European Economics

After a period of intense economic and political turbulence during the 1970s and a deep recession in 1980–81, the course of the European economy was much calmer, thanks in large measure, it seemed, to a new vigor in regional cooperation. Originally, many staff members of the IMF had worried that the new regional monetary institution, the EMS, would produce adverse spillover effects for the world economy: if managed too conservatively, it might produce a deflationary drag; if too aggressively, it would fuel world inflation once again. The Fund rapidly came to terms with the EMS, however, and accepted a certain loss of influence in regard to European developments. Perhaps faint memories of the EPU experience also played a part in making the EMS seem more acceptable: the IMF had at the outset opposed the existence and operation of the EPU, which had soon proved highly successful, and disproved the skeptics. In the end the EPU offered a promising channel to greater multilateral, and global, liberalization and to a widespread adoption of currency convertibility (see Chapter 4). The public pronouncements of the Fund in consequence were favorable to the new EMS. The 1979 Annual Report stated that “the task of stabilizing rates will require a concentrated effort toward policy coordination. It is expected by the participants that the greater exchange rate stability gained by more concerted intervention policies will facilitate the task of harmonizing financial policies.”⁸

European regional integration in the 1980s came to depend on two economic pillars. The first was the mechanism evolved at the end of the 1970s to deal with international exchange rate instability and strengthened in the first half of the 1980s in response to U.S. indifference to the international value of the dollar. The second lay in the promise of further political integration with corresponding repercussions for fiscal and monetary policy. For much of the 1980s, Europe appeared to have produced a stable and successful solution to the classic problem of the coordination of policy across frontiers.

The worldwide recession of 1981–82 made for a troubled infancy of the EMS. The first four years of the EMS were very turbulent, and some observers began to predict that the new zone of greater monetary stability would soon share the fate of the European snake. The same phenomenon that was cited frequently as evidence of instability, the frequency of parity alterations, in fact allowed the system to survive. Between March 1979 and March 1983, seven parity realignments occurred, with the effect that the central rate of the deutsche mark against the French franc rose by 33 percent. The IMF noted how the EMS divergence indicator “has to date signaled the need for adjustment only for the weaker currencies,” whose parities (rather than those of the deutsche mark or the Netherlands guilder) were altered.⁹ The combination of exchange rate changes and the strengthening of anti-inflationary policies in the deficit countries gradually produced a sustainable monetary order. The major breakthrough, which finally established the credibility of the EMS as a system, came in March 1983. The same policy change in France which marked the beginning of economic policy convergence on a global level (see page 429) also cemented a regional economic arrangement. The outcome of the French economic crisis of 1983 meant a strengthening of both the European and the international financial systems.

In 1983, France faced a major crisis, the result of two years of attempting an expansion of domestic demand at a time when the rest of the world had begun to pursue monetary stability. The program implemented by the new socialist government in 1981 included the nationalization of major industries and banks, higher minimum wages and social benefits, a reduced working week and a fifth week of annual holidays, as well as a fiscal stimulus that contributed to a substantial increase in domestic demand in 1982. Instead of reducing unemployment, which actually continued to rise, the government’s actions led to increased imports, capital flight, and an acute payments problem. The franc was devalued within the EMS exchange rate mechanism (ERM) in October 1981 and again in June 1982.

In March 1983, with a new franc crisis, the government faced the choice between a continuation of expansive policies with a flexible external exchange rate (a course advocated by the influential Minister of State for Industry and Research, Jean-Pierre Chevènement, and for some time also favored by President Mitterrand), and an abandonment of fiscal experimental ism within the confines of the disciplines imposed by membership the EMS. Rejecting the EMS, it was feared, would also mean a weakening of other forms of European cooperation, including the European Community itself, and reducing French influence on them. In the end, many French officials became convinced that the alternative to staying in the EMS was a loss of confidence, a dramatic fall in the franc, and austerity imposed from the outside by the IMF. One of Mitterrand’s advisers minuted that “leaving the EMS will send us to the IMF.” In the final days of the crisis, the threat of leaving the EMS as a result receded, although it was still used by France as a bargaining tool to oblige the German government to accept a greater degree of deutsche mark revaluation.¹⁰ President Mitterrand began to criticize excessive government bureaucracy and interventionism, and then reshuffled the cabinet, dismissed Chevènement, and increased the powers of the Minister of Economy, Finance and Budget, Jacques Delors, who was committed to solving the French crisis within a European context. Delors negotiated first a new franc devaluation and then a stabilization package supported through an ECU 4 billion ($3.5 billion) loan through the EC medium-term facility.¹¹

The 1983 U-turn of the French government was followed in Europe by a period of much greater stability. Signs of a new franc crisis in the second half of 1983 did not force a realignment, and the system seemed to have defeated the speculators. There was no change in the central EMS rates until July 1985, when the Italian lira was devalued relative to the other currencies. In January 1987 a new realignment came as a result, not of any fundamental misalignment within the EC currencies, but because of the strains on the system caused by the depreciation of the U.S. dollar as short-term funds moved into the “strong” European currencies.¹² The reduced number of realignments, falling inflation rates, and less spread between the maximum and minimum inflation rates within the EMS could all be cited as testimonies to the success of the system in creating the conditions for stability (see Figure 14-3). In 1985, the IMF Annual Report noted that “the countries participating in the exchange rate arrangements of the EMS have been largely successful in stabilizing exchange rates among their currencies.… While the EMS system could not easily be extended or reproduced elsewhere, its success under the circumstances in which it operates may offer encouragement to those searching for greater stability of exchange rates in the world economy.”¹³

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Exchange Rate Mechanism: Consumer Price Inflation¹

(In percent per annum)

Source: International Monetary Fund, World Economic Outlook.¹ Includes eight original ERM members: Belgium, Denmark, France, German, Ireland, Italy, Luxembourg, and the Netherlands.

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At the same time, the EC began to act as a regional analogue to the global system created at Bretton Woods. In this new system, economics and politics became as closely intertwined as they had been in the global Bretton Woods system in the 1950s and 1960s. Balance of payments support, which could be offered within the EC system as well as through the international system, became a subject for political deals. The most striking case is that of Greece, which joined the Community in 1981 (but was not a member of the EMS exchange rate system). Greece obtained an ECU 1,750 million ($1,550 million) facility under the Community Loan Mechanism in December 1985, with almost no conditionaliy attached by the EC Monetary Committee. The Greeks made little attempt at adjustment, and the central government deficit scarcely changed.¹⁴ The facility was the subject of intense negotiation, and an eventual compromise decided by a political barter. Support of Greece became entangled in the much larger issue of the political reordering of the Community. Greece had initially opposed the proposed reforms to the Treaty of Rome to be discussed at the European Council meeting in Luxembourg on December 2–3, 1985, which included the institution of voting by qualified majority (rather than unanimity) for measures required for the creation of an internal market. The opposition was dropped, and Greece merely added a statement that the creation of the internal market should “take place in such a way as not to harm sensitive sectors of member states’ economies.”¹⁵ In return for agreeing to the general reforms, Greece obtained the balance of payments support required to continue its government’s expansionist policy with little modification. The Greek negotiation was important politically in that the Greek government was compensated for not obstructing the process of further European integration.

In the second half of the 1980s a new dynamic of European integration developed: a push in part sustained by higher rates of growth, which made countries more willing to accept the dislocating effects of integration, but in part also driven by the reflection and the fear that there might be a falling off of growth and a return to the coordination failures and the deep pessimism of the early 1980s. Greater integration was seen by many governments as a way of generating sustained growth at higher rates. Real GDP in Europe grew at a respectable rate of over 2 percent after 1984; but only in the exceptional circumstances of 1988 and 1989 was there a performance comparable to the spectacular rates of the “golden years” of the 1950s and 1960s. The overall growth rate in the 1980s in the EC was half that of the 1960s.¹⁶ An important initial consideration in moving further than the EMS exchange rate mechanism had been the difficulties of global economic and financial coordination in the early 1980s, with the resulting appreciation of the dollar to such an extent that by 1985 many Europeans feared a “crash landing.” Later shocks that threatened destabilization, such as the stock market crisis of October 1987, or the later political upheaval of Central Europe in 1989, and the drama of German unification in 1990, only strengthened the commitment of European governments to the process of integration.

The discussions on the Commission White Paper at Luxembourg produced the 1986 Single European Act, which directly provided for the creation of a single internal market within the EC by the end of 1992, “an area without frontiers in which the free movement of goods, persons, services and capital is assured.” It also implied a wider program. The act contained a reference to the October 1972 statement by heads of state and government approving the “objective of the progressive achievement of economic and monetary union.” The concept of the single market was also extended through a Council decision of June 1988 to liberalize capital movements by July 1990, and by the Delors Report of April 1989, presented later to the Madrid Community summit.

The report drawn up under the chairmanship of Commission President Jacques Delors laid out a three-stage mechanism for the creation of a European System of Central Banks and then of a European Central Bank as a way of instituting monetary union. “Economic union and monetary union form two integral parts of a single whole and would therefore have to be implemented in parallel.”¹⁷ Unlike the Werner Report, it did not provide a set of rules for the operation of budget policy and the creation of a fiscal rapprochement, but simply a rule limiting national budget deficits.¹⁸

The liberalization of short-term capital movements, which formed a part of the move to closer integration, prompted large capital inflows into those EMS members with higher interest rates and inflation levels, and made more difficult the control of inflation. Italy in January 1988 lifted controls on trade-related short-term capital movements, and in October ended most restrictions on capital movement by residents. By May 1990, the liberalization was complete. Capital inflows into Italy, which had already risen in 1988, surged in 1990 (see Table 14-1). In January 1990, France lifted the ban on French citizens holding deposits denominated in foreign currency and removed restrictions on lending by nonresidents. Spain in June 1989 joined the EMS in the wider band arrangements originally (in 1979) agreed for Italy. Attempts to control the growth of domestic demand through monetary and fiscal measures only accelerated the inflow of funds. Both the average money market rate and consumer price inflation rates rose in 1989 and 1990.

Table 14-1.

Italy, Spain, and United Kingdom: Capital Inflows

(In percent of GNP)

Sources: Bank of Italy and Ministry of Budget and Treasury; Bank of Spain, Statistical Bulletin, August 1993 and August 1994; International Monetary Fund. International Financial Statistics Year Book, 1994; and United Kingdom, Central Statistical Office, Financial Statistics, January 1994 and September 1994.

Table 14-1.

Italy, Spain, and United Kingdom: Capital Inflows

(In percent of GNP)

	1986	1987	1988	1989	1990	1991	1992
Italy	0.4	1.2	2.0	2.9	4.0	2.0	0.8
Spain	–1.2	4.0	3.3	4.4	4.6	6.1	1.1
United Kingdom	–0.1	4.4	2.9	2.7	3.3	2.0	0.3

Sources: Bank of Italy and Ministry of Budget and Treasury; Bank of Spain, Statistical Bulletin, August 1993 and August 1994; International Monetary Fund. International Financial Statistics Year Book, 1994; and United Kingdom, Central Statistical Office, Financial Statistics, January 1994 and September 1994.

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Table 14-1.

Italy, Spain, and United Kingdom: Capital Inflows

(In percent of GNP)

	1986	1987	1988	1989	1990	1991	1992
Italy	0.4	1.2	2.0	2.9	4.0	2.0	0.8
Spain	–1.2	4.0	3.3	4.4	4.6	6.1	1.1
United Kingdom	–0.1	4.4	2.9	2.7	3.3	2.0	0.3

Sources: Bank of Italy and Ministry of Budget and Treasury; Bank of Spain, Statistical Bulletin, August 1993 and August 1994; International Monetary Fund. International Financial Statistics Year Book, 1994; and United Kingdom, Central Statistical Office, Financial Statistics, January 1994 and September 1994.

The mechanism of the EMS was strengthened through an agreement (known as the Basle-Nyborg Agreement, September 1987) allowing for the support of intramarginal intervention through Very Short-Term Financing (VSTF), and lengthening the time limit of the VSTF use from one to three and a half months. It represented a recognition that intervention was more efficient if undertaken before a currency reached its EMS floor or ceiling and that greater uncertainty about the timing of intervention would serve as a deterrent to speculative flows. The Basle-Nyborg Agreement also provided for intensified surveillance on the basis of indicators and projections by the Monetary Committee and the EC Committee of Central Bank Governors, and recommended less frequent and smaller realignments. In this sense it formed a part of the movement of the late 1980s for greater integration, and a modest accompaniment to the more ambitious schemes for monetary union. But like other negotiations concerned with integration, it contained fundamental ambiguities. The German Bundesbank, for instance, interpreted the agreement as a reaffirmation of its right to call for currency realignments, rather than as a fixing or hardening of the system.

As a result of the major integration initiatives of 1985–89, the character of the EMS changed. It had begun as an anti-inflationary mechanism for ensuring greater economic stability in member countries, and gradually became a part of a much broader drive to harmonization. At first it had depended on an anchor, then it developed its own institutional momentum, and finally it derived almost all its energy from that momentum. In the era of its greatest success, after the initial upheavals of 1979–83, the credibility of the system had rested on the commitment to the low inflation anchor of the deutsche mark, held stable by the Bundesbank’s monetary policy. The success of this stage provided an encouragement to move further. The Delors Report continued to describe the deutsche mark as the “anchor” for the monetary policy of EMS members. The non-German members of the system reaped the benefits of currency stability, with the consequence that some commentators even began to ask themselves what motives Germans had for continuing to be members of the EMS. A similar question also occurred to many in the Bundesbank, which had traditionally regarded the EMS as an occasionally irritating constraint on its freedom and its responsibility to run a monetary policy aimed at monetary and price stability.¹⁹

At the end of the decade the source of stability shifted. The EMS now came to depend not so much on the exchange rate mechanism itself, but on the belief that it represented only a transitional stage on a way to a completely fixed exchange rate system as part of the process of monetary union. That transitional phase was unstable because of the introduction of capital account liberalization. Alan Walters, the British Prime Minister’s Economic Adviser, described the EMS (in its new form, with open capital markets) as “half-baked,” neither a currency union nor a floating system. Tommaso Padoa-Schioppa referred more moderately but no less critically to the “inconsistent quartet” of policy objectives: free trade, capital mobility, fixed (or managed) exchange rates, and independent monetary policies. He concluded with the same logic as Walters, that “in the long term, the only solution to the inconsistency is to complement the internal market with a monetary union.” The liberalization of capital movements represented a practically irreversible dynamic. Countries might impose, or reimpose, restrictions on their residents, but the speculative movements frequently reflected choices by external agents, such as American or British banks, pension funds, or hedge funds. The problems of the EMS reflected only one aspect of the limitations imposed on national economic management by the globalization of finance.²⁰

The credibility generated by the politics of European integration was sufficiently powerful to cushion, at least for a time, even the strains to the system imposed in the aftermath of German unification in 1990. The cost of reconstructing the former German Democratic Republic threatened to produce a medium-term fiscal deficit in the new Germany, and in the short term Germany shifted from a major capital exporter to running current account deficits. Structurally, Germany had occupied within the EMS a situation analogous to that of the United States within the classical Bretton Woods par value system, and the deutsche mark constituted the European “key currency.” Like the United States in the 1960s, Germany now threatened the stability of the system with its large deficits. But the German threat was not quite identical with that posed by the United States at the end of the 1960s (loose fiscal and monetary policy). In its economic policy stance, post-1990 Germany bore more of a resemblance to the United States in the early 1980s, with the mix of fiscal deficits pushed up by political requirements, and the exercise of tight monetary policy to control inflation.

The drive to monetary integration reached a preliminary climax with the Treaty prepared at the EC summit at Maastricht on December 10–11, 1991, and signed on February 7, 1992. The Treaty on Economic and Monetary Union specified “the irrevocable fixing of exchange rates leading to the introduction of a single currency, the ECU,” and the goal of “definition and conduct of a single monetary policy and exchange rate policy the primary objective of both of which shall be to maintain price stability.”

Stage II of the integration process, in which a European Monetary Institute (EMI) and a European System of Central Banks (ESCB) would operate, would begin on January 1, 1994. Before this, all restrictions on capital movements between member states and between member states and other countries would be removed; and the various national governments would adopt multiyear programs to ensure the convergence needed by the individual countries to participate in economic and monetary union. The EMI would facilitate the use of the ECU, and create a regulatory, organizational, and logistical framework for the ESCB to begin Stage III by the end of 1996. Convergence required that there should be no excessive deficits. (Elsewhere, the Treaty specified “reference values” that included a ratio of budget deficits to GDP of less than 3 percent, and of government debt to GDP of less than 60 percent.) The inflation rate should not exceed that of the best three inflation performers by more than 1.5 percent, and the average long-term interest rate in the year before the examination of the convergence criteria should not he over 2 percent above that of the best three in terms of inflation performance.) By December 31, 1996, the European Council would decide whether a majority of member states had met the Maastricht criteria for the adoption of a single currency, with the additional stipulation that if by the end of 1997 no date had been set for Stage III it would begin on January 1, 1999. At the start of Stage III, the European Central Bank would begin to operate, and the EMI would be liquidated. The Maastricht protocol states that “all Member States shall, whether they fulfill the necessary conditions for the adoption of a single currency or not, respect the will for the Community to enter swiftly into the third stage of Economic and Monetary Union, and therefore no Member State shall prevent the entering into the third stage.” Maastricht had created an almost completely automatic timetable for union.

The economic treaty had a counterpart in the form of a political treaty. The latter came as a result of a German insistence that too much strain should not be put on monetary policy by making it the major mechanism for economic convergence in the Community. A common monetary policy alone, without accompanying fiscal measures and economic adjustment, would according to this view be too likely to be pushed in the direction of expansionism and inflation. Immediately after the signing of the Treaty, the Bundesbank took care to warn that monetary union should be accompanied by political union and that the strict conditions of entry should not be watered down.²¹

In practice, the political Treaty of Maastricht was much less specific than the provisions for monetary union and contained few indications of how the politics of the convergence process could be handled. It spoke of “a new stage in the process creating an ever closer Union [the Dutch draft had originally specified “Union with a federal goal”] among the peoples of Europe, where decisions are taken as closely as possible to the citizens.” It also referred to a “common foreign and security policy,” a modest strengthening of the powers of the European Parliament (the addition of the ability to scrutinize Community finances and to veto or amend some Council Acts), and the extension of the terms of office of the Commission from tour to five years.

The two treaties soon provoked a populist backlash, against the treaties themselves and against the governments that had negotiated them. This was not an inevitable response: to a large extent, it originated from the context of a depressed European economy that contrasted with the bullish mood that had underlain the integration euphoria of the late 1980s. International cooperation or coordination is always hardest in periods of slow or negative growth. Germans worried most about the loss of monetary sovereignty. The popular Bild-Zeitung carried the headline, “Our Beautiful Money: The Mark Will Be Abolished.” A former member of the Bundesbank Central Council wrote a polemical book against the Maastricht treaties.²² On June 2, 1992, by a very narrow majority Danish voters said “no” in the referendum required (for Denmark alone) under the terms of the Maastricht Treaty. The day after the Danish vote, President Mitterrand announced a French referendum, which was required neither under the terms of the treaty not by the French constitution, and which was scheduled for September 20, 1992. It soon became clear that the French referendum would also be very close (in the event, the voters approved Maastricht).

The political nervousness highlighted the economic strains within the EMS. The macroeconomic convergence had not been completed. Instead, there was an inner core, with a high (or in the case of Germany and the Netherlands almost total) degree of convergence, and an outer group, composed of Italy, Spain, Portugal, and the United Kingdom (with the position of Ireland unclear). In the outer group, the “convergence play” of fund managers seeking higher yields began to resemble a much more speculative exercise: a movement of funds in search of higher returns, accomplished in the knowledge that the authorities’ commitment to the process of integration would provide at least a sustained defense should expectations be reversed. Interest rates were held at high levels (attracting the inflows), while the exchange rate was held by a strong political commitment. The political will to establish a European union appeared to create a number of one-way bets. The inflows generated high levels of monetary expansion, inflationary development, and a consequent real appreciation of the exchange rate that threatened economic performance. An estimated $300 billion was involved in this kind of movement, a figure exceeding the total supply of reserves ($270 billion) involved in the eventual crisis of the system in 1992–93.²³ The extreme sensitivity of central banks and governments to the possibility of providing the markets with any early warning signs that a change of parity might be appropriate or imminent made impossible the discussion of exchange rates in any international forum: the EC Economic and Financial Committee, the Central Bank Governors Committee, the Bank for International Settlements, or the IMF. By the summer of 1992, many participants believed that a crisis was imminent, yet remained convinced that it was impossible to discuss that imminence.

Pressure from the markets built up with the belief that the costs of the overvalued exchange rates in terms of lost growth and higher unemployment would eventually be too great; but the meeting of EMS finance ministers in Bath, England, on September 5–6, 1992 failed to consider any realignment. The British Chancellor of the Exchequer, Norman Lamont, and the French Finance Minister, Michel Sapin, refused to contemplate devaluation of their currencies. Instead, on four occasions, Lamont with increasing intemperance asked the Bundesbank President Helmut Schlesinger to reduce interest rates, and four times was told “no.” The Dutch Prime Minister, Ruud Lubbers, later said that the Bath failure to discuss exchange rates was a “black page in the book of 1992.” In the aftermath of Bath, the pressure against the Italian lira intensified, and the Bundesbank mounted a substantial support operation. Large German purchases of lire from September 7 to September 11, 1992 threatened the Bundesbank’s control of the German money supply.

The attempt to defend currencies under speculative attack raised a question that had never been straightforwardly examined. Under the terms of the initial EMS agreement, central banks were committed to unlimited intervention when currencies reached their fluctuation margins, and in addition through the 1987 Basle-Nyborg Agreement they later agreed to a “presumption” of increased intervention between the margins (the French even spoke of “a presumption of automaticity”). Logically the intervention obligations entailed a commitment, if necessary, to replace the entire stock of lire or pesetas or francs or sterling with deutsche mark in the event of a sustained speculative attack, but such an outcome would be unacceptable both for the Germans and their partners. In this sense, the final crisis of the system arose not so much out of an inadequacy of reserves in the face of an all-powerful market (as was often claimed by commentators) but rather in the widespread nagging doubt for the officials responding to crises that the market might be right and that the alternative would be politically impossible.

At an emergency meeting of the Bundesbank Council on September 11, 1992, attended by the German Finance Minister, Theo Waigel, but also by Chancellor Helmut Kohl, Schlesinger asked for the German government to renegotiate the European exchange rate structure. If this were agreed, the Bundesbank would lower interest rates, as the exchange rate would carrypart of the burden of anti-inflationary policy. A package was prepared in consultation with the Italian government in which the lira would be devalued by 3 percent and the deutsche mark revalued by 3 percent against the other EMS currencies. But this amounted to a de facto devaluation of all currencies relative to the deutsche mark, and the abandonment of the concept of the deutsche mark anchor. France refused to alter the franc-deutsche mark parity before the Maastricht referendum, because it would mean political humiliation. The French Finance Ministry also refused to call a meeting of the Community’s Monetary Committee. The British Prime Minister, John Major, did not believe that the “fundamentals” of sterling were wrong or required a parity change, and refused to take part in the operation. Possibly, if Chancellor Kohl had intervened directly with Major, the British position might have been different; but Germany was reluctant to be so openly assertive, and instead the Italian Prime Minister, Giuliano Amato, served as a more congenial intermediary in the talks with Britain. As a result of Major’s unwillingness to act, Italy was left alone with a change of parity. Over the weekend, the Italian government decided to devalue the lira by 7 percent, and the Bundesbank agreed to interest rate cuts, but by a smaller amount than if a larger EMS realignment had been accepted. The ¼ percent cut of the key Lombard rate was published on Sunday, September 13, 1992.²⁴ The move was announced to other European central banks by the Director of the French Treasury, Jean-Claude Trichet, who merely asked his partners, over the phone, for their consent to a devaluation of the lira. Like John Major, he saw the goal of the operation as avoiding a general change of parities.

On September 15, 1992, a movement out of the British pound began. In the evening, reports of an interview of Schlesinger by journalists from the Wall Street Journal and the German Handelsblatt emerged, in which the Bundesbank President called for a general realignment (in other words, an operation that would include at least the devaluation of sterling, which German officials had believed to be consistently overvalued since Britain joined the EMS in 1990). On September 16, 1992 the pound fell on the markets, despite two interest rate rises, and the United Kingdom, faced by a collapse in the credibility of its monetary and economic policy, had no choice but to suspend membership in the EMS exchange rate mechanism. The next day, September 17, Italy too withdrew from the mechanism. In this fashion, a general EMS realignment resulted, not according to the plans of politicians, but as dictated by financial markets.

The crisis demonstrated both the costs of intervention, and its limits. The Bundesbank claims on the EMS VSTF reached DM 92 billion ($65 billion), and its losses in the exchange rate crisis are estimated at DM 1 billion ($710 million).²⁵ France at the end of September was believed to have lost all of the F 97 billion ($20 billion) reserves held at the end of August, and it was later revealed that by the end of September 23, when the French crisis ended, the Bank of France had bought F 160 billion ($33 billion) in the successful defense of the national currency.²⁶ The United Kingdom attempted to support the pound with an ECU 10 billion ($6,950 million) foreign currency borrowing program beginning on September 3, and used some £15 billion ($27,700 million) in currency market intervention. On September 18, Sweden concluded an ECU 8 billion ($5,550 million) syndicated loan as part of an equally unsuccessful attempt to defend the link of the krona to the deutsche mark (but outside the EMS).

However large these figures were, they were dwarfed by the size of the international security markets. Daily foreign exchange dealings in mid-1992 amounted to approximately $1 trillion; currency futures worth an average $8 billion were traded daily in London (and the amount in New York was even more substantial, $23 billion).²⁷ The lesson of September 1992 was that the world’s institutional investors, and the world’s speculative hedge funds, were capable of defeating governments’ attempts to preserve exchange rate regimes merely through intervention. For the moment it was not a lesson taken to heart by the managers of the European economies.

The currency crisis was followed by a debate about whether an “inner core” (consisting of five countries of the original EEC six) should proceed more quickly to monetary union. Franco-German convergence in inflation and interest rate performance, as well as the Franco-German defeat of the speculative attacks on the franc, indicated that this might be a realistic option. Some close to the inner core, but critical of the operation of the system in practice, attacked the devaluers for engaging (in the first major instance since the 1930s) in competitive devaluation.²⁸

To others, it appeared that the EMS had what the British Prime Minister (and the principal architect of Britain’s EMS/ERM membership), John Major, termed “fault lines.” Bundesbank President Helmut Schlesinger called the obligation of central banks to intervene to support weak currencies, which constituted the heart of the system, “a powerful incentive for speculation.” He stated in a series of exceptionally candid speeches and interviews that currency intervention was “not only expensive for the taxpayer, but in the final analysis purposeless.”²⁹ It could not be a substitute for policy adjustment. In this case, central bank intervention could not counter the perception that two fundamentally opposed political pressures were pulling the system apart. Germany, threatened by a large fiscal deficit as a consequence of the high costs of political unification, required monetary restraint. Tight money policies, however, elsewhere in Europe were blamed for the severity of the recession, and political pressure mounted for a relaxation. Germany’s neighbors faced a dilemma: if they followed German monetary restraint, their recession would be intensified; if they failed to tighten, funds would flow out and lead to an exchange rate crisis. Outside Germany, many believed that Germany had used the mechanism of the monetary system in order to export the consequences of the shock generated by German unity. A latent crisis built up over German interest rates. Even former advocates of the EMS turned into critics. On July 29, 1993, when the Bundesbank failed to meet expectations that it would cut its discount rate, the markets’ belief that an incompatibility of political demands lay at the heart of the exchange rate mechanism produced a new speculative onslaught against the French franc.

In crisis meetings over the weekend of July 31 and August 1, 1992, the suggestion to scrap the ERM altogether was made (by Spain) but was rejected. Instead the same emergency device was used as with the attempted rescue of the analogous but global Bretton Woods par value system at the G-10 Smithsonian meeting in December 1971: wider margins. The ERM was placed in limbo by the adoption of such wide floating margins (15 percent rather than the previous 2.25 percent—at the Smithsonian 22 years earlier the move had been from 1 percent to 2.25 percent) that in practice it resembled a free float. Only the Netherlands and German currencies remained within the old narrow bands. At a subsequent calmer meeting of the EC Monetary Committee, the decision was taken not to move quickly back to the narrow bands.

At least in the medium term, the crises of 1992–93 effectively destroyed the EMS in its established form. Fixed or semifixed systems find it hard to respond to shocks from the outside. It is even harder when that shock emanates from one of the members of the system. It is hardest of all when it is the central member of the system that produces the shock. This was the case with Germany in 1990–93 (as it had been with the United States in 1969–71). In the event, even a regional institution, in which had been invested an enormous amount of political good will, proved ineffective when it came to reconciling the fundamentally divergent national interests of its members. The fact that in 1993 all responsible politicians in France and Germany insisted over and over again on the permanence of the Franco-German relationship made no difference to the way the markets responded to what they saw as a sharp conflict of policy preferences.

It is hard to say what effects the EMS crises and the probable lengthening of the timetable for European monetary union will have on economic performance. There were quite different reasons to be worried about the path of the European economy.

Even a successful program of European trade liberalization (as the result of the Single European Act of 1986) and a very stable system of currency management (until 1992) failed to address major economic issues of great political concern. Europeans began to worry that they faced severe long-term structural problems: that European industry was uncompetitive and that high levels of unemployment would persist (the average rate in the EC in the 1980s had been 9.2 percent).³⁰ The dramatic events of the late 1980s and early 1990s provided a reminder that growth and prosperity (of the kind that characterized the second half of the 1980s) may make agreement about cross-national cooperation easier; but also that monetary institutions and monetary integration do not by themselves deliver that growth and prosperity.

A lesson of the EMS crises was not only that regional surveillance had failed completely with regard to exchange rates but also that global surveillance had been abdicated in the face of a powerful regional dynamic. The IMF consultations before the 1992 crises included stern comments criticizing Italian fiscal policy,³¹ but in the short run such warnings had produced little effect. To some extent, even after the first large crisis, the IMF remained too complacent about the dangers confronting European currency arrangements. The Annual Report published in 1993, after the final EMS crisis, but written a few months earlier, had concluded its analysis on an excessively optimistic note. “In early 1993, interest rates generally declined with the abatement of inflationary pressures; this decline has both reflected and contributed to an easing of tensions in the ERM.”³² In general, in the European exchange traumas of 1992–93, the IMF remained on the sidelines.

The experience of the EMS prompted a need for a reconsideration of the surveillance process in the face of the enormous power of capital markets in a world economy more open than at any previous moment in postwar history. Surveillance clearly needs to be conducted with regard to regional monetary institutions in order to highlight the concerns of the global system; it also needs to be conducted on an increasingly frequent basis in order to adapt to rapidly changing circumstances. The Fund’s Executive Board began to hold as a result of the EMS strains much more frequent sessions devoted to the world market and world development to supplement the twice-yearly cycle of World Economic Outlook discussions. In addition, interim editions of the World Economic Outlook were produced and discussed. The response to the EMS crisis was to attempt a strengthening of the surveillance process—though in this particular case, it looked very much like a case of closing stable doors after bolted horses.

Shocks and the CFA Franc

The CFA franc zone, unlike the EMS, is a fully fledged monetary union, with nothing “half-baked” about it. It represented an important solution to the quest for monetary stability and confidence building. The origins of the area were very evidently political. It began as a “political rather than economic entity,”³³ which included widely dispersed French imperial possessions: islands off the coast of Newfoundland and Madagascar, Réunion and Comoros in the Indian Ocean, as well as African territories. By the 1970s, it had become a regional grouping of central and west African states, but with currencies still linked to the French franc. The franc area consists of two separate currencies issued by two central banks in separate but parallel monetary unions: the West African Monetary Union (WAMU) with the Banque Centrale des Etats de l’Afrique de l’Ouest as the central bank (Benin, Burkina Faso, Côte d’Ivoire, Mali, Niger, Senegal, and Togo), and the Central African Monetary Area (CAMA) with the Banque des Etats de l’Afrique Centrale (Cameroon, the Central African Republic, Chad, Congo, Equatorial Guinea, and Gabon). Comoros has its own central bank, but follows the same exchange rate regime as the monetary unions with their CFA francs tied to the value of the French franc. The heart of the system lies in an exchange rule that kept the parity of the CFA franc unchanged from 1948 to 1994, first at 2 French francs, and then (after the introduction of the new franc and the canceling of two zeroes from the French currency) at 2 centimes. The franc was freely convertible into French francs (though in 1993 limitations were introduced restricting the sale of CFA francs outside the territory of the area), and its relation to other currencies essentially determined by French policy on exchange rate and convertibility. For instance, when the French franc was devalued in 1969, the IMF Executive Board also decided that a “fundamental disequilibrium” existed in the CFA area and without any hesitation or debate agreed to a devaluation by the same amount as for the French franc.³⁴

The existence of a currency union requires coordinated monetary and fiscal policies—the establishment of a system of rules. Monetary policy in the CFA area was set as a result of the obligation to hold reserves to meet eventual balance of payments deficits. Since the mid-1970s it was also supplemented by the formulation by the central banks of annual targets for monetary aggregates. These could then be translated into national targets, including in some cases figures on credit to be allocated to specific sectors of the economy. The fiscal discipline necessary for the operation of the zone has also followed from a quite simple rule, limiting by statute the amount of governmental credit from the banking system (the limit was originally set at 10 percent of total bank credits, but was subsequently raised, and has been 20 percent since 1973).³⁵ An international support mechanism is an essential part of the area. The operating account at the French Treasury functioned as a substitute for any other lender of last resort or provider of emergency assistance, since interest-bearing overdrafts could be run on the operating accounts. In this way, the region could for a long time function as a self-contained “micro” international system, and its use of the institutions of the global system were for a considerable period of time quite limited. Like the EPU, conceptually this zone did not require the existence of a global institution such as the IMF.

The historical peculiarity of the zone lies in its diversity and in a relatively low Level of integration as measured by trade shares. The CFA region has a quite diversified economic structure. The largest economy in the CAMA, Cameroon, became in the course of the 1970s and 1980s a significant petroleum producer, as did Gabon; while the major exports of the largest member of the WAMU, Côte d’Ivoire, are coffee and cocoa, which are also important products for the Central African Republic, Benin, and Equatorial Guinea. Commodity shocks in consequence inevitably produced rather different effects on the various members, which are not able to respond to the varying degrees of change in the terms of trade by parity alterations. In this sense, the region does not really meet the standard academic criteria for the functioning of an “optimum currency area.“³⁶ The ability to respond to differential shocks however makes relatively little difference to intraregional commerce as the trade of member countries within the CFA has been consistently low (much lower than, for instance, in the case of the EC). It was 5 percent in the mid-1960s, and rose only to 7 percent by the mid-1980s. The linkage to the French franc makes more sense than the existence of a common area, in that a very large proportion of trade has been with France (48 percent in the 1960s, falling to 30 percent in the 1980s), as well as with countries in Europe whose currencies are closely tied to the French franc.³⁷

The major gain from the exchange rate link has been very low inflation levels; but the corresponding trade-off has been an inability to use the exchange rate as an instrument of policy. As a consequence, the area has been highly vulnerable to the dramatic fluctuations of commodity prices in the 1970s and 1980s. In the 1970s, the coffee and cocoa producers benefited from the commodity boom, and then suffered from a sharp fall in the terms of trade between 1977 and 1982. Almost all countries attempted to deal with the domestic economic and social consequences by the costly method of extending price subsidies. Many had relatively small fiscal deficits in the mid-1970s (less than 3 percent of GDP); by the early 1980s, some had deficits over 10 percent of GDP.³⁸ They attempted to finance these deficits through borrowing on international markets (for the more prosperous economies with market access, which participated vigorously in the borrowing boom of the late 1970s), or through bilateral or multilateral development assistance. At this stage, some of the members of the CFA franc area also began to look to the IMF and the World Bank for support in coming to terms with the commodity shock. The external shocks brought the zone into contact with international financial institutions. Gabon had its first stand-by arrangement with the IMF in 1978, the Central African Republic in 1979, and Niger in 1983. After 1982, commercial lending was dramatically curtailed, and the former borrowers looked to the international institutions rather than the market. Côte d’Ivoire concluded an IMF extended arrangement in 1981, and a stand-by arrangement in 1984; Cameroon negotiated its first stand-by arrangement in 1988. Lower-income countries were also eligible for resources under the newly established IMF facilities, the structural adjustment facility (SAF) and then the enhanced structural adjustment facility (ESAF). (See Chapter 15.) Niger (in 1986), Senegal (in 1986), Togo (in 1989), Benin (in 1989), and Burkina Faso (in 1991) borrowed from the IMF under these facilities. Many countries also obtained sectoral lending from the World Bank.

In 1985 a new, and much more severe, commodity shock affected the CFA economies, with a simultaneous renewed deterioration of coffee and cocoa prices (which had recovered slightly after 1983) and a fall in oil prices. As a consequence, the terms of trade of all members of the CFA franc area deteriorated sharply (by an estimated 45 percent),³⁹ the real exchange rate rose significantly, and the external account deteriorated and showed large current account imbalances. At the same time, the very serious fiscal problems that had appeared earlier in the decade became less and less soluble. Revenues from taxes appeared to have reached a ceiling, as further increases in rates would only promote an increase in evasion. At the same time, revenue from customs duties, which had been a major source of government income, stagnated, at least in part because the increasingly overvalued exchange rate encouraged the development of large-scale smuggling.⁴⁰

The link with the French franc, and the international implications as the franc rose against the dollar in the aftermath of the Plaza agreement, also contributed to the extent of the CFA crisis. The fall of the dollar began in 1985, at exactly the time of the commodity shock (“the wrong thing at the wrong time for countries in the franc zone,” as the World Bank put it).⁴¹ In addition, domestic inflationary pressures pushed up costs and prices, despite the external anti-inflationary currency peg. As a result, the CFA franc became notably overvalued. Even against the French franc, the real exchange rate of the CFA franc area appreciated because of domestic inflation (between 1985 and 1990 this appreciation amounted to 7 percent for Côte d’Ivoire); but the rise was much greater for other trading partners (vis-à-vis other industrial countries, the real exchange rate appreciation amounted to 44 percent).⁴²

The borrowing countries now found credit almost impossible to obtain; in the absence of available funds, the financing gaps identified by the IMF increased; and it became increasingly difficult to draw up a satisfactory program. Borrowing by the government from the domestic banks increasingly paralyzed the financial sector. Without the ability to change the exchange rate, the burden fell on what was termed “internal adjustment”: a sharp reduction in government spending and in domestic wages and prices; in short, a dramatic program of domestic deflation. The reforms of government expenditure involved cuts in education, health, and infrastructure. In practice, this amounted to a diminution of the long-term capacity for growth. Until the early 1990s, some governments implemented very radical packages, with yearly wage and salary cuts for public sector employees, and large-scale dismissals; but the strain imposed by such adjustment proved less and less acceptable. In some countries virtual public bankruptcy forced mass layoffs. These pay and staff cuts were often politically difficult to manage, especially as many countries contemplated more extensive democratization. In spring 1990, Côte d’Ivoire reversed a previous decision to cut nominal wages. In November 1993, a strike wave broke out in Cameroon after the attempted imposition of a 50 percent wage cut.⁴³ The discontent was the price paid for exchange rigidity. The inability to change the exchange rate meant that no alternative existed except to reduce domestic costs through deflation, a very slow process with a severe effect on output and an uneven and inequitable distribution of the costs of adjustment across sectors.

Some IMF stand-by arrangements were still negotiated, but in many cases the programs broke down quickly, and the extent of access to funds was reduced sharply. (For instance, a 1987 stand-by arrangement for Côte d’Ivoire could not be drawn on; in 1989 a new arrangement was rapidly revised to reduce access to funds.) As this deterioration took place, and as it became obvious that a major part of the problem lay in the exchange rate commitment, after 1989 the IMF privately and the World Bank more publicly began to question the defense of the parity.

It was however a long time before the member countries agreed to a devaluation—a long time during which debt arrears, both domestic and international, mounted, and growth fell off in comparison with neighboring countries such as Nigeria and Ghana that had been able to adjust their exchange rates. The extent of domestic debt threatened the stability of the banking system and produced a further disincentive to economic activity. However, governments were frightened of the labor unrest that a devaluation might provoke, as it would cut the purchasing power of incomes and the ability to purchase imported goods. In some of the poorer economies, large parts of the population were dependent on imported food. Devaluation seemed in consequence as fraught politically as “internal adjustment,” and—unlike adjustment—required a clear political act. It could not be considered as a matter of technical economics, but rather as a profound political issue that would be determined by the heads of states. An intense informal discussion of the CFA problem by the IMF’s Executive Board in November 1990 reached the conclusion that whatever the economic benefits of exchange rate adjustment, the Fund needed to recognize “the commitment of the zone members to the CFA arrangement.”⁴⁴ The case aroused powerful political passions, in which leading figures appeared to lock themselves into inflexible positions. In 1993, for instance, in the course of the election campaign in Senegal, President Abdou Diouf repeatedly promised not to consent to a devaluation of the CFA franc. The issue threatened the political solidarity of the member countries. Some countries appeared steadfastly opposed to change, while others (notably Côte d’Ivoire) tried to signal the urgent need for a change of parity.⁴⁵

As a result of the difficulties of reaching an adequate international program, the Fund and the World Bank both increasingly withdrew from financing the CFA area, which became increasingly dependent on support from France. Bilateral support rose every year, and very dramatically after 1988. In effect, the French Treasury was paying off the CFA debt to the Fund and the Bank. By 1993, of the CFA members only Benin had a fully operating stand-by arrangement with the Fund. As the situation worsened, the Fund engaged in very intense high-level diplomacy in order to secure an agreement to devalue. The Bank’s criticism was more public and explicit. In July 1992, an agreement was very close, but failed in the last instance. France accepted the African reluctance, perhaps motivated by the consideration that a weakening of the franc zone would undermine the domestically difficult defense of the strong franc in the European context. The French cost of support for Africa, however, increased (fourfold between 1987 and 1992); in 1992, the defense of the CFA zone cost France an estimated F 4 billion ($750 million).⁴⁶ The major turning point came when, after a change in government, the new French Prime Minister, Edouard Balladur, announced in a letter to the CFA heads of state, as well as in a statement published in Le Monde, that French support could not continue without agreements with the IMF. “Fot several years the World Bank has received more from Africa than it has lent, and has practically ceased to intervene to the advantage of the franc zone.… Only countries that have courageously begun the indispensable policy of adjustment can in the future count on the lasting support of France but also of the international community.”⁴⁷ In effect, this amounted to a French instruction to follow the advice of the IMF and devalue, with the result that the eventual devaluation became a rather badly kept secret.

At a meeting of heads of state and government leaders at Dakar on January 10–11, 1994, the CFA members agreed to a devaluation to one centime. The statement accompanying the decision spoke of boosting exports, ensuring the return of flight capital, and increasing savings levels. It also referred to a promise of the quick restoration of Fund programs, and of World Bank support, as well as concessional aid that would allow the settlement of domestic debt as well as a negotiated reduction of international debt. France forgave F 25 billion of CFA debt (all of the outstanding debt of the ten poorest countries and a cancellation of half of the debt of the richer four); and in addition announced the creation of a new “special development fund.” The IMF and the World Bank resumed substantial assistance, the IMF through the newly renewed ESAF arrangements for the 11 countries that met the eligibility criteria.

The eventual devaluation was sufficiently large to eliminate for the foreseeable future the possibility of the necessity of a renewed devaluation. Only in this way could the credibility function of the CFA area—which had been the key to its past successes—be preserved.

The experience also, however, demonstrated the inability of a currency area to survive on its own, isolated in a cocoon from the international economy and from international institutions, in the face of fierce external shocks. Occasions arise when, as in 1971 in the international system as a whole, following a simple rule is not sufficient. In the CFA case, the maintenance of the franc parity had led to a delay of almost a decade between the onset of a major change in the terms of trade and the response; a delay that had been costly in terms of lost opportunities and of welfare losses (the decline in real incomes is estimated at some 40 percent over this period).⁴⁸ Use of the exchange rate strategy requires a different approach, in which international institutions would play a role not simply in providing assistance, but also in offering information and specific policy advice. The widespread fear that exchange rates would be used competitively in a beggar-thy-neighbor strategy has created a demand and need for a regional surveillance of exchange rates that includes not just members of the CFA franc zone but also their neighbors. The international order and international institutions have proved to be an indispensable part of a politically sustainable attempt to make adjustment.

Currency Blocs

Stable regional currency arrangements have very clear attractions. For a long time, the CFA franc provided stability and low inflation. Even in the turmoils of 1992 and 1993, the EMS still appeared to have produced great benefits for the members of the system. Some of those advantages, however, provoked skepticism: for instance, it was often claimed that the EMS in its heyday provided an effective way of reducing inflation rates through the credibility effects of association with a low-inflation anchor. The critics replied that some states outside the EMS had seen better successes in reducing inflation, and that a lowering of inflation rates represented a phenomenon common to most industrial countries. Another advantage following from the reduction in exchange rate uncertainty was claimed to be trade enhancement: but the growth of inter-EC trade also responded to the 300 directives following the Single European Act. Sometimes the supporters of the EMS also said that it provided a framework in which capital movements could be liberalized; but in fact this liberalization represented an important cause of increased instability within the system by the early 1990s.

The more modest case argued in favor of the EMS presents it as a desirable step in the direction of policy coordination that had most effect when international coordination was most riven by dissension, in the first half of the 1980s. It was, as the critics of regionalism had always admitted, a solution to a problem of insufficient coordination: but a second-best solution.

Asian Economics

Such a solution always looked less attractive to the Asian economies, for whom the global export market constituted the primary lever for growth. To a far greater extent than in Europe, the export market meant long-distance intercontinental trade, rather than commerce with neighboring countries. The success of Asia is a story of rapid transitions in the structure of the economies, but also of dramatic shifts in the relative position within the world trading system. This economic structure is the primary explanation for the lesser appeal of regional solutions in Asia.

From 1960 to the early 1980s, the share of the Pacific (excluding the United States) in the global product rose from 9 percent to 19 percent (while the U.S. share fell from 40 percent to 27 percent).⁴⁹ The growth of exports showed a particularly dramatic path after the rest of the world trading system had slowed down. As oil and debt and dollar shocks hit traders and producers elsewhere, Asia continued to grow, and at an accelerated rate. The Asian share of world exports, which had remained almost constant during the 1960s (and fallen if Japan is excluded), rose after 1970: from 12.5 percent in 1970 to 22.2 percent in 1990 (or, without Japan, 5.9 percent and 13.5 percent).⁵⁰

To what extent did this part of the world consider itself an economic region? If it was united, it appeared so less by geography or common interests than by a common way of doing business: and this represented a link that could and did lead to competition as much as to cooperation. The major industrial economy in the region, Japan, looked consistently to markets outside its own region as a mechanism for inducing greater adaptability and higher rates of productivity growth. Many Japanese referred to the development process as “westernization” or “de-orientalization” (datsua-ron).⁵¹

The earliest postwar attempts at Pacific economic integration reflected the Japanese “westernizing” or non-Asian outlook. In 1960, Japan launched an initiative to create a five-member Pacific Free Trade Area with Australia, Canada, New Zealand, and the United States. Even in 1980, the Japanese and the Australian Prime Ministers proposed a Pacific Economic Cooperation Conference, analogous to the Organization for Economic Cooperation and Development. As in Europe, chaos and disorder in the world system prompted further thoughts about regional togetherness, but such yearnings rarely went much further than tentative suggestions. During the first oil crisis in 1973 and in the aftermath of the currency disorder that followed the breakdown of Bretton Woods, some South and East Asian states developed a plan for an Asian clearing union, on the model of the EPU of the 1950s, in which liabilities would be settled in a new currency unit and not in dollars or sterling. The scheme never developed, perhaps because of Japanese opposition (although Japan had promised “technical assistance”), but also because for economies trading so extensively outside the region, such a scheme could have little appeal.⁵²

Other Asian states followed a different course, but only moved very slowly and hesitantly toward the creation of a regional institutional framework for economic cooperation and coordination. The main political organization of Asian states, the Association of South-East Asian Nations (ASEAN), created in 1967 by Brunei, Indonesia, the Philippines, Singapore, and Thailand, initially aimed much more at providing political security for the region and remained opposed to the idea of wider Pacific economic cooperation.⁵³ In 1977 ASEAN attempted to establish a system of Preferential Trading Arrangements, but the effects on inter-Asian trade were extremely limited. It was only much later, as the ending of the Cold War elevated economic concerns relative to security considerations and as European integration seemed to offer a threat to traditional markets, that ASEAN began to develop a systematic economic project analogous to European economic integration. In 1992, it announced that beginning in January 1993, its members would reduce tariffs on nonagricultural goods to a maximum of 20 percent within five years and to no more than 5 percent by 2008. Given this program, ASEAN might become, in the words of the Prime Minister of Singapore, Goh Chok Tong, “a strong player in the new world order.”⁵⁴ But ASEAN itself appeared as too small a unit to rival the EC.

Other alternative groupings existed. In 1989 the APEC (Asian Pacific Economic Cooperation) forum was launched, with the intention of including 15 members: the ASEAN states, Japan, China, Taiwan Province of China, Hong Kong, Korea, Australia, Canada, New Zealand, and the United States. The United States saw it as an opportunity for a “framework” for trade and investment, but these hopes immediately provoked the interpretation that the U.S. aim lay in restricting the growth of new manufactures in newly industrializing countries. Tension over whether the United States should be included in a regional grouping prompted an exclusive response, chiefly the result of a Malaysian initiative. The East Asia Economic Caucus was devised as an organization within APEC that excluded the “white” countries (the United States, Canada, Australia, and New Zealand) with the intention of pressing the organization to respond to genuinely “Asian” concerns. Then in 1991 the Malaysian Prime Minister Mahathir Mohamad proposed the creation of an East Asian Economic Group on the grounds that “we have to be united and have a trade and market pact of our own.”⁵⁵

The existence of a large number of potential groupings is a characteristic of the early stages of regional integration. In the late 1940s, Europeans had experimented with units of varying size, with ideas of a large payments union, and smaller free trade areas (Finebel, Fritalux) before the establishment of the six-nation European Coal and Steel Community (and then the European Economic Community). The three-nation Benelux, agreed already during the Second World War by their governments in exile, proved a conspicuous success. In the late 1950s, the coexistence of the EEC and the rival seven-member European Free Trade Association (EFTA) ensured that Europe was “at sixes and sevens.” Even in the 1990s, a political structure including “variable geometry” is frequently recommended as a solution that would take into account different levels of income and development in Europe. But a constant choice between different sizes and shapes makes regional integration much harder.

In the case of Asia, the ambivalence of the area’s strongest economy toward regionalism remains a permanent obstacle. Japan’s trade remained predominantly outside East Asia. In the course of the 1970s, Japan’s exports to the East Asian newly industrializing economies, however, increased (the export share rose from 11.2 percent to 14.5 percent), as they did to the ASEAN countries (20.9 percent to 26.5 percent).⁵⁶ The growth of Japanese foreign direct investment also reflected little orchestrated concern with building up a regional position; but it played a qualitatively highly significant role in the early stages of industrialization of some of the East Asian newly industrializing economies. Thus, for instance, the first automobiles in Taiwan Province of China were made as a result of a joint venture with the Japanese firm Nissan. At this stage, Japanese capital exports were relatively small in quantitative terms, but played a major role in the East Asian economic area. By the end of the 1970s, for instance, 60 percent of the cumulative foreign investment in Korean industry had come from Japan.⁵⁷

In the course of the liberalization of the Japanese economy, however, the regional emphasis in investment flows began to fade. Between 1969 and 1979, Japanese capital controls were progressively lifted in part as a way of halting the appreciation of the yen. After 1980, Japanese capital exports rose dramatically, but the share of Asian investments declined. From 1980 to 1990, Japanese foreign direct investment in Asia rose sixfold, while in North America it increased by a factor of seventeen.⁵⁸ There were, of course, momentary Japanese surges in investment in specific Asian economies: in Thailand in 1990 (where the result was described as “Operation Sushi Storm”),⁵⁹ or in China in 1992. Such manias for particular business opportunities, however, are characteristic of the swings of mood that regularly dictate market behavior and are not indicative of a political will underlying economic drives.

What Japan did offer to its neighbors was not a regional focus, but rather a model, or a “growth pole.”⁶⁰ A favorite analogy was that of “flying geese,” in which countries proceeded, in phases, through various stages of economic growth. At the outset, an import substitution strategy involved a growth of light industry (mostly textiles) providing a basis for subsequent development. Japan had reached this point before the First World War. Then came the development of an export sector, concentrating on those goods in which an initial comparative advantage had been achieved. There followed the emergence of heavy industries: engineering, shipbuilding; and then the production of advanced technological goods. In each period of growth, skills necessary for the transition to the next could be amassed. And each stage provided a model for the countries flying behind in the later tiers of the formation of geese.⁶¹ In the second flight were the “four dragons” or “four tigers,” Hong Kong, Korea, Singapore, and Taiwan Province of China. Behind them came Thailand, Malaysia, Indonesia, and perhaps the Philippines; at the fourth stage, Viet Nam, coastal China, and perhaps some of the economies of South Asia.

Precisely what each flight of geese learned from its predecessors has been fiercely disputed. The “second generation” Asian economic model demonstrates both the long-term beneficial role of state action, and the dramatic gains brought through opening and liberalization. Over a long time frame, the state had succeeded in creating a stable framework for expectations, high levels of education, and (through land reform) a just social order. These created a springboard for economic growth. The development of policy has been masked by the popularity of at least three profoundly misleading analyses: that what occurred in the “miracles” represented a sustained development resulting from the application of consistent policy; that it occurred because “outside” or “Wesrern” advice was rejected or ignored; and that instead there existed a single “Asian” alternative.

First, the Asian development was by no means smooth. Rather it was characterized by sharp disruptions, of which the two most significant were at the beginning of the 1960s and at the beginning of the 1980s, These caesuras produced a dramatic change of policy; in both cases those changes involved greater orientation toward an international system and were supported by international institutions. One of the characteristics of the successful East Asian economies is that they proved very skilled in dealing with economic crises and shocks, and in using them or harnessing them as an opportunity for a reassessment and reorientation of policy.

Because the policy transformations in the aftermath of shocks took place on the whole in the context of close and rather harmonious cooperation with multilateral institutions, in particular the IMF and the World Bank, as well as with regional development institutions (notably the Asian Development Bank), it often appeared to many as if there was little outside intervention or help in producing “miracles” or “success stories.” (This is an instance of a general rule: the most effective programs and consultations take place in the absence of large substantive disagreements, and as a result it is often hard in retrospect to detect a particular policy input from the international community.)

It is also hard to identify a single policy regime followed by all the successful East Asian industrializers. In the case of two of the Tigers, openness was an inevitable result of size and position. Hong Kong and Singapore are small city-states, with the advantages and vulnerabilities that had characterized sixteenth-century Antwerp or Venice, or twentieth-century Shanghai or Beirut. The other two Tiger economies had been growing quickly for a substantial period of time, indeed already in the period of Japanese colonial rule. Between 1911 and 1938 both Korea and Taiwan Province of China demonstrated slightly higher growth rates than that of Japan itself.⁶²

After the Second World War, the newly industrializing economies began a fast period of growth essentially as closed economies, although they had some social and structural advantages. Korea and Taiwan Province of China both demonstrated in the post-1945 period how a relatively egalitarian income distribution can promote social stability and a widespread acceptance of the growth process. In Taiwan Province of China, a land reform that established a small-scale and highly productive peasant agriculture had already been undertaken under Japanese rule.⁶³ In Korea, a similar reform came later, in the 1950s, as a consequence of the Korean war. Both Korea and Taiwan Province of China placed a high premium on education, reducing illiteracy, and encouraging technical and scientific training. In both cases, as perhaps also in the case of the most successful postwar West European economy, the Federal Republic of Germany, the existence of a systemic competition with powerful communist neighbors meant that governments consciously attempted to avoid sharp income disparities and maintain social cohesion. An experience of open or latent civil war produced a similar effect in other Asian economies, for instance, in Malaysia and in the Philippines. At the same time, the constant presence of an external threat also strengthened the state’s domestic power. It is often recognized that unstable, rapidly changing authoritarian governments have a strong incentive to loot and exploit the society that has the misfortune to be subjected to them. More stable authoritarian regimes and democracies are in a better position to take account of the long-term interests of societies; and some authoritarian regimes may have the additional advantage, as regards the development process, of greater immunity to the demands and pressures of interest groups.⁶⁴

The East Asian states played a major role in setting an appropriate framework for development. Budgetary restraint helped to create price stability. High real interest rates produced high savings ratios. In the 1960s, unified exchange rates replaced a complicated discriminatory system of multiple exchange rates designed to reduce dependence on imported goods.

Until the late 1950s, both Taiwan Province of China and Korea vigorously pursued import substitution strategies and built up domestic textile and other consumer goods industries through multiyear development plans. At the end of the decade, as in Latin America, these policies ran into major problems. In most of the Latin American cases, countries required major balance of payments support. But on this, as on subsequent, occasions, in Asia quite severe external shocks generated a modification and a reformulation of policy. Crises became a learning opportunity. The East Asian experience could be summed up as the productive use of shocks.

The crisis of import substitution arrived slightly earlier in Taiwan Province of China (1958–59) than in Korea (1960–62). In Korea it led to major social unrest, which provided the backdrop to a military coup in 1961.⁶⁵ Popular unrest targeted the profiteers from import substitution. Businessmen were forced to walk in the streets with placards around their necks stating “I was a parasite on the people.”⁶⁶ In both cases, however, the experience produced a long-lasting shift in the character of policy. In Korea, the adoption of an export promotion policy began in 1960. In 1964 the currency was devalued, and interest rate controls were relaxed. From 1965, the opening of the Korean economy was supported by a series of annual IMF stand-by arrangements. The increased confidence generated very large capital inflows.⁶⁷

After this, the two governments turned consciously, frequently as the result of recommendations of foreign advisers, to export promotion. The new strategy required adjustment to a wider market, as well as accepting a price structure that had developed as a result of supply and demand on the global market. The domestic market alone could not give an adequate incentive to development and would not lead to the movement of labor out of lowproductivity employment.

Even during the “import substitution” phase in Taiwan Province of China, at least some momentum had developed for export production. By 1958 the island had become a net exporter of textiles.⁶⁸ Its Second Four-Year Plan (begun in 1958) stated as a goal that “the Government should positively undertake to guide and help private investments so that they do not flow into enterprises which have a surplus productivity and a stagnant market.”⁶⁹ Finding export markets would constitute a way of achieving this objective.

The geographical distance from the United States, combined with a dependence on the United States and on the “West” for defense, made East Asian governments much more inclined to take external advice than were most of the regimes of Latin America. In 1960 in Korea, exports were only 1.8 percent of GDP; the ratio rose dramatically to 9.9 percent in 1970 and 30.0 percent in 1980. Taiwan Province of China had a slightly higher ratio in 1960 (10 percent), and reached 48 percent by 1980.⁷⁰ One decade later, the next formation of geese took the same adjustment measures, and began their own outward orientation. As a consequence of the strategy of import substitution they had originally also adopted, their share in world trade had contracted. Only in the 1970s did they look to exports as a source of dynamism.

By the early 1970s, rising wages made labor-intensive industrialization, even with an export orientation, less attractive. The market created incentives to undertake more capital-intensive projects, and businesses responded; so did the planners. The planning authorities nominated specific sectors. Korea’s 1973 Heavy and Chemical Industry Plan, for instance, targeted six industries for development. These included automobiles, electronic goods, plastics, shipbuilding, and steel. Government officials worked with the large industrial combines (chaebol) to estimate future market developments and restrict access to potential new entrants. They promoted publicly funded institutes that would coordinate information flows and facilitate new technical developments.⁷¹

Inevitably, such an approach led to some misjudgments and miscalculations. It would be surprising if they had not, if anyone, whether a government official or corporation executive, could exactly forecast the development of the future.

Both Korea and Taiwan Province of China concentrated too heavily during the 1970s on shipbuilding (for which there had existed a rationale in security policy) and the production of man-made fibers. An inflationary boom developed, with Labor shortages in key sectors. After 1976, real wages rose faster than productivity, and the new market conditions prompted an increase in labor radicalism. Fiscal policy became looser. By the time of the second oil price shock, substantial industrial overcapacities had developed. At the end of the decade, it appeared that many of the objects of state-promoted industrialization had become at least temporary “white elephants.” One analysis concluded that “economic planners—and just about everyone else in South Korea—think that too many companies are spending too much on heavy industry.”⁷² Another pause in the growth process prompted another opportunity for reflection about the appropriate direction of change.

The Asian crisis at the end of the 1970s took its most severe form in Korea. Strikes and riots spread after the assassination of President Park. The world recession and the second oil shock made the situation more acute, as more expensive oil alone ate up 4.5 percent of Korea’s GNP. In order to deal with the situation, Korea borrowed larger and larger sums on the world’s capital markets, $2.4 billion in 1978, $4.6 billion in 1979.⁷³ Some lenders assumed that these infusions were simply an extension of the economic miracle story of the 1980s. As the Economist put it in March 1980, with a surprising but revealing factual inaccuracy, “the most successful non-oil borrowers were a fast-growing Brazil and South Korea, which ran large current deficits and never had an agreement with the IMF. Bankers liked them despite that, precisely because of their growth.”⁷⁴ (Korea had, in fact, arranged yearly stand-by programs with the IMF since 1965, and these had represented a vital part of the Korean growth strategy. In some years, no funds were drawn under the stand-by arrangements; and in these cases the agreement simply had a confidence-building effect; but in other cases, all or part of the agreed amount was used. The Economist’s slip indicates quite how widespread the assumption had become in the late 1970s among some self-styled believers in the market that successful economies could not be involved in drawing up programs with the Fund.) As interest rates mounted, debt servicing became a problem. The climate of international opinion then changed quite abruptly. Analysts began to assume that the East Asian miracle had faded and that the center of dynamic growth in Asia would shift further south.⁷⁵

The year 1980 was one of obvious crisis. Real GNP in Korea fell by 5 percent, inflation reached 30 percent, and the external current account deficit amounted to 9 percent of GNP. The crisis produced a dramatic reformulation of policy, supported with an IMF two-year stand-by program (March 1980, with a revised program in February 1981). The fiscal deficit and the rate of monetary growth were cut, and by 1981 inflation had already been reduced to below the amount specified in the Fund program. The depreciation of the won against the dollar stimulated exports. In addition, the government continued with structural reform policies. The preferential allocation of credit, which had previously been a feature of the Korean financial structure, was reduced, and greater autonomy was given to financial institutions. The import liberalization program continued, with tariff reductions in 1980 even despite the current account bottleneck. In general, the IMF programs of the early 1980s proceeded quite harmoniously, because of a substantial agreement of views between the Korean government and the Fund. Only in 1982 was there any significant contention, when the Fund urged further depreciation of the won,⁷⁶ a strategy that when adopted proved so successful that within a few years it generated complaints that the won had been deliberately undervalued.

A radical improvement in the current account in 1986 caused problems. The United States complained about Korea’s $7 billion trade surplus with it, and asked for special consultations about the exchange rate, under the surveillance procedures of the amended IMF Article IV, claiming that the won had been artificially depreciated. It also asked for an investigation by the GATT of barriers to the import of specific goods, notably beef. American economists supported the claim that the won was undervalued and that the deliberately adopted Korean strategy of running current account surpluses was misguided. Others talked more appropriately about further trade liberalization.⁷⁷ The IMF staff produced a report on the exchange rate issue praising Korea’s “virtually unprecedented turnaround” and criticizing some of Korea’s bilateral responses to American pressure (in particular the adoption of voluntary export restraints—VERs). But the IMF also recommended some measure of exchange appreciation, as well as further market opening. Korea attempted to deal with the external criticism by pointing out its status as a debtor country, the extent of trade liberalization already achieved, and also that the origins of the complaint lay in a fundamentally bilateral problem, the trade surplus with the United States (in 1986 there had been simultaneously a $5.5 billion deficit with Japan).⁷⁸

The Korean economic miracle in the 1980s revived again on a rather different, and now even less state-initiated and more liberal basis. At the same time, some of the earlier projects, which had been largely the result of government guidance, began to come right. In the case of Korea, by 1984, three fifths of exports came from the sectors specified as heavy and chemical industries, in line with the projections that had been made in 1973.⁷⁹ For the next phase of development, a planning or guidance framework still existed: in Korea, the 1982 Long-Term Semiconductor Plan. Like earlier initiatives, some of the emphasis may have been mistaken. The production of 64K DRAM chips began just at the time when the scarcity price they had previously commanded started to disappear, and the market was flooded with products, with the result that the new plants could initially operate only at very low capacity levels.⁸⁰ As export growth slowed down in the late 1980s, commentators once again assumed that the growth process had reached a new impasse, with a “major market-access problem in the 1990s.”⁸¹

In fact, the waves of optimism and pessimism that have inspired outside judgments of East Asian economic performance arise because the achievement is frequently analyzed in an artificially segmented way. Popular commentators look at activity in particular sectors, such as steel in the 1970s or high-technology goods in the 1980s, and then generalize about the economy as a whole. In fact, the success story of the 1980s lies in a response to the process of trade opening: the diversification of products, which makes the exporting economies less vulnerable to developments in particular markets.

At the same time, other countries in the region adopted parts of the earlier phases of the Tiger strategy: export orientation and liberalization. In the early 1980s, China created Special Economic Zones, three out of five of which were located in the southern province of Guandong. Output in Guandong grew at an exceptionally rapid rate throughout the 1980s, albeit from very low initial levels. The real rate of growth was estimated at an annual 13 percent. The region had made itself part of the expanded Tiger economy of Hong Kong, in anticipation of the political transfer scheduled for 1997. Hong Kong companies created some 2 million jobs in Guandong in the course of the 1980s.⁸²

The newer developers confronted the same worries about the future openness of the world economy as did the Tigers. One of the frequently noted characteristics of the development process is a leap-frogging effect. Latecomers have an advantage in that they can learn from the past mistakes of others, and (especially when they are open) profit from and adopt the best available technology. Instituting best practice is not, however, merely a characteristic of technical change: it also applies in the case of the choice of an appropriate policy mix. Here what might be termed institutional leapfrogging took place. The second generation of Tigers proceeded to liberalization and openness at a far quicker pace than had their predecessors. Malaysia, for example, after 1971 created export-processing zones, in which tax concessions attracted foreign investment. Again, as elsewhere, adjustments were prompted by crisis. After a severe recession in 1985–86, the government began a deliberate move away from state-dominated industrialization. The state sector was dismantled. The government partially privatized the automobile industry (the Proton factory), which had been a cornerstone of the modernization strategy.⁸³ The most important lesson learned by the later generation from its predecessors concerned the advantage of opening and liberalizing—at an increasingly rapid pace.

Europe, the CFA franc area, and East Asia present three contrasting examples. Europe, with a far better institutional framework for regional integration, has shown how hard it is, even under optimal circumstances, to solve the coordination problem. It has also demonstrated how much easier coordination and cooperation become in periods of fast economic growth; but the continuation of such dynamism depends on global openness and trade. Regional cooperation is sometimes a substitute, and often an enhancement, of worldwide opening; but it is never an exclusive alternative. The monetary lesson of the CFA franc zone, in which an adjustment was delayed too long for considerations fundamentally political, echoed that of the EMS.

East Asian success, on the other hand, has consistently depended on the expansion of global, cross-regional trade, and on the availability of a powerful and attractive local example of how to adapt to the international economy. The region provides an instance of a powerful growth mechanism in the absence of a strong institutional framework for regional integration. It owes its success to the combination of high levels of savings and investment, entrepreneurial dynamism unleashed by an appropriate government policy mix, and open world markets.

If anything in the future prompts the formation of a more tightly integrated economic area in East Asia, it will be the continued persistence of a threat to international trade or of any renewed protectionism. The fear that the United States or Western Europe might close off markets is a central consideration when East Asian states contemplate the extent of their common interests. It is often the unilateral interpretation of the rules and principles of the international economy that leads to the search for regional defense mechanisms. In trade, this unilateral step may be the application of antidumping measures on the basis of a determination made solely by national authorities (the most conspicuous example is the provision of the 1988 U.S. Trade Act known as Super 301); in monetary arrangements it is the attempted manipulation of the exchange rate for economic advantage. By 1993, the Prime Minister of Malaysia, Mahathir Mohamad, was complaining that: “Managed trade has advanced. And there are respectable western scholars who even advocate it as a legitimate model for the conduct of future world trade. There are politicians who openly advocate it without blushing with shame.”⁸⁴ East Asian—and indeed other developing economies—have a common stake in the preservation of an open market. The uncertain state of world markets has had a remarkable effect in pushing the rapidly growing economies away from their insistence on the virtues of managed trade.

East Asia will only be a model that other developing economies seek to imitate providing world markets continue to expand. With widespread protectionism, the East Asian states could not be powerful economic performers. Although a contraction of world markets might in the short-term produce enhanced East Asian political and economic cooperation, the region would no longer serve as an alluring example of growth-promotion through regionalism.

Regionalism has been at best only partly successful in solving the problem of economic policy coordination across frontiers. It can never fully or adequately substitute for global coordination, cooperation, and growth; and the political loyalties it produces may frequently stand in the way of effective international surveillance. The strongest recent economic performance of any region has come from an area consistently reluctant to engage in the search for regional solutions.

The advantages and costs of monetary regionalism in fact represent two sides of the same coin. The attraction of regionalism is that, in a relatively fluid and unconstraining world economy, it offers a tighter rule, imposed with substantially greater political authority, and as a consequence can create greater confidence and stability. It may be a better or more encouraging framework within which decisions about the future can be made by the agents in the economic game. It also often entails an escape from the principles of global economic surveillance. The converse of the enhanced credibility is a limitation of flexibility in responding to shocks, whether policy shocks (as in the case of the EMS after German unification) or commodity shocks (as in the story of the CFA franc). By contrast, perhaps the greatest single superiority of East Asian policy has been its flexibility in reacting and responding to external shocks: because of the looser constraints, these societies rebounded after shocks with a vigor that surprised most observers. It is in dealing with such shocks that the combination of policy advice with adjustment assistance by multilateral institutions has been, and is, at its most valuable. On the other hand, Europe and Africa experienced disturbances that placed a considerable strain on the regional mechanism and that required dramatic corrective action before the advantage of enhanced stability and confidence brought by a strong regional identity could again be realized.