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In the 1980s the right place to be was inside the EMS, Francesco
Giavazzi told a lunchtime meeting organized by CEPR and the London
office of the Commission of the European Communities on 11 January:
membership allowed disinflation at relatively little cost in terms of
reduced output. In the 1990s, however, financial integration will
eliminate many of the System's advantages: intra-EC trade imbalances are
likely to grow, and so steps towards monetary unification may be
self-defeating unless they are accompanied by real convergence. The major accomplishment of the EMS in the 1980s, Giavazzi noted, has been a disinflation at a very low cost in terms of lost output. To bring about an almost equal reduction in the inflation differential vis-à-vis Germany (10%) required a loss of 13 percentage points of output growth (relative to trend) for the United Kingdom, as opposed to 5 percentage points for Italy. The EMS has been much less successful at bringing about `real convergence', in particular of fiscal policies. Nevertheless the System has avoided the danger that stabilization of real exchange rates, coupled with divergent fiscal policies, would spill over to the current account and create large intra-European trade imbalances, which simply did not exist before 1987, Giavazzi noted. Giavazzi's research with Alberto Giovannini highlighted the importance of exchange controls in averting intra-EMS current account imbalances, despite differences among members in their fiscal policy stances. The EMS has been characterized by a centre country Germany whose Central Bank pursues its own monetary targets independently of policies pursued by the other members. German interest rates are not affected by most intra-EMS shocks, such as expectations of parity realignments. Interest rates denominated in other currencies suffer the whole impact of intra-EMS portfolio disturbances. Countries like Italy and France have used control of the money supply to peg their currencies to the DM, with exchange controls permitting them to cool the economy down whenever output threatened to grow faster than in Germany, helping prevent current account deficits vis-à-vis Germany. Will the advantages of EMS membership continue, now that financial integration is the name of the game in Europe? The answer, according to Giavazzi, depends on the assessment of the effects of financial integration. One common argument emphasizes the difficulties likely to be experienced by a system of fixed but adjustable parities such as the EMS in the face of speculative attacks. If such speculative attacks were the only difficulty created by integration, they would be unimportant, Giavazzi argued. Such attacks meant only that the EMS must in the short run reinforce its financing mechanisms, such as the Very Short-Term Financing Facility, and in the medium term speed up the move towards monetary unification. The real problems facing the EMS as a result of the move towards financial integration were different and more serious, according to Giavazzi. Financial integration will remove exchange controls from the toolkit of central banks, so that the target of current account balance is no longer within their reach. Having lost the ability to control domestic interest rates, members other than Germany can no longer cool down their economies: the result is healthy growth, but large external imbalances vis-à-vis Germany. EMS members are therefore likely to face problems very similar to those now experienced by the United Kingdom, Giavazzi concluded, so the macroeconomic advantages of EMS membership may disappear as liberalization proceeds. If intra-European current account imbalances do emerge as financial integration takes place, should we worry about them? The answer, according to Giavazzi, depends on the countries concerned. A Spanish current account deficit vis-à-vis Germany may simply reflect healthy investment of German savings in fast-growing Spain. This is desirable, because it is certainly simpler to move machines from Düsseldorf to Andalucía than to move workers the other way. The current account deficits of Italy, and possibly the United Kingdom, on the other hand, reflect borrowed consumption, rather than investment. The US experience in the 1980s suggests that as soon as the market begins to think that the economy has embarked on an unsustainable path, the exchange rate will collapse. At that point no safety-net will be able to save the EMS. Giavazzi concluded that European moves towards financial integration and monetary unification may be self-defeating in the sense that they may create the conditions for their own defeat unless they are accompanied by what he termed `real convergence', in particular of fiscal policies. Europe-wide automatic stabilizers would help achieve this convergence, he argued. Automatic stabilization could be achieved by centralizing a portion of social security contributions and the entire payments of unemployment benefits. This would redistribute resources across Europe and smooth the divergences in fiscal policy that are responsible for current account imbalances within Europe. One member of the audience was puzzled by the assumption of fixed exchange rates with differing fiscal stances, but Giavazzi emphasized EMS members' need to retain at least one policy instrument to cope with shocks, given that shocks affect differently countries with different economic structures. It was also suggested that targeting current account balance would not be necessary: though central banks' ability to affect the current account would be restricted, high capital mobility could surely induce automatic correction of intra-EC trade imbalances. |