The European Commission has now proposed its case for the Community's monetary union (in `One Market, One Money', European Economy, 44, October 1990), which Research Fellow Jacques Mélitz reviews in Discussion Paper No. 556. While the report comprehensively weighs the gains from reduced transaction costs and uncertainty against the costs of sacrificing national exchange rates as policy instruments and in particular the implications of a common currency for inflation control it pays little attention to the differences in these costs and benefits faced by low- and high-income member states. It also overstresses the importance of terms-of-trade stability, since adjustments to the individual prices of goods are a more suitable adjustment mechanism than exchange rate changes for high-income countries engaged in two-way trade in the same industries.

Mélitz notes that the Commission's argument that fiscal policy requires protectionism to offset its large spillover effects contradicts the results of simulations using the IMF's MULTIMOD and its own QUEST model. Fiscal policy affects not only traded goods but also services and non-traded goods, and its repercussions on trade relate in part to trade outside the union; the fixed internal exchange rate implies a positive spillover, while the flexible external exchange rate creates a negative spillover. Although the Commission notes these spillovers, it argues that fiscal coordination is required because the union's current account balance will be a Community-wide public good. This makes little sense, however, since the citizens of one member state can derive no direct utility or disutility from a deficit in another.

Mélitz notes theoretical concerns about tax competition and empirical evidence on the behaviour of federations' member states which provide as many reasons to fear excessive fiscal conservatism as the opposite. Apprehensions about Italy's debt could be allayed by recommendations on prudential rules, provisions for market risk assessment, and appropriate protection for individual banks. If fiscal autonomy is to be restricted, these proposals for fiscal federalism are coherent, but the success of EMU need not depend on any major reform of this type. Mélitz questions the view that a single currency will in fact be introduced `once-and-for-all': if there is to be a transitional phase with parallel units of account in each country, its psychological and computational costs may be cut by letting the new unit coincide with one of the major existing ones.

Mélitz lastly notes the Commission's fundamental oversight in neglecting the role of a lender of last resort. By fulfilling this role for the Community's banks, the Eurofed could safeguard against the possible repudiation or forced rescheduling of member governments' debts, so the risk of high public debt to the banking sector could be averted without infringing national sovereignty outside the monetary sphere. Such a transfer of existing central bank functions to a new central bank would put the Commission on much firmer ground than imposing new limitations on national fiscal authorities.

Brussels on a Single Money
Jacques Mélitz

Discussion Paper No. 556, July 1991 (IM)