Maxi Versus Mini Emu: The Political Economy of Stage III

4 Colum. J. Eur. L. 375 (1998)

Michele Fratianni. AMOCO Professor of Business Economics and Public Policy, Indiana University School of Business, Bloomington, Indiana.

The European Union is about to achieve its dream of creating a monetary union. The road to monetary union started at the Hague Summit of 1969, which inspired the Werner Report of 1970 along with many other reports and proposals, and led all the way to the Accord that the European heads of state and government signed in the Dutch town of Maastricht in December 1991. The Accord, later to be ratified as the Treaty on European Union (TEU, also referred to as the Maastricht Treaty), lays down the Community’s strategy to achieve economic and monetary union (EMU) no later than 1999. This paper focuses on the relationship between monetary policy under EMU and the size of the EMU, and consists of two sections. In the first section, I examine the reasons why EMU would be large. In the second section, I consider the relative merits of two opposing hypotheses: a soft EMU versus a hard EMU.

Despite an interlude of multi-speed approaches and variable geometry schemes that characterized the period following the September 1992 currency crisis, EMU will be large, comprising at least eleven Member States. Had Denmark, Sweden, and the United Kingdom wanted to be part of it, EMU would start with fourteen of the fifteen EU Member States. The reasons for a “maxi” EMU are the difficulty of revising the Maastricht Treaty, the significant fiscal correction made by Spain, Portugal, and particularly by Italy, the fiscal difficulties of Germany, and the leftward swing in the European body politic.

Financial markets have judged that a maxi EMU means a weak euro; the evidence comes from the dollar appreciation in relation to the currencies of the potential EMU participants. But some economists feel that the markets have gotten it wrong: the euro will be strong because the European Central Bank (ECB) will want to build a reputation for monetary stability from the very start and because the EMU currency will benefit from a large portfolio redistribution against the U.S. dollar. In Section II of the paper, I caution against the hard-euro view, believing that the heterogeneity of the membership will tend to pull in the opposite direction.

The EMU is not an optimal currency area. Monetary policy actions will have different effects in participating countries, depending on their price and wage rigidities. National governors will not be of the same mind about the thrust of monetary policy once their economies are hit by negative supply shocks. Their differences will have much less to do with personal preferences about inflation than with strategic considerations of how their economies react to money. Those countries that are part of an optimal currency area would be less reflationist than countries with more entrenched price and wage rigidities. On the other hand, the EU-appointed members of the Executive Board will be more inclined to exploit the tradeoffs between inflation and unemployment because their interests are defined in terms of the EMU-area price level and EMU-area output and employment. The larger the EMU, the “softer” the euro.

One could object to this conclusion by pointing out that the ECB will be completely independent of political authorities, has a clear objective of pursuing price stability, and is prohibited from (directly) financing government deficits. Are these not conditions for a “hard” euro? Not necessarily. The ECB is an unproven institution with no history of its own. Its reputation is grounded in a treaty rather than in the support of the European public. Will this public come to the defense of the ECB when it is attacked by politicians who have a different view of the desirable thrust of monetary policy? There is little indication yet to suggest that the relationship between the ECB and the European public will be anywhere close to the relationship between, say, the Bundesbank and the inflation-averse German public. Had such a relationship been projected, the excess deficit procedure of the Maastricht Treaty and the subsequent Stability and Growth Pact would have been redundant Why would the Treaty constrain fiscal authorities if the regime were one of monetary policy dominance? The answer is that in a heterogeneous EMU, it is difficult to obtain legitimacy such as that enjoyed by the Bundesbank. The legislated fiscal constraint substitutes, although imperfectly, for such legitimacy.