EMU is an event, whereby national currencies are abolished and replaced by a single European currency. This happening is comparable to a transition in two steps. In the first step exchange rates between national currencies are irrevocably fixed while different currency denominations are abolished in the second step. Economically, the first step is decisive. By fixing exchange rates irrevocably the currencies involved change character. They become perfect substitutes. The second step has no economic significance. It is a matter of denomination of objects. After having created perfect
substitutes out of diverse objects in the first step there remains no justification for calling one and the same thing by different names. Why should we use different names for one and the same thing? Names are noise and smoke as Goethe said. And we can still learn from Goethe.

    But this is not all. There is a further change involved. EMU replaces also the national, mutually independent central banks by a single European one that will be in charge for all member countries. The current national central banks will become executive outlets of the new European central bank.

    By the transition from the national currencies to the European currency the monetary assets do not loose value. They are just renamed. The same happens with prices and values. By this transition nobody looses or gains. The monetary union is not a currecny reform.

    In the transition to EMU it is not a currency that has lost its reputation by high inflation rates that is being replaced by a new currency for which a promise of stability is given. On the contrary, several currencies all of comparable stability are replaced by a unified and stable currency. (Opponents of EMU and pessimists probably would formulate it differently: They would say with respect to the FRG, that the introduction of EMU is upsetting the conventional notion of currency reforms. While in a conventional currency reform an unstable currency is replaced by a stable one, with the introduction of EMU a
stable currency is replaced by an unstable one. I do not see it like that, which is to say that I am a supporter of EMU and that I am an optimist.)

    In a conventional currency reform an unstable currency is replaced by a stable one while by the transition to EMU a series of currencies with similar stability properties is replaced by a unique stable currency. This immediately leads to the question: "What is this excercise good for"?

    I want to start by showing that the transition to EMU is a solution to a fundamental problem. Then I want to show that there exist other solutions for the problem. Then I want to ask the question: what are the benefits and the costs of the chosen solution in comparison with other solutions.

2. A fundamental problem
 

I start from the assumption that there are three desirable elements for the international monetary order:

    1.    fixed exchange rates;

    2.    free movements of capital;

    3.    an independent monetary policy.
 

    Why are these elements desirable?

    With  fixed exchange rates  the risks of exchange rates are excluded. With flexible exchange rates the actual exchange rates can follow a course that is completely unexpected. That is an economic danger for those sectors of the economy which export and import. Fixed exchange rate are therefore preferred by the producers and the consumers of an economy.

    Free capital movements permit the markets, to direct the economic ressources into their optimal uses. Therefore, the common market in Europe provides for free movements of capital. The Single European Act prohibits restrictions also of short run capital movements.
 
    With an independent national monetary policy each country can choose the inflation rate that suits its preferences. The Germans can decide for a zero-inflation rate and Italy can try to tax the money holdings of the Mafia and the profits of its underground economy by a positive inflation rate.

    Yes, you have correctly understood. An essential property of an inflation is that it has effects like a tax on money holdings. And as long as someone holds money stocks he is subject to the tax of a positive rate of inflation. The tax load consists in the loss of value of the money stocks subject to inflation. The tax load corresponds to the algebraic product of the inflation rate and the money holdings. The inflation rate is the tax rate. The money holdings are the tax basis. The socalled flight into real assets that is observable during a lasting inflation is nothing else than a kind of flight for tax evasion.

    Let me add something: Someone who holds the opinion that we should have a zero inflation rate in Europe also holds the opinion that the Mafia and the underground economy in general should get away tax free.

    Now, where is the problem which I mentioned? The problem consists in that the three desirable goals cannot be realized simultaneously. They are mutually exclusive. This is so not only on the theoretical-logical level but also in the range of historical experiences.

    The Bretton-Woods System, which is the International Monetary System that was established after the Second World War, has failed for this problem. In the beginning of the Bretton-Woods System capital had limited mobility. The unsurmountable problems began when the restrictions on capital movements were abolished. The problems were eliminated in 1973 when Germany and other countries violated international obligations and treaties by switching to flexible exchange rates.

    A further historical example is the EMS. The EMS functioned quite well as long as capital movements between European countries were controlled and limited. In the course of realizing the Internal Market Programme (Single Market Programme) the existing capital movements were abolished by 1990 and it took only two years until the first serious problems arose within the EMS and it took only another year until the EMS broke down in 1993 by a transition to flexible exchange rates. (I consider the six- to seven-fold multiplication of the band width from +/--2,25% to +/--15% practically as a transition to flexible exchange rates and the transition to flexible exchange rates as a breakdown of the EMS.)

    As these examples show the question of the conistency of the above list of desirable properties is not a matter of academic beauty but a question of avoiding real economic catastrophes.

Catastrophes will occur inevitably if one is ready to assume an inconsistent system and is forced after a certain lapse of time to change the system by eliminating one of the inconsistent elements. In the Bretton-Woods-System and in the EMS it were the fixed exchange rates that were eliminated.

    Now, the EMU can be interpreted as an undertaking by which the consistency of the elements of the system is provided not by eliminating the fixed exchange rates but by eliminating the national independent monetary policies. If seen in this manner, the EMS is a special solution of the problem.

    Of course, on purely logical grounds there is the possibility to solve the problem by eliminating the freedom of capital movements. However, that would be inconsistent with the goal of the common market and would have to be rejected by reasons of economic efficieny.

    Therefore one basically has the choice between three alternatives:

    1.  Restrictions on capital movements and elimination of the concept of a common market.

    2. Transition to flexible exchange rates, i.e. elimination of fixed exchange rates.

    3. Abolishing independent national monetary policies and transition to a coodinated monetary policy.

 
    If one favours EMU one opts for a coodinated monetary policy, i.e. for the third alternative and is implicitly refuting the two other alternatives.

    Not even the opponents of EMU would like to give up the common market and the freedom of capital movements. Because if one is giving up the freedom of capital movements then trade in goods will fall back to the level of inefficient bilaterality or to bureaucratic rule. And in the realm of portfolio- and direct investments the arbitrariness of bureaucrats would replace the market functions.

    The only alternative that remains, is the one between flexible exchange rates on one side and the coordinated monetary policy with fixed exchange rates, i.e. EMU, on the other side.

    The decision for or against EMU can be formulated as one of weighing the costs against its benefits. The costs of EMU are the benefits of flexible exchange rates. The benefits of EMU are the disadvantages of flexible exchange rates and the benefits of monetary cooperation.

 
3.1 Advantages

Flexible exchange rates provide the following advantages:

    1. They permit choosing one's own inflation rate;

    2. They provide an adjustment mechanism for asymmetric real shocks;

    3.  They hinder the international transfer of monetary shocks;

    4.  They weaken the international transfer of real shocks.
 

 
3.2 Choice of one's own inflation rate

  The main advantage of flexible exchange rates consists in that a country with independent monetary policy can choose its own inflation rate, which is an important rate of taxation, independently of the inflation rate of the other countries. This opportunity of choice will no longer exist in EMU. The inflation rate of EMU will be the result of decicions of the ECB council. In this council, the FRG will be adequately represented but not dominating. But nobody can say with certainty that the inflation rate, that is going to be targeted by this board, will be significantly higher than the one we had in the FRG. There are also no hints as to whether the inflation rate is likely to be higher than it was in the past of the FRG.

    Here, it is hardly possible to refer to the past. After all, in most countries (e.g. in France, England, and Italy a.o.) the central bank used to be dependent on the state. If, according to the respective laws of their states, the former board of governors of these central banks had to support their governments in the financing of their budgets, then this does not mean that in the future, under now independent central banks, they will support an unstable European currency. On the contrary, the members of the board of governors of the future European central bank will develop a professional ambition to reach price stability for the whole of Europe and will abstain from bargaining in favor of special national interests.

In addition, flexible echange rates offer an adjustment mechanism for asymmetric real shocks. If the demand turns away from German products (e.g. of Audis) and towards French products (e.g. Renaults), then the employment in the FRG will threaten to diminish at Audi and in France there is the chance of additional jobs at Renault. The employment problem created by this change would be easily resolved if the workers layed off at Audi would migrate to Renault and would get the jobs created at Renault. Unfortunately, this kind of solution is difficult to handle in practice. Of course, language problems are one reason. But also numerous other factors hinder the mobility of workers. Neither last nor
least, there are the benefits of the welfare state standing in the way of an increase in labour mobility. State subsidies for home buildings are an example.

    Now, the flexibility of exchange rates could compensate for the lack of mobility of the labour force. In the present example, a devaluation of the DM against the French Franc could, firstly, weaken the shift of demand from Audis to Renaults and could, secondly, induce a shift in demand in favour of German products. As a consequence, the workers at Audi could perhaps not stay in the car industry but at least remain in Germany.
 
    The extent to which the employment stabilizing effects of flexible exchange rates really occur depends in a decisive manner on the degree to which nominal exchange rate changes also become real exchange rate changes. This will be less and less the case the more internationally intertwined an economy is, in other words, the more open an economy is, and the more, therefore, the labour unions will take into account the prices of imported goods into their wage demands.

    Some opponents of EMU consider the loss of this adjustment mechanism as the major argument against EMU. I myself do not consider this loss to be so dramatic for the following reasons:
 

    Changes in nominal exchange rates are an instrument, the effectiveness of which depends on market imperfections. As a market imperfection in this sense I consider the unequal speed of adjustment of goods market and labour market prices in comparison with prices on the markets for money, capital and foreign exchange. Due to these market imperfections, a nominal exchange rate change becomes also a real exchange rate. But this it does only temporarily.

    Because of the merely temporary nature of their effects, nominal exchange rate changes only grant a postponement for other necessary adjustments. Changes of nominal exchange rates are no final solution of the problems, they produce merely a gain in time for the final solutions. Postponement is not abolishment.

Flexible exchange rates avoid that changes in the quantity of money (monetary base) are transferred as such from one country to another one. In this sense, flexible exchange rates are closing an economy.

    Flexible exchange rates can also contribute in another sense to avoid the international transfer of (asymmetric) monetary shocks. If in a country, on account of a monetary shock, all prices change to the same relative degree while the nominal exchange rate remains constant then a change of the real exchange rate takes place with real consequences for the international trade of goods, employment, and GNP, both domestically and abroad. With flexible exchange rates, the international transfer of the monetary impulse can be weakened and in the extreme case even be avoided. A necessary condition for the extreme case is that wages, goods prices and exchange rates are not only flexible but are even flexible to the same relative degree. If in this respect there are market imperfections then flexible exchange rates do not perform this shoring up function. In the real world this commensurate flexibility is not present, at least not in the short run.

    The transfer of real shocks is also weakened by flexible exchange rates. Therefore flexible exchange rates are closing an economy on the money side and are functioning as a shock absorber.

    Consequently, we see that flexible exchange rates are an adjustment mechanism in case of real disturbances of an economy, and they can reduce and weaken the international transfer of monetary and real disturbances, even though they cannot avoid their transfer completely.

Flexible exchange rates have the following disadvantages:

    1. They cause useless transaction costs.

    2.  They produce avoidable risks.

    3.  They reduce transparency on goods markets.

    4.  They produce unnecessary adjustment burdens and adjustment pressures.

    5.  They incite non-cooperative behaviour (beggar-my-neighbour policy).
 

 
4.1 Transaction costs

Today, the exchange of one currency into another one is costly. One has to pay fees to banks and exchange booths. For an exchange of a hundred-DM bill into 10 ten-DM bills banks normally do not charge a fee. The economic reason for this difference is the basic flexibility of the exchange rate between he different currencies. Within a currency, we have unalterable fixity of exchange rates. Here, the principle, DM equals DM, holds. This principle will also hold for the EURO.

    The exchange fees or transaction costs are an outright loss for an economy. The resources that banks apply for the exchange of currencies could be applied more usefully in other areas. There are diverse estimates of the volume of transactions costs. The estimates of the Commission in Brussels are rather conservative. The Commission speaks of 0,4 % of GDP of the EU, annually. (Some people would call this peanuts.)

 
4.2 Exchange rate risks

    Flexible or non-flexible exchane rates cause risks in international trade and international investments. Only part of these risks can be eliminated, without further problems, by the use of certain hedging instruments of the markets for money and foreign exchange.

    Problems of hedging occur above all in the area of production with a long production period (e.g. in ship-building and in the aerospace industries) and in the realm of direct investments. Of course, one can also do hedging for direct investments, by establishing a seperate production unit in each currency area. It is obvious that in this way the advantages of mass production, the economies of scale, get lost. Though hedging appears as possible, it is very costly and therefore forbidding.

    By means of exchange rates that are really fixed, as they will be in EMU, these risks are abolished.

    In the discussion about exchange rate risks often the point is being made that the empirical evidence for the negative effects of exchange rate risks on the volume of international trade and international investments is not unequivocal. The difficulties are well known. Econometric analyses suffer from the simplifying identification of exchange rate variability and exchange rate uncertainty. But, basically, these are separate issues that need not be correlated.

    During a period of empirical observations, the exchange rate of a country may have been fixed, i.e. without any visible change, and in spite of that there may have been high uncertainty about the future value of the exchange rate. As long as variability of the exchange rate and uncertainty of the exchange rate are not measured seperately, such investigations are not convincing. On the other hand, opionion polls tend to confirm the aversion of the entrepreneurs and investors against exchange rate risks.

    Furthermore, in the discussion about exchange rate risks one encounters the argument, that by fixed exchange rates the risks of an economy that are visible as exchange rate risks cannot really be eliminated but can only be transferred to another area of the economy. The idea behind this position is that in each economy there is an unavoidable volume of risk that cannot be altered by the choice of a system of exchange rates. By a decision about the system of exchange rates one only determines where in an economy the risks show up and become visible.

    According to this view, the exchange risks do not really disappear by a transition to fixed exchange rates but resurface in another form, e.g. as higher interest rate risks.

    I do not share this view. I think this is a purely speculative position. There are no empirical investigations that support this view.

    However, there are empircal investigations that show that in the case of EMU the transition to fixed exchange rates destroys risks. I myself have found that the European money demand function, due to a portfolio diversification effect, becomes significantly more stable than the money demand function of the country with the most stable money demand function. Holland and Germany are among the countries with the most stable money demand functions. The European money demand function will therefore be more stable than the German money demand function.

    The higher stability of the money demand function may be interpreted as a destruction of risk by risk pooling. Such a pooling is possible by having a fixed exchange rate, i.e. due to the common currency. It is not possible with flexible exchange rates. Flexible exchange rates prohibit a monetary pooling of risks.

    A stable money demand function was and is an important premise for the monetary policy strategy of the Deutsche Bundesbank. This premise will also be fulfilled for Europe. In addition, the higher stability of the European money demand function provides the possibility to obtain in Europe lower inflation rates with a higher degree of reliability than they could have been reached in the FRG by the Bundesbank. Whether this possibility is really exploited or not depends on the actual behaviour and the monetary policy strategy of the future European central bank. Here, the respective decisions have not yet been made. The council of the EMI (European Monetary Instritute) has handed the hot potato of determining the monetary policy strategy to the Council of the future European Central Bank. (Intermediary target strategy with the quantitiy of money as an intermediary target; final target strategy with the rate of inflation or the level of prices as the final target. Conflict between the British and the German position.) With the decision of Great Britain not to join EMU right from the beginning the chances have risen that the German position will have the upper hand in these matters.

    At any rate, there exist stabilization potentials in EMU that were not available before.

    Flexible exchange rates, i.e. the existence of diverse currencies under exchange rates that are not fixed, provide for segmented goods markets and create opportunities for welfare reducing price discrimination by goods producers and dealers. Exploiting these opportunities implies that e.g. car prices for identical models in the various countries vary more than can be explained by transport costs between the geographical points of comparison. The transition to a common currency eliminates the market segmentations as far as they are conditioned by exchange rates and it will reduce the volume of price discrimination. This will increase efficiency and lead to a gain in consumer rents.

A main disadvantage of flexible exchange rates is the peculiarity that partial disturbances are transformed into disturbances for the whole economy. Firms that are internationally competitive are obstructed by an appreciation of the exchange rate that was not caused by them. Firms that lack international competitiveness will be hindered by such appreciations in their efforts to adjust. Similar statements hold for devaluations. Changes of the exchange rate have general effects and require adjustments also in such sectors and with such firms where no reason for such an adjustment exists. Appreciations and devaluations work in a non-discriminate fashion.

Devaluations, in order to raise the competitiveness of the export industry, are typical measures of adjustment according to the principle of St. Florian. By devaluations unemployment is exported aboad. Such devaluations are an expression of non-cooperative behaviour and run the risk of retaliation by the foreign countries. The experiences of the great depression in the thirties shows that there can be races for devaluation at the end of which all the participants find themselves in the same position from which they started.

    For these reasons devaluations were frowned upon in the Bretton-Woods System and in the EMS the one-sidedness of devaluations was eliminated and replaced by a voting mechanism that required unanimity.

    I do not want to doubt that there are situations in which the European countries, could agree without antagonism and unanimously on necessary devaluations.

    The fact that in the EMS devaluations were only sparsely used has perhaps been misunderstood. Probably, it was less an expression for the absence of a need for adjustment that could have been satisfied via devaluations but more a consequence of anticipated problems in finding a consensus in a club that requires unanimity.

    When, after the deregulation of capital movements, the possibility was created, the market enforced in 1992 and 1993 the necessary and hitherto suppressed exchange rate adjustments. That there existed a need for such adjustments is obvious from the diverse monetary developments (price level developments) observable in the EMS countries.

It should be noted that this kind of adjustment need that required parity changes on account of divergent monetary policies in the EMS countries will no longer exist in EMU.

    In EMU, there will be a unique monetary policy, i.e. the monetary policies of Europe will assume a cooperative character. The monetary developments in the member countries cannot lead anymore to tensions that, in the EMS, could and had to be eliminated by changes in the exchange rates. In EMU, there will be a unique trend inflation rate.

    Of course, the advantages of monetary cooperation can also be obtained by an asymmetric organization of monetary policies. If one country is the (Stackelberg) leader of monetary policy and all other countries are followers then a system without conflicts may arise. Up to a certain degree the EMS has functioned in such a way. Germany was the Stackelberg leader of monetary policy. However, if one counry did not behave as required by its role as a Stackelberg-follower the country ran into balance of payments problems. The asymmetry of the Stackelberg-leader-follower solution cannot be imposed on the other countries permanently. Because, to be a follower means to abstain from excercising a sovereign monetary policy without sharing in the monetary policy decision. This will be different in EMU. Here, the individual countries will lose their autonomy in matters of monetary policy, however, they participate in the cooperative process of decision making of monetary policy. The politically unacceptable asymmetry of the Stackelberg-solution is avoided.

As you can see, based on historical observations, empirical investigations and theoretical arguments I have drawn a picture of the exchange rate mechanism in which the effects of changes of exchange rates on balance have to be judged ambivalently. Flexible exchange rates are and remain a problematic instrument for adjustments of the real economy. In the monetary area of an economy, adjustments of exchange rates are indispensable for independent national monetary policies under free capital movements. But, they can be dispensed with if monetary policy is cooperative i.e. uniform as in EMU.

    However, I do not want to exclude that, in future EMU, there may exist situations or conditions under which exchange rates might be applied in an undoubtedly meaningful way to ease real adjustments. Such conditions are not given by asymmetric shocks as usually defined but by asymmetries of a kind where differences in the cyclical position of the counries occur (asynchronous business cycles). If, e.g. one can divide the European countries in two groups such that in one group we have a boom while there is a recession in the other group then a revaluation in the boom countries can stop the cyclical overheating there and stimulate the recession countries by the associated devaluation.

    In such a case the feature that the real effects of nominal exchange rate changes are not permanent but exist only transitorily would not be a disadvantage since, by definition, booms and recessions are merely transitory phenomena, that may be dampened by exchange rate changes. The delay in the effects of exchange rate changes mentioned already would remain a disadvantage. And the problem of the proper choice of the dosis under uncertainty would continue to exist.

    But as soon as a grouping of the countries into two asymmetric business cycle camps is not feasible then there will be third country effects that put the advantages of the exchange rate instrument again into question.

    Since, in this argument, the assumed asymmetries between the countries are referring to the cyclical situation of entire economies, the unnecessary adjustments which were described above are significantly reduced. However, those problems would resurface if the cycles within the individual countries were split and would not evolve homogeneously but heterogeneously.

The EMU is a method of constructing a consistent, contradiction-free monetary order in Europe. The only feasible alternative under free movements of capital are flexible exchange rates, i.e. the system that we currently have.

    The transition to EMU is combined with benefits and costs:

    1. The abolishment of intra-european currency crises as a consequence of independent national monetary policies     under high capital mobility.

    2.  A reduction of monetary risks by the pooling of risks and an increase of the potential for stability within Europe.

    3.  A reduction of transactions costs and, as a consequence, an improvement of the resource allocation.

    4.  The avoidance of unnecessary adjustment burdens in the real economy.

    5.  The elimination of beggar-my-neighbour-policies by the choice of exchange rates.

    6.  The abolishment of market segmentation due to exchange rates, an increase in market transparency and a reduction of price discriminations.
 
 

    1.  In the FRG, we cannot choose anymore an inflation rate independently of the other countries.

    2.  The exchange rate instrument is lost as an adjustment mechanism. On one side, this loss is justified by the fact that the need for exchange rate adjustments will disappear due to the unified monetary policy in EMU. On the other side, for the real economy only a knife with two cutting edges gets lost which in addition is not permamently but only transitorily effective.
 

In my calculation the benefits outweigh the costs. Therefore, I am in favour of EMU and I thank you for your attention.

For further articles on EMU click here to go to the author's webpage

Prof. Dr. Nikolaus K.A. Läufer, Universität Konstanz
Mon May 18 14:55:30 MET 1998