Alexandre Lamfalussy,
the President of the European Monetary Institute, outlines the nuts and bolts of monetary union
The European Monetary Institute
has a very heavy agenda. It is responsible for ensuring that all technical
preparations are completed in time for the decision as to which countries
should join Economic and Monetary Union (EMU) in 1999 - a decision which is likely
to be taken by our political leaders in December 1997 or January 1998.
It is enshrined in the Maastricht Treaty that the future monetary policy
of the European System of Central Banks (ESCB) has a primary objective of
maintaining price stability in the monetary union. However, the treaty leaves
open the means of achieving this. At present, EU central banks have different
monetary strategies, which have generally evolved as a consequence of historical
events, economic and financial structures and the influence of financial
innovation. When EMU begins, the ESCB must make a choice. Options most widely
discussed are the use of a monetary aggregate as an intermediate target
of monetary policy, as in Germany, or to target inflation directly, as in
the UK. I am confident that we shall come up with a consensus view on this
issue.
Work is also under way on the instruments that will be used by the ESCB
in the implementation of monetary policy. This is a more technical field,
but it is here that I foresee genuine problems. The instruments must be
efficient and market-oriented and lend themselves to decentralised implementation.
They must be sufficiently harmonised to ensure that uniform decisions must
be reached early enough for the existing systems to be adjusted in time
for EMU. Here again, central banks of the member states have different ways
of guiding money market conditions; they typically have a package of instruments,
including compulsory reserves, standing facilities and open market operations,
which together allow the central bank to influence short-term market interest
rates. A simple compromise between the various systems which took elements
from each of the national central banks' current systems would more than
likely be unmanageable. Hence, firm decisions are required, taking into
account both the advantages and disadvantages of each instrument, for example,
weighing the costs of compulsory reserves as a 'tax on banking' against
their benefits in terms of monetary control. Behind the veil of technicalities
lie many traditions and, more importantly, vested interests.
Another area where lead times are long is the large-value payment systems
infrastructure. For a single monetary policy, it is essential that an infrastructure
exists which allows the various national money markets of the present day
to be effectively one money market with one interest rate structure for
the single currency. Equally, the system must be safe and minimise the risks
to which payments systems are subject.
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But these preparations will only be of practical use if EU countries
are ready for EMU in time. To ensure that monetary union is viable and sustainable,
the Maastricht Treaty provides that no member state can enter EMU unless
the Council of Ministers concludes that it 'fulfils the necessary conditions'
in terms of convergence to do so. The emphasis is on price stability, sustainability
of fiscal positions, exchange rate stability and convergence of long-term
interest rates. Here too, the EMI is assigned an important role. In the
course of 1996 and, more importantly, for the end of 1997, it must prepare
a report to the European Council which will - together with a report by
the Commission - serve as the basis for the assessment of convergence by
the Council and its recommendation to the Heads of State of Government on
the composition of monetary union.
Where do we stand now in the process of convergence? Concerning price
stability, the picture is quite bright: member states have made remarkable
progress since 1990. This is reflected in average inflation in the EU, which
stands at a historical low of around 3 per cent; ten years ago, it stood
at around 8 per cent. In many EU countries, virtual price stability
(ie an inflation rate of 2 per cent or less) has been established, and there
was a marked deceleration in inflation rates in those countries which entered
the 1990s with the highest inflation rates. The relatively favourable overall
inflation performance was certainly due, in part, to the severity of the
recession in the early 1990s. But much more important is the fact that price
stability has, for some time, been accepted in the EU countries as one of
the major objectives of economic policy in general and as the primary objective
of monetary policy. As a result, 'home-made' inflationary processes in many
countries have been brought under control.
However, risks remain. The significant exchange rate changes seen in
1995 could, if sustained, pose a threat to price stability in the countries
whose currencies have depreciated, as underlined by increased inflationary
pressures in countries such as the UK, Italy and Sweden. Wage pressures
may increase as the scope for income increases. Expectations of agents in
the economy and credibility of the authorities are essential to subduing
price pressures. Nevertheless, even with all these qualifications I feel
that we are on track in achieving price stability.
Despite the turbulence in international bond markets in 1994, the long-term
interest rates of individual countries have moved broadly together. As a
result, the pattern of convergence of long-term interest rates is similar
to that of inflation.
Public finances are the weakest point of convergence. The overall public
sector deficit in the EU in 1994 amounted to around 5.5 per cent of GDP
- the highest level since the founding of the EC and almost twice the maximum
of 3 per cent allowed under the Maastricht Treaty. Despite a strong
economic recovery during 1994-95, the overall public deficit is expected
to decline only marginally. Most member states have imbalances of over 3
per cent; only Denmark, Germany, Ireland and Luxembourg are expected to
have deficits below 3 per cent in 1995. The worrying features of the
rise in deficits since 1990 are that only a relatively small part of the
deterioration can be attributed to the recession; and the rise in deficits
was accompanied by a significant expansion in the share of the public sector
in the economy. The government debt ratio in the EU has also soared above
the 60 per cent limit, reaching 68 per cent in 1994 and an anticipated 70
per cent in 1995. Debt ratios have a particularly wide range: ten countries
have debt/GDP ratios in excess of 60 per cent and Italy, Greece and Belgium
have debt ratios of well above 100 per cent. For most EU countries, fulfilling
the fiscal criteria will certainly entail a substantial effort in reducing
deficits and restraining public expenditure, but these objectives are in
any case essential to cope with future challenges such as the ageing of
the population.
To top
On
balance, I must acknowledge that it seems likely that only a limited number
of EU member states will be able to take part in EMU in 1999. But this should
not be seen as disastrous; quite the contrary, it would be highly damaging
for the monetary union to include states that have not converged. The treaty
allows quite explicitly for EU countries to join EMU at a later stage. It
is important, however, for there to be appropriate exchange rate arrangements
between EMU and non-EMU countries which will facilitate convergence of the
latter. Such an arrangement will require both co-operation and co-ordination
among central banks, continuing that already being developed with the help
of the EMI prior to EMU.
Setting aside all the problems we are facing in the technical preparation
of monetary union which, I am sure, we shall be able to solve, there are
three main challenges which we are going to encounter. To be able to meet
them will require both political will and political wisdom.
The first, of course, will be the selection of the countries which will
be judged eligible for irrevocably locking their exchange rates on 1 January
1999. We intend to give firm advice to the politicians who will make this
decision - and by firm, I mean maintaining strict adherence to the convergence
criteria. I hope that the commission will follow the same line. But the
final decision belongs to the heads of government and heads of state. It
seems to me of paramount importance that their decision should be based
on an assessment as to which countries should lock their exchange rates
without putting at risk the proper functioning of monetary union. We cannot
afford to fail because, if we fail in this respect, there would not be a
second opportunity for a very long time indeed.
The second challenge is the co-existence of a core monetary union with
EU countries outside the Union. It is arguable that the countries outside
monetary union could suffer exchange rate instability, which could threaten
the single market. We have to envisage, I believe, an arrangement which
would help to ensure the stability of real exchange rates for those non-EMU
members which maintain prudent and convergence-oriented policies. It is
in everybody's interests to find a workable solution. A credible system
of this kind combined with stability-oriented domestic monetary policies
should ensure that interest rate premiums remain low and that convergence
of non-members is aided, enabling them to join the monetary union at an
earlier date. To avoid making the initial choice of eligible countries even
more difficult than it will in any case be, we should reach a consensus
view on how to meet this second challenge well before the 1997-98 summit
meeting.
Last but not least, we shall have to deal with the potential conflicts
arising from an inappropriate mix of monetary and fiscal policies after
the locking of exchange rates. The risk of the wrong policy mix will be
small at the start of monetary union, but might be greater in the long term,
if we are not careful.
Despite the crises and the scepticism, I believe that EMU remains on
course. The Maastricht Treaty has been ratified by all member states, three
new members have joined the EU and the institutional preparations for EMU
are well under way. Convergence under the Maastricht Treaty is also under
way - although progress in fiscal consolidation remains essential. The economic
case for EMU remains sound. Politicians are aware of what is at stake. On
balance, and while not underestimating the economic and political difficulties,
it has to be emphasised that the most important requirement for EMU is the
political will to move towards further integration.
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©Kensington Publications 1996