The crisis of the European Exchange Rate Mechanism in the 1990s was analogous to the demise of Bretton Woods, in that the members of the ERM were essentially hostages to German monetary policy. Established in 1979, by the end of the 1980s the ERM appeared to confer on its members the benefits of German monetary policy, namely a credible commitment to low inflation, and therefore relatively low interest rates. This was the main reason for the British decision to join, six weeks before Margaret Thatcher’s deposition in 1990. However, this coincided fatefully with the collapse of the Soviet empire in Eastern Europe and the reunification of Germany, leading to a dramatic increase in the German federal deficit. The resulting surge of new German bond issues to finance unification with the former German Democratic Republic pushed up not only the German debt/GDP ratio but also German interest rates. (To be precise, German public debt rose from 42 per cent of GDP in 1991 to just over 60 per cent in 1996, almost twice the figure for 1980; the average public sector deficit for the years 1991–6 was 5.5 per cent of GDP.) In the absence of the ERM, the deutschmark would certainly have appreciated against other European currencies. The rules of the system, however, required interest rates to rise throughout the system. By 1992 it was apparent that the domestic political costs of higher interest rates – not least those on Conservative voters’ mortgages – were proving intolerable in Britain and in Italy and in September of that year both currencies were forced out of the system by a speculative onslaught which the various central banks were unable (or perhaps, in the case of the Bundesbank, unwilling) to resist. Spain, Portugal and Ireland were also forced to devalue; and in the summer of 1993 pressure on the French franc led to a widening of the bands within which the remaining currencies were allowed to fluctuate against one another.72
Finally, it is possible to have contagion on the periphery even in the absence of a major policy shock emanating from the core. Once the credibility of one currency peg was lost in Asia – when the Thai baht was allowed to float, or rather sink, on 2 July 1997 – the credibility of neighbouring currencies soon followed.73 This was partly because foreign investors did not make distinctions between Asian emerging markets, but also because the related problems of unhedged foreign exchange borrowing, short-term loans to finance long-term investments and moral hazard (the presumption that the government or IMF would bail the private sector out in a crisis) were present in most of the affected economies.74
Like clouds, currency crises have silver linings. The main beneficiaries of the Asian crisis were Americans, all of whom benefited from sharply reduced import prices – and particularly American economists, who were supplied with a fresh subject for study just as interest was fading in the problems of post-Soviet ‘transition’. Some analysts blamed the Asian economies for practising ‘crony capitalism’, a shorthand for myriad problems of inadequate financial regulation. Others blamed the IMF for failing to act as an international lender of last resort.75 Policy prescriptions abounded. It was claimed that the Asian crisis illustrated the need for controls or at least brakes on short-term international capital flows of the sort introduced in Chile in the 1980s. Another school of thought recommended the development of deeper domestic capital markets to allow more long-term borrowing in domestic currencies. One argument was simply for (a return to) a ‘dollar standard’ for Asia, including Japan as well as the emerging markets.76 But perhaps the most surprising argument to resurface in the wake of the crisis was the need for ‘dollarization’, meaning the complete substitution of the US currency for the baht et al., a policy long ago adopted by Panama.77
This argument for currency union with the United States had its parallel in the argument in 1992 (advanced by The Economist among others) that the breakdown of the Exchange Rate Mechanism demonstrated the need for European monetary union. It is to this alternative solution to the exchange rate problem that we now turn.
CURRENCY UNIONS
From conception, through gestation, birth and into its early infancy, the euro has consistently proved the sceptics wrong. Some thought that chauvinistic voters would reject the single currency in referenda. Others doubted that all the applicants would fulfil the Maastricht deficit criterion. Still others predicted that disputes over the European Central Bank’s presidency might abort the entire enterprise. Yet Economic and Monetary Union has thus far proceeded according to plan. The electorate’s petit oui in the French referendum may have required a little gentle massaging, and the Maastricht Treaty’s convergence criteria may have been honoured partly in the breach. But the important point is that the fixed exchange rates within the ‘Eurozone’ have held firm, despite divergences in economic fundamentals, and prophecies of speculative attacks on individual members during the transitional phase have yet to be fulfilled.78
It is true that the new currency has been subject to 20 per cent depreciation against the dollar between its launch and the time of writing (May 2000). But nobody ever claimed that the euro would have a fixed rate against the dollar, or any other currency for that matter. Nor can anyone be certain whether it will go up or down in the next twelve months. On the one hand, as Figure 31 shows, compared with the performance of its predecessor, the unit-of-account ecu, the euro is still some way above its historic nadir. On the other, there is some reason to expect the euro sooner or later to recover against the dollar when the latter weakens, a likely consequence of the widening US balance of payments deficit and accumulating external debt described in the previous chapter.79 If that happens, the prophets and architects of the single currency will no doubt relish their moment of – apparent – vindication, just as their opponents have savoured the ‘progress’ of the euro in the foreign exchange markets since its launch. The pro-euro triumph is likely, however, to prove a fleeting one. For no monetary union can long endure when the mobility of labour is so hampered by cultural barriers and regulation; and, perhaps more importantly, when the fiscal policies of its member states are so out of kilter.80
Figure 31. US dollars per ecu/euro, 1975–1999
Source: Global Financial Data.
The proposition that monetary unions can be undone by fiscal imbalances rests in part on comparative history. The difficulty is in deciding which previous monetary unions most closely resemble EMU; none does exactly. Indeed, given the fact that all EMU members are democracies and that monetary policy is today regarded as ‘the primary macroeconomic stabilization instrument’, it is arguable that there are no real historical parallels.81 True, a number of authors have sought to draw comparisons with the pre-1914 gold standard. However, others maintain that EMU is more like a national monetary union, because there is a common central bank (or, at least, a system of central banks) and no prescribed right to exit EMU; we should therefore compare it with the experience of Italy and Germany in the nineteenth century, when monetary unification was an integral part of national unification, or possibly with the more protracted process in the United States.82
None of these parallels is in fact very illuminating. As we have seen, the gold standard was an informal system without a single central bank from which states always had the option to exit in an emergency: it was much more like a large-scale version of the pre-1999 Exchange Rate Mechanism.83 On the other hand, comparing EMU with the monetary unions achieved in the United States, Italy or Germany is unconvincing. Even the success of the Dutch United Provinces as a monetary union was inseparable from their political unification. In each case, political (and hence fiscal) union came before monetary union. Nor is it helpful to compare currency unions between giants and dwarves (such as that between France, Andorra and Monaco). The best analogies are with monetary unions between multiple states with only loose (if any) confederal ties and negligible fiscal centralization. Two such systems exist in francophone Africa: the West African Economic and Monetary Union and the zone of operation of the Central Bank of Equatorial Africa.84 But these are essentially satellites of the French monetary system (and therefore now of EMU itself), since their currencies are pegged to the
franc.
In fact, there is no need to look so far afield for antecedents of EMU. A monetary union of this sort has precedents in European history. One possible analogy is with the Austro-Hungarian monetary union after 1867, since the Habsburg Dual Monarchy was ‘an economic entity providing for the free circulation of goods and capital, with a unique central bank, and with complete fiscal autonomy for each part of its constituences’ as well as multiple nationalities.85 (Unlike the EU, however, there was a common army.) Both Austria and Hungary regularly ran quite sizeable deficits in the period up until 1914, but these were absorbed by the domestic and international bond markets with little difficulty. However, the dramatic but asymmetric increase in expenditure and borrowing occasioned by the First World War caused inflation to accelerate. The political disintegration of the Dual Monarchy at the end of the war led almost immediately to the disintegration of the monetary union, beginning with the Yugoslavian decision to secede by literally stamping all currency in its territory in January 1919. Its example was quickly followed in March by the new Czech and Austrian governments. When the Austro-Hungarian Bank protested, the Czech Minister of Finance replied that the action was a necessary response to the Bank’s ‘systematic destruction [through inflation] of the Austro-Hungarian krone’. Once the process had begun, it was hazardous for other former Habsburg states not to follow suit, since the Austro-Hungarian Bank continued to print unstamped notes until it was liquidated in September 1919. These unstamped notes quickly went to a premium since they could be used wherever the policy of stamping had not been adopted (Poland and Hungary until the spring of 1920).86
An even more illuminating precedent is the Latin Monetary Union (1865–1927), which made the coinages of France, Belgium, Switzerland, Italy, the Papal States and (later) Greece freely exchangeable and legal tender within a single currency area. True, there was no Latin Central Bank. But one obvious parallel with EMU is that the LMU had a consciously political motivation. A driving force behind the LMU Convention of 23 December 1865 was the Frenchman Félix Parieu, who dreamt that the LMU would ultimately lead to a ‘European Union’ with a ‘European Commission’ and ‘European Parliament’.87 However, the costs to the other members of Italian (and especially Papal) fiscal laxity were high. The Papal government financed its deficits by issuing silver subsidiary coinage with high seigniorage profits – in short, debasing the coinage and allowing private agents to export it to the rest of the Union. This was a flagrant breach of the rules of the Convention. At the same time, to finance its deficits (11 per cent of GDP in 1866, on top of an existing debt of 70 per cent of GDP), the Italian government issued largely inconvertible paper currency, which broke the spirit if not the letter of the Convention. This helps explain why, despite initial efforts to attract new members, none was admitted after Greece, despite applications from Spain, Austria-Hungary, Romania, San Marino, Colombia, Serbia, Venezuela, Bulgaria and Finland.88 The war of 1870 removed the political rationale of a French continental hegemony; and the only reason the LMU survived after 1878 was ‘to avoid the cost of dissolution’.89 Like the more modest Scandinavian Monetary Union founded in 1873 by Sweden and Denmark, the LMU was belatedly pronounced dead in the 1920s.
More recently there have been three monetary unions that have scarcely survived more than a few years after the break-up of earlier political unions: that between the eleven members of the Confederation of Independent States of the former Soviet Union; that between the former members of the Federal Republic of Yugoslavia; and that between the Czech Republic and Slovakia after they separated. In two cases, the break-up was associated with hyperinflation as internally weak member states raised revenue the easy way by printing money.
Past experience therefore tends to suggest that asymmetric fiscal problems – often, but not necessarily, generated by war – quickly cause monetary unions between politically independent states to dissolve. In the case of present-day Europe, it seems quite possible that the strains caused by unaffordable social security and pension systems could have a similar centrifugal effect: the Habsburg scenario, with welfare substituting for war as the fatal solvent.
As Chapter 7 showed, the majority of EMU member states have severe generational imbalances, though they vary considerably in scale. Yet it is extremely hard to imagine any of the policy options necessary to eliminate these imbalances being adopted by any of the nine EMU members that need to act, much less all of them. To recap: in order to achieve generational balance, Finland needs to increase all taxation across the board by 17 per cent; Austria by 18 per cent; Spain by 14 per cent and Italy by 10 per cent. Even Germany needs to increase taxes by 9.5 per cent, or cut all government transfers by 14 per cent.90 The main reason such increases will not happen is obvious: there would be insuperable political opposition, whether fiscal reform took the form of cuts in government consumption, cuts in government transfers, increases in all taxes or just increases in income tax. The political conflicts over tax increases and/or welfare cuts are easy enough to imagine: indeed, in Germany and Italy they have already begun. One reason for the fall of the government of Massimo D’Alema in April 2000 was its inability to achieve reform of the Italian state pension system – the most expensive in the EU, with an annual cost of nearly 14 per cent of GDP – in the face of trade union opposition. It is especially unfortunate that so many continental Social Democrats persuaded themselves in the 1980s that early retirement schemes would boost employment opportunities for the young, a theory with disastrous fiscal implications wherever it was put into practice. Nor does it help that short-run macroeconomic arguments against fiscal tightening can so easily be devised: plainly, the problem of high unemployment in Germany and other EMU member states would hardly be improved by tax increases – and indeed the Schröder government has opted for tax cuts. The worsening fiscal situations of many European states could, of course, be eased by a permanent increase in the average rate of growth. However, there are good reasons to be doubtful about the likelihood of this happening in the core European countries. In particular, the rigidity of the European labour market has suggested to many economists that monetary union is premature.91 (One reason the pre-1914 gold standard could function as it did was the high level of international labour mobility that went with it.92)
The stark choice facing nearly every country in the Eurozone (leaving aside an end to immigration restrictions) is therefore between increases in taxation unprecedented in peacetime or reductions in public expenditure greater than anything achieved in the 1980s. Neither option is likely to be popular. Indeed, it seems more likely that most governments will allow generational imbalances to worsen in the short term.
What then are the monetary implications of this impending fiscal grid-lock? One assumption often made is that various countries will find it progressively harder to keep within the specified budgetary limits set out in the Maastricht Treaty and the Growth and Stability Pact. However, the possibilities for creative accounting with traditional measures of debts and deficits have not yet fully been exhausted. As the Maastricht criteria are based on measures of debt which are economically arbitrary, there is every reason to expect them to be laxly enforced: indeed, this has already happened. No fewer than eight of the EMU members had debts above the Maastricht 60 per cent threshold in 1997.93
In any case, rising borrowing by the EMU member states is not really the issue. Past experience (for example, the German monetary union after 1871) suggests that monetary unions can co-exist with federal fiscal systems in which some member states issue substantial volumes of bonds. Different levels of issuance may also result in a divergence of bond yields after the convergence of the pre-EMU period. But the existence of yield spreads is not incompatible with monetary union: markets cannot be forbidden from attaching different default risks to different member states. This can already be seen in the case of Austrian yields, which rose around 20 basis points above German yields as it became clear that the xenophobic Freedom Party was likely to enter the Austrian
government. There is no more reason for European bond yields to be uniform than there is for companies issuing euro-denominated bonds to offer investors the same returns. Nor is it the point that high levels of state borrowing necessarily lead to inflation, as is sometimes assumed.94 Much depends on the international bond market’s demand for grade AAA or AAB sovereign debt, and with more and more people living for two decades after retirement that demand should, if anything, strengthen.
The implications of generational imbalance are not simply that European states will have to run deficits. Because generational accounts are based on the idea of the inter-temporal budget constraint, it is already assumed within the calculations that they will. The figures imply not an increase in future borrowing, but an inevitable need to raise taxes, reduce expenditure or issue money. The real question is what happens when Austria, Finland or Spain – or all three – reach a political impasse on taxation and public spending.
At this point it seems plausible to expect that the countries with the most severe generational imbalances will attempt to exert pressure on the European Central Bank to relieve the pressure on them by loosening monetary policy.95 Time and again in history, as we saw in Chapter 5, a leap in inflation has been the line of least resistance for governments in fiscal difficulties: the defeated powers after the First World War, for example, or Russia and the Ukraine since the collapse of the Soviet economy. This, of course, would be the moment of truth for the single currency. One possibility – which cannot be ruled out – is that the ECB will cave in, allowing the euro to depreciate and inflation in the Eurozone to rise. It seems unlikely, however, since the Bank is explicitly prohibited from acceding to a request for monetary financing under the institutional framework established by the Maastricht Treaty. To be precise, there is a strict ‘no bail-out rule’ enshrined in Article 104 of the Maastricht Treaty (now Article 101 of the Treaty establishing the European Community) and in Article 21 of the Statute of the European System of Central Banks. This is the crux of what has been called the ‘unprecedented divorce between the main monetary and fiscal authorities’ brought about by EMU.96
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