Reglonal Science and Urban Economics 23 (1993) 401425 North-Holland

European monetary union and central

bank- independence

Mlchele Fratlannl
Indiana Unrverxty, Graduate School of Busmess, Bloommgton, IN 47405, USA and Fondo
lnterbancarro dl Tutela der Deposrtz, Rome, Italy

Jtirgen von Hagen*

Umversrty of Mannherm, Mannherm, Germany, lndtana Vnrversrty, Graduate School of Busmess,
Bloommgton, IN 47405, USA and The Centre of Economic Research, London, UK

Received September 1992

The paper focuses on the mam pohcy Issues facmg a future EMU, m particular the determmants
of mflatlon Monetary umon 1s a form of collusion among central bankers, which 1s clearly bad
If It IS compared with an Ideal competltlve scenario with Independent central banks We argue,
however, that EMU could contnbute to tmprovmg the quahty of monetary pohcy m Europe
The greatest benefit from EMU stems from Its potential as a commitment mechamsm to price
stablhty which many countries may not have available domestically It IS paramount that the
European monetary authority be independent of the political system, m general, and the fiscal
authorities, m particular Unless EMU IS interpreted as leading to pohtlcal union m Europe,
there IS no need for any greater coordmatlon or centralization of government spending m the
monetary union Fiscal coordmatlon and centrahzatlon run contrary to the establishment of a
low-inflation EMU because they weaken the relative strength and independence of the monetary
authority Finally, we reject the call for fiscal restraints m a EMU

1. Introduction

There IS very httle m the Rome Treaty of 1957 to suggest that the
foundmg fathers of the European Community were planning for a European
Monetary Union (EMU) Altogether there are SIXarticles m the Treaty that
may be construed as having some bearing on EMU Article 104 states that
each Member State - and not the Community as a whole - shall pursue the
three objectives of economic pohcy overall balance of payments, high
employment and stable prices Article 103 blandly states that ‘Member States

Correspondence to Mlchele Fratlanm, Indiana University, Graduate School of Business,

Bloommgton, IN 47405, USA
*An earher version of this paper was read at the Mount Pelerm Society General Meeting m
Munich, Germany, 2-8 September 1990 We thank two anonymous referees for valuable
comments

016&0462/93/$06 00 0 1993-Elsevler Science Pubhshers B V All rights reserved

402 M Fratlanm and J van Hagen, European monetary union and central bank mdependence

shall regard their conJunctural pohcles as a matter of common concern ’

Article 107 narrows down the range of ‘common concern’ to exchange rates
If exchange rates turn out to be inconsistent with the ObJectives stated m
Article 104, the Commlsslon may authorize other Member States to take
actions to offset anti-competltlve condltlons In other words, Article 107
opens the door to the use of exchange and capital controls Article 105 calls
for the formation of a Monetary Committee with a simple advisory status
‘ to facilitate attainment of the obJectives set out m Article 104 ’ Article
108 calls for a program of mutual assistance, but Article 109 m essence says
that, m an emergency, Member States can take any measure they like
without any conslderatlon about what such measures may have on others In
sum, even the most optlmlstlc reader will find little evidence that EMU was
m the minds of those who drafted the Rome Treaty
Monetary union was first adopted as a long-term goal of the EC at the
Hague conference m 1969 which gave impetus to the celebrated Werner
Report [Council (1970)] The Werner Report, like the Delors Report,
proposed an lmplementatlon of monetary union m stages The first stage,
from 1971 to 1974, would create the machinery for coordinated pohcy-
making The second stage would make exchange rate changes depend on
explicit member agreements A Community central bank, shaped after the
Federal Reserve System, would centralize monetary pohcy m the final stage
The Werner Report led directly to the Snake agreement m 1972, the creation
of the European Monetary Cooperation Fund m 1973 and a spate of
directives aimed at mstltutlonahzmg pohcy coordmatlon [Christie and
Fratlanm (1978)] The MarJohn Report (1975) discussed the relationship
between trade and goods market integration and monetary integration m the
EC It argued that monetary union should be postponed until the achleve-
ment of a high degree of economic integration m the Community Reducing
barriers to trade and factor moblhty would create a unified internal market
which would be a sound basis for subsequent monetary unification The
MacDougall Report (1977) discussed the posslblhty of monetary integration
from the perspective of fiscal federalism The Report stressed the role of a
unified fiscal system m a monetary union and concluded that a monetary
union would not be viable without a sufficiently large Community budget for
fiscal policy
The concept of building monetary union gradually and on the basis of
economic union was crltlclzed by the Commlsslon’s President Roy Jenkins m
his Florence speech of 1977 Jenkins (1978) advocated a big leap forward to
EMU instead of a laborious ‘pohtlque des petlts pas’ Monetary union would
become the driving pohtlcal force to reach economic integration
After the unsuccessful experience of the Snake, the EC countries agreed to
form the European Monetary System (EMS) m December 1978 The EMS
Charter describes its goals as achieving ‘a greater measure of monetary
 M Fratlanm and J von Hagen, European monetary won and central bank mdependence 403

stability’, ‘growth with stability’ and ‘convergence of economic development’,

but it IS clear that the mam obJectlve IS monetary stability More than 10
years later, It IS fair to say that the EMS has surprised many for having
survived In fact, the majority of the economics profession on both sides of
the Atlantic, arguing on the srength of conventlonal open-economy macro
theory, predlcted the mevltable failure of an exchange rate arrangement
where high-inflation France and Italy would have to co-exist with low-
mflatlon Germany [Fratlanm and von Hagen (1990a)]
Followmg a period of stagnation m the early 198Os, the process of EMU
regained momentum durmg the Community’s current efforts to complete Its
internal market, the ‘Europe 1992’ program In Its latest step, the Council
adopted the Delors Report [Commlsslon (1989)] as the off~clal blueprmt for
monetary umiicatlon This report discussed the relatlonshlp between econ-
omic and monetary integration agam at length In what appeared to be a
compromlse between the positions of the MarJohn and MacDougall Reports
and the pohtlcal posltlon of Jenkins (1978), the Delors Report developed the
concept of parallehsm monetary and economic mtegratlon are two aspects of
the same process and have to be pursued simultaneously The Delors Report
also dealt with the role of fiscal polrcy m a monetary umon, calling
repeatedly for Its fiscal pohcy coordmatlon and the lmposltlon of bmdmg
restraints on members’ budgetary pohcles Like the Werner Report, the
Delors Report proposed to build monetary umon m three stages and
outlined mstltutlonal arrangements for each step ’
The Delors Report was a big leap forward m the process to achieve EMU
The document, which took for granted the deslrablhty of a monetary umon,
was oftiaally accepted by the Member States m the 1989 Madrld Summit
and paved the way for the revision of the EC Treaty agreed by the European
Council at the 1991 Maastricht Summit
The Maastricht Accord elevated EMU, price stability and sound pubhc
finances to the level of the Commumty’s fundamental obJectives, prepared a
strategy to achieve such ObJectives by the end of this century, and designed
the mstltutlonal framework that would sustain EMU While accepting the
gradual approach to EMU, Maastricht differs m several ways from the
recommendations of the Delors Committee 2 The Accord sets up condltlon-
ahtles and a precise timetable leading to EMU These condltlonahtles
concern the entry to Stage Three and aim at the convergence of Inflation
rates, the performance of pubhc finances, and the development of the

‘For a detaded view of the Delors Report and Its strategy to achieve EMU, see Fratlanm and
von Hagen (19904
‘For a detaded account read Fratlanm et al (1992a) For example, Maastricht drops
altogether the prmclple of parallehsm and envIsIons, at the begmnmg of Stage Two, the creation
of a new European Monetary Institute, which would admmlster the EMS and would prepare
the ground for the European Central Bank (ECB) The European Monetary Institute would
disappear when the ECB begms operations m Stage Three
404 M Fratlanm and .I van Hagen, European monetary won and central bank rndependence

monetary mstltutlons m the EC 3 Stage Two, the transltlon stage, is

scheduled to begin on 1 January 1994 and Stage Three, the final stage, no
later than 1 January 1999 Smce the Maastricht Summit, Danish voters have
reJected the Accord, while many other member countries have yet to ratify it
Consequently, there 1s some uncertainty as to how much of Maastricht will
survive the ratlficatlon process
This paper deals with the mam pohcy issues facmg a future EMU
Transitional problems, such as the length of Stage Two and so-called end
games, are not central to our interest 4 What 1s instead central here 1s the
issue of price stability [Dowd (1990)] Despite the considerable saving m
terms of transaction and mformatlon costs, the case for monetary union
cannot be settled wlthout knowing the price performance of the future ECB
There are two components to price mflatlon the trend and the deviation
from trend The former 1s a tax the costs of which must be weighed against
alternative forms of taxation The latter introduces ‘noise’ m the price
mechanism and consequently affects negatively the natural rate of output
Our analysis on the whole proceeds as d the Community had already
adopted a common currency or fixed Irrevocably exchange rates Sectlon 2
interprets EMU as a form of collusion among national central banks In
contrast to the standard notion about collusion, however, we argue that such
collusion can improve or dlmmlsh the quality of monetary pohcy, depending
on the mstltutlonal design of EMU Section 3 considers the lmphcatlon of
monetary dommance For that we develop a model of a high-inflation
country Joining a credible fixed-exchange rate system - that is, Stage Three
of EMU - under the assumption that the central bank 1s fully independent of
the fiscal authority We parameterlze the model and find that the 1980s have
already brought most EC countries close to the fiscal stance reqmred for a
EMU committed to price stability Section 4 looks at the role fiscal pohcy
should play m a monetary union Having learnt from the previous section
what central bank independence lmphes for the behavior of the national
fiscal authontles, we assess the proposal of lmposmg quantltatlve limits on
budget deficits We discuss, and rgect, the recommendations for greater
coordmatlon of fiscal pohcles m a EMU In sectron 5 we spell out the

3To be eligible for EMU, a country’s mflatton rate must not exceed the lowest three EC
milatlon rates by more than 1 5 percentage pomts, Its mterest rate on long-term government
bonds must not exceed those of the three Member States with the best mflatlon performance by
more than 2 percentage pomts, Its total government deficit must not be above 3% of GDP,
while Its outstandmg government debt must not exceed 60% of GDP For at least two years, the
country’s exchange rates v1s-a-v1s other EMS currencies must have remained wlthm Its EMS
band wlthout a devaluation of Its central parltles Finally, the statutes of national central banks
must be compatible with the statutes of the European System of Central Banks For more
details refer to Fratlanm et al (1992a)
4The relevance of the entry condltlons m solvmg end-game problems IS discussed m Fratlanm
et al (1992a, pp 19-21)
 M Frattanm and J van Hagen, European monetary umon and central bank mdependence 405

mstltutlonal requirements that would ensure a low-mflatmg ECB The final

section presents the mam conclusions of the paper

2. Central bank collusion vs. central bank competition5

Public choice literature regards monetary union as a form of collusion
among central banks [e g Vaubel (1980, 1989a)] This view contrasts the
monetary union with the alternative of a ‘competltlve scenario’ of pohcymak-
mg [e g Currle (1989), UK Treasury (1989) and Dowd (1990)] In a world of
free currency convertlblhty, capital mob&y, and flexible exchange rates,
central banks are subject to the pressures of international monetary pohcy
competltlon A high-inflation central bank encourages the private sector to
hold assets denominated m more stable currencies Consequently, the central
bank’s benefits from inflation - revenues from selgmorage and the ability to
conduct stablhzatlon pollees - disappear In contrast, a low-inflation central
bank IS rewarded by an mcreasmg use of its currency Competition of
monetary pohcles therefore exerts an important dlsclphnary force on central
bankers and prevents them from inflating too much
According to this view, the creation of a monetary union reduces the
degree of competltlon By tixmg the relative prices of their currencies and,
possibly, lssumg a common currency, central bankers eliminate ‘product
dlverslficatlon’ and adopt a common monetary pohcy instead As a result,
the threats and rewards from competltlon disappear Monetary union
destroys the dlsclphne of pohcy competltlon and thereby worsens the quality
of the product, that IS, it results m high average inflation
The negative assessment of monetary union based on the competltlve
scenario rests on three assumptions First, each central bank can pursue a
credible low-inflation pohcy independently of others under competltlve
circumstances Second, collusion among the members of the monetary union
reduces the degree of effective competltlon m the international arena Third,
the mdlvldual mcentlves to inflate are the same for each central bank m the
monetary union, collusion only reduces the cost of high inflation and the
reward for low inflation To assess the consequences of a EMU, the
important question 1s how valid these assumptions are

2I Credlbdlty of low-mnjlatlon pokes

Governments generally cannot make credible commitments to ex-ante

optimal, low-inflation pohcy rules, because, m practice, there IS no formal
punishment for breaching those commitments Barro and Gordon (1983)

5Thls sectlon draws from Fratlanm and van Hagen (1990~) and von Hagen and Fratlanm
(1990)
406 M Fratlannl and J von Hagen, European monetary won and central bank mdependence

have shown that, If nominal wages are rlgld and markets understand
pohcymakers’ mcentlves, the unenforceablhty of pohcy announcements biases
monetary pohcy outcomes towards higher inflation Equlhbrmm mflatlon 1s
positive although it generates no output or employment gains, because a
zero- or low-Inflation pohcy rule IS not time-consistent and its announcement
therefore IS not credible
The inflation bias and the lack of credlblhty stem from a deficiency m the
pohtlcal mstltutlons, namely the lack of an effective commitment mechanism
These failures cannot be simply rectified by appomtmg a ‘conservative’
central banker - as Rogoff (1985) and Thompson (1981) propose - because
such appomtments would be equivalent for pohtlclans to precommlt m-
directly to a low-inflation strategy The inflation bias must be viewed as the
result of a struggle between the confllctmg interests of elected government
pohtmans, who are mostly concerned with using monetary pohcy to ensure
levels of output and employment favorable for re-election, and central bank
offlclals who are concerned with price stability The more the central bank
has to give m to pohtlcal pressure, the less credible 1s the commitment to
price stability and the higher IS the inflation rate
Tabelhm (1988) has formalized these ideas using a two-period model where
the central bank Identifies with the interest of the private sector, whereas the
fiscal authorities (elected pohtlclans) behave like Buchanan’s Leviathan, that
IS, they care only about public expenditures The fiscal authorities are
interested m extracting as much selgmorage as possible but are limited by
the wlllmgness of the central bank to monetize a portion of the government
debt The higher the leverage of the fiscal authority on the central bank the
lower is the cost of financing a given government deficit Inflation, not
surpnsmgly, IS a positive function of the outstandmg volume of debt and the
degree of fiscal dominance The central bank (and by assumption the private
sector) benefits from more independence The optimal monetary arrangement
calls for complete monetary independence 6 In turn, complete monetary
independence forces the fiscal authorities to balance the budget at each point
in time
So we can conclude that the more submissive IS the central bank the less
credible is its commitment to price stability and the higher 1s the inflation

% recogmtlon of this prmclple, the Maastricht Accord grants full Independence to the ECB,
furthermore, the ECB will have price stablhty as Its prtmary objective [Fratlanm et al (1992a,
Table 2)] A central bank wtth such characterlstlcs may mcur the risk of placmg too much
weight on the objective of prxe stablhty and too little weight on the oblective of output growth
stabthty [Alesma and Summers ( forthcommg)] However, Independent central banks understabl-
hze output growth If they are too conservattve [RogoB (19831 Frattanm et al (1992b) show
that optimal Independent central bankers need not be too conservative m pursuing the price
stabthty ObJectWe, whtle Lohman (1992) reduces the risk of too much conservattveness by lettmg
the pohcymaker retam the rtght to overrtde the central banker’s dectslons
 M Fratlannr and J von Hagen, European monetary unron and central bank mdependence 407

rate The quality of domestic monetary pohcy IS endangered by the lack of a

commitment mechanism and the influence of pohtlclans on the central bank,
a pomt neglected m the competltlve literature

22 Borrowtng credtbtltty from a foretgn central bank

The delegation of monetary pohcy need not be limited to a domestic

central banker Alternatively, a central bank may decide to fix the exchange
rate between its currency and the currency of a country whose central bank
1s well known for its strong commitment to price stability This IS the basis
of a recent interpretation of the EMS, which holds that traditional high-
mflatlon countries, like France and Italy, have used the EMS to submit their
pohcles to the authority of the Bundesbank By fixing their exchange rates
with the DM, these countries have adopted the Bundesbank’s low-inflation
pohcy and gamed additional credlblhty of their own new commitment to
price stability [Glavazzl and Pagan0 (1988), Glavazzl and Glovannml
(1989)] The fixed exchange rate relieves these central banks from some of
the pohtlcal pressures and thus lowers then inflation bias The Bundesbank
1s regarded as the dominant central bank m the EMS
The interesting point of this interpretation of the EMS 1s that international
collusion can provide countries with a commitment mechanism not available
domestically The credlblhty argument implies that monetary union serves to
improve the average quality of monetary pohcy if it facilitates precommlt-
ment to a low-inflation pohcy Neglecting this posslblhty, the competltlve
scenario lmphcltly assumes that all central banks enjoy a large degree of
independence from domestic pohtlcal pressures to begm with, an assumption
that seems unrealistic m the European case
It 1s worth noting that a monetary union 1s likely to be a more efliclent
device of pohcy delegation than an exchange rate system with a dominant
low-inflation country The functlonmg of the exchange rate system 1s
complicated by a conflict between the high-inflation countries and the low-
mflatlon country, which results from the fact that the fixed exchange rate
alters the inflation mcentlves for the low-inflation central bank [Fratlanm
and von Hagen (1990a, b)] Being the ‘leader’ of the system, the low-inflation
central bank can partly export the inflation of a domestic monetary surprise
to other members With fixed exchange rates, this central bank therefore
faces a more favorable unemployment-inflation trade off, and hence her
incentive to generate unpredictable inflation rises The private sector 1s aware
of this change and adjusts by raising mflatlon expectations The inflation rate
rises The low-inflation country therefore ends up with a higher inflation rate
m the EMS than with an independent monetary pohcy But this higher
inflation rate results from the assumption that national monetary authorities
pay no attention to the inflation cost of domestic monetary expansions m
408 M Fratlanm and J van Hagen, European monetary umon and central bank mdependence

other countries 7 In a monetary umon, this externahty would not occur If

monetary pohcy IS conducted by a common authority concerned with price
stability m all member countries Provided that the monetary authority of
the union IS as commltted to price stablhty as the central bank m the low-
inflation country, the inflation rate would be lower in a EMU than m the
EMS

23 Monetary union and the degree of effective poky competltlon

The competltlve hypothesis obJects to monetary unification because It

restricts competltlon among monetary policymakers Vaubel (1989a) elabor-
ates on this point referring to Hlrshman’s prmctples of ‘exit’ and ‘voice’
[Hlrshman (1970)] ‘Exit’ IS the ability to mvest m assets denommated m
different currencies ‘Voice’ IS the voter’s ablhty to disapprove of erroneous
monetary pohcles through the ballot box EMU dilutes ‘voice’ because
collusion among policymakers makes pohtlcal responslbllltles more diffuse
and ehmmates the demonstration effect that a successful monetary pohcy m
one country has on other countries In the context of monetary union, ‘exit’
1s a more powerful prmclple than ‘volce’, because elections are decided over a
variety of issues But even m the competltlve scenario, ‘exit’ 1s limited by the
fact that citizens of one country are forced to use then home currency for
transactions, e g tax payments
To what extent then would EMU limit the power of ‘exit’ as claimed by
the competltlve argument? One important Issue IS how large the monetary
union IS relative to the remaining non-member economies Central bank
collusion m a EMU clearly restricts some competltlon of monetary pohcy,
but it does not create an international monopoly ‘Exit’ opportunities will
remam through the avallablhty of non-EC currencies such as the U S dollar,
the SWISS franc, and the Japanese yen, to name a few Monetary pohcles m
non-EC countries can still impart ‘good lessons’ The effectiveness of ‘exit’
does not require the largest possible number of mdlvldual policies, Just as
competltlon m goods markets can prevail even d the number of firms is not
very large
On the other hand, EMU promotes the ehmmatlon of barriers to
competltlon by favoring the dismantling of exchange and capital controls VIS-
d-vls non-members The Community has proposed and begun the dlssolutlon

‘The recent EMS hterature that views the Bundesbank ds the hegemon of the system [e g
Gldvazzl and Glovanmm (1989)] 1s an extension of the older hterature on ‘hegemomc stablhty
theorem’ [e g Kmdleberger (1973) and Keohane (1984)] The leader-follower pdradlgm comes
out of single-shot models of monetary pohcy games When the game IS repedted this paradigm
breaks down, unless the cost of returnmg to d flexible exchange rate regime falls entirely on the
high-Inflation country [van Hagen (1992)] Furthermore, Elchengreen (1989) shows that both
the Umted Kmgdom, during the gold standard, and the United States, durmg Bretton Woods,
behaved much less hegemomcally than the earlier literature recogmzed
 M Fratlanm and .I uon Hagen, European monetary umon and central bank independence 409

of such controls erga omnes (that IS, with respect to all countries) as part of
the process of financial Integration In a monetary umon, their relmposltlon,
although legally possible, would likely be SubJect to the consent of all
members, and therefore be removed at least partly from the discretion of
national pohtlclans By opening mdlvldual financial markets to more outside
competltlon, EMU actually strengthens the force of and opportumtles for
‘exit’

3. Adjustment to monetary dominance

We have argued that the private sector would benefit from the central
bank regaining full independence vls-i-vls the fiscal authorities We now give
operational slgruficance to this concept wlthrn the context of EMU, using a
simple one-country model
Take a (relatively) high-inflation, high-debt country like Italy wanting to
Join a monetary union m an environment with a high degree of financial and
goods market integration, that is, the sltuatlon prevailing today To simplify
the analysis, let the rest of the monetary union exert price leadership over
Italy, meaning that prices and interest rates m the rest of the union are given
for the Italian economy Italy has a demand for monetary base

mt-p,=at-Rt, (1)

where m IS the log of the monetary base, p the log of the Italian price level, a
the growth rate of Italian output, t IS time and R the market rate of interest
m Italy Italy 1s financially integrated with Germany If debt IS growing faster
(slower) than real output m Italy, bra-denominated assets bear a risk
premium

R,=R:+E,s,+, -s,+rl,,
where R* IS the interest rate m the rest of the union, E 1s the expectation
operator, s the log of the exchange rate (the bra price of one DM) and r] the
risk premium As to what constitutes the source of the risk premium, there
are several posslblhtles In addition to direct capital levies, governments can
resort to debt consohdatlon (Italy m the 1920s and the 193Os), admmlstratlve
constraints on the banking system (Italy m the 1970s and the early 1980s) or
debt repudiation [Alesma (1988), Spmelh and Fratlanm (1991)] Risk
premium evolves according to the followmg equation

rlt= J(G(- a), (3)

where 6 1s a coefliclent and LYthe growth rate of Italian real debt Eq (3)
reflects the mtertemporal hquldlty constraint of the Italian government Debt
410 M Fratumm and J van Hagen, European monetar) umon and uwtral hank mdependence

growth cannot exceed real output growth permanently wlthout, ht some

future point m time, requirmg an Increase in taxes or a surprise monetary
expansion to monetize part of the debt The risk premium compensates
buyers of Itahan debt for the capital loss incurred d this were to happen The
Italian price level adjusts to the union price level and to stochastic
movements of the real exchange rate, 4

Pt = P: + St+ i,

The monetary base 1s created by monetizing part of the debt

where ,ul 1s the monetlzatlon parameter and $7a stochastic term

In the EMU, realignments are ruled out and the expected change m the
exchange rate 1s zero With union price leadershlp, the monetary base m
Italy must adjust so as to maintain the fixed exchange rdte Let the rest of
the union aim at a low or zero Inflation rate If Italian debt IS growing
relative to output, money m Italy must grow less raptdly than m the rest of
the umon to prevent a contmuous shift mto DM-denominated assets More
formally, with J&s,+ 1 - s, = 0,

(6)
and

We set p: = s, = 0 for analytlcal convenience and solve for the monetary base

p”o= -c(R:+6(a-a)), T,=cj,, I-‘1 =u

According to this solution, the monetary base responds posltlvely to

output growth and negatively to an increase m the union interest rate, R*,
and the risk premium The more real debt growth exceeds real output
growth, the more restrictive Italian monetary pohcy must be to prevent a
contmuous shift mto DM-denominated assets This 1s the market dlsclplme
that ultimately constrains fiscal authorities, and about which the Delors
Report and the Maastricht Accord are very skeptical
To see the lmphcatlons of this on Italy’s fiscal pohcy, we begin by defimng
the budget deficit

Def/Y + R( 1 - ~)b, = m,(M/M) + b,(B/B), (9)

where Def = the primary budget deficit, Y= nominal GNP, z = tax rate on
 M Fratlanm and J von Hagen, European monetary umon and central banh Independence 411

Interest Income, B=nommal value of debt, b,= the ratio of debt to GNP,
and m,,=the ratio of the monetary base to GNP In long-run eqmhbrmm,
Italian real government debt cannot grow faster than real GNP, so that the
debt/GNP ratlo must be constant The steady-state solution of debt to GNP,
6,, 1s
6y = [&f/Y - my( M/M)]/[a - R( 1 - z)] (10)
Monetary dominance means that, m the monetary union, the fiscal authority
has to accept the growth rate of the monetary base as given Therefore, the
money growth rate, p1 =a, imphes that the budget deficit must adjust as
follows

Def/Y=b;[a-R(l --)]+m,a (11)

Note that an increase m the domestic interest rate forces the fiscal
authority to reduce its deficit Suppose now that the Itahan Treasury chooses
a debt growth rate which exceeds the growth rate of real GNP From eqs
(S), the central bank will respond by reducing the monetary base so as to
raise the domestic interest rate and prevent contmuous capital outflows In
turn, the ensuing rise m the domestic interest rate induces the Treasury to
reduce its deficit In this sense, monetary dominance, coupled with a risk
premium, exerts dlsclplme on fiscal pohcy
The risk premium 1s proportional to the difference between real debt
growth and economic growth In a non-inflationary monetary union this
translates mto a money rule that sets the growth rate of the monetary base
equal to the growth of output Fig 1 plots the average value of this
difference for the period 1984-1988 for mne countries of the Community The
graph can be interpreted either as an index of country risk or as a measure
of the deviation from steady-state equlhbrlum Systematic differences between
real debt and output growth are not sustainable Either money adJusts to
debt or debt adlusts to money
Table 1 explores the budgetary lmphcatlons of an independent and
dominant monetary pohcy The question we try to answer is the following
Suppose the monetary authorities (1) were to follow a money rule consistent
with the average of the output growth for the period 1984-1988 and (11)
wanted to stabilize the debt-to-output ratio at the 1990 value - subject to
1989 values of m4 and T How would the fiscal authorities have to adjust?
This endogenous behavior of the fiscal authorities [cf eq (1 l)] 1s called m
table 1 the required primary deficit The last row of the table computes the
size of the adjustment from the actual to the required primary deficit
Belgium, Greece, Italy and the Netherlands have been the high-debt coun-
tries of the Community Belgium, Denmark, France and the United
Kingdom had a primary surplus m 1990, an mdlcatlon of rather conservative
fiscal pohcles m the mid-1980s Italy has reduced its primary deficit since
412 M Fratlantn and J oon Hagen, European monetary union and central bank Independence

TT-----
-7--

,B DK F D GR I NL ES UK,
Countries
Fig 1 Real debt growth mmus money rule Average 1984-1988 B=Belgmm, DK=Denmark,
F = France, D =Germany, GR = Greece, I = Italy, NL =The Netherlands, ES = Spam, UK =
Umted Kingdom

Table 1
Required primary deficit to stablhze the debt ratio at 1990 values (%)

B DK D F GR I NL ES UK
Money rule = a 2 28 2 11 2 52 214 200 2 96 2 34 3 50 3 40
(avg 1984-1988)
Net debt/GNP 11960 2350 2360 2470 8240 9720 6000 3050 3070
1990 value
Short-term real 4 89 5 96 5 13 645 -210 6 38 5 89 8 06 490
rate of interest
1990 value
Wthholdmg tax 2s 00 000 000 2700 2500 12 50 000 2000 2500
Money base/GNP 118 4 72 10 50 600 2000 1560 960 2240 4 30
1989 value
Reqmred DEF/GNP -150 -080 -035 -051 335 -209 -191 -012 006
Primary DEF/GNP -400 -260 090 -100 7 60 0 30 060 090 -220
1990 value
surplus = -
AdJustment -250 -180 125 -049 4 25 2 39 251 102 -226
tightness = +
Notes B = Belgmm, DK = Denmark, D = Germany, F = France, GR = Greece, I = Italy,
NL=Netherlands, ES =Spam, and UK = United Kingdom Primary DEF refers to general
government primary balance
Sources OECD, Economic Outlook, no 45 data chskettes and Econormc Outlook, no 48 and
IMF, International Fmanclal Statlstlcs
 M Fratrannr and .I von Hagen, European monetary unwonand central bank independence 413

1985, whereas Greece continues to be fiscally profhgate Germany, the

Netherlands and Spain show modest levels of primary deficits Greece, Italy
and Spain have high values of my, m part reflecting high reserve requirements
Greece, the Netherlands and Italy would have to make the largest
adJustments m then primary deficits Greece would have to achieve and
mamtam permanently a primary budget deficit of 3 35% of GNP against an
actual deficit of 7 2% of GNP For Italy the stablhzatlon of b, requires a
permanent primary surplus of 2 1% of GNP, for the Netherlands a primary
surplus of 19x, for Germany a surplus of 0 35’?, and for Spain almost a
balanced primary budget On the other hand, Belgium, Denmark, France,
and the United Kingdom would have to continue the pohcles already
implemented The positive message of table 1 1s that fiscal adJustment 1s
within reach and limited to a small group of EC countries *
One peculiar feature of table 1 1s that Greece, a high debt and deficit
country, can stabilize the debt-to-income ratio by running a primary deficit
instead of a surplus This result 1s due to a negative real rate of interest that
enables the Greek government to borrow at subsidized cost The negative
real rate of interest, m turn, reflects the importance of controls on exchange
rates and capital flows that insulate Greece from the rest of the world Once
these controls are removed, Greek real rates of interests would have to rise
to the Community level and the Greek government would have to achieve a
primary surplus to stabilize the debt-to-income ratlo Italy, on the other
hand, can no longer rely on exchange and capital controls and 1s faced with
a competitive cost of borrowing For Italy the fiscal adjustment, condltronal
on a regime of monetary dominance, requires a permanent surplus To see
the lmphcatlon on fiscal adjustment of a competitive cost of borrowmg,
assume that Greece were to fully hberahze capital flows and that, as a
consequence, real interest rates m Greece were to rise to the level of real
interest rates m Italy (m other words, the Greek risk premium would be no
lower than Italy’s) Leaving everything else the same, the Greek government
would have to run a primary surplus of 19% of GNP instead of a deficit of
3 3% of GNP to stabilize b, at the 1990 value Consequently, the fiscal
adlustment of Greece, under a regime of monetary dominance, would be m
the order of 9 5% of GNP
Table 2 explores what EMS countries would gam if, as a result of
monetary dominance and a commitment of the Treasuries to adapt to this
regime, differences m risk premla among the Community members were to
disappear In terms of the model, it would mean that for each country
R=R* Table 2 assumes that R 1s equal to 5%, 1 e the lowest value
appearing m table 1 9 Not surprisingly, the gains would be significant for

%mdar conslderatlons can be read m European Economy (1990, p 174)

‘Five percent IS approximately the real rate of Interest prevalhng m Belgmm, Germany and
the Umted Kmgdom
414 M Fratlanm and J uon Hagen, European monetary umon and central bank mdependence

Table 2
Required primary deliclt to stabdlze the debt ratlo no risk premium (%)

B DK D F GR I NL ES UK
Money rule = a 2 28 211 2 52 2 14 200 296 2 34 3 50 3 40
(avg 19861988)
Net debt/GNP 11960 23 50 2360 24 70 8240 9720 6000 3050 30 70
1990 value
Short-term real 500 500 500 500 500 500 500 500 500
mterest rates
no risk premla
Wlthholdmg tax 2s 00 000 000 2700 25 00 1250 000 2000 2500
Money base/GNP 118 472 1050 600 2000 1560 960 2240 4 30
1989 value
Reqmred DEF/GNP -159 -058 -032 -024 -104 -091 -1 37 063 004
Primary DEF/GNP -400 -260 090 -100 7 60 0 30 060 090 -220
1990 value
surplus = -
Adjustment -241 -202 1 22 -076 8 64 121 197 027 -224
tightness = +
Notes B = Belgium, DK = Denmark, D = Germany, F = France, GR = Greece, I = Italy,
NL = Netherlands, ES = Spain, and UK = Umted Kingdom The value of my for Italy comes from
1987 and that for the UK from 1986 Primary DEF refers to general government primary
balance
Sources OECD, Economw Outlook, no 45 data diskettes and Economic Outlook, no 48 and
IMF, International Fmanctal Statistics

high-debt countries Italy could run a primary surplus of 0 9% of GNP

instead of a surplus of 2 1% of GNP of table 1 The Netherlands would gam
m excess of 50 basis points These numbers, while lllustratlve, Indicate the
quantitative importance of interest rates on budget deficits and, consequently,
the potential benefit of governments to adopt a regime that would reduce its
cost of borrowing and adJustment to such a regime

4. The role of fiscal policy

4 I Delors, Maastricht and fiscal pol~y’~

The Delors Committee 1s very skeptical about the ability of the markets to
dlsclplme the fiscal authorltles Indeed the Report speaks of ‘effective upper
limits on budget deficits of mdlvldual member countries’ and ‘the definition
of the overall stance of fiscal pohcy over the medmm term including the size
and the financing of the aggregate budgetary balance’ (para 33) Fiscal
restraints are regarded as one of the ‘basic elements’ of an ‘economic union
m conJunction with a monetary union‘ (para 25) Its reasoning appears to
rest on the existence of a moral hazard problem m a monetary union that

“This and the followmg section draw from Fratlanm and von Hagen (199Oc)
 M Fratlannl and J van Hagen, European monetary utnon and central bank Independence 415

reduces the fiscal dlsclplme of its members Indlvldual members may be

tempted to raise public debt beyond levels considered sustainable outslde the
union because they can expect the common monetary authority to come to
their rescue should a financial crisis emerge Such rescue operations would
tax citizens of other member countries either exphcltly or through a high
inflation rate m the monetary union [Lamfalussy (1989)] Fiscal restraints,
such as balanced buget provlslons or cellmgs on deficits, are required to
guarantee the soundness of fiscal pohcles m the union Slmllar skepticism 1s
voiced m the Maastricht Accord where member states are prohibited from
runmng excessive budget deficits [Fratlanm et al (1992a, p 39)]
The basic flaw m this argument IS that the moral hazard 1s a consequence
not of the exchange-rate regime but of closer international coordmatlon and
integration Recent experience with the debt of the LDCs and Eastern
European countries 1s clear evidence of this point Industrial countries have
agreed to reschedule and forgive debt, Irrespective of the exchange-rate
arrangement lmkmg debtor and creditor natlons Solidarity, not monetary
union, 1s the source of ball-outs Certainly, monetary union will raise the
degree of solidarity among its members But it 1s mlsleadmg to attribute the
moral hazard problem to the monetary union itself In fact, the Maastricht
Accord specifies that neither the Community nor mdlvldual member states
shall be responsible for debts incurred by other member states
On the other hand, there are forces at work m a monetary union which
enhance fiscal dlsclplme and work against the negative incentive effect
Reputatlonal conslderatlons suggest that excessive debt 1s incurred by
governments that have direct access to the prmtmg press As argued above,
Jcmmg a monetary union with an independent monetary authority ehmmates
such access and reduces deficits and debt [Goodhart (1989)] The assured
independence of the common monetary authority can indeed be regarded as
an mstltutlonal substrtute for fiscal restraints EMU has no need for fiscal
restraints, d monetlzmg public debt by the common central bank 1s firmly
precluded From that perspective, the Committee’s call for fiscal restraints
suggests that it regards the full pohtlcal independence of the future European
central bank as a lost cause
Even if one assumes that sohdarlty and reputatlonal effects together work
towards ralsmg public deficits and debt, bmdmg rules can only be Justified if
capital markets m the Community do not price mdlvldual country risk
differentials adequately to offset the mcenhve for higher deficits by larger risk
premla The Delors Report m fact takes this position

To some extent market forces can exert a dlsclplmary influence [but1

market perceptions do not necessarily provide strong and compellmg
signals and that access to a large capital market may for some time even
facilitate the financing of economic imbalances The constraints
416 M Fratlannl and J van Hagen, European monetary umon and central bank Independence

imposed by market forces might either be too slow and weak or too
sudden and disruptive (para 30)

Therefore, governments must rectify a market failure with an admmlstratlve

rule Again, we note that the market failure argument does not pertam to
monetary integration, it arises with independent monetary pohcles as well A
monetary union - m which international interest rate differentials are
clouded by exchange-rate expectations - would raise the vlslblhty of risk
premla embedded m interest rate differentials and, thus, would enhance the
efficiency of market forces [The Council of Economic Advisors to the
German Mmlstry of Economics (1989)]
On the other hand, there 1s no reason to assume a prior1 that fiscal
restraints imposed by the Community would be more effective than market
forces Public choice theory suggests that national pohcymakers would seek
and find ways to circumvent such rules, d doing so serves then own pohtlcal
interest At the same time, the rules and the enforcement mechanisms
designed by the Community would emerge from a pohtlcal process at the
Commumty level that would not necessarily reflect the best economic
rationale Hlstoncally, the performance of the Community m enforcing
common rules has been rather poor [Mortensen (1990) and de Grauwe
(1992)] Furthermore, the evidence from the United States suggests that
formal fiscal restraints do little to change average fiscal performance and do
not slgmticantly lower the probability of extreme outcomes [Fratlanm and
von Hagen (199Oc) and von Hagen (1991)] Despite the obvious fact that the
Umted States differs structurally and mstrtutlonally from the EC, this
evidence casts doubt on the promise that formal fiscal restraints can enhance
fiscal dlsclplme m a European monetary union and reduce the monetary
authority’s risk of acting as a lender of last resort In conclusion, there are
neither theoretical nor practical reasons to believe that bmdmg rules can
rectify alleged market failures m restraining the growth of government debt

4 2 Harmomzatlon, mternatlonal transfers and coordmatlon of fiscal polwes

Recent literature has pointed to the potential damages international

mconslstencles of tax systems can cause an economic union I1 Taxes on
goods, services and factors of production distort relative prices which trigger
mefflclent flows of goods, services, capital and labor and produce regional
trade imbalances The harmomzatlon of national tax laws 1s a critical
element m brmgmg about the EC’s internal market Monetary Integration
reinforces the importance this element m that exchange rates can no longer
be used to rectify regional imbalances One can go further by saying that the
harmomzatlon of tax systems 1s itself a precondltlon of monetary umficatlon

“See, for example, Tanv and Ter-Mmawan (1987), Isard (1988), Vegh and Gmdottl (1989)
 M Fratzannz and J van Hagen, European monetary unzon and central bank zndependence 417

as long as the union retams mdlvldual national currencies tied together

through fixed exchange rates mamtamed by foreign exchange market mter-
ventlon Persistent trade imbalances due to mconslstent tax laws would
undermine the sustamablhty of the umon A significant degree of harmomza-
tlon 1s therefore mdlspensable m a EMU
The traditional literature on optimal currency areas stresses the role of
fiscal pohcy m a monetary union as the primary instrument for absorbing
regional economic shocks [e g Kenen (1969)] This was also the position of
the MacDougall Report Since monetary pohcy can no longer be used
autonomously m the various parts of the union, and exchange rates no
longer adjust, fiscal pohcy has to play the role of eqmhbratmg regional
differences m the fluctuations of output and employment Let us suppose, an
adverse supply shock hits Belgium without affecting other European coun-
tries With flexible exchange rates, the Belgian franc would depreciate,
allowing for a real depreciation of the currency The resulting increase m
export demand would help Belgium to recover from the shock In a
monetary union and with sluggish prices, adJustment can occur through a
lower tax burden or the migration of labor to more prosperous regions
Since, m the presence of transactions cost, migration 1s an mefliclent response
to transitory shocks, the fiscal system has to serve as the prmclpal shock
absorber It must faclhtate income redistribution wlthm the union m
response to regional shocks The lack of such a system would cause strain to
develop m the union along with dlssatlsfactlon with the fixlty of exchange
rates
Such a system can be implemented m a EMU m two alternative ways The
first one operates via government spending and has been advocated by the
MacDougall Report The EC would allocate a sufficiently large fiscal budget
m Brussels, which would allow its central admmlstratlon to direct funds to
areas of relatively weak economic performance Since the budget would be
funded by all members, the necessary degree of income redlstrrbutlon would
be achieved by an appropriate regional distribution of EC spending The
MacDougall Report concluded that, m view of the size of regional shocks
and the central government budgets commonly available for such purposes,
EMU remained unfeasible without a Community Budget of at least 57% of
Community GNP The Delors Report, and Lamfalussy (1989) m one of its
contnbutlons, follow the same approach, but argue that the EC 1s not
pohtlcally ready to accept such a large Community budget Instead, close
coordmatlon of national budgets 1s required to serve the same purpose
It IS important to understand, however, that a fiscal redistribution system
can work alternatively on the government revenue side and without any need
for centralized government spendmg Income redistribution to equilibrate
regional shocks can be achieved through a Community-wide income tax and
transfer system The system would have to be designed such that relatively
418 M Fratranm and J van Hagen, European monetary unron and central bank mdependence

depressed regions are tdxed less heavily than relatively prosperous regions,
e g by progressive income taxation, and would have to facilitate the transfer
of tax revenues from the latter to the former As m other federal systems, e g
West Germany, regional income redlstrlbutlon can be achieved through rules
of sharing taxes collected at the federal level among the mdlvldual member
states In combmatlon with national mstltutlons such as unemployment
compensation, the tax system would execute automatic transfers among
regions, without requiring any appropriations and spendmg authority at the
Community level nor coordination of national spending policies
From a pohtlcal-economy point of view, however, the two alternatives are
not equally desirable Increasing the Community budget means increasing
the power of the central admlnistrdtion both m comparison with the national
governments and with the EMU monetary duthority It raises the pay-off for
dnd encourages lobbying at the central admmlstratlon and creates new
opportumtles for log-rolling and influence-peddling Based on the experience
with government spending programs at the national level, the efficiency of
centralized or coordinated spending to buffer transitory regional shocks is
highly questionable, given the sluggishness of the pohtlcal process and the
well-known dlfflculty to end regional subsidies A redlstrlbutlve tax system, m
contrast, would not make the actual transfers subject to political dlscretlon
In addition, It would leave the spending power with the national admml-
stratlons The theory of fiscdl federalism suggests that national admmlst-
rations would recognize better the priorities and needs of the mdlvldual
member countries Finally, a tdx-bdsed redlstrlbutlon with decentralized
spending would favor competition among fiscal authorities dnd help preserve
the independence of the common monetary authority
The drive towards building a significant central budget or, as a pohtlcally
more promising substitute, towards the coordmatlon of national fiscal
policies m d monetary union drises from very different grounds Assuming
that the ‘Europe 1992’ program 1s successful m promoting goods market and
findnclal market integration, this will increase mtra-EC trade and raise the
share of exports and imports m each country’s GNP Financial market
integration will tend to increase the mternatlonal substltutablhty of financial
assets within the region, particularly dt the shorter end of the market Thus,
each economy becomes more ‘open’ and more closely integrated m the
regional capital mdrkets
The important lmphcatlon of these trends IS that national fiscal pohcy is
likely to lose much of its power to control output and employment, even m
the short run Greater openness implies greater spill-overs of aggregate
demand between the economies dnd, hence, reduces government spending
multipliers Ndtlondl fiscal pohcymakers will therefore see then power and
influence dlmmlsh as economic integration proceeds m Europe Public choice
theory suggests that these pohcymakers will seek ways to regain their
 M Frarranm and J von Hagen, European monetary umon and central bank rndependence 419

leverage and restore the effectiveness of their pohcy instruments Coordl-

nation of national polrcles and centrahzatlon of fiscal pohcy at the Commun-
ity level are both promlsmg strategies to achieve that goal Both are m
essence forms of collusion among fiscal pohcymakers and both serve to
increase the clout of fiscal pohcy relative to monetary pohcy m a monetary
union Both raise the probability of fiscal dominance of the monetary union
which m turn tends to endanger its usefulness as a commitment mechanism
for price stability For this reason, greater fiscal coordmatlon 1s not only
unwarranted, but counterproductive for the performance of a EMU
The Delors Committee and, to a lesser extent, the Maastricht Accord may
have feared that uncoordmated fiscal pohcres m a monetary union would
yield mconslstent fiscal actlvlsm at the national level, and put a strain on the
monetary system The Committee’s recommendation of coordmatlon cum
bmdmg constraints on fiscal pohcles may be interpreted as an attempt to
prevent such mconslstencles while hmltmg the clout of fiscal pohcy by
lmposmg constraints But there 1s little reason to follow this approach The
reduced effectiveness of fiscal pohcy, due to integration and the greater
competltlon national governments will face m the capital markets, reduce
benefits and raise the economic cost of national fiscal actlvlsm Greater
economic Integration and competltlon among national fiscal pohcles there-
fore tend to induce governments to adopt stable fiscal pohcles compatible
with stable monetary pohcy m the union In contrast, the regulatory
approach most likely mvltes fiscal pohcymakers to find ways around the
constraints and use coordmatlon as a way to maxlmlze their own influence
over the EMU’s monetary and economic pohcles Another impetus for
greater fiscal centralization or coordmatlon m a EMU results if EMU 1s
understood to lead mevltably to the political umficatlon of the Commumty
With political unification, the Community would have to provide basic
pubhc goods such as a common defense, pohce and a Justice system, that
may raise the Community budget to the level of 5-7x of Community GNP
envlsloned by the MacDougall Report But, apart from such pohtlcal
conslderatlons, EMU does not require centrahzatlon or coordmatlon of
government spending

5. Institutional requirements for a low-inflation EMU

We can now summarlse the pros and cons of central bank cooperation
Compared with an independent, national pohcy environment, a monetary
union produces an important change m the number of players mvolved m
the monetary pohcy game In the national environment, each central bank
has its own government as the opponent In contrast, the EMU monetary
authority will face Commumty offlclals and all national governments
together as opponents As long as electlons are not synchronized and there
420 M Frattanm and J von Hagen, European monetary umon and central bank Independence

are national ldlosyncracles m the timing of business cycles, the pohtlcal

interests of the mdlvldual governments are likely to differ and the resulting
pohtlcal pressures are likely to neutralize each other to some extent This
would leave the EMU monetary authority with more freedom to follow its
own preferred pohcy Provided that central bank offlclals m a EMU share
similar preferences for low inflation, this improved strategic position raises
the attractiveness of monetary union As a corollary, monetary union
appears again to be a more attractive delegation device that an exchange-
rate arrangement
However, monetary union can only Improve the average quality of
monetary pohcy If its mstltutlonal design facilitates a credible precommlt-
ment to low-inflation pohcles Three important requirements must be
fulfilled mstltutlonal independence, personal independence and professional
competence l2 First the monetary authority must be fully independent from
pohtlcal pressure Bide and Parkm (1987) have shown emplrlcally that there
1s a significant positive relationship between the degree of independence of
monetary authorities and price stability In turn, three condltlons must be
satisfied to obtain central bank independence [see Neumann (1991)] First,
national and Community pohtlclans cannot interfere with the conduct of
monetary pohcy In particular, the monetary authority must have full control
over the assets and hablhtles of its balance sheet This excludes compulsory
lending to public-sector authorities and the monetlzatlon of public debt l3
The example of the Bundesbank demonstrates that monetary control 1s
possible even without resorting to open market operations of significant size
Balance-sheet autonomy also excludes that a government or the Community
can impose exchange-rate pohcles Recent experience with international
pohcy coordmatlon has shown that governments all too wlllmgly engage m
efforts to manipulate exchange rates without regard to the future inflation
consequences [Funabashl (1988), von Hagen (1989)] Furthermore, the
monetary authority must not be obliged to follow mstructlons by govern-
ments or Community authorities This includes general clauses such as
supportmg the Community’s economic pohcles which create opportumtles for
government officials to exert pressure on the monetary authority l4
The second condltlon 1s that central bank officials m the union must have
personal independence This entails that the duration of then appointment be
sufflclently long to shield them from the short-run orientation of electoral
interests On the other hand, there should be no re-appointments, otherwise

‘*The governance of the ECB and the nature of country representation m this mstltutlon are
not discussed m this paper For that refer to Fratlanm and von Hagen (1990~) as well as Casella
(1992), Graboyes (1990) and Chang (1991)
13Barro (1983) shows that a government’s ablhty to monetize pubhc debt IS a further source
of mflatlon bias
14The Delors Report (para 32) proposes such a clause, the effectiveness of which IS medlated
however by the condltlonahty of the monetary authority’s commitment to price stabkty
 M Fratlanm and J van Hagen, European monetary umon and central bank mdependence 421

central bankers would be mclmed to serve political interests to assure a

second term As a practical solution, Neumann (1991) proposes to set a
mmlmum age for appointment to the central bank board and terms which
are long enough for the appointee to reach normal retirement age Personal
independence also conflicts with accountablhty to national governments or
the European Parliament As demonstrated by the U S example, the need to
report to pohtlcal authorltles on a regular basis creates incentives for central
bank officials to bow to pohtlcal pressures l5 This does not exclude, of
course, that the monetary authority be audited and supervised to ensure that
its pohcles are conducted on sound bankmg and accounting prmclples
Finally, central bank ofliclals should be professionally competent to
understand the role of money m the economy and be prepared to educate
the public and pohtlclans about the limits of monetary pohcy Consequently,
the salary level ought to be commensurable with those earned by top
management m the private sector Otherwise, there 1s a danger that central
bank posltlons would be primarily regarded as stepping stones to more
lucrative private sector Jobs, m which case central bankers would be eager to
seek good contacts with private interest groups Wage increases during the
term of office should be linked to performance, as 1s true m the private
sector Bofinger (1990), for example, has proposed to fix the nominal level of
the salaries to enhance the achievement of price level stability l6
Even d these condltlons were fulfilled, the monetary union need not
provide an effective solution to the precommltment problem, so long as
pohtlclans can regain control over monetary pohcy relatively easily and at
their discretion Under such circumstances, the private sector would ratlon-
ally foresee that pohtlclans revert to discretionary monetary pohcles under
pohtlcally opportune condltlons Indeed, the failure to identify plausible and
significant costs for reneging on a pre-announced, low-inflation exchange rate
target is one of the mam reasons why most credlblhty mterpretatlons of the
EMS m the literature remam unconvmcmg I7 EMU as a commitment
mechanism requires that the pohtlcal cost of regime reversals be large
enough to outweigh the potential for short-run gains This brings m two
further requirements First, pohtlclans must find it very hard and pohtlcally
costly to change the status of the monetary authority, so that Its mdepen-
dence IS not subject to the discretion of the political sector This could be
achieved by elevating the monetary statute of the EC to the rank of
constltutlonal law Second, since the mdlvldual member states retam their
formal sovereignty to withdraw from the union, their commitment to

15The Delors Report (para 32) proposes that the chalrman of the EMU monetary authonty
shall report to the European Parhament and the European Councd
16To compensate for pnce shocks and increases m productlvlty, Bolinger would set the salary
sulliclently high at the begmnmg of the term m office
“See von Hagen and Fratlanm (1989) and von Hagen (1991) for a dIscussIon
422 M Fratlanm and .I UT Hagen, European monetary umon and central bank mdependence

membership must be rendered credible by makmg wlthdrawal sufiiclently

costly to outweigh the potential short-run gams from leaving the union and
returning (temporarily) to an independent and more inflationary monetary
pohcy To raise the cost of withdrawal, EMU membership should therefore
have constltutlonal status m all member countries Furthermore, the mon-
etary union should have very visible mstltutlons, such as a common central
bank, so that voters would regard membership withdrawal as a loss of
reputation of their country Finally, the adoption of a common currency -
instead of retammg the existing ones and simply fixing exchange rates as
proposed by the Delors Report - would enhance the credlblhty of the EMU
commitment by raising the cost of reverting to an independent monetary
regime

6. Conclusions
Monetary umon 1s a form of collusion among central bankers While
collusion 1s unambiguously bad if it IS compared with an ideal competltlve
scenario with independent central banks, we have argued m this paper that
there are reasons why EMU could contribute to Improving the quality of
monetary pohcy m Europe EMU would not create a monopohstlc scenario,
as there ~111 remam strong competltlve forces m the international monetary
pohcy arena The positive impact of EMU stems from its potential as a
commitment mechanism to price stability which many countries may not
have available domestically The important task therefore IS to design the
structure of EMU so as to make it a credible institution For that purpose it
1s paramount that the European monetary authority be independent of the
pohtlcal system, m general, and the fiscal authorities, m particular This
prmclple 1s embedded m the Maastricht Accord The autonomy of the
European central bank can and should be strengthened by lsolatmg its
officials from the short-run orientation of electoral interests and by designing
a remuneration structure thdt is linked to price-level performance The
proper functlomng of a monetary union requires the harmomzatlon of tax
laws to avoid incongruent dlstortlons of relative prices and provlslons
faclhtatmg income redlstrlbutlon among the members to buffer regionally
diverse economic shocks Both features can be achieved by an appropriate
design of the tax system Unless EMU 1s Interpreted as leading to pohtlcal
union m Europe, there IS no need for any greater coordmatlon or centrahza-
tlon of government spendmg m the monetary union Such tendencies arise
because national fiscal pohcymakers are losing power as a consequence of
greater integration But fiscal coordmatlon dnd centralization run contrary to
the establishment of a low-inflation EMU because they weaken the relative
strength and independence of the monetary authority
Finally, we reject the call for fiscal restraints m a EMU Imposing formal
 M Fratranm and J van Hagen, European monetary umon and central bank Independence 423

constraints on budget pohcles does not seem to be a more promlsmg way to

prevent unreasonable budget deficits than market forces On the other hand,
fiscal restraints invite pohtlclans to seek ways to cn-cumvent the budgetary
rules and ultimately make the public control of government more dlfflcult

References
Alesma, Alberto, 1988, The end of large pubhc debts, m Francesco Glavazzl and Lmgl
Spaventa, eds, High public debt The Italian experience (Cambndge University Press)
Alesma, Albert0 and Lawrence H Summers, forthcommg, Central bank independence and
macroeconomic performance Some comparative evidence, Journal of Money, Credit and
Banking
Bade, Robm and Michael Parkm, 1987, Central bank laws and monetary pohcy, typescript
Barro, Robert J, 1983, Inflationary finance under dlscretlon and rules, Canadian Journal of
Economics 16, l-16
Barro, Robert J and David B Gordon, 1983, A positive theory of monetary pohcy in a natural
rate model, Journal of Political Economy 91, 589-610
Bofinger, Peter, 1990, Unresolved Issues on the road to economic and monetary union (EMU) m
Europe, CEPR Dlscusslon paper no 405, Mar
Casella, Alessandra, 1992, Partlclpatlon m a currency union, American Economic Review 82,
847-863
Chang, Roberto, 1991, Bargammg m a monetary union, Typescrlpt (New York Umverslty)
ChrIstie, Herbert and Mlchele Fratlanm, 1978, EMU Rehablhtatlon of a case and some
thoughts for strategy, m Mlchele Fratlanna and Theo Peeters, eds, One money for Europe
(Macmillan, London)
Commlsslon of the European Commumtles, 1975, Report of the study group, economic and
monetary umon 1980 [MarJohn Report] (Brussels) Mar
Commlsslon of the European Commumtles, 1977, Report of the study group on the role of
public finance m European integration [MacDougall Report], Vols 1 and 2 (Brussels)
Commlsslon of the European Commumtles, 1989, Committee for the study of economic and
monetary umon, 1 Report on economic and monetary union m the European Community
2 Collection of papers submitted to the Committee for the Study of Economic and
Monetary Union [Delors Report] (Office for Official Publications of the European
Commumtles, Luxembourg)
Council of Economic Advisors to the German Mmlster of Economics, 1989, Europalsche
Wahrungsordnung (Boss, Germany)
Councd of the European Commumtles, 1970, Interim report on the estabhshmg by stages of
economic and monetary union, Supplement to Bulletm 11-1970 of the European
Commumtles, the Werner Group, under the chairmanship of Pierre Werner (Oflice for
Official Pubhcatlons of the European Commumtles, Luxembourg)
Curne, David, 1989, European monetary umon or competing currencies Which way for
monetary umon m Europe?, Economic Outlook, London Busmess School, Ott , 11-24
de Grauwe, Paul, 1992, Fiscal dlsclplme m monetary unions, International Economic Journal 6,
101-120
Dowd, Kevin, 1990, Does Europe need a federal reserve system?, CAT0 Journal 3, 423-2
Elchengreen, Barry, 1989, Hegemonic stability theories of the mternatlonal monetary system, m
Richard N Cooper, Barry Elchengreen, C Randall Henning, Gerald Holtham and Robert D
Putnam, eds , Can nations agree? (Brookmgs Institution, Washmgton, DC)
European Economy, 1990, Budgetary pohctes m stage I of EMU, Dee , 163-178
Fratianm, Mlchele and Jurgen von Hagen, 1990a, The European monetary system ten years
after, m Allan H Meltzer and Charles Plosser, eds, (Carnegie-Rochester Conference Senes
on Public Pohcy) 32, 173-241
Fratlanm, Michele and Jurgen von Hagen, 1990b, Asymmetries and realignments m the EMS,
m Paul de Grauwe and Lucas Papademos, eds, The European monetary system m the
1990s (Longman, London)
424 M Fratlanm and J oon Hagen, European monetary umon and central bank rndependence

Fratlanm, Mlchele and Jurgen von Hagen, 199Oc, Pubhc choice aspects of European monetary
undicatlon, CAT0 Journal 3, 389411
Fratlanru, Mlchele, Jurgen von Hagen and Christopher Waller, 1992a, The Maastricht way to
EMU, Essays m International Fmance no 187, June (Internatlonal Finance Section,
Prmceton, NJ)
Fratianm, Michele, Jurgen von Hagen and Christopher Wailer, 1992b, Central bankmg as a
pohtlcal prmapal-agent problem, typescript (Indiana Umverslty, IN)
Funabashl, Yolshl, 1988, Managmg the dollar From the Plaza to the Louvre (Institute for
International Economics, Washington, DC)
Glavazzl, Francesco and Albert0 Glovannnn, 1989, Llmltmg exchange rate varlablhty The
European monetary system (CambrIdge University Press)
Glavazzl, Francesco and Marco Pagano, 1988, The advantage of tying one’s hands, European
Economic Review 32, 1055-1082
Goodhart, Charles, 1989, The Delors Report Was Lawqon’s reaction tustlfiable? London School
of Economics, typescrlpt
Graboves. RF. 1990. A Yankee recme for a EuroFed omelet. Federal Reserve Bank of
R&mond Review, July/Aug .
Hlrshman, Albert 0, 1970, Exit, voice, and loyalty (Cambrldge, MA)
Isard, Peter, 1988, The lmphcatlons of fiscal condltlons and growmg mternatlonahzatlon for
monetary pohcles and financial market condltlons, Workmg paper 88/52 (IMF, Washmgton,
DC)
Jenkins, Roy, 1978, European monetary union, Lloyds Bank Review, Jan
Kenen, Peter B, 1969, The theory of optlmal currency areas An eclectic view, m Robert A
Mundell and AK Swoboda, eds, Monetary problems of the international economy
(University of Chicago Press, Chicago, IL)
Keohane, Robert 0, 1984, After hegemony Cooperation and discord m the world pohtlcal
economy (Princeton University Press, Princeton, NJ)
Kmdleberger, Charles P, 1973, The world in depresslon, 1929-1939 (Umverslty of Cahforma
Press, Berkeley and Los Angeles, CA)
Lamfalussy, Alexandre, 1989, Macro-coordmatlon of fiscal pohcles m an economic and
monetary umon m Europe, m Commission for the Study of Economic and Monetary Umon,
ed , Report on economic and monetary union m Europe (European Commission,
Luxembourg)
Lohmann, Susanne, 1992, Optimal commitment m monetary pohcy Credlblhty versus flexlblhty,
American Economic Review 82, 273-286
Mortensen, Jorgen, 1990, Federalism vs co-ordmatlon Macroeconomic pohcy m the European
commumty, CEPS Paper no 47 (Centre for European Pohcy Studies, Brussels)
Neumann, Manfred J M , 1991, Precommltment by central bank independence, Open Economies
Review 2, 95-l 12
Rogoff, Kenneth, 1985, The optimal degree of commitment to an mtermedlate monetary target,
Quarterly Journal of Economics 100, 1169-l 189
Spmelh, Franc0 and Mlchele Fratlanm, 1991, La storla monetaria d’ltaha 1861-1980
(Mondadorl, Mdano)
Tabelhm, Guldo, 1988, Monetary and fiscal pohcy coordmatlon with d high pubhc debt, m
Francesco Glavazzl and Lulgl Spaventa, eds, High public debt The Itahan experience
(Cambridge University Press)
Tanzl, Vito and Teresa Ter-Mmasslan, 1987, The European monetary system and fiscal pohaes,
m SlJbren Cnossen, ed , Tax coordmatlon in the EC (Kluwer, Deventer)
Thompson, Earl A, 1981, Who should control the money supply?, American Economic Review
Papers and Proceedmgs 71, 35&361
U K Treasury, 1989, An evolutionary approach to economic and monetary union, Nov
Vaubel, Roland, 1980, The return to the new EMS, m Karl Brunner and Allan Meltzer, eds,
Monetary mstltutlons and the pohcy process, Carnegie-Rochester Conference on Pubhc
Pohcy, Vol 13 (North-Holland, Amsterdam) 173-221
Vaubel, Roland, 1989a, Currency unification, currency competition, and the private ECU
Second thoughts, Working paper (University of Mannhelm)
Vaubel, Roland, 1989b, Uberholte Glaubenssatze, Wlrtschaftsdleust, June, typescript (Umverslty
of Mannhelm)
 M Fratranm and J van Hagen, European monetary umon and central bank Independence 425

Vegh, Carlos A and Pablo E Gmdottl, 1989, Optlmal taxation pohcles m the EMS A
two-country model of public finance, IMF Working paper WP/89/40
von Hagen, Jurgen, 1989, Monetary targetmg with exchange rate constramts - The Bundesbank
m the 198Os, Federal Reserve Bank of St LOU Review 71, no 5, 53-69
von Hagen, Jurgen, 1991, A note on the empIrIca effectiveness of formal fiscal restramts, Journal
of Pubhc Economics 44, 199-210
von Hagen, Jurgen, 1992, Pohcy delegation and fixed exchange rates, InternatIonal Economic
Review, forthcommg
von Hagen, Jurgen and Mlchele Fratlanm, 1990, Monetar and fiscal pohcy m a /Eurppean
/y
monetary umon Some pubhc choice conslderatlons, Paper pry>ented at the Eurbpean
Monetary Integration Conference’ organized by the American tnstltute for Contemporary
German Studies and the Johns Hopkms Umverslty, Washmgton, DC, 8 May/