Speech by John Townend, Director for
Europe
At a International Seminar on 'The
American Continent and the Future of Regional Integration', Sao Paulo, Brazil,
4 April 2001
The Euro: Experiences and Perspectives of Integration
Let me first say what a great pleasure it is to be here in São Paulo again, if only very briefly, and to have been invited to contribute to this International Seminar at the Auditorio Simon Bolivar on 'The American Continent and the Future of Regional Integration', in celebration of Mercosur's 10th anniversary.
Regional integration is clearly something of which we in Europe now have considerable direct experience. Europe has, in the past 50 years or so, gone well beyond the kind of common market which you have been familiar with in Mercosur, to become a highly integrated single market; with a single currency covering twelve countries; and with supranational institutions, including the European Commission, European Court and European Parliament, with powers to make laws which have direct application in all Member States.
I am not, however, here to preach or to extol the virtues of the European model; nor to predict how Mercosur will develop in the first half of this new century, since you are much better qualified to do that than I. I simply note that there is great interest on both sides of the Atlantic in the evolution of our respective arrangements, and also considerable optimism about the prospect of closer ties between us - to include, but going well beyond, trade relations. Chris Patten, the European Commissioner for External Relations, for example, recently expressed the hope that the on-going negotiations will have achieved critical mass by the time of next year's Madrid Summit between the European Union and Latin America.
I have been asked to speak about the euro, the European single currency which was launched now over two years ago, at the beginning of 1999. This is the latest - and arguably the most important - step in European integration since the Second World War. I want to put the introduction of the euro into context, by explaining how integration in Europe has come about. And I will of course be talking to you from a UK perspective - in other words, as a member of the European Union, but not as a member of Economic and Monetary Union. I hope, therefore, that I can give you an objective assessment!
The history of integration in Europe
For a long time, European integration consisted of little more than the vision of a few people. What really enabled the vision to become a reality was the end of the Second World War. After the War, European statesmen were determined to avoid, at all costs, a repetition of the events which had led Europe into conflict twice within thirty years. The founding fathers of the European Community believed that the best way to avoid military conflict and trade protectionism was to bind Europe so closely together in economic terms that another war at the heart of Europe would become impossible in political terms.
Although the subsequent process of European integration has been very much dominated by economic aspects, in fact in the immediate post-war aftermath many of the great statesmen envisaged a political re-orientation. Winston Churchill, for example, spoke of building a kind of 'United States of Europe' to recreate the 'European family' and to give a real prospect of living in peace, safety and in freedom.
The first attempts towards European integration, in the West, were in exactly this spirit. Symbolically, the first step towards realising it was the foundation of the European Coal and Steel Community, which came into effect some fifty years ago. The Community was of symbolic importance, because the coal mines and steel mills in the Ruhr valley on the borders between France and Germany had helped to produce the aircraft, ships and tanks used to fight the war between France and Germany. By pooling their coal and steel resources, France and Germany - and the four other countries involved - were determined to make another conflict between them impossible.
It is now of some historical interest to recall that the European coal and steel industry was governed by a supranational High Authority, indicating a willingness for political integration going beyond purely economic relations. This was even more evident in the proposed Treaty on the Establishment of the European Defence Community, but the French National Assembly refused in 1954 to ratify this. Although this refusal could have heralded the end of the European integration process, the fact that it did not is ample testament to the strong will to learn from the past, and the vision and persuasiveness of the then leading politicians. However, from that point onwards, the fundamental direction and method of integration of policy changed, to concentrate almost exclusively on the economic front.
Market integration
Not by chance did the 1957 Treaty of Rome create a European Economic Community. Subsequently, the critical project in achieving this broader economic community was the Single European Market, launched after Jacques Delors became President of the European Commission in 1985 (and enshrined in the 1986 Single European Act).
The underlying objective of the Single Market is to enable a company with business in one European country to conduct its business on the same basis in any other European country. This has not been achieved by attempting to harmonise all the different national regulations involved. Politically, that would have been far too difficult, and in practical terms, it would have taken far too long. Instead, the Single Market has been implemented by agreeing in each case the minimum level of harmonisation required and, above that minimum, by mutual recognition of one country's rules in all the others. On this basis, the European Economic Community - or the European Union, as it is now known - has over the past 15 years made great strides towards implementing a Single Market. Of course, the Single Market is still not complete. But the European Union is much more of a single market now than ever before.
Monetary integration
Although the Single Market intensified trade between different countries in the European Union, they retained separate national currencies. After the Bretton Woods agreement broke down in the early 1970's, their currencies fluctuated against each other. Every country had its own monetary and exchange rate arrangements. Some of them proved more successful than others. By common consent, the most successful monetary policy was run by the Deutsche Bundesbank, fiercely independent of government, and with a mandate - strongly supported by the German people - to take whatever monetary policy action necessary to avoid again the kind of hyperinflations experienced twice earlier in the century. The Bundesbank presided over a strong and stable currency, the Deutsche mark.
The idea of closer monetary integration in Europe was to create a zone of monetary and exchange rate stability, with the Deutsche mark as its anchor. This idea began to develop in the 1970's, after the breakdown of Bretton Woods and in response to the first oil price shock. Initial attempts to implement this by limiting exchange rate fluctuations between different national currencies (through what was called 'the snake in the tunnel') were not very successful. The first real practical step forward was the introduction of the Exchange Rate Mechanism in 1979. Participants agreed on a set of central exchange rates between each other's currencies, and agreed to limit exchange rate fluctuations within relatively narrow (2¼%) bands around these central rates, either by changing interest rates, or by concerted central bank intervention in the foreign exchange market. The central rates could be adjusted, if they proved no longer sustainable.
To start with, there were frequent realignments in central exchange rates. Then, in 1983, a fundamental change in French policy occurred. The French Government resolved to make the franc as strong and stable as the Deutsche mark. Over a period of time, the new arrangements began to acquire credibility in financial markets. However, the Exchange Rate Mechanism was most effective only when not put to the test. That is because fixed exchange rates can prove an invitation to speculators, if central banks do not have the necessary foreign exchange to defend them; and the scale of reserves required to defend them has inevitably increased considerably over time as the foreign exchange markets have become deeper (as the UK incidentally found to its cost in the autumn of 1992, when sterling was forcibly ejected from the Exchange Rate Mechanism). Moreover, in the period after German reunification in 1989, the relatively high interest rates needed in Germany to finance reunification put the other participants in the Exchange Rate Mechanism under pressure. Some withdrew. Others devalued. And in 1993, the narrow bands had to be abandoned in favour of wide bands of 15%.
Although German reunification helped to cause very significant pressures within Europe's Exchange Rate Mechanism, it also gave a political boost to those advocating closer monetary integration in Europe. In effect, a political agreement was reached between France and Germany that France would not object to German reunification, provided that Germany agreed to give up the Deutsche mark in exchange for a new single European currency.
A Committee of European Central Bank Governors, chaired by the President of the European Commission, Jacques Delors, was set up to decide how Economic and Monetary Union should work, if there was the political will to achieve it. The Committee's report was a technical one. But the Maastricht Treaty transformed the technical exercise into a political objective, with deadlines. In particular, President Mitterrand succeeded in introducing a clause into the Maastricht Treaty saying that Economic and Monetary Union would go ahead at the beginning of 1999 at the latest. This meant that Europe's commitment to Monetary Union was no longer conditional. It was absolute.
But there was still a question of which countries should be eligible to join. The prevailing view was that Economic and Monetary Union in Europe would not work, unless there was a sufficient degree of economic convergence between the participants, not just at a particular point in time, but sustainably over an indefinite period into the future. An objective way had to be found of measuring economic convergence. That was the origin of the famous Maastricht convergence criteria, which set quantifiable standards for countries to meet in order to qualify to join Monetary Union: low inflation; low budget deficits; low or sufficiently declining levels of public debt; low long-term interest rates; and stable exchange rates. Eleven countries were judged to have met these convergence criteria, and joined Economic and Monetary Union at the start. Greece qualified to join at the beginning of this year.
There was agreement that Monetary Union should involve the introduction of the euro as a single currency in place of the old national currencies (Deutsche marks, French francs and so on). This was partly because a single currency was politically neutral. It would not have been possible politically to accept the Deutsche mark as Europe's single currency. But there was also a question of credibility involved. You can have a Monetary Union without a single currency, if you have irrevocably fixed exchange rates between different national currencies. But if national currencies are retained, there is always an element of uncertainty whether the fixed exchange rates between them will subsequently change. In that sense, fixed exchange rates are like locking the door and keeping the key. Replacing national currencies with a single currency is like locking the door and throwing away the key.
That is what the participants did, when the euro was launched at the beginning of 1999. Fixed conversion rates were established between the euro and the component national currencies (in practice, the ERM central rates were used). In legal terms, the old national currencies became denominations of the euro: like cents on the dollar, but not of course in the ratio of 100 to one. From the beginning of 1999, a three year transition period began, to allow for the changeover of national currencies to the euro. The wholesale financial markets changed over to euro at the start. But most transactions outside the financial markets remain denominated in the old national currencies. They need to be converted to euro by the end of this year. From the beginning of next year, to complete the process, euro banknotes and coin will be issued and the old national banknotes and coin will be withdrawn, within two months. That will be an immense logistical challenge: around 50 billion euro coins are being minted and over 14 billion euro notes printed - enough if laid end to end, apparently, to stretch to the moon and back twice!
You cannot have a single currency without a single monetary policy. And a single monetary policy means a single short-term interest rate, set by a single central bank. In the euro area, the central bank is a single central bank system, consisting of the European Central Bank, based in Frankfurt, and the national central banks of the participating countries (the Bundesbank, the Banque de France, and so on). Together, they form what is called the Eurosystem, with the ECB at its heart. The ECB is run by a Governing Council, with decision-making in practice by consensus. Its primary objective, enshrined in statute, is to maintain price stability in the euro area, and it is independent of government in pursuing this objective. In this sense, it is modelled quite closely on the old Bundesbank.
Economic integration
The monetary aspects of Economic and Monetary Union have never been seriously in dispute. But there has been much less agreement on what is required on the economic side. By contrast to the United States, the European Union has only a very small central budget - just over 1% of total EU GDP - and no-one is arguing to increase it. The 12 participating countries continue to decide at national level how public money should be spent, and how revenue should be raised to finance expenditure. This creates a risk of 'free riding'. The risk is that countries, which have met the strict convergence criteria in order to qualify for Monetary Union, subsequently relax their fiscal policies, once they join; their budget deficits increase; and this undermines, not only their own individual fiscal positions, but also the credibility of Economic and Monetary Union as a whole.
So the participants in Economic and Monetary Union have agreed to co-ordinate their fiscal policies through a Stability and Growth Pact. This is designed to constrain national governments to run budget deficits of no more than 3% of GDP, save in the most exceptional circumstances. It is backed by the threat of fines. As budget deficits vary at different points in the economic cycle, the 3% limit means that participating governments should aim to be broadly in budget balance over the economic cycle as a whole, implying that at the peak of the cycle they should be in substantial fiscal surplus.
But the practical application of this rule is not straightforward. At the moment, for example, there is an issue whether some countries which have been growing much faster than the euro area average and, partly in consequence, have higher inflation rates than for the euro area as a whole, should tighten their fiscal policy. The most obvious example is Ireland. This country, however, already has a substantial budget surplus, and is understandably reluctant to raise taxes or cut expenditure in an attempt to reduce its inflation rate. To resolve issues of this kind, the euro area relies on voluntary co-ordination between the members and peer pressure.
Besides fiscal policy co-ordination, the other economic ingredient that is needed to make Monetary Union work well is flexibility on the supply side of the economy. I think that the best way of explaining this is to compare the position in an individual country with the position across the euro area as a whole. If economic performance varies in different parts of a single country, parts of the country that are well off help to subsidise other parts that are relatively less well off. And people move to areas of the country where the work is. But across the European Union, there is insufficient money to do this, as the central European Union budget - as I have already noted - is very small. And people do not move from one European country to another to find work anything like as much as they do within the same country, not least because of language and cultural barriers. So more flexibility is needed in the euro area, particularly in labour markets.
Of course, that leaves open the question of whether or not it is a good idea for a country to join Monetary Union, if its own economy is rather more flexible than the economies of the existing participants, as arguably is the case in the UK compared with our core continental European partners. On the one side, the risk in joining is that its economic performance will be adversely affected by the lack of flexibility among the existing participants. On the other side, joining may eventually encourage greater flexibility throughout the region, and lack of flexibility in the rest of the region may help the joining country to compete in the meantime. So this is a difficult question to answer, and the answer may depend on the particular circumstances. But it is clearly one of the questions that will be relevant to the future UK debate about possible EMU entry.
Deepening and widening
The Single Market and Monetary Union are about deepening the European Union. But the Union is not only about deepening. It is also about widening. Only six countries joined at the outset: all of them countries on the European Continent badly affected by the Second World War. But over the past quarter of a century, the number of participants has grown: first of all, to include Denmark, Ireland and the UK; and subsequently, Austria, Finland, Greece, Portugal, Spain and Sweden.
Since the fall of the Berlin Wall, the next big prize for the widening of Europe is enlargement to the East to include countries like Poland, the Czech Republic and Hungary. These countries are demonstrably European but, after the Second World War, they were cut off from the European Community by Communism. When the Berlin Wall fell in 1989, enlargement became a political possibility, and indeed for many a political imperative to bring peace and stability to the entire European Continent. Economically, of course, a great deal has needed to be done to help bring this about. The UK Government has been a 'champion' of enlargement, and fervently hopes that the first Central and Eastern European countries will join the European Union in 2004. After enlargement, the European Union could have a population of up to 500 million people.
Variable geometry
One of the important consequences of widening the European Union is that it is no longer feasible to require everybody to do everything. At the start, all the rules applied to all the participants - though initially, of course there were only six of them. And all potential members still have to agree to a large number of Community rules and regulations.
But there is also an element of so-called 'variable geometry' involved. Countries joining the European Union can negotiate transition periods after they join before some Community measures come into effect. And while most members of the European Union have also joined EMU, the UK, Denmark and (in practice) Sweden have so far decided not to do so. Although there is a strong feeling in Europe that the Union should not just consist of a menu from which participating countries can pick dishes à la carte, the use of variable geometry is bound to increase as the European Union grows in size in future. Indeed, there is a provision in the new Treaty of Nice, signed earlier this year, that some countries can move ahead of others, subject to a number of conditions, the most important of which is that all members can join any new arrangements, if they wish to do so.
The UK's approach
I have tried to explain how and why integration has progressed in Europe over the past 50 years. But I have not so far mentioned my own country's attitude to European integration. At the beginning, the UK was something of a benevolent bystander. We wished the European Community well. But we had our own historic ties with the United States and with the Commonwealth. We turned down the opportunity to join the European Coal and Steel Community at the beginning. We joined the European Community sixteen years after the founding members. And we are not currently participating in Economic and Monetary Union. We can see both economic advantages and risks for the UK, if we were to join. The main advantage would be the nominal exchange rate certainty provided for businesses in the UK trading across the euro area. The main risk would be the 'one-size-fits-all' monetary policy of the European Central Bank, which might not suit economic conditions in the UK
The balance of these arguments pointed, virtually indisputably, strongly against UK participation in EMU at the outset. The UK economic cycle was out of phase with that in Continental Europe so, had the UK joined, it would have given the European Central Bank a considerable headache to try to determine the single interest rate appropriate to both the UK and the Continental European members over the period since the euro's launch.
The British Government has made clear, however, that it does not see any constitutional barrier to UK entry. Instead, UK entry will depend on the national economic interest. And the Government has set a number of economic tests to measure this. Our Prime Minister has defined clearly the window within which the Government will assess these five tests, namely within two years of the forthcoming General Election, although not within a matter of months. If the Government reaches a positive assessment, UK entry would then be subject to the so-called 'triple lock', involving a recommendation by Government to join Monetary Union, a vote in Parliament and finally a Referendum of the British people.
The international dimension
Finally, I have talked about integration in Europe, as though it were a self contained issue for Europeans. But actually, of course, it has implications of global significance. There are implications for world trade from forming a free trading bloc in Europe already of well over 300 million people, with a combined GDP roughly equivalent to the United States. And there are implications for the international monetary system as a whole. This is deliberate. The architects of Monetary Union in Europe wanted to create a counterweight to the dollar. It is early days but, if Monetary Union works well as we all hope that it will, the euro should become one of the three main pillars of the international monetary system, alongside the dollar and the yen.
Conclusion
Let me sum up. The first ingredient to make a success of regional integration is economic. In Europe, we have pursued this through establishing the single market and now through introducing a single currency. As you can see, we have made considerable progress, although we still have further to go on the supply-side. Given the progress already made over the past half century and in prospect in the foreseeable future on the economic side, the question now is to what extent economic integration should be accompanied by political integration and, if so, what form this might take. This question obviously has to take into account the future enlargement of the European Union to the East, which is likely within the next few years. I am happy to say, however, that I can legitimately end at this point, since this is obviously a question for politicians and certainly not for central bankers!
