European Monetary System
Transitional programmes

With the abolition of exchange controls almost completed, the EMS is now in a transitional stage. According to Francesco Giavazzi and Patrick Minford, speaking at a CEPR lunchtime meeting on 18 January, the EMS without capital controls will behave very differently from before. The convergence and stability that characterized the System's first 11 years of operation will be undermined, and it may even break down.
Francesco Giavazzi is Co-Director of the Centre's International Macroeconomics programme and Patrick Minford is a CEPR Research Fellow. The meeting was held as part of a new research programme on `Financial and Monetary Integration in Europe', led by Giavazzi and funded by the Commission of the European Communities. The opinions expressed by Giavazzi and Minford were their own, not those of the European Commission or of CEPR, which takes no institutional policy positions.
Giavazzi's remarks were based on CEPR Discussion Paper No. 369, with Luigi Spaventa, entitled `The New EMS'. He described fundamental changes in the operation of the System over the last three years. Parities used to be realigned at least once a year, and weaker currencies were sheltered from even more frequent adjustments by the tight capital controls imposed by five of the seven countries then in the Exchange Rate Mechanism. Now, however, this shelter is being removed. All restrictions on capital flows have already been lifted in France and are scheduled to disappear in Italy very soon. For over three years to January 1990, there have been no changes of the central EMS parities. Early in the most recent period, strong pressures against the French franc and the lira were successfully resisted and on more than one occasion the offer by Germany of an across-the-board appreciation of its currency, often but vainly solicited in the past, was actually turned down.
Many commentators argued that controls on capital mobility were necessary for the EMS's stability and that it could not survive their abolition. So far, however, financial liberalization seems actually to have strengthened the EMS. Giavazzi explained that policy-makers in the countries with weaker currencies realized that, once exchange controls were gone, the mere possibility of a realignment would stir up an unsustainable speculative attack and a run on the currency. Now that realignments are virtually impossible, the commitment to fixed exchange rates is the only way to preserve the stability of the System, and governments' commitment to stick to the existing parities has become credible to the financial markets. The convergence of the variability of Italian and French interest rates to that of West German rates confirms that exchange rate expectations have stabilized.
Giavazzi warned, however, that the process of disinflation, a substantial achievement of the System's first eight years, has apparently stopped. Firms in higher-inflation countries with high domestic interest rates have taken advantage of the removal of capital controls to shift their borrowing abroad. The result is large capital flows into countries such as Italy and Spain, threatening monetary targets. Despite attempts at sterilization by the monetary authorities in these countries, credit aggregates have soared, but policy-makers dare not allow interest rates to fall because the resulting expansion of domestic demand would frustrate the disinflation.
This creates tensions in the EMS: high-inflation countries are frustrated in their attempts to keep domestic demand under control, while the Bundesbank finds the maintenance of price stability increasingly difficult. This is reminiscent of the conflict between the United States and Germany that eventually brought down the Bretton Woods system. The experience of the interwar period confirms that `fixed-but-adjustable' exchange rate systems do not survive long without capital controls. Eliminating altogether the risk of realignments, Economic and Monetary Union will remove remaining inflation and interest rate differentials. But the long transition towards EMU envisaged by the Delors Committee will prolong the period of vulnerability, according to Giavazzi, and should therefore be accelerated.
In his remarks, Minford outlined his disagreements with the Delors plan for a `manufactured common currency' and European Central Bank. In particular, he argued, EC members would be deprived of the ability to use monetary policy for independent objectives. Countries whose costs have risen against the rest of the EC will no longer be able to respond by allowing their exchange rate to depreciate. Although in the long run any attempt to offset rising costs through depreciation must be offset by rising wages and prices, in the short run a depreciation can ensure less painful adjustment, lowering real costs and improving competitiveness. Minford's empirical research, conducted using the Liverpool model of the world economy, suggested that in most EC countries (the exceptions are Belgium, Italy and the Netherlands), wage and price-setting behaviour is such that devaluations can be effective in this way. Another reason why some EC countries are unlikely to relinquish monetary independence, he argued, is that their higher inflation rates contribute to public finances in the form of an `inflation tax', since inflation erodes the real value of government debt.
The only way Minford could foresee these `weaker' countries agreeing to participate in EMU, giving up their monetary powers, is if they were given voting power in the new institutions. Hence the Delors Report proposes giving each member country equal representation on the board of the European Central Bank. This symmetry is the central flaw of the Delors plan, according to Minford, since the influence of the `weaker' members will ensure it is less committed to monetary stability than the Bundesbank, which underpins counter-inflationary policy in the EMS. We should therefore expect the monetary policy of federal European institutions to be systematically more inflationary than in the EMS, perhaps converging on the highest common denominator of the member countries' inflationary preferences.
Schemes for competing currencies, in contrast, of which the UK Treasury's is one, would not remove national central banks' independence. Instead the private sector, untrammelled by exchange controls, would be able to choose which currencies to hold, steadily raising the market share of the most stable and exerting strong downward pressure on monetary policy throughout the EC. In contrast to the Delors plan, therefore, Minford argued that competing currencies would induce convergence on the lowest inflation rate in the European bloc. A further attraction is that the arrangements most suited to Europe's future would emerge through the interplay of consumer, firm and government preferences in the market, while the Delors plan brings the risk that arrangements imposed by political and bureaucratic decision would turn out unsuitable for the future.
Minford agreed that, once exchange controls are abolished, the `new' EMS would be vulnerable. He thought it likely that EMS currencies will polarize into two groups: some would effectively float, like the lira in the early 1980s, while others, like the guilder recently, would be effectively fixed against the Deutschmark. The EMS would have to allow for both sorts of currencies if all the members of the System were to participate in its evolution to monetary union. He therefore favoured continuing the ability of some currencies to float within broader EMS bands, as the peseta does at the moment.