© 1999 Patrick Minford

Fixed versus floating exchange rates:

There is a huge literature about fixed exchange rates. Since the effective break-up in 1970 of Bretton Woods (the post-war international agreement to fix exchange rates), the general consensus among economists has been that major economies were better off under floating exchange rates (we ignore here the discussion of what is right for small, especially developing, economies where there may be a case for fixing exchange rates under the tough conditions of a 'currency board'). This was underlined in a major study of the international economy using all available World Models- Bryant et al (1993); this found that monetary policy conducted with a fixed exchange rate target was distinctly inferior to that using domestic targets- whether for money supply, inflation or output. Within that volume work on the Exchange Rate Mechanism (Hughes Hallett et al) found that this particular fixed exchange rate regime gave extremely poor results- the UK's difficulties are well known (see Walters, 1990 and 1992).

Bryant, Ralph C., Peter Hooper and Catherine L. Mann (eds.) (1993) Evaluating Policy Regimes- new research in empirical macroeconomics, Brookings Institution, Washington DC.

Hughes Hallett, Andrew, Patrick Minford and Anupam Rastogi (1993) 'The European Exchange Rate Mechanism', in Bryant et al (1993).

Walters, A. A. (1990) Sterling in danger: the economic consequences of pegged exchange rates, Collins (Fontana) with the Institute of Economic Affairs, London.

-------------------(1992) 'Britain and the exchange rate mechanism', in The Cost of Europe (P. Minford ed.), Manchester University Press, Manchester, pp. 119-124.
 
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Monetary Union- general

Monetary Union involves fixing exchange rates 'indefinitely'; of course nothing is really for ever and what is meant is that undoing a currency union is much more costly than leaving a fixed exchange rate arrangement, since under monetary union a country actually gives up the right to print its own currency hence in order to leave the union it must issue a new currency. This higher cost reduces the probability of departure substantially, hence the 'indefinitely'. But when participating nations remain sovereign, they can always decide to leave; thus the possibility remains open in principle at all times. As is noted in our 'encyclopaedia' section, there are many examples of monetary unions that failed because of the departure of one or more members.

Good general guides to the issues raised by monetary union are:

De Grauwe, Paul (1994) The Economics of Monetary Union, Oxford University Press.

Kawai, Masahiro (1992) 'Optimum currency areas', in New Palgrave Dictionary of Money and Finance (Peter Newman, Murray Milgate and John Eatwell, eds), Macmillan.

Minford, Patrick (1993) 'The Path to Monetary Union in Europe', The World Economy, Vol. 16, No. 1, January 1993, pp. 17-27.

They are organised around the original ideas of Robert Mundell, Ronald McKinnon and others dating back to the 1960s of an 'optimal currency area'. The basic idea is simple. There are gains in principle from having a common money, these being the reduction in 'transactions costs', a general term for the costs of having to change money to do business. But economic conditions in different countries are likely to differ because of 'asymmetries' (these can come about because the primary shocks are different or because the 'transmission mechanisms'- i.e. the effects of any given shock in each economy- differ); to deal with this different interest rates and exchange rates are required. The two go together: if interest rates differ this creates an incentive to move money from the low-interest-rate country to the other, and in order to stop this flow of money (which would deplete reserves) the exchange rate between the two must move until the expected capital loss due to the exchange rate movement just offsets the interest rate differential. The inability of a country to set its own interest rates and exchange rate will in general make its economy more unstable- unemployment will be larger in slumps and overheating worse in booms. Thus we have a prima facie comparison of the benefits from lower transactions costs with the costs from asymmetries. This is an empirical matter for investigation: it is assumed that the more cross-country transactions there are ('integration') the higher the transactions costs and the less the asymmetries. Hence union is recommended for regions that have already achieved a high degree of integration: in practice this has coincided with the boundaries of states.
 
Andrew K Rose, in his CEPR discussion paper No 2329 'One Money, One Market: Estimating the Effect of Common Currencies on Trade', uses a gravity model to assess the separate effects of exchange rate volatility and currency unions on international trade. We examine his paper here.

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The argument does not stop there: a country may substitute other mechanisms to deal with its own asymmetries. These consist of:

(a) labour mobility: people in ar eas in a recession can move to those in an upswing.

(b) wage flexibility: the real wages ( and so labour costs) in depressed areas can fall relative to those in prospering areas.

(c) fiscal transfers: the central government in the Union can transfer money from the prospering areas to the depressed areas, either through taxes or benefits.

However, one notes at once that (a) and (c) are intimately connected with being part of a state; labour mobility is assisted by being within a common jurisdiction, so that legal rights are preserved and fiscal transfers require a central budget. (b) can occur regardless of jurisdiction; it merely requires a flexible labour market without intervention by the state or by state-legitimised unions to stop real wages adjusting to equate desired labour supply with firms' demand for labour. In this discussion much depends on the rapidity of these responses; noone today argues that asymmetric shocks or responses will prevent a region adjusting ultimately to a permanent change in its circumstances under a monetary union as under floating exchange rates- in principle it should in both cases reach the same ultimate situation. The issue is whether the adjustment is more painful and involves greater volatility, especially of unemployment, under monetary union because the responses from these alternative mechanisms are slower than those of interest rates and exchange rates.

De Grauwe also discusses at some length the 'new monetary union' argument: that countries can acquire monetary credibility in the fight against inflation by transferring their monetary sovereignty away from home politicians to an independent (foreign) central bank. However, this argument has been sidelined by the obvious capacity of a country to generate its own domestic monetary credibility by suitable policies and institutions. The clearest recent demonstrations are from the UK, New Zealand, Canada and the USA.
 
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There is another economic concern about monetary union: sharing a single currency means that all countries issue their debt denominated in it and consequently when one country threatens to default the others may be called upon to 'bail it out'. Why? There is a common concern for the reputation of the currency- in other words lenders may require a higher interest rate from all if one debt-issuer defaults, because lenders have inadequate information to distinguish between borrowers in fine detail. Another reason is that under monetary union there is more coordination and so the crisis created by the default is relevant to the collective decision; there is then political pressure to help a member of the collective (even if in fact the Maastricht Treaty explicitly states that each government must deal with its own obligations without help). The fear of pressure to bail out governments with poor public finances led directly to the Maastricht Treaty conditions for ceilings on debt and deficits, as well as to the Stability Pact setting targets for deficits to be eliminated.

To many people the key argument is political: they either do or do not want political union and see monetary union as a means to advance that political aim. At first sight it is obscure why monetary union should be seen as such a step to political union. But the above economic arguments reveal why. The need to find alternative mechanisms to deal with regional difficulties strengthens the case for a central state with fiscal powers and jurisdiction over the 'single market in labour'. The fear of bail-out is another reason for stronger central controls over member governments in fiscal policy. Finally, one may note that the test of a union is in the end its acceptability to the member peoples; the stronger the central institutions the harder it is for dissatisfied peoples to withdraw. Plainly the case for 'co-ordination' now being pressed by Germany in particular can be seen as justified by the need to advance political union.

De Grauwe (1994) contains the essential arguments and also many supporting references. His own conclusion is that a narrow group of countries consisting of the old DM-bloc of Germany, Benelux and Austria, plus France- because of their demonstrated commitment to pegging to the DM over a long period of time- represent an 'optimal currency area'; in other words the costs for this bloc are probably smaller than the benefits. But that any wider group would not constitute such an optimal currency area. However, the inclusion of France in the narrow group can certainly be queried; as a large economy with a history of very different behaviour from Germany since the war, it remains to be seen whether its economy can be managed within the union in a way its citizens ultimately agree with.
 
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EEC Commission (1990) 'One market, one money: an evaluation of the potential benefits and costs of forming an economic and monetary union', European Economy, no.44, October. Finds that costs of intra-EU currency exchange for country with advanced banking system are about 0.1% of GDP (this is the only estimate of the transactions cost gain available). Suggests but cannot quantify risk-premium reduction on borrowing costs because of union. Carries out 'stochastic simulation' (see below under 'asymmetric' for criticisms) which purports to show that EMU produces more stability in output and inflation than floating- the reason being that it eliminates the volatility in intra-EU-currencies risk-premia.

One symptom of transactions costs is foreign trade: there should be some effect of exchange rate volatility on the volume of trade or the pricing behaviour of traders. The consensus of studies is that such effects are not significant. A typical one is:

Bailey, M., G.S. Tavlas and M. Ulan (1987) 'The impact of exchange rate volatility on export growth: some theoretical considerations and empirical results' Journal of Policy Modelling, 9, pp. 225-243.

Where there is an increase in medium term real exchange rate volatility (ie when there are long swings in competitiveness as opposed to fluctuations in exchange rates as part of the business cycle) researchers have found evidence of effects on trade volumes. But such swings are not in principle connected with floating rates- competitiveness in the medium term should be unaffected by the type of exchange rate regime because over that time-scale relative wages and prices will adjust one way or the other as much as they can. Examples of these findings are:

De Grauwe, P. (1987) 'International trade and economic growth in the European Monetary System', European Economic Review, 31, pp. 389-398.

Peree, E. and A. Steinherr (1989) 'Exchange rate uncertainty and foreign trade', European Economic Review, 33, pp. 1241-1264.

Recent studies have looked at 'pricing to market' where firms absorb exchange rate fluctuations into their profit margins, keeping import prices stable in the domestic currency of consumers; if this was a factor and was costly there should be an effect on the rate at which import costs are 'passed-through' to the consumer and a riskpremium in the import price mark-ups. However, again not much has been found e.g.:

Sapir, Andre, and Khalid Sekkat (1990) 'Exchange rate volatility and international trade' in The European Monetary System in the 1990s, Paul De Grauwe and Lucas Papademos (eds), Longman, pp. 182-198.
 
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The consensus of a variety of studies is that the regional shocks in EU countries are highly asymmetric, at least as much as and possibly somewhat more than those in the regions of the USA. The latest such studies are:

Duarte, Agustin and Ken Holden (2000) 'The Business Cycle in the G7 Economies', in which the authors decompose real GDP for the G7 countries into cyclical and trend components. They find that since 1990 two seperate cycles have developed: one for Germany, France and Italy; and one for the US, UK and Canada. This paper is available as an Acrobat PDF file here.

Horvath, Michael (1999) 'Empirical Evidence on Common Money and Uncommon Regions in the United States' and

Carlino, Gerald A. and Robert DeFina (1999) 'Monetary Policy and the U.S. States and Regions: Some Implications for Common Currency Areas'; both in Jurgen von Hagen and Christopher Waller (eds.) Common Money, Uncommon Regions, forthcoming Kluwer.

A number of previous studies include:

Eichengreen, Barry (1990) 'One money for Europe? Lessons from the US currency union' Economic Policy 10, Blackwell.

Neumann, Manfred, and Jurgen von Hagen (1991) 'Real exchange rates within and between currency areas: how far away is EMU?' discussion paper, Indiana University.

Bayoumi, Tamim, and Barry Eichengreen (1993) 'Shocking aspects of European Monetary Integration', in F. Torres and F. Giavazzi (eds.) Adjustment and growth in the European Monetary Union, Cambridge University Press (for CEPR, London).
 
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De Grauwe, P., and H. Heens (1993) 'Real exchange rate variability in monetary unions', Recherches Economiques de Louvain, 59.

De Grauwe, P., and W. Vanhaverbeke (1993) 'Is Europe an optimum currency area?: evidence from Regional data', in P.R. Masson and M.P. Taylor (eds.) Policy Issues in the operation of currency unions, Cambridge University Press.

A further argument, documented by Krugman (1993), is that greater specialisation by region occurs with greater integration and reduction of regulative barriers (also possibly encouraged by monetary union); this has been visible in the USA (eg Silicon Valley in California, automobile production in Pittsburgh, defence in New England) and in the EEC would worsen the asymmetries already visible as it proceeded further:

Krugman, Paul (1993) 'Lessons of Massachusetts for EMU', in F. Torres and F. Giavazzi (eds.) Adjustment and growth in the European Monetary Union, Cambridge University Press (for CEPR, London).

The first two of these find that EMU generally causes substantially more instability in the member economies than floating exchange rates; the EEC study finds the opposite but the reason, explored by the first two, is that it has entered a special class of shocks (to intra-EEC interest rate risk-premia) whose volatility it has arbitrarily assessed and very likely over-estimated.

Minford, Patrick, Anupam Rastogi and Andrew Hughes Hallett (1993) 'The price of EMU revisited', Greek Economic Review, 15 (1), pp.191-226.

Masson P. and S. Symansky (1992) 'Evaluating the EMS and EMU Using Stochastic Simulations: Some Issues', in 'Macroeconomic Policy Coordination in Europe, the ERM and Monetary Union', R. Barrell and J. Whitely (eds.) London, NIESR, 1992

EEC Commission (1990) 'One market, one money: an evaluation of the potential benefits and costs of forming an economic and monetary union', European Economy, no.44, October.

The studies following have found that labour migration in the USA between regions is very high compared with that between countries of the EU and even compared with that between regions of the same countries within the EU.

Eichengreen, Barry (1993a) 'European Monetary Unification', Journal of Economic Literature, 31, pp. 1321-1357.

-------------------------(1993b) 'Labour markets and European monetary unification' in Paul Masson and Mark Taylor (eds.) Policy Issues in the operation of currency unions, Cambridge University Press, pp. 130-162.

Decressin, Jorg, and Antonio Fatas (1995) 'Regional labour market dynamics in Europe', European Economic Review, 39, pp. 1627-1655.

Obstfeld, Maurice, and Giovanni Peri (1998) 'Regional non-adjustment and fiscal policy', Economic Policy, 26, April 1998, pp.207-259.

De Grauwe, P., and W. Vanhaverbeke (1993) 'Is Europe an optimum currency area?: evidence from Regional data', in P.R. Masson and M.P. taylor (eds.) Policy Issues in the operation of currency unions, Cambridge University Press.
 
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A wide variety of studies dating back to the late 1970s have shown western labour markets generally to have a low response of regional real wages to regional unemployment. In the USA this is generally interpreted as reflecting high labour migration (see above)- rather than take a wage cut workers move to other regions. At the aggregate level of the whole USA US wages appear to be highly flexible whereas those in Europe are not; the reason appears to lie in the social support of wages in Europe either through unemployment benefits, minimum wages, unions or a combination of all three; this is consistent with estimates of structural unemployment (also termed 'the natural rate' of unemployment, the rate at which inflation can be stabilised, and the 'non-accelerating-inflation rate of unemployment or NAIRU)- high, perhaps double digit on the European continent compared with low, around 4.5%, in the USA.

Grubb, D., R. Jackman and R. Layard (1983) 'Wage rigidity and unemployment in OECD countries', European Economic Review.

Bruno, M., and J. Sachs (1985) Economics of worldwide stagflation, Blackwell.

Layard, Richard, Steven Nickell and Richard Jackman (1992) Unemployment: macroeconomic performance and the labour market, Oxford University Press.

Blanchflower, David G., and Andrew J. Oswald (1994) The Wage Curve, MIT University Press.

Kincaid, R. G., W. Lee, A. Jaeger, B. Drees, W. Merz, V. Valdivia, H. Faruquee (1997) 'Germany- selected issues', IMF Staff Country Report No. 97/101, 8/8/1997.

McMorrow, Kieran (1996) 'The wage formation process and labour market flexibility in the Community, the US and Japan', European Commission Economic Papers, No. 118, Brussels.

Blanchard, Olivier J., and Lawrence F. Katz (1992) 'Regional evolutions', Brookings Papers on Economic Activity, 1992 (1), pp. 1-75.
 
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Early estimates of the extent to which a fall in a US region's GDP would generate extra net revenue from the Federal Budget were of the order of 0.3 (Sala-i-Martin and Sachs, 1989). However, the later research listed has reduced this to some half of this. Nevertheless, it is substantial set beside the obviously negligible figure in the EU- the regional funds are irrelevant in this context because they do not react to cyclical or other marginal changes in regional GDP.

Sala-i-Martin, Xavier, and Jeffrey Sachs (1992) 'Fiscal federalism and optimum currency areas: evidence for Europe form the United States', in Mathew Canzoneri, Vittorio Grilli and Paul Masson (eds.) Establishing a central bank: issues in Europe and lessons from the US, Cambridge University Press. Pp. 195-227.

Von Hagen, Jurgen (1991) 'Fiscal arrangements in a monetary union- evidence from the US' in D. Fair and C. de Boissieux (eds) Fiscal policy, taxes and the finacial system in an increasingly integrated Europe, Kluwer.

Fatas, Antonio (1998) 'Does EMU need a fiscal federation?' Economic Policy, 26, April 1998, pp. 165-203.

Bayoumi, Tamim, and Paul R. Masson (1995) ' Fiscal flows in the United States and Canada: lessons for monetary union in Europe', European Economic Review, 39, pp.253-274.

The recent Mexican, Asian and Brazilian crises have illustrated the pressures for bail-out. The following discuss these, with varying opinions about the likelihood of bail-out in Europe.

Eichengreen, Barry, and Charles Wyplosz (1998) 'The stability Pact: more than a minor nuisance?' Economic Policy, 26, April 1998, pp. 67-113.

Crawford, Malcolm (1993) One Money for Europe?, Macmillan.

Buiter , Willem, Giancarlo Corsetti, Noriel Roubini (1993) 'Excessive deficits: sense and nonsense in the Treaty of Maastricht', Economic Policy 16, pp. 58-100.

The costs of harmonisation for low cost members of the EU such as the UK is evaluated as of significant size in:

Minford, Patrick (1998) 'Europe and the new world order' chapter 8 of Markets Not Stakes, Orion, London.

Layard, R, S. Nickell and R. Jackman (1990) Unemployment- macroeconomic performance and the labour market, Oxford University Press, bring together evidence on labour markets around the world and find that state interventions which increase real wage inflexibility and raise labour costs (e.g. by subsidising long-term unemployment) also raise unemployment. In the conditions of general wage rigidity prevailing in continental Europe harmonisation as a levelling-up of taxes and social charges would raise unemployment both in countries where these rise and so overall.
 
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