Part 6 – Economic and Monetary Union: learning to walk before we can run

In the period 1970-71, the international financial markets got increasingly out of control due to the fiscal policies being pursued by the Nixon administration in the USA. Finally, in August 1971, the Bretton-Woods International Monetary System collapsed. The effect of this, as far as the six member states of the European Community (EC) were concerned, was to allow each country to follow different monetary policies, despite the spirit and intention of the EC treaty. Not unexpectedly, this new situation led to exchange rate tensions arising among them.

Disruptive economic conditions made any ambitious project for monetary union a very difficult enterprise. Equally detrimental to the European project were divergences of opinion among the EC countries regarding the implementation of The Werner Report proposals.

In France, the Gaullists regained political strength and this led to a re-nationalisation of French monetary policy. Georges Pompidou, the President of France, would not move towards a pooling of national sovereignty in monetary matters and he was not in favour of the proposals of a political union, which the Federal Republic of Germany (FRG) government maintained would be necessary for any prospective Economic and Monetary Union (EMU). At that time, the French President was mainly interested in short-term monetary assistance.

To compound the problems, skepticism about the proposals that Willy Brandt had made at the Bonn EC summit meeting soon emerged in the FRG, as well. On the one hand, proponents of an accommodation with the Americans were still very strong. On the other hand, the success of the FRG model in the economic turbulence of the early 1970’s suggested that a strategy of national autonomy was the best viable option.

Europe had been seriously weakened by the currency turmoil in the late 1960’s and early 1970’s. The combined effect of the devaluation of the French franc, the upward revaluation of the Deutsche mark and the collapse of the Bretton-Woods system had all contributed to the destabilisation of the European economies. Furthermore, the exchange rates between the currencies of the EC member states had to be fixed before a proper common market could be created.

The FRG Minister for Finance and Economic Affairs, Karl Schiller was known for his austere financial policy and advocated a rigorous stability policy in order to resolve the crisis. Schiller wanted all the EC currencies to float. Pompidou, and his Finance Minister, Valéry Giscard d’Estaing, opposed Schiller’s proposal and preferred to fix parities via exchange rate controls. The Germans rebuffed such an interventionist approach. France was above all trying to avoid an overvalued French franc, since that would harm French exports and might slow economic growth and even lead to social unrest. Eventually, France and the FRG reached agreement on how to achieve monetary stability. The Smithsonian Agreement, signed in Washington on 18 December 1971, set new parities between European currencies and the US dollar. It also introduced what was known as the currency tunnel, which extended the exchange rate fluctuation margins of the main European currencies to 2.25% around a central rate.

On 10 April 1972, at a meeting in Basle, the Committee of Governors of the European Central Banks introduced an additional mechanism to further narrow the exchange rate fluctuation. Accordingly, the Basle Agreement set up the European currency snake in the tunnel. The snake entered into force on 24 April 1972 and allowed the Central Banks of the EC countries to buy and sell their currencies provided that the spread between the exchange rates for any two currencies at any given time did not exceed 2.25 %, or half of the authorised margin (4.5%) between any one of these currencies and the dollar (“the tunnel”). The snake therefore reduced the tunnel to half its size. While their EC accession procedure was under way, the UK pound, the Irish punt and the Danish krone were allowed to join the snake on 1 May 1972. But these three currencies, not unlike the US dollar, came under speculative attacks and were forced to leave the exchange-rate mechanism a few weeks later.

The tunnel eventually collapsed in 1973 when the US dollar was allowed to float freely. The mechanism of the snake continued although it eventually proved to be unsustainable, with several currencies leaving and in some cases rejoining. By 1977, it had become an unofficial Deutsche mark exchange rate zone with just the Belgian and Luxembourg franc, the Dutch guilder and the Danish krone tracking it.

The 19 October 1972 marked a very important milestone in the advancement of the EC for a number of reasons. By special invitation, the four future new members of the EC, the United Kingdom, Denmark, Ireland and Norway, attended a summit meeting of leaders of the EC countries for the first time. The summit meeting was convened by Pompidou and it was held in Paris. The summit was the culmination of a number of preparatory meetings to decide on the way forward for the expansion, development and consolidation of the Community. At the conclusion of the summit the heads of the ten states issued a sixteen point joint declaration.

The declaration stated, among other aims, that “The Member States have resolved to strengthen the Community by forming an Economic and Monetary Union, as a token of stability and growth, as the indispensible basis of their social progress and as a remedy for regional disparities” and that “The required decisions will have to be taken “during 1973 to allow transition to the second stage of the Economic and Monetary Union on 1 January 1974 and in view of its complete realization by 31 December 1980 at the latest”. In addition, the following was also stated “The Heads of States and Government have assigned themselves the key objective of converting, before the end of this decade and in absolute conformity with the signed Treaties, all the relationships between Member States into a European Union“.

In his reaction to the mention of European Union in the declaration, the President of the EC Commission, Sicco Mansholt, stated that “politically speaking [it] was the key concept to emerge in Paris” and remarked that this term could mean “much or nothing”. He went on to say that “in the end, everything would hinge on the resolve of people, the Governments and the Community Institutions”. He added that personally he thought that the outcome would be neither a federation nor a confederation but something “sui generis” (ie. of its own kind, unique), which should take into account the history of the peoples of the Member States and their hopes. At any event, added Mansholt, the future Union should have autonomous powers of decision; in other words, a government, and be responsible to a Parliament democratically elected.

On 1 January 1973,  the United Kingdom, Denmark and Ireland officially joined the EC. Norway had also been expected to join the EC but the ratification in Norway failed and so this did not happen.

On 18 February 1974, the EC Council was unable to reach agreement on the transition to the second stage of economic and monetary union owing to deep disagreements between the member states. The process of implementing the Werner Report was therefore, de facto, suspended. But the Council adopted several important measures for the economic component of the future economic and monetary union – the decision on the realisation of a high degree of convergence of economic policies (also known as the “convergence decision”), the directive on stability, growth and full employment in the Community and the decision to set up an economic policy committee by merging the Conjunctural Policy Committee, the Budgetary Policy Committee and the Medium-Term Economic Policy Committee.

During 1975, the European Council was formally established and comprised of the heads of state of the EC member countries. Previously, summit meetings of the leaders of EC countries had taken place on an ad-hoc basis, as and when necessary. This new body was different to the Council of the European Communities (“the Council”), which was the institution set up in terms of the EC Treaty with legislative powers and consisted of representatives from each of the EC member countries. The Commission of the European Communities (“the Commission”) was the EC executive body responsible for proposing legislation to, and implementing the decisions of, the Council. In addition, the Commission monitored the adherence of the member countries to the provisions of the treaties and managed the day-to-day business of the EC.

The oil crisis of 1973 and the ensuing stagflation, were of fundamental importance to induce changes in the conceptions of French economic policy-makers. These world events showed very clearly that the openness of the French economy made it vulnerable to external developments. The effects of the oil crisis on the French economy made the French government aware that there were limits to activist economic policies, and that France had to take into account the external constraints. In 1976, Raymond Barre was appointed Prime Minister of France, while retaining the Economics and Finance portfolio. Barre had taken over the Economics and Finance portfolio when Giscard d’Estaing replaced Pompidou as French President. French economic policies then became more stability oriented. The exchange rate became a crucial element in the strategy to instill discipline on the French economy and Barre also pushed through measures to liberalise prices and moved towards a more classical, market-driven economic model.

On 20 October 1977, the President of the EC Commission, Roy Jenkins, revived the monetary union project and put forth a strong plea for the EC to pursue the objective of the European Monetary Union, initially envisaging movement towards a single European currency and monetary authority. He claimed that such a union would lower inflation, increase investments and reduce unemployment. While not espousing such an ambitious objective, Helmut Schmidt, who became Chancellor of the FRG in 1974, took up Jenkins’ initiative to make progress towards greater integration and co-operation in the EC monetary sphere. Supported by d’Estaing, he presented his ideas at the European Council summit meeting in Copenhagen on 7 April 1978. Political consensus was reached to proceed with the creation of a European exchange rate system defended by common reserves.

On 7 July 1978, at a European Council summit meeting in Bremen, Schmidt and d’Estaing presented their final version of the proposed common monetary system to the other leaders of the EC member countries. There had, by then, become a pressing need to stabilize the currency exchange rates among the EC countries. In addition, European leaders were becoming increasingly worried about the stagnation of the European integration process and the ensuing risk that the achievements of the past could fall apart. The monetary system proposals were generally well received by all the EC countries, except for the UK who rejected the plan. The conclusions of the meeting did not mention an economic and monetary union but a “scheme for the creation of closer monetary co-operation leading to a zone of monetary stability in Europe”. The principal aim was to reduce the disruptive impact of the sizable exchange rate devaluations and regulate changes in parities.

On 4 December 1978, at the European Council summit meeting in Brussels, the plan was approved and the scheme came into operation 0n 13 March 1979 with eight (France, the FRG, Belgium, the Netherlands, Italy, Luxembourg, Ireland and Denmark) of the the nine EC countries participating in it. The UK declined to join the scheme.

This “closer monetary co-operation scheme” became the European Monetary System (EMS). The EMS was launched against considerable skepticism, especially from academic economists but also from monetary experts. However, the political leaders who succeeded in getting it off the ground claimed that they had achieved “a victory of political intuition over expert opinion”.

The intention was to make the EMS become an improved and more flexible monetary snake. The more limited objectives of the EMS were also reflected in the legal framework of the exchange rate mechanism and this would take the form of an agreement between the central banks of the member states.

Monetary stability, the objective of the EMS, had a double dimension, internal and external. This was a compromise and synthesis between the ideas of the “monetarists”, led by France, emphasizing the importance of external stability (exchange rate stability) and of the “economists”, led by the FRG, advocating internal stability (price stability) and the co-ordination of economic policy. These two opposing schools of thought had dominated the debate on monetary matters in Europe.

The monetarist position maintained that the creation of a monetary union would provide the stimulus for deeper economic integration and that economic integration would automatically follow on from that – the locomotive theory.

The economist position maintained that economic structure and economic performance have to converge first; this process may be accompanied by institutional changes and this could ultimately lead to a monetary union – the coronation theory.

The “coronation theory” was the dominant theory in the FRG. This theory contended that just a small core of countries should be admitted initially to an economic & monetary union and only those countries whose economies came closest to the necessary degree of homogeneity. Other countries might be admitted eventually, but only once they achieved the requisite competitiveness and fiscal convergence. EMU membership would be the last “crowning” step in a process of attaining that goal.

The “locomotive theory” was the dominant theory supported by France and some other EC countries. This theory argued, by contrast, for a union that would be as inclusive as possible. A larger number of countries would be part of the union at inception. It would then be expected that the rigorous demands and the institutional constraints of a monetary union would act as a locomotive to pull any errant members along, compelling them to undertake the reforms needed to compete effectively.

In the end, the locomotive theory prevailed and this thinking influenced the decisions made up to the inception of the European Monetary Union in 1999.

The basic elements of the EMS were: the definition of the European Currency Unit (ECU) as a basket of currencies; and an Exchange Rate Mechanism (ERM) based on the concept of fixed currency exchange rate margins, but with variable exchange rates within those margins. Exchange rates were to be based on the ECU, whose value was determined as a weighted average of the participating currencies.

Officially, no currency was designated as the anchor. However, the Deutsche mark and the Bundesbank were, unquestionably, the centre of the EMS. All other currencies followed their lead. Monetary co-operation became closer and the links between National Central Banks (NCB) were strengthened. Internal and external monetary stability became important goals. Domestic economic policies were instrumental in achieving exchange rate stability. Countries with relatively high inflation found it easier to pursue disinflation policies. This fostered a downward convergence of inflation rates, reduced excessive exchange rate volatility, and promoted trade and an improvement in overall economic performance. However, the lack of fiscal convergence remained a source of tension as some countries ran persistently large budget deficits.

The EMS lasted from 1979 until the launch of the euro in 1999. During these two decades it went through four main phases and several periods of turbulence.

The period from 1979 to 1985, represented the first phase of the EMS during which some countries still maintained capital controls in place and exhibited significant inflation differentials. Together with fixed nominal exchange rates, this resulted in continued mis-alignments that required frequent adjustment of the official parities. Full nominal convergence had not yet been established. Differentials in budget deficits and public debt were also substantial. The adjustment of official parities often occurred in the wake of financial market turmoil, which periodically brought up questions about the sustainability of the ERM. All in all, during this first phase, there were eight adjustments involving several currencies at the same time.

In May 1981, François Mitterrand became the first socialist president of France. He immediately implemented a strong socialist economic program, including an expansionary budgetary policy and nationalisations. This both increased and reinforced the divergence in policy measures between France and the FRG. The ensuing loss of competitiveness of the French economy and the on-going capital outflows repeatedly put strong pressure on the French franc and this let to increases in interest rates and several devaluations. Faced with renewed heavy pressure on the French franc in early 1983, Mitterrand had to accept that his policies were not working. In order to avoid further devaluations of the French franc, he was then forced to pursue a more orthodox economic policy, the “politique de rigueur”.

This new policy was implemented by the French Finance Minister, Jacques Delors, and 1983 can be considered to be a turning point in the functioning of the EMS, especially in the relationship between the French franc and the Deutsche mark. The changes in the new French domestic economic and monetary policy created more stability, and a greater degree of economic convergence gradually developed in the EC. There was also greater stability between the currencies of the EC countries and there were far less parity changes.

By the mid-1980s the EC had grown to twelve members: France, the Federal Republic of Germany, Italy, the Netherlands, Belgium and Luxembourg, the United Kingdom, Ireland, Denmark, Greece, Spain and Portugal. Although the EC had produced a large number of directives and regulations, it was having problems in implementing them because the need for consensus made it difficult to move forward with the single market project. The enlargement of the EC also increased the pressure for change.

February 14, 1984 was a very significant date in the European Communities history. It was the first time that the European Parliament had really done anything of any significance.

Since its inception in 1958, the European Parliament had served largely only in a symbolic role. It existed to give the illusion that the democratic process underpinned the dealings of the EC. Then in 1979, to further strengthen the democratic illusion, the members of the European Parliament were directly elected for the first time. However, the assembly still wielded little or no power over the affairs of the EC.

In the 1979 elections, Altiero_Spinelli, a European federalist from Italy, was elected to the European Parliament as an independent member on the list of the EuroCommunist Party. He immediately set to work gathering together like-minded Members of the European Parliament to table a motion for the Parliament to set up a special committee to draft a proposal for a new treaty on European Union. The motion was successful and “the Committee on Institutional Affairs” was set up in January 1982 with Spinelli as Co-Ordinator and Mauro Ferri as Chairman.

On 14 February 1984, the European Parliament adopted the “Draft Treaty Establishing the European Union“, that had been complied by the Spinelli committee. The “Spinelli Draft”, as it became commonly known as, was a comprehensive set of proposals designed to establish a proper union of European states. The draft treaty was effectively ignored by most of the EC countries and so Spinelli made an appeal to the President of the European Council, France’s Mitterrand to help further his project. Mitterrand found some aspects of the Spinelli Draft appealing and decided to use it as a stepping stone to further his own EC aims.

On 25 June 1984, at a European Council summit meeting in Fontainebleau, Mitterrand suggested that a committee should be set up to consider the future institutional reform of the Community. The EC agreed to this proposal and the Committee for Institutional Affairs was formed, under the chairmanship of James Dooge, a former Irish foreign minister. The members of the committee would be comprised of representatives of the heads of the EC countries. The brief given to the Dooge Committee was to “make suggestions for the improvement of the operation of European cooperation in both the Community field and that of political, or any other, cooperation”. It’s interesting to note that the name given to the Dooge Committee was exactly the same name that the Spinelli committee called themselves, “the Committee for Institutional Affairs”. And in addition, reference to Spinelli’s draft Treaty was made in the Dooge Committee’s final report (Spinelli’s legacy).

On 29 March 1985, the Dooge Report was presented to the European Council summit meeting in Brussels. The report recommended that an Inter-Governmental conference be held “to negotiate a draft European Union Treaty based on the findings and recommendations in the Dooge Committee report and the Stuttgart Solemn Declaration on European Union and guided by the spirit and method of the draft Treaty voted by the European Parliament.”

In 1985, Jacques Delors became the President of the European Commission, and shortly after he took office, the Commission under the chairmanship of its Vice-President, Arthur Cockfield,  produced a white paper titled “Completing the Internal Market” which set out a timetable for the measures required for the completion of its single market by 31 December 1992 at the latest. In the report, 279 barriers to trade were listed, with a timetable for them to be abolished.

On 28 June 1985, at the European Council summit meeting in Milan, the findings of the Dooge Report and the Commission’s White Paper were discussed.  Despite opposition from Britain, Denmark and Greece, who feared that the institutional reform would erode national sovereignty, the Dooge Committee’s proposal for an Inter-Governmental Conference was accepted. The White Paper was also accepted by the European Council. Given the green light, the Commission set about to implement the decisions taken.

Delors wanted to advance the progress of an economic and monetary union by getting the single market programme included in the envisaged amendment of the EC Treaty, The Single European Act. However, since there was still some reluctance in France towards greater supra-national powers and structure, the Commission’s final amendment proposals contained only general objectives.

The single market idea was intended to be a soft and gentle approach by which the leaders of more skeptical member states, like the prime minister of the UK, Margaret Thatcher, could be encouraged to support, without appearing to be a move towards economic and monetary union. In addition, the FRG was reluctant to agree to anything that would impact upon their currency, especially if this was done by EC treaty and without proper ratification by their parliament. Delors was not going to give up on his project so easily.

“In ten years, 80% of the laws on the economy and social policy will be passed at a European not the national level…“

(Jacques Delors, European Commission President, 1985-1995)

All of these recommendations finally culminated in the drafting of the Single European Act (SEA), which was signed in Luxembourg by the 12 EC member states on 17 February 1986. The SEA came into effect in July 1987. The primary aim of the SEA was, to “add new momentum to the process of European construction so as to complete the internal market by 1992”. The SEA was the first major revision of the 1957 Treaty of Rome. The SEA amended the rules governing the operation of the European institutions and expanded the Community powers, notably in the field of research and development, the environment and common foreign policy.

The second phase of the EMS spanned from 1986 to September 1992. Several EMS members, but not all, managed to bring down their inflation rates towards the FRG inflation rate. In addition, the EMS had continued to be an unofficial “Deutsche mark area” of sorts, where the other members felt forced to follow the stability-oriented policy of the German Bundesbank or otherwise had to depreciate their currencies against the Deutsche mark to maintain parity. As a result, the feeling of disgruntlement toward the FRG and the monetary policy of the Bundesbank still existed, although all the EC countries were participants in the EMS.

According to the “impossible trinity” proposition, all the EC central banks participating in the Exchange Rate Mechanism (ERM) had “de facto” renounced their independent monetary policy.

The “impossible trinity” proposition, also known as the ‘trilemma”, defines a set of economic policies that a country is not able to manage together and at the same time in an open economy. The proposition contends that policymakers can implement only two out of three policy options, at any one time:

• free capital flows (ie. the absence of capital controls); and/or
• a fixed or stable exchange rate; and/or
• independent or autonomous monetary policy.

Although the aim of the EMS was to bring some stability to the EC currencies, constant difficulty was being experienced in trying to achieve this. Between early 1986 and January 1987 there were three more adjustments.

In 1987, the French Finance Minister Édouard Balladur, presented a memorandum that called for the creation of a new, less asymmetric monetary policy arrangement. This proposal was supported by Giuliano Amato, the Italian Treasury Minister, who issued a similiar memorandum. The essence of the Franco-Italian criticism was that the restrictive monetary policy pursued by the Bundesbank was, judged by economic conditions in many other EMS member states, too restrictive. To defend the fixed exchange rate, weaker countries were thus forced to follow, from their perspective, an inappropriately restrictive monetary policy. Free capital movements threatened to exacerbate this asymmetry. Without the option of capital controls, weaker countries could only attempt to put a stop to speculative capital flows by raising interest rates.

In 1987,  on the initiative of Helmut Schmidt, a social democratic and former chancellor of Germany, and Valery Giscard d’Estaing, a former president of France, the lobbying group “Association for the monetary union of Europe” (AMUE) was established. Founded by Fiat, Philips, Rhône-Poulenc, Solvay and Total, and supported by several hundred leading European multinational companies, including Volkswagen, Daimler-Benz, Commerzbank, Deutsche Bank, Dresdner Bank, BP, Alcatel as well as many major European banks, the AMUE quickly emerged as an important force in the debate on the EMU in the late 1980s and early 1990s. It objective was to act as a business pressure group for the adop­tion of a single currency in Europe. Membership of the AMUE was ‘open to any business, provided it shares the vision of Europe as a single-currency zone’. It held conferences, published research and undertook opinion surveys on issues of monetary integration and the transition to full EMU. The AMUE served to link pro EMU politicians with sympathetic business representatives and the group also collaborated closely with the European Commission in order to bring about their shared goal. Once stage three of EMU was achieved in 1999, the rationale for the organisation became less apparent and it wound up its operations soon thereafter.

In January 1988, in response to the Franco-Italian criticism of the EMS, the FRG Foreign Minister Genscher issued a “Memorandum for the Creation of a European Currency Area and a European Central Bank.” On the one hand, the memorandum constituted a break with the previous German standpoints in currency matters. Leaving behind a strictly economistic course, Genscher moved towards the monetarist position by accepting that economic convergence and monetary integration can happen concurrently. In doing so, Genscher was taking the initiative to carry out the much-needed reform of the European currency system, but at the same time representing the FRG’s position on the all-important issues of the day. In fact, Genscher’s memorandum underlined the need for economic convergence between member states, and the proposals made on the institutional structure of a European central bank were likewise based on principles which were rather German in nature, for instance, political independence and the primacy of price stability.

During this period, the on-going compromise between monetarist and economistic thinking caused all sorts of difficulties. A widely held view was that the Single Market was not expected to be able to exploit its full potential without a single currency. A single currency would ensure greater price transparency for consumers and investors, eliminate exchange rate risks, reduce transaction costs and, as a result, significantly increase economic welfare in the Community. In addition, it was evident that the EMS structure had severe short-comings, where all participating countries, except for the currency anchor country, had ‘de facto’ no control over their country’s monetary policy. Instead, a new currency and a common central bank would allow all EC member states to share influence over monetary policy decisions.

On 27 June 1988, at the European Council meeting in Hanover, Genscher’s memorandum was debated and consensus was reached to set up a dedicated committee to propose a phased plan for an economic and monetary union. The committee comprised of the central bank governors from each of the EC member states under the chairmanship of the President of the European Commission, Jacques Delors.

On 12 April 1989, after considerable wrangling and compromise in the committee, the final draft of the Delors Report was presented to the finance ministers of the EC countries.

The report was titled “Report on economic and monetary union in the European Community”.It foresaw the general objective of an economic and monetary union that would preserve the specific features of the various Member States.

“16. Economic and monetary union in Europe would imply complete freedom of movement for persons, goods, services and capital, as well as irrevocably fixed exchange rates between national currencies and, finally, a single currency. This, in turn, would imply a common monetary policy and require a high degree of compatibility of economic policies and consistency in a number of other policy areas, particularly in the fiscal field. These policies should be geared to price stability, balanced growth, converging standards of living, high employment and external equilibrium. Economic and monetary union would represent the final result of the process of progressive economic integration in Europe.

17. Even after attaining economic and monetary union, the Community would continue to consist of individual nations with differing economic, social, cultural and political characteristics. The existence and preservation of this plurality would require a degree of autonomy in economic decision-making to remain with individual member countries and a balance to be struck between national and Community competences. For this reason it would not be possible simply to follow the example of existing federal States; it would be necessary to develop an innovative and unique approach.”

The Delors Committee were very careful to try to present a set of proposals that would find acceptance from all EC member states. To this end, the report issued a clear stability-oriented mandate and outlined the political independence of the new central bank, with the need for an absolute minimum of economic convergence prior to introducing the new currency. On the other hand, the commission called for the speedy establishment of a new European system of central banks (EuroSystem) and a European Central Bank (ECB) in the second phase of the transition to the monetary union. The report proposed that a single European currency be introduced in three successive stages, beginning on July 1, 1990 at the latest and concurrent with the removal of capital controls. In the final stage, Member States could only participate in the union if they could show a high degree of lasting convergence confirmed by the fulfillment of four economic criteria (inflation, long-term interest rates, fiscal debt and deficit, and exchange rates).

On 26 June 1989, at the European Council meeting in Madrid, the Delors Report was accepted by the leaders all the EC Member States. The Ecofin Council, comprising all of the finance ministers from each EC country was formally established and given a mandate to take the necessary measures to allow stage one to begin on the date indicated in the report (1 July 1990) and to undertake the work for the complete and adequate preparation of the Intergovernmental Conference provided for in this stage.

• Part 7 – Economic and Monetary Union: the EU and EMU become a reality