a monetary union is to strengthen the fiscal discipline practised by a member country with a view to limiting the extent of possible adverse cross-border fiscal effects. The strengthening of discipline, however, has the consequence of limiting the capacity to respond to shocks that may affect the national economy. The risk is that a rule could lead to an increase in the scale of fluctuations affecting a country and, at the same time, increase the heterogeneity of economic cycles within the union. This is likely to increase the amplitude of cyclical variations in the union as a whole. A fiscal rule applied to all members of a monetary union faces two related challenges. The first is to ensure that a fiscal policy conducted by applying the rule fulfils its objectives in the long term; the second is to ensure that the rule itself is sustainable, i.e. is applied in the long term without being questioned by the stakeholders, namely the member countries and national public opinion. It is therefore useful to add two properties to the ideal rule in a monetary union. The first is an economic property: 8. Be compatible with the macroeconomic stabilization of the monetary union as a whole. This property means that the rule must take account of cross-border effects and ensure that these do not contribute to increased macroeconomic fluctuations in the partner countries and in the union as a whole. The second additional property is political. 9. Be credible at the level of the union, and therefore be the subject of a consensus within the union and accepted by public opinion in the member countries. The application of a framing rule imposed on the member countries of a union represents a limitation of their fiscal sovereignty. This limitation is politically delicate: it must be accepted by the national electoral bodies. However, the electorates are tempted to decide on expenditure by postponing the concern for its financing through taxation and are inclined to run a budget deficit. They must endorse a rule that is tantamount to weaning them off this addiction: it is hard to think that it will be easy. The adoption itself can only take place at the level of the Union and apply to all member countries. It would indeed be astonishing for countries to unilaterally accept a limitation of their fiscal sovereignty.

6.5.2

Types of Rules

Different framing rules have been proposed, discussed and, in some cases, applied. Some relate to deficits, and others to the amount of public debt: 1. The rules governing the current deficit. The rules relating to the current deficit limit the amount of the deficit. The “limit” can range from an unconditional prohibition to conditional overruns, which are

6.5 Fiscal Rules

2.

3.

4.

5.

227

provided for in the rule. The more conditions precedent provided for in the rule, the less stringent is the rule. The amount of the deficit is usually given in relation to a measure of aggregate product, such as GDP or GNP. The simplest rule is that the government budget is balanced and the government deficit is outright prohibited. A less strict rule is that the ratio of the deficit to aggregate output may not exceed a certain percentage. This provision may be supplemented by conditions precedent, depending on the circumstances. These provisions seek to reconcile fiscal discipline with the desire to maintain a degree of flexibility in fiscal policy to respond to circumstances or avoid aggravating them. The rules governing the structural deficit. In the same vein, some rules refer to the “structural deficit,” i.e. not the current account deficit but a measure of the deficit adjusted for developments due to the economic cycle. A structural deficit balance rule requires that the public accounts are balanced not on a year-by-year basis but over the economic cycle as a whole. Such a rule aims to increase the counter-cyclicality of fiscal policy by obliging the government to run surpluses in the upper part of the cycle so that it can finance the deficits needed to sustain activity in the lower part of the cycle. Rules based on the golden rule. It can legitimately be argued that not all public expenditure is equivalent and that capital expenditure in public budgets can be validly financed by borrowing. A golden rule provided that only current government expenditure (including loan repayments) should be financed by tax and other revenues and not by the deficit [33]. The rules governing public debt. Some rules may govern public debt and relate to stock variables and not flow variables such as the deficit. Again, these rules relate to ratios, not absolute amounts of debt. For example, the ratio of debt to an aggregate output indicator, such as GDP or GNP, is capped. Logically, the ideal rule should be that the net worth of public assets be positive, i.e. public debt should be at most equal to public assets. Such a rule is inconceivable because it is impossible to properly assess what public assets are. We are therefore obliged to rely on debt-to-GDP ratios, for example. The rules governing public expenditure or tax progression. Finally, rules may relate to public expenditure or levies and regulate them more or less firmly. Their justification is that such provisions make lax behaviour with serious financial disadvantages impossible.

In a monetary union, the question is at what level these rules should apply. If the union is not linked to a federation, they can only apply to the member States. Otherwise, they can apply to the federal Treasury as well as to the Treasuries of the member States. If they apply only to one level and not the other, the one with full fiscal latitude is clearly at an advantage. The definition of a fiscal rule in a monetary union can only be defined at the level of the union since it implies a sharing of

228

6 Fiscal Policies in a Monetary Union

fiscal sovereignty. It is based on a process of cooperation between member States. However, it comes up against two difficulties: 1. Goodhart’s law. The first is linked to “Goodhart’s law,” which can be expressed as follows: When a statistical measure becomes a target, it ceases to be a good measure.29

The deterioration of a statistical measure, such as a deficit/GDP ratio, when it has become a target in a fiscal rule, is due to the fact that this transformation of the status of a measure into a target changes its signification, because agents play strategically and change their behaviour according to this target. In the case of fiscal rules enacting a maximum deficit/GDP ratio, this maximum becomes the “allowed” deficit norm according to which governments determine their budgets, almost independently of the economic situation. Goodhart’s law applied to a monetary union represents a new challenge to institutional discipline in that it imposes constraints, particularly quantitative ones, on fiscal indicators. 2. Creative accounting. When he proposed his law, Goodhart inferred that the incentives to manipulate the indicator were increased by the fact that it became a target. If a decisionmaker believes that the target cannot be met, there may be a temptation to manipulate it in order to avoid the difficulties or costs associated with not meeting the target [22]. In terms of public finances, this translates into imaginative accounting measures that undermine cooperation and the functioning of a monetary union.

6.5.3

Fiscal Rules in a Monetary Union

In view of what has just been said, the institutions of monetary unions governing the fiscal policies of member countries or jurisdictions are unlikely to be identical. Indeed, existing or past monetary unions reflect a wide variety of institutional arrangements [18]. In national monetary unions based on a federal political system, such as the United States, Switzerland, Canada and Germany, framework rules are often imposed at the level of sub-national jurisdictions, rarely at the federal level. In the United States, all but one of the 50 states of the American Union, Vermont, have adopted balanced budget rules, sometimes with variations in calculation methods and clauses that make it more or less easy to break free of them [38]. Despite

29 The original formulation proposed by Goodhart [17] is as follows: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” On Goodhart’s law, see Chrystal and Mizen [11].

6.5 Fiscal Rules

229

these facilities, government debt is low. Some states may have added additional constraints on the growth of public expenditure and/or taxes. At the federal level, the federal public debt ceiling is set by law. However, this latter rule is hardly binding because Congress has the power to move this ceiling as it sees fit. Rather, this ceiling is the occasion for parliamentary jousting in which the majority and the opposition make their differences in fiscal matters heard. In Switzerland, an extremely decentralized federation, the fiscal capacities of the cantons are limited by rather diverse but well respected framework rules [28]. The first rule generally adopted is that of financing operating expenses, excluding investment, strictly through taxation, which is therefore a golden rule. In some cantons, a rule of strict budget balance applies. The referendum culture specific to Switzerland makes fiscal policy in any case under the control of residents. Germany has long lived without a rule governing the public finances of the Länder. It was only in 2009 that the Federal Parliament passed a law on the subject. It was indeed strange that the German leaders almost unanimously demanded a framework for the public finances of their partners in the European monetary union when they did not feel the need for it within the German federation. In the case of multi-national monetary unions, the same diversity can be found. The case of the European Monetary Union is the best known. Its analysis has been the subject of numerous works, both theoretical and empirical [7]. The Maastricht Treaty made little reference to fiscal issues [6]. In the years that followed, European leaders sought to better control the public deficits of the member States through a “Stability and Growth Pact”, adopted by a resolution of the European Council in June 1997 at its meeting in Amsterdam [3, 30]. This pact was based on two principles: 1. The definition of the permissible deficit for member States as less than 3% of GDP except in the event of a severe recession (when GDP contracts by more than 2%) 2. The development of a sequence of penalties for unjustifiably exceeding this limit. The procedures for auditing the accounts and ensuring that deficits comply with the Pact are particularly cumbersome, especially since they are coupled with “convergence programmes” submitted by member States to the European Commission to ensure that the path of their public finances is deemed to be in line with fiscal discipline. However, the decision whether or not to apply the “excessive deficit” procedure is left to the discretion of the European Council. The public accounts framework provided by the Stability and Growth Pact is ultimately not very restrictive, too complicated to implement and incomprehensible to European public opinion. This explains why it had to be amended, given the impossibility of applying it seriously and effectively, first in 2005 and then in 2011, in the midst of the crisis triggered by Greece’s near default on its public debt.

230

6.6

6 Fiscal Policies in a Monetary Union

Conclusion

This chapter highlights the extent of cross-border fiscal interdependencies. The conduct of fiscal policy by a country (or a jurisdiction in the case of a national monetary union) is significantly affected by the fact that it belongs to a monetary union. On the one hand, fiscal policies generate cross-border effects that affect the functioning of the union and need to be taken into account by policy-makers. On the other hand, their weight (measured by their economic impact or by the role they are asked to play) is increased by the non-existence of exchange rates and national monetary policies. This explains the paradox of the concomitance of the important weight given to fiscal policies and the increasing constraints on the fiscal authorities. Fiscal policies are heavily constrained in a monetary union by the common monetary policy and the need to ensure the sustainability of the union, while they are required to play a greater role in cyclical stabilization and crisis management. How can this paradox be managed? The view that an “every man for himself” approach would lead to an optimal functioning of the union is theoretically conceivable but under such restrictive and unrealistic conditions that it is reasonable to rule out this option. Both for directly economic and financial reasons, national fiscal policies are interdependent. Since there are cross-border spillover effects, policies designed from a strictly national perspective are sub-optimal from both the union and national points of view since the public authorities of a member country, neglecting the consequences of their decisions on partners, also neglect the feedback consequences of their induced decisions on the national economy. More broadly, non-cooperative fiscal policies lead to a probably sub-optimal outcome for each of the economies under consideration. This theme is at the heart of international macroeconomic thinking and gives rise to debates on the extent of the gains to be made from international cooperation in monetary unions.

References 1. Adao B, Correia I, Teles P (2009) On the relevance of exchange rate regimes for stabilization policy. J Econ Theory 144:1468–1488 2. Asdrubali P, Sorensen B, Yosha O (1996) Channels of interstate risk sharing: United States 1963-1990. Q J Econ 111:1081–1110 3. Beetsma R, Uhlig H (1999) An analysis of the Stability and Growth Pact. Econ J 109:546–571 4. Boadway R, Shah A (2009) Fiscal federalism: Principles and practice of multiorder governance. Cambridge University, Cambridge 5. Buiter W (2003) Ten Commandments for a Fiscal Rule in the E(M)U. Oxf Rev Econ Policy 19:84–99 6. Buiter W, Corsetti G, Roubini N (1993) Excessive deficits: sense and nonsense in the Treaty of Maastricht. Econ Policy 8:57–100 7. Calmfors L (2015) The roles of fiscal rules, fiscal councils and fiscal Union in EU Integration. In: Research Institute of Industrial Economics Working Paper n◦ 1076. 8. Canzoneri M, Cumby R, Diba B (2005) The need for international policy coordination: what’s old, what’s new, what’s yet to come? J Int Econ 66:363–384

References

231

9. Carlino G, Inman R (2013) Local deficits and local jobs: can US states stabilize their own economies? J Monet Econ 60:517–530 10. Carlino G, Inman R (2016) Fiscal stimulus in economic unions: what role for states? Tax Policy Econ 30:1–50 11. Chrystal K, Mizen P (2003) Goodhart’s law: its origins, meaning and implications for monetary policy. In: Mizen P (ed) Central banking, monetary theory and practice: Essays in honour of Charles Goodhart. Edward Elgar Publishing, London 12. Engler P, Voigts S (2013) A transfer mechanism for a monetary union. In: SFB Discussion Paper n◦ 649 13. Evers M (2012) Federal fiscal transfer rules in monetary unions. Eur Econ Rev 56:507–525 14. Farhi E, Werning I (2016) Fiscal multipliers: Liquidity traps and currency unions. In: Taylor J, Uhlig H (eds) Handbook of Macroeconomics, vol 2. Elsevier-North-Holland, Amsterdam, pp 2417–2492 15. Farhi E, Werning I (2017) Fiscal unions. Am Econ Rev 107:3788–3834 16. Farhi E, Gopinath G, Itskhoki O (2013) Fiscal devaluations. Rev Econ Stud 81:725–760 17. Goodhart C (1975) Monetary Relationships: A View from Threadneedle Street. Papers in Monetary Economics, Reserve Bank of Australia, n◦ 192 18. Grembi V, Nannicini T, Troiano U (2016) Do fiscal rules matter? Am Econ J Appl Econ 8:1–30 19. Hindriks J, Myles G (2013) Intermediate public economics. MIT press, Cambridge MA 20. Hjortsò I (2016) Imbalances and fiscal policy in a monetary union. J Int Econ 102:225–241 21. Hohberger S, Kraus L (2016) Is fiscal devaluation welfare enhancing? Econ Model 58:512–522 22. Irwin T (2012) Accounting devices and fiscal illusions. In: International Monetary Fund Staff Discussion Notes 2012. https://doi.org/10.5089/9781475502640.006 23. Kaplow L (2010) The theory of taxation and public economics. Princeton University, New York 24. Kaufmann C (2016) Optimal fiscal substitutes for the exchange rate in a monetary union. In: Deutsche Bundesbank Discussion Paper No 44/2016 25. Keen M, Konrad K (2013) The Theory of International Tax Competition and Coordination. In: Auerbach A, Chetty R, Feldstein M, Saez E (eds) Handbook of Public Economics 5, Supplement C. Elsevier, Amsterdam, pp 257–328 26. Keynes J (1929) The German transfer problem. Econ J 39:1–7 27. Keynes J (1931) The end of the gold standard. Essays in Persuasion, Macmillan, London 28. Kirchgässner G, Pommerehne W (1996) Tax harmonization and tax competition in the European Union: Lessons from Switzerland. J Public Econ 60:351–371 29. Kopits G, Symansky S (1998) Fiscal Policy Rules. In: International Monetary Fund Occasional Paper n◦ 192 30. Larch M, Jonung L (2014) The Stability and Growth Pact of the European Union. In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, Basingstoke 31. Leeper E, Traum N, Walker T (2017) Clearing up the fiscal multiplier morass. Am Econ Rev 107:2409–2054 32. Leith C, Wren-Lewis S (2011) Discretionary policy in a monetary union with sovereign debt. Eur Econ Rev 55:93–117 33. Menguy S (2017) Advantages of Following a Golden Rule in a Monetary Union. Macroecon Dyn 21:279–310 34. Musgrave R (1959) The theory of public finance. McGraw-Hill, New York 35. Nakamura E, Steinsson J (2014) Fiscal stimulus in a monetary union: Evidence from US regions. Am Econ Rev 104:753–792 36. Oates W (1972) Fiscal federalism. Harcourt Brace, New York Jovanovich 37. Ohlin B (1929) Transfer difficulties, real and imagined. Econ J 39:172–182 38. Poterba J (1995) Balanced budget rules and fiscal policy: Evidence from the states. Natl Tax J 48:329–336 39. Ramey V (2011) Can government purchases stimulate the economy? J Econ Lit 49:673–685 40. Sarno L, Taylor M (2003) The economics of exchange rates. Cambridge University, Cambridge

232

6 Fiscal Policies in a Monetary Union

41. Serrato J, Wingender, P (2016) Estimating local fiscal multipliers. In: National Bureau of Economic Research working paper w22425 42. Wickens M (2012) Macroeconomic theory: a dynamic general equilibrium approach. Princeton University, New York 43. Wilson J (1999) Theories of tax competition. Natl Tax J 52:269–304 44. Wyplosz C (2012) Fiscal rules: Theoretical issues and historical experiences. In: Alesina A, Giavazzi F (eds) Fiscal policy after the financial crisis. University of Chicago, Chicago

7

The Policy Mix

Abstract

Chapter 7 studies the policy mix in a monetary union. The possibility to reach an optimal policy mix such that a monetary union functions smoothly and perfectly stabilizes cycles appears irrealistic. The very existence of a monetary union makes insulation impossible, contrarily to what happens in a flexible exchange rate world: No member country can be made fully independent from the fiscal impulses coming from the other member countries. Therefore the institutional design of a monetary union is of central importance. Addressing the issue of policy dominance, a variant of the model discussed in Chap. 3 including fiscal variables is analysed. It shows that no specific design can be thought of as superior in any circumstances.

One of the lessons of the previous chapters is that the functioning of a monetary union closely depends on the interaction between monetary and fiscal policies. Three propositions can be put forward on the basis of the preceding chapters. 1. Macroeconomic stabilization is carried out jointly by the central bank and the fiscal authorities. 2. The unsustainability of the debt of a member country of the union and the arrangements for resolving a sovereign default within the union are decisive factors in the soundness of a monetary union. 3. In the event of a banking and/or a financial crisis, the public authorities of the union must cooperate in some form or other to resolve it, reconstitute the financial or banking system on a sound basis and assume the social and economic consequences thereof. In particular, we saw in Chap. 6 that the effectiveness of fiscal policies in stabilizing the union depends on the conduct of monetary policy, whether or not it is © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_7

233

234

7 The Policy Mix

accomodative. To better understand this effectiveness, we need to consider the relationship between the fiscal authorities of the member countries of the union and its central bank. The interdependence of fiscal and monetary policies stems from the cross-border effects of fiscal and monetary decisions taken in the monetary union (Foresti [10]). These decisions influence the economic incentives to which agents in the union react and the operating conditions of markets, particularly financial markets, modifying the terms of (re)financing for these agents. This chapter deals with the articulation of monetary policy and fiscal policies with a view to macroeconomic stabilization, still leaving aside the question of a possible federal fiscal authority. The question of crisis management is being postponed to Chaps. 9 and 10. Section 7.1 is devoted to the presentation and discussion of some general findings on the articulation of economic policies in a monetary union, focusing on the question of the “policy dominance policy” of one authority over the other. The discussion will be continued in Sect. 7.2 by studying variants of the simple monetary union model that we have already examined in Sect. 3.3 of Chap. 3, which will allow us to return to the question of the rules governing fiscal policy in a monetary union.

7.1

The Policy Mix in a Monetary Union

In an economy with monetary sovereignty, the interaction of monetary and fiscal policies (the “policy mix”) is a major economic policy issue. Monetary union makes this issue even more delicate. It covers many aspects: the institutional framework that governs the responsibilities and capacities of each authority, the objectives of these authorities and the behaviour of each one, the conditions of their cooperation or their hierarchical relationship. What are the constraints on the different authorities? Are they hierarchical, dependent or independent? To what extent are some in a position to impose their decision and mode of action on others?

7.1.1

Is an Optimal Monetary Union Possible?

We saw in Chap. 3 that the principle of central bank independence from national political authorities can be considered reasonable in a monetary union. Otherwise the sharing of monetary sovereignty would be unbalanced, and it is doubtful that one country would agree to relinquish its monetary sovereignty to another. We can therefore argue that the central bank does not cooperate with national fiscal authorities or that it cooperates with all on an equal footing. The first question regarding the articulation of economic policies is: “Can it be done well?”. Can the ideal scenario of a well-functioning monetary union that works to everyone’s satisfaction be achieved? With respect to macroeconomic stabilization, the answer is theoretically positive. Adao et al. [1] study a monetary union, or more precisely an international economy with fixed exchange rates. The economy is represented by a two-country dynamic stochastic general equilibrium

7.1 The Policy Mix in a Monetary Union

235

model. It is characterized by imperfections, relating to imperfect price flexibility and/or imperfect labour mobility. In addition, the demand for money depends on a prior holding constraint which requires agents to have nominal balances available before making consumption purchases. Countries are affected by idiosyncratic shocks. These imperfections and shocks generate fluctuations that justify the willingness to pursue active policies or a desire to share risks within the monetary union. Imperfections generate costs within the monetary union, as discussed above. Fiscal instruments are assumed to be distorting and the Pareto optimum is not achievable. The question is whether a monetary union with structural imperfections can, thanks to the macroeconomic policy measures taken, function as well as an economy with flexible exchange rates and without nominal imperfections. If the answer is positive, this implies that the exchange rate system is of no economic consequence or that there is functional equivalence regardless of the exchange rate regime. In other words, one can conceive of configurations where the exchange rate regime is inessential to the functioning of the economy. Adao, Correia, and Teles show that this result is obtained if several conditions are met. 1. On the one hand, monetary and fiscal policies are decided cooperatively, or by an authority responsible for all economic policy instruments, seeking Ramsey’s allocation.1 2. On the other hand, in addition to the monetary instrument, which is the amount of cash available in the economy, the fiscal instruments are tax rates on consumption and tax rates on labour income. Tax revenues make it possible to finance public expenditure that is assumed to be exogenous. Adao et al. obtain this result under the assumption of perfect cooperation.2 The question can be taken the other way around and asked under which conditions cooperation is inessential and the allocation obtained in the absence of any cooperation is identical to the allocation obtained under full cooperation, or the optimal allocation. Dixit and Lambertini [8] answer this question on the basis of a static model of a monetary union of countries responsible for their fiscal

1

A Ramsey allocation is the optimal allocation chosen by a benevolent planner forced to use existing policy instruments. 2 Ramsey’s allocation implies that this cooperation will last over the supposedly infinite time horizon. Kempf and von Thadden [13] have addressed this issue, as well as the impact of the absence of pre-commitment, in a generic model where the different players are in a situation of interdependence: Their well-being depends on their actions, as well as those of the other players. Alternative modalities of cooperation, possibly partial, between subsets of players are formalized by different coalition structures, and patterns of engagement by different extensive forms of play. They show that games characterized by different coalition structures and patterns of engagement can have the same solution if clearly defined external effects cancel each other out. It is thus possible that the absence of cooperation and commitment may lead to the optimal solution when all authorities cooperate but under extremely severe conditions.

236

7 The Policy Mix

policies, inspired by the model of Barro and Gordon [2] and similar to the model presented in the previous chapter. The objective functions of the various authorities are quadratic loss functions and the functioning of the economy is given by a set of linear constraints. The private sector is assumed to be consolidated into a single representative individual. Externalities present in the model are only of a fiscal nature. As we have seen above, issues of cooperation and pre-commitment are present in such an economy. However, under particular conditions, Dixit and Lambertini show that cooperation and pre-commitment patterns are inessential in the following sense: The Nash equilibrium solution is the optimal solution obtained in any configuration of cooperation (partial or not) or commitment (perfect or not). These conditions are an identity of the objectives present in the loss functions of the different authorities and the equality between the number of instruments, hence of economic policy authorities (when it is assumed that each controls a single instrument) and the number of objectives. Dixit and Lambertini refer to this set of conditions as the “symbiosis” between economic policy authorities. This result of perfect optimality is stronger than that of Adao et al. because it does not assume perfect cooperation of the authorities, or full control of the instruments by a Ramsey planner. It is obtained under very restrictive conditions. In particular, the assumption that all policy-makers share the same inflation and output gap objectives is highly questionable.3 A less ambitious question is what economic policy configuration is capable of minimizing the impact of imperfections and rigidities on the functioning of the union. Cooper and Kempf [6] address the issue of fiscal policy in a monetary union without assuming cooperation, in an overlapping-generation model.4 The authors study these agents successively in a variant where each country has its own currency and in the variant of a monetary union. The economy is hit by preference shocks and real shocks. Since the authorities’ objective is to maximize the expected utility of agents, they have a “risk-sharing” objective. The fiscal authorities are concerned about their nationals and have an objective of sharing intertemporal risk while the central bank is concerned about the welfare of all residents in the union and seeks to share risk spatially across countries. The only durable asset in the economy is money and budget deficits are covered by transfers from the central bank. In the case of an economy with monetary plurality, the foreign exchange market is not open continuously but at the end of the period, once the exchange of goods has been completed. This creates an imperfection from which the monetary union is freed. This is the essence of Mundell’s dilemma: The single currency saves on transaction costs but involves the loss of monetary instruments. Cooper and Kempf seek to answer the question: Under which conditions does monetary union generate

3

Kempf and von Thadden [14] generalize and discuss this result. In particular, they show that it depends on the quadratic-linear formalization chosen. 4 An overlapping-generation model is an intertemporal general equilibrium model. The economy is made up of successive and nested generations: At each date, agents born at different dates coexist, most often with a finite life span.

7.1 The Policy Mix in a Monetary Union

237

higher welfare than an economy with a plurality of currencies? They show that, in the absence of fiscal policies, the superiority of the monetary union depends on the correlation properties of different shocks, in accordance with Mundell’s logic. When the countries of the union have fiscal instruments that allow them to insure individuals against the risk of unemployment and the central bank is able to pre-commit itself, i.e. to create money and make transfers at the beginning of the period, the central bank decides not to intervene and to leave the responsibility for risk-sharing to the national fiscal authorities. The consequence of the decisions of the national fiscal authorities, although taken in an non-cooperative manner, is to generate an aggregate welfare that is always higher than the welfare achieved in the economy with multiple currencies. This result amounts to the disappearance of the Mundellian dilemma made possible by fiscal instruments. Fiscal instruments substitute for monetary transfers by central banks in the case of non-monetary unification and provide financing for unemployment insurance, thus sharing risk. In short, the loss of monetary autonomy is not costly since it is compensated for by fiscal instruments. Since, at the same time, monetary union eliminates transactions costs, which depend on shocks affecting agents’ preferences, this monetary regime is preferable to an exchange rate regime. One consequence of this result is that the nature of the shocks and the extent of their correlation no longer determine the desirability of a monetary union. In a different macroeconomic approach, based on dynamic stochastic general equilibrium models, Gali and Monacelli [12] show the possibility of an optimal monetary policy from the point of view of the union. This allows for both an aggregate output gap (calculated on the aggregate product of the union) and zero inflation. But the result is made fragile by the fact that Gali and Monacelli assume a monetary union consisting of a large number of member countries, so that the strategic effects of economic policies are cancelled out. Ferrero [9], using the same modelling approach, removes this limitation by analysing a monetary union with two countries that retain their fiscal autonomy. He finds similar results: Fiscal policies (defined by rules) focus on stabilizing idiosyncratic shocks while the monetary policy rule is to stabilize the inflation of the union. Taken together, these contributions lead to a simple conclusion: A monetary union can work optimally but the conditions for doing so are extremely stringent and are unlikely to be met by a real monetary union. We have to set this aside and accept that a monetary union is imperfect in the following sense: No policy configuration is capable of putting the economy on the path that would be achieved in the absence of any structural imperfections or real or nominal rigidity, apart from distortions due to the use of fiscal instruments.

7.1.2

Is Insulation Within a Monetary Union Possible?

In the previous section we posed a normative problem. But we can also adopt a positive approach and look at the effective functioning of the policy mix in a monetary union and try to assess the impact of the interdependence of economic

238

7 The Policy Mix

policies within it. In particular, the first question that comes to mind is whether it is possible for one policy to “neutralize”, i.e. cancel out, the consequences of another policy conducted in the union. If the monetary union is not optimal, it may be because the actions of some countries have negative impacts on the whole and on other countries in particular. Is it then possible to offset these negative effects in the union as a whole, or to ensure that the external effects on other countries are cancelled out? To put it more bluntly, is it possible to protect oneself from the fiscal imbalances that a member country may suffer? Can such an objective be imposed on the central bank of a union? Cooper et al. [7] addressed these questions. Their model of a monetary union is once again a model with overlapping generations of two countries sharing the same currency. To the extent that it is a general equilibrium model, deficits are financed by public debt. Agents are immobile and pay their taxes in one country. One country has an active fiscal policy and conducts a deficit policy financed by borrowing, the other has no fiscal policy or has a zero deficit. The central bank of the union follows a fixed monetary policy rule and distributes the seigniorage inflows between the treasuries of the two member countries. The instrument of monetary policy is unspecified and can be either money creation or an interest rate. The presence of money is justified by a pre-purchase money holding constraint. To the extent that any monetary policy involves money creation, either directly or indirectly because of the need to balance the money market, which is distributed between the two countries, a monetary policy rule may be formalized by a transfer rule, specifying the amount transferred and the distribution of this amount.5 In this context, Cooper et al. make two general propositions: 1. No monetary policy rule can ensure that the stationary equilibrium of the economy does not depend on the deficit of the fiscally active country. 2. No monetary policy rule can ensure that the level of stationary consumption in the fiscally inactive country is unaffected by the deficit of the fiscally active country.6 The first proposition indicates that the macroeconomic situation of the union is necessarily affected by the fiscal policies conducted by the member countries and the central bank does not have the capacity to neutralize this impact. This is because two transmission channels are at work: On the one hand, the remunerations of the factors of production, capital and labour, are affected by the amount of public debt circulating within the union and, on the other hand, the monetary policy rule that depends on the macroeconomic configuration a priori generates transfers to the States. It is possible for monetary authorities to use an appropriate rule to cancel one

5

From this perspective, any monetary union is a transfer union. This presentation is consistent with the public finance approach to monetary policy discussed in Chap. 5. 6 This result is obtained in the vicinity of the stationary state corresponding to a monetary policy without monetary creation.

7.1 The Policy Mix in a Monetary Union

239

of these two channels but it is never possible for them to cancel these two channels simultaneously. Once it has been accepted that the overall situation of the union is inevitably affected by the fiscal policy of a member country, a less demanding and seemingly more easily attainable objective can be set: to “insulate” a particular member country from the consequences of a fiscal policy practised in another country for which it is not responsible and from which it does not benefit directly. The second proposition gives a negative answer to this question: This objective is unattainable. Insulation is impossible in monetary union. Specifically, the central bank cannot achieve this insulation because, even for a single country, it cannot ensure that the two transmission channels are simultaneously neutralized. These two propositions do not imply that different rules have the same macroeconomic impact. Cooper et al. discuss the impacts of different monetary policy rules, such as inflation targeting or interest rate targeting. In other words, the point is not to argue that monetary policy in a monetary union is inessential but simply to recognize that the objective that might be to neutralize the consequences of monetary policy on all or part of a monetary union is unattainable.

7.1.3

The Issue of Dominant Policy

The relationship between economic policy authorities can be addressed through the notion of dominant policy. Let us start from a rather vague definition of the dominant fiscal policy for a unitary economy: A dominant fiscal policy exists when the fiscal authority is in a position to constrain the monetary policy adopted by the central bank because the central bank has to react to fiscal decisions. The definition of dominant monetary policy is the opposite: It is the fact that the monetary authority is able to constrain the government’s fiscal policy. Problems of dominant policy arise in a monetary union. They can be of great importance to the functioning of a monetary authority. This is confirmed by the article by Cooper and Kempf [6] presented above. We have presented the case of a dominant monetary policy since the central bank played at the beginning of each period, before the fiscal authorities. Now, when we assume two symmetric countries and that the fiscal authorities have the possibility of determining the amount of transfers to their unemployed nationals (again in a non-cooperative manner) before the central bank chooses the amount of money created (giving rise to transfers to States to supplement their fiscal resources), the result of the game is as follows: The fiscal authorities choose not to tax their employed nationals and leave it to the central bank to finance the transfers to the unemployed through the issuance of money and the inflation tax. This creates an externality that did not exist in the previous case since the financing of the unemployed in a country is financed via the inflation tax by all the agents of the union. This externality is negative because it discourages individual decisions to work. Under these conditions, it is no longer true that a monetary union is superior (in the sense of Pareto) to an economy with

240

7 The Policy Mix

monetary plurality. This is true only if the risk of unemployment is low enough and the variance of shocks sufficiently large. This theoretical example is sufficient to alert us to the importance of the relations of political dominance between monetary and fiscal authorities in a monetary union. What remains to be done is to give a precise definition of this notion of policy dominance. Macroeconomists follow several approaches. 1. A first approach to dominant policy in macroeconomics is based on the fiscal theory of the general price level. This theory is based on a consideration of how to satisfy the government’s budget constraint and argues that fiscal policy is dominant because it determines the general price level, or inflation, in lieu of monetary policy. 2. A second approach is based on the notion of pre-commitment. A dominant monetary (fiscal) policy exists when the central bank (the fiscal authority) can pre-commit itself to the fiscal authority (the central bank). The hierarchical relations between authorities are expressed by time lags in decisions: One authority is in a dominant position with respect to another when it takes its decision before the decision of the dominated authority. Formally, one authority holds a leadership capacity, in the sense of Stackelberg, over another. 3. A related approach is to say that one authority is dominant when it has greater latitude of action than another, in particular because the latter is subject to (more) binding framework rules. 4. A final approach contrasts economic policies according to whether they are “active” or “passive” in their response to public debt shocks.7

7.1.3.1 Policy Dominance in a Monetary Union The fiscal theory of the general price level appears paradoxical. Friedman [11] famously claimed that “inflation is always a monetary phenomenon”? This adage is the basis of the idea that monetary policy should be primarily concerned with inflation control. The contradiction is only apparent. It disappears when it is accepted that monetary policy can be dependent on fiscal policy. It is used to close the government’s accounts and finance its deficit; the resulting inflation is therefore determined by the requirements of fiscal policy. In other words, fiscal policy dominates monetary policy. In these circumstances, macroeconomists refer to the “fiscal theory of the price level (of inflation)” (Bassetto [3], Woodford [17]). The fiscal theory of the price level takes two forms (Carlstrom and Fuerst [5]). The weak form of the fiscal theory of the price level (FTPL) is related to the seigniorage revenues from the money-issuing institution that the Treasury may enjoy. The Treasury determines a sequence of primary deficits excluding transfers that oblige the central bank to provide it with the liquidity, at one time or another, necessary to avoid default. This mechanism was analysed by Sargent and Wallace [16], who showed how it could lead to immediate inflation even though the central 7

This approach was initiated by Leeper [15].

7.1 The Policy Mix in a Monetary Union

241

bank had been pursuing a monetary policy of constant money issuance for some time. The strong form is more demanding analytically and requires a good understanding of macroeconomic analysis and its mysteries. It is not based on the change in the money supply and the transfers available to the Treasury, but on the property of indeterminacy of the initial general price level. The notion of “initial period” is familiar to macroeconomists who, when setting up a dynamic model, need a beginning or an initial period. In the real world, it is difficult to define a beginning: There is always a past, likely obscure and imperfectly known. Bypassing this difficulty, let us assume that every monetary regime has an initial date. An initial general price level is necessary, and it is indeterminate. According to the strong variant of price level fiscal theory, fiscal policy and the requirements of closing the public accounts remove this indeterminacy and set the initial price level. Monetary policy can control price dynamics, i.e. inflation, but not the position of the price path. By setting the price level, the fiscal authority determines the real weight of its present and future debts, and thus its liabilities. The theory of the price level can be applied to the case of a monetary union, but the multiplicity of actors makes it considerably more complex than in a simple economy (Bergin [4]). If we reason at the level of the union, we must take into account the consolidated budget constraint, corresponding to the union. We can refer to a “consolidated fiscal dominant policy” (in the strong or weak variant): The price level in the union is determined by the financing needs of the public Treasuries present in the union. The problem with this notion is that it does not justify the origin of this dominant policy imposed on the central bank of the union. If we differentiate between the various public Treasuries and their budget constraints, it is logical to distinguish several forms of policy dominance. 1. If monetary policy accomodates the financing needs of the federal Treasury (in a weak or strong form), it amounts to a “dominant federal fiscal policy”. 2. If monetary policy accomodates the financing needs of a country j ’s Treasury, we refer to it as country j ’s dominant fiscal policy. The latter case is not purely academic. In Argentina, at the end of the 1990s, the province of Buenos Aires, which covers 60% of the country’s population, ran out of funds and introduced a parallel currency. Within a few years, this quasi-monetary financing of the deficit forced the country’s central bank to abandon its monetary policy, which was intended to be independent of public financing needs through a currency board. This is an example of the dominant fiscal policy of one component of a monetary union. 3. But the analysis cannot stop at these fiscal-monetary cases. Let us assume that we are in a situation of dominant monetary policy, vis-à-vis any fiscal institution active in the union. Nevertheless, it is possible that a dominant regional-regional fiscal policy may occur, where the financing needs of one fiscal institution are met by a dominant policy on other regions or other fiscal institutions in the union. This may take the form of a weak or a strong policy. In the case of a weak form, the adjustment variable by which the dominant policy of country i on country

242

7 The Policy Mix

j materializes is the fiscal transfer from j to i. In the case of a strong form, the adjustment variable will be the ratio of regional price levels, or the regional component of the general price level in the union. On similar grounds, we can refer to a dominant federal-regional or regional-federal fiscal policy. 4. Finally, country i may be fiscally dominant vis-à-vis country j but dominated vis-à-vis country k. Country i is then a simple intermediary and country k is (indirectly) dominant vis-à-vis country j .

7.1.3.2 Policy Dominance, Default and Transfers It should be noted that policy dominance is closely linked to the notion of default. One authority may be obliged to assist another in order to avoid its default. Conversely, the default of a fiscal authority is due to the fact that it is not in a position to oblige others to help it. The fiscal instrument of dominance is transfer, whether direct in the case of the weak form or indirect in the case of the strong variant. From this perspective, the distinction between stabilization and redistribution objectives loses its meaning since a transfer is an instrument of redistribution used to stem the adverse consequence of the manipulation of other instruments for stabilization purposes. This remains true in a monetary union. Since in a monetary union there may be more direct or indirect transfer instruments than seigniorage alone, the interaction between stabilization and redistribution is even closer, to the point where it becomes almost useless to distinguish between them. It is only in the case of perfect homogeneity of the components of a union characterized by a dominant monetary policy and Ricardian equivalence that the stabilization of the union does not require transfers. Ultimately, the dominant policy tests the solidarity between the components of a monetary union. The relationships between the institutions responsible for macroeconomic policy in the union express power relations. This is what is meant by the term “dominant policy”. An authority may be forced to adopt measures that do not serve its primary interest. Dominant policy relationships are more difficult to manage in a monetary union than in a unitary economy (with a single fiscal authority). The multiplicity and complexity of the exchanges between the components of a union make it difficult to identify or reconstruct the channel through which the dominant policy of one component is exercised over the others. These channels are the result of an institutional arrangement where the term “institution” covers, in addition to legal and regulatory provisions, the conventions, routines and usual modes of operation of economic agents. It is therefore logical, given the potential importance of the forced transfers implied by the institutional set-up of a monetary union, to question its properties and its acceptability to the populations of the member countries.

7.1.4

The Policy Trilemma of a Monetary Union

Consider a closed monetary union, including all countries and based on a “world” unique currency. Is this the end of any conflict of objectives, or of any triangle

7.2 Lessons from a Simple Model

243

of impossibilities? Of Mundell’s trilemma, yes, obviously, since we ignore any exchange rate problem and therefore any attack on the currency and the plurality of monetary policies does not exist anymore. But another triangle of impossibility emerges. It is impossible to reconcile three properties within a monetary policy: 1. Perfect capital mobility. 2. The independence of the union’s monetary policy. 3. The independence of national fiscal policies. This is another way of presenting the result of the impossibility of insulation. Capital mobility means that assets of the same quality have the same price in the union. This, together with the uniqueness of monetary policy, means that the financial conditions placed on the fiscal authorities are the same and therefore that none of them can free themselves from the consequences of what the others do.

7.2

Lessons from a Simple Model

In this section, we look at the articulation of monetary decisions taken by the central bank and fiscal policy decisions taken by the fiscal authorities in the union for macroeconomic stabilization purposes by means of a simple model, a variant of the model with expectations developed in Chap. 4 in which we introduce fiscal instruments.

7.2.1

Modelling the Policy Mix

Consider a monetary union with two symmetrical countries hit by a real global shock. In each country, there is a fiscal authority handling a fiscal instrument in accordance with its objectives, noted gj for country j . The central bank assumed to be independent from the national fiscal authorities is responsible for a monetary policy instrument. The aggregate output of country j is given by the following equation   yj = yˆ + agj + (1 − a)g−j + b π − π e + uj

∀j = 1, 2,

(7.1)

where yj represents the aggregate output in country j , yˆ the natural aggregate output in country j , π the inflation rate in the union, π e the inflation rate expected by private agents in the union, g−j the fiscal instrument of the country other than j and ui the (real) shock affecting country j . ui is a white noise, an independent and identically distributed random variable at any period (i.i.d.), of zero expectation and variance σu2 . The distribution of real shocks in the two countries is the same but the actual shocks may differ. As the aggregate product is a function of the two fiscal variables, there is a cross-border fiscal effect. The smaller the coefficient a, the larger

244

7 The Policy Mix

the size of this effect. We assume that a > 1/2. Lastly, the natural aggregate output is the same in both countries. The local multiplier of a local impulse is therefore a and the cross-border multiplier is (1 − a). Inflation is the same in both countries of the union. It is given by the following equation π =c

2

gj + πM + ε,

(7.2)

j =1

where πM represents the instrument controlled by the central bank of the union and ε the monetary shock affecting inflation uniformly. ε is a white noise, an i.i.d. random variable of zero expectation and variance σε2 . Inflation is a function of fiscal instruments, and the central bank can seek to counter this influence by manipulating its monetary instrument πM . Following the logic of the models developed in Chap. 4, the various public authorities are characterized by loss functions that formalize their preferences. The loss function of the fiscal authority of country j is given by the following formula Lj =

2 1 1  θ yj − χ˜ + π 2 , 2 2

(7.3)

where χ˜ is the desired level of output aggregated by the fiscal authority of country j . We assume that the fiscal authorities have the same aggregate output target (χ) ˜ and inflation target (0). θ is the weight given to the output target relative to the inflation target. This weight is assumed to be the same in both countries. Thus, the loss functions are the same for both countries. The union central bank’s loss function is given by LM =

1 1 θM (y − χ˜M )2 + π 2 , 2 2

(7.4)

where χ˜ M is the level of aggregate output of the union desired by the monetary authority and y the average aggregate output of the union. This output is defined by the following equation y = yˆ +

  1 ¯ (g1 + g2 ) + b π − π e + u, 2

(7.5)

where yˆ is the average natural output level in the union, equal to the natural output in each country and b¯ is the average of the coefficients bj . θM is the weight given by the central bank to the output target relative to the inflation target. The lower the weight, the more concerned the central bank is about controlling inflation. The loss functions of the fiscal authorities, which are identical, differ from the central bank’s loss function. The differences between the players relate to their levels of product targets and their weighting between the two objectives in the

7.2 Lessons from a Simple Model

245

loss χ˜ M = χ˜ and θM = θ . In fine, the vector of model parameters is  functions: a, b, c, y, ˆ σu2 , σε2 , χ˜ M , χ˜ , θM , θ . In the rest of the calculations, for simplicity, we will retain only one difference: χ˜ M = χ. ˜

7.2.2

Institutional Options

Relations between the central bank and the fiscal authorities may be based on framing rules, i.e. constraints on the decision to be taken by the central bank or on the fiscal capacities of the states that limit their capacity to act. In particular, a constraint may consist in the obligation to balance national budgets. Fiscal cooperation may also specify hierarchical dependency relationships between public authorities: The institutional arrangements in force in the monetary union may place one authority under the control of another. In this section, we focus on an analysis of different framing rules that are more or less restrictive and alternately weigh on one authority or another. It is interesting to study a constraint on fiscal policies, given the numerous discussions on the desirability of limiting the size of public deficits, or even imposing systematic budget balance, in monetary union. Here we will use the budget constraint gj = 0, assuming that this instrument represents the public deficit of country j . The model is static: There is no lagged term in this economy. The endogenous variables in the model are functions of current shocks and the objectives of the monetary and fiscal authorities. The sequence of decisions is as follows: 1. Private agents form their inflation expectations. 2. A state of nature occurs: The values of the shocks are known. 3. The various fiscal and monetary policy-makers make their decisions on the value of the instruments. 4. Output and inflation are deducted. It is possible to calculate the losses incurred by the public authorities (treasuries and central bank). The decisions in step 3 depend on the relationship between the economic policy authorities. To show the importance of framework rules in a monetary union, we will distinguish five options. In all cases, we will assume that the authorities do not cooperate. 1. The first is that of very tightly constrained fiscal policies (FU 1). The Treasuries are unable to conduct a macroeconomic policy. We assume: gj = 0 ∀j = 1, 2. We can interpret this constraint as the respect of a strict fiscal balance. In this option, the only economic policy decision in step 3 is taken by the central bank, which assumes sole responsibility for macroeconomic stabilization according to its preferences alone. 2. The second option is that of tightly constrained fiscal policies (FU 2). We assume the leadership of the central bank, which makes its decision before fiscal

246

7 The Policy Mix

decisions. Step 3 breaks down as follows: 3a/ decision by the central bank; 3b/ decisions by the national Treasuries, playing in a non-cooperative way. 3. The third option is that of autonomous fiscal policies (FU 3). In this option, there is no quantitative constraint or hierarchical relationship. The economic policy authorities make their decisions in step 3 simultaneously and in a noncooperative manner. 4. The fourth option is that of weakly constrained fiscal policies (FU 4). This is the opposite of option FU 2, in which the Treasuries benefit from leadership over the central bank. Step 3 breaks down as follows: 3a/ decisions by the national Treasuries, playing in a non-cooperative way; 3b/ decision by the central bank. 5. Finally, the fifth option is that of very weakly constrained fiscal policies (FU 5). In this option, we assume a total lack of autonomy of action by the central bank. Inflation results solely from the (non-cooperative) decisions of the national fiscal authorities. Formally, we assume πm = 0. This option is symmetrical to the FU 1 case. In order not to make the section too heavy, as our aim is not to be exhaustive but to show that the choice of an institutional arrangement is complex we will limit ourselves to the study of variants 1, 3, and 5, which are the most interesting and closest to the controversies on central bank independence and budget constraints, which are recurrent in economic policy.

7.2.3

Calculation of Expected Losses

Combining the different equations of the model, we obtain the following expressions for the losses of the different policy authorities Li =

  2 1  θ (a + bc) gi + (1 + bc − a) g−i + b πM + ε − π e + ui − χ 2 1 + (c (g1 + g2 ) + πM + ε)2 (7.6) 2

LM =

1 θ 2



 2   1 + bc (g1 + g2 ) + b πM + ε − π e + u¯ − χM 2

1 + (c (g1 + g2 ) + πM + ε)2 2

(7.7)

with χM = χ˜ M − y, ˆ χ = χ˜ − y. ˆ u¯ is the average real shock. We normalize the problem by asking χM = 0. We interpret (for ease of language) χ as the difference between the aggregate output targets of the monetary and fiscal authorities. To compare the different policy options, we use the losses of the different policy authorities as indicators and we are interested in comparing the values of expected losses E (Li ) and E (LM ) obtained in the different options.

7.2 Lessons from a Simple Model

247

7.2.3.1 Very Tightly Constrained Fiscal Policies (FU 1) In the event  that the national fiscal authorities are unable to manipulate their instrument gj = 0, ∀j , the losses become immediately Lj = LM =

 2 1  θ χ + b (πM + ε) + uj + (πM + ε)2 2

(7.8)

 1 θ (χM + b (πM + ε) + u) ¯ 2 + (πM + ε)2 . 2

(7.9)

Since the fiscal authority’s objective plays no role in this variant and, given the properties of the shocks, the inflation expectations of private agents are π e = 0.

(7.10)

1∗ is given by the following equation (see The optimal solution that we note πM Appendix)

θb 1∗  u¯ − ε. πM = − 1 + θ b2

(7.11)

The central bank’s decision responds negatively to both real and nominal shocks. Insofar as it is the only authority acting in this variant and with a single instrument, it is normal that it seeks to offset their expansive and inflationary impact, whereas its product and inflation targets are zero. The central bank fully offsets the nominal shock to inflation. Moreover, it increases its counter-action to fight off the impact of the average real shock. The loss expected by the monetary authority in this configuration, which we note E L1∗ M , is given by the following formula ⎡  2  2 ⎤   1 θ b θ 1 ⎣θ   +   ⎦ σu2 =   σ 2. E L1∗ M = 2 2 2 1 + θb 1 + θb 2 1 + θ b2 u (7.12) Let us calculate the loss of fiscal authority in this configuration. According to the 1∗ , we obtain expression for πM  1  = E L1∗ i 2



 θ (θ b)2 + θ σu2 + χ 2 . 2 1 + θb 2

(7.13)

The central bank neutralizes the impact of the monetary shock on the aggregate output of each country and thus of the union. The absence of additional (fiscal) instruments does not enable it to neutralize the impact of real shocks. In the absence of these shocks, the central bank would be able to achieve its output and inflation

248

7 The Policy Mix

objectives and would incur a zero loss. The exclusive central bank’s action shields it from the decisions of the fiscal authorities and it is not affected by their output target χ. The higher the variance of real shocks, the higher the expected loss. On the other hand, the national fiscal authorities suffer an expected loss, which depends on their output objective since the central bank has not taken it into account: Its action takes them away from the level they want which represents a loss for them. Moreover, they are more affected by the variance of the real shock than the central bank. This is because the central bank responds to the real shock according to its own loss and that is not enough from the point of view of the national fiscal authorities.

7.2.3.2 Autonomous Fiscal Policies (FU 3) For this option, the losses (data above) are Li =

1 θ ((a + bc) gi + (1 + bc − a) g−i + b (πM + ε) + ui − χ)2 2 1 + (c (g1 + g2 ) + πM + ε)2 (7.14) 2 LM =

1 θ 2



 2 1 + bc (g1 + g2 ) + b (πM + ε) + u¯ 2

1 + (c (g1 + g2 ) + πM + ε)2 . 2

(7.15)

The resolution of the economic policy authorities’ optimization programs gives us the following decision rules for the different authorities g1 =

θ (a + bc) 1−a a u1 + u2 χ− 2a − 1 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b] (7.16)

g2 =

θ (a + bc) a 1−a u1 − u2 χ+ 2a − 1 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b] (7.17)

πM = −

(2c + θ b) θ (a + bc) χ + cu1 + cu2 − ε. [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b] (7.18)

Notice that the nominal shock is fully compensated by the central bank action and does not affect the decision of the fiscal authorities. The latter leave the central bank to act alone to offset the impact of this shock on the economy. The central bank’s action is affected by the fiscal authorities’ output objective: In a non-cooperative logic, the central bank compensates by a restrictive action for the tendency of the

7.2 Lessons from a Simple Model

249

fiscal authorities to achieve a higher level of aggregate output than it considers desirable. Finally, the central bank responds positively to real shocks, rather than negatively as in the case of the previous option. That is because the national fiscal authorities do not perceive the negative externalities of their non-cooperative decisions on their partner: Each of them acts too strongly to counter the impact of real shocks. The central bank, which has an objective of stabilizing the union as a whole, seeks to offset this negative consequence for the union by acting in the opposite direction, reacting positively to the real aggregate shock. It is now possible to calculate the loss expectations of individual policy-makers. For the fiscal authorities, the expected loss is given by the following equation 2   ∗ 1 θ (θ b − 2 (1 − c) (bθ (a + bc) − c))2 + θ 2 b (a + bc) E L3i = χ2 2 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]2   2abc 2 2 1 + θ σu . (7.19) 2 2a − 1 Similarly, the following equation is obtained for the central bank .2  ∗  1 2 [cθ (a + bc) (1 + bc)]2 + θ 2 b (a + bc) E L3M = χ . 2 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]2

(7.20)

The central bank’s expected loss is affected solely by the difference in the product target. Not only has the central bank’s action enabled it to neutralize the nominal shock, but, moreover, the combination of actions in response to real shocks means that, on average, they have no impact on the level of output and on inflation. The bank’s expected loss does not depend on any shock variance. On the other hand, it is affected by the deviation from the product targets: Since the bank reacts to the actions of the fiscal authorities and these depend on a high output target, it reacts to this target that is incorporated in the bank’s expected loss. The expected loss of a fiscal authority is not affected by the variance of the nominal shock since the nominal shock is fully neutralized by the central bank. On the other hand, it is affected by the variance of the real shock, unlike the central bank. This is the repercussion of the externalities of an idiosyncratic real shock on the union as a whole: The situation of non-cooperation does not allow them to be managed optimally. Similarly, again because of the lack of cooperation between the various authorities since the fiscal authorities react to the action taken by the central bank with a different product objective from their own, they cannot achieve their product objective and their expected loss depends on that objective.

250

7 The Policy Mix

7.2.3.3 Very Weakly Constrained Fiscal Policies (FU 5) This option is characterized by πM = 0. The losses become ⎡ ⎛ ⎞ ⎞2 ⎤ ⎛ ⎞2 ⎛ n n n 1⎢ ⎥ Li = ⎣θi ⎝χ˜ i + aij gj + bi ⎝c gj + ε⎠ + ui ⎠ + ⎝c gj + ε⎠ ⎦ 2 j =1

j =1

j =1

(7.21) ⎡

LM

⎛ ⎞ ⎞2 ⎛ n n n 1⎢ ⎝ 1 = ⎣θM χ˜ M + aij gj + b¯ ⎝c gj + ε⎠ + u¯ ⎠ 2 n i=1 j =1

j =1

⎛ ⎞2 ⎤ n ⎥ + ⎝c gj + ε⎠ ⎦ .

(7.22)

j =1

The decisions of the fiscal authorities are given by the following equations g1 =

θ (a + bc) θ (a + bc)2 + c2 . χ − u1 θ (a + bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2 (2a − 1) +-

g2 =

(7.23)

θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) . ε u2 − θ (a + bc) (1 + 2bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2 (2a − 1)

θ (a + bc) θ (a + bc)2 + c2 . χ − u2 θ (a + bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2 (2a − 1)

(7.24)

θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) . +ε. u1 − 2 θ (a + bc) (1 + 2bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c (2a − 1) Since the central bank does not intervene, the fiscal authorities cannot rely on its instrument, which is useful in combating the nominal shock. They have to respond to the nominal shock themselves. It is possible to calculate the expected losses of the various protagonists. For the fiscal authorities, they are given by the following formulas   2 2  ∗ 2 2θ c + (θ (a + bc)) 2 E L5i = 7c  2 χ 2 θ (a + bc) + 2c   c2 + θ (a + bc)2 2 2 2 + 2 2c σu + σε θ (a + bc) (1 + 2bc) + 2c2

(7.25)

7.2 Lessons from a Simple Model

251

and for the central bank of the union we obtain    ∗  1 θ 2 (a + bc)2 (1 + 2bc)2 +4c2 2 E L5M = χ .2 2 θ (a + bc) + 2c2  +  ×

1+2bc 2

1+2bc 2

2 -

2

.2 θ (a + bc) (2bc − 1) + 2c2 + (2cθ (a + bc))2 σu2 .2 2 θ (a + bc) (1 + 2bc) + 2c

[bθ (2bc − 1) + 2c (c − 1)]2 + θ 2 (a + bc)2 σε2 . .2 2 θ (a + bc) (1 + 2bc) + 2c

(7.26)

When the central bank is forced to take no action, its expected loss is affected by the fiscal authorities’ aggregate output target. This is the consequence of the fact that the decisions of the fiscal authorities, linked to this objective, affect the level of actual output and deviate it from its desired output level, which is zero. It is also affected by the variances of all the shocks, including the variance of the monetary shock against which it does not act. The expected loss of a fiscal authority also depends on the level of the output target and on the variances of the shocks. This is due to the fact that the fiscal authorities do not cooperate and do not properly manage the externalities which their actions entail for their partner. This cause of sub-optimality explains why the objectives are not perfectly achieved, in particular the aggregate output target. Since the fiscal authorities manage two instruments in a non-cooperative manner to deal with the presence of three shocks in the economy, they cannot perfectly stabilize their economies in the face of these shocks. In particular, the absence of monetary policy exposes them to the risk that they cannot be immune to the impact of the nominal shock, as in the intermediate option FU3 examined above.

7.2.4

Comparison of Options

The results for these three options can be summarized in Table 7.1. On reading this table, we can make a few methodological remarks. 1. No policy mix option appears to be systematically preferable, i.e. generating the expected losses for the three authorities that are lower than the other options, whatever the vector of the parameters. It is even difficult to identify for which parameter configuration an option is Pareto-superior to the others. 2. It is possible to show that option 1, which corresponds to a strong limit on States’ fiscal capacities, is, for certain configurations of parameters, a modality of operation of the monetary union that is Pareto superior to the other two. But in the opposite direction, we can find configurations of parameters for which option 5, where the central bank is inactive, is Pareto-superior.

252

7 The Policy Mix

Table 7.1 Expected losses Fiscal authority j  FU 1 FU 3

+

1 2



FU 5

Central bank



(θ b)2 + θ σu2 1+θ b2  2 2 2 1 θ (θ b−2(1−c)(bθ (a+bc)−c)) + θ b(a+bc) χ2 2 [θ (a+bc)(1+2b(1−c))+2c(1−c)−θ b]2 2  2abc + 12 θ 2a−1 σu2

θ 2 2χ

1 θ 2 2 1+θ b2 σu .2 [cθ (a+bc)(1+bc)]2 + θ 2 b(a+bc) χ2 2[θ (a+bc)(1+2b(1−c))+2c(1−c)−θ b]2   θ 2 (a+bc)2 (1+2bc)2 +4c2



2 2 c2 2θ c +(θ (a+bc)) χ2 (θ (a+bc)+2c2 )2   2 2 c +θ (a+bc) 2c2 σu2 + σε2 + (θ (a+bc)(1+2bc)+2c2 )2



+

χ2 2 2[θ (a+bc)+2c2 ] 2 . 2 1+2bc θ (a+bc)(2bc−1)+2c2 +(2cθ (a+bc))2 2

+



1+2bc 2

2

[θ (a+bc)(1+2bc)+2c2 ]2 [bθ (2bc−1)+2c(c−1)]2 +θ 2 (a+bc)2

[θ (a+bc)(1+2bc)+2c2 ]2

σu2

σε2

3. As a general rule, the interests of the different authorities are opposed. The option desired by the central bank is generally not the one desired by the national fiscal authorities. If the different assumptions made to simplify the calculations are removed, the formulae given for expected losses become more complicated and the causes of opposed interest increase. 4. The nature of the shocks and their distribution laws play a decisive role in the calculation of expected losses. Here the only asymmetry introduced between the two countries comes from the fact that they are affected by idiosyncratic shocks, generated by the same distribution law. If we loosen this hypothesis, opposition between authorities will increase. 5. More generally, we have assumed symmetrical countries and national political authorities—the Treasuries—with identical objectives. If we introduce asymmetry between countries and different macroeconomic preferences, the conclusion is reinforced: Except under very special conditions, no institutional option defining the relationship between fiscal policy authorities and central banks is systematically Pareto-superior.

Put in more political terms, one cannot expect a consensus on the architecture of the links between the different authorities in charge of economic policies in a monetary union. 6. This conclusion would be confirmed if the table were supplemented by the expected losses obtained in options FU 2 and FU 4.8 7. We have adopted a hypothesis of non-cooperation between the various authorities in charge of economic policy. Given the cross-border effects at work in monetary union, each authority takes as data the decisions of the others to calculate its reaction function, i.e. the formula by which its decision is taken without

8

We abstain from covering these cases, as our aim is not to determine the “right” fiscal cooperation. Moreover, other forms of fiscal cooperation could be considered.

7.3 Conclusion

253

internalizing the consequences of its decision on the behaviour of the other players. Non-cooperation explains why, except in special cases, it is not possible to identify an option preferred by all. What sets the policy mix in a monetary union apart is the presence of a large number of players (typically N + 1), having to manage multiple sources of heterogeneity, with different objectives, except in special cases, and handling instruments that produce cross-border effects that have to be managed. This complexity is increased by the configuration of the relative powers of those responsible for economic policy. The constraints, captured here by configurations of anteriority in sequential games, that institutionally weigh on the authorities clearly affect the quality of the policy mix. This explains why it is not possible to define a ranking of these configurations and recommend one form of monetary union over another. The assessment of the “right” policy mix option in a monetary union has to be made on a case-by-case basis.

7.3

Conclusion

The interaction of fiscal and monetary policies in a monetary union is very different from that in an open economy regulated by flexible exchange rates. Cross-border spillover effects make it impossible to isolate one component of a union from fiscal decisions taken by fiscal authorities in other components. This raises the question of policy dominance in a monetary union. Which policies dominate the others? What are the consequences of different forms of dominance? The analysis of a simple model shows large outcome differences due to different forms of dominance. We know from the previous chapter that there is no institutional form of sharing fiscal sovereignty, in the form of a framing rule, that is systematically preferable to the others. This conclusion applies to the analysis of the policy mix, i.e. the combination of monetary and fiscal policies in a monetary union, and more generally to the relations between the central bank and the fiscal authorities; it also stems from our analysis of the opportunistic behaviour to which the political authorities of the entities in a monetary union may lend themselves. This reinforces what we concluded in the previous chapter. This is not surprising. The economic complexity of a monetary union makes it inconceivable that institutional solutions will work in all circumstances. The articulation of fiscal policies poses a major problem for collective action. The effects of non-cooperation in fiscal matters and the opportunistic behaviour that a monetary union gives rise to are phenomena that potentially hamper the functioning of the union and offset the benefits that can be derived from it. These effects are amplified by the structural heterogeneity of the union. They need to be dealt with institutionally and collectively, but a prerequisite for the success of this collective action is a good understanding of the structural data of the monetary union. There remains another form of organization of a monetary union, which involves a delegation of sovereignty, rather than a sharing of sovereignty as in the case of

254

7 The Policy Mix

fiscal cooperation: that corresponding to a federal system, where national fiscal authorities coexist with a federal fiscal authority, covering the union as a whole. We address this issue in Chap. 10.

Solution for 7.2.3 (Calculation of Expected Losses) Very Tightly Constrained Fiscal Policies (FU 1) We assume that gj = 0, ∀j . The optimisation programme of the monetary authority is minπM LM =

 1 θ (b (πM + ε) + u) ¯ 2 + (πM + ε)2 2

(27)

The first-order condition is ∂LM = θ b (b (πM + ε) + u) ¯ + (πM + ε) = 0 ∂πM 1∗ is deduced: and the optimal solution πM 1∗ πM = −

θb  u¯ − ε 1 + θ b2

(28)

Using this in (27), given gj = 0, ∀j , the loss incurred from the monetary authority in this configuration is equal to: L1M

⎡ 2 ⎤ 2   1⎣ θb 1  u¯ ⎦ = u¯ +  θ 2 1 + θ b2 1 + θ b2

  and the expected losses is denoted by E L1∗ M : ⎡   2 2 ⎤   1 ⎣θ  1  σu2 +  θ b  σu2 ⎦ =  θ σ2 E L1∗ M = 2 1 + θ b2 1 + θ b2 2 1 + θ b2 u (29) In this configuration the loss of a fiscal authority defined as: L1j

    2  2  1 1 1 θ b π M + ε + uj − χ + π M + ε = 2

7.3 Conclusion

255

1∗ : is, using πM

⎡    2 ⎤ 2  1 θb θb  u¯ + uj − χ + −   u¯ ⎦ L1j = ⎣θ b −  2 1 + θ b2 1 + θ b2 Hence:  1  = E L1∗ j 2



 θ (θ b)2 + θ σu2 + χ 2 2 1 + θb 2

(30)

Autonomous Fiscal Policies (FU 3) In this case, the loss function for country j is Lj =

  2 1  θ (a + bc) gj + (1 + bc − a) g−j + b πM + ε − π e + uj − χ 2 1 + (c (g1 + g2 ) + πM + ε)2 (31) 2

and for the central bank: LM =

1 θ 2 +



 2   1 + bc (g1 + g2 ) + b πM + ε − π e + u¯ 2

1 (c (g1 + g2 ) + πM + ε)2 2

(32)

Lj can be expressed as: Lj =

1  2 1  2 θ ϕj + φj 2 2

LM =

1 1 θ (ϕM )2 + (φM )2 2 2

and LM :

The programme of the fiscal authority j is maxgj Lj =

  2 1  θ (a + bc) gj + (1 + bc − a) g−j + b πM + ε − π e + uj − χ 2 1 + (c (g1 + g2 ) + πM + ε)2 2

256

7 The Policy Mix

The first-order condition is     ∂Lj = θ (a + bc) gj + (1 + bc − a) g−j + b πM + ε − π e + uj − χ (a + bc) ∂gj + c (c (g1 + g2 ) + πM + ε) = 0 from which we derive for country j : 

 θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) (θ (a + bc) b + c)    πM −  ε g−j −  gj = − θ (a + bc) + c2 θ (a + bc) + c2 θ (a + bc) + c2 −

θ (a + bc) θb (a + bc) θ (a + bc)  uj +  χ +   πe 2 2 θ (a + bc) + c θ (a + bc) + c θ (a + bc) + c2

(33)

The programme of the monetary authority is maxπM LM

1 = θ 2 +



 2   1 e + bc (g1 + g2 ) + b πM + ε − π + u¯ 2

1 (c (g1 + g2 ) + πM + ε)2 2

The first-order condition is      1 ∂Li e = θb + bc (g1 + g2 ) + b πM + ε − π + u¯ +c (g1 + g2 )+πM +ε = 0 ∂πM 2 from which we get

πM

    θ b 12 + bc + c θb θ b2    u¯ − =− πe −  (g1 + g2 ) + 2 2 1 + θb 1 + θb 1 + θ b2

∗ must satisfy Solutions g1∗ , g2∗ , πM

  1 + θ b2  ε 1 + θ b2 (34)

  θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) (θ (a + bc) b + c)    πM −  ε g1 = − g2 −  2 2 θ (a + bc) + c θ (a + bc) + c θ (a + bc) + c2 θ (a + bc) θ b (a + bc) θ (a + bc)  u1 +  χ +  πe − θ (a + bc) + c2 θ (a + bc) + c2 θ (a + bc) + c2 g2 = −

(35)

  θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) (θ (a + bc) b + c)    πM −  ε g1 −  θ (a + bc) + c2 θ (a + bc) + c2 θ (a + bc) + c2

7.3 Conclusion

257

θ (a + bc) θ (a + bc) θ b (a + bc)  u2 −  χ +  πe − θ (a + bc) + c2 θ (a + bc) + c2 θ (a + bc) + c2

πM

    θ b 12 + bc + c θb θ b2    u¯ − ε = πe − (g1 + g2 ) −  1 + θ b2 1 + θ b2 1 + θ b2

(36)

(37)

We assume g1 = f1χ χ + f11 u1 + f12 u2 + f1ε ε

(38)

g2 = f2χ χ + f21 u1 + f22 u2 + f2ε ε

(39)

πM = fMχ χ + fM1 u1 + fM2 u2 + fMε ε

(40)

π e = feχ χ

(41)

We know that: π e = cE (g1 + g2 ) + E (πM ) Hence:   feχ = c f1χ + f2χ + fMχ Notice that:   g1 + g2 = f1χ + f2χ χ + (f11 + f21 ) u1 + (f12 + f22 ) u2 + (f1ε + f2ε ) ε From (35) and (38) we get    θ (a + bc) (1 + bc − a) + c2  f2χ χ + f21 u1 + f22 u2 + f2ε ε f1χ χ +f11 u1 +f12 u2 +f1ε ε = − . θ (a + bc)2 + c2  (θ (a + bc) b + c) (θ (a + bc) b + c)   fMχ χ + fM1 u1 + fM2 u2 + fMε ε − − .ε θ (a + bc) + c2 θ (a + bc)2 + c2 +-

θ (a + bc) θ (a + bc)2 + c2

.χ − -

θ (a + bc) θ (a + bc)2 + c2

. u1 + 

θb (a + bc)  feχ χ θ (a + bc) + c2

258

7 The Policy Mix

Hence:   θ (a + bc) − θ (a + bc) (1 + bc − a) + c2 f2χ − (θ (a + bc) b + c) fMχ + θ b (a + bc) feχ   f1χ = θ (a + bc)2 + c2   θ (a + bc) + θ (a + bc) (1 + bc − a) + c2 f21 + (θ (a + bc) b + c) fM1   f11 = − θ (a + bc)2 + c2   θ (a + bc) (1 + bc − a) + c2 f22 + (θ (a + bc) b + c) fM2   f12 = − θ (a + bc)2 + c2   (θ (a + bc) b + c) (1 + fMε ) + θ (a + bc) (1 + bc − a) + c2 f2ε   f1ε = − θ (a + bc)2 + 2c2

and:   θ (a + bc) − θ (a + bc) (1 + bc − a) + c2 f1χ − (θ (a + bc) b + c) fMχ + θ b (a + bc) feχ   f2χ = θ (a + bc)2 + c2   θ (a + bc) (1 + bc − a) + c2 f11 + (θ (a + bc) b + c) fM1   f21 = − θ (a + bc)2 + c2   θ (a + bc) + θ (a + bc) (1 + bc − a) + c2 f12 + (θ (a + bc) b + c) fM2   f22 = − θ (a + bc)2 + c2   (θ (a + bc) b + c) + θ (a + bc) (1 + bc − a) + c2 f1ε + (θ (a + bc) b + c) fMε   f2ε = − θ (a + bc)2 + c2

Given the symmetry between the two countries, the following obtains f1χ = f2χ , f11 = f22 , f1ε = f2ε , f12 = f21 Given the expression for πM , we also get     ⎞ θ b 12 + bc + c 2 θ b  feχ −   2f1χ ⎠ χ fMχ χ+fM1 u1 +fM2 u2 +fMε ε = ⎝  1 + θ b2 1 + θ b2 ⎛

7.3 Conclusion

259

  ⎛  ⎞ θ b 12 + bc + c (f11 + f21 ) θb    ⎠ (u1 + u2 ) +  −⎝ 1 + θ b2 2 1 + θ b2       θ b 12 + bc + c 2f1ε + 1 + θ b 2   − ε 1 + θ b2 hence: fMχ =

fM1

fM2

θ b2 (θ b (1 + 2bc) + 2c)   feχ − f1χ 2 1 + θb 1 + θ b2

  ⎛  ⎞ θ b 12 + bc + c (f11 + f21 ) θ b   ⎠ +  = −⎝ 2 1 + θ b2 1 + θ b2   ⎛  ⎞ θ b 12 + bc + c (f11 + f21 ) θ b   ⎠ +  = −⎝ 1 + θ b2 2 1 + θ b2

fMε

      θ b 12 + bc + c 2f1ε + 1 + θ b 2   =− 1 + θ b2

With respect to ε, we get (θ (a + bc) b + c) (1+fMε ) . f1ε = − θ (a + bc) (1 + 2bc) + 2c2 Combining the expressions for fMε and f1ε , we get

fMε

      θ b 12 + bc + c 2f1ε + 1 + θ b 2   =− 1 + θ b2

equivalently:

fMε

     θ b 12 + bc + c (θ (a + bc) b + c) (1+fMε )  2  . = − 1 + θ b 1 + θ b 2 θ (a + bc) (1 + 2bc) + 2c2

260

7 The Policy Mix

equivalently:  fMε

1 + θb2

      1 θ (a + bc) (1 + 2bc) + 2c2 − θb + bc + c (θ (a + bc) b + c) 2

       1 + bc + c (θ (a + bc) b + c) − 1 + θb2 θ (a + bc) (1 + 2bc) + 2c2 = θb 2

Hence: fMε = −1,

f2ε = f1ε = 0

With respect to χ, we get     θ (a + bc)2 + c2 f1χ = θ (a + bc) − θ (a + bc) (1 + bc − a) + c2 f2χ − (θ (a + bc) b + c) fMχ + θ b (a + bc) feχ and   1 + θ b 2 fMχ = θ b2 feχ − (θ b (1 + 2bc) + 2c) f1χ Combining this equation and the equation for feχ , since f1χ = f2χ , we get     1 + θ b2 fMχ = θ b 2 2cf1χ + fMχ − (θ b (1 + 2bc) + 2c) f1χ Hence:     fMχ = 2c θ b 2 − 1 − θ b (1 + 2bc) f1χ = − (2c + θ b) f1χ   Using the equality feχ = c f1χ + f2χ + fMχ = 2cf1χ + fMχ , we get     θ (a + bc)2 + c2 f1χ = θ (a + bc) − θ (a + bc) (1 + bc − a) + c2 f2χ   − cfMχ + θ b (a + bc) feχ − fMχ     θ (a + bc)2 + c2 f1χ = θ (a + bc) − θ (a + bc) (1 + bc − a) + c2 f1χ + (2c + θ b) f1χ + 2cθ b (a + bc) f1χ

7.3 Conclusion

261

Hence: 

 θ (a + bc)2 + c2 + θ (a + bc) (1 + bc − a) + c2 − (2c + θb) − 2cθb (a + bc) f1χ = θ (a + bc)   θ (a + bc) (1 + 2b − 2cθb) + 2c2 − 2c − θb f1χ = θ (a + bc)

equivalently: f1χ =

θ (a + bc) = f2χ [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

fMχ = − feχ = −

(2c + θ b) θ (a + bc) [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

θ 2 b (a + bc) [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

If c = 1, we get f1χ =

a+b a

fMχ = θ b

a+b a

We now analyse fjj , fj k et fMj . We know that: f11

  θ (a + bc) + θ (a + bc) (1 + bc − a) + c2 f21 + (θ (a + bc) b + c) fM1 =− . θ (a + bc)2 + c2

and: 

fM1 = fM2

f12

(θ b (1 + 2bc) + 2c) (f11 + f21 ) + θ b   =− 2 1 + θ b2



  θ (a + bc) (1 + bc − a) + c2 f22 + (θ (a + bc) b + c) fM2 =− . θ (a + bc)2 + c2

f11

  θ (a + bc) + θ (a + bc) (1 + bc − a) + c2 f21 + (θ (a + bc) b + c) fM1 =− . θ (a + bc)2 + c2

f21

  θ (a + bc) + θ (a + bc) (1 + bc − a) + c2 f11 + (θ (a + bc) b + c) fM1 =− . θ (a + bc)2 + c2 f22

  θ (a + bc) (1 + bc − a) + c2 f12 + (θ (a + bc) b + c) fM2 =− . θ (a + bc)2 + c2

262

7 The Policy Mix

Computing:   − θ (a + bc)2 + c2 (f11 + f21 ) = θ (a + bc) + (θ (a + bc) b + c) fM1   + θ (a + bc) (1 + bc − a) + c2 f21 we get f11 + f21 = −1 It implies fM1 = fM2 = c Hence: f11

  −θ (a + bc) + θ (a + bc) (1 + bc − a) + c2 (1 + f11 ) − (θ (a + bc) b + c) c = . θ (a + bc)2 + c2 =−

a 2a − 1

and finally: f21 =

1−a a −1= 2a − 1 2a − 1

Summing up, we get g1 =

θ (a + bc) 1−a a u1 + u2 χ− 2a − 1 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

g2 =

θ (a + bc) a 1−a u1 − u2 χ+ 2a − 1 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

πM = −

(2c + θ b) θ (a + bc) χ + cu1 + cu2 − ε [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

The reaction functions are perfectly identified. Losses We now turn to the computation of the expected losses. Since   ϕi = (a + bc) gi + (1 + bc − a) g−i + b πM + ε − π e + ui − χ

7.3 Conclusion

263

from above we get  ϕ1 = (a + bc)

a θ (a + bc) 1−a χ− u1 + u2 2a − 1 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θb]

 + (1 + bc − a)  +b −



1−a θ (a + bc) a χ+ u1 − u2 (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θb] 2a − 1 2a −1 [θ

2cθ (a + bc) χ + cu1 + cu2 − ε [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θb]





+bε + ui − χ

equivalently:  ϕ1 =

 −a (a + bc) + (1 − a) (1 + bc − a) + bc + 1 u1 2a − 1

 (a + bc) (1 − a) − a (1 + bc − a) + bc u2 + 2a − 1 

 +

 θ (a + bc) (a + bc + 1 + bc − a − 2bc) −1 χ [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b] = (−1 − bc + bc + 1) u1

+

2abc θ b − 2 (1 − c) (bθ (a + bc) − c) χ u2 + 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

=

2abc θ b − 2 (1 − c) (bθ (a + bc) − c) u2 + χ 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

Similarly: φj = c (g1 + g2 ) + πM + ε = c (g1 + g2 )−  =c 2 −

(2c + θ b) θ (a + bc) χ+cu1 +cu2 −ε+ε [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

θ (a + bc) χ − u 1 − u2 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]



(2c + θ b) θ (a + bc) χ + c (u1 + u2 ) [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

264

7 The Policy Mix

=−

θ 2 b (a + bc) χ [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

So:   1  2 1  2 E L∗3j = θ E ϕj + E φj 2 2  2   2abc 2 2 1 θ (θ b − 2 (1 − c) (bθ (a + bc) − c))2 + θ 2 b (a + bc) 1 2 χ + σu θ 2 2 2a − 1 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]2

=

(42)

Through a similar reasoning, we get  ϕM =  =

  1 2cθ (a + bc) + bc (g1 + g2 ) + b − χ 2 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]  + cu1 + cu2 − ε + ε + u¯

 =

   1 + bc (g1 + g2 ) + b πM + ε − π e + u¯ 2

1 + bc 2



2θ (a + bc) χ − (u1 + u2 ) [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

2cbθ (a + bc) χ+ − [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b] " =





 1 + bc (u1 + u2 ) 2

# cθ (a + bc) (1 + bc) χ [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

φM = φi = −

θ 2 b (a + bc) χ [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θ b]

Hence:  2 [cθ (a + bc) (1 + bc)]2 + θ 2 b (a + bc)

  1 1 1 E L∗3M = θ (ϕM )2 + (φM )2 = χ 2 2 2 2 [θ (a + bc) (1 + 2b (1 − c)) + 2c (1 − c) − θb]2

(43)

7.3 Conclusion

265

Very Weakly Constrained Fiscal Policies (FU 5) In this case, the central bank is inactive: πM = 0 (assuming θM = θ and χM = 0). The programme of a fiscal authority, combined with πM = 0, is  maxgi E (Li ) = E

2 1  θ (a + bc) gi + (1 + bc − a) g−i + bε − bπ e + ui − χ 2  1 2 + (c (g1 + g2 ) + ε) (44) 2

Lj can be written: Lj =

1  2 1  2 θ ϕj + φj 2 2

The first-order condition is   ∂Lj = θ (a + bc) (a + bc) gj + (1 + bc − a) g−j + bε − bπ e + ui − χ ∂gj + c (c (g1 + g2 ) + ε) = 0 d’où:     θ (a + bc)2 + c2 gj = − θ (a + bc) (1 + bc − a) + c2 g−j + bθ (a + bc) π e − (θ (a + bc) b + c) ε + θ (a + bc) χ − θ (a + bc) uj We deduce   θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) g1 = − g2 − . .ε 2 θ (a + bc) + c2 θ (a + bc)2 + c2 +-

θ (a + bc) θ (a + bc)

2

+ c2

.χ − -

θ (a + bc) θ (a + bc)

2

+ c2

. u1 + -

bθ (a + bc) θ (a + bc)2 + c2

.πe

  θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) g2 = − g1 − . .ε 2 2 θ (a + bc) + c θ (a + bc)2 + c2 +-

θ (a + bc) θ (a + bc)

2

+ c2

.χ − -

θ (a + bc) θ (a + bc)

2

+ c2

. u2 + -

bθ (a + bc) θ (a + bc)2 + c2

.πe

266

7 The Policy Mix

We assume g1 = f1χ χ + f11 u1 + f12 u2 + f1ε ε g2 = f2χ χ + f21 u1 + f22 u2 + f2ε ε π e = f1e χ Notice:   bθ (a + bc) g1 + g2 = f1χ + f2χ + 2 . f 1e χ + (f11 + f21 ) u1 + (f12 + f22 ) u2 + (f1ε + f2ε ) ε θ (a + bc)2 + c2

As: π = c (g1 + g2 ) + ε we get π e = E (π) = c (g1 + g2 ) Hence: f1e = 2cf1χ   θ (a + bc) (1 + bc − a) + c2     f2χ χ + f21 u1 + f22 u2 + f2ε ε f1χ χ + f11 u1 + f12 u2 + f1ε ε = − θ (a + bc)2 + c2 θ (a + bc) θ (a + bc) bθ (a + bc) (θ (a + bc) b + c) ε +  χ −   u1 +   f1e χ − θ (a + bc)2 + c2 θ (a + bc) 2 + c2 θ (a + bc)2 + c2 θ (a + bc)2 + c2

This implies f1χ

  θ (a + bc) + bθ (a + bc) f1e − θ (a + bc) (1 + bc − a) + c2 f2χ = . θ (a + bc)2 + c2 f11 = −

  θ (a + bc) + θ (a + bc) (1 + bc − a) + c2 f21 . θ (a + bc)2 + c2

f12

  θ (a + bc) (1 + bc − a) + c2 =− f22 . θ (a + bc)2 + c2

7.3 Conclusion

f1ε

267

  (θ (a + bc) b + c) + θ (a + bc) (1 + bc − a) + c2 f2ε =− . θ (a + bc)2 + c2

and: f2χ

  θ (a + bc) + bθ (a + bc) f1e − θ (a + bc) (1 + bc − a) + c2 f1χ = . θ (a + bc)2 + c2

f21 = −

  θ (a + bc) − bθ (a + bc) f1e + θ (a + bc) (1 + bc − a) + c2 f11 . θ (a + bc)2 + c2 f22

f2ε

  θ (a + bc) (1 + bc − a) + c2 =− f12 . θ (a + bc)2 + c2

  (θ (a + bc) b + c) + θ (a + bc) (1 + bc − a) + c2 f1ε =− . θ (a + bc)2 + c2

Because of symmetry: f1χ = f2χ , f11 = f22 , f1ε = f2ε , f12 = f21 As feχ = 2cf1χ : f1χ =

θ (a + bc) + bθ (a + bc) feχ = f2χ θ (a + bc) (1 + 2bc) + 2c2

we get 

 θ (a + bc) + 2c2 f1χ = θ (a + bc)

Hence: f1χ =

θ (a + bc) = f2χ θ (a + bc) + 2c2

θ (a + bc)2 + c2 . f11 = − θ (a + bc) (1 + 2bc) + 2c2 (2a − 1) θ (a + bc) (1 + bc − a) + c2 . f12 = = f21 θ (a + bc) (1 + 2bc) + 2c2 (2a − 1)

268

7 The Policy Mix

f1ε = −

(θ (a + bc) b + c) θ (a + bc) (1 + 2bc) + 2c2

Notice that: g1 + g2 = 2f1χ χ + bθ (a + bc) f1e + (f11 + f21 ) (u1 + u2 ) + 2f1ε ε and: (a + bc) f11 + (1 + bc − a) f21 + 1 =   θ (a + bc) [(1 + 2bc) (1 − 2a)] + (1 − 2a) c2 + θ (a + bc) (1 + 2bc) + 2c2 (2a − 1) . θ (a + bc) (1 + 2bc) + 2c2 (2a − 1) = -

c2 . θ (a + bc) (1 + 2bc) + 2c2

c2 . (a + bc) f12 + f22 (1 + bc − a) = θ (a + bc) (1 + 2bc) + 2c2

Finally: f11 + f21 = − -

θ (a + bc) . θ (a + bc) (1 + 2bc) + 2c2

and: 2cf1ε + 1 =

θ (a + bc) θ (a + bc) (1 + 2bc) + 2c2

From these equalities we deduce g1 + g2 = 2

θ (a + bc) θ (a + bc) χ+ (u1 + u2 ) + 2f1ε ε θ (a + bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2

Summing up, the decisions of fiscal authorities are given by: g1 =

+-

θ (a + bc) θ (a + bc)2 + c2 . χ−u1 2 θ (a + bc) + 2c θ (a + bc) (1 + 2bc) + 2c2 (2a − 1)

θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) . u2 − ε θ (a + bc) (1 + 2bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2 (2a − 1)

7.3 Conclusion

g2 =

+-

269

θ (a + bc) θ (a + bc)2 + c2 . χ − u2 θ (a + bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2 (2a − 1)

θ (a + bc) (1 + bc − a) + c2 (θ (a + bc) b + c) . ε u1 − 2 θ (a + bc) (1 + 2bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c (2a − 1)

Given the definition of ϕj i , we get   ϕj = f1χ − 1 χ + ((a + bc) f11 + (1 + bc − a) f21 + 1) u1 + ((1 + 2bc) f1ε + b) ε + ((a + bc) f12 + f22 (1 + bc − a)) u2 Hence:  ϕj =

−

θ (a + bc) − θ (a + bc) − 2c2 θ (a + bc) + 2c2

 χ+

c2 u1 θ (a + bc) (1 + 2bc) + 2c2

c c2 ε+ u2 2 θ (a + bc) (1 + 2bc) + 2c θ (a + bc) (1 + 2bc) + 2c2

equivalently: ϕj = −

−2c2 c2 χ+ u1 2 θ (a + bc) + 2c θ (a + bc) (1 + 2bc) + 2c2

c c2 ε + u2 θ (a + bc) (1 + 2bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2

Similarly we get   φj = c (g1 + g2 ) + ε = c 2f1χ χ + (f11 + f21 ) (u1 + u2 ) + (2cf1ε + 1) ε Hence:

φj =

2cθ (a + bc) cθ (a + bc) χ− (u1 + u2 ) θ (a + bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2 +

θ (a + bc) ε θ (a + bc) (1 + 2bc) + 2c2

270

7 The Policy Mix

The expected values are:  2 E ϕj =



2c2 θ (a + bc) + 2c2

2

 χ2 + 2

c2 θ (a + bc) (1 + 2bc) + 2c2



c + θ (a + bc) (1 + 2bc) + 2c2 

E φj

2

 =

2cθ (a + bc) θ (a + bc) + 2c2  +

2

σu2

2 σε2



cθ (a + bc) χ +2 θ (a + bc) (1 + 2bc) + 2c2 2

θ (a + bc) θ (a + bc) (1 + 2bc) + 2c2

2

2 σu2

2 σε2

The expected losses obtain   1  2 1  2 E L∗5j = θ E ϕj + E φj 2 2     2θ c2 + (θ (a + bc))2 c2 + (θ (a + bc))2 2 2 2 2 χ = c2  + σ + σ 2c 2  2 u ε θ (a + bc) + 2c2 θ (a + bc) (1 + 2bc) + 2c2 (45)   We proceed similarly for E L∗M (assuming χM = 0). LM =

1 θ 2



2  1 1 1 1 + bc (g1 + g2 ) + bε + u¯ + (c (g1 + g2 ) + ε)2 = θ (ϕM )2 + (φM )2 2 2 2 2

with: ϕM =

θ (a + bc) (1 + 2bc) χ+ θ (a + bc) + 2c2  +

1 + 2bc 2



   θ (a + bc) (2bc − 1) + 2c2 1 + 2bc . (u1 + u2 ) 4 θ (a + bc) (1 + 2bc) + 2c2

 -

bθ (2bc − 1) + 2c (c − 1) .ε θ (a + bc) (1 + 2bc) + 2c2

and: φM = c (g1 + g2 ) + ε = φi

References

271

Finally: E



L∗5M



  θ 2 (a + bc)2 (1 + 2bc)2 + 4c2 2 = χ .2 θ (a + bc) + 2c2 2  .2 1+2bc θ (a + bc) (2bc − 1) + 2c2 + (2cθ (a + bc))2 2 + σu2 .2 θ (a + bc) (1 + 2bc) + 2c2 2  1+2bc [bθ (2bc − 1) + 2c (c − 1)]2 + θ 2 (a + bc)2 2 + σε2 (46) .2 θ (a + bc) (1 + 2bc) + 2c2

References 1. Adao B, Correia I, Teles P (2009) On the relevance of exchange rate regimes for stabilization policy. J Econ Theory 144:1468–1488 2. Barro R, Gordon D (1983) Rules, discretion and reputation in a model of monetary policy. J Monet Econ 12:101–121 3. Bassetto M (2008) Fiscal theory of the price level. In: The New Palgrave Dictionary of Economics. Palgrave, London 4. Bergin P (2000) Fiscal solvency and price level determination in a monetary union. J Monet Econ 45:37–53 5. Carlstrom C, Fuerst T (2000) The fiscal theory of the price level. Economic Review Federal Reserve Bank of Cleveland, vol 36, pp 22–42 6. Cooper R, Kempf H (2004) Overturning Mundell: Fiscal policy in a monetary union. Rev Econ Stud 71:371–396 7. Cooper R, Kempf H, Peled D (2014) Insulation impossible: monetary policy and regional debt spillovers in a federation. J Eur Econ Assoc 12:465–491 8. Dixit A, Lambertini L (2003) Symbiosis of monetary and fiscal policies in a monetary union. J Int Econ 60:235–247 9. Ferrero A (2009) Fiscal and monetary rules for a currency union. J Int Econ 77:1–10 10. Foresti P (2018) Monetary and fiscal policies interaction in monetary unions. J Econ Surv 32:226–248 11. Friedman M (1963) Inflation: Causes and consequences. Asia Publishing House, Bombay 12. Gali J, Monacelli T (2008) Optimal monetary and fiscal policy in a currency union. J Int Econ 76:116–132 13. Kempf H, Von Thadden L (2008) On policy interactions among nations: when do cooperation and commitment matter? European Central Bank working paper 880. 14. Kempf H, von Thadden L (2013) When do cooperation and commitment matter in a monetary union? J Int Econ 91:252–262 15. Leeper E (1991) Equilibria under ‘active’ and ‘passive’ monetary and fiscal policies. J Monet Econ 27:129–147 16. Sargent T, Wallace N (1981) Some Unpleasant Monetarist Arithmetic. In: Quarterly Review, Federal Reserve Bank of Minneapolis, vol 5, pp 1–17 17. Woodford M (1994) Monetary policy and price level determinacy in a cash-in-advance economy. Econ Theory 4:345–380

Part III Toward an Ever Closer Union

8

Structural Adjustments and Reforms

Abstract

This chapter addresses the issue of structural reforms, which is the subject of concern for many policy-makers in a monetary union. A monetary union requires specific adjustment mechanism to supplement the absence of exchange rates. Structural reforms are not necessarily focused on markets with the aim of freeing markets. The public sector may be the object of reforms. Issues of impact and implementation of structural reforms are discussed. A model of structural reforms in a monetary union is presented and used to discuss the outcome of a non-cooperative game on reform adoption. It is shown that it can take the form of a coordination game generating multiple equilibria.

Economic policy aims at reducing the impact of economic dysfunctionings, conjunctural or structural. Understanding how these dysfunctions can be reduced is critical for the assessment of complex economic policy operations of uncertain effectiveness. In a monetary union, as we saw in Chap. 1, the disappearance of exchange rates and the single monetary policy managed by the central bank of the union put to the fore the problem of adjustments to the external accounts of the member countries. Some of them may be in persistent deficit or surplus, suggesting that their economic structures are fragile and need to be changed. The difficulty stems from the fact that the member countries are heterogeneous in terms of their history, their sociopolitical organization and their economic positioning: as the possible imperfections resulting from these determinants differ from one country to another, the structural reforms likely to alleviate them are of a different nature and scope from one country to another, whereas they have an impact on the union as a whole because of the interdependence between member countries. This explains why, despite these complexities, a strategy of “structural reforms” is frequently put forward as the solution to the difficulties of a monetary union. This © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_8

275

276

8 Structural Adjustments and Reforms

is particularly the case for the leaders of the European Monetary Union. In a speech delivered on 22 May 2015, ECB President Mario Draghi [12] remarked: In all the press conferences that have taken place since I became President of the European Central Bank (ECB), my introductory statement has always ended with a call for an acceleration of structural reforms in Europe. The same message has also been conveyed repeatedly by my predecessors, in three-quarters of all press conferences held since the introduction of the euro. The term ’structural reforms’ is mentioned in approximately one third of all speeches delivered by individual members of the ECB’s Executive Board. By comparison, the term “structural reform” appears in only around 2% of the speeches delivered by the governors of the Federal Reserve System.

At the same conference, Willem Buiter [4], Chief Economist of Citigroup, expressed surprise at these statements, noting that since central banks are independent and responsible for the sole conduct of monetary policy, their leaders were stepping out of their role in commenting on non-monetary policies (or lack thereof). Obviously the subject of structural reforms appears to be sufficiently important for monetary policy to justify that these leaders talk about them frequently and strongly, at the risk of irritating political leaders and public opinion. Let us try to understand what is at stake in the interaction between monetary policy and monetary union adjustments. To do so, we need to answer two questions: 1. How does the problem of structural reforms in monetary union arise? To address this issue, we must return to the point established in Chap. 1: the adjustment processes in a monetary union must allow external accounts to balance in the absence of exchange rate mechanisms. Structural reforms are designed to facilitate this balance in the long term. 2. Is an active policy of structural reform conducted by the governments of the member countries the solution to the problems of a monetary union? Section 8.1 presents a general discussion of structural reforms in a monetary union. More specifically, the macroeconomic dimension of structural reforms is discussed in Sect. 8.2. The implementation of structural reforms in a monetary union is discussed in Sect. 8.3. Section 8.4 is devoted to the study of a model of structural reforms in a monetary union.

8.1

Understanding Structural Reforms

As a first step, it is necessary to present what structural reform is and how to analyse it economically. This is not specific to monetary unions. The OECD, for example, considers that one of its tasks is to promote structural reforms and it carries out an

8.1 Understanding Structural Reforms

277

annual review of these reforms.1 Let us reason for the moment in the context of a closed economy, leaving aside international and monetary issues. A structural reform policy is defined as a policy aimed at improving overall productive efficiency and increasing the long-term growth path of a decentralized economy. It is a “supply-side” policy. It is called “structural” because it seeks to change the behaviour of economic agents by modifying the contractual and regulatory environment in which they operate. It is a long-term policy, as opposed to cyclical fiscal policies, which aim to support economic activity in the short term by regulating aggregate demand. Improving the productive efficiency of an economy may mean: 1. Promoting the productivity of the factors of production and the productive mix (intensive margin) 2. Increasing the use of production factors (extensive margin) Given the complexity of the productive structure of today’s economies, a wide variety of structural reforms can be expected. The public debate on these reforms is unfortunately simplistic because it focuses only on the issue of price and wage flexibility. The theme of “structural reforms” seems to be a policed and circumvented way of debating economic liberalization, a politically too sensitive terminology to be used openly, especially in public or international institutions such as the OECD and central banks, which are supposed to be “neutral” or in any case not subject to the constraints (electoral) and freedoms (counterparts of political commitment) of democratic debate. Hence the question: are structural reforms really a covered plea for liberalism? Is it a code word for market liberalization policies without explicitly saying so for political reasons? The answer to this question needs to be qualified. Contrary to what is often argued, structural reforms cannot be reduced to the sole dimension of wage and price flexibility. But it is true that market adjustment mechanisms are necessarily a major focus of attention in a decentralized economy, justifying structural reforms if necessary. This is particularly true in a monetary union as we shall see below. Moreover the reforms undertaken, following lengthy and pragmatic debates, do not necessarily move in the direction of greater flexibility. Note, for example, that the UK introduced a minimum wage in 1998 (De Linde et al. [11]) and Germany in 2015 (Dustmann et al. [13], Mabbett [20]). Structural reforms are not limited to measures to make markets more flexible or more deregulated. Three types of structural reforms can be distinguished: 1. Structural reforms relating to price and wage flexibility aim to improve the productivity of components or factors of the productive system. Their object is to improve the allocation of resources by eliminating rents, made possible by barriers to market entry or exit. 1

See https://oecdecoscope.blog/2019/07/12/the-time-for-reform-is-now/.

278

8 Structural Adjustments and Reforms

2. Others aim at improving the productivity of the system as a whole. The efficiency of a productive system cannot be reduced to the sum of the productivities of each factor; it also depends on the combination itself.2 The issue of innovation is particularly important from a growth perspective. The fastest and cheapest adoption of the productive system to technological change may require structural reforms to facilitate it. Since innovation is equated with a positive technology shock, structural policies to support research and development may aim to stimulate the frequency and magnitude of such shocks. For example, reforms relating to rights and patents or intellectual property protection aim to improve productivity by stimulating technological innovation performance. Public policies can also improve the reallocation of factors in response to shocks. Since this reallocation should be permanent in the case of supply shocks with a long-term impact, it should be facilitated and accelerated at a reduced cost. In the case of short-term shocks with a temporary effect, a structural reform aims to facilitate responsiveness to that shock by protecting the production factors concerned in the case of a negative shock and enabling them to take rapid advantage of a positive shock. Reforms relating to public services can be understood as relating to overall productive efficiency, to the extent that greater efficiency in the public sector contribute to this efficiency. A tax reform aimed at reducing tax evasion or improving the quality of the tax collection system also improves the overall productivity of the economy, irrespective of the issue of tax pressure and incidence. Public policies relating to the transmission of information, the quality of forecasting, education, training, the management of public infrastructure or the quality of the system of financing the economy can be analysed in the same way. 3. Finally, structural reforms are aimed at improving the coordination of economic activities in a decentralized economy. The economy can suffer from “coordination failures” (Cooper [7]): this happens when agents acting in a decentralized manner coordinate, spontaneously or through the legacy of history (path dependence), on a sub-optimal equilibrium. It is possible through collective intervention that coordination takes place on a socially preferable equilibrium. The public authorities can then act as a coordinating body, if necessary through law or regulation. An example of this type of structural reform is the National Industrial Recovery Act (NIRA), enacted by the Roosevelt administration in the USA in 1933, which coordinated the commercialization process of the automobile industry (Cooper and Haltiwanger [8]). French-style planning can also be seen as a forum for economic coordination. As can be seen, structural reforms can concern either the private sector and the improvement of the functioning of markets or the public sector. They can also deal

2

That is, “total factor productivity”, which is supposed to explain the Solow residual.

8.1 Understanding Structural Reforms

279

with the interaction between markets and public action. The OECD, consistently and vigilantly promotes structural reforms, proposes, for example, the creation of new financial markets, which implies new regulation by public authorities. Similarly, this institution is at the forefront in the evaluation of education policies as a prerequisite for their possible reform. The confusion of structural reforms with “ultra-liberal” policies is therefore incorrect. In advanced economies where corporatist traditions are firmly entrenched and interest groups (not only trade unions) are well organized, the emphasis is often on dismantling the barriers in place in the various markets. In emerging countries, structural reforms probably need to focus first on governance arrangements, the fight against corruption and the “legalization” of the informal economy (understood as the transition to legally valid forms of contract).

8.1.1

Market Reforms

Discussions on structural reforms focus mainly on the functioning of markets, much less on institutional and public policy reforms.

8.1.1.1 Goods Markets Markets for goods (and services) contribute to the overall productivity of the economy because they condition the profitability of firms and influence their productive choices. Markets must allow resources to be allocated in such a way that the factors of production are used in the most efficient way possible. This implies the reduction or even the disappearance of rents, i.e. remunerations received by certain agents simply because of their position in the productive system without being the counterpart of a productive activity.3 The reason for this is that they reduce the sums available for the remuneration of the factors of production themselves. Structural market reforms should aim at reducing these rents. They are of three types: 1. A policy aimed at opening up markets, i.e. the removal of barriers to the entry of new producers or the exit of established producers, makes it possible to challenge vested interests and associated rents. 2. A policy facilitating the mobility and reallocation of factors of production (thus reducing the costs lost in the event of dislocation or disinvestment) makes factors of production more capable of taking advantage of new opportunities. 3. Finally, improving the way in which prices are set on the markets should ensure that the information contained in prices is more reliable and better guides the decisions of consumers, investors and employees. In short, structural reforms designed to strengthen competition on markets and fight off monopoly situations when they are not justified by technological reasons should lead to a better

3

Positional rents must be distinguished from annuities linked to the availability of scarce resources or raw materials.

280

8 Structural Adjustments and Reforms

capacity to adapt to economic shocks. This adaptability is thus in line with the theme of flexibility.

8.1.1.2 Labour Markets The issue of labour market reforms is more sensitive than reforms of goods markets. For one simple reason: transactions that take place in the provision of labour, between employer and employee, relate to a contract of employment, which is much more complex than the mere exchange of a quantity of product between a supplier and a demander. The employment contract is an incomplete, lasting contract with multiple counterparties. It is incomplete because it relates to a provision of the employee and cannot specify in detail all the obligations of both parties. It is durable because it extends over time, possibly for an indefinite period. It provides for multiple counterparts: in addition to the salary counterparts that are the responsibility of the employer, it gives rise to rights (compensation or pensions) linked to insurance schemes, most often public. The employment contract, which is both an insurance contract and a market exchange, is at the heart of social organization in developed countries where the salaried workforce is the ultradominant form of mobilization of labour resources. Product market reform is a localized microeconomic policy from which significant productive improvements are expected at the macroeconomic level. In contrast, labour market reforms, directly or indirectly modifying labour contracts, are macroeconomic policies from the outset. They modify the mechanisms of macroeconomic adjustment and affect the social contract that constitutes society. More specifically, the redistributive effects that these reforms inevitably generate are significant at the macroeconomic level and are the subject of general attention and major political debate. Possible labour market reforms relate to the regulatory framework within which the employment contract operates. Their modalities are much more diverse, even conceptually, than those relating to the product market and more difficult to carry out, given the complexity of this contract. They may relate to the way in which employees are represented in professional negotiations and in particular wage negotiations, the existence of a minimum wage, the recognition of individual qualifications, the system of unemployment benefits, the social protection granted to employees, if necessary imposed on employers, and public policies to support worker mobility. The complexity of a labour contract is the result of a slow legal sedimentation, nourished by historical and socio-cultural peculiarities. Countries with very different social functions coexist in the world economy and achieve comparable macroeconomic results in terms of growth. It is not possible to think that there is one institutional form that stands out as ideal and to which it is possible to refer when seeking to reform it. Empirical studies of structural reforms in labour markets do not show that measures to deregulate or liberalize labour markets are systematically beneficial. However, the significance of these studies is limited by the fact that they are based on limited policy variations.

8.1 Understanding Structural Reforms

281

It should not be inferred from the preceding remarks that the contingency of social organization makes the notion of structural reform inoperative when it comes to labour markets. The fact that there is no model to refer to does not mean that everything is equal. Not everything is possible in the name of the singularity of the social fabric and the macroeconomic results are there to serve as warning signals. The functioning of a decentralized economy has its requirements. It can be combined with a variety of social rules but compliance with the objectives of productive efficiency makes it necessary to link the productive contribution of labour with the cost of labour, both unit and aggregate, in one way or another. There is always room for structural improvements, depending on indicators that show a major insufficiency or disruption in labour markets. For example, Sweden carried out major reforms during the severe depression in 1992. In the early 2000s, the German Chancellor Schrœder, faced with high public deficits and unemployment, endorsed the proposals of the Hartz Commission4 for reforming the labour market and made extensive legislative and regulatory changes from 2002 to 2005. In both cases, these socially costly reforms led to macroeconomic rebalancing, lower unemployment and a return to sustainable growth.

8.1.1.3 Financial Markets A banking and financial system cannot operate independently of a regulatory framework and the regulatory framework must adapt to the circumstances. The crisis that began with the spectacular and retrospectively dramatic collapse of the US financial firm Lehman Brothers in 2008 has renewed reflections at all levels on the reforms to be made to financial markets. After the years of financial deregulation in the 1980s, initiated in the USA and the UK, we are now witnessing a re-regulation of this sector. In the United States with the Dodd–Frank Act, in the UK following the Vickers report, and finally in Europe with the Liikanen Commission report (Krahnen [18], Vinals et al. [28]). The tools of banking regulation are multiple: price (interest rates) fixing, prohibition of certain practices, compliance with prudential obligations and specialization of activities. The current trend is to introduce a segmentation of the banking sector, retail banks being prohibited from certain activities or practices and a strengthening of prudential regulation. We shall pursue the discussion in the next chapter: we shall see that the sustainability of a monetary union requires the establishment of a banking union, understood as a common framework regulating financial markets and the operation of banks. The establishment of such a union is clearly a structural reform in banking and financial matters for the member countries of the union.

8.1.2

Public Sector Reforms

Public sector reforms are no less important than market reforms.

4

Named after its president, Peter Hartz.

282

8 Structural Adjustments and Reforms

Firstly, for microeconomic reasons, linked to productive efficiency. Taxes and compulsory levies5 create distortions to which the public authorities must be attentive and which must be minimized. The use of public funds also has important productive impacts, whether we think of public infrastructure, the education or health system, or the spin-offs of basic research. Secondly, for macroeconomic reasons. Policies to support consumption or savings, macroeconomic stabilization policies must also be effective. In particular, recourse to public debt must be such that it does not jeopardize the sustainability of public accounts. Financial crises created by sovereign defaults have indeed significant and lasting negative consequences. Structural reforms may concern the administration and organization of public authorities as much as the definition of intervention tools and the implementation of public policies. They are made necessary by the gradual obsolescence of public systems and difficult to put in place due to the resistance of vested interests.

8.1.3

Structural Reforms and External Constraints

In an open multi-currency world, made up of economies trading internationally in goods, services, factors of production and financial flows, parities (exchange rates) are fixed on the foreign exchange markets. Does this affect the analysis of structural reforms? The question of the growth path is central. A country that is open to the rest of the world may suffer from an imperfect allocation of production factors due to locational rents and therefore from a lower growth path than in the absence of these rents. But macroeconomic problems are not just about the pace of growth. There is also the question of the balance of its trade with the rest of the world. Foreign trade is denominated in foreign currencies and currencies are convertible on the foreign exchange market. Economic exchanges must be balanced over time. If currency reserves accumulate, this represents an unused purchasing power, a permanent excess of savings. Not indebted to the rest of the world, the country does not risk default but its situation is unsatisfactory since the object of production is consumption, not hoarding. On the other hand, if foreign trade is in permanent deficit, the external debt, both private and public, is constantly increasing and the country is forced to default on this debt in the long run because it cannot pay it back. The process of indebtedness is more dangerous than the accumulation of surpluses because it leads to a serious economic crisis. Hence any economy must balance its accounts through a sufficient capacity to export goods and services: an economy must be competitive. The concern for competitiveness is thus a major issue in an open economy. The competitiveness of country j refers to the ability of an open economy to manage international competition, mainly in goods and services. It is both a synthetic

5

Broadly understood, i.e. including social contributions and social transfers.

8.1 Understanding Structural Reforms

283

and relative notion: a national economy is competitive vis-à-vis the other national economies with which it interacts when its firms are able to sell their products on world markets.6 Let us recall the lessons of Chap. 1. Parities are relative prices, adjustment variables that are supposed to resolve the balance of net foreign exchange supply and demand. If an economy balances its accounts, its net demand for foreign exchange is zero. Reversing the reasoning, if the exchange rate regime is such that it makes net demand for foreign exchange zero, the external accounts are in balance. Competitiveness is resolved by adjusting exchange rates. This reasoning, which transposes the logic of the general equilibrium of pure and perfect competition to the case of a multi-currency world economy, is valid only under a set of extremely constraining assumptions, in particular because it neglects the purely financial trade-offs that take place on currency markets. For our purposes, we need only to admit that there is no such thing as perfect exchange rate flexibility: Exchange rate adjustment mechanisms are not sufficient to ensure that external accounts balance rapidly and that productivity gains are in line with those of the rest of the world. Consider the case of a country with a long and worrying succession of external deficits.7 This cannot be due solely to contingencies but refers to a structurally unbalanced macroeconomic configuration. Eliminating these imbalances requires structural reforms. In this perspective, the structural reforms to be carried out are seen as internal devaluation modalities (Petroulakis [24]), to make up for the insufficient adjustment of exchange rates that should make it possible to reduce the prices of produced goods expressed in foreign currencies, offered on foreign markets. This decrease in internal prices should lead to a deterioration in the terms of trade, thus increasing exports and decreasing imports. In addition to this substitution effect, there is also an income effect. Macroeconomically, the fall in internal prices amounts to a fall in consolidated purchasing power since imports are more expensive. There is a decline in internal consumption relative to production. Part of the production becomes available for export. With the same effects playing out in the rest of the world, the production available for import decreases. The increase in exports and the reduction in imports, at an unchanged exchange rate, restore the external accounts. As the structural reforms in question have a lasting impact, deficits are reduced on a sustainable basis. The decline in purchasing power associated with these structural reforms can be offset by fiscal countermeasures such as a reduction in indirect charges based on wages. These measures have the advantage of preserving the purchasing power of

6 The use of the term “competitiveness”, borrowed from industrial economics, is unfortunate because it confuses the microeconomic and macroeconomic levels. It suggests that measures to support the competitiveness of an economic sector are justified for reasons of external balance. This is a flawed line of reasoning: if the reasons for a persistent external deficit are macroeconomic, due to excess consumption and insufficient aggregate investment, microeconomic measures cannot solve them and will probably even have negative consequences. 7 We do not use the international savings excess hypothesis put forward to explain the benign nature of the US deficit by Bernanke [2].

284

8 Structural Adjustments and Reforms

employees but the disadvantage of increasing the public deficit if public expenditure is not reduced.8 As a result, domestic demand is not reduced and the margins available for exports are not increased. The adjustment mechanism is undermined by this fiscal compensation. From the point of view of a recovery of the external accounts, the preferred structural reforms are those that affect the functioning of markets: the focus is on the goods and labour markets. Let us assume that the structural reforms we have summarized above are effectively carried out and lead to lower prices (by eliminating rents) and productivity-related wage adjustments. This has two direct effects on exports: an increase in the volumes exported by exporting firms (intensive margin) and an increase in the number of such firms (extensive margin). Both contribute to the restoration of the external balance. But structural market reforms do not work all in the same way. The fall in prices induced by reforms in the goods market reduces firms’ margins (depending on the rents appropriated by firms and reduced by these reforms), while the fall in labour costs due to labour market reforms may increase them. Thus the pass-through of structural reforms to lower export prices may not be complete as it depends on the margin policy of exporting firms. Depending on their market, firms may safeguard, or even increase, their profit margins by playing on the segmentation of the international economy. Overall, the fall in prices is not equivalent to the fall in labour costs. The impact of these structural reforms does not stop at these initial effects. Other indirect effects may also arise. The fall in purchasing power may be offset by a capacity for innovation but also by a reallocation of production factors, including labour, and positioning on new traded sectors. This is the link with the issue of productivity and growth discussed at the beginning of this section. Structural market reforms cannot be equated with supply-side policies in an open economy: as we have seen, they mainly consist in a reorientation of aggregate demand from domestic to foreign demand in order to stimulate exports. But they have an undeniable “supply” side: restoring competitiveness implies more efficient and better specialized, better positioned companies. Insofar as the restoration of competitiveness and the return to a balanced current account imply a reduction in “national” financial risk, this makes it possible to lower risk premiums for all private and public borrowers and, as such, reduces the financial cost of investments. As a result, increased productive capital formation, whether public or private, leads to apparent productivity gains. The two dimensions appear complementary. The favourable scenario just described, where structural reforms lead to the sustainable elimination of external account imbalances within a reasonable time frame, cannot be taken for granted. Other macroeconomic linkages may occur, which could qualify or even invalidate it. Keynesian linkages may be set up, where the fall in purchasing power weighs on activity and internal well-being to such an extent that the recovery does not take place without external demand taking over. The sluggishness of demand caused by these reforms may contribute to demand-led

8

The resulting public deficit then poses another structural problem.

8.1 Understanding Structural Reforms

285

“secular stagnation” (Summers and Rachel [27]). Finally, the international situation may be such that external demand does not respond to the fall in the prices of domestic products. Let us nevertheless remain in the case of this favourable scenario and ask what is the international impact of structural reforms. Notice that the incentive to undertake structural reforms for reasons of competitiveness cannot be felt by all countries at the same time because they cannot all be in deficit at the same time. Surplus countries have no reason, given their already existing competitiveness, to carry out such reforms. When carried out in a deficit-laden economy, the effect of these reforms will depend on the relative size of the country in question in the international economy. Other countries will see their consolidated surplus shrink, or their relative competitiveness shrink. If they are conducted simultaneously in several countries, the rebalancing effects of the external accounts will be amplified, reducing “global imbalances”. The reduction of external imbalances is ceteris paribus a good thing because it reduces the likelihood of international crises. This makes the world economy more robust. In addition, international productive specialization improves as a result of reduced internal rents and greater capacity to set up firms, and the volume of international trade may be expected to increase. In short, conditional on the achievement of this favourable scenario, structural reforms in one country or group of countries generate positive externalities across the global economy. Under these conditions, leaving aside the political difficulties that this poses, is there a need to coordinate structural reforms at the international level? To answer this question, two considerations are worth noting. On the one hand, since externalities are positive, a process of cooperation would only amplify or accelerate the positive effects; it may therefore be desirable, but it is not imperative as would be the case if the externalities were negative. On the other hand, competition by comparison works. In an open world economy, national experiences are observed, judged, evaluated by all: carefully by public officials in all similar countries, more vaguely and imprecisely by public opinion. National public officials are able to assimilate and learn from successful policies in other countries. The spur to international emulation is there: the structural reforms needed to avoid the international crisis or to stimulate growth are being taken—perhaps with delay— to avoid “falling behind” comparable countries. An international cooperation effort is required in the establishment of institutions to observe, collect and disseminate information on a global scale. This is indeed the major role played by many international institutions, such as the IMF or the OECD. Can we go further in terms of structural reforms? Measures that eliminate the causes of artificial market segmentation are desirable since they make economies of scale and scope possible. International agreements on standardization and certification of standards and market access for tradable goods can only be made on a cooperative basis. They have the macroeconomic advantage of allowing a (faster) recovery of external accounts because they increase price competition. Finally, as we saw in the previous section, the transition period before structural reforms produce their positive effects is delicate. In the context of the global economy, they pose a deflationary risk that can be transmitted to countries that have been in surplus

286

8 Structural Adjustments and Reforms

and thus become widespread. Authorities in countries with shrinking surpluses may be tempted to adopt restrictive policies to restore them, thereby cancelling out the expected benefits of structural reforms in a deficit country. In these circumstances, macroeconomic policy cooperation may be appropriate. This is particularly true for international monetary cooperation, which can facilitate the transition towards the reduction of global imbalances. However, it is difficult to cooperatively reform circuits or practices rooted in differentiated national contexts and sustained by singular and heterogeneous political systems. International cooperation on structural reforms thus quickly finds its limits. The conclusion we reach is therefore similar to that reached earlier in a closed economy: structural reforms in the context of open economies are delicate tools, entailing certain costs, with uncertain and long-term consequences. When an economy operates in an international context from which it cannot isolate itself, structural reforms become in certain cases (large deficits, risk of imminent sovereign default) unavoidable despite the heavy economic and social costs they entail. Often necessary, sometimes indispensable, but involving costly adjustments, they cannot appear to be a panacea, a miracle solution, which at the same time rapidly restores competitiveness and the path of growth.

8.1.3.1 Redistributive Effects By construction, structural reforms have redistributive impacts. In the case of product market reforms, the aim is to dry up rent-seeking opportunities. This is also the case, although it is not the primary objective, of labour market reforms. Typically, these impacts are microeconomic in nature and have little direct macroeconomic impact within a country that implements them, through a consolidation effect (what one loses is gained by the other). In the case of a monetary union, in addition to these redistributive effects, there are also redistributive effects between member countries of the union. In the first configuration studied above, the resorption of the external deficit of one member country implies the resorption of the surplus of another. This has a net macroeconomic impact within the union. But it is not the only one. Parity adjustments in a multi-currency world have redistributive effects. First, between sectors, because they strengthen the exporting sectors. But also via the revaluation of financial or real assets according to the currency in which they are denominated. An asset denominated in a foreign currency sees its relative value increase following a depreciation of the domestic currency. In other words, asset holders face a capital risk as a result of currency manipulation, while non-holders face only an exchange rate risk (as we have seen, a relative impoverishment due to higher import prices). Let us now place ourselves in a monetary union and more precisely in the first configuration defined above. Under these conditions, holders of assets denominated in the currency of the union are protected from any capital risk arising from currency manipulation. The burden of external adjustment through structural reforms directly or indirectly affects the remuneration of factors of production, in particular employees. Put bluntly, a monetary union protects capital holders from the capital changes associated with the

8.1 Understanding Structural Reforms

287

exchange rate adjustments generated by external balance adjustments, in particular via structural reforms, but exposes employees to increased pressure. From a policy perspective, structural reforms will be more difficult to push through because they challenge the status quo, imposing costs that depend the position occupied in the productive system and the wealth held, better perceived by individuals and interest groups than the costs associated with a change in parity.

8.1.4

The Macroeconomic Impact of Structural Reforms

Structural reforms have a macroeconomic impact, even if they seek to change microeconomic behaviours, markets or institutions (De Bandt and Vigna [10]). They cannot, therefore, be carried out independently of cyclical stabilization policies. Let us focus on reforms of goods markets in the most favourable case, when structural reforms are effective, changing behaviour and structures and allowing productivity gains and an increase in the expected growth path. Labour market reforms that would lead to lower labour costs could be analysed in the same way. During implementation, the acceleration of competition in the goods market increases price pressure and slows down the rate of inflation, which may even turn negative. As the different nominal interest rates will not immediately and perfectly adjust, this decrease in the inflation rate leads to an increase in the real interest rate, which weighs on growth. The first effect of the reform may therefore be contrary to the proclaimed objective, leading to misunderstandings and challenges to the reforms. Once these temporary effects have been absorbed, and again assuming that the reforms have achieved their objectives, the market adjustment mechanisms have been modified: the price system has become more responsive; the rates of use of production factors, and in particular labour, have increased. This has been accompanied by a decline in the average unemployment rate as well as in the average duration of unemployment, and in particular a better integration of young people into the labour market (faster and more fine-tuned to individual qualifications). Macroeconomically, this can be expected to lead to a (weak) acceleration of growth, a gain in potential output, but also to greater macroeconomic volatility. The greater responsiveness to shocks does not in fact mean that the shocks are immediately neutralized. The greater capacity to create (disappear) firms, made possible by the decline in annuities, explains this increased volatility. Structural reforms in financial markets also have a macroeconomic impact. If they succeed in improving the capacity of financial intermediaries to absorb shocks, particularly of a systemic nature, and in curbing the risks of contagion, they reduce the likelihood of deep financial crises that disrupt economic activity on a lasting basis. If they reduce the costs of financial intermediation and, more broadly, financial frictions, the financing costs borne by economic agents are lower and the allocation of resources is improved.

288

8.1.5

8 Structural Adjustments and Reforms

Structural Reforms and Macroeconomic Policy

All in all, structural reforms, regardless of the judgement made on their merits, have the effect of modifying the adjustment and balancing processes of a decentralized economy. In particular, they modify more or less radically the channels of transmission of economic policy impulses and influence its implementation and effectiveness. How are structural reforms and macroeconomic policy linked? They can be seen as complementary. Stabilizing macroeconomic policy helps to alleviate the transitory and negative consequences of structural reforms by supporting economic activity and thus facilitating the adjustments induced by the reforms. In doing so, it makes them more socially and politically acceptable and increases their chances of success. For example, higher real interest rates make an accomodative monetary policy desirable (all other things being equal). The same applies to fiscal policy. On the other hand, structural reforms determine the effectiveness of economic policy. As far as monetary policy is concerned, reforms have an impact on the way forward prices are formed and condition the anticipation of the inflation path. They therefore influence the implementation of monetary policy. Let us take the example of reforms relating to the price–wage loop, which are perceived as credible (not likely to be called into question before their natural end) and which limit the processes of automatic wage indexation to changes in the price index. Agents anticipate a lower future inflation rate. This helps the central bank to guide expectations. As regards fiscal policy, structural reforms are also important. A reform policy that raises the potential growth path makes public financing easier, as the primary surplus is increased and thus the execution of public expenditure programmes (reasoning on an unchanged volume basis). More generally, structural reforms amount to seeking to lower the “sacrifice ratio”, i.e. the ratio between the fall (rise) in the inflation rate and the concomitant rise (fall) in the unemployment rate, which in a way represents the “price” to be paid for a fall in inflation when it is deemed too low (in terms of rising unemployment) or for a fall in unemployment (in terms of rising inflation). The lower this ratio, the easier the economic policy conditions are. On the contrary, a macroeconomic stabilization policy can be pursued to mitigate the adverse consequences of structural shortcomings and result in undermining the justification for structural reforms. Let us take the argument to the extreme: if structural reforms are taken only under the pressure of a crisis situation, when public opinion has become aware of the need for profound change, an active macroeconomic policy can work against structural reforms because it postpones the moment of adjustment. Short-term gains are paid for by long-term costs (low or even sluggish growth). Moreover it can lead to the maintenance of structurally inefficient productive units. These two arguments are not of the same order. The first focuses on the economic mechanisms at work in the event of structural reforms, the second relates to the conditions for setting up and implementing these reforms. In any event, the changes brought about by structural reforms are not without consequences for

8.2 The Challenge of Structural Reforms in a Monetary Union

289

macroeconomic policy since the macroeconomic environment has changed, and hence the mechanisms for transmitting economic policy impulses. The complexity of the interaction between economic policy and structural reforms is best demonstrated in the case of the liquidity trap, when the floor of the nominal interest rate is reached. Here again, let us consider the favourable (and of course hypothetical) case of effective and beneficial structural reforms. If the interest rate of monetary policy is above this floor, the fall in the price level and inflation can allow for a fall in the monetary interest rate that combines smoothly with the increase in the growth path: accomodative monetary policy supports structural reforms as we have seen above. But if the floor is reached, structural reforms that reinforce the fall in prices and inflation raise the real interest rate, which has a recessive effect. Monetary policy can no longer act to counterbalance this effect, and structural reforms may well prove to be inappropriate or even harmful. In this case, and more generally when an economy is in a severe recession, reforms aimed at raising prices (making them more rigid) are in fact useful because they support aggregate demand and have a counter-cyclical effect. Under these circumstances, Eggertsson [14] considers a paradoxical measure: that of temporarily giving monopoly power to firms and unions. This policy is tantamount to creating a temporary price increase and thus lowers the real interest rate, which supports activity. This is how Eggertsson justifies the 1933 NIRA corporatist policies in the USA. In the end, structural reforms entail actual and sizable costs while their consequences are uncertain and their benefits can only be felt gradually. This is particularly true for labour market reforms. It is therefore understandable that the political authorities have little appetite for this type of measure.

8.2

The Challenge of Structural Reforms in a Monetary Union

8.2.1

External Constraint in a Monetary Union

The same questions arise in a monetary union: How do we analyse structural reforms? What are their objectives? What is their purpose? The question of external constraint is twofold in the case of a monetary union. We must distinguish between the external constraint of the monetary union, taken as a whole, vis-à-vis the rest of the world, and the external constraint of a member country within the union.9 The external accounts of the union may be in balance, while the external accounts of some (or even all) member countries are not. In this case, the external deficit of one translates into the surplus of the other. A country’s external debt is owed to the rest of the union and not to the rest of the world. This raises two questions:

9

See Chap. 1, Sect. 1.2.

290

8 Structural Adjustments and Reforms

1. If the external accounts of the union are in balance but a country’s external accounts are in chronic and substantial deficit, how can—or should—the adjustment of that country’s external balance be made? 2. If the union has chronic and substantial deficits vis-à-vis the rest of the world, how can—or should—the external balance of the union be adjusted? In the first configuration, since the relative price structure of tradable products cannot result from a change in parity, the member country can only achieve the rebalancing of its external accounts through structural reforms, changing the adjustment pattern in price and income formation to regain competitiveness on external markets, and through a reduction in the public component of aggregate demand. While in the multi-currency world, structural reforms appear to complement parity adjustment, they appear as the only possible option in monetary union, however delicate and costly it may be. A monetary union introduces three major differences in the analysis of the structural reforms envisaged or implemented by a member country of the union: 1. The adjustment of the external constraint is more complex in monetary union because of increased economic integration. 2. Cross-border effects are more important. In particular, the single currency and the fiscal arrangements in place in the union generate transfers within the union. 3. The redistributive effects are different from those associated with monetary manipulation of parity. Consequently, their implementation in that country poses specific problems that are more difficult to resolve than if that country has full monetary sovereignty. This represents a potential factor in the fragility of a monetary union. In the second configuration, the union is in the situation analysed in the previous section. The adjustment of the external parity of the union’s exchange rate is part of the panoply of possible measures. If this parity adjustment is not sufficiently effective, it must be supplemented by reforms and structural adjustments. Where the union has such a capacity, it can resort to structural reforms that are valid within the union. But these reforms will have a differentiated impact in the member countries, given their productive singularities. In the case where the monetary union is not able to impose structural reforms, the question of the balance of the external accounts becomes thorny because we are faced with a “tragedy of the commons” (Hardin [17]): the deterioration of the situation is the fault of all the member countries, since they all benefit from parity of the union’s currency and collectively contribute to these chronic and substantial deficits, but no national authority considers itself responsible for the situation, nor capable by its efforts alone of restoring the external accounts of the union. There is a further complication. Monetary union has effects on the productive structure of the countries in the union: greater integration fosters increased productive specialization and trade between member countries; financial unification— which may result in a simpler interest rate structure—increases gross financial flows

8.2 The Challenge of Structural Reforms in a Monetary Union

291

within the union, thus increasing the capacity to sustain external deficits. Their mobility is also increased which may contribute to financial fragility. Strengthening economic and financial integration in a monetary union increases the effects of competition between member countries. As a result, a monetary union is likely to make structural reforms more necessary. Structural reforms in a member country of a monetary union have important cross-border effects within the union. Let us place ourselves once again in the first configuration and assume that the structural reforms adopted by the deficit country are effective and allow its external deficit to be rapidly reduced. The first effect is indisputable: the resorption of a member country’s deficit has as a counterpart the resorption of the consolidated surplus of the other member countries. Overall, this is desirable. Since the financial instability of one country weakens the union as a whole, reducing it strengthens the union. The other member countries may nevertheless see this reduction as a loss of outlet for their national production. Other effects may be felt in the longer term. The change in production cost structures within the union due to structural reforms feeds a reorientation of the allocation of production factors within the union. Workers may migrate and investment flows may occur to take advantage of this change. Similarly, national fiscal positions may change as a result of adjustments induced by structural reforms, particularly supply-side adjustments. The fiscal configuration of the union may therefore be permanently affected by a process of unwinding external imbalance within the union. In any event, this readjustment of internal trade flows amounts to a change in the transmission channels of monetary and fiscal policies within the union. The union central bank must be attentive to these reforms and their effects, as they are likely to alter the transmission channels of its decisions throughout the union.

8.2.2

The Macroeconomics of Structural Reforms in a Monetary Union

The macroeconomic impact of structural reforms is altered when there is a single currency. As in the general case, a distinction has to be made according to whether the nominal (short-term) interest rate is positive or has reached its lower limit (conventionally zero). We always reason in the case of the first configuration and focus on structural market reforms carried out by a deficit country, which are assumed to be effective and efficient and amount to internal devaluation.

8.2.2.1 In Normal Times The internal devaluation practised by a member country implies the resumption of exports and economic activity in that country. But if there is no support from the central bank of the union, the nominal interest rate does not fall. This raises the real interest rate in the country concerned and depresses investment and therefore economic activity. This is reinforced by the interplay of expectations: as expectations of future inflation fall in line with the fall in activity, the rise in the

292

8 Structural Adjustments and Reforms

real short-term interest rate is lasting and is passed on to the long-term interest rate. As the central bank sets its monetary policy according to the overall situation in the union, its reaction to the recessive impact of structural reforms will be conditional on the economic weight of this country in the union. It may be negligible if this relative weight is low. In any event, the compensatory effect of monetary policy will be mitigated. In other words, we find the same problems as in the case of an open economy. But they are magnified by the fact that the single monetary policy is logically less accomodative and counters little or no internal recessive effects of structural reforms. So what about the tool of fiscal devaluation? This tool, manipulated by domestic authorities, can play a compensatory role. But if fiscal policy has been (one of) the cause of the deterioration of the external accounts (systematic public deficits contributing to excess demand), it is doubtful that the Treasury has the capacity to reduce charges, in any case with unchanged expenditure. If it does so while reducing the budget, and thus aggregate demand, competitiveness will recover well but the immediate recessive effect is still present. Let us introduce a new element: the credibility of structural reforms. Until now, we have assumed that structural reforms are effective and perfectly credible. On the contrary, let us suppose that they are not credible in the following sense: the probability that they will be abandoned at each period for a return to previous arrangements is non-zero. Under these conditions, an indirect effect is added to the direct recessive effect. The probability of abandoning structural reforms feeds expectations of future contraction in activity, which immediately slows down present activity, through the fall in productive investment. All in all, the transitory depressive effect of structural reforms on economic activity cannot be offset by fiscal policy or mitigated by monetary policy. In other words, the objective of restoring the external accounts can be achieved, but at the price of a deeper recession than in monetary sovereignty. Under these circumstances, it is difficult to present these reforms as raising the potential growth path, as it is quite possible that this will not happen, or not before a substantial period of time. When the countries of the union collectively implement union-wide reforms, this reasoning no longer holds. If these reforms have a recessive impact, it weighs on the union as a whole. The central bank is therefore in a position to adjust its monetary policy to mitigate this recessive effect.

8.2.2.2 In the Liquidity Trap When the interest rate has reached its lower limit, the conventional monetary policy of interest rate manipulation (e.g. via a Taylor rule) becomes inoperative: it cannot accompany structural reforms. The recessive effect cannot be countered by a conventional monetary policy. A first option is for the central bank of the union to conduct a non-conventional monetary policy, either quantitative easing or credit easing, in order to support aggregate demand. A second option is studied by Eggertsson et al. [15]. Generalizing the scenario studied by Eggertsson [14], these economists develop a DSGE model of a two-country monetary union. The external accounts are in balance but imperfections in the goods and labour markets

8.3 Implementing Structural Reforms

293

in the non-traded goods sector, leading to high mark-ups, justify long-term structural measures. The objective of these reforms is to increase the growth path since external balance problems do not arise. In the presence of a liquidity trap, they can have a stabilizing effect on economic activity. Eggertsson et al. study the scenario of temporarily increasing the monopoly power of firms and trade unions by manipulating tax rates in the non-traded goods sector. Their simulations show the cyclical support to economic activity of these measures.

8.3

Implementing Structural Reforms

How to implement structural reforms? Structural reforms involve costs. Otherwise, they would not pose major problems and their adoption would depend only on the relevance of the analysis behind them. At a minimum, structural reform entails adjustment costs, which are temporary in nature, as well as undue annuities or benefits to individuals or groups. These represent sectoral costs and revenue losses. Lastly, the macroeconomic consequences of a reform may have transitory, and sometimes even permanent, costs. Managing these costs, particularly in relation to their time profile, is a delicate matter. From a macroeconomic point of view, the consensus is that structural reforms entail costs that are concentrated in the short term, whereas their benefits are felt over a longer term, depending on the time taken by the gradual change in behaviour. But there is another important asymmetry between costs and benefits. The former are fairly well valued, while the latter are more uncertain. Social engineering, of which structural reforms are a part, is far from being an exact science and the body of knowledge of economists does not allow them to advance orders of magnitude with great reliability. Observations drawn from past reforms, taken in singular contexts, are of course valuable but cannot claim to be indisputable proof— and uncontested by the interests concerned—of the effectiveness of a planned measure. The trade-off for structural reform is between immediate and localized costs and future, uncertain and widespread gains. Allocation effects are random and differentiated. The result is a political asymmetry: opponents of the measure are easily mobilized while beneficiaries are not.10 Uncertainty about the impact of structural reforms can lead to another effect: if, following a structural reform, there are losers and winners but the identity of each is not precisely known, there may be a majority of opponents to the implementation of this reform even though it is beneficial for society as a whole (the expectation of gain is positive for all). These mechanisms are at the root of the “tyranny of the status quo” and explain the difficulty of getting a structural reform programme adopted. The choice of strategy is dominated by the question of the pace of reform. Two opposing approaches can be put forward. The first is gradualism. The second is the

10 This

is an application of Olson’s theory of the logic of collective action in a random framework (Olson [23]).

294

8 Structural Adjustments and Reforms

“big bang” reform approach. From a strictly economic point of view, gradualism is logical (always under the hypothesis of efficient structural reforms): reforming the goods market releases purchasing power for employees, supports economic activity. This makes it easier to carry out reforms on the labour market, which probably always involve an initial increase in unemployment, either because redundancies are made easier or because the work employed is better used. But the eco-political logic can, on the contrary, justify the big bang: the broad support of public opinion for a all-encompassing reform policy only makes itself felt in situations of lasting and deep crisis. Finally, we have seen that the effectiveness of a reform depends on the economic situation. The crisis is an important moment for the collective awareness of the need for structural reforms because the costs associated with these reforms are compared with the costs of inaction, linked to the deepening of the crisis. In a recent paper, Agnello et al. [1] empirically studied the circumstances under which structural reforms are taken, using a database of 60 countries over the period 1980–2005. They showed that recessions play an important role in the adoption of structural reforms in finance and trade, particularly for OECD countries. Banking and financial crises contribute to financial reforms. In 1933, Roosevelt was able to seize the opportunity of the banking crisis of unprecedented magnitude that shook the US at the onset of his first presidential mandate and passed a series of banking laws that brought about in-depth and lasting reforms of the US banking and finance industry, despite the opposition of its leaders (Myers [22], Calomiris [5]). The same happened in Sweden and Germany in the 1990s. The degree of openness contributes to the adoption of these reforms: external pressure is felt. Lastly a period of sustained activity is conducive to the implementation of a policy of reforms, particularly in the labour market and the banking sector. The initial costs (which are expected to dissipate over time if the reform is well thought out and carried out) are made more bearable by the fact that unemployment is low and the conditions for profitability high. It is therefore very difficult to make recommendations as to when they should be implemented. More than the economic situation, what is at stake is the vision and planning capacity of political leaders and their ability to cope with the unpopularity of difficult reforms. The implementation of structural reforms is more delicate in a monetary union than in the usual case of a country with monetary sovereignty. Since the externalities are different, the stake of international cooperation is altered. Moreover it is twofold, depending on whether structural reforms are implemented by a member country or at the level of the union, by the governing bodies of the union.

8.3.1

National Structural Reforms

Let us start with the first configuration: a member country implements structural reforms with the aim of improving its relative position in the union. Let us assume that these reforms are well thought out and effective. The difficulty lies in the fact that they have been adopted in a non-cooperative manner, that is, without

8.3 Implementing Structural Reforms

295

the government having taken into account the externalities they are likely to generate in the union, which are not all positive. The option of non-cooperation in implementing structural reform is costly. Simply imitating good practice is not a sufficient incentive to implement these reforms. At best, the gains of some sectors or groups will offset the losses of others. Structural reforms at State level may have perverse effects and undermine the strength of the union. The case of the German labour market reforms under Chancellor Schröder’s leadership in 2003–2004 may illustrate these risks. The laws inspired by the Hartz Commission were passed in a context of low growth and high unemployment, itself a consequence of German reunification in 1989–1990. They consisted of reforming unemployment benefits (in the sense of tightening provisions), increasing low-paid jobs and providing incentives for the unemployed to return to work. Unemployment decreased from 11.7% in 2005 to 4.5% in 2013 (Krebs and Scheffel [19]). Germany also achieved considerable external surpluses: systematically positive since 2006 (5.7% of GDP) to 2015 (8.4%). Germany has not proceeded with a macroeconomic rebalancing parallel to labour market reforms through an increase in the level of the average wage, for example, which would have had the effect of supporting imports and balancing the external accounts. As a result, these structural reforms, a perfect example of internal devaluation, could be seen as non-cooperative, with negative effects for Germany’s partners: the fall in German unemployment was at the expense of unemployment in other countries. Internal devaluation is a “beggar thy neighbour” strategy, as were the exit strategies from the gold exchange rate regime in the 1930s which had catastrophic consequences (Eichengreen [16]).

8.3.2

Multi-National Structural Reforms

The second option is to reform the monetary union itself, i.e. to make institutional changes to the union and to all its components. Their implementation depends on the institutional framework of the monetary union. It is facilitated in the case of a national monetary union to the extent that there is a single government body capable of discussing and enacting reforms at the national level. When the US Congress decided in 1913 to create the federal reserve system, thereby creating the central bank of the American monetary union, this was a major structural reform for the entire American union (Meltzer [21]). More recently, the Indian parliament, under the impetus of the Indian government led by Narendra Modi, voted in favour of a single VAT in 2017, uniformly applying to the Indian monetary union.11 In the case of an international monetary union, things are more complicated: comprehensive structural reforms encroach on the sovereignty of member States and must be approved by them. When the European Union discusses the reform of the conditions of remuneration of “posted” workers within the union, seeking to revise

11 See

https://www.bloomberg.com/news/articles/2017-06-29/-plenty-of-hiccups-expected-asindia-rolls-out-new-tax-reform.

296

8 Structural Adjustments and Reforms

a 1996 directive, it is seeking to change the conditions of worker mobility within the union, and the adjustment mechanisms within the union.12 Given the sensitivity of the subject and the divergent interests of its member States, it is not surprising that the discussions are difficult, given that this is a key issue for the proper functioning of the European monetary union. Underlying the institutional arrangements for their discussion and implementation, such reforms imply cooperation between member countries. This cooperation may involve the exchange of information and collective consultation. The purpose of such an exchange is to inform partner countries. It may imply the establishment of a system of budget transfers to alleviate the internal social costs in the reforming countries or the economic costs incurred in the partner countries. Finally, it may take the form of a process of convergence of economic structures so as to reduce their heterogeneity within the union. We have seen above that monetary union has structural effects, linked both to greater integration and greater competition between member countries. This provides an incentive to put in place regulatory conditions compatible with this greater integration in order to obtain a “level playing field” for all partners. The banking union is an example of homogenizing structural reform. At the extreme, structural reforms can lead to a perfect structural similarity of the countries of the union. An example of structural reforms covering the whole union is the unification of the unemployment benefit system. Such a proposal is topical in the case of the European Monetary Union and is often mentioned as a possible avenue for reform (Claeys et al. [6]). Such a measure is justified by its macroeconomic interest in the cyclical management of the union: it creates a system of automatic stabilizers covering the euro area and generates international transfers to compensate for the differences in activity recorded by the various countries. But it also has longterm structural effects: on the one hand, it encourages the mobility of employed workers within the union since it facilitates the international recognition of an employee’s acquired rights to unemployment benefits; on the other hand, it makes it impossible (or at least more complicated) for individual member countries to take non-cooperative decisions on these rights. Through the unification of unemployment benefits, countries indirectly have a say in national labour market policies. In the end, what is better? At what level should structural reforms be implemented? At the level of the member States or at the level of the union? Actually national reforms do not meet exactly the same objectives as reforms at union level. National reforms aim at restoring the external balance of a country whereas reforms at the level of the union aim at strengthening the cohesion of the union, either by cooperating in the implementation of reforms or by adopting homogeneous measures for the whole union. In any event, in a monetary union, the introduction of structural reforms can only benefit from collective, cooperative treatment. Finally, what difficulties should be overcome in their implementation? Essentially political difficulties. We have noted the bias in favour of the status quo in

12 See

http://ec.europa.eu/social/main.jsp?catId=471&langId=fr.

8.4 A Simple Model for Structural Reforms in a Monetary Union

297

the case of a sovereign country. It is often only when the situation has become untenable and is recognized as such by public opinion, that structural reforms are implemented. The question is whether the proclivity to procrastinate is attenuated or exacerbated in the configuration of the monetary union. In terms of political economy, monetary union produces three combined effects. On the one hand, increased competitive pressures within the union and the disappearance of exchange rate adjustment make the need for structural reforms stronger and more urgent. On the other hand, the obligation of objective solidarity between member countries created by the single currency gives a country with a deficit the capacity to put pressure on its partners, which may enable it to postpone politically painful decisions. Finally, the implementation of structural reforms at the union level depends on the modalities of negotiation between member countries, which depend on the internal political situation in each country. From this brief examination of the determinants of public decision-making on structural reforms, the emerging conclusion is that the political game is complex and that it is impossible to say with any certainty whether these reforms are made easier in the presence of a single currency. Quite simply, failure to adopt structural reforms in time may mean the failure of the monetary union itself.

8.4

A Simple Model for Structural Reforms in a Monetary Union

To better understand structural reforms in a monetary union, let us develop a simple model of a monetary union based on a model developed by Blanchard and Giavazzi [3] for the analysis of structural reforms in a closed economy. The Blanchard and Giavazzi model is a static general equilibrium model. Structural reforms are understood as measures to deregulate goods and labour markets. When these measures reduce rents, they generate significant redistributive effects that alter macroeconomic dynamics. Its extension to the case of a monetary union provides us with a better understanding of the problems that structural reform programmes in a monetary union seek to address and the difficulties that such programmes face. Consider an international monetary union consisting of J sovereign countries indexed by j .13 National governments are in a position to carry out national structural reforms. In each country, firms compete monopolistically but this monopolistic competition is exercised over the whole union: households in the union consume all the goods produced in the union, which they value in a differentiated way (these goods are not perfectly substitutable). The firm producing good ij is located in country j . The number of firms in country j is denoted by mj and may be variable. The creation of a firm implies paying a fixed cost cj . A firm located in country j solely employs workers from country j . The international mobility

13 We shall

return below to the case of a closed national monetary union (no exchange with the rest of the world).

298

8 Structural Adjustments and Reforms

of workers within the union is limited. The economy is a static economy (nondynamic, with no accumulation variable). The only factor of production is labour. The wage paid by a firm is negotiated with a union, with the negotiation being about the sharing of the firm’s surplus. This sharing is affected by the benefits received in case of unemployment, which depend in a decreasing way on the aggregate level of unemployment u: f (u), where f  (u) < 0. The model can be studied in the short run, with a fixed number of firms, and in the long run, where this number is endogenized.

8.4.1

Demand and Monopolistic Competition

In view of the monopolistic competition within the union, the production to firm i located in country j , Yij , is given by the following formula Y Yij = m



Pij Pj

−σj 

Pj P

−ζj ,

(8.1)

 where m represents the number of firms present in the union, m = j mj , fixed in the short term. Y is the aggregate product of the union as a whole. The relative share of demand for good ij , Yij /Y , depends in a decreasing way on the number of goods consumed in the union, m, as well as on two relative prices Pij /Pj and Pj /P , where Pj represents the price level in country j and P represents the general price level in the union as a whole. Note that there are two instances of competition: intra-national competition, parameterized by domestic price elasticity σj , and international competition, parameterized by price elasticity ζj . The second relative price, Pj /P , represents the terms of international trade (within the union) between country j and the rest of the union. It is implicitly given by:  m   P −ζj Yj j j = , Y m P

(8.2)

where Yj represents the aggregate demandof consumers in the union to producers in the union and is defined as Yj = i Yij . The share of the total demand addressed to producers in country j is a decreasing function of the international terms of trade where ζj represents the price elasticity of the demand addressed to domestic producers. An increase in this ratio, representing a loss of competitiveness of domestic producers, implies a relative loss of demand and therefore of production. This relative price represents a first cross-border spillover effect. A price variation in country j  impacts on demand in country j via its impact on the general price level in the union. This is a pecuniary externality since it involves price-related shifts in demand. But these prices themselves are linked to structural rigidities. Here we see that structural data generate externalities within the union. The relative domestic price, Pij /Pj , depends on the functioning of the labour market in j .

8.4 A Simple Model for Structural Reforms in a Monetary Union

8.4.2

299

Labour Markets

Let us come to national labour markets. Workers are homogeneous within country j. a/ Let us first assume perfect immobility of workers within country j . They can only be employed by firms in country j ; if they are unemployed, they cannot leave the country and depend on the unemployment benefit system in country j . The reservation wage of a worker depends on unemployment in country j , which we  note uj , and is given by the function fj uj , which captures the unemployment  benefit system in place in country j , with fj uj ≤ 0. The relative price Pij /Pj is given by the following formula    Pij      Pij = 1 + μij fj uj = 1 + μij fj uj , Pj Pj

(8.3)

where μij represents the mark-up of firm ij , calculated between the relative price of the firm and the reservation wage in country j . The mark-up μij , which determines the unit surplus of firm ij , is the same for all firms assumed to be in the same structural situation as regards their pricing: μij = μj . This mark-up rate is a   decreasing function of domestic price elasticity σj : μj mj = σj1−1 = σ¯ g m1 −1 , j ( j) which itself is an increasing function of mj . Thus the relative domestic price is linked to two singularities of country j : the domestic price elasticity and the unemployment benefit system. A firm’s employees, knowing the monopolistic competitive position of the firm, want to capture part of the firm’s profit from this position and from the price power available to the firm. The real wage (purchasing power) calculated with reference to the prices of goods produced by firms in j is negotiated (implicitly) between employee representatives and employers. In this negotiation, unemployment benefits serve as a guaranteed remuneration in the event P of failure of the negotiation: they are in any case vested in the workers. Pijj is an indicator of the profitability of firm i. The higher the reservation bargaining power βij , the more workers are able to have a high share of the profit of firm i.14 If this power is low, at the negligible limit, employees have the minimum remuneration linked to unemployment benefits. For the sake of simplification, we assume that βij = βj . W Formally, according to this reasoning, we assume that this real wage, Pijj , is given by the following formula     Wij = 1 − βj fj uj + βj Pj

14 The



reasoning is fully developed in Blanchard and Giavazzi.

Pij Pj

 .

(8.4)

300

8 Structural Adjustments and Reforms

Using (8.3), we obtain     Wij = 1 − βj μj fj uj . Pj

(8.5)

It should be noted that, since all companies in country j are in the same situation, they all charge the same salary. We can write that Wij = Wj , ∀i. It is immediate to qualify Wj as the average wage in force in country j . b/ Let us now relax the hypothesis of partial mobility of workers. Let us assume that a worker who is unemployed in country j can try his luck in another country, depending on the unemployment there. The reservation wage in the country then depends on the unemployment rates observed in all the countries of the union. The purchasing power of the employee is now calculated according to the general price level in the union P . Formally, by noting {uk }Jk=1 the vector of unemployment rates in the union, the real wage in country j is written  P .  Wj Wj Pj j = = 1 + βj μj fj {uk }Jk=1 · . · P Pj P P

(8.6)

  The function fj {uk }Jk=1 nevertheless remains idiosyncratic: the indirect effect of external unemployment depends on mobility capacities, which may differ from country to country and the compensation system remains defined by the national authorities. For example, the following function can be posed     J fj {uk }k=1 = fj uk ; αj k , k

where αj k is an indicator of worker mobility between j and k. The higher it is, the more the unemployment rate in country k exerts a downward influence on the reservation wage in country j : workers from country j have fewer external options and reduce their wage claims in country j ; moreover, this increase in unemployment pushes workers from country k to try their luck in country j , again exerting downward pressure on the real wage in country j . The hypothesis of perfect immobility is a particular case of this formulation by posing αjj = 1, ∀j and αj k = 0, ∀j, ∀j = k. c/ Another special case is that of perfect and universal mobility within the union. Under these conditions, workers have the same external options regardless of the country in which they reside and the reservation wage depends on the total unemployment existing in the union. But their compensation scheme remains national. So we have   fj ({uk }) = fj uk . k

8.4 A Simple Model for Structural Reforms in a Monetary Union

301

For example, we can consider that the unemployment  benefit is calculated on the basis of average unemployment in the union: u¯ ≡ J1 k uk . d/ Finally, we can complement this hypothesis of universal total mobility with a hypothesis of uniform unemployment compensation  fj ({uk }) = f (u) ¯ =f

 1 uk , ∀j. J k

The labour markets are fully integrated. The real wage differentials that exist result from the different wage bargaining capacities of different countries. Options b/, c/ and d/ highlight cross-border effects on labour markets. Option a/, on the other hand, corresponds to an autarkic functioning of national labour markets. A national monetary union is certainly better represented by options b/, c/ and d/. The unifying character of the nation means that the regulatory framework is marked by a high degree of integration and homogeneity between the components of the union and that worker mobility is also high. In the opposite direction, options a/ or b/ are consistent with a multi-national monetary union, where national borders are less permeable and the regulatory frameworks, defined nationally, are heterogeneous.

8.4.3

The Structural Configuration of Monetary Union

In a monetary union such as the one we have just described, there are many indicators of rigidity, possibly linked to the public regulations in force. The causes of market rigidity, which may be modified by structural reform policies, are represented by three sets of parameters: 1. The entry costs cj borne by a firm setting up in country j . These costs may differ according to the regulations and constraints specific to a country. They may also result from regulations valid for the whole union. 2. Price elasticities of demand for a good, σj and ζj . σj measures the intensity of competition within country j and depends on regulatory measures and, more generally, on public policies specific to country j . ζj , on the other hand, measures the intensity of competition within the union faced by country j . ζj may be specific to country j even if this parameter reflects regulations and measures taken at the level of the union and is valid for the union as a whole. Indeed, they may have differentiated effects according to the productive specializations and social specificities of the different member countries.   3. Rigidities linked to labour markets: βj , fj ({uk }) and αj k k . They relate to the sharing of monopoly rents made by companies in country j . In the model, we assume that this sharing takes place at the level of firms, not at the level of countries or the union. We strongly constrain the modalities of this sharing. In particular, the share of the surplus allocated to workers βj , which reflects the union’s bargaining power, is valid for all firms in country j . One could

302

8 Structural Adjustments and Reforms

alternatively assume that this power is specific to the firm, βij , or on the contrary the same for the union as a whole, β, if union power is homogeneous throughout the union. In any case, national and international provisions affect this sharing. Indeed, the mobility of labour and the legal provisions valid in the union mean that the reservation wage of workers from country j depends on the economic conditions in the rest of the union. Here these cross-border effects are formalized by the incidence of national unemployment rates, via the mobility incentives and unemployment benefit schemes that can be mutualized within the union. We qualify as “structural configuration” the vector of structural that     parameters characterizes this monetary union: cj , σj , ζj , βj , fj ({uk }k ) , αj k ik j . Structural reform policies consist in modifying the structural configuration of the union. They can be implemented at the level of the union or at the level of a country.

8.4.4

Equilibria

We must distinguish between the internal equilibrium of a given country and the overall equilibrium of the union.

8.4.4.1 Internal Equilibrium We reason within the framework of one country, taking the variables of the other member countries as data. In country j , since all the firms are in the same situation in relation to each other, we obtain     Pij = 1 = 1 + μj fj uj . Pj Hence we get   fj uj =

1 . 1 + μj

(8.7)

Substituting in (8.5), we obtain Wj 1 − β j μj Wij = = . Pj Pj 1 + μj

(8.8)

8.4.4.2 External Equilibrium Let us look at the external accounts of the countries of the union. As we saw in Chap. 1, the challenge of a multi-national monetary union is to ensure the balancing of the external accounts of the member countries, which cannot be guaranteed by external parity. This balance must be achieved through direct adjustment via the formation of income (mark-up and wages) and prices and not indirectly via the exchange rate. In a national monetary union, integration implies public transfers

8.4 A Simple Model for Structural Reforms in a Monetary Union

303

between entities strong enough to compensate for these imbalances. Since we disregard public transfer policies in this model, we focus on the case of a multinational monetary union. The simplest indicator to capture the competitiveness of a national economy is the foreign trade balance or the current account net position (balance). Let us note Sj the current account balance of country j . In the model we are constructing, the essential element is wage bargaining, from which wage setting is derived. A firm sets the selling price of its output by applying a mark-up to the unit labour cost resulting from the bargaining process. It is reasonable to assume that the competitiveness of country j depends on the ratio between the average wage in country j and the world average wage:  Sj = S

Wj W



 =S

Wj Pj



Pj P



W P

−1  (8.9)

.

The function S (·) is continuous and continuously derivable with S  < 0. We assume that S (−∞) = ∞, S (∞) = −∞ and S (1) = 0. The sum  of the external balances is necessarily zero (since the monetary union is closed): Sj = 0. Using (8.2), we j

obtain  Sj = S  =S

Wj Pj



m Yi mj Y

1 − β j μj 1 + μj



−ζj 

m Yi mj Y

W P

−1 

−ζj 

W P

−1  (8.10)

.

It is important to look at the bilateral balance of country j with respect to country j  , which we note Sjj   Sjj  = S

1 − β j μj 1 + μj



1 − β j  μj  1 + μj 

−1 

Yj mj

−ζj 

Yj  mj 

ζj   .

(8.11)

To complete the model, let us introduce a very simple production function Yij = Nij .

(8.12)

The labour supply is inelastic and normalized to 1 in each country. The equilibrium of job flows implies 1 = Nj + uj

(8.13)

304

8 Structural Adjustments and Reforms

with Nj =

 i

Nij We deduce, using (8.7), Yj = 1 − uj = 1 − f

−1



1 1 + μj

 (8.14)

.

We can therefore rewrite (8.11) ⎛



⎜ 1 − β j μj Sjj  = S ⎝ 1 + μj ⎛ ⎜ ×⎝

1 − f −1



mj 



1 − β j  μj  1 + μj 

1 1+μj 

−1

⎛ ⎝

1 − f −1



1 1+μj

 ⎞−ζj

mj

⎠

 ⎞ζj  ⎞ ⎟ ⎟ ⎠ ⎠.

(8.15)

Note that (8.11) depends on the different structural parameters that we noted above with the exception of c: βj , μj , βj  , μj  . At this stage, let us treat the aggregate claims Yj and Yj  for both countries as exogenous, as well as the numbers of firms in the two countries. We obtain ∂Sjj  < 0, ∂βj

∂Sjj  ∂Sjj  ≷ 0, > 0, ∂μj ∂βj 

∂Sjj  ≷ 0. ∂μj 

Some consequences can be drawn from this: 1. The external balance of country j is reduced when the bargaining power of employees increases. 2. The sign of the change in this equilibrium is ambiguous when the mark-up rate increases. 3. It also depends on the structural situation prevailing in country j  . This is logical since it is a balance and competitiveness is relative. The deterioration of competitiveness in the partner country improves the external balance of country j . For the moment, we do not have any endogenous mechanism to balance external trade or to assume that external balances are zero. On the contrary, in a multinational economy with multiple currencies and flexible exchange rates, the external surplus equation shows the exchange rate. Formally, (8.9) is written  Sj = S

εj Wj W

 ,

(8.16)

where εj is the exchange rate of the currency of country  j in the “currency of the rest of the world”. Under these conditions, the vector εj j =1,...,J must ensure

8.4 A Simple Model for Structural Reforms in a Monetary Union

305

generalized external equilibrium in this economy, i.e. ) * εj∗

!  ∗  ε W ! ! S j j = 0, ! j =1,...,J W

∀j = 1, ..., J,

(8.17)

) * where εj∗ is the vector of exchange rates ensuring the external equilibrium of all countries participating in international trade. Under flexible exchange rates, the exchange rate εj adjusts so that εj Wj = W and Sj = 0, ∀j . Countries can be characterized by different rigidities: despite these structural rigidities, external balances are ensured through exchange rate flexibility. Exchange rate adjustment modifies the capacity to extract monopoly rents and distribute them between entrepreneurs and employees. In the monetary union regime, based on (8.9) and not on (8.16), the problem of external equilibrium arises and seems to have no solution: since the exchange rate adjustment mechanism is absent, what should replace it? Assuming perfect labour immobility (option a/ for the labour market), the general equilibrium of this union is formally characterized by the following set of equations ⎛   ⎞−ζj ⎛ 1  −1 1 − f −1  1 − β j  μj  1+μj ⎜ 1 − β j μj ⎝ ⎠ S⎝ 1 + μj 1 + μj  mj ⎛ ⎜ ×⎝

1 − f −1



mj 

1 1+μj 

 ⎞−ζj  ⎞ ⎟ ⎠

⎟ ⎠=0

(8.18)

∀j, j  . The crucial feature of the model is that it lacks an adjustment mechanism that ensures external equilibrium: we do not know how to justify the last equality, in the presence of price rigidities, unlike what happens in a world economy with fixed exchange rates.

8.4.5

Domestic Structural Reforms and the External Balance

The question that arises is therefore: how to adjust the external accounts in a monetary union? More specifically, is it possible through structural reforms to rebalance the external accounts between member countries? What are the consequences? To answer these questions, let us proceed gradually. The first question is the following: For which structural configuration(s) is the external balance achieved? A first answer is immediate. If the countries are structurally identical, characterized by the same structural parameters and the same number of firms, the

306

8 Structural Adjustments and Reforms

consumption flows to each country are the same and surpluses are all in equilibrium: imports are perfectly offset by exports (in value). Since perfect structural homogeneity solves the major problem of a monetary union, it appears to be the ideal solution. Better still, if the structures can be integrated at the level of the union, as in option d/ detailed above, the problem is solved. It is understandable that analyses and policy recommendations for a given monetary union favour the convergence and the integration options. This is not the only solution to the problem of the external balance. On the one hand, differentiated configurations of structural parameters can also lead to Eq. (8.9) being satisfied. The limitations of the model are such that other adjustment mechanisms are missing, in particular dynamic adjustments: via capital formation, financing modes, savings and investment flows. And as we have seen, crossborder transfers can compensate for external deficits generated by competitiveness differentials. However, there is no guarantee that this broadening of reasoning guarantees the external balance. On the contrary, savings flows may very well amplify these differentials by going to the most productive economies and it is doubtful that transfers are permanently available to compensate for structural defects. This brings us to a second (dual) question: Given a structural configuration, if a country’s external equilibrium is not achieved, how can we move towards that equilibrium? What structural reforms decided by the national authorities are most effective? At this stage, it is clear that external surpluses depend on the structural configuration of the union. By modifying these parameters, it is possible to change the size of surpluses and, if necessary, to ensure their reduction and convergence towards equilibrium. Such a modification can be interpreted as a structural reform programme. But this poses a new problem: Structural reforms generate externalities. How do they affect the external balance? We have noted the cross-border effects of the various structural parameters. Suppose that βj is modified in a way that decreases the price level in country j , Pj . This modification affects the surplus of j but also P via the cross-border effects. More specifically, it changes the relative competitiveness of j in relation to j  and the relative surpluses of all countries in the union. Under these conditions, it is possible that a structural reform aimed at improving the external accounts of a given country deteriorates the external accounts of the other member countries and, ultimately, that the external accounts remain unbalanced or even marked by increased imbalances.

8.4.5.1 National Structural Reforms In the context of our model, let us look at how structural reforms undertaken by a country can ensure balanced external trade, or at least reduce the imbalance. Suppose that the monetary union consists of two countries. Under these conditions, we have Sjj  = −Sj  j = Sj = −Sj  , ∀j = 1, 2.

8.4 A Simple Model for Structural Reforms in a Monetary Union

307

In the Short Term The short term is defined by a fixed number of firms. Consider country 1 (without loss of generality). According to (8.11), we can write

S12

⎛   ⎞−ζ1 ⎛ 1  −1 1 − f −1  1+μ1 1 − β 2 μ2 ⎜ 1 − β 1 μ1 ⎝ ⎠ =S⎝ 1 + μ1 1 + μ2 m1 ⎛ ×⎝

1 − f −1



m2

1 1+μ2

 ⎞−ζ2 ⎞ ⎠

⎟ ⎠.

The structural characteristics of country 2, β2 and μ2 , are taken as given. The question is whether the manipulation of β1 and μ1 allows the external balance to be maintained. We are looking for pairs (β1 , μ1 ) such that S12 = 0. It is clear that given the properties of the function S (·), such pairs exist. For example, if we assume that ∂S12 ∂μ1 < 0, if for a pair (β1 , μ1 ) the external balance is negative, the mark-up rate must be decreased to restore the external balance. Note that this measure will have the automatic effect of reducing the competitiveness of country 2 and its external surplus. This is indeed the manifestation of the externalities produced by a policy of structural reforms. In the Long Term For the time being, we have reasoned with a constant number of firms. In the long term, the number of firms is endogenous: some firms are created, others disappear (in the short term, all firms make a profit and have no reason to disappear). The creation of firms in a given country takes place as long as the monopoly profit is higher than the cost of entering the market, which we have assumed to be fixed, cj . The mark-up rate μj is a decreasing function of the number of firms mj . The number of firms in the long run is therefore determined by an equilibrium equation    μj m j 1 − β j   = cj . 1 + μj m j

(8.19)

A national structural policy may consist of varying the cost of entering markets, cj . ∂μ ∂μ Since ∂cjj and ∂mjj are negative, a decrease in this cost leads to an increase in the number of firms and to a reduction in the mark-up rate of each firm. Moreover, the W variation in cj indirectly leads to a variation in the real wage Pjj . Since the markup and the real wage have a negative impact on the external balance, an action on the creation of firms is a structural reform that makes it possible to influence the external balance and, if necessary, to reduce it (according to the reasoning above). Notice that two structural parameters were left aside. These are the two elasticities of substitution ηj and ζj . Governments do not have the capacity to determine the

308

8 Structural Adjustments and Reforms

preferences of agents (at least in democratic societies) and their relative tastes. Nevertheless, it can be argued that public policies can indirectly modify relative tastes: through urban planning policy, advertising regulations, land use planning and access to new markets.

8.4.5.2 The Possibility of Multiple Non-cooperative Equilibria So far, we have reasoned about structural policies pursued by a country that is a member of a monetary union, taking as a given the structural configuration of the other country. This is an unrealistic assumption: politicians in one country react to structural reforms in another country because, as we have seen, they have crossborder effects. The study of the impact of structural reforms carried out in a monetary union must take these induced effects into account. One way of doing so is to argue that these reforms are determined in a non-cooperative game between the public officials in charge of the structural configuration of their country. Let us reason about the case of a monetary union with two countries of the same size (m1 = m2 , fixed). The two member countries are structurally identical. We assume β1 = β2 = β, ζ1 = ζ2 = ζ, f1 (u) = f2 (u) = f (u). The number of firms established in each country depends on the fixed cost cj , which is determined by the public authority of country j (j = 1, 2). The public authority may set the cost at its discretion in the interval [cmin , ∞[, with cmin ≥ 0. It follows that the level of wages and thus unemployment in country j are functions of the setting of the cost cj . According to (8.7), (8.14) and (8.19), we get   μ mj (1 − β)   , (8.20) cj = 1 + μ mj   f uj =

1  , 1 + μ mj 

Yj = 1 − uj = 1 − f

−1

 1   . 1 + μ mj

(8.21)

(8.22)

We slightly modify the determination of the external balance, given by (8.10), to take account of the fact that the (closed) union is formed by two countries. Let us assume ⎛ ⎞     −1  −ζ     1 − βμ mj 1 − βμ mj  Yj mj ζ Wj ⎠.     Sj = S =S⎝ Wj  Yj  mj  1 + μ mj 1 + μ mj  (8.23)

8.4 A Simple Model for Structural Reforms in a Monetary Union

309

In each country, the public authority of country j (j = 1, 2), the government seeks to minimize a loss function whose arguments are the size of the external surplus and unemployment. It is written Lj =

 2  1 Sj + λ uj 2

j = 1, 2.

(8.24)

The government has an external objective, which is to reduce its external balance (and not to be too competitive because this implicitly represents a lack of consumption) and also an internal objective, to reduce unemployment. Unemployment is an increasing function of the cost of setting up a business (because it rises when the margin rate and the wage increase). We have seen that the external balance is an ambiguous function of the number of firms in a country, and therefore of the cost of setting up a business.15 We can write ⎞   −1  −ζ     ζ   1 − βμ mj  1 − βμ mj Yj mj ⎠ = S cj , cj      Sj = S ⎝ Yj  mj  1 + μ mj 1 + μ mj  ⎛

(8.25)   since c and c condition m , m , Y and Y . Let us approximate the function j  −j j j j j  S cj , cj  as a quadratic function of the difference between the two creation costs:    2 S cj , cj  = s · cj − cj 

(8.26)

with s being positive or negative (since we have just said that the external balance is an ambiguous function of cj and therefore of cj  ).16 Similarly, suppose that unemployment is an increasing function of the cost cj   uj = v c j

(8.27)

  with v  > 0. If the function S cj , cj  is decreasing in cj , the decrease in this cost decreases but increases the external balance. Otherwise if the  unemployment  function S cj , cj  is increasing in cj ), it reduces both unemployment and the external balance. The functioning of the monetary union depends on the pair (c1 , c2 ) that results from the fixation by each of these authorities. Let us assume that this fixation is the result of an uncooperative interplay. The game unfolds as follows: 1. Governments simultaneously but uncooperatively determine the pairs of structural parameters c1 and c2 . 2. Wages are negotiated, prices of goods are set and transactions take place on the markets. 15 From 16 The

(8.20) and (8.22), mj and Yj are indirect functions of cj . case where s is null is excluded.

310

8 Structural Adjustments and Reforms

Each government solves the following optimization problem minLj = cj

2   1     1 Sj + λ uj = s · cj − cj  + λν cj 2 2

j = 1, 2 (8.28)

under the constraint c−j

given.

The first-order conditions lead to the following reaction functions cj =

s s+

λ  2ν

      cj  = R cj  , cj

∀j = 1, 2; j  = 1, 2.

The reaction function R(·) is increasing in cj  if s is positive and decreasing otherwise. From this we immediately deduce the following results 1. The costs of creation of the companies are “strategic complements” if s is positive dcj < 0. dcj  2. They are “strategic substitutes” if s is negative and sufficiently different from 0 dcj < 0. dcj  Since the two countries are structurally identical, the equilibrium of the game is defined by the balance of the external balances of the two countries S1 = S2 = 0 and the solutions of the governments’ optimization programmes are c1 = c2 . These properties are important to define the game equilibrium properties. We can indeed put forward the following proposition Proposition 8.1. 1. If s is negative and sufficiently different from 0, the solution of the equilibrium of the game, cN , is unique.

8.4 A Simple Model for Structural Reforms in a Monetary Union

311

Fig. 8.1 Equilibria

2. If s is positive, there can be multiple equilibria, corresponding to multiple solutions. Figure 8.1a,b allows us to understand what happens depending on the shape of the curves corresponding to decreasing or increasing reaction functions. According to Proposition 8.1, there may be multiple equilibria in structural adjustment when the reaction functions of the players are increasing. The structural reform game is a coordination game [7]. If cost decisions are strategic substitutes, the increase in the action of one player leads to the decrease in action of the other player. This has a countervailing effect and the equilibrium is unique. In the case of strategic complements, on the contrary, a reinforcing effect occurs. This reinforcing effect can lead to multiple equilibria. Let us consider that there are two such equilibria. The “low” equilibrium (at low cost c) is clearly preferable to the “high” equilibrium because it implies lower unemployment rates in both countries, the external balances being zero in any case. It is thus possible (under certain conditions, which are met here) to classify the equilibria according to their normative properties. This opens up a new question: how to move from a lower equilibrium to a higher equilibrium? This is a coordination problem. The impetus for national governments to coordinate and jump from a lower to a higher equilibrium may come from an external body17 or an inter-governmental consultation procedure. The point of Proposition 8.1 is to show us that it is not enough to study a structural

17 The

role of the European Commission in the European Union and its “right of initiative” may be understood as a coordination device.

312

8 Structural Adjustments and Reforms

reform such as reducing the cost of setting up a business in a single member country. Indeed, a structural measure taken in one country depends on its context. More generally, the decision to carry out structural reform generates reactions in the partner countries. Possibly in the same direction: this is the meaning of the concept of strategic complementarity. If this is the case, the economy of the union may be characterized by several equilibria. It is likely that these equilibria are not equivalent in terms of well-being. One may be a “low” equilibrium, leading to low welfare. In our example, high unemployment. The other may be a “high” equilibrium; in our example again, low unemployment. Put in different terms, it is not enough for a member country to simply embark on a programme of structural reform to solve its problems. The reaction of partner countries can lead to a result that is contrary to what is anticipated. A structural reform programme can lead to unwanted effects, which can cancel out or even worsen the situation. It should be noted that the cooperative solution or the one that would be taken by a federal authority able of choosing a fixed cost level valid for both countries of the union would be different. Formally, such an authority, attaching equal weight to each of the two countries, minimizes the following loss function    L1 + L2 = E (S1 )2 + (S2 )2 + λ (u1 )2 + (u2 )2 . We can offer the following proposition Proposition 8.2. The cooperative decision on a fixed cost common to both member countries of the union is cmin . The explanation is simple. The federal authority takes into account the fact that current balances must be equal and that the macroeconomic balance of the union requires that they be zero, regardless of the level of cost. The loss function that this authority minimizes is therefore   L1 + L2 = E (u1 )2 + (u2 )2

j = 1, 2.

Since countries are symmetric and unemployment rates are increasing functions of the fixed cost, the optimal solution is cmin . This solution is lower than the noncooperative solution if cN > cmin . This is due to the existence of a negative externality that is taken into account. The search for a reduction of the surplus by one country through the manipulation of the fixed cost implies an increase in the surplus in the other, which represents an increase in its welfare loss, a negative externality. This other country is led to react to it by varying its own cost. The result is a non-cooperative solution that is superior to the cooperative solution cmin . The first lesson to be drawn from the resolution of this model is that a structural adjustment programme in a single member country of a union generates spillover effects across borders and leads to compensatory reactions from the other member countries. The result is sub-optimal. In our model, the non-cooperative equilibrium is characterized by a higher-than-optimal cost of creation and hence a higher level

8.4 A Simple Model for Structural Reforms in a Monetary Union

313

of unemployment. It is therefore impossible to analyse a structural adjustment programme carried out in one country, and by extension structural reform, without taking into account the impact it has on other countries. It is logical to think that such a programme generates structural adjustment reactions in these countries.

8.4.6

Structural Reforms at the Union Level

The demonstration of the superiority of a cooperative solution covering an entire monetary union naturally leads us to reflect on the advisability of envisaging that a programme of structural reforms be carried out by an authority covering the union and seeking to optimize the functioning of the economy of the union and not of a single country. In the framework of our model, in addition to the action on the cost of setting up firms that we have just studied, a structural policy at the level of the union can relate to the degree of international mobility or to the definition of a uniform unemployment compensation policy. The first is, for example, the proposal that the degree of mobility be uniform: αj k = α, ∀j, k, and that a supra-national authority be responsible for determining (or acting on) mobility in order to reduce differences in the degree of mobility between countries. The second is to replace national compensation schemes with a single scheme, or to have the reservation   wage determined by a single scheme: f (u) ¯ = f J1 k uk . Analysis of these policies in our model would follow the reasoning in the previous subsection. The major problem is political. Behind the technical question of programme resolution lies the question of the capacity of a supra-national authority to control such structural adjustment variables and the question of the political acceptance by member countries (and their electorates) of the objectives, logically supra-national, that such an authority aims at.

8.4.7

Additional Remarks

To summarize what we have learned from this model of structural adjustment, we can conclude with the following methodological remarks: 1. As a result of cross-border effects, structural reforms modifying the structural parameters of one country or group of countries affect the external positions of all the countries of the union without these effects being mitigated by parity adjustments. Lack of cooperation leads to a sub-optimal solution because national decision-makers do not internalize the consequences of their structural decisions on their partners and on the economy of the union as a whole. 2. In the absence of a concerted procedure on structural reforms (or on structural adjustment programmes), a multiplicity of non-cooperative equilibria is conceivable. This poses a problem of coordination between member countries because some equilibria may be preferred to others.

314

8 Structural Adjustments and Reforms

3. Structural reforms, leading to changes in relative wages, generate winners and losers throughout the union and not only in the country(ies) implementing them. The distributional consequences of a structural reform programme are felt throughout the union.18 4. As structural reform measures in one country have cross-border effects and unintended effects on other countries, it is desirable that these programmes be defined cooperatively at the level of the union. 5. Structural reforms defined at the union level may apply to all its member entities. They may be decided and implemented by a federal authority or by consensus among the member countries of the union. The decision-making bodies of these reforms must be attentive to the redistributive effects they generate. The model that has just been used to study structural reforms is obviously a very imperfect description of the complexity of a monetary union. The absence of dynamic considerations and intertemporal exchange rate effects has already been mentioned. Moreover, the model lacks any monetary and financial dimension. Lastly, it can be argued that the key problems of a modern economy are not simply frictions on market adjustments. One may want to design, based on evidence, fantasy or both, an alternative model that is believed more adequate to tackle the problems of adjustment in a monetary union. But when studying this alternative model, the validity of these methodological conclusions on the problems encountered in adjusting and reforming the economic structures of the union will necessarily emerge.

8.5

Conclusion

Belonging to a monetary union does not exempt a member country from implementing structural reforms, as it could do in an open economy, if it has monetary sovereignty and benefits from exchange rate adjustments. The reasons for structural reforms are not rendered inoperative by the existence of a monetary union: growth shortfalls due to an imperfect allocation of production factors and chronic and substantial external deficits. We have focused on external deficits because their control is vital for a monetary union. Their counterpart is an increase in the external debt of a member country that it cannot cope with by depreciating its currency. It is likely to jeopardize the durability or the configuration of the union. A monetary union cannot be based solely on cyclical policies and macroeconomic regulation tools. These tools are useful for macroeconomic stabilization, not for the correction of structural imbalances. But the existence of a monetary union makes structural problems more acute and the structural reforms designed to remedy them more complex and difficult to implement. They raise issues that are as sensitive as the problems they are supposed to solve. Macroeconomic policies are less able to accompany them; spillover effects across borders are likely to be stronger in a

18 See

Poilly and Sahuc [25].

8.5 Conclusion

315

monetary union, other things being equal; the political procedures for adopting these reforms are more complex. The first criticism often levelled at structural reforms is that they are a vicious form of “beggar thy neighbour” policy, dragging the countries of the union into a depression. The error of the classics in the 1930s denounced by Keynes is being repeated. This criticism is based on a correct argument: there are compositional effects in international macroeconomics, cross-border effects. However the criticism is insufficient because it does not focus on monetary union as such but is a general criticism that is valid for any international economy. A second criticism is that structural reforms relating to goods and labour markets in particular and assimilated to policies of systematic deregulation are based on an uncritical faith in market adjustment capacities and are liberal in inspiration [9, 26]. This criticism has an element of truth: it is difficult to seek to improve the functioning of markets without a minimum of confidence in the role that prices (including wages) play in agents’ decisions and in the allocation of resources. But this does not amount to having absolute confidence in market mechanisms: if such confidence were founded, the dysfunctions that the structural reforms seek to correct would not have occurred and the structural reforms would be pointless. Moreover, structural reforms should not be equated with deregulation, let alone the process of regulation. Suffice it to note that some reforms consist of a strengthening of regulation, whether it be the fight against tax fraud, for example, or the setting up of a banking union. Above all, such criticisms miss the point. Monetary unification requires the direct adjustment of prices and incomes for logical reasons: their indirect adjustment through changes in parity (which does not lead to unbridled liberalism) does not occur in such a system. This requirement is unavoidable regardless of the quality of the price system, i.e. its capacity to clear markets at the lowest cost and quickly. Structural reforms take on considerable importance in a monetary union because they seek to address the difficult issue of the heterogeneity of economic conditions within the union. They amount to internalizing local constraints in the country where they appear and thus avoiding that these constraints be transferred to the central bank of the union. If successful, they alleviate the pressure on the central bank, in particular by reducing the probability or frequency of a serious crisis within the union that would require the bank’s intervention. It is therefore easy to understand why the central bank of the union should be attentive to them and insist, if necessary, on their necessity. To be fully effective, the adjustment of member countries’ current accounts must be both upward and downward, depending on the relative situation of the countries, for the union to function well. The deficit of one country is a reflection of the surplus of the other, and chronic and substantial external surpluses can also be analysed as a structural defect or a failure to adjust macroeconomically. What matters in these joint imbalances is an inadequate international relative price structure, which can be interpreted as prices (including wages) being too low in the surplus country, thereby fuelling a shortfall in aggregate demand. Yet there is always a bias in favour of not increasing incomes and prices upwards in a surplus country. This is a variant of the Bretton Woods dilemma, highlighted

316

8 Structural Adjustments and Reforms

by Keynes, applied to structural reforms. We have already mentioned the existence of such a dilemma in a monetary union in Chap. 1, and we need to come back to it. The burden of balance-of-payments adjustment—through structural reforms—rests on deficit countries, while surplus countries are unwilling, or at least not compelled, to reduce their surpluses. In doing so, they create a negative externality in the international system. This fundamental financial asymmetry is found in a monetary union, for the same reasons. Thus external imbalances in a monetary union highlight the nagging problem of a monetary union: structural asymmetry undermines the adjustment capacity of the system, including through structural reforms. Therefore the question of adopting and implementing a programme of structural reforms is the most delicate issue in a monetary. A reform programme designed for a member country with a deficit is difficult to put in place and to defend before public opinion in the country concerned for three reasons: 1. The costs involved are immediate and fairly accurately assessed by those who bear them, while the benefits to be expected in the long term are uncertain, global and difficult to anticipate. Opponents are determined, while supporters of reforms are difficult—if not impossible—to mobilize. 2. It is tempting to seek to shift the burden of adjustment onto partner countries or to wait for exceptional assistance from partners, thus adopting an non-cooperative attitude. 3. It is not obvious that the adjustment of external accounts should be limited to the country in deficit. Moreover, since they increase, at least temporarily, the heterogeneity in the union and sharpen the redistributive effects, they fuel dissension within the union. Structural reforms are more difficult to adopt in a monetary union than in a simple economy. The solution to this dilemma lies in a cooperative approach to the adjustment of external accounts within a monetary union. The fundamental reason for this is that a country’s situation is relative. Part of the reason why a country’s situation is worsening is because one of its partners is taking advantage of the system. A consistent case for structural reforms requires recognition of some form of cooperation, whether adopted by a set of countries or by all, at the level of the union. This is the same observation that we made with regard to the budget. The coordination of structural reforms thus contributes to the economic and social integration necessary for monetary union.

References 1. Agnello L, Castro V, Tovar Jalles J, Sousa R (2015) What determines the likelihood of structural reforms? Eur J Polit Econ 37:129–145 2. Bernanke B (2005) The global saving glut and the US current account deficit. Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/boarddocs/speeches/2005/ 200503102/

References

317

3. Blanchard O, Giavazzi F (2003) Macroeconomic effects of regulation and deregulation in goods and labor markets. Q J Econ 118:879–907 4. Buiter W (2015) Unemployment and inflation in the euro area: why has demand management failed so badly? ECB Forum on Central Banking, Sintra 5. Calomiris C (2010) The political lessons of depression-era banking reform. Oxf Rev Econ Policy 26:540–560 6. Claeys G, Darvas Z, Wolff G (2014) Benefits and drawbacks of European unemployment insurance. Bruegel Policy Brief 2014/06 7. Cooper R (1999) Coordination games. Cambridge University Press, Cambridge 8. Cooper R, Haltiwanger J (1993) Automobiles and the national industrial recovery act: evidence on industry complementarities. Q J Econ 108:1043–1071 9. Crespy A, Vanheuverzwijn P (2019) What ‘Brussels’ means by structural reforms: empty signifier or constructive ambiguity? Comp Eur Polit 17:92–111 10. De Bandt O, Vigna O (2008) The macroeconomic impact of structural reforms. Bulletin de la Banque de France 11:5–31 11. De Linde L, Stanley M, Doucouliagos H (2014) Does the UK minimum wage reduce employment? A meta-regression analysis. Br J Ind Relat 52:499–520 12. Draghi M (2015) Opening speech, ECB Central Banking Forum, Sintra, 22 May 2015. https:// www.ecb.europa.eu/press/key/date/2015/html/sp150522.en.html 13. Dustmann C, Fitzenberger B, Schönberg U, Spitz-Oener A (2014) From sick man of Europe to economic superstar: Germany’s resurgent economy. J Eco Persp 28:167–188 14. Eggertsson G (2012) Was the new deal contractionary? Am Econ Rev 102:524–555 15. Eggertsson G, Ferrero A, Raffo A (2014) Can structural reforms help Europe? J Monet Econ 61:2–22 16. Eichengreen B (1992) Golden fetters. Oxford University Press, New York 17. Hardin G (1968) The tragedy of the commons. Science 162:1243–1248 18. Krahnen J (2015) Rescue by regulation? Key points of the Liikanen report. In: Dombret A, Kenadjian P (eds) Too big to fail III: structural reform proposals. De Gruyter, Berlin,pp 23–46 19. Krebs T, Scheffel M (2013) Macroeconomic evaluation of labor market reform in Germany. IMF Eco Rev 61:664–701 20. Mabbett D (2016) The minimum wage in Germany: what brought the state in? J Eur Publ Policy 23:1240–1258 21. Meltzer A (2003) A history of the federal reserve, 1913–1951, vol 1. Chicago University Press, Chicago 22. Myers M (1970) A financial history of the United States, Columbia University Press, New York 23. Olson M (1965) Logic of collective action: public goods and the theory of groups. Harvard University Press, Cambridge 24. Petroulakis F (2017) Internal devaluation in currency unions: the role of trade costs and taxes. European Central Bank Working Paper n◦ 2049 25. Poilly C, Sahuc J-G (2008) Welfare implications of heterogeneous labor markets in a currency area. Banque de France Working Paper 109 26. Scharpf F (2014) Comment: The eurocrisis as a victory of neoliberalism? In Fossum J, Agustín J (eds) The European Union in Crises or the European Union as Crises? Arena, pp 143–154. https://www.sv.uio.no/arena/english/research/publications/arena-reports/2014/report-2-14.pdf 27. Summers L, Rachel L (2014) On falling neutral real rates, fiscal policy and the risk of secular stagnation. Brookings Papers on Economic Activity BPEA Conference Drafts 7 28. Vinals J, Pazarbasioglu C, Surti J, Narain, Erbenova M, Chow J (2013) Creating a safer financial system: will the Volcker, Vickers, and Liikanen Structural measures help? IMF Staff Discussion Notes 13/04

9

Fiscal Union

Abstract

A critical component of a monetary union is the fiscal setting under which member countries operate. Chapter 9 looks carefully at this setting, which can be seen as a fiscal union as member countries must agree on some fiscal operating regulations. Two main options are possible: fiscal federalism or intergovernmental negotiations. It is impossible to claim that one is superior to the other. The issue hampering a fiscal union of any variety is an opportunistic behaviour of member states, exploiting moral hazard. The mutualization of public bonds and the creation of a union-endorsed bond or security are discussed as well as the implementation and assessment of a fiscal union.

From the preceding chapters it is clear that it is impossible to establish and operate a monetary union without taking into account the fiscal powers of the public entities that form the monetary union, both in their relations with the monetary issuing institution of the union and between them, in an intertemporal perspective. The interdependencies between public Treasuries exist regardless of the monetary arrangement. If we reason on the basis of sovereign States, these interdependencies depend on the established exchange rate regime. International macroeconomics has long identified and studied them (Feenstra and Taylor [5]). But variations of the exchange rate make them less effective. Foreign countries are less affected by the fiscal vicissitudes of a given country thanks to exchange rate movements. Exchange rate movements are a manifestation of the market discipline that operates at the international level on sovereign public debt. This discipline is reflected in the borrowing interest rates that are offered to sovereign states. Yield spreads, linked to default risks, affect international financial flows and exchange rates. Moreover, there is no international lender of last resort: The IMF is careful not to play this role and simply facilitates negotiations between creditors and the defaulting state, if necessary through temporary and conditional loans. In the absence of exchange © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_9

319

320

9 Fiscal Union

rates, the management of this interdependence raises the question of fiscal union, associated with a monetary union. Section 9.1 defines what is meant by fiscal union. The option of international cooperation in fiscal matters is discussed in Sect. 9.2. The problems surrounding fiscal federalism are presented in Sects. 9.3 and 9.4. Section 9.5 deals with opportunistic behaviour in fiscal matters and Sect. 9.6 with the question of the mutualization of public debt. The establishment of a fiscal union is dealt with in Sect. 9.7 and the evaluation of such a union in Sect. 9.8.

9.1

What Is a Fiscal Union?

Fiscal interdependencies between sovereign countries belonging to a monetary union lead to a de facto fiscal union. It is then compulsory to establish the legal and institutional frameworks necessary or desired to manage this inevitable solidarity. Let us define a fiscal union by adapting the definition we have given of a monetary union: A fiscal union is an institutional agreement between public entities that are fiscally autonomous but economically interdependent, covering the fiscal constraints and possibilities imposed on the parties to the agreement.

Such a definition emphasizes the permanence of the links established, as opposed to ad hoc cooperation linked to particular circumstances. Based on this definition, we can distinguish between inter-national and national fiscal unions. The former concerns sovereign States, the latter public authorities within a given State. Nothing in the previous definition presupposes monetary unification. This is selfevident in the case of a national fiscal union. But there is no requirement that an international fiscal union must be achieved within the framework of a single currency. In fact, the example of the IMF is a good illustration of this. By creating the IMF, an institution that, in the event of an exchange rate crisis, has the capacity to intervene in the budget of the requesting country according to the rules laid down and agreed upon by the member countries of the agreement, the Bretton Woods agreements founded an international fiscal union.

9.1.1

Why a Fiscal Union?

The question of a fiscal union among sovereign members of a monetary union arises because of the fiscal interdependencies that bind these countries together. There are positive interdependencies that lead to an agreement to pool resources or decide public policies together. If a government does not take into account the positive effects of private or public decisions in determining its public policies, it underestimates the benefits to the community. If this is the case for all governments, the result will be a set of sub-optimal decisions in the sense of Pareto.

9.1 What Is a Fiscal Union?

321

It is also possible that there may be economies of scale or scope within the set of nations considered. Joint public action by a group of countries on a larger scale is more effective and therefore beneficial to each of the partner countries, or better ensures diversity of needs through greater differentiation of public provision. But there are also negative interdependencies. Cross-border effects can be negative and amount to nuisances, generated by one country and suffered by another (or others). Similarly, there may be diseconomies of scale:1 The increase in size or pooling of fiscal instruments leads to a loss of effectiveness of these instruments because they are less adapted to differentiated economic conditions or because their management entails increasing unit costs. In any event, whatever the direction of these effects, a concerted policy of the countries concerned is desirable and justifies a form of fiscal union. The terms used seem to refer to public economics and not to macroeconomics. But such a separation is misleading. It is easy to give directly macroeconomic examples of positive or negative cross-border effects. Positive cross-border effect: Think of a fiscal stimulus policy practiced by a given country in case of under-activity. It will benefit its trading partners through an additional outlet for their products. Negative cross-border effect: Two countries are in opposite phases of the business cycle. The counter-cyclical policies pursued are contradictory and harm each other through cross-border effects. Let us also consider the financial difficulties of one country. These will weaken creditor countries and increase the cost of credit (public and/or private). More generally, cross-border effects are not limited to allocation problems but are also present in terms of stabilization.

9.1.2

Fiscal Union Between Integration and Differentiation

Abstracting from historical and political considerations, since there are many fiscal interdependencies as seen in Chaps. 5 and 6, an immediate temptation is to think that the solution lies in a single fiscal authority capable of internalizing all externalities. However, fiscal integration is not systematically desirable for two main reasons. On the one hand, national communities (to simplify, we reason for the moment on the basis of a plurality of Nation—States) have different preferences for public goods; national economies are differentiated and the channels of transmission of public policies differ. It is simpler to take this diversity into account through a variety of public institutions, which are better able to differentiate and respond to national specificities. To the extent that taxation in the union is uniform or independent of national preferences for public goods, integration will create tax distortions. Moreover it is likely to be combined with a trend towards uniformity of public policies. Conversely the idea that preference differentiation legitimizes the differentiation of public authorities has been theorized by Tiebout [13] and is at the foundation of local public economics: In a situation of factor mobility, in the absence of cross-border externalities, economic agents “vote with their feet” and

1

We neglect the case of diseconomies of scope.

322

9 Fiscal Union

group together into homogeneous communities according to different preferences for public goods, which may be different. Public management (whether microeconomic or macroeconomic) requires quality information. This quality is likely to improve if the public decision-maker is close to the field of intervention. A local decision-maker, responsible for a local jurisdiction, has better information and more generally a better information capacity, so as to take decisions that must “stick to the ground”, than a central decision-maker having to manage an enormous mass of information corresponding to differentiated local situations. On the other hand, interdependence requires public management tools capable of taking into account cross-border effects, be they negative or positive, and therefore going beyond the national framework. Full-fledged integration, which is too radical and probably too costly, not being the solution, a fiscal union appears as a reasonable option. The contours of a fiscal union can be seen as a trade-off between the factors pushing for the integration of nations (jurisdictions) and those legitimizing their differentiation.

9.1.3

Sovereignty and Fiscal Union

Fiscal union raises the question of the fiscal sovereignty of its member States. Two types of fiscal union are conceivable: inter-national fiscal union and supra-national fiscal union. 1. An inter-national fiscal union is based on the sharing of fiscal sovereignty between member States. The sharing of fiscal sovereignty is understood as the fact that some of the fiscal decisions taken by member States are taken in consultation with all the members of the union. However they retain the exclusive right to decide on taxing and spending in their respective territories. An example of an inter-national fiscal union is the establishment of common rules applied to the member States of a monetary union. Similarly, public spending and tax cooperation agreements between member States are part of such a union. 2. A supra-national fiscal union is based on a partial transfer of member States’ fiscal sovereignty to a supra-national institution. The transfer of fiscal sovereignty means that member States give to a supra-national institution the capacity to levy certain taxes and to spend in their respective territories. The union agreement covers the characteristics of this supra-national institution, its governance and the precise definition of its fiscal and spending capacities. It defines the tax bases, the types of taxes allowed and the spending arrangements of this institution. The establishment of a federal fiscal authority by the member States is characteristic of a supra-national fiscal union. The federal Treasury can levy certain taxes throughout the territory of the union. The public expenditure that it finances by these taxes involve international transfers because the Treasury does not systematically return as public expenditures in a member State the proceeds of federal taxes levied on residents in its territory.

9.1 What Is a Fiscal Union?

9.1.4

323

International Transfers

The fiscal union options have differentiated consequences for public financial transfers between member States. The option of constraining rules for member States’ public finances is a priori the least favourable to these transfers. It is logical to think that their introduction is explained by the collective desire of member States not to make such transfers. By limiting public deficits or debt, international transfers are in fact capped. But not excluded: in the event of a major crisis, the rules themselves may allow member States to suspend the ceilings or to apply an opt-out clause. Inter-governmental cooperation does not prohibit transfers but, if they are practised, it is on a discretionary basis when one State agrees to help another within the framework of the cooperation that binds them. As this is a sensitive political decision that must be justified to the taxpayer/voters, it logically occurs only in the event of a serious crisis. Fiscal federalism is, on the contrary, based on such transfers: The net transfer to a member State is equal to the difference between what the federal Treasury spends in the national territory and the federal taxes it collects in that same territory. It is indeed a transfer received from other Member States since this difference is covered by taxes levied in those other member States.2 This is the essence of fiscal federalism: using federal fiscal instruments, including international transfers, with the aim of ensuring risk-sharing throughout the union.3

9.1.5

Policy Dominance

The fiscal union options resolve the relationship between fiscal authorities and the central bank in different ways. The option of a union based on constraining rules is the most conducive to central bank independence as it constrains national fiscal authorities and, if effective, reduces the financing needs of member States and thus their pressure on the central bank. The other options are ambiguous. They may increase pressure on the central bank or, on the contrary, strengthen collective fiscal discipline. Supranational fiscal institutions, set up within the framework of fiscal federalism, are the natural interlocutors of the central bank of the union, which is also a supranational institution. The question of the dominant policy among these institutions then logically arises. The problem also arises in the case of inter-governmental cooperation, which can be interpreted as the establishment of a coalition between governments. This coalition can play the role of conciliation with the central bank as well as increased pressure and the search for a dominant position. The strategic position of the central 2 3

We assume for simplicity of reasoning that the federal budget is balanced. Said differently, no member State can claim “I want my money back”.

324

9 Fiscal Union

bank is in any case modified by the presence of a fiscal union in a way that is not necessarily favourable to its independence.

9.2

International Fiscal Cooperation

A fiscal union can be thought of as a scheme for international cooperation. Cooperation means jointly taking or at least consulting each other on economic policy decisions on the basis of shared information and diagnosis, then each partner implements the policy decided upon according to a pre-established negotiation procedure, as far as it is concerned, i.e. manipulates—according to the agreement reached—the instruments under its control. Let us reason within the framework of a simple multi-national monetary union, without a supra-national fiscal authority, consisting of a single supra-national authority, the central bank, and the national fiscal authorities, responsible for their fiscal policies. In such a framework, cooperation between fiscal authorities is able to improve the functioning of the union by internalizing the cross-border effects of fiscal policies. This cooperation can be seen in two ways: 1. Cooperating between authorities of the member countries of the union in the definition of fiscal policies. 2. Establishing rules to ensure the coexistence of these policies and limit or eliminate their collectively harmful aspects for the union. In practice, what is meant by the concept of cooperation between national fiscal authorities? Different degrees of cooperation can be envisioned. 1. The exchange of information. The purpose of this first option is to define standardized procedures and typologies, making fiscal decisions easier to understand and limiting “imaginative accounting” operations. For institutional and historical reasons, fiscal procedures differ from one country to another. Not only in terms of policymaking, but also in terms of recording flows because public accounting rules differ from one country to another. If sovereign States decide to form a monetary union, given the importance of the fiscal component in the functioning of the union, it is necessary to discuss the problems posed by these differences. The first problem is the commensurability of figures and accounting aggregates. It is important that the same terms correspond to the same realities, or that the quantified measures actually measure the same things, so that the assessment of the respective fiscal situations can be made properly. Otherwise, similar numbers (like a deficit of x% of GDP) for two countries could lead to erroneous diagnoses because the realities measured differ. Addressing this first problem involves a twofold conceptual and statistical challenge. On the one hand, the accounting definitions used must be homogeneous. On the other hand, the statistical input devices must also be reliable and of the highest possible quality.

9.2 International Fiscal Cooperation

325

The second problem is the compatibility of public fiscal procedures and practices. The preparation of budgets by public institutions must comply with common rules of sequencing, control and commitment so that comparisons are made possible, both for market operators and for regulators responsible for institutional discipline. There may be a need to reform fiscal procedures before forming a monetary union, or joining an already formed union. Lastly, remark that there are no natural and objective criteria for drawing up a budget that would be binding on all. There is a contingency or a degree of freedom in fiscal matters that cannot be eliminated, despite efforts to achieve commensurability and homogenization. It is within this margin that the fiscal sovereignty of a State can be exercised and allow it to take opportunistic measures, aimed at disguising the fiscal reality either to take advantage of existing rules or hide their political incapacity or administrative incompetence to contain the deficit. The list of ways in which fiscal constraint can be loosened is endless and is covered by the term “imaginative accounting”. This trend is not specific to countries that are members of a monetary union but it is certainly stronger in this case. Indeed, institutional discipline in the union gives rise to the temptation for those in charge of a public institution to free themselves as much as possible from the constraints it implies in fiscal matters and use the existing room for manoeuvre in the best interests of the immediate interests of the institution in question. One might think that this modality of cooperation does not pose any difficulty between partners who have pooled their monetary sovereignty: They all have an interest in ensuring that none of them lies about its budget or conceals its fiscal and fiscal decisions. But this is far from obvious. Despite the establishment of Eurostat, Greece, for example, has for years been able to disguise its public accounts and underreport the size of its deficits. Similarly the example of the transparency of fiscal rulings painfully introduced in the euro zone is a perfect illustration of the difficulty of this statistical and procedural cooperation.4 In any case, it is difficult to envisage a permanently functioning monetary union without such an exchange of information. 2. The establishment of joint actions in normal circumstances. This second option consists in the definition and implementation of the macroeconomic policies of the member countries in a cooperative manner through deliberation or the application of commonly agreed procedures. The prerequisite for this option is the sharing of a macroeconomic diagnosis covering the union as a whole and the needs of the various member countries. The application of the measures decided on must be the subject of cross-checks and a joint assessment by the partners. Such cooperation does not imply that the measures taken by the various national fiscal authorities are identical but that they are approved by the various partners. It requires credible cooperation institutions.

4

On tax approvals by member States in Europe and the recent decision of the European Commission to investigate such approvals, see [4].

326

9 Fiscal Union

Sharing information is one aspect, but not the only one. Indeed, in drawing up budgets, national administrations must communicate and share their proposals, under the control of governments. The adoption of a national budget is the work of elected and representative assemblies. In the case of a cooperation procedure, these assemblies must assume this objective and validate by their vote the idea that the measures adopted are adopted partly with a view to ensuring the coherence of the monetary union and to helping partner countries. In other words, they must assume before their electorate that part of the taxes collected serves objectives that lie beyond the country’s borders. This is a delicate task, as such behaviour runs counter to the political logic on which the Nation-State was built. The fact that this cooperation takes place under normal circumstances means that the cooperation itself is normal and regular. The various instances involved in this cooperation and the process itself are the results of an institutional agreement between the member countries. Fiscal cooperation thus represents a sharing of fiscal sovereignty in the following sense: The decision on the national budget is not taken exclusively by the national parliaments, just as its ex post validation is not the sole responsibility of the national parliament. 3. The establishment of joint actions in exceptional circumstances. Fiscal cooperation between member countries is probably easier in exceptional crisis circumstances. On the one hand, crisis circumstances, whether economic or international, are most often common to all member countries and affect them in a way that is at least similar, if not identical. A common response is easier to find since the interests of all are convergent. On the other hand, common action in times of crisis is itself perceived as exceptional. Moreover, these exceptional and often catastrophic circumstances make it easier to diagnose and reduce the weight of the political positions of the national governments in power. 4. The introduction of rules of fiscal commitment. A final modality of cooperation is the adoption of fiscal commitment rules through consultation, for example with regard to automatic stabilizers. It can be assumed that rules setting up automatic stabilizers in member countries are adopted by consultation between member countries. These rules may make public expenditure programmes dependent on indicators relating to the union as a whole, or on the cross-border effects at work in the union. This does not make these rules less visible, nor does it take them out of the political discussion. But discussions on their merits and their possible challenges are not linked to the diagnosis and the macroeconomic conjunctural forecasts. Such rules also imply a sharing of fiscal sovereignty, in their necessarily collective elaboration or their adoption by the various parliaments of the member countries.

9.3 Fiscal Federalism

9.3

327

Fiscal Federalism

A supra-national fiscal union can be seen as a federation, providing for a supranational budget authority with its own resources and spending capacity. A federation is thus a pyramidal (nested) structure of public entities differentiated by their territory of intervention. A federation is based on (at least) two fiscal levels: the national public Treasuries and the federal Treasury. An agreement between member States provides for the conditions of legislative and judicial control of the latter body. Fiscal federalism refers to all the public financial arrangements governing the fiscal actions of the various public authorities, and in particular inter-jurisdictional fiscal relations. The advantage of fiscal federalism is that it provides new instruments and allows intervention at the level of the union as a whole. On the other hand, its more complex functioning raises the question of the coordination of decisions taken by the various fiscal bodies and the allocation of responsibilities between these bodies. We are used to seeing a federation as a hierarchy of public authorities where the central level plays the leading role and the lower levels depend on the central level both for the definition of their field of action and their fiscal autonomy. This is logical in the case of a State since the central level exercises sovereign powers and has the national sovereignty that conditions all other public policies. Other configurations than the one of a centrally led hierarchy are possible. Such as the opposite situation, where the central level acts by delegation from the lower authorities, both in terms of the amount of resources it may have at its disposal and the actions it is authorized to carry out. Thus the hierarchical relationships between levels of government are not necessarily top-down, but can be bottom-up. For a long time a privileged field of study of local public economics, fiscal federalism is most often approached in a national framework without any monetary dimension (Kitchen et al. [9]). The macroeconomic dimension of fiscal federalism is less studied. This is reasonable when local authorities are small and have no macroeconomic responsibility, which is the assumption made in local public economics. But it is not justified when, as in the case of a monetary union, the components of the federation are sovereign countries of significant size, with significant instruments at the macroeconomic level and capable of assuming fiscal policies of stabilization or orientation of growth. Fiscal federalism can be associated with a national monetary union. In this case, the federal level concentrates fiscal sovereignty and the sub-national entities act by delegation from the central level. But it can also be combined with a supranational monetary union. In this case, as mentioned above, the member States of the union retain some fiscal sovereignty and delegate some of it to a supra-national fiscal authority, which does not have the status of a State under international law. Analysing fiscal federalism consists in studying the distribution of competences and fiscal instruments (taxes and expenditure) among hierarchical public authorities. It is approached through the classic triptych of the public economy, stabilization—

328

9 Fiscal Union

redistribution—allocation. The redistributive function is generally considered to be the responsibility of the national level, which is the guarantor of national unity. The distribution of public responsibilities in terms of resource allocation can be analysed by mobilizing several factors: comparative advantages of different territories, differentiated preferences of populations, mobility of factors, transborder economic effects (or territorial externalities). In this respect, the problem of competition between territories to attract factors of production according to their degree of mobility is emerging. Even within a national entity, local authorities are de facto in competition with each other.

9.3.1

Macroeconomic Analysis of Fiscal Federalism

Similarly, the issue of macroeconomic stabilization can arise at the central level as well as at the level of sub-national governments. Traditionally, fiscal federalism, rooted in public economics, has paid little attention to this issue, particularly because the size differences between the central and local governments in most countries deprived the latter of macroeconomic responsibility. This changes in the case of a monetary union such as the European Monetary Union, which is made up of large nations with complex productive structures and fiscal tools assuming a stabilizing function in national economic activity. Fiscal federalism consists of supplementing this macroeconomic intervention mechanism with a supra-national fiscal authority, capable of intervening in the union. Implicitly, it is accepted that this fiscal authority is concerned with the economy of the union as a whole, has the means to analyse and monitor the economic situation, and uses tools that cover the entire union with a concern for equity between member countries. All these hypotheses are debatable but let us admit them in order to advance in the reasoning. The analysis of stabilization in the framework of fiscal federalism amounts to studying the use of various fiscal instruments. This study is based on a diagnosis of the nature of the shocks, which may be global or idiosyncratic, the cross-border effects of these various shocks (which overlap, among other things, with the tax competition effects mentioned above), the relative effectiveness of the various instruments as derived from the analysis of the channels of transmission of fiscal impulses and the objectives of the various fiscal authorities. The macroeconomic objectives of fiscal federalism are in line with those of fiscal policy in general: cyclical stabilization in the short to medium term and orientation of the growth path in the long term. However, the fact that fiscal federalism applies to a union of sovereign countries introduces an additional dimension: Fiscal federalism can ensure the relative stabilization (or growth) of the components of the union as well as the stabilization (or growth) of the union as a whole. This is a major difference from monetary policy insofar as the central bank provides a single nominal anchor within the union but is not concerned (in general) with the control of relative inflation within the union. How should the instruments of fiscal federalism be designed? First, there is the classic distinction between automatic and discretionary instruments. To remain

9.3 Fiscal Federalism

329

within the field of stabilization, fiscal federalism can be based on automatic stabilizers. More novel is the fact that the instruments of the federal Treasury can be direct or indirect. They are direct if they directly affect the economic agents of the union; they are indirect if they are channelled through the national budgets. Indeed, it is conceivable that the federal budget is financed not by taxes but by transfers from the national budgets and that spending decided or planned by federal intervention programmes is channelled through payments to the national budgets. Several conditions are necessary for a well-functioning system of fiscal federalism. The federal fiscal authority must have good macroeconomic information at its disposal, which is essential for assessing the situation and making reliable forecasts. The fiscal process at the federal level must be transparent and efficient. Finally, the transmission channels of economic policy must be properly identified through good macroeconomic modelling.

9.3.2

Fiscal Federalism in Practice

What do the existing federations teach us about fiscal matters (Bordo [2])? The literature on the comparison of federal experiences is immense (Ter-Minassian[12]). Without attempting to be exhaustive, let us review three cases that will allow us to see the diversity of forms of federation and their contrasting dynamics. These three federations have one thing in common: They are associated with national monetary unions. Their past or present difficulties are instructive for the case of a multi-national monetary union.

9.3.2.1 The American Case When it comes to public spending per se, the American states have long predominated relative to the federal state. On the eve of Roosevelt’s administration, local and state governments accounted for 70% of public expenditures and the federal state for 30%. By 2016, these percentages have changed to 35% and 65%, respectively.5 The federal government increased its share of public spending, relative to sub-national public entities. The balanced budget rules applied to states mean that they have little capacity to resort to counter-cyclical fiscal policies. In fact, government spending by states is pro-cyclical, probably because of the need to balance the budget. The US solution is to reserve responsibility for macroeconomic stabilization to the federal Treasury. This is done in part through federal budget transfers to the states, either on a discretionary basis or through automaticity rules. All in all, the American system appears to be reasonably coherent, backed by a multi-secular experience that has allowed for gradual adjustments, most often made on the occasion of major economic or political crises.

5

Out of a total of $7 trillion, or 38.5% of GDP, according to the OECD.

330

9 Fiscal Union

9.3.2.2 The German Case Germany has lived under a federal regime since its unification in 1871 (except during the Nazi period from 1933 to 1945). The Federal Republic of Germany, whose constitution was adopted in 1949, now consists of 16 states (Länder) since its reunification with the German Democratic Republic. Its federalism is often described as “cooperative” (Auel [1]). It is strongly tempered by the constitutional provisions governing the fiscal powers of the various authorities. Federated states are strictly framed by the federal power with the desire for a strong harmonization of living conditions and purchasing power. While the states have a great deal of autonomy in terms of public spending, this is no longer true in fiscal matters. Taxes are decided at the federal level and tax competition between states is made impossible. The states are represented at the federal level by the Bundesrat, which has a veto over tax legislation. The states have to cooperate with each other and with the federal government in order to arrive at the setting of taxes. The distribution of these taxes between the different levels of government and between the states is carried out in a particularly complicated threestage procedure. The result is large transfers from the “rich” to the “poor” states, but also from the federal state to these states in the name of the obligation to standardize living conditions within Germany. German federalism thus appears to be highly controlled and based on a principle of centralized decision-making, particularly with regard to taxation. Moreover, the federal state, through its transfers to the states, has a strong capacity for intervention. Under these conditions, the FRG has been able to operate with a low degree of constitutional constraint on the states. It was only in 2009 that the obligation to balance the budgets of the states was introduced, in connection with the adoption of the same principle for the federal state. The responsibility for macroeconomic stabilization policy lies with the federal state. The independence of the federal central bank, the Bundesbank, was enshrined in the 1949 constitution with the aim of protecting itself from the monetary errors of the 1920s and was generally credited with the success of the fight against inflation until the advent of the euro. Under these circumstances, the federal government managed the counter-cyclical fiscal policy actively but without excess. German public deficits were large in the 1990s following the structural shock of German reunification and then increased significantly following the 2008 crisis. The principle of a balanced budget in the medium term should constrain this stabilizing capacity in the future. 9.3.2.3 The Case of Argentina The Argentine Republic is a federation of 23 provinces of very different sizes. Its functioning is the antithesis of the German case. The provinces have major fiscal responsibilities, both in terms of spending and taxation. The constitution provides that areas of intervention not explicitly vested in the Argentine central state are assumed by the provinces. In particular, social intervention expenditure (related to the welfare state) is carried out by the provinces. With regard to public expenditure,

9.3 Fiscal Federalism

331

the system is based on strong decentralization with little capacity for coordination among the provinces. The only taxes that fall exclusively under the jurisdiction of the central government are customs duties. Indirect taxes are levied jointly by the central government and the provinces while direct taxes are levied exclusively by the provinces. The provinces are free to choose their own tax scales. The central government is in vertical competition with the provinces.6 But the provinces have delegated the administration of taxes, not only their collection but also their setting, to the central government. As a result, the central government, by collecting taxes instead of the provinces, transfers a very large part of its own tax revenues to the provinces. More than half of its budget is made up of transfers to the provinces. The result is a situation of extreme complexity, a “fiscal labyrinth” to use the expression of Saiegh and Tommasi [11], feeding the irresponsibility of all parties involved. This architecture leads to a situation of strong tax competition between the provinces but also to “opportunistic” behaviour. Public spending and deficits are pro-cyclical since the provinces take advantage of expansionary phases to increase their spending and the services they provide to their citizens without raising their tax rates, and turn to the central state to come to their rescue in the turnaround phase when tax revenues dry up. Consequently, the counter-cyclical stabilization policy does not work in the Argentine case. The provinces have the capacity to borrow on the same basis as the central government. Recourse to the central government can therefore be delayed. In fact, the central government provides an implicit guarantee on the public debt of the provinces, which results in a lower market assessment of the provinces’ default risks and lower borrowing interest rates than if the provinces were deprived of this possibility of federal relief. Argentina is a perfect illustration of a State whose public entities operate with a “soft” fiscal constraint. The functioning of the Argentine federation appears to be an example of perverse fiscal federalism since the juxtaposition of government levels is not counterbalanced by powerful coordination or coercive capacities that ensure that the different levels, neglecting the external effects of their decisions, do not adopt irresponsible policies. Other examples could be given, often linked to multi-ethnic or multinational federations, where fiscal laxity towards local (non-national) governments or constituent nations is seen as a parry against the risk of secession. We can draw some lessons from this brief overview of some existing federations. The first is that there is no ideal federal formula that should be applied in any circumstances. It stems from the dilemmas or the different and sometimes contradictory goals that a federation seeks to achieve. The result is a great diversity of existing federation formulas. This diversity can be explained by different historical roots or different formation processes. The second is that fiscal federalism is a formula designed to deal with the diversity of political entities that make up a State or to reconcile national unity with this diversity that stems from history or is dictated by physical or human geography.

6

Vertical tax competition occurs when two public jurisdictions levy taxes on the same tax base.

332

9 Fiscal Union

In other words, a federation is always under the more or less latent threat of break-up or secession. The third is that there can be virtuous or perverse federal logics. Virtuous logic exists when the economic and political functioning of the federation gradually strengthens it, nurturing the growing integration of the parts of the federation and reducing the threat of secession. On the contrary, a federation is in a perverse and ultimately dangerous dynamic when its functioning progressively reduces the desire of its components to act in solidarity, particularly because they find it advantageous to play with soft budget constraints. Constraining rules seem to be a necessary condition for the good functioning of a federation. Its sustainability is based on medium- or long-term fiscal discipline. More specifically, the financial responsibility of the sub-federal jurisdictions of the federation must be established in one way or another in order to limit the deleterious effects of a transfer of burden from one to the other that is not desired by all. Ultimately, a federation is based on mutual trust between its components. It is impossible to rely solely on the legal or administrative texts organizing the federation as these are always imperfect and the constraints imposed can be circumvented.

9.4

Fiscal Federalism or Inter-Governmental Cooperation?

How to choose between a supra-national fiscal union (fiscal federalism) and an inter-national fiscal union (based on inter-governmental cooperation)? Despite its apparent simplicity, cooperation is a complex formula that requires a lot of commitment on both sides, which is difficult to achieve. Firstly, because it is not anchored, or loosely so, in supra-national institutions, it must be more systematically recast than the federal formula and these commitments renewed regularly. It is more exposed to the vicissitudes of national political life, and therefore more fragile. Regardless of their differences of opinion or diagnosis (which is the essence of democracy), political leaders in power or competing for power tend to have short-term objectives linked to their election or re-election. But the benefits of cooperation are obtained in the long term when solidarity has been exercised to the benefit of one or the other, the time needed for national electorates to become convinced and support the formula. The “tragedy of the horizons” is a major weakness of the cooperative formula. Secondly, because any fiscal policy has redistributive effects, even if this is not its objective or at least not its stated objective. The sharing of risks within a monetary union linked to the stabilization policy, as we saw in Chap. 1, implies international transfers. However, the electorates are to varying degrees subject to uncooperative arrangements or sensitive to identity-based pressures that often (and badly) hide the will not to share. The sustainability of cooperation is therefore fragile. Fiscal federalism too is a formula that is delicate to put in place. If it is based on stronger institutional arrangements than cooperation, it can, on the other hand, be extremely complex to operate and generate major inefficiencies, due to

9.4 Fiscal Federalism or Inter-Governmental Cooperation?

333

its cumbersome nature, information issues, the difficulty of implementing fiscal policies and of reconciling the positions of the different levels of government. Fiscal federalism cannot appear as a panacea and generates conflicts of interest between stakeholders. In particular it generates international transfers that can create divisions between member States.7 Let us leave aside the important issues of implementation, trust and credibility. Assuming that each of the two formulas enjoys the most favourable situation in these matters and that its solidity is not threatened, it is still not possible to argue that one or the other of these two options should be preferred to the other. The reason for this is simple. The advantage of fiscal federalism in terms of the macroeconomic stabilization of a monetary union is twofold: On the one hand, the federal authority has (logically) a global vision of the economy of the union and therefore seeks by vocation to take into account the cross-border effects of shocks; on the other hand, it increases the number of macroeconomic instruments used, which a priori makes stabilization easier. But this formula has a drawback: It brings a new player into the game and this changes the strategic relations between all of them. The autonomy of the federal authority implies that it behaves in a non-cooperative manner vis-àvis the national fiscal authorities. The resulting non-cooperative effects may well be negative. Inter-governmental cooperation does not a priori imply the introduction of additional instruments. But—assuming that it is sincere—it does make it possible to internalize and take better account of the cross-border effects of national fiscal decisions by the very fact that the fiscal authorities cooperate. From a theoretical point of view, the comparison of the two formulas can be summarized as follows: – The advantage of direct cooperation between member countries of a monetary union over the federation lies in the fact that the cross-border effects of economic policies are taken into account, whereas federalism does not imply that the different authorities work together to define their policy. – Its disadvantage is that, unlike the federation, it does not increase the number of additional economic policy instruments. The federation creates an additional policy operator, the federal Treasury, with its own capacity for intervention and concern for the overall functioning of the federation, unlike the national political authorities. All in all, the two options have opposite advantages and disadvantages. With regard to the option of inter-governmental cooperation, the negative effects of the non-cooperation of fiscal federalism may outweigh the positive effects resulting from the presence of an authority covering the whole union and having additional fiscal instruments. By exploiting these advantages and disadvantages, a macroeco-

7

Contemporary examples are the regionalist claims and controversies over the organization of sovereignty in Britain, Italy and Spain.

334

9 Fiscal Union

nomic model of the type used in previous chapters can show that neither of these two institutional formulas is preferable to the other in all circumstances (Kempf [7]). Without a detailed analysis of the structure of the monetary union to be stabilized, it is impossible to pick up the right formula. However, we should be careful not to oppose the two options too radically. A federation is based on cooperation: The Latin term from which this word derives, “foederatio”, means alliance. The setting up of a federation, the selection of its governing bodies and the articulation between the different levels of government cannot take place without forms of cooperation between the member countries of the federation. Conversely, we have seen that cooperation implies the setting up of supra-national bodies for the diagnosis and monitoring of macroeconomic conjunctures. Both formulas are based on the willingness of the authorities concerned to rely partly on their institutional partners. Both are based on solidarity mechanisms and redistributive effects between the partners and more broadly between the electorates; they therefore pose similar problems of political acceptance. In either option, there is no clear and systematic winner. To sum up, both options represent a long-term gamble based on trust between the partners.

9.5

Opportunistic Behaviour and Fiscal Union

In the previous chapters, we have seen how States could engage in opportunistic behaviour by using common pool or moral hazard effects to take advantage of the provisions and institutions of the monetary union. This is also true for a fiscal union. The problem of opportunistic behaviour is probably more pronounced in a fiscal union because the decisions are in fact about international government transfers. To show this formally, we will use a model that is extremely simple and does not correspond to any real situation. Let us consider two countries that are members of a fiscal union (we are not considering any nominal dimension here) and that are structurally identical. Both economies are hit by a global natural shock, which we note ζ . There is also an “opportunistic” country-specific shock ηi . This opportunistic shock can be interpreted in two ways: either as a modulation of the effectiveness of fiscal action, or as a bias introduced in the public announcement of fiscal action or its effectiveness. A national fiscal authority has one instrument at its disposal: a fiscal policy instrument gi . The manipulation of g and its effectiveness depends on the type of fiscal cooperation that the two countries will put in place. We denote by s the type of fiscal union under consideration and we formalize the level of welfare achieved by country j in this union as a function of shocks and public spending   F s ζ, ηi , ηj , gi , gj

∀i, j = 1, 2, j = i.

(9.1)

9.5 Opportunistic Behaviour and Fiscal Union

We assume that   ∂F s ζ, ηi , ηj , gi , gj 0 ∂gi

  ∂ 2 F s ζ, ηi , ηj , gi , gj ∂ηi2   ∂ 2 F s ζ, ηi , ηj , gi , gj ∂gi2

> 0 ∀i = 1, 2, j = i, (9.3) 0, ∂ζ ∂g

∂ 2 Fs (ζ, η1 , η2 , g1 , g2 , π) < 0, ∂ηi ∂g

∀ (ζ, η1 , η2 , g1 , g2 , π)

A priori this curve has indeterminate properties, and in particular can very well be (locally) increasing.

338

9 Fiscal Union

Fig. 9.3 Fiscal regime frontier

careful analysis of the hazards that will affect it, including the opportunistic hazards that it is bound to generate. It helps to illustrate our central proposition: It is not possible to decide which fiscal union is preferable in a monetary union without taking into account the two hazards that occur, natural hazards and opportunistic hazards. The perception of the dilemmas created by the joint presence of these two shocks determines the choice in favour of one form of fiscal union or another. A more detailed analysis, which would take into account not only global shocks but also idiosyncratic shocks specific to member countries, would lead to a similar assessment: If these shocks are relatively large, this reinforces the interest of an accomodating fiscal union. Advocates of a fiscal union based on strong limitations on the latitude of national (or sub-national in the case of a national fiscal union) fiscal authorities can justify their choices by arguing that opportunistic hazards are important relative to natural shocks. Conversely, advocates of strong fiscal autonomy for member States may be right if they can show that natural shocks are relatively important. Finally, it should be noted that opportunistic hazards—or rather their magnitude—are themselves dependent on the institutional arrangements in which the actors are placed. We have assumed them here as manipulable instruments. More complicated models would allow more refined analyses based on asymmetric information effects.

9.6 Fiscal Union and Public Debt

9.6

339

Fiscal Union and Public Debt

So far, the fiscal union options we have considered have focused on the definition and manipulation of fiscal policy instruments, taxes and public expenditure, mainly for macroeconomic stabilization purposes. Fiscal union can also be about the financial instruments used by member States and the financial capacity at their disposal. In an intertemporal logic, public debt is spreading the tax burden over several periods. Mechanisms for pooling this burden among several public jurisdictions that are members of a monetary union thus amount to creating a fiscal union in the sense we have given above. These mechanisms are complex and refer to sophisticated financial techniques that are difficult to decipher. They allow transfers, which are staggered in time and spread over several financial years, are less visible than those made through a fiscal union, which involves the pooling of part of the member States’ expenditure and taxes. This is a way of overcoming popular mistrust and possibly circumventing public opposition to a pattern of explicit transfers. Using the distinction developed in the previous sections, let us distinguish between two main varieties of financial fiscal union. 1. In the absence of fiscal federalism, the member States have the possibility of cooperating on the financial side. In particular, they can decide to jointly issue debt instruments once they have agreed on their characteristics, in particular the repayment terms. 2. In the context of fiscal federalism, a supra-national fiscal institution, a federal Treasury, is created by the member States. This institution may be endowed with the capacity to issue federal debt. The federal debt indirectly represents a mobilization of joint financial capacity since it is repaid by means of tax levies on all taxpayers in the Union. Insofar as the repayment of the federal debt is ensured by the fiscal instruments of the federal Treasury, it does not pose any specific analytical difficulties. Let us therefore concentrate on the first option, which is to mutualize all or part of the debts of the Member States. This mutualization can take different financial forms.

9.6.1

Mutualization of Public Debt

Leaving aside the purely financial issues, we focus on the study of a particular form of debt pooling based on the issue by a group of member States of a monetary union of “mutual” bonds. Let us define a mutual bond as an issue, collectively assumed by such a group, of securities intended to finance all or part of the deficits of these States. Such an issue implies that the conditions for the repayment of this joint debt are agreed by all the contracting parties. Mutual bonds imply a common commitment of the participating States, which share their financial sovereignty as they share their

340

9 Fiscal Union

monetary sovereignty through the creation of a common currency. The deferred or non-deferred financing of public expenditure is always provided by taxation, and the consent to taxation is political. A joint liability is no exception to the rule. In case no form of joint and several liability will find sufficient political support in the member States despite its intrinsic advantages, no mutual bonds are issued. The term “mutual bond” covers very different options, which need to be carefully considered in order to assess their respective merits. Jointly issued mutual bonds are compatible with the autonomy of a member State in its fiscal choices, i.e. in the allocation of the resources at its disposal. It is assumed that a member State is a better judge of what is good for its country by an argument of proximity. Mutual bonds are justified when there is an interest in pooling a financial capacity for indebtedness.

9.6.2

The Economics of Mutual Bonds

To get a clearer picture, we assume the following sequence: 1. Governments issue debt securities to finance their deficits. 2. A part of these debts is pooled, i.e. its repayment is jointly assumed by the States involved. The (partial or total) mutualization of public debts is both a way of making the requirement to redeem the securities issued more solidary and disciplining financial solidarity between member States, each accepting a common procedure. It is not in itself a lax measure facilitating the financing of member countries’ deficits, contrary to what is commonly claimed. Mutualization can be achieved in different ways. Three main options can be considered, classified by increasing degree of mutualization: 1. Issuance by a State of a bond, which is redeemed at maturity by the issuing government but is jointly guaranteed (in the event of default) by the member States. 2. Issuance by a State of a bond, joint repayment by the member States according to a predefined distribution key. 3. Issuance of a single bond by a financial institution without own fiscal resources, joint repayment by the member States in accordance with a predefined distribution key. In the event of default, the States are collectively responsible for the debt issued.

9.6.2.1 Advantages of Mutual Bonds Mutual bonds have two types of advantages, financial and macroeconomic. The financial benefits are twofold.

9.6 Fiscal Union and Public Debt

341

1. They are issued on a deeper market, attracting more participants, than the securities markets of the member States. As it is a potentially larger market with a high volume of securities issued and traded, it is more liquid. Since participants can easily dispose of their securities, they reduce the risk premium associated with high illiquidity. This contributes to a lower interest rate compared to interest rates on government securities, which are a priori less variable. This satisfies the need of risk-averse investors of benefiting from a risk-free security, minimizing the risk of capital loss. All in all, the cost of debt is potentially lower. 2. Mutual bonds promote access to the financial markets of the financially weakest member States, eliminating the cumulative effect of rising risk premiums that contribute to the risk of default. Thus they play a potentially useful role in protecting against the risk of contagion that can occur if a member country defaults on its sovereign debt (Delpla and von Weizsäcker [3], J.-C. Juncker and G. Tremonti, “E-bonds would end the crisis”, The Financial Times, 6 December 2010). There are four macroeconomic advantages. 1. Mutual bonds are a good way to internalize the cross-country intertemporal effects of shocks. If country B ultimately benefits from the fiscal policy of country A, a good way to internalize these benefits is to help finance the instruments used by country A to manage these shocks. 2. Such a financial instrument is useful for the conduct of monetary policy. Indeed, the interest rate attached to mutual bonds, because it stems from financial needs from all parts of the union, is a good indicator of the aggregate conditions prevailing there. Consequently, its variations are consistent indicators of the monetary impulses given by the central bank of the union improving the signals on the monetary policy stance. The existence of joint bonds should be expected to improve the transmission channels for monetary policy. Moreover, this instrument, if the statutes of the union central bank so permit and if accepted as a counterparty in the bank’s liquidity operations, facilitates the conduct of monetary policy since it is potentially more liquid and safer. 3. The better information given by mutual bonds to the financial markets enhances the effectiveness of market discipline and enables States to better base their decision to run a deficit. 4. At the same time, mutual bonds strengthen institutional discipline within the union because they are the result of a common agreement. This agreement incorporates provisions on issuance and redemption, which are binding on all participants.

9.6.2.2 Disadvantages of Mutual Bonds But mutual bonds have also disadvantages. 1. They do not resolve the question of the sustainability of a member State’s public accounts but modify their financial terms. Indeed, the method of financing a State

342

2.

3.

4.

5.

9 Fiscal Union

does not substantially modify its fiscal problems. Mutual bonds do not provide new tax resources, which are ultimately the key to the sustainability of States. It is even feared that the market discipline that applies to Member States may be weakened (Issing [6]): The States participating in the issue may feel that it is a new financing facility. Mutual bonds remain subject to opportunistic risks, in particular information failures on the part of member States and inadequate supervision. Member States may be tempted to take advantage of collective guarantees so as to increase their financial demands. They may also use the threat of defaulting so as to obtain decisions in their favour. The effects of contagion and systemic risk do not disappear with the creation of mutual bonds. They appear in other forms and may lead to a self-sustaining rise in rates on mutual bonds themselves. Mutual bonds create distribution problems. Member States bear the same rate on these assets while they bear differentiated interest rates on the sovereign securities they issue alone. A well-rated country participating in the issuance of mutual bonds de facto subsidizes the lower-rated countries because this is likely to result in higher borrowing rates for itself but also in lower rates for the lowerrated countries. There is an implicit transfer from the highly rated countries to the poorly rated countries via interest rates. A mutual bond program is not Paretoimproving, unless special conditions are met. This poses a first problem. Why would a highly rated country, relatively privileged compared to its partners, want to join a mutual bond program? A second problem is whether it is possible to set up a compensation scheme to limit or even cancel these transfers. However, it is clear that the complexity of such a scheme is detrimental to the viability of mutual bonds. Finally, the financial markets may consider that a security is worth what the weakest issuer of the security is worth. In other words, the risk premium embedded in a mutual liability may be calculated on the basis of the highest sovereign risk in all participating States. This effect depends on the default clauses that apply to that security.

Mutual bonds seek to reconcile two different and apparently opposing objectives, market discipline and solidarity between member States in a monetary union. They are part of a financial logic and rely on market discipline as the preferred means of ensuring the sustainability of public debt. But they dilute and undermine it through an overall assessment of risk rather than an individualized assessment designed to facilitate transitions and adjustments between member countries.

9.6.2.3 Mutual Bonds and Inter-Governmental Transfers Returning to the intertemporal perspective developed in Chap. 5 provides a better understanding of what is at stake in the issuance of mutual bonds. Mutual bonds are a method of financing deficits. If we keep the sequence of deficits identical and disregard the interest rate variations that such an asset can induce, the intertemporal budget constraint of a member State is not modified and

9.6 Fiscal Union and Public Debt

343

this State remains subject to the question of the sustainability of its debt. In the event of default, nothing is changed if there is no solidarity. The expected net present value of a State’s commitments remains unchanged. If there is solidarity, the expected net present value of a State’s commitments is modified according to the probabilities of default of its partners. There are potential transfers between States participating in the issue. Let us now consider the impact of mutual bonds on interest rates. As we have seen, interest rates are likely to be affected by the presence of such a security. The expected present value of the public commitments is modified. Let us go further. For the most financially secure governments, the use of mutual bonds likely leads to an increase in the average cost of financing, and therefore an increase in the expected present value of their debt, while for the least secure governments, it leads to a decrease in this cost, and therefore a decrease in this value. In other words, there are indeed transfers between participating States (the extent of these transfers depends on a multitude of factors and may ultimately be negligible). A mutual bond issue scheme is a method of public transfers between participating States through interest rate variations or possible solidarity in the event of default. It is therefore logical to argue that the issuance of mutual bonds is a way of implementing a fiscal union based on cooperation without using the term explicitly. Promoting mutual bonds is a way of taxing and making transfers between member States in a monetary union that is less visible, because it is staggered in time and spread over several fiscal years, than through a cooperation-based fiscal union in due form. This can be justified from a political economy perspective. It is a way of overcoming popular mistrust and possibly circumventing public opposition to a pattern of explicit transfers. The contributions of the euro area member States to the Greek rescue amounted to (in the form of very long-term loans at very low interest rates, which in actuarial terms amounts to transfers) EUR 250 billion, a large part of which will not be repaid.

9.6.2.4 Fundamental Dilemma Mutual bonds face a fundamental dilemma based on the distinction between natural and opportunistic hazards. Natural hazards States are exposed to natural hazards against which they must cover themselves. In the logic of insurance, it is in the interest of a State to pool its debt in order to better manage risk, benefit from scale effects without being penalized by distribution effects and mitigate by the size effect the risk of contagion that can take over the markets, under certain conditions: – If the risks are the same for all countries. – If the risks are idiosyncratic and (roughly) identically distributed for all. If the risks are too different, the drawbacks of mutual bonds (dilution of market discipline, exacerbation of contagion risks due to market perceptions of structural fragility) prevail.

344

9 Fiscal Union

Opportunistic events We saw in Chap. 3 that monetary unification creates the temptation of opportunistic behaviour. So do mutual bonds. A mutual bond results from a collective decision to access a common pool and to manage it jointly. The analysis of common goods (Ostrom [10]) such as fisheries or a water basin has identified the difficulties of the (poor) collective management of these goods: overexploitation, lack of maintenance and insufficient investment, which gives rise to the tragedy of the commons. Mutual bonds are likely to cause similar problems: over-issuance, lack of control over the actions of the members of the collective, neglect of the unintended effects of individual actions. States are thus caught up in the need to arbitrate between the desire to better cover themselves through financial mutualization and the risk of being exposed by their partners to opportunistic hazards with costly consequences for them.

9.6.2.5 Mutual Bonds and Monetary Union In the light of these developments, mutual bonds appear neither as a miracle solution to the financial problems of the member States of a monetary union nor as an operation easily put in place. A mutual liability is an additional financial instrument, allowing for increased and safer risk pooling and thus a better allocation of resources. This is the main gain, and it is a gain in efficiency. But it is an instrument that generates implicit transfers between issuers, either through risk premiums or through the guarantees granted. A mutual liability poses problems of equity, which are difficult to manage politically. These transfers must ultimately be accepted by the taxpayers concerned, first and foremost in the countries that are called upon to contribute. Finally, the existence of this additional means of financing may give rise to opportunistic effects of a new kind. It cannot be taken for granted that mutual bonds represent a significant reduction in financial risk and thus lead to a fall in sovereign interest rates. In the end, certain conditions must be met if mutual bonds are to be useful for member States and politically accepted, thereby strengthening the soundness of monetary union: – Financial economies of scale are important. – The economic conditions of individual countries are such that spreads between risk premiums on bonds issued directly by member States are limited. – Contagion factors in the absence of these securities play a decisive role in the setting of sovereign interest rates. – The repayment conditions, especially in the case of a mutual guarantee, are credible for each country, i.e. there is a clear political consensus, expressed for example through constitutional arrangements. On the other hand, it is not necessary for the financial needs of the different countries to be synchronous, nor over a long period of time for them to be proportional to the size of the countries. These asymmetries must, however, be taken into account in the conditions for issuing, guaranteeing and redeeming mutual bonds.

9.6 Fiscal Union and Public Debt

9.6.3

345

Implementing Mutual Bonds

9.6.3.1 Agreeing on Mutual Bonds Mutual bonds are necessarily the result of an inter-governmental agreement between countries that choose to issue mutual bonds together. As it is a financial contract, necessarily complex, this issue is delicate to set up. At all stages, the procedural details reflect the tension between discipline and solidarity that we mentioned above. A mutual bond agreement must address the following issues. 1. Assessment of financial needs Mutual bonds are issued for the financing of member countries’ deficits, logically at their request as they have not given up their fiscal sovereignty. Is this request automatically met (where appropriate, within the limits provided for in the agreement) or are they assessed beforehand, and by whom? 2. Reimbursement The financial burden (servicing of interest and repayment at maturity of the principal) must logically be met from fiscal resources. Is there also a pooling of tax resources dedicated to this purpose? If not, how is the burden shared? It is logical that this should be in proportion to the financing obtained. But it is equally justifiable to envisage a joint reimbursement, if necessary through a federal Treasury. These contractual arrangements thus reveal the political project of the fiscal union. 3. Guarantee A financial contract specifies the guarantees provided by the issuer. In the case of a mutual bond, three guarantee formulas are possible. – Member States may offer multiple and separate guarantees. Each State participating in the issuance of mutual bonds is responsible for a fraction of the repayment of the issue, in proportion to the national shares in the total volume issued, or according to another distribution key provided for in the mutual bond agreement. – State guarantees may be multiple, separate but reinforced. The guarantee of a mutual bond is split as in the previous formula and, moreover, by agreement, the States grant advantages to the common debt that increase the security of their share. This can be through seniority clauses (priority repayment), dedicated resources, or the specification of a clearly identified collateral. – The guarantee of the mutual bond can be pooled. All participants are collectively responsible for the volumes issued and undertake to substitute for a defaulting government that is unable to ensure the share of repayment corresponding to the fraction of debt issued to its benefit. 4. Decision Mutual bonds are legally issued by a supra-national institution created by the partner countries. This agency is legally responsible for the issuance and

346

9 Fiscal Union

management of the mutual bonds. Partner countries are represented in this body. The degree of delegation of sovereignty implicit in the decision to issue mutual bonds is reflected in the mode of governance of this institution. In particular, are decisions taken by unanimity, qualified majority or simple majority? 5. Control Because mutual bonds pose a common resource problem, the issue of monitoring the situations, actions and capacities of partner countries plays a key role in the success of a mutual bond system. It is necessary that everyone, in particular potential lenders as well as partner countries, have a reliable, therefore independent and precise control of the taxation scheme and the state of public finances. For obvious reasons, this must be ensured by an independent/supranational agency with a public information capacity. Member States will have to accept an external (and multiple) right of scrutiny over their public finances and see some of their fiscal projects (such as tax exemption schemes) deemed incompatible with the proper functioning of the mutual bond system in which they are involved. 6. Default It cannot be ruled out that a member State defaults on its sovereign debt and is not in a position to meet its repayments under the mutual bond system. The clauses of the mutual bond contract must specify whether the partner countries take the place of the defaulting State or whether part of the burden is automatically not assumed. In any case, this will increase the risk premium associated with the mutual bond, i.e. the burden on all Partner States is increased. The solidarity implicit in a mutual bond scheme works in all directions, in good and bad times. 7. Exit How to get out of the agreement? Two formulas can be envisaged: unilateral denunciation (voluntary exit) or by force (forced exit). In the latter case, the decision would be taken by the partners of the “weak link”, in its absence, on the advice of the common financial agency. It could also be envisaged that the vote would be weighted according to the exposure to risk incurred as a result of the weak link. However, it is impossible not to see that, in any form whatsoever, a decision to expel a State would appear to be a failure of a mutual bond system.

9.6.3.2 Managing Mutual Bonds The management of a mutual bond scheme is delegated to a financial institution created and mandated by partner States to issue securities on the financial markets, service debt charges and repay debt on maturity. It may operate under various statutes. – It may be fully autonomous, particularly in its financial policy, being able to borrow. It has its own resources, fiscal or otherwise. It is then a public Treasury almost like any other, even though it is not backed by a sovereign State. – It can be a technical issuing institution, working by delegation and therefore under the control of national governments. But even in this case, the managing

9.7 Assessing a Fiscal Union

347

agency remains a political body, not an independent one, in the sense that it would be independent from national governments, as is the ECB. Being linked to the “Power of the purse”,10 its implication with the politics of the union is obvious. Moreover, by the very nature of mutualization, it is a supra-national body. For these two reasons, the question of its democratic control is essential and sensitive.

9.7

Assessing a Fiscal Union

According to which criteria should we be guided in the development of a fiscal union (possibly linked to monetary unification)? How should we evaluate a fiscal union, actual or future? The first temptation for an economist is to look for conditions of Paretian optimality. The idea can be defended in the case of monetary matters. It can be argued that monetary issues are technical, that they require a high degree of economic and financial expertise, daily intervention in the markets by the issuing institution, and that there is a consensus on what we are entitled to expect from a monetary system. These considerations do not apply in the case of a fiscal union. A fiscal union almost inevitably involves international transfers and leads to delicate issues of redistribution. It is almost impossible to ensure that there are no losers in such a construction. It is therefore meaningless to pursue the search for a fiscal union that is both Pareto-optimal and operational. However, a more realistic approach can be based on the premise that the essential objective of a fiscal union is to be sustainable and able to withstand the vicissitudes of economic, in particular economic crisis situations. In this perspective, it is useful to pay attention to three criteria. 1. A fiscal union must be financially solvent over time. 2. It must contribute to the cohesion of the union, in particular at macroeconomic level. 3. Finally, it must receive the support of the jurisdictions that make up the union, given the existing institutional constraints.

9.7.1

Financial Solvency

The criterion of financial solvency refers to the problem of the sustainability of public accounts in a fiscal union, which we dealt with in Chap. 5. It is a minimal criterion: If the public accounts are not balanced and lead to a financial crisis, the fiscal union is in jeopardy and its survival is in question.

10 This

expression is used in Article 1, Section 7, clause 1 of the American Constitution, which provides that the power to tax is vested in the American Congress.

348

9 Fiscal Union

The problem is whether the sustainability in question is that of the components of the fiscal union or of the union as a whole. The inability of a member State to honour its financial commitments to its creditors creates an open financial crisis in the union. It is a threat to the very existence of the union because it can set in motion a contagion process, increase risk premiums for other member countries and in turn lead to their insolvency. There are two possible scenarios. 1. The first option is that the fiscal union can provide a rescue mechanism or a financial solidarity mechanism, as other member countries assume the obligations that a country cannot meet. In these cases, individual solvency is ensured, but it is the solvency of the union as a whole that is at stake. This mechanism may call into question the capacity of the union to collectively meet the obligations contracted by its members or contracted directly by a fiscal body under the authority of the union. The problem of solvency is not solved; it is simply displaced. 2. Under a second option, the fiscal union may provide for or allow a process of sovereign default and negotiated reduction of the insolvent country’s debt burden to operate. This process logically leads to suspicion on all the member countries of the union, if only because the solidity of the union is challenged. This may trigger a contagion phenomenon. In any case, because creditors belonging to the union are harmed or because the union is weakened, this option is a threat to the durability of the union. How to choose between these two options? The advantage of the second option is to ensure the solvency of the union as a whole in difficult circumstances. In a situation of ignorance, asymmetric information or difficulty in controlling chain effects, a member country is put in front of its responsibilities, cross-border budget transfers are limited and market discipline is expected to work to dissuade leaders from taking measures incompatible with the solvency of the accounts. But the first option is not without virtues. Behind the “veil of ignorance” and assuming that no one wants to put the union in crisis, everyone would choose this option because it is the one that ensures the best risk-sharing between member countries while preserving the integration capacities and therefore the benefits of the union. Debt Sustainability The logic of public debt sustainability in the case of mutual bonds is actuarially identical to the existence of a federal Treasury, since mutual bonds are a particular way of arranging the transfers between member countries necessary to ensure the overall sustainability of a monetary union. The option of constraining rules clearly aims at ensuring the sustainability of member States’ public debts. The framing modality may differ as we have seen. The question of whether this option achieves its objective relates to its credibility and operability. We have seen that neither is guaranteed. In the case of an intergovernmental cooperation scheme, the sustainability of public debt is certainly part of the partners’ concerns and becomes a reason for concerted intervention. The

9.7 Assessing a Fiscal Union

349

question then arises within the union as to whether one of the partners may not take advantage of this to transfer the burden of its deficits to the others. Fiscal federalism raises the question of the sustainability of public debt at the federal level as well as at the national level (or sub-national level in the case of a national monetary union), as we detailed in Chap. 5. There may be a transfer of responsibility between levels, the sustainability of one level being ensured only by questioning the sustainability of the other. We have seen in the examples of fiscal federalism detailed above that this can happen in Argentina and, to a lesser extent, in the USA. Thus, fiscal federalism does not by itself resolve the question of the sustainability of public debt in a monetary union. The mutualization of public debt is justified as a means of ensuring this sustainability—in the name of solidarity between partner States—without going through a quantitative constraint as in the case of framework rules. The difficulty lies in the fact that mutualization is based on the establishment of a regulatory and financial mechanism available to member States. Depending on the properties of this more or less restrictive mechanism, some States—if not all—may be tempted to abuse the implicit aid granted by their partners through debt pooling and to relax their own efforts at fiscal discipline. Thus, for the same reasons as in the case of fiscal federalism, debt pooling does not automatically ensure the sustainability of public debt. It depends on the mutualization mechanisms, which we have seen to be varied but complex in any case. The sustainability of public debt can be ensured by a mutualization scheme if it provides for procedures for auditing public accounts and for the possible supervision of the participating States.

9.7.2

Economic Cohesion

The second criterion is economic. The purpose of a fiscal union is to bring economic benefits in the not too distant future to all parts of the union. Whether it is better protection against shocks, better management of national or international risks, internalization of positive or negative cross-border effects so as to better exploit growth opportunities, the union must make it possible to strengthen the economic cohesion of the community formed by the member countries. This objective of economic cohesion leads us to look at the risks that need to be managed through fiscal union. Because a fiscal union changes the structure of incentives and sanctions on which these authorities base their decisions, their behaviour is changed relatively to a world in which such a union does not exist. This is done in two ways. On the one hand, each authority may behave in an non-cooperative manner in the union and seek a “free rider” advantage, i.e. seek only its own advantage without taking into account the cross-border effects of its decisions. On the other hand, each authority may seek to use the informational advantage it has over its own situation to disguise the presentation of its policy and in particular its fiscal situation. In both cases, behavioural contingencies amount to trying to make a profit at the expense of its partners.

350

9 Fiscal Union

Obviously, such behaviour is detrimental to the overall cohesion of the union. It is therefore necessary for the union agreement to seek to limit the occurrence of such behaviour.

9.7.3

Political Consensus

This last criterion is a political one. A fiscal union can only survive in the long term if it has the support of public opinion and the political bodies of the countries that make it up. Indeed, a member country remains sovereign and can denounce an international agreement.11 A fiscal union must therefore obtain the support of its components. We have said above that there is no unanimity criterion that can be used to evaluate a union because a fiscal union implies volens nolens of transfers and depending on the circumstances of the losers and winners. But a political consensus is not necessarily based on unanimity either, nor does it have to be verified at all times. On the other hand, it is validated according to political procedures which, in a democracy, are based on legal procedures. In a State governed by the rule of law, a fundamental principle is that of popular consent to taxation. This principle applies to the case of a fiscal union since it implies a redistribution of fiscal powers, directly or indirectly. Democratic consensus in the fiscal union is indispensable and an essential element in its assessment and configuration. However, this goes to the heart of the political problem raised by the notion of a fiscal union: What democratic representation is involved? What democratic forum should approve actions and validate the existence of a fiscal union? In the case of inter-governmental cooperation on fiscal matters, the solution seems fairly simple. In line with the principle of consent to taxation by the people, the parliaments of each country, in accordance with the constitution and fiscal procedures in force in that country, approve the national budgets, including those relating to fiscal cooperation. The latter has been elaborated through international negotiations conducted by the competent national authorities, executive and/or legislative. This cooperation may be validated by the unanimous vote of the legitimate national representatives of the States of the union. In the case of fiscal federalism, the matter is more complicated since the question of democratic control of the federal budget arises. There are two possible approaches. The first is to consider that the federal Treasury is jointly controlled by the national parliaments of the member countries of the union, according to the procedures for drawing up, approving and controlling it provided for in the

11 We

reason here in the framework of a fiscal union formed by sovereign countries. The phenomena of secession of a region belonging to a sovereign country are more complex than the denunciation of an international treaty. Even in the case of a federation, a political consensus is indispensable for the functioning of the fiscal union.

9.7 Assessing a Fiscal Union

351

international agreement creating this administration. The second is to create a democratic body covering the whole of the union, with political responsibility for the federal fiscal process: It controls the preparation of the budget by the federal Treasury, it votes on it (as well as any amending laws) and monitors its implementation ex post. This amounts to creating a federal political union in terms of fiscal federalism. In the latter case, the national parliaments remain responsible for national budgets. This poses many problems, two of which are major. 1. The first is that of the election of the federal parliament. It can be elected by an electoral body covering all citizens of (constitutional) voting age, according to a principle of strict equality of votes, without mediation and regardless of national borders within the union. Or it can be elected by the national electoral bodies, with each country sending a fraction of the federal deputies, according to its own rules. Or the federal parliament can be formed by delegation from the national parliaments. This is not the place to open a discussion on the properties of the various possible electoral systems. But this brief survey on the diversity of democratic formulas is enough to show that what is at stake is the existence or not of a “people” consenting to the federal tax and to the transfers between taxpayers and between nations that it implies. A federal fiscal union poses a political problem that cooperation does not. The fate of a federal fiscal union depends on the political decision-making mechanisms associated with it. Here we find again the issue of sovereignty. Based on solidarity, the members of a fiscal union are prepared to accept some sharing of sovereignty within the fiscal union. This in turn determines the form of the fiscal union and the principles of democratic control of this union, or its institutional contours. Political sovereignty consists in accepting the public acts and transfers necessary to maintain the agreed union. 2. Given the interdependence of fiscal decisions, as a result of horizontal and vertical tax competition, opportunities for conflict between parliaments are inevitable since their constituents have different and sometimes divergent interests. It is necessary to put in place procedures for resolving such conflicts. Two formulas can be considered. The first is to set up conciliation bodies between parliaments to harmonize their decisions. The second is to establish a hierarchy of parliaments or to stipulate that the decisions of one parliament take precedence over those of another. One example is the primacy of the federal parliament over national parliaments.

9.7.4

Creating a Fiscal Union

What factors should be taken into account when a community or a set of public entities, such as States, seeks to establish a fiscal union? Let us assume that the creation of a fiscal union is not circumstantial but has a long-term perspective. It is therefore necessary to reflect on the structural features of the group likely to be

352

9 Fiscal Union

part of the union. We continue to reason on the basis of sovereign states covering different jurisdictions (to simplify, nations). Kempf and Rossignol [8] study the conditions under which an international agreement between two democratic countries is developed. Since such an agreement must be ratified, it must be approved by the electorates of the two countries concerned. The conditions for negotiation, the constitutional constraints on the agreement, the inequality both within each country and between the countries themselves (as measured by an average or median income gap), and the importance of the gains to be derived from the agreement both for the nations as a whole and for critical voters, those on whom the agreement’s achievement or failure to achieve it depends, are the determining factors in the process. Two conclusions emerge from this analysis. On the one hand, an international agreement may not be reached even though it is beneficial to both nations as a whole. On the other hand, an agreement always generates a different net burden for different agents. Its viability and democratic validation are determined by the distribution of the gains and losses it generates. In other words, issues of distribution and inequality, both intra- and international, play an essential role in the development of an international agreement, in its success or failure. These considerations clearly apply to a fiscal union since it regulates in a more or less detailed way the fiscal flows that apply in a State, and therefore the burdens that fall on taxpayers in each country. Any minister of finance can confirm the extreme attention he or she pays to questions of distribution of the tax burden and thus income inequality within the nation for which he or she is responsible. In the case of a supra-national fiscal union, the difficulty is compounded by the fact that it also involves transfers between nations, whether direct or indirect. On the one hand, the process of developing a fiscal union implies that the economic environment, in particular the heterogeneity of economic structures, must be taken into account. By this we mean both the nature of the shocks that hit national economies and the specificities of the productive and distributive apparatus. Macroeconomically, it means taking into account the channels of transmission of shocks, and in particular fiscal impulses. But we must not forget the interdependencies between economies that, as we have seen, determine the appropriateness of a fiscal union. On the other hand, a fiscal union is a political agreement. As such, it reflects the diversity of preferences of the constituent entities or electorates (in the case of democratic countries) responsible for ratifying the agreement. As such an agreement is always a compromise, it will be all the more ambitious if there is a convergence of views between the stakeholders, or if the heterogeneity of national preferences is limited. As an electorate is not homogeneous, voters will be affected differently by the rules or the system of international transfers that a fiscal union represents. The calculation of the distribution of the gains and burdens associated with the agreement is therefore central to the development of the agreement. Moreover, a fiscal union agreement is a legal document, whether it is incorporated in the constitution of a sovereign state or in an international treaty. It is

9.8 Conclusion

353

dependent on the legal rules governing the political decisions taken in the countries concerned, in particular their constitutions. Finally, history plays a role. It is certain that national preferences have been expressed through political decisions that over time have shaped public policies, particularly fiscal policies. These have, in the long run, affected the productive and distributive structure of the national economy. The “constituent” agreement of a fiscal union must specify the areas of fiscal intervention at the different levels and the ambitions of the union. An important distinction is between one-off interventions, linked to crisis management, and regular interventions, linked to the management of current economic activity. For example, it is conceivable that the central or federal level may be mobilized only in exceptional circumstances while the lower levels have all the power to manage the economy. The IMF is an example of a fiscal union that works in times of crisis, the organization of fiscal powers put in place by the Federal Republic of Germany being a case of a union designed to manage the macroeconomic situation.

9.8

Conclusion

After this exploration of the concept of fiscal union and its link to monetary union, it appears that this concept is a catch-all concept and a distinction should be made between different types of fiscal union as well as different types of monetary union. The fiscal arrangement in a national monetary union is fairly simple to conceive: The uniqueness of the State’s monetary and fiscal sovereignty implies a federal organization to manage the possible diversity of citizens’ expectations and territorial segmentation. Fiscal union in such a monetary union may be difficult to manage in practice but it does not pose a thorny theoretical problem. The case of an international monetary union is different. The plurality of the fiscal sovereignties of the member States makes the question of fiscal union delicate because a fiscal union touches the heart of the power of the States, the power to tax and therefore their identity. More precisely, it combines technically and legally complicated public finance arrangements and difficult political issues because fiscal sovereignty is at stake. The first necessary distinction is between inter-national fiscal unions based on inter-governmental cooperation and a sharing of fiscal sovereignty, and supranational fiscal unions based on supra-national bodies to which member States delegate part of their fiscal sovereignty. Secondly, different varieties of fiscal union can be distinguished according to the instruments and institutions on which they are based, the constraints they impose and the relations they establish between the fiscal authorities of the member States. In any case, the different options can only ensure their credibility and sustainability by relying on binding and transparent institutional procedures. The articulation with monetary union depends on the type of fiscal union envisaged or analysed since a fiscal union has its own properties in terms of public finance management, creating a specific environment for monetary policy and central banking.

354

9 Fiscal Union

The complexity of the problem is such that it is impossible to say a priori which is the “best” fiscal union, or the “optimal fiscal union” compatible with a monetary union.

References 1. Auel K (2014) Intergovernmental relations in German federalism: Cooperative federalism, party politics and territorial conflicts. Compar Eur Polit 12:422–443 2. Bordo M, Jonung L, Markiewicz A (2013) A fiscal union for the euro: some lessons from history. CESifo Eco Stud 59:449–488 3. Delpla J, von Weizsäcker J (2011) Eurobonds: the blue bond concept and its implications. Bruegel policy contribution 509 4. Directorate general Competition (2016) DG Competition working paper on state aid and tax ruling. https://ec.europa.eu/competition/state_aid/tax_rulings/index_en.html 5. Feenstra R, Taylor A (2017) International macroeconomics. Worth Publishers, New York 6. Issing O (2009) Why a Common Eurozone Bond Isn’t Such a Good Idea. Center for financial studies, Goethe-Universität Frankfurt white paper 3 7. Kempf H (2021) Fiscal federalism in a monetary union: the no-cooperation pitfall. Open Eco Rev 32:109–151 8. Kempf H, Rossignol S (2013) National politics and international agreements. J Public Econ 100:93–105 9. Kitchen H, McMillan M, Shah A (2019) Local public finance and economics. Springer, Berlin 10. Ostrom E (1990) Governing the commons: the evolution of institutions for collective action. Cambridge University Press, Cambridge 11. Saiegh S, Tommasi M (1999) Why is Argentina’s fiscal federalism so inefficient? Entering the labyrinth. J Appl Econ 2:169–209 12. Ter-Minassian T (ed) (1997) Fiscal federalism in theory and practice. International Monetary Fund, Washington 13. Tiebout C (1956) A pure theory of local expenditures. J Polit Econ 64:416–424

Banking Union

10

Abstract

Chapter 10 tackles the banking union necessarily concomitant to a monetary union given the present technologies of payment and exchanges. It presents the three facets of such a union: supervision, resolution and deposit insurance. The specificities of such a banking union come from the necessary bonds coming from a unique currency and a unique central bank. A banking union needs to address the financial cross-border spillovers existing in a monetary union which create increased contagion effects and heighten banking fragility.

At its meeting in June 2012, the European Council took a twofold decision: the creation of the Single supervisory mechanism and the creation of the “European stability mechanism”. This twofold decision was the first step in the creation of a European banking union combined with the EMU (Bush and Ferrarini [9], Schoenmaker [33]). Let us define a banking union as follows: A banking union is a common regulatory framework covering the mode of operation and supervision of the activities of banks operating in the monetary union area.

In a national monetary union, given its importance in the functioning of decentralised money-based exchanges, the banking system must be subject to public regulations in order to ensure the durability and credibility of the payment system used by agents. If confidence in banks and the reliability of the means of payment they manage disappears, agents will stop exchanging or will resort to more costly and much less secure methods of exchange. Thus banking regulation represents a major responsibility and a prerogative of public authorities. By their decision in 2012, 20 years after the approval of the Maastricht Treaty, European political officials have decided on a major transfer of their national sovereignty to common European public bodies. Until then they had not made © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_10

355

356

10 Banking Union

this step forward, certainly not wishing to relinquish this part of their national sovereignty. First of all, the financial crisis that began in September 2008 with the collapse of the financial firm Lehman Brothers revealed the structural weakness of many European banks and the systemic risk created in the euro area. Then the European sovereign debt crisis, which began in 2009 in Greece, showed that some European banks in great difficulty could not be bailed out by their own government, in particular because it no longer had the capacity to issue liquidity at will. Worse, there was a risk of contagion within the euro area to the extent that there were doubts about its viability. In brief, these crises made clear that the banking system in a monetary union is fragile and requires some form of banking union. A banking union is both a set of regulatory provisions governing banking activity in a monetary union and an institutional architecture specifying the respective responsibilities of the various public and political bodies involved in its governance. The purpose of this chapter is to investigate the way to control banking and establish a banking union in conjunction with a monetary union. Section 10.1 briefly develops what a banking union is, generically speaking. Sections 10.2 and 10.3 address the fragility of a banking system and summarize what banking regulation is about. As such, they set the background of a banking union. Sections 10.4 and 10.5 are their counterparts in a monetary union. The setting-up of a banking union is covered in Sect. 10.6 and the relationship between a banking union and its corresponding central bank covered in Sect. 10.7. Concluding remarks are contained in Sect. 10.8.

10.1

Why a Banking Union?

A monetary union cannot function without a banking union as defined above because of an inescapable fact: a monetary union is based on a unified payment system, i.e. a clearing house where the reciprocal obligations of the banks as they result from the payment transactions of their customers are settled. Spread throughout the zone, banks must submit to the same procedures for exchanging, clearing and recording transactions. These procedures are put in place at the very moment of the creation of a monetary union. Moreover, to ensure competition between banks and prevent distortions, a monetary union provides for freedom of establishment, freedom of account and freedom of capital flows. Put another way, the interbank payment system is the first pillar of a monetary union. The crisis that began in 2008 gave rise to major and persistent imbalances between national banking systems within the euro area. Any inter-national monetary union may be subject to such imbalances, as national banking systems are only interconnected but not fully integrated to the extent that they form a single, homogenous network covering the union as a whole. Banks in certain countries in difficulty were able to continue their operations because they were structurally indebted to the European banking system as a whole. However, interbank debts

10.1 Why a Banking Union?

357

are very short-term and are not intended to ensure sustainable operations. The worsening of unbalanced positions is indicative of a crisis situation.1 There are two ways of analysing these imbalances. 1. They can be seen as a mirror of macroeconomic imbalances within the monetary union. Unbalanced positions between banks are the (partial) translation in the bank accounts of current account imbalances within a union. Thus, through the bank accounts we find the same problem as the one we posed in Chap. 1 and studied in particular in Chap. 9. 2. They can be analysed from a strictly banking point of view. From this perspective, they would be the manifestation of banking laxity, or at least of a defect in the banking regulatory framework covering monetary union. Specifically, an explanation for this regulatory deficiency could be found in the excessive fragmentation of national regulatory systems and the lack of an integrated view of the functioning of the zone. These two readings are not contradictory: the functioning of a banking system (or, more broadly, a financial system) has major macroeconomic impacts; conversely, macroeconomic imbalances result in changes in financial flows that are more or less accentuated depending on the regulations in place. Both converge towards the idea that these imbalances reflect a structural fragility of the union itself. In any case, whatever the interpretation of these imbalances, they represent a risk to the stability and even the sustainability of the banking system, on which monetary union is based, and therefore to the union’s payment system. Why is the banking industry not an industry like any other? Firstly, because a bank is not a business like any other. As a financial intermediary of a particular type, collecting deposits from non-financial agents for whom it executes payment orders, it uses these liquid assets to grant credit to its customers. In other words, it works with the funds of its depositors, benefiting from asymmetric information on the use it makes of them. The consequence can be excessive risk-taking unknown by depositors. Secondly, because the payment system, based on banks, can be analysed as a collective good for which users are not individually responsible. The interdependence of the banks makes them all potentially vulnerable to the failure of one of them. Moreover, since the payment system is dematerialised, it depends on the confidence that non-financial agents have in the soundness of this system. If this confidence disappears, the payment system collapses, leading to a literally catastrophic economic crisis. This creates systemic risk. Common interest and

1

The interpretation of this sudden rise in these imbalances, clearly correlated to the double crisis resulting from the collapse of Lehman Brothers in 2008 and then to the difficulties in refinancing Greek public debt from 2010 onwards, is the subject of controversy, which is particularly stirring among German economists. See the book by Sinn [34] and the article in the opposite direction by Fratzscher [18].

358

10 Banking Union

information asymmetry justify government intervention. With a dual objective: to ensure the overall stability of the payments system and protect non-financial agents. Both objectives are linked by the fact that the payments system depends on trust. A banking union as defined above aims to remedy these two shortcomings by reducing risks assumed by banks. This is achieved by adopting an appropriate regulatory framework, i.e. one that takes into account the functioning of the banking system at the level of the monetary union. Let us consider a monetary union based on a banking system with the following characteristics: an integrated interbank payment system, full capital mobility, exclusively national regulatory systems, banks registered in a single country and subject to its national regulatory framework, bank customers that may be confined to the country in which the bank is registered or, on the contrary, spread throughout the union. In other words, this union is characterized by an extreme fragmentation of its regulatory framework on a national basis. The regulatory authorities have exclusively national motivations: to ensure the viability of their banking system. They are fully sovereign in this respect but have no means of creating liquidity and can only obtain resources through leverage. This configuration corresponds to a minimal banking integration, reduced to the sole clearing capacities due to the common money as we saw above. In contrast, complete banking integration exists when all banking regulatory resources are held by a supra-national institution covering the entire union and are exercised uniformly over the union’s banking system. Incomplete banking integration is said to exist when only some of these means are exercised by a supranational institution, the remainder being assumed by national institutions having authority over banks legally registered in the country. Perfect banking integration occurs when the lending and refinancing conditions characterising two structurally identical banks located in different countries are identical. In contrast, imperfect banking integration occurs when lending and refinancing conditions differ. The size of the differences between these conditions indicates the degree of imperfect banking integration.2 A monetary union aims at perfect banking integration. In such a configuration, the credit channel for the transmission of a monetary policy decision is indeed the same in all countries of the union: all residents of the union are treated homogeneously. The banking union must allow for perfect banking integration or, at the very least, help to reduce the degree of imperfection in banking integration by homogenising the conditions for the distribution of credit in the union.

2

These concepts can be generalized to finance. The simple observation of differences in interest rates between member countries (or between regions) does not lead to the conclusion that financial integration is imperfect. Logically, it is necessary to compare rates for comparable credit relationships, i.e. involving identical assets, between identical lenders and identical borrowers. In other words, empirical evidence can only rarely conclude with certainty. They can, however, give us valuable insights into the likely degree of financial integration.

10.2 Banking Fragility

10.2

359

Banking Fragility

The basis of any financial system in an economy is the system of payments between agents used to unwind financial contracts and the transactions that bind them. The methods of payment used are numerous in a modern economy and go beyond simple liquidity in banknotes. The system must allow for the processing of payment orders placed by agents and the intermodality of payments. In addition to an integrated technological support, the payment system implies standardization of payments, a coherent regulatory framework, and a requirement for financial intermediaries and institutions to process, supervise and, where appropriate, impose sanctions. Since a large proportion of payments are made through banks which manage the deposit accounts of the agents through which they make payments, banks play a leading role in this system. An efficient payments system is an asset to an economy because it reduces the transaction costs, both direct and implicit (related to the degree of risk involved in making transactions), borne by agents. Conversely, when a technological accident occurs in the processing of payments, the transaction chain is broken. This represents a major economic risk because it calls into question the continuity of economic activity. Indeed, a failure in a payment sequence between certain agents puts them in financial difficulty and renders them unable to honour their own obligations to other agents or leads them to revise their spending or loan plans downwards. The breakdown spreads throughout the economy and can lead to a systemic crisis, i.e. involving the entire economy. The proper functioning of a payments system is therefore a major responsibility of public authorities.

10.2.1 Bank Failures and the Notion of Lender of Last Resort When a bank is on the verge of failure because it is unable to find the loans it needs to meet its financial obligations in the markets, the question arises whether the central bank should lend it the needed funds, thus becoming its lender of last resort (Jones [24]). This has been a sensitive issue since the nineteenth century and will remain so as long as banking crises are ongoing. Freixas et al. [19] define the lender of last resort function as the discretionary provision of liquidity by the central bank to a financial institution (or to the market as a whole) in response to an adverse shock that causes an abnormal increase in demand for liquidity that cannot be met by any other means.

The question arises as to when the central bank is entitled to intervene as lender of last resort. Bagehot’s classic answer3 is based on the origin of the bank’s difficulties. The bank may be illiquid or insolvent. In the first case, the bank is in difficulty 3

English lawyer and journalist, born in 1826, died in 1877. His book on the banking system and the Bank of England’s responsibility for managing banking crises, Lombard Street, was published in 1873.

360

10 Banking Union

because it cannot liquidate a sufficient quantity of its assets, given their maturity; in the second case, it is in difficulty because the value of the assets it holds has deteriorated to the extent that their liquidation is not sufficient to meet the bank’s obligations. It is reasonable to allow an illiquid bank to overcome its difficulties and lend it the liquidity it temporally lacks. But this is not justified in the case of an insolvent bank because a loan from the central bank, by definition temporary and short-term, cannot solve its difficulties but at most delay its failure. The distinction between illiquidity and insolvency has proved difficult to maintain. On the one hand, the classic recommendation is that the central bank loan should be at a high rate (to avoid neglect and let it go in the bank’s management). On the other hand, this amounts to weakening the bank financially and bringing it closer to a situation of insolvency. An illiquid bank can slide into insolvency if, seeking to quickly liquidate its long-term assets, their low valuation leads to a more or less rapid revision of the value of all its assets. In other words, a bank’s situation cannot be analysed independently of its market environment. The central bank must base the appropriateness of its intervention in favour of a particular bank on an overall analysis of the banking system, not on an analysis at a given time of the structure of that bank’s balance sheet. A final problem with last resort lending of is its practical implementation. In exchange for its loan, the central bank receives a security. The quality of this collateral thus transferred to the central bank is crucial since it determines the risk assumed by the central bank. A bank in difficulty after having liquidated its risk-free assets can only present as collateral riskier assets with a long maturity or backed by financially unsound issuers whose ability to repay is uncertain. A central bank may even advance liquidity to a bank in the interbank payment system by requiring only a simple acknowledgement of debt (“IOU”), without collateral. By lending as a last resort, a central bank assumes risk: the operation can be seen as a transfer of risk from the distressed bank to the central bank.

10.2.2 Banking Panics and Deposit Insurance Modern analysis has proposed an alternative justification for public intervention (Freixas and Rochet [20]). Based on the contribution of Diamond and Dybvig [14], the aim is to respond to the risk of bank run caused by a self-fulfilling prophecy mechanism. A bank finds itself in difficulty because its depositors are massively seeking to withdraw their deposits (analytically bank’s short-term debts) while its assets are partly immobilized in long-term securities because each one, taken in isolation, anticipates a race to the bank of depositors draining the bank’s liquidity and wants to take the lead, thus creating a banking panic. The configuration can be analysed as a coordination game: there are multiple equilibrium solutions because of agents’ expectations. Two equilibria are possible: one with banking panic, the other without. Under these conditions, the intervention of a deposit insurance institution, or rather the anticipation of its intervention as a last resort, is sufficient to secure depositors and allow the selection of the equilibrium without panic.

10.3 Banking Regulation

361

This phenomenon may, if necessary, spread to all banks and lead to a general crisis or even a systemic crisis (Allen, Carletti and Gimber [3]). The crisis spreads from bank to bank through the interbank market where lending relationships and financial interdependence between banks are created. This risk of contagion reinforces the need for constant central bank oversight and the legitimacy of intervention as a lender of last resort. But this intervention creates a risk of moral hazard since it functions as an insurance mechanism for banks (Keister [25]). A bank that anticipates this intervention as a last resort rationally takes on more financial risk and increases the maturity mismatch that characterises its balance sheet, thus increasing the probability that it will be in difficulty. A bank whose financial situation is fragile may go so far as to significantly increase its risk-taking in order to increase its capacity to cause systemic damage and force the public deposit insurance institution (where applicable, the central bank) to come to its rescue. A financial institution may even try to put itself in a position to be rescued in the event of difficulty by becoming “too big to fail” or “too systemic to fail”. Another source of banking panic may occur: the bad management and risk-taking of a bank when its creditors have insufficient information (asymmetric information). In this case, the observation by each individual of the behaviour of other creditors is a source of information and can lead to a sudden episode of withdrawal of deposits or cessation of lending to that bank. In any event, whether the central bank is in charge of insuring deposits or not, it is involved in the resolution of a banking crisis since its bank refinancing policy is a central parameter of the liquidity of the banking system and its ability to overcome a banking panic.

10.3

Banking Regulation

The fragility of a national banking system is evidenced by the numerous banking crises that have occurred since economic development began in the eighteenth century (Reinhart and Rogoff [31], Kindleberger [27], Calomiris [10]). They occur for fundamental reasons: the banking system as a whole may underestimate macroeconomic risks or systemic risks due to unbalanced bank balance sheet structures.4 The crisis may also be due to the lack of sufficient state intervention and bailout capacity. The inherent fragility of the banking system justifies close public oversight and regulation of the banking sector and the action of a lender of last resort in the event of the withdrawal of other creditors. But government intervention itself can contribute to financial fragility. The ease of last resort lending and deposit insurance arrangements (creating moral hazards) and the presence of national antagonisms within the union make it fragile.

4

This was the cause of the 1997 financial crisis in South-East Asian countries.

362

10 Banking Union

In a banking or financial crisis, or in the likelihood of such a crisis occurring, the regulations governing banks, financial institutions, financial markets and the insurance mechanisms in place to compensate agents for the losses they incur as a result of a banking and financial crisis are at stake. These regulations constitute the “prudential framework” of an economy. The crisis that began in 2008 led policymakers and economists to distinguish between micro-prudential (Vives [36]) and macroprudential policies (Forbes [17]). This is also true in a monetary union. It is impossible to conceive of a monetary union without thinking about the causes and consequences of a banking crisis and how to prevent or remedy it. However, government involvement in the banking economy is not without its problems. 1. On the one hand, the State is both judge and party in banking matters. It is a party insofar as it itself uses the system to solve its financing problems. It may be tempted to facilitate the placement of public debt by using banks or by designing a lax regulatory framework. 2. Second, the government may be constrained by insufficient information or lack of expertise. It is then forced to rely on the collaboration of the banks themselves in the implementation or monitoring of regulations. This opens the door to possibilities of circumventing regulation. 3. The public authorities may be tempted to postpone the updating of a regulatory provision or their intervention in the event of banking difficulties. Such measures lead to a clarification of the situation and an assessment of the costs and returns (anticipated in the case of regulation) borne by both sides, in particular taxpayers. It likely disturbs vested interests. If the public decision-maker’s horizon is short (particularly when it is limited by electoral deadlines), she will be tempted to procrastinate and postpone a possible intervention until later, gambling for resurrection to avoid the fiscal and political costs of an intervention. 4. Finally, the banking sector, on the strength of its expertise and economic weight, seeks to influence public regulation and the conditions for public intervention. There may be a capture of the bodies responsible for the supervision of banks and financial institutions by the latter. It will result in a bias in the reports of these bodies on the basis of which the public authorities take their decisions on prudential regulation. Public authorities may intervene ex ante to prevent the occurrence of a crisis or ex post to manage its effects and improve the overall financial situation. It is customary to distinguish three strands of government involvement. 1. Prevention. Ex ante, the public authorities have an objective of preventing banking crises, whether they are limited to a single bank or affect the system as a whole. The 2008 crisis showed the need to combine a micro-prudential policy with a macroprudential policy. Prevention involves two phases. The first is the implementation of the prudential regulatory framework. The second is supervision, that is, monitoring banks’

10.3 Banking Regulation

363

compliance with this framework. In practice, supervision is extremely important because it should make it possible to detect the appearance of difficulties faced by a bank or the system as a whole. Three objectives can be assigned to prudential regulation: (a) to contain the risk-taking of these institutions so as not to jeopardize the overall financial stability of the system while maintaining sufficient freedom so that economic activities are not strangled by a lack of financing due to a precautionary principle applied too rigidly; (b) to put in place measures that are sufficiently general and simple to be easily applicable and yet effective, with a view to avoiding circumvention of the regulations by inventive institutions; (c) to limit as far as possible the opportunistic behaviour of these institutions that could result from the public guarantees necessary to ensure overall financial stability. Two types of regulation can be distinguished. The first type deals with the structure of the banking sector as a whole: the distinctions between institutions according to their activities, the rules on entry into the sector, the modalities of competition, particularly with regard to international activities. The second deals with the actual activities of banks, what they are allowed to do and what they are not allowed to do. Specifically, they deal with a bank’s balance sheet. 2. Resolution. Once a crisis has broken out, governments can intervene (directly or indirectly, through the financial institutions themselves) to limit or compensate for losses incurred by counterparties of troubled institutions and prevent the crisis from spreading or worsening. Such intervention may be aimed at bailing out or liquidating a bank, or at ensuring the maintenance of market activity, by taking a position as a counterparty. It can take both micro- and macroeconomic forms. When a bank is in serious difficulty, two options are open to the public authorities concerned. Either the bank is bailed out or it is liquidated. Bailing out implies a recapitalisation of the bank, necessary to provide for the losses incurred on its assets. This recapitalisation may be done through nationalisation; it may also involve recourse to private investors. In this case, one option may be the conversion of debts into capital, with the lenders becoming owners of the bailed-out bank (bail-in). In this phase the central bank can intervene by assuming a role as lender of last resort. When a bank no longer finds the loans it needs on the financial markets to continue its business and refinance itself, the central bank can intervene on its behalf and provide it with the liquidity it needs. As noted above, the distinction between illiquidity and insolvency has become obsolete, since the interconnectedness of banks reveals the fragility of the banking system as a whole. But the responsibility of a central bank in managing a banking crisis remains. When a bank is liquidated, all its assets are sold on the market or taken over by other banks. Creditors are compensated according to the characteristics of their securities, in proportion to their claims, from the proceeds of the liquidation.

364

10 Banking Union

3. Insurance. When a bank is liquidated, the fate of the depositors remains to be settled. A deposit is considered a debt of the bank but the depositor is not a creditor like any other. The banking system is based on depositors, taken collectively. Depositors are unable to assess the risks to banks and the banking system because they lack the competence and the resources to do so. They must therefore be insured against the risks they incur without being able to control them. Otherwise they are tempted to avoid using the banking system which must be strengthened and safeguarded. One of the solutions, now commonly used in practice, is to set up a deposit insurance system, under the aegis of the public authorities.5 This insurance function can be collectively assumed by the banks, via a guarantee fund.

10.4

Banking Integration in a Monetary Union

The fragility of banking system is even more true for a monetary union, especially an international one. Monetary unification increases the fragility of the banking system linked to it (compared to what would be the case in a simple economy) and creates new sources of fragility. Here again, we will reason in the case of an multi-national monetary union. Banks take advantage of the economies of scale that it makes possible (harmonization of procedures, reduction of transaction or set up costs, unification and deepening of markets, removal of regulatory barriers, etc.). A bank straddles several countries and potentially depends on several regulatory authorities. This is true in a financially open economy where some banks develop international activities; it is even more true in a monetary union. On a theoretical point, Bignon, Breton and Rojas-Breu [6] have developed a formal argument proving the desirability of banking integration in a monetary union but also emphasizing that it is true under specific circumstances. A world of two exchanging economies may function either under multiple currencies or monetary union. There is no risk-sharing incentives as the various utility functions are supposed to be linear. So the only impediment to trade is due to various costs and frictions. Frictions in this economy come as markets do not simultaneously operate but open sequentially within a period. In addition there are two fixed costs. The first one is a fixed cost of currency conversion. The second one is a cost linked to cross-border credit transaction. To obtain a credit in the Foreign country, a Home resident transacting in the Foreign country faces a cost of credit offered by a Foreign bank higher than if he were a Foreign resident. This is justified by the authors by an informational relative inefficiency: Foreign banks have less capacity to detect former Home credit defaulters. But actually many more justifications could be given

5

Such a system was implemented as early as 1933 in the United States. It was introduced in Europe in the 1970s.

10.4 Banking Integration in a Monetary Union

365

to such a differential. Suffice it to say that such a cost is a comprehensive index of banking integration. The model built by Bignon et al. is such that there is a systemic utility advantage in acquiring and consuming the Foreign good. Therefore one might think that a monetary union is beneficial to agents. But actually it is not true in all circumstances. In particular, if the cross-border financial cost is sufficiently as is the (exogenous) inflation rate, borrowers have a higher interest in defaulting which in turn induces banks to restrict the supply of credit. In brief, monetary unification interacts with banking integration in ways which can be detrimental to welfare. The cross-country credit premium assumed in this model implicitly refers to the difficulty to integrate banking within an economy and in particular in a monetary union. The crux of the problem is that monetary union drastically limits the ability of member States to constrain banking activities under their control or to exercise financial repression. Without monetary sovereignty, States lose a means of modifying the structure of bank balance sheets by manipulating the external parity of their currencies. They can no longer isolate them or reduce their external exposure through this manipulation or through the use of inflation to change real rates of return. Finally, because monetary unification implies the harmonization of bank payment procedures within the union, States lose an important part of their regulatory capacity over banks established in the country. On top of that, if monetary unification cannot reduce the various cross-country costs linked to financial transactions, the ultimate outcome may be detrimental to collective welfare. In short, monetary union makes it necessary to think about banking regulation in an original way.

10.4.1 The Stability of the Payment System in a Monetary Union A monetary union is based on a single payment system allowing payments between residents to be processed.6 In particular, it involves an interbank settlement system covering the banks of the union, necessarily in conjunction with the central bank of the union. More specifically, this system is based on uniform treatment of all banks registered in the union. The conditions for the registration of banks, their access to the system and their supervision must be identical and there must be no privileged treatment of transactions of some banks to the detriment of others. For example, the eurozone operates through an interbank payment system that records payment flows between banks. In the euro area, the TARGET 2 system (which succeeded TARGET in September 2007) is an multi-national system in which national central banks consolidate the positions of commercial banks resident in their country. The central banks’ positions (surplus or deficit) in TARGET 2 are a good indicator of imbalances between national banking systems. The surplus of the central bank of

6

The opposite is not true. A payment system can operate with a plurality of currencies. This is the case with the SWIFT network, which is used in international banking settlements.

366

10 Banking Union

country j is interpreted as a consolidated credit granted by the banking system of country j to the banking systems of the rest of the union and, conversely, a deficit is interpreted as a borrowing from the rest of the union. The central bank of the union is a major element of this system. It is the guarantor of the union’s payment system, which is an essential link in the transmission through the economy of monetary policy decisions taken in connection with the interbank market. In the case of a non-conventional monetary policy which, as we have seen, significantly affects the balance sheets of the central bank and the banks, it is through the interbank system that the central bank injects or withdraws liquidity. It is logical that this system should be placed under the responsibility of the central bank of the union. This does not pose a major problem. Let us even acknowledge that this is a major asset for the central bank. It gives it an intimate, disaggregated (bank by bank) and continuous knowledge of the overall banking situation in the union. The informational capacity that it thus has at its disposal enables it to intervene effectively and rapidly in the event of a banking crisis and also to make a detailed assessment of the channels of transmission of monetary policy through the banking system.

10.4.2 International Finance and Monetary Union The original theory of optimal currency areas did not mention the financial dimension or the role of financial flows within the area. Implicitly, it assumed that the current accounts of each element of the zone had to be balanced (the optimality of the zone was derived from this property). This is likely due to the fact that in the early 1960s, States were still able to pursue a resolute policy of financial repression, both by regulating interest rates and by controlling capital flows (Eichengreen [16], chapter 4.). But the demise of the Bretton Woods system brought an end to this financial stranglehold and triggered global financial liberalization. The development of international finance raises the question of whether or not it is contradictory to the institution of a monetary union. The first to ask the question was Kenen [26], as we saw in Chap. 2. Mundell [29] responded by arguing that financial integration reinforces a currency area. Indeed, financial flows smooth out the idiosyncratic shocks that affect the monetary union. A member country affected by such a shock can resort to external savings (to finance its deficit, for example, in the event of a negative shock) to mitigate its immediate impact. For savers residing in the union, financial openness represents the possibility of portfolio diversification and therefore better protection against contingencies. In other words, in the logic of the theory of optimal currency areas, if labour mobility and the possibilities of fiscal transfers are deficient, the financial markets allow countries (State and private agents) to insure each other against the specific shocks that hit them. The more open and friction-free are financial markets, the more deficit countries will be able to borrow from surplus countries at low interest rates (i.e. where the component due to financial frictions is reduced). In financial jargon, this will be referred to as a recycling of external surpluses within the union at a reduced cost.

10.4 Banking Integration in a Monetary Union

367

Mundell’s answer is not surprising and is in line with the neo-classical conception of finance: international openness is an opportunity for a better diversification of financial risks and allows, from a macroeconomic point of view, a better intertemporal smoothing of shocks. Thanks to it, risk is better shared. This leads to a lower-cost management of shocks or a gain in efficiency in the allocation of resources. In particular, it is supposed to allow the disappearance of sudden financial crises (sudden stop crises) when a country is suddenly unable to find counterparties to its financing needs. The experience of the last forty years showed that financial liberalisation on a global scale is far from having eradicated financial crises, whether local or global. Financial flows are the result of trade-offs that are not only the result of assessments of the fundamentals of an economy. Above all, as financial markets are marked by imperfections and frictions, there is no guarantee that international finance will lead to optimal management of savings flows throughout the world. This is sufficient to be cautious about the beneficial role of financial liberalisation in a monetary union. Since the union is characterised by a single nominal interest rate but national inflation rates differ, real interest rates are lower in high inflation countries. This pushes both private and public agents into debt or into taking on more risk. Specifically, it can lead them to underestimate the risks they take, leading to an inefficient intertemporal allocation of resources. Over-consumption of durable and capital goods leads these countries to run an external deficit, while countries with higher real interest rates run a surplus.7 Borrowers themselves must recycle their surpluses and finance these deficits. But since this additional expenditure is not backed by sufficient returns, doubt is gradually building up about the ability of these loans to be repaid. Then comes a moment when the crisis breaks out: borrowers suddenly stop financing. This scenario is not an extreme scenario, due to bad luck, but stems from monetary unification. This is exactly what happened from 2009-2010 onwards in the euro area. The peripheral countries (Ireland, Spain, Portugal, Greece) after their entry into the zone took advantage of low (real) interest rates and financed a toxic development, based on real estate investment or increased public deficits. The 2008 crisis turned investors’ expectations upside down, leading them to reduce their risktaking, thus suddenly demanding sharply higher risk premiums. This precipitated these countries into a serious and prolonged crisis. Thus the financial liberalisation that goes hand in hand with monetary union is a double-edged sword. Factors of financial fragility make it necessary to provide a regulatory framework for the financial sphere. In other words, those in charge of a monetary union cannot ignore the financial consequences of this union any more than they can ignore the fiscal dimension of this union. Financial crises are in a position to jeopardise the monetary union itself because they can cause such difficulties that a member country will prefer to leave the union in order to regain control of

7

For convenience, we assume a monetary union isolated from the rest of the world. Relaxing this assumption would not invalidate the reasoning.

368

10 Banking Union

the usual weapons for emerging from financial crises: default, financial repression, recourse to monetary financing. Particular attention must be paid to the fragility of the banking system, a crucial segment of the financial system since it provides the link between the monetary system itself and the financing of the economy.

10.4.3 Structural Heterogeneity and Banking Fragility Banking fragility (understood as the exposure of the banking system to a crisis of banking origin) is complicated by the structural heterogeneity of the union in banking and finance. Leaving fiscal policies completely aside, let us assume a banking sector fully integrated in the union: subject to the same prudential regulations, the banks covering the whole union are all equally exposed to national or sectoral hazards. When we consider that the banking sectors are organised on a strictly national basis in an international monetary union as indices of banking concentration, regulatory frameworks and banking operations are different, banking sectors are differently exposed to the risk of a banking crisis and the ability to cope with it. Banking fragility must therefore be analysed on a country-by-country basis. Can a banking crisis in one country spread to the rest of the union? In an international economy based on a multiplicity of currencies, exchange rates play a role in stemming banking crises because the changes in exchange rates caused by the banking crisis lead in the very short term to a reorientation of international capital flows to support the banking sectors of other countries and, in the longer term, a change in relative competitiveness that supports domestic firms and banking sectors.8 In the case of a banking union this isolation mechanism does not work. Given the cross-border banking flows resulting from economic flows, a domestic banking crisis has a higher probability of spreading to the rest of the union. In our scenario of country-differentiated banking sectors, if a banking crisis occurs in one country, its impact will be felt mainly in that country, weakening the national economy and in particular its public accounts, relative to the rest of the union. This reinforces the structural heterogeneity of the union. In particular, it complicates the conduct of monetary policy. The link between banking fragility and structural heterogeneity makes the management of a banking crisis more delicate in a monetary union than it is in a unitary economy. It should be added that if the banking crisis turns into a systemic crisis, it is the very existence of the union that may be called into question, especially in the case of a multi-national union. The use of a plurality of currencies (the dismantling of the monetary union) can indeed be seen as the least bad solution to get out of the crisis because it allows a country to decouple its banking system and protect itself from the banking fragility that affects another country.

8

It should be pointed out that this containment role only works within a certain limit and does not imply the impossibility of an international banking crisis.

10.4 Banking Integration in a Monetary Union

369

10.4.4 Banking Panics in a Monetary Union Monetary union introduces an additional difficulty in the analysis of banking panics. In a simple economy, one can envisage a limited panic concerning a single bank or a systemic panic concerning the entire banking system when all banks are attacked at the same time. In an multi-national monetary union, an intermediate level is introduced: banking panic, actual or imminent, may occur at the level of a member country. This may be due to a self-fulfilling phenomenon or to actual factors specific to the national banking subsystem concerned. What are the implications of a national banking crisis in the union? First of all, depositors and creditors of a bank in a country in crisis do not necessarily reside in that country. The banking panic produces cross-border effects via non-resident depositors and creditors. As the banking subsystems remain interconnected, an episode of banking crisis in one member country has the potential to spread to the entire union. There may even be a contagion effect based on selffulfilling phenomena: the observation of banking panic in one member country may trigger banking panic in the other countries of the union. In a monetary union, agents residing in one country are more attentive to what is happening in another country than is the case in a multi-currency international economy. From the perspective of the multiple equilibria linked to the anticipation effects mentioned above, a banking crisis in one country of the union may trigger precautionary reflexes among depositors (more generally, lenders) in other countries of the union and thus a phenomenon of banking panic in those countries. There may be contagion from banking crises and, more broadly, from financial crises in a multi-currency world, either by mimetic effect or a domino effect through the international links that bind the banks. The South-East Asian crisis of 1997 is a good example of this. The risks of contagion are greater in a monetary union for three reasons. 1. Financial markets may not be able to assess the differentiated risks borne by national banking systems, particularly in relation to their exposure to national sovereign risk. In the event of difficulties in one country, lenders may consider that the problem is set in the same terms in other countries of the union and increase the risk premium borne by all banks in the union (if necessary, in varying proportions). 2. Economic integration reinforcing the correlation of business cycles within the monetary union means that in the event of a banking crisis in a union country, correlated with a depressive phase in that country, the financial situation of the banking system as a whole is weakened. 3. Finally, the intensity of financial linkages as a result of the microeconomic effects of a monetary union also reinforces interdependencies between banks: financial exposures to risk incurred by a national banking system gradually spread throughout the union.

370

10 Banking Union

Let us assume that a systemic banking crisis occurs in all banks in the union, either by extremely rapid spread or by contagion. Deposit insurance schemes may not have been homogenised and member countries may have retained control over them. National officials are not equipped to assess the full extent of the crisis and are confining their actions to the banks they supervise. They behave non-cooperatively, by not taking into account the cross-border effects of their interventions or wishing to postpone the most costly or difficult measures to be taken in other countries of the Union. The conditions of intervention can change from one country to another and consequently vulnerability to an episode of banking panic differs from one country to another. More seriously, there may be a competitive effect on national deposit insurance systems. Depositors may use their ability to deposit at any bank in the union and choose a bank with the most advantageous system for them. This is the source of new cross-border effects. Finally, once a banking crisis is triggered, the measures put in place will themselves have cross-border effects. In particular, the compensation offered to depositors of failed banks and, more generally, to certain creditors represents transfers within the Union but not necessarily within member countries. In short, the fragmentation of national insurance systems represents a structural weakness in the fight against banking panic and, more generally, banking fragility. In banking matters, the cross-border effects are manifold and require treatment designed at the level of the Union, either by unifying the deposit insurance system or by close coordination and regulatory homogenization of national systems.

10.4.5 Home Bias Finally, it is an additional cause of the financial fragility created by monetary union, linked to the home bias. The first argument that European leaders used to justify their decision to help Greece in June 2012 was that they were seeking to break the “vicious circle” between banks and public authorities.9 What they meant by the expression “vicious circle” was not so much that banks hold government securities but that banks in a euro area country disproportionately hold that country’s government securities. This holding, which amounts to the financing by a bank of the public deficit of the country in which it is domiciled, is the manifestation of a home bias.10 The home bias in banking (measured by the percentage of a bank’s assets held in its country of domicile) is a permanent feature of euro area bank balance sheets. On average, 59% of banks’ assets are invested in their home country, 24% in other EU countries and 17% in the rest of the world (Schoenmaker [33]). There are many

9

“It is imperative to break the vicious circle between banks and sovereigns”, statement at the end of the euro area summit on 28–29 June 2012. 10 The notion of home bias is broader. In macroeconomics, home bias refers to the FeldsteinHorioka paradox.

10.4 Banking Integration in a Monetary Union

371

reasons for this bias. The first is related to transaction costs, depending on a bank’s degree of internationalisation. A bank with a low degree of internationalisation will be inclined to acquire domestic public securities which are easier to manage locally than foreign securities traded with remote intermediaries. It is also opportunistic. By holding domestic government securities, a bank can expect more leniency from national prudential authorities. But above all, it is a way to enhance the potential government support for a bank. In the event of difficulties, a government could suffer from having its securities liquidated to relieve that bank, so it has an interest in rescuing a bank that is linked to it. This bias creates a vicious circle since it is tantamount to linking the risks assumed by a country’s banks with sovereign risk. The increase in sovereign default risk weakens the balance sheets of the holders of these securities, thus increasing their own risk premium applied to the loans they take out. This is what has happened in the euro area. Alter and Schüler [4] have shown that, during the crisis that began in 2007, the risk premiums on CDSs of a European country became important determinants of the CDS premiums of banks based in that country. But one bank is not an asset holder like another. The fragility of a bank or of the banking system may imply government intervention to ensure the continuity of the payment system. Such intervention implies that the State itself must be solvent and capable of bailing out part of the banking system. If the banks’ difficulties come from the sovereign itself, either through lack of funds or default, a public bailout operation is impossible. The systemic risk is redoubled by the lack of public intervention capacity. The consequences of this bias are obvious: the fragility of the financial situation of a State in a monetary union leads to the fragility of its banking system (De Grauwe [13]). Indeed, a government in a delicate financial situation does not want to make it more difficult for national banks to subscribe to its securities by tightening its regulations. When markets’ perception of a government’s default risk increases, this has two effects on domestic banks: first, the higher risk premium weakens their financial position by depreciating the government securities they hold; second, as markets doubt the guarantee provided by the government as lender of last resort, they increase their perception of the risk that banks represent and charge them a higher risk premium. The two effects combine to raise the cost of bank debt and make banks more vulnerable. This fragility increases with the proportion of domestic government securities held by a bank.11 It is amplified in a monetary union because the government does not have the instruments of monetary sovereignty: the currency in which it is indebted is the currency of the union and it cannot monetize its deficits. These two channels mean that a government cannot act on its refinancing conditions via the exchange rate with its foreign creditors. Compensatory effects via exchange rate depreciation (assuming that this depreciation supports economic activity) do not occur.

11 The reciprocal

is true: the fragility of a banking system, whether perceived or revealed, increases the government’s commitments, thus increasing its risk of default and the interest rates it bears.

372

10 Banking Union

Two solutions exist to reduce or eliminate the home bias. 1. The first is to move towards a form of fiscal union, whether through the mutualisation of public debts, cross-border transfer mechanisms or fiscal federalism. The link between the public financial situation and the financial situation of the national banks is attenuated to a greater or lesser extent depending on the capacities of the established fiscal union. 2. The second is to resort to banking regulations valid in the union, thus emanating from a banking union and limiting the proportion of national public securities that a national bank may hold.

10.4.6 The Triangle of Financial Impossibility in a Monetary Union Global financial integration, which has accelerated since the 1980s, has led experts to suggest the existence of a “financial trilemma” (Schoenmaker [32]). According to this trilemma, international financial integration, financial stability and the ability to conduct strictly domestic financial policies cannot be achieved jointly. Two terms may coexist but make the third impossible. For example, financial stability (understood as the equilibrium of financial flows with the rest of the world of a country) can be combined with international financial integration (understood as the free flow of international financial flows) but requires that national financial regulation be aligned with global regulatory conditions so as not to divert financial flows. As Obstfeld [30] notes, exchange rate manipulation by monetary policy is able to alter financial flows vis-à-vis the outside world, at least in the short term, and to curb the destabilizing effects of these flows, but not to invalidate the trilemma itself. The external constraint on the regulatory capacity of a country’s financial and banking activities is therefore not specific to a member country of a monetary union and is not confined to the pressure exerted by its partners in the union. Moreover, taken as a whole, a monetary union is itself subject to this financial trilemma in its relations with the rest of the world: a concerted, even cooperative effort on a global scale is required to ensure the financial stability of a globalized financial system. But, within a monetary union, this trilemma is set in specific and even more pronounced terms. Not only does the non-existence of exchange rates make it impossible to manage (wisely or unwisely) short-term capital flows but monetary unification and the requirements of the union’s currency circulation increase financial integration within the union. Thus, in a monetary union, the attempt to regulate on a country basis financial and banking activity is simply not possible under pain of permanent financial instability which would endanger the monetary union itself. In view of the macroeconomic and microeconomic weaknesses that we have just summarised, it is clear that the banking system is caught in the contradiction between the economic and financial integration made necessary by monetary unification and the fragmentation of the regulatory system.

10.5 Banking Union and Regulation

10.5

373

Banking Union and Regulation

A banking union, in one form or another, is intended to solve this contradiction. 1. Macroeconomically, the aim is to establish a coherent macroprudential framework to monitor the soundness of the banking system as a whole in the face of macroeconomic risks and deal properly with systemic risk. The difficulty in monetary union is compounded by the fact that a banking crisis spreads within the union and has differentiated effects within the union. This leads to different assessments of the impact of the crisis and differentiated solutions to be implemented. The events which hit the EMU in 2012 are a perfect illustration of this. The immediate cause of the growing and contagious anxiety that led to the rise in interest rates on European public securities was the growing difficulties of Spanish banks and the inability of the Spanish State to bail out its banking system. The Spanish authorities then appealed to the European Union to help recapitalise the ailing banks. This amounts to exporting the Spanish banking difficulties, in particular through a generalised increase in interest rates. This increase itself contributed significantly to the decision of the European Council in June 2012. The US financial crisis of 1893 implemented similar diffusion mechanisms within the monetary union. Due to the Sherman Silver Act of 1890, which introduced the bimetallic system and created speculative attacks, banking panic became widespread throughout the Union. The crisis exacerbated tensions between the American regions, pitting the western states that produced silver and agricultural products against those of the industrial north-east.12 2. Microeconomically, the aim is to eliminate the proximity between the banking system and national regulatory authorities, as well as the unintended cross-border effects that this juxtaposition of regulations generates and that lead to distortions of competition or an overall lax framework. A banking union is both a set of regulatory provisions governing banking activity in a monetary union and an institutional architecture specifying the respective responsibilities of the various public and political bodies involved in its governance.

10.5.1 Going Beyond Banking Sovereignty The member countries of a monetary union enter the union with different regulatory traditions, corresponding to banking systems that are themselves specific. The result is a complex regulatory apparatus which is both a source of costs for

12 On the 1893 crisis, see Wicker [37], chapter 4, and Hoffmann [23]. On its spread

Union and the regional political conflicts it generated, see Kolko [28].

in the American

374

10 Banking Union

banks and a generator of cross-border externalities, often negative.13 Moreover, financial integration within the monetary union allows banks to use avoidance strategies by taking advantage of their freedom to set up or transfer business. These strategies generate increased risks (by concealment or equivocation) and difficulties of resolution in the event of a crisis (who is responsible for what when a bank collapses?). 1. National authorities, with a national perspective, may seek to support their own banking system and favour their banks in the face of competition from other countries in the union. Their regulatory power is used to distort competition. Moreover, because their supervisory and reporting arrangements are limited and do not extend to the entire union, they have a myopic view of the situation of banks under their authority that are active throughout the union. Finally, the national authorities disregard the cross-border effects of their decisions. Formally, the non-cooperative behaviour of national authorities leads to a suboptimal balance and a weakening of the quality of supervision and insufficient prudential quality in the union.14 2. Banking sovereignty is at the origin of a bias in favour of the solution of the external rescue (bail-out) of banks in difficulty rather than the involvement of a bank’s creditors in its internal bail-out (bail-in) by transforming their claims into capital, for example. The cost is borne by the union’s taxpayers who are numerous and poorly mobilised. This gives a competitive advantage to the national banking sector. But the consequence is a tendency for banks to be undercapitalized (they do not need much capital as a guarantee of solvency) and to assume high risks (Admati and Hellwig [1]). 3. Public regulation theory has long addressed the issue of the capture of the regulatory authority by the interests it is charged with controlling. The authority tends to adopt the viewpoint of the regulated agent or institution or by making decisions in their favour at the expense of the public interests it is supposed to

13 The international consequences of the reform of banking regulations decided by the German authorities in 2005 are a good example of this. This reform lowered the costs of entering the covered bond market. This benefited the “Landesbanken”, German regional public banks, whose activities are traditionally oriented towards public authorities and construction financing, to extend their activities towards more remunerative financial products. The greater competition on this market pushed the banks issuing these bonds which had become less remunerative, such as the Franco-Belgian bank Dexia, to take more risks. In September 2008, Dexia was on the verge of bankruptcy and had to be bailed out by the Belgian and French States for an amount of 5.5 billion euros. The Landesbanken themselves were severely weakened by the financial crisis of 2008. 14 Dell’Aricia and Marquez [12] have shown how international competition in banking regulation leads to a “race to the bottom” and a sub-optimal level of regulation. By reasoning in an economy with information asymmetry between regulators and banks, Boyer and Kempf [7] showed that this competition leads to inefficient regulation in the sense that banks are not discriminated and properly regulated according to their quality. These results justify the interest of an integration of banking regulation, or a banking union.

10.5 Banking Union and Regulation

375

defend.15 This can be done through overt or insidious corruption. The banking system is not immune to these phenomena of capture for two reasons. The first is the size of the sums involved. The second is the close relationship between regulators and bank managers, based on shared expertise in complex situations. National proximity further increases the risk of capture in a monetary union in the absence of a banking union (Boyer and Ponce [8]). These risks and hazards make it necessary to consider banking regulations covering the entire union, i.e. a banking union.

10.5.2 Supervision A bank in a monetary union is legally registered in a country and thus subject to the regulations of that country. However, having activities throughout the union, it organizes its activities through subsidiaries or branches established in other countries. Who has supervision responsibility for these entities? If it is the national authorities of the country where the subsidiary or branch is located, is the bank as a whole properly regulated given that it responds to at least two regulation authorities? It may take advantage of the diversity of supervision arrangements, just as a multinational company takes advantage of differences in national tax policies. Logically a single authority over banking activities throughout the union and capable of setting up a comprehensive supervisory framework avoids conflicts of interest or jurisdiction between regulators and supervisors and allows an assessment of banking risks at the level of the union. But it may be penalised by a lower quality of information or a lesser capacity to process it properly than a national supervisor. This opens up a conflict over “subsidiarity”. The use of national supervisors is supposed favourable to the quality of supervision but with the disadvantage of being more narrow-focused and sighted and opening up the risk of inconsistency in supervision. On the other hand, integration through a single supervisory body for the whole union, perhaps less well informed, is supposed to be less favourable to the quality of supervision but to have a broader and more coherent view of the situation of individual banks and the banking system as a whole.

10.5.3 Resolution Solving the difficulties encountered by a bank is much more difficult than supervising banking risks. The reason is simple. A consensus about supervision whose aim is to ensure that these difficulties do not arise, is (more or less) easily achieved. Resolution, on the other hand, necessarily implies that losses must be assumed by certain parties, creditors, shareholders of the bank, or even taxpayers. In contrast 15 Politicians

and economists agree on this point even if they treat it with different tools.

376

10 Banking Union

to supervision, resolution generates distribution conflicts and raises questions of fairness. In the context of a monetary union, these conflicts are most likely to arise between parties from different member countries. They have an international dimension and, as such, directly affect the political and institutional strength of the union itself. Moreover, as we saw in Sect. 10.3, the arrangements for resolving a banking crisis generate moral hazard of all kinds: the risk of underreporting, underpricing of risks or biased reporting. Depending on the architecture chosen to organise resolution in monetary union, these phenomena take different forms but they do not disappear. Several options are possible for the organisation of the resolution framework. It can be done on a national basis: a national public authority is in charge of this resolution whether through temporary assistance, restructuring or liquidation. Is it satisfactory? Clearly not, except in the rare case where the activities of the bank in difficulty are strictly confined to the country in which it is registered. In such cases, given the conflicts of interest between the parties, some may fear that they will not be treated fairly by that authority because they are not located in the country where the authority is registered. They will therefore refuse this solution. The problem is not specific to monetary unions. It arises in any resolution of a bank with international activities. For example, the US authorities have decided that US subsidiaries of foreign banks will be treated by the US authorities according to US regulations (Hellwig [22]). The resolution raises the question of the confidence that the parties have in their regulator. Trust is hard to obtain, easily lost and therefore can never to be taken for granted. It can also be envisaged that the national authorities would be responsible for the management of the components of the bank that fall within their jurisdiction. Actions taken by national public authorities may be inconsistent with each other or may lead to conflicts of interest between national public authorities with different views on the future of the bank in question or its components.16 Given these remarks, one is tempted to conclude that the responsibility for the reorganisation or liquidation of banks in difficulty should be entrusted to a supranational authority covering the whole union. But such a solution does not solve the issue of distribution (i.e. the balance of gains and losses associated with a resolution of these difficulties) or of equity, which makes any operation to resolve a banking crisis so delicate. In other words, the political legitimacy and trust that the residents of the union place in this authority cannot be taken for granted by the mere assumption that, since this authority is supra-national, it has the right point of view. Actually the delegation of banking resolution to a supra-national authority creates specific problems. As said above, one of the advantages of a supra-national solution is that the overall risks run by the union are (potentially) taken into account. In terms of

16 The case of the liquidation of Fortis, a Dutch-Belgian bank, (badly) managed jointly by Belgium and the Netherlands after its collapse in 2008, finally split into two components, a Belgian one sold to BNP Paribas, the Dutch one sold to ABN Amro, is a good example of these inconsistencies.

10.5 Banking Union and Regulation

377

bank resolution, this may lead to a tendency to procrastinate: taking into account global risks (systemic risks, fear of contagion) may lead an integrated authority into a situation of waiting and non-decision making that a national authority does not experience (Allen, Carletti and Gimber [3]). Moreover, this tendency will be reinforced if the supra-national authority has (which is likely) more financial resources, especially because the costs are borne by all the taxpayers in the union: in these conditions, since it may incur greater losses, it may tend to wait longer, at the risk of seeing the bank’s difficulties worsen. However, the major difficulties relate to the question of endorsement of losses linked to the restructuring or liquidation of a bank.17 Let us assume that the costs of resolving a bank registered in a member country are borne by the taxpayers of the union. This may fuel this tendency to procrastinate. Since the authority in charge (especially if it is integrated) has more means and the capacity to pass the costs on to a larger mass of taxpayers, it may tend to wait longer, at the risk of seeing the bank’s difficulties worsen. In addition, taxpayers in other countries are likely to feel that they are paying unduly for a crisis for which they are not responsible and which they attribute to the recklessness of their partners. If, on the contrary, these costs are borne by the taxpayers of the member country, the supra-national resolution authority may be tempted to “load the boat” and approach the issue with a lack of care that will lead to a political trial of incompetence or negligence. These political considerations mean that there is a bias in a monetary union in favour of the involvement of the parties (bail-in), even if this is not always the preferable solution because of its indirect consequences. Such a solution avoids opening a conflict with taxpayers. It is therefore to be expected that the resolution procedures will be difficult to negotiate and put in place as they concern a major problem of distribution of the net costs of a banking crisis.

17 A

good example of these difficulties in deciding who should bear the financial consequences of banking crises in monetary union can be found in the case of the euro area in 2010. At the beginning of 2010, Ireland was facing a banking crisis as a result of the collapse of Lehman Brothers. Irish banks, heavily indebted in relation to their capital, could no longer find the loans they needed to refinance themselves on the markets and were in a serious crisis situation. The current President of the ECB, Jean-Claude Trichet, was in favour of a rescue by the European authorities, first and foremost the ECB itself, without involving the creditors of Irish banks. In November 2010, he wrote a comminatory letter to the then Prime Minister, urging him to request financial support from the Eurogroup. His fear was probably that some bank failure would trigger a process of financial fragility that could, by contagion, affect the entire euro area. However, in the Greek case, the political authorities of the euro zone decided in the opposite direction. In October 2009, the new Greek Prime Minister, George Papandreou, made public the make-up of the Greek public accounts and announced an actual public deficit of 12% of GDP. The European Council of February 2010 recognised the unsustainable nature of Greek public debt. But German Chancellor Angela Merkel and French President Nicolas Sarkozy agreed that foreign banks would assume part of the losses on their Greek asset portfolios involved in the rescue of the Greek accounts and banking system. Thus the internal bailout and the external rescue were implemented simultaneously. This example shows the contingent and highly political nature of the banking crisis resolution decisions due to their redistributive implications.

378

10 Banking Union

10.5.4 Deposit Insurance Insuring deposits in a banking union again raises the issue of who bears the costs. As we have seen, a compensation scheme is backed by the Treasury, without which its credibility is not assured. Suppose that some banks located in a member country are liquidated and the depositors concerned need to be compensated. If this compensation is made on an exclusively national basis, its credibility depends on the state of the public finances of the country concerned. We encounter the vicious circle that we have seen to be at the heart of the union’s financial fragility. This is not the only drawback of a strictly national basis for deposit insurance. In a monetary union, mobility is not just about workers. Under the unification of the capital market, depositors are given the opportunity to open an account throughout the union. This amounts to competition between national bank compensation schemes. Indeed, depositors can arbitrate between competing insurance options. Depending on the degree of international mobility of depositors (their propensity to open accounts in countries other than their country of residence), national authorities may be tempted to play on the guarantees offered to increase the mass of deposits received by their banking system at the expense of other national banking systems. This leads to a bidding mechanism, or a “regulatory race to the top”, depending on the degree of sensitivity of depositors to the guarantee.18 This race to the bottom increases the potential burden borne by public Treasuries and, by worsening their tax situation, weakens the entire insurance system. In such a case, the risk may become unsustainable.19 A monetary union, by removing the monetary weapon that allows States to use directly for their own benefit the mechanisms of financial repression represented by inflation or devaluation of the currency, sharpens the dilemmas related to the control of banking systems. The banking dilemmas of a monetary union are manifold. 1. The payment system of the union, which is based on networked banks, is weakened by political fragmentation whereas banking and financial integration is both facilitated and made necessary by monetary unification. 2. As a result, banking and financial risks are increased compared with the situation in a unitary State, with equal institutional and professional quality. It is difficult to prevent, close or restructure unprofitable and dangerous banks, either because of a lack of information and coordination or because of the conflicts of distribution that a prudential policy unavoidable creates. 3. It is therefore necessary in a monetary union to set up institutions and procedures linked to the financial and banking integration which is an inevitable

18 In

a mechanism analogous to the race to the bottom in international tax competition configurations. On this mechanism and its consequences, see Chap. 6. 19 The case of the collapse of Icelandic banks that had attracted many foreign depositors with very attractive returns, following the subprime crisis of 2007, is exemplary: neither the Icelandic central bank nor the Icelandic Treasury were able to guarantee the deposits of foreign depositors.

10.6 Establishing a Banking Union

379

consequence of monetary union, taking account of the difficulty of organizing financial repression on a national basis in a monetary union. But this implies a consequent transfer of sovereignty. The fact that it deals with abstruse issues that are beyond the comprehension of most people does not make it any less important structurally or even historically.

10.6

Establishing a Banking Union

The establishment of a banking union capable of achieving this twofold objective poses thorny problems. 1. We saw in the previous section that the solution of transferring the entire prudential policy to a supra-national body uniformly covering all the banks active in the monetary union, the complete banking union solution, poses its own problems and cannot be considered as a solution valid for all configurations of the banking system. The institutional architecture of prudential policy (in both its microeconomic and macroeconomic components) in a monetary union faces a difficulty of the same order as fiscal policy and its articulation with monetary policy. How should the banking and financial heterogeneity of the union be managed? Is the standardisation of regulations compatible with this heterogeneity? Should the various aspects of regulation be left to the authorities of the components of the union, at the risk that cross-border effects are not properly managed, or should everything be centralised and entrusted to an entity covering the whole union, at the risk of creating structural misalignments similar to those we noted in Chap. 3 concerning monetary policy? 2. Banking regulation is a complex matter with long-term effects that are felt over several decades. Any changes are delicate and slow to develop. In any event, a banking union must be sustainable and its provisions known so that banks can commit to multi-year, even long-term, plans. It must make it possible to overcome local or systemic crises, which are low-frequency events. This implies paying particular attention to the conditions of its governance. Finally, it must nevertheless be capable of evolving to adapt to changes in the banking industry, particularly technological changes but also changes linked to competition from the rest of the world. As a structuring element of a monetary union, the banking union must be established with care and with a long-term perspective, even if it may be born or transformed during a major banking crisis.

10.6.1 Regulatory Federalism or Cooperation In terms of institutional architecture, as in the case of the fiscal union, we can oppose a federal option and a cooperative option. In the first option, we can speak of regulatory federalism: a supra-national regulatory authority is responsible for the

380

10 Banking Union

banking union, but may delegate some of its responsibilities and tasks to national authorities. This supra-national authority is accountable to a political body that is itself supra-national. In the second option, the steering of the union is ensured by inter-governmental cooperation.

10.6.2 The Banking Union Between Integration and Subsidiarity Unlike fiscal union, it is difficult to envisage a banking union based solely on the cooperation of the member States of the monetary union, on the basis of strictly national institutions and intervention capacities. A banking union almost always relies of necessity on supra-national institutions, even if their creation takes place in the context of a monetary union not backed by a federal state. There are two simple reasons for this. 1. The banking union is linked to the circulation of money within the union. This circulation is homogeneous and integrated throughout the union. It implies uniform regulations and operating conditions. Insofar as the banking networks are the vehicles of this circulation of money, they must operate in an identical manner. As these networks rely on the banks, they tend to be subject to the same regulations which can only be thought of on a supra-national basis. 2. Given the cross-border externalities which exist in banking and finance and the speed of financial flows, the international consequences of a national regulatory decision are rapidly transmitted throughout the union. However, the various components of a banking union do not pose the same problems. In particular, fiscal capacities may have to be mobilized but these may be strictly national. A key question for a banking union is therefore to define the balance between the responsibilities to be integrated, i.e. assumed by the union as a whole, and those left to national authorities. This balance is posed in different terms depending on the aspects of the banking union.

10.6.2.1 Supervisory Institutions Prudential regulation in a monetary union is logically supra-national in nature. Microeconomically, it must ensure or respect the harmonisation of conditions of competition and operation between banks. This promotes banking integration within the union. Macroeconomically, given the economic integration of a monetary union and the cross-border effects of a banking crisis in the union, an overall assessment of the situation of the banks is required. Supervision consists in the practical verification of the application of prudential regulations by the banks. As said above, an integrated approach to supervision runs the risk of neglecting local particularities that a local authority would have taken better account of. On the other hand, it may be carried out by agents who are better qualified or less sensitive to capture.

10.6 Establishing a Banking Union

381

Agarwal et al. [2] studied the banking supervision arrangements in place in the United States and uncovered some disturbing facts. Supervision of US banks is carried out jointly by federal and state agencies (depending on the states themselves), under a system of rotation over a specified period of time. Analysis of the data shows that federal supervisors are stricter than state regulators, with the former lowering the ratings given to banks twice as often as the latter. But state regulators raise those ratings more frequently. Finally, this greater severity does not seem to be due to a lower risk of capture by local interests, but to more resources and more qualified personnel put in place by the federal supervisory agency.

10.6.2.2 Resolution Institutions The assignment of resolution procedures to one level or another is more ambiguous. It depends on the scope of action of a distressed bank. If it is national, it makes sense to use a national mechanism. If, on the other hand, the bank’s activities cover the whole of the union, this solution does not naturally apply. In any event, the resolution of its difficulties requires close cooperation between the national resolution agencies. The resolution of a bank’s solvency problems becomes even clearer when it is achieved through the bail-out of the bank in question. If it is supported by its national Treasury, this contributes to increased fragmentation, via home bias: a bank will tend to restrict its activities to the national arena since it provides it with a better guarantee. If the bailout financing is international, this creates the risk of contagion, depending on the financial capacity available for bailout purposes. In the case of liquidation, a national solution takes into account the interests of the bank’s borrowers, especially if they are located in the country and the bank’s creditors or owners are spread throughout the union. But it runs the risk of contributing to a spread of the crisis to the whole union by weakening some banks which suffer losses because of this liquidation and whose interests have not been (sufficiently) taken into account by the national authority. Here again, this solution is likely to fuel financial fragmentation. The question arises as to whether or not national liquidation clauses and practices should be harmonised. Non-harmonisation introduces a distortion of competition between banks of the same status or structure but located in different countries. An integrated solution may, on the other hand, adopt other liquidation criteria, probably more favourable to parties resident outside the country in question. It may also be less attentive, or prone to procrastination, as discussed above. It is difficult at this stage to favour one solution over another. But it can be taken for granted that the resolution of an insolvent bank is likely to fuel conflicts of interest and disagreements over the solution found that will cut across state lines. 10.6.2.3 Deposit Insurance Institutions The credibility (and hence its prudential effectiveness) of a deposit insurance scheme depends on the ratio between the size of the banking sector and the financial capacity for compensation that it relies on. More specifically, we saw in the previous section that it depends mainly on two factors: the soundness of the

382

10 Banking Union

financial configuration (through a guarantee fund and/or a Treasury) that can be mobilised, and the mobility of depositors within the union. If deposit insurance is assumed on a national basis, this may lead to depositor mobility within the union in search of the most advantageous insurance system. The lack of mutualization of deposit insurance is clearly sub-optimal and is a factor of weakness in the banking union. Moreover, competition for deposit guarantees creates a new channel of fragility in the union, putting pressure on the central bank since, in the event that the public treasuries are unable to meet their explicit commitments or not, it will have to provide compensation to depositors. On the other hand, if compensation is financed by schemes that weigh on the union as a whole, this makes competition between compensation schemes inoperative and increases the financial capacity to compensate depositors of a bank (or a fraction of banks). This enhances the reliability of the deposit guarantee, other things being equal. But such a solution is open to two criticisms. The first is to increase the opportunities for moral hazard: because the guarantor is supranational and large, individual banks may be inclined to increase their risk-taking. The second is that this amounts to creating (potential) solidarity between taxpayers belonging to the monetary union. This solidarity poses the issue of sharing the costs of the guarantee and can be difficult to assume politically. This is exactly what happened in the euro area when, following the decisions of July 2012, a common deposit insurance scheme was created. The German leaders were opposed to this, under pressure from public opinion that feared they would have to pay the cost of compensating depositors from other EU countries who were clients of banks that were poorly managed or had taken excessive risks.

10.6.3 Banking Union Politics The banking union must find political legitimacy and the decisions taken must enjoy the consensus of national public opinion, if necessary through their political representation. How to counter claims that banking authorities act irresponsibly or unfairly? How can we ensure that the distributive consequences linked to the banking union do not lead to an aggravation of conflicts of interest within the union, or even to a weakening of the monetary union itself? These serious but infrequent events have significant and lasting consequences, but on which it is difficult to make an unquestionable diagnosis (how to judge a financial bubble? It is impossible, except a posteriori when this diagnosis is only of interest to academic economists). The crux of the problem is that the scope of a bank’s activity does not correspond to the scope of a regulatory body. The choice of an institutional architecture is linked to the political balance in place in the monetary union. More precisely, since a banking policy is made credible by being backed by a fiscal framework, the choice of a banking union is congruent with the choice of a fiscal union. Whichever option is chosen, the difficulties of coordination and negotiation between the public authorities concerned, with their

10.6 Establishing a Banking Union

383

possibly divergent interests, cannot be underestimated. The regulatory institutions themselves may play an uncooperative role. Whatever the type of political management of the banking union, the regulatory bodies must comply with a number of potentially contradictory requirements. 1. Staff must be competent: banking regulation is a complex task which individually requires extensive training and collectively requires a combination of several types of expertise. 2. The management bodies of the regulatory agencies of the banking union must logically be collegial in nature. This requirement is needed in the case of the banking union because it brings together sovereign States that are very sensitive to ensuring that the specific characteristics of their countries are properly taken into account. In other words, the credibility of the banking union makes it necessary for the boards of the union’s agencies, but also their staff, to be representative of the union and its possible banking diversity. 3. As we have seen above, the transition to the banking union and the creation of supra-national agencies do not eliminate the risk of these bodies being captured by private interests, first and foremost the banking lobbies, but also national vested interests. Political pressure can be brought to bear on the regulatory bodies of the union. In order to be credible and minimize regulatory distortions, they must be independent, i.e. free from the influence of private or political interests so that regulatory procedures are applied fairly. Independence does not mean absence of control. On the contrary, on the contrary, since we have seen that the distribution of the actual or potential costs of the banking union is one of its most sensitive points. Clear provisions must allow the colleges of the Union’s regulatory agencies to be accountable to the political bodies that guarantee the soundness of monetary union. In order to be effective, these provisions must be the result of a trade-off between the justification of the merits of the decisions taken, based on reliable and precise information, and the need not to unduly worry public opinion about the state of the union, which could lead to the opposite result from the one expected, i.e. a weakening of the union. 4. Last but not least, the last difficulty to be resolved is that of coordination of bodies. The components of a banking union are interdependent but cannot be confused. Because a banking system is necessarily complex, the different parts of the banking union cannot be entrusted to a single agency. The difficulty is compounded by the fact that the political fragmentation of a multi-national union into sovereign States adds to economic differentiation. A banking union relies on a diversity of public agencies, each with different responsibilities and national ties. Effective coordination of the whole is an imperative of a banking union. However, it is not guaranteed, in particular because conflicts of interest may exist between these institutions.

384

10.7

10 Banking Union

Banking Union and Central Banking

10.7.1 Banking Union and Monetary Policy A banking union, because it makes monetary policy more secure, better protected from banking and financial crises, strengthens a monetary union. The question does not arise as to whether the central bank of the union has an interest in the banking union (assuming that it is reasonably effective in eliminating, or at least mitigating, banking crises arising from individual or collective risk-taking): the answer is clearly in the affirmative. A banking and broader financial crisis has two negative effects on monetary policy, one of the tasks of the central bank. 1. It forces the central bank to give priority to rescuing the payment system and leads it to deviate from normal/conventional monetary policy. This is why, since 2008, we have witnessed non-conventional policies conducted by central banks. 2. More insidiously, it seriously disrupts the transmission channels of monetary policy. In the case of a monetary union, the alteration of these mechanisms means an increase in the differentiation of the sectoral effects of monetary policy. In other words, financial integration within the union is jeopardised by the crisis. Under these conditions, the central bank of the union has everything to gain from a banking union, provided that it is efficient and drastically reduces the risks of a banking crisis. The most obvious advantage lies in the reduction of banking risk. An effective prudential policy, leading to a marked reduction in the likelihood of banking crises, means that the central bank of the union is less likely to play the role of lender of last resort to rescue banks in liquidity or, worse, solvency difficulties. Monetary policy is therefore less likely to be affected by a banking crisis. Moreover, the lower probability of a banking crisis represents lower macroeconomic variability, and, for example, a lower risk of inflation. This is in line with the central bank’s mandates. In addition to the greater financial strength of banks, prudential policy contributes to better discipline with regard to public debt. With less pressure from the situation of national Treasuries, the dominant fiscal policy is less to be feared. Because the banking union homogenises the conditions under which banks operate, it contributes to financial integration within a monetary union: two banks with identical characteristics lend under the same conditions. This means that borrowers with identical characteristics face the same interest rate structure. Moreover, prudential policy (to the extent that it is well thought out and well conducted, coordinated within the union) represents a significant reduction in the risk of bank insolvency. Thus, there is both harmonisation and a reduction in risk premiums in the union. Prudential policy also has the effect of reducing distortions of competition in the union’s banking sector (through implicit subsidisation of fragile or insolvent banks).

10.7 Banking Union and Central Banking

385

As a result of these various effects, the transmission channels of monetary policy within the monetary union are harmonised. Indeed, we have seen that the transmission of monetary impulses may differ from one member country to another because of the heterogeneity of national economic structures. In particular, the heterogeneity of banking structures contributes to the differentiation of monetary policy transmission channels. The banking union, to the extent that it homogenises credit conditions in the monetary union, contributes to a harmonisation of the effects of monetary policy. In particular, it aims to put an end to the sudden liquidity dry up which can occur locally following a local banking crisis and thus raises the interest rates on the loans granted. Finally, the coordinated supervision of the union as a whole leads the prudential authorities to better control risk-taking by banks and credit policy in the union. This also contributes to greater stability in the transmission channels of monetary policy in the union. Returning to the situation of EMU in 2012, this episode is a good example of the links between banking union and monetary policy and shows how a process of banking integration facilitates the conduct of monetary policy, especially in times of crisis. Since the beginning of 2012, there has been a process of rising premiums on the public debt of European countries, linked to the Greek crisis, and a phenomenon of contagion of the expectations of operators on the financial markets. This contagion was fuelled by the increasingly acute perception that the deterioration of a country’s public finances weakened the country’s banks, due to the home bias, and that this banking fragility in turn weakened national public finances. As mentioned above, the European Council at the end of June then decided to lay the foundations for a banking union, citing as one of its main objectives the breaking of the vicious circle between banks and States. The decisions taken were followed on 26 July by a famous speech by Mario Draghi, President of the European Central Bank, in which he announced that the ECB would take whatever decisions were necessary (“whatever it takes”) to ensure the smooth functioning of the euro area and set up a massive programme of purchases of government securities (Outright Monetary Transactions) [15]. The coincidence of these two actions, on the banking and monetary fronts, led to a rapid decline in risk premia on European government securities. Véron [35] argues that it was only because the European banking union was officially launched that the ECB was able to take such a bold stance which it had until then always refused to do. In any case, the decisions of the European Council clearly worked in the same direction as the ECB’s decisions and fed the rapid fall in rates on sovereign debt that it wanted to set in motion. Since banking union is linked to monetary union, we must ask ourselves what role the central bank plays or can usefully play in this regulatory framework. More concretely still: should the central bank of the union be entrusted with the management of a part or the totality of prudential policy? If, to shed some light on this, we look at the evidence, we see a wide variety of situations, proof that there is no unequivocal and obvious answer to this question. The example of the United Kingdom speaks for itself: prudential responsibilities were assumed by the Bank of England until 1997, then were returned to it in

386

10 Banking Union

2012, following the financial crisis of 2007–2008, the prelude to which was the sinking of the Northern Rock Bank in September 2007, which resulted in the State nationalizing almost 75% of the British banking sector. In the light of this catastrophic record, UK officials felt that supervision by independent authorities had clearly failed and that it was preferable to back up prudential policy with the central bank [5]. Let us try to understand the advantages and disadvantages of the solution consisting in integrating all or part of the prudential policy into the central bank of the union.20 An illustration of central bank involvement in macroprudential policy is provided by the European Central Bank. The ECB has been entrusted by the European authorities with oversight of this policy through the European Systemic Risk Board.

10.7.2 The Role of the Central Bank in Supervision Assigning responsibilities for banking supervision to the central bank of the union is easily justified. 1. The first advantage stems from the fact that the central bank is a supra-national institution with a global vision, politically independent, and with collective expertise in banking and financial matters. It is competent and statutorily capable of resisting requests from political authorities to save a bank or, on the contrary, to delay regulatory intervention. 2. In particular, being in permanent contact, on a daily basis (where appropriate through the national central banks, as is the case in EMU) with the banks of the union, monitoring their financial position on an ongoing basis, it has detailed and first-hand information on the banking system. As the key variable of a prudential supervision policy, both in its micro- and macroeconomic aspects, the central bank is naturally able to assume this role. It is in a position to make a precise diagnosis of a bank’s difficulties and its possible fragility. Supervision of the banking system is certainly the prudential task that can most easily be entrusted to the central bank. For this activity, the central bank takes full advantage of its informational advantage and operational stability. In the case of a monetary union, this advantage is all the stronger as the central bank is a supranational institution. The consequences in terms of distortion of competition, the risk of its independence from the political authorities being called into question, are minimal. The risks of moral hazard are also reduced if the central bank limits itself to this prudential activity.

20 For

[11].

a modelling of macroprudential policy in a monetary union, see Dehmej and Gambacorta

10.7 Banking Union and Central Banking

387

10.7.3 The Role of the Central Bank in Resolving the Crisis Giving an important role to the union’s central bank in the resolution of a banking crisis appears to be in line with its responsibility as lender of last resort. This role is at least as important in a monetary union as in a unified economy but more difficult to carry out. At least as important because the risks of a banking crisis, their potential severity and in particular the risks of an international extension are high, and probably increasing with the structural heterogeneity of the union. Its expertise, the professional quality of its staff and its knowledge of the functioning of a bank give the institution the capacity for rapid intervention in terms of resolution. In a situation of banking fragility, the ability to intervene before panic grips the correspondents of an institution in difficulty, or even the depositors, is a decisive factor in the success of an intervention. More difficult to carry out because of the heterogeneity of the monetary zone and the international redistributive effects implied by central bank intervention in favour of certain banks located in certain countries. The first difficulty for the central bank of the union is to know which bank to save. How to carry out the diagnosis on the viability of a bank? On the basis of what information should it base its intervention as a last resort? Mastering the union’s payment system is not enough because the diagnosis of a bank’s viability depends on knowledge of the banks’ balance sheets. This question relates to the organisation of “micro-prudential policy” in the union. If micro-prudential policy is the responsibility of the national authorities of the home country of the bank in difficulty, this raises the question of the institutional links between the central bank and these authorities. The fragmentation of the monetary union increases the opportunities for opportunistic behaviour or moral hazard. Cross-border effects or risks of contagion increase the severity and dangerousness of a national banking crisis, making the union’s banking system more vulnerable to bank failure. This weakens the credibility of the central bank, insofar as it is considered manipulable by the banking sectors of the union. Finally, the central bank, as a supra-national institution, intervenes to rescue banks or a subset of banks linked to a component of the union (or a sub-group of the union). The central bank then risks being caught in conflicts of interest and conflicts of legitimacy within the union. Let us first assume that the loan is secured by a security. It is likely that the central bank will have to relax its collateral requirements to support a bank, for example, commercial paper from a financially weak issuer. This poses a problem of fairness: securities of the same type are treated differently. To avoid this problem, the central bank is led to loosen all its collateral requirements across the union, vis-à-vis all banks. Suppose now that the loan is unsecured and consider a monetary union to two countries where the only means of financing agents are bank credits. Suppose that country A is in a banking crisis. Taken on a consolidated basis, the banks in country A are in difficulty vis-à-vis their counterparties in the union, the banks in

388

10 Banking Union

country B (also taken on a consolidated basis). In the interbank payment system, banks A are debtors while banks B are creditors. The amount of these claims is an indicator of the difficulties of banks A. But it can also be interpreted as the current account balance (since the only international financial flows are credit flows and the balance of international flows to a country is equal to its current account balance). In this configuration, the banking crisis can be read as a balance of payments crisis within the union. We now see that the external crisis can be linked to a banking crisis. When the central bank comes to the rescue of banks A as a last resort lender, it advances them liquidity to meet their obligations to banks B. In doing so, it resolves the external trade imbalance between the two countries: the central bank of the union is the solution to the balance of payments crisis within the union. But it is a purely accounting settlement. In fact, it favours country A to the detriment of country B, which has to suffer the consequences of the growth of the monetary base decided by the central bank to avoid the banking crisis in A, and in particular the inflationary consequences. More generally, by increasing banking facilities for all banks, it allows creditor banks to support a volume of claims towards higher debtor banks. Let us open the union to the rest of the world and allow capital flows between the rest of the world and the countries of the union, to the exclusion of all bank credit. Capital from the rest of the world can come in and finance banks A. As banking difficulties accumulate in country A, this capital is led to disengage from banks A more or less quickly, thus increasing their difficulties and the severity of the pending banking crisis. Under these conditions, the central bank is led to replace this foreign capital.21 These difficulties decrease the confidence of non-financial agents in their banking system, which is the desired goal of a lender of last resort policy. Indeed, they may lead the central bank to postpone its intervention, even though rapid intervention would be desirable to avoid the propagation of the difficulties in the union. Paradoxically, it is easier for the central bank of the union to intervene in the event of a systemic crisis affecting the banking and financial systems of the union as a whole, since its intervention then appears to be unquestionably legitimate to all agents. The central bank may allow a local banking crisis to worsen and spread until, faced with the growing dangers to which everyone is exposed, there is a consensus on its intervention.22

21 The

notion of lender of last resort is sometimes extended to the case of an insolvent government avoiding sovereign default through recourse to the central bank and the monetisation of government debt, through the purchase of government securities by the central bank, or even the outright creation of liquidity on the government’s account. What the two interventions have in common is the creation of money by the central bank for the benefit of an economic agent on the verge of bankruptcy. But their logic and the risks incurred or avoided are different. It is preferable not to confuse the two interventions under the same expression. 22 This is how the ECB’s delaying tactics during the sovereign debt crisis that began in 2009 can be interpreted until 2012.

10.7 Banking Union and Central Banking

389

10.7.4 The Role of the Central Bank in Deposit Insurance It is reasonable to argue that in a monetary union, as in a simple economy, the central bank does not have to assume a role in deposit insurance. Such a policy, which is part of a public spending policy, must be backed by the public Treasury. This function is therefore at the intersection between the banking union and the fiscal union. But the central bank may have to intervene in order to safeguard the integrity of the monetary union (the “whatever it takes” principle). Indeed, we have seen that deposit insurance may lead to a major fiscal crisis which forces the central bank of the union to bail out a member State.

10.7.5 Monetary Policy Versus Macroprudential Policy? A final question is whether the union central bank should assume responsibility for both monetary policy and macroprudential policy at the same time, or whether responsibility for macroprudential policy should not interfere with the ability to conduct an effective monetary policy (Dehme and Gambacorta [11]). 1. There may be a contradiction between a macroeconomically desirable monetary policy action and the management of a banking problem. Consider, for example, a rise in interest rates, which increases the difficulties of a financially fragile bank. The central bank may find itself caught between competing demands. This can damage its institutional credibility, which is one of the first conditions for its effectiveness, and one of the most important things that it has to worry about. For example, a bank liquidation, necessary for prudential reasons, may be seen by public opinion (or certain segments) as a failure of the central bank. Such a case of incompetence is clearly detrimental to the credibility of monetary policy. 2. The combination of the two responsibilities by the central bank potentially creates a situation of moral hazard and may weaken its strategic position. The central bank can ex ante display a tough prudential stance in order to ensure the effectiveness of the transmission of monetary policy, as we have seen. But ex post, once a banking crisis has broken out, the central bank can adopt a more lenient attitude in order not to endanger banks or part of the banking system in the name of financial stability. The banks can then exploit this temporal inconsistency and embark on a very risky credit policy. 3. This brings us back to the problem of dominant fiscal policy. The dual roles of the central bank may lead national Treasuries to go through their banking system to put pressure on the central bank or even to be bailed out. The independence of the central bank is thus limited. 4. There is an institutional contradiction between the two responsibilities, prudential and monetary. On the one hand, monetary policy requires the central bank to be at least operationally independent of the public authorities; but on the other hand, the management of a banking problem (to prevent or cure

390

10 Banking Union

a banking crisis) implies proximity to the public authorities. There may, for example, be issues of financing or takeover of banks or assets. This proximity does not imply consensus. It is more likely that the point of view of a political authority differs from that of the prudential institution, if only with regard to the distribution of the costs of rescuing the banking sector. Moreover, conflicts of interpretation or interest between governments and the central bank may exacerbate the difficulties and make the solution more difficult to implement or less effective. 5. A central bank which has to assume prudential responsibilities in addition to the conduct of monetary policy faces a major organizational challenge. The synergy of the two policies implies that qualified central bank staff should work closely together to make the most of their expertise and informational capacity. But the effectiveness and credibility of monetary policy require that they be kept as separate as possible. 6. Prudential policy intervenes directly in the banking system and changes the conditions of competition between banks. Prudential rules can benefit some banks and disadvantage others.23 Similarly, the conditions for resolving a bank’s serious difficulties, by liquidation or bail-out, may result in subsidising a marginally fragile bank or, on the contrary, favouring some banks over others depending on the intensity of competition. In any case, the prudential authority is led to objectively favour some banks and should expect to be criticised, rightly or wrongly, for doing so. Prudential policy thus runs the risk of breaking the level playing field between banks. This is the principle on which monetary policy is based. As we can see, entrusting a central bank with prudential responsibilities is not without its problems and jeopardises its monetary effectiveness. It is easy to imagine that these problems are redoubled in a monetary union because conflicts of interest are exacerbated by the political fragmentation of the union. It is possible to consider entrusting only a fraction of prudential policy to the central bank in order to avoid these difficulties as much as possible and thus jeopardize the conduct of monetary policy (Véron [35]). But the distinctions we have used are not watertight and do not hold in the event of a major crisis. Particularly in the event of a systemic crisis: we have seen that the central bank is forced to act to ensure the continuity and therefore the soundness of the payment system. Finally, there is the political dimension of the banking responsibilities assumed by the central bank. Insofar as the central bank of the union is by construction a supra-national institution, it cannot escape the necessarily political dimension of a

23 This was recently seen in the case of the euro area when the European Commission considered separating, by means of a split, the investment banking and merchant banking activities of banks representing systemic risk (“too big to fail”). This proposal, which affected almost exclusively the French banking sector (3 of the 4 banks concerned were involved) provoked an outcry in France, with the French authorities actively intervening to derail it.

10.8 Conclusion

391

banking crisis, whether it is confined to one bank or generalised to the entire banking system of the union. This represents a risk for the credibility of the central bank and puts at stake its ability to remain neutral and free from conflicts of interest within the union. Minimising this risk requires the central bank’s ability to communicate and build consensus on its diagnosis of the current crisis and on its reporting of events, its action and its results. In any event, the central bank’s involvement in banking regulation shows that it cannot be left unchecked by the community and its political representatives, particularly in a democratic system.

10.8

Conclusion

A monetary union is inconceivable without a banking union that provides, in addition to the integration of payments into the union, for the prudential policies necessary to minimise the likelihood of banking crises and, if such a crisis occurs, the implied macroeconomic costs. It presupposes a regulatory unification of the banking system and fosters the integration of the banking system since the single payments area represented by monetary unification lowers the costs of banking and financial transactions and encourages banks to expand throughout the union to exploit potential economies of scale. They are held back, irrespective of their ability or willingness to do so, by prudential considerations: if prudential regulation is carried out on a national basis, the arrangements may be disparate and contradictory, generating unintended effects that are potentially dangerous for all. The absence of a common or coordinated prudential policy amounts to a fragmentation of the banking area. There is a contradiction between the prospects opened up by monetary union and national treatment of prudential regulation. A monetary union should make it possible to overcome this contradiction. However, the question of prudential regulation arises in a monetary union in a different way than it does in a monetarily sovereign country. Instruments of financial repression are considerably reduced by the financial integration on which the monetary union is based (emergency regulation, capital control, redirection of private savings) or rendered non-existent (monetary financing, currency devaluation) by the monetary union. A monetary union has an important implication: a banking crisis that appears in one member country is logically transmitted to the entire union, without the firewalls that foreign exchange represents.24 Insulation is impossible in both banking and fiscal matters. A banking union, understood as a coherent set of institutions in charge of the prudential policy applied in the union, is the necessary complement of a monetary union. But the type of banking union, the definition of these institutions, their 24 It may be that, in practice, a bank in serious difficulty is small enough that the management of this crisis by the State responsible for it has no impact on the functioning of the union, and therefore on the central bank.

392

10 Banking Union

respective responsibilities and the overall coherence of their actions remain to be defined. The architecture of this union is plastic and its creation is contingent on the history of the banking systems of the member countries, their economic characteristics and the political negotiations that lead to it. It depends on the characteristics of the monetary union itself, and in particular on the status of the central bank of the union. Macroeconomically A banking union has consequences for public finances. The credibility of a banking union depends on the existence of a lender of last resort or even a market counterparty of last resort. This implies that a player, or a coalition of players, has sufficient financial resources to deal with any contingency. This raises the question of the integration or coordination of budgets, but also the role of the central bank which is the only supra-national institution with literally indefinite financing capacity. The simplest case is for the banking union to be supported by a supra-national financial institution. This institution be a federal Treasury, if the monetary union is based on a federal system. But member countries may choose to create an ad hoc prudential institution. This is the solution chosen in the euro area. Indeed, it is not always possible or desired to adopt the federal solution. In any case, the question of the link between the banking system and the sovereign has not disappeared with the creation of a banking union. It may have been distended or posed in new terms but there is no guarantee that the vicious circle of the link between banks and national sovereigns has disappeared. A regulation imposing a decorrelation between the issuance of securities by a national Treasury and the balance sheets of a member country’s banks is probably too stringent politically and not necessarily effective as it may increase the risk of a sovereign crisis spreading within the union or the risk of contagion. More broadly, it should not be assumed that the more or less perfect financial integration made possible by the banking union eliminates the risk of systemic banking crises. Microeconomically The solutions found to solve the problems of coordination and cooperation are certainly complex and therefore generate new risks. It must be borne in mind that this regulatory domain is likely to give rise to opportunistic behaviour on the part of banks or even the States themselves. In concrete terms, opportunities for moral hazard or anti-selection are likely to increase in proportion to the complexity of the banking union. This is in fact the central dilemma of the banking component of a monetary union: • The absence of a banking union, or rather the overly decentralised nature of banking regulation within the union, leads to a significant segmentation of the banking fabric. This segmentation undermines the efficiency of the

References

393

union, disrupts the transmission channels of monetary policy, is a factor of potential imbalances between national areas. National regulation increases this segmentation and generates considerable and potentially dangerous cross-border effects for monetary union. • Strengthening the banking union is therefore desirable. But this integration does not necessarily lead to the disappearance of cross-border effects and may create new opportunity effects that are equally dangerous for monetary union (Goodhart and Schoenmaker [21]). The ability to manage this dilemma effectively determines the usefulness of monetary union and its appropriateness.

References 1. Admati A, Hellwig M (2014) The bankers’ new clothes: what’s wrong with banking and what to do about it. Princeton University Press, New York 2. Agarwal S, Lucca D, Seru A, Trebbi F (2014) Inconsistent regulators: evidence from banking. Q J Econ 129:889–938 3. Allen F, Carletti E, Gimber A (2012) The financial implications of a banking union. https:// voxeu.org/article/financial-implications-banking-union 4. Alter A, Schüler Y (2012) Credit spread interdependencies of European states and banks during the financial crisis. J Bank Financ 36:3444–3468 5. Bank of England (2018) The Prudential Regulation Authority’s approach to banking supervision. https://www.bankofengland.co.uk/prudential-regulation/publication/pras-approach-tosupervision-of-the-banking-and-insurance-sectors 6. Bignon V, Breton R, Rojas-Breu M (2019) Currency union with or without banking union. Int Econ Rev 60:965–1003 7. Boyer P, Kempf H (2020) Regulatory arbitrage and the efficiency of banking regulation. J Financ Intermediation 41:100765 8. Boyer P, Ponce J (2012) Regulatory capture and banking supervision reform. J Financ Stab 8:206–217 9. Busch D, Ferrarini G (2015) European banking union. Oxford University Press, Oxford 10. Calomiris C (2009) Banking crises and the rules of the Game. National Bureau of Economic Research 15403 11. Dehmej S, Gambacorta L (2019) Macroprudential policy in a monetary union. Comp Econ Stud 61:195–212 12. Dell’Ariccia G, Marquez R (2006) Competition among regulators and credit market integration. J Financ Econ 79:401–430 13. De Grauwe P (2011) Managing a fragile Eurozone. CESifo Forum 12:40–45 14. Diamond D, Dybvig P (1983) Bank runs, deposit insurance, and liquidity. J Polit Econ 91:401– 419 15. Draghi M (2012) Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London26 July 2012. https://www.ecb.europa.eu/press/key/ date/2012/html/sp120726.en.html 16. Eichengreen B (2019) Globalizing capital: a history of the international monetary system. Princeton University Press, New York 17. Forbes K (2019) Macroprudential policy: what we’ve learned, don’t know, and need to do. AEA Pap Proc 109:470–75 18. Fratzscher M (2013) Deutschland ist ein grosser Target-Gewinner. https://www.faz.net/aktuell/ wirtschaft/wirtschaftspolitik/standpunkt-marcel-fratzscher-deutschland-ist-ein-grossertarget-gewinner-12639778.html

394

10 Banking Union

19. Freixas X, Giannini C, Hoggarth G, Soussa F (2000) Lender of last resort: what have we learned since Bagehot? J Financ Serv Res 18:63–84 20. Freixas X, Rochet J-C (2008) Microeconomics of banking. MIT Press, Cambridge, MA, 2nd ed. 21. Goodhart C, Schoenmaker D (2009) Fiscal burden sharing in cross-border banking crises. Int J Central Bank 5:141–165 22. Hellwig M (2014) Yes Virginia, there is a European Banking Union! But it may not make your wishes come true. Max Planck Institute for Research on Collective Goods Preprint 2014/12 23. Hoffman C (1970) The Depression of the nineties: an economic history. Greenwood Publishing Corporation, Westport 24. Jones G (ed) (2016) Banking crises. Palgrave Macmillan, London 25. Keister T (2015) Bailouts and financial fragility. Rev Econ Stud 83:704–736 26. Kenen P (1969) The theory of optimum currency areas: an eclectic view. In Mundell R, Swoboda A (eds) Monetary problems of the international economy. University of Chicago Press, Chicago, pp 41–60 27. Kindleberger C (1978) 2011 Manias, panics and crashes. A history of financial crises, 6th edn. Palgrave Macmillan, London 28. Kolko G (2008) The triumph of capitalism. Simon and Schuster, New York 29. Mundell R (1973) Uncommon arguments for common currencies. In Johnson H, Swoboda (eds) The Economics of Common Currencies. Allen and Unwin, London 30. Obstfeld M (2015) Trilemmas and trade-offs: living with financial globalisation. BIS Working Paper 480 31. Reinhart C, Rogoff K (2009) This time is different: eight centuries of financial folly. Princeton University Press, New York 32. Schoenmaker D (2013) Governance of international banking: the financial trilemma. Oxford University Press, Oxford 33. Schoenmaker D (2015) Firmer foundations for a stronger European Banking Union. Bruegel Working Paper 2015/132 34. Sinn H-W (2014) The Euro trap: on bursting bubbles, budgets and beliefs. Oxford University Press, Oxford 35. Véron N (2015) Europe’s radical banking union. Bruegel essay and lecture series 5 36. Vives X (2016) Competition and stability in banking: the role of regulation and competition policy. Princeton University Press, New York 37. Wicker E (2006) Banking panics of the gilded age. Cambridge University Press, Cambridge

The Fate of a Monetary Union

11

Abstract

Chapter 11 considers the evolution of a monetary union, its transformations, its maturing, its possible enlargement, breaking-up and ultimate death. It considers successively the various stages of its development: creation, development, extension of membership, exit and possibly its disappearance. It uses both some analytical results and history to illuminate these issues. It makes clear that the social compact underlying the creation of a monetary union and the strength of the commitment to support it are the key factors of viability.

A monetary union is a collective organization that results from a gradual, more or less rapid, institutional transformation. It is not immutable, given forever. It evolves because economic, political and technological conditions change. As we have seen, it can take different institutional forms. We noted in Chap. 1 the diversity of monetary unions, both in terms of the period of operation, the countries involved and the historical configurations (colonialism, concern for independence, the impact of wars and crises, etc.). The evolution of a monetary union involves successive phases: creation, maturation, variation in geographical extension (membership, exit) and, where appropriate, the death of the union (by denunciation of the union contract). How to study this evolution? 1. It is of course necessary to look at the historical experiences of monetary unification to learn some stylized facts. However, history is an unsure guide. There are two reasons for this. The first is that each monetary union is singular: its configuration, its conditions of historical development, the crises or tensions it has faced are specific and difficult to generalize. The second is that a monetary union is dependent on existing payment and financing technology as well as on the international (world) monetary system in which it is embedded. These © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_11

395

396

11 The Fate of a Monetary Union

two essential elements of the environment for a monetary union have changed significantly in the past and are likely to change further. We can already anticipate the disappearance of paper and metallic money. There is no doubt that this will have consequences for the opportunity to create, join or leave a monetary union. 2. We also have the opportunity to draw on the thinking of the theorists who, like Mundell, have taken an interest in monetary unions. Their views are valuable but do not constitute a complete corpus and research is still going on. Section 11.1 is focused on the creation of a monetary union and Sect. 11.2 on its development. Section 11.3 is devoted to the issue of joining a monetary union and Sect. 11.4 to exiting. Section 11.5 logically covers the possible breaking-up and dissolution of a union. The last section concludes.

11.1

Creating a Monetary Union

The creation of the union is logically the first step in the development of a monetary union. If the union is that of a single sovereign country, possibly of a federal type, it poses no legal or analytical difficulties. A State is logically willing to exercise full sovereignty including monetary sovereignty. More surprising is the case where, at its birth, a State wishes to depend on the monetary zone of another State. This is an exceptional case, but not impossible, linked to the history and small size of the country in question. Luxembourg, at its birth as a State in 1867, joined (unilaterally) the Latin Union. Similarly, Panama, created by secession from Colombia in 1903 (at the instigation of the United States), chose the option of dollarization in 1904. More complex is the creation of a monetary union by a plurality of sovereign States, pooling their monetary sovereignty. This is the case that we will deal with. The creation of a monetary union implies answering two questions: its desirability (do economic conditions make it desirable to create a monetary union?) and its possibility (do political and, more broadly, strategic conditions lead to its creation?). Based on previous chapters, it is clear that the answers to the first question by each of the potential stakeholders are the result of a complex trade-off between multiple costs and benefits, often marked by such uncertainty that they become difficult to quantify. As for the answers to the second question, they are beyond the scope of economic analysis. Finally, if these answers are positive, there is no guarantee that the decision to create this union automatically follows. Indeed, it is likely to be affected by non-cooperative behaviour between the countries concerned.

11.1.1 Why Creating a Monetary Union? The creation of a monetary union depends strongly on its potential membership and institutions. When a country unilaterally gives up its sovereignty and decides to use the currency of another country (dollarization), the creation of such an asymmetrical

11.1 Creating a Monetary Union

397

union is easy, provided there is no opposition from the anchor country (which is very unlikely). If, on the contrary, the union under consideration is symmetrical and amounts to the pooling of the monetary sovereignty of the member States, these States must unanimously desire it. Mundell posed a more restrictive question, as we saw in Chap. 2: under what conditions is it optimal (implicitly Pareto-optimal) to create an area of currency circulation? His analysis showed that these conditions are demanding. The discussion in previous chapters has proven that the list of criteria to be taken into account in assessing a monetary union is much longer than Mundell thought originally, as Kenen [24] and McKinnon [28] had clearly noticed. Similarly, the costs and benefits are quite different from the gains in transactions costs alone that were central to the discussions about optimal currency areas. The desirability of creating a monetary union results from an analysis of its possible consequences and the means necessary for its implementation and proper functioning. A synthetic presentation enables us to summarize what has been discussed in the previous chapters. The analysis of the consequences of the creation of a monetary union can be assessed in three main perspectives: 1. Monetary unification has microeconomic consequences because the single currency changes the methods of calculation and arbitrage used by agents. On the positive side, it can be anticipated that monetary unification will lead to greater microeconomic integration. By simplifying economic and financial calculations, the single currency makes economies of scale in investment and transactions possible. These economies allow a better allocation of resources and efficiency gains. They may imply a higher growth path. In so doing monetary unification can exacerbate competition, thereby eliminating producers and creating pockets of unemployment, or lead to the creation of oligopolies established at the level of the union. 2. Macroeconomically, monetary unification amounts to cooperative monetary behaviour between member countries. This should lead to greater stability in terms of trade between producers in the union. Monetary unification may provide greater credibility. As we saw in Chap. 2, a group of countries may wish to discipline the process of money creation by joining with a country whose monetary institutions ensure a controlled process and by setting up institutions that are credible at the level of the union because they cannot be manipulated by a country on its own. We have seen in the first chapters that other macroeconomic effects need to be taken into account. The monetary union does neither resolve the question of the balance of current account balances for member countries nor the asymmetry between surplus and deficit countries. More generally, the use of a single currency does not abolish the possibility for member countries to adopt uncooperative behaviour, in particular through the fiscal policies they pursue. 3. Monetary unification goes hand in hand with increasing banking integration as compensation between banks necessarily takes place at the level of the Union. Banking integration is fuelling financial integration between member countries. By this we mean a better capacity to finance investment through deeper, more

398

11 The Fate of a Monetary Union

competitive and safer financial markets. It is also a means of potentially easier and cheaper financing of public debt issued by member countries. To the extent that de jure or de facto transfer procedures (transfers of the labour factor through migration, public or private financial transfers) are put in place in the union, the union makes possible a better sharing of idiosyncratic risk at the country level. On the other hand, monetary union does not forbid the possibility of financial crises as it creates new channels of crisis or financial destabilization, in particular through the ambiguity that may exist on the microand macroeconomic prudential adjustment mechanisms. These perspectives are in no way independent. To take just one example, the microeconomic calculations include risk premiums included in borrowing costs, which themselves depend on the macroprudential assessment of the monetary union and therefore on its macroeconomic credibility. The actual costs of creating a monetary union are easier to identify, if not to quantify. 1. There is the loss of economic policy autonomy, both structural and cyclical. This autonomy results from the transfers of sovereignty implied by the monetary union. Based on previous developments, it is clear that these are not limited to the monetary sphere alone. There is much more to the creation of a monetary union than the loss of an autonomous monetary policy and the exchange rate instrument because money can be separated neither from the fiscal dimension, as we saw in the second part, nor from the financial dimension. Monetary union implies an agreement on public finances, which more or less severely limits sovereignty in fiscal matters, as well as a series of agreements on banking and finance. The renunciations to full sovereignty, which it is reasonable to account for as costs as long as the nation-state model prevails, are therefore not slight. 2. The creation of a monetary union may also require structural reforms made with the intention of complying with the requirements of the union, not the immediate objectives of resident citizens, as discussed in Chap. 9. Depending on the extent of these reforms, they may amount to a more or less strong challenge to the social pact that forms the bedrock of a nation. From this perspective, the opportunity to create a monetary union can be seen as the sanction of a dilemma between autonomy (economic and political) and solidarity. Both terms have their advantages and costs. The creation of a monetary union results from the resolution of this dilemma. The elements of this choice are difficult to quantify. Not only because the present sheds little light on the future when the future involves a break with the past, but also because the complexity of the interdependencies thus created. This is especially true in the open, globalized and financially sophisticated economies in which we now live. It is therefore not on the basis of a detailed and numerical analysis of the advantages and disadvantages that a monetary union seems appropriate to the countries concerned. Ultimately, the balance of costs and benefits is conditional on

11.1 Creating a Monetary Union

399

the quality of the institutions to be set up, their credibility and the reasoned ambition of the union.

11.1.2 When and How Forming a Monetary Union? How is a monetary union created? Let us first look at what economic theory tells us.

11.1.2.1 What Economic Theory Tells Us Cooper and Kempf [10] examine this issue in a model where there are only advantages to using a single currency and joining a monetary union (equated with an optimal currency area). However, although it is Pareto-optimal to use a single currency, Cooper and Kempf show that each country has an incentive to deviate from such a scheme, thus making it impossible for the gains associated with the single currency to materialize. In other words, the problem is exemplary of a prisoner’s dilemma. The benefits of cooperation are cancelled out by the uncooperative behaviour of the players. It is necessary to go through a political agreement involving pre-commitment from the countries concerned. Without a strong pre-commitment, monetary unification will not be achieved if it is to be the result of unilateral cooperative behaviour in monetary institutions. The model developed by Cooper and Kempf is an overlapping-generation model of a two-country economy that can be studied either in the configuration of a plurality of currencies with a foreign exchange market (supposedly flexible) or in the configuration of a single currency in which international transactions are carried out. It is thus possible to compare the welfare associated with each of these configurations and, if necessary, to show that the monetary union is Pareto superior to the multi-currency configuration. It is also possible to study the policy behaviour of governments in the case of a monetary union and show that it does not correspond to the equilibrium of the non-cooperative game played by governments. The two countries are structurally identical (symmetric), each inhabited by a continuum of agents affected by idiosyncratic shocks. Each country specializes in the production of a non-durable good, produced with the help of labour. Individuals are immobile, living two periods and wish to consume both goods in old age while working in their youth, which implies international trade in goods. Money is the only asset that transfers income from youth to old age. In the case of the multi-currency configuration, each government imposes the use of the currency it issues for local transactions. The international exchange of goods involves the exchange of currencies, hence a foreign exchange market. An agent’s foreign exchange transactions take place at the end of his youthful period, depending on his anticipation of purchasing both goods and in particular the foreign good that must be paid for in foreign currency. The creation of liquidity gives rise to a transfer to the old, equal for all. This is the unique instrument of economic policy. In the multi-currency case, the money supplies, amounting to inflation taxes applied in both countries, are decided by the governments that allocate the tax to a transfer reserved for their residents only. Since

400

11 The Fate of a Monetary Union

government decisions are made in an uncooperative manner, this constitutes a first friction due to the coexistence of currencies. A shock on the relative preference of the two goods specific to each agent in the two countries is revealed at the beginning of the old age period, after the decision about working, i.e. after the choice of holding the amount of money circulating locally (in the country where the work is carried out). In the case of a multi-currency world, as currency holdings have been decided, this represents a second friction, of a financial nature. This friction disappears in the case of a single currency. As an agent must hold foreign currency, he is subject to the inflation tax of the foreign country, for the sole benefit of the residents of the foreign country. This opens up the possibility of opportunistic behaviour by both governments and the uncooperative exploitation of this friction. Each government is supposed to maximize the expected utility of a representative agent resident in the country. The resolution of the macroeconomic equilibrium in the multi-currency configuration shows that the rate of money creation, which is equal in both countries because of symmetry, is positive. Consumers are subject to inflation in the foreign country via their consumption of the foreign good (which depends on the rate of foreign money creation). Since inflation is distorting, less effort is supplied. In the case of a monetary union (a single currency), money creation gives rise to a uniform transfer to all agents in the union. The rate of money creation is decided by the central bank of the union that is the sole active public authority. It is supposed to maximize the expected utility of a representative agent resident in the union. The inflation rate chosen is zero: no inflation tax is levied. This result is logical: in the multi-currency configuration, inflation is used to tax the holders of the foreign currency. In the non-cooperative equilibrium, these advantages cancel each other out. In the monetary union, this mechanism is inoperative. The result is no tax distortion and a higher labour supply. Under these conditions, it becomes clear that by eliminating two frictions, which generate non-cooperative and distorting behaviours, monetary union is preferable for the representative agent in each country. It is Pareto-optimal. However, when it comes to the question of whether the two countries will decide to adopt a common currency, the answer is negative. Let us consider the following sequence of decisions in an non-cooperative game played by national governments: 1. In a first step, each government decides whether or not to impose “legal tender” on the national currency. If it is not imposed, any currency can be used in transactions. 2. In the second stage, each government decides its rate of money creation, according to the model presented above. In accordance with what we have just seen, a situation in which each country would decide not to impose the forced rate and practice zero inflation would be Paretooptimal: since the support of the monetary transaction does not matter, the universal circulation of foreign currency would give an allocation and welfare identical to those obtained in the monetary union, but they would be obtained as a result of an

11.1 Creating a Monetary Union

401

non-cooperative game, therefore without reciprocal commitment on the part of the two governments. This solution is impossible.1 If one government decides not to impose the forced rate of its currency, the other government has an interest in imposing the forced rate. This would cause the former currency to lose its value in favour of the strictly national currency that could indeed circulate in both countries, to the benefit of the issuing country because its currency is the only one allowed to circulate in both countries. The country imposing the forced exchange rate could therefore take maximum advantage of the inflation tax, while the other country would derive no benefit from the emission of its currency since it would be dominated and therefore not circulate. If the variance of the preference shock is not too high, the only equilibrium in the sequential game is when each country imposes the forced rate and non-zero inflation, which corresponds to a standard multi-currency world. The conclusion is that, in order to achieve the gains of monetary cooperation (the prohibition of the sub-optimal effects of non-cooperation), one cannot rely on the discretion of the States concerned. They must commit to a single and not only common currency, without being able to defect from this commitment, i.e. they must irrevocably decide to do so.2 Thus, the teaching of the model is that the creation of a monetary union by several sovereign countries must be the result of a common political decision and a constituent act, such as an international treaty, making the commitment to participate in it definitive and intangible. The mere fact that it is desirable to free oneself from the constraints of limited monetary circulation is not sufficient to induce States to renounce to their own controlled currency.

11.1.2.2 What History Tells Us If we turn to the lessons of history, the suppression of the forced exchange rate in a country and the legal acceptance of the circulation of a foreign currency

1

Analytically, it is not a “subgame perfect Nash equilibrium.” When he was the Minister of Finance in the Greek government led by Alexis Tsipras and engaged in a tug of war with the European authorities and the IMF, Yanis Varoufakis had worked in secret on the creation of a parallel banking system, linked to the Greek Treasury. The aim was to dispense with the support of the ECB and create a parallel payment system, denominated in euros. Initially reserved for the payment of taxes, this could, in the event of Grexit (Greece’s exit from the euro zone), be converted into payments in (neo-)drachmas and be generalized to all types of payments. The plan represented a variant of a dual currency system, where the euro and the national currency coexist in Greece, which represented for Greece the advantage of an autonomous monetary creation, thus an inflation tax to the sole benefit of Greece by defecting from the monetary discipline common to the euro zone, in accordance with the Cooper and Kempf model. The minister’s resignation on 6 July 2015 is probably linked to this plan that was not endorsed by Prime Minister Tsipras. Its implementation would indeed have provoked Grexit very quickly under pressure from Greece’s partners that could not have tolerated such a non-cooperative behaviour.

2

402

11 The Fate of a Monetary Union

along with the maintenance of full monetary sovereignty have never happened.3 A monetary union, insofar as it represents a greater or lesser surrender of the monetary sovereignty of one or more countries, is always a political decision. But this decision is more or less easy to take. It can be facilitated by the relative sizes of the countries in the union. Very small States (Monaco, Andorra, Luxembourg, even Panama) have no interest in exercising monetary sovereignty because of the transaction and management costs of a currency and prefer to form a totally asymmetrical monetary union (what we called dollarization in Chap. 1) with the State to which they are most linked, by trade, culture or history. It is dependent on the existing monetary and financial technologies as well as on international monetary system. Creating a monetary union in the nineteenth century, in a gold standard system, did not present the same difficulty as it does at the end of the twentieth century or the beginning of the twenty-first century, in a system of (relatively) flexible exchange rates and high international mobility of capital and largely deregulated financial flows. The Latin Union is a good example of this (Bordo and Jonung [5], Einaudi [15], Flandreau [17], Flandreau [18]). It was created in 1865 and linked four countries: France, Belgium, Switzerland and Italy in the context of the international crisis of bi-metallism (gold and silver) due to the discovery of gold deposits in California in 1848.4 The principle of the 1865 convention was to harmonize the metallic content of national currencies so as to allow their international circulation (between the signatory countries) and resist the international monetary crisis. A total of 11 countries signed association agreements and 12 unilaterally associated themselves with the convention. The operation of the gold standard ensured the balance of external accounts, and the terms of trade were dependent on the evolution of internal prices in each country due to net gold flows. The Scandinavian Monetary Union, created in 1873, was set up for similar reasons in a similar environment (Bergman, Gerlach and Jonung [4], Bergman [3]). The European Payments Union is another example of a monetary union with limited ambition and linked to the international monetary system (Kaplan and Schleiminger [23]). It was created in 1950 under the auspices of the Organization for European Economic Cooperation (OEEC).5 European countries, in the process of rebuilding after the destruction of the Second World War, had to import construction goods and pay for their imports in dollars, a currency they did not have because of their weak export capacity at the time. The European Payments Union significantly reduced the need for dollars and lifted the potential bottleneck that the shortage of dollars represented: purchases between member countries were recorded by the European Payments Union and only balances were paid at the end of the month.

3

This does not mean that, in practice, a foreign currency does not circulate in a country or that it is prohibited to issue securities in a foreign currency. 4 Greece joined in 1868. 5 Ancestor of the Organisation for Economic Cooperation and Development (OECD).

11.1 Creating a Monetary Union

403

The European Payments Union was dissolved in December 1958 and replaced by the European Monetary Agreement, which was closed in 1972. In brief, a monetary union is created according to the historical circumstances that made it both possible and necessary. The monetary history of the Austro-Hungarian Empire reveals the impact of historical circumstances in the birth of a monetary union (Flandreau [19]). The Austro-Hungarian Empire, weakened by its defeat by Prussia in 1866, had to cope with the Hungarian national affirmation. This resulted in the “1867 compromise.”6 Austria and Hungary became two separate national entities, sharing sovereignty in certain regalian matters and being independent in all other matters. Currency and monetary policy were among the shared domains and the Austro-Hungarian Empire became a multi-national monetary union. Public finances were regulated according to a hybrid system. Each entity had its own budget and the capacity to take on debt without any common solidarity mechanism. Common expenses were covered by a common (federal) budget, financed by contributions from the national budgets and customs duties, the empire being a common market and customs union. This budget was controlled by delegates from the national parliaments. Hungary relinquished all monetary sovereignty: the Austrian National Bank was confirmed as the bank of the Austro-Hungarian Empire and retained its monopoly on the issue of legal tender. Another example of the weight of historical circumstances is the franc zone, or the monetary unions linking French-speaking African countries as well as the Comoros to France since decolonization.7 Two monetary unions were created in 1959, the Monetary Union of West African States8 and the Monetary Union of Equatorial African States and Cameroon, which became the Economic Union of Central African States.9 Similarly, monetary agreements bind France to the Union of the Comoros, which became an independent State in 1975, since 1979. Each of these unions has a central bank, and there is also a Central Bank of the Comoros. These central banks are closely linked to the Banque de France. The currency of the two African monetary unions is the CFA franc, and the Comoros has the Comorian franc.10 Relations between France and these monetary unions are based on four principles: unlimited convertibility guaranteed by the French Treasury, fixed parities, free transferability and the centralization of foreign exchange reserves. In return for the French Treasury’s guarantee, the three central banks are required to deposit part of their foreign exchange reserves in a so-called operations account opened in the Treasury’s books. In other words, the credibility of these currencies is ensured by the Banque de France which has de facto control over the scale of

6

This compromise was valid for ten years and was to be renewed periodically. In fact, it lasted until the defeat of 1918 and the disappearance of the empire itself. 7 Guinea-Bissau, a Portuguese-speaking country surrounded by French-speaking countries, joined WAEMU in 1997. 8 In French, “Union Économique et Monétaire de l’Afrique de l’Ouest.” 9 In French, CEMAC. 10 Since 1999, the peg of these currencies has changed from the franc to the euro.

404

11 The Fate of a Monetary Union

monetary issuance, i.e. seigniorage resources, and also over external parities. This is a good example of a monetary union whose birth is due to very special historical circumstances. In any case, the choice to join a monetary union remains a sovereign one: Guinea was the only French-speaking country in sub-Saharan Africa that chose full monetary sovereignty. To conclude this brief detour through history, let us mention the American case. Bordo and Jonung [5] classify the United States as a national monetary union. This is forgetting the origins of the American republic. When independence was declared in 1776, it was a confederation of former colonies that considered themselves sovereign or potentially sovereign, particularly in monetary matters. According to the Articles of the Confederation, the first constitutional text of the young American republic, written between 1776 and 1777 and ratified by the thirteen states in 1781, the states retain all powers and rights not specifically vested in the United States Congress (Article 2). The ninth article specifies that the United States Congress has the exclusive right to regulate the composition of the alloy and the value of coins minted under its authority or that of the States. It further stipulates that all regulations concerning currency and, in particular, the minting of coins, must be adopted by a qualified majority of nine States. According to the Articles of Confederation, the US Congress therefore does not have a monopoly on issuing currency. In fact, the states did not hesitate to issue large quantities of paper money to pay their soldiers and meet their obligations in the War of Independence. This led George Washington, then General-in-Chief of the US Army, to remark with acidity that “a cartload of notes is not enough to buy a cartload of military supplies” (Stahr [36], p. 105).

11.1.2.3 Immediate or Conditional Creation? A final question arises. Should creation be immediate, as soon as the union is decided, or should it be conditional, taking shape once the required conditions are met by the countries concerned? This was, for example, the case for the euro zone. The Maastricht Treaty, adopted by the European Council in 1992 and ratified by all the countries of the European Union in 1993, provided for European monetary union to be established between 1997 and 1999. The decision on accession was to be taken at a meeting of the European Council and would therefore be political, not automatic. Indeed, 11 countries, some of which did not meet the agreed convergence criteria, were admitted to the euro area in 1999.11 The choice between immediate or deferred and conditional union depends on historical circumstances and the size and ambitions of the union in question. If it involves two very asymmetric but highly interdependent countries, an immediate

11 These countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Grand Duchy of Luxembourg, the Netherlands, Portugal and Spain. Greece is admitted to the euro area on 1 January 2001. According to the Maastricht Treaty, Sweden is supposed to join the euro area, but in a referendum the Swedes voted against their country’s entry. Two other countries involved in the negotiations of the Treaty obtained an opt-out clause, the United Kingdom and Denmark.

11.2 The Transformation of a Monetary Union

405

creation is reasonable. If, as in the case of the European Monetary Union, it involves many countries, very heterogeneous, with different macro- and microeconomic characteristics, outside a context of crisis that requires an urgent decision, it is logical that the founders opt for a conditional creation. The question remains as to the conditions for such a creation. The precedent of European Monetary Union is instructive in this respect. Member countries had to meet five criteria to be admitted to the Union: 1. An inflation rate no more than 1.5% higher than the average of the rates of the three member countries with the lowest inflation rates 2. A real long-term interest rate no more than 2% above the average of the rates of the three member countries with the lowest rates 3. No monetary devaluation in the two years preceding integration into monetary union 4. A budget deficit of less than 3% of GDP 5. A public debt of less than 60% of GDP The first three are criteria for the control of nominal developments, and the last two are criteria for the control of public finances. These criteria have been widely criticized for their lack of economic justification (Buiter, Corsetti and Roubini [6], Artis [2]). These controversies echo the discussions that took place in Europe in the 1960s between “economists” and “monetarists” on the exchange rate system to be applied within the Common Market (Marsh [27], p. 45–46). It is actually quite judicious, for the creation of an international monetary union, to emphasize criteria of nominal convergence as well as financial soundness, leaving to market adjustments and public policies the responsibility of ensuring real convergence and homogenization of living standards within the union. To do otherwise would run the risk of overly restrictive conditions, the fulfilment of which, always debatable for reasons of statistical vagueness, would give rise to interminable controversy.12

11.2

The Transformation of a Monetary Union

Once created, a monetary union must last. This requires its evolution and transformation. The transformation of a monetary union can be linked to three types of factors: the evolution of the economic and social environment in which it takes place and of its institutional development.

12 The

use of these criteria in assessing the proper functioning of the euro area, in particular in relation to the Stability and Growth Pact, is more debatable.

406

11 The Fate of a Monetary Union

11.2.1 Economic Transformation A monetary union must adapt to its economic environment. Let us focus on two dimensions of the economic environment: changes in economic flows of goods and services and changes in financial flows. In the financial sphere, technological, legal and political developments (changes in the international monetary system, changes in international financial transfer modalities) are modifying the trade-offs resulting from international financial flows and are subjecting a monetary union to new tensions to which it must adapt. To take just one example, the end of the Bretton Woods system led to exchange rate instability, which increased the external imbalances of the member countries of the French-speaking African monetary unions and led to a major change in the parity between the CFA franc and the franc in 1995. Similarly, the financial deregulation that has gradually become widespread in the world economy since the 1980s (the end of financial repression mechanisms, such as capital and financial return controls, market segmentation and regulation of financial transactions) led to the financial crisis of 2007–2008. The crisis forced central banks to adopt non-conventional policies and governments to make major changes to their prudential supervision. This was particularly evident in the case of the European Monetary Union, whose political leaders urgently put in place the foundations for a banking union. But these preliminary remarks are insufficient. What is more salient is that monetary union in turn changes its economic and financial environment. Monetary unification promotes economic and financial integration among member countries. In fact, it is often explicitly intended to do so. A monetary union, depending on its degree of ambition and requirement (since we now know that it is not necessarily reduced to a simple monetary arrangement or even a common monetary policy), induces an endogenous transformation of productive and financial systems. The report of the committee chaired by Jacques Delors, which paved the path towards the negotiations on the EMU, made this clear: Greater convergence of economic performance is necessary (. . . ) The process of integration therefore requires, even within the framework of existing exchange rate arrangements, more intensive and effective coordination of policies, not only in the monetary field, but also in those areas of national economic management that affect aggregate demand, prices and production costs. ([8], p. 4).

From this perspective, a monetary union should be seen as a monetary and financial unification process that takes place over a long period of time, marked by institutional changes that occur infrequently, usually in the context of an economic or political crisis. Consequently, the question of comparing the costs and benefits of a monetary union changes direction. These costs and benefits can no longer be assessed at a given time but must be anticipated. In other words, no precise measure, given the weakness of our predictive capacities, can reliably provide us with the answer to the question of the dynamics of a monetary union. This is the implicit meaning of the 1998 article by Frankel and Rose [20]. Frankel and Rose challenged the

11.2 The Transformation of a Monetary Union

407

criteria commonly put forward to justify the creation of a currency area by arguing and showing empirically that these criteria were endogenous to the creation of the area itself. While the magnitudes and even the long-term trend of this impact are discussed, on the other hand, the idea that monetary unification, in one form or another, ultimately modifies economic and financial flows between member countries is now accepted. The intensity of cross-border flows varies with the transition to a single currency because the conditions of profitability, via the terms of trade or interest rates, gradually change. As the comparative advantages of different countries change, logically investment decisions should take this into account. The productive structure of member countries cannot be considered intangible and insensitive to monetary integration. This raises two questions. The first is whether or not it strengthens the union. In the case of member countries, the exploitation by each country of its comparative advantages should lead to greater specialization of its industrial branches and thus greater international heterogeneity between member countries. The management of the monetary union is then made more complicated, and the monetary union is weakened. But it may be necessary to reason at a finer level: regions (sub-national entities) and intra-industry sectors. If changes in comparative advantages induce productive changes at these geographic/economic levels, the countries themselves will become more diversified. We can argue, following Kenen [24], that diversification is beneficial to monetary union. Monetary unification has productive effects that are felt over time, and these changes themselves mean that the institutions and policies of the monetary union will have to be adapted. The second is whether integration is equally beneficial to all. Without excluding it, there are reasonable grounds for doubt. One of the fundamental results of economic analysis, acquired since Ricardo, is that opening countries to international trade is beneficial to all member countries (and implicitly to all its residents). Irrespective of the empirical validity of this result, it cannot be extended to a monetary union that represents a much more demanding form of integration than simple trade integration, regulated by exchange rates. The American precedent is there to show it: in the long term, the growth rates of the American economic regions are very heterogeneous and there is no trend towards convergence towards an average trend (Krugman [26]). This is not surprising. In the first place, the objectives of the monetary union under consideration may be modest, limited to a monetary agreement, and may not aim at strong economic integration. The objective of integration may be vaguely understood and the institutions of the union may not provide compensatory and incentive transfer mechanisms that would guarantee both growth and convergence of living standards over a defined term. There may be countries that benefit more than others from monetary unification. There can even be winners and losers. Monetary policy on an area-wide basis may be more appropriate for some countries than others, their banking and financial sectors may be relatively strong and attractive and their fiscal policies may be both

408

11 The Fate of a Monetary Union

counter-cyclical and sustainable, allowing low interest rates, feeding positive net investment and creating a virtuous circle. But the reverse is also conceivable. A dichotomy cannot be ruled out between a core, made up of countries concentrating the economic and financial activity of the union, and a periphery, made up of less active and prosperous countries. Tensions within the monetary union may thus emerge and become stronger over time. Growing structural heterogeneity makes the coordination of public policies within the union increasingly difficult and the conduct of monetary policy more delicate. It was with these difficulties in mind that Feldstein [16] wrote in 1997 about the European Monetary Union: Rather than increasing European harmony and global peace, it is more likely that the changeover to the euro and the ensuing political integration will lead to growing conflicts within Europe and between Europe and the United States.

Such an extreme point of view has the merit of emphasizing the conflicts of interest and distribution that a monetary union can quite logically generate.

11.2.2 Social Transformation Changes in a monetary union may involve structural reforms. Structural reforms are often the first markers of changes in a monetary union since they are intended as an attempt to allow macroeconomic adjustments compatible with the monetary union. More broadly, taking up Polanyi’s perspective, the social pact is being transformed. In the case of a national monetary union, these transformations are facilitated by the total unification of legislation: commercial laws, labour laws, banking and financial laws are modified by the sovereign, the parliament in democratic regimes. In the case of a multi-national monetary union, the difficulty is increased by the fact that legislation is partly national. The transformation of legislation can then only be conceived in a logic of harmonization and search for coherence that is an inevitable consequence of having founded a monetary union. The obstacles encountered and the shortcomings in this harmonization process are sources of greater or lesser difficulties in the adaptation and therefore the success of a multi-national monetary union. The case of the EMU provides a simple illustration of this. The labour market reforms in Germany, initiated by the two governments of Helmut Schröder (1998– 2005) and continued by Angela Merkel, were taken in the light of the German macroeconomic situation, without taking into consideration the consequences for a monetary union still in limbo, and without Germany’s partners themselves measuring these consequences. The competitive advantage that these reforms, combined with an irreversible exchange rate due to the changeover to the euro, implied for Germany, however, contributed significantly to the European crisis of

11.2 The Transformation of a Monetary Union

409

the 1990s.13 The crisis itself has prompted a number of countries to change their labour market legislation.14 The fact that these reforms have not been the subject of consultation between eurozone countries shows that there may be a search for coherence on the part of the national political authorities but certainly not for maximum efficiency.

11.2.3 Institutional Transformation The transformation processes just mentioned may require institutional changes adapted to the new conditions. It would be intellectually appealing to refer to “stages of monetary union,” in the same way as we refer to stages of economic growth, assuming that the growth process is unilinear. But conceiving an ideal pattern of monetary union towards which all experiences of monetary unions, once they are permanent, would gradually converge over time, is irrealistic. We know the reasons for this. We have seen in previous chapters that a monetary union can accomodate very different institutional frameworks, particularly because it can have multiple objectives and operate in different environments. In particular, we have no reason to believe that an international monetary union such as the European Monetary Union should necessarily adopt a federal principle or disappear. The opposite can even be argued. Eichengreen and Wyplosz [14], for example, set out a series of conditions (and thus reforms) for the survival of the euro on the assumption that fiscal federalism is impossible because it is unwanted. But neither do we have any reason to believe that the principle of a monetary union is compatible with any form of institution as long as there is a single central bank and a single currency, together with an irreversible commitment to parities. A monetary union, like any monetary system, must perform a number of functions and these requirements imply coherence between the institutions of the union. This institutional coherence can be achieved gradually, sometimes under the pressure of events. It is made difficult because it is played out both in the economic and political spheres. In the case of a multi-national monetary union, the difficulty is redoubled by the fact that these transformations may involve transfers (or repatriations) of sovereignty. An example of such international adjustments is the Austro-Hungarian union. Let us pick up the thread of history where we left off. In 1877, on the occasion of the first renegotiation of the 1867 compromise, the Hungarians obtained a rebalancing of the union to their benefit. The Austrian National Bank became the Austro-Hungarian

13 For

an assessment of these reforms, see Dustmann et al. [12]. has undertaken several major labour market reforms between 2010 and 2012 (Horwitz and Myant [22]). The Italian government of Matteo Renzi did the same in 2014 (Pinelli et al. [32]). France also reformed its labour market with the El Khomri law in 2016 and the reforms carried out by ordinances in 2017 after the election of Emmanuel Macron as the President of the Republic (Carcillo et al. [7]). 14 Spain

410

11 The Fate of a Monetary Union

Bank. It opened a branch in Budapest. Its governor was appointed by the Emperor on the joint recommendation of the Austrian and Hungarian finance ministers. In the 1890s, the two governments agreed on an overhaul of monetary policy that allowed the central bank to have better control over money issuance and gradually to join and operate on the basis of the gold standard. All this was not without complex and often difficult negotiations between the two governments and the central bank.

11.2.4 The American Example The American case is a perfect illustration of these mutations caused as much by historical circumstances as by economic developments and the gradual discovery of the inadequacy of the original institutions. The United States of America has been a federal State since its independence in 1776. It is a system that has evolved considerably, both legally and economically. At the present end of its evolution, it is characterized by a dominant position at the federal level, made possible by the interpretation of the United States Constitution by the Federal Supreme Court for more than two centuries. Since the major reforms of 1913 (creation of the federal reserve system and income tax) and the New Deal, this system has shown great institutional stability, despite policy variations and changes in the economic environment. Once American independence was achieved in 1783, the articles of confederation soon came under strong criticism, particularly for the monetary and financial turmoil they allowed. In an attempt to reform these articles, delegates from the states met in Philadelphia in the summer of 1787. Acknowledging the failure to discipline and coordinating the states under the Articles of Confederation, they drafted a new constitution (exceeding the mandate given to them by the states), which was ratified and came into force in 1791. This Constitution aims to strengthen the federal level. During Washington’s first presidency, its Finance Minister Alexander Hamilton successfully proposed an extremely bold plan for federal intervention in public finances, since it provided for the federal government to assume the debts of the states, a legacy of the War of Independence. Thus, on the crucial issue of any system of fiscal federalism, the United States is opting for a financial rescue of the states by the federal government. However, it did not persist in this choice. With the financial panic of 1837, some struggling states turned to the federal state, arguing that they had an implicit guarantee of rescue. But the van Buren administration (the eighth president, in power from 1837 to 1841) and Congress refused their support, reversing Hamilton’s policy. State or local governments were never again to receive an explicit or implicit guarantee from the federal government (Sargent [34]).15 Some states went bankrupt. Gradually, all states (except Vermont) introduced amendments or articles to their

15 With

the exception of the District of Columbia in the 1990’s under Article 1, Section 8, which places that district under the direct administration of Congress.

11.2 The Transformation of a Monetary Union

411

constitutions that established a balanced budget rule.16 In any event, it is clear that the federal Treasury will never intervene directly to save a state or sub-state entity from default.17 The policy of not providing fiscal relief extends to sub-state public entities. Municipalities and counties sometimes default and are rarely rescued by the states. After the Civil War, the highly decentralized and state-regulated American banking system was redesigned on the basis of national banks, and this new system was to last until the beginning of the twentieth century (Friedman and Schwartz [21], chapter 1). However, dissension and conflicts of interest did not stop there, they shifted. They shifted from the industrial north opposed to the slave-owning south to the industrial east opposed to the agricultural (and silver-producing) west. The reason for this was the monetary and banking organization. Farmers accused the banks of not taking sufficient account of their seasonal credit needs before the summer harvest and, with the support of the Progressive Party, militated for bi-metallism, from which they expected a more abundant supply of liquidity. In an attempt to meet these demands, the federal reserve system was created in 1913 under the presidency of Woodrow Wilson (Friedman and Schwartz [21], Chapter 5, Meltzer [29]). The Great Depression precipitated a major banking crisis, the resolution of which involved Franklin Roosevelt’s two major banking acts (1933 and 1935). Bordo and Jonung are right to view the United States as a national monetary union. But this union was formed through a process that spanned more than 150 years. Over time, the sovereignty of the member states has been eroded: the American states are not sovereign under international law and do not have access to the management of the common currency, the dollar. Monetary policy and the management of the US financial system are the responsibility of the federal state, through its specialized agencies or its exclusive control of the central bank.18 This is a major difference with the European case.

16 These

are easily circumvented devices that act more as a safeguard or brake than as a clear-cut ban on indebtedness. 17 The latest manifestation of this position was President Obama’s refusal to come to the rescue of the state of California in June 2009 and to provide a federal guarantee for the state’s debt obligations. 18 The federal reserve system is based on 13 different reserve banks that cover the US territory and whose presidents are involved in the monetary policy decision. But the Congress took care that the areas covered by the reserve banks (the districts) do not correspond to state borders to avoid setting up a system that could have made the states feel that they could intervene in monetary matters. Missouri is even divided and depends on two reserve banks, those of St. Louis and Kansas City.

412

11.3

11 The Fate of a Monetary Union

Joining a Monetary Union

Once a monetary union is created by founding countries and proven a success, some other countries may wish to become members. What are the reasons for wanting to join the union? The monetary union is a success because its dynamics that we have just reviewed have changed the pattern of costs and benefits. Time has allowed the institutional arrangements to be tested and even improved; the macroeconomic policies pursued have proved to strengthen the union; possible structural changes have been decided upon; microeconomic integration has developed, leading to greater productive efficiency and even a higher growth path. In this way, the union has become more credible, more efficient and therefore more attractive. The entering (or candidate) country may seek to benefit from this increased credibility and efficiency. It may itself be in a different macroeconomic situation, in particular one marked by shocks that are more violent and less easily manageable on its own. It may also expect better protection against economic hazards through solidarity mechanisms and transfers explicitly or implicitly at work in the monetary union. Staying out becomes more costly, at least in terms of missed opportunities. It is unlikely that a candidate country will be able to discuss the terms and in particular change the structures, principles and institutions of the union. It therefore has less negotiating capacity than it had (or would have had) when the union was created. This country can accept a minor position. We have seen that a monetary union does not necessarily give equal weight to all its members, nor does it necessarily give them equal responsibilities. How can it be explained that the member countries accept this candidacy and the enlargement of the union that it implies? The admission of a new member is not an easy decision to make for several reasons, even if one disregards purely political considerations. Member countries may fear a dilution of their own relative weight in the union. They may also fear a destabilization of the union: what worked with n partners may no longer work at n + 1. Management and negotiation costs are not proportional to the number of member countries but can be exponential. Finally, non-cooperative behaviour, which has been curbed until now, may develop at the time of enlargement because it changes the strategic situation for all. Conversely, accepting a new member represents gains, in terms of trade (the famous conversion costs saved) and economies of scale: better economic and financial integration, less currency turbulence. It is by arbitrating between these considerations that the member countries of a union approach the question of enlarging the union. Together with the decision of acceptance comes the question of the modalities of integration. Two options are possible: accession conditional on the fulfilment of certain criteria, which amounts to making accession gradual, or unconditional and

11.3 Joining a Monetary Union

413

immediate accession.19 In the case of European Monetary Union, the first option is used, as candidate countries have to meet the criteria laid down in the Maastricht Treaty in order to join. This raises a question: should the process of enlarging a monetary union, since it sanctions its success, lead to the integration of all the countries involved in international trade? Kohler [25] sheds an interesting light on this question using the theory of the endogenous formation of coalitions (Demange and Wooders [11]). In a multi-currency economy with flexible exchange rates, the effects of non-cooperative behaviour make the situation non-optimal: in the event of a negative supply shock, each country has an interest in exporting its inflation by raising its exchange rate through a restrictive monetary policy. Monetary union with several countries is one way of countering this phenomenon. But the larger the union is, the less likely it is for an individual country to be part of it, since it benefits from a positive externality because the union has curbed exchange rate hikes and this makes it easier for it to export its inflation by raising its own exchange rate, particularly against the currency of the monetary union. In other words, the size of a union creates its own brakes on its expansion. The entry of a country into a monetary union can be formally treated as entry into a cartel: a monetary union (like a cartel) is said to be stable when the external country has an interest in entering on the basis of the existing n member countries, and none of the latter has an interest in leaving on the basis of a union with n + 1 members. Kohler shows that it is impossible (on the basis of her model, commonly used in studies on international monetary cooperation) for a grand coalition to form, i.e. that all the countries participating in international trade wish to participate in a single monetary union. The international monetary system remains fragmented. Admission to a monetary union is a strategic decision and conditions may make it not in a country’s interest to lose monetary sovereignty. Beyond analysing a cross-border effect explaining the size of monetary unions, the article shows that the enlargement of a union changes the cost–benefit calculation of all countries. Empirically, Nitsch [31] examines entering into a monetary union. Statistical data are scarce. Over the period 1948–1997, he found 7 entries into a monetary union. If the creation of the European Monetary Union is taken into account, that the total rises to 17. This is obviously not a very large number for a satisfactory econometric treatment. On the basis of this small sample, it seems that the entering countries are poorer and smaller than the countries of the union they are joining. They also have a higher average inflation rate, are less open to international trade and are less dynamic in terms of international trade. In addition, their fiscal position is more fragile. Finally, Nitsch is interested in the question of whether the economic conditions prevailing in the acceding country before entry condition the performance of the acceding country after entry (measured by the difference between the growth rates calculated over five years, before and after entry). Pre-existing economic conditions

19 Eichengreen

[13] refers to the “coronation approach” for the first formula and the “just do it approach” for the second.

414

11 The Fate of a Monetary Union

may be relative to the member countries of the union and be assumed to meet the criteria of the theory of optimal currency areas, or they may reflect the Maastricht criteria, for example. In both cases, these results do not support the idea that these prerequisites, whether theoretical or institutional, condition a country’s relative performance after entry. Rather, they support the idea that there are many factors at play in the entry and functioning of a monetary union that go beyond the macroeconomic diagnosis that can be made of a country.

11.4

Exiting a Monetary Union

Exiting a monetary union is frequent, contrary to what one might think. According to the data collected by Rose [33], 69 countries, territories or “entities” left a monetary union over the period 1945–2005 (excluding actual dissolutions, such as the USSR or Yugoslavia) while 61 remained permanently in a monetary union, understood as a zone of currency circulation without the possibility of manipulation of the terms of trade within the zone.

11.4.1 Causes of Exit from a Monetary Union In light of the theoretical insights provided in the preceding chapters, three types of arguments can be advanced for leaving a monetary union: 1. Structural asymmetries were underestimated at the creation of the monetary union or gradually developed after its creation, for one reason or another. Under these circumstances, the management of a common monetary policy is increasingly difficult and less and less in tune with the particular situation of a member country or group of member countries. Imbalances within the union are growing, marked by current account deficits for some member countries. As we saw in Chap. 1, these imbalances within the union can create mistrust and trigger speculative behaviour on the financial markets, making a country’s situation untenable. 2. Divergent national policies are practised by member countries, particularly in the fiscal field. They too can fuel imbalances within the union. In particular, a member country may accumulate deficits in its public accounts and see its public debt become unsustainable. Under these conditions, it has the choice only between a bailout by its partners and/or the central bank of the union or sovereign default. But these crisis solutions do not solve its lack of competitiveness or the internal imbalances it suffers from. If political leaders (under pressure from the electorate) decide that it is impossible to bear the costs of a structural adjustment compatible with remaining in the union, they will choose to leave the union and issue a new currency, in the hope that this will redefine the terms of its external trade and balance its current accounts.

11.4 Exiting a Monetary Union

415

3. Finally, exit from the union may be due to political causes and be linked to a change of political regime or to a change in relations between the partner entities of a union. The decolonization movement in the last half-century of the twentieth century was thus an opportunity for some of the new sovereign countries to achieve monetary emancipation from the former colonial power. But radical regime changes, such as the end of the USSR, were also the occasion for an exit from monetary union. This political change may be felt gradually, or even delayed. For example, the Republic of Ireland, which has been independent since 1921, did not break its monetary union with the United Kingdom until 1979, once it joined the European Union.20 The exit from a monetary union is the sanction for a severe dysfunctioning of the union, unable to discipline the member countries or to manage its economic heterogeneity. It represents a failure of the integration of the member countries. A monetary union remains asymmetrical, with surplus countries in no hurry to reduce their surpluses and contribute to the equilibrium of the area as a whole. In the same vein, unsustainable fiscal policies may develop in a monetary union because of insufficient credibility and commitment. Thus, exiting a union is a shared responsibility, even if the decision to exit is the exclusive responsibility of a sovereign country. Rose in his above-mentioned study investigated the factors leading to exit from a monetary union (in the sense that they are predictors of such an exit). The econometric results he obtained are, by his own admission, fragile. This is not surprising, given the small statistical sample. They are nevertheless suggestive and interesting: 1. Countries with higher inflation are more likely to emerge from a monetary union. This suggests that monetary unification, at least in its weak form of a common currency area, does not lead to convergence of inflation rates. The inflation differential is an indication that inflation is not strictly determined by monetary factors and refers to divergences in the way prices and wages are formed between member countries. Thus, a monetary union does not automatically ensure high monetary credibility. Credibility can only be achieved in monetary unions with strong institutions and thus provide a binding framework for member countries. 2. From a political point of view, the correlation between political independence and exit from a monetary union is weak but significant. 3. Size, per capita income and democratic quality are predictors of exit from a monetary union. This is consistent with the idea that monetary institutions (their establishment as well as their maintenance) imply fixed costs that large and rich countries can assume on their own without associating with other sovereign countries.

20 More

specifically, the European Economic Community, the forerunner of the European Union.

416

11 The Fate of a Monetary Union

4. There is no break in macroeconomic dynamics for countries emerging from a monetary union.

11.4.2 The Consequences of Exit The assessment of the consequences of leaving a union must be seen from a dual perspective, that of the country or countries leaving the union and that of the remaining country or countries. Let us neglect transition effects and assume that exit is immediate, unconditional and implies that all agreements (banking, financial and public finance-related) valid within the monetary union are null and void. Employment and price contracts binding residents are immediately converted by law (i.e. without direct cost) into the new currency at a parity chosen by the political authorities of the exiting country. It is likely that the chosen parity will imply a deterioration in the parity between the currency of the union and the new currency (compared to a de facto one-for-one parity that prevailed in the union, since one euro in a euro area member country trades against one euro with the other countries). This immediate deterioration is likely to continue over time, depending on the perceived risks of holding the new currency on the foreign exchange markets. The result is an immediate and possibly lasting depreciation in the terms of trade. For the exiting country, the benefits are linked to the recovery of full monetary sovereignty and the end of the institutional constraints that tied it to its partners. They are permanent. They imply the possibility of manipulating the terms of trade so as to restore external accounts, as well as the possibility of resorting to monetary financing of public accounts and the ailing banking system. The costs from an exit are more complex to detail. A distinction must be made between immediate “once and for all” costs and deferred costs. The first ones are primarily related to the re-creation of a new internationally recognized currency and the reorganization of the national banking network: reorganization of banking circuits, re-establishment of a common monetary policy, relocation of autonomous prudential control bodies, computer reprogramming, supply of currency in cash, training and re-qualification of bank staff. These costs are easily calculable and bearable; they are probably not the most important from an economic point of view since they are not associated with any significant risk of accident or failure.21 The deferred costs are related to the deterioration in the terms of trade with the rest of the world. It implies a sizable, probably lasting impoverishment of the country in question since it has to produce more to acquire a foreign product. Even more worrying are the costs related to the financial contracts in progress in the outgoing country. Some of these contracts were concluded between nationals:

21 Leaving

aside the size of the exiting country.

11.4 Exiting a Monetary Union

417

they can easily be converted by law into the newly created currency22 without this representing a real increase in the burden of debt for the borrower (he does not have to devote a larger share of his output to its repayment) or a reduction in the purchasing power of the present value of his assets for the lender (assuming a constant rate of inflation compared to that implicit in the contract’s negotiation). Others bind nationals to foreign parties that we will assume are part of the exited monetary union. Assuming (which is likely) that the exit from the union implies a deterioration in the exchange rate, this implies an increase in the debt burden (since it has to devote a larger share of its output to this purpose). The situation is not necessarily more favourable for lenders who benefit de facto from a reappraisal of their debt in the new currency. But these gains are effective only to the extent that they purchase goods or services in the exiting country. They can be offset by increased default risk on the part of borrowers if the deterioration of their situation following exit leads to bankruptcy or insolvency. This applies to the government as a borrower. Its sovereign debt (issued on international financial markets and held outside the country) is made more expensive by the deterioration of the exchange rate. This can lead to defaults. This argument is often put forward to argue that the exit from a monetary union by a country with a high sovereign debt would be counterproductive because, far from relieving the servicing of this debt, it would probably make it more burdensome. It is important to note in this perspective that the agreements between Greece and its private creditors in 2011 provided that new debt contracts would be governed by English law and not Greek law, which prohibits the Greek government from unilaterally changing the terms of these contracts in the future. This amendment thus appears to be a protection of the European Monetary Union against the risk of Grexit. The immediate and probably lasting deterioration in the conditions under which nationals of a country interact with the rest of the world, particularly with the union they have left, relates to the banking system. Its fragility is indeed increased in proportion to the indebtedness of the consolidated banking system to the rest of the world. The increase in the cost of servicing consolidated bank debt is deteriorating the financial situation of this sector. In a worst-case scenario, this deterioration may be cumulative and, if necessary, lead to a freeze on interbank transactions. Macroprudential mechanisms are inoperative, especially since the new institutions for the supervision and management of banking risks have not had time to set up. Systemic risk is increased, and only the issuance of money, leading to high or extreme inflation, can ensure the survival of banks. This leads to an increase in the risk premiums charged by lenders to borrowers, all else being equal. If this increase materializes, the ensuing rise in interest rates is a brake on the resumption of investment and thus on economic activity.

22 Even

if it uses an old denomination such as “guilder” or “franc,” it is a new currency, regardless of any rhetorical efforts to argue that it is a return to a previous currency.

418

11 The Fate of a Monetary Union

The second effect is the loss of the transfer mechanisms in place, implicitly or otherwise, within the monetary union, particularly in crisis situations. These can be powerful, as we have seen in the case of the US monetary union. Finally, the emerging country suffers a loss of credibility, both internally and externally. Indeed, we have seen that one of the (potential) advantages of a monetary union is the gain in inflation credibility, by making monetary policy less dependent on pressures to monetize deficits or free from discretionary practices. Exiting the union means that the outgoing country loses credibility advantages. A priori, one should expect—all other things being equal—a resumption of inflation and higher risk premiums for issuers of securities (private or public) from the exiting country. This is all the more likely since the country left the union in order to practice a more accomodating monetary policy and in particular to allow the monetization of large public deficits. The (re-)distributive consequences of this exit should not be forgotten. Not all residents are equal before this exit, i.e. equally exposed to its consequences. Some may even gain from this exit: consider holders of foreign securities or producers of goods or services whose demand is not very price elastic, who will be able to protect their margins and costs by raising their prices. Put another way, there are winners and losers at the exit of a monetary union. Exiting a monetary union therefore raises questions of equity and can sharpen political conflicts in the exiting country. It should be noted that the costs associated with the increased financial fragility of the exiting country, the disappearance of the insurance mechanisms implicit in the monetary union and the loss of credibility following exit are largely deferred, i.e. they are felt over a more or less long period following exit from the union. In short, exit from the union leads to a loss of credibility, expectations of higher inflation and increased financial fragility of private residents, the government and the banking system. All in all, the costs of exiting a monetary union are not negligible and make the decision far-reaching since it is the dynamics of future growth that depend on it. They are all the higher, the higher the degree of economic integration within the monetary union. It is logical to assume that they are highest for countries of intermediate size in the global economy and in the union. A large country has a diversified productive structure, exchanges relatively little with the outside world, has the resources and skills to meet the direct costs of transition and within the union benefits relatively little from the transfers and risk-sharing mechanisms that have been put in place. The direct and indirect costs of exit from the union are therefore relatively low. The analysis of the opposite case, that of a small country, leads to the same conclusion, except in the case where it benefits from high risk sharing within the union. Since its size prevents it from assuming full monetary sovereignty and since it does not have its own financial system, it will anchor itself on a foreign currency and thus import its credibility. But it should be noted that these countries also have the least reason to want to leave the monetary union. It is important to note that exit is not the opposite of entering a monetary union and does not mean a return to the anterior situation. Indeed, the union creates irreversibilities and changes the economic structure of the member countries. The

11.4 Exiting a Monetary Union

419

single currency is a vector of productive and financial integration. Unravelling the complex relations that have been built up as a result of monetary unification, both at the microeconomic and macroeconomic levels, is a difficult, certainly costly and high-risk set of operations. Exiting a union is the result of a cost–benefit trade-off that is very different from the trade-off that led to entry. Because entry went well, it cannot be assumed that exit will be as easy. Let us now turn to the consequences for a monetary union following the exit of a member country. The assessment of these consequences is also important because it conditions the negotiating capacity of the country tempted by the exit from the arrangements of the union that are favourable to it. We noted above that the number of participants in a monetary union affects the gains and, more specifically, the stability of the monetary union. It is in accordance with this principle that the consequences of a member country’s exit must be assessed. For the union, there are costs associated with an exit. These are parallel to those incurred by the exiting country: direct costs, economic and financial costs, and loss of credibility. An additional cost must be added, that of possible contagion. The immediate administrative costs are negligible unless the exiting country is a major contributor to the various institutions. The economic costs are potentially higher. The gains from cooperation are decreased as an exiting country no longer integrates the cross-border effects of its monetary and fiscal decisions; similarly, risk sharing is reduced. Finally, the union may be weakened financially if the exit is concomitant with a sovereign default when a fraction of the defaulted public debt is held in the union, and with the non-compliance of the exiting country’s financial commitments to institutions or agents resident in the union. This financial weakening may also occur if its currency depreciates against the currencies of the rest of the world, which may occur as a result of the contagion effects that we will discuss. The external credibility of the union is also at stake since the exit reveals a dysfunction of the union, gives a signal of the institutional inadequacy of the union and leads financial market operators to reassess the risks associated with the union in general and its members in particular. This is reflected in higher risk premiums and widening credit spreads. The magnitude of these (perhaps negligible) increases gives an indication of the revised credibility of the union. Most worryingly, the exit of a country can trigger a cumulative phenomenon, an exit contagion. To use the language of coalition theory, there is no guarantee that the union, which is unstable at n member countries, since one country has decided to leave, is stable at n − 1 member countries. We have argued above that the size of a monetary union matters for the cost–benefit calculations practised by its members. This principle can be applied in the case of an exit. One possible scenario is that the exit of country j leads to an increase in the risk premiums paid by country j  . Under these conditions, country j  also decides to exit. The union is now at n−2 countries. The same scenario can be repeated, and the union can be gradually reduced, to the point where its existence is called into question.

420

11 The Fate of a Monetary Union

This scenario may have a self-fulfilling variant. In this variant, the exit of country j serves as a “focal point” for operators speculating against union.23 These speculators raise the risk premiums of the weakest country in the reduced union. The latter is forced to leave, and so on. With respect to the benefits of an exit for the rest of the union, the most obvious ones are simplification of procedures, administrative efficiencies and negotiation procedures made easier by reducing the number of parties involved. From a Mundellian perspective, another advantage may be linked to the strengthening of economic coherence within the union in so far as the exiter is arguably the most dissimilar country in the union, either structurally or in terms of its fiscal policy choices. Finally, from a strategic point of view, the union can gain in credibility to the extent that the rules on which it is based are better accepted by the remaining members. Put another way, if the outgoing country is the weakest link in the union, its exit represents a strengthening of that chain. Moreover, these costs and benefits depend on the conditions of exit. Exit can be “cold”: this was the case for Ireland, which severed its monetary ties with the United Kingdom in 1979. Or “hot”: Greece’s exit from the euro zone, if it had taken place in 2014, following remarks by the German Chancellor Angela Merkel that she was ready to accept it, would have taken place in a situation of major international crisis, which would probably have considerably increased the bill, both for Greece and for the European Monetary Union. As a result of these developments, it is impossible to propose a simple criterion for determining who should leave a monetary union and when. Quite simply, the exit from a monetary union is not an insignificant event, either for the country leaving or for the rest of the union. For the latter, the exit of one of its members can lead to its strengthening as well as its weakening, which can even go as far as its disappearance.

11.4.3 How to Leave? Exiting a monetary union is always an option for a sovereign State. The secession of a region or the dismantling of a State is also conducive to monetary secession and the establishment of independent monetary sovereignty. Let us focus on the first case, that of a sovereign State. While there are good reasons for exiting a monetary union, we need to know how to exit in a way that minimizes the negative consequences of such an exit. Most exits from a monetary union have taken place without major consequences since we have seen that it is difficult to notice a different macroeconomic dynamic between the exiting and the remaining countries.

23 A focal

point is the solution to which players in a coordination game but without communication skills refer to as the solution chosen by the other players. See Schelling [35].

11.4 Exiting a Monetary Union

421

From this we can deduce some rules for a smooth exit from a monetary union: • An exit is all the easier as it appears reasonable to observers, especially in financial terms. This is the case when the exiting country has the means to assume the consequences of its monetary autonomy, for example, when the country in question is large and at an advanced level of development. • It is easy when it has been anticipated and prepared. This was the case when Ireland left the sterling zone, almost sixty years after its independence and under a flexible exchange rate system. • It is easy when the public institutions responsible for macroeconomic and financial policies are credible whether because of internal quality or because the exit is managed with the help of the international financial institutions. • Finally, it is all the easier when the monetary union in question is itself of a weak form, based on a limited integration of public policies, particularly financial policies. Under these conditions, the disruptive effects are limited and confined to aspects of monetary circulation. Conversely, an exit is made difficult and costly both for the exiting and the remaining countries when it occurs under the pressure of events in a crisis context, when it occurs by surprise and when the monetary union is based on significant sovereignty sharing. A sovereign country can leave the union on its own initiative or “be pushed” into leaving by its partners. Under these circumstances, how can the exit mechanism from a monetary union be designed so that it does not contribute to the weakening of the monetary union in question? Cooper [9] has proposed an ingenious exit process that paradoxically serves to strengthen the monetary union. Specifically, it should be thought of as a disciplinary mechanism to limit the ability of member countries to engage in fiscal behaviour that is detrimental to the union. This requires that the exit is a credible punishment for the deviant country, conceived as an alternative to bailout by partner countries. The mechanism proposed by Cooper is that of a partial exit from the union in the event of a request for a bailout. It is similar to a form of dollarization. The exiting country does so only partially because it withdraws from all the governing and decision-making bodies of the union, first and foremost from the union’s central bank. But it retains the use of the currency of the union and does not have to renegotiate its contracts or suffer the financial consequences of issuing a new currency. Cooper shows in a very simple model that all countries prefer this partial exit mechanism to a total exit. Agents in the deviating country avoid the transaction costs due to the duality of currencies, while nationals of partner countries reduce the cost of a bailout, particularly because the deviating country still bears the inflation tax associated with it. The consequence is that each country has less incentive to have an irresponsible fiscal policy and eventually default. It would be interesting to extend the model and to see under what conditions a “partially exited” or even “dollarized” country can ask for full (re)integration into the monetary union.

422

11 The Fate of a Monetary Union

This mechanism can only be applied in connection with irresponsible fiscal policy. It cannot deal with other crises within the monetary union: imbalances in a country’s current accounts, a sudden banking crisis, etc. It cannot deal with other crises within the monetary union: imbalances in a country’s current accounts, a sudden banking crisis, etc. Under these conditions, exit from the union may prove inevitable. But it has the merit of showing that mechanisms designed in advance to provide for this exit make it possible to strengthen the union and not, as one might spontaneously think, to weaken it by somehow legitimizing this exit.

11.5

Death of a Monetary Union

Monetary unions are mortal. No wonder: international monetary systems themselves succumb and are replaced by a new one in the course of history. The demise of a monetary union is the result of a gradual and mostly insensitive and unobserved accumulation of structural tensions.

11.5.1 The Causes of the End of a Monetary Union The causes of the end of a monetary union are of the same order as those of an exit: growing structural asymmetries, divergent policies, major changes of political regime. Circumstances can be most diverse here again, from a major crisis to the end of the planned and consensual union. The end of a union is in a way a collective exit. Nitsch [30] has devoted an empirical study to the question of the determinants of the end of a monetary union, understood in the sense of a currency circulation area. Despite the statistical difficulty inherent in this type of work, his results are interesting. The data used cover the period 1948–1997. During this period, 245 common currency links between two countries are recorded and 128 of these links were dissolved. Not all of these breaks imply the end of the monetary union concerned when it involves more than two countries, but this is the case in the vast majority of the cases studied. Countries that maintained their currency links during the period serve as a control group. The results obtained are as follows: 1. The first predictor of the dissolution of a monetary union is the inflation differential between member countries. This result confirms Rose’s result for exit from the union. 2. Growth differentials between countries and asymmetries in fiscal policy do not seem to lead to the break-up of a monetary union. The exception is public deficits: a deficit differential between countries is a predictor of a break-up of a monetary union. In terms of foreign trade, we do not note that the current external balance behaves very differently between countries maintaining a monetary union and the others.

11.5 Death of a Monetary Union

423

3. Finally, the break-up of a political union between countries (in particular, during a decolonization process) is a predictor of the end of the monetary union between these countries, even if the two events are not necessarily concomitant.24 But the political break does not systematically translate into the monetary break. Again, this result is parallel to that obtained by Rose. However, these interesting results are limited in scope by the period of time considered, a period of strong growth and development of international trade. While it has experienced turbulence (oil shocks, Latin American and Asian payment crises, for example) and the end of the fixed exchange rate system, it has not been marked by severe crises, such as the one that hit the world economy in 2008. If we look at the more distant history of monetary unions, a lesson can be learned. Monetary unions often end during a major historical crisis. This was the case, for example, with the Latin Union and the Scandinavian Monetary Union, which were dissolved with the outbreak of the First World War (Bordo and Jonung [5]). The financing needs of the war effort in France, Belgium and then Italy forced the belligerant countries to resort to monetary financing and more specifically to the issue of banknotes. As these methods of payment were not recognized within the Latin Union, the payment area was de facto dissolved. It was legally dissolved only after the end of the war, on Belgium’s initiative in 1925, without any drama, as the member countries had had time to implement their full monetary sovereignty and monetary debates were then dominated by the question of a return to the gold standard. The case of the Scandinavian Monetary Union is similar. The conversion of banknotes issued in the union into gold was initially suspended, which called into question the automatic one-for-one conversion of these banknotes, issued by the member countries, even though the issuing policies soon diverged. Gradually, the international circulation of means of payment within the union was suspended. The Scandinavian Monetary Union was legally dissolved in the 1920s. Some monetary unions ended without major drama, such as the monetary union between Ireland and the United Kingdom, mentioned above. The European Payments Union was dissolved smoothly in December 1958, once the reasons for its creation (the shortage of available dollars in Europe after the Second World War) had disappeared. Similarly, the dismantling of a country (often a federation) often leads to the end of monetary integration. This was the case in the disappearance of the Austro-Hungarian Empire, the USSR, Yugoslavia and Czechoslovakia. In these cases, the cause of the end of monetary union was clearly political, not (directly) economic. In the end, both for monetary unions between sovereign countries and for monetary unions corresponding to federations, purely political factors play a major role in their end.

24 The

end of the USSR is curiously not taken into account in the database used.

424

11 The Fate of a Monetary Union

11.5.2 How a Monetary Union Ends The end of a monetary union is often concomitant with a major political crisis, usually international, such as a war or a revolution.25 This can be explained by the fact that a political crisis acts as a revelation of the flaws and shortcomings of a monetary union. These have remained unnoticed or neglected in quiet times, by virtue of short-sightedness often at work in political decision-making. They have led to an accumulation of internal tensions that are fully released during the crisis and are then impossible to control because there is no time to put in place the institutions necessary for the survival of the union. As the costs of the end of a monetary union are very high for the reasons given above, the crisis is an opportunity to (make) public opinion bear them without too much difficulty. It can also be argued that the political crisis renders obsolete the reasons that led to the creation of the monetary union. The Latin Union is a good example of such a scenario. But the crisis is also an opportunity to see the development of uncooperative behaviour on the part of the parties involved. Sovereign countries are then tempted by the “every man for himself” approach. The crisis can be seen as a sequence of chain reactions. The result (the disappearance of the monetary union and the liquidation of its institutions), due to this runaway, may well be unwanted by each of the players. It is in difficult situations that cooperation is most necessary. But because the conditions for cooperation between the parties, without which there can be no lasting monetary union, are lacking, the union disappears. It is in this sense that political responsibility is involved in this outcome.

11.5.3 Post-monetary Union for Member Countries This being said, the consequences for each of the stakeholders of the disappearance of a monetary union are potentially stronger than those of an exit by one of its members, and in particular its own exit. Indeed, the disappearance of a monetary union will lead to widespread uncooperative behaviour in monetary and exchange rate policy and can lead to large-scale international monetary and financial disorder if the monetary union is of a significant size in the world economy or if circumstances are appropriate. For the former member countries, they now have to manage their regained autonomy in a context of crisis. They have to fit into a potentially new international monetary system and ensure the external credibility of the (re-)created national currencies. The consequences of the post-union period are modulated by the size and diversity of the economic system of each of the countries concerned. They are logically the least negative for (very) small countries or, on the contrary, for countries with a high size, level of development or degree of productive diversification, for the same reasons as those described above.

25 Sometimes

a political crisis provides an opportunity to strengthen a monetary union, as was the case with the US monetary union after the Civil War.

11.6 Conclusion

425

These consequences are also modulated by the degree of national consensus that prevails in the country in the post-union period. It is indeed necessary to reconfigure a social pact on a purely national basis. However the death of the union does not have the same effects on everyone; it can produce winners as well as losers. In a context of international crisis, this reconfiguration may be difficult and increase the difficulties encountered. The consequences for the rest of the world depend on the relative importance of the union that has disappeared on a global scale and the international monetaryfinancial system in place. They can be significant if the monetary union has an important place in the international monetary system. Imagine the state of crisis in which the world economy would find itself if, for some unexplained and unexpected reason, the US currency zone was to fragment, say into twelve currency zones overlapping with the current districts of the federal reserve system! In a financially integrated economy such as the global economy of the twenty-first century, if the union is of significant size, given the precedent provided by the collapse of Lehman Brothers in the United States in 2008, we can expect a sudden and general change in attitude towards risk, involving a “flight to quality,” an increase in the risk premiums supported by the most fragile issuers of financial securities and widespread financial fragility due to internationally transmitted sequences of financial loss. The consequence would logically be a marked and lasting economic crisis. Potentially, especially if the currency of the vanished union was an international reserve currency or an international transaction currency, this could lead to a systemic risk on a global scale that could lead to a major crisis.

11.6

Conclusion

A monetary union is a complex entity that develops over time. Its development is of course dependent on the ambitions of its builders. The dynamics of the euro area and the European Payments Union cannot be compared, as their objectives differ so much. Its potential, but also its weaknesses, is gradually becoming apparent and is revealed during political and economic crises. Its dynamics is complex and develops through a succession of phases of consolidation and change. The observation of historical monetary unions, first and foremost the American and European monetary unions, bears eloquent witness to this. The solidity of a monetary union, i.e. its ability to withstand major shocks, depends on its institutional deepening. This deepening may take time and may take place during economic and political crises that show the need to change the institutional framework. The solidity of a monetary union is reinforced by the place it has taken in the international monetary system. Its extension protects it because it facilitates the financial conditions for the management of the difficulties it faces. But its complexity potentially feeds its fragility. An intrinsic fragility linked to the imbalances it generates, if they are not compensated for by sufficient cross-border solidarity

426

11 The Fate of a Monetary Union

(without prejudging the form this solidarity takes) and well thought out and effective safeguard procedures in the event of a crisis. This fragility may lead, depending on historical circumstances, to its outright disappearance. This disappearance is costly for the member countries, in proportion to the importance acquired by the monetary union in the world economy. It is therefore necessary to be vigilant and to watch out for the chains of events that can lead to it, even if they are unintentional. In any event, those responsible for a monetary union should never assume that it will last. At whatever level they operate, they must remain mindful of its preservation. Three lessons can be drawn from the analysis of the future of monetary unions, particularly from the historical experiences of unions: 1. The fate of a monetary union depends crucially on the control of the public finances of the member countries or of the fiscally autonomous entities integrated into the union. Monetary unions will continue as long as they have found a way to control uncooperative fiscal behaviour, either through effective market discipline, as in the case of the Austro-Hungarian monarchy, or through legal provisions strong enough to ensure control over the issuance of means of payment, as in the case of French-speaking African monetary unions. When this control gives way for one reason or another, the monetary union soon disappears, as was the case for the Latin, Scandinavian and Austro-Hungarian unions, which were swept away by the catastrophe of the First World War. This was also the case with the rouble zone, established within the Commonwealth of Independent States after the sudden collapse of the USSR in 1991, which disappeared in 1995 because of the capacity left to member States to grant bank credits, and therefore to issue currency without restriction. This reinforces the attention we have given in previous chapters to the problems of public finance management in a monetary union and the importance of a sound contract on public deficits, what we have called a fiscal union. 2. But it is equally true that a monetary union must be able to overcome banking crises and manage financial instability. While the US financial crises of the nineteenth century could be managed without major government intervention, the rise in financial imbalances and the resulting social unrest led US leaders to establish a central bank and then to strengthen its powers and add other prudential institutions. The Austro-Hungarian Union also managed the banking crisis of 1873. The Russian financial crisis of 1997, on the other hand, was the death knell for plans to resurrect a rouble zone. 3. Behind the control of public finances and the strictly institutional game, what ultimately counts is the solidity of the union’s social pact, i.e. the acceptance by the populations of the union, through the agreements made to establish it and applied (with more or less opportunism) by successive governments, of the rules of the union’s game. If the Austro-Hungarian monetary union did not withstand the First World War, it was because the two nations had long been engaged in a slow process of estrangement that insidiously undermined the political and social

References

427

consensus on monetary union and accelerated dramatically with the defeat of 1918. The implicit or explicit rules of the game do not mean uniformity for all and the disappearance of the singularities of national social pacts but acceptance by the peoples of the priority of the objective of preserving the union over national and short-term objectives. A monetary union can only be thought of in relation to the eminently political questions of sovereignty. According to Bordo and Jonung, the main factors explaining the evolution of a monetary union are political (Bordo and Jonung [5], p. 32). Thus it is not surprising, for example, that in the debate surrounding Scotland’s independence in 2015, the problem of the monetary regime of an independent Scotland and a possible union with England was raised (Armstrong and Ebell [1]). Not all monetary unions have a future, but our future is inconceivable without monetary unions.

References 1. Armstrong A, Ebell M (2014) Scotland: currency options and public debt. Natl Inst Econ Rev 227:R14–R20 2. Artis M (1996) Alternative transitions to EMU. Econ J 106:1005–1015 3. Bergman M (1999) Do monetary unions make economic sense? Evidence from the Scandinavian Currency Union, 1873–1913. Scand J Econ 101:363–377 4. Bergman M, Gerlach S, Jonung L (1993) The rise and fall of the Scandinavian Currency Union 1873–1920. Eur Econ Rev 37:507–517 5. Bordo M, Jonung L (1999) The future of EMU: what does the history of monetary unions tell us? NBER Working Paper 7365 6. Buiter W, Corsetti G, Roubini N (1993) Excessive deficits: sense and nonsense in the Treaty of Maastricht. Econ Policy 8:57–100 7. Carcillo S, Goujard A, Hijzen A, Thewissen S (2019) Assessing recent reforms and policy directions in France: implementing the OECD Jobs Strategy. OECD Social, Employment and Migration Working Papers 227, https://doi.org/10.1787/657a0b54-en 8. Committee for the study of economic and monetary union (1989). Report on economic and monetary union in the European community. http://aei.pitt.edu/1007/1/monetary_delors.pdf 9. Cooper (2012) Exit from a monetary union through euroization: Discipline without chaos. National Bureau of Economic Research working paper 17908 10. Cooper R, Kempf H (2003) Commitment and the adoption of a common currency. Int Econ Rev 44:119–142 11. Demange G, Wooders M (eds) (2005) Group formation in economics: networks, clubs, and coalitions. Cambridge University Press, Cambridge 12. Dustmann C, Fitzenberger B, Schönberg U, Spitz-Oener A (2014) From sick man of Europe to economic superstar: Germany’s resurgent economy. J Econ Persp 28:167–188 13. Eichengreen B (2012) When to dollarize? J Money Credit Bank 34:1–24 14. Eichengreen B, Wyplosz C (2016) Minimal Conditions for the Survival of the Euro. Intereconomics 51:24–28 15. Einaudi L (2001) Money and politics: European monetary unification and the international gold standard (1865–1873). Oxford University Press, Oxford 16. Feldstein M (1997) The political economy of the European Economic and Monetary Union: political sources of an economic liability. J Econ Perspect 11:23-42

428

11 The Fate of a Monetary Union

17. Flandreau M (1993) On the inflationary bias of common currencies: the Latin Union puzzle. Eur Econ Rev 37:501–506 18. Flandreau M (2000) The economics and politics of monetary unions: a reassessment of the Latin Monetary Union, 1865–71. Financ Hist Rev 7:25–44 19. Flandreau M (2006) The logic of compromise: monetary bargaining in Austria-Hungary, 1867– 1913. Eur Rev Econ Hist 10:3–33 20. Frankel J, Rose A (1998) The endogeneity of the optimum currency area criteria. Eco J 108:1009–1025 21. Friedman M, Schwartz A (1963) A monetary history of the United States. Princeton University Press, New York 22. Horwitz L, Myant M (2015) Spain’s labour market reforms: the road to employment – or to unemployment? ETUI Working Paper 2015.03 23. Kaplan J, Schleiminger G (1989) The European payments union: financial diplomacy in the 1950s. Oxford University Press, Oxford 24. Kenen P (1969) The theory of optimum currency areas: an eclectic view. In Mundell R, Swoboda A (eds) Monetary problems of the international economy. University of Chicago Press, Chicago, p 41–60 25. Kohler M (2002) Coalition formation in international monetary policy games. J Int Econ 56:371–385 26. Krugman P (1993) Lessons of Massachusetts for EMU. In Giavazzi F, Torres F (eds), Adjustment and growth in the European Monetary Union. Cambridge University Press, Cambridge 27. Marsh D (2012) The Euro. The battle of the new global currency. Yale University Press, New Haven 28. McKinnon R (1963) Optimum currency areas. Am Econ Rev 53:717–725 29. Meltzer A (2003) A history of the federal reserve, 1913–1951, vol 1. Chicago University Press, Chicago 30. Nitsch V (2004) Have a break, have a. . . national currency: when do monetary unions fall apart? CESifo Working Paper 1113 31. Nitsch V (2006) How to enter a currency union? Lessons from the Past. mimeo 32. Pinelli D, Torre R, Pace L-J, Cassio L, Arpaia A (2017) The recent reform of the labour market in Italy: a review. European Economy Discussion Papers 201-072 33. Rose A (2007) Checking out: exits from currency unions. Centre for Economic Policy Research DP 6254 34. Sargent T (2012) Nobel lecture: United States then, Europe now. J Polit Econ 120:1–40 35. Schelling (1981) The strategy of conflict. Harvard University Press, Cambridge 36. Stahr W (2005) John Jay, founding father. Bloomsbury Academic, New York

General Conclusion

12

Abstract

Chapter 12 is the general conclusion of the book. It summarizes the main lessons which may be drawn from the book. A monetary union can be seen as a “total economic fact,”, affecting every component of the member economies and radically modifying their adjustment processes and modes of functioning. This creates multiple collective action issues. In brief, a monetary union must be analysed through the lenses and tools of international political economics.

Following the creation of the EMU in 1993, the concept of monetary union, hitherto rather neglected by economists, gave rise to an abundant literature, often empirical and centered on the problems encountered in its gestation and in its operation. Based on this important research effort, we have sought in this book to clarify and better understand what this term covers. In this conclusion, let us first summarise the salient results of our survey, and then synthesise them by presenting a monetary union as a “total economic fact”. We argue that the problems of the creation and functioning of a monetary union, because it requires the cooperation of the public entities involved in the union, entails political dilemmas that economists can only explain or clarify but not solve, leaving decisions to electorates and governments.

12.1

What Have We Learned?

Let us first summarize the main lessons from previous developments. 1. The concept of monetary union covers very different forms. Two criteria for differentiation are particularly important: the intra- or international character of the union and the degree of power-sharing between its public entities.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9_12

429

430

12 General Conclusion

2. A monetary union cannot be analysed solely as the sharing of a single payment device and assimilated to an area of circulation of a common currency, thus suppressing the need for currency convertibility. This would be disregarding the different dimensions of the union. In particular, it is essential to take into account the interactions between monetary and public finance issues on the one hand, and the banking and financial implications of the area of circulation of the same currency on the other. A multi-national monetary union must be seen as an international monetary system, in that it necessitates the balancing of national external accounts. The absence of adjustment by exchange rates does not abolish this requirement. In a national monetary union, the problem does not arise (or is less acute) because transfers between public entities are facilitated by legal and political homogeneity. In line with the view of a monetary union as a international monetary system, its functioning and sustainability depend on the social contract (in the sense of Polanyi and Eichengreen) that governs it, or on the compatibility of national social contracts in the case of a multi-national monetary union. 3. The economic assessment of a monetary union is difficult to make. Firstly, because this evaluation could be attempted from a number of points of view, depending on whether one is interested in the functioning of a union within a given perimeter, the opportunity for a group of countries to create it or the opportunity for a country to join it. Secondly, because monetary unification changes the behaviours and structures of the economies concerned. New problems arise such as opportunistic behaviour, non-cooperation between public authorities collectively responsible for the union, etc. 4. A monetary union is faced with the difficulty of regulating a heterogeneous economic and political area while the number of economic policy instruments is reduced by the disappearance of exchange rate instruments. This management is apprehended differently in a national monetary union than in a multi-national monetary union. In a national monetary union, transfers between jurisdictions are facilitated (but not abolished) by the existence of political unity and the possibility of public transfers within the federation. 5. The regulation of a monetary union is carried out jointly by market discipline and institutional discipline. (a) Market discipline, in particular the role of the financial markets, does not disappear along with the foreign exchange markets. Interest rates continue to play a major regulatory role, particularly sovereign interest rates (on the public debts of member entities). However, there is no guarantee that this discipline is effective and sufficient. Speculative behaviour does not disappear with the foreign exchange markets but instead focuses on the possibility of dismemberment of a monetary union. (b) Institutional discipline, or the institutional architecture governing the responsibilities of the public authorities operating in the union, is a determining factor in the solidity (its capacity to endure) of the union.

12.1 What Have We Learned?

431

6. There is no ideal institutional form of a monetary union. (a) The central bank of the union, in charge of monetary policy, is necessarily a supra-national institution in a multi-national monetary union. But it is not systematically true that the delegation of monetary policy to an independent central bank is the natural institutional formula in a multi-national monetary union, preferable to direct negotiation between the political authorities. (b) In any event, the credibility of the institutions of a monetary union is central to its soundness and appropriateness legitimacy. 7. Monetary policy in the union is conducted using the same instruments as in a single economy. But the monetary authorities in charge of monetary policy may take a global perspective, looking at the union as a whole, or they may take into account the different macroeconomic situations of the entities in the union, depending on the mandate they have been given. Monetary policy logically has differentiated impacts on the different entities of the union. 8. A monetary union necessarily has a fiscal dimension. (a) Insulation is impossible in a monetary union. No member entity of a union can isolate itself with its fiscal policy or be isolated by monetary policy, i.e. not be affected by the fiscal decisions of the other member entities. (b) The issue of government debt is a major problem in a monetary union. Public debt is often merely an expression of external imbalances within the monetary union. (c) Balancing the national accounts of the various entities generically requires transfers. In a multi-national monetary union, these transfers, in the absence of exchange rates, are made on the initiative of the national political authorities to ensure the smooth functioning of the union and, in the event of a systemic crisis, to guarantee its survival. (d) As the fiscal dimension is essential to the functioning of a monetary union, it calls for a fiscal union, understood as an agreement between member entities on the modalities admitted within the union for their fiscal policies. Nor does such a fiscal union have an ideal form, i.e. one that would be preferable to any other possible option. (e) A fiscal union can be conceived as a “negative” union (constraining the fiscal autonomy of the partner political entities) or a “positive” union, with the pooling of fiscal instruments such as debt management or the establishment of a fiscal federalism mechanism. (f) Fiscal federalism is not necessarily preferable to inter-governmental negotiation on fiscal matters. 9. A monetary union in a modern economy is inconceivable without a banking union (in the broadest sense) because banks and financial institutions are key elements in the transmission mechanisms of monetary policy. These institutions need to be subject to a coherent and consistent set of regulations. In particular, mechanisms for the resolution of banking and financial crises must be put in place to reduce risk premia and contribute to the soundness of the monetary union. The banking union is linked to the fiscal union through the regulation of

432

12 General Conclusion

public securities, especially when there are common debt regimes among the different entities of the union. 10. The common monetary policy alone cannot resolve the imbalances within the union. Fiscal tools are also limited. Macroeconomic stabilization and, specifically, the reduction of external imbalances require structural measures. These measures often aim at a better functioning of markets, through greater price and wage flexibility. They also may be in the direction of demand support or public sector reforms. These reforms concern the definition of the social contract compatible with monetary union. 11. A monetary union, both in its creation and in its operation, generates winners and losers. In other words, the monetary, fiscal and regulatory policies pursued within it have (re-)distributive effects between the member entities of the union. 12. A monetary union as a specific monetary regime is dependent on existing financial, banking and monetary technologies as well as on the evolution of its international environment. A union is subject changes in response to developments in the economic and historical environment, which may result in a changing scope or even outright disappearance, as shown by various historical examples of monetary unions.

12.2

Monetary Union, a Total Economic Fact

These points make it clear that monetary union is much more than just an arrangement for the organisation of monetary payments within a given economic area. Drawing inspiration from the French anthropologist Marcel Mauss [1],1 we argue that a monetary union, especially a multi-national one, is a “total economic fact”. Let us define a total economic fact as a device that sets in motion the entire economy and its institutions, or at least a very large number of institutions, and thus widely affects the economic decisions and exchanges of individuals living in that economy.

The creation of markets such as insurance markets or international organizations such as the IMF, reforms such as a reform of land ownership in an agricultural economy can rightly be qualified as “total economic facts” insofar as they profoundly modify economic behaviour and modes of regulation beyond their primary purpose and immediate effects.

1

Marcel Mauss (1872-1950) is a French sociologist and anthropologist, founder of the French School of Anthropology. His Essay on Gift first published in 1923 had a major influence on the social sciences, particularly in the economists’ reflection on individual rationality. Marcel Mauss defined the “gift” he studied in non-market societies as a “total social fact”: “The facts we have studied are all (...) total social facts (...): that is, they set in motion in some cases the whole of society and its institutions (...) and in other cases a very large number of institutions, especially when these exchanges and contracts concern individuals.”

12.2 Monetary Union, a Total Economic Fact

433

In the light of the preceding developments, a monetary union corresponds to the definition of a total economic fact: it leads to a modification of the decision-making methods of individuals and public authorities and therefore of the functioning of the markets and public institutions active in the union area. The overall economic functioning of each of the member countries is affected by the fact of its belonging to a monetary union. Two major consequences flow from this proposition. 1. The first is that we are a long way from the idea that money is neutral. Not that this idea is false: monetary economists are still debating it. But, correct or not, it relates only to a limited aspect of a monetary arrangement: the quantitative manipulation of monetary policy instruments, given the institutional framework within which monetary policy is conceived and conducted. On the contrary, establishing a monetary union within a given economic area is potentially conducive to major structural changes likely to modify the regulation of this area, by affecting agents’ decision-making and adjustment methods. 2. The second consequence is that the foundation and evolution of a monetary union are based on major collective choices. These are not strictly technical decisions but political decisions as they concern the regulation of differentiated economic groups, and are likely to have a considerable and lasting impact on the living conditions of individuals residing in the area under consideration. More specifically, such decisions have differentiated and possibly opposing effects on agents or sectors of activity. As we have seen repeatedly in previous chapters, it would be quite surprising if there were not losers as well as winners in the creation and development of a monetary union. There is every reason to believe that there is a general fear of being among the losers and that most everyone sees himself as a loser and the others as winners. These fears and recriminations are more pronounced in multi-national monetary unions than in national unions because equalization mechanisms are less secure. Because the management of a monetary union—beyond regular monetary policy— raises questions of distribution and equity among its components and among the individuals who reside there, it depends on major political decisions and is not simply a problem of monetary technique to be left to seasoned experts. The difficulty is compounded by the fact that these political decisions necessarily involve economic and technical issues that are complex and difficult to master, as this book has attempted to demonstrate. Designing the tools for monitoring fiscal policies, understanding the different types of moral hazard arising from a monetary union, setting up the instruments, particularly the financial instruments of a fiscal union, or even constructing effective banking regulations for a monetary union as a whole, are not problems that are easy to solve or for which we can rely on the vox populi to obtain the right answer. Monetary union is both an economic issue whose management requires solid expertise and a political institution whose sustainability depends on the support it receives from the populations concerned.

434

12.3

12 General Conclusion

Collective Choices in a Monetary Union

It is possible to shed light on the complexity of the institution of a monetary union by starting with a reflection on the collective issues at stake in monetary matters. That money is a “public good” is a common proposition among economists. Clearly, no one can appropriate it or create their own money: by its very nature, money circulates between individuals and firms and is useful only because it is common to a given community. The production of this collective good is done at zero cost, or even yields a profit for its issuer, the State, and its use by agents is also of zero or negligible cost (in most cases): money retains its face value regardless of the number of users, the frequency of its use or the length of time it is kept. Thinking about monetary union makes it possible to go beyond this all too easy evidence and show the usefulness of approaching money through the lenses of public economics. To understand this, let us start with the functional approach to money, the traditional starting point of monetary economics. Money has three functions: unit of account, (virtually) universal means of payment for market goods and store of value.2 Public economics, for its part, distinguishes at least three types of collective goods that need to be detailed. The definition of public goods is based on two properties: 1. the property of non-excludability: a good is said to be non-excludable when it is impossible to prevent economic agents from having access to and using it; 2. the property of non-rivalry: a good is said to be non-rivalry when its use by one economic agent does not reduce the use or enjoyment of it by other agents. Note that these properties refer to a given collectivity (a set of agents). Using these properties, we can distinguish three collective goods. 1. A “pure public good” is both non-exclusive and non-rival. A typical example of a pure public good is national defence. 2. A “club good” is both exclusive and non-rival. Its access is restricted to club members, implicitly paying an entrance fee or bearing a membership cost. They enjoy the club without hindering each other. 3. A “common good” is both non-exclusive and rival. All agents have access to the common good but its use by one agent reduces the use that others can make of it. Implicitly, the common good is available in limited quantities and is subject to depletion. Non-market natural resources, such as air quality, are examples of the common good. But we can also think of an irrigation network serving a farming community, or a fishery. The distinction between these goods is important because each poses different problems of collective choice. 2

It is assumed that the reader of a book on monetary unions is aware of this tri-functionality.

12.3 Collective Choices in a Monetary Union

435

1. A pure collective good poses the twofold problem of the optimal quantity of the good to be supplied and the distribution of its production cost over the entire community served. 2. A club good must also be produced and financed. In addition, the scope of the club and, more broadly, its composition are subject to collective deliberation. The three issues are interdependent: the size and composition of the club depends on the quantity of the good to be produced and its financing, and vice versa. 3. Finally, a common good poses a problem known as the tragedy of the commons. The combination of free access and individual enjoyment penalizing the enjoyment of others generates a phenomenon of collective overexploitation that is not encountered in the other two cases. Each person accessing the resource, not caring about the negative externality that it inflicts on other users, consumes too much of it relatively to what would be collectively optimal, given the needs of all, the quantity available and the rate of reconstitution of this resource. In any case, the management of public goods is made difficult by the fact that preferences are not revealed through the price system since demand is not regulated by the market price. The non-observability of the preferences and contributive capacities of potential users of these goods leads these users to conceal what they want or their ability to pay. This brief exposition of public goods is sufficient to return to the issue of money as a collective good. This formulation is too vague and therefore inoperative: it does not tell us which property of money is referred to and what type of collective good is associated with it. Let us clarify this point and see how it enlightens us on the management of a monetary union. Money as a unit of account is a pure public good: no one is prevented from measuring in dollar or sesterce the value of things, and this does not harm anyone. In fact, this property poses no management problem, since the cost of producing a unit of account is obviously zero (or negligible). A unit of account is an intellectual production and simply depends on a shared convention. Money as a means of payment is a club good: its area of circulation, or the monetary zone in which it is valid, is circumscribed. The club character of a monetary zone is obvious when this zone corresponds to the territory of a State which institutes the forced use of the currency it issues, i.e. it makes compulsory the use of this currency in commercial exchanges between agents on its territory. But, in doing so, the State settles the question of the extension of the monetary club and who belongs to it. Because the creation of currencies has gone hand in hand with the establishment of States, and in particular nation-States, the problem of the limits of a monetary zone has not preoccupied economists. The question literally did not arise. The question arose with the dematerialization of currencies during the twentieth century, that is to say the progressive abandonment of any gold currency, coinciding with the development of international trade, and Mundell’s merit is to have been the first to ask the joint question of the extension of currency areas and the plurality of

436

12 General Conclusion

currencies. As we saw in Chap. 2, he did so by imposing a theoretical coup de force: by disregarding the public and therefore political dimension of money. But the various manifestations of monetary union that have occurred in connection with this dematerialisation of monetary exchanges and the increase in the number of States raised the question of the extension of the club that is a monetary area. It is becoming less and less obvious that every State must have its own currency or that it can properly control its use. As we have seen, the delimitation of the boundaries of a club refers to the question of the cost that members are prepared to pay to belong to it and enjoy the benefits of the club. Not all members are willing to pay the same cost; not all members receive the same benefits from club membership. It is therefore in terms of the costs and benefits to its potential members that the question of the limit of a monetary union, seen as a club, arises. The foundation of a monetary union is by nature a collective decision (the effects of armed conflict and annexation should be disregarded) because it requires unanimous agreement. Its enlargement is also a collective decision because any entry (or non-entry) of a potential new member generates external effects and must therefore be approved by its members. The exit from a union is rather an individual decision taken by a State wishing to recover its monetary sovereignty. Lastly, money is a common good. In a narrow view of money, limited to its three functions, and in a closed and simple economy, the assumption most commonly made in the early stages of monetary economics, the reserve value of money understood as monetary liquidity is only diminished by inflation, not by the practices of other users of money. Let us broaden the reasoning. First, let us start from the fact, amply illustrated in the previous developments, that money should be understood as much more than liquidity. What is at issue is the payment system and the bank-financial complex. It is on the basis of this whole that financial assets, including money, retain their value. To understand this, we need only imagine a major negative financial shock that significantly weakens this sector, its structure and its capacity to withstand future shocks. As this shock causes a sharp rise in interest rates, with risk premiums increasing, it induces a loss in value of (non-mature) financial assets, particularly those held by financial intermediaries and banks, which see the structure of their balance sheet deteriorate and may be unable to cope with this deterioration, resulting in negative consequences for their creditors, owners or depositors. What is at issue is the soundness of the financial-banking sector on which the payments that agents make to each other depend. The financial resilience of a monetary union (as opposed to financial fragility) is a common good. Financial intermediaries and banks both benefit from this strength and potentially affect it through their decisions. Each institution, taken in isolation, may take financial risks—through investments or debt-to-equity ratios—that are higher than what appears optimal: indeed, each institution, acting individually, has overlooked the fact that all other institutions are doing similarly and the overall level of risk is increasing. Individually, institutions overestimate the strength of the sector or overexploit it without taking into account the fact that they worsen the overall situation. They behave like fishermen collectively overexploiting a fishery.

12.3 Collective Choices in a Monetary Union

437

The difference is that the decline in fishing resources is gradual and constant while the deterioration in the soundness of a financial-banking system is marked by sudden financial crises. Let us now reason in the context of a monetary union. A monetary union is a common good, particularly through its ownership of financial and banking stability. The users of this good are the users of integrated financial and banking services (extensions of the unification of the payment system), private non-financial agents, financial intermediaries and public administrations. All benefit from the same financial-banking arrangement and the advantages of financial integration. They all benefit from the transfer capacities that we have seen the role they can play in a monetary union, through the banking union and the fiscal union that are attached to it. The union is thus a non-exclusive good, since everyone benefits from it. But it is also a rival good because its collective utility is threatened by the use made of it by its users. To convince us of this, let us take the example of one member State. It may be tempted to take on more debt than it would if it had full monetary sovereignty because it enjoys an implicit and partial guarantee from its partners or because it benefits from the financial depth made possible by monetary union. But it thus undermines the financial soundness of the whole, generating a negative externality for its partners. As a result of the composition effect, with all adopting the same behaviour, the overexploitation of the system leads to a net loss of credibility, excessive collective risk-taking and thus a gradual reduction in the effectiveness of the protection or risk-sharing mechanisms. The same reasoning can be applied to the behaviour of financial intermediaries and banks. Imbalances in external accounts are markers of this scenario. We have seen the difficulty of forcing surplus countries to reduce their surpluses and the risk that deficit countries pose to the union when they rely on the support of their partners. These are two examples of the overuse of the common good of monetary union. The problem of the common good associated with its financial-bank stability, what we can call the “tragedy of monetary union”, is made more difficult for two reasons. 1. Financial and banking institutions tend to over exploit the financial-monetary arrangement as well as the public components of the union. As we have seen in Chaps. 9 and 10, the question of public debt is linked to the financial stability of a monetary union. The tragedy of a monetary union can come from overindebtedness. But we have seen that market discipline may be insufficient or ineffective in regulating this indebtedness. 2. The implementation of control and prevention procedures is difficult. The member entities of the union, in particular the States in multi-national unions, are judges and parties in the implementation of these procedures. Public authorities have a common interest in putting in place rules that eliminate or reduce abusive behaviour, but individually they may want to take advantage of a loose framework. The plurality of public authorities responsible for developing such rules and the fact that they have conflicting objectives explain the difficulty of establishing an effective regulatory framework that applies to all uniformly.

438

12 General Conclusion

Thus, the common good of financial-bank stability is more difficult to manage in a monetary union than in a single economy which benefits from the double advantage of unity of decision-making and the (relative) simplicity of its economic structure. Paradoxically, monetary technique issues per se are the least difficult ones in a monetary union. Monetary union does not change the way in which monetary problems are approached even if they must be adjusted to take account of the heterogeneity of the union, as we saw in Chaps. 3 and 4. On the other hand, we now see that the most difficult collective choice problems facing a monetary union are of two kinds: – the question of membership and the parameters of the union (the union as a club); – the question of financial-banking stability (the union as a common good). The first problem is a collective problem insofar as it involves defining the rules of membership. The latter one is more critical than the former because it calls into question the very durability of a union whereas membership raises the question of its adequacy. We saw in Chap. 11 that the durability of a union cannot be considered as assured once it has been created. One of the economic reasons for its potential fragility lies in the tragedy of the commons of the union. The resolution—good or bad—of these problems requires institutional measures. From this perspective we can understand the advisability of adding a fiscal and a banking component to a monetary union to make it stronger. The fiscal and banking arrangements put in place are designed both to limit collective risk-taking and to better manage it through protective and effective risk-sharing mechanisms. Let us add immediately that the two orders of collective choice are distinct but linked. Indeed, it is impossible to separate the calculation of the costs and benefits of belonging to a union from a reflection on its institutional organisation. The arrangements that ensure (or seek to ensure) the viability of a union and its capacity to withstand crises whether it is a banking union or a fiscal union, necessarily affect the way the union operates, and therefore the net benefits derived by its components and their residents. We can also say that the collective choice of membership is an ex ante choice, whereas the collective choice of the management of the common goods linked to the union is an ex post choice.

12.4

Monetary Union and Politics: Between Sovereignty and Cooperation

Our initial thinking began with the observation that a monetary union is situated between national sovereignty and international trade. At the end of our investigation, by continuing our reflection on the collective choices concerning monetary union and by putting ourselves on a strictly political level, we can argue that a monetary union is situated at the crossroads of national sovereignty and cooperation between the components of the union.

12.4 Monetary Union and Politics: Between Sovereignty and Cooperation

439

In the case of a national monetary union, national sovereignty is not involved by construction. The management of the union is simplified by the legislative and executive unity of the State. Its institutions are not the result of negotiation and consultation between sovereign public authorities. But the heterogeneity of the union, the existence of autonomous and fiscally responsible components, means that the question of their effective cooperation arises. The problem is of a completely different nature in the case of a multi-national monetary union in which the States are sovereign and on an equal legal footing (we exclude the case of dollarization where, by definition, there is no cooperation). To say that collective choices have to be made to found or transform a monetary union amounts in this configuration to saying that the member States (where appropriate, potentially) must cooperate or use their sovereignty to collectively curb their individual capacity for action. The question of maintaining or forgoing sovereignty is often poorly posed and apprehended because one fails to see that it can be exercised in two opposite directions: either to be alone and refuse to cooperate, or, on the contrary, to negotiate with partner States about sharing or transferring sovereignty. Monetary union, in its different compartments, must be thought as a cooperation scheme between the different polities involved.3 This is true not only at the time of its founding act—which is cooperative in nature—but in its very management. The issue of structural adjustment and reform is a perfect example of this, as we saw in Chap. 8. A monetary union is international cooperation in action. Rather than questioning the possible convergence of the components of a union (we have seen that it is impossible to conclude on this point), it is more fruitful to scrutinize the obstacles to cooperation between member States. The institutions of a monetary union are the fruit of compromises between the stakeholders and derive their legitimacy from them, thus establishing the credibility of the monetary union’s ability to manage shocks and the structural heterogeneity of the union. Indeed, these compromises are linked to the economic and political circumstances in which they emerged. Contingent on these circumstances, they may become obsolete and may need to be reconsidered, renegotiated and, if necessary, denounced. A monetary union thus remains dependent on a willingness to cooperate between the member parties that can be affirmed and reaffirmed in all circumstances. Its solidity depends on the solidarity between its members, more than on the institutions that shape it. It cannot be neglected or, worse, forgotten, without jeopardizing the durability of the union. Under these conditions, it is necessary to resolve intra- and international conflicts of interest when intervention capacities are fragmented, plural and destined to remain so. This is the essence of the dilemma between sovereignty and cooperation.

3

A ‘polity’ is defined by Aristotle as a political regime in which the government is provided by the people for the purpose of seeking common happiness.

440

12 General Conclusion

How then can we better conclude than by quoting the economist with whom we began our investigation? Speaking as early as 1973 about European monetary unification, Mundell wrote: There is no need to base the case for a European currency on economic arguments (...) Political considerations (...) alone would justify the collective effort needed to create a European currency ([2], p. 166).

Such a stance, highlighting purely political considerations, represents a striking change of perspective compared to Mundell’s 1961 article. The considerations that Mundell had in mind in 1973 were related to the collapse of the Bretton Woods system and the opposing interests of the United States on the one hand and the European nations on the other. Mundell’s reasoning on the European case can be extended to any monetary union. Such a union poses institutional problems that go beyond the monetary dimension in the narrow sense of the term and set in motion questions of sovereignty, cooperation and international solidarity. Eminently political issues. Economic analysis is essential for analysing and understanding the functioning of a monetary union, and for revealing its potential as well as its shortcomings and even its perverse effects. It must be used to reflect on the measures to be adopted or the changes to be made to existing measures. But it does not provide the necessary arguments to decide in favour of one or the other of the envisaged solutions, since they involve mechanisms of equity and redistribution, touching on the very heart of what constitutes a political community and referring to political trade-offs. In short, the study of the economics of monetary unions is necessarily a study in political economics.

References 1. Mauss M (2016) The Gift. HAU, London 2. Mundell R (1973) Uncommon Arguments for Common Currencies. In Johnson H, Swoboda A (eds) The Economics of Common Currencies. Allen and Unwin, London

Index

A Accountability, 151, 154 Austro-Hungarian Union, 12, 13 Austro-Hungarian union, 409 Automatic stabilizers, 204, 296

Credibility, 51, 53, 57, 60, 65, 107, 122, 147, 152, 191 Credit easing, 107, 109 Crowding-out, 198, 200 Currency area, 28

B Balance of payments, 21, 22 Balassa-Samuelson effect, 65 Banking crisis, 59, 157 Banking panic, 360, 369 Banking union, 10, 355, 431 Bank panic, 360 Bretton Woods, 7, 12, 31, 315, 366 Business cycle, 41, 52, 63, 64, 87, 88, 151, 192, 202–204, 217, 226, 227, 321, 369

D Debt sustainability, 233, 348 Delors Report, vii, 42, 193, 406 Deposit insurance, 360 Dollarization, 10, 11, 15, 36, 59, 64, 396, 402, 421 Dominant policy, 239

C CEMAC, ix, 9, 14, 403 Central bank, 9, 33, 65, 72, 97, 121, 156, 172, 187 Central bank independence, 51, 134 Commitment, 399 Commonwealth of Independent States, 426 Communication, 151 Competitiveness, 18, 24, 33, 34, 43, 89, 102, 216, 220, 282, 290, 298, 303, 414 Contagion, 48, 153, 157, 187, 201, 287, 341–343, 348, 356, 361, 369, 377, 381, 385, 392 Cooperation, 324, 326 Coordination game, 311 Creative accounting, 228

E European Central Bank, vii, viii, xv, 9, 65, 82, 110, 137, 156, 276, 385, 386 European Monetary Union, vii, ix, 14, 16, 39, 68, 82, 154, 229, 276, 296, 328, 373, 385, 404, 406, 408, 413, 417, 420, 429 European Payments Union, 13, 402 The European Payments Union, 423 European Union, 68 External constraint, 18, 19, 282, 289, 290, 302 External imbalance, 29, 32, 71, 88, 220, 285, 291, 316, 406, 431, 432

F Factor mobility, 69, 188, 200 Federal Treasury, xiv, 28, 170, 171, 173, 187, 197, 227, 241, 322, 323, 327, 329, 339, 345, 350, 411 Feldstein-Horioka paradox, 199, 201, 370

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 H. Kempf, Monetary Unions, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-030-93232-9

441

442

Index

Financial crisis, 28, 157 Financial integration, 32, 45, 48, 57, 70, 72, 199–201 Financial repression, 33 Fiscal devaluation, 220 Fiscal federalism, 204, 323, 327, 332, 349 Fiscal multiplier, 206 Fiscal policy, 50, 72, 197, 198 Fiscal rule, 191, 225 Fiscal sovereignty, 191 Fiscal theory of the price level, 240 Fiscal union, 10, 319 Forward guidance, 106, 109

Monetary sovereignty, 3, 5, 10, 52, 58 Multipliers, 198, 200 Mundell-Fleming model, 42, 44 Mutual bonds, 339

G Goodhart’s law, 228 Government budget constraint, 169

P Phillips curve, 97, 105 Policy coordination, 220 Policy dominance, 241, 323 Policy mix, 233 Productive structure, 57, 62 Public debt, 167, 168, 199 Public debt overhang, 185 Public debt sustainability, 168, 178, 182, 190, 195 Public deficit, 168, 188, 194

I Imported inflation, 21 Inflation, 65, 89, 90, 123, 168, 177 Inflation bias, 51, 53, 127 Inflation tax, 178 Inflation-unemployment dilemma, 90 Institutional discipline, 187, 190 Insulation, 237 Inter-governmental cooperation, 332, 348 International monetary system, 5, 12, 30 IS-LM-BP model, 208 IS-LM model, 198, 208

K Keynes, 202

L Labour mobility, 57 Latin Union, 12, 13, 396, 402, 423, 424 Lender of last resort, 59, 112, 157, 359 Liquidity trap, 106

M Maastricht Treaty, vii, viii, 14, 65, 68, 229, 355, 404, 413 Market discipline, 187 Misalignment indicator, 92 Monetary policy, 77, 78, 121 Monetary policy committee, 144

N Neo-Keynesian macroeconomics, 53 Nominal rigidity, 53, 90, 198, 237 Non-conventional monetary policy, 106 O Optimal currency area, xiii, 41, 50, 55, 72

Q Quantitative easing, 107, 109 R Redistribution, 286 Reserve requirement, 81 Risk-sharing, 29, 57, 67 S Scandinavian Monetary Union, 13, 402, 423 Seigniorage, 5, 11, 13, 59, 178, 242 Separation principle, 83, 107 Sovereign default, 168, 183, 185, 188, 242 Speculation, 29 Stability and growth pact, 229 Structural heterogeneity, 78, 88, 108, 147, 153, 156 Structural reforms, 275 Systemic crisis, 157 T Tax competition, 223 Taylor rule, 80, 87

Index Trade, 3, 49, 57, 61, 102, 105 Transfers, 170, 174, 180, 187, 323, 333, 339 Transversality condition, 179 Treaty of Lisbon, 156 Treaty of Rome, 13 Triffin’s dilemma, 33

443 U UEMOA, ix, 9, 14, 403

Z Zero-lower-bound, 106