While most member countries of the European Community favour monetary integration by administrative fiat, the UK government has recently proposed that a new European monetary order could emerge from institutional competition between a `hard-ecu' issued by a `Hard-Ecu Bank' and existing ERM member currencies. In Discussion Paper No. 512, Research Fellow Peter Bofinger analyses the UK proposal in the context of the theory of political economy. He notes two preconditions that underlie the proposal: that there is no theoretical knowledge of a single currency's advantages; and that markets will produce a Pareto- efficient arrangement.

By analysing the microeconomics of currency competition on the basis of traditional functions of money, he shows that the hard- ecu's prospects are very limited. By definition it protects its holders against intra-ERM devaluations, and this promotes its use as a means of exchange. A hard-ecu bank note can be replicated by a national bank note plus a free call option that entitles its holder to exchange it for the strongest ERM currency at any time. This option's value depends on the difference between national and lowest-EC inflation rates, which is greater in peripheral countries (including the UK) than in the core. This distortionary subsidy supports one currency unit, however, so the proposal in fact presupposes theoretical merits of a single currency that it claims to deny. The benefits of switching from a national currency to the hard-ecu must also be set against the additional transaction and information costs of using several currencies in one currency area. Private agents reduce such costs by adopting a convention; but the established convention of using national currencies has only been repudiated historically during hyperinflations. As a store of value, the implicit option reflects interest rate differentials between national currencies and the hard-ecu. The establishment of a distinct hard-ecu market is unlikely, however, since markets can efficiently use the highly liquid established trading channels for Deutschmarks.

Turning to the UK proposal's macroeconomic implications, Bofinger shows that such an additional nominal anchor could only contribute positively to monetary stability if all the major ERM central banks pursued inflationary policies, but the Hard-Ecu Bank's management will only behave completely differently from all other national central bankers if its statutes are much more stringent than those of existing central banks. The UK proposal fails to address this point and therefore does not apply the theory of political economy comprehensively. Bofinger concludes that the proposal is half-baked: its emphasis on currency competition in a market is quite inconsistent with subsidies it proposes to the holders of hard-ecu notes and deposits, and without such official backing it cannot create a Pareto-efficient European monetary order.

The Political Economy of the Hard-ECU Proposal
Peter Bofinger

Discussion Paper No. 512, February 1991 (IM)