The Maastricht Treaty set out a strategy and timetable for monetary union in the European Community based on the gradualist philosophy of the Delors Committee Report. The steps towards EMU in particular the final step are conditional on the achievement of convergence in inflation, interest rates and budgetary indicators. In Discussion Paper No. 658, Research Fellow Paul De Grauwe considers the entry requirement that EMS members' inflation rates be no more than 1.5% above the average of the three lowest-inflation members. He notes that the remarkable success of the EMS in achieving inflation convergence hides increasingly divergent price levels, as certain countries have had persistently higher inflation rates than others since the last realignment in 1987. He examines the possible sources of these systematic divergences and finds that they have little to do with productivity differentials. They are probably best explained by the differential inflation reputations of national monetary authorities. In fixed exchange rate systems in which countries retain their own central banks, their different reputations ensure the persistence of residual differences in inflation expectations and hence in observed inflation.

De Grauwe illustrates the difficulty of achieving complete inflation convergence under a fixed rate regime by comparing the EMS since 1987 with the Bretton Woods system of the 1960s, which displayed similar divergences in national price indices. This is unlikely to be sustainable: if the competitiveness of certain EMS countries continues to decline, devaluations will be required in the 1990s, and convergence of national inflation rates will be postponed. He also analyses inflation convergence among the German Länder and finds that their annual deviations occasionally reach levels of 1.0-1.5%; but they do not cumulate systematically in one direction as in the EMS, so divergences in price levels within Germany are extremely small. It therefore seems paradoxical that the Maastricht Treaty imposes, as an entry condition for EMU, a degree of convergence that is only observed in a full monetary union, in which a common currency and common central bank impose the discipline required to achieve this criterion. De Grauwe concludes that the Maastricht inflation convergence requirement is unnecessarily severe: if the final stage of EMU is viewed simply as a monetary reform, this tight convergence requirement may be abandoned.

Inflation Convergence During the Transition to EMU
Paul De Grauwe

Discussion Paper No. 658, June 1992 (IM)