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European
Economic Perspectives 24
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Ready
Recent
speculative attacks on emerging market currencies underline the need for
Europe’s transition economies to establish a robust macroeconomic
strategy as they prepare to join the European Union and eventually its
single currency. A new Report explores how this strategy should be
designed.
What
macroeconomic policies should the accession countries of Central and
Eastern Europe pursue in the run-up to membership of the EU and
ultimately EMU? A new Report from the Economic Policy Initiative (EPI),
a joint venture involving CEPR, the EastWest Institute and six local
partner institutes in the Associated Countries, addresses this issue,
which is at the heart of the enlargement negotiations.
A
central question is the appropriate exchange rate regime and the Report
recasts this choice within the framework of the objectives, targets and
instruments of monetary policy. The starting point is the choice of an
inflation rate or, more precisely, the speed of disinflation and the
longer-term target for the inflation rate. There are some reasons for
thinking that the benefits of lower inflation may be greater in
transition economies than in mature economies. Lower inflation may, for
example, accelerate financial deepening and reduce uncertainty, two
processes that transition economies badly need. In addition, lower
inflation reduces the distortions arising from inadequate inflation
accounting.
A
number of arguments, however, pull in the opposite direction. Early in
transition, the social returns on investment should be abnormally high.
With acute capital market imperfections and poor tax compliance, the
costs of public revenue are high but the benefits large. This suggests
that the inflation tax may have higher social value than in mature
economies. In addition, relative price adjustment is likely to be
significant as the economy is restructured: given downward nominal
rigidities, some inflation may facilitate more rapid real adjustment.
Finally, disinflation usually imposes costs that are politically
expensive: governments may rationally decide to use their limited
political capital to nurture some of the structural changes that are a
prerequisite to the success of transition instead of reducing inflation
more quickly.
Inflation
soared at the outset of transition in a number of countries, though not
in Hungary and the Czech Republic. The need for a nominal anchor, and
the possibility of using the exchange rate for that purpose, thus
differed from one country to another. At any rate, the evolution of
monetary regimes among the leading transition economies has been greater
than it appears at first sight. For example, the Czech Republic, which
had maintained its central parity unchanged since 1991, was forced in
May 1997 to float and depreciate. It then pursued a policy of managed
floating, precisely the approach adopted in Slovenia and Croatia, where
the exchange rate has been tightly managed, as actively as within many
so-called fixed regimes.
The
general lesson from comparing the different exchange rate regimes that
have been adopted seems to be that rigid monetary targets cannot be
upheld when the determinants of money demand are changing. Yet,
inflation targets are unattractive until price liberalization and
structural adjustment are completed. This is probably why, to date, no
regime appears to be a clear winner.
This
line of reasoning has important implications for enlargement. Early
insistence by EMU members on limiting the exchange rate flexibility of
the accession countries may be seen as a way of ensuring a commitment to
adhere to EMU’s standards. But it is likely to be costly to accession
countries early on, and may even slow down their progress in other
aspects of transition, especially if higher inflation is justified by
the costs of reform.
Of
course, accession countries should not join EMU until their economic
structures are ready. This is an argument for timing accession
carefully, especially adoption of the single currency, which can be
delayed until well after accession. Frontloading ‘good’ EU behaviour
by insisting on limited exchange rate flexibility may trigger a vicious
circle of delayed reforms as governments concentrate on the wrong policy
objectives, which would further delay accession.
In
the end, the Report concludes, a reasonable approach for transition
economies is to focus on structural adjustment and fiscal
responsibility. Unless both exist, those responsible for monetary policy
will always be making the best of a bad situation. And without progress
in these fundamental areas, early disinflation may prove difficult to
sustain. Monetary policy must aim to secure an appropriate balance
between provision of a suitable nominal anchor, avoidance of an
uncompetitive real exchange rate and promotion of structural adjustment.
When
capital mobility is high, exchange rate policy is essentially monetary
policy. But, without prudent fiscal policy, either deficits are
monetized, in which case nominal exchange rate commitments lead quickly
to real appreciation and pressures to devalue; or deficits are not
monetized, in which case eventually fiscal solvency is threatened,
leading to inexorable pressure to create inflation. Unless fiscal policy
is sufficiently prudent, any fixed exchange rate policy is
unsustainable.
The
Report explores the link between the fiscal policy and the success of
the exchange rate policy. Appropriate fiscal policy is a requirement for
the monetary and exchange rate strategies. Moreover, policy regimes that
involve exchange rate management must always recognise the possibility
that speculative attacks may occur, and ideally should take steps in
advance to minimize the likelihood of being blown off course by such
attacks.
The
Report notes the useful distinction drawn by Matt Canzoneri and
colleagues in two CEPR Discussion Papers (Nos. 1772 and 1899). These
define fiscal dominance as a policy regime where, in the end, monetary
policy will always be called on to solve fiscal unsustainability. In
contrast, monetary dominance corresponds to the case where a debt
build-up will have to be dealt with by fiscal means, either a closing of
the deficit or a debt default. In a monetary dominance regime, in other
words, there are no circumstances in which the central bank can be
coerced into bailing out an undisciplined government.
In
a regime of fiscal dominance, central bank independence, when it exists,
is largely cosmetic. When, instead, the government recognises
responsibility for maintaining fiscal solvency without automatic
monetary financing, it better evaluates the value for money it obtains
from its spending and the efficiency with which its taxes are collected.
This
distinction offers a useful key for examining the process of fiscal
stabilization in transition countries that started out with rapidly
growing public debts. Fiscal stabilization can be defined as the
transition from fiscal dominance to monetary dominance. Once this is
achieved, the central bank can control the price level and, therefore,
the exchange rate.
This
approach also carries policy implications for the link between
macroeconomic achievement and some aspects of structural adjustment. A
narrow band and pre-announced parity crawl will be robust only if
monetary policy can defend the parity. For such a strategy to be upheld,
shocks to solvency that customarily arise in the structural adjustment
process must be dealt with by fiscal policy alone.
The
fiscal response to any imbalance does not necessarily have to be
immediate, but it must be widely understood that this is, indeed, the
solution that will be eventually be implemented. It is present values
that matter – any sign of reluctance is bound to make defence of the
exchange rate policy regime impossible. The bond and foreign exchange
markets are in effect the arbiters of whether the required adjustment is
likely to be accomplished.
The
link between fiscal policy and the exchange rate regime must be kept in
mind when considering the accession path. The tighter is the exchange
rate commitment (for example, adherence to a new exchange rate mechanism
with narrow bands) the more fiscal policy must take on responsibility
for its own sustainability and for dealing with shocks and the costs of
completing restructuring. Unless fiscal policy is under control, the
central bank is likely to face strong pressure to monetize government
debt.
Central
bank independence is part of the response, of course. Still, the mature
economies of Western Europe have concluded that central bank
independence alone was insufficient: the Maastricht Treaty imposed
macroeconomic convergence criteria and was supplemented with the
adoption of the Stability Pact. It may be optimistic to assume that
central bank independence will suffice in transition economies.
Incentives for responsible fiscal policy should be given at least as
much weight as formal exchange rate agreements and nominal convergence
criteria.
This
article summarizes ‘Monetary
and Exchange Rate Policies, EMU and Central and Eastern Europe’
(Economic Policy Initiative Forum Report No. 5) by David Begg, László
Halpern and Charles Wyplosz. Begg is at Birkbeck College, London;
Halpern at the Hungarian Academy of Sciences, Budapest; and Wyplosz at
the Graduate Institute of International Studies, Geneva. All are
Research Fellows in CEPR’s Transition Economics research programme.
Wyplosz is also a Programme Director of CEPR’s International
Macroeconomic research programme and Begg a Research Fellow in this
programme.
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