The third and final phase of European Economic and Monetary Union (EMU) was successfully launched on January 1, 1999, when the exchange rates of 11 participating countries were irrevocably locked, the European Central Bank (ECB) assumed responsibility for executing a unionwide monetary policy, and the euro was adopted as the common currency. Over a three-and-a half-year transition period, the euro will gradually replace national currencies, with the transformation scheduled to be complete by July 1, 2002, when the euro becomes the only legal tender for participating EMU countries. In a recent IMF Working Paper, Real Wage Rigidities, Fiscal Policies, and the Stability of EMU in the Transition Process, Norbert Berthold, Rainer Fehn, and Eric Thode, participants in the IMF Research Department’s Visiting Scholar program, suggest that political considerations dominated the design and launch of EMU. They argue that the failure to take economic considerations into sufficient account could have serious consequences for the stability of EMU, particularly during the unsettled transition period.
An inherent problem with EMU from its inception, the authors note, is that although it is a monetary union and its members constitute a currency area, it does not fit easily into the standard definition of an optimum currency area. A well-functioning monetary union is characterized by one or more of the following features: low incidence of asymmetric shocks, a highly mobile labor force, flexible real wages, and a system of fiscal federalism. Even with these features in place, there is no guarantee of permanent stability. This is probably the principal reason, the authors observe, that monetary unions not accompanied by political unification always remain somewhat unstable.
The 11 participating EMU countries have widely varying production structures, so sector-specific shocks are bound to affect each country differently. This is not at all surprising, the authors note, considering that the prospective boundaries of EMU stretch from the Mediterranean to the Arctic Circle. Furthermore, given that the capacity to adjust to adverse shocks also differs considerably among countries, even symmetric shocks can be expected to exert asymmetric effects on member countries. Given the current economic and structural diversity of prospective member countries, asymmetric shocks are still bound to occur from time to time. The transition phase, in which asymmetric shocks pose the greatest threat to the stability of EMU, will therefore be particularly fragile.
In principle, four channels are available through which countries can adjust to adverse shocks without raising unemployment: labor mobility, real-wage flexibility, monetary policy, and fiscal policy. The first of these, the authors note, is not an option for Europe; intercountry mobility is already low, and deeply entrenched cultural and language barriers will likely keep it so.
Real-wage flexibility, because it relies on market forces, seems to be the most desirable alternative to labor mobility. However, even though persistent unemployment has been an issue in Europe since the late 1980s, resistance to labor market reforms has been strong, and little progress has been made in reducing real-wage rigidities. The authors demonstrate that with current high levels of real-wage rigidities in Europe—coupled with the entrenched resistance to reform—real wages cannot be relied upon to absorb adverse shocks. It is therefore safe to assume that the current rigidity of European labor markets will persist during the transition phase.
Accommodative demand policies
In the absence of real-wage flexibility and high labor mobility, the pressure to use accommodative demand policies in the face of negative shocks is particularly marked. In a review of the experience of representative European countries from 1970 to 1995, the authors find that all countries surveyed used demand policies to some extent to counter the negative employment effects of adverse shocks. Monetary policy was the chief instrument until the 1980s and 1990s, when concerns about high and volatile inflation prompted a switch to fiscal policy.
In countries with high real-wage rigidity, the pressure to adopt a discretionary accommodative fiscal policy is particularly strong. Rigid real wages are an important cause of high unemployment, which needs to be financed. Moreover, an expansionary fiscal policy helps keep unemployment down, at least in the short run. But both channels lead to higher fiscal deficits and, during periods of very high unemployment, higher government debt.
Recourse to accommodative fiscal policy by EMU members may, however, be circumscribed by the Stability and Growth Pact. Signatories to the pact, which was adopted in July 1997, have committed themselves to attaining medium-term budgetary balance and to keeping the general government deficit below 3 percent of GDP. It has been argued that these restrictions on fiscal policy are necessary to prevent excessive levels of government debt from undermining monetary stability in EMU. Without such constraints, countries with high levels of government debt and unsustainable fiscal deficits could pressure the ECB to adopt a more lenient monetary policy, which would very likely trigger higher inflation.
Instability in transition
Currency risk between EMU participants presumably disappeared forever on January 1, 1999. This assumption, as embodied in the Maastricht Treaty, implies that none of the initial EMU members will withdraw and EMU will not only persevere but grow in time. However, because the issue of dealing with asymmetric shocks and the tensions between fiscally conservative and fiscally profligate members has not been adequately addressed, countries may regard the transition phase as a testing period and decide to abandon the system if the costs of staying in are too high.
For EMU members, monetary policy is no longer available as a policy instrument for adjusting to idiosyncratic shocks. Thus, the pressure to use expansionary fiscal policy will be greater than in the past, but the Stability and Growth Pact theoretically limits the use of expansionary fiscal policy at the national level. The authors question whether the pact will actually be able to restrain fiscal deficits, particularly since loopholes make it possible for countries to misbehave fiscally without being penalized. Large asymmetric shocks, which could well occur during the transition phase, could put the stability of EMU under severe strain, while conflicts between fiscally conservative and fiscally profligate EMU participants are bound to arise if the Stability and Growth Pact is not enforced. If, however, the pact is successful in limiting the use of national fiscal policy, rising unemployment in some countries could strengthen calls for a system of fiscal federalism to accompany the euro, even though such a system would impose a disproportionate burden on fiscally prudent members.
The experience of other monetary unions supports the suggestion that some form of fiscal federalism will evolve in the medium to long run, the authors observe, but such an elaborate system takes a long time to develop and would certainly not be available to EMU members during the transition period. Both fiscally conservative and fiscally profligate countries will then have to decide either to stay in EMU and accept the associated costs, which could include unsustainably high rates of unemployment, or to drop out.
Although currency risk within EMU is technically eliminated by the establishment of the euro as legal tender, the authors caution that an economic risk remains. In economics, “nothing is forever,” and history has demonstrated that there is no such thing as irrevocably fixed exchange rates. This is true not only for fixed exchange rate systems but also for monetary unions. Whether a country decides to stay in a monetary union or to leave depends on a cost-benefit analysis. The Maastricht Treaty has no provision for countries wishing to leave EMU, but a sovereign country can hardly be forced to stay in EMU against its will. A country wishing to withdraw unilaterally and reintroduce its national currency cannot reasonably be prevented from doing so. Such a pullout is more likely to happen during the transition phase, according to the authors, because it is much cheaper to reintroduce a national currency that is still in circulation as the only legal tender than to recreate a national currency from scratch.
When EMU officially came into existence, economic considerations based on concerns about fiscal policy in several member countries and the lack of labor market flexibility throughout Europe were brushed aside. The three-and-a-half-year transition period between the irrevocable locking of participants’ exchange rates and the replacement of national currencies with the euro as the only legal tender is therefore a crucial time for EMU, the authors observe. Large asymmetric shocks could pose a serious challenge to the union’s viability. Without real wage flexibility and an appropriate mechanism for dealing with asymmetric negative shocks—either at the country level or EMU-wide—speculative attacks against currencies in economic distress could cause the country concerned to leave the system if the costs of staying inside EMU become too large to bear.
Copies of IMF Working Paper 99/83, Real Wage Rigidities, Fiscal Policies, and the Stability of EMU in the Transition Process, by Norbert Berthold, Rainer Fehn, and Eric Thode, are available for $7.00 each from IMF Publication Services. See page 284 for ordering information.