Bättre Sverige som ett självständigt "Europas Kanada"
än att reduceras till ett "Europas Norrland"

Håkan Larsson (c) Hudiksvalls Tidning 15/1 2003

Mundell är idag besviken på att Kanada inte gick in i en valutaunion med USA.

Canada's Chilling Lesson for EMU
Wall Street Journal 97-07-14

Mr. Connolly, head of the European Commission unit "EMS, National and Community Monetary Policies" from 1989 to 1996, is executive director and senior economist with AIG International Inc., London.

Mr. Crow, governor of the Bank of Canada from 1987 to 1994, is a senior advisor to AIG Trading Group.

Last week the yield spread between Italian and German 10-year government bonds fell below 100 basis points for the first time ever. Market players continue to make big bets that European Monetary

Union will produce almost complete yield convergence. That may be. But traders seem to be entirely ignoring the possibility that EMU, if it happens, will cause interest rates to converge at higher, not lower, levels. The experience of the United States and Canada, countries that possess monetary sovereignty at a federal level, holds lessons for EMU.

Regrettably, those lessons are mainly about the features of EMU that make it different from the monetary systems of these two North American countries, differences that mean monetary union in Europe faces an uphill struggle.

In the U.S. and Canada, despite their federal structure, monetary sovereignty lies squarely with the central government. In contrast, it is far from obvious where monetary sovereignty would lie in EMU-land. Unless and until the area became a country, capable of exercising sovereignty

in the monetary and other domains, it would seem that EMU would simply extinguish monetary sovereignty in the EU.

Of course, monetary power would still be exercised by someone, but nobody would possess monetary sovereignty. This has weighty constitutional implications. But our focus here is simply the financial consequences of the absence of monetary sovereignty and the potential impact on price stability and economic performance of conflicting monetary and fiscal programs. The problems that faced Canada in the late '80s and early '90s provide a benchmark.

Bank vs. Provinces

At that time a private sector demand boom created overheating in the Canadian economy, requiring the monetary authority to tighten monetary conditions in an effort to curb inflation. But the move was complicated by the fact that the deficits and debts not only of the central government (a sovereign borrower), but also of several provincial governments (non-sovereign borrowers), were set on a course that would likely be unsustainable.

This meant that the efforts of the Bank of Canada to restrain and cut inflation might never succeed unless central and provincial governments undertook major efforts of deficit reduction. Otherwise, there would always be a suspicion in the minds of the markets that political pressures would force the central bank to ease monetary conditions inappropriately, in a bid to make life easier on the fiscal side.

Mere concerns about such pressures would themselves push up real interest rates, thus intensifying the fiscal difficulties, increasing concerns about political pressures, and so on.

The provinces could in theory default, and were therefore more market-constrained than the federal government. Either financial market pressures, expressed through credit downgrades and rising spreads, would force them into politically painful fiscal retrenchment, or they would, by exerting political pressure on the central bank, force monetary conditions to accommodate their existing fiscal programs.

In the end, this battle in an ongoing struggle against inflation was won by the forces of price stability and fiscal responsibility. But the battle was made unnecessarily painful by the credibility-reducing effect of initially-unsustainable fiscal programs.

There were two crucial reasons why the monetary authority was able to come out ahead in Canada. The first was that, at least as far as the provinces' behavior was concerned, financial market pressures exercised on non-sovereign borrowers made sure that the battle could not be a protracted one. Second, monetary policy in Canada is unambiguously a federal responsibility and the Bank of Canada has a degree of political legitimacy (derived from its relationship with the federal govemment) in taking action to reduce inflation, even at the expense of fiscal difficulties.

These two elements, which are clearly interdependent, would not be present in EMU. The Maastricht treaty was intended, by at least some of its architects, to subject member governments to the same financial constraints as private-sector borrowers. But no private-sector borrower (or even non-sovereign public-sectom borrowers such as the Canadian provinces) has ever been allowed by bond markets to run debt ratios nearly as high as those that likely EMU members currently have, and still retain investment-grade status.

So EMU countries, if the plan worked as advertised, would face the prospect of being forced into much harsher fiscal retrenchment than the stability pact, if it ever functioned, would require.

That seems unlikely. Implicitly, the markets now believe that EMU governments will metain the substance, if not the form, of sovereign borrower status. Since EMU-land is not a country, no government could expect its citizens to accept the fiscal implications of the Maastricht blueprint for monetary union in the name of an inflation objective for which neither it nor any other govemnment felt wholly responsible. So for the European Central Bank, unlike the Bank of Canada, the odds would be stacked against it sustaining its position in the conflict that would inevitably result from this fiscal resistance.

In other words, while the rules for the ECB will give it even more monetary power than the Bank of Canada, it obviously starts with less moral authority or political legitimacy. If it is seen to be creating fiscal problems for national governments, it will be in trouble; European economic integration and political amity will be in trouble with it.

The clearest implication of this is that bond and foreign exchange markets should expect inflation in EMU-land to be higher than it now is. The fragile politics of EMU are unlikely to permit either bondmarket disciplines or binding, collectively-agreed rules to be brought to bear on national fiscal authorities.

One way or another, governments simply will not retain their present status. If they are treated by markets like non-sovereign borrowers, they will have to engage in draconian fiscal austerity once in EMU.

But since the markets seem to believe that no major EMU country would be allowed by the others to default, this is not on the cards. Given that the formal "no bailout" rule will probably be respected, what will that mean in practice? It could only mean that any individual country, while relinquishing monetary sovereignty in a constitutional sense, would nevertheless retain monetary power. A country that got into fiscal trouble would put pressure on the ECB to loosen monetary conditions – that is, to run a higher inflation rate than otherwise in an attempt to stimulate growth and thus tax revenues and to reduce real borrowing costs.

And even if governments do get some market leeway with their debts, they will still be members of a wide monetary union with many members, which will certainly be far from an optimum currency area at the outset and will encompass countries (most of which, it should not be forgotten, will face fearsomely difficult decisions on the enormous cost of public pensions provision) with widely differing economic cultures and cyclical conditions. There will almost always be at least one country that is facing fiscal difficulties. That means the ECB will be under continuous pressure to help out, at the cost of implementing monetary conditions that are too loose overall.

The imperative of avoiding political breakdown is likely, whatever the ECB voting rules and the personal qualities of the bank's council members, to ensure that monetary policy has to adapt to fiscal circumstances, not the other way around.

Vicious Circle

The unpleasant implications for the direction of bond market convergence will become increasingly obvious. Rising bond yields in anticipation of inflation would mean excessively high real interest rates.

And, in turn, economic growth would remain sluggish at best. Thus the risk of fiscal problems in the early years of EMU would increase, further raising the probability of inflation, feeding back into higher real interest rates, and so on. A Canadian-style solution of standing fast monetarily until bond-market disciplines were brought to bear effectively on "regional" governments would hardly be compelling: The ECB could will be seen as a "foreign" power enforcing austerity on the home country.

The stability pact, instead of helping, may make things worse. Its very existence, and the knowledge that triggering sanctions, certainly in the case of one of the larger countries, could mean the end of both EMU and the European Union, will simply add to the pressure on the ECB to accommodate fiscal problems in a member-state.

The upshot is this:

Because the successful conduct of monetary policy depends on the unambiguous delineation of monetary sovereignty, you are hard pressed to have a successful monetary union without creating a country first.

Canada is a country, even if a federal one.

EMU-land is not.

Bättre Sverige som ett självständigt "Europas Kanada"
än att reduceras till ett "Europas Norrland"

Håkan Larsson (c)
Hudiksvalls Tidning 15/1 2003

Se also: The Swiss say no, Mar 8th 2001 The Economist

Mer om EMU