Bankers' Versus Workers' Europe : A Problem of Adverse Selection in Emu

As European countries strive to meet the Maastricht criteria before the end of 1997, doubts and concerns about the new institutional framework are rapidly growing . On one hand, the worsening unemployment rate raises the spectre of further tightening of fiscal and monetary policy (Bankers' Europe). On the other, there is apprehension that inflation and monetary turmoil may be back in Europe under the pressure of deficit-prone countries (Workers' Europe). Is there a rationale for such concerns? Are price stability and/or employment at risk in the new monetary regime? The paper addresses these questions. We define a monetary union as an institutional framework such that : i) agents in (two) independent countries employ the same currency; ii) monetary policy is delegated to a single Central Bank, and revenue from seignorage is redistributed to the national governments, iii) national governments are responsible for fiscal policy, and they choose the tax rate(s) on labor income, as well as the supply of a national public good(s). In a monetary union, the European Central Bank (ECB) is able to affect revenues from seignorage in participating countries, and thus may be tempted to choose the common inflation rate, with a view to reducing distortions in national fiscal policies. But the delegation of monetary policy to a supra-national body may raise the incentives to manipulate information by national policy-makers. Even when the (national) central banks and the governments share the same information about the state of the national economy, we typically observe that governments over- emphasize the need for more lax monetary policy and lower interest rates, on the basis of rosy assessments of current inflation prospects and optimistic projections of public imbalances. In our model, this will be the case if domestic shocks to output in the participating countries are idiosyncratic, b) they are not(immediately) verifiable by the European central bank, and monetary policy must be run on a day-to-day basis, relying (at least temporarily) upon information made available by national official sources. The paper shows that problems of this kind can generate both an inflation and primary deficit bias (in line with the worries of Workers' Europe addressed by the "stability pact") as well as an excess monetary discipline and recession bias (in line with the worries addressed by the Bankers' Europe concern)