The Future of Europe By Antonio Martino

am very grateful to Ed Feulner for having invited me today and for choosing the title of this lecture. In the seven months during which I was Foreign Minister, I received the most violent criticisms from European federalists who accused me of practically e verything be- cause of my views on European monetary unification and on the future of Europe in general. For example, II Cor7iere della Sera-once the most authoritative, now just the largest sell- ing newspaper in Italy-on the eve of the Franco-Italian su m mit in Aix-en-Provence published an article titled "Italy betrays Europe," attributing the expression-in quote marks!-to Franqois Mitterrand. The subtitle explained that the French President had "harshly criticized Foreign Minister Martino's views on the M aastricht Treaty." All of this was plainly false, as President Mitterrand made a point of telling me the following day, and as his "porte parole" made clear in an apologetic letter to the Italian Ambassador in Paris, stating that Coryiere della Sera had s o If ossly misquoted him as to make him say exactly the opposite of what he had actually said. Another example of the fair treatment given to my views on Europe by federalists, left- wingers, and assorted lunatics was offered by an editorial in the weekly L Espresso, in which I was blamed for the depreciation of the lira... because of my criticism of the Maastricht strategy of monetary unification!2 On the other hand, my views on Europe are usually con- sidered optimistic if not outright federalist by Englis h Euro-skeptics, so that I welcome this opportunity to clarify my position.

3 EUROPE'S MONETARY FUTUR I am convinced that to a very large extent the future of the European Union depends on the strategy of monetary unification we are going to follow in the next few years. Should we continue with the present strategy, based on gradual convergence according to the Maas- tricht parameters, a common currency for Europe is unlikely to be achieved. Furthermore, the "convergence paradigm" might result in the divis i on of Europe, in the separation of the group of "virtuous" countries that have succeeded in meeting Maastricht's arbitrary criteria from all other European countries, presumably unfit to be admitted to the exclusive club of the virtuous. Such an outcome w o uld represent yet another illustration of the disastrous po- litical consequences of unsound economic decisions. In order to illustrate this view, I shall analyze the future of Europe's monetary unification in the light of the experience of the past twent y -five years and in the perspective of what I consider a necessary revision of our strategy. I maintain that pegging the exchange rates and trying to impose uniform convergence criteria on all European countries not only will pro- duce undesirable conseque n ces, but will not bring us any closer to a common European currency. That outcome depends on whether we adopt a monetary Constitution or not-on whether, that is, we succeed in spelling out a set of rules of monetary conduct capable of providing adequate g uarantees against European monetary mismanagement.4 In other

Antonio Martino served as Foreign Minister of Italy from April 1994 to January 1995. He spoke at The Heritage Foundation on April 26, 1995. ISSN 0272-1155 0 1995 by The Heritage Foundation.

w ords, a monetary rule is a necessary precondition for moving toward a common European currency. If, on the other hand, money continues to be used as an instrument of discretion- ary polity, monetary unification is unlikely to be achieved. 5 Therefore, tho s e of us who believe that monetary unification is desirable should concen- trate on identifying the rules most suited to that end. ADVANTAGES OF A COMMON CURRENCY 6 Let me start by refuting some mistaken notions on the need for monetary union. First of all , it's simply not true that a single market is unachievable without monetary unification. It is perfectly possible to have one without the other: Commonwealth countries had a com- mon currency without economic integration; Canada and the U.S.A. have econom i c integration without a common currency. At present, we have a single European market with- out a European currency. Secondly, it's dubious, to say the least, that claiming that there is a "fundamental link" between political and monetary union would brin g us closer to a com- mon currency for Europe. 7 But would Europe benefit from a common currency? If, for the moment, we ignore both the difficulties of achieving that result and the preoccupations with the conduct of monetary policy after the establishmen t of a common currency, the an- swer is positive: Europe and the world would probably benefit a great deal from a common European currency. Interestingly enough, most commentators seem convinced that the only advantage of a common currency for Europe would be that of reducing uncertainty in foreign exchange markets. 8 1 do not wish to deny the importance of reduced uncertainty in foreign exchange markets and of a saving in transactions costs, but first of all I think it's reductive to see no other ad- vanta g e in a common currency for Europe: as I shall try to show, there are other, possibly more relevant, advantages. Secondly, I believe it is this reductive interpretation of the bene- fits of a common currency that has led to the fallacious identification of monetary unification with fixed exchange rates, which is responsible for some of the difficulties which we have encountered thus far. Let me first start to list what I consider to be some of the main advantages other than the reduction in transactions cos t s. International stability. A common European currency could provide an alternative to the U.S. dollar as an instrument of international liquidity. The "national" currency of such a large market could achieve the same degree of acceptability presently enj o yed by the dollar. The competition between the two major international currencies would result in some kind of "Gresham's law" in reverse because the more stable currency would be preferred in international transactions. The overall stability of the inter n ational monetary system would increase. 9 In particular, Europe would benefit in that it would be able to use its own currency, rather than the U.S. dollar, as a reserve asset. 10 Needless to say, this would not be a minor advantage and, by itself, might i n fact be as important as (if not more important than) the saving in transactions costs. The U.S. would also benefit to the extent that a monetary system based on two currencies would make the external value of the dollar less volatile. Balance of payment s equilibrium. Inside Europe, a common currency would eliminate balance of payments problems, making the "adjustment process" smooth and automatic. There would be no balance of payments problems between, say, England and France because both countries would be using the same currency. National economic policies would, therefore, be relieved of one of their present worries.

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internal stability. With a common European currency, provincial considerations would play no role in monetary decisions, which woul d aim at overall stability rather than respond to "local" pressures. As a result, for example, there would only be one rate of inflation rather than twelve. This is a very important consideration indeed: I know of no economist willing to argue that a prol i feration of regional currencies within a given country would increase overall monetary stability on a national level. I I Freedom and efficiency. A common currency would make the liberalization of capital movements within Europe automatic and irreversible , with all the known advantages in terms of personal liberty and economic efficiency. It would be as difficult to restrict capital movements in an area using the same currency as it is within a given country. The overall efficiency of the single market wou l d be enhanced. These are not necessarily all of the benefits from a common currency for Europe, but it seems to me that they are possibly more important than the advantage of reduced uncer- tainty in foreign exchanges and of savings in transactions costs. Furthermore, while the smoothness of the adjustment process and the elimination of balance of payments problems could also be achieved by a system of freely floating exchange rates among European na- tional currencies, all the other advantages can only be attained by a single currency for Europe.

OBJECTIONS TO A COMMON CURRENCY Several objections have been raised to the idea of adopting a single European currency. While some are undoubtedly well-founded (if not insurmountable), others are, in my view, defi nitely dubious. Here are some of the major objections. The most common objection is that "money does not manage itself": discretionary mone- tary management requires political control. Europe's present political institutions are inadequate for that kind o f task. A variation on this theme is that the surrender of monetary sovereignty is unjustifiable at this point, since the existing European political institutions could not guarantee member states that the common currency would be managed in a way of which they would approve. Another objection is that a common currency would be premature, given the present het- erogeneity of the various European national economies. Monetary unification, according to this view, should follow, not precede, "economic integrati o n." A third objection states that monetary unification would be beneficial to "high-inflation countries" and harmful to "low-inflation countries." The idea here is that, with a common European currency, inflation in Europe would settle at some kind of ave rage of the existing national inflation rates. Finally, there is a problem which is seldom explicitly stated: money creation is an impor- tant source of revenue for national governments, and they are not ready to give it up easily.

ARE THE OBJECTIONS VALID ? None of the preceding objections is insuperable. Some are totally false: for example, dif- ferent regions of the same national economy are often very heterogeneous, yet this does not prevent them from using the same currency. As previously mentioned, no one has advo- cated the introduction of separate regional currencies as an instrument to reduce national heterogeneity.

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A different version of this argument draws on Keynesia nism: a monetary union would pre- vent "individual member countries from each attaining their optimum combination of inflation and unemployment on the so-called Phillips curve. "I However, asVaubel pointed out, the "tradeoff between inflation and unemploy m ent has disappeared," and few econo- mists today believe that much good can result from monetary instability. From this point of view, therefore, Vaubel's conclusion seems as valid today as it was fifteen years ago: "If na- tional monetary policy can no l o nger be used to raise employment, the economic cost of joining a monetary union must be small indeed." 13 Also, there is no reason to suppose that a common currency would result in an inflation rate equal to the average of today's national rates. If Europ e would adopt a common cur- rency, it would have one rate of inflation (rather than twelve), which would be "high" or "low" depending on whether the rate of growth of the money supply at the European level was "high" or "low." The classification of countri e s as "high-inflation" and "low-inflation" is highly misleading because it suggests that somehow the degree of monetary stability/in- stability of a country is determined by some "inevitable law of historical destiny," and it has nothing to do with the cou n try's actual monetary policy. Monetary history provides irrefuta- ble evidence that this is not the case. It seems to me that there are only two valid objections to a common currency. One is re- lated to the use of money as an instrument of discretionary policy; the other is connected with its use as a source of revenue by European national governments. But, before discuss- ing these, I shall make a few remarks on the transition process.

THE TRANSITION PROCESS "Does all this mean that European monetary uni on, let alone European political integra- tion, is not an aim worth striving for? In my view, such a conclusion would be premature. It may very well be that European monetary union would be a great achievement, but that the road by which we are trying to r each it is conducive to serious breakdowns and accidents and, indeed, does not lead to its ultimate destination. What must worry all advocates of European integration is precisely that the choice of an unworkable strategy will-again, and this time fatally - discredit the whole idea of a united Western Europe." Y4 Vaubel was right: even today, much of the discredit surrounding the idea of a common European currency is due to the political attempts at planning a strategy for the transition process. This is tru e of the earlier efforts as it is of the present one. The "original sin" is that of identifying monetary unification with fixed exchange rates. 15 It is an old mistake: it was the basic assumption of the Werner plan of 1970, of the 1972 "snake," and of the present European Monetary System. As for the Maastricht strategy, it is based on the notion that irrevocably fixed exchange rates between national currencies and coordination of policy between separate national authorities are necessary (and sufficient?) f irst steps toward monetary union. Once fixed exchange rates are attained, monetary unifica- tion will be completed. Despite the experience of the past twenty-five years, we still proceed on the assumptions that fixed rates are almost indistinguishable fro m monetary union, and a necessary step to- ward that goal. I find this view unacceptable. 16 Furthermore, while a single European currency automatically implies a single monetary re- gime and is, therefore, immune from balance of payments problems, 17 a sy stem of fixed exchange rates among different national currencies does not. It can survive if, and only if, it

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succeeds in imposing coordinated patterns of behavior on all member countries. This last possibility, witness the events of September 1992, is rather remote. 18 Finally, it isn't true that fixed exchange rates would bring Europe closer to monetary uni- fication. In fact, the opposite might very well be true. 19 This is so because under fixed exchange rates, domestic policy goals are at times i ncompatible with external balance. When such a dichotomy arises, the alternative to a change in the exchange rate is that of im- posing the burden of the adjustment process on domestic macro-variables. Balance of payments equilibrium is then achieved with o ut any change in the exchange rate parity but at the cost of sacrificing domestic stability. Such a choice is neither desirable nor likely to be made: should a country find itself forced to'choose between pursuing domestic policy goals or adhering to "irr e vocably fixed rates," it would most likely let the exchange rate adjust to a new equilibrium. The arrange- ment suggested by the present transition strategy is, therefore, unlikely to succeed. Needless to add, the failure of the authorities to maintain th eir "irrevocably fixed rates" for an indefinite period of time would result in frustration and would discredit the idea of monetary unification.

GRADUALISM AND CONVERGENCE The crucial error of identifying fixed exchange rates with monetary unification is p rob- ably the result of a mistaken concept of gradualism. Gradualism is a very useful political tool, but it can be applied only to problems which have a divisible solution; it certainly can- not be used for problems with an indivisible solution (of the a l l-or-nothing type). A common European currency is indivisible: we either have it or we don't-we cannot have just a bit of it.20 It has been possible to liberalize trade gradually because tariffs are divisible and can be reduced progressively. But I don't s ee how a common currency can be divided into separate allotments to be incrementally added to the existing bundle. And, in any case, fixed exchange rates do not represent the "partial" creation of a common currency. Similar considerations apply to the con v ergence criteria adopted at Maastricht. While fi- nancial discipline is undeniably desirableperse, it's hard to understand why financial convergence should be a precondition for a common currency. Belgium and Luxembourg have a common currency, despite wid e differences in their public finances. As for economic performance, regions within a given country show extensive variation in their economic structure, rate of growth, and unemployment. Yet these differences do not prevent them from using the same curren c y. The obvious conclusion is that convergence is neither a nec- essary nor a sufficient condition for monetary unification. A COMMON CURRENCY AND FISCAL DISCIPLINE 21 A major obstacle in the introduction of a common European currency is the obvious one th a t money creation is an important source of revenue for national governments, and we must assume that they are reluctant to give it up. On the other hand, this would also be one of the main advantages of a common European currency. Some supporters of a uni t ed Europe, in fact, saw this as the major reason for hav- ing it. 22 If Europe had a common currency, this would, in and of itself, represent a significant change in the existing fiscal Constitution of national governments, as they would have to forego th e use of inflationary finance, the "inflation tax," debt monetization as a means to finance public spending. As Luigi Einaudi maintained, it would be a substantial

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improvement over present fiscal procedures. Of course, it is an open question whether na- tional governments can be persuaded to give up such a source of revenue.

A EUROPEAN MONETARY CONSTITUTION The preoccupations with the issue of monetary sovereignty are entirely justified: money matters and, as Milton Friedman has often repeated, is too important to be left to central bankers. The reasons that make us worry about monetary management by national central bankers are even more valid when referred to a single currency for Europe. Monetary mis- management on a national level can be a disaster ; on a European level it would be a catastrophe of unbearable proportions. 23 Moreover, the argument against binding rules-that they are "undemocratic" because they prevent "elected officials from responding as best they can to the wishes of the elector- a t e"-obviously does not yet apply to the case of Europe. 24 The problem arises because, with the end of the gold standard, money, in addition to its traditional functions, has become an instrument of discretionary policy to an extent that was inconceivable b efore. Discretionary manipulation of monetary aggregates on the part of "in- dependent" central banks can produce pro-cyclical rather than anti-cyclical consequences. Instead of achieving a higher degree of stability, monetary policy becomes an autonomous source of instability. 25 This in no way implies incompetence on the part of the monetary authorities: even the most competent central banker does not possess all the knowledge that would be required to make a discretionary anti-cyclical monetary policy s u cceed. Information about the work- ing of our macroeconomic systems is inadequate; short-term predictions are seldom sufficiently reliable; decisions my be untimely; and lags in the effects of monetary changes are largely unknown in advance.2 In any case, the outcome of discretionary monetary policy in terms of increased economic instability, already harmful at the national level, would be disastrous at the European level. It's hardly surprising, therefore, that so many people consider that risk unacceptab le and op- pose a common currency for Europe altogether.

A EUROPEAN MONETARY CONSTITUTION? The need to constrain discretion in the conduct of monetary affairs has long been recog- nized. From the pioneering, classic paper of Henry C. Simons (1936)-arguing that "an enterprise system cannot function effectively in the face of extreme uncertainty as to the ac- tion of monetary authorities" -to contemporary times, several economists have supported the view that monetary policy should be entrusted to rigidly sp e cified rules rather than to the discretion of "authorities." 27 For public choice theorists, for example, only a constitutional set of rigid rules can pre- vent the ordinary working of political incentives from resulting in monetary instab ity. 28 For the m , "the absence of an explicit monetary constitution is unacceptable." 29 A common currency for Europe would be desirable if its adoption meant an end of discre- tionary short-term policy. Should European nations agree on some kind of monetary constitution , making discretionary manipulation of monetary aggregates impossible, a com- mon currency for Europe would greatly increase overall stability both in Europe and in the world. One could think of a rule fixing the rate of growth of some monetary aggregate t o a

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predetermined level and mandating its continuation for an extended period of time (say, three-five years).30 The adoption of a monetary rule would be highly desirableperse if it would eliminate the variability of monetary growth, with its accompanying eco n omic instability and uncertainty. But it would also be the solution for the creation of a common currency for Europe. All the justified worries about the surrender of national monetary sovereignty to a (politically irre- sponsible) European central bank w o uld lose meaning if money was entrusted to predetermined (and agreed upon) rigid rules rather than to the whim of policy makers pos- sessing discretionary power. Furthermore, all the advantages of a common currency for Europe, referred to before, could be attained. The problem is that even among those who believe in rigid monetary rules, there. is no general agreement on the specific type of rule to adopt.31 This is, however, less important than the decision to have a rule at all. Once the principle of a d i scretionary manipulation of monetary aggregates by an "independent" European central bank is rejected, and the oppo- site one of a rigid monetary rule is introduced, the specifics of the rule can be progressively improved upon, as experience dictates. 32 W hat I mean is that the main point to be made about rules is that there is no such thing as "the ideal" rule because, among other things, as our knowledge progresses, new devices are thought of which can replace older arrangements.33 Once the principle of e ntrusting money creation to a rule is accepted, in other words, the choice of the best possible rule will be determined by accumulation of experience and ana- lytical progress.34 What is essential, regardless of the kind of rule adopted, is that the targe t rate'of growth of the chosen monetary aggregate is adhered to for several years (so as to fa- vor stable expectations). The concrete design of a European monetary constitution would also have to consider the problem of enforcement, so that it should cont ain the principle of accountability of the person(s) in charge. 35

CONCLUSION A common currency for Europe could provide a good chance for introducing the kind of constitutional discipline monetary economists and public choice theorists have advocated for years. It's hard to tell whether politicians and central bankers will in the end become convinced by this argument, but one thing seems clear enough: the present approach does not seem likely to bring about a common currency for Europe. Since it does not s olve the problem of the shift of monetary sovereignty, it will lead nowhere. Furthermore, committed as it is to the enforcement of fixed exchange rates among European currencies, it is likely to promote political conflict and disagreement rather than the h armonization it attempts to achieve. If Europe does not get a common currency, it will not reap its great advantages, and mone- tary policy will continue to be in the hands of national central bankers. Money will remain exposed to the temptations of natio n al governments to use it as an instrument for financing public spending, and monetary stability will be harder to achieve. Those of us who believe in a united Europe and in the advantages of a common currency should abandon the eco- nomically fallacious a nd politically dangerous strategy of gradual convergence and work towards the goal of a monetary constitution for Europe. This is, I believe, the greatest chal- lenge of our time.36

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REFERENCES

Bradley, Michael D., and Jansen, Dennis W., "Unders tanding Nominal GNP Targeting," The Federal Reserve Bank of St. Louis Review, Vol. 71, No. 6, November/December 1989, pp. 31-40. Brennan, H. Geoffrey, and Buchanan, James M., Monopoly in Money andInflation, The Insti- tute of Economic Affairs, Hobart Pape r 88, London, 1981. Buchanan, James M., "Monetary Research, Monetary Rules, and Monetary Regimes," The Cato Journal 3, Spring 1983, pp. 143-146, reprinted with revisions as "Constitutional Strategy and the Monetary Regime," in The Searchfor Stable Money: E s says on Monetary Reform, James A. Dorn & Anna J. Schwartz, editors, University of Chicago Press, Chi- cago & London, 1987, pp. 119-127. Committee for the Study of Economic and Monetary Union, Report on Economic andMone- tary Union in the European Communit y ("Delors Report"), 12th April 1989, mimeographed. Curzon Price, Victoria, 1992: Europe's Last Chance? From Common Market to Single Market, The Institute of Economic Affairs, Occasional Paper 81, London, 1988. Curzon Price, Victoria, "Three Models of Euro p ean Integration," in Whose Eurqpe?@ Compet- ing Visionsfor 1992, The Institute of Economic Affairs, London, 1989, pp. 23-38. Dowd, Kevin, Private Money, The Path to Monetary Stability, The Institute of Economic Af- fairs, Hobart Paper 112, London, 1988. E i naudi, Luigi, Iprvblemi economici della Federazione Europea, Lugano, 1944, reprinted in Europa Padri e Figli, Gli antesignani italiani dell europeismo, Editrice Europea, Roma 1985, pp. 100-153. "European Monetary Union," The Economist, June 24, 1989. Frat i anni, Michele, "The European Monetary System: How Well Has It Worked?," The Cato Journal, Fall 1988, pp. 477-501. Friedman, Milton, "Should There Be an Independent Monetary Authority?," in In Searrh of a Monetary Constitution, Leland B. Yeager, editor, Ha r vard University Press, Cambridge, Mass., 1962, reprinted in Dollars andDeficits, Inflation, Monetary Polity andthe Balance of Payments, Prentice-Hall, Inc., Englewood Cliffs, 1968, pp. 173-194. Friedman, Milton, "The Political Economy of International Mon e tary Arrangements" (1965), i n Dollars and Deficits, Inflation, Monetary Polity and the Balance of Payments, p p. 266-279. Friedman, Milton, "Monetary Policy for the 1980s," in To Promote Prosperity, U.S. Domestic Polity in the Mid-1980s, John Moore, edit o r, Hoover Institution, Stanford University, 1984. Hayek, Friedrich A., Denationalisation of Money, The Institute of Economic Affairs, Hobart Paper Special 70, London, 1976. Jordan, Jerry L., "Monetary Policy as a Fiscal Instrument," The Cato Journal, Wint er 1986, pp. 733-741.

Langfeldt, Enno, Scheide, Joachim, and Trapp, Peter, "The Case for Money Supply Rules," Geld und WahrunglMonetary Affairs, May 1989, Volume 5, 2/3, pp. 30-47. Leigh-Pemberton, Robin, The Future of Monetary Arrangements in Europe, with a Commen- tary by Patrick Minford, The Institute of Economic Affairs, Occasional Paper 82, London, September 1989. Leijonhufvud, Axel, "Inflation and Economic Performance," in Money in Crisis, Barry N. Siegel, editor, Ballinger Publishing Co., Cambri d ge, 1984, pp. 19-36. Leijonhufvud, Axel, "Constitutional Constraints on the Monetary Powers of Government," in The Search for Stable Money, Essays on Monetary Reform, pp. 129-143. Martino, Antonio, "La politica monetaria e il piano Werner", Rivista dipoli f ica economica, May 1971a, pp. 605-612. Martino, Antonio, "II problema monetario internazionale", Nuovi studipolifiti, May 1971 b, pp. 77-81. Martino, Antonio, "L'unificazione monetaria europea: problemi e prospettive", Quinterni Economid della Cassa di Ri s parmio di Roma, October 1976, pp. 11-17. Martino, Antonio, "Verso una moneta europea?", Quinterni Economid della Cassa di Risparmio di Roma, October 1977, pp. 10- 17. Martino, Antonio, "Un nuovo ordine monetario europea?", Quinterwi Economid della Cassa d i . Risparmio di Roma, July 1978a, pp. 9-14. Martino, Antonio, "L'unificazione monetaria europea: verso una soluzione intermedia?", Theina, n. 2, October 1978b, pp. 68-72. Martino, Antonio, "La ComunitA Economica Europea, a trent'anni dalla Conferenza di Me s sina", Economia delle sceltepubbliche, anno IV, nn. 1-2, January-August 1986, pp. 103- 107. Martino, Antonio, "Riflessioni in tema di unificazione monetaria europea", La Comunitd In- zernazionale, Vol. XLIII, N. 2, Second Quarter 1988, pp. 181-191. Martin o , Antonio, "A Common Currency for Europe or Monetary 'Union'?" in A Cifizen's Charterfor European Monetary Union, The Bruges Group, Occasional Paper 5, London, December, 1989, pp. 15-19. Martino, Antonio, "A Monetary Constitution for Europe?," The Cato Jo u rnal, Vol. 10 n. 2, Fall 1990, pagg. 519-533; ristampato in AAVV, Reshaping Europe in the Twenty-First Cen- tury, a cura di Patrick Robertson, Macmillan, London 1992, pagg. 97-118; nuovamente ristampato, con modifiche, sotto il titolo "Europe's Monetary F u ture," Studia Diplomafica, Vol. XLVII: 1994, n. 6, Institut Royal des Relations Internationales, Bruxelles, pagg. 15-28; ripubblicato in Bangladesh Institute of International and Strategic Studies Journal, Volume 16, Number 1, January 1995, pagg. 45-68. M a rtino, Antonio, "Quale Europa monetaria?", Etruria Oggi, Anno XI, n. 32, gehnaio 1993, pagg. 43-45. Martino, Antonio, "Verso quale Europa economica?", Affari Esteri, anno XXV, n. 97, gen- naio 1993, pagg. 117-122. Martino, Antonio, "Nationalism, Money, an d Europe," National Review Institute (in corso di pubblicazione).

Romer, Christina D., "Is the Stabilization of the Postwar Economy a Figment of the Data?," The American Economic Review, June 1986, pp. 314-334. Simons, Henry C., "Rules Versus Authoriti es in Monetary Policy," The Journal of Political Economy, 44 (1936), pp. 1-30, reprinted in Readings in Monetary Theory, F. A. Lutz and L. W. Mints editors, R. D. Irwin, Inc., Homewood, Illinois, 1951, pp. 337-368. Vaubel, Roland, Choice in European Monet a ry Union, The Institute of Economic Affairs, Occa- sional Paper 55, London, January, 1979. Vaubel, Roland, "Currency Competition versus Governmental Money Monopolies," in The Cato Journal, Winter 1986, pp. 927-942. Vaubel, Roland, "A Public-Choice Interpr e tation of the Delors Report," Statement at the Conference on the Political Economy of International Economic Organizations, Clare- mont, November 1989, unpublished manuscript. Walters, Alan, "A Critical View of the EMS," The Cato Journal, Fall 1988, pp. 5 03-506.

Endnotes 1. Il Cor7iere della Sera, December 16, 1994, "LItalia tradisce I'Europa," p. 7. 2. M. Riva, "Professor Martino, sulla lira non cambia mai idea?," LEspresso, March 24, 1995,p.153. 3. What follows is based, with modifications, on my 19 90 paper. 4. By monetary constitution, I mean a regime "in which the discretion of the policy mak- ing authorities is constrained, at least in the short run." (Leijonhufvud 1987, p. 130) 5. Agreement on the need for a monetary rule is far more important t h an the choice of the actual monetary constitution. As pointed out by J. M. Buchanan, agreement on the need for a monetary constitution should take precedence over that on the specific kind of rule to be adopted: I think that this debate-discussion (on mon e tary reform) is prematurely joined when we start referring to the advantages and disadvantages of this or that rule, this regime or that regime .... Debates about which of the alternative regimes is to be preferred must take place. But, prior to this disc u ssion, we should try to attain consensus on the need for some alternative regime that will embody greater predictability than the unconstrained monetary authority that describes that which now exists. The familiar analogy is with the traffic chaos that wo u ld exist if there were no rules. The first requirement is that there be some rules of the road. Whether or not these rules require driving on the left or the right is of secondary importance to the requirement that there be a rule. (Buchanan 1983, 1987, p . 124) 6. What follows draws on my 1989 paper and, to a lesser extent, on previous work; see Martino 1971a, 1971b, 1976, 1977, 1978a, 1978b, 1986, 1988. 7. As maintained by Karl Lamers, "Compelling case for monetary union," Financial Times, November 7, 199 4 , p. 16. 8. For example, in the words of a European central banker: [I]n what circumstances would the benefits of a single currency exceed the costs? The benefits are fairly easy to identify. Where prices within an area are quoted in a common currency, un c ertainties arising from unpredictable exchange rate fluctuations within the area are removed. In consequence, business decisions are not complicated by a need to take account of possible exchange rate changes within the currency area, which would help to i mprove confidence, particularly in relation to investment decisions with long time horizons. Furthermore, there would no longer be any transactions costs associated with exchanging one currency for another or with trying to hedge against changes in rates. (Leigh-Pemberton 1989, p. 12) Apparently, this has also been the consensus among professional economists and pub- lic opinion: There is little disagreement among economists about the benefits of monetary union, i.e. of a system in which exchange-rate risk s, exchange control risks, payments restrictions, the costs of information about exchange rates and exchange-market prospects, and hopefully the costs of money-changing are eliminated. Monetary union defined in this way intensifies competition and

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international integration of product as well as factor markets. (Vaubel 1979, p. 19) There would also be a big saving in transaction costs. The story goes that somebody setting out of Britain with S1,000 to visit each of the EEC countries, changing his mo n ey into local currency every time but buying nothing, would arrive back with only S500. Monetary union would be such a blessing to people like that. And to everybody else. (The Economist, June 24, 1989, p. 20) 9. For the analysis of currency competition, s ee, for example, Hayek 1976, Vaubel 1986, and Dowd 1988. 10. If Europe had a common currency, there would be one central bank rather than twelve. Even more important, the dollar reserves presently used by the national central banks would become unnecessar y and, if the common currency was allowed to float freely in international markets, the European central bank's reserve requirement would be very small. 11. It is in the light of this argument that one should read The Economist's point: "simply ask whether America would be better off with separate currencies for each of its states." Strangely enough, the only problem that the authoritative publication sees in having the U.S.A. use 50 different currencies is that of the cost of converting one into another! 1 2 . See Vaubel 1979, p. 20. 13. Ibid. 14. Ibid, p. 19. 15. "The adoption of a single curmty, while not strictly necessary for the creation of a mone- tary union, might be seen-for economic as well as psychological and political reasons- as a natural and des i rable further development of the monetary union." (Delors Report, April 1989, p.10) Strangely enough, this identification of monetary union with a system of fixed ex- change rates is explicitly accepted even by The Economist. "A fully fixed system would e l iminate the bands within which the currencies are allowed to fluctuate. Monetary un- ion would then go one step further by adopting a single currency." (The Economist, 1989, p. 18) 16. In the words of Professor Milton Friedman: The basic fact is that a un i fied currency and a system of freely floating exchange rates are members of the same species even though superficially they appear very different. Both are free market mechanisms for interregional or international payments. Both permit exchange rates to m o ve freely. Both exclude any administrative or political intermediary in payments between residents of different areas. Either is consistent with free trade between areas, or with a lessening of trade restrictions. On the other hand, national currencies li n ked by pegged exchange rates, whether or not through the mechanism of gold, and a system of variable exchange rates, controlled and manipulated by governmental bodies, either through an adjustable peg or day-to-day market operations, are also members of t he same species. Both are interventionist standards. Neither, in my opinion, is consistent with a permanent lessening of barriers to international

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trade, but only with oscillating barriers as nations shift from surplus to deficit. (Friedman 1968, pp . 271-272) 17. Professor Milton Friedman has repeatedly argued that the two necessary and almost suf- ficient conditions for disequilibria in the balance of payments are fixed exchange rates and autonomous national central banks. 18. In the words of Rolan d Vaubel: "The snake approach, the monetary-harmonization ap- proach and the combined money-supply and exchange-rate approach all belong to one family: they are all co-ordination strategies. They do not lead to the creation of a com- mon currency. The cruc i al defect of all co-ordination strategies is that they rely on discretion instead of automaticity .... Since the co-ordination approach lacks automaticity, it fails to make exchange rates predictable. If it involves the fixing of parities, it may in- deed lead to more errors and uncertainty than exchange-rate flexibility and the pre-announcement of definite rates of national money-supply growth which exchange- rate flexibility makes possible." (Vaubel 1979, p. 25) 19. As Sir Alan Walters has argued: "Compa r ed with a floating system, the EMS entails a considerable politicization of exchange rates. The occasion for realignments involves a great political bargaining session rather than an occasion on which to review the funda- mentals of real exchange rates .. . . If the ultimate objective is the monetary integration of Europe through a European Central Bank in a single currency area, then the EMS seems to be hardly a step in the right direction. It creates too many tensions, both eco- nomic and political." (Walt e rs 1988, pp. 505-506) 20. Of course, this does not imply that its introduction cannot be gradual, as Vaubel recom- mends. (See Vaubel 1979, pp. 28-30) 2 1. "...money can be a potent tool for controlling and shaping the economy. Its potency is exemplified. . . by the extent to which control over money has always been a potent means of exacting taxes from the populace at large, very often without the explicit agree- ment of the legislature." (Friedman 1962, p. 174) 22. Einaudi (1944), 1985, pp. 102-103. 23. "I n a mo'netary union the design of the central authority is crucial. It must be the anchor against inflation that gold was in the gold standard and the D-mark is in the present EMS. An EMU under a badly run European central bank would be much worse than the EMS under the well-fun Bundesbank. In setting up the new central bank a balance would have to be struck between accountability and independence." (The Economist 1989, p. 20)

"The main costs [of monetary union] arise from the loss of autonomy over domestic monetary policy..." (Leigh-Pemberton 1989, p. 12)

"Who would control such a central bank?" (Minford 1989, p. 28) 24. See Leijonhufvud 1987 for a criticism of such an argument. 25. It is not enough, in other words, to say that empirical evidence does not support the view that stabilization policies have in fact had a stabilizing effect on the economy (Romer 1986). The problem is that empirical evidence suggests that they may have had a destabilizing effect. According to Friedman: "Anna Schwartz and I have examined the cyclical behavior of the quantity of money in the United States for the whole period since 1867. Throughout that period monetary growth has risen and fallen not with but

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before economic activity. The cyclical peak of monetary growth re gularly precedes the cyclical peak of economic activity by an interval that varies a great deal, but on average is something like six to nine months; the cyclical trough of monetary growth regularly precedes the cyclical trough of economic activity by an a verage interval of roughly the same length. Moreover, sizable monetary accelerations and decelerations tend to be fol- lowed by sizable expansions and contractions in economic activity; modest accelerations and decelerations, by modest expansions and cont r actions .... The evidence is clear: vari- ability in the rate of monetary growth is associated with variability in economic growth. High monetary variability accompanies high economic variability, and vice versa .... The Federal Reserve has sought to use m onetary policy to stabilize the economy-that is, to vary monetary growth in order to offset forces introducing disturbances into the econ- omy. Had it succeeded, high monetary variability would have been associated with low economic variability, not with h igh economic variability. The correlations between the moving standard deviations that we have calculated would have been negative or zero, rather than systematically positive. The implication is again that monetary variability has been a source of econom i c variability, not an offset." (Friedman 1984, pp. 33-34) 26. "A common criticism of policy making is that economists and policy makers do not know enough about how the economy functions to have a model that describes accu- rately the behavior of macroeco n omic variables like real GNP and the price level. In this case, it has been argued that policy action based on a flawed or incomplete model might cause more harm than good." (Bradley and Jansen 1989, p. 37) As a result, "one cannot be confident that relax i ng ... constraints on discretionary policyrnaking will bring a net so- cial benefit." (Leijonhufvud 1987, p. 131) 27. For example: "The monetary authorities of the United States-that is, the Administra- tion, the Congress, and the Federal Reserve System-d o not obey any reasonably well defined set of policy rules that would tend to produce some particular, reasonably pre- dictable path of the price level over the long haul. There is no monetary constitution in effect that limits the short-run options of the authorities for the purpose of providing long-run stability ... none of these uncertainties would matter very much if some set of constitutional constraints were in force that would prevent the rapid cumulation of moves in one direction." (Leijonhufvud 19 8 4) 28. For example: "For many of these politicians, 'doing good' comes down to the spending of public monies. Hence, even for the most benevolent of politicians, revenue becomes a goal to maximize, an instrument through which they can promote public happi n ess and well-being. Would it not then follow that, for such well-meaning politicians, reve- nue-increasing policy is to be preferred to revenue-decreasing policy? Would it not follow that, for such agents, inflation might still offer a very tempting sourc e of gain?" (Bren- nan and Buchanan 1981, p. 58) Which leads Kevin Dowd to the pessimistic conclusion: "Whenever the government is involved in the monetary system, monetary policy becomes an inherently political mat- ter determined by the interplay of poli t ical (and to some extent, bureaucratic) interests. There is no mechanism to ensure that this non-market incentive structure delivers a de- sirable outcome." (Dowd 1988, p. 21) 29. Brennan and Buchanan 1981, p. 65. As is well known, the main proponent of a monetary rule has been Milton Friedman:

If ... we cannot achieve our objectives by giving wide discretion to independent experts, how else can we establish a monetary system that is stable, free from irresponsible governmental tinkering, and incapabl e of being used as a source of power to threaten economic and political freedom? A ... possibility is to try to achieve a government of law instead of men literally by legislating rules for the conduct of monetary policy. The enactment of such rules would enable the public to exercise control over monetary policy through its political authorities, while at the same time preventing monetary policy from being subject to the day-to-day whim of political authorities. (Friedman (1962) 1968, p. 190) See also: "P r oponents of stable monetary policy have studied the quality of specific rules. If central banks would concentrate on keeping the money supply on the path they have committed themselves to they would provide a public good: price level stabil- ity. Such a p r edictable policy would, as empirical evidence shows, contribute to a stable development of overall demand, a result which has not been achieved by the discretion- ary policies actually pursued in industrial countries. It would eliminate a great deal of th e price variations on financial markets about which many observers complain so much." (Langfeldt, Scheide, and Trapp 1989, p. 40) 30. A monetary constitution would also impose fiscal responsibility on national govern- ments, thereby achieving two goals at o nce. In this case, Jerry Jordan's opinion, according to which a fiscal reform is needed in order to achieve the desired monetary re- form, would not apply: the monetary reform would achieve both. ... meaningful monetary reform cannot precede reform of the fiscal regime.... Reform of the fiscal regime is a necessary, but not a sufficient condition for reform of the monetary regime. Reform of the monetary regime is neither necessary nor sufficient for reform of the fiscal regime. (Jordan 1986, p. 741) 31. Pe r sonally, I agree with the view of Langfeldt, Scheide, and Trapp: "An important ele- ment in a policy rule is that the central bank uses a monetary aggregate that it can control with sufficient precision. Broader aggregates (M I, M2 or M3) can be influence d through changes in the monetary base, but the link seems to become weaker the broader the measure is. So it appears best to use the monetary base which reflects pre- cisely the actions of the central bank." (Langfeldt, Scheide, and Trapp 1989, p. 40) 32. See Buchanan's opinion quoted above. 33. This has always been explicitly recognized by Milton Friedman: "I should like to em- phasize that I do not regard this proposal as a be-all and end-all of monetary management, as a rule which is somehow to be writt e n in tablets of gold and enshrined for all future times. It seems to me to be the rule that offers the greatest promise of achieving a reasonable degree of monetary stability in the light of our present knowl- edge. I would hope that as we operated with i t , as we learned more about monetary matters, we might be able to devise still better rules which would achieve still better re- sults." (Friedman (1962) 1968, pp. 193-194) 34. As is well-known, in the light of the American experience, Milton Friedman has r e- cently changed his proposal of stating the rule in terms of MI (Friedman (1962) 1968, p. 193) and has suggested instead that "the quantity of high-powered money-non inter- est-bearing obligations of the U.S. government-be frozen at a fixed amount." (Fr iedman 1984, pp. 48-49) This clearly illustrates the need for "trying out" proposed

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rules in order to ascertain how well they work in practice, and formulating alternative proposals when the "experiment" is not as successful as it was hoped. No matter what rule is chosen, however, it seems to me that it must conform to the principles spe l led out by Langfeldt, Sheine, and Trapp (1989, p. 43). 35. The need for a monetary constitution governing the common European currency would be reduced, but not eliminated, if it was introduced through a competitive process of the kind advocated, for exam p le, by Vaubel (1979) and Minford (1989). For, if the com- petitive process would lead to a monopoly in money enjoyed by either the "European" or a national currency, the need for some kind of monetary constitution would again pre- sent itself. The mere po s sibility of creating an alternative to the dominant currency would not be sufficient to constrain the inflationary tendencies of the monetary monopolist. This is why, though I agree with the parallel currency approach to the introduction of a common Europ e an currency, I still believe that a monetary constitution is needed. 36. Unless European countries are prepared to give up discretion in the conduct of mone- tary policy (which means giving up money as an instrument of policy), the only kind of monetary u n ification that can be achieved is that which will spontaneously arise from the liberalization of markets. As indirectly recognized by the "Delors Report," "full free- dom of capital movements and integrated financial markets" would discipline "incompatibl e national policies." Stable currencies would be preferred in international transactions, and some kind of competition among national currencies would be estab- lished. Countries with a high degree of monetary instability would see their national currency r ejected by increasingly competitive markets and would, as a result, be forced to change their policy. Therefore, even if a common currency for Europe is not intro- duced, Europe might still get some kind of discipline in monetary affairs thanks to the "fi l ter mechanism" inadvertently introduced by the Single Act. As pointed out by Victoria Curzon Price: "It is often said, and rightly so, that creating a single European currency would represent such a loss of sovereignty that were we to get there, we would n ot be far off full political integration. And yet, if EMS govern- ments stick to their stated commitments ... they will have tied their hands as firmly as if they had actually created a European central bank ... Even if they retain the right to vary their exchange rates within the EMS, the need to compete for their citizens' savings will force them to behave with extreme fiscal and monetary caution." (Curzon Price 1989, p. 37)

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