Year XXVII, 1985, Number 1, Page 38
The Strengthening of the European Monetary System
The present attitude of the Bundesbank constitutes one of the main obstacles to the European Commission’s various proposals for a strengthening of the European Monetary System (EMS). Its objections are best and most authoritatively summarized in Governor Pohl’s article in the March 16 issue of the Frankfurter Allgemeine Zeitung: «More Integration through Monetary Policy».
They are perfectly valid insofar as they are directed against any proposals to implement prematurely the ambitious objective of full monetary union, repeatedly endorsed at various summit meetings by the Heads of State or Government of the Community, as a long-term objective. This objective would entail either the full merging of present national currencies into a common ECU currency or, at least, the irrevocable stability of nominal exchange rates between these currencies. As long, however, as some member countries remain less able than others to master domestic cost and price inflation, any mutual commitments to stabilize nominal exchange rates might require that their resulting payments deficits be financed by excessive loans from the less inflationary countries (including, presumably and principally, Germany), imposing «imported inflation» upon these countries.
Considerable progress toward the elimination of these differential cost and price rises has been achieved over the last two years; and, in sharp contrast with previous years, no bilateral exchange-rate realignments have proved necessary since March 1983. Yet this progress is too recent, insufficient and fragile to exclude totally the need for further realignments in the forthcoming years, or even months. The credibility of irrevocable exchange rate stability without excessive recourse to external credits must await not only further progress in the harmonization of domestic policies, but also their consolidation through institutional reforms, switching the control over monetary issues from national authorities to federal authorities.
I share, in that respect, the concern of Germany about the negotiation of legal provisions ensuring a sufficient degree of independence to the monetary authorities called about to manage a European Federal Reserve Bank, and would prefer to have them appointed by the Governors of national central banks, but would add two other observations.
The first is that legal texts may not be as significant in this respect as might be imagined, for a Federal Reserve Bank as well as for national central banks. The ability of the latter to resist inflationary pressures from the political authorities will continue to be determined primarily by entrenched national traditions and the character of appointed officials far more than by legal texts. Even if the designation of the European Federal Reserve Board were left entirely, as suggested above, to the governors of national central banks, these would obviously consult previously with their ministers of finance, and be more receptive in some countries than in others to the advice received from them.
Equally obvious, however, is the fact that a Federal Board of Governors would be far less dependent on national political authorities than most central bank governors can be today.
Secondly, in the absence of reform, external inflationary pressures on all Community countries (including Germany as well as others) will remain determined by the policies of other member countries, and even more of the United States. The Federal Reserve Bank of a full economic and monetary union would be far more able to reduce and resist such pressures than is the case in the present unorganized international monetary system.
Much more should be said in this respect, but I shall refrain from doing so, for what is relevant today is not this long-term ambitious objective, but a different proposal aiming only at making the EMS capable of decreasing the excessive dependence of member countries’ economies on the unpredictable and wildly fluctuating paper dollar.
The proposals now under negotiation, however, are far more modest, being confined to what could and should be done immediately, in an intermediate phase – initially envisaged to take place in March 1981, at the latest, but postponed until an «opportune moment» by the European Council of Luxembourg, in December 1980 – to strengthen the present EMS machinery. Such strengthening seems to me most «opportune », vital and urgent today to enable it to face the awesome tensions to be expected from a new and major crisis of the dollar exchange rates. As mentioned by Governor Pöhl himself, in the second paragraph of his article, the success of the EMS over its first six years of operations belies the initial pessimism of its opponents – including the Bundesbank – but was facilitated by the strength of the dollar, which entailed a relative weakness of the mark, thus decreasing somewhat the frequent tensions between the strongest EMS currency and its weaker partner currencies. These tensions are now reappearing and might reach a breaking point if the dollar continues, as is certainly possible and even likely, to pursue its decline vis-à-vis the mark and other relatively strong Community currencies.
I suspect, therefore, that the following arguments of Governor Pöh1 against some of the modest proposals of the Commission are inspired primarily by the fear that the proposed EMS strengthening might, if successful, reinforce the arguments for a passage to the full monetary union discussed under I. above.
These arguments are indeed far less convincing, and the most valid of them could be met constructively by other appropriate suggestions, such as those presented under III. below.
Let me distinguish, at this stage, the objections against an extension of the official use of the ECU and those related to its private use.
A. The official use of the ECU.
1. Two of the main proposals of the Commission relate to the use of ECU financing in “intra-marginal” as well as in “marginal” exchange-rate interventions, and to its full acceptability – now limited to 50% – in the settlement of the claims thereby accumulated by the creditor central banks.
a) The first objection raised against these proposals is that the ECU is not convertible for settlements of deficits outside the Community. This is true only to a very limited extent. The bulk, and often the entirety, of central banks’ ECU accounts in the FECOM is the counterpart of their gold and dollar deposits (20% of their total holdings). Extra-Community deficits are settled today nearly exclusively in dollars, and these settlements entail a reduction pari passu: of the 20% dollar reserves held in the FECOM; of the 80% dollar reserves held outside the FECOM. The external convertibility of these two types of reserves is, therefore, legally identical.
It is true that this automatic convertibility is not applicable to the acquisition of ECUs financing exchange-market interventions, but this financing has been minimal at most, rarely exceeding 2 billion ECUs (i.e. only a fraction of the credits extended in fact to the United States through dollar investments), and fully repaid by the debtors within a few months at most. I shall come back to this question under III. below, showing how their convertibility could be fully assured through some additional provisions to the present EMS Agreement.
b) The second objection raised against the full acceptance of ECUs in financing and settlements is that they carry interest rates calculated, as the average of official discount rates and inferior to market interest rates. This objection should now be dropped since an agreement has been reached to raise them to the average of market rates. As mentioned already by Governor Pöhl, agreement has also been reached recently among central banks concerning the use of the ECU for intra-marginal interventions. He recognizes that such interventions might be appropriate to fight speculation, but points out that they should not be used to preserve artificial rates, significantly out of line with purchasing power parities. I fully agree with him on this point, and suggest in section III. provisions aiming at avoiding any such abuses of interventions.
2. Another proposal is to enlarge the use of the ECU to the central banks of countries closely linked to the Community and to institutions such as the BIS. Governor Pöhl mentions that this may not be durable, since ECU accounts are now created through swaps renewed quarterly and therefore of limited duration. He also doubts whether foreign central banks would wish to purchase meaningful amounts of ECUs in view of the limits to their usability. These doubts should disappear if the suggestions presented in Section III. prove, as I hope, to be negotiable.
3. More generally, the Commission hopes to give a role to the ECU in the international monetary system, as a reserve instrument similar to the dollar and the yen, in order to strengthen the position of the Community in the attempt to restore a stable monetary order. Governor Pöhl considers this as a laudable objective in view of the present instability of exchange rates, but that it cannot be imposed upon central banks as long as the ECU lacks some important currency attributes. But why stop there? A more constructive answer to this objection should be to endow the ECU with these missing attributes, as suggested under III. below.
B. The extension of the private use of the ECU.
Some of the arguments presented by Governor Pöhl – and others – against the extension of the private use of the ECU are undoubtedly understandable, but also susceptible of being met constructively by an appropriate negotiation package, including desirable quid pro quo commitments for both the stronger and the weaker currency countries.
1. The Commission’s plea for extending the private use of the ECU precisely requests such a quid pro quo:
a) All countries should fully liberalize capital movements within the Community, as promised indeed in the Rome Treaty: this would entail the lifting of such restrictions by weaker currency countries, particularly France – which has recently moved considerably in this direction already – and Italy.
b) Germany and the United Kingdom have fulfilled this commitment, but should lift two important shortcomings. The United Kingdom has not agreed yet to implement the stabilization of its currency vis-à-vis the ECU, long accepted by all other countries. Italy should also reduce the authorized margins of the lira’s exchange-rate fluctuations from 6% to the 2¼. As for Germany, it should lift its prohibition against the use of the ECU in private borrowings. This prohibition is regarded by the Bundesbank as imposed upon Germany by the law prohibiting the «indexation» of borrowing contracts, the ECU being considered by its lawyers as a mere «unit of account» rather than a «currency». If this were so, this law should be amended, in the overwhelming interest of German residents as well as of Europe as a whole, but most people would argue that this is a misinterpretation of the current situation. The ECU has become a currency of payment, not only among central banks – with some limitations that should be lifted, as argued elsewhere – but also between commercial banks and between their customers. Moreover, even German residents are already allowed to make in effect ECU transfers by transferring the component national currencies pro rata of their proportion in the ECU basket; this merely entails for them the payment of costly commissions on a double series of unnecessary exchange transactions: the conversion of ECUs by the payer into the component national currencies, and the reconversion of these national currencies by the payee into ECUs.
This patent absurdity probably explains the fact that Governor Pöhl refrains from mentioning this legal argument in the article cited above.
Even if the liberalization of ECU capital movements within the Community were to entail gradual progress only by some countries toward its full implementation, it is hard to see what Germany could lose in authorizing the use of the ECU in borrowing contracts, all the more so as it is also argued that little use would be made of such authorization. Why not leave the decision to market participants, in full accordance with German commitments to market principles?
As far as lenders are concerned, Governor Pöhl also argues that ECU loans would be of little or no interest to residents of strong currency countries (such as Germany) since they would have to weigh the risk of exchange losses against the advantage of higher interest rates. This is undoubtedly correct, but would again suggest that the matter should be left to free market decisions.
2. Most surprising is the argument that “the private use of the ECU is not necessary to the functioning of the exchange mechanism, which is the hard core of the EMS”. Any prohibition of the use of the ECU, indeed, tends to perpetuate the quasi-monopoly of the dollar in this use, and to make the issue of deposit money by commercial banks dependent on the vagaries of a highly fluctuating dollar rate. This constitutes to my mind a most convincing argument for regarding the extension of the private use of the ECU as a crucial contribution to a less erratic and obnoxious functioning of the exchange mechanism.
The strengthening of the EMS contemplated for the intermediate phase immediately ahead would admittedly require from each member country some sacrifice of short-term interests, real or imaginary; but most of these sacrifices would demand only from politicians to abandon inflationary facilities, detrimental in the long run to the national interest of their own country. They are, in any case, insignificant in comparison with the potential disasters that would be implied for every member country by the refusal to give the EMS the instruments necessary to reduce their vulnerability to foreseeable failures of current US policies.
The creation of the European Monetary Fund (or Bank, as I would prefer to call it) initially envisaged for the end of 1982 should be perfectly negotiable immediately, if four conditions are fulfilled.
1. The first is to demonstrate that such a bank, far from being a « machine de guerre » against the dollar, would constitute on the contrary an indispensable instrument for the efficient cooperation of the Community with the United States and other countries in solving problems common to all of them. The Community must not only speak – as is too often said – with a single voice: just «speaking» will never convince the US administration and its public opinion, prone to proclaim that what matter is «deeds not words ».
Concerted action of the major countries is recognized as essential to the success of the world fight against inflation, recession and unemployment, but the spokesmen of the Administration – such as Dr Feldstein, formerly – never tire of asserting and reasserting that such concertation is impossible between the United States and Europe, because the European countries must preoccupy themselves with their balance of payments deficits, while the paper-dollar standard frees the United States from any constraint of this sort. On the contrary, their external deficits may be financed painlessly by net capital inflows which at the same time finance an important fraction of their huge budgetary deficits: more than a half, last year.
The denial of this «exorbitant privilege» is certainly in the long-term interest of the United States themselves, as well as of the rest of the world. And the efficient co-operation of Europe to a viable, enduring, solution of the world dollar problem is the only way to convince the United States to bring their indispensable participation to the fundamental reform of the scandal that constitutes today the world monetary non-system.
2. On the European political level, the immediate implementation of the second transitional stage – a European Monetary Bank – toward a total Monetary Union does not raise the obstacles that the latter continues to raise for the most obdurate nationalists. On the contrary, it should rally a rare consensus between them and the most convinced Europeans. The former French Prime Minister, M. Debré, for instance, obviously would not wish to see the ECU replace the French franc; but he would be delighted to see it replace the Euro-dollars, Euro-marks, Euro-Swiss francs, etc. in which European commercial banks denominate today $ 850 billion to $ 900 billion of their claims and debts.
3. On the European economic plane, there exists no divergency whatsoever among participating countries regarding their fundamental economic policy objectives: they are all in favour of the «holy trinity»: avoid inflation, maximize production and employment, and balance their external accounts. The difference – but it is obviously crucial – lies in their capacity to impose upon their public opinion the disciplines indispensable to the success of these commonly accepted objectives. The countries which have succeeded best – notably Germany – refuse to accept the inflation risks that would be entailed by the obligation to finance by their credits the stability of the nominal exchange rates of the countries which fail to eliminate their domestic inflation and thus to avoid the external deficits flowing from such inflation.
4. As mentioned above, six years of experience have amply demonstrated that this uneven success of anti-inflationary policies could be met without excessive recourse to credits. Deficit countries have been as averse to incurring excessive indebtedness in order to stabilize their nominal exchange rates as surplus countries were averse to granting them. Eight exchange rate realignments have offset, relatively promptly, persistent or excessive cost and price differentials, and preserved real exchange rate stability at levels consonant with long run balance-of-payments equilibrium.
Nevertheless, Germany and other creditor countries may legitimately fear that this attitude might not necessarily prevail in the future, and that ECU financing might be abused to preserve inappropriate nominal exchange rates, at the cost of imported inflation for the lending countries, and of the impossibility for the European Bank to honour the convertibility of the ECU accounts accumulated by them in the process.
I would, therefore, include in the proposed reforms provisions assuaging such fears:
a) By requiring deficit countries to consult their partners concerning any recourse to international credits, including their borrowings from the market and from foreign official agencies as well as from the European Bank. This obligation should have as a quid pro quo the obligation of the surplus countries to submit similarly to a review by the Community the manner in which they finance their surpluses by lending – particularly through the accumulation of foreign exchange assets by their central banks – to their Community partners, to the United States, and to other countries. The «imported inflation» of which they rightly complain has too often been due to excessive financing of countries – particularly the United States – other than their Community partners.
b) As a consequence, occasional exchange-rate realignments would remain unavoidable, in the future as in the past, as long as member countries do not succeed in reducing sufficiently – and hopefully downwards – the remaining divergencies between their national paces of inflation.
(i) Any country – in surplus or in deficit – deeming a realignment preferable to an excessive increase of its claims or indebtedness should receive the benefit of the doubt whenever its central rate appears clearly over-competitive or under-competitive commercially. The coincidence of calculated purchasing power disparities with an undesirable evolution of the trade-balances network should be accepted as a presumptive criterion that central rates should be readjusted.
(ii) Conversely, the countries opposed to an exchange-rate realignment should receive the benefit of the doubt when the strength or weakness of their currency on the exchange market cannot be explained by such a disequilibrium on current account, but is due primarily to speculative capital movements. One should, in this case, explore the possibility of avoiding exchange rate realignments that might prove superfluous and even unbalancing in the long, or even medium term. If it became necessary for that purpose to have recourse to exchange restrictions – as foreseen in the Bretton Woods Treaty – restrictions upon capital inflows toward strong currency countries should be acceptable and even desirable to them as a way to reduce their fears of imported inflation; and they would reinforce the efficiency of the restrictions placed by deficit countries upon capital outflows. Obviously better still would be market controls: a better co-ordination of interest rates and even, maybe, an «interest-equalization tax» similar to that imposed by the United States in 1963, but evidently difficult to enforce in practice.
This exploration should take into account the geographic constellation of these disequilibrating capital movements, largely due today to the enormous capital transfer between the United States and the rest of the world, including in particular the countries of the European Community. A coordination of these countries’ official interventions in the exchange market and continuous negotiations with the United States regarding exchange rates, interest rates, etc. are particularly desirable in this respect.
5. These provisions should make «credible» the capacity of the European Bank to honour the convertibility of ECU holdings accumulated through the financing of appropriate stabilization interventions on the exchange market as well as through gold and dollars (and, eventually, other· agreed currencies, including those of member countries, as foreseen in the initial Bremen agreement) through the utilization of a minor fraction of its ample gold and dollar reserves.
The legal convertibility of the ECU into dollars would not, however, guarantee the stability of the exchange-rate applied to these conversions, any more than it would guarantee it for the national currency of any participating country. But the chances of a substantial appreciation of the present exchange rate of the dollar vis-à-vis the ECU are certainly far smaller than those of a depreciation; and the strengthening of the EMS would improve greatly the efficiency of policies aiming at combating the excessive fluctuations of the dollar, upward or downward, deemed detrimental by the countries of the Community, and would help preserve, in any case, a greater stability of their mutual exchange rates, far more important to them than dollar exchange rates.
52% of the Communitv countries’ total trade is accounted for by their mutual trade, “65% by their trade with the other countries of Western Europe, and 83% by their trade with all «Europe-oriented» trading areas, as against 8% only by their trade with the United States. These proportions are practically identical for German trade (about 49, 67, 82 and 7%, respectively). This confirms the argument made above for the use of the ECU in preference to the dollar as a monetary unit for international contracts, settlements, and reserve accumulation by central banks, commercial banks, firms and individuals.
6. The inclusion of the above provisions in the new phase of EMS strengthening should make it possible to transform the present trimestrial gold and dollar swaps into simple exchange transactions converting definitely into ECU reserve accounts the gold and dollar deposits of participating countries.
This is essential to the pursuit of a common policy regarding the exchange rate of the ECU – and of participating currencies – notably vis-à-vis the dollar. Indeed, a common policy obviously demands a «communautarization» of exchange risks, while these continue to be supported today – downward as well as upward – by each country separately under the swaps system.
If psychological and political considerations made it too difficult for some countries to accept a permanent transfer of their gold deposits, the simplest and most easily acceptable solution would probably be to exclude gold from the system of compulsory deposits, increasing correspondingly the dollar (and other currencies?) deposits where common management is essential to any concerted policy of interventions on the exchange market. It would be inappropriate to develop here the details of such a solution, of various alternative suggestions I have presented in the past to the experts of the Commission, and of those mentioned in its own publications.
I shall conclude by the answer I gave, in May 1984, to the question put to me by the Federal Reserve Bank of Boston, on the occasion of the fortieth anniversary of Bretton-Woods: “The EMS: Tombstone or Cornerstone?” The EMS is not a tombstone, but should be the cornerstone of a world monetary system that should be rescued from its tomb, as rapidly as possible, to put an end to the «stagflation», or rather «infession» from which we have suffered for more than ten years.
The first step in this direction should be its transformation into a European Bank, perfectly negotiable in the immediate future, and which could later become the instrument most indispensable to the completion of the full Economic and Monetary Union, repeatedly promised by European Heads of State and Government, but where negotiation and implementation still appear today very distant, and even uncertain.
See, in particular, the “Dossier sur le Système Monétaire Européen” in Economie Européenne, n. 12, Juli 1982.
Included in The International Monetary System: Forty Years after Bretton Woods, Federal Reserve Bank of Boston, 1984, Conference Series n. 28, pp. 127-178.