The Substitution Account as a First Step Toward Reform of the International Monetary System

The creation of a substitution account might be costly to the United States, but the cost could be greatly reduced by adopting a cost-sharing regime or assessing an annual fee on depositors. The United States also must consider the effect of reserve currency diversification by central banks that now hold larger dollar reserves than they need to cope with balance-of-payment problems. Large-scale diversification could cause extremely disorderly depreciation of the dollar. To avoid this, Kenen recommends revisiting the potential costs and benefits of a substitution account lodged in the International Monetary Fund (IMF), which could act as a barrier against further development of a multi-currency reserve system.

Currency Areas, Policy Domains, and the Institutionalization of Fixed Exchange Rates

Emerging-market countries are being urged to choose between freely floating exchange rates and firmly fixed rates supported by strong institutional arrangementsûcurrency boards, monetary unions, or formal dollarization. This paper assesses the benefits and costs of institutionalizing fixed rates by synthesizing and supplementing the theory of optimum currency areas (OCA theory). It shows that (1) OCA theory and related empirical work have been excessively influenced by the special case used originally by Robert Mundell, where exogenous shocks display mirror-image asymmetry; (2) OCA theory ignores a vital difference between the domains of monetary policy under a monetary union and other institutional arrangements; (3) because it neglects the way in which a monetary union reduces the debt-creating effects of fiscal stabilizers, OCA theory understates the strength of the case for combining a monetary union with a fiscal federation. The paper also criticizes recent work by Jeffrey Frankel and Andrew Rose in which they claim to show that monetary union reduces asymmetric shocks and thus makes monetary union less costly. The paper suggests that their results may reflect the effects of monetary union on the transmission of shocks rather than their incidence.Monetary unions, exchange rate regimes, policy domains

EU Accession and the Euro: Close Together or Far Apart?

In May 2004, ten countries are due to join the European Union. They are therefore obliged to join the European Monetary Union (EMU) and adopt the euro as their national currency. Most of them, moreover, have been eager to do that. None of them sought an opt-out of the sort that Britain and Denmark obtained in 1991, when the Maastricht Treaty was drafted. Membership in EMU is not automatic, however, because the accession countries must first satisfy the preconditions contained in the Maastricht Treaty. Although those preconditions are rigorous, and some of the accession countries are still far from meeting them, most of those countries have indicated that they want to enter EMU at the earliest possible date.

The Outlook for EMU

Confounding forecasts of disruption and market turbulence, the transition to monetary union in Europe took place very smoothly. Some recent developments, however, are cause for concern, and important problems must still be resolved. The governments of most euro-zone countries do not subscribe to the ideological consensus on which the Maastricht Treaty was based--the belief that monetary policy should focus entirely on price stability, that fiscal policy can play no useful role in macroeconomic management, and that European unemployment is due mainly to structural rigidities. The leadership of the European Central Bank (ECB) does not appear to understand that the political legitimacy of the ECB depends on its deference to democratic accountability. The governors of the national central banks are unduly attentive to economic conditions in their own countries, rather than conditions in the whole euro zone, and have insisted on retaining responsibility for the conduct of monetary and exchange-rate policy, limiting the role of the ECB. Yet the monetary union is not likely to collapse. The costs of defection would be very high, even if it did not entail withdrawing from the European Union.EMU