European Monetary System
World model?

The EMS was greeted with considerable scepticism in 1978, but European currencies and intra-European competitiveness have remained relatively stable over the past ten years. By contrast the unprecedented swings of the dollar and the dramatic worsening of the US current account have prompted recent proposals for international monetary reform. In Discussion Paper No. 285, Programme Director Francesco Giavazzi and Research Fellow Alberto Giovannini discuss the reasons for the success of the EMS in order to assess whether the System could be copied outside Europe.
One important benefit of the EMS, for countries other than West Germany, could have been the shift in inflationary expectations, originating from the public's awareness that monetary policy in EMS countries is run largely by the Bundesbank. Giavazzi and Giovannini estimate a system of three equations explaining CPI inflation, wage inflation and output growth, using quarterly data for five EMS members and the United Kingdom. They conduct dynamic simulations, using parameter estimates obtained from 1960-79 data and the actual values of money growth and the relative prices of intermediate and final goods. They identify for each country the date at which the simulated and actual paths of inflation and output growth begin to diverge systematically. Divergences in the actual and simulated paths of inflation and output occur after the inception of the EMS: in Germany actual inflation is higher than its simulated value and output growth is lower, while for the other countries the paths diverge in the opposite directions. These results are consistent with theoretical models of imported reputation, but there remain some questions. Expectations may have shifted in France, Ireland and Italy, for example, because of shifts in domestic policies, though in the first two countries at least the authorities justified unpopular policies as necessary to stay in the EMS.

For Germany the terms of trade and the output-inflation trade-off worsened after 1979. In order to identify Germany's reasons for accepting EMS membership despite these disadvantages, Giavazzi and Giovannini focus on German competitiveness relative to its trading partners. The authors construct the real effective exchange rate of the Deutschmark vis-à-vis its EMS partners and compute the correlation between the index of global competitiveness and that of Germany's competitiveness inside the EMS. In the 1960s and 1970s the correlation between the two indices is very high; but after 1979 this phenomenon reverses, indicating that the EMS has protected Germany from the effects of dollar fluctuations and stabilized its overall competitiveness.

This analysis leads Giavazzi and Giovannini to conclude that an institution like the EMS would not work outside Europe. First, the basis of the System is the credibility of its members' exchange rate targets. This credibility arises from the high degree of economic integration in Europe and the development of institutions, such as the Common Agricultural Policy, that depend on exchange rate stability. Second, a centre country is required to determine monetary policy for the System. Finally, the authors discuss the implications of monetary convergence for public finances; a monetary contraction reduces the portion of the budget deficit that can be financed by printing money and causes real interest rates to rise and output to fall. The divergent behaviour of government debt after 1979 indicates that the pursuit of monetary convergence among countries with different fiscal structures may necessitate fundamental fiscal reforms. He discussed these issues in a lunchtime meeting.

Can the EMS be Exported? Lessons from Ten Years of Monetary Policy Coordination in Europe
Francesco Giavazzi and Alberto Giovannini

Discussion Paper No. 285, January 1989 (IM)