Institutions matter: great (and not so great) transformations and their macroeconomic consequences.

Author:Zalewski, David A.

As the next millennium approaches, global economic institutions increasingly resemble those that characterized the laissez-faire era of a century ago. Most representative of this transformation is the return to a self-regulating market system, as countries open their borders to unfettered trade while slashing social welfare programs to become more competitive.

Perhaps the most controversial response to increasing globalization is the European initiative to create a more comprehensive economic and political union. The culmination of this effort is the European Monetary Union (EMU), which will replace national currencies with the euro by January 2002. Advocates of this program argue that the use of a single currency will stimulate trade and capital flows by eliminating exchange rate risk among EMU members and by lowering transactions costs, enabling Europe to become an economic power that will rival the United States and Japan.

Until recently, much of the discussion on European monetary unification focused on whether enough countries would meet the budgetary and financial requirements to proceed with the first stage of implementation in 1999.(1) By October 1997, however, significant progress by several nations in meeting the convergence criteria and a promise by officials to be flexible when selecting the "first wave" participants by mid-1998 almost guarantees the transformation will take place as scheduled.(2)

Because of these developments, policymakers must now consider whether the agreement should be modified to increase the likelihood of the regime's success. By considering monetary unification in a social and political context suggested by Karl Polanyi [1957], this paper recommends that a federal fiscal authority be established to address labor and social welfare issues. The reason for this proposal is an anticipated shift of uncertainty from capital to labor that may accompany currency unification. Although firms possess the means to manage exchange rate uncertainty, the requirements for membership in the EMU will leave policymakers with few options to address labor s insecurity.(3) Consequently, the current strategy for monetary union is misguided since it will lead to what Polanyi [1957, 132] described as the double movement, in which voters will pressure policymakers to adopt protective mechanisms in response to a further expansion of the self-regulated market. Unless European leaders can effectively respond to this uncertainty and obtain labor's support for the euro, increasing agitation for political solutions will undermine the credibility of the regime and eventually lead to its collapse.(4)

Monetary Unification, Efficiency, and Growth

Despite their inability to coordinate economic policies as required by the European Monetary System, members of the European Union (EU) committed themselves to monetary integration by signing the Maastricht Treaty in December 1991. The provisions of this agreement call for fixing exchange rates and delegating the responsibility for monetary policy to the European Central Bank (ECB) by January 1, 1999, and replacing national currencies with the euro by January 2002. To be eligible for membership, countries must achieve convergence on government budget deficits, inflation, and exchange rates.(5) Currently, only Luxembourg meets the criteria spelled out in the Agreement.(6)

EMU supporters argue for monetary unification on both practical and theoretical grounds. European business leaders predict that the use of a single currency will enable them to increase their exports to other EU countries by lowering transactions costs and eliminating exchange rate risk. Politicians expect the euro will help further economic and political integration, which will prevent economic domination by other nations. Moreover, classical economic theory contends that inappropriate currency values distort prices and limit the realization of gains from specialization and exchange. Finally, advocates argue that currency unification will help promote global economic growth by further integrating capital markets.

Will the euro increase efficiency and growth as its supporters predict? The key is whether policymakers can establish the reputation of the ECB as an...

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