European Affairs

Accordingly, all the official and legal texts portray the euro as an egg that cannot be unscrambled. That image is false. The euro is more like a solution that can be distilled back into its component currencies. There are significant costs associated with the distillation process. But they are not so high as to sustain monetary union under all conceivable circumstances. The various scenarios in which European monetary union shrinks or disintegrates, which I shall describe more fully later, are striking for their practicality.

None of these procedures, of course, can be found in the Maastricht Treaty. But much history would be extinguished if treaties were never broken or re-negotiated. From the perspective of the euro's fifth birthday in early 2004, it is highly plausible that there will be demands for a re-negotiation of the Treaty before its tenth birthday. Threatened exit is one bargaining tactic of the country or countries demanding reform. In the case of Germany in particular, the threat is a very powerful weapon. Monetary union would probably not survive a German pull-out. The Netherlands, Belgium and Luxembourg have historically been attached to a German monetary anchor and would almost certainly decide to follow Germany out of a truncated union.

Germany has much reason to be disillusioned with the functioning of EMU to date, even though it played a lead role in its design. During the period of creation, Germany had tremendous influence on the design process. France was the lead supplicant, begging Germany to give up the Deutsche mark and monetary hegemony in Europe. German negotiators understandably expected much in return. In particular, they insisted that the European Central Bank (ECB) adopt the stability framework of the Bundesbank. They totally failed to imagine that the German economy could enter a Japanese-style lost decade, from which the only exit might be zero interest rates and currency devaluation. Once in union these conditions for a return to German economic prosperity could be impossible to achieve.

There is no reason to expect German voters to meekly resign themselves to the errors of past policy makers. If German economic performance does not improve, then at least one mainstream party will surely seize the opportunity to win votes by demanding EMU reform. The more aloof and incompetent the conduct of the ECB, the more likely will this become. Suppose, for example, that the euro zone were to move into a deflationary stagnation which could be attributed plausibly to the ECB's policy errors during 2001-2004. Attacks on the ECB and reform proposals could then become themes for political debate as early as the German Bundestag elections due in the autumn of 2006.What would be in the agenda for reform?

Germany could insist that ECB policy makers place a larger focus on divergent business cycles within the euro zone. This demand is justified by the underlying economics of EMU. There are important spillovers from Germany onto the other countries. In particular, Germany's present process of extracting itself from stagnation by enduring a fall in its prices relative to other euro members (meaning an increase in the competitiveness of German products) has limits. The other countries would ultimately experience deflationary conditions in their export industries.

The ECB should take this knock-on effect into account when deciding on the appropriate present level of policy determined interest rates. The German government could act as a catalyst to pre-emptive monetary policy by installing a boldly charismatic monetary expert as head of the Bundesbank, who would exert much influence in the boardrooms of the ECB. (Perhaps the recent appointment of Professor Axel Weber as Bundesbank President in place of Mr. Ernst Welteke could prove to be just such a step). Given powerful enough domestic support, the new Bundesbank President could also show disrespect to the secrecy conventions instituted under Wim Duisenberg, the ECB's first president. These have fortified the undemocratic features of the Bank, making it remote from the general European public.

It would take only one powerful central banker to defy ECB secrecy to bring about rapid reform in this area. This would include not just open voting and full minutes of meetings but an obligation for ECB council members to testify, on a rotating basis, before national parliaments, which have the ultimate power of censure over the ECB. They, not the European Parliament, can initiate or sanction changes in the Treaty of Maastricht or unilateral exits from EMU.

The various national electorates might feel less alienated from the proceedings around the ECB council table if they could see evidence of their own central bank president acting effectively. German voters would be impressed if the Bundesbank President were arguing eloquently and forcefully that the ECB should set its inflation target in a way to take account of the severe economic conditions in Germany.

Revamping the inflation-targeting process would be central to reform. In its early years, the ECB viewed a highly simplistic and strict inflation targeting system as essential to winning confidence in the new money. The ECB, unlike the Bundesbank, enjoyed no reservoir of public trust. But now the inflexible pursuit of price stability (interpreted as an annual inflation rate of two percent or very slightly less) is a handicap to economic recovery. Ideally, the ECB, in consultation with the Finance Ministers of the Eurogroup, would determine the appropriate medium-term target range for low inflation, given current economic circumstances in the euro zone and the world outside.

Take, for example, a situation of wide divergence between the degrees of slack in the member economies, where large changes in relative price levels could advance overall prosperity. In such a case, the ECB should adopt a somewhat higher and broader inflation target range than when business cycle conditions were largely synchronous. Substantial changes in price relationships would require an actual fall in prices in some countries (those, in our example, where the degree of slack was large) if the overall inflation target for the whole union were set very low. Normal rigidities, however, mean that it is painful economically to achieve falls in wages and prices.

As another illustration of the benefits of flexibility in inflation targeting, take the present situation, in which the country with the largest savings deficit in the world, the United States, has abnormally low real interest rates. It follows that the countries in savings surplus ­ including the euro zone ­ should have even negative real rates. Otherwise private capital will not flow out of the savings surplus countries to the United States and their currencies, if freely floating, will enter an upward spiral.

The inflation target in the euro zone should be adjusted flexibly so as to allow real rates there to fall. The present and continuing morbid strength of the euro has been in considerable part due to the ECB setting its rigidly defined aim of price level stability in a spirit of splendid isolation. It is hard for those ECB officials, including President Jean-Claude Trichet, who saw monetary union as a way of gaining independence from dollar hegemony, to admit that even now their monetary policy should bend before U.S. economic realities.

EU Finance Ministers have not used their powers under the Maastricht Treaty to override the in built isolationism of the ECB policy makers in Frankfurt. The Ministers could have taken the lead on currency market intervention, initiating plans (via the formal intermediation of the European Commission) for massive joint dollar purchases by their respective central banks, financed by government debt issuance, which would be implemented unless the ECB eased its monetary policy.

Hopefully the Ministers will be less tame if events prove that ECB policy makers have failed their publics miserably by allowing deflation to take hold. (The present spike in world oil prices does not diminish that risk in that the primary impact is to dampen aggregate demand). A coherent reform package should include the suspension of the ECB's independence from governments under conditions of deflation. An economy cannot be extracted from a deflation trap by a central bank on its own.

No reform would be complete without an overhaul of the European Stability and Growth Pact. An unconventional way forward here would be to make an explicit reference in a revised Maastricht Treaty, or in the new European constitution, to the possibility of withdrawal from monetary union. Then fiscal policy in each member country would be constrained by the possible threat of bankruptcy, which would involve an emergency pull-out from EMU and the activation of a national money printing press. So long as the legal fiction persists that monetary union is unbreakable, investors understandably question the seriousness of the "no bail-out" rule, which bars the ECB from lending to governments in crisis.

There is a common interest among member countries in avoiding the external costs of a default crisis. These would be greatest in the case of a forced withdrawal of Germany. And so some type of Stability Pact is ultimately needed to restrain German fiscal policy. Here lies the central paradox of monetary union. The French founders of EMU believed that it would give France more influence and Germany less than the old European currency regime. But as it has turned out, Germany is now in a unique position to pose existential risks for the euro.

France has gained no tangible sway over European monetary policy. Arguably, Paris has increased its influence on policy-making in the Group of Seven leading nations. This is illustrated by the lead role of Mr. Trichet, as ECB President, in articulating traditional concerns of the French economic policy elite about the dangers of U.S. deficits for the world economy. But his strategy of joining forces with U.S. mercantilists against the Asian dollar bloc has so far brought tears not celebration for French industry, now weighed down by a super-strong euro.

Monetary powerlessness could eventually be a source of discontent in France. But it is difficult to imagine the pro-EMU center ground in French politics losing its strategic hold. The Netherlands and the UK are more plausible direct or indirect drivers of EMU reform. The Netherlands has lost much from monetary union. Its real estate boom and bust has brought severe problems of economic adjustment that could have been solved less painfully with an independent monetary policy and currency flexibility. What has the Netherlands achieved in return for sacrificing those options?

It has acquired a seat on the board of the ECB, and the first ECB president was Dutch. But the Netherlands has foregone the prestige and economic benefits of marketing its own small currency brand to compete with the Swiss franc. The disadvantages of a small currency, so heavily emphasized in the literature promoting monetary union, have diminished with the development of technologies that make possible dual pricing and multiple currency accounts. A threatened or actual withdrawal of the Netherlands would not trigger a general dissolution of EMU, but it could be a wake-up call to the need for democratic reform.

The UK's power to bring change depends on how far present euro members see political and economic advantages from British accession. London could make any eventual bid contingent on the calling of an intergovernmental conference to press a reform agenda. The actual mechanics of such an approach, however, are dubious. Which of the other countries would take London seriously before a Yes to the euro had been obtained in a British referendum? But if the referendum were held before reform, the political opposition to the euro in the UK would make much of the imperfections admitted by the government pressing for entry.

The alternative to reform is a rising possibility of separation or dissolution. In particular, a small or medium-sized country could make an exit either abruptly or by stages over several years. The staged withdrawal would involve relaunching a national currency which at first would be fully convertible on a 1:1 basis into the euro. The government of the departing country would breathe life into its new money by adopting it for its own use in expenditure and taxation.

In a second stage the new money would be floated within fixed limits against the euro and the government would expand the area of its mandatory use (for example to real estate rental agreements, public utility pricing and most wage contracts). In the private sector, computer technology could easily handle dual pricing and payments ­ allowing retail prices to be quoted in both euros and the new money. In the final stage, a fully-fledged independent and freely floating national money would emerge.

To make a rapid exit, the government would decree a re-denomination of resident deposits and loans with the domestic banking system into the new national money. During a transitional period, until new banknotes were printed, deposits in the new money could not be converted on a 1:1 basis into currency. Euro bills and coins would remain the only form of currency and would trade at a variable rate against the new money ­ in line with its exchange rate against the euro. In the retail economy, euro banknotes would continue to be used and dual pricing would be the rule. Advanced technology should allow banks to operate a system of variable charges or credits (depending on the exchange rate) on withdrawals of euro cash from automatic teller machines. Such withdrawals would be debited from current accounts in the new money.

Unlike gradual separation, the rapid exit scenario might well entail substantial windfall losses in the banking industry, owing to a mismatch between the totals of resident deposits and loans. As an illustration, take the case of a hypothetical Dutch withdrawal. If there were a large excess of resident euro deposits over euro loans to residents, the forced redenomination of these deposits into a reincarnated guilder that started its new life at a discount to the euro would inflict exchange losses on the Dutch banks. The government would have to provide partial compensation in extreme cases in order to avert a banking crisis, triggered by a large write-down of bank capital. But the government would have the advantage of being able to effect an immediate devaluation or revaluation of the new currency ­ and thus achieve a quick exit from either deflationary or inflationary conditions in the euro zone.

Both rapid and staged exits would ideally occur within the context of cooperation between the departing country and those remaining in the union. In particular, the departing country would agree to redeem the euro banknotes which seeped back to the truncated euro zone. This seeping back process would stem from residents in the departing country selling euro bills in exchange for the new national banknotes. The sold euro bills would swell the total deposits that banks in the now shrunken euro area would hold with the ECB. A redemption agreement would provide for the government of the departing country to buy back the euro bills that used to circulate on its territory. Otherwise the ECB would have to mop these up by selling government bonds from its portfolio, losing important interest income in the process, so as to avoid an inflationary increase in the money supply over the territory of the truncated zone.

Cooperation would be vital in the case of a general dissolution of EMU. In this case, each country would re-denominate resident euro deposits and loans into national currency units. Non-resident positions would be converted into a reincarnated European currency unit, or ECU (a basket currency made up of the new national monies weighted according to economic size). Euro bills would be convertible 1:1 into ECU-denominated deposits at a member central bank. Each of the central banks would bear its share of responsibility for redeeming these on demand, delivering their respective national monies in due proportion against ECU deposits presented for conversion into national components.

The technical hurdles in the way of dissolution are no greater than for the original introduction of the euro. Until the new bills in national money were introduced, euro bills would continue to serve as the main cash medium of exchange. Their day-to-day conversion rate with respect to any of the new national monies would be in line with the relevant ECU exchange rate. In effect euro bills would have become ECU bills, without there being any need to print these. The main technical challenge would be to provide for the debiting of euro bills withdrawn from automatic teller machines at the current ECU exchange against bank deposits in the respective new national money. And there would be the inconvenience during the interim period (until national bills become available) of dual pricing in the retail economy. One price would be for settlement in the new national money, the other for settlement by cash ­ in the form of euro bills.

General dissolution would be an unwelcome development for several governments in the new member states which joined the European Union in May 2004. Adoption of the euro as soon as possible was to be the fast road towards gaining the benefits of access to highly developed money and capital markets. It is possible that a few past members of EMU would enter into discussions about a shrunken union that the new member states could join, subject to satisfying the specified eligibility conditions. But it is difficult to imagine this becoming reality without the participation of Germany. And there could be political qualms in Central and Eastern Europe about submitting to a new German monetary hegemony. The present supranational European monetary order is much more acceptable, even though it suffers from a deep democratic deficit.

The lack of democracy and of progress toward European political integration, however, strengthens the conclusion that the euro zone may not be able to hold together. Many large currency areas, including the United States, would long ago have splintered into regional currency areas if it had not been for the unifying force of political federation and of widespread respect for the central monetary authority. In the case of Europe, political idealism may have originally persuaded citizens to vote for a monetary union of dubious economic benefit. But they will not continue to approve a currency union that demonstrably inflicts overall harm on their economies as the political ideal fades away. National self-interest will surely reassert itself. If that happens first in Germany, the life expectancy of European monetary union will be short.

Brendan Brown is director and head of research at Tokyo-Mitsubishi International plc in London and author of EURO ON TRIAL: to reform or split up (Palgrave, March 2004). He is the author of many previous books on international finance, including The Yo-Yo Yen (Palgrave), The Flight of International Capital (Routledge) and Monetary Chaos in Europe (Routledge). He is a regular columnist in the Nihon Keizai Shimbun. Based in London, he provides advice on international investment strategy to a wide range of European and Japanese clients.


This article was published in European Affairs: Volume number V, Issue number II in the Spring of 2004.