The potential economic benefits of Europe's eventual monetary integration are widely understood, but the political considerations that will dominate the transition have received less attention. In Discussion Paper No. 618, Michele Fratianni, Research Fellow Jürgen von Hagen and Christopher Waller argue that any exchange rate regime for the transition must retain enough flexibility to accommodate idiosyncratic shocks, while remaining compatible with free capital mobility and not prone to speculative attacks. The commitment to EMU and price stability must also be credible and conducive to the establishment of an independent ECB.

They propose that a `two-tier' version of the EMS with five basic elements will fulfil all these conditions. First, all member countries must intervene to keep their currencies within 6% of their central parities; they may also declare narrow bands of 2.25% (initially) to signal a stronger commitment to EMU. As exchange rates approach the limits of the narrow bands, the risk to speculators of capital losses reduces the danger of speculative attacks. Second, whenever a currency persistently remains outside the band, the Council of EMS Central Bank Governors should formally decide whether to realign or maintain the central parities: the regularity of its meetings should reduce their symbolic content and allow the ERM to combine credibility with flexibility in face of asymmetric shocks. Third, member governments must gradually reduce their control of monetary policy to allow an independent ECB to become established. Fourth, there should be a gradual tightening of the ERM's narrow bands as convergence and the authorities' commitment to fixed exchange rates both increase. Fifth, the final decision to implement EMU should be delayed until three years after the last realignment, once the national monetary authorities judge their own independence to have attained the level required for the ECB.

The authors also compare the draft proposal for the ECB constitution in the draft prepared for the December 1990 Rome summit with that of the Bundesbank. For a model of an agency problem in which the public desires low inflation and stable output and employment and entrusts the control of monetary policy to a central bank, they find that , the `right' central banker exercising discretion will serve the public better than a rigid price rule so long as supply shocks remain. They note three fundamental flaws in the ECB draft: the price stability objective takes the form of an overly rigid rule; independence is defined in very restrictive terms, which forbid the ECB even to seek outside advice; and the explicit prohibitions on the ECB's extension of credit to national governments or direct purchase of their debt obligations leave it free to conduct unlimited open market operations and purchases of government debt via institutions.