At a lunchtime meeting on 12 October, Tommaso Padoa-Schioppa discussed the recent turbulence in European monetary policy and financial markets. Padoa-Schioppa is Deputy Director-General of the Banca d'Italia and was formerly Director General of DG II of the Commission of the European Communities (Economic and Financial Affairs) and Rapporteur for the Delors Report. His remarks were based in part on his CEPR Occasional Paper No. 7, `Agenda for Stage Two: Preparing the Monetary Platform', written with Fabrizio Saccomanni. Sponsorship of Dr Padoa-Schioppa's visit to the UK from Citibank is gratefully acknowledged. The views expressed by Dr Padoa-Schioppa were his own, however, not those of the Banca d'Italia, Citibank or CEPR, which takes no institutional policy positions.

Padoa-Schioppa first described the results of his paper, written during the final phase of the pre-Maastricht negotiations in November 1991. This described the work needed in the transition to the final stage of EMU to enable the European System of Central Banks to operate effectively from the start of Stage III and concluded that unifying the operations and regulatory procedures of the national central banks over payments systems, monetary policies and banking supervision was needed from the start of Stage III. Burdening a new supranational institution with the task of operating several heterogeneous national systems would only exacerbate the difficulties surrounding the establishment of a single monetary policy.

Padoa-Schioppa then turned to the recent turbulence in European monetary policies and currency markets, starting with the Danish referendum and culminating in September's withdrawal of sterling and the lira from the Exchange Rate Mechanism of the EMS, which was unexpected but not unpredicted. As early as 1987, he had noted that the removal of capital controls and non-tariff barriers would lead to an `inconsistent quartet' of free trade, full capital mobility, fixed exchange rates and national autonomy to conduct monetary policy. Historical experience of monetary unions indicated that at least one of these must be abandoned: with full capital mobility and fixed rates, divergences of member countries' real economic performance encourage speculative attacks on individual currencies.

Padoa-Schioppa suggested that this highly unstable system had survived until September 1992 because the widespread expectation that it would develop smoothly into a monetary union had itself acted as a stabilizer. Hence, for example, Italy experienced no major exchange rate pressures in early 1992 so long as the markets `discounted' EMU, despite tensions in the government debt market and political instability arising from the uncertain outcome of the April election. Only after the negative outcome of the Danish referendum did these specifically Italian factors affect currency markets, whose instability was exacerbated by the fall of the US dollar against the Deutschmark, which strengthened vis-à-vis other EMS currencies. Continued uncertainty throughout August about the outcome of the French referendum, combined with certainty about the date on which this would be resolved, created the classic conditions for the currency markets to bet.

Padoa-Schioppa noted that four separate `Treaty ratification' processes had been proceeding simultaneously: the French referendum; the interactions between the Bundesbank and the German Federal government over how to implement Maastricht and manage the transition; Italy's attempts to comply with the necessary convergence conditions; and `market ratification', as the primarily London-based currency speculators anticipated the removal of at least one set of intra-bloc exchange rates from the set of their possible operations. The breakdown of the fixed parities of the ERM was therefore attributable to one fundamental cause and several contributory factors.

Turning to the prospects for monetary cooperation in Europe, Padoa-Schioppa maintained that the worst of the turbulence was now past. On the negative side, two currencies had left the ERM, the speculators were seen to have `won', and the authorities' credibility had been eroded seriously. On the positive side, the ratification of the Maastricht Treaty is continuing following the French result, and the franc has resisted a major speculative attack and thus demonstrated the ability of the ERM to defend a currency that has no underlying reason to realign, with joint intervention from both affected central banks.

Padoa-Schioppa concluded that the EMS cannot return to what it was before September 1992, since the markets' ability to invest in expectations of realignments is an order of magnitude greater than the resources available to the authorities. He outlined three possible options. First, if managing the EMS `more flexibly' meant responding to market pressures by realignments even when they were not justified by real divergences, this would undermine the fundamental purpose of the EMS, since capital mobility with a crawling peg would generate rather than cure divergences in national inflation rates. Second, improved cooperation among EC member states' monetary authorities which should cease to base their behaviour solely on national factors is the best option in the short run; on several occasions in the previous few weeks, this would have led to better outcomes. Third, the only valid, long-term solution is to accelerate progress to monetary union; recent events have not been a crisis of EMU, but rather a crisis of non-EMU and in particular of a transitional phase that was always known to be unstable.