Monitoring European Integration: The Making Of Monetary Union

In the second of a series of Annual Reports, Monitoring European Integration: The Making of Monetary Union, published on 24 October, a panel of CEPR Research Fellows present a simple proposal that will permit EC member states to join a monetary union without the need to meet `convergence conditions' in advance. They also stress the important but hitherto neglected role that the proposed European Central Bank (ECB) will have to play in the regulation and supervision of the Community's banking system. This year's panel comprised David Begg (Birkbeck College, London), Pierre-André Chiappori (DELTA, Paris), Francesco Giavazzi (Università Bocconi, Milano), Colin Mayer (City University Business School, London), Damien Neven (INSEAD and Université Libre de Bruxelles), Luigi Spaventa (Università degli Studi di Roma, `La Sapienza'), Xavier Vives (Universitat Autònoma de Barcelona) and Charles Wyplosz (INSEAD and DELTA). The German Marshall Fund of the United States provided generous financial assistance that was essential to the completion of the Report, but the opinions expressed are those of the authors alone, and not those of the German Marshall Fund nor of CEPR, which takes no institutional policy positions.
The authors assume that Europe's economic and monetary union will finally take place and focus on how this can best be achieved. They note two main pitfalls. First, in the search for a political compromise, the process may emphasize immediate but transient concerns at the expense of a more suitable framework for policy-making in the longer run. This danger applies both to current proposals that require inflation convergence prior to EMU and to those that seek to impose overly restrictive limits on national fiscal sovereignty. Second, the muddle over macroeconomic issues inflation, debt and deficits is leading to neglect of vital microeconomic considerations. A European Central Bank will need significant regulatory powers to safeguard the financial system; their form, the timing and manner of their introduction, and their connection with monetary policy all need discussion now.
The Report is in two parts, which deal respectively with the macro- and microeconomic issues involved in establishing EMU. Part I develops five key points. First, low-inflation countries (Germany and possibly the Netherlands) will derive little direct economic benefit from EMU beyond its general function in underpinning the 1992 programme. Since they will therefore be unwilling to incur significant costs from EMU, it must be seen to be inflation proof, which in turn requires the ECB's complete independence from political control and equal independence of the member states' national central banks.
Second, such independence is incompatible with current proposals to assign exchange rate policy to national Treasuries operating through the European Council of Economics and Finance Ministers (ECOFIN). The external exchange rate is determined by the interaction of monetary and fiscal policies; so assigning its control to ECOFIN is wholly incompatible with ECB independence and would be a certain recipe for inflation in the longer run. The mere discussion of any possibility other then ECB control of the external exchange rate is indicative of the economic muddle and political fudging that have characterized the negotiations.
Third, requiring any substantial convergence of national fiscal policies (budget deficits and government debt) as a precondition for EMU is unwise and unnecessary: unwise because it will straitjacket national fiscal policies, which should assume greater flexibility once a single European monetary policy is in place; and unnecessary because prudential rules and regulation of the financial system are superior means of ensuring that individual EMU member countries' irresponsible fiscal policies are deterred ex ante and suitably quarantined in their effects ex post. Fourth, preconditions on inflation convergence before EMU are also misplaced: it is the credible commitment to implement EMU that will best serve to attain rapid inflation convergence; and delaying the start of the process may even jeopardize the convergence that has been achieved already. Fifth, for the same reason, fears of a final realignment are unhelpful, and this possibility should be ruled out as quickly as is practical: Stage Two of any Delors-type transition should be as brief as possible.
The authors propose that EMU may be achieved most simply and easily through the following process: (i) member states should sign a Treaty at Maastricht to agree the rules under which individual countries may choose to join EMU; (ii) these should be free to announce their intention to join from January 1992 onwards, and they should become full members two years after announcing their intention to do so; and (iii) such announcements should entail the commitment unilaterally to maintain their exchange rates i.e. to maintain their parities within the narrow bands of the ERM against the hardest EC currency during this two-year `probationary' period.
This proposal has four main virtues: (i) it is simple; (ii) it allows individual countries to choose whether and when to join; (iii) it offers prospective members the convergence bonus they will enjoy from announcing their intentions to join, while nevertheless forcing them to bear most of the adjustment burden of pre-entry disinflation by themselves; and (iv) it prevents destabilizing speculation, since individual countries must complete any realignments required to offset the accumulated accidents of history before declaring their intentions to join.
Part II of the Report focuses on the microeconomic issues involved in the regulation and supervision of the banking system in an EMU. The ECB will be required to oversee the smooth operation of the payments system, but there is little discussion of its supervisory functions in the draft statutes or indeed elsewhere. These issues are important in their own right; and there are also potential conflicts between the ECB's responsibility for financial stability and its commitment to price stability.
After 1992, capital will flow freely throughout the European Community, and banks authorized in any one member state will be entitled to export banking services and to establish branches and subsidiaries in all the others. Competition in banking has already increased with domestic deregulation, and it is expected to increase further with the completion of the 1992 programme. The resulting fall in bank profitability will reduce reserves and potentially increase the risk to depositors of financial failure following imprudent, high-risk lending decisions.
The integration of Europe's financial markets requires the harmonization of bank regulation, since national regulators may take insufficient account of the interests of non-residents. The recent case of the Bank of Commerce and Credit International (BCCI) illustrates that the costs of a bank failure may be largely borne by foreign depositors; and the failure of one bank may increase the risk of runs on others leading to a contagious collapse in the rest of the financial system. Financial integration will increase the exposure of banks in each country to the effects of failure in others; and with the emergence of a single currency such failures may also have cross-border repercussions through the payments system.
The authors note that the Community has made considerable progress in harmonizing bank regulation, and further progress in harmonizing deposit insurance is expected. Current proposals nevertheless suffer from a fundamental deficiency, since it is relatively easy to harmonize regulatory rules, but it is much harder to harmonize the discretion national authorities use in their original authorization of banks, their subsequent supervision, and interventions to rescue failing banks. Even with agreement on rules, banking standards will therefore differ across countries: some will adopt a liberal attitude to new entry to encourage the growth of their financial centres, while others will be more concerned to safeguard their financial stability.
Coordination of authorization and supervision by committee is probably sufficient to ensure that national regulators act in overall Community interests concerning individual banks, but such coordination will be harder when there are systemic rather than individual bank risks. In such cases, minimum levels of deposit insurance will be required to ensure that home countries' deposit insurance provides adequate protection to host countries' financial systems. Once financial integration reaches the point that national regulatory failures affect the Community as a whole, coordination by committee will be quite inadequate: central agencies must then take responsibility for monitoring and controlling banks' authorization and for the supervisory and intervention functions previously undertaken at the national level.
At this stage, the ECB should assume responsibility for banks' authorization and act as lender of last resort in case of illiquidity. A separate regulatory agency may better perform the tasks of administering insolvency, supervising bank closure and providing deposit insurance, however, since this will avoid the risk that authorizing institutions will be reluctant to reveal their failures by closing down banks. Further, in cases of serious failure for which the accumulated reserves from risk-based premiums are inadequate the relevant authority may need tax-raising powers that will lie outside the authority of the ECB.
Centralization of banking regulation should not mean harmonization, however, since differences in the functions of banks across countries impose different risks on depositors which require different regulatory responses. Regulators should set solvency ratios more closely related to risk than at present, and regulation should be properly priced wherever possible. The premiums charged on deposit insurance should normally be sufficient to ensure that such schemes are self funding, but in extreme cases claims on such insurance funds may have to be supplemented by general taxation.