Monetary Integration and Small Country Adjustment:A Necessary Trade-off ?

Erik Jones*


The smaller countries on Germany's borders have long since abandoned much of their monetary sovereignty to their larger, central neighbor. Austria, Belgium and the Netherlands have targeted their Deutschemark exchange rates with greater or lesser success since the early 1970s. Denmark has done the same since the founding of the European Monetary System. Therefore, these countries should have little difficulty forming a monetary union with Germany. Indeed, economists already include the smaller countries in a de facto Deutschemark zone, just as politicians are wont to include them Europe's monetary 'hard core.'

Nevertheless, considerable challenges remain before a monetary union can be realized. With the exception of Austria, the newest participant in the European integration process, the border countries must struggle to achieve the fiscal convergence criteria outlined in the Maastricht Treaty. As Table 1 demonstrates, the smaller countries are well above the 3 percent deficit-to-GDP and 60 percent debt-to-GDP ratios necessary to proceed to economic and monetary union (EMU). In spite of their close monetary relations, the smaller countries face even greater fiscal reform challenges than Germany. Moreover, as a rule, the smaller countries allocate a larger percentage of domestic production to the public sector than their central neighbor, primarily for transfers from the welfare state.

Table 1: 1993 Public Sector Balances (General Government)

Percentage GDP Debt Deficit Public Sector Transfers
Germany 46 -3.3 50.8 27.3
Austria 57 -2.9 52.3 28.2
Belgium 142 -7.0 56.5 27.8
Denmark 66 -4.6 62.7 31.4
Netherlands 81 -4.1 55.9 33.0

Source: European Commission and OECD.

The purpose of this survey is to suggest that such data are symptomatic of a fundamental obstacle to monetary integration, and that they cannot be disregarded as simply the result of past welfare state 'excesses'. The smaller countries have a tradition of 'excessive' welfare state expenditure at least in part as a result of their monetary dependence on Germany. Therefore, as these countries rein in welfare state outlays it is possible that they will become less (and not more) suitable candidates for monetary integration. This claim is based on two separate arguments, one economic and one political:

The economic argument begins with the observation that the loss of monetary sovereignty to Germany is a constraint on (and not an objective of) small country economic performance. Given their dependence on German imports, the smaller countries cannot rely on changes in the nominal exchange rate to change relative prices. Moreover, the movement of productive factors, such as labor and capital, exacerbates differences in economic performance between the smaller countries and Germany. For example, when the smaller countries perform poorly relative to Germany, capital flows into the Deutschemark as a safe-haven while labor remains relatively immobile. The result for the smaller countries combines higher interest rates and higher unemployment. Thus, the smaller countries cannot safely rely on market forces to make the adjustments necessary to keep up with German economic performance, nor can they manage their performance through changes in the nominal Deutschemark exchange rate.

The political argument is that the smaller countries have traditionally relied on cooperation between the social partners -- representatives of organized labor and business -- to change domestic relative prices, in particular the cost of labor relative to capital. Such corporatist price-incomes policies rely heavily on a sense of national solidarity, meaning a willingness on the part of industry and labor to share in the burdens of adjustment. In practical terms, this means that trade unions are often forced to accept real wage cuts in exchange for the promise that industry will translate higher profits into job-creating and productive investment. The welfare state is both part and parcel of this national solidarity; creating institutional bonds between employed and unemployed workers, as well as between labor and capital.

Putting these two arguments together, fiscal consolidation in line with the Maastricht criteria potentially threatens the national solidarity essential to small country economic adjustment. To the extent that the smaller countries are forced to break the institutional linkages between employed and unemployed workers or between labor and capital, they will be less able to engineer changes in the price of labor relative to capital and therefore less capable of matching German economic performance. Unless union-wide labor and capital markets can be expected to work more efficiently than they do at present, and absent a system of explicit international fiscal transfers within the monetary union, the smaller countries would be ill-advised to formalize their monetary integration with Germany.

Clearly this is a powerful indictment of European monetary integration. In spite of the efficiency advantages -- ease of trade, etc. -- that come along with monetary union, the smaller countries may perform worse as de jure than as de facto participants. As an indictment of monetary integration, this argument deserves more careful examination than the thumbnail sketch provided above. Therefore, this essay will proceed in three sections:

II - Patterns of Adjustment in Monetary Unions

Adjustment (perhaps more accurately, cost adjustment) is a loose term in economics that broadly encompasses the short-term stabilization of income performance within a given geographic region as well as the medium-to-long term redistribution of wealth or resources across geographic regions. Short-term stabilization is important to the adjustment process because it prevents otherwise sound industries from collapsing as a result of stochastic shocks; say, when the demand for fuel or some other commodity decreases because of an unusually mild winter or because of a temporary change in consumer tastes. However, admittedly, adjustment is usually considered in the context of medium-to-long term redistribution, as wealth or productive resources move to areas where they can be utilized most effectively.

The reason for stretching the concept of adjustment to include the short- as well as the medium-to-long term stems from the practical requirements of managing an economic and monetary union. If the objective is economic prosperity for the whole of the union (the greatest good for the greatest number) then the ambition should be to prevent different regions from responding unnecessarily to economic change while at the same time ensuring that all regions are capable of making necessary adjustments. In theory, both stabilization and redistribution can be managed by efficient markets -- a prospect imbedded in Mundell's theory of the optimum currency area. Because most monetary unions do not encompass such perfectly efficient markets, however, the government often steps in to provide both stabilization and redistribution through union-wide fiscal flows.

Thus the two basic patterns for regional adjustment found in existing monetary unions reveal different mixtures of market and government-organized stabilization and redistribution. For example, the labor markets provide the driving force for adjustment in the United States. When the US automotive industry suffered a shake-down in the early 1980s, automotive workers rapidly migrated from the depressed Great Lakes region of the country to the more prosperous Sun-Belt states. The US federal fiscal system plays only a minor and sometimes even perverse role in the adjustment process. Although federal income tax burdens decline and transfers increase when personal income suffers a short-term drop, the stabilization effect is not as great as some would hope (see Gros and Jones, 1994). Moreover, there is some statistical evidence to support the assertion that the long-term effect of the federal transfers is to redistribute resources from poor regions to rich, and not the other way around (1).

The situation in Germany is the reverse of the United States. German labor markets are less effective in promoting regional economic adjustment, while the German system for inter-regional transfers is far more efficient than the American. German regional governments, Länder, participate in a financial 'equalization' scheme which automatically transfers resources from temporarily prosperous regions to those affected by an adverse shock. The Länder also benefit from a redistribution program that shares VAT revenues from regions with a wealthy tax base to regions that are less prosperous.

If we compare these American and German patterns for regional adjustment to the de facto monetary union between Germany and its smaller neighbors, we would expect the countries participating in the de facto union to be far less able to make necessary adjustments than American regions or German Länder. Labor does not migrate between the smaller countries and Germany with the same ease that it moves across regions in the United States, and neither do the small countries benefit from German-style fiscal transfer mechanisms. Nevertheless, statistical evidence for per capita income performance during the 1970s and 1980s shows that the smaller countries were better able to match West German performance over the short-, medium- and long-term than the US regions were able to match each other (Jones, 1993). Indeed, Belgian economists Paul De Grauwe and Wim Vanhaverbeke (1990) have gone so far as to suggest that the smaller countries somehow outperformed five of the northern West German Länder during the early 1980s. Whether or not it is true that the smaller countries outperformed the northern Länder, and the assertion has been disputed, the fact that they matched north German performance without the benefit of German federal fiscal transfers requires explanation (2).

III - Solidarity and Adjustment in De Facto Monetary Unions

The answer is to be found in cooperation between the social partners of the smaller countries and in the national solidarity engendered by small-country welfare states. The smaller countries have traditionally responded to the need for price adjustment through negotiated (and sometimes even statutory)price-incomes policies, whereby trade union representatives accept to moderate wage claims in exchange for industry promises of productive investment.

The difficulties with price-incomes policies are two-fold: organized labor must agree to sacrifice worker income in the interests of the unemployed and organized business must agree to channel profits into job creating investment. Therefore the welfare state must play leadership, intermediary and supportive roles at the same time: determining the direction of economic policy; assuring agreement between the social partners; and reinforcing the discipline internal to organized business and labor groups. Often this means that the government must compromise in its economic objectives, as, for example, when the Belgian government assumed a share of business contributions to social insurance during the austerity period in the early 1980s or when Dutch prime minister Ruud Lubbers agreed to moderate austerity in exchange for increased wage restraint from the trade unions, also during the early 1980s.

Here it is perhaps useful to begin with the case of Austria, the country with the strongest tradition of social partnership in economic policy-making, the most recent participation in the formal process of European integration, and the fewest 'problems' meeting the convergence criteria outlined in the Maastricht Treaty. Of the four border countries referred to in this essay, Austria has traditionally been the most insular with respect to its participation in world markets, largely out of geopolitical necessity. As a consequence, the pattern for economic policy-making in Austria developed around the close participation of the social partners -- representatives of organized labor and industry -- at each level of decision-making. The effects of this collaboration between government and the social partners can be seen in the early 1980s, where the Austrian response to global recession and the need for price adjustment came in the form of corporatist price-incomes policy, managed by the social partners themselves. Austria did not participate in the shift to the center-right that took place in much of Europe at the start of the 1980s, and only adopted more neo-liberal (and less corporatist) policies in 1986-7 and in response to government deficits on the order of 3 percent of GDP and unemployment rates equal to around 6 percent.

The Belgian, Dutch and Danish adjustments during the early 1980s are more dramatic although their pattern for corporatism is less extensive than in Austria. Each of these three countries imposed statutory price-incomes policies during the shift to the center-right in 1981-2, which resulted in a rapid decline in the cost of domestic labor relative to capital. However, it would be a mistake to assume that the statutory character of these policies represented a radical departure from the corporatist model. Trade unions accepted wage restraint imposed by the government in exchange for the right to negotiate over the content of welfare state reform. Strike activity fell off in all three countries in spite of the loss of real labor income, and the center-right governments were returned in 1985-6.

My point here is not to laud the corporatist paradigm as the ultimate pattern for adjustment in small countries. Rather it is to suggest that had the trade unions (particularly) and the social partners (in general) not been willing to participate in the national adjustment program, the process of adjustment would have been longer, more painful, and more controversial. Evidence for this assertion is anecdotal rather than concrete, and yet it is instructive to note that both Austria and Denmark saw a change of government policy in 1986-7 when adjustment measures began to threaten popular perceptions of the 'Austrian' and 'Scandinavian' models for the welfare state. In Belgium and the Netherlands, where the need for adjustment was greater, the trade unions nevertheless announced the limits to their complicity as when the Martens VI government announced deeper cuts in welfare state outlays (1985) or, somewhat earlier, when Dutch prime minister Lubbers began to cut back on public sector employment.

IV - The Risks of Monetary Integration

Price-incomes policies were necessary for small country adjustment during the 1980s simply because there was no alternative. Changes in the nominal Deutschemark exchange rate offered scant prospects to lower the relative cost of labor to capital within the small countries; workers were unlikely to migrate from the border countries to the more prosperous German Länder in significant numbers; and there was no organized system for fiscal stabilization or redistribution across national boundaries, particularly among what are generally considered to be prosperous countries. Moreover, the necessity for small countries to rely on price-incomes policy has not changed in the early 1990s. To take but two examples: the Dehaene government in Belgium enacted a nation-wide nominal wage freeze in December 1993; and the government and social partners in the Netherlands unanimously rejected suggestions from German economist Alfred Kleinknecht that they abandon price-incomes policies in 1994.

The purpose of this concluding section is to suggest that a formal economic and monetary union between the smaller countries and Germany might destroy the prospects for price-incomes policy without offered any mechanism for small country adjustment in return. To understand this point it is necessary to consider the relationship between the welfare state, organized labor and national solidarity. Simply put, as the welfare state comes under external constraints like those imposed through the 'multilateral surveillance' and 'excessive deficit' clauses at the heart of the EMU project in the Maastricht Treaty, government officials will become less able to negotiate effectively with the social partners, particularly trade unions. And, as the European Union assumes greater responsibility for the management of economic policy, trade unions will be more interested in centralizing at the European rather than at the national level. The feeling of solidarity that enables national trade union federations to act in the interests of the unemployed as well as dues paying members will necessarily suffer as a result. This means that the unions will be less able to accept -- or, perhaps more importantly, to enforce -- moderation in wage claims in the service of job creation.

Seeds of this argument can be found almost at the origins of the welfare state, when Swedish economist Gunnar Myrdal (1956) noted that an essential ingredient to national integration was the inclusion of labor representatives in the process of economic policy-making. The welfare state, Myrdal argued, transformed a diffuse international labor movement into a concrete and well-disciplined instrument for the promotion of national economic welfare. Here it may be instructive to note that price-incomes policies were used throughout Western Europe during the 1950s and early 1960s. However, only the most extensive and most corporatist welfare states were able to extend their reliance on price-incomes policies into the final quarter of the century.

A Europeanization of the trade unions is likely to undermine the prospects for national price-incomes policies in two ways. It may promote Europe-wide wage claims in competition with national price-incomes policies through the greater access to information about relative wages afforded by a common currency. At the same time, by weakening solidarity at the national level, it is likely to reinforce the tendency for regional or sectoral unions to make wage claims in the interests of employed workers rather than in the interests of national economic welfare -- the unemployed as well as the employed. In either event, the prospects for small country adjustment within a monetary union will diminish.


The conclusion to draw from this discussion is not regressive. The welfare state is in need of reform throughout Western Europe and the prospects for successful price-incomes policy have receded with each successive recession; a fact which explains why Belgium, Denmark and the Netherlands had to resort to statutory rather than consensual policies in the 1980s. Moreover, most professional economists agree that monetary union is a valuable complement to European integration, and there is clearly a strong political determination to proceed to EMU. Nevertheless, I believe it would be dangerous to proceed with the EMU project without careful consideration as to how the smaller countries can adjust to economic misfortune in the future.

Possible scenarios for the development of a European EMU lead in opposing directions. Either the small countries can accept the need for a centralized economic authority and throw their support behind the creation of a union-wide tax and transfer system capable of stabilizing and redistributing regional income. Or the small countries can demand greater leeway in refashioning their welfare states, hoping to retain the bonds of national solidarity that tie the employed to unemployed, and that unite the interests of labor and capital. The first path leads to a construction of Europe along the German model, and the second to an unprecedented experiment in regional corporatism. The danger lies in attempting to steer a course between the two alternatives. Unfortunately, that appears to be where Europe is heading.



(*) Research Fellow, Centre for European Policy Studies, (CEPS). Rue Ducale, 33 1000 Brussels, and Central European University, Prague.
(1) My colleague, Daniel Gros, and I have come up with two different hypotheses to explain why the US federal transfer system might redistribute resources from poor regions to rich regions over the long term. To begin with, federal fiscal transfers are directed at households and not geographic regions, and so it is possible that richer regions contain a disproportionate number of extremely poor households, as in the inner-cities of New York and Los Angeles. A second possibility is that, since most federal transfers are provided as 'matching resources' to supplement state-run social welfare programs, the richer states also offer more generous social welfare benefits.
(2) The comparison between the smaller bordering countries and the north German Länder is also important because it admits the existence of an asymmetric shock, that had a greater impact on the mature industrial regions of North Germany than on the more prosperous southern Länder