VoxEU Column Economic history EU institutions

Making the European Monetary Union

Recent policy and academic debates have begun to influence Eurozone reform. But how sound is the advice we give out? This column argues that calls for a Eurozone or full-fledged EU superstate are overstated. Yes, developing an adequate system of European banking supervision is a matter of urgency if we hope to tackle the threat posed by an overdeveloped and opaque financial system. But calling for a superstate misunderstands the reasons politicians introduced the euro in the first place.

It is often claimed – especially but not only by US economists – that the travails of the euro show that it is impossible to have a monetary union in the absence of a political union, and that Europe is necessarily embarking on a US-style experiment in federalism. Thomas Sargent used his Nobel Prize speech to urge Europeans to follow the model of Alexander Hamilton (2011). Likewise, Paul de Grauwe recently stated the case quite simply: “The euro is a currency without a country. To make it sustainable a European country has to be created” (2012).

Such advice seems appallingly radical. Almost every politician denies that there is any real possibility of creating a European state, and almost every citizen recoils at the prospect.

The idea that Europeans simply need a country because they happen to have a currency reflects a misunderstanding about the reasons politicians embarked on the economic and monetary union of Europe.

Why the euro was created

The creation of the euro was fundamentally driven by two needs:

  • A need to tackle problems of the international monetary order; and
  • A need to respond to the tensions created by German current account surpluses;

The first need was created by the disintegration of the dollar-based fixed but adjustable exchange rate regime (i.e. Bretton Woods). European monetary integration appeared urgent in the late 1960s and early 1970s, as problems of the dollar mounted, and in the late 1970s when US monetary policy was subject to big political pressures and the dollar collapsed.

The final push for a European solution to a global problem occurred in different circumstances. When the dollar was soaring in the mid-1980s, when US manufacturing was threatened and when there appeared to be the possibility of a protectionist backlash, the finance ministers of the major industrial countries pushed for exchange-rate agreement. At the G7 finance ministers Louvre meeting in 1987 they agreed to lock their exchange rates in to a system of target zones.

In practice, nothing came of that global plan, but then Edouard Balladur, the French finance minister who had largely been responsible for the Louvre proposal, came up with a tighter European scheme. When German foreign minister Hans Dietrich Genscher appeared sympathetic, Europe’s central bankers were asked by the president of the European Commission, Jacques Delors, to prepare a timetable and a plan for currency union.
The second need for European monetary cooperation arose from the strains created in Europe by German current-account surpluses – a problem that re-emerged in differing guises at regular intervals, in the late 1950s, in the late 1960s, in the late 1970s, in the late 1980s (and then again in the late 2000s).

In the Bretton Woods era of fixed exchange rates and controlled capital markets, even relatively small deficits could not be financed, and produced immediate pressure on the exchange markets. The deficit countries then had to apply fiscal brakes in a stop-go cycle. Germany’s partners, notably France, were faced by the prospect of austerity and deflation in order to correct deficits. This alternative was unattractive to the French political elite, because it constrained growth and guaranteed electoral unpopularity. Their preferred policy alternative was thus German expansion, but this course was unpopular with a German public worried about the legacy of inflation, and was opposed by the powerful and independent central bank, the Deutsche Bundesbank.

Figure 1. Sum of current-account balances (share of GDP)

1From 1991 the balance of payments statistics also include the external transactions of the former German Democratic Republic.

Sources: OECD Economic Outlook; European Commission; BIS Annual Macroeconomic database.

Solving the question of the German current accounts in the European setting at first appeared to require some sophisticated and ingenious political mechanism that would force French politicians to do more austerity than they would have liked, and Germans less price orthodoxy than they thought they needed. A political mechanism, however, requires continual negotiation and public deliberation that would have been painful given the policy preferences in the two countries (and in those countries that lined up with each one of the Big Two). The increased attraction of monetary union was that it required no such drawn-out political process. Monetary policy followed automatically from a decision to adopt price stability as a goal. The operation of an entirely automatic device would constrain political debate, initiative, and policy choice.

But monetary union produced an outcome that was inevitably slightly fudged and messy. Tommaso Padoa-Schioppa, the Italian economist, explained to Bundesbank President Karl Otto Pöhl in a letter of 1981: “To couple the defence of monetary orthodoxy with that of the institutional status quo may lead to defeat in terms of both monetary stability and independence. Your ‘monetary constitution’ has been too successful on the fight for stability. It will now either become the monetary constitution for Europe or be contaminated by the sins of the others. That is, by the way, a very ‘deutsches Schicksal’ [German destiny]”(James 2012: 193).

A risky institutional choice

In choosing a ‘pure’ money in the 1990s, free of any possibility of political interference and simply designed to meet the objective of price stability, Europeans were taking an obvious risk. That is, they were deliberately flying in the face of modern and dominant thinking about money.

The creation of money is usually thought to be the domain of the state. This was the widely prevalent doctrine of the nineteenth century, which reached its apogee in Georg Friedrich Knapp’s highly influential book, State Theory of Money. Money could be issued by the state because of government’s ability to define the unit of account in which taxes should be paid. In the Bible, Christ famously answers a question about obedience to civil authorities by examining a Roman coin bearing the head of Augustus and telling the Pharisees: “Render unto Caesar the things which are Caesar’s.” The design of the euro makes the novelty clear: unlike most banknotes and coins, there is no picture of the state or its symbols – no Caesar – on the money issued and managed by the ECB.

The planning for monetary union was unbelievably sober and meticulous. In the debates of the central bankers’ group that Delors chaired in 1988-89, before the fall of the Berlin Wall, two main issues were highlighted:

  • First, fiscal discipline was needed for currency union;

An explicit discussion took place as to whether the capital market by itself was enough to discipline borrowers, and a consensus emerged that market discipline would not be adequate and that a system of rules was needed. The influential economist from the Bank for International Settlements, Alexandre Lamfalussy, a member of the Delors Committee, brought up cases from the US and Canada, as well as from Europe where cities and regions were insufficiently disciplined. Jacques Delors himself at this time appropriately raised the prospect of a two speed Europe, in which one or two countries might need a “different kind of marriage contract”.

The need for fiscal discipline arising from spillover effects of large borrowing requirements is a European issue, but it is clearly not one confined to Europe alone. In emerging markets, this problem was identified after the 1997-98 Asia crisis, and the problem of major fiscal strains became primarily one of the industrial world – and especially of the US. An appropriate response would involve some democratically legitimated mechanism for limiting the debt build-up, as in the Swiss debt brake (Schuldenbremse) which was supported by 85% of voters in a referendum.

  • Second, central bankers identified flaws in the European plans as they prepared for monetary union;

In the original version of a plan for a central bank that would run a monetary union, the central bank would have overall supervisory and regulatory powers. That demand met strong resistance, above all from the German Bundesbank, which worried that a role in maintaining financial stability might undermine the future central bank’s ability to focus on price stability as the primary goal of monetary policy. There was also bureaucratic resistance from existing regulators. The ECB was thus never given overall supervisory and regulatory powers and – until the outbreak of the financial crisis in 2007-08 – no one thought that was a problem.


By now, the extent of the challenge has become clear. Developing an adequate system of European banking supervision is a matter of urgency if we hope to tackle the threat posed by an overdeveloped and opaque financial system.

The euro story holds broader lessons:

  • Fiscal sustainability in the long run requires some sort of politically negotiated agreement;
  • Mega-finance is a danger to fiscal stability.

James, Harold (2012), Making the European Monetary Union, Cambridge, MA, Harvard University Press.

Sargent, Thomas (2011), “United States Then, Europe Now”, Nobel Prize speech 2011.

De Grauwe, Paul (2012), “The Eurozone’s Design Failures: can they be corrected?”, LSE Public Lecture, 28 November.

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