1. The Breyer Center for Overseas Studies in Florence Bing Overseas Studies Program Stanford University Academic Year 2009/2010 European Economic and Monetary Integration 6th Lecture – II Part, November 2, 2009 From the European Monetary System (EMS) to European Economic and Monetary Union (EMU) Instructor: Prof. Pompeo Della Posta peoposta@ec.unipi.it

2. Why the Euro? But first: why fixed exchange rates in Europe? Let’s step back and see what is the “Long road” that lead to the Euro, that passed through the establishment of a fixed exchange rate system, the European Monetary System, created in 1979. The Treaty of Rome contained no commitment to EMU. The 1969 Hague Summit envisaged EMU by 1980, but the initiative (formalized with the Werner Report) failed in the face of the monetary instability of the 1970s. In 1971-72 the fixed exchange rate system of Bretton Woods, based on the dollar, collapsed. The European currencies had benefited of a period of stability and of relative certainty about the conversion rate of one currency against another. This was very beneficial for European trade.

3. After the collapse of the BW system, the European countries started thinking about a new monetary arrangement assuring certainty about the European exchange rates. After the failure of the ‘snake in the tunnel’, created in 1972 (that by 1973 had become a ‘joint float’ of currencies linked to the D-mark against the dollar), this lead to the creation of the European Monetary System in 1979. The main reason for fixed exchange rates in Europe and for the euro later on, then, has to do with the openness of European countries to each other, namely to the high intra-European trade: while each single European country is rather open (with some of them very open – characterized by an import/GDP or export/GDP ratio close to or even higher than 1), Europe altogether is as open (or as close) as the US or Japan (with a ratio slightly above 10%). The need to adjust for agricultural prices in different countries as a result of the fluctuations in exchange rates, for example, implied a lot of administrative costs, and the need to compensate the farmers of the countries whose exchange rates had been appreciating.

4. Moreover, for Germany, the fluctuation of the Deutsch Mark against the other European currencies implied its strengthening i.e. its appreciation: a stronger DM implied a lower German competitiveness (German goods were more expensive). A further reason for joining a fixed exchange rate system was represented by the need to face the high inflation rates that were plaguing many European countries also as a result of the first oil shock.

5. A fixed exchange rate system allows importing anti- inflationary credibility from abroad: “weak countries” may benefit of the reputation of the strong, anti-inflationary foreign Central banks (like the Bundesbank): the private sector might not believe in the promise by the domestic Central bank not to print money (thereby producing inflation) if it recognises that the CB might have that incentive at some point. The only way to convince the private sector is “to tie one’s hands” by finding an exogenous anchor (Ulisses and the sirens). We will analyze credibility theory next time.

6. The European Monetary System In 1979, the European Monetary System was established and entailed: the exchange rate mechanism; introduction of the ECU; a divergence indicator; and monetary co-operation. The ECU was the forerunner of the euro The EMS was supposed to be a symmetric system (all countries at the same level, thereby both weak and strong countries intervening to stabilize the exchange rate), but it soon become asymmetric: the DM was playing the same role as the $ was playing in BW (and as the British £ was playing during the Gold Standard period). Germany provided the anchor for the system, using the money supply to control German inflation.

7. The European Monetary System went through several phases: 1979-1983: pragmatism made of easy and unconditioned exchange rate realignments; 1983-1987: gradual tightening of the participation conditions; 1987-1992: full rigidity i.e. no exchange rate realignments. After the currency crisis of September 1992. In August 1993 most ERM margins were widened to +/- 15 per cent.

8. In 1992, just after the approval of the Maastricht Treaty that decided the passage to the EMU, the EMS was subject to a series of speculative attacks: the Italian lira was devalued in September 1992; the British pound soon after; the Spanish peseta, and the Portuguese escudo, etc. In 1993 the French Franc was also attacked and the system de facto ended: the fluctuation margins were widened enormously so that it become a flexible rather than a fixed exchange rate system.

9. Why did the EMS collapsed? 1. German reunification –The risk of inflation resulting from the high demand for goods coming from the former East Germany induced the Buba to increase the interest rates (since it was not possible: a) to prevent the conversion of East German D-marks into Western D-Marks with a conversion rate equal to 1; b) to revalue the D-Mark given the opposition of France). Higher German interest rates, however, were not acceptable for the other European countries for several reasons (public debt in Italy, unemployment in France etc.), so that the German monetary policy could not be accepted by the follower countries.

10. 2. Liberalisation of capital movements: the “Inconsistent Trinity” (as a result of the Mundell-Fleming Model, see class explanation).

11. During the first period of the EMS (1979-83) participating countries maintained controls on capital movements and there were frequent realignments of exchange rates. After 1983 Italy and France managed to acquire exchange rate stability but only through losing autonomy for monetary policy and recourse to capital controls. Britain realised free capital movements during the 1980s, but only at the cost of exchange rate stability. The Single Market and EMS implied a commitment to free capital movement with fixed exchange rates. This system could survive only as long as the other ERM countries were prepared to sacrifice monetary autonomy and accept German policy leadership.

12. After re-unification this was no longer the case and the system broke down. EC countries regained a degree of monetary autonomy, but at the price of sacrificing fixed exchange rates from August 1993. The way forward proposed by the Treaty of Maastricht was to combine the first two elements of the list with a common monetary policy for the euro area.

13. 3. Divergent behaviour of “weak” inflationary countries and excessive rigidity of the last phase of the EMS 4. Self-fulfilling speculative attacks (the case of France).

14. During the late 1980s, the objective of EMU was revived for a number of reasons: Exchange rate uncertainty between the EC currencies was another obstacle to trade that should be eliminated in the internal market. The aim was to take the relatively successful experience of co-operating in the EMS one step further.

15. The boom of the late 1980s was beginning to flag so methods of prolonging business confidence were needed. EMU could push the integration process further towards political union. The EC Commission (and Delors in particular) and the French and German Governments (despite the hesitancy of the Bundesbank) were active in re-launching the initiative.

16. The main provisions of the Maastricht Treaty with regard to EMU were: Convergence criteria a country has to meet before it could participate in EMU, though allowance was made for certain countries opting out. A timetable for the three stages in introduction of a single currency. The main institutional features of EMU and, in particular, of the European Central Bank.

17. Convergence criteria contained in the Maastricht Treaty: In order to participate to the EMU, European countries had to satisfy 5 criteria: Deficit/Gross Domestic Product < 3% Public Debt/GDP < 60% Inflation criterion: Inflation higher by no more than 1,5% than the average inflation rate of the three more “virtuous” countries

18. Interest rate criterion: Long term interest rate higher by no more than 2% than the average inflation rate of the three more “virtuous” countries; Exchange rate stability: the exchange rate should not be subject to “fundamental instability” during the two years preceding the EMU

19. The Maastricht Treaty and the three stages to get to the EMU: 1990-1993 Liberalize capital movements and introduce long- run convergence programs; 1994-1996 (or 1998) Refine the convergence process; arrange the appropriate institutional modifications; create the European Monetary Institute (forerunner of the ECB)

20. 1999: start of the EMU (but with no real banknotes: the euro was just a unit of account that replaced the previous unit of account, the ECU (2002: actual introduction of banknotes in euro).

21. Key Dates in the EMU Programme 1 1989 Delors Report on EMU. 1990 Beginning of stage one and abolition of capital controls in July for most member states. 1993 Maastricht Treaty. 1994 Stage 2 of EMU begins with the creation of the EMI. 1995 The Madrid European Council announced that the third stage would be launched from 1999, and adopted the name ‘euro’ for the single currency. 1996 Stability and Growth Pact agreed at the Dublin European Council.

22. Key Dates in the EMU Programme 2 1998 The European Council of May decided on the euro members, and fixed the exchange rates between the currencies of the participating countries irrevocably. May/June 1998 The President and Executive Board of the ECB were chosen, and it came into operation from June.The ECU is converted into the euro, and the third stage of EMU began. In May 1998 the 11 countries wishing to adhere to the EMU, including Italy - which had been hesitating and considering a two-speed EMU until it was clear in 1995 that Spain wanted to participate to EMU from the very beginning – did so. 2001 Greece joins.

23. Key Dates in the EMU Programme 3 2002 Euro notes and currencies introduced, and national currencies withdrawn. 2005 Reform of the Stability and Growth Pact 2007 Slovenia joins. 2008 Cyprus and Malta join