A brief history

The European Union experience provides a guide to both the positive steps to take and the mistakes to be avoided in the construction of a monetary union. The road to European monetary union was not easy – it took over four decades to realise, and involved a step-by-step process of block expansion (Siddiqi, 2006:32). In real-ity, European monetary integration can be traced back as far as the Treaty of Rome, where it was acknowledged that the exchange rates of member countries should be regarded as a matter of “common interest”. The revaluation of the Dutch guilder and the German mark in 1961 prompted discussion of how the customs union could be extended to the monetary domain.

By the mid-1960s, this had led to the creation of the Committee of Central Bank Gov-ernors (Eichengreen, 1996:153). But the key date was in 1969, when the European Council reaffirmed its intention of moving ahead to full economic and monetary union. This was motivated “in part by the incipient instability of the dollar and by fears that a disorderly revaluation of European currencies would endanger the EEC” (Eichen-green, 1996: 153). This led in 1970 to the formation of a study group of high-level officials chaired by the Prime Minister of Luxembourg, Pierre Werner.

The Werner Plan envisaged the creation of a European monetary union by 1980.

This was to be achieved in stages, with each step bringing the fluctuations in intra-European exchange rates ever closer to the ideal of being irrevocably fixed. Along the way, the participating member States would also begin to establish patterns of coor-dination in other fields of economic policymaking in order to facilitate the conver-gence of national currencies and to reap other cooperative advantages (e.g. through greater intra-regional trade).

It is important to stress that international monetary conditions were seemingly pro-pitious to monetary union in 1970, with the prevailing Bretton Woods arrange-ments providing currency stability, and a relatively small and homogenous set of six EU members. These countries broadly shared a similar Keynesian outlook on macroeconomic management. Nevertheless, “the project fell apart even before it could begin. The closure of the gold window in 1971, the oil price shock in 1973, and the sharp

In the absence

global recession of 1975, made a mockery of European attempts to narrow the fluctua-tions of their bilateral exchange rates” (Jones, 2002: 5).

The collapse of Bretton Woods caused some very significant problems for European economies. The structures that had been in created in 1957 did not offer an effec-tive vehicle for any pan-European economic policy, but it was obvious that an era of floating exchange rates coupled with failure to support the dollar was hitting Euro-pean countries in two ways. Not only did EuroEuro-pean exchange rates tend to appreci-ate against the dollar, thus damaging competitiveness (especially for Germany), but they did so at different rates, thus upsetting the pattern of exchange rates within Europe, not least by making currency relationships volatile and unstable (Hutton, 2002: 370).

The first response of Europe to the collapse of the Bretton Woods system in the early 1970s consisted of “snake” and “snake-in-the-tunnel” arrangements that were designed to stabilize the intra-European exchange rates within relatively narrow bands in an environment of extreme volatility. This was followed by the creation of the EMS in 1979 with the participation of the members of the European Economic Community (EEC), and eventually by the introduction of the euro and the estab-lishment of the European Monetary Union (EMU) in 1999. Thus it took some 30 years to go from soft pegs to hard pegs (UNCTAD, 2001: 118).

Jones (2002:6-7) stresses the considerable diversity that existed among the European countries prior to embarking on the project of monetary union. On the one hand, France was more vulnerable to currency instability within the Bretton Woods system than Germany (having been obliged, like the United Kingdom, to devalue its cur-rency on several occasions). Italy reflected an important economic dualism between the dynamic, prosperous regions of the north and the much poorer regions of the south.

Finally, although all countries embraced Keynesian demand management techniques, the ways in which macroeconomic policy was actually designed and implemented differed very significantly from one country to another. Thus the French directed their economy through credit rationing, while the Belgians and Dutch resorted more to indicative planning and concerted wage bargaining, and the Germans had an his-torical proclivity to stress “increasingly rigid notions of absolute price stability”.

During 1979-1999, the European Monetary System (EMS) became the forum for the harmonization of monetary policies of the member economies. Progress was indeed difficult. In the absence of monetary integration, intraregional free flow of trade and investment, remained exposed to currency rate fluctuations, especially for investment, as modern capital-intensive investments generally large-scale, involve long-term uncertainty and risk. Free movement of labour also remains exposed

The events leading to many hazards as incomes earned in one currency may not be comparable with

incomes earned in another currency within the region (Dutta, 2002).

Jones (2002:6) notes that during this period, two competing perspectives of mon-etary integration coalesced: one called “monetarist”, advocating irrevocably fixed exchange rates as an instrument for the promotion of economic convergence, and the other called “economist”, insisting on economic convergence as a precondition for irrevocably fixed exchange rates. Member countries were split into two camps:

the French, Italians and Belgians advocating the monetarist view, and the Germans and Dutch preferring the economist argument.

In April 1987, Tommaso Padoa-Schioppa, a senior Bank of Italy official, warned in a report that the complete freedom of capital movements envisaged by the Single European Act would threaten the capacity of the EMS to continue, and over the next year pressed the case for a single European currency as the only effective response.

Jacques Delors, then the President of the European Commission, understood that France had only two realistic options: either to opt for floating rates, in which case European integration would be irrevocably damaged and the Bundesbank’s position would remain unchallenged; or to opt for full monetary integration. And what was true for France was true for Europe (Hutton, 2005: 375).¹⁰

The events leading to the 1992–1993 EMS crisis provide useful lessons on how regional currency arrangements, even with supporting institutions, can break down when exchange rates are inconsistent with underlying inflation and interest rates (UNCTAD, 2005: 120). The problem with the European system was that it forced countries to have the same monetary policy and placed control of that policy in German hands. During the 1980s, this was not a problem, because all of the coun-tries shared the same goals. Sooner or later, however, a crisis was bound to come.

When Germany reunified, the massive costs of supporting and rebuilding the East meant a huge fiscal expansion. To prevent that expansion from causing inflation, Germany adopted very tight monetary policies. The problem was that other Euro-pean countries were forced to match the monetary tightening without the fiscal expansion, which meant a severe recession that spread across the whole continent, eventually touching Germany itself (Krugman, 1996:138).

The last pretensions of French leadership were shattered when, after Britain and Italy were forced out of the EMS in 1992, France succumbed to overwhelming foreign exchange speculation the following year. Shadowing high German interest rates fol-lowing reunification had created a deepening French recession. “The tight bands that the EMS had operated were relaxed to allow France to remain a titular member

revolv-10 According to Krugman (1996:138), prior to the crises of 1992/1993, “the Europeans looked at the success of the European Monetary System between 1982 and 1990 and saw it as a fundamental endorsement of sound money, rather than realizing that it was a temporary success based on special circumstances.”

The relative success of the launching of the euro has rekindled interest in monetary union among developing countries

ing around the German sun” (Hutton, 2002: 385). One hundred sixty billion French francs (about $32 billion) were reportedly spent on the currency’s defence in the week ending 23 September 1992 (Eichengreen, 1996: 173)

The speculation that forced the sterling out of the EMS in 1992 was mountainous, reaching $20 billion on “Black Wednesday” alone (Hutton, 2005: 410). The Swed-ish situation also bore a strong basic resemblance to its BritSwed-ish counterpart: a severe recession brought on by the need to match German interest rates, with the Swedish currency clearly overvalued by normal standards, especially given the devaluations by the United Kingdom and Finland. Indeed, there was a speculative attack on the Swedish crown just after the United Kingdom crisis, which was beaten back only by pushing short-term interest rates up to 500 per cent (Krugman, 1996: 139).

Reserve losses incurred in the six days preceding the devaluation are reported to have amounted to $26 billion, or more than 10 per cent of Sweden’s GNP (Eichengreen, 1996: 174).

Thus, without capital controls, the EMS had to resort to fiercely conservative eco-nomic policies in order to maintain itself. Essentially, members had to shadow German interest rates, inflation and budgetary policy if they were to have a chance of staying within the grid. It was this experience that convinced France that it had to opt for a single European currency even before German reunification made the case politically as well as economically pressing. In 1993, its third financial crisis – after 1969 and 1981-1983 when the franc was again hit by an irresistible wave of specula-tion, marked the moment when France became completely convinced. In a world in which neither floating nor fixed exchange rates offered sovereignty, the only course was to establish a single European currency (Hutton, 2002: 410).

3.4.2 Launching of the euro

The relative success of the launching of the euro has rekindled interest in monetary union among developing countries. Defenders of the single currency have argued that the establishment of the euro has provided Europe with an autonomy that would not otherwise exist. In the words of Hutton (2002:411): “the brutal reality is that no single European country by itself in an era of floating exchange rates has the same autonomous capacity to manage demand. That can only be regained at the European level.”

As we saw earlier, the standard advice on monetary integration is that no develop-ing country should embark on such a project – the necessary macroeconomic and fiscal conditions simply do not exist. While it is true that the European experience does not completely negate such advice, the history of European monetary

integra-There are good reasons for thinking that critics of the European project of monetary integration have exaggerated the weaknesses of the European economy vis-à-vis its perceived strengths tion does suggest a more nuanced interpretation of the facts, and consequently a

more sophisticated and less dogmatic reading of economic theory.

Prior to the introduction of the euro, some analysts were very sceptical, if not openly critical. Feldstein (1997), one of the more outspoken critics, argued that:

“The economic consequences of EMU, if it does come to pass, are also likely to be negative. Imposing a single interest rate and an inflexible exchange rate on countries that are characterised by different economic shocks, inflex-ible wages, low labour mobility and separate national fiscal systems with-out significant cross-border cyclical transfers will raise the overall level of cyclical unemployment among the EMU members. The shift from national monetary policies dominated by the Bundesbank within the European Monetary system to a European Central Bank governed by majority voting with a determined exchange rate policy will almost certainly raise the aver-age level of future inflation. The emphasis on common economic and social policies will reduce the scope for the experimentation and competition that would otherwise lead to reduction in the current extremely high levels of structural unemployment.”

Has such a negative prognosis been borne out by subsequent events? There are good reasons for thinking that critics of the European project of monetary integration have exaggerated the weaknesses of the European economy vis-à-vis its perceived strengths (Todd, 2002; Hutton, 2002). On unemployment, for example, it has been pointed out that European definitions of unemployment tend to give much higher figures than their American counterparts.

Some analysts have suggested that the relatively high growth rates registered by the United States economy in the late 1990s was in part the product of an erroneous evaluation of the ITC sector boom. The overvaluation of the dollar and the collapse of the high-tech boom, which had boosted exports of ITC equipment, took their toll on United States exports, which lost one fifth of their market share between 2000 and 2003 (see Glyn, 2006: Chapter 6). It has also been pointed out that the higher growth rates registered in the United States depended to a large extent on an expanding labour force (due to higher rates of immigration) compared to the stag-nant demographics of Western Europe and Japan (Todd, 2002). The subsequent fall of the dollar vis-à-vis the euro may in part reflect a re-evaluation of the long-term performance of the United States economy, as well as a more positive interpretation of the perspectives for the euro area.

Several points need to be borne in mind in any evaluation of the relative perform-ance of the euro since its introduction:

Being part of a currency union requires discipline, and the loss of the exchange rate as an instrument for coping with economic shocks can be costly

(a) As we have just seen, European monetary union has taken a long time, starting with the ERM in the 1970s. There were serious crises in the 1990s for countries like France, the United Kingdom and Sweden. The path to the euro has certainly not been smooth, which suggests that any developing country taking a similar path needs to be careful to avoid costly macroeco-nomic mistakes.

(b) Early evidence suggests that macroeconomic performance has not improved under the discipline of the euro. The experience of the first seven years dem-onstrates that membership has its benefits, but that these benefits are not free (Aherne and Pisani-Ferry, 2006). Being part of a currency union requires discipline, and the loss of the exchange rate as an instrument for coping with economic shocks can be costly. Within the euro area, some members such as Ireland are thriving; others, especially among the southern member States, are struggling and face painful adjustments in the future. For instance, Ire-land and Portugal have experienced marked real exchange appreciation, but with very different consequences for export growth. There has been real depreciation in both Germany and France, but only Germany’s exports have flourished.

(c) As noted in section 3, a dichotomy exists between the European Com-mission and analysts like Krugman on the differential impacts of shocks on monetary unions. According to the European Commission, differen-tial shocks will occur less frequently in a monetary union, because trade between the industrial nations of the EU is to a large degree intra-industry trade. According to Krugman, specialization under integration will increase shocks.

In any evaluation of the experience of the euro, three additional dimensions to the process need assessment:

(a) Even though structural funds pre-date the establishment of the euro, have they been instrumental in providing compensation and a cushion for asym-metric shocks?

(b) Has the independent central bank, the ECB, acted consistently with the objectives of a monetary policy for the euro zone?

(c) Finally, considering a possible “deflationary bias” in the EU Stability Pact, has the convergence criteria been necessarily the right ones for promoting growth and employment creation in the euro zone.

These questions are clearly complicated, and space constraints here do not allow an exhaustive evaluation of all these issues. Moreover, bearing in mind that convergence has proven to be a long-term phenomenon, it needs to be stressed that the seven years that have passed since the full implementation of the euro do not give enough

Persistent budget time for a full assessment. However, some basic observations can be made. Firstly,

contrary to the propositions of Rose (2002) and others, there is little evidence that the euro has increased the intensity of intra-European trade (figure 1).¹¹

Secondly, despite the strictness of the budgetary criteria and the anti-inflationary stance of the ECB, there is some evidence that the implementation of the euro gave rise to inflationary pressures, particularly in the service sectors, with very high one-off increases (as much as 30 per cent in some sectors) in price levels, as producers took advantage of the introduction of the single currency to increase their prices.

Figure 3.2

Total and Intra-Euro Zone Trade, 1970-2004

0

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Billions of US dollars

% of total Euro-zone trade

Total trade of group Intra-trade of group

Source: UNCTAD Statistical Yearbook 2005

Thirdly, budgetary targets for the EU Growth and Stability Pact foundered in 2004 on German and French deficits, which remained stubbornly high as growth in the euro zone stagnated. Persistent budget deficits are telling signs of lack of business confidence in the prospects for profitable investment (Glyn, 2006: 36). This experi-ence would suggest that the convergexperi-ence criteria have been excessively focused on stability rather than on promoting growth. Given their key role in setting the goal

11 Using a panel data analysis, Micco et. al. (2003) claim to have found evidence of such an effect of European Monetary Union on trade, with an increase in bilateral trade of 5 to 10 per cent between 1992 and 2002 (much smaller of course than the anticipated “Rose” effect). However, their analysis clearly does not capture the full impact of the creation of the euro, because this was only implemented in 1999.

The Maastricht criteria have become something of a model for African countries

posts for membership in the European single currency, the convergence criteria that were adopted in Maastricht in 1991 need to be examined closely.

3.5 Convergence criteria

The Maastricht Treaty of 1991 stipulated that the transition to the final stage of monetary union was conditional on a number of “convergence criteria”, and that a country could join the union only if:

1. Its inflation rate is not more than 1.5 per cent higher than the average of the three lowest inflation rates among the EU member States;

2. Its long-term interest rate is not more than 2 per cent higher than the aver-age observed in these three low-inflation countries;

3. It has joined the exchange rate mechanism of the EMS and has not expe-rienced a devaluation during the two years preceding the entrance into the union;

4. Its government budget deficit is not higher than 3 per cent of its GDP (if it is, it should be declining continuously and substantially and come close to the 3 per cent norm, or alternatively, the deviation from the reference value (3 per cent) should be exceptional and temporary and remain close to the reference value (Art. 104c (a); and

5. Its government debt should not exceed 60 per cent of GDP (if it does, it should diminish sufficiently and approach the reference value (60 per cent) at a satisfactory pace. (De Grauwe, 2005: 143).

The designers of the treaty clearly thought that the main danger was that fiscal policy

The designers of the treaty clearly thought that the main danger was that fiscal policy