Since the Delors Report was published in April 1989, a lively debate has ensued about the costs and benefits of economic and monetary union (EMU) in Europe. The EC Commission’s study on monetary union, “One Market, One Money,” which used stochastic simulations of the IMF’s MULTIMOD model to compare variability of output and inflation under different exchange rate arrangements, was sanguine about the favorable effects of monetary union. Their simulations suggested that although the European Monetary System (EMS) of the mid-1980s produced more output variability (but less inflation variability) than freely floating rates, the evolving EMS and, even more so, EMU would produce improvements in both output and inflation variability for the EMS countries taken together.
This study was, however, criticized by Patrick Minford and collaborators, who presented their own simulations of the operation of the EMS and of monetary union, using a different model, the Liverpool World Model. They concluded that EMU is unambiguously bad for the United Kingdom, and also bad for the other three major EC countries if the United Kingdom joins. Especially where the EMS countries pursue monetary targets (either independent targets, as under floating, or a joint target, as would be the case in EMU), floating dominates monetary union. They criticize the EMS even more strongly; it is destabilizing, and the system itself is subject to instability, which throws doubt on whether it can survive in its current form.
This paper attempts to understand the sharply contrasting conclusions of these two significant model simulation studies of monetary union. Its major conclusion is that the EMS seems to be much less of an engine of instability than is implied by the studies of Minford and associates. At the same time, the paper does not, on the basis of stochastic simulations that admittedly account for only a limited set of factors, find a strong case for EMU.
The differences in findings seem to relate to fairly arbitrary choices in modeling realignments and in estimating the size of risk premiums in foreign exchange markets. On the one hand, the treatment of realignments by Minford and associates appears to account for the instability in their results. The paper does not find their choice of the rule as a description of how the EMS actually operates to be particularly convincing. Moreover, the fact that the rest of the world seems to be equally, or even more severely, affected by the EMS than the member countries themselves throws doubt on their results. On the other hand, the EC Commission’s method of estimating risk premiums produces much larger gains from EMU than those obtained using other methods. It may well be, however, that existing econometric models are not well suited to capture the advantages of a common currency insofar as they do not capture the saving of transactions costs and the anti-inflationary discipline resulting from a multilateral central bank.