Economic and Monetary Union.
ECONOMIC AND MONETARY UNION
For many, the launch of euro bank notes and coins in 2002 will symbolise the greatest achievement in post war European integration since the Treaty of Rome. For others it represents a premature step on the road to closer co-operation. This analysis will approach the contentious issue of Economic and Monetary Union by drawing upon two related themes: adjustment and co-ordination. The first will be situated within the debate surrounding the pros and cons of EMU participation. The second will consider the actual operation of EMU and the policy architecture, which governs its behaviour. The investigation will conclude with a brief introduction to the debate surrounding the UK's involvement with Economic and Monetary Union. But first there will be a short consideration of the political issues relating to EMU.
THE POLITICS ECONOMY OF EMU
As is usual in the case of the EU it can be argued that EMU is an economic means to a political end, increasing political integration. EMU had its political roots in the problems of the EMS, principally that for a stable system other Member States had to adjust their economic policy to conform to Bundesbank monetary policy. It came to be seen that a share of pooled sovereignty over monetary policy, was better than a largely illusory national sovereignty. This was particularly the case since increasingly governments were delegating monetary policy to independent national central banks. So the change to an independent European Central Bank did not seem that great. Since such a bank would set monetary policy based on the needs of the EMU area, rather than just one country, this seemed a distinct improvement. The extent of monetary independence exercised by such a bank, by virtue of the size of the area and its limited external trade, would be much greater than that enjoyed under EMU.
Another impetus for EMU was provided by external events, with the fall of the Berlin Wall in 1989, German unification became a realistic possibility. This conjured up fears in the rest of the EU particularly in France. A reunited Germany would be by far the largest country in the EU. Reunification could draw a line under Germany's rehabilitation and a more independent Germany could emerge. With Germany's traditional hinterland in Central and Eastern Europe, also emerging from Communist rule, there was concern that Germany's attachment to the EC could diminish. Ultimately reunified Germany raised fears of a militaristic past. EMU was regarded as way of tying Germany more closely into the EU, under these changed circumstances. Given Chancellor Kohl's pro-integration views and his desire to achieve reunification, giving up the Deutschmark was a price well worth paying.
The EMU system raises some interest issues of governance such as the legitimacy of the ECB, and the operation of the coordination of fiscal policy under the Stability and Growth Pact (SGP). EMU differs from national monetary unions because it does not have a powerful federal government. There is no, well coordinated and strong, governmnet counterpart to the very independent ECB. There is concern that this means that democratic accountability in the system is weak, this it could be argued may be more apparent in EMU, but is inherent in the delegation of monetary policy to an independent technocratic grouping. It is possible to argue that what is important is not democratic accountrability within the system, but that the systems rule were established by a democratic process.
The SGP is interesting because national governments have voluntarily chosen to restrict their fiscal policies (the balance between government expenditure and revenue). The system chosen to do this an unique mix of hard law (with steep penalties) and soft law (with no penalties) only pressure from peers and public opinion. There are questions over whether the penalties will apply and whether nation states will abide by the rules.
ADJUSTMENT
Economic and Monetary Union contains a number of components.
* A single currency, the euro.
* A single monetary authority: the European Central Bank (ECB)
* A single interest rate in the euro zone.
* A common exchange rate vis-à-vis the rest of the world.
* A co-ordinated approach to economic policy.
The initial analysis of EMU will take the form of a cost benefit analysis. As we might expect, the basic premise is that participation in EMU is favourable if the benefits outweigh the costs. The benefits of participation tend to be improvements in microeconomic efficiency, while those costs are largely macroeconomic associated with adjustment.
The Benefits of a Common Currency
. Direct gains from elimination of transactions costs: Estimated to be around 0.5% of GNP, the gains are small because most international currency transactions take place in large amounts where margins are smaller. Gains are larger for consumers and small firms.
2. Welfare gains from reduced uncertainty: Individuals and companies are generally risk averse so by eliminating one source of uncertainty caused by fluctuating exchange rates monetary union should improve welfare.
3. Elimination of transactions costs and uncertainty and competition: The use of different currencies acts as a very significant NTB because they add to the costs of trade and increase uncertainty. This means that competition between countries even within a single market such as the EU will be reduced. Using one currency will enable companies to buy their inputs where they are cheapest today without worrying that exchange rate changes will eliminate the price advantage in the future. Thus the single currency will lead to gains from specialisation and economies of scale. It potentially could encourage greater regional specialisation within the EU.
4. Reductions in prices: price differences across the EU should be reduced, as consumers are able to compare prices directly and to pay easily across national frontiers. Both these effects are of course enormously enhanced by the potentialities of e-commerce.
5. Exchange Rate Uncertainty and Economic Growth: Since the use of a single currency reduces one source of uncertainty within EMU it could be argued that it leads to a lower level of interest rates. If this is correct the level of investment should be higher. In the neo-classical growth model this will only lead to a temporary increase in growth (the long run growth rate is determined exogenously by the rate of technological progress and the rate of population growth). In endogenous growth models increased investment could raise growth by raising productivity as a result of economies of scale or possibly technological improvements.
The problem with this argument is that fixing exchange rates has not eliminated risk it has merely shifted it. Thus the risk now is that the adjustment to shocks may be less efficient. So the question of the impact of EMU on risk, investment and growth is an empirical question. There is not an established empirical link between exchange rate stability and economic growth or between country size and economic growth.
6. Seigniorage: If the € became accepted as a stable rival to the $, countries and individuals could be expected to hold significant reserves of the currency. So in exchange for paper money the monetary authorities of the EC would acquire the ability to buy overseas assets. The return on assets acquired as a result of the issue of paper money is called seigniorage. There is another kind of seigniorage problem associated with membership of a monetary union, this is because some governments with inefficient tax system may choose to finance some of their expenditure by printing money. It may be less costly for these countries to raise money by inflation than by taxation. The amounts raised can be quite large 1986-90 Portugal raised the equivalent of 1.9% of GNP by seigniorage revenues. But inflation imposes costs on the economy and all the Southern Europe countries have shown themselves able to finance their government activities through taxation.
We can also add a couple of macroeconomic benefits to this list.
7. Improved macroeconomic performance: The EU as a whole potentially has a greater macroeconomic autonomy than individual countries. The Commission study (Emerson et al, 1990) assumes that this ability will be used to create greater price stability and that this will lead to higher growth. Both these assumptions are uncertain there is no guarantee that more independence in macroeconomic policy will lead to greater stability and that greater price stability will lead to increased economic growth.
8. Improved international economic co-ordination: With the EC as a single economic bloc, the EC, the USA and Japan could exert enormous influence over the world economic situation again co-ordinated stabilisation. This would depend upon agreement between the countries and although theoretically agreement would be easier with fewer players in reality this does not seem to be the case, in view of the fall in the value of the € against the $.
The costs of a common currency
In addition to the sunk costs of the changeover to a common currency, the most significant cost of a common currency concerns the loss of the exchange rate as an instrument of economic policy. The magnitude of this loss, depends upon:
* effectiveness of the exchange rate as an instrument of policy (considered last week).
* availability and effectiveness of other adjustment mechanisms.
* differences in economic preferences between countries.
* extent to which economic performance will differ between countries.
Differences in economic performance
Asymmetric shocks
Economic performance will be determined not only by the nature of the economy and government policy but also by random shocks e.g. oil price rises, the Russian crisis.
These shocks may be of various kinds:
* Long run: permanent
* Short run: temporary
* Demand: changes in preferences for a country's goods
* Supply: changes in the cost of inputs.
For shocks to be a problem for EMU they must have a significant macroeconomic impact on one country. If the impact is sub-national adjusting the XR would not help anyway. If the macroeconomic effect is felt across the union i.e. it is symmetric then a change in union policy will be the appropriate response.
The exchange rate may provide a short run solution to such a shock but the effects will be eroded in the long run. Even where there is no long run effect the use of the exchange may reduce the costs of adjustment.
Thus the problem associated with relinquishing the exchange rate depend upon the likelihood of asymmetric shocks and the effectiveness of the exchange rate adjustment.
A number of attempts have been made to ascertain the significance of asymmetric shocks by examining the correlation of rates of economic growth among European countries. This has not proved a very successful way identifying the extent of asymmetric shocks. Fluctuations in economic growth originate not just in external shocks but in national government policies. In addition observed fluctuations are after government stabilisation and so differences reflect the success of these policies as well as differences in shocks. More sophisticated methods seem to indicate the existence of a core where fluctuations from the normal growth path are correlated with Germany's this predictably includes Austria, Switzerland, France, Denmark and the Benelux countries. More peripheral countries with much lower correlations are the UK, Italy, Spain, Portugal, Ireland, Greece and Finland. (Bayoumi and Eichengreen, 1996)
Lucas critique
One fundamental problem with analysing a system change such as EMU is that there will be a shift in the behaviour of the economy so that the past will be a poor guide to future behaviour (the Lucas Critique). So joining EMU is likely to increase integration and lead to commonality of economic policy increasing the correlation of economic growth across the monetary union.
Differences in inflation rates
If different countries have different preferences with regard to unemployment and inflation, it could be argued that joining a monetary union would force a high ...
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Lucas critique
One fundamental problem with analysing a system change such as EMU is that there will be a shift in the behaviour of the economy so that the past will be a poor guide to future behaviour (the Lucas Critique). So joining EMU is likely to increase integration and lead to commonality of economic policy increasing the correlation of economic growth across the monetary union.
Differences in inflation rates
If different countries have different preferences with regard to unemployment and inflation, it could be argued that joining a monetary union would force a high inflation country to accept a higher level unemployment to achieve a lower rate of inflation. But if there is no long run trade-off between inflation and unemployment, i.e. the long run Phillips curve is vertical, then joining a monetary union would only cause a transitory increase in unemployment. Indeed EU countries achieved substantial convergence of inflation rates in the run up to monetary union. Although unemployment was high this was true for all countries it did not appear to be a problem for particular countries.
Other adjustment mechanisms
There are six main alternative adjustment mechanisms, which Member States can consider. These are analysed in some detail in Begg and Hodson (2000), so it suffices here to simply present a broad overview.
. Price flexibility
2. Wage flexibility
3. Mobility of labour
4. Mobility of capital
5. Fiscal policy (analysed with the Stability and Growth Pact)
6. Inter-jurisdictional transfers
Wage and price flexibility
If a country's goods are less competitive because of a negative demand or supply shock it is possible a reduction in domestic prices would have the same effect as devaluation. A necessary condition for price flexibility is wage flexibility since wages are the major element of costs under the employers' control. According to (Calmfors and Driffill, 1988) real wage flexibility can be achieved under two extreme wage bargaining systems:
* centralised national bargaining between employers organisations and trade union
* decentralised company/plant level bargaining.
In the first case the bargains have obvious macroeconomic effects so the trade unions are prepared to trade-off lower wage increases for higher levels of employment. This has been the situation in the Netherlands and Ireland. With decentralised bargaining wage increases will have a direct impact on the performance of the company and on jobs so trade unions have to be realistic in their wage demands. In between these two extremes the bargains are too small for trade unions to appreciate their macroeconomic impact in total and too large to accept the effects on individual firms.
The degree of flexibility of wages and the responsiveness of employment to output changes are likely to be enhanced by changes in labour market regulation. These changes could alter employment legislation making it easier to make workers redundant. This may encourage employers to expand employment more quickly if demand expands and it may act to dampen workers wage demands. Reductions in the replacement rate (unemployment benefits as a proportion of the average wage) and minimum wages may lead to expansion of employment for low skill and younger employees. Active labour market policies can try to make the labour market more flexible by ensuring workers have the right skills and qualities for the jobs that are available.
Labour mobility
There are two aspects to labour mobility:
. Geographical mobility: willingness to physically move between regions/nations.
2. Job mobility: willingness to change jobs within the same geographical locality.
If the demand for goods and services produced by one nation diminishes relative to that of another nation then one way to prevent unemployment rising is for labour to move. Labour mobility is an important adjustment mechanism between states within the US monetary union. Europe is characterised by much more persistent regional unemployment than the US (Obstfeld and Peri, 1998) and low interregional and international migration. This low migration does not seem to be the result of low region specific shocks but an unwillingness to move. Thus migration does not seem to be an adjustment mechanism available within EMU. European countries may also be less willing to accept the implications of migration of increased congestion in areas of inward migration and decline in area of outward migration.
Even if the demand for a country's goods and services is maintained the composition of the demand may change. To respond to such changes without structural unemployment will require workers to be flexible between jobs. The extent of this flexibility may depend upon a variety of factors: the ease with which employers can dismiss staff; the educational and training requirements of the new jobs compared to the old; the education and training of the workforce; facilities for education and training; the location of the new jobs compared to the old.
Mobility of capital
If workers will not move, capital could move between areas to reduce vulnerability to asymmetric shocks. There are various ways in which this could happen. If investment portfolios diversify away from a country as a result of EMU incomes will become less vulnerable to country specific shocks. In response to temporary shock private borrowing could increase moderating the impact. The problem is that the cost and availability of borrowing is likely to be adversely affected by a downturn in the national economy. EMU and the single market will however lead to increasingly integrated capital markets which will provide a number of mechanisms for insurance against shocks. Evidence from the US suggests that capital mobility is the largest element of adjustment to fluctuations in regional GDP (Eijffinger and de Haan, 2000. De Grauwe, 2000; pp. 219-220).
Interjurisdictional transfers
National economies typically have large transfers between regions. These transfers take three forms intertemporal stabilisation, interregional insurance and redistribution (Eijffinger and de Haan, 2000). Intertemporal stabilisation is the process of allowing the public sector deficit to widen in a recession to be repaid during a boom, so that it acts in a counter-cyclical manner. In the US with limited state budgets intertemporal stabilisation must necessarily involve the Federal Government. In EMU this is not the case, individual Member States retain substantial public sectors so centralised intertemporal transfers are not essential. Interregional insurance transfers funds from states with more rapid growth to states with slow growth. Interregional redistribution aims to reduce differences in relative wealth with transfers from rich states to poor states. Once interregional insurance is separated from these other transfers the initial 30% reduction in disposable income volatilty caused by the federal budget reduces to around a 10% reduction achieved by the insurance component. How essential such a reduction in volatility is to EMU depends upon the significance of asymmetric shocks and the availability effectiveness of other adjustment mechanisms. As has already been argued at least for the European core the business cyclical is reasonably synchronised but labour mobility and flexibility are limited. So there could be a case for interregional insurance but politically this is a non-starter. There is also a moral hazard problem that such an insurance element reduces incentives to improve other adjustment mechanisms.
On the whole, this costs-benefit approach to EMU gives rise to a rather pessimistic assessment of the prospects for joining the euro. A few notes of caution are required here, however.
* It is difficult to compare microeconomic benefits with macroeconomics costs.
* There is a risk that the importance of asymmetric shocks may be exaggerated when it comes to Europe. The evidence on this count is mixed.
* Some people doubt the usefulness of this approach in evaluating the desirability of a monetary union. Canada, for one, has a somewhat immobile labour force, while the alleged North-South divide in the UK may result from the predominance of asymmetric shocks within the British economy. Waltraud Schekle (2000), is also very sceptical and suggests that the theme of co-operation is more appropriate.
CO-OPERATION
EMU, involves a direct transfer of monetary sovereignty from the national to the Union level. Such sovereignty now rests with the Eurosystem of (participating) national central banks and the supranational European Central Bank (ECB).
The ECB and the Eurosystem
* Objectives: The primary objective of the ESCB shall be to maintain price stability. It shall also support the general economic objectives of the Community, but only in so much as this support does not prejudice the maintenance of price stability. (Article 105.1)
* Independence: The ESCB and the ECB are to be independent: "Neither the ECB nor a national central bank, nor any member of their decision making bodies shall seek or take instructions from Community institutions or bodies, from any government of a member state or from any other body." (Article 108 ex107).
The European Central Bank
The ECB is the most important example of a current vogue in economic policy making viz. the establishment of independent central banks. The economic justification for the creation of an independent central bank rest upon the view that there is an inflationary bias to discretionary policy making by political actors. Although it may not be possible to raise the long run growth of output and employment, the short time horizons within which politicians work mean a temporary boost to output, employment and its accompanying surprise inflation may be in the government's interest. The problem is that economic agents: companies, unions and the financial markets will factor inflation into their expectations. Thus at each level of output/employment, inflation will be higher than if expectations of inflation were lower. This is the inflation bias of the system. One solution is to delegate monetary policy to a 'conservative' central bank, which has long time horizons and is committed to controlling inflation. Such a central bank should be credible i.e. economic actors believe that it will meet its avowed aim of low inflation. Thus replacing incredible national government control of monetary policy by credible independent central control could reduce the costs of disinflation because economic actors expectations will be adjusted downwards to a lower level of expected inflation.
The difficulty is how to develop the credibility of an existing or in the case of the ECB a new institution. The effectiveness of central bank independence in moderating inflation may be related to the wider institutional and social setting within which it is located. To establish credibility and effectiveness it is also important that the central bank has legitimacy: the belief by the public that the institution is the correct one to carry out the functions assigned to it. Legitimacy can be established by clear democratic accountability or embedding in the shared values of the polity. Thus success in controlling inflation in a culture that valued this achievement, could establish a central bank's legitimacy. In EMU the approach to these issues has primarily been to make the ECB exceptionally independent and to model it upon the Bundesbank, in the hope of inheriting its credibility and legitimacy.
The ECB has legal personality and it is independent. To be independent the ECB must be in a position when making decisions to ignore pressure from other institutions and individuals. Thus the Treaty specifies legal requirements of the ECB's institutional, financial and personal situation so as to guarantee independence. Institutionally neither the ECB nor any member of its decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a member state or from any other body. To ensure that financial pressure cannot be put on the ECB it has its own budget.
The TEU provides for the establishment of a European System of Central Banks (ESCB), the ESCB is the ECB and the NCBs of all EU Member States whether they are members of EMU or not. The General Council of the ESCB is composed of the President and Vice-President of the ECB and the NCB central bank governors of all EU Member States and its primary responsibility is to provide advice on the preparations for membership of EMU. Since three EU Member States are not members of EMU, the Eurosystem has been created to undertake the decision making responsibilities of the ESCB. The Eurosystem comprises the ECB and the NCBs of the 12 Euro zone Member States. Decision-making in the Eurosystem is undertaken by the Governing Council (GC) and the Executive Board (EB), which consists of the EB of the ECB and the governors of the national central banks. Since National Central Banks are integral to the system they are required to conform to similar requirements for independence as the ECB. It is the GC that is the principal decision making body of the Eurosystem deciding monetary policy (e.g. setting interest rates), authorising the issue of euro banknotes and coins, adopting regulations to ensure the smooth operation of payments systems and fulfilling the advisory role of the ECB. The EB of the ECB comprises the President and Vice President of the ECB and four other members. These EB members are appointed by common accord of the Member States. The EB is responsible for day to day operations and for the administration of the ECB. The decisions rule for the GC and the EB is a simple majority of their members, but under Wim Duisenberg decisions have been taken by consensus, with no votes. The ECB's primary objective is price stability. It is required to contribute to the achievement of other objectives of the Community such as non-inflationary growth and a high level of employment but only to the extent that this does not compromise the primary objective of price stability. To achieve these objectives the Eurosystem: defines and implements the monetary policy of the euro area; conducts foreign exchange operations and hold and manages the official reserves of the Member States; and issues banknotes and coins in the euro area
The credibility and legitimacy of the ECB also requires that it be accountable (i.e. being held responsible for its actions) and transparent (explaining the reasons for its actions). Accountability is achieved in various ways through legal requirements: the publication of Annual Report; the attendance of the ECB President and other members of the EB at competent committees of the European Parliament. The President of Ecofin and a member of the Commission may attend GC meetings without having the right to vote. So far the president of Ecofin has seldom exercised this right. In addition to these legal requirements the president of the ECB gives press conferences every month and after interest rate changes, the ECB publishes a Monthly Bulletin and the EP holds regular hearings with ECB board members.
In comparison with other central banks the ECB enjoys considerable independence this is shown by the legislative provisions governing its constitution and operation. Thus the governor and members of the EB are appointed by common accord of the Member States, have a long non-renewable term of office (8years) and are fully independent acting in a personal capacity. NCB governors are similarly required to be independent. The Eurosystem is given an overriding primary objective price stability and the final authority over monetary policy. It can be argued that ECB independence goes beyond this. The ECB's primary objective is rather vaguely defined "to maintain price stability." Thus the it enjoys considerable goal independence in deciding what the objective of policy should be as well as instrument independence the ability to decide how to use policy instruments to achieve this objective. ECB independence is reinforced by the absence of a counterweight in the form of a European government. Political leverage over the Eurosystem is also limited by the decentralised nature of the system and the use of one member one vote and simple majority voting.
National central bank (NCB) governors are, however, powerful in the system. There are 12 governors compared with 6 ECB Executive Board members. NCB governors have considerable standing and resources. The ECB has only 500 employees compared with 20,000 at the Bundesbank and 16,000 at the Bank of France. The importance of the NCB Governors in the system could be regarded as a problem leading to an overemphasis on individual nations rather than the euro zone as a whole. This is dubious, an individual NCB Governor is only one among eighteen on the governing council. Central bank governors are likely in any case to be cautious and to take decisions in the interests of the euro zone as a whole, a development which is being fostered by the ECB's collegiate approach to decision making with decisions being taken by consensus. There is perhaps a short-term problem that most NCB governors have no experience of operating a major currency like the Euro this could have contributed to a lack of consistency and decisiveness in ECB policy. The Eurosystem reflects the political realities of the EU, it is a decentralised system, characterised by strong nation states and a comparatively weak centre.
The ECB has established ex post transparency commenting on decisions after they have been made and being judged on whether goals have been met. In contrast the Bank of England has ex ante transparency explaining how it intends to achieve its goal by publishing its forecasts and various possible outcomes of policy. The ECB is however considering the possibility of publishing its forecasts. The Federal Reserve is between these two extremes it does not publish its own forecasts but it does publish the forecasts of the individual reserve banks. The ECB's ex post approach could undermine the attempt to establish the credibility of a new institution such as the ECB by making it more difficult for markets to understand its actions. ECB transparency is also limited with regard to its discussions, only the decisions of the Governing Council are known, not the differences of opinion, nor the voting records, a system of collective accountability. The Federal Reserve and the Bank of England publish unattributed views and individual voting records. The collective accountability of the ECB seems desirable given the high degree of decentralisation of the ECB and the possibility for interests to diverge along national lines. Although there are good reasons for these policies they do reinforce the independence of the ECB and make it potentially vulnerable, being held responsible for euro-zone economic performance as a whole and not just for inflation.
The operation of the ECB
In deriving its policy strategy the ECB had a difficult task, it sought to inherit the anti-inflation credibility of the Bundesbank, be inclusive of the traditions of the other member central banks and to respond to the new situation represented by EMU. It is clear however, that the Bundesbank inheritance is the most important of these elements, this is reflected in the one target and two-pillar strategy agreed in October 1998. The target is price stability defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HCIP) of below 2%. The first pillar is a reference value for the annual growth of M3 set at 4.5% and the second pillar is a broadly based assessment of the outlook for future price developments. The two-pillar approach especially when one of the pillars is so vague gives considerable discretion to the ECB in its monetary policy decisions. But this discretion makes it more difficult for the ECB to communicate the reasons for its decisions and to convince the markets that it is following its declared intentions. This creates special difficulties for a new institution such as the ECB, which has to establish its credibility. Even the monetary targeting part of the Bundesbank's strategy was far from precise. In retrospect it was probably a mistake to simply inherit the Bundesbank strategy, this strategy worked partly at least because it was implemented by the Bundesbank. These difficulties compound the problems of transparency and accountability considered above.
There has been much criticism that the ECB has adopted an excessively deflationary approach. The target of less than 2% inflation is rather low particularly given the heterogeneity of the euro zone and the initial problems of acclimatisation (country's entered EMU with very different initial economic situations). A higher rate of inflation might have made the adjustment to EMU easier. In reality the target has been less stringent than it appears, because of the way the HICP measures inflation, thus UK inflation on the HICP has been consistently below the domestic Retail Price Index. In practice the ECB's policies have held inflation near to and often above 2%. Recently the ECB has clarified its policy with the inflation target as near to but below 2%. The monetary pillar seems to have been largely ignored in setting policy and its status has been downgraded.
Economic Policy in the euro zone
There are two essential elements in the macroeconomic policy mix for the Euro zone monetary and fiscal policy. Whilst there is a clear central authority for monetary policy in EMU the situation for fiscal policy is much less clear. Fiscal policy is the control of the balance between the overall level of public expenditure and taxation to try to influence the level of aggregate demand and output of the economy. Unusually for a monetary union public expenditure and taxation remain overwhelmingly decentralised under the control of national governments. National budgetary discipline is necessary to protect the credibility of the ECB by removing the possibility of national government defaults and bailouts. Monetary policy will also operate more effectively in a stable fiscal environment where there is consistency between the policies. In practice it is difficult to make rapid changes to government expenditure and revenue so it can be argued that fiscal policy should be the subject of longer term planning and monetary policy should be used for short-term adjustments.
Co-ordination of economic policy is based on three interrelated mechanisms: Broad Economic Policy Guidelines (BEPG), Multilateral Surveillance and the Excessive Deficit Procedure. The BEPG are contained in an annual report adopted by the European Council addressing such issues as the overall macroeconomic situation, public finances, structural reforms, employment and growth. Co-ordination is sought through advice and peer pressure as no sanctions are involved, outcomes are not very precisely defined although there is perhaps some tightening over time. The BEPG most directly seek to influence outcomes through the multilateral surveillance, Commission and Ecofin evaluation of annual updates of Member States stability programmes. These are 5 year programmes detailing national governments' budgetary positions. Multilateral surveillance seeks to ensure that national economic policy is broadly consistent with the guidelines and thus with the proper functioning of EMU. The Stability and Growth Pact consists of two regulations, for the surveillance and the excessive deficit procedure (EDP) which define more precisely the processes by which Ecofin ensures compliance with the BEPG. Compliance with surveillance is to be achieved largely by peer pressure because the only sanction is a recommendation to a Member State to modify policy. Fiscal policy is more tightly controlled by the EDP when a country's deficit exceeds 3% of GDP Ecofin can decide by a qualified majority that an excessive deficit exists, make recommendations for its correction and impose penalties if the Member State fails to remedy the situation. Excessive deficits are those exceeding 3% of GDP except where the excess is exceptional and temporary. The restrictions on Government Debt are looser, this should be less than 60% of GDP unless it is diminishing towards the reference value at a satisfactory pace. Penalties include non-interest bearing deposits and ultimately fines. These procedures are geared to the achievement of medium-term budgetary positions close to balance or in surplus. Fiscal policy acts as an automatic stabiliser, the public sector deficit (PSD) expanding in a recession due to rising social security expenditure and falling tax revenue, this will tend to boost economic activity offsetting the effects of the recession. For this effect to operate there must sufficient headroom with the 3% deficit ceiling for the PSD to expand in a recession hence the aim for the medium term of balance or close to surplus.
At the same time the creation of a currency zone substantially deepens economic integration, thus increasing the scope for both institutional and regional spill over (Bayer, 1999). The former arises from a situation in which a single monetary institution faces twelve separate national economies. A divergence between the policy preferences of the ECB with those of all - or indeed some of - the national fiscal authorities could present a barrier to the achievement of price stability (Ardy, 2000). No matter how credible the ECB may appear, stable prices will become increasingly difficult to achieve in the presence of, for example, loose and inflationary fiscal policies. Wage developments at the national level will, by the same token, have an effect on euro zone inflation National wage setting mechanisms will, in consequence, be of some concern to the ECB.
EMU also strengthens the ties between the national economies themselves such that the effects of national policies will now be felt more acutely in the rest of the euro zone (Gross and Thygesen, 1998). Whereas before, an increase in the deficit spending of, say, Germany may have yielded higher German interest rates, the same action will now trigger a rise in euro zone interest rates. This means, in effect, that the entire euro zone would pay the 'price' for Germany's fiscal profligacy. From a German perspective, it would spread the cost of its actions over its peers, thus diluting the strength of previous incentives for fiscal rectitude, although other countries could benefit from the fiscal expansion in terms of increased demand. This also assumes that the market views euro denominated debt as the same, irrespective of the country which issues it and that country's economic policies. The ECB is not allowed to help a country that gets into difficulties servicing its debt, the no bail-out clause (Article 101)
The Union has responded to fears of institutional and regional spillover by decreeing that Member States must now consider their economic policies as a matter of common concern and co-ordinate them within Council with a view to achieving - amongst the other objectives in Article 2 - sustainable and non-inflationary growth. If economists have generally welcomed the prospect of enhanced economic policy co-ordination under EMU they have failed to agree on the precise form that such co-ordination should take (Mooslechner and Scheuez, 1999). When initial plans for EMU were unveiled, the supranational monetary authority was to be flanked by an economic counterpart, charged with the responsibility of formulating fiscal policies that are compatible with the objectives of the Eurosystem. These suggestions were later echoed in calls for the establishment Fiscal Federation, comparable with the US model, and designed to provide tax decreases and grant-in-aid to national economies, which faced asymmetric economic disturbances (Sachs and Sali-i-Martín, 1992).
In practice, however, the architects of EMU have steered clear of any supranational economic policy. This decision may be motivated, in part, by a lack of political appetite for any further policy transfer (Dyson and Featherstone, 1999), but it can also be justified on economic grounds. Such arguments suggest that while measures are required to avert negative spillover, they should not prevent Member States from adjusting to disturbances in a manner which best suits the characteristics of their economy. Given the radical differences between euro zone economies with respect to such characteristics as production structure and labour market flexibility, a single adjustment response seems unworkable. Providing that they do not generate negative spillover, adjustment mechanisms at the national level seem preferable since they are better suited to their economy's own specificity. A belief in this logic pervades a policy architecture that is characterised by a combination of legally binding rules, soft policy and institutional linkages.
The risk of institutional spill over is addressed in the first place, not through the creation of a supranational economic institution, but rather by opening channels of communication between existing bodies. A representative of the ECB attends meetings of the Council of Economic and Finance Ministers (ECOFIN), while the President of ECOFIN is present at meetings of the Eurosystem's Governing Council. This political communication is supported at the technical level by the Economic and Finance Committee (EFC), an advisory body that is made up of representatives from national finance ministries, national central banks and the ECB. Concerns over wage developments in the euro zone have been addressed through the Macroeconomic Dialogue. This body, which was established under the auspices of the Cologne Process, brings together representatives of ECOFIN, the European Commission, the ECB and the social partners twice a year to discuss the overall economic policy mix. Together these bodies ensure that national governments, the Eurosystem and, to a lesser extent, social partners meet regularly to exchange information and opinions. This will, it is hoped, bring a degree of consistency to monetary and fiscal policies in the euro zone. Such measures are supported at the policy level through a peer review process, known as the Broad Economic Policy Guidelines. These annual guidelines enable the Council of Ministers to issue a (legally non-binding but politically important) recommendation for corrective action in the event of a conflict between the objectives of fiscal and monetary policies.
The risk of regional spill over is addressed primarily through the Stability and Growth Pact. In essence, this agreement records the commitment of its signatories to maintain their budget deficits within 3% of GDP and to maintain their medium term budgetary position close to balance or in surplus. Government also required to maintain public debt under 60% of GDP, unless the debt is approaching this percentage at a satisfactory pace (Article 104c and Protocol 5). The Pact is enforced through a system of multi-lateral surveillance and an excessive deficit procedure. The former requires each Member State to formulate a Stability Programme (or Convergence Programmes in the case of a non-participant), which sets out an agenda for national economic policy that confirms to the spirit of the pact. In the event of this spirit being broken, the Council can issue a recommendation for corrective action. In the event of an infringement of the pact itself, an excessive deficit can be launched, which begins with formal recommendation and can end with formal sanctions and monetary fines. Once again, therefore, the issue of economic policy co-ordination has avoided the supranational approach and sought to promote virtuous policies through more intergovernmental means.
The Union's approach to the issue of adjustment has, as was suggested, chosen to concentrate on national adjustment capabilities rather than the creation of supranational alternatives. The central tenet here that while each Member State faces an adjustment challenge that implies a need for greater budgetary and factor market flexibility, the precise nature of such flexibility is likely to differ between Member States. Thus, while the pursuit of such flexibility is encouraged at the Union level, the emphasis remains clearly on policy initiatives at the national level.
The Stability and Growth Pact is a case in point. While one objective of the pact is to prevent regional spill over, another is to boost the efficiency of national budgetary stabilisers. The argument here suggests that compliance with the terms of the pact will leave more room for budgetary manoeuvre in the face of an asymmetric economic disturbance. The manner of compliance - providing it is successful - remains, however, a decision for the Member State alone.
The Employment Package is a second instance of what amounts to an ultimately intergovernmental approach to economic policy under EMU. In particular, the Luxembourg and Cardiff Processes are designed to tackle the problem of factor market reform within in the Union (Hodson and Maher, 2000a).
The Luxembourg Process is designed to 'improve the efficiency of labour markets by improving employability, entrepreneurship, adaptability of businesses and their employees, and equal opportunities for men and women in finding gainful employment' (European Council, 1996, p1). If this process was originally motivated by the persistence of unemployment throughout the Union, then the impetus behind its launch rests with the perceived urgency of labour market reform under EMU (Hodson and Maher, 2000b). The process is implemented through an annual cycle, which begins with the formulation of 'Employment Guidelines' at the European Council. These are targeted at the Union as a whole and identify a range of priorities for employment policy. The guidelines delineate no common courses of action, placing the emphasis instead on the enablement of national policy initiatives. This is followed by the publication of a National Action Plan by each Member State, which details the proposed manner in which the Employment Guidelines will be achieved. In the final stage of the cycle, the Commission and Council assess the NAPS in the Joint Employment Report, passing recommendations, where necessary, on the performance of individual Member States, while at the same time highlighting instances of best practice.
A similar method underpins the implementation of the Cardiff Process. The central objective here is 'to improve the functioning of markets through better multilateral surveillance and co-ordination of structural reforms' (European Council, 1997, p1). The progress towards structural and economic reform is assessed from a number of perspectives. First, Member States are required to draw up an annual report assessing their own progress in this field. The Commission is required, at the same time, to draft two reports; Cardiff I concentrates on developments in product and capital markets, while Cardiff II focuses on labour market reform. Thirdly, the Economic Policy Committee monitors structural reform in each Member State and presents its findings in the form of a Synthesis Report. As a whole, this multilateral surveillance feeds into to the Broad Economic Policy Guidelines. Like the Luxembourg Process, the Cardiff Process reflects the view that although Member States face similar challenges with respect to structural reform, the optimal course of action lies at the national level. The role of the Union is to co-ordinate national responses through a system of bench marking, best practice, recommendations and multilateral surveillance.
It should be clear now that EMU entails considerably more that the creation of a single currency. It ultimately changes the nature of macroeconomic policy making. This is, however, far short of the much-feared 'Super State'. Two questions remain open at this point.
* Are the provisions described sufficient to deliver appropriate economic policies?
* Will there be a political spill over from this economic integration?
BRITAIN AND EMU
In addition to the themes of adjustment and co-operation, the question of EMU membership raises issues such as convergence, the strength of sterling and the political spill-over from EMU. This, it must be stressed, is not meant as an exhaustive list.
I. Convergence is a basic pre-requisite for entry to the euro zone.
Questions concerning the divergence of UK and euro zone business cycles make regular appearances in the EMU debate. The main thrust of these questions is that the euro zone interest rate is unsuited to the needs of the British economy. In thinking about this question, it is useful to consider the following points.
* To move to EMU it was decided that it was necessary to achieve "a high degree of sustainable convergence" (Article 121.1 ex109j.1). This was to be measured in terms of four criteria which were identified in Article 109j but defined in the Protocols of the Treaty, the Protocol on excessive deficit procedure and the Protocol on the convergence criteria (Article Protocol:
. Price Stability: "an average rate of inflation, observed over a period of one year before examination that does not exceed by more than 1.5 percentage points that of, at most, the three best performing Member States in terms of price stability ... measured by means of the consumer price index on a comparable basis".
2. Government Financial Position:
* Government deficit:
"3% for the ratio of planned or actual government deficit to gross domestic product at market prices;"
* Government debt:
60% for the ratio of government debt to gross domestic product at market prices."
3. ERM exchange rate: "the observance of the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other Member State;"
4. Long term interest rates: "observed over a period one year before the examination, a Member State has had an average nominal interest rate that does not exceed by more than two percentage points that of, at most, the three best performing Member States in terms of price stability."
These EU requirements are a narrow and measurable assessment of narrow financial convergence. The UK Chancellor of the Exchequer, Gordon Brown, has added some five further convergence criteria of his own. These are wide measures concerned with the real performance of the economy and essentially questions of interpretation rather than exact measurement.
. Cyclical convergence: this partly dealt with by the convergence criteria but also requires similarity of growth both in terms of the rate and the direction of change.
2. Flexibility of products, wages and employment: two problems in particular are seen for UK in EMU skills shortages and the impact this could on wage increases.
3. Investment: entry to EMU should not adversely affect investment particularly FDI in the UK.
4. Financial services and the City of London: membership of EMU should not harm the UK financial services industry and the City of London as an international financial centre.
5. Growth, Stability and Jobs: should not be adversely affected.
It is in every Member States interest that a country of the UK's size should be convergent as any divergence could re-weight the euro zone average away from their own specific needs. These criteria have also been seen as a way of avoiding a politically difficult and devisive referendum on UK membership of the euro zone.
II. EMU will place the EU on the road to a 'European Super State'.
Obviously the idea of a Super State is based on the rather peculiar UK views about federalism in general, and especially in relation to the very decentralised confederal system of the EU. This is not to say that EMU does not have implications for the roles of EU and national institutions in decision making. EMU is more than a matter of monetary integration; the economic and political dimensions are just as important. As such there is some degree of truth in the claim that the single currency will demand further integration. In assessing whether or not such spill over demands the creation of a Super State, however, is controversial. It is clear that the economic dimension to EMU is proceeding on a largely intergovernmental footing. National sovereignty in matters of economic policy is, particularly in view of France and Germany's problems with the SGP, alive and well. By the same token, however, EMU has raised important questions about the legitimacy of the project and in particular about the issue of democratic accountability. Deeper integration in the field of economic policy will place greater emphasis on democracy of the system. Under one interpretation this will require a strengthening of the European Parliament's powers in this area.
Conclusion
It is difficult to be objective in debates over EMU, critical judgements hinge on the point of analytic departure. From the perspective of cost and benefits the case against EMU appears clear cut, while the criticisms of its operation are serious indeed. This perspective shifts somewhat when the theme of co-ordination is analysed. Measures have been put in place to pursue an appropriate policy mix in the euro zone, even if questions surrounding their efficiency arise. If the themes of adjustment and co-ordination are likely to occupy the British debate on EMU then so too will issues of convergence, exchange rate and political spill over. For pro and anti arguments alike, considerable caution must be exercised before any judgement is passed, particularly while it is still in its infancy.
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Economic and Monetary Union 1
