European Monetary Union: Progress and Prospects

European Monetary Union European Monetary Union: The way forward analyses the economic effects of the changeover to a unified European currency and assesses the pressures caused by a dual-currency system over the three and a half years transition period to the Euro. Subjects discussed include: •

fiscal transfer payments: the implications of the US structure for the EMU

•

the arbitrage consequences of parallel currency 1999–2002

•

the feasibility of a single currency without the exchange rate mechanism

•

the relationship between the UK and Europe

•

accounts of moves towards monetary union in Austria, Portugal and Finland

Providing a detailed overview of the financial implications of European Monetary Union, this collection contains contributions by professional financial specialists from a number of European countries. It will be extremely useful for all those studying contemporary European economics and politics. Professor H.M.Scobie is Director of the European Economics and Financial Centre, London.

European Monetary Union The way forward

Edited and co-authored by H.M.Scobie European Economics and Financial Centre, London

London and New York

First published 1998 by Routledge 11 New Fetter Lane, London EC4P 4EE This edition published in the Taylor & Francis e-Library, 2003. Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 © 1998 H.M.Scobie All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data European monetary union: the way forward/edited by H.M.Scobie. p. cm. Includes bibliographical references and index. 1. Monetary unions—European Union countries. 2. European Monetary System (Organization) I. Motamen-Scobie, Homa. HG3942.8.E924 1998 332.4′566′094–dc21— 97–14248 CIP Library of Congress Cataloging in Publication Data ISBN 0-203-19229-X Master e-book ISBN

ISBN 0-203-26538-6 (Adobe eReader Format) ISBN 0-415-17408-2 (Print Edition)

CONTENTS

List of figures List of tables 1

2

ix x

THE CHANGEOVER TO A UNIFIED EUROPEAN CURRENCY: WHY A ‘BIG BANG’ APPROACH IS NECESSARY H.M.Scobie, S.A.Buckley and R.Fox, European Economics and Financial Centre, London Introduction Background The Green Paper Drawbacks of the ‘critical mass’ approach The experience of German currency conversion Areas of further concern Extensive education needed for the launch of the single currency Conclusions Appendix A: Selected Articles from the Treaty on European Union Appendix B: Summary of the Green Paper’s proposals for public education Appendix C: Extracts from The Preparation of the Changeover to the Single European Currency (Interim Report)

1

1 1 1 3 6 12 13 13 14 16 20 21

Notes

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FISCAL TRANSFER PAYMENTS: IMPLICATIONS OF US STRUCTURE FOR THE EUROPEAN MONETARY UNION H.M.Scobie and T.Day, European Economics and Financial Centre, London Background US transfer payments for unemployment

23

v

23 23 24

CONTENTS

Concluding remarks References

30 30

EUROPEAN MONETARY UNION: SINGLE CURRENCY FEASIBLE WITHOUT THE ERM H.M.Scobie, Director, European Economics and Financial Centre, London and Professor of Economics, University of London Introduction Objectives of ERM Limits of ERM Concluding remarks Note References

31

4

THE SINGLE CURRENCY The Rt. Hon. Lord Kingsdown K.G., House of Lords, Former Governor of the Bank of England

40 40

5

EMU: THE OBSTACLE RACE TO SUCCESS Philippe Maystadt, Deputy Prime Minister and Minister of Finance and Foreign Trade, Belgium Why must EMU succeed? No true Single Market without EMU EMU in a tripolar world monetary system How can EMU succeed? Sticking to the Maastricht Treaty Strengthening the credibility of the final stage Budgetary discipline Relations between the inner and outer groups Conclusion

53 53

THE UNITED KINGDOM AND EUROPE Quentin Davies, Member of Parliament, House of Commons The Single Market Common foreign and security policy Justice and home affairs Economic and monetary union The way forward

60 60 60 61 65 68 78

3

6

vi

31

31 31 34 36 38 38

53 53 55 55 56 58 58 58 59

CONTENTS

7

SOME THOUGHTS ON THE MONETARY FRAMEWORK IN EMU Age F.P.Bakker and Guido F.T.Wolswijk, Nederlandsche Bank Introduction Changes in the environment Choice of strategy Principles in selecting monetary instruments Choice of instruments Harmonisation of instruments Conclusion Notes

80 80 80 81 82 83 85 86 87 87

8

FINLAND ON THE WAY TO THE EMU Arja Alho, Minister of Finance, Finland

89 89

9

THE INTERNATIONAL COMPETITIVENESS OF EUROPEAN MANUFACTURING: EVIDENCE FROM COST AND PRICE MEASURES Jozef van’t Dack, Bank for International Settlements, Basle, Switzerland Introduction Broad trends in European manufacturing in recent years Real effective exchange rates Measuring the level of competitiveness The impact of non-tradables on international competitiveness Concluding observations Notes References

94

118 AUSTRIA ON THE WAY TO EMU Dietmar Spranz, Director of Bank Austria Introduction Advantages of a monetary union for Europe Feasibility of a monetary union for Europe Feasibility of EMU participation for Austria Expected changes in Austrian monetary policy as a consequence of participation Expected consequences of participation for the Austrian financial market Consequences for Austria if EMU were postponed (or if Austria could not participate) Note

vii

94 94 95 98 106 110 112 114 116 118 118 118 118 118 119 120 121 122 123

CONTENTS

11 ADHERING TO THE CONVERGENCE CRITERIA: THE CASE OF PORTUGAL Vitor Bento, Director General, Portuguese Treasury Introduction Benefits of membership Relation to convergence criteria Index

124 124 124 125 126 129

viii

FIGURES

Figure 1.1 Figure 1.2 Figure 1.3 Figure 1.4

Figure 2.1 Figure 9.1 Figure Figure Figure Figure

9.2 9.3 9.4 9.5

Figure 9.6 Figure 9.7

Countdown to EMU The introduction scenario proposed by the Expert Group for the Changeover to the Single Currency The introduction scenario proposed by the Green Paper GDR: simplified outline of the banking system and interbank relations at the time of the currency conversion Share of federal contribution to unemployment benefit payment in US Indicators of manufacturing in selected regions and countries Export market share in manufacturing Trade balances of major industrial countries Real effective exchange rate measures Relative unit labour costs in major European countries Comparative levels of unit labour costs in recent years Indices of unit labour costs for the tradable and non-tradable sectors

ix

2 4 7

14 24 96 98 99 102 105 109 113

TABLES

Table 1.1 Table 2.1 Table 2.2 Table 3.1 Table 3.2 Table 9.1 Table 9.2 Table 9.3 Table 9.4

Demonstration of an arbitrage system US social welfare expenditure, on unemployment insurance and unemployment services: 1991 US federal grants to different states during the fiscal year 1993 The status of European exchange rates in relation to ERM as of September 1992 US consumer price inflation in selected areas The exchange rate and PPPs for tradables in 1990 Labour compensation, productivity and unit labour costs in manufacturing in 1990 Average annual productivity growth by sector: 1970–1991 Unit labour costs by sector in 1991

x

9 25 28 34 37 107 108 111 112

1 THE CHANGEOVER TO A UNIFIED EUROPEAN CURRENCY Why a ‘big bang’ approach is necessary H.M.Scobie, S.A.Buckley and R.Fox European Economics and Financial Centre, London

1 INTRODUCTION A question mark still hangs over the way in which a European common currency (hereafter referred to for convenience as the ‘Euro’) can be introduced. The debate on the subject has been about whether the national currencies and the ‘Euro’ should be allowed to circulate together over a fairly long period of time, or whether the latter should be introduced through a ‘big bang’. This study examines the ‘critical mass’ method of launching the single currency, and compares it to the ‘big bang’ method. 1 It analyses the pros and cons of each system, and highlights the problems associated with ‘critical mass’. It also poses a series of questions to which the decisionmakers for the changeover to the single currency must address themselves. It is argued in this study that changing to a new European currency at one instant of time would be feasible, and would be the best approach, i.e. one that stands the least risk of break-up.

2 BACKGROUND Since the signing of the Maastricht Treaty on 7 February 1992, 2 a number of working groups have been engaged to produce various consultation documents and analyses. They have endeavoured to develop some practical solutions, and project some workable scenarios. Among the groups to produce publications are the ‘Expert Group on the Changeover to the Single Currency’, which was chaired by Mr Cees Mass 3 (referred to here as the Cees Mass group), ‘the European 1

Figure 1.1 Countdown to EMU

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Commission Green Paper’, and the ‘EMU Committee of the London Investment Banking Association (LIBA)’. The Cees Mass group presented two sets of reports; one was in the form of an Interim Report, presented to the European Commission on 20 January 1995.4 Another was in the form of a Progress Report, presented to the Commission on 10 May 1995. 5 Following this Progress Report, the European Commission published on 31 May 19956 a Green Paper which presents a reference scenario for the changeover to the single currency (pp. 23–30). In response to the Green Paper, the London Investment Banking Association (LIBA) produced a report on 17 October 1995, 7 which voices some caveats associated with the transition. In the above mentioned documents, alternative procedures for the introduction of the single currency have been proposed. Among these are the following.

2.1 ‘Big bang’ method The ‘big bang’ approach is one where the conversion to the single European currency would occur on a specific date. Accordingly, after an overnight switchover, all monetary transactions would take place in the new common currency. One notable precedent for this approach is the conversion of Ostmarks to Deutschmarks in Germany on 1 July 1990, described below in Section 5 of this chapter. Another is the decimalisation of sterling in 1971, when there was a change from pounds, shillings and old pence to pounds and new pence.

2.2 ‘Critical mass’ method Under the ‘critical mass’ approach, monetary union would begin with national currencies and the ‘Euro’ circulating together over a very lengthy period of time, as long as three years, while the national currencies become fixed and irrevocable. It would end with the adoption of the ‘Euro’ as the single currency of the participating countries. Thus, there would be a time lag between these events. This approach assumes that monetary policy would be conducted in ‘Euros’ immediately after the fixing of exchange rates. It also assumes that interbank and capital markets, and new issues of public debt would be in ‘Euros’. This volume of transactions would constitute a ‘critical mass’, and is estimated to account for 90% of all transactions. Consumers would continue to use their own currencies.

3

Figure 1.2 The introduction scenario proposed by the Expert Group for the Changeover to the Single Currency, 10 May, Luxembourg

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2.3 ‘Mounting wave’ method Another terminology used to describe the launch of the single currency is the ‘mounting wave’. This implies that the new currency, the ‘Euro’, would initially be used only in transactions between central banks and commercial banks. From there, its use would gradually spread to other transactions nationally. 2.4 ‘Delayed big bang’ method The single currency may also be introduced via the ‘delayed big bang’ approach, which was advocated by Germany’s Bundesbank. Under this approach, the new currency would exist only in central bank ledgers for around three years after the fixing of exchange rates. Subsequently, the new currency would rapidly replace the old one. This would avoid the costs associated with national currencies and the ‘Euro’ circulating together.

3 THE GREEN PAPER The European Commission’s Green Paper of 31 May 19958 highlights the ‘hurdles to cross’ in the transition to the single currency, and proposes steps to overcome them. The publication takes the gradualist ‘critical mass’ approach, and divides the transition to a single currency into three phases. These phases are outlined in Figure 1.3. The specific starting time for the transition has yet to be decided by ‘the Council’, which comprises Heads of State or Heads of government of the European Union member states. 3.1 The Green Paper’s proposed Phase A Assuming that monetary union begins in January 1999, Phase A should begin in January 1998 at the earliest. It is a phase in which preparations will be made for the move to Stage III of EMU, as provided for in the Maastricht Treaty. This phase is not explicitly provided for in the Maastricht Treaty, which proposes a swifter transition between the decision to form EMU and the act of forming it (see Article 109, shown in Appendix A, of this chapter). At the start of Phase A, ‘the Council’ will decide to go ahead with EMU (Appendix A, Articles 109j and 1091). The European System of Central Banks (ESCB) and the European Central Bank (ECB) will be created. These institutions will make the preparations for monetary policy to be carried out in ‘Euros’. ‘The Council’ will also specify the length of the delay before the introduction of ‘Euro’ notes and coins. This should not 5

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exceed a maximum of four years from the beginning of Phase A. During Phase A the following steps need to be taken: • • • •

First, legal changes required for the launch of the new currency must be made. Secondly, the particulars and precise features of the new currency have to be determined. Thirdly, ‘national steering structures’ need to be set up to oversee the introduction of the new currency. Fourthly, banks and financial institutions in each country should decide upon a plan for the transition. 3.2 The Green Paper’s proposed Phase B

The start of Phase B will be characterised by three fundamental developments: (a) the establishment of the European Central Bank as well as the European System of Central Banks by ‘the Council’; (b) the irrevocable announcement of parities of European currencies; (c) the ECU becoming a currency on its own (say the ‘Euro’), rather than a basket of currencies. The basket ECU’s exchange rate with non-participating countries should become the ‘Euro’s’ initial rate with these countries (see Appendix A, Articles 109g and 1091(4)). However, ‘the Council’ retains the right to override this (Appendix A, Articles 109(1) and 109(3)). Interbank and capital markets and new issues of public debt must be denominated in ‘Euros’ after the start of Phase B. Taxes and major public expenditures may also be in ‘Euros’. Consumers would continue to use their old national currencies. 3.3 The Green Paper’s proposed Phase C All that remains of the old currencies will be replaced by ‘Euros’. This phase will last as long as this process takes, which, according to the European Commission, should be several weeks. 4 DRAWBACKS OF THE ‘CRITICAL MASS’ APPROACH This section highlights the problems and risks associated with the ‘critical mass’ approach, as compared with the ‘big bang’ approach. It is demonstrated that delays in introducing the new currency could subject the system to severe risks, and could undermine efforts to make EMU irreversible. 6

Figure 1.3 The introduction scenario proposed by the Green Paper Source: European Commission, One currency for Europe—Green Paper on the Practical Arrangements of the Single Currency (1995), Office for Official Publications of the European Communities, Luxembourg, 31 May.

EUROPEAN MONETARY UNION

Ostensibly, once the currencies are fixed irrevocably, they should move against other non-EMU currencies in exactly the same proportion. However, another picture can emerge. For as long as national currencies are in operation, and are used in day-to-day foreign trade, the demand and supply for those currencies will be affected by the size of exports and imports in those currencies. Thus, if a country has a persistent external trade surplus against, say, the US, its national currency, e.g. the Deutschmark, can appreciate against the US dollar. If this pattern continues, it can experience further appreciation against the US dollar. The reverse can be true for an EMU member country with a trade deficit against the US. Accordingly, a downward pressure would develop for that currency against the dollar. The longer the delay in entirely replacing the national currencies with the ‘Euro’, the higher the risk that the proposed single currency will collapse. This delay could bring about turmoil in the currency market, destroy confidence in the fixed exchange rates and act as a source of great instability. The causes of the instability are spelled out below. 4.1 Arbitrage risk During Phase B, countries participating in EMU will still have separate exchange rate relationships with other non-EMU countries. These would include the non-participating European Community countries, as well as others such as Japan and the United States. It may be possible for one EMU member currency, say sterling, to depreciate against a non-EMU currency, say, the dollar, while another EMU currency, say the Deutschmark, appreciates against the dollar. This would give rise to arbitrage opportunities. The arbitrage opportunities thus arising could be exploited by first converting dollars into sterling, then converting the sterling into Deutschmarks at the fixed rate, and finally converting the Deutschmarks back into dollars. That is to say, arbitrage positions could arise through one EMU currency appreciating or depreciating at a different rate relative to another EMU member currency. In this situation, by converting a nonEMU third currency, say, the dollar, into one EMU currency, then converting at the fixed rate into another EMU currency, and back again to the original currency, a considerable gain could be made. This can be demonstrated by means of an example of three currencies, say the US dollar, the Deutschmark and sterling. Assuming that both the UK and Germany will join the monetary union at the beginning of Stage III, i.e. on 1 January 1999 it is assumed, and the currencies of these two are fixed irrevocably. This example is shown in Table 1.1, and should help to demonstrate 8

CHANGEOVER TO A UNIFIED EUROPEAN CURRENCY

Table 1.1 Demonstration of an arbitrage system

the argument. Let us assume on 1 January 1999, when the third stage of monetary union begins, the following exchange rates hold: • • •

Deutschmark to sterling rate is 2.16. Dollar to sterling exchange rate is 1.60. Deutschmark to dollar rate is 1.35.

These exchange rates are shown in column 1 of Table 1.1. At this stage, the sterling to Deutschmark exchange rate becomes fixed irrevocably. At the beginning of Stage III, i.e. 1 January 1999, using the rates quoted in this example, if one converts $10 to sterling, then to Deutschmarks, and back to US dollars one would reobtain $10 (namely, $10 converts to £6.25, which in turn converts to DM13.50, which converts back to $10). It should be noted that these examples are highly exaggerated in order to demonstrate the argument. A much smaller imbalance in an EMU member currency against another can still lead to arbitrage positions. Two scenarios can be considered for 1 July 1999, i.e. half a year into Stage III of EMU. Under one scenario, the Deutschmark appreciates against the dollar, moving from DM1.35 to the dollar to DM1.25 to the dollar while sterling depreciates against the dollar, from $1.60 to the pound, to $1.55 to the pound. On 1 July 1999, converting $10 to sterling gives £6.45, which converts to DM13.93, which in turn converts to $11.14. The gain from this transaction is $1.14. Under the second scenario, the Deutschmark appreciates against the dollar from DM1.35 to the dollar to DM1.25 to the dollar, a rise of 7.4%. Sterling appreciates against the dollar, from $1.60 to the pound to $1.62 dollars to the pound, a rise of 1.25%. As the Deutschmark to dollar rate is appreciating faster than the dollar to sterling rate, arbitrage opportunities emerge again. Converting $10 to sterling gives £6.17, which gives DM13.33. Converting DM13.33 to dollars gives $10.66. The 9

EUROPEAN MONETARY UNION

gain from this transaction is $0.66. The gain from this arbitrage position is smaller than that from Scenario 1, which was $1.14, though it remains, nevertheless, a gain. Intervention by the European central banks will still remain a powerless tool, for the size of any central bank’s intervention is limited by the reserves of that central bank and its supporting central banks. While the size of the world currency dealing today exceeds 1 trillion dollars per day, the limit of the central bank reserves runs into hundreds of billions of dollars. The movements of EMU member currencies against non-EMU currencies demonstrated in the above example can give rise to two problems, which are discussed below. 4.1.1 The pressures of break-up under fixed exchange rates Both of the above scenarios involve a conversion of sterling into Deutschmarks. If this conversion is a large one, it could cause serious problems for national central banks. 9 At present, there are no restrictions on the volume of transactions from one currency to another, and there appear to be no plans to introduce such restrictions when rates are fixed. However, if massive conversion of sterling to Deutschmarks occurs, the European Central Bank may have to impose limits on the size of such conversions. Once limits are imposed on the volume of conversions, a grey market emerges which can bring about different rates from the official fixed rates. The emergence of a grey market could give rise to doubts over the irrevocability of the exchange rate. This would make it difficult for interest rates to be equalised in all participating currencies. If there were a possibility that one currency had to be devalued, or leave the system, its interest rate would tend to rise relative to the rate in the other countries. 4.1.2 Resistance to EMU from countries with strong currencies The example outlined above demonstrates that it may be possible during Phase B for the Deutschmark to appreciate against the dollar more quickly than the ‘Euro’. Thus, it could trigger a potential danger that Germany could become be unwilling to replace the Deutschmark with a currency which is perceived as being weaker. This danger is already visible, as the following instances show. German private investors have recently shown a lack of enthusiasm for the idea of a single currency. Moreover, German private investment in Swiss franc assets has shown a dramatic increase, despite the lower returns they tend to offer. On 4 November 1995, Edmond Stoiber, the Prime Minister of Bavaria 10

CHANGEOVER TO A UNIFIED EUROPEAN CURRENCY

gave a speech at the German parliament expressing his reservations about EMU. He stated that from the date of signing the Maastricht Treaty in 1992, it was evident that a number of the EU countries were not able to satisfy the Maastricht criteria for EMU. Thus, it was apparently desirable for some member states to overrule the Treaty. This seemed totally unacceptable to Germany. Mr Stoiber felt it was more important to substitute the Deutschmark with a ‘stable’ European currency than to stick to the timetable of the Treaty, which seemed to him overambitious. 4.2 Other risks According to the study carried out by the London Investment Banking Association (LIBA), mismatches could develop between the assets and liabilities of citizens during Phase B discussed above. Take the example of a company that buys bonds in ‘Euros’ during Phase B. Its liabilities during this phase will be in national currencies. If the company doubts the irrevocability of the exchange rates it will insure against losses that could occur due to this mismatch. This would be done by buying assets in currencies which are perceived to be strong, and selling those in currencies which are seen as weak. This process could put great pressure on the fixed exchange rates (London Investment Banking Association 10). 4.3 Costs associated with dual circulation Under the ‘critical mass’ approach, national currencies and the new common currency would exist side by side. By its nature this system would be far more expensive than the ‘big bang’ approach. Some of the reasons why it would be more expensive are outlined here. If the national currencies and the new currency are to exist in parallel for a period, operators will have to maintain accounts in two currencies (at least). This dual accounting is likely to increase the cost of transactions significantly. Germany is concerned that its small banks will face huge transaction costs and logistical difficulties if they have to operate parallel currencies. In preparation for the transition to EMU, banks will have to update their computer systems, and retrain their staff. The Association for the Monetary Union of Europe (AMUE) has estimated that, in the case of a ‘big bang’, a large European bank would have to spend 100m–150m ECUs (the equivalent of $120m–185m) over a period of five years. It has also estimated that the ‘critical mass’ approach would cost banks around 50% over and above the cost incurred under a ‘big bang’ approach. As it seems likely that notes and coins issued by national central banks during Phase B will be legal tender only in the country of their issue (see 11

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Appendix C), there will still be a need to use the foreign exchange market in this phase. This can be demonstrated with the example of the Dutch guilder and the Deutschmark. The exchange rate between these currencies closely approximates a fixed rate: the guilder/deutschmark exchange rate has not changed since 1983, and the fluctuation band has been reduced to about 1%. Despite this, transaction costs still accounted for around 0.5% of the actual transaction, which was not much lower than those in exchange markets which fluctuate more.

5 THE EXPERIENCE OF GERMAN CURRENCY CONVERSION On 6 February 1990, the German Chancellor Helmut Kohl announced plans for the monetary union of East and West Germany to occur on a ‘big bang’ basis on 1 July 1990. The previous plan proposed by the Bundesbank for a step-by-step approach to monetary union was abandoned. This former plan had called for a gradual approach which would have led to monetary union by the end of 1992. The new plan, however, called for an immediate switchover. In preparation for the changeover to a single currency in united Germany, 10,000 stations were made available for East Germans to exchange their Ostmarks for Deutschmarks. These stations were the existing savings banks as well as additional temporary branches installed in order to meet the demands of the currency conversion. Starting on 1 July 1990, each adult aged between 15 and 60 was allowed to convert up to 4,000 Ostmarks for Deutschmarks at a one-to-one conversion rate. Children under the age of 15 were allowed to exchange 2,000 Ostmarks while people over the age of 60 were allowed to exchange 6,000 Ostmarks, both at the favourable rate of one-to-one. Moreover, in order to lessen the impact of the impending inflation due to the massive switchover, each person was allowed to exchange only 2,000 Ostmarks at par in the first seven days. In all, the Bundesbank, by then overseeing the currency conversion for the new united Germany, transported DM25bn to East Germany to meet the demands in the first week of the changeover. The initial transition on 1 July 1990 was a success and involved only a few minor disturbances. At one Dresdner Bank branch 4,000 East Germans queued to convert their money while bank tellers processed a cheque at an average rate of one every six seconds. After the allotted amount of each person was exchanged at the one-toone rate, the East Germans were free to exchange any additional savings at a two-to-one rate. There were 66 billion Ostmarks exchanged at par and, as in the currency reform in West Germany in 1948, the worthless currency was literally buried in the ground. An additional 125bn Ostmarks were 12

CHANGEOVER TO A UNIFIED EUROPEAN CURRENCY

exchanged at 2:1, bringing the total converted from East German personal savings and cash to 191bn Ostmarks. It was also estimated prior to the switchover that 275bn Ostmarks in East German onshore bank liabilities and cash would be converted. 6 AREAS OF FURTHER CONCERN It is stipulated in the Maastricht Treaty that the basket ECU will disappear at the beginning of EMU, as the ‘Euro’ is to take over its role (Article 1091(4), Appendix A 11 ). However, the basket ECU incorporates eleven different currencies and the Maastricht Treaty states that this composition will not change (Article 109g, Appendix A). The question remains as to whether the ECU would still disappear if only a small number of currencies (four or five) were to join the single currency? If so, there will obviously be a discontinuity between those assets denominated in basket ECU and those denominated in ‘Euros’. 7 EXTENSIVE EDUCATION NEEDED FOR THE LAUNCH OF THE SINGLE CURRENCY To counter confusion during the transition phase, there should be a prolonged education programme. Such a programme should contain clear details of what the conversion rates of participating currencies are likely to be. It should indicate a broad range of the likely values of each currency against the ‘Euro’. Based on current rates, the sterling/‘Euro’ conversion rate could be in the range 75–85 Euros. Much of the public’s unwillingness to take on board a new currency can be attributed to a lack of information. The Fahrenheit and Celsius temperature scales provide an illustrative example. As long as the rates are quoted in parallel, those who use one scale are often unwilling to learn the other. This is due to the fact that there is no real need to do so rather than due to confusion or a lack of intelligence on the part of the public. It is argued, therefore, that the public could cope with a ‘big bang’ type switchover and learn to cope with a new currency if they had to do so. 8 CONCLUSIONS It is important to realise that the forces that brought about the collapse of the ERM would not have gone away under a system of fixed exchange rate. In other words, the imbalances that arose under ERM and led to depreciation or realignment of currencies could still arise under a system of fixed exchange rates and lead to pressures that would result in breakage of the fixed links. 13

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Figure 1.4 GDR: simplified outline of the banking system and interbank relations at the time of the currency conversion Source: Deutsche Bundesbank, Monthly Report, July 1990, p. 17.

The current volume of currency dealing is of the order of $1.2 trillion per day whereas the size of the reserves of the central banks is limited to hundreds of billions of dollars. The reserves of ECB and ESCB are still 14

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limited relative to the size of the ‘hot money’ in the global currency market. As long as this imbalance exists, no amount of intervention can hold the balance for the survival of a system of fixed exchange rates. The ‘hot money’ that is available today for speculative purposes will be actively seeking such arbitrage positions. The ‘big bang’ method is workable as an approach to monetary union as indeed was proved by Germany at the time of its monetary union in July 1990 (described in Section 5 above). It is argued in this study that maintenance of a prolonged period of fixed exchange rate is extremely risky for the launch of the single currency. National governments may find it easier to exit the currency union before the ‘Euro’ is universally adopted. Hence, if EMU is proving politically unpopular, there is a risk that one or more members may choose to leave it, and the fragile system could break down altogether before the operational launch of the single currency.

15

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APPENDIX A Selected Articles from: The Treaty on European Union (The Maastricht Treaty) Signed on 7 February 1992 (following the Maastricht Summit in December 1991) Article 105a 1

2

The ECB shall have the exclusive right to authorise the issue of bank notes within the Community. The ECB and the national central banks may issue such notes. The bank notes issued by the ECB and the national central banks shall be the only such notes to have the status of legal tender within the Community. Member states may issue coins subject to approval by the ECB of the volume of the issue. The Council may, acting in accordance with the procedure referred to in Article 189c and after consulting the ECB, adopt measures to harmonise the denominations and technical specifications of all coins intended for circulation to the extent necessary to permit their smooth circulation within the Community. Article 109

1

3

By way of derogation from Article 228, the Council may, acting unanimously on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability, after consulting the European Parliament, in accordance with the procedure in paragraph 3 for determining the arrangements, conclude formal agreements on an exchange rate system for the ECU in relation to non-Community currencies. The Council may, acting by a qualified majority on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability, adopt, adjust or abandon the central rates of the ECU within the exchange rate system. The President of the Council shall inform the European Parliament of the adoption, adjustment or abandonment of the ECU central rates… By way of derogation from Article 228, where agreements concerning monetary or foreign exchange regime matters need to be negotiated by the Community with one or more States or international organisations, the Council, acting by a qualified majority on a recommendation from the Commission and after consulting the ECB 16

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shall decide the arrangements for the negotiation and for the conclusion of such agreements. These arrangements shall ensure that the Community expresses a single position. The Commission shall be fully associated with the negotiations. Agreements concluded in accordance with this paragraph shall be binding on the institutions of the Community, on the ECB and on member states. Article 109g The currency composition of the ECU basket shall not be changed. From the start of the third stage, the value of the ECU shall be irrevocably fixed in accordance with Article 1091(4). Article 109j 1

The Commission and the EMI shall report to the Council on the progress made in the fulfilment by the member states of their obligations regarding the achievement of economic and monetary union. These reports shall include an examination of the compatibility between each member state’s national legislation, including the statutes of its national central bank, and Articles 107 and 108 of this Treaty and the Statute of the ESCB. The reports shall also examine the achievement of a high degree of sustainable convergence by reference to the fulfilment by each member state of the following criteria: the achievement of a high degree of price stability; this will be apparent from a rate of inflation which is close to that of, at most, the three best performing member states in terms of price stability; the sustainability of the government financial position; this will be apparent from having achieved a government budgetary position without a deficit that is excessive as determined in accordance with Article 104c(6); the observance of the normal fluctuation margins provided for by the Exchange Rate Mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other member state; the durability of convergence achieved by the member state and of its participation in the Exchange Rate Mechanism of the European Monetary System being reflected in the long-term interest rate levels.

The four criteria mentioned in this paragraph and the relevant periods over which they are to be respected are developed further in a 17

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Protocol annexed to this Treaty. The reports of the Commission and the EMI shall also take account of the development of the ECU the results of the integration of markets, the situation and development of the balances of payments on current account and an examination of the development of unit labour costs and other price indices. 2

On the basis of these reports, the Council, acting by a qualified majority on a recommendation from the Commission, shall assess: for each member state, whether it fulfils the necessary conditions for the adoption of a single currency; whether a majority of the member states fulfil the necessary conditions for the adoption of a single currency,

and recommend its findings to the Council, meeting in the composition of the Heads of State or of government. The European Parliament shall be consulted and forward its opinion to the Council, meeting in the composition of the Heads of State or of government. 3

Taking due account of the reports referred to in paragraph 1 and the opinion of the European Parliament referred to in paragraph 2, the Council, meeting in the composition of Heads of State or of government, shall, acting by a qualified majority, not later than 31 December 1996: decide, on the basis of the recommendations of the Council referred to in paragraph 2, whether a majority of the member states fulfil the necessary conditions for the adoption of a single currency; decide whether it is appropriate for the Community to enter the third stage,

and if so set the date for the beginning of the third stage. 4

If by the end of 1997 the date for the beginning of the third stage has not been set, the third stage shall start on 1 January 1999. Before 1 July 1998, the Council, meeting in the composition of Heads of State or of government, after a repetition of the procedure provided for in paragraphs 1 and 2, with the exception of the second indent of paragraph 2, taking into account the reports referred to in paragraph 1 and the opinion of the European Parliament, shall, acting by a qualified majority and on the basis of the recommendations of the Council referred to in paragraph 2, confirm which member states fulfil the necessary conditions for the adoption of a single currency. 18

CHANGEOVER TO A UNIFIED EUROPEAN CURRENCY

Article 1091 1

4

Immediately after the decision on the date for the beginning of the third stage has been taken in accordance with Article 109j(3), or, as the case may be, immediately after 1 July 1998… At the starting date of the third stage, the Council shall, acting with the unanimity of the member states without a derogation, on a proposal from the Commission and after consulting the ECB, adopt the conversion rates at which their currencies shall be irrevocably fixed and at which irrevocably fixed rate the ECU shall be substituted for these currencies, and the ECU will become a currency in its own right. This measure shall by itself not modify the external value of the ECU. The Council shall, acting according to the same procedure, also take the other measures necessary for the rapid introduction of the ECU as the single currency of those member states.

19

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APPENDIX B Summary of the Green Paper’s Proposals for public education The Commission Green Paper defines a number of tasks aimed at educating the public about the new currency, at each stage of the transition: Tasks Preceding Phase A The Commission proposes talks in late 1995. These will involve parties from the European Parliament, the European Monetary Institute, and the private sector. Plans agreed in these talks are to be enacted in early 1996. These plans are aimed at preparing computer systems for the new currency, and at educating the general public about the launch. Tasks to be Carried out in Phase A In this phase, member states will individually take on board the plans outlined above. Tasks to be Carried out in Phase B Around six months before Phase C, there will be an intensive programme aimed at making the public au fait with the ‘Euro’. This is to involve dual pricing. Task to be Carried out in Phase C The education will not cease on the introduction of ‘Euro’ notes and coins. The emphasis will be on the needs of special interest groups, such as the old and the blind.

20

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APPENDIX C Extracts from: European Commission (1995), The Preparation of the Changeover to the Single European Currency (Interim Report), January 20, Expert Group on the Changeover to the Single Currency, Luxembourg. There is no need for today’s ECU to continue to exist, nor is there a need to construct a new basket. This will hold true despite the fact that not all member countries will join Stage III from the first. The Group takes the view that the function of the present private ECU basket will be taken over by the single currency of the Monetary Union (p. 10) As a general rule, ECU notes and coins (whether issued directly by the ECB or by national central banks) should be legal tender throughout the single currency area, whereas notes and coins denominated in national currencies should be legal tender only in the country of issue. For practical reasons, a situation where payment instruments in all national currencies and the ECU were legal tender in all participating member states would be difficult to manage (p. 19).

NOTES The authors wish to express their gratitude to many colleagues who have discussed and commented upon the issues raised in this study, in particular Michael Feeny of Sumitomo Bank, Rony Hamaui of Banca Commerciale, Dieter Proske of Austrian National Bank, Chris Sanders of SAMBA Asset Management and Hasse Ekstedt of the University of Goteberg. Special thanks go to M. McAdam and A. Pandya of the European Economics and Financial Centre for their assistance in the preparation of this paper. 1 Both methods are explained below. 2 The text of the Maastricht Treaty can be found in: European Commission (1992), Official Journal of the European Communities, No C224, Volume 35, August 31, Office for Official Publications of the European Communities, Luxembourg. 3 Of the TNG Bank of the Netherlands. 4 European Commission (1995a), The Preparation of the Changeover to the Single European Currency (Interim Report), January 20, Expert Group on the Changeover to a Single Currency, Luxembourg. 5 European Commission (1995b), Progress Report on the Preparation of the Changeover to the Single European Currency, May 10, Expert Group on the Changeover to the Single Currency, Luxembourg. 6 European Commission (1992), Official Journal of the European Communities, No C224, Volume 35, August 31, Office for Official Publications of the European Communities, Luxembourg.

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7 London Investment Banking Association (1995), The Practical Implications of Converting London’s Capital Markets to a Single Currency, October 17. 8 European Commission (1995), One Currency for Europe—Green Paper on the Practical Arrangements for the Introduction of the Single Currency, May 31, Office for Official Publications of the European Communities, Luxembourg. 9 The European Monetary Institute maintains that national central banks will remain responsible for issuing notes and coins in their respective currencies during Phase B and the size of the currency issues will be demand driven. 10 See paragraph 6 of The London Investment Banking Association (1995), The Practical Implications of Converting London’s Capital Markets to a Single Currency, London, October 17. 11 This has recently been re-stated by the Cees Mass group (Appendix C, Paragraph 1).

22

2 FISCAL TRANSFER PAYMENTS Implications of US structure for the European Monetary Union H.M. Scobie and T.Day European Economics and Financial Centre, London

1 BACKGROUND There has been a great deal of misconception and prejudgement on the outlook for the European single currency and its consequences in the future. Some foresee a great deal of unemployment emerging in the uncompetitive regions of Europe and particularly among the less industrially competitive states of the continent in the aftermath of the single currency. The sceptics argue that without an adequate compensation scheme (for the newly unemployed) on the part of the European Union, the system of the single currency will be unsustainable. Since such a scheme of transfer payments by the EU does not exist, they draw up a disaster scenario and predict the collapse of EMU. The proponents of the doomsday scenario maintain that a regime of a single currency can only function and be ‘optimal’ if there exists the possibility and availability of a scheme of transfer payments from the central authorities (or the federal body) of a group of states with a common currency in circulation. As a rule such sceptics quote the example of the United States where a common currency is implemented alongside a system of transfer payments, and the federal budget provides for all the regional unemployment. This, however, is a complete fallacy. In these cases, the US system of transfer payments is totally misquoted by the sceptics and the arguments put forward by such groups reveal a lack of familiarity with the unemployment benefit system in the US.

23

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Figure 2.1 Share of federal contribution to unemployment benefit payment in US (percentage)

2 US TRANSFER PAYMENTS FOR UNEMPLOYMENT The responsibility of any payment for a worker who becomes unemployed in the US lies primarily with the ‘state government’ and not with the ‘federal government’. The contribution of the federal budget for supporting the unemployed is marginal, if not negligible. Some average figures for the contribution of the federal budget to the unemployment benefit in the US are quoted below. This should provide the reader with some rough order of magnitude. When an individual becomes unemployed in the United States, for every $1 lost in an individual’s income, the federal government loses 24

FISCAL TRANSFER PAYMENTS

Table 2.1 US social welfare expenditure, on unemployment insurance and unemployment services: 1991

Source: Table 573 on US Social Welfare Expenditure, by Source of Funds and Public Program: 1991, Statistical Abstract of the United States (114th edition), the National Data Book, US Department of Commerce, Economics and Statistics Administration, US Bureau of the Census, 1994.

something of the order of 30 cents in tax revenue. Yet for the same $1 lost in income, an individual may receive on average something of the order of 10 cents from the federal government towards his/her unemployment benefit. These are not precise figures, however, and can vary across different states in the US. The newly unemployed are in fact the responsibility of the state government and not the federal government. To corroborate the above, data related to governmental expenditure on unemployment in the US has been examined. The information that is of primary interest is unemployment payments in the United States and (i) the contribution of the federal government; (ii) the contribution of the state government; and the proportion of each in the total expenditure on unemployment. In the United States unemployment insurance is administered by the US Employment and Training Administration and for each state by the state’s employment security agency. Based on the data provided by the US Department of Commerce (published in The Statistical Abstract of the United States) one can obtain a breakdown of US social welfare expenditure by source of funds and public programmes. Hence, it is possible to trace the component of federal contribution in the total expenditure. It is evident that the share of federal contribution to the unemployment bill is small. For example, for the year 1991 Table 2.1 shows that out of US$31,313 million of unemployment benefit payments, the share of the federal contribution was US$3,613 million, amounting to a mere 11% of the total unemployment bill, and the share of the state contribution was US$27,700 million, amounting to 89% of the total. The above percentages, shown in Table 2.1, were the latest published data available for the purpose of our analysis. It is worth noting that obtaining aggregations of such figures across the states is rather 25

Table 2.2 US federal grants to different states during the fiscal year 1993 (in millions of dollars except per capita)

Continued…

Continued…

Table 2.2 (continued) US federal grants to different states during the fiscal year 1993 (in millions of dollars except per capita)

Source: US Bureau of the Census, Federal Expenditures by State for Fiscal Year 1993. 1 Includes amounts not shown separately 2 Based on estimated resident population as of 1 July 3 For the disadvantaged 4 Includes family support payments, social services block grants, children and family services, foster care and adoption assistance, low income home energy assistance, community services, block grants, refugee assistance and assistance for legalised aliens 5 Includes public housing, housing payments to public agencies, and college housing

Table 2.2 (continued) US federal grants to different states during the fiscal year 1993 (in millions of dollars except per capita)

FISCAL TRANSFER PAYMENTS

cumbersome and the data are not readily available. Such data always appear with a time lag. The accounts for revenue and expenditure have to be compiled separately for every state in the US. Hence, detailed breakdown of all the items of fiscal flows from the federal budget to each state is compiled with some time lag. Figure 2.1 shows this small and declining share of the federal contribution to unemployment payment. It can, therefore, be deduced that the belief that the absence of federal transfer payments in the European Union is a constraint upon the formulation of a single currency is unjustified. Of more importance are the trend and the ratio of the federal to the total benefit payment. Table 2.1 shows that this ratio has been on the decline from 24% in 1980 to 11% in 1991. State by state breakdown of federal grants is presented in Table 2.2. This table shows federal aid in both per capita and aggregate form, across the fifty states in the US. Since Table 2.2 presents some details on the exact magnitude of the transfer payments in the different states of the US, it provides a crosssection overview of the very poor regions of the US as well as the mediumincome and the wealthier states. It can be seen from Table 2.2 that the federal grants cover the following areas: • • • • • • • • •

education environment health human studies housing urban development training employment transport

By providing a detailed picture of fiscal transfers in US, Table 2.2, thus, throws further light on the current confusion that exists (and is used by the Euro-sceptics) on the necessity for the existence of large fiscal transfers in Europe for the survival of EMU. It is evident that, rather than paying for unemployment benefit, the federal transfer payments tend to be more focused on areas such as aid to families who are very poor with dependants (this includes single mothers), aid to the very old and aid to the uneducated (also with dependants).

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3 CONCLUDING REMARKS The US federal and state statistics presented here show that the share of the federal contribution to unemployment benefit is both small and declining. There have been substantial structural changes in the US fiscal transfer system in the last decade. Another important outcome of the analysis is that a system of currency union can exist without resort to devaluation to rescue the economy. Indeed, devaluation has never provided a long-term solution to rescue any domestic industry or unemployment. Problems of industrial efficiency and unemployment have to be tackled at root and require structural reforms rather than devaluation to resolve and remove them.

REFERENCES Barro, R. and Sala-i-Martin, X. (1992), Convergence, Journal of Political Economy, vol. 100, no. 2, 223–251. Bureau, D. and Champsaur, P. (1992), Fédéralisme budgétaire et unification économique européenne, Observations et Diagnostics Economiques 40, April, 87–99. Scobie, H.M. (1992), Managing within the ERM—Conventional Wisdom versus Market Perceptions, Paper presented at the Conference on Economic Policy Coordination, held at the Central Bank of the Netherlands. Scobie, H.M. (1993), Constraints of ERM: Issues to Be Considered, Paper presented at the Conference on Economic Policy Formulation, held at the Austrian National Bank, Vienna. Scobie, H.M. (1994), The European Single Market: Monetary and Fiscal Policy Harmonisation, Chapman and Hall, London. Scobie, H.M. and Starck, C. (1992), Economic Policy Coordination in an Integrated Europe, Bank of Finland, Helsinki. Scobie, H.M., Buckley, S.A. and Fox, R. (1995), The Changeover to a Unified European Currency: Why a ‘Big Bang’ Approach Is Necessary, Economic and Financial Review, Winter. US Bureau of the Census (1993), Federal Expenditures by State for Fiscal Year 1993. US Bureau of the Census (1994), Statistical Abstract of the United States (114th edition), The National Data Book, US Department of Commerce, Economics and Statistics Administration. US Social Security Administration, Social Security Bulletin, Fall 1993 and selected prior issues.

30

3 EUROPEAN MONETARY UNION Single currency feasible without the ERM H.M.Scobie Director, European Economics and Financial Centre, London and Professor of Economics, University of London

INTRODUCTION The object of this chapter is to demonstrate how the shortcomings and experiences of the Exchange Rate Mechanism should not cloud the benefits of the single currency and to show how ERM is not the only gateway to a single European currency. To understand the relevance of a single European currency, it is useful to go back a few years and examine why the European Exchange Rate Mechanism (ERM) was formulated in the first place. What was the rationale for mounting it and, given the performance of ERM in the first half of the 1990s, why may there be concern with the route to Stage III of European Monetary Union (EMU)?

OBJECTIVES OF ERM The roots of ERM go back to 1979 and lie in the formation of the EMS (European Monetary System) which was formulated and introduced at that time. In fact the roots go even further back as there is a long history of demand for a workable currency system in Europe. On close examination it becomes apparent that the prime reason for the establishment of a European currency system was the search for stability in currencies. Stability of exchange rates was the important factor needed in order to give security to those engaged in external trade. In short, the prime objective of ERM has been the creation of a stable and long-lasting exchange rate environment that would in turn create conditions conducive to easier and more efficient trade. It was presumed that through the elimination of the currency risk, enlargement of the European market for each producer should thereby result. Principal stability and certainty are the two main variables that are needed in order 31

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for producers of goods and services to handle their external transactions efficiently. Fluctuations in currencies and adverse movements in exchange rates are capable of turning a profit into a loss for an exporter or an importer engaged in trade. Though a stable currency helps with dampening inflationary pressures, the assistance with domestic inflation control is more a by-product of currency stability than the key objective. ERM has been primarily established for the benefit of trade expansion. If manufacturers are exporting they need to know at what price the good or service will be sold or bought. Or if importers are buying goods or services they want to know exactly what price has to be paid. In 1987 the Exchange Rate Mechanism was introduced with two bands, 6% and a 2.25%. The bands were subsequently widened to 15% in August 1993. Under the ERM regime the options open to a government, if its currency falls below the floor of the band, have been threefold. Within this restricted structure (i) the government in question can use its reserves: whereby its central bank allocates its reserves to defend its exchange rate through intervention and effective buying of its own currency; (ii) the monetary authorities can raise interest rates; or (iii) the country has the option of realignment. The reverse of the above three options is true if a currency exceeds the upper limit of its band. These have been the three main options that have been open to the monetary authorities of a European economy to regulate and operate within this regime. Let us examine what has in effect happened since the introduction of ERM in 1987 and the results that have emerged subsequently. Under this mechanism what can be observed is that while the principle of restricted bands may seem feasible, there can emerge shifts exogenous to the system that can basically affect the behaviour of ERM and paralyse the working of the system. These exogenous developments can produce extra pressures that radically disturb the system, and make its future as unstable as if there were no certainty about the band in question, i.e. the margin of fluctuation of the given currency. Accordingly the currency has to be devalued or realigned or go into a different band. This takes the protection against exchange rate risk away from importers and exporters. In short, if a band is frequently revised, or widened, there seems little reason for maintaining it. Accordingly it gives little assurance to the international trader seeking to minimise currency risk. The country might as well have a floating currency. To throw more light on the shortcomings of ERM we can examine the status of the different European economies as they were before 16 September 1992—the date referred to in the UK as ‘Black Wednesday’. Shortly before this date the status of the European currency system was as shown in Table 3.1. The different types of bands within which each country operated at that time are shown in this table. Under the turbulent 32

SINGLE CURRENCY FEASIBLE WITHOUT ERM

currency condition of the time each country attempted to do its best to defend its currency—expensive as it was—in order to maintain its position within the ERM system. The significant developments in the September 1992 currency turmoil were caused partly by the uncertainties that were created in the run-up to the ratification of the Maastricht Treaty by the French. In the ensuing autumn the Maastricht Treaty had to be ratified in France and the crisis came to a head on 16 September. The nervousness of the world currency market during that summer, however, started first with Finland, followed by Sweden, Italy and the United Kingdom in that order. At that time Britain, which had joined the ERM in 1990, had been locked into the system for nearly two years, operating within the 6% band. By September 1992 the economic conditions of the UK had deteriorated substantially— not just as a result of the structure of ERM but mainly as a result of the severe mistiming of her entry into the system. The ill-timing of UK entry was due to joining the ERM at a time of high inflation and high interest rate. The high interest rate Britain was maintaining in the late 1980s to curb inflation had pushed up the UK exchange rate. With this combination of economic variables the year 1990 was the worst possible time to enter the ERM system of restricted bands. This was for the reason that once the UK had entered the system, it was obliged to defend the exchange rate whatever the required level within the 6% band. As it happened, the UK entered ERM with a very high exchange rate of nearly DM 3 to £1 sterling. (A detailed account of the poor timing of UK entry into the ERM system is given in Chapter 7, ‘Timing of Entry into the European Economic System: Economic versus Political Influences’, in Scobie and Stark (eds), Economic Policy Coordination in an Integrated Europe. In that chapter the status of capacity utilisation in the UK economy prior to joining the ERM is portrayed and subsequently compared with the status two years later.) Britain joined the ERM in October 1990 shortly before the Conservative Party conference. The timing was chosen for political reasons against the advice of the IMF. Severe strains were put on the economy as a result of the high interest rates that had to be maintained to support the currency. Thereafter, capacity utilisation in the UK economy substantially deteriorated as a result of joining the ERM. It is useful to examine in more detail the strains that were exerted on the UK economy following entry into the ERM. The high rate of interest that was necessary to be maintained in order to defend the pound, given the high exchange rate chosen at the point of entry, pushed up the cost of borrowing for UK industry. This caused widespread bankruptcies throughout the country. On the one hand, this was an internal problem of the UK due to the mistiming of entry and on the other it was caused by the exogenous developments in Germany. The cost of German reunification was the 33

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Table 3.1 The status of European exchange rates in relation to ERM as of September 1992

Source: OECD

principal factor that forced the rate of interest in Germany to be raised and kept at a high level. Therefore, it was an exogenous shock that was imposed on the system—one that could not have been absorbed under the particular ERM currency regime. During the first half of the 1990s it was shown repeatedly that the conditions of ERM have been out of line with the developments of the market. In these circumstances, when the market perceives and doubts the authorities’ ability to defend a currency, it puts this system of fixed band exchange rate to the test. It is at this point that it cripples the powers of monetary control. An economy whose exchange rate is under speculative attack is forced to pull out of the system as in the case of the UK and Italy, or has to devalue as in the case of Spain, or has to realign as has occurred in the case of France.

LIMITS OF ERM There are several fundamental reasons why the ERM is ineffective as a mechanism to create stability among the European currencies. If exchange rate stability is the objective of the regime, this particular system will indeed not satisfy those requirements. First there are limits to the size of reserves of any given central bank. These limits determine the bank’s 34

SINGLE CURRENCY FEASIBLE WITHOUT ERM

ability at any given time to defend its currency. The size of the reserves of any central bank are known to the market operators. This can be observed by the way in which some of the European central banks tried to defend their currencies in the first half of the 1990s. For instance, in the case of Italy during the September 1992 currency turmoil, not only did it use all of its reserves, it ended leaving ERM with a loan of DM 24 billion to the German government. The second reason why the ERM is unsustainable is that while there are limits to reserves of a central bank, there are virtually no limits to the volume of world currency trade that can materialise in today’s global market. Whereas the volume of currency trade runs into trillions of dollars—something in the region of $3 trillion—the reserves of central banks run into hundreds of billions of dollars. In addition there are two important factors that are also responsible for the currency volume of trade increasing over time. These are improvements in technology and further market efficiency. Over the last decade, as a result of enhanced technology, the world market has become a great deal more efficient. There has also been liberalisation of exchange rates in most regions of the world. The imbalance that has been created by the limit of the reserves and the volume of trade has really neutralised the instruments of economic policy and made them ineffective. The two instruments of economic policy which are rendered powerless are (i) interest rate and (ii) central bank intervention. Basically the operations of the market show little response to the instruments of economic policy. Indeed, in 1992 interest rates in the case of Sweden experienced an initial jump of some 75% before they rocketed to 500%. The market was inelastic and did not respond to this massive rise in interest rates. At that time Sweden announced that it was willing to borrow up to 25% of GDP and still was not able to calm the nerves of the market and bring about the desired effect. Equally in the case of the UK the rise in interest rate was not able to restore equilibrium to the market. At the time of the September 1992 currency crisis, base rate, which is the official UK interest rate, rose by as much as 5%. For Britain this was a dramatic jump, since this particular interest rate affects the retail end of the market. It was not the money rate in the UK that was changing. It was the base rate that affects every consumer in the country. Yet even that massive (by UK standards) jump of 5% did not move the market at all and did not prevent the massive selling of sterling which occurred at the time. Both the UK and Italy pulled out of the system in September 1992. Subsequently there were continual pressures on the other European currencies that remained in the ERM system. Ireland became subjected to heavy pressures by currency speculators in February 1993. The Irish money market rate of interest rose to 100%. Failing to restore confidence in the Irish punt the monetary authorities reduced the interest rate again to 35

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14%. These are some examples of the vast fluctuations in interest rates and the inability of the instruments of economic policy to function under these circumstances and defend the currency within the ERM regime. Finally, in August 1993, the turbulent market conditions forced the European monetary authorities to widen the band to 15% as the narrower bands of ERM were shown to be ineffective and unsustainable for many of the ERM members. In most circles it has been understood that ERM is a necessity and the only route to a single currency. Many of the arguments that are put forward in this respect reflect a misunderstanding that a ‘fixed exchange rate’ is the same as a ‘single currency’. The significant point to get across is to demonstrate and emphasise that a fixed exchange rate is not the same as a single currency. A system of fixed exchange rate exists when two or more different currencies have a fixed parity and the central bank is obliged to support that particular currency at that fixed rate. The crucial issue is that the argument of fixed exchange rate is not applicable to the formulation and maintenance of a single currency. The rationale behind it is twofold, (a) There is still the element of uncertainty for the international trade in goods and services. With respect to exchange rate risk, there remains the uncertainty for the importer or the exporter and possible occurrence of devaluation, (b) The central bank of the country has the responsibility of supporting the currency (under a fixed exchange rate) if its market value falls below the parity. For a single European currency there will be only one central bank and there will not exist several currencies locked into each other. That is the first principle of a single currency and it is the responsibility of one federal central bank to support the currency. Reservations have been expressed in some corners about a single European currency—doubting its validity and workability—primarily pointing to the problems that have been incurred under ERM. The opponents of the single currency tend to conclude: ‘If ERM has not worked, a single European currency will not work.’ It is important to realise that the mechanism of ERM is not the necessary path to a European currency for the reasons expressed above. Sooner or later it will be revealed to policy-makers that a single currency can be formed without ERM as its prerequisite route.

CONCLUDING REMARKS The drive for a single currency will remain no matter what reservations are expressed by the sceptics. Indeed no plan ever goes ahead in a straight line, it normally tends to move forward in a jagged line. If an a priori 36

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Table 3.2 US consumer price inflation: selected areas

Source: US Bureau of Labor Statistics, CPI Detailed Report Notes: Highest inflation rate in 1991:7.2% for Honolulu, HI MSA Lowest inflation rate in 1991:2.7% for Minneapolis—St Paul, MN—WI MSA Difference between the lowest and the highest: 4.5 points of inflation

specified path is knocked off course by events, it is brought back into line repeatedly until the final target is reached. The rate at which countries eventually lock into a single currency will be to a great extent a function of their purchasing power and their economic conditions and partly of the market rate of their currency at the time of joining. However, whatever exchange rate is used at the time of locking the exchange rate, economic adjustments will be made to the rate over time. That is to say, if an incorrect parity has been chosen by a given country at the time of locking its exchange rate, there will be selfequilibrating forces at work in the market that will bring about the 37

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necessary adjustments over time in line with the economic conditions of that country. The point to re-emphasise is how a single currency can operate in the US with its fifty states—each with a different inflation rate. Yet these fifty states (each with its own independent legislative body) are able to operate with a single currency. Moreover, each state has its own fiscal system. Table 3.2 demonstrates the divergence of inflation rates for different US regions. Indeed the model of the US economy and its parallels with the European economy has been little examined by economists in Europe. Table 3.2 shows consumer price statistics for different regions of the US with data provided by the US Bureau of Labor. Inevitably the power of domestic central banks of each of the European countries in their present form will be greatly reduced as a result of the introduction of the single currency The power of conducting monetary policy will be in the hands of the autonomous European Central Bank which will conduct its policies in the context of a unified Europe. Again this is an area that the European economists should take a closer look at—namely the structure of the US Federal Reserve Board and its interaction with the Reserve Banks which are the regional central banks. The argument used by some of the European central bankers against a single currency in Europe is that without further political integration a single currency would not be feasible. What they seem to ignore is that the political structure for a single currency is already in place with the presence of the European Parliament and the role of the Council of Ministers in Europe. Perhaps the power of the European Parliament could be further strengthened. But it is not as if Europe needs a new political structure in order to introduce a single currency. The structure is already in place for putting EMU into action. Finally, it should be stressed that though the introduction of a single currency would happen at one moment in time, EMU should be thought of as an ongoing process rather than an isolated and a once-and-for-all event. Adjustments to it over time will be inevitable to make the path smoother and its operations more efficient.

NOTE Part of this paper was published in the journal Economic and Financial Review, vol. 2, no. 2, 1995.

REFERENCES Santer, H.E.Jacques, President, European Union, ‘The Advantages of EMU’, Economic and Financial Review, vol. 2, no. 2, Summer 1995.

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Sapin, M. ‘The Convergence Criteria for EMU—Do they require revisions, or a more flexible interpretation?’, Economic and Financial Review, vol. 2, no. 2, Summer 1995. Scobie, H.M. “Managing within the ERM—Conventional Wisdom versus Market Perceptions’, Paper presented at the Conference on Economic Policy Coordination, held at the Central Bank of the Netherlands, 1992. Scobie, H.M. ‘Constraints of ERM: Issues to Be Considered’, paper presented at the conference held at the Austrian National Bank, Vienna, 1993. Scobie, H.M. (ed.), The European Single Market: Monetary and Fiscal Policy Harmonisation, Chapman and Hall, London, 1994. Scobie, H.M. and C.Stark (eds), Economic Policy Coordination in an Integrated Europe, Bank of Finland, Helsinki, 1992.

39

4 THE SINGLE CURRENCY The Rt Hon Lord Kingsdown K.G. House of Lords, former Governor of the Bank of England

I take a lecture, as opposed to a speech, to be a performance which has an element of the didactic in it, to be objective in survey rather than advocational in presentation. At any rate I have set about this topical, controversial and, nowadays, fast-moving subject on which you have invited me to speak in this spirit and it will be for you to judge how far I have succeeded. The idea of a single currency should be simple enough: one currency circulating in a given area as the sole legal tender, although in these days of rapid foreign exchange transactions there are few places in the world where other currencies do not also circulate acceptably in the same area. It is possible therefore to recognise also a parallel currency in an area, or a currency common to several areas. While this recognition is important it is the area itself which deserves more consideration, especially the concept of an optimum currency area— the area of appropriate geographic size, matched economic development and political unity in which a single currency, based on a single monetary policy controlling the supply and price of that currency, is as efficient as it can be as the means of exchange. It is worth looking at some of the currency areas which have been formed in the past, either as an act of deliberate policy or as the result of evolutionary process, to see how well nowadays a group of individual countries such as those in the EU can form such an area and operate an effective monetary union. Illustrations from history include a group of unions still in existence after a long tradition: the England—Scotland Monetary Union which has operated from 1707, the federal Reserve System of the USA dating from 1781, Belgium and Luxembourg from 1922, and more recent ones like the CFA franc zone which started in 1945, or, the most recent, the 20th century German reunification dating from 1989. Time does not permit a detailed study of these or any one of them, but a few general conclusions and distinctions can be drawn. First, the concept 40

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of the optimum currency area does not appear to have been a starting point: discussions before, and justifications of, past unions do not seem to have analysed in detail the extent of regions’ economic similarity, the ‘optimum’ element in the area. This is partly perhaps because the concept had not developed at the time; even after it had developed it was clearly not an important factor in the one union which did take place, namely German reunification. Clearly, however, there will have been some economic factors at work in each case, however dimly analysed; it is nevertheless possible to distinguish, again in very general terms, between two groups. One group was explicitly ‘nation-building’, involving the negotiation of a wide-ranging political contract between regions or even countries aimed at political union or one nation. Examples are the England-Scotland Union, the German unifications in the 19th and 20th centuries, the USA, and Italian Monetary Union dating from 1847. It is worth noting that the England-Scotland Union of 1707 was very unpopular at the time and certainly would not have survived a referendum. But a favourable exchange rate for the Scottish currency and a promised transfer payment from England, only a part of which was in fact made, paved the way for a union which worked and contributed undeniably to the industrial development of Scotland in the next two centuries. By contrast, the union with Ireland was not made on favourable terms to Ireland and this, combined with lack of national resources, is generally considered to have contributed to Ireland’s comparative poverty at the time and thereafter. The other group could possibly be said to be ‘nation-following’; that is, established nations retain their individuality but form a union for mutual advantage and perhaps for limited purposes and time. Examples are the Gold Standard (1867–1931), the Belgium-Luxembourg Economic Union (1922 to the present) and the Bretton Woods system of the postwar years. Perhaps these are better described as ‘quasi-unions’ since individual countries retained their currencies and joined for a time and purpose, limited at their option. Nevertheless, the main ones were effective: the periods of the Gold Standard and of the Bretton Woods system were periods of low inflation and stable currencies. Each system tended to be dominated by its major reserve currency, the pound sterling in one case and the US dollar in the other; and each system came to an end when the reserve currency weakened and failed to fulfil its role, although in the case of Bretton Woods increasing capital mobility hastened the trend. Such ‘quasi-unions’ tended to have more limited objectives than the ‘nation-building’ unions: they were essentially spontaneous and involved little political union. While it has been possible, it would seem, to achieve monetary union with no political union, it is clear that such a state is not a 41

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steady one: the enduring unions have been characterised by some form of political integration. How does the proposed European EMU (of whatever size) compare with these lessons from the past in terms of history, diversity and scale? Traditional optimum currency area ideas would not appear to be sufficient for explaining the genesis and evolution of such monetary union. It is unprecedented in terms of the number of established nations seeking union and it would probably be the largest ever in terms of proportion of world GDP at inception: it would be unusual in coming together by the grand design of ‘big bang’ and it would be unique in being a ‘nation-following’ union that was not a quasi-union as described above but a complete union, yet retaining national identities. Historical precedent, except perhaps the Gold Standard, would appear to be against this, and hence the anxiety for some, and the objective for others, regarding some degree of political union. Let me not get involved at this stage in what political union is thought to mean, but we must acknowledge that for this European Union to work there will have to be a strong element of common political will. I think, however, we now have a new element which was not an influence in previous unions. The growth of industrial economies in the last two centuries coincided with the increasing establishment of the nation state, and, as a result the two, the national state and the national economy, are seen as a consequence and part of each other. I believe that connection is fast disappearing. The large multi-national company knows no national frontiers: the components of a single modern automobile are made in four or five countries and assembled in another, the daily transactions of the foreign exchange markets exceed tenfold the total reserves of the world’s central banks, and modern technology can transfer funds at a speed and on a scale that is truly global. Such considerations drastically limit the independence of action of the modern nation state and its government, and their ability to maintain internally an individual economy, currency area and currency. Here I wish to digress for a moment to consider how we have come to use the word ‘sovereignty’, because I believe that daily usage nowadays is inaccurate, confuses thought and raises emotional reactions which confuse patriotism and national interest. When sovereign states enter into treaty relationships they may limit their independence of action but they do not lose their sovereignty. It is to be assumed that the limitation of independence is in the national interest in view of corresponding benefits under the treaty; but the sovereign power can ultimately rescind the treaty, not easily done I concede, but constitutionally possible. Perhaps this is rather facile of me before a learned audience, but I think the distinction is worth the emphasis as we come to consider the anxiety 42

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of those who see the single currency as the forerunner of a federal Europe and plead increasingly loss of sovereignty. Professor Guiliano Amato, the former Italian Prime Minister and Finance Minister, in a notable lecture recently at Ditchley, said that the eager supporters of a federal Europe who keep expecting their dream to come true and the anxious Euro-sceptics who see the D-day of a federal Europe not as a dream but as a dreadful future are both wrong. Europe is not confronted with a mega-sovereignty or a return to the polycentric sovereignties of the past. In his view we should all be aware that the real danger is the second one, certainly not the first, and he wondered whether behaviour aimed at preventing a European mega-sovereignty, which he considers impossible, may have the sole result of paving the way to a ruinous return to the past. He goes on, ‘Let us not undo what we have been doing. Let us look at the further steps that are needed in this light, and in the acquired certainty, like it or not, that there is at the end of the process no federal Europe but a continuous re-arrangement of the multilevel system of government into which our interdependence has been so admirably translated and organised.’ Perhaps that will not satisfy the Euro-sceptics but I regard it as an important summary of what has been achieved in the last fifty years in Western Europe. Surely the reconciliation between France and Germany, the increasing unity between so many countries with a history of strife, physical and economic, the prosperity and stability which have flowed from it and which in turn caused the Iron Curtain and the Communist system to collapse without a shot, will be seen by history as the great achievement of the second half of the 20th century; and countries to the East are queuing up to join this union. If I show my true colours in such a flowery passage, I am not ashamed but I do pride myself that ever since I first served on the Delors Committee and became involved in this great subject, I have tried to keep my feet on the ground, to be pragmatic rather than idealistic, to be evolutionary rather than revolutionary; but I do believe this great concept does justify and does need a degree of vision and, yes, a visionary or two, like Jacques Delors. Now I wonder if I have set the scene adequately to justify asserting that the relationship now between certain countries makes economic and monetary union between them a realistic possibility? Why is it that monetary union has been and is being pursued? It has been seen for a long time as an important, even fundamental, element in an ever deepening union and above all essential to the completion of the Single Market; but it has also been an elusive one. More than twenty years ago, a Luxembourg expert called Werner was put to work and he and colleagues produced the Werner Plan for a single currency; it was, however, then seen not to be a 43

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practical reality and was shelved, partly because of the turbulence of the first oil price shock. Undeterred, the proponents then produced the currency snake, in which currencies moved on a variable line in relation to each other; the UK joined this, but soon left, finding the restriction on sterling too tight. Then there appeared the European Monetary System, a loose alliance of currencies and policies which found finance ministers and central bank governors committed to a regular round of meetings and expressions of policy aimed at smoothing out the imbalances in national monetary policies and consequent exchange rate relationships. From this flowed the more formal exchange rate mechanism—a device in which for the first time there was a specific commitment to bands for exchange rates, and collective funds and actions to assist currencies under pressure. As you all know, the UK joined the mechanism in October 1990 but in the wide band; and as you all know, the UK left the mechanism rather painfully in September 1992 along with Italy, and the surviving members are now only able to maintain a formal mechanism of 15% bands in contrast to the narrow band at the height of the system of 2¼%, although once again now France, Germany, Belgium, Luxembourg, the Netherlands, Denmark and Austria are de facto within that narrow band. It is worth giving a word or two of explanation of the failure of the early ERM. There had in fact been no realignment of currencies within the ERM for nearly five years before the debacle of September 1992. Enthusiasts were beginning to talk of having established exchange rate stability within the Community—with some justification, perhaps; and maybe they could detect, as they thought, an evolutionary move in exchange rate relationships at least among the narrow band members, from which a single currency could flow. Sadly, this blinded ministers to a growing difficulty emanating from the real economies of the member states: the relationship was becoming increasingly hard to maintain against the background of high German interest rates, largely consequent on German reunification. The strain began to be felt in early 1992 and by the summer was becoming enough to provide the circumstances in which hitherto a realignment would have been sought. Unfortunately, too many governments had pledged their credibility on ‘no devaluation’; Germany, understandably in my view, was not minded to revalue the DM or lower interest rates, and the break-up occurred. I have dwelt on this episode because it conveys three messages. First, no monetary mechanism or relationship will survive unless conditions in the real economies reasonably converge. Economic reality in the shape of unemployment levels, productivity and competitiveness cannot be held at bay for long. 44

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Secondly, on the other hand, but for the exogenous shock of German reunification which brought about such a sharp end, the later years of the ERM had shown that it was possible for an appropriate set of countries, given the necessary political will, to cooperate in working a common monetary system to a respectable and recognisable degree—at any rate for a period. Thirdly, and this is the most relevant for our purposes this evening, the break-up of the ERM made the European monetary proponents even more convinced that a durable monetary union could only be achieved through a single currency. However much progress might be made in relationships between individual currencies, that relationship would always be vulnerable to some shock, unforeseen, uncontrollable and from outside sources in all probability, that would break it. And we must recognise that work on the single currency has proceeded, undeterred by the events of September 1992 and August 1993, on this basis and in the face of those critics who say that the demise of the old ERM has made EMU impossible. On this reasoning, that is not so; indeed, perhaps perversely it has made EMU more urgent if monetary fragmentation in the EU is to be avoided. Let us leave this episode now, but with ringing in our ears the lesson that monetary union of any sort is not likely to succeed if it is unreal in terms of the underlying economies. Should it happen? Should some countries move to a single currency? Certainly not, unless it can succeed; if it could succeed, will it happen? These are the two great questions to which we must now proceed. They are two questions, different in kind. In trying to decide whether a monetary union can succeed, one is weighing up a mass of economic and monetary considerations—and in that sense, one is dealing with an economic question. The fact that so much of the answer to that question is judgemental and that it is not possible to be certain about the conclusion, means that the answer to ‘will it happen?’ is ultimately political, and much will turn on political leadership and public reaction. Those who are working on the proposal are well aware that success, and durable success, turns economically on the extent to which the economies of the countries concerned are adequately converged and can remain so; hence the Maastricht Treaty criteria—on interest rates, inflation rates, government deficits expressed in annual terms, total government debt and, finally, track record in exchange rate stability. Let us note for the moment that these Treaty criteria are confined to what are termed macro-economic elements; elements in the real economy like unemployment rates, growth in the economy, production costs and so on are not specifically measured, although some are implied or even referred to in a general paragraph in the Treaty. At this point I think it necessary to emphasise that unemployment, 45

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structural unemployment which underlies the structure of the economy and does not fluctuate much if at all with economic cycles, is much more a matter of social, educational and labour market policies than it is of money management. Good money management makes its contribution by providing stable medium-term conditions for business out of which medium—and long-term confidence grows and whence investors are ready to risk their money against predictable conditions. This is the source of soundly based employment. Anyway, unemployment rates as quoted are a source of difficulty. The relative policy imperative is the social unrest risked or generated rather than the vagaries of a statistical series; and this cannot be measured precisely. Let us also fit in here another aside. The pursuit of the Maastricht criteria is held to be responsible, typically, for tight fiscal policies and monetary stringency in several countries; and thus the unpopularity of the supposed slow growth in economies and the undeniably high levels of unemployment in those countries are hung round the neck of EMU. This may be tempting for Euro-sceptics, but it is not entirely fair. The Maastricht criteria, especially the reduction of fiscal deficits, are in themselves worthy, indeed necessary, objectives, quite apart from EMU; inflation has largely been put in its place in most sophisticated countries—one of the great macro-economic achievements of international economic cooperation in the last ten years—but fiscal deficits remain, and remain a serious threat to the long-term stability of many countries, whether aspiring to EMU or not, especially when the burden of high public debt levels cannot be inflated away as in the past. Nevertheless, it is necessary to enquire how sustainable the projected regime of an EMU might be. It would remove from a member country individual management of its monetary policy and, inherent in this, the opportunity to devalue its currency either as a deliberate act of policy or simply as a matter of indifference or neglect in allowing it to float downwards. How important is this right? How widely has it been and can it be used? And let us initially take the word ‘widely’ in its geographic or regional sense. Traditionally an increase in credit with or without a devaluation has been the means of stimulation of an economy in the doldrums, and traditionally, such being the association between national boundaries and modern economies, it has been a national instrument. Thus the surrender of such a national instrument is indeed a serious restriction of independence of action, even, as some would put it, a loss of sovereignty. Let us consider for a moment, however, such a state of affairs in another large single currency area, the USA. At any given time, there are and have been serious contrasts in prosperity across the union: a boom in the North 46

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Eastern states in contrast to California or the Deep South. No one has ever considered a separate monetary policy, let alone a separate currency, for, say, California: the implications for the free flow of business across state borders would be unthinkable, the practical problem of enforcing different interest rates in our age of instant information and money transfer overwhelming. This picture can in fact be translated to the smaller scale of the UK; I believe that at any one time the rates of unemployment can vary between individual parliamentary constituencies from the highest at 25% to the lowest at 3%. No one has ever suggested that this should be alleviated by a separate currency for, say, the old rust-belt regions of the North or longsuffering seaside towns. The remedy, as we all know, lies in transfer payments made through the agency of the national government from the richer regions and individuals to the poorer in the form of welfare entitlements or special development grants, supplemented to some extent by the readiness of individuals to move home from areas of low employment to areas of high employment demand. This mobility of labour is probably more pronounced in the US than anywhere else and is facilitated by a single language, a free market tradition and a readiness to live if necessary in mobile homes. This can hardly be said to apply in Europe—mass annual migrations in search of seasonal work were I believe more common in mediaeval Europe than many of us realise—but nowadays national boundaries, difference of language and the expectation of a more sedentary existence would suggest we cannot expect labour mobility to make much of a contribution to national or regional contrasts in economic activity. We are thrown back on transfer payments, therefore, and how can these work in a union of national states? Only, it is said by the sceptical or even the cautious, by a much more formal system of allocation of funds than exists at the moment: to wit, some operational body of supranational standing, yes, something verging on political union. I have never heard anyone, on either side as it were, really define political union in this or any other context. Some see it as a desirable objective, some see it as anathema; and here we are back with the principles so eloquently dealt with by Guiliano Amato to which I referred earlier. However, the issue has got to be faced in practical terms and I would like to submit some observations of my own towards this. If EMU is to work there will have to be a degree, a substantial one, of common political will to make it work; if that is labelled ‘political union’, so be it—but I do not think it is real political union. The problem of economic divergence is always presented as a national one: one country is thriving and rich, another is stagnant and in need. I believe this at any one 47

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time to be only partly true: the contrast between Northern and Southern Italy is perhaps the most obvious example. The existing regional policy of the Council of Ministers and the Commission recognises this with allocations to poorer regions within surplus countries as well as in deficit countries. This sort of approach would clearly have to be extended under EMU, certainly in volume of payments and probably by regions, but I cannot see why the existing machinery could not do this without a change in kind in national independence. There would have, in all probability, to be a change in amount but I believe that members of an EMU would have to accept this and that the increase could be manageable. At the moment most countries raise in taxes and spend, almost entirely internally, 45–50% of GDP in each year, whereas 1% of GDP is the average contribution of each country to European funds (and half of this goes on the CAP). Economists have calculated that the direct benefit from EMU of saved transaction costs could be 1% of GDP. Thus, could one reasonably expect greater contributions, maybe that extra 1%? It may be said ‘Why should we pay taxes to solve other people’s problems?’ The answer is that we all do so already but for the most part they are our own people. The gradual transformation of the poorer parts of Europe is, in my view, in the interests of all of us. The change in political stability in the Iberian peninsular is not unconnected with the change in prosperity there. The new roads in those countries, the flow of capital investment in Spanish car plants or Portuguese real estate in holiday areas are, as I see it, in the interests of all of us, not only as direct beneficiaries of such products but as members of neighbouring countries freed of the worry of the extreme governments, internal political uncertainties and tensions of the earlier post-war period in Europe. An essential feature of an EMU is to be its central bank—one central bank managing one currency for whatever number of countries are in the Union. It has as its main object stability of the currency and a duty to pursue policies to that end above all other, but nevertheless as far as possible consistent with the general economic aims of member countries. This is laid down in statutes validated by the Maastricht Treaty and no one will be surprised that these statutes follow very closely the act of parliament which created the Bundesbank—at least they ought not to be surprised, as I had a hand in drafting and agreeing them. Maastricht also requires that the national central bank of any member country must be independent—independent, that is, of government direction in the formulation and management of monetary policy. The principles of, the advantages of and the objections to the concept of an independent central bank exist writ large in the case of the European Central Bank: can such a far-reaching function as controlling monetary 48

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policy be delegated to a body with little or no democratic accountability, either nationally or federally? Critics and sceptics are anxious, if not dismissive. Such a body is quite capable, they say, in the name of monetary rectitude, to tolerate, if not engineer, a level of unemployment in the union which would be politically unacceptable, and nothing could be done about it. I doubt this, quite honestly. I do not believe that the modern central banker is either so reactionary or so unrealistic as to be impervious to political reality or social unrest. True they may have often enough to tread a delicate path between their calling of sound money and the pressures on them of political reality; and they will be alert surely to the facts that they and their central bank are no more than creatures of statute and that statutes can in extremis be amended or repealed—admittedly at the European level only by amendment of the Treaty by national governments (yes, sovereign ones in this context)—with all that involves. My view (and it would be, wouldn’t it?), is that the advantage of monetary policy based on delegated statutory power and administered solely by the central bank with the main object of monetary stability outweighs the value of a government having the right to intervene, such intervention almost by definition being in the name of short-term expediency and subjecting the value of people’s money to the risks of the political cycle. And let me just say that this view, as I have described it, is increasingly being adopted across the world—above all with resounding success in New Zealand—as governments eschew the opportunity of short-term adjustment for the confidence and stability that central bank independence seems able to bring. Moreover, I do not believe that it by any means follows that an ECB will have to be permanently or overly restrictive. Once that bank has achieved credibility, and I acknowledge that track record and therefore time is necessary here, and if the Euro is accepted in the markets as an inherently sound currency, I like to think the bank will have a degree of latitude and discretion in its policy that is denied at the moment to so many central banks whose currency is so subject to market opinion. I think too that, given adequate convergence in member countries’ economies, the changeover to a single currency can be managed technically. I will not go into the mechanism in detail but the EMI has progressed a fair way down this road and I have faith in their expertise and objectivity. Nevertheless, there could be a difficult and potentially vulnerable period in the transition when national currencies are locked but are still in existence and identifiable to the markets and thus open to attack. However, if the markets believe in convergence, yields will be so similar that there will be nothing to attack. Bond yields in the core six countries already discount EMU in 1999 fully. 49

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Let us follow the bond markets then and recognise that EMU could well happen, and happen on time in 1999. I used to be an unequivocal evolutionist about when it should happen; that is, members of the EU should continue to work to improve convergence, they might introduce not a single currency but a common or parallel currency alongside national currencies which would no doubt appeal to international companies and tourists alike and gradually spread in use as its convenience and value were appreciated. In fact, this process is somewhat envisaged in the intermediate stage of EMFs planned transition but the difference is that the transitionary period is finite and national currencies disappear on a fixed date. I confess to halting now between two opinions—the evolutionary as I have described, and the big bang. Events have moved forward much faster than I expected when I once said on the Today programme that I doubted if the single currency would come in this century but that it would come in my natural lifetime. ‘What do you mean by that?’, asked the interviewer, and I replied, ‘You had better take a look at me and make your own actuarial estimate.’ Since then the political imperatives have become sharper and official work has intensified and progressed on the official assumption of the Maastricht timetable. There is a sentence in the so-called Kingsdown Report which reads as follows: ‘EMU will not take place unless Germany is willing and France is able.’ Let us assume for a moment that Germany is willing: a union without France—or Germany, Austria, the Netherlands, Luxembourg possibly, Belgium and Finland—would be little more than a DM bloc, and the Euro would be the DM writ new. France is essential to give the Union its balance and its European credential. Ever since the early 1980s when Jacques Delors, as Finance Minister, persuaded Mitterrand that France could not credibly go it alone down a path of inflationary growth and devaluation, all that is associated with the franc fort has been fundamental to French policy and French aspiration to be an equal partner in Europe with Germany. This is not going to be abandoned easily, whatever the protests from the unions; and it is worth noting that a recent survey showed that 80% of the managerial class in France supported EMU and the place of France in Europe and EMU. Devaluation is an option France has no desire to possess: unfortunately, so long as the option exists it is almost impossible to convince the markets it will not be used (NB for UK—more later!). A consequence is the need to pay a higher interest rate premium whenever the markets believe the country might want to exercise its devaluation option. This is a price France does not wish to pay but can cease to do so only by eliminating the option—that is precisely what EMU will achieve. Indeed, France’s efforts so far have convinced the markets and the premium has virtually disappeared except for the very short maturities. 50

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Equally, the last thing German industry wants is devaluation by another big European economy—least of all France, Germany’s most important single trading partner. That might be no great risk if the narrow-band exchange rate mechanism that fell apart in August 1993 could be made certain once more. But it cannot. France might even sever its links with the Deutschmark and much more besides if the door on EMU were to be shut by too tight a monetary policy and too restrictive an interpretation of the Maastricht Treaty. That is not a risk it would make any sense for Germany to run. Add to all this what I believe to be the fear and sense of urgency working on Chancellor Kohl that, as his generation in Germany with direct experience of a divided Europe is overtaken by one without that recollection, there may arise increasingly an impatience in his country with its Western neighbours who prove unworthy trade partners and a consequent inclination to look East for outlets: from this a re-emergence of the Rhine as a divide in Europe, and hence his albeit brief, highly speculative reference to war. Germany sees that the ‘price of non EMU’ is now very high—both economically and politically. I must acknowledge that I am indebted to Martin Wolfe and his article in the Financial Times of 9 February 1996 for much of this description of what I term the political imperatives at work in the two critical countries, but there they are and I think we would be wise to recognise them and their consequences for us. And the consequences are that we in the UK will be confronted early in 1998 with having to make a choice about joining an EMU or not. The Kingsdown Enquiry set itself the specific task of trying to answer the question of where the UK’s interests lay in such circumstances. The answer, very briefly, was that if the Union was going to work well, it would be in our interest to join: interest rates would be lower, our access to the Single Market would be assured, a stability and predictability would develop in business prospects that we have not known in this country, perhaps since the Second World War. And our interest in joining lay as much in the disadvantages of not joining as in the advantages. Such disadvantages were the risk of being seen not to be at the heart of Europe and thus no longer as attractive as a place of inward investment: a risk that the City, for all its long lead over its rivals at the moment as a global financial centre, might gradually lose its eminence, most of all as not being the centre of an important new currency, and even a risk that some aspects of the Single Market regulations might be operated in a discriminatory way against us. Should we not join (and I fear I do not see the necessary political will being mobilised in time) a lot will turn on perceptions of why. Should we be ineligible but imply joining once the criteria are met, we can surely look forward to sympathetic treatment and policy from members. If we are 51

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eligible and nevertheless refuse to join as a matter of principle, we do run a risk of discrimination—for what could be seen to be the reason except a desire to retain the right to go our own way of currency devaluation as it suited us? (As an aside, I have heard the comment ‘What in this global world does sovereignty amount to except retaining the right to devalue?’) Should we be eligible but express the option to join in due course—a splendid British way of doing things—we would still be confronted with the pressure of conforming to the spirit of EMU as far as monetary and foreign exchange policy are concerned—and we would be struggling to do that on our own, perhaps the worst of both worlds. Let me speculate on what I think may happen—dare I say, will happen. An inner core of countries will form an EMU and they will make a success of it: they cannot afford not to, they have a track record of monetary cooperation and economic progress which they have striven for and which they will not want to sacrifice. The Euro will be introduced and will assume a role in world currency affairs at least comparable to, and probably more widely and flexibly used than, the DM—a third world currency alongside the US dollar and the yen. It will be available for us in the UK to use, just as in a world with no foreign exchange control any currency theoretically is available. Our companies with European business will increasingly use it, as will our individuals for travel and European holidays. It will develop into a parallel currency alongside sterling and gradually the day will come when the convenience of the Euro will be accepted as justifying its adoption as our currency. It would be a typically British way of doing things—reminiscent perhaps of the performance of an official called Bretherton who attended in 1965 as an observer for the UK the Messina Conference at which the original six first formed their union. He reported back, ‘They will not agree, if they do agree it will not work. If it does work, it will not matter.’ Shall we once again watch others form a club, disdaining an invitation to be a founder member; then seeing how agreeable the club is, come along and ask to join, probably at the same time suggesting a special subscription and, yes, one or two changes of the rules. It would be a thoroughly pragmatic way of doing it. It might indeed be in the national interest, given the divided state of opinion in the country. It would probably prove expensive in the long term but that will not be immediately perceptible. I doubt if I can say more, except to end on a facetious note. It may be that my original evolutionary approach will prove to be our actual one and that if you want to know when the UK will join EMU, you can look at me (if you can bear to do so for a moment longer), make your actuarial calculation and place your bet.

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5 EMU The obstacle race to success Philippe Maystadt Deputy Prime Minister and Minister of Finance and Foreign Trade, Belgium

1 WHY MUST EMU SUCCEED? We have entered a period of intense debate on the opportunity and feasibility of European Monetary Union. Whereas some people work with determination preparing EMU or increasing the credibility of the final stage, others are devoted to scepticism or announce a ‘bloodbath’. This debate should be as constructive as possible, since what is at stake is not only the convenience of happy travellers using the same coins and notes across Europe, but also the very existence of the dynamics of integration and eventually the stability of our continent. I would like to answer two questions: first, why must EMU succeed and, secondly, how can EMU succeed?

2 NO TRUE SINGLE MARKET WITHOUT EMU The economic and monetary difficulties of 1993–6 perfectly illustrate the main reasons why we must succeed in establishing economic and monetary union, as set out in the Maastricht Treaty. These difficulties have in fact once again brought to the fore not only the need for monetary union and a single currency, but also the need for an adequate convergence of policies and economic performances between member states. The great fluctuations between European currencies in 1994–6 have posed a threat to the European Single Market. Indeed, they have introduced dramatic competitive distortions among producers based in the various member states. In a number of them, including Belgium, the most affected industries have called for protective or corrective measures, and threatened to delocalise activity and withhold investment decisions. The uncertainty resulting from the widespread currency instability in Europe is 53

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a drag on fair internal trade and on investment, at the very opposite to the objectives of the Single Market. Moreover, it invites protectionist temptations to knock at our doors. Although Europe can survive severe monetary shocks in the short term, I am deeply concerned about the potential destabilising effects of a prolonged period of widespread misalignment of currencies. This, I fear, would mean at the best stagnation and at the worst degeneration of the European integration process. It is worthwhile to recall the links between the European Single Market and the process of monetary union. In the late 1980s, after the approval of the White Paper on the Single Market, the member states realised that monetary union was inevitably the next step. The reasoning was the following: (i) Exchange rate stability is desirable in order to avoid competitive distortion and to reduce uncertainty within the Single Market. (ii) Capital should flow freely in order to allow a better allocation of resources and to achieve the Single Market for banking and financial services. (iii) We know, from both economic theory and the ERM crisis of July 1993, that one cannot combine exchange rate stability and free capital movements while maintaining independent monetary policies (or even expectations of independent monetary policies). Consequently, the Single Market requires a single monetary policy. (iv) The best way to implement a single monetary policy is by adopting a single currency. The validity of this approach has in no way been weakened by the monetary problems that we have experienced in the last three years. The first ERM crisis, in 1992, confirmed that the exchange rate stability cannot be decreed and requires a sufficient degree of economic convergence. The second ERM crisis, in 1993, showed that convergence of the fundamentals, while being a necessary condition, is not sufficient to ensure exchange rate stability. This crisis, within the so-called ‘hard core’ of the ERM, confirmed that even with converging fundamentals, exchange rate stability cannot be granted when markets anticipate the possibility of diverging monetary policies. Finally, the recent currency misalignments confirmed the potential risk of a chain reaction between competitive devaluation and protectionist actions. The expression ‘reducing the Single Market to the zone of the single currency’ was circulating in the last quarter of 1995 and indicates what is really at stake. It should be clear that floating exchange rates are not an option available within the Single Market, and that the discrepancy between Single Market and single currency (or currently, the zone of monetary stability) should not last. 54

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Even within the so-called ‘hard core’ around the Deutschmark, maintaining a standstill is not a desirable option. Indeed, the 1993 crisis showed that the credibility of converging monetary policies can be challenged at any time by the markets, especially when a country has to face a specific shock. This can quickly result in disruption of exchange rate stability, with at least two damaging consequences. First, the anticipation of this means a quasi-permanent and volatile risk premium on interest rates visà-vis the anchor currency. Secondly, the problem is particularly acute when, as in the case of German reunification, the monetary authorities of the anchor currency have to fight specific inflation pressures resulting from the fiscal stance or from wage settlements. The Bundesbank has often complained that too much weight was put on monetary policy rather than other economic policy instruments to contribute to price stability. It is reasonable to think that this has an influence on the anticipations of the bond market operators and thus contributes to a high level of real long-term interest rates. This provides another reason for the ‘core-currency’ countries to proceed to Stage III of EMU along the lines of the Treaty as soon as they meet the convergence criteria.

3 EMU IN A TRIPOLAR WORLD MONETARY SYSTEM The recent turbulence in the European currencies was also linked to the great fluctuations of the DM/dollar and yen/dollar exchange rates. The world monetary system is characterised by a progressive evolution towards a tripolar exchange rate mechanism. This evolution confronts us with a double challenge: the first relating to the definition of reasonable exchange rates between the three major economic zones, the second relating to the speed and power with which monetary tensions within a zone can have repercussions on the other two. This is particularly important for Europe. These matters require a more rigorous management of the exchange rate system at world level. It would be preferable by far if Europe could participate in this debate by relying on a single monetary authority and by emphasising the interests of a single European currency having the same international reserve status as the dollar and the yen.

4 HOW CAN EMU SUCCEED? These are the main reasons why EMU must succeed. I will now turn to the question, ‘How can we make it succeed?’ I remain convinced that the provisions of the Maastricht Treaty give us the proper steps for a transition to a single currency. They should be fully respected and certainly not be altered. However, the Treaty does not 55

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provide the complete tool box for a credible functioning of its third stage. We need to enhance the credibility of Stage III in two respects: • •

First, the discipline and coordination of the fiscal policy of the member states which will enter monetary union should be reinforced. Secondly, the relations between this group of countries and the other member states should be organised with a view to ensuring stability and continued economic convergence.

Let me briefly elaborate on the necessity to stick to the Maastricht Treaty in the transition period and develop new aspects for Stage III. 5 STICKING TO THE MAASTRICHT TREATY As we progress through the transition period, questions related to the calendar and the scenario are getting more precise. I am convinced that we should stick to the calendar provided for by the Maastricht Treaty. Any sign of postponement would reduce the credibility of the process and would erode the willingness to implement the measures necessary to ensure convergence, not to mention the legal implications of departing from the Treaty. The Treaty stipulates (Article 109j(4)) that the decision on which member states will enter Stage III, shall be taken at least six months before entry. Moreover, according to the EMI, this decision should be taken ‘about one year’ before, due to the technical problems to be solved during this period. With respect to the effective introduction of a single currency, the Treaty, in Article 1091(4) clearly distinguishes the irrevocable fixing of exchange rates on the day of the coming into effect of Stage III from the measures to be taken for a rapid introduction of the single currency. In fact, four important dates mark the process towards the complete changeover: (i) In January-February 1998, the European Council will decide which member states will participate in the Monetary Union. (ii) On 1 January 1999, the exchange rates between the currencies of the participating member states will be replaced by irrevocably locked conversion rates. The national currencies and the European currency will become different denominations of the same currency. The European Central Bank will start conducting its single monetary policy in the European currency. (iii) At the latest, three years after the start of Stage III, the European Central Bank will start issuing European bank notes and coins and exchanging national bank notes and coins for European ones. (iv) Six months after the first day of introduction of the European bank 56

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notes and coins, national bank notes and coins will lose their legal status. The changeover to the single currency will have been completed for all operations and all agents. The length and content of these phases were confirmed at the 1995 meeting of the European Council in Madrid. The Treaty should not only be respected as far as the calendar is concerned but also with regard to the convergence criteria. I am indeed convinced that it would be a mistake either to relax or, on the contrary, to strengthen the convergence criteria. We should stick strictly to the criteria as well as to the assessment procedure defined by the Treaty. Since September 1994, the European Union has formally applied the procedure on ‘excessive public deficits’. The recommendations of the European Union give the member states a precise idea of the distance they still have to go before complying with the criteria of participation in the final stage of EMU. The first two exercises of the recommendations by the Council have allowed the correction of certain misunderstandings concerning the interpretation of the Treaty provisions on the control of public indebtedness. As you all know, the Treaty stipulates on that subject that the excessive deficit procedure will be started if the ratio of government debt to GDP exceeds the reference value of 60%, ‘unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace’ (Article 104c(2b)). The decision not to apply the procedure to Ireland has already shown that it is the tendency of the reduction compared with the reference value that has to be taken into consideration and not the present indebtedness level. As we have always stressed, contrary to other interpretations, the two budgetary criteria of the Maastricht Treaty are of a different nature: the deficit criterion is formulated in level terms, whereas the indebtedness criterion is expressed in tendency terms. However, it is clear that the correct interpretation of the public finance criteria does not leave the way open to laxity. On the contrary. For Belgium, it has as a logical consequence that we commit ourselves to a strict application of the 3% norm as regards the budget deficit. It also forces us to devote any room for manoeuvre to a faster reduction in indebtedness ratio. In the medium term, the dynamic reduction of the debt ratio, which one could call the ‘reversed snowball effect’, will have to be maintained by stabilising, beyond 1996, the primary surplus at a level of about 6% of GDP. This fiscal guideline should bring about a structural and accelerating decline of the debt-to-GDP ratio, which is all the more desirable given the increasing pressure of an ageing population to be experienced at the end of the next decade.

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6 STRENGTHENING THE CREDIBILITY OF THE FINAL STAGE If the Maastricht Treaty provides the appropriate steps for the transition to a single currency, we should take new initiatives in order to strengthen the credibility of Stage III in two respects: budgetary discipline and the relations between the member states participating in EMU and those which will enter at a later date. 7 BUDGETARY DISCIPLINE Belgium entirely shares the concerns expressed by Germany in its proposal for a ‘Stability Pact for Europe’ on the need to enhance the credibility of the monetary union, even if some specific aspects of this proposal are open to debate. In particular, we agree on the need for additional basic rules in terms of fiscal policy as well as on credible sanctions to be applied in the event of deviant behaviour. We also share the view that, if 3% is a ceiling, the normal target for the public deficit should be lower in order to act as a buffer, in case of adverse economic conditions. Indeed, if 3% were to be the normal level as well as the maximum level, it would lead to systematic procyclical policies. Moreover, Belgium also considers that countries with a high debt-toGDP ratio at the time of entry into monetary union should accept additional norms which guarantee that they will stick to a path of debt reduction once they have entered EMU. We believe that this additional norm has to be expressed in terms of primary surplus relative to GDP in order to bring about a stable and consistent policy stance. 8 RELATIONS BETWEEN THE INNER AND OUTER GROUPS A second initiative should be taken in order to reconcile the interests of the first group of member states to join EMU and the others. Indeed, EMU should not be a source of division within the European Union, but rather an instrument of stability for all member states. The purpose is twofold: (i) The member states which will not at first be part of EMU, should in no way have sanctions imposed on them by the financial markets, as this would severely handicap their convergence. (ii) In the meantime, the risk of competitive devaluations of certain currencies should be ruled out. As already mentioned, such competitive devaluation could severely damage the functioning of the Single Market. 58

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Let me stress that these two points are in the interests of all member states, whether or not they belong to the first group of countries joining EMU.

9 CONCLUSION The monetary turmoil of the last three years in the European and even the world monetary systems can in no way be seen as an argument to drop or to postpone EMU. On the contrary, I am convinced that it provides ample evidence of the necessity of proceeding with EMU. As far as the transition is concerned, I think in the first place we should rely on a correct and complete reading of the Maastricht Treaty. But this is not enough. We should take the appropriate steps in order to enhance the credibility of EMU vis-à-vis public opinion and the financial markets. EMU will only succeed if it is credible, if it helps all the member states to implement converging policies and if it is complemented by sensible macro-economic coordination and structural policies able to bring growth and higher employment back to Europe.

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6 THE UNITED KINGDOM AND EUROPE Quentin Davies Member of Parliament, House of Commons, UK

In his first speech as Foreign Secretary, Malcolm Rifkind stated that the UK’s foreign policy should be founded simply on an assessment of our own national interests. No Conservative would disagree with that. That principle must apply also to our membership of the European Union. Does it meet the test? What are British interests in the EU? And what kind of Union will best defend them? The object of the European Union is to promote those interests of the citizens of Europe which cannot, or cannot so effectively, be advanced at the level of the individual member states. Article 3(b) of the Maastricht Treaty—enshrining the principle of subsidiarity—makes that division of responsibility explicit. And the successive European treaties—consolidated at Maastricht into the Treaty on European Union—set out fields in which action is indeed expected to be more effective at the Union level. These include the creation of a Single Market, which is far more than a customs union since it aims to eliminate all non-tariff barriers to trade under a single regulatory framework (Pillar I of the Union), a common foreign and security policy (CFSP) (Pillar II), cooperation in the fields of justice and home affairs (Pillar III), and monetary union. Does the UK stand to benefit from these policies, and if so what should be our contribution to their formulation and implementation?

THE SINGLE MARKET The Single Market—largely a British initiative—is not controversial, at least among Conservatives. This paper, therefore, principally focuses on the other areas. But before we leave the Single Market it must be said that it has begun to work impressively. It accounts for 58% of UK visible exports (£88 billion in the 12 months to November 1995, as opposed to £62 billion to the rest of the world). Our exports to the rest of the EU have also grown at an above-average rate: by 6.5% in 1993, the first year of 60

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operation of the Single Market, by 11.1% in 1994, and by 18% in 1995, contributing very significantly to the recovery of the economy. But it must also be said that the Single Market has yet to be completed. And the fields in which non-tariff barriers remain—telecommunications, energy and airlines—are those in which the UK, with major international companies in these sectors emerging directly from the successful privatisations of the 1980s, has a very special interest. Agreement was secured at the Corfu Summit in 1994 to open the telecommunications market by 1998. But we are still a long way from forcing open the monopolistic Continental energy distribution networks (Gaz de France, Electricité de France, Gasunie, Ruhrgas, RWE, etc.) and from airline deregulation and open competition such as the US has enjoyed for a decade. It must be a British priority to secure these objectives at the Intergovernmental Conference (IGC). A further British priority should be to extend the Public Procurement Directive to defence equipment, removing the protection which the Treaty (in Article 233) permits member states to extend to their defence industries. Since we have the largest and (measured in terms of defence equipment exports) most successful defence industry in the Union we would obviously stand to reap the greatest industrial gains from such a move. But every member state would benefit as greater competition reduced its own defence procurement costs. Such a move, moreover, would surely be an essential element in the greater defence cooperation to which the Maastricht Treaty looks forward.

COMMON FOREIGN AND SECURITY POLICY The European Union agreed at Maastricht on the ‘implementation of a common foreign and security policy including the eventual framing of a common defence policy’ (Article B). This was not a position from which we sought any derogation and it remains the expression of British government policy. But so far little or nothing has been done to put it into practice. Is that a good or a bad thing? Is this, or is this not, an area in which British interests demand that progress be made? The recent history of European foreign policy and defence cooperation is lamentable. Until the last hours before the Anglo-American ultimatum to Iraq in July 1991, which followed the invasion of Kuwait, France (which later took a distinguished part in the military operation) was pursuing its own diplomatic initiative. Saddam Hussein can only have assumed that he could play off one EU and NATO member against another, and this can only have increased his intransigence. Once the war had started, Belgium initially refused an export licence for the Belgian armaments company F.N. Herstall to sell arms to the UK. In former Yugoslavia the record is—if anything—worse. The warring parties did not receive a clear, consistent 61

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and coherent message from the European powers until the Americans finally took charge of the direction of both diplomatic and military activity in the summer of 1995, when the EU member states broadly agreed to support them. If the Americans had not taken the lead the war would certainly be continuing (and the danger of its spreading to Kosovo, or Macedonia or beyond might by now be greater than before). That the Americans were very fortunately prepared to take on this responsibility reflected both their great exasperation at European disunity, pusillanimity and ineffectiveness, and a particular conjuncture of domestic American politics. The first will have weakened our influence with the US, and undermined our international credibility when we are confronted with future threats or crises. The second fact should warn us of the dangers of assuming that the Americans will always be there to come to our rescue if we fail on future occasions. A further disturbing aspect of the Gulf and Bosnian crises is that when military action was ultimately launched only three EU member states took part: Britain and France in the Gulf, Britain, France and the Netherlands in Bosnia. For if in defending the interests of world peace and of stability in our region our soldiers and airmen were risking their lives in the interests of the inhabitants of Paris and Bordeaux, of London and Glasgow, of Amsterdam and Rotterdam—as they certainly were—they were no less defending the vital interests of the citizens of Rome, Vienna, Berlin or Stockholm. A scheme of things under which, when it comes to the military crunch, two or three countries alone send their own troops in the service of all is not satisfactory. ‘Free riding’ cannot be the basis of the common defence of Europe. So what is to be done? An ideal solution in some people’s minds will be to turn the EU into a coordinated diplomatic and military power—a Europe of nations within, which can nevertheless effectively act as a superpower without, focusing the combined economic and diplomatic influence, and, if necessary, the combined military resources, of the Union in pursuit of its common objectives. Such a Union could indeed form the equal pillar of the Atlantic Alliance for which the Americans have long hoped—one which would share with them the burdens of common defence, and coordinate with them actions across the globe. This is, however, an ambitious aspiration, controversial even if theoretically attractive, and one certainly impossible of realisation in a single leap. It would require the emergence of an effective collective decision-making procedure on foreign policy, the pooling of diplomatic resources and—most difficult of all—the creation of a military role for the EU, or the merger of the EU with the Western European Union, itself designated by the Maastricht Treaty as ‘an integral part of the development of the Union’, whose task is ‘to elaborate and implement decisions and actions of the Union which have defence implications’ (Article J4). 62

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It would be a great mistake to suppose that the only obstacle to the realisation of such a project was British recalcitrance. There are at least three other difficulties to be accommodated: 1 2

3

Four neutral members of the Union (Ireland, Austria, Finland, Sweden) have not chosen to apply for full membership of the WEU. The same set of states have at least so far not wished to join NATO— and it would be very dangerous for other EU members to accept the mutual defence obligations of the WEU Treaty in respect of countries who have not also bound the US to their defence by joining NATO. There are three countries who are full members of the WEU, but who are not members of the EU—Iceland, Norway and Turkey.

In short, there are some countries who could take part in a common foreign policy as foreseen in the Treaty but not a common defence policy (the neutrals), and some who might theoretically take part in the latter but not the former (the non-EU WEU member states), and some with whom it would actually be dangerous in present circumstances to enter into a mutual defence arrangement at all. Some work has been done since the signature of the Maastricht Treaty in addressing these contradictions: for example, provision for EU cooperation in humanitarian and peace-keeping missions—so-called ‘Petersberg missions’ after the Petersberg Conference. (However, what happens if, for example, the Swedes agree to participate in a joint peace-keeping role, but on the understanding that their troops will leave if any actual shooting starts? Foreign policy and even peace-keeping cooperation in the absence of solidarity in defence presents many difficulties and dangers.) The British paper on CFSP presented to our partners in March 1995 suggested back-toback meetings of the WEU and EU councils, thus attempting to coordinate— if not to merge—the two organisations. The Irish, Austrians and Finns— though markedly not the Swedes—have signalled that their ‘neutralism’ is not immutable, and that if a genuine and effective EU common foreign and defence policy emerged they would not exclude becoming parties to it. But, meantime, the sad fact remains: no single decision has been taken within the scope of the CFSP. Since the Treaty of Maastricht created the concept, hundreds of thousands of lives have been—probably avoidably— lost in former Yugoslavia and we remain no nearer to addressing more effectively similar or greater dangers in the future. Among the challenges currently facing the Union are sanctions facing Nigeria, the right response to revived Communism and nationalism in Russia, the recognition of Chechnya, policy towards Algeria, and Islamic fundamentalism across the Maghreb, and, of course, the future of Bosnia—and who knows what tomorrow may bring? In all these cases it is evident in advance that purely national decisions have no chance whatever of influencing events. It is equally clear that the combined and focused resources of the EU could be 63

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decisive. But it is far from clear that the EU will have the collective will or the mechanisms in place to exercise constructively the potential influence at its disposal. So the practical question is what can presently be done, short of the full superpower model, to achieve at least some of the advantages of a CFSP? Four suggestions—three of them already well rehearsed in recent intergovernmental discussions—are particularly worth pursuing: 1

2

3

There should be some common evaluation and planning machinery established within the EU to cover the foreign policy and defence fields. Precisely because the influence of the Union as a whole can be greater than that of the sum of its parts it is important that the Council should have available to it an evaluation of global EU interests and means of response. The proliferation of bureaucracies is inherently undesirable. Moreover, it is essential that the Union’s trade and aid policies—the responsibility of the Commission—which have enormous foreign policy significance, should be fully coordinated with the CFSP. This new responsibility should therefore be given to the Commission. (There are two possible doctrinaire objections to this: first, that such an arrangement would breach the intergovernmental character of Pillar II and, secondly, that it would be undemocratic since Commissioners are unelected. But neither objection stands up to scrutiny. The Commission need not be given the power of initiative in the CFSP area: it would simply service the Council, and any other administrative unit charged with this function would also be run by officials appointed by the Council who were thus at three removes from the electorate—exactly the position of the Commission.) A French suggestion that there should be a political figure (‘Monsieur PESC’ or ‘Mr CFSP’) charged with presenting and carrying out agreed policies is a conscious imitation of the American presidential representative. It would be counter-productive to create a third public face of the Union, rivalling both the current presidency and the President of the Commission. Such a formula would be a recipe for confusion, conflict and diffusion of influence. Moreover, it would be important that any such figure should have been selected deliberately by the Council, or by a summit, for the task. A Vice-President of the Commission should therefore be personally designated for this role. A new suggestion would be to reinforce this machinery, to ensure the greatest possible degree of coordination with domestic foreign ministries and, to emphasise the essential element of intergovernmentalism in the structure, a third innovation should be introduced. The ‘political directors’—the ambassadors who represent individual member states at the Union level—should be charged with forming a permanent Committee of Permanent Representatives on 64

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4

Foreign and Security Affairs. This would be the equivalent of the current COREPER in Pillar I, and would ensure that member states could monitor and influence the detailed formulation and implementation of policy on a continuing basis between Council meetings. The success or failure of the CFSP ultimately depends, however, on the ability of the Union to take timely and effective joint decisions. The present requirement for unanimity in deciding whether or not an issue is a suitable subject for common action, and therefore for subsequent treatment under Qualified Majority Voting (QMV), is a virtual guarantee of permanent paralysis—just as the equivalent ‘liberum veto’ enjoyed by any member of the old Polish Sejm was the cause of that unhappy land’s inability to respond to external challenges, and of the whole country’s eventual disappearance in the eighteenth century. The EU found itself disbarred from taking any effective action in former Yugoslavia for many months as a result of a Greek veto. The system must be changed before we pay an even higher price for its continuance.

The great majority of our partners are now persuaded of the merits of utilising QMV on a regular basis in CFSP deliberations. Not so the UK. Is there a way of reconciling these two conflicting positions? The British concern, very understandably, is not to be forced into taking part in any action, diplomatic or otherwise, of which we do not ourselves approve. The principle that every member state must retain the right to veto its own forces’ participation in any military operation is accepted by all our partners. But vetoing others’ actions is surely a different matter. Could not the principle be established, at least by the foreseeable future, that the Union’s actions should be decided by QMV but that on overriding national interest grounds a member state may opt out of itself participating in any agreed initiative? That, at least, would be a great improvement on the present situation, and a viable basis for agreement at the IGC. And it must be emphasised that such a proposal would in no way be inconsistent with the government’s present opposition to the extension of QMV to new areas of the Union’s activities or competence. Some degree of utilisation of QMV in Pillar II has been envisaged and provided for from the outset.

JUSTICE AND HOME AFFAIRS International crime respects no frontiers. It is quite clear that this is an area in which the very real threats posed to the citizens of Europe by terrorism and other forms of organised crime must be met by a common and coordinated police response. Information should be shared, there should be provision for joint police operations, no haven should given in 65

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one member state to persons wanted for offences in another, and the principle of hot pursuit should be established so that fugitives from justice do not gain an advantage by making for the nearest frontier. The latter should be a particular objective of the United Kingdom. Were hot pursuit available, the task of the RUC and the other security forces in combating terrorism in Northern Ireland would be enormously facilitated. But there is an important issue within this policy area—or ‘pillar’— which does cause difficulty for the British government. The Maastricht Treaty commits its signatories to create ‘an area without internal frontiers in which the free movement of goods, persons, services, and capital is ensured’ (Article 7(a)). Some member states have already implemented the free-movement-of-persons principle by the Schengen Agreement, and abolished frontier controls between themselves. The British government decided not to do this, and secured a general declaration at the Maastricht Conference to the effect that ‘nothing in these provisions shall affect the right of member states to take such measures as they consider necessary for the purpose of controlling immigration from third countries’. The interpretation of that declaration in relation to the Treaty is controversial and likely to become the subject of a judgement of the European Court of Justice (ECJ). It will be necessary for the British government to be seen to be acting in good faith, and not blocking freedom of movement beyond the extent, if any, really required to control immigration from third countries, if such a case is to be won. No civilised or sensible person would advocate the maintenance of frontier controls for their own sake. It was the Labour Foreign Secretary in the 1945 government, Ernest Bevin, who said that he looked forward to the day when it would be possible go to Victoria Station, buy a ticket and travel anywhere in Europe without a passport. Before 1914 that right extended across Europe as far as the borders of the Russian Empire. In establishing freedom of movement perhaps early in the 21st century, we would be doing no more than retrieving a right which our ancestors took for granted as an intrinsic aspect of European civilisation in the 19th. On the other hand, there would be near-universal agreement that it would be quite unthinkable to abandon controls on immigration from third countries. Most people would be willing to give up their own ‘freedom of movement’ if that was a necessary price to pay for effective immigration controls. But is it? It is often argued that the cursory glance which EU passports currently receive at immigration controls in EU countries is little more than a waste of time: it is not difficult to produce a ‘passport’ with a passing resemblance to an EU passport—all that those checks require. Nor is it possible, given the volume of travellers, to subject everyone to the more searching examination given to visitors from outside the Union. Really effective immigration controls would therefore need to be enforced internally through employers, through social security offices, or by 66

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instituting a universal identity card system. At all events there must be thorough identity and visa verification at the external EU frontier. If this is ineffective, arguably the present system of subsidiary and very cursory checks at internal frontiers is also useless. If, however, the Union’s external controls were made really effective then clearly great economies of scale could be achieved by abolishing the current secondary internal controls, and in addition, genuine freedom of movement could be enjoyed by all EU citizens without any price being paid in terms of illegal immigration. Is the common external frontier at present sufficiently monitored and effectively controlled? There is little doubt that it is not. Because of weaknesses in others’ current frontier controls and immigration enforcement, France has to date refused to implement its own Schengen commitments. In present circumstances there can be no question of the UK relaxing its own individual controls (though we may well delude ourselves on their effectiveness). We should therefore adopt in any suit before the ECJ the practical argument that we are entirely favourable to free movement in principle, but cannot be expected to implement it until we are satisfied by the quality of controls on the Union’s external frontier. Of course, some would wish to argue that the issue ought not to be one of pragmatism but of principle, and that we should never depend on any foreign official to determine who may be in a position subsequently to enter the UK. But, sadly or otherwise, it is not easily open to us to adopt such a position, for we have accepted just such a reliance for over 70 years. Ever since 1922 we have relied on the judgement of Irish officials as to who should be allowed to enter our own zone of freedom of movement (which could accurately be described as the Anglo-Irish Schengen). Despite the recurrent problem of terrorism—which arguably would have made this frontier the most obvious one to control—we have never over that period established passport or immigration controls between the UK and the Irish Republic. Anyone allowed to enter the Republic can thereafter without hindrance travel to any part of the UK. There is a further—ultimate—irony here. If the Irish Republic itself decided to accede to Schengen, or to implement the freedom of movement clauses in the Treaty by abolishing its own frontier controls with other member states of the Union, we should face an invidious choice—either to institute for the first time passport controls between the UK and the Irish Republic, or to accept our incorporation de facto into a wider area of freedom of movement in the EU, but at a time of the Irish government’s, and not of our, choosing.

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ECONOMIC AND MONETARY UNION Money should be the servant of mankind and never its master. Monetary arrangements should be determined by the extent to which they contribute to the welfare of the people, and not advanced—or rejected—for their own sake or on the grounds of sentiment, dogma or political enthusiasm. Does the EMU project pass or fail the test? No such step could possibly be contemplated without the greatest possible measure of prior thought and careful preparation. And a detailed balance sheet of advantages, costs and risks would have to be drawn up. So far the debate has had too much of the character of a ‘dialogue of the deaf. Each side has advanced its own case. Neither has been sufficiently willing to examine and to address the arguments of the other. The following paragraphs attempt to do just that. The prospective attractions of a single currency are momentous. We would willingly have paid a high price indeed for shelter from the currency crises which have beset us intermittently, and very destructively, over the past 30 years, when we were experiencing them— though memories are short. No trading nation can for long disinterest itself in the value of its currency in relation to those of its major trading partners, and crises are inevitable from time to time under a regime of fragmented currencies. On the other hand, it can be argued that the Euro would still fluctuate against the US dollar and the yen. But our exposure to such fluctuations would be greatly reduced, partly because from the outset a much reduced proportion of our trade would be exposed to them (less than half), and partly because a large part of EU trade with third countries would most probably over time come to be denominated in the Euro itself. Among the further important advantages of the EMU would be the removal of the foreign exchange and other transactional costs when doing business within the Single Market. The European Commission has estimated these at 0.4% of GDP. Those opposed in principle to monetary union have tended to argue that this figure indicates that the burden is not significant. Nevertheless it amounts to a trade tax of £3 billion per annum at the present time. That burden will not be without economic consequences, and falls disproportionately on exporters rather than importers (the buyer usually specifies the currency) and on smaller businesses (who cannot negotiate such good terms with their banks, and who will often lose 2–3% on converting currency, and in addition face charges for clearing foreign currency cheques and drafts, and delays in being credited with payments). Even more significant for such businesses are the risks of dealing in other currencies. Taken together, these two factors certainly deter some small firms from seeking business elsewhere in the Single Market, or cause them to lose business by increasing their 68

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prices to take account of these costs. In those circumstances, trade, output and employment are all lost, and wealth is forgone. Another great attraction of monetary union would be that travellers within the single currency area would no longer face foreign exchange costs, which typically amount to 10% of foreign exchange purchased at retail outlets—a large slice of a family holiday budget. However, all these benefits, substantial though they are, are almost eclipsed by the stability and cost-of-capital attractions of a single currency. Despite the Medium Term Financial Strategy of the 1980s, and the inflation targets of the 1990s, despite recession, and despite the ERM, we have failed to achieve either the level of inflation or the low inflationary expectations enjoyed by the Germans, French and Dutch. And international financial markets remain very fearful of our tendency to devalue. As a result, our interest rates have to include a premium against inflationary and devaluationary risk—or, in other words, real interest rates have to be higher here. This has an immediate and direct cost to the taxpayer which is relatively easy to quantify. Gilt-edged stocks (British government bonds) have consistently yielded 1.5 to 2 percentage points above equivalent German government bonds over the three and a half years since the UK left the ERM. Our public debt is of the order of £350 billion. The cost to the taxpayer of the risk premium demanded by the markets is therefore of the order of £5–7 billion per annum (or 3–4p on the standard rate of income tax). Much greater still, though obviously less easy to estimate precisely, would be the gain to the economy as a whole of acceding to monetary union. The higher the cost of capital to business the less the investment undertaken and the lower the rate of economic growth—and the resulting wealth gap will of course compound over time. If joining the Euro area brought us a German degree of stability and a German cost of capital to add to our existing economic strengths that would be a historic prize indeed. However, before we endorse the case for the monetary union without further ado, the serious arguments that have been raised against the idea must be addressed. A number of main objections to the project have been deployed: 1

It is said that the concept would be a denial of national or parliamentary sovereignty. That argument has often been refuted. We are not today nationally sovereign in our monetary policy—nor can we be in a world of no exchange controls and free capital movements. A decision by the American or German authorities to adjust significantly their interest rates will have an immediate impact on the sterling parity and/or on interest rates. So powerful would be the likely influence of the Euro that if sterling remained outside the project it 69

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might without exaggeration be said that the German or French (or even Luxembourg) central bank governors who determined monetary policy in the European Central Bank would have more influence in the determination of British monetary policy than our own Chancellor or Governor. That would be a particularly absurd position for us to arrive at ostensibly in pursuit of a policy of national sovereignty. This is clearly a case where sovereignty is to be pooled, not sacrificed—and where the leverage on events we would acquire would be greater than we could hope to enjoy on the basis of purely national policies. There is a further source of perceived threats to national sovereignty in the EMU project. The fear is often expressed that monetary union would constrain the fiscal (taxing, public spending and borrowing) policies of its member states, and that this would necessarily lead to fiscal uniformity and to a ‘federal’ state. The first of these assertions is one third true—but the rest are not true at all. A zone of monetary union, if it is to remain stable, must indeed imply some mechanism for ensuring a measure of discipline in the matter of public debt. The reason for this is simple. When the same authority—the national government—is responsible for both fiscal and monetary policy then, if that authority borrows more money that its taxpayers are subsequently willing to repay, it can ‘monetise’ its outstanding debt—in other words reduce its real value through inflation. It is no secret that, whether by accident or by design, that was precisely the process whereby the real burden of the public debt accumulated by the UK in the 1970s was considerably reduced (in other times and places the technique has of course been practised with even greater ruthlessness—and with more drastic effects on investor confidence and social stability). Once governments lose their ability to monetise their own debt, however, their only possible reaction to loss of investor confidence and insolvency is default. And default by a government will generate a crisis in the whole financial and economic system, and especially in the other parts of the system sharing the same currency, as banks, insurance companies, pension funds, businesses and individuals who hold that debt find themselves having to write off a significant portion of their assets. By definition all parts of the system thus impacted suffer—however responsible and sound the fiscal policies of their own governments may have been. It might be, therefore, that in such circumstances the offending government could blackmail its partners into coming to its rescue—at the expense of those partners’ taxpayers. If that happened the prodigal would be rewarded at the expense of the virtuous—and an incentive for fiscal irresponsibility would be created that was of awesome proportions. For this reason, every monetary union must have effective measures in place to prevent excessive government borrowing. The pre-1914 70

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Gold Standard addressed this problem very effectively through the mechanism of gold convertibility—anyone accumulating claims on a government could convert them readily into gold. The excess deficits procedure of the Maastricht Treaty, with its provision for interest-free deposit, replicates the essence of that discipline for EMU. But EMU implies no restriction whatever on what member state governments can spend—provided only that they raise the required current revenue to finance it (or borrow within the limits of the rules). Some may welcome such a discipline both as a valuable reinforcement of democratic accountability and as an economic gain for Europe as a whole. Others may see it is a cost of monetary union. But, in either event, it would not constrain governments or parliaments in their essential decisions either on the levels, or on the distribution, of taxation and spending. Nor is it easy to see it as a threat to national sovereignty. Whatever may be said of the Europe of 1914, in which government borrowing was so effectively constrained, insufficient national sovereignty was not one of its more obvious shortcomings. Among the economic objections to EMU the most obvious one is that we should not give up the weapon of devaluation. Devaluation as a means of accommodating (and therefore nurturing) permanent high inflation or permanent productivity failure in an economy (very much the model of the British economy in the 1960s and 1970s—and in a more extreme form of many Latin American countries for much of this century) is not a policy formula which should appeal to any Conservative. But there are two other arguments which deserve to be examined at slightly greater length, and which are somewhat more sophisticated variations of the same theme. Those sceptical of monetary union often claim that while secular or repetitive devaluation may be very damaging, occasional devaluations or revaluations may be necessary to compensate for unexpected events which alter the demand for, or the supply of, a country’s exports in a different direction from those of other areas in the single currency zone (in the technical jargon, ‘asymmetric shocks’). The argument is theoretically sustainable. But does it do more than describe a theoretical special case?

It is not in fact easy to envisage a genuine shock from outside whose impact would be very asymmetric between the likely initial members of currency union—say, in the first instance, France, Germany, Austria, Benelux (the ‘hard core’), and perhaps ourselves and Denmark. The asymmetric influences on countries’ economies have in practice proved to be divergences between government economic policies—sometimes the result of different economic philosophies, these days in Europe more often simply the reflection of different electoral cycles. The asymmetric effects 71

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of the two shocks of recent European history were both very substantially the result of policy decisions. That was the case with the 1973 oil crisis and with German reunification. All West European countries except Norway were more or less equally affected by the oil crisis—even in the UK oil never accounted for more than 4% of GDP. What were starkly different were the policy responses of governments. Britain and France loosened fiscal and monetary policy to accommodate higher oil prices, thus inducing inflation and fiscal crises (deeper and more prolonged in Britain than in France), while Germany and Switzerland held monetary and fiscal policies steady. Under EMU, of course, monetary policy would by definition be common, and fiscal policy would therefore have arisen. The asymmetric shock of German reunification was actually made possible by the absence of monetary union—had monetary union then applied, the German government would have had to finance reunification largely through tax increases from the start, a response which everyone would now agree in retrospect would have been the correct one, and which would have avoided the substantial rise in interest rates, and pressure on others’ parities, which occurred. The experience of these cases actually reinforces the case for EMU rather than otherwise. Even if for the sake of argument we take the theoretical case of shocks which are not policy-induced, and are the product of uncontrollable events in the world or, for example, natural disasters at home, such events are probably more likely to be asymmetric between regions within member states (where devaluation would not be a possible response anyway since regions do not have their own currencies, and European currency union would therefore be irrelevant). Moreover, given that there is considerably less economic specialisation between member states of the EU, and especially between the ‘hard core’ member states, than exists between the states of the USA (in other words, the economies of individual EU member states are more diversified), any international shock would in principle be less likely to impact asymmetrically on the participants in a European monetary union than on the USA. Since the latter has enjoyed a very successful monetary union for a long time, the chances of such an asymmetric shock threatening monetary union in Europe may therefore reasonably be regarded, on historical experience, as not being very high. The argument is often made that in the USA there is greater scope for fiscal adjustment in such circumstances. But that argument is not as valid as is generally assumed. Comparisons between EU and US fiscal transfers at the union level are set out in Section 6 below. They do not support the assertion. Furthermore, since almost all Americans states have balancedbudget laws, whereas the Maastricht rules provide for some fiscal flexibility for individual EU member states, there is actually greater fiscal adjustment potential at the member state level in Europe. 72

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Let us, however, at least for the sake of theoretical completeness, assume that the classic asymmetric shock beloved of opponents of monetary union did arise. For devaluation to be the appropriate response two additional conditions would need to be satisfied. First, demand for the exports of the country concerned would have to be sufficiently sensitive to price changes (in technical terms their price elasticity of demand would have to be high). Otherwise, real price adjustment through devaluation would prove futile in increasing demand for its exports and inflation would simply be added to the country’s woes without any compensating increases in output or in employment. But the evidence is that in sophisticated economies the demand for their exports is not highly price-sensitive. If it were, Germany and France (and Japan) would surely now be in substantial deficit and not in surplus on their trade accounts following those countries’ massive revaluations in recent years. And the UK would perhaps be in substantial surplus and not still in deficit following our devaluation. Secondly, even in the limited case where demand for a country’s exports is sufficiently sensitive to real price changes, devaluation will only bring such a change about if those setting prices domestically, including very importantly wage rates, do not attempt to compensate themselves for the fact of devaluation by increasing domestic prices. Modern experience—as much as modern rational expectations theory—indicates that such passivity is unlikely to occur, except perhaps temporarily in a recession. Domestic firms do increase their prices if the local price of competing imports rises. And wage bargainers are not easily, or for long, taken in by the illusion that ‘the pound in your pocket has not been devalued’, and real wages— not ‘nominal’ or cash wages as in the original Keynesian theory— generally prove be too ‘sticky’ over the longer term. In such circumstances devaluation is certainly worse than useless—no new employment is generated and the economy, investment and future job prospects are instead simply undermined by inflation. Finally, the ‘devaluation in response to asymmetric shocks’ argument assumes—mistakenly—that foreign exchange markets are always rational and that their response to a shock is necessarily proportionate to its impact. Experience shows the reverse. Anyone familiar with the foreign exchange markets—or with other financial markets—knows that they always overswing or over-react. A recent British example well illustrates the point. In the UK under floating rates the foreign exchange markets reacted to the doubling of the dollar price of oil in 1979, and to the accompanying though perhaps coincidental change in fiscal and monetary policy introduced by the Thatcher government, by lifting the sterling parity by 30% in 2 years. By 1985 the sterling parity had returned to its 1979 level though a swathe of UK manufacturing capacity had meantime been wiped out—unable to compete or to adapt in the face of such a precipitous rise in 73

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the exchange rate. By the time the exchange rate fell back to its 1979 level of course it was too late. Currency union would surely have been a better option! To sum up, whatever may be the position in developing countries, devaluation between the prospective members of the European Monetary Union who have achieved the level of convergence required by the Maastricht criteria is likely to make sense only in a doubly special version of a rather unlikely event, and even then would probably only do more good than harm on some fairly heroic assumptions about the rationality of the foreign exchange markets. If there are strong reasons, on stability, trade or other grounds for sacrificing the devaluation weapon the asymmetric shock argument is not likely to weigh very heavily against them. A further and very influential version of the ‘need for devaluation’ argument is that the high levels of unemployment presently suffered by all countries of the EU (varying from 7% to 24% of the workforce) make currency union impracticable. The implication is that these levels of unemployment are a result of overvalued exchange rates, or that, more generally, they are a reflection of insufficient demand which can only be cured by a degree of monetary or fiscal expansion that would be inconsistent with monetary union. In fact the evidence points entirely in the opposite direction. All the countries likely to form the first echelon of monetary union (the ‘hard core’ listed above) have recently been enjoying growth rates of around 2% per annum, and all have their current accounts in balance or in slight surplus. Those facts are not consistent either, respectively, with demand sufficiently or with an over-valued exchange rate. Moreover, Spain, the country which has undergone the greatest measure of devaluation since 1992, currently suffers by far the highest unemployment level (24%). The Continental countries whose parities have appreciated most have among the lowest unemployment rates (Germany 8.5%, Netherlands 7%). The sad truth is that the high core level of unemployment, which ought indeed to be a matter of very considerable political concern, is largely policy-induced. It is the direct result of political action. It is also essentially a supply-side problem. Social insurance premia have created a growing gap between the cost to employers of taking on workers, and the return to the workforce for their labour. Still more significantly, welfare payments and other benefits to those out of work (in this country in the form of Income Support, housing benefit or mortgage interest, Council Tax relief, free prescriptions and school meals, help with VAT on domestic fuel etc.) are at such a level in relation to the net return available from unskilled or semi-skilled jobs as to offer a less than sufficient inducement to many people to return to work. Such policies—generous and wellintentioned as the motives which prompted them undoubtedly are—could 74

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never have been reasonably expected to do otherwise than increase the core level of unemployment. Some countries (Spain and France are the most obvious) have excessively regulated labour markets, and high minimum wages—measures again surely guaranteed to reduce the demand for labour and to increase core unemployment. Britain and Portugal at the other end of the scale of regulation have much lower unemployment rates (8.5% and 7% respectively). There are, of course, other major deficiencies on the supply-side of the labour market throughout Europe—skill mismatches, and the rigidities existing in both the public and the owneroccupied sectors of the housing market among them. One thing, however, is quite certain. It would be not merely illogical but deeply damaging to treat supply-side problems of this kind with a dose of devaluation or demand reflation. The result would be higher inflation, current accounts deficits and economic crisis, for no increase in employment, and over the longer term a considerable sacrifice in the number of jobs available, as investment confidence and growth rates declined. It is sometimes alleged that in the absence of devaluation there will be great pressure from lower income and lower productivity countries for transfers from the more prosperous areas, and that those could only be at the expense of taxpayers in the latter (the ‘fiscal transfers’ argument). This argument is based on a double ignorance of the facts. First, productivity and per capita incomes are remarkably close in the prospective ‘hard core’ of countries likely to accede in the first instance to monetary union and net fiscal transfers between them are minimal. It is true that there are at the present time (and in the absence of monetary union) very significant transfers under the Structural and Cohesion funds from these countries to the Mediterranean members of the Union and the Republic of Ireland, which in the case of three of the cohesion countries will meet the convergence criteria in the Maastricht Treaty and accede to monetary union this century. If and when they do so their economies would no doubt in any event be less reliant on such transfers—though in fact a mechanism providing for them is already in place! In short, monetary union on the Treaty’s terms and timetable both in respect of the ‘hard core’ and of the rest of the EU need in this field change nothing. There is a rather delicious irony in the ‘fiscal transfers’ argument, which does not always appear to have been appreciated by those who advance it. After all, the only way in which the UK could suffer under it by joining monetary union in the first wave would be if our economy turned out to be so successful and so prosperous by the standards of Germany, France and Benelux, that we found ourselves under pressure to subsidise the latter. Since these countries have a GDP per capita 30–50% higher than our own, the premise to the argument if it were realised would surely be an even greater source of satisfaction than the very uncertain threat of net transfer outflows would be cause of anxiety. In any event, one 75

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thing must surely be quite clear. No one can simultaneously argue that the British economy will be so weak in relation to a Euro area that it will be unable to forgo devaluation, and that it will be so strong that it will be the natural source of fiscal transfers to other members. It is frequently claimed that monetary union is impractical since the British financial system is very different from that prevailing on the Continent, particularly in the very large proportion of households who have floating-rate mortgages, and of small businesses that depend on floating-rate overdrafts, whereas in the ‘hard core’ countries on the Continent most mortgages and business loans are advanced for long periods at a fixed rate. The description is accurate, and the contrast correct. But this phenomenon is itself merely another manifestation of the relative lack of monetary credibility we have been able to achieve in the UK. Depositors and other savers will not easily take the risk of placing their money at a fixed rate for extended periods for fear of inflation reviving in the future. The cure for such lack of monetary credibility is of course monetary union itself. In that circumstance, exactly the same financial products would be available here as on the Continent, and both households and businesses would be able to enjoy the security of readily and relatively cheaply funding their debt at long-term fixed rates of interest. The ‘different financial structures’ argument takes as a reason for rejecting monetary union what is in fact one of its salient advantages. Monetary union, especially on the Maastricht terms, is an idea which ought to appeal instinctively to all Conservatives. It combines the insights of monetarist and rational expectations economics with the traditional Conservative recognition of original sin—and the need to construct solid institutions to guard against it. Which Conservative does not believe in eliminating as far as humanly possible all barriers and frictional costs to trade? And which Conservative would not consider it a historic achievement to find an effective way of removing from governments the temptation to manipulate the money supply for political purposes or to borrow excessive amounts of money? Europe lived very successfully under such disciplines during the half century before 1914, on the Gold Standard. That was a period of exemplary stability, and, largely in consequence, of unprecedented growth in international trade, international investment and prosperity. A simple return to the Gold Standard is an impractical absurdity, but EMU replicates, on a still sounder basis, its most essential attractions. Of course, the creation of monetary union is far from certain. Economic recession or political crisis may yet delay it, or abort it altogether. Nor is it certain— though it seems increasingly likely—that the Maastricht criteria can be protected from dilution. The Prime Minister, John Major, was quite right in these circumstances to negotiate an option for Britain. Given that option there is no need to take a decision now. Indeed it would be crazy to do so. 76

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But it is surprising that there should be those in the Conservative Party who believe that the UK should remain outside a zone of monetary stability in Europe, even if one were to be effectively created on the soundest financial principles. Moreover, in the latter event the costs to us of rejecting monetary union would no longer be theoretical opportunity cost, but a practical competitive handicap to our economy. Some of the resultant difficulties can be anticipated unambiguously in advance. Our traders, for instance, would be at a disadvantage in the Single Market: they would be dealing in a foreign currency with all the costs and risks that that would entail, whereas their competitors would be dealing in their own currency. It is difficult to see how we could avoid some deflection of investment, since industrial capacity designed to address the single currency area would naturally tend to be located within that area to avoid foreign exchange uncertainty and transactional costs (theoretically, other factors might outweigh those—higher investment subsidies for example, or lower wages—but such compensation would be a considerable cost to our people). Of course, if there were any fears in the minds of investors— British or overseas—that our declining to join monetary union might presage some future decoupling of Britain from full membership of the Single Market (though there is no constitutional or legal basis for this to take place) that displacement of investments could readily reach very alarming proportions. Worst of all, there would be great difficulties in managing sterling. The Euro, together with the dollar and the yen, would be one of the world’s reserve currencies—and even more of the world’s trade might come to be denominated in it than in the other two since the EU is already responsible for the largest individual share of the world trade. International investors would no doubt readily hold their assets in all those three currencies. But they would require a special reason or inducement to hold them in other denominations—in short, a higher yield. In the case of sterling, with our reputation for devaluations (and especially if, untypically in the modern world, politicians rather than the central bank remain responsible for monetary policy) that yield premium might have to be high. In other words, real interest rates would always need to be significantly higher here than on the Continent, the cost of capital to British business and industry would be greater, and investment and our growth potential correspondingly less, and that at least is surely a price that no responsible government could placidly contemplate for very long.

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THE WAY FORWARD British policy towards the European Union has long been veined with contradictions. We aspire, in John Major’s phrase, to be ‘at the heart of Europe’, and yet we regularly find ourselves in a minority of one in its deliberations. We are inclined to complain vociferously about the Union’s lack of effectiveness in foreign policy and other fields, but we instinctively reject any proposals that are made to strengthen it. When asked what we consider the main priority we unhesitatingly respond ‘enlargement’. But we are unwilling to face up either to its likely constitutional implications, including the need to develop a more cohesive voting and decision-making system (is the whole Union to be vetoed by Latvia, or Malta?) or to its budgetary consequences. Nor is it adequate to say that enlargement can be financed simply by CAP or Structural Fund reform—that would mean the price would be paid almost entirely by the cohesion states, and by other Mediterranean countries including France, who are themselves much less politically committed to enlargement than are Germany and the UK, and thus much less inclined to pay any price at all. The same lack of coherence appears in our approach to constitutional issues. It is a standard cliché of British political debate to denounce the Commission as undemocratic and unelected. But we have strenuously resisted suggestions that the Commission should be elected, or even that its members’ nominations be individually confirmed by the European Parliament. Perhaps we mean that the Commission, or the President of the Commission, should be directly elected by universal suffrage? Such a suggestion would cause apoplexy in certain circles in London. We routinely say that we aspire to give national parliaments a greater role in decision-making. But we have made no proposals to this effect, and the European Standing Committee of our own House of Commons is so constitutionally emasculated that its resolutions quite simply have no effect at all— they do not even trigger a debate and vote on the floor of the House, let alone alter the line which ministers take on behalf of the UK in the Council of Ministers. All these contradictions, and others like them, will need to be resolved, imperatively over the medium term and ideally sooner if we wish our contribution to the determination of the Union’s future policies, in the IGC and in other fora, to carry the weight which our country’s importance deserves. For we must have the clarity to define our interests before we can hope effectively to defend or to promote them. Otherwise any such efforts are likely to be ineffectual, or even perverse. And no Conservative could be content with that. This task will require a great deal of new 78

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thinking, of courageous challenges to cherished and comforting prejudices, of traumatic adjustment to new but unalterable facts. And it will also require the application of two venerable Conservative virtues: determined devotion to our people’s interests, and pragmatism and therefore an open mind in their pursuit.

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7 SOME THOUGHTS ON THE MONETARY FRAMEWORK IN EMU Age F.P. Bakker and Guido F.T. Wolswijk Dr Bakker is Deputy Director of the Nederlandsche Bank and Professor of Monetary and Banking Issues at the Vrije Universiteit of Amsterdam. Dr Wolswijk is Economist at the Monetary and Economic Policy Department of the Nederlandsche Bank.

1 INTRODUCTION One of the main tasks of the European Monetary Institute (EMI), in which all EU national central banks cooperate, is to make all the necessary preparations which are required for the conduct of the single monetary policy in the monetary union. At the end of 1996, the EMI has completed the specification of the monetary framework of the European System of Central Banks (ESCB). It reported on the outcomes in the report ‘The Single Monetary Policy in Stage Three: Specification of the Operational Framework’, published in January 1997. The monetary strategy and the instruments that will be at the disposal of the system are presently being prepared in detail within the working parties of the EMI. Although the formal competence to decide eventually on this framework rests with the ECB Council, which will be established in mid-1998, the contours of major aspects of the framework are already emerging. This monetary framework consists of three elements: the primary objective, the strategy and the monetary instruments and procedures to be employed. With regard to the primary objective there can be no dispute: the Statute of the European Central Bank clearly defines price stability as the ultimate goal. As for the monetary strategy, the discussion in the EMI has resulted in a reduction of the number of options to two. The final element, the body of the framework, monetary instruments and procedures, is now very much on the agenda. In the following, the strategy of the European Central Bank and the monetary instruments and procedures will be discussed. 80

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2 CHANGES IN THE ENVIRONMENT However, it is necessary first to look at the external environment in which the ECB is likely to operate because this partly determines what is appropriate in terms of strategy and instruments. The environment in which the future ECB will operate will be quite different from the current one. The situation at present is that most member states of the European Union tie their currency to the Deutschmark, albeit to differing degrees. The future environment will differ markedly from this. The external exchange rate constraint, then, vis-à-vis third currencies, will no longer apply, in contrast to the situation now for many countries. It is extremely unlikely that international monetary arrangements involving exchange rate constraints will develop in the coming years. The switchover to monetary union will therefore imply that the European currency will float, just as the combined European currencies, tied to the Deutschmark in the European Monetary System, are floating at present. On the other hand, a policy of complete ‘benign neglect’ of the exchange rate is unlikely. Particularly in the case of a major weakening of the European currency vis-à-vis the US dollar or the Japanese yen, the ECB might consider taking appropiate action, especially if exchange rate developments were to jeopardise the attainment of the primary objective, price stability. It is likely that the Euro will become a hard currency. What this implies is not always understood correctly, and gives rise to confusion. Having a hard currency will not be the goal of the monetary policy of the ECB, but an outcome. The goal will be to maintain price stability, that is, to safeguard the internal value of the euro. The external value then is a result of this policy, based on the judgements of financial markets. Another element of the future environment of the ESCB relates to the exchange rate relationships with the so-called derogation countries, i.e. members of the European Union which do not yet participate in the single currency area. Here an exchange rate mechanism will be established, called ERM II. Similar to the present ERM, the new mechanism will be based on two parallel agreements, one between governments and one between central banks. Central rates will be defined vis-à-vis the Euro, with relatively wide fluctuation bands. The ECB will have the possibility of suspending intervention and financing if the primary objective of price stability were seriously affected. 1 There may be large differences with respect to the state of convergence among the group of derogation countries and thus with respect to the time horizon in which they can be expected to join the single currency area. In view of these uncertainties with regard to the external environment of the ECB, the monetary framework to be developed should contain sufficient flexibility to be adapted to changing external circumstances. Exchange arrangements, be they with the currencies of derogation countries or with 81

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non-EU reserve currencies, should not be allowed to disturb monetary conditions within the single currency area, since the credibility of the European currency has to be built up.

3 CHOICE OF STRATEGY As regards the strategy of the ECB, although there is some relation between the choice of strategy and the selection of instruments, it appears to be a weak one only, so that they may be discussed separately. Regarding the choice of strategy, a distinction can be made between direct targeting of price stability, and an indirect approach, by which an intermediate target is adopted. 2 Most European countries nowadays follow an indirect approach, with either a monetary aggregate or the exchange rate as their target, or both, as is the case of France. As far as the strategy of the ECB is concerned, the choice is between a direct inflation approach and an indirect one based on a monetary aggregate. Other candidate targets, such as the exchange rate, have been discarded. For small, open economies, an exchange rate target may be an obvious choice to safeguard price stability, but for a large, relatively closed economy such as the European, this makes less sense. With respect to direct inflation targeting, it is interesting to note that in countries that have adopted this approach, such as the United Kingdom, Sweden and Finland, the outcomes so far appear encouraging. However, it should be kept in mind that this approach is a relatively new one, and the track record is not very long. The real test has yet to come when capacity utilisation rates reach or exceed their normal levels, and inflation pressures start to build up. By then, a number of possible limitations may have come to the surface, such as the long and variable timelags between monetary policy actions and changes in the rate of inflation. 3 Because of these factors, the effects of interest rate changes on inflation are difficult to predict. Furthermore, the rate of inflation not only depends on the actions of the European Central Bank, but also on factors beyond its immediate control, such as wage agreements and budgetary policy. The importance attached to this latter factor is reflected in the incorporation of the excessive-deficit procedure in the Maastricht Treaty, and the Stability and Growth Pact which was agreed upon by the European Council in December 1996. In practice, stability-oriented policies of the ECB may be thwarted by developments beyond its control. The creditworthiness of the ECB hiight be undermined if, under a direct inflation target, it were to be held accountable for deviations from the target value because of non-monetary factors. Especially in the case of EMU where there is no supra-national budgetary authority at the European level, the ECB may be in a particularly vulnerable position. 82

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Experiences with the indirect approach, with monetary authorities targeting money supply, have been favourable in Germany.4 Adopting the strategy of that country with its strong anti-inflation stance might lead to inheriting its credibility. Preferably, monetary targeting should be embedded in a medium-term approach, thereby avoiding the likelihood of small, short-term deviations from the desired growth of money supply evoking an overreaction by the monetary authorities. A precondition for employing the indirect approach is the stability of the demand for money. Evidence so far suggests that the European demand for money is relatively stable, but additional studies are needed to make more final judgements, also taking into account the fact that the future environment will differ from the present one. Though in theory the differences between the two approaches are evident, in practice, both approaches have many similarities, and the differences should therefore not be exaggerated. In conducting a money supply strategy, variables other than money supply are monitored, while in a direct inflation strategy the money supply is an important factor. Though in our view it appears that the indirect approach has some advantages over direct inflation targeting, elements of both approaches are useful, in particular at the start of monetary union. This initial phase may be characterised by structural shifts, a less stable money demand and larger-than-usual uncertainty. Monitoring more variables than just monetary growth, such as (expected) inflation, will then be very useful. In addition to monitoring information variables other than money supply, it might be considered necessary to temporarily increase the size of the band within which the growth of the money supply is allowed to fluctuate in the initial phase.

4 PRINCIPLES IN SELECTING MONETARY INSTRUMENTS A single monetary policy lies at the heart of the creation of the monetary union in Europe. This will be realised if the interest rate on central bank money is equal in all participating countries. To create a truly single monetary stance, a number of conditions have to be fulfilled. Apart from harmonised instruments and procedures, money markets in the participating countries have to be completely integrated. This occurs when commercial banks have and take the opportunity to eliminate interbank interest rate differentials through arbitrage. A necessary condition for this arbitrage is that national payment systems be integrated, allowing for transactions and same-day settlements between the former national markets. This will be the case as soon as the Europe-wide TARGET (Trans-European Automated Real-Time Gross Settlement Express Transfer) system starts its operations. It is foreseen that this system will start operating when the third stage commences, in 1999. 83

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For a proper functioning of monetary policy, it is deemed necessary that policy-induced changes in overnight rates be transferred to changes in the more broadly denned money market rates and the capital market. These rates, in turn, will have effects on the real economy. It is well known that the effects of changes in short-term interest rates on the economy vary from country to country, but the differences are not believed to be so large that they will hamper the execution of monetary policy. Furthermore, it can be expected that financial structures will gradually converge. Present differences in financial structures are partly the result of past experiences with inflation. After the introduction of monetary union, however, low inflation rates will prevail in the participating countries, thereby creating the conditions for a lessening of differences in financial structures and transmission mechanisms. A single monetary policy by definition involves centralised decisionmaking. This is the essence of a single monetary stance. It is a different question whether the execution of the single monetary policy should take place at a centralised level or at a decentralised level. The Maastricht Treaty stipulates that this should be decentralised ‘to the extent deemed possible and appropriate’. A major advantage of a decentralised execution of monetary policy is the experience the national central banks have with this, the use of existing financial infrastructures, and the knowledge they have of the national financial markets. As it turns out, the idea of a decentralised execution is generally subscribed to, though on some occasions, for instance when the speed of action so requires, centralised actions may be most appropriate. Most likely, this will only be the case in exceptional circumstances. For such cases, the ECB should have the operational capacity to conduct these operations if it deems such actions necessary. For a decentralised implementation of monetary policy actions to be feasible, certain conditions have to be met. An important condition is that the monetary instruments have to be harmonised to a large extent, so as to create a level playing field for commercial banks. If not, the idea of equal treatment of financial institutions, regardless of the country of origin, would be harmed, and cause undue delocation of financial activities. Furthermore, differences in facilities create noise in the operational framework, due to the fact that policy signals may not be as precise as they should be, thereby running up against the basic principle of a truly single monetary policy. Possibly an exception to the rule of harmonisation can be made for the collateral that is used in monetary policy actions, as this does not appear to conflict with the principles set out above.

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5 CHOICE OF INSTRUMENTS After this general discussion of instruments, the concrete monetary instruments that the ECB will have access to will now be discussed. 5 In choosing the appropriate monetary policy instruments, a number of general principles are of importance. Effectiveness is an important one, as the ECB must have close control over the interest rate it targets. Other principles imply that the instruments should comply with the principles of an open market economy, that financial institutions are treated equally across the single currency area, that instruments as far as possible are a continuation of instruments presently employed by national central banks, and that they are simple and transparent. Other issues at stake are the appropriate level of decentralisation, and the harmonisation of instruments. Finally, cost efficiency should be mentioned. The costs to the commercial banks of certain instruments, such as the costs of non-remunerated compulsory reserves, can be rather high. In view of the competitive position vis-à-vis the rest of the world, this is a point that should play a major role in the discussion on the operational framework, and that needs close monitoring. Though only the ECB can ultimately decide what instruments it will use, a broad consensus has emerged on a number of instruments the ECB will most likely be using in its monetary policy operations. Disregarding for this moment the compulsory reserves, these instruments are: •

•

•

a marginal refinancing facility, to provide end-of-day liquidity to banks. The interest rate on this standing facility represents an upper limit for money market rates, similar to the German Lombard facility; a deposit facility, i.e. a standing facility at which banks can deposit liquidity. Under this facility they receive a deposit rate, which acts as a floor to the money market rate; open market operations, with fixed maturities of 2 weeks and 3 months, and a weekly (respectively monthly) emission, through which short-term market rates are steered within the interest rate corridor, set by the Lombard rate and the deposit rate; this rate will set money market rates prevailing in the single currency area.

Also, a variety of structural and fine-tuning instruments could be used by the ECB, depending on the particular circumstances, such as foreign exchange swaps, issuance of short-term paper by the ESCB, and outright sales and purchases. A number of issues are still under discussion, such as the question of how frequent the ECB should be in the market. Present experiences in Europe differ to a large extent, with some central banks operating on a daily basis, and others perferring to give leeway to market forces within certain limits. The latter option has the advantage that it takes the interest rate out of the political arena. Furthermore, very active and frequent 85

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interventions conflict with the medium-term orientation of monetary policy, and may hamper a decentralised execution. Another choice still under discussion relates to compulsory reserves. This instrument can be used to create a liquidity shortage in the money market. Based on the present situation, the money market in the monetary union will probably be in a shortage position even without implementing cash reserves. It is therefore questionable whether this instrument must continually be used for this purpose. Another function of monetary reserves is related to the choice of monetary strategy. There might be a case for introducing cash reserves that are less than fully remunerated if the ECB were to decide on a strategy of monetary targeting, in line with present practice in Germany. Not fully remunerated reserves enhance control over money growth, by increasing the difference between the yields on monetary and non-monetary assets. This positive element has to be weighted against possible practical drawbacks of doing so. Levying a tax on banking, which is what imposing non-remunerated or not fully remunerated required reserves basically does, causes disinter-mediation and delocation of financial activity. Furthermore, whether a not fully remunerated compulsory reserve is necessary to increase control over the money growth remains to be seen, as it might be that the interest elasticity already is large enough without a non-remunerated reserve. It therefore remains to be seen whether less than fully remunerated cash reserves should be introduced. Further empirical research on the effects of such reserves should provide better guidance on this question. If cash reserves, either fully remunerated or not, were to be introduced, they would be endowed with an averaging facility, which can be used by banks to accommodate unexpected liquidity shocks and to smooth out fluctuations in overnight rates.

6 HARMONISATION OF INSTRUMENTS As pointed out above, certain instruments are very likely to be in the toolkit of the European Central Bank. Faced with the inevitability of making adjustments to the monetary framework, the question arises whether advantages can be obtained by harmonising monetary instruments before the start of the third stage. Indeed, some adjustments in the monetary framework of countries such as Austria and Finland were at least partially driven by the prospect of the monetary instruments and procedures the European Central Bank is likely to employ. In the Netherlands, it was decided to move to change monetary instruments as well, in the course of 1997. The averaging facility would be transferred from a credit facility to the cash reserves, and a marginal refinancing facility introduced. The objective of harmonising instruments before the start of the third stage is to gain experience with the 86

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new set of instruments and procedures, by both the national central banks and the commercial banks. A number of factors may limit the possibilities of achieving a major degree of harmonisation of instruments before the start of the single currency area. Some uncertainty on the precise contents of the instruments and procedures will prevail until the ECB makes its final choice in 1998. Also, the specific characteristics of the money markets as well as the exchange rate targets in many countries in the European Union pose certain limits on the possibility of copying the future instruments of the ECB. Nevertheless, there appears to be room for making further adjustments to the monetary framework, creating favourable conditions for a rapid introduction of European instruments and procedures. In view of the enormous changes in market behaviour which will be required anyway at the start of the third stage, especially because of the switchover from segmented national currency markets to integrated interbank and money markets denominated in Euros, anticipation of the necessary transformation of the monetary framework is useful in creating favourable conditions for a successful start of the monetary union. A certain measure of harmonisation now may mitigate the shock to financial institutions on 1 January 1999.

7 CONCLUSION Creating a monetary union in Europe is a major challenge for all parties involved. This not only refers to the national central banks, who are at present designing the monetary framework of the ECB in detail, but also to the counterparties, who will have to make changes to their operations as well. The EMI is on track with its preparations, as witnessed by the recent publication of the specification of the operational framework. The ECB therefore will have effective means to ensure that the desired monetary policy stance is implemented, with the ultimate aim of price stability. If it succeeds in that, which there is no reason to doubt, then the Euro will become a solid currency, and will be able to play an important role in the world economy as a reserve currency.

NOTES 1 2

More information on the new exchange rate mechanism is included in the EMI report ‘The Single Monetary Policy in Stage Three: Specification of the Operational Framework’, annex 9, January 1997. For more information on this subject, we refer to the EMI report, ‘The Single Monetary Policy in Stage Three—Elements of the Monetary Policy Strategy of the ESCB’, February 1997, to C. Goodhart (1994), ‘Strategy and Tactics of

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3 4 5

Monetary Policy: Examples from Europe and the Antipodes’, LSE Financial Markets Group Special Paper, No 61, and to O. Issing (1994), ‘Monetary Policy Strategy in the EMU’, in: J.A. H. de Beaufort Wijnholds et al., A Framework for Monetary Stability, Kluwer, pp. 1135–1148. See C. Goodhart (1989), ‘The Conduct of Monetary Policy’, Economic Journal, 99, pp. 293–346. See J. von Hagen (1994), ‘Inflation and Monetary Targeting in Germany’, in: L. Svensson and L. Leiderman, Inflation Targets, CEPR, pp. 107–121. For more details, we refer to the EMI report ‘The Single Monetary Policy in Stage Three: Specification of the Operational Framework’, Chapter II, January 1997.

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8 FINLAND ON THE WAY TO THE EMU Arja Alho Minister of Finance, Finland

I shall limit my comments to three issues. First, I shall describe how the EMU will influence economic policy-making and the instruments available for economic policy purposes. Second, I shall briefly comment on the measures taken in Finland to ensure stability and efficiency in the economy and to alleviate the unemployment situation. Finally, I want to stress the importance of how continued convergence in the European economies is required to allow as many member states as possible to take part in the third stage of the Economic and Monetary Union from the very beginning. I would like to make one observation: economics is the only branch of science where in different times one can get different answers to the same questions. In order to maximise the benefits of the single currency from its very introduction, and to minimise the costs of the transitional stage, careful preparations are needed in all sectors of the economy. The preparatory work must include the dissemination of information to all economic actors well in advance of the transition to the single currency. The arrangements for the transition have not yet been worked out completely. This is the right time for wide and open discussion on the matter; the fact that the unresolved questions are debated openly should not make anyone nervous. The discussions and debate, and the preparatory work done in the Council, the Commission and the European Monetary Institute should culminate in the adoption of a timetable for the transition in the European Council meeting at the 1995 Madrid Summit. A precise schedule for the transition is essential in order to guarantee the credibility and irreversibility of the process. A gradual, stepwise transition is the most feasible way of introducing the single currency. The first steps will be taken by the governments and the financial sector. Consumers will be given some more time to become 89

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familiar with the single currency before they actually have the new coins and bank notes on their pockets. In Finland, the transition will not be too dramatic owing to the fact that electronic forms of payment are highly developed and financial services extensively automated. In order for consumers to get used to the prices indicated in the single currency, dual price displays can be used over a sufficiently long period of time. While a gradual transition will familiarise currency users with the single currency in a more convenient way, it will also involve costs for the financial sector which will have introduced the single currency for certain transactions, but will continue to use the national currency denomination in others. Hence, in order to curb the costs of the transaction and to maintain the credibility of the process, the transitional phase should not be longer than necessary. With the start of the third stage of Economic and Monetary Union, the environment in which economic policy-makers operate will change. Monetary policy will no longer be available as an instrument for domestic economic adjustment. There will be no national exchange rate any more. The impact of a member state’s imprudent budgetary policies will be felt immediately by its EMU partners through the impact of such policies on interest rates within the monetary union. Consequently, it is crucial that public finances are kept in good order in all member states also during the third stage. Cyclical fluctuations have traditionally been relatively accentuated in Finland. In the EMU, how can we best adjust to external shocks, as the exchange rate instrument disappears from the toolkit? Before answering this question, a few relevant factors will have to be considered. First, we should not exaggerate the potential of our national monetary policy. In a small country like Finland, with free movement of capital and far-reaching financial integration, the scope for independent monetary policies is already very limited. The exchange rate is not a variable which the government or the central bank could fix at the level of its choice. Exchange rates are basically determined on the markets, and national central banks’ opportunities of influencing them are modest. Those member states which participate in the third stage of the EMU will be represented in the Council of the European Central Bank and hence will have a say in the design of the single monetary policy. The Council of the European Central Bank may be in a better position than any individual central bank to influence monetary and exchange rate developments. Secondly, the fact is often neglected that the EMU will eliminate certain types of economic shocks, notably some of those originating in the international or exchange markets. Thirdly, using a devaluation of the exchange rate as an instrument for 90

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economic adjustment has several well-known drawbacks. Devaluations lead to higher inflation, and the economy easily falls into a vicious circle of successive devaluations. Successive devaluations may encourage inefficient investment and hinder the necessary diversification of the productive base, which would reduce the vulnerability of the economy to sector-specific shocks. So, to come back to the question: how will Finland adjust to asymmetric shocks in the monetary union? It is essential that all sectors in the economy enhance their ability to withstand external shocks. Companies have to consolidate their balance sheets in line with productivity increases. In the monetary union, the effectiveness of fiscal policy will increase, as its effects are not offset by changes in interest rates and exchange rates. Policy coordination among the member states can help to smooth the shocks. The EMU presents many great opportunities for us, but it also involves risks. Economic agents should be aware of the risks and adapt their behaviour accordingly in order to reap the full benefits of the single currency. An erosion of competitiveness in a region of the monetary union may lead to a worsening of the employment situation. Monetary stability in the EMU will not be a substitute for structural policies which will have to ensure the efficient functioning of markets; price and wage-setting will have to reflect cost and productivity developments. Considering the EMU from Finland’s viewpoint, with all its benefits and risks, the balance is distinctly positive. Our government’s aim was fulfilment of the convergence criteria to allow Finland to be among the first to enter the third stage of the EMU. Our chances of satisfying the criteria were evaluated in our first convergence programme, which the government approved in September 1995. The convergence programme shows that Finland’s chances of meeting the convergence criteria very soon are good. The inflation and interest rate criteria are already satisfied. The rate of inflation in Finland is the lowest of all the member states: in October 1995, the 12-month rise in consumer prices was 0.3%. The comprehensive wage agreement concluded among the central labour market organisations in September limits wage increases to 3.7% between September 1995 and January 1998. The agreement covers all the major industrial branches. The strengthening of the markka, together with soaring exports, have boosted the current account surplus. Low inflation and low interest rates will ensure that the external value of the markka will remain stable. The general government deficit fell below the 3% reference value in 1996. The ratio of general government debt to GDP started declining in 1996 from a level of 65%. Our government’s economic policy line and the convergence criteria 91

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reflect the same objectives and the same strategy. Economic performance which satisfies the convergence criteria would be necessary even in the absence of any plans for an EMU. Public finances constitute a good example of this: indeed, with regard to the consolidation of central government finances, our government’s ambitions are set even higher than the fulfilment of the convergence criteria. Without sound public finances we cannot achieve sustainable economic growth which, in turn, is the most important precondition of lower unemployment. The government’s main objective was to halve Finland’s dramatic unemployment rate, which during 1995 was close to 17%. To tackle the unemployment situation, a multi-annual employment programme was drawn up by a working group composed of representatives of several ministries and the Prime Minister’s Office. The multi-annual employment programme builds on the economic policy strategy of the government’s programme and the convergence programme; it is a complement to the convergence programme, not a modification to it. Our government took a decision in principle on the measures needed to implement the employment programme. The decision in principle reflects our belief that the EMU and the objective of high employment are not contradictory but mutually supportive. There must be no compromising on the strict application of the convergence criteria. Member states which are not able to participate in the third stage from the very beginning must continue their efforts towards the fulfilment of the criteria. They will have the transitional status of ‘a country with a derogation’. The fulfilment of the convergence criteria is assessed at least once every two years, or at the request of the member state concerned. All member states share, and will continue to share, the same common basis, which includes the Single Market, the common policies and the coordination of national economic policies. Trade and investment flows have made the member states’ economies highly interdependent. The EMU will be a natural complement to this common basis; at present, all member states are participating in its second stage. In the third stage of the EMU, the member states with a derogation will remain, in a very profound manner, involved in the economic and policy activities of the EMU. The derogations are transitional by nature. It is not only in the interest of the member states with a derogation, but also in the interest of their EU partners that the final stage of the EMU should embrace as many member states as possible. Every member state which joins the third stage of the EMU will enjoy the benefits of a stable currency, elimination of exchange risk and lower transaction costs. The EMU represents stability and sound economic 92

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policies. Establishing confidence in the government’s economic policy will be more difficult outside the EMU than inside. Nevertheless, most of the gains arising from membership in the monetary union will be the greater, the more countries participate in it— provided, of course, that the convergence criteria are fully respected. I shall mention just a few examples of the benefits of a large monetary union. •

•

•

After the introduction of the single currency, companies, investors and travellers no longer need to buy foreign currency for their transactions within the EMU area. It is evident that the cost savings will be greater, the larger is the single currency area. The elimination of exchange rate risk will further encourage trade and investment flows within the single currency area. The larger the monetary union, the stronger the boost given to intra-EU trade and investment. In the global setting, the potential for the single currency to become a major international medium of exchange and reserve currency will be the stronger, the larger is its ‘home base’.

The examples which I have just described clearly show the advantages of a broad-based EMU. However, I would like to add one more argument whose importance reaches beyond the economic sphere: if more and more member states come to regard their temporary derogations as a quasipermanent arrangement, the risk emerges that we would reinforce the image of a multispeed Europe, or ‘Europe a la carte’. In view of the Union’s future enlargement, it is important to ensure the internal coherence of the existing Union. Many member states are very close to the fulfilment of the convergence criteria in the coming years. I hope—and I am confident—that those member states will maintain their determination to balance their public finance, stabilise inflation and satisfy the convergence criteria. As I have emphasised, all Union members share an extensive system of common policies and structures. Also the economic and monetary union should be seen as a part of this common basis, and not as an element leading to a reinforcement of a multispeed Union. My hope is that member states which are not able to participate in the third stage of the EMU from the beginning would step up their efforts to join in soon thereafter. Finland is a small, open economy which needs the stability and credibility of a broad-based EMU. While the Economic and Monetary Union is a positive-sum game for all players, I believe that my country stands to gain even more than many other participants. Finally, I believe that all problems are man-made, which is why man has to solve them. And man—or woman—can be as great as he or she wants to be.

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9 THE INTERNATIONAL COMPETITIVENESS OF EUROPEAN MANUFACTURING Evidence from cost and price measures Jozef van’t Dack Bank for International Settlements, Basle, Switzerland

INTRODUCTION Europe’s manufacturing sector did not fare very well in the second half of the 1980s and early 1990s. Output and employment in the sector grew only sluggishly, if at all, while relative to GDP, trade with countries outside the European region did not show the same buoyancy as the extraregional trade of other major world regions. To a large extent this development was reflected in a growing merchandise trade deficit between 1985 and 1991. Many factors deserve consideration in order to get an overall view of Europe’s market performance. They range from the external environment in which enterprises operate to the internal aspects of enterprise organisation and management. 1 Undoubtedly, one of the more important determinants of market performance is price and cost competitiveness of manufacturing enterprises in domestic and international markets. But even this more narrow aspect of market performance can be considered in a variety of ways that do not always lead to unambiguous answers. Indeed, several measures of price and cost competitiveness are in use in economic analysis. One important and widely used group of such indicators comprises the real effective exchange rate indices. They serve to describe the changes in price and cost competitiveness of one country vis-à-vis a set of competitor countries. Of equal importance, but much less easily quantifiable, are measures of the level of countries’ competitiveness. For industrial countries, some operational measures of the level of labour costs are finding increasing acceptance. Finally, competitiveness of nonmanufacturing is attracting attention given that this sector’s output is becoming increasingly tradable and constitutes an important input into 94

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manufacturing. This would argue for a more comprehensive approach involving price and cost developments in both the tradable and the less trade-oriented sectors. The present paper serves two purposes. First, it attempts to survey the various measures that are in use for evaluating a country’s price and cost competitiveness. Secondly, the paper applies these measures to Europe’s manufacturing sector. To do so, the next section briefly describes some of the salient features of developments in this sector in recent years. It is followed by a discussion of the information that can be distilled from various measures of (1) real effective exchange rates; (2) unit labour cost levels; and (3) tradable versus non-tradable cost competitiveness. The final section sums up the overall impression left by these indicators with respect to Europe’s price and cost competitiveness.

BROAD TRENDS IN EUROPEAN MANUFACTURING IN RECENT YEARS Although manufacturing output in Europe rose at a fairly steady though modest pace between 1980 and 1992, its rate of growth fell well short of that recorded in the Asian region. 2 Even compared with North America where manufacturing production contracted sharply in the early 1980s, European output growth turned out to be lower over this 13–year period (see the left panel of Figure 9.1). As a result, manufacturing output of the major European countries which, when converted at (estimated) 1980 PPP rates, still exceeded that of North America and the Asian region in 1980, was surpassed—massively in the case of the Asian region—by output in the two other regions by 1992. The relative decline of European manufacturing can also be diagnosed when the trend in the share of tradable goods production—mainly manufacturing—in total GDP is considered. This share remained fairly stable (at around 33% of GDP) in the United States, and actually grew markedly in Japan, but in the major European countries it shrank from about 45% in 1970 to just over 40% in the early 1990s. The relative sluggishness of output growth in Europe contributed to a sizeable shake-out of manufacturing employment (see the middle panel of Figure 9.1): total employment in this sector fell by over 15% between 1980 and 1992. By comparison, employment losses in North American manufacturing were more moderate (almost 11%), whereas employment in Japan increased by 14%. The presence of Europe in international markets relative to other major regions has similarly been in decline. The overall merchandise trade share of Western Europe (as a whole) did rise between 1980 and 1992, with the region remaining the dominant trading area, but much of this trend and dominance reflected the large and rising trade flows within Europe 95

Figure 9.1 Indicators of manufacturing in selected regions and countries Source: Estimates based on OECD and UN data. Notes: 1 Value added is expressed at 1980 prices and converted at 1980 manufacturing PPPs. 2 Share of manufactured exports outside own region in total extra-regional exports. 3 European G-10 countries plus Spain

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itself. If trade between the European countries is excluded, and intraregional trade is similarly disregarded for the Asian region and the North American Free Trade Area, Europe’s total merchandise trade share in the early 1990s was comparable to that of these other regions, rather than being dominant. This point emerges even more strongly when only manufacturing trade is considered. As the right panel of Figure 9.1 shows, Europe’s share of the world market for manufactured goods (again excluding trade taking place within each of the separate regions) fell by 1992 just short of that of the NAFTA countries and trailed that of the Asian region by a very wide margin. Back in the early 1970s (not shown in the graph), Europe’s share significantly exceeded that of the Asian region (35% versus 25% for Asia). 3 Relatively strong trade growth within Europe therefore did not coincide with strong growth of trade with the rest of the world. As a percentage of GDP, Europe’s manufactured goods trade with third countries tended to decline between 1985 and 1992. In the other major world regions extra-regional trade rose as a percentage of GDP over this period. Moreover, being equivalent to only 7% of GDP, Europe’s extra-regional trade accounted in 1992 for the lowest proportion of output of the regions considered. A further indicator of export performance in manufactured goods for the period since 1985 is provided in Figure 9.2 which shows for various regions or countries the ratio of growth of export volumes to that of export markets. The comparison indicates that manufacturers in the major European economies were not able to take full advantage of the expansion of their international markets. By contrast, manufactured exports of the dynamic Asian developing countries grew faster than markets expanded, while US manufacturers (re-)gained export market shares in the second half of the 1980s. As a final piece of evidence on Europe’s performance in international markets in recent years, Figure 9.3 shows the movements in the combined trade balance of the major European countries. Following a large surplus in 1986, Europe’s trade balance steadily deteriorated, culminating in a deficit of $33 billion in 1991. This turnaround in Europe’s trade balance between these two years amounted to over $75 billion.4 In the course of 1992 matters improved noticeably, partly as a result of cyclical divergences in economic growth between Europe and its major trading partners, but partly also as a result of the exchange rate induced changes in Europe’s competitiveness which will be discussed in the next section. In both 1993 and 1994 sizeable surpluses were realised in Europe’s merchandise trade account. Part of these surpluses, however, might be more illusory than real given that the introduction in 1993 of a new trade reporting system within the European Union is likely to have significantly distorted the trade statistics. 5

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Figure 9.2 Export market share in manufacturing (quarterly averages, 1985 = 100) Notes: 1 Belgium, France, Germany, Italy, the Netherlands, Spain, Sweden, Switzerland and the United Kingdom. 2 Hong Kong, Indonesia, Korea, Malaysia, Singapore, Taiwan and Thailand.

REAL EFFECTIVE EXCHANGE RATES The best known measures of price and cost competitiveness—at least of changes therein—are the indices of real effective exchange rates. The real effective exchange rate is defined as the nominal effective rate—itself a weighted average of bilateral exchange rates—deflated by the ratio of home prices and/or costs to a similarly weighted average of prices and/ or costs in competitor countries. 6 In order to appreciate better the evidence on trends in competitiveness of European manufacturing shown by these real effective exchange rate indices, a brief overview of some of the major methodological issues involved in their construction could be instructive. Methodological considerations Three issues deserve particular attention in the construction and interpretation of effective exchange rates. 7 They are (a) the choice of the competitor countries/currencies to be included; (b) the choice of the weighting scheme; and (c) the choice of price and cost deflators. These aspects are discussed briefly in the following paragraphs. The choice of currencies/countries is determined by the number of relevant competitors a country is facing in domestic and international markets. 8 In some indices, such as the one calculated by the US federal 98

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Figure 9.3 Trade balance of major industrial countries (in billions of US dollars) Source: National data Note: * European G–10 countries plus Spain

Reserve System (see Pauls (1987)), the number is kept limited to the industrial countries belonging to the Group of Ten; in other indices, such as the index developed by the Federal Reserve Bank of Dallas (see Cox (1986 and 1987)), competitors number over 100. The effective rates used in the present paper include all industrial countries, as well as five important new competitors in the developing world, viz. the Asian NIEs and Mexico. At times, important divergences in the value of alternative effective exchange rate indices arise from differences in the choice of the weighting scheme. In international trade analysis three schemes have found broad acceptance: global trade weights, bilateral weights and double (export) weights. 9 The choice between these weighting schemes depends in the first instance on the characteristics of the goods traded and the nature of the competition in individual markets. If goods tend to be homogeneous and are traded in uniform world markets, global weights based on the relative importance of the various competitor countries in overall world trade would be appropriate for purposes of constructing an effective exchange rate index. However, if it is assumed that countries produce distinct goods and compete in each of their export markets (rather than in a ‘world’ market) against the local producer of import substitutes, the relative importance of a given country’s competitors, and in turn their weight in the effective exchange rate index, can be approximated by the share of exports of the given country flowing to each of these competitors, hence by bilateral export shares. For manufactured goods, the first two weighting schemes above tend to 99

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be extreme cases. Such goods cannot be characterised as homogeneous goods, reducing the appropriateness of global weights; at the same time they are sufficiently substitutable to allow for competition in each market not only between the local producer and a given exporter to this market, but equally between these two producers and all other suppliers to this market, i.e. producers from third countries. These competitive features are best allowed for by using double export weights. Such a scheme weights the competitor countries according to both (a) each of these countries’ contribution to the total supply in each market, and (b) the relative importance of each market in a given country’s international trade. The indices used in the present paper are based on such double weights. Ideal comprehensive price and cost deflators to convert nominal into real effective exchange rates are unlikely to be found. In empirical analysis of manufacturing trade three to four price and cost variables have been the preferred choice of price and cost deflators. On the price side, export prices, consumer prices and wholesale (or producer) prices have been most widely used. On the cost side, unit labour costs have been most frequently chosen. Notwithstanding their relative popularity, neither one of these deflators is without deficiencies. A serious problem when using export prices is that international competition tends to keep variations in export prices across countries within bounds. The resulting observed stability in relative export prices can therefore mask important differences in cost developments and profitability between countries. In addition, whatever variation is shown by export prices could be due in part to compositional changes in manufactured goods trade, because these export ‘prices’ are typically derived from unit value statistics rather than from a representative basket of internationally traded manufactured goods. Consumer prices by contrast have the advantage of being based on a basket of goods that is fairly comparable across countries. They are moreover regularly published, up to date and—quite important when constructing real indices for developing countries—reasonably accurate. But consumer prices cover many items that are not considered tradable (such as several services included in the consumption basket) while excluding goods that are eminently tradable (such as capital goods). Cross-country differences in the rate of growth of non-tradable goods prices (which, as will be argued in a later section, are likely, given crosscountry differences in productivity growth of the tradable goods sector) could therefore affect real effective exchange rate calculations in ways that do not reflect changes in trade competitiveness. The varying incidence of indirect taxes and subsidies across countries further complicates the international comparability of consumer prices. In trying to get closer to the concept of tradable goods prices, some studies have made use of wholesale prices as deflators. Unfortunately, the coverage 100

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of these price indices varies widely across countries, and not infrequently a large share of homogeneous raw materials and semi-manufactured goods is included in the wholesale goods basket, and the prices of these vary little from country to country. As labour costs constitute a major component of manufacturing costs, most measures have looked at the price of labour in evaluating cost competitiveness. But labour costs are not the only important cost facing manufacturers. Purchases of goods and services to be used as inputs into the production process, the cost of capital and residual profit margins all account for sizeable shares of the gross value of output and contribute to the overall cost competitiveness of enterprises. Unfortunately, very few statistics of these costs are available on a consistent, frequent, comparable and current basis, leaving labour costs as the most readily accessible and internationally comparable cost component. Usually, labour costs are combined with labour productivity data to produce unit labour costs. Given that labour productivity tends to rise in recoveries and fall in recessions, its combination with labour costs makes the resulting unit costs cyclically sensitive. To avoid incorrect interpretations of relative unit labour cost developments, some form of data smoothing is normally performed to minimise the cyclical factor. Recent developments Figure 9.4 presents several real exchange rate measures calculated on the basis of the methodology described above, for the major industrial countries and the four Asian NIEs. The real exchange rates shown in the graph for the major European countries (as well as those for the Asian NIEs) deserve some additional comments. Rather than taking the average of the individual countries’ indices, weighted by their share in total European trade, the indices shown in Figure 9.4 attempt to quantify the changes in Europe’s competitiveness vis-à-vis third countries—in essence North America and Asia—by assigning zero weights to the intra-European bilateral exchange rates of the major European countries and renormalising the remaining weights. The composite index for the major European countries is then arrived at by averaging together the renormalised series for each country weighted by its relative importance in (major) Europe’s trade with third countries. This adjustment has a marked impact on the evaluation of Europe’s competitiveness. Given extensive intraregional trading links within Europe and the pursuit of policies aimed at stabilising intra-European exchange rates, nominal effective rates of most European countries have been characterised by relatively great stability. Moreover, growing price convergence has given real rates a similar degree of stability. But Figure 9.4 shows that this stability did not also apply to competitiveness trends vis-à-vis the outside world: the relative unit labour 101

Figure 9.4 Real effective exchange rate measures (1985=100, logarithmic scale) Source: BIS

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cost measure that excludes intra-regional trade (the heavy line in Figure 9.4) was subject to much more pronounced swings than the simple measure which does not correct for intra-regional trade (the light dashed line). By late 1992, Europe had suffered a major loss of competitiveness. On the eve of the currency crisis of September 1992, Europe’s relative prices and costs stood some 40% to 50% above their levels in early 1985. 10 This real appreciation in the second half of the 1980s and early 1990s reflected a significant nominal effective appreciation of the major European currencies and a modest deterioration in relative prices and costs (expressed in domestic currency). It wiped out all of the progress made— to a large extent thanks to the protracted appreciation of the US dollar—in the first half of the 1980s which had remedied the lack of competitiveness characterising European manufacturing in the late 1970s. In contrast with the other countries/regions considered, Europe’s relative export unit values rose closely in line with relative unit labour costs between 1985 and 1992. This may have reflected a tendency in Europe to preserve profit margins even at the cost of market share losses. Moreover, relative export unit values in Europe outpaced relative consumer prices, suggesting a proportionately more modest rise in Europe’s non-tradable goods prices (which figure prominently in the consumer price index) and accordingly an apparent comparative advantage for Europe in producing non-tradable goods, an issue explored later. The major changes in intra-European exchange rates between September 1992 and August 1993, and the concomitant weakening of the European currencies vis-à-vis the Japanese yen and, albeit at a more modest rate, vis-à-vis the US dollar, contributed much towards improving Europe’s competitiveness: by August 1993, relative prices and costs on average had fallen across Europe by over 15% from their peaks a year earlier. In the subsequent year-and-a-half or so, relative unit labour costs remained stable notwithstanding a significant appreciation against the US dollar in 1994 and early 1995. Relative consumer prices and export unit values, however, tended to rise somewhat, suggesting a widening of the profit margins of European manufacturers. Within Europe competitiveness trends have diverged markedly since the mid-1980s. As Figure 9.5 shows, Belgium, France, the Netherlands and Switzerland—all countries with good price performances—have kept real rates stable around their 1985 levels in the period since; Belgium and the Netherlands thus consolidated the substantial gains in competitiveness that they had realised in the early 1980s. By contrast, policies aimed at stabilising exchange rates vis-à-vis the stronger ERM currencies in combination with above-average inflation produced significant real exchange rate appreciation in Italy, Spain and Sweden in the second half of the 1980s and early 1990s. Although the UK real exchange rate rose only modestly from its low in 1986 and remained below the levels recorded in 103

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the early 1980s, it nevertheless stood in mid–1992 some 40% above its level in mid–1977, just prior to the second oil shock. Against this background, it is likely that the UK non-oil manufacturing sector continued to experience a deep-seated competitiveness problem. At any event, the combined trade balance of all four countries with less favourable competitiveness trends deteriorated significantly in the course of the second half of the 1980s and the early 1990s; by 1992 their combined trade deficit was four times as large (at about $45 billion) as it had been in 1986. These misalignments contributed to the exchange rate adjustments which took place within Europe from September 1992. In Italy and Sweden, the adjustment was particularly marked; by April 1995 their real exchange rates stood at their lowest levels since the breakdown of the Bretton Woods system, as modest economic growth and tighter economic policies helped to contain the impact of the steep currency depreciation on price inflation. In Spain and, to a somewhat lesser extent, the United Kingdom, real exchange rates also fell to close to their historical lows. Quite strikingly, trade balances reacted quickly to the gains in competitiveness, improving markedly in each of these countries: by 1994 their combined trade accounts showed a surplus of nearly $14 billion. Moreover, relative to trading partners, profit margins may have widened appreciably in these countries as relative export unit values fell much less than relative unit labour costs. Notwithstanding the large nominal appreciation of their currencies within Europe, cost competitiveness of Belgium, France, the Netherlands and Switzerland was rather well preserved in the aftermath of the European currency crises. This reflected their currencies’ concomitant depreciation against the US dollar and the Japanese yen, on the one hand, and broad stability, if not small gains, of competitiveness vis-à-vis their major trading partner, Germany. Indeed, one noteworthy development in relative unit labour costs in Europe has been the strong rise recorded in German manufacturing since 1985. This rise, some 45% between early 1985 and April 1995, reflected steady nominal effective appreciation combined with upward pressure on labour costs and rather sluggish productivity growth in Germany for a major part of this period. 11 The deterioration in relative cost terms, however, was not mirrored in a similar increase in relative prices. Based on consumer prices or export unit values, Germany’s real effective rate appreciated much less in the period after 1985. The divergence between price and labour costs indices could be due to two factors: first, costs other than labour costs might have grown much more slowly, allowing output prices and in turn export prices to remain relatively stable, or secondly, profit margins might have been squeezed to maintain market shares. The above discussion shows that the competitiveness indicators based on effective exchange rate indices do not allow unambiguous judgements of 104

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Figure 9.5 Relative unit labour costs in major European countries (1985=100) Source: BIS Note: * Relative consumer prices

trends and causes. In general, changes in effective exchange rate indices can say relatively little about whether they move the economy to a level of competitiveness that can generate internal and external equilibrium or whether by contrast they cause even greater imbalances to arise. In order to make more informed judgements in this respect, the measures of changes in competitiveness should be supplemented by indicators of the level of 105

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competitiveness of individual countries and by measures which give some indications of the impact of other sectors on the competitiveness of the manufacturing sector. These issues are addressed in the subsequent sections.

MEASURING THE LEVEL OF COMPETITIVENESS Measures of the level of price competitiveness have typically sought to compare the prices of baskets of goods in different countries, i.e. the calculation of purchasing power parities (PPP). Level estimates of cost competitiveness, meanwhile, have addressed the issue of converting levels of unit labour costs in individual countries into a common currency, thereby using prices for valuing output that are consistent across countries. These measures of levels of competitiveness will be discussed in turn. Much statistical effort (as well as economic thought) has been spent on deriving and analysing measures of purchasing power in various countries.12 One general conclusion of these studies is that cross-country ratios of PPPs based on broad and very detailed baskets of goods, and exchange rates tend to diverge. This divergence, however, cannot be taken as evidence that exchange rates do not reflect equilibrium conditions. For one thing, the relationship between exchange rates and purchasing power parities is obscured by the presence of many non-tradable items in the basket of goods used for calculating economy-wide PPPs. But even if such a relationship can be established, it is likely to be constantly changing given that not only the price levels of non-tradable goods but also their rate of change can vary markedly over time and across countries. The differential productivity model (see Balassa (1964)) suggests that under conditions of wage equalisation across sectors within an economy, non-tradable goods prices in countries with rapid productivity—and thus wage—growth in the tradable goods sector, will rise faster than in countries with a less productive tradable goods industry. Marked and changing cross-country productivity differentials in the tradable goods sector could therefore cause important divergences to occur between exchange rates and broad-based PPPs. Econometric evidence shows that differential productivity growth, approximated by per capita GDP growth, does affect the relationship between PPP and the exchange rate (see Turner and van’t Back (1993) for some simple regressions). The positive impact of per capita GDP growth on the ratio of PPP to the exchange rate is particularly pronounced when purchasing power comparisons are made only for non-tradable goods. By contrast, it is rather insignificant for tradables. Notwithstanding the closer link between PPPs for tradable goods and exchange rates, full correspondence between the two is not entirely borne out by the facts. Table 9.1 presents data on estimated PPPs for tradable goods and actual exchange rates in 1990. It is clear that the latter did not fully 106

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Table 9.1 The exchange rate and PPPs for tradables in 1990

Source: OECD 1992 Notes: 1 Approximated by PPP for gross fixed capital spending on machinery and equipment. 2 Weighted average using PPP-valued GDP weights in 1990.

reflect PPPs. In particular the large weighted deviation in Europe between exchange rates and PPPs is worrisome: on this measure European exchange rates appear to have been overvalued on average by some 25% in 1990.13 By contrast, within Europe exchange rates tended to approximate the tradable goods PPPs.14 Comparing bilateral DM exchange rates with the PPP ratios vis-à-vis Germany’s PPP for tradables in 1990 uncovers few deviations greater than 4.5%; only Italy seemed to have had in the early 1990s an overvalued exchange rate on the basis of these PPP comparisons. The level of unit labour costs in Europe compared with those in competitor countries can provide one further key element in gauging the cost competitiveness in European manufacturing in the early 1990s. Labour cost data are compiled by various institutions; 15 productivity data, however, are much less easy to come by. In the present paper, the 107

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Table 9.2 Labour compensation, productivity and unit labour costs in manufacturing in 1990 (United States=100)

Sources: OECD 1992 and National Accounts Notes: 1 Derived by applying changes in unit labour costs to the 1990 base year estimates. 2 Weighted average (excluding Spain and Switzerland) using PPP-valued GDP weights in 1990.

statistically least onerous approach is taken in deriving internationally consistent productivity data. 16 Specifically, national accounts data on manufacturing value added and employment are used to calculate output per hour in individual countries which are then converted into a common currency by using PPPs for manufactured goods. Given the uncertainties surrounding the data used in calculating productivity, great care is advised in drawing strong conclusions from the data. 17 Table 9.2 presents the results of calculations based on data of hourly labour compensation and value added per hour as compiled by the OECD in its national accounts statistics. 18 The following features of this table deserve special mention. As regards hourly compensation, Europe topped the United States and Japan by a significant margin. Only Italy and the United Kingdom recorded hourly compensation levels that were below those in the United States. For Italy, this might be due to the high incidence of (lower-paid) self-employed labour in its manufacturing industry; in the United Kingdom low labour costs reflected not only modest direct pay levels but also low indirect labour costs, certainly when compared with continental European countries. 19 Europe’s relatively high labour costs were not offset by higher labour productivity than elsewhere: in fact, Europe appeared to lag the United States by a margin of no less than 25% (although this margin varied significantly from one European country to another). As a result, 108

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Figure 9.6 Comparative levels of unit labour costs in recent years (in manufacturing, United States = 100) Notes: The estimates of unit labour costs relative to US levels in 1990 have been extended using the estimates of unit labour costs underlying the BIS competitiveness indicators. The averages for Europe and Other Asia are weighted according to 1990 GDP valued at PPPs. 1 Of the European countries shown. 2 Korea and Taiwan.

Europe’s unit labour costs tended to exceed those in the United States—as well as those in Japan—by close to 50% in 1990. 20 The situation did not improve more than temporarily in the succeeding 109

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years. In Figure 9.6 the base figures for 1990 presented in Table 9.2 are extended both backwards and forwards by using the data on changes in unit labour costs which underlie the real effective exchange rate calculation discussed in the preceding section. The gap between European and US unit labour costs continued to widen until the middle of 1992, at which point the exchange rate adjustments in Europe produced some partial correction. Not surprisingly, the improvement was particularly marked in those countries whose currencies were devalued most strongly. Italy and in particular Sweden would now appear to have labour costs that are the lowest in Europe and are similar to those in the United States.

THE IMPACT OF NON-TRADABLES ON INTERNATIONAL COMPETITIVENESS Although (by definition) not directly affecting international competitiveness, developments in the non-tradable goods sector can have an important indirect impact on the efficiency of manufacturing operations. Given the sometimes heavy reliance on non-tradable goods as inputs to production, the competitiveness of the tradable goods sector is determined in part by the cost efficiency of the domestic production of non-tradable goods. It might therefore be instructive, and in some cases necessary, to supplement the analysis of the competitiveness of tradable goods with information on how prices, costs and productivity in the non-tradable goods sector develop. In much theoretical work, the ratio of prices of tradable to nontradable goods (the ‘internal terms of trade’) is considered to be the most appropriate definition of a country’s real exchange rate. 21 In principle, changes in this price ratio capture changing incentives for resource allocation across the two sectors. These incentives are not necessarily reflected correctly by the real effective exchange rate measures discussed above. Indeed, only if changes in these real effective rates are accompanied by changes in the ratio of tradable to non-tradable goods prices, will a real effective appreciation/ depreciation affect trade flows. But theoretical appeal is not always equivalent to empirical usefulness. The ratio of tradable to non-tradable prices is in practice not very useful for precisely the reason already given before, namely that per capita GDP growth affects the prices of non-tradable goods much more than the prices of tradable goods. Without any correction for the impact of per capita GDP growth on non-tradable goods prices (which moreover varies substantially from one country to another), simple reliance on the internal terms of trade would tend to suggest significant and varying degrees of competitiveness losses in the manufacturing sectors of most industrial countries. 110

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Table 9.3 Average annual productivity growth by sector: 1970–1991 (in percent)

Source: OECD, National Accounts

Sectoral national accounts allow us to calculate, however, a number of more revealing statistics on the relative costs in the tradable and nontradable goods sectors. Table 9.3 summarises data on labour productivity growth (defined as sectoral value added divided by total employment) in both sectors. 22 In general, productivity has tended to grow much more rapidly in the tradable goods sector than in the non-tradable goods sector.23 But, given comparatively fast productivity growth in its non-tradable goods sector since 1970, this growth differential is significantly smaller in Europe than in other industrial countries. In Germany and Sweden it is virtually zero. These sectoral productivity differentials have important implications for cross-country differences in sectoral unit labour costs. Table 9.4 presents the data on unit labour cost levels in the tradable and non-tradable goods sectors in 1991. Noteworthy is the fact that in the nontradable goods sector Europe’s unit labour costs compare more favourably with these in the United States than in the tradable goods sector; in Belgium, Germany and Italy they are at about the same level. In Japan, by contrast, unit labour costs in the non-tradable goods sector are very high. This would suggest that in Europe’s case, the comparatively high labour costs in tradable goods production somewhat overstate the lack of cost competitiveness, given that this measure fails to reflect the costs of inputs of non-tradable goods which appear to be much more in line with those of competitors. Overall cost competitiveness of Europe in international markets might therefore be better than that suggested by labour cost competitiveness alone. This point is further amplified in Figure 9.7. Relative to the United States, Europe’s labour cost competitiveness deteriorated strongly in the 111

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Table 9.4 Unit labour costs by sector in 1991 1 (United States=100)

Sources: OECD 1992 and OECD, National Accounts Notes: 1 Based on value added and total labour earnings as compiled in the national accounts. 2 Weighted average using PPP-valued GDP weights in 1990.

tradable goods sector between 1985 and 1991. The deterioration was however, much smaller when labour costs in the non-tradable goods sector are compared. In fact, Figure 9.7 suggests that, relative to the United States, labour cost competitiveness in Europe’s non-tradable goods sector was still better in 1991 than it had been at the outset of the 1980s. Within Europe, the comparison of unit labour costs in the tradable and non-tradable goods sectors reveals equally remarkable trends. Germany, which in the course of the late 1980s saw its unit labour costs in the tradable goods sector deteriorate significantly relative to developments experienced by its European trading partners, by contrast succeeded in gaining an important competitive edge when non-tradable goods production is considered. As German manufacturing benefited from the comparative cost advantage of its domestic supply industries, the losses of competitiveness since 1985 suggested by the appreciation of Germany’s real effective exchange rate would seem to exaggerate the true losses of cost competitiveness in manufacturing. The opposite might be said of Italy: gains in cost competitiveness in this country’s tradable goods sector coincided with significant losses in its non-tradable goods sector and may therefore have been more modest overall. CONCLUDING OBSERVATIONS The various cost and price measures surveyed in this paper all suggest that European manufacturing suffered significant losses of international competitiveness in the second half of the 1980s and the early 1990s. 112

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Figure 9.7 Indices of unit labour costs for the tradable and non-tradable sectors (1980=100)1 Source: BIS Notes: 1 An increase indicates an appreciation. 2 Average of European countries aggregated using 1990 GDP weights at PPP exchange rates, excluding Germany and Italy respectively.

Measures based on changes in competitiveness, such as the real effective exchange rate indices based on relative unit labour costs, estimated these 113

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losses at 45% between early 1985 and mid–1992. Measures of absolute levels of unit labour costs suggested that labour costs in European manufacturing were more than 50% higher than those in US manufacturing in the early 1990s. The exchange rate adjustments in Europe between September 1992 and August 1993, coinciding with greater yen and dollar strengths, did much to arrest and partially turn this trend around. The improvements in export performance were particularly marked in those countries where currencies were devalued most. The exchange rate turbulence in Europe in recent years should therefore be seen in the first instance as a reaction to and as a major factor in helping to correct the lack of competitiveness not only of the manufacturing sectors of a number of European countries but also of European manufacturing as a whole. As regards the relative merit of the various measures of competitiveness surveyed in this paper, one general observation might be that real effective exchange rates, particularly those based on unit labour costs in manufacturing, are rather easily accessible and in most circumstances appropriate measures of competitiveness. Their usefulness can, however, be much enhanced when they are supplemented with indicators which allow us to measure the level of cost competitiveness across countries. Unfortunately, the outcome of such calculations is still very preliminary, mainly because of the difficulties of producing estimates of productivity valued at internationally consistent and comparable prices. A further important enhancement of the more traditional measures of changes in the (labour) cost competitiveness of manufacturing, is the development of cost measures for those sectors which are not necessarily internationally active, but whose efficiency can have an important bearing on the performance of the tradable goods sector. Very few countries produce statistics on the cost of inputs coming from the non-manufacturing sector, or of factors of production other than labour.24 Yet, as shown by the exercise on the labour costs in the nontradable goods sector in this paper, this information can at times qualify significantly the assessment of the competitiveness of the tradable goods sector that is based on the narrower measures. The data surveyed here indeed suggest that a rather efficient non-tradable goods sector in several European countries offsets some of the lack of cost competitiveness of manufacturing which the more sector-specific measures reveal.

NOTES This paper was presented at the conference on ‘Money, Foreign Exchange and Capital Markets’, at the Central Bank of Malta, 2–4 November 1994. I am indebted to John Bispham and Philip turner for useful comments and to Angelika Donaubauer and Philippe Hainaut for statistical assistance. The views expressed in this paper are mine and do not necessarily represent those to the BIS.

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1 The regularly published World Competitiveness Report (jointly by the International Institute for Management Development and the World Economic Forum), for instance, bases its rankings on eight criteria, including government policies, infrastructure and science and technology. A report by the European Commission (1994) attached more importance to enterprise organisation, distribution channels and R&D than to labour costs, as major determinants of the lack of competitiveness of European industry in high-growth markets vis-àvis Japan and the United States. Another example of a comprehensive evaluation of Europe’s competitiveness stressing similar factors to the Commission report can be found in UNICE (Union of Industrial and Employers’ Confederations of Europe (1993)). 2 Unless noted otherwise, (major) Europe is defined as comprising the European G 10 countries (Belgium, France, Germany, Italy, the Netherlands, Sweden, Switzerland, the United Kingdom) plus Spain. The Asian region includes Japan, the four Asian NIEs (Hong Kong, South Korea, Singapore and Taiwan), China, India, Indonesia, Malaysia, the Philippines and Thailand. 3 For more details on the changes in manufactured goods trade see BIS (1994, pp. 73–74). 4 A similar albeit smaller deterioration (of about $50 billion) can be observed for trade in manufactured goods only. 5 Under-reporting of exports is likely to have been less pronounced than that of imports given that tax-refund considerations have prompted speedier and more complete recording of exports. This might have artificially boosted Europe’s trade surplus by over $20 billion in 1993, an overstatement that is likely to have been carried over into the 1994 outcome (see BIS (1994, p. 81 and 1995, p. 56)). 6 The concept of real exchange rate is subject to different definitions. In the present section it is defined as the ratio, expressed in a common currency, of the weighted average of foreign to domestic prices of traded goods. Many authors, however, consider the ratio of tradable to non-tradable goods prices as a more relevant definition of the real exchange rate. Both definitions need to be considered when viewing the real exchange rate as the ratio of the prices of a given basket of goods in two countries (the so-called purchasing power parities). The latter two definitions are touched upon in the later sections of this paper. 7 For more extensive discussions of all issues involved in constructing effective exchange rates and a review of the methodology underlying some of the more frequently used effective rate indices, see Durand, Simon and Webb (1992), European Commission (1985), McGuirk (1987) and Turner and van’t Back (1993). 8 In principle, not only the countries with which a given country currently has significant trading links, but also those countries that are on the verge of becoming important trading partners, should be considered as relevant competitors. This argues in favour of including (as is done in the indices developed by the BIS) a number of dynamically growing developing countries in the list of competitor countries. 9 A fourth scheme based on weights derived from model estimates, such as the IMF’s MERM (Multiple Exchange-Rate Model) rate, has ceased to be used widely. Indeed, the MERM rate is no longer published by the IMF. Its relative lack of popularity was due to the complexities of estimating the weights, giving them the reputation of being derived from a ‘black box’. 10 This development prompted comments on the potential overvaluation of European currencies in the EC Annual Report (see European Commission (1993)).

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11 Output per hour in Germany rose at an average annual rate of 18% between 1985 and 1993. Of the major industrial countries, only Canada (12%) and the Netherlands (15%) recorded a smaller annual rate of growth of labour productivity in manufacturing (Source: US Bureau of Labor Statistics). 12 See Kravis and Lipsey (1983) for a review of the academic literature on purchasing power parity, and Turner and van’t Dack (1993) for a summary of the various calculations of purchasing power parity. 13 By contrast, Table 9.1 suggests that the US dollar was under-valued by about one-fourth. Lack of effective goods arbitrage between these two large economic regions in which most trade takes place intra-regionally, might be a possible explanation for the divergence. 14 This seems to confirm the greater degree of market integration within Europe suggested in the preceding footnote. 15 Sources for these data are the US Bureau of Labor Statistics, Eurostat and the Swedish Employers Federation, as well as sectoral national accounts data. 16 The same approach is followed in Hooper and Larin (1989). A second approach is to build up productivity data from detailed industry-based data. This procedure is reviewed in van Ark (1993). 17 A comprehensive study of the measurement of comparative levels of unit labour costs in manufacturing was made by Hooper and Vrankovich (1994). To express productivity levels in a common currency unit, they correct expenditure-based PPPs for factors that make these PPPs deviate from relative output prices, such as differences in distribution margins, indirect taxes and the influence of international trade. 18 The data in Table 9.2 include estimates of the labour cost and productivity of self-employed persons. The precise methodology is detailed in Turner and van’t Dack (1993). 19 According to data collected by the US Bureau of Labor Statistics, social security expenditures and other labour taxes constituted some 16.5% of hourly compensation of production workers in UK manufacturing in 1992. In the major continental European economies, with the exception of Switzerland, these indirect labour costs accounted for between 23% (Germany) and 31% (Sweden) of total labour costs. 20 A comparison with some of the newly industrialising developing countries, such as Korea and Taiwan, shows that labour compensation in Europe dwarfs that in these developing economies, but that some (but not all) of this cost disadvantage is offset by much higher productivity levels in Europe. 21 Examples are Dornbusch (1980), Edwards (1989) and the volume edited by Frenkel (1993). 22 Note that the tradable goods sector corresponds to manufacturing. Non-tradable goods are assumed to be all services except government and financial services. 23 Moreover, the cross-country dispersion in labour productivity growth of the tradable goods sector is larger than that of the non-tradable goods sector. Both observations represent the stylised facts of sectoral productivity growth (see for instance Bhagwati (1984) and Kravis and Lipsey (1983)). 24 The cost of capital, the other major factor of production, has received relatively little attention in empirical studies of competitiveness. Nonetheless, marked differences across countries can exist in this cost component due, for instance, to differences in interest rate levels, stock market efficiency and tax regulations. UNICE (1993) quotes a study undertaken for the European Commission which showed that in this respect both Japan and the United States enjoyed sizeable cost advantages over Europe.

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REFERENCES Ark, Bart van (1993), ‘The ICOP approach—its implications and applicability’, in Szirmai et al. (1993), pp. 365–398. Balassa, Bela (1964), ‘The purchasing-power parity doctrine: a reappraisal’. Journal of Political Economy, December, pp. 584–596. Bank for International Settlements (1994), 64th Annual Report 1993–94. Basle. Bank for International Settlements (1995), 65th Annual Report 1994–95. Basle. Bhagwati, Jadish N. (1984), ‘Why are services cheaper in poor countries?’. Economic Journal, June, pp. 279–286. Cox, Michael W. (1986), ‘A new alternative trade-weighted dollar exchange rate index’. Federal Reserve Bank of Dallas Economic Review, September, pp. 20–28. Cox, Michael W. (1987). ‘A comprehensive new real dollar exchange rate index’. Federal Reserve Bank of Dallas Economic Review, March, pp. 1–14. Dornbusch, Rudiger (1980).Open economy macroeconomics. New York: Basic Books. Durand, Martine, Jacques Simon and Colin Webb (1992). ‘OECD indicators of international trade and competitiveness’. OECD Economic Working Paper No. 120, July. Edwards, Sebastian (1989). Real exchange rates, devaluation and adjustment. Cambridge, Massachusetts: The MIT Press. European Commission (1985). ‘The calculation of double export weights for use in deriving effective exchange rates’. Mimeo. European Commission (1993). ‘US, Japanese and Community competitiveness developments’. European Economy, No. 54, Annual Report for 1993, pp. 159–178. European Commission (1994). Growth, competitiveness, employment. The challenges and ways forward into the 21st century. (White paper). Luxembourg: Office for Official Publications of the European Communities. Frenkel, Jacob, (ed.) (1993). Exchange rates and international macroeconomics. Chicago.University of Chicago Press for NBER. Hooper, Peter and Kathryn A.Larin (1989). ‘International comparisons of labor costs in manufacturing’. Review of Income and Wealth, December, pp. 335–355. Hooper, Peter and Elizabeth Vrankovich (1994). ‘International comparisons of the levels of labor costs in manufacturing’. Paper presented at the Festschrift conference in honour of Robert M. Stern, University of Michigan. 18–20 November. Kravis, Irving B. and Robert E. Lipsey (1983). ‘Toward an explanation of national price levels’. Princeton Studies in International Finance No. 52, November. McGuirk, Anne K. (1987). ‘Measuring price competitiveness for industrial country trade in manufactures’. IMF Working Paper 87/34, April. OECD (1992). Purchasing power parities and real expenditures: 1990, vol. 1. Pauls, Dianne B. (1987). ‘Measuring the foreign-exchange value of the dollar’. Federal Reserve Bulletin, June, pp. 411–422. Szirmai, Adam, Bart van Ark and Dirk Pilat (eds) (1993). Explaining economic growth. Amsterdam: North Holland. Turner, Philip and Jozef van’t Dack (1993). Measuring international price and cost competitiveness. BIS Economic Paper, No. 39, November. UNICE (1993). Making Europe more competitive—towards world-class performance. Union of Industrial and Employers’ Confederations of Europe, December.

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10 AUSTRIA ON THE WAY TO EMU* Dietmar Spranz Director of Oestereichischer Nationalbank (OeNB)

1 INTRODUCTION A European Monetary Union, as has been agreed on by the parliaments of all fifteen member states, still makes sense and seems feasible for Europe. Participation of Austria within this monetary union from the beginning is still to be regarded as practicable and useful. 2 ADVANTAGES OF A MONETARY UNION FOR EUROPE The introduction of a single currency increases transparency and thus reduces costs of information and calculation. With the irrevocable fixing of exchange rate parities, exchange rate volatility vanishes between participating countries. In addition the enlargement of the currency area and pooling of foreign reserves may also decrease exchange rate variations vis-à-vis third currencies. Vanishing or declining exchange rate volatility not only reduces hedging costs but improves the efficiency of the price system in allocating resources. An inefficient allocation of scarce resources can be avoided only if exchange rate risks are eliminated completely. According to the European Commission,1 this is an important prerequisite ‘for the Single Market to work smoothly’. The pooling of exchange reserves, the enlargement of the foreign exchange market vis-à-vis third countries, and the collective management of monetary policy by the participating central banks will also diminish the disturbing influence of speculators on monetary policy and hence increase the effectiveness and sovereignty of that monetary policy. 3 FEASIBILITY OF A MONETARY UNION FOR EUROPE Recent developments of relevant economic fundamentals show that Europe is on the right track towards a stability-oriented monetary union. 118

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Inflation rates have remained quite low despite the economic upswing of 1993–95. At present, all but four EU countries would fulfil the inflation criterion. Hand-in-hand with inflation rates, long-term interest rates have converged. Public sector deficits have also been reduced recently by most EU members, Practically all countries have made substantial efforts to fulfil at least the deficit-related part of the fiscal criterion. In a number of cases, governments took rather unpopular measures to cut the budget deficit and accepted that this might be politically costly for the ruling parties. Resolute efforts to consolidate the budget have been made by Belgium, which passed comprehensive measures to reduce the deficit ratio to 3% GDP in 1996 in order to assure the country’s participation in EMU from the very beginning. There are fears, however, that efforts will be relaxed once countries have acquired membership of EMU. In order to ensure continuing convergence of participants, sanctions are foreseen in the Maastricht Treaty for countries violating the fiscal criteria. In this context the prohibition of central bank financing of the public sector and the elimination of privileged access by public bodies to financial institutions have to be mentioned. As excessive public deficits therefore must be financed exclusively by means of capital markets, selfregulating of markets will take place. Sanctions provided by the Maastricht Treaty and letters from Brussels will not be effective as compared to the impact of interest rates which will lower the willingness to enlarge public debt. The most important fact about the convergence criteria is not merely their role as an entrance barrier but the fact that they exist and that they provide an objective orientation for the markets continually to assess the discipline of the countries participating in the monetary union. It is likely that every effort will be made by five, seven or eight countries to participate from the beginning and that this effort will be successful. Secondly, it is expected that the countries which are not able to start immediately will do their best to achieve convergence as soon as possible, and disturbances as a consequence of a two-speed approach should not be overestimated. All things considered, a monetary union for Europe seems to be desirable and feasible.

4 FEASIBILITY OF EMU PARTICIPATION FOR AUSTRIA At present Austria fulfils the inflation criterion, the interest rate criterion and the exchange rate criterion. It does not meet the two fiscal criteria at the moment. This may occur by the end of 1997 when the decision will be made on who enters the third stage of EMU. Favourable economic 119

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fundamentals provide a sound basis for the achievement of this goal. Austria’s inflation rate is half a percentage point below the EU average. Income policy is moderate, with real wage growth being significantly lower than productivity growth. The unemployment rate is significantly below that of Germany. Austrian export turnover has been increasing for many years, despite the real appreciation of the schilling. The savings ratio of more than 12% of GDP is high in international terms. The fact that Austria does not fulfil all convergence criteria at present is therefore due not to major economic problems but originates mainly from political difficulties which have been quite usual in most European countries but are rather new in Austria. In other words, the government crisis showed that Austria in the latter half of 1995 was becoming increasingly ‘European’ in this respect also. In a way, the government crisis was a result of the attempt to bring the budget deficit down from nearly 5% to 3% of GDP as required by the Maastricht Treaty. There was readiness in all major political parties to consolidate the budget. The government broke up over how to reduce the deficit and not over whether to reduce it or not. The ruling parties were united in their determination to fulfil the fiscal criteria; they were split with regard to the method of achieving this goal. Similarly to the central banks of other EU member states, the Oesterreichische Nationalbank (OeNB) follows a ‘policy as if EMU will be realised. The bank’s engagement in an intense level of preparation shows how confident it is about the feasibility of EMU. Nevertheless, the bank has also prepared for alternative scenarios, such as the possible postponement of EMU.

5 EXPECTED CHANGES IN AUSTRIAN MONETARY POLICY AS A CONSEQUENCE OF PARTICIPATION The monetary policy of the OeNB will change fundamentally as soon as it becomes part of the ESCB. It will no longer pursue an Austrian monetary policy but participate in a joint European monetary policy. Up to now, Austria has pegged its currency to the Deutschmark with the aim of importing price stability. Within the framework of this unilateral exchange rate targeting, the Austrian central bank has of course had no influence on the monetary policy of the anchor currency central bank. Within the irrevocable fixing of exchange rates in the third stage of EMU and the subsequent introduction of a common currency, Austria will not only be able to import price stability but have an active influence on monetary policy-making in Europe. As long as the OeNB follows an exchange rate goal, its monetary policy will be demand-oriented. The practically fixed exchange rate of the 120

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schilling against the Deutschmark does not allow the use of money supply targets or interest rate targets. Given the exchange rate anchor and liberalised financial markets, any sizeable interest rate differential would trigger flows of capital in search of higher yields to or from the anchor currency country. As capital flows lead to changes in monetary aggregates, this in turn would restore the original equilibrium of money market rates. As a consequence of the participation in EMU, Austria’s monetary policy will no longer pursue an exchange rate goal and the OeNB will lose its function as a market maker in daily clearing of the foreign exchange market. For the ESCB, open market operations, especially repurchase agreements, should play the dominant role in the management of money market conditions. They should provide the principal means of supplying or withdrawing liquidity and steering interest rates. The Austrian central bank is well prepared for such a strategy as it has already improved its open market policy instruments in this direction. Furthermore it is likely that the role of standing facilities (rediscount and Lombard) and minimum reserves will decline.

6 EXPECTED CONSEQUENCES OF PARTICIPATION FOR THE AUSTRIAN FINANCIAL MARKET As far as expected changes for banks and financial markets are concerned technical questions of the changeover to the single currency have dominated the discussions among bankers in the recent past. But it seems necessary, at least for decision-makers in Austrian banks, to focus their attention more on the competitive effects of the common European currency area. The single currency will increase competition in the Austrian financial sector much more than the free movement of services and capital and the freedom of establishment have done up to now. Only the single currency will complete the Internal Market for financial products and thus enhance competition in this field among financial institutions of EMU participants. Countries with a dual banking system and a large variety of financial products can be expected to offer them in countries with a universal banking system, which will lead to an innovation drive there. In other words, the transition to a single currency will bring about a diversification and internationalisation of the range of products. Market depth as well as market breadth will increase. If Austrian banks, with their traditionally high degree of intermediation, do not respond in time to this challenge they will undoubtedly lose business. Although the continued existence of the national central banks within the ESCB points to the intention of upholding national financial markets, this will not be achieved automatically but will require suitable measures. 121

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There is a considerable risk that the sovereignty of small national financial markets will vanish. If Austrian banks are not cautious enough they run the danger of becoming mere subcontractors of ‘wholesale producers of financial products’. Vienna, which is a small peripheral financial centre, will have to improve its attractiveness in order to remain competitive. The common European financial market does, however, not only bear risks for Austrian financial institutions. One of the strengths of Vienna as a financial market place is its geographically and historically determined role as a mediator between East and West. At present, Austria is the second largest investor in Central Europe after Germany. Austrian banks have considerable know-how in the Central and Eastern European region, which enables them to play a significant role in the financial intermediation process between that region and the EU. The comparative advantage they have in this field can be better used in a common financial market. For example, it will be easier for them to launch large issues of newly privatised companies within a larger currency area.

7 CONSEQUENCES FOR AUSTRIA IF EMU WERE POSTPONED (OR IF AUSTRIA COULD NOT PARTICIPATE) A small open economy which is highly integrated with the countries constituting the European stability core would have no alternative but to peg its currency to a stable anchor currency. In the case of Austria, the Deutschmark would undoubtedly remain the anchor currency. This peg of the schilling to the Deutschmark can be maintained only if economic fundamentals in Austria do not deviate from those in Germany in the long run. In conclusion, the consequences for policy-making in Austria are about the same in both cases, a continuation of the schilling-Deutschmark peg or participation of Austria in EMU. The long-term convergence of economic fundamentals is indispensable in either case. In this sense, it could be argued that convergence is an Austrian invention as it was in practice performed long before the term was used in the Maastricht Treaty. But even though it is true that economic policies in Austria have to be stability-oriented anyway and the OeNB could also continue its present policy in the case of a postponement of EMU, we would definitely regard this as only a second best solution.

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NOTES

1

This paper was a contribution to the Conference on The Road to Monetary Union convened by the European Economics and Financial Centre and Bengue Paribas, November 1995. European Commission (1995): ‘Green Paper on the Practical Arrangements for the Introduction of a Single Currency’, Brussels.

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11 ADHERING TO THE CONVERGENCE CRITERIA The case of Portugal Vitor Bento Director General, Portuguese Treasury

1 INTRODUCTION Portugal seems to have made good use of its membership of the European Economic Community—now European Union. In fact, at entry (in the mid–1980s), Portugal had the lowest per capita income in the Community, representing only 53% of the EEC average. The inflation rate was in the twenties, the budget deficit was above 10% of GDP and the public debt was around 69% of GDP. There were no long-term interest rates (due to the high-inflation history) and short-term rates were above 20%. The exchange rate was subject to a crawling peg system, in place for almost a decade. The banking sector was almost completely nationalised and most of the basic economic sectors were also subject to strong intervention from the state. Today, the country is no longer the European Union’s tail (so to speak), its income per capita is now 10 percentage points higher in terms of the Union average (PPP-adjusted and using the same geographical base), the inflation rate is 4%, the budget deficit is estimated to be around 5.5% of GDP and the public debt at 71% of GDP. Interest rates on 10-year government paper are at around 11% (still too high, indeed, but already below Italy’s), and 3-month interest rates are at around 9%, below Italy’s and Spain’s. The escudo has been a member of the ERM since April 1992, and has survived the turmoil that has afflicted the system since mid–1992. This has been not without pain, of course, but with less volatility than any of the so-called soft currencies, actual or former members of the system— all that while managing to keep one of the lowest unemployment rates in the Union. The government has withdrawn substantially from the economy. In the banking sector, the government-owned institutions represent only 30% of 124

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the total assets, compared with more than 90% in the mid-1980s. Likewise, public institutions today represent 8% of GDP, against some 20% in the mid-1980s. In part, success was the result of favourable circumstances. High world demand until the beginning of the 1990s, the reverse oil shock of the mid1980s, decreased world interest rates and the weakening US dollar, were among the general circumstances that stimulated growth and brought about a substantial improvement in the terms of trade, favouring the early phase of Portuguese membership.

2 BENEFITS OF MEMBERSHIP Membership of the Union also created some additional favourable circumstances. The political and economic risks of the country were reduced, improving the prospective profitability of the investment and attracting huge sums of foreign direct investment. Community transfers, associated with the solidarity towards a more even development and towards a more cohesive Union, provided also an important source of funds to invest in the infrastructures of development—physical and human. Although favourable and contributing to the good results just described, most of those conditions were common to many other countries and do not explain relative performance. Furthermore, those conditions influenced only the earlier part of the period I am referring to. In 1992–6, the enveloping conditions have been rather adverse: general recession, exchange market instability, diversion of the flows of foreign direct investment towards competing destinations in economies that are emerging out of the new world political and economic order. Also, during the so-called ‘good years’, economic policy was faced with huge amounts of highly disturbing and speculative capital inflows. These inflows were naturally a nuisance and a serious obstacle to the disinflation process. Therefore, most of what was achieved was the result of economic and political management, taking advantage of a favourable environment, confronting adverse conditions, but subjected to a determined strategy. In particular, the need to establish exchange rate stability as the cornerstone of economic policy, against a background of competing devaluations from our competitors and amid an economic recession, required a very firm stance from the monetary policy, with obvious adverse consequences in the short run. Of course, all these achievements were not painless. The economy underwent a major transformation with some sectors being seriously hurt by the increasing competition. This was especially so in the case of agriculture. The sector suffered heavily with the introduction of the Common Agricultural Policy (which, as you know, is not a good economic model). A major transformation is thus under way in the primary sector, 125

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with a reduction of the relative contribution to the value added in the economy (8% to 5%), but with substantial improvements in productivity, as the employment share of the sector decreased from 22% to 11%. However, from the social point of view the cost was remarkable. Other sectors have also been subjected to an enormous competitive shock as the clutches of the exchange rate adjustments were withdrawn and the economy was opened up further. Partly as a consequence of those adjustments, the recent recession was deeper in Portugal than the European average, triggering greater social discontent. However, we should bear in mind that the Portuguese economy has long been an open economy and used to foreign competition, as the country was earlier a member of the EFTA. Also, the economy seems to be re-emerging in better shape to face the challenges ahead. In fact, an overall real exchange rate appreciation of around 20% between 1987 and 1994 (using consumer price indices), an almost balanced current account, a stable trade deficit (in percentage of GDP), and some improvements in the market share of exports, can only be reconciled by fast productivity growth.

3 RELATION TO CONVERGENCE CRITERIA Therefore, if we look back to the achievements of a decade of participation in European economic integration, what remains to be done to meet the necessary convergence criteria in time to join the EMU by 1999 seems achievable. There seems to be the political will to do what will follow from the economic policy decisions. The public deficit has to be further reduced to 3% of GDP. The two main parties that disputed the last parliamentary elections—in fact representing the ousted and the new governments— publicly agreed, during the campaign, to meet the deficit requirements of the convergence programme. This commitment was restated by the new government after it was sworn in. The budget deficit is already within the same range of values as are the deficits of Austria and France, countries generally included in the core group of the EMU. This being so, I fail to understand the doubts, often expressed, about the ability of Portugal to meet this criterion, unless they come from quarters that believe that higher public deficits are an essential element of development and are necessary to foster real convergence. I frankly don’t subscribe to that view—quite the contrary—and I fail to see scientific support for it in modern economic theory. The public debt began to decrease in 1996, due to the proceeds from the speedy privatisation programme. But again, on this criterion our situation is better than those in Belgium, the Netherlands and Denmark, just to mention countries in the ‘core’ or close to it. Those are the two criteria that depend exclusively on the actions of 126

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government. The other three—exchange rate stability, inflation and interest rates—are only partly dependent on those actions and are influenced, to different degrees, by the behaviour of exogenous factors. As regards exchange rate, the authority has shown great determination in fighting to pursue exchange rate stability as the pivot of economic policy. That determination, as I mentioned, led to the substantial increase of short-term interest rates in the middle of the last recession and, when the currencies of competitors were allowed to depreciate substantially, to alleviate the drag of the recession. The new government has reiterated its determination to pursue the same objective. That statement was strongly made during the electoral campaign, when there would have been a natural tendency to avoid possibly unpopular issues. This issue was not a very popular one as some analysts blamed the exchange rate policy for the depth of the recession. With inflation, I recognise that further improvements will be marginally more demanding from now on. As domestic demand picks up, pressures on the price level will increase. On the other hand, as unemployment declines, wage demands may grow stronger, requiring a firm hand from the government. Finally, the catching-up process may require an increase of the relative price of non-tradables, which, reflected in the CPI, may be confused with inflation. Of course, an appreciation of the nominal exchange rate would produce the same outcome without penalising the indicators of inflation. In favour of the objective, however, one should align the purpose of the authorities, the improved credibility of the exchange rate policy, acting as a nominal anchor for the economy, and the great flexibility of the Portuguese labour market. Finally, long-term interest rates. This criterion depends only very indirectly on policy actions. It depends essentially on the perception and conviction of the market about the result of those actions. That is to say, on the credible acceptance, by market participants, of the other factors. It is therefore reasonable to expect that if the country succeeds in the other areas, long-term interest rates will fall significantly. To sum up, I am not saying that meeting the convergence criteria will be an easy task for Portugal. I am not even saying that Portugal will do it. What I say is that the task is feasible and is not necessarily more difficult than it is for other countries fighting for the same objective and that are usually counted in. The political will seems to exist, together with the political and social conscience that short-term sacrifices may be required. In spite of the unavoidable emergence of ‘contrary’ voices at the two extremes of the political spectrum, a large majority of the country seems to support the objective of participation in the EMU from the beginning, as can be seen from the results of the last elections. There, the two parties that explicitly defended this objective collected almost 80% of the vote. 127

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If the country succeeds or not is, of course, a matter to be seen and a matter on which one can lay bets. But I should remind you that perhaps ten years ago very few people would bet on the country being where it is today. In any event, meeting the criteria should not be seen as an alien imposition, nor as necessarily linked to monetary union They are very good objectives, per se, with or without monetary union. They are part of the establishment of a sound macro-economic framework, based on sound public finances and financial discipline, and should be pursued, regardless. In fact, public deficits and public debts should be contained as they represent exploiting future generations. As I am sure that none would like to indulge in a good life at the expense of their children’s future, we should not allow this basic idea to be blurred by the dilution of its direct effect into an aggregation as a macro-economic variable, unless, of course, it can be demonstrated—and you will forgive my doubts—that those public deficits are originating a larger and better production potential that will enrich our children. The same goes for inflation. As you all know, inflation imposes a nondemocratic hidden tax, beyond the control of parliament, and therefore leading to the pre-democratic system of taxation without representation. It interferes arbitrarily, unfairly and inefficiently with income distribution and adversely affects resource allocation and economic efficiency. Modern economic theory has long disowned the idea that inflation was subject to a trade-off with growth and established instead that inflation is harmful to long-run sustained growth. Thus it makes sense to eliminate inflation as a malign virus living off the economy. If that is so, it is rather puzzling to see so much fuss about the convergence criteria, as if they were a sacrifice—a kind of entrance fee— imposed to get access to a ‘glorious select club’. That is not the case. If they are enough to ensure a stable and efficient monetary union is a rather different matter, beyond the scope of this presentation. But if the idea of monetary union has helped the European Union economies to put their financial houses in order, then it has already produced a very important service to those economies and in particular to future generations.

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aid policies 64 airlines, deregulation of 61 Algeria 63 Amato, Guiliano, Professor 42, 47 arbitrage, opportunities for 8–10, 15, 83 Association for the Monetary Union of Europe (AMUE) 11 asymmetric shocks 71–4, 90–1 Austria 119–22 averaging facility 86 balance of payments 18; see also trade balance banding: for growth of money supply 83; within ERM 32, 36, 44, 50–1; see also ‘snake’ basket ECU see ECU basket Belgium 57, 61, 119;economic union with Luxembourg 40–1 benefits:of monetary union 31–2, 48, 53–6, 68;of size in monetary union 93 Bevin, Ernest 66 ‘big bang’ approach to single currency 1–5, 11–15 passim, 42, 50 ‘Black Wednesday’ 32–3 Bosnia 62–3 breakdown of EMU, possibilities for 8, 15, 23 Bretton Woods system 41 budget deficits 17, 46–7, 57–8, 119–20, 126, 128 Bundesbank, the 12, 48, 55

Cees Mass group 1–4, 21 central banks: independence of 48–9; interventions in currency markets 35; see also reserves;political awareness of 49: see also European System of Central Banks CFA franc zone 40 Chechnya 63 cohesion fund, European 75 coins, circulation of see notes and coins common foreign and security policy (CFSP) 60–5; recent failures of 61 Common Agricultural Policy 125 compensation payments see transfer payments competitiveness in manufacturing 94– 114; measuring levels of106–12; trends in 102–4, 112–13 compulsory reserves 86 confidence 46 consumer price indices 100, 102 consumers: disadvantaged groups of 20, 29: use of currency by 3, 6, 89–90 contributions to European Union funds 48 convergence criteria 17–18, 44–5, 54– 8, 74–5, 91–3, 119, 122, 126–8; possible dilution of 76 conversion of currencies, limits on 10 core group within ERM see ‘hard core’ Corfu Summit 61 costs of monetary union 11

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crawling peg system 124 crime, action against 65 ‘critical mass’ theory for launch of single currency 1–5; drawbacks of 6–12 currency areas 40–1 currency dealing, worldwide scale of 10, 13–14, 35, 42 currency risks see traders’ interests cyclical fluctuations 90, 101 debt, government 3, 6, 57, 70–1, 128 decimalisation of sterling 3 defence industries 61 defence policy 61–4 deflators, choice of 100 ‘delayed big bang’ 5 Delors, Jacques 43, 50 derogation countries 81–2, 92–3 Deutschmark, currencies linked to 81, 120 devaluation 46, 50–2, 69–77 passim, 90–1, 113; competitive 54, 58, 125 differential productivity model 106 diplomatic co-operation 62–3 disadvantages of monetary union 11, 69–76 double export weights 99–100 dual accounting 11 dual pricing 20, 90 ECU basket 13, 17, 21 education about monetary union 13, 20 employment programmes 92 equilibrating forces 37 ERM II 81 European Central Bank 5–6, 10, 16–19 passim, 38, 48–9, 56, 70, 80–1, 90; choice of strategy for 82–7 European Commission, appointment of 78 European Court of Justice (ECJ) 66–7 European Monetary Institute (EMI) 17, 20, 49, 56, 80, 89 European Monetary System 31, 44

European Monetary Union: evolutionary approach to 49–50, 52; likely future course of 52; need for 53–6; see also benefits; reservations about 10–11 European Parliament 16, 18, 20, 38, 78 European Standing Committee (House of Commons) 78 European System of Central Banks (ESCB) 5–6, 17, 80–1, 121–2 European Union, achievements of 43 excess deficit procedure 71, 82 exchange rate risks see traders’ interests exchange rates: of Euro against nonERM currencies 16–17, 81, 118; fixed (as distinct from single currency) 36; floating 81;locking of 6, 37, 56, 120: of national currencies against non-ERM currencies 8–9; relationship with purchasing power parities 106–7; stability of 31, 34, 44, 54–5, 127; targets for 87, 120–1; see also fixed exchange rates Exchange Rate Mechanism (ERM): early failure of 44; limits of 34–6; origin and development of 31–3 Expert Group on Changeover to Single Currency see Cees Mass group export price indices 100, 102 exporters see traders’ interests exports, price elasticity of demand for 73 federal Europe 42–3, 70 financial institutions, impact of monetary union on 121–2 Finland 89–93; employment programmes in 92 fiscal policy 46–7, 70–3, 91 ‘fiscal transfers’ argument 75–6 fluctuation margins 17, 32; for derogation countries 81 foreign direct investment see inward investment foreign policy see common foreign and security policy

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France 50, 61, 67, 75 free movement of persons 66 frontier controls 66–7 Germany: attitude to monetary union 50–1; banking system 11; currency conversion see Ostmarks; relative unit labour costs 104, 111–12; reunification 33–4, 40–1, 44; unemployment 74 Gold Standard 41–2, 71, 76 Green Paper on monetary union 3, 5, 20 grey market in currencies 10 Gulf War 61–2 ‘hard core’ of ERM 55, 71–6 passim, 126 hard currency 81 harmonisation of monetary instruments 84–7 ‘hot money’ 14–15 hourly labour compensation 108 humanitarian missions 63 Hussein, Saddam 61 identity cards 67 immigration into Europe from third countries 66–7 importers see traders’ interests inflation 12, 32, 46, 69–73 passim, 76, 128; non-monetary factors affecting 82; targets 82–3; see also price stability interbank transactions 3–6, 14 interest rates:differentials in 44, 69,77, 83; floating 76; movements in 10, 17; policy for 35–6; targets for 121 internal terms of trade 110 International Monetary Fund (IMF) 33 intra-European trade 101 inward investment 51, 77, 125 Ireland 35–6, 57, 67, 75 Islamic fundamentalism 63 Italy 35, 41, 44, 109 Japan 95, 111

Kingsdown Report 50–1 Kohl, Helmut, Chancellor 12 labour costs see hourly labour compensation; unit labour costs labour mobility 47 legal tender 21, 40, 57 level playing field 84–5 Lombard rate 85 London Investment Banking Association (LIBA) 3, 11 Maastricht Treaty 1, 5, 11, 13, 33, 45– 6, 48, 60, 62–3, 66, 71–2, 82, 84; Articles from 16–19; need to respect provisions of 55–9; sanctions provided by 119 Madrid Summit 89 Major, John 78 manufacturing competitiveness 94–114 marginal refinancing facility 85–6 margins of fluctuation see fluctuation margins monetary framework 80–6 monetary instruments, choice of 84–7 monetary policy 40, 46, 48–9; decentralised execution of 84; scope for national independence in 90: unification of 54–5, 83–4, 118, 120 monetisation of government debt 70 money supply targets 83, 86, 121 ‘mounting wave’ method of introducing single currency 5 multi-national companies 42 multi-speed Europe 93 ‘nation-building’ and ‘nationfollowing’ 41–2 nation states, modern role of 42 national accounts statistics 108, 110 NATO (North Atlantic Treaty Organisation) 63 Netherlands, the 74, 86 neutral countries 63 New Zealand 49 Nigeria 63 non-tariff barriers to trade 60–1

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non-tradable goods, competitiveness in 110–11, 114 Northern Ireland 66 notes and coins 5, 11, 16, 21, 56–7, 90

repurchase agreements 121 reserve currencies 41, 55, 77, 82, 87, 93 reserves, remunerated and nonremunerated 86 reserves of central banks 10, 14–15, 34–5 ‘reversed snowball effect’ 57 Rifkind, Malcolm 60 risks of monetary union 91; see also breakdown Russia 63

objectives of monetary union 81 Oesterreichische Nationalbank (OeNB) 120–2 oil crisis (1973) 72 open market operations 85, 121 optimum currency area 40–2 Ostmarks, conversion of 3, 12–13, 15 output growth 95 over-reaction by financial markets 73

Schengen Agreement 66–7 security policy see common foreign and security policy simultaneous circulation of national currencies and Euro see parallel currencies single currency as route to monetary union 45 Single Market, European 43, 53–4, 60, 77 ‘snake’, currency 43–4 social unrest 46, 49, 126 sovereignty 42–3, 46, 52, 70–1 Spain 48, 74–5 speculative pressure on currencies 15 34–5, 49, 118 stability of economic conditions 46 see also exchange rates; price stability Stability and Growth Pact 58, 82 statistics of international trade 97 sterling: decimalisation of 3; parity against the Euro 13 Stoiber, Edmond 10 structural fund and policies 75, 91 subsidiarity, principle of 60 supply-side problems 74–5 sustainability of monetary union 46 Sweden 35, 109

parallel currencies 3–5, 11, 40, 50 parities see exchange rates; purchasing power parities payments systems 83 peace-keeping 63 Petersberg Conference 63 phasing of monetary union 5–7, 20, 56–7; see also timetable ‘political directors’, European 64–5 political integration 41–2, 47 political will to achieve monetary union 45, 47, 51, 126–7 Portugal 48, 75, 124–8 price stability 16–18, 48–9, 55, 80, 82; see also inflation productivity, measures of 101, 107–8, 110–11, 114 profit margins 103 protectionism 54 public expenditure denominated in Euros 6 Public Procurement Directive 61 public support for monetary union 127 purchasing power parities 106–7 Qualified Majority Voting (QMV) 65 rational expectations 73, 76 real effective exchange rate indices 94– 5, 98–105, 109, 112–14; definition and construction of 98–101 regional policy 47–8

TARGET (Trans-European Automated Real-Time Gross Settlement Express Transfer) 83

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INDEX

targeting, direct and intermediate 82–3; see also exchange rates; inflation; money supply taxation denominated in Euros 6; see also fiscal policy telecommunications market 61 temperature scales 13 terrorism 65–7 timetable for monetary union 2, 4, 11, 56, 89; see also phasing Today programme 50 trade balance 94, 97 trade with non-European countries 96–7 trade policies 64 traders’ interests in single currency 32, 36, 68–9, 77, 93 transaction costs, saving of 48, 68 transfer payments to compensate for effect of monetary union 23–30, 47–8 transitional costs 89–90 Treaty on European Union see Maastricht Treaty unemployment 23, 45–7; core level of 74–5 unemployment benefit system 23–30

unit labour costs 18, 94–5, 100–2; relative levels of 103–14 United Kingdom: choice about joining EMU 51, 76–7; competitiveness 103; entry into and experience of ERM 33–5, 44; policy towards Europe 66, 78–9; trade within Single Market 60–1 unemployment 75; union of England with Scotland and Ireland 40–1 United States: production of tradable goods 95; as single currency area 38, 40–1, 46, 72; system of transfer payments 23–30 value added in manufacturing 96, 108 vetoing of European Union decisions 65 Vienna 122 welfare payments 74–5 Warner Plan 43 Western European Union 62–3 Wolf, Martin 51 working groups on monetary union 1– 2, 80 Yugoslavia, former 61–3, 65

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