What are the costs and benefits for individual European countries of moving to a monetary union? This is the question addressed by Jacques Mélitz and Axel Weber in recent work. They note that except for attempts to apply large scale macroeconomic models, previous research has primarily tried to distinguish between either common and idiosyncratic or symmetric and asymmetric shocks. Only idiosyncratic or asymmetric shocks imply any costs of monetary union.

But these efforts all leave open the fundamental question of whether these countries can at present use monetary policy to respond to idiosyncratic shocks. As Willem Buiter points out above, if monetary policy feeds directly into money wages and prices, then this policy cannot affect real variables, and no matter how large the idiosyncratic shocks may be, sacrificing monetary independence cannot cost much in terms of stabilization. Both very small and very open economies have little scope for using monetary policy to smooth the responses to any kinds of shocks.

By analysing the recent experiences of France and Germany and then comparing events in both countries with a hypothetical scenario in which one country sets joint monetary policy for the two of them or they both choose the policy together, Mélitz and Weber examine how each country would have fared if its monetary policy had been dictated partly or wholly by the other’s preferences and experience.

The pertinence of the exercise is clear: if differences between shocks and responses to shocks in France and Germany imply high welfare costs of pursuing an identical monetary policy, this should show up when either country is allowed to dictate monetary policy in the other.

Defining what constitutes an identical monetary policy in both countries is important. A common monetary policy is taken to mean two things: first, identical money supply shocks in both countries; and second, the disappearance of money supply shocks coming from the other country. Of course, the common supply shocks may be German ones, French ones or a mixture of the two, depending on complete German dominance, complete French dominance, or a joint influence over monetary policy in the two countries.

The researchers’ estimates confirm the consensus view that French decision-making would have caused monetary policy to be more unstable in Germany during the period from January 1977 to April 1990. At the same time, German decision-making would have caused tighter monetary policy in France. The estimates suggest that with France at the monetary controls, Germany would have experienced somewhat higher inflation and higher current account surpluses. If Germany had been at the helm, France would have experienced a more significant impact: less inflation, greater current account deficits and higher output.

The period preceding French adoption of the policy of the ‘franc fort’ weighs heavily in these results. The differences in outcomes following this change in French policy are less marked than those before the change.

Given the relative magnitudes of the changes over the entire sample, it can be inferred that Germany probably would have disliked the French policy choices, whereas France would have preferred the German ones. Such conclusions depend for the most part on conventional views about social preferences in the two countries.

They indicate that from the standpoint of the quality of policy decisions (based on national tastes), France has nothing to fear from monetary union with Germany, while the opposite is not evident. On these grounds, a Franco-German monetary union might require France to compensate Germany politically, for example, in the areas of foreign affairs and defence.

Mélitz and Weber’s final conclusion is that the pursuit of a joint monetary policy would have promoted monetary integration since there is a reduction in the variability of interest rate differentials between France and Germany in all of their examples of a common monetary policy. In addition, the presence of Germany at the controls produces greater narrowing of interest rate differentials and hence greater monetary integration.