Chapter 4. A Flawed Monetary Union

Tamim Bayoumi
Published Date:
October 2017
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The costs of the Euro area banking crisis were enormously amplified by the flawed design of European Monetary Union (EMU). By joining EMU, Euro area members gave up the ability to print money in the face of a crisis. For regions within a typical currency union, such as California within the United States of America, the inability to print money is of limited concern as the federal government provides an emergency backstop. By contrast, European Monetary Union was designed in a highly decentralized manner, with little or no ability for countries in crisis to access centralized support. Rather, the risk of a crisis was supposed to be constrained by rules that limited unwise behavior, in particular too much government borrowing. Lax enforcement of these rules allowed the Greek government to borrow excessively in the 2000s using the financial credibility of the union as a whole. The discovery of this subterfuge in 2009 led to a rapid increase in borrowing costs for governments in the Euro area periphery, which rapidly turned the unsustainable economic booms in the periphery into crises as governments floundered in the face of the mounting fiscal costs associated with banking crises and recessions.

The flaws in European Monetary Union reflected longstanding differences between France and Germany on the role of monetary union in the wider project of European economic integration.1 The French saw a single currency as a crucial step to bringing about European economic integration, while the Germans saw a currency union as a validation after economic integration had been achieved. The interaction between these different views explains why the Euro area was so badly designed. It is also crucial to thinking about the future of EMU since exactly the same tensions manifested themselves in Franco-German disagreements about the response to the crisis, with the French wanted to provide emergency support to the crisis countries while the Germans focused on maintaining the discipline implicit in existing rules.

The Maastricht Treaty that laid out the road to monetary union was a finely honed compromise that papered over these tensions rather than resolving them. This reflected several dynamics. First, the Treaty was a rushed job that reflected the political imperatives coming from the unexpected fall of the Berlin Wall and the 1989 reunification of Germany. The single currency was created as a defensive reaction to German reunification rather than as a positive affirmation of European integration. Reflecting this speed, the final treaty closely followed the plan created by the earlier Delors Committee that had been dominated by European central bankers. These bankers produced a plan for EMU that focused on ensuring that the new European Central Bank remained independent of political pressures while leaving existing national fiscal and financial arrangements in place. The Delors Committee planned a fine central bank but a substandard monetary union.

Another crucial dynamic was the close relationship between President Mitterrand of France and Chancellor Kohl of Germany. To a large extent, the overall direction of the final Treaty signed by ten heads of state at Maastricht was the product of bilateral agreements between these two leaders, neither of whom was very interested in economics. The resulting Treaty succeeded in its political objective of ensuring that the newly unified Germany remained anchored in western Europe but unfortunately retained the economic deficiencies of the Delors Committee plan. More generally, while in any major policy decision there is inevitably some separation between the “visionaries” who initiate the project and the “planners” who implement it, the degree of separation between the two processes was exceptionally large for the Maastricht Treaty. While the vision agreed between President Mitterrand and Chancellor Kohl was driven by the need for a political compromise between European Union governments with a focus on Paris, Berlin, and Brussels, the implementation was based on earlier work by central bankers. The technical bent of the Delors Committee that planned the monetary union is illustrated by the fact that the Committee met at the Bank for International Settlements in the Swiss city of Basel, an international organization located outside of the European Union and equally far removed from its politics.

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Differing Visions of Monetary Union

The signing of the Treaty of Economic Union on February 7, 1992 in the picturesque town of Maastricht in the south of the Netherlands remains an historic moment. After centuries of nationalism and conflict, the leaders of the future Euro area came together to agree on an “irrevocable” path to monetary union that was to start at the latest on January 1, 1999. Despite a ratification process that proved more challenging than expected, this is indeed what transpired.

Maastricht was an appropriate venue for the Treaty on Economic Union even if the location was largely determined by the vagaries of the revolving Community leadership. It nestles conveniently between France or Germany without being part of either. It is some 100 kilometers from Bonn (the seat of the German Bundestag until June 1991), 250 kilometers from Frankfurt (the location of the Bundesbank, the independent German central bank whose views were a vital ingredient in the negotiations), and 350 kilometers from Paris, which housed both the French government and the Banque de France. Equally symbolically, it is only 250 kilometers from Brussels, the home of the European Commission that led the drive for a single currency. By contrast, it is a much longer and more difficult trip from London or Rome, the capitals of the other two major European Union members.

Postwar European economic integration embodied the Franco-German desire to cement their peace and create an economic counterweight to the United States. The first step was the European Coal and Steel Community of 1951, which integrated these two vital industrial sectors that straddled their common border. The Community had six members—West Germany, France, the Netherlands, Belgium, Luxembourg, and Italy. The inclusion of Italy in the initial agreement was an important step. It could easily have been left out as its citizens were much poorer than those of the other five members and also more distant—all of the other countries had contiguous borders with at least two other members while Italy touched only France. It was included because of a strong political wish to widen the Community beyond the narrow confines of France, West Germany, and the nations in between, particularly to a country that was also a protagonist in World War II. This desire for a wide membership was to be a recurring feature of the drive to European integration, including the decision to include the subsequent crisis countries—Italy, Spain, Portugal, Greece, and Ireland—in the Euro area.

The Treaty of Rome, signed in March 1957, was a milestone that set out an ambitious vision of future European economic integration. It created the European Economic Community comprising the same six countries that had entered into the coal and steel pact. It accelerated the process of economic integration by promising the elimination of taxes on trade across the six by 1970, thereby creating a customs union within which trade could thrive. It also committed the six governments to move toward the more ambitious goals of a common market of goods, workers, services, and capital and a monetary union. In addition, the Treaty of Rome also created the European Commission, whose job was to oversee the achievement of the objectives of the treaty. The Commission was an important addition to the landscape as it created an official body whose job was to make progress on European economic integration, thereby ensuring that the project was kept alive even when members’ short-term political considerations were unfavorable.

Since this ambitious future vision was embodied in an international treaty, it was and remains extremely difficult to change its provisions. Hence, the members of the European Economic Community (subsequently renamed the European Union) were officially committed to “ever closer” economic integration. By contrast, two other proposed communities that would have moved towards a broader vision of a federal Europe, one on defense and the other on political integration, never came to fruition.2 Agreeing to economic convergence was one thing; meshing political and defense systems was seen as quite another. This unwillingness to surrender sovereignty to the center was to be a key feature of the Maastricht Treaty.

Within this relatively unified Franco-German vision of an integrated European economy, however, were two very different views about the role of monetary union in the process.3 On the one hand were the so-called “Economists” who saw a single currency as the culmination of a broader process of creating a truly common market and at least some form of federated budget able to react to shocks. In this view, closely integrated markets for goods, workers, services, and capital were necessary precursors for an effective monetary union. It reflected the opinions of the German government, the Bundesbank (the fiercely independent German central bank), and like-minded “hard money” governments such as the Netherlands. In the parlance of the theory of optimum currency areas, the union should only be formed once the preconditions for such a union were already in place. It was the cherry on top.

An extremely different view was held by the “Monetarists”, who saw monetary union as an important step to creating economic integration in Europe. The Monetarists (not to be confused with the followers of Milton Friedman who also went under this name) felt it would be impossible to create a truly integrated European economy across countries that still had their own currencies. The risk of disruption to international commerce would always discourage deep economic integration. Only in the case of an irrevocable commitment to a single currency would the private sector be prepared to see political borders as irrelevant. In optimum currency area terms, they saw monetary union as a vital ingredient toward creating an integrated European economy. This was the view held by successive French governments as well as by other “soft money” countries such as Italy.

This bifurcation in views about the value of a single currency reflected the different historical experiences of France and Germany.4 In France, the franc was made legal tender in 1795 before the centralization of the political system under Napoleon. This sequence led to a belief that a strong central government could and should respond flexibly to events. By contrast, the German mark was only made legal tender in 1873, after Bismarck’s wily diplomacy had created the highly decentralized German empire in 1871 and well after the creation of a customs union that aimed, but largely failed, to promote German political integration. The decentralized German federation emphasized the importance of binding rules across its constituent parts, as opposed to the French focus on flexibility at the center.

The differences over the relationship between monetary union and economic integration resulted in different views on the role of the central bank. For the Germans, the central bank should be independent of governments and precluded from providing financial support. After all, if the region was already prepared for a single currency because of its high level of fiscal and economic integration, no further support would be needed for governments. Indeed, such support would muddy incentives as a government could game the system by running reckless policies with the prospect of being bailed out. By contrast, for the French, it was essential for the central bank to be under some form of political control and be allowed to provide significant support to national governments, for example by buying national debt. Similarly, fiscal policy across the union should provide a means of support for ailing members. Such support would be particularly necessary in the transition phase as the monetary union evolved from a region with limited economic integration into a smoothly functioning currency area. These differences stymied earlier attempts at a single currency, most notably the 1970 Werner Report.

Irreconcilable Differences: The Werner Report

Plans for European monetary union can be traced back to around 800 AD, although the early concepts were linked with imperial ambitions (of Charlemagne or Napoleon, for example) or utopian visions of a United States of Europe (Victor Hugo).5 Somewhat more relevant are the multi-country currency unions created during the late nineteenth century. The 1865 Latin League, comprising France, Italy, Belgium, Switzerland and (later) Greece, created francs and liras of a standard weight and purity of silver that circulated freely across the members.6 Indeed, in 1869 there was talk of joining this system with the gold-based monetary standards of Britain and the United States, but the British parliament baulked at the implied devaluation in the gold value of the British sovereign (the coin, not the monarch). Similarly, the 1873 Scandinavian monetary union unified the currencies of Denmark, Sweden, and Norway. This came about in response to the shift by Germany, their dominant trading partner, from a silver standard to gold. While both monetary unions survived on paper into the 1920s, they were effectively ended by the financial and inflationary strains created by World War I.

In the light of the Franco-German debate about the role of a single currency in economic integration, it is of interest that neither the Latin nor the Scandinavian monetary unions seem to have created a significant move to closer economic and political union. The collapse of these multi-country currency unions stands in contrast to the successful German and Italian monetary unions that were created at around the same time following the unification of both countries, strongly suggesting that political cohesion is a vital element for a successful monetary union.

With all of that said, the main precursor to the Maastricht Treaty was the Werner Report of 1970 which, like the Delors Report almost 20 years later, set out a plan and a timetable for a currency union. The Werner Report was part of an effort to deepen as well as widen the European Community to create a counterweight to the US dollar. Unlike the earlier gold standard, the Bretton Woods system set up at the end of World War II involved a two-tiered global system, with the dollar pegged to gold and other currencies pegged to the dollar. Since the dollar was the major international reserve asset (with sterling playing a smaller and diminishing role as the British Empire faded) the United States was guaranteed a steady increase in demand for its assets as the need for reserves expanded along with the global economy. In the view of the Europeans, the low cost of borrowing coming from this “exorbitant privilege” (in the words of then Finance Minister Giscard d’Estaing of France) was being used to finance excessive fiscal deficits such as those used to pay for the Vietnam War in the late 1960s.

This US financial recklessness in the 1960s was seen as creating international financial instability, including pressures to appreciate the currencies of the competitive and fast-growing West German and Japanese economies. It is worth noting that tensions were not limited to the United States, and that similar strains were occurring within the European Community, where low West German inflation was creating pressures for Deutsche mark appreciation against higher-inflation currencies such as the French franc. Indeed, it was only following a significant (and overdue) devaluation of the French franc and a revaluation of the Deutsche mark in 1969 that leaders of the six countries in the Community agreed to set up the Werner Commission to produce a detailed plan for European economic and monetary union. At the same time, they decided to increase the potential heft of the Community by opening negotiations for entry of four additional countries—the United Kingdom, Ireland, Denmark, and Norway.

While the desire to create a viable alternative to the dollar created some unity across the Werner Committee, different views on the role of a monetary union in economic integration generated divisions.7 In line with the Economist/Monetarist split, Germany with support from the Netherlands argued that greater economic coherence was a prerequisite for monetary union while France, Luxembourg, Belgium, Italy, and the Commission backed an early union. The final report was a compromise between these two positions with a focus on “parallelism”—in which progress would be made in all areas. The text opened by arguing that because policy cohesion across the Community had not kept up with the increase in trade and interconnectedness coming from the customs union there was a risk that instability in one country could be transmitted to others. To solve this problem, the report envisaged a gradual transformation in stages from the existing situation to union where “goods, and services, people and capital will circulate freely and without competitive distortions, without thereby giving rise to structural or regional disequilibrium”.8 This would be overseen by a federal state in which the “principal decisions of economic policy will be taken at the Community level and therefore the necessary powers will be transferred from the national plane to the Community plane”. This would lay “a leaven for the development of political union, which in the long-run it [monetary union] cannot do without” (emphasis added).

The report only contained a detailed discussion of the first stage in this process, in which “the [European] Council will be the central organ of decisions of general economic policy”. Coordination of short-term policies would gradually improve through three regular annual surveys of member policies. The first survey would mainly gather facts, the second would provide some guidance to members on policies, while the third would give more detailed instruction and would also be formally sent to the European Parliament. Such guidance to members would become “more binding and ensure a sufficient degree of harmonization in monetary and budget polices”. The text was vague on timing, suggesting that the first stage get underway at the start of 1971 and might last three years, after which an intergovernmental conference would have to agree to the needed changes to the Treaty of Rome required to move to stages 2 and 3.

The report opened up the familiar Economist/Monetary fissures. The German government’s response was positive, with the cabinet accepting a plan to work on initial steps “in coming weeks”. However, the independent Bundesbank was much less enthusiastic, with its Central Bank Council arguing that monetary policy should not be under the ultimate purview of the European Council, but should be determined independently by central bankers via the long-windedly named Committee of Governors of the Central Banks of the member States of the European Economic Community. (I will follow the normal convention of shortening this to the Council of Governors.) Privately, President Emminger of the Bundesbank was much more suspicious, seeing this as a French plan to use “a European currency block as a battering ram against the dollar” to “put shackles as quickly as possible on what they see as our sinister German monetary policy”.9 He considered that “improved access to mutual balance of payments assistance” underlay French thinking. The French were even less happy because of the implied loss in sovereignty. Finance Minister Giscard d’Estaing, the senior official most likely to be sympathetic to the report, commented that it offered “too centralized a conception”.

Given this frosty reception, Chancellor Brandt and President Pompidou met in early 1971 to try and sort out Franco-German differences. With Pompidou unwilling to give up any significant degree of sovereignty over fiscal policy, however, Brandt concluded that the French were not serious about the Werner Report and the Germans pushed for a sunset clause on moves to monetary union.10 Based on these concerns, it is no surprise that when the European governments formally adopted the Werner Plan in March 1971 there was no timetable for implementation. Rather, they agreed that the European currencies would fluctuate in modestly narrower limits against each other than those implied by bands around the dollar in the Bretton Woods system, an extremely modest move to European monetary integration.11 These new bands were supposed to be put in place in June 1971, but this was upended in the spring when the Germans unilaterally floated their currency against the dollar in the face of mounting inflows from international investors.

Interest in forming a currency union continued. Indeed, in October 1972 a Community summit in Paris agreed to start the transition to the second stage of the Werner Plan in January 1974 as well as the creation of a European Monetary Cooperation Fund to support this move.12 This distinctly half-hearted agreement, however, did not survive the final collapse of the Bretton Woods fixed exchange rate system in 1973. Ultimately, the unwillingness of the French, in particular, to surrender sovereignty over fiscal policy to the European Council torpedoed the Werner Report. The future Delors Report was to take a much more decentralized approach to sovereignty, in large part because it was driven by French dissatisfaction with the growing dominance of the Deutsche mark in European monetary policy, a dynamic to which we now turn.

The Hard D-Mark

In the period from the early 1970s to the mid-1980s plans for monetary union were overshadowed by monetary instability coming from the collapse of the Bretton Woods system of fixed exchange rates. Globally, the main challenges were managing the switch from fixed to floating exchange rates and taming inflation, which rose in the wake of the 1973 oil price shock. On curbing inflation, Germany and Japan were notably more successful than other major economies including the United States and other members of the European Economic Community such as France, Italy, and the United Kingdom. Within Europe, interest in wider European integration faded as policymakers grappled with the task of achieving exchange rate stability across the expanded Community despite continuing pressure for Deutsche mark (or D-mark as the Germans called it) appreciation.13 As early as March 1972, the European Community Council of Ministers (ECOFIN) launched a plan to limit intra-European currency fluctuations via the “snake”—a system in which European Community currencies limited their fluctuations to within 2¼ percent of each other’s central parities, half the amount allowed under the Smithsonian Agreement that attempted to resuscitate the doomed dollar-based Bretton Woods fixed exchange rate system. The snake was also widened to include prospective new members of the Community, with the United Kingdom, Ireland, Denmark, and Sweden joining the arrangement. However, the United Kingdom and Ireland left after only two months.

On March 11, 1973, European finance ministers reaffirmed the 2¼ percent fluctuation margins between European currencies while ending any efforts to stabilize their currencies against the dollar. This marked the moment when the Bretton Woods exchange rate system was replaced by a global float of the major currencies overlaid by attempts to stabilize intra-European exchange rates via the snake. The strains caused by different inflation rates, however, ensured that the membership of the snake was partial. It excluded two major European countries, Italy and the United Kingdom. Even more importantly, the French franc was forced to leave the snake in early 1974 in the face of speculation and persistently higher inflation in France than in West Germany. Although the franc rejoined the snake in July 1975 it was again forced to exit in March 1976. In the absence of these major European currencies, the snake effectively became a Deutsche mark zone in which smaller European currencies fixed against the West German currency with occasional realignments. This was a long way away from the broad region of European financial stability that had been initially envisaged.

The dissatisfaction of the French and German leaders with this state of affairs led to the replacement of the snake by the Exchange Rate Mechanism (ERM) in 1979. The new arrangement was driven from the top, cooked up in bilateral meetings between President Giscard d’Estaing and Chancellor Schmidt and done, in the view of the British Foreign Office, “in spite of their own bureaucracies”.14 The ERM was formally proposed by Schmidt at a “fireside chat” of leaders (without ministers or advisers) in Amalienborg castle during the Copenhagen European leaders summit of April 7–8, 1978. The idea was to relaunch the snake but with a more symmetric system involving the creation of a European Monetary Fund modeled after the International Monetary Fund. The new European Monetary Fund would pool part of the reserves of member countries and would be responsible for a European unit of account which would help to ensure European currency intervention was more symmetric.15

The ERM proposal reflected two powerful political forces: German Chancellor Schmidt’s desire to bring the French into the European exchange rate system and French President Giscard d’Estaing’s desire that more of the burden of staying in such a system be taken on by the countries with stronger currencies (in other words Germany) rather than being borne almost entirely by countries with weaker currencies (such as France). This was a new version of the familiar Economist/Monetarist split. Germany wanted France to follow more conservative “German” policies to make the system work while France wanted Germany to meet the costs of divergent policies halfway.

The central issue of who should bear the burden for maintaining the system was negotiated under the guise of a technical discussion about whether intervention would be defined relative to a basket of European currencies or only take account of the deviation of individual bilateral rates from their central parity. The crucial difference was that the former would tend to isolate the Deutsche mark as the exchange rate furthest away from the basket, thereby triggering German intervention rather than requiring intervention from countries with weaker currencies. Unsurprisingly, this larger role for Germany in maintaining European exchange rate stability was strongly opposed by the Bundesbank and the German Finance Ministry.

In the end, the ERM arrangement agreed in late 1978 and implemented in early 1979 made few concessions to French desires. It was a long way away from the initial vision, with marginal decisions almost always favoring the preferences of the German bureaucrats to maintain the existing system. For example, while the system included a new unit of account—the European Currency Unit (ECU) which was officially stated to be “at the center of the system”—in practice, currency intervention and debt settlement rules remained asymmetric and favored stronger currencies. There was also little progress on reserves. The agreement made some concessions to French desires by allowing more borrowing across central banks within the system, but the creation of the proposed European Monetary Fund was delayed for two years and with it plans to pool reserves, provide loans, and potentially issue ECUs. The fund was eventually abandoned, given irreconcilable differences about its level of independence from political controls and its role in national policies. In practice, the ERM was essentially a reworking of the snake with a wider membership.

Crucially, the need to obtain agreement from the independent Bundesbank led Chancellor Schmidt to make a side deal. On a visit to the Bundesbank, Schmidt told its Council that whatever the theoretical rules in place, the German central bank would not have to intervene in unlimited quantities if this would undermine German economic and financial stability. He also explained, however, that the sensitivity of this arrangement made a formal written agreement impossible and hence this decision was not communicated to Germany’s partners. This piece of subterfuge may have been crucial to keeping both the French and the Bundesbank on board with the ERM but stored up resentment when it was revealed in the later ERM crisis in 1992.

Like the snake, the Exchange Rate Mechanism was a semi-fixed exchange rate system that limited bilateral European exchange rates to within 2¼ percent of a central parity. The main exceptions were the lira, which was allowed wider bands of 6 percent, and the pound, as the British chose not to participate (both currencies, however, were part of the ECU, complicating and eventually marginalizing the ECU as the central peg for the exchange rate regime). Parities could be altered, in theory after discussion with other partners, although in practice this was often ignored (as in the earlier Bretton Woods exchange rate system). Initially dismissed by some as “a mere crawling peg”, the early years saw relatively frequent changes in parities given major difference in rates of inflation rates across members.16 Over time, however, the mood shifted. Smaller Community countries increasingly saw ERM parities as a useful way of importing German policy credibility and of constraining domestic inflation.

French policies, however, were creating increasing strains in the ERM. In 1981, President François Mitterrand became the first postwar socialist leader of France.17 The new government set out a radical and expansionary agenda, including nationalizing the banking system and some major industrial companies, activist employment policies, and increasing social spending. Unsurprisingly, this agenda led to inflation, a drop in investor confidence, and a series of devaluations of the French franc within the ERM. France’s Community partners made it increasingly clear to President Mitterrand that he would have to choose between his desire to follow his own political leanings and to continue as a key member of the European project.18 In 1983, in the aftermath of a series of political setbacks for the government and after a significant period of indecision and consultation, Mitterrand followed the advice of his market-orientated ministers Michel Rochard (Agriculture) and Jacques Delors (Finance) and switched to a “franc fort” policy involving keeping the franc strong (fort) within the European Monetary System.

This was a crucial step. By choosing European economic integration over his initial go-it-alone expansionist socialist policies, Mitterrand accepted the dominance of the Deutsche mark within the European Monetary System and the need to adapt French policies to maintaining the peg by reversing course and imposing fiscal austerity. The franc fort policy led to a steady hardening of the ERM. A series of changes in parities in 1985 and 1986 were topped off in January 1987 by a revaluation of the Deutsche mark and the Netherlands guilder (by 3 percent) and the Belgium franc (by 2 percent). The next realignment did not occur until January 1990 and was in any case a technical one as the lira switched from 6 percent to 2¼ percent intervention bands. It was in this atmosphere of apparently successful exchange rate stability, but French dissatisfaction with the asymmetry of the ERM, that the next plan for monetary union was born.

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Jacques Delors and His Committee

After the franc fort policy unified European views on the virtues of monetary stability, the focus of European policy returned to achieving greater economic integration. The new agenda was significantly boosted by the arrival as the head of the European Commission of the energetic, ambitious, and diplomatically savvy Jacques Delors. Indeed, the two developments were linked. In 1984, when contemplating a needed reshuffle of his government, Mitterrand considered making Delors his prime minister. However, Delors was a known advocate of fiscal austerity, the domestic counterpart to the franc fort policy. As Mitterrand did not want to advertise his switch to austerity, he chose a more traditional socialist for the job. This left Delors, a powerful up-and-coming force in the French Socialist Party, without a position but with strong market-orientated bona fides. As Mitterrand had decided to make European economic integration into a major plank of his future agenda, he proposed Delors as the head of the European Commission. Delors was chosen as his market orientation made him acceptable to more right-wing leaders, in particular Prime Minister Thatcher and Chancellor Kohl.19

The first major initiative from the Delors Commission was the 1986 Single European Act. The act, the first amendment to the Treaty of Rome, set a deadline of the end of 1992 for completion of the single market by freeing the movement of goods, services, labor, and capital within the European Union. Its passage reflected the new pro-market political alignment across the three major European powers as Mitterrand’s conversion to market economics moved France into step with the long-standing desire of Germany for a larger market for their goods and with the Thatcher government’s pro-market philosophy.

The importance Mitterrand placed on the Single European Act is illustrated by his use of carrots and sticks to overcome Prime Minister Margaret Thatcher’s concerns about the centralization of power implied by the extension of the use of majority voting in the European Commission, which was also contained in the act. The carrot was an agreement on a permanent British rebate from the Community budget, which had been a major issue for Thatcher and on which Mitterrand made concessions against the interests of the powerful French agricultural lobby. Regarding the stick, Mitterrand and Kohl brought up the possibility of moving to a two-stage Europe in which some countries would be in an inner circle and others part of a fringe, with its implied threat to make the United Kingdom into a second-class member of the Community.

The Single European Act was seen as having a mixed impact on the future of monetary union. The text reinforced this goal by mentioning it in the preamble, and the commitment to allow the free movement of funds across the Community by the end of 1992 reduced the ability of members to pursue divergent monetary policies. On the other hand, the new rules required a unanimous vote for any changes to existing monetary arrangements. This gave Britain, a known skeptic of monetary union, veto power over any proposals for a single currency. It is to how UK skepticism and the Monetarist/Economist split were overcome in the Delors Committee that we now turn.

The Delors Committee

After the passage of the Single European Act, the French government refocused on making European monetary arrangements more symmetric. In particular, in early 1988 Prime Minister Balladur presented a memorandum to European finance ministers on the reform of the Exchange Rate Mechanism. In addition to rehashing old French concerns that weaker currencies were being forced to adjust even when they were not necessarily the source of any strains, the memorandum added a new twist by arguing that the liberalization of capital markets required a zone with a single currency, managed by a common central bank. The Balladur initiative created confusion in the German government. Hans-Dietrich Genscher, the “febrile” West German Foreign Minister, presented his own memorandum which emphasized the need for an independent European Central Bank pledged to price stability but without the traditional German emphasis on political and economic convergence.20 Finance Minister Stoltenberg responded with a more traditional plan that focused on the need for political union, while the Bundesbank argued that any plans for a future monetary union be channeled through the central banks themselves via the Council of Governors. Faced with this range of advice, Chancellor Kohl bucked his advisors and chose to back French plans to look into the feasibility of a monetary union.

In early June 1988 at Evian on the shore of Lake Geneva, Kohl and Mitterrand agreed that a committee of experts was needed to set down a road map for monetary union.21 The committee was duly proposed by Kohl at a European leaders meeting in Hanover later that month. The committee was to be composed mainly of central bankers, a necessary step to gain support from Prime Minister Thatcher as well as to avoid problems with the Bundesbank. Relatively late in the discussions, as agreed at Evian, Kohl successfully proposed that the Committee be chaired by Jacques Delors. This was a crucial step. All of a sudden, the new committee of experts would be under the stewardship of a powerful and strongly pro-monetary-union politician. Indeed, when he first heard about the chairman, President Pöhl of the Bundesbank wanted to refuse to join the proposed committee, a move which would have severely undermined its effectiveness. He asked his closest central banking counterpart, Wim Duisenberg of the Nederlandsche Bank, to do the same, but he was eventually persuaded by Duisenberg and others to participate.

The success of the Delors Committee in overcoming the headwinds to monetary union owed much to its design. All members worked in their own capacity, were not accompanied by any staff, and agreed not to quote each other.22 In addition to its chairman, the Committee comprised the twelve Community central bank governors, four experts, and two staff (Tommaso Padoa-Schioppa, a past director of monetary affairs in the European Commission, and Gunter Baer, an official from the Bank for International Settlements). The staff positions were the most controversial, with Pöhl vetoing Delors’ proposal that the second staff member be another ex-Commission employee and instead insisting on a German. Pöhl also unsuccessfully proposed adding a third, British, staff member, which would have further increased the number of monetary union skeptics in staff positions.

An important factor forging consensus on the report was that the central bank governors already met on a regular basis and hence were known quantities to each other. In addition, the three most important governors (De Larosière of the Banque de France, Leigh-Pemberton of the Bank of England, and Pöhl of the Bundesbank) took seriously the fact that they were working in their own capacity and deviated from the policies of their governments in crucial ways. Governors Jacques de Larosière and Leigh-Pemberton enlisted technical support from their central banks but kept a distance from their finance ministries. Both were also extremely polite and tactful. In particular, Leigh-Pemberton (who had been told by Thatcher “I have confidence in Karl Otto Pöhl. If he is proposing something, you can accept it.”) helped to harness and constrain Pöhl.23 Karl Otto Pöhl was a more difficult member of the Committee. He chose to work completely on his own, but his boast that he “played things by ear” did not always result in clear or consistent positions. One example of this was that, having got agreement in the Committee that the new central bank should be modeled after the Bundesbank, in a subsequent meeting he confused the discussion by switching his position and suggested that the US Federal Reserve system was a better blueprint. He also showed an element of disdain for the rest of the group, sometimes reading papers during meetings and at times leaving others to debate significant issues. This lack of consistency strengthened the position of the staff. In particular, Padoa-Schioppa, who was close to Delors, was able to drive the agenda.

The mixture of monetary union enthusiasts and skeptics made the Committee complicated to handle. To improve the chances of reaching consensus, it was made clear that the objective was to set out a possible path to economic and monetary union, not to adjudicate its value, so that “even skeptics in the Committee could believe they were achieving their goals by just spelling out precisely what monetary union would involve (and thus precisely showing how difficult it would be)”.24 The agenda was also formulated as questions coming from earlier initiatives—the Single European Act, the Exchange Rate Mechanism, and the European Currency Unit. This led to a less clear final paper, but avoided the radicalism that doomed the Werner Report.

The Committee’s arrangements allowed agreement on two major sticking points in the Economist/Monetarist debate, the relationship of the central bank to political authorities and fiscal policy arrangements. On the former, the crucial moment was the decision by Governor de Larosière to support an independent central bank focused on price stability. Given the importance of this deviation from the typical French policy, he discussed this at a one-on-one meeting with President Mitterrand. According to his own account, he explained that

if France wanted agreement with the Germans, we had to accept that monetary policy would be a single policy and that national central banks would be members of a system of central banks where all would have to be independent of governments. The European Central Bank would work only if its policies were not subject to negotiations between governments. … President Mitterrand did not answer specifically. … I said to myself ‘I’m going to take that as giving me the green light.’25

With Governor de Larosière on board, the other central bank governors quickly agreed to an independent central bank. This was relatively easy as the necessary intermediate step of making the national central banks independent of the government gave them more power.

The discussion on the relationship of the central bank to fiscal policy became a debate on the relative merits of market discipline, mechanisms to promote coordination, and fiscal rules. The initial draft of the report proposed greater coordination through non-binding guidelines on fiscal deficits, on access to monetary financing, and on government borrowing in non-Community currencies. Later, these guidelines were to be overseen by a new institution, the Centre for Economic Policy Decisions (CEPD), which would promote convergence and coordination of economic policies in the Community. Following a new Treaty, legislative and executive measures leading to the creation of a European fiscal system of the type envisaged in the Werner Report were to be taken at the Community as well as the national level.26 Alexandre Lamfalussy, the general manager of the Bank for International Settlements and one of the experts on the Committee, argued that a “Community-wide macroeconomic fiscal policy would be the natural complement to the common monetary policy of the Community”.27 Whatever its technical merits, such a change in the fiscal architecture and reduction in sovereignty would have created political tensions of the kind experienced in response to the Werner Report.

It was Pöhl who switched the plan from policy coordination to binding and relatively inflexible budget rules. He argued that coordination would be less effective than rules, so that a better approach would be if “all member states of the Community would commit themselves to a policy which would lead to inflation rates, let us say below 3% as an example, and to reduce their budget deficits to levels, let us say below 3% of GDP, very concrete steps which wouldn’t need any institutional change but would be a very major step in the direction of a monetary and economic union”.28 It was thus the President of the Bundesbank who successfully championed the replacement of Community-wide coordination on fiscal and other economic issues, with its implication of further political integration—a hallmark of the federalist program that the Bundesbank and German government had traditionally championed, including in the Werner Report—with a decentralized fiscal system that maintained national sovereignty of the type supported by the French, albeit in return for accepting rules on fiscal deficits and debt.29

The only issue that the Committee could not agree on was whether or not to recommend the creation of a European Reserve Fund to pool reserve assets in Stage 2 of monetary union. In the end, this was left open. Other areas of contention—for example whether to move to a central bank in Stage 2 (de Larosière) or Stage 3 (Pöhl) and pressure to progressively weaken Stage 1 (Pöhl and Leigh-Pemberton) were generally resolved in favor of Pöhl. That said, the report was almost upset at the penultimate meeting of the Committee when (after a visit to the Bundesbank by Margaret Thatcher) Pöhl came with thirty pages of “quite radical comments”.30 Wim Duisenberg—who was trusted by Pöhl as he saw him as a fellow skeptic of the single currency—produced a winning compromise by suggesting that the relevant Community bodies, the Monetary Committee and the Council of Governors, be invited to make concrete proposals on the basis of the existing report.

While the final report published in April 1989 claimed to be about economic and monetary union, it focused almost entirely on monetary union. Considerable space was given to economic integration, but the text was vague except in stating that no new institutions were needed as existing ones could be adapted. This was consistent with the principle of subsidiarity, namely that tasks should continue to be performed at the national level unless there were compelling reasons to change the architecture, and helped the plan gain political acceptance. On fiscal policies, for example, the text proposed rules to limit government deficits and debt but had only a vague discussion of greater cooperation. Equally crucially, bank supervision and support remained at the national level. Lofty and largely meaningless calls to better coordinate policies across countries were a hallmark of the discussion outside monetary issues, which otherwise largely repeated policies that had been previously agreed.

On monetary union, the text made clear that the final monetary union involved irrevocable parities and a new autonomous Community institution to run policy, but hedged on whether there would be a single currency (probably). The union was to be achieved through three stages. The first stage of the union involved little more than the adoption of narrow ERM bands by all countries and an enhanced role for the Committee of Governors in monetary policy decisions, including the creation of subcommittees on monetary, foreign exchange, and banking supervision (the last only in an advisory role since banking supervision was to remain a national responsibility). After agreeing on the needed revisions to the Treaty of Rome, stage 2 would provide a trial run for stage 3 as the new European System of Central Banks absorbed the European Monetary Cooperation Fund (which oversaw the ERM) and the Council of Governors. Finally, in stage 3 the System of Central Banks would take over control of monetary and exchange rate policy.

Few members of the Committee expected the Delors Report to have much impact. Pöhl described the Report as “a confused piece of work” and said that “when it was formulated, I did not think that monetary union with a European Central Bank could come about in the foreseeable future. I thought it might come in the next hundred years”.31 Leigh-Pemberton was also doubtful, saying in private that “most of us, when we signed the Report in May 1989, thought we would not hear much about it. It would be rather like the Werner Report.” Even supporters of the process were cool. Tommaso Padoa-Schioppa, close to Delors and a key author, declined to write a paper on the report because he thought the outcome would not be significant. As one historian of the process has put it, “the outcome looked more like an extension of the principle of international monetary cooperation and coordination—which is exactly what it was”.32

* * *

The Maastricht Treaty

It was the unanticipated collapse of Soviet control in Eastern Europe later in 1989 that triggered a rapid push for monetary union that embraced the only plan readily available, the one in the Delors Report. On November 28, 1989, just three weeks after the fall of the Berlin Wall, Chancellor Kohl presented a ten-point plan for German unity to the Bundestag without consulting his allies. Two days later, President Mitterrand told German Foreign Minister Hans-Dietrich Genscher that Germany was now a “brake” on European integration and that unless Germany agreed to serious negotiations on a single currency by the end of 1990 it risked a revival of the pre-1913 “triple alliance” between France, Britain, and the Soviet Union.33 Faced with the prospect to diplomatic isolation, Chancellor Kohl agreed to initiate an intergovernmental conference on monetary union at the Strasbourg summit of European leaders on December 8, 1990, just before Mitterrand’s deadline expired.

Chancellor Kohl clearly felt pushed into a rapid monetary union. He described the Strasbourg summit as the most “tense and unfriendly” he had ever attended.34 Concern about the role of a unified Germany abounded. For example, Thatcher declared: “Twice we beat the Germans and now they are here again.” In a bilateral meeting with Mitterrand she took out a map of German borders before and after World War II. Strikingly, Kohl confessed to the US Secretary of State James Baker that such a union “was against German interests. For example, the President of the Bundesbank is against this development. But the step is politically important for Germany needs friends.” Germany accepted monetary union for political reasons, not economic ones.

Almost exactly a year later, a summit of Community leaders at Maastricht agreed on the Treaty on Economic Union. The Maastricht proceedings were closely choreographed by President Mitterrand and Prime Minister Andreotti of Italy.35 In particular, the Treaty specified that economic and monetary union would take place by January 1999 for all countries that fulfilled the convergence criteria without any possible renegotiation of the rules. The only exception was the United Kingdom, which obtained a specific opt-out (later, Denmark also pulled out after a referendum rejected EMU). Prime Minister Thatcher had pushed for a more flexible opt-out option but was rebuffed so as to avoid any further delay or new demands from Germany, for example involving greater political integration. While this was an understandable ploy given German doubts about the speed of EMU, the feeling of being pushed into an excessively early monetary union explains German intransigence over reinterpreting the rules when Euro area went into crisis after 2008. In the end, the Maastricht Treaty did not solve Franco-German differences over monetary union, it merely papered over them.

In retrospect, Mitterrand’s decision to use the centripetal intra-European political forces from German unification to achieve a binding treaty preserved monetary union from the centrifugal economic effects of German unification. German unification was always going to lead to some overheating of the German economy and pressure to revalue the Deutsche mark, implying inevitable strains across the ERM. These strains were exacerbated by the decision to convert East German Ostmarks to West German Deutsche marks at the inflated rate of one-to-one, as well as by larger-than-necessary pressures on German government spending coming from the decision to subsidize new capital investments rather than new jobs in the former East Germany. This led to an influx of plants with large amounts of machinery that benefited from subsidies but created few jobs for unemployed East Germans.

The Bundesbank responded to German economic overheating by raising interest rates aggressively, which left Germany’s partners with the conundrum of how far to raise rates to defend the currency peg at the cost of slowing growth. The final outcome of these strains was a crisis in the Exchange Rate Mechanism that resulted in the ejection of the British pound and the Italian lira in 1992 (the lira rejoined in 1996) followed by a face-saving widening of the intervention bands from 2¼ percent to 15 percent to avoid French ejection in 1993. If the Maastricht Treaty had not been in place before the economic effects of German unification became apparent, it is difficult to imagine that the plan for monetary union would have survived.

Unsurprisingly given the haste involved, the Treaty closely followed the plan laid down in the Delors Report. It involved a highly independent central bank whose statutes were written by the Committee of Governors under the chairmanship of Bundesbank President Pöhl until his resignation in early 1991. In particular, the new central bank’s Governing Council was made essentially immune from interference by national governments, in part by defining its objective as maintaining price stability with no responsibility for ensuring adequate growth. In addition, the new central bank was forbidden from providing monetary financing to member governments by directly buying their bonds. The Treaty also included a no-fiscal-bailout clause that specified that the debts of individual national governments were not the responsibility of the Community or of any other members of the currency union. Governments that got into fiscal difficulties were on their own, while remaining responsible for supporting their own banking systems.

The Treaty stipulated four convergence criteria that were needed for a country’s entry into EMU: (1) the inflation rate should not be more than 1½ percentage points higher than the average of the three lowest inflation rates in the Community; (2) the long-term interest rate should be no more than 2 percentage points higher than the average of the three lowest members; (3) the members should have been part of the Exchange Rate Mechanism for two years before entering and the central parity should have not been devalued in that time; and (4) the fiscal deficit should be below 3 percent of output and the debt level below 60 percent of annual output, or should be approaching this value at a satisfactory pace.

Details on how to police the fiscal rules that aimed to ensure probity after entry into monetary union, which were delayed to Stage 2, brought further Franco-German disagreements. The German government proposed a system of large automatic fines for transgressors. However, the French proposal of a softer version involving the European Council was adopted at a difficult summit in December 1996. Tellingly, the agreement that had been initially proposed as simply a Stability Pact was renamed the Stability and Growth Pact, signaling the introduction of a wider view on the impact of such rules on economic activity.36 This erosion of rigorous surveillance of the members of the Euro area was underlined in 2003 when, facing a recession, France and Germany backed by Italy suspended sanctions for fiscal deficits above 3 percent of output.

Gradually, the 3 percent fiscal deficit figure that had been originally seen as an upper limit for governments aiming for budget balance came to be seen as more like a target, as France, Germany, and Italy, under pressure from low growth and (in the case of Germany) the cost of unification, continued to run significant government deficits. The lack of support for rigorous surveillance is what allowed the Greek government in the 2000s to go on exactly the type of lending and spending binge based on the credibility of the Euro area as a whole that the Stability and Growth Pact was supposed to protect against.

A similar “pragmatism” and acceptance of modest rule-bending was evident in 1998 when it came time to choosing which countries could enter the monetary union. Both Germany and France preferred a wide union although for somewhat different reasons—the French in order to dilute the influence of German on the union, the Germans to avoid stiffer competition from those who did not enter. An additional complication was the desire to include Belgium, which had a debt ratio of 130 percent of output, which undermined the case for rejecting Italy, whose debt ratio was 120 percent. In the end, supported by a range of special measures and generous statistical interpretations, all of the potential entrants were admitted into monetary union starting on January 1, 1999.

* * *

The Flawed Single Currency

The drive to create a single European currency unexpectedly succeeded largely due to a dose of sheer luck and two underlying dynamics. The good luck was the unexpected fall of the Berlin Wall that created a need to bind a unified Germany more fully to the rest of the European Union, an imperative used to create the single currency. One dynamic was the understanding between Mitterrand and Kohl on the need for progress on greater European monetary integration that allowed crucial decisions to be made without the process getting bogged down in bureaucratic niceties. The other dynamic was that the detailed planning for the single currency was done by technocratic central banks rather than more politicized finance ministries, which allowed the plan to overcome the Economist/Monetarist split that had bedeviled previous efforts to create a single currency.

Part of the reason that the flaws in the Maastricht Treaty were missed was that neither of the two major drivers, Mitterrand and Kohl, were comfortable with, or interested in, economics. This is in stark contrast to their predecessors, Giscard d’Estaing and Schmidt. Schmidt said of Mitterrand “we were able to cooperate personally and politically, [but] in economic and particularly in monetary matters, Mitterrand didn’t have great knowledge or judgment” (emphasis added), while Giscard said that Mitterrand was “not very interested in monetary or financial affairs”.37 Similarly, Kohl’s grasp of economics was weak, as shown by decisions over German unification such as supporting the former East Germany through subsidies to investment, when the objective was to encourage jobs.

The outcome of this tortuous process was an early but extremely narrow and compartmentalized monetary union. With political decisions tending to ensure agreement at the lowest common denominator, the monetary union made much more political than economic sense. In particular, it provided no effective macroeconomic support in respond to large shocks to the finances of individual members. The central bank was prohibited from supporting governments; fiscal policy was almost entirely national; and so was banking supervision and support. In the final analysis, the French and Germans fought each other to a bloody draw. The Germans obtained an independent central bank that was prohibited from bailing out countries in fiscal difficulties, a no-bailout clause for other members of the union, and strict rules on fiscal deficits—provisions that only made sense in an area that was already highly economically integrated. The French, on the other hand, achieved an early monetary union in a region with limited economic integration.

Rather than the old adage “hope for the best but plan for the worst”, economic and monetary union could be characterized as “hope for the best and plan for the best”. The Maastricht Treaty essentially plonked a single currency and an independent European Central Bank into the middle of a region where almost all other economic decisions were national. In addition, plans for tough rules on member states’ deficits and debts were largely undermined by the absence of serious surveillance on members’ behavior, which subsequently allowed the Greek government to easily circumvent them. When the Euro area crisis came, the lack of an effective backstop for member governments put the entire Euro area project at risk through a self-reinforcing cycle in which questions about the viability of banks increased fiscal strains even as questions about fiscal solvency increased strains on banks.

Understanding the process by which this flawed union came about is important for the future as it explains why it continues to be so difficult to change the structure laid down in the Maastricht Treaty. The underlying tension between the Germans and the French was never resolved. As the country with the soundest economy and finances as well as a federal system backed by binding rules, the Germans naturally revert to the view that monetary union should work without the need for new mechanisms to share risk, consistent with their view that such a union should have only occurred after adequate economic integration. Countries that got into crisis did so by breaking the rules, so that offering them bailouts would only encourage further bad behavior. The French and other weaker currency economies with their tradition of a powerful, flexible central government maintain the view that bailouts of crisis countries are needed to limit the macroeconomic damage to the Euro area as a whole.

Given these different starting positions and the associated suspicions, it is unsurprising that there is little appetite for a major renegotiation of the Maastricht Treaty. Indeed, even changes that were envisaged by the Treaty, such as the potential need for centralized supervision of banks, took a long time to agree even after the crisis. Moving forward, the underlying tensions are unlikely to be solved by technicians, as occurred within the Delors Committee, since views on the future of EMU are highly politicized. More generally, in the absence of a priority as compelling as the need to create a single currency to bind a unified Germany to the rest of western Europe, it is difficult to see any Euro area leader being prepared to accept changes to EMU that are not in their economic interest, as Chancellor Kohl believed he did at the 1990 Strasbourg summit that set the EMU process in motion.

Combining an early move to monetary union with an independent central bank and decentralized fiscal arrangements was always going to be tricky. While such an arrangement would work smoothly in a boom, in the absence of rapid economic integration it was always going to be tested by the limited ability to provide macroeconomic support to countries in a slump. It was efficient but not robust. The North Atlantic crisis came close to splitting the monetary union so painstakingly assembled over the late 1980s and 1990s. The crisis led to an improvement in the institutional framework, but the crucial test for EMU going forward will be the ability to deliver the rapid economic integration predicted by the French, so as to create an integrated monetary union of the type envisioned by the Germans. This subject is left to a later chapter.

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