Monetary Stability in Europe

Stefan Collignon

• Publisher: Routledge
• Year: 2003
• ISBN:
  9781134499274
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

In this book, the author presents fresh perspectives on the theories surrounding European Monetary Union. Urging the reader to examine conventional ideas from new viewpoints, he discusses the events which led to EMU, analyses the current situation, and projects possible futures.
Essential reading for academics and professionals concerned with the background and implications of EMU, this book will also be of considerable interest to scholars in the fields of European studies, monetary economics, international economics and economic history.

1
Why stable money matters or ‘the loss of paradise’

Europe has a new currency, the euro. It has been the fruit of a long evolution of European monetary co-operation. But despite this apparently irresistible historic process, many observers have been puzzled: was it inevitable or merely an arbitrary political decision without economic foundation? Was there no alternative to old nations of Europe giving up the symbol of national sovereignty? In Europe, changes in monetary arrangements have usually reflected the chaotic ups and downs of its history. This is nowhere more obvious than in Austria which, by the end of the twentieth century has had its sixth currency in less than 100 years. Thus, even such a fundamental institution as money can be short-lived and volatile. Will the adventure of European Monetary Union (EMU) succeed—or will it disappear as many other regimes in the past? Of course, impermanence is the essence of the world. Even though nothing lasts forever, some things last longer than others. How long will the euro last?

As far as the Treaty on European Union (TEU) is concerned, the single currency will last forever. In the public debate Eurosceptic warnings about impending disaster (e.g. Feldstein 1997; Congdon 1997) were not infrequent, but few (Lascelles 1997) have spelt out how EMU could become undone. Others, like the Bundesbank (Tietmeyer 1995; Jochimsen 1998), have insisted that ‘ultimately a monetary union is an undisolvable community of solidarity’ and, therefore, only countries with a sufficient degree of convergence ought to join. This argument implicitly assumes that joining EMU without sufficient convergence could create difficulties for premature qualified members, and that they would have to be bailed out by the others. But what would happen if this solidarity and loyalty to each other did not exist? Would countries wish to leave? Ultimately, EMU’s sustainability begs the question: Why do some international monetary regimes fail while others succeed? Which domestic or international conditions bind nations together in economic agreements, and which break them apart? (McNamara 1998).

For the neoclassical economic theorist, the question of the sustainability of monetary institutions is odd: Why should it matter? If economic agents were free of money illusion, they would distinguish monetary from real magnitudes, at least in the long term. Economic value is derived from utility. In general equilibrium, markets would determine relative prices, that is, the ratios at which goods are exchanged, in proportion to their respective utilities. The money market would determine the stock of money and money prices (Grandmont1983).Yet this implies that the value of money in relation to goods is zero. Thus, it cannot serve a purpose at all (Duffie 1990). Consequently, why would one bother with making money last? This question is related to a second one: how can money an intrinsically worthless means of exchange, acquire value? Traditional explanations centred around the functions of money, such as means of exchange, payment, unit of account or store of value. In overlapping generations models, money has value if it either facilitates existing trades or allows for new ones. But as Blanchard and Fischer (1989:159) show, trust in the value of money is necessary for money to have value. If at a period zero the young do not believe that money will be valued at time 1, they will not buy money, and money will never be valued. Modem theories emphasise the role of money under conditions of uncertainty and asymmetric information (Goodhart 1989; Brunner and Meltzer 1971). For Riese (1986a, 1990, 1995) the value of money derives from the fact that it serves as a means of payment—and not just a means of exchange--- and this requires that money is kept ‘scarce’ by the central bank. We will return to this argument in Chapter 8. What matters here, is that we can assign utility to the use of money which is derived from the functions it serves. If for some reason, money does not fulfil these functions correctly its functions are transferred to different carriers or assets and money loses its value and ultimately becomes ‘useless’. In an international context this process is explained by currency substitution models (Mizen and Pentecost 1996) or by models of monetary hierarchy (Nitsch 1995; Herr 1992). What all these explanations have in common is that for money to be used, it needs to have a positive value. Therefore, sustaining money as an institution requires maintaining this value.

Over the course of history money has taken all kinds of forms, from metal coins (copper, silver, gold) to bank notes and deposits, although the unit of accounts (pound, franc, dollar…) have normally covered longer periods than their material support. For centuries, economists have sought to explain the origin of money (Menger 1892). Early theories linked it to a commodity. A modern look reveals it to be a more effusive concept with a variety of assets and means of payment covering a range of instruments from bank notes to electronic transfers and credit cards (Collignon 1998). Money’s characteristics as an asset became apparent at the end of the eighteenth century, when money was related to the monopoly of note issue by the central bank and no longer to the coinage of precious metals. Ever since, monetary management has been a matter of credibility. Money has become a promise to pay—if it ever has been anything else. Trust in honouring the promise is essential for the sustainability of money as an institution.

However, it is not only the institution of money itself that is of uncertain durability but also the organisations that manage it. Sweden is the country with the longest tradition (since1668) of central banking; the Bank of England was founded in 1694; the Banque de France in 1800 and the Deutsche Reichbank in 1875. But the Bundesbank only appeared in 1957. On an international level, the Bretton Woods Agreement in 1944 set up an international monetary system with rules which were abolished in 1971, but IMF as an organisation continued to exist with new objectives. With the birth of a new currency the euro and the European System of Central Banks (ESCB) as its organisation, one may ask how long this newcomer is going to last. In fact the question has even been raised whether central banks are a necessary institution at all (Smith 1936). I will not discuss these arguments here. Instead, I will show in the next section that money is an institution that matters and, therefore, deserves to be sustained. In the rest of the chapter, we will then look at the historical background against which we can explain not only the emergence of EMU, but also the expectations that it implicitly raises.

Money as an institution

The human mind is of a fickle nature—a fact well known to philosophers and literary artists, but less to economists. Usually, economic theory works with utility maximising economic agents who have fairly constant preference structures or tastes.This might be a perfectly justified assumption—over the short run. However, over time, preferences are not stable. For example, public consensus on international monetary arrangements has shifted five times in one century. From the Gold Standard the world moved to flexible exchange rates after World War I; from the Bretton Woods fixed system again to a flexible rate regime in the 1970s; and now EMU reverts to monetary stability in Europe. These oscillations are puzzling. Each time flexible exchange rate regimes have been coincidental with macroeconomic instability and low growth, and fixed rates with welfare improvements. Does every generation have to learn the same lessons anew? It might well be that the Golden Age only appears golden after it is over. We live, after all, as Hirschman put it,

…in a world in which men think they want one thing and then upon getting it, find out to their dismay that they don’t want it nearly as much as they thought or don’t want it at all and that something else, of which they were hardly aware, is what they really want…

(Hirschman 1982:21)

It may also be that once we have experienced disappointment, the ‘rebound effect’ makes for an exaggeration of the benefits and an underestimate of the costs of the action that provides a counterpoint to what has been done previously. We will deal with volatile policy preferences in the case of EMU in Chapter 6. Yet, the history of monetary arrangements of Europe in the twentieth century implicitly poses a normative question: are fixed rates preferable over flexible ones or is it the other way round? And if preferences are not stable, then why may social phenomena have any durability at all?

A short philosophical digression on institutional norms

Part of the answer is that society consists of more than a set of utility maximising individuals with given preferences. Of course, individuals have preferences, however, they also share mutual beliefs. Methodological individualism, the philosophical tenet of economics, usually abstracts from these shared values and thereby reduces collective intentionality to individual intentionality.¹ However, the reproductive processes of society are determined by individuals as much as by institutions and organisations that fix patterns of human actions, supply information to other agents and enable regular and predictable behaviour in an uncertain, highly complex world with limited information. Thus, institutions are constraints that structure human interaction in order to reduce uncertainty. Society is held together by contracts that oblige or bind individual players to some correlated strategy. The content of these contracts is determined by institutions, that is, rules of the game, and by organisations which are the players (North 1993).²

We will call the institution of EMU the set of rules, fixed by the Maastricht Treaty (TEU), that are designed to structure monetary relations in the Union and give sense and purpose to monetary policy. Similarly, the Stability and Growth Pact is an institution to guide and direct fiscal policy in EMU. However, these rules are all derived from the primary norm of maintaining price stability.³ On the other hand, the ESCB, the Euro group, the European Commission or national governments are the players of the game; they are organisations. A functional society requires that contracts, whether explicit or implicit, reflect a credible commitment by the players. When creating a new currency like the euro, ex ovo, the interesting question is how such a social contract comes into being and what sustains it. The question is not how Maastricht was negotiated⁴ or what games individual players played, but rather what the consensual foundations are which make such a treaty possible.

Money is one of the most fundamental institutions in a liberal society with a market economy (Collignon 1995). This is because money is assigned its status by collective intentionality. Money thereby acquires a normative character, and this fact structures the whole of society. A long-standing philosophical tradition, going back to Hume (1740), maintains that normative statements cannot be derived from objective, scientific statements. Some economists have drawn the conclusion from this axiom, that ‘positive economics is in principle independent of any particular ethical position or normative judgements…’ (Friedman 1953). This implies that once the economist has described economic facts, any evaluation is still left absolutely open. Against this view, Searle (1969:263) has argued that ‘in the case of certain institutional facts, the evaluations involving obligations, commitments and responsibilities are no longer left completely open because the statement of the institutional fact involves these notions.’ Consequently when we are dealing with the institutional fact of money we cannot dissociate our analysis from the normative context which gives money its legitimacy, that is, that which creates the belief in its validity. For example, it would be senseless to argue that it is a fact that one of the functions of money is to have purchasing power, but the objective of maintaining price stability is a normative value judgement independent of this fact. Therefore, when we analyse the sustainability of institutions like EMU, we have to do two things: we need to state the rules of the ‘social contract’ which sets up the institution of money (constitutive rules) and then assess the likelihood that the related organisations will behave in such a way that the credibility (legitimate validity) of the institution will be maintained.

Searle (1995:43-5) has shown with respect to the evolution of paper money how constitutive rules create institutional facts. There is, as he put it,‘an element of magic, a conjuring trick, a sleigh of hand in the creation of institutional facts’. It results from the collective intentionality assigning a new status to some phenomenon which cannot be performed solely by virtue of its intrinsic physical features. For example, the material support of money, such as coins, paper, electronic data, is intrinsically rather worthless, but it obtains value because society uses it with a commonly shared, collective intentionality. Without some underlying norms, or constitutional rules, individuals would not be able to communicate their intentions, nor could they behave accordingly. This explains why the persistence and sustainability of institutions is so dependent on credible commitments, for they alone will keep the collective agreement alive and the institution legitimate. Nowhere is this more obvious than in the field of monetary policy in a large sense. Sustaining EMU means maintaining the credibility and legitimacy of monetary institutions of Europe.

North (1993) distinguishes between motivational and imperative credibility. Motivational credibility applies, if the players want to continue to honour their commitment at the time of performance (i.e. time consistent behaviour). In this case, institutions are self-enforcing and the success of the institutions sustains their success. Alternatively, the credibility is ‘imperative’ when the performance of the players (i.e. the application of the constitutive rule by the related organisations) is coerced or at least discretion is disabled. This requires regulative rules (Searle 1995:27). However, both forms of credibility derive naturally from the normative status of constitutive rules, for any rule implies the possibility of abuse. Therefore, imperative credibility is necessary to protect motivational credibility. Regulative rules, which can only work on the background of the related constitutive rules, are necessary to maintain the ‘imperative credibility’ of the institutions. Figure 1.1 shows the inter-relatedness of norms, rules and motivations as the structure of collective intentionality (arrows indicate the direction of influence).

Figure 1.1 The structure of collective intentionality.

This model of social institutions could explain why the political process towards EMU, notably during the negotiations of the Maastricht Treaty (see Bini-Smaghi et al. 1994), has focused on institutional ‘stability conditions’ as the normative constitutive rules. The norm of maintaining price stability is at the core of the collective European monetary agreement. Once EMU had started, monetary policy rules, such as targeting the growth of money supply aggregates or the level of inflation rates became regulative rules to serve the Treaty objectives.

Collective intentionality is necessary to create the institutional fact of money. But if it requires a norm, such as maintaining the purchasing power of money to make the system functional, this is not a one-way street. If the constitutional rules that establish money are credible, then they also create an environment of certainty which will feed back into the anticipations and behaviour of the players. This creates a degree of moral cohesiveness in society⁵ and gives rise to very different behaviours than if the legitimacy of the monetary system is under doubt.

This interdependence between constitutive and regulative rules has been a central preoccupation in the theories of the German ordo-liberals who laid the intellectual foundations of Germany’s post-war economic model (Bernholz 1989). Röpke made the point that

a sophisticated economic system which involves a widely developed division of labour and hence a considerable mutual dependence of the individuals concerned, can only be developed and maintained if an important assumption is made. This is that those who have entered this kind of dependence must feel safe enough in their moral, legal and institutional surroundings to continue to accept the risks involved in such interaction.

(Röpke 1951)

To achieve this, two prerequisites are required, according to this school of thought: ‘a free, stable and internationally convertible currency’ and a’stable legal order’. One does not have to share all aspects of ‘ordo-liberalism’ to see that the monetary constitution influences the daily economic process (Eucken 1989:122). Clearly, money matters for these thinkers.

Sustaining institutions

According to our analysis, institutions are necessary to make human behaviour predictable in the social realm, that is, w...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Illustrations
• Preface
• 1: Why stable money matters or ‘the loss of paradise’
• 2: After Bretton Woods
• 3: International consequences of bloc floating
• 4: The instability of the bloc floating regime
• 5: A fresh look at Optimum Currency Area theory
• 6: Is EMU sustainable?
• 7: Sustaining price price stability
• 8: Monetary policy and structural unemployment
• Notes
• Bibliography