The less developed EU-member countries have been supporting an EMU the most and want to participate in it as soon as possible. The reason is, that they believe it will foster their economic development.⁵ One can differentiate between direct and indirect development-enhancing effects of the EMU. The direct development-enhancing effects are:

• the removal of exchange rate uncertainties;
• (the expected) rise in direct foreign investment; and
• a possible increase of financial transfers to the less developed European Union countries.

The most important aspect is the expected rise in direct foreign investment as a response to the elimination of exchange rate uncertainty. Here again, the expectations of substantial growth effects have been supported by the new growth theory. This approach argues, that the decisive development-enhancing factors are technology transfer from the higher developed countries and investment in infrastructure in particular in education and training (human capital) in the less developed EU-countries. The main hypothesis is: EMU would increase foreign direct investment in less developed member countries; and these direct foreign investments would bring in the technology needed for development. Based on this hypothesis one can derive positive spillovers to other sectors, which will lead to an increase in human capital in the whole economy. Indirect development-enhancing effects include all the positive stabilization effects that can be expected for less developed countries, but also for developed countries due to spillover effects from the prospect of entering the European Monetary Union (EMU). The main stabilization effects are:

• the discipline forced by the convergence criteria,
• the credibility gained from the European Central Bank, and
• an increase in political stability.

These stabilization effects have a supporting function for the intended convergence, because the necessary sustainable growth process will occur probably in a situation of political and economic stability.

The negative expectations of the European Monetary Union, on the contrary, have referred mainly to the following two aspects:

Table 2: Intstitutional precautions/arrangements of the EMU

There are three areas of economic policy in which the Maastricht treaty introduced important institutional arrangements. These fields are:

1. monetary policy,
2. fiscal policy, and
3. structural adjustment policy.

Here, the statute of the European Central Bank is of particular relevance.⁸ In order to minimize the inflation risk, the ECB has been assigned a strong position. This can be seen in the following three aspects:

1. commitment of the ECB to price stability as its main goal (article 105 treaty establishing the European community (ECT)),
2. institutional independence of the ECB and independence of its employees (article 107 ECT), and
3. prohibition of government deficit financing by the ECB (article 104 ECT).

In the fiscal policy area two aspects are important:

(i) the "no bail-out" clause (article 104 ECT), and

1. the fiscal convergence criteria, which restrict the government budget deficit and the overall government debt to certain (politically accepted) levels.

Further criteria set up in the Maastricht treaty are designed to ensure, that the structural convergence process has gone far enough. Countries that want to participate in EMU are obliged to fulfill the inflation, the interest rate and exchange rate criteria as laid out in the Maastricht treaty.

Here the provisions of the so called stability and growth pact agreed on in Dublin in 1996 and confirmed in Amsterdam in 1997 are particularly important. This pact provides a framework for maintaining and enforcing the Maastricht fiscal criteria after the EMU has begun. It restates the commitment to a maximum budget deficit of 3% of GDP and except for special circumstances applies sanctions to countries whose deficits excede this level. However, whether such sanctions can really be enforced is an open question but at least an attempt has been made.

1. size of transaction domain,
2. stability of monetary policy,
3. stability of the political system and
4. fall-back value.

It is obvious, that a currency, which is used by a hundred million people is much more liquid than a currency which is money for one million people. The larger the single currency area, the better it can act as a cushion against shocks. Comparing the size of the GDP of the European Union of eleven or fifteen member countries and with the ones of Japan and the USA all of a sudden, the EU becomes a monetary "player" on the same scale as the United States and Japan. Over time, as other EU-member countries join, as the per capita incomes of the poorer members of the EU catch up, and as the EU expands into the rest of Central Europe, the EU will have a substantially larger GDP than the United States. This size of the market is attractive not only for domestic, but also for foreign investors, mostly because of the stability and the size of the new currency.

As already argued in section 1.2.3, the european monetary policy will have the primary goal of price and monetary stability. Especially, if one analyses the institutional design of the European Monetary System all forseeable steps have been undertaken for stable currency.

Monetary stability, of course, depends on monetary policy, and monetary policy is in turn affected by political stability. Strong international currencies have always been linked to strong and stable governments. How strong the European Political Union from a purely political perspective will be in the future, depends on whether the European Union is able to undergo major reforms in its political and economic policy organisations. There are some first (hopeful) signs, but this process has just started and it is an open question, how successful the European Union will be in this respect.

Most modern currencies have no real fall-back factor as the older currencies had, which were either gold or silver standards or convertible into one or both of those metals; hence unlike the modern paper currencies, the former currency had a fall-back value if the state collapsed. However, most European member countries have a considerable amount of reserves in US-$ and in gold, which can be treated as a fall-back factor. If one considers these facts, the Euro should stand up against the US-$, especially as it has two great strengths: First, a large and expanding transaction size, and a culture of stability surrounding the ECB in Frankfurt. Initially the EU-11 member countries will be smaller than the dollar area, but as other members enter, as the EU expands and as the poorer countries catch up, the Euro area will eventually be larger than the dollar area. From the standpoint of monetary policies, there is also not much to choose between the two areas. Information is globally mobile and there is no reason, why the ECB should not become as efficient as the Federal Reserve System in the United States. However, the Euro has still two weaknesses: it is not backed by an European Federal Union and it has no real fall-back value. In an unstable world these weaknesses could be fatal. A test will be when the Asian crises spreads out to the North and South American or to Europe.

It is unrealistic to argue, that the introduction of the Euro leaves other things constant. If one assumes, that the Euro is successfully, it will then probably adopted by the remaining four members of the EU. Then countervailing steps might be taken by the United States including perhaps the expansion of the dollar area into Latin America. Whatever the forcasts the US-$-Euro exchange rate are, it will become a matter of great concern to Europe, to the United States and to the rest of the world. Diversification from the dollar into the Euro would create the threat of a soaring Euro, which could come into conflict with the sensitive issue of unemployment in Europe. The alternative of a falling Euro would raise the expectation of an rising inflation that would necessitate deflationary policies. Hence, the most urgent focus of management will be on the dollar-Euro exchange rate. As a world moves from monetary unilateralism to monetary bilateralism, policy coordination will become much more important. Under unilateralism, other countries were comparatively free to fix or change their currency against the dollar, with a kind of benign neglect of exchange rate on the part of the United States. That will no longer be possible under the existence of the Euro. If intervention is required, it should be cooperative. In the view of the long period of transition from a mainly dollar world into a world, in which the dollar and the Euro are quasi equal partners, it maybe necessary to develop new institutions capable of dealing with this problem. What is the essence one has learnt from parts 1.2 and 2.1? For most western European countries it seemed worthwhile to shift domestic monetary policy to a transnational (European) level. The expectation and hope is that a better monetary policy will be the outcome, i.e. a stable hard currency and low inflation rates but also a better predictability of monetary policy. Hence such a change from a domestic institutional monetary arrangement to a transpational one may be worthwhile to consider also for development or industrial countries, if they face a financial crises and are not able to scope with it as we have seen in the Asian Crises. In the next two chapters a first and preliminary attempt is made to develop a new international financial institution with much more intervention rights as well as more flexible and more incentive orientated instruments than the IMF has it.

The financial and economic crises of Asia is one of the best examples of an unexpected event, which had neither been foreseen by private rating agencies, nor by the international monetary organisations. The Asian financial and economic crises resulted in an contraction of output, and employment and poverty are rising sharply. Negative spillover effects have affected numerous other countries and one cannot say get with confidence (March 1999) that a global crises has been avoided. At this stage, the growth in world output is projected at just 2,5% for 1998, about 2 % points below the projection made before the outbreak of the Asian crises – a loss of some US-$ 800 billion in 1998 alone. The question arises, what can be done better in the future and what can be done by the international monetary institutions. The latter will be discussed – as an example – with respect to the reaction of the IMF; so far the only international monetary institution which has some experience in dealing with financial crises.

During the past two decades the IMF´s surveillance has relied on indicators, especially in the periods between consultation-discussions, to monitor economic developments and to draw conclusions from their likely future trends. While a crises prevention is mentioned nowhere specifically as one of the IMF´s main purposes, there is an urgent need to undertake reforms, so that the IMF can react more quickly and properly to events like the Asian crises. Thus, while the aims of the IMF are clearly more ambitous than mere crises prevention, the latter can be said to be an indispensable prerequisite for the achievement of these objectives. In so far, crises prevention should be indeed a core function of the IMF, and surveillance should be the IMF´s principle tool for crises prevention. Hence it is no surprise then, that the surveillance activities, broadly defined, absorb the largest share of the IMF´s human ressources. Surveillance over the funds 182 member countries is, however, a continous process, and the executive boards meets about once a month in informal country matters sessions, that aim to facilitate early identification of emerging financial tensions by focussion on potential problems and providing additional empirical material on a selective basis. The staff informs management monthly on important country developments, but also ad hoc when it is necessary. Beyond the usually annual consultation visits, formal financial arrangements, precautionary arrangements, informal staff-monitored programs and enhenced surveillance provide additional channels for more intensive contact between the staff and country authorities. The closer monitoring in the context of a quantitative framework, that accompanies these modalities of the IMF´s involvement tends to reassure interested third parties, such as donors, creditors and financial markets, and thereby can contribute to crises prevention.

It should be briefly mentioned that the IMF has also undertaken regional and multilateral surveillance. The former, which is increasingly becoming important in the surveillance of the European economies, complements bilateral surveillance in areas where policy responsibilities have been shifted to the supranational level. Executive board discussions of regional surveillance reports provide guidance to the staff in conducting bilateral surveillance with the countries affected. In the future, this is to be expected to increase with respect to monetary policy in the Euro area, for consultation missions to both EMU participants and countries, that have close links with the Euro era. The multilateral surveillance exercise provide valuable input for bilateral surveillance, e.g. in form of projections for the growth of trading partner markets or market assessments of country financing prospects.

The eruption of the Mexican crises in late 1994 and especially the outbreak of the Asian crises 2,5 years later raised severe questions about the effectiveness of the IMF surveillance. The issue of relevance to today´s talk is not so much whether this crises could have been prevented. Of course, they could have been avoided through better economic policies or subsequently mitigated by the readyness on the part of the government in the crises countries to deal swiftly and decisively with the emerging panics.

If one examines the record of surveillance in the Asian region, the IMF appeared to have been more aware of the risks in Thailand´s economic policy course than had most market observers. In other cases in Asia, however, the IMF, while having identified critical weaknesses, particular by the financial sector, had been taken by surprise, owing in part to lack of access to required information and also to an inability to see the full consequences of the combination of structural weaknesses in the economy and contagion effects. In particular, in the case of Korea, the IMF had not attached sufficient urgency to the financial tensions that had begun developing in early 1997.

From this short remarks about ability of the IMF to react to severe economic and financial crises it can be seen, that there is a need either to undertake major reforms of the IMF, so that the IMF is better able to fulfill its tasks; or to create a new international monetary institution. Both steps require, however, much more far-reaching rights than the ones of the IMF. It will be shown with the help of constitutional economics, that the new monetary institution will only be successful in handling this policies, if it can (re)act (at least for a certain time span) like an independent central bank with the additional rights to discipline governments and other actors in those countries. This new monetary institution can only act successfully if this institution is really independent; this means that no pressure from major countries can be put on it or that it might be misused as a lender of last resort. An attempt to develope and justify such a framework will be undertaken in the next two parts.

The modern theory of financial institutions (like central banks or international monetary institutions) stresses the importance of the independence of these institutions and of the incentive structures of the decision makers responsible for monetary policy. According to Grilli, Masciandaro and Tabellini (1991), the monetary institution can be described by their political and economic independence. Economic independence is defined as the ability of the monetary institution to determine the use and choice of its monetary (and if necessary other) policy instruments to act autonomously and without interference from national governments or national organisations⁹. Economic independence may be adversly affected by the monetary institutions obligations to finance national governments, to supervise commercial banks and by a lack of freedom to set interest rates¹⁰.

Political independence is defined as the ability of the monetary institution to choose monetary policy goals autonomously and without interference from the government. The basic determinants for this ability are found in personal independence, (e.g. procedures for appointing and dismissing the decisive managers of such an international monetary institution (and their terms of office)), in the national government´s rights (or international institution´s rights) to give instructions to the international monetary institution as well as the right to veto, to suspend or to fire the top executives (of such international monetary institutions) decisions.

A starting point for the theoretical foundations of the independence of a monetary institution can be, that the behaviour of politicians is also greatly influenced by the existing rules of the political game¹¹. Even for the simple case, that we have either benelovent policy makers (i.e. policy makers who behave like social planners) or we assume selfish policy makers who are opportunistic and have partisan preferences, the existing incentive constraints can lead to suboptimal policies. The fundamental reason for this is, that policy makers operate in a discretionary regime, i.e. monetary policy decisions are taken sequentially over time in a second-best world and therefore a socially desirable monetary policy may suffer from a lack of credibility caused by time inconsistency¹². According to Blanchard and Fischer (1989), a policy is time inconsistent, when a future policy decision, that forms part of an optimal plan, formulated at an initial date ex ante is no longer optimal at the time the policy is implemented ex post, although there is no relevant new information¹³. Various economic decisions are based on agents expectations of future monetary policy, if we assume, that a monetary authority is able to influence the inflation rate. For instance, when deciding on labour supply, wage contracts, investments or portfolio allocation, agents have to form expectations of the future inflation rate. In a discretionary regime, policy makers can make revisions of ex ante announced policy decisions and therefore create more inflation than forward looking agents expect. One possible way to deal with this "credibility" problem consists in removing all discretionary power from the government – however, quite an unrealistic assumption. The establishment of an independent (international monetary) authority would then be unnecessary, if a strict, legally embedded simple x-% money supply rule will be used. Government would then only have to pass a law requiring the government to fix the growth of money supply at a steady rate. However, studies on the employment motive for monetary expansion show, that when stochastic shocks are taken into account, the optimal monetary policy does not conform to a simple rule but also includes an optimal shock absorbtion mechanism¹⁴. By following a simple rule the government might be able to eliminate the inflation bias, but would produce suboptimally high output fluctuations. On the other hand statutory entrenchment of the optimal state contingent rule appears to be extremely difficult, because it is hard to imagine how all contingencies might be described ex ante and verified ex post. What remains is a choice between simple rules, which are inflexible, and discretionary policies which lead to an inflation bias. It is this trade-off between credibility and flexibility, which has led to a game theoretic foundation of the independence of monetary institutions (like a central bank). In principle, two approaches can be differentiated: on the one hand, Rogoff´s (1985), approach to delegate monetary policy to an independent "central" banker and the contracting approach by Walsh (1995 a,b) on the other hand. What both theories have in common, is that they propose the establishment of monetary institution structures which permit monetary policy to react to economic disturbances independently without interference from the government.

In the following some basic guidelines for a new monetary institution are developed using the contracting approaches, which seems more suitable for such a new framework¹⁵. However, they differ in their policy advises regarding the determination of central bankers' objectives and incentives. Starting from a principle agent approach Walsh (1995a) and Persson and Tabellini (1993) come to the conclusion, that even though the government should transfer the control of a monetary policy instrument to an independent monetary institution, the government should also provide this institution with incentives to optimize a social welfare function. This will be done in form of a (performance) contract between the government (as the principal) and the monetary institution (as the agent). Under the assumption, that the preferences of the government and the monetary institution coincide, Walsh (1995a) shows, that a simple contract which makes the central bankers‘ remuneration linearely dependent on a realised rate of inflation eliminates the inflation bias without any sacrifice in stabilisation efficiency. In addition he showed that the incentive structures of optimal performance contracts can also be generated through the implementation of inflation dependent dismissal rules (Walsh (1995b)). Such dismissal rules come close to the corresponding rules of price targeting agreements practised, for example, in the New Zealand Central Bank System (Walsh (1995b)).

As incentives in the traditional approaches depend exclusively on deviations between realized inflation from the socially desireable rate of inflation, performance contracts are frequently interpreted in the sense of direct inflation targeting as well. Svennson (1997) shows, that under conventional assumptions the result of an optimal monetary institution contract can also be achieved, when the government imposes an inflation target of the international monetary institution which is below the socially desireable inflation and other monetary targets.

However, an optimal monetary institution contract becomes considerably more complex if we consider "distorted" or selfish preferences of the governments. If optimal contracts are very complex, problems with regard to their implementation are raised, because it becomes more difficult to review the compliance and the design in the incentive structures. Walsh (1995a) shows as well, for example, that the incentive structures of an optimal monetary organisation contract are not solely dependent on inflation but also on output, if the managers of this international organisation try to maximize their income (Walsh (1195a), pp. 158 ff). Svennson (1997) highlights the importance of persistance in the labour market, which, among other things, leads to a discretionary monetary policy not only entailing an increased inflation bias but also a stabilization bias. The reason for this is, that surprise inflation also leads to real economic effects in subsequent periods.

In general these theoretical considerations show, that it is quite difficult to achieve from the monetary theory an optimal framework under which an international monetary organisation should operate. However, some of the guidelines of the contract approach can be used for modelling an institutional design of an international monetary organisation.

After having experienced the Asian crises, the existing international monetary institutions were not able to deal adequately with these problems. Either they gave the wrong advise or they were under considerable pressure from the major donor governments to behave in a way, which was in no way useful for the affected countries (like Indonesia or Korea). To lay down the right policies ex ante, so that such a major crises can be overcome in the forseeable time or even might be avoided in other countries is an awfully difficult task. Under the current structure of the IMF and especially the powerless instruments this organisation has to achieve its goals, one should think of a completely different (new) institution with much more enforceable instruments. The following suggestion may sound "wild" and normative but on the other side if one realises, what happens in such major financial and economic crises, like in Indonesia, Thailand or South Korea, it might be necessary to create a new monetary institution. If this institution is called for help, it should be layed down in an agreement between the affected country and this institution, that this organization may act like a completely independent central bank but coming from outside. For a certain period of time (one year, two years) one should give this monetary institution such a task, which all the influence of a central bank. The idea behind these suggestions is, that on the one side the moral hazard problem of the IMF (i.e. the IMF is a lender of last resort and bails out these countries) is considerably reduced and that this new monetary institution has a strong incentive to undertake policies for the affected country, which are suited best for it, because it has now the full responsibility with respect to the monetary policy over this country so that it can quickly act. As the financial help from the donor countries depends on the success to overcome the crises in this country, there are strong incentives for this new institution to act accordingly. On the other side there are now considerable higher costs for affected countries, because the governments in these countries loose a considerable part of their (monetary and fiscal policy) power, strong pressure can be put on them from the new financial institution to undertake necessary reforms, and (may be most important) the "easy" bail-out option does not exist any more! When creating such an institutional design for the new international monetary organisation two aspects are very important: The first is the institutional design and policy tasks of this new institution, and the second are the implementation problems.

An important requirement of autonomous and successful central banking is the installment of a two-tier banking system.¹⁶ This means, that there should be a strong and independent central bank and the new monetary institution should can play this role for a certain time, till it has reformed or built up such an institution together with a number of competitive commercial (private) banks. Once we have such a type of banking system, where the Central Bank sets out clear policy guidelines in controlling the private banking system (with minimum reserve and other monetary policy guidelines) a certain stabilization can be expected. But even when establishing such a two-tier banking system, the new international monetary organisation should be able to do more and to undertake a reform of the economic and financial environment of the affected state. In particular in the following fields major reforms are necessary: Thorough restructuring of the banking system, a stable legal and administrative framework and the establishment of control mechanisms on the fiscal authority.

A main precondition for an efficient conduct of monetary policy is a well functioning market-based banking system. It is not enough to commercialize state-owned banks and to give them new tasks and in addition let a number of new private banks emerge. In order to enable commercial banks to function effectively under market conditions, a deregulation and sometimes privatization of these institutions might be necessary and an adequate supervisory capacity is also absolutely necessary, because a weak and inefficient banking system hinders or even prevent a successful monetary policy: They distort the transmission mechanism of monetary policy, because unsound banks, that are not able to control the balance sheets, are less responsive to changes in reserve money or interest rates. In addition, the central bank (or the international monetary institution) may come under pressure to give credits for bailing out banks and to loosen monetary conditions thereby undermining their monetary control. Moreover, there are additional problems with unsound banks. There is a general consensus among economists that indirect instruments of monetary policy are more effective than direct instruments that promote more efficient financial intermediation.¹⁷. In the presence of unsound banks, however, introducing indirect instruments such as a credit auction or similar market-based facilities may induce adverse selection and moral hazard effects, because unsound banks may be willing to borrow at any cost to avoid illiquidity. What is needed are institutional innovations such as specific supervisory policies and bank restructuring scemes.¹⁸

In order, for market economies to function, a stable legal and administrative framework is extremely important, as we have seen in the crises of some of the Asian states. The installment of a independent legal system, however, usually takes a lot of time. During this period, the investment process in the real sector as well as in the financial sector is hampered by great uncertainty. As long as a stable legal framework has not been established, private investments are regarded as very risky by potential investors. Thus private domestic investments tend to be very low and urgently needed foreign investments are delayed. However, it is not only the legal environment that counts, the administrative and moral environments are important, too.¹⁹. Administrative inefficiency and corruption impose essential restrictions on the feasibility of projected monetary policy, rendering the assesment of the international monetary institutions performance very difficult.²⁰ During such a transition period this new financial institution can help to install confidence for domestic and foreign firms to invest in this "crises" country with a reliable monetary policy which brings back monetary stability.

The domestic monetary institutions are more or less permanently under the pressure of the fiscal authorities to ease their restrictive (anti-inflational) monetary policy. In the Public Choice literature, central banks are regarded as beeing exposed to strong political pressures to behave in accordance with government preferences.²¹. The point is, that restrictive monetary policy aggravates the budgetary position of the government. Since a (tempory) slow down of economic activity, induced by restrictive monetary or disinflational policy reduces tax income and receipts from seniorage and since a short term increase in interest rates means an additional burden on public debts, that worsens the deficit, the government may prefere "easy money" and hence collect public support to push the Central Bank in this direction. Some evidence exists at the relatively independent U.S. Federal Reserve has often complied with such pressures and also the German Bundesbank²². Hence it seems to be very likely, that the relatively independent monetary institution will have difficulties to withstand such a pressure for a longer time. Such pressures from the fiscal policy side can make the commitment of the international monetary institution, to follow a steady anti-inflationary policy incredible since the sustainability of such a policy is doubted. This problem can only be overcome if some control mechanisms on the fiscal authority are established, like in the Maastricht treaty in the case of the European Monetary Union.

In a perfect world all of the above mentioned institutional changes should be implemented instantly – and hence it would also be desireable to implement all reform elements simultanously. This, however, is wishful thinking. The problem of sequencing and of making a wrong decision respecting the sequence of reform steps cannot be neglected. For example it is not sufficient to have formerly independent monetary institutions in such crises countries, if they have not the sufficient institutional and political support for such a step. In order to strengthen the position of the monetary institution and to enhance the credibility of its announcements, there are two ways to improve the situation: The first way is to implement appropriate institutional control mechanism in order to control the inflation driving authorities or groups (such as the fiscal authority and wage price setting groups). Or one could bring forward the idea of the introduction of constitutional restriction of government debt. The second way is to choose an appropriate nominal anchor in order to conduct monetary policy successfully. The question of nominal anchors is important, because the credibility of the monetary policy strategy eventually determines the success of the monetary institution. Credibility, however, is dependent not only on the classical time inconsistency aspects (namely the incentives of the monetary institution to deviate from its goal) but also upon the expected implementability of the strategy that is a function of the reform stage.

In this paper an attempt has been made to demonstrate that we have a completely new situation after creating the European Monetary Union and after heavy experienced the Asian crises. The European Monetary system has become a legal and instituitional framework that a stable currency will be most likely the result. This changes the picture of the world financial system because two major currencies operate in this financial system which are competitors and where the rate between the Euro and the US-$ is a crucial factor. In the light of this new development a first attempt is made to put forward some ideas of a more powerful and effective new international monetary organisation. It is argued that only the policies of this organization will be successful, if it is really independent especially from its major donors and can act independently if it is "called" for help in certain countries. Then it is shown, that various instruments should be developed for this new organization giving him a status of an independent central bank in an affected country for a certain time period, so that this organization can really control the monetary policy and has the appropiate instruments to interfere within the country fiscal policy aspects, so that the goals of this institution can really put through. In general this paper should be seen as a first attempt of suggesting new international monetary institutions under the aspect of two major world currencies, the US and the Euro and after having experienced the Asian financial and economic crises.

Endnotes