- Email: [email protected]
Alice in wonderland or malice in blunderland?
695
EUROPEAN
MONETARY
Alice in Wonderland Blunderland?
UNION
or Malice
in
Klaus Gretschmann
Prologue The date is 1 January of the year 2003. Ten years ago the Single European Market was completed in the Europe of the Twelve. As a birthday present, we are witnessing today the inauguration of a Eurofed and the baptism of a single European currency: the franc fort. Guess where we are celebrating. At the ultimately determined seat of the Eurofed-Frankfurt. After a decade of haggling and bargaining, the suggestion of the German Bundesbank, that Frankfurt is the natural location, has apparently hit home with Germany’s European partners. On the winding and stormy road to this single currency, the EC was confronted with several serious problems: while in the course of the 1990s the EC had managed to reach considerable common ground in the area of economic and monetary policy (largely due to the anchor function of the Deutschmark), in the wake of German unification the Deutschmark softened and lost some of its dominance, and thus endangered monetary stability. In addition, the enlargement of the Community increased economic divergence and required that 20 national currencies had to be managed and merged. However, the Swedish President of the EC Commission, a crusader for economic and monetary union (EMU), managed to get a compromise accepted, encompassing both rather tight rules on national public spending and borrowing and a handsome amount of money to be given to the weaker member states, to alleviate the inevitable macroeconomic adjustment shock. But the good old days will not be forgotten. In a prominent place of the Luxembourg Museum of Modern Monetary History stands a glass case containing coins and bills of the former national currencies, as well as some accounting documents which were used for dealing with the predecessor of the franc fort, the European Currency Unit (ECU). Unfortunately, the ECU never really lived up to expectations that it would become a single European currency. Let us slip back now for a moment to the year 1991 in order to see how the EMU concept was born and how its progenitors fought with each other about what it should become. Klaus Cretschmann European Institute Netherlands.
FUTURES
September
is Professor of Economics and Head of the Community of Public Administration, OL Vrouweplein 22, NL-6211
1991
0016-3287/91/070695-14
Policy Unit at The HE Maastricht, the
@ 1991 Butterworth-Heinemann
Ltd
696
European
monefary
union
At the cradle: the experience
of the 1980s and the challenges
of the 1990s
The idea of EMU is not a new one. As long ago as 1970 the Werner Report set out a three-stage process of greater economic and monetary integration. Its proposals never got off the ground, largely because of the lack of convergence between the economies of the member states and a lack of political determination to promote such convergence. Since 1979, cooperation in the field of monetary policy between the member states of the EC has taken place under the aegis of the European Monetary System (EMS). After overcoming initial teething troubles, the system has functioned satisfactorily and in the course of time has become a source of growing monetary stability. Since the year 1987, there has been no general realignment of exchange rate parities. This may be taken as a clear indication that the EMS has proved extremely successful in bringing inflation and interest rates down in some formerly high-inflation countries.1 In fact, it has turned the EC into a Deutschmark zone:2 the German Bundesbank fixed its monetary policy autonomously while other member states sought to stabilize their exchange rates against the Deutschmark by controlling their monetary basis. This has introduced asymmetry into the EMS by putting the burden of adjustment on the inflating countries. Although this has been widely recognized as successful, German leadership has been less and less readily accepted. Several EC countries felt that their economic policies were unduly restricted by the high priority assigned by the Bundesbank to preventing inflation and trying strictly to control the money supply. Particularly for political reasons, France and several other member states felt the need to underline the essential character of EMS as a truly European arrangement, rather than a pure Deutschmark block. In the late 1980s these countries moved towards freeing their monetary policies from the dictee allemande. In 1988, the French minister of Finance, Balladour, and his Italian colleague, Amato, proposed that one European central bank should substitute for EMS in order to overcome the loss of autonomy resulting from German domination of EMS. The Germans reacted with mixed feelings, but rather than blocking they took the initiative and proposed at the Hannover Summit to set up a committee, chaired by Jacques Delors, President of the European Commission, with the task of studying and proposing steps leading to a European Monetary Union. The Delors Committee Report3 presented in June 1989 brought EMU to the forefront of the European debate. EMU was defined as an irreversible locking of exchange rates, leading to the adoption of a single European currency. This currency would be managed by an independent European Central Bank, setting the level of interest rates across the Community. Ingeniously, the scene had been set to start negotiations on how to redesign European monetary cooperation and how to assign it Treaty status. For this purpose, in December 1990 an Intergovernmental Conference (ICC) on Economic and Monetary Union was convened and was supposed to work its way through the jungle of practical and theoretical scenarios which are part of the EMU business. But there were also economic reasons why an ‘ever closer’ economic and monetary union was a ‘non-obscure object of desire’:
FUTURES
September
1991
European
monetary
union
697
(I)
In the summer of 1991, the completion of the internal market is within reach. Its full benefits, however, can only be reaped if exchange rate uncertainty, as well as other obstacles, are removed.4 Accepting ‘1992’ as most business people consider exchange rate a foregone conclusion, fluctuations to be the major remaining barrier to trade. The combination of the ‘1992 programme’ with EMU would translate not only into static but also into a higher sustainable rate of economic growth gains, (dynamic effects). Empirical estimates show that reduced exchange rate uncertainty would permit a reduction in the rate of return necessary to stimulate new investment. No matter to what extent this argument can stand scrutiny, its psychological impact is undisputed: if politicians develop and present credible strategic commitments to EMU, economic agents will doubtlessly adjust their expectations and anticipate the would-be changes in their behaviour. (2) Growing economic and financial interdependence, particularly the free circulation of capital across national frontiers, is eroding member states’ autonomy in economic and monetary policy making. Once every financial institution in the EC is free to accept deposits and to grant loans to any customer in any national currency, the capability of national central banks to control monetary aggregates will be lost.5 As the PadoaSchioppa report has put it: you cannot have free capital movement, fixed exchange rates and independent national monetary policy making at the same time. With liberalization of capital markets, the area in which a currency is used and the jurisdiction in which its banking system operates will no longer dovetail. This will make a truly supernational institutional arrangement necessary. (3) It is frequently argued that efficiency gains would accrue from a move to EMU. These include a reduction in all exchange rate-related transaction costs such as bid-spreads and other commissions in foreign exchange transactions. These costs add up to at least 0.5% of gross domestic product per year for the EC as a whole, ie about 15 billion ECU in positive effects will result from the eliminaabsolute figures. 6 Moreover, tion of information costs and the reduction of incentives for price discrimination made possible by the simultaneous use of a number of national currencies. Through EMU, prices will be made directly comparable. Finally, economic opportunities will arise, resulting from the fact that foreign exchange reserves, formerly held in order to defend intraunion exchange rates and to fend off speculative attacks on a currency, will be set free.
All these points explain why EMU has indeed been put on top of the agenda of European integration for the 1990s. However, leaving the EMS behind and turning towards EMU involves some risks. It is not only the expected loss of national sovereignty in the area of monetary and economic policy making that makes some member states hesitate to commit themselves to a fully-fledged EMU. Even more significant is the uncertainty of whether or not a European currency and a European Central Bank would be able to establish the same degree of stability and credibility as was achieved by the Bundesbank in the 1980s. Confidence in stable prices and stable exchange rates cannot be decreed, it must evolve. No legal act can force monetary
FUTURES
September
1991
698
European
monetary
union
union if the economic prerequisites are not already present. It is the markets, not the politicians, that ultimately decide about the success or failure of the EMU. One of the major problems of EMU is that the objective of price stability in some countries can be bought only with unacceptably high social costs, particularly a significant increase in unemployment. It goes without saying that for many countries EMU will put strong adjustment pressures on their economy. As the exchange rate as an instrument for adaptation to international markets will no longer be available, national wage and interest rates will have to be flexible enough to bolster adjustment shocks. However, without compensation for wage and interest rate adjustment, economic pressure will mount in weak currency countries. In order to lessen the temptation for those countries to print money aggressively, much regional redistribution (possibly in the form of a dramatic increase in structural funds) will be required as no country will voluntarily accept a levelling down of the economic well-being of its citizens.’ The decoupling of European monetary cooperation from German dominance certainly will entail some benefits but it will also imply costs. The hard currency countries like Germany, the Netherlands or even France will have to sacrifice some of their stability achievements, whereas the soft currency countries will have to suffer from adjustment pressures.
EMU: bringing it into existence
and making it tick
In theoretical terms there are basically economic and monetary union:
three
different
ways to bring
about
(I)
The so-called overnight or leap-in-the-dark approach, involving the the pooling of the member states’ immediate set-up of a Eurofed, and finally, the overnight replacement of national currency reserves, currencies by a common European currency. Such a shock treatment would lead to serious problems in adaptation and adjustment for investors, consumers, lenders and borrowers.8 (2) There is the model of currency competition: all national currencies and the ECU would be accepted as legal tender everywhere in the EC. Competition will then help select the best currency, which over time will crowd out the least liked currencies. This resembles a process which is the inverse of the famous Gresham law .9 This approach is not without having to deal with a number of currencies rather than problems either: just one will, at least for the transitional period, lead to an increase in information and transaction costs. Moreover, when several currencies are accepted as legal tender throughout the EC, while at the same time only one institution (National Central Bank) in each member state remains responsible for setting the parameters of monetary policy in its respective currency area, unbalanced and asymmetrical markets will result. (3) The third and last possibility is a gradual, step by step approach. This is exactly the model put forward in the Delors Report, distinguishing three stages of introducing economic and monetary union.lO Stage 1, requiring free movement of capital and some coordination of monetary policies,
FUTURES
September
1991
European
monetary
union
699
began in July 1990. During the second stage, originally planned to start in January 1993, but later postponed by at least one year, European exchange rate realignments would be ultra-rare. The European Central Bank (ECB) would be set up to achieve more comprehensive coordination of monetary policies, but ultimate monetary sovereignty would still rest with national central banks. In stage 3, the ECB would completely control monetary policy, with exchange rates permanently fixed. It would start soon after stage 2, when the national governments decided that the time was ripe. To prevent poorer EC economies from being rushed into stage 3 prematurely, they would be allowed a ‘grace period’. Plan (3) has not defined, however, what respective national and supranational monetary authorities are supposed to do at the various stages. This lack of clarity may introduce considerable uncertainties in the financial markets. Given these imponderables, economic agents cannot form firm expectations on the stance and behaviour of national and supranational monetary policies. The crucial question is: who will be in the driver’s seat when the ECB and national central banks exist side by side, both having a say during the second stage? As no one is clearly in charge of national monetary policies during the second stage, criticism concentrates on this stage. Formulas to ‘strengthen to ‘develop the instruments and the coordination of monetary policy’, procedures needed for the future conduct of a single monetary policy’, to ‘closely monitor the development of the ECU’ are empty shells and do not contribute at all to stabilizing the financial markets in the period of transition. When discussing the role of the second stage, we are faced with two concepts. One aims at a short, mainly technical second stage, which would start only when the permanent fixing of exchange rates is accomplished. The other concept contains a second stage which would start much earlier Its aim is to bring convergence and policy and would last much longer. coordination to a point where the third stage may be entered and the conduct of monetary policy be handed over to the ECB. however, entails a risk: if an ECB is to lead a The latter approach, shadowy existence possibly for many years during the second stage, with its tasks restricted just to coordination rather than the conduct of policy, it is bound to become a weak institution with a low standing in international markets. This will then lead to low confidence in the European currency which the ECB is supposed to issue and control in stage 3. This criticism found its strongest expression in the German Draft Treaty on EMU submitted in early 1991. On the transition to EMU, the German government made four central proposals. First, an EC Bank should not be established prior to achieving currency union, the final stage of EMU, which would begin in 1997 at the earliest. This is to avoid overlapping responsibilities and competing interests between national monetary authorities and supranational institutions. Second, no new currency would be created in the second stage which is to start in 1994. Instead, devaluation of the ECU would be ruled out, in order to make it a perfect substitute for the Deutschmark, the strongest currency presently. Third, transition to full currency union would only follow agreement that a majority of member
FUTURES
September
1991
700
European
monetary
union
states had achieved acceptable convergence of inflation, budget deficits and interest rates.. Currency union would be limited to those member states that had reached these standards, while the others could onty join later. Fourth, there should be binding ceilings on the budget deficits of those member states joining the currency union. This proposal has been severely criticized -above all by the European Commission and several member statesaccusing Germany of dragging its feet on progress towards EMU. The proposal, none the less, reflects considerable scepticism towards a graduaiist approach to EMU as long as there is not enough convergence in the real economy of the member states.‘l The movement towards more convergence in economic performance has definitely made headway in recent years. However, this does not apply to the same degree to all EC countries; it holds primarily for those countries which opt for more discipline in the EMS exchange rate mechanism. At present, economic divergences in the EC remain considerable. Among member states: l inflation rates range from 2.5% to 22%; * short-term interest rates range from 9% to 19%; I, budget balances range from a surplus of I% of GDP to a deficit l unemployment rates range from f.5% to 16%.
of 17%;
Hence, it does not seem to make much sense to fix the dates for the transition to stage 2 or 3 strictly in accordance with the calendar, as has been proposed, because there are considerable risks attached to any premature move to EMU. If a future ECB pursued the rigorous and sustained monetary policy necessary for the achievement of price stabitity, it would entail heavy costs for the least prosperous regions in the EC. They might become increasingly uncompetitive and face a sharp rise in unemployment. This would probably lead either to a relaxation of monetary policy or to pressure for a massive increase in EC expenditure to finance fiscal transfers to poorer regionsJz Such transfers, however, can never be an effective and durable solution to the problem of lack of competitiveness. But, as they bolster the adjustment process, such transfers might be counterproductive, slowing down the adjustment process. At any rate, this is the view of the strong currency countries. The vantage point of the weak currency countries is a different one. Given the menu of choice between more infiation and more unemployment, they opted fur a different point on the famous Philips curve, due to Political preferences, however, often just reflect ecopofiticaf preferences. nomic ones. Germany and other countries with ageing populations and a high level of savings and wealth are on the anti-inflation side. Countries like are much less interested in protecting Portugal, Spain, Italy and Greece financial assets, the holding of which is not a widely spread phenomenon in their economies. They are faced with high youth unemployment and their primary objective is the creation of jobs. They have therefore been willing bearing in mind that inflation redisto accept a higher level of inflation, tributes from the saver (creditor) to the investor (debtor). If preferences about inflation and unemployment are split within the EC, is it not then a logical consequence that EMU wilt take place at one of two speeds, with a
FUTURES
September 1991
European
monetary
union
701
core consisting of the happy few-countries like France, the Netherlands, Germany, Belgium and Denmark?13 In economic terms this would probably be the adequate solution. Yet it would involve political costs, particularly a weakening of the integration In the past, the weaker member states of the EC were able to process. countervail economic dominance of the big players through political voting. In a system which excludes the weaker ones, Germany, France and Benelux would decide on European economic and monetary policy on their own, regardless of what the interests of the weaker countries were. Against this background it has become sufficiently clear that Europe should not opt for a two-speed approach. EMU has to be designed in such a way that neither the strong nor the weak currency countries will lose. The weak currency countries should be aware of the fact that in the absence of an exchange rate instrument, with a restricted scope to national fiscal policy and with limited cross-border labour mobility, adjustments in EMU will have to be made mainly via a curb on wage costs and prices, ie they will grow more slowly than in strong currency countries. If such curbs are not deep enough, economic growth and employment will definitely suffer. Loss of the exchange rate tool in the process of approaching European EMU makes it all the more necessary for the job market to operate flexibly in order to keep wage costs under control. This may, however, lead to social unrest.
European Central
Bank-player
or pawn?
A common currency as the final objective of EMU implies a European Central Bank issuing and controlling it. Agreement is necessary both on its tasks and on the extent of its political autonomy. In any monetary union the design of the central authorities is crucial. It must be the anchor against inflation, comparable to gold in the gold-standard and the Deutschmark in the present EMS. The Delors Report suggests a Central Bank Board with members appointed by the Council of Ministers and a Central Bank Council composed of the governors of the existing national central banks plus members of the Board. The Council will be responsible for the formulation of monetary policy; the Board and the staff for its execution and implementation. The Council would submit annual reports to the European Parliament and the Council of Ministers and its chairman could be invited to report at other times. The independence of the Council would be bolstered by giving its members security of tenure. There has been a widespread agreement on the following policy essentials of EMU: (1) The primary commitment of the ECB should be to monetary stability, ie price stability. (2) The ECB should be protected against any form of political influence and pressure. (3) The main lines of external monetary policy shall be a political responsibility, exercised by the Ministers of Finance while the ECB shall have a large measure of autonomy in its implementation.
FUTURES
September
1991
702
European
Why price
monetary
union
stability?
The anti-inflationary stance the ECB is supposed to take starts from the assumption that inflation distorts price signals and leads to sub-optimal allocation of resources. Inflation induces risk and uncertainty for both the investor and the consumer, leading to higher risk premiums in terms of profit margins on the one hand, and to some reticence in purchasing on the other hand. Moreover, inflation entails steeper transaction costs-economic agents invest time and effort to escape inflation and to find ways and means to invest in non-inflationary areas. This has serious consequences to the extent that the exchange-rate signals are biased by inflation, and investors will diversify their assets and change the maturity patterns of their investments. Finally, inflation has serious distributional consequences, mainly to the detriment of the small saver.
Why political
independence?
There is full consensus that for the attainment of the primary objective, viz price stability, it is important that the decision-making bodies shall not be influenced by considerations which could be in conflict with the pursuit of price stability. The statute of the ECB, therefore, establishes the principle of independence in that it states that its institutions and decision-making bodies shall act independently of instructions from political authorities. This is not exactly easy to realize politically. Central Banks within the EC at present differ widely in responsibility and position. Some, like the Bank of England, are not responsible for determining monetary policy but are charged with executing the Treasury’s policy. The Bank of France, too, is charged with advising and executing the monetary policy determined by the government. The ECB, if set up along the lines agreed upon during the intergovernmental conference, would therefore in no way reflect the situation currently prevailing in Europe but would be rather like a German type of Central Bank.14 But how should the powers which governments have been unwilling to entrust to their own Central Banks be entrusted to the new European one? Despite lip service to Central Bank autonomy this remains one of the major leaks in the EMU vessel.
Why political
control
of external
monetary
policy?
The ECB is unlikely to be permitted to intervene in third currencies. The political authorities of the EC will want to decide on the nature of the exchange rate regime, whereas the ECB may intervene only within this framework. This will inevitably lead to conflicts: the Germans think that the fixation of the exchange rate towards non-EC countries’ currencies should not be possible against the vote of the Central Bank and that changes in the exchange rate regime by Council should be decided unanimously; the French plead for a qualified majority. As monetary policy cannot be carried out without the corresponding external safeguards, any credible solution (to be accepted by the markets) requires an adequate right of codetermination by the Bank. Purely political decisions to be enacted by the Council of
FUTURES
September
1991
European
Ministers will therefore have to be excluded. It is clearly greatest risks to the ECB’s autonomy are looming.
Budgetary
monetary
union
703
this area where
the
policy: leeway and limits
In addition to the issues dealt with above, the Bank’s prohibition to finance deficits of public authorities is another major bone of contention. The prohibition to finance public deficits is a decision which sends signals to the financial markets and which also has serious implications for the fiscal policies of the member states. By definition, if the EC adopts a single currency, governments will relinquish their sovereignty over monetary policy. Control over interest rates and money supply, and consequently inflation, will pass to the new Central Bank. To what extent will member countries in EMU also have to accept constraints on national budgets? All member states seem to agree that the ECB would not be obliged to finance a national deficit. Moreover, the EMU will eliminate monetary financing of budgets and hidden tax collections through regulation of banking reserves. It will no longer be possible to generate public revenues through national money creation. Government profit from coinage will be limited to that which results from European money creation. It will also not be possible to levy hidden taxes through banking reserve requirements that are higher than those interest rates for public borrowers imposed by member states. Privileged which would discriminate against national banks shall be excluded. As a result, financing of public sector borrowing will have to occur through the capital markets at non-privileged rates. In order to compensate for revenue loss in the monetary area, member states would have to revise their taxation policies, or to increase their current level of state indebtedness. Experience in most member countries has proved conclusively that the absence of direct recourse to central bank finance does not necessarily prevent national governments from running large deficits. Excessive national deficits of some member countries, implying a disproportionate use of Community savings or of the acceptable scope for total monetary financing, could result in heavy strains, both economic and political. Efficient economic policy making at any stage of a monetary union therefore calls for a reasonable regulation of the relationship between the ECB and public sector borrowers.‘j The experience in some southern EC countries shows clearly that market forces are often too weak to restrict and discipline large-scale public sector debtors. Under the conditions of EMU, excessive public sector debt on the part of a member state is no longer restricted (as it is in the EMS) by pressures on the exchange rate, rising interest rates, or a deterioration of the current account. From the point of view of an individual member state, borrowing in the Community-wide capital market becomes easier, as interest rates and balance of payment risks are born by the Community as a whole. This could provide an incentive to behave in a way detrimental to other member states and would encourage a misallocation of savings within the EC. Often the argument is heard by free marketeers that after EMU governments will have to compete for best borrowing terms and this would prevent overborrowing. Critics hold against this argument that EMU may be interpreted by the financial markets as a collective device for backing up
FUTURES
September1991
704
European
monetary
union
those member states that are in financial trouble. A generally overexpansionary fiscal policy stance in the EC would confront monetary policy makers with the tricky alternative of either accommodating higher demand at the expense of price stability or crowding out private demand by means of higher interest rates. Irrespective of what side one takes in this debate, in the interest of stability it will be necessary to complement market disciplines with binding rules on member state budget deficits. Later this will probably give way to a strictly coordinated,16 or even centrally determined fiscal policy, which would require a single European finance ministry. Anybody who is unable to accept this curtailment of national autonomy in terms of budgetary discipline cannot be in favour of monetary union either. This highlights the central problem of the planned EMU: the deep curtailment of national sovereignty in the field of fiscal policy will fundamentally challenge the self-respect of member state governments-and few of them are prepared to accept that challenge, at least not yet. On the other hand, a common monetary policy without general budgetary discipline will undermine stability and endanger welfare. Member states cannot have it both ways. EMU requires an adequate commitment of all member states to a permanent stabilization of deficit policies. All countries agree that economic union should entail multilateral surveillance procedures, with regular EC reports on each national economy containing recommendations and policy guidelines. But there is wide disagreement on how far the EC should stick its nose into national affairs. When talking about binding guidelines for national budget deficits, what do we have in mind? Basically, two golden rules are being discussed. First, the quota of public deficits to GNP should not exceed a certain figure. Secondly, deficits should only be allowed up to the total of public investment in the national budget. One might, however, consider another more flexible rule: it is not the deficit that counts in economic terms, it is the burden resulting from deficits and that is interest payments. I therefore propose a rule according to which the interest payments resulting from a certain deficit should not exceed a share of the public budget. This rule would give policy makers more discretion about how to finance public spending, because interest payments can be influenced by skillful debt management. This rule would give some leeway to policy makers within a definite framework that would limit their proclivity for borrowing at a maximum threshold (interest payments). The largest unsettled question about applying binding limits is the demand from some member states for financial penalties against any country that refuses an EC order to cut its budget deficit. An unpublished paper presented to the ICC recently spelled out what penalties deficit makers would face. Initially, EC ministers would recommend in private to the country how the deficits should be dealt with. If that failed to produce an acceptable result, the ministers would make their recommendations public, in other words, give a public reprimand. If that produced no improvement, the freezing of EC transfers, such as structural fund grants to the country concerned, would be invoked. or Sala-i-Martin18 have pointed Economists such as Buiter and Kletzerl’ to the decisive problem of EMU. The EC is planning to harmonize monetary
FUTURES
September
1991
705
policies in the presence of 12 different budgetary policies. In order to make EMU tick, the budgetary policy side has to be strengthened either via ex ante coordination of national budgets or via a considerably increased role of the EC budget. As long as the latter only accounts for about for about 1% of Community GDP, it is not a suitable instrument for fiscal policy at the European level. However, at the end of the road, there probably will be a centrally determined fiscal policy for the EC as a whole-in other words a single finance ministry.
Conclusions:
EMU between
economics
and politics
There can be no question, Europe needs a common currency. A common currency reduces the costs of international transaction, avoids the risks of exchange rate fluctuations and thus contributes to optimal allocation of the overall economic effects, quantitatively resources in Europe. w However, considered, are only marginal. Really important is the political objective of demonstrating that Europe, which is at the same time an economic giant and a political dwarf, is able to marshal its forces and transfer national sovereignty to truly European institutions. Against this background, EMU serves as a symbol. It is an evident sign of the irreversibility of the process of integration, emphasizing the growing together of European nations to an economic and finally a political whole. There is another significant political dimension involved here, a dimension rarely discussed openly but none the less relevant on the operative level. The Germans are persistently suggesting to their partners not to drop the economic advantages of the European Monetary System with the strong terms Deutschmark as an anchor currency. 2o They argue that in political most EC countries do not really suffer a loss of monetary autonomy since financial interdependence has in fact already made them largely dependent made by the Bundesbank in Frankfurt. Behind this on policy decisions argument is the realization that it would be mainly Germany which would be required to sacrifice its present preponderant position in monetary decision making in Europe-and not only in the Europe of the Twelve. The strategic choice from this perspective is whether EMU is an instrument to transfer monetary policy competence to the European level or to keep it more or less a domainhowever informal-of the German Bundesbank. This question will be-unofficially-one of the key issues in the debate during the coming years. One thing is for certain: a full currency union will deprive its members of the power to issue their own money. The political consequences of this are enormous but are normally overlooked in the EMU debate. Once there is a single European currency, EMU will prevent member state governments from cheating their citizens through inflation. That has been made abundantly clear in the debate on the so-called inflation tax; inflation-permitted and controlled by national monetary authorities-is a means of devaluing the public debt. The private citizen who has lent his savings to his own government, will now have to trust the new ECB which will take over monetary control and apply European rather than national standards to controlling inflation and public deficits and thus decide over the value of his
FUTURES September 1991
706
European
monetary
union
savings. But who is to control the Eurofed? Who is to ensure that the same process of devaluing nominally fixed loans will not occur on the supranational rather than the national level-parliamentary control, autonomous Central Bankers or anonymous financial markets? This is still an open question,*’ yet it is certain that none of those mentioned can be trusted completely.
Epilogue Let us return to the prologue and the year 2003. The 1990s indeed turned out to be a stormy decade as far as EMU was concerned. The first IGC did not produce a generally acceptable solution. It was followed by new proposals and counterproposals, overlayed by the discussion about accession of several former EFTA countries as new member states-which in the last analysis tipped the scale in favour of a strong, independent Eurofed. Here are some of the solutions to the fundamental questions that were on the agenda of 1991: l
l
l
l
l
In order to control excessive budget deficits and to implement the a Debt Council of the Finance Ministers procedure described above, (DCFM) was set up with the ultimate power to stop Community transfers to those member states which violated the rules. The Central Bank (Eurofed) was granted wide-ranging autonomy within broad political guidelines set by the Council of Ministers of Economics and Finance (Ecofin). In cases of conflict between the Central Bank and Council, the European Parliament will play the role of arbiter (Dutch model). After prolonged controversy it was agreed that the full competence for determining external monetary policy-the management of exchange rates-was assigned to the Central Bank. The decisive argument was the recognition that internal and external monetary policy is indeed indivisible. Although there were prolonged negotiations and endless discussions about a two-speed approach and the provision of a ‘grace period’ for some member states, in the end all 20 decided fully to join EMU in one shot. In order to absorb the adjustment shock on weak currency member states it was decided already in 1998 to double the structural fund transfers over was reached on another the following four years. In 2002 agreement by an increase in the doubling of the funds. This was made possible number of net contributors to the EC budget. Several of the new members admitted in the 1990s joined Germany and the UK as net payers.
There was also much discussion about the price tag attached to EMU-what would the people have to pay and what would they get for it? The case of German unification was after all a vivid demonstration of the costs of integration. But no one was prepared or able to identify or quantify in detail the costs and benefits of EMU. In the last analysis, it was the political will to move on with integration that tipped the scale in favour of EMU. Post-World
FUTURES
September
1991
European
monetary
union
707
War II prosperity in Western Europe was seen as a major result of integration-and no one wanted to risk this prosperity. Finally, there was the ideal of a united Europe, a politically and economically strong Europe that guaranteed peace and security at home and could develop into a major stabilizing factor, not only for the countries of Central and Eastern Europe -which are hoping to join the 20 member states as soon as possible-but also on the world scene. The idea of a united Europe, a loose European federation of states, rich in cultural diversity, which were prepared to relinquish part of their autonomy and sovereignty to common institutions, developed into a pervasive force among the people and the political class in most countries. It was this pervasive force which moved politicans to act and in the last analysis also broke the (justified) hesitation of economists and even the German Bundesbank.
Notes and references 1. Ch. Goodhart, ‘Economists’ perspectives on the EMS’, Journal of Monetary Economics, 26, 1990, pages 471-487; A. Giovannini, ‘On gradual monetary reform’, European Economic Review, 35, 1990, pages 457-466. 2. G. Kirchgissner and J. Wolters, ‘Gibt es eine DM-Zone in Europa?’ Paper presented to the Conference on Monetary Areas of Tension in the World Economy, October 1990, Wtirzburg, Germany. 3. Delors Committee, Report on Economic and Monetary Union in the EC (Brussels, European Commission, 1990). 4. T. Padoa-Schioppa, ‘Financial and monetary integration in Europe: 1990-1992 and beyond’, Group of 30 Occasional Paper, New York, London, 1990. 5. L. B. Smagi and St. Mcossi, ‘Monetary and exchange rate policy in the EMS with free capital mobility’, in Paul de Crauwe and Lucas Papademos (editors), The European Monetary System in the 90s (London and New York, Longman, 1990) pages 120-161. 6. European Commission, ‘One market-one money: an evaluation of the potential benefits and costs of forming an economic and monetary union’, European Economy, 44, October 1990. 7. D. MacDougall, The Role of Public Finance in European Economic integration (Brussels, Commission of the EEC, 1976); J. Sachs and C. Sala-i-Martin, Federal Fiscal Policy and Optimum Currency Areas (Harvard University, Cambridge, MA, mimeo, 1989). 8. The experience with German monetary unification, when on 1 July 1990 the Deutschmark was overnight introduced in the former GDR replacing the old ‘funny money’ Ostmark, has clearly demonstrated the enormous economic adjustment burden resulting from such a radical approach. 9. Sir Thomas Cresham (1519-1579) was an English merchant and adviser to the British government. He noticed that coins that were manipulated by polishing off gold, gradually replaced good coins. (‘Bad money always drives out good money’.) 10. N. Thygesen, ‘Institutional development in the evolution from EMS to EMU’ in de Grauwe and Pademos, op tit, reference 5. 11. Giovanni, op tit, reference 1. 12. A. J. Marquez Mendez, ‘Economic cohesion in Europe: the impact of the Delors Plan, Journal of Common Market Studies, September 1990. 13. J. Menkhoff and F. L. Sell, ‘The advantages of a small European monetary union’, Intereconomics, 26, 1990, pages 64-67. 14. R. Hasse, Europlische Zentralbank: Perspektiven for eine Weiterentwicklung des europ%sthen Wahrungssystems (Gtitersloh, Bertelmann, 1989). 15. J. E. Meade, ‘The EMU and the control of inflation’, Oxford Review of Economic Policy, 6, 1990, pages 100-107. 16. P. van den Bempt, ‘National fiscal policies in an economic and monetary union’, European Business Journal, 1991, pages 10-18. 17. W. Buiter and K. Ketzer, ‘Reflections on the fiscal implications of a common currency’, London, CEPR Discussion Paper, 418, 1990. 18. Op tit, reference 7.
FUTURES
September
1991
708
European
monetary
union
19. Chr. de Boissieu, ‘Avantage de l’union economique et monetaire’, Revue de I’konomie publique, 101, 1991, pages 153-166. 20. Bundesbank, ‘Stellungnahme der Deutschen Bundesbank zur Errichtung einer Wirtschaftsund Wahrungsunion in Europa’, in Monatbericht der Deutscher Bundesbank, October 1990, pages 41-45. 21. H. Christophersen, ‘La subsidiarite et I’union economique et monetaire’, and R. Jochimsen, ‘La subsidiarite dans le domain de I’union Cconomique et monetaire’, both in SubsidiaritC: DCfis du Cbangement, Acte de Colloque lacques Delors (Maastricht, EIPA, 1991).
FUTURES
September
1991
EUROPEAN
MONETARY
Alice in Wonderland Blunderland?
UNION
or Malice
in
Klaus Gretschmann
Prologue The date is 1 January of the year 2003. Ten years ago the Single European Market was completed in the Europe of the Twelve. As a birthday present, we are witnessing today the inauguration of a Eurofed and the baptism of a single European currency: the franc fort. Guess where we are celebrating. At the ultimately determined seat of the Eurofed-Frankfurt. After a decade of haggling and bargaining, the suggestion of the German Bundesbank, that Frankfurt is the natural location, has apparently hit home with Germany’s European partners. On the winding and stormy road to this single currency, the EC was confronted with several serious problems: while in the course of the 1990s the EC had managed to reach considerable common ground in the area of economic and monetary policy (largely due to the anchor function of the Deutschmark), in the wake of German unification the Deutschmark softened and lost some of its dominance, and thus endangered monetary stability. In addition, the enlargement of the Community increased economic divergence and required that 20 national currencies had to be managed and merged. However, the Swedish President of the EC Commission, a crusader for economic and monetary union (EMU), managed to get a compromise accepted, encompassing both rather tight rules on national public spending and borrowing and a handsome amount of money to be given to the weaker member states, to alleviate the inevitable macroeconomic adjustment shock. But the good old days will not be forgotten. In a prominent place of the Luxembourg Museum of Modern Monetary History stands a glass case containing coins and bills of the former national currencies, as well as some accounting documents which were used for dealing with the predecessor of the franc fort, the European Currency Unit (ECU). Unfortunately, the ECU never really lived up to expectations that it would become a single European currency. Let us slip back now for a moment to the year 1991 in order to see how the EMU concept was born and how its progenitors fought with each other about what it should become. Klaus Cretschmann European Institute Netherlands.
FUTURES
September
is Professor of Economics and Head of the Community of Public Administration, OL Vrouweplein 22, NL-6211
1991
0016-3287/91/070695-14
Policy Unit at The HE Maastricht, the
@ 1991 Butterworth-Heinemann
Ltd
696
European
monefary
union
At the cradle: the experience
of the 1980s and the challenges
of the 1990s
The idea of EMU is not a new one. As long ago as 1970 the Werner Report set out a three-stage process of greater economic and monetary integration. Its proposals never got off the ground, largely because of the lack of convergence between the economies of the member states and a lack of political determination to promote such convergence. Since 1979, cooperation in the field of monetary policy between the member states of the EC has taken place under the aegis of the European Monetary System (EMS). After overcoming initial teething troubles, the system has functioned satisfactorily and in the course of time has become a source of growing monetary stability. Since the year 1987, there has been no general realignment of exchange rate parities. This may be taken as a clear indication that the EMS has proved extremely successful in bringing inflation and interest rates down in some formerly high-inflation countries.1 In fact, it has turned the EC into a Deutschmark zone:2 the German Bundesbank fixed its monetary policy autonomously while other member states sought to stabilize their exchange rates against the Deutschmark by controlling their monetary basis. This has introduced asymmetry into the EMS by putting the burden of adjustment on the inflating countries. Although this has been widely recognized as successful, German leadership has been less and less readily accepted. Several EC countries felt that their economic policies were unduly restricted by the high priority assigned by the Bundesbank to preventing inflation and trying strictly to control the money supply. Particularly for political reasons, France and several other member states felt the need to underline the essential character of EMS as a truly European arrangement, rather than a pure Deutschmark block. In the late 1980s these countries moved towards freeing their monetary policies from the dictee allemande. In 1988, the French minister of Finance, Balladour, and his Italian colleague, Amato, proposed that one European central bank should substitute for EMS in order to overcome the loss of autonomy resulting from German domination of EMS. The Germans reacted with mixed feelings, but rather than blocking they took the initiative and proposed at the Hannover Summit to set up a committee, chaired by Jacques Delors, President of the European Commission, with the task of studying and proposing steps leading to a European Monetary Union. The Delors Committee Report3 presented in June 1989 brought EMU to the forefront of the European debate. EMU was defined as an irreversible locking of exchange rates, leading to the adoption of a single European currency. This currency would be managed by an independent European Central Bank, setting the level of interest rates across the Community. Ingeniously, the scene had been set to start negotiations on how to redesign European monetary cooperation and how to assign it Treaty status. For this purpose, in December 1990 an Intergovernmental Conference (ICC) on Economic and Monetary Union was convened and was supposed to work its way through the jungle of practical and theoretical scenarios which are part of the EMU business. But there were also economic reasons why an ‘ever closer’ economic and monetary union was a ‘non-obscure object of desire’:
FUTURES
September
1991
European
monetary
union
697
(I)
In the summer of 1991, the completion of the internal market is within reach. Its full benefits, however, can only be reaped if exchange rate uncertainty, as well as other obstacles, are removed.4 Accepting ‘1992’ as most business people consider exchange rate a foregone conclusion, fluctuations to be the major remaining barrier to trade. The combination of the ‘1992 programme’ with EMU would translate not only into static but also into a higher sustainable rate of economic growth gains, (dynamic effects). Empirical estimates show that reduced exchange rate uncertainty would permit a reduction in the rate of return necessary to stimulate new investment. No matter to what extent this argument can stand scrutiny, its psychological impact is undisputed: if politicians develop and present credible strategic commitments to EMU, economic agents will doubtlessly adjust their expectations and anticipate the would-be changes in their behaviour. (2) Growing economic and financial interdependence, particularly the free circulation of capital across national frontiers, is eroding member states’ autonomy in economic and monetary policy making. Once every financial institution in the EC is free to accept deposits and to grant loans to any customer in any national currency, the capability of national central banks to control monetary aggregates will be lost.5 As the PadoaSchioppa report has put it: you cannot have free capital movement, fixed exchange rates and independent national monetary policy making at the same time. With liberalization of capital markets, the area in which a currency is used and the jurisdiction in which its banking system operates will no longer dovetail. This will make a truly supernational institutional arrangement necessary. (3) It is frequently argued that efficiency gains would accrue from a move to EMU. These include a reduction in all exchange rate-related transaction costs such as bid-spreads and other commissions in foreign exchange transactions. These costs add up to at least 0.5% of gross domestic product per year for the EC as a whole, ie about 15 billion ECU in positive effects will result from the eliminaabsolute figures. 6 Moreover, tion of information costs and the reduction of incentives for price discrimination made possible by the simultaneous use of a number of national currencies. Through EMU, prices will be made directly comparable. Finally, economic opportunities will arise, resulting from the fact that foreign exchange reserves, formerly held in order to defend intraunion exchange rates and to fend off speculative attacks on a currency, will be set free.
All these points explain why EMU has indeed been put on top of the agenda of European integration for the 1990s. However, leaving the EMS behind and turning towards EMU involves some risks. It is not only the expected loss of national sovereignty in the area of monetary and economic policy making that makes some member states hesitate to commit themselves to a fully-fledged EMU. Even more significant is the uncertainty of whether or not a European currency and a European Central Bank would be able to establish the same degree of stability and credibility as was achieved by the Bundesbank in the 1980s. Confidence in stable prices and stable exchange rates cannot be decreed, it must evolve. No legal act can force monetary
FUTURES
September
1991
698
European
monetary
union
union if the economic prerequisites are not already present. It is the markets, not the politicians, that ultimately decide about the success or failure of the EMU. One of the major problems of EMU is that the objective of price stability in some countries can be bought only with unacceptably high social costs, particularly a significant increase in unemployment. It goes without saying that for many countries EMU will put strong adjustment pressures on their economy. As the exchange rate as an instrument for adaptation to international markets will no longer be available, national wage and interest rates will have to be flexible enough to bolster adjustment shocks. However, without compensation for wage and interest rate adjustment, economic pressure will mount in weak currency countries. In order to lessen the temptation for those countries to print money aggressively, much regional redistribution (possibly in the form of a dramatic increase in structural funds) will be required as no country will voluntarily accept a levelling down of the economic well-being of its citizens.’ The decoupling of European monetary cooperation from German dominance certainly will entail some benefits but it will also imply costs. The hard currency countries like Germany, the Netherlands or even France will have to sacrifice some of their stability achievements, whereas the soft currency countries will have to suffer from adjustment pressures.
EMU: bringing it into existence
and making it tick
In theoretical terms there are basically economic and monetary union:
three
different
ways to bring
about
(I)
The so-called overnight or leap-in-the-dark approach, involving the the pooling of the member states’ immediate set-up of a Eurofed, and finally, the overnight replacement of national currency reserves, currencies by a common European currency. Such a shock treatment would lead to serious problems in adaptation and adjustment for investors, consumers, lenders and borrowers.8 (2) There is the model of currency competition: all national currencies and the ECU would be accepted as legal tender everywhere in the EC. Competition will then help select the best currency, which over time will crowd out the least liked currencies. This resembles a process which is the inverse of the famous Gresham law .9 This approach is not without having to deal with a number of currencies rather than problems either: just one will, at least for the transitional period, lead to an increase in information and transaction costs. Moreover, when several currencies are accepted as legal tender throughout the EC, while at the same time only one institution (National Central Bank) in each member state remains responsible for setting the parameters of monetary policy in its respective currency area, unbalanced and asymmetrical markets will result. (3) The third and last possibility is a gradual, step by step approach. This is exactly the model put forward in the Delors Report, distinguishing three stages of introducing economic and monetary union.lO Stage 1, requiring free movement of capital and some coordination of monetary policies,
FUTURES
September
1991
European
monetary
union
699
began in July 1990. During the second stage, originally planned to start in January 1993, but later postponed by at least one year, European exchange rate realignments would be ultra-rare. The European Central Bank (ECB) would be set up to achieve more comprehensive coordination of monetary policies, but ultimate monetary sovereignty would still rest with national central banks. In stage 3, the ECB would completely control monetary policy, with exchange rates permanently fixed. It would start soon after stage 2, when the national governments decided that the time was ripe. To prevent poorer EC economies from being rushed into stage 3 prematurely, they would be allowed a ‘grace period’. Plan (3) has not defined, however, what respective national and supranational monetary authorities are supposed to do at the various stages. This lack of clarity may introduce considerable uncertainties in the financial markets. Given these imponderables, economic agents cannot form firm expectations on the stance and behaviour of national and supranational monetary policies. The crucial question is: who will be in the driver’s seat when the ECB and national central banks exist side by side, both having a say during the second stage? As no one is clearly in charge of national monetary policies during the second stage, criticism concentrates on this stage. Formulas to ‘strengthen to ‘develop the instruments and the coordination of monetary policy’, procedures needed for the future conduct of a single monetary policy’, to ‘closely monitor the development of the ECU’ are empty shells and do not contribute at all to stabilizing the financial markets in the period of transition. When discussing the role of the second stage, we are faced with two concepts. One aims at a short, mainly technical second stage, which would start only when the permanent fixing of exchange rates is accomplished. The other concept contains a second stage which would start much earlier Its aim is to bring convergence and policy and would last much longer. coordination to a point where the third stage may be entered and the conduct of monetary policy be handed over to the ECB. however, entails a risk: if an ECB is to lead a The latter approach, shadowy existence possibly for many years during the second stage, with its tasks restricted just to coordination rather than the conduct of policy, it is bound to become a weak institution with a low standing in international markets. This will then lead to low confidence in the European currency which the ECB is supposed to issue and control in stage 3. This criticism found its strongest expression in the German Draft Treaty on EMU submitted in early 1991. On the transition to EMU, the German government made four central proposals. First, an EC Bank should not be established prior to achieving currency union, the final stage of EMU, which would begin in 1997 at the earliest. This is to avoid overlapping responsibilities and competing interests between national monetary authorities and supranational institutions. Second, no new currency would be created in the second stage which is to start in 1994. Instead, devaluation of the ECU would be ruled out, in order to make it a perfect substitute for the Deutschmark, the strongest currency presently. Third, transition to full currency union would only follow agreement that a majority of member
FUTURES
September
1991
700
European
monetary
union
states had achieved acceptable convergence of inflation, budget deficits and interest rates.. Currency union would be limited to those member states that had reached these standards, while the others could onty join later. Fourth, there should be binding ceilings on the budget deficits of those member states joining the currency union. This proposal has been severely criticized -above all by the European Commission and several member statesaccusing Germany of dragging its feet on progress towards EMU. The proposal, none the less, reflects considerable scepticism towards a graduaiist approach to EMU as long as there is not enough convergence in the real economy of the member states.‘l The movement towards more convergence in economic performance has definitely made headway in recent years. However, this does not apply to the same degree to all EC countries; it holds primarily for those countries which opt for more discipline in the EMS exchange rate mechanism. At present, economic divergences in the EC remain considerable. Among member states: l inflation rates range from 2.5% to 22%; * short-term interest rates range from 9% to 19%; I, budget balances range from a surplus of I% of GDP to a deficit l unemployment rates range from f.5% to 16%.
of 17%;
Hence, it does not seem to make much sense to fix the dates for the transition to stage 2 or 3 strictly in accordance with the calendar, as has been proposed, because there are considerable risks attached to any premature move to EMU. If a future ECB pursued the rigorous and sustained monetary policy necessary for the achievement of price stabitity, it would entail heavy costs for the least prosperous regions in the EC. They might become increasingly uncompetitive and face a sharp rise in unemployment. This would probably lead either to a relaxation of monetary policy or to pressure for a massive increase in EC expenditure to finance fiscal transfers to poorer regionsJz Such transfers, however, can never be an effective and durable solution to the problem of lack of competitiveness. But, as they bolster the adjustment process, such transfers might be counterproductive, slowing down the adjustment process. At any rate, this is the view of the strong currency countries. The vantage point of the weak currency countries is a different one. Given the menu of choice between more infiation and more unemployment, they opted fur a different point on the famous Philips curve, due to Political preferences, however, often just reflect ecopofiticaf preferences. nomic ones. Germany and other countries with ageing populations and a high level of savings and wealth are on the anti-inflation side. Countries like are much less interested in protecting Portugal, Spain, Italy and Greece financial assets, the holding of which is not a widely spread phenomenon in their economies. They are faced with high youth unemployment and their primary objective is the creation of jobs. They have therefore been willing bearing in mind that inflation redisto accept a higher level of inflation, tributes from the saver (creditor) to the investor (debtor). If preferences about inflation and unemployment are split within the EC, is it not then a logical consequence that EMU wilt take place at one of two speeds, with a
FUTURES
September 1991
European
monetary
union
701
core consisting of the happy few-countries like France, the Netherlands, Germany, Belgium and Denmark?13 In economic terms this would probably be the adequate solution. Yet it would involve political costs, particularly a weakening of the integration In the past, the weaker member states of the EC were able to process. countervail economic dominance of the big players through political voting. In a system which excludes the weaker ones, Germany, France and Benelux would decide on European economic and monetary policy on their own, regardless of what the interests of the weaker countries were. Against this background it has become sufficiently clear that Europe should not opt for a two-speed approach. EMU has to be designed in such a way that neither the strong nor the weak currency countries will lose. The weak currency countries should be aware of the fact that in the absence of an exchange rate instrument, with a restricted scope to national fiscal policy and with limited cross-border labour mobility, adjustments in EMU will have to be made mainly via a curb on wage costs and prices, ie they will grow more slowly than in strong currency countries. If such curbs are not deep enough, economic growth and employment will definitely suffer. Loss of the exchange rate tool in the process of approaching European EMU makes it all the more necessary for the job market to operate flexibly in order to keep wage costs under control. This may, however, lead to social unrest.
European Central
Bank-player
or pawn?
A common currency as the final objective of EMU implies a European Central Bank issuing and controlling it. Agreement is necessary both on its tasks and on the extent of its political autonomy. In any monetary union the design of the central authorities is crucial. It must be the anchor against inflation, comparable to gold in the gold-standard and the Deutschmark in the present EMS. The Delors Report suggests a Central Bank Board with members appointed by the Council of Ministers and a Central Bank Council composed of the governors of the existing national central banks plus members of the Board. The Council will be responsible for the formulation of monetary policy; the Board and the staff for its execution and implementation. The Council would submit annual reports to the European Parliament and the Council of Ministers and its chairman could be invited to report at other times. The independence of the Council would be bolstered by giving its members security of tenure. There has been a widespread agreement on the following policy essentials of EMU: (1) The primary commitment of the ECB should be to monetary stability, ie price stability. (2) The ECB should be protected against any form of political influence and pressure. (3) The main lines of external monetary policy shall be a political responsibility, exercised by the Ministers of Finance while the ECB shall have a large measure of autonomy in its implementation.
FUTURES
September
1991
702
European
Why price
monetary
union
stability?
The anti-inflationary stance the ECB is supposed to take starts from the assumption that inflation distorts price signals and leads to sub-optimal allocation of resources. Inflation induces risk and uncertainty for both the investor and the consumer, leading to higher risk premiums in terms of profit margins on the one hand, and to some reticence in purchasing on the other hand. Moreover, inflation entails steeper transaction costs-economic agents invest time and effort to escape inflation and to find ways and means to invest in non-inflationary areas. This has serious consequences to the extent that the exchange-rate signals are biased by inflation, and investors will diversify their assets and change the maturity patterns of their investments. Finally, inflation has serious distributional consequences, mainly to the detriment of the small saver.
Why political
independence?
There is full consensus that for the attainment of the primary objective, viz price stability, it is important that the decision-making bodies shall not be influenced by considerations which could be in conflict with the pursuit of price stability. The statute of the ECB, therefore, establishes the principle of independence in that it states that its institutions and decision-making bodies shall act independently of instructions from political authorities. This is not exactly easy to realize politically. Central Banks within the EC at present differ widely in responsibility and position. Some, like the Bank of England, are not responsible for determining monetary policy but are charged with executing the Treasury’s policy. The Bank of France, too, is charged with advising and executing the monetary policy determined by the government. The ECB, if set up along the lines agreed upon during the intergovernmental conference, would therefore in no way reflect the situation currently prevailing in Europe but would be rather like a German type of Central Bank.14 But how should the powers which governments have been unwilling to entrust to their own Central Banks be entrusted to the new European one? Despite lip service to Central Bank autonomy this remains one of the major leaks in the EMU vessel.
Why political
control
of external
monetary
policy?
The ECB is unlikely to be permitted to intervene in third currencies. The political authorities of the EC will want to decide on the nature of the exchange rate regime, whereas the ECB may intervene only within this framework. This will inevitably lead to conflicts: the Germans think that the fixation of the exchange rate towards non-EC countries’ currencies should not be possible against the vote of the Central Bank and that changes in the exchange rate regime by Council should be decided unanimously; the French plead for a qualified majority. As monetary policy cannot be carried out without the corresponding external safeguards, any credible solution (to be accepted by the markets) requires an adequate right of codetermination by the Bank. Purely political decisions to be enacted by the Council of
FUTURES
September
1991
European
Ministers will therefore have to be excluded. It is clearly greatest risks to the ECB’s autonomy are looming.
Budgetary
monetary
union
703
this area where
the
policy: leeway and limits
In addition to the issues dealt with above, the Bank’s prohibition to finance deficits of public authorities is another major bone of contention. The prohibition to finance public deficits is a decision which sends signals to the financial markets and which also has serious implications for the fiscal policies of the member states. By definition, if the EC adopts a single currency, governments will relinquish their sovereignty over monetary policy. Control over interest rates and money supply, and consequently inflation, will pass to the new Central Bank. To what extent will member countries in EMU also have to accept constraints on national budgets? All member states seem to agree that the ECB would not be obliged to finance a national deficit. Moreover, the EMU will eliminate monetary financing of budgets and hidden tax collections through regulation of banking reserves. It will no longer be possible to generate public revenues through national money creation. Government profit from coinage will be limited to that which results from European money creation. It will also not be possible to levy hidden taxes through banking reserve requirements that are higher than those interest rates for public borrowers imposed by member states. Privileged which would discriminate against national banks shall be excluded. As a result, financing of public sector borrowing will have to occur through the capital markets at non-privileged rates. In order to compensate for revenue loss in the monetary area, member states would have to revise their taxation policies, or to increase their current level of state indebtedness. Experience in most member countries has proved conclusively that the absence of direct recourse to central bank finance does not necessarily prevent national governments from running large deficits. Excessive national deficits of some member countries, implying a disproportionate use of Community savings or of the acceptable scope for total monetary financing, could result in heavy strains, both economic and political. Efficient economic policy making at any stage of a monetary union therefore calls for a reasonable regulation of the relationship between the ECB and public sector borrowers.‘j The experience in some southern EC countries shows clearly that market forces are often too weak to restrict and discipline large-scale public sector debtors. Under the conditions of EMU, excessive public sector debt on the part of a member state is no longer restricted (as it is in the EMS) by pressures on the exchange rate, rising interest rates, or a deterioration of the current account. From the point of view of an individual member state, borrowing in the Community-wide capital market becomes easier, as interest rates and balance of payment risks are born by the Community as a whole. This could provide an incentive to behave in a way detrimental to other member states and would encourage a misallocation of savings within the EC. Often the argument is heard by free marketeers that after EMU governments will have to compete for best borrowing terms and this would prevent overborrowing. Critics hold against this argument that EMU may be interpreted by the financial markets as a collective device for backing up
FUTURES
September1991
704
European
monetary
union
those member states that are in financial trouble. A generally overexpansionary fiscal policy stance in the EC would confront monetary policy makers with the tricky alternative of either accommodating higher demand at the expense of price stability or crowding out private demand by means of higher interest rates. Irrespective of what side one takes in this debate, in the interest of stability it will be necessary to complement market disciplines with binding rules on member state budget deficits. Later this will probably give way to a strictly coordinated,16 or even centrally determined fiscal policy, which would require a single European finance ministry. Anybody who is unable to accept this curtailment of national autonomy in terms of budgetary discipline cannot be in favour of monetary union either. This highlights the central problem of the planned EMU: the deep curtailment of national sovereignty in the field of fiscal policy will fundamentally challenge the self-respect of member state governments-and few of them are prepared to accept that challenge, at least not yet. On the other hand, a common monetary policy without general budgetary discipline will undermine stability and endanger welfare. Member states cannot have it both ways. EMU requires an adequate commitment of all member states to a permanent stabilization of deficit policies. All countries agree that economic union should entail multilateral surveillance procedures, with regular EC reports on each national economy containing recommendations and policy guidelines. But there is wide disagreement on how far the EC should stick its nose into national affairs. When talking about binding guidelines for national budget deficits, what do we have in mind? Basically, two golden rules are being discussed. First, the quota of public deficits to GNP should not exceed a certain figure. Secondly, deficits should only be allowed up to the total of public investment in the national budget. One might, however, consider another more flexible rule: it is not the deficit that counts in economic terms, it is the burden resulting from deficits and that is interest payments. I therefore propose a rule according to which the interest payments resulting from a certain deficit should not exceed a share of the public budget. This rule would give policy makers more discretion about how to finance public spending, because interest payments can be influenced by skillful debt management. This rule would give some leeway to policy makers within a definite framework that would limit their proclivity for borrowing at a maximum threshold (interest payments). The largest unsettled question about applying binding limits is the demand from some member states for financial penalties against any country that refuses an EC order to cut its budget deficit. An unpublished paper presented to the ICC recently spelled out what penalties deficit makers would face. Initially, EC ministers would recommend in private to the country how the deficits should be dealt with. If that failed to produce an acceptable result, the ministers would make their recommendations public, in other words, give a public reprimand. If that produced no improvement, the freezing of EC transfers, such as structural fund grants to the country concerned, would be invoked. or Sala-i-Martin18 have pointed Economists such as Buiter and Kletzerl’ to the decisive problem of EMU. The EC is planning to harmonize monetary
FUTURES
September
1991
705
policies in the presence of 12 different budgetary policies. In order to make EMU tick, the budgetary policy side has to be strengthened either via ex ante coordination of national budgets or via a considerably increased role of the EC budget. As long as the latter only accounts for about for about 1% of Community GDP, it is not a suitable instrument for fiscal policy at the European level. However, at the end of the road, there probably will be a centrally determined fiscal policy for the EC as a whole-in other words a single finance ministry.
Conclusions:
EMU between
economics
and politics
There can be no question, Europe needs a common currency. A common currency reduces the costs of international transaction, avoids the risks of exchange rate fluctuations and thus contributes to optimal allocation of the overall economic effects, quantitatively resources in Europe. w However, considered, are only marginal. Really important is the political objective of demonstrating that Europe, which is at the same time an economic giant and a political dwarf, is able to marshal its forces and transfer national sovereignty to truly European institutions. Against this background, EMU serves as a symbol. It is an evident sign of the irreversibility of the process of integration, emphasizing the growing together of European nations to an economic and finally a political whole. There is another significant political dimension involved here, a dimension rarely discussed openly but none the less relevant on the operative level. The Germans are persistently suggesting to their partners not to drop the economic advantages of the European Monetary System with the strong terms Deutschmark as an anchor currency. 2o They argue that in political most EC countries do not really suffer a loss of monetary autonomy since financial interdependence has in fact already made them largely dependent made by the Bundesbank in Frankfurt. Behind this on policy decisions argument is the realization that it would be mainly Germany which would be required to sacrifice its present preponderant position in monetary decision making in Europe-and not only in the Europe of the Twelve. The strategic choice from this perspective is whether EMU is an instrument to transfer monetary policy competence to the European level or to keep it more or less a domainhowever informal-of the German Bundesbank. This question will be-unofficially-one of the key issues in the debate during the coming years. One thing is for certain: a full currency union will deprive its members of the power to issue their own money. The political consequences of this are enormous but are normally overlooked in the EMU debate. Once there is a single European currency, EMU will prevent member state governments from cheating their citizens through inflation. That has been made abundantly clear in the debate on the so-called inflation tax; inflation-permitted and controlled by national monetary authorities-is a means of devaluing the public debt. The private citizen who has lent his savings to his own government, will now have to trust the new ECB which will take over monetary control and apply European rather than national standards to controlling inflation and public deficits and thus decide over the value of his
FUTURES September 1991
706
European
monetary
union
savings. But who is to control the Eurofed? Who is to ensure that the same process of devaluing nominally fixed loans will not occur on the supranational rather than the national level-parliamentary control, autonomous Central Bankers or anonymous financial markets? This is still an open question,*’ yet it is certain that none of those mentioned can be trusted completely.
Epilogue Let us return to the prologue and the year 2003. The 1990s indeed turned out to be a stormy decade as far as EMU was concerned. The first IGC did not produce a generally acceptable solution. It was followed by new proposals and counterproposals, overlayed by the discussion about accession of several former EFTA countries as new member states-which in the last analysis tipped the scale in favour of a strong, independent Eurofed. Here are some of the solutions to the fundamental questions that were on the agenda of 1991: l
l
l
l
l
In order to control excessive budget deficits and to implement the a Debt Council of the Finance Ministers procedure described above, (DCFM) was set up with the ultimate power to stop Community transfers to those member states which violated the rules. The Central Bank (Eurofed) was granted wide-ranging autonomy within broad political guidelines set by the Council of Ministers of Economics and Finance (Ecofin). In cases of conflict between the Central Bank and Council, the European Parliament will play the role of arbiter (Dutch model). After prolonged controversy it was agreed that the full competence for determining external monetary policy-the management of exchange rates-was assigned to the Central Bank. The decisive argument was the recognition that internal and external monetary policy is indeed indivisible. Although there were prolonged negotiations and endless discussions about a two-speed approach and the provision of a ‘grace period’ for some member states, in the end all 20 decided fully to join EMU in one shot. In order to absorb the adjustment shock on weak currency member states it was decided already in 1998 to double the structural fund transfers over was reached on another the following four years. In 2002 agreement by an increase in the doubling of the funds. This was made possible number of net contributors to the EC budget. Several of the new members admitted in the 1990s joined Germany and the UK as net payers.
There was also much discussion about the price tag attached to EMU-what would the people have to pay and what would they get for it? The case of German unification was after all a vivid demonstration of the costs of integration. But no one was prepared or able to identify or quantify in detail the costs and benefits of EMU. In the last analysis, it was the political will to move on with integration that tipped the scale in favour of EMU. Post-World
FUTURES
September
1991
European
monetary
union
707
War II prosperity in Western Europe was seen as a major result of integration-and no one wanted to risk this prosperity. Finally, there was the ideal of a united Europe, a politically and economically strong Europe that guaranteed peace and security at home and could develop into a major stabilizing factor, not only for the countries of Central and Eastern Europe -which are hoping to join the 20 member states as soon as possible-but also on the world scene. The idea of a united Europe, a loose European federation of states, rich in cultural diversity, which were prepared to relinquish part of their autonomy and sovereignty to common institutions, developed into a pervasive force among the people and the political class in most countries. It was this pervasive force which moved politicans to act and in the last analysis also broke the (justified) hesitation of economists and even the German Bundesbank.
Notes and references 1. Ch. Goodhart, ‘Economists’ perspectives on the EMS’, Journal of Monetary Economics, 26, 1990, pages 471-487; A. Giovannini, ‘On gradual monetary reform’, European Economic Review, 35, 1990, pages 457-466. 2. G. Kirchgissner and J. Wolters, ‘Gibt es eine DM-Zone in Europa?’ Paper presented to the Conference on Monetary Areas of Tension in the World Economy, October 1990, Wtirzburg, Germany. 3. Delors Committee, Report on Economic and Monetary Union in the EC (Brussels, European Commission, 1990). 4. T. Padoa-Schioppa, ‘Financial and monetary integration in Europe: 1990-1992 and beyond’, Group of 30 Occasional Paper, New York, London, 1990. 5. L. B. Smagi and St. Mcossi, ‘Monetary and exchange rate policy in the EMS with free capital mobility’, in Paul de Crauwe and Lucas Papademos (editors), The European Monetary System in the 90s (London and New York, Longman, 1990) pages 120-161. 6. European Commission, ‘One market-one money: an evaluation of the potential benefits and costs of forming an economic and monetary union’, European Economy, 44, October 1990. 7. D. MacDougall, The Role of Public Finance in European Economic integration (Brussels, Commission of the EEC, 1976); J. Sachs and C. Sala-i-Martin, Federal Fiscal Policy and Optimum Currency Areas (Harvard University, Cambridge, MA, mimeo, 1989). 8. The experience with German monetary unification, when on 1 July 1990 the Deutschmark was overnight introduced in the former GDR replacing the old ‘funny money’ Ostmark, has clearly demonstrated the enormous economic adjustment burden resulting from such a radical approach. 9. Sir Thomas Cresham (1519-1579) was an English merchant and adviser to the British government. He noticed that coins that were manipulated by polishing off gold, gradually replaced good coins. (‘Bad money always drives out good money’.) 10. N. Thygesen, ‘Institutional development in the evolution from EMS to EMU’ in de Grauwe and Pademos, op tit, reference 5. 11. Giovanni, op tit, reference 1. 12. A. J. Marquez Mendez, ‘Economic cohesion in Europe: the impact of the Delors Plan, Journal of Common Market Studies, September 1990. 13. J. Menkhoff and F. L. Sell, ‘The advantages of a small European monetary union’, Intereconomics, 26, 1990, pages 64-67. 14. R. Hasse, Europlische Zentralbank: Perspektiven for eine Weiterentwicklung des europ%sthen Wahrungssystems (Gtitersloh, Bertelmann, 1989). 15. J. E. Meade, ‘The EMU and the control of inflation’, Oxford Review of Economic Policy, 6, 1990, pages 100-107. 16. P. van den Bempt, ‘National fiscal policies in an economic and monetary union’, European Business Journal, 1991, pages 10-18. 17. W. Buiter and K. Ketzer, ‘Reflections on the fiscal implications of a common currency’, London, CEPR Discussion Paper, 418, 1990. 18. Op tit, reference 7.
FUTURES
September
1991
708
European
monetary
union
19. Chr. de Boissieu, ‘Avantage de l’union economique et monetaire’, Revue de I’konomie publique, 101, 1991, pages 153-166. 20. Bundesbank, ‘Stellungnahme der Deutschen Bundesbank zur Errichtung einer Wirtschaftsund Wahrungsunion in Europa’, in Monatbericht der Deutscher Bundesbank, October 1990, pages 41-45. 21. H. Christophersen, ‘La subsidiarite et I’union economique et monetaire’, and R. Jochimsen, ‘La subsidiarite dans le domain de I’union Cconomique et monetaire’, both in SubsidiaritC: DCfis du Cbangement, Acte de Colloque lacques Delors (Maastricht, EIPA, 1991).
FUTURES
September
1991