ESSAYS IN INTERNATIONAL FINANCE

ESSAYS IN INTERNATIONAL FINANCE are published bythe International Finance Section of the Department ofEconomics of Princeton University. The Section sponsorsthis series of publications, but the opinions expressed arethose of the authors. The Section welcomes the submis-sion of manuscripts for publication in this and its otherseries. Please see the Notice to Contributors at the backof this Essay.

The author of this Essay, Maurice Obstfeld, is the Classof 1958 Professor of Economics at the University of Cali-fornia, Berkeley. He has written articles in the fields ofinternational finance, macroeconomics, and internationalmonetary history. His most recent book is Foundations ofInternational Macroeconomics (1996), coauthored withKenneth Rogoff. The following Essay was delivered as theFrank D. Graham Memorial Lecture on April 9, 1998. Acomplete list of Graham Memorial Lecturers is given at theend of this volume.

PETER B. KENEN, DirectorInternational Finance Section

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Library of Congress Cataloging-in-Publication Data

Obstfeld, Maurice.EMU: ready or not? / Maurice Obstfeld.p. cm. — (Essays in international finance ; no. 209)Includes bibliographical references.ISBN 0-88165-116-81. European Monetary System (Organization). 2. Monetary unions—European Union

countries. 3. Monetary policy—European Union countries. I. Title. II. Series.HG925.025 1998332.4′566′094—dc21 98-27697

CIP

Copyright © 1998 by International Finance Section, Department of Economics, PrincetonUniversity.

All rights reserved. Except for brief quotations embodied in critical articles and reviews,no part of this publication may be reproduced in any form or by any means, includingphotocopy, without written permission from the publisher.

Printed in the United States of America by Princeton University Printing Services atPrinceton, New Jersey

International Standard Serial Number: 0071-142XInternational Standard Book Number: 0-88165-116-8Library of Congress Catalog Card Number: 98-27697

CONTENTS

1 INTRODUCTION 2

2 THE END OF THE BEGINNING: CHOOSING IRREVOCABLE PEGS 4

3 INTEREST-RATE POLICY BEFORE STAGE THREE 11

4 IRISH IRONY 15

5 THE PROBLEM OF FINANCIAL-SECTOR STABILITY 20

6 FISCAL CONVERGENCE AND THE CONDUCT OF MACROECO-NOMIC POLICY 23

7 CONCLUSION: THE FUTURE OF THE EUROPEAN CENTRAL BANK 29

REFERENCES 30

FIGURES

1 The Official vs. Private ECU Spread, January 1991 toJune 1998 6

2 One-Year Forward Rates vs. Central Rates againstthe Deutsche Mark, March to July 1998 9

3 Converging to Stage Three 13

4 Punt and Deutsche Mark Three-Month Interest Rates,March to June 1998 15

5 Punt-Deutsche Mark Spot and Central Exchange Rates,March to June 1998 19

TABLES

1 Macroeconomic Data for Ireland, 1994–1998 17

2 Changes in EU Government Budgets: Selected Countries,1991 and 1997 27

EMU: READY OR NOT?

I acknowledge with thanks the assistance of Stefan Palmquist and Jay Shambaugh, aswell as research support from the Center for German and European Studies at theUniversity of California, Berkeley, and from the National Science Foundation (under agrant to the National Bureau of Economic Research). Fiona Murtagh kindly provideddata.

This essay is based on the 1997–98 Frank D. Graham Memorial Lecture,which I had the honor of presenting at Princeton University on April 9,1998. Frank Graham was deeply concerned with the interplay amongnational policy sovereignty, exchange-rate regimes, and price-levelstability. Today, the world offers an embarrassingly rich diversity ofnational and regional arenas in which domestic political realities and thedesire for exchange-rate stability have come—or threaten to come—intoconflict. Europe, where a new common currency, the euro, is to belaunched on January 1, 1999, will not be exempt from this tension inthe foreseeable future. True, an independent European Central Bank(ECB), rather than national authorities, will set monetary policy for theeuro zone. But even as the twenty-first century approaches, nationalpolitical identity remains a dominant force in the European Union(EU). So long as it does, monetary policies motivated by Europe-wideconditions will invite energetic national challenge, and conflicts overalternative national visions of the ideal framework for economic policywill continue.

More than a quarter-century ago, Max Corden’s (1972) celebratedGraham lecture on Monetary Integration invoked Frank Graham’s (1943,p. 22) own somber prediction concerning a multinational system for the“stabilization of both price levels and exchange rates through theimposition, on all countries, of the requisite monetary policy, with somecentral bank for central banks as the ultimate governing authority.”According to Graham (p. 22),

the struggle for control of such a central bank would be fierce. . . . Thechances are strong that the system would be sabotaged by the action ofsome powerful country, or countries, reluctant to follow the general policyof the controlling authority or in disagreement with the methods by whichit sought to make its policies effective.

1

Corden’s essay quoting Graham was inspired by the Werner Reportof 1970, precursor to the Delors plan for monetary union and, there-fore, to the Treaty on European Union (Maastricht Treaty). However,his reference to Graham’s words was incidental to Corden’s main text.Given the remoteness in the 1970s of the Werner plan’s seeminglyutopian goal, Corden understandably decided against focusing hisinquiry on the political questions raised by full currency unification.His decision may have been fortunate, for Monetary Integration is,even today, often startling in its economic insights, and it remains anessential part of the analytical foundation underlying current researchon the euro.

In the late 1990s, though, Frank Graham’s warning should resonatemuch more strongly for Europeans. Economists have increasinglybecome cognizant of the role politics plays in determining economicoutcomes, and with European economic and monetary union (EMU)finally under way, potential fault lines are apparent. EMU, it is oftensaid, is, at bottom, about politics, not economics. Political change,however, is an ongoing, dynamic process, and it is a mistake to thinkthat the visions motivating today’s European leaders will be enough tosustain EMU indefinitely. If EMU generates economic, social, orcultural stresses, the political ramifications of these stresses will shapethe monetary union’s evolution and, indeed, will determine its survival.

1 Introduction

On March 25, 1998, the Commission of the European Communities(European Commission) formally recommended to the Council of theEuropean Union that eleven countries be admitted as founder membersof EMU.1 The EU finance ministers and heads of state or governmentratified the Commission’s recommendation in Brussels on May 2, 1998.Despite an awkward twelve-hour quarrel about the presidency of theEuropean Central Bank (ECB), the new bank was operating by July 1,1998. Wim Duisenberg of the Netherlands was at its head, havingpromised publicly—at French insistence—to relinquish his appointmentat an unspecified time well before its statutory terminal date.

Under the Maastricht Treaty, the ECB would have no monetary-policypowers until the introduction of the euro on January 1, 1999. Its chargefor the balance of Stage Two of EMU was to complete the infrastructure

1 The eleven countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy,Luxembourg, the Netherlands, Portugal, and Spain.

2

for the introduction of the single currency. This task was a formidableone. The overarching conceptual framework for monetary policy, theset of monetary instruments to be used, the ECB Council’s mode ofcommunication with the public, and myriad other issues remained tobe decided (see Kenen, 1998, for a review). The large-value europayments system intended to link the eleven national payments systemsand to facilitate the single monetary policy (TARGET) still requiredcompletion and debugging.2 Such technical preparations would beessential for a smooth lift-off on EMU’s first day of business, Monday,January 4, 1999.

The problem of Europe’s readiness for EMU goes far beyond theimmediate technical tasks that the newborn ECB has faced, despite acontinuing state of denial among many observers. Nearly everyoneacknowledges, for example, that European unemployment is perilouslyand unsustainably high, and that labor-market reform would ease lifeunder the single currency. Yet the hope in Europe is that the singlecurrency itself will induce greater flexibility in member states’ labormarkets. That outcome, it is argued, follows from several features ofEMU, notably the independence of the ECB and the greater cross-border transparency and competition that common adoption of theeuro will allow. Unfortunately, it is not hard to come up with equallyplausible arguments under which labor-market flexibility does notdecline on its own; see, for example, Calmfors (1998).3

In this essay, I shall focus on two specific hazard areas in the transi-tion from Stage Two to Stage Three, as well as on some key problemsof Stage Three that EMU’s monetary and fiscal structures appear illprepared to handle. The transitional hazards, discussed in sections 2and 3, are of considerable theoretical as well as policy interest. Theyconcern the best ways to coordinate monetary stances and to lockexchange parities for a smooth switch from eleven national currenciesto a single joint currency. A potential problem of Stage Three, whichlies behind the difficulty of the transition and is central for EMU andfor any currency union, is the possibility of nationally asymmetric realshocks. Section 4 reviews this topic in the context of Ireland’s recentexperience. Section 5 discusses weaknesses in the structure of Stage

2 TARGET stands for Trans-European Automated Real-Time Gross SettlementExpress Transfer System.

3 An unfortunate reminder of the labor-market problem was the one-day strike calledby the European Commission staff the day before the Brussels summit. The strike was aprotest against management proposals that Commission employees feared would reducejob security and benefits.

3

Three that are connected with the provision of lender-of-last-resortfacilities in the euro zone and with the framework for supervisingfinancial institutions. The deficit and debt limits embodied in theexcessive-deficits procedure of the Maastricht Treaty and the subse-quent Stability and Growth Pact have been justified by the threat highdebts might pose to the stability of the euro zone’s financial markets.Section 6 reviews the past and prospective fiscal adjustments of theeleven countries that will be founder members of EMU (the EMU 11)and asks what difficulties these adjustments might pose for macroeco-nomic policy and growth. Section 7 concludes the discussion.

2 The End of the Beginning: Choosing Irrevocable Pegs

An inescapable requirement of the transition from Stage Two to StageThree is to redefine all nominal prices in the eleven member econo-mies in terms of the euro. Thus, the EU must decide the value of aeuro in terms of deutsche marks, French francs, and so on. The deci-sion is an important one because two issues are at stake. First, thechoice of irrevocable conversion rates of member currencies againstthe euro affects relative levels of national wealth. Second, and arguablymore important, the choice of conversion rates affects the initialrelative price levels in the member states, provided nominal prices andwages display some stickiness. That is, the choice of conversion ratesaffects relative competitiveness at the start of monetary union.

In thinking about the effects of alternative conversion rates, it isimportant to distinguish the consequential from the incidental. Whatreally matters are the bilateral conversion rates between national cur-rencies implied by the chosen rates against the euro. The “scale” or “size”of the euro currency unit itself is irrelevant: there are no real effectsfrom multiplying each national currency rate against the euro by thesame constant. As an example, imagine that for France and Germany,the chosen conversion rates against the euro are SFF/E francs per euro andSDM/E marks per euro. These rates imply the bilateral conversion rateSDM/FF = SDM/E /SFF/E. If PFF is the French franc price level at the start ofStage Three, and PDM is the deutsche mark price level, then, after theconversion to euros, the Franco-German real exchange rate will be

PFF

/SFF/E

PDM

/SDM/E

SDM/FF

PFF

PDM

.

4

All that counts for this ratio in the short run (that is, given nationalmoney price levels) is the implicit bilateral conversion rate, SDM/FF .

The Maastricht Treaty (Article 109l[4]) and a subsequent 1995decision of the European Council at Madrid tightly delimit the proce-dure for choosing the conversion rates of EMU member currenciesinto euros and, hence, the implied bilateral conversion rates. A mem-ber currency’s conversion rate into euros is to equal its end-of-Stage-Two market exchange rate against the European Currency Unit (ECU)basket of twelve EU currencies. This requirement has the relativelyminor implication that the euro’s scale probably cannot be known untilDecember 31, 1998 (Denmark, Greece, and the United Kingdom willnot adopt the euro in 1999, but their currencies are components of theECU basket). Much more important is a second implication—that thebilateral conversion ratios for Stage Three will equal the bilateralmarket exchange rates at the close of Stage Two. These provisions andtheir implications are discussed at length in Obstfeld, 1998 (whichprovides references to related literature). This interpretation of therelevant EU legislation is confirmed by the joint communiqué issued atthe Brussels summit (EU, 1998).

Why did the EU choose this mode of determining conversion rates?European leaders have hoped that the ECU would evolve into Europe’ssingle currency and, for that reason, have long sought to promote theECU market by promising that arbitrary EU decisions—such as changesin basket composition upon the accession of new EU members—wouldnot be allowed to modify the ECU’s value. The ECU’s reserve-currencystatus in the European Monetary System (EMS) was another motivationfor avoiding such modifications. Moreover, the ECU referred to inmany private contracts is a purely inside currency that is not convertibleinto its basket components, simply because no outside authority guaran-tees that convertibility. Because no national economy issues or prices inthe private ECU, its exchange rate would be indeterminate without theprospect that some day, the private ECU would be pegged to a truecurrency (Folkerts-Landau and Garber, 1995). To support the privateECU market, EU authorities have long had an interest in cultivating theexpectation of such a peg. Figure 1 illustrates the behavior of theprivate ECU compared with the corresponding official currency basketfrom 1991 through June 8, 1998.

Because the ECU basket has had a tendency to depreciate againstthe hard currencies of the exchange-rate mechanism (ERM) core,public relations have called for a different name for the new currency.The name “euro” was duly chosen by the Madrid Council in December

5

contracts would be payable in euros at this par, and market participantsnow expect that this will generally be the case.5

A fully credible promise of a 1-to-1 conversion rate for private intobasket ECU (that is, into euro) would have driven the values of thetwo very close to equality, eliminating at the same time the possibilityof an indeterminate value for the private ECU. The data in Figure 1,however, show that for the 1990s, the most sizable discounts of theprivate ECU relative to its basket counterpart occurred after theMadrid Council’s end-of-1995 ruling. Figure 1 reminds us that untilquite recently, markets harbored considerable doubts that EMU wouldhappen. As of early June 1998, however, the private ECU was tradingvery close to par.

Leaving aside the rationale behind the mandated procedure forchoosing conversion rates, what are its implications? At one time, it waspopular to recommend that the EU authorities somehow “let marketsdecide” the closing Stage Two bilateral exchange rates, which wouldthen become the immutable Stage Three conversion rates. However,such procedures could lead to excessive volatility in exchange rates and

ECU basket. In order for the equality 1 euro = 1 ECU to govern the euro’s introductionwhen both sides are reckoned in, say, deutsche marks, the condition

CDM/E S

DM/ECU

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i 1

aiS

DM/i

must hold (as confirmed in EU, 1998). This constraint must hold equally, however, forany other EMU currency, for example, the French franc, so that

CFF/E S

FF/ECU

12

i 1

aiS

FF/i SFF/DM

12

i 1

aiS

DM/i ,

where triangular arbitrage among the end-1998 market rates has been assumed. The lasttwo equations imply, however, that

CFF/E/C

DM/E CFF/DM

SFF/DM .

Thus, the Stage Three bilateral conversion rates must equal the December 31, 1998,market rates.

5 The Madrid Council’s decree gave rise to some confusion in markets but has nowbeen clarified. Council Regulation (EC) No. 1103/97 of the Council of Ministers,approved on June 17, 1997, provides, in the words of the European Monetary Institute(EMI, 1998, p. 121), that “contracts making reference to the Community definition ofthe ECU (i.e., ‘basket’ ECU) will be converted into euro at the 1:1 rate and establishesa presumption that the same will happen in the case of contracts without such adefinition of the ECU, although this presumption will be rebuttable taking into accountthe intention of the parties, thereby preserving the principle of contractual freedom.”

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also open the door to possible beggar-thy-neighbor depreciations byfuture EMU members (see Obstfeld, 1998, for discussion). As a result,the EU announced on May 2, 1998 (at the Brussels summit) that theERM bilateral central rates then prevailing would be adopted as thebilateral conversion rates on the first day of Stage Three (EU, 1998).

A notable feature of this plan is that the preannouncement of bilateralrates cannot have the force of a legal commitment. Ministers are bound,instead, to derive the bilateral conversion rates from the December 31,1998, market exchange rates against the basket ECU. Nothing in EU lawrules out the earlier May 2 announcement concerning bilateral rates,however, and EU officials clearly hope that the announcement will bebelieved by the markets, which then will obligingly drive bilateral marketrates to a pinpoint December 31 landing on the chosen rates.

The problem with this scenario is that the authorities’ announcementcannot be fully credible. To see why, imagine that markets do notbelieve the announcement and, instead, drive bilateral market rates toDecember 31 levels that are different from those that have beenannounced. In that event, EU authorities would be obliged to ignoretheir May 2 announcement in favor of the market’s verdict. So conspic-uous a failure would not enhance the credibility of future EMU policy.

But why should markets disbelieve the authorities’ promises? As anexample of why they might, suppose the Irish economy acceleratesabove its current torrid pace, prompting the country’s central bank toraise interest rates and allow the punt to rise further relative to itscentral parity. Markets might then begin to expect a revaluation of thepunt to slow the economy more forcefully prior to the launch of EMU.Indeed, this is just what the EU did on the weekend of March 14–15,1998, when the punt’s central rate was unexpectedly revalued by threepercent.

The official argument for the small revaluation of the punt in March1998 was that it would render more credible the subsequent announce-ment in May that the existing central rates would stand as irrevocableStage Three parities. It is nevertheless hard to be confident that furtherrealignments will be precluded by the May 2 announcement. After all,1998 is the last year for adjusting a national exchange rate in responseto a national problem. In the absence of a credible announcement tyingdown the December 31 bilateral rates, however, exchange-rate volatilitycould emerge, particularly in the face of severe market shocks.

One can look for evidence on the credibility of the Brussels prean-nouncement in one-year bilateral forward exchange rates, which aremarket-based forecasts of the future Stage Three conversion rates.

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track (except for a brief flurry of [unfounded] revaluation speculationprior to the Brussels summit) and serves as a control currency.

Even before the May 2 announcement, it was widely anticipated thatthe Europeans would wish to choose negotiated ERM bilateral centralrates as the future Stage Three conversion rates. Figure 2 shows thatmarkets strongly factored in a possible revaluation in the punt’s centralrate through March 13, as the Irish currency’s forward rate hoverednearly 200 basis points below its central rate. Even after the smallrevaluation, a sustained discrepancy of about 30 basis points remainedthrough April, however, suggesting that markets were wary of a secondpossible realignment. The other currency showing a sustained discrep-ancy prior to the Brussels summit is the Italian lira, which displayedthe slight possibility of a devaluation (the largest discrepancy in Aprilbeing 62 basis points). There were also discrepancies for currenciesthat are not pictured. The discrepancy for Finland’s markka, nonnegli-gibly negative early in March, was reduced by half shortly after thecentral bank (Suomen Pankki) raised Finnish interest rates in mid-month (an action discussed further below).

In the week after the Brussels preannouncement of the conversionratios on May 2, all the forward rates moved strongly toward theircentral rates. Since then, some have moved away again, although notgenerally so far as to reach levels that prevailed before May. Theescudo has shown a slight but economically significant discrepancy.More strikingly, the Irish punt has continued to show a larger (andapparently growing) gap. Evidently, the market attaches a small, albeitstill positive, probability to an additional punt realignment.

nominal interest rates iFF and iDM on instruments of duration T maturing after January 1,1999, arbitrage guarantees that

S centralFF/DM

SFF/DM

1 TiFF

1 TiDM

.

(Of course, interest differentials must converge to zero as T→ ∞, given certainty aboutthe conversion rates.) However, covered interest parity ensures that the forward ex-change rate FFF/DM (for any duration T maturing in Stage Three) also must satisfy thepreceding displayed relationship, implying that

FFF/DM

S centralFF/DM

.

This implication is the basis for the test in Figure 2. Notice that current spot exchangerates need not be very close to central rates, even if forward rates equal central rates,when there are sizable interest differentials and Stage Three is still some time away.

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The problem of a noncredible announcement of permanent conver-sion rates can be avoided if the national central banks of the futureEMU members intervene in some concerted way to drive marketbilateral rates to the preannounced levels. Several schemes have beenproposed (see Obstfeld, 1998). For example, Robert Flood and PeterGarber (1998) suggest forward-market intervention at the end of StageTwo. This intervention would peg at the preannounced levels thebilateral exchange rate on contracts with value dates at the start of StageThree. The authors argue (p. 4) that “the details of TARGET systemoperations are a key element in making credible unlimited interventionin support of selected bilateral exchange rates prior to January 1, 1999.”Obstfeld (1998) shows that the same forward pegging can be accom-plished through forward instruments denominated in euros, implying ascheme that is workable even in the absence of the theoreticallyunlimited intercentral bank credits entailed by TARGET. So far, thecompetent authorities, shrouding their intentions in “mystique,” havenot revealed how they intend to guarantee that the bilateral marketexchange rates on December 31, 1998, equal their promised values. TheBrussels communiqué on conversion ratios for the euro (EU, 1998, p. 1)notes only that “the central banks of the Member States adopting theeuro as their single currency will ensure through appropriate markettechniques that on 31 December 1998 the market exchange rates,recorded according to the regular concertation procedure used forcalculating the daily exchange rates of the official ECU, are equal to theERM bilateral central rates as set forth in the attached parity grid.”

3 Interest-Rate Policy Before Stage Three

Some methods of driving market exchange rates to preordained levelscould be macroeconomically destabilizing, in the sense that they mightaccentuate the divergences among member economies over the last partof 1998. In particular, a monetary policy forcing interest rates to con-verge along with exchange rates might well be counterproductive. TheDeutsche Bundesbank, followed by other central banks in low-interest-rate countries, seemed to be embarking on such a route when it raisedinterest rates late in 1997, and much market commentary has presumedthat the policy rates of central banks will have to converge by the endof Stage Two.7 But this is not necessary or, in general, even desirable.

7 After the Brussels summit, the Financial Times dropped its Monday front-page EMSexchange-rate grid in favor of a “Euro Interest Rate Convergence” grid promising to trackthe way in which the eleven national official short-term interest rates will converge to acommon value forecast by Money Market Services (initially 3.75 percent per year).

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To see this point, imagine an EMU made up of two countries thecentral banks of which maintain constant money supplies throughoutthe balance of Stage Two. Country 1 has higher output than Country 2,a shorthand that captures in a crude way the possibility of cyclicaldivergences as Stage Three nears. I derive the path of interest andexchange rates in this scenario under a (hypothetical) credible announce-ment of the Stage Three bilateral conversion ratio. I then compare thatequilibrium informally with the one that would result from purposefulinterest-rate coordination. (Later, I shall examine the implications ofthe credibility problem raised in section 2.)

Assume a simple model in which the monetary equilibrium in eithercountry is given by

where ij is Country j’s short-term nominal interest rate, uncovered

Mj

Pj

yje λij, j 1, 2 ,

interest parity holds, and purchasing-power parity (PPP), P1 = SP2, isassumed. Let S* denote the preannounced bilateral conversion rate.Then, at the start of Stage Three—assuming no immediate change inthe euro zone’s total money supply—the euro nominal interest rate, i*,is given implicitly by

where P is the euro area price level measured in Country 1 currency

M1 S M2

P(y1 y2)e

λi ,

units. Assuming a constant real interest rate, i* equals that real rateplus expected inflation, so that the preceding equation can be solvedfor i* and P (under rational expectations) in the usual way.

Consider now the behavior of short-term nominal interest andexchange rates when y1 > y2 but S* = M1 /M2 (meaning that the an-nounced bilateral conversion rate would be the current equilibriumexchange rate at equal output levels). The Country 1 nominal interestrate will be above that in Country 2, and S = P1 /P2 will be below S* =M1 /M2, that is, Country 1’s currency will be relatively strong comparedto its Stage Three conversion rate. But if i1 > i2, interest-rate parityimplies that S must be rising over time (Country 1’s currency is depre-ciating against that of Country 2). And S rises at an accelerating rate!The price level in Country 1 is simultaneously rising, pushing thenominal interest rate further up, while that in Country 2 is falling,allowing its interest rate to decline over time.

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Of course, longer-term interest rates will converge closely even if

between December 31 and January 4, despite interest-rate differentials over theweekend, if the December 31 exchange rate for same-day settlement differs slightly fromthe day’s next-business-day settlement rate. See footnote 6.

(very) short-term rates do not.This behavior of short-term interest rates may be surprising, even

counterintuitive, but it is the only way to reconcile the output diver-gence with monetary equilibrium absent active interest-rate policy. Andit is realistic. The central bank of Finland, currently growing at one ofthe EU’s fastest rates, and showing slightly higher inflation than theEMU core, did push up domestic interest rates on March 19. AsFigure 4 shows, Irish three-month interest rates actually rose relativeto deutsche mark rates from mid-March 1998 (when the punt wasrevalued) through early June of that year.

These interest-rate responses illustrate the inadvisability of analternative policy of enforcing short-term interest-rate convergenceprior to Stage Three in the face of divergent cyclical developments.Imagine a non-PPP, sticky-price version of the oversimplified model Ihave been discussing. Suppose that Country 1 is Ireland and Country 2is Germany and that their central banks steer both countries’ interestrates toward some estimate of i* during Stage Two. In Ireland, growthand inflation will accelerate further as the real interest rate falls; inGermany, the opposite will occur. The earlier approach of the ex-change rate toward its ultimate level will reinforce the divergenttendencies. These dynamics are reminiscent of Sir Alan Walters’critique of the ERM in the 1980s. Compared to policies that holdrelative domestic money supplies constant over Stage Two, this planwould cause the two countries to start Stage Three with a greatercyclical divergence than they otherwise would have had.

Of course, a policy of interest-rate independence at the shortestmaturities cannot have big effects once Stage Three is close. A morepotent antidote to overheating would be to revalue the punt againbefore Stage Three. No doubt, market participants still have thatpossibility somewhere in mind, however remotely (recall Figure 2).Given the much greater difficulty of tailoring monetary policy toindividual members’ needs after Stage Three begins, the temptation touse exchange-rate policy when it is still available, even to make minoradjustments, is great.

This brings us back to the credibility problem raised earlier. Mydiscussion in this section has assumed a fully credible future fixed

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be unnecessary (for the contrary view, see Lane, 1997). Ireland is theparagon of a small open economy. In 1996, Ireland’s exports accountedfor 80 percent of its gross domestic product (GDP)—with two-thirds ofthose exports directed toward the future euro area; its imports amountedto 61 percent of GDP—with more than half of those imports comingfrom the EMU-11 countries (EMI, 1998, table 10 for Ireland). Even inthe early 1970s, Corden (1972) concluded that Ireland, then running acurrency board based on sterling, could not possibly benefit from anindependent exchange-rate policy, although Belgium and the Netherlandscould. Yet situations like Ireland’s certainly could recur in the future, andEMU is ill prepared to deal with them.

The standard cost of foregoing an adjustable nominal exchange rateis the consequent inability to adjust rapidly, with minimal unemploy-ment, to an idiosyncratic real shock to the domestic economy. IfFrance suffers a permanent fall in export demand, say, but maintainsthe French franc’s peg, output will decline and unemployment will rise.The culprits in these developments are sticky nominal prices andwages, which, if they were fully flexible, would fall immediately so as tomaintain output and employment. Even under nominal rigidities, amore gradual domestic deflation will induce a real currency deprecia-tion that eventually restores external demand and employment, whileleaving the terms of trade permanently lower. But the process is longand socially wasteful. The unemployment problem is exacerbated in theEU by low labor mobility coupled with high capital mobility, whichallows capital to flee depressed countries while labor stays put (Corden,1972, p. 27). A discrete nominal devaluation of the franc that leftinternal money prices unchanged could restore employment muchmore quickly.

The exchange-rate option is typically thought to be unavailable forsmall and very open economies. In such settings, a currency deprecia-tion is much more likely to feed quickly into nominal prices and wages.Notwithstanding the greater utility of exchange-rate independence forlarger countries, the Irish experience nonetheless offers a relevantexample of a small economy that has gained from using its exchangerate as an adjustment tool.

Ireland has been booming since 1994, its growth propelled by anumber of idiosyncratic factors. The Programme for Competitivenessand Work, negotiated centrally with labor, limited wage growth from1994 to 1996 in return for government promises of cuts in the incometax and lower social-insurance taxes. The program was renewed in1997. The result has been high investment profitability, a sharply

16

increased share of profits in the economy, booming investment, yetdeclining unit labor costs and slowing inflation (see Table 1). High(though falling) unemployment, coupled with growing inward migra-tion, has contributed to wage restraint. Alberto Alesina and RobertoPerotti (1997) present empirical evidence on the link between taxesand unit labor costs under varying degrees of labor-market central-ization.

TABLE 1MACROECONOMIC DATA FOR IRELAND, 1994–1998

1994 1995 1996 1997 1998a

Real GDP growth 7.0 10.4 7.7 10.5 8.6Growth in unit labor costs −1.4 −4.3 −0.8 −1.3 0.9CPI inflation rate 2.7 2.0 1.1 1.2 3.1General government surplus −1.6 −1.9 −0.9 0.9 1.5Return on business capital 11.6 13.7 14.8 16.0 17.8Employment growth 3.0 4.8 3.4 4.2 3.6Unemployment rate 14.8 12.2 11.9 10.2 9.3Punt-DM exchange rate 2.42 2.30 2.41 2.63 2.50

SOURCE: OECD Economic Outlook, June 1998b.a OECD estimate/forecast.

The promised tax cuts imparted a sharp stimulus to the Irish economyin 1995, contributing to a GDP growth rate of more than 10 percentthat year. The magnitude of the stimulus is, of course, understated bythe small measured increase in the fiscal deficit, given the extremelyrapid growth in the economy. Additional tax reductions have continuedto fuel the economy. The sharp appreciation of sterling after thesummer of 1996—in part, caused by fears of a weak euro—had a bigincipient effect on Ireland’s competitiveness, because the UnitedKingdom is the country’s most important trading partner. The authori-ties responded to the expansionary pressures by allowing the punt toappreciate sharply within the ERM. Between 1995 and 1997, the puntappreciated against the deutsche mark by about 14 percent.

Nonetheless, the punt depreciated back toward its central rate over1997 as EMU became more of a certainty. Real GDP grew by 10.5percent in 1997. At the same time, the economy showed increasingsigns of overheating: asset prices boomed, especially for housing, anddomestic credit grew at a rate double that of nominal GDP. Forecastsof the Organisation for Economic Co-operation and Development(OECD, 1998b), as well as those of the EMI, called for higher future

17

inflation. According to the EMI (1998, p. 68), “these risks to inflationare being exacerbated in the run-up to EMU by the expected furtherdecline in short-term interest rates and, should this materialise, by aresulting decline in the effective exchange rate.” It was in this contextthat Ireland requested a 3 percent revaluation of the punt’s centralrate.9 The adjustment would have left the punt at its new central ratehad the currency not promptly appreciated by about 1 percent (as aresult of Ireland’s still relatively high nominal short-term interest rate;see Figure 4). Figure 5 shows how the punt-deutsche-mark spot ratebehaved relative to the bilateral central rate.10

From a global EMU perspective, the punt revaluation ran the risk ofbeing counterproductive in two related ways. First, it risked destabiliz-ing the process of attaining preannounced currency conversion rates (asargued above). Second, it sent a signal that EMU will indeed impose atight monetary constraint on its members, at least in its first years, sothat it is helpful to make even minor adjustments now if that improvesthe initial conditions and lessens the subsequent political pressures onthe new ECB.

From the more limited perspective of the Irish economy, however, themove definitely was helpful in reducing the size of the eventual devalua-tion entailed by EMU entry and in appreciating the currency in the shortterm. The realignment relieves some upward inflation pressure, both bykeeping import prices down and by maintaining the real wage so as todiscourage nominal wage growth. Higher domestic real interest rates willrestrain the boom, as will the increase in the real value of consumerdebts and mortgages. Ireland will enter EMU less vulnerable to a suddenrun-up in euro interest rates. Note that in principle, fiscal policy couldhave been used to slow consumption growth and cool the economy, butin practice, major fiscal tools were unavailable. Government outlays werealready being cut as rapidly as was politically feasible, whereas income-tax

9 Ireland’s finance minister “was . . . adamant that the decision [to revalue] was takenat Ireland’s request,” not under EU pressure. See John Murray Brown, “Irish ‘JudgmentCall’ on Revaluation,” Financial Times, March 16, 1998, p. 2.

10 Footnote 6 implies that if markets had revised their expectation of the Stage Threepunt-deutsche mark conversion rate by the full 3 percent of the central parity realign-ment, the punt should have appreciated by the same 3 percent at unchanged interestrates, and not by roughly 1 percent. It did not appreciate by 3 percent because, asFigure 2 shows, markets had already settled on a nearly 2 percent expected revaluationof the punt’s central rate prior to the event. Longer-term Irish interest rates did fall byabout 50 basis points just after the punt realignment, but they soon returned to pre-revaluation levels.

18

nominal currency realignment is a much more effective tool than in theIrish case for adjusting quickly to unexpected real asymmetric shocks.

None of this is meant to deny that certain asymmetric financial shocksare avoided by a common-currency regime—notably shocks caused byunjustified shifts in exchange-market sentiment. Corden (1972, p. 28)was overly optimistic when he predicted that “the Canadian experience,as well as well-known theoretical arguments, suggest that short-termcapital movements in a floating-rate system are, on the whole, likely tobe stabilizing.” Destabilizing exchange-rate movements certainly havebeen a feature of the post-1973 experience. But if an important mem-ber country is hit by a big asymmetric real shock in Stage Three, it willnot soften the pressures on the ECB to explain to unemployed workersthat the euro has spared them the effects of many hypothetical finan-cial shocks.

5 The Problem of Financial-Sector Stability

The current asset-price boom in Ireland brings to mind the possibilityof financial shocks that are not directly related to currency movements,but that emanate, instead, from domestic asset markets. Paul De Grauwehas depicted quite vividly the risks Stage Three poses to financialstability.11 Some EU members, such as Finland, have already gonethrough boom-crash cycles and have spent large sums strengtheningtheir financial systems. France and Italy are currently cleaning up morelimited domestic banking messes. Nonetheless, the Maastricht Treaty’sblueprint for safeguarding financial stability contains grave inherentweaknesses. The set of safeguards currently in place corresponds to thepath of least political resistance but is unlikely to be highly effective inpreventing or managing financial crises.

The Maastricht Treaty gives the ECB no statutory mandate to act asa lender of last resort; moreover, the bank’s supervisory responsibility forcredit institutions is limited to specific tasks assigned by the ECOFINCouncil through a unanimous vote, on a recommendation of theEuropean Commission, after consultation with the ECB, and with theassent of the European Parliament.12 Supervision and regulation ofcredit institutions is explicitly left in the hands of the existing nationalauthorities, following the principle of decentralization. The ECB has a

11 See De Grauwe, “Economic and Monetary Turmoil,” Financial Times, February 20,1998, p. 22.

12 But the Treaty does not forbid a lender-of-last-resort role, although the Bundesbank,on which the ECB is modeled, offers little or no precedent in this regard.

20

vague mandate to “contribute” to the supervisory efforts of nationalauthorities and to promote smooth operation of the euro paymentssystem. Just how it should do so is nowhere explained.

This set of arrangements reflects two characteristics also found inthe German system. The Bundesbank has no statutory lender-of-last-resort role, and in Germany, responsibility for the supervision of creditinstitutions is separate from responsibility for monetary policy. In manycountries, the monetary and supervisory functions are separate, andprospective EMU members differ among themselves in this respect.The United Kingdom moved to such a system following the grant ofinstrument independence to the Bank of England. One justification forseparation might be to avoid situations in which the central bank’sresolve to raise interest rates is weakened by too intimate a knowledgeof the effects on particular banks’ balance sheets. Charles Goodhartand Dirk Schoenmaker (1995) argue that when the fiscal authority,rather than the central bank, bears primary responsibility for financialrescue operations, it is natural that it should also take the leading rolein supervision.

The Bundesbank’s ability to avoid a lender-of-last-resort role,however, and, indeed, to limit its interventions to smooth money-market interest rates, flows from special features of the German finan-cial system, including a relatively low degree of securitization, thedominant position of large universal banks, the high levels of reservesand collateralizable securities that German banks hold, and otherfeatures of the domestic payments system. As David Folkerts-Landauand Peter Garber (1992, p. 97) put it:

Financial systems with a limited extent of securitization have in practice asmall number of large universal banks in the market for wholesale funds.Wholesale payments and securities transactions are cleared internally inthese organizations. The risk of nonsettlement is low due to the lack ofsignificant exposure to non-bank financial institutions and an increasedability to work out unexpected problems quickly among the small numberof players. Hence, although the clearing banks ultimately clear on the booksof the central bank, there is little need for the central bank to provideintra-day credit or stand ready to act as lender-of-last-resort to the clearing-house to ensure the payments settlement.

The euro financial system will not share these structural features ofthe German system—certainly not if it aspires to support a financialmarket competitive with, and eventually absorbing, London. Further-more, the TARGET system will be a real-time gross-settlement (RTGS)system, whereby payments are made with finality within seconds,

21

rather than becoming final only at the end-of-day clearing of a nettingsystem. The EU chose an RTGS system to avoid the risk of an unwind-ing crisis, in which a day’s payment instructions are all revoked becausea small number of parties cannot settle their net balances in central-bank reserves at the end of the day. Real-time gross-settlement systems,however, require much more liquidity than do netting systems ifpayment delays and queues are to be avoided.13 Accordingly, theEuropean System of Central Banks (ESCB) will provide fully collateral-ized and generally unlimited intraday credit to TARGET users; astanding marginal lending facility will provide overnight credit onsimilar terms.

Because of idiosyncrasies in national financial institutions, there willbe two classes of collateral, so-called “Tier I” collateral, satisfyingstandards specified for the entire euro area, and “Tier II” collateral thatEMU’s national central banks (NCBs, which of course will belong to theESCB) certify as eligible. To minimize the moral-hazard problem ofNCBs certifying the risky paper of home institutions as collateralizable,the certifying NCB will bear the entire default risk for a Tier II asset,whereas the ESCB will bear the default risk for Tier I assets (Folkerts-Landau et al., 1997, p. 175). This rather contorted set of rules isnecessitated by the political demand that EMU respect diversity innational financial cultures and traditions, a diversity unlikely to survivefor long if the euro leads to a truly integrated European financial market.

The greater liquidity needs of TARGET participants and growingfinancial-market sophistication will gradually push the ESCB to play amore active role in money and other financial markets than the Bundes-bank currently plays. As a result, an implicit lender-of-last-resort role islikely to evolve—and experience in the United States suggests that itwill be necessary (Folkerts-Landau and Garber, 1992). Certainly, in thecase of a systemic payments crisis, only the ESCB will be able tomobilize liquidity quickly enough to avert disaster. The ESCB will bemore effective in the role of lender of last resort, and better able tofulfill that role without compromising its mandate to pursue pricestability, if it has access to timely information on the balance sheets ofprivate credit institutions.

Perhaps the main weakness in the planned structure of euro-zoneprudential supervision is the division of regulatory responsibility amongnational regulators, some of them NCBs, and hence closely connectedwith the ESCB, but many of them not. This seems a misguided appli-

13 For an excellent description of alternative payments systems and the attendant risks,see Pu Shen (1997).

22

cation of the principle of subsidiarity, because it is hard on severalgrounds to conceive of the optimal domain of regulation in an integrat-ed financial market as being smaller than the market itself. One reasonis that national regulators may not fully internalize the adverse reper-cussions of a financial crisis, particularly when the bill for containmentarrives at the EMU or EU level. An additional problem, stressed byBarry Eichengreen (1993), is that national regulators might favornational institutions or financial centers through lax application of therules. This sort of problem has arisen in enforcing the Basle Committee’s1988 international bank-capital standards, as national regulators havebeen pressed by domestic financial interests to adopt overly broaddefinitions of eligible capital.

Problems can be reduced by harmonizing prudential standards,exchanging information, and clearly assigning regulatory responsibilityin areas of possible ambiguity, but gaps seem sure to arise nonetheless.Competitive regulatory leniency, especially coupled with the ESCB’suncertain readiness to act as a lender of last resort, poses a genuinethreat to the euro zone’s financial stability. Regulatory authority forthe euro zone need not be placed in the hands of the ESCB. Suchassignment, though, would have the advantage of giving the ESCBbetter information on borrowers’ balance sheets. In the absence of asupranational fiscal authority, moreover, it would conform to theGoodhart-Schoenmaker (1995) prescription that regulatory powers andfinancial responsibility should go hand in hand. Plainly, however,supervision should be exercised at a global level. As the EMU countries’financial markets become more unified and more similar, any supposedadvantages of local regulation will, in any case, wither away.

6 Fiscal Convergence and the Conduct of Macroeconomic Policy

The year 1997 was a time of high fiscal drama, as observers wonderedwhich (if any) core players would achieve fiscal consolidation sufficientto qualify them for entry into EMU. The uncertainty was resolved withnear finality when the European Commission (1998) recommended onMarch 25, 1998, that all existing excessive-deficit judgments of theECOFIN Council, save that on Greece, be abrogated. In a reportissued the same day, the EMI expressed reservations about the sustain-ability of fiscal adjustment in many of the EMU-11 countries butstopped far short of questioning the Commission’s recommendation(EMI, 1998). Subsequent reports of the Bundesbank and the Banquede France, the heads of which had already signed the EMI document,

23

took similar tacks. The contrasting tones of the Commission and thecentral bankers are suggestive of future conflicts between EMU’smonetary and fiscal authorities.

The Commission took a sanguine view of fiscal adjustment in theEMU-11 countries. Technically, all of them had met the 3-percent-of-GDP deficit test in the short run—France only barely—and forecastspredict smaller deficit ratios in 1998. The 60-percent-of-GDP debt testwas interpreted very loosely, so that even Belgium and Italy, with ratiosover 120 percent of GDP, qualified on the grounds that their debtlevels were declining under the force of primary surpluses. The Com-mission (1998, p. 18) noted that “the Belgian government has recentlyconfirmed its commitment to maintain the primary surplus at a highlevel over the medium term.” Italy seems to have made a more quali-fied commitment, assuming that even slight variations in Commissionformulas are immensely significant. Italy promised only “to maintainthe primary surplus at an appropriately high level over the mediumterm” (Commission, 1998, p. 24; emphasis added). Recent increases indebt-to-GDP ratios for Austria, France, and Germany were rationalizedaway, and without reference to the cyclical factors that feature in theStability and Growth Pact.

As the EMI noted in its own assessment, the Belgian and Italianprimary surpluses, even if sustained over the long term, could leave theBelgian and Italian debt-to-GDP ratios above the 60 percent referencevalue for as long as fifteen to twenty years. By that time, as the EMIalso noted, unfunded public pension systems—also present in Franceand Germany—will be placing public finances under serious strain.Significantly, the EMI report used the same language to describe theBelgian and Italian fiscal adjustments as it applied to Greece (EMI,1998, pp. 37, 55, and 79):

Notwithstanding the efforts and the substantial progress made towardsimproving the current fiscal situation, there is an evident ongoing concernas to whether the ratio of debt to GDP will be “sufficiently diminishing andapproaching the reference value at a satisfactory pace” and whether sustain-ability of the fiscal position has been achieved; addressing this issue willhave to remain a key priority for the [Belgian, Greek, Italian] authorities.

The Commission’s precedent-setting decisions have signaled, however,that it is unlikely to push countries toward “forceful” debt reductionnearly as hard as the ECB would like.

The EMI’s concern did not stop at the high-debt countries. Francewas singled out as having its debt on a rising trajectory relative toGDP; other countries’ deficits were compared unfavorably to the

24

medium-term goal of a nonnegative budget balance specified in theStability and Growth Pact. These criticisms, however, may representthe central bankers’ last hurrah. In future, the ECB will be able toexpress its unsolicited views on fiscal policy but will have little leverageto make its views effective except by trading interest-rate cuts for fiscalconcessions on the part of EMU member governments.

Are the EMI’s views alarmist? Economists have had a hard timecoming up with plausible externalities that might justify the excessive-deficit procedure of the Maastricht Treaty or the stability pact (see, forexample, Eichengreen and Wyplosz, 1998). Perhaps the best story is theone told by Peter Kenen (1995, pp. 95–96), that a government debtcrisis might have cascade effects that endanger the euro paymentssystem as a whole, prompting a monetary expansion that might not betotally reversible. The urgency with which the EMI has focused on debtlevels (as well as on the maturity structure of debt) is also motivated bymore prosaic fears, I believe, and these fears may paradoxically becaused by the stability pact itself!

Consider a situation in which Italy’s debt ratio remains high andItaly is suffering a recession, while for the rest of the euro zone, higherinterest rates are appropriate. With a budget in surplus and little debt,Italy would have the option of expanding fiscal policy to offset theECB’s monetary tightening. Under current conditions, however, Italy’sinterest payments would rise sharply, perhaps pushing it into fiscal cutsto avoid later stability-pact sanctions. The ECB’s statutory indepen-dence would, in theory, allow it to proceed anyway, but the presenceof unresolved fiscal vulnerabilities could certainly worsen the asymmet-ric transmission of ECB monetary policies and thus threaten the bank’sacceptance by the public over the longer run. The EMI’s concernabout short government-debt maturities is consistent with this fear, aswell as with the fear of a generalized euro-zone financial crisis trig-gered by a government liquidity crisis.

But is it plausible that the stability-pact limits will ever become aserious issue? EMU optimists like Barry Eichengreen and CharlesWyplosz (1998) suggest not, and EMU pessimists like Reimut Jochimsen(1997) agree. I am not so sure. Much depends on the zeal of theECOFIN Council in enforcing the pact, of course, and that zeal will beprocyclical and may decline under a future socialist German chancellor.But it is hard to believe, given the nature of the fiscal adjustments madeto satisfy the EMU entry requirements, that intractable deficits areentirely a thing of the past, even if countries such as Italy do not revertto their old dissolute ways.

25

A primary concern is the composition of the fiscal adjustment thathas taken place—an issue acknowledged by the Commission but notadequately addressed in its report. In a study of OECD countries after1960, Alesina and Perotti (1995) find that fiscal consolidations based oncuts in government wage bills and transfer payments tended to berelatively durable; those based on tax increases or cuts in governmentcapital outlays typically were much more quickly reversed.

Alesina’s and Perotti’s empirical model would predict that much ofthe fiscal consolidation in preparation for EMU is not durable. Table 2summarizes patterns of fiscal adjustment between 1991 and 1997.14

Roughly speaking, the countries fall into several groups. Austria,France, and Germany have generally been moderate-deficit countries,but rising public debt and unemployment over the 1990s would haveleft them wide of the Maastricht reference deficit in 1997 had they nottaken corrective measures. To offset increases in social benefits andinterest payments, they have mainly raised taxes and cut capital outlays.Of the three countries, only Germany has made an effort to cut thepolitically sensitive government-wage bill. In France, that item hasactually increased by nearly 1 percent of GDP, and the Jospin govern-ment has proposed that public employment be expanded and the workweek cut. The Alesina-Perotti findings thus would lead one to questionthe sustainability of current public-deficit levels, especially with regardto France and Germany.

Finland, Ireland, and the Netherlands form a second group ofcountries, in which adjustment, to differing degrees, looks more dura-ble. Facing problems similar to those of France (but more severe),Finland has slashed both categories of government consumption,although tax collections have simultaneously risen somewhat and capitaloutlays have been cut. Ireland’s successful fiscal turnaround has beenrewarded by lower interest rates on its still sizable public debt. TheNetherlands has cut government consumption and taxes. It has alsobeen able to cut social spending and subsidies sharply (by 3.3 percentof GDP) with the help of labor-market reforms. Not surprisingly, thesethree countries, along with Luxembourg, were the only first-roundEMU entrants not subject to prior excessive-deficit findings by theECOFIN Council.

Belgium, Italy, Portugal, and Spain make up the final group ofcountries that have generally high structural deficits. For these countries,

14 The table is based on June 1998 OECD data. It updates a similar table in Obstfeld(1997), which was based on OECD projections of 1997 outcomes.

26

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27

the durability of their adjustments will be especially important for lifeunder the EMU stability pact. Belgium’s deficit reduction comes froma sizable tax increase coupled with smaller cuts in social benefits andgovernment nonwage consumption. Government wage paymentsactually have risen, but the country has benefited from falling interestrates. Italy has so far profited somewhat less than Belgium from lowerinterest rates, but it has cut wage consumption by more than 1 percentof GDP. The bulk of its deficit reduction comes, however, from lowercapital outlays and much higher tax revenues. In Portugal, govern-ment wages and social spending have risen. The large deficit reductionshown for Portugal in Table 2 is the result of sharply increased taxrevenues and a large cut in the interest bill as inflation dropped fromover 12 percent per year in 1991 to only 2.2 percent in 1997.15 InSpain, a cut in capital outlays has been the main force driving the fiscaldeficit down. None of the efforts of these final four countries comfort-ably meets the Alesina-Perotti prescription for durability.

One might argue that in the larger European countries, cyclicalfactors make current fiscal deficits look artificially high. But the obser-vation that this has generally been true throughout the 1990s limits thesolace one can draw. As the EMI (1998) pointed out, demographictrends imply a worsening fiscal trend for countries that, like the UnitedStates, have unfunded pension systems. Furthermore, in France,Germany, and Italy, unemployment has played a dominant role indetermining the evolution of social-insurance spending (and vice versa).Europe’s fiscal problem will remain a live issue as long as its structuralunemployment problem is not seriously addressed. France, for one,with its remarkably high share of government outlays in GDP, showsno sign of doing this. The other principal EMU countries have beenmoving slowly as well.

As has often been noted, EMU will lack the natural shock absorbersprovided by fiscal federalism in politically unified currency areas (seeObstfeld and Peri, 1998, for a survey). With national fiscal policyhobbled, these stabilizers will be missed even more in Europe thanthey would be in the United States, because structural rigidities aregreater in Europe, geographic and occupational mobility is lower, andprivate risk diversification is more limited. It has been reported that 43percent of Americans own stock shares outright or through mutualfunds. The corresponding percentages in Europe are 25 percent in the

15 An implication is that the fall in Portugal’s real (inflation-adjusted) governmentdeficit is much smaller than the 4.3 percent figure given in Table 2.

28

United Kingdom, 16 percent in France, 11 percent in Italy, and 7percent in Germany, and even these limited holdings reflect a homebias in equity choice.16 The euro surely will promote greater financialintegration, and the investment habits of European households arechanging visibly already. But will they change quickly enough?

7 Conclusion: The Future of the European Central Bank

The ECB is the centerpiece institutional innovation of EMU. In anarrangement unprecedented in history, it will be the common centralbank for major sovereign nations that have distinct national traditions.It is already clear that some of these nations harbor different viewsabout the way in which the ECB should function. Such differences laybehind the very public and, in the longer term, probably damagingdispute over the first ECB presidency at the 1998 Brussels summit. Ifany of the pitfalls I have discussed materialize, the ECB will attractblame, and there will be intense pressure to modify its statutory inde-pendence, formally or informally.

Even though the ECB has no formal monetary role until Stage Threestarts, a debacle in setting the “irrevocable” conversion rates will fall atits door, and it will inherit any macroeconomic imbalances accentuatedby faulty monetary-policy coordination in the final months of StageTwo. Any systemic credit problems arising in Stage Three will damagethe ECB’s prestige, and the stability pact, when it binds, will probablymake matters more difficult for the bank. Indeed, whenever the singlemonetary policy of Stage Three fits badly with the needs of leadingEMU members, the ECB will come under intense political fire—moreintense than the U.S. Federal Reserve Board would draw in a similarcase. The European identity is not yet fully forged; arguably, the verysuccess of European institutions like the ECB will play an integral rolein shaping that identity. Europe has therefore taken a gamble in placingmonetary unification so far ahead of political unification. If the ECB isweak, the cause of European unification will be fatally impaired.

It could turn out otherwise. Money, as James Tobin has observed, isa language. France seems determined that it be a lingua franca, in theliteral, Italian, sense. The ongoing Franco-German dispute over “eco-nomic government”—code for a significant political influence overmonetary policy—will be resolved by events and the voters’ reaction to

16 See John Tagliabue, “Selling Europe on the Stock Market,” New York Times, March1, 1998, section 3, p. 1. The Italian numbers refer to direct stock ownership only.

29

them. It is hard to believe that the EMU-11 club of finance ministerswill refrain from forceful comment on ECB policy, including, but notlimited to, exchange-rate developments. The ECB, in its turn, will surelyweigh in on fiscal matters. It is not unthinkable that ongoing policy fric-tions could transform the ECB’s political “interlocutor” into an inquisitor.

Along several key dimensions, Europe is not ready for EMU, and theeuro zone’s future economic performance and political cohesion are morethan usually uncertain. The Europeans’ arguments for proceedingnonetheless are two: (1) To prepare completely would be to postponeEMU forever, and (2) EMU economies and institutions will in any caseevolve to make the single currency fit all fairly comfortably. The firstargument is clearly correct, although some might argue, with MartinFeldstein (1997), that indefinite postponement would be a good thing.The second argument is based on a pure leap of faith. If it is wrong,EMU could come apart or evolve into an institution very different fromthat which its architects intended.

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Obstfeld, Maurice, and Giovanni Peri, “Regional Non-Adjustment and FiscalPolicy,” Economic Policy, 26 (April 1998), pp. 205–259.

Obstfeld, Maurice, and Kenneth Rogoff, Foundations of International Eco-nomics, Cambridge, Mass., MIT Press, 1996.

Organisation for Economic Co-operation and Development (OECD), FiscalPositions and Business Cycles (diskette, 1998/1), June, 1998a.

———, OECD Economic Outlook, Paris, OECD, June 1998b.Shen, Pu, “Settlement Risk in Large-Value Payments Systems,” Federal Reserve

Bank of Kansas City Economic Review, 82 (No. 2, 1997), pp. 45–62.

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FRANK D. GRAHAM MEMORIAL LECTURERS

1950–1951 Milton Friedman1951–1952 James E. Meade1952–1953 Sir Dennis Robertson1953–1954 Paul A. Samuelson1955–1956 Gottfried Haberler1956–1957 Ragnar Nurkse1957–1958 Albert O. Hirschman1959–1960 Robert Triffin1960–1961 Jacob Viner1961–1962 Don Patinkin1962–1963 Friedrich A. Lutz (Essay 41)1963–1964 Tibor Scitovsky (Essay 49)1964–1965 Sir John Hicks1965–1966 Robert A. Mundell1966–1967 Jagdish N. Bhagwati (Special Paper 8)1967–1968 Arnold C. Harberger1968–1969 Harry G. Johnson1969–1970 Richard N. Cooper (Essay 86)1970–1971 W. Max Corden (Essay 93)1971–1972 Richard E. Caves (Special Paper 10)1972–1973 Paul A. Volcker1973–1974 J. Marcus Fleming (Essay 107)1974–1975 Anne O. Krueger (Study 40)1975–1976 Ronald W. Jones (Special Paper 12)1976–1977 Ronald I. McKinnon (Essay 125)1977–1978 Charles P. Kindleberger (Essay 129)1978–1979 Bertil Ohlin (Essay 134)1979–1980 Bela Balassa (Essay 141)1980–1981 Marina von Neumann Whitman (Essay 143)1981–1982 Robert E. Baldwin (Essay 150)1983–1984 Stephen Marris (Essay 155)1984–1985 Rudiger Dornbusch (Essay 165)1986–1987 Jacob A. Frenkel (Study 63)1987–1988 Ronald Findlay (Essay 177)1988–1989 Michael Bruno (Essay 183)1988–1989 Elhanan Helpman (Special Paper 16)1989–1990 Michael L. Mussa (Essay 179)1990–1991 Toyoo Gyohten1991–1992 Stanley Fischer1992–1993 Paul Krugman (Essay 190)1993–1994 Edward E. Leamer (Study 77)1994–1995 Jeffrey Sachs1995–1996 Barry Eichengreen (Essay 198)1996–1997 Wilfred J. Ethier1997–1998 Maurice Obstfeld (Essay 209)

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PUBLICATIONS OF THEINTERNATIONAL FINANCE SECTION

Notice to Contributors

The International Finance Section publishes papers in four series: ESSAYS IN INTER-NATIONAL FINANCE, PRINCETON STUDIES IN INTERNATIONAL FINANCE, and SPECIALPAPERS IN INTERNATIONAL ECONOMICS contain new work not published elsewhere.REPRINTS IN INTERNATIONAL FINANCE reproduce journal articles previously pub-lished by Princeton faculty members associated with the Section. The Section wel-comes the submission of manuscripts for publication under the following guidelines:

ESSAYS are meant to disseminate new views about international financial mattersand should be accessible to well-informed nonspecialists as well as to professionaleconomists. Technical terms, tables, and charts should be used sparingly; mathemat-ics should be avoided.

STUDIES are devoted to new research on international finance, with preferencegiven to empirical work. They should be comparable in originality and technicalproficiency to papers published in leading economic journals. They should be ofmedium length, longer than a journal article but shorter than a book.

SPECIAL PAPERS are surveys of research on particular topics and should besuitable for use in undergraduate courses. They may be concerned with internationaltrade as well as international finance. They should also be of medium length.

Manuscripts should be submitted in triplicate, typed single sided and doublespaced throughout on 8½ by 11 white bond paper. Publication can be expedited ifmanuscripts are computer keyboarded in WordPerfect or a compatible program.Additional instructions and a style guide are available from the Section.

How to Obtain Publications

The Section’s publications are distributed free of charge to college, university, andpublic libraries and to nongovernmental, nonprofit research institutions. Eligibleinstitutions may ask to be placed on the Section’s permanent mailing list.

Individuals and institutions not qualifying for free distribution may receive allpublications for the calendar year for a subscription fee of $40.00. Late subscriberswill receive all back issues for the year during which they subscribe. Subscribersshould notify the Section promptly of any change in address, giving the old addressas well as the new.

Publications may be ordered individually, with payment made in advance. ESSAYSand REPRINTS cost $9.00 each; STUDIES and SPECIAL PAPERS cost $12.50. Anadditional $1.50 should be sent for postage and handling within the United States,Canada, and Mexico; $1.75 should be added for surface delivery outside the region.

All payments must be made in U.S. dollars. Subscription fees and charges forsingle issues will be waived for organizations and individuals in countries whereforeign-exchange regulations prohibit dollar payments.

Please address all correspondence, submissions, and orders to:

International Finance SectionDepartment of Economics, Fisher HallPrinceton UniversityPrinceton, New Jersey 08544-1021

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List of Recent Publications

A complete list of publications may be obtained from the International FinanceSection.

ESSAYS IN INTERNATIONAL FINANCE

172. Jack M. Guttentag and Richard M. Herring, Accounting for Losses OnSovereign Debt: Implications for New Lending. (May 1989)

173. Benjamin J. Cohen, Developing-Country Debt: A Middle Way. (May 1989)174. Jeffrey D. Sachs, New Approaches to the Latin American Debt Crisis. (July 1989)175. C. David Finch, The IMF: The Record and the Prospect. (September 1989)176. Graham Bird, Loan-Loss Provisions and Third-World Debt. (November 1989)177. Ronald Findlay, The “Triangular Trade” and the Atlantic Economy of the

Eighteenth Century: A Simple General-Equilibrium Model. (March 1990)178. Alberto Giovannini, The Transition to European Monetary Union. (November

1990)179. Michael L. Mussa, Exchange Rates in Theory and in Reality. (December 1990)180. Warren L. Coats, Jr., Reinhard W. Furstenberg, and Peter Isard, The SDR

System and the Issue of Resource Transfers. (December 1990)181. George S. Tavlas, On the International Use of Currencies: The Case of the

Deutsche Mark. (March 1991)182. Tommaso Padoa-Schioppa, ed., with Michael Emerson, Kumiharu Shigehara,

and Richard Portes, Europe After 1992: Three Essays. (May 1991)183. Michael Bruno, High Inflation and the Nominal Anchors of an Open Economy.

(June 1991)184. Jacques J. Polak, The Changing Nature of IMF Conditionality. (September 1991)185. Ethan B. Kapstein, Supervising International Banks: Origins and Implications

of the Basle Accord. (December 1991)186. Alessandro Giustiniani, Francesco Papadia, and Daniela Porciani, Growth and

Catch-Up in Central and Eastern Europe: Macroeconomic Effects on WesternCountries. (April 1992)

187. Michele Fratianni, Jürgen von Hagen, and Christopher Waller, The MaastrichtWay to EMU. (June 1992)

188. Pierre-Richard Agénor, Parallel Currency Markets in Developing Countries:Theory, Evidence, and Policy Implications. (November 1992)

189. Beatriz Armendariz de Aghion and John Williamson, The G-7’s Joint-and-SeveralBlunder. (April 1993)

190. Paul Krugman, What Do We Need to Know About the International MonetarySystem? (July 1993)

191. Peter M. Garber and Michael G. Spencer, The Dissolution of the Austro-Hungarian Empire: Lessons for Currency Reform. (February 1994)

192. Raymond F. Mikesell, The Bretton Woods Debates: A Memoir. (March 1994)193. Graham Bird, Economic Assistance to Low-Income Countries: Should the Link

be Resurrected? (July 1994)194. Lorenzo Bini-Smaghi, Tommaso Padoa-Schioppa, and Francesco Papadia, The

Transition to EMU in the Maastricht Treaty. (November 1994)

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195. Ariel Buira, Reflections on the International Monetary System. (January 1995)196. Shinji Takagi, From Recipient to Donor: Japan’s Official Aid Flows, 1945 to 1990

and Beyond. (March 1995)197. Patrick Conway, Currency Proliferation: The Monetary Legacy of the Soviet

Union. (June 1995)198. Barry Eichengreen, A More Perfect Union? The Logic of Economic Integration.

(June 1996)199. Peter B. Kenen, ed., with John Arrowsmith, Paul De Grauwe, Charles A. E.

Goodhart, Daniel Gros, Luigi Spaventa, and Niels Thygesen, Making EMUHappen—Problems and Proposals: A Symposium. (August 1996)

200. Peter B. Kenen, ed., with Lawrence H. Summers, William R. Cline, BarryEichengreen, Richard Portes, Arminio Fraga, and Morris Goldstein, From Halifaxto Lyons: What Has Been Done about Crisis Management? (October 1996)

201. Louis W. Pauly, The League of Nations and the Foreshadowing of the Interna-tional Monetary Fund. (December 1996)

202. Harold James, Monetary and Fiscal Unification in Nineteenth-Century Germany:What Can Kohl Learn from Bismarck? (March 1997)

203. Andrew Crockett, The Theory and Practice of Financial Stability. (April 1997)204. Benjamin J. Cohen, The Financial Support Fund of the OECD: A Failed

Initiative. (June 1997)205. Robert N. McCauley, The Euro and the Dollar. (November 1997)206. Thomas Laubach and Adam S. Posen, Disciplined Discretion: Monetary

Targeting in Germany and Switzerland. (December 1997)207. Stanley Fischer, Richard N. Cooper, Rudiger Dornbusch, Peter M. Garber,

Carlos Massad, Jacques J. Polak, Dani Rodrik, and Savak S. Tarapore, Shouldthe IMF Pursue Capital-Account Convertibility? (May 1998)

208. Charles P. Kindleberger, Economic and Financial Crises and Transformationsin Sixteenth-Century Europe. (June 1998)

209. Maurice Obstfeld, EMU: Ready or Not? (July 1998)

PRINCETON STUDIES IN INTERNATIONAL FINANCE

63. Jacob A. Frenkel and Assaf Razin, Spending, Taxes, and Deficits: International-Intertemporal Approach. (December 1988)

64. Jeffrey A. Frankel, Obstacles to International Macroeconomic Policy Coordina-tion. (December 1988)

65. Peter Hooper and Catherine L. Mann, The Emergence and Persistence of theU.S. External Imbalance, 1980-87. (October 1989)

66. Helmut Reisen, Public Debt, External Competitiveness, and Fiscal Disciplinein Developing Countries. (November 1989)

67. Victor Argy, Warwick McKibbin, and Eric Siegloff, Exchange-Rate Regimes fora Small Economy in a Multi-Country World. (December 1989)

68. Mark Gersovitz and Christina H. Paxson, The Economies of Africa and the Pricesof Their Exports. (October 1990)

69. Felipe Larraín and Andrés Velasco, Can Swaps Solve the Debt Crisis? Lessonsfrom the Chilean Experience. (November 1990)

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70. Kaushik Basu, The International Debt Problem, Credit Rationing and LoanPushing: Theory and Experience. (October 1991)

71. Daniel Gros and Alfred Steinherr, Economic Reform in the Soviet Union: Pasde Deux between Disintegration and Macroeconomic Destabilization. (November1991)

72. George M. von Furstenberg and Joseph P. Daniels, Economic Summit Decla-rations, 1975-1989: Examining the Written Record of International Coopera-tion. (February 1992)

73. Ishac Diwan and Dani Rodrik, External Debt, Adjustment, and Burden Sharing:A Unified Framework. (November 1992)

74. Barry Eichengreen, Should the Maastricht Treaty Be Saved? (December 1992)75. Adam Klug, The German Buybacks, 1932-1939: A Cure for Overhang?

(November 1993)76. Tamim Bayoumi and Barry Eichengreen, One Money or Many? Analyzing the

Prospects for Monetary Unification in Various Parts of the World. (September1994)

77. Edward E. Leamer, The Heckscher-Ohlin Model in Theory and Practice.(February 1995)

78. Thorvaldur Gylfason, The Macroeconomics of European Agriculture. (May 1995)79. Angus S. Deaton and Ronald I. Miller, International Commodity Prices, Macro-

economic Performance, and Politics in Sub-Saharan Africa. (December 1995)80. Chander Kant, Foreign Direct Investment and Capital Flight. (April 1996)81. Gian Maria Milesi-Ferretti and Assaf Razin, Current-Account Sustainability.

(October 1996)82. Pierre-Richard Agénor, Capital-Market Imperfections and the Macroeconomic

Dynamics of Small Indebted Economies. (June 1997)83. Michael Bowe and James W. Dean, Has the Market Solved the Sovereign-Debt

Crisis? (August 1997)84. Willem H. Buiter, Giancarlo M. Corsetti, and Paolo A. Pesenti, Interpreting the

ERM Crisis: Country-Specific and Systemic Issues (March 1998)

SPECIAL PAPERS IN INTERNATIONAL ECONOMICS

16. Elhanan Helpman, Monopolistic Competition in Trade Theory. (June 1990)17. Richard Pomfret, International Trade Policy with Imperfect Competition. (August

1992)18. Hali J. Edison, The Effectiveness of Central-Bank Intervention: A Survey of the

Literature After 1982. (July 1993)19. Sylvester W.C. Eijffinger and Jakob De Haan, The Political Economy of Central-

Bank Independence. (May 1996)

REPRINTS IN INTERNATIONAL FINANCE

28. Peter B. Kenen, Ways to Reform Exchange-Rate Arrangements; reprinted fromBretton Woods: Looking to the Future, 1994. (November 1994)

29. Peter B. Kenen, Sorting Out Some EMU Issues; reprinted from Jean MonnetChair Paper 38, Robert Schuman Centre, European University Institute, 1996.(December 1996)

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The work of the International Finance Section is supportedin part by the income of the Walker Foundation, establishedin memory of James Theodore Walker, Class of 1927. Theoffices of the Section, in Fisher Hall, were provided by agenerous grant from Merrill Lynch & Company.

ISBN 0-88165-116-8Recycled Paper