by S. E. G. Lolos Department of Economic and Regional Development Panteion University Contents 1 Introduction... 1 1. The background of EMU... 2 2. The Rationale for Monetary Union... 4 3. Possible Consequences of Monetary Union... 4 4. The Blueprint for a European Central Bank... 5 4.1 Independence... 5 4.2 Accountability... 6 4.3 Responsibility for Prudential Supervision... 6 5. The Maastricht Criteria... 7 April 1999 Introduction European Monetary Unification (EMU) is a process for which there exists precedent. no historical Countries with own histories of monetary sovereignty and long-standing central banks establish a common central bank. Central bank accountable to them jointly with control of national monetary policies, including the power to issue a common currency Is EMU a leap in the dark? EMU justified by the reduction in transaction costs that comes with the single currency. This must be weighted against the abolition of policy autonomy and the abolition of national currencies. Neither theory nor empirical work provides evidence on the balance of costs and benefits. 1 Main references: B. Eichengreen (1993), European Monetary Unification, Journal of Economic Literature, Vol 31, September. Also, O. Issing (1998), The European Central Bank on the Eve of EMU, Speech delivered to the LSE, 26 November (Internet: http:/www.ecb.int). 1
1. The background of EMU The deep origins of European monetary unification extend back to the founding of OECD in 1948 and the establishment of European Payments Union in 1950. Countries of Western Europe pooled their international reserves and coordinated their policies with the goal of restabilising current account convertibility (achieved in 1958). In 1962 the Commission ot he European Communities drafted its first plan for monetary union with a deadline for completion within nine years. Plan overly ambitious. So far, collective achievements: European Coal and Steel Community Euratom ( an atomic energy community) European Economic Community (EEC, a customs union, Treaty of Rome) Common Agricultural Policy (farm product subsidization) In 1964 was set up a Committee of Central Bank Governors (but started operating in the 1970s) So long as the Bretton Woods System persisted: Intra-European exchange rates indirectly pegged by the parity commitments to the US dollar. But once Bretton Woods began to unravel pressures on interest rates intensified In 1969, set up a committee to draft a report, the Werner Report (1970): Monetary union within ten years. The Werner Report sketched a transition to take place in three stages: 1 st : limited exchange rate fluctuations, governments would begin to coordinate monetary and fiscal policies. 2 nd : further reductions of exchange rate variability and price divergences. 3 rd : exchange rates irrevocably fixed, capital controls removed, control of monetary policies of member countries by a system of central banks ( modelled on the US Federal Reserve System). Also increase of community s budget and coordination of national tax and expenditure programmes. In March 1972: Implemented elements of Werner Report. Agreed in limiting bilateral exchange rate movements to 2,25 per cent ( the Snake ). But the first oil shock (1973) created different levels of unemployment and inflation in various countries. Countries followed different policies: Some currencies devalued others revalued. Some countries left the Snake temporarily, others permanently. Hence, arrangement proved incapable of delivering its central goal: exchange rate stability. This realization lead to a new round of exchange rate stabilization negotiations (Bremen, 1978) that lead to the creation of the European Monetary System (EMS) in 1979. Its central element, the Exchange Rate Mechanism (ERM) was designed to accommodate the different policies pursued by different countries: different fluctuation bands (wide, narrow) 2
countries allowed to realign central rates (the mid -point), when balance-of-payments disequilibrium controls on capital transactions retained In 1986 the member states initialled the Single European Act (SEA) for the establishment of the Single European Market by 1992: Members committed to the creation of the an integrated market free of obstacles (free movement of commoditie s, capital, labor). [EEC loosing competitiveness, see later] With the process of European economic integration gathering speed, in 1988 set up a committee, chaired by Jacque Delors (President of European Commission) to study the feasibility of supplementing the single market with a monetary union Recommendations of the Committee for the Study of Economic and Monetary Union (Delors Report, 1989) provided the framework for intergovernmental negotiations. Note the following: At the heart of the Delors Report was a new entity, the European Central Bank (ECB) to formulate and execute the Community s single monetary policy. National central banks though they would not abolished, would become mere operating arms of the ECB. Prior responsibility of ECB price stability. ECB responsible for the operation of monetary and exchange rate policies and of the payments system. ECB will not supervise commercial banks, but should help national authorities to coordinate policies. Compared to the Werner Report, the Delors Report embraced less centralization (fiscal policies) and more centralization (monetary control). Finally, the Delors Report insisted on the early introduction of a single currency to insure the irreversibility of the move to monetary union. In 1989, following the Delors Report, the member states convened an Intergovernmental Conference to amend the Treaty of Rome (the basic law of the European Community). The new treaty, the Maastricht Treaty, was designed to be implemented in three stages, as follows: Stage One (July 1990, some countries later): Removal of capital controls. Reduction of inflation and interest rate differentials and increasing stability of exchange rates. Stage Two (beginning of 1994): Further convergence of national economic policies. Creation of a temporary entity, the European Monetary Institute (EMI), to coordinate member-country monetary policies and to plan the move to monetary union. Stage Three (1 st January, 1999): Establishment of the independent central bank and transferring the responsibility for the conduct of monetary policy. Exchange rates irrevocably fixed. The EMI will be succeeded by the ECB, assuming control of monetary policies. The date of replacement of national currencies was left open (was decided later, for 2001). 3
Note the emphasis on policy convergence as a precondition for monetary union. Also, the Maastricht Treaty echoes provisions of the Werner Report issued more than 20 years ago. Recently (199?) EU countries agreed on the Development and Stability Pact in Amsterdam. 2. The Rationale for Monetary Union Why renewed impetus for monetary unification following the passage of the Single European Act in 1986. Recall that according to a number of Reports (Cecchini) the EC member states as a whole had been loosing competitiveness vis-à-vis their main competitors (USA and Japan, especially in high technology). To turn the segmented European markets into an integrated economy (to specialize according to comparative advantage, factors of production to flow freely to reap highest returns) cannot be challenged on efficiency grounds. But why a single currency and a European central bank? Costs of separate currencies: Pose a significant barrier to commodity and factor market integration (conversion costs, estimated to 0.4 percent of GDP, are low). Also, uncertainty associated with possibility of exchange rates changes, depressing foreign investment and trade. But stabilization of exchange rates failed in past. Hence, monetary unification follows. Also, problems with the CAP (when exchang e rates change frequently), since green exchange rates different from market rates and officially set. 3. Possible Consequences of Monetary Union A single currency is unlikely to come without costs. If monetary policy is capable of affecting output and employment, monetary independence has a cost (loss of a strong policy instrument). Furthermore, if demand disturbances on decentralized markets (of member states) and monetary policy is centralized have costs on various markets. With European market integration (long-run) adverse effects fade out. But problem with labour mobility (linguistic, cultural differences, not like the USA). Although integration enhances incentive and capacity to migrate. Having abandoned monetary autonomy, national governments confronted by asymmetric shocks may have other policy instruments. If governments faced with domestic recession they can follow fiscal policy. But economic and monetary integration could tighten the constraints on fiscal policy: No problem is posed, if government wishes to run a budget deficit temporarily for business-cycle-related reasons. 4
In the medium-term, although fiscal autonomy is generally retained (possible variation in tax rates between countries), binding constraints posed by Maastricht Treaty on budget deficits (see below). To counterbalance these adverse effects, economic aid given to low-income regions (countries) to cope with structural problems and achieve real and nominal convergence. Aid financed through the Structural Funds of the EC Budget, the Community Support Frameworks (CSF): 1 st Delors package 1989-93, 2 nd Delors package 1994-99, Sander package 2000-2006). What is the role of the CSFs (activate endogenous growth mechanisms, income support). 4. The Blueprint for a European Central Bank 4.1 Independence The Maastricht treaty and the Delors Report attach great importance to the creation of the European Central Bank (ECB) dedicated to price stability. The ECB is forbidden from providing credit to the EU or to national, state and local governments (cannot buy up debt of fiscal crises). Monetary policy is formulated by Governing Council and implemented by Executive Board. To insulate monetary policy makers further from political pressure for inflationary finance and to insure ECB independence: ECB officials enjoy long terms in office. The Executive Board is comprised of the president, the vise-president and four members appointed by common accord of the heads of state or government (serve eight-year term). The Governing Council includes, in addition, the governors of the national central banks of the participating countries (minimum five year term). Individuals with other political responsibilities are prohibited from serving on the ECB s Governing Council. Officials are prohibited to receive instructions from their national governments. Neither national governments nor other EU bodies must approve monetary policy decisions. All this implies a very independent European Central Bank. However, the ECB does not and cannot function in a political vacuum. This is so since, for instance: The President of the EU Council of Ministers and a member of the EU Commission are permitted to participate in the Governing Council. Not entitled to vote but may submit motions for deliberation and has influence over proceedings. Also, the Council of Ministers, not the ECB, is empowered to conclude agreements on an exchange rate system linking the Euro to non-eu currencies. 5
The Council of Ministers (with a qualified majority) is authorized to change central rates of the Euro. Some say that these provisions for the ECB resemble the German Bundesbank law. 4.2 Accountability While the ECB at least as independent as the Bundesbank, it may be less accountable, given current institutional arrangements: The proceedings of the Governing Board are confidential. The ECB must publish a quarterly report and submit an annual report to the European parliament. Members of the Executive Board may be called to testify before committees of the Parliament. Not clear if provisions by Maastricht Treaty suffice. Notion of the European s Union democratic deficit : EU decisions are insufficiently accountable to the European public they represent. 4.3 Responsibility for Prudential Supervision Normally, the domain of the authorities responsible for monetary policy and bank regulation is the same: monetary policy is set, and banking systems are supervised by national officials Thus, national central banks: Are empowered to extract seigniorage from national monetary systems. In return, they assume the costs of running the national payments system and bailing out banks. In most cases, they bear supervisory responsibility. In contrast, the Maastricht Treaty vests the ECB with little regulatory responsibility Only to contribute to the smooth execution of policies by the national authorities Divorce of monetary policy from prudential supervision in ECB: Because ECB s responsibility for financial stability may undermine its anti-inflationary commitment (example). Although monetary policy is centralized, there is no provision for shifting bank regulation from member states to the EU. Decentralizing bank regulation within a monetary union creates competitive deregulation problems (intensified competition creates financial instability). To cope with this introduced Directives to standardize Solvency Ratios and Own Funds, but enforcement at national level. 6
Also, market integration blurs the borders between national systems (the more banks operate, the less clear which national authority is responsible). The EU Second Banking Directive specifies that banks should be supervised by their home countries, although host countries are responsible for liquidity standards (harmonization of national regulations). 5. The Maastricht Criteria All EU countries are eligible and it is desirable to participate in EMU. But admission necessitates similar monetary and fiscal performance of member states. Otherwise the monetary union will be destabilized and the ECB will be subjected to inflationary pressures. This fear led the framers of the Maastricht Treaty to specify four preconditions for participating in the EMU (the convergence criteria ): 1 st criterion. The country s inflation rate should converge to a level not too far above that of the three EU s lowest inflation countries. Under monetary union member states have to run very similar inflation rates. 2 nd criterion. Budget deficits should not be larger than three percent of GDP ( reference value ). 3 rd criterion. Public debts should not be larger than sixty percent of GDP ( reference value ). The rationale of the second and the third criteria is that admitting into the EMU members displaying inadequate fiscal discipline will subject the ECB to pressure to purchase debt, with inflationary consequences. Note: In Amsterdam these criteria were qualified after a political compromise between the Northern and the Southern countries, since some Mediterranean countries registered debt ratios over 100 percent. Thus, the debt criterion is considered to be satisfied if the debt ratio is substantially and continuously declining over the last three years. But, in this case these countries must try to eliminate their budget deficits. 4 th criterion. Convergence of long-term interest rates. This goes along exchange rate and price stability. Indeed, qualifying countries must have maintained (stabilized) their exchange rate within the normal EMS fluctuation bands for two years prior to entering the EMU. Ability of participant country to defend her exchange rate commitments 7