Monetary union: European lessons, Latin American prospects

North American Journal of Economics and Finance 13 (2002) 297–321

Monetary union: European lessons, Latin American prospects Eduard Hochreiter a,∗ , Klaus Schmidt-Hebbel b , Georg Winckler c a

Oesterreichische NationalBank, P.O. Box 61, A-1011 Wien, Austria b Banco Central de Chile, Santiago, Chile c University of Vienna, Vienna, Austria

Received 14 April 2002; received in revised form 28 August 2002; accepted 3 September 2002

Abstract This paper analyzes the long-run sustainability of monetary unions. We infer from the EMU experience that for monetary union to be sustainable, fiscal policy rules are necessary. That does not imply a formal Stability Pact, however. Labor market flexibility is more important for sustainability than cross-border labor mobility. Sound financial markets are another precondition. Lessons for Latin America and the Caribbean include, first, that the benefit-cost balance of a shift to monetary union is much less favorable in Latin America and the Caribbean than in Europe and, most important, that the region is some distance away from satisfying the necessary conditions for monetary union. That leaves dollarization as a limited option for small countries and floating rates combined with inflation targeting for much of the rest. © 2002 Elsevier Science Inc. All rights reserved. JEL classification: E42; E52; E58; F33 Keywords: Exchange-rate regimes; Monetary union; Emerging market economies

1. Introduction The world is in a state of flux regarding the choice of monetary and exchange-rate regimes. One option is giving up national currencies to join a monetary union. Since Mundell (1961), the literature has emphasized conventional optimum currency area (OCA) criteria in shaping this decision. European Monetary Union (EMU), the largest historical experiment in giving up sovereignty in monetary (and other) policy areas, has captured the imagination of policy makers and researchers alike. It has also brought other issues related to complementary areas ∗ Corresponding author. Tel.: +43-1-404-20-7200; fax: +43-1-404-20-7299. E-mail address: [email protected] (E. Hochreiter).

1062-9408/02/$ – see front matter © 2002 Elsevier Science Inc. All rights reserved. PII: S 1 0 6 2 - 9 4 0 8 ( 0 2 ) 0 0 0 9 7 - 9

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of reform and integration to the forefront of theory and policy analysis. These issues shape the discussion about monetary union and, more generally, about optimal regime choice for countries in other regions, including Latin America and the Caribbean (LAC). The purpose of this paper is to assess the long-run sustainability of monetary unions, in the light of theory and of the experience of EMU, and to draw lessons for regime choice, and monetary union in particular, for LAC. In Section 2, we briefly review recent global trends in exchange-rate regimes and discuss the benefits and costs of EMU. This leads to three issues crucial to the long-run sustainability of monetary union, namely, fiscal policy, labor market rigidities, and financial market integration (Section 3). These considerations provide insights in Section 4 into the forces that shape monetary and regime choice in LAC and Section 5 concludes.

2. Monetary and exchange-rate regimes: optimality considerations and real-world constraints 2.1. Global trends in monetary and exchange-rate regimes Both industrial and developing countries are revising their monetary (M) and exchange rate (ER) regimes. Many countries and regions have shifted regimes—either gradually by careful design (as in EMU) or quickly in reaction to market forces (as in Ecuador in 2000 or Argentina in 2002). The evolution of official ER regimes is illustrated in Fig. 1. The share of fixed ER regimes— comprising systems with no independent currency, currency boards, and pegged ERs—has declined from 68% of countries in 1979 to 48% in 2001, while managed and independent floats have increased from 17 to 44%. Intermediate regimes, where ERs are adjusted by indicators (sliding pegs, bands, and sliding bands), have fallen from 15% of countries in 1979 to 8% in 2001. As a long-term trend, a shift to ER floats is evident.1 More recent IMF data based on a finer regime disaggregation confirm the ongoing trend consistent with the two-corner hypothesis (Fig. 1).2 Between 1999 and 2001, ERs adjusted by indicators have fallen from 12 to 8%, countries without independent currencies have increased from 20 to 22%, managed floats have risen from 14 to 23%, while independent floats have declined from 25 to 21%.3 The recent evolution in M regimes is reflected in a survey conducted among 93 central banks in 1998 by Mahadeva and Sterne (1998) and in the larger IMF data base of annual country-based official regime definitions, available since 1999 (Fig. 2). The evidence shows a relatively uniform distribution of M regimes (ER, monetary aggregate, and inflation targets) in the Mahadeva and Sterne data for 1998. The IMF data show a dominance of ER targets, but one which weakens between 1999 and 2001. This is consistent with the growing trend away from monetary and ER anchors and toward inflation targets. ER and M regimes are certainly not independent of each other and hence it is revealing to look at their joint distribution.4 As of December 2001, the combined global distribution of ER and M regimes (IMF classification) shows an obvious concentration of regime combinations on the diagonal of Table 1.5 It is noteworthy that today the world’s most popular regime combinations are the currency board or a pegged ER with an ER target (48 countries), followed

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Fig. 1. Country distribution by exchange-rate regime (IMF classification: 1979, 1986, 1999, and 2001). Source: Authors’ calculations are based on the International Monetary Fund’s International Financial Statistics. (1): For 1979 and 1986, the “No Independent Currency” and “Currency Board/Pegged” categories were both classified as “Fixed” by the IMF.

Table 1 Combined country distribution of exchange rate and monetary regimes (IMF classification December 2001) No independent currency No independent 40, 100%, 100% currency Exchange-rate target Money target Inflation target None/other Total cases and countries

40

Currency board and pegged exchange rate

Exchange rate adjusted by indicators

Managed float

Independent float

Total cases 40

48, 76%, 100%

15, 24%, 100%

1, 5%, 2%

48

63

2, 11%, 13%

11, 58%, 26% 7, 37%, 18% 19 1, 6%, 2% 15, 83%, 38% 18 31, 63%, 72% 18, 37%, 45% 49

15

43

40

Source: Authors’ calculations based on the International Monetary Fund’s International Financial Statistics. Note: There are 186 countries and cases for exchange-rate regimes, and 189 cases and 186 countries for monetary regimes. The number of cases for any combination are indicated in bold in each cell. The first percentage indicates the probability of the cell’s exchange-rate regime conditional on the row’s monetary regime (the ratio of the bold figure in the cell to the number of countries in the last cell of the corresponding row). The second percentage indicates the probability of the cell’s monetary regime conditional on the column’s exchange-rate regime (the ratio of the bold figure in the cell to the number of countries in the last cell of the corresponding column).

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Fig. 2. Country distribution by monetary regime (Mahadeva & Sterne, 1998; IMF, 1999, 2001 classifications). Source: Authors’ calculations are based on Mahadeva and Sterne (2000) and the International Monetary Fund’s International Financial Statistics. (1) Sample comprises only countries (or monetary areas) with an independent currency. Sum of shares exceeds 100% as some countries have adopted more than one monetary regime.

by no independent currency (40 countries), and a managed float with no conventional or explicit M regime (31 countries). Among the large (and growing) group of managed and independent floats, several combinations of the last two ER regimes with monetary regimes are observed. Conditional probabilities of one regime, given the other regime, vary considerably across cells in Table 1. For example, the conditional probability of having an independent float when an inflation target is in place is 83%. The opposite conditional probability—adopting an inflation target when an independent float is in place—is only 38%. Managed floats—often based on non-disclosed or ad hoc rules of intervention—are strongly associated with the absence of a conventional or explicit M regime (the conditional likelihood of no explicit or a conventional M regime when a managed float is in place is 72%). This stands in contrast to independent floats, which are more likely to be associated with explicit money or inflation targets (the conditional likelihood of no explicit or conventional M regime when an independent float is in place is 45%). Hence, rule-based ER regimes tend to be associated with rule-based M regimes. There are several reasons for the large and ongoing shifts in ER and M regimes that are observed worldwide: 1. Multilateral adoption of currency union, often as part of an evolving integration process (as in EMU); 2. Transition toward future monetary union, with adoption of intermediate exchange-rate regimes, as in some central and eastern European countries prior to euro accession;

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3. Response to domestic weakness or financial crisis caused by some combination of fiscal dominance, weak banking systems, inflexible ER system, and price and wage rigidities. Abandonment of intermediate ER regimes in favor of one corner (dollarization, e.g., Ecuador) or the other (floating ER, e.g., Argentina); 4. Small open countries adopt pegged ERs or abandon their national currencies in favor of a dominant foreign currency (e.g., El Salvador) or monetary union with similarly small states (e.g., the Eastern Caribbean Currency Area, ECCA); 5. Among countries that have managed or independent floats in place, a monetary regime shift from money to inflation targeting. The latter, labeled “constrained discretion” (Bernanke, Laubach, Mishkin, & Posen, 1999), is increasingly popular among industrial and developing economies alike.6 2.2. Overview of costs and benefits of giving up a national currency Cost-benefit and political considerations drive countries to modify their ER and M regimes. In this section, we discuss the costs and benefits of one particular regime shift: joining a monetary union, exemplified by EMU.7 Table 2 summarizes estimates of costs and benefits of EMU (and elsewhere, if applicable). Among major considerations are the following: • The traditional OCA literature (Mundell, 1961; McKinnon, 1963) argues that countries joining a monetary union will benefit from lower transaction costs associated with trading goods and assets in different currencies. Lower transaction costs would enhance trade and therefore generate higher benefits from economic specialization. • Recent empirical evidence stresses the large positive effects of currency unions on trade (Rose, 2000; Glick & Rose, 2001) and income (Frankel & Rose, 2002). However, new evidence suggests that Rose and associates might be grossly overestimating the impact of currency unions on trade due to sample selection and non-linearities (Persson, 2001) and the endogeneity of the decision to join the union (Tenreyro, 2001). • Other potential microeconomic efficiency gains arise from elimination of nominal exchange-rate volatility and hence lower interest rates, lower real exchange-rate volatility, deeper financial integration, and (in the case of joining a dominant currency area, like the euro) international use of the currency. • The microeconomic efficiency gains of a currency union may be offset by lower macroeconomic flexibility. Countries joining a currency union lose their ability to stabilize output through an independent monetary policy and give up nominal exchange-rate flexibility. In sum, the traditional approach states that countries with close international trade and financial links are more likely, whereas countries with asymmetric business cycles are less likely, to be members of an OCA (Artis & Toro, 2000). • For candidates of a currency union, microeconomic benefits increase and macroeconomic costs decline with the degree of trade integration and business-cycle symmetry. Empirical studies for the EU show that countries with closer trade linkages exhibit highly correlated business cycles. • OCA criteria are dynamic: net benefits of currency union increase because trade integration and business cycle correlation increase after joining the union (Frankel & Rose, 1998; Rose & Engel, 2001).

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• Non-traditional OCA factors include the distribution of seigniorage, inter-regional fiscal transfers, and lender-of-last-resort considerations. There is some evidence that for small countries, benefits of EMU outweigh costs by a relatively large margin, mainly because the loss of the exchange-rate instrument does not impose significant costs (e.g., Austria, Benelux). However, net benefits of monetary union are not the same for all members. EMU members at the periphery may not be as strongly viable in the long run as the states of the U.S. (Kouparitsas, 1999). Furthermore, for EMU to benefit the original 12 members, fiscal reforms need to be implemented in order to attain larger co-movement among members (Haug, MacKinnon, & Michelis, 2000). Output variability is dampened by the aggregation effect and the mean of stochastic variables fluctuates by less than its components. The loss of seigniorage is marginal once price stability has been reached and minimum reserve requirements are harmonized and remunerated. Differences in preferences regarding cash holdings (currently the predominant reason for “winners and losers”) might diminish over time as the importance of cash is being reduced (plastic money, etc.), but not eliminated (need for cash in the underground and criminal economies). As for dynamic gains, Crespo-Cuaresma, Dimitz, and Ritzberger-Grünwald (2002) estimate the growth effects of EU membership using an endogenous growth model and panel data. They find a growth bonus from membership, which is permanent and relatively higher for poorer member countries.

3. Fundamental issues on the long-run sustainability of a monetary union This section examines three key issues pertaining to economic and monetary union: fiscal policies, labor mobility and wage flexibility and financial market integration and supervision.8 The euro area is now characterized by one common currency and centralized monetary policy. Other policies, including fiscal policy, labor-market issues and financial-sector regulation are only partly and incompletely integrated. This has raised questions about the sustainability of monetary union without full centralization in other key policy domains. 3.1. The role of fiscal policies: unpleasant fiscal arithmetic, monetary dominance, and fiscal coordination The relationship between fiscal and monetary policies in monetary unions has been the subject of many studies in recent years, largely in response to the Maastricht Treaty of 1992 and the Pact for Stability and Growth (SGP), adopted by the EU-Council in 1997.9 The Treaty institutionalized binding fiscal rules for monetary convergence; the Pact defined these rules by specifying limits on deficits and debt; it empowers the Council to impose sanctions for non-compliance in the form of non-interest bearing deposits (maximum 0.5% of GDP), which are converted into a fine after 2 years, unless the infraction is corrected. Are such fiscal rules really necessary for the success of a monetary union? Some authors suggest that they may be a nuisance (see Eichengreen & Wyplosz, 1998). Some argue from

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the perspective of static macroeconomics, on which the theory of optimum currency areas is built, that no restrictions on the use of fiscal policies should be imposed: IS and LM curves can be shifted independently. Of course, for reasons of overall efficiency, coordination should seek optimal policy mixes. Yet, given that monetary policy is centralized in monetary unions and, in the case of EMU, shaped by the European System of Central Banks (ESCB), many argue that “nationalized” or even “regionalized” fiscal policies should be fixed individually and complemented by inter-regional fiscal transfers to cope with asymmetric shocks within the monetary union. From a neoclassical perspective, binding fiscal rules would also be unwarranted. If Ricardian Equivalence holds, fiscal deficits are macroeconomically irrelevant and have no effects on real interest rates. If it does not hold, but financial markets are efficient, sovereign credit risk will be priced like any other financial risk and reflected by interest rate spreads or by credit rationing. Questions also arise with respect to policy credibility and enforcement. Why should there exist bureaucratic procedures, based on an ambiguous pact, which makes determination of “excessive deficits” and imposition of fines a political issue? Will large EU members comply with such rules or, will they flex their political muscle? Will members deny a country latitude for political reasons, knowing that they may require similar flexibility in the future? There is nevertheless a growing literature on why fiscal rules make sense in a monetary union. One justification is based on imperfect financial markets, especially with respect to the pricing of sovereign credit risks. Another draws on insights from dynamic macroeconomics. Sargent and Wallace’s (1981) unpleasant monetarist arithmetic argues that a restrictive common monetary policy, yielding a small inflation tax (seigniorage) only, may be insufficient to balance exogenously determined primary public deficits and to prevent public debt from exploding. Eventually, monetary policy will be forced to adapt and accommodate, providing more seigniorage in the process. Thus, monetary policy yields to fiscal policy in a game of chicken. Winckler, Hochreiter, and Brandner (1998) argue instead that the architecture of EMU implies the opposite by imposing an unpleasant fiscal arithmetic. In Euroland, national fiscal authorities will eventually have to yield to the ESCB’s monetary policy. Dixit (2001) analyzes games of monetary and fiscal interactions in the EMU, which indicate that unconstrained national fiscal policies undermine the ESCB’s monetary commitment. This not only justifies fiscal constraints like the SGP, but calls for coordination among regional fiscal authorities. Woodford (1995, 1998), Canzoneri and Diba (1996), Buiter (1998), Daniel (2001), and many others have contributed to the fiscal theory of the price level. According to Woodford, economies are always confronted by random shocks which trigger unexpected variations in deficits and public debt. Fiscal sustainability requires two reactions in the case of negative shocks: (1) higher inflation taxes, following a shift to a more expansionary monetary policy that diminishes the burden of nominal debt or (2) fiscal policies aimed at reducing primary deficits in subsequent periods. The former indicates a regime of fiscal dominance, since monetary policy adapts, whereas the latter describes a regime of monetary dominance, since fiscal policies change. It may seem that the choice of regime is a matter of political preference. Keynesian preferences may suggest fiscal dominance, monetarist preferences monetary dominance. In the context of EMU, however, where monetary unification co-exists with independent national fiscal policies, the fiscal authority of the European Union as an entity remains negligible relative to

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Fig. 3. Primary surplus and debt ratio, EU 15, 1990–2002. Source: ECB, European Commission.

the member states. Hence, with one unified monetary policy, but many national fiscal policies, the question of dominance cannot be answered on the grounds of political preferences at the EU level. Obviously, giving priority to monetary policy avoids the issue of which nation’s fiscal policy should be in the lead and how other states should follow. Only if national fiscal policies were sufficiently coordinated, would a regime of fiscal dominance become meaningful in EMU. Unfortunately, empirical tests aimed at assessing regime shifts between fiscal and monetary dominance in the EU are highly inconclusive.10 Inspection of aggregate EU data in Fig. 3 suggests, however, that in 1993, when the Maastricht Treaty became effective, a regime shift from fiscal to monetary dominance took place. Monetary dominance was further reinforced in 1996. Fiscal rules in monetary unions are necessary, but that does not imply a formal SGP. A formal SGP is not necessary, but is it sufficient? Based on the seminal paper by Mundell (1961), some argue that the SGP is not sufficient to maintain a monetary union since it lacks a transfer mechanism to cope with asymmetric shocks. However, Kletzer and von Hagen (2001) note that the welfare effects of such fiscal insurance schemes are quite ambiguous and hence no substantial fiscal insurance schemes against asymmetric shocks are necessary in a monetary union. The SGP is sufficient. Another concern is that the SGP may unnecessarily constrain national fiscal policy in cases of idiosyncratic shocks. However, if the Pact’s goal of rough budget balance or surplus over the medium term, i.e., over the business cycle, is reached, then automatic stabilizers can work without endangering the 3% deficit limit. In addition, the Treaty stipulates that, under exceptional circumstances, the 3% deficit limit may be overshot without invoking the Excessive Deficit Procedure of Article 104. 3.2. Labor mobility, wage flexibility, and integration Elimination of the nominal exchange rate as an instrument to absorb idiosyncratic shocks raises the question about how such shocks can be dealt with without straining monetary union. Mundell (1961) argued that monetary union remains workable in the presence of asymmetric shocks as long as there is sufficient labor market mobility and/or aggregate and relative real

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wage flexibility. In contrast to the U.S., where regional labor mobility and real wage flexibility have been substantial, Europe is said to lack both (Layard, Nickell, & Jackman, 1991; Tyrväinen, 1995; IMF, 1999). Thus, rigid labor markets could raise unemployment and create severe political tensions (Feldstein, 1997, 1998). Geographical labor mobility has traditionally been very low in Europe, both across countries and within countries (Braunerhjelm, Faini, Norman, Ruane, & Seabright, 2000). Overall, cultural, legal, institutional and other reasons account for this immobility.11 Labor mobility remains extremely low, despite the Single Market, which removed legal barriers to intra-EU migration and the Schengen agreement, which removed physical border controls.12 Tightly regulated labor markets in Europe, including job protection and minimum wage legislation, working time regulation, etc., as well as generous unemployment benefits help to sustain real wages above their full-employment equilibrium levels and, at the same time, compress the wage dispersion necessary for bringing less qualified labor back into the market. In addition, strongly unionized wage bargaining processes, add not only to high real wages, but to their stickiness. In this context, it is noteworthy that trade unions have maintained their influence in a number of EU countries despite falling membership,13 in part by extending collective wage contracts to non-unionized sectors. France and Spain may serve as two extreme examples. While union membership in the two countries is around 15%, the coverage of wage contracts extends to 90 and 70% of workers, respectively (cf., IMF, 1999). Such arrangements strengthen the position of insiders to the detriment of unemployed outsiders. This overall characterization of European labor markets masks substantial differences. Boeri (2002) and Bertola, Boeri, and Nicoletti (2001) find that there are no less than four social policy models in the EU, ranging from high levels of protection and universal welfare provision (“the Nordic model”) to social welfare systems focusing on old-age pensions and employment protection (“the Mediterranean model”). The “Anglo-Saxon model” combines relatively high social assistance of the last-resort type with weak unions and comparatively wide wage differentials. As a result, labor market rigidities, wage dispersion and participation rates vary widely across the EU. On average, labor markets of countries in the euro area are even more regulated than in the EU as a whole (IMF, 1999). Unemployment levels and their persistence are highest in the largest EU countries (Germany, France, Italy, Spain). In contrast, other EU members either prevented massive increases (Austria) or managed to substantially reduce unemployment over time (Denmark, Ireland, The Netherlands, Portugal, U.K.). Labor markets in the smaller (more open) EU countries appear to have been more responsive to the changes brought about by the Single Market and EMU. This finding is supported by Pentecost and Sessions (2000), who study sacrifice ratios (SR) in EU member states in order to proxy differences in wage-formation processes. They find that the openness of the economy and labor productivity are important determinants of the SR. This suggests that EMU-driven economic integration may increase labor market flexibility.14 Labor market flexibility is affected by regulatory restrictions on work time and part-time work, minimum wages and job protection laws and by the specifics of the wage formation process. A number of initiatives have been undertaken recently to ease regulatory constraints, to reduce structural unemployment and to make wages more responsive to cyclical fluctuations.15

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The experience of the 1990s suggests that short- and long-term real-wage flexibility has increased in recent years. Hofer and Pichelmann (2002) find a sharp increase in short-term (cyclical) real-wage flexibility. They also construct a wage gap indicator by relating the real wage to the unemployment rate. Coincident with the disinflation process, the wage gap indicator drops continually after 1992 and lies below its 1970 level in 2001. This downward movement of the real-wage gap indicator may be interpreted as an increase in long-term (structural) real-wage flexibility. Cukierman and Lippi (2001) argue that EMU alters the strategic interactions among wagebargaining partners. In a monetary union, trade unions become relatively smaller, feel macroeconomically less responsible and thus will be more aggressive when negotiating wage contracts. As a result, unemployment will rise. Knell (2002) extends this model to open economies and, in contrast, finds that the establishment of EMU has had no effect on unemployment, essentially because a shadow monetary union existed before 1999. Well before 1999, trade unions were concerned with international competitiveness and price stability, which was guaranteed by the anchor central bank (the Bundesbank). Yet, there are at least two issues regarding the evolution of trade unions and the centralization and decentralization, respectively, of wage-bargaining processes in EMU. The first relates to the question of whether trade unions will remain nationally segmented or whether they will attempt to “regain their relative size” by cooperating and eventually merging across the euro-zone. Calmfors (2001) argues that while the macroeconomic dialogue within the framework of the employment act offers a platform for transnational wage setting within the EU, coordination of wage setting seems unlikely due to prohibitive coordination costs. At most, one could imagine trans-EMU wage bargaining taking place in multinational firms, where coordination costs are lower and similarities in management principles and employee interaction are greater. The second issue relates to unemployment as a regional and sectoral problem (Soltwedel, Dohse, & Krieger-Boden, 1999). Unemployment rates show large intra-EMU dispersion, with very high rates observed in weak regions like Eastern Germany, the Mezzogiorno and parts of Spain, Portugal, and Greece. The European Commission (2000), the IMF (1999), and the OECD (1999) have identified European unemployment as a predominantly structural problem, which can only be tackled through fundamental labor market reform. At the same time, differences in unemployment rates call for decentralization of wage bargaining and wage setting, to allow for larger wage dispersion (Davies & Hallet, 2001). As an alternative, centralized wage setters could negotiate more differentiated real wages across sectors and regions. Such a development appears not to be completely unrealistic. We conclude that Stage 3 of EMU did not cause regime shifts in labor markets of countries that had a long history of pegging their currency to the Deutsche Mark (e.g., Austria, Belgium, The Netherlands). They had lived with the constraints of a quasi-monetary union for a long time. Labor mobility in Europe has not responded to the Single Market, the abolition of physical border controls and to the commencement of Stage 3 of EMU, partly because strong disincentives to move remain. EMU can function smoothly without cross-border labor mobility, provided that labor markets and wages are sufficiently flexible. Thus, the really important issue is to secure sufficiently flexible wages and structural adjustment. While some progress in institutional reform has been made, much more is needed to sustain EMU.

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3.3. Financial integration and supervision Financial market integration is a worldwide phenomenon, driven by globalization and technological progress. The adoption of the euro added a catalytic dimension for financial integration in the Eurozone. Following the introduction of the euro in January 1999, the (unsecured) money markets were integrated almost immediately and smoothly (Gaspar, Perez-Quiros, & Sicilia, 2001) into a Single Market, as reflected by the substantial decline in bid-ask spreads (Galati & Tsatsaronis, 2001). Bond markets have widened and deepened appreciably, but government bonds remain only imperfect substitutes for each other. Yield differentials among equal-quality sovereign bonds persist. German and Dutch government bonds, for example are both rated AAA but continue to be priced differently. At the same time, there was a sharp rise in non-sovereign bond issues. The euro quickly emerged as the second most important bond issuance currency after the U.S. dollar. Yet progress has been uneven. The “Lamfalussy Report” (2001) finds that the process of financial market integration remains slow and incomplete. Padoa-Schioppa (2002) identifies market-related factors (fragmented infrastructure for cross-border clearing and settlement of security transactions) and policy-related conditions (regulatory obstacles) as inhibiting factors. This is also true for other financial sectors and, in particular, in the field of banking and capital-market supervision. The European cross-border clearing and settlement infrastructure, which is essential for smoothly and efficiently functioning securities markets, remains highly fragmented. There are some 20 different systems in operation at the present time (Giovannini Report, 2001; von Thadden, 2001) resulting in expensive and cumbersome cross-border transactions and clearing procedures. Major steps in integration and consolidation of the infrastructure have yet to be undertaken. The unified monetary policy of the euro area is confronted with regulatory and supervisory authorities which are specialized both nationally and across sectors. This does not pose a problem as long as financial markets remain nationally segmented, in which case the principles of home-country control and host-country responsibility greatly overlap (De Grauwe, 2000). Increasing cross-border mergers or market integration, however, blur responsibilities and may contribute to slower and less efficient crisis management. The ECB’s regulatory and supervisory roles are defined in Protocol no. 3 of the statute of the ESCB and the ECB. Article 3 only states that “the ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system.” Article 25 lays down the consultative role of the ECB in prudential supervision. Thus, regulatory and supervisory functions are assigned to national authorities. While precise institutional responsibilities differ markedly across EMU, national central banks are involved in one way or another in all Eurozone countries (Hochreiter, 2000),16 a point which is also frequently stressed by the ECB. This set of separated institutional arrangements has drawn severe criticism. Favero, Freixas, Persson, and Wyplosz (2000) argue that European integration will intensify competition among financial institutions, reducing profits and raising systemic risk. The problems will grow once cross-border mergers proliferate. Hence, the authors call for more centralization of prudential supervisory structures, possibly by assigning a larger role to the ECB. Benink

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and Wihlborg (2002) argue that market discipline should play a larger role when regulating banks. Yet, the “Brouwer Report” on Financial Stability (European Commission, 2000, p. 7; emphasis added) concludes that “the existing institutional arrangements provide a coherent and flexible basis for safeguarding financial stability in Europe. No institutional changes are deemed necessary.” Europe, however, does need a strengthening of cross-sector and -border cooperation among financial regulators and supervisors (European Commission, 2000). There is a need for effective crisis management and emergency financing. Bruni and De Boissieu (2000) distinguish three financing channels to defuse a crisis: tax payers money, private capital and central bank financing through its lender-of-last-resort (LOLR) function. In the Eurozone, there are no clear provisions for a LOLR function and how such lending should be shared between the ECB and national central banks (Bruni & De Boissieu, 2000). The Treaty does not assign LOLR responsibilities, which raises concerns about managing a fast-developing liquidity crisis (Prati & Schinashi, 2000). Our conclusion is that no major change in the European institutional regulatory and supervisory architecture is in the offing at the present time.17 Thus, the first major (systemic) crisis will provide the litmus test of the adequacy of current institutional arrangements.

4. Monetary regime choices in Latin America and the Caribbean (LAC) In this section we review recent trends in monetary and exchange-rate regimes in LAC and discuss regime options, with particular attention to monetary union. 4.1. Exchange rate and monetary regime trends in LAC The global trend away from pegged ER regimes and toward more flexible arrangements described in Section 2 is even more pronounced in LAC.18 Regarding M regimes, the world trend toward inflation targeting among floaters is also more intense in LAC than elsewhere. In 1994, LAC’s dominant regime combination was an ER regime of limited flexibility (adjustable peg or ER band) combined with an ER or a monetary growth target (Table 3). Since then, LAC has evolved toward the two-corner set-up. In 2002, five countries comprising 87% of LAC’s GDP (Brazil, Chile, Colombia, Mexico, and Peru) operate regimes which combine a managed or an independent float with inflation targeting. Their relatively independent central banks have brought about price stability with inflation targeting and have improved the policy-making process by raising transparency and accountability. They have made progress toward a floating ER regime, where the “fear to float” is mostly reflected by occasional, but at times intensive, exchange-market interventions (Schmidt-Hebbel & Werner, in press). Three small countries that produce 2% of regional GDP have adopted the U.S. dollar (the upper left-hand corner in Table 3): Panama (since the early 20th century) and Ecuador (in 1999) and El Salvador (in 2000). Many small economies, particularly in Central America and the Caribbean, may follow suit. Six very small island economies in the Caribbean form the Eastern Caribbean Currency Union (ECCU), whose currency is pegged to the U.S. dollar.

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Many small LAC economies have diversified foreign trade and suffer from idiosyncratic shocks and hence are not highly synchronized with the U.S. or any other large economy. They face stiff tradeoffs regarding regime choice between renouncing their national currency or strengthening it by adopting a float, possibly with inflation targeting. Among the latter countries are Bolivia, Costa Rica, Honduras, and Nicaragua, which currently operate ER regimes of limited flexibility. They are likely to join the majority of LAC economies that have migrated to either of the corners. Three larger economies that are still in critical condition— Argentina, Uruguay, and Venezuela—were forced off their previously rigid ER regimes. 4.2. Costs and benefits of giving up national currencies in LAC There are few studies for Latin America of the suitability of currency union. Ahmed (1999) analyzes the sources of economic fluctuations in LAC’s three largest economies—Argentina, Brazil, and Mexico—to assess the implications for the choice of ER regime. External shocks account for only 20% of output fluctuations and U.S. interest rate shocks have anomalous effects (first expansionary, then contractionary) on Latin American output levels. These findings argue against fixed ERs, MU or unilateral dollarization. However, real ERs are found to be only weakly responsive to U.S. interest rate and terms-of-trade shocks in the three countries, thereby weakening arguments in favor of floating.19 Contrary to the findings of Frankel and Rose (1998) and Rose and Engel (2001) for the EU, Calderon, Chong, and Stein (2002) show that the impact of trade integration on business cycle synchronization is much smaller in developing countries in general and, in the case of LAC, is not significantly different from zero.20 For Caricom countries, Kendall (2000) finds little evidence of convergence. Morandé and Schmidt-Hebbel (2000) assess the pros and cons of unilateral dollarization and monetary union for Chile. High production and export specialization in commodities and highly idiosyncratic external and domestic shocks explain the negative (or low positive) output correlations between Chile and prospective currency partners like Mercosur, the U.S. and the EU. Chile is found to be a less likely candidate than Argentina, Brazil and Mexico. 4.3. Monetary union in Mercosur and NAFTA In discussing the options of monetary union for Mercosur, Eichengreen (1998) finds that Mercosur members exhibit unusually large real-exchange-rate volatility, reflecting the influence of idiosyncratic macroeconomic shocks. Levy Yeyati and Sturzenegger (2000) find that Mercosur countries do not satisfy OCA criteria. Intra-Mercosur trade integration is very low compared with the EU, as documented by Belke and Gros (2002), and hence more intra-Mercosur exchange-rate variability is desirable. Mercosur institutions and policies are weak, making Mercosur more vulnerable to foreign and domestic idiosyncratic shocks. Weak output correlations and segmented labor markets reduce the ability of labor markets to absorb large asymmetric shocks. In NAFTA, recent studies have assessed the costs and benefits of monetary union (e.g., Buiter, 1999; Morales Castañeda, 2001; Chriszt, 2000). Much progress is required in financial and labor market integration and the issue of LOLR has to be addressed before adopting a

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monetary union. However, even if economic arguments favor such a union, political factors are likely to remain the largest hurdle to attain a currency union. On one hand, the will to relinquish monetary sovereignty to the U.S. is not well developed in its two partner countries. On the other hand, the U.S. is certainly unenthusiastic about sharing its monetary sovereignty. 4.4. Dollarization Substitution of the U.S. dollar for national currencies has a long history in LAC. Currency and asset substitution was a rational response to high domestic inflation, weak banks, and pervasive devaluation fears. De facto dollarization of transactions and asset holdings exhibits hysteresis and hence is difficult to reverse (Calvo & Vegh, 1992). Large de facto dollarization is widespread in small and medium-sized LAC economies, like Bolivia, Costa Rica, Guatemala, Peru, and Uruguay. In addition, all LAC economies hold large amounts of dollar-denominated net foreign liabilities, exposing them to significant wealth losses in the wake of currency devaluation. De facto dollarization and large dollar debts often dominate conventional OCA criteria when evaluating official dollarization—as recently demonstrated by El Salvador. Panizza, Stein, and Talvi (2000) argue that official dollarization in Central American and Caribbean economies may reduce inflation and financial fragility by reducing the volatility of key relative prices. However, Edwards and Magendzo (2002), confirming the inflation gain from dollarization, argue against dollarization by providing evidence that dollarized countries grow at significantly lower rates and are not spared from major current account reversals. 4.5. Lessons from EMU and prospects for regime choice in LAC The foregoing suggests six lessons for regime choice and prospective monetary union in LAC. First, sound fiscal policy plays a dominant role among the prerequisites for successful monetary union. The Maastricht Treaty and the SGP brought about a shift from fiscal to monetary dominance in the Eurozone. The EMU experience shows that monetary dominance is a necessary condition, but a fiscal agreement like the SGP is a sufficient condition for successful monetary union. LAC has, on average, achieved significant progress towards fiscal and monetary stability during the past decade. The five LAC countries that have adopted inflation targeting have been careful to strengthen their fiscal institutions in order to avoid fiscal dominance—a major prerequisite for successful inflation targeting (Bernanke et al., 1999). However, many LAC countries are still fiscally fragile and in need of further fiscal reforms. Second, EMU is not a model for achieving labor market flexibility in LAC, where two types of labor markets are to be found. In most of Latin America, labor markets suffer from legislation and practices, modeled on Continental Europe and the source of wage rigidity, unemployment, and large informal employment. In the small English-speaking countries of the Caribbean, where labor legislation and practices follow the liberal Anglo-American model, formal-sector employment is larger (Heckman & Pagés, 2000). As in EMU, trade unions in LAC must adapt and adjust. Yet, in contrast to EMU, pervasive government regulation of industrial relations needs to give in industrial relations in LAC give way to a system in which unions play a major role in collective bargaining (Márquez & Pagés, 1998). The clear lesson from EMU is that

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cross-border labor mobility is secondary to domestic labor-market deregulation and real-wage flexibility. Third, EMU shows that a well-regulated, sound financial sector is a necessary condition for achieving efficient financial intermediation (required to reap the micro-benefits of a monetary union) and reducing the likelihood of banking crises (required to maintain fiscal solvency and growth). This stands in contrast to LAC, where most banking sectors are fragile, beset by bad debt and exposed to significant maturity, currency, and credit risks. However, EMU still exhibits major differences in national financial infrastructures and regulation and supervision of banking and capital markets, while the respective roles of the ECB and the national banks in the lender-of-last-resort function have not been clarified. Similar shortcomings would be a major hindrance for successful monetary union in LAC, where countries follow widely different standards of prudential regulation and supervision, and where lender-of-last-resort roles are exercised by central banks in ad hoc ways. Fourth, with much progress in price stabilization—LACs average inflation rate has fallen from more than 100% per year in the 1980s to single-digit levels in recent years—seigniorage is now a negligible source of fiscal revenue in most LAC economies. But this does not mean that the sacrifice of seigniorage in unilateral dollarization is uncontroversial in LAC. Few countries—particularly the medium-sized and large economies—are willing to give away their seigniorage revenue without compensation or a say in monetary policy—both still unacceptable propositions for the U.S. This leads to our fifth inference: the importance of politics. Europe’s willingness to sacrifice national sovereignty—in macroeconomic management, structural policies, and, even, politics—improves the prospects of monetary union. For a variety of reasons, including their own histories and state of economic development, LAC countries show very little willingness to compromise sovereignty in economic matters. Finally, there is no conflict between the long-term strategies required for achievement of stronger national currencies or of monetary union. To a large extent, the preconditions for a viable national monetary policy of floating rates and inflation targeting are identical to those of monetary union. Both require sustainable fiscal policies, strong prudential regulation and supervision of financial markets, flexible labor markets, and significant trade linkages. Successful adoption of rule-based macroeconomic and structural policies is exemplified in LAC by Chile, where early adoption of inflation targeting, a fiscal rule anchored in a structural fiscal surplus, a floating exchange rate, and tight regulation and supervision of financial markets have allowed the country to weather adverse regional shocks (Schmidt-Hebbel & Tapia, 2002b).

5. Concluding remarks This paper started by documenting the worldwide shift away from intermediate exchangerate regimes toward either of two corners: floating exchange rates or currency union/dollarization. In LAC, unilateral dollarization was adopted in order to control adverse macroeconomic conditions (as in Ecuador) or in response to longer-term optimality considerations based on OCA criteria (as in El Salvador). At the other extreme, adoption of a floating exchange rate

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cum inflation targeting can be a response to a crisis situation (as in Brazil) or the gradual evolution toward more flexibility and monetary policy independence (as in Chile). The available evidence on the costs and benefits of abandoning national currencies suggests significantly less favorable conditions in LAC than in Europe. Low intra-regional trade, idiosyncratic shocks, differences in policies and institutions, and heterogeneity in economic development militate against monetary union in the region generally and in the existing trade areas as well. Currency union among the members of Mercosur remains a distant dream. Currency union in NAFTA faces considerable political hurdles. Overall, LAC is some distance away from satisfying the necessary conditions and shows little political will for monetary union. Our review of European economic and monetary union leads to the following conclusions. First, while fiscal rules are necessary in monetary union, the SGP is sufficient but not necessary. Second, it is not so much cross-border labor mobility that is important for a smooth functioning of monetary union as real-wage flexibility and structural adjustment. Dollarization seems to be more feasible for smaller LAC economies that are highly correlated and integrated with the U.S. or are pushed to abandon their national currencies because of domestic crises. However, for most medium-sized and large economies, neither intra-regional monetary union nor dollarization appear to dominate the option of strengthening national currencies by means of floating rates and inflation targeting. Indeed, if countries manage in this way to lock in macroeconomic stability and to establish market flexibility, they may be on the best course yet toward intra-regional monetary union in the long run. Notes 1. IMF data on exchange-rate regimes in Fig. 1 and monetary regimes in Fig. 2 are based on official regime classifications. Official data on ER regimes have been criticized for being a poor indicator of ER flexibility. Calvo and Reinhart (2000) argue and provide evidence that nominally independent floaters among emerging countries exhibit fears to float through various forms of ER interventions. Levy Yeyati and Sturzenegger (2002) take up this point by constructing a new database of ER regimes, inferred from cluster analysis of ER and reserve behavior. While their share of de facto fixed ER regimes is on average higher than in the IMF data, they also document the trend decline in de facto fixed regimes between 1979 and 2000. 2. This trend is also confirmed by Fischer (2001). 3. von Hagen and Zhou (2001) test the hollowing-out hypothesis for 25 transition economies in Europe and find that although corner regimes dominate, in the steady-state intermediate regimes will not disappear completely. 4. Kuttner and Posen (2001) argue that exchange rate regimes, central bank autonomy, and domestic targets should not be considered in isolation, but rather as inter-connected systems. 5. Several combinations of ER and M regimes are not feasible. Selecting a particular ER regime (for example, a float) restricts the choice of M regime (to money or inflation targeting). Table 1 is arranged in a way such that most feasible regime combinations are located close to the diagonal while the upper right-hand and lower left-hand corners remain empty.

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6. As of mid 2002, 20 countries have adopted inflation-targeting regimes (Schmidt-Hebbel & Tapia, 2002a). A growing body of comparative cross-country research provides evidence of the success of inflation-targeting countries in attaining their targets at relatively low output costs due to increased policy credibility (e.g., Bernanke et al., 1999; Cechetti & Ehrmann, 2001; Corbo, Landerretche, & Schmidt-Hebbel, 2001; Mishkin & Schmidt-Hebbel, 2001; Schmidt-Hebbel & Werner, in press). 7. There is an increasing body of literature on optimal exchange rate regimes that we will not review. For emerging market economies, see Larra´ın and Velasco (2001) and for Latin America, see French-Davis and Larra´ın (2002) and Escaith et al. (2002). 8. We do not discuss trade and goods market integration, because EMU seems to suggest that this integration is a prerequisite for forming a MU and reaping its benefits. 9. Resolution of the European Council on the Stability and Growth Pact Amsterdam, June 17, 1997; Official Journal C 236, 02/08/1997: 0001–0002. 10. See Canzoneri and Diba (1996). First, most EU countries adapted their measures of public debt to Maastricht standards in 1990, thereby precluding comparison of pre- and post-1990 debt series. Second, only annual data are available. To increase the number of observations, a panel study should be pursued. However, due to many special circumstances in the individual EU states a host of dummy variables have to be included. Third, one needs to concentrate on statistical procedures to test for structural breaks. 11. Given the history of labor immobility in the EU despite very substantial intra- and intercountry income differentials, it is noteworthy that the perceived threat of immigration from the EU candidate countries from central and eastern Europe is a major worry for EU politicians and the population at large. Also note that the accession to the EU of Greece (1981) and Portugal and Spain (1986) did not induce large migration flows to high-income EU states. 12. Of course, strong disincentives for migration, such as the non-portability of workers’ rights across borders, remain. 13. Calmfors et al. (2001) find that average union density in Europe declined from 44% of employment in 1979 to 32% in 1998. 14. For a good discussion of the role of labor markets in EMU see, e.g., Buti and Sapir (1998). 15. For good summaries of strategies and measures taken in individual countries, see the Broad Economic Policy Guidelines, National Action Plans for Employment (NAPs), and the Annual Reports on Structural Reforms by the EU Economic Policy Committee. 16. This remains true after the recent changes in the supervisory structures in Austria and Germany, where an independent Financial Market Authority was established. 17. More recent efforts to extend the Lamfalussy approach from the securities market to financial markets as a whole may qualify this statement. 18. According to the IMF classification, the share of countries with fixed ER regimes, among 18 LA countries, fell from 67% in 1979 to only 16% in 2002; the share of independent floaters increased from 0% in 1979 to 32% in 2000; and intermediate regimes of ER adjustment by indicators have remained stable at 27%, while managed floats have increased from 27 to 44%.

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