Progress toward a European monetary union.

Herve Carre, of the staff of the Commission of the European Communities and currently visiting the Board, and Karen H. Johnson, of the Board's Division of International Finance, prepared this article.

Economic and monetary union has been a longstanding ambition of the European Community. The Heads of State or Government of the member states of the European Community first put it forward as an objective in 1969. Yet only recently has the commitment to economic and monetary union (EMU) been reconfirmed and a strategy for implementing it been defined. In the past three years, important steps have been taken, and negotiations are under way for amending the treaty establishing the European Community (EC) to bring about EMU. The outcome of these negotiations is crucial. If significant progress is made, in a few years the European continent will be very different. While the change would affect European countries primarily, it would have an impact on international economic and monetary relations as well.

This article reviews the progress to date toward European economic and monetary union. The first section provides historical background to the current move, from the signing of the Treaty of Rome (1957) to the 1988 meeting in Hanover of the European Council, which consists of the Heads of State or Government of the EC member states. In Hanover, the European Council gave new impetus to the movement toward EMU. The second section outlines the general design for EMU that was endorsed by eleven of the twelve EC member states before the opening of the present negotiations and that is based on the report issued in 1989 by a group of experts chaired by Jacques Delors, currently president of the EC Commission. The next section addresses the main questions under discussion that remain to be settled, and the last section presents an assessment of the likely prospects for and consequences of EMU.

THE SEARCH FOR A MONETARY IDENTITY

The Treaty of Rome, which established the European Economic Community in 1957 to bring about a closer union of European countries, has no provisions for monetary arrangements. This omission is largely the result of the international context at the time. The currencies of the six initial member states were part of the international monetary system of fixed exchange rates negotiated at Bretton Woods. In the years after the signing of the Treaty of Rome, the main achievements of the EC were the completion of the customs union and the establishment of the first common policy-the Common Agricultural Policy. These steps led to a growing interdependence of the economies of the member states and to an increasing awareness that national policies were becoming less autonomous. Since the inception of the EC, the progress achieved in European integration and the changes in the international environment have led to attempts to establish a European monetary identity, a concept that finds its fullest expression in the term "economic and monetary union."

The Werner Plan

In 1969, acknowledging that closer coordination and even harmonization of economic and monetary policies were necessary, the Heads of State or Government expressed their wish to see the Community develop into an economic and monetary union through the implementation of a phased plan. A group of experts chaired by Pierre Werner, then Prime Minister of Luxembourg, prepared the plan, which was endorsed in 1971. Accordingly, procedures for strengthening the coordination of economic policies were introduced; an agreement was reached on narrowing margins of fluctuation of the Community currencies (the "snake"); and the European Monetary Cooperation Fund (EMCF) was established as the intended forerunner of a Community system of central banks. But the movement soon ran out of steam. The new coordination procedures became primarily a matter of form, the snake rapidly lost its Community character when many countries chose to withdraw their currencies, and the EMCF never assumed more than accounting functions. The process of monetary integration could not proceed because countries could not agree on policies in response to the shocks of the period: the oil crisis and the collapse of the Bretton Woods monetary system. Not until the end of the 1970s did the Community definitely establish the base for more lasting monetary integration by setting up the European Monetary System.

The European Monetary System

A system of stable but adjustable exchange rates, the European Monetary System (EMS), was established in 1979 to create a zone of monetary stability in Europe. Based on an agreement among central banks, the EMS has three main features: the ECU, which is at the center of the system; an exchange rate and intervention mechanism, designed to ensure the stability of Community currencies; and credit mechanisms that organize financial support among the participating countries (see box 1).[1]

In the twelve years of its existence, the EMS has achieved its main objective of lowering rates of inflation.[2] As a result, it has helped to reduce the variability of real exchange rates among the participating currencies and to narrow interest rate differentials. Closer coordination of the economic policies implemented by the EC member states has resulted in observed convergence of their economic performances. By providing a basis for multilateral surveillance within the Community, the EMS has contributed to this improved policy coordination. However, inflation rates have also declined in many industrial countries that are not in the EMS, and the extent to which the EMS has contributed to lowering inflation has been widely debated.[3]

The Single European Act

The perceived success of the EMS has contributed to further progress in European integration. The Single European Act, which was signed in 1986, was the first major revision of the Treaty of Rome. It reaffirmed old objectives and established additional ones, such as the achievement of the single market, the strengthening of economic and social cohesion, and the gradual realization of EMU. It also set the end of 1992 as a deadline for completion of the single market and proposed new methods of operation, such as extending the scope for the Council to vote by qualified majority rather than requiring unanimity and introducing systematic arrangements for mutual recognition by each member state of other members' standards and regulations.[4] However, the prospect of completion by the end of 1992 of the single market soon appeared to be a challenge for the current economic and monetary arrangements. A unified financial market in which capital flows, including speculative flows, were unimpeded might make keeping exchange rates fixed, as required by the EMS, impossible. Moreover, even when persons and goods can move freely within a single market, exchange rates will remain as barriers to trade. For these reasons, a single market would benefit from having a single currency. According to a 1989 business survey conducted by Ernst and Young for the EC Commission, opinions on the prospects for the business climate become much more positive when a single currency complements the single market. EMU thus appears to be the economic and monetary backbone for the success of the Community wide internal market.

The march toward EMU resumed in 1988 when, at its meeting in Hanover, the European Council entrusted to a committee chaired by Delors the task of studying economic and monetary union and preparing concrete stages leading toward this goal. The committee, which included representatives from the central banks of the member countries plus several experts, presented its report in April 1989.

THE GENERAL DESIGN OF ENU

The Delors Committee report is a unanimously agreed-upon statement of the goal of economic and monetary union and the means for achieving it.

The Goal

The Delors Committee report proposes a framework for EMU and identifies the essential elements of such a union. Three conditions used to define monetary union are the following:

1. The total and irreversible convertibility of currencies

2. The complete liberalization of capital transactions and fuR integration of banking and financial markets

3. The elimination of margins of fluctuation and the irrevocable locking of exchange rate parities.

This definition, which originated in the Werner plan, has important implications for monetary policy. As soon as exchange rates are irrevocably locked and perceived to be so, with perfect capital mobility, there can be only one interest rate for assets of the same maturity and risk for all participants, whatever the currency denomination of the assets. Thus, the irrevocable fixing of exchange rates implies the same structure of interest rates across the union. But exchange rates will be considered irrevocably fixed only if all monetary authorities within the Community guarantee without limit the conversion of any currency of the system into another at the fixed rate. Such a guarantee requires giving the responsibility for monetary policy to a single institution, since without this provision any money created by a national monetary authority would spill over throughout the union; the other member states would be unable to shelter themselves from its consequences. Thus, for practical purposes monetary union implies a single monetary policy.

The definition of economic union is less clear-cut because such union involves a wide array of measures relating to different fields. The Delors Committee report describes economic union in terms of four basic elements:

1. A single market within which persons, goods, services, and capital move freely

2. A rigorous competition policy and other measures aimed at strengthening market mechanisms

3. Common policies aimed at structural change and regional development

4. A close coordination of economic policies, including binding rules for budgetary policies.

This definition has less sweeping consequences than does the one for monetary union. A single economic policy is not necessary for economic union as a single monetary policy is for monetary union; and, correspondingly, there is not the same need for institutional change. However, some harmonization of a basic set of regulations and procedures-for example, for tax rates and financial services-is necessary. Completion of the single market would lead to a lower degree of market integration in the EC than that in other existing federations. Capital mobility across countries can be expected to be almost perfect; but the integration of the markets for goods and nonfinancial services can be expected to increase only slowly, and labor mobility is bound to remain limited because of cultural and linguistic barriers. In addition, because the Community budget amounts to only some 2 percent of total EC government expenditures, its distribution and its stabilization functions cannot be compared with those of central government budgets that represent between 45 percent and 65 percent of total public expenditures in such federal states as the United States, Canada, and Germany. If asymmetric shocks affected real economic conditions in the EC member states, other adjustment mechanisms would have to function as stabilizers in the place of a central EC budget; if aggregate fiscal policy measures were required, most of them would have to be implemented through coordination of economic policies among member states.

Stages of EMU

The Delors Committee report specifies a method and a sequence of steps for implementing movement to EMU. The report proposes three stages:

1. Stage one involves the completion of the single market, the strengthening of economic and monetary policy coordination, and the negotiation and ratification of the treaty amendments needed to establish EMU. In particular, the Committee of Central Bank Governors would have more authority and a higher profile. The Committee's policy recommendations to the Council and to the monetary authorities would be made public. Coordination procedures based on multilateral surveillance would also have to be reinforced, so that member states would enter into reciprocal commitments.

2. Stage two, which would include entry into force of the new treaty, would be the transition period for the new institutional arrangement. A European System of Central Banks (ESCB) would be established. The ESCB would design and test the operational framework for formulating and applying a common monetary policy. On the economic front, medium-term guidelines would need to be drawn up for the main macroeconomic variables, and surveillance procedures would be made more stringent and more efficient.

3. Stage three would start with the irrevocable fixing of exchange rates and would involve the transfer of powers necessary for administering economic and monetary union. The European System of Central Banks would be in charge of the single monetary policy, and a single currency would replace the national currencies. On the economic side, rules and procedures would become binding.

In defining a method for moving toward EMU, the report makes several recommendations. No timetable is laid down, although the report suggested that stage one should get under way at the latest by July 1, 1990, that is, the date of implementing the liberalization of capital movements according to the single market program. The report stresses parallelism in the development of economic and monetary integration. Also, the report accepts the idea of flexible arrangements for participation. Although accession of all twelve member states to the new treaty is the preferred option, the proposal allows a degree of flexibility concerning the date and conditions under which different countries would join various arrangements. Finally, the report states that the realization of EMU must be seen as one process. The decision to embark on stage one implies the acceptance of the entire process and, hence, the prospect of negotiations on a new treaty. Preparatory work for these negotiations therefore should take place at the same time as work on launching stage one.

The general approach to EMU set forth in the Delors Committee report was well received by the European Council. In June 1989, the European Council decided that stage one would start on July 1, 1990, and gave instructions to begin preparatory work for an intergovernmental conference, the forum for negotiations on a treaty revision. Most of the preconditions for stage one were met ahead of the deadline, and stage one began as scheduled.

Costs and Benefits of EMU

Acceptance of the Delors plan for proceeding to monetary union was accompanied by efforts of the EC authorities and other analysts to estimate the expected costs and benefits of EMU. According to Robert A. Mundell's seminal contribution to the literature on "optimum currency areas," the judgment on the formation of a monetary area depends on balancing two factors:

1. Monetary union, especially with a single currency, provides benefits by eliminating transaction costs and the uncertainty associated with exchange rate variability.

2. If labor and capital cannot move freely among the regions of the union, adjustment to some kinds of economic shocks, without changes in the nominal exchange rates of the regions, will lead to unemployment and lost output.[5]

On this basis, the overall cost-benefit balance of EMU may be uncertain because labor mobility in the Community is limited and is bound to remain limited at least for a time. Direct examination of the criteria for an optimum currency area for the EC member countries suggests that regional problems are likely. Compared with the U.S. economy, the EC member states show significantly lower labor mobility; have experienced to a greater degree economic shocks that have affected the constituent regions asymmetrically; and, as a result, have relied far more on adjustment of real exchange rates across regions.[6]

The analysis of the costs and benefits of monetary union has been extended to include other considerations. In particular, some analysts have argued that the openness and the industrial diversification of the economies concerned are important criteria that need to be taken into account. The larger the volume of interregional trade, the greater are the cost savings stemming from a monetary union that links the regions.[7] Changes in exchange rates to help sustain economic performance are less critical in a diversified industrial economy, with more intra-industry trade, than in a more specialized economy.[8] In addition, recent developments in the theory of economic growth point to dynamic gains, potentially much greater than the direct gains associated with the elimination of transaction costs and more stable exchange rates. These gains would result from an improvement in the business climate that leads to a self-reinforcing cycle of stronger growth.[9]

In 1990, the EC Commission staff published its evaluation of the potential benefits and costs of forming an economic and monetary union. On balance, the Commission staff found that EMU benefits are likely to outweigh the costs (see box 2).

However, the present move toward EMU is essentially politically driven and is accompanied by parallel negotiations aimed at European Political Union. Since the Delors Committee report was published, EMU has gained fresh momentum with each European Council meeting. At the Madrid meeting in June 1989, the European Council set the date for the start of stage one; at the Strasbourg and Dublin meetings, in December 1989 and June 1990 respectively, it adopted a timetable for the Intergovernmental Conference and for ratification of its conclusions; and at the Rome meeting in October 1990, it set January 1, 1994, as the date for the beginning of stage two, with agreement also reached among eleven of the twelve member states on an overall design for EMU closely modeled on that set out in the Delors Committee report.

The Agreed upon Design of EMU

Using this overall design, negotiators at the intergovernmental conference have addressed the specific details of EMU. As agreed at Rome, monetary union will be fully realized only with the adoption of a single currency, a strong and stable ECU. A single currency means a single monetary policy, formulated and implemented by a new Community institution, the European System of Central Banks. According to the draft statute for the ESCB, which was prepared by the Committee of Central Bank Governors and which has been broadly endorsed by the negotiators, the ESCB will have price stability as its overriding objective; subject to that objective, it will support the general economic policy set at the Community level.

The ESCB will also have a federal structure, but decisionmaking will be centralized. A two-tier system will be established, consisting of the existing national central banks and a new central institution, the European Central Bank (ECB). The national central banks wiU form an integral part of the System and will have to act in accordance with the instructions and guidelines of the ECB. The function of the ECB will be to ensure the implementation of the tasks of the System, either through its own activities or through the activities of the national central banks. The decisionmaking bodies of the whole System will be the ECB Council and the Executive Board of the ECB. The ECB Council will be responsible for formulating the Community's monetary policy; it will be composed of the President, the other members of the Executive Board, and the governors of the national central banks. Each member of the ECB Council will have a vote; this principle of "one person, one vote" reflects the desire to orient the decisionmaking process toward the requirements of the Community as a whole rather than toward regional concerns. The Executive Board will be in charge of implementing monetary policy and will be composed of the President and a few other members, all selected from among persons of recognized standing and professional experience.

The draft statute also mandates that the ESCB will be independent. Empirical research has established a strong link between the independence of a central bank and its performance in terms of price stability.[10] There are four major elements of this independence. First, institutional independence: The ECB, the national central banks, and the members of their decisionmaking bodies will be independent of instructions from political authorities or any other bodies; national legislation will have to be changed in countries where the central bank is not currently independent to satisfy this condition. Second, operational independence: The System will have full availability of the necessary instruments of monetary policy. Third, personal independence: The members of the decisionmaking bodies will be appointed for long terms of office, and the appointments will be irrevocable. Fourth, financial independence: The System will enjoy financial autonomy.

Finally, the statute calls for the ESCB to be democratically accountable. The System will be established by a treaty, which will have to be approved by member states and ratified by national parliaments. The treaty will clearly delineate the tasks of the System and the responsibilities of the decisionmaking bodies. The President and the other members of the Executive Board will be appointed by the political authorities (the European Council) after consultation with the European Parliament. The President of the ECB will be responsible for reporting regularly on monetary policy and explaining it to the other institutions, including the European Parliament. Furthermore, to ensure transparency and consistency, the President of the Council and a member of the Commission will have the right to participate-but not to vote-in the meetings of the ECB Council.

These features are drawn from two existing models, the U.S. Federal Reserve System and the German Bundesbank. The ESCB differs from the Federal Reserve System and resembles the Bundesbank in the following provisions:

Objective. The proposed ESCB will have a statutory mandate to aim at an overriding objective-price stability. Other economic objectives will clearly have a subordinate character. The Federal Reserve currently has no such statutory mandate; the Bundesbank does.

Decisionmaking Process. The design of the ECB Council is close to that of the Federal Open Market Committee (FOMC) of the Federal Reserve System as the governors of the national central banks plus the members of the Executive Board sit on the ECB Council whereas the District Bank presidents and members of the Board compose the FOMC. The functions of the ECB Council-decisions relating to monetary targets, key interest rates, and the supply of reserves-will be similar to those of the FOMC. However, all of the national bank governors vote on all ECB policy decisions in contrast to the FOMC, on which only five of the twelve presidents vote at any time. As a result, the ECB procedure in giving more weight to the regional representatives than does that of the FOMC resembles more closely Bundesbank practice.

Accountability. No provision currently exists in the Federal Reserve Act for the participation of representatives of the Administration in the deliberations of the governing body. This is a distinctive feature taken from the Bundesbank law.

Within EMU, economic policies, in contrast to monetary policy, would remain largely decentralized. However, economic policies of the member states will need to be consistent across countries and with Community monetary policy. A large consensus has formed about the framework for coordination. Multiyear guidelines, defined at the Community level, would provide the point of reference for multilateral surveillance. The surveillance exercises would be designed to detect at an early stage any signs that member states are diverging from sound economic policies and to induce necessary corrections. Most member states also agree with the Commission that a scheme for special financial support should be established; such a scheme would be highly conditional and would be activated only when one member state or several states were hit by major economic problems. These instruments are aimed at achieving the high degree of convergence of economic performance that a monetary union implies. In this respect, fiscal policies deserve particular attention because increasing fiscal imbalances could make achieving the goal of price stability more difficult, if not impossible. Hence, all twelve member states agree on the need for two binding rules to be included in the treaty: no financing of public deficits by credits from the ESCB or preferential market access for the public authorities with a view to the placing of public debt; and no automatic bailing out of a member state in financial difficulties by the Community or by the other member states.

The member states also agree that excessive budget deficits that are liable to endanger the monetary stability of the union should be avoided. This principle will be laid down in the treaty, but the arrangements for applying it are still under discussion.

THE REMAINING QUESTIONS

On the basis of this broad consensus, the Intergovernmental Conference opened in December 1990. Since then, negotiations have been under way to settle the remaining open questions. Four issues of particular importance have not yet been clearly resolved: the role of the ECU, the transition, exchange rate policy, and the necessary fiscal discipline.

The ECU

At the European Council in Rome, eleven member states agreed that "the Community will have a single currency-a strong and stable ECU-which will be an expression of its identity and unity. " However, this agreement leaves open the question of how to transform the present ECU, a composite currency, into the strong and stable currency of the union. So far, three approaches have been proposed.

The Hard ECU. This plan, proposed by the British, calls for a parallel currency that would compete with national currencies and be managed according to its own criteria. This idea is a variant of the competing currencies scheme presented by the U.K. government in November 1989 as an alternative, market-based strategy for the design of monetary arrangements in Europe-a plan that did not find support from the other eleven member countries." Because the hard ECU would be a parallel currency, this plan is strongly opposed by those who argue that it would further complicate the already difficult task of coordinating various monetary policies and would involve an additional source of money creation that could undermine price stability. [12] Furthermore, the result of the scheme is uncertain; a single currency is presented as one possible culmination of a long and uncertain process essentially driven by market forces. Thus, the plan is also opposed by those who favor the single currency.

The Hard Basket ECU. This alternative allows the ECU to retain its composite nature until the locking of exchange rates. At each realignment, however, the basket would be modified so that the ECU could not lose value against any of the System's currencies. Presented as a compromise solution, this proposal has given rise to some objections. First, it overturns the rules under which the present System operates. Because each realignment would lead to a new composition of the ECU, any strain in the EMS would lead operators to expect a modification of the basket, thus increasing the risks involved in the use of the ECU. Second, this scheme would eventually lead to a parallel currency. Because of the exchange rate guarantee conferred on the ECU, its medium-and long-term interest rates would differ from the theoretical rates derived from the interest rates of the component currencies. As a result, the arbitrage of banking operators would be greatly complicated, and the ECU would eventually have to be managed by an institution.

A Comprehensive Policy of Strengthening the ECU. This plan seeks to increase the use of the present ECU and includes a proposal to freeze the composition of the ECU, that is, to fix the amounts of the component currencies. The freeze would allow the relative weight of the component currencies to evolve over time: The weights of the appreciating currencies would rise while the weights of the depreciating currencies would fall. Thus the value of the ECU would tend toward that of the strongest currencies in the system. This proposal is the one most favored by market operators because not only would it remove the uncertainty that surrounds the ECU market every five years as the date for a basket revision approaches, it also would avoid any danger of discontinuity between the present ECU and the single currency of the union.

The Transition

Stage two, the transitional stage of the Delors Committee report, was not thoroughly defined. The report states that "the fundamental difficulty inherent in this transition would lie in the organization of a gradual transfer of decisionmaking power from national authorities to a Community institution," but it does not propose any detailed blueprint for accomplishing this transition. However, the whole idea of a progressive transfer of responsibilities in the field of monetary policy was revised. It is now recognized that monetary policy is indivisible, and that the decisionmaking power in this area cannot be split.

This change in conception had immediate consequences. The nature of stage two had to be redefined-either as an extension of stage one or as a forerunner of stage three-and the discussion has focused on the degree of convergence of economic performance by the member states that would be required before irrevocably fixing exchange rate parities. Two traditionally conflicting views are relevant to the discussion.

At one extreme is the so-called coronation theory, according to which the passage to a higher stage of monetary integration should only ratify (or "crown") the convergence that has already been achieved. The arguments used to support this position differ. Some take the view that given the existing wide differences in levels of economic welfare, premature fixing of exchange rates would lead to political pressures, not only for increased budgetary transfers from richer to poorer regions, but also for easier monetary policy to promote growth. Others argue that an early fixing of exchange rate parities would aggravate regional disparities and impart a deflationary bias to the monetary union. At the other extreme, the so-called monetarist school holds that convergence could always be achieved through adherence to exchange rate commitments, which could therefore be taken without any preceding convergence.

The experience of the EMS suggests that neither of the two extreme positions should be adopted. While the convergence by member countries to low inflation rates is widely acknowledged as the main achievement of the EMS (see the chart), the strains the EMS experienced in the first years of its existence, when realignments were frequent, also illustrate the difficulties that can arise when convergence is insufficient.

Those, especially the Commission, who advocate a short transition have advanced further arguments. First, the period ahead involves risks of instability, because financial integration will be achieved before the completion of monetary union. The integration of financial markets will facilitate currency substitution and financial mobility to such an extent that the present degree of monetary policy coordination may no longer be adequate. Second, EMU will yield its most important benefits only during the final stage, whereas most of the costs will be incurred in the preparatory stages of the process. Third, an economic case also exists for setting fixed and credible timetables to foster convergence and encourage anticipatory adjustments. Fourth, the process of convergence has already advanced in recent years, and further progress can be expected as a result of the new arrangements adopted as preparation for stage one.

The difficulties of the discussion have been compounded by the emergence of a third option, the so-called two-speed Europe, under which an inner core of countries would move rapidly to full EMU while the remaining countries would join later. Those member states who advocate a long transition have strongly criticized this option. They fear that the inner core countries could make decisions that would shape the future of the Community, and they do not want to be outsiders. As a matter of fact, most of the progress made in European unification has been achieved through a "multi-speed" process. The EMS is an example of this approach in that eight countries currently participate in the narrow band of the exchange rate mechanism (ERM), two countries have joined only recently and utilize a wider band, and two others have not yet joined the ERM. The liberalization of capital movements, with four countries maintaining restrictions while the other eight have implemented free movement of capital, provides another example. To a large extent, the drawbacks of this two-speed option seem to have been exaggerated during the discussion. The crux of the matter is to design open arrangements, that is, arrangements that allow every member state to participate and that provide for a certain degree of flexibilily concerning the timing and conditions under which some member states would participate.

The issue of convergence remains unresolved and calls for a political answer. Building on the consensus reached in Rome last year, negotiators recently agreed that while it is clear that EMU needs a considerable degree of convergence of real and financial economic conditions in the member states, the important question may be how to achieve this degree of convergence. All member states appear to have decided to adopt, as soon as possible, medium-term adjustment programs specifically designed to reduce existing divergences. With this provision, convergence criteria will have to be met before the move to stage three but not before the move to stage two. Also, a compromise agreement seems to have been reached on the conditions for participating in stage three, according to which no country could prevent its partners from establishing a single currency if they had met certain convergence criteria; no country that had met those criteria could be excluded; and no country could be compelled to join.

Exchange Rate Policy

Which institution should have the responsibility for external monetary relations has long been a matter for extensive discussions within the member states. There are two opposing schools of thought. One side argues that since the exchange rate is an important instrument of economic policy, it should be managed by the political authorities. Those who take this view underline the fact that, after monetary union, the exchange rate policy of the Community will have important consequences for other countries and, therefore, cannot be separated from broader political issues. The other side holds that, because an exchange rate policy may conflict with a domestic monetary policy geared to price stability, it should be the responsibility of the central bank; they consider that all decisions on intervention should be assigned to the ESCB, because full responsibility in this field is a necessary condition for the conduct of a monetary policy oriented toward stability.

In an attempt to reconcile these conflicting views, the Commission has suggested a distinction among three levels of decisionmaking, and an allocation of responsibilities for each level:

1. At the highest level, policymakers choose the exchange rate regime and negotiate international monetary agreements. These activities should clearly be a matter for political authorities, assisted by the ESCB-as is the case now in all countries.

2. At the lowest level, interventions are transacted in the foreign exchange markets, and the daily management of foreign exchange reserves occurs. These activities should be a matter for the ESCB.

3. At the intermediate level, policymakers must decide upon exchange rate and intervention policy-decisionmaking that is the core of the problem. Acknowledging that the exchange rate is an important element of both monetary policy and external economic policy, the Commission has suggested a structure for organizing the dialogue necessary for resolving potential conflicts. It has proposed that exchange rate policy should be defined in a framework of close cooperation between the monetary authority and the economic policymakers and should follow some basic principles, especially that foreign exchange interventions vis-a-vis third currencies should not conflict with the overriding objective of monetary policy. This "cooperative solution" is the basis of the present negotiations.

Budgetary Discipline

Budgetary discipline is a concern for the monetary authorities because fiscal policy and monetary policy are interdependent in the long run. If not corrected, protracted deficits leading to unsustainable buildups of outstanding public debt result either in debt monetization or government default. In the first case, the monetary authorities give up their objective of price stability in order to rescue the government. In the second, they stick to their objective, but force the government to repudiate part of its debt.

Even in less extreme cases, a lack of fiscal discipline in one or more member states could jeopardize the policy stance of the ESCB and affect the other member states through three channels. The first would be pressuring the ESCB to ease its monetary policy stance. Even if monetary policy is legally insulated from government pressures, the very fact that a refusal by the ESCB to ease its stance could turn a difficult budgetary situation into a genuine financial crisis acts as a de facto constraint on the central bank. Second, even if the ESCB sticks to its stance, persistent budgetary laxity in one country could affect the other countries because this country eventually would have either to declare default or to withdraw from the EMU. The credibility of EMU would be weakened. Finally, the ESCB could also be subject to pressures to engage in other forms of financial solidarity, such as the purchase of a disproportionate share of bonds issued by a specific country; the consequences of the lack of budgetary discipline would then be felt in the overall market for government paper.

This is why, in considering the framework for EMU, large deficits and debts are a matter of concern for the Community as a whole. Budgetary discipline, defined as the avoidance of an unsustainable buildup of public debt, is a vital condition for the success of EMU. The nature of the rules and procedures that should be enshrined in the Treaty to avoid excessive deficits is therefore being extensively discussed.

It has been argued that no special provision or quantitative rule should be mentioned in the Treaty provided that the central bank is granted complete independence and is fully sheltered from government pressures; any form of financial solidarity among member states is ruled out; and existing regulations, especially prudential rules, are modified to correct any bias in favor of government paper. 13 Under these conditions, it is maintained, markets would assess the relative riskiness of various governments' paper, and a lack of discipline would result in an increased cost of borrowing.

The conditions necessary for such a system of market discipline to succeed, however, are rather strict and may not be met. First, expecting markets to rule out financial solidarity when solidarity itself is a basic principle of the Community may not be realistic. Second, the record of markets in assessing risks is not perfect, as illustrated by the 1975 New York City liquidity crisis and the Latin American debt crisis. Third, governments may not react adequately to market signals. Therefore many analysts doubt that market discipline alone would achieve the desired results. Thus, negotiators have agreed to supplement market discipline by a system of rules. As mentioned in the previous section, the principle that excessive deficits shall be avoided will be included in the amended treaty. The negotiations are currently addressing the question of what criteria should be used in defining excessive deficits and what ways are appropriate for enforcing the principle. It is already agreed that peer pressure, possibly in the form of public recommendations, would promote discipline. Whether procedures providing for sanctions should be developed is still under discussion.

CONSEQUENCES AND PROSPECTS

The impact of EMU will not be limited to just the European countries. The consequences of monetary union in Europe and the emergence of the ECU as a major currency are likely to be felt in the international financial markets and in nonEuropean countries, including the United States.

Implications of EMU for the International Financial System

Completion of EMU and conversion by some or all of the EC member countries to the use of the ECU are likely to affect the international use of the dollar, the ECU, and other currencies by holders of official reserves and by private firms and individuals. Changes in currency demands could, in turn, affect the behavior of exchange rates.

International Role of the ECU. The emergence of the ECU as the single currency for a more integrated EC economy would naturally tend to make that currency suitable as a reserve asset to be held for official purposes by countries outside the EC. Once the ECU has become established as the EC currency and various ECU-denominated securities are widely traded on international capital markets, officials in other countries may choose to diversify their official reserve holdings to include ECU balances. Such a response is particularly likely among the countries of Europe that are not EC members, where trade and investment links to EC member countries are strong, and among countries that currently peg to an EC currency or to the present ECU basket, such as Austria and the non-EC Scandinavian countries.

The move toward the ECU as the single EC currency would also affect the official reserve holdings of the participating countries. Although the precise arrangements that will govern the treatment of international reserve assets held by EC countries have not yet been decided, some consolidation of these balances is likely. The EC countries would, of course, no longer hold each others' currencies as reserves. Pooling of the reserve balances held by EC countries may permit some economizing on reserves, including dollar reserves.

As the currency of a major part of the industrial world, the ECU would come to be widely used in international transactions of all kinds. EC firms, when dealing with firms in other parts of the world, may choose to use the ECU for transaction, accounting, and investment purposes to a greater extent than they now use European currencies. Firms from non-EC countries may use the ECU when dealing with EC firms and, over time, may find it convenient to use the ECU even in trades that do not involve EC enterprises.

The further development of integrated financial markets in Europe, as part of the internal market spawned by the Single European Act, and the introduction of a single currency should reinforce each other. The switch to a single currency would facilitate the provision of banking, investment, and other financial services on a European-wide basis. Conversely, a broadening and deepening of banking and capital markets for various ECU-denominated financial instruments would aid the emergence of the ECU as a major world currency.

Behavior of Exchange Rates. The switch to a single European currency would completely eliminate the possibility of exchange rate changes among the European currencies. As a consequence, exchange rate movements within Europe would not be able to contribute to the adjustment of the national economies to developments such as changes in world off prices or cyclical swings in the economies of trading partners. When such events occur after EMU, fluctuation of the ECU against the currencies of the rest of the world, such as the dollar or yen, might be greater than we now observe in such instances for a European currency like the German mark. After EMU, more of the adjustment process must occur through changed dollar or yen rates than is currently the case.

Counteracting the tendency for increased exchange rate variability after the move to EMU is the convergence of economic performance among the EC countries that we have already seen and that can be expected to continue once monetary union is established. The success of the EMS during the past few years in accommodating such events as the Gulf War and the resulting oil price fluctuations and the recession in the United States without realignment among EMS currencies suggests an increasingly similar response within the EC economics to such developments. In that case, there may be no need for greater variability of the exchange rate of the ECU in terms of the dollar or other currencies than now occurs in order to accommodate adjustment.

International Policy Coordination. Creation of the ESCB and a single monetary policy for the EC may have implications for the representation of EC countries in international institutions such as the International Monetary Fund and the Bank for International Settlements, and at meetings such as those now conducted by the G-7 finance ministers and central bank governors. EC governments have not yet determined the details of how representation of their countries might be changed by monetary union, but the ESCB would participate in international meetings and the European position would be more homogenous.

A unified European approach to monetary policy could contribute to the present tendency for international coordination of economic policy, including perhaps exchange rate policy, to become a tri-polar effort among the United States, Japan, and Europe. Simplification of the coordination process may facilitate reaching agreement under some circumstances, although the United States could at times find its leadership role challenged as well.

Implications of EMU for the United States

The role of the dollar in international transactions may be reduced in a relative sense by the emergence of the ECU as a major world currency. However, the impact of this development on the U.S. economy is likely to be gradual and minimal. On balance, the U. S. economy would benefit from a stronger, less inflationary economic performance by one of its major trading partners.

The asymmetric role of the dollar and of the United States in the international financial system is likely to be reduced further by the establishment of monetary union and a single currency in Europe. The EC countries and others may lower their official holdings of dollar reserves, and the use of the dollar as a vehicle currency in international transactions may continue to wane. These developments are already occurring to some extent as the economies of Japan, Germany, and other major industrial countries continue to grow, and their currencies become more important in world financial markets. Even if EMU had not been proposed, the dollar would continue to move toward a somewhat reduced international role relative to the mark, the yen, and the other major currencies. The tendency for the international role of the dollar to shrink, at least in relative terms, as the ECU becomes more important is likely to have little impact on U.S. interest rates and on dollar exchange rates.

U.S. firms doing business in Europe would benefit along with European firms from the reduced transaction costs and the elimination of exchange rate risk that would result from the introduction of a single currency. They would benefit as well from any strengthening of economic growth and expansion of trade that EMU would help to support, provided EC markets remain genuinely open to international trade. On balance, a stronger, more efficient European economy means better markets for U.S. goods. If, as intended, EMU contributes to creating a low-inflation, growth-oriented, and open economy in Europe, its benefits would be felt in Europe, the United States, and throughout the world.

Outlook for EMU

Given their implications, the remaining issues that have been reviewed in the previous section leave ample scope for further discussion. Predicting the moment when they will be solved is difficult. However, these issues are more political than technical in nature, and there is no reason to expect that the political momentum that has motivated and accompanied the recent revival of the move to EMU will be lost. The drive toward EMU has already accommodated important shocks such as German reunification and the Gulf crisis. In these circumstances, EMU might well be a reality in Europe by the end of this decade.

1. Under the current arrangements, the ECU or European currency unit, is a "basket" or composite currency. In the final stage of EMU, plans call for the ECU to cease to be a basket currency and to become a currency in its own right.

2. Susan Collins, "Inflation and the European Monetary System," in Francesco Giavazzi, Stefano Micossi, and Marcus Miller, eds., The European Monetary System (New York: Cambridge University Press, 1988), pp. 112-39.

3. Charles Goodhart, "Economists' Perspectives on the EMS," Journal of Monelary Economics, vol. 26 (December 1990), pp. 471-87.

4. The Council, which consists of minister representatives of the EC member governments, enacts legislation proposed by the Commission. Participants at Council meetings change on the basis of the subject being considered.

5. Robert A. Mundell, "A Theory of Optimum Currency Areas," American Economic Review, vol. 51 (September 1961), pp. 657-65.

6. Barry Eichengreen, "Is Europe an Optimum Currency Area?" Working Paper 3579 (Cambridge, Mass.: National Bureau of Economic Research, 1991).

7. Ronald 1. McKinnon, "Optimum Currency Areas," American Economic Review, vol. 53 (September 1%3), pp. 717-25.

8. Peter Kenen, "The Theory of Optimum Currency Areas: An Eclectic View," in Robert A. Mundell and Alexander Swoboda, eds., Monetary Problems in the International Economy (Chicago: University of Chicago Press, 1969).

9. R. Baldwin, "The Growth Effects of 1992," Economic Policy (October 1989), pp. 248-81; R. Baldwin and R. Lyons, "External Economies and European Integration: The Potential for Self-fulfilling Expectations," in European Economy: The Economics of EMU, special issue.

10. A. Alesina, "Politics and Business Cycles in Industrial Democracies," Economic Policy (August 1989), pp. 57-89.

11. Guido Carli, "The Evolution towards Economic and Monetary Union: A Response to the HM Treasury Paper" (paper presented to the Council, December 1989). An edited version, "Co-ordination, not competition," was published in the Financial Times (London), January 17, 1990.

12. Karl Otto Pohl, "The Further Developments of the EMS," Annex to the Report on Economic and Monetary Union in the European Community (Delors Committee report) (Luxembourg: Office for Official Publications of the European Communities, 1989), pp. 129-56.

13. Graham Bishop, "Creating an EC Monetary Union with Binding Market Rules," European Business Analysis (London: Salomon Brothers, February 22, 1990). 1. The Main Features of the European Monetary System

The ECU. The ECU is a composite currency made up of fixed amounts of all member states' currencies, which are weighted to take account of each country's gross domestic product and importance in intraCommunity trade. The composition of the ECU is revised every five years. The current amounts of national currency, the sum of which is defined to be one ECU, are the following:

Belgian frac                            3.301
Danish krone                             .1976
German mark                              .6242
Greek drachma                           1.440
Spanish peseta                          6.885
French franc                            1.332
Irish pound                              .008552
Italian lira                          151.8
Luxembourg franc                         .130
Dutch guilder                            .2198
Portuguese escudo                       1.393
Pound sterling                           .08794

The value of one ECU in terms of any currency is equal to the sum of these amounts expressed in that currency.

In the EMS, the ECU's main functions are as numeraire for setting central rates in the exchange rate mechanism, as the unit of account for operations under the intervention and the credit mechanisms, and as a reserve instrument and means of settlement among EMS central banks. For this purpose, the European Monetary Cooperation Fund provides an allocation of ECUs against the deposit of 20 percent of the gold and dollar reserves held by the participating central banks.

The Exchange Rate and Intervention Mechanism. Central rates in ECUs are set for the currencies of those countries participating in the exchange rate mechanism (ERM), and they are used to establish a grid of bilateral central rates. Fluctuation margins, established around the bilateral central rates (usually 2.25 percent), determine the limits or intervention points. When a currency reaches a limit, the two central banks concerned must intervene in the market to ensure that the limit is not exceeded. Currently, aU the EC countries except Portugal and Greece participate m the ERM.

Changes in the central rates are always possible, but the decision can never be a unilateral one. Realignment by common accord is a fundamental EMS rule; it constitutes a guarantee against competitive devaluation and represents a commitment by all the participants to the parity grid.

The Credit Mechanisms. A member state can obtain credit through three mechanisms. Very-short-term financing is available in unlimited amounts to finance interventions at the limits. A system of short-term monetary support among the member countries is designed to meet financing needs stemming from temporary deficits in the balance of payments. Medium-term financial assistance is available in the form of loans to member states that are experiencing or are seriously threatened by difficulties m their balance of payments. A member state may avail itself of all these facilities in tam. Their combined availability increases the credibility of the EMS.

2. The Main Benefits and Costs of EMU

The Commission of the European Communities recently completed an analysis of the main benefits and costs of forming EMU. The following statement, which is quoted from that study, groups the benefits and costs under five headings: [1]

(i) Efficiency and Growth. Elimination of exchange rate uncertainty and transaction costs, and further refinements to the single market are sure to yield gains in efficiency. Through improving the risk-adjusted rate of return on capital and the business climate more generally there are good chances that a credible commitment to achieving EMU in the not-too-distant future will help further strengthen the trend of investment and growth.

(ii) Price Stability. This is a generally accepted objective, and beneficial economically in its own right. The problem is that of attaining price stability at least cost, and then maintaining it. The Community has the opportunity of being able to build its monetary union on the basis of the reputation for monetary stability of its least inflationary Member States. Given the paramount importance of credibility and expectations in winning the continuous fight against inflation at least cost, this is a great advantage.

(iii) Public Finance. A new framework of incentives and constraints will condition national budgetary policies, for which the key-words will be autonomy (to respond to country-specific problems), discipline (to avoid excessive deficits) and coordination (to assure an appropriate overall policy-mix in the Community). EMU will also bring valuable gains for many countries' national budgets through reductions in interest rates, as inflation and exchange risk premiums are eliminated. These benefits will very probably outweigh the loss of seigniorage revenue to be experienced by some countries.

(iv) Adjusting to Economic Shocks. The main potential cost of EMU is that represented by the loss of monetary and exchange rate policy as an instrument of economic adjustment at the national level. This loss should not be exaggerated since exchange rate changes by the Community in relation to the rest of the world will remain possible, whereas within the EMS the nominal exchange rate instrument is already largely abandoned, and EMU will reduce the incidence of country-specific shocks. Relative real labour costs will still be able to change; budgetary policies at national and Community levels will also absorb shocks and aid adjustment, and the external current account constraint will disappear.

Moreover, model simulations suggest that with EMU, compared to other regimes, the Community would have been able to absorb the major economic shocks of the last two decades with less disturbance in terms of the rate of inflation and, to some extent also, the level of real activity. This is of renewed relevance, given that the Gulf crisis of summer 1990 once again subjects the Community to a potentially damaging economic shock.

(v) The International System. With the ECU becoming a major international currency, there will be advantages for the Community as banks and enterprises conduct more of their international business in their own currency; moreover the monetary authorities will be able to economize in external reserves and achieve some international seigniorage gains. EMU will also mean that the Community win be better placed, through its unity, to secure its interests in international coordination processes and negotiate for a balanced multipolar system.

[1]. Commission of the European Communities, One market, one money: An evaluation of the potential benefits and costs of forming an economic and monetary union,' Study of the Directorate-General for Economic arid Financial Affairs, European Economy (October 1990), P. 11.

3. Timetable for Economic and Monetary Union

Steps toward union              Date
Treaty of Rome                  March 25, 1957
Werner Plan                     October 1970
EMS                             March 13, 1979
Single European Act             February 28, 1986
Delors Committee report         April 1989
EMU: stage one                  July 1, 1990
EMU: stage two                  January 1, 1994
EMU: stage three                To be negotiated