The experience of recent decades in Europe will be largely irrelevant to the large and relatively closed economic area of EMU. So European policy-makers probably have more to learn from the United States – another large and closed economy – than from any individual EMU member, especially given the US economy’s recent success in achieving sustained growth with low inflation.

Since Europe resembles the United States, it is natural to expect the ECB to behave more like the Fed, devoting far less attention to the exchange rate than national central banks in Europe have done in the past, perhaps even pursuing a policy of ‘benign neglect’. Inside EMU, as in the United States, policies will be mainly set with a view to domestic objectives while the exchange rate is left to float. There will only be concern when swings in competitiveness become ‘excessive’, like the sharp dollar appreciation of 1984–5.

But the ECB cannot merely imitate the Fed’s policy: Europe’s monetary union differs from the United States in many important dimensions:

• Monetary policy will be run by a new institution, one endowed with a strong legal design but without a track record.
• In contrast with the Fed, which has developed a fairly good understanding of how the US economy works, the ECB will face substantial uncertainty, particularly over how a common monetary policy will affect prices and output across the euro zone.
• Fiscal policies under EMU will be run by independent governments, though with some coordination via the Stability Pact.

Despite the careful monetary architecture built along the road from Maastricht, and despite the inheritance of low inflation and some continuity of personnel, it is likely that the ECB will consider early action to establish a track record. Initially, monetary policy may well be tighter than would otherwise be the case as the ECB attempts to establish its reputation for anti-inflationary rigour.

Greater precision in the specification of the implicit contract under which the ECB operates would reduce ambiguity, and make reputation-building easier while avoiding the risk of creating a deep recession. As an important corollary, if the ECB operates primarily in the light of expected inflation, its operating procedures for forecasting inflation should be transparent.

Early on, the ECB will have to be more cautious than the Fed in running monetary policy, since the response of the EMU-wide economy to its actions will be largely unknown. In particular, the impact of the common monetary policy will vary greatly across countries. To the extent that these variations result from differences in financial structure, financial integration and harmonization across the EMU members will be a vital complement to the single monetary policy.

Regulatory changes should be made to facilitate such integration. For example, if different financial structures are the result of different tax structures, tax rules should be harmonized during the transition to EMU. This provides an additional rationale for fiscal harmonization inside EMU, which goes beyond the traditional argument that differences in fiscal rules can distort the allocation of savings.

The ECB will also need to be concerned with exchange rate fluctuations between the euro and other European currencies, notably those of Eastern Europe. These exchange rates will become increasingly important as intra-European trade relations grow and shift towards intra-industry trade. Fluctuations in the euro-dollar exchange rate will also affect some European regions and industries more than others. There is a risk that such fluctuations will lead to calls for protectionist measures.

Of course, monetary policy discussions between Europe and the United States will only be serious when currency fluctuations are large and persistent enough to threaten a trade war. How should such discussions be organized? Past experience suggests that the only viable arrangements will be informal, resembling those already in place between the existing European currencies, the dollar and the yen.

But precisely because the only feasible exchange rate arrangements between EMU and the United States are informal, institutions are needed that facilitate international dialogue and cooperation among different authorities on the two sides of the Atlantic. There is a danger that EMU will disrupt the operation of the two key institutions – the IMF and the G-7 – thus limiting the scope for international policy coordination.

EMU will be a moving target for those who aspire to coordinate macroeconomic policies internationally. Monetary policy-making authority will be centralized in the ECB, but authority over fiscal policy will remain significantly decentralized, which will make representing European interests and engineering mutually advantageous policy adjustments considerably more complex. Making explicit provision for representation of the euro zone in IMF and G-7 deliberations is therefore essential. Inevitably this will require increasing the number of parties around the table, both because the degree of centralization will differ for different policies and because the membership of EMU will continue to evolve.

What will make Europe unique is that one monetary authority will face as many fiscal authorities as there are EMU members. At this stage, only national governments have effective control of fiscal policy and this is unlikely to change for quite a while. This implies a two-level coordination problem – between the ECB and the governments taken together, and among governments – which has three implications.

First, in facing multiple fiscal authorities, the ECB will be less able to rely on its own rules and credibility to provide adequate discipline incentives to governments than a central bank facing a single government. The result is likely to be an inefficient policy mix. What is worse, if the ECB shares the public blame for the inefficient outcome, it may have to abandon its tendency to offset lax fiscal policies, with the result that inflation is higher than is socially desirable.

Second, the lack of coordination among national fiscal authorities complicates the relationship between the ECB and those authorities.

Third, there is a case for some constraint on national fiscal policies even if the credibility of the ECB is unquestioned – a rationale for the Stability Pact. The purpose of tighter fiscal polices is on average to allow looser monetary policy than would otherwise have been undertaken at an unchanged rate of inflation. But there is no more reason to believe that responsible fiscal policy should be defined in terms of a rigid fiscal straitjacket than there is to believe that responsible monetary policy should entail a rigid monetary straitjacket. One clear implication is that the Pact should apply to cyclically-adjusted budgets, not to unadjusted budgets, which vary across the business cycle.

Although the agreement at the EU’s Dublin summit goes a small ad hoc step in this direction, by itemising particular cyclical circumstances in which exemptions to normal rules would apply, this is a very incomplete solution. If the result is excessively tight fiscal policies, the Pact will put the ECB under pressure to opt for a tight fiscal-easy money policy mix, hence impeding rather than assisting the ECB. Eventually, therefore, the Pact will have to be replaced by a more supple procedure that brings together the ECB and national governments.

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