Introduction

At the end of the 1970s, several Latin American countries pursued a new kind of stabilization programs. These programs, which have been labeled “new style,” mixed some variant of exchange rate targeting with monetarist-oriented stabilization policies (see Diaz Alejandro 1981, Dornbusch 1982, Calvo 1983). The interest for these programs, when they were first put in place, came from their stark differences from the traditional International Monetary Fund (IMF)-sponsored plans. The latter relied on nominal exchange rate adjustments to correct relative price distortions and on budget discipline to stem the pressures to inflate. The former, instead, aimed at fighting inflation through nominal exchange rate pegging. In addition, another important pillar of the “new style” programs was an increase in nominal interest rates as part of a package of liberalization of domestic financial markets and international capital flows.

The idea of stabilizing inflation through the exchange rate gained increased popularity in the 1980s, with the prominent examples being the Israeli stabilization and the experience of European countries. After 1983, the high-inflation countries that belonged to the exchange rate mechanism of the European Monetary System (EMS) took a stronger resolve on the stability of their exchange rate vis-à-vis the low-inflation country in the system, West Germany. The relative longevity of the EMS, the enthusiasm for the single-market program in the EC and the liberalization of international capital flows all contributed to making the exchange rate mechanism of the EMS a pole of attraction for many countries, both within and outside the EC.

Introduction: from the policy questions to the theory

In Europe the issue of currency substitution has surfaced in the debate on monetary policy and economic and monetary union (EMU). The main concern is that the liberalization of financial and goods markets can bring about instabilities in money demand with undesirable side effects.

The removal of capital controls has eliminated restrictions on holdings of liquid assets in foreign currency by the residents of countries in the European Community (EC). A noticeable increase in cross-border deposits, documented for example by Angeloni, Cottarelli and Levy (1991), has accompanied the financial liberalization.

The increase in cross-border deposits raises two separate questions. The first, discussed especially by Angeloni et al., concerns the statistical definition of monetary aggregates. If monetary aggregates used by central banks for policy design and implementation do not include a large and growing stock of cross-border deposits, the control problem of the monetary authorities can be made more difficult. Suppose, for example, that a stable demand relationship exists between the ‘true’ monetary aggregates (which include, in some appropriate way, cross-border deposits) and observable variables. But suppose central banks, in their day-to-day management, use monetary aggregates that do not include cross-border deposits. Then the stability of the aggregate used by central bankers depends on the stability of the stock of cross-border deposits.

The chapter by Peter Sorensen provides an admirably clear synthesis of the research on the policy questions surrounding capital income taxation in the presence of international capital mobility, and of some of the problems facing European countries. Like the literature it surveys, the chapter does not take a stand on the welfare effects of alternative regimes of capital income taxation, and therefore it does not answer the biggest question currently facing European countries: what are the efficiency losses of the current regime, and can governments afford to leave it unchanged, despite substantial integration of goods and factor markets?

The purpose of my comments is to highlight the reasons why, in the current state of the art, a reliable answer to this question is not available. Yet I believe that an analysis of the current regime and of its problems does help to evaluate alternative reform proposals. Interest in the field of international taxation began when capital controls were liberalized by a number of industrial and developing countries during the 1980s. This interest is at an all-time high in Europe, as EC countries embark on economic and monetary union. International taxation, however, like other areas of public finance, does not always rest on firm analytical grounds: hence the proliferation of terms like ‘criteria’ and ‘views’.

This volume contains a selection from the papers presented at the conference on ‘Finance and Development in Europe’, jointly sponsored by the Centre for Economic Policy Research and the Xunta de Galicia. The conference was part of the CEPR research programme in International Macroeconomics, and was hosted by the Xunta de Galicia in Santiago de Compostela on 13–15 December 1991. We gratefully acknowledge the Xunta's impeccable hospitality and financial support.

I would like to thank a number of individuals who have contributed to the success of this project. First and foremost is Guillermo de la Dehesa, a member of the Centre's Executive Committee, who encouraged me in the pursuit of the project, organized the conference with me, and put CEPR in contact with the sponsors. Guilllermo's enthusiasm is a powerful engine of CEPR activities. David Guthrie and Kate Millward have pushed this volume through the various production stages with unfailing energy and determination. John Black of the University of Exeter, as Production Editor, has helped maintain the high standard of CEPR publications.

The creation of the Single European Market and Economic and Monetary Union (EMU) are likely to change in a profound way the economic landscape of Europe. These processes are effectively taking away from national governments their ability to regulate the economy, both directly – by imposing pan-European regulatory standards, or giving regulatory authority to EC institutions – and indirectly – by allowing greater mobility to factors of production, thereby facilitating regulatory avoidance.

What would be the effects of the single market and EMU? Suppose that non-tariff barriers have persisted until 1992, and will be largely eliminated in 1993 or soon after. Standard international trade models would suggest that the elimination of the last barriers to trade would produce, in every country, greater specialization, by causing the progressive shrinkage and elimination of entire sectors located in individual countries, and – correspondingly – the booming of other sectors. Less standard models, emphasizing external economies and the gains from geographical proximity, would predict that increased international factor mobility would create new pockets of poverty, possibly exacerbate the problems of existing underdeveloped areas, and at the same time bolster richer areas.

These phenomena, coupled with the reduced effectiveness of government policies, will – according to some – signficantly increase the exposure of the standard of living of individuals in every European country to economic disturbances, by decreasing the ability of governments to provide insurance against income fluctuations.

Introduction

Some background

The issue of the appropriate exchange rate (ER) system for Europe is now hotly debated. Yet the question of whether Europe should have a single currency is not new. It goes back to the very first debates surrounding European economic integration of the late 1940s and the 1950s. From the very beginning people have asked what, in our opinion, is a central question: why do ER problems seem not to exist within some subsets of countries or within a country with a diversity of regions (as, for instance, the United States), while they do exist in the world as a whole? Put differently, why has the ‘irrevocably fixed’ ER system within the US functioned well, while the Gold Standard and the Bretton Woods systems collapsed? Economists have phrased this question in the following way: what constitutes an optimum (or at least reasonably good) currency area?

Different schools have answered this question differently. Classical economists argued that the key variable to exchange rate regimes is transactions costs. Because these transactions costs represent social losses, they should be minimized and the way to do it is to have a single worldwide currency. Thus the entire world is an optimum currency area. J. S. Mill puts it in a very illustrative way: