The European Council in Madrid requested the Ecofin Council, the European Commission and the European Monetary Institute to study the relationships between those Member States "fulfill(ing) the necessary conditions for the adoption of a single currency" (Article 109j, paragraph 4; the so-called "ins") and those that do not (the so-called "pre-ins"). In this context, a possible formal link between the pre-in currencies and the euro seems to merit special attention. It is assumed, of course, that there will be pre-ins, an assumption that appears to be well founded in economic reality. The convergence situation is so dismal, at least as far as public finances are concerned, that the question might rather be how many ins there are likely to be.
Why would such a link be deemed necessary? There is nothing very specific in the treaty hinting at the necessity of a formal exchange rate régime between ins and pre-ins. After all, beeing a pre-in is supposed to be short-lived (a possibly doubtful supposition). Nevertheless, there are sound reasons for an exchange rate arrangement. The most important one is, that such a system could provide -if its construction is right- an incentive for strong convergence efforts by the pre-ins. Such efforts in the framework of an exchange rate system would be mutually re-enforcing: the stronger convergence efforts are, the stabler is the exchange rate, aiding in turn the convergence policy. In this context, a formal obligation to safeguard the -realistic- exchange rate would provide an argument for the defence of possibly strong stability-orientated measures, undertaken in a Member State's own interest. A commitment not to use the exchange rate for the purpose of enhancing the competitiveness of the domestic economy to the detriment of the other Member States would furthermore have positive consequences for the Single Market. It must be said, though, that this argument is not as strong as it seems, for three reasons. Firstly, Member States already are under the obligation to treat their exchange rate policies as a matter of common interest (Article 109m), which means that they must refrain from competitive devaluations. Secondly, a devaluating pre-in would forgo the possibility of becoming an in for another two years because of the pertinent convergence criterium of exchange rate stability. Thirdly, competitive devaluations are not good economic policy, because they are counter-productive in the long run, potentially destabilizing the economy. This might be one of the main reasons why there have not been any competitive devaluations so far.
At first glance, one could arrive at the conclusion that the exchange
rate régime in stage three between ins and pre-ins could
be a simple extension of the European Monetary System. However,
this would pose several problems, as the current construction
of the European Monetary System is not free of problems. It seems
worthwhile, therefore, to look first at some parameters for the
construction of the future system.
2.1. No interference with monetary policy!
Firstly and most importantly, it must not endanger the pursuit of price stability by the European Central Bank via its independent monetary policy. The European Central Bank will be a new institution without history, therefore without record of success (nor failure) in maintaining price stability. Any perception by the financial markets of a lack of credibility of the European Central Bank in the pursuit of price stability could have potentially desasterous consequences. A laxist monetary policy is punished by the markets in several ways, the most direct beeing a risk premium in addition to an inflation premium on interest rates. That an inflation-prone monetary policy is a bad policy not even only in the long but also in the not so long run, has become a consensus among the Member States since some time now. This is not the occasion to elaborate on the negative effects of an inflationary policy -and the absence of positive effects like higher employment-, but such is the state of opinion in the economic science.
To preserve the credibility of the European Central Bank, it should therefore not be burdened with the unlimited obligation to intervene in the exchange markets in favour of pre-in currencies. Such an obligation could undermine its monetary policy, especially if the currency of a large Member State had to be supported by the European Central Bank. Even if sterilized, markets could assume that monetary policy was out of control. And there would necessarily come the point where sterilisation would no longer be possible. It must be borne in mind, that the most stable currencies will have by then entered the euro area, leaving as pre-in currencies those that are more prone to exchange rate fluctuations.
Apart from that reasoning, the events in the Exchange Rate Mechanism in the years 1992 and 1993 have shown that unlimited intervention in foreign exchange markets has the unpleasant effect of providing one-way bets for speculators. An exchange rate stability that is achieved at the expense of internal monetary policy would be counter-productive in any event. One last reason arguing against the obligation to unlimited intervention is a practical one: at the beginning of the third stage, the demand for money in the euro area is still uncertain and will probably be different from the sum of previous demand behaviour in the ins. Arbitrary movements of funds into and out of the euro area would make the task of the European Central Bank of orienting its monetary policy more difficult. This would be the case independently of the concept for monetary policy chosen.
It would therefore the logical responsibility of the pre-ins to ensure a reasonable exchange rate stability of their currencies, for three reasons already elaborated above:
The exchange rate system in stage three would therefore be much
more asymmetrical than the European Monetary System. In particular,
foreign exchange interventions by the European Central Bank should
come to an end, once the defence of an exchange rate is no longer
realistic. The European Central Bank should therefore have the
right to suspend interventions in such cases and possibly initiate
the re-alignment procedure. It follows logically from what has
been said, too, that the short-term financing mechanism of the
European Monetary System should not be unlimited.
2.2. Should there be an anchor currency?
Secondly, should the system have an anchor? This question is in
reality moot: the euro will be the pivotal currency, whether a
successor to the ECU is constructed or not. In hindsight it seems
fair to say that the European Monetary System could have done
without the ECU completely. It never assumed its pre-ordained
rôle in the centre of the system and never developed into
a parallel currency, contrary to the long-time strategy of the
European Commission. So it seems clear that a new construct should
be avoided, since the euro will become the anchor naturally because
of its presumed stability, the economic weight of the euro area
and the size of its financial market.
2.3. Is there a case for central exchange rates?
Thirdly, should there be central exchange rates? There should, because what would be the purpose of an exchange rate system without them? However, history has shown that governments or even central banks have no special insight into which exchange rates ought to be the right ones. Central rates should therefore be more flexible in the future and changes de-politicised. This was one of the lessons drawn from the exchange rate crises in 1992 and 1993, mentioned in both the reports of the Monetary Committee and the Committee of Governors to the Council. It may be a good idea to give the right to initiate a re-alignment also to the European Central Bank Council, alongside with the Member States.
Should there be central rates between the pre-in currencies and
the euro only or also between the pre-in currencies? Central rates
between the pre-in currencies and the euro imply cross-rates between
the pre-in currencies. It could therefore be concluded that a
formalization of bilateral rates would not be necessary. Such
a conclusion would make the system simpler and remove a possible
source of instability. The consequences for the bilateral relationships
of the pre-in currencies would be negligible because of their
central rates against the euro. The fiction that all currencies
are equal will no longer need to be maintained, since membership
of the euro area is the declared goal of the pre-ins. Instead
of being politically not acceptable, the pre-eminence of the euro
will be, on the contrary, politically desirable.
2.4. Fluctuation margins or not?
Fourthly, should there be fluctuation margins around the central rates? The question rather is: how could there not be fluctuation margins around the pre-ins' central rates? Anything else would mean that the pre-ins had in praxis entered the euro area. The only decision in that respect is that on the width of fluctuation magins. In the history of the European Monetary System there was a maximum of three configurations at the same time: fluctuation margins of plus/minus 2,25 or 6 % and no fluctuation margins. Presently there is a margin of plus/minus 15 % while several Member States do not participate in the Exchange Rate Mechanism and others maintain much closer links to the present anchor currency of the European Monetary System, the deutsche mark. Given the already mentioned plausible assumption that the pre-ins will be those with less stable currencies, it is hard to see how a narrow margin of e.g. 2,25 % could be maintained between a pre-in currency and the euro.
Another consideration in this respect is, how flexible the mechanism for adjusting the central rates will be. If, for instance, central rates were constantly monitored against a set of economic indicators with the aim of avoiding distortions of real exchange rates, margins could be narrower than in the case where nominal exchange rates are sacrosanct for political reasons and hardly ever adjusted, as was the case so often in the history of the European Monetary System. Were the system, to sum up, geared towards a stabilisation of real instead of nominal exchange rates, a narrower fluctuation margin than 15 % could be possible. Since the record of achieved stability-orientated convergence of each Member State is -at least potentially- different and will remain so in the future, different fluctuation bands would make sense, with the possibility of Member States to be "promoted" to a narrower band if the fundamental data show sustained improvement.
Still, the situation of the individual currencies is different. Their exchange rates do not only react to inflation differentials, but also to perceived changes in the credibility of their economic policies. It cannot be overstated that the credibility of a stability-orientated economic policy is hard to achieve, but easy to lose. Fluctuation margins must reflect the possibility that sudden movements of exchange rates occur that do not seem to be warranted by the fundamental economic data of the country concerned.
In summary, an exchange rate régime between the ins and pre-ins in the third stage would show similarities as well as differences to the European Monetary System. But it could share one feature of it, the legal base. Consisting of a political decision of the European Council and an agreement among the central banks of the Member States, it has shown great flexibility and proven its worth. Formal legislation in this field is not only superfluous but too inflexible to react to the very fast changes that occur in today's financial markets. On a political level, it would set a precedent for a political intervention into an important aspect of monetary policy.
The described system can be argued to be superior to the present European Monetary System. It would relinquish the crutches of unlimited intervention and credit and rely on the own efforts of the pre-ins. That such a system functions very well is easily demonstated by a comparison between the European Monetary System and the already existing monetary union between The Netherlands, Germany and Austria (from left to right). There was no obligation of the Deutsche Bundesbank to intervene in favour of the schilling before it joined the European Monetary System and there has never been any necessity to do so in favour of the gulden. There was no credit line available to the Oesterreichische Nationalbank, and the Nederlandse Bank never had to use its. Nevertheless, one would have to look up the day when there were no stable exchange rates between the three currencies.