Liberalized capital markets, state autonomy, and European monetary union

Abstract

The conventional wisdom is that capital market integration and now monetary union have limited the options available to macroeconomic policy makers in Europe. The question considered here, therefore, is why many prominent Europeans insist that mone- tary union is a rational response to capital market integration. Monetary union eliminates exchange rate volatility - but only at a cost in terms of tightening the constraints on macro- economic policy. Using a combination of macroeconomic theory and (descriptive) statisti- cal analysis of European performance, I find that: capital market integration has increased macroeconomic flexibility through a mitigation of the current account constraint; European states have combined macroeconomic policies in a manner that has taken advantage of greater flexibility on the current account; the cost of such flexibility in terms of the impact of financial volatility on the real economy manifests differently in different countries; and monetary union both enhances flexibility on the current account and mitigates financial volatility.