Journal Issue

Europe—The Quest for Monetary Integration

International Monetary Fund. External Relations Dept.
Published Date:
January 1990
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As the European Community countries prepare for a crucial conference on economic and monetary union, a number of issues need to be addressed

Over the past 20 years, the European Community (EC) has tried several times to move in the direction of economic and monetary union. But these attempts have always fallen far short of their goals. Recent developments, however, have significantly altered the picture, for the first time giving rise to beliefs that over the next few years, a solid groundwork will be laid for such a union. These include:

• the success of the European Monetary System (EMS). Following the comprehensive realignment of March 1983, the countries then participating in the exchange rate mechanism (the ERM—see box) pursued policies that resulted in a greater convergence of costs and prices. Realignments occurred less frequently and the deutsche mark emerged as the anchor currency of the system. Thoughts turned to how the stability of the EMS could be enhanced and a more efficient framework provided for future cooperation in exchange rate and monetary policies.

• the formation of a single internal market by the end of 1992. This promises the realization of still unattained objectives set by the founding fathers of the EC in the 1950s—notably, the establishment of a truly common market as the basis for full economic integration, closer political cooperation, greater social cohesion, and higher living standards.

In light of these developments, the debate over exactly what type of economic and monetary union (EMU) would be desirable, and how and at what pace this should be achieved, has intensified. Fundamentally, the debate is about the questions of whether, when, and to what extent, countries will be ready to surrender sovereignty in the economic, and in the last analysis, the political, field. Intergovernmental conferences on economic and monetary union, and political union—which are scheduled to begin on December 14, 1990, and may last well into 1991—must grapple with the many philosophical, as well as institutional and technical, issues.

Background to the debate

The debate about the form and objectives of future EC monetary cooperation and integration began in the mid-1980s with discussions on more technical issues, such as intervention practices, use of the very short-term financing facility of the EMS, and the role of the ECU (European Currency Unit)—a composite of a basket of the EC currencies that serves as the unit of account for the EMS. Initially, the key players were senior officials of governments, central banks, and the EC Commission. But in early 1988, the debate gained significant momentum and a political dimension when politicians from various EC countries expressed support for EMU, although with differing degrees of urgency. Soon, EMU became a prominent subject at the regular meetings of the European Council (consisting of the heads of state and government of the EC countries), and in June 1988, the Council set up a special committee—chaired by EC Commission President Jacques Delors, and including the governors of the EC central banks—to outline concrete stages that would eventually lead to EMU.

This article is based on Occasional Paper No. 73 “The European Monetary System: Developments and Perspectives,” by Horst Ungerer, Jouko J. Hauvonen, Augusto Lopez-Claros, and Thomas Mayer, November 1990. For more information on the main features of the EMS, see “Main developments in the European Monetary System,” by the author. Finance & Development, June 1983.

The following April, the Delors Report was unveiled. It proposed the realization of EMU in three stages of undefined duration, with parallel progress envisioned in both the economic and monetary fields, reflecting a broadly held consensus that the building of institutions and the strengthening of policy coordination influence each other in a mutual and dynamic fashion. Monetary union was defined as total and irreversible convertibility of currencies; complete freedom of capital movements in fully integrated financial markets; and irrevocably fixed exchange rates, with no fluctuation margins between member currencies. Economic union was defined as a single market within which persons, goods, services, and capital could move freely; common competition, structural, and regional policies; and sufficient coordination of macroeconomic policies, including binding rules on budgetary policies regarding the size and financing of national budget deficits.

At the heart of the Delors Report was the proposal to set up a European System of Central Banks (ESCB) as the vehicle for creating a monetary union and a single currency. The ESCB would be organized in a federal form, consisting of a central institution and national central banks, with a Council composed of the governors of the central banks and the members of the Board (the latter to be appointed by the European Council). It would be committed to the objective of price stability, and, subject to this commitment, it would support the general economic policy set at the Community level. It would formulate and implement monetary policy, manage exchange rates and reserves, and maintain a properly functioning payments system. It would be independent of instructions from national governments and Community authorities and would not be allowed to lend to public sector authorities.

Stage one would aim at a greater convergence of economic performance through the strengthening of policy coordination within the existing institutional framework. All EC currencies still freely floating would have to be brought into the EMS exchange rate mechanism.

Stage two would be a period of transition, further promoting convergence and centering on institutional reforms—most importantly, the setting up of the ESCB, whose key task would be to begin the transition from the coordination of independent monetary policies to the implementation of a common monetary policy.

The final stage would start with a move to irrevocably locked exchange rates. Common structural and regional policies would be further strengthened, and rules in the macroeconomic and budgetary field would become binding. The transition to a common monetary policy would be made, and the ESCB would assume all its responsibilities. Decisions on exchange market interventions in third currencies would become the sole responsibility of the ESCB Council, and official reserves would be pooled and managed by the ESCB. The introduction of a single, common currency would also take place.

Debate over the Delors Report

Not surprisingly, the Delors Report met with a wide range of responses. There were those countries (mainly France and Italy) who, based on what they perceived to be the great challenges of European integration, argued for speedy moves toward common institutions and policies. There were others (mainly Germany and the Netherlands) who felt that an extended period of closer cooperation and greater economic convergence—more or less circumscribed by the proposed first stage of the Delors Report—was required before more far-reaching institutional arrangements could be put in place.

In the United Kingdom, official reactions, particularly at the highest level of government, were less forthcoming. Nonetheless, at the European Council’s June 1989 meeting in Madrid, it was agreed to launch stage one on July 1 of the following year. In November 1989, the UK authorities presented their own concept of EC monetary integration, advocating an “evolutionary” approach, as an alternative to the “institutional” approach of the Delors Report. They suggested that national currencies (and thus, national monetary policies) be allowed to compete with each other in a multicurrency system centered on national monetary authorities, thereby minimizing problems of political accountability.

The EMS could evolve into a system of more or less fixed exchange rates, and a “practical monetary union” would be achieved. But although the proposal sparked some interest, there were serious doubts as to whether a “competition of currencies” would result in a stable and desirable monetary order for the EC. As long as national currencies were not irrevocably linked to each other, one could not speak of a monetary union, nor could one expect its full benefits—in terms of reducing transaction costs and eliminating exchange rate risks—to materialize.

In June 1990, the UK Chancellor of the Exchequer John Major presented another proposal, stressing the need to strive for more convergence in economic performance. It envisaged an important role for the ECU by having it exist alongside and compete with national currencies. First, a European Monetary Fund would be established that would issue ECUs on demand against EC currencies. Second, a “hard ECU” would be created as a genuine currency, which would never devalue against other EC currencies. In time, the ECU would be more widely used; it could become a common currency and, in the very long run, the single currency for the EC. But the UK proposal left open a number of questions, such as the institutional features of the European Monetary Fund. One of the main perceived shortcomings was that it provided little guidance on when the conditions would be right for moving to the final stage of full monetary union.

Among the many questions under discussion, there are two of particular importance.

The EMS and the exchange rate mechanism

The European Monetary System (EMS), established on March 13, 1979, includes all 12 EC member countries (Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands. Portugal. Spain, and the United Kingdom). However, two of them (Greece and Portugal) have not yet joined the exchange rate mechanism (ERM), preferring their currencies to float freely, while two others joined only recently (Spain, in June 1989, and the United Kingdom, in October 1990). The ERM keeps the participating currencies within certain defined upper and lower limits in relation to each other; most may fluctuate up to 2.25 percent in either direction, although Spain and the United Kingdom have opted for margins of 6 percent.

How much power should be exercised at the Community level over macroeconomic policies? The Delors Report emphasized the need for action in the field of macroeconomic coordination, including binding rules in the budgetary field. It argued that uncoordinated and divergent national budget policies would undermine monetary stability and generate imbalances in the real and financial sectors of the Community. Since the Community’s own budget was too small to play any significant role, the task of setting a Community-wide fiscal policy stance would have to be performed through the coordination of national budgetary policies. The report, therefore, advocated binding rules that would impose upper limits on budget deficits of individual member countries, exclude public sector access to direct central banking credit and other forms of monetary financing, and limit recourse to external borrowing in non-Community currencies.

There is general agreement that monetary and budgetary policies need to be compatible and that no—or only limited—recourse to monetary financing should be available. Also, undisciplined governments should not be bailed out. The question is whether the compatibility of policies can best be achieved by market forces, intensified coordination between individual countries, or a centralization at the Community level.

Some argue that without central bank financing—but with freedom of capital movements—financial markets would penalize undisciplined budgetary behavior with higher interest rates, thus creating pressure for convergence toward sound fiscal policies. Others stress that in view of the limited size of the Community budget, it is at the national budget level that coordinating action would be required. On the basis of experience, however, there is skepticism about placing too much faith in effective voluntary coordination. At the same time, financial markets are not seen by these skeptics as effectively improving budgetary discipline of divergent countries. Furthermore, in this view, should a country run into serious budgetary problems, political pressure on other member countries is likely to develop and a bailout could not be excluded.

How much independence should the future European central bank have? At issue is whether it should be independent of instructions from national governments and Community authorities. The background to this debate is a basic conceptual difference regarding the framework and objectives of economic policy. One concept holds that all aspects of economic policy, including monetary management, should be subject to a unified approach and be formulated, implemented, and made consistent by the government, which through parliament is answerable to the electorate. Price stability is only one—albeit often an important one—of several economic policy objectives, such as economic growth, high employment, balance of payments equilibrium, and exchange rate stability.

The other concept considers price stability to be an essential, quasi-constitutional part of the basic framework within which economic and social policy is conducted. This stability is regarded as a complement—as well as being equal to—other essential elements of a country’s economic order, such as market economy principles, private property, and freedom to engage in domestic and international economic activity; hence the rationale for a high degree of independence for some central banks, such as in Germany, Switzerland, and the United States. While these central banks are independent in the pursuit of their tasks and their policies, they are not independent in the sense of being free of democratic control and outside the general process of opinion formation. Democratic control is exercised not by day-to-day government intervention in policy formation but in the setting of the determinants of monetary policy: the laws governing central bank responsibilities and activities; appointment procedures for top officials; and regular reporting to parliament and to the public at large.

Nigel Lawson, UK Chancellor of the Exchequer when the Delors Report was issued, emphasized the aspect of democratic accountability and found it wanting in the Delors proposals. Others, such as Deutsche Bundesbank President Karl Otto Pohl, saw democratic control as ensured if a European central bank came about by an agreement between democratic governments and was provided with a clearly defined mandate. Top officials could be appointed by European political bodies, such as the European Council or the EC Council of Ministers.

Initial steps toward EMU

On July 1, 1990, stage one of a process leading to EMU, as envisaged in the Delors Report, began. One of the immediate goals was to prepare the groundwork for an intergovernmental conference on EMU to draft amendments to the treaty that established the European Economic Community. The conference had been called for at the European Council’s December 1989 meeting. Then in April 1990, the Council pronounced itself “satisfied with progress achieved so far towards establishing the single market without frontiers” and asked that the intergovernmental conference “conclude its work rapidly with the objective of ratification [of the Treaty amendment] by member states before the end of 1992,” so as to coincide with the envisaged completion of the internal market. In June, the Council decided to open the conferences on EMU and political union in mid-December; both were to take place in Rome. At the European Council meeting in late October, the EC countries, with the exception of the United Kingdom, agreed to begin stage two on January 1, 1994, subject to further progress in economic and monetary integration. They also agreed that a new monetary institution for the EC should be established at the beginning of this stage.

During these months, a number of important events took place in the fields of financial and monetary integration. France and Italy abolished remaining capital restrictions (January 1 and May 14, 1990, respectively), ahead of the July 1 deadline stipulated in the 1988 EC directive on the liberalization of capital movements. Belgium-Luxembourg ended the dual-exchange market regime for current and capital transactions in March 1990. Spain joined the exchange rate mechanism (ERM) in June 1989, availing itself of the wider fluctuation margins, and Italy adopted the narrower margins in January 1990. Also of interest was Belgium’s decision in June to tie the franc firmly to the deutsche mark. On October 8, the United Kingdom finally joined the ERM, a move expected to reduce sterling’s fluctuations against ERM currencies and assist in lowering inflation.

The preparations for stage one started soon after the June 1989 European Council meeting. In March 1990, the EC Council of Ministers adopted amendments to decisions on economic convergence and central bank cooperation. The decision on convergence now refers explicitly to the achievement of “sustained non-inflationary growth, together with a high level of employment” and asks the Council of Ministers to survey member countries’ economies, and together with the Commission, report the results to the European Council and the European Parliament.

The amendment to the decision on central bank cooperation expands and defines more precisely the mandate of the Committee of Central Bank Governors. This includes intensified coordination of monetary policies, with the aim of achieving price stability as a necessary condition for the proper functioning of the EMS and the realization of the objective of monetary stability. The Committee can express opinions to individual governments and the Council of Ministers on policies that might affect the Community’s internal and external monetary situation, in particular, the functioning of the EMS. Further, the Committee is to prepare annual reports; its chairman may be invited to appear before the European Parliament and may be authorized by the Committee to make the outcome of its deliberations public. In the meantime, the Committee has drafted statutes for the ESCB, and begun studying the compatibility of monetary targets for the major EC currencies.

Other EC bodies have also begun to prepare for the EMU conference. The Monetary Committee, consisting of senior officials of the finance ministries and central banks of EC countries and the EC Commission, has been discussing questions such as the extent to which central and binding coordination rules would be needed for budgetary policies to be consistent with a common monetary policy, and whether the final responsibility for exchange rate and exchange market intervention policy should rest with the political authorities or the ESCB.

The EC Commission in March 1990 endorsed the general approach of the Delors Committee to EMU, although it deviated by not calling for uniform binding rules on budgetary policy, arguing instead for binding procedures. The convergence of budgetary policies should mainly be sought by incorporating budgetary rules into national law and enforcing such strategies through regular mutual surveillance at the Community level. In October, the Commission published a report that examines in detail the likely economic effects—costs as well as benefits—of the move to EMU.

An issue that has created some controversy is whether EC countries (such as Belgium, Denmark, France, Germany, Ireland, Luxembourg, and the Netherlands) that have achieved a high degree of price and cost convergence, should move ahead in forming the EMU. Other countries would join as soon as they were ready, in particular in terms of inflation and budget performance. It was pointed out, however, that such a two-speed procedure would be damaging to the coherence and further development of the EC.

It will be up to the intergovernmental conference on EMU to resolve, or at least identify possible solutions to, numerous issues. They encompass institutional and technical problems: how a European central bank should be organized and operate, the scope of its responsibilities, and the degree of its independence from political interference. There are problems with economic and political significance: they relate to the speed of the process of monetary integration and the contentious issue of a possible “two-speed” process. Also, the question of the extent to which monetary and economic union should be developed simultaneously and at a similar pace is at the heart of the dispute about binding coordination procedures for budgetary policies. Ultimately, the underlying question is one of a willingness to surrender sovereignty to common European institutions and to share in a common decision-making process.


Choosing an Exchange Rate Regime: The Challenge for Smaller Industrial Countries

Edited by Victor Argy and Paul De Grauwe

This collection of papers, presented at a Brussels seminar in December 1989, examines issues surrounding the choice of an exchange rate regime in smaller industrial countries. It contains a comprehensive summary by Jacques J. Polak.

Available in English. ISBN 1-55775-133-1. v + 391 pp. 1990.


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