Two Cases for Sand in the Wheels

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Two Cases for Sand in the Wheels of International Finance

Author(s): Barry Eichengreen, James Tobin, Charles WyploszReviewed work(s):Source: The Economic Journal, Vol. 105, No. 428 (Jan., 1995), pp. 162-172Published by: Blackwell Publishing for the Royal Economic SocietyStable URL: http://www.jstor.org/stable/2235326 .

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The Economic ournal,105 (January), I62-I72. ( Royal Economic Society I995. Published by BlackwellPublishers, io8 Cowley Road, Oxford OX4 iJF, UK and 238 Main Street, Cambridge, MA 02I42, USA.

TWO CASES FOR SAND IN THE WHEELS OFINTERNATIONAL FINANCE

BarryEichengreen,ames Tobinand CharlesWyploszI. INTRODUCTION

The incompatibility of pegged exchange rates, international capital mobilityand national monetary autonomy is a basic postulate of open economymacroeconomics. Prior to the breakdown of the Bretton Woods System,economic analyses commonly held that nations seeking to maintain exchangerate stability would have to compromise their monetary independence.Subsequent experience suggests that these conclusions, formed as they were ina period when many countries retained controls on capital movements, ifanything understated the dilemma. In today's world of high capital mobility,even the minor exercise of policy autonomy can produce major exchangemarket pressures. Modest uncertainty about whether national monetaryauthorities are inclined to make use of their theoretical independence can leadto significant financial market volatility. If currencies are floating, they canfluctuate widely.' If the authorities attempt to peg them, the costs of doing so,measured by reserve losses or interest-rate increases, can be extremely high.Even a government otherwise prepared to maintain a pegged exchange ratemay be unwilling or unable to do so when attacked by the markets and forcedto raise interest rates to astronomical heights. Attempts to peg the exchangerate can be defeated, in other words, by rational and self-fulfillingattacks.2This leaves two possibilities. One is to make exchange rates inflexible andunadjustable- irrevocably fixed, as is true within the United States, Canada,and other federations. The only means of credibly doing so is monetaryunification. By eliminating the exchange rate, m'onetaryunification eliminatesexchange rate fluctuations.This is the path that the European Union has optedto follow. But as the slow and rocky road from Maastricht has shown, thereremains ample scope for exchange rate instability during the transition-instability so severe that it threatens to prevent the EU from reaching its goal.Another option is to live with floating exchange rates. In a sense this isinevitable: even if a core of EU countries forms an early monetary union, theday when monetary unification encompasses all of Europe, much less theGroup of Seven, the emerging industrial economies of Asia and the rest of theworld, is many times more distant. We will be stuck with national currenciesfor many years to come. We should find a way to live with them.

1 In the most influential formulation (Dornbusch, I976), this is due to the different speeds at which assetand commodity markets adjust. The volatility of exchange rates relative to fundamentals has beenextensively ocumentedWoo,I985; Rose, I994).2 See Flood and Garber (I983) and Obstfeld (i986). Obstfeld (I994) describesa variety of circumstancesin which an optimising government wishing to peg the exchange rate will be forced to abandon thatcommitment by a self-fulfilling attack.

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[JAN. I995] WHEELS OF INTERNATIONAL FINANCE I63Either way, a case can be made for 'throwing sand in the wheels' ofinternational finance. Where monetary unification is not an option, this is a

way to make distinct national currencies tolerable and international moneyand capital markets compatible with modest national autonomy in monetaryand macroeconomic policy. For EU countries striving to create a monetaryunion, it is the only politically and economically feasible way of completing thetransition to Stage III of the Maastricht process.

II. A GLOBAL TRANSACTIONS TAX3Nostalgia for the pre-I97I Bretton Woods System reflects a 'grass is greener'mentality rather than thoughtful analysis. Bretton Woods benefitted fromcircumstances that do not now obtain. The system was organised around aleading country, the United States, with the international financial clout tomake its currency inviolable. The dominant currency, the dollai-, p)r-ov,idedfocal point for other countries, easing the process of international policycoordination.

In addition, countries could and did protect their currencies by applyingexchange regulations and capital controls. The effectiveness of controls wasbuttressed by restrictions on international banking legislated in response to theGreat Depression, and by the fact that international bond markets had not yetrecovered from the defaults of the I930s. In this environment, controls couldwork. Together with quiescent markets, they limited international financialflows and provided governments room for manoeuvre. They softened thetradeoff between domestic objectives and defence of the exchange-rate peg.Though never impermeable and progressively less effective as time passed, theyreduced the cost of defending a currency peg and provided breathing space forgovernments to consult prior to devaluations. Controls made pegged butadjustable exchange rates feasible.

Finally, voters were more tolerant of the economic consequences ofmisaligned exchange rates because postwar reconstruction and 'catch-up'afforded singular scope for growth. With the industrial countries growingrapidly, their governments felt little need to engage in discretionary monetaryand fiscal policies. In these circumstances, voters were little disturbed by thecosts of misaligned currencies. The political insulation thus conferred ongovernments enhanced the credibility of their commitment to pegged rates.Nowadays governments are held more responsible for macroeconomicoutcomes. The politicisation of macroeconomic policymaking has eroded thecredibility of exchange rate commitments. The rise of international capitalmobility has sharpened policy tradeoffs, reducing governments' room formanoeuvre. It has eliminated the breathing space required to consult and toarrange orderly realignments. For all these reasons and more, adjustable pegsare no longer viable.4

3 This section elaborates an argument first advanced by Tobin (1978).4 Consequently, serious advocates of official parties have been moving towards market flexibility bywidening substantially the bands of permissible deviations from parities, and by smoothing formulas forautomatic adjustment of the central paritiesthemselvestowardsmarket experience. See forexample Henning

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I64 THE ECONOMIC JOURNAL [JANUARYAt the same time, experience since I97I has not validated the more extreme

claims of the advocates of floating rates. They thought that exchange ratescould be left to private markets, that official neglect of them would beunambiguously benign, indeed optimal. Governments, it turned out, could notbe indifferent to currency markets. Volatility in exchange rates and interestrates induced by speculation and capital flows could have real economicconsequences devastating for particular sectors and whole economies. Forexample, the appreciation of the US dollar against the Japanese yen in theearly Ig8os nearly destroyed the American automotive industry andjeopardised support for multilateral trade liberalisation in the United States.

Advocates of floating rates had argued that they would free nationalmonetary policies from constraints imposed by commitments to defend officialparities. But the same interest arbitrage that limits the autonomy of a centralbank in a fixed-exchange-rate regime restricts its powers under floating. Ifsimilar financial assets denominated in different currencies are perfectsubstitutes in private portfolios, they cannot bear different interest returns intheir domestic currencies unless those differences are offset by expectedexchange rate movements. Central banks and governments cannot alwayscreate exchange rate expectations consistent with the domestic interest ratesthey desire. It is true that exchange market volatility itself should make assetsin different currencies imperfect substitutes and create a bit of room forindependent monetary policies. But the swings in market sentiment thatgenerate much of the volatility are not helpful.

The globalisation of financial markets has been a much heraldedachievement. Innovations in technologies of computation and communications,new markets and institutions, and tides of deregulation have released a flood ofdomestic and international financial transactions. Vast resources of humanintelligence are engaged. Evidently gross foreign exchange transactions aloneamount to a trillion dollars daily. Economies of scale are enormous. Transactioncosts are small and virtually independent of the amount transacted. Arbitrageor speculative transactions in foreign exchange are so large that minusculepercentages of price spell enormous gains or losses on the capital at stake. Theoutcomes of financial markets impinge on real economies, local, national, andinternational, where adjustments are sluggish, transactions are costly,transportation is slow and expensive, substitutions are imperfect and time-consuming, and expectations are fuzzy.

When some markets adjust imperfectly, welfare can be enhanced byintervening in the adjustment of others. Transactions taxes are one way tothrow sand in the wheels of super-efficient financial vehicles. A half percent taxtranslates into an annual rate of 400 on a three months' round trip into aforeign money market, more for shorter round trips. It is this effect that createsroom for differences in domestic interest rates, allowing national monetary

and Williamson (I994). Even so, these parametersof the system, the central parities and the limits of thebands, remain vulnerable to speculative attack whenever it appears that the risks of official change in themare predominantly in one direction.( Royal Economic Society I995


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I995] WHEELS OF INTERNATIONAL FINANCE I65policies to respond to domestic macroeconomic needs. The same tax would bea smaller deterrent to slower round trips. It would be a negligible considerationin long-term portfolio or direct investments in other economies. It would be toosmall, relative to ordinary commercial and transportation costs, to have mucheffect on commodity trade.J. M. Keynes pointed out in I936 that a transactions tax could strengthenthe weight of long-range fundamentals in stock-marking pricing as againstspeculators' guesses of the short-range behaviour of other speculators. Keynes'sbeauty contest also applies to the foreign exchange market (as he recognised byrecommending the maintenance of exchange restrictions at Bretton Woods):speculators concentrate on how 'the markets' will respond to news, not onbasic economic meanings and portents.

The hope that transactions taxes will diminish excess volatility depends onthe likelihood that Keynes's speculators have shorter horizons and holdingperiods than market participants engaged in long-term foreign investment andotherwise oriented toward fundamentals. If so, it is speculators who are themore deterred by the tax. It is true that some stabilising transactions might alsobe discouraged; fundamentalists alert to long-run opportunities created byspeculative vagaries would have to pay the tax too. The judgement that thosebenign influences are not now dominant in short runs is based on apresumption that the markets would not be so volatile if they were.

The principal purpose of the tax is to expand the autonomy of nationalmonetary policies. That does not depend on its success in reducing volatility.5The tax would not, of course, permit national macroeconomic authorities toignore the international repercussions of their policies. In particular, it couldnot protect patent mis-valuations in exchange parities; speculators' gain frombetting on inevitable near-term realignments would far exceed the tax costs.Nor would the tax make macroeconomic policy coordination among majorgovernments unnecessary or undesirable. The G-7 ought to concern itself, morethan it does now, with the world-wide average level and trend of interest rates,from which individual nations would deviate in accordance with theircircumstances.

A transactions tax on purchases and sales of foreign exchange would have tobe universal and uniform: it would have to apply to all jurisdictions, and therate would have to be equalised across markets.6 Were it imposed unilaterallyby one country, that country's forex market would simply move offshore. If thetax was only applied by France, for example, French banks could ship francsto their foreign branches, where they would be sold for foreign currency free oftax. Enforcement of the universal tax would depend principally on major banksand on the jurisdictions that regulate them. The surveillance of nationalregulatory authorities could be the responsibility of a multilateral agency likethe Bank for International Settlements or the International Monetary Fund. It

5 On this question, see Kupiec (I992).6 Certain exchanges might be exempted on application from the governments involved to the internationaladministrator of the system.

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I66 THE ECONOMIC JOURNAL [JANUARYmight be authorised to set the size of the tax within limits. It would have topossess sanctions that could be levied on countries that fail to comply with themeasure.

Those inclined to dismiss such proposals as unrealistic deserve to bereminded that another multilateral organisation, the GATT, has succeededrather well at enforcing much more complex rules of international economicconduct. Moreover, there is good reason to think that the future of the BIS andthe IMF lie precisely in the realm of international financial surveillance. Asnational banking and payments systems become more closely intertwined,systemic risks will grow. No one national lender of last resort will have anadequate incentive to support a global network of interlinked nationalpayments systems, creating a dangerous free-rider problem and an obvious rolefor multilateral surveillance and intervention. If this is the direction in whichthe BIS and the IMF are headed anyway, then it is hardly a stretch to assumethat one or both of these institutions could eventually be made responsible foradministering a global foreign exchange transactions tax.

III. A TAX ON LENDING TO NON-RESIDENTS FOR STAGE II OF THEMAASTRICHT PROCESS7

Members of the European Union, for whom Maastricht's deadlines loom,cannot await a global solution. They must proceed before receiving assurancesthat other countries will follow. Hence we recommend that they apply a tax ordeposit requirement to all domestic-currency lending to non-residents todiscourage all speculative sales of that currency equally, regardless of themarket in which they are booked.

The Maastricht Treaty specifies the conditions under which a country willqualify for participation in Europe's monetary union. One of them is that itsexchange rate has remained within the 'normal' ERM fluctuation bandswithout devaluation for at least two years prior to entry. Consequently, aspeculative attack which forces a country to devalue or to suspend itsmembership in the ERM during the last two years may effectively rule out itsparticipation in EMU.

The official response is that countries need only adopt policies of convergencesufficient to ensure that their exchange rates are held within the normal ERMbands for the requisite period. But when there exists scope for self-fulfillingspeculative attacks, a commitment to policies of convergence and har-monisation will not suffice. Consider for example a country willing to endurehigh interest rates and other forms of austerity now in return for qualifying forEMU later. Its past and current policies will be consistent with the maintenanceof exchange rate stability. If a speculative attack occurs, however, it will beforced to raise interest rates to still higher levels in order to ward off speculativesales. The costs of austerity now are increased relative to the benefits of EMUmembership later, which may lead the government to conclude that the cost of

7 This section draws on joint work with Andrew Rose (Eichengreen, Rose and Wyplosz, I994).( Royal Economic Society I995


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I995] WHEELS OF INTERNATIONAL FINANCE I67qualifying for EMU has become too high. Once it forsakes the lure of EMUmembership, it has no reason to resist shifting policy in a less austere direction;and the markets, aware of its incentives, have reason to attack.8

The implication is that the Treaty of Maastricht may fail even if countriesadopt macroeconomic policies consistent with its letter and spirit.9 And thesedangers will surely intensify in the run-up to Stage III. The markets will havegood reason to anticipate last-minute realignments motivated by attempts toboost competitiveness before parities are locked in (Froot and Rogoff, I99I).Political brinkmanship will grow as the deadline nears, heightening doubts thatexchange rates are really locked.10

Might it be possible to minimise the odds of this happening by throwing sandin the wheels of international finance? Currency traders wishing to bet againstthe French franc, to take a concrete example, must obtain francs in order to sellthem short. Except for francs made available by the liquidation of existingoffshore asset positions, which are by definition limited in amount, these can beobtained only by borrowing from French financial institutions. Hence the ideaof taxing or placing deposit requirements on loans in domestic currency to non-residents. In the latter case, the deposit could be proportional to the loan andwould have to be maintained interest-free at the central bank. While the cost,in the first instance, is borne by the lending bank, it will be passed along topotential borrowers wholly or in part. The opportunity cost of the interestforegone would move with the interest rate and thereby rise automatically inperiods of speculative pressure.

This proposal, unlike that of Section II, is for a temporary measure to beapplied exclusively by countries en route to EMU, since monetary union offersthem a permanent solution to the problem posed by exchange ratefluctuations.11 It is a strategy to which one is driven only if the other routes tomonetary union are foreclosed. The best route, of course, is the most direct one.Suppose that financial market participants awoke one Monday morning tolearn that a subset of EMU countries had formed..a monetary union over theweekend, that the European Monetary Institute had been transformed into theEuropean Central Bank, and that the latter was henceforth the sole issuer of theparticipating countries' currencies, which it stood ready to exchange for oneanother at par. Transitional problems would be ruled out by ruling out thetransition. In practice, however, this outcome is most unlikely. The very reason

8 In theory, the central bank can fend off the attack if it is willing to raise interest rates. Given the largecapital gains available in short order in the event of a realignment, it may be necessary, however, to allowinterest rates to rise to stratospheric levels, as illustrated by the case of Sweden in October-November I992and by Greece in May I994. This may be politically insupportable. The implication is that the interest-ratedefence may fail because the markets know that it is costly. See Bensaid and Jeanne (I 994) and Ozkal andSutherlandI994) for theoretical reatments.' For variations on this theme, see Eichengreen and Wyplosz (993), Obstfeld (994), Svensson (I994),and Rose and Svensson (1994).10 For example, the German Constitutional Court has ruled that the final decision to go ahead withmonetary unification belongs to the Bundestag. It is easy to guess how the markets will react if there is evenan off-chance that the Bundestag is headed toward a negative vote." Of course, the members of the monetaryunion would continue to experience exchange-ratefluctuationsagainst other parts of the world. Kenen (I 992) and Alogoskoufis and Portes (I 992) discussthe implicationsfor currency variability vis-a-vis the rest of the world.

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i68 THE ECONOMIC JOURNAL [JANUARYGermany insisted on the three-stage transition of the Maastricht Treaty and onthe convergence criteria of its protocol on monetary union was to rule outabrupt action.Another strategy is to hope that it will be possible to declare the wide bandsof the post-July I993 EMS the 'normal bands' referred to in the protocol, andto move to monetary union after a subset of EU countries have held theircurrencies within bands of plus or minus I5 per cent for a period of two years.This assumes, of course, that holding exchange rates within I5 per cent bandsis qualitatively different from holding them within 24 bands. But there is goodreason to think that an oil shock, a recession, or an electoral surprise couldcause even I5 per cent bands to be tested. Experience with floating exchangerates in the I970s and Ig80s showed that cumulative bilateral nominalexchange rate movements of I5 per cent over a period of two years are notuncommon.Furthermore, German officials (who insisted on the convergence criteria toforce their potential EMU partnersto demonstrate theirwillingnessto live withthe consequencesfor macroeconomic policy of monetary union) are unlikely toregard I5% bands as a sufficiently stringent test of policymakers' resolve."2One might raise the same objection to the imposition of non-interest-bearingdeposit requirements on bank lending to non-residents, of course: thesemeasures are tantamount to an implicit widening of the band, in that theyrelax the external constraint on domestic policy."3The difference is that non-interest-bearing deposit requirements bind only in periods of speculativeattack. The rest of the time, governments will have ample opportunity todemonstrate their commitment to the policies mandated by the MaastrichtTreaty.An objection to this proposal is that it will weaken monetary discipline.Governments insulated from the discipline of international financial marketsmay embark on policies which further destabilise exchange rates. That thereexists the potential of moral hazard is clear from the analogy between ourproposal and the standard argument for insurance: deposit requirementscouldinsure the EU against policy mistakes that would otherwise derail Stage II ofthe Maastrichtprocess. If one thinks that the costs of failure are very high, thenan investment in insurance is justified. But just as any sensible insurancecompany would monitor the behaviour of its policy holders, the EU shouldmonitor the behaviour of governments receiving 'deposit insurance'. For-tunately, it has the appropriatemechanismsin place: the European MonetaryInstitute and the Monetary Committee, which are authorised to survey the

12 The German Constitutional Court has also ruled that the Maastricht Treaty's so-called convergencecriteria must be interpreted narrowly, which throws into question the realism of this strategy.13 Non-interest-bearing deposit requirements on bank lending to non-residents are equivalent to animplicit widening of the exchange rate band. Why then not simplywiden the band and avoid interferingwiththe operation of capital markets? One answeris that non-interest-bearingdeposit requirements, by alteringthe incentives for the authorities to defend the currency peg, increase the exchange rate stabilising effectidentified by modelsof exchange rate target zones (Krugman, I99 I ). Because deposit requirements ntroducea wedge between on- and offshore interest rates, they reduce the cost to the authorities of using the interestrate to defend the peg. The knowledge that the authorities are more likely to defend the edge of the bandreduces the incentive for speculators to test it.

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I995] WHEELS OF INTERNATIONAL FINANCE I69policies of EU countries, to recommend corrective action, and to levy variouspenalties against governments which fail to comply."4Could the measure be rendered ineffective by the diversion of domestic-currency loans to assets that are not covered by the deposit requirement?Recent Spanish experience illustrates the point. Between September andNovember I992, the Bank of Spain imposed a measure similar to the one underconsideration here. It applied a deposit requirement on new lending by banksto non-residents through swaps."5 The measure succeeded for a few days butthen lost its effectiveness. Within a week of the imposition of the depositrequirement, the differential between domestic and off-shore interest rates onswaps in pesetas fell to levels too low to deter speculation. Spanish banks hadapparently sent pesetas to their London subsidiaries to circumvent the depositrequirement."6 Thus, limiting the measure to lending to finance transactions inone financial instrument, even if the latter is the most widely used undernormal circumstances, will not suffice, since currency traders will shift to otherinstruments in response to the policy. Accordingly, the policy must apply to allloans to all non-residents.17

Then there is the question of avoidance. Even if the measure applies to allbank lending to non-residents, non-bank mechanisms for channelling domesticcurrency offshore may be developed in response to the imposition of aunilateral deposit requirement. A French bank instructed to make non-interest-bearing deposits when lending francs to non-residents could lend francsto French corporations, which could in turn lend them to non-residents(including their own non-resident operations or non-resident branches of theinitiating French bank). This raises the danger that a scheme which started outas a deposit requirement on loans to non-residents would have to be broadenedand, if lending was diverted to other windows, be imposed on all bank lending.

Clearly, no measure of the sort we describe here is ever IOO% effective. Butto slow down speculative activity and provide time for orderly realignments itis not necessary for it to be water-tight.18 The extent of evasion is likely todepend on the length of time for which the deposit requirement remains in

14 A useful guide to the procedures is Kenen (I992).15 The reason for limiting the measure to swaps was that this is the normal vehicle for short-termspeculative lending; exempting lending for other purposes was meant to shield non-speculative activity. SeeLinde I993) andLindeandAlonzo I993).16 See Freitas de Oliveira (1994).17 The carefulreader will note that the formof the proposalhas been refinedconsiderablysince it was firstmooted in Eichengreen and Wyplosz (I993), mainly to take into account the problem described in thisparagraph.18 Fieleke (I994) dismisses as ineffectual the capital controls applied by Ireland, Spain and Portugal in

1993 on the grounds that 'all three countries were obliged to devalue within months after imposing orintensifyingcontrols'. Leaving aside the question of whether these countries'controlswere well designed, thiscriticism misses the point that these three countries were all able to realign and stay in the ERM whereascountries that did not apply controls, like Italy and the UK, were driven out of the system. For similarreasons we think Kenen (this issue)understatesthe importanceof exchange restrictions n the pre-I987 EMS,where their role was not to support seriouslymisaligned currencies but only to provide the breathing spacerequired to organiserealignments (which, revealingly, no longer took place once the most important controlswere removed). Indeed, one can argue (as in Eichengreen, 1994) that the removal of controls and rise ofcapital mobility sets into motion a systematic tendency for adjustable-pegsystems to firstgrow more rigidand then break down.( Royal EconomicSociety1995


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I 70 THE ECONOMIC JOURNAL [JANUARYeffect. Firms may be unwilling to incur even small costs of avoidance if thebenefits are transitory; it is well-known that small fixed costs may havelarge effects (Dixit, I99I). Hence, non-interest-bearing deposit requirementsare most likely to work if their imposition is limited to the last two years of thetransition to EMU.One might object that a policy which discriminates against loans to non-residents runs counter to Article 73f of the Maastricht Treaty. Foreigners couldprotest an implicit tax not also levied on domestic borrowers. There is someambiguity about the proper interpretation of Article 73f, since the treatyalready allows temporary measures in case of emergency. Nevertheless, the bestresponse would be to amend the treaty to authorise such a measure explicitlyduring the remainder of Stage II.19

The Maastricht Treaty provides for an Inter-Governmental Conference inI996 to modify provisions which have proven undesirable. The IGC couldprovide the amendments required for the temporary establishment of depositrequirements when and where needed to protect the ERM and therefore ensurethat the goals of the treaty are achieved.

The strategy we describe here is most compelling if one believes that otherfeasible routes to EMU are foreclosed. Those who continue to believe in thefeasibility of pegged-but-adjustable rates and narrow bands, despite theaccumulation of evidence to the contrary - most recently from the ERM crisesof I992 and I993 - will not be convinced. Others who continue to hope that theEU can move directly to Stage III from I5% bands despite the GermanConstitutional Court's insistence on a strict interpretation of the provisions ofthe Maastricht Treaty will not see the urgency. We think they are whistling inthe dark.

IV. CONCLUSIONThe other contributors to this symposium offer compelling reasons to hesitatebefore throwing sand in the wheels of international finance. We haveconsiderable sympathy for their arguments. But the task of economics is toweigh alternatives. It is not enough to point to the administrative difficulties ofintervening in the operation of markets or to risks of evasion. These costs mustbe weighed against those of alternative courses of action, including doingnothing. For Europe the alternative, namely failure to complete the transitionto EMU, may be costly indeed, especially if the breakdown of the monetary-unification process jeopardises completion of the Single Market. Economistsshould be realists: here realism requires admitting that alternative routes toEMU are foreclosed.

For the world as a whole, the costs of the status quo are high ifmacroeconomic policy is hamstrung and if it is diverted from more fundamentaltargets by exchange rate swings. The progress of European monetaryunification creates grounds for hoping that this problem can eventually beaddressed. The number of major monetary authorities whose support must be

19 Absent an amendment, the question of Maastricht compatibility would have to be adjudicated in theEuropean Court of Law, which would create an extended and undesirable period of uncertainty.? RoyalEconomicSociety 995


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1995] WHEELS OF INTERNATIONAL FINANCE 171mobilised for an initiative to reform the international monetary system will bereduced if Europe ultimately speaks with a single monetary voice.Such reform certainly will not take the form of a single currency for the G-7, much less the entire world. A clear lesson of Maastricht is that politicalsolidarity and economic convergenceareprerequisites ormonetary unification.Europe has been embarked on this processfor nearly half a century, as anyonefamiliar with the historyof the EEC can attest. It is unrealistic to hope that themajor industrial countries can make comparable strides towards politicalunification in our lifetimes. And if pegged exchange rates between distinctnational currencies are infeasible in today's world of high capital mobility, aswe have argued, then exchange rate fluctuations are here to stay. Institutionalinnovation is then needed to reduce exchange rate instability and assure amodicum of national monetary autonomy. The theory of the second bestreminds us that when other markets, in this case the markets for labour andcommodities, adjust imperfectly to shocks, welfare can be improved bythrowing sand in the wheels of international finance.University f California t BerkeleyYale UniversityINSEAD

REFERENCESAlogoskoufis, George and Portes, Richard (I992). 'European monetary union and international currenciesin a tripolar world'. In Establishing CentralBank: Issues n Europe ndLessonsrom the US (eds MatthewCanzoneri, Vittorio Grilli and Paul Masson), pp. 273-302. Cambridge: Cambridge University Press.Bensaid, Bernard and Jeanne, Olivier (I994). 'The instability of fixed exchange rate systemswhen raisingthe nominal interest rate is costly.' Unpublished manuscript, ENPC.Dixit, Avinash (i99i). 'Irreversible investment with price ceilings.' Journalof PoliticalEconomy, ol. 99, pp.

54I-557.Dornbusch, Rudiger (I 976). 'Expectations and exchange ratedynamics.' Journal f PoliticalEconomy, ol. 84,pp. II6I-iI76.Eichengreen, Barry (I994). InternationalMonetaryArrangementsforhe21st Century.Washington, D.C.: TheBrookings Institution (forthcoming).Eichengreen, Barry, Rose, Andrew and Wyplosz, Charles (I 994) . 'Is there a safe passage to EMU? Evidenceon capital controls and a proposal'. Paper presented to the CEPR/NBER/Bank of Italy Conferenceonthe Micro-Structure of Foreign Exchange Markets, Perugia,July.Eichengreen, Barry and Wyplosz, Charles (I 993). 'The unstable EMS.' Brookings apers nEconomic ctivity,vol. 2, pp. 5II43-Fieleke, Norman (994). 'International capital transactions: should they be restricted?' New EnglandEconomic eview March/April), pp. 28-39.Flood, Robert and Garber, Peter (I983). 'Gold monetization and gold discipline.' Journal of PoliticalEconomy, ol. 92, pp. 90-107.Froot, Kenneth and Rogoff, Kenneth (i99i). 'The EMS, the EMU, and the transition to a commoncurrency.' NBER Macroeconomicsnnual,vol. 6, pp. 269-3I 7.Freitas de Oliveira, Luis F. (I 994). 'Deposit requirements as an alternative to curb speculativeattacksin theEMS: a view of the Spanish experience and market reactions.' Unpublished manuscript, INSEAD,January.Henning, Randall and Williamson, John (I994). 'Managing the monetary system.' In Managing he WorldEconomy ifty YearsAfterBrettonWoods ed. Peter B. Kenen) pp. 83-I I I. Washington, DC: Institute forInternational Economics.Kenen, Peter (I992). EMU after Maastricht.Washington, D.C.: Group of Thirty.Krugman, Paul (199I). 'Target zones and exchange rate dynamics.' Quarterlyournalof Economics,ol. 5I,pp. 669-682.Kupiec, Paul H. (I992). 'Noise traders, excess volatility, and a securities transactions tax.' Unpublishedmanuscript, Board of Governors of the Federal Reserve System.

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I72 THE ECONOMIC JOURNAL [JANUARY 1995]Linde, Luis (I993). 'Las medias del Banco de Espana de septiembre y octubre de I992 penaliando laespeculcion cambiaria.' Paeles de Economia Espanola.Linde, Luis and Alonzo, Javier (I 993) 'Currency marketsand foreign exchange crises: a note in connectionwith the Group of Ten Report of April I993.' Unpublished manuscript, Bank of Spain.Obstfeld, Maurice (1 986). 'Rational and self fulfilling balance of payments crises.' American conomic eview,vol. 76, pp. 72-8I.Obstfeld, Maurice (1994). 'The logic of currency crises.' NBER Working Paper No. 4640.Ozkan, F. Gulcin and Sutherland, Alan (I993). 'A model of the ERM crisis.' Unpublished manuscript,University of York.Rose, Andrew (I994). 'Are exchange rates macroeconomicphenomena?' FederalReserve ankofSanFranciscoEconomic eview,vol. I, pp. 19-30.Rose, Andrew and Svensson, Lars (I994). 'European exchange rate credibility after the fall.' EuropeanEconomic eview forthcoming).Svensson,Lars (I 994) . 'Fixed exchange ratesas a means to price stability: what have we learned?' EuropeanEconomic eview,vol. 38, pp. 447-468.Tobin, James (I978). 'A proposal for international monetary reform.' EasternEconomic ournal,vol. 4, pp.

I 53-159.Woo, Wing T. (i 985). 'The monetary approach to exchange rate determination under rationalexpectations.' Journalof Internationalconomics,ol. I5, pp. i-i6.

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Two Cases for Sand in the Wheels

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