Pitfalls on the Path to a Single European Currency

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EUI Working Paper RSC No. 96/21 Arrowsmith: Pitfalls on the Path

to a Single European Currency

WP 321 . 0 2 0 9 4 ° % i s ^ © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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The Robert Schuman Centre was set up by the High Council o f the EU1 in 1993 to carry out disciplinary and interdisciplinary research in the areas o f European integration and public policy in Europe. W hile developing its own research projects, the Centre works in close relation with the four departments o f the Institute and supports the specialized working groups organized by the researchers. © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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E U R O P E A N U N I V E R S I T Y I N S T I T U T E , F L O R E N C E

R O B E R T S C H U M A N C E N T R E

P it f a lls o n t h e P a th t o a S in g l e E u r o p e a n C u r r e n c y

JOHN ARROWSMITH

Senior Research Fellow

National Institute of Economic and Social Research London E U I W o r k in g P ap er R S C N o . 9 6 /2 1 B A D I A F I E S O L A N A , S A N D O M E N I C O ( F I ) © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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N o part o f th is p a p er m a y b e rep ro d u ced in a n y form w ith o u t p erm issio n o f th e author.

© Joh n A rr o w sm ith Printed in Italy in M a y 1 9 9 6 E u rop ean U n iv e r s ity In stitute

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I Introduction

At the European Council meeting in Madrid on 15-16 December 1995. the Heads of State or Government affirmed that entry into Stage 3 of Economic and Monetary Union (EMU) will take place on 1 January 1999; that the decision as to which countries shall participate will be taken “as early as possible in 1998”; and that the national currencies of participating countries will have been replaced, for all purposes, by the single European currency, to be called the Euro, no later than 30 June 2002.' Although pronouncements of the European Council, unlike those of the Council (of Ministers), have in themselves no legal force, it is taken as a working hypothesis for most of the present paper that a group of between six and ten countries do indeed move to monetary union and adopt a single currency according to this timetable. It does not concern itself with the question of which countries might qualify to take part and which might be debarred (or elect to stay out) - a judgement entailing detailed economic forecasts and much political speculation. Instead it is assumed that a sufficient number of Member States, with compatible economies and serious intent, will embark on the path to a single currency while others do not and that in each group there will be at least two of the larger countries: Germany and France in the group that goes ahead (the ‘Insiders’); and Italy, Spain and quite possibly the United Kingdom in the group of countries (the ‘Outsiders’) that do not qualify (the ‘Can’ts’) or who may qualify but do not wish (the ‘Won’ts’) to join them.

These five countries account for about 80% of both the population and the gross domestic product of the Community; and together they account for 55% of the total weighted votes relevant to Council decisions which require only a qualified majority (compared with 71 % actually needed to reach a qualified majority).1 2 The economic and political reality therefore is that precisely which, or how many, of the smaller countries turn out to be in one group or the other will not greatly affect the economic or political judgements that might be made about a two-tier or two-speed EMU - other than perhaps of the ‘moral’ legitimacy of a move by

1 Conclusions of the Presidency, Madrid, 15-16 December. For the remainder of this note the single currency will be referred to as the ‘euro’, the lowercase ‘e’ denoting its status as a currency in its own right and the inverted commas the faint hope that, before it becomes a reality, a happier name for it might be adopted.

2 For a more detailed analysis of the balance of power in a two-tier EMU, and the economic and monetary implications of this, see Arrowsmith (1995a) and Arrowsmith (1995b). © The Author(s). European University Institute. version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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possibly a numerical minority of members of a ‘commonwealth' of states pursuing in their own interests a course of action which might prove detrimental to the majority.

The focus here instead is on the six-year process, from now until mid- 2002, of moving from a Community of equals, with all Member States subject to the same set of rules which govern Stage 2 of EMU. to a two- tier Stage 3 in which different sets of rights and obligations apply to different Member States.1 * 3 Insufficient attention has so far been given to the constitutional, legal, monetary and financial pitfalls that the authors of the Maastricht Treaty left hidden along the path to monetary union. If the Member States, driven forward by the Maastricht and Madrid timetables, do not anticipate these traps, the financial markets may be lying in ambush when they stumble. The purpose of this paper is to identify the principal pitfalls and to suggest steps which might be taken in time to avoid them. Even with such precautions, risks and uncertainties, both economic and political, will remain. The paper concludes that there is therefore a need also to prepare, against the possibility that the whole project is delayed or even abandoned, a fall back framework to protect the existing achievements of the European Community from the potentially disastrous consequences of such a break-down.

II The Maastricht and Madrid timetables and procedures

According to the timetable laid down by the European Council in Madrid last December, the key decisions on the move to monetary union must be taken during the course of 1998 in order that exchange rates between the national currencies of participating Member States shall be ‘irrevocably fixed’ on 1 January 1999,4 with ‘euro’ notes and coin replacing national denominations, after a further three years of preparation, between 1 January 2002 and 30 June 2002. This declaration by the Heads of State or of Government, however, is not sufficient to override the prior requirement of the Maastricht Treaty that a detailed process of

1 Indeed, if the United Kingdom were to exercise its option not to proceed to Monetary Union, there would exist a three-tier EMU, since, according to the UK Protocol to the Maastricht Treaty, the UK would be exempt from slightly more of the Stage 3 obligations than would Member States who are granted the standard set of derogations.

4 Fortuitously a Bank Holiday Friday, allowing a ‘long’ weekend for financial markets to adapt to the new situation.

3 © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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assessments and decisions be first undertaken during the course of 1996 in order to establish which countries might qualify.5 whether they constitute a majority of Member States and. if so. whether and when it would be appropriate to move to Stage 3. Taking the Maastricht and Madrid provisions together, therefore, the timetable for monetary union stretches continuously from the present year until the middle of the year 2002, but with four distinct phases (see Annex).

Phase 1 (1996)

The first phase has already arrived. Before the end of 1996 the members of the European Union must have completed the following procedures: (i) the European Commission and the European Monetary Institute

(EMI) each prepare a report on the development of the ECU and the operation of the Single Market; on the progress made by each Member State to ensure that its central bank and the European Central Bank (ECB). and all members of their decision-making bodies, are independent of any outside instruction or influence; on whether the Member State meets the four convergence criteria; and on its performance in respect of its balance of payments, and unit labour costs and other price indices;

(ii) the United Kingdom notifies the Council whether it intends to move to Stage 3;

(iii) the Council (meeting as Economic and Finance Ministers - ECOFIN) voting by qualified majority assesses, on the basis of these reports, which Member States fulfil the necessary conditions for the adoption of a single currency and whether they constitute a (simple unweighted) majority;

(iv) ECOFIN recommends its findings to the Council (meeting as Heads of State or of Government) which decides by qualified majority vote before the end of 1996 - on the basis of the ECOFIN recommendation and taking due account of the EMI and Commission reports and an opinion of the European Parliament - whether a majority of Member States fulfil the necessary conditions, whether it is appropriate for the Community to move to Stage 3 and, if so, to set a date for the move.

5 In particular whether they meet the convergence criteria, regarding price stability, sound public finances, exchange rate stability and the sustainability of these conditions as indicated in long-term interest rates.

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By now it is quite clear that the Council will find that a majority of Member States do nor fulfil the necessary conditions on this occasion; but the Treaty nevertheless requires that the whole procedure - including the UK notification of its intentions with regard to participation if the decision were to proceed to Stage 3 - must be gone through before the end of 1996. Whether this is regarded as an empty gesture merely to satisfy the Treaty obligation or as a full dress rehearsal for the real decisions to be taken in 1998, it will require all the parties involved to address within the coming few months a number of ambiguities and politically sensitive issues which they might prefer not to face until much closer to the final date. If these are not satisfactorily resolved now. greater confusion and uncertainty is likely to result.

All four convergence criteria, although ostensibly objective and concrete, are hedged about with qualifications which allow a considerable degree of subjectivity to enter into the judgements - to be reached separately by the Commission, the EMI, ECOFIN and the Heads of State or Government - as to whether or not they have been met. The reference values for inflation and long-term interest rates are to be calculated in relation to the rates in at most the three best performing Member States in terms of price stability. The intention of the drafters of the Maastricht Treaty in choosing the number three had been to overcome the risk of an unrealistic target if one Member State were to register a ‘rogue’ low, or even negative, rate of inflation and the purpose of the words ‘at most’ is to limit the dilution of the criterion any further. It would be consistent with this intention to take the average of the three lowest, but it is sometimes suggested that the number could be less than three or that the reference value could be set by the third lowest alone. Each of these interpretations is likely to yield a different base-line for the inflation and interest rate criteria and hence the choice of interpretation could materially affect whether a borderline country satisfied the criteria or failed to meet them.

For a country to satisfy the requirement of a ‘sustainable government financial position’ it must in principle have a ratio of government deficit to GDP of no more than 3% and a ratio of government debt to GDP of no more than 60%; but it can avoid the first requirement if it is judged that its deficit ratio has ‘declined substantially and continually’ or the excess is only ‘exceptional and temporary’ and the ratio is ‘close to’ 3%; and it can avoid the second requirement if it is judged that its debt ratio is ‘sufficiently diminishing and approaching’ 60% at ‘a satisfactory pace’. The exercise of such judgement in the annual monitoring of convergence

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led both the Commission and ECOFIN to rule in 1994 that, of all the 13 Member States who breached at least one of the two fiscal requirements, only Ireland - with a debt ratio of around 90% - satisfied the convergence criterion.

With the widening of the ERM fluctuation band after the exchange rate crises of 1992-1993, the definition of exchange rate stability adopted in the Treaty as a convergence criterion is now virtually meaningless and a potentially serious source of uncertainty and confusion. When the Treaty was signed, “observance of the normal fluctuation margins provided for by the exchange rate mechanism of the EMS” was clearly understood to refer to the margins of + 214% of the then “narrow band” - rather than the + 6% margins of the ‘wide band' - with the possibility that there might be a further narrowing of margins as Stage 3 approached. To reinterpret the Treaty as referring to the now sole (but still officially temporary) fluctuation margins of + 15%, which allow currencies in the ERM to move by up to 30% against each other, would be to make a nonsense of the express purpose of the criterion, which is to demonstrate exchange rate stability.

The European Commission have proposed (Ravasio 1994) that this undermining of the convergence requirement might be remedied by specifying that currencies must have been in the 15% band ‘without large fluctuations’, but they have not said how these are to be defined. The EMI and ECOFIN have so far refrained from offering any guidance at all. The exchange rate criterion, however, must be met throughout the two years running up to the Commission’s and the EMI's reports on convergence to the ECOFIN Council. For the 1996 decision procedure, the qualifying period has thus started at least 18 months ago and even for the 1998 procedure the clock will start ticking within the next few weeks.6 To leave reinterpretation of the Treaty criterion until the end of the qualifying period and then to introduce, ex post, a definition of de

facto stability would enable each of the bodies in the decision procedure

to make arbitrary and politically charged judgements about which currencies (and hence which countries) had satisfied the requirement and which had not. Not only is this inherently unfair, it also maximises uncertainty about which countries might eventually qualify and it increases the chances of destabilising speculation in financial markets. Such a retrospective approach can no longer be avoided in the 1996

6 The Italian and Swedish authorities have hinted that because of this they may seek to bring their currencies into the ERM at this point.

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procedure but the opportunity must now be seized to establish, by reference to exchange rate performance over the past two years, what the

ex ante requirement will be for the decisions to be taken in early 1998.

These ambiguities in the Maastricht convergence criteria are well-known and documented. What is less well appreciated is that there are a number of other points at which Article 109j of the Maastricht Treaty admits subjective judgements as to which countries qualify for participation in the move to a single currency. In preparing the two reports, the Commission and the EMI are required not only to look at the four convergence criteria but also to take account o f “the development of the ECU, the results of the integration of markets, the situation and development of the balances of payments on current account and an examination of the development of unit labour costs and other price indices”. No indication is given as to what weight either of these bodies should attach to such considerations. Furthermore, the ECOFIN Council will undertake its assessment on the basis of these reports; and the Council in the composition of Heads of State or of Government will take its decision on the basis of the recommendations of the ECOFIN Council. Thus at each step in the procedure a further subjective element is added, making the outcome as to which countries qualify for monetary union far less predictable, and potentially more politically charged, than if the convergence criteria narrowly defined were the only consideration. What importance the Commission and the EMI give to the ancillary criteria in their reports and how closely the Council, in its two different compositions, bases its judgements on the findings of those reports will be closely scrutinised by politicians, financial institutions and other outside observers. The balance achieved between economic and political considerations in 1996 will be taken as the touch-stone for the crucial decisions which remain to be taken in 1998.

Phase 2 (Second half of 1997 to early 1998)

The second phase will start in earnest only months after the first phase has ended. Indeed, in one very important sense, it will already have begun early in Phase 1: as pointed out above, if the exchange rate criterion is to be satisfied, a country must have achieved the (so far undefined) requisite stability for the two years prior to the decision (and perhaps therefore prior to the preceding Commission and EMI reports) which is to be taken in early 1998. To meet this deadline, even though reliable data about government finances in 1997 will not yet be

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available, the Commission and the EMI will have to begin work on their reports in the final months of 1997. Because of the inherently subjective and potentially politically charged nature of the process, the same issues as in the first phase are likely to resurface - but with even greater intensity this time if they have not already been clarified in 1996. The whole procedure, as in 1996. will have to be gone through, with the exception of the requirements that the Council find that a majority of

countries qualify, and that it is appropriate to proceed to Stage 3.

During this period there is additional scope for uncertainty. The Treaty decrees that “if by the end of 1997 the date for the third stage has not been set, the third stage shall start on 1 January 1999”. It is difficult to imagine, however, that governments would feel bound by this obligation if they knew that such a move lacked popular support or if virtually no country could be judged to meet the criteria. It would be consistent with the Treaty if Luxembourg on its own were to become a monetary union, fixing its currency to the ‘euro’ and implementing the monetary policy of the ECB on whose Governing Council it would be outnumbered four to one by the permanent executive, but it is implausible. Only slightly less plausible is that Stage 3 would start but every Member State would have a derogation. Rather, in circumstances such as these, the Stage 3 provisions would be deferred or set aside. It is technically possible to do this within the present Treaty framework - from the language quoted above it can be seen that it would be possible before the end o f 1997 to set any particular date which was after (or before) 1 January 1999. It is more likely, however, that the Member States would modify the Treaty so that another date could be chosen later, after a further decision process.

Phase 3 (early 1998 to 1 January 1999)

From the start of the third phase, once the Council in the composition of Heads of State or of Government has made its decision, two facts will be quite clear: the date at which Stage 3 will start and the list of countries which qualify for participation in the monetary union from the outset. The overall picture, however, will still not be completely clear until monetary union comes into effect on 1 January 1999, when the Council (ECOFIN) is required to adopt the conversion rates at which the Insiders’ 7

7 Unique amongst the 15 Member States, with a Financial Year which runs from April to April, the United Kingdom will presumably be judged on actual results for 1996/97 and projections for 1997/98. Definitive results for some Member States, on their past records, are not available until almost a year after the end of the calendar year to which they relate.

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national currencies are to be irrevocably fixed to each other and to the ‘euro’. The economic and foreign exchange market considerations which will enter into this decision are discussed in Sections III and IV below. The Maastricht Treaty offers no guidance on how the rates are to be chosen. As regards procedure, however, the important features of the Treaty are that adoption of these conversion rates will require a unanimous vote, in the Council, of those countries which will be participating in the monetary union;8 and that previously there must have been a proposal from the Commission and consultation of the European Central Bank - which cannot be set up until “immediately after 1 July 1998”. The other major question-mark in the second half of 1998 will be the ability of the governments of the prospective members of the monetary union to secure, before 1 January 1999, the necessary political endorsement (in their national legislatures and, for some Member States at least, in all probability, from their electorates through referenda) of the surrender or pooling of monetary sovereignty which the move to Stage 3 entails and the passage of any national legislation that would be required.9 This would also be the period when, for the first time, the identity of the outsiders will be known and their prospects outside the monetary union open to detailed scrutiny.

Phase 4 (1 January 1999 to First Half 2002)

The fourth and final phase, lasting 3'/2 years, will be the most protracted - indeed longer by a year or more than the three ‘decision’ phases combined. Although few decisions at the Community level are required by the Treaty, it is in this phase that the participating Member States, their banking systems, financial markets, firms and private citizens will all, at different speeds, be required to adapt to the new situation in which exchange rates between national currencies are deemed to be ‘irrevocably fixed’ and gradually, for various purposes, national currencies come to be replaced by the ‘euro’. Whether this process will be seamless, offering no chink for financial markets to exploit, remains

8 In principle, therefore, any of those countries could on its own block agreement and hence the coming into effect of Stage 3; but, with equal legal force, it would be constrained from so doing by the Protocol on the transition to the third stage of EMU, forming part of the Maastricht Treaty, which requires that ‘‘no Member State shall prevent the entering into the third stage".

9 The much-vaunted safeguarding of parliamentary sovereignty, made explicit in the United Kingdom's ‘option’ Protocol, is not seen by other Member States as a uniquely British prerogative: most of them, too, foresee a need to secure constitutional affirmation (and possibly political or popular approval) of the surrender of monetary sovereignty when the time comes.

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to be seen (see Section III below). It is in this dependence on economic agents, individually and collectively, rather than on formal decision procedures at the European level, that the principal uncertainties of the fourth phase lie. This is the one period in which the detailed arrangements for the monetary union - and any formal framework for the relationship between Insiders and Outsiders - will be definitively established and open to thorough testing.

Ill Financial market flashpoints

The decision procedures and timetable described above bring together four ingredients to produce a potentially powerful fuel for financial market - and especially foreign exchange market - speculation: the public commitment of governments to take key decisions on fixed (or closely defined) known dates; discrimination, in those decisions, between countries and between currencies; uncertainty not only as to what judgements will be made but even as to the basis on which they will be made; and a hierarchical and drawn-out advisory procedure the substance of which, while not transparent, is unlikely to remain secret. The attention of financial markets during the first phase, in 1996, is likely to focus on the manner in which the Commission, the EMI, ECOFIN and the Heads of State or of Government interpret the convergence criteria and exercise their judgement: from this the markets might seek to deduce both which countries are likely to qualify in 1998 and the likelihood of the move to Stage 3 taking place in 1999. A strict interpretation of the criteria in 1996 - for example a negative judgement on fiscal grounds in respect of Austria, the Netherlands and possibly France - might be viewed as pointing to a soundly constituted monetary union but at the same time as virtually ruling out the possibility that it will take place in 1999. Conversely, a lax interpretation might be seen as increasing the likelihood of monetary union going ahead but on a less satisfactory basis. Either outcome could generate differential exchange rate pressures among the principal candidate countries over the coming months.

During the second phase, from the latter part of 1997 and the first few months of 1998, the markets will have a further opportunity to take positions on which currencies will be deemed fit to proceed to Stage 3 and to test the collective will of the European Union to create a monetary union. In so far as the decision to be reached in 1998 may be definitive, speculative pressures throughout this phase might be much more intense than in 1996, even to the point of preventing particular countries from

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meeting the convergence criteria. There are some precautions, however, which the authorities could take to forestall such pressures: if. during the 1996 decision process, they were to remove the uncertainties and ambiguities in the convergence criteria and to make clear how they were balancing the objective and subjective and the economic and political elements in reaching their judgements, the markets would be better able in 1996 to anticipate the 1998 outcome (using their own economic predictions), adjustments being made now rather than accumulating in intensity in 1998. In particular, the authorities would need in 1996 to: • announce before embarking on the decision procedure what

construction they will place upon ‘at most, the three best performing Member States’ for the purposes of the inflation and interest rate criteria;

• also announce beforehand the definition of exchange rate stability which is to be applied both for the 1996 decision and to assess the convergence of Member States over the next two years before the 1998 decision - this must be clearly seen to be , for 1998, an ex ante rather than an ex post requirement;

• make clear, during the 1996 decision process, the rationale that is being applied in the judgement as to which countries who do not precisely conform to the numerical ceilings of 3% and 60% for the ratio of government deficits and debt stocks to GDP are being judged nonetheless to be meeting the fiscal criteria - how does one justify the inclusion of Ireland and the exclusion of the Netherlands or Belgium and, if those too are included, how does one justify excluding Italy or Spain?

• clarify what is meant by taking decisions ‘on the basis o f the EMI and Commission reports and ECOFIN’s recommendations.

Failure to resolve these questions in 1996 will merely compound the risks in 1998.

In the third phase, during the second half of 1998, market attention is likely to switch from the question of which countries will qualify for monetary union (which, in principle, will have been settled ‘as early as possible in 1998’) to the exchange rates at which the Insiders’ currencies would become “irrevocably fixed” on 1 January 1999 and on the economic prospects and future exchange rate behaviour of the Outsiders.

II © The Author(s). European University Institute. Digitised version produced by the EUI Library in 2020. Available Open Access on Cadmus, European University Institute Research Repository.

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To the extent that the emphasis in the decision procedure had been based on a clear interpretation of the criteria and on objective economic rather than political considerations and that the economies of the participating countries are seen to be truly convergent, the risk of exchange rate instability during this period will be lessened. Even so, the currencies of the Insiders will still be susceptible to internal political events (such as parliamentary debates or national referenda about the irrevocable step to fixed parties) and to external economic shocks (including movements in the currencies of the Outsiders) which may lead markets to exploit the scope for currency movements within the ERM band or even to speculate about the likelihood of “one last realignment”.

There are several ways in which the authorities might seek to minimise this danger. One approach would be to announce in advance that ECOFIN would adopt as the conversion rates the market exchange rates on the day (or the eve) of the irrevocable fixing and to rely in the interim, as Kenen (1995) recommends, on the flexibility of the 15% band as the best (although not infallible) defence against market pressures for "one last realignment”; but that very flexibility would leave scope for considerable exchange rate movement - a de facto realignment within the 15% band from market rates at the time of the announcement to whatever market rates are ruling when the irrevocable fixing takes place.

A different approach would be to announce in advance - even at the time at which the participating countries were named - the precise conversion rates which the ECOFIN Council intended to adopt on 1 January 1999; these might be the current ERM bilateral central rates or any other set of rates within the ERM fluctuation margins.10 If the political commitment of the participants and the degree of economic convergence they had achieved were credible, market forces should, in principle, move the market exchange rates towards these pre-announced rates. Goodhart (1996) argues in favour of pre-announced rates in part because of pre commitment by the authorities but also because of the attraction of being able to choose, in advance, fairly rounded numbers that are consumer- friendly for the conversion factors between each Insider’s national currency and the 'euro’ (even if the bilateral rates between Insiders’ national currencies are still awkwardly angular). In response to the kinds of shock referred to above, however, the markets might still override the Council’s intentions. An alternative, proposed by Richards (1995), would

10 The implications of such an announcement for those Outsiders who are members of the ERM parity grid would also need to be taken into account.

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be to announce in advance not the precise rates but a formula by which the conversion rates would eventually be determined - for example, the average spot market exchange rate over the final month (or even a much longer period) prior to the irrevocable fixing. This would help to build stability into the market and would be compatible with (although would not necessarily entail) some of the proposals for achieving greater exchange rate stability not just between prospective members of the monetary union but, more widely, throughout the Single Market (see Section IV below).

If agreement could be reached on one of these approaches, well in advance of the irrevocable fixing, it would reduce the risk that exchange rates between the Insiders are disrupted by market movements in Outsider currencies. The Maastricht Treaty, however, creates a legal obstacle to the pre-determination of conversion rates, whether by a pre announcement of specific rates or by means of a formula. This problem is examined in Section 4 below, where a technical solution is proposed. The fou rth , an d fin al, period of uncertainty and potential market pressure will start on 1 January 1999 with the adoption of the conversion rates between participating national currencies and of the rates at which the European currency is to be substituted for them. It will not end until 2002, when the national currencies are completely replaced by the European currency. The EMI (1995) has asserted that in this phase “there will no longer be foreign exchange markets between [national currencies] but only purely arithmetical conversions” and also that the national currencies “will cease to be foreign currencies in terms of one another. In economic terms, there will remain only one currency which can be expressed in different ways: either in terms of the European monetary unit or in terms of any of the national monetary units”. These claims, however, are undermined by the EMI’s own admission that the ESCB would encourage the use of the European currency in the foreign exchange markets by conducting its own foreign exchange market operations only in terms of the European currency and also that “most enterprises are expected to continue to operate in the national monetary units”. The Commission (1995a) make a similar claim for the foreign exchange markets, while emphasising the need to achieve from the outset a “critical mass” of activities - including exchange rate policy, the inter bank, money, capital and foreign exchange markets, new government debt issuance and wholesale payment systems - conducted solely in the European currency in order to give greater credibility to the claim that the conversion rates were “irrevocable”. To achieve such a critical mass

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virtually overnight between Friday 1 January and Monday 4 January 1999 would be quite a tall order.

In contrast the Financial Law Panel (1995) suggest that in law. unless the obligations evidenced by the national currencies are subsumed at the start of Stage 3 in the obligations of the ECB, there will exist in each participating country obligations denominated in the European currency which are obligations of the ECB and also obligations in the national currency which are obligations only of the relevant national central bank; and that it therefore remains to be seen whether non-EC nationals and the financial markets generally will regard such legally distinct obligations as economically interchangeable. Bishop (1995) considers that, during this long period of fixed exchange rates, risk-averse investors may be tempted to convert large amounts of financial assets into the monetary unit perceived to be the strongest11 - most likely the Deutschmark, especially in view of the relative depth and liquidity of that market. De Grauwe (1994) argues that an increase in the demand for money in one member of the union relative to another, and the resulting capital movement between them, will require the monetary authorities to intervene in both currencies and that these operations are likely to have negative effects on the credibility of the “irrevocable” fixing of exchange rates.

Which of these two schools of thought is correct? It is instructive to look at the more detailed analysis offered by Kenen (1992 and 1995), based on the schematic representation of transfers between commercial banks and their customers, the national central banks and the ECB and also of the balance sheet position which would result from various kinds of initial transaction. This demonstrates how, provided that there is an efficient market in banks' reserve holdings of the European currency at the ESCB, and provided that the markets for government securities are fully integrated, transactions between Insider countries would be cleared automatically at the agreed conversion rates. Kenen sets out a number of other conditions which need to be satisfied if this result is to be valid. Of these, Taylor (1995a) notes the importance of the requirement that each Insider central bank will be ready to swap its national currency (and the currencies of other Insiders) for the European currency at par, without limit and without margins or commissions. Therein lies the key. The

11 The Commission (1995a) also recognise this possibility but, in a rather circular fashion, argue that it is less likely to happen if most financial transactions are conducted in the European currency from the outset.

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implication of Kenen’s analysis is that exchange market pressures should not emerge during the period of fixed exchange rates provided that (and

as long as) the ECB, the national central banks and national governments can convince the markets that the following propositions will remain

valid in all circumstances:

• each and every Insider would be prepared if necessary to see bank deposits denominated in its own currency entirely replaced by deposits denominated in the currency of another Insider;

• the government of each Insider would attach (and honour) endorsements, guaranteeing the value in terms of the 'euro', to its debt denominated in its national currency;

• the ECB would be willing to accept without limit a build-up of its holdings of securities denominated in any one national currency, provided it had been endorsed in terms of the 'euro' by the government of the country of issue, and a corresponding fall in its holdings of endorsed securities denominated in another national currency, even though this might result from a strong market preference for the latter over the former.

Careful thought would need to be given to how best to ensure that these propositions are seen to be credible. The mere assertion of government commitment may not be sufficient to create and sustain market confidence, as the breakdown of the original ERM framework (in which the role of the Bundesbank was analogous to that of the ECB in the monetary union) has shown. This analogy is certainly not perfect - participation in the ERM is a voluntary undertaking with no formal legal basis, whereas participants in EMU will be legally bound by obligations under the Treaty and under associated secondary legislation deriving from the Treaty. But financial markets might still need to be convinced that these very demanding commitments of each and every Insider would be honoured in all foreseeable circumstances. Some sort of Solemn Declaration by the Insider governments to this effect might be helpful, the more so if this could be reinforced by a joint and several guarantee - although that might be held to violate the Treaty requirement that ‘neither the Community nor any Member State shall be liable for or assume the commitments of any other Member State’ and to undermine fiscal discipline. The most important requirement, however, will be that each Insider - its government and its electorate - fully understands and

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accepts the nature of the obligations that are being assumed during this phase of the transition to a single currency.

IV Insiders and Outsiders: living together

A number of factors and flashpoints have been identified around which, and in anticipation of which, disruptive pressures might build up in financial markets. There are a number of additional reasons for supposing that - in the event that some but not all Member States “irrevocably fix” their exchange rates on 1 January 1991 - destabilising movements affecting the currencies of Insiders and of Outsiders could become intense and recurrent. This could undermine the credibility of the nascent monetary union during the crucial period in which the 'euro' was being introduced; and it could also frustrate the efforts of the Outsiders to persevere with policies directed towards the stability and convergence required for admission to the monetary union in due course. There is thus a strong prama facie case for establishing, well in advance of Stage 3. a clear and mutually supportive framework to govern monetary and exchange rate relations between Insiders and Outsiders, not only during the potentially unstable period of the transition but also once the monetary union has been consolidated with the adoption of a single currency.

All Member States currently participate in Stage 2 of EMU on an equal footing within a framework of common rights and obligations. Once Stage 3 starts (deemed by the Heads of States or of Government to be on 1 January 1999), Stage 2 will cease and with it the common framework. In its place will be a legal and institutional structure designed expressly, and almost exclusively, to meet the needs of a common monetary policy and ultimately a single currency. Countries which participate in this monetary union will thereby assume new rights and obligations. Those which do not participate will be treated largely by exception, being granted derogations from many of the key provisions in the sphere of monetary and economic policy, and therefore exempted from certain obligations and denied the associated rights.12

12 The situation for the United Kingdom, if it were to exercise its right to opt out of monetary union, would be slightly different. The UK Protocol attached to the Maastricht Treaty contains a list of articles to be disapplied, which is a little longer than the list of articles from which other non-participants would have derogations. Thus the United Kingdom alone would not be legally obliged to grant independence to

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The monetary policy of the monetary union will be the responsibility of the European System of Central Banks (ESCB) which will consist of all the national central banks (including those of the Outsiders) together with the European Central Bank (ECB). Decisions regarding the monetary policy of the monetary union, however, will be taken by the Governing Council and the Executive Board of the ECB, on which the Outsiders will not be represented. Outsiders will retain their existing national responsibilities for their own monetary policies. A third decision-making body of the ECB, the General Council, on which the central banks of all the Member States are represented, would provide a forum for monetary policy co-operation, in practice, however, any co ordination of policies is likely to be limited: all members of the General Council would be obliged, under the Treaty , to uphold the ESCB's primary objective of price stability within the monetary union; its meetings would be chaired by the President of the ECB (in whose appointment the Outsiders would have no say); the Vice-President of the ECB would also have a vote; and its Secretariat would be drawn from the ECB staff.

The Treaty empowers the ECOFIN Council to formulate any exchange rate policy for the monetary union in relation to non-Community currencies and bestows on the ESCB the responsibility for its execution, with non-participants excluded from voting on such decisions. The Treaty does not provide any explicit framework for determining or managing exchange rate relations between the monetary union and the Outsiders - although Article 109m does require each Member State with a derogation (the Outsiders) to treat its exchange rate policy as ‘a matter of common interest’. Continuation of the European Monetary System (EMS) and its Exchange Rate Mechanism (ERM) would, however, be compatible with the Treaty. Some of the Articles indeed imply that the EMS would remain in place: the ERM criterion would still need to be met by Outsiders seeking to join the monetary union after the start of Stage 3; and a General Council of the ECB will be charged with taking over the EMI’s present responsibility for the co-ordination of exchange rates within the ERM and for managing the EMS. But there is no explicit requirement that the EMS continue - although the Commission (1995b) have asserted that ‘the expected situation for Member States is that they would participate in the ERM at the latest at the start of Stage 3' - and

its central bank or to avoid excessive deficits. For a detailed description of the Treaty provisions for a two-tier EMU, see Arrowsmith (1995b).

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there is no provision for any alternative framework to take its place. The Treaty is also silent about where decisions concerning exchange rates between the single currency (or the national currencies) of the monetary union and the currencies of non-participants are to be taken and what the voting procedures might be.

How economic and monetary policy-making and performance will in practice be affected by the new legal framework and the economic and political geography of a two-tier EMU, or what judgements the financial markets will make, cannot be forecast with any confidence. However, on the fundamental assumption that the monetary union is well-founded and ultimately successful - an assumption which is more open to challenge the more widely cast is the initial membership of the union - it is possible to draw some tentative conclusions.

Given that the Deutschmark has set the benchmark until now for interest rates in the Community, most of the Insiders other than Germany are likely to experience a fall in nominal interest rates (even though market perceptions of relative credit risks may mean that some differences in interest rates remain). In addition, a number of Insiders are likely to see a reduction in their domestic rate of inflation, in response to the “best practice” imposed by the common monetary policy. It is possible that some Insiders (and even the monetary union as a whole) will enjoy the twin benefits of both lower inflation and lower interest rates in real terms as well (if their nominal interest rates fall by more than the rate of inflation). To these potential gains from participating in a well-founded EMU should be added the benefits to trade and cross-border investment stemming from the elimination of exchange transactions costs and of exchange rate risk - by virtue of the Insiders’ commitment to “irrevocably fixed” exchange rates between their currencies and, even more securely, once national currencies are replaced by a single European currency. Against these benefits must be offset any costs which might result from dispensing with the exchange rate as an instrument of adjustment should the monetary union encounter severe shocks which affect individual participants in different ways or in differing degree. The more convergent and the more compatible are the economies that form the monetary union, the less these costs should be.

In contrast, the Outsiders would be denied (or would forego) any net economic benefits from monetary union and so suffer a relative disadvantage in terms of increased interest rate and inflation rate differentials. If the financial markets were to take the view that this

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change in the relative economic position of Insiders and Outsiders would have an adverse impact on the competitiveness and overall economic performance of the Outsiders, they might mark down their currencies in the foreign exchange markets at the same time as exacting higher interest rates. These interest rate and exchange rate (and hence inflation rate) penalties - in absolute terms - would compound the relative disadvantages to which the Outsiders were already exposed, making it more difficult for them to catch up and join the Insiders later and perhaps even sapping their political will to do so.

There are other grounds, too, for thinking that the markets might exact a penalty from the Outsiders. Those countries that are denied access to the monetary union and its “irrevocably fixed” exchange rates, especially if there is no agreed framework within which to regulate the conduct of monetary and exchange rate policies, may be seen as retaining the right to inflate their economies and to devalue their currencies in order to maintain their competitive position. Retaining the freedom to use the exchange rate as one means of adjustment while more fundamental structural reforms are being undertaken in order to participate in the monetary union at a later date, might be regarded as appropriate for a country that has failed to qualify for admission at the outset. The market judgement of a country that has qualified in most major respects but has chosen not to participate may be less benevolent. This too might be the judgement of those Member States who go ahead and assume the rights and obligations that come with full participation in Stage 3 of EMU, arguing that such a country might intend to indulge in competitive devaluation - indeed, market forces might actually bring about a drop in the exchange rate that could be construed as competitive, beggar-thy- neighbour, devaluation. If the Insiders were then to seek to take countervailing measures, the Single Market framework could start to unravel.

If the task of the Community, as defined in Article 2 of the Maastricht Treaty, to “promote throughout the Community a harmonious and balanced development of economic activities ... and economic and social cohesion and solidarity among the Member States” is to retain any meaning, a co-operative answer needs to be found, well in advance of 1999. One such solution is already implicit in the Treaty - the continuation of the EMS and its exchange rate mechanism. This may be thought to be unacceptable to a number of Member States but the reasons for that are more political than economic. The original framework broke down in 1992-1993 because too much was expected of the mechanism

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and not enough was required of the participants when faced with hard choices. With some rethinking of the original design to accommodate the new circumstances of a two-tier EMU. it could provide the key elements of a co-operative solution: a non-rigid and adjustable exchange rate framework, co-ordination of monetary and exchange rate policies, rules governing intervention behaviour and temporary (and perhaps conditional) financing facilities. Each of these elements could be adjusted in ways which would safeguard the interests of the monetary union while providing a safety-net for those outside and encouraging them to pursue sound policies leading to economic convergence. The precise form of the mechanism itself need not be identical to that of the original ERM: the ‘normal’ fluctuation band could be made rather wider than + 2lA% and the permitted degree of fluctuation could be expressed in terms of a rolling average deviation (see. for example. Johnson (1994) and Taylor (1995b)). Such a framework would also be helpful in providing an ex ante definition of exchange rate stability for the purposes of the convergence criterion (see Section 3 above).

If such a clearly articulated arrangement proves in the event to be politically infeasible, some other co-operative solution would be needed - unfettered floating would not provide an answer to the dangers which have been identified. As a minimum, this might take the form of a mutually agreed code of conduct enshrined in Community law, consisting of some agreed notion of exchange rate stability and possibly common inflation targets; a multilateral surveillance procedure and presumptions of policy action to meet these commitments; rules governing the use of Member States’ national currencies and the European currency in intervention; and financing facilities to which access was conditional upon the adoption of appropriate economic and monetary policies in accordance with the pursuit of continuing convergence. If such a code were taken as a basic requirement for all Member States, other optional arrangements, more closely drawn, could be built upon it to suit the different needs of different Member States; a case could be made for each country to choose which arrangement best suited its own circumstances. Thygesen (1995), for example, suggests a currency board relationship for Denmark, with the krone pegged rigidly to the European currency and domestic money creation dependent on reserve holdings of the European currency. For Italy, he suggests associate membership of the monetary union with completely fixed exchange rates (and subsequent adoption of the single currency) but with no voting rights in the ECB until the resultant benefits from lower

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domestic interest rates had brought about a sufficient improvement in its government's finances.

V Transforming the ECU into the euro

The Maastricht Treaty specifies that, at the same moment that exchange rates between the national currencies of the Insiders are “irrevocably fixed”, the ECU will become a “currency in its own right”, convertible into each of those currencies at a rate which is also “irrevocably fixed". The Treaty further requires that implementation of these provisions “shall by itself not modify the external value of the ECU”. The European Council in Madrid last December decreed that, from the start of Stage 3, the European currency is to be called the Euro and that ‘the specific name Euro will be used instead of the generic term ‘ECU’ used by the Treaty to refer to the European currency unit’. This decision is “the agreed and definitive interpretation of the relevant Treaty provisions”. Furthermore, it decided that from 1 January 1999 the official ECU basket will cease to exist. Unfortunately these stipulations, in the Treaty and in the Conclusions of the European Council, may well not be sufficient to ensure that the ECU translates, without any discontinuities, into the

‘euro’ at the start of Stage 3.

The ‘official’ ECU, as used for a variety of Community purposes including the EMS and EC Budget receipts and payments, is defined in terms of a basket containing (since November 1993) fixed amounts of the currencies of the 12 Member States prior to the accession of Austria, Finland and Sweden in 1995. Its ‘internal’ value is the sum of the component currency amounts, valued at their respective exchange rates against any one of the component currencies; its ‘external’ value is the sum of the component currency amounts, valued at their exchange rates against any chosen currency outside the basket (see Annex II, Section 1). The original presumption, which runs through much of the Treaty, was that all Member States would participate in the monetary union13 and that the exchange rates of all their currencies would therefore be fixed irrevocably at the same moment. This locking of national currencies would automatically fix ‘irrevocably’ the respective weights of the national currency components of the ECU basket. The concept of the

13 The eventuality that some Member States do not participate at the outset is provided for by means of derogations from particular Treaty provsions.

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ECU as a currency basket or composite currency unit would then be redundant, the ‘internal' value of the ECU thereafter being ‘irrevocably’ fixed by reference to any of the national currencies, rather than changing continuously according to the market movements against each other of all the currencies in the basket. With the ECB and national central banks at the same time acquiring the authority to issue ECU liabilities, the ECU would thus have become "a currency in its own right"14 alongside the national currencies within the monetary union. The architects of the Treaty recognised that it might prove to be desirable for the conversion rates to be adopted at the “irrevocable fixing" to be different from the rates quoted in the foreign exchange markets on that date (or at the previous close); this might be to achieve a pre-announced set of rates or to effect one last realignment of relative prices among the participating countries.15 They believed that it would nevertheless not be helpful to confidence in the future stability of the European currency and of the monetary union itself if a deliberate discrete change of this kind in the relative values of the national currencies were to create a discontinuity in the ‘‘external" value of the ECU at the moment it ceased to be a basket (or composite currency unit) and became “a currency in its own right". The intention behind the inclusion in the Treaty of the words “this measure shall by itself not modify the external value of the ECU", therefore, was to prevent the occurrence of such a discontinuity arising in the ‘external’ value of the ‘official’ ECU as an automatic (arithmetical) consequence of the particular choice of conversion rates on 1 January 1999 (see Annex II, Section 2). The requirement to maintain the ‘external’ value of the ECU basket does not apply to the ‘private’ ECU which is traded in the financial markets, whose value reflects the supply of and demand for ECU assets and can (and often does) diverge from the value of the ‘official’ ECU. The Treaty provision therefore cannot prevent there being a change or discontinuity in the value of the ‘private’ ECU at the moment of the ‘irrevocable fixing’.16 Thus its direct contribution to market stability is likely to be modest.

14 There was some debate, while the Treaty provisions were being drafted, about whether or not it would be necessary, or desirable, for the ECB and national central banks not only to have the authority to issue but actually to issue ECU liabilities from the start of Stage 3. This question was left unresolved.

15 The economic arguments for and against “one last realignment” are discussed in Kenen (1995).

16 Thereafter, the ‘internal’ value of the ‘euro’ (both for official and for market purposes) would be ‘irrevocably fixed’ in terms of the Insiders’ currencies, if necessary with the help of market operations by the ESCB, at the conversion rates adopted by the Council but its ‘external’ value would be determined by market forces.

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What might prove to be of much greater economic and financial relevance is the constraint that the provision places on the choice of conversion rates by the Council on 1 January 1999. If the Council wished to adopt conversion rates which differed from the market rates at that time, it would have to choose a combination of devaluations and revaluations which, in weighted terms, exactly offset each other.17 The political difficulty of reaching agreement on a set of rates which satisfies this requirement could well be greater than at past realignment conferences where there was no such constraint. Ironically, the wording of the equal value condition is borrowed from the pre-Maastricht procedure whereby the currency amounts in the ECU basket were subject to periodic readjustment in order to prevent the currencies which had appreciated from acquiring ‘excessive’ weight in the basket; it is the Treaty itself that has discontinued this practice in order to ‘harden’ the basket ECU in preparation for monetary union. At realignments in the past, the ‘external’ value of the ECU has always changed but the Maastricht Treaty requires that on 1 January 1999 it must not change. One practical effect of the Treaty provision would therefore be to discourage the Member States from considering ‘one last realignment’. Publicly to announce this might provide some reassurance to the markets. However, the provision also effectively rules out two alternative measures which have been suggested (see Section III above) as possible ways of reducing market volatility - pre-announcing either a particular set of conversion rates or a market-related formula from which conversion rates would be derived. This is because there could be no certainty that the external value of the ‘basket’ ECU implied by the constellation of market exchange rates for the component national currencies on the day (or eve) of the ‘irrevocable fixing’ would be exactly the same as the ‘external’ value of the ECU as ‘a currency in its own right’ that was derived from the pre-determined set of conversion rates and the ‘external’ exchange rate of any of the national currencies (see Annex II, Section 3).

The above analysis of the choice of conversion rates and the maintenance of continuity in the value of the ECU is based on the implicit assumption that all Member States whose currencies are represented in the ECU

17 Any attempt at ‘rounding’ market exchange rates to make the new conversion rates between national currencies and the ECU more consumer-friendly would also have to meet this requirement.