Working Paper
The Impact of EMU on European Transition Economies

An interesting theory of transition must give a convincing account of structural adjustment and supply side improvement. In this paper, I discuss the incentives for government to undertake costly supply side improvement and how these relate to incentives governing the design of monetary and fiscal policy during transition. The government cares about deviations of inflation, output and government spending from their ideal levels, is subject to a budget constraint in which inflation yields some real revenue, and recognizes the distortionary effects of excess levels of taxation. Costly structural adjustment enhances future output by reducing supply side distortions.Within this framework, optimal policies are derived. For a given level of inherited structural capacity, optimal levels of inflation, output and government spending are derived. A poor structural inheritance forces high tax distortions, low output, and heavy reliance on the inflation tax. Hence there is a negative cross-country correlation of output and inflation, because of differences in structural inheritance, even though each country faces a vertical long run Phillips curve. Relative to the first best, failures of monetary precommitment lead to an inflation bias. Joining EMU may improve matters by solving this problem, but may induce two other difficulties: it may reduce the inflation tax too much, and it may lead to stabilization of the wrong shocks. It need not be welfare enhancing.The incentive for structural adjustment is then examined. Compared with the first best speed of adjustment, a failure of monetary discretion, by raising distortions, increases the marginal benefit of reform and induces more rapid adjustment. If transition economies willingly enter EMU, their distortions are reduced and in consequence they will reform more slowly. Since this seems at variance with current perceptions, the paper then introduces two further failures, namely in fiscal commitment and in commitment to reform itself. It is shown that these can interact to make complete stagnation of reform the optimal policy conditional on the failures remaining. In those circumstances, EMU membership, or even its prospect, may be a powerful force for speeding up the pace of reform in countries that otherwise would have stagnated.