The debate in Ireland on the proposals in the Maastricht Treaty pertaining to European Monetary Union compares unfavourably with that in the UK, although arguably this latter debate was driven by political rather than economic considerations. While an extensive literature exists on the area of optimum currency areas, monetary unions, and European Monetary Union in particular, the conclusions thereof have been neither aired in public debate nor incorporated into the policy prescriptions of the Government of Ireland. This is highly regrettable and may have seriously adverse consequences for the economy at a later stage.
This paper will canvass the hypothesis that monetary union poses a threat to the Irish economy. It will be argued that inadequate measures have been taken, or seem likely to be taken, to remedy this scenario and, as such, monetary union represents the assumption of substantial, and indeed unnecessary risk. The paper is organised as follows. Firstly I will outline the rationale for monetary union and consider the benefits thereof. It is acknowledged that the benefits of the elimination of transactions costs, peso premia and exchange rate uncertainty do represent compelling enticements, but, as will be shown, the costs associated must also be evaluated. The principal cost is the loss of the exchange rate as a tool of macroeconomic policy. The arguments relating to the substance of this loss will then be considered. A general discussion will follow.
In considering the transactions costs argument the Commission (1989) argues that the completion of a true single market as distinct from a free-trade area necessitates the removal of non-tariff barriers, as well as the introduction of a common currency, the latter amongst other considerations to eliminate the transactions cost advantage domestic producers would possess over foreign competitors. This cost argument goes deeper, however. The allocation of resources to foreign exchange constitutes a directly unproductive activity, and the elimination of such transactions costs liberates the resources employed to be productively used elsewhere in the economy. This cost includes not only the direct fees and commissions paid to financial institutions, but also the resources allocated by firms and households to foreign exchange management, treasury and accounting services in house costs. The Commission (1989) estimates that transactions costs amount to 0.5% of EU GDP and 1% of GDP for economies such as Ireland small and very open. Bean (1992) disputes these figures, however, arguing that the apparent implication that one in every two hundred people employed in the European Union is engaged in currency transactions is a figure lacking in credibility. Nonetheless the gains will exist however small they are.
The further principal gain to the EU from a monetary union is the elimination of exchange rate variability and uncertainty. Central to the issue of the elimination of variability is whether volatility and variability reflect deficiencies of the international monetary system or of domestic macroeconomic policies. Any attempt to buck the [efficient] market will deflate or inflate the economy with welfare-adverse consequences.
On the issue of uncertainty, however, it is possible, in a partial equilibrium framework, to make certain assertions. The assumption of risk as a normal good (de Grauwe (1988) demonstrates the necessity of this assumption) suggests that the elimination of uncertainty emanating from the foreign exchange markets will increase trade activity, although de Grauwe finds that this apparently is not a potent barrier to the growth of international trade. The International Monetary Fund (1984) similarly found no strong link between exchange rate volatility and the volume of international trade. Given that intra-EMS exchange rates are already stable the gains herein are unlikely to be vast. Nevertheless the Commission (1990) argues that foreign direct investment responds positively to exchange rate stability and exchange rate stability is highly valued by industrialists.
The introduction of the ECU will mean that equivalent securities become substitutes and so the law of one price will be obtained in securities markets throughout the EU. Thus debt will be raised at lower interest rates effectively a once-off and permanent easing of monetary policy. This represents a pure welfare gain, not a loss to savers, as an aspect of the risk securities carried previously has now been eliminated. This gain will accrue to all participants, save Germany and the Netherlands, who are not currently plagued with a peso premium, and will reduce the cost to the Irish Exchequer of funding the National Debt. Precise quantification of the principal gains outlined is necessarily difficult but it is clear that the benefits merit serious consideration.
Secondary benefits will also exist. Recent application of game theory to the area of monetary economics suggests that monetary union will, for nations such as Italy, Spain, the UK, Portugal and Greece, represent a mechanism to overcome domestic institutional difficulties in attaining, and maintaining, price stability, difficulties arising from time inconsistency. Essentially, commitments to low inflation lack credibility because of the benefits that arise from a surprise easing of monetary policy following the incorporation by agents of inflationary expectations into decision making (wage demands and expenditure plans). A surprise easing leading to inflation may reduce the real burden of debt on the public sector or lead to a substantial output effect. Thus, from the perspective of the government, the optimal degree of monetary tightness in period t (formation of expectations) is not optimal in period t+1 (nominal wages or interest rates fixed) because of these benefits. This time inconsistency in policy is discounted by the private sector, and an excessive rate of inflation will then prevail. A monetary union will circumvent this problem, as the independence of the European Central Bank from political considerations, coupled with its sole mandate of price stability, will give it the required credibility to deliver price stability. This argument will not apply directly to Ireland given that our Central Bank is already independent.
The question thus arises whether shocks which may pertain in the European Union may be characterised as symmetric or asymmetric. Tamim Bayoumi and Barry Eichengreen (1992) undertook a study of the symmetry or otherwise of economic shocks in Europe in the period 1962-1988 using a structural vector autoregression and argued that demand and supply shocks which drove output fluctuations in the proposed currency area are correlated significantly less with an anchor region (Germany) than are shocks in US regions correlated with the equivalent anchor in the case in the US the mid-Atlantic. Most alarmingly, Ireland was found to have negative correlation.
It may well be argued that some, perhaps much, of the pre-1979 negative correlation may be explained away by the pursuit of independent monetary policies by the UK during the period, which would be eliminated through a single monetary policy. Shocks arising from adverse exchange rate movements with trading partners will be eliminated to a degree at a European level. In addition the possibility of fiscal shocks will be curtailed through constraints on fiscal policies imposed by the Maastricht Treaty. Furthermore, it is argued by the Commission that EMU will deepen the process initiated by the 1992 programme intra rather than inter-industry trade lessening the possibility of product-specific shocks. Finally the absence of exchanges rates will eliminate the shock occurring when domestic interest rates surge in response to speculative selling of the Irish pound associated with a sudden depreciation of sterling in international foreign exchange markets.
Nonetheless, the problem of asymmetry will remain to a degree. Despite a federal fiscal system, which served to transmit to an extent, shocks across regions significant asymmetry within the US was found to prevail in the Bayoumi and Eichengreen study. Such asymmetrical shocks may require relative price adjustment a change in the price of tradeables relative to non-tradeables, and internal resource allocation between the traded and non-traded goods sectors adjustment which cannot take place through exchange rate policy but ruled out by monetary union.
The possibility, or even probability, of asymmetric shocks in itself is insufficient reason to jettison proposals for a monetary union. Further necessary conditions will be outlined. Robert Mundell (1961) considered the case of two nations (the analysis applies similarly to regions within nations) A and B, and allowed an asymmetric shock there occurs an exogenous shift in demand away from the production of country B to the production of country A. Further assume a monetary union and sticky nominal wages/prices. Denied the possibility of exchange rate adjustment, the consequent inflation in country A and unemployment in country B can be alleviated by a sufficient movement of labour from B to A. The balance of payments dis-equilibrium will also be eliminated if income levels and expenditure patterns across the area are homogeneous. Thus Mundell argued that the region and not the nation defined the optimum currency area, the region possessing internal factor mobility and external factor immobility.
Thus sufficient internal labour mobility constitutes, in theory, an alternative to exchange rate adjustment in the event of an adverse shock. Yet the European Union is characterised in general by labour immobility, arising from linguistic, cultural and even race barriers: It has been recognised that large scale labour mobility in the Community is neither feasible, at least not across language barriers, nor perhaps desirable. Meade (1957) condemned the idea of a single currency in Europe for this reason. Exceptions to this immobility within Europe do exist, perhaps most notably the labour mobility between Ireland and the UK, mobility which will provide some mechanism for adjustment for Ireland in the event of an adverse shock. Given the apparent absence of labour mobility a further alternative mechanism of adjustment is a federal fiscal system which will act as a stabiliser.
But, where labour is immobile or emigration is not considered a socially acceptable solution, an alternative mechanism of adjustment is a federal fixed system which would act as a stabiliser. In the event of a fall in activity, less is paid in taxation by the region to central government and more received in transfers. The result is that for a $1 fall in output in the USA, taxes paid fall by 30 cents and transfers rise by 10 cents, hence, disposable income might only fall by 60 cents. In the European Union the budget of the Commission amounts to less than 1.5% of EU GDP, the spending of which is predetermined, and so this mechanism of adjustment also is denied. Furthermore the fiscal constraints in the Maastricht Treaty will limit the scope of domestic fiscal policy to offset shocks leading to questions as to whether the fiscal criteria are excessively tight. A further alternative to exchange rate adjustment occurs when sufficient wage/price flexibility pertains in the domestic economy so that real relative prices can adjust to a shock without a painful and prolonged deflation. It was readily apparent in the currency crisis of 1992-93 that such flexibility was sorely absent in the Irish economy. Indeed, Doyle (1993) argues that the economy is characterised by excessive rigidity not flexibility and so the scope for price adjustment to adverse shocks is virtually non-existent: The economy as a whole is resistant to change... One only has to think of recent examples of refusal to change what are euphemistically described as working practices, and so on, to realise how unresponsive the economy has become. This is an ominous contention given the commitment to EMU where responsiveness and flexibility will prove critical in the absence of alternative mechanisms of adjustment.
The Commission, however, argues that exchange rate adjustment will provide only short term relief and that real exchange rates can still adjust. The example of real exchange rate fluctuations in Canada is cited as an example. Honahan (1993) also subscribes to this view arguing that real wage rigidity can lead the benefits of exchange rate adjustment to be overstated. However such short term adjustments may be desirable, even necessary, especially if hysteresis effects prevent the economy moving back to its previous equilibrium after the (temporary) shock has subsided. In addition, while empirical evidence in Europe points to real rather than nominal wage rigidity, this effect may be asymmetric nominal wages will rise rapidly in response to inflation, but will workers accept nominal wage cuts in response to disinflation? The example of the sterling appreciation of 1981 and the devastation wrought on the UKs manufacturing base is powerful example of the effect of a temporary shock which will not be reversed when the source of the shock dissipates.
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