Morgan Stanley's Eric Chaney examines EMU five years on. As he declares at the end, euro bull I was, and euro bull I remain - even if he does confess to being a disillusioned bull. Nevertheless his reflection involves some very interesting points. He does ask the question: "is the very structure of the monetary union so flawed that participating countries would be better off if they hadn't joined?" As he informs us this question "among others....was debated at the Euro-50 roundtable in Tokyo on June 12." Chaney is still convinced the EMU experiment had been a net plus, I am not so sure. One of the arguments presented, lower real interest rates, seems a lot less valid in a world were rates generally are declining towards zero. He does, however, set out some important objectives.
1. Lock-in exchange rates were not economically founded. The final exchange rates did not reflect economic fundamentals, in particular did not reflect the relative levels of unit labour costs. They resulted from a guessing game between markets and central banks, and were largely pre-determined by the central parities in the exchange-rate mechanism (ERM), themselves resulting from tortuous political negotiations. As a result, Portugal, the Netherlands and to a lesser extent, France, benefited from a competitive advantage. On the other hand, Germany entered into EMU with a large overvaluation of its real exchange rate. Coupled with wage rigidity, this is now creating serious deflationary pressures in the German economy. Initial conditions matter a lot. This is one of the painful lessons of EMU, which the UK seems to have well understood.
2. The mission of the European Central Bank was not enough specified in the Treaty. The EMU Treaty says that the ECB must deliver price stability and, provided that this target is achieved, must support the economic policy as it is decided by the Council of finance ministers. However, neither "price stability" nor “supporting economic policy” were precisely defined in the Treaty, which, by default, let the ECB have its own interpretation. In particular, an explicit inflation target should have been specified and its value open to revisions.
3. Without fiscal federalism, the lack of fiscal co-operation is deflationist. There are no fiscal stabilisers in the euro area and there will be no such thing in the foreseeable future, as long as federal taxes are not levied. Only domestic stabilisers can be used. The sharp rise of deficits in 2002 and 2003 is a good reminder of the importance of fiscal stabilisers. However, the Stability Pact does not allow countries to let stabilisers play neutrally. Hence, fiscal policies are becoming pro-cyclical, which, in current conditions means deflationist. Symmetrically, during the 1998-2000 boom, governments had no incentives to use the opportunity of the good years to cut their deficits more than cyclical factors implied. The Stability Pact should thus be re-negotiated and ideas such as creating market mechanisms to allow governments to trade "rights to run deficits" should be given a chance. A pre-requisite is that the finance ministers of the euro area must have an institution of their own.
4. Creating a single capital market is an urgent necessity. Whereas capital mobility is largely achieved, European companies cannot reap the full benefit of the monetary union as long as capital markets remain fragmented and divided by subtle regulatory differences. As long as currency risks were incentives to keep savings at home, capital markets could not be unified, despite the unification of most product markets. This restriction does not hold anymore and the obstacles to a single capital market should be ironed out as soon as possible. At stake is a lower cost of capital. With hindsight, I believe that monetary union and capital-market unification should have been implemented together.
Source: Morgan Stanley Global Economic Forum
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