Graham Bishop *
As Stage Two of EMU dawns, market participants are wondering
whether it will have any content and, if so, whether that content will
lead anywhere. Scepticism abounds - because memories of the monetary disrup-tions
of the past 18 months are still fresh. However, on balance 1993 was not
as disastrous as some argue and the expected modest turn-up in the economic
cycle will coincide with a wave of national elections which may refresh
the political drive for European integration. Meeting the convergence criteria
will hinge on the political judgement made on which states have an "excessive
government deficit". This decision could be de-politicised by incorporating
the judgement of the financial markets - as reflected in the yield spread
on long-term bonds - but sharply toughening the standard from the current
limit of a 2% spread.
The 1993 Economic Policy "Balance Sheet" of the European UnioN
Market participants' confidence in the European Union's
(EU) planned monetary union, understandably, has been diminished by a string
of events perceived as "liabilities".
• 'Eurosclerosis' returned with a vengeance: the economic disease of the early 1980s re-appeared as European Community (EC) GNP fell by about ½% during 1993 and unemployment soared.
• Public finances deteriorated: the aggregate budget deficits of EC members exceeded 6% of GNP and public debt levels on average exceeded the threshold - 60% of GNP - which was intended to be the ceiling.
• The ERM collapsed: the widening of the fluctuation bands to 15% deprived the mechanism of any practical effect. However, by the year-end, the crucial French franc/Deutschmark exchange rate was back within its old boundaries - without any official support.
The scale of the liabilities was sufficiently great that
many market participants concluded that the EMU project was effectively
dead. That conclusion may be overhasty because the EC racked up a list
of "assets" which would otherwise be judged impressive.
• The Treaty of Maastricht was ratified and entered into legal force.
• CAP and GATT disputes were finally resolved - though the implementation of CAP reforms may cause friction again.
• The European Monetary Institute was set up and the other necessary legislation implemented to enable Stage Two to start according to the original schedule.
• Inflation fell to 20-year lows, and is likely to reach a 30-year low in 1995.
• The unemployment problem was addressed by the European Commission's White Paper and broadly accepted by the Heads of Government as the basis for an "action plan". Recognising that "there is no miracle cure," the plan emphasises medium-term measures to liberalise the labour markets. This is a prerequisite for a durable monetary union as it should provide the necessary flexibility in relative prices that was formerly created by flexible exchange rates.
• Yield curves for the bond markets of several member
states moved dramatically closer. In particular, the French and German
yield curves closed up to the point that the markets are no longer discounting
any trend movement between the French franc and Deutschmark in the next
It can be argued that the EU finished 1993 with an economic
balance sheet recording significant "net assets". Moreover the market has
priced in the same conclusion. In sharp contrast to the emotional state-ments
of many market participants, the intellectual judgement expressed in
bond market prices is that an effective monetary union between several
states already exists.
1994 and Beyond
As the EU manages to regain its composure after the monetary disturbances of 1992 and 1993, can the risk of further disturbances be ignored? The answer must be an emphatic "NO" - the freedom of capital movement is steadily working through the economic system via the implementation of the Directives that create the Single European Market.
EU governments are already taking advantage of these opportunities
to sell their debt in the securities markets - debt securitisation - to
minimise servicing costs. Correspondingly, as we pointed out in a recent
publication 1, more open capital
markets and increased debt securitisation have raised the incentive for
govern-ments to establish low inflation expectations and low long-term
interest rates as a policy target. The creation of large and efficient
government bond markets in most EU countries has boosted the share of securitised
government debt and the share that is held overseas or by active portfolio
investors. The increase during the 1980s in non-resident acquisitions of
European bonds - particularly in France, Spain, Italy and Denmark - is
evident. The Bundesbank estimates that non-residents held more than DM500
billion worth of German securities at the end of 1992. Retrenchment among
banks is also boosting the share of private debt that is financed via capital
Figure1. Net Purchases of Government Bonds From Abroad, 1980-93 (As a Percentage of Net Issuance)
aIn 1988-90, net debt repayments amounted to £30.69
billion. b 1993 figures extend through June in France, Denmark and the
Netherlands; August in Germany, Italy and Spain; and September in the United
Kingdom. NA Not applicable. NM Not meaningful.
Note: Foreign purchases of French emprunts before 1986 were marginal. Foreigners were not permitted to acquire Danish Government bonds in 1979-83. Recent German figures may be overstated by recycling of German investment funds through Luxembourg.
Source: National central banks.
The greater the securitisation of financial markets and the greater their openness internationally, the more difficult it is for a government to inflict an inflation tax on savers. Thus, governments that try to overstimulate their economies find that the adverse long-term effects of inflation policies - a depreciating currency and higher long-term interest rates - occur very quickly in a world of mobile capital: bondholders have an incentive to respond rapidly to fiscal risks because of the potential for a major loss in the value of the bonds. Moreover, any rise in long-term interest rates in a securitised capital market extracts a financial cost from the government and tends to dampen business investment. By contrast, fiscal prudence can reduce debt-servicing charges .
When 25-50% of new government bond issues are sold outside their country of origin, it is clear that the financial markets are fulfilling their usual economic function of redistributing risk. But redistribution on this scale - if it persists - would rapidly weld the EU
into a single financial entity where shocks in one state are rapidly transmitted to the others via the financial system. Any shock to the process would then open up the risk of an explosive reversal of these capital stocks. The rationale for continuing down the path towards monetary union remains strong - even if unpopular.
The politicians may have become painfully aware that they are sitting on a powder keg now that the capital markets have been liberalised. However, their ability to respond is constrained by the political and economic cycles - both of which will have to be synchronised, and be in the right phase, before the Maastricht Treaty's process for starting Stage Three can be begin.
The political cycle is set by the election schedule shown in Figure 2. Remarkably, nine of the twelve EU member states will probably have elections within the next two years. Therefore, the electorate will have full opportunity to review the European policies being pursued by their governments. In the crucial French and German elections, the leading contenders have already made their pro-European convictions clear. By the time decisions have to be taken on starting Stage Three, most EU governments will have obtained a fresh electoral mandate for their chosen route - whichever way that turns out to be.
Figure 2. Major Nationwide Elections in the EU, 1994-98
|Date||Country||Type of Election|
|Jun 1994||EC States||Euro-Parliament|
|Jun 1994||Luxembourg||Lower Chamber|
|Autumn 1995/Spring 1996a||United Kingdom||Parliament|
|Late 1997||Ireland||Parliament and President|
a The UK elections will probably be held before their April 1997 deadline.
Notes: The legal deadline for Italian general elections is 1997, but elections are expected in the spring of 1994. Other parliamentary dates represent legal deadlines, but elections could occur before these deadlines.
Source: Government Ministries.
The economic cycle is showing signs of revival - though not uniformly across Europe. Forecasts for economic growth in the EU, as a whole, point to an acceleration during 1994 so that output in 1995 may be nearly 2% higher than this year's level. Though that may create some growth in employment, it will hardly even halt the rise in unemployment.
However, there are interesting parallels with a decade ago. On its 25th birthday - in March 1982, when 'Eurosclerosis' was at its most virulent - The Economist was so impressed by the EC's prospects that its front cover featured a gravestone for the EEC! That year, output grew by a meagre 0.7%, accelerating to 1.6% in 1983 and 2.3% in 1984. Unemployment jumped from 9.0% in 1982 to 10.6% in 1984.
The Euro-pessimists' arguments were understandable, but history records
that they were entirely wrong. Political vision was restored with the appointment
of Jacques Delors as President of the European Commission at the beginning
of 1984. The 1985 White Paper outlined the steps required to complete the
Single European Market, and the Single European Act was signed in 1985
- even as unemployment continued to rise. A decade later, there may be
a sense of déjà vu, but will Europe's politicians rise to
the challenge and obtain a fresh mandate for European integration during
this cycle of elections?
Meeting the Convergence Criteria
Even if the political will is revived, the problem remains that the Maastricht convergence criteria must be satisfied. These criteria cover four areas: price stability, soundness of public finance, ERM membership and interest rate convergence.
Widening the ERM bands to 15% has posed a problem: will sufficient states ever be able to meet the ERM membership criterion in the precise form set out in the Treaty? This criterion is detailed in Article 3 of the Protocol on Convergence Criteria and requires members to respect "the normal fluctuation margins" of the ERM ... "without severe tensions" ... "for at least two years" before the moment of decision; and not to have devalued "its currency's bilateral central rate ... on its own initiative" in those two years. This test is to demonstrate the credibility of locking exchange rates by showing that it has worked effectively. However, pressure for change can be suppressed for several years at the risk of an eventual explosion - as was recently demonstrated.
The new 15% fluctuation bands will probably not be narrowed again in the foreseeable future and several currencies - those of Benelux, Denmark and France - are likely to settle into a trading range against the Deutschmark once turbulence subsides. The peak-to-trough fluctuations may be within boundaries which are similar to the old "narrow bands" but could be centred on a rate which is significantly different from the existing central rate. There are two basic options to move to Stage Three whilst complying with the letter of the Treaty:
• A set of formal devaluations to bring ERM central rates into line with these new market rates. Apart from political objections, the two-year period would have to be restarted - unless this realignment were judged not be on the "own-initiative" of the devaluing countries.
• Formally recognise the new 15% bands as the "normal fluctuation margins" and test the behaviour of currencies to see whether they maintain a stable relationship against the anchor currency "without severe tensions". That test would be satisfied if the new trading range were comparable with the old narrow bands. As it would be a judgement test, it opens the possibility of "soft" margins to absorb temporary shocks.
However, the recent move by the French and Danish currencies back within
the old narrow bands raises the possibility that this debate will become
Inflation has been curbed by the severity of the recession. On
the basis of the European Commission's autumn 1993 forecast, Greece, Spain,
Portugal and Italy would fail the inflation convergence test in 1994. Next
year, however, only Greece and Portugal would fail.
The interest rate convergence criterion is rarely discussed yet it encapsulates many useful properties: it is forward-looking up to ten years, is less easily manipulated by governments, reflects the risks of public finance, is most easily met in a world of stable prices and, crucially, is dominated by the market's view about the likely movement of exchange rates.
The principal reason why more attention is not given to this criterion is probably because the test - average long-term interest rates must not exceed those of the three lowest inflation states by more than 2% - is so lax that it is virtually meaningless in an EC context. At the moment when Stage Three of EMU is about to begin, there should be total conviction that exchange rates between the participants will never change. Therefore, the yield spread between long-term bonds of the relevant governments should reflect only the perception of credit risk. If the market's judgement is that there are not excessive deficits and that debts are manageable, then the debt rankings of such leading industrialised countries should be amongst the best in the world and therefore very similar to each other. Accordingly, long-term bond yields should be close, perhaps less than 0.5% - not 2% - apart.
Despite this criticism, the criterion is embedded in the Treaty and must be respected. Interestingly, a careful reading of the Convergence Protocol suggests that Spain would qualify on this criterion because its long-term bond yield is presently hovering 2% above Danish levels. Denmark is one of the "three best performing member states in terms of price stability" and the Treaty does not exclude Denmark from this calculation - despite its currently stated intention to opt out. Spanish participation is likely to be a key to obtaining the quorum of member states required to start Stage Three.
Sound public finance is the final hurdle and is likely to prove most difficult: the impact of the recession has driven member states far away from the deficit targets. However, the convergence criterion is not specified by the Treaty in terms of simple numerical tests. Rather, it lays down a procedure for determining whether a member has an "excessive government deficit". Article 104 C specifies the process - which ends with "the Council shall ... decide after an overall assessment whether an excessive deficit exists."
This final step is a judgement and many observers will question whether this judgement is reasonable under all the circumstances - which will undoubtedly be highly politicised. For example, the German Parliament, in its ratification law, entrenched its right to check that this process had not been weakened. The German Constitu-tional Court - in its October decision - explicitly reco-gnised that the Council's decision would be a judgement and referred back to the Parliament's resolution that the transfer to Stage Three of EMU also requires an assessment by the German Parliament. Its vote will be based on the same material as the German ministers would use when voting in the EU Council of Ministers.
The Treaty-makers were correct in emphasising public finance as one of the entry tests. In the final analysis, the series of treaties that started with the European Coal and Steel Community in 1950 is designed to achieve a political goal - European union. Future generations will decide what that union means in precise practical terms, but it certainly implies substantial political co-operation as well as economic integration. That political relationship is the mechanism intended to secure that ultimate goal - enhanced security. Therefore, any event that threatens to fracture political co-operation would correspondingly damage the security objective.
There is insufficient popular feeling of pan-European solidarity to withstand a major shock, such as a large transfer of national wealth to pay off the debts of another member state. Recognising this, the Treaty-makers embedded a strategy into the Treaty in an effort to guard against an economic shock with the obvious potential to shatter the EC's political structure.
The Treaty strategy is straightforward:
• No entry to EMU for states with excessive deficits or debts.
• Peer pressure on EMU members that subsequently stray from fiscal rectitude.
• Sanctions on persistent offenders - ranging from public criticism to warning investors of the risks.
• A formal and explicit commitment not to bail out any state, even if it threatens to default.
EC policymakers now face the key question: is this strategy sufficiently credible to assure that political co-operation - the essence of European union - is not shattered by a financial shock stemming from public finance? If there are doubts about EC politicians' willingness to enforce the no-bail-out rule, then it is inevitable that - in the new world of EMU - some financial institutions will underestimate the risks and accumulate substantial portfolios of higher-yielding debts to benefit from the yield margin. If that group of institutions were sufficiently large, their insolvency might pose a risk to the EU's financial system. The consequences could well crystallise the lack of popular pan-European solidarity.
The vital purpose of the "excessive deficit" procedure is to minimise such risks by excluding from Stage Three any state which might cause the no-bail-out rule to be operated. The procedure requires judgement to be exercised by (a) the European Commission, (b) the Monetary Committee and (c) the Council of Ministers. All these officials will be operating in a highly politicised environment.
Perhaps there is scope for incorporating the neutral assessment of the
financial markets. This could be accomplished by tightening the existing
interest rate convergence criterion - which can be done by unanimous Council
decision. Alternatively and more simply, the European Commission could
declare that it will regard a long-term yield spread of more than 0.5%
within "all other relevant factors" when it prepares its initial report
on whether a state has an excessive deficit. Such a step could help depoliticise
the single most crucial judgement in the decision to move to Stage Three.