More specifically, the aim of my remarks is, first, to give some historical background information on the process of European monetary integration, and then to consider three general economic aspects of European monetary integration in which MESD plays an active part. These are policy co-ordination in Stage Two, the issue of convergence and the EMI's role in the process and, finally, consideration of some of the economic issues raised by the plan for EMU. I shall conclude with a personal view of prospects for EMU.
Plans to create a European zone of monetary stability have been laid a number of times in the post-war period. The reason for this is closely related to the desire to foster economic integration and trade between European countries.
One major landmark was the Werner Report of 1970. The Report was intended to pave the way towards Monetary Union in 1980 in three stages - with the final stage involving either an irrevocable interlocking of EEC exchange rates or the introduction of a single currency. Despite having been unanimously approved by the ECOFIN Council, it was never implemented - being overtaken by world events. In particular, this was precisely the period during which the Bretton Woods agreement was breaking up, as various economies exhibited differential policy responses to the shocks to the world economy in the 1970s. One lesson that could be learned from this experience was that for a zone of monetary stability to succeed in Europe, there must also be a high degree of economic convergence among European countries. Comparing the plan set out by the Werner Report for Monetary Union with that laid down in the Maastricht Treaty there are some notable differences, which reflect developments in economic thinking over the past twenty-five years. Among these, the Werner Report was very sketchy about the nature of the central monetary authority, and its relationship to political authorities. On the other hand, it provided for much greater central influence on fiscal policy within the EC.
That, of course, is not the end of the story - greater stability of exchange rates was the focus of attention in the setting-up of the European Monetary System (EMS) in 1979, which provided limits on the fluctuations of currencies participating in the exchange rate mechanism (ERM). Further significant steps towards closer monetary and economic integration were taken in the mid-1980s. First, the Single Market programme was launched by the Single European Act of 1985. This has made considerable progress, with the latest European Commission figures suggesting that well over 90% of the proposed legislation has now found its way into national law.
A second strand of this development was the revival of plans to establish a Monetary Union within Europe. The Maastricht Treaty, which came into force after its ratification by all (then) twelve Member States in November 1993, envisages a three-stage process to Monetary Union - the final stage being the introduction of a single currency for participating countries. Stage One of this process was deemed to have begun on 1st July 1990, and was marked by the abolition of remaining capital controls among Member States. Stage Two began in January 1994 and is marked by a number of developments; increased co-operation among central banks, the prohibition of monetary financing by central banks of governments, and a major change in terms of the institutional structure, the creation of the EMI.
The main focus of the EMI's work is on preparations for EMU. But the EMI also has an important role in Stage Two to strengthen co-operation among the national central banks and to strengthen the co-ordination of national monetary policies with a view to ensuring price stability. In considering this issue, it is essential to recognise, first, that the EMI is not the European Central Bank and that it has no responsibility for the conduct of monetary policy in the European Union in Stage Two, which rests solely with the national central banks. Second, national central banks themselves are operating in a rapidly changing environment. Financial liberalisation and deregulation, the abolition of exchange controls, innovation, institutionalisation and the growth of xenomarkets constitute important components of recent financial change. These have entailed, for example, a decline in credit rationing, and hence a need for a more market-based approach to policy, as well as heightened instability of prices and flows in financial markets. The evolving pattern of volatility is considered to have entailed a major shift in the stability of central banks' environment and poses difficulties for monetary policy.
It is acknowledged to be in the interests of all central banks to co-ordinate their actions in such an environment. Lacking co-ordination, the actions of some can have an immediate and perhaps undesired influence on others, particularly as markets may overreact to certain policy measures.
The core of co-ordination is the monthly meeting of the EU central bank Governors at the EMI, at which policy topics - and in particular the appropriateness of monetary policies - are freely debated. To enhance such co ordination, the EMI carries out an annual forward looking assessment of Member States' policy intentions in order to assess their consistency with the objectives of price convergence and stable exchange rates. This exercise is followed by regular ex post examinations of "burning issues" arising for monetary policy. These exercises are accompanied by EMI research on aspects of economic policy and behaviour, which seeks to enable countries better to understand the environment and constraints within which their neighbours operate. Reflecting the importance of fiscal policy to the environment of monetary policy, a regular report is also prepared on public finances in EU countries.
The overall approach is pragmatic in several respects. The assessment of the appropriateness of monetary polices cannot be mechanistic. It has to remain judgmental and take into account various economic, financial and monetary indicators. Equally, it has to take into account the different approaches of countries to monetary policy. For example, while Germany continues to target M3, in several countries an explicit inflation target is now used as the preferred anchor for monetary policy, partly because monetary aggregates have ceased to have a stable relationship with nominal GDP, owing to structural change and innovation in the financial system. For most small open economies, the exchange rate target remains the primary objective of monetary policy, even if tactics are adjusted in a more flexible way in the new ERM. In this context, the challenge for the Institute is to promote co ordination through sound analysis and effective persuasion.
The importance of the ERM to policy co-ordination in the EU is reflected both in an annual report on its functioning prepared by the EMI, and in regular monitoring by central bank officials of exchange rate developments. Here the key challenge is that the new ERM regime, which was introduced by the decision to widen the bands to ±15%, may not by itself provide the kind of disciplinary mechanism which has, in the past, been instrumental in promoting nominal convergence. The risk of exchange rate misalignments cannot be totally excluded, whether owing to inappropriate policies or the behaviour of financial markets. However, the authorities have made it clear that the new ERM regime should not be viewed as being a system of floating exchange rates. The decision to widen the bands primarily aimed, firstly, at preserving central parities which were regarded as sustainable by the authorities and, secondly, at eliminating the possibility offered to speculators to make safe one way bets at the expense of the monetary authorities.
The wide-ranging preparations for Monetary Union will only be of practical use if EU countries are ready for EMU in time. In order to ensure that the Monetary Union is viable and sustainable, the Maastricht Treaty provides that no Member State can enter EMU unless the Council, meeting in the composition of Heads of State or Government, finally concludes that it "fulfils the necessary conditions" in terms of convergence to do so.
The emphasis is on sustainability of fiscal positions, price stability, exchange rate stability and convergence of long-term interest rates. Here too, the EMI is assigned an important role. In the run-up to the decisions, it must prepare a report to the European Council, which will - together with a report by the Commission - serve as the basis for the assessment of convergence by the Council of Ministers and its recommendation to the Heads of State or Government on the composition of the Monetary Union. In the context of convergence, it is relevant to outline the overall economic justification, and an overview of the current situation, as seen by the EMI.
- The criterion on price stability reflects the consensus that price stability is essential for the achievement of the sustainable and balanced growth of economies, thereby creating the best conditions for fostering employment and improving standards of living. It is widely accepted that beyond the very short term there is no trade-off between inflation and unemployment to be exploited, and there is also growing awareness of the costly economic distortions that inflation creates, hampering the long-term growth prospects of economies.
- Similar arguments may be derived for the fiscal criteria, with the 3% and 60% reference values for deficits and debt. These criteria will not only be examined for the purpose of convergence, but will also be applied in Stage Three, when fiscal policy will continue to be set in a decentralised manner. In other words, they are not merely entry conditions for EMU and guidelines for a sustainable fiscal strategy, but also a cornerstone for macroeconomic stability once the European currency area is in place. There are a number of reasons why fiscal discipline is essential in a monetary union. Respecting the debt criterion will safeguard the Monetary Union against the risk of a situation where an individual country is ultimately unable to service its debt within the parameters of its own fiscal revenues. Compliance with the debt criterion clearly reduces the chances of an unsustainable fiscal position emerging. The debt criterion is also included as a convergence requirement to prevent the risk of financial market instability.
- Furthermore, turning to fiscal deficits, there may be important repercussions on monetary policy from large deficits, thereby unfavourably affecting the policy mix, while there may also be spillovers across borders affecting the Monetary Union as a whole from lax fiscal policies in individual Member States. This would penalise those members of the Monetary Union which had retained sound fiscal policies and would also complicate monetary policy for the Monetary Union as a whole. Finally, some disturbances to aggregate supply or demand affecting individual countries or the Monetary Union as a whole may occur: in this context fulfilment of the fiscal criteria will be essential to ensure that the automatic stabilisers of the fiscal system are able to operate in affected countries without generating an excessive deficit.
- Exchange rate stability typically requires markets to consider that current and expected inflation is sufficiently low to sustain competitiveness at current nominal exchange rates, and monetary authorities to have built up counter-inflationary credibility. Equally, a sound fiscal policy may generate confidence and thereby contribute to exchange rate stability. Long-term interest rates are traditionally seen as being closely related to domestic inflation expectations, as well as to the credibility of the authorities in maintaining price stability. There is also a tendency for risk premia in long-term rates to be linked with fiscal developments (with risk premia increasing as deficits and debt rise, and vice versa).
- Turning to recent performance, public finances are the weakest point of convergence. The overall public sector deficit in the EU in 1994 amounted to around 5.5% of GDP, which is one of the highest levels recorded since the foundation of the Community and almost twice the maximum of 3% permitted under the Treaty. Despite an economic recovery during 1994-95, the overall public deficit only declined marginally, to stand at 5% in 1995. The vast majority of Member States had imbalances of over 3%. A worrying feature of the rise in deficits since 1990 is that only a relatively small part of the deterioration can be attributed to the recession; in many countries there was a major increase in structural deficits. Also, it was accompanied by a significant expansion in the share of the public sector in the economy. The government debt ratio in the EU has also soared above the 60% limit, reaching 71% in 1995. Debt ratios have a particularly wide range, with only a handful of EU countries having debt/GDP ratios below 60%, and Italy, Greece and Belgium having ratios of well above 100%. For most EU countries, fulfilling the fiscal criteria will certainly entail a substantial effort in reducing deficits and restraining public expenditure, but these objectives will be essential in any case to cope with future challenges such as the ageing of the population. If consolidation is seen as credible by the public and the markets, any contractionary effect of the fiscal tightening will be cushioned by declining risk premia on long-term bonds and improvements in business and consumer confidence.
- Concerning price stability, the picture is brighter; Member States have made remarkable progress since 1990. This is reflected in average inflation in the EU, which stands at the historically low rate of 3%. Twelve years ago it was nearly 8%. In many EU countries, virtual price stability, i.e. an inflation rate of 2% or less, has been established, and there has been a marked deceleration in inflation in the countries that had entered the 1990s with the highest inflation rates.
This relatively favourable overall inflation performance was certainly due, in part, to the severity of the recession of the early 1990s. But much more important is the fact that price stability has, for some time, been accepted in EU countries as being one of the major objectives of economic policy in general and as the primary objective of monetary policy.
- Turning to exchange rates, although the system of wide ERM bands instituted in 1993 is considered to have been successful in relieving tensions and preventing speculative attacks, the turbulence of early 1995 has raised a number of issues for central banks and the EMI. Particularly for ERM currencies, these include the appropriate response of countries to a depreciation of their currencies within the band; notably for non-ERM currencies there is the issue of spillovers in the event of depreciation, which could affect inflation, trade and the Single Market. On balance, experience confirms the need for a strengthening of the convergence process in order to maintain exchange rate stability.
- Despite the turbulence in international bond markets in 1994, the long-term interest rates of individual countries have moved broadly together. As a result, the pattern of convergence of long term interest rates is similar to that for inflation. However, it is also worth noting that, in the context of the global increase in bond yields in 1994, as well as in early 1995, the countries whose yields rose the most had relatively high fiscal deficits and had a poor track record of inflation and exchange rate stability. This underlines the fact that bond yields may provide a "summary" of the other indicators.
- On balance, it must be acknowledged that it seems unlikely that all EU Member States will be able to take part in EMU in 1999. However, this should not be seen as disastrous; quite the opposite, it would be highly damaging for the Monetary Union to include Member States that have not converged. The Treaty quite explicitly allows for EU countries to join EMU at a later stage.
I should now like to turn to an overview of the economic benefits of European monetary integration.
The benefits in terms of growth of the Single Market can only be fully exploited if the transactions costs of exchanging different currencies are eliminated. These costs, which include commission charges and the bid-offer spread, account for around 0.4% of European Union GDP. Although small, they are not insignificant, particularly since they effectively form an additional barrier to exports, allowing prices to be higher and competition less in the importing country than would otherwise be the case.
- Monetary Union will eliminate short-term (day-to-day) intra-EU exchange rate volatility, thus eliminating the difficulties caused to trade and investment from this source. It is possible to distinguish the risk of longer-term real exchange rate misalignments from this day-to-day volatility. Misalignment is a serious problem in the EU, as experience in 1995 showed, particularly as it can at times be exceedingly difficult to bring such misalignments under control. Protracted misalignments of real exchange rates give rise to the misallocation of resources (for example, in the location of investment), major macroeconomic effects, and may also trigger protectionism and hence pose a threat to free trade. Such misalignments are particularly devastating in the EU given the level of economic integration; even recent, rather limited, real exchange rate developments are leading to - albeit still rather isolated - calls for protection and compensation. Such pressures, if left unchecked, could place the survival of the Single Market at risk.
- By eliminating exchange rate uncertainty, Monetary Union should lower the risk premia built into interest rates. Other aspects of Monetary Union will underpin this effect. Price stability in EMU, as discussed below, will again help to ensure low yields. Again, fiscal discipline among members of the Monetary Union will reduce any upward pressure on interest rates from this source. Furthermore, to the extent that the introduction of the single currency will increase the substitutability of the bonds of those countries that form EMU, as a consequence of the elimination of exchange rate risk, then some improvement in the liquidity of the bond markets of those countries that form EMU can be expected. This could lead to the development of a bond market which would rival that of the United States in terms of liquidity and hence the bond markets of even the largest countries in EMU could benefit from a reduction in liquidity premia vis-à-vis the United States. Lower yields will benefit borrowers in both the private and public sectors. Thus, it should enhance investment, which in turn should have a strong impact on growth.
The benefits to trade and investment of lower transactions costs, reduced exchange rate volatility and misalignments, as well as lower risk premia and a broader domestic market, are likely to increase with the existing degree of integration. In this context, it is important to stress that the integration of the real economies and financial markets of the Member States has already reached a high level. On the basis of recent estimates, nearly one-half of EU trade is intra-Union. But equally, the single currency should stimulate further integration, with accompanying efficiency gains.
- Monetary Union should promote and maintain price stability. It is laid down in the Maastricht Treaty as the primary objective of monetary policy and will be (or is already) explicitly incorporated in the statutes of the national central banks before participation in EMU. The ESCB will enjoy full independence to determine the appropriate level of interest rates in order to satisfy this requirement of the Treaty. The members of the Executive Council of the ESCB and the Governing Council of the ESCB will have long-term mandates and can only be dismissed for serious misconduct or inability to perform their duties. These provisions imply that the concept of monetary stability will benefit from explicit legal protection. The ESCB should also have reputational benefits, both as developed by the EMI and inherited from constituent central banks. This structure should reduce the costs of maintaining low inflation in the EU considerably, because consumers', businesses' and financial markets' expectations of inflation should adjust favourably in response to the independent status, reputation and statutory objective of the ESCB.
- For balance, I should mention the main counterargument often put forward against establishing Monetary Union in Europe. This suggests that in a world of inflexible labour and goods markets, individual countries should retain the ability to change their exchange rates as a means of responding to adverse "asymmetric" shocks to the macroeconomy. Asymmetry is crucial; if shocks affect all EMU member countries, the single monetary policy may respond appropriately. Also, if markets were perfectly flexible, or almost, so that full employment was guaranteed by the working of the price mechanism, or via labour mobility, the loss of the exchange rate as a policy instrument would be immaterial and Monetary Union would not entail any costs. If not, the sudden appearance of significant cost differentials within a Monetary Union would, it is argued, depress the less competitive area in a chronic manner and could generate an unsustainable political and social situation. Therefore, EU countries should retain the ability to change exchange rates, as this would ease their adjustment to shocks.
There is no doubt that labour and also goods markets in most European countries show insufficient flexibility. However, this is not an argument against EMU. The source of the problem lies in structural rigidities that prevent the timely adjustment of domestic prices and wages. It is widely acknowledged that the reduction of such rigidities, especially in labour markets, is an objective which has to be pursued irrespective of EMU. Rigidities are rightly seen as being largely responsible for the high levels of EU unemployment. It is clear that macroeconomic policy can contribute little to its absorption; there is only one way to fight unemployment and that is to reform labour markets with a view to enhancing flexibility, in parallel across EU countries. Significant steps have already been taken in this direction in some countries, while further progress is needed in others.
Moreover, in an environment of labour market rigidities, changing the nominal exchange rate may not be effective against adverse country-specific shocks. If real wage restraint is needed to prevent a negative shock from raising unemployment, it has to be the case that wage-setters are prepared to admit this through a depreciation of the national currency but are not willing to accept it by means of nominal wage restraint. This presupposes a degree of "money illusion", which is unlikely to exist beyond the very short run.
There are important interactions between monetary unification and economic integration. The latter is likely to make asymmetric shocks less frequent for several reasons. One reason is that economic structures may become more uniform over the zone. Also, there will probably be a deepening of intra-industry trade, with the manufacture of a single product spread across several countries. There may be a convergence of labour market structures, which will aid this process. Another reason for optimism in relation to the correction of asymmetric shocks is that the transmission mechanism of such shocks will work faster in the absence of barriers to trade and to price adjustment. Thus, a shock of asymmetric origin would soon become a shock for the zone as a whole owing to rapid spillover effects.
I should like to conclude with a personal view of prospects. The state of expectations in financial markets regarding European monetary integration in general, and prospects for Economic and Monetary Union (EMU) in particular, have fluctuated a great deal. In the early 1990s, prior to the conclusion of the Maastricht Treaty, optimism about EMU was considerable and progress towards it appeared to acquire an unstoppable momentum. Then, the Danish referendum in May 1992 and the currency crises of 1992-93 seemed to cast doubt on the whole concept. More recent trends in the real economy have again given rise to a degree of pessimism.
However, despite the crises and the scepticism, the EMU process remains on course. The Treaty has been ratified by all existing Member States, three new members have joined the EU and the institutional preparations for EMU are well under way. Convergence under the Maastricht criteria is also under way - although progress in fiscal consolidation remains essential. Politicians are aware of what is at stake. The economic case for EMU remains sound. On balance, and while not underestimating the economic and technical difficulties, it has to be emphasised that the most important requirement for EMU is the political will to move towards further integration.