Neither the Delors Report nor the European Commission paper of March 1990 specifies the process of transition to Economic and Monetary Union. The controversy over a common versus a single currency is not urgent, despite the emphasis on it in the recent Ernst and Young and Butler Reports. A common currency is certainly the ultimate goal, and a currency reform will be a useful step towards this end, but the key problems will be the stability of the EMS during the transition and the role of `Eurofed' in harmonizing Community and national monetary and exchange rate policies.
These problems are far from insuperable, however, and I propose to demonstrate below that they can be overcome quite easily provided that three essential conditions are met. First, bilateral central exchange rates must be irrevocably fixed from the start of Stage I of Delors, to avoid the danger that monetary convergence will be postponed indefinitely. Second, in order to make these fixed parities credible, governments should declare now that instead of responding to disruptions in the foreign exchange markets by realignments, they will instead meet any destabilizing speculation by accelerating the move towards monetary union. Third, the European System of Central Banks recently christened `Eurofed' should initially be formed of two separate bodies, an Exchange Rates Stabilization Authority and the Board of Central Bank Governors, whose distinct roles in the transition period are carefully defined below.
The Delors Report underestimates the threats to monetary stability and the EMS presented by the deregulation of financial markets. Speculators will seek to exploit exchange rate volatility without capital controls and with destabilizing innovations in European banking and financial markets, as well as changes in the relative demands for European currencies as private agents are increasingly able to use any of the EMS currencies to settle bilateral obligations. Further, if private agents expect a devaluation of the exchange rate, and wages and prices increase as a result, then the central bank has only two unpalatable options: it can either refuse to accommodate this increase in inflation, thus giving rise to a real appreciation and a current account deficit, or accommodate it by devaluing the exchange rate, thus validating expectations.
Bilateral central rates must be irrevocably fixed from the start of Stage I, in order to avoid the danger that monetary convergence could be postponed indefinitely. These fixed exchange rate parities may be made more credible, while preserving flexibility for national monetary authorities to adapt to changing conditions, if it is agreed and announced in advance by the national governments that any disruptions in foreign exchange markets that would traditionally be met by realignments will be met instead by an acceleration of the final monetary reform. In this way, it will be possible to prevent the possibility of successful destabilizing speculation while still preserving the virtues of gradualism.The political obstacles to such an acceleration of the union in the face of disruptions during the transitional stages should be minimal compared with the likely undoing of the project. Indeed, the opportunity cost of substituting a single currency for a system of irrevocably fixed exchange rates should be zero. The institutional details of a European central bank will be worked out soon, and the costs of the proposed acceleration are unlikely to be significant. Moreover, the option of acceleration would in any case be unlikely to be exercised in a world of rational agents and properly functioning markets.
Since financial markets are not always characterized by rational behaviour, however, it is necessary to develop an institutional framework for Eurofed that will be capable of absorbing shocks and facilitating the coordination of national monetary policies during the transition period. This may be achieved by dividing the Eurofed into an Exchange Rates Stabilization Authority (ERSA), with a mandate to manage intra-European exchange rates and foreign exchange operations relative to the dollar, and a Board of Central Bank Governors (BCBG), which would act as a consulting body to coordinate national monetary policies during the transition, during which the central banks will continue to control their domestic credit policies.
The division of responsibilities between ERSA and BCBG thus corresponds to the separation of the two fundamental functions of central banking under fixed exchange rates money creation and foreign exchange market intervention and will lead to increased transparency, by making the sterilization of ERSA's operations by any country more clearly identifiable. The credibility of the fixed exchange rates will be enhanced by the delegation of their management to ERSA, and flexibility will be provided by the ability of ERSA to absorb currency-specific shocks without compelling countries to adjust to them immediately.
ERSA should manage intra-European exchange rates and foreign exchange operations relative to the dollar. Its portfolio must be large enough to carry out foreign exchange interventions without recourse to borrowing from member countries. My preliminary estimates suggest the optimal ERSA portfolio would be 5-10% of the total supply of money of the member countries.
BCBG should coordinate national monetary policies, which retain a degree of autonomy, and review the operations of ERSA. Shifts in the composition of ERSA's portfolio will act as a warning sign that national monetary policies are inconsistent with the fixed exchange rates. BCBG would act on these signals. It would not decide on the appropriate monetary stance for individual central banks, but would help them to identify viable alternatives and reach informal agreements. BCBG would have no need for voting rules, since none of its tasks involve collective decisions. It should be granted maximum independence from outside bodies such as national governments, and this should make it better able to encourage sound anti-inflationary policies than is possible with the present informal bargaining in the EMS.
The ultimate objective of the project of European integration is the currency reform, which will occur either after successful refinements of the rules governing the twin institutions the ERSA and the BCBG or whenever the slow transition proves to be too vulnerable to financial market instabilities. The currency reform is a simple redefinition of units leaving the real value of all existing assets and liabilities in the economy unaffected. A currency reform amounts to a joint declaration by the 12 governments that their new currencies are all equal to the ECU, which can then be printed by national central banks to replace old banknotes.
A currency reform over and above the irrevocable fixing of exchange rates is to be preferred for two reasons. First, the persistence of odd exchange rates across European currencies complicates transactions significantly, makes national moneys different from each other per se, and hence renders monetary integration incomplete. Second, a one-to-one exchange rate is a clearer message that the monetary union is permanent. For this reason, the national central banks should start to use the symbol of the ECU together with that of national currencies (for example the new Deutschmark note could have both DM and ECU logos on it), since the public has to be convinced that there are no remaining differences among national currencies. This reform is the best way of ensuring the ECU's emergence as the European currency, since it does not generate the monetary instabilities associated with its introduction as a parallel money. Immediately after the currency reform, the power to determine the common monetary policy should be permanently transferred to the ESCB, Since national currencies will by then have disappeared, ERSA can be relieved of its initial tasks, and should transform itself into the open-market branch of the system (carrying out both foreign exchange and domestic open-market operations).
Undoubtedly, this reform will produce a one-time dramatic increase in the use of pocket calculators and a considerable but short-lived nuisance, since it will require the recalculation of all prices and all outstanding assets and liabilities. This loss should be compared, however, with the present discounted value of all the gains from moving to a permanent regime in which all European currencies will have exactly the same value, and therefore all transactions across Europe and in particular the management and control of Europe-wide businesses will be enormously facilitated.
This proposed institutional structure is well suited to evolve into a `permanent' European central bank for the final phase of monetary unification, as BCBG could develop from a purely consultative into a proper decision-making body and ERSA into the principal foreign exchange intervention bank of the new system. The final currency reform would in effect amount to no more than a simple redefinition of units, but would be worth implementing nevertheless, first in order to simplify transactions in intra- European trade, and second to send a clearer message that the monetary union was permanent.



This is an abridged version of a paper presented by Alberto Giovannini (Columbia University and CEPR) at a lunchtime meeting in Brussels on 21 March, organized jointly by CEPR and the Institut d'Etudes Européennes. The full text of Professor Giovannini's report is available from CEPR for £5.00 as Occasional Paper No. 2, The Transition to Monetary Union.