Monetary Union Encourages Labour Market Reform

What is the impact of monetary policy cooperation between countries – either with or without a common currency – on labour market reform, inflation and welfare? According to new research by Professor Anne Sibert published in the January 1999 issue of the Economic Journal, monetary cooperation without a common central bank is apt to lead to less fundamental structural reform – and possibly even lower economic welfare – than no coordination. In contrast, when countries are sufficiently similar, cooperation in the form of a monetary union leads to optimal levels of reform and welfare.

Sibert''s analysis starts from the idea that inflexible labour markets and inefficient tax systems tempt policy-makers to allow inflation. Thus, the success of monetary union or other forms of monetary policy coordination depends on fundamental economic reform. Some academics and policy-makers argue that the anticipation of monetary integration leads to structural change. EMU, for example, altered countries'' behaviour in advance of its launch. Others, however, suggest that the prospect of integration alone is insufficient to induce necessary and costly reforms. Sibert constructs a model of a world where governments first undertake costly fundamental economic reforms and then choose monetary policy. She supposes that monetary policy has harmful international spillovers – loose policy in one country has bad effects on others. Both the spillovers and policy-makers'' incentives to allow inflation are increased by distortions in labour markets and inefficiencies in tax systems. Because of the international repercussions of monetary policy, governments may seek to coordinate their monetary policy. But the way in which they cooperate may influence the incentives of policy-makers to carry out reforms.

It might seem that the ideal form of cooperation would involve an international monetary policy contract and country-specific currencies. The international effects of each country''s policy would be taken into account, but a common currency would not be imposed on countries with different circumstances. But it is unrealistic to think that countries could draw up a contract in advance: it is too complicated to imagine every event that could occur and to propose a response. However, countries might be able to cooperate on current policy. In Europe, for example, the European Union might provide an institutional framework for monitoring and enforcing agreements. Sibert shows that if monetary policy is coordinated without a common central bank, then policymakers will choose reform with the intent of influencing their share of the gains from cooperation. If a country can make other countries more anxious to reach an agreement, it improves its position in an international bargaining process. One way it can do this is by not reforming as much as it otherwise would. Thus, cooperation without a common central bank leads to too little reform.

If countries form a monetary union, then a common central bank chooses a single monetary policy. This means that agreement will be reached; hence, policy-makers do not have an incentive to make a breakdown in negotiations unattractive. Thus, monetary union does not have the deleterious effect on reform that cooperation without a central bank does. Sibert shows that if countries are sufficiently similar, governments choose the ideal levels of reform.

''Monetary Integration and Economic Reform'' by Anne Sibert is published in the January 1999 issue of the Economic Journal. Sibert is Professor of Economics at Birkbeck College, University of London, 7-15 Gresse Street, London W1P 2LL. Her research was supported by a grant from the Economic and Social Research Council (ESRC).