The Euro: Evolution and Prospects

The Euro

The Euro Evolution and Prospects

Philip Arestis Professor of Economics, South Bank University London, UK

Andrew Brown Lecturer in Economics, University of Leeds, UK

Malcolm Sawyer Professor of Economics, University of Leeds, UK

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Philip Arestis, Andrew Brown and Malcolm Sawyer 2001 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data Arestis, Philip, 1941– The euro : evolution and prospects / Philip Arestis, Andrew Brown, Malcolm C. Sawyer. p. cm. Includes bibliographical references and index. 1. Euro. 2. Monetary policy—European Union countries. 3. Fiscal policy—European Union countries. I. Brown, Andrew, 1971– II. Sawyer, Malcolm C. III. Title. HG925 .A974 2001 332.4'94—dc21 2001023728

ISBN 1 84064 583 0 Printed and bound in Great Britain by Biddles Ltd, www.biddles.co.uk

Contents List of figures List of tables

vi vii

1. Introduction Philip Arestis, Andrew Brown and Malcolm Sawyer 2. From common market to EMU: an historical perspective on European economic and monetary integration Philip Arestis, Kevin McCauley and Malcolm Sawyer 3. The conditions surrounding the launch of the euro Philip Arestis, Kevin McCauley and Malcolm Sawyer 4. Monetary and financial arrangements accompanying the euro Philip Arestis, Andrew Brown and Malcolm Sawyer 5. Channels of monetary policy and implications for the euro Philip Arestis, Iris Biefang-Frisancho Mariscal, Andrew Brown and Malcolm Sawyer 6. The causes of euro instability Philip Arestis, Iris Biefang-Frisancho Mariscal, Andrew Brown and Malcolm Sawyer Bibliography Index

1

5 34 64 82

106

135 145

v

Figures 6.1 6.2a 6.2b 6.3 6.4 6.5 6.6 6.7 6.8 6.9a 6.9b 6.10 6.11 6.12

Daily exchange rates: US dollars per euro US–eurozone real, short-term interest rate differential US–eurozone real, long-term interest rate differential $/euro exchange rate and revisions to GDP growth forecasts Eurozone, US and Japan growth rates Annual percentage change in eurozone M3 Eurozone annual growth rates of GDP Eurozone output gaps Eurozone unemployment Eurozone annual inflation Eurozone inflation rates, measured by HICPs Eurozone GDP growth Eurozone unemployment rates Eurozone budget surplus/deficit (in national currencies)

vi

107 111 112 114 117 122 124 125 127 128 130 131 132 133

Tables 3.1

Economic indicators and the Maastricht Treaty convergence criteria 3.2 Mean and standard deviation of unemployment rate 3.3 Unemployment rates (percent of work force) 3.4 Retrospective application of the excessive deficit procedure: number of cases where the 3 per cent reference value would have been exceeded 3.5a GDP growth rates (annual percentage rates) 3.5b EU average GDP growth rates 3.6 Variance ratios: relative GDP growth rates 3.7 Current account balances as a percentage of GDP 4.1 Empirical assessments of the impact of monetary policy on output in various European countries 4.2 Financial position of the private sector in selected euro area countries (1996, as percentage of GDP) 5.1 Cointegration tests 5.2 Cointegration vectors 5.3 Dynamic models 5.A2a Multivariate tests 5.A2b Univariate tests 5.A2c Dynamic models 6.1 Investments in the eurozone and current account surplus (billions of euro) 6.2 Selected economic indicators for the eurozone

vii

36 42 43

48 52 52 54 55 75 76 90 91 93 102 103 104 118 123

1. Introduction Economic and Monetary Union constitutes a profound change in the economic, social and political spheres of Europe. Inevitably, it has been the subject of intense debate. The single currency, launched in January 1999, has served to concentrate many diverse aspects of the debate around one question: is the euro in the interests of Europe? This book presents a sustained argument that the single currency as currently implemented does not promise to deliver enduring economic growth in the European Union. We argue that the economic impact of the euro and its accompanying institutions, the European Central Bank and the Eurosystem, is likely to be deflationary and destabilising; that the political impact is profoundly undemocratic; and that the social consequences are likely to be deleterious. We do not, however, argue that the project of a single European currency is inherently flawed. On the contrary, we propose a Keynesian alternative to the economic policies and institutions that currently surround the euro. In this way, we argue that the broad question is not whether to be ‘for’ or ‘against’ the euro per se, as if there were no alternative to the monetarist structures underpinning the euro outside of its abolition. The Keynesian alternative we propose can provide many of the benefits of the single currency as recognised by its proponents, whilst avoiding many of the costs identified by its detractors. Chapter 2 sets the inception of the euro in the context of the postwar history of the attempts to forge economic and monetary union in Europe. The chapter charts the path towards economic union within Europe in terms of the sporadic attempts to forge monetary integration and ultimately monetary union. When, in the context of deregulated capital markets and the Single European Market, the institutional structure that currently underpins the euro was laid down, neoliberal monetarist ideas were very influential on policy. At the same time the (conservative) Bundesbank was considered a model for the European Central Bank. Thus we stress the historical reasons for the fact that the institutional structure accompanying the euro conforms to what we have elsewhere termed the ‘new monetarism’ (Arestis and Sawyer, 1998b). Chapter 3 first examines the conditions surrounding the launch of the euro, noting that the fiscal criteria stipulated by the Maastricht Treaty were not, on any strict interpretation, met by many of the countries that entered the single currency. Furthermore, we note that unemployment rates across the eurozone 1

2

The euro

were both high and divergent and that rates of economic growth across the eurozone diverged. The Optimum Currency Area literature highlights the potential problems such asymmetries cause, yet unemployment and growth rate targets were not a part of the Maastricht criteria. In the context of these difficulties, the chapter considers the fiscal arrangements surrounding the euro in terms of its accompanying institutional structure (the ECB and the Eurosystem) and the fiscal conditions laid down by the Stability and Growth Pact (the 3 per cent limit on national government deficits). We note that the 3 per cent deficit limit effectively curtails discretionary fiscal policy on the part of national governments and, judging by past evidence, is likely to disrupt the operation of automatic stabilisers. Nor can there be any fiscal policy at the EU-wide level, given the relatively small EU budget and the requirement for EU budget balance. Finally, there can be little coordination of monetary and fiscal policy, given the separation of the monetary authorities (ECB and Eurosystem) from the fiscal authorities (national governments). Hence, to the extent that fiscal policy is possible at all, it may well pull in a different direction to monetary policy. Related to the above points, EU-wide regional transfers are of a negligible size relative to the large disparities in unemployment and GDP growth rates noted above. Our Keynesian alternative proposal broadly aims to combat high unemployment and regional asymmetries through an institutional framework of EU-wide fiscal policy; coordination of monetary and fiscal policy at an EU-wide level, and of regional transfers at this level. We propose an alternative to the Stability and Growth Pact along these lines and a revamped European Investment Bank able to promote investment in low-growth regions. Chapter 4 turns from fiscal issues to the consideration of the monetary and financial arrangements accompanying the euro. Within the Eurosystem, the independent European Central Bank is responsible for setting the eurozonewide interest rate, whereas the national central banks have regulatory responsibility. The ECB’s first responsibility is price stability, which has been defined as Eurozone inflation of no more than 2 per cent over the medium term. We argue that healthy respective rates of GDP growth and of unemployment should be high on the list of policy objectives; the inherent deflationary dangers of the prioritisation of price stability are especially worrying given the aforementioned problems regarding European unemployment and growth rates. In the face of asymmetries of economic performance, and the lack of institutions to cope with them, we argue that a single interest rate cannot be appropriate; it may serve to exacerbate regional differences as policy is suited to an average inappropriate to ‘outlier’ countries. Furthermore, there are very diverse monetary and financial institutions across Europe, which entail that the influence of interest rate movements will be different across countries, increasing the difficulty of achieving appropriate EU-wide monetary policy. Turning to regulatory matters we note that the lender of last resort function is not built into

Introduction

3

the remit of the ECB and Eurosystem. Problems are particularly acute if coordinated action were to be required in the face of financial crises across the zones of control of the national central banks. We argue also that the separation of monetary from fiscal policy may raise problems regarding the monetisation of deficits, which must occur in the normal course of economic growth. A significant worry relates to the destabilising effects of capital movements now unfettered by national currency considerations within the eurozone. Long-term bank-based investment finance is likely to be increasingly replaced by the shortterm demands of mobile capital. Our alternative proposals are designed to remedy the weaknesses identified above. The ECB should have full employment and a high rate of economic growth as objectives equal in importance to price stability. It should be responsible for regulation of the financial system and must be required to provide the lender of last resort function. In order to be able to perform these functions, and in view of the highly undemocratic nature of the ECB at present, we propose that the European parliament, and indeed national governments, should exert democratic control over the ECB. Chapter 5 contributes to one aspect of the empirical work mentioned in Chapter 4. The chapter employs econometric techniques in order to estimate demand for money functions of the eleven countries comprising the eurozone. The results of the estimation lend support to the view that there are significant asymmetries of interest rate elasticity in the demand for money across the eurozone. For Austria, the Netherlands, Finland, Ireland and Luxembourg we find that interest rates do not have any significant effect upon the demand for money at all. For the other countries we find significant but widely differing effects. Furthermore the estimations support the view that the short-run impact of both interest rate and income changes on the demand for money varies widely across the eurozone countries. In terms of the ECB’s own theoretical framework (which would appear to incorporate the idea that the stock of money can be controlled and is exogenous to the private sector), whereby monetary targeting is one route towards controlling inflation, these results raise serious problems, for they imply that monetary targeting at an EU-wide level will have very diverse effects across countries such that it may not be possible to reach the chosen target. Given what we would consider to be a more realistic framework (that money is endogenous credit money created within the private sector by the banking system) the result raises serious problems of a different nature, in that it indicates, and estimates quantitatively, one particular channel of monetary policy influence that is highly asymmetric across the eurozone and which is therefore likely to have a destabilising macroeconomic impact upon the area as a whole. Chapter 6 examines the impact of the euro since its inception in the context of the search for an explanation for its declining external value. We show how the most recent evidence concerning the macroeconomic impact of the euro

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The euro

lends support to the arguments of the previous chapters and, in so doing, we are able to provide an empirically robust explanation for the fall in value of the euro. In the literature, the steadily weakening euro has often been attributed to the peculiar strength of the US economy, rather than to any inherent difficulties of the imposition of the single currency in Europe. If the eurozone itself is focused upon then this is only to stress the ‘inflexibility’ of European markets (particularly the labour market). We find the widespread notion that labour market inflexibility is at the root of so-called ‘eurosclerosis’ to be an unconvincing argument. Instead we argue that it is not US strength on its own, but this strength in combination with a structural weakness of the eurozone that is endogenous to the imposition of the euro, that has caused an outflow of direct investment capital, leading to the exchange rate decline. By ‘structural weakness’ we do not refer to inflexible labour markets but to the situation analysed in previous chapters: the imposition of the single currency, without the appropriate institutions and policy framework, onto a set of economies which are in a divergent state, with low growth and high unemployment. The most recent evidence shows that the divergent state of the eurozone has persisted, and may even have worsened, since this imposition. Thus the argument that the institutional structures underpinning the euro must be replaced by our proposed alternative is well supported by the most recent evidence on the impact of the euro, and goes some way to explaining the instability of the euro exchange rate. This book is the result of a project on the EMU and the euro funded by the Jerome Levy Economics Institute (Bard College, New York). We are grateful to the Institute and in particular to its Executive President Dimitri Pepedimitriou, for their financial support and encouragement. This was a two year project, 1998–2000. Over this period a number of people contributed to its genesis and development. We are grateful to them. Kevin McCauley was first to join the project and worked with us for a year. He produced the first full draft of Chapter 2, he contributed substantially to Chapter 3, and he put together the data set used in Chapter 5. Andrew Brown succeeded Kevin McCauley in October 1999. In the meantime Iris Biefang-Frisancho Mariscal began work on Chapter 5, to which she made a substantial, indeed a major, contribution along with Andrew Brown. Iris also participated in the preparation of Chapter 6. Andrew Brown made a substantial and major contribution to Chapter 6. In addition, Andrew took responsibility for revising all six chapters and for rearranging a great deal of the material for the book. We wish to thank Edward Elgar and Dymphna Evans for their encouragement and close collaboration on this and, of course, on many other projects. As always we are grateful to both of them and their staff.

2. From common market to EMU: an historical perspective on European economic and monetary integration 2.1 INTRODUCTION The roots of a European single currency and monetary union can be traced back to the start of the common market in 1958 and possibly further still to the creation of the Latin Monetary Union by Belgium, Italy, Switzerland, Bulgaria, and Greece 130 years ago.1 Since the establishment of the European Economic Community (EEC) in 1957, attempts at monetary integration and, ultimately monetary union, have tended to assume importance only as a result of financial crisis and becoming a vague objective as soon as the crisis recedes. In recent years, however, this search has assumed greater urgency for three main reasons. First, monetary union can be viewed as a response by European policy makers to the increases of intra-European trade which has meant that different currencies and fluctuating exchange rates have become an increasing nuisance. Since the [successful] implementation of the Single Market Programme this has become more evident. Second, politically, there was a continual search for increased stability and security in Europe, which crucially hinged on anchoring Germany within Europe. And third, many economic interest groups especially business interests perceived a single unified and integrated European economy as serving their interests (Pinder, 1996, p. 123). Economic union has followed a rather smoother transition path. Economic integration was used after the Second World War to realise political goals, chiefly to anchor West Germany within a Western European alliance. Under this scheme common governance was deemed to be the best structure; other structures such as intergovernmental cooperation were not perceived to be as effective. The European Coal and Steel Community (ECSC), in 1951, was the first attempt at creating such a governance structure, which was described by Jean Monnet, the ECSC’s architect, as the ‘first concrete foundation of a federation which is indispensable to the preservation of peace’ (Pinder, 1996, p. 124). The ECSC treaty which set up a customs union for coal and steel materials was followed by the European Economic Community (EEC 1958), the Single European Act (SEA 1987) and the Treaty on European Union (TEU 5

6

The euro

1993), each new treaty either extending the scope of the community or refocusing its objectives.

2.2 THE ORIGIN OF EUROPEAN COOPERATION After the Second World War most European economies lay in ruin or were severely disrupted. The deleterious results of the war were manifest in the infrastructure and the poverty affecting large sections of the population which created the potential for social upheaval. The poor harvest of 1946 and the drought of the summer of 1947 placed further strain on European economies. Apart from the devastation and the loss of millions of lives, the Second World War created some profound discontent with international arrangements which had promoted conflict between nations and had enabled the growth of Fascism. The prolonged interwar depression with its accompanying poverty and mass unemployment generated the desire for economic change. The period before the war was characterised by international disintegration (Tsoukalis, 1997, p. 10). Countries emphasised national economic autarky and state control of trade and industry intensified. The events of the prewar period (for example the depression, disintegration of the international economy, the rise of Fascism) and the experience of the war helped to create a political atmosphere tolerant of notions of cooperation and federalism at the European level. And as war-ravaged countries sought to reconstruct their economies, the Marshall Plan helped sow the seeds of European economic cooperation. All European countries were hungry for reconstruction funds and the United States of America was the only country capable of providing the much needed financial resources. For its part the US realised that its assistance was urgently needed in order to assist economic recovery, and to forestall further social unrest and the build up in support for the left-of-centre in politics in general and for the Communist Party in particular (Jovanovic, 1997, pp. 2–3). But American aid in the form of the European Recovery Programme (Marshall Plan) was conditional on cooperation among European governments and progressive liberalisation of intra-European trade and payments (Tsoukalis, 1997, p. 9). The aid was offered not on a bilateral basis but on a continental basis. In order to comply with the conditions of the Marshall Plan, and to coordinate and realise its objectives, the European governments established the Committee of European Economic Cooperation (CEEC). The motive behind American aid was not entirely altruistic, as it also helped to serve America’s strategic interest. By assisting the integration of the European economies back into the world trading and productive systems, America hoped to create stable and reliable partners. The Marshall Plan was approved in 1948 and America poured $15 billion of aid into the debilitated European economies. Having created the CEEC

An historical perspective on economic and monetary integration

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as an ad hoc institution to meet the demands imposed by American aid, the need for a more permanent institution soon became apparent, consequently, in April 1948, the Organisation for European Economic Cooperation (OEEC) was created to provide a long-term forum for economic cooperation. Discussions prior to the creation of the OEEC were heated and centred on two opposing views on economic cooperation: the British–Scandinavian view and the French–Continental view. These different interpretations on how economic cooperation should develop would be echoed many times in the future and would eventually lead to the creation of the ECSC. A range of bodies outside of governments and the established political parties were launched in Western Europe to campaign for European unity and for panEuropean political structures. It was hoped to replace the old political system with a new political system which would be organised in such a way as to prevent war recurring. Foremost among these groups were Alto Spinelli’s Union of European Federalists which sought the creation of a united Europe along federal lines and the less ambitious United European Movement, set up by Winston Churchill in 1947, which advocated a limited form of European integration within an intergovernmental framework. These two distinct groupings reflected the division between the French–Continental approach and the British–Scandinavian approach, which was based on political, cultural and geographical differences. At the Hague in May 1948, representatives from the European movement gathered to hold a Congress of Europe, at which matters of common interest would be debated and methods for promoting greater political and economic cooperation would be devised. Differences between the federalist and functionalist positions came to the fore at the congress. Although both groups agreed on the same broad aims: the desirability of European Union and the need to create an international organisation with a parliamentary body, they differed on the method of implementation. One proposal to the Congress, which came from the ‘federalist’ camp and received support from the French and Belgian governments, called for the creation of a European Assembly with legislative powers and a Committee of Ministers who would prepare and implement the Assembly’s decisions. A counter proposal was made by the British government which was functionalist in nature and advocated an assembly of government-appointed delegates who would be responsible to an inter-governmental body. After six months of deliberation, a compromise was reached which established a Council of Europe, consisting of a Committee of Ministers, responsible to national governments, and a Consultative assembly to deliberate and make recommendations to the Committee of Ministers, but to have no legislative function. Although floated as a compromise, the adopted proposal was a defeat for the federalists. The Council of Europe served only as a forum for the exchange of ideas and information, its only important legacy was in the area of human

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The euro

rights.2 Shortly after the fledgling political assembly came into being, its shortcomings were evident to the more federal-minded members. Among these members of the Assembly there was growing dissatisfaction with the existing powers of the European Council. In order to rectify this, a series of proposals were made to extend and deepen the power of the Assembly and of the Committee of Ministers to allow them to pass European acts binding on all participating states without the ratification of national parliaments. These proposals were unacceptable to Britain and the Scandinavian countries. Despite efforts to reconcile the federalist and functionalist approaches to European union, an impasse was reached. The failure to extend the Council’s powers and the slow progress towards European union frustrated the ‘federalist’ members who realised that economic integration would have to be achieved outside the institutional framework provided within the Congress of Europe. These members sought the creation of an alternative institutional structure to speed up economic integration. Their answer was to develop economic cooperation outside the framework of the Council of Europe. One person who had remained detached from the wrangling of the Congress of Europe was Jean Monnet. As early as 1943 Monnet, who was director of the French Modernisation plan, suggested that the only way to prevent war in Europe was to replace national sovereignty by a ‘States of Europe’ along federal lines. This goal could only be achieved by functional integration, that is supranational cooperation in specific economic sectors. Monnet was a political pragmatist and realised that if governments decided to pursue this goal, then the decision to do so would have to be taken privately at the ministerial level, rather than by a congress of several hundred people. However according to Monnet, only a crisis would impel the European governments to suppress their political caution and curb their desire to protect national sovereignty and force them to take the necessary steps to implement this approach to European integration. Aware that such a crisis had not yet occurred, Monnet resigned himself to wait until one occurred before he could act.

2.3 ECONOMIC INTEGRATION Monnet did not have to wait long for a crisis to develop. The Marshall plan had offered aid on a continental basis and the US viewed the regeneration of Europe as intrinsically linked to the regeneration of Germany. But the French Modernisation plan was based on the continuation of punitive measures against Germany. Any attempt to assist German economic recovery was interpreted by France as a threat to economic recovery and its own national security.

An historical perspective on economic and monetary integration

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After the war, the British and American administrations began to relax their repressive policies toward Germany, but the French government continued with their policies aimed at keeping Germany demilitarised, decentralised and deindustrialised, even refusing to merge the French occupation zone with the Anglo-American ‘Bizonia’ in 1947 (Dinan, 1994b, p. 19). The softening of Allied policy toward Germany endangered French economic recovery for two main reasons: France sought ownership of the coal-rich Saar region and control over the Ruhr region to stifle German economic recovery. As long as Britain and the US wished to placate the Soviet Union and preserve the Grand Alliance, then France would have an ally to help block any attempts at rapprochement with Germany. This strategy collapsed after the breakdown of a foreign ministers meeting in March 1947, any desire by Britain and the US to placate the Soviet Union faded and France was presented with a problem regarding its German policy. The Ruhr region fell under the jurisdiction of the British and American authorities and France had no influence over policy formulation. In an attempt to claim some control the French-controlled zone was merged with the Anglo-American zone to create the Federal Republic of Germany in September 1949, whilst France obtained a concession in the form of the Ruhr International Authority in order to exert some degree of control over industrial production. But this proved a futile attempt by the French, and the US pressed for economic growth in Germany to help European economic recovery. The Western powers also concluded that the German economy must be revitalised to act as a bulwark against the Soviet Union (Palmer and Lambert, 1968, pp. 257–8 and Tsoukalis, 1997, p. 11). France was faced with the need to reformulate its policy toward Germany. Monnet immediately saw this as an opportunity which he could exploit. Monnet approached Robert Schuman, the French Foreign Minister, with his proposal for a supranational coal and steel community. Before making a public announcement, Schuman sought and received German and American support. In May 1950, Schuman made a public statement. The Schuman Plan proposed that German and French coal and steel production be pooled and placed under a common supranational authority.3 The treaty creating the ECSC was signed in Paris in April 1951 and the process was concluded in July 1952 with the ratification of the treaty by France, Germany, Italy, the Netherlands, Belgium and Luxembourg. Other European countries did not join the ECSC because at the time they did not feel the political need, or else argued that international cooperation should take place in the wider setting of the OEEC. For Britain in particular, there was an unpalatable condition placed on participation at the negotiations, namely the acceptance of the principle of shared sovereignty (Dinan, 1994a, p. 25). The ECSC was a response to the strong drive behind ‘the movement for European unity’ which was fuelled by ‘the memory of the war and ... the obvious and visible threat of Soviet military power’ (Jenkins,

10

The euro

foreword to Broad and Jarret, 1972), and was also intended to act as a reconciliatory gesture between France and Germany (Kirschen, Bloch and Basset, 1969, p. 2; and Pinder, 1996, p. 126). Moreover it was also aimed at the eventual achievement of full political and economic union between the participating states. The ECSC was unique in that it was the first time that institutional structures were established which had supranational powers. The Paris Treaty established an institutional structure for administering, controlling and supervising the tasks defined in the Treaty. There were four main institutions: the High Authority, the Council of Ministers, the Common Assembly and the Court of Justice. The High Authority was the main institution responsible for the implementation of the Treaty. It had the authority to make legally binding decisions, to fix a Community price system decreeing minimum and maximum prices for certain products and fine firms for breach of ECSC competition rules or failure to implement binding decisions. The Council of Ministers was composed of the representatives of the member states. The Council was not mentioned in the original plans for the Community, but was added as a check on the powers of the high authority where the member governments were not prepared to surrender national autonomy. Hence, its main task was to ensure the actions of the High Authority were consistent with the wishes of national governments. The ECSC’s assembly had a purely consultative role. It had limited power in that it could only pass censure on the High Authority’s annual report which could force the Higher Authority to resign. The Court of Justice provided a judicial check on the actions of the Higher Authority, governments and individual firms. All judgements were binding. In addition a Consultative Committee was established, composed of representatives of producers, consumers and workers. It had the right to be consulted by the Higher Authority on most matters. The ECSC was a limited exercise in economic integration involving only two, albeit important, sectors. A free trade area was created in coal and steel, tariffs and quotas were removed. Free trade in these materials was promoted, so that no country could monopolise them for their own purposes and individual could purchase goods from where they wished within the ECSC.4 In this way Germany became free to regenerate its economy while assuaging the fears of other European countries who were concerned that it would use its revitalised economy to become a military power again. At this stage, European monetary integration did not appear to be on the agenda, and this was for two main reasons. First, the Bretton Woods exchange rate system was functioning with stable exchange rates which were not under pressure during the 1950s. Second, many of the European economies which were at the centre of the ECSC were performing in a similar manner in terms

An historical perspective on economic and monetary integration

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of economic growth and inflation (Hitiris, 1988, p. 90). Even though the ECSC was established under an economic pretext, there was, nonetheless, a clear political agenda as stated in the preamble to the Treaty: to substitute for their historical rivalries a fusion of essential interests ... to establish by creating an economic community the foundations of a broad and independent community among people long divided by conflicts; and to lay the basis of institutions capable of giving direction to their future common destiny. (Palmer and Lambert, 1968, pp. 167–8)

2.4 POLITICAL INTEGRATION The beginning of the Korean war increased the possibility of conflict between eastern and western countries in Europe. The US realised that if a confrontation developed with the Soviet Union, then its resources would be stretched. In response to this problem it asked its allies to increase their military expenditure, a request which was firmly rejected (Urwin, 1991, pp. 60–61). The US were forced to consider other alternatives, and swiftly suggested two changes to the North Atlantic Treaty Organisation (NATO) structure:5 the rationalisation of European armaments and the participation of West Germany in NATO. The latter proposal was disturbing for the other European countries since it had been only five years since the end of the war and the rest of Europe was still fearful of a rearmed Germany. For this reason, and also inspired by the success of the ECSC, a compromise was agreed, whereby the six members of the ECSC elected to form a federal army called the European Defence Community (EDC). The treaty was signed, with NATO approval, in May 1952. Later the treaty was ratified by all the parliaments with the exception of the French Chamber of Deputies who rejected it in 1954. This was the first setback suffered on the move to European integration and it scaled the fate of a more ambitious plan for a European Political Community (EPC) – the EDC treaty contained an article on the convening of an assembly which would have been charged with the preparation of a European federal constitution.6 The failure of the EDC signalled the end of active attempts to establish a form of supranational political governance structure; subsequently, the political leaders of the ECSC concluded that the next step for closer union was to be taken in the economic area. There was widespread conviction that the Community system offered more advantages than the traditional intergovernmental formulae, thus the ECSC blueprint was applied at the next stage. At an ECSC conference in Messina in June 1955,7 the Benelux countries made four proposals, two of which received support, an atomic energy community and a European Common market for all goods and services.

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The euro

The Treaty of Rome in 1957 led to the creation of two more communities, the European Atomic Energy Community (Euratom) and the European Economic Community (EEC). European integration had taken a step forward despite the calamitous failure of the EDC and EPC. The two new communities had different experiences. In the early 1960s the Euratom community was hampered by reduced funding when governments diverted money to their own national programmes. Consequently, the Euratom community was marginalised quite quickly. By contrast, the EEC had a much broader agenda, the creation of a common market in all economic sectors through competition without distortion.

2.5 EUROPEAN ECONOMIC COMMUNITY In addition to the swathe of articles of the Treaty of Rome establishing a customs union of six founder countries (Belgium, France, Germany, Italy, Luxembourg and the Netherlands), Article 4 of the treaty created four main institutions to oversee the EEC. The institutional pattern of the ECSC was copied in the EEC. The decision-making and executive functions are fulfilled by two bodies: the Council of Ministers and the Commission. Yet in key aspects the institutional structure of the EEC Treaty differs from the ECSC Treaty. First, the Council is the primary decision-making body and second, the Commission is responsible for initiating decision making and fulfils an executive function. Commission members were to be selected for their ‘general competence’ and by unanimous agreement of the national governments. All important matters of policy including the adoption of draft legislation or decisions to be submitted to the Council are taken by the Commission. The Commission has three main duties: 1. initiator of almost all policy,8 2. executive organ of the community, 3. custodian of the Treaty. The Council of Ministers consisted of one minister from each member government authorised to make decisions at ministerial level. Groundwork is completed prior to the decision-making process at the meeting of national experts or by permanent representatives. The Council’s executive power is devolved to the Commission in many cases and legislative power is shared with the European Parliament with which it holds joint budgetary authority. Article 104 of the Treaty of Rome gives the Council the power to coordinate the economic policies of member states. The Council of Economic and Finance Ministers (Ecofin) is one such session of the Council of Ministers, and usually

An historical perspective on economic and monetary integration

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meets monthly to discuss the macroeconomic situation in member states, to coordinate the Union’s position on international financial institutions and to adopt legislation in respect of tax harmonisation, financial liberalisation and the financing of the Union. The qualified majority system normally applies. At the heart of the Community system lies the interaction between the Commission and the Council. The Commission plays an active role at Council sessions and is treated on an equal footing. Its derives its power from two channels: the right of initiation and the implication of the voting rules. The Commission puts forward only proposals that it deems fit into the areas covered by the Treaty and it alone selects the timing of the presentation of the proposals to the Council. In areas of policy where unanimity is the rule, the Commission plays the role of honest broker, striving to reach consensus on an acceptable text. It seeks compromise whilst at the same time defending the Community’s position. The Assembly, established by the Treaty of Rome, became known as the European Parliament in 1962. Its members were originally nominated by the parliament of the six member states, but they were not bound by instructions from national parliaments or governments. The EEC Treaty defines the Assembly’s powers as ‘advisory and supervisory’. Relating to its advisory power is the right to be consulted on budgetary matters, and to recommend action or policies on its own initiative. With its supervisory functions comes the ability to censure the executive and force it to resign, to put questions to members of the executive and Council, and to discuss the executive’s annual report. In 1979 members were directly elected to the European Parliament for the first time. The Court of Justice acts as the final arbiter in disputes arising from community treaties. It was established by ECSC Treaty to ‘ensure that in interpretation and application, the law is observed’ and its area of competence was extended by the Rome Treaty. The Court’s jurisdiction includes the failure of member states to fulfil treaty obligations and judicial review (review of the legality of Regulations, Directives or Decisions adopted by the Council of Ministers or the Commission and certain acts of the European Parliament); if the Council, Commission or European Parliament fails to act and in so doing infringes a requirement laid down by the Treaties, and if an interpretation of treaty or validity of acts of community institutions are questioned, then the national court can ask the Court to give a preliminary ruling. Other important institutions are the Economic and Social Committee which is an unelected representative body (employers, trade unions and other interest groups). The Council of Ministers is bound to obtain the Committee’s opinion on draft legislation in certain subject areas, though this opinion is not binding. The Monetary Committee was established under the Treaty of Rome (Article 105) as an official-level advisory body to the Council of Ministers in the

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economic and financial field. It was created to promote the coordination of the policies of member countries in monetary matters to the extent necessary to ensure the operation of the common market and was tasked with monitoring the monetary and financial situation of member states. In 1964 the Council extended the Committee’s work to include coordination of the Community’s position in international financial institutions. The European Council consists of meetings of the heads of state or of governments of the member states of the EC and the president of the European Commission. The Treaty establishing the European communities makes no mention of the European Council. President de Gaulle originally suggested meetings of heads of state and governments as part of his proposal to create a political union (Morgan, 1976, p. 9). Although the proposal was ultimately rejected, it created sufficient interest among the governments of the six member states for them to hold a first meeting of heads of state and government in Paris in February 1961. A later conference in Bonn in July 1961 agreed ‘to hold, at regular intervals, meetings whose aim will be to compare views, to concert their policies and to reach common positions in order to further the political union of Europe’ (Morgan, 1976, p. 10). At a later meeting in Paris in December 1974 it was agreed that the Council should meet three times a year with the possibility of special sittings. The Committee of Central Bank Governors (CCBG) was first given institutional standing in May 1964 when Ecofin decided to complement the existing Monetary Committee by establishing a body to coordinate activities of central banks. The Committee’s remit was to hold consultation about broad lines of policy of central banks and exchange information at regular intervals. The EEC was based on the creation of a common market which was achieved through specific measures outlined in Article 3 of the treaty: the elimination of custom duties and of quantitative restrictions on intra-EEC trade; the establishment of a common external tariff and of a commercial policy toward third countries; the free movement of goods, services, persons and capital; common policies in agriculture and transport; the introduction of procedures to allow the coordination of economic policies, and the rectification of disequilibria in the balance of payments; the establishment of a system to ensure undistorted competition in the common market; the approximation of laws to enable the proper functioning of the common market, and the creation of the European Structural Fund (ESF) and European Investment Bank (EIB) to improve employment opportunities, support economic expansion and raise the standard of living (Jovanovic, 1997, p. 9; Kirschen, Bloch and Basset, 1969, pp. 9–10).9 As mentioned above, there were important exceptions, such as agriculture and transport, with a high degree of government intervention such that it would not have been practical to remove the barriers, and instead a common policy was adopted.

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In contrast, the Treaty of Rome was less explicit about macroeconomic policy and monetary policy. However, the Treaty of Rome did detail some general economic and monetary objectives: equilibrium in overall balance of payments, maintenance of confidence in currency, a high level of employment and stable prices (Article 104). And in order to attain these objectives, three instruments were specified. First, the coordination of economic policy through government and central bank collaboration. In this respect, the Monetary Committee was enjoined with ensuring that member countries complied with this objective. Second, the stabilisation of exchange rates (Article 107). And third, member states had recourse to limited credits and to other unspecified mutual assistance in the event of balance of payment problems (Kirschen, Bloch and Basset, 1969, p. 33). Despite these declared aspirations there were no specific provisions made in the treaty regarding coordination in the macroeconomic field. Article 2 refers to the ‘harmonious development of economic activities’ and to ‘a continuous and balanced expansion’ but there were not sufficient instruments created to realise these objectives. Regarding the lack of precise instruments for macroeconomic coordination, several explanations can be offered. First, Keynesian ideas still held sway and governments wished to retain direct control over fiscal and monetary policies. Second, greater capital mobility across national boundaries would undermine the effectiveness of national monetary instruments. Third, the governments did not wish to push too far in case the whole enterprise was placed in jeopardy (Tsoukalis, 1997, pp. 13–14). In addition, exchange rate stability and a basic framework for policy coordination were provided externally by the Bretton Woods system (Fratianni and von Hagen, 1992, p. 12). In the Preamble to the Treaty of Rome mention is made of narrowing the differentials between regions, but it was not until 1972 that the European Regional Development Fund was established.10 The target was set to establish a customs union within 12 years with the possibility of an extension to 15 years. In the event, all tariffs for EC internal trade were eliminated on 1 July 1968, one and a half years before the target date and, at the same time, the common external tariff came into force. To avoid duplication of work the commissions for the three communities were merged in 1967; the Council of Ministers for the ECSC had already merged with the Councils of the EEC and Euratom in 1958. This move heralded a change in emphasis between the ECSC and the EEC despite the basic institutional pattern remaining unchanged. Under the ECSC the High Authority had the primary role, having considerable powers of direct action, and only needing the consent of the Council of Ministers in specific areas, whilst under the EEC the most important decisions were made by the Council of Ministers, the Commission’s influence derived from its right of initiative.

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Previously there had been a single community whose sphere of control covered two sectors, now there were three communities coexisting whose interest encompassed most of the economic spectrum. These communities were seen by many as a step on the way toward full economic and political union (Palmer and Lambert. 1968, p. 167).

2.6 MONETARY UNION In 1959 and again in 1961 pronouncements by Monnet’s Action Committee for the United States of Europe called for monetary integration. In response to a persistent balance of payments surplus with the rest of the world among the EEC members, the CCBG was given a brief to coordinate exchange rate management and international monetary policy. In 1962 the EEC Commission in ‘The Action Programme of the Community for the Second Stage’ proposed an adjustable peg exchange rate system and a reserve currency established by the end of the decade (Pinder, 1996, pp. 127–8; Snyder, 1998, p. 11). Yet these calls went unheeded because exchange rate stability and a framework for macroeconomic policy coordination were provided externally by the Bretton Woods system. This was to change in the early 1970s with the collapse of the Bretton Woods system, and the unexpected volatility of exchange rates which ensued. The EEC’s position vis-à-vis the outside world and related loss of control over monetary affairs for internal stabilisation purposes provided the major impetus towards monetary union (Study Group on EMU, 1973, p. 1). Both internal and external factors were important: economic and monetary union (EMU) was born as a result of a convergence of widely different interests, ranging from a German need for ‘Westpolitik’ to a concern about the customs union and Common Agricultural Policy (CAP); the CAP price system was threatened by exchange rate fluctuations (Pinder, 1996, p. 128); and other concerns ranged from the safeguarding of fixed exchange rates to the protection of the community from British entry and the possibility of its dilution into a free trade area, and the need to adopt a common policy vis-à-vis the United States (Tsoukalis, 1977, p. 169). The speedy implementation of the customs union coupled with the erosion of the stability of the dollar-centred Bretton Woods system fractured the external exchange rate stability of the EC and resulted in calls for monetary union to protect the EC from break-up. The increased monetary instability of the 1960s led to the Barré Report in 1969; the Commission proposed that to counter currency instability, macroeconomic coordination should be improved, and that fluctuation margins around the currencies of the six members of the EEC should be eliminated on the first step towards fusing them into a single currency. In this respect, an early landmark was the decision of the EEC heads of states and gov-

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ernments, at the Hague summit of December 1969, to proceed gradually to EMU, a decision which made monetary integration an explicit Community objective (Hitiris, 1988, p. 92). The goal of a single currency was agreed by Ecofin in February 1970 but differences in opinion among members meant that precise details were not agreed. Instead a special study group under Pierre Werner was established to review EMU in greater detail and to propose a concrete plan for moving ahead. The Werner Report 1971 advocated the movement toward economic and monetary union by 1980. Like the Delors Report which it preceded, it proposed an EMU in three stages. There was a clear view of what monetary union entails: A monetary union implies inside its boundaries the total and irreversible convertibility of currencies, the elimination of margins of fluctuation in exchange rates, the irrevocable fixing of parity rates and the complete liberation of movements of capital ... monetary union ... may be accompanied by the maintenance of national monetary symbols or the establishment of a sole Community currency. From the technical point of view the choice between these two solutions may seem immaterial, but consideration of a psychological and political nature militate in favour of the adoption of a sole currency which would confirm the irreversibility of the venture. (Werner Report, 1970, p. 5)

The first stage, which was intended to last from 1971 to 1973, was directed at getting the economic underpinning right and preparing the ground for any institutional development in order to facilitate coordinated policymaking. The second stage consolidated the economic and institutional progress of the previous stage. At this stage exchange rate changes could only be made with the explicit agreement of members. The first two stages would see increased policy coordination leading to convergence, a common policy on government budgeting, and a progressive narrowing of currency fluctuation bands. Institutional tinkering would, however, be kept to a minimum, although the European Monetary Cooperation Fund (EMCF) would be created in stage 2 to manage a proportion of the member states reserves and to provide short-term and mediumterm finance for intervention in the foreign exchange markets. The EMCF was responsible to the Committee of Central Bank Governors, which itself was charged with coordinating monetary and exchange rate policy. Ecofin would meet more regularly to coordinate macroeconomic policy. Coordination entailed the prescribing of medium-term objectives and of annual programmes which were to be based on multilateral surveillance. And in stage 3 exchange rates would be irrevocably fixed and a community level central bank would be created to operate monetary policy. Opposition to these measures came particularly from the Gaullists then in power in France which ensured that progress would have to be mindful of French sensitivities. As a result institutional consolidation would have to be

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evolutionary and cautious – France would only assent to a managed currency arrangement. In addition, a dispute raged over which strategy to adopt to achieve economic and monetary union. One group, of France, Belgium and Luxembourg, wanted to lock into irrevocably fixed exchange rate parities as soon as possible, even before the effectiveness of economic policy coordination had been established. Another group of West Gernany and the Netherlands wished to establish a system of economic policy coordination before eventually progressing to a fixed exchange rate. Ultimately, the Werner Report reached a compromise between the positions by developing a strategy of parallelism for economic policy coordination and for monetary union. In March 1971 Ecofin agreed on EMU, although only stage 1 was elaborated. Mechanisms for closer cooperation among central banks were agreed. An ‘optout’ clause was included if agreement on the second and more substantive stage of EMU was not reached by January 1976, then monetary cooperation measures should be abandoned. The notion of irrevocably locking exchange rates together without any margin of fluctuation, as suggested in the Werner report, was abandoned in favour of a mechanism to reduce the margin of fluctuation around the central parities at which one EEC currency was exchanged for another. Intra-EEC exchanges were confined to a narrower band of fluctuation than was permitted in respect of EEC currencies against the dollar (the ‘snake in the tunnel’). This attempt to limit intra-European exchange rates was seen to serve to advance the objective of EMU by promoting trade in goods and services and capital flows within Europe. In addition it would help to reduce the cost of servicing the CAP, the Community’s agricultural support system (Klein, 1988, p. 5). The emerging economic conditions of the early 1970s were unpropitious to establishing a European Monetary Union. Faced with rising unemployment and slow economic growth, the US pursued an easy monetary policy which was the converse of that desired by the authorities in European countries. The tensions created by these divergent policies eventually led to a series of speculative attacks against the dollar. The dollar rescinded its gold convertibility in August 1971 and, finally, the Bretton Woods system collapsed in December 1971 when the G7 nations agreed the Smithsonian accord to allow a 4.5 per cent band of fluctuation against the dollar and 9 per cent bilaterally.11 After the collapse of the Bretton Woods system the ‘snake’ was introduced in April 1972, only to be replaced by the ‘floating snake’ when the dollar floated in December 1973. The ‘snake’ was a mechanism to reduce intra-EC exchange rate fluctuations. Bilateral fluctuations among EC members were halved from the 9 per cent band of the Smithsonian agreement to a 4.5 per cent band. But the attempt to preserve some of the elements of Bretton Woods at the regional level proved to be a futile exercise. The snake was quickly transformed into a Deutschmark zone after the withdrawal of sterling, the punt, the lira and the

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French franc. The EEC had itself expanded from six to nine countries in January 1973 with the UK, Ireland and Denmark joining. Progress toward EMU was persistently hampered: first, the shocks to the international monetary system that followed the dollar crisis in 1971–73), and the first oil crisis and inflationary push of 1973; and, second, conflicting national objectives and unwillingness to surrender national sovereignty in pursuit of a Community objective. Circumstances had dictated that the lowest common denominator solution be agreed, thus the EC countries settled on a common goal of economic and monetary union and a weak mechanism for exchange rate control (Kruse, 1980, ch. 9; Pinder, 1996, p. 129). The ‘snake’ did not succeed in its explicit aim of creating a zone of monetary stability (Tsoukalis, 1997, p. 38). With the collapse of the Bretton Woods system and the floating dollar, the process of monetary union ground to a halt. When the Commission eventually came round to consider proceeding to stage 2, no agreement could be reached at the Ecofin Council and EMU was abandoned in December 1974. The move towards monetary union was by no means universally applauded. The Marjolin Report (1975) argued that monetary union should be postponed until after the achievement of a high degree of economic integration in the EC. It advocated that a single unified market would provide a sound basis from which to launch monetary union. From another standpoint, the MacDougall Report (1977) stressed the role of a unified fiscal system in a monetary union and concluded that a monetary union would not be viable without a sufficiently large community budget for fiscal policy (Fratianni and von Hagen, 1992, p. 13). From its inception the ‘snake’ was beset with problems and burdened with an inherent asymmetry. It placed the burden of adjustment on the weak-currency countries and was unable to provide adequate financing for weak-currency central banks when their currency was subject to currency speculation (Klein, 1998, p. 5). By 1979, only Germany, Netherlands, Denmark, Norway, Sweden, Belgium and Luxembourg remained within the fixed exchange rate system. The EMU project did have concrete achievements and it would serve as a blueprint for those proposing EMU in the future. Foremost among these achievements were the strengthened cooperation among central banks with the creation of the EMCF and the agreement on the attainment of a high level of convergence of the economic policies of member states. It highlighted the economic and political difficulties associated with such moves towards EMU. The experience of the EMU project also demonstrated that a sustained record of stable currency management was an indispensable precondition for any serious attempt to adopt a single currency. No lasting progress towards EMU could be achieved without appropriate institutional reforms guaranteeing a transfer of responsibility in the macroeconomic field from national to the European Community level.

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2.7 THE EUROPEAN MONETARY SYSTEM In 1977 Roy Jenkins, President of the Commission, reactivated plans for establishing a monetary union. Support for his plan was provided by a Franco–German alliance without which it would have been a non-starter.12 In July 1978, the heads of state of the nine member countries met to discuss closer monetary cooperation. The European Council adopted a resolution establishing the European Monetary System (EMS) later that year. A new attempt at establishing monetary stability was launched in March 1979 with the EMS replacing the ‘snake’. The second stage, the creation of the European Monetary Fund to replace the EMCF, was planned for two years later, however, the deteriorating economic climate put this move on hold. The EMS was established to pursue three main policy objectives: the creation of a ‘zone of monetary stability’ involving both low inflation and stable exchange rates; the provision of a framework for improved economic policy cooperation between member states; and the easing of world monetary instability through the adoption of common policies in relation to third countries (European Commission, 1989, p. 2). Finally, it was hoped that the EMS would lead to economic and monetary convergence, and ultimately a stepping stone to economic and monetary union. It introduced innovations to overcome problems that had led to the collapse of the ‘snake’. The divergence indicator, as discussed below, was created to counter excessive German dominance and establish symmetry. Realignments were to occur only after unanimous agreement, not taken as a unilateral decision as was the general rule under the ‘snake’. This procedure was introduced to prevent countries harming the system by taking actions only in their self-interest. To realise these objectives the EMS provided a tool called the Exchange Rate Mechanism (ERM) which consisted of four components: European Currency Unit (ECU), the parity grid, the divergence indicator and credit financing. The ECU had two uses: it was a monetary unit based on a basket of EU currencies (a fixed quantity of each currency in the basket with the weights of the currencies varying over time with fluctuations in intra-European exchange rates), and a reserve instrument issued by the EMCF to the EMS central banks in exchange for 20 per cent of gold and dollar reserves. The EMCF was first set up in 1973 as part of the attempt to establish monetary union. The failure of the first attempt at EMU in the mid-1970s and the subsequent reduction in the membership of the ‘snake’ to a small block of countries diminished the role envisaged for the EMCF. However, the new attempt at establishing a monetary system saw its relaunch as a part of the EMS. The parity grid tied each currency to every other currency in a system of mutually agreed exchange rates. When one currency diverged from parity, all other exchange rates also diverge, hence all countries must respond through intervention to re-establish parity. The central rate is the amount of a country’s

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currency equal to one ECU and is only revised by unanimous agreement of participating governments. The central rates determined the bilateral exchange rates with fluctuation bands set at ±2.5 per cent and ±6 per cent for Italy; when the currency reached this limit the central bank must intervene. Under the EMS, once either the upper or lower limit was reached, it signalled the need for intervention by the central banks. However, the EMS was designed not to be a rigid system but adjustable to changing economic conditions and the economic performance of member countries. The divergence indicator was used to give a warning when a country was diverging from its central rate. The divergence indicator acted as a supplementary intervention device. When movements in the daily exchange rate pegged against the weighted average movement of the other EMS currencies exceeded 75 per cent of the maximum possible divergence spread, it signalled the need for a country’s monetary authority to take corrective measures: diversified intervention (intervention in a range of currencies, rather than in a single currency), domestic monetary policy (which would have an effect on interest rates), changes in central parity, or other measures of economic policy (fiscal or incomes policies). The divergence indicator applied equally to relatively weak and strong currencies with the intention of introducing symmetry into the EMS. Accordingly, there would be equal sharing of the adjustment of balance of payment disequilibria between deficit and surplus countries. Credit facilities were made available to ERM members for intervention in the foreign exchange market. Three types of finance facility were provided to member countries to intervene in the foreign exchange markets once their currency approached the upper or lower limits of their exchange rate band: very short term (45 days–3 months) and short term (3–9 months), which are administered by central banks, and medium term (2–5 years) administered by the Council of Ministers (Kondonassis and Malliaris, 1994, p. 296). The members of the European Community participating in the ERM (the UK remained outside the ERM until October 1990) chose to fix their bilateral exchange rates, but did try to coordinate their monetary policies. Nevertheless, each country tended to gear monetary policy towards maintaining their own exchange rate. The optimists argued that the stability of the exchange rates between member countries would promote economic trade and growth, and the more inflationary economies would have to move to lower inflation rates. Eventually the EMS would increase the interdependence of European countries by providing a tool for exchange rate stabilisation and for encouraging convergence of economic and monetary policies (Kondonassis and Malliaris, 1994, pp. 295–6). It was described as ‘a fundamental component of a more comprehensive strategy aimed at lasting growth with stability, a progressive return to full employment, the harmonization of living standards and the lessening of regional disparities’ (Jovanovic, 1997).

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The EMS was implemented by agreement between central banks of the Community, which implied that the CCBG became the routine management agency for intervention within the ERM. From 1974 the Monetary Committee was consulted on alterations in a currency’s exchange-rate parity. This function was carried over to the EMS. Obligatory consultation of the committee in matters on capital liberalisation and emergency balance of payment loans or assistance extended to individual member states. Even at an early stage there were concerns raised about the viability of the EMS. The EMS faced the asymmetry problem of a fixed exchange rate system that deficit countries are under pressure to deflate but surplus countries are not under similar pressure to reflate. When two currencies reached their agreed limits, both countries had to intervene in the strong currency to buy the weak currency. The weak-currency country could use the very short-term facility to fund intervention. But a problem existed when a currency approached its lower limit; speculators would enter the foreign exchange market selling the overvalued currency, thus forcing the weak country to intervene before the currency reached its limit. This intramarginal intervention was discretionary and the strong-currency country was not bound to take action, nor was very short-term facility available. The full burden of adjustment falls on the weak currency. The rules of the EMS may have been constructed to insure that the immediate effects of intervention were perfectly symmetric. However, the final liquidity effects need not be symmetric. Central banks sterilise foreign exchange interventions and the EMS does not legislate in this respect. This gives rise to asymmetry because hard-currency countries find it easier to secure the large amounts of foreign currency required to engage in sterilised intervention than weak-currency countries. Asymmetry in the system was aggravated further by two other factors: intramarginal intervention which far exceeded formal obligatory intervention, and the lack of a common policy toward the dollar. The EMS was also susceptible to disruptive capital flows; as the dollar weakened the DM replaced it as a reserve currency, causing the DM to appreciate within the EMS and further destabilising the system. This highlighted the degree of interdependence in the world economy – the EMS experienced shocks even though the developments occurred elsewhere in the world. As mentioned above, the introduction of this new exchange rate system occurred against the backdrop of large inflation differentials between participating countries. Changes in relative prices between countries shift competitiveness. Between 1979 and 1987, there were eleven realignments within the ERM. These realignments were by high inflation countries devaluing their currencies to remain competitive with the low inflation countries. Countries were forced to implement capital controls to prevent the destabilising effects of capital flows. This highlighted the fundamental weakness of the ERM, a

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fixed exchange rate system operating without the coordination of monetary and fiscal policies. When in 1986 the EU amended the Treaty of Rome with the Single European Act, the end of 1992 was set as a target date for the removal of all remaining barriers to the free flow of goods, services and resources. A greater degree of macroeconomic coordination among member states was now required, as a consequence of which the EMS was strengthened because of the desire to achieve greater convergence in economic policies and the Basle/Nyborg agreement was reached in 1987. This introduces a series of measures aimed at promoting the coordination of economic policies through the surveillance of economic indicators and the refinement of the EMS intervention mechanism to counter speculation after capital liberalisation. The very short-term credit facility would be available for intramarginal intervention. Between 1987 and 1992 there was only one realignment, a 3.7 per cent technical depreciation of the Italian lira to allow for the narrowing of the fluctuation margin. Other countries became members of the ERM: Spain in June 1989, the UK eventually deciding to join the ERM in October 1990 and Portugal in April 1992; all the currencies participated in the 6 per cent band. At last the EMS appeared to realise its purpose and variations in the real exchange rates and money supplies among EMS members (Germany, France and Italy) were smaller than non-members (Japan, UK and US) between 1979 and 1988 (MacDonald and Taylor, 1991). And among EMS members, there was convergence in inflation rates, interest rates, budget deficits and government debt as a percentage of GDP between 1987 and 1992 (Salvatore, 1996, p. 605). By July 1990, all restrictions to intra-community capital movements were removed and all remaining restrictions to the free flow of goods, services and labour were eliminated at the beginning of 1993 – the single market was in existence. The status quo, however, could not remain unchanged: a fixed exchange rate system is only compatible with the free flow of capital if macroeconomic policy is fully coordinated. Until 1992, it appeared that the EMS was an unqualified success, however, the system had not weathered a crisis. There was a suspicion that a large aggregate demand shock would unsettle the whole system, and in 1992 it was about to be tested. Germany was grappling with the cost of financing the restructuring of East Germany, and had historically high interest rates to curb inflationary pressure. Tight monetary policy in Germany acted as a trigger for the ERM crisis. But pressures had been building up in the EMS since the signing of the Maastricht Treaty and the subsequent failure by Denmark to ratify it due to the no vote in their referendum. Financial market liberalisation and unfettered capital flows coupled with the EMS required full monetary policy coordination. In the financial markets, there was a lack of sufficient credibility in the consistency and coordination of economic policy and a general feeling that

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central bank power of strong currency countries would be used to suit their own interests regardless of the rest (Giordano and Persaud, 1998, p. 17). In September 1992, faced with the strain of keeping their currencies within their respective bands, the UK and Italy were forced to abandon the ERM. This was followed by six other devaluations: the peseta in September 1992; the escudo and peseta in May 1993; the punt in January 1993, and again the peseta and escudo in May 1993. France remained within the ERM only after heavy intervention in the foreign currency market by the Bundesbank and the Bank of France. Pressure was eased in the Spring of 1993 when the Bundesbank made three interest rate reductions. Respite was only temporary, and when the Bundesbank failed to lower the interest rate in August 1993, as was expected, it started a run on the franc and the currencies of Denmark, Spain, Portugal and Belgium. In spite of foreign exchange market intervention on a massive scale, defeat was accepted and the narrow band of 2.25 per cent was abandoned in favour of 15 per cent. The crisis highlighted the effects of member countries operating uncoordinated monetary policies. Germany had ignored the warning of other ERM members and had adopted a high interest rate policy in the face of a growing money supply. The ERM was a free-floating system in all but name, and it appeared that the move toward monetary integration had been permanently derailed. At the end of 1996 all ERM currencies with the exception of the Irish punt were within the 2.25 per cent band, while sterling and the drachma remained outside the ERM. The creation of a monetary union, EMS, was a continuing process during the 1979–1992 period.13 The EMS seemed to have succeeded in promoting convergence in inflation rates, interest rates, budget deficits and government debt as percentage of GDP from 1987 to 1992 (Salvatore, 1996, p. 605), although Fratianni and von Hagen (1992, pp. 30–31) point out that the inflation performance of EMS countries has been no better than non-EMS countries. In this regard, realignments changed from being a passive reaction to inflation to being an instrument to control inflation and used in conjunction with domestic measures.

2.8 THE SINGLE MARKET AND THE SINGLE EUROPEAN ACT The EC had emerged from the 1970s intact but considerably weakened. The decision-making process was paralysed, the cost of CAP was spiralling out of control, the Commission was impotent and the Community’s solidarity was strained by national politicians, who only seemed to have national interests at heart (Dinan, 1994b, pp. 99–100). In the early 1980s, the Community was char-

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acterised by a paralysed decision-making process, a feeble Commission and agricultural expenditure out of control (Dinan, 1994b, p. 14). Slowly, however, things began to change. The accession of Greece and the pending accession of Spain and Portugal generated pressure for institutional reform. Direct elections to the European Parliament were held for the first time in June 1979. All these factors helped to create a new momentum in Europe for change. Early results were a resolution to the British budget question,14 and a renewed effort to implement the single market. The single market project was to bring many other changes in its wake. In the early 1980s, recession had hit the European economies hard; with it came the winds of change bringing a new ideology to Western Europe. The tenets of this ideology were monetarism, deregulation and neo-liberal theory. In the US, President Reagan and in Britain, Prime Minister Thatcher were applying these doctrines in the belief that they would restrain inflation and reinvigorate the economy. Interest in the completion of the single market among the new ideologues was inspired by the notion that liberalisation of the markets would improve efficiency and promote growth. The neoliberal politicians were not alone in this respect; business leaders were also supportive of a single market, though they doubted the Commission’s ability to deliver one (Dinan, 1994b, p. 138). Despite those doubts, the Commission played a key role in promoting the single market as seen by the encouragement it gave to technological collaboration in the Community. High technology was an area that would clearly benefit from the single market (due to economies of scale and gains associated with learning curves), yet it was in these areas where no common market existed. Apart from the fiscal, physical and technical barriers preventing crossborder trade, national public procurement practices were another problem with which the high technology industry had to contend. Governments would direct purchases towards national champions. Financial support to national champions was also provided in the form of state aid (Vickerman, 1992, p. 130). Considerable headway was made in addressing the issue of competitiveness when leading firms in the electronics industry launched the European Strategy Programme for Research and Development in Information Technology (ESPRIT) in order to promote closer intra-European R&D and to end the fragmentation of the single market (Tsoukalis, 1997, p. 36). This approach provided the template for other similar schemes and led to a proliferation of joint R&D programmes. Moreover, the ESPRIT programme demonstrated that the Commission could be a constructive partner and an agent for economic revival. It also helped to cast aside persistent doubt on the Commission’s capability to deliver a single market. Europe’s loss of competitiveness and the subsequent loss in jobs and rise in unemployment was linked, in part, to the fragmentation of the European market

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The euro

due to the existence of non-tariff barriers. Despite tariff elimination the single market was still fragmented by non-tariff barriers. The White Paper, the Cockfield Report of June 1985, was a supply-oriented ‘Programme for the completing of the Internal Market’. It tackled the issues involved in dismantling non-tariff barriers and creating a genuine and homogenous frontier-free internal market by 1992. The 1992 Programme was widely accepted and seen as a panacea for Euroscelerosis and an added boost to integration. The main aspects of the programme were the removal of non-tariff barriers for internal trade, increased competition, promotion of cooperation among firms in R&D, unification of factor markets through liberalisation of factor mobility, monetary integration and social protection (Jovanovic, 1997, p. 16). On its own the White Paper was not sufficient to guarantee the completion of the single market, it would undoubtedly have become bogged down in procedural wrangling in the Council of Ministers. The Single Market Programme highlighted the need for institutional and constitutional reform of the Community as did the assertiveness of the newly elected European Parliament and the accession of Spain and Portugal.15 This provided the required impetus for reform resulting in the Intergovernmental Conference that led to the Single European Act. Another force for change which placed institutional reform on the agenda was the Dooge Report, which identified ‘priority objectives’ to realise European union. These were a homogeneous internal economic area, restrictions on the use of unanimity in the Council of Ministers, an enhanced legislative role for the European Parliament and greater executive power for the Commission (Dinan, 1994b, p. 142). The SEA advocated the adoption of measures which would bring about an integrated internal market ensuring the free movement of goods, services and resources by December 1992, and recognised that the smooth implementation of the 1992 Programme required a change in the decision-making process of the EC. The subsequent reform of the Treaty of Rome by the Single European Act (1 July 1987) helped speed up the 1992 programme. The SEA extended the use of majority voting to most areas except for fiscal matters, rights of employees and free movement of people, thereby sweeping aside the Luxembourg Compromise.16 This seemed to shift the balance of power to the EC from the national governments: the Council of Ministers got new powers to act on a qualified majority basis after consultation with the European Parliament and the Economic and Social Committee; the Commission gained in importance as it had to prepare proposals for the Council of Ministers to realise the 1992 Programme; and the European Council was formalised. The Single European Act was the community’s response to demands for institutional reform and was the first major amendment to the Treaty of Rome. It gave formal recognition to the European Council and formalised procedures known as European Political Cooperation.17 The Single Market Programme was initially realised quickly

An historical perspective on economic and monetary integration

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but got bogged down in the legislation field; not only was the problem in the detail, but over the Community’s budget. To fulfil expansion in budget expenditure created by the Cohesion Fund, the Commission arrived at a five year budget plan in 1988 (Delors I). But, the Single European Act was more than a simple device to achieve a Single Market: ‘The 1992 goal was clearly intended as completion, but new policies had been substantively embraced and institutions had been strengthened, thus deepening was in hand, and widening had occurred for a third time without momentum being lost’ (Wallace, 1989, cited in Dinan, 1994a, p. 18). At the end of 1995, the Commission estimated that 93.2 per cent of SEA directives had been implemented by member states. However, in important areas such as public procurement the figure remained below that level (El-Agraa, 1998, p. 158). The SEA focused on economic integration and did not explicitly mention EMU except through the need for economic and monetary policies to converge ‘for the further development of the community’. To this end the Delors Committee was set up to examine ways of achieving EMU. The EMS was established primarily to create monetary stability, but it should also be seen as an attempt to move the Community towards the goal of a monetary union. Therefore the SEA should be seen as the economic complement to the EMS and both could be described as stepping stones to monetary union.

2.9 THE DELORS REPORT When Jacques Delors took up his position as President of the Commission in 1985 he had a number of priorities: a single market, institutional reform, a new monetary initiative and extending the Community’s competence in the field of foreign policy and defence (Dinan, 1994a, p. 17). Delors would have preferred to concentrate on EMU but realised that monetary policy lay too close to the core of national sovereignty. If he chose to follow such a politically sensitive strategy, then it would have provoked hostility from national governments and created tensions within the community. Instead he sought a shared problem where consensus could be reached on achieving a solution. At the time a common shared problem was the recession hitting economies, as Europe suffered the second recession since the war. European industry was losing its competitiveness against American firms in new technologies and newly-industrialised countries in old ones. There was a common agreed solution, namely the completion of the single market. It was argued that the establishment of a common market had stimulated the economies of the original six member countries; non-tariff barriers had remained and continued to fragment the single market. The intention was that the completion of the single market would remove the causes of fragmentation and stimulate the economies of EC

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The euro

countries. Delors recognised quite quickly that the single market was the obvious option. It was simply reaffirming an objective that had been agreed by the heads of states under the Treaty of Rome. Moreover, successful implementation of the Single Market could be a mechanism for improving decision making and renewing interest in the EMU. The momentum created by the Single Market Programme and the success of the EMS in achieving monetary stability did focus attention back onto the EMU. And at the European Summit in Hanover in June 1988, the heads of government agreed to establish a committee with ‘the task of studying and proposing concrete stages leading towards this union’. The committee delivered its findings in the Delors Report, the following year, at the Madrid Summit. The report identified four key elements to achieve economic union. First, the creation of a single market; second, competition policy to strengthen the market mechanism; third, macroeconomic policy coordination coupled with binding rules for budget deficits; and fourth, common policies to strengthen structural change and regional change. Economic union would not require a single economic policy. By contrast monetary union would necessitate a common monetary policy to be controlled by a central institution, though a single currency was not mandatory. Prerequisites for monetary union were identified as the total and irreversible convertibility of currencies, the complete liberalisation of capital transactions, elimination of margins of fluctuation and the irrevocable fixing of exchange rate parities. The central institution overseeing the Community’s monetary policy was a European System of Central Banks (ESCB) based on federal lines, which would formulate and implement monetary policy. Its primary objective would be price stability while it would maintain total independence from member states. The report recommended a transition towards full monetary union in three stages. To insure momentum the transition would be a single process. The first stage, defined as an initiation process towards EMU, advocated the convergence of economic performance and cooperation in monetary and fiscal policies. The common market was to be completed by the removal of all restrictions to intra-community capital movements, in principle all countries should enter the ERM at the narrow band and measures to encourage convergence of key macroeconomic indicators. It also addressed the issue of non-participating states in the ERM. An Intergovernmental Conference would be convened at a later date to determine treaty revisions that would be needed in subsequent stages. This stage would see the expansion of the role of the Committee of Central Bank Governors in coordinating policy. The organisation and the remit of the committee would be redefined and an economic unit would be added. The committee chairman was permitted to attend Ecofin meetings, otherwise the institutional structure was sufficient to fulfil the requirements of the first stage.

An historical perspective on economic and monetary integration

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The second stage was a transitionary period where consolidation of procedures established in stage one would take place and an institutional framework would be created. Policy would still remain in the hands of national government, though policy guidelines would be mandated by majority voting. A framework would be established for key economic objectives with a monitoring function, for setting non-binding rules on the size of annual budget deficits and for the EC to behave as a bloc in matters relating to economics and the exchange rate. The European System of Central Banks (ESCB) would coordinate the independent monetary policies of member states. The ESCB would also seek to achieve harmonisation of supervisory and regulatory functions. The third and final stage would begin with the irrevocable fixing of participating states’ exchange rates whilst national central banks would relinquish control of the domestic money supply to the EC institutions. Eventually national currencies would be replaced by a single currency. Other key developments were that macroeconomic and budgetary rules and procedures would become binding, and structural and regional policies would be strengthened. The ESCB would pursue a single monetary policy that would entail engaging in foreign exchange market interventions and union-wide open market operations, formulation and implementation of monetary policy, and the technical preparation necessary for a single currency. The first stage was adopted unanimously by the European Council at the Madrid Summit in June 1989 and began on 1 July 1990, timed to coincide with the liberalisation of capital movements as part of the Single Market Programme. After agreement at Maastricht on a new treaty to delegate responsibility for monetary policy to a new common institute, the second stage began on 1 January 1994. The European Monetary Institute (EMI) was created to assume a coordinating role. The EMI was set up as a precursor to the ECB – the central institution of stage III. The EMI’s role was to strengthen cooperation between central banks and the coordination of monetary policies of member states, to monitor the functioning of the EMS, to take over the tasks of the EMCF and to facilitate the use of the ECU and oversee its development. In addition it had the general responsibility to make preparations for stage III of EMU. In so doing it was to draw up recommendations on the overall orientation of monetary policy and exchange rate policy – policies which might affect the internal or external monetary situation – and to members concerning the conduct of their monetary policy. The Monetary Committee was to assist in monitoring economic convergence at stage II and to become the Economic and Financial Committee at the beginning of stage III. Member countries (except Denmark and the UK) were required to take measures to make their central banks independent. The third stage, the completion of full monetary union by either 1997, if a majority of the countries met convergence criteria, or 1999 even if only a

30

The euro

minority of countries met the criteria, would see the Maastricht Treaty and the creation of the European Monetary Institute (EMI) which was the forerunner of the European Central Bank (ECB) by 1994.18 And finally, in May 1998 the European Council was to meet to announce which countries met the necessary conditions for the adoption of a single currency. The third and final stage of EMU began on 1 January 1999. The participating states adopted ‘irrevocably fixed’ exchange rates, the euro being substituted for national currencies, and the ECB as the sole issuing authority for euro notes.

2.10 MAASTRICHT AND BEYOND The Rome Summit in December 1990 launched a year-long process of intensive bargaining. And eventually at Maastricht the Treaty on European Union was signed in December 1991, establishing a union which consisted of three pillars: the Treaty of Rome, the Common Foreign and Security Policy, and cooperation on justice and home affairs. In addition majority voting on implementing decisions was accepted. The Maastricht Treaty was a political compromise where each country gave some ground in order to gain some movement on an objective. In a nutshell the Maastricht Treaty can be shown to reflect this compromise. The single currency and defence and foreign policy arrangements satisfied France’s ambitions, the increase in the power of the European Parliament and the direction of the money policy was German-inspired. The cohesion fund and the Social Chapter was included to satisfy Spain and the Netherlands respectively. Britain secured two opt-outs, one from the Social Chapter and one from the single currency (Jovanovic, 1997, p. 16). The Maastricht Treaty was also a compromise in other respects; for those who wished to set a ceiling on integration by emphasising subsidiarity and intergovernmentalism and those who wished to strengthen European union (Wallace, 1994, p. 64). At Maastricht, greater detail was added to the process towards economic and monetary union, which was seen as a means to ‘promote economic and social progress which is balanced and sustainable’. The Maastricht Treaty added to the Treaty of Rome and set up a number of new institutions as well as specifying the stages by which EMU was to be achieved. EMU was not seen as a means in itself rather as a means of securing ‘economic and social progress’ (Article B TEU) and ‘price stability’ (Article 3a EEC). The underlying argument behind this assumes that the efficiencies and benefits from a single market (economic union) will only be maximised when the costs and risks of currency exchange are eliminated (monetary union). The Maastricht Treaty adopted the Delors three stage plan with some important revisions. At stage II, the EMI would replace the CCBG and inherit

An historical perspective on economic and monetary integration

31

the duties of EMCF. Agreement was reached to set five strict criteria which would have to be met before a nation had to join the final stage of monetary union, which are detailed at the beginning of the next chapter. As well as these five criteria, there was a provision made for the European Commission and the EMI to make regular reports to the Ecofin Council on the economic performance of the member states regarding the convergence criteria. Ecofin’s responsibilities were extended by the Maastricht Treaty which gave it a supervisory role, in collaboration with EMI, of the progress towards EMU. The European System of Central Banks (ESCB) and European Central Bank (ECB) were to assume responsibility for monetary policy in the eurozone at the beginning of stage III. Article 105 of the Maastricht Treaty enjoins the ECB with the primary objective ‘to maintain price stability ... smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system’. The ECB has the general right of consultation on all legislation, European or national, in its area of competence. At the insistence of the German government, the Dublin Summit in December 1996 introduced the Stability and Growth Pact, and this Pact ensured the continuation of limits on budget deficits in member countries. This provided the detail to an otherwise vague recommendation on excessive deficits in the Maastricht Treaty. It specified limits for deficits and procedure to follow in case limits are exceeded, and outlined the sanctions that the deficit country would incur if it breached the limits, though it did provide automatic and discretion exemptions under certain conditions. Also at the Dublin Summit meeting, arrangements were made for ERM II, which outlined the exchange rate system for countries who had opted out of the third stage or did not meet the Maastricht criteria. In May 1998, the European Council selected the countries qualified to participate in stage III of EMU. Their decisions were based on reports, by the EMI and European Commission submitted in March 1988, which assessed how each country had complied with the convergence criteria. In June 1998 the ECB replaced the EMI, and in January 1999 it took over responsibility for monetary policy within the eurozone. The Maastricht Treaty, which provides the institutional framework for the introduction of the single currency, was signed in late 1991, which was a time when neoliberal ideas held sway and when political power was generally held by the right. Neoliberal ideas still prevail, though perhaps are in some decline as evidenced by the electoral victories of the left-of-centre parties in many of the EU countries. But the neoliberal agenda has moulded the environment within which the euro will be introduced. The euro (at least for those 11 countries which have signed up) is embedded within an institutional and policy setting which we have elsewhere described as ‘new monetarism’ (Arestis and Sawyer, 1998b).

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The euro

2.11 CONCLUSION Since the establishment of ECSC, the economies of member states have slowly integrated. The economic environment which existed in the 1950s is a far cry from the integrated European Community of today. In the 1950s, European currencies were not convertible and domestic trade was highly protected. IntraEuropean trade was based on bilateral clearing arrangements institutionalised by the European Payments Union. Today, capital controls, intra-EU tariffs and quotas have been eliminated, and the single market has been completed. The ECB determines monetary policy for the eurozone. And the ERM II provides the framework for stability between euro area currencies and the currencies of other EC states remaining outside the eurozone.

NOTES 1. This monetary union experiment lasted from 1865 to 1925, when instability after the First World War led to its demise. Each country’s coins were made legal tender throughout the member territories (Bainbridge and Teasdale, 1995). 2. The European Convention for the Protection of Human Rights and Fundamental Freedoms which establishes the Court of Human Rights came into effect in September 1953 as a recommendation of the assembly in September 1949. 3. There was considerable fear of an uncontrolled revival of the Ruhr heavy industries, which might once again serve aggressive national policies. France offered to relinquish full control over her own industries in return for a measure of European control over German industry. Coal and steel were chosen for political and economic reasons – the two industries were essential to any war effort and to the modern industrialised economy (Palmer and Lambert, 1968, p. 290). 4. The Treaty of Paris was intended to eliminate barriers to trade and encourage competition in the two sectors; however, anomalies still existed which is not surprising given the history of the two sectors – Belgian coal and Italian steel were exempt from some of the conditions imposed through membership of the ECSC. 5. The treaty establishing the North Atlantic Treaty Organisation (NATO) was signed by the foreign ministers of Belgium, Britain, Canada, Denmark, France, Iceland, Italy, Luxembourg, the Netherlands, Norway, Portugal and the USA in April 1949. 6. The Pleven Plan for EDC in 1950 gave rise to the suggestion that the federal army proposed by the plan should be under the control of an elected supranational authority – the EPC was the proposed authority. 7. Britain was in attendance as well as the six members of the ECSC, however, it withdrew after only a few months when it realised that its proposals for a free trade area within the OEEC framework would not be accepted by the others who advocated further economic integration along supranational lines. 8. In rare cases the Council of Ministers can also initiate policy. 9. So far as capital movements were concerned the degree of liberalisation was ‘to the extent necessary to ensure the proper functioning of the common market’ (Tsoukalis, 1997, p. 14). 10. There were few specific provision made for regional policy and industrial policy apart from the European Investment Bank and the European Social Fund; even these were designed to operate in the Mediterranean member countries. 11. There were strains on the Bretton Woods system throughout the 1960s when the sustained growth in dollar liabilities relative to gold stocks created a crisis of confidence over con-

An historical perspective on economic and monetary integration

12.

13. 14. 15. 16.

17. 18.

33

vertibility. By 1968, gold convertibility had for all intents and purposes ceased as the US let it be known that they were unwilling to exchange gold for the dollar reserves held by other countries. This was compounded by inflationary pressure primarily caused by the financing of the Vietnam war which from the mid-1960s onwards put unbearable pressure on the system. Germany was keen on monetary integration because at that time the US was in recession and the dollar was weak. The Americans were applying pressure on the German government to reflate the economy to assist international economic recovery. Although Germany was fearful of the impact of reflation on monetary stability, there was greater concern for the strains that rebuffing America’s demands would have on their political and security alliance. Monetary integration provided Germany with the answer, it allowed the strains of reflation to be spread over the whole community (Pinder, 1996, p. 130). In the political arena, the European Political Cooperation (EPC) was established to coordinate foreign policy. Because of the political sensitivities involved, the EPC remained at an intergovernmental level with a minimal role for the Commission and the European Parliament. Britain was one of the poorer countries in the EEC in terms of GNP per head, yet it was the second largest net contributor. A solution to this problem was reached at the Fontainebleu meeting of the European Council in June 1984. Enlargement of the EC coupled with the Single Market programme would have seriously aggravated the economic and social divide between richer and poorer countries. In 1966 the EC was unable to compromise on proposals put forward by the Commission. France objected to the increase in the powers of community’s institutions that one proposal would entail. Subsequently France left its chair empty at the Council of Ministers. After seven months a compromise was reached about decision-making in the Council of Ministers, essentially this gave countries the right of veto when their national interest was concerned. From 1970 member states used procedures termed European Political Cooperation to discuss and coordinate their position on foreign affairs to act in unison. The CCBG and the EMCF merged in January 1994 to form the EMI at stage II of EMU.

3. The conditions surrounding the launch of the euro 3.1 INTRODUCTION Chapter 2 discussed how we arrived at the establishment of EMU. This and the chapter which follows deal with the policy conditions and the institutional arrangements which surround the introduction of the euro. The euro was adopted in January 1999 with the member currencies locked together from that point, and with the intention that the euro is used as the sole currency in the participating countries from early 2002. Criteria were set down under the Maastricht Treaty to determine which countries should (or would have to) join the single currency. The operation of the euro is to be governed by the Stability and Growth Pact. The terms of the Maastricht Treaty and of the Stability Pact will be discussed below. Over the next two chapters we assess the introduction of the euro, its accompanying institutions and future prospects for the euro and the European economies. Our focus is on macroeconomic policies and the euro, and we divide the discussion into fiscal policies and problems (this chapter) and monetary and financial policies and problems (next chapter). This chapter argues that the effective preclusion of active fiscal policy, either on an EU-wide or individual government basis, and of coordination of fiscal with monetary policy, is likely to perpetuate the already high and divergent levels of unemployment. It is also likely to exacerbate asymmetries of economic performance across the eurozone. Alternative proposals are put forward that will remedy this situation, as part of an alternative ‘full employment, growth and stability pact’ (see also Arestis, McCauley and Sawyer, 2001).

3.2 THE CONDITIONS OF EURO PARTICIPATION The Maastricht Treaty provided convergence criteria which were intended to be met by those seeking to join the euro. These criteria were: 1. average exchange rate not to deviate by more than 2.25 per cent from its central rate for the two years prior to membership; 34

The conditions surrounding the launch of the euro

35

2. inflation rate was not to exceed the average rate of inflation of the three community nations with the lowest inflation rate by 1.5 per cent; 3. long-term interest rates not to exceed the average interest rate of the three countries with the lowest inflation rate by 2 per cent; 4. budget deficit not to exceed 3 per cent of its GDP; 5. overall government debt not to exceed 60 per cent of its GDP. In effect, the Stability and Growth Pact, which is further discussed below, retained and built upon the budget deficit and government debt criteria. Eleven countries out of the 15 member countries of the European Union were deemed to have both met these criteria and wished to join. Greece was deemed not to have met the criteria, and Sweden, the UK and Denmark negotiated the right to abstain from any move to the EMU and the single currency. It is instructive to examine the relevant data at the time countries were deemed to have met the criteria. This may provide some indication to the degree to which there was a political determination to establish the euro even if the economic conditions were not met. It also may have some bearing on the subsequent movement of the euro in that in effect the signal was given to the financial markets that a range of fiscal and monetary conditions would be met which were not in the outturn fully met, thereby undermining to some degree the credibility of the euro and the surrounding institutions. The decision on membership of the euro and whether the convergence criteria were met was based on data available in March 1998, and Table 3.1 reproduces the relevant figures. France and Luxembourg were the only countries which, on a strict interpretation, satisfied all the convergence criteria for membership of the euro. However, nine more countries were deemed as meeting all the convergence criteria, even though they did not meet them on a literal interpretation. It can be seen that seven of them – Belgium, Germany, Spain, Ireland, the Netherlands, Austria and Portugal – failed on the debt/GDP criterion, one on the ERM participation for at least two years (Finland), and one on both of these criteria (Italy). In terms of the countries which are not participating from the birth of the EMU, Greece is the only country that met none of the convergence criteria. Sweden failed both the debt and the ERM participation criteria, and the UK and Denmark both belong to the category of failing only one criterion, that of ERM participation and the debt/GDP ratio respectively. On the independence of national central banks, Belgium, Germany, Ireland, Italy, the Netherlands, Portugal and Finland had legislation which meets the criterion of independence and price stability. Spain, France, Luxembourg and Austria had national legislation ready which when enacted at the date of the establishment of the ECB met this criterion. Greece is another country with relevant national legislation which is compatible with this criterion. Sweden had plans for legislative changes, but the then current legislation was not compatible with this

Table 3.1 Economic indicators and the Maastricht Treaty convergence criteria HICP inflation(a) 2.7 (1997)

Reference value Belgium Denmark Germany Greece 36 Spain France Ireland Italy Luxembourg

1996 1997(d) 1998(e) 1996 1997(d) 1998(e) 1996 1997(d) 1998(e) 1996 1997(d) 1998(e) 1996 1997(d) 1998(e) 1996 1997(d) 1998(e) 1996 1997(d) 1998(e) 1996 1997(d) 1998(e) 1996 1997(d) 1998(e)

1.8 1.4 – 2.1 1.9 – 1.2 1.4 – 7.9 5.2 – 3.6 1.8 – 2.1 ** 1.2 – 2.2 *** 1.2 – 4.0 1.8 – *** 1.2 1.4 –

Long-term interest rate(b) 7.8 (1997) 6.5 5.7 – 7.2 6.2 – 6.2 5.6 – 14.4 9.8 – 8.7 6.3 – 6.3 ** 5.5 – 7.3 *** 6.2 – 9.4 6.7 – *** 6.3 5.6 –

General government surplus (+) or deficit(c) 3.0 (1997) –3.2 # –2.1 # –1.7 # –0.7 # 0.7 # 1.1 –3.4 # –2.7 # –2.5 –7.5 –4.0 # –2.2 –4.6 # –2.6 # –2.2 –4.1 # –3.0 # –2.9 # –0.4 # 0.9 # 1.1 –6.7 # –2.7 # –2.5 # 2.5 # 1.7 # 1.0

General government gross debt(c) 60.0 (1997)

#

# # # #

# # #

126.9 122.2 118.1 70.6 65.1 59.5 60.4 61.3 61.2 111.6 108.7 107.7 70.1 68.8 67.4 55.7 58.0 58.1 72.7 66.3 59.5 124.0 121.6 118.1 6.6 6.7 7.1

Exchange rates ERM participation Yes Yes Yes Yes(f) Yes Yes Yes Yes(g) Yes

Netherlands

37

1996 1997(d) 1998(e) Austria 1996 1997(d) 1998(e) Portugal 1996 1997(d) 1998(e) Finland 1996 1997(d) 1998(e) Sweden 1996 1997(d) 1998(e) United Kingdom 1996 1997(d) 1998(e)

*

** *

1.4 1.8 – 1.8 1.1 – 2.9 1.8 – 1.1 1.3 – 0.8 1.9 – 2.5 1.8 –

*

** *

6.2 5.5 – 6.3 5.6 – 8.6 6.2 – 7.1 5.9 – 8.0 6.5 – 7.9 7.0 –

# –2.3 # –1.4 # –1.6 –4.0 # –2.5 # –2.3 –3.2 # –2.5 # –2.2 –3.3 # –0.9 # 0.3 –3.5 # –0.8 # 0.5 # –4.8 # –1.9 # –0.6

# # # #

# # #

77.2 72.1 70.0 69.5 66.1 64.7 65.0 62.0 60.0 57.6 55.8 53.6 76.7 76.6 74.1 54.7 53.4 52.3

Yes Yes Yes Yes(h) No No

Notes: *, **, *** = first, second and third best performer in terms of price stability. # = general government deficit not exceeding 3% of GDP; general government gross debt not exceeding 60% of GDP. (a) Annual percentage changes; HICP is the harmonised index of consumer prices. (b) in percentages. (c) As a percentage of GDP. (d) Data for HICP inflation and long-term interest rate refer to the twelve-month period ending January 1998; European Commission (spring 1998 forecasts) for general government surplus or deficit and general government gross debt. (e) European Commission projections (spring 1998 forecasts) for general government surplus or deficit and general government gross debt. (f) Since March 1998. (g) Since November 1996. (h) Since October 1996. Source: European Commission (1998) and EMI (1998).

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criterion. Recent UK legislation had moved towards meeting the requirements (but still the independence granted to the UK central bank is operational, allowing the inflation target rate to be decided by the Treasury). Denmark was deemed to need to introduce relevant legislation. The two reports, EC (1998) and EMI (1998), confirm that with a few exceptions which were judged not to jeopardise the overall functioning of the ESCB, the statutes of almost all national central banks are compatible with the Maastricht Treaty. The ERM participation criterion was deemed to have been met by all countries joining the euro. The eleven countries appeared to have enjoyed exchange rate stability with their currencies trading very close to the unchanged central rates during 1996, 1997 and 1998. The Irish currency, though, deviated from its central rate significantly. The Italian and Finnish currencies had participated in the ERM only since November 1996 and October 1996 respectively, and the Greek currency only entered the ERM in March 1998. The Swedish and UK currencies did not participate in the ERM during the reference period. The overall conclusion, then, is that with the exception of the inflation rate and the interest rate, the criteria were not met as comfortably as it might appear from the claims made by the EC (1998) and the EMI (1998).1 With the exception of Greece, all EU member states had inflation rates less than 2 per cent, which is below the reference value of 2.7 per cent. Inflation is measured here using the HICP (Harmonised Index of Consumer Prices). These indices have been produced by Eurostat in conjunction with national statistical institutes. At least in the case of the UK, the rate of inflation based on HICP tends to be significantly below the rate of inflation based on the national RPI (see, for example, Economic Trends, December 1998). Inflation had been falling across the EU since 1990, and within that general fall the variation in inflationary experience narrowed. On the basis of national inflation data, the average rate fell year by year from 6.5 per cent in 1990 to 2.5 per cent in 1996, with the standard deviation falling from 5 per cent to 1.8 per cent over the same period. The interest rate criterion was met by all member countries, with the exception of Greece. The average long-term interest rate in the fourteen countries converged to levels of between 5.5 and 7 per cent, below the reference rate of 7.8 per cent. Note, though, how high the real rate of interest is allowed to be: with the reference rate of 7.8 per cent in nominal terms and with a reference inflation rate of 2.7 per cent, the implied, and acceptable, real rate is over 5 per cent. The government budgetary positions show that, with the exception of Greece, all countries had government deficits of 3 per cent of GDP or less, and three countries achieved a budget surplus. Despite the EC’s (1998) and EMI’s (1998) critical attitude of the one-off measures taken by a number of countries which

The conditions surrounding the launch of the euro

39

contributed to the 1997 figures, the reports conclude that on the whole the deficit reductions can be maintained over time. The government debt criterion was only met by four countries. The EC and the EMI report that substantial decreases in the debt ratio were recorded during the period up to 1997, for those countries with a debt/GDP ratio above the 60 per cent reference value; and since for these countries this ratio had been diminishing and approaching the reference value of 60 per cent, the expectation was for a continuation of a sustained decline in this ratio in the years to come. The debt/GDP ratios in Belgium and Italy were (and continue to be) much higher than in other countries, and it would require many years of government surpluses to reduce the ratio to the reference level of 60 per cent. The EC and the EMI expected the debt ratio in Belgium and Italy to decline as they ran a surplus in the budget. However, a combination of high interest rates and low growth rates will undermine the sustainability of any debt position. The Deficit and Debt Criteria The criteria for a budget deficit of 3 per cent of GDP and a government debt of 60 per cent of GDP are given as ‘reference values’ and their precise status was a matter of considerable debate. Whilst the other criteria have a clear rationale in terms of a single currency (in the sense that, following the introduction of a single currency, there would be a fixed exchange rate and near equality of inflation rates and interest rates) that cannot be said for the budget deficit and government debt criteria. The particular figures chosen are quite arbitrary, but two justifications appear to have been given. The first is reflected in the following: The Commission say that if the Treaty conditions did not exist there would still be strong need for budgetary adjustment, and that the budget criterion is about sustainability: The targets of 3% deficit and a 60% debt/GDP ratio would result in a stable debt/GDP ratio in a steady state economy with 2% inflation and 3% real growth. (TUC Report on European Common Currency: the italicised part is a quote from a paper by Chris Boyd, a member of the cabinet of Jacques Delors then President of the European Commission, presented to the 1993 TUC Congress)

This statement is misleading in two crucial respects. First, a 3 per cent deficit and a 60 per cent debt/GDP ratio are consistent with any combination of inflation and growth which adds up to 5 per cent per annum. Similarly any size of deficit is consistent with a twentyfold larger stable debt/GDP ratio when the nominal rate of growth is 5 per cent per annum. The 3 per cent and 60 per cent figures have effectively been plucked out of the air, and there is no reason why, say, 4 per cent and 80 per cent could not be chosen. Second, there is some

40

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suggestion that the attainment of the 3 per cent and 60 per cent figures would lead to the attainment of a steady-state economy which would not be the case. But there is little reason to think that the future will provide 5 per cent nominal growth divided into 2 per cent inflation and 3 per cent real growth. It is interesting to note that a 2 per cent rate of inflation is assumed here when the convergence criteria only refer to a country’s inflation rate being close to the lowest inflation rates being experienced within the EU. Concern over the government budget deficit should arise from the possibility that it will lead to mounting national debt, and that will be the case (for a constant primary deficit, that is excluding interest payments, relative to GDP) when the (post tax) rate of interest exceeds the rate of growth. This condition masks a basic problem, namely that if it is not met then the 3 per cent overall deficit (including interest payments) can only be maintained by a growing surplus on the government budget excluding interest payments on the national debt.2 The second justification would seem to be (as argued by Buiter, Corsetti and Roubini, 1993) that the choice of the 3 per cent figure for the deficit to GDP ratio arose from a combination of advocacy of the so-called ‘golden rule’ (that current expenditure should be covered by current revenue) and that ‘EC public investment averaged almost exactly 3 per cent of EC GDP during 1974–91’ (p. 63). They argue that ‘such a derivation of the fiscal guidelines is illegitimate unless inflation is literally zero. Otherwise, inflation accounting must be properly done; it is the inflation-adjusted deficit that must not exceed public investment’ (p. 63, italics in original). With a 2 per cent rate of inflation, a 60 per cent debt/GDP ratio declines in real value by the equivalent of 1.2 per cent of GDP per annum, so that public investment equivalent to 3 per cent of GDP would be compatible with an inflation-adjusted deficit of 4.2 per cent. The criteria may also reflect a view that a deficit/GDP ratio of 3 per cent is the maximum that the financial markets would readily finance since the requirement is set for the European Central Bank not to monetise any budget deficit: hence any budget deficit has to be financed by the sale of government bonds. The non-monetisation of the deficit reflects the essentially monetarist approach namely that ‘inflation is always and everywhere a monetary phenomenon’ and that the stock of money can be controlled by a Central Bank with a consequent control of the rate of inflation. Both components of this argument have been shown to be problematic by recent evidence and academic literature of the Keynesian variety.

3.3 SUSTAINABILITY OF CRITERIA There is a critical question at this stage as to whether the outcomes achieved in 1997 and 1998 to meet (at least partially) the Maastricht criteria are sus-

The conditions surrounding the launch of the euro

41

tainable and as robust as the two reports (EC, 1998; EMI, 1998) claim them to be. One aspect of this is the extent to which the convergence criteria are met may depend on the state of the business cycles in the member countries. In particular, it would be expected that it is more difficult to achieve the budget deficit condition during recessions than in boom conditions. Economic growth has generally been above trend since 1993, and the output gap (of actual GDP below potential) has fallen steadily (see Chapter 6). On the basis of output figures there has been some cyclical upswing, which tends to reduce the budget deficits. Buti, Franco and Ongena (1997) found that the budget balance is negatively linked to GDP growth, they estimated that a 1 per cent change in GDP will also cause a 0.5 per cent change in the budget deficit at the EU level. At the country level the effect can be more dramatic, for example the estimates were 0.8 and 0.9 per cent for the Netherlands and Spain respectively. But this upswing has made little impression on the level of unemployment, which has been stuck at around 10 per cent (see Table 3.2). It is particularly worrying that unemployment of around 10 per cent is consistent with output close to what is deemed potential, which suggests that there is not sufficient capacity to underpin full employment. The decisions taken by the EC (1998) and the EMI (1998) have been presented as having been taken against a background of an economic situation in Europe which is sound. It was claimed that the economic fundamentals in Europe were healthy, with low inflation, favourable monetary conditions, high profitability and sustained external demand leading to trade surplus (EC and EMI, op. cit.). However, this overlooks the high levels of unemployment and the wide disparities between regions and countries to which we refer below. Another aspect of the sustainability of current economic performance is that the deficit/GDP ratio has become the most important for the euro decision makers. A number of ‘measures’ were taken with the specific aim of ensuring that the deficit criterion was met. It is widely accepted that a number of ‘creative’ devices were adopted and implemented by a number of countries with respect to the deficit position. This appears to have been particularly the case in the major countries, France, Germany, Italy, Spain and Belgium.3 It is estimated by the EMI (1998) that the impact of these temporary deficit-reducing measures in 1997 accounted for between 0.1 and 1 per cent of GDP in the five countries just mentioned. Whatever ‘success’ in terms of meeting the Maastricht criteria may be reported, this has been achieved at a high cost in terms of unemployment.4 Table 3.3 shows the high levels of unemployment being experienced in Europe. The rate of unemployment exceeds 10 per cent in all the major economies other than the UK, and above 5 per cent in all with the exception of Luxembourg. There has been some convergence of unemployment rates as measured by the

42

The euro

standard deviation since 1993 (cf. Table 3.2), but there had previously been an increase. Table 3.2 Mean and standard deviation of unemployment rate

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Average rate of unemployment

Standard deviation of unemployment rate

9.25 9.26 9.09 8.69 8.16 7.47 7.03 7.59 8.69 10.11 (10.54) 10.34 (10.81) 9.83 (10.26) 9.76 (10.15) 9.19 (9.54) 8.50 (8.79) 7.74 (7.97)

4.47 4.97 5.03 4.88 4.41 4.09 4.12 4.43 4.47 5.10 (4.99) 5.19 (5.05) 4.80 (4.68) 4.61 (4.52) 4.38 (4.33) 4.16 (4.16) 3.72 (3.74)

Weighted average rate of unemployment

9.72 9.96 9.83 9.56 8.94 8.15 7.60 7.90 8.71 10.57 10.92 10.51 10.63 10.40 9.80 9.08

Weighted standard deviation of unemployment 3.71 4.10 4.14 4.05 3.81 3.43 3.31 3.47 3.88 4.19 4.46 4.20 4.03 3.86 3.67 3.17

Note: Figures exclude Austria prior to 1993 as comparable figures not given in source (figures in parenthesis exclude Austria). Source: Economic Outlook, OECD (various issues).

The Maastricht convergence criteria contained no reference to either the level of economic activity (unemployment, output) or the balance of trade position (this is clear from Table 3.1). Countries have entered into the single currency with quite different rates of unemployment and GDP growth, and with differing balance of trade positions (see Tables 3.3, 3.5 and 3.7 below). The rates of unemployment may be, to some degree, a reflection of countries being at different phases of the business cycle (though if that is so, it would raise issues not only of convergence but of the sustainability of the convergence of inflation which has been observed). But a major part of the differences in unemployment appear to reflect more than cyclical patterns. They could be labelled structural but the causes of the differences in unemployment could be much

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43

Table 3.3 Unemployment rates (percent of work force) 1992 1993 1994 1995 1996 1997 1998 1999 Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden UK Average for EU countries Standard deviation

3.8 10.0 8.2 16.8 12.3 8.4 9.6 14.4 11.2 3.2 7.1 7.0 24.1 9.4 9.6

3.9 9.9 7.2 15.2 11.7 8.2 10.0 12.3 11.6 2.9 6.9 7.3 22.9 8.8 8.7

4.3 9.7 6.8 14.5 12.4 8.9 9.8 11.7 11.7 3.0 6.3 7.3 22.2 9.6 8.2

4.4 9.4 5.6 12.6 12.3 9.9 9.7 9.9 11.7 2.7 5.2 6.8 20.8 9.9 7.0

4.5 9.5 5.2 11.4 11.8 9.4 10.9 7.6 11.9 2.7 4.0 5.2 18.8 8.3 6.3

4.5 9.0 5.2 10.2 11.3 8.7 10.7 5.8 11.4 2.3 3.3 4.5 15.9 7.2 6.1

8.69 10.11 10.34 4.43 5.10 5.19

9.83 4.80

9.76 4.61

9.19 4.38

8.50 4.16

7.74 3.72

7.2 9.2 11.6 10.4 4.5 8.7 15.4 8.8 2.1 5.6 4.2 18.4 5.6 10.0

4.0 8.8 10.1 16.4 11.7 7.9 9.7 15.6 10.2 2.6 6.6 5.7 22.7 9.1 10.5

Source: Calculated from OECD Economic Outlook (various issues).

broader than is usually implied by the term structural. They could, for example, be arising from sustained differences in the level of aggregate demand or from the economy’s trade performance (see Chapter 6 for further detail and the most recent evidence on convergence). Stability and Growth Pact The Stability and Growth Pact accompanied the introduction of a single currency in the European Union as part of the third stage of economic and monetary union. It will govern the economic policies of the member countries which have joined the single currency and strongly constrain the policies of those who do not join. In its earliest form the Stability Pact was advanced by Theo Waigel, the former German finance minister, in November 1995. Agreement on the main components of the now renamed Stability and Growth Pact was reached at the European Council Summit in Dublin in December 1996, and it was formally adopted at the Amsterdam Summit in July 1997. Before the final settlement on

44

The euro

the Pact was reached, there had been several rounds of negotiations. It was suggested by the French government that a better balance would have to be struck between budgetary discipline and employment policy. Two suggestions were made: the first called for greater emphasis to be placed on Articles 102a and 103 of the Maastricht Treaty and was aimed at reforming economic coordination; and the second called for greater political control over economic policy which would have to include monetary policy. The second proposal was a nonstarter for the German and the Dutch governments. The aim of the first proposal was reflected in the Resolution on Growth and Employment, which was adopted by the European Council along with the Stability and Growth Pact. However, unlike the Stability Pact, this resolution was not accompanied by any secondary legislation nor, it would seem, the political will from member states to implement it. The Resolution simply states an aspiration, that employment policy should be coordinated at the EU level; however, employment policy implementation still remains firmly in the hands of national authorities. It appears unlikely that there will exist a sufficient legal framework for EU level employment policy (Snyder, 1998, p. 64). The Stability and Growth Pact, alongside the Maastricht Treaty, creates four rules for economic policy. The four rules are that the ECB was granted independence from political influence; the rule of no-bailout of national government deficits was introduced; the monetary financing of government deficits was prohibited; and member states must avoid ‘excessive’ deficits (defined as more than 3 per cent of GDP). The Stability and Growth Pact consists of three components: a single European Council Resolution and two Council Regulations. The Resolution commits all parties, member states, the Commission and the Council ‘to implement the Treaty and the Stability and Growth Pact in a strict and timely manner’. The Council Regulations themselves, unlike the Resolution, have legal force and can be seen as composed of two complementary elements. First, the ‘preventative’ element: this resolution refers to the strengthening of budgetary positions and the surveillance and coordination of economic policies. It commits those member states which join the single currency to submit to the Commission a stability programme. These stability programmes will have to be updated annually and must detail the member states’ medium-term budget objectives, the main assumptions about economic developments, and the projected paths for both the deficit ratio and the debt ratio. Non-euro members should submit a ‘convergence plan’ which should be similar in outline to the stability programme. These programmes are intended to act as an early warning system and will signal when a member state is close to breaching the reference values detailed in Protocol 5 of the Treaty. The second Council regulation is the ‘deterrent’ element. This is aimed at speeding up and clarifying the imple-

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45

mentation of the excessive deficit procedure and it seeks to reduce the scope for discretion, which is allowed under the Maastricht Treaty. The Stability and Growth Pact appears to be based on what we have elsewhere termed new monetarism (Arestis and Sawyer, 1998b). The essential features of new monetarism are: (i)

Politicians in particular, and the democratic process in general, cannot be trusted with economic policy formulation with a tendency to make decisions which have stimulating short-term effects (reducing unemployment) but which are detrimental in the longer term (notably a rise in inflation). In contrast, experts in the form of central bankers are not subject to political pressures to court short-term popularity, and can take a longerterm perspective where it is assumed that there is a conflict between the short term and the long term. The logic underpinning this reasoning mirrors that found in the rules versus discretion debate. Policymakers’ scope for using discretion should be curtailed and the possibility of negative spillovers from irresponsible fiscal policy must be reduced within the eurozone, hence, fiscal policy will be permanently constrained by the Stability Pact and monetary policy has been removed from national authorities and from political authorities and placed with the ECB. (ii) Inflation is a monetary phenomenon and can be controlled through the monetary policy. The money supply is difficult (or impossible) to control directly, but the central bank can set the key interest rate (the ‘repo’ rate) to influence the monetary conditions, which in turn influence the future rate of inflation. (iii) The level of unemployment fluctuates around a supply-side determined equilibrium rate of unemployment, generally labelled the NAIRU (nonaccelerating inflation rate of unemployment). The level of the NAIRU may be favourably affected by a ‘flexible’ labour market, but is unaffected by the level of aggregate demand or by productive capacity. (iv) Fiscal policy is impotent in terms of its impact on real variables and as such it should be subordinate to monetary policy in controlling inflation. It is recognised, though, that the government budget position will fluctuate during the course of the business cycle, but in the context of an essentially passive fiscal policy. The main feature of the Stability and Growth Pact is a requirement that the national budget deficit does not exceed 3 per cent of GDP, and failure to meet that requirement could lead to a series of fines depending on the degree to which the deficit exceeds 3 per cent (as further discussed below). Non-euro members are also required to exercise similar fiscal control through convergence programmes, though they are not subject to excessive deficit penalties.

46

The euro

A government which aims to avoid an ‘excessive’ budget deficit of more than 3 per cent of GDP would have to ensure that the 3 per cent limit is not breached during economic slowdown; and hence that the average deficit during the course of the business cycle would have to be much lower than 3 per cent. A country’s budgetary data become available for the Commission to scrutinise on 1 March each year when the stability programmes are submitted. Each programme will contain information about the paths of the ratios of budget deficit to GDP and national debt to GDP. The Council (ECOFIN) will examine the stability reports and shall deliver an opinion on a recommendation by the Commission (within two months of the report’s submission). If the stability programme reveals that a country is significantly diverging from its mediumterm budgetary objective, then the council will recommend that the stability programme is strengthened. If the situation persists then the member state will have been judged to have breached the reference values. The Pact details ‘escape’ clauses which allows a member state that has an excessive deficit to avoid sanction. If there is an economic downturn and output has fallen by more than 2 per cent, then the member state will escape sanction automatically, but the deficit should be corrected once the recession has finished. If output falls between 0.75 and 2 per cent then the Council can use discretion when making a decision on an ‘excessive’ deficit: other factors will be taken into account such as the abruptness of the downturn, the accumulated loss of output relative to past trends and whether the government deficit exceeds government investment expenditure. When the Council has sifted through all relevant information pertaining to the country whose financial position is under review, it must decide as to whether an excessive deficit exists or not. In making the decision, the Council operates with a qualified majority, and under the Maastricht Treaty, all EU member states have a vote, including those countries that are not in the euro area and even the country which is under consideration. If a country is found to have breached the reference values, then it has four months to introduce the corrective measures suggested by the Council. If the country follows the Council’s recommendations, then the ‘excessive’ deficit can continue, but the budget deficit must be corrected within a year following its identification. A country which chooses not to introduce corrective measures will be subject to a range of sanctions (Article 104c(11)), at least one or more must be imposed, of which one must be in the form of a non-interest-bearing deposit lodged by the national government. In this instance, it will fall upon EMU members, excluding the member country under consideration, to reach a decision on sanctions. The non-interest-bearing deposit consists of a fixed component (0.2 per cent of GDP), and a variable component (one tenth of the difference between the deficit ratio and the 3 per cent reference value). If the budget deficit is not corrected within two years, the deposit is forfeited and becomes a fine, whereas if the

The conditions surrounding the launch of the euro

47

deficit is corrected within two years the deposit is returned and the penalty becomes the foregone interest. The penalty clause would add to the deficit it is meant to cure, and as such it could generate national opposition. Von Hagen and Eichengreen (1996) and Eichengreen and Wyplosz (1998) argue that the Stability and Growth Pact tends to suppress the symptoms without treating the source of the problem. The constraints imposed by the Pact will severely reduce national fiscal independence and effectively preclude the use of national fiscal policy for demand management purposes. This is especially the case at present where countries have entered EMU at the upper limit of the Stability and Growth Pact; OECD (1998) estimates suggest that eight of the eleven countries have budget deficit targets in the range of 1–2 per cent of GDP over the next few years, which is not sufficient to allow automatic stabilisers to work under the Stability Pact. Bayoumi and Eichengreen (1995) suggest that this restriction on the workings of automatic stabilisers could lead to weaker fiscal stabilisation and greater output volatility. Further, von Hagen and Eichengreen (1996) argue that if automatic stabilisers cannot function fully, then pressures will build for fiscal federalism to provide them. This system of financial penalties for breaches of the budget deficit criterion, implies that deflationary fiscal policies will continue, and indeed intensify as those countries which just met the 3 per cent requirement in conditions of cyclical upswing will have to tighten the fiscal stance to meet the 3 per cent requirement in times of cyclical downswing especially. It was indicated above that a clause was inserted into the Stability Pact, which allows a country to have a larger deficit in the face of recession. However, even this formal recognition that automatic stabilisers and active fiscal policy could be hampered may not be sufficient to prevent the Stability and Growth Pact operating to exacerbate recessions. A downturn in economic activity which was widespread across the EU would create a great deal of distress as each country deflated to preserve its budget position, which would not only add to the domestic deflation but also impose further deflation on fellow EU member countries. Buti et al. (1997) applied the Stability Pact requirement to previous recession episodes in the EU between 1961 and 1996. Table 3.4 summarises some of their findings, column 2 shows that governments which entered a severe recession (a fall in GDP of greater than 0.75 per cent) with a balanced budget were more likely to avoid breaching the excessive deficit procedure in the year following the recession than those countries with a pre-recession position deficit of 2 per cent of GDP. This evidence would suggest that the early stages of EMU are likely to be fraught with difficulty for member states who have entered Stage Three with deficits ranging from 2 to 3 per cent of GDP, especially in light of the OECD’s estimates to which we referred above. Column 4 also offers evidence that countries with

48

The euro

Table 3.4 Retrospective application of the excessive deficit procedure: number of cases where the 3 per cent reference value would have been exceeded 1961–1996

Total number of recessionary episodes D = 0 per cent Number of recessionary episodes exceeding the D =3 per cent Number of recessionary episodes exceeding the D =3 per cent in the year following the recession D = 2 per cent Number of recessionary episodes exceeding the D =3 per cent Number of recessionary episodes exceeding the D =3 per cent in the year following the recession

Severe Mild Economic recession+ recession++ slowdown+++ 24

9

17

11

1

0

5

1

0

18

5

6

16

1

5

Notes: + at least 0.75 per cent fall in GDP ++ 0–0.75 per cent fall in GDP +++ GDP growth positive but at least a 2.5 per cent worsening in the output gap D is an arbitrary pre-recession position upon which actual deficit changes are simulated. The balanced budget position (that is, D = 0 per cent deficit) was selected because it is consistent with the ‘close to balance’ requirement and the D = 2 per cent position was chosen because it is the likely budgetary position of several member states of the eurozone. Source:

Tables 8, 9, 10, 11, 12 and 13 of Buti et al. (1997).

a pre-recession position deficit of 2 per cent will breech the excessive deficit procedure following an economic downturn. Unlike the case of a severe recession, this situation does not provide exemption from the excessive deficit procedures and sanctions will be invoked automatically. More worrying is the finding that even countries with low pre-recession budget deficits (or even surpluses) are at risk of breaching the reference level in the event of a long recession (Buti et al., 1997, p. 29). In addition, the Pact imposes a heavy burden on those countries with high elasticity of deficit to GDP as the budget deficits rise sharply in the face of declining GDP.

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49

Fiscal Arrangements Accompanying the Euro The institutional arrangements accompanying the euro involve the creation of an ‘independent’ (of political control) European System of Central Banks (ESCB) with its operating arm, the European Central Bank (ECB) and the national central banks, which is given the sole policy objective of price stability, defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 per cent over the medium term.5 The dominant feature of the ECB’s institutional structure is the complete separation between the monetary authorities (in the form of the Central Bank) and the fiscal authorities (in the shape of the national governments comprising the EMU), where the latter are constrained to keep their budget deficit below 3 per cent according to the Stability and Growth Pact. It follows that there can be little coordination of monetary and fiscal policy. Apart from the separation of the monetary and fiscal authorities, there is also the requirement that national governments (and hence the fiscal authorities) should not exert any influence on the ECB (and hence the monetary authorities). Any strict interpretation of that edict would rule out any attempt at coordination of monetary and fiscal policies. Indeed the primacy of monetary policy over fiscal policy is guaranteed because of the institutional structure and rules of the ESCB. The budget of the EU itself is relatively small. It represents around 1.5 per cent of EU GDP, and there is a requirement that it is in balance, with revenue from member governments determined so as to cover planned expenditure. The EU is, thus, constrained to run a balanced budget on an annual basis. Articles 199 and 201 of the amended Treaty of Rome (EU, 1998) require that ‘the revenue and expenditure shown in the [Community] budget shall be in balance’ and that ‘the budget shall be financed wholly from own resources’. Consequently, the scale and balanced budget nature of EU expenditure clearly means that there is no role for fiscal policy at the EU level (even of a passive form whereby budget deficits vary with the business cycle). In order to meet the upper limit of 3 per cent of GDP on national budget deficits during a recession, it is likely that member governments would need to run significant surpluses during economic upswings, and over the course of the business cycle the average budget deficit will be small or perhaps zero. The 3 per cent of GDP rule for budget deficits may well mean that over the business cycle the budget position is balanced or in surplus. This means that ‘National governments will need to aim at a balanced budget or surplus, or the deficit limit of 3 per cent could well prevent the proper working of fiscal stabilisers over the economic cycle’. It also means that ‘governments could be required to raise taxes, or cut government spending, as the economy moves into recession, thereby exacerbating the downturn’ (Currie, 1997, p. 13). In the past decade, the budget position in the UK has swung from a surplus of 1 per cent

50

The euro

of GDP to a deficit of nearly 8 per cent. If a comparable swing in the budget position occurred in the future, with the largest deficit constrained to 3 per cent, then the surplus would be 6 per cent, with an overall surplus averaging around 1 per cent of GDP. A more cautious government which aimed for, say, a maximum deficit of 2 per cent to provide a margin of error would clearly run a somewhat larger surplus. The EMU approach to policy obviously means that there is no policy instrument at the EU level addressed towards the levels of employment and unemployment, and in effect (un)employment disappears as a policy objective. The loss of the exchange rate instrument means that shocks (positive or negative) which hit one (or a small number of) EU countries cannot be offset by movements in the exchange rate. In particular, negative shocks to an economy which raise unemployment cannot be offset by a currency depreciation, though it can be noted that in the volatile floating exchange rate system there may be perverse responses by the exchange markets to a negative shock. The overall effect is likely to raise unemployment: there is a clear upper limit to the degree to which countries that experience a positive shock can benefit through lower unemployment, while countries with a negative shock may suffer a considerable increase in unemployment. In a similar vein, limited labour mobility means that there will not be a great deal of movement of labour from areas of high unemployment to those with low unemployment. The problem of unemployment will be particularly serious in those cases where governments have chosen the wrong exchange rate at entry. An overvalued entry exchange rate will mean an extended period of recession to accommodate its effects which emanate from the absence of the adjustable exchange rate safety valve. This is accentuated by the virtual absence of fiscal transfers, whether automatic or discretionary, from the relatively rich regions to the relatively poor ones. There is clearly not a tax and social security system operating at the federal level which in other federal systems serves to make transfers between rich and poor in an automatic manner, and to provide an element of fiscal stabilisation. The expenditures on regional aid and to a lesser degree agricultural policies do make some transfers from rich to poor, but on a very limited scale. In short, the European Federal budget is not on a sufficient scale nor of the right design to provide significant interregional insurance not present in the EMU (Fatas, 1998a). Eichengreen (1997) offered the suggestion that the European Investment Bank (EIB) can borrow off-budget to perform these functions, however, this would exceed the EIB’s remit. Article 198e of the Maastricht Treaty states that ‘the task of the EIB shall be to contribute, by having recourse to the capital market and utilising its own resources, to the balanced and steady development of the common market in the interest of the community’. Whether the functions of the EIB can be enlarged to include stabilisation policy (distribution over time) is extremely questionable. It can entail redistribution across countries, and it is

The conditions surrounding the launch of the euro

51

specifically this function which should be expanded and strengthened from its present form where assistance is only in the form of loans and guarantees. The economic analysis which lies behind these type of policies appears to be one in which macroeconomic demand conditions, including monetary and fiscal policies, cannot affect the (equilibrium) level of unemployment of labour and more general of the level of economic activity. The level of unemployment and of economic activity is viewed as solely a supply-side phenomenon. Optimum Currency Area Considerations It is useful to draw on the ‘optimum currency area’ literature for guidance on the future prospects of the EMU.6 This literature suggests three conditions should be met for an ‘optimum currency area’ (Mundell, 1961): (a) factor mobility and openness of markets; (b) relative price flexibility; and (c) fiscal transfers. It would be desirable for a single currency to be used in an economic area within which there is openness of goods markets and mobility of factors of production (labour, capital) and where members shared similar inflationary tendencies. Mobility of labour within the EU remains low (especially by comparison with the US) and that is unlikely to change radically. Openness of goods markets may very well prevail in the EMU area, but integrated stabilisation and political unification are distant possibilities. Furthermore, relative price flexibility is absent and the differences in labour market institutions, notably over wage determination, mean that there are differing inflationary tendencies and different responses to shocks. Fiscal transfers at the EU federal level are rather small as mentioned above. The optimum currency area literature suggests that there should not be substantial differences in underlying economic conditions in a common currency area. And yet, in terms of the structural rates of unemployment and the cyclical levels of economic activity within the EU, the differences are significant. The disparities in the underlying rates of unemployment are striking. As Table 3.3 shows, leaving aside the case of Luxembourg (on the grounds of the smallness of this economy), the average unemployment rate over the period 1992–99 varied from 4.2 per cent in the case of Austria to 20.7 per cent in the case of Spain. The standard deviation of the (country) average rate of unemployment is 4.5 per cent. In 1999 Austria, Belgium, Denmark, Germany, Ireland, Luxembourg, Netherlands, Portugal, Sweden and the UK, had rates of unemployment below 10 per cent, while of the remaining five, four (France, Finland, Greece and Italy) had rates above 10 per cent, and one (Spain) had a rate over 15 per cent. The cyclical behaviour of economic activity shows a similar story. The continent’s bigger economies remain sluggish, while the smaller ones are enjoying more buoyant conditions. In Tables 3.5a and 3.5b the average GDP growth rate of the big economies (France, Germany, Italy, Spain and the UK)

52

The euro

is shown to be consistently lower than that of the smaller countries (Austria, Belgium, Denmark, Finland, Greece, Ireland, Luxembourg, Netherlands, Portugal and Sweden). The divergence of growth rates (on an annual basis) has fluctuated over time, and in particular the standard deviation of growth rates was rather high in the late 1980s and early 1990s and has declined somewhat during the 1990s. However, the figures for the mid-1990s are very similar to those of the early and mid-1980s, and there is little evidence from those figures of any general convergence of growth rates (see, also, Artis and Zhang, 1999).7 Table 3.5a GDP growth rates (annual percentage rates)

Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden UK EU

1992

1993

1994

1995

1996

1997

1998

1999

1.3 1.6 0.6 –3.3 1.3 2.2 0.7 3.3 0.8 4.5 2.0 2.5 0.7 –1.6 0.1 1.1

0.5 –1.5 0.0 –1.1 –0.9 –1.1 –1.6 2.6 –0.9 8.7 0.8 –1.1 –1.2 –2.4 2.3 –0.4

2.4 3.0 5.5 4.0 1.8 2.3 2.0 5.8 2.2 4.2 3.2 2.2 2.3 4.1 4.4 2.7

1.7 2.5 2.8 3.8 1.9 1.7 2.1 9.5 2.9 3.8 2.3 2.9 2.7 3.7 2.8 2.4

2.0 1.0 2.5 4.0 1.1 0.8 2.4 7.7 1.1 2.9 3.0 3.2 2.3 1.1 2.6 1.6

1.2 3.5 3.1 6.3 1.9 1.5 3.4 10.7 1.8 7.3 3.8 3.7 3.8 2.0 3.5 2.5

2.9 2.7 2.5 5.0 3.2 2.2 3.7 8.9 1.5 5.0 3.7 3.9 4.0 3.0 2.2 2.7

2.2 2.5 1.6 3.5 2.9 1.5 3.2 8.7 1.4 4.9 3.6 3.0 3.7 3.8 2.1 2.3

Source: OECD, Economic Outlook, June 2000.

Table 3.5b EU average GDP growth rates

Big EU economies Small EU economies Difference

1992

1993

1994

1995

1996

1997

1998

1999

1.02

–0.40

2.60

2.40

1.58

2.50

2.62

2.32

1.16 0.14

0.49 0.89

3.64 1.04

3.51 1.11

2.98 1.40

4.50 2.00

4.13 1.45

3.70 1.38

Source: Calculations based on Table 3.5a and on an unweighted-averages basis.

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53

Additional evidence can be adduced by examining the relative GDP variance ratio (Vw), which is the weighted average of GDP growth autocorrelations, and measures the volatility of the permanent and temporary components of GDP (Cochrane, 1988). In each country, the GDP relative to the aggregate of the other fourteen countries is utilised, where Vw is calculated as follows: w–1

Vw = [1/w][var(yt – yt–w)]/[var(yt – yt–1)] = 1 + 2 ∑ [(w – j)/w]ρj j=1

where y is the logarithm of GDP of the country concerned relative to the EU GDP, ρj is the jth autocorrelation of the growth rate of output and w is the ‘window’ for which the ratio is calculated. This formula is based on the premise that any series can be thought of as a combination of a random walk, which carries the permanent part of a shock, and of a stationary series, which carries the temporary part of a shock. The numerator in the above formula is the variance of the shocks to the random walk component (the permanent component of GDP growth rates), and the denominator is the variance of first differences (the temporary component of GDP growth rates). The variance of the permanent component of GDP growth rates can then be compared with the variance of the annual GDP growth rates. This is, therefore, a measure of whether an economic system dampens cyclical disturbances, and thus returns to its trend following a shock, or whether shocks are amplified leading to permanent effects on GDP. When the variable in question is trend stationary, cyclical disturbances disappear through time, in which case the variance of the shocks to the random walk component is zero. If the relevant variable is a purely random walk, then shocks have permanent effects – the two variances in the Vw expression are equal. In Table 3.6, reproduced from Fatas (1998, p. 190), the variance ratio is calculated for the fifteen EU countries for three ‘windows’ (5, 10 and 15 years), over the period 1960–96 (using annual data). It is clear that relative GDP is far from being a stationary variable, implying that fluctuations in GDP growth are lasting and that permanent shocks are large and frequent. Indeed, in the case of France, Spain and Greece the high Vw ratio indicates that the relative GDP growth rates are unstable. Since then, cyclical movements are persistent and have permanent effects on the level of GDP; a fiscal mechanism is required to deal with the shock and the interregional transfers caused by it. The generation of fiscal transfers by the authority would be redistributional and help create conditions of real convergence. An important problematic aspect of the policy framework is the symmetry or otherwise of shocks. Given the one instrument only nature of monetary policy within the eurozone, the extent of asymmetrical shocks becomes paramount. If shocks are indeed asymmetrical the one-policy framework cannot tackle effectively even the one-target objective of price stability. From the perspective of

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the business cycle, it could be argued that Ireland with output above trend to the extent of over 2.5 per cent of GDP and Italy with output below trend to the extent of 2.5 per cent of GDP require quite different macroeconomic policies.8 Table 3.6 Variance ratios: relative GDP growth rates Country Germany France Italy Netherlands Belgium Luxembourg UK Ireland Denmark Spain Greece Portugal Sweden Finland Austria

V5

V10

V15

1.072 1.698 0.829 1.014 1.028 1.314 1.460 1.514 0.887 2.291 1.705 0.898 0.930 1.288 0.940

0.884 2.501 0.986 1.031 0.816 1.563 1.530 1.594 0.318 2.694 2.703 0.890 0.613 0.907 0.698

0.778 2.921 1.005 0.689 0.841 1.648 1.853 1.398 0.282 2.980 3.165 0.920 0.440 0.619 0.425

Source: Begg et al. (1998).

The optimists would tend to believe that the introduction of the euro and the continuing effects of the single market would lead to further integration between the national economies. This integration could then be reflected in some convergence between national business cycles and a reduction in the extent of asymmetric shocks (that is shocks which impact on some economies but not on others). If there were full integration between the national economies then a unified economic policy would be appropriate, though we would argue that a single policy instrument such as interest rates is not sufficient to achieve multiple objectives. (The actual impact of the euro on integration in the sense in which we have indicated, since its introduction in January 1999, is scrutinised in Chapter 6.) As indicated above, the results generated by Fatas (1998b) for the period 1960–96 imply that relative GDP is both far from being stationary, and in the case of some countries unstable. Asymmetric shocks are thus bound to be far more important in the case of the eurozone. However, some literature appears to disagree with this proposition. This we discuss next.

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Funke, Hall and Ruhwedel (1999) report a decline in the importance of country-specific shocks over the past 20 years, although they were only looking at manufacturing industries. However, they conclude that ‘not all countries are equally far along this path [of convergence] and so the implication is that, if European governments are prepared to trade the costs of surrendering the exchange rate as a policy instrument for the benefits of a common currency, monetary union should only include a small core group of countries that have reached the symmetric league (Germany and the Netherlands and possibly France and Austria; certainly not Greece or Portugal, and the UK is probably not fully ready yet)’ (pp. 63–4 ). The figures on the current account position (see Table 3.7) indicate that the EU as a whole has generally been running a substantial surplus with the rest of the world in the past few years (though the UK is a clear exception to that). But within the overall EU surplus with the rest of the world, there are substantial variations in the degree of current account surplus across countries. The current account position will, of course, be influenced by the business cycle, which prevents any definitive answer to the question of whether the exchange rates are correctly set. But there is some suggestion in the figures of Table 3.7 that the European Union currencies have generally been undervalued Table 3.7 Current account balances as a percentage of GDP

Austria Belgium Denmark Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Sweden UK EU countries Euro zone countries US

1992

1993

1994 1995 1996 1997 1998 1999

–0.4 2.5 2.6 –4.5 0.4 –0.7 –4.4 1.0 –2.5 2.2 –0.2 –3.6 –3.0 –1.7 –1.0 –0.9 –0.8

–0.5 4.1 3.3 –1.3 0.8 –0.5 –3.1 3.7 0.9 4.2 0.4 –1.2 –1.3 –1.7 0.1 0.4 –1.3

–1.5 4.2 1.8 1.1 0.5 –1.1 –2.4 2.7 1.3 5.1 –2.5 –1.3 1.2 –0.2 0.2 0.3 –1.7

Source: OECD Economic Outlook, June 2000.

–2.3 4.1 1.0 4.0 0.5 –0.8 –4.7 2.6 2.3 5.8 –0.1 0.0 3.0 –0.5 0.5 0.7 –1.5

–2.1 4.2 1.8 3.9 1.3 –0.3 –5.7 2.8 3.3 5.3 –4.2 0.0 2.8 –0.1 1.0 1.2 –1.7

–2.5 4.8 0.6 5.5 2.7 –0.1 –6.2 2.5 2.9 7.3 –5.4 0.4 3.1 0.8 1.5 1.7 –1.7

–2.3 4.1 –1.1 5.6 2.8 –0.2 –3.0 2.0 1.9 6.5 –6.8 –0.2 2.9 –0.1 1.1 1.4 –2.5

–2.8 4.0 1.1 5.2 2.6 –0.9 –3.1 0.3 1.0 5.8 –8.9 –2.1 2.5 –1.4 0.3 0.6 –3.7

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relative to non-European Union ones (at the prevailing levels of economic activity), but that the structure of exchange rates between European Union countries has not been compatible with the current account balance of one member country with the others in the sense that some countries within the EU are running large trade surpluses (for example, the Netherlands) and others significant deficits (for example, Portugal). Despite the current account surplus, the euro has been falling (against the dollar and other currencies) since January 1999. But whatever the external value of the euro vis-à-vis the dollar, there would still be large differences in the current account position of countries, and correspondingly flows of capital into or out of countries.

3.4 ALTERNATIVE PROPOSALS We would argue for a new Stability and Growth Pact in a way that involves the objectives of both ‘stability’ and ‘growth’, not merely ‘stability’. This proposal emanates from the obvious recognition that within a single country there are substantial, often virtually automatic, transfers of income from the more prosperous to the less prosperous regions. The automatic elements come from the tax and social security system and other elements come through regional policy and allocation of funds to local government. Countries with federal structures have a significant amount (say around half) of government expenditure at the national level with the national government having an ability to run deficits and operate fiscal policy, as well as to redistribute income between states. This is completely absent from the EU. Transfers from the operation of automatic stabilisers do not occur at the EU level and the discretionary transfers are relatively small. Hence the check on the decline of weak regions which emanates from these transfers is largely absent. The problems this entails will be particularly acute for those regions (countries) of the EMU and any entering the single currency with a trade deficit and high levels of unemployment (witness the high unemployment rates in some EMU countries as discussed above). Given the lower degree of labour mobility in Europe across national borders than within them, the complete loss of the exchange rate adjustment possibility requires an adequate policy of regional transfers through an EMU fiscal policy to accompany the proposed common EMU monetary policy. The absence of such coordination, indeed the non-existence of fiscal policy at the EMU level, implies that the interest rate variations necessary to achieve price stability become even more uncertain. This raises concerns about the volatility of the euro in relation to the dollar and the yen which is expected to be unusually high (Goodhart, 1998).

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Fiscal Policy Two specific considerations inform our approach to fiscal policy. The first is the idea that there is no strong reason to believe that the private sector will generate sufficient demand to underpin full employment, and consequently full employment may well require a budget deficit which in effect mops up excess private savings. This is not to say that budget deficits are inevitable or in some way desirable in themselves, but rather may be a necessary element in the achievement of full employment. The second is the potency or otherwise of fiscal policy in stimulating aggregate demand. Here it is argued that within the European Union, fiscal policy would be expected to be a more, rather than a less, effective policy as compared with fiscal policy at the national level. The European Union will constitute a relatively closed economy, and as such there would only be small leakages of any demand stimulus. It is ironic to note that fiscal policy is being downgraded at a time when it may become more potent. In our discussion of fiscal policy, it should be clearly understood that we are not advocating any form of ‘fine tuning’ involving frequent (more than annual) changes in tax and expenditure policies. Instead we would be advocating ‘coarse tuning’ under which budget deficits are used to support aggregate demand as necessary, given the levels of private demand. At both national and European Union level, the use of fiscal policy is heavily constrained by the Stability and Growth Pact. It has been indicated above that the limit in the Stability and Growth Pact on budget deficits of no more than 3 per cent of GDP translates into a requirement for a budget that is in surplus or very small deficit averaged over the business cycle. A balanced budget implies (as a matter of an accounting identity) that the net sum of private savings minus investment plus trade deficit (borrowing overseas) is zero. There is little evidence that high levels of employment would necessarily generate an equality between savings and investment, and specifically it is expected that there would be an excess of savings over investment which needs to be mopped up by foreign lending or budget deficit. The limits on budget deficits would prevent this occurring, and hence full employment would require a balance of trade surplus and the consequent foreign lending. At present, the European Union runs a significant trade surplus with the rest of the world, but the counterpart is, of course, that other countries run a trade deficit and are borrowing from the European Union. It is doubtful whether such a pattern of surpluses and deficits is sustainable in the long term with the consequent build up of interest flows to service the borrowing. We noted above that the 3 per cent of GDP limit on budget deficits in the Stability and Growth Pact is arbitrary, and that this figure appears to have been plucked out of the air. In view of this argument and also of the ability to absorb shocks as well as to underpin high levels of aggregate demand, would suggest

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that the figure of 3 per cent is highly inappropriate. In the absence of an EU level fiscal policy, national governments should be allowed to pursue budget deficits as they think appropriate. Ideally, this should be seen as a temporary arrangement during a period in which a proper EU fiscal policy is generated. In the interim, national governments may well be constrained by the financial markets on how far they can borrow, and different governments may face different credit ratings in the financial markets (as different states within the United States of America do at present). There are no doubt ‘externalities’ of one country’s fiscal policy on another in the context of the European Union, which can operate through the spillover effects of demand from fiscal policy and perhaps through the effects on interest rates. There is a paradox here in that interest rate is used as an instrument of monetary policy with the ‘repo’ rate set by the ECB, and concern over the size of budget deficits through their impact on interest rates. There is then much to be said for coordinated fiscal policies, but in the context where that coordination is over the stances of active fiscal policies and where the policies themselves are aimed towards the achievement of high levels of economic activity. In view of the arguments of the European Commission (what is known as the McDougall Report, 1997), such coordination of fiscal and monetary policies become paramount. The euro will be greatly enabled to work under such circumstances. Rules which specify a fixed limit on government borrowing fail to recognise that it serves as a mechanism for distributing over time the cost of adjustment to shocks and for smoothing the tax burden associated with public investment. We would argue that constraints on government borrowing reduce the flexibility of national governments’ fiscal policy and make fiscal coordination extremely difficult. Moreover, we would suggest that the motivation behind the adoption of fiscal constraints by the Maastricht Treaty and their strengthening through the Stability and Growth Pact are questionable. Borrowing restrictions are not present in existing monetary unions (Eichengreen, 1997). In fact, it could be reasoned that borrowing constraints would be justified only if the sub-central government had little or no tax raising powers and was dependent on central government for most of its income because this increases the risk of a bailout. In instances where a significant proportion of sub-central government expenditure was generated from its own tax base, then the central government could force the sub-central government to take remedial action by either a decrease in expenditure or an increase in taxation, or indeed both, and government borrowing restraints should not be employed. The latter case applies to European monetary union, national governments still retain tax powers with a large tax base and as such it can use this as a means to finance borrowing. The separation of the monetary authorities from the fiscal authorities and the decentralisation of the fiscal authorities will inevitably make any coordination of fiscal and monetary policy difficult. Since the ECB is instructed to focus on

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inflation while the fiscal authorities will have a broader range of concerns, there will be considerable grounds for conflict. This suggests a need for the evolution of a body that is charged with the coordination of these monetary and fiscal policies. In the absence of such a body, tensions will emerge in the real sector when monetary policy and fiscal policy pull in different directions (Begg and Green, 1998, p. 131). The Stability and Growth Pact in effect resolves these issues by establishing the dominance of the monetary authorities (ECB) over the fiscal authorities (national governments). From this discussion, our proposals concerning fiscal policy would include three elements. First, the present constraints on national budget positions should be removed, and national governments should be allowed to set fiscal policy as they deem appropriate in the light of economic circumstances, and their perceptions of the costs and benefits involved. Second, institutional arrangements for the coordination of national fiscal policies should be strengthened. Third, European Union institutional arrangements are required for the operation of an EU fiscal policy and to ensure that monetary authorities do not dominate economic policymaking. Adjustment Mechanisms The adoption of a single currency by eurozone countries clearly removes the possibility of variation in the value of their domestic currency. Changes in the exchange rate can allow a country to offset differential shocks and differences in economic performance. It may be questioned how far a country can determine its own exchange rate in the globalised financial markets, though since an exchange rate is the relative value of one currency in terms of another it is rarely the case that one country can completely determine the value of its own currency. It is also the case that exchange rates have been highly volatile since the breakdown of the Bretton Woods system, and that exchange rates have diverged significantly from purchasing power parity (see, for example, Krugman, 1989; Rogoff, 1996). Nevertheless, variation in the exchange rate (whether in the context of a fixed or a flexible exchange rate system) does provide a safety valve to adjustment to differential shocks and economic performance, even though the safety valve may not always work quickly (in the case of fixed exchange rates) or may often be faulty (in the case of flexible exchange rates). It is clear that there are few, if any, mechanisms with the Stability and Growth Pact and the single currency for a country or region to adjust to differential shocks and economic performance. There is a notable absence of automatic stabilisers at the level with the requirement of a balanced EU budget and the small scale of that budget. The ability of national governments to stabilise their own economies becomes more circumscribed through the requirements of the Stability and Growth Pact and the limits on the size of budget deficits. It is

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often pointed out that most single currency zones involve a central or federal government tax and public expenditure programme, which is substantial relative to national GDP, and a government budget, which can run significant deficits.9 The tax and public expenditure programme generally involves redistribution from richer regions to poorer ones, whether as an automatic consequence of a progressive tax and social security system or as specific acts of policy. The redistribution acts as a stabiliser with negative shocks leading to lower taxation and higher social security payments in the region which is adversely affected. With the removal of exchange rate variations as an adjustment mechanism, it could be expected that economies would adjust to differential shocks and economic performance through a variety of other routes. These would include (in response to a negative shock) declines in economic activity, reductions in living standards and outward migration. There is then a requirement for the development of a larger EU tax base within a progressive tax system and the use of the tax revenue in a redistributive manner. The problem of unemployment will be particularly serious in those cases where governments have chosen the wrong exchange rate at entry. An overvalued entry exchange rate will mean an extended period of recession to accommodate its effects, which emanate from the absence of the adjustable exchange rate safety valve. This is accentuated by the virtual absence of fiscal transfers, whether automatic or discretionary, from the relatively rich regions to the relatively poor ones. There is clearly not a tax and social security system operating at the European Union level which would make transfers between rich and poor in an automatic manner, and provide an element of fiscal stabilisation. The expenditures on regional aid (structural and cohesion funds) and to a lesser degree agricultural policies do make some transfers from rich to poor, but on a very limited scale. In short, the European budget is neither on a sufficient scale nor of the right design to provide significant interregional insurance in the EMU (Fatas, 1998b). Investment Bank The present disparities in regional unemployment levels (and also in labour market participation rates) within the EU would suggest that even if full employment were achieved in some regions, there would still be very substantial levels of unemployment in many others. In the presence of such disparities in unemployment, the achievement of a low level of unemployment overall (not to mention full employment) would be well-nigh impossible. Inflationary pressures would build up in the fully employed regions, even when the less prosperous regions were still suffering from significant levels of unemployment. Interest rates would then rise to dampen down the inflationary pressures in the prosperous regions without consideration for the continuing unemployment in other regions.

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Eichengreen (1997) offered the suggestion that the European Investment Bank (EIB) can borrow off-budget to perform tax-smoothing functions; however, this would exceed the EIB’s present remit.10 Article 198e of the Maastricht Treaty states that ‘the task of the EIB shall be to contribute, by having recourse to the capital market and utilising its own resources, to the balanced and steady development of the common market in the interest of the community’. Whether the functions of the EIB can be enlarged to include stabilisation policy (distribution over time) is extremely questionable, however, it can entail redistribution across countries, and it is specifically this function which should be expanded and strengthened from its present form where assistance is only in the form of loans and guarantees. Therefore, a further recommendation would be to have a revamped EIB to supplement the activities of the ECB, with the specific objective of enhancing investment activity in those regions where unemployment is acute. Enhanced investment activity will, thus, aim to reduce the dispersion of unemployment within the framework of reducing unemployment in general. This could be achieved through encouraging long-term investment whenever this is necessary by providing appropriate finance for it. We suggest an overhaul of the EIB’s remit because of the changing environment in which it operates. As highlighted by Honohan (1995), the EIB was established at a time when national capital markets were less developed than at present. Now, however, many lenders of loanable funds compete with the EIB and in this respect its public policy role is shrinking. Despite this trend, there still remains scope to extend the EIB’s public policy role. In particular, one area for possible intervention has been identified. The case for a revamped and extended EIB is based on three considerations. First, there is a need for differentiated policies, which will enable the less prosperous regions to catch up with the more prosperous ones, which will enable higher average levels of employment and economic activity. Second, the forces of cumulative causation in the context of a single currency and market will tend to stimulate investment in the more prosperous regions rather than in the less prosperous ones. Third, the high set-up costs of venture capital projects and the disproportionate number of small firms in the EU peripheral areas (which generally experience higher levels of unemployment) provides scope for the provision of subsidies for venture capital activities because costs are mainly independent of the scale of borrowing (Honohan, 1995).

3.5 SUMMARY AND CONCLUSIONS We have discussed in this chapter the conditions that surrounded the implementation of the EMU and the launch of the euro. The criteria that were set

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down under the Maastricht Treaty to determine which countries could join the single currency have been discussed and found problematic. Also problematic is the operation of the euro as governed by the Stability and Growth Pact. Alternatives have been suggested and discussed. We next turn to an assessment of the early life of the euro, its accompanying institutions and future prospects for the euro and the European economies.

NOTES 1. There were also rounding-up rules which helped a number of marginal cases to be deemed to have met the criteria. 2. Label B as the primary budget deficit (that is excluding interest payments), D as the government debt, r as the post tax rate of interest and g as the rate of growth (r and g can be in nominal or real terms as long as there is consistency though the Maastricht conditions appear to be in nominal terms). The growth of outstanding debt will be in line with the growth of GDP (and hence the debt to GDP ratio constant) when (rD + B)/D = g, and hence when (rD + B)/GDP = gD/GDR The left-hand side of this equation is the budget deficit (including interest payments) to GDP ratio and the right-hand side the growth rate multiplied by the debt-to-GDP ratio. Thus figures for deficit of 3 per cent of GDP, debt of 60 per cent of GDP are consistent with a growth rate of 5 per cent. Note, however, that if the growth rate is less than the rate of interest, the primary budget deficit (B = (g – r)D) will be negative, that is, primary budget would be in surplus. Further, the primary budget surplus would be growing over time as the interest payments mounted. 3. Belgium sold some of her gold reserves; France included a one-off transfer of ‘France Telecom’ pension fund to public-sector accounts; Germany reclassified hospital debt which took billions of marks of this debt out of the public sector (and, also, revalued her gold reserves); Italy levied a repayable euro-tax; and Spain privatised a series of State-owned companies. All of this ‘creative’ accounting enabled countries to achieve the all-important budget deficit criterion, and keep it below the 3 per cent benchmark. For these and other relevant accounting practices, see Dafflon and Rossi (1998). 4. It is instructive to compare EU unemployment rates with those of comparable countries outside the EU. The latter do not appear to have been experiencing the same high unemployment rates as the EU members. Comparable countries to the EU member-states, Canada and the US in particular, have actually been enjoying falling unemployment rates continuously since 1992. See, however, Palley (1998), who suggests that although the US unemployment has been lower and more jobs have been generated than in the EU, ‘these jobs have been produced at great cost in terms of income inequality, stagnating wages, and increased income insecurity’ (p. 338). Norway is another good example of a country which has chosen to remain outside the EU and her unemployment rate has been falling steadily since 1993. We may even refer to the UK case where, since 1992, when the UK left the ERM mechanism, unemployment has been falling steadily with the exception of 1993 when it increased slightly. 5. The ECB and the national central banks in the pursuit of the objectives of the ESCB may ‘operate in the financial markets by buying and selling (spot and forward) or under repurchase agreement and by mending or borrowing claims and marketable instruments, whether in Community or in non Community currencies, as well as precious metals; conduct credit operations with credit institutions and other market participants with lending being based on adequate collateral’ (Article 3 of Protocol on the Statute of the European System of Central Banks and of the European Central Bank). 6. We would stress that this literature must be placed within a Keynesian theoretical context (see Chapter 6).

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7. See Chapter 6 for further empirical detail and analysis of the most recent evidence regarding the impact of the euro on divergence within the eurozone. 8. Figures refer to output gap and are taken from OECD Economic Outlook, June 2000. 9. The CFA zone in Francophone West Africa is an exception. 10. The Treaty of Rome created the EIB in 1959. It specifically focused on the financing of infrastructure and other fixed capital formation projects. The scale of its operation has been very small (see Eichengreen, 1997).

4. Monetary and financial arrangements accompanying the euro 4.1 INTRODUCTION Chapter 3 discussed the conditions surrounding the launch of the euro and explored the fiscal arrangements accompanying the euro in the light of these. This chapter turns first to consideration of the ECB and monetary policy. Subsequently, the focus broadens out in order to consider the differing financial and monetary institutions of the 11 EMU countries and, finally, the possibility of financial crisis in the face of the unfettered and unprecedented capital mobility unleashed by the euro.

4.2 MONETARY AND FINANCIAL INSTITUTIONAL ARRANGEMENTS The institutional policy framework within which the euro has been introduced and will operate has three key elements which relate directly to monetary and financial policy. First, the ECB is the only effective federal economic institution. The ECB has the one policy instrument of the rate of interest (the ‘repo’ rate) to pursue the main objective of low inflation. The Governing Council of the ECB agreed on the main features of their stability-oriented policy strategy (EC, 1998). The single monetary policy will have a euro area-wide perspective. The president of the ECB at a press conference on 13 October 1998, clearly stated that monetary policy ‘will not react to specific regional or national developments’. A quantitative definition of price stability was adopted: the annual increase in the Harmonised Index of Consumer Prices (HICP) for the euro area should be less than 2 per cent. This is to be achieved through the policy weapon of the rate of interest, and by announced quantitative reference values for the growth of the broad M3 monetary aggregate set at 4.5 per cent. Being a reference level, there is no mechanistic commitment to correct deviations in the short term, although it is stated that deviations from the reference value would, under normal circumstances, ‘signal risks to price stability’. It has also 64

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been agreed that a broadly-based assessment of future price developments will be undertaken, but not publicly announced. Second, the ECB and the national central banks are linked into the ESCB with a division of responsibility between them. The ECB has the responsibility for setting interest rates in pursuit of the inflation objective and the national central banks’ responsibility for regulatory matters. In order to achieve its objectives, the ECB will conduct open market operations, it will offer standing facilities (overnight lending against eligible assets and deposit facilities to the institutions subject to minimum reserves with national central banks), and it will impose minimum reserve requirements. The latter will be interest-rate bearing (at the repo rate) on institutions holding accounts with it. The reserve ratio will be 2 per cent of eligible liabilities,1 and the reserves will be lodged with national central banks. One notable feature of the operation of the ESCB is the apparent absence of the lender of last resort facility. The protocol under which the ECB is established enables, but does not require, the ECB to act as a lender of last resort. The relevant article of the protocol suggests that: In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may: operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non Community currencies, as well as precious metals; conduct credit operations with credit institutions and other market participants with lending being based on adequate collateral. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions. (from Protocol No. 3, on the Stature of the European System of Central Banks and of the European Central Bank).

A lender of last resort function requires that base money is essentially provided on request to the banking system by the Central Bank, and in particular would be supplied if reserves were low following an expansion of broader money. More generally, the lender of last resort function recognises the role of a central bank in securing a stable financial system, but that specific objective of the stability of the financial system is not included in the remit of the ECB. It is clear that, on occasions, the lender of last resort function may require base money to be supplied when pursuit of a price stability target would point in the opposite direction. Third, the ECB is intended to be independent of the EU Council and Parliament and of its member governments. Thus there is a complete separation between the monetary authorities, in the form of the ESCB, and the fiscal authorities, in the shape of the national governments comprising the EMU.

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National governments are given the objective of keeping any budget deficit below 3 per cent according to the Stability and Growth Pact (see Chapter 3). It follows that there can be little coordination of monetary and fiscal policy. Apart from the separation of the monetary and fiscal authorities, there is also the requirement cited below that national governments (and hence the fiscal authorities) should not exert any influence on the ECB (and hence the monetary authorities). Any strict interpretation of that edict would rule out any attempt at coordination of monetary and fiscal policies.

4.3 THEORETICAL PROBLEMS Interest Rates We can begin by considering the possible impact on interest rates, with consequent effects on national fiscal policy and on the euro exchange rate. There are two major considerations concerning interest rates. The single policy instrument of the repo interest rate cannot be set in a manner appropriate for different regions suffering from different shocks and/or at different points of the economic cycle. A particular concern here would be that the interest rate may be set more with regard to those regions which are viewed as ‘overheating’ rather than to those regions which are ‘freezing’. It is clear that, in general, an interest rate level that is appropriate to an average will not be appropriate for the individuals that make up the average, especially in the case of ‘outliers’. Empirical evidence on this is provided below. One line of argument is that there will have to be further convergence of interest rates since there will be a single repo interest rate set by the ECB. How far that single repo rate is translated into a uniform set of interest rates across member countries is a matter of conjecture. It should be noted that national governments will receive different credit ratings from the financial markets (as, for example, happens between different states in the US) which would lead to different borrowing rates on government bonds. Further, different financial systems will generate different interest rates; for example, the mark-up of loan rates over the repo rate would vary from country to country. The use of monetary policy to target the rate of inflation draws on two broad sets of assumptions. The first is that monetary conditions are the cause and inflation the effect, and that interest rates can affect monetary conditions. In the simple monetarist story, the money supply determines the rate of inflation. But if there is reverse causality, whereby inflation influences monetary conditions, then seeking to set the latter becomes much less attractive. The second broad assumption is the classical dichotomy under which there is a separation between the real and the monetary sides of the economy, and under

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which the monetary conditions do not influence the real side of the economy, either in the short run or the long run. The non-accelerating inflation rate of unemployment (NAIRU) is a reflection of this notion, as it represents a supplyside equilibrium rate of unemployment, at which inflation is constant. In its usual representation, the NAIRU is settled by labour market factors, and not influenced by capacity or by aggregate demand. The ECB will have no choice but to raise interest rates when the prospect is of inflation rising. The ECB may operate on evidence of prices rising faster or any evidence such as unemployment falling below the estimated NAIRU (or some combination of factors). Interest rates are likely to be a rather blunt instrument for this purpose. There are questions over how much impact a rise in interest rates will have on the rate of change of the money supply, and further whether changes in the money supply have a causal effect on changes in prices. It is also the case that increases in interest rates raise prices, whether directly through impact on mortgage payments (particularly significant in the UK) or indirectly through impact on firm’s costs.2 The ECB though has no alternative to the use of interest rates and attempts to control the growth of the stock of money in the pursuit of the low inflation objective. The range of other economic policies which have or could be used to influence the pace of inflation are out of reach of the ECB. Thus, incomes policy, coordinated pay bargaining, the creation of a more balanced, less inflation-prone economy or even fiscal deflation are policy options which are simply not available to the ECB.3 Endogenous Money Monetary policy is often discussed in essential monetarist terms, namely that the stock of money can be changed (or targeted) by the Central Bank, and the growth of the stock of money determines the rate of inflation, leaving output and employment determined on the supply side of the economy (invoking the classical dichotomy between the real and monetary sides of the economy). But whatever is the rhetoric, the reality is that the relevant stock(s) of money are bank deposits (whether narrowly defined as demand deposits or broadly defined to include time deposits) which are created by banks but remain in existence only when there is a demand to hold them. Further, and of particular significance here, is that monetary policy operates through interest rates. A change in the repo rate works through the effect on the spectrum of interest rates and thereby on the demand and supply of loans and the willingness of the public to hold money. From these rather obvious observations, three considerations arise. First, the basis of the classical dichotomy is undermined. In particular, it would be anticipated that variations in the rate of interest would have an impact on the level of investment (and thereby future productive capacity) and the exchange rate. Monetary policy in the form of interest rates is viewed as

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operating through the effect of the level of economic activity and thereby on the rate of inflation. In so far as interest rate changes are effective in influencing the pace of economic activity, they can be seen to do so through exchange rates (and thereby on demand for import and exports) and through investment. Second, there are a range of reasons for thinking that monetary policy will have a differential impact across regions and countries. As the Monetary Policy Committee (1999) recognises, monetary policy ‘sets one interest rate for the economy as a whole and can only take account of the impact of official rate changes on the aggregate of individuals in the economy’ (p. 7). Monetary policy is undifferentiated in that a single official rate will apply. But there are differences in financial structures between countries in the eurozone, and in particular differences in the extent of variable rate and fixed rate borrowing and in the effect of interest rate changes on economic activity. The effects of interest rate changes will be far from uniform across eurozone countries. An interest rate rise may succeed in slowing down economic activity in some countries but not in others; it may have little effect on inflation in some but act to speed it up in others. The empirical evidence is reviewed below. Third, there is the question of how effective the interest rate is as an (or the) instrument of demand management policy. The overall impact of interest rate policy is likely to be very difficult to predict, in the light of the considerations above. Monetary Policy and the ECB Monetary policy typically operates through the setting of a key interest rate (such as the repo rate), rather than through controls over the stock of money. This means that there is a single instrument (of the interest rate) which is taken to influence the future path of the rate of inflation. But the rate of interest (or more accurately the spectrum of interest rates which rests upon this key rate) has a wide range of influences, and of particular importance is that over the exchange rate and possibly the rate of investment. A recent review of the properties of the major macroeconometric models of the UK indicates that ‘the chief mechanism by which the models achieve change in the inflation rate is through the exchange rate’ (Church et al., 1997, p. 92). The effects of an exchange rate change will be much smaller on the European Union economy which trades relatively little with non-European Union economies than on, say, the Dutch economy where imports and exports amount to over 50 per cent of its GDP. The relatively closed nature of the European Union in terms of international trade (with imports and exports amounting to less than 10 per cent of GDP) means that variations in the exchange rate of the euro will have much less impact on prices than in more open economies. The emergence of the euro will lead to a rather novel situation in which there are two or three dominant

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currencies at the global level: the dollar, the euro (especially if the UK joins the EMU) and possibly the yen (depending on resolution of the present difficulties in the Japanese economy). Each of these major currencies will have a basket of other currencies usually from the surrounding regions whose value is virtually fixed relative to it. The setting of the euro interest rate will be heavily conditioned by the dollar and the yen interest rates and, in particular, there is the threat of instability as one set of interest rates responds to the setting of the others. For example, the pursuit of inconsistent exchange rate targets through interest rates would lead to a form of interest rate war. Further monetary problems arise regarding the ability of the ECB and Eurosystem to expand the money supply, in line with the pace of economic growth, through monetising deficits. A government budget deficit can be financed by borrowing or by issuing base money (M0), and the expansion of the economy involves some expansion of the stock of money. Credit has to be available to permit the expansion of expenditure to be financed, and an expansion of national income will usually generate a greater transactions demand for money. The expansion of the form of money (say M1) which is largely used to finance transactions is of particular significance. It is necessary for government to run a budget deficit which was partially monetised in order that base money (M0) increased. A growing economy required an expansion of the stock of money (say M1), and such an expansion requires the underpinning of a growth in M0 to prevent a continuous decline in the reserve ratio (between M0 and M1 in this instance). In the context of EMU, there is a complete separation between the fiscal authorities and the monetary authorities, and moreover the appropriate fiscal authorities are barred from running any deficit. As the EU budget must be balanced each year, there can be no (base) money creation from that direction. It may well be that over the cycle there would be no net budget deficit (for the reasons indicated above). But in any case deficits run by member states must be covered by borrowing for they cannot be monetised since that would require credit to be granted to the national government by the ECB. This is clearly prohibited: Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments. (Article 104 of the Treaty of Rome)

There would seem to be three possible responses by the ECB to this apparent inability of the ECB to create high powered euros. The first is that in effect the ECB does actually monetise national government debt through open market operations. The quote from Article 104 of the Treaty of Rome given above

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rules out the direct monetisation of national government deficits (the prohibition of ‘purchase directly’) but to leave open the possibility of indirect purchases, that is through open market operations. Bonds would be sold by national governments, and then at some later stage sold on to the ECB (or to one of the national central banks). The ECB could justify this on the grounds that their stated objective is price stability, which is compatible with growth of the stock of money in line with the growth of national income.4 Under this scenario, the ECB would gradually accumulate the bonds of national governments: the interest on the bonds being paid by the national governments to the ECB, which then makes a profit, which is paid to its ‘shareholders’, the national governments (cf. Article 32 of the Protocol). The second is that the ECB permits the ratios of broader money (for example, M1, M3) to base money (M0) to grow over time. This would mean that the ECB foregoes the imposition of any reserve ratio requirement which would run counter to their announced reserve ratio for M3. The growth of these broader measures of money would be driven by the demands for those moneys, and in particular the growth of M1 would be driven by transaction requirements. This could only continue if the banks were willing to collectively become less liquid over time in the sense that the ultimate source of liquidity is base money, and the ratio of base money to broader measures of money would decline. The third is that the ECB imposes reserve ratio requirements on banking and other financial institutions as it is permitted to do under Article 19 of the Protocol, which prevents the reserve ratios from falling. The ECB has announced a reserve ratio on M3 of 2 per cent. The clear consequence of this would be that the necessary monetary expansion to underpin economic growth could not occur (unless M1 grew even though the broader notion of M3 did not). Even if real growth did occur, it would have to be accompanied by price deflation. This is not to accept any simple quantity theory formulation, but rather to accept that expansion of the economy requires credit creation. Further, the ability of the European financial system to grant credit to finance investment and expansion would be severely limited. Financial Regulation and Financial Capital Mobility Central banks usually have a range of roles linked with regulation and stability of the financial system, but these appear to be lacking in the case of the ECB. In particular, there is no specific requirement for the ECB to act as lender of last resort, though the ECB can decide to do so (see, for example, Articles 17 and 18 of the Stature of the European System of Central Banks and of the European Central Bank). Under a single currency there is no proper framework for crisis management. The traditional role of a central bank has been completely decoupled, with the ECB assuming monetary control and the national central

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banks retaining the supervisory role. It is argued that in the event of a banking crisis these two roles overlap, the national bank, acting as lender of last resort, would wish to inject liquidity into the financial system; however, it would be constrained given that money supply control falls under the remit of the ECB (Financial Times, 23 September, 1998). This argument should be qualified in an important way. The ECB’s main objective is the pursuit of price stability, but it is also responsible, along with national central banks, for banking surveillance (Hahn, 1991; Article 105(5) of the Stature of the European System of Central Banks and of the European Central Bank), though in this respect it can only offer a non-binding opinion. Yet in this area the ECB’s potential role could be enhanced considerably; there remains scope for an expansion of its current supervisory role subject to ECOFIN approval (Article 105(6), op. cit). Furthermore, prevention can play an important role in limiting the possibility of financial crisis: higher capital and liquidity reserve requirements than those currently in operation can in principle reduce the severity of crises and strengthen banking supervision which would lessen the risk of bank bankruptcies. The increase in the degree of financial capital mobility within the EMU reveals additional difficulties. Financial institutions within the eurozone area hold about 90 per cent of their portfolios in domestic assets. With the removal of foreign exchange risks and regulations which inhibit holdings of foreign assets, as well as the elimination of currency conversion costs, financial institutions will increase their holdings of euro assets substantially. The clear implication is that the amount of funds moving within the euro area will make a quantum leap. The regulatory and institutional environment will remain national at least during its initial phase when institutions have not adapted to the new environment. Rates of return will differ across EMU members, but banks will be able to borrow at the same interest rate. Under these circumstances financial disturbances are likely to materialise. A stronger boom in, say, Third Italy than in the rest of the EMU, will be associated with asset inflation there, with the ECB being unable to initiate policies specific to the needs of Third Italy. We can envisage that there will be substantial money flows into areas where asset prices are rising and which offer the prospects of high returns. The inflow will generate further rises in asset prices, generating further asset inflation. The boom cannot continue forever, and at some stage the bubble will burst, with asset prices collapsing causing financial distress in the local banking system. Recent experience in the Far East is probably indicative of what may happen. There may be difficulties emanating from increased volatility of the euro, especially if it were to become reserve currency challenging the dollar. To begin with, investors and borrowers that were not interested previously in European currencies because of the limited size of the money markets, are expected to increase substantially their demand for euros. At the same time, though, the

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holdings of different European currencies to diversify their risk will be reduced, thus containing the increased demand for euros just referred to. In fact, there is the potential of ‘dollar overhang’, the possibility of excess supply of foreign exchange reserves within the ESCB, in view of the replacement of the eurozone countries’ reserves by the euro. Estimates range from a large excess supply to a possible excess in demand (see Arrowsmith, Barrell and Taylor, 1999, for more details). A further potential shift into euros is changes in the currency composition of other countries’ official reserves and of international investors’ portfolios. Arrowsmith et al. (op. cit.) estimate that If the attraction of the euro as a reserve currency to official holders outside EMU were sufficient to restore its share of world reserves to that taken at present by the currencies of the 11 participating members of EMU, their euro holdings would rise by $66 bn; for the euro, over time, to achieve a share equal to that of the US dollar in non-EU countries’ reserves would require (assuming the currencies’ shares are unchanged) a switch from the dollar to the euro of $260 bn) (in 1996 terms); and, similarly, equality with the dollar in total world reserves would entail a switch to the euro of $360 bn. (p. 9)

As for international investors’ portfolios, ‘a switch of $250 bn into euro deposits would be required’ (ibid., p. 10) to retain the share of euro in total world foreign currency deposits (at the pre-EMU percentage of non-banks’ holdings of the EMU-11 currencies as foreign currency deposits. Furthermore, ‘to achieve an equal share with the dollar would entail a switch of $180 bn (to give a 27 per cent share in total foreign currency deposits after EMU)’ (ibid., p. 10). Portfolio shifts should also be expected in the international debt market. Arrowsmith, Barrell and Taylor (1999) argue that ‘a movement of $410 bn would restore the euro’s share in the international debt market to that presently held by the EMU-11 currencies, while reaching parity with the dollar would require a shift of $320 bn’ (p. 11). Similar arguments could be advanced in the case of international borrowers, thus further adding to the uncertainties just alluded to. Furthermore, and as agreed at the Madrid summit in December 1995, all new government debt issued after 1 January 1999 by EMU members is denominated in euros. In addition, all the eurozone countries have committed themselves to renominate existing debt into euros from national currencies. Thus the re-denomination of government and corporate bonds in euros, and the adoption of a uniform set of conventions in the securities markets, have contributed towards significant changes in the eurozone financial markets. These developments have resulted in a substantial market with euro-denominated securities. The expectation that these developments (the growth of stronger capital markets) would entail a transformation from bank finance which is the traditional form of company finance, towards market finance (that is bonds and stocks), appears to have been borne out. The corporate bond market denomi-

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nated in euros has grown rapidly to be equal in size to that denominated in dollars (both roughly 40 per cent of the world market). This growth, and concomitant changes, has helped to finance the recent boom in mergers and acquisitions activity within Europe (Eichengreen, 2000). The recent ‘transformation of Germany’s business culture’, away from bank-based finance, is both symptomatic of the general change within Europe and symbolic of that change, given Germany’s traditional status as the very ‘model’ of bank-based finance (Financial Times, Survey of Germany Banking and Finance, 23 October 2000). Still a further implication of these developments is that the channels of influence of monetary policy will inevitably change throughout the EMU member countries.

4.4 EMPIRICAL PROBLEMS A number of problems are expected to surface in view of the architecture of the EU banking systems and financial markets. The banking systems are at different stages of development with different characteristics where the capacity of banks to create credit depends on their stage of evolution (Chick and Dow, 1995). Banking systems in the peripheral countries (Greece, Portugal, Spain, Ireland) differ substantially from the ones in the core countries in this respect. There are also important differences within the core countries, which are particularly pertinent. For example, the distinction between bank-based (for example Germany) and capital-market-based (the UK is a good example) financial systems is pertinent in this context. These institutional and behavioural characteristics across EMU countries, along with differences in the timing and amplitude of cycles, are expected to have serious implications for the transmission mechanism, and thus channels of monetary policy, throughout the EMU area. They are significantly different across the member states. The ECB monetary policy is thus expected to have asymmetric effects across the Union. So that ‘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’ (Arrowsmith, 1995, p. 84). An important piece of evidence relating to asymmetric shocks is Arrowsmith, Barrell and Taylor (1999). This study concentrates on the volatility of the euro and its possible asymmetric effects. The sole objective of price stability suggests that monetary policy will have serious implications to the euro exchange rate stability. The non-availability of national exchange-rate adjustment for shocks which have differential effects on the eurozone economies will have serious implications. The euro interest rate will have to cope with these shocks, implying uncomfortable consequences for the exchange rate. This exchange

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rate volatility will have uneven impacts on the eurozone economies. The study by Arrowsmith, Barrell and Taylor (1999) simulates the impact of exogenous exchange rate disturbances on individual economies under the assumption of the ECB pursuing the single objective of price stability. Their results confirm these propositions unambiguously.5 The available empirical evidence on the transmission mechanism is on balance supportive of the view that monetary policy will have different effects across the EMU countries. Empirical studies which are based on large multiequation econometric models suggest significant differences, while studies based on small VAR-type models suggest insignificant differences. Table 4.1 provides a summary of the findings of an empirical assessment of the impact of monetary policy on output in various eurozone countries (including the UK for comparative purposes). They clearly support the suggestion just alluded to. Dornbusch, Favero and Giavazzi (1998), when reviewing the evidence, conclude that in view of the usual difficulties associated with the interpretation and origins of reduced-form relationships, the evidence adduced from largescale models is more reliable. Further support of the argument of asymmetric effects of monetary policy is the possibility that consumers display different responses to interest rate changes across the EU. For example, consumers in the UK may be more sensitive to interest rate changes than in some other countries in the EU, due in part to the system of mortgage finance. Additional institutional differences, such as the system of equity markets, may also account for differences in behaviour. Evidence based on simulations with macroeconomic models run by national central banks confirm the differential impact of interest rate changes across the EU. The following example is an interesting and relevant result that makes the point about the differential impact of interest rate changes on economic activity. It suggests that ‘for the UK, the impact of an interest rate change on domestic demand after two years is four times the EU average’, so that ‘the impact of any change in European monetary policy would be disproportionately channelled through the UK’ (CEPR, 1997, p. 17). The channels of monetary policy are likely to change, especially in view of the pressures the financial sector is likely to come under, crucially in terms of credit allocation. Table 4.2 makes the point vividly. Private sector balance sheets in five euro-area countries show that whilst the net assets of both households and enterprises as a percentage of GDP are fairly similar across countries, the composition of gross assets and liabilities varies significantly. In addition, the response of lending rates to changes in policy interest rates also vary. Increasing competition amongst financial institutions will thus give a significantly wider choice of financial instruments. Financial institutions themselves will inevitably react to these developments. As a result, more emphasis is likely to be on interest rates and less on credit availability (OECD, 1998, p. 143).

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Table 4.1 Empirical assessments of the impact of monetary policy on output in various European countries Impact on real GDP, percentage deviation from baseline in second year after shock Study Type Germany France Italy United Spain Netherof Kingdom lands shock Single country macro models(a) National Central Bank models (BIS, 1995)

1

–0.4

–0.4 –0.4

–0.9

Multi-country macro models(b) Fed MCM model (BIS, 1995) IMF Multimod standard multiplier Quest II (Commission Services) Taylor (1995)

1 2 2 2

–0.7 –0.5 –0.4 –0.4

–0.7 –0.3 – – –0.4 –0.3 –0.4 –0.4

–1.2 –0.5 –0.4 –0.1

– – –0.4 –

Small structural models Britton and Whitley (1997)(c) Britton and Whitley (1997)(d)

1 1

–0.5 –0.4

–0.5 –0.4

– –

–0.3 –0.4

– –

– –

3

–0.5

–0.5 –1.1

–0.5

–0.4

–

3

–1.4

–1.5 –2.1

–0.9

–1.5

–

4 4 4 4 1

–0.6 –0.6 –0.6 –0.3 –1.0

–0.4 –0.4 –0.4 –0.2 –0.5

–0.2 –0.5 –0.4 –0.6 –0.7

–0.1 –0.3 –0.4 – –

0.0 –0.6 –0.3 – –

Reduced from equation Dornbusch, Favero and Giavazzi (1998)(e) Dornbusch, Favero and Giavazzi (1998)(f) Structural VARs Ehrman (1998) Ramaswamy and Sloek (1997)(g) Barran, Coudert and Mojon (1996)(h) Gerlach and Smets (1995)(i) Gerlach and Smets (1995)(j)

–0.1 –0.5 –0.3 –0.2 –0.5

0.0a

–0.2 – – –0.3 –

Notes: (a) Fixed ERM rates for Germany, France and Italy; endogenous exchange rate for United Kingdom. (b) Endogenous exchange rates. (c) Each country estimated separately. (d) All countries estimated jointly. (e) Effect after 8–12 months. Response variable is monthly output data. (f) Effect after 2 years. Response variable is monthly output data. (g) Baseline model. (h) Baseline model (model 1). (i) 1 standard deviation shock. (j) 1 per cent interest rate hike for 2 years. Types of monetary shock: Type 1: 1 per cent joint rise in short-term interest rates sustained for at least two years: Type 2: 1 per cent permanent decrease in money target; Type 3: 1 per cent simultaneous permanent increase in short-term interest rates; Type 4: 1 standard deviation interest rate shock which in many cases is close to one percentage point. Sources: Kieler and Saarenheimo (1998) and Ehrman (1998); OECD (1998) where all the relevant references can also be found.

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Table 4.2 Financial position of the private sector in selected euro area countries (1996, as percentage of GDP)

Non-financial enterprises Net assets Gross assets of which: Short-term(a) Long-term(b) Equity Gross liabilities(c) of which: Short-term loans Long-term loans Households Net assets Gross assets of which: Short-term(a) Long-term(e) Equity Gross liabilities of which: Short-term loans Long-term loans

Germany(f)

France

Italy

Spain(g) Belgium

–35 70

–73 249

–67 39

–43 80

–81 135

21 9 23 105

24 4 176 322

9 4 20 106

39 19 16 123

26 38 71 216

21 45

16 42

25 17

n.a. n.a.

21 61

124

138

163

78

217

59 54 17

21 41 71

44 60 36

73 7 40

75 79 102

2 8

8 32

7 12

n.a. n.a.

4 36

Notes: (a) Cash, deposits and short-term loans and securities. (b) Bonds and long-term loans. (c) Including own shares. (d) Including, in some cases, corporate bonds. (e) Bonds and net equity of life insurance reserves and pension funds. (f) Figures relate to 1995. (g) Data for long vs. short loans not available. It is assumed that half of total loans on the asset side are short and the other half long. Source: Financial Accounts of OECD Countries, OECD (1998).

The implementation of monetary policy involves the major difficulty that the interest rate is unlikely to be appropriate for all areas of a monetary union, and this difficulty is exacerbated in the case of the eurozone with the known differences in banking systems and the responsiveness of the economies to interest

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rate changes. In the context of a relatively closed economy such as the eurozone, interest rates may influence the exchange rate but that change would have relatively little influence on aggregate demand. But interest rates may well operate on investment, and the use of interest rates as a counter-inflation policy may well harm investment and hence future productive capacity.

4.5 ALTERNATIVE MONETARY AND FINANCIAL PROPOSALS These observations lead us to certain institutional and policy recommendations. On the monetary side, the key question is the role of the independent central bank. We would argue for the objectives of the bank to include the pursuit of full employment and economic growth as well as price stability (recognising that there may be interdependence between the objectives, though not necessarily in the manner suggested by the Philips curve).6 The central bank would also have the objective of the regulation of the financial system, with the further aim to provide an orderly functioning of the credit system. It is imperative, therefore, that the ECB is able and willing to assume the traditional role of any central bank, that of the lender of last resort. In this context there is also a requirement for more effective accountability, as argued above, which requires mechanisms of democratic influence (if not control) over the central bank from the European Parliament (and we would extend that to national parliaments). This accountability would reinforce the legitimacy of the institution and avoid at the same time dramatic conflicts between monetary policy and other EU objectives. A much wider membership of the board of directors than the present constitution (see footnote 3) to include representatives of industry, trade unions, regions, and so on would help a great deal on this score. Inflation Much of the Stability and Growth Pact focuses on the achievement of low inflation through the use of monetary policy, and interest rates in particular. As noted above, there are a range of views as to how monetary policy, change in interest rates more specifically, influences the pace of inflation, and it is worthwhile to give further detail on two particular views. The first, which is essentially a monetarist view, is that there is a causal mechanism running from changes in the stock of money to the rate of inflation. This view rests on either the stock of money being exogeneous for the private sector but subject to change by the authorities, or the supply of money being manipulated by interest rates. In the latter case there is the question of how to manipulate interest rates to

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affect the money supply since the liquidity preference of banks may lead to a different stock of money than what is intended. For example, it may very well be that the authorities raise interest rates to try to achieve a lower (than otherwise) stock of money, but commercial banks increase the supply of credit and thus the stock of money since it is now more profitable to do so. It is also the case that money has to enter the system in some way, and the most obvious route is that it is created by the banking system in response to a demand for loans (credit) by the private sector. However, the view that inflation is a monetary phenomenon and that expansion of the money supply can be used as a control mechanism over the rate of inflation appears to lie behind the operations of the ECB. The second, which runs along the lines suggested by the Bank of England (1999) in their discussion of the transmission mechanism of monetary policy, focuses on the impact which interest rates have on aggregate demand, and then the impact which demand has on the pace of inflation. The Bank of England (1999) view the official interest rate as influencing market interest rates, asset prices, expectations and confidence, and the exchange rate. These factors then influence domestic and net external demand, which in turn influence domestic inflationary pressures and import prices. The growth of the stock of money adjusts to the pace of inflation as the stock of money is willingly held by the public, and the demand for money depends on the level of nominal income. The first view suggests that inflation can be controlled by monetary policy without any harm to the real side of the economy. The second view would suggest that the stock of money adjusts to inflation, generated on the real side of the economy, and that monetary policy in the form of interest rates can have effects on the real side of the economy. Further, it should also be recognised that monetary policy through the manipulation of interest rates may not be an effective way of guiding the economy, and the effects of interest rate changes on economic performance are highly indirect and uncertain, and as such difficult to predict. We thus cast some doubt on the effectiveness of interest rate policy in the relatively closed EU economy, specifically in terms of the inflation objective. In so far as interest rate policy can influence the pace of inflation, it does so through suppressing aggregate demand, which in turn may well have detrimental effects on investment and the creation of productive capacity and have hysteresis effects on labour force participation. The perspective on inflation underlying our proposals is rather different. Inflation is generated by factors on the real side of the economy, and then in effect validated by a growth of the stock of money. The achievement of high levels of economic activity without inflationary pressures then requires two elements. First, institutional arrangements for collective wage determination and price setting which are conducive to low inflation. Wage determination within the EU is currently undertaken on a decentralised and fragmented basis,

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even where it is (or has been) centralised within a particular national economy. The institutional arrangements for collective wage determination at the EU level do not currently exist, and this effectively rules out any possibilities for the operation of incomes policy or similar for the next few years. There are a number of examples in Europe (within and without the EU) of centralised institutional arrangements, which have been conducive to relatively low inflation: for example Austria, Germany and perhaps the most successful Norway. Second, in addition to the construction of relevant institutional arrangements, it is necessary to construct a well-functioning real economy which is also conducive to combining low inflation with high levels of economic activity. We take the view that a major element of that would be the construction of a level and location of productive capacity which is capable of providing work to all that seek paid employment. This would require that not only is the general level of productive capacity raised, but also that much of that increase is directed towards the less prosperous regions of the EU. This would require the enhancement of the functions of the EIB (or a similar institution) to ensure high rates of capital formation, appropriately located across the European Union, and we have made proposals for an extended European Investment Bank in the previous chapter. Inflation has generally recently reached low levels, not just in European economies but almost worldwide. The present danger is more one of deflation, both in terms of low levels of demand and of falling prices, rather than of inflation. The construction of European-wide institutional arrangements would be a long-term project, and is not something which the European Union or its member countries can readily bring into being. It may, though, be able to act as a facilitator through appropriate legislation on the role of trade unions and employers’ organisations, and the encouragement of the operation and growth of such organisations at the European level. The ECB The ECB at present stands as the only body which can implement economic policy at a European Union level. The ways in which the ECB operates is crucial for the economic health of the European Union, although we argue below that economic policymaking at the EU level should be also substantially extended. The ECB suffers from two major shortcomings, namely its undemocratic and unrepresentative nature, and the objective which it has been set. Hence, we argue that the ECB should be changed in two significant ways: the membership of the board of directors should be broadened and the directors made directly answerable to the European Parliament, and the objectives set for it reformulated. A further change would be an increase in the transparency of the operations of the ECB. The setting of interest rates seems to be regarded by some as a technical matter: indeed part of the rationale for an independent central bank is that

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decisions on interest rates are depoliticised by being taken out of the hands of politicians. When, in contrast, interest rates have distributional consequences and have differential impacts on regions and industries (whether directly or indirectly through, for example, the exchange rate), then the setting of interest rates should be influenced by those possible consequences. The board of directors of the ECB should be broadened through the explicit representation of different industrial sectors and of workers and consumers. An alternative would be for the board of directors to be appointed by the European Parliament in a way which, at least informally, leads to a wide representation of interests. An alternative full employment, growth and stability pact would, thus, involve major changes to the operations of the ECB. We have argued for a change in the objectives set for the ECB, and a recognition of the channels of monetary influence with due regard being paid to the distributional effects of interest rate changes. Further, there is a need for the reformulation of the regulatory role of the ECB. In this respect, the ECB’s most important function is that of ensuring that orderly conditions prevail in the money market. In order to achieve this, the reformulated ECB should be required to act as lender of last resort and not merely possess the potential to act as such. Moreover, the ECB should adopt a more proactive stance regarding bank surveillance and supervision. The proposal for the reformulation of objectives readily follows from what has been previously said: that is the ECB should be charged with setting interest rates in a manner which encourages growth and full employment, rather than merely inflation.

4.6 SUMMARY AND CONCLUSIONS We have examined in this chapter the conditions surrounding the introduction of the euro. In doing so we have focused on the institutional environment created by the EMU and the euro, and considered both the ECB and the monetary policy pursued by it. We have also considered the differing financial and monetary institutions of the 11 EMU countries. We conclude that the possibility of financial crises in the face of the unfettered and unprecedented capital mobility unleashed by the euro is very real. We also conclude that alternatives are needed within the EMU institutional environment to avoid the kind of problems identified in this chapter.

NOTES 1. Eligible liabilities are: overnight deposits; deposits with agreed maturity up to two years; deposits redeemable at notice up to two years; debt securities issued with agreed maturity up to two years; and money market paper.

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2. Whether interest rates have the direct effect postulated depends on the way which the consumer price index is constructed. But it is also of relevance how people regard interest rate rises. If they are perceived as having caused prices to rise, whether or not recorded in the official statistics, there may be some impact on other prices and on wages. 3. The Executive Board of the ECB will comprise the President, Vice President and four other members who ‘shall be appointed from among persons of recognised standing and professional expertise in monetary and banking matters’ (Article 11 of Protocol on the Statute of the European System of Central Banks and of the European Central Bank). The Governing Council comprises the Executive Board and the governors of the national central banks. The ESCB ‘shall be governed by the decision making bodies of the ESCB’ (Article 8). It is clear that financial and banking interests will be well represented but there will be no representation of national or regional governments, trade unions, industrial and business interests. This heavy reliance on banking and financial interests is likely to generate an emphasis on ‘sound’ money and the pursuit of overly deflationary policies. Little regard will be paid to issues of unemployment or growth. 4. This should not be read as supporting a monetarist view on inflation, though the ECB and others appear to adhere to an essentially monetarist view of inflation and hence could use an argument akin to growth of money supply equal to growth of national income. 5. The simulations reported in Arrowsmith, Barrell and Taylor (1999) are undertaken on the large multi-country model developed and operated by the National Institute of Economic and Social Research, the so-called NIGEM model (see NIESR, 1998). 6. Worries about unemployment have been expressed by a number of contributors, both academics (see, for example, Eltis, 1998; Goodhart, 1998), and central bankers (see, for example, George, 1998).

5. Channels of monetary policy and implications for the euro 5.1 INTRODUCTION1 This chapter contributes to one strand of the empirical work drawn upon in Chapter 4, regarding the demand for money. The demand for money is an important variable to monetary policy as operated at the moment by the European Central Bank (ECB). The empirical properties of both the individual member states and the aggregate European Monetary Union (EMU) demand for money, would have to be closely monitored by the ECB. The literature on the demand for money in the EMU countries recognises that the conduct of monetary policy in a monetary targeting regime relies heavily and crucially on a stable demand for money along with theory-consistent interest elasticities. Otherwise, the transmission mechanism of monetary policy becomes uncertain. Similarly, when a combination of both monetary and direct inflation targeting is pursued, here again the conduct of monetary policy relies, to a very large extent, on the properties of the demand for money relationship in the member states of the EMU. The stability of the demand for money is regarded as the prerequisite to both regimes of targeting. However, when an inflation target is preferred to a monetary target, to be influenced by the rate of interest, the presupposition of a stable demand for money is not so crucial. Although money aggregates could potentially continue to provide information on inflation forecasts, this may not be deemed necessary by the Central Bank. The Bank of England, for example, does not consider such information as useful simply because there is the belief that the demand for money is so unstable as to render itself unhelpful for this purpose. The transmission mechanism as envisaged by the Bank of England is predicated on channels which do not rely on a stable demand for money relationship (see, for example, MPC, 1999, especially Figure 1). In the case of the ECB, inflation targeting is the thrust of monetary policy within the eurozone while the targetry of M3 is still viewed as a reference point. When the money supply is off the set target, a policy reaction is not triggered automatically. It may still be argued, though, that ‘money aggregates are likely to continue performing an important role as a source of information for fore82

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casting inflation rates and an intervention indicator for monetary policy’ (Hayo, 1999a, p. 222). A careful study of the demand for money in the member states of the EMU is thus important. Ideally, these issues should equally apply to the aggregate EMU demand for money. Whilst such a notion has been discussed in the literature (see, for example, the latest attempt on the matter by Hayo, 1999a), we doubt the value of a European demand for money prior to the establishment of the ECB in January 1999, when an arbitrary aggregation, which would have to include assumptions on appropriate exchange rates to be used, would be inevitable. Such a relationship has been found to be stable. This may be unavoidable in view of the aggregation and the averaging out of the problems that might give rise to a potentially unstable EMU demand for money. In any case, even if empirical evidence on the EMU money demand relationship were established, the exercise prior to January 1999 would probably be fruitless. This argument is connected with the idea of the ‘Lucas Critique’, that the transition to EMU constitutes a structural break which is more than likely to alter previous behavioural relationships. Arnold (1996) and Arnold and De Vries (1998) make the point and suggest that money demand shocks to individual countries prior to January 1999 were idiosyncratic and tended to cancel each other. After January 1999, these type of shocks would have common sources and would tend to be more correlated, so that an unstable aggregate EMU demand for money is more likely to prevail. We would argue, though, that the only ‘shock’ that has had a common source since 1 January 1999 is the rate of interest, so that the ‘Lucas Critique’ and ‘Goodhart’s Law’ may have become operable in so far as the demand for money is concerned. Janssen and Bhundia (1998) suggest that a simple construction and estimation of an EMU aggregate demand for money is invalid simply because monetary aggregates are not weakly separable from real income (but see Hayo, 1999a, p. 222, for a critique of this view). This is so since decisions to hold money are not independent from decisions to spend. We take the view that empirical work should investigate the stability of an aggregate EMU demand for money. However, such an exercise would have to wait until a sufficient number of time series data materialise now that the ECB publishes data for the whole EMU area. This would be a superior approach to the one that involves aggregation from data on individual countries with all the well-known problems this process entails. A panel cointegration approach may overcome a number of problems identified by the studies we referred to above (see, for example, Petroni, 1998a, 1998b). However, even if the data for aggregate EMU demand for money were available, it would still be of interest to explore whether that demand for money was the same across countries. The empirical results reported below in this study suggest significant differences, especially of interest elasticities as well as error-correction

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coefficients across countries, and these differences may well remain after the introduction of the euro. We contribute to the debate by looking at all member states of the EMU countries. Consequently, the first distinguishing characteristic of this chapter in relation to other recent studies (Hayo, 1999a; Bruggeman, 2000, are just two examples), is that it deals with individual EMU countries instead of an aggregate demand for money for the whole eurozone. The second is that it uses a framework that sharply distinguishes between short-run money demand dynamics and the long-run equilibrium relationship. A third characteristic is that it utilises a common variables definition and a common sample period, as far as that is possible. We utilise the M3 definition of money, since this is the one adopted by the ECB for the purposes of the common EMU monetary policy. The fourth is that a system context is utilised throughout, as explained in Section 5.3, which is not an approach pursued by other studies dealing with the demand for money in the EMU (with the exception of Hayo, 1999a, in the case of an aggregate European demand for money). We proceed as follows. Section 5.2 briefly refers to theoretical considerations. Section 5.3 explains the econometric methodology pursued, discusses the data and variables utilised, and reports our findings. A final section summarises and concludes.

5.2 THEORETICAL CONSIDERATIONS In general terms equation (5.1) describes a traditional demand for money at a steady state situation. It is a relationship between the optimum nominal amount of money held and the equilibrium value of the explanatory variables. It is thus a long-run equilibrium relationship: M = APa1Ya2exp[a3ownt + a4rt + a5 ∆(InP)]

(5.1)

where M is the M3 definition of money, P is the price level, Y is real income, ownt is the own rate of interest, rt is the long-term rate of interest (rl) or the short-term rate (rs) and ∆InP is the inflation rate. The price and income elasticities are a1 and a2, respectively, while a3 and a4 are interest rate semi-elasticities and a5 registers the impact on the demand for money of a change in inflation, which is also a semi-elasticity. The expected signs of the parameters are a1 = 1 (the well known homogeneity postulate), a2 > 0, a3 > 0, a4 < 0, a5 < 0, and possibly a3 = –a4. In the latter case, the spread (ownt – rt) stands for the opportunity cost of holding money. Some theories predict particular values for a2, as, for example, the Baumol-

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Tobin model, which suggests a2 = 0.5, or formulations of the quantity theory of money that predict homogeneity between money and income. Empirically, we occasionally find that a2 > 1. This is usually interpreted as proxying omitted variable effects, particularly wealth effects. The inclusion of wealth variables in (5.1) is justified under a standard portfolio approach of asset demand, in which money is the most liquid asset in a range of financial assets. Although there is an important strand of literature that is concerned with wealth effects in European money demand functions (see, for example, Fase and Winder, 1996; Deutsche Bundesbank, 1995), we do not pursue this approach here due to lack of reliable and consistent wealth variables for the European countries we are dealing with. Furthermore, there is empirical evidence which suggests that the inclusion of a wealth variable does not always convey information as to the long-run determination of broad money demand (see, for example, Biefang-Frisancho Mariscal et al., 1995; Deutsche Bundesbank, 1995). The inclusion of the inflation rate in the long-run demand for money relationship is controversial. Conventionally, the inflation rate describes the substitution process between financial and real assets. The European countries we study here have enjoyed long periods of relatively low inflation over the sample period and they also have sophisticated financial markets. Furthermore, since the removal of capital controls in the early 1980s in the European countries under scrutiny in this chapter (except for France and Italy where they were removed in 1989/90), finance capital has become mobile. Therefore, under these circumstances we would expect the degree of substitution between money and financial assets to be strengthened and that between money and real assets to be weakened. This is precisely what our empirical results indicate (see Section 5.3.1, below). Equation (5.1) is, of course, a long-run equilibrium relationship, and cointegration analysis is utilised to examine its properties. Clearly, cointegration by itself is not so interesting in the absence of knowledge of the adjustment dynamics. In other words, we need to combine (5.1) with the short-term dynamics embedded in the system which underpin this relationship. It is thus paramount that empirical verification of (5.1) is undertaken in two stages: one that relies on cointegration analysis, and another that is concerned with the short-run dynamics (Hendry and Mizon, 1993; see, also, Juselius, 1996). We pursue this approach throughout this study. A dynamic formulation of (5.1) is presented, whereby the long-run properties of the demand for money are determined jointly with the short-run adjustment process. An error-correction mechanism is specified, along with the well-established proposition that the homogeneity postulate prevails. It is thus assumed that the price elasticity of the demand for money is equal to unity. We may now write (5.1) as:

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∆ln(M/P)t = β[ln(M/P)t – a2lnYt – a3 ownt – a4rt – a5(∆lnP)t]t–1 + ∑aj ln∆(M/P)t–j + ∑bj ∆lnYt–j + ∑cj∆ownt–j + ∑dj∆rt–j + ∑ej∆(∆lnP)t–j + εt (5.2) In (5.2) the error-correction term is defined as the deviations from the equilibrium relationship (5.1). Equation (5.2) is thus a general formulation for the specification and estimation of the demand for money in the eleven EMU countries referred to above. Conceivably, though, equation (5.2) contains a number of endogenous variables which would have to be accounted for in the estimation process. A further important aspect of the approach adopted in this study is that special attention is paid to the interaction and feedback effects within the system. The ‘encompassing VAR’ approach (Hendry and Mizon, 1993) is utilised throughout. This approach estimates structural economic models by making simplifying exogeneity and identifying restrictions which encompass the whole structure of the relationships involved. The relevant details are provided in the section that follows immediately.

5.3 ECONOMETRIC ISSUES AND EMPIRICAL INVESTIGATION The following sections are concerned with the estimation and testing of model (5.2). A recently developed method, which is used in this chapter, is the ‘encompassing VAR’ approach by Hendry and Mizon (1993) and Hendry and Doornik (1994), which attempts to recover structural economic models from congruent statistical representations of the data. This implies that the modelling approach itself is data based in the sense that we look at data as structured by a statistical model which allows for a variety of economic theories and testable hypotheses. The starting point (see Section 5.3.1) is an unrestricted vector autoregressive model (UVAR) which contains all the variables of interest. It is the baseline model that determines the lag length of the UVAR and identifies trends and other deterministic variables that ensure a congruent representation of the data. This general dynamic statistical model can be reparameterised into a vector error correction model (VECM) which isolates the long-run relationships from the short-run dynamics (as shown in Section 5.3.2). Structural models are recovered from the unrestricted VECM by imposing identifying and over-identifying restrictions on the long- and short-run reduced form parameters of the VECM (Pesaran and Shin, 1994; Johansen and Juselius, 1992). On the basis of the cointegration results an unrestricted vector error correction model (UVECM), which has the cointegration relationships incorporated, is estimated.

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Identifying and over-identifying restrictions on the system led to an unconditional parsimonious vector error correction model (PVECM). This parsimonious reduced-form system is checked for data congruency by diagnostic system tests on the residuals and for parameter constancy. From tests involving the long-run model backed up by tests of the significance of the error correction terms in the PVECM, it is possible to condition on the weakly exogenous variables and to proceed to structural modelling. Loosely speaking, structural modelling allows for contemporaneous relationships between the endogenous variables. The results of this procedure along with the final dynamic models and their tests for data congruency are presented in Section 5.3.3. 5.3.1 Model Checking and Rank Determination The application of Johansen’s (1988) cointegration analysis involves estimating a UVAR, in which all the variables in vector z are treated as endogenous and which can be interpreted as the general unrestricted reduced form of the system. The UVAR is represented by: zt = µ + A1zt–1 + ... + Akzt–k + ψDt + νt

(5.3)

where Ai with i = 1,...,k is an (n × n) matrix of parameters, Dt is a k × q vector of dummy variables and a deterministic trend and µ is a k × 1 vector of constants, zt is a k × 1 vector of variables as real M3 (mt – pt), real GDP (yt), a short-run (rs,t) or a long-run interest rate (rl,t), an own interest rate on M3 (ownt), and price inflation (∆pt). All variables, with the exception of interest rates, are in logarithms and are, for all countries except Austria, seasonally adjusted. Interest rates are in levels and are in no case seasonally adjusted. A full description of the data sources is given in Appendix 5.1. The estimation period is from 1979 quarter 1, the beginning of the ERM, until 1998 quarter 3 (data permitting, see Appendix 5.1). Although we found for most countries a mild shift in M3 between 1990 and 1991, the breaks were severe for France and Finland. For both countries, we had to split the sample period in 1990 quarter 2. In the following sections, Finland1 (France1) refer to results of the first estimation period and Finland2 (France2) denote the results when utilising the remaining period. An apparent break in the Belgian time series necessitated shortening the sample to 1994 quarter 2.2 The determination of the lag length of the UVAR is always problematic. Additional lags increase the number of estimable parameters exponentially, while the presence of serial correlation affects the cointegration tests. In this study, the lag length was determined on the basis that the errors are Gaussian. Since most M3 and GDP are trended, a deterministic trend which was signifi-

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cant in all UVARs is included. Furthermore, in order to obtain residual normality, impulse dummies are included where necessary.3 For Germany, there is an obvious shift in GDP and M3 due to German Monetary Union (GMU). The empirical literature is controversial with respect to how to capture this shift. Wolters, Terasvirta and Lutkepohl (1998) use a step and an impulse dummy, where the former enters the cointegration relationship restricted. In contrast, Beyer (1998) stresses that unification has not substantially destabilised the demand for M3. In his analysis, the break for unification is captured by an impulse dummy, thus indicating only a temporary structural break. We experimented with both step and impulse dummies and found that the impulse dummy for 1990 quarter 3 was sufficient to account for the break. In the empirical analysis we found that for all countries the inclusion of the inflation rate prevented us from deriving sensible economic relationships amongst this set of variables. This result is in line with Juselius (1996) for Germany and Clausen (1998) for a group of European countries. Tables 5.A2a and 5.A2b, in Appendix 5.2, are based on the UVAR as described in equation (5.2), except for the rate of inflation. They present the results of the multivariate (Table 5.A2a) and univariate (Table 5.A2b) misspecification tests. The results clearly indicate that we have statistically well-specified models for all countries. The multivariate and univariate diagnostic tests for autocorrelation, heteroscedasticity and normality are insignificant for all countries except for Belgium and Germany. For Germany, there is some minor indication of residual normality, in the money and income relationships. There may be small serial correlation problems in the case of Belgium. The UVAR models are the basis for the subsequent cointegration analysis. 5.3.2 Cointegration The UVAR is reformulated as a reduced-form VECM: ∆zt =

p −1

∑ Γi ∆zt −i + Πzt −1 + ΦDt + µ + ε t

(5.4)

i =1

When the series are cointegrated Π will have reduced rank and can be decomposed into two matrices α and β' as follows: ∆zt =

p −1

∑ Γi ∆zt −i + αβ' zt −1 + ΦDt + µ + ε t i =1

(5.5)

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where β'yt is the matrix of cointegrating vectors and α is a matrix of loading vectors showing how each deviation from the equilibrium affects other variables. For all countries, a deterministic trend and an intercept were included. The latter enters unrestrictedly, while the former is restricted to lie in the cointegration space.4 The results of the cointegration tests are presented in Table 5.1. For Austria, Belgium, Finland2, France2, Germany, Ireland, Italy, the Netherlands, Portugal and Spain the likelihood ratio tests for cointegration suggest one cointegration vector at most, although for France2, the maximal eigenvalue test indicates the possibility of a second cointegration relation. We pursued this possibility (particularly because of the results for France,), but it was not possible to identify empirically the second cointegration relationship. For Germany, the case is different in that there is only evidence of one cointegration vector on the basis of the trace test. Table 5.A2b shows that there is a (minor) problem with normality in two equations for Germany. Monte Carlo results show that the trace test is more robust in the presence of both excess kurtosis and skewness than the maximal eigenvalue test (Cheung and Lai, 1993). We proceed for Germany on the basis of one cointegration vector. For the first periods in Finland and France, there is clear evidence of two cointegration vectors. For Luxembourg, the maximal eigenvalue and the trace statistic are significant at the 10 per cent level. We proceed on the basis of one cointegration relation for Luxembourg. For Finland1 and France1, the identification process for the two vectors may now be explained. We started by normalising for income, explained by interest rates and a deterministic trend, which may be interpreted as a modified IS relationship when the coefficient of the interest rate is less than zero (Juselius, 1996). This restriction was rejected for both countries. In the case of France1, the test of stationarity of the interest rate spread was also rejected. The reported second cointegration vector in Table 5.2 for Finland and France, is like an ‘excess demand’ equation with the deviation of output from trend having a positive long-run relation to money. Taken together, the results of Finland1/Finland2 and France1/France2 indicate that the causality between M3 and GDP may very well be bidirectional, although to establish this proposition satisfactorily further tests are required – a task which is beyond the scope of this chapter. Identifying and over-identifying restrictions on the cointegration vectors show conventional long-run money demand relations for Belgium, Finland1, France1, France2, Germany, Italy, Portugal and Spain which for ease of expression we summarise in group 1. For all countries in group 1, the coefficients in the money demand relations are correctly signed and statistically significant. In group 1 countries, interest rates play a significant role in the long-run demand for money equations. Only for France could we find a significant effect of the own rate on broad money demand, which could be restricted to a

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Table 5.1 Cointegration tests Country

Ho

LR (r, r + 1)

Austria

r=0 r≤1 r=0 r≤1 r≤2 r=0 r≤1 r≤2 r=0 r≤1 r≤2 r=0 r≤1 r≤2 r≤3 r=0 r≤1 r≤2 r=0 r≤1 r≤2 r=0 r≤1 r=0 r ≤1 r≤2 r=0 r≤1 r=0 r≤1 r=0 r≤1 r≤2 r=0 r≤1 r≤2

22.95* 5.292 40.23** 15.17 4.355 36.4** 24.53** 8.713 36.92** 8.901 5.483 47.46** 31.24** 18.6 9.384 26.79* 20.67* 4.125 24.15 16.43 2.427 29.14** 8.241 26.69* 14.95 0.8884 18.49 [19] 6.579 22.08* 1.981 38.5** 18.03 14.86 80.34** 14.96 6.42

Belgium

Finland1 Finland2 France1

France2 Germany

Ireland Italy

Luxembourg Netherlands Portugal

Spain

LR (r, N) 28.24* 5.292 59.75** 19.52 4.355 69.65** 33.25** 8.713 51.31** 14.39 5.486 106.7** 59.23** 27.99* 9.384 51.59** 24.79 4.125 43.01* 18.86 2.427 37.38** 8.241 42.53* 15.84 0.8884 25.07 [25.3] 6.576 25.07 1.981 74.86** 36.36 18.33 101.7** 21.38 6.42

Notes: * significant at the 5 per cent level; ** significant at the 1 per cent level; square brackets contain 5 per cent critical values; LR (r, r + 1) for the max eigenvalue statistic; LR (r, N) for the trace statistic.

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Table 5.2 Cointegration vectors Austria:

(m – p)

=

y

Belgium:

(m – p)

=

Finland1:

(m – p)

=

4.86y (0.63) y

y

=

Finland2:

(m – p)

=

0.13(m – p) (0.03) y

France1:

(m – p)

=

y

y

=

France2:

(m – p)

=

0.58(m – p) (0.04) y

Germany:

(m – p)

=

Ireland:

(m – p)

Italy:

– –

7.62rs (1.35) 2.19rs (0.42)

– + +

–

0.00rs (n/a) 1.59r1 (0.34)

– + 4.59own (0.80)

+ +

+ 1.87sp1 (0.62) –

=

1.29y (0.02) y

(m – p)

=

y

–

Luxembourg: (m – p)

=

Netherlands: (m – p)

=

6.61y (1.19) y

Portugal:

(m – p)

=

y

Spain:

(m – p)

=

y

–

1.09rs (0.17) – 2.12rs (0.38)

– – +

–

1.77r1 (0.21)

– + 5.86sps (0.60)

+

0.00t (n/a) 0.02 (0.00) 0.01t (0.001) 0.01t (0.001) 0.02t (0.003) 0.004t (0.001) 0.002t (0.00) 0.01t (0.001) 0.00t (n/a) 0.05t (0.01) 0.01t (0.00) 0.06t (0.02) 0.001t (0.003) 0.002t (0.000) 0.004t (0.000)

spread (sp1) between the own and the long-run rate in the case of France2. In the Spanish money demand relationship, the interest rate spread (sps), defined as the difference between the own and the short-run interest rates, also plays a significant role. The semi-elasticities of the short-run (rs) and long-run (r1) rates vary considerably between the countries in this group. For example, the German semi-elasticity is slightly less than half of that in Italy, and one-seventh of that in Belgium. These differences in elasticities probably reflect differences in the degree of sophistication of the banking systems in the countries examined. For all countries in this group, except for Belgium and Germany, we find that trend adjusted velocity is cointegrated with interest rates.5 The results reported in Table 5.2 show that the homogeneity restriction cannot be accepted in either Belgium or Germany. This is actually a common result for Germany and con-

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ventionally attributed to omitted variables, typically to the omitted wealth effect (Browne, Fagan and Henry, 1997). The second group of countries comprises Austria, Ireland, Finland2 and the Netherlands, where trend adjusted velocity is stationary.6 Since the interest rate variables are integrated of order one, velocity and interest rates cannot cointegrate. Furthermore, since there is only one cointegration relation, interest rates do not cointegrate with each other. In fact, the data accept the overidentifying restrictions. Furthermore, weak exogeneity tests for all countries in the second group suggest that money is weakly exogenous. Luxembourg belongs to group 2 in that money demand is interest insensitive. However, the high income elasticity prevents a restriction to trend-adjusted velocity in that country. This interest rate insensitivity of the demand for money implies, of course, that central banks in Finland during the 1990s and in Austria, Ireland, Luxembourg and the Netherlands over the whole period, were able to exert a more powerful impact on the economy than otherwise through money supply changes. The further implication in terms of the EMU membership of these countries is that variations in the ECB interest rate would hardly affect the demand for money, thus potentially imposing serious constraints on the conduct of monetary policy in the case of these countries. The stability tests of the cointegration relations were carried out and the detailed results are available on request. The recursive eigenvalues (after partialling out the full-sample short-run dynamics) are relatively constant for all cointegration vectors. Over time, the eigenvalues are well above zero, thus confirming the main results of the cointegration tests. The stability of the eigenvalues is a necessary condition for these vectors to be interpretable as structural relationships. The sufficient condition is, of course, their empirical performance which is satisfactory. 5.3.3 Dynamic Modelling We turn to the discussion of the dynamic relationships. In contrast to the structural identification of the long-run economic relationships, economic theory is generally vague on the short-run structure. Since we do not have any strong prior hypotheses about identifying restrictions such as zeros or other linear restrictions on the short-run structure, the procedure that was adopted in the present analysis is to find a statistically well-defined dynamic model that provides plausible estimates of the short-run structure. By this we mean that the signs and, where possible, the size of the derivatives are plausible. Above all, we are concerned with plausible estimates of the error correction terms with respect to the identified long-run relationships. This is particularly pertinent in

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view of the fact that the adjustment coefficients relate the short-run structure with that of the long-run. The dynamic analysis begins with the short-run unrestricted reduced form model in which the cointegrated relations are fixed. Typically the unrestricted reduced form is overparameterised, including many insignificant coefficients. In a stepwise procedure, this general model was reduced to a PVECM that was data congruent and encompassed previous models. From weak exogeneity tests in the cointegration analysis, backed up by tests of the significance of the error correction term(s) in dynamic equations, a conditional PVECM was derived. Large correlations in the correlation matrix of the conditional models indicate that there are simultaneous effects between error correction models so that endogenous variables were included as additional right-hand-side variables. The estimates of the conditioned dynamic models and their likelihood ratio tests with k-overidentifying restrictions are shown in Table 5.3.7 These tests give strong support for the imposed restrictions. Furthermore, the usual diagnostic statistics do not indicate any serious specification problems.8 We find that for Finland1, France1, Germany and Portugal the interest rates representing opportunity costs are weakly exogenous, while for Belgium and Italy the short-run interest is endogenous and we could condition on GDP. For France2 and Germany, the interest rate spread and GDP growth are endogenous, while for Spain the spread is endogenous. Table 5.3 Dynamic models Belgium ∆(m – p)t

∆rs(t)

Variable

Coefficient

t-value

∆rs(t–1) ECM(t–1) ∆yt ∆yt–1 ∆yt–5 Const

0.372 –0.103 1.058 –2.608 –1.374 –9.742

2.17 –5.06 2.50 –5.13 –3.34 5.06

Standard error = 0.0103661 Test of Overidentifying Restrictions Chi2(9) = 16.115 [0.065]

Variable ∆rs(t–1) ∆rs(t–2) ∆rs(t–4) ∆rs(t–5) ECM(t–1) ∆yt–3 Const

Coefficient 0.150 0.217 0.186 0.170 –0.066 –1.183 –6.234

t-value 1.22 1.75 1.66 1.44 –5.21 –3.73 –5.22

Standard error = 0.00826341

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Finland1 ∆(m – p)t Variable

Coefficient

∆yt t-value

Variable

∆(m – p)t–2 –0.283 –2.73 –2.39 ∆(m – p)t–3 –0.304 ∆(m – p)t–4 –0.448 –3.53 0.770 2.56 ∆yt 0.420 2.09 ∆yt–1 ECMm(t–1) –0.307 –5.08 –0.607 –2.51 ∆rs(t) Const –0.244 –4.82 0.043 3.58 D85Q4 0.045 3.05 D88Q4 0.006 0.49 D83Q2 Standard error = 0.0112074

Coefficient

t-value

∆(m – p)t–1 –0.178 –2.28 ∆(m – p)t–2 –0.155 –1.81 ECMy(t–1) –0.830 –5.72 ECMm(t–1) 0.163 3.52 Const 16.187 5.72 D85Q4 0.007 0.75 D88Q4 0.011 0.99 0.006 0.62 D83Q2 Standard error = 0.00957812

Test of Overidentifying Restrictions Chi2(5) = 4.499 [0.480] France1 ∆(m – p)t Variable

Coeff

t-value Variable

∆yt Coeff

∆ownt t-value Variable

∆(m – p)t–2 0.346 3.33 ECMy(t–1) –0.260 –4.51 ∆(m – p)t–5 0.417 3.84 Const 2.769 4.52 ∆(y)t–3 0.684 3.64 Standard error = 0.00496801 ∆ownt–5 –0.790 –2.49 ECMm(t–1) –0.129 –3.02 ∆r1(t) 0.650 3.01 ∆r1(t–1) 0.488 1.82 Const –0.079 –2.98 Standard error = 0.00648772 Test of Overidentifying Restrictions Chi2 (13) = 12.812 [0.462]

Coeff t-value

∆yt –0.416 –2.30 ownt–5 –0.138 –0.83 ECMm(t–1) 0.0681 3.79 Const 0.0431 3.70 Standard error = 0.0033742

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France2 ∆(m – p)t

∆sp1(t)

Variable Coefficient t-value 0.303 2.13 ∆(m – p)t–1 0.190 1.31 ∆(m – p)t–2 0.749 1.79 ∆sp1(t–2) –0.201 –2.40 ECMt–1 –0.755 –2.13 ∆yt 1.06 2.79 ∆yt–2 Const 0.004 1.09 Standard Error = 0.00849008

Variable Coefficient t-value ECMt–1 0.078 3.03 Const –0.001 –1.37 ∆sp1(t–2) 0.176 1.19 Standard Error = 0.00356057

Test of Overidentifying Restrictions Chi2 (8) = 5.926 [0.656] Germany ∆(m – p)t

∆yt

Variable Coefficient t-value –0.088 –2.36 ECMt–4 –0.545 –2.98 ∆rs(t–1) Const –0.659 –2.33 0.145 16.32 D90Q3 –0.041 –4.71 D97Q2 0.0456 5.17 D97Q3 Standard error = 0.0087911

Variable Coefficient t-value ∆(m – p)t–2 0.362 5.81 ∆yt–4 0.251 3.18 0.171 3.57 ECMt–1 ∆rs(t) 0.409 1.91 Const 1.299 3.57 D90Q3 0.015 1.52 –0.004 –0.39 D97Q2 0.0004 0.04 D97Q3 Standard error = 0.00952559

Test of Overidentifying Restrictions Chi2(5) = 6.663 [0.573]

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Italy ∆(m – p)t

∆rs(t)

Variable Coefficient t-value ∆(m – p)t–4 0.349 2.95 ∆rs(t–1) –0.285 –1.58 ∆rs(t–2) –0.296 –1.79 ∆rs(t–3) –0.363 –2.21 ECMt–1 –0.152 –2.74 ∆yt –0.363 –1.58 ∆yt–1 –0.993 –3.17 Const 0.015 2.93 D92Q3 –0.004 –0.26 Standard error = 0.0143402

Variable Coefficient t-value ∆rs(t–1) 0.180 1.82 ECMt–1 –0.117 –4.07 Const 0.007 2.87 D92Q3 0.043 5.30 Standard error = 0.00793162

Test of Overidentifying Restrictions Chi2 (5) = 4.499 [0.480] Portugal ∆(m – p)t Variable Coefficient ∆(m – p)t–3 –0.303 ∆(m – p)t–4 0.228 ∆(m – p)t–5 –0.317 ∆r1(t) –0.738 ∆r1(t–1) –0.666 ∆r1(t–2) 0.921 ∆r1(t–4) –0.723 ∆sp1(t–2) 0.846 ∆sp1(t–3) 0.535 ECMt–1 –0.268 D85Q3 0.078 Const 0.006 Standard Error = 0.0202159 Test of Restrictions (Against General Dynamic Model) F(14,40) = 1.005 [0.467]

t-value –3.21 2.54 –3.27 –2.37 –2.21 2.05 –2.44 2.18 1.93 –4.50 3.50 2.045

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Spain ∆(m – p)t Variable Coefficient t-value ECMt–3 –0.039 –2.32 Const –0.008 –1.36 ∆yt 0.665 3.04 Cseason1 –0.024 –7.54 Cseason2 –0.021 –6.68 Cseason –0.053 –17.00 D82Q4 –0.008 –0.78 D82Q2 0.003 0.33 Standard error = 0.0092872

∆sps(t) Variable Coefficient t-value ∆sps(t–1) 0.236 2.99 ∆sps(t–2) 0.387 5.31 ∆sps(t–3) 0.292 5.04 ECMt–1 0.140 10.97 Const 0.042 10.23 ∆yt –0.357 –2.79 ∆yt–3 0.654 5.22 Cseason1 –0.000 –0.04 Cseason2 0.001 0.65 Cseason –0.003 –1.49 D82Q4 –0.047 –9.14 D82Q2 –0.024 –4.72 Standard error = 0.00476395

Test of Overidentifying Restrictions Chi2 (6) = 5.750 [0.452] We begin with the discussion and the comparison of the dynamic demand for money equations across the seven countries. The error correction terms in the money demand equations are all significant and correctly signed. The adjustment process in response to a disequilibrium error varies in the six countries quite significantly, where Spain has the lowest rate of adjustment. Full adjustment is achieved after around one year in Italy, France and Portugal, after about two years in Belgium and Finland1 and after three years in Germany. In the short-run money demand growth equation for Finland1, there is evidence that the excess of income growth over money demand growth in previous periods has a positive effect on the short-run demand for money. The effect of the interest rate on money demand growth is, as expected, negative. A significant interest effect of the same direction was also found for Italy and Germany. In the period from 1979 until 1990, French interest rate effects on money demand growth show that during this period of rapid financial innovation economic agents experienced a learning process, which seems to have come to an end during the second period. Furthermore, in Italy and France, there is evidence of inertia in the money demand growth equation. While in France and Germany the growth of income has the same effect as in the long-run relationship, there is in Italy a negative coefficient on income growth with respect to money. This result is consistent with precautionary and buffer stock theories of money demand (see for an overview Milbourne, 1988). Although these models

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predict that in the long-run target real balances increase with income, they allow for a negative relationship between money and economic activity in the shortrun, so that changes in GDP are partly financed by running down M3 balances. We turn to the equations for changes in interest rates and income growth. These relationships are potentially useful for economic investigation in that we may identify an economic structure in a well-defined statistical system. However, since the set of variables used in the system is broadly insufficient to model these variables, we can only give indicative interpretations, which are mainly related to the effects of the disequilibrium errors from the long-run relationships. We start with the discussion of the interest equations for Belgium, Italy, France and Spain. These interest rate equations show inertia and are significantly explained by the error correction term from the money demand equation. When economic agents hold money in excess of the equilibrium position described by the cointegration relationship, they will tend to use the excess holding of money to buy other assets as, for example, bonds or goods and services, or pay off loans. As a consequence, the price for bonds will rise, which implies a fall in the short-run interest rate. This is the mechanism suggested by the interest rate equation for Belgium, Italy and Spain. For the first period, the French equation describes the change in the deposit rate, which is explained by a significant positive error correction term from the long-run money demand relationship. This effect may be explained by economic agents’ tendencies to reduce excess holdings of money by buying other financial assets. Since banks are concerned to attract deposits, the deposit rate will rise. For the second period, the change in the French interest rate spread depends positively on the equilibrium error derived from the cointegrated money demand relationship. Similar to the discussion of the Italian and the France1 cases, excess holdings of money motivates economic agents to buy bonds and banks to offer higher deposit rates. As a consequence, the absolute spread between the deposit and the long-term interest rates narrows. The income growth equations for Germany and Finland1 relate the monetary and the real sector through the disequilibrium error in the money demand function, where an excess of money holding is transferred into growth in GDP. This effect is reinforced by a lagged effect of monetary expansion on income growth in the German case. Although these equations are statistically satisfactory, their economic interpretation is limited which may be due to missing variables as, for example, the terms of trade.

5.4 SUMMARY AND CONCLUSIONS The main interest of this chapter is to investigate the nature of money demand functions for the eleven EMU member countries. We chose a data set and estimation period that was comparable for all countries.

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A possible common empirical regularity in the long-run money demand determination in these eleven EMU countries is that there is an income elasticity of one (except for Germany, Belgium and Luxembourg). A further result is that interest rate variables are important long-run determinants of money demand in EMU countries. The exceptions are the cases of Austria, the Netherlands, Finland2, Ireland and Luxembourg for which we find interest inelastic demand functions. For those periods and countries where the demand for money is interest elastic, the semi-elasticity coefficients vary extensively. The short-run adjustment mechanisms also vary widely amongst countries. These differences in the estimated demand for money functions amongst the EMU member countries contain certain interesting implications. The first is that aggregation problems assume particular significance when aggregate money demand relationships are estimated at the European level. The second is that the differences in the interest rate semi-elasticities amongst the EMU countries pose serious problems in the conduct of the ECB common monetary policy. This problem is particularly prevalent in those countries where no interest elasticity in the respective demand for money relationship was found. On a priori grounds, the one club policy approach currently implemented could potentially produce serious discrepancies in economic performance amongst the EMU member states.

NOTES 1. We are also grateful to Peter Howells and Marco Barassi for helpful comments on a draft of this chapter. Any remaining errors are, of course, our responsibility. 2. See Appendix 5.1 for a full explanation of breaks. 3. See Appendix 5.1 for full details and justification of the inclusion of dummy variables in the individual equations. 4. Note that Dt in equations (5.4) and (5.5), in contrast to equation (5.3), is a vector of dummies, only. 5. The likelihood ratio tests on the reported cointegrating vectors are Chi2(1) = 0. 118 [0.731] for France2, Chi2(1) = 2.180 [0.140] for Italy, and Chi2(5) = 9.378 [0.095] for Portugal. 6. The likelihood ratio tests on the reported cointegrating vectors are Chi2(2) = 5.853 [0.0536] for Finland2, Chi2(2) = 3.340 [0.188] for Austria, Chi2(1) = 1.547 [0.2135] for Ireland, and Chi2(1) = 3.382 [0.066] for the Netherlands. 7. These estimations utilised the used two stage least squares technique. 8. The diagnostic tests are reported in Appendix 5.2. The graphs of recursive Chow tests are available on request. Three types of Chow tests are available: conventional one-step tests (where the null hypothesis is constant parameters); forecast F-tests which are Chow-type tests having an increasing forecast horizon; and break-point F-tests which have a decreasing forecast horizon.

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APPENDIX 5.A1: DATA AND DUMMY VARIABLES Sources of Data: Two main sources were used: the IFS CD-ROM and the MIMAS online database. All interest rate data (short-term, long-term and own) were taken from the IFS CD-ROM with the exception of the own rate measures for Italy and Spain, which were taken from the MIMAS online database (the short-run interest rate for Luxembourg was proxied by the corresponding Belgian rate). All data for M3, GDP and the GDP deflator were taken from the MIMAS online database with the exceptions of the GDP and GDP deflator figures for Germany, Ireland, Portugal and Belgium. For Germany these are from the IFS CD-ROM. For Belgium, Ireland and Spain they are from OECD Main Economic Indicators. Definitions of Data: The ‘short-run interest rate’ is the call money rate for France, Germany, Spain, Ireland, Belgium, Austria and the Netherlands; the money market rate for Italy; the discount rate (end of period) for Portugal; and the average cost of Central Bank debt for Finland. The ‘long-term interest rate’ is the government bond yield for France, Germany, Austria, Belgium, Ireland, Portugal, Spain and the Netherlands; the government bond yield long-term for Italy; and average bank lending for Finland. The ‘own rate’ is the deposit rate for the Netherlands, Belgium and France; the 24-month deposit rate for Finland; the 3-month deposit rate under 1m for Germany; the 3-month interbank loans/Quantum for Spain; the minimum time deposit rate for Portugal; ordinary savings for Austria; Deposits 5000–25000 ASS.BANKS for Ireland; and interbank deposits (3-month)/Quantum for Italy. For all countries the price index used is the GDP deflator. This is seasonally adjusted (using the moving average method in the cases of Belgium, Ireland, Netherlands, Portugal and Spain) for all countries except Austria. GDP and M3 are also seasonally adjusted for all countries. Time Period for Data: All data series start at 1979q1 with the exception (due to unavailability) of the own rate series for Finland and the Netherlands which both start at 1981q1. All series end at 1998q3 with the exceptions of the Finnish short-run interest rate and the German, Belgian, Portuguese GDP and GDP deflator series. These end at 1998q2 for Germany, 1996q4 for Belgium and Luxembourg, and 1997q4 for Ireland and Portugal. Also, the money series for Portugal, Ireland and Belgium end at 1996q4. Structural breaks: The marked break in the French M3 time series – a visible shift to a lower trend gradient – starting from 1990q2 coincides with similar, though less exaggerated, shifts of M3 for the majority of countries under study in 1990–91. This reflects the effects of financial deregulation in preparation

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for the single market. The French reform of monetary aggregates in October 1990 indicates the particularly severe distortions arising from financial innovations in France. For Finland, the collapse of the Soviet Union – an important Finnish trading partner – exacerbated the effects of financial deregulation as indicated by the very marked break in Finnish GDP, also from 1990q2. Unsurprisingly, no plausible results obtain over the full sample period for either France or Finland. Accordingly, both the French and Finnish samples were split at 1990q2 and estimated separately. The Belgian M3 series displays a clearly visible break: from a steady upward trend it falls dramatically from a peak in mid-1994 and does not return to this peak level. This movement may reflect the highly deregulated nature of the Belgian capital markets, by 1994, coupled with the volatile capital movements of the period. The sample was shortened to end at 1994q2. Dummy Variables: Centred seasonal dummies were used for Austria, where the data were not seasonally adjusted. The seasonal adjustment procedure was found not to have removed seasonality in the Dutch and Spanish money aggregates; hence centred seasonal dummies were used for these countries also (highly significant in the money equation). The Austrian dummy for 1987q1 coincides with a temporary hike in interest rates in that period following massive inflows of foreign capital, only partly sterilised, in the second half of 1986. The Spanish dummy of 1987q2 is necessary for a well-specified VAR but insignificant in the final model. The relatively small but significant dummy of 1982q2 (-0.024, t-value = –4.72) and the larger dummy of 1982q4 (–0.046, t-value = –9.14) coincide with efforts to relieve a period of intense pressure from rising inflation and a deteriorating current external balance. These efforts culminated in the 8 per cent devaluation of the peseta in December 1982. The Finnish dummy for 1983q2, though necessary for a well-specified UVAR, is insignificant in the final model. The 1985q4 and 1988q4 dummies are both statistically significant in the money equation (with respective t-values of 3.58 and 3.05) but relatively small in magnitude (0.043 and 0.045). The former (1985q4) may be an effect of anticipation of Finland becoming a full member of EFTA on 1 January 1986. The latter (1988q4) may be due to an influx of capital from abroad as foreign exchange regulations were relaxed in July 1988. In the case of Germany, German Monetary Union is captured by an impulse dummy for 1990q3. The dummy for 1981q1 is significant only for the UVAR and is dropped from the short-run modelling. Heavy investment in foreign securities explains the negative and significant effect of the 1997q2 dummy in the money equation; the reverse sign on the next quarter’s dummy (1997q3), reflects the ‘flight to quality’ in the wake of the Asian crisis. The positively signed Portuguese dummy of 1985q3 may be due to problems of classification of emigrant’s savings and to restrictions on bank deposits. The Dutch dummy of

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1982q4 reflects the unusually robust measures taken to keep the strong guilder within its EMS band (culminating in the March 1983 realignment). During the ERM crisis in September 1992, the Italian lira depreciated and Italy temporarily left the ERM, which is accounted for by a dummy for 1992q3.

APPENDIX 5.A2d: DIAGNOSTIC TESTS1 Unrestricted Vector Autoregressions Table 5.A2a Multivariate tests Country

Autocorrelation

Austria

F(20,94) = 1.6211 [0.0635] Belgium F(36,65) = 1.9171 [0.0112]** Finland1 F(27,15) = 0.3063 [0.9964] Finland2 F(27,53) = 1.0202 [0.4618] France1 F(48,90) = 0.9117 [0.6319] France2 F(27,53) = 1.1703 [0.3059] Germany F(45,92) = 1.4014 [0.0871] Ireland F(20,120) = 0.9104 [0.5749] Italy F(45,116) = 0.8738 [0.6911] Luxembourg F(16,74) = 1.0633 [0.4046] Netherlands F(20,100) = 1.1947 [0.2749] Portugal F(80,65) = 1.2543 [0.1728] Spain F(45,113) = 1.1823 [0.2379]

Notes: * Significant at the 5% level; ** Significant at the 1% level.

Normality

Heteroscedasticity

Chi2 (4) = 3.5791 [0.4660] Chi2 (6) = 4.1673 [0.6540] Chi2 (6) = 6.1911 [0.4021] Chi2 (6) = 8.0273 [0.2361] Chi2 (8) = 3.3547 [0.9102] Chi2 (6) = 6.6859 [0.3509] Chi2 (6) = 14.158 [0.0279]* Chi2 (4) = 1.7559 [0.7805] Chi2 (6) = 4.102 [0.6629] Chi2 (4) = 1.6665 [0.7968] Chi2 (4) = 2.055 [0.7256] Chi2 (8) = 12.331 [0.1370] Chi2 (6) = 7.4388 [0.2833]

F(66,99) = 0.6910 [0.9452]

F(48,77)= 1.0022 [0.4886] F(100,140)= 1.0027 [0.4901] F(48,77) = 0.7607 [0.8449] F(228,32) = 0.1867 [1.000] F(18,175) = 0.8198 [0.6753] F(192,114) = 0.4662 [1.000] F(102,27) = 0.2275 [1.0000] F(54,120) = 0.7191 [0.9128]

F(156,142) = 0.8145 [0.8948]

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Table 5.A2b Univariate tests

Austria: (m – p) y Belgium: (m – p) y rs Finland1: (m – p) y rs Finland2: (m – p) y rs France1: (m – p) y r1 own France2: (m – p) y sp1 Germany: (m – p) y rs Ireland: (m – p) y Italy: (m – p) y rs Luxembourg: (m – p) y Netherlands: (m – p) y Portugal: (m – p) y sp1 r1

Autocorrelation

Normality

F(5,53) 1.7119 [0.1479] 0.7368 [0.5992] F(4,32) 1.5872 [0.2016] 1,8272 [0.1479] 1.3623 [0.2689] F(3,13) 0.7721 [0.5300] 0.0094 [0.9987] 0.7861 [0.5228] F(3,26) 1.0491 [0.3875] 2.9693 [0.0503] 0.8924 [0.4582] F(3,35) 2.5406 [0.0722] 0.2343 [0.8719] 0.6545 [0.5855] 1.8785 [0.1512] F(3,26) 0.1669 [0.9177] 0.8046 [0.5027] 1.6615 [0.1997] F(5,43) 1.5732 [0.1880] 1.6523 [0.1668] 1.7570 [0.1422] F(5,66) 2.0386 [0.0845] 1.1048 [0.3664] F(5,51) 1.3256 [0.2683] 1.8253 [0.1245] 0.6441 [0.6671] F(4,42) 1.4034 [0.2494] 1.9510 [0.1197] F(5,56) 2.2982 [0.0571] 1.2432 [0.3014] F(5,34) 1.5528 [0.1999] 0.7590 [0.5856] 2.3767 [0.0594] 2.5526 [0.0458]*

Chi2 (2) 2.0809 [0.3533] 2.3405 [0.3103] Chi2 (2) 2.2993 [0.3168] 1.7139 [0.4245] 0.0062 [0.9969] Chi2 (2) 5.7578 [0.0562] 0.4252 [0.8085] 1.8264 [0.4012] Chi2 (2) 2.2476 [0.3250] 1.9662 [0.3742] 5.7863 [0.0554] Chi2 (2) 0.4835 [0.7852] 1.2949 [0.5234] 0.3934 [0.8215] 0.4710 [0.7902] Chi2 (2) 0.0687 [0.9662] 2.8602 [0.2393] 1.5724 [0.4556] Chi2 (2) 8.1708 [0.0168]* 6.2637 [0.0436]* 1.5322 [0.4648] Chi2 (2) 0.7194 [0.6979] 0.9224 [0.6305] Chi2 (2) 0.3096 [0.8566] 1.0446 [0.5931] 2.3682 [0.3060] Chi2 (2) 1.8600 [0.3946] 0.2819 [0.8685] Chi2 (2) 2.4097 [0.2997] 0.8373 [0.6579] Chi2 (2) 4.7168 [0.0946] 1.0785 [0.5832] 0.2178 [0.8968] 2.6045 [0.2719]

ARCH

Heteroscedasticity

F(4,50) 0.8117 [0.5237] 1.0738 [0.3794] F(4,28) 1.1168 [0.3684] 0.2894 [0.8824] 1.2295 [0.3209] F(3,10) 0.0439 [0.9870] 0.0088 [0.9988] 0.5534 [0.6574] F(3,23) 1.7235 [0.1901] 0.9831 [0.4180] 1.8475 [0.1668] F(3,32) 0.2031 [0.8935] 0.9232 [0.4408] 0.1919 [0.9011] 1.8303 [0.1616] F(3,23) 0.9076 [0.4526] 1.3045 [0.2969] 0.3263 [0.8063] F(4,40) 0.5316 [0.7132] 0.3005 [0.8759] 0.1103 [0.9782] F(4,63) 1.5177 [0.2078] 0.4757 [0.7534] F(4,48) 0.9373 [0.4505] 0.1684 [0.9535] 2.8453 [0.0339]* F(4,38) 0.1320 [0.9697] 0.6884 [0.6045] F(4,53) 2.4278 [0.0591] 1.7121 [0.1611] F(4,31) 0.2713 [0.8942) 0.3660 [0.8309] 0.4865 [0.7455] 0.8226 [0.5208]

F(22,35) 0.6608 [0.8457] 1.2631 [0.2625]

F(8,20) 0.9611 [0.4921] 0.6604 [0.7194] 1.8048 [0.1356] F(3,32) 1.1277 [0.3787] 0.7089 [0.7085] 0.6261 [0.7785] 1.4832 [0.1995] F(8,20) 0.4745 [0.8598] 1.8028 [0.1360] 0.3457 [0.9368] F(38,9) 0.1721 [1.0000] 0.2156 [0.9996] 0.2956 [0.9961] F(6,64) 0.5944 [0.7337] 0.8118 [0.5647] F(32,23) 0.4379 [0.9844] 0.3886 [0.9931] 0.6428 [0.8776] F(34.11) 0.3471 [0.9912] 0.2385 [0.9994] F(18,42) 0.7410 [0.7507] 0.8908 [0.5917]

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Table 5.A2b (continued) Spain: (m – p) y sps

F(5,50) 2.3127 [0.0575] 1.3854 [0.2457] 0.7461 [0.5928]

Chi2 (2) 1.2345 [0.5394] 0.6046 [0.7391] 5.1942 [0.0797]

F(4,47) 0.5363 [0.7098] 0.2414 [0.9135] 0.0597 [0.9932]

F(26,28) 0.9880 [0.5105] 0.5186 [0.9519] 0.7244 [0.7943]

Note: Significant at the 5% level.

Table 5.A2c Dynamic models ∆(m – p)t

Belgium AR F(4,41) Norm Chi2 (2) ARCH F(4,37) Het F(20,24)

1.820 [0.143] 0.811 [0.667] 0.872 [0.490] 0.947 [0.545]

∆rs(t)

2.341 [0.071] AR F(16,82) 0.885 [0.588] 3.867 [0.145] Norm Chi2 (4) 4.718 [0.317] 0.233 [0.918] Het F(60,81) 1.210 [0.211] 1.731 [0.100]

∆(m – p)t

Finland1 AR F(3,24) Norm Chi2 (2) ARCH F(3,21) Het F(16,10)

Vector

∆yt

Vector

1.992 [0.142] 1.910 [0.155] AR F(12,46) 1.188 [0.320] 8.118 [0.017]* 0.849[0.654] Norm Chi2 (4) 7.306 [0.121] 0.537 [0.662] 0.912 [0.452] Het F(48,33) 0.636 [0.924] 0.866 [0.615] 0.449 [0.926]

Note: * Significant at the 5% level.

∆(m – p)t

France1 AR F(3,27) Norm Chi2 (2) ARCH F(3,24) Het F(16,13)

0.670 [0.578] 1.973 [0.378] 0.784 [0.515] 0.717 [0.739]

France2 AR F(3,22) Norm Chi2 (2) ARCH F(3,19) Het F(16,8)

∆yt

∆ownt

Vector

2.125 [0.120] 2.891 [0.054] AR F(27,70) 0.908 [0.599] 2.076 [0.354] 3.030 [0.220] Norm Chi2 (6) 7.843 [0.250] 0.612 [0.614] 0.381 [0.768] Het F(96,80) 1.388 [0.066] 0.453 [0.933] 1.633 [0.189]

∆(m – p)t

∆sp1(t)

Vector

3.914 [0.022]* 2.757 [0.067] AR F(12,44) 1.696 [0.101] 2.449 [0.294] 1.445 [0.485] Norm Chi2 (4) 4.209 [0.379] 0.909 [0.455] 0.327 [0.806] Het F(48,30) 0.582 [0.953] 0.301 [0.981] 0.763 [0.694]

Note: * Significant at the 5% level.

Monetary policy and implications for the euro

Germany AR F(5,56) Norm Chi2 (2) ARCH F(4,53) Het F(14,46)

Italy AR F(5,59) Norm Chi2 (2) ARCH F(4,56) Het F(14,49)

∆(m – p)t 1.502 [0.204] 4.627 [0.099] 0.844 [0.504] 0.350 [0.982] ∆(m – p)t 0.182 [0.968] 0.240 [0.887] 1.790 [0.144] 1.175 [0.323]

∆yt

105

Vector

1.863 [0.116] AR F(20,108) 1.279 [0.209] 2.790 [0.248] Norm Chi2 (4) 7.192 [0.126] 0.310 [0.870] Het F(42,143) 0.576 [0.980] 0.582 [0.865] ∆rs(t)

Vector

1.247 [0.299] AR F(20,112) 0.802 [0.706] 3.369 [0.186] Norm Chi2 (4) 4.546 [0.337] 2.693 [0.040]* Het F(42,149) 0.720 [0.892] 0.481 [0.933]

Note: * Significant at the 5% level.

Portugal AR F(5,49) ARCH F(4,46) Norm Chi2 (2) Het F(21,32) RESET F(1,53)

Spain AR F(5,57) Norm Chi2 (2) ARCH F(4,54) Het F(14,49)

0.798 [0.556] 0.575 [0.682] 0.574 [0.750] 0.331 [0.100] 0.314 [0.578] ∆(m – p)t 2.251 [0.052] 0.827 [0.661] 0.315 [0.866] 0.446 [0.949]

∆sps(t)

Vector

0.621 [0.684] AR F(20,108) 0.745 [0.771] 5.357 [0.069] Norm Chi2 (4) 6.354 [0.174] 0.542 [0.706] Het F(42,143) 0.676 [0.929] 0.419 [0.961]

NOTE 1. The single equation and multiple equation tests are those reported by PcFiml and described fully in Doornik and Hendry (1997). Single equation: the test for autocorrelation is an LM test based on a regression of the residuals on the original variables and lagged residuals; the autoregressive conditional heteroscedasticity test is an LM test based on a regression of the squared residuals against their lagged values and a constant; the normality test is that of Doornik and Hansen (1994); the heteroscedasticity test is White’s test based on a regression of the squared residuals on the original regressors and all their squares. Multiple equation: these are analogous tests for the system as a whole – see Doornik and Hendry (1997).

6. The causes of euro instability 6.1 INTRODUCTION The euro was formally launched in January 1999, and at the time of writing (November 2000) its value against the dollar is substantially below its initial level. There has been a general decline through the period, with a low reached in May 2000, and a further, all-time low reached in September 2000. Figure 6.1 provides the details. The purpose of this chapter is to examine the causes of this general decline in the value of the euro. The various explanations proffered in the literature are assessed. In the light of this assessment, the future prospects of the euro and of, more broadly, the eurozone are drawn out. The introduction of the euro and the associated operation of the European Central Bank (ECB) has been under considerable scrutiny which is reflected in a relatively large number of scholarly papers providing a detailed assessment of the performance of the euro, the ECB and of the EMU macroeconomy more generally (for a recent example see OECD, 2000). Although our assessment draws on these papers in a critical manner, we provide further explanations consonant with the analyses of the previous chapters. Section 6.2 reviews the decline in the value of the euro. Section 6.3 examines two explanations, and argues that neither mere ‘bad luck’, nor fundamentals such as interest rate differentials or measures of long-run equilibrium magnitudes explain the decline. The next two sections attempt to construct a more satisfactory explanation. In Section 6.4 the argument, prevalent in the literature, that the decline in value of the euro is due to ‘US strength’, rather than to any inherent difficulties with its imposition, is thought to be rather undeveloped. We suggest that US strength is an important but partial factor in euro decline. The other side of US strength is, we stress, eurozone weakness. Section 6.5 reviews the (poor) performance of the ECB and assesses the level of macroeconomic convergence of eurozone countries. The early indications are that the divergent state of the eurozone countries has not been reversed, indeed it may have worsened, since the inception of the euro. In the absence of monetary and fiscal coordination and of large-scale regional transfers, such divergence is a fundamental weakness in a single currency area. Yet, the institutions accompanying the euro preclude the coordination of macroeconomic policy and the magnitude of regional transfers within the eurozone is negligible. Thus, Section 6.6 concludes that a 106

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combination of eurozone weakness, endogenous to the inception of the euro, and of US strength, most plausibly explain the euro’s decline in value. Whilst the future value of the euro remains uncertain, the future prospects for the eurozone are bleak as long as the current institutions underpinning the euro remain in place, with the associated tendencies towards deflation.

6.2 THE DECLINE IN VALUE OF THE EURO Contrary to the predictions of its proponents, in the first two years of its existence the euro declined in value by over 25 per cent against the dollar (see Figure 6.1), 30 per cent against the yen and 13 per cent against pound sterling since its inception in January 1999. It declined by 20 per cent on the (narrow) ECB measure of its effective rate (ECB, 2000). Several possible explanations are reviewed and found wanting below. Before we embark upon them, we ask the question of whether the euro is in fact ‘undervalued’. The answer to the question whether the euro is undervalued requires some discussion of the notion of the ‘right’ value of the euro. We suggest two types 1.19 1.14 1.09 1.04 0.99 0.94 0.89

04/01/99 04/02/99 04/03/99 04/04/99 04/05/99 04/06/99 04/07/99 04/08/99 04/09/99 04/10/99 04/11/99 04/12/99 04/01/00 04/02/00 04/03/00 04/04/00 04/05/00 04/06/00 04/07/00 04/08/00 04/09/00

0.84

Source: Pacific Exchange Rate Service © 2000 Prof. Werner Antweiler. Time period: 4 Jan 1999–22 Sept 2000.

Figure 6.1 Daily exchange rates: US dollars per euro

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of benchmark are appropriate, namely the value of the currency which would correspond to a trade balance, and a purchasing power parity level. The eurozone maintains a trade surplus (in 2000, quarter 1, the surplus of exports over imports as a percentage of GDP was 2.1 per cent). On the face of it this would suggest that the euro is undervalued relative to the exchange rate which would generate a balance of trade. Chinn (2000), Coppel, Durand and Visco (2000) and Deutsche Bank Research (2000) provide some of the most recent attempts to gauge the ‘real’ value of the euro. Chinn (2000) estimates an econometric ‘monetary model’, augmented by the relative price of nontradeables, using the value of the synthetic euro; Coppel, Durand and Visco (2000) prefer more direct indexes of the real ‘long-run’ or ‘equilibrium’ effective exchange rates, such as relative unit labour costs, manufacturing prices and consumer prices and indicate that there has been a divergence between such indices and the movement of the exchange rate. Both papers also survey recent attempts to estimate the equilibrium exchange rate (see also the review of PricewaterhouseCoopers, 2000, chapter 3). The striking feature of their own, and other such, estimates is that the current level of the euro is, with few exceptions, found to be way below its supposed ‘real’ level by a magnitude of 15 per cent or more, no matter what method is employed. Thus Deutsche Bank Research (2000) show that the euro moved more than 15 per cent away from their PPP measure of the real exchange rate in late 1999 onwards. Consequently, Duisenberg’s comments, on announcing recent increases in euroland interest rates, that the euro is clearly undervalued,1 are well supported by the relevant empirical work. It would seem then that the current value of the euro cannot be explained by appeal to any notion of its ‘fundamental’ value, whether that value is deemed to be purchasing power parity, fundamental equilibrium exchange rate or similar. We now proceed to discuss a number of explanations of the fall in the value of the euro.

6.3 TWO INITIAL EXPLANATIONS A number of explanations of the fall in the value of the euro suggest themselves. This section deals with two initial ones which are the ‘just bad luck’ argument and interest rate differentials. We discuss both in this section and we find them not persuasive enough. We begin with the first. Just Bad Luck? It is widely recognised that a host of contingencies affect the short-run movements of the exchange rate, not least the vagaries of market sentiment.

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Thus it can be argued strongly that the fall in the value of the euro is simply ‘bad luck’ with little underlying significance. This point of view can be coupled with the argument that, in historical perspective, the decline is not dramatic and the current level is not unusually low (Buiter, 1999b; Coppel, Durand and Visco 2000; Corsetti and Pesenti 2000). It can start from the observation that the decline in the euro (say during the year of 1999) is not unprecedented. We have reported elsewhere (Arestis and Sawyer, 1996) that over the period 1980 to 1995 the average ratio of the maximum level of sterling relative to the mark to the minimum level during a year was 1.13, and the corresponding figure for the dollar relative to the yen was 1.17 (with a figure of 1.28 in 1985 and 1.30 in 1986). The pound, for example, fell by around 25 per cent from 1984 to 1985 and by roughly the same percentage in the winter of 1992–93; similar or greater volatility is displayed by other comparable exchange rate series. This lends some weight to the view of Favero et al. (2000) that ‘lamenting a weak euro is patently unjustified’. This can be further supported by the idea that the value of the euro was relatively high on its introduction. Hence a decline from a relatively high level may have been anticipated.2 The interesting question, though, is how should this fall, even if there are precedents for the extent of its fall, be interpreted. A first possibility is that this decline is indeed ‘bad luck’. We may bet on the toss of a coin, and let us say that tails represents a loss and heads a win. A string of tails arising from repeated tossing of a coin may represent ‘bad luck’ for us as the gambler but may not be unprecedented. If we regard the movement of the exchange rate as a ‘random’ event, then there will be ‘runs’ of generally negative movements in the exchange rate. However, although the decline in the euro is by no means unprecedented, many of the large movements in exchange rates do appear to have some underlying cause. For example, the rise and then fall of the dollar during the 1980s can be ascribed to tight monetary policies and then the impact of the Plaza agreement. A related possibility is that these declines in the value of the euro could be seen as an example of a self-perpetuating ‘bubble’ in financial markets in which expectations of price rises (falls) fuel those price rises (falls). A variant of the ‘bubble’ argument has been put forward recently by De Grauwe (2000). This contribution attempts to explain the apparent lack of a relationship between fundamentals and the falling euro by resorting to the uncertainty of the impact of fundamentals on the exchange rate and of the precise equilibrium value of the euro/dollar exchange rate. This uncertainty promotes ‘beliefs’ about the exchange rate which have nothing to do with fundamentals. Under these conditions exchange rate movements themselves become the focus and a signal to search for those fundamentals might explain the given exchange rate movement. So that when in early 1999 the euro began to fall against the dollar, it was interpreted as a signal that the US economy was strong and the eurozone

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weak. Given the conflicting evidence of underlying strengths and weaknesses, such search is normally successful. Those ‘beliefs’ have reinforced the euro fall since then. Nonetheless, treating the decline of the euro as a ‘bubble’ may still raise the question of the cause of the start of the ‘bubble’ even if there are mechanisms by which the ‘bubble’ is perpetuated. We would argue that the ‘bad luck’ argument captures an important but partial truth. The bulk of the literature is right to eschew the straightforward argument that the falling euro, per se, undermines the case of the euro’s proponents. However, it is also correct to stress that, if the proximate causes of exchange rate movements are the beliefs of market participants, and such beliefs have a random component, then, equally, beliefs are not purely contingent. Neither pure truth, nor pure whimsy, market beliefs do have some connection with economic reality. Thus, the historical and comparative precedents for the fall in the euro were not always a matter of ‘luck’. On the contrary, in many cases, they have an underlying economic logic, as suggested above. It is significant that proponents of the euro had predicted that its value would rise from January 1999 (Buiter 1999b admits that he was one such proponent). Such predictions stemmed not only from the relatively buoyant economic outlook at that time, but also from the view that the inception of the euro would contribute to the rosy economic future of the euro area. It is in this context that the decline in the value of the euro should be appraised. Whilst it is true that the decline provides prima facie evidence against proponents of the euro, it is the underlying causes of the decline that provide the critical evidence for any assessment of the exchange rate debate. If the decline in value is most plausibly attributed to a change in the economic conjuncture that is external to the euro’s inception, then the decline does not, after all, count against the euro. If, on the other hand, such external causes are not sufficient to explain the decline, then the spotlight must fall on factors endogenous to the euro and its accompanying institutions such as the European System of Central Banks (ESCB) and the Stability and Growth Pact. One obvious candidate for explaining the decline is considered next, followed by other explanations subsequently. Real Interest Rate Differentials The effects of interest rate differentials on the exchange rate appear at first sight paradoxical. A general presumption would be that raising the (domestic) interest rate would raise the exchange rate. The mechanism is quite simple: the higher interest rate makes acquiring financial assets in that currency more attractive, and wealth holders acquire the currency in order to be able to acquire the financial assets. But uncovered interest rate parity indicates that the nominal interest rate differential is equal to the expected decline in the exchange rate. Thus a high interest rate differential foretells a declining exchange rate. These

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two ideas can be reconciled with an argument which is reminiscent of the ‘overshooting’ theories. The immediate impact of an (unexpected) increase in the domestic interest rate is a sharp rise in the exchange rate, and the persistence of the interest rate differential is associated with a declining exchange rate. The extent of the initial rise in the exchange rate could be seen to depend on the expectations of the time period for which the interest rate differential persists. An interest rate differential of, say, 2 per cent expected to persist for five years would signify a cumulative decline in the exchange rate over those five years of just over 10 per cent. The measure of interest rate differential depends, not surprisingly, on the interest rate chosen for the comparison, and it cannot be assumed that the different interest rate differentials tell the same story. In terms of short-term interest rates, the differential between the US and the eurozone has been positive, fluctuating around 1.5 percentage points: the month-by-month movements in this differential are given in Figure 6.2a. But the differential in terms of long-term interest rates has generally been negative, particularly over the past 12 months, as shown in Figure 6.2b. Consequently, the picture over the sign and size of the interest rate differential between the US and the eurozone 2.5 2 1.5 1 0.5

Note: US–eurozone real 3-month money market rate differential. Source: ECB (2000).

Figure 6.2a US–eurozone real, short-term interest rate differential

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is a confused one. But the size of the differential is clearly not large enough to explain the rate of change of the value of the euro over this time period in terms of uncovered interest rate differentials. 0.4 0.2 0 –0.2 –0.4 –0.6 –0.8

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Note: US–eurozone real 10-year bond yield differential. Source: ECB (2000).

Figure 6.2b US–eurozone real, long-term interest rate differential With US interest rates moving roughly in parallel with euro rates, and inflation rates likewise moving in rough parallel, there has been little change in the real interest rate differential between the US and the eurozone since January 1999. This is true of both short-term (Figure 6.2a) and long-term real interest rates (Figure 6.2b). Thus, Gros et al. (2000) report that the clear negative correlation between long-term interest rates and exchange rate movements, empirically robust in the past (as confirmed also by Coppel, Durand and Visco, 2000), has broken down from mid-1999. In the case of Japan, the real long-term interest rate differential was at the same level in April 2000 as it was in January 1999, with a ‘hump shape’ in between. Real shortterm interest rates do drift against the eurozone during 1999 (from 2 per cent to below 0.5 per cent), but they drift in the opposite direction during 2000 (moving back up above 1 per cent), with no reversal in the exchange rate decline (ECB, 2000). Clearly, interest rate differentials do not explain the decline in the value of the euro.

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6.4 US STRENGTH There has been much focus on the euro:dollar exchange rate in general and in this chapter also. Clearly from that perspective the weakness of the euro can be treated as the other side of the coin of a strong dollar. The euro, however, has also declined against sterling and against the yen (reaching its lowest level in September 2000). In the case of sterling, the decline of the value of the euro has been less pronounced. It is also the case that many of the arguments which have been applied to explaining the weakness of the euro against the dollar can be carried over to explaining the weakness of the euro against sterling. The UK economy has experienced relatively strong growth and interest rates have been similar to American rates. Turning to the yen, its strength against the euro is more difficult to fit in with the explanations of the euro:dollar rate. The Japanese economy has experienced sluggish growth (and zero in the second half of 1999) and interest rates have been low – in fact zero for most of the period under scrutiny. Although the explanation of the relationship between the euro and the yen is not the focus of this chapter, these observations are relevant to the arguments advanced below. In this section we concentrate on explanations for the weakness of the euro by looking at the strength of the dollar and in turn we look at the perceived strengths of the US economy. Expected and Actual Growth Rate Differentials Eichengreen (2000), Buiter (1999b), Corsetti and Pesenti (1999, 2000), von Hagen (1999), Favero et al. (2000) Coppel, Durand and Visco, (2000), OECD (2000) and Deutsche Bank Research (2000) all point to the strong performance of the US (and the partial recovery of Japanese prospects) as being the fundamental cause of the decline in the value of euro. The continuing strength of the US in 1999 coincided with a rather slower growth than had been expected in the euro area during the first half of 1999. During the four quarters of 1999, US GDP growth rate was, expressed at an annual rate, 3.9 per cent, 3.8 per cent, 4.3 per cent and 4.6 per cent. The corresponding figures for the eurozone are 1.8 per cent, 2 per cent, 2.5 per cent and 3.1 per cent. In addition to the actual GDP figures, these authors offer striking graphical evidence (a graph first presented by Corsetti and Pesenti, 1999) for the ‘strong US’ explanation. A very close fit obtains between the graph of the daily dollar:euro exchange rate and the graph of the difference between consensus 1999 GDP growth projections for the euro area and the US. As can be seen (Figure 6.3), the fit holds very well through 1999 (the results of a similar exercise for the yen are almost as striking). Thus, it is argued, the ‘fundamentals’, as expressed in actual and/or expected growth rate differentials, explain the decline in the value of the euro. However, difficulties remain in explaining the precise significance of the graph

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Data Source: Consensus Economics, European Central Bank. (Reproduced from Corsetti, 2000. We would like to thank Professor Giancarlo Corsetti for permission to reproduce this Figure)

Figure 6.3 $/euro exchange rate and revisions to GDP growth forecasts

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for the decline in value of the euro. So much so that Corsetti (2000), the cooriginator of the graph, remarked recently that ‘to be honest, it is hard to find a convincing interpretation of the recent evolution of the euro’ (p. 2). The different interpretations will be scrutinised below. Eichengreen (2000) interprets the differing expected, and actual, growth rate performance as follows: ‘With demand growing relatively slowly and excess capacity pervasive in Europe, a weak Euro was the market’s way of pricing European goods into international markets. The same general explanation holds for the yen...’ (p. 2). Yet, Eichengreen offers no explanation as to why international currency markets should behave in the way he postulates. If trade in international goods is the key, then the eurozone’s trade surplus would lead to an appreciation rather than a depreciation of the euro. Buiter (1999b) provides a different interpretation. According to him, growth differentials affect the exchange rate through (1) money demand and (2) the anticipated future path of short-term interest rates. On the first one, Buiter does not spell out the mechanism he has in mind, but we would interpret it as follows. Given the amount of money in existence and the level of prices, an acceleration in the rate of growth causes an increase in the demand for money, which in turn causes interest rates to rise (so that interest rates in the US are expected to be higher than in the eurozone). However, this view relies on the money supply being regarded as exogenously given. In the (to our mind) more realistic case of endogenous money, an increased demand for money would lead to an increase in its stock without interest rates necessarily rising. On Buiter’s second point, interest rates may be anticipated to be higher in the future, but how does that lead to a rising exchange rate? In so far as financial assets are held in the form of bonds, then the anticipation of higher future interest rates is an anticipation of lower bond prices. Hence the anticipation of higher US interest rates would make US bonds less attractive now (than otherwise) and tend to generate a capital outflow rather than inflow. But financial assets may be held in the form of interest-bearing deposits. With low transactions costs, there is little reason to shift financial assets from one currency to another in this period for the prospects of higher future interest rates, but rather to shift when those higher interest rates materialise. Thus we are unconvinced that anticipated higher future interest rates can explain a rise in the value of the dollar (and hence decline in the value of the euro). In any case, and as noted above, it is clear that the actual interest rate differential has not moved substantially in favour of the US (see above, and Figures 6.2a and 6.2b) at any time since the inception of the euro, nor is it currently expected to do so in the future (for example, Deutsche Bank Research, 2000). Coppel, Durand and Visco, (2000) and Corsetti and Pesenti (1999) invoke the strong correlation of expected growth rate differentials and the dollar:euro exchange rate but they do not explain, in detail, just how the growth differential translates into a declining euro. Two explana-

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tions may be in order: (1) the vague notion of ‘market confidence’ whereby low growth prospects entails low ‘confidence’ and a movement of speculative capital to the strong US – a possible ‘self-fulfilling prophecy’; (2) the view that a relatively stagnant eurozone cannot match the prospective earnings potential of the buoyant US so that direct, and possibly portfolio, investment capital flows from the eurozone to the US. Despite being vague, these explanations tied in well only with the situation in the second half of 1999, when the decline in value of the euro appeared as little more than a reversal of a previous rise and when the recent growth performance of the euro was disappointing, especially relative to US strength. They have the effect of ‘absolving’ the euro, and its accompanying institutional structure, from blame, for they suggest that the decline in value is a purely cyclical phenomenon that will naturally reverse, in tandem with a future reversal of the relative cyclical positions of the US and the euro. Thus, by focusing upon the growth rate differential, it is possible to justify remaining sanguine about the fall in value of the euro. However, recent developments have served to cast doubt upon the cyclical explanation, and led to a search for a clearer articulation of the relation between the expected US–eurozone growth rate differential and the exchange rate. In fact, as noted above, the growth performance of the eurozone started to pick up in the second half of 1999 and has continued on this upward path in the first quarter of 2000 (growing at 3.4 per cent p.a.), and growth at over 3 per cent is forecast for the eurozone in 2001 (OECD, Economic Outlook, June 2000). Yet the value of the euro has not risen in tandem with the growth acceleration. On the contrary, it continued to decline and only began its (minor and short-lived) recovery in mid-May, which has been followed by severe falls again. At the time of writing it is over 25 per cent below its value at its inception. On the other hand, the US growth performance has matched the eurozone quarterly increases (growing at 5.1 per cent p.a. in 2000 quarter 1), so that the actual growth differential has remained relatively stable in the five quarters since the inception of the euro (Figure 6.4). The point we would stress is that the ‘cyclical’ explanation is more convincing when the eurozone is clearly sluggish, as was apparent in the first half of 1999. The subsequent pick up in the eurozone should, ceteris paribus, have led to profitable investment opportunities. There is no reason to suppose that the parallel growth increase in the US indicates a parallel increase in the earnings potential of direct investment. Indeed the cheap euro should have provided the eurozone with an advantage in this regard, now that the eurozone recovery is well under way (Gros et al., 2000). These considerations are all the more pertinent for the case of Japan, given its below zero growth in quarter 4 1999 (Figure 6.4). This may be one reason why, in the light of developments, Corsetti (2000) has considerably modified his explanation from that provided in Corsetti and Pesenti (1999). He now stresses that, ‘a growth-

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centered perspective of the euro-dollar exchange rate is far from being “cyclical”’ (p. 7). His more detailed explanations are considered next. 6 5 4

%pa

3 2 1 0 –1 99Q1

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US

Source: ECB (2000).

Figure 6.4

Eurozone, US and Japan growth rates

Corsetti (2000) shows that the consensus expected growth differential between the US and eurozone in 2000 has shown a similar pattern to 1999 (Figure 6.3). The relationship with the yen has broken down in 2000, however, confirming that the expected or actual growth differential cannot be the main explanation of the euro’s slide against the yen. If, given the argument of the above paragraph, Figure 6.3 cannot be interpreted to support a purely cyclical explanation of exchange rate decline, how, then, is it to be interpreted? Corsetti suggests that the high domestic US demand can explain the graph, and so the exchange rate movement. Because US domestic demand growth outstrips US output growth (US consumption demand grew by 7.5 per cent in the first quarter of 2000), Corsetti argues that domestic US producers will export less product abroad, in order to satisfy domestic demand. For such a relative fall in exports to occur, the real price of US goods vis-à-vis foreign goods needs to rise, in this view (causing non-US consumers to substitute towards non-US products from US products). This is no more than to say that the real exchange rate must appreciate. At the same time the current account will move (further) into deficit.

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By definition such an appreciation can occur through nominal exchange rate appreciation or through higher US inflation, or both. Thus, this explanation focuses entirely upon the US side, irrespective of the situation in the eurozone, and so, like the explanations considered above, it has the effect of ‘absolving the euro from blame’ (though the explanation may be complementary to, rather than excluding, explanations that focus on the eurozone). In itself, Corsetti’s theoretical argument is highly questionable. It relies upon the idea that US output is determined fully on the supply side, and that it will be sold domestically, until domestic demand is saturated. We would argue, however, that aggregate demand is a spur to the growth of output. Clearly, such growth has not (yet) increased exports of goods and services to, over imports from, the eurozone. It may be that such demand has, instead, ‘sucked in’ foreign direct investment. This would provide one alternative explanation for Corsetti’s (2000) graphs showing a strong and positive correlation between the exchange rate and both the expected US–eurozone consumption demand differential and the expected investment demand differential (though the strong association between growth expectations and demand expectations may, in any case, be a sufficient explanation). This alternative is focused upon below. Investment Flows Evidence on investment flows from the eurozone highlights their potential importance in explaining the decline in value of the euro against the dollar (see Table 6.1). Table 6.1 Investments in the eurozone and current account surplus (billions of euro) Direct investments Portfolio investments Current account surplus 1997 1998 1999

–48.1 –102.6 –147.3

–22.8 –85.3 –21.3

76.2 63.4 24.3

Source: ECB (2000).

Table 6.1 provides evidence that one proximate cause of the decline in the value of the euro is an outflow of direct and portfolio investment far in excess of the current account surplus (a number of recent publications concur with this view: Gros et al., 2000; PricewaterhouseCoopers, 2000; ABN-AMRO Bank, 2000). But what explains the net outflow of investment? A widely discussed possibility is that the outflow is due to the strong US equity market.

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However, as both Corsetti (2000) and Gros et al. (2000) note, the evidence from BIS (2000) is that ‘the appreciation of the dollar coincided with the sell off in the US equity market, defying the view that US stock prices drive the dollar’ (cited in Gros et. al., 2000, p. 51). The negative correlation has continued to the present. Moreover, the interest rate influence on the stock market and on the exchange rate provides the economic logic for such a correlation (an actual or expected interest rate increase could depress the stock market and raise the exchange rate simultaneously). Gros et al. (2000) note also that the net capital outflow cannot be explained by the selling of euro denominated equity by investors outside of the eurozone. The figures show that eurozone investors purchased (around 60 billion euros) more foreign-denominated equity than euro-denominated equity in 1999. Gros et al. (2000) suggest, therefore, that the outflow of capital might stem from a structural (the outflow started before the inception of the euro) economic imbalance of long-term investment capital, rather than from more speculative sources. They suggest that the latter type of explanation may explain the portfolio investment outflow: the rise in the ECU prior to 1999 being attributed to a ‘euphoria’ that served to mask the underlying structural imbalance so that ‘many wrong-footed investors who overinvested in the euro at the beginning of 1999 have had to “capitulate” since then, which may go a long way towards explaining the downward trend of the euro over the past fifteen months’ (pp. 52–3). Gros et al. (2000) thus provide, in our view, a more convincing argument than Corsetti (2000) as to just why relative US strength, as expressed in actual and expected growth differentials, should contribute to the decline in value of the euro. However, in this case, US strength can be only half the story. A buoyant US economy will only attract foreign direct investment from the eurozone if equally profitable opportunities for investment in the eurozone are perceived to be unavailable. As argued above, the actual growth pick up of the eurozone would, ceteris paribus, suggest suitable investment opportunities in the eurozone are growing. It is true that the continual slide in the expected growth differential might be taken to suggest a growing lack of investor confidence in the eurozone, but why should investors perceive the eurozone to be weak? The import of this latter question is suggested also by a very different consideration: the validity of strong US growth figures has been the subject of significant doubt. Gordon’s (1999) widely discussed analysis suggests that (1) strong US productivity growth is largely confined to just the IT sector; and (2) in that sector changes in the statistical estimation of price declines, and quality improvements, serve to inflate greatly the true productivity growth. Finally, for the case of the decline in the euro against other currencies, such as the yen, US strength is clearly irrelevant and, as has been illustrated for the case of Japan, similar growth differentials do not obtain.

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In conclusion, if Gros et al. (2000) are right, then the next important question to ask in order to get to the bottom of the decline in value of the euro, is why has the eurozone been perceived by investors to be weak? The timing of the investment outflow, which began about a year before the inception of the euro, is clearly consonant with the view that the inception of the euro itself has played a significant role in harming investor perceptions of the eurozone. Indeed, this view is plausible even if a more cautious stance towards the interpretation of Gros et al. (2000) is adopted, so not taking the net outflow of direct investment as necessarily fundamental. For, it remains pertinent to ask just what market and speculative perceptions of the eurozone have, for nearly a year and a half, helped to force down a range of currencies other than the US dollar. The extent of eurozone weakness and the possible links of such weakness to the inception of the euro are discussed in the next section.

6.5 EURO AND EUROZONE WEAKNESS One does not have to go far in order to find the argument that the structural weakness of the eurozone has caused the decline in value of the euro. George (2000), Dornbusch (2000), PricewaterhouseCoopers (2000) and (invoking high German labour costs) Gros et al. (2000) and many other commentators within academia and the media, all point the finger at structural market rigidities, and in particular labour market rigidity. Others such as Feldstein (2000a) argue against the introduction of the euro, because of the perceived presence and effect of such ‘rigidities’. Of course, the vague notion of ‘labour market inflexibility’ underlying ‘eurosclerosis’ has been around for over 20–30 years. Consequently, it raises the question of why ‘the German mark surged against the dollar during the 1970s and later during 1985–89 when it doubled in value’ at a time when ‘rigidities in Germany were probably stronger than today’ (De Grauwe, 2000, p. 11). Consequently, even if the notion were to be accepted, it would require a great deal of further analysis in order to provide a satisfactory explanation of the decline in value of the euro. In any case, we do not accept, either on theoretical or empirical grounds, the notion, widespread through the entire literature, that ‘labour market inflexibility’ is the cause of poor European economic performance – a point to which we will return below. However, it is by no means necessary to accept the ‘labour market rigidity’ thesis, in order to recognise that the economic and institutional arrangements accompanying the euro itself (their monetarist bias), along with the divergent state of the eurozone, lead to eurozone weakness; a weakness that could plausibly cause outflows of both long-term and ‘posteuphoric’ speculative capital, and that might, therefore, go some way to

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explaining the decline in the euro value (in conjunction with the considerations above regarding US strength). The euro has, of course, ushered in a single monetary policy. At the same time it has constrained national fiscal policy (via the Stability and Growth Pact) and it has made exchange rate revaluation impossible for the individual EMU countries. It is widely recognised that this arrangement requires a high degree of convergence of the patently very diverse economies of the eurozone. Without such convergence, it will enforce inappropriate economic policies on its member states, constrain automatic and discretionary fiscal stabilisation, and negate room for manoeuvre in the face of economic asymmetries. In addition, a heavy burden of coordination is placed upon the European Central Bank (ECB) and the Eurosystem, through the need to pursue a coherent monetary policy, and to be perceived as so doing. The question of the performance of the Eurosystem and the ECB will first be addressed below, then the issue of convergence will be taken up. The ECB and the Eurosystem It can be noted that the credibility of the Eurosystem was set back, at the outset, by the ‘fudging’ of the Maastricht criteria. As we have demonstrated in Chapter 3, various member states of EMU resorted to accounting ‘tricks’ and the like in order to meet the criteria for entry into the single currency. This must have raised market concerns and also begs the question, to be explored below, of the extent to which divergence has taken place since the inception of the euro. Furthermore, the performance of the ECB, in terms of its presentation and the transparency of its decision making, has been widely condemned. Additional problems include: important ECB policy decisions have been leaked prior to official announcement; the speeches of different ECB bankers have given different signals regarding ECB policy; the ECB does not publish minutes, nor divulge information on its econometric models and forecasts; the 4.5 per cent target for M3, which is one pillar of the ‘two pillar’ monetary strategy has not been met at all (Figure 6.5), and yet it has been largely ignored. The ECB itself and sympathetic commentators, such as the OECD (2000) or Favero et al. (2000), argue, in defence of this performance, that the ECB and the Eurosystem are very new and lack the historical time series and the relative stability that only time can bring. More significantly, for the question of the exchange rate decline, much of the academic literature plays down the significance of the problematic nature of the ECB and other relevant institutional arrangements for the exchange rate fall, focusing, instead, upon US strength. In the light of the foregoing arguments, we would agree that ECB weakness is by no means the whole, or even the main, story. However, as argued above, US strength is not sufficient to explain the exchange rate decline. The weakness

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7

Annual % change

6

M3

5 4

Reference Value for M3

3 2 1

Jan-99 Feb-99 Mar-99 Apr-99 May-99 Jun-99 Jul-99 Aug-99 Sep-99 Oct-99 Nov-99 Dec-99 Jan-00 Feb-00 Mar-00 Apr-00 May-00 Jun-00 Jul-00

0

Source: ECB (2000).

Figure 6.5 Annual percentage change in eurozone M3 of the ECB reflects the problems associated with trying to implement a single currency on as diverse an economic area as the eurozone. It is one aspect of eurozone weakness that is specific to the euro itself, and therefore accords with the timing of the euro’s decline in value. It could have contributed to the ‘posteuphoric’ speculative outflows and to long-term fears regarding the ability of the euro to cope with eurozone divergence. Thus, we would argue that it is more important than the academic literature is willing to recognise. The issue of divergence is examined next. The Euro and the Divergent Eurozone Table 6.2 provides the current respective growth, inflation, unemployment, budget deficit, government debt and output gap figures for the eurozone (Luxembourg is included in the table but ignored in the descriptive analysis in view of its small level of relative importance). There is a relatively low growth camp consisting solely of Germany (2.3 per cent). There is also a high growth camp of Spain (4.2 per cent), Belgium (5.1 per cent) and, spectacularly, Ireland (11 per cent!). Inflation rates show Ireland to be way above the rest, once again, on 5.4 per cent, with Spain on 3.5 per

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Table 6.2 Selected economic indicators for the eurozone Country

Growth Inflation rate rate (SA) (SA) % p.a. % p.a. 2000Q1 Jun–00

Eurozone Belgium Germany Spain France Ireland Italy Luxembourg Netherlands Austria Portugal Finland

3.4 5.1 2.3 4.2 3.4 11[Q3] 3.0 4.9+ 3.9 3.9 3.0+ 5.1

Note:

+

2.4 3 2 3.5 1.9 5.4 2.7 4.4 2.5 2.4 2.8 3.1

Unemploy- Budget Gross Output ment rate deficit nominal Gap (SA) 1999 consolidated 1999 May–00 debt as % of GDP 1999 9.2 8.4 8.4 14.3 9.8 4.7 10.7[Apr] 2.2 3 [Apr] 3.2 4.5 9.5

–1.2 –0.9 –1.2 –1.1 –1.8 2.0 –1.9 2.4 0.5 –2.0 –2.0 2.3

72.1 114.4 61.0 63.5 58.6 52.4 114.9 6.2 63.6 64.5 56.7 47.1

–1.1 –0.9 –1.5 –0.2 –0.6 2.6 –2.5 N/A 0.9 0.0 –0.3 –0.1

% increase of 1999 period over 1998 period.

Source: Eurostat; OECD Economic Outlook; ECB (2000).

cent, and at the other end of the scale, France on 1.9 per cent and Germany on 2 per cent. Unemployment rates vary greatly from 14.3 per cent in Spain to 3 per cent in the Netherlands. The budget deficit and output gap figures confirm the differing fiscal and cyclical positions of the EMU members, with Ireland’s deficit at +2 per cent, and output gap at +2.6 per cent, whereas the respective figures for Italy are -1.9 per cent and -2.5 per cent. Portugal and Austria also have relatively large deficits of -2 per cent. Finally, both Italy and Belgium record debt levels of well over 100 per cent of GDP. Thus there are large differences of economic performance – even though it is early days for the euro, there is no sign that it has contributed to any diminishing of these differences. Still, the proponents of the euro could argue that the evidence thus far provides only a snapshot of the eurozone economy. It is necessary, then, to look at the eurozone economic performance through time, if questions regarding convergence, or divergence, are to be answered. First, the recent performance will be considered in its broad, historical context. Secondly, the most recent and detailed evidence on the impact of the euro will be examined.

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The Recent Performance in Historical Context The importance of the historical trends for divergence/convergence is recognised by the ECB as reflected in two recent ECB studies, ECB (1999) and Angeloni and Dedola (1999). These papers will be considered along with an examination of the annual series for GDP, the output gap, unemployment and inflation. As a preliminary it can be noted that the ‘degree of convergence’ is difficult to measure since the relative weighting to be accorded to individual countries is difficult to decide upon. Both the spread (from highest value to lowest) and the standard deviation are, for example, dependent upon ‘outliers’, but, in fact, such outliers are, in some respects, of equal interest to countries of far greater size. Thus small countries, such as Ireland (which contributes less than 2 per cent of eurozone GDP), should, to some extent, be given a greater weighting in analysis than mere regions of comparable size such as London. But just to what extent is not clear. In this circumstance, plotting the evolution of each country, side by side on the same graph, is preferable to merely quoting summary statistics, since the shape of the eurozone as a whole can be discerned. Figure 6.6 plots the annual growth in GDP rates of the past 17 years. Looking over the period as a whole, we would stress that a divergent state of the eurozone 12 10 8 % per annum

6 4 2 0 –2 –4

Belgium Germany Netherlands Italy

Spain Austria

France Portugal

Source: OECD Economic Outlook, June 2000.

Figure 6.6 Eurozone annual growth rates of GDP

Ireland Finland

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

–8

1983

–6

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is the norm. Even excluding the smallest and most volatile countries (Ireland, Finland, Portugal and Luxembourg), the difference between the highest and the lowest GDP growth rate, for each given year, for the most part fluctuates between the 1.5 per cent and 2.5 per cent levels. The difference has never fallen below the 1.3 per cent level and reaches a maximum of 4.2 per cent (1987). The most recent figure is 2.3 per cent in 1999. The inception of the euro has not, at this early stage, produced any outstanding change in the norm, but has maintained the eurozone in a divergent state, with Ireland clearly threatening to overheat. Excluding the outliers of Ireland and Finland, a process of divergence is visible, from the unusually convergent state of 1995, through to 1997; this higher level of divergence has been maintained, though not widened further, through 1998 and 1999. Figure 6.7 plots the output gaps. The output gap is a measure of the difference between the actual and potential output of the country, here expressed as a percentage of the country’s potential GDP. Thus it provides one indication of a country’s cyclical position. The consistently wide spread between highest and lowest, and the many criss-crossing lines, suggest that the eurozone is in a continually divergent cyclical state, over the period, consonant with the growth rate data. There is an indication of a recent process of cyclical divergence with 8 6 4 % of potential GDP

2 0 –2 –4 –6 –8

Belgium Germany Italy Netherlands Source: OECD Economic Outlook, June 2000.

Figure 6.7

Eurozone output gaps

Spain Austria

France Portugal

Ireland Finland

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

–12

1982

–10

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Germany and Italy falling further from potential output, in 1999, whilst France, and most other countries, move towards potential (further above potential, in the case of the Netherlands). This evidence appears to contradict the suggestion of both ECB (1999) and Angeloni and Dedola (1999), that there has been a generally high level of cyclical convergence over the time period, with a significant recent increase in the level of convergence. Both papers base their view on the decomposition of key indicators (GDP growth, industrial production growth, employment growth and inflation) into trend and cycle components using the Hodrick-Prescott filter (ECB 1999) or fourth quarter difference in logs (Angeloni and Dedola, 1999, who report that they achieve very similar results with the Hodrick-Prescott filter). For the period 1994–98, ECB (1999) find divergence in the growth rate of GDP trend but a correlation of around 0.7 to 0.8 (10 year rolling average) for most countries’ cyclical GDP growth component with that of the eurozone average; this compares with lower correlations (down to 0.4) in the early 1990s. Angeloni and Dedola’s (1999) analysis confirms the ECB (1999) findings and suggests that German unification caused the divergence in the early 1990s (this is a point that the evidence on output gaps corroborates). For the early and mid- 1980s, both papers find levels of cyclical convergence approaching the high levels of the mid-to-late-1990s. What explains the apparent contradiction of divergent output gaps and high measures of ‘cyclical’ correlation over the period? This is an important question for an assessment of the prospects for the euro, as currently implemented. We would suggest that the divergent spread of output gaps and growth rates, and the many criss-crossing lines evident on both graphs, reveal that the ‘cyclical’ correlation coefficient of 0.7 to 0.8 should not be considered ‘high’ in any absolute sense. Rather, it simply picks up the fact that there is a broad common cycle in the eurozone. Within this broad cycle, however, there is clearly much room for a great deal of divergence, of a ‘cyclical’ as well as ‘trend’ nature. In any case, such divergence is of obvious policy relevance whatever its nature. For we reject the view that trend growth is a purely exogenous matter, of no concern to economic policy; on the contrary, the obvious quantitative significance of the ‘trend’ implies its policy significance. Overall, then, the GDP and output gap data reveal that the eurozone remains in a divergent state with an evident recent process of divergence. Figure 6.8 plots annual unemployment rates in the eurozone from 1982 to the present. The outstanding feature is the continual divergent state of the eurozone, with the diverse unemployment rates deviating relatively little in their ordering in terms of relative magnitude (Finland being a clear outlier, in this respect). In comparison with the previous graphs there are very few criss-crossing lines other than that of Finland. Spain is an outlier, remaining nearly 5 percentage points above the next highest country in 1999, at 15.9 per cent, having peaked

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at 24.1 per cent in 1994, when the rate was over 10 percentage points above the next country of substantial size, France.

25 20 15 10

Belgium Germany Italy Netherlands

Spain Austria

France Portugal

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

0

1983

5

1982

% of civilian labour force

30

Ireland Finland

Source: OECD Economic Outlook, June 2000.

Figure 6.8 Eurozone unemployment Annual inflation rates, plotted on Figure 6.9a show strong convergence over the past two decades to the low magnitudes of around 1 per cent in 1999. This provides a much better outlook for the institutional mandate of the Eurosystem in general and the ECB in particular (its prime goal being a low and steady eurozone inflation rate), than would higher and more divergent rates. However, there are a number of downsides to this evidence. Chapter 2 described how the Maastricht Treaty was conceived in the late 1980s, when neoliberal monetarism held considerable sway over policy (see also Wyplosz, 1999). Since then, however, the general lowering of inflation, evident on the graph, has downgraded the importance of inflation, certainly in the public perception. Furthermore, the sustained improvement in inflation performance across the eurozone has coincided with a period of sustained sluggishness in terms of growth rates, as described above, and has also coincided with a general fall in the rates of inflation worldwide in industrialised economies. This provides some evidence that the prioritising of inflation is misguided. Finally, it should be noted that the Harmonised Index of Consumer Prices (computed by Eurostat),

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The euro

only available for recent years, tells a slightly different story to the OECD measures for the period from 1998 to 1999. Whereas the non-standardised measure of the OECD shows some convergence for 1998 to 1999, the harmonised index shows divergence, with Ireland moving above the 2.5 per cent level and Spain pushing well above 2 per cent. This hints at the recent inflationary worries regarding Ireland and Spain, described in more detail below. 30 25

Annual rate

20 15 10 5

–5

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

0

Belgium Germany Italy Netherlands

Spain Austria

France Portugal

Ireland Finland

Source: OECD Economic Outlook, June 2000.

Figure 6.9a Eurozone annual inflation Before moving on to look at the impact of the euro on convergence in detail, it can be noted, finally, that ‘Optimum Currency Area’ (OCA) theory and the debate surrounding it (see Angeloni and Dedola, 1999) suggests that the observable variables reviewed above are not the whole story. Rather, it is ‘nonobservable’ shocks, either to aggregate demand (for example a shift in tastes) or aggregate supply (for example, a technology shift), that are ultimately of significance. This is because, essentially, OCA theory provides an assessment of the appropriateness of a single currency through a weighing up of the costs and benefits of its introduction. The benefits are reduced transactions costs and transparency of relative prices. The costs are the loss of exchange rate and national monetary policy as ‘buffers’ and adjustment mechanisms in the face of ‘asymmetric shocks’. The important point is that these are non-observable

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shocks to aggregate demand, or to aggregate supply; the observable series reviewed above are only the outcomes of the unobservable demand and supply shocks. Bayoumi and Eichengreen (1993) first attempted to identify and estimate the underlying shocks, concluding that their correlation for the eurozone is, on average, smaller than that prevailing in the US. Angeloni and Dedola (1999) update this work. They find that the correlation of shocks in the eurozone is very low, that is the eurozone suffers from very asymmetric shocks. Corsetti and Pesenti (2000) have stressed the importance of this finding (in response to the ECB arguments regarding the observable cyclical convergence, discussed above). Our stance towards this evidence offers an opportunity to clarify our theoretical approach towards the evidence on convergence as a whole. It is no secret that, as McCombie (1999) and, with gusto, Buiter (1999b) point out, the theoretical and econometric assumptions made in order to try to identify non-observable shocks are severe. On top of the well known list of strong assumptions, we would add the following general point. The business cycle is not driven purely by economic ‘shocks’ to an otherwise smooth process towards general equilibrium, though, of course, exogenous shocks are very significant. Rather, the business cycle is an ongoing and endogenous economic process. On the financial side, Minsky (1975, 1978, 1982) has charted the inherent tendencies towards fragility of the unfettered capitalist economy. On the real side of the economy, Mydral (1957) and Kaldor (1972, 1985) have analysed the processes of cumulative causation and uneven development generated by the operation of unfettered markets. It is such endogenous processes that are the fundamental context for the single currency. The potential for increased regional asymmetries of demand and of resources unleashed by the single currency make it imperative that the current monetarist structure behind the euro is transformed fundamentally. The evidence presented thus far, showing on the whole a divergent state and recent process of further divergence, corroborates this perspective. A more detailed look at the recent impact of the euro is provided below. The Impact of the Euro: Detailed Evidence The impact of the inception of the euro on the evolution of most recent and frequent series for inflation, growth, unemployment and the budget deficit will be assessed in turn. Figure 6.9b plots the evolution of inflation, in annual percentage terms, from January 1999. In terms of the issue of convergence, the outstanding feature of the graph is the exceptionally high inflation rate of Ireland which moves from 2 per cent to 5.4 per cent, that is 1.9 percentage points above the next highest rate. Not since 1985 has the Irish inflation rate reached such a level so this

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The euro

6

Annual rate

5 4 3 2

Belgium Germany Italy Netherlands

Spain Austria

Jun-00

May-00

Apr-00

Feb-00

France Portugal

Mar-00

Jan-00

Dec-99

Nov-99

Oct-99

Sep-99

Aug-99

Jul-99

Jun-99

May-99

Apr-99

Mar-99

Feb-99

0

Jan-99

1

Ireland Finland

Source: Eurostat.

Figure 6.9b Eurozone inflation rates, measured by HICPs evidence may well indicate inflationary pressures building up. If Ireland is excluded, then the rest of the countries show, in fact, a slight convergence. Nevertheless, two display notable acceleration: Spanish inflation has remained high relative to other countries, reaching its highest level of 3.5 per cent in the latest month (June). Belgium has jumped to fourth highest out of the eurozone, from third lowest in November 1999. Figure 6.10 plots the quarterly GDP growth performance over 1999 of the eurozone countries (data for Portugal is unavailable). Here, once again, the outstanding feature is Ireland, which is way above the other countries, and which causes divergence of the countries as a whole. Again, if Ireland is taken out, there is slight convergence over 1999, as Germany and Italy slowly begin to recover, and Belgium spurts, but there is divergence in 2000 quarter 1, owing to Germany growing at a constant rate while Belgium continues to accelerate and Spain picks up again. Figure 6.11 plots the evolution of unemployment. Essentially the spread is wide and static, though Spain’s rate has continued to fall from its very high level. The general recovery in the eurozone, evidenced in the previous two graphs, has not served to reduce unemployment any more than a percentage point since early 1999. Figure 6.12 plots the evolution of the budget deficits of

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12

% per annum

10 8 6 4 2 0

99Q1

99Q2

Belgium Germany Italy Netherlands

99Q3 Spain Austria

99Q4 France Finland

00Q1 Ireland

Source: Eurostat; Bank of Ireland.

Figure 6.10 Eurozone GDP growth the eurozone from 1996. It shows the difficulties Italy has had in achieving the Maastricht criterion (–3 per cent of GDP limit), starting from below –7 per cent in 1996. The spread from 1998 to 1999 has shrunken slightly, as deficit countries have found that the recovery has eased them above the –3 per cent level. The graph, in conjunction with the previous graphs, shows how the slow recovery of 1999, and loose monetary policy of 1999, has generally served EMU well, with Italy being the one country to experience fiscal difficulties. Assessment It is obviously early days for the euro and two years is not enough time to make clear-cut assessments regarding the issue of divergence. Clearly, Ireland is an exceptional case within the eurozone, causing some overall divergence on the graphs. Undoubtedly, the Irish inflation rate is a cause for concern, and may demonstrate the dangers of inflationary pressures as policy has been tailored to suit an average from which Ireland is an outlier. Spain and Belgium show some danger of inflationary pressures building up. But the recovery, and the fact that it has been the larger countries, Germany and Italy, that have been at the bottom of their cycle suggest that the jury is still out on fears regarding the deficit levels

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The euro

25

% (SA)

20 15 10 5 0

1998:4 1999:4 1999:12 2000:1 2000:2 2000:3 2000:4 Year: month (broken scale) EUR11 Belgium Germany Spain France Ireland Italy Netherlands Austria Portugal Finland Source: Eurostat.

Figure 6.11 Eurozone unemployment rates and general deflationary bias of the single currency. It is hard to believe that, when the roles are reversed, and it is the more peripheral countries, such as Ireland, Finland, and countries such as Spain, that are at the bottom of their cycles, with Germany and Italy at the top of theirs, that monetary policy will be loose. That will be the real test for the eurozone. What is clear is that there remains a chronic problem of high unemployment, and also large asymmetries within the eurozone; there has certainly been no significant trend towards convergence caused by the euro. Business cycles are by no means synchronised, though they do overlap. In terms of OCA theory, countries are likely to receive different shocks as well as being affected differently by shocks. The recent experience has shown that a truly divergent state of eurozone economic cycles persists: few would argue that Germany actually requires the same monetary policy as Ireland! Growth has picked up, but there is no evidence that this is any more than a cyclical recovery around the low trend rate of growth. In terms of OCA theory then, it is very clear that the eurozone is not an OCA, and the euro has not endogenously encouraged the necessary convergence for the eurozone to become one. Nor has the euro overcome the longstanding difficulties of the eurozone. When the economic conjuncture shifts the euro may well prove to harm them.

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4

Per cent of GDP

2 0 –2 –4 –6 –8

1996

Eurozone Belgium Italy Netherlands

1997 Germany Austria

1998 Spain Portugal

1999 France Ireland SUO/Finland

Source: Eurostat.

Figure 6.12 Eurozone budget surplus/deficit (in national currencies)

6.6 CONCLUSION The US economy has been growing faster than the eurozone in the past few years, and the general perception of the strength of the US economy relative to the eurozone economies is likely to have contributed to the strength of the dollar and the weakness of the euro. However, there is no consensus as to just how US strength causes the value of the euro to fall. US strength cannot, of course, explain euro weakness against other currencies such as the yen. We have suggested that the most plausible explanation concerns long-term investment flows and (following Gros et al., 2000) shorter term post- ‘euphoria’ flows of portfolio investment. This view stresses that the other side of the coin of US strength is eurozone weakness. Reviewing the recent evidence, it seems clear that the inception of the euro itself, with its restrictive monetarist institutional structures, to an area which is in a divergent state, which has recently been widened by a process of divergence, is ample reason for long-term investors and, indeed, post-‘euphoric’, short-term speculators, to regard the eurozone as structurally weaker since January 1999. It is difficult to predict the future course of the euro; once portfolio investors have shifted fully back

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The euro

to their pre- ‘euphoria’ level of holdings of euros, then any number of contingencies may come into play; not least the possibility of the US bubble bursting. As it stands, the low trend performance of the eurozone, and high unemployment, is set to continue. From the perspective established, the evidence and its policy implications provide a very different picture to the majority of the literature. The prevalent stress on the need for ‘structural reform’ and the existence of asymmetries can be seen as an attempt to express the idea that asymmetries and structural factors undermine the neoliberal institutional structures associated with the euro, as currently implemented. But this attempted expression is hamstrung by the prejudice towards the efficacy of unfettered markets and so is, ultimately, a failure. The problem with the euro and its associated institutions is not that it diverts attention from, or otherwise hinders, the ‘needed labour market reforms’; asymmetries are not merely short-run, external ‘shocks’ to an otherwise smooth tendency towards a general equilibrium. Rather, policy must be enabled to play its vital role in overcoming aggregate demand asymmetries and uneven processes of cumulative causation through coordination of fiscal and monetary policy, within a transformed institutional setting. Thus we take the same phrase (‘structural reform’), backed up by the same evidence (that is high and divergent unemployment rates; low and divergent growth rates) to mean utterly different things with radically opposed policy implications. If the markets are right to see problems with asymmetries and the need for ‘structural reform’ then they are hopelessly wrong in equating ‘structural reform’ with something called ‘labour market flexibility’ (and the like). What is needed is an expanded institutional setting, allowing the coordination of fiscal and monetary policy and large-scale regional transfers, guided by an alternative to the stability and growth pact.

NOTES 1. Duisenberg (2000) states that the euro has ‘clearly overshot a level which could be regarded as being in line with the fundamentals’. 2. Relevant time series are available, beginning in the early 1990s on both narrow and broad measures of the effective rate and, beginning in 1979, on a ‘synthetic’ euro construct (see, ECB, 2000; OECD, 2000). The narrow ECB measure includes only the 13 main trading partners with the eurozone, whereas the broad measure includes 30 countries (ECB, July 2000). The synthetic euro is based upon a weighted average of the respective exchange rates of the eleven EMU countries (with the dollar, for example), where the weights used are the country share in eurowide GDP. It is calculated as a chain-linked index, taking the same value as the euro on 4 January 1999. The data show that the ‘historical perspective’ argument on the level of the euro was more persuasive in mid-October 1999, than in late 2000. Since mid-October 1999 the value of the euro declined by a magnitude of the order of more than 10 per cent.

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Index agricultural policy 14, 50 Common (CAP) 16, 18, 24 agricultural prices 16 Angeloni, I. 126, 129 Arnold, I. J. M. 83 Arrowsmith, J. 72, 73–4, 81n5 atomic/nuclear energy 11–12 Austria 3 economic performance 54, 55, 122–8 euro criteria and 35, 37, 43 financial performance 89, 90, 91, 92, 99, 102–3 inflation rate 79, 129 unemployment 43 balance of payments 15, 16 balance of trade see trade balance Bank of England 78, 82 banking surveillance see financial regulation banking system 73 see also central banks; European Central Bank; European System of Central Banks Barré Report, 1969 16 Barrell, R. 72, 73–4, 81n5 Basle/Nyborg agreement, 1987 23 Baumol-Tobin model 84–5 Bayoumi, T. 47, 129 Belgium 5, 7, 9, 11, 24 coal production 32n4 economic performance 54, 55, 88, 93, 122–8, 130, 131 as EEC member 12, 18 euro criteria and 35, 36, 39, 41, 43, 62n3 financial performance 76, 89, 90, 91, 93, 97, 98, 99, 102 inflation rate 128 unemployment 43 Beyer, A. 88

Bhundia, A. J. 83 Boyd, C. 39 Bretton Woods exchange rate system 10, 15, 16, 18, 32n11 budget deficits 35, 38–40, 41, 45, 49–50, 57–8, 62n3, 66, 130–31 causes of 57 excessive 44–5, 46–8 no-bailout rule 44 penalties for 46–8 Buiter, N. 40, 110, 113, 115, 129 business cycles 41, 42, 45, 54, 129, 132 Buti, M. 41, 47, 48 capital movements 23, 28, 32n9, 61, 70–73 as destabilising 3, 4, 15, 22 central banks: cooperation between 18, 19 function 2, 21, 22, 28, 29, 45, 62n5, 65, 70–71 independence of 35, 38 national 2, 3, 14, 16, 17, 21, 22, 28, 29, 35, 38, 49, 65 see also European Central Bank; European System of Central Banks Chinn, M. D. 108 Churchill, W. 7 Clausen, V. 88 Cockfield Report, 1985 26 Cohesion Fund (of EEC) 27 Committee of Central Bank Governors (CCBG) 14, 16, 17, 22, 28, 30–31, 33n18 Committee of European Economic Cooperation (CEEC) 6–7 common currencies see the euro; Optimum Currency Areas Common Foreign and Security Policy 30 communism 6 145

146

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competition 22–3, 25–6, 27, 32n4 rules of 10, 14, 28 Congress of Europe, The Hague, May 1948 7 convergence plans 44, 45 Coppel, J. 108, 112, 113, 115–16 Corsetti, G. 40, 113, 115–17, 118, 119, 129 Council of Economic and Finance Ministers (Ecofin) 12–13, 14, 17, 18, 19, 28, 31, 46, 71 Council of Europe 7–8 Court of Human Rights 32n2 credit facilities 3, 21 crisis management 70–71 currencies: Optimum Currency Areas 2, 51–6, 128, 132 pound sterling 107, 109, 113 US dollar 106, 107, 109–10, 113–20 yen 107, 113, 117, 119 see also the euro currency fluctuations 16–17, 20, 24 currency reserves 16, 65, 71–2 eligible liabilities 65, 80n1 Currie, D. 49 De Gaulle, C. 14 De Grauwe, P. 109, 120 De Vries, C. G. 83 debt see government debt Dedola, L. 126, 129 Delors, J. 27, 39 Delors Report, 1989 27–30 Denmark: economic performance 54, 55 as EEC member 19, 24, 35 euro criteria and 35, 36, 38, 43 unemployment 43 Deutsche Bank Research 108, 113 Deutsche Bundesbank 1, 24 Dooge Report 26 Doornik, J. A. 86, 105n1 Dornbusch, R. 74 Duisenberg, W. 108, 134n1 Durand, M. 108, 112, 113, 115–16 economic crises 8, 18, 27, 47–8 economic growth see economic performance

economic and monetary union 1, 5–33 advantages of 5 Delors Report on 27–30 European Monetary System 20–24, 27 federalist position 7–8 functionalist position 7 institutional structure 5–8, 9–12, 17, 26–7, 28–30 Marshall Plan and 6–7 political union 7, 10, 11–12, 14, 16, 33n13 process of 5–27, 28–9 reasons for 5 Single European Market 1, 5, 25–7, 29, 32 see also the euro; Maastricht Treaty economic performance 3, 10–11, 18, 41, 42, 51–6, 59–60, 122–8, 134 euro impact on 1, 2, 4, 34, 41, 113–18, 130 United States 4, 19, 33n12, 113–18, 133 economic policy see fiscal policy; monetary policy Eichengreen, B. 47, 50, 61, 113, 115, 129 employment policy 44 the euro: adjustment mechanisms 59–60 alternative structure for 1, 2, 56–61 criteria for participation 34, 35–40, 121; sustainability of 40–56, 121 as destabilising 3, 4, 64 eurozone 34, 35, 106–7, 113–33 financial regulation and 70–73 future prospects 106–7, 126, 133–4 historical survey 1, 5–33 impact of 1, 3–4, 66–8, 70–74, 129–34 institutional structure 49, 64–6, 79, 106–7, 110, 120, 121–2 launch of 1–2, 34–63 performance see value of below as structurally weak 120–33 as undemocratic 1, 3 as undervalued 108, 109, 110, 134n2 value of 4, 35, 71–2, 106–32; against pound sterling 107, 109, 113; against US dollar 106, 107,

Index 109–10, 113–20; against yen 107, 113, 117, 119; at launch 109 see also economic and monetary union European Atomic Energy Community (Euratom) 12, 15 European Central Bank (ECB) 1, 2, 29, 49, 126, 129 control of 3, 44, 65 criticism of 121 financial regulation by 70–73 function 2–3, 21, 40, 61, 62n5, 64–5, 66–73, 82, 121 management structure 81n3 monetary policy 3, 64, 68–70, 73, 82–3, 121 performance 106, 121–2 restructuring (proposed) 79–80 European Coal and Steel Community (ECSC) 5, 7, 9–1, 15, 32n3 conference, Messina, June 1955 11, 32n7 European Convention for the Protection of Human Rights…, 1953 32n2 European Council 14, 26, 29 European Court of Justice 13 European Currency Unit (ECU) 20–21 European Defence Community (EDC) 11, 32n6 European Economic Community (EEC) 5–6, 12–16, 19 expansion 19, 25, 33n15 fiscal policy 15, 34–63 function 14, 15 institutional structure 12–14, 15 membership 19, 25, 33n15, 34, 35 monetary policy 15, 16–24, 64–81 policy making 12–13, 14–19, 30–31 European Investment Bank (EIB) 14, 32n10, 50, 63n10 re-structuring (proposed) 2, 50–51, 60–61 European Monetary Cooperation Fund (EMCF) 17, 19, 20, 31, 33n18 European Monetary Fund (EMF) 20 European Monetary Institute (EMI) 29, 30–31, 33n18 European Monetary System (EMS) 20–24, 27 crises in 23–4

147

European Monetary Union (EMU) 16–19, 20, 27, 28, 30, 34, 46, 47, 50 future of 51–6 money supply/demand in 83–105 see also the euro European Parliament 12, 13, 26, 30 direct elections to 25 see also European Economic Community European Political Community (EPC) (proposed) 11, 32n6 European Political Cooperation (EPC) 26, 33n13, 33n17 European Recovery Programme see Marshall Plan European Regional Development Fund 15 European Social Fund 32n10 European Strategy Programme for Research and Development in Information Technology (ESPRIT) 25 European Structural Fund (ESF) 14 European System of Central Banks (ESCB) 28, 29, 31, 49, 62n5, 65 function 65 independence of 49 management structure 81n3 European Union: budget 2, 49–51, 59–60, 69–70 eurozone 106–7, 113–33; see also the euro fiscal policy 2, 3, 44, 49, 56 monetary policy 2–3 regional funds 2 Exchange Rate Mechanism (ERM) 20–21, 22–3, 28, 35, 38 crises in 23–4 Eurosystem 1, 2, 121–2 function 3, 69 see also the euro; institutional structure exchange rates 4, 5, 15, 16, 17, 18, 28, 34, 50, 59, 60, 67–8, 73–4 adjustable peg system 16 Bretton Woods system 10, 15, 16, 18, 32n11 fixed 19, 29 foreign exchange markets 17 ‘snake’ mechanism 18–19, 20 Fatas, A. 53, 54

148

The euro

Favero, C. 74, 109, 113 financial markets 72–3, 134 as inflexible 4 influence of 110, 116, 129 financial regulation 3, 70–73 deregulation 1 Finland 3 economic performance 54, 55, 122–8 euro criteria and 35, 37, 38, 43 financial performance 87, 89, 90, 91, 92, 93, 94, 97, 98, 99, 102–4 inflation 128 Soviet Union and 101 unemployment 43, 126, 127 fiscal policy: alternative proposals for 56–61 in EEC 15, 34–63 at EU level 2, 3, 44, 49, 59 euro criteria 34, 35–40, 121; sustainability of 40–56 of individual governments 2 monetary policy and 45, 49, 58–9; see also monetary policy Optimum Currency Areas 2, 51–6, 128, 132 Stability and Growth Pact 2, 31, 34, 35, 43–8, 49, 57, 59–60, 80, 121 France 7 economic performance 54, 55, 85, 122–8 as EEC member 12, 17–18, 30, 33n16 as ERM member 23, 24 euro criteria and 35, 36, 41, 43, 44, 62n3 financial performance76, 87, 89–91, 93, 94–5, 97, 98, 102–4 Germany and 8–10, 20, 33n12 inflation 128 Modernisation plan 8 unemployment 43 Franco, D. 41 Fratianni, M. 24 Funke, M. 55 GDP growth see economic growth German Monetary Union (GMU) 88 German reunification 23, 126 Germany 5, 9, 11 banking system 73 Bundesbank 1, 24

economic performance 10, 54, 55, 73, 122–8, 130, 131–2 as EEC member 12, 18, 30, 31 as ERM member 23, 24 euro criteria and 35, 36, 41, 43, 44, 62n3 financial performance 76, 88, 89, 90, 91–2, 96, 97, 98, 99, 102–3, 105 France and 8–10, 20, 33n12 inflation rate 79, 128 Marshall Plan and 8–9 occupation of (post-Second World War) 9 unemployment 43 United Kingdom and 9 United States and 6–7, 33n12 Giavazzi, F. 74 gold convertibility 18, 32n11 Goodhart’s Law 83 Gordon, R. J. 119 government debt 35, 39–40, 58, 72 Greece: banking system 73 economic performance 54, 55 as EEC member 5, 25, 35 euro criteria and 35, 36, 38, 43 unemployment 43 Gros, D. 119, 120 gross domestic product (GDP) see economic performance Hall, S. 55 Harmonised Index of Consumer Prices (HICP) 49, 64, 127–8 Hayo, B. 82–3, 84 Hendry, D. F. 86, 105n1 home affairs 30 Honohan, P. 61 human rights 7–8, 32n2 industrial development 8, 9–10, 32n3 industrial policy 32n10 inflation rates 2, 10–11, 15, 22–3, 25, 33n12, 34, 35, 38, 45, 109, 123 control of 49, 62n5, 64–5, 67, 71, 77–9, 82 euro, impact of 127–8, 129–30 monetarist view of 70, 77–8, 81n4, 127 money supply/demand, influence on 85

Index institutional structure 1 alternative proposals for 1, 2, 50–51, 56–61, 79 basis of 1, 2 of economic and monetary union 5–8, 9–12, 17, 26–7, 28–30 of EEC 12–14, 15 for the euro 49, 64–6, 79, 106–7, 110, 120, 121–2 European variations in 2 weaknesses in 4, 110, 134 see also individual institutions interest rates 2, 23, 34, 38, 45, 60, 81n2, 98 differentials in 110–12 the euro and 66–7, 79–80, 110–12 money supply/demand and 3, 83 ‘repo’ rate 64, 65, 66 short-term 115 United States 111–12 investment activity 61, 67, 118–20, 133 Ireland 3, 24 banking system 73 economic performance 54, 55, 122–8, 129–30, 131 as EEC member 19 euro criteria and 35, 36, 38, 43 financial performance 89, 90, 91, 92, 99, 102–3 inflation 128 unemployment 43 Italy 5, 9 coal production 32n4 economic performance 54, 55, 122–8, 130, 131–2 as EEC member 12 as ERM member 23, 24 euro criteria and 35, 37, 38, 39, 41, 43, 62n3 financial performance 76, 85, 89, 90, 91, 96, 97, 98, 102–3, 105 inflation 128 unemployment 43 Janssen, N. G. J. 83 Japan 23, 69 economic performance 113, 115 Japanese yen value against the euro 107, 113, 117, 119

149

Jenkins, R. 20 Johansen, S. 87 Jovanovic, M. N. 21 Juselius, K. 88 Kaldor, N. 129 labour market 14, 15, 134 as inflexible 4, 120 see also unemployment rates labour mobility 50, 51 Lambert, J. 11 Latin Monetary Union 5, 32n1 legal framework 10, 13 lender of last resort function 2–3, 65, 70 living standards 14 Lucas Critique 83 Lutkepoht, H. 88 Luxembourg 3, 9, 11 economic performance 54, 55, 122–8 as EEC member 12, 18 euro criteria and 35, 36, 41, 43 financial performance 89, 90, 91, 92, 99, 102–3 unemployment 41, 43 Luxembourg Compromise, 1966 26, 33n16 Maastricht Treaty, 1991 30–31, 34, 61 fiscal criteria 1–2, 34–63, 121 sanctions available under 46–7 voting criteria under 46 see also Stability and Growth Pact McCombie, J. S. L. 129 MacDougall Report 19, 58 Marjolin Report, 1975 19 Marshall Plan 6–7, 8–9 mergers and acquisitions 73 Milbourne, R. 87 Minsky, H. P. 129 Mizon, G. E. 86 mobile capital see capital movements models/modelling: dynamic 92–3 of money supply/demand 84–105 parsimonious vector error correction model (PVECM) 87, 93 unrestricted vector autoregressive (UVAR) model 86, 87–9

150

The euro

unrestricted vector error correction model (UVECM) 86 vector error correction model (VECM) 86, 88 Monetary Committee 13, 15, 22, 29 monetary policy: alternative proposals for 77–80 coordination of 21 credit facilities 3, 21 of ECB 3, 64, 68–70, 73, 82–3, 121 in EEC 15, 16–24, 64–81 at EU level 2–3, 28–32, 44, 121 euro, impact of 64–81, 121 fiscal policy and 45, 49, 58–9; see also fiscal policy inflation control 49, 62n5, 64–5, 67, 71, 77–9, 82 interest rates see interest rates modelling of 74–7, 84–105 money supply/demand see money supply/demand problems caused by 73–7 ‘snake’ mechanism 18–19, 20 United States 18, 25, 69 Monetary Policy Committee (of EU) 68, 82 monetary union see economic and monetary union; the euro money supply/demand 3, 45, 67–70, 115 data sources on 100 definition 100 in EMU 83–105 inflation rates, influence of 85 modelling of 84–105 Monnet, J. 5, 8, 9, 16 Morgan, A. 14 Myrdal, G. 129 national governments: economic and monetary union and 8 sovereignty issues 8, 9, 10, 19, 24 National Institute of Economic and Social Research (US) 81n5 Netherlands 3, 9, 11 economic performance 54, 55, 56, 122–8 as EEC member 12, 18, 30 euro criteria and 35, 37, 41, 43, 44 financial performance 89, 90, 91, 92, 99, 102–3

inflation 128 unemployment 43 ‘new monetarism’ concept 1, 31, 45 non-accelerating inflation rate of unemployment (NAIRU) see unemployment North Atlantic Treaty Organisation (NATO) 11, 32n5 membership 11, 32n5 Norway 62n4, 79 oil crises 19 Ongena, H. 41 Optimum Currency Areas 2, 51–6, 128, 132 Organisation for European Economic Cooperation (OEEC) 7, 9, 32n7 Palley, T. I. 62n4 Palmer, M. 11 Paris, Treaty of, 1951 9, 10, 32n4 Pesenti, P. 113, 115–16, 129 Pleven Plan 32n6 policies/policy making 45 agricultural 14, 16, 18, 24, 50 in EEC 12–13, 14–19, 30–31 on employment 44 fiscal see fiscal policy home affairs 30 industrial 32n10 monetary see monetary policy regional 15, 32n10, 50, 56, 60 transport 14 Portugal: banking system 73 economic performance 54, 55, 56, 122–8 as EEC member 23, 24 25, 26 euro criteria and 35, 37, 43 financial performance 89, 90, 91, 96, 97, 102–3, 105 inflation 128 unemployment 43 price fixing 10 agricultural prices 16 price stability see inflation rate regional aid 50, 56, 60 regional policy 15, 32n10

Index Resolution on Growth and Employment 44 Rome, Treaty of, 1957 12, 13, 14, 15, 23, 26, 30, 49, 63n10, 69–70 Roubini, N. 40 Ruhr International Authority 9 Ruhwedel, R. 55 Schuman, R. 9 Second World War, 1939–45: impact of 5, 6, 8 security issues 5, 8, 9, 11, 32n3 Common Foreign and Security Policy 30 Single European Act, 1987 (SEA) 5–6, 23, 26–7 Single European Market 1, 5, 25–7, 29, 32 see also economic and monetary union ‘snake’ mechanism 18–19, 20 Social Chapter (of Maastricht Treaty) 30 social security systems 60 sovereignty issues 8, 9, 10, 19, 24 see also national governments Soviet Union: Finland and 101 as a threat 9, 11 Spain: banking system 73 economic performance 54, 55, 122–8, 130, 131 as EEC member 23, 24, 25, 26, 30 euro criteria and 35, 36, 41, 43, 62n3 financial performance 76, 89, 90, 91, 97, 98, 102–3, 105 inflation 128 unemployment 43, 126–7 Spinelli, A. 7 Stability and Growth Pact 31, 34, 43–8 adjustment mechanisms in 59–60 alternatives to 2, 56–61, 80 criteria 2, 31, 35, 44, 49 effects of 57, 121 function 43, 77 stability programmes 44, 46 subsidiarity principle 30 Sweden 35 economic performance 54, 55

151

euro criteria and 37, 38, 43 unemployment 43 Switzerland 5 tax systems 60 Taylor, C. 72, 73–4, 81n5 technological cooperation 25, 26 technology sector 119 Terasvirta, T. 88 trade 101 customs unions 12, 15, 16 free trade areas 10, 14, 23, 26, 27–8, 32n4 intra-European 5, 6, 15, 68 trade balance 42, 57, 108, 115, 117 trade tariffs 12, 14, 15 non-tariff barriers 26 Trade Union Congress (TUC) (UK) 39 transport policy 14 Treaty on European Union (TEU), 1993 5–6 Tsoukalis, L. 32n9 unemployment rates 3, 18, 25–6, 41 in EEC 43, 51, 60, 61, 62n4, 81n6, 126–7, 130 euro, impact of 2, 4, 34, 41–3 NAIRU 45, 67 reduction in 45, 50, 57 see also labour market Union of European Federalists 7 United European Movement 7 United Kingdom: budget deficit 49–50 economic and monetary union, attitudes to 7, 32n7, 35 economic performance 54, 55 as EEC member 19, 25, 30, 33n14 as ERM member 23, 24 the euro, abstention from adoption of 35 euro criteria and 37, 38, 41, 43 financial system 73 Germany and 9 monetary policy 25 sovereignty issues 9 under Thatcher 25 unemployment 41, 43, 62n4 United Kingdom pound: value against the euro 107, 109, 113

152

The euro

United States 23 economic performance 4, 19, 33n12, 113–18, 133 Germany and 6–7, 33n12 interest rates 111–12 Marshall Plan 6–7, 8–9 monetary policy 18, 25, 69 under Reagan 25 security issues 11 unemployment 62n4 Vietnam war, financing of 32n11

United States dollar: value against the euro 106, 107, 109–10, 113–20 Visco, I. 108, 112, 113, 115–16 von Hagen, J. 24, 47, 113 Waigel, T. 43 Werner Report, 1971 17, 18 Wolters, J. 8 Wyplosz, C. 47