'The only guarantee there will be a parallel between economic and monetary policy is a political union.' - Jacques Delors
EMU, denoting 'Economic and Monetary Union' means the creation of a single market in commodities, capital and labour (economic union, now constituted) and a single currency (monetary union). No historical precedent exists for the current EMU process. There are cases where separate political entities formed a political union before adopting a common currency and single central bank, such as Italy following unification (1861). There are examples like the monetary union of the 1870s between Belgium, France, Italy and Switzerland, where special sovereign countries standardised their coinage but without establishing a common central bank. Yet there are no precedents for Europe's current course, in which countries with histories of monetary sovereignty and well established central banks form a common central bank accountable to them jointly with the control of their national monetary policies, including the power to issue a common currency. As Eichengreen (1993) elucidates, 'It would seem paradoxical that the European Community, the one part of the world that has succeeded in largely insulating itself from exchange rate variability, is where the call for monetary union was taken up.' The objective of this paper is to examine whether a single currency is a technically necessary concomitant of a single market in capital, labour and goods. The essay is divided into three parts. The first section lays out the historical backdrop to EMU. Next, the advantages and drawbacks of proceeding with a monetary union will be weighed. The final section suggests some urgent measures that need to be taken in the transition to inevitable monetary union and concludes that the rationale for a single currency as a corollary of a single market derives to a large extent from political economy considerations.
Since the 1969 Hague Summit, EMU has been an official objective of the European Community. In a period when economists were hopelessly divided over the advantages of a system of free-floating exchange rates, on the one hand, and the best road to monetary stability on the other, a decision was taken by Giscard, Schmidt and Jenkins to get out of the deadlock. The European Monetary System (EMS) with a European currency unit, the Ecu was proposed, came into force in 1979, and has been successfully implemented. Within the system, member states' exchange rates could fluctuate only slightly in relation to one another (by no more than 2.25% on either side of a fixed rate). This was the first step towards the ultimate goal of fixed exchange rates in the final stage of EMU. The first decisive step to economic and monetary union came in June 1988 when the Hanover European Council appointed a committee of experts (chaired by Jacques Delors) to examine ways and means of gradually bringing about EMU. The decision to set up this committee was promoted by the implementation one year earlier of the Single European Act (SEA), which brought about the completion of a frontier-free market at the beginning of 1993 (economic union). In June 1989, the Madrid European Council set the date of July 1990 for the beginning of Stage I (convergence) of economic and monetary union, a target which was met. The first stage saw the removal, with just a few exceptions, of all restrictions on capital movements between member states co-ordination and multilateral surveillance of the economic policies of the member states was intensified and cooperation between the central banks was stepped up through the Committee of Governors of the Central Banks.
The EMS had allowed long periods of exchange rate stability due to fixed rates, with periodic realignments redressing serious competitive problems. This was possible because capital controls protected central banks' reserves against speculative attacks motivated by anticipations of realignment. The Maastricht Treaty ruled out their use from the beginning of Stage II. After undermining the viability of the 'Old EMS', monetary unification followed inevitably. This second stage (institutional) commenced at the beginning of 1994 when member states had to start even more intensive preparations for the final stage. The European Monetary Institute (EMI) has been created as a prefiguration of the European Central Bank. The ECB will be solely responsible for defining the Community's monetary policy This centralisation removes a priori any possibility of conflict between different monetary policies within the zone. This institution would also guarantee unlimited convertability of the different national currencies and the fixity of their parities. These currencies would thus be perfectly substitutable and by definition there would be a single monetary policy.
Guidelines in the Maastricht Treaty make transition to EMU conditional on several convergence criteria of national economic performance. Observed over a period of one year before the examination of the final stage, a member states average rate of inflation and nominal long term interest rate must not exceed by more than 1.5. and 2 percentage points respectively, that of the three member states who have the best results in terms of price stability. The deficit and total government debt for any member must not exceed 3% and 60% of GDP respectively. Finally, member states must have respected the normal fluctuation margins (2.25%) provided for by the exchange rate mechanism of the EMS without severe tensions for at least two years before examination. Before the end of 1996, the heads of state or government will decide, by a qualified majority, whether it is appropriate for a majority of the member states to move to the final stage of EMU. Even if by the end of 1997 no agreement has been reached for the beginning of the third stage, it will commence on January 1, 1999. The number of member states launching this final stage of economic and monetary union would not then have to constitute a majority. A mere four years before the 1999 deadline, however, public interest is focused on mass unemployment and the persistent recession rather than on feverish preparations for monetary union. Turning fifteen segmented European markets into an integrated economy whose constituents can specialise fully in producing goods and services in which factors of production can flow freely to wherever they gain highest returns is hard to challenge on efficiency grounds (economic union). Yet is there an economic logic for a single currency and a European Central Bank accompanying this process.
Only a single currency completely eliminates the costs of exchanging currencies, a saving of as much as 19 billion ecu (or 0.5% of Community GDP). These gains are larger for small open economies like Ireland (0.9% of GDP) than for larger economies (0.1% to 0.2% of GDP). Even if exchange rates are irrevocably fixed, doubts about this fixity will encourage residents to use their home currency instead of a foreign one. There will be a complete elimination of exchange rate uncertainty inside the Community which varied from 0.7% in monthly variations for the original members of the exchange rate mechanism of the EMS to 1.9% for the other Community countries. The addition of single money to a single market will brighten the business climate considerably, given recent surveys provide strong evidence that foreign exchange risk is still considered a major obstacle to trade. Europe's business sector has declared an overwhelming preference for a single currency as distinct from a common thirteenth currency. While economists argue that compared to a floating exchange rate regime, EMU improves greatly on the stability of inflation and real economic activity. It also improves on the EMS; especially as regards the stability of real economic activity. Reductions in uncertainty will permit a reduction in the rate of return of investment demanded by shareholders, which in turn boosts investment and growth. Only a modest reduction in this rate of return of 0.5 % is already sufficient for a gain in output accumulating to 5% of GDP. The dynamic gains, occurring through a widened increase in investment, will strongly amplify the static efficiency gains and will be instrumental in leading the community to a higher sustainable growth path.
However, de Grauwe (1988) found exchange rate uncertainty not to be a substantial barrier to international trade. The IMF (1984) reached a similar conclusion. Since intra-EMS rates are already stable, the gains are unlikely to be vast. A lower risk due to less exchange rate variability can have a double negative effect. It reduces the real interest rate and it reduces the expected value of future profits of firms. Similarly de Grauwe (1992) indicates that consumer surplus is greater when prices are more variable. When prices are low, the consumer increase demand to profit from lower prices. When prices rise, he does the opposite, thereby limiting the negative effect the price increase has on his welfare. From this, we may deduce that if gains from a common currency and an ensuing drop in risk are to be expected, they will be found elsewhere than in these static welfare gains. Empirical evidence also suggests a weak link between monetary union and economic growth. The greater exchange rate stability that the EMS countries experienced in the 1980s did not provide a great boost to the growth rates of output and investment. In fact, these growth rates have been larger in non-EMS countries that experienced relatively large movements in their exchange rates.
The rationale for retaining flexibility in rates of exchange rests on the assumption that governments aim to achieve both internal and external balance, and as Tinbergen (1952) has shown, to achieve these simultaneously at least an equal number of instruments is needed. Internal equilibrium is tackled via financial instruments (monetary and fiscal policies) while external equilibrium is sought after using the exchange rate. If countries deprive themselves of rates of exchange as policy instruments they impose on themselves losses that are essentially losses emanating from enforced departure from internal balance (Corden, 1972a). The central element of the solution to the problem of loss of autonomy is policy coordination on stabilisation and budgetary policies. This approach finds its theoretical underpinning in game theory (e.g. Hamada, 1985). In all types of games in which the policy of one country affects the variable making up another country's welfare function, better results are possible with a cooperative rather than with a non-cooperative attitude. Steinherr (1984) studies in detail the reasons why cooperation is the exception rather than the rule in a Monetary Union. The efficiency of the coordination process (consistent movement of partners) and the effectiveness of its outcome (credibility in markets) depend critically on the gradual reinforcement of the regulatory and institutional set-up (Molle, 1994). At any rate, in most cases, there is an alternative to using exchange rates. For example, when confronted with a loss of domestic competitiveness, countries can use contractionary demand policies aimed at regaining competitiveness, though such a measure can be more difficult than simply changing the exchange rate.
Moreover, Allen and Kenen (1980) and Allen(1983) have demonstrated that although monetary policy has severe drawbacks as an instrument for adjusting cyclical imbalances within a monetary union, it may be able to influence the demand for goods produced by member countries within the short term, provided the markets of the member nations are not too closely integrated. Their model indicates that economic integration in this sense, can be created as a consequence of the substitutability between nations' commodities, especially their financial assets. The moral of this is that the central bank of a monetary union can operate disparate monetary policies in the different partner countries without compromising their internal and external equilibria, a severe blow to those who stress the costs from monetary integration (El Agraa, 1990).
Another area to be examined is that of price stability. The cost of bringing down inflation to a low level is minimised if there is a credible commitment to stable prices. A monetary union cannot be sustained if inflation rates diverge. In the long run, higher than average inflation rates of EU countries inevitably lead to a corresponding depreciation of their currencies. Thus, inflation rate convergence and at a lower rate is necessary for the group of countries aiming at EMU. Low inflation is associated with low variability of inflation, and therefore of relative prices. The economic literature suggests that a 1% decrease in relative price variance could increase real output by 0.3% of GDP, for instance. The costs incurred in a disinflation process arise because of wage rigidity and a lack of credibility of the national authorities. A credible exchange rate commitment will minimise output losses by reducing nominal interest rates and accelerating the adjustment on wage and price setting, as exemplified by the French, Danish and Irish disinflation experiencesin the EMS during the 1980s. In addition, as I have outlined using Allen's analysis, changes in real exchange rates remain possible and desirable within EMU. This is why wage and price flexibility is a necessary condition of success. National exchequers will lose revenues from the inflation tax (seignorage) and gain from the lower interest rates to be paid on public debt. These benefits, which though of a transitional nature, could lie between 2% and 5% of GDP, will far outweigh the loss of seignorage revenue (0.5% in Spain/Italy, to 1% in Greece/Portugal) to be experienced by some countries. When a monetary union establishes a central fiscal authority with its own budget, then the larger the size of this budget, the higher the degree of fiscal harmonisation (MacDougall Report, 1977). This has many advantages; regional deviations from the internal balance can be financed from the centre, and the centralisation of social security payments financed by contributions or taxes on a progressive basis would have some stabilising and compensation effects, modifying the harmful effects of monetary integration (Corden, 1972a).
Furthermore, if a member country of a monetary union is in deficit, it can borrow directly on the union market, or raise its rate of interest to attract capital inflow and therefore ease the situation. However, the integration of economic policies within the union ensures that this help will occur automatically under the auspices of the common central bank. Since no single area is likely to be in deficit permanently, such help can be envisaged for all the members. Hence, there is no basis for the assertion that one country can borrow indefinitely to sustain real wages and consumption levels that are out of line with the nation's productivity and the demand for its product (Corden, 1972a). The introduction of ecu will mean that equivalent securities become subsitutes and the 'law of one price' will be obtained in securities market throughout the European Unoin. This implies that debt can be raised at lower interest rates, which will reduce the cost of financing the National Debt.
EMU could tighten constraints on national fiscal policy, a benefit or a cost, depending on one's viewpoint. If capital and labour are freely mobile within the economic union, however, borrowing today which implies higher taxes tomorrow may induce mobile factors of production to move to lower tax jurisdictions, reducing the tax base. Investors know a government's ability to borrow now is limited by its ability to tax in the future, which in turn is limited by factor mobility. Therefore, they may refuse to lend to governments threatening to exceed their borrowing capacity. Yet the fact that certain factors will remain relatively immobile in Europe compared to say the United States, will allow greater variation in tax rates. Moreover, European governments require their central and commercial banks to hold substantial amounts of their debts~ so some fiscal autonomy will remain. The principal cause of fiscal restraints will be the clauses of Maastricht, (summarised earlier) which advise member states to 'regard their economic policies as a matter of common concern and (to)... coordinate them within the Council.' EMU would also lower the costs of economic shocks. For example, simulation of the shocks from 1970-1990 (a turbulent period) under alternative exchange rate regimes suggests that EMU with a single currency might, compared to the EMS of the mid-1980s, witness a decrease in inflation fluctuations of one-fourth (0.6% - 1.5% less variation) and of output growth fluctuations by one fifth (0.3 to 0.7% less variation) (the ECU report, 1991). A symmetric shock, one which impacted proportionately on product markets throughout the EU, such as a commodity market shock, would require no policy response, merely resource allocation best achieved through decentralised market mechanisms. On the other hand, asymmetric shocks would be brought to a fast resolution with an exchange rate adjustment, which could quickly bring a change in prices that would otherwise only come from a prolonged and expensive deflation. Furthermore, the Commission professes that EMU will deepen the process initiated by the 1992 programme, that is intra rather than inter-industry trade, lessening the possibility of product specific shocks, eliminating the shocks that occur when domestic interest rates surge in response to speculative selling of the Irish pound associated with a sudden depreciation of Sterling.
The benefits of EMU will be particularly significant for smaller countries like Ireland whose economies are much more exposed to international trade. The foreign trade ratio (exports plus imports as % of GDP) is 115% for the Republic compared to 50% for the UK. Therefore, anything that reduces or removes the impediments to trade is of greater significance to small open economies. In addition, the current less well-off regions have a real opportunity for rapid catch up if they maximise potential synergies between EC policies and national development efforts. Economic and monetary union, like 1992, is a positive sum game (Commission, 1990). Whilst sovereignty may be lost at the national level, it is regained at the centre.
Finally, the importance of the Community in the world economy will be strengthened with ecu as a single currency, assuming the role of an international currency as powerful as the Yen or the U.S. Dollar, a larger weight of the Community in macroeconomic policy coordination, possibly evolving into a more balanced multipolar international monetary system. As an international currency, the ecu would allow a saving in the Community's exchange reserves of about 160 Billion ecu (allowing this financial capital to be allocated more optimally), increase the share of ecu - dominated assets in the world financial portfolio by 5% and increase the invoicing in ecus (with 10% of EC trade). This amplified use of the ecu would provide for a decrease in the transaction costs with third countries (up to 0.05% of EC GDP) and bring international seignorage revenues from a possible long-term accumulation of some 28 billion in ecu notes outstanding abroad (Ecu Report, 1991). However, the use of an integrated area's currency as a major reserve currency doubtless imposes certain burdens on the areas but in the particular case of the EU, it would create an oligopolistic market situation which could either lead to collusion, resulting in a permanent reform of the international monetary system, or intensify the reserve currency crisis and lead to a complete collapse of the international monetary order. The latter possibility is, of course likely to result in the former outcome; it is difficult to imagine that the leading nations in the world economy would allow monetary chaos to be the order of the day.
Since to a large degree, labour immobility and fiscal restraints will be prevalent in a European monetary union, the domestic economies must try to be flexible to cope with adverse economic shocks. To avoid large-scale emigration and rises in unemployment, and to benefit from monetary unification, we must end restrictive practices, increase deregulation and encourage a stringent competition policy in the non-traded sector.
Some believe in light of a recent deterioration in Europe's economic circumstances (20 million unemployed), that the date for EMU should be postponed. After all, most countries have moved away from the Maastricht criteria thresholds. For example, Molle indicates that if 1993 had been chosen as the reference year, the inflation threshold would be 3.4% not 1.5%. Only six currencies would have met the exchange rate criteria at the end of 1993 (Germany, Denmark, France, Benelux, and Ireland) and three more did not participate in the ERM (Itlay, Greece and the United Kingdom). The 3% deficit-to-GDP ratio was achieved by just Ireland and Luxembourg in 1993 and in Belgium, Italy and Greece, the government debt-to-GDP ratio stands at a very high level(above 100%). Despite these shortcomings, a long period of transition to EMU is also undesirable. EMU cannot include all EC countries from the start. This is recognised by the provision that a majority of countries can go ahead on their own. Should those countries which are ready now go ahead and reap the benefits of a 'small monetary union?'
There could be a strong temptation to go down the path of a clear 'two speed ' EMU. For some countries it would be sensible from an economic point of view to tie their monetary fate to others, for example Benelux with Germany. Other EC countries may find it favourable to wait and see, until the benefits outweigh the costs. Britain is opting for the slow lane. Whilst there would be political difficulties in taking such a decision, although we must evaluate the cost to the individual member states, and to the collective endeavours, of doing nothing. Such a process may encourage Mediterranean countries to speed up convergence to enjoy the benefits of a monetary union. Doubts about Ireland's ability to enter EMU focus on our dependence on Britain, which is now in fact less than commonly perceived. The reliance is not 32% as often quoted, but 15% to 20%, as trade in agriculture and energy products is largely unaffected by sterling exchange rate movements. Moreover, entry by Ireland into EMU will further accelerate diversification from the UK market.
If speedy transition to EMU is impossible, as I believe it is, there are numerous temporary remedies. Larger and more frequent exchange rate adjustments during the transition to monetary union would be one option. This would require allowing exchange rates to flow more freely and fluctuate more widely. A more secure interim measure would be to request all institutions to take open positions in foreign exchange to make non-interest bearing deposits with their central bank to slow down speculation (Eichengreen and Wyplosz, 1993). This would provide time to organise realignments, ensuring the survival of the EMS over the remainder of the transition, Corden (1972b) suggests a 'pseudo union', where exchange rates are fixed but monetary policies are not fully integrated and there is no monetary authority. Yet fixed exchange rates, no matter how earnestly enforced, always raise the spectre of devaluation. To quote Portes in Eichengreen (1993), 'Permanently fixed exchange rates are an oxymoron'. The single currency is an essential feature of EMU. In the same way as it is not acceptable that a single monetary policy should be determined by one of the existing national central banks, it is not desirable that the single currency should be one of the existing national currencies. Furthermore, it should not be a new thirteenth currency. As we move closer to Stage III, the basket definition of ecu will have less and less practical relevance. If all currencies perform well, the average is as good as the best and the ecu becomes de facto a hard ecu. This is already more and more the case.
Factor and producer-market integration could proceed under floating exchange rates as well as under a common currency. Yet with floating exchange rates and greater integration, we will move to a point where only the most efficient firms will survive. This is the basis of a single market and an economic union. Yet if national industries under pressure to remove trade barriers found their competitive position eroded further by unforeseen exchange rate swings, the opposition to the single market would rise sharply. Therefore, it seems to be for reasons of political economy, not economic efficiency, that monetary union is sought. Monetary unification serves as a stepping stone to deeper political integration. German insistence on strengthening the powers of the European Parliament in conjunction with progress on EMU supports this hypothesis. As Jacques Delors once pronounced 'Our community is the fruit not only of history and necessity but of political will.'
BOOKS
Eichengreen, B., (1993) 'European Monetary Unification' (1993) Journal of Economic Literature, Vol 31.
Eichengreen, B. and Wyplosz, C., (1993) 'The Unstable EMS'
El-Agraa, A.M., (1990) 'Economics of the European Community'
4. Bayoomi, T. and Eichengreen, B. 'Shocking Aspects of European Monetary unification' (1992)
de Grauwe, P.(1988) 'Exchange Rate Variability and the Slow-down in the Growth of World Trade'
de Grauwe, P.(1992) 'The Economics of Monetary Integration'
Molle, W. (1994) 'The Economics of European Integration'
Corden (1972a) 'Economies of Scale and Customs Union Theory' , Journal of Political Economy, Vol. 80
Corden (1972b)'Monetary Integration', Essays in Internatinal Finance, No. 93
Allen and Kenen (1980)'Asset Market, Exchange Rates and Economic Integration'
Allen (1983)'Cyclical Imbalance in a Monetary Union' Journal of Common Market Studies, Vol 21 No. 2
Tinbergen, J.(1952) 'On The Theory of Economic Policy'