The authors argue that when thinking about the exchange rate policy for EMU, the first step must be to throw away the small-open economy spectacles. Past European experience will be largely irrelevant to the authorities of a large and relatively closed economic area. European policymakers thus have more to learn from the US experience than from any European country’s own recent history. EMU will be a relatively closed economic area. The incentive to learn from the United States is reinforced by the recent success of the US economy in achieving sustained growth with no inflation.

Because Europe will resemble the United States, the ECB will behave much more like the Fed, devoting far less attention to the exchange rate than has been the case with European central banks so far. A flexible and ad-hoc approach to exchange rate management is the only one that could be implemented

However, the authors warn that passive imitation of the United States could be misguided, though, because EMU will differ from the US in many important dimensions.

 

• Its monetary policy will be run by a new institution, endowed with a strong legal design, but which initially will not have a track record of its own.

 

• Contrary to the Fed which has developed a fairly good understanding of how the US economy works, the ECB will face substantial uncertainty, particularly in the way in which a common monetary policy will affect prices and output throughout the region.

 

• Although standard measures of openness suggest that EMU will be as closed as the US, the nature of exchanges in Europe is different from the US, particularly as trade with the countries in central and Eastern Europe expands.

 

• Fiscal policy in the EMU will be run by many independent governments, under the coordination mechanism provided by the Growth and Stability Pact.

 

• The ECB is likely to consider that it must take early action to establish a track record. It is thus widely expected that initially monetary policy will be tight, indeed tighter than normal, as the new central bank attempts to secure its reputation.

EMU-wide monetary aggregates will, at least initially, be quite unstable. The desirable monetary policy framework for the ECB is an inflation target operated via an interest rate instrument. An additional difficulty will initially arise from the possibility that the cross-country effects of a common monetary policy might be quite different, as a result of the differences that exist in financial structures and thus in the transmission channels of monetary policy from one EU state to another. It is important to understand that the introduction of a single currency will automatically produce more harmonization, and the extent to which this requires active policy decisions.

There are important differences with respect to the United States.

 

• Exchange rate fluctuations between the euro and other European currencies (pre-ins, and the currencies of countries that have not yet joined the EU) will continue to matter.

 

• Exchange rate fluctuations vis-a’-vis the countries in central and Eastern Europe will deserve new attention. These exchange rates will become increasingly important as trade relations between those countries and EMU grow, and change in nature (more intra-industry trade.)

 

• Fluctuations in the euro-dollar exchange rate will also affect some regions and industries more than other, inducing the risk of a call for protectionist measures.

Monetary policy discussions between Europe and the United States will only be serious in the presence of very large exchange rate misalignment – that is in the presence of fluctuations in the euro-dollar exchange rate that are large and persistent enough to threaten a trade war.

Therefore the only feasible exchange rate arrangements between EMU and the United States will be informal. This suggests that there will be a need for institutions that facilitate international dialogue and co-operation among different authorities on the two sides of the Atlantic.

There is a danger that Emu will disrupt the operation of the two most important among these institutions (the IMF and the G7) thus limiting the scope for international policy co-ordination. At this stage, only national governments have effective fiscal policy power, a situation that is likely to prevail for quite a while. This original set-up implies a two-level co-ordination problem: between the ECB and the governments taken together, and among governments. This analysis suggests two conclusions and one policy implication.

 

• The ECB will be less able to rely on its own rules and credibility to provide adequate discipline incentives to member governments than in the case of one central bank-one government. The result is an inefficient policy mix. The ECB may have to abandon its tendency to offset lax fiscal policies, with the result that inflation is higher than socially desirable.

 

• The lack of co-ordination among national fiscal authorities complicates the relationship between the ECB and its member governments. The policy implication is the emergence of a case for some constraint on national fiscal policies even if the credibility of the ECB is unquestioned.

One clear implication is that the Stability and Growth Pact should apply to cyclically-adjusted budgets, not to unadjusted budgets that are cyclically dependent. Although the Pact agreed at the Dublin Summit goes a small and ad hoc step in this direction, by itemising particular cyclical circumstances in which exemptions to normal rules would apply, in our judgement this it is a very incomplete solution. If the result were excessively tight fiscal policies, the Pact will put the ECB under pressure to opt for a tight fiscal-easy money policy mix. It will therefore impede rather than assist the ECB. Eventually, therefore, the Pact will have to be replaced by a more supple procedure which brings together the ECB and national governments.