nicholas c garganas : exchange - rate regimes on the road to emu : lessons from greece ’ s experience luncheon address by mr nicholas c garganas, governor of the bank of greece, at the seminar on “ monetary strategies for accession countries ”, hungarian academy of sciences, budapest, 28 february 2003. the references for the speech can be found on the bank of greece ’ s website. * * * ladies and gentlemen, i would like to thank magyar national bank, the institute of world economics of the hungarian academy of sciences, and the center of european integration studies of the university of bonn for inviting me to speak to you today. in contemplating the subject of this seminar, one is struck by how dramatically things have changed in the course of a decade. in 1992 and 1993, when the exchange rate mechanism - or erm underwent a series of speculative attacks, the prospects of a european monetary union were viewed, by many observers, with considerable skepticism. this skepticism was not without foundation. after all, hadn ’ t there been previous false starts on the road to emu? hadn ’ t the werner report prescribed a european monetary union by the end of 1970s? yet, here we are today, having fulfilled the dreams of pierre werner and his colleagues and having celebrated the fourth birthday of emu. today, i would like to address some lessons from the experience of greece, the newest member of the euro area, in its quest for emu membership. i will confront what appears to be a dilemma. as we have heard this morning, much of the economics profession appears to have been converted to the “ hypothesis of the vanishing middle ” ; for economies well integrated into world capital markets, there is little, if any, middle ground between floating exchange rates and monetary unification. effectively, this hypothesis rules out intermediate regimes. yet, a requirement for entering the euro area is participation in erm ii, which is, after all, an intermediate regime. how can this dilemma be resolved? the retreat from intermediate regimes before i discuss greece ’ s experience, let me address the reasons underlying the retreat from intermediate regimes. what has caused this retreat? first, an explosive increase in capital flows during the 1990s has made the operation of intermediate regimes problematic. as has already been discussed at this seminar by jorge braga de macedo and helmut reisen, according to the thesis of the impossible trinity, developed in the 1980s, under a system of pegged exchange rates and free capital mobility, it is not

then, in order to limit the degree of depreciation that would be required for the market rate to reach its central rate and the resulting inflationary pressures, the central rate was revalued by 3. 5 per cent in january 2000. the rest, as they say, is history ; having fulfilled all the maastricht criteria, on january 1, 2001 greece became the 12th member of the euro area. concluding remarks what are the key lessons that emerge from greece ’ s experience? let me highlight the following. first, an intermediate exchange rate regime can be viable in today ’ s world of high capital mobility provided that ( 1 ) the participants adhere to sound and sustainable policies, including those that ensure the existence of a well - functioning market economy, and, ( 2 ) the intermediate regime is used as a transitional arrangement on the road to the corner solution of a monetary union. there is no contradiction between the existence of erm ii and the hypothesis of the vanishing middle regime. second, erm ii provides the credibility of a systems ’ arrangement, built up in a darwinian evolution, and flexibility through the wide fluctuation bands that may be necessary to achieve nominal convergence. the credibility derived by participating in the erm ii should not, however, be endangered by use of frequent adjustments of the central parity. as the erm experiences of the 1980s and 1990s vividly demonstrated, frequent adjustments of central parities within a pegged regime are feasible only in the presence of capital controls. in today ’ s world of high capital mobility, exchange - rate changes are not instruments that policy - makers can use flexibly and costlessly. the more often they are used, the less can be the credibility of a pegged exchange - rate system. third, the need of a consistent policy mix is crucial and has important implications in terms of how we need to view policy analysis. an implication of both the mundell - fleming model and mundell ’ s famous assignment problem is that monetary policy and fiscal policy constitute two, separate policy instruments. yet, the simple accounting fact that government expenditure has to be financed by either taxation, borrowing, and / or money creation, implies that any analysis of monetary policy must make consistent assumptions about fiscal policy. monetary policy and fiscal policy, in other words, are not independent policy instruments. they must work in tandem on the road to emu, and in emu. fourth, ultimately, a credible exchange - rate regime depends upon the trust