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Hurdles to monetary union in Europe.

Ferocious currency speculation and competitive devaluations have cast a pall on the European Monetary System--an essential precursor to monetary union in the EC. Yet hopes for union remain strong, with many governments fearful of the floating-rate alternative.

Barely two years ago, the European Community seemed poised to become the world's leading economic area, unified by a single currency, and eventually expanding to include all the continent. Today, this dream is dead. Countries applying for EC membership are having second thoughts. Eastern Europeans feel slighted by closed borders, and war has erupted in the Balkans. The Maastricht Treaty, the plan for establishing a single currency by 1999, teeters on the brink of rejection. A deep recession has sent unemployment rates soaring to record levels--even in countries such as Sweden, Norway, and Finland, which had never before seen large-scale unemployment. Is the project doomed after the recent speculative crises? Maybe, but don't write it off yet. Ironically, much of today's difficulties can be traced to the Maastricht Treaty. When the treaty was concocted, the European Monetary System appeared to be an amazing success. In fact, it was already moribund, fundamentally destabilized by the freeing of capital movements. Even though a single currency could have been the appropriate answer, the drawn-out transition imposed by the treaty created a depressing catch-22 situation: Violent currency crises will continue to arise as long as the EMS exists, but monetary union without the EMS won't be achieved. ALL FOR ONE?

Europe is not really ripe for a single currency, and maybe it never will be. To understand why, contrast the situation in the U.S. with that in Europe. For example, as California founders in the midst of a recession, a depreciation of the Californian dollar by some 20 percent would help. Boosting exports soon would end the recession, but, of course, this is not an option. Instead, Californians simply move to other states. The lesson: When currencies cannot change, businesses take the hit, and people move. In Europe, however, people do not move, because they do not speak the same languages and have different traditions; thus, both businesses and people will take the hit. So, why shoot for a single currency? For lack of a better alternative. A crucial turning point occurred with the adoption of the Single European Act, ratified in 1988. It sought to remove all remaining impediments to the movement of people, goods, and assets within the EC. In particular, the act mandated by July 1990 the removal of all restrictions to capital movements. However, the act did not account for the fact that the EMS owed its survival to the widespread existence of capital controls.

The exchange-rate realignments, which used to occur on average every eight months, always had been easy to foresee. With nothing to lose and much to gain, exchange traders happily triggered speculative attacks against soon-to-be-devalued currencies. Capital controls, although never airtight, were effective enough to provide the authorities with the time and room to organize the parity change.

Without controls, the amount of speculative capital has become unmanageable, leaving Europeans with just two options: They can either let their currencies float freely, as in the U.S. or Japan, or they must ban realignments forever and, therefore, aim for a monetary union. Europe suffered a nasty experience with floating rates in the early 1930s. Competitive devaluations responded to competitive devaluations in frustrated attempts to escape the Great Depression. In the end, a tariff war resulted in the collapse of international trade. That specter still haunts Europeans, whose countries are now completely open to each other. This is why, despite all its dangers, monetary union is the lesser of the two evils.


The future European Central Bank has been patterned after the German Bundesbank. It will be mandated to deliver low inflation and a strong currency, objectives that spell drastic implications for interest rates.

In contrast with the current situation in the U.S. and with past experience in most non-German countries in Europe, interest rates will not be allowed to fail to levels barely matching inflation. On the flip side, because inflation will remain low, interest rates will never rise much either. This is reassuring news for industries that rely on credit-financed sales--chiefly housing and construction, cars, and durable goods--as they will face fewer ups and downs in their markets. Relatively stable interest rates also will exert a steadying influence on housing and stock prices, providing a less volatile environment for the banking and financial sector.


The Maastricht Treaty mandates some "good behavior" criteria--with financial penalties in case of offense--that also will act as EMU entry conditions:

* The inflation rate should not exceed by more than 1.5 percent the average of the three countries where it is lowest.

* The (long-term) interest rate must not exceed by more than 2 percent the average observed in the three countries with the lowest rate of inflation.

* The exchange rate must remain safely for at least two years within the normal bands of fluctuations.

* The budget deficit must not exceed more than 3 percent of gross domestic product.

* The gross public debt must not exceed more than 60 percent of GDP.

Today, only Luxembourg qualifies for EMU membership, a pity since this country does not even have a currency of its own. The convergence criteria already have sparked dramatic effects. By refusing to jump-start their economies in 1990-1992 for fear of moving away from the Maastricht targets, nearly all European governments have turned what could have been a mild and short-lived slump into a major recession. And yet, because of the recession, they have been unable to stem the tide of red ink in their budgets. Two exceptions stand out. Germany has let its budget slip to finance reunification and, for that reason, will have been the last to experience a slow-down, and a mild one at that. The U.K., which was the first to go into recession and has had the most pronounced one, has belatedly taken expansionary measures.

Even when public debts drop below the arbitrary level of 60 percent, the 3 percent rule will restrain national budgets and exert a continuous contractionary bias on EC economies. Since 1975, only once have the EC countries achieved a net deficit below the 3 percent mark (this observation only includes the first nine members; if Spain, Portugal, and Greece were added, the picture would be even grimmer). As the European Central Bank is unlikely to play the counteracting role taken over in the U.S. by the Federal Reserve Bank, the conclusion is unmistakable: Europe, which has been able for most of the postwar years to limit the depth and length of its business cycles, will not continue to do so.

One can only conjecture what fiscal and monetary passivity will mean for businesses operating in Europe. Labor relations remains the most challenging issue. For several decades, European workers have been accustomed to much cozier conditions than their U.S. counterparts. Optimists look at the post-Thatcher U.K. and see a sharp reduction in the powers of trade unions. Pessimists expect gradually hardening resistance from unions, eventually boiling over into open rebellion.


Many believe monetary union will push Europe irrevocably toward federalism. This is far from a foregone conclusion. At present, the EC Commission budget--the equivalent of a federal budget--amounts to less than 2 percent of EC GDP, most of it earmarked for the (in)famous Common Agricultural Policy. Federalism would have to be the outcome of an unlikely big push.

National budgets originate with defense, justice, education, and infrastructure. There is no incentive to govern any of those components at the EC level. The number of transfers from rich regions or countries to poorer ones undoubtedly will grow over the years. Yet, over the coming decade at least, the amounts cannot become significant. More likely is a move toward harmonization, or rather competition, in the area of taxation. This is clear for corporate and asset taxes: With capital freely mobile, it will too easy to look for fully legal tax havens. Competition may well spread, even to implicit forms of taxation such as labor regulations foreshadowed by the Hoover case. THE EXCHANGE CRISIS

As soon as Denmark voted against the Maastricht Treaty in June 1992, the exchange markets started to speculate against the Italian lira, the EMS' weakest currency. In mid-September, fueled by a growing lack of solidarity among the authorities, the attacks escalated. Within hours, Italy and the U.K. lost their foreign-exchange reserves, were unable to defend any parity, and were forced out of the system. Amazed by their newly discovered power in this new world of free capital mobility, the markets methodically went down the list of EMS currencies. Spain devalued three times, Portugal twice, Ireland once. Denmark, France, and Belgium endured several violent attacks until it was decided at the end of July 1993 to suspend the system by allowing margins of fluctuation around the official parity so deep that the EMS has now lost its soul. Only Germany and the Netherlands emerged unscathed. Speculative attacks are not new for the EMS. Yet, never before had the system itself cracked. Thus, the first wave of attacks under conditions of full capital mobility proved fatal. It had to happen; since 1990 the EMS had become a time bomb. It simply took a particular set of circumstances (the disastrous referenda in Denmark and France, German unification, and a deep recession) to reveal the system's fundamental flaw.

No one claims that Denmark's or France's currencies are overvalued. But pressures on both have forced the suspension of the EMS. Neither was the Irish punt ever overvalued, nor was there any good reason for the Spanish peseta to have been devalued three times in six months. Perhaps exchange markets force events for wrong reasons? The bottom line is that speculative attacks can be self-fulfilling. Exchange markets are bigger than central banks. By forcing a currency to depreciate, they radically alter the incentives of the monetary authorities. Deeply committed central banks may fight by raising interest rates to high, even stratospheric levels, as Sweden did by going to 500 percent. Once they have been forced to let the exchange rate go, keeping interest rates high serves no purpose: The relaxation that follows justifies the market's bet after the fact.

That attacks can be self-fulfilling is ominous. Nearly every currency stands at risk. Markets, not by design but rather by growing consensus, can force fundamental policy changes as seen in the U.K. and Italy. Minutes before their currencies went down in flames, the British and Italian authorities had no intention whatsoever of changing their minds. The next day, in a famous statement, Norman Lamont, then British Chancellor of the Exchequer, said he had been singing in his bath at the thought of being free at last to conduct a "monetary policy good for Britain." What was he doing before? Finally ratified by all 12 countries, the Maastricht Treaty went into effect on November 1. Current conventional wisdom holds that it is stillborn. That may be too early a burial. In theory, as an international treaty, it supersedes national legislation.

In practice, things are different. One key preliminary step is the requirement that exchange rates be maintained within their "normal" bands for at least two years. When the treaty was adopted, the bands were narrow (2.25 percent on either side of the central parity). At the end of July 1993, the bands were "temporarily" widened (to +/-15 percent). Which bands are the normal ones? Chances are the Bundesbank will not agree to anything short of the old narrow bands. If that is so, the EMS must revert to these bands before the end of 1996 to make the January 1, 1999, deadline.

This leaves a maximum of three years to rebuild the EMS. Optimists bet that the resumption of growth and the absence of further disturbances will propel Europe all the way to monetary union. Pessimists think the 15 percent bands are not deep enough and expect speculation to resume, tearing apart the EMS and killing monetary union. Realists invariably note that the fatal flaws of the EMS--the inherent incompatibility of full capital mobility and fixed exchange rates--are still here, and that proper policy planning must envisage worst-case scenarios. So far, realists have been ignored, pessimists have been proven right, and governments have been optimistic.

Charles Wyplosz is an economics professor at Fontainebleau, France-based INSEAD, the Institut Europeen d'Administration des Affaires (The European Institute of Business Administration). He is also an adviser to the Russian Ministry of Finance.
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Title Annotation:includes related article
Author:Wyplosz, Charles
Publication:Chief Executive (U.S.)
Date:Jan 1, 1994
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