European Monetary Union

The purpose of this chapter is not to offer a detailed account of the history of European monetary integration. Excellent accounts are available such as the well-documented book by L. Tsoukalis (1977), which was a major source of information in writing the first section of this chapter. We will rather focus on a general reflection about the nature of, and the problems posed by, European Monetary Union (EMU) in the specific context of the European integration process.

In the period since President Jenkins (1978) stimulated serious debate again on European monetary integration, the European Monetary System (EMS) has settled into the landscape more comfortably than one might have expected from the debate surrounding the negotiation period. Already in April 1979, only a month after the EMS began its operating, Christopher McMahon (1979), now deputy Governor of the Bank of England observed: ‘If the EMS did not exist, it — or something similar — would have to be invented.’

Emerson’s paper is wide-ranging, interesting and informative but in the end it leaves a feeling of dissatisfaction. I think there are three main reasons for this.

While there was almost unanimity among economists, politicians, and practitioners in the middle of the seventies — at least in so-called ‘strong’ countries — that a flexible cxchange-rate regime was an optimal solution for the time being, this consensus discontinued in the course of 1977 and 1978, when the US government repeatedly put pressure on European countries and Japan to reflate their economies and at the same time they were badly frustrated in their efforts to successfully do so because of the sustained depreciation of the dollar.

This paper gives answers, inter alia, to the following questions:

One feature of the European Monetary System (EMS) is the introduction and the use of the European Currency Unit (ECU). As is well known, the ECU is defined as a basket of currencies in much the same way as the SDR. The objective of the introduction of the ECU was to contribute to a fully-fledged European Monetary Union. Whether or not this objective will be attained is uncertain. The question remains outside the scope of this article.

These three chapters address themselves to some very important issues. From the wide range of specific questions considered there emerge four critical concepts which are in urgent need of clarification, and which form the focus of this discussion. These concepts are stability, convergence, symmetry and balance, both internal and external.

Following a decade of comparative stability in domestic and international monetary arrangements, the 1970s was a period of considerable turbulence. The uncertain, and at times volatile, international environment proved to be unconducive to the attainment of the ambitions of the Werner Report, and revealed a degree of disparity in economic performance among members of the EC that denied significant progress towards formal monetary integration.

The late Richard Crossman contrasted political man with a fish swimming in a stream. The fish has no way of visualising the world which lies outside the river banks, whereas man is able to make the necessary intellectual ‘leap’ and analyse his social, political and economic framework in the context of the world at large and not merely within narrow geographical constraints.

Flexible exchange rates have never commanded universal support among economists, but it is fair to say that they found more enthusiastic adherents during the 1950s and 1960s, when a (more or less) fixed-exchange-rate regime was in force, than they do now, after close to a decade of experience with them. In this chapter, I seek to contribute to the ongoing debate about flexible exchange rates in a number of ways. First, I shall review briefly the by now well-known arguments about fixed and flexible exchange rates that monetary economics in and of itself permits us to develop. Second, I shall consider what may loosely be termed the political arguments about ‘discipline’, or lack thereof, in the conduct of policy that alternative exchange-rate regimes are said to promote, in the light of the experience of the 1970s. I shall pay particular attention here to British experience. Finally, I shall consider the issues raised in the first two substantive sections of this paper from a more general perspective, and will argue that there still remains a powerful case to be made for flexible exchange rates as a means of organising international monetary relations. The case however is essentially political rather than economic.

The major industrialised countries have substituted the reduction of the inflation rate for ‘full’ employment as their principal economic policy objective. In pursuit of a lower rate of change of prices they have allowed their unemployment rates to increase to levels that would not have been considered politically possible as recently as a decade ago. It is arguable, however, that further increases in unemployment, or even maintenance of current levels for an extended period of time, would impose costs which would be unacceptable in both economic and political terms. It may, therefore, be asked whether European Monetary Union, apart from any other advantages it may offer, can facilitate the reduction of member countries’ inflation rates at a relatively lower cost in terms of both short- and long-run unemployment. The answer to this question rests on an assessment of the inflation bias of flexible relative to fixed exchange rates. In our discussion of the inflationary bias of alternative exchange rate regimes we shall consider, in contrast to other studies that have addressed this question, the impact of exchange-rate flexibility not only on policy-makers’ preferences but also on the constraints that face them. That is, we shall argue that the relative inflation bias of flexible exchange rates is at least partially dependent on how the short-run trade-off between the inflation rate and unemployment, and therefore the natural rate of unemployment, is affected if exchange rates are allowed to be freely determined in the foreign exchange markets.

Through the use of alternative approaches these two papers come to different conclusions on the fixed versus floating exchange rate debate in 1980. Laidler presents a pragmatic and persuasive case for floating rates without stating the positive merits of the fixed rate alternative, while Sumner and Zis present a useful survey of the theoretical literature on the relationships between exchange rates and inflation, and by rectifying certain faults of the literature conclude that floating rates exhibit an inflation bias.

The economic costs of belonging to a monetary union are closely correlated with the size and the frequency of disturbances that affect the member countries differently. Such disturbances are described as ‘asymmetric disturbances’.

Polly Allen’s paper reports the results of an interesting exercise. It explores the consequences of asymmetrical supply-side shocks on the output, income and price levels of the members of a monetary union, within a carefully specified analytical framework. In detail, the results of course must necessarily reflect the very precise assumptions of the model from which they are derived. Nevertheless, the spirit of the exercise must be that the experiment and its results speak to realistic concerns. Indeed, the particular choice of disturbance for examination is a good one. The comparative absence of such shocks has been suggested as a criterion for an optimal currency area whilst, closer to home, some observers have foreseen particular dangers for a country like the UK, prone to nominal wage disturbances, in joining the EMU and particular benefits for countries like West Germany, which are not so prone. Subject to a qualification, this paper speaks to those concerns. The qualification is that what most observers have had in mind in speaking of the British and German interests in EMU is, actually, not so much disturbances around the trends of nominal variables themselves as divergencies between the trends. At the level of direct analogy, the disturbance examined here is more akin to the famous ‘événetments de 1968’.

My first reaction to writing this chapter was to add a short sub-title ‘In search of principles’. But I decided against the idea because the search for basic principles has been going on for some time. It has been going on both within the EC in the form of numerous memoranda and notes sent by the Commission to the Council; in the form of various studies commissioned by the Commission, among which the MacDougall Report (1977) was an outstanding piece of work likely to be referred to for many years to come; and, finally, in the now growing number of papers dealing with this topic as well as articles in serious journals throughout the world.

Let me start my discussion by making two subsidiary points. First, I would turn round what Mr Rybczynski says about large interregional transfers having made little difference to growth rates; it was because the structurally-determined components of the growth-rates already differed that the transfers were required, and one could argue that in relation to their size they were pretty effective. Second, I do think Mr Rybczynski is technically wrong in regarding the ‘up to 1 per cent of the yield of a uniform VAT’ as not an ‘own resource’, but this is metaphysics!

Monetary union has twice been a live issue in the politics of the European Community — first, in the late sixties and early seventies, when the Werner Group proposed a phased plan for the achievement of monetary union by stages, and when member governments rashly committed themselves to full-scale monetary union by 1980; and, second, in the late seventies, when Mr Roy Jenkin’s Florence speech ‘relaunching’ the concept in October 1977 was followed not more than a year later by the decision to set up the European Monetary System. Both in the first, ‘Werner’, phase and in the second, ‘Jenkins’, phase, the most enthusiastic advocates of monetary union clearly appreciated that it had immense political and institutional implications. The final report of the Werner Group explicitly said that in the final stage there would have to be a ‘centre of decision for economic policy’ and a ‘Community system for the central banks’ (Commission of the European Communities, 1970, pp. 12–13). Jenkins (1978a) did not go quite as far as this, but in his Florence speech he said that monetary union ‘would imply a major new authority to manage the exchange rate, external reserves and the main lines of internal monetary policy’; and in a speech to the European Parliament a few weeks later, he declared that in a monetary union ‘two of what are generally regarded as the more important functions of a modern government — control over the exchange rate and control over the money supply — would be exercised by a central Community institution instead of by governments’ (Jenkins, 1978b).

Monetary policy — as some within the British Government are again discovering — does not exist in isolation. It interacts with a wide range of other areas of policy: economic, industrial, commercial, foreign policy. So it is with monetary co-operation. The relationship between the dollar and the major European currencies may rest in the first instance on the technical expertise of central banks, consulting and co-operating closely with each other within a tight and relatively closed network. But the context within which those central bankers operate is shaped by much wider economic, political and security factors.

I respond to the chapters by David Marquand and William Wallace as a student of politics and particularly of the phenomenon of supranational integration. I will also be making one remark as a participant in the political process later on.