3. The EMU: genesis
3.1 The attachment to exchange rate stability
- the gold standard
- the Bretton Woods-regime
- European exchange rate cooperation
3.2 Politics and EMU: the road to Maastricht
3.3 The institutional set-up of EMU
1
The gold standard

The gold standard: notes and coins of participating countries were backed by and
convertible into specific weights of this metal; external imbalances led to gold
flows and an automatic adjustment process (cf. Ch. 4)

The gold standard was widespread in the late 19th century (in the UK since 1814)
but came to an end as a consequence of the inflationary finance of world war I.
Finland was on a silver standard as from 1865 and on the gold standard from 1878

Most European countries went back to the gold standard in the 1920s (often at an
overvalued parity), and abolished gold only reluctantly during the great depression
in the 1930s (Finland, following the UK, abandoned gold in 1931)

NB: the gold standard was ”sort of” a fixed exchange rate system (if strictly
adhered to) even though there was no common currency

NB: Historically, monetary union has typically been a bedfellow to political union;
e.g. the Roman empire (though it took centuries for a uniform currency to spread
across the whole empire), and the US (though the US became a MU only after its
civil war)
2
(cont.)

Some exceptions (and rather long lasting): the Latin Monetary Union and the
Scandinavian Monetary Union

The former (comprised of FRA, ITA, BEL, SWI, GRE) was a bimetallic union (gold an
silver), it lasted from 1865 to 1927

The latter (comprised of DEN, SWE, NOR) lasted from 1873 to 1920

These monetary unions did not have the political cohesion or institutions to
survive once economic developments led to conflicting interests and policies

There are still those convinced that only gold as the basis for the currency can
guarantee price and exchange rate stability (not fiat money)

While economists see some merits in flexible exchange rates, citizens and
politicians tend to have a strong preference for stable exchange rates
3
The Bretton Woods-regime

A new international monetary order was agreed at Bretton Woods (New
Hampshire, US) in 1944 (with Keynes as one of the key contributors)

BW established fixed parities of other currencies to the dollar, itself pegged to gold

The operation of the BW-regime was to be policed by a new institution, the
International Monetary Fund or IMF (the World Bank was also set up)

Competing devaluations (”beggar-thy-neighbour”) were to be avoided, but
devaluations were accepted in cases of ”fundamental disequilibria”

During the 1960s, US balance of payments deficits caused US debt to central banks
(and other asset holders) to become quite large relative to the US government’s
gold stock, which undermined the credibility of the dollar/gold-link (and France
indeed insisted on converting French dollar assets into gold by the US)

US monetary policy was expansionary/inflationary to finance the Vietnam war,
which caused large capital outflows; BW came to an end on 15 August 1971 when
Nixon terminated convertibility of US dollars into gold
4
European exchange rate cooperation

Most EU (or ”EEC”) countries agreed in 1972 to prevent fluctuations between their currencies
exceeding 2.25 % (”the currency snake”), while fluctuating freely against other currencies

In 1979 this was replaced by the European Monetary System with ECU, a European currency unit,
defined as a basket of currencies as a focal point; national currencies were not supposed to deviate
more than 2.25 % from their central ECU-rates

the ERM, the exchange rate mechanism (part of the ESM), envisaged adjustment of national
parities (to the ECU) in case of serious need (but normally parity should be defended by monetary
and other policies)

In practice the system put the burden of adjustment on deficit countries, running out of reserves,
which had to devalue or to defend their currencies with tight policies; in practice, D-mark was the
key European currency: the strength of the D-mark posed problems for countries with a tendency
to higher inflation

Recurrent speculative attacks forced UK and Italy to withdraw from the EMS in 1992, and in 1993
the fluctuation bands were increased to +/- 15 % (mitigating one-sided speculation)

Finland was not a member of the EMS but had already in 1991 been forced to devalue the markka
5
The impossible trinity (pick 2 out of 3)
Politics and EMU: the road to Maastricht

A group chaired by the prime minister of Luxembourg, Pierre Werner, presented a
plan for setting up an economic and monetary union in 1970; this plan foresaw a
need for a political union - but did not spell out how to achieve it. Subsequent
exchange rate turbulence led to the burial of the Werner plan.

In the late 1970s, German chancellor Helmut Schmidt and French president
Giscard d’Estaing saw EMU as a way of strenthening price stability as well as
European unity and as a way to ”escape German domination”

French president Francois Mitterand foresaw German reunification already in the
late 1980s and started to ponder its implications; he wanted Germany to share its
monetary policy with France in exchange for security guarantees

He later agreed with German chancellor Helmut Kohl that Germany would give up
the D-mark through setting up the EMU with a view to deepening European
integration (arguably necessitated by German reunification)

In 1988 they set up a committee of experts (central bankers) to prepare EMU
7
(cont.)

The committee (chaired by Jacques Delors) made wide-ranging proposals and
stressed the need for ”parallel advancement in economic and monetary
integration” (factor mobility, wage and price flexibility…)

There was not a formal bargain of Germany signing up to EMU and giving up the Dmark in exchange for german reunification, but the former would have been
unlikely to happen without the former

Mitterand pointed out to Kohl that, lacking serious negotiations on EMU, Germany
risked facing a triple alliance of France, UK and the Sovjet Union (later Russai),
which could lead to German isolation

The Maastricht treaty, agreed in 1991, set a timetable for EMU by 1999 at latest
and the main requirements, including the convergence criteria to be fulfilled in
order to qualify (low inflation, low long term interest rates, a stable exchange rate,
below 3 % of GDP budget deficit and below 60 % of GDP public debt)

NB: The Maastrich treaty was agreed despite strong misgivings by the Bundesbank
8
(cont.)

The convergence criteria were political as well as economic (helping to keep out some member
states if so wished)

The numbers were arbitrary: 3 % because of French figures for 1993, 60 % because that would be
compatible with 3 % deficit and 5 % nominal GDP growth(!)

Why was the debt criterion later disregarded in deciding on membership? Because LUX was ok and
was in a monetary union with BEL (which had a debt ratio of 120 % but had to get in so as not to
break LUX-BEL apart); thus, ITA also escaped the requirement to fulfill the debt criterion; what was
meant to be a union around the ”hard core” (FRA+GER+Benelux) became large and heterogenous
(politics)

The final preparations started in 1995 with the specification of a reference scenario for the
changeover to the euro and by agreeing that the name should be ”euro” instead of ”ecu”

For Kohl, EMU was ”a matter of war and peace”, for his successor, Gerhard Schröder, it was a
”premature sickly child”

EMU was a monetary and economic constructiojn but above all a political project
9
EMU: the institutional set-up

The European Central Bank (ECB), modeled upon the ”Buba” (Bundesbank)

The eurogroup (agreed in 1997), as a forum for policy coordination (or, for the
French, as a ”gouvernement économique”)

Fiscal rules: the Excessive Deficit Procedure (EDP), meant to prevent ”excessive”
(above 3 % of GDP) general government financial deficits, and the Stability and
Growth Pact (SGP), meant to complement the EDP by requiring member states to
aim at overall balance or surplus in their public finances in the medium run

NB: decisions on the EDP are taken by qualified majority and can involve sanctions
if corrective action is not taken (at least in principle)

A general obligation to economic policy coordination (the broad guidelines of
economic policy, a Community act giving overall and country-specific
recommendations on economic policies (no sanctions though)
12
(cont.)
 No central bank financing of governments is allowed (interpreted to mean
that the ECB or national CBs must not buy government paper in the
primary market)
 No privileged access of public bodies to lending by financial institutions
 No bailout of member states in financial difficulties by other member
states or by Community institutions (the ”no bailout-rule”)
 NB: The purpose of these rules is to ensure ”sound” public finances, that
EMU does not strengthen the deficit bias in public finances
 NB: the purpose is also to ensure that each member state faces up to its
responsibilities, that debts cannot be ”mutualized”, that governments pay
the rate of interest demanded by market conditoins (or they default)
13
The European Central Bank

The ECB and the national central banks (NCBs) of the euro area countries together make up the
Eurosystem; the ECB and the NBCs of all EU member states make up the less important European
System of Central banks (ESCB)

The main tasks of the ECB is to formulate and implement the monetary policy of the euro area.
Other tasks include:
- the conduct of foreign exchange operatioins
- the holding and management of official foreign exchange reserves
- promotion of the smooth operation of the payments system
- authorisation of the issuance of banknotes in the euro area
- to contribute to prudential supervision of credit institutions and the
maintenance of financial stability

NB: ”the primary objective of the ECB shall be to maintain price stability” (the treaty); it may
support other policy objectives only if this does not undermine the primary objective
(”lexiographic” target function)

NB: The ECB is goal independent: it is the ECB itself which has defind the price stability objective as
a rate of inflation in the medium term below (but close to) 2 %

NB: The ECB is operating a two-pillar monetary framework, focussing on expected price
developments but also considering the rate of growth of the stock of money
14
(cont.)
 The ECB is exceptionally independent: the members of the Executive
Board (six members) and the NCB governors (now 18), which together
make up the decision-making body, that is the Governing Council, are
frobidden to seek or take instructions from governments and Community
institutions.
 Also, the members of the Governing Council have long and non-renewable
terms of office and the NBCs and the ECB is financially independent.
 The ECB is accountable to the European Parliament (reporting obligation)
but it has no obligation to accept instructions by the parliament, on the
contrary (it must be independent)
 Monetary operations of the ECB are partly implemented by the NBCs but
under strict guidance from Frankfurt
15
Questions:
 What are the main monetary regimes that we have experienced in Europe?
 Many earler monetary regimes have broken down: why?
 What is the impossible trinity?
 Why was the EMU set up?
 What are the key elements of the institutional set-up of EMU?
 Is the ECB democratically accountable?
16
Summary and final comments on the genesis of the EMU

European citizens and decision makers have always had a strong preference for exchange rate stability, be
it in the form of the gold standard, the Bretton Woods-regime or European exchange rate cooperation

European exchange rate cooperation turned out to be vulnerable to differences in national circumstances
and policies and often led to currency speculation and turbulence

It was gradually realized that the impossible trinity necessitates giving up monetary autonomy if fixed
exchange rates are to be compatible with free capital flows

EMU has been seen as one further step towards deeper political integration, and the fall of the Berlin Wall
was the triggering point (geopolitics )

The euro area became large and heterogenous, also a consequence of political considerations

The institutional basis of the EMU is thin, this is a consequence of the great difference between German
and French views:
- Germany: ”Stabilitetsgemeinschaft”, binding rules, sanctions (preferrably automatic) versus
- France: ”gouvernement économique”, discretionary decision-making, role for politicians

Also opposite views on the desirability of CB-independence (key for Germany, nuisance for France)

The euro is a political project and yet a currency without a state, an asymmetric construction. It was
conceived of as a rule-based system, where the only body making discretionary decisions for the area as a
whole would normally be the ECB.
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