Lorenzo Bini Smaghi
Monetary stability and economic stability can be seen as two sides of the same coin. Periods of protracted economic instability tend also to be periods of monetary instability, and vice-versa. Although the main objective of society is economic stability, in particular in the form of sustainable growth, policy-makers attach great importance to monetary stability, insofar as it is instrumental to achieving economic stability. If the economy could grow at a stable and sustainable rate even in conditions of monetary instability, the latter would cause no great concern. Since, on the contrary, monetary instability produces undesired effects on economic activity ("money is a veil, but when the veil flutters the economy sputters"), the authorities are highly concerned about the former.
Monetary stability can be defined in terms of the stability of the value of money, which can be measured in terms of: i) its domestic purchasing power (the price level); ii) the opportunity cost with respect to amounts of money available in the future (the interest rate); and iii) its relative value with respect to other currencies (the exchange rate).
It is beyond the scope of this note to examine how these three prices
are determined in the goods and financial markets. The focus, instead,
will be on the two questions of greatest interest for policy-makers, especially
in the light of recent developments in the process of European economic
and monetary integration. First, what is the impact of monetary instability
on economic activity? Secondly, how can monetary instability be countered?
2. THE EFFECTS OF MONETARY INSTABILITY
The impact of monetary instability can be assessed on the basis of the three criteria mentioned above, the price level, the interest rate and the exchange rate. I will devote only a few words to the first two.
It is now widely agreed among academics and policy-makers that price stability is an important condition for sustainable growth. Unexpected inflation may stimulate economic activity in the short run; however, the effect is temporary and in the longer run the economy is faced with a higher level of inflation but no permanent gains in terms of production or employment. Moreover, when inflation is high, it tends to be more variable and hence more difficult to predict; it also distorts relative prices and therefore undermines the allocation of resources and the productive potential of the economy.
Another condition for sustainable growth is that economic agents be confident of the continuance of monetary stability. This requires that the purchasing power of money be maintained and that money continue to perform its main functions through time. This translates into low and stable interest rates, which is an important factor for stimulating investment and capital accumulation and facilitating savings decisions and portfolio allocation.
Turning now to the third criterion, exchange rate stability can be defined in nominal or in real terms, i.e. with respect to the rate of exchange between two currencies or their relative purchasing power. When examining the impact on economic activity, it is the latter definition which matters, while the former is relevant only to the extent that it affects the latter.
The effect of real exchange rate instability on economic activity depends on the degree of openness of an economy. This needs to be measured in terms not only of the country's trade in goods and services with the rest of the world but also of its ability to influence relative prices. For instance, the absence or removal of tariffs or other types of barrier that can affect the relative prices of traded goods makes an economy more open and therefore more sensitive to exchange rate changes.
The countries of the European Union (EU) are fairly open between themselves. On average, over 50 per cent of each country's trade is with the rest of the area. Within the EU, countries have agreed to eliminate tariffs and other internal barriers and to adopt a common external trade and commercial policy. The creation of the internal market implies a further opening of the member states' economies. Indeed, the main principle underlying the internal market is that there should be no discrimination between economic transactions between residents of two different countries and similar transactions between two residents of the same country.
In an integrated environment such as the Community, real exchange rate instability between European Union currencies produces at least three undesired effects.
First, it alters relative prices, giving rise to resource misallocations and trade distortions both within countries, between the sectors that are exposed to external competition and those that are not, and between countries. It modifies the competitive advantage of producers located in different countries, independently of their productivity and the quality of their products. It therefore breaches the main principle of the internal market mentioned above. Even temporary real exchange rate instability may produce permanent effects on trade in view of the fixed costs incurred by firms when entering markets.1 Furthermore, exchange rate uncertainty tends to increase the costs incurred by firms in trading and hedging decisions. Transaction costs in retail currency exchange tend to be even greater.
Empirical evidence on the effects of short term exchange rate variability on trade is scarce. This is evidence of the methodological difficulty of examining this issue econometrically more than proof of the absence of a relationship2.. Besides, trade and investment decisions are not so much affected by the short-term variability of exchange rates as by the longer-lasting fluctuations. There is ample evidence that exchange rate variations produce substantial effects on export and import volumes and prices. When such variations are wider than what is justified by countries' underlying economic fundamentals trade flows tend to be seriously distorted.
In the second place, exchange rate misalignments tend to undermine policy co-operation. Countries that feel damaged by exchange rate misalignments may resort to retaliation in the form of competitive counter-devaluations or other disguised measures aimed at discouraging foreign competition. Furthermore, exchange rate instability hampers the conduct of common policies, especially in the Community. In the case of the common agricultural policy, the distortions produced by exchange rate changes are obvious in view of the difficulty of adjusting agricultural prices to keep up with exchange rate changes and avoid opportunities for speculative trades.3 But exchange rate fluctuations also create problems for the conduct of a common policy in other fields of EU competence, such as competition, industry, regional aid, etc. Even the instability of a few currencies can jeopardize the whole cooperation framework. For instance, the September 1992 devaluations undoubtedly affected the exchange rate stability of the other ERM currencies in the following months and undermined the credibility of policy coordination.
Finally, exchange rate instability has consequences for the other two measures of monetary stability. For smaller countries, in particular, exchange rate variations create problems for the achievement of price stability. The openness of the economy means that changes in the prices of traded goods tend to spill-over on to those of domestic goods, hampering inflation control. This explains why most small countries conduct their monetary policies on the basis of an exchange rate target.
In summary, exchange rate instability within the EU
is hardly compatible with the survival of the internal market and the pursuit
of monetary stability in the whole area.4
3. Pursuing monetary stability in the European Union
The search for monetary stability has been a constant reference point in the European integration process.
Exchange rate stability was not a major issue at the inception of the EEC as member states' currencies were linked through the Bretton Woods system. After its breakdown, attempts to maintain stable exchange rates were pursued through the Snake, without much success. With the establishment of the EMS in 1979, the aim of creating an area of monetary stability was made explicit. With the Maastricht Treaty, a clear project has been designed, with monetary stability as one of the cornerstones.
The conditions for the passage to the final stage of EMU aim at ensuring a comparable degree of monetary stability in all the member states. Indeed, the criteria for joining the Union regard convergence of inflation and long-term interest rates and the stability of exchange rates within the EMS.
In the final stage of EMU, price stability is not only the primary objective of monetary policy, which will be conducted by an independent monetary authority, but one of the main guiding principles of the Union.5 Exchange rate stability is ensured through the irrevocable fixity of exchange rates and the adoption of a single currency.
A crucial issue is the extent to which real exchange rate stability can be ensured in EMU through nominal exchange rate fixity. Real exchange rate misalignments tend to arise mainly when nominal exchange rates are allowed to fluctuate even between economies with converging price performances. However, the pursuit of fixed or semi-fixed nominal exchange rates does not mean that misalignments will be avoided. Experience with the EMS shows that substantial changes can occur in real exchange rates even when nominal exchange rates are stable, especially if domestic price and costs developments are not subject to the same discipline as the exchange rate.
There are few conditions for a fixed exchange rate system to avoid exchange rate misalignments, that need to be fulfilled for the irrevocable fixity of exchange rates and the creation of monetary union.6
First, monetary policy must be consistent with a fixed exchange rate system. With full capital mobility, this implies identical monetary conditions (above all in terms of interest rates) and a credible commitment to maintain exchange rates fixed. Secondly, the participating economies need to be highly integrated and not subject to major asymmetric shocks likely to affect relative prices. Thirdly, there should be alternative adjustment mechanisms able to replace the exchange rate. Fourthly, an overall framework is required that will ensure the political acceptability of economic policies and of the adjustment mechanism.
The first condition is met, in the final stage of EMU, through the irrevocable fixity of exchange rates and the creation of the European System of Central Banks, which will be in charge of conducting the single monetary policy of the Union. Before reaching the final stage, this condition will be hard to satisfy in view of the difficulty of managing a fixed but adjustable exchange rate system with full capital mobility and autonomous monetary policies. Events in 1992-93 have shown that even the currencies of countries with strong economic fundamentals can be subject to speculative attacks. Under these circumstances, the defence of exchange rate stability means that monetary policy has to become more restrictive in countries having a relatively better performance in terms of price stability, thereby creating policy dilemmas between external and internal objectives of economic policy.
As regards the second condition, it should be noted that the economies of the EU countries are relatively homogeneous, much more so than the US states, so that real shocks affecting the demand or supply of certain types of goods are less likely to affect member states differently.7 Asymmetric shocks tend to be caused more by different national macroeconomic policies. Such differences, however, are less likely to occur in the final stage of EMU, in view of the specific constraints the Treaty imposes on national policies, in particular budgetary policies. The existence of a single monetary policy will also limit the scope for differentiated developments across countries in wages and costs, with respect to productivity growth. This does not exclude the possibility of asymmetric shocks occurring, as they do at present at the regional level, but they are likely to be less important in the final stage of the Union.
The third condition is that if shocks occur, since the monetary and exchange rate instruments will not be available, adjustment will have to be based largely on countries' internal mechanisms, in particular budgetary and incomes policies. The question is whether these policies can be used with sufficient flexibility within the constraints laid down in the Treaty. If not, new policies will have to be devised, eventually at the Union level. An important issue in this respect is the degree of centralization of budgetary policy in the Union. At present, although the budget is quite small, important transfers take place from the richer to the poorer EC countries (Ireland, for instance, receives net transfers amounting to around 6 per cent of its GDP). These transfers are largely of a structural nature and designed to compensate for income differentials rather than counteract the effects of temporary shocks. For the latter, countries have to rely on the national budgets. It is not yet clear whether budgetary policy in the Union would be more effective at a centralized or a decentralized level. It is interesting to recall in this respect that the US started its monetary union with a decentralized fiscal system and progressively moved, in particular after 1929, to a federal system, with the federal budget playing a comparatively larger role. This shift was partly reversed in the 1980s.
The last aspect concerns the consistency of the whole policy framework, with the checks and balances needed by any socio-economic entity. This issue refers to the degree of political union required to ensure the sustainability of the system, but goes beyond the scope of this short paper. It should be noted that a revision of the Treaty is planned for 1996 to address these problems.
In summary, the EU countries have become so integrated that their economies are highly dependent on the maintenance of monetary stability, not only within countries but also between them.
Ensuring such stability is not an easy task with fully
liberalized financial flows and decentralized monetary policy decisions.
The experience of 1992-93 has confirmed this hypothesis. The exchange rate
instability that emerged during the EMS crisis produced serious repercussions
on trade and production patterns within the EU, aggravating the recessionary
phase in some countries. These effects may seriously undermine policy cooperation
and the pursue of the European integration process. However, the situation
is now different with respect to the one prevailing in the early 1970s,
after the collapse of the Bretton Woods System. With the Maastricht Treaty
the EU has set a specific agenda for the realization of monetary stability
that would contribute to economic prosperity in Europe. The task for the
authorities is to carry out the actions needed to meet the agenda.