Prospects for a wider Monetary Union after the Dublin Summit
In recent months the assumption appears to be taking hold that the group of countries to move to the third stage of European Monetary Union in January 1999 will be relatively large. The probabilities assigned by the markets to the various countries (Spain among them) joining this group have increased notably.
The main reason for this is no doubt the progress in convergence made by those countries departing from more unfavourable positions. In Spain's specific case -a case broadly similar to that of other countries- there has been significant headway towards price stability, while public finances have moved onto a clearly improving path. More important still, such progress appears to be sustainable in agents' eyes, which has made in turn for continuing exchange rate stability and a drastic reduction in interest rates and in the related spreads vis-à-vis the traditionally more stable EU members.
At the same time, another very important contributing element has taken root: namely the perception that the Monetary Union project (MU) is driven by political determination that is forceful enough to negotiate the obstacles and narrow the divergences that might jeopardise the completion of the project on schedule. This perception was largely based, at the time, on the resolutions of the 1995 Madrid European Council, and it has been appreciably reinforced at the recent Dublin European Council.
The favourable implications for MU arising from the Dublin summit are due to the fact that the agreements reached address some of the key problems for its future. Prior to Dublin there had been differences over such problems, including most notably the conditions governing MU membership and relations between the future euro countries and those temporarily excluded. This article will address the discussion of the foregoing aspects from a standpoint influenced by the positions held to date by Spain.
2. Conditions for MU membership
The advantages of a broad Monetary Union (i.e. with as large a number of countries as possible joining) are, in principle, clear-cut. For one thing, the various problems inevitably caused by the segmentation of the EU into those countries sharing a currency and the rest are lessened. For another, the full benefits of a consolidated single market could be had. Yet at the same time these benefits would evaporate and become daunting obstacles for the working of MU if, for the sake of a broad Union, countries displaying an insufficient degree of convergence were to have access to the third stage. The problems this would pose would affect both the Union as a whole and the countries that were given access without being adequately prepared. It is thus not difficult to agree that the examination of the countries and their degree of compliance with the established criteria must strictly be in the terms originally agreed and accepted by all, and as laid down in the Treaty. Undoubtedly, the Treaty offers some (limited) scope for flexibility of interpretation. Such scope will have to be applied bearing in mind the risks of both excessive leniency and excessive rigour.
The most worrying aspect for EU countries at present is no doubt fiscal positions. It is important that the progress in reducing budget deficits and public debt that may ultimately be disclosed as of the time of the examination should be sustainable. Specifically, progress should be the result of perseverant and consistent discipline-oriented policies, and not of ad-hoc measures allowing transitory improvements to be presented. This concern over sustainability underlies one of the most significant Dublin summit resolutions, which regards the so-called Stability Pact and which tackles the need to ensure fiscal rigour once MU is set up.
Well-known is the theory behind the idea that, in a Monetary Union in which the various countries retain fiscal sovereignty, the propensity to run budget deficits may be greater than in the absence of Monetary Union. Were this hypothesis to hold, it would greatly endanger the stability of the entire euro area. Even if this greater propensity to budget deficits were not to emerge in the initial years of the third stage, the prospect of it occurring in the future would seriously undermine confidence in the soundness of the MU project.
Hence the Dublin agreements, which frame a reinforcement of the degree of fiscal stringency in MU compared with the entry criteria, are a very important step to consolidate the project. Much has been written on the previous proposals to give form to the Stability Pact, and the discussions thereon have been widely aired. It need merely be added here that the final crafting of the Stability Pact establishes sound principles and criteria that are sufficiently clear and accepted by all, ranging from the medium-term budgetary equilibrium objective to the multilateral surveillance mechanisms and penalty procedures. Particular mention should be made of the capacity to reach agreements demonstrated on this very difficult point. This is mainly what bolsters the soundness and viability of the common project.
3. Relations between countries participating and not particating in the euro area
Despite the progress made, it is highly likely that some EU countries will not join MU from the outset, whether due to a political decision or because of an insufficient degree of convergence. The relationship between the euro-area countries and the remaining EU members is one of the thorniest and most discussed issues of MU construction.
A lack of balanced arrangements to govern relations between MU founder members and those initially excluded may entail grave risks for the single market. Indeed, it may prompt serious cracks in the EU-wide political cohesion that is needed. These risks will no doubt be all the greater the smaller the initial group is and the less precise and immediate the prospects for enlargement are.
The balance referred to should preserve two basic aspects. First, the soundness of the Monetary Union initially in place, which means ensuring that the stability of the euro area should not be affected by developments in the remaining EU countries. Second, the subsequent integration of other countries should be harmonious, without imposing conditions on them that unnecessarily hamper or delay their convergence.
At the start of the third stage of MU, the general background will differ from at present. It is highly foreseeable that there should be, on one hand, a core group of countries with -hopefully- a strong, stable currency whose macroeconomic performance will be of crucial importance for the remaining European countries. Further, there will be a group of countries temporarily excluded from the euro area which are obliged -under the Treaty and by their own decision- to attain convergence as soon as possible, this implying that their economic policy will be very strongly determined by that of the euro area's members. This all makes for a notable increase in asymmetry in the formulation of economic policies in the EU.
In the foregoing situation the excluded countries will see their scope for economic policy sovereignty drastically cut. At the same time, they will be continuously and closely subject to market assessments about their possibility of meeting the convergence criteria, which may lead at certain junctures to bouts of financial instability in the form of medium- and long-term interest rate movements and exchange rate swings. A situation in which these bouts were of some intensity would enormously hamper convergence efforts by the countries initially excluded (thereby refuelling financial instability) and would have a bearing on trade and financial flows in the EU as a whole. The harm to all, including euro-area members, would be serious.
The need to set mechanisms in place to prevent such undesirable developments led, at the Dublin summit, to the approval of a proposal on the framework of relations between the countries included in the euro area and those initially excluded. The proposal seeks to strike a balance between various concerns and viewpoints and is based on two key principles. First, the need to avoid major misalignments of real exchange rates and an excessive volatility of nominal exchange rates between the euro and the excluded countries' currencies. Second, recognition that the desired stability can only be attained through sustainable convergence of economic fundamentals.
On the basis of these two principles, the framework of relations proposed between the euro countries and the remaining EU members has two complementary parts: a new exchange rate mechanism between the euro and the surviving national currencies, and arrangements to strengthen convergence between both groups of countries.
The structure of the new exchange rate mechanism combines the flexibility needed so as not to hamper convergence by the excluded countries with mechanisms to prevent the defence of a specific parity from having undesirable effects on the euro area. The voluntary nature of membership of the new ERM is thus retained, and a standard system of broad bands is established, which co-exists alongside the possibility of certain excluded countries formally or informally instituting closer bilateral ties to the euro. The band limits will continue to entail mutual obligations of automatic and unlimited intervention, and the mechanisms for the short-term financing of operations will be virtually unchanged.
On the other hand, a series of elements strengthen the safeguards against detrimental effects on the euro area. The central parities of the various currencies will be decided and monitored by a multilateral procedure in which institutions representing the euro area bring significant weight to bear. At the same time, it is expressly excluded that intervention and financing commitments may endanger the price stability objective in the MU, which is tantamount to an escape clause for the ECB in the face of foreign exchange interventions that might, due to their scale, hamper monetary control.
The arrangements for reinforcing convergence -which should underpin the stability of the new euro exchange rate system- are based, as is known, on the greater demands made of convergence programmes and on greater stringency in multilateral surveillance procedures. These programmes should include a specific commitment to a budgetary consolidation path consistent with convergence objectives. Thus, just as MU participants will have to cope with the demands of the Stability Pact, the excluded countries will face a similar constraint, in the form of convergence plans, commensurate with their starting position.
This overall framework is in response to a complex balance of interests among EU countries. It is the result of members' different initial positions and of their different expectations about monetary integration. In that a balance has been struck and accepted by all, the framework is an achievement of great importance both for the countries to make up the euro area and those which may subsequently join. In the practical application of this proposal, it will be necessary to ensure that differing interpretations affecting this balance do not arise in the future. In this respect, it is stressed that the application of this framework of relations should not entail, either directly or indirectly, a breach of the principle of equal treatment for the countries that join MU subsequently. This is particularly relevant for interpreting the convergence criteria on public finances and foreign exchange stability.
The foreseeable advance by the euro-area countries in fulfilment of the Stability Pact, which sets more ambitious fiscal consolidation goals, should not alter the terms for the convergence examination of the countries that attain fiscal consolidation subsequently: the reference values and margins of flexibility should be the same as those applied to the countries initially admitted. The same should apply to the exchange rate stability criterion. Although the new ERM provides for tighter commitments, this cannot become an -implicitly or explicitly- obligatory requirement: exchange rate stability should be interpreted with reference to the broad bands and in the same terms used for the founder countries. Regarding this matter there are, in addition to arguments about equity, others of a purely economic order. There is a temptation to believe that imposing stringent exchange rate rules on countries with a derogation would protect MU members from the consequences of intra-Community exchange rate swings. However, this belief is belied by the experience of the ERM, which shows that, to facilitate convergence, even between countries with very sound fundamentals, it has been necessary to accept exchange rate agreements with some degree of formal flexibility. Excessive rigidity of the latter leads only to an increase in instability and turbulence, which is harmful to all in the long run. These considerations are particularly relevant for the period immediately after the announcement of the countries that will make up the euro area. At that point the markets may impose appreciable adjustments on the exchange rates of the countries excluded, and any attempt to avoid this would lead only to the destruction of the credibility of an exchange rate commitment that were too narrow to be sustainable in such circumstances.
4. The outlook for Spain in the run-up to Monetary union
Spanish integration into the European economy has proceeded apace. A high degree of interdependence manifest at all levels of economic relations has been achieved in recent years. The Spanish economy is thus fully involved in the European project structured around MU. From this perspective, the future of the Spanish economy is closely tied up with its capacity to face the challenges MU poses. There are very forceful political and economic reasons why Spain is interested in participating in MU from the outset, if the necessary conditions for successfully doing so come into place. Chief among the "political" reasons, perhaps, is the capacity to influence relevant decisions in the European setting. Among the economic reasons, it is clear that if MU is to come about, being outside the founding group would entail costs that may -depending on the circumstances- be very high.
The benefit which, according to certain quarters, may be had from tackling convergence more gradually is not at all clear. It is very doubtful that such gradualism may actually widen economic policy scope; on the contrary, convergence difficulties would increase once MU were up and running.
Consequently, to attain monetary integration, the Spanish economic policy strategy should be to seek to meet the convergence criteria as soon as possible. Doing this would moreover be a positive move towards creating the conditions that are, in any event, necessary for ensuring sustained economic growth and job creation. For it to be sustainable and have no adverse consequences in the future, such convergence should be underpinned by more efficient markets and the elimination of the structural obstacles that have fuelled Spain's past economic disequilibria.
Spanish economic policy seems firmly oriented along these lines. Most notable progress has been made, the clearest reflection of which is the higher probability assigned by the markets to Spain's presence in MU in 1999. Yet it should be stressed that, were this aim not to be achieved, that would not warrant changing the bearings of economic policy. A country that has been excluded, but has converged to such an extent that its prompt entry is envisaged, will suffer the disadvantages of exclusion to a much lesser extent than others with a clearly insufficient degree of nominal convergence and a faltering economic policy that prevents venturing how long the exclusion period may be. While in the latter case the markets' sanction could be very harsh, in the former only temporary and moderate upsets would be expected, and these would not endanger the economy's medium-term stability and the viability of the convergence process.