ws 09/10 ©prof. dr. friedrich schneider, university of linz, austria1 10. the consequence of the...

WS 09/10 ©Prof. Dr. Friedrich Schneider, University of Linz, AUSTRIA 1

10. The Consequence of the EMU and the Role of International Monetary Institutions after the

World Financial Crises: Some Preliminary Ideas Using Constitutional Economics


The Consequence of the EMU and the Role of International Monetary Institutions after the World Financial Crises: Some Preliminary Ideas Using Constitutional Economics - Content

1. Introduction

2. The Consequences of the European Monetary Union (EMU)

3. The New Challenging Tasks of the International Monetary Fund under the aspect of the world financial crises

4. Some Theoretical Ideas, about the Functioning of a New International Monetary Institution Should Work

5. Some Ideas about the Institutional Design of a New International Monetary Institution

6. Summary and Conclusions


1. Introduction

1. The consequences of the EMU

2. Do we need a new or reformed IMF with respect to the global financial crises?

3. If so how should this institution look like?


Table 2.1: Positive and negative expectations of the European Monetary Union (EMU)

Positive expectations Economic theory

(1) Economic growth (in general)

(2) (Faster) development/convergence of less developed EU-countries

New growth theory

Negative expectations

(1) Higher inflation, especially in low inflation EU-countries

(2) Increased (and permanent) onesided transfer payments

→ Bail out problem

New stabilization theory; theory of optimum currency areas

2. The Consequences of the EMU


(1) Economic Growth

(2) Faster growth of less developed EU-countries

The direct development-enhancing effects are:- the removal of exchange rate uncertainties;- (the expected) rise in direct foreign investment; and- a possible increase of financial transfers to the less developed

European Union countries.

Indirect development-enhancing effects include all the positive stabilization effects – like:

- the discipline forced by the convergence criteria,- the credibility gained from the European Central Bank, and- an increase in political stability.

2.1. Positive expectations of the EMU


The negative expectations of the European Monetary Union are:

(1) Higher inflation in the low inflation EU-countries, and

(2) Conflicts between EU-members because of large one-sided transfer payments, or how to fulfill the Maastricht convergence criteria.

2.2. Negative expectations of the EMU


Table 2.2: Institutional precautions/arrangements of the EMU

Institutional arrangements:

1. In the Maastricht treaty

1.1. Statute of the ECB i. Commitment to price stability

ii. Independence of the ECB

iii. Prohibition of government deficit financing

1.2. No bail-out clause

1.3. Fiscal convergence criteria i. Government budget deficit

ii. Government overall debt

1.4. Monetary structural convergence criteria

i. Inflation convergence

ii. Long term interest rate convergence

iii. Exchange rate stabilization

2. Stability pact Fiscal and budgetary discipline

2.3. The Institutional Set-up of the EMU


The stability of the Euro depends on the following four factors:

(1) size of transaction domain,

(2) stability of monetary policy,

(3) stability of the political system and

(4) fall-back value.


It is obvious, that a currency, which is used by a hundred million people, is much more liquid than a currency which is money for one million people.

The larger the single currency area, the better it can act as a cushion against shocks.

Ad 1: Size of transaction domain


Ad 2: Stability of the monetary policy

The stability of the Euro depends on the institutional arrangements which proved so far to be successful.


Ad 3: Stability of the political system

Long term monetary stability, of course, depends on monetary policy, and monetary policy is in turn affected by political stability.

Strong international currencies have always been linked to strong and stable governments.


Most modern currencies (like the EURO) have no real fall-back factor as the older currencies had, which were either gold or silver standards or convertible into one or both of those metals.

Ad 4: The fall-back factor

In sum, the Euro has two weaknesses: it is not backed by an European Federal Union and it has no real fall-back value.


(1) For most western EU-countries it was worthwhile to shift domestic monetary policy to a transnational (European) level. The expectation is a stable hard currency and low inflation rates but also a better predictability of monetary policy, which has been met up to now!

(2) Hence such a change from a domestic institutional monetary arrangement to a transpational one may be worthwhile to consider also for other countries.

Two Preliminary Conclusions


3. The New and Challenges Task of the IMF after the World Financial Crises

(1) The IMF is quite often severly criticized for his policy measures especially in crises periods.

(2) Quite often a major reform of the IMF and of other financial institutions is demanded.

(3) One outflow of this discussion is the request of a Tobin tax which should be monitored or excuted by an international financial institution.

(4) Also a better monitoring and hopefully a prevention of financial crises is demanded.


4.1. The economic and political independence of monetary institutions

(1) The modern theory of financial institutions stresses the importance of the independence of these institutions and of the incentive structures of the decision makers responsible for monetary policy.

(2) Economic independence is defined as the ability of the monetary institution to determine the use and choice of its monetary (and if necessary other) policy instruments to act autonomously.

(3) Political independence is defined as the ability of the monetary institution to choose monetary policy goals autonomously and without interference from the government.


4.2. Institutional solutions

Two approaches of independent monetary institutions can be differentiated:

(1) Rogoff‘s (1985) approach to delegate monetary policy to an independent „central“ banker and

(2) The contracting approach by Walsh (1995).

Both theories have in common, that they propose the establishment of monetary institution structures which permit monetary policy to react to economic disturbances independently, i.e. without interference from the government.


4.3. A Suggestion of a “New” IMF

Institutional arrangements

1. Statute of the IMF 1.1 Commitment to stable currencies

1.2 Commitment to price and fiscal stability

1.3 Independence of the new IMF from donor countries

2. No bail-out clause

3. Fiscal convergence criteria (pre fixed limits) of

3.1 Government currencies budget deficit

3.2 Government overall debt

4. Monetary structural convergence criteria

4.1 Inflation convergence

4.2 Long term interest rate convergence

4.3 Exchange rate stabilization

Table 1: Institutional precautions/arrangements for a “new” IMF


4.3. A Suggestion of a “New” IMF – cont.

There are three fields of economic policy for important institutional changes in the policy of the „new IMF“:

(1)No-bail-out clause

This new institutional arrangements prevents a bail-out situation, because the addressee (the “new IMF” or the donors countries) is not allowed to act so by its statutes.

(2) Monetary Policy

In order to minimize the inflation risk and a weak currency, the „new IMF“ has been assigned a strong position, with respect to three aspects:

i. commitment of the new IMF to price and currency stability as its main goal,

ii. institutional independence of the new IMF and independence of its employees, and

iii. strong influence with the help of fiscal convergence criteria on the countries public deficit financing.


4.3. A Suggestion of a “New” IMF – cont.

(3) Fiscal Policy

i. the “no-bail-out” clause, and

ii. to each country specific set up of the fiscal convergence criteria, which restrict the government budget deficit and the overall government debt to certain (politically accepted) levels.


5. Some ideas about the institutional design of a new IMF

(1) If this new or reformed institution is called for help, it should be layed down in an agreement between the affected country and this institution, that this organization may act like a completely independent central bank but coming from outside.

(2) For a certain period of time one should give this monetary institution the task and (political) authority, to act like a independent central bank.

(3) The idea is, that on the one side the moral hazard problem of the IMF (i.e. the IMF is a lender of last resort and bails out these countries) is considerably reduced and that this new monetary institution has a strong incentive to undertake policies for the affected country, which are suited best for it.

5.1. General Remarks


(4) As the financial help from the donor countries depends on the success to overcome the crises in this country, there are strong incentives for this new institution to act accordingly.

(5) On the other side there are now considerable higher costs for affected countries, because the governments in these countries loose a considerable part of their (monetary and fiscal policy) power, strong pressure can be put on them from the new financial institution to undertake necessary reforms, and (may be most important) the „easy“ bail-out option does not exist any more!

5.1. General Remarks – cont.



A two-tier banking system means, that there should be a strong and independent central bank and the new monetary institution should can play this role for a certain time, till it has reformed or built up such an institution together with a number of competitive commercial (private) banks.

5.2. A two-tier banking system


(1) A main precondition for an efficient conduct of monetary policy is a well functioning market-based banking system.

5.3. Thorough restructuring of the banking system


(2) In order to enable commercial banks to function effectively under market conditions, a deregulation and sometimes privatization of these institutions might be necessary as well as an adequate supervisory capacity, because a weak and inefficient banking system hinders or even prevent a successful monetary policy.

5.3. Thorough restructuring of the banking system



(1) Pressures from the fiscal policy side can make the commitment of the international monetary institution to follow a steady anti-inflationary policy incredible since the sustainability of such a policy is doubted.

(2) This problem can only be overcome if some control mechanisms on the fiscal authority are established, like in the Maastricht treaty in the case of the European Monetary Union, however with a better and more effective sanction mechanism.

5.4. Establishment of control mechanisms on the fiscal authority



(1) In a perfect world all of the above mentioned institutional changes should be implemented instantly – and hence it would also be desireable to implement all reform elements simultanously. This, however, is wishful thinking.

(2) The problem of sequencing and of making a wrong decision respecting the sequence of reform steps cannot be neglected.

(3) For example it is not sufficient to have formerly independent monetary institutions in such crises countries, if they have not the sufficient institutional and political support for such a step.

5.5. Implementation problems



(4) In order to strengthen the position of the monetary institution and to enhance the credibility of ist announcements, there are two ways to improve the situation:

The first way is to implement appropriate institutional control mechanism in order to control the inflation driving authorities or groups (such as the fiscal authority and wage price setting groups). Or one could bring forward the idea of the introduction of consti-tutional restriction of government debt.

The second way is to choose an appropriate nominal anchor in order to conduct monetary policy successfully (e.g. a currency board).

5.5. Implementation problems (cont.)


(1) The European Monetary system has become a legal and institutional framework from which a stable currency resulted so far. This changes the picture of the world financial system because two major currencies operate in this financial system which are competitors and where the rate between the Euro and the US-$ is a crucial factor.

(2) In the light of this and the world financial crises a first attempt is made to put forward some ideas of a more powerful and effective new international monetary organisation.

It is argued that only the policies of this organization will be successful, if it is really independent especially from its major donors and hence can act independently if it is „called“ for help in certain countries.

6. Summary and conclusions


(3) It is shown, that various instruments could be developed for this new organization giving him a status like an independent central bank in an affected country for a certain time period, so that this organization can really control the monetary policy and has the appropiate instruments to interfere within the country fiscal policy aspects, so that the goals of this institution can really put through.

6. Summary and conclusions


Source

Friedrich Schneider, The role of International Monetary Institutions after the Euro and the Globalisation: Some Preliminary Ideas Using Constitutional Economics.

published in Arie Arnon and Warren Young (eds.): The Open Economy Macromodel: Past, Present and Future, Dordrecht: Kluwer Academic Publishers, 2002, pp.289-305.

ws 09/10 ©prof. dr. friedrich schneider, university of linz, austria1 10. the consequence of the...

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