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Volume XXXIII No. 2 (April-June 1998)
Sustainable EMU
*
By Stefan Collignon
Eleven countries have been chosen to start European Monetary Union on 1 January 1999. This selection reflects the substantial improvements in economic convergence of recent years. In the convergence reports which the European Monetary Institute (EMI) and the European Commission had to submit to the European Council according to Art. 109j of the Treaty on European Union (TEU), 1 both institutions concluded that only Greece and Sweden did not fulfil the requirements set in the Treaty, while the United Kingdom and Denmark have invoked their opt-out clause. 2 However, the debate on EMU has moved on.
While Eurosceptics long hoped that the start of the project would be delayed, they now point to the dangers that it may fall apart, 3 The EMI Report on Convergence, in particular, put the focus not only on meeting the convergence criteria in the year 1997 but also on the requirements for and likelihood of sustaining the economic performance of recent years. The question today has become: will EMU last? What does it take to assure that it will?
Criteria for an Optimum Monetary Union
Economist have debated for a long time whether Europe is an optimum currency area and under what conditions countries might find it favourable to join a monetary union. These arguments can be extended to the question of the sustainability of EMU. If countries join a monetary union yielding net benefits to them, they are likely to stay in the union as long as those benefits are maintained. It is less certain, however, that they would leave as soon as those benefits turned negative. Thus, one has to assess the potential benefits from EMU as well as the possibility that those benefits may not be static.
The potential benefits of being part of a monetary union have been well established in the literature. They can be summarised under three headings:
All these benefits are of a microeconomic nature, although they may have substantial consequences for improving the macroeconomic environment, creating higher growth and job creation in Europe.
On the cost side, macroeconomic policy considerations related to giving up the exchange rate as an adjustment instrument dominate. Of course, it is also true that the one-off cost of the change-over to the new currency represents a microeconomic costs for firms, but most banks and companies seem to indicate that these costs will be recovered within a year; they are therefore of minor importance. The usefulness of the exchange rate as a policy instrument, however, has been the subject of a long debate. It is generally accepted that in the short term a variation in the exchange rate will have consequences on output, production and employment. Thus, in principle, a devaluation can be used as an instrument to fight unemployment. But in the long run this advantage disappears. A depreciation of the currency automatically increases import prices and thereby lowers standards of living. If wage bargainers resist this reduction in real wages, the usefulness of an exchange rate variation for stimulation of economic activity disappears. With workers defending their living standards, labour markets become increasingly “rigid”. Thus, instead of facilitating adjustment, frequent exchange rate changes create an inflation mentality with rigid labour markets. Therefore, the disadvantage of not having the exchange rate as an adjustment tool under monetary union is only a loss if seen in a short-term perspective; in the long run it might turn out to be an advantage.
What matters when deciding whether to join or stay in a monetary union, is the net balance between costs and benefits. All microeconomic benefits increase with the size of monetary union. The costs, on the other hand, depend on the short-term preferences for output stabilisation compared to a long-term preference for price stability. Thus, the larger the size of EMU and the higher the commitment to price stability by the authorities in the countries participating, the greater the benefits for the participating member states.
However, this also means that a commitment to price stability is crucial for the maximisation of net benefits from EMU. If certain countries were to reduce their commitment to price stability in monetary union, then the costs for all member countries would increase, making EMU less sustainable. From this perspective, an optimum currency area would maximise the trade-off between larger benefits from size and greater costs resulting from an inflation preference. However, two optima may be considered:
In theory, it may appear that a Pareto optimising monetary union would be more sustainable as it requires no altruism.
An Empirical Approximation
It is easily to see that these two different conceptions of an optimum currency area have been implicit to the European debate about selecting member countries. Thus, it might be of interest to assess whether the EMU of eleven member countries follows either of these particular models.
First, one should remember that the Treaty of Maastricht does not give one single country the power to veto another, as one would expect if the Treaty envisaged a Pareto Optimum Currency Area. The decision on member countries has to be taken by qualified majority and this means that not even two large countries can veto another. Qualified majority means a vote of approximately 70 percent and as Figure 1 shows, this is far from being a veto.
Second, although an attempt has been made to capture the logic of the two models empirically, it is impossible to evaluate the relative preference for price stability over output stabilisation of public authorities and therefore exact costs cannot be known. Nevertheless, in order to give an idea of magnitudes, the Maastricht convergence criteria on inflation have been taken as the relevant magnitude of what would be acceptable for EMU member states. The actual inflation rate has been taken as a “revealed policy preference” by the respective authorities. The benefits from size are assumed to be a function of the logarithm of the GDP size of each country. Figures 2 and 3 show the results.
The first graph indicates that only two countries would have failed the Pareto criteria in 1997: Luxembourg and Greece. Greece is less surprising since, as is well known, it did not fulfil any of the convergence criteria. Yet, Luxembourg’s Pareto disqualification is unexpected and can be explained by the fact that the benefits from accepting Luxembourg would be small due to its low GDP, while it had an inflation rate that was higher than that of five other countries. The trade-off between size and inflation was not sufficiently favourable. And yet there has never been any doubt that Luxembourg would be part of EMU; this indicates that the selection of EMU did not follow a Pareto OCA criteria.
The BOCA chart shows how the net benefits from EMU due to size have increased despite the successive addition of countries with a high inflation rate. Given that the Maastricht inflation target is taken as the zero line here, the benefits for the whole union increase with the addition of every country with the exception of Greece. If Greece had been accepted to EMU, the currency area would still have yielded positive benefits for all member countries, although they would have been lower than for a union of fourteen. Therefore, the Benthamite optimum would have included 14 EU countries. Given that the United Kingdom, Denmark and Sweden displayed a positive trade-off between size and inflation, the selected union of eleven member country is sub-optimal. We may conclude from this analysis that EMU with eleven countries is closer to a Benthamite currency area than to a Pareto Optimum Currency Area, although the distinction is negligible. It appears quite clearly, however, that European Monetary Union will yield significant benefits and advantages to the participating member countries from the beginning.
Shocks to EMU Benefits
The next question is whether these benefits are sustainable. This question must be divided into two separate parts. First, benefits may well disappear if the union or an individual country is hit by a temporary economic shock. But if the shock is not permanent, it will pass and the benefits will return. Alternatively, if the shock is permanent, say because the European Central Bank is unable to maintain price stability, the cost for each member of being part of such a currency union would gradually increase until the balance turns permanently negative. It is argued here that the first aspect is not a threat to EMU sustainability while the second is.
A temporary shock
The temporary nature of a shock to the benefits from participating in EMU implies that after the shock has passed, the benefits return. If a country were to leave as soon as it perceived that its benefits had turned negative, it would loose the potential for future benefits. If long-term expectations remain positive, small temporary shocks will not be able to put EMU in jeopardy. It may not always be clear, however, whether a shock is temporary or permanent. Even the simple possibility that it might revert creates uncertainty. Under those circumstances, the decision to participate in or leave a monetary union can be looked upon as an uncertain investment decision.
Leaving the union would be an option and the value of this option increases with uncertainty. However, the benefits from leaving EMU would be asymmetrically low, given that a country that leaves the large currency area would loose all the benefits of size. Furthermore, while a part of EMU, a country would always be able to influence the preference of its neighbours. This increases the option-value of staying inside EMU and reinforces the cohesion of the monetary union. It might well be that the attempt to change collective preferences could increase “noise” and appear more conflictual, but the asymmetric structure of the benefits deriving from being part of a large currency area or from being on one’s own inevitably makes leaving the union an unattractive proposition.
A permanent deterioration of benefits
If net benefits deteriorate permanently, however, say because price stability is not maintained in the union, then it might appear advantageous to leave the union. In order to assess the likelihood of such a development one has to assess the probability of price stability not being maintained in the euro zone. This could be due to
These factors will now be examined.
Monetary policy preferences.
The most significant process in the convergence of European economies is the reduction in inflation rates which has taken place in all EU countries (see Figure 4). The former president of the European Monetary Institute, Alexandre Lamfalussy, has called this a cultural revolution in Europe. It is true that disinflation has also taken place in countries outside the European Union, but this does not invalidate the transformation of attitudes in the EU. For clearly without a change in general attitudes towards inflation, the high degree of price stability that can be observed would have been impossible. Furthermore, the strong preference for price stability is also expressed by the high degree of central bank independence written into the Maastricht Treaty (Art. 2b, 103). As the economic literature on central banking has clearly established, there is a positive relation between a high degree of central bank independence and low average rates of inflation. Given the thorough constitutional arrangements in the Maastricht Treaty, the European Central Bank (ECB) will be more independent than the German Bundesbank has been and this should be a strong guarantee for long-term price stability.
Labour market developments.
It is often maintained that European labour markets are inflexible. Although this may be true with respect to certain legal considerations, 4 it is not justified to argue that labour markets are so rigid that they could cause a threat to price stability in Europe. In fact, since the signing of the Maastricht Treaty, there has been significant convergence not only in price stability but also in the development of unit labour costs. In recent years, nominal wages have converged to productivity increases, so that unit labour costs have become rather stable. As a consequence, the cost-pressure on prices has become weak or even negative. In fact, in several EU countries, unit labour costs have fallen in absolute and relative terms with respect to most other industrialised countries. This is important for monetary policy. If cost pressures are high, the Central Bank has to lean into the wind. But in the new European economic environment, monetary policy could become less restrictive and finance economic growth and the creation of new jobs instead. Part of this encouraging development in labour costs is due to the fact that wage bargainers have interiorised the new regime of price stability and the impossibility of correcting excessive wage bargains by exchange rate adjustments. This development is proof of the fact that wage bargaining is endogenous to the monetary regime. 5
Fiscal policy.
The sustainability of public finances has received much attention in the run-up to EMU and beyond. The Stability Pact concluded in Amsterdam is one instrument whereby governments have attempted to avoid “gross errors” in the pursuit of budgetary policies. Not only should deficits remain well below the 3 percent reference value stipulated by the Maastricht Treaty, but the aim should be to keep a balance or surpluses over the medium term. The recent reports by the European Commission and the EMI on convergence in the European Union have taken this medium-term objective as the benchmark for assessing the sustainability of public debt. 6
The Sustainability of Public Debt in Europe
Although it is right, especially for highly indebted countries, to reduce their debt ratio over time in order to regain policy margins, there is no consensus about the period in which that level should be reduced to the stipulated reference values or beyond. This issue may become important in the policy debate in coming years in the European Union. But from an academic point of view, it is not clear whether debt sustainability should be defined so narrowly. In fact, the literature distinguishes between a weak form of sustainability, when government finances respect the intertemporal solvency constraint whereby today’s debts have to be repaid by future net tax income, and a harder form of sustainability which emphasises the need to extract primary surpluses in order to pay previous debt and these may be limited by people’s willingness to pay taxes.
By analysing these concepts in detail, Collignon and Mundschenk have shown that all fourteen EU countries, with the exception of Greece for which harmonised data were not available, are now fulfilling the weak debt sustainability requirement. 7 Although most countries had unsustainable debt positions in the early 1990s during the deep economic crisis, all have now greatly improved their records. Part of this improvement has been due to public savings efforts and part to a better macroeconomic environment with higher rates of growth and lower interest rates (see Table 1).
However, analysis brings to light that Italy is the only country in the European Union for which doubts about clear debt sustainability still persist. Figure 5 shows the weak sustainability index. The value of this index is positive when the primary surplus is higher than the debt service. Consequently, the debt ratio falls when the index is positive. This can be calculated for yearly figures or by discounting future returns to the present. 8 Figure 5 reveals that Italy has only just managed to return to a positive sustainability index and that this is the consequence of consistently improving primary surpluses over the last ten years while simultaneously reducing debt service. The debt service has, of course, merely been falling because interest rates have been coming down to European levels. Consequently, it is clear that even though Italy’s position is fragile, Italian debt and public finances are sustainable with greater certainty inside EMU than outside of it. However, this conditional statement may also explain why Italy’s partners within the Union are concerned about the Italian debt level. Persistent efforts will be needed to reduce Italian debt within a reasonable period of time.
Secondly, the hard sustainability constraints have been used to assess the absolute level of primary surpluses which the population is willing to support. Estimates by Mongelli reveal that this is close to 4 percent in most countries, although it may go up to 6 percent in Italy. 9 Here too, Italy is in a marginal position with respect to the rest to Europe.
A third approach to measuring the sustainability of public debt and finances in the European Union looks at whether the budget rules of the Stability and Growth Pact are sufficient to ensure that public debt will stabilise and not explode. It turns out that a simple stability condition exists: the increase in the primary surplus required to bring the deficit back to the 3 percent reference value stipulated by the treaty has to be at least as high as the growth adjusted interest rate (that is, the difference between the real interest rate and the economic growth rate). The higher the speed of adjustment in resorbing an excessive deficit, the greater the stability of public finances. By econometric analysis of past behaviour, it appears that all EU countries fulfil the stability conditions. Therefore, one can be confident that the debt levels in the European Union will stabilise and not explode. However, given the dissatisfactory growth experience in the European Union in recent years it is unlikely that the stable debt ratios will be less than 60 per cent. In fact, based on past experience, several countries will stabilise around 70 percent and Belgium even above 90 percent. However, the important conclusion is that even though the debt levels may not reach the required 60 percent, they are no threat to the stability and sustainability of public finances in Europe. Therefore, they cannot threaten the sustainability of the single currency.
Conclusion
In conclusion, it would appear not only that economic convergence has been significant between the eleven EU countries, but also that it expresses a fundamental shift in policy preferences towards price stability. Therefore, the net benefits from being a member of the union are likely to be substantial. European Monetary Union, once it has started, will be substantially more solid and durable than sceptics believe. This is partly because the political economy of being a member of EMU will push members to preserve the benefits they have obtained from being member of the union, partly because shocks in the Union are not likely to lead to exit. In the long-run, however, the durability of EMU will depend on the policies pursued by the members of the union. Here, the strong institutional commitment to price stability should help to preserve the benefits for the members of the currency area, while the fiscal dynamics implicit in the Stability and Growth Pact are likely to prevent destabilising effects on the public finance side. Labour costs developments are also more stable than often appreciated. However, one must not underestimate the dangers to European integration rooted in the high level of unemployment within the Union. Unless Europe finds ways to tackle this problem, it is not only the euro but the European Union itself that is under threat.
Stefan Collignon is Director of Research and Communication at the Association for the Monetary Union of Europe.
Endnotes
*: Article prepared in connection with the international conference “The Euro and its Consequences for Europe, the International System and Italy” organised by the IAI with the sponsorship of the Ligurian Regional Administration and the Cassa di Risparmio di Genova e Imperia, and held in Genoa on 21-21 March 1998. Back.
Note 1: Council of the European Communities/Commission of the European Communities (1992), Treaty on European Union, Office for Official Publications of the European Communities, Luxembourg, 15 May 1998. Back.
Note 2: Convergence Report 1998 (Brussels: European Commission, 1998); Convergence Report (Frankfurt: European Monetary Institute, 1998). Back.
Note 3: M. Feldstein, “EMU and International Conflicts”, Foreign Affairs, vol. 76, no. 6, Nov-Dec 1997. Back.
Note 4: OECD, The OECD Jobs Study: Evidence and Explanations (Paris: OECD, 1994). Back.
Note 5: Sievert gives a clear analysis of why that may be so: O. Sievert, “A Currency One Cannot Create Oneself: A Regulatory Case for European Monetary Union”, De Pecunia—German Economists on EMU (Brussels), vol. V, no. 2, October 1993. Back.
Note 6: Convergence Report 1998, European Commission; Convergence Report, European Monetary Institute. Back.
Note 7: S. Collignon and S. Mundschenk, “The Sustainability of Public Debt in Europe”, The Sustainability Report (Paris: Association for the Monetary Union of Europe, 1998). Back.
Note 8: The medium-term index used here reflects a time horizon of five years. Back.
Note 9: F. Mongelli, “The Effects of European Economic and Monetary Union (EMU) on National Fiscal Sustainability”; IMF Working Paper WP/96/72 (Washington: IMF, July 1996). Back.