PRECONDITIONS FOR THE SUCCESS OF THE EUROPEAN MONETARY UNION I. INTRODUCTION

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1 PRECONDITIONS FOR THE SUCCESS OF THE EUROPEAN MONETARY UNION I. INTRODUCTION The project of a new, common currency in Europe has raised a tremendous wave of emotions. This can mainly be explained by the uncertain socio-economic consequences of this institutional innovation. The European Monetary Union (EMU) should be regarded more as a political project and not so much as an economic project. That is, the idea of EMU was not derived straightforwardly from an approach based on solid economics. Instead the EMU project, though partially justifiable in terms of modern economic theories, was grounded on the general hopes of politicians, hopes that mainly referred to avoiding the assumed costs of exchange rate fluctuations inside the EU, improving the international competitiveness of the EMU countries or companies, fostering economic development and convergence in living standards among the EMU countries, and ensuring political stability and peace in Europe. These hopes, however, were accompanied by fears of academic researchers in particular that mainly referred to an increase in inflation and lasting one-sided transfer payments, and to the danger of inducing economic divergence within EMU. These fears have led to the establishment of various institutional precautions in the so-called Maastricht Treaty and in the subsequent "Stability Pact". There are, however, still doubts as to whether EMU will be successful or "efficient". In this paper, we regard EMU as being successful or efficient if it fulfils the expectations or hopes of its proponents and ensures its stability or survival by avoiding the political legitimation crisis which is expected to arise if the fears of its opponents are realised. Sections II and III discuss the hopes and fears associated with EMU and highlight the respective social-scientific underpinning. Section IV analyses the institutional precautions which have been taken by the European Union to minimise the feared dangers. Section V includes a preliminary evaluation of the actual effects of EMU during the first year of its existence. Section VI first emphasises the continuing lack of research and then analyses some of the likely future priorities of social/economic science and research, seen from the viewpoint of European integration. Section VII concludes the paper.

2 2 II. HOPES ASSOCIATED WITH EMU The main hopes associated with EMU have referred to an increase in economic growth (as a general prospect or hope) and to a relative improvement of living standards within the EU (as a hope of some EMU members, namely the lessdeveloped member states). Besides these "economic hopes", there have also been "political hopes" based on the view that EMU is a step towards a political union and enduring peace in Europe 1. In the following, however, I shall concentrate on the economic hopes and their social-scientific underpinning. 1. Economic growth The "scientific foundation" for the hope of an increase in economic growth, and hence in living standards, is based mainly on the following hypotheses derived from traditional macroeconomics, especially from monetary economics and from growth theory: the introduction of a monetary union leads to a reduction in exchange rate uncertainty, hence to a decrease in the risk premium of the interest rate and therefore to a decrease in the economy s real interest rate. Furthermore, it leads to a decrease in transaction costs, in particular in costs of exchanging currencies and of insuring against risks of exchange-rate fluctuations. In addition, it increases price transparency and thus leads to more competition and therefore to an increase in productivity growth, and also to price decreases with the consequence of increases in demand and output and of an improvement in international competitiveness. In particular, the hope of an improvement in international competitiveness was very important for the second wave of EMU plans during the 80s (the first plan had been launched as early as the 1960s and its implementation started in 1970; however the process was stopped in the mid- 1970s because of the turmoil caused by the world-wide supply shocks experienced at the time) 2. An additional impetus for the second EMU project arose from the perspectives of a long-run growth increase 3 derived from a new social-scientific theory that was borne in the 1980s and is known under the term "endogenous" or "new" growth theory 4. The main arguments there are as follows 5 : the decrease in the real interest 1 The German government for instance has always emphasised the association between international economic policy coordination, political union and peace. 2 For more detail, cf., e.g., Wagner (1998b). 3 The traditional growth theory, however, was only able to predict a short-run growth effect. 4 Cf. Romer (1994) and Aghion/Howitt (1998). 5 For more detail cf. Wagner (1995, 1998b).

3 rate derived above is supposed to imply not only a "substitution effect" from labour to capital, thereby increasing per-capita income (this is the typical effect derived from the "old" neo-classical growth theory 6 ) but also a "learning effect" leading to repeated or permanent increases in per-capita-income. The mechanism that is presumed to exist in the "new" growth theory runs as follows: the capital accumulation from the substitution effect explained above leads to an increase in labour productivity ("endogenous technological progress") over the following time periods caused by learning effects in the context of the accumulation of additional knowledge embodied in the capital accumulation process. This is fostered or extended by the public-good aspect of knowledge that is effective across companies, sectors and countries and is embodied in inter-company, inter-sectoral and inter-national spillovers. It should be emphasised, however, that this theory is not free of controversy. For example, the derivation of a decreasing interest rate is sometimes criticised by pointing to the reduction in the number of currencies by the introduction of a monetary union. This reduction in the number of currencies reduces the opportunities for portfolio diversification and hence increases risk. Furthermore, it may also be argued that the "new" growth theory is simply "too" new, i.e. it is still in its infancy and includes too many simplistic assumptions, so that relying on this foundation should be regarded with caution. For instance, the new growth theory has not sufficiently taken into account the role of institutions and transaction costs when deriving the above conclusions 7. The supposed learning process, for example, only takes place if the previously relevant institutional infrastructure, including legal and political stability as well as human capital, is already in place Economic development and convergence The "less" developed EU member countries, moreover, hope that joining the EMU will foster their economic development, or even lead to a convergence in living standards among the EMU countries at a high level. An important aspect here is the expected rise in foreign direct investments mainly caused by the removal of exchange rate uncertainty. The decisive development-enhancing factors are technology transfer from the more highly developed countries and investment in infrastructure, in particular in education and training (human capital). The main hypotheses or hopes here are: - An EMU would increase foreign direct investment in the less developed member countries. 6 Cf. Solow (1956). 7 For more detail cf. Wagner (1995, 1998b).

4 4 - These foreign direct investments would bring in the technology needed there for development. We can then expect spillovers to other sectors that increase human capital in the whole economy, which is seen as the basis of a development process. Whether it will be successful in the sense of convergence at a high level of living standard depends particularly on the infrastructural basis, because technological spillovers can only produce the desired learning effects if the institutional preconditions are already present. The above line of argument has also been nourished by the "new" growth theory. This approach implies that the decisive development-enhancing factors are technology transfers from the more highly developed countries and investment in infrastructure, in particular in education and training (human capital). Moreover, there are also positive stabilisation effects that can be expected for the "less" developed countries caused by the prospect of entering the EMU 8. These are: - the discipline forced by the "convergence criteria" (joining the final stage of EMU and remaining in the EMU has been made conditional on a number of "convergence criteria", see below in section IV), - the credibility gain through the European Central Bank 9, and - an increase in political stability 10. These stabilisation effects have a supporting function for the intended convergence of living standards at a high level, because the necessary sustainable growth process can only occur when there is political and economic stability. 11 III. Fears associated with EMU The fears of critical observers of the EMU project, particularly those in the economics profession, have been based mainly on the following aspects or 8 See Wagner (1998b, 1998e). 9 This means that by giving away the decision-making power on monetary policy and hence the possibility of seigniorage financing, fiscal policy is also disciplined. This fiscal discipline raises the (stability) reputation of a government and makes its announcements more credible. This issue relates to the relationship between inflation and debt dynamics. 10 This may be less necessary for the current EMU member states, but it is particularly important and useful for potential future member states from Central and Eastern Europe. 11 Such aspects may be worked out in more detail within a branch of modern macroeconomics called "new political economy of macroeconomic policy". Cf. Persson/ Tabellini (1990).

5 dangers: conflicts and instability because of continuing one-sided transfer payments; development polarisation; and higher inflation in those EU member states that previously enjoyed low inflation. In particular in the EMU member states that previously enjoyed low inflation there are fears of higher inflation, whereas in the richer EMU member states there are fears of transfer burdens. (The overlapping of these two groups is usually very great, since rich states are mostly also low-inflation states, which can be explained in part by the costs of high inflation.) In Germany in particular, the majority of those in the economics profession have been in opposition to the EMU project and launched a barrage of counter-arguments against the project that were based mainly on the two fears referred to above Political conflicts and instability The traditional arguments against an EMU are derived from the "theory of optimum currency areas" 12 and are based on the following hypotheses: (1) Asymmetric (country-specific) real shocks, e.g. demand shocks, can still arise in an EMU. (2) The shock absorption mechanisms that in principle are present in a monetary union are: - price (wage) flexibility - mobility of labour - financial transfers (between countries or regions). The exchange rate, however, is no longer available as an absorption instrument in a monetary union. (3) Price (wage) flexibility and labour mobility are not sufficiently effective (in particular in Europe), so that the job of shock absorption has to be done mainly through financial transfers. 12 This theory has been developed mainly by Mundell (1961), McKinnon (1963) and Kenen (1969). For a survey see, e.g., Tavlas (1993). In short, the theory of optimum currency areas states that countries form an optimum currency area if the following conditions are fulfilled (Calmfors et al 1997, 70ff.): - there is a high degree of political integration, i.e. the participating countries share common economic objectives or stabilisation goals; - the shocks that may affect the participating countries are symmetric; - nominal wage and price flexibility are high; - international trade among these countries and the mobility of production factors are high.

6 6 (4) As long as there are no constitutional laws with respect to regional redistribution, such as the German system of "Finanzausgleich" (under the Maastricht Treaty there are no plans for centralisation of the budgetary process in this way in the EMU), political conflicts will arise because of the discretionary redistribution associated with financial transfers. In so far, an EMU that tends to produce political conflicts about permanent discretionary redistribution will destabilise itself. The worst possible consequence will then be a failure or withdrawal of the monetary union, which, however, would leave the EU with large sunk costs. There are also other reasons for the fear of a so-called "transfer union" emphasised mainly in the public choice literature 13. One main argument is that there is an incentive for individual members of a monetary union to increase their government debt because they can shift part of their debt burden to the other member countries. 2. Economic divergence There is a real danger for the "less" developed EMU member countries of getting caught in an underdevelopment trap in Europe if foreign direct investments are concentrated in "highly developed" member countries or regions, thus leaving poorer countries or regions (with poorer infrastructures) behind. The main arguments for this, based on the new trade theory 14 and the new development or growth theory 15, are as follows 16. The less-developed EU-countries also tend to have been high-inflation as well as high-debt countries. In the period of transition to EMU, these countries are forced by the convergence criteria (see below) to reduce levels of inflation and indebtedness. This, however, usually requires them to accept high unemployment in the course of the restrictive fiscal policies that are necessary to reach these goals 17. The compulsion to restrictive fiscal policy in order to comply with the fiscal convergence criteria (which members must continue to follow after joining the EMU) and to fulfil the interest parity condition in a monetary union means that important infrastructural (public) investments can no longer be financed in the less-developed EU member states. Poorer infrastructural conditions, however, 13 Cf. Vaubel (1994). The public choice approach is sometimes also called "new political economy". 14 Cf. Helpman/Krugman (1989). 15 See above. 16 See for this in more detail Wagner (1998b, 1998e). These aspects today mainly refer to the intended E(M)U-enlargement respecting Greece and some Eastern European countries. 17 For a survey on the possible effects of EMU on unemployment in Europe cf. Vinals/Jimeno (1996) and Belke/Rhein (1998).

7 reduce the attractiveness for foreign direct investments in these countries, which are very important for these countries to enable them to make use of the positive externalities (technology or knowledge) from such investments. In so far there is a great danger for these countries to get stuck in long-term unemployment and relative underdevelopment. Up to now, social-science research on this has been rather meagre and thus this topic will remain a central field for future research on European integration, especially in the light of plans to enlarge the EU Higher inflation in previous low-inflation countries If the problems described above, such as distribution conflicts, excessive indebtedness or economic divergence, become reality, then the danger arises that the EMU member countries will try to solve or alleviate these problems in a shortsighted, supposedly easy way, i.e. by creating inflation. At least those countries which are directly endangered by these problems will try to set up political coalitions in order to avoid or reduce the resulting costs at the expense of the other member states. This kind of "beggar-thy-neighbour policy" which is usually done by devaluing national currencies (which is no longer possible in a monetary union) may then take the form of monetary financing of coordinated expansionary fiscal policies or bail-out measures. These fears or theories may be derived from modern lines of argument of monetary macroeconomics, mainly from the so-called "time-inconsistency theory" 18, as well as from public choice theory or the theories of the "new political economy". The latter approach also emphasises inflation effects based on the view that a monetary union is a form of collusion between central bankers. As we know, however, collusion among producers of goods reduces competition and induces suppliers of these goods to lower the quality of their goods. Central bankers can be regarded as suppliers of the good "price stability". From this the opinion is sometimes derived that the European Central Bank (ECB) will tend to lower the quality or degree of price stability 19. This fear refers to the following danger: by reducing competition between European monetary policies, EMU destroys the disciplinary force imposed on central bankers by the threat of exchange rate devaluation. Hence the danger of an excessively expansionary/inflationary monetary policy arises. The main counter-argument, however, is the following: even when collusion between EU-central bankers reduces competition inside the EMU, it will not produce a word-wide monopoly. That is, there will still be enough competition/alternatives in the form of non- 18 This theory first was worked out by Kydland/Prescott (1977) and Barro/Gordon (1983) and has since gained extreme influence in modern theories of economic policy. 19 Cf. Vaubel (1994).

8 8 European currencies such as the US-dollar or the yen. In so far there will still exist enough discipline force imposed by these currencies on the European central bankers. An additional fear, which is also derived from these two theoretical lines of argument, as well as from the theory of public finance 20, emphasises that the common EMU inflation rate will be an average rate of the inflation rates which would be realised autonomously by the single EMU countries. This means that traditionally low-inflation countries like Germany would have to fear that the EMU inflation rate will be higher than their own autonomously set rate. This fear of higher inflation can be, and has been, supported by different lines of theoretical argument. The main line of argument refers to structural differences between the member countries. The main structural differences that matter are: (1) differences in preferences about inflation and unemployment (2) differences in labour market institutions (3) differences in fiscal systems. The main hypothesis with respect to the derivation of inflation effects from (1) is: The price stability reputation of a newly established European Central Bank (ECB) will be lower than that of the German Bundesbank (previously the key central bank in the EMS). Consequently, inflation expectations will tend to be at least temporarily higher for those countries which previously enjoyed low inflation. These higher inflation expectations will work through to higher wage and price increases. Difference (2) mainly refers to different wage bargaining institutional mechanisms in the EMU countries 21. Difference (3) regarding the fiscal system resembles different "optimal" inflation rates as argued in the theory of optimal public finance. Inflation is regarded here as part of a nation s tax system. In this line of reasoning, inflationary tendencies of an EMU for today s low inflation countries can be derived if the following hypothesis is accepted: different optimal inflation rates in the member countries 22 will work out in a monetary union in such a way that political pressures from the countries with high optimal inflation rates will produce a kind of "average inflation rate in the EMU that is higher than the desired rate of countries with lower optimal inflation rates. 20 Cf. Mankiw (1987). 21 See, e.g., Bruno/Sachs (1985) and Calmfors/Driffill (1988). 22 Different optimal inflation rates can be derived from the fact that the marginal costs of raising revenues through traditional taxes are higher in some member states than in others because of an underdeveloped tax system characterised by a low tax collection ratio and high tax evasion.

9 9 IV. INSTITUTIONAL PRECAUTIONS 23 In order to fulfil the hopes and to take care of the fears described in section II and III above, certain institutional precautions are required. On the one hand, institutional changes or innovations must be established in order to realise these hopes. These requirements have by and large already been worked out in the 1993 EC White Paper on "Growth, Competitiveness, Employment" 24. They mainly refer to doing away with labour market rigidities, establishing an infrastructure that creates a climate of optimism creating incentives for technical or product innovations and coordinating economic policies. On the other hand, institutional precautions against the feared dangers described above also have to be implemented. The aim of these precautions, which are described in the following, is to reduce or minimise the dangers of economic divergence, of excessive or illegitimate transfer payments, and of their monetary financing and thus of political legitimation crises which may endanger the continuation of EMU. Politicians and their advisers were largely aware of and took care of the possible dangers or fears associated with EMU described above when they initiated the EMU project. Therefore they introduced various institutional precautions in the Maastricht Treaty and at subsequent EU summits, which will be examined below. However, they have hitherto rather neglected the establishment of the institutional innovations highlighted in the EC White Paper mentioned above which are necessary for fulfilling the hopes that I have described. We may also say that the establishment of these innovations has largely not been regarded as a common European political task but has been left to the single member states. Section V will deal with this in greater detail. 1. The Maastricht Treaty There are in particular three fields of economic policy for which the Maastricht Treaty set important institutional precautions. These three fields are monetary policy, fiscal policy, and structural adjustment policy. Monetary policy The Statute of the ESCB is of particular relevance here. In order to minimise the future inflation risk outlined above, the future ESCB has been given a strong position. This is shown in the following three aspects: 23 In this section, I draw heavily on a recent AICGS research report (Wagner 1998c). The arguments of sections I to III, however, are worked out in more detail in Wagner (1998b). 24 European Commission (1994).

10 10 (1) Price stability as the main objective (Art. 105 of the ECT) There are at least three reasons for imposing price stability on the ESCB as the primary monetary objective: i) Today it is widely believed that, in the long run, inflation is closely related to money growth and monetary policy instruments, and is economically and socially costly. ii) Governments try to exploit the short-run benefits of an unanticipated high inflation rate (i.e. higher employment, higher government revenues or better re-election perspectives) at the expense of a permanent inflation bias. A clear legal mandate for the ESCB to pursue the goal of price stability is supposed to reduce the possibility of short-run political considerations leading to changes in the objectives of monetary policy, and should therefore strengthen the political independence of the ESCB. iii) Imposing price stability as the primary goal on the ESCB is supposed to reduce the democratic accountability problem because it restricts the discretionary powers of non-elected central bankers with regard to the choices between alternative objectives, which are inherently political choices, and because it is easier to monitor performance with an explicit simplification of attainable primary goals. See Section VI.2.1 below, for open questions on this and the following point. (2) Personal and institutional independence of the ECB (Art. 11, 14 of the Statute of the ESCB and Art. 107 of the ECT) Central bank independence is today seen as the most promising institutional solution to the inflation bias problem. The fundamental reason for an inflation bias in market economies is the fact that policy-makers operate in a discretionary regime, i.e. monetary policy decisions are taken sequentially over time in a second-best world and therefore a socially desirable monetary policy suffers from a lack of credibility caused by time-inconsistency. One possible way to deal with this credibility problem consists in removing all discretionary power from the government. For instance, by following a simple k% money supply rule, the government might be able to eliminate the inflation bias, but would produce suboptimally high output fluctuations. On the other hand, statutory entrenchment of the optimal state-contingent rule appears to be extremely difficult, because it is hard to imagine how all contingencies might be described ex ante and verified ex post. What remains is the choice between simple rules, which are inflexible, and discretionary policies which display an inflation bias. It is this trade-off between credibility and flexibility which has led to a game-

11 theoretic foundation of central bank independence as a solution to the inflation bias problem 25. (3) Prohibition of government deficit financing by the ECB (Art. 104 of the ECT). This was adopted to suppress the revenue motive, i.e. the incentive of governments to push the European central bank to create money for financing governmental budget deficits 26. For open questions on this topic see section VI.2.1 below. 11 Fiscal policy Here, the two following institutional aspects have been implemented in order to minimise the danger of future increasing indebtedness: (1) "No bail-out" clause (Art. 104b of the ECT) This clause has been established to avoid single countries intentionally running excessive budget deficits based on the expectation that other member countries will help them out if they run into a debt crisis ("moral hazard" problem) 27. (2) Fiscal convergence criteria These criteria restrict the government budget deficit and the government debt to certain (politically accepted) levels. A country which wants to participate in the EMU may not have - a government budget deficit ratio of more than 3 % of its GDP - a government debt ratio of more than 60 % of its GDP. These criteria are supposed to avoid excessive budget deficits and excessive indebtedness, the negative effects of which arise from the crowding out effects of government debts and from the incentive of heavily indebted countries to build coalitions to prevent an anti-inflationary monetary policy course of the ECB, which would raise real interest rates and thus increase the debt burden problem of those heavily indebted countries 28. See Section 2 below on additional requirements which were introduced later. 25 See for this, e.g., Rogoff (1985b), Cukierman (1997), Kißmer/Wagner (1998). 26 On this, see, e.g., Cukierman (1992). 27 See, in more detail, De Grauwe (1997) or Wagner (1998b). 28 Ibid.

12 12 Structural adjustment policy Further criteria set up in the Maastricht treaty were designed to ensure that the structural convergence process has gone far enough. Countries that wanted to participate in the EMU were obliged to fulfil the following three criteria (as a precondition for entrance): - the inflation criterion, which says that the inflation rate of a participating country should be not more than 1.5 % higher than the average of the three "best performing Member States in terms of price stability"; - the interest rate criterion, determining that the long-term interest rate in a future member country should not be more than 2 % higher than the average of the three "best performing Member States in terms of price stability"; - the exchange rate criterion, which says that a future member country should have kept its currency within the "normal EMS band and not have devalued it against the other member countries currencies during the two years before it joined the EMU. On the basis of these criteria the EU council decided in May 1998 that 11 EU member states were ready to participate in EMU in the first round (from on). These criteria are still relevant for the so-called pre-ins or the candidates for EU enlargement. Social science researchers are still arguing whether these criteria are well-founded and reasonable or not. 2. Recent summit arrangements The provisions of the so-called "Stability and Growth Pact", agreed on in Dublin in 1996 and confirmed in Amsterdam in 1997, are particularly important here. This pact provides a framework for maintaining and enforcing the Maastricht fiscal criteria after EMU has begun. It restates the commitment to a maximum budget deficit of 3 % of GDP and, except in special circumstances, applies sanctions to countries with deficits exceeding this level. This threat of sanctions presumably reduces the incentive to violate this fiscal convergence criterion 29. Whether this Pact, however, is going to be effective is controversial, in particular because the social-science recommendation of an automatism of sanctions has not been realised in the Pact. Discretionary decisionmaking namely tends always to create political conflicts and coalitions between 29 Cf. Eichengreen/Wyplosz (1998).

13 violators of the criterion. In so far, the quarrel about the appropriateness of this kind of Pact will go on, and there is need for further research in this field. 13 V. THE FIRST YEAR S EXPERIENCE WITH EMU The question arises of whether it makes sense to attempt an evaluation of the EMU just one year after it came into force 30. It should really be said that it is still too early for this. However, both optimists/supporters and pessimists/opponents are already claiming that their assessments have been confirmed. Optimists, or supporters of the EMU project point to the smooth transition from national currencies to the euro, and to the (up to now) trouble-free functioning of European monetary policy (in the sense of the efficacy of monetary policy instruments and achieving monetary policy targets). The euro has a high level of internal stability. The inflation rate, as was the aim, was clearly below 2 percent throughout In addition, the feared conflict of national interests in the ECB council has not taken place. All members have behaved in an apparently disciplined manner, in the sense of their obligations towards the common monetary policy target. It may naturally be said in rebuttal that the task of fighting inflation last year was not particularly difficult. The behaviour of the collective bargaining partners and the enhancement of productivity have established a favourable environment for price level stability. In addition, the competitive pressure (in the sense of locational competition between countries or regions) generated through the process of globalisation is increasingly exercising discipline on politicians, and is therefore making the business of monetary politicians easier 31. However, this image is tarnished by the development of the euro's external value in the last twelve months, and pessimists or sceptical observers of the euro system point this out. After starting the year with a reference level of $1.1789, the external value of the euro as against the US dollar fell to just above $1 by the end of the year. This means that the external value of the euro fell during this period by about one sixth as against the dollar. Of course, it may be said that the introduction of the euro was accompanied by a certain degree of euphoria and exaggeration. This euphoria "gave way during the course of the year to more dispassionate considerations, and political trends and the perspectives of the euro countries entered the foreground: how quickly will the existing obstacles in the single market be overcome? Will the members be able to gain control of their structural problems in the labour and goods markets? In addition, the economic development in the USA continued to be extremely robust and to speed ahead of 30 The last version of this paper was delivered just over one year after the EMU came into existence. 31 Cf. Wagner (2000).

14 14 trends in Europe" (President of the Bundesbank in an interview in the "Welt am Sonntag" on 2 January 2000; translated). One can draw the conclusion here that the euro has a "clear revaluation potential" (ibid.), due above all to the expected alignment of growth rates in Euroland and the USA. The "alleged" weakness of the euro is therefore frequently interpreted as an expression of a greater appreciation of the dollar and of the previous difference in interest rates which has led to an outflow of capital from Euroland to the USA. However, this does not exclude the danger that the external value of the euro as against the dollar is forced even lower, and even significantly below the level of $1. It may be said that all this is not too bad because, as ECB studies show, the exchange rate of the euro has only a very limited influence on the rate of inflation. The reason for this is above all the relatively low proportion of imports in relation to economic output. The ECB estimates that the previous devaluation of the euro could increase the rate of inflation by up to 0.2 percentage points with a certain time delay (ibid.). But the main problem of a further devaluation of the euro, for whatever reason, lies in the fact that the external value of the euro has a symbolic power that extends far beyond its fundamental economic significance. The result of this is that the reputation of the only recently established ECB would also suffer, even though its target is not the stabilisation of the external value of the euro, but of its internal value, and there is no doubt that the aim of the euro's internal value will be achieved in the near future. A further fall in the value of the euro might be interpreted as an indication that the euro is not accepted by the financial markets, so that a run out of the euro could take place which could force the ECB (above all for political reasons) to alter its monetary policy strategy in favour of one that places greater emphasis on the external value. This would then lead to credibility problems for European monetary policies with the consequence of higher interest rates and higher inflation. A further danger of a continuing fall in the external value of the euro would be that the number of opponents of joining the EMU in the pre-in countries United Kingdom, Sweden and Denmark might increase. Along with the devaluation of the euro as against the dollar, the following subjects are being discussed as additional controversial problems fields for EMU: lack of accountability and the monetary policy strategy of the ECB, which is still incomprehensible to many, and the lender of last resort function in the EMU, which has still not been satisfactorily regulated. As I have said, it is still too early to attempt to evaluate the development of the EMU after just one year. We will have to give the EMU still more time before making extensive evaluations. In spite of this, both the public and economists must pay great attention to the EMU's development from the very beginning.

15 15 VI. FUTURE RESEARCH TOPICS 1. Lack of social science research As we have seen, there is still need for further research on various fields of European monetary integration. Much is still under-researched with respect to the question of the socio-economic consequences of EMU and the necessary institutional precautions. The main problem here is that there are no real historic experiences that might be used, because EMU is a unique institutional innovation. Hence we have to rely on much speculation and guesswork. Extensive research on this topic did not start until the 1990s. Moreover, this research has largely dealt with the effects of EMU on inflation and debt. There is a specific lack of research into the effects of EMU on unemployment and economic divergence. The consequences of a failure of EMU remain rather unclear as well. Another field lacking specific research is the field of institutional reforms that are necessary to realise the hopes referred to above that are associated with EMU. As I have already briefly mentioned, these reforms mainly refer to - a decrease of rigidities on the labour markets - setting-up the infrastructure necessary for increasing economic growth throughout the EU - incentives for technical progress or innovations. Here in particular the scope and the mechanisms of co-ordination of economic policies within Euroland are still very controversial. There are still many open questions in particular with regard to the hopes of less developed EU countries of faster development or of convergence of living standard as a consequence of joining EMU. There is the danger 32 that the hope of the "less developed" countries of achieving faster real alignment (convergence) with the richer, more highly-developed EU member states by joining the European Monetary Union, may prove to be deceptive. Whether this danger is realised depends also on certain exogenous factors which these countries cannot fully influence by themselves (for example, the financial solidarity of the other countries and the decisions on direct investments made by international companies). It also depends essentially on the political enforceability of, in part, painful economic policies, to which a country that has to catch up must subject itself to achieve the aim of real convergence in the EMU. The edge between real convergence and divergence is narrow, and a country's own opportunities for exercising an influence on the result are restricted. In so far, the enterprise "joining 32 See Wagner (1998e).

16 16 the EMU" is a dangerous venture for those EU member states that have to catch up (and later on for the "acceding countries" in the course of the eastward expansion of the EU). It may turn out to be a grandiose development programme, but may also lead to a kind of "mezzogiornisation", with destabilising political consequences for the whole of Europe. These political economy aspects appear to be a fruitful field for further research, and there is certainly still a substantial lack of research. 2. Some future research topics The question posed here is: what should be the priorities of social science and research in the future, seen from the viewpoint of European integration? There are many of them. In my opinion, the following 3 (not necessarily new) topics will be of special interest for future research: 1. What kind of co-operation between monetary and fiscal (and wage/incomes) policies should be followed?, 2. What is the relationship between monetary (economic) integration and social/societal integration, and how can it be influenced by politics or institutions?, 3. What are the socio-economic consequences of different kinds or scopes of EU enlargement, and what are the institutional precautions necessary for a successful (welfareenhancing) enlargement? 2.1 Co-ordination of economic policies On joining the EMU, the significance of fiscal policy increases as it becomes the only policy instrument to react to national shocks. (I assume here that price flexibility and/or labour mobility is not high enough to absorb shocks in the short term, i.e. before political legitimacy gets damaged. The exchange rate, on the other hand, can no longer be used as a policy instrument. 33 ) However, there is the problem that fiscal policy itself is a potential source of internal shocks and thus can disturb monetary policy. Monetary policy therefore needs the support of fiscal policy and of wage policy as well, just as fiscal policy needs the support of monetary policy in the range that it does not conflict with the price stability commitment of the ECB; or, put differently, policy co-ordination is needed. The reason is that, on the one hand, an unnecessarily tough monetary policy course creates excessive unemployment; and, on the other hand, the inflation expectations which affect interest rates and actual inflation are formed by the market participants on the basis of expectations about fiscal and wage policy. This means that there is a necessity for long-term consistency of common (centralised) 33 This scare scenario, however, overlooks the fact that the introduction of an EMU may endogenously create the effects of an increasing price flexibility and of an increasing labour mobility which may offset the abolition of the exchange rate as an absorption instrument of country-specific shocks. Cf. Wagner (1998c).

17 monetary policy and national (decentralised) fiscal policies. The question, however, is how this can or should be implemented. At present there is no institution in Europe which is in charge of co-ordinating the economic policies of the member states and of harmonising monetary and fiscal policy. This institutional disequilibrium tends to produce negative effects on the quality of the ECB's monetary policy. The main reason is that the ECB tends to become the target of criticism and of dissatisfaction with economic developments in the EU. The ECB will therefore be under permanent public and political pressure to loosen its monetary policy course in order to participate in the fight against the persistent high levels of unemployment in Europe. There is a danger that the ECB will either be too tough in order to prove its independence to the financial markets, or it will, in the end, be forced to give in, even though it may be convinced that fighting largely structural unemployment by means of an expansive monetary policy is fruitless and only creates higher inflation (expectations) 34. There are different controversial proposals as to how to prevent this. One is to establish a coordinating institution. However, opponents of this type of economic policy council for the EU fear that coordination of this kind could exercise an excessive influence on the ECB and undermine its independence 35. In the context of such a persistent need of policy co-ordination, the commitment of the ECB to the sole dedication to price stability dictated by the Maastricht Treaty (see above) 36 is and will remain controversial among politicians and economists, and thus will tend to remain a central research topic in the future. The dedication to price stability has become the dominant trend in the theory and practice of monetary policy over the last two decades. Central banks from New Zealand to Finland have made this commitment, either by following a mandate of their governments or by exercising independent discretion granted them by their governments 37. This dedication of monetary policy to price stability is sometimes Stabilisation policy (including monetary, fiscal and wage policy) is directed towards fighting inflation and cyclical unemployment. However, in order to fight structural unemployment (which presently is likely to be the main economic problem in Europe), growth policy in particular is demanded. This includes policies such as law policy, antitrust policy, free trade policy as well as innovation policy and a policy addressing social consensus. 35 The counter-argument emphasises that governments in the EU will try to put pressure on the ECB even without an economic policy council. There may be even a disadvantage in so far as, without such a coordinating institution, political influence will take place in a spontaneous and therefore intransparent way. This, however, may weaken the credibility of the ECB. 36 In principal, this commitment is only relative. That is, the Treaty says, "The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community..." (ECT Art. 105(1)). 37 These monetary policy strategies are also called "inflation targeting", see, e.g. Svensson (1997), and, for a survey, Wagner (1998d; 1999).

18 18 criticised as expressing "official indifference to real macro-economic outcomes employment and unemployment, real domestic product and its growth rate. These are likely to be ignored or drastically subordinated in the priorities of most central banks today" (Tobin 1998, 14). 38 Imposing price stability as the primary goal on the ESCB, however, should reduce the democratic accountability problem, as has been explained above in section IV.1.(1)(iii). 2.2 Relationship between monetary integration and societal integration There is no general consensus as to the role of monetary integration in a broader process of economic, political and societal integration 39. On the one hand, EMU can be regarded as an instrument for further integration in a context beyond narrow economics. Monetary integration may contribute to facilitating the flow of information about cultures across borders, to stimulating interest in other nations problems 40 and acceptance of the respective viewpoints 41. In this sense, "social capital" 42 may become mobile, preparing the way for societal integration. On the other hand, EMU may fail if policy-makers do not take into account the requirements imposed by the particular cultural and societal circumstances in Europe 43. Historically, societies in European nations have developed different ways to deal with risk, authority, information and other basic factors. Different institutions and attitudes have developed, leading to different economic and societal outcomes 44. Monetary union as a common institution can only be successful if it is accepted and supported throughout the cooperating cultures. In this respect, the discussions about the need to share a sort of "stability culture" 45 illustrate the interdependence of monetary and societal integration. To shed more light on this relationship, research must be carried out into what fundamental characteristics distinguish societies, whether heterogeneity of 38 Commitment to price stability has been favoured by a "new orthodoxy" in macroeconomics, born in a paradigmatic change during the 1970s from Keynesianism to New Classical Macroeconomics or (today) a somewhat strange mixture between both strands of theoretical approaches. See Wagner (1998a). 39 Cf. Wagner (1998e). 40 It may, for example, help to promote regional cohesion programmes in favour of less developed EU-regions. 41 For example, consumers comparison of EMU-wide services denominated in a single currency on the common market may have the above-mentioned side effects. 42 The term "social capital" itself deserves to be a research topic. See for example Putnam (1993), Coleman (1988) and Fukuyama (1995). 43 Cf. Greif (1994). 44 Cf. Brennan/Buchanan (1985), Binmore (1994). 45 Cf. Bofinger/Hefeker/Pfleger (1997), chapter 9.

19 cooperating societies constitutes a danger for the union as a whole, and whether economic integration may induce a process of cultural convergence EU enlargement and its social consequences EU enlargement raises basically two distinct questions: The first question is on the shape the European Union will finally take: taking a normative point of view, we have to ask how many nations should form part of the EU, and which ones should be chosen. There is already a number of theoretic approaches dealing with these issues and using methods of evolutionary economics, transaction-cost economics and club theory 47. Closely related to this point is the institutional question of how to organise tasks and distribute power within a union. A remarkable volume of literature on "fiscal federalism" has indeed emerged 48. However, these abstract theories have generally not yet provided clear-cut guidelines for the design of the EU. On the political agenda, recent considerations on a European Constitution and the current accession talks 49 point to the urgent need to address the design of a community that allows cultural heterogeneity while securing economic and political stability. Secondly, if we accept a certain final form for the Union as an objective, the appropriate way to reach this aim is far from evident. Early and/or wide EU enlargement may prove to be very costly, in so far as the new-comers have also to commit themselves to the conditions of stage 2 of the EMU. This is likely to induce problematic economic and social consequences not only for these countries but also for the core-countries. Still, there may also be an advantage in early enlargement because imposing pressure on early structural adjustment may help to avoid the transitional costs that result from a more gradual strategy. In the economic debate about the transition to a market economy, strong arguments are put forward in favour of a "shock therapy" 50. But thorough research is needed to analyze whether this point of view can be transferred to the field of social integration. In particular, the politico-economic analysis of distributional conflicts between nations and within nations both during a transition period and after an enlargement promises to be a fruitful topic for further research Cf. Kasper/Streit (1998) chapter 12, Boyd/Richerson (1985). 47 Cf. Cornes/Sandler (1996) part IV, Alesina/Spolaore (1997), Bolton/Roland/Spolaore (1996). 48 Cf. Walsh (1992), Casella/Frey (1992), Persson/Roland/Tabellini (1996). 49 Discussions in candidate countries show a certain fear that the cultural identity of these nations may have to be abandoned in the process of socially adjusting to EU. 50 These arguments rely on efficiency considerations (World Bank 1991) as well as on problems of time-inconsistency (Martinelli/Tommasi 1997). For a critical discussion see also Wei (1997). 51 See Wagner (1995, 1998b): , Baldwin/Francois/Portes (1997).