As part of CEPR's continuing analysis of the implications of the transition to EMU, a new Occasional Paper on the options for future exchange rate policies under EMU was published in February 1998. The paper was written by David Begg (Birkbeck College, London, and CEPR), Francesco Giavazzi (IGIER, Università Bocconi, Milano) and Charles Wyplosz (Graduate Institute of International Studies, Geneva). At a lunchtime meeting on 12 February, David Begg (Birkbeck College, London, and CEPR) outlined the main conclusions of the paper, which dealt particularly with the options for the euro in relation to the dollar. Begg argued that future exchange rate policies will have to be determined along necessarily informal, yet supple lines and that this had implications for the current Stability and Growth Pact as well as for the way in which the future European Central Bank (ECB) would adopt its policies.

Begg maintained that, when thinking about the exchange-rate policy for EMU, the first step must be to throw away the small-open-economy spectacles. Past European experience will be largely irrelevant to the authorities of a large and relatively closed economic area. European policy-makers thus have more to learn from the US experience than from any European country's own recent history. This incentive is reinforced by the recent success of the US economy in achieving sustained growth without inflation.

Because Europe will resemble the United States, the ECB will behave much more like the Fed, devoting far less attention to the exchange rate than hitherto has been the case with European central banks. A flexible and adhoc approach to exchange rate management is therefore called for. Begg warns, however, that passive imitation of the United States could be misguided, because EMU will differ from the US case in several important dimensions. First, monetary policy will be run by a new institution, endowed with a strong legal design, but initially lacking a track record of its own. Second, contrary to the Fed, which has developed a fairly good understanding of how the US economy works, the ECB will face substantial uncertainty about the European economy, and particularly about the way in which a common monetary policy will affect prices and output throughout the region.

A third difference is that, although standard measures of openness suggest that EMU will be as closed as the US economy, trade in Europe will be different in nature from that in the United States, particularly as exchanges with the countries in Central and Eastern Europe expand. Fourth, fiscal policy in the monetary union will be run by many independent governments, under the coordination mechanism provided by the Stability and Growth Pact. Finally, the ECB is likely to consider that it must take early action to establish a track record. It is thus widely expected that monetary policy initially will be tight – indeed tighter than normal – as the new central bank attempts to secure its reputation.

It follows, according to Begg, that EMU-wide monetary aggregates will, at least initially, be quite unstable. Consequently, the most desirable monetary policy framework for the ECB would be an inflation target, operated via an interest-rate instrument. An additional initial difficulty will arise from the possibility that the cross-country effects of a common monetary policy might be quite different, on account of the differences that exist in financial structures and, thus, in the transmission channels of monetary policy from one EU state to another. It is important to understand, therefore, that the introduction of a single currency will automatically produce more harmonization, and that this, in turn, will require active policy decisions.

Again, Begg suggests, there are important differences with respect to the United States. One difference is that exchange rate fluctuations between the euro and other European currencies (pre-ins, and the currencies of countries that have not yet joined the EU) will continue to matter. A second is that exchange rate fluctuations vis-à-vis the countries in Central and Eastern Europe will deserve new attention. These exchange rates will become increasingly important as trade relations grow, and as they change in nature (e.g., through more intra-industry trade). A third difference is that fluctuations in the euro-dollar exchange rate will also affect some regions and industries more than others, inducing the risk of a call for protectionist measures.

Notwithstanding all these differences, monetary policy discussions between Europe and the United States will become serious only in the presence of a very large exchange rate misalignment – that is, if and when fluctuations in the euro-dollar exchange rate become large and persistent enough to threaten a trade war. Taken together, these considerations imply that the only feasible exchange rate arrangements between EMU and the United States will be informal in nature. This suggests, in turn, that there will be a need for institutions that facilitate international dialogue and cooperation among different authorities on the two sides of the Atlantic.

At the same time, there is a danger that EMU will disrupt the operation of the two most important among these institutions – the IMF and the G7 – thus limiting the scope for international policy coordination. At the outset, only national governments will have effective fiscal-policy powers, and this situation is likely to prevail for some time. This set-up implies a two-level coordination problem: between the ECB and the governments taken together and among governments. Two conclusions and one policy implication seem to follow from this.

First, the ECB will be less able to rely on its own rules and credibility to provide adequate discipline incentives to member governments than in the normal case with one central bank and one government. The consequence is likely to be an inefficient policy mix. The ECB may have to abandon any tendency to offset lax fiscal policies, with the result that inflation will end up higher than socially desirable. Second, the lack of coordination among national fiscal authorities will complicate the relationship between the ECB and its member governments.

The policy implication is the emergence of a case for some constraint on national fiscal policies, even if the credibility of the ECB proves unquestioned. Thus the Stability and Growth Pact may have to apply to cyclicallyadjusted budgets, and not to unadjusted budgets that are cyclically dependent. Although the Pact agreed at the Dublin Summit took a small (and ad hoc) step in this direction, by itemising particular cyclical circumstances in which exemptions to normal rules would apply, this was a very incomplete solution. If the result turns out to be excessively tight fiscal policies, the Pact will put the ECB under pressure to opt for a tight fiscal-easy money policy mix. It will therefore impede, rather than assist, the ECB and, eventually, the Pact will have to be replaced by a more supple procedure which brings together the ECB and national governments.