Is Africa Ready for the Afro?(II)

Let’s have a quick look to what the introduction of the euro led for Europe.

The creation of a single currency in Europe has been accompanied by some major changes in the institutional setting for fiscal policy. Ideologically the new institutional framework should have led to a change in the conduct of fiscal policy in the members of the euro area, which is what the AU hopes for by introducing the “afro”.

But it didn’t. Or not entirely.

The run up to the launch of the euro was already difficult and driven by strict criterias. Because this was a process driven by entry requirements, limited attention was paid to the long run optimality of these conditions.

With the introduction of the euro in January 1999 the issues became broader and moved from a matter of debate in the academic profession to a real time challenge for policymakers. Within the first years of the European Monetary Union (EMU), the framework for fiscal policy embedded in the Stability and Growth Pact (SGP) has been subjected to many criticisms and has certainly failed to provide a credible framework for the conduct of fiscal policy.

Although the pact was intended to be conducive to an environment of discipline, coordination, and stability, its constraints became binding for several countries and presented challenges to macroeconomic stability and to the credibility of the pact at the very early years of the EMU.

Longterm Sustainability

[…]Longterm sustainability is central to the institutional setting of fiscal policy in EMU. For emerging markets, confidence in the sustainability of government budgets has direct effects on interest rates and economic performance. Many of the deepest crises in these countries have been characterized by large increases in the risk premium or defaults on government debt.

In developed countries, the concerns started with the increase in government debt levels in the mid- 1970s, and while these levels have stabilized or have even gone down in recent years, the uncertainty of the consequences of future demographic changes has kept the debate alive. The difficulty of governments to produce sustainable budgetary plans became known in the academic literature as the deficit bias of government.  This deficit could be due to the common pool problem or the strategic behavior of politicians in power as they tie the hands of the new elected governments or it could be simply a sign of short sightedness of policies.

Under extreme circumstances, unsustainable fiscal policy plans can lead to a deterioration of credibility and the expectation that monetary policy will bail out governments by creating unexpected inflation. In the context of a shared currency it can be that this bias becomes stronger as governments do not internalize the consequences of their behavior on the credibility of the common currency. This could create externalities in terms of credibility or simply through interest rate channels.

While sustainability relates to the long term behavior of fiscal policy, it is connected in many ways to the discussions around business cycle stabilization policies. The lack of discipline in fiscal policy can make the macroeconomic management of the economy difficult.

Although the main concern of the EMU fiscal policy framework was long term sustainability, the implementation of the rules have led to debates that have focused much more on the cyclical behavior of fiscal policy. […]

Why the interest in monetary union in Africa?

There are two principal reasons for the enthusiasm for African Monetary Union—both of which transcend the conventional economic aims of higher growth and lower inflation.

First, it is clear that the euro’s launch has most probably stimulated interest in monetary unions in other regions. But in Africa, fiscal problems are much more severe and the credibility of monetary institutions is more fragile. If the process of creating appropriate institutions was so difficult for a set of rich countries with highly competent bureaucracies that have cooperated closely for more than 50 years, then, realistically, the challenge for African countries must be considered enormous.

Second, African Monetary Union has been motivated by the desire to counteract perceived economic and political weakness. For example, regional groupings could help Africa in negotiating favorable trading arrangements, either globally (in the World Trade Organization context) or bilaterally (with the European Union and the United States).While the objective of regional integration seems well founded, it is unclear whether forming a monetary union would contribute greatly to it. A currency that is ill managed and subject to continual depreciation is not likely to stimulate pride in the region or give the member countries any clout on the world stage.

Euro-area countries have much better communication and transportation links than African countries, so Africa may not expect the same gains from economies of scale and reduction of transaction costs, even in proportion to its economic size, that are expected to result from Europe’s monetary union. Because they are highly specialized, African countries suffer large terms of trade shocks, which often do not involve the same commodities and hence do not move together. Neither structural features of the economy nor available policy tools hold much promise for facilitating adjustment to these shocks. Labor mobility in some African regions is higher than in Europe but is still limited and politically sensitive. And currently little scope exists for intra African fiscal transfers.

“A critical question for Africa is whether the creation of a regional central bank can be a vehicle for solving credibility problems that bedevil existing central banks.”

The analysis, when applied to Europe, usually has assumed that institutional design issues have largely been resolved. In particular, the central bank can be insulated by statute from having to finance government spending. (In Europe, this is ensured by a no-bailout provision preventing the central bank from lending to governments, buttressed by a history of central bank independence, particularly in Germany.) The main danger is that fiscal policy may indirectly put pressures on monetary policy, although the euro zone’s Stability and Growth Pact was aimed at minimizing that danger.Considerable controversy surrounds the effectiveness of the pact—in part because several governments have breached the deficit ceiling—but there is no immediate concern that the European Central Bank’s independence is in peril. In Africa, however, the institutional challenges are much greater. Existing national central banks generally are not independent and countries with their own currencies have often suffered periods of high inflation because the central banks were forced to finance public deficits or other quasifiscal activities. A critical question for Africa is whether the creation of a regional central bank can be a vehicle for solving credibility problems that bedevil existing central banks. If so, establishing a central bank that is more independent and exerts greater discipline over fiscal policies than national central banks do may enable it to become an “agency of restraint” (in the words of Paul Collier, a prominent economist who has worked on a wide range of economic topics concerned with African development).

However, history tells us that such an agency of restraint requires other institutional buttresses and does not emerge directly from monetary union alone. In fact, the experiences of Africa’s two long-standing monetary or formal exchange rate unions—the CFA franc zone (comprising two regions, the West African Economic and Monetary Union and the Central African Economic and Monetary Community) and the Common Monetary Area CMA) based on South Africa’s rand—do not suggest that the existence of a monetary union per se is associated with a dramatic increase in regional trade and policy coordination. The extent of intraregional trade is greater than predicted by the basic gravity model in the West African Economic and Monetary Union (WAEMU) and the CMA, while this is not the case for the Central African Economic and Monetary Community (CAEMC). In the CFA franc zone, it took the severe crisis of the late 1980s and early 1990s to spur a major effort at policy coordination, leading to new supranational institutions. In the CMA, asymmetry in size gives South Africa the power to set monetary policy for the region. Explicit macroeconomic coordination is less necessary as the smaller CMA countries—Lesotho, Namibia, and Swaziland—do not have access to monetary financing from the South Africa Reserve Bank. In terms of macroeconomic performance, while the CFA franc zone has unambiguously delivered lower inflation than other currency regimes in Africa, the evidence on growth is mixed—depending on the period under consideration. However, the success and endurance of the zone is also partially due to the special circumstances of French support, particularly the French Treasury’s guarantee of convertibility embodied in the operations account. The CMA countries have also generally benefited from low inflation and there is evidence of per capita income convergence in the union.

Related articles:

Europe and the euro -The bonds that tie—or untie, Economic Conferences, August 2011

Source: “Euro and Fiscal Policy”, Antonio Fatás, Ilian Mihov, Feb.2010, “A single currency for Africa (PDF)”

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