198 COMPARATIVE POLITICAL STUDIES April 1996 again under attack on currency markets,remaining ERM members agreed to widen fluctuation bands to 15%(the Dutch guilder and DM remained in a 2.25%band).Although the reduced ERM has been stable,questions persist about the future of monetary integration. This brief survey indicates how varied the fortunes of attempts to reduce exchange-rate variability within Europe have been.For more than 20 years, stable exchange rates have been a stated goal of the EU and its member governments,but success has varied greatly over time.And there has also been wide variation in the degree to which particular European countries have been able to sustain fixed exchange rates against the DM.I now turn to attempts to explain this variation,over time and across countries. 2.EXPLAINING THE COURSE OF EUROPEAN MONETARY INTEGRATION There is only a small body of thought on the political economy of national exchange-rate policy,of which European monetary integration is a subset.s However,two literatures are germane.One is specifically targeted at explain- ing aspects of European integration,including monetary integration.The other has to do with the national welfare effects of different exchange-rate regimes,including currency union.Both are useful for our purposes.I first summarize them,then go on to present my argument about the impact of goods and capital market integration on European exchange-rate politics The first body of knowledge relevant to explaining European monetary integration,not surprisingly,is that designed explicitly for this purpose.Here several factors that help explain the process have been widely commented upon.All played a role,and I do not argue against their importance.I do believe that they must be supplemented with an understanding of the differ- ential impact of goods and capital market integration,to which I turn after summarizing extant views. One factor that gave impetus to monetary integration was the Common Agricultural Policy (CAP).The EU's agricultural subsidies involve setting Union-wide food prices,and when a currency is devalued,the EU reference price would normally be raised in the devaluing country to counterbalance the devaluation.This "passing through"of the exchange-rate change to food prices would mitigate the devaluation's attempt to restore price competitive- 6.Among the exceptions,disparate in their coverage and concerns,are Destler and Henning (1989),Eichengreen (1992a),Henning(1994),and Gowa (1988).Edison and Melvin (1990)is a good survey
Frieden IMPACT OF GOODS 199 ness in the nonagricultural sectors.For this reason,the Union devised a series of compensatory arrangements and accounting exchange rates.For our purposes,what is important is that exchange-rate fluctuations complicate Union agricultural policy by changing compensatory farm payments in ways that disrupt EU farm policy.This was indeed one of the original reasons for monetary integration and remained important through the adoption of the EMS(McNamara,1993).However,the CAP is a constant,and although it explains the persistence of EU attempts at monetary integration,it cannot explain variation in their success.There is,in fact,no evidence that national support for monetary integration is related to reliance on the CAP. Another reason for variation in the success of monetary integration is institutional variation,both over time and across countries.It is certainly plausible that the EMS was more successful than the snake because of an increase in the amount of money available to EMS members for short-and long-term financing of payments deficits,as well as 5 billion ECU in concessionary development loans made available,essentially to Ireland and Italy,as a side payment to the two countries with the largest adjustment burden (van Ypersele,1985,pp.61-64;the subsidy component of the con- cessional loans was a billion ECU).All told,the resources committed to the EMS were about three times those committed to the snake,which made affiliation with the system that much more attractive to potential members. However,there is little evidence that the funds involved were particularly important to the process-Italy did not even use its concessionary finance, and the other funds were rarely central to EMS developments.And again, with the exception of the concessionary funds to Ireland,this factor cannot explain variation among EU members.It might be argued that the more institutionalized nature of the EMS helped cement its effects,but again this does not help much to explain differences in behavior among members of the system.Indeed,one of the more successful exchange rate pegs in Europe has been that of the Austrian schilling to the DM,engineered at a time when Austria was not even contemplating EU membership. A third,less tangible,but nonetheless crucial,explanation for monetary integration-and especially for the greater success of the EMS than of the snake-was the relationship between them and broader EU participation. There was never a sense that the snake was an essential component of the EU;neither national politicians nor Union leaders staked much political capital on the arrangement.The EMS was different.The French and German heads of state launched the attempt with great publicity,and the Commission regarded the EMS as of paramount importance
200 COMPARATIVE POLITICAL STUDIES/April 1996 This linkage of the EMS with broader EU participation was important.In the early 1980s,with the European economies beset by stagnation and unemployment,many segments of society began to look upon an intensifi- cation of European economic integration as the last best hope for the region (Katseli,1989).The threat of relegation to second-tier status within Europe led many to reconsider their position on monetary integration.Previously,it had been possible to oppose national policies to stabilize the exchange rate while evincing great enthusiasm for the EU generally.With the 1992 program tied to monetary integration,such a division of the question was less feasible. In many real and prospective EU members,participation in the EMS was seen as critical for full EU membership.This was important and has been dealt with in detail elsewhere (Frieden,1994b;Garrett,1994;Martin,1994). The second literature of relevance,which is very large,is that which analyzes the circumstances in which national welfare is improved by a fixed exchange rate,and at the limit,by a monetary union (see Genberg,1990,for a survey).Fixing the exchange rate imposes costs-the monetary authorities give up a policy instrument-and is only desirable from a national welfare standpoint if counterbalanced by greater benefits. One crucial observation is that in an economy financially integrated with the rest of the world (or the relevant region),the government is faced with a choice between monetary policy independence and exchange-rate stability. In a financially open economy,interest rates are constrained to world (or regional)levels.?Monetary policy largely involves the exchange rate:Mone- tary expansion drives the exchange rate down,makes locally produced goods cheaper in comparison to imports,and stimulates the demand for domesti- cally produced tradable goods.Fixing the exchange rate forgoes this instru- ment,removing the possibility of an independent monetary policy.Put differently,as countries become more financially integrated,the effectiveness of national monetary policy declines.In this sense,the social welfare gains to be had from a stable exchange rate tend to rise along with financial integration.8 7.To be precise,it is covered (exchange rate-adjusted)interest rates that are constrained to be equal.The insight is that of the famous Mundell-Fleming approach,which originated with Mundell (1962 and 1963).The basic model can be found in any good textbook discussion of open-economy macroeconomics;a useful survey is Corden (1986). 8.Or,what is the same thing,the costs of forgoing the exchange rate as a policy instrument tend to fall with financial integration.This is a bit oversimplified and assumes that exchange-rate stability is desirable in and of itself.However,there is no question that the trade-off between exchange-rate stability and monetary autonomy,absent or weakin a financially closed economy, grows in importance as the economy becomes more financially open
Frieden IMPACT OF GOODS 201 A related argument comes from the literature on optimal currency areas. Such areas,which are tantamount to monetary unions,can be regarded as particularly binding fixed exchange-rate regimes.In this framework,cur- rency union makes economic sense for regions among which factors are mobile and economic shocks are correlated (Mundell,1961,and McKinnon, 1963,are the classic statements).If two regions are so economically inte- grated that market conditions are closely linked between them,having a common monetary policy is efficient(and having separate monetary policies may be impossible). Here,too,the integration of goods and capital markets plays a crucial role The more integrated economies are among themselves,the less effective independent monetary policies will be(due to the ability of factors and goods to move in response to different policies),and the more desirable is monetary union.The economic analysis is therefore quite clear:The attractiveness of fixed exchange rates rises with the level of economic integration.This does not address the differences between full monetary union and other fixed-rate regimes.For the sake of this analysis,the two can be regarded as points relatively close on a continuum that runs from complete floating up to cur- rency union. These efficiency-based arguments for fixing exchange rates confront problems as explanations of European monetary integration in practice.There is,in fact,plenty of evidence that Europe has not met the criteria by which fixed exchange rates would improve social welfare;social welfare grounds do not support Economic and Monetary Union (EMU)as an economically efficient policy for EU members(Eichengreen,1992b,pp.4-25).Before the late 1980s,the EU was not very integrated financially-capital controls were common.0 Factors remain only imperfectly mobile among the members of the EU,and EU economies are not so integrated that they share common macroeconomic conditions.Neither fixed exchange rates nor currency union are clearly welfare-improving at this stage within the EU.Put differently, even if government policies were driven entirely by efficiency criteria,this could not explain the movement toward monetary integration in the EU,for neither fixed rates nor currency union are economically efficient policies for EU members.Certainly,as the EU has become more integrated over time, 9.Of course,economic integration and currency union can interact:Having one currency makes it easier for factors to move within a region.On such interactive effects in international monetary relations,see Frieden(1993). 10.Since the middle 1980s,capital controls have been removed and the EC has become more integrated financially.This,however,does not explain the course of the EMS before financial integration
202 COMPARATIVE POLITICAL STUDIES/April 1996 monetary integration is somewhat more economically defensible than it once was,but efficiency-based economic principles cannot be evinced to explain the EMS,EMU,or variations in national policy toward them. Although these factors are important,they are not sufficient to explain change over time or across countries in willingness to fix exchange rates within Europe.I present below,and evaluate empirically in what follows,an argument that variations in the level of trade and investment with potential currency-regime partners is a crucial contributor to explaining variations in exchange rate policy. Although current levels of goods and capital market integration do not make stabilizing exchangerates unambiguously welfare-improving for mem- bers of the EU as a whole,they do make it attractive to stabilize exchange rates for those economic agents heavily involved in intra-EU trade and payments.Currency arrangements have a differential effect on firms and individuals,which can be expected to translate into cross-cutting political pressures on national policy makers.The crucial political issue typically has to do with how important currency predictability is,relative to the ability of national monetary authorities to depreciate the exchange rate to stimulate the local economy or increase the competitiveness of national producers.Re- linquishing this option is not popular,other things being equal,even if it does lead to more stable currency values. However,higher levels of cross-border trade and investment increase the size and strength of domestic groups interested in predictable exchange rates. Firms with strong international ties support a reduction of currency fluctua- tions.These effects are especially important to banks and corporations with investments throughout the EU.In addition,tradable producers with EU-wide markets,and for whom price competition is relatively less important-those whose appeal is based primarily on quality or technological prowess-may be less concerned about ability to devalue than about currency stability.12 11.In this context,it is important to keep in mind that eliminating the ability to devalue for high-inflation countries typically leads to a transitional (inertial)real appreciation of the exchange rate.This is especially troublesome for producers of tradable goods that compete primarily on price,as fixing the exchange rate in conditions of inflation above the EU average exposes import competitors to substantial price pressure. 12.It is often objected that forward markets allow firms to protect themselves against potential currency fluctuations.Although this is true for short-and medium-term exchange-rate movements,it is not true over the longer time horizon typically of concern to investment planners.Indeed,the existing literature on corporate finance distinguishes clearly between transaction exposure,which can be effectively hedged,and operating exposure,which cannot. See,for a typical example,Shapiro(1992),chapter 10.I am indebted to Rich Lyons for bringing this to my attention