Still plenty of scope for an early monetary union

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The Independent Online
According to my calculations, 1996 is just two years away. Further research shows that the next general election need not take place for almost three years - not until May 1997, to be precise. I can therefore exclusively reveal that the next general election may not take place until after the EU heads of government meet to decide, under the terms of the Maastricht Treaty, whether the conditions for European Monetary Union (EMU) have been met.

I make these points because the uneasy truce in the Conservative Party on the European issue seems based on the assumption that the question of EMU is now off the agenda. For example, the Chancellor told the Treasury Select Committee last week that 'anyone who started talking about the prospects of a single currency in the Council of Finance Ministers would be regarded as having taken leave of his senses'. He dismissed EMU as a 'tedious irrelevance' which would not trouble the present Parliament, or possibly the next.

He may be right. It is possible to imagine a scenario involving a defeat for Chancellor Kohl in the German elections in October, and/or the election of Jacques Chirac in the French presidential elections next May, either of which would make EMU improbable this century. But it is also possible to imagine the re-election of Chancellor Kohl in Germany, along with a victory for Edouard Balladur or Jacques Delors in France. In the latter scenario, it is far from fanciful to suggest that the leaders of Germany and France would see it as their 'historic duty' to implement the Maastricht Treaty as quickly as possible.

Let us recall what was agreed in the treaty. The EU heads of government must meet no later than 31 December 1996 to decide whether a simple majority ( at least seven) of EU members can proceed to EMU. If no date can be set at that summit, then the move to EMU is intended to take place automatically on 1 January 1999, when a minority of member states (presumably only two in the limiting case) could form a monetary union.

The clear intention of the treaty is that the Council of Ministers should decide by qualified majority both when EMU should start, and who should be in it. This means, in theory, that no individual country could veto the process. Furthermore, only the UK and Denmark have the constitutional right to step aside from the monetary union if the council decides they are qualified to join.

Presumably this raises the insane possibility that one or more countries might be forced to join EMU even though they do not want to. In the real world this obviously could not happen, but it does demonstrate the degree of automaticity which was intentionally built into the treaty.

British opponents of EMU have reassured themsleves with the thought that this automaticity is tempered by the conditions which have to be met before EMU can go ahead. These conditions relate to consumer price inflation, bond yields, budget deficits and public sector debt ratios. The table shows how the member states would match up to these requirements if the EMU decision were being taken now.

On price inflation and bond yields, the majority of members already meet the Maastricht requirement. Assuming that there will be no major inflationary shocks in the next few years (and there is no reason to think there will be), the only large countries which seem likely to have to worry about these criteria are Italy and Spain. The rest should match up.

The budget criteria, on the other hand, seem at first sight to pose an insurmountable problem. Currently, only Luxembourg meets both of the suggested limits, and most other countries are moving away from the limits rather than towards them. However, two points are relevant. First, budget deficits will start to improve quite sharply from next year onwards as the European economies move into a phase of strong recovery. Second, and more important, the precise numerical limits for the budget deficit (3 per cent of GDP) and the public sector debt ratio (60 per cent of GDP) shown in the table are in fact only intended to be illustrative guidelines as to whether budget deficits are 'excessive'.

Provided that countries are making satisfactory progress towards these numerical guidelines, then the Council of Ministers can deem the budget criteria to be met. In other words, if there is a strong political will to proceed towards EMU, then the treaty allows the Council to turn a blind eye to failures to meet the budget limits.

There is one more convergence requirement included in the treaty, which is that any currency qualifying for EMU should have been within the 'normal' bands of the ERM for at least the previous two years, with no change in the central parity over that period. Here, it turns out that the supporters of monetary union have enjoyed a huge slice of luck, since the 'normal bands' in the treaty were clearly intended to be the narrow bands of the ERM.

The drafters of the treaty apparently used the word 'normal' instead of 'narrow' because there was a possibility that some countries might move to super-narrow bands before 1997. But the upshot is that the break- up of the narrow bands of the ERM last year will not of itself prevent the transition to EMU from taking place, since the current 15 per cent fluctuation bands can now be defined as the 'normal' bands. On such twists of fate can history turn.

Despite this stroke of fortune for EMU, most economists felt, in the immediate aftermath of the ERM debacle last August, that the narrow bands would have to be stitched back together before a single currency could be created. The original intention of the Maastricht drafters was that the eventual transition to the final stage of monetary union would be almost imperceptible, since economic convergence would already have been achieved, and currencies would have been virtually fixed for a prolonged period ahead of EMU. The idea was that the final stage before EMU would be a proving ground for the real thing.

However, there were always doubts about whether this plan would prove feasible. There was no guarantee that the narrow bands would have been compatible with the absence of capital controls among member states for a period of up to five years ahead of EMU. A particular fear was that the market would expect one final realignment just before full EMU in order to ensure that no serious competitiveness problems would be locked into the monetary union. This could have led to speculative attacks on the parity grid, possibly forcing late realignments which would breach the criteria of the treaty.

These problems have essentially been eliminated by the operation of wide bands, since any feasible realignment to allow for competitiveness divergences can now be comfortably accommodated within the 15 per centfluctuation margins.

An increasing number of economists are beginning to speculate that EMU may involve a 'big bang' directly from wide bands to full union. Although scarcely a fashionable concept in 1994, perhaps monetary union is not such a 'tedious irrelevance' after all.

----------------------------------------------------------------- CONVERGENCE CRITERIA FOR MONETARY UNION ----------------------------------------------------------------- Consumer 10-year Budget Gross public price bond deficit1 debt ratio inflation2 yield (% of gdp, (% of gdp, (%, 1994 (%, latest) 1994 1994 forecast) forecast) forecast) ----------------------------------------------------------------- Maastricht requirement3 3.5 9.8 3.0 60.0 Germany 3.0* 7.3* 3.1 53.7* France 1.8* 7.7* 5.6 57.2* Italy 3.9 10.9 9.5 111.3 UK 3.5* 8.6* 6.0 50.5* Spain 4.8 11.1 7.2 64.2 Netherlands 2.3* 7.1* 3.6 80.9 Belgium 2.6* 8.3* 5.4 146.3 Denmark 2.0* 8.5* 4.6 68.5 Portugal 5.6 12.0 6.2 70.6 Greece 10.2 n/a 17.9 109.5 Ireland 2.8* 8.6* 2.5 87.7 Luxembourg 2.9* n/a 0.4* 7.0* ----------------------------------------------------------------- 1 European Commission Forecast, May 1994 2 OECD forecast, June 1994 3 Consumer price inflation must be within 1 1/2 % of the average of the best three members; the bond yield must be within 2% of the avergae bond yield in the three countries with the lowest inflation rates ----------------------------------------------------------------- * Maastricht criterion met -----------------------------------------------------------------