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.

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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