European Monetary Union: An assessment in its first decade.

This is an assessment that I made of monetary union, the EU’s most ambitious project to date. It was written, I believe, in 2007, and predates the 2008 great crash, followed by the Greek meltdown. For my views on these two events, see under “media articles”, “The Euro is a fiscal no-man’s land”, “Russia, China and the global financial crisis”, “Greek bail-out and German public opinion”, a piece I wrote earlier this year. In this assessment I present a brief history of the origins and launch of monetary union, the key components and context of the Maastricht Treaty, what “convergence” entailed in theory and in context, and what monetary union implied. The piece then outlines the arguments for and the arguments against monetary union for the European society of states, and for the European project. And the piece draws interim conclusions, to the effect that the jury in 2007-8, was still out–a very different appreciation to the flood of laudatory comments penned about the Euro at the time. Maybe the present events will open the way to serious discussions about Europe in the future. Hope springs eternal!

Monetary union is the most far-reaching enterprise that the EU has ever undertaken. The ambition to create a monetary union and one capital market was present from the very start of the post-war history of European integration. But its achievement took much longer than its supporters expected. The history of three major attempts since 1957 illustrate the difficulties in reconciling different ideas and interests in a multi-state society of states such as the EU. National economies must converge if the transition into a single monetary regime is to be successful. Whether monetary union is or is not beneficial remains speculative until the experiment has been made, and the currency has a history of at least a couple of decades—the time horizon required by the DM to emerge as an international reserve currency.
The Treaty of Rome, establishing the European Economic Community (EEC) in 1957,avoided the subject as too controversial. Member states retained their powers “to take the necessary protective measures” in the event of a sudden crisis in their external accounts. But the Treaty required that member states act in the “common interest” when formulating and executing exchange rate policies. This became more problematic as inflation rates edged upwards in the 1960s, and the fixed rate arrangement hingeing on the dollar, referred to often as the “Bretton Woods” system began to unravel.
In 1970, the Werner Plan proposed a three-stage move to monetary union, with a single currency, free capital movements, centralised EEC economic policy-making and a European central bank. Member state leaders at their Paris summit in October 1972 envisaged full European economic and monetary union by 1980. Instead, divergent economic policies and performances led the member states to adopt a floating exchange rate regime, where the smaller countries pegged their currencies to the DM, and sought to adjust their policies in line with Germany’s.
The European Monetary System (EMS), conceived as a Franco-German initiative in April 1978, was launched in March 1979. The EMS effectively recreated a regional Bretton Woods. Currency fluctuations were limited to 2 1/4 % in relation to a bilateral parity grid. The ECU as a weighted basket of member country currencies was retained as an indicator of a currency’s margin from parity. Participating governments were to contribute 20% of their gold and U.S. dollar holdings to a European Monetary Cooperation Fund (FECOM).In exchange, they received ECU balances to support EMS parities. To this was added a fiscal transfer mechanism, designed to improve intra-EU payments imbalances and to facilitate payments adjustment.
FECOM was indefinitely delayed for a “more opportune moment” at the European Council meeting of Brussels in December 1980. The ERM became an extended DM-zone, with the Bundesbank operating as Europe’s de facto central bank. France disliked the arrangement, and at Luxemburg in December 1985, President Mitterrand agreed to liberalise capital movements in exchange for Chancellor Kohl’s recognition of monetary union as a goal. Three initiatives,(1) completing the internal market, (2) liberalisation of capital movements, and (3) monetary union, formed part of a broader strategy pursued by Commission President Delors to advance the EU towards political union..
France sought to end the Bundesbank’s lock on European interest and exchange rates on the grounds that the DM-dominated ERM was too restrictive. The French Finance Ministry’s proposal of early 1988 for a common currency in essence aimed to have the Bundesbank hold ECUs as counterpart to German external surpluses, rather than dollars, and use them to subscribe to French Treasury bonds. The German Cabinet countered with a proposal for a single currency, entailing free capital movement, priority to price-stability, political independence of the ECB, no inflationary financing of government deficits, and a federal political system. The European Council at Hanover in June created a special committee, chaired by Delors and including all EU central bank governors, to investigate ways of achieving economic and monetary union.
The Committee’s report in spring 1989 reflected its composition. It proposed a programme for the creation of EMU through irrevocably fixed exchange rates, a single European currency, a common monetary policy under the direction of a European central bank and rules to constrain national governments with regard to budgets. The Bundesbank’s reticence on the ECU was recorded in the reference to its having “potential”. The report sketched three stages to monetary union. Capital movements were to be freed on July 1, 1990. The second stage would start at an unspecified date, once a new Treaty had established a European Central Bank(ECB) and precise, but not binding, rules on the size of government deficits. The third stage would start once the mechanisms for the internal market were in place.
The report was broadly endorsed at the Strasbourg European Council in December 1989, as German unification gathered momentum. German unity was completed on October 3, 1990 ahead of the December general election. Kohl supported the Bundesbank’s terms, presented to other governments as “non-negotiable” (my italics)demands: political union; price stability, completion of the internal market; political independence of the ECB and member banks, and an ECB monopoly on all necessary instruments. Prior to union,price levels had to converge on a stable and low norm.There was to be no inflationary financing of government deficits, and there were to be binding rules on government spending.
The Maastricht Treaty, signed on 7 February 1992, incorporated a German programme for a single currency. France accepted these terms, and the German government signed away the DM. During the transition, member states were to strive to achieve the convergence criteria, defined in a protocol. These were essentially financial: low inflation, stable interest rates, stable currencies in the ERM and moderate government deficits and public debt. A “European Monetary Institute” (EMI) was to be created in 1994 with responsibility “to coordinate monetary policies.” Stage Three would start in January 1999. If enough states were not ready by 1996, the EU would decide in 1998 and by majority vote which countries were prepared. National currencies were to be fixed in price, and the new currency was first to be introduced in 1999 on the wholesale markets and by 2002 on retail markets.
Public opinions and the Bundesbank were less than enthusiastic about the Treaty. World financial markets doubted the credibility of existing exchange rates, and challenged them repeatedly in the course of 1992-93. Germany won support to locate the ECB in Frankfurt, to call the common currency the “Euro” over the French choice of “ECU”, and to introduce a “stability pact”, whereby governments running excessive deficits would be fined. But France continued to champion the ECB’s political accountability to the European Council, and agreed to tighten joint supervision of exchange rate policies—an “ERM 2”, whereby “out” currencies would move within the prevailing 15% bands in a grid hinged on the Euro. The Bundesbank insisted that the ECB would have no obligation to intervene on behalf of weak currencies: the burden would be on them.
Convergence conditions.
The concept of “convergence” between national economies may be explained in terms of the mechanics of a fixed or stable exchange rate regime and of the asymmetry between Germany and France in particular.
The mechanics of a stable exchange rate regime.
If an exchange rate between two currencies (such as the DM and the FF) is to be locked-in over time under a fixed-rate regime, there must be convergence in expected real interest rates, that is, in nominal interest rates and over the longer term in expected rates of inflation. This convergence can be brought about at any rates that are politically acceptable to participating countries. The credibility of the exchange rate link in the eyes of the financial markets requires that convergence comes sooner rather than later.
The exchange rate is only one of the many prices, such as wages or interest rates, that governments may be keen to regulate. The central bank may buy or sell its own currency to achieve a particular exchange rate objective and then neutralize the impact of the intervention by means of domestic monetary policies. In such cases the central bank either gains or loses reserves, and the country encounters a balance of payments surplus (undervalued currency) or deficit (overvalued currency). This in turn leads to a change in the central bank’s external reserve position, increasing it in the former case and eroding it in the latter. The exchange rate between the two currencies becomes incredible to the financial markets, as the deficit country loses external reserves, while the surplus country runs a balance of payments surplus and gains external reserves. This process continues until one of two developments occur. The deficit country’s reserve holdings or capacity to borrow externally becomes impaired; the surplus country fails to neutralise the expansion of money and credit through monetary policy, risking a general rise in the level of prices(inflation), and decides therefore to end intervention in the markets to keep the currency undervalued. At that point, either the fixed exchange-rate relationship will come apart or the two countries will have to bring domestic inflation and interest rates into alignment, usually under duress.
Convergence under conditions of asymmetry.
This story of convergence also incorporates lessons about the asymmetrical relationship between Germany and France prior to the Euro. From 1973 on, the DM emerged as Europe’s key reserve and transactions currency. As the key currency country, Germany looked to its domestic monetary policy in the first instance, while all other countries derived their domestic monetary policies from the fixity of their exchange rate relative to the key currency. In 1987, the French government adopted the “hard franc” policy and accepted the liberalisation of capital movements. The Banque de France had a choice: 1. Continue to keep domestic interest rates down, and end the fixed exchange rate to the DM. 2. Keep the fixed exchange rate, in which case it had no option but to watch the interest rate rise instantly towards the levels prevailing in Germany.
The inflow of French capital to Germany also brings German interest rates down, perhaps against the desire of the Bundesbank. This confronts the Bundesbank with a choice: 1. Keep the DM-Franc rate, on condition that the Banque de France sticks to the Bundesbank’s priority for tight money.2. Unhinge the Franc from the DM, freeing German monetary policy from the exchange rate constraint, but leaving the DM directly exposed to the fluctuations of the dollar. The second option was the Bundesbank’s favourite and that of the growing lobby of German DM-bond holders, hostile to inflation which devalued their investments, but it was regularly countered by Germany’s equally powerful export lobby, concerned at the loss of price competitiveness of their goods on world markets. They preferred the DM to be sheltered from dollar movements in a stable exchange rate regime within the EU.
A high interest rate in Germany was particularly problematic for France when the US Federal Reserve opted for a lowering of US interest rates in order to stimulate domestic growth. Since President Nixon’s August 1971 decision to end the dollar’s convertibility to gold, and the Bundesbank’s action in March 1973 no longer to buy up surplus dollars at the cost of losing control over domestic monetary policy, the Bundesbank’s prime counterpart was the Federal Reserve, not the Banque de France. The Bundesbank gave priority to its national objective of price stability in managing the DM’s relations with the dollar, while the propensity of the Federal Reserve was to absorb the US’ “double deficits” on the federal budget and current account by either allowing the dollar to slide against the DM and yen, or allowing the dollar to rise as funds flowed in from the rest of the world to feed US capital markets. The US economy experienced over three decades of export- or import-driven expansion.
The difference between the US world regime of 1945-71, and the Germany-centred regional regime since 1973 was that Germany ran restrictive monetary policies, and trade surpluses. The Bundesbank’s preference was for the DM’s price to be set by world financial markets. The result was a steady revaluation of the DM. This provided an additional incentive for German manufacturers to move up-market into value-added products, less price sensitive on international markets. German wage levels rose relative to others, thereby accentuating the importance of achieving high levels of productivity. Import prices exerted a stabilising effect on the general level of prices. But occasionally, as in the winter of 1977-78, the Bundesbank lost policy autonomy, and intervened on the foreign exchange markets in order to hold the DM down: that winter, it sold DM bonds on to the world markets, marking the DM’s rapid emergence as a reserve currency.
The benefits of running a reserve currency are that the country can finance its needs by running up credits to the rest of the world denominated in its own currency. Under the ERM, Germany had it all ways: the Bundesbank set the parameters of exchange and interest rate policies for France and other participating countries; restrictive domestic policies were interpreted into large trade surpluses; these were neutralised as reserves accumulated; the Bundesbank only accepted dollars in reserves, and reinvested them on US Treasury bond markets; the German government issued DM bond debt to finance structural government deficits; German diplomacy had ample means to take over the GDR and buy off the Soviet Union in 1989-90. Such hegemonic conduct was arguably in breach of the Rome Treaty commitment that member states act in the “common interest” when formulating and executing exchange rate policies.
The squeeze on France was particularly severe when German and US interest or exchange rates diverged. In March 1973, the Bundesbank hiked interest rates, and German producers accentuated their search for exports. In late 1973, and again in early 1979, oil exporting countries moved to recuperate the value of their dollar reserves, endangered by the dollar’s slide, by raising the oil price. France subsequently ran trade deficits with Germany, the US, OPEC exporters and Japan. In February 1981, the Bundesbank drove up interest rates to record heights while world savings flowed to the US to feed President Reagan’s defense-expenditure boom. The French electorate in spring elected President Mitterrand with a mandate to cut employment, but his expansionary policies induced three devaluations of the Franc by March 1983, when the President decided to keep the Franc in the ERM, and to have French domestic policy converge on German financial priorities.
This decision of March 1983 marks the key turning point in the history of monetary union: thereafter, successive French governments single-mindedly pursued their objective in the EU to create a currency and monetary regime to counter the dollar’s hegemony, and to loosen or terminate the very special relationship in currency management between the Bundesbank and the Federal Reserve. The single currency, the ECB and the single capital market establish the EU as the US counterpart, and—in the French government perspective—consolidate the European Council as the legitimate authority to shape macro-economic policy for the EU as a whole. France gains in that it makes economic and monetary policy on a footing of equality with Germany; Germany gains in that monetary union no longer exposes it to French resentment at its acquired position as de facto, but not de jure central bank for Europe. Monetary union is the EU’s answer to the re-emergence of an imbalance of power in Europe before, and even more so after German unification.
Until 1990, Germany’s major security partner in the context of the cold war was clearly the US. In essence, Germany acquiesced in the dollar’s privileges as a reserve and transactions currency because the US was its prime protector in the cold war. The US played the central role as Germany’s partner in the 1990 rush to state unity. At Maastricht, the EU failed to develop a coherent and effective foreign and security policy. The task of ensuring Europe’s security devolved by default to NATO, and to the US. Yet the EU’s move to monetary union creates the Euro as a potential rival to the dollar, and the Euro-capital market as an alternative to the US capital market for investors around the world. Since German unity, and until the 2003 Iraq way, a realist might have noted the tension inherent to the EU’s situation whereby the EU continues security dependence on the US, but mounts a monetary challenge to the dollar.
Preferences and expectations in an asymmetrical relationship.
There was another asymmetry in the relation between Germany and France, of crucial importance to the future history of the Euro. We have seen that France imported Bundesbank preferences in order to win Germany’s support for a new monetary regime in the EU. There were two aspects of this. One aspect was that France voluntarily absorbed German preferences for a hard currency because it discovered that the old combination of growth-inflation-devaluation no longer serves. The history of this is important in terms of the German population’s “memory for the future”, in other words the expectations that German people, concerned about price stability as a priority, entertain for the future in the light of what they know about the French inflationary past.
The second aspect is that Germany absorbs French preferences for expansion, once the DM is abolished. EU labour market institutions have not been reformed according to liberal market prescriptions. Unemployment rates continue to rise, resources both human and capital are under-utilised, continental Europe is in trade surplus, and wage rates are sticky. The EU is a prime candidate for a Keynesian capital-spending programme. A Euro-capital market, equivalent in size to that of the US, can provide the funds in a non-inflationary way. The potential French allies for an expansionary EU policy under the Euro is the novel, but expanding lobby in Germany of the un-and under-employed. The Euro/DM bondholder lobby could be brought round to joining them on condition that the project’s financing is non-inflationary.
German bondholders still question French sincerity in view of their “memory of the future” relating to the inflationary nature of Keynesian programmes. Had France(or Italy) been sincere in converting to stability-oriented policies, it would not have had to “tie the hands” of government by linking the Franc to the DM. France preferred to import the discipline of the Bundesbank through fixing the exchange rate to the DM, rather than to unilaterally earn credibility on the international markets by its own exertions. Indeed, France had always refused to go-ahead and form a “hard currency” core with Germany and the Netherlands. The suspicion in the German bondholders’ lobby was that France prefers the companionship in EMU of expansion-oriented countries, like Italy.
If trust was a fragile plant in the Franco-German relationship in the run-up to EMU, it barely existed as far as German bondholders were concerned with regard to Italy, as a prospective entrant to the Euro in January 1999, and on account of Italy’s inflationary record. In Italy, such an attitude tended to be seen as an expression of German racial sentiment, illustrating that the technical discourse of EMU also covers ancestral voices in Europe. Yet the German export and unemployed lobbies favoured Italy’s early entry, as a floating lira outside the Euro could provide Italy’s formidable exporters with a major cost advantage on EU markets. French manufacturers agree, but Italy in the Euro is also a valuable companion for France in favour of EU expansionary policies after the Euro has been installed.
The “stability pact-cum-ERM 2”,negotiated in the course of 1995-96, illustrates the depth of German anxieties. The stability pact seeks to impose a legal constraint on budgetary policies after the Euro’s introduction. But the French emphasis on the European Council as the ultimate arbiter of economic policy indicates that such a legal constraint is open to political interpretation. Once the Euro was introduced, it was Ireland and Portugal, two small and peripheral member states, which were lectured by the Commission on allowing their deficits to exceed the 3% gdp rule. But as was predictable, such a rule could not be applied to France or to Italy, especially when the prime infringer turned out to be Germany itself. Similarly, the ERM-2 stands witness to the hard currency countries’ interest in avoiding “competitive devaluations” by countries whose currencies do not join the Euro in 1999, and simultaneously the interest of the core countries’ producers in roping weaker currency countries into the new regime in order to hold their harder currencies down against the dollar. This is particularly the case of Germany, which broke free of the ERM in 1993, only to find the DM shoot up against the dollar in early 1995, when the dollar came under pressure on the world markets following the Mexican peso crash and the Kobe earthquake. When the British Chancellor of the Exchequer is reminded that two and one half years have to be spent in the ERM-2 before entry to the Euro, while candidate countries from central eastern Europe have to expect pressures to join a tight-exchange rate regime, before they have completed the transformation of their economies.
Credibility and legitimacy in a fixed exchange rate relationship.
We have observed the conflict between the credibility of an exchange rate, and the financial market’s reading of its legitimacy in the eyes of one or other of national opinions. The concept of “credibility” refers to a government agency, which announces a policy that the public believes will, and can be, implemented. It will be implemented because the government agency has a reputation that announced policies are implemented; it can be implemented because the agency has a reputation for selecting policy initiatives that have proven to be manageable. In both cases, the past actions of the agency are a guide to present expectations about outcomes of policy initiatives. Second, but rather less convincing, the policy will and can be implemented because the government has established rules that prevent the agency from taking inconsistent actions, such as printing money in exchange for Treasury bills while preaching monetary virtue to the public. But it is rather less convincing than reputation, because rules are a stake in the political struggle. They exist to be respected or disrespected, according to circumstances. Central bank charters for “independence” are insufficient conditions for a central bank’s reputation, just as constitutions are notoriously inadequate guides to the politics of a state.
There are a number of points worth making under a discussion of credibility. As an agency with a special relationship to the financial markets, the central bank from the perspective of public policy is embedded in a network of power relationships with other agencies, political parties etc. These other players consider the central bank only as one among many of their pre-occupations. In order to preserve its autonomy, the central bank has to work permanently at building and maintaining an effective coalition to which it can appeal for support when one or other of the players ask it to renege on its reputation, or seek to override it. It may not always win the battle. The long history of incidences when the Bundesbank did not have its way, particularly over the prospect of the DM’s abolition, suggests that the Bundesbank’s credibility in the eyes of the markets and of the relevant players in Germany, and in the broader European polity, should have been a depreciating asset as the moment approached for the Euros introduction. In effect, in the last years of its existence, the DM became a super-hard currency, suggesting that the Bundesbank had reason to be an enthusiastic supporter for monetary union. For more mercantile reasons, France had every reason to make flattering comments about the strength of the German economy in order to ensure the DM’s entry to the Euro at an over-valued rate.
The credibility hypothesis also suggests that once a central bank’s reputation for consistent inconsistency(the analogy of the eternally repentant drunkard) has been established, it is a reputation that can only be shaken off with great difficulty. This raises the question of how its credibility can be restored, and in what time frame: one option is to peg the exchange rate to a currency that is known to be credible. A credible currency has more options than a currency which has yet to earn credibility, because financial markets may be prepared to give it the benefit of the doubt when its tutelary authority deviates from the path of virtue. But for a currency in search of a reputation for stability, only a policy judged as compatible with maintaining a fixed exchange rate with a virtuous currency is acceptable. It may build up its stock of credibility only in the longer term.
The credibility and legitimacy of exchange rate policy are not readily compatible. Legitimacy of policy may be expressed in terms of perceived benefits and costs, now and in the future, among citizens In the case of France, the longer the transition period from Franc to Euro, the more France had to gear economic policy to the joint preferences of the Bundesbank and world financial markets. This was difficult to achieve when the Bundesbank considered that restrictive monetary policy is required to preserve the DM’s credibility. A stability orientation won political support in Germany, where the Bundesbank cultivated the public’s concerns about inflation. But opinion polls in France have shown for decades that the public’s prior concern is unemployment. The credibility of the DM-Franc exchange rate was thus weakened by the markets’ knowledge that the legitimacy of the exchange rate was challenged by a section of the French electorate, which equated high unemployment with the import of the Bundesbank’s restrictive policies.
The relation of credibility to legitimacy also effects implementation. Commitment to a fixed rate policy is credible when the state acquires the means to implement it. Acquiring the means is likely to be controversial, since institutions must be adapted:
* The central bank must be able to effect the supply of money and credit. This depends on how and why the central bank uses standard monetary policy tools such as open-market purchases or changes in bank reserve requirements etc. The choice of such tools is of crucial importance to the financial system and to the structures of corporate governance. With the Euro, these powers are centralised in the ECB, operating together with the former national central banks. The Euro in additional aggregates national monetary markets, and capital markets of all member states. Here is the heart of the financial dynamic effecting public and corporate finance, deriving from the Euro’s existence.
* The charters of the central banks managing a fixed exchange rate regime have to be similar. These were aligned on the ECB standard in the run up to the Euro’s launch. How effectively the ECB manages its political autonomy from demands to expand or to contract the supply of money and credit has a great deal to do with what happens to interest rates and exchange rates.
*Fiscal policies must converge, as different tax and spending policies exert different pressures on the demand for money and credit, which in turn places strains on the exchange rate. As mentioned, the political struggles over the role of fiscal policy remain unsettled.
*There must be a high degree of political consensus among countries pursuing a fixed exchange rate regime with regard to monetary, fiscal and labour market policies, as well as on policies on competition, mergers and acquisitions, state aids etc. The financial and economic policy communities of countries seeking macroeconomic convergence have to agree on policy priorities, implement them with identical success, and enjoy strong support from organised interests and in public opinion.
At the limit, there is only one central bank and one monetary policy, and only one federal or confederal budget and fiscal policy, with all member states having to finance any budgetary deficits in a single capital market. Fixed exchange rate regimes like monetary union have little prospect of success without far-reaching political integration. Hence, the never-ending series of intergovernmental conferences accompanying the introdction of the Euro, and in particular, the evidence of different philosophies of politics inspiring the European democracies, such as German legalism, the French Napoleonic design, and British common law and parliamentary representation.
One reason to believe that the Euro has a long way to go after 1999 to earn credibility is that it has a limited track record, and that the EU does not have far-reaching political integration. The Bundesbank always held that effective progress toward EMU would not be credible without far-reaching political integration. A crucial aspect of the Euro’s future credibility would be accordingly the early design of EU political institutions that are seen by the markets to be both effective and legitimate.
On the other hand, were the EU not to go through with its most ambitious project to date, it would forgo its credibility in the eyes of citizens and of the world financial markets. The markets would never forget that the EU could not live up to its commitment. It is for this reason of credibility that there can be no turning back, no delay, no postponement.

Monetary union.
As indicated, monetary union is regarded by many as an integral part of the EU’s political development and a logical extension of the process of economic integration. At its most fundamental level, of course, it is intended to eliminate national currencies and exchange rates among the participating countries. As a consequence, monetary union eliminates associated transaction costs, where payments are made between buyers and sellers in two or more currencies. This clearly reinforces the basic idea of a common market in goods and services and parallels the single market initiative to clean-up remaining market distortions.
Beyond that, monetary union makes possible for the first time a unified market for money and capital, one which would be increasingly seamless with respect to debt and equity instruments. No longer would companies issuing securities have to worry about various pockets of investors separated by foreign exchange risk, nor would investors have to worry about asset-allocations across currency-zones where they would face not only the possibility of exchange-rate changes but also different directions in economic policies and their subsequent impact on relative asset values. Capital would be allocated in an optimal way on the basis of the underlying risks and returns which (like regional free trade) provides an immediate booster-shot by allocating this scare resource more efficiently on an EU-wide basis, reflected in turn in a higher level of GDP. At the same time, a unified capital market could be expected to help raise the rate of savings and investment, technological change, and other determinants of economic growth. By continually feeding capital to viable industries and denying it to industries that have lost their competitive advantage at global market prices, a single capital market could thus be expected to accelerate the rate of economic growth in a global competitive context — sometimes called dynamic benefits of monetary union.
Both the static and dynamic capital-allocation benefits of monetary union are hypothetical unless there is parallel institutional development of financial intermediaries that ensures vigorous and contestable competitive conditions within the integrated market. For this reason it was important that the Second Banking Directive and the Investment Services Directive, along with the Capital Adequacy Directive develop in tandem with, and perhaps ahead of, the move toward monetary union. It is important that the financial intermediation infrastructure is in place at the time of monetary union in order to obtain the maximum leverage from this development.
Monetary union means a single financial market in which all borrowers except the sovereign (the EU as a whole) must compete on an even footing. The European Central Bank (ECB) presumably can only purchase EU debt instruments in order to assure adequate growth of the money supply and, under such circumstances, only the EU as a whole can finance deficits by having its debt monetised (purchased and held by the central bank). Nations like Spain, Italy or Germany could continue to finance budget deficits or infrastructure development by issuing debt, but this debt would have to compete on an even footing with all other types of debt in the market, including that issued by corporations, banks, financial and non-financial institutions, regional governments and municipalities, etc. All debt would be evaluated by potential investors and much would be rated by independent rating agencies in terms of default risk, which in turn would be reflected in the interest rates associated with individual financings. Governments of EU member states would thus be on a relatively short leash, and this would have to be clearly reflected in their fiscal policies. As noted earlier, the ability of EU member states to run budgetary deficits would be akin to that of the federal states in the United States. The bond markets would demand prompt corrective action in the event of irresponsible fiscal conduct, and this would be signaled by interest-rate changes and/or the success or failure of new issues. Monetary union and the absence of national central banks, in short, requires bringing fiscal policies under significantly greater discipline.
After 1999, there is only one central bank and one monetary policy, and only one federal or confederal budget and fiscal policy, with all member states having to finance any budgetary deficits in the single capital market, very much like the states and municipalities of the United States (and European municipalities today). Their securities will be subject to default risk, they will be rated by the bond rating agencies, they will be priced accordingly in terms of the interest rates at which they will sell, and their acceptability by domestic and international investors will be determined accordingly. In short, they will no longer be sovereign instruments, since they will no longer be purchasable by a domestic central bank that no longer exists, so that participating countries fiscal affairs will be subject to strict market discipline, just as is the State of New Jersey or the City of New York today.
Finally, monetary union has significant implications for industrial and labour market policies as well. First, the ability of governments to support uncompetitive industries would be constrained by virtue of the fiscal discipline imposed by monetary union, favouring privatisation and winding-down of the kinds of massive government subsidies that have been the hallmark of industrial policy in a number of European countries. Second, industrial adjustment to changing competitive conditions may well accelerate as the fluidity of capital increases, creating turmoil in labour markets and requiring much greater occupational and locational mobility of the labour force. Labour policy will have to accommodate this in lubricating the adjustment process in ways that support rather than retard it.
The disciplines imposed by unified capital markets under conditions of monetary union are decidedly uncomfortable, and require rethinking a broad range of policies associated with the deployment of productive resources in Europe. These cannot be elaborated without far-reaching political integration. Given the magnitude of such an agenda, whether monetary union is or is not beneficial remains speculative until the experiment has been made. Arguments for and arguments against may be listed as econopmic, political, security-related, and institutional.
The arguments in favour of EMU.
Economic arguments: European societies and economies have been transformed by the broadly successful policies of the 40 years prior to 1989. The density of interdependence among EU states requires the EU to establish a regime of common norms and practices governing money and exchange rate policy. National governments alone can no longer maintain fixed exchange rates, discretionary macroeconomic policies, and freedom of capital movement. They may operate two of the three policies, but not all three together. The least satisfactory combination excludes fixed exchange rates: frequent currency realignments endangers the internal market, as businesses located in hard currency countries lobby for protection against competition from suppliers located in soft currency countries. Even if fixed exchange rates are included, the rates are reversible as their very existence implies an escape clause.
EMU eliminates the overshooting of exchange rates, which have caused much harm to all member states at one time or another when corporate plans have been turned upside down by sudden and unexpected realignments in currencies. One currency lengthens corporate planning horizons and reinforces the unification of product and service markets. Consumers will benefit as prices across the EU become more comparable. Transaction costs between buyers and sellers in different currencies are eliminated. Smaller companies, which do not have ready access to hedging facilities on futures markets, will find it easier to service an EU-wide market.
A single currency creates a large capital market, which offers borrowers a lower cost of capital, and creates demands by governments or companies for some harmonisation in taxation and in accounting laws. Investors are no longer limited by law to place a proportion of their holdings in national instruments, but are free to search for the best return across the whole internal market and without currency risk. This is of great importance to a satisfactory resolution of pension funding in many of the EU states, notably Germany, which is confronted with a swiftly aging population. Investors also request greater accountability of managers, opening up the many secluded corners of corporate governance in the EU.
All of the above factors helps improve the competitiveness of European companies on markets in Europe and around the world. They reduce the vulnerability of national economies to gyrations in the dollar. Member governments jointly exert greater control over the EU’s financial system than any one was able to do alone. The conversion of all member country wholesale markets into Euros in 1999 creates a liquid Euro-bond market, comparable in size to that of the US markets. This enables corporations and governments to draw on huge resources to meet the demands for a re-design of European infrastructure on a continental basis. But the issue of tradable Euro-bonds with maturities below one year also expands moneys markets. Savings tied into low yield deposits have the option to turn to the higher-yielding money markets.
EMU de-nationalises corporate strategies and helps unwinds national corporate cross-shareholdings. Effective competition policies have to be further developed in order to ensure that monopolies or oligopolies are not established on a European scale. In the longer run, an EU capital market promises to create a broad share-holding public, with a stake in publicly listed corporations. But the subsidiarity principle, and the widespread desire among “Mittelstand” firms to retain owners’ discretion, is likely to ensure that firms’ owners do not face an ineluctable move to shareholder dominance, as is the case in the UK and the US.
The ECB’s institutional design is not as novel as may appear. Governments are represented in all institutions related to monetary union. They cooperate in working a common regime, but their specific interests are taken into consideration. They retain many areas of discretionary policy, so that EMU meets the criterion of subsidiarity. EMU’s public officials confront a different order of responsibility, given the scope of a single currency, just as companies have to get used to a higher order of structural mobility in an integrating EU economy. EMU accelerates the de-nationalisation of labour markets with regard to cross-frontier movements, equivalence of training diplomas, transferability of pensions etc. In addition, active labour market policies will be required to bring people–disadvantaged initially by the implementation of the single currency–back into the workplace.
There is an urgent need to reform and develop the EU budget. The EU’s budget is just over 1% of gdp, compared to a federal budget in the US of over 20% gdp. The US budget provides offsetting expenditures for states which experience a downturn in economic activity, thereby helping to smooth over the local effects of integration in a single market the size of the US. The EU lacks such a facility, but must rapidly develop a federal budget, funded by “own resources” of the EU, and equivalent to about 6% gdp. As it is, the structural imbalances in a multi-currency system are played out on the foreign exchange markets; with EMU, but no federal budget, such volatility may be displaced to the bond markets, particularly if national governments pursue irresponsible fiscal policies.
The political arguments for: The move to floating exchange rates after 1971 has promoted the resurgence of national economic policies, and has encouraged the continuation of “beggar-thy-neighbour” practices. There have been many manifestations of this propensity in a lax monetary and foreign exchange environment for European states to satisfy their domestic interests first, and to think as an afterthought about the effect of those policies on the rest of the EU member states. Such movements have been a major factor in undermining mutual trust, and in fostering nationalist resentment against other member states.
A Europe of the States ensures German hegemony in Europe. Such a Europe is bound to stimulate nationalist fears and passions. It cannot be anything but volatile. Paradoxically, Germany has moved in to its hegemonic position as Europe has widened with the end of the cold war. Germany is thus too large for its neighbours comfort, but too restricted in means to structure its environment. Germany is in any case facing the challenge of globalisation. If Germany were to have to continue to act as Europe’s central banker, from lack of EU agreement on rapid progress to EMU, its desperate efforts to meet its de jure responsibility for the DM would become increasingly difficult to reconcile with its de facto role for the EU. Resentment throughout Europe would be bread by German weakness, posturing as strength.
For Germany’s, and for Europe’s sake, the Bundesbank should no longer be the Bank That Rules Europe. This is the accomplishment of the Maastricht Treaty. Germany no longer makes policies for others on a national mandate alone. With an ECB, German-type institutions and preferences are embedded in the Treaty, which ensures that the Bundesbank’s vote in the ECB will be one out of 15. The Bundesbank loses its structural power over other countries’ national economies. France, Italy and Spain will gain a greater say over macro-economic policies. This is the best counter to the revival of national sentiment in Europe. Stable domestic political conditions are a pre-requisite for a stable post-cold war Europe. These are greatly furthered by a stable financial environment..
The security arguments for: Another pre-requisite is the creation of a predictable security structure. A Europe of the states does not provide such a structure. Indeed, the Atlantic Alliance of pre-1990 has gone with the cold war, and it would be folly to return to a European polity predicated on the balance of power between greater and lesser states. This was the mechanism that dragged Europe into the two world wars of the first part of this century.
The EU provides a way forward, but as it forms the kernel of Europe in construction, it is not adequate on its own. The Atlantic alliance between the democracies of the western world has ensured peace for two generations and has bound the US in to European affairs. The US has always supported European unity, including the move to currency union–indeed the first postwar proposal for currency union emanated from the Marshall Plan. US support was of course self-interested–Congress was reluctant to vote funds for Europe’s security, and hoped that a European entity would reach sufficient consensus to relieve the US of some of the burden.
Now that the cold war is over, it is more urgent than ever for the Europeans to take charge of their own affairs. The US may not be always relied on to pull the EU’s chestnuts from the fire. But the danger to Europe of overt US leadership is that decisions of direct concern to European security will continue to be taken in Washington, and that the Europeans will remain unprepared to provide more for their own security. Such a condition of continued dependency cannot provide the basis for a sound long-term relationship between Europe and the US.
Hence, the EU must have its own security instrument (WEU)integrated into the EU. This too requires a combination of domestic reforms(professionalisation of the armed forces, changes in German practice to allow German troops to intervene in out-of-NATO-area zones…) and military capabilities. This in turn requires the development of an effective EU foreign policy capability.
Institutional arguments for: EMU requires political union, not just on account of the need for the ECB to be held accountable for its actions to representative institutions, but because those same institutions will have to be able to take and implement decisions of vital import to the European people. There can be no more disguising the need for a move to a fully fledged federal design for Europe. A federal Europe is the only means to assure the peace and prosperity of Europe; the individual nation-states of Europe have long since lost their ability to do so. Indeed, Delors’ prophesy in 1988 that in ten years time 80% of legislation would originate in Brussels is increasingly true, as the regulatory reach of the Commission, the ECJ and to a lesser extent, the influence of the EP extends into the domains of the states.
The Commission study “One Money, One Europe” spells the centralisation of monetary power, and the development of one regulator for all financial institutions. This is required for the purpose of monetary and exchange rate policy, but also to ensure the smooth functioning of the financial system.. The prevailing home country principle in theory holds the home country responsible for the EU operations of the branches of institutions headquartered at home, but in effect host country authorities also insist on retaining their regulatory rights. This is a recipe facilitating financial disasters, such as occurred in the BCCI affair in 1991.
How to reconcile this inevitable need for centralisation with the diverse reality of Europe? The Maastricht Treaty has incorporated the principle of subsidiarity, so that only those powers that are necessary for the good functioning of the EU will be centralised. All else will be delegated to the states and regions. This is the essence of a federal system. The EU may not be compared to the USSR, or to Yugoslavia: there will be a balance struck between centralisation, and decentralisation, which leans heavily in favour of the latter.
There are some knotty problems to resolve at the ongoing intergovernmental conferences. One is essential to the EU’s governance: the big four states have 80% population, but are under-represented relative to the smaller states. Yet the smaller states, and The Netherlands in particular, wish to avoid a Europe of the big powers slipping back through a new weighting that reduces the ability of the smaller states to trade their votes. The Netherlands proposes a better representation of the bigger states more in proportion to their population, but that is to be accompanied by a move to extensive use of majority voting.
The Dutch are also to the fore in asking for a further extension of parliamentary powers, in order to meet complaints about the EU’s “democratic deficit”. In essence, the argument in favour of a balanced increase in EP powers is that the policy issues specific to the EU should be held more accountable to the EP, which should come to represent the people of Europe. There is one European people, composed of many branches, or put another way, Europe is a nation of nations.
The arguments against EMU.
The economics arguments against: The theory of an optimum currency area suggests that the reduction in transaction costs with a common currency should be balanced against the benefits of retaining monetary independence and exchange rates as instruments of adjustment. National governments lose the use of exchange rate and monetary policy, and deficit financing is constrained. Many commentators have tried to downplay the importance of monetary and exchange rate policies on the grounds that governments have lost their autonomy to global markets. If this were the case, then policy choice would not exist and it would be meaningless to criticise governments for policy failures. In effect, governments manage the national currency as one among many in world markets.
Why governments manage national currencies goes to the heart of the argument against EMU. With the move to universal suffrage across Europe in 1918, government money and exchange rate policies could no longer be set with a view to satisfying the interests of wealthy investors in stable prices, balanced budgets, and a fixed exchange rate based on a metallic standard, such as gold. Governments henceforth had to devise economic policies that would satisfy the demands of their electorates for employment and rising living standards. Government responsibility for the management of national economies was the central principle of the Bretton Woods accords of 1944. The accords assumed that states would look first to their domestic concerns, and devised rules to ensure that the international regime would make allowance for national divergence from the norm. Hence, for instance, the rule that under conditions of “fundamental dis-equilibrium”, a currency could be realigned after international discussion.
Bretton Woods established a principle of government discretion in monetary policy, inhibited by an assumption of readiness to live by the measure of an adaptable international regime. EMU is not an adaptable international regime, as it deprives member states of any autonomy in monetary and exchange rate policy. Once national currencies have been abandoned, there is no exit. Policy will be set for the EU as a whole, which may not be compatible with the domestic exigencies of any one member state. In view of the number of realignments in currencies in the past quarter century or more, there is no evidence whatsoever that national economies in the future will not need to continue to exercise autonomy in monetary and foreign exchange policy.Further progress in achieving the integration of the EU markets is best achieved through making allowance for the fundamental feature of the EU, which is the diversity of its constituent units–the member states. EMU does not make allowance for this diversity, nor for the diverse ability of member states to absorb the permanent flow of unexpected events that throw the best laid plans off track.
Nor is there any satisfactory evidence that exchange rate uncertainty inhibits trade between countries. Traders have access to forward exchange markets, and to a range of instruments provided by financial markets, to cover exchange rate risk. What inhibits trade between countries is tariffs, quotas, and an array of non-tariff barriers. The EU has helped to reduce tariffs and quotas between member states, and with the rest of the world, in prolonged negotiations that have always taken the diverse political demands of the member states into account. The member states furthermore agreed to negotiate their diverse interests in the internal market programme of 1986-1993,during which process the EU deployed its usual range of negotiating tactics, making allowance for special exemptions, spinning out the period of adjustment, reaching minimal accords on occasion or maximal accords in favour of market opening in a very few cases. This pragmatic approach served the EU and the world well in the past: there is no reason to believe that jettisoning this pragmatic approach for a rigid straitjacket imposed uniformly on all member states will serve in the future.
EMU requires that labour markets be flexible, understood as downward movement of wages in a particular area, adaptability of workers to technology changes, their mobility between locations, and simply the ability of managers to hire and fire. In the EU, with the exception of the UK and Ireland, wages tend to be inflexible downwards on account of minimum wage laws, social security financing, and rules on hiring and firing. All member states face a major problem of what to do with underskilled young male labour, which is not adaptable to new technologies. Mobility of labour within and between states is minimal, and continental member states refuse to grant managers power to hire and fire, other than under severe legal constraints.
Such rigidities in labour markets means that downturns in one region of the EU economy are unlikely to be met by resources flowing in to a depressed area in order to make use of lower relative wages. This is unlike depressed regions within a national economy which rapidly receive compensating transfers from national budgets. With EMU, and given the size of the EU’s budget of a little more than 1% EU gdp, such transfers out of federal funds would be minimal. Under EMU, too, national governments will not be able to have recourse to the printing press, and autonomy to set tax levels are limited. The integration of goods and factor markets tighten the budget restraint, as firms and people flee high tax zones. There is little sign of a compensating sense of fiscal solidarity among the member states, comparable to that existing in any one of the EU member states.
Paradoxically, while EMU is presented as designed to protect the social fabric of the EU, it accentuates the pressures to move to “Anglo-Saxon” capitalism in that the whole of the EU is to be incorporated into a single currency area. It will create a huge and liquid capital market; competition between financial institutions for corporate business and to attract savings will become fierce; companies which wish to benefit by a single, transparent market will have to raise capital; shareholders will not be inclined to buy shares unless returns on their investment are attractive; managers will want to accentuate the drive for efficiency; lay offs will accelerate. Eventually, no doubt, the EU economy will start to grow rapidly as resources are re-deployed to meet the demands of a continental as opposed to a set of distinct national economies.
The political arguments against: EMU supporters invoke Jean Monnet, one of “the founding fathers” of European integration. His method of overcoming the traditional rivalries of Europe could not have been more pragmatic. If one method encountered too much resistance, he dropped it and sought for alternatives. He eschewed confrontation. He sought to avoid challenging the inherited rituals and creeds of the member states. By a process of serendipity, he chanced on market integration. In fact, the Rome Treaties setting up the “common market” and Euratom took into account the diverse practices, views and interests of the member states. Euratom at the time was deemed to be much more important that the “common market”. It came as a surprise that Euratom was quickly neutered, and the common market became the prime vehicle for the politics of integration.
Monetary union is a deviation from tried and tested paths to EU integration. A moderate path to reconcile the various requirements of the member states(macro-policy autonomy, fixed rates, free capital movements) could have elaborated on the institutions and arrangements of the EMS, negotiated on the initiative of Schmidt and Giscard d’Estaing in 1978-79. Such a moderate version would have followed much along the lines proposed by Balladur in his proposal of January 1988. The écu would have been installed as a central bank unit of account, to be used by all central banks including the Bundesbank; the Bundesbank would have accumulated écus in reserves, just as it acumulated $s, and would have re-invested the écus in French Treasury paper, just as it re-invested $s in US T-bonds.
But the German government, and not just the Bundesbank, countered with a proposal for a single currency under a federal regime. There is every reason to believe that the German government advanced such a counter-proposal in the expectation that it would not be taken up, precisely because if the other member states decided to negotiate, Germany would be able to appear as more European than the Pope. German negotiators would be able to lay down the terms on which the DM would be ended, and on which the écu/Euro would be introduced as a supranational and single currency. These terms enabled the German government to pursue two objectives simultaneously: if France wanted a new monetary regime, that regime could only be defined on German terms. If it was not defined on German terms, there would be no new monetary regime, and the DM would be kept.
The Delors report in effect sidelined the French proposal for a common currency, and placed the German proposal for a single currency at centre stage. Mitterrand, observing Germany moving to unity, decided to take the radical step of accepting the German challenge: monetary union would be the ineluctable passageway towards political union. Kohl eventually conceded in March 1990, and offered monetary and political union to France in compensation for the move to German unity.In this way, monetary union was hi-jacked out of the hands of the moderates by the radicals. The radicals proposed an all-or-nothing way into the future: all the way to monetary union, or a return to great power politics as the norm in post cold war Europe.
During the negotiations, starting with the Bundesbank’s October 1990 statement on its “non-negotiable demands”, the German delegation insisted on getting its way. The Maastricht Treaty was taylored to German requirements, and hedged about with German conditions. After the Treaty had been signed, German diplomacy went to work to ensure that Frankfurt became the host to Frankfurt, sidelining both London’s and Amsterdam’s claims. Then the German Constitutional Court, the Bundesbank and the Bundestag all wrote in de facto addenda to the Treaty, which amounted to a German opt-out clause.
France behaved no better. As mentioned, Germany was not allowed to re-value the DM, as sound economic policy in the interest of the EU as a whole would have counseled. France insisted before, during and after the negotiations that economic policy, as Mitterrand stated in September 1992 was to be decided by elected politicians. France got some of its way: it won a commitment from Kohl, that infuriated the Bundesbank and Finance Ministry, on an “irrevocable” move to EMU; the ECOFIN would set the parameters of foreign exchange policy.
This hard-line pursuit of national interests “in the name of Europe” barely concealed the after-thoughts and hidden agendas of the main parties. For the German delegation, a transition period lasting through 1999 and beyond gave plenty of scope for the project to be blown off course, while it meant that France would have to subordinate the urgent requirements of its national economy to meeting the criteria. But for France, the word “irrevocable” meant in effect that Germany in 1999 would surrender the DM unconditionally, once the financial criteria had been met. The DM would exist no more, and the French nightmare of having economic policy determined by the Bundesbank would be banished forever.
The terms negotiated in the Treaty meant that the national states of the EU were being dragooned into a uniform mold, which threatened their domestic fabric. Each one of the member states was being asked to align domestic institutions and policies on a negotiated outcome between self-seeking states. Whereas proposals were dressed in universal terms, they barely veiled self-seeking policies. The “excessive deficit procedure”, for instance, was aimed against Italy(as far as Germany was concerned), and against Belgium(as far as the UK was concerned). Belgium was a pro-federal EU state. Not allowing it in to the first round would be awkward for the federalist states; allowing it in would demonstrate that the criteria were thoroughly subjective, and that consequently there would be no reason to exclude the UK.
Similarly, France opposed the UK’s so called “opt out” clause for fear that Germany would cite it. In other words, the French delegation did not trust Germany enough, or worse, did not care about the Bundestag being consulted. In any event, the Constitutional Court and the Bundestag gave themselves a de facto “opt-out” clause, but not before Kohl had cited the UK’s “opt-out” clause as a sign of its limited commitment to the EU.
Not least, élites in France, Germany, Italy and the UK lost the support of alienated publics. In Germany, 80% of the population was opposed to losing the DM; in France, unemployment, crime and immigration are the prime concerns of a population which considers its politicians with disdain. Italy has thrown the political class which was responsible for Maastricht(and the deficits, corruption etc)into jail, where the present Prime Minister may yet follow; and the UK electorate is very concerned at losing self-governance in a united Europe.
The domestic politics of EMU shows that the states do not trust each other; that they have escalated their demands, and indulged in a perilous form of diplomatic brinkmanship; that the recession of the early 1990s was policy induced; that EMU lacks the consent of the peoples of Europe; and that EMU threatens to derail the whole EU project. EMU is driven by great power politics, not by any consideration of making a policy to fit the reality of Europe, which is its diversity and heterogeneity.
The result of EMU will be a capitalist revolution perpetrated by the EU’s élites from above, but without the political loyalties and the political institutions required to absorb the inevitable tensions inherent to such a move. It is much more radical than anything which Prime Minister Thatcher ever contemplated. It is furthermore a lie perpetrated on the peoples of the EU, because it amounts to a capitalist plot to break out of a “high unemployment, unaffordable welfare state” syndrome. Above all, it lacks political legitimacy.
Under such conditions, the probability that EMU will prove to be a smooth passage from a multi-currency regime to a single currency regime is low. It is most likely to be accompanied by severe political strains within member states, and an aggravation of relations between them. One such source of strain between states will be the desire of the continental European states to shackle the world capital market in London by imposing reserve requirements on financial institutions, and duplicating the governance procedures of the German capital market on the fledgling Euro-market. Predictably, the City will seek to mobilise its allies across the EU to protect traditional freedoms. Just as predictably, the forces opposed to “Anglo-Saxon” financial practice will mobilise their allies across the EU to corral the free markets in London. London in other words will become the epicentre of an EU-wide struggle, incorporating all the ancient hates and rivalries of Europe. Economics and politics cannot be dissociated in EMU.
Security arguments against: EMU fails on the two key criteria required to ensure European security: it threatens the domestic stability of member states, and it perpetuates the division between “western” and “eastern” Europe. Domestic stability is a pre-requisite for a stable structure for Europe. The politics of EMU has inverted the order: a stable structure for Europe can only be achieved by de-nationalising politics. The efforts to do so through the internal market legislation and the introduction of EMU has tended to alienate public opinions, but the present discontents is nothing compared to what happens when the single capital market is introduced, hugely accentuating the power of market forces across the length and breadth of a continent without the institutions to accommodate them.
The end of the cold war opens up an opportunity to overcome Europe’s division. The newly liberated countries of central-eastern Europe need major political support to help them in their transitions from party-states and planned economies to constitutional pluralist states and market economies. The politics pose manageable problems as a successful transition depends largely on domestic initiatives; but the conversion to market economies requires western Europe to continue along the growth path of preceding years and to keep markets open. Negotiations on Maastricht saw to it that growth ground to a halt as European interest rates were dragged up in the wake of German rates, given the fixed exchange rate system in which the member states had trapped themselves. As growth rates declined, protectionist voices grew increasingly vociferous against “unfair” competition from the newly liberated countries. Western Europe turned inward, divided within itself, and ungenerous to its poorer neighbours.
Maastricht is short-hand for the pre-eminence of Franco-German relations. This was evidently the case over Yugoslavia. France and Germany took different sides and in the course of 1990-91 found their relations ever more soured by events in the Balkans. Better, it was agreed, to focus on our own relationship, rather than sacrifice it on account of our differences elsewhere. In other words, Yugoslavia was the first and fatal casualty of Maastricht. It was fatal because disagreement there underlined the impracticality of seeking to create a common foreign and security policy between member states with different interests. For all the high sounding phrases emanating from EU capitals about “Europe” taking charge of its own affairs, in fact the US in 1995, again in 1999, and most evidently in 2003, took firm control over the wider European security agenda. The vain hope of creating a common external policy for the EU has given way to a humiliating dependence on the US.
One view of the US presence is that without it the Europeans would probably soon be at war with each other again. It echoes Kohl’s repeated arguments that unless the member states move to a united Europe they will fall back into a world of great powers and competing alliances. Both views are unduly pessimistic and self-serving: they are self-serving because they justify continued US dominance in Europe or because they provide a vague rationale in favour of a federal Europe. They are unduly pessimistic, because they fail to take into account thee complex realities of Europe in the 1990s. There are at least four reasons why Europe is unlikely to repeat the wars of the first half of the twentieth century:
*The memories of the catastrophe are fresh in people’s minds, and if they forget for a moment, the media and the cinema are there to remind them with a daily diet of war films, reminiscences, horror stories etc.
*All European states are now democratic for the first time in history. Democracies do not tend to wage war against each other. Furthermore, all European states subscribe to the same basic principles of human rights, regular elections, a free press etc. For the first time in two hundred years, ideological differences have been extracted from the European polity.
*The economies of European countries are highly interdependent. No-one has the slightest interest in endangering these close relations, and if they were tempted to–as was William II in 1914–they would face overbearing opposition in their own political processes, through the elaborate network of multilateral fora into which the European states have bound themselves these past fifty years, and from neighbouring states.
*Not least, France,Britain,Russia and the US are nuclear weapon states. There will never again be a 1939-1940 tank campaign to end the independence of Poland and of France. The possession of nuclear weapons suggests that they are there for a purpose. A non-nuclear state that went to war with a nuclear state in the European context is likely to learn very soon in the struggle what an error was made.
EMU is likely to aggravate conflicts between and within states, and detract member states from the successful pursuit of more mundane, and therefore more effective policies, such as facilitating cross-border cooperation in education, creating a more open internal market, developing a viable and competitive European cultural industry, etc.
Institutional arguments against:Europe is not a nation of nations, but a society of nation states with their own histories and institutions. Any sound policy for Europe must be based on the fact of its diversity, and on the awareness that too little unity is just as dangerous as too much. Too little unity pits one country and people against another, as is evident in the football stadiums of Europe. Too much unity forces peoples into a strait-jacket which they find oppressive, and that they are bound to shrug off. EU member states must co-operate across the spectrum of policies, but they must not be coerced. As Prime Minister Thatcher said at Bruges, the best way to build a successful EC is “willing and active co-operation between independent sovereign states”.
EMU is an ambitious attempt to merge nation-states. Its advocates promise temporary costs and long term benefits. This is simplistic in the extreme: European realities cannot be reduced to a simple cost-benefit analysis. The argument that France + Germany +The Netherlands +Italy + the UK etc add up to a single and stronger whole is the equivalent of some youthful and overpaid MBA counseling ceos to merge their corporations on account of a list of “synergies” that said consultant has cooked up, after a brief examination of a few variables. And as any savvy manager knows, few corporate mergers are successful. Their major problem is the incompatibility of corporate cultures. How much more so does this same logic apply to modern states.
Europe is different to the US. What holds in the US does not necessarily hold in Europe. The US is no proximate model which Europeans can imitate. The US has one language, one law, one money, one national flag, and one Constitution. Furthermore, the central political issue in pre-1860s US was whether the majority( northern states) could override a minority. This is already a central issue in the EU. In the US, the problem was resolved by civil war. Presumably, European federalists consider that such a future does not await their endeavour to mold such a diverse area of the world into a single whole.
EMU has stimulated fears among European states that the new design for a complete Union will be tailored to the preferences of one or other of the states. This is a clear indication that the project has gone far beyond what is wise, and has blundered into stimulating fear of the EU becoming a German Europe, a French Europe or a British Europe.
*In Britain, but also in France and elsewhere, there have been leaders who have argued that the federalist project is bound to lead to creeping centralisation, as has occurred in Germany. Powers will be attributed to the Union, much as the Federal Republic has seen powers attributed to Bonn and Frankfurt.
*In Germany, EMU is presented as a project, designed in France by the élites of the grandes écoles, to deprive Germany of its DM and of its right to self-government. France is continuing the policy of Cardinal Richelieu in new forms and under modern conditions: that is to divide up the country into regions and to deprive it of autonomy.
*In France and Germany, there have been fears voiced that the EU is a British plot to inflict free market capitalism on a continent which has always rejected it. Indeed, Chancellor Lawson inverted the argument in his speech of January 1989 whereby he maintained that EMU was a plot by continental corporatists designed to derail the EU’s internal market project.
Not surprisingly, with all these mutual suspicions floating around, there is no agreement on the details of EMU governance, let alone on other aspects of public policy for a united Europe:
*There is no reason to believe that one central bank can manage a single monetary policy, while 15 governments seek to manage 15 separate national budgets.With 25 member states the prospect of success is even more distant.
*It is too early to say that the ECB will be independent in practice. The Presidents of the EU Council and of the EC Commission are permitted to participate in the Governing Council. National central bank governors will outnumber members at large in the Governing Council. ECOFIN may conclude agreements on an exchange rate system.
*The ECB is accountable to none. The European Parliament has nowhere near the same clout as the US Congress does with regard to the Federal Reserve. Without accountability, the ECB can count on little support. It will therefore be highly vulnerable tio takeover by irrate politicians.
*The ECB has little regulatory responsibility. Bank regulation remains in the hands of the states. Greater centralisation of regulatory functions would avoid the inevitable overlap in responsibilities, but none of the states–including the apparently most federal-minded–have been keen to renounce their own regulatory functions.A single currency is therefore likely to accentuate competition in financial markets, leading to bankruptcies and failures, but without any clear point of responsibility.
*Payments systems: the Treaty says the ECB should concern itself with the operations of the payments system, but does not specify what it should do when that responsibility conflicts with the priority attached to price stability. Should it provide overnight funds to the bank in question at the expense of monetary policy; or should it allow the bank to go to the wall, at the expense of financial market stbility? The Treaty gives no answer. Why?, because agreement could not be reached.
Indeed, a federal EU is much more likely to be protectionist than a loosely structured EU. A loosely structured EU allows member states to veto any protectionist policy which they consider hostile to their interests in unfettered access to world markets. This is likely to be much more difficult in the event of a federal Europe. One of the objectives of the federalists is to defend the existing social policies from “unfair” competition in the rest of the world. Given the drastic situation in which the French and German economies find themselves, the existence of qualified majority voting within a federal system would facilitate the isolation of a free-trade coalition. Waiverers could be brought on board through side-payments.
At the very least, this is not the right time to try EMU. There are better things for the EU to be getting on with. It is far too ambitious, and has involved the EU in taking on far more than its member states–whatever they proclaim–can possibly undertake successfully. Better to postpone the whole project for the moment, and if people so wish, to revisit this “building site” in ten years time.
Exiting from history as an interim conclusion.
At two year old, the Euro’s health report holds two apparently contradictory signs. The one is that the Euro began life on the foreign exchanges at $1.18, floating down to below a $1.00, and then has risen sharply since 2002-3. The other sign is more encouraging for a doctor concerned about the infant’s future. The Euro has become the number one issuing currency in the bond markets. The dollar and Euro account for 45% of bond issues, and the pound sterling for the remaining 10%.
What to make of these signs? Without any doubt, the ECB’s policy of holding interest rates low, combined with the unexpected reaction of the foreign exchange markets to down-grade the Euro relative to the dollar, yen and pound sterling, helped to stimulate growth over 1999. But booming equity markets were probably a more important growth consideration. The Euro has fulfilled the expectations of its two ancestors, Helmut Schmidt and Valéry Giscard d’Estaing, to form a “zone of monetary stability” in Europe, shielded from the movements of the dollar. Corporate investors now have a stable and predictable business environment in which to plan for the future, and on a continental scale.
The advent of the Euro has opened new sources of finance for corporations, previously many of which were limited to their own narrow national capital markets. It is not surprising that a major growth area is in corporate bonds, given that financial officers in Germany, France or Italy have for long preferred recourse for external funding to the corporate bond market. Even so, corporations wishing to issue new equities have access to a much wider pool of investors than before.
Locking the Euro-zone member states in to a single currency ensures that managers and unions have to moderate wage rises below productivity increases. When Germany entered the Euro, labour costs were 30% higher than in France, a world leader in labour productivity league tables. But the Europ can scarcely be recorded as a major moderating factor on government or union policies, in view of the French government’s introduction of a 35 hour week, or the extension of no-firing policies in Germany to firms employing more than 5 people.
The birth of the Euro has transformed the structure of global finance. At the time of the Asian meltdown, the US-centred “global” debate about globalisation’s blessings or dangers generated a plethora of proposals to reform “ the international financial architecture”. One pillar of that new architecture is clearly the Euro, and related EU institutions. The Euro’s success so far vindicates the process of European policy to ensure a balance between competition and co-operation in Europe’s mosaic of states and peoples. But the adoption of the Euro creates a structure of incentives to move to an integrated polity and economy, while the mentalities and inheritances of European peoples, regions and states are marked by their diversity. The Euro abolished eleven currencies, but it did not abolish eleven political systems. It created one capital market, but did not end the existence of eleven different financial systems.
But the Euro has not abolished the de facto inequality between the states, as evidenced in the struggle over fiscal policy. The single capital market has not abolished the European states’ inherited reflexes to protect their national champions, despite the fact that 16% of shares listed on the Deutsche Börse are in the hands of foreign investors, and up to 40% in the case of Paris. France’s finance establishment could not stop worrying about the outcome of BNP’s bid for Société Générale and Paribas, or at ING’s more recent bid for the French bank CCF. Lisbon reacted to Mr Champalimaud’s proposal to sell to Spain’s Santander, as if Philip II was still alive in El Escorial. Not least, Italy’s Mediobanca showed how the Euro-capital market could be used to protect a national champion like Telecom Italia from Deutsche Telekom’s unwelcome grasp, and kept in the hands of another national champion, Olivetti.
The one truly European country is the United Kingdom, without doubt the most liberal of markets among EU member states in the sense that foreign companies, banks, personnel or products have ready access to a market where the rhetoric, and to a great extent the reality of policy is geared to benefitting the consumer. The fundamental reason why British public opinion is sceptical about Euro-land is the gap between the language of “solidarity” and the reality.
This is particularly visible in labour markets. Unemployment in the EU is 10%, but in the poorer peripheral areas such as Andalusia or Sicily, the figures are at least 30%. France, Spain and Italy have 25% of their under twenty-five year olds unemployed. Legislation notoriously defends workers in work, but is not predicated on the prior principle that all citizens have a right to work. Economic expansion, through a rise in consumer demand, is the only way, Lord Keynes argued in the 1930s, to reduce unemployment under conditions of sticky labour markets; Because labour markets in the major EU countries are sticky, and they remain very hazardous terrain for ambitious politicians, the EU’s growth policy can only be managed by a combination of lower interest rates and low exchange rates. They now feature low interest rates, bloated budgets, rigid labour markets in France, Germany and Italy and a high exchange rate. The fundsamental deficiency in implementing the Euro is that product, labour and financial markets have not been liberalised to the extent required in a monetary union, and for them to operate at optimum efficiency. And they have not been liberalised, because there is no consent for liberalisation in the major countries. The Euro was launched as a top-down project; but it can only survive if the ideological battle is won to ensure a bottom-up support for a liberal market society.


About Jonathan Story, Professor Emeritus, INSEAD

Jonathan Story is Emeritus Professor of International Political Economy at INSEAD. Prior to joining INSEAD in 1974, he worked in Brussels and Washington, where he obtained his PhD from Johns Hopkins School of Advanced International Studies. He has held the Marusi Chair of Global Business at Rensselaer Polytechnic Institute, and is currently Distinguished Visiting Professor at the Graduate Schoold of Business, Fordham University, New York. He is preparing a monograph on China’s impact on the world political economy, and another on a proposal for a contextual approach to business studies. He has a chapter forthcoming on the Euro crisis. His latest book is China UnCovered: What you need to know to do business in China, (FT/ Pearson’s, 2010) ( His previous books include “China: The Race to Market” (FT/Pearsons, 2003), The Frontiers of Fortune, (Pitman’s, 1999); and The Political Economy of Financial Integration in Europe : The Battle of the Systems,(MIT Press, 1998) on monetary union and financial markets in the EU, and co-authored with Ingo Walter of NYU. His books have been translated into French, Italian, German, Spanish, Chinese, Korean and Arabic. He is also a co-author in the Oxford Handbook on Business and Government(2010), and has contributed numerous chapters in books and articles in professional journals. He is a regular contributor to newspapers, and has been four times winner of the European Case Clearing House “Best Case of the Year” award. His latest cases detail hotel investments in Egypt and Argentina, as well as a women’s garment manufacturer in Sri Lanka and a Chinese auto parts producer. He teaches courses on international business and the global political economy. At the INSEAD campus, in Fontainebleau and Singapore, he has taught European and world politics, markets, and business in the MBA, and PhD programs. He has taught on INSEAD’s flagship Advanced Management Programme for the last three decades, as well as on other Executive Development and Company Specific courses. Jonathan Story works with governments, international organisations and multinational corporations. He is married with four children, and, now, thirteen grandchildren. Besides English, he is fluent in French, German, Spanish, Italian, reads Portuguese and is learning Russian. He has a bass voice, and gives concerts, including Afro-American spirituals, Russian folk, classical opera and oratorio.
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