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Economic and monetary union in a multi-tier Europe.

It is now looking increasingly plausible that, at some point between the middle of 1997 and the beginning of 1999, a number of EC Member States (perhaps even a majority) will move to the final stage of Economic and Monetary Union. The macro economic consequences of EMU and the costs and benefits of participating are already the subject of active and extensive academic analysis. Very little attention has so far been given to the question of how a two-tier EMU, with only some EC countries participating in Stage 3, would function and what implications there might be for those remaining in Stage 2.

The purpose of this Note is to highlight some of these issues, which will need to be studied and understood in much greater depth before a decision is taken. It looks at the legal and institutional framework set out in the Maastricht Treaty, the relevant experience of nearly-fixed European exchange rates from 1987 to 1992 and the economic and political implications of particular country configurations in a two-tier EMU, concluding that mutually satisfactory management of such a relationship will require greater political will and co-operative spirit than has been in evidence so far.


Almost five years ago, on 1 July 1990, Stage 1 of Economic and Monetary Union (EMU) came into effect in the twelve Member States of the European Community. Of itself, this was a quite minor step enshrined in two pieces of secondary Community legislation(1) which formalised existing arrangements and procedures for coordinating economic and monetary policies. It did not require any amendment of the Treaty of Rome and few of the Community's citizens were aware that it had taken place. Yet that step was regarded by most Member States' governments as a public affirmation of their commitment to proceed in two further steps, to a single monetary policy and a single currency, within the foreseeable future.

1990 was, in a number of other respects, a year of considerable significance for European monetary integration. The lira moved from the wider ([+ or -] 5 per cent) fluctuation band of the Exchange Rate Mechanism (ERM) to join the seven Community currencies already in the narrow ([+ or -] 2 1/4 per cent) band and sterling moved into the ERM to join the peseta in the wider band. Coinciding with the start of Stage 1, on 1 July 1990 a Council Directive(2) requiring the complete liberalisation of capital movements (by the end of 1992) came into effect. On the same day, the monetary unification of East and West Germany took place, seeming to provide an illustration of how, if the political will existed, the creation of a monetary union and adoption of a single currency need not be a traumatic economic or logistical undertaking.

Yet each of these events was before long to contribute to a crisis of confidence that threatened to throw into reverse the process of European integration. Within three years of the start of Stage 1, despite the formal opening of the Single Market on 1 January 1993 and the signing on 7 February of the Treaty on European Union(3) at Maastricht, with its timetable for achieving monetary union in less than six years, the sense of Europhoria had all but evaporated. The ERM, which had come to be seen as a guarantee of safe passage to monetary union, was breaking apart: the European economy was in recession, unemployment and inflation were both rising and public finances were deteriorating [ILLUSTRATION FOR CHARTS 1 AND 2 OMITTED].

Now, the conjunction of circumstances has changed again. Economic recovery in Europe is under way, inflation is subdued, unemployment is beginning to fall and public finances to improve. The reformulated ERM, with its fluctuation margins widened from [+ or -] 2 1/4 per cent and [+ or -] 6 per cent to [+ or -] 15 per cent, has withstood its first major test: the peseta and escudo were devalued by 7 per cent and 3 1/2 per cent on 6 March but both currencies have remained within the mechanism. The institutional development of the Community has also continued. Stage 2 of EMU came into effect in all Member States on January 1 1994, and with it more extensive procedures for co-ordinating economic policies; rules to constrain government deficits and the manner in which they may be financed; and the establishment of a European Monetary Institute (EMI) as the precursor of a European Central Bank (ECB). In what is envisaged as the final expansion of membership before monetary union takes place, Austria, Finland and Sweden joined the Community on 1 January 1995. Shortly afterwards the Austrian schilling joined the ERM, bringing back to 10 the number of currencies in the parity grid.

Against this more positive background, its principal supporters have been regaining confidence in their vision of achieving Economic and Monetary Union, in accordance with the terms and timetable of the Maastricht Treaty, within the next four years. Reflecting the chastening experience of the previous few years, however, this vision is more circumscribed: the earliest date envisaged at Maastricht, is now less than 2 years away and is no longer considered likely to see any countries moving to Stage 3 of EMU; and the latest date, explicitly provided in the Treaty, of 1 January 1999 is generally regarded as plausible only for a limited number - perhaps even a minority - of the 15 Member States. The notion of a multi-speed Europe had a negative connotation in the early-1990s - a small group of countries losing interest in the wider European dimension and leaping ahead at an early date, with divisive effect, to an exclusive monetary club for the wealthy few. Now a two-speed or even a multi-speed approach to EMU, in which some countries move ahead before others, is more widely accepted as the only realistic way of both maintaining momentum towards the monetary integration of Europe and meeting the key Maastricht requirements of sustainable low inflation and sound public finances.

Institutional Background and the Timetable for Stage 3

From the outset, European leaders had envisaged that the route to EMU would involve a sequence of steps. The European Council (which consists of the Heads of State or of Government and the President of the European Commission) meeting in Hanover in June 1988, charged that a Committee be set up, under the Chairmanship of the Commission President, Jacques Delors, to 'study and propose concrete stages leading towards economic and monetary Union'(4).

Reporting in April 1989(5) the 16-man Committee (which included the Governors of the 12 Members States' Central Banks) proposed three stages, in each of which action would be taken in parallel on both the monetary and the economic policy fronts. Progressively closer coordination of policies and convergence of economic performance during the first two stages would prepare the way for the final stage in which exchange rates would be fixed, a single monetary policy would be formulated and implemented by a European System of Central Banks (ESCB) and macro-economic and budgetary policies would be made subject to legally binding Community rules and procedures. Adopting the conditional mood throughout, the Report studiously avoided the political question of whether this was a process on which the Community should embark. Moreover, it warned emphatically against pre-set performance targets or timetables for advancing beyond Stage 1:

'The conditions for moving from stage to stage cannot be defined precisely in advance nor is it possible to foresee today when these conditions will be realised. The setting of explicit deadlines is therefore not advisable. This observation applies to the passage from Stage 1 to Stage 2 and, most importantly, to the move to irrevocably fixed exchange rates. However, there should be a clear indication of the timing of the first stage, which should start no later than 1 July 1990 when the Directive for the full liberalisation of capital movements comes into force'.(6)

Likewise the Committee recommended that not all Member States should be obliged to proceed from one stage to another at the same time, acknowledging the need for 'a degree of flexibility concerning the date and conditions on which some member countries would join certain arrangements' but also the need for those arrangements to be managed in a way that would 'facilitate the integration of other members'.

In June 1989 the European Council in Madrid(7) endorsed the recommendation that Stage 1 of EMU should start on 1 July 1990 but in the ensuing negotiations there were marked differences of view among the Member States as to how the closely inter-related questions of conditions, timing and participation for the subsequent steps to Stages 2 and 3 should be addressed.(8) The outcome in the Maastricht Treaty was, inevitably, a compromise in which the warnings of the Delors Committee were set aside: Stage 2 would start on 1 January 1994 in every Member State regardless of the degree of convergence actually achieved by then. Stage 3 would start during 1997 or at the latest on 1 January 1999, but only for those countries who, in the course of Stage 2, had been able to demonstrate a 'high degree of sustainable convergence' as measured by four objective criteria (see Box 1). Countries which are judged, largely by reference to these criteria, not to have achieved a sufficient degree of convergence would be barred from the movement to Stage 3 of EMU, and would be granted a derogation from the Treaty obligations which relate to Stage 3, until such time as they are judged to qualify. In addition, the UK and Danish governments negotiated the right, set out in two Protocols, for their countries to abstain from any move to Stage 3. The Maastricht Treaty thus not only admits the possibility of a two-speed approach to EMU - and hence a two-tier EMU in which some Member States operate at a higher level of monetary integration than others - but virtually ensures it.

Economic and Monetary Background

In 1990, the economic and political situation in the European Community had the appearance of providing a sound and stable base from which a large majority of its members, adhering to the discipline of the ERM, could proceed without serious strain to monetary union in the second half of the decade. December of the same year saw the opening of the Inter-Governmental Conference whose task was to provide the legal framework for this in the form of a Treaty amending the Treaty of Rome. Yet a number of diverse developments were taking place which were shortly to interact with such violence that the whole project of European monetary integration seemed at risk of collapse even before the new Treaty could be signed at Maastricht in February 1993.

One of these factors was essentially external to the European Community: under the influence of monetary tightening by the Federal Reserve, the long period of buoyant activity in the United States was coming to an end and dollar interest rates were beginning to fall. On the evidence of previous cycles, this might have been expected to generate serious tensions within the ERM as mobile capital flowed out of the dollar and into the D-mark rather than into other European currencies.

That this did not happen in 1990 or 1991 is attributable to market perceptions of developments in the ERM itself. There had been no significant realignment of exchange rates within the ERM since January 1987 as countries had adopted the 'hard currency' policy of maintaining unchanged central rates with the D-mark. In the optimistic political and economic climate of 1990 there arose a belief, among market operators and official circles alike, that the existing parity grid offered the currencies participating in the ERM a stable 'glide-path' to monetary union. This belief was reinforced, rather than undermined, by the movement of the lira from the wide to the narrow band (in January 1990) and by the participation of the peseta and sterling, in the wider band, for the first time (in June 1989 and October 1990 respectively). Consequently, extensive 'convergence trading' took place as investors, assuming that the economic performance of Member States would continue to converge in preparation for EMU, moved into the higher-yielding currencies, which previously had been regarded as higher-risk, in preference to the D-mark(9).

The third factor, also apparently benign, was the unification of Germany. Faced with the sudden demands for social spending and industrial reconstruction in the Eastern Lander, the German government resorted to market borrowing: the general government financial position which had been in small surplus in 1989 (West Germany) showed cumulative deficit of over 11 per cent of GDP (all Germany) over the four years 1990-93. Faced with this continuing fiscal stimulus, together with rising wages in the Eastern Lander, the generous rate at which Ostmark savings balances were converted into D-mark deposits and uncertainty as to whether past monetary relationships would hold good in the enlarged Germany, the Bundesbank progressively tightened monetary policy. It raised its Lombard lending rate, in four steps, from 8 per cent to 9 3/4 per cent between November 1990 and December 1991, and then held the rate at this record level for a further nine months [ILLUSTRATION FOR CHART 3 OMITTED]. The 'hard currency' policy being pursued by other members of the ERM obliged them to follow suit [ILLUSTRATION FOR CHART 4 OMITTED] by raising short-term interest rates in their own markets or postponing any reductions regardless of their individual domestic economic circumstances. Reinforced by convergence trading, the European currencies appreciated en bloc against the dollar as US interest rates continued to fall.

By the middle of 1992, however, the foreign exchange markets had begun to question the sustainability of the parity grid and the durability of the convergence process, in view of the cumulative loss of competitiveness being suffered by Italy, Spain and Portugal (see Table 1) the effects of high interest rates on already large public sector deficits in Italy and Belgium and the political will to maintain high interest rates and a rising exchange rate against the dollar in the face of growing unemployment and deteriorating fiscal positions in France and the United Kingdom. Against the background of Denmark's rejection of the Maastricht Treaty in its June 1992 referendum and the possibility of a similar outcome in France in September, convergence trading abruptly went into reverse and the parity grid rapidly started to unravel. A 7 per cent devaluation of the lira at the beginning of September was almost immediately followed by the withdrawal of both sterling and the lira from the parity grid and a 5 per cent devaluation of the peseta. By the following August the peseta had devalued twice more, the [TABULAR DATA FOR TABLE 1 OMITTED] escudo had devalued twice and the punt once and the 2 1/4 per cent and 6 per cent bands of the ERM had been replaced - ostensibly as a temporary measure only - with a fluctuation margin of 15 per cent.

Implications of the Exchange-rate Crisis for EMU

By the autumn of 1993, before the new Treaty had even come into force, the process of monetary integration in Europe appeared to many observers to have completely stalled and the Maastricht provisions for EMU to be a dead letter. Although, assisted by recession, 6 out of 12 countries met the convergence criterion in relation to inflation and 8 out of 12 the interest-rate criterion, only Luxembourg met both the fiscal convergence requirements (see Table 2) and it seemed likely that government finances in most Member States would continue to deteriorate for some time. Furthermore, there was now a major question mark over the exchange-rate criterion. The Treaty requires that, to qualify for Stage 3, a country must have maintained its currency within 'the normal fluctuation margins' of the ERM for the two preceding years without serious tensions and without devaluation; this was unquestionably drafted with the narrow band margins of 2 1/4 in mind. Reinterpretation of the Treaty specification of 'normal fluctuation margins', in the absence of a formal 2 1/4 per cent band, so that the required [TABULAR DATA FOR TABLE 2 OMITTED] discipline was merely to have observed the new (and supposedly temporary) margins of 15 per cent, or even to have contained the movement of bilateral market rates de facto within notional limits of 2 1/4 per cent either side of unchanged central rates in the parity grid, could well be open to legal challenge(10). Abandonment of the criterion however, would require an amendment to the Treaty.

More recently, however, with economic activity reviving, for the majority of Member States there is a renewed prospect of non-inflationary growth, converging long-term interest rates, lower government deficits and a gradual reduction in stocks of government debt. With this improvement in the economic climate has come a revival of confidence that monetary union is attainable within the Maastricht timetable, even though 1999 is now generally regarded as more realistic than 1997(11) and the number of participants at the start is likely to be fewer than originally envisaged. There is a growing acceptance that some Member States should integrate more closely and quickly(12), as a 'core' - and even a 'core within a core'(13) - around which the other Member States and European countries outside the Community would form more loosely integrated circles(14). The functioning of the ERM between January 1987 and September 1992, in which at first eight and eventually eleven Member States maintained virtually fixed exchange rates and accepted a common baseline - set by the Bundesbank - for their monetary policies has been characterised as a de facto(15) or quasi(16) monetary union. As this 'hard ERM' broke up, so a tiering of monetary relations between the Member States reasserted itself, with a 'core' group maintaining the semblance of a monetary union, the other participants in the 15 per cent band of the EMU forming an 'inner circle' and the three Member States outside the mechanism an 'outer circle'.

Before discussing the implications, and possible configuration, of a two-tier EMU it is instructive to consider any lessons relevant to this which may be drawn from the experiences of the 'quasi monetary union' and its dissolution over the past few years. These can be presented as a series of propositions:


A common monetary policy which is geared primarily to the needs of one country, even if that is the dominant economy, will strain the credibility of the union itself; in particular, each participant must accept that the objective of the common monetary policy is price stability in the union as a whole rather than the maintenance of price and cost stability, or competitiveness, in its own national economy.


German reunification provided a valuable case-study of a country-specific shock, in which a real appreciation of the D-mark was required in order to secure the transfer of the real resources needed for economic reconstruction in the Eastern Lander. The Bundesbank, committed to the maintenance of domestic price stability, largely succeeded in preventing this from coming about through a rise in the German inflation rate. The other members of the ERM sought to prevent it from taking the form of nominal appreciation of the D-mark against their own currencies. Initially, therefore, the Bundesbank achieved real appreciation by means of nominal appreciation of the D-mark (dragging with it the other ERM currencies) against the dollar and other non-ERM currencies. Over time, however, it also took the form of falling inflation rates in the other Member States (in a number of countries falling below that in Germany, which was rising); formal currency devaluations within the ERM; and the sharp depreciation of sterling and the lira on leaving the ERM. Between the members of a monetary union exchange-rate changes would not be possible and, if the common monetary policy were directed at the average rate of inflation in the Union as a whole, more of the adjustment in relative prices would have taken place through a higher rate of inflation in Germany, thus attenuating the deflationary impact and unemployment consequences elsewhere within the monetary union(17). For other Member States outside the union, however, the dilemma over how to respond to monetary tightening within the union, even if less acute, would have been essentially the same as in 1990-3.


The monetary stance of the Bundesbank was inappropriate to the needs of most of the other members of the 'quasi' monetary union on whom it was imposed via the linkages of the ERM. It follows that if the Bundesbank's domestic tightening was correctly judged to match the counter-inflationary requirement in Germany, it was more than would have been required of a common monetary policy in a monetary union to maintain a constant degree of anti-inflationary pressure in the union as a whole: with a jointly-determined monetary policy, less of the German fiscal stimulus would have been offset by monetary tightening. Hence in a monetary union it is possible for any individual member government to secure in its national economy, by unilateral fiscal relaxation, a more expansionary mix of (national) fiscal and (common) monetary policy at the expense of the other members of the union who would suffer a somewhat tighter monetary policy in consequence. The Treaty obligation, in Stage 3 of EMU (see Box 2), to avoid excessive deficits may serve as a check on such 'free riding', but there would no longer be any risk of censure in the foreign exchange markets and the temptation to undertake fiscal relaxation may be kept alive by the dictates of national politics.


The experience of 'convergence trading' suggests that, among a group of countries whose economic and monetary policies are perceived as being appropriate and mutually consistent, national governments may have equal access to international capital in a 'quasi monetary union'. If that perception changes, foreign exchange risk - the risk of currency devaluation - will become the dominant concern of investors and massive discriminatory capital flows may take place across the exchanges. Within a true monetary union, foreign exchange risk will be absent but, if inappropriate or mutually inconsistent policies are being pursued, its place may be taken by credit risk - the risk that a heavily indebted government which has difficulty meeting its debt servicing obligations and is no longer able to reduce the real cost of doing so by devaluing its currency will resort to default. The risk of default within a monetary union might be regarded by investors as less immediate than the risk of a devaluation among national currencies but the potential for large-scale discriminatory flows between the member states would still be there and could result in a 'free-riding' government quite suddenly being denied any further financing.(18)


A common monetary policy is likely to have an asymmetric impact across the union because of institutional and behavioural differences between countries. Differences in the responsiveness of other financial markets to changes in money market interest rates and differences in the net financial positions and interest sensitivities of personal, corporate or financial sectors will mean that the burden of adjustment will not be evenly distributed. The events of 1992 have shown that the burden can fall particularly heavily where, as in the UK mortgage market or the Italian government bond market, long-term indebtedness is financed at floating short-term interest rates.(19)


National differences in the timing and amplitude of economic cycles will also cause the incidence of a common monetary policy - geared to the aggregate conjunctural situation - to be uneven.


If small open economies belonging to a monetary union have major trading or financial links with countries outside the union they may come under particular strain unless their outside partners pursue - and are seen to be able to continue to pursue - policies which are compatible with those of the union. This can be expressed in terms of the theory of optimum currency areas: for such countries the monetary union will not constitute an optimal currency area unless their economic partners, outside the union de jure, act credibly as de facto members of the union. The ERM experiences of Ireland (in relation to the United Kingdom), Portugal (in relation to Spain) and Denmark (in relation to the other Nordic countries) over the past three years illustrate the problem. The economic case for or against a particular country's participation in Stage 3 of EMU or, indeed, the viability of the whole undertaking, can thus not be fully established in the absence of fairly precise information about which other countries will be participating.

Moving to Stage 3: Decision Procedures and Criteria

The Maastricht Treaty (Article 109j) lays down a quite complex procedure for arriving at a decision as to whether and when a move to Stage 3 of EMU should take place and which countries will participate. The reason for complexity is two-fold: the officials drafting the Treaty shared the view of the EC Monetary Committee (of which many of those officials were members) that although the decision should be based on specific objective criteria these must be applied not in an automatic way but with the exercise of judgement;(20) and they recognised that several Community bodies have legal competence in this area.

The European Commission and the European Monetary Institute (EMI) are required, well before the end of 1996, each to report to the Council of Economic and Finance Ministers (ECOFIN) their assessments of the extent to which 'a high degree of sustainable convergence' has been achieved, by reference to the fulfilment by each Member State of four objective criteria relating to price stability, sustainable government financial positions, exchange-rate stability and the markets' verdict on the durability of convergence as reflected in long-term interest rates (see Box 1). The two reports are also required to take account of developments in 'unit labour costs and other price indices' and current account payments balances, the integration of markets, the development of the ECU and the conformity of national central bank statutes with the independence requirements specified for the European System of Central Banks.

The ECOFIN Council is then required to reach a view, 'on the basis of these reports' by qualified (weighted) majority, as to which Member States fulfil 'the necessary conditions for the adoption of a single currency' and whether those countries which do so constitute a (single, unweighted) majority of the Member States. This view is to be presented, in the form of a Recommendation, to a Council of Ministers specially composed of the Heads of State or of Government.(21) This specially constituted Council of Ministers, 'taking due account of the reports' of the Commission and the EMI and of an Opinion from the European Parliament, is required, not later than 31 December 1996, to decide by qualified majority 'on the basis of the recommendations of the (ECOFIN) Council' whether a majority of the Member States fulfil the necessary conditions for the adoption of a single currency, whether 'it is appropriate' for the Community to enter Stage 3 and, if so, when Stage 3 will start.

If this procedure, or any early repetition of it after 31 December 1996, does not yield a positive decision before the end of 1997 - and in principle such a decision could be one to initiate a move to Stage 3 at a specific date several years ahead - the Treaty requires that the whole procedure be repeated before 1 July 1998. Those countries which are then judged (again by qualified majority in the specially constituted Council of Ministers) to meet the necessary conditions, even if they do not then constitute a simple majority of the Member States, shall move to Stage 3 on 1 January 1999. Those Member States which do not qualify to participate in this move (or, in the case of the UK and Denmark, exercise their right not to) effectively stay put in Stage 2 and move automatically to Stage 3 when, in the course of periodic reviews, they are judged to qualify; in the case of the UK and Denmark such a review would take place only at the request of the government concerned.

There are some interesting, and potentially crucial, peculiarities in the majority requirements attached to this positive decision process. For a decision before the end of 1997 to be taken that some countries shall move to Stage 3, a (simple) majority of Member States must be judged to fulfil the necessary conditions. The United Kingdom's protocol attached to the Treaty, however, specifies that, if the UK has notified the Council of Ministers that it does not intend to move to Stage 3, it 'shall not be included among the majority of Member States which fulfil the necessary conditions' which is required for a positive decision before the end of 1997, and there is a similar provision in the Danish protocol. It is clear, in this event, that the UK and Denmark are to be excluded from the numerator in calculation of the majority but there is no indication as to whether they should also be excluded from the denominator. Thus if both the UK and Denmark qualify and indicate their wish to participate only 6 other countries would need to qualify to make a majority of 8 out of 15; but if neither the UK nor Denmark were to opt for Stage 3 a majority would either require 8 other countries (out of 15) or 7 (out of 13).

Decisions by the specially constituted Council of Ministers as to whether and when to move to Stage 3 and which countries are eligible will require a qualified majority of 62 out of a total of 87 weighted votes (see Table 4). Thus countries that between them hold 26 votes - for example, the United Kingdom, Italy, Denmark, and Ireland - could constitute a blocking minority. In a compromise agreement relating to the accession of Austria, Finland and Sweden there is a further provision that where any Council decision is opposed by countries holding between 23 and 25 votes, the decision must be postponed and discussions continued without time limit. Thus in principle three countries such as the UK, Spain and Portugal together could delay a decision on the move to Stage 3, although to do so would be contrary to the commitment, in a special protocol attached to the Maastricht Treaty, that all Member States 'shall...respect the will for the Community to enter swiftly into the third stage and therefore no Member State shall prevent the entering into the third stage'.

In 1996, while the Member States and Community bodies (Commission, EMI, European Parliament, ECOFIN Council, Council of Heads of State or of Government) are undertaking their first evaluation of the appropriateness and possible timing of a move to Stage 3 of EMU, the Member States will be following another, quite separate, procedure which is also stipulated in the Maastricht Treaty. Article N. 2 of the Treaty requires that a conference of representatives of Member State governments (an Inter-Governmental Conference) be convened to address a number of difficult political and institutional questions which may lead to further revision of the Treaty. Some of these arise out of the recent and the prospective enlargement of the Community. They are likely to include the balance of voting powers between the larger and the smaller Member States, replacement of the unanimity requirement by qualified majority voting in a greater number of areas and the appropriate size of blocking minority. Others concern the evolution of and distribution of executive and legislative responsibilities at the Community level: the balance of power between the Council, the Commission and the European Parliament; the consultation and decision-making procedures of the Community; and further development of a Community dimension in foreign policy and defence and in justice and home affairs.(22) It is not intended that the IGC should re-open any of the economic and monetary issues which were resolved at Maastricht but it is nevertheless quite possible that in practice conduct of the decision-making procedure on EMU, and even its outcome, will be influenced by the course of negotiations in the IGC: no terminal date has been set for these negotiations and any changes to the Treaty will require unanimity. Horse-trading in one forum could well spill over to the other.

Possible Political and Economic Configurations of a Two-Tier EMU

On the face of it, it does not seem likely that the Heads of State or of Government will be able to decide by the end of 1996 that a majority of the member States 'fulfil the necessary conditions for the adoption of a single currency' and hence to set a date for the beginning of Stage 3. Forecast data for 1996 (see Table 3) suggest that only Germany and Luxembourg would meet all four quantitative tests. All the other Member States would fail at least one of the two numerical criteria relating to government finances. However, in conducting the first of the annual 'Excessive Deficits' surveillance exercises last year, the Commission and the ECOFIN Council judged that Ireland, despite a debt/GDP ratio of almost 90 per cent, met the debt criterion on the grounds, allowed under the Treaty, that the ratio was 'sufficiently diminishing and approaching the reference value at a satisfactory rate'(23). If similar flexibility were exercised in respect of budget deficits - on the grounds that they were close to 3 per cent of GDP and either had declined substantially and continuously or were only exceptionally and temporarily in excess of 3 per cent - France and the [TABULAR DATA FOR TABLE 3 OMITTED] UK might also be deemed, alongside Germany, Luxembourg and Ireland, to satisfy all four quantitative criteria. This would still leave the Community three countries short of the majority required for a move to Stage 3, even if the UK were to agree to take part and the problem of the ERM criterion were resolved. A rather more heroic judgement, or a better than projected outturn, in respect of debt/GDP ratios in Denmark, the Netherlands and possibly Finland, could bring the number of countries qualifying to the required total of 8, but even then a decision to move to Stage 3 could not be taken in 1996 if the UK and Denmark were to opt out.

It is almost inevitable that political considerations will play a part in these judgements and, indeed, in any assessment of the requisite degree of exchange-rate stability within (or even outside) the 15 per cent margins of the ERM. The stand taken by Germany will be of crucial importance. The German Federal Parliament has declared that it would not authorise its government to acquiesce in a decision by the Council of Ministers which either weakened the Treaty criteria or departed from a strict interpretation of them; but, in endorsing this position, the German Constitutional Court acknowledged that a decision by the Council on EMU requires an evaluation of whether the criteria have been met and that differences of opinion are to be settled by majority vote(24). It seems quite likely that the German government would approach the EMU decisions with considerable caution but also a measure of flexibility, in the exercise of which calls from the parliament (and no doubt the Bundesbank and Finance Ministry) for rigour will be weighed against external political considerations. In addition to any interplay with the IGC negotiations, the potential repercussions for countries like Austria, Belgium and Sweden, if they were excluded but their principal trading partners were to take part, might give cause for delay, especially if the economic conjuncture offered a prospect of some further convergence in economic and financial performance. Indeed, the Institute's latest world economic forecast, presented elsewhere in this Review, suggests that the process of convergence in terms of the Maastricht criteria could well continue at least to the end of the decade.

Although the questions of which countries and when remain open, it may nevertheless be instructive to look at country groupings, selected according to a subjective view of economic and political coherence, to illustrate the manner in which the structure of the Community might be affected by a two-speed approach to EMU. A plausible small 'hard core' of countries that might move to Stage 3 on 1 January 1999 could consist of France and Germany (without whom monetary union would almost certainly not take place), Luxembourg, the Netherlands and Austria. Together these countries represent 44 per cent of the Community's population and 53 per cent of its GDP (see Table 4). Bearing in mind the development of the ECU financial markets and the need to effect a smooth transition from the present currency basket to the ECU as a currency in its own right, the four core-country currencies (the Austrian schilling not being included in the basket) at present exchange rates account for 65 per cent of the ECU basket. Yet the formal political weight of such a 5-country EMU might be very much less than its economic weight. In terms of the Community's present voting structure, (although this might change as a result of the IGC negotiations in 1996) the five would hold only 31 [TABULAR DATA FOR TABLE 4 OMITTED] (i.e. 36 per cent) of the 87 weighted votes in the Council of Ministers - a comfortable blocking minority (for which normally only 26 votes are needed) but only half way to a qualified majority (which requires a minimum of 62 votes).

Of the 5 countries shown in the second group in Table 4, Belgium, Finland and Sweden are assumed to have been excluded because of unsound government finances, Denmark (because of domestic opposition and the position of its three Nordic neighbours) to have exercised its right to remain in Stage 2 and Ireland to have negotiated a similar concession because of its close economic and financial ties with the UK. If these various considerations were set aside and all five were to join the 5-country core either in 1999 or within a few years of EMU being established, there would be an appreciable further consolidation of the economic position of the union. It would account for around 53 per cent of the Community's population and around 63 per cent of Community GDP, while the ten national currencies, to be replaced by the single currency of the union, would represent 77 per cent of the ECU basket.

The shift in trading patterns which would result if the core countries were to be joined in a monetary union by the inner ring would be even more pronounced (see Table 5). 29 per cent of the core countries' total merchandise trade takes place between each other(25), 35 per cent is with the rest of the Community and slightly more than that is with the rest of the world. The trading pattern of the inner and outer rings, taken together, is similarly well spread: 33 per cent is between themselves, 31 per cent is with the core countries and 36 per cent is with the rest of the world. If, however, the inner ring were to join the core in a monetary union, 44 per cent of the merchandise trade of the union would be amongst its members and only 21 per cent (equivalent to 5 per cent of GDP) would be with the five Community countries remaining outside the union; in contrast, only 14 per cent of the trade of these outer five would be with each other while 47 per cent [TABULAR DATA FOR TABLE 5 OMITTED] (equivalent to 8 per cent of GDP) would be with the ten countries of the union. This relative self-sufficiency within the monetary union and relative dependency of the outer ring on trade with the union could lead to frictions in the development of trading policies and future Single Market legislation. It could also exacerbate the asymmetry in monetary and exchange-rate relations between the union and those countries remaining outside: the incentive for members of the union to participate in an arrangement of mutual obligations such as the original ERM would be much less than it has been in a Community in which almost two thirds of all merchandise trade is between individual Member States.

The five additional members would also contribute significantly to the formal political weight of the monetary union in the Community, raising the number of weighted Council votes held within the union from 31 to 49-56 per cent of the total but still 13 votes short of a qualified majority. Thus those remaining outside the union would retain a comfortable blocking minority. Once Stage 3 has come into effect, the lack of a qualified majority for the union in the full Council would not be relevant to the taking of decisions concerning the economic and monetary policies of the union, since only members of the union would be entitled to vote on such matters. It would, however, be relevant to Council decisions on other matters and could give rise to political tensions between those inside and those outside the union. Even so, the Community would not necessarily polarise immediately into two blocs. On some issues France (and Belgium and Ireland) might feel uncomfortable with the North-East tilt the other 7 members gave to the union. The United Kingdom might equally at times feel ill at ease in a predominantly South-West grouping of relatively poor and populous countries facing endemic structural problems.

Differences between the Stage 2 and Stage 3 Regimes

The principal features of Stage 2 and Stage 3 are set out in Box 2. The most marked differences between the regime to which those who have moved to Stage 3 will be committed and that applying to those remaining (or arriving) in Stage 2 will be in the sphere of monetary policy. On the economic and budgetary policy front, the Treaty requirements for Stage 3 are not much more extensive than those which have already come into effect in Stage 2. The procedures for the co-ordination and multilateral surveillance of economic policies in accordance with broad guidelines laid down by the Council of Ministers are in place. So too are the prohibitions on central bank financing of public sector deficits, on privileged access for public sector borrowers to financial institutions and on the Community or its Member States bailing out an over-indebted government. Member States are already enjoined in Stage 2 to endeavour to avoid excessive government deficits (and excessive stocks of debt) and are subject to peer group scrutiny and pressure, with the possibility that an adverse finding may be officially published; the difference for participants in Stage 3 will be that they may be required to take specific steps to rectify the situation within a specific period and may be fined for non-compliance, be obliged to publish 'health warnings' when they issue debt or find that the EIB will cease lending to them. Member States remaining in Stage. 2 will retain in full their rights to participate in all economic policy discussions and decisions except the stiffer Stage 3 procedures for non-compliance with the excessive deficit requirement.

It is in the monetary sphere that the change of regime will be most felt. For those moving to Stage 3, monetary sovereignty will be pooled. Monetary policy will be decided in the Governing Council of the European Central Bank and implemented by the Executive Board, either directly or through instructions to the participating national central banks. Exchange rates between national currencies will be irrevocably fixed and, as rapidly as possible, national currencies will be replaced by the ECU (although this could take a number of years). Foreign exchange reserves will be pooled as will income accruing to national central banks from the issuing of banknotes and from any compulsory reserves held with them by the commercial banking system; much of that income will then be re-distributed to the national central banks in proportion to their contributions to the capital of the ECB. The Council of Finance Ministers (excluding ministers representing countries remaining in Stage 2) will be ultimately responsible for deciding the exchange-rate system or the 'general orientations for exchange-rate policy' governing the relationship between the ECU and non-EC currencies.

For those countries remaining in Stage 2, the national authorities will retain their existing responsibilities for monetary and exchange-rate policy and may well also choose to continue with their present policy frameworks and techniques, although - as since the founding of the Community - they will still be required to treat their national exchange-rate policies as 'a matter of common interest'. Their national central banks will not participate in, nor be subject to, the deliberations or decisions of the Governing Council of the ECB (although they may be asked to contribute to running costs). In the event that some Member States do remain behind in Stage 2, however, a third decision-making body of the ECB will be set up: a General Council will take over any tasks of the European Monetary Institute which still need to be performed, as well as contributing to the various advisory and reporting functions of the ECB. The General Council will be made up of the President and Vice-President of the ECB and the Governors of all the national central banks in the Community. This provision would appear to allow for the continuation of the ERM in some form, governing exchange-rate relations between the currency of the monetary union and the currencies of Member States remaining in Stage 2; but exclusive reference to relations with third countries' currencies in that part of the Treaty which arrogates to Ministers the powers of decision in matters of exchange-rate policy leaves some degree of uncertainty on this point. The Treaty as currently drafted, also requires that Member States which do not qualify for (or have an option to refrain from) participation in Stage 3 at the outset must satisfy all the convergence criteria, including participation in the ERM within 'the normal margins of fluctuation' before they may subsequently be admitted. This issue is considered further below.

Further Enlargement of the Community

It is the intention of the present Member States to postpone active consideration of any further increase in membership of the Community until the outstanding issues regarding its institutional structure and balance of powers have been resolved, as a result of the 1996 IGC negotiations, and economic and monetary union has been securely established. From about the year 2000, however, the question of enlargement is likely to return to the Community's agenda. There are no grounds at present for supposing that popular aversion to the EC in Norway and Switzerland - economies which could be assimilated without difficulty - will have diminished to such an extent that the governments of those countries will be seeking to apply. Accession of the two 'micro-states' of Cyprus and Malta, with populations not very different from that of Luxembourg, per capita incomes not very different from those of Portugal and Greece and quite modest inflation rates, should also not pose any major problems.

However, at least 9 other European countries - whose economies so far seem much less compatible - will [TABULAR DATA FOR TABLE 6 OMITTED] be expecting to open negotiations leading to their accession: the Baltic States of Estonia, Latvia and Lithuania; Hungary, Poland and the Czech and Slovak Republics (the Visegrad Four); Slovenia, and Turkey. To enlarge the Community (see Table 6) to the east would represent a much more radical challenge - both administrative and economic - than Member States have faced in any previous enlargement. On present data, the accession of the Visegrad Four countries alone would increase the population of the Community by a sixth but would increase the Community GDP by only one twentieth. GDP per capita in Greece and Portugal is less than a third(26) of that in Sweden and Germany, but their population represents only about 5 1/2 per cent of the population of the Community of 15. Among the Visegrad Four, per capita GDP even in Hungary is less than half that of Greece; in Poland and Slovakia (as well as Latvia and Lithuania) it is not much more than one tenth of the EC average(27). Yet in terms of population, the 'Visegrad Four' are larger than the United Kingdom or France. Turkey has a population as large and as poor as Poland. All of these countries have inflation rates at least four times the Community average.

In a detailed study of the implications of extending Community membership to Central and Eastern European countries, Baldwin(28) has estimated that the annual net cost to the EC budget of admitting even just the Visegrad Four in the year 2000 might be as much as ECU 58 billion (ECU 38 billion under the Common Agricultural Policy plus ECU 26 billion of Structural Funds transfers less ECU 6 billion of budget contributions from the new members), representing a budget increase (or equivalent need for spending cuts) of some 68 per cent. His study also suggests that, under current practices, these four countries would be likely between them to receive 22 weighted Council votes - one more than the four least affluent members of the present Community.

A Multi-Tier Economic and Monetary Union in Practice

The prospect of a two-speed move to Economic and Monetary Union among the present Community of 15 raises a number of important questions which will require serious and detailed attention from both academics and politicians as the debate about dates and participation intensifies and as the preparations for the Inter-Governmental Conference get under way. Further enlargement of the European Community to embrace the Visegrad countries, Slovenia, the Baltic States, the micro-states of Malta and Cyprus and quite possibly Turkey, and hence the prospect of a three-tier and even three-speed Europe, would raise many more issues still. The purpose here is merely to highlight a few of those issues which have so far received little attention and which need urgently to be addressed.

It was pointed out above that a North-Eastern bloc in the present Community of 15 would have considerable economic weight and an even greater share of voting power - although still short of a qualified majority - in the Council of Ministers on matters of EC-wide concern. If the community of interest among these countries, already (or, in the case of France, at least so far) quite strong on a number of issues, were cemented by a common monetary and exchange-rate policy, a common set of interest rates, a single currency and substantial internal trading links, they might feel less inclined to accommodate the wishes or needs of those remaining in Stage 2. In a three-tier Europe, with major disparities in living standards and marked structural differences, the question might be even more pointed. In the interest of safeguarding what they had just secured, those who moved to Stage 3 might feel obliged to pursue joint or national policies that exacerbate the situation, or reject Community-wide policies or inter-Community transfers that might ameliorate it, for those left behind. The risk of this happening, for the countries outside the union, increases with the number of countries in the union.

Alternatively, it is possible that the steps already taken by the Stage 3 participants to meet the convergence criteria in the Maastricht Treaty might prove insufficient to offset the potentially disruptive effects of residual structural, fiscal and political differences when they are confronted by the demands of a single monetary and exchange-rate policy. Internal strains might appear in the union and cohesion might be undermined to the point where some participants might see their interests as corresponding more closely with those of countries in Stage 2. The risk, to the union, of this happening may also increase with the number (and hence structural and political diversity) of participating countries.(29)

The question of fiscal transfers, at the Community level, from the more successful to the less successful members of the Community may perhaps be avoided, or at least put aside for the time being, if monetary union takes place only among the members of the present Community of 15. Centripetal labour mobility and centrifugal capital flows together may be sufficient, and may be socially and politically acceptable to exporting and importing counties alike, within the union itself and even within the present configuration of the EC. With a much more far-flung Community, of far greater economic, legal, linguistic and cultural diversity, the degree of mobility and acceptability might well be much less. If the concept of Community, and with it the Treaty terminology of Economic and Social Cohesion, is to retain any meaning in an EC stretching from Finland or Estonia to Malta and from Turkey to Portugal, while encompassing the highly developed economies of the West European core, the question of fiscal transfers from the richer Member States to those who enter at the start of the new millennium can not be shirked.

A move to monetary union by a sizable sub-set of Member States could pose a number of problems in the monetary sphere for those remaining outside. As was mentioned above, the Maastricht Treaty allows for the possibility, but does not require, that exchange-rate relations between countries that have moved to Stage 3 and those which remain in Stage 2 be governed by the existing exchange-rate mechanism of the EMS, whether in its previous configuration of 2 1/4 per cent and 6 per cent fluctuation margins or with the present 15 per cent band. It remains to be seen whether the 'temporary' 15 per cent formulation can be reconciled with the Treaty criterion of ERM participation and indeed whether it would prove sufficiently robust in practice to deliver candidate currencies safely to the point of irrevocable exchange-rate fixing.

It does not seem likely that the ERM in its earlier form will be re-introduced. Even though both the Committee of EC Central Bank Governors and the Monetary Committee of the European Community shared a consensus(30) in the spring of 1993 that the 'fault-lines' revealed by the crisis the previous autumn were not in the exchange-rate mechanism itself but in the inappropriate manner in which it had come to be operated, it was already apparent that there was no longer the political will to retain a symmetrically binding system of mutual rights and obligations. If however, the ERM were to be retained in some form once some countries had moved to Stage 3, the single currency (even of a monetary union of five countries) would be much more dominant in the parity grid than the D-mark has been and the rights and obligations of ERM membership would be even more likely to be applied in an asymmetrical fashion. This could pose particular problems for any countries currently in the ERM who do not initially qualify for admission to Stage 3 and who hence would have even less say in the monetary policy of the monetary union than they may have had until now in the (rather modest) provisions for monetary and exchange-rate policy co-ordination in Stages 1 and 2 of EMU.(31)

To abandon the ERM altogether might well be taken by those remaining in Stage 2, and by the markets, to mean that the monetary union was cutting itself free and denying them future access to EMU's upper tier. Countries in the lower tier would be deprived of what had been regarded as a valuable instrument of convergence. It would be open to those countries unilaterally to adopt margins of fluctuation for their currencies against the (fixed rate) currencies or common currency of the union, but the monetary policy of the union would then dominate their own economies to an even greater degree than would have been the case in the ERM. As Britton and Mayes (32) have noted, such an arrangement might prove to be regressive, making it harder for current members of the ERM who do not join the monetary union at the outset to meet the necessary convergence requirements subsequently.

Moreover, such unilateral margins would allow twice as much movement between the currencies of the countries staying in Stage 2 as between those currencies and the ECU. Kenen(33) points out other disadvantages, both to members of the union and to those remaining outside, of unilateral pegging and argues the case for co-operative arrangements.

One conclusion which we might draw from these brief analyses is that if there is no longer a clear exchange-rate mechanism to provide a formal framework for exchange-rate policy co-ordination - or even if the constraints within such a mechanism are too loosely drawn - there may be a need for a 'code of conduct', established in Community law, to which the non-participating countries would conform in pursuing their monetary and exchange-rate policies.

A related set of issues arises in respect of the ECU. The Maastricht Treaty provides that at the start of Stage 3 'the ECU will become a currency in its own right', convertible into the national currencies of countries participating in Stage 3 at irrevocably fixed rates. The Treaty is silent about how, if not all countries participate in Stage 3 and if the ERM were to be retained, this transformation of the ECU could be reconciled with a continuation of the official ECU basket for the purposes of the EMS. In principle the basket ECU could co-exist - not only in the ERM but also in financial markets - with the new ECU of the monetary union, but its properties would be different not only from those of the 'single currency' ECU of the EMU but also, to a lesser degree, from those of the basket ECU as it is at present. The values of each, and interest rates on financial assets denominated in them, could diverge considerably, with potentially significant financial and contractual consequences for borrowers and lenders, creditors and debtors and buyers and sellers.

The consequences of a move by some, but initially not all, Member States to monetary union would reach also beyond the macro-economic and monetary spheres. A two-tier EMU would introduce new lines of segmentation within the Single Market. With trade barriers and major regulatory differences already removed, national differences in legal, accounting and fiscal systems and of language and custom as well as exchange-rate uncertainty all still stand in the way of a truly uniform Community-wide market. Inside a monetary union, with at least one of these remaining obstacles - exchange risk - removed, the playing field will become more level than it is among the countries outside. This could have an impact on the European strategies of firms, from outside the Community as well as within. The further levelling of the playing field within the monetary union, however, could also throw into greater relief the national differences that still remain, especially those in the fiscal area where pressures for greater harmonisation of tax regimes and tax rates (and similarly social security contributions and benefits) among the members of the union could intensify.

Concluding Remarks

This note has highlighted a number of issues which warrant further study as the prospect of several Member States moving ahead of others to the final stage of EMU draws closer. Political as well as economic considerations suggest that such a move is unlikely to be as early as 1997 but that it is a realistic possibility for 1 January 1999. Which countries would then take part would be for decision during the first half of 1998, in the light of economic data relating primarily to 1997; but it is possible now to envisage at least a core group of five or six, consisting of France and Germany and several much smaller countries - or perhaps even a majority of the Member States - then constituting a reasonably coherent and viable economic and monetary grouping.

Experience with the ERM over the past few years suggests, however, that even for a fairly well-matched group of countries the operation of a common monetary policy may at times give rise to economic strains and political tensions. A policy directed towards price stability across the union as a whole may not always meet the immediate domestic concerns of a particular member of the union. Inflation in Germany, for example, might at one time be higher and persist longer than the Bundesbank might wish; monetary policy might need to be tightened before a cyclical recovery was fully established in France or while the Irish economy was being dragged into recession by the United Kingdom outside the union; the impact of a particular action by the ECB might be felt more acutely in the Netherlands than elsewhere. This non-discriminating nature of a common monetary policy might also be exploited by individual governments seeking, against the general policy stance within the union, to finance domestic activity by borrowing, in the knowledge that the effect of a compensating monetary tightening by the ECB would be spread across the whole of the union: the efficacy of the disciplinary powers associated with the Excessive Deficits procedure in Stage 3 has yet to be tested.

With two-thirds of the Community's trade in goods taking place between the Member States and trade with the rest of the world accounting for only 8 per cent of GDP, there is a danger that a monetary union will become inward-looking, the more so the larger its membership. Not only trade relations but also monetary relations between the members of the union and those members of the Community who remain outside could become much more asymmetric than they are at present, the incentive for the inner group to take into account the interests of those in the outside ring being considerably reduced. It would also fall to the members of the union and not the Community as a whole to decide on the place of the ECU in the international monetary order.

Coping with the internal strains which are likely to arise from time to time under a common monetary policy will require of members of a monetary union a greater spirit of co-operation than has been needed, and perhaps than has been shown, so far. Each government that expresses the political will to move with others to Stage 3 will need to be sure that it also has the political will to persevere, in this spirit of co-operation, within both the Council of Ministers and in the ECB Council. If the commitment under Article 2 of the Maastricht Treaty to 'promote throughout the Community a harmonious and balanced development of economic activities ... raising the standard of living and quality of life, and economic and social cohesion and solidarity among Member States' is to be honoured, the same spirit of co-operation must extend also to relations between those who have entered Stage 3 and those who remain in Stage 2. It is not clear that the institutional and legal framework established for a Stage 2 in which all Member States participate will be adequate to the purpose when some members have moved on to a much greater degree of integration. Still less do the present Stage 2 arrangements seem adequate to cope with a significant eastward extension of Community Membership.

Participation by the United Kingdom in a move to Stage 3 in 1999 could add considerably to the economic and political substance of the union, subject to the same provisos as any other participant concerning the political will and underlying economic convergence. It would also help to ensure that the Community (and the union) acts, as required under Article 3a of the Treaty, 'in accordance with the principle of an open market economy with free competition'.


(1) Council Decision of 12 March 1990 on the attainment of progressive convergence of economic policies and performance during stage one of economic and monetary union, (90/141/EEC); Council Decision of 12 March 1990 amending Council Decision 64/300/EEC on co-operation between the central banks of the Member States of the European Economic Community, (90/142/EEC).

(2) Council Directive of 24 June 1988 for the implementation of Article 67 of the Treaty, (88/361/EEC).

(3) Treaty on European Union, Office for Official Publications of the European Communities, Luxembourg, 1992.

(4) Conclusions of the Presidency of the European Council, Hanover, 27-28 June 1988.

(5) Report on Economic and Monetary Union ['Delors Report'], Committee for the Study of Economic and Monetary Union, Office for Official Publications of the European Community, Luxembourg, 1989.

(6) Six years on, this concern still resonates in central banks. "I nevertheless find it difficult to judge now whether or when the necessary conditions can or will be met. (.....) It would be unfortunate nevertheless if, in moving in the right direction, some countries felt obliged to move at a pace that was driven by artificial deadlines rather than at a pace appropriate to their national circumstances":, Eddie George, Governor of the Bank of England, in Economic Integration in Europe, Address to the Institut d'Etudes Bancaires et Financires, Association Franaise des Banques, 31 January 1995.

(7) Conclusions of the Presidency of the European Council, Madrid, 26-27 June 1989.

(8) For a description of the main points of contention and how these evolved in the course of the negotiation, see The Transition to EMU in the Maastricht Treaty, Bini-Smaghi, L., Padoa-Schioppa, T., and Papadia, F., Essays in International Finance, No 194, Princeton, November 1994.

(9) See International Capital Movements and Foreign Exchange Markets, Report to the Ministers and Governors by the Group of Deputies, Group of Ten, April 1993. The report notes that net purchases by foreigners of domestic securities in the United Kingdom, Italy and Sweden amounted to $112 bn in the 2 1/2 years to mid-1992, while net portfolio inflows into Spain amounted to $27 billion, and these were mostly predicated on continued convergence. It also attributes to convergence trading in ERM currencies the growth of short-term global income funds in the United States which are estimated to have grown from virtually zero at the end of 1989 to $25 bn by mid-1992.

(10) So far the Council of the European Monetary Institute has confined itself to an Opinion, endorsed by the Council of Economic and Finance Ministers (ECOFIN) that 'in the current circumstances, [it] considers it advisable to maintain the present arrangements and that member countries should continue to aim at avoiding significant exchange rate fluctuations by gearing their policies to the achievement of price stability and the reduction of fiscal deficits, thereby contributing to the fulfilment of the requirements set out in Article 109j(1) of the Treaty and the relevant Protocol'. Annual Report 1994, European Monetary Institute, Frankfurt.

(11) Wim Duisenberg., Governor of the Nederlandsche Bank, sees 'no chance that the Maastricht criteria would be met by a majority of [Member States] in two years' time. See interview in Le Monde, 31 January 1995. Hans Tietmeyer, President of the Bundesbank, does not think that there is 'any likelihood' that the majority of Member States will meet the Maastricht criteria for Stage 3 by 1997 and 'for the time being [he] can not see that a two-thirds majority of [the Member States] will say that it is appropriate to move to a monetary union'. See interview in The Guardian, 16 March 1995. The European Commission, however, believes that a majority of Member States might be ready to move to Stage 3 in 1997: see The Progress of EMU in Everybody's Europe, speech by Giovanni Ravasio, Director General, Economic and Financial Affairs (DG XV), Federal Trust Conference, London, 17 November 1994.

(12) 'It seems to me perfectly healthy that some [Member States] should integrate more closely or more quickly than in others': UK Prime Minister John Major, William and Mary Lecture, University of Leiden, 7 September 1994. He does, however, add: 'I see real danger in talk of a "hard core", inner and outer circles, a two-tier Europe. I recoil from ideas for a union in which some would be more equal than others'.

(13) Reflections on European Policy, Wolfgang Schable and Karl Lamers, CDU/CSU-Fraktion des Deutschen Bundestages, 1 September, 1994.

(14) French Prime Minister Edouard Balladur envisages the nations of Europe forming three circles, (with three types of organisation - monetary, economic and diplomatic and defence) and moving at several speeds while preserving an effective central core. See interview in Le Figaro, 30 August 1994, and article for The Guardian/Le Monde, 1 December 1994.

(15) See Padoa-Schioppa, T., The Road to Monetary Union in Europe, Clarendon Press, Oxford, 1994.

(16) An expression used in two separate reports to the ECOFIN Council in April 1993: Implications and Lessons to be Drawn from the Recent Exchange Rate Crisis, Committee of EC Central Bank Governors and Lessons to be Drawn from the Disturbances on the Foreign Exchange Markets, EC Monetary Committee.

(17) Model-based simulations of fiscal policy shocks under different exchange rate regimes, presented in Box D, pp. 51-52, in the World Economy chapter of this Review, lend support to this proposition. Review. See also simulation results reported in Whitley, J.D., 'Aspects of Monetary Union', in Barrell, R. and Whitley, J. (Eds), Macroeconomic Policy Coordination in Europe, NIESR., Sage Publications, London (1992).

(18) This danger was foreseen in the 'Delors Report': 'Rather than leading to a gradual adaptation of borrowing costs, market views about the creditworthiness of official borrowers tend to change abruptly and result in a closure of access of access to market financing. The constraints imposed by market forces might be either too slow and weak or too sudden and disruptive.'

(19) The potential problems which may result from such differences under a common monetary policy are noted in a special Box in the 1994 Annual Report of the EMI. For a description of the structures of personal and company sector fixed and floating-rate debt and the implications for the monetary transmission mechanism in a number of industrial countries, see Miles, D., 'Fixed and Floating-Rate Finance in the United Kingdom and Abroad', Bank of England Quarterly Bulletin, Vol.3 No. 1, February 1994. For econometric evidence of cross-country differences in the degree of stickiness in lending rates, see Cottarelli, C., and Kourelis, A., 'Financial Structure, Bank Lending Rates and the Transmission Mechanism of Monetary Policy', IMF Working Paper No. WP/94/39, International Monetary Fund, March 1994.

(20) Report of the Monetary Committee to ECOFIN, July 1990, quoted in Bini-Smaghi,L., et al., (1994), see (8) above. At that time the key decision was assumed to be that between Stage 1, which would be a quite lengthy period in which convergence was achieved, and Stage 2 which would be a short period of transition.

(21) This is not synonymous with the European Council which, unlike the Council of Ministers, has no power to take legally binding decisions and includes as an equal among its members the President of the Commission.

(22) The European Union created by the Maastricht Treaty is a structure with three 'pillars': two of these - common Foreign and Security Policy and Justifce and Home Affairs - so far provide only for inter-governmental co-operation rather than supra-national competence; the European Community continues, now as the third pillar of the Union, to encompass all policies derived from the original Treaties, in which some measure of competence has passed to the European level. In this Note the term Community or EC is used throughout to avoid possible confusion with Economic and Monetary Union.

(23) This is noted in the 1994 Annual Report of the EMI, which goes on to argue that countries with high debt ratios may need to achieve deficits smaller than 3 per cent of GDP if they are to demonstrate that their debt ratios are diminishing sufficiently.

(24) Ruling of the Federal Constitutional Court, 2 BvR 2134/92 and 2 BvR 2159/92, 12 October 1992. The ruling also states that the date of entry into Sage 3 is 'to be regarded as an objective date rather than a legally binding deadline'.

(25) Luxembourg is treated, in this analysis of trade patterns as a member of the inner ring rather than the core since a geographical breakdown of its trade is not available separately from that of Belgium.

(26) At current exchange rates. Using standardised 'International dollar' exchange rates, which incorporate an allowance for estimated differences in the cost of living, per capita income in Portugal and Greece is half that of Sweden and Germany (see Table 6, column 4).

(27) Estimated in 'International dollar' terms, these differences are only perhaps a half to one third as great but the estimated cost-of-living comparisons entailed in such calculations are acknowledged to be particularly unreliable in the case of newly-liberalising command economies.

(28) Baldwin, R.E., Towards an Integrated Europe, CEPR, London 1994.

(29) Pisani-Ferry, in a detailed analysis of the origins of the 1992-93 ERM crisis and its differential effects among the eleven participating countries, observes that during the period in which central rates in the parity grid remained unchanged, both the costs (from loss of the exchange rate as an instrument of adjustment to asymmetric shocks) and the benefits (deriving from exchange rate stability) of EMU may have seemed small, 'supporters and opponents of EMU giving the impression of arguing about the sign of a magnitude in the region of zero'; the subsequent exchange-rate turbulence resulting from asymmetric pressures has made both the risks and the rewards of EMU more visible - 'the stakes have been raised'. See Pisani-Ferry, J., 'Union monetaire et convergence: qu'avons nous appris?', Working Paper No. 94-4, CEPII, Paris December 1994.

(30) Reports by the EC Monetary Committee and the Committee of EC Central Bank Governors to the ECOFIN Council, April 1993, see (16) above.

(31) For a contrary view, in which monetary leadership in a Stage 2/Stage3 ERM by the ECB and the 'union ECU' would be more appealing to EC Member States excluded from the union than the present Bundesbank-and Deutschemark-dominated ERM, see Schioppa, C., 'The Relationship Between the Single Currency and the Other Currencies in the Union: Is there EMS after EMU?' in ECU No.31-1995/II, ECU-Activites asbl, Brussels 1995.

(32) Britton, A., and Mayes, D., Achieving Monetary Union in Europe, AMUE and NIESR, Sage Publications, London 1992.

(33) Kenen, P.B., EMU After Maastricht, Group of Thirty, Washington 1992. Elaborating a year later, he notes that the Maastricht Treaty 'contemplates arrangements even less symmetrical than those of the present EMU' and that 'a two-speed approach could greatly damage the cohesion of the EC without conferring very large economic benefits on the fast-speed countries', asking 'what price would the fast-speed countries pay for scuttling the Maastricht Treaty?': see Kenen, P.B., 'EMU Reconsidered', mimeo, 1993.


1. 'a high degree of price stability': a sustainable price performance and an average rate of price inflation over the previous year no more than 1 1/2 percentage points above that of 'at most, the three best performing Member States in terms of price stability'; price inflation measured by the 'consumer price index on a comparable basis, taking into account national definitions'.

Drafters of the Treaty specified 'at most three' Member States to overcome the risk of an unrealistic target if one Member State were to register a 'rogue' low (or even negative) rate of inflation; 'at most three' is intended to set a limit to the dilution of the criterion.

2. 'sustainability of the government financial position': absence of a deficit that is excessive as defined under the 'excessive deficits procedure' (to proscribe 'gross errors'), ie:

* a planned or actual ratio of government net borrowing to GDP no greater than 3 per cent, unless it has 'declined substantially and continually and comes close to' 3 per cent or the excess is only exceptional and temporary and the ratio remains close to 3 per cent; and

* a ratio of total general government gross debt to GDP no greater than 60 per cent unless it is 'sufficiently diminishing and approaching' 60 per cent at 'a satisfactory pace'.

The numbers are not arbitrary: they reflect the average record of those Member States which pursued prudent fiscal policies in the 1970s and 1980s; 60 per cent is the figure at which the stock of debt will stabilise if a country sustains a 3 per cent government deficit and annual nominal GDP growth of 5 per cent (for example, 2 per cent inflation and 3 per cent real growth). Technical terms and statistical data are defined in Council Regulation (EC) No 3605/93 of November 1993.

3. exchange rate stability: participation in the exchange rate mechanism of the EMS, 'respecting the normal margins of fluctuation', for at least two years without the Member State concerned devaluing 'on its own initiative' the bilateral central rate for its currency against the currency of any other Member State.

4. convergence of interest rates: durability of convergence and of ERM participation being reflected in an average nominal long-term interest rate over the past year no more than 2 percentage points above 'that of, at most, the three best performing Member States in terms of price stability' interest rates measured on the basis of long-term government bonds or comparable securities 'taking into account differences in national definitions'.

A margin of 2 per cent rather than, as for the inflation criterion, 1 1/2 per cent was intended to allow for an interest rate premium of up to 1/2 per cent in countries where long-term bond markets are less liquid.

Other factors to be taken into account in assessing convergence:

* the compatibility of each Member State's national legislation, including the statutes of its central bank, with the Treaty requirements (Articles 107 and 108 and 3rd Protocol) relating to ECB and national central bank independence;

* the development of the ECU;

* 'the results of the integration of markets' (ie. operation of the Single Market);

* the development of balances of payments on current account;

* the development of 'unit labour costs and other price indices'.

(a) Articles 109j(1) and 104c(2) and 5th and 6th Protocols.


STAGE 2 (with effect From 1 January I994)

Economic Policies

* Member States to conduct their economic policies 'in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources' (Article 102a), to regard them as 'a matter of common concern' and to co-ordinate them within the ECOFIN Council (Article 103);

* ECOFIN to adopt 'broad guidelines of the economic policies of the Member States and of the Community;

* 'multilateral surveillance' to be undertaken by ECOFIN to monitor convergence of Member States' economic performance and consistency of national policies with 'broad guidelines'; ECOFIN may make (and may publish) a Recommendation to a Member State whose policies are not consistent with these guidelines;

* the European Monetary Institute (see below) may submit Opinions or Recommendations to governments and to ECOFIN on 'policies which might affect the internal or external situation of the Community and, in particular, the functioning of the EMS (Article 109f(4)).

National budgetary policies and government finances

* no monetary financing of the public sector, either through borrowing from national central banks (Article 104) or through 'privileged access' to financial institutions (Article 104a);

* no bailing out (taking over the public sector financial commitments) of a Member State by the Community or by other Member States (Article 104b);

* Member States 'shall endeavour to avoid' excessive government deficits (Article 109e(4));

* 'Excessive deficits procedure' for ECOFIN monitoring of compliance by Member States, on the basis of reference values for government deficits and debt stocks (see box on Convergence Criteria on page 79;

* if ECOFIN decides an 'excessive deficit' exists it may make a Recommendation to the Member State concerned and, if no effective action is taken, the Recommendation may be made public (Article 104c and 5th Protocol).

Monetary and exchange rate policies (Articles 109f and 109m and 4th Protocol)

* Monetary policies remain the responsibility of national monetary authorities

* European Monetary Institute established, with the task of strengthening co-operation between national central banks and co-ordinating national monetary policies 'with the aim of ensuring price stability';

* Exchange rate policies remain a national responsibility but each Member State 'shall treat its exchange rate as a matter of common interest';

* EMI to monitor the functioning of the EMS and to take over from the European Monetary Co-operation Fund responsibility for the multilateral accounting and financing arrangements of the ERM;

* EMI may formulate (and may publish) Opinions or Recommendations on 'the overall orientation' of monetary and exchange rate policies and related measures in each Member State and on the conduct of a Member State's monetary policy;

* EMI to be consulted by Member States and by ECOFIN on any draft legislation which touches on any matters in which the EMI has competence;

* EMI to prepare the 'instruments and procedures necessary' for conduct of the single monetary policy in Stage 3 and, at the latest by 31 December 1996, to specify the 'regulatory, organisational and logistical framework necessary for the ESCB to perform its tasks'.


Economic Policies

* No additional powers given to ECOFIN;

* ESCB (see below) required, 'without prejudice to the objective of price stability', to support 'the general economic policies of the Community (Article 105(1));

* ESCB assumes from EMI the right to submit opinions to ECOFIN, other Community institutions or national authorities, on matters within its field of competence (Article 105(4); 3rd Protocol, Article 4(b).

National budgetary policies and government finances

* Avoidance of excessive deficits becomes mandatory (Article104(1)) and 'excessive deficits procedure' reinforced, with possible sanctions:

* ECOFIN, in a Decision, may specify remedial action to be taken within a given period by a Member State which has persistently ignored a Recommendation regarding its excessive deficit (Article 104c(a));

* if the Member State does not comply with that Decision, ECOFIN may require the Member State to publish additional information in prospectuses for its bonds and securities, invite the EIB to reconsider its lending policy towards the Member State, require the Member State to make a non-interest-bearing deposit with the Community and/or impose a fine upon it (Article 104c(11)).

Monetary and exchange rate policies

* European Central Bank and European System of Central Banks (consisting of ECB and those national central banks participating in Stage 3) established as soon as decision taken on a date for the start of Stage 3, taking over the tasks of the EMi which is then liquidated (Article 1091(1) and (2));

* at the start of Stage 3, ECOFIN adopts irrevocable conversion rates for national currencies of participating countries and between those countries and the ECU, which becomes 'a currency in its own right', and takes measures for 'the rapid introduction of the ECU as the single currency' (Article 1091(4));

* primary objective of ESCB is to maintain price stability; it is also required, without prejudice to this objective, to 'support the general economic policies in the Community' (Article 105(1); 3rd Protocol, Article 2);

* one of the ESCB's basic tasks is 'the definition and implementation of the monetary policy of the Community' (Article 105(2); 3rd Protocol, Article 3.1);

* European Central Bank takes over consultative functions of EMI (Article 105(4));

* ECB has exclusive right to authorise the issue of banknotes (which may be issued by ECB or national central banks); approval of ECB needed for issuing of coinage by Member States (Article 105a);

* ECB to have recourse to national central banks 'to the extent deemed possible and appropriate' to carry out its operations; statutes of national central banks to be compatible with independence requirements of Treaty (Article 108 and 3rd Protocol, Articles 12.1 and 14.1);

* ECOFIN (acting by unanimity among participating Member States) may, on an ECB or Commission recommendation and after consulting the ECB 'in an endeavour to reach a consensus consistent with the objective of price stability', 'conclude formal agreements on an exchange rate system for the ECU in relation to non-Community currencies' (Article 109(1));

* in the absence of an exchange rate system in relation to third currencies, ECOFIN may, by qualified majority following a similar procedure, 'formulate general orientations for exchange rate policies' in relation to third currencies (Article 109(2));

* ESCB empowered to conduct foreign exchange operations which are consistent with any exchange rate policies determined by ECOFIN and to hold and manage the official foreign exchange reserves of the participating Member States (3rd Protocol, Article 3.1);

* national foreign exchange reserves, up to an initial aggregate figure of ECU 50 bn, to be pooled at the ECB; the remainder (with the exception of 'working balances' which may be held by Member States' governments) to be held and managed by national central banks, but transactions by governments or central banks above a certain limit to be subject to ECB approval (Article 105(3); 3rd Protocol, Article 31).
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Author:Arrowsmith, John
Publication:National Institute Economic Review
Date:May 1, 1995
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