The Euro and the Reform of the

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The Euro and the Reform of the Stability and
Growth Pact By C.A.E. Goodhart 1.
Introduction There are many potential facets to
discussions on the record of the Euro. I shall
deal with three- (a) its conjunctural recent
history (b) its monetary features (c) its
unique structural features. I shall only deal
briefly with (a) and (b), in order to concentrate
primarily on (c).
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2. Conjunctural History As shown by Chart 1
initial sharp decline, to autumn 2001 followed by
sharp rise until 2004. Comparative inflation
and current account surplus would have suggested
gentle trend rise, (assuming starting point was
at the correct equilibrium level). However
excessive volatility (relative to Purchasing
Power Parity) has been a feature of main
bilateral rates under floating exchange rates,
e.g. Dm/, Yen/, and is not peculiar to
Euro/. After these fluctuations, no obvious
strong indication that Euro/ is out of
equilibrium. Could go either way (a)
Appreciate US current account deficit,
portfolio rebalancing of assets, (reserves,
etc.) (b) Depreciate Relative interest rates,
relative growth rates. Best predictor is Random
Walk, i.e. remain the same.
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3. Monetary Developments ESCB operates
successfully from the outset in 1999. Control
over short-term interest rates within a unified
money market fully achieved. Intra-bank payment
system (TARGET) successfully established, though
transaction costs (inter-country) for customers
still too high. Introduction of single currency
(Euro) was a triumph. Primary objective, low
and stable inflation rate largely achieved.
Nominal interest rates have been below inflation
rate for much of the last two years, (i.e.
negative real interest rates), but growth
disappointing in central countries, (Germany and
Italy). Monetary pillar is an embarrassment, as
monetary growth much higher than consistent with
the path of nominal incomes. Integration of
other European financial markets varies from good
(Euro-bonds) to poor (equities).
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4. The Unique Structural Features of the Euro
and the SGP A. Theory Currency unification
helps to promote economic efficiency and reduces
transactions costs. But such unification
reduces ability to adjust to (asymmetric, demand
and supply) shocks by monetary and exchange rate
policies. Such policies are less needed when
price/wage flexibility and labour mobility high,
(i.e. market-led adjustment works
well) Although much discussion of Optimal
Currency Area theory, in practice currency areas
have been determined by national boundaries.
When empires and confederations break-up, e.g.
British, Austro-Hungarian, Soviet, Jugoslav, so
does currency unification. When countries fully
merge, e.g. Italy, Switzerland, a single currency
follows.
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Why does currency area and nation state share
boundaries, although many nation states not an
OCA? (1) Labour market adjustment, especially
mobility, easier within State than between
States. (2) Fiscal policies provide a means of
smoothing adjustment, and insurance against
adversity. Subsidiary governments of regions
within a currency area can also use fiscal
policy, though they cannot print money (Euros)
and hence are at greater risk of default, but
problems arise because of- (a) no market
reaction in interest rates and exchange
rates. (b) Likelihood of bail-out, especially
if failure has contagious financial
implications. So implicit bargain in most
federal states. Central Government undertakes
stabilisation and redistribution. Subsidiary
government balances budget.
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B. Euro Practice Euro area unique in that it
combines a federal monetary policy with policy
control in most other fields primarily determined
by subsidiary nation states (e.g. fiscal
policy). Also, and partly as a consequence,
labour market adjustment has remained weak.
Germany has succeeded, but Italy has not. If
adjustment is so poor what will happen? Could
Italy leave the Euro-zone? N.B. New members
still keen to join, but UK and Sweden will not
join in foreseeable future.
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C. Stability and Growth Pact Concern about
temptation to imprudent fiscal policies by (some)
member states, and implications for
bail-out/inflation (by ESCB) led to SGP, (Role of
Central Bankers, desire to exclude Italy). But
no quid pro quo of central Federal Budget to
provide stabilisation and insurance. Also
sanctions were inoperable. So transgression of
SGP limits. Note however that European deficits
much less than in US or Japan. What to
do- (i) Monetary unification meant to put
pressure on system to lead to greater political
unification (French Monetarists vs German
Economists). But referendum defeat on
Constitution puts paid to that.
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(ii) Shift some stabilisation functions to
Central Federal Budget. Several Reports
MacDougall Report (1977), EC Report (1993).
Decisively voted down. (iii) Strengthen
Euro-zone group institutions, (Pisani-Ferry,
Breugel Group Think-tank), but cuts across other
EU wide institutions. EU was never intended to
work with a sizeable minority of countries
outside the Euro-zone. (iv) Enhance market
discipline on excessive government debt and
relax formal sanctions- (a) Place more weight
on debt ratio (Melitz) (b) ECBs latest
announcement on collateral, but a trigger point,
not a sliding scale. (c) More appropriate credit
risk requirements (my own proposal).
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5. What will the Future Bring? The Euro is
unique in its structural form. It has a strong
idealistic core, but also considerable
weaknesses. (a) Lack of adjustment mechanisms.
Watch Italy, perhaps Greece. (b) Conflicts
between federal monetary policy and national
(fiscal) policies. SGP was a flawed mechanism
for constraints by official intervention. Move
back to more market discipline. Sooner, or
later, perhaps later, some political party will
run on ticket of opposition to Euro-constraint.
What happens if it wins? Can a country ever
leave the Euro without some kind of default?
Would that trigger massive contagious capital
flows? How likely could such nightmares be?