Question

What is the main problem with the design of the Euroarea monetary system?

How   could that problem be fixed?

Answer 1

he selection of exchange rate regime is one of the most fundamental policy issues in macroeconomics. The spectrum of possible choices ranges from the hard peg to a freely floating nominal exchange rate, with a variety of intermediate arrangements that are often called soft pegs. This latter group of regimes includes the conventional fixed (but adjustable) exchange rate, the crawling peg, an exchange rate band, and a crawling band. A crawling peg is given by a peg that can shift gradually over time. An exchange rate band is defined by the central bank having committed itself to a certain range for the exchange rate, while a crawling band is an exchange rate band that can shift over time. A managed float is an exchange rate regime that lies between the soft pegs and the freely floating. In this case the central bank may intervene in the exchange rate market, but it has not committed itself to a certain exchange rate or exchange rate band. The hard pegs include currency boards and situations where a country does not have a domestic currency, such as in a monetary union.

There are three main reasons why a country may want to peg its exchange rate. First, a floating exchange rate can be highly volatile and be difficult to predict not only in the short run, but also in the longer run. The costs that are linked to such exchange rate uncertainty are difficult to quantify and differ according to factors like size and degree of openness of a country. Second, pegging to a low-inflation currency may serve as a commitment device to help contain domestic inflation pressures. Third, for countries attempting to bring inflation down from excessive levels, fixed rates may help to control price developments for traded goods and provide an anchor for inflation expectations in the private sector.

Any scheme for classifying de facto exchange rate regimes is inherently subjective and therefore open to criticism. For example, it may in some circumstances be difficult to judge whether an exchange rate is de facto a soft peg with a very broad exchange rate band or a managed float. In the case of Europe, however, it seems fair to say that since the speculative attacks on several European currencies in the early 1990s there has been a strong tendency for the countries to move towards the corners of the exchange rate regime spectrum and, in particular, in the direction towards the hard peg. By 2006 there are now 12 countries that have given up their domestic currency in favour of the euro and the 10 countries that joined the European Union in 2004 have stated their intent of adopting the single currency once they fulfil the Maastricht criteria.

At this stage we may ask what may help explain the observation that many countries, especially in the developed world, seem to move towards the two corners of the exchange rate spectrum: a hard peg or a flexible exchange rate? A well-known proposition for addressing this question is Mundell’s “impossible trinity”. It states that among the three desirable objectives:

stabilize the exchange rate;

free international capital mobility; and

an effective monetary policy oriented towards domestic goals

The contributions should be based on both the deficit and the debt level because both represent warning signs of impending insolvency or liquidity risk (this is also the reason why both were included in the Maastricht criteria and both matter for the Stability and Growth Pact, although in practice the debt ratio has played less of a role). It could be argued that contributions should be based on market indicators of default risk rather than the suggested parameters. But the existence of the EMF would depress CDS spreads and yield differentials among the members of the EMF, making such a procedure impossible.Contributions would be invested in investment-grade government debt of euro area member countries. Debt service (in case funds had to be raised in the market) would be paid from future contributions.

Countries with exceptionally strong public finances would not need to contribute because they would de facto carry the burden should a crisis materialise. Their backing of the EMF (and the high rating of their bonds in the portfolio of the EMF) would be crucial if the EMF were called into action and the accumulated funds were not sufficient. The EMF should thus be given the authority to borrow in the markets to avoid having its accumulated contributions fall short of the funds required to deal with the crisis at hand.