EMU and the International Monetary System

15 EMU and the Euro: Ensuring a Successful Launch

Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
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Michel Camdessus

I hope you have found your discussions at this conference interesting and thought-provoking. Certainly, we at the Fund value this exchange of views and the opportunity it provides to enrich our thinking about the external implications of Europe's forthcoming EMU.

EMU, and the economic convergence it has inspired, is certainly one of the most important and promising developments in the international monetary system in recent decades. For prospective members, the drive toward EMU has provided strong incentives to strengthen domestic economic policies and to begin addressing deep-rooted structural problems. For the EU as a whole, EMU will help reinforce monetary stability and cement economic integration. And for the world, EMU holds out the promise of a strong new pillar for the international monetary system.

For all of these reasons, EMU is a momentous and, indeed, historic enterprise. It is hardly surprising, then, that EMU is also the object of intense public scrutiny and that, as the date for starting Stage III approaches, the inevitable questions concerning the final transition are attracting greater attention. Will Stage III begin on time? How many countries will ride the first wave of monetary union? And what about the other countries that aspire to join EMU but are not among the initial participants? As interest in these and other questions mounts, each new statistic, government action, and barometric reading of market sentiment is scrutinized all the more closely for what it may portend for EMU.

This conference provides a welcome occasion to step back and take a longer view, and in my remarks to you today, I would like to do just that. Let me begin by recalling why Europe has embarked on such an ambitious project and how far EMS members have come toward its achievement. Then, I would like to discuss what remains to be done to ensure EMU's successful commencement in January 1999 and development thereafter.

Why is EMU so important? Certainly, Europe will reap a number of economic benefits from the introduction of a sound common currency. A common currency will lower transaction costs, reduce exchange risk, stimulate competition, and facilitate the broadening and deepening of European financial markets. It will also cement a larger economic space, which will then be better able to face external challenges and more impervious to adverse external shocks. All of these factors should contribute to sustained, noninflationary growth and more rapid job creation, once structural impediments are removed.

But clearly, there is more to EMU than this. Indeed, EMU is the crowning achievement of four decades of European economic integration, a process that, let us not forget, sprang from the ashes of a devastating war among European countries. I would venture to say that, seen from this perspective, EMU is, above all, an essential building block in Europe’s growing political unity.

Let us also not forget just how far this process has come. Remember the beginning of the 1950s: European currencies were not convertible, domestic markets were highly protected, and intra-European trade took place on the basis of bilateral clearing arrangements. Today, the situation could hardly be more different: European currencies are freely convertible, and all capital controls have been eliminated. Intra-European tariffs and quotas have long since been removed, and the single market program has further strengthened market integration and the role of market forces.

Meanwhile, during the nearly 20-year existence of the EMS, monetary cooperation among central banks has steadily strengthened. The repeated realignments that marked the early years of the EMS have given way to economic convergence to support exchange rate stability and to limited, and coordinated, central bank action to smooth market fluctuations. In the meantime, intra-European exchange rates have achieved a high degree of stability—at times, even when dollar rates have fluctuated sharply. Indeed, for all intents and purposes, a number of EMS members have already been part of a de facto monetary union for many years.

Certainly, important work still lies ahead, and I will come to that in a moment. Nevertheless, contrary to a widespread popular misperception, the conditions for EMU's successful start are already largely in place.

First, across Europe there is a remarkable consensus on the approach to macroeconomic management—namely, that monetary policy should be directed to price stability; that budgetary policy should aim toward medium-and long-term fiscal sustainability; and that structural reform, especially labor market reform, has an essential role to play in achieving sustained, non inflationary growth and promoting job creation.

Second, most EU members have achieved a high degree of macroeconomic convergence. Inflation in the 15 members of the EU—now projected at 2¼ percent in 1997—is lower than at any point in the last 35 years. Equally striking is the unprecedented narrowing in the dispersion of inflation. All EU members except Greece are expected to have inflation below 3 percent this year and to be in compliance with the reference value in the Maastricht Treaty.

Important progress has also been made in the fiscal area. EU-wide, the general government deficit is projected to be 3¼ percent of GDP in 1997—that is, 3¼ percentage points of GDP below its 1993 peak. Over 2 percentage points of this adjustment is expected to occur in 1996-97, with almost three-quarters of it representing a strengthening of the underlying fiscal position. Among the countries aiming to participate in Stage III from the beginning, all except Italy are projected to satisfy, or come close to satisfying, the Treaty’s 3 percent reference value for the fiscal deficit on the basis of measures already announced. In the case of Italy, after the large package adopted last year, the authorities intend to introduce additional measures shortly, with a view to satisfying the reference value. I should add that, when adjusted for the current weakness in economic activity, 1997 deficits are projected to be significantly below 3 percent of GDP in all countries except Greece—although in most cases still short of the close-to-balanced underlying position agreed in the Stability and Growth Pact.

With significant convergence in inflation and public finances, and with progress toward EMU gathering momentum, long-term interest rate differentials vis-à-vis Germany have fallen substantially over the past two years—especially for countries that have had relatively high differentials in the past. The differential for about half of the EU countries is about ½ of 1 percent or less, and all countries aiming to participate in Stage III from the outset would satisfy the Treaty on the basis of the current pattern of interest rates.

But more important, it seems to me, is the fact that this major progress in the macroeconomic and financial areas reflects a significant change in attitudes. Many in Germany, but also in other countries, have rightly sought to make the establishment of a culture of stability a precondition for achieving EMU— and they have prevailed.

Third, solid institutional arrangements are being put in place to ensure the euro’s credibility. The Statute of the ECB guarantees the Bank's independence and gives clear priority to low inflation in the conduct of monetary policy. Moreover, the Stability and Growth Pact, with its early warning system and various procedures for enforcing appropriate fiscal adjustment, lays out a strong framework for maintaining budgetary discipline after January 1999. At the same time, the Pact appears to leave sufficient room to tailor policy prescriptions to fit individual country circumstances. All of this augurs well for EMU and the euro.

Finally, I would note that the technical preparations for EMU are well advanced. In particular, the EMI's recently published blueprint of the monetary policy framework in Stage III shows the detailed work that has gone into preparing the full range of monetary policy instruments that the ECB will need to have at its disposal and into readying the cross-border payments system (TARGET) that will help integrate national financial markets. Important agreements have also been reached on the so-called ERM II, which will provide a framework for maintaining stable exchange rates between the euro and EU currencies that do not participate initially in the euro area.

I would observe, however, that the vast amount of internal preparation for EMU stands in sharp contrast to the attention devoted so far to EMU's external dimension. Indeed, the Maastricht Treaty is largely silent on external issues, and little technical work has been done on them so far. Thus, it was high time to hold this conference, which I hope will lead to much more intensive work in this area.

So what does all of this suggest about EMU? In my view, it suggests that this enterprise has been too long in the making, its foundation too solidly laid, and its achievement too important to European integration to court the uncertainties that would stem from its delay. In short, it is time to put to rest, once and for all, any lingering doubts about the future of EMU and to finish the job that is, in any case, so close to completion. So, leaving aside all possible doubts and remaining hesitations, let's concentrate on what “finishing the job” means.

For 1997, finishing the job means that countries must concentrate on fulfilling their Maastricht commitments, especially those concerning deficit reduction. This is the only way to dispel concerns that the desire to begin EMU on time could take precedence over economic fundamentals. Laying these concerns to rest is essential, both to safeguard the credibility of the euro in the financial markets and to ensure public support for EMU. Let me salute countries’ courageous efforts to this end.

Will meeting the 3 percent of GDP reference value be an easy task? No, but in most cases, it is feasible. Certainly, this year's budgetary outturn will be influenced by the pace of economic activity in Europe, which has not been as strong as desired. However, there are good grounds for believing that growth will be stronger this year than last and that countries' budgetary positions will improve.

But what if growth turns out to be weaker in 1997 than currently projected? In more normal circumstances—especially where countries were already making a substantial fiscal effort—there would be good reason to allow automatic stabilizers to work. However, the preparations for EMU make the issue more complex. In fact, if slippage in meeting fiscal goals increased market concerns that Stage III were postponed, the consequences could well be more damaging for economic growth than would additional fiscal restraint. In these circumstances, if there were a need to support economic activity—while inflation remained subdued and fiscal consolidation was proceeding—an easing of monetary conditions might be considered. Certainly, the more credible countries' fiscal efforts were, the more scope there would be to pursue such a course.

In the final analysis, however, the most important thing is to ensure that the underlying pace of fiscal consolidation is adequate, and above all, that countries' commitments beyond 1997 are consistent with the Maastricht Treaty. It is on this basis that decisions on which countries will join at the beginning of Stage III will need to be made. Indeed, the Treaty offers some scope for interpretation along these lines. In the meantime, markets need reassurance that the process will be managed in a steady and harmonious way. In this regard, it will be important to avoid taking positions that might unduly narrow the options when the time comes to make decisions on the initial participants in Stage III.

But, let me insist on this: Europe's adjustment task will not be confined to 1997; it also has an important medium-term dimension. First, on the fiscal side, the need to meet the longer-term challenges arising from aging populations and to provide a reasonable amount of scope to accommodate periods of sluggish growth calls for gradually reducing cyclically adjusted budget deficits to near zero, and perhaps, in some cases, turning deficits to surpluses. From this perspective, I would note that the pace of fiscal adjustment required under the Stability and Growth Pact is consistent with the adjustment EU members need to undertake for their own economic well-being, especially given the large uncovered liabilities of their pension systems.

Likewise, both EMU and the need to accelerate growth in Europe call for much more vigorous structural reform, particularly in labor markets and related social policies. In contrast to the record on inflation, fiscal consolidation, and long-term interest rates, progress in addressing labor market rigidities has been painfully slow in most EU countries. Much more determined action is needed, especially in the area of social benefits and the regulations affecting wage structure and severance procedures. As regards EMU, it is widely recognized that greater labor market flexibility is needed to allow economies to adjust to asymmetric shocks. On the other hand, persistently high unemployment associated with labor market rigidities could undermine the credibility of the euro as a stable currency, if markets believe that such rigidities will make it difficult to pursue prudent macroeconomic policies. Beyond these considerations, European economies need to increase labor market flexibility so that they can react more quickly to changing conditions in global markets and raise their potential rates of output growth.

In this connection, EMU must not be saddled with the political blame for necessary, but unpopular, measures to rein in government spending, reform social welfare programs, and remove other structural impediments to growth. Certainly, the drive to create and participate in EMU has provided some useful political leverage to improve policies and promote convergence. But national authorities need to make it clear to the public that the policy reforms they are undertaking are, above all, good for their own countries—not simply good for EMU.

Let me also say a few words about the countries that plan to join EMU but may not be among its initial members. All countries have a strong interest in seeing that EMU gets off to a good start, even those—or perhaps I should say, particularly those—that are not among the first participants. Indeed, those initially outside EMU may benefit most from a solid euro zone, since it is they who would have the most to gain from increased market confidence as their performance converges with that of EMU members. Thus, later entrants must also help ensure that EMU begins on time, and with an appropriate initial size—but most important, that it begins on a sound economic footing. The essential thing is that a clear road map be established for them to join as soon as possible thereafter, so that there are no adverse market reactions and the political will to persevere in the adjustment process is sustained.

Finally, let me say a few words about EMU's implications for the rest of the world—even if more is said on this subject during the regular conference sessions. It is clear that the euro will become a major pillar in the international monetary system. Naturally, this will be an important innovation in the system; hence, it is essential for the rest of the world, as well as for Europe, that the transition be managed well.

At this point, it is very difficult to predict just how the euro will fit into the constellation of other reserve currencies. However, we can safely assume that its position will depend in large part on the strength of its domestic foundations—that is, on the continued macroeconomic convergence of its member countries, the pace of structural reform, the depth and breadth of euro-denominated financial markets, and the degree of political cohesion among EMU members on key policy issues. It is on these grounds that the euro will most likely be judged; and it is in these areas that prospective members must work to ensure EMU's success.

Whatever the uncertainties, we do know that EMU is an ambitious project, but one whose time has come. We know also that the euro's impact on the rest of the world will be large, and that it is our task to make sure that its introduction and development become a positive-sum game for the entire world. Here we must face squarely the risk of higher instability in major currencies’ exchange rates in a bi- or tripolar world.

As a matter of fact, the Fund has learned a lot since 1978; each episode of major misalignment—and they were not infrequent—has left us with its lessons. I can tell you that we have learned well a few apparently obvious things:

  • how to recognize misalignments;

  • how to correct them; and

  • what this implies in terms of international dialogue and cooperation.

Thus, we are equipping ourselves to play, in such instances, the role we could be called upon to carry out.

We are mindful of the hesitations of key players today to ask us for assistance in this area. But key players are mindful also of the systemic consequences of their actions, and they are certainly as concerned as we are by the fact that many speakers have reminded us of—namely, that incidences of misalignments could become more frequent and more damaging in a bi- or tripolar world.

If such misalignments do occur, let us hope that the call of Paul Volcker for the expertise of the Fund to be properly used will be heeded and that the Fund will be called upon to do its job, that is—and here I quote Article I of our Articles of Agreement—to “provide the machinery for consultation and collaboration on international monetary problems.” The IMF has a major responsibility in this regard. I have no doubt that we will enjoy the full cooperation of the present and future European authorities in developing a constructive dialogue on the potentially difficult issues we may face. Concentrating early enough—and openly enough—on these issues, with the technical support of the professional staff of this institution and the contribution of its entire membership, will be essential in ensuring that EMU and the euro achieve their full potential.

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