3. The EMU: genesis

1. 3. The EMU: genesis 3.1 The attachment to exchangeratestability - the gold standard - the Bretton Woods-regime - Europeanexchangeratecooperation 3.2 Politics and EMU: the road to Maastricht 3.3 The institutionalset-up of EMU

2. The gold standard • The gold standard: notes and coins of participatingcountrieswerebackedby and convertible into specificweights of thismetal; externalimbalances led to gold flows and an automaticadjustmentprocess (cf. Ch. 4) • The gold standardwaswidespread in the late 19th century (in the UK since 1814) butcame to an end as a consequence of the inflationary finance of worldwar I. Finland was on a silverstandard as from 1865 and on the gold standardfrom 1878 • MostEuropeancountrieswentback to the gold standard in the 1920s (often at an overvaluedparity), and abolished gold onlyreluctantlyduring the great depression in the 1930s (Finland, following the UK, abandoned gold in 1931) • NB: the gold standardwas ”sort of” a fixedexchangeratesystem (ifstrictlyadhered to) eventhoughtherewas no common currency • NB: Historically, monetaryunionhastypicallybeen a bedfellow to politicalunion; e.g. the Roman empire (thoughittookcenturies for a uniformcurrency to spreadacross the whole empire), and the US (though the US became a MU onlyafteritscivilwar)

3. (cont.) • Someexceptions (and rather long lasting): the LatinMonetary Union and the ScandinavianMonetary Union • The former (comprised of FRA, ITA, BEL, SWI, GRE) was a bimetallicunion (gold an silver), itlastedfrom 1865 to 1927 • The latter (comprised of DEN, SWE, NOR) lastedfrom 1873 to 1920 • Thesemonetaryunionsdidnothave the politicalcohesionorinstitutions to surviveonceeconomicdevelopments led to conflictinginterests and policies • Therearestillthoseconvincedthatonly gold as the basis for the currencycanguaranteeprice and exchangeratestability (notfiat money) • Whileeconomistsseesomemerits in flexibleexchangerates, citizens and politicianstend to have a strongpreference for stableexchangerates

4. The Bretton Woods-regime • A new international monetaryorderwasagreed at Bretton Woods (New Hampshire, US) in 1944 (with Keynes as one of the keycontributors) • BW establishedfixedparities of othercurrencies to the dollar, itselfpegged to gold • The operation of the BW-regimewas to bepolicedby a new institution, the International MonetaryFundor IMF (the World Bank wasalso set up) • Competingdevaluations (”beggar-thy-neighbour”) were to beavoided, butdevaluationswereaccepted in cases of ”fundamentaldisequilibria” • During the 1960s, US balance of paymentsdeficitscaused US debt to centralbanks (and otherassetholders) to becomequitelargerelative to the US government’s gold stock, whichundermined the credibility of the dollar/gold-link (and France indeedinsisted on convertingFrenchdollarassets into gold by the US) • US monetarypolicywasexpansionary/inflationary to finance the Vietnam war, whichcausedlarge capital outflows; BW came to an end on 15 August 1971 when Nixon terminatedconvertibility of US dollars into gold

5. Europeanexchangeratecooperation • Most EU (or ”EEC”) countriesagreed in 1972 to preventfluctuationsbetweentheircurrenciesexceeding 2.25 % (”the currencysnake”), whilefluctuatingfreelyagainstothercurrencies • In 1979 thiswasreplacedby the EuropeanMonetary System with ECU, a Europeancurrencyunit, defined as a basket of currencies as a focalpoint; national currencieswerenotsupposed to deviatemorethan 2.25 % fromtheircentralECU-rates • the ERM, the exchangeratemechanism (part of the ESM), envisagedadjustment of national parities (to the ECU) in case of seriousneed (butnormallyparityshouldbedefendedbymonetary and otherpolicies) • In practice the systemput the burden of adjustment on deficitcountries, running out of reserves, whichhad to devalueor to defendtheircurrencies with tightpolicies; in practice, D-markwas the keyEuropeancurrency: the strength of the D-markposedproblems for countries with a tendency to higherinflation • Recurrentspeculativeattacksforced UK and Italy to withdrawfrom the EMS in 1992, and in 1993 the fluctuationbandswereincreased to +/- 15 % (mitigatingone-sidedspeculation) • Finland wasnot a member of the EMS buthadalready in 1991 beenforced to devalue the markka

6. The impossibletrinity (pick 2 out of 3)

7. Politics and EMU: the road to Maastricht • A groupchairedby the primeminister of Luxembourg, Pierre Werner, presented a plan for settingup an economic and monetaryunion in 1970; thisplanforesaw a need for a politicalunion - butdidnotspell out how to achieve it. Subsequentexchangerateturbulence led to the burial of the Werner plan. • In the late 1970s, Germanchancellor Helmut Schmidt and Frenchpresident Giscard d’Estaingsaw EMU as a way of strentheningpricestability as well as Europeanunity and as a way to ”escapeGermandomination” • Frenchpresident Francois MitterandforesawGermanreunificationalready in the late 1980s and started to ponderitsimplications; he wanted Germany to shareitsmonetarypolicy with France in exchange for securityguarantees • He lateragreed with Germanchancellor Helmut Kohl that Germany wouldgiveup the D-markthroughsettingup the EMU with a view to deepeningEuropeanintegration (arguablynecessitatedbyGermanreunification) • In 1988 they set up a committee of experts (centralbankers) to prepare EMU

8. (cont.) • The committee (chairedby Jacques Delors) made wide-rangingproposals and stressed the need for ”paralleladvancement in economic and monetaryintegration” (factormobility, wage and priceflexibility…) • Therewasnot a formalbargain of Germany signingup to EMU and givingup the D-mark in exchange for germanreunification, but the formerwouldhavebeenunlikely to happenwithout the former • Mitterandpointed out to Kohl that, lackingseriousnegotiations on EMU, Germany riskedfacing a triplealliance of France, UK and the Sovjet Union (laterRussai), whichcouldlead to Germanisolation • The Maastricht treaty, agreed in 1991, set a timetable for EMU by 1999 at latest and the main requirements, including the convergencecriteria to befulfilled in order to qualify (lowinflation, low long terminterestrates, a stableexchangerate, below 3 % of GDP budgetdeficit and below 60 % of GDP publicdebt) • NB: The Maastrichtreatywasagreeddespitestrongmisgivingsby the Bundesbank

9. (cont.) • The convergencecriteriawerepolitical as well as economic (helping to keep out somememberstatesifsowished) • The numberswerearbitrary: 3 % because of Frenchfigures for 1993, 60 % becausethatwouldbecompatible with 3 % deficit and 5 % nominal GDP growth(!) • Whywas the debtcriterionlaterdisregarded in deciding on membership? Because LUX was ok and was in a monetaryunion with BEL (whichhad a debtratio of 120 % buthad to get in so as not to break LUX-BEL apart); thus, ITA alsoescaped the requirement to fulfill the debtcriterion; whatwasmeant to be a unionaround the ”hardcore” (FRA+GER+Benelux) becamelarge and heterogenous (politics) • The finalpreparationsstarted in 1995 with the specification of a referencescenario for the changeover to the euro and byagreeingthat the nameshouldbe ”euro” instead of ”ecu” • For Kohl, EMU was ”a matter of war and peace”, for hissuccessor, Gerhard Schröder, itwas a ”prematuresicklychild” • EMU was a monetary and economicconstructiojnbutabovealla politicalproject

12. EMU: the institutionalset-up • The European Central Bank (ECB), modeledupon the ”Buba” (Bundesbank) • The eurogroup (agreed in 1997), as a forum for policycoordination (or, for the French, as a ”gouvernementéconomique”) • Fiscalrules: the ExcessiveDeficitProcedure(EDP), meant to prevent ”excessive” (above 3 % of GDP) general governmentfinancialdeficits, and the Stability and GrowthPact(SGP), meant to complement the EDP byrequiringmemberstates to aim at overallbalanceorsurplus in theirpublicfinances in the medium run • NB: decisions on the EDP aretakenbyqualifiedmajority and caninvolvesanctionsifcorrective action is nottaken (at least in principle) • A general obligation to economicpolicycoordination(the broadguidelines of economicpolicy, a Community act givingoverall and country-specificrecommendationson economicpolicies (no sanctionsthough)

13. (cont.) • No centralbankfinancingof governments is allowed (interpreted to meanthat the ECB ornational CBsmustnotbuygovernmentpaper in the primarymarket) • No privilegedaccessof publicbodies to lendingbyfinancialinstitutions • No bailoutof memberstates in financialdifficultiesbyothermemberstatesorbyCommunityinstitutions (the ”no bailout-rule”) • NB: The purpose of theserules is to ensure ”sound” publicfinances, that EMU doesnotstrengthen the deficitbias in publicfinances • NB: the purpose is also to ensurethateachmemberstatefacesup to itsresponsibilities, thatdebtscannotbe ”mutualized”, thatgovernmentspay the rate of interestdemandedbymarketconditoins (ortheydefault)

14. The European Central Bank • The ECB and the national centralbanks (NCBs) of the euro areacountriestogethermakeup the Eurosystem; the ECB and the NBCs of all EU memberstatesmakeup the lessimportantEuropean System of Central banks (ESCB) • The main tasks of the ECB is to formulate and implement the monetarypolicy of the euro area. Othertasksinclude: - the conduct of foreignexchangeoperatioins - the holding and management of officialforeignexchangereserves - promotion of the smoothoperation of the paymentssystem - authorisation of the issuance of banknotes in the euro area - to contribute to prudential supervision of creditinstitutions and the maintenance of financialstability • NB: ”the primaryobjective of the ECB shallbe to maintainpricestability” (the treaty); itmaysupportotherpolicyobjectivesonlyifthisdoesnotundermine the primaryobjective (”lexiographic” targetfunction) • NB: The ECB is goalindependent: it is the ECB itselfwhichhasdefind the pricestabilityobjective as a rate of inflation in the medium termbelow (butclose to) 2 % • NB: The ECB is operating a two-pillarmonetaryframework, focussing on expectedpricedevelopmentsbutalsoconsidering the rate of growth of the stock of money

15. (cont.) • The ECB is exceptionallyindependent: the members of the Executive Board (sixmembers) and the NCB governors (now 18), whichtogethermakeup the decision-makingbody, that is the GoverningCouncil, arefrobidden to seekortakeinstructionsfromgovernments and Communityinstitutions. • Also, the members of the GoverningCouncilhave long and non-renewableterms of office and the NBCs and the ECB is financiallyindependent. • The ECB is accountable to the EuropeanParliament (reportingobligation) butithas no obligation to acceptinstructionsby the parliament, on the contrary (itmustbeindependent) • Monetaryoperations of the ECB arepartlyimplementedby the NBCsbutunderstrictguidancefrom Frankfurt

16. Questions: • Whatare the main monetaryregimesthatwehaveexperienced in Europe? • Manyearlermonetaryregimeshavebrokendown: why? • What is the impossibletrinity? • Whywas the EMU set up? • Whatare the keyelements of the institutionalset-up of EMU? • Is the ECB democraticallyaccountable?

17. Summary and finalcomments on the genesis of the EMU • Europeancitizens and decisionmakershavealwayshad a strongpreference for exchangeratestability, beit in the form of the gold standard, the Bretton Woods-regimeorEuropeanexchangeratecooperation • Europeanexchangeratecooperationturned out to bevulnerable to differences in national circumstances and policies and often led to currencyspeculation and turbulence • Itwasgraduallyrealizedthat the impossibletrinitynecessitatesgivingupmonetaryautonomyiffixedexchangeratesare to becompatible with free capital flows • EMU hasbeenseen as onefurthersteptowardsdeeperpoliticalintegration, and the fall of the Berlin Wall was the triggeringpoint (geopolitics ) • The euro areabecamelarge and heterogenous, also a consequence of politicalconsiderations • The institutionalbasis of the EMU is thin, this is a consequence of the greatdifferencebetweenGerman and Frenchviews: - Germany: ”Stabilitetsgemeinschaft”, bindingrules, sanctions (preferrablyautomatic) versus - France: ”gouvernementéconomique”, discretionarydecision-making, role for politicians • Alsooppositeviews on the desirability of CB-independence (key for Germany, nuisance for France) • The euro is a politicalproject and yet a currencywithout a state, an asymmetricconstruction. Itwasconceived of as a rule-basedsystem, where the onlybodymakingdiscretionarydecisions for the area as a wholewouldnormallybethe ECB.