Following two decades of increasing integration of European financial markets, the proposed date for European Monetary Union is drawing closer. Consequently, much European academic and political discussion is focusing now on the costs of losing national control over monetary and exchange rate policy tools, as well as on the consequences of financial integration for the efficacy of monetary policy. On the occasion of the 150th anniversary of the Banco de Portugal, a conference – jointly sponsored by the Banco de Portugal and CEPR – was held on 22 November 1996 at the Centro Cultural de Belem in Lisbon to address these and related issues. The organizers were Vitor Gaspar (Banco de Portugal) and Francesco Giavazzi (IGIER, Università Bocconi and CEPR).

A paper entitled ‘Learning to be Credible’, presented by In-Koo Cho (Brown University), and written with Thomas J Sargent (University of Chicago and Hoover Institution, Stanford University), examined the acquisition of macroeconomic credibility, building on the classic Kydland and Prescott (Barro-Gordon) Phillips curve model.

In the one-period economy, since the Nash equilibrium is inferior to the Ramsey equilibrium, there is value in a commitment mechanism. In the infinitely repeated economy, there is a large set of equilibria, including the Ramsey solution. The authors used learning as a means of selecting among the equilibria. One of the conclusions was that only the Nash and the Ramsey outcomes occur with positive probability. The bad news, however, is that the Nash outcome occurs most of the time, thus confirming the value of a commitment mechanism. Matthew B Canzoneri (Georgetown University and CEPR), suggested that central banks could be differentiated by different learning mechanisms. Roger H Gordon (University of Michigan) questioned the slow learning speed.

In ‘Do Exchange Rates Move to Address International Macroeconomic Imbalances?’, Matthew B Canzoneri (Georgetown University and CEPR), Javier Valles (Banco de Espana) and Jose Viñals (Banco de Espana and CEPR), addressed the economic desirability of a European monetary union (EMU) by focusing on the potential cost of losing the nominal exchange rate as a tool for macroeconomic stabilization. Most of the literature has documented the relevance of asymmetric shocks and large real exchange rate movements, and has concluded that a wider union would be too costly. The authors concluded, however, that the asymmetric shocks that caused international imbalances were not the ones that were moving exchange rates, from which they inferred that the loss of the exchange rate tool would not be very important. They also found that money and financial shocks explain less than 10% of the short-run variation in relative national outputs, so that joining a currency union would not eliminate the major sources of imbalances. Overall, they concluded that the costs of EMU had been exaggerated.

Axel Weber (Universität Bonn and CEPR) questioned whether the data had been tested for co-integration and criticized the absence of a more complex model. Preston Miller (Federal Reserve Bank of Minneapolis) questioned whether past estimates could be used for the new EMU regime.

Roger H Gordon (University of Michigan) and Vitor Gaspar (Banco de Portugal) analysed the ‘Taxation of Asset Income: Implications of Monetary Union’. Whereas some previous literature predicted that, in a financially integrated world, low capital-mobility costs should drive down the tax rates on income from capital, this did not seem to have taken place. The authors’ explanation was that domestic residents hold domestic equity as a means of hedging the risk in relative prices of domestic and foreign goods. This explanation is valid if agents ‘prefer’ domestic goods and the monetary authority stabilizes the exchange rate rather than the domestic price level. In this environment, the prediction that in a financially integrated world tax competition would drive the tax rates to zero does not hold. The authors also analysed the welfare implications of a monetary union and its impact on the optimal tax rule. They concluded that the union would have a negative welfare effect and that the tax rate could be zero.

The implications of taxation of income from capital in a financially integrated world were also considered in ‘Foreign Direct Investment, Transfer Pricing Rents and Ownership Structure’, by Kai A Konrad (Freie Universität Berlin and CEPR). Taxation of income from capital gives multinational firms an incentive to use transfer pricing to reduce their tax base. According to received wisdom, these incentives cause inefficiencies. Konrad’s paper, however, suggested the opposite view, by taking into account the ‘hold-up’ problem associated with FDI.

The argument runs as follows. Suppose a firm is considering a (potentially) highly profitable FDI venture. Suppose further that the firm knows that the host-country government’s objective is to maximize domestic welfare and that it has an incentive to confiscate all of the profit generated by the investment once the firm has undertaken the sunk cost of investment. In these circumstances, the foreign investor would anticipate the government’s incentive, with the result that the investment would not take place. If, however, the foreign investor could use transfer prices to shift part of the profit, the government would be unable to identify and, hence, to confiscate the true profits. Thus the transfer-pricing mechanism helps to overcome the ‘hold-up’ problem.

Konrad analysed this mechanism more closely in a principal-agent setting, showing how the existence of asymmetric information between a foreign investor and the host government, together with the transfer-pricing mechanism, reduces the ‘hold-up’ problem. Moreover, he showed that welfare can be further increased if host-country citizens acquire a minority shareholding in the project. The paper thus provides an efficiency reason for ‘indigenization’ of FDI. Isabel Correia (Banco de Portugal, Universidade Católica Portuguesa and CEPR) stressed that the analysis abstracted from fully dynamic ‘folk-theorem’-type arguments, and that an alternative policy that would solve the time-consistency problem would involve subsidies to initial investment. She also argued that a truly benevolent government would take into account the economic benefits (and costs) from foreign investment.

In ‘What Happens When Countries Peg Their Exchange Rates? (The Real Side of Monetary Reforms)’, Sergio Rebelo (University of Rochester and CEPR) argued that the real effects of adopting a fixed- exchange rate regime could be explained by the expected behaviour of fiscal policy. Such an exchange-rate rule must impose fiscal discipline. Rebelo calibrated a dynamic general-equilibrium, small open-economy model that reproduces the stylized facts created by a stabilization programme. Following the introduction of a peg, such economies will tend to experience an increase in GDP, with a large expansion of production in the non-tradable sector and a contraction in the tradable sector, a current account deficit, and a sharp increase in prices of non-tradable goods.

Referring to the case of Portugal, which joined the ERM in the early 1990s, Antonio P Barbosa (Universidade Nova de Lisboa) argued that a high risk premium had prevented the Portuguese economy from experiencing the consumption boom predicted by the model. Richard Portes (London Business School and CEPR) argued that some puzzles remain to be explained. In some cases, the real appreciation had happened before the stabilization; in Eastern Europe, however, the opposite was true. For Rebelo, the former outcome resulted from anticipation of the reform; in the latter case, the fiscal reforms were minor relative to other events in those economies.

Stefan Gerlach (Bank for International Settlements and CEPR) and Frank Smets (Bank for International Settlements) presented ‘MCIs and Monetary Policy in Small Open Economies under Floating Rates’. MCIs, (monetary conditions indices) are defined as a weighted average of an interest rate and an exchange rate, real or nominal, and are used by some countries as an operating target of monetary policy in the context of floating exchange rates. The authors’ model consists of a system of equations describing aggregate demand, aggregate supply, and the nominal and real interest rates. Their paper discussed theoretical and empirical issues relating to the construction of MCIs.

How should the European Central Bank (ECB) pursue monetary policy, and how should this policy be coordinated with EU countries that remain outside EMU?

According to Torsten Persson (Institute for International Economic Studies, Stockholm, and CEPR) and Guido Tabellini (IGIER, Università Bocconi and CEPR), some policy-makers suggest that the ECB should adopt an intermediate money target and that the outside countries should unilaterally stabilize their exchange rates towards the single currency.

In their paper on ‘Monetary Cohabitation in Europe’, however, Persson and Tabellini argued that a system of mandatory inflation targets would be preferable. One reason was that this system was more symmetrical. In addition, an inflation target would have the advantage over a money target of offsetting velocity shocks and of facilitating accountability of the ECB’s actions. For coordination of monetary policy, a regime of symmetric inflation targets would remove the incentive to engage in competitive devaluations and restore domestic credibility to a low inflation policy (although these two objectives could be achieved by a money target as well).

‘Inflation Targets: Extensions’, presented by Lars E O Svensson (Institute for International Economic Studies, Stockholm, and CEPR), extended his previous work on the inflation-targeting regime in a closed economy to a small open economy. In addition, he described the responses of monetary policy to various shocks under such a regime and discussed issues of model uncertainty.

Abel M Mateus (Banco de Portugal and Universidade Nova de Lisboa) presented ‘Optimal Asset and Debt Portfolios: A Hedging Strategy’, written with Sweder van Wijnbergen (University of Amsterdam, London School of Economics and CEPR). Relatively few instruments may be needed to construct the optimal portfolio of assets to be held by a central bank as a means of hedging exogenous trade shocks. In their view, in the Portuguese case, a portfolio comprising Deutschmarks, US dollars and gold would suffice. Joseph Zeira (Hebrew University and CEPR) supported the basic idea in the paper that agents should hold assets of the countries that supply their imports, and should issue debt to be held by the countries that purchase their exports. Berthold Herrendorf (University of Warwick) questioned the assumption that risk was exogenous.

In ‘Managing the Public Debt in Fiscal Stabilizations: Theory and Practice’, Alessandro Missale (Universita di Brescia and CEPR), Francesco Giavazzi (IGIER, Università Bocconi) and Pierpaolo Benigno (IGIER, Università Bocconi and Princeton University) examined episodes of fiscal stabilization. They found that, at the outset, governments were more likely to lengthen the maturity of the public debt the higher their initial reputation, the more credible the stabilization programme, and the higher the roll-over risk due to exogenous uncertainty about future interest rates.

The authors presented a model consistent with these facts, in which there is imperfect information on the government’s willingness to implement an expenditure-reducing programme. For a government determined to implement such a programme, it is costly to shorten the maturity of the debt because this would expose the budget to interest-rate variation, which would reduce the probability of success. That policy, however, reduces future interest payments, because such debt will be refinanced at a lower rate once private agents observe that the spending cuts have taken place. A government that is determined to achieve success may therefore issue short-term debt in order to reveal its credentials as an ‘expenditure reducer’. Preston Miller (Federal Reserve Bank of Minneapolis) suggested the need to improve the modelling of the behaviour of the private sector and the government. Berthold Herrendorf (University of Warwick) criticized the assumption that the maturity of the debt is chosen at the beginning of the programme and cannot be changed.

In ‘Imperfect Competition, Risk Taking and Regulation in Banking’, Carmen Matutes and Xavier Vives (Institut d’Anàlisi Econòmica, CSIC and CEPR) explained the links between imperfect competition for deposits and risk-taking in the banking sector with limited liability. Since failure implies a social cost – which banks do not internalize – the authors considered alternative deposit insurance regimes and information structures. They concluded that, when the portfolio risk is not observable, and the social cost of failure is large, deposit (or interest rates) regulation should be complemented by direct asset restrictions. The same holds in case there is flat premium insurance, independently of the social failure cost. Risk-based insurance dominates uninsured competition in welfare terms, but rate regulation still may be needed to improve welfare. Luis Cabral (London Business School, Universidade Nova de Lisboa and CEPR) suggested extensions in terms of informational requirements (e.g. optimal regulation taking into account information costs). One participant questioned whether social cost of failure was compatible with deposit insurance, since in this case there would be no bank runs.

Mario I Blejer (Hebrew University and University de San Andres) presented ‘Exogenous Shocks, Deposit Runs and Bank Soundness: A Macroeconomic Framework’, written with Ernesto V Feldman and Andrew Feltenstein (Virginia Polytechnic Institute). The paper analysed the effects on real economic activity of a bank run, and evaluated alternative macroeconomic stabilization policies. Michael J Stutzer (University of Minnesota) criticized the model for not being precise as regards the welfare criterion.