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Abstract:
Most countries commonly classified as "in transition" are still recognisably different from other countries with a similar income per capita in some respects: a larger share of their work force is in industry, they use more energy, they have a more extensive infrastructure and invest more in schooling. However, in terms of the "software" necessary for a market economy, two groups emerge: the countries that are candidates for EU membership seem to have partly completed the transition. By contrast, the countries from the former Soviet Union that form the CIS and the South-eastern European (SEE) countries, are still largely lagging behind in terms of the enforcement of property rights and the development of financial markets.

Transition economies, development level

Abstract:
This paper shows that countries with weak banking system and fiscal institutions, should benefit from the presence of foreign banks, which can constitute a commitment and transparency device. Foreign banks can also reduce the probability of
self-fulfilling speculative attacks. A strong presence of foreign banks can make a currency peg feasible in the first place by rendering it more resistant to speculative attacks. The European experience is instructive in this respect. In all the 10 countries from Central and Eastern Europe (CEEC) that will join the EU in 2004/7 the banking system is now dominated by foreign banks.

Abstract:
The belief that the ECB follows the US Federal Reserve in setting its policy is so entrenched with market participants and commentators that the search for empirical support would seem to be a trivial task. However, this is not the case. We find that the ECB is indeed often influenced by the Fed, but the reverse is true at least as often if one considers longer sample periods. There is empirically little support for the proposition that there has been for a long time a systematic asymmetric leader-follower relationship between the ECB and the Fed. Only after September 2001 is there more evidence of such an asymmetry. We also find a clear-cut structural break between the pre-EMU and the EMU period in terms of the relationship between short term interest rates on both sides of the Atlantic.

co-movement of interest rates, European Central Bank, Federal Reserve, monetary policy, policy coordination

Abstract:
Iceland has developed an oversized banking system - with assets valued at 8 times its GDP - which has effectively transformed the country into a hedge fund. Domestic banks have borrowed heavily abroad to buy foreign banking assets, leveraging their capital base several times over. As a bust is following the global boom in the banking sector, the country is highly exposed to the current crisis. The lender of last resort in Iceland would not be able to save even one of the large domestic banks should write downs in the value of foreign assets bring any one of them into difficulties. Other European countries with financial centres have either avoided becoming lender of last resort for their banks (Luxembourg) or accumulated large foreign assets as a cushion (Switzerland). By contrast, Iceland's extremely high net foreign debt ratio adds to the vulnerability of the country, which thus resembles a hedge fund with negative capital. Moreover, Iceland has experienced a construction/housing boom even more extreme than in the US or the one now ending in Spain. This exposes the country to the classical combination of an exchange rate cum banking crisis coupled with a long real estate bust. Exchange rate devaluation can provide only limited compensation for the housing construction bust that seems unavoidable because Iceland is a rather closed economy, with manufacturing exports accounting for less than 10% of GDP.

Economic Policy of non-EU countries

Abstract:
This paper deals with potential instabilities in the Eurozone stemming from an insufficient interplay between monetary policy and reform effort on the one hand and the emergence of intra-Euro area divergences on the other. As a first step, we assess the effect of EMU on structural reform and investigate this question by an examination of the relationship between fixed exchange rates and reform in two wider samples of countries. We also stress that loose monetary conditions, which prevailed until some months ago, can also manifest themselves in asset price inflation, notably in the housing market. When these bubbles burst (e.g., when housing prices stop rising) this often leads to a prolonged period of economic instability and weakness rather than consumer price inflation. As a second step, we point out that risks for EMU are not only increasing because longer-term disequilibria become evident in fiscal and monetary policy, but also because serious divergences are now appearing within the Euro area which threaten its long-term cohesiveness. The most manifest example of this threat comes from what promises to be a long-term divergence between Germany and Italy, which for the time being was offset by asynchronous developments of house prices in both countries. There are still large differences within the Euro area, with the small countries performing much better than the large ones on almost every indicator. This suggests that better policies can make a large difference even if monetary policy is the same for everybody.

asset prices, international competitiveness, EMU, instabilities, labor markets, monetary policy regime, structural reform

Abstract:
This paper presents a composite indicator for euro area housing prices and compares its evolution over the long run with that of the US. The main findings are two-fold:

1. The euro area average index of real housing prices has risen almost as much as that of the US and is now (as is also the case with that of the US) about 40% above its 30-year average. This is similar to the overvaluation of Japanese real estate at the height of the Japanese bubble, which was then followed by over a decade of decline.

2. Over the last 30 years, the euro area index for real housing prices has tended to follow that of the US quite closely, but with a lag of around 18 months. Given that the US market turned in mid-2006, one could thus expect that the euro area market is likely to do the same as 2007 turns into 2008.

Microeconomic Policy, Economic Policy

Abstract:
What policy objective should a common central bank in a heterogeneous monetary union pursue? Should it base its decisions on the EU-wide average of inflation and growth or should it instead focus on (appropriately weighted) national welfare losses based on national rates of inflation and growth? We find that a central bank that minimises the sum of national welfare losses reacts less to common shocks. This can lead to higher average union-wide expected welfare if the variability of common shocks is large relative to the inflation bias and if idiosyncratic demand shocks in the non-tradables sector are not too high.

Monetary Policy, Monetary Union, Transmission Mechanism

Abstract:
Should a common central bank in a heterogeneous monetary union base its decisions on EU-wide averages of economic variables or on national welfare losses? A central bank that minimizes the sum of national welfare losses reacts less to common shocks. Under certain parameter constellations this leads to higher average union-wide expected welfare and it might thus be preferable that decision-making is dominated by national representatives. Countries with a transmission mechanism far from the average benefit from an orientation on national welfare losses. For countries with a transmission mechanism close to the average, welfare can be lower in this case.

Abstract:
What policy objective should a common central bank in a heterogeneous monetary union pursue? Should it base its decisions on the EU-wide average of inflation and growth or should it instead focus on (appropriately weighted) national rates of inflation and growth? We find that a central bank that minimises the national welfare losses reacts less to common shocks. However, average union-wide expected welfare is lower under a central bank that cares about union-wide variables if the variability of common shocks is large relative to the inflation bias. For a single country, welfare is lower in this case if its transmission mechanism is close to the average. The inflationary bias depends on the interaction between the transmission mechanism and distortions in labour markets.

Monetary policy, monetary union, transmission mechanism

Abstract:
This paper explores three areas in which the experience of the Great Depression might be relevant today: monetary policy, fiscal policy and the systemic stability of the banking system. We confirm the consensus on monetary policy: deflation must be avoided. With regard to fiscal policy, the picture is less clear. We cannot confirm a widespread opinion according to which fiscal policy did not work because it was not tried. We find that fiscal policy went to the limit of what was possible within the confines of sustainability, as they existed then. Our investigation of the US banking system shows a surprising resilience of the sector: commercial banking operations (deposit-taking and lending) remained profitable even during the worst years. This suggests one policy conclusion: At present the authorities in both the US and Europe have little choice but to make up for the losses on ‘legacy’ assets and wait for banks to earn back their capital. But to prevent future crises of this type, one should make sure that losses from the investment banking arms cannot impair commercial banking operations. At least a partial separation of commercial and investment banking thus seems justified by the greater stability of commercial banking operations.

Financial Markets, Institutions

Abstract:
This paper tests whether the volatility in the fundamentals that ought to determine exchange rates is large enough to produce the observed volatility in exchange rates.
The results show that monetary and portfolio balance considerations cannot explain the observed variability in the exchange rate of the deutsche mark vis-a-vis the U.S. dollar Japanese yen and Swiss franc. However monetary and portfolio balance considerations can explain the observed variability of the deutsche mark vis-a-vis other EMS currencies. This suggests that the EMS has been successful in reducing the exchange rate volatility to the minimum compatible with the volatility in the fundamentals.

Abstract:
The paper measures the effects of the integration of European financial markets and lower inflation in the EMS on the revenue from seigniorage for the EC member countries with particular focus on the high inflation countries. Assuming that by 1992 all EC members participate fully in the EMS and reserve requirements are unified, the revenue from seigniorage will be reduced by about 2 percentage points of GDP in Greece and Portugal and 0.5-0.8 percentage points in Italy and Spain. Two different measures of seigniorage yield similar results regarding the change, but differ regarding the level.

Abstract:
This paper presents a simple, basic model to compute the welfare consequences of the introduction of a tariff on the CO2 content of imported goods in a country that already imposes a domestic carbon tax. The main finding is that the introduction of a carbon import tariff increases global welfare (and not just the welfare of the importing country) if there is no (or insufficient) pricing of carbon abroad. A higher domestic price of carbon justifies a higher import tariff. Moreover, a higher relative intensity of carbon abroad increases the desirability of high import tariff imposed by the home country because a border tax shifts production to the importing country, which in this case leads to lower environmental costs.

If both instruments are used to maximise global welfare, the optimal domestic price for carbon should be higher than the external effects (assuming that there is no carbon pricing in the rest of the world) and the optimal tariff rate would be somewhat lower than the domestic carbon price.

If the importing country has a fixed ceiling on emissions instead of a constant carbon price (as provided under the EU’s Emissions Trading System), an import tariff is always beneficial from a global point of view and its imposition lowers the price of domestic allowances, but less than proportionally.

carbon tax, tariffs, global welfare

Abstract:
This paper presents a simple, basic model to compute the welfare consequences of the introduction of a tariff on the CO2 content of imported goods in a country that already imposes a domestic carbon tax. The main finding is that the introduction of a carbon import tariff increases global welfare (and not just the welfare of the importing country) if there is no (or insufficient) pricing of carbon abroad. A higher domestic price of carbon justifies a higher import tariff. Moreover, a higher relative intensity of carbon abroad increases the desirability of high import tariff imposed by the home country because a border tax shifts production to the importing country, which in this case leads to lower environmental costs.

International Climate Change, CO2, Carbon, Environmental Costs

Abstract:
This paper presents a simple, basic model to compute the welfare consequences of the introduction of a tariff on the CO2 content of imported goods in a country that already imposes a domestic carbon tax. The main finding is that the introduction of a carbon import tariff increases global welfare (and not just the welfare of the importing country) if there is no (or insufficient) pricing of carbon abroad. A higher domestic price of carbon justifies a higher import tariff. Moreover, a higher relative intensity of carbon abroad increases the desirability of high import tariff imposed by the home country because a border tax shifts production to the importing country, which in this case leads to lower environmental costs.

Climate Change, Carbon, CO2, Global Welfare

Abstract:
This paper provides background information on the likely challenges the rise of China and India will pose for the economy of the EU. The purpose is mainly descriptive, namely to spell out what kind of trading partner China and India will represent for the EU in the foreseeable future. A first observation is that India is several times smaller than China in economic terms. Moreover, because its investment rates in both human and physical capital are much lower than in China, its growth potential is likely to remain more limited.

China already now exports more manufacturing goods than all other emerging markets together. But its export structure is also evolving rapidly and has become rather similar to that of advanced economies like the EU. This 'convergence' is likely the result of a very rapid accumulation of human and especially physical capital. If current trends continue, China will have a capital/labor ratio similar to that of the EU by the end of the next decade. In terms of human capital, China has already caught up considerably, but further progress will be slowed down by its stable demographics and the still low enrollment ratio in tertiary education. In both areas, India lags China by several decades.

The rapid accumulation of capital suggests that the emergence of China will put adjustment pressures mainly on capital-intensive industries, not the traditional sectors, such as textiles. Another source of friction that is likely to emerge derives from the abundance of coal in China, resulting in a relatively carbon- and energy-intensive economy.

Economic Policy of non-EU countries, Energy and Climate Change

Abstract:
This paper demonstrates the long-run ineffectiveness of quantitative capital controls using a model in which economic agents can evade controls by incurring costs at the time that capital is transferred. Differentials between domestic and off-shore interest rates, together with expectations about future yield differentials, provide incentives for capital flows, which in turn feed back to eliminate the differentials in the long run. Consequently, under fixed exchange rates, the proportion of a change in domestic credit that is "offset" by capital flows is a function of time; quantitative capital controls can provide only some temporary autonomy for national monetary policy.

Abstract:
The paper develops a two-country model of trade in differentiated products and contrasts the determinants of, and inter-relationships between, trade and competitiveness in the short run (when wage rates and the exchange rate are fixed), the intermediate run (when wages and the exchange rate are flexible, but the number of firms is fixed), and the long run (when all variables can adjust). The two-country general-equilibrium model yields predictions that differ considerably from those obtained from comparable small-country models and describes how and why the relationship between the trade balance and competitiveness might vary over time.

Abstract:
In his latest Policy Brief, Daniel Gros gives a new angle on why the existence of current account ‘imbalances’ should provoke the greatest financial crisis in living history if the raison d’être of a financial system is to deal with imbalances (between savers and investors). He argues that one has to take into account the way current account deficits are financed and how flow imbalances accumulated into large stock disequilibria. In his view, the securitisation leading to the crisis was the product of a maturity mismatch between foreign savers seeking short-term assets and excess supply of long-term US mortgage debt.

economic policy, macroeconomic policy

Abstract:
In recent decades the EU has widened and deepened to such an extent that it now deals in almost all areas of policy-making. Its budget, however, has barely changed over this period. It thus needs to be radically reformed if it is to reflect the priorities of an expanding and deepening Union. Over 40% of spending still supports agriculture, a declining sector; spending for research and innovation, recognised as the main driving force of productivity growth, is too low, and there is no room in the budget for the new public goods of domestic and external security that the public demands. However, the budget is determined through an inter-governmental negotiation in which no entity defends the over-arching European interest since all countries (rationally) care only about their 'net balance'. Radical changes in budgetary decision-making procedures are no longer possible since the Reform Treaty, now in the ratification process, essentially cemented a procedure that combines the primacy of national interests with a very strong status quo bias. The latter arises because in the absence of a unanimous agreement on new priorities the old budget automatically continues to apply. If this status quo bias cannot be broken major reforms become virtually impossible.

The forthcoming mid-term review of the budget should be used to achieve political agreement on breaking the status quo bias by introducing 'sunset' clauses, which stipulate that major spending programmes will be discontinued after a certain period of time unless their usefulness can be ascertained and a new agreement reached allowing their continuation. Movement in the right direction can thus start immediately, even within the present legal framework, especially if Parliament uses its influence to push for a better allocation of expenditure.

Reform of EU Institutions, Economic Policy

Abstract:
In the wake of the Irish no-vote on the Treaty of Lisbon, numerous scenarios are currently being debated. This paper critically assesses the legality and political feasibility of the principal proposals and then puts forward an alternative 'Plan B', which the authors believe would amply satisfy both criteria.

Institutional Affairs, Reform of EU Institutions

Abstract:
The existing literature on dual exchange rate regimes assumes that the separation between the two foreign exchange markets is perfect. In this paper, by contrast, a divergence between the two exchange rates induces a flow of arbitrage activity, the magnitude of which depends on both the costs of evading exchange controls and the size of the exchange rate differential. These arbitrage flows lead to a gradual convergence of the two exchange rates. In the long run, therefore, a dual exchange rate regime with a fixed commercial rate imposes the same constraints as a fixed unified exchange rate.

Abstract:
The variability of the euro seems to have a statistically significant and economically small, but non-negligible, impact on labour markets in Euroland. Unemployment tends to increase and employment growth tends to fall whenever the effective exchange rate of the euro or the bilateral euro/dollar exchange rate becomes more variable. In the US a similar effect seems to be operating, but it is statistically less strong, especially concerning employment growth, which seems largely insulated from exchange rate variability. These results fit the general observation that US labour markets are more flexible and that the euro area is considerably more open than the US (exports of goods and services amount to close to 18 per cent of Euroland GDP versus only about 11 per cent for the US).

Abstract:
This paper estimates the impact of the ongoing housing bust and oil price boom on the US and European economies. It finds that large house price movements (changes in construction investment) are useful to predict exceptionally bad and good times for the US economy, but not for most large European countries. In Europe housing market developments have led to extreme values of GDP, mainly in the UK, Spain and some Nordic countries.

Exceptionally good or bad times are defined as realisations of the output gap (the difference between actual and trend GDP) that fall in the 5% tail of the distribution. Our definition of a 'bad time' thus does not necessarily imply a recession, which is officially defined as two consecutive quarters of falling GDP (and employment). A prolonged period of sub par growth could also lead to an equivalent output gap.

Our model allows us to estimate the probability of the US and European economies experiencing exceptionally bad times. We find that the probability for the US is over 50% if one assumes that house prices will continue to fall throughout 2008. Adding the high oil price to the picture increases this probability to over 80%.

For most European countries we find a much lower probability; except for Spain, where the probability of a large output gap will rise to over 85 % by the end of 2008 if house prices were to fall as much as in the US.

Economic Policy, Macroeconomic Policy

Abstract:
The belief that the European Central Bank (ECB) follows the US Federal Reserve (the Fed) in setting its policy is so entrenched with market participants and commentators that the search for empirical support would seem to be a trivial task. However, this is not the case. We find that the ECB is indeed often influenced by the Fed, but the reverse is true at least as often if one considers longer sample periods. There is empirically little support for the proposition that there has for a long time been a systematic asymmetric leader-follower relationship between the ECB and the Fed. Only after September 2001 is there more evidence of such an asymmetry. There is a clear-cut structural break between the period pre-economic and monetary union (EMU) and EMU itself in terms of the relationship between short-term interest rates on both sides of the Atlantic.

Abstract:
Even though the financial crisis might have started in the US, CEPS Director Daniel Gros finds in a new CEPS Policy Brief that even more combustible material had accumulated in Europe, and that therefore that it likely that the cost will be higher here and the recovery slower than on the other side of the Atlantic. This conclusion is based on a careful analysis of two indicators of looming financial instability: credit expansion (or leverage) and asset price bubbles.

Financial Markets and Institutions, Macroeconomic Policy

Abstract:
This paper discusses stabilization policy in the presence of bands for the exchange rate. The bands are modelled in a probabilistic sense: monetary policy has to be such as to keep the probability, that the exchange rate stays within the bands, above a certain threshold. In contrast to other models of target zones, this formulation leads to a linear decision rule and implies sizeable intra-marginal interventions, which corresponds to the experience in the EMS. The extent to which short-run monetary policy is constraint by the bands depends on its own long-run components and on fiscal policy.

Abstract:
A simple two-country stochastic model is used to analyze monetary policy interaction in a system of exchange rate bands such as the EMS, in the context of internationally-integrated financial markets. We consider the widely-acknowledged asymmetry of the system, as it pertains to member countries` use of monetary policy to offset shocks that impinge on their national incomes. Our results suggest, among other things, that tightening the exchange-rate bands would lead to more intervention by all members, even if formal responsibility for keeping exchange rates within the bands lay only with the peripheral countries.

Abstract:
This paper points out that education should be the central objective of the post-2010 Lisbon Process. Compared to other OECD countries, the member states of the European Union perform poorly when it comes to key indicators of innovative potential, such as the percentage of students enrolled in tertiary education and the educational quality of Europe's students. Education makes a three-fold contribution to a country's economic health. First it is beneficial for employment rates, second it is a key driver for long-term economic growth and third it appears to be beneficial for social cohesion. It will be crucial for European countries to attain higher levels of tertiary education and increase the quality of their education.

Economic Policy, Macroeconomic Policy

Abstract:
It is widely assumed that a common currency makes it desirable to have also a common fiscal policy. However, if fiscal policy is a source of shocks, independent national fiscal policies are generally preferable because they allow for risk diversification.

Currency union, fiscal policy coordination, stabilisation

Abstract:
This paper makes the case for full euroization of the Balkans. It argues that the full adoption of the new currency, including the use of euro notes and coins, would bring important benefits for the countries in south east Europe. The key benefit of euroization would be the opportunity it would provide to radically reform and open the financial system, thus changing the equilibrium of the domestic political economy (by eliminating political influence over credit allocation). It also argues that the loss of seigniorage would be minor, but that there is no reason why the rich EU should benefit from this. Compensation for the loss of seigniorage would be technically easy to implement. Finally, the paper presents a small model that demonstrates how a devaluation might actually impair the debt-servicing capacity of the government. This implies that the exchange rate cannot easily absorb shocks to the interest rate to be paid on external debt, or to the availability of capital for emerging markets in general. A deterioration in the availability of external capital might thus trigger extremely large exchange rate adjustments, which in turn can disrupt the domestic financial system. This should be an important consideration for such a highly indebted region.

Abstract:
This paper explores the question of whether there is a trade-off between maintaining price stability and financial stability (much in the same way as there can be a trade-off between price stability and output stability when supply shocks occur) and if so, which of the two objectives should take precedence. The authors analyse how such a trade-off can arise and further examine the issue of how to define and monitor financial stability and assess which policy instruments the ECB could deploy to maintain financial stability.

macroeconomic policy

Abstract:
This article puts forward a methodology to assess the fiscal implications for the new EU members from central and eastern Europe (CEECs) of joining the euro area. An application of this methodology under a specific set of conditions shows that the rules of the ECB on the distribution of seigniorage favour poorer countries so that one would expect the new member countries to benefit from participating in the distribution of the profits of the ECB. For two countries the gains could indeed be sizeable, initially almost 1 per cent of GDP, per annum. But for others the gains are more modest. Two factors have tended to reduce the expected financial gains for the new Member States: Firstly, since the introduction of the euro, cash use has fallen considerably in the euro area; and secondly, some of the new CEEC members have in general much higher cash-to-GDP ratios and therefore earn, for the time being, relatively high domestic seigniorage revenues. Illustrative calculations show that, in present value terms, the gains could reach up to 10 per cent of GDP for poorer countries that catch up only slowly to the EU average. But countries that enter with a GDP per capita above about one-half of the EU average might actually lose if initially their cash ratios are much above the euro area value.

Abstract:
The main message of this contribution is that lean times are here to stay for the old member states. The main reasons are deep seated: Deteriorating demographics continue with ratio of working age population to total population falling. There are thus fewer and fewer producers for every consumer and recipient of transfers. On top of this productivity growth is declining as labour quality is falling and investment growth slowing. In the new member countries the demographic trends also unfavourable, but they are (more than) compensated by catch up growth as a relatively well educated work force finds its place in the internal market.

What does this diagnosis imply for the role of structural policies? No Lisbon agenda change demographics trends, nor can it change the declining capital/labour ratio due to insufficient investment growth. But structural reforms might counteract the impact of these two negative trends. Moreover, the performance gap between big and small member countries suggests that policy can make a difference.

Lisbon Strategy, population aging, productivity, fiscal policy, European Union

Abstract:
Which policy objective should a central bank pursue in a monetary union with asymmetric monetary transmission and different rates of inflation? Should it base its decisions on the EU-wide average of inflation and growth or should it instead focus on (appropriately weighted) national utility losses based on national rates of inflation and growth? We find that a policy which minimises the sum of national utility losses leads to higher average utility if the variability of common shocks is large relative to idiosyncratic demand shocks in the non-tradables sectors. We draw conclusions for the appropriate weight of common and national objectives in the union.

Abstract:
With inflation increasing all over the world, central banks have to consider with some care how quickly to re-establish price stability. A key issue in this context is the short-run cost in terms of foregone output and higher unemployment. The aim of this paper is to determine the 'sacrifice ratio' for the Euro Area and for the United States. The main findings are: the cost of reducing inflation is in most cases higher in the US than in the EA. For example, reducing (headline) inflation by 1% point requires a decline of output of 1.4% in the EU, but 2.3% for the US. Considering core inflation, the sacrifice ratio in terms of output is somewhat higher for the Euro Area (around 4) compared to 3.2 for the US. However, the sacrifice ratios in terms of unemployment are always much larger for the US. Reducing headline inflation by 1% requires an increase in unemployment of little more than 1% in the EA, compared to 8% in the US.

However, there is also a long-run 'hysterisis' cost that is specific to the Euro Area since the reaction of unemployment to output depends on the state of the economy. During downturns this relationship worsens. This implies that a recession engineered to combat inflation will have an additional cost in terms of lower unemployment later, even after the recovery of the economy.

Economic Policy, Macroeconomic Policy

Abstract:
The purpose of this contribution is to illustrate the mechanism by which higher oil prices might lead to lower interest rates in the context of a simple model that takes into account the global external savings equilibrium. The simple model has interesting implications for how one views the huge US current account deficit and how the emergence of China’s savings surplus and oil supply shocks impact the global economy. We show that the new equilibrium is located at a lower interest rate but also at a lower income level than without the China effect. Moreover, we argue that the lower real interest rates resulting from excess OPEC savings have facilitated the adjustment to the subprime crisis.

China factor, current account adjustment, interest rate, oil prices, saving glut

Abstract:
The massive financial instability of 2007–08 was, in the main, the result of lax monetary policy. Regulation compounded this error by allowing and encouraging excessive leverage and maturity transformation by banks. Innovation did contribute to reckless credit expansion and investments, but without lax money and excessive leverage, reckless bets on asset price increases would not have been possible. Therefore, a repeat of this instability could be avoided by correcting these two policy faults. There is no need for intrusive rules constraining non-bank intermediaries and financial innovation. The main message is: keep it simple.

Abstract:
Evaluating the costs and benefits of exchange rate stability, requires a different approach to Mercosur than to the European Union (EU). Trade integration within Mercosur is much more limited; currencies are driven by other factors such as confidence in the ability to serve external debt and the solidity of domestic political institutions. This also implies that the correlation between exchange rates and interest rates is different. This research paper at first provides a comparative picture of the degree of trade integration within the EU, and within the Southern Cone. It then investigates the correlation between two aspects of financial market volatility¿exchange rate and interest rate volatility¿and compares the situation in the Southern Cone and in the EU between the 1980s to 1990s.

Abstract:
The paper analyzes the importance of credible institutions in the process of trade liberalization. It combines aspects of credible policy announcements with adjustment costs. We show that if industries' profits are subject to adjustment costs, a dynamic link between periods arises that creates constituencies for a non-discretionary trade policy regime. The conditions for a government to select such an institutional solution are derived.