Why Europe Didn't Take The Last Step Toward UnionRobert Kuttner
It has become fashionable to conclude that the European Monetary System collapsed of its own weight and that we are better off letting markets set exchange rates. I doubt it.
The EMS, founded in 1979, attempted to protect Europe's economic union from destabilizing currency-exchange fluctuations. Currencies could fluctuate only within very narrow margins; the Continent's central bankers and governments pledged to intervene collectively to maintain those parities. When economic fundamentals--rates of interest, inflation, and growth--sharply diverged, nations were allowed to revise their target exchange rates provided they were orderly and infrequent. Thus, the EMS blended monetary order and monetary flexibility in a region, much as the Bretton Woods system of fixed rates (that collapsed in 1973) had done globally.
The sponsors of the EMS had several goals. Chaotic currency fluctuation has a high price. Businesses have to spend real money hedging exchange-rate risks. Trade is deterred. There is a wider risk of periodic competitive devaluation. In the 1930s, nations sought to export their unemployment by cheapening their currencies, with the collective result of global deflation and financial chaos.
MARCHING IN STEP. The very process of monetary coordination was intended to produce greater convergence of economic fundamentals. A system of fixed exchange rates can work only when member nations' deficits, interest rates, and growth rates are reasonably close to one another. The discipline of managing the EMS forced the Europeans to bring their economic policies into closer alignment.
Currency coordination was seen as a precursor to greater political unity. By cooperating to manage their fiscal and monetary policies, the Europeans were breaking down old national enmities and creating political and financial alignments conducive to an eventual single currency and a European central bank. It was tacitly understood that the EMS depended on French-German cooperation and on the Bundesbank's interim role as Europe's de facto central banker.
Although the proximate cause of its collapse was speculative pressure against the French franc, the EMS failed mainly for political reasons--a collective retreat from the exigencies of European union. London left the exchange rate mechanism last fall, unwilling to align its fiscal and monetary policies with those of the Continent. Bonn rated absorption of the eastern Germans ahead of its loyalty to the European Monetary System, even though this imposed high interest rates and slow growth on the entire Continent. To keep the franc strong, the French were determined to match the high German interest rates.
In the end, no nation would subordinate its short-run interest to the greater cause of European union. In principle, the reversion to floating rates liberates the rest of Europe from the punishment of matching high German interest rates. Yet the risk of currency wars, which the EMS was designed to avoid, remains. At this writing the old parities are defunct, but several smaller nations continue to defend their currencies with preposterously high interest rates. Belgium, in a recession and suffering 13.5% unemployment, pushed up short-term rates to 25%. Others, perhaps even France, may take the opposite course and seek to boost exports with lower domestic rates and a cheaper currency.
SPLINTER EFFECT. Competitive currency manipulation exacts real economic costs--just as the architects of the EMS and the Bretton Woods system grasped. It is a form of economic nationalism ultimately incompatible with the logic of European union. The Bundesbank has now made it clear that it places Germany's national economic goals above those of Europe, and there is no supranational bank to take its place. By contrast, in 1979, when the EMS was founded, the government of German Chancellor Helmut Schmidt, a committed European, overcame Bundesbank opposition to the whole idea. But during the week of July 24, the Bundesbank had the full support of Chancellor Helmut Kohl and Finance Minister Theo Waigel when it effectively killed the EMS by refusing to cut German interest rates.
Thus, the entire European union project is now in a dangerous stall. Ancient hostilities have been revived. There is talk of national fortress economies, and a catch-22 blocks further progress: Until there is a central European bank, there will be unstable currency markets. But the very instability in today's currency markets and the collapse of the EMS undermine the interim steps necessary to create such a central bank.
The faint silver lining is that eventual lower interest rates and cheaper currencies will stimulate higher growth in the weaker economies, and then Germany will finally lower its own rates. If such a convergence does occur, a rebasing of fixed parities and a restoration of a stable exchange rate mechanism at least becomes technically possible.
But the system still needs to be managed by statesmen with a pan-European vision. The EC has come a long way since its 1957 founding. But the home stretch will require the largest strides, and none among the EC's current leaders seems able to fill the shoes of its founders.