|The Courier N° 145 - May - June 1994- Dossier : European Union: the Way forward - Country Report: Ethiopia (EC Courier, 1994, 104 p.)|
by Alexandre Lamfalussy
The European Monetary Institute (EMI) was set up under the Maastricht Treaty with the task of contributing 'to the realisation of the conditions necessary for the transition to the third stage of economic and monetary union' This is the stage at which the establishment of a European currency and a European Central Bank (ECB)is envisaged. Once Stage Three is reached the plan is for the EMI to be wound down, with its functions effectively being taken over by the new Central Bank.
Alexandre Lamfalussy, who was appointed in October 1993 to head the European Monetary Institute (EMI), has had a long and distinguished career in the financial sector, both private and public. He studied economics at Louvain and Oxford before going to work in a Belgian bank In 1976, he took up a post with the Bank for Intemational Settlements in Basel, where he rose to the position of Director-General.
Be/ow, we reproduce an abridged version of a speech delivered by Mr Lamfalussy in March to a group of German bankers. In it he sets out the role of the EMI and discusses how he sees it working - alongside national central banks - to. wards the goal of European Monetary Union.
Right from its beginnings, the process of economic integration in Europe has been the subject of fluctuating and sharply contrasting assessments, more or less in line with the 'stop-go' development which has marked the process itself. Although European integration has clearly been on a rising trend, euphoria has tended to alternate with phases of 'Europessimism'.
There is no area to which this general observation applies more than that of monetary integration. Just look at the events of the past three years. Some time during the early 1990s, financial market participants apparently acquired the conviction that the then prevailing exchange rate pattern would survive until Stage Three. This strangely optimistic belief was radically revised as a result of the successive ERM ' crises that occurred between September 1992 and August 1993. The dominant view then became that, with the 'collapse' of the ERM (which was an exaggeration, even without the benefit of hindsight), the process of monetary integration might as well be written off for good. I am curious to see what the next development will be: what interpretation will be given to the return of several currencies to the narrow band that was abandoned last August?
It was in this unsettled environment that the European Monetary Institute came into being. No wonder that views on its importance and its prospects vary considerably. Some regard its establishment as a non-event. Others look upon it as being (almost) equivalent to the creation of a genuine European monetary authority. The main point I am trying to make is that these extreme views are mistaken. Just as the pre-1992 euphoria was mistaken, so too is the idea that European Monetary Union (EMU) can be cast into the dustbin of history.
In all fairness, however, I have to acknowledge that the prevailing uncertainty concerning the EMI cannot simply be attributed to shifts in public opinion. It also has to do with the genuine difficulty of defining Stage Two in the process leading to monetary union and, therefore, the role of the Institute itself, which is the institutional embodiment of this Stage. Moreover, a number of the articles of the EMI's Statute reflect political compromises, and such compromises naturally invite divergent interpretations.
Some of these problems surfaced quite early on and are evident even to the casual reader of the Maastricht Treaty. The crux of the matter is that, during this stage of transition to monetary union, responsibility for the design and conduct of monetary policy remains vested unequivocally in the national monetary authorities. At the same time, one of the primary tasks of the EMI is to 'strengthen the coordination of the monetary policies of the Member States'. Is it possible to coordinate independent monetary policies without encroaching on the exclusive preserve of national monetary authorities? I shall give my own answer to this question, but let me first deal with the other major mandate of the EMI, namely that of preparing Stage Three and, more specifically, the setting up of the European System of Central Banks (ESCB).
This mandate has not received much public attention. This is regrettable, but understandable. Institution-building is not a glamorous subject. Admittedly, ensuring the non-inflationary convergence of our economies, and therefore creating the conditions for the political decision to move to monetary union, is a daunting task, which logically precedes all others. But once a decision is taken to freeze exchange rates, we must be absolutely sure that an institutional framework can be put in place which will allow the single monetary policy to operate satisfactorily, as well as enable the ESCB to function normally in all other fields of competence.
The Maastricht Treaty, of course, sets out the Statute of the future ESCB but, as regards the modus operandi of the single monetary policy, this Statute, quite rightly, only states general principles. These include, for example, the principle of open markets with free competition, the ban on central bank financing of public deficits and the possible decentralisation of the execution of the ECSB's operations, so that recourse can be had to national central banks 'to the extent deemed possible and appropriate'. Defining the precise way in which the single monetary policy should operate is one of the major tasks of the EMI.
The preparatory work will be labour and meeting-intensive. It will have to involve not only stock-taking - in other words, identifying institutional differences between different countries - but also decisions on matters that, behind the veil of technicalities, have a bearing on national traditions, may favour or hurt very specific interests, and imply strategic options. There is a wide range of areas to be covered if we want to create the regulatory, organisational and logistical framework necessary for the ESCB to perform its tasks in Stage Three of EMU. I do not want to start listing all these areas, but let me draw your attention to just one of the key fields where work is already in progress: the strategy and operating techniques of the single monetary policy.
When I speak of decisions on strategy, I do not mean any possible questioning of the final objective of monetary policy. That matter has been settled by the Treaty, which assigns to the ESCB the primary objective of maintaining price stability. But how is this to be achieved? By setting an immediate target? If so, what target? If that target is to be a monetary aggregate, which monetary aggregate? Alternatively, can one dispense with an explicit intermediate target and aim directly at price stability? On this assumption, can one not use monetary aggregates at least as information variables? Whatever agreement we reach on the intermediate target, the European Central Bank will still need a well-defined operational target, such as the level of short-term interest rates, as well as agreed instruments and procedures for reaching it. Regarding the instruments, for example, it will be necessary to consider the pros and cons of compulsory reserves, their remuneration, the range of institutions to which they should apply, and so forth.
The final answer to some of these questions will have to be given closer to the time of entering Stage Three. Take the example of an intermediate monetary supply target. The use of such a target has a number of attractive advantages. It is easy to explain to the public at large, for whom the quantity theory of money is one of the rare macroeconomic propositions that appears to be in line with common sense. This is especially the case for those who have been through the experience of hyperinflation. It also protects the monetary authorities from the usual laxist temptations associated with purely ad hoc assessments of current economic conditions. It shelters them, to some extent, from political pressure on their decision making process. If they reach the target, even if only in the medium-term, their credibility is enhanced. These are weighty arguments. But the usability of a money supply target hinges critically on two conditions. Firstly, there should be a sufficiently stable relationship, at least in the medium term, between prices (which are the final target) and the targeted money supply. Secondly, central banks should be able to control the medium term path of the money supply measure that has been targeted.
So far, these conditions have been met in Germany and in some other European countries - not perfectly, but to a degree considered sufficient by the monetary authorities for continuing to use an explicit money supply target. In other countries - the UK is the main example in Europe, but there are also Canada and the USA - at least one of these conditions, and sometimes both, have broken down.
Whether or not these conditions will obtain in Europe at the time a single monetary policy is implemented is a matter for conjecture. We can and should try to understand the reasons why they have held in some countries but not in others. What, for instance, is the role of deregulation and of financial innovation? But at the end of the day, the answer will be provided by facts, not by theorising. It will depend on the evolution of the instruments, the operating techniques and the structures of the markets themselves. But this does not mean that we should just wait and see. Whatever final decision is reached on intermediate targeting, considerable preparatory work has to be carried out in the months and years ahead. The stock-taking of how the different national money markets function, and whether these differences matter for the future, has only just begun. Statistics have to be harmonised. A lot of work can be done on operational targeting, the use of reserve requirements and in the harmonisation of money market instruments. This last-mentioned is something that will need to be done, irrespective of the choice of intermediate targets.
Last but not least, we shall have to reach agreement on more explicitly
normative matters: what are the desirable changes, with a view to monetary union, in the structure and operations of the individual money and capital markets? This will not simply be an academic exercise. To reiterate, it is the evolution of markets that will, in the end, determine the usability of intermediate targeting. But this evolution is not just the outcome of spontaneous decisions taken by market participants. Many of the initiatives will be a response to legislative, regulatory or deregulatory decisions taken by the various national authorities both in the process of implementing the single financial market and in preparation for Stage Three. To a certain extent, but to an extent that will not be easy to identify, such decisions by the authorities will not be without relevance for the usability or otherwise of money supply targeting by the European Central Bank. But we should have no illusions: in a financially integrated, strongly innovative world, the European authorities will not enjoy a great deal of freedom in their endeavours to constrain market developments and practices. This suggests good prospects for lively debate within the EMI Council.
Some of you may wonder whether all this difficult, time-consuming and expensive preparatory work is really worthwhile. Are we going to reach monetary union in the foreseeable future? My own answer to this question is an unequivocal 'yes'. I do not know how many countries we will begin with. I do not know whether it will be the outcome of a peaceful and gradual convergence (to which the EMI should make its own contribution) or be triggered by a crisis (which it should try to avoid). But I do believe that it will happen sooner rather than later. This belief does not stem simply from my respect for the timetable of the Maastricht Treaty, although I would caution against underestimating the political and institutional dynamics set in motion by the Treaty. It reflects just as much my conviction that the facts of the integration of the 'real' economy in Europe, combined with the development of a single financial market, will compel us to embark on monetary union.
The argument can be summed up in a few propositions which I shall put to you simply at the risk of sounding dogmatic:
- The integration of our countries' 'real' economies has not only reached the point of no return, it continues to progress. The single market is a reality. Its preservation is becoming a matter of vital interest for the majority of Europeans.
- Major misalignments of real exchange rates among the member countries would not only significantly reduce the benefits for Europe of the single market; it could also lead to socially and, therefore, politically unacceptable developments, putting the single market itself at risk.
- Floating currencies have in the past afforded no protection against exchange rate misalignments - rather the contrary;
- 'Intermediate' arrangements of the ERM type may provide a shelter against such misalignments, at least for a time - observe the relative stability of real exchange rates among some (but by no means all) of the European countries;
- But however valuable they are for limited periods, such arrangements do not offer a foolproof, lasting solution: with free capital mobility, they can be derailed by speculative pressures responding to real, perceived or anticipated policy failures or actions.
- In the long run, only monetary union provide an appropriately stable framework for the functioning of the single market - it being understood, of course, that the stability of nominal exchange rate relationships within the Union will only be tolerable for countries which have achieved a reasonable degree of convergence among themselves, and which accept a very high degree of economic (and political) union, complementary to the monetary union itself.
To say the least, the realisation of all this will not be easy, but I cannot see any aiternative if we want to preserve the single market, let alone to reap its benefits.
I shall now return to the other basic remit of the EMI, namely that of strengthening the coordination of Member States' policies in the period leading up to Stage Three, while the responsibility for setting and conducting these policies remains firmly in the hands of the national central banks. I do not share the view that this mandate amounts to 'squaring the circle' for the fundamental reason that the Treaty explicitly defines the aim of the coordination in terms of 'ensuring price stability'. This qualification has a two-fold importance. On the one hand, successful coordination defined in this way would pave the way for meeting what is probably the most important single convergence criterion laid down by the Treaty for embarking on Stage Three. On the other hand, it should also be regarded as a more general and permanent mandate given to the central banks for the conduct of their monetary policies - almost irrespective, if I may say so, of the pace of progress towards, and the time of implementation of, monetary union.
The mandate given to the central banks to ensure price stability did not find its way into the Treaty solely because of German insistence. The firmness of the German view played a major role but could not have carried the day had there not, prior to the Treaty negotiations, been a massive conversion to the cause of price stability (a sort of 'cultural revolution') in almost all western countries, and notably in Europe. This conversion was born of the realisation that, ultimately, inflation erodes our economies' growth potential or, more positively, that price stability is one of the main prerequisites of lasting growth. It is, therefore, no accident that inflation rates in a number of European countries have for several years now been running at less than 3 % and have been on a declining trend even in those countries whose currencies have depreciated. Inflation has decelerated not simply as a result of a hardline currency policy, but because of a weakening of forces responsible for home-made inflation. These facts, even more than any formal provision of the Treaty, should help to lay to rest concerns among the German public about their neighbours' inflationary proclivities and, for the more distant future, about swapping the Deutsche Mark for a European currency. In a growing number of countries, those proclivities belong to the past and there will be no swap unless the European currency is as strong as, and possibly stronger than, the D-Mark.
While the anti-inflation role assigned to monetary policies provides a firm framework within which the EMI can perform its coordinating activity, such coordination will also be helped by the work carried out in our committees and working parties, and importantly, in the EMI Council itself. Given the acceptance of the common objective of price stability, and the visibly successful pursuit of this objective, the door is gradually opening to a process of reaming from each other - something that could hardly be envisaged if there were a doctrinal dividing line between Union central banks on the final objective of monetary policy. But since such a rift no longer exists, the debate will focus not so much on what to achieve as on how to achieve it. And with the diversity of experience in money markets, operating techniques, linkages between the money and bond markets, financial innovation, the transmission mechanism whereby monetary impulses pass to the real economy, and not least in budgetary policies and the working of the real economy, opportunities arise for a genuine exchange of views. Germany as a whole, and the Bundesbank in particular, have deservedly earned the respect of their European partners (and of the wider world) for a long period of success in a stability oriented monetary policy. The decision to establish the EMI in Frankfurt is a tribute to this success. But one should not be surprised to discover that other European countries have learned something in the process.
To conclude, the task of the EMI is not going to be an easy one, but it can be done. 'External' circumstances may arise over which the Council members and myself have no control. If such circumstances are not to derail our efforts, we shall need the wisdom of our countries' political leaders and some luck as well. There are areas - and I have tried to point to some of them here - in which the responsibility for success or failure will rest on our shoulders. But, in any event, we will need the help of the public at large and of the financial community in particular. Much of our work has to be carried out within the traditional confines of central banking discretion, which I intend to respect scrupulously. But we shall be dealing with matters of great complexity and, moreover, in a fast-evolving financial and economic environment. I know only too well that there is no substitute for keeping in touch with the realities of the market place. A.L