Once Malta is an EMU member, the foreign currency and local currency rating will be equalised but at what level will depend mostly on the fiscal account.”  BIS Review 61/2004  3  ECB; and that even if the degree of business cycle synchronisation with the euro area is already significant, national economic and financial structures might respond to the ECB’s monetary policy stimuli differently from the average euro area Member State. While this might not matter much when other tools of adjustment such as the exchange rate are available, the argument continues, the use of these tools is thwarted in a single currency area such as EMU. On the one hand, exchange rate flexibility is conditioned by the maximum allowable bands in ERM II, and is given up altogether upon the irrevocable fixing of the exchange rate at the point of euro adoption. Additionally, the Stability and Growth Pact constrains the use of fiscal policy for fine tuning the economy. Consequently, any underlying imbalances in the economy are bound to persist. While based on sound theoretical principles, this argument is largely not applicable to Malta. In particular, the business cycle is already fairly synchronised with that of the euro area, and the degree of trade integration is also quite significant. At the same time, sectoral GDP and employment data both reveal a strong correspondence with euro area economic structures, after allowance is made for the relatively more dominant role of tourism in Malta.
Adair’s talk therefore provides an excellent opportunity to pause and review some of the ways in which policy and theory have been interacting so far. The literature on myopia and the crisis I want to begin with theory not policy, and the paper by Shleifer et al cited by Adair helps to provide an organising framework. This paper reflects the growing response of the economic profession to the crisis, and should hearten us all that theory is alive and well and productive. Unlike most papers written over the past three to four decades, Shleifer abandons rational expectations (RE) in favour of a world in which agents are seriously myopic about certain low probability, high impact risks. It is worth reminding ourselves of the RE paradigm, which has dominated macroeconomics and finance since the ‘70s. It posits a state of affairs in which agents know the world – know the structure of the model, and so have model-consistent expectations. Bad things can happen – but only in virtue of exogenous shocks. And depending on the structure of the world, those bad states can be relatively small beer, as famously argued by Lucas on the relative unimportance of business cycles. Disagreeing with that, the so-called salt-water economists wanted to show that, upon the crystallisation of those exogenous shocks, really bad things, recessions and persistent unemployment, can happen due to flaws – or, as economists like to say, frictions – in the make up of the world.