The early 1990s marked a distinction between the EMS as a vehicle for creating monetary stability, and the EMS as a vehicle for moving towards monetary union. The same period also saw big changes in the configuration, power structure and interactions between the industrialized economies. Most of these changes have taken place on each side of the Atlantic. In Discussion Paper No. 1190, Research Fellow Andrew Hughes Hallett and Yue Ma investigate these issues using a multi-country model set in a game-theoretic framework. Different decision strategies and different regimes are compared for their ability to substitute for `perfect' coordination; that is, for their ability to avoid the costs of raw non-cooperation, and for their ability to distribute those gains across participants. They model that distinction by contrasting policies generated by preference transfers from the lead country (to create the EMS discipline of `tying one's hands') against policies generated by extending the domain of policy-making to Europe-wide targets.

The authors' findings show that both solutions are incentive incompatible compared to simple non-cooperative policy-making, unless the aim becomes the social welfare of Europe as a whole. Various modifications are considered, but incentive compatibility requires some monetary relaxation in order to redistribute the gains. That combines German monetary discipline with differentiated fiscal-monetary mixes for the different economic structures elsewhere in the system. These results are used to explain why wider bands paradoxically provide a more credible route to monetary union.

Economic Cooperation within Europe: Lessons from the Monetary Arrangements in the 1990s
Andrew J Hughes Hallett and Yue Ma

Discussion Paper No. 1190, June 1996 (IM)