Abstract
For the latest thinking about the international financial system, monetary policy, economic development, poverty reduction, and other critical issues, subscribe to Finance & Development (F&D). This lively quarterly magazine brings you in-depth analyses of these and other subjects by the IMF’s own staff as well as by prominent international experts. Articles are written for lay readers who want to enrich their understanding of the workings of the global economy and the policies and activities of the IMF.
The Maastricht agreement provides a blueprint for a European economic and monetary union
The past five years have seen a remarkable acceleration of economic integration in Western Europe. The meeting of European heads of state and government in the Dutch city of Maastricht in December 1991 not only reaffirmed the commitment of the European Community (EC) to the creation of a single market but also resulted in agreement on the creation of an economic and monetary union (EMU). More specifically, the Maastricht agreement provides a framework for the transition to a common monetary policy and to a single EC currency managed by an independent European central bank.
The participants also agreed on a treaty that formally establishes a European Union, commits the EC’s member states to strive for closer cooperation on foreign and security policy, and somewhat expands the powers of the European Parliament. The EC Treaty requires that this agreement be “ratified by all the member states in accordance with their respective constitutional requirements.” The rejection of the Maastricht agreement by a small majority of the Danish voters in a binding referendum held on June 2, 1992, has complicated the process. It cannot be excluded that other EC member states may fail to ratify the Maastricht agreement. Various solutions are being discussed, including partially renegotiating the draft treaty; attaching a protocol that could temporarily exempt Denmark or other countries in a similar position from the treaty obligations; and—although this is seen as less likely—negotiating a separate treaty, outside the legal framework of the EC, by other EC countries.
The agreement on EMU may come to be seen as a major event in the economic history of Europe. A European monetary constitution with the goal of price stability would not only shape the economic fortunes of the EC member states but would also exercise a worldwide influence. It is likely to serve as an economic policy guidepost for prospective EC members, such as Austria, Sweden, and Finland, and the emerging market economies of Central and Eastern Europe, which expect to tie themselves more closely to the EC. Monetary union would also provide the EC with a currency that matches its weight in the world economy (see “Europe—The Quest for Monetary Integration,” by Horst Ungerer, Finance & Development, December 1990).
The creation of an economic and monetary union is a complex task, both technically and politically, that requires a high degree of convergence of economic policies and performance. At the same time, it would significantly reduce the economic sovereignty of the participating states. Indeed, the often different economic and monetary policy traditions of the EC member states have given rise to conflicts that were resolved only after protracted negotiations. Agreement hinged on a number of fundamental issues: the timing of the union, the conditions for participation, and the independence of monetary policy from government influence. More generally, there was the question regarding to what extent countries would be willing to cede national sovereignty to EC institutions. These issues, among others, also dominate the current debate over ratification of the treaty.
Under the Maastricht agreement, EMU would be reached in three stages. During the first two stages, member governments would endeavor to achieve greater convergence of their economies as measured by four criteria: inflation, interest rates, exchange rate stability, and the sustainability of the fiscal position. In the third stage, which could begin as early as 1997 but no later than 1999, member states that meet the economic criteria would irrevocably fix their exchange rates and issue a single currency. This article presents the main features of the draft treaty on EMU.
Historical background
In the late 1950s, the newly formed European Economic Community (EEC) was, by and large, conceived as a customs union, without a strong commitment to the coordination of economic and monetary policies. By the end of the 1960s, when the customs union had been successfully built, plans were already being laid for an eventual economic and monetary union. Following the first summit conference of the six EC member states in 1969, the so-called Werner Committee was established to elaborate a blueprint for the transition to an economic and monetary union. However, the collapse of the Bretton Woods system in March 1973 and the economic instability engendered by rising oil prices in 1973-74 hampered movement toward more monetary integration. Monetary cooperation was limited to the establishment of the European Common Margins Agreement—the “snake”—which quickly shrank to a “DM zone” in which the currencies of some of the smaller European countries—Belgium, Luxembourg, the Netherlands, Norway, Sweden, and Austria—were grouped around the deutsche mark.
The snake was superseded by the European Monetary System (EMS) in March 1979, an arrangement that has survived largely unchanged to the present day. The objective of the EMS was to create a European zone of exchange rate and price stability. Despite a number of general exchange rate realignments in the early 1980s, the EMS is now considered a success by most observers. Increased convergence of economic performance among most of the major countries and the anchor role played by the deutsche mark have made it possible to avoid a general realignment of exchange rates since 1987.
In June 1988, the European Council appointed the Delors Committee to devise a new plan for an economic and monetary union. Its report, submitted in April 1989, proposed a three-stage approach, culminating in the creation of a single EC currency. Monetary policy would be made by a European System of Central Banks (ESCB), consisting of a European Central Bank (ECB) and the central banks of the member states. The EC Commission and the Council of Ministers would be responsible for coordinating economic, and especially fiscal, policy in the EC. There was concern that unsustainable fiscal policy in one or more countries could undermine the common monetary policy.
The European Council later decided to begin the first stage of economic and monetary union on July 1, 1990, and to initiate two intergovernmental conferences—one on economic and monetary union and the other on political union—in December 1990.
A European monetary constitution
Even before the conference on EMU began, there was broad agreement that the chief goal of monetary policy should be to safeguard price stability and that an independent central bank offered the best assurance of such a monetary policy. Further, economic—in particular fiscal—policy coordination would have to be enhanced.
Central bank independence. The concept of central bank independence has several facets. First, the central bank must be politically independent, neither seeking nor taking instructions from national governments or other EC institutions. Second, it must be functionally independent; that is, the central bank must have at its disposal the instruments needed to effectively conduct monetary policy. Third, members of the decision-making bodies of the central bank must be personally independent; this can be achieved by appointing members for a sufficiently long term and by compensating them appropriately.
After considerable deliberations, the Maastricht treaty provided the ESCB with a high degree of political independence. Policy will be made by a Governing Council consisting of a board of directors and the governors of the national central banks. Members of the board of directors are to be appointed for a single term of eight years. National central bank governors are to be appointed for terms of at least five years, and the national central banks are to be made independent of government direction before the beginning of stage three.
A crucial issue that determines whether the central bank is truly functionally independent is exchange rate policy. The debate on this question started with a basic consensus that the choice of an exchange rate system (e.g., between a par value system and floating exchange rates) would be the province of the political authorities, or, in the EC, of the Council of Ministers. Carrying out day-to-day exchange market intervention would be the responsibility of the ECB. There was significant disagreement, however, about who would be in charge of determining intervention policy vis-à-vis third currencies in the absence of a supraregional exchange rate system. Some countries argued that decisions on foreign exchange intervention policy should fall entirely within the domain of the central bank, and that any departure from this principle would create a loophole that could undermine the bank’s monetary policy. Others believed that the exchange rate was a central instrument of economic policy, with a profound impact on employment and growth, and that final responsibility for exchange rate policy should, therefore, be placed in governments’ hands.
In the draft treaty, one finds something of a compromise between these positions, although greater weight was given to the first point of view. The choice of an exchange rate system for the single currency vis-à-vis third countries is left to the Council of Ministers. However, such decisions must be taken unanimously, after consultation with the ECB, and must not jeopardize price stability. If a par value system is chosen, a qualified majority of the Council must approve the central rates. In the absence of an exchange rate system, the Council, acting by qualified majority vote, may provide orientations for exchange rate policy, but only if these do not impair the central bank’s ability to maintain price stability.
Guidelines for economic policy. A prolonged debate also took place on the coordination of economic policy in the negotiations leading up to the treaty. Some countries, notably France, advocated the formulation of guidelines for economic policy, including monetary policy, at the level of the European Council.
The draft treaty made no mention of guidelines for monetary policy. Instead, it allows the Council of Ministers, by qualified majority voting, to devise “broad guidelines” for economic policy in the EC, which are submitted to the European Council for discussion. On this basis and as a final step, the Council of Ministers, again acting by qualified majority vote, may issue “recommendations” for economic policy.
Main events leading to economic and monetary union
January 1, 1958: Founding of the European Economic Community
December 1-2, 1969: Meeting of European Community heads of state and government at The Hague
October 1970: Werner Report
April 24, 1972: Establishment of the European Common Margins Agreement (the “snake”)
March 13, 1979: Establishment of the European Monetary System
April 17, 1989: Report of the Delors Committee
July 1, 1990: Beginning of the first stage of the Economic and Monetary Union (EMU)
December 13, 1990: Start of intergovernmental conferences on EMU and political union
December 10, 1991: Maastricht agreement on EMU and political union
February 7, 1992: Signing of treaty on EMU and political union
Fiscal stability. From the beginning, there was widespread agreement that a stable monetary union would require close coordination of national fiscal policies, as well as some kind of restriction on public sector deficits and debt. Excessive fiscal deficits, often financed by monetary expansion, endanger price stability and should, therefore, be avoided. Further, it was thought that market discipline, in the form of rising risk premia on interest rates, would by itself be insufficient to rein in an unsustainable fiscal policy. As the experience with developing country debt had shown, financial markets often react too little, too late, and then tend to panic. The fear was that under a monetary union, the costs of excessive fiscal deficits would have to be borne by all countries and that undisciplined countries would have to be bailed out by the other members.
An excessive deficit was defined, in a protocol attached to the draft treaty, as a general government deficit that exceeds 3 percent of GDP. In addition to the limit on fiscal deficits, the treaty also specifies a limit on the public debt ratio of 60 percent of GDP. More highly indebted countries are expected to take measures to ensure that their debt ratio approaches this benchmark at a satisfactory pace.
To enforce fiscal discipline, the treaty provides for sanctions. It also envisages an initial phase before actual sanctions are imposed, in which the Council of Ministers may issue warnings and request the adoption of appropriate measures. An effort was made to ensure that sanctions would be both effective and feasible. In increasing order of severity, they are:
• publication of detailed economic and budgetary information in connection with sales of debt instruments;
• reconsideration of lending to the member by the European Investment Bank;
• placement of an interest-free deposit with the EC until the problem is corrected; and
• fines of an appropriate size.
Transition to the third stage
Participation in the EMU described above will require profound changes in the economic policies and institutions of many EC member states. For some countries, these changes will mean nothing less than a shift in the framework governing economic policy. Not only must there be further convergence of inflation and interest rates in order to engender greater exchange rate stability, but fiscal deficits and debt also must be brought under control. Moreover, the instruments of monetary policy, financial market laws, and economic statistics will need to be harmonized.
The intergovernmental conference devoted great attention to the transition to stage three, principally to the content and length of the second stage, which is scheduled to begin on January 1, 1994. All participants recognized that the length of the second stage and the timing of entry into stage three would depend on the degree and speed of economic and financial convergence achieved among the signatories. At the time the agreement was being negotiated, a minority of countries with low inflation rates and sound public finances would already have been in a position to form a de facto monetary union. However, several member states were concerned that there should not be a “Europe of two speeds.” The negotiators, therefore, consciously sought a formula that would in principle allow all countries to simultaneously enter into an economic and monetary union, while allowing those that were unable to meet the basic economic requirements a temporary reprieve.
The draft treaty accomplished this by laying out both a timetable and economic convergence criteria for the transition to stage three. A country must fully meet the following requirements for the adoption of a single currency: Its inflation rate must be not more than ½ percentage points higher than the inflation rate of the three member states with the lowest inflation; its interest rates on long-term government debt must be no more than 2 percentage points higher than comparable interest rates in the same three member states; its exchange rate must be maintained within the narrow band of fluctuation of the exchange rate mechanism (ERM) for two years without a devaluation at the initiative of the country in question; and the fiscal criteria must be satisfied.
The European Council will, however, have discretion in applying these criteria and will take decisions by qualified majority voting. In coming to a decision, the Council will consider other economic indicators, such as unit labor costs, the current account of the balance of payments, and progress made toward implementing the single market program. The wording of the treaty also allows ample leeway in judging fiscal policy. The deficit must have “declined substantially and continuously and have reached a level that comes close to the reference value,” and the debt ratio must be “sufficiently diminishing and approaching the reference value at a satisfactory pace.”
A first opportunity to set a date for the transition to stage three will come in 1996. By the end of that year, the heads of state and government will establish, by qualified majority voting, whether a majority of the member states fulfills the economic criteria for the adoption of a single currency and whether it is appropriate for the EC to enter the third stage. If so, a date will be set for the beginning of stage three. The ECB will then be created and will issue a single currency, to be called the ECU, sometime after the beginning of stage three.
Countries that do not meet the economic criteria will obtain an exemption from the treaty and may join later as they are judged to meet the economic conditions. Countries with an exemption will not be represented in the policy-making bodies of the ECB (i.e., the Board of Directors and the Governing Council).
If most countries do not fulfill the economic criteria by the end of 1997, stage three will begin on January 1, 1999. This means that those that meet the economic conditions will be permitted to form a monetary union, while all other countries will obtain a derogation.
These provisions apply to all countries, with the exception of the United Kingdom and Denmark. From the beginning, the government of the United Kingdom had strong reservations about efforts to form a monetary union by creating new EC institutions. Instead, it advocated a more evolutionary approach to monetary union via the creation of a parallel currency, the “hard ECU,” which would compete with other currencies, gradually displacing those that were weak.
In order to avert a veto of the entire treaty by the United Kingdom, a compromise was reached, allowing the United Kingdom to opt out of participation in the economic and monetary union, even if it fulfills the necessary economic conditions. However, the United Kingdom will retain the right to join the monetary union at a later date. Denmark also requested and obtained a special exception.
Views also differed on the nature and tasks of the common monetary institutions to be established at the start of stage two. Some governments advocated creating the ECB at the beginning of the second stage, with authority for monetary policy, however, remaining in the hands of national institutions. Germany and the Netherlands strongly opposed this proposal on the grounds that if such a central bank were endowed with significant powers, it might undermine national monetary sovereignty during stage two.
A compromise proposal envisaged that the existing Committee of Central Bank Governors be augmented by an outside president and assisted by a small technical staff. Such a body, to be called a European Monetary Institute, will be created at the beginning of the second stage. It has no direct authority over monetary policy, although it may formulate recommendations. Its main tasks will be to strengthen cooperation among central banks, monitor developments in the EMS, and make technical preparations for the establishment of the ESCB. The Institute may also manage foreign exchange reserves as an agent for national central banks.
Some of the poorer EC member countries, such as Greece, Ireland, Portugal, and Spain, feared that a monetary policy geared toward EC-wide price stability might damage their prospects for economic growth and expressed a desire for a “cohesion fund” to support poorer countries. Although the creation of such a fund was agreed in principle, EC member states were reluctant to take on further financial commitments.
Final thoughts
The agreement of Maastricht on economic and monetary union of the EC provides a solid legal basis for a single currency and a common monetary policy. However, the treaty by itself will not guarantee monetary and price stability. Since the economic criteria, especially the fiscal criteria, allow considerable discretion, the fear is that countries that are not ready to adopt the single currency on purely economic grounds may nonetheless be permitted to do so for political reasons. In the past, not all EC member states have shown a strong commitment to stability-oriented macroeconomic policies. In particular, budget deficits and public debt of some countries are far higher than would be consistent with medium-term financial stability.
Finally, a single currency means that changes in relative labor costs and other prices among countries can no longer be offset by exchange rate changes. The loss of the exchange rate instrument, therefore, requires that national wage settlements be closely linked to developments in productivity. Whether this is possible will depend to a large extent on labor market institutions, especially the rules governing negotiations between employers and trade unions. Price stability will also crucially depend on whether a popular consensus can be reached in Europe on the desirability and, indeed, the necessity of a stability-oriented monetary and fiscal policy.