EMU: Political and Economic Implications

Wolfgang Munchau

The Royal Institute of International Affairs

November 1997, FSS BRIEFING No. 38

Introduction

The rush to meet the 1999 deadline for the final stage of European economic and monetary union (EMU) has turned into the overriding theme of European politics. The process has led to an unprecedented degree of budgetary rigour and economic convergence across the EU, but has also provoked an anti-incumbent effect in several national elections. EMU has the potential both to trigger some of the most profound changes to the competitiveness of the EU economies, and to lead to further political integration. The overall process and timetable are essentially driven by politics.

Delay or no delay

It is highly probable but not certain that EMU will go ahead as scheduled on 1 January 1999. In Germany, however, the single currency remains deeply unpopular. A number of state premiers - Edmund Stoiber in Bavaria (CSU), Gerhard Schröder in Lower Saxony (SPD) and Kurt Biedenkopf in Saxony (CDU) - have called for EMU to be delayed. Their views have struck a chord with the public, especially after the French government admitted that it will exceed the Maastricht Treaty's target of a budget deficit of 3 per cent of GDP this year. Nevertheless Chancellor Helmut Kohl remains firmly opposed to a delay on the grounds that it could endanger the project.

Even if EU leaders were to find a legally watertight way of delaying, they would still need to overcome other obstacles if postponement is not to mean abandonment. First, the decision would require unanimity, not so much for legal but for political purposes. Second, financial markets would need to be convinced by the new arrangements - a difficult task. Third, EU leaders would need to be clear about what they hoped to achieve by delaying. If it was in order to achieve greater convergence, they would need to explain why a further two years of convergence efforts would succeed when the previous seven years had not done so. Finally German elections, scheduled for September 1998, could, in theory, interfere. The SPD might put up Gerhard Schröder, the prime minister of Lower Saxony and a vociferous proponent of EMU delay, as its candidate for chancellor next year. But it is doubtful whether, if elected, he could single-handedly change the timetable at such a late stage.

The arguments for EMU

In the late 1980s, EMU was seen largely as a political device to foster European integration. By the time the Maastricht Treaty was signed the rationale had shifted, so that both aims - political and economic union - were to be pursued in parallel. But the lack of progress towards further political union at the 1997 Amsterdam summit suggests that the justification behind EMU has almost entirely shifted from politics to economics or that EMU itself is seen as as the key step towards political integration.

The theoretical foundations for a currency union among independent nation-states are not strong prima facie. Among international economists, it is widely accepted that free trade areas do not require monetary union in order to function effectively. A frequently cited example is the North American Free Trade Agreement (NAFTA). Indeed, permanently fixed exchange rates could be positively harmful since changing parities can act as a buffer to absorb economic shocks.

EMU will have no such buffers. The exchange rates will be permanently fixed among EMU members. Fiscal policy will be heavily constrained by the Stability and Growth Pact, aimed at keeping budget deficits at under 3 per cent of GDP. The pact, agreed at the Dublin EU summit in December 1996, grew out of a proposal from the German government, which had come under domestic pressure to seek further guarantees about fiscal stability under EMU to ensure a strong euro. The new Socialist government in France, whose leaders criticized the Maastricht Treaty during the French election earlier this year, sought to renegotiate the pact in June 1997, but failed to make any significant inroads, as the German position prevailed almost unchanged.

With the stability pact in place, the number of shock absorbers is diminishing. Since the EU is a single market, countries cannot erect trade barriers. Nor are the wealthier states willing to agree to substantial transfers to the poorer states, as happens among Germany's Lä nder. The only conceivable pressure valve under EMU - in the absence of labour mobility - would be deregulation of labour and product markets. Given the political difficulties involved in deregulating labour markets, the danger may be that EMU leaves little room for adjustment to economic shocks.

To justify EMU on economic grounds in the face of all these potential problems, its proponents argue that the single currency will complete the single European market. While traders can already, in theory, treat the entire EU area as their home market, many are in practice constrained from doing so because of the residual exchange-rate uncertainty.

The economic consequence of the single-market extension argument is that EMU could lead to greater price harmonization in product markets, and certainly to greater price transparency, especially in markets that can be penetrated by direct mail, which may take on the function of price arbitrageur in goods markets. Depending on their degree of harmonization, EU prices could be expected to move downwards as competition intensifies.

There are other minor economic benefits, e.g. lower transaction costs, or lower hedging costs, but at the level of the economy as a whole they are unlikely to be a significant factor, let alone a justification for EMU.

Economic convergence

For a monetary union to work in the absence of a political union, it is generally accepted that a great degree of economic convergence is required from the outset. The exception would be an asymmetric system, in which the smaller members follow the lead of the largest, as in the monetary union between Belgium and Luxembourg.

EMU will not be asymmetric. Indeed, the move from an asymmetric system, one which is dominated by the Bundesbank, to a more symmetric system, in which each country has its own representative on the governing board of the European Central Bank (ECB), was one of the central aims behind the move towards EMU. It was, in part, meant to end the German domination of the system.

The Maastricht Treaty defines the convergence criteria purely in terms of monetary and fiscal policy - inflation, short-term interest rates, exchange-rate stability, the level of the stock of debt, and public-sector budget deficits. It does not include criteria for so-called real convergence, i.e. convergence in economic growth and employment.

In terms of its narrow definition in the Maastricht Treaty, convergence has been surprisingly successful. Even Spain and Greece, countries with traditionally high rates of inflation, achieved substantial success in fiscal and monetary convergence.

According to EU statistics, every member state except Greece qualifies in terms of inflation - which means that their inflation rates are within 1.5 per cent of the average of the best three performers, as specified in the Maastricht Treaty. Short-term interest rates have come down throughout the EU. Exchange rates have also been relatively stable in the last two years. The debt criterion - which stipulates that the stock of national debt should not exceed 60 per cent of GDP - is being interpreted with such a degree of flexibility that even Italy and Belgium, with debt-to-GDP ratios of over 100 per cent, qualify easily. The only criterion with the potential to separate the ins from the outs will be the deficit-to-GDP ratio.

But it is doubtful whether even Germany and France will reach the ceiling in the current year, at least not if the criterion is interpreted in the strictest numeric sense. Theo Waigel, the German finance minister, insis-ted that 3 per cent constitutes a precisely defined limit, but Germany itself may fail to cross the hurdle which it set up for others to fail. The irony is that many of these countries, including Portugal and Spain, fulfil the criteria, while Germany and France may not.

The current timetable: key events

February 1998: the European Monetary Institute is expected to present its final convergence report, highlighting the progress the 15 EU member states have made in fulfilling the Maastricht criteria. It is not clear yet whether this report will contain specific recommendations about who should join EMU.

March or April 1998: the Ecofin council (composed of national economics and finance ministers) may reach a pre-decision about EMU participants. Controversial decisions, such as the exclusion of a country against its will, will almost certainly have to be deferred to the EU summit in early May.

May 1998: The EU Council decides on participants, and fixes bilateral convergence rates.

Between May and December 1998: the European Central Bank will be formally established.

1 January 1999: start of EMU. National banknotes and coins of participating members will become odd denominations of the euro. They remain legal tender in their home countries only.

1 January 2002: The ECB introduces euro banknotes and coins.

1 July 2002: national banknotes lose legal tender status. The euro will be the sole currency in the EMU zone.

France will have even greater difficulty than Germany. The Jospin government's late conversion to the Maastricht criteria prompted a series of corporate tax measures, but even those are unlikely to be sufficient. The best outcome for France, on current forecasting assumptions, is to achieve a deficit of between 3 and 3.5 per cent.

If neither Germany nor France meets the criteria, a decision to press ahead on the basis of the current timetable would almost certainly face strong opposition inside Germany, and possibly a challenge in the Constitutional Court. A delay would also be impractical for the reasons already mentioned. Germany and France face a classic policy dilemma. However, managing German opposition may be substantially easier if deficits are within one or two decimal points of the stipulated criteria, rather than one or two percentage points.

Real convergence

Despite the relatively good progress on fiscal and monetary policy, progress on real convergence has been poor. The high EU unemployment, at 18 million, follows an uneven distribution pattern. It is extremely high throughout Spain and in large parts of France, eastern Germany and several areas in western Germany affected by the demise of old industries, while falling rapidly in the UK and Ireland.

The UK, Ireland and also Portugal benefit from strong economic growth, while growth in the Benelux countries, Germany and France is subdued. A recent study by Goldman Sachs suggests that there exists some limited real convergence in the EU's core group - Germany, Austria, Benelux and France - but this does not extend to the UK, Scandinavia and the south of Europe. The lack of real convergence remains one of the most important arguments against a wide EMU embracing virtually the entire EU by the year 2002 (except the UK, Sweden and Denmark, which are likely to opt out of the processinitially).

The unanswered question is whether economic convergence and the move towards monetary union are a self-reinforcing mechanism. This could be true to the extent that EMU leads to further harmonization of fiscal policies, social security systems, and regulatory issues. The greater the economic impact of the single currency, the greater the pressure for and chance of further harmonization.

Franco-German disagreements

It is generally assumed and rarely disputed that EMU could not proceed without Germany and France. Yet the French election has opened up a disconcerting scenario: not merely that France may miss the 3 per cent deficit-to-GDP ratio this year - as looks likely following the recent French budget estimate - but that the two countries may be pursuing increasingly different economic policies over the long run. A fundamental policy split between them could threaten the successful functioning of the single currency.

The German government is committed to reform in labour markets, taxation, and social security. Even a change of government at next year's federal elections is unlikely to derail Germany's extremely slow but steady move towards reform. Although German politicians disagree over spending and taxation, most of them oppose deficit financing. Trade unions and employers are already negotiating markedly more flexible labour agreements.

The German constitution also stipulates that the deficit must not exceed the level of investment spending. While the delineation of investment spending against current expenditure is open to question, this restriction imposes severe constraints on the budgetary process.

The French government, by contrast, has set out to pursue a policy that would rely heavily on the public sector and less on market forces to reduce unemployment. Several commentators have described this policy as a leap back to the recipes of the 1970s. But whatever its merits, the French approach stands in conflict with the German model, and it is certainly in conflict with the approach by the new Labour government in the UK. Currently the most troubling aspect of the economics of EMU is that France and Germany are no longer in agreement about the central thrust of economic policy. (This analysis assumes that the French government delivers on its election promises, rather than changing course when the pressures build up, as previous Socialist administrations did.)

This growing sense of drift comes on top of an already lingering dissent over monetary policy between France and Germany. French politicians from the right and the left are deeply sceptical about central bank independence, and the hardline monetarism which this may imply. The French government wants a political counterweight to the ECB, and has also expressed reservations about Wim Duisenberg, the president of the European Monetary Institute (EMI) since July 1997, who is the front runner for the ECB presidency. In part the underlying differences arise from the French aim, in moving to the single currency, of preventing the Bundesbank from effectively determining monetary policy, whereas the Germans wanted to recreate the Bundesbank at a European level.

Wide or narrow EMU?

Certain participants:

Austria, Belgium, France, Germany Luxembourg, the Netherlands.

Probable participants:

Finland, Ireland, Portugal, Spain

Possible but doubtful member:

Italy

Certain to fail the qualification criteria:

Greece

Voluntary exiles:

Denmark, Sweden, UK

For EMU this is a potentially dangerous development. If France and Germany were to pursue different fiscal policies in the long run, tensions would be bound to build up in the country with the lower budget deficits - which would be Germany under this scenario. Faced with asymmetric fiscal policies throughout the EMU zone, the ECB is likely to tighten monetary policy in response to loose fiscal policies in some of the member states. If France and Italy were to run loose fiscal policies, the consequence would be higher interest rates than would be warranted given Germany's relatively tight fiscal stance. The permanent bias towards high interest rates - compared with their levels before EMU - would dampen economic growth and keep unemployment high. The political effect could be severe disillusionment in Germany shortly after the start of EMU.

Hard euro or soft euro?

With France abandoning its policy of austerity and the German government's climbdown over the revaluation of the Bundes- bank's gold reserves, the chances of a more flexible interpretation of the convergence criteria have increased. From an economic point of view this is not a problem as such; however, the growing differences between France and Germany in virtually all areas of economic policy - fiscal, monetary, trade, regulation - are much more worrying.

There is a central assumption in financial markets and among policy-makers that a soft interpretation of the Maastricht criteria would invariably lead to a wider membership and consequently to a softer euro. That may be a mistaken assumption. A flexible interpretation of the criteria that leads to an ultra-wide membership could conceivably endanger EMU if the adjustment pressures became intolerable or if the single monetary policy were judged to be fundamentally at odds with the requirement of individual countries. A flexible interpretation could conceivably also lead to a hard euro, at least initially. The new central bank is likely to assert itself early on in the process and may move swiftly to raise interest rates, especially since it will take office during an incipient economic recovery, a time when central banks have to exercise particularly sensitive judgments. There is a risk that the ECB may overcompensate to demonstrate its independence.

Many central banks are expected to switch some of their foreign currency reserves into euros, to achieve a greater balance between the distribution of their reserves and their underlying trade flows. The result could be that even if the euro area were to operate a fundamentally soft fiscal policy, the euro could still end up as a hard currency - hard for all the wrong reasons. This is the famous Camembert scenario - hard on the outside, soft on the inside. It is probably the worst of all worlds. Not only would a fiscally conservative country face a harsher monetary stance than it would do under a nationally autonomous monetary policy, it would also face a harder currency and its exporters would suffer.

Exchange and conversion rates

The new Labour government in the UK has said it will almost certainly not participate in the first wave of EMU. Sweden and Denmark are also not expected to join at the start. The others, except Greece which wants to join in the year 2001, are politically committed to meeting the 1999 starting date.

One of the most difficult areas to assess is the impact on those who are staying outside. In the very short run, before 1999, doubts about both the timetable and the success of EMU are likely to result in a rise in the currencies of the outs (those who want to stay out as opposed to those not likely to meet the qualifying criteria) against the currencies of the ins. After 1999, the euro promises to be a highly volatile currency under almost any scenario. This alone could constitute an obstacle to membership of the outs, since some form of exchange-rate stability is required before a country can become a member.

Since the widening of the ERM bands from a normal fluctuation margin of 2.25% to 15% in 1993, the old exchange-rate mechanism has lost much of its purpose. There is a legal debate about the significance of the old ERM criterion in the Maastricht Treaty, especially the reference to the observation of normal fluctuation margins. Prospective members of EMU will need to observe some form of currency stability before they join, involving entering into the post-1999 ERM 2. In practice, the Treaty's stipulation of a two-year formal membership is likely to be treated with some degree of flexibility. However, sustained exchange-rate stability is a prerequisite.

One of the most critical problems faced by EU leaders in the short run has been the mechanism by which conversion rates are determined. The Maastricht process contains a serious logical flaw. The Treaty stipulates that the conversion rates between national currencies and the euro should be fixed on the first day of monetary union. EU leaders agreed at some point to fix the euro at a one-to-one parity with the ECU, the basket of European currencies. But since not every EU country will participate in 1999, the value of the ECU will be determined in part by currencies outside the system. A sudden surge in the pound, for example, could seriously unhinge the process.

EU ministers have agreed to resolve this problem by announcing in advance the bilateral conversion rates - i.e. the bilateral rates between national currencies rather than their euro rates. One suggestion is that the current ERM parities may simply be taken as the conversion rate, although this would require, for example, a significant devaluation of the Irish punt, which trades near the upper limit of its 15 per cent fluctuation margin. The bilateral rates will be announced at the same time as selection of countries qualifying for EMU, which should help to avoid instability in the financial markets.

After the start of EMU, attention will focus on the relationship between the euro and the currencies of the EU countries that are likely to join EMU as part of a second or subsequent wave - on current calculations the UK, Denmark, Sweden and Greece.

There is a possibility that the euro could turn out to be a highly volatile currency shortly after its inception, for largely technical reasons, such as a shift in foreign reserves by central banks, or a shift in international portfolios. In the medium term, the currencies of the pre-ins will need to be stabilized against the euro in some form. A post-EMU exchange-rate mechanism, with wide bands or perhaps even without any bands at all but with a central parity, might serve as a stabilizing mechanism. The exact order of events will be determined after 1999, and w has beeill depend to a large extent on the volatility of the euro.

EMU and the European economy

EMU is bound to have a significant influence on the EU economy under any scenario. It could lead to a downward pressure on prices in some industries. It could bring about greater price transparency and so more competition for consumers. However, there are fears that the single currency might even accelerate a concentration process in industry, through more intense price competition. The banking sector, in particular, is likely to experience change. In a single market with a single currency, companies may decide that they do not need to deal with as many banks as they do today.

EMU could also affect the balance between Europe's financial centres, but the City of London is unlikely to be threatened by either Frankfurt or Paris. The City has more employees than Frankfurt has inhabitants, and since industries tend to cluster around certain locations there is unlikely be a sudden shift under any of the scenarios. But there may be scope for small selected shifts. For example, Frankfurt could pose a real challenge to London as a financial centre for the futures markets.

A leap in the dark

When and if it happens, EMU will be one of the biggest economic events in postwar Europe. Its economic implications are impossible to forecast precisely, but it would be prudent to expect that it would act as a trigger for further consolidation and efficiency gains. Combined with a likely bias towards higher interest rates, this bodes ill for efforts by EU governments to reduce unemployment. This is where the political risks set in.

Yet this factor may be balanced or even outweighed by dynamism brought about by extra competition. If prices were to fall in some sectors and in some regions, real disposable income and hence consumer spending would rise, which in turn could feed a consumer-driven boom. After a decade of sluggish growth throughout the EU, EMU starts at a time when the economic cycle points to a pick-up in growth. The combined macro-effect may well be a golden scenario. However, even here the gains and losses resulting from EMU are bound to be very unevenly distributed.

The main function of convergence - fiscal, monetary and real - is to eliminate the residual uncertainties, though it is conceivable that EMU could be perceived as a success even without full convergence, at least in its honeymoon years. While fiscal and monetary convergence has been high among most of the EU members, real convergence has occurred mainly in the EU's inner core - Germany, France, Benelux and Austria. A small monetary union here would be relatively safe, under almost any conceivable scenario. A large monetary union - which has become increasingly likely - will face serious economic and, ultimately, political risks. These risks are essentially incalculable. It may all end well, despite the objections raised here. But if EMU were to go ahead only to break up a few years later, the process of European integration would suffer its worst setback yet.