Europe's progress towards monetary union is turning into an epic voyage. Ever since the course was charted in the Maastricht treaty in 1992, winds threatening to blow the whole project off course have been rising. First the markets ejected sterling and the Italian lira from the exchange rate mechanism (ERM); more recently the French franc has looked perilously vulnerable. In the meantime it has become abundantly clear-so clear that it has even been admitted by some national politicians-that certain member states (such as Italy) will fail to meet the convergence criteria laid down in the treaty. In addition to this, popular sentiment in many countries appears to be antagonistic to the objective itself: although a majority of Germans still favour closer European union, nearly two in three oppose a single currency.
Yet the higher the seas rise, the more determined are most European politicians to stick to the course. The signs are that they will lash themselves to the mast at the summit in Madrid: the "reference group" charged with preparing for the summit has reported "unanimous agreement" on maintaining both the timetable and the convergence criteria laid down at Maastricht.
Can the the member states' national governments make it happen by sheer force of political will? More to the point, if it does happen, will it work?
CONVERGENCE CRITERIA
The Maastricht treaty set out a number of "convergence criteria" for monetary union: comparative price stability, long term interest rates, exchange rate stability and fiscal prudence [see box on p.72]. The importance of these criteria depends on how they are interpreted. Interpreted generously, the criteria would not necessarily be too demanding. The exchange rate condition has been effectively relaxed by the move to wide bands within the ERM, although strictly speaking this has not yet been agreed. The price stability and long term interest rate conditions should be relatively easy for most north European countries to meet, though they may cause difficulties for some of the Mediterranean states. The fiscal criteria on state borrowing are widely seen as the most difficult and restrictive, but these can be subject to interpretation. Even so, it could still be a close call whether a majority of member states could achieve the necessary conditions for Emu before 1999, depending on the accession of new members, the interpretation of certain members' fiscal positions (such as Belgium and Ireland), and whether Denmark and the UK-which might be able to meet the criteria-will use their opt-outs or not.
But the Germans have recently raised the temperature by insisting that the criteria should be narrowly and rigidly interpreted, though quite what that means for the exchange rate conditions is not yet clear. Moreover, they have successfully insisted that the decision on which countries meet the criteria, to be taken by July 1998, should be based on the prior year 1997. The problem with this is that slow growth and high unemployment in the meantime is making it harder for other countries such as Austria and France to meet the fiscal criteria, or to do so at an acceptable economic and political cost.
But even if Emu cannot start before January 1st 1999, because a majority of states fail to meet the criteria, the terms of the Maastricht treaty require it to happen then anyway-among all those states that do meet the criteria. However, if not enough countries manage by that time to meet the criteria to make Emu viable, the starting date might have to be (temporarily) deferred. But the question of when it happens is surely secondary; the key question is whether it happens at all-and that depends on Germany.
NATIONAL MOTIVES
The core of Europe will move to monetary union if both France and Germany are in favour. There is already a de facto tight currency linkage between Germany, the Netherlands and Austria, with Germany the dominant partner. These countries could move to monetary union immediately, with no fuss, but they would probably only be prepared to do so as part of a wider European agreement. If France joined such a union, the Belgians would want to join too. Not only is Brussels the administrative centre of the EU, but the Fleming and Walloon regions are so mutually antagonistic that Belgium hardly exists any more as a viable nation state-it depends on being part of a larger whole. Similarly, Luxembourg already has a monetary union with Belgium, and is subject to the same kind of pro-federal incentives.
Despite its proud and nationalistic history, and the doubts of the general public revealed in its 1992 referendum, it is clear that France would be in favour of monetary union. The French political elite remains virtually unanimous that this is the best way forward for France (though some doubts may now be emerging). There are three reasons for this. First, it feels that without European union a medium-sized country such as France would fall inexorably behind the rising power of Germany, while a divided Europe would fall behind in competition with the US and the two prospective Asian powers. Second, the French feel that without Emu they pay too high a price for monetary discipline. Since 1983 they have consistently maintained the policy of pegging the French franc to the Deutschmark, as a pre-commitment to achieving the counter-inflationary credibility enjoyed in Germany under the leadership of the Bundesbank. Having maintained this policy despite the ERM debacle in 1992-93, and seen the UK and Italy take the opportunity to lower their interest rates while France itself sought to claw its way back to the currency parity, the French have been reinforced in their belief that the markets do not give them credit for their firmness of policy.
Moreover, they have been made acutely aware that the fundamental decisions on such policies are taken in Frankfurt, and on almost entirely German criteria. Hence the third reason for the enthusiasm of French leaders: Emu would give them a greater role in monetary policy formation. With considerable justification, the French political elite perceives itself as having great ability to manipulate the federal bureaucracies.
The German attitude is more complex. On the one hand the country's leading politicians have been imbued, by the lessons of history, with an appreciation of the need for European unity and of the dangers of rampant nationalism. They are, perhaps, purer and keener federalists than the French, who see Europe as an indirect route to reassert French influence. On the other hand, the Germans have more to lose than most: they have to be reassured that, if they allow Emu to proceed, they will not be giving up their prized stability to become a member of a financially ill-disciplined group. Although Germany ratified the treaty, it may have left itself enough loopholes-both constitutionally and in terms of the convergence criteria-to avoid Emu occurring in the foreseeable future. (Some observers even believe that the German finance ministry has already decided to use the convergence criteria as the means to bury Emu.) Until recently, the Bundesbank had effectively led the Euro-sceptical faction within the German establishment. But now, the widespread public opposition to Emu is causing the political elite to break ranks: witness the recent shift towards a Euro-sceptic view by the Social Democrats. The fact that Germany is putting its dominant position at some risk, and is also the key country without which Emu will fail, gives it enormous bargaining power; hence, for example, the location of the European Monetary Institute in Frankfurt.
So what do the Germans want? Whereas the French see Emu as a necessary step to secure the benefits of European union, the Germans believe that monetary union needs at least to be accompanied, and preferably preceded, by wider political and economic convergence and cohesion within Europe, for example by giving a stronger democratic mandate to European institutions like the Parliament. In that respect they feel that the Maastricht treaty provided only some of the necessary measures to establish a sustainable European union. If the Germans are to dilute their current position of superiority, they will want to mould European institutions-including monetary ones. This has already happened with the European central bank, which was modelled along the lines of the Bundesbank. The Germans are likely to come to the 1996 Inter-Governmental Conference (IGC) with a long shopping list of mainly political measures to strengthen the central European institutions.
That will bring them face to face with the UK. The forthcoming IGC is likely to represent yet another bruising confrontation between the UK and most of the rest of the EU, as the British government attempts to resist the federal initiatives proposed by Germany and widely supported elsewhere. Only if the French and Germans antagonise the smaller European nations by overtly treating the EU as an effective Franco-German duopoly are the British likely to find many allies. And while a future Labour government would, at least initially, be less antagonistic, there can now be little likelihood of a general election before the IGC. So the other countries foresee the need to play the exercise long, to extend the IGC until after the forthcoming UK general election.
Whether Germany succeeds in revising European institutions to its design at the IGC, against likely UK opposition, will be more important in determining whether Emu comes into being than the technical details of the convergence criteria. What this indicates is that the timing, the identity of the member states participating, and even the eventuality of Emu itself remain uncertain.
COSTS AND BENEFITS
If the factors which will determine whether Emu will happen are more political than economic, so too are the criteria by which its success should be judged. Not that there are no tangible, economic benefits-but it is hard to believe that their magnitude will be great.
The most direct of the potential benefits are the removal of transactions costs and of the currency risk premium. If Emu is to boost the community's economic growth, it will be because it removes much of the cost and uncertainty involved in long term, cross border investment. So long as there remain distinct national currencies, whether or not their exchange rates are irrevocably linked, there will still be some transactions costs. These are not trivial; European Commission studies in 1990 assessed them as worth at least 0.5 per cent of European GDP per year. Furthermore, so long as there remain separate currencies, within whatever framework of fixed or semi-fixed exchange rates, national interest rates may still incorporate a premium against potential future realignment. The Commission has optimistically assessed that eliminating this risk premium would be capable of raising incomes in the community significantly-"possibly up to 5-10 per cent in the long run."
Incidentally, even these tangible benefits may prove elusive, thanks to technical difficulties. The treaty mapped out a three-stage process for arriving at Emu. According to this plan, stage three will consist of the "irrevocable" fixing of exchange rates, followed by the adoption of a single currency. This may prove to have been an oversimplification; the latter step is likely to take much longer and may, indeed, never take place at all. To illustrate one aspect of the difficulty involved: the combination in the treaty of the requirement that there be no prior devaluation, with the provision that the ecu value of each national currency is irrevocably fixed at the start of stage three, would seem to force member nations to enter Emu with the basic unit of their national currencies equivalent not just to a vulgar but to a totally barbaric and hideous fraction of an ecu. For example, the ecu central rate for the Irish punt is 0.808628. Normally currency reforms simply shift the decimal point. Not in this case. Trying to change all the paper currency and coins of all the member states into a userfriendly European form is going to be so difficult, so expensive and so wildly unpopular that it could endanger the whole exercise.
The commission has also emphasised the benefits of price stability that would come with the establishment of a European central bank mandated to achieve that objective. This is an odd argument. While an independent central bank might indeed be a good thing, it is not clear why price stability could not be achieved just as well, or better, by individual national central banks within the member states. In sum, the Commission's mammoth study on Emu, "One Market, One Money," which was seen as less than neutral and unprejudiced, did not persuade many independent observers that the quantifiable, tangible benefits of Emu would be large.
Against this some would argue that Emu carries with it the disadvantage that it would prevent a member country from responding to local deflation and impaired competitiveness with a more expansionist monetary policy: lower interest rates and exchange rate devaluation. The counter argument is that monetary expansions and devaluations have only transitory effects on real output, and soon get dissipated in worse inflation. This is a contentious subject; differing schools of thought are still at odds. The UK economy's recovery after exit from the ERM in 1992 is widely held to be a counter example to the view that such policies are ineffective in anything other than the short term.
Many economists have tended to the view that the net balance of purely economic advantages and disadvantages from Emu is quite finely weighted: in principle, those who believe that economies are naturally self-stabilising should perhaps come down in favour of Emu, while the Keynesians and doubters of market efficiency should be more reluctant to abandon national control over demand management. In practice, however, the right-wing monetarists, who tend to believe in self-stabilising forces, are often also nationalistic opponents of Emu; whereas the interventionist Keynesians support it.
BROADER ADVANTAGES
It was always a misapprehension to believe that Emu was to be assessed primarily within a narrow economic calculus. A potentially much more powerful argument, endorsed by most continental economists, is that monetary union is essential not only to extend, but even to maintain the achievements that have already been made to obtain a single market within Europe.
Virtually all economists applaud the single market programme, with free movement of goods and factors of production. Some believe that member countries, such as France, will not leave their economies open to free movement of goods, enterprises and factors of production if they suspect that other countries are trying to obtain an unfair trading advantage-by competitive devaluation. Opponents of Emu argue that flexible exchange rates provide a means of adjusting to external (balance of payments) shocks, and hence should allow a free and open international market to operate better. They argue that, in practice, the North American Free Trade Area (Nafta) negotiations were noticeably free of concern over exchange rates.
Although currency realignments need not impede progress towards a single market, it seems clear that the adoption of a single currency supports free trade and the free movement of labour and capital much more effectively than a regime of pegged but adjustable rates. With a single currency there is the inestimable boon that there are no official data on the balance of trade, or balance of payments, between states. That, by itself, reduces pressures for measures to be taken that benefit the local economy at the expense of the wider federal whole.
A second argument in favour of Emu, from this broader political perspective, is that it may be necessary to the success of any centralised fiscal regime. Fiscal transfers between member states under the auspices of the EU are still quite small relative to fiscal transfers within the member states themselves. But even such as they are-and the Common Agricultural Policy (CAP) is the prime example-these international fiscal systems are extremely difficult to maintain with freely floating exchange rates. Certainly it is hard to imagine any significant extension to the scope of community-wide fiscal transfers without monetary union.
The main reason for this is largely a matter of appearances-though not less important for that. It is that the existence of separate national currencies facilitates the calculation of the net fiscal transfer between member states. It is inevitable then that net national winners and losers will be identified, obscuring the effect that transfers have on different types of individual across the member states. Because the continuation of separate currencies encourages the calculation of benefits and costs in national terms, it exerts a centrifugal force on the member states, causing national politicians to fight for "our money," the juste retour, and so forth.
THE MISSING FISCAL UNION
Why then might Emu not work? In the US the economic costs to the constituent states of giving up control over monetary policy may well be less than in Europe, because the US could be more akin to an "optimal currency area." The cost to any state of not having a separate currency and monetary policy-to the extent that monetary policy is an effective tool in demand management or stabilisation-is that it cannot respond to a shock that affects that state differently from others. If all economic shocks-such as a big increase in the price of oil-are symmetric across a group of states, then the same policy should be followed whether it is promulgated at the federal or the national level. In terms of economic theory, an area in which shocks are broadly symmetric in this way is an optimal currency area.
So: is Europe an optimal currency area? Empirical research on this subject has produced mixed results. It suggests that the inner north-central core of Europe-France, Benelux, and the German trading group-may already be as symmetric as the the US, but that the European periphery-Scandinavia, the British Isles, and the Mediterranean countries-does face more asymmetric shocks, which would continue to require separate policies.
The likely occurrence of asymmetric shocks matters less if markets, particularly labour markets, can adjust quickly and efficiently. Here the US has a clear advantage over Europe: not only are wage structures more flexible, but Americans are more able and willing to migrate across their country to find jobs in expanding economic regions. European housing and employment policies, culture, tradition and, above all, language differences tie us to our home countries. Even within European countries the willingness to migrate is less than it is in the US to move between states. If an adverse shock should hit a European country, the population would be more likely to stagnate in unemployment than to search for jobs in other countries.
In the absence of flexible markets, the effects of asymmetric shocks on inter-state inequalities of income can be mitigated only by redistributional federal taxation, and their effects on cyclical changes in incomes and employment can be lessened by the stabilising properties of fiscal measures. Unlike in the US, virtually all such stabilising and redistributive fiscal functions in the EU are currently undertaken at the national level. If the monetary boundary is changed-replacing national currencies with a single European one-then there are strong arguments for centralising (some of) the fiscal functions of redistribution and stabilisation as well.
Why? First, the ability of national governments to undertake countercyclical fiscal stabilisation will be significantly constrained by the provisions of the treaty which restrict government deficit and indebtedness. Second, national governments may not make the most of their fiscal stance because measures in one country can spill over into neighbouring areas. Some overspills, such as those resulting from a high marginal propensity to import, may make a national or regional authority less fiscally active than desirable. Third, to the extent that the single market promotes greater market flexibility, nationally run fiscal policies may prove increasingly ineffectual. It is already difficult within the EU to impose differential taxes on highly mobile tax bases such as financial transactions, savings or corporate profits. If labour should also become more mobile, it could become difficult to differentiate nationally between benefits to, or taxes on, labour.
Beyond all this there is perhaps a more fundamental argument linking fiscal union to "social union." If the community is to work at all, then there must be some implicit understanding that all members of the union should be treated alike. Assuming that the benefits go to people who are dependent, unemployed, or poor, and that taxes are raised on the usual principles relating to personal expenditure, income, or wealth, then the consequence of social union is that there should be transfers from more prosperous to less prosperous regions (for example, from northern Europe to Mediterranean regions).
Within the EU, however, there is not now-nor in sight-an agreement that all citizens should face broadly the same menu of benefits and taxes. And the federal budget has virtually no redistributive effect. The gross flows are very small relative to national budgets; the form of the expenditures (mainly through the CAP), and of the taxes (mainly through value added tax), are not highly responsive to economic fluctuations; and the EU cannot, by law, run a deficit.
CONCLUSIONS
If the Germans remain committed, and if the French keep their resolve, Emu is likely to happen-in some form. It is most likely that a core group, made up of Germany, France, Benelux, and probably Ireland, will move quickly to monetary union, while the periphery will either opt out, like Denmark and perhaps the UK, or be kept out by a failure to meet the convergence criteria (most or all Mediterranean and Scandinavian countries).
But Emu is likely to proceed, if it does, under the burden of two handicaps that will differentiate it from most other currency unions. First, its labour markets are likely to remain quite rigid, especially geographically. Second, there will be very few, if any, federal fiscal transfers to alleviate any resulting distress. Whereas there were no such transfers to relieve distress in the monetary unions of the 19th century, at least when conditions became too bad at home the unemployed and poor just emigrated. That safety valve is no longer available.
The risk of moving to Emu in these circumstances is that adverse shocks will cause persistent pockets of unemployment. Politicians are then bound to blame it all on the abandonment of national, sovereign control over the key levers of economic policy. A move to Emu in these circumstances could generate a backlash towards an even more aggressive nationalism, even fascism.
On the other hand, a successful evolution to Emu, besides generating greater growth, could lead to a wider acceptance of a multi-layered system of government in which federal, national, regional and municipal authorities each had their respective roles. Such a vision, however, represents a nightmare to Thatcherite Tories.
