Sui Generis EMU?

In the many debates that rage about the sustainability and success of European Monetary Union, politicians and economists frequently reach for examples from history, whether it be the painstaking progress towards monetary union in the United States, or the doomed currency arrangement within the Austro-Hungarian Empire.

CEPR Researcher Barry Eichengreen argues in a new paper that every single one of the historical examples cited in these arguments is misleading - because a project like EMU has never before been attempted.

One commonly-used comparator is the gold standard, for example - the system by which governments agreed fixed convertibilities between their currencies, and promised to back them with gold reserves. Eichengreen argues that comparing EMU to the gold standard misses the point that members kept their own national currencies, and management of monetary policy remained with national central banks.

In times of financial distress, a government could choose to suspend convertibility to gold and temporarily allow its currency to float, rejoining the gold standard at a later stage (sometimes with disastrous results, as with Britain after the first World War). Joining the euro area, by contrast, involves a once-and-for-all decision, with no mechanism envisaged for temporary or permanent departure. Currency fluctuations are not simply narrowed or suspended, they are abolished; so the boost to trade between member countries should be greater than that between adherents to the gold standard.

Another forerunner of EMU was the Latin monetary union of 1866 between France, Belgium, Italy and Switzerland, which established that the currency of each would be accepted as legal tender by the others. But Eichengreen argues that this was chiefly an attempt to tackle the problem of bimetallism: standardising the value of gold and silver coins in circulation, against a background of fluctuating world metal prices. In this, it failed; but since there was no common monetary authority, it can hardly be seen as analagous to EMU.

Similarly, the Scandinavian monetary union that existed from the 1870s, and was finally dissolved in the 1920s, involved no central bank: each country retained the ability to regulate its own money-supply; and for much of the period, two of the three member-countries, Sweden and Norway, were in political union.

Many of the other examples of monetary unification, such as France-Monaco, Italy-San Marino-Vatican City, are not relevant either, because they consist of a large country that makes the policy rules, and smaller ones that piggyback on the credibility of the other member.

Perhaps the most instructive examples for the purposes of understanding EMU are the cases where full monetary union has eventually been established - in Germany, Italy and the US, for example. But crucially, these countries had political union, unlike in the European case where, as Eichengreen puts it, 'there exists a central bank whose domain is wider than that of the national political institutions whose consent is required for its creation and continued existence.' It is this element of the project, he says, which is simply unprecedented.

Even after the US Civil War, for example, there was still little financial integration at the federal level. Jacksonian political suspicions of centralising, US-wide institutions meant that financial markets remained regional; there was little interbank lending, and it was difficult for banks to diversify away from their local area. That meant interest rates varied widely - frequently by a full percentage point between one part of the US and another.

In Europe, by contrast, financial integration has long been seen as an end in itself; and the foundations of a single financial market were laid more than a decade before monetary union.

Some of the ambiguities that dogged the progress of US financial and monetary union are also absent in the European case. One of the major failings of the US system in the waves of banking crises after the Great Crash was the squabbling between the regional reserve banks about who was responsible for freeing up the money markets. The ECB's prompt action in last summer's crisis, while the bailout of German bank IKB was arranged by the Bundesbank, at local level, suggests, Eichengreen argues, that responsibilities are more clearly defined than they were in the US.

Finally, Eichengreen examines the case of the collapse of the currency union that prevailed throughout the Austro-Hungarian Empire in the wake of World War One. This example is often seen as evidence that exiting monetary union need not be economically devastating. Austria, Czechoslovakia and the other nations that emerged from the empire all managed to establish their own currencies.

But Eichengreen stresses that the costs of this process were actually very large: countries imposed draconian exchange controls to prevent mass capital flight, and suspended international trade and even cross-border travel to limit the funds leaving the country. Such an approach would hardly be politically acceptable today - and Eichengreen suggests that the Argentine government's bungled attempt to suspend parity with the dollar, in 2001, which resulted in bank runs, street riots, and the overthrow of a series of presidents, is more indicative of the problems of leaving a currency union.

Although there are lessons to be learned from many of these previous attempts at monetary union - some more successful and long-lasting than others - Eichengreen argues that EMU's peculiar conjunction of monetary union and financial integration, combined with a lack of political union, is uncharted territory, and it is a mistake to draw pat conclusions from these other experiences.

While it may be sui generis, however, the euro-area is not an island; and a separate CEPR paper suggests that the unique nature of the experiment should not preclude the ECB from taking more account of financial developments in the rest of the world when it sets interest rate policy.

Because of the considerable size of the euro area, the ECB's models treat it effectively as a closed economy, focusing on the forces within Europe, and ignoring the impact of shocks from outside. CEPR Researchers Carlo Favero and Francesco Giavazzi argue that this is a mistake.

Favero and Giavazzi use a Vector Auto Regression model to analyse what forces affect long-term euro-area bond yields - considered the best measure of the market's assessment of the inflation outlook. They find that almost all the movements in long yields can be predicted solely by US economic events. Domestic, Europe-based shocks seem to have almost no impact; and this is just as true after the beginning of EMU.

Policy-makers themselves also seem more responsive to US-based shocks than to domestic events, the authors suggest; but this is not reflected in ECB modelling.

They also investigate the relative importance of financial market shocks, such as shifts in asset prices and monetary policy shocks, caused by unexpected shifts in interest rate policy. The financial market events appear to have a much stronger impact, and the authors urge the ECB to take more account of these, too, in its modelling.

This pair of papers suggests that caution is due when analysing the euro-area, and the policies of the ECB. It is tempting for economists to reach for apparently similar historical experiences to explain why monetary union is destined for success or doomed to failure, depending on what example they choose. But Eichengreen's examination of potential precedents suggests that they all have critical shortcomings, and EMU is best seen as sui generis. However, Favero and Giavazzi's research suggests that it can be a mistake for euro policy-makers to be too solipsistic, and fail to appreciate the importance of events thousands of miles away for policy at home.

CEPR DP6442 Sui Generis EMU;
Barry Eichengreen
CEPR 6654 Should the Euro-Area Be Run as a Closed Economy?
Carlo Favero and Francesco Giavazzi