The advantages of tying Austria's hands: The success of the hard currency strategy

Abstract

The paper offers support for the following thesis: Austria opted for an exchange rate peg at a time (1974) when the economic (optimum currency area — OCA) prerequisites were not yet met. It needed an appreciation of the schilling relative to the D-Mark between 1979 and 1981 to signal a hard rule and to earn credibility. This hard-currency-option triggered off adjustment processes (i.e., real wage flexibility) which ultimately made Austria part of an OCA with Germany. Using the theory of time consistency, a model demonstrates that for a small economy such as Austria an exchange rate rule constitutes a good focal point. Employing criteria derived from the OCA-theory it is shown that for Austria asymmetric real shocks dominated the observation period (1973–1989), at least until the mid 1980s. Then, through domestic policies induced by the hard-currency-option, one can argue that Austria became part of an OCA with Germany. A successful fixed exchange rate rule in the face of asymmetric shocks and restricted factor mobility requires a (relatively) high degree of real wage flexibility, as can be shown for Austria. Only a credible long-term policyenables a country to fulfil the OCA-criteria. Austria may therefore be viewed as an example for a fixed exchange rate system, at least between smaller countries and an anchor country, even if OCA criteria (initially) are not being met.