Europe’s (and to some extent Canada’s) model of regional response differs from that of the USA. Changes in regional real exchange rates are small in all countries. Outside of the USA, however, there is more reliance on inter-regional transfer payments, less on labour migration, and the pace of regional adjustment appears to be slower. If EMU aims at the same degree of economic and social cohesion that its constituent nationals enjoy today, this suggests that its members may find it hard to resist the eventual extension existing of EU mechanisms of income redistribution – a transfer union. The authors propose an alternative strategy based on a relaxed Stability and Growth Pact, further strictures against central EU borrowing, labour market and fiscal reform and the issuance of individual member states of debt indexed to nominal GDP.

The authors further argue that comparative analysis of North American and European currency unions yields several regularities and contrasts that might be useful in evaluating the future performance and evolution of EMU:

• Labour mobility is a weaker aid to regional adjustment in Europe than in the USA or even in Canada. The authors envisage a glacial pace of regional labour market adjustment accompanied by high and persistent regional employment differentials.
• Despite relatively low inter-regional labour mobility and despite the absence of independent macro policy options for substantial European regions, regional real exchange rate flexibility is not greater than in currency unions with higher labour mobility
• Fiscal transfers from booming to depressed regions, for both redistributive and stabilization purposes, play a significant role in all the currency unions the authors examined – although their role seems modest in the USA. Transfer flows and the economic shocks to which they respond appear to quite persistent, making it difficult to draw a sharp line between the long-run redistributive and short-run stabilizing roles of transfers. By providing long-lived fiscal inflows from the rest of the country, existing systems of fiscal federalism in Europe ensure that regions experiencing permanent negative idiosyncratic shocks will be relieved of some of the pressure to adjust.
• The authors also suggest four measures which might make EMU more attractive to its detractors:
• First, the authors suggest that the Stability and Growth Pact and the excessive deficits procedures should be relaxed as soon as possible after EMU starts. Since these provisions of the EMU constitution reduce local fiscal powers while providing no substitute at the centre, countries encountering deficit difficulties have a natural opening to press for a central fiscal institution. Greater fiscal latitude at the national level would equip countries only to cushion temporary asymmetric shocks, but that in itself would reduce the pressure for a European Transfer Union (ETU).
• Second, the EU’s total borrowing power could be limited – a guarantee against fiscal pulls on the centre, in the manner of Canada. If EMU member states can borrow, there is little justification for giving the European Investment Bank an expanded role.
• A third and very essential task is internal restructuring – including further reductions in the generosity of pension and other support programmes, lower taxes on employment, more hiring and firing flexibility, vigilant financial liberalization and housing market reform. Such measures would increase each member state’s capacity to adjust rapidly to shocks.
• Fourth, each individual national government could act as a capital market intermediary for its residents, making insurance payouts to them in the form of higher transfers or lower taxes. To accomplish this end, governments would issue perpetual euro-denominated liabilities indexed to domestic nominal per-capital GDP growth. The process would be invested in an international diversified portfolio of assets. In this way each government could lay off some of its GDP risk; its net cash flow would tend to go up when GDP growth was unexpectedly low, just as under an ETU. Permanent and transitory shocks alike could be handled. But no central EU institution is need to carry out the plan.

These alternative scenarios raise significant challenges for the European Union. EMU is about to be born, only because Europe has shown the creativity and determination to meet such challenges in the past. The same qualities will now be needed in abundance to make EMU work.

EMU: Prospects and Challenges for the Euro is a special issue of the review, Economic Policy: A European Forum. It contains revised versions of the papers presented to the Twenty-Sixth Economic Policy Panel Meeting held in Bonn on 17/18 October 1997, with the support of the Zentrum für Europäische Integrations-forschung. The Economic Policy Panel meets twice annually to discuss papers that are specially commissioned by the editors to provide timely and authoritative analyses of the choices confronting policy-makers. The articles use the best of modern economic analysis, but are easily accessible to a wide audience and highly readable. Each paper is discussed by a rotating Panel of distinguished economists whose comments are published to provide the reader with alternative interpretations of the evidence and a sense of the liveliness of the current debate.

Economic Policy is published in association with the European Economic Association for the Centre for Economic Policy Research, the Center for Economic Studies of the University of Munich and the Département et Laboratoire d’Economie Théorique et Appliquée (DELTA), in collaboration with the Maison des Sciences de l’Homme.

Maurice Obstfeld is the Class of 1958 Professor of Economics at the University of California, Berkeley. He is also a Research Fellow in CEPR’s International Macroeconomics programme. Giovanni Peri is a graduate of Università Bocconi and is based now at the University of California, Berkeley.