Who Needs an External Anchor? CEPS Working Document No. 161, March 2001

Gros, Daniel. (2001) Who Needs an External Anchor? CEPS Working Document No. 161, March 2001. [Working Paper]

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Abstract

This paper argues that there might be non-monotonic relationship between the strength of the domestic framework for fiscal policy and the interest of a country to use an external anchor to achieve price stability. Countries with a strong domestic framework, e.g. low public debt, little pressure for excessive expenditure and an efficient tax system, would anyway enjoy low inflation rates and therefore have little need for an external anchor. Countries with high debt or very weak institutions would greatly benefit from an external anchor to save them from the extreme inflation rates they would otherwise have to endure because the market knows that the temptation for them to inflate public debt away is so strong. By contrast, countries with moderately weaknesses might be in a situation where they need some inflation to supplement government revenues with seigniorage, but the inflation resulting from the interaction with the market, which knows about this, is still moderate. Applied to the enlargement process this implies that both countries with very strong and those with very weak institutions might have an interest in joining the euro area quickly. The choices of Estonia (very strong) and Bulgaria (very weak), to adopt the euro/DM via currency boards, seem to reflect these considerations.

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