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Jens H0iberg-Nielsen JENS H0IBERG-NIELSEN MONETARY INTEGRATION AND THE NATIONAL ADJUSTMENT PROCESS MACROECONOMIC POLICIES OF DEFLATION IN A SMALL OPEN ECONOMY The Case of Denmark Thesis submitted for assessment with a view to obtaining the Degree of Doctor of the European University Institute Florence, May 1983 European University Library 3 0001 0012 3308 1 - i - »'■is, s < * \ L j J S f r* "$>1 Table of Contents "i-i o 2 nd Acknowledgements pags 1 t h e s e s 1. Introduction. 5 332 49489 2. Monetary Integration and the National Adjustment Process. The Scope for HOI Analysis. 21 3. Smallness and Openness of an Economy, and their Implications for the Effec­ tiveness of Domestic Macroeconomic Policies. 53 4. Micro- and Macroeconomic Conditions for Monetary Integration. 89 5. Adjustment Policies in a Currency Area. A Clarification of Some Central Issues. 115 6. The Coordination of National Economic Policies Inside a Currency Area. 141 7. The Economic Effects of an Over Reliance on Tight Monetary and Lax Fiscal Poli­ cies . 213 8. Exchange Rate Movements, Competitiveness and Public Sector Deficits. A Compara­ tive Analysis. 263 9. Towards A Reinterpretation of the "Cen­ tral Problem" of Monetary Integration. The Balance of Payments as a Fiscal Phe­ nomenon. The Case of Denmark 327 - ii - 10. Summaries and Conclusions. page 371 List of Bibliography 381 PREFACE AND ACKNOWLEDGEMENTS Admittedly, this rather bulky study of the adjustment process of a small open economy participating in a currency area makes at times both tedious and burdensome reading. This was never explicitly the aim for the author, but in a way this was an outcome to be expected, when I first set out to analyze the monetary unification process seen from the angle of a small open economy, because one of the aims for the study was to show that the monetary integra­ tion process was far more complex than established theory on monetary integration purports to show. Monetary integration theory, of mainly a monetarist orientation, from the last decade, tends to show the ad­ justment process to uniform rates of domestic inflation as a mechanistic outcome of a harmonization of national sup­ plies of credits. This belief that credit restraint is the panacea for balance of payments disequilibria is based on the dictum that the exchange rate is the relative price of two monies, hence the adjustment process is mainly a question of having national money supplies converging. Indeed the present study shows that the adjustment process for a small inflation prone open economy is far more complicated. The process is burdensome and tedious, and by interpreting external disequilibria as a fiscal phe­ nomenon, this study suggests that a broader range of in­ struments be used. - 2 - The previous over reliance on restrictive monetary policies combined with a high degree of short to medium term autonomy for fiscal policy have had serious struc­ tural repercussions by changing the pattern of production and consumption for the economy. The resulting squeeze on the tradeables sector as a direct result of restrictive monetary policies, shifts the adjustment burden from the nontradeables sector to the tradeables sector. The result, as demonstrated in the present study, is a chronic expansion of the public sector, which in turn makes future adjustment yet more difficult. The chances are now that the economy will experience a new variety of a "vicious circle", from overvaluation of the currency to a permanent expansion of the public sector. The study is laid out in the following way: chap­ ters 1 and 2 focus on monetary integration from an indi­ vidualistic point of view, opposed to the more common collective approach of traditional integration theory. The apparent lack of fiscal integration theory in litera­ ture is noted. The theme in chapters 3 and 4 is the impact of smallness and especially openness on domestic economic policy-making, and the necessary preconditions for mone­ tary integration. Chapters 5 and 6 present an analysis of adjustment strategies and a framework for international economic co­ ordination, respectively. A formal model of the present - 3 - policy-mix dilemma is presented in chapter 7. The stress is on changing relative prices. Chapter 8 is a comparative empirical analysis of movements in nominal and real effec­ tive exchange rates for the EMS countries, minus Ireland, economic performance and public sector growth. Chapter 9 is an analysis of the Danish experience, and by interpret­ ing the balance of payments deficit as an essentially fis­ cal phenomenon, we see the real constraints on domestic fi­ nancial policies in a small open economy. Chapter 10 contains the more important conclusions to draw from the study. I aim indebted to several persons and institutions for valuable advice: Prof. M. De Cecco, ray dissertation super­ visor, proved indispensable during the long process of writing this study. Prof. N. Thygesen read parts of the study at various stages, and has made constructive com­ ments. Dr. H. Lehment made me interested in the link be- t tween stabilization policies and public sector growth. I am also very indebted to the kind assistance which at vari­ ous stages came from Mr. P. Schelde-Andersen of the OECD, Mr. V. Puggard of the Danish confederation of industries, the Danish delegation at the OECD, and last, but certainly not least, the staff at the Institut fur Weltwirtschaft, Kiel, and the staff at the European University Institute, Florence»for kind assistance. The research was conducted at the EUI, Florence, and it was financed by a grant from the Danish Ministry of Edu- - 4 - cation. I was also in the happy position to receive the ’Kurzstipendium fur jüngere Wissentschaftler’ from the DAAD, Bonn, which enabled me to stay at the Institut für Weltwirtschaft in Kiel for a period. Both contributions are thankfully acknowledged. - 5 - Chapter 1 Introduction "Mr. Micawber solemnly conjured me to observe that if a man had twenty pounds a year for his income, and spent nineteen pounds nineteen shillings and sixpence, he would be happy. Eut that if he spent twenty pounds one he would be miserable. After which he,.borrowed a shilling of me for porter and cheered up." It is this dilemma of Mr. Micawber imposed on interna­ tional monetary integration the following study attempts to analyze. An externally given exchange rate target, which produces an external disequilibrium, the strong currency option, is chosen by a small open economy as the main in­ strument for checking domestic inflation for mainly two reasons: i. The emergence of a feeling of economic interdependence and ii. The importance of the open sector as a transmitter of inflation, as devised in the Scandinavian inflation model. In the present chapter the repercussion of this on domestic parameters is discussed. The question of why and how mone­ tary integration can benefit a small open economy is fur­ ther elaborated upon in chapter 2. So the following study intends to analyze adjustment policies of a small open economy in the context of monetary integration. As an example of the small open economy, Den- 1) Charles Dickens, David Copperfield, var, editions. - 6 - mark is chosen, both because of the author's familiarity with the subject and because Denmark has participated both in the European "Snake" and now participates in the Euro­ pean Monetary System (EMS). Hence it is the aim to see how an external given exchange rate target influences the conduct of monetary, and especially, fiscal policies, and what longer term effects such policies will have for do­ mestic economic structure. A considerable amount of research has been done on costs and benefits of joining a monetary union. Most of these studies have been solely concerned about the global advantages or disadvantages of monetary integration. Analyses from the angle of the national state have been more rare. An explanation of this bias towards globality instead i of individuality is according to Hamada that economists, if potentially representative of the interest of a partic­ ular country or group, sound more persuasive when they ad­ vocate a programme that appears general, rather than one that speaks to the national interest". However as we shall see, national interest in the present context does not necessarily have a negative connotation. Looking at the distribution of costs and benefits for 2 the individual nation, Hamada shows that the benefits of 1) K. Hamada, "On the Political Economy of Monetary Inte­ gration", in R.Z. Aliber, The Political Economy of Monetary Reform, New York T9T6. 2) K. Hamada, op. cit. - 7 - monetary integration have the qualities of a public, or collective, good, whereas the costs of monetary integra­ tion are highly individual. The costs and benefits of monetary integration in turn, are distributed so that costs precede benefits. Individual costs precede collec­ tive benefits. With this in mind, the logical subject for research, when focusing on the adjustment process to new inflation standards of a potential monetary union, is the national state. The chances of survival of any system increase with the amount of confidence the participants have in the system. If the initial costs by joining an exchange rate un- i ion suddenly seem excessive, by the way of an overvalued exchange rate for instance, in comparison with the per­ ceived later benefits, the chances are that some members will "cheat", i.e. not play according to the agreed rules, however vaguely defined they may be. This reminds very much of the zero-sum game, stress­ ing the importance of a real coordination of policies amongst the contracting parties. The degree of confidence is the central issue when­ ever an international system is going to work as a result of cooperative efforts. Confidence in the system and support for the system are determined by the attractiveness of the ultimate 1) Cf.
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