Two major unresolved issues in the process towards European financial and monetary integration are the role of fiscal policy and the problems of the transition. Several aspects of these issues were examined at a workshop held by CEPR and the Banco de España in Madrid on 15 December. The workshop was organized by Research Fellow George Alogoskoufis, and it took place as part of the Centre's research project on `Financial and Monetary Integration in Europe', which is funded by the Commission of the European Communities under its SPES programme.

Luigi Spaventa (Università degli Studi di Roma and CEPR) opened the workshop with a paper on `Fiscal Rules in a European Monetary Union: A No-Entry Clause', written jointly with Alberto Giovannini. Spaventa argued that the undesirable spillover effects arising from the uncoordinated discretionary setting of national budgetary policies cannot be averted by means of `budget rules'. He maintained that such coordination problems may not be of great importance in Europe, whereas the sustainability of fiscal policy is critical to a number of EC member countries. Economic and monetary union may exacerbate the problems of countries with `unsustainable' fiscal positions, which may threaten the stability of any union of which they are members. Spaventa suggested that monetary discipline enforced by a `conservative' European Central Bank, accompanied by enhanced market discipline, would be unlikely to impose sustainability or offset the effects of some members' unsustainable fiscal positions. He advocated more specific sanctions or threats, such as a pre-announced `no-entry' clause that would make membership of the union for some countries contingent on their fiscal positions.

George Alogoskoufis (Birkbeck College, London, and CEPR) and Frederick van der Ploeg (Universiteit Tilburg and CEPR) discussed the effects of growth on budgetary, monetary and exchange rate policies, which they had examined in two joint papers, `On Budgetary Policies, Growth and External Deficits in an Interdependent World' and `Money and Economic Growth Revisited'. They used a class of overlapping generations endogenous growth models to demonstrate that a general rise in the ratio of public debt to output or the share of government consumption in GDP will reduce both savings and economic growth, while a relative rise in a single country's debt-output ratio or the government consumption share in GDP will lead to a relative fall in its national savings rate, a current account deficit and a reduction in external assets. They found that this reduced growth will be associated with increased inflation, even when debts are not monetized and growth of the money supply remains constant. An increase in the monetary growth rate will increase inflation by less than one to one, since it will reduce the debt-GDP ratio and increase both private savings and growth.

Alogoskoufis and van der Ploeg maintained that European monetary union will increase the Community's average debt-GDP ratio and therefore reduce average savings and the growth of output, unless the reduction of monetary growth is accompanied by fiscal consolidation. Moreover, inflation may fall by less than monetary growth. They concluded that the `high-inflation' countries must find other fiscal means of stabilizing their debt-GDP ratios if they and the remaining EC member countries are to benefit from monetary union.

José Viñals (Bank for International Settlements and CEPR) and Juan Dolado (Banco de España) then presented a paper written jointly with Fernando Ballabriga entitled `Fiscal Deficit Targets in the Transition to EMU'. They argued that fiscal policy guidelines must be both conducive to financial sustainability and also appropriate to the Community's macroeconomic policy mix. They suggested as a compromise that national fiscal positions conform to medium-term targets with extra flexibility in the shorter term. A possible solution would be to apply the well- known `EMS rules' to fiscal policy, permitting countries to shift their annual budget deficits within a `band' around a specified national target and in exceptional circumstances to ask their partners for a `realignment' of the target budget deficit. Such a mechanism would avoid explicit unilateral fiscal action and provide the `flexible discipline' that is necessary to the transition to full economic and monetary union.

Andrew Hughes Hallett (University of Strathclyde and CEPR) presented a paper written with David Vines on `Macroeconomic Adjustments in a Monetary Union', focusing on the implications of asymmetric shocks for alternative exchange rate regimes. He presented a number of simulations based on a numerical neo- Keynesian model with price sluggishness but with forward- looking price setters to show that monetary union increases the adjustment costs borne by real variables, since relative asymmetric shocks can no longer be accommodated by exchange rate policy. Hughes Hallett noted that fiscal flexibility can reduce these costs and may be necessary to make monetary union acceptable. Nevertheless, it does not solve the main problem of obtaining a satisfactory distribution of costs and benefits while securing an improved aggregate performance.

Marcus Miller (University of Warwick and CEPR) and Alan Sutherland (University of Warwick) presented the final paper of the workshop on `The Walters Critique of the EMS: A Case of Inconsistent Expectations'. According to Sir Alan Walters, an inflationary economy entering a monetary union without capital controls such as the UK joining the ERM in late 1990 will be forced by financial arbitrage to reduce its nominal interest rates, which in turn will reduce its real interest rates, stimulate the economy and exacerbate inflation. This tendency for inflation to diverge will be checked only if the peg is not credible. Miller and Sutherland used a small macroeconomic model with forward-looking wage setters to demonstrate that the `perverse' real interest rate effect highlighted by Walters operates only when financial markets view the peg as credible, but labour markets do not. Moreover, even if inflation diverges on joining, there are two powerful stabilizing mechanisms. First, the real exchange rate will appreciate as prices rise, thus checking aggregate demand and inflation; second, if the monetary union is rigidly enforced, so that realignments never occur, expectations will converge through `learning' in both markets, again reducing relative inflation to zero. Miller and Sutherland concluded that even if expectational inconsistency generates the short-run effects that Walters predicts, stability will be restored in the longer run.