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January/February 1994
Volume 79, Number 1
Federal Reserve
Bank of Atlanta
In This Issue:
Some Lessons from Finance for State and Local
Government Development Programs
Monetary Union in Europe
/Review Essay
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Review
January/February 1994, Volume 79, Number 1
bonomìe
^feview
of Atlanta
President
R o b e r t P. Forrestal
S e n i o r Vice P r e s i d e n t a n d
Director of R e s e a r c h
Sheila L. T s c h i n k e l
'
V i c e President a n d
A s s o c i a t e Director of R e s e a r c h
B. Frank K i n g
Research Department
William Curt Hunter, Vice President, Basic Research
Mary Susan Rosenbaum, Vice President, Macropolicy
Thomas J. Cunningham, Research Officer, Regional
William Roberds. Research Officer, Macropolicy
Larry D. Wall, Research Officer, Financial
Public Affairs
Bobbie H. McCrackin, Vice President
Joycelyn Trigg Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.
Material may be reprinted or abstracted if the Review and author are credited. Please provide the
Bank's Public Affairs Department with a copy of any publication containing reprinted material.
Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713
(404/521-8020). Change-of-address notices and subscription cancellations should be sent directly to the Public Affairs Department. Please include the current mailing label as well as any new
information. ISSN 0732-1813
Contents
Federal Reserve Bank of Atlanta Economic Review
January/February 1994, Volume 79, Number 1
Some Lessons f r o m
Finance f o r State and
Local Government
Development Programs
Sheila L. Tschinkel and
Larry D. Wall
Private sector involvement is almost a prerequisite for successfully
addressing many social problems. Government may encourage private participation in socially desirable projects by capturing part of
the gains and sharing them—in the form of infrastructure improvements or worker training, for example, or subsidized loans.
The challenge for government is finding effective ways to structure such incentives. Poorly structured assistance may result in private parties bearing excessive risk or may reduce incentives for them
to exert effort. In order to structure incentives effectively, a thorough
understanding of each party's interests is critical. This article discusses the nature of those interests and analyzes the merits of a number of
assistance schemes, such as grants and tax abatements, from the perspective of the state or local government supplying the assistance.
The authors conclude that because of the individual nature of state
and local development projects, each development opportunity's particular factors should be carefully considered to determine the best
methods for providing assistance.
Monetary Union
in Europe
Joseph A. Whitt, Jr.
jReview Essay—Selected
Finance and Trade Reference
Books on Latin America:
An Update
Jerry J. Donovan
Tumultuous events in the foreign exchange markets have thrown
plans for European monetary union into disarray. This article reviews
the official plan for monetary union as set out in the Maastricht
Treaty and the foreign-exchange developments since Maastricht, exploring various possible causes of the crises that led Britain and Italy
to pull out of the European Monetary System and most of the other
members to widen dramatically the target bands for their exchange
rates. The author concludes that the fundamental source of strain appears to have been the fallout from German unification. In the absence of shocks on a similar scale in the next few years, a limited
monetary union by the end of the decade is still attainable, the author
predicts, with a number of European Community members likely to
be left out initially.
Increasingly, U.S. investors and others in import/export trade
seek to take advantage of Latin America's recent rapid economic
growth. This review examines reference books containing information relevant to foreign investment and trade with Latin American
countries. The titles reviewed provide a partial checklist for researchers in foreign trade, finance, and public policy, as well as
academicians and librarians who seek information sources for Latin
America.
S o m e Lessons from
Finance for State and
Local Government
Development Programs
Sheila L. Tschinkel and Larry D. Wall
11 levels of government have problems funding the programs their
constituents want at the tax levels their constituents are willing to
accept. At the federal level this conflict has resulted in large and
prolonged fiscal deficits that the current Congress and administration are struggling to reduce. Similarly, many states have had to
cut their budgeted programs substantially. This continuing mismatch of limited revenues and pressing social issues has led to creative financing of new
activities whenever possible.
Tschinkel is Senior Vice
President and Director of
Research at the Atlanta Fed.
Wall is a research officer in
the financial section of the
Atlanta Fed's research
department.
Federal Reserve Bank of Atlanta
One way in which the government may reduce its burden in many social
projects is by engaging the participation of the private sector. Indeed, private
sector involvement is almost a prerequisite for successfully addressing many
social problems. However, while the private sector is willing to invest in socially beneficial projects, private participation is likely only if the developer
can expect to earn a positive risk-adjusted rate of return. Projects whose
costs are likely to exceed the risk-adjusted, present value of the cash flows
to the private developer generally will not receive private funding.' Even if
the project generates very large benefits to the surrounding community, the
developer cannot capture these benefits, and he or she is likely to assign little value to them.
Government may encourage private sector involvement in socially desirable projects by capturing part of the gains and sharing them with a private
Economic Review
1
developer. For example, the government perceives
gains in economic development that provides more
constituents with jobs and income, thereby reducing
demand on social welfare programs and expanding
the tax base. Similarly, community development projects, such as the development of new and improved
infrastructure, can improve development prospects in
areas with limited financial resources. Over time, such
efforts would also raise standards of living and improve the tax base. These gains can be shared with a
private developer by providing resources free, such
as infrastructure improvements or worker training, or
at a below-market price—subsidized Joans, for example. 2
This article takes as given that opportunities exist
for governments to gain from encouraging private development efforts and focuses on the problem of how
best to structure incentives. 3 Finding the most effective ways to structure the assistance is in many important respects similar to the challenge facing investors,
including financial intermediaries, who seek appropriate behavior on the part of entrepreneurs having
projects and talent but insufficient financial resources.
In both cases, everything depends on entrepreneurs
choosing projects with appropriate risk levels, avoiding excessive risks after starting the project, and exerting maximum effort to make the project succeed.
A potential obstacle is that an entrepreneur's interests may diverge from that of the financier after the
money or other resources are in hand. Investors and
corporations have worked on establishing financial
structures that minimize the costs of these diverging
interests, and the corporate finance and financial intermediation literatures offer one important lesson: a
thorough understanding of each party's interests is
critical. Although it is true that some participants in
development projects will do the right thing because it
is the right thing, the only safe assumption is that each
will act in the manner that best promotes his or her
self-interest within the confines of the financial agreement. 4 Thus, the first part of this article discusses the
interests of the various parties involved in economic
development.
The second section analyzes the merits of a number of assistance schemes—such as grants, tax abatements, and subsidized loans—from the perspective of
the state or local government supplying the assistance.
Unfortunately, as in corporate finance, no perfect solution emerges to address all the problems accompanying state and local d e v e l o p m e n t p r o j e c t s . Each
assistance alternative has its own mix of advantages
and disadvantages. For example, a subsidized govern-
2
Economic Review
ment loan may create only minimal costs if the project succeeds but may be very costly if the project fails.
The conclusion suggests that development opportunities should be carefully, individually considered to
determine the best method or combinations of methods
for providing development assistance.
The Interests of t h e Various Parties
To the extent that government-supported development generates positive returns to the government, taxpayers benefit. Obtaining these returns often begins
with the sponsoring government body providing assistance, usually through a development agency, to a private developer with a project likely to generate adequate returns. The assistance is combined with the
developer's own funds and perhaps those of a private
lender, such as a bank, in order to build the necessary
investment. The developer manages the project, and its
proceeds must be divided in a way that earns an at
least adequate expected rate of return for taxpayers.
Government faces the problem of how to structure
the development assistance program to maximize its
rate of return. Keeping in mind that each of the other
parties' primary goal is to maximize the net present
value of their cash flows from the project, government
somehow has to encourage private investment that will
maximize the sponsor's gains while minimizing its
cost of providing development assistance.
The ideal scenario would be one in which a government sponsor rewarded other participants in a development program on the basis of the project's outcome. 5
For example, a portion of increased taxes or reduced
government spending would be shared with a developer. This approach would provide the greatest incentive
both to develop projects that would benefit the government sponsor and to manage them toward that end. In
a world in which the outcomes from a development
depended solely on the ability and effort of the other
participants, such a system would work. However, factors that are not perfectly predictable and are outside
participants' control, such as national economic conditions or natural disasters, also influence the course of a
development project. State assistance entirely contingent on the outcome of individual development projects would force the other participants in the process
to bear increased risk. 6
If the other participants bear all of the risk, some
projects likely to yield acceptable risk-adjusted rates
of return will nonetheless not be proposed because
J anuary/February 1994
they impose too much risk on some other participant.
Taxpayers could encourage the development of riskier
projects by assuming some or all of the risk. However,
increasing taxpayer risk may create its own problems.
First, a developer may take greater risks because he or
she would be in a position to keep almost all the private gains from successful projects yet would share
the losses from failed projects with the taxpayers. Second, a developer may not try as hard because the costs
of failure would be borne at least in part by the government.
Thus, an understanding of each participant's role in
the development process is essential for structuring development programs optimally. The structure will influence the effort individual participants exert as well
as their approaches to managing risk. The following
analysis considers the main issues facing each of the
parties in a development project and also points out
how a poorly structured program may induce perverse
responses.
The Government Sponsor. Investment in publicly
supported programs, like investment in a purely private development, should be analyzed in terms of the
return and risk of the project. One way of measuring a
program's return is to calculate its expected costs and
benefits. Of course, the costs, which will probably be
borne through a development authority, should generally be expected to exceed the gains. Losses encompass the cost of evaluating the proposed projects to
determine their economic and social merits along with
any costs beyond those covered by private revenue that
are required to induce a developer to undertake a project. It is important to note that a project may generate
economic losses even if it generates no accounting
losses. For example, a low-interest loan repaid on
schedule will not generate accounting losses, but if interest on the loan does not adequately compensate the
government for the time value of money, it will generate economic losses.
Costs incurred by the development authority may
be somewhat offset by gains to the sponsor's budget
that result from a project. For example, gains f r o m
higher tax revenues channeled to government or from
lower social w e l f a r e s p e n d i n g or both m a y begin
sometime after a project has started.
In general, the expenses of assisting private development occur before any gains are obtained. One way
of recognizing the timing differential is to calculate a
net present value of a project to the government sponsor. The first step is to add the expected increase in
tax revenue to the expected reduction in social welfare spending and subtract the cost of the subsidy in
Federal Reserve Bank of Atlanta
each future period. Each period's net gains or losses
are then discounted for the time value of money and
the riskiness of the project. The sum of the discounted
values would be the project's net present value. Although estimates of net present value may be subject
to error because of a variety of factors, the process of
calculating it at least enforces the discipline of detailing expected amounts and timing of the various cash
flows.7
The risk in a project lies in the fact that both the
value of the assistance to the project and of the benefits from the project may vary substantially f r o m
expectations. For many projects the sponsoring government's more diversified revenue stream puts it in a
better position to bear the project's risk. For any given
small project, the government sponsor may thus be
the most efficient risk bearer. However, excessive risk
arises when the government absorbs too much risk
from larger projects or from a large number of smaller
projects.
The outcomes from most development projects are
likely to be highly correlated with the overall health of
the local economy. That is, a project will likely succeed
when the rest of the community is in good economic
health but will most likely fail and further drain local
resources during those times when a community is already suffering economic problems and can least afford
further losses. Thus, it is crucial that a government
carefully evaluate its potential risk exposure under alternative financing schemes to ensure that it could
handle the maximum losses possible from supporting
a given project. These calculations should consider the
overall risk picture as well. In extreme cases, a state or
local government may be forced to defer or eliminate
projects if the total risk generated by all governmentassisted projects would be excessive. One way of reducing the risk to any individual government body is
to share the risks across jurisdictions. The financial issues involved in such sharing are discussed in the box
on page 4.
The State Development Agency. Although some
types of development support schemes do not require
the establishment of a separate government agency, in
most cases states have set up agencies to oversee state
support of private development projects. An agency is
responsible for analyzing proposed projects and negotiating the assistance package with the developer. In
effect, it acts as an agent for the taxpayers just as the
management of a private corporation is acting as an
agent for the shareholders.
The senior managers of a development agency, like
the senior managers of a corporation, are concerned
Economic Review
3
Pooling of Development Projects across Jurisdictions
O n e w a y for a state or local g o v e r n m e n t unit to diversify its portfolio of d e v e l o p m e n t projects is to pool resources with other state or local g o v e r n m e n t s to f u n d a
geographically dispersed set of projects. 1 T h e net result
of such diversification would b e to reduce the chances of
s p e c t a c u l a r s u c c e s s f o r a n y o n e g o v e r n m e n t , b u t it
would also reduce the risk of disastrous loss.
T h e pooling of projects across jurisdictions to reduce
risk is s i m i l a r to b a n k s r e d u c i n g the c o n c e n t r a t i o n of
loans in their portfolio by "participating o u t " part of the
loan—that is, selling part of the cash f l o w s f r o m a loan
to another bank. 2 T h e selling bank typically retains responsibility for collecting loan payments and distributing
them to the b a n k s that purchased the participation. T h e
purchasing bank, h o w e v e r , takes a proportional share of
the risk that the loan will not be fully repaid. O n e danger
r e c o g n i z e d in the loan participation m a r k e t is that the
selling bank may choose to sell only its high risk loans
or that it may not adequately monitor the borrower.
P u r c h a s i n g b a n k s rely on several protections to red u c e t h e risk that they a r e b u y i n g bad l o a n s . S e l l i n g
banks typically keep part of the loan so that they will also suffer losses if the loan is not repaid. Further, b a n k s '
c o n t i n u i n g access to t h e loan participation m a r k e t dep e n d s on their maintaining a g o o d reputation for participating out quality loans. Finally, the p u r c h a s i n g b a n k
c a n — a n d regulators expect that it w i l l — c o n d u c t an independent analysis of the loan b e f o r e entering into the
participation. T h e s e protections usually result in loans
that are of higher quality or are easier to value or both.
H o w e v e r , s o m e b a n k s h a v e s u f f e r e d very large losses
and e v e n failed as a result of not adequately analyzing
the loan participations that they purchased. 3
with promoting their own interests as well as those
of their principal. For example, they are likely to be
concerned with increasing their lifetime earnings as
well as with enhancing the budget and prestige of their
agency. Thus, the sponsoring government should be as
careful as the shareholders in a private corporation to
consider the incentives it creates for these senior managers.
The sponsor will wish to reward a development
authority for its success in identifying and assisting
projects that both would not occur without government support and that will provide net benefits to the
taxpayers. However, because the sponsor has only limited information on the opportunities and actions of a
development authority, it cannot easily structure a system that provides appropriate rewards. Without com-
4
Economic Review
Pooling resources across governmental units m a y
present risks similar to those created by loan participations. Each governmental unit is depending on the others
to evaluate and monitor o n g o i n g projects. H o w e v e r , the
s p o n s o r s a n d their d e v e l o p m e n t a g e n c y m a y not h a v e
equal abilities to e v a l u a t e and to m o n i t o r projects that
m i g h t place the stronger d e v e l o p m e n t a g e n c i e s at risk
f r o m the w e a k e r agencies. Further, reducing the share of
risk borne by a sponsor and its development agency may
e n c o u r a g e support of projects with l o w e r e x p e c t e d returns and higher risk.
T h u s , u n d e r ideal c i r c u m s t a n c e s p o o l i n g r e s o u r c e s
across jurisdictions will reduce the risk borne by individual g o v e r n m e n t sponsors. H o w e v e r , the problems created in less than ideal c i r c u m s t a n c e s — t h e likely situation
in almost all c a s e s — m a y be severe. G o v e r n m e n t sponsors should carefully evaluate the risks they are taking in
pooling resources before agreeing to participate in such
programs.
Notes
1. See Zelinsky (1984) for the argument in favor of pooling
development investment across geographic regions.
2. However, because most projects would not be expected
to earn a market rate of return, the funds would need to
be pooled at the start rather than allowing each government to choose individual projects.
3. Zweig (1985) points out that Seafirst was forced to merge
with B a n k A m e r i c a , and Continental Illinois required
FDIC assistance in large part because of problems with
loans they participated in with Penn Square Bank in Oklahoma.
plete information as a basis, incentives may miss the
mark.
One problem area concerns ensuring that a development authority screens projects effectively for economic viability. Appropriate incentives should lead a
development authority away from projects that have
no reasonable prospect for success. However, care
m u s t b e t a k e n to p r e v e n t t o o m u c h e m p h a s i s on
avoiding failure. Recall that the primary social purpose for state support of development projects is that
the projects may yield social gains even though they
would produce net losses to a private developer. Thus,
a successful development authority should expect to
suffer economic losses. 8 If an authority is not incurring
losses, it may be that its support is being wasted on
projects that would have received adequate private fi-
J a n u a r y / F e b r u a r y 1994
nancing had there been no government support. Further, strong incentives to avoid losses may encourage
development agency administrators to hide problem
loans in the hope that they will not be revealed on the
current administrator's watch. One costly example of
excessive incentive to avoid losses may have been decisions by federal government officials to defer recognition of l o s s e s in the t h r i f t i n d u s t r y that h e l p e d
contribute to the massive losses by the thrift deposit
insurance agency (see Edward J. Kane 1985). Thus,
the incentives to avoid losses may be too strong or too
weak.
Another challenge is providing incentives for agencies to pursue development opportunities. If too few
are given to the authorities, then their officials may not
put forth sufficient effort. However, if the incentives
are too attractive, the authority may get involved in too
much and provide unnecessary support simply to appear to meet the taxpayers' goals. For example, an authority may be too aggressive in supporting projects
that would have occurred in its jurisdiction even with
less aid. By providing the unnecessary support, the development agency would be inflating the number of
successful projects supported.
A related problem occurs when different sponsors
and development agencies compete, especially for
large economic development projects. Each sponsor
and its development authority may measure the costs
and benefits of supporting the development from the
narrow perspective of its individual jurisdiction. This
sort of competition may result in a private developer receiving support far in excess of what would have
been required to induce undertaking the project. Indeed, a " w i n n i n g " development agency may provide
incentives to a developer that cost virtually the entire social gain the sponsor might have hoped to obtain. 9
The Private Developer. A private developer is generally responsible both for helping to identify development projects with potential for government support
and managing approved projects. In the absence of
governmental assistance a developer will analyze a
project solely on the basis of expected cash flows. With
government assistance a developer may be willing to
undertake socially desirable projects that would otherwise be avoided because they would yield an inadequate rate of return. However, the structure of the
government assistance may significantly influence decisions about the types of projects initiated and the
way in which the projects are managed.
An obvious goal in structuring state assistance is to
provide the minimum level of state assistance that will
Federal Reserve Bank of Atlanta
persuade developers to embark on socially useful projects. However, only the developer knows precisely
what that minimum level of aid is. 10 It should generally be expected that taxpayer assistance will exceed the
amount required by the developer by at least some
small amount. Thus, a development authority should
anticipate that a developer will earn an above-market
rate of return, adjusted for risk, on any given development project. Nevertheless, the authority should try to
limit the size of the excess returns."
Another important issue in structuring development assistance is that of how risk would be divided
should the project fail. If the project's riskiness is independent of a developer's decisions and actions, then
efficient risk-bearing considerations suggest that the
taxpayers should bear a relatively large part of the
risk of failure. However, there are several ways in
which a developer may influence the riskiness of a
project. First, a developer selects the projects for which
taxpayer assistance is sought. If the taxpayer assumes
too large a fraction of the risk of failure, the fact that a
developer's losses would be mostly covered by a development agency in the event of failure creates an incentive for the developer to propose risky projects
that would yield large gains if successful. Second, depending on the specific contract with the development
agency, a developer may be able to shift some of the
investment to the relatively riskier parts of the development project, which would increase the risk of loss
to the agency. 12 Third, a developer may choose to forgo additional investment in the safer parts of a project
if most of the gains from doing so would go to the
taxpayers or other creditors. 1 3 Thus, if the state absorbs too much risk, the developer is encouraged to
further increase the riskiness of the project. Although
it may not be desirable to eliminate the risk-taking incentive, careful structuring of the aid (discussed below) may reduce a developer's incentive to take more
risks.
The Private Lender. A private lender may supplement a developer's investment and the state's assistance with a loan to the developer. If so, a lender may
provide a separate evaluation of the economic merits
of a development project and may also monitor ongoing projects to ensure that they are well managed and
continue to be economically viable.
The structure of the government assistance program
may significantly influence private lenders' efforts in
analyzing and monitoring loans. They should be expected to exert effort only up to the point at which the
marginal benefit of further effort equals the marginal
cost of that effort. By absorbing some or all of the risk
Economic Review
5
of failure, a government assistance program may reduce the marginal benefits of analyzing and monitoring loans. With nothing at stake, the lender has little
incentive to undertake costly analysis and monitoring
of development loans.
F o r m s of Project Support
Government aid to development projects may take
a number of different forms, including grants, subsidized inputs, tax abatement, loans, loan guarantees,
and interest subsidies. T h e type of development aid
may have a major impact on expected costs and risks
involved in assisting a project and on the probability
of a project's success.
Grants. One way of supporting a development project is to give the developer financial or real resources—
for example, land on which to build a factory—with no
repayment required. If not properly structured, such
grants may serve as an incentive for developers to create uneconomic projects to obtain the money. However, careful screening or requiring a developer to invest
a substantial amount of private funds as a precondition
for receiving the grant can reduce the risk that developers will misuse grants.
After receiving a grant and investing in a project, a
developer has the same incentives as if the government
had not provided any assistance. A developer reaps all
direct rewards and bears all costs of failure. Thus, a
developer has an incentive to exert maximum effort
and to manage the risk of the project optimally. If a
developer also seeks a private loan, the lender retains
the full incentive to evaluate the economic merits of
the project after adding in the grant.
A development agency does not share in any of the
gains from successful projects awarded grants, but neither is it at any additional risk from a failed project.
The sponsoring government is at risk, however, in that
taxpayers who provided the grant will receive the benefits of increased taxes or reduced spending only if the
development is successful.
Subsidizing Improvement of Local Production
Factors. A government may assist a developer by
promising to upgrade one or more local factors of production at taxpayers' expense. For example, a state
may promise to subsidize worker training or lease a
state facility at a below-market rate.
Subsidizing a production factor reduces a developer's costs but leaves him or her responsible for the remaining investment. A developer retains most of the
6
Economic Review
risk of failure and reaps all of the private rewards from
a successful project. As a consequence, this kind of
development assistance does not provide a developer
with an incentive to increase the risk of the project.
The expected cost of the program to a development
agency is fixed. However, the government sponsor's
risk is reduced by this form of aid because the sponsor retains something of value even if the project fails.
For e x a m p l e , if a d e v e l o p m e n t agency subsidized
worker training, the local area will benefit from having more highly skilled workers whether the project
succeeds or not. 14
Tax Abatement. The government sponsor may encourage economic development by agreeing to reduce
or eliminate required tax payments from the developer
for a specified period of time. For example, the sponsor may agree not to levy property taxes on the development site or income taxes on income earned from
the development.
The value of tax abatement to the developer is positively correlated with the success of the project. If
the project fails, the developer may not have paid any
taxes even without the abatement. However, if the
project succeeds, the tax abatement may be very valuable. Thus, tax abatement provides added incentive
for the developer to make the project a success. Tax
abatement also discourages developers from operating
in a high-risk fashion since the abatement may be almost worthless if the development fails. The one possible disadvantage of tax abatement is that it may
assign relatively too much of the risk to a private developer. That is, if a project succeeds the developer
receives benefits, but if a project fails a developer
may not actually receive any assistance even though
the offer of tax abatement was necessary to get the
project under way.
Tax abatement may minimize the risk to the government sponsor. Although tax revenues from the developer are reduced, the largest reductions occur when
the project succeeds, in which case the state should
see increased tax revenues from the workers as well as
a possible reduction in social welfare spending. However, if the government is able to bear risk at a lower
cost than a private developer, tax abatement may result
in an inefficient sharing of risk.
Loans. The state may assist a developer by providing loans to finance a project. Alternatively, the state
may guarantee some or all of the private loans to a developer. In either case a private developer receives a
subsidy equal to the difference between the cost of obtaining the loan without state backing and the cost of
the loan with state backing.
J a n u a ry/He bru a ry 1994
Full Loan Guarantee. If the state absorbs all the risk
from loans, then it can create an incentive for a developer to take additional risk. A developer keeps all returns in excess of the loan value but is liable for losses
only to the extent of his or her investment in the project. Thus, the amount of investment required may play
an important role in determining the risks taken by that
developer. An agency may also protect itself by monitoring the developer during the course of the project.
A development agency cannot count on assistance
in evaluating and monitoring loans f r o m a private
lender if the loan is 100 percent guaranteed. Protected
f r o m loss by the development authority, the private
lender has little incentive to undertake costly activities.
Although it bears considerable risk, the government
sponsor may receive substantial benefits in this scenario when a project succeeds. The loan is repaid—or
at least the loan guarantee is not activated—while the
government also receives higher tax revenues and may
have lower outlays. However, the risk may be especially great if the outcome of the development project is
highly correlated with the state of the local economy.
Shared Risk. A state development agency may reduce its risk and encourage private lenders to expend
more effort in analyzing and monitoring loans by absorbing only part of the loan losses from failed develo p m e n t p r o j e c t s . A d e v e l o p m e n t a g e n c y has two
general options for sharing the risk: (1) the agency absorbs the first X percentage of the losses (where X is
some n u m b e r between 1 and 100), and the private
lender bears any remaining losses; and (2) the agency
shares proportionately in the loan losses with the private lender. Both options may be achieved through direct loans from the development agency or via loan
guarantees from the development agency to the private
lender.
The extent to which the first option reduces a development agency's risk exposure depends on the type of
project being funded and the value of X. If the losses
on a particular type of development project are usually
less than 50 percent of the loan amount, then a state
loan guarantee of 90 percent of the loan will be only
marginally better than a 100 percent guarantee. The 90
percent guarantee likely absorbs virtually all of the
risk that the project may fail so that private lenders
have very little incentive to screen such a loan carefully; primary responsibility for analyzing such borrowers remains with the state. However, if the typical loss
on a type of development in the event of its failure is
80 percent and the state loan guarantee is for only 50
percent of the loan value, the development authority
has shifted significant risk to a private lender. One way
Federal Reserve Bank of Atlanta
of measuring the expected loss is to evaluate the value
of the collateral. The risk of loss may be low if the collateral for the loan is a high proportion of the loan's
value and the collateral can be readily sold at market
value.1"'
The second option reduces losses in direct proportion to a private lender's share of the losses. For example, if the state guarantees 75 cents of every dollar lost
on failed loans, then the private lender is taking 25
percent of the risk.
The state may reduce its risk exposure and increase
a private lender's effort by reducing its share of the
risk of loan failure. However, the value of a partially
government-backed loan to the private developer is directly proportional to the amount of risk absorbed by
the state. One way for the development agency to reduce its risk and increase private monitoring without
reducing the value of the subsidy is to reduce its
charge to the private developer, either by reducing the
interest rate on the government loan or by reducing the
fees for obtaining a government loan guarantee.
Loans versus Guarantees. Although loan guarantees may contain the same risk-sharing features as direct loans, the use of loan guarantees may be riskier
for the government sponsor. Direct loans from a development agency appear to be costly because they
require the g o v e r n m e n t to a p p r o p r i a t e t a x p a y e r s '
funds or to borrow every dollar loaned. Loan guarantees may seem to be less costly, particularly if the
government sponsor appropriates funds equal only to
the expected cost of the guarantees. Sponsors may
seek to leverage appropriated funds by guaranteeing a
far higher dollar value of loans than it would be able
to provide through a direct lending program. However, loan guarantees carry exactly the same risk as
comparably structured direct loans from a development agency. The loan guarantees could be very costly if the expected losses were underestimated on the
basis of overly optimistic figuring or unexpectedly
adverse economic conditions. Failure of a large fraction of the development loans at a time when the local
economy is already distressed could make the higher
volume of loan guarantees especially costly to the
government sponsor.
Interest Subsidy to the Borrower. A development
agency may subsidize a project without discouraging
the private lender's analysis and monitoring by providing an interest subsidy to the borrower. An interest
subsidy is similar to government loan and loan guarantee programs in that both types of assistance work by
lowering a private developer's effective cost of funds.
However, the two alternatives have very d i f f e r e n t
Economic Review
7
incentive and risk-sharing implications. The interest
subsidy approach does not significantly reduce the risk
borne by a private lender. Thus, private lenders are left
with a strong incentive to screen, monitor, and collect
on loans to private developers. If a private lender is
less diversified than a g o v e r n m e n t sponsor of the
development agency, these incentive effects may be
somewhat offset by less efficient risk-sharing. However, there are cases in which having a private lender retain all risk may be more efficient than shifting it to
the government, and interest rate subsidies may be the
best assistance mechanism. For example, some banking organizations are more diversified than any individual state government because they have subsidiaries
in a number of different states.
Conclusion
Different types of assistance to development projects have different consequences for state and local
governments as well as for private developers. States
should consider not only the financial condition but also the risk aversion of developers in structuring their
financial packages. However, they should also consider the implications of alternative support schemes in
terms of the incentives each creates for developers and
private lenders as well as the likely effect on the state's
financial condition. In some cases state or local governments may prefer support schemes that appear to
be more expensive but that have better incentive or
risk-sharing implications. The various alternatives may
also be combined so as to carefully calibrate the risk
borne by the developer, the private lender, and the state.
The basic principles discussed in this essay should help
in analyzing more complicated support schemes.
The expected cost of an interest subsidy program to
a development agency is the amount of the subsidy.
Whether the subsidy is paid after a project fails depends on how the program is structured. However, the
key in evaluating a development agency's risk is that
in no case is the agency liable for more than the amount
of the subsidy.
Notes
1. There are at least three other reasons why private developers may not be able to obtain funds to undertake projects
with a positive net present value: (1) analysis of the loan
may be loo costly, (2) monitoring of the loan may be too
costly, and (3) collecting on the loans from successful projects may be too costly. Srinivasan (forthcoming) considers
the case for government intervention in these cases with a
special focus on the experience of third-world programs.
agendas are not necessarily responsive to shifts in voters'
preferences.
One could argue that voters also face a problem inducing
elected representatives to consistently follow policies in society's best interest. However, a discussion of the optimal
design of a representative government is well beyond the
scope of this paper. Thus, it is assumed that elected representatives have the same goal as voters.
2. One problem in providing resources free or at reduced
prices is that doing so may change the developer's incentives in perverse ways. For example, the provision of grants
may encourage the developer to promote projects that have
little chance of success but involve minimal cost of failure.
5. The term other participants
r e f e r s to the d e v e l o p m e n t
agency, private developers, and, when applicable, private
lenders.
6. One problem with forcing the other participants to bear risk
is that their cost of doing so may exceed the government
sponsor's cost of bearing it. One way of measuring the cost
of financial risk to the various participants in a development
is to compare the expected value of the risky cash flows with
their certainty equivalent value to each of the participants.
The certainty equivalent value is the amount of cash to be
received with certainty that is required to make the individual indifferent between the risky cash distribution and the
certainty equivalent amount. The taxpayers will often have the
lowest cost of bearing risk because the government is likely
to be more diversified than the other participants in most
cases. The greater diversification arises because the government has the ability to levy taxes on the entire community.
3. Bartik (1991) provides evidence that development programs
run by state and local governments may increase social welfare.
4. In some cases the private parties will participate for civic
reasons rather than personal gain. However, a government
program that depends on public-spirited developers may
miss significant opportunities if too little return is offered to
less altruistic ones. Alternatively, if the rules are too loosely
written, the government may suffer losses because of unscrupulous or well-intentioned but naive developers.
The state development authority is likely to take account
of the sponsoring government body's goal. However, government agencies often develop agendas on the basis of the
costs and benefits of alternative policies to the agency. Their
8
Economic Review
7. Several variables can affect the accuracy of estimates of net
present value. For example, the expected value of many of
J a n u a r y / F e b r u a r y 1994
the relevant cash flows must be estimated; extremely successful development projects may require additional spending on infrastructure; and many of the jobs may be taken by
unemployed workers that move in from or commute from
other jurisdictions rather than individuals in the local tax
base. In addition, extremely successful projects may result
in spinoff projects that generate higher tax revenues than
anticipated, at least partially offsetting any higher infrastructure costs involved.
A simple way of measuring the cash flows would be to
calculate the expected cash outflow from the government in
every period and to determine the expected tax receipts
based on projected employment for every period. An example
of this type of analysis is provided by Marvel and Shkurti
(1993). ( N o t e , h o w e v e r , that they s u m m e d cash f l o w s
through time rather than using cash flows discounted for the
time value of money and for risk). The analysis becomes
more complicated if other factors should be recognized, as
is often the case. For example, worker training and improved roads may facilitate other development that could
increase the expected cash flows from the development assistance. Conversely, some of the workers for a project likely would have been employed in a different job absent the
project, so the use of these workers' total tax payments will
tend to overestimate the true increase in tax receipts. Given
that the evaluation of projects at this time is as much an art
as a science, government sponsors should not overlook resources for analysis that may be available through local universities.
u 8. Also, recall that the losses of the development authority
should be offset by gains from higher tax revenues or lower
spending by the government sponsor.
9. Another reason that development agencies may bid too high
is the so-called winner's curse. The winner's curse arises in
bidding situations in which the projected benefits of winning the bid are subject to measurement error. If the bidders
are unaware that their estimates are subject to measurement
error, then the bidder that most overestimates the projected
benefits will likely win the auction. Thus, the winner of the
auction is likely to find that they overbid in the auction. See
Thaler (1988) for a discussion of the winner's curse.
10. The minimum required aid will depend on the characteristics of the project and of the developer. In general the developer should be expected to know more about the project's
prospects than does the development agency. The characteristics of the developer are important in a number of ways.
For example, a developer with above-average risk aversion
may require a higher expected return than one with belowaverage risk aversion.
11. One way potential gains to developers could be reduced or
eliminated would be if the developers have to bid on a common project for government aid. However, in many cases
bidding competition is not feasible because only one developer has both the local expertise and an interest in participating in the project. Another way the authority may try to
limit the size of the returns is by developing its own estimate of the minimum aid required to induce the private sector to participate in the project. The cost of making such an
estimate may exceed the benefits for small development
projects but could prove valuable in determining how much
to offer for larger projects.
12. This danger is called risk shifting in the corporate finance
literature. Barnea, Haugen, and Senbet (1980) show that
private firms are most likely to engage in risk shifting if
their loans mature after the p r o j e c t ' s cash flows are received. This is the case because in such loans a private
lender may not demand compensation after observing the
type of project actually undertaken by the firm.
13. The risk that a firm will f o r g o profitable investment is
called the underinvestment problem in the corporate finance
literature. Myers (1977) first points out that debt-financed
firms may have an incentive to forgo profitable investments
if most of the gains are received by the debtholders in the
form of a reduction in debt and in the probability that the
firm will default.
14. The value of the increase in worker skills will depend on
the type of training they receive. In some cases most of the
training may be readily transferred to other firms, but in
other cases most of the training may be useful only for a
specific firm. Also, the continuing value of training to the
local government will depend on the availability of firms
that will use the new skills. If demand for the new skills is
reduced, then some of the trained workers may move to locations where they can use their new skills.
15. Local banks and other lenders may also be able to provide
reasonable estimates on the expected losses on loans to different industries.
References
Barnea, Amir, Robert A. Haugen, and Lemma W. Senbet. "A
Rationale for Debt Maturity Structure and Call Provisions in
the Agency Theoretic Framework." Journal of Finance 35
(1980): 1223-34.
Bartik, Timothy J. Who Benefits from State and Local Economic Development Policies? Kalamazoo, Mich.: W.E. Upjohn
Institute for Employment Research, 1991.
Federal Reserve Bank of Atlanta
Kane, Edward J. The Gathering Crisis in Federal Deposit Insurance. Cambridge, Mass.: MIT Press, 1985.
Marvel, Mary K., and William J. Shkurti. "The Economic Impact of Development: Honda in Ohio." Economic
Development Quarterly (February 1993): 50-62.
Myers, Stewart C. "Determinants of Corporate Borrowing,"
Journal of Financial Economics 5 (1977): 147-75.
Economic Review
9
Srinivasan, Aruna. "Intervention in Credit Markets and Development Lending." Federal Reserve Bank of Atlanta Economic Review 79 (forthcoming 1994).
Thaler, Richard H. "Anomalies: The Winner's Curse." Journal
of Economic Perspectives (Winter 1988): 191-202.
10
Economic Review
Zelinsky, Edward A. "The Dilemma of the Local Social Investment: An Essay on 'Socially Responsible' Investing." Cardozo Law Review 6 (1984): 111-46.
Zweig, Phillip L. Belly Up: The Collapse of the Perm Square
Rank. New York: Crown Publishers, Inc., 1985.
J a n u a r y / F e b r u a r y 1994
^Monetary Union
in Europe
Joseph A. Whitt, Jr.
uilding on the foundation of the European Monetary System
(EMS), European leaders announced in late 1991 that they had
agreed to move forward to monetary union by the end of the
decade. At the time, monetary union was widely seen as the next
logical step in a process of gradual economic integration that had
been pursued by the European Community (EC) since the 1950s. Now,
more than two years later, planning for monetary unification continues, but
the foundation for this step has crumbled: the Italian lira and British pound
were forced out of the EMS exchange rate bands in September 1992, and in
1993 the bands of most of the remaining members were widened dramatically, leaving the EMS a shadow of its former self.
The author is an economist
in the macropolicy section of
the Atlanta Fed's research
department. He thanks
Roberto Chang, Marco
Espinosa, William
Roberds,
and Mary Rosenbaum for
helpful comments and
Michael Chriszt for
research
assistance.
Federal Reserve B a n k of Atlanta
This article reviews the plans for European monetary union and the tumultuous events in the foreign exchange markets that have thrown those
plans into disarray. As background, the discussion first sketches the development of the E M S from its founding in 1979 until the collapse of the
Berlin Wall in 1989. The official plan for monetary union, as set out in the
Maastricht Treaty, is reviewed, as are foreign exchange developments since
Maastricht. Only six months after the Maastricht Treaty was announced, the
EMS exchange rate bands came under severe strain. The initial result was
the departure of the Italian lira and British pound from the system; however,
in the summer of 1993 severe pressure returned, culminating in a drastic
widening of the bands for the French franc and nearly all the remaining
members of the EMS. The discussion explores various possible causes of
Economic Review
11
the E M S crises, which occurred after a n u m b e r of
years of remarkable stability. In some countries, there
is evidence that devaluations were almost inevitable,
given the policies of their governments. In others, market speculators have been blamed, but this argument
has weaknesses. The f u n d a m e n t a l source of strain
appears to have been the fallout from German unification. The final section presents conclusions and possible implications for the future of European monetary
union.
.Evolution of the EMS
Serious attempts to move toward European monetary union date back to the early 1970s, when the Bretton Woods system of fixed exchange rates broke up.
During the Bretton Woods period most of the exchange rates between the United States, Japan, various
countries in Western Europe, and other countries such
as Australia were all fixed by international agreement
supported by governmental commitment to intervene
to maintain the rates. When the Bretton Woods system
broke down, various m e m b e r s of the EC sought to
limit exchange rate movements within Europe while
maintaining flexibility as compared with outside currencies, notably the U.S. dollar. Early attempts were
unsuccessful, but the EMS, which began operating in
1979, succeeded in reducing exchange rate variability
among its members, especially in the second half of
the 1980s.
The original members of the EMS were West Germany, France, Italy, the Netherlands, Belgium, Denmark, Ireland, and Luxembourg. They set target or
parity values for their bilateral exchange rates and
agreed to intervene to ensure that market exchange
rates remained within a band of plus or minus 2.25
percent from those parities. The one exception was
Italy; its allowable band was considerably wider (plus
or minus 6 percent), thereby providing greater freedom of action for its central bank.
Although the EMS imposed tight limits on most of
the exchange rates within the system, it did not freeze
them indefinitely. In particular, the agreement allowed
for occasional realignments of the parity rates. Realignments were intended to keep the exchange rate
parities consistent with longer-term economic fundamentals, such as a persistent divergence of inflation
rates in different member countries.
During the early years of the system, realignments
occurred on average about once a year. Several of the
12
Economic Review
largest realignments were caused by a policy divergence between the two largest members of the EC,
France and Germany. The election of President Mitterand in 1981 brought the first Socialist government
to power in France since the 1950s. 1 The new government initially pursued expansionary macroeconomic
policies designed to stimulate the sluggish French
economy while at the same time nationalizing various
industries. During this period, Germany was tightening macroeconomic policy to fight inflation, which
had soared in the wake of the oil price rises of 197980. This policy divergence produced large outflows of
capital f r o m France to Germany, as well as heavy
pressures on the French franc. As a result, there were
three devaluations of the franc against the deutsche
mark between October 1981 and March 1983, totaling
over 20 percent.
After the third devaluation, the French government
did a policy U-turn. Anti-inflationary measures were
enacted, and French monetary policy was reoriented
toward the goal of maintaining the parity value of the
franc versus the deutsche mark. Over the remainder of
the decade, there were only two relatively small devaluations of the franc vis-à-vis the deutsche mark, the
last one occurring in early 1987.
By the m i d - 1 9 8 0 s , there was fairly widespread
agreement among European policymakers, supported
by some economists, that the E M S had successfully reduced exchange rate fluctuations among a core
group of countries. West Germany was to some extent
the anchor or leader of the system, by virtue of its economic size, the long-term strength of its currency (during the various realignments of the EMS, the deutsche
mark was never devalued in relation to any other
member currency), and the prestige and independence
of its central bank.
The leadership position of West Germany in the
EMS was to some extent contrary to the intentions of
the designers of the system, who hoped that the burden
of adjustment to disequilibria in the exchange markets would be shared symmetrically by the members
(Jacques van Ypersele 1979, 6). In its actual operation,
though, there was a common perception that the burden of a d j u s t m e n t fell mainly on higher-inflation
countries with external deficits and not on West Germany. According to the formal rules of the EMS, both
deficit and surplus countries were supposed to intervene to maintain the exchange rate pegs, but as Cristina M a s t r o p a s q u a , S t e f a n o M i c o s s i , and R o b e r t o
Rinaldi (1988) show, most of the intra-European intervention was by Germany's partners. As for Germany,
which usually had a surplus, it appeared to fully steril-
J anuary/February 1994
ize its intervention within three months; when Germany did intervene, it usually did so in the market for
U.S. dollars.
The result of this asymmetry was that, in the words
of Massimo Russo and Giuseppe Tullio (1988, 41),
"Germany decides its domestic inflation rate and all
other members adopt policies to adjust their own gradually to it." As discussed by Charles Wyplosz (1989)
and Horst Ungerer and others (1990, 9-11), this asymmetry was basically attributable to the necessity for
deficit countries to limit their reserve losses while surplus countries (notably Germany) faced no comparable pressure in the other direction. An alternative
e x p l a n a t i o n discussed by F r a n c e s c o Giavazzi and
Marco Pagano (1988) is that countries with a history
of inflationary policy deliberately chose to tie their
currencies to the deutsche mark as a way of strengthening the credibility of their commitments to a lowerinflation future.
Empirical work on the extent of asymmetry has
been mixed. Daniel Cohen and Wyplosz (1989) found
that movements in German short-term interest rates affect similar rates in other EMS members (in particular,
France and the Netherlands) but that some of the other members also have an impact on Germany's rates.
Their results are not inconsistent with the idea that
Germany is preeminent in the EMS, though, because
past movements of German interest rates explain a
substantial portion of movements in French and Dutch
interest rates while the other E M S countries show
much smaller, if any, impacts on Gemían interest rates.
Using a more complex model of interest rate movements that allows for a variety of possible interactions,
Jiirgen von Hagen and Michele Fratianni (1990) found
that while other EMS members react to German monetary policy, Germany reacts to policy changes in the
others as well. Nevertheless, von Hagen and Fratianni's results support a preponderant, though not dominating, role for German policy in the EMS: in most
cases the response of German interest rates to movements in rates in other EMS members is much smaller
than the response in the other direction. 2
Other studies definitely favor a predominant role
for Germany. With regard to interest rates, Giavazzi
and Alberto Giovannini (1987) examined interest rate
movements preceding EMS realignments, finding
large movements of French and Italian offshore interest rates but almost no changes in German rates.
In their view, this asymmetry is a reflection of Germany's central role in the EMS, as portfolio shocks
are absorbed almost entirely by its partners. Moreover,
P. Artus and others (1991) examined both short- and
Federal Reserve Bank of Atlanta
long-term interest rates; they found that French shortterm interest rates are affected by developments in
Germany while German short-term rates are affected
by U.S. variables but not by French rates.
With regard to inflation determination, Bernhard
Herz and Werner Roger (1992) found that they cannot
reject the hypothesis that German inflation is independent of policy variables in other EMS countries but inflation in the other member countries is affected far
more by German monetary actions than by their own.
Overall, the evidence favors a preponderant role for
Germany in the EMS.
In the late 1980s, several developments occurred
that changed the nature of the EMS. Hoping to stimulate growth by eliminating the remaining artificial barriers to trade, capital flows, and labor mobility, the EC
governments agreed to the Single European Act in
1986, which set in motion a process sometimes called
Europe 1992. One provision of the act required that restrictions on capital flows within Europe be abolished
by July 1, 1990. 3 The abolition of capital controls made
the EMS exchange rate bands more vulnerable to sudden speculative attacks; without controls, vast sums
could be moved from one currency to another almost
instantly, requiring massive government intervention
to maintain the bands even for a short time. Policymakers responded by essentially announcing that there
would be no more realignments, in the hope that this
posture would eliminate the incentive for a speculative attack to begin. Such a stance was at least somewhat credible for several years because, as Chart 1
shows, by the late 1980s inflation rates in the core
countries of the E M S had converged substantially,
thereby reducing the need for periodic currency realignments.
The second important development was the expansion of the EMS to include additional countries. The
most important addition was the United K i n g d o m ,
which joined the EMS in October 1990 after several
years of shadowing the system. 4 Spain also joined in
1989. - These additions made the EMS a less homogeneous group of economies: Spain is poorer than most
of the other members, and the United Kingdom is a
major oil producer while the other members all import
most of their oil.
The third, and most important, development was
the collapse of communism in Eastern Europe and the
resulting unification of Germany. As a result, Germany, for years the anchor of the EMS, moved almost
overnight from having very low inflation, tight fiscal
policy, and a large current account surplus to considerably higher inflation, massive budget deficits, and a
Economic Review
13
Chart 1
CPI Inflation: 1978-93
Twelve-Month
Percent C h a n g e
1979
1981
1983
1985
1987
1989
1991
1993
Source: Calculated by the Federal Reserve Bank of Atlanta using data from the International Monetary Fund.
large current account deficit. Moreover, the collapse of
communism created a dilemma for the EC. Before the
collapse, the EC was concentrating its efforts on deepening the political and economic integration of its existing membership—for example, in the Europe 1992
initiative. After the collapse, another possibility beckoned: widening the Community to include additional
countries. Various neutral countries that had previously been constrained by political factors from joining
the EC, such as Austria and Finland, began seeking
membership, as did some of the formerly communist
countries, such as Poland and Hungary.
In the financial markets, the immediate reaction to
the collapse of communism was a sharp rise in longterm interest rates in Germany and most other industrialized countries. The most common explanation for
this rise was the notion that the formerly communist
countries, filled with obsolete machinery and equipment, offered tremendous investment opportunities
and would soon begin to attract large inflows of capital from the West. This new source of demand for cap-
14
Economic Review
ital would raise real (adjusted for inflation) interest
rates throughout the world.
Early on, some economists argued that the deutsche
mark be revalued vis-a-vis its E M S partners; David
Begg and others (1990, 65) wrote that "the case for
an immediate D M realignment is overwhelming." 6
However, the EMS seemed to experience no immediate strain, and policymakers in Europe rejected the
option of an EMS realignment. Instead, they vowed to
push forward with the Europe 1992 initiative, and
they moved ahead with negotiations to go beyond
the E M S ' s limits on exchange rate movements to full
monetary union.
M o n e t a r y Union and the
Maastricht Treaty
Under the most c o m m o n proposals for monetary
union, a new European currency would replace the
J a n u a r y / F e b r u a r y 1994
various currencies of individual nations. A new European Central Bank, governed by directors from various countries, would be responsible for m o n e t a r y
policy; the existing national central banks would lose
the ability to conduct independent monetary policies. 7
In a sense, monetary union would mean a tightening of the EMS structure, with exchange rates being
fixed permanently and the allowable fluctuations being shrunk to zero. However, the proposed monetary
union would go beyond simply fixing exchange rates
because as long as separate currencies continue to circulate, it would be a simple matter to change exchange
rates at some future time. The potential for a quick
change in exchange rates would provide an incentive for private market participants to shift massive
amounts of funds from one currency to another whenever the credibility of the government's commitment
was in doubt. By contrast, if a new European currency
replaced the old national monies, changing an exchange rate would require a government to introduce a
whole new money.
Monetary union was seen by policymakers as a logical next step in the process of European economic integration. From an economic perspective, one gain
from monetary union would be the savings in transactions costs on the huge volume of cross-border trade
within Europe. Travelers within the EC could go from
one country to another without the expense of converting one currency into another, just as Americans can
use dollars in any of the fifty states. More importantly,
business transactions between, for example, France
and Germany could be done without the necessity of
converting francs and deutsche marks. Using bid-ask
spreads in the foreign exchange markets to measure
transactions costs, the European Commission (1990,
68) estimated the savings at 0.3 to 0.4 percent of annual GDP. The gain would arise as bank employees and
other resources currently used to convert funds from
one currency to another were redirected into other
uses. Leaving aside transaction costs, the reduction in
exchange rate variability inherent in monetary union
could increase the volume of international trade and
provide an additional gain in social welfare. 8
Another benefit arises from the possible elimination
of negative cross-border externalities of economic policy. Koichi Hamada (1976) used game theory to show
that if each country makes policy choices separately,
without considering the external impacts of its decisions, the resulting policies are suboptimal, in the sense
that every country could be made better off if they made
policy choices in a joint, cooperative fashion, taking account of all external impacts. Monetary union and the
Federal Reserve Bank of Atlanta
replacement of national central banks by a single European central bank might represent a move to cooperative policymaking, with benefits for all EC members. 9
On the negative side, there is the possible cost of
giving up exchange rate changes as a stabilization device. In Robert Mundell's (1961) analysis, a drop in
demand for the output of a particular region may produce intolerable increases in u n e m p l o y m e n t . With
wage rates sticky, prevented from dropping by longterm contracts or social convention, firms react to
such a drop in demand by laying off workers, thereby
resulting in unemployment. This increase in unemployment could be ameliorated in two ways. If the
exchange rate for this region fell, the real wages of its
workers would fall relative to real wages elsewhere,
thereby encouraging firms to hire in this region and
potentially restoring employment (though not income)
to its initial level. Alternatively, if workers were mobile, those who were laid off could move to other regions and get jobs there. Accordingly, Mundell concluded that it would be unwise to fix the exchange
rate between two regions (or countries) permanently
unless they either shared the same industries (implying that they would tend to experience similar shocks
simultaneously) or had substantial labor mobility between them.
Peter Kenen (1969) proposed a different criterion
for determining whether two regions should fix their
exchange rate permanently through monetary union:
industrial diversification. He argued that if two areas
both have a variety of industries, they might experience disparate d e m a n d or supply shocks but these
would not c a u s e severe u n e m p l o y m e n t b e c a u s e a
shock to a particular industry would affect only a fraction of either region's workers. In a highly diversified
region, those w h o were laid off could p r e s u m a b l y
switch to other industries within their own region,
without the necessity of moving to the other region. 10
Critics of European monetary union, such as Barry
Eichengreen (1990), emphasize that the mobility of labor across national borders is low in Europe, particularly in comparison with the mobility of labor between
different parts of the United States; they conclude that
currency union in Europe is dubious. More sanguine
observers, such as Kenneth A. Froot and Kenneth Rogoff (1991), point out that capital mobility, which is
high in Europe, especially now that capital controls
have been largely eliminated, may be a substitute for
labor mobility; laid-off workers may not have to move
to other regions to get jobs because capital equipment
can move to them, generating new jobs in different industries. Froot and Rogoff also point out that European ,
Economic Review
15
countries satisfy Kenen's diversity criterion. For example, Europe's auto industry is not concentrated in a
single center such as Detroit in the United States; instead, Europe has major auto producers in Germany,
F r a n c e , Italy, the U n i t e d K i n g d o m , and S w e d e n .
Charles R. Bean (1992) argues that Mundell's criterion
is not applicable because it assumes nominal wage
stickiness, but research indicates that real, not nominal, wages are sticky in Europe. He concludes that because real wages are sticky, exchange rate variability
buys very little stabilization in the European context.
nology. A positive demand shock caused by an increase
in the money supply would be expected to raise both
output and inflation, though in the long run economic
theory suggests that the effect on output would eventually fade away to zero. A positive supply shock caused
by the development of computers that made factories
more efficient would be expected to raise output but
lower inflation. In recent years, sudden rises in the price
of oil caused by OPEC decisions to limit oil exports
have often been cited as negative supply shocks to industrialized countries that rely heavily on imported oil.
Much of the research on the desirability of European monetary union has attempted to measure the
variability of economic shocks within Europe and to
compare them with some alternative. Stephen S. Poloz
(1990) studied real exchange rates (that is, exchange
rates adjusted for price level changes), which can move
around because of economic shocks even when the exchange rate itself is fixed by government action. Within
a country, regional real exchange rates can move as
well; when the price of oil soared around 1980, the resulting economic boom in oil-producing U.S. states
raised prices in general in areas like Texas, thus lowering the real purchasing power of a dollar there relative
to its value in other regions. Poloz found that regional
real exchange rates within Canada were more variable
than national real exchange rates in Europe. Considering that Canada has a single currency, he concluded
that the Europeans could have monetary union also.
However, Eichengreen (1990) has argued that Canada
is a poor standard for comparison because its regions
are so highly specialized in production. As an alternative, he calculated real exchange rate variability among
various large regions of the United States, finding that
variability within the country is substantially smaller
than variability among countries in Europe. He concluded that Europe is a poorer candidate for monetary
union than the various regions of the United States.
Using their model, Bayoumi and Eichengreen estimated the historical time series of aggregate demand
and supply shocks in each country." Taking Germany
as the anchor country, they found substantial positive
correlations between demand and supply shocks in core
countries (France, the Netherlands, Denmark, and Belgium) and similar shocks in Germany. They concluded
that monetary union makes much more sense for these
core countries than for the entire EC, as envisaged by
the Maastricht Treaty. Using similar techniques but different data, Joseph A. Whitt, Jr. (1993), concluded that
even the core European countries may not be good candidates for monetary union with G e r m a n y because
asymmetric demand shocks appear to be common.
Tamin Bayoumi and Eichengreen (1992) measured
the variability of shocks by estimating a vector autoregressive model (VAR) and then using a long-run restriction to identify the underlying shocks to aggregate
demand and supply. In a VAR model, at a moment in
time each included variable is a function of its own
lagged values and the lagged values of all the other included variables, plus a random error or shock term.
Bayoumi and Eichengreen estimated a model with
two variables, output growth and inflation. They assumed that movements in these two variables are induced by shocks to aggregate d e m a n d , caused, for
example, by changes in monetary policy, or shocks to
aggregate supply such as changes in production tech-
16
Economic Review
Another consideration is the lack of cross-country
fiscal transfer mechanisms in Europe. Xavier Sala-iMartin and Jeffrey Sachs (1991) have argued that the
United States has a successful monetary union in part
because the federal government, through its tax system
and various benefit programs, cushions to a considerable extent the impact of regional economic shocks. In
their view, if Europe moves to monetary union without
establishing such systems, regions experiencing negative shocks would face prolonged regional depressions
because exchange rate changes would no longer be
available to cushion the adjustment. Of course, there is
little evidence that existing fiscal transfers within European countries have solved regional problems: the difficulties of southern Italy or the coal-mining areas of
Britain come to mind. 1 2 Moreover, Bean (1992) has
countered that because cross-border labor mobility is so
limited in Europe, asymmetric shocks will simply result
in substantial differences in real wages; after all, the
Community exists now even though wages in Spain are
just over half the level in Germany. In addition. Bean argued that the immobility of labor across borders ensures
that national governments in Europe would have more
freedom to have independent tax and fiscal policies after monetary union than is possible for state governments in the United States. For example, Italy could
continue to choose to tax its prosperous northern re-
J anuary/February 1994
gions in order to finance aid to the depressed areas in
southern Italy without inducing a massive migration of
people and jobs from northern Italy into France.
While economic considerations were part of the
story, other motivations may have been more important to policymakers. One possibility is that for some
countries, notably France and Italy, monetary union
was seen as a way of further enhancing anti-inflation
credibility, thereby reducing interest rates and promoting economic growth. By the late 1980s, inflation rates
in France and Italy had fallen fairly close to German
levels; nevertheless, interest rates in both countries remained above German rates, at least in part because
investors demanded a risk premium for holding French
or Italian bonds, believing that at some time in the future, devaluation vis-à-vis the deutsche mark was possible. Monetary union would eliminate the possibility
of a future devaluation, thereby eliminating this source
of a risk premium in French and Italian interest rates.
Another possible motivation is the desire to reduce
the power of the Bundesbank over monetary policy in
other countries. As mentioned above, there is a widespread perception that Germany played the lead role in
the EMS and that other members were forced to subordinate their monetary policy goals to the actions of the
Bundesbank. With monetary union, monetary policy
would be determined by the European Central Bank,
which would have input from all members.
Whatever the motivation, in late 1991 the members
of the EC announced that they had reached agreement
on a timetable for European monetary unification. The
agreement became known as the Maastricht Treaty,
named for a city in the Netherlands where the final negotiations took place.
The Maastricht Treaty laid out a complex path to
monetary union. 13 The treaty contains various criteria
that countries are supposed to meet in order to qualify
for joining. The key criteria were intended to ensure
that only countries with low inflation, at least some history of exchange rate stability, and manageable budgetary situations would be able to participate in the
monetary union. In particular, a country's inflation rate
is supposed to be at most 1.5 percentage points above
the average of the three lowest inflation rates in the EC.
Also, a country is supposed to keep its exchange rate
within the narrow 2.25 percent EMS target band, with
no devaluations or revaluations, for a period of at least
two years prior to joining the union. With regard to the
budget, a country's overall budget deficit must be no
more than 3 percent of GDP, and the total stock of outstanding government debt must be no more than 60 percent of GDP. 14
Federal Reserve Bank of Atlanta
The rationale for having such criteria is to ensure
that only countries whose macroeconomic policies are
compatible with monetary union and a low-inflation
future are able to join. The inflation criterion requires
that high-inflation countries must take austerity measures and bring their inflation rates down before entering the union, not after. The exchange rate criterion
ensures that a country must have successfully demonstrated a commitment to exchange rate stability for
some time prior to monetary union. The budget deficit and government debt criteria reportedly reflect
German concerns that if countries with large deficits
or stocks of debt (such as Italy) enter the monetary
union, they would inevitably be tempted to favor inflationary policies for the union as a whole as a way of
reducing the real burden of their debts. Moreover, considering that national governments may be "too big to
fail," the European Central Bank might find itself under irresistible pressure to inflate rather than allow a
member government to default on its debt. 13
At the time that the Maastricht Treaty was signed
most EC members were in violation of one or more of
the criteria. The treaty provides a timetable that gives
such countries several years to alter their economic
policies in order to attain compliance. In addition, it
calls for a new institution, the European Monetary Institute, to be set up in 1994; it would administer the
EMS and also help coordinate monetary policies in the
various countries, but only in an advisory capacity.
By the end of 1996, according to the treaty, E C
governments must assess whether a majority of them
are in compliance with the various inflation and budget criteria and ready for monetary union; if so, the
qualifying countries could carry out monetary union
and the European Central Bank could take over monetary policy from their central banks as soon as policymakers chose.
If a majority is not ready in 1996, the treaty provides that those countries that meet the convergence
criteria will nevertheless move ahead to full monetary union no later than January 1, 1999; their central
banks will turn over monetary policy authority to the
new European Central Bank. The other countries may
join later, after they meet the convergence criteria.
Signs of Strain: The Lira and
Sterling Crises of 1992
In the first few months after the Maastricht Treaty
was announced, there was a widespread belief that the.
Economic Review
17
road to monetary union would be smooth; interest rate
differentials within Europe narrowed, and the E M S
exchange rate bands seemed under little pressure.
However, in June 1992 the financial markets were
stunned when the people of Denmark, voting in a referendum that was part of the ratification process, rejected the treaty. Even though Denmark is one of the
smaller members of the EC, its action had major consequences. The treaty had been written on the assumption that it would be ratified by all EC members; it was
uncertain whether it could take effect legally if even
one m e m b e r rejected it. Once the Danish rejection
heightened the possibility that monetary union might
be delayed or derailed, the doubts that already existed about whether certain countries would proceed
smoothly to monetary union were crystallized. The result was a currency crisis, as shaken investors pulled
out of currencies that were perceived to have a risk of
devaluation.
The British pound and especially the Italian lira
faced the most pressure. Several factors made Italy
vulnerable. One was its history of inflation and currency devaluation. During the last year before the crisis
(1991), Italian consumer prices rose 6.4 percent, compared with 3.5 percent in Germany. During much of
the 1980s, the differential was even wider, and as a result the lira was devalued relative to the deutsche mark
during a number of the EMS realignments of the early
and mid-1980s. Another factor was Italy's large budget deficit, which has been more than 10 percent of
G D P in recent years, far above the Maastricht Treaty's
limit of 3 percent. In addition, the currency crisis began at a time of political disarray: a national election
had occurred a few w e e k s earlier and a caretaker
g o v e r n m e n t was in office while Italian politicians
wrangled over the composition of a new governing
coalition.
In the case of Britain, pressure on the pound was
fueled by doubts that the British government would
raise interest rates to defend the pound at a time when
the British economy was just beginning to recover after two years of recession. With Germany raising interest rates to fight inflation, the British faced the
dilemma of raising rates also or allowing the pound to
drop out of the EMS, which Britain had joined less
than two years before.
The crisis came to a head in September 1992, just
prior to a French referendum on the Maastricht Treaty.
With public opinion polls showing a significant possibility that French voters would reject the treaty, expectations of an imminent EMS realignment resulted in
heavy pressure on the lira and the pound. On Septem-
18
Economic Review
ber 13 a limited realignment was indeed announced,
with the lira being devalued by 7 percent. The following day the Bundesbank lowered its discount rate with
the announced intention of easing the pressures on the
EMS, but market participants regarded the cut as too
little, too late; speculative pressures continued, requiring massive government intervention to maintain the
E M S exchange rate bands. On September 16 Britain
withdrew from the EMS and allowed the pound to fall;
very soon afterward, the Italian lira dropped out as
well, and the Spanish peseta was devalued 5 percent.
M e l t d o w n : The F r e n c h Franc
in Crisis, 1993
A few days after Britain and Italy dropped out of
the EMS, the French electorate voted in favor of the
Maastricht Treaty, but the margin was so narrow that
doubts about the treaty's eventual implementation remained. Moreover, the decline of the British pound
and Italian lira worsened the competitive position of
French industries, thereby boosting the pressure on the
French government to devalue also. Nevertheless, for
many months France maintained its pegged exchange
rate largely by keeping French interest rates well above
German ones most of the time. Chart 2 shows threemonth interbank rates in France and Germany during
1992 and 1993. At times, the French also used heavy
doses of intervention to keep the franc in its EMS target zone.
The franc came under especially severe pressure in
the weeks leading up to the French national election in
March 1993. Many market participants suspected that
despite c a m p a i g n p r o m i s e s to d e f e n d the f r a n c , a
newly elected government would renege and blame a
quick devaluation on the previous government. Once
the election was over, the incoming government restated its commitment to maintaining the franc, and for a
few weeks pressure in the markets eased substantially.
The Bank of France was able to lower interest rates
sharply from their pre-election levels, until by June
short-term French interest rates were slightly below
rates in Germany.
In July, pressure on the EMS returned as market
participants increasingly bet on the likelihood of some
kind of increase in the value of the deutsche mark. By
this time, Germany and much of the rest of the EC had
fallen into a recession, but the Bundesbank remained
concerned about Germany's continuing inflation. Most
EMS members were clearly hoping for German interest
J anuary/February 1994
rates to fall rapidly, thereby allowing other members to
cut interest rates as well and to stimulate their sluggish
economies without forcing an EMS realignment, but the
Bundesbank continued to cut rates slowly. The latest
economic data from Germany indicated that its recession might be bottoming out, and money growth was
above the Bundesbank's target range, bolstering the
likelihood that the Bundesbank would not take major
easing steps. At the same time, evidence of economic
sluggishness was mounting in France, thus increasing
the pressure for more stimulative policies there.
As pressure on the system mounted, France and
other EMS members raised interest rates while carrying out massive intervention to try to preserve their
parities with the deutsche mark. However, when the
Bundesbank failed to cut rates at its meeting on July 28,
reemphasizing its determination to keep German monetary policy focused on cutting German inflation and
not on preserving the EMS, pressure on the official exchange rate bands became overwhelming.
The following weekend (July 31-August 1) the EMS
was essentially suspended. Technically, no currency
was devalued, but the allowable bands were widened
dramatically, from plus or minus 2.25 percent before
the change to plus or minus 15 percent afterward. By
not changing the central rates, g o v e r n m e n t s could
avoid the embarrassment of devaluations while still
maintaining that the old exchange rates would be restored at some time in the future. One country, the
Netherlands, chose to retain its narrow band vis-à-vis
the deutsche mark; the Dutch currency has shadowed
the deutsche mark for a number of years and was never under much pressure during the crisis.
According to the Economist (August 7, 1993), the
Europeans considered several other options before settling on the 15 percent bands. Spain suggested abolishing the bands a l t o g e t h e r but got little support.
Germany initially suggested a smaller widening of the
bands, to 6 percent; this option had ample precedent
because Italy (for over a decade) and Britain (for two
years) had had 6 percent bands. However, France rejected the German proposal, fearing it would be too
vulnerable to market pressures. The French proposed
allowing the deutsche mark to float while all the other
currencies maintained the narrow bands. Because of
the large size of the French economy, this proposal
would have made the French franc the dominant currency in a shrunken EMS, but it was rejected by Belgium and the Netherlands, which insisted on retaining
links to the deutsche mark.
Chart 2
Interest Rates in France and Germany
(Weekly
Data:
1992-93)
Yield
12
\A
k L
\
10
EMS b a n d s
widened
dramatically
V
Germany
8
Britain, Italy leave EMS
^ ^ ^
K
•
/
6
4
—
French National
Elections
11| 1111| 1111|1111| 111]1111| || 11; 1111 [ IHIimiMllllMIHMII
I
M l i m i l l l l l l l l ! M 11 Ml 111 ! Il 11IH 111 '
1992
1993
1994
Source: Three-Month Interbank Rate, Board of Governors of the Federal Reserve System.
Federal Reserve Bank of Atlanta
Economic Review
19
In the days following the widening of the target
bands, the French franc and the other currencies with
wider bands dropped versus the deutsche mark, but
only modestly; as shown in Chart 3, the French franc,
Belgian franc, and Danish Kroner all remained for the
most part less than 5 percent below their previous lower limit, and well above their new lower limits. All
three countries remained cautious about lowering their
interest rates, despite sluggish economic conditions, in
order to avoid a sharper decline of their currencies. By
contrast, when the British pound and Italian lira suspended participation in the E M S entirely in 1992,
those currencies quickly dropped more than 10 percent
below their previous lower limits. As of this writing,
the widened target bands have not yet been challenged
seriously by market participants; all of the currencies
that have the wider bands have not only remained
above their new lower limits but in many cases moved
back inside their previous narrow target bands.
Alternative Explanations of
Strain in the EMS
The turmoil that struck the EMS during 1992 and
1993 has several alternative explanations: incompatible policies in the devaluing countries, self-fulfilling
speculative attacks, and German unification. Moreover, given the number of countries involved, the same
explanation does not necessarily apply to all.
Incompatible Policies in Devaluing Countries.
One possibility is that the devaluing countries were pursuing policies that were basically incompatible with
eventual monetary union without any more exchange
rate realignments. Even before the turmoil began, some
observers such as Froot and Rogoff (1991) argued that
the strategy of announcing monetary union as an eventual goal while allowing a prolonged and uncertain
preparation period before deciding on the final exchange rates was subject to a credibility problem because governments might be tempted to carry out one
last realignment before unifying their currencies. In the
absence of capital controls, turmoil in the markets
would feed on any indication that such a realignment
was imminent. In particular, governments with heavy
debt burdens (for example, Italy and Belgium) would be
likely candidates for devaluation as a way of cutting the
real value of the debt before currency union constrained
the ability of such governments to inflate it away.
The departure of Italy and Britain from the EMS in
1992 is consistent with Froot and R o g o f f s analysis:
20
Economic Review
Italy's record of inflation, its large continuing fiscal
deficit, and its current account deficit made it an obvious candidate for devaluation. In the case of Great
Britain, the severity of its recession (possibly reflecting its entry into the E M S at an unrealistically high
real exchange rate) and the recentness of its entry into
the E M S probably w e a k e n e d the credibility of its
commitment to remaining in the system. France is another story, however.
When the crisis began, the French currency's parity
with the deutsche mark had been maintained successfully for some years, since the realignment of early
1987. The French inflation rate was lower than Germany's, and its current account was in surplus. The
French budget was in fairly good shape; indeed, in
1992 France was the only major EMS member that
was in compliance with both fiscal policy criteria set
out in the Maastricht Treaty (Willem Buiter, Giancarlo
Corsetti, and Nouriel Roubini 1993, 64). Competitiveness of French industry, as measured by unit labor
costs relative to G e r m a n y ' s , showed no signs of a
problem for France (see Eichengreen and Wyplosz
1993, 73). Despite these favorable macroeconomic indicators, the franc came under severe pressure in 1992
and 1993, requiring massive intervention, ultimately to
no avail. 16
The main factor that seemed to be weighing on the
French currency was the economic slowdown and the
accompanying rise in unemployment, which was generating political pressure for doing something to stimulate the economy. The most common prescription was
looser monetary policy, but, given the EMS, French
monetary policy was constrained by the high interest
rates available in Germany.
On many occasions, the French (and others) urged
the Bundesbank to loosen up, in the hope that such a
shift would allow France to loosen as well. Other tactics may also have been used to nudge the Bundesbank
toward ease. According to Eichengreen and Wyplosz
(1993, footnote 35), in October 1991 French short-term
interest rates were cut below German levels in the hope
that the Bundesbank would lower rates as well, but the
Bundesbank failed to budge and the French were soon
forced to back down. Another nudge may have occurred in June 1993, when French interest rates were
again lowered below German ones but failed to elicit
any substantial change of Bundesbank policy. Instead,
the t e m p o r a r y French m o n e t a r y e a s i n g may have
helped undermine the credibility of France's commitment to maintaining its exchange rate peg.
Denmark is another difficult case. Although Danish
voters initially rejected the Maastricht Treaty, thereby
January/February 1994
Chart 3
Key EMS Exchange Rates
O l d Floor vs.
(Weekly
Data:
1992-93)
G e r m a n Mark = 1 0 0
110
105
100
95
90
85
80
75
1992
1993
1994
Source: Computed by the Federal Reserve Bank of Atlanta from Board of Governors of the Federal Reserve System data.
precipitating the E M S crisis in 1992, they later approved a slightly modified version. In any event, their
rejection appears to have reflected a protest against
various trends in the EC, not specific opposition to
currency union. 1 7 Economic indicators showed little
sign that the Danish exchange rate was out of line.
Danish unit labor costs were little changed from 1987
to 1992 relative to a multilateral index of its trading
partners, and relative to Germany its unit labor costs
were actually felling during the two years prior to the
crisis (Eichengreen and Wyplosz 1993, 72). In terms
of fiscal policy, the budget deficit was well below the
Maastricht limit, and the level of debt was only modestly above its guideline (Buiter, Corsetti, and Roubini 1993, 64). The current account was solidly in
surplus.
Another reason to doubt that French and Danish
policies were incompatible with monetary union is
provided by the behavior of their currencies in the
months following the widening of their fluctuation
bands. As shown in Chart 3, just a few months after
the widening these two currencies floated back above
their old lower limits. By contrast, as of the end of
Federal Reserve Bank of Atlanta
1993 the British and Italian currencies were still well
below their old lower limits.
Self-Fulfilling Speculative Attacks. If economic
fundamentals in France and Denmark do not explain
why their currencies were under pressure, what does?
Policymakers in France have decried "Anglo-Saxon
speculators," who supposedly bet against the franc and
forced its downfall. Leaving aside the nationality of
the speculators, there are various economic models of
speculative attacks. Paul Krugman (1979) and Robert
P. Flood and Peter M. Garber (1984) showed that if
government policies and economic fundamentals are
inconsistent with maintaining an exchange rate peg in
the long run, severe pressure on the peg can develop
even when a government still has substantial foreign
e x c h a n g e r e s e r v e s . T h e basic idea is that r a t h e r
than w a i t i n g f o r the g o v e r n m e n t ' s r e s e r v e s to run
o u t through a gradual p r o c e s s of current a c c o u n t
deficits, speculators will attack the currency through
massive capital outflows as soon as the amount of resources at their command is large enough (relative to
the governments' reserve holdings) to give them the
ability to force a devaluation. These models may help
Economic Review
21
explain the British and Italian cases, but, as discussed
earlier, France and Denmark had current account surpluses, and their other economic fundamentals did not
seem to necessitate devaluation.
Another possibility that is more in line with the
complaints of French policymakers is the notion of
self-fulfilling speculative attacks. Maurice Obstfeld
(1986) has shown that if monetary policy is altered
following a speculative attack, then the attack may become self-fulfilling in terms of inducing devaluation
even though prior to the attack there was no need to
devalue. Eichengreen and Wyplosz (1993) argued that
the convergence criteria in the Maastricht Treaty created the preconditions for self-fulfilling speculative attacks. In particular, the treaty requires that prospective
members of the European monetary union maintain a
stable exchange rate for at least two years prior to
joining. For a country struggling to maintain tight
monetary policies in order to qualify for monetary
union, a speculative attack would disqualify it, thereby
eliminating the rationale for tight policies. The government would respond by loosening policy, thus necessitating a devaluation that would not have occurred
without the speculative attack.
A weakness of the explanation that is based on selffulfilling speculative attacks is the failure of the EMS
to break apart sooner, especially as capital controls
were phased out in the late 1980s. In the case of France,
interest rate differentials show that the markets perceived a substantial risk of devaluation throughout
the late 1980s. According to Francesco Caramazza
(1993), the nominal interest differential on twelvemonth Eurofranc and Euromark deposits was over 4
percent throughout 1987, fell sharply but remained
above 2 percent in 1988, and remained above 1 percent until late 1990. Nevertheless, there was only one
EMS realignment in these four years—a modest revaluation of the German mark, Dutch guilder, and Belgian f r a n c in January 1987. Moreover, as Rudiger
Dornbusch (1993, 133) has argued, contrary to Obstfeld's theoretical scenario Italy's government did not
loosen policy sharply after w i t h d r a w i n g f r o m the
EMS. In fact, it took more steps toward satisfying the
Maastricht criteria after withdrawing than before. Nevertheless, Italy's currency still dropped immediately
after withdrawing, and as of December 1993 it remained well outside its old target band (see Chart 3).
Fallout from German Unification. There is one
other explanation of the crisis of the EMS: the economic shocks resulting from German unification. Almost overnight, West Germany expanded its territory
by about one-third and its population by one-quarter.
22
Econom ic Review
By (West) German standards, the capital stock, infrastructure, and productivity level in the newly incorporated area were very low. Almost immediately, the
German government began spending large sums to improve roads and other infrastructure in the East, as
well as large amounts on various types of subsidies designed to discourage East Germans from migrating en
masse to the West.
Early on, various economists argued that German
unification would create pressures for deutsche mark
appreciation, at least in the short run. For example,
Lewis S. Alexander and Joseph E. Gagnon (1990),
Paul R. Masson and Guy Meredith (1990), and Horst
Siebert (1991) emphasized the effects of an investment
boom; with plenty of educated workers but little capital in the former East Germany, rates of return on
investment there should be high, thus prompting a
capital inflow into Germany that would push up the
deutsche mark. 18 Taken as a whole, Germany's future
output would be considerably larger than its current
output; rather than squeezing domestic consumption to
finance the investment in the East, at least part of the
investment would be financed by borrowing abroad.
The counterpart to the foreign borrowing would be a
swing toward deficit in Germany's current account.
Begg and others (1990) emphasize the competitive
advantages that West Germany has, being a traditional
exporter of capital goods located on the doorstep of
Eastern Europe (and with special ties to the former
East Germany to boot). Given these advantages, a disproportionate share of the new investment spending in
the East should fall on West German goods rather than,
for example, French or American products. Accordingly, demand for deutsche marks to pay for these
goods would rise relative to demand for other currencies, implying upward pressure on the deutsche mark
in foreign exchange markets.
An alternative and complementary interpretation
focuses on the consequences for the deutsche mark of
the major shift toward fiscal ease that occurred in Germany at the time of unification. Warwick J. McKibbin
(1990) has provided simulations showing that without
a realignment other E M S m e m b e r s would have to
tighten monetary policy considerably and endure an
economic slowdown; the slowdown would be moderated considerably if the other EMS members allowed
their currencies to depreciate versus the deutsche mark.
More recently, William H. Branson (1993) argued that
the fiscal expansion put upward pressure on German
interest rates, which in turn raised the equilibrium
value of the deutsche mark. For a time the lack of an
E M S realignment held the deutsche mark below its
J a n u a ry/Fe bru a r y 1994
new equilibrium, but the shock was so large that eventually the E M S c a m e apart. In his view, the same
mechanism explains the rise of the U.S. dollar following the shift to fiscal ease in the United States in the
early 1980s. 19
To a considerable extent, the early projections of
the economic impact of German unification turned out
to be correct. As government spending in East Germany soared, the German budget deficit ballooned as
well. Aggregating the various levels of the German
government, including the state-owned postal and railway systems, plus the Treuhandanstalt agency, which
took over many failing East German enterprises, the
overall deficit increased from approximately zero in
1989 to 5 percent of (West) German G D P in 1992.
Moreover, as of May 1993 the 1993 deficit was projected to rise to about 6 percent of G D P (Organisation
for Economic Cooperation and Development [OECD]
1993, 76). For comparison, the general government
deficit rose somewhat less in the United States during
the early 1980s, from 1 percent of G D P in 1980 to 3.4
percent in 1985 (see OECD 1992, 214).
The current account also moved dramatically toward deficit. In terms of dollars, Germany went from a
$58 billion surplus in 1989 to a $26 billion deficit in
1992. The total swing was $84 billion, about half as
large as the $161 billion swing in the U.S. current account from 1980 to 1987. Measured as a fraction of
each nation's GDP, the German swing was actually
larger than in the U.S. case: the German current account moved from a surplus of 4.9 percent in 1989 to a
deficit of 1.4 percent in 1992; for the United States,
the current account deficit was approximately zero in
1980 but peaked at 3.6 percent of G D P in 1987.
Such large c h a n g e s in G e r m a n m a c r o e c o n o m i c
conditions could have been expected to put pressure
on exchange rates. In the case of the United States in
the 1980s, the value of the dollar rose sharply—about
50 percent—between 1980 and 1985, falling to roughly its initial level over the next several years. 20 In the
G e r m a n case, by contrast, the impact on exchange
rates was constrained for several years by the refusal
of European governments to realign the E M S parities.
The deutsche mark was able to rise somewhat versus
outside currencies, dragging the other EMS members
along. For example, in the first quarter of 1992 (just
prior to the onset of the EMS crisis) the deutsche mark
was up about 14 percent versus the U.S. dollar from its
1989 average. On a trade-weighted basis, however, the
deutsche mark was up less than 5 percent. 21
Writing after the initial crisis that focused on Britain
and Italy but before the events of the summer of 1993,
Federal Reserve Bank of Atlanta
B r a n s o n ( 1 9 9 3 ) , D o r n b u s c h ( 1 9 9 3 ) , and R i c h a r d
Portes (1993) all focused on Germany, especially its
shift in fiscal policy, as the prime source of strain in
the EMS. The main caveat in the story, as noted by
Eichengreen and Wyplosz (1993), is the question of
timing: the unification of Germany and the shift in fiscal policy were well under way in 1990, and yet the
crisis did not develop until 1992. Exchange markets,
like stock markets, are forward-looking and react immediately to news, but in this case the reaction seemed
to be delayed for more than two years. 22
There may be various explanations for the apparent
delay. The main one is that the full extent of the shift in
German policy and the current account did not become
clear overnight. For example, an OECD Economic Survey released in June 1991 showed that the German government was planning for the federal deficit to peak at
70 billion DM in 1991, falling to 41 billion in 1993 and
31 billion in 1994 (1991, 71). However, since then the
outlook has dimmed considerably. A recent report by a
major German bank projects federal deficits of 68 billion D M for both 1993 and 1994. The turnaround in
the current account was also much larger than suggested in early projections. For example, Alexander and
Gagnon (April 1990) projected a $15 billion worsening
in the current account for 1992, with the largest decline
being $29 billion in 1998. The actual decline has been
much larger. As noted earlier, in 1992 the current account was down $84 billion from its 1989 level.
Another factor may have been uncertainty arising
from the Iraqi invasion of Kuwait and the ongoing
turmoil in the Soviet Union, which culminated in the
fall of Mikhail Gorbachev, his replacement by Boris
Yeltsin, and the move to independence by the nonRussian republics in late 1991. During this period,
substantial numbers of Soviet troops were still at bases
in the former East Germany, and a reversal of the Soviet policy of withdrawing from Germany (had it occurred) would have had major political and economic
consequences for Germany. Accordingly, market participants may have hesitated to bet too heavily on the
deutsche mark during 1990 and 1991.
Conclusions a n d Implications f o r the
Future of European Monetary Union
What does the recent EMS crisis tell us about the
feasibility of pegging e x c h a n g e rates when capital
flows are unrestricted? If self-fulfilling speculative attacks were the source of the crisis, then some sort of-
Economic Review
23
restriction on capital flow seems necessary for exchange rates to be pegged. 23 However, in this author's
view the evidence points to the shocks resulting from
German unification as the main source of strain, with
speculative attacks playing a supporting role. Incompatible policies in Britain and Italy also contributed,
making an eventual realignment almost inevitable. The
fairly smooth operation of the E M S during the late
1980s, even after most restrictions on capital flows
w e r e lifted, suggests that in the absence of m a j o r
asymmetric shocks such as German unification, exchange rates can be pegged, at least for some time.
In the longer run, of c o u r s e , pegged e x c h a n g e
rates break down if there is not a considerable degree
of e c o n o m i c c o n v e r g e n c e , especially on inflation
rates. Even when the E M S appeared to be working
smoothly, its long-run stability was questionable because Italy, for example, had an inflation rate significantly higher than most other members. Accordingly,
the implicit decision after 1987 to rule out all realignments when economic convergence had not yet
been achieved was misguided.
As for the future, if shocks on the scale of German
unification are unlikely in the next few years, then perhaps the Maastricht Treaty's goal of monetary union by
the end of the decade is still attainable. Absent a huge
expansion of the community's aid programs for poorer
regions and countries or an unlikely increase in labor
mobility, areas that suffer adverse economic shocks will
need some flexibility of real wages to avoid prolonged
recessions. Moreover, the recent crisis highlights the
difference between pegged exchange rates and a true
common currency. No matter what promises governments may make, as long as different currencies are in
circulation, there is a possibility that economic or political shocks may result in exchange rate changes. By
contrast, if a true common currency is in use, exchange
rates can be changed only by introducing new currencies, a much more complex and disruptive undertaking. 2 4 Accordingly, monetary union should involve
replacing national currencies with a single European
currency, not merely announcing that exchange rates
within Europe will be pegged permanently with no fluctuations allowed, as some have suggested.
In recent months, the ratification process for the
Maastricht Treaty has been completed; accordingly, as
a legal matter those members of the EC that meet the
convergence criteria are committed to going ahead
with monetary union no later than January 1, 1999.
Nevertheless, an enormous amount of uncertainty continues regarding the timing of monetary union and
about the identities of the participating countries. To
shrink the lengthy period of uncertainty that invites
turmoil in the foreign exchange markets, it would be
desirable for those countries that meet the convergence criteria to move ahead to monetary union earlier. The treaty itself allows for an earlier union but only
if a majority of members are ready by the end of 1996.
Because this condition appears unlikely to be met, the
treaty itself is an obstacle to earlier union. Moreover,
the period of uncertainty might continue into the next
century because it is possible that none of the EC members will satisfy all the treaty's criteria for union by the
deadline of January 1, 1999.
Most likely, monetary union could occur late in this
decade, but with a number of members left out—probably Britain, Italy, Greece, and Portugal, and possibly
Spain, Belgium, and Ireland. With so many countries
not included, particularly Britain and Italy, and Germany expanded by its unification with the East, the
new monetary union would probably be even more
dominated by Germany than the EMS. France in particular may be unwilling to subordinate its monetary
policy to Germany's in such a limited union; however,
it may nevertheless go ahead in the belief that being in
the union and having some representation on the board
that determines monetary policy for Germany and the
rest of the union is better than being on the outside,
with no representation (see Portes 1993).
In short, the transition from the EMS to European
monetary union is proving to be far more difficult than
politicians realized when they signed the Maastricht
Treaty in late 1991. Additional turmoil is likely at
least as long as it remains uncertain which countries
will end up unifying their currencies, and at what exchange rates.
Notes
1. The experience of the French economy in the early 1980s is
r e v i e w e d in S a c h s and W y p l o s z (1986) and M u e t and
Fonteneau (1990).
24
Economic Review
2. Gardner and Perraudin (1993) perform a VAR analysis of
daily interest rates from October 1987 to August 1992, thus
covering pre- and post-German unification periods. Split-
J a n u a r y / F e b r u a r y 1994
ting their sample into various subperiods, they find that
French interest rate innovations usually have a significant
effect on German rates, though it is smaller than the German effect on French rates. The exception is 1990, the year
just after the Berlin Wall fell, when France was predominant.
percentage points above the average long-term interest rate
in the three countries having the lowest inflation rates in the
EC. Presumably a country with some combination of current or expected inflation and budgetary or other circumstances that generated a large risk premium on its long-term
government debt would violate this criterion.
3. Some of the smaller countries were allowed to retain capital
controls somewhat longer: Spain and Ireland had a deadline
for abolition at the end of 1992, and Portugal and Greece
could retain controls until 1995.
4. Technically, the United Kingdom had been a member of the
EMS since its founding; it deposited part of its reserves in
the European Monetary Cooperation fund in exchange for
ECUs, and sterling was a component of the basket of currencies defining the ECU. However, the United Kingdom
did not officially join the system of exchange rate bands until October 8, 1990, and even then it chose to have wide 6
percent bands like those of Italy during the system's first
decade (see Ungerer and others 1990, 4).
15. The phrase "too big to fail" originated in discussions of the
U.S. banking system; it is sometimes argued that certain
banks are so large that their failure would inevitably destabilize the entire banking system, thereby making regulators
unwilling to close them even when by normal criteria such
action would be in order. Some observers think that a European Central Bank would face similar pressures if one of its
member governments had difficulty paying its debt.
5. Spain joined the EMS on June 19, 1989, with a 6 percent
exchange rate band like Italy's (see Ungerer and others
1990, 94).
6. For a contrary view on the need for a deutsche mark revaluation, see Gros and Thygesen (1992, 192-96).
7. The existing EMS had already constrained the ability of
most central banks, except perhaps the German Bundesbank, to conduct independent monetary policy, but monetary union would completely eliminate independent monetary policies.
-
8. For a review of the literature on exchange rate variability
and international trade, see Kumar and Whitt (1992).
9. A less sanguine appraisal of coordinated policymaking is
provided by Rogoff (1985), who argued essentially that if
policy is set cooperatively, governments have weaker incentives to avoid inflation; the private sector reacts by anticipating higher inflation, with negative consequences for
social welfare. The literature on international policy coordination is reviewed in Espinosa and Yip (1993).
10. McKinnon (1963) has proposed a third criterion: openness.
In his view, countries that trade heavily with one another
are good candidates for monetary union because exchange
rate changes are more disruptive than would be the case if
their trade was on a small scale. By this criterion, the members of the E C are good candidates for monetary union.
11. Blanchard and Quah (1989) showed that by using a longrun restriction—namely, that demand shocks have zero
long-term impact on real variables such as output or unemployment—it is possible to decompose the estimated shocks
from the V A R into the u n d e r l y i n g d e m a n d and supply
shocks.
12. De Grauwe and Vanhaverbeke (1991) have provided statistical evidence that labor mobility between regions of the
same EC country is much lower in Spain and Italy than in
northern European countries such as France, Germany, and
the United Kingdom.
13. Key provisions of the Maastricht Treaty are discussed in
Bean (1992) and Kenen (1992).
14. Another criterion requires that the interest rate on a country's long-term government debt must not be more than 2
Federal Reserve Bank of Atlanta
16. Mussa and Isard (1993, 147) also stated that macroeconomic developments did not indicate a need for devaluation by
France, or by Denmark, yet both currencies (as well as others) came under attack in 1992 and again in 1993.
17. According to the New York Times (June 3, 1992, 3), opposition to the treaty centered on fears that Denmark would be
dominated by Germany and a French-speaking bureaucracy
in Brussels. In addition to its provisions on monetary union,
the Maastricht Treaty calls for movement toward common
foreign and national security policies for all members, as
well as g r e a t e r c o m m o n a l i t y of p o l i c i e s on m i n i m u m
wages, working hours, and the like.
18. For example, Alexander and Gagnon (1990) estimated in
their principal simulation that German unification would
cause the deutsche mark to appreciate immediately by 7.8
percent versus the U.S. dollar. As the East German capital
stock expanded, the deutsche mark would fall back, but it
would still be above its initial level at the turn of the century.
19. In the long run the effect is quite different: to service the foreign debt accumulated during the period of fiscal ease, the
currency must eventually fall below its initial level to generate the increase in net exports required for current-account
balance. Similarly, the simulation in Masson and Meredith
(1990) shows the real effective exchange rate of the deutsche
mark falling below its initial level around the turn of the century. Using a different model, Wyplosz (1991) also found
that the deutsche mark would depreciate in the long run, but
his results were ambiguous in the short run.
20. As measured by the nominal effective exchange rate in the
IMF's International Financial
Statistics.
21. On a real or inflation-adjusted basis, the IMF calculates a
somewhat larger but still limited rise of 8.5 percent from
1989 to the first quarter of 1992.
22. Eichengreen and Wyplosz (1993, 54) also argued that by
"the time the crisis erupted, most E M S countries had successfully carried out the changes in relative prices and costs
required to maintain their E M S parities."
In this author's view, this conclusion is questionable.
Focusing on France, their Figure 7 suggests that relative to
Germany, France's unit labor costs fell 2 to 4 percent from
the announcement of German unification (sometime late in
1989 or early in 1990) to early 1992, just prior to the onset
of the exchange crisis. The decline in French labor costs
was a move in the right direction, but if German unification
was an economic shock comparable in size to the shifts of
Economic Review
25
the early 1980s, then a much larger decline may have been
needed. For comparison, between 1980 and 1985 German
unit labor costs fell 4 0 percent vis-à-vis the United States;
see U.S. Department of Labor (1993, Table 10).
23. Eichengreen and Wyplosz (1993, 120-22) advocate a socalled Tobin tax on transactions in foreign exchange to dis-
courage speculative capital flows that in their view make
pegged exchange rates untenable.
24. An example of creating new currencies has occurred recently in parts of the former Soviet Union, where various newly
independent republics are ceasing to use the ruble.
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Economic Review
27
eview Essay
Selected Finance and Trade
Reference Books on Latin America:
An Update
jerry j. Donovan
The reviewer is the research
librarian in the Atlanta Fed's
research library. He is grateful
to a number of people who
assisted in making
available
and evaluating the publications reviewed in this article.
Particularly helpful were
Marian P. Francois,
Information Specialist, the Overseas
Private Investment
Corporation (OP/C) Library,
Washington, D.C.; the staff of the Joint
World
Bank-International
Monetary Fund Library, Washington, D.C.; as well as Joe
Whitt, Roberto Chang, and
Michael Chriszt of the Atlanta
Fed's research
department.
28
Economic Review
ollowing years of debt crisis and economic stagnation, much of
Latin America has recently achieved political stability, privatization, and other economic progress, including the amelioration of
inflation. Such successes have moved U.S. investors and others
engaged in import/export trade to take advantage of the area's
rapid growth over the past few years. U.S. Commerce Department aggregate
data on U.S. exports to Latin America point up this burgeoning economic activity. Data on selected principal Latin American trading partners during the
1988-93 period illustrate the point vividly: hefty gains for U.S. exports are
clear in the aggregate and by country for the five-year period (see Table 1).
This essay is devoted to reference books that are about, or include, information on foreign investment and trade with Latin American countries. It
updates earlier reviews of reference titles devoted to or including Latin
American investment and trade information appearing in four previous articles in the Economic Review. The first article in the series in particular referred to numerous worldwide directories and compendia including sections
on Latin America and Latin American countries. 1
The current discussion focuses upon seven additional reference publications, two of which are new. One title, the Statistical Abstract of Latin
America (SALA) series from UCLA's Latin American Center, has been men-
J a n u a r y / F e b r u a r y 1994
tioned before; it emphasizes sources f o r statistical
data. T h e s e titles, together with those reviewed in
the earlier articles, provide a useful checklist for researchers in foreign trade, finance, and public policy,
as well as for academicians and librarians who seek
information sources for Latin America. A bibliographical essay that focuses on periodical literature of the
same region will appear in a future issue of the Economic Review.
International Historical Statistics: The
Americas,
1750-1988, by B.R. Mitchell (New York: Stockton
Press, 1993; 2d ed.) is a monumental collection of retrospective statistics for both North and South America. 2
The author is a fellow of Trinity College, University of
Cambridge, where he lectures in the Economics Department. T h e objective of the book is to provide
economists, historians, and policymakers, as well as
other members of the academic, government, and business communities, statistical data suitable for crosscountry studies. An attempt is made to ensure the best
possible comparability of the statistics and to facilitate
the identification of sources and access to them. The
volume is replete with explicit notes on credibility of
the source material.
Although the title implies that the book provides
statistics from 1750 through 1988, it will come as no
surprise that data for the earlier years, which cover only
population, are sketchy and not rigorously comparable.
For instance, Table A l , "South America: Population of
Countries" (total population by sex) shows data from
eighteenth-century censuses by actual years, detailing
information about data sources. On the other hand, in
Table A4, "South America: Population of Major Cities,"
the first column is titled "cl750," with footnotes as needed to document actual years the data were recorded.
The engaging introduction of International
Historical Statistics: The Americas, 1750-1988 emphasizes
the increasing recognition of historical statistics as
" m a j o r raw material" for the study and planning of
economic growth and development. It also observes
that "numbers begin to attain a level of subtlety and
precision beyond that of words." 3 Without belaboring
a warning against "careless and casual use [of statistical dataj over time and between countries," Mitchell
d e s c r i b e s pitfalls e x i s t i n g f o r the u n w a r y , u r g i n g
thoughtful skepticism. (Consider, for example, whether
data were actually by-products of a military preparedness program for which men may have misrepresented
their true age to avoid conscription so that the age distribution of the male population is biased.) Other introductory information includes a three-page list of
Federal Reserve Bank of Atlanta
official national statistical sources that have been most
often cited, weights and measures conversion ratios,
and symbols used in the text.
The statistical tables constituting the body of the
text are arranged in ten broad subject divisions designated A through J, with major groups within each. The
number of groups ranges from two, in "Table I, Education" ("Pupils and Teachers in Schools" and "Students
in Universities"), to twenty-five in "Table D, Industry"
(which includes "Indices of Industrial Production" as
well as imports and exports of coal, petroleum, and
iron ore, by main trading countries). 4
The tables in International Historical Statistics mirror the demographic and socioeconomic evolution in
Western Hemisphere nations and the growth in importance of numerical records for national and international purposes. The tables reflect how national censustaking began and developed in Latin America and became important for cross-country c o m p a r i s o n s . In
1945 the newly founded United Nations took up the
task begun by the League of Nations of collecting and
publishing uniform national and international statistical data, which have proved extremely useful for policymakers, economists, and financiers in the last halfcentury. Mitchell surveys an abundance of these data,
especially in tables for external trade, finance, and national accounts, for which he draws on sources like the
International Monetary Fund's International
Financial
Statistics and the International Labour Organization's
Yearbook of Labour Statistics. Other sources include
the United Nations' Educational, Scientific, and Cultural Organisation (UNESCO) and the United Nations
Food and Agricultural Organisation (FAO), as well as
the League of Nations. A useful addition to this volume would be a complete list of international organizations whose statistical publications have been cited.
Admittedly, many of the modern data in International Historical Statistics are available in machinereadable format and might be profitably downloaded
for computerized calculation and study. At the same
time, even those with the most advanced computational technology at their disposal will probably find the
volume (and others in its set) useful; the compendium
will be a strong resource in libraries and research units
where quantification is a concern in economics, public
policymaking, and history.
The Statistical Abstract of Latin America
(SALA)
(Los Angeles: UCLA Latin American Center; annually;
began 1955) is a cornerstone for building a reference
collection of Latin American statistical data. SALA 28
(28th ed., 1990) was reviewed and recommended in an
Economic Review
29
Table 1
U.S. Exports to Latin America, 1988-93
(Millions of
1988
1989
1990
1991
1992
1993a
Percent C h a n g e
Since 1 9 8 8
Total
43,859
49,080
53,930
63,441
75,799
78,476
78.9
Mexico
Brazil
Argentina
Venezuela
Colombia
Chile
20,628
4,266
1,054
4,612
1,754
1,066
24,982
4,804
1,039
3,025
1,924
1,414
28,279
5,048
1,179
3,108
2,029
1,664
33,277
6,148
2,045
4,656
1,952
1,839
40,592
5,751
3,223
5,444
3,286
2,466
41,635
6,045
3,771
101.8
41.7
257.8
3,229
84.1
Country
a
Dollars)
—
_
—
Preliminary
Source: U.S. Department of Commerce, U.S. Foreign Trade Highlights 1992; U.S. Merchandise Trade Report for December 1993 (FT900).
earlier essay. The edition now at hand, SALA 30 (Volume 30, Parts 1 and 2, 1993), warrants additional comment here as the latest in the SALA series. 5
Comprehensive and detailed, SALA 30 is a statistical reference for current and historical data on the
twenty "standard definition" Latin American countries. 6 Data typically are gathered from international
agencies, permitting uniformly defined cross-country
comparisons. Time series typically range twenty or
more years depending upon the subject matter of the
tables.
Part 1 of Volume 30 consists of seven sections that
coalesce sets of related statistics by country: geography and land tenure; transportation and communication; p o p u l a t i o n , h e a l t h , e d u c a t i o n , and w e l f a r e ;
politics, religion, and the military; working conditions
and migration; illegal and legal industry; and the concluding section, which contains three scholarly articles
of potential interest to public policymakers, economists, and demographers, among others. 7 For example,
the first of these—"United States Foreign Assistance
to Central America, 1946-89: A Tool of Foreign Policy," by Christof Anders Weber—presents data on U.S.
foreign assistance to the Central American countries, focusing particularly on the case of aid to El Salvador. 8
Weber provides abundant scholarly documentation in
his article, and the titles of its data tables are included
in the general index at the end of the volume. 9
Part 2 of SALA 30 has five sections (Parts VIIIXII), continuing the format of sets of related data.
These data sets cover mining, energy, and sea and
30
Economic Review
land transportation; foreign trade; financial flows; national accounts, government policy, and finance; and
prices. The final section presents two articles about
development of (inferences f r o m ) the data: "Food
Production in Latin America, 1952-90," by Maureen
D e L u c c a , and " M e x i c o ' s ' L o s t D e c a d e , ' 1980-90:
Evidence on Class Structure and Professional Employment from the 1990 Census," by David E. Lorey
and Aida Mostkoff Linares.
The data series presented throughout both parts of
SALA 30 offer abundant topics, some of which go well
beyond the socioeconomic data one might expect. For
example, there is a table for " M a j o r Earthquakes in
Latin America, 1797-1992" (Table 125), which begins
with the February 4, 1797, Quito, Ecuador, earthquake
that took 41,000 lives.
Footnotes to SALA tabular data can be used as an
index to both exotic and routine data sources. The
most frequently cited sources are itemized on the inside covers of both parts of SALA 30, providing easyto-use survey tools for identifying relevant statistical
agencies.
Nonetheless, annoying editorial and production
problems plague SALA 30. Sloppy bibliographical and
organizational detail in the volume mar access to its
content. And there is a lack of logic behind the hierarchical use of "part" and "chapter" that is confusing
and results in time lost trying to grasp the flow of substantive information—for example, the fact that the
word part is used both for physical volumes and for
section headings at groups of related tables. Wrongly
J a n u a r y / F e b r u a r y 1994
paginated entries in the table of contents in Part 1 are
particularly bothersome, as is the mistaken designation
of " G e o g r a p h y " as Chapter 30 when it is actually
Chapter 1. Further, the table of contents shows the
years covered by Weber's study on U.S. foreign assistance as beginning with 1956 while it actually dates
back to 1946, a mistake that could be costly to researchers. (The fifty-two year time series in the article,
however, are no less welcome.)
Despite thesee problems, the SALA series traditionally has been, and continues to be, a formidable array
of official and unofficial statistical data on many Latin
American phenomena. It should continue to prove useful for quantitative research in banking and finance,
marketing, and the export/import trade. Economists
and public policy researchers should also find it helpful.
The Economic Survey of Latin America and the
Caribbean 1991 (Santiago, Chile: United Nations' Economic C o m m i s s i o n for Latin A m e r i c a and the Car i b b e a n [ E C L A C ] ; text in E n g l i s h a n d S p a n i s h ;
annually; began 1984 in present format) is published in
two volumes. The first volume discusses and illustrates,
with tables and graphs, principal macroeconomic topics
for various geographical entities: Latin America and the
Caribbean as a whole; the oil-exporting and the non-oilexporting countries; regions (including the Organization
of Eastern Caribbean States—Antigua and Barbuda,
Dominica, Grenada, Saint Kitts and Nevis, Saint Lucia,
and Saint Vincent and the Grenadines); and individual
countries. The second volume consists of nineteen individual country studies.
Volume I consists of three main parts and a "Statistical Annex." Time series typically cover ten to twenty
years, although this range may vary. The first part,
"Economic Trends in Latin America and the Caribbean
in 1991," for instance, embraces main economic trends,
levels of economic activity, total supply and demand,
and macroeconomic policy and inflation. The second
part, "The International Economy," looks at trends in
global output and policies; international trade; the international oil market; and savings, investment, and
the international transfer of resources. The third part,
"Exchange Rate Policy in Latin America in the early
1990's," examines the role of the exchange rate, measurement of real exchange rates, trends in exchange
rate policies in the 1980s, and the new economic and
financial situation in the region and the world. The
"Statistical Annex" consists of nineteen pages of tables, one for each country, breaking out real effective
exchange rate indexes for 1978-91.
Federal Reserve Bank of Atlanta
The nineteen country studies in Volume II differ in
format from country to country, but they typically
provide a comprehensive discussion of recent economic trends, economic policy, and the economic outlook. Discussions are supported by graphs and charts
correlating selected economic indicators (for example, "Growth of GDP, Imports and Investment, 19801990"). Tables for m a j o r economic indicators complete the studies, which vary in length but are typically
about twenty-five pages long.
ECLAC's Economic Survey of Latin America and
the Caribbean changes its format from year to year, a
practice exasperating to readers comparing information in two or more years' volumes. In three consecutive recent editions, the tables of contents for the first
volumes (of the two-volume sets) listed a "Statistical
Annex," a "Statistical Appendix," and, in the earliest
of the three sets, neither. Exigencies of collecting and
publishing international data are well known, but a
welcome addition to E C L A C ' s Economic Survey of
Latin America and the Caribbean would be more consistent formatting.
Major U.S. accounting firms frequently publish for
their clients series of references with information essential for international trade and investment. These
series include studies of large and small countries.
Ernst & Young International, Ltd., for instance, publishes an International Business Series that includes
country studies and a worldwide tax guide. Typical in
the series is the latest volume, Doing Business in Argentina (New York: Ernst & Young International Ltd.,
1992). A brief and practical b o o k , it p r o v i d e s an
overview of the fundamentals that investors and business people need to know about the Argentinean investment and trade climate.
An executive summary opens the book, and the
chapters that follow expound upon the rubrics of the
executive summary: government restrictions on foreign
investment; government attitude and incentives; tax
system, financial reporting, and audit requirements;
other matters of concern to foreign investors such as
tax legislation that changes annually; and useful addresses and telephone numbers. The volume concludes with
appendixes that offer useful comparative macroeconomic and financial data (comparative annual series ranging
from three to five years, depending upon availability of
the data) on a variety of subjects: economic performance statistics, currency exchange, major industries,
imports and exports, major trading partners, corporation tax calculation, depreciation rates, deductible expenses for individuals, nonresident withholding taxes,
Economic Review
31
and treaty withholding taxes. When appropriate, chapters bear editorial comment in italics at their beginning. For instance, Chapter C, "Foreign Investment,"
includes the following observations: "Argentina encourages foreign investment, particularly now that
economic growth and privatization are a priority. Consequently, prior government approval of foreign investments is no longer required."
Each country study in the International
Business
Series gives a caveat noting the complexity of making
foreign investment decisions and pointing out the necessity for an intimate knowledge of a country's commercial c l i m a t e and how r a p i d l y c o n d i t i o n s m a y
change. Accordingly, there is an "as o f ' note in each
book reflecting the date when its text was completed
and considered up-to-date. All reference books, of
c o u r s e , share a lag t i m e b e t w e e n c o m p l e t i o n of a
manuscript and date of publication and availability, but
the "as o f ' feature makes explicit the date after which
updated information will be required.
Ernst & Young International, Ltd., publishes International Business Series country studies for the following Latin American nations: Argentina, Brazil,
Chile, Colombia, Ecuador, Mexico, and Venezuela.
The company also makes available its Worldwide Corporate Tax Guide and Directory, an annual, providing
tax information on all the Latin American nations
mentioned above (and other nations around the world).
T h e tax guide, while not exhaustive, does provide
more detailed information than found in the country
studies.
T h e c o u n t r y studies and w o r l d w i d e tax g u i d e s
provide executives and researchers c o m p a c t , wellorganized overviews of foreign business, economic,
financial, and political factors, and they do so with a
measure of substantive detail. Some topical information in the handbooks may need updating, yet information on many patterns and trends remains useful
over time. While the Ernst & Young country studies
do not o f f e r strict intercountry comparability, the
volume-to-volume protocol of information follows
roughly the same sequence. The studies provide useful first steps for someone investigating financial and
trade information about major Latin American countries.
Guia 1993 {Banking Guide 1993) (Bogota, Colombia:
Latin American Federation of Banks [FELABAN],
1993; began 1983) offers basic bank information similar to that found in U.S. bank directories. However,
Guia 1993 enhances these bank data by adding basic
national economic data, country by country, to the
32
Economic Review
separate chapters on the nineteen Latin A m e r i c a n
countries that are members of FELABAN. Five-year
comparative tables, by country, of selected economic
indicators (GNP and GDP, external debt and foreign
investment, and exports and debt servicing) are a useful portion of the section called "Guidelines for the
Foreign Investor." Guia 1993, the twelfth edition, attempts to summarize the main factors that foreign
entrepreneurs and bankers should consider when analyzing decision-making in Latin American countries.
The guide consists of three main sections: a calendar
s h o w i n g bank holidays; b a n k i n g system d e v e l o p ment, financial statistics, and the main directory of
established banks in each of the nineteen F E L A B A N
countries; and, finally, an overview of the economic
indicators, taxation regime, and legal restrictions a
foreign investor may encounter when trying to establish business in any of these countries.
Bankers and other investors may particularly welcome acquaintance with F E L A B A N , which was
founded in 1965 in Argentina and subsequently moved
to Bogota, Colombia. Its function is to bring together
Latin American banks to promote international economic integration and bank development. Through
technical committees that serve as liaisons with banks,
the General Secretariat in Bogota coordinates FELABAN programs that focus not only on economic dev e l o p m e n t but also on technical matters like bank
automation.
Researchers who do not read Spanish should not be
put off by Spanish-only sections of Guia 1993. The
most important portions of the guide are bilingual: for
example, individual banking directories, by country,
with sketches of the country's total population, economically active population, population employed in
banking, and exchange rate, as well as the economic
indicators section, also by country. Some tables are
presented solely in Spanish, but their nature seems
self-evident.
The bank directory sections show individual bank
assets, deposits, capital and reserves, loans, and profits. They also furnish names of executives; mailing addresses; and telephone, telex, and fax numbers, along
with i n f o r m a t i o n on the date each institution was
founded, whether it is privately owned, its number of
employees, and so on.
This compact one-volume guide, combining macroeconomic and banking information, will serve many
researchers as a beginning step in those two areas.
Guia 1993 can be an opening wedge for marketing
and the establishment of commercial and financial
contacts with the FELABAN banks.
J anuary/February 1994
Latin America: A Directory and Sourcebook
1993
(London: Euromonitor PLC, 1993; 1st ed.) carefully
delimits its coverage to the eight leading Latin American economies: Brazil, Mexico, Argentina, Venezuela,
Chile, Colombia, Ecuador, and Peru. It provides an
expanded analysis of five countries it deems "major
m a r k e t s " — A r g e n t i n a , Brazil, Chile, M e x i c o , and
Venezuela.
The stated aim of this directory/sourcebook is to
s e r v e as an essential m a r k e t i n g tool with clearly
sourced and up-to-date statistical data providing details about the major companies in each country as
well as an overview of the regional context. The book
c o n s i s t s of f o u r s e c t i o n s : " L a t i n A m e r i c a in the
1990's: An Overview," "Major Companies," "Sources
of Information," and "Statistical Factfile." A detailed
general index concludes the volume.
The overview of Latin America presents a discussion of the region's leading economies in a worldwide
e c o n o m i c context. The discussion also touches on
Latin America as a consumer market, considering such
factors as levels of disposable income, urban/rural demographics, and the possibility of future infrastructure
inadequacies. The overview also compares regions in
terms of population (total as well as urban versus rural), illiteracy rates, gross domestic product, sovereign
debt, and illegal drug infrastructure and activities.
T h e overview section also p r o v i d e s individual
country risk studies for the five "major markets" mentioned earlier. These studies offer succinctly organized
overviews of macroeconomic, demographic, and political factors based on official national and international
sources. All the discussions in the overview section include tables based on data from international agencies
like the World Bank, the International Labour Organization, and the International Monetary Fund, permitting
uniformity for valid cross-country data comparisons.
From time to time Euromonitor cites information from
its own widespread data base. The time span of data
series typically is ten years or less.
The b o o k ' s second section provides information
about m a j o r c o m p a n i e s in the eight leading Latin
American national e c o n o m i e s . T h e c o m p a n i e s are
grouped by industry: consumer goods manufacturers,
heavy and light industrial companies, key retailers,
service c o m p a n i e s , p a s s e n g e r and cargo transport
companies, and banks and finance. The entry for each
company contains addresses; telephone, telex, and fax
numbers; and a description of business activity. Personnel information such as the names of management
or the number of employees is not included. Some financial information is provided "when possible."
Federal Reserve Bank of Atlanta
The third section's lists of national and international, official and privately collected information sources
justify the publication's claim to being a sourcebook.
The section includes international, regional, and country (for the eight e c o n o m i e s profiled) information
sources, including official agencies, private research
publishers, trade journals, data bases, research academies and institutes, major libraries, regional trade associations, and trade unions.
A "Statistical Factfile," the fourth section, contains
coded tables for macroeconomic indicators and national level population figures. A coded access list for
these data sets appears immediately after the book's
table of contents. M u c h of the data for the tables
comes from the International Monetary Fund as well
as some other international agencies, such as the United Nations' Food and Agriculture Organization and
the World Tourism Organization. This commonality of
data sources o f t e n p e r m i t s r e a s o n a b l y s y s t e m a t i c
cross-country comparisons; however, for some tables
such comparisons cannot be made because part of the
data are taken from various national statistical agencies, whose technical definitions may differ.
Although the statistical tables are faithfully documented, there is no master list of references, so researchers must comb through the "Sources of Information" sections to find out how to contact statistical
agencies for clarification or augmentation of data. A
list of agency acronyms with their meanings would also make the book easier to use.
These drawbacks notwithstanding, Latin America:
A Directory and Sourcebook sets itself apart from runof-the-mill coverage of marketing topics in its designated areas. The book is highly recommended as a
reference on Latin American trade and finance.
The World Business Directory (Detroit: Gale Research, Inc.; produced by the World Trade Centers Association fWTCA], New York; annually; began 1992)
indexes more than 100,000 international trade businesses around the world, including Latin America, in
its premier four-volume edition. As one might expect,
the WTCA has worldwide resources for assembling its
formidable directory, an important component of the
W T C A program to promote international business
relationships and trade and to increase Third World
participation in trade.
The directory covers all Latin American countries,
the amount of information relating approximately to
each country's volume of participation in world trade.
Each geographic section begins with complete listings
for World Trade Centers located in that area. Each
Economic Review
33
company listing includes information such as telephone, telex, and fax numbers; executives' names and
titles; financial data; the number of employees; company type; products traded; and industry activity. The
directory p r o v i d e s product i n f o r m a t i o n t h r o u g h a
" H a r m o n i z e d C o m m o d i t y Description and Coding
System" (HS) to facilitate world trade and expedite
statistical compilation. Volumes 1-3 consist of names
of companies listed alphabetically by country (with
countries, likewise, arranged in alphabetical order).
Volume 4 contains three indexes to the information in
Volumes 1-3: (1) a product index, arranged by HS
codes; (2) an industry index, with countries classified
by principal business activities; and (3) an alphabetical
index.
The World Business Directory can help researchers
explore international markets or establish joint ventures
by locating potential trading partners, by name or by
product. The coding system allows the user to target
specific products for marketing purposes or other analysis. The directory is a nicely designed, self-contained
reference for identifying companies by industry around
the world and providing standardized information
about them. It is also available in machine-readable
formats on magnetic tape and floppy disk.
Notes
1. The series of bibliographical essays on sources of information on foreign investment and trade appeared as follows in
the Federal Reserve Bank of Atlanta's Economic
Review:
" I n t e r n a t i o n a l T r a d e and F i n a n c e R e f e r e n c e S o u r c e s , "
May/June 1991, 30-37; "International Trade and Finance Inf o r m a t i o n S o u r c e s : A G u i d e to P e r i o d i c a l L i t e r a t u r e , "
July/August 1991, 55-64; "Doing Business in Eastern Europe and the Newly Independent States: Information Sources
to Get Started," November/December 1992, 38-46; "Business Information Sources for Eastern Europe and the Newly
Independent States: A Guide to Periodical Literature," January/February 1993,37-41.
2. This volume is one in a set of three by the same author and
publisher, covering different world areas. The other two, International Historical Statistics: Europe, 1750-1988 and International Statistics: Africa, Asia and Australasia,
17501988, are available at this time. A fourth volume, announced
for October 1994, will cover Eastern Europe and the newly
independent states of the former Soviet Union.
North America, as here defined, consists of Canada,
Costa Rica, Cuba, the Dominican Republic, El Salvador,
Guatemala, Haiti, Honduras, Jamaica, Mexico, Nicaragua,
Panama, Puerto Rico, Trinidad and Tobago, and the United
States of America. South America is defined as Argentina,
Bolivia, Brazil, Chile, Colombia, Ecuador, G u y a n a , Para g u a y , Peru, S u r i n a m e , U r u g u a y , and V e n e z u e l a . Brief
sketches provide geographical information and key historical
dates for the national entities.
3. W. Paul S t r a s s m a n , Risk and Technological
(Ithaca: Cornell University Press, 1959), 5.
34
Economic Review
Innovation
4. Other data divisions enumerated in the table of contents include population and vital statistics, labor force, agriculture,
external trade, transport and c o m m u n i c a t i o n s , f i n a n c e ,
prices, and national accounts.
5. Since 1976 SALA has used a " v o l u m e " designation rather
than a "year of e d i t i o n " in its title. H e n c e , V o l u m e s 17
through 28, published from 1976 to 1990, were called "editions." Moreover, with Volume 29 (1992) SALA began to be
published in two parts making up one volume number. The
c o m p l e t e V o l u m e s 2 9 and 3 0 c o m e in t w o books each,
called Part 1 and Part 2.
6. The twenty "standard definition" countries (all of which are
sovereign nations, thus excluding, for instance, protectorates
such as Martinique and French Guiana) are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Cuba, the Dominican Republic, Ecuador, El Salvador, Guatemala, Haiti,
H o n d u r a s , Mexico, Nicaragua, Panama, Paraguay, Peru,
Uruguay, and Venezuela. This standard definition omits the
two former British protectorates Belize and Guyana as well
as Suriname, a former Dutch protectorate, which are often
included in such lists.
7. These sections, actually called "Parts I-VII," should not be
confused with "Parts 1 and 2" of Volume 30 itself.
8. Central A m e r i c a is d e f i n e d as Costa Rica, El Salvador,
Guatemala, Honduras, Nicaragua, and Panama.
9. For a discussion of U.S. foreign assistance to other Latin
A m e r i c a n c o u n t r i e s , see C h r i s t o f A n d e r s W e b e r , " A n nounced U.S. Assistance to Latin America, 1946-88: W h o
gets it? How much? and W h e n ? " Statistical Abstract of Latin
America 28, chap. 35.
J a n u a r y / F e b r u a r y 1994
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