A joint CEPR/ESRC workshop on ‘North versus South? The Political Economy of EMU’ was held in London on 15 September 1997. The workshop, which received financial support from HM Treasury and fell within the ambit of the International Macroeconomics programme, was organized by Marcus Miller (University of Warwick and CEPR) and Michael Wickens (University of York and CEPR). A major objective of the workshop was to reconsider earlier views that the blocking power of those excluded from a narrowly defined EMU would be sufficient to ensure either a broad EMU or no EMU at all.

Paul De Grauwe (Katholieke Universiteit Leuven and CEPR) opened the proceedings with a paper on ‘Prospects of a Mini Currency Union in 1999’, an updated version of his earlier CEPR Discussion Paper. De Grauwe argued that the countries excluded from European Monetary Union (EMU) will use their negative voting power to bar the entry of some core countries. Over the past year, as the fundamentals defined by the Maastrict Treaty had converged, at least for countries willing to participate in EMU, the distinction between ‘core’ and ‘periphery’ had become quite fuzzy. This had now effectively ruled out the German game plan whereby the Maastricht convergence criteria would enable some (core) countries to form a mini currency union. Indeed, looking at the criteria – and with a flexible interpretation of the Maastricht Treaty – a maxi monetary union (with the possible exception of Greece) now appeared feasible. Paradoxically, however, this good news had led to public disenchantment with EMU in Germany because of mistrust of south European countries’ economic policies.

De Grauwe argued that Germany’s investment in EMU was unique. It had to pay up front the irreversible cost of abandoning an extremely valuable brand – the Deutsche mark – and of forgoing the use of monetary policy, knowing that the (uncertain) returns to EMU would accrue only in the future. The increased likelihood of a broad currency union, including countries believed to be less inflation averse, and the growing fear that the prospective benefits might have declined, had increased the attraction for Germany of a wait-and-see approach. In response to Richard Portes (LBS and CEPR), who asked about current perceptions of the euro’s external value, De Grauwe said it was perceived to be weak. George Tavlas (Bank of Greece and IMF) believed that Germany’s problems in meeting the budget-deficit ratio meant the Maastricht criteria were backfiring on the country. On the value of the euro, however, Tavlas noted that in the previous few months, as it had became more probable that EMU would occur, the Deutsche mark had appreciated by roughly 15% against the US dollar. This reflected market sentiment that if there was to be a euro it could not be a soft currency. Peter Bofinger (Universität Würzburg and CEPR) was unsure whether De Grauwe’s model, with only one agent and one utility function, fully captured the German situation in which different agents with different interests were interacting. Those who really favoured EMU wanted it immediately, while opponents used the postponement strategy to disguise their opposition. Bofinger also doubted whether the still very high Italian and Belgian debt-GDP ratios could be said to be consistent with the convergence criteria. Luigi Spaventa (Università degli Studi di Roma, ‘La Sapienza’ and CEPR) regarded the date of the German elections as an important and relevant element. He also questioned the underlying assumption in De Grauwe’s paper that the game between Germany and Italy was a zero-sum game.

A different viewpoint was offered by Marcus Miller (University of Warwick and CEPR). In ‘Eurosclerosis, Eurochicken and the Outlook for EMU’, Miller claimed there was fundamental mistrust between northern and southern EU member states. The mistrust was reflected in the various Maastricht convergence criteria, in the increased restrictions on the use of fiscal policy (the ‘stability pact’) and in the likelihood that the European Central Bank (ECB) would adopt a fairly conservative monetary policy in order to build up a reputation. Miller saw the omission from the Maastricht Treaty of any mention of a lender-of-last-resort role for the ECB as striking and, given the recent surge of banking and exchange rate crises, as worrying. He was also sceptical of the separation of monetary sovereignty from fiscal authority, which could lead not only to solvency problems but also to liquidity crises.

In his paper, therefore, using a game-theoretic approach, Miller had modelled the incentives for two groups of countries: those favouring a mini EMU (Germany in particular), and those favouring a maxi EMU (e.g. Italy). He had found that, with persistent unemployment and assuming that EMU postponement would have severe costs, a mini currency union was the most likely outcome. Furthermore, analysis of the delegation of monetary policy under persistent unemployment revealed that EMU might be characterized by an inflexible labour market along with an inflexible monetary policy. Miller thus concluded that willingness to initiate labour-market reforms would be a far more effective criterion for membership than the current Maastricht conditions. Switching to such a criterion would imply postponing the Maastricht timetable for EMU, but would be far more likely to lead to a well-functioning currency area.

The ensuing discussion focused mainly on the future ECB’s lender-of-last-resort function, or lack of it. Willem Buiter (University of Cambridge and CEPR) felt this was not a problem since the ECB would deal with banking crises in a discrete way, should this be necessary to avoid moral hazard problems. Richard Portes thought the ECB would shoulder its responsibilities if needed, and alluded to the track record of the Bundesbank in the case of, for instance, the Herstatt Bank. Peter Bofinger agreed, noting that the Bundesbank’s statutes do not mention any role of lender of last resort. Bofinger took issue with two other views. First, that the ECB will suffer from mistrust among member states; historically low long-term bond yields show this is not the case. Second, Miller’s classification of the ECB as more rigid than the Bundesbank was questionable. The Bundesbank had proved quite flexible vis-à-vis its announced monetary targets, but very inflexible in lowering interest rates. Finally, Bofinger argued that, with the Maastricht Treaty in place, treating government bonds as zero risk would be problematic. Given that national central banks could no longer finance government debt, there would be a solvency risk for the state.

Luigi Spaventa reported that one major ratings agency had started to incorporate solvency risk into government bond debt. Berthold Herrendorf (University of Warwick and CEPR) pointed out that it is extremely difficult to change the statutes of the ECB. These had been defined in the Maastricht Treaty, and Treaty changes required agreement from member states. George Tavlas noted that, once the euro is in place, the possible occurrence of banking crises will pose several political and jurisdictional problems. For instance, if there were a banking crisis in Italy, would we expect to see (say) German and French representatives on the board, and would they be in favour of bailing out the banking sector in question?

Luigi Spaventa (Università degli Studi di Roma, ‘La Sapienza’, and CEPR) presented ‘Italy: From Outsiders to Insiders?’. In his view, the probability of a mini EMU was nil. Since the summer of 1996, several events had rendered it impossible to continue speaking about ‘core’ and ‘peripheral’ countries. The first was insiders’ arrogance – as seen, for instance, in assertions that countries inside EMU would have greater voting powers and that outsiders would remain outside for some time. Peripheral countries had responded with drastic economic measures so successful that it was no longer possible to speak of a ‘Club Med’. These measures had been facilitated by the marked appreciation of the US dollar. The second event had been the unexpected election of a socialist Prime Minister, Lionel Jospin, in France, who favoured Italy’s inclusion in EMU.

Furthermore, Spaventa concluded that there were now no realistic scenarios which might still lead to Italy’s exclusion. There was no question of Italy voluntarily agreeing to stay out. Nor could failure to meet the fiscal criteria be invoked, since Italy would merely point out that both Belgium and Germany also did not fulfil them. And, while inventing new criteria – for instance, taking debt as a percentage of EU, rather than national, GDP – might enable Belgium to pass the test, Italy could argue that other criteria – such as debt maturity – would also need to be taken into account. Thus, said Spaventa, as far as Italy was concerned, if the decision regarding which countries will participate in EMU is to be based on the existing Treaty of Maastricht, then Italy would definitely be in. If there was a problem about who would participate, that problem was purely German and purely political.

In ‘The Evolving Debate in Germany and its Implications for 1999’, Peter Bofinger (Universität Würzburg and CEPR) argued for a recognition of the different actors and interests present in Germany regarding EMU, and tried to offer a better understanding of Germany’s alleged mistrust of southern EU states. The first notable actor was the German public which, according to opinion polls, was currently against EMU by 55% with only 45% in favour. Second was the Bundesbank, whose regional central bankers would find themselves left with no real power should EMU occur. Third was the banking industry, which was divided: large banks favoured the euro because it raised possibilities of expansion into other European markets; the small banks (Volksbanken), however, were anti-euro. Fourth were the German industry federations, all of which were in favour of EMU. The press, which was mainly opposed to the euro, and currently displayed strong mistrust of France and its politicians, was a fifth actor. Finally, there were Germany’s own politicians, among whom Chancellor Kohl was perceived as wanting EMU at any cost. Yet, Bofinger claimed, since Kohl was already near the end of his political career, he most probably would not have to face any of the potential negative implications of EMU. Edmund Stoiber, the influential Land President of Bavaria, and the CSU, by contrast, were opposed to the euro.

Bofinger went on to list a few German risk factors that could yet prevent EMU from starting in 1999. These included: the resignation of Chancellor Kohl (e.g. owing to health problems, or a Bundesrat vote against EMU); a formal German request for a delay; and a German constitutional court decision that the European Council technically had not respected the Maastricht criteria. A negative assessment of EMU by the Bundesbank also could present a major potential obstacle to the start of the euro.

In joint discussion of Spaventa’s and Bofinger’s presentations, Marcus Miller asked whether there was a real risk that Germany, backed by its constitutional court, might vote against participation. Richard Portes replied that the Treaty did not allow for unilateral withdrawal, while Willem Buiter added that, if the European Council decided a country had satisfied the criteria, that country was required to enter EMU unless it had an ‘opt-out’ – which Germany did not. Rolf Günther Thumann (Salomon Brothers International Ltd) disagreed. He considered that Germany effectively had an opt-out option – it could simply let its budget deficit exceed the critical 3.0% of GDP ratio and then point out that it no longer qualified.

On the high-indebtedness criterion, Paul De Grauwe considered the duration of the maturity of the debt a very important issue. Furthermore, he disagreed with the conventional view that short-term duration was dangerous and should preclude countries from joining EMU. In fact, short-term duration of debt gave less incentive to inflate the economy and monetize the debt. William Allen (Bank of England) wondered why only government debt should be taken into account, rather than – as he favoured – looking at all forms of debt. Finally, referring to Bundesbank intervention on the foreign-exchange market, Paul De Grauwe remarked that, given the existing 30% margins of fluctuation within the ERM, once final parities had been announced, there would be no need to intervene. Richard Portes added that it was necessary to maintain the external value up to
1 January 1999 but that this could be done without any risk through unlimited central bank intervention at the very last minute.

In a paper entitled ‘Economic and Non-Economic Aspects of EMU: The UK’s Economic Policy Choices’, Martin Wolf (Financial Times) based his argument on two assumptions: first, that EMU would happen (i.e. Germany would not block it); and second, that it would be a broad monetary union. The main points bearing on the UK’s EMU-membership decision were: UK prospects were no worse than those of other EU countries; The United Kingdom and other European economies were in different cyclical positions, with the result that sterling was overvalued and no UK government would want to join in these circumstances; and unlike in Continental Europe, UK borrowers were highly exposed to short-term rates. Hence, within EMU, variations in short-term ECB rates would affect the UK economy disproportionately.

The UK’s options were to join at the start; to join in later, for instance, when the euro is circulating as cash; to wait and see; or never to join. According to Wolf, the first option was out of the question, both for cyclical reasons and because the UK public were not prepared for it politically. The second option – which Wolf believed Prime Minister Blair would prefer – was more likely, but by 2002 the UK economy might be in recession and Continental Europe in a boom. The last two solutions – which were virtually indistinguishable – were slightly less plausible. For the United Kingdom to join EMU, the government needed to take three steps: first, raise taxes to reduce its structural deficit, which was currently in good shape, but relied too much on very tight government expenditures; second, take early steps to encourage long-term borrowing; and third, bring sterling back to a more reasonable value. In Wolf’s opinion, these requirements pointed to ‘wait and see’ as the best strategy.

William Allen questioned Wolf’s sentiment that short-term borrowing was a problem. Indeed, borrowing on short maturities avoided the uncertainties associated with long-term borrowing. On the issue of whether a monetary union was sustainable without a political union, Peter Bofinger was rather sceptical. Those who criticise EMU for its lack of political union often do so only because they do not want EMU at all. Paul De Grauwe questioned Wolf’s assertion that EMU would be unsustainable together with different national fiscal authorities. Wolf’s response was that this was due to the inherent conflict of interest among member states’ fiscal policies. On whether a late UK entry would involve important costs – because, for instance, the UK’s influence on the EU’s monetary policy would be small – Wolf thought that any such costs would be transitional.

‘Monetary Union, Entry Conditions and Economic Reform’ was the title of a paper presented by Alan Sutherland (University of York and CEPR) and written jointly with Gulcin Ozkan (Brunel University, Uxbridge) and Anne Sibert (Birkbeck College, London, and CEPR). Their paper set out to model the decision problem facing a potential entrant into a monetary union where admittance is conditional on the entrant meeting one of the Maastricht criteria, namely a target inflation rate. Since inflation performance in a monetary union depends in part on such variables as tax-system efficiency and labour-market flexibility, the question investigated by the authors was whether the imposition of this entry requirement would encourage or discourage structural reforms by potential entrants. They showed that entry conditions can have two undesirable effects. First, they can lead to multiple equilibria by generating self-fulfilling inflationary expectations. Second, and paradoxically, tighter entry conditions can inhibit reform by helping to lower inflationary expectations during the qualifying period, thereby reducing the ‘need’ for structural reforms.

Berthold Herrendorf was puzzled by the fact that, in the model, membership of the union did not seem to matter at all. Willem Buiter asked whether, if the reform costs faced by policy-makers are interpreted as a social cost rather than a political-embarrassment cost, a low level of reform would then be an efficient outcome. Marcus Miller enquired about the benefits of asking potential entrants directly to undertake structural reforms rather than to meet an inflation target. Anne Sibert’s reply that it was easier to monitor the inflation performance of potential entrants drew a rejoinder from Buiter to the effect that this argument risked undermining the whole paper, which considered inflation as a substitute for reform, and concluded that the outcome might be less reform. It therefore strengthened Miller’s point that inflation was an inappropriate target. Guido Ascari (University of Warwick) thought the model lacked an important feature in the form of the discipline factor: once a country had entered EMU it would be easier and less costly to tackle labour-market reform.

The workshop ended with a panel discussion chaired by Paul De Grauwe. William Allen reported on the view of the financial markets regarding the prospects for EMU. According to implied future correlations of exchange rates based on option prices – a technique developed at the Bank of England – the markets’ thoughts appeared to be that EMU would happen on time and that the union would be a broad one, with Italy, Spain and Portugal expected to be included, but not the Uinted Kingdom. Willem Buiter focused on the post-1999 transition period up to 1 July 2002 (when all national currencies are to be demonetized), during which the euro will coexist with national currencies, and exchange rate risk will persist inside the Union. Buiter recommended that potential entrants from among other countries should not opt for a narrow EMS version. He was also of the view that the euro would be a strong currency (because the selected central banker was likely to be very conservative and would need to build a good reputation and track record for the ECB).