The EMS, the EMU, and the Transition to a Common Currency

When a central bank is about to relinquish control over its exchange rate and enter into a currency union, it faces very low reputational costs of devaluation. As with any finite-horizon game, the endpoint affects the earlier expectations of private agents, here causing them to demand higher interest rates and higher wages from countries whose currencies are relatively weak. In looking at the countries within the EMS, we find that Italian long-term interest rates as well as price and wage levels relative to those in Germany show evidence of growing gaps. We also find that the real appreciation of the lira appears to be partly due to increases in relative Italian government spending, and not just to rapid Italian productivity growth. Taken together, this evidence suggests that reputational considerations may not be enough to foster continuing convergence within the EMS. Furthermore, moving forward the date of currency union may in the short run increase both the rate of growth of the gaps and the need for exchange-rate realignment.