Social Education 57(4), 1993
1993 National Council for the Social Studies
Defining the European Currency Unit
The heart of the European Monetary System is the European Currency Unit. The ECU is a somewhat artificial construct, more a unit of account than an actual currency. (Governments and banks sometimes issue financial instruments denominated in ECU, but you cannot use ECUs to buy food at the grocery store-at least not yet.) Strictly speaking, the ECU is a basket of currencies in which each national currency has a specific weight according to its economic importance. Germany's currency, the deutsche mark, has by far the greatest weight within the ECU; it counts for about 30 percent of the total. (By contrast, look at the next two "heaviest" currencies within the basket: The French franc weighs in at a bit over 19 percent of the total, the British pound sterling at latest count was just under 13 percent.)
Role of the ECU in the European Monetary System
Although the ECU is like a fixed center of gravity for the European Monetary System, the day-to-day functioning of the EMS revolves around another, more dynamic construction, the Exchange Rate Mechanism. Within the Exchange Rate Mechanism, eleven currencies (where the ERM is concerned, the Belgian and Luxembourg franc count as one) try to maintain stable relationships (exchange rates or parities) with each other, either bilaterally or in relation to the ECU. The bilateral parities (i.e., the relationship of one national currency to another, rather than the exchange rate between any single national currency and the ECU), are what matter most within this mechanism. Although the Exchange Rate Mechanism was designed to promote exchange-rate stability within Europe, it allows some flexibility. Most of the national currencies are allowed to stray 2.25 percent above or below their official bilateral exchange rates. Weaker currencies, like the Spanish peseta, or currencies in more independent-minded countries (such as the United Kingdom-which joined the ERM in October 1990 only to leave it two years later because of the September 1992 EMS crisis described below), have been granted a broader band of flexibility (6 percent above or below their bilateral rates with other countries). When currencies participating in the Exchange Rate Mechanism depart from these narrow or broad bands, the central banks in the affected countries are supposed to intervene in currency markets (buying up weak currencies and selling strong ones) to restabilize the currencies. If central bank intervention fails to put the currencies back on track, then it is possible for the finance ministers in the various countries to realign their currencies at a realistic level within the Exchange Rate Mechanism.
To make matters even more complicated, some member currencies of the European Monetary System are not simultaneously members of the Exchange Rate Mechanism, even though they are weighed within the ECU basket and have official exchange rates in relation to the ECU. This was the case for Britain from 1979 to 1990, and again after September 1992, and is still the case for Greece. Italy, a member of the ERM from the outset, recently moved from the broad to the narrow band but had to suspend its membership altogether during the September 1992 crisis.
EMS's Anchor Currency: The Deutsche Mark
Where does Germany, the country with the greatest weight within the European Monetary System, fit into this system of stable but flexible exchange rates? Why does it participate within the EMS? How has it sought to shape the system? And what problems have emerged as a result of German unification and the European Community's expressed desire to move toward economic and monetary union by the end of the century?
First, it is important to understand why the Federal Republic of Germany, working closely above all with France, created the European Monetary System in the first place. For most of the postwar period, German prosperity was well served by the system of fixed but periodically adjustable exchange rates established at Bretton Woods in the 1940s. Throughout the 1960s, the deutsche mark was not only stable but undervalued (in spite of occasional realignments in relation to the dollar)-offering German exports a considerable (and artificial) advantage on world markets. German business and the Bundesbank (Germany's federal reserve) liked things this way until it became apparent that the Bretton Woods system was about to break down. When the system of exchange rates based on a stable dollar-gold standard collapsed in the early 1970s, and when Germany could no longer resist the powerful trend to revalue its mark upward, the Bundesbank became a convert to more flexible exchange rates. To provide a modicum of stability within Europe during this internationally turbulent period, however, Germany joined with other European currencies to create a currency snake-a chain of currencies that were linked to each other but that had some flexibility. The EMS, launched in 1978 and formally inaugurated in 1979, is the European currency snake's successor.
Germany's Chancellor Helmut Schmidt (together with then French President Giscard d'Estaing) decided to create the European Monetary System because of the dollar's dramatic fall in the late 1970s. Where Germany was concerned, the dollar's decline created special problems because currency traders fleeing a weak dollar sought refuge above all in the strong deutsche mark. The result was not only imported inflation (which the Bundesbank had to fight to neutralize) but a German currency that was considered too strong against other European currencies (not just against the dollar). This was of concern to Germany because most of its exports have always gone to other European countries, and a too-strong mark resulting from a too-weak dollar threatened to cut into Germany's intra-European trade. To stabilize the deutsche mark's relationship with European currencies, while allowing for flexibility against the dollar and other non-European currencies, Schmidt decided to press forward with the creation of the European Monetary System. The Germans viewed the EMS as a kind of European shock absorber for the deutsche mark. A system of stable but adjustable exchange rates in Europe would cushion the mark against international body blows by spreading shocks more evenly among those other European currencies associated with the mark.
The Bundesbank was not altogether happy with the EMS, which it saw as something of a threat to its institutional autonomy and to its newly found preference for flexible exchange rates. Throughout the 1980s, however, the Bundesbank learned to live with, and even love, the EMS. It could live with the new system partly because in practice the ECU never played as big a role as the bilateral exchange rates (the so-called parity grid). This made it easier for the Bundesbank to communicate with other central banks on a country-by-country basis, rather than have its actions curtailed by highly centralized rules. As the decade went by, the European Monetary System developed more and more into a "deutsche mark zone" in which the mark became the European anchor currency.
The EMS developed into a German-led currency zone because more and more countries in the European Community began orienting their policies around the low-inflation policies of the Bundesbank. The major turning point in this direction came when the new French government, led by the Socialist President François Mitterrand (who replaced Giscard d'Estaing in 1981), abandoned its expansionary, redistributive policies of the early 1980s for an austerity policy more like that being pursued in Germany by the government of Helmut Kohl (the conservative chancellor who succeeded Schmidt in 1982). France's success in emulating German stability encouraged other EC members to import credibility from Germany in the field of monetary policy. Exchange rate markets began to trust those currencies whose countries were conducting economic policies like Germany's. The spread of German-style monetary credibility throughout the European Community helped to stabilize the Exchange Rate Mechanism. The ERM, which at the outset had required numerous realignments in order to function, began to need fewer and fewer such adjustments. By 1987 it began to look as though realignments were a thing of the past. It was at this point that discussions began about turning the European Monetary System into a true monetary union, in which exchange rates would be irrevocably fixed and national currencies would eventually disappear in favor of a single European currency.
From EMS to the Maastricht Treaty
European integration was reviving from the slumbers of the 1970s because of the push toward a single market by the end of 1992. Monetary union was seen as the logical complement to the single market plan. While the single-market project was underway, a committee chaired by EC President Jacques Delors issued a report recommending the creation of an Economic and Monetary Union building on the strengths of the increasingly stable, and increasingly German-oriented, European Monetary System. The Delors Report became the basis for Maastricht Treaty provisions that address monetary union, which foresaw monetary union proceeding in several stages. In the first stage, all members of the European Community not yet participating in the Exchange Rate Mechanism would be required to join and coordinate their economic policies.
In the second stage, a European Monetary Institute would be created to prepare the way for a European Central Bank, while the central banks of member countries would be required to become as independent as the Bundesbank. All countries would also have to strive toward meeting certain stringent convergence criteria:
German unification presented the Federal Republic with strong political reasons for wanting to sign on to this timetable for European monetary union. The politics and economics of German unification, however, created new tensions in the relationship between a now-united Germany and those countries who had come to see the deutsche mark as the anchor currency of the European Monetary System.
A united Germany needed to seek monetary union as a way of reassuring fearful neighbors that the most populous and economically most powerful country in the European Community would remain integrated in the community. To gain French and British approval for German unification in the "two-plus-four talks" on German unification (among the former West Germany, East Germany, and the four victorious powers of World War II), the Federal Republic had to demonstrate a strong commitment to European integration as early as 1990, when preparatory talks for what would become the Maastricht Conference were already underway. German leaders themselves believed that opportunities for anchoring a post-cold war, Central European power firmly in the West depended on creating a tighter economic, monetary, and political union by the end of the century.
German eagerness not to miss irretrievable windows of opportunity for Europe, however, was thrown off balance by the politics and economics of German unification. When the Federal Republic of Germany (West Germany) created a currency union with the German Democratic Republic in July 1990, the former citizens of the Communist German state received their new hard currency at a favorable rate bearing little relationship to the old German Democratic Republic currency's purchasing power. The Bundesbank, worried about inflationary consequences, accepted the currency union for political reasons, but was unhappy about not being consulted over the terms of exchange. Bundesbank President Otto Pöhl eventually resigned from office, and for the next several years the Bundesbank was determined to demonstrate its independence by pursuing a tight anti-inflationary course. In December 1990, Chancellor Kohl won reelection in both West and East Germany by promising that the high cost of uniting the two German economies and states would require "no new taxes." As a result of this promise, massive transfers from the central government in Bonn to the new states of the former East Germany had to be financed by increasing public debt. The skyrocketing debt, coupled with the Bundesbank's determination to counter the government's loose fiscal policy with a tight monetary policy, led to high interest rates in Germany. This policy mix obliged other EC countries following the German lead to raise interest rates to levels even higher than Germany's. As Europe (and some European countries in particular, notably Britain) entered a period of slow growth and recession in the 1990s, Germany ceased to be the model of stability and growth it had been in the 1980s.
When the Maastricht Treaty was signed in December 1991, Kohl agreed to a fixed timetable for monetary union to be accomplished by the end of the century. He acceded to this French (and Italian) wish for a deadline even though both supporters and opponents of European monetary union within Germany did not believe it should be rushed or undertaken without a simultaneous commitment to political union. The Bundesbank was also unhappy with the decision to complete European monetary union by 1999. Worried about an inflation rate approaching 4 percent (high by German standards), and anticipating a new bout of price increases following wage negotiations scheduled for the spring of 1992, the Bundesbank raised interest rates although the ink on the Maastricht Treaty was barely dry.
The Danish Referendum and the Currency Crisis
Then came the fateful Danish referendum on whether to ratify the Maastricht agreements in June 1992. When Danish voters decided by a narrow margin to reject Maastricht, currency traders began to doubt what they had started to believe since 1987-that the stability of the European Monetary System was a prelude to monetary union. Interest rates were high in Germany but low in the United States, and markets no longer believed that other European governments had the political stamina to follow the Bundesbank's lead. The Bundesbank raised its discount rate again following the Danish refusal. Throughout the summer of 1992, pressure mounted within the European Monetary System as markets tested the viability of the Exchange Rate Mechanism. The removal of controls on capital movement in the European Community in 1990, as part of the single-market program, had a profound effect on the speculators' ability to attack weak currencies in the EMS. By autumn, the crisis came to a head as public opinion polls began to indicate that French voters might not ratify the Maastricht Treaties in a referendum scheduled for September 20. EC leaders had enough problems responding to the outcome of the Danish referendum; a French rejection, they knew, would kill Maastricht for good. In the week before the French vote, the Federal Republic struck a deal with the Italian government to devalue the lira in return for a symbolic lowering of interest rates in Germany. What the Bundesbank had really wanted was a general realignment within the Exchange Rate Mechanism. But this bilateral bargain could not forestall a general crisis of the ERM because currency markets started to put pressure on the British pound and French franc. It did not help matters when word leaked out to the financial press that the new Bundesbank President, Helmut Schlesinger, did not have much faith in the overvalued British pound. A massive run on British currency in the week before the French referendum forced the pound out of the ERM. The Italian lira also left the mechanism. Late in November, the Spanish peseta and the Portuguese escudo were devalued. That French voters narrowly approved the Maastricht Treaties could not prevent a crisis of confidence in France's currency in the week after September 20, but tight collaboration between the Bundesbank and Banque de France managed to stem the tide and restore a stable value for the franc. The dream of a smooth transition from European Monetary System to Economic and Monetary Union was tarnished significantly.
The long-term consequences of the September 1992 currency crisis have yet to be sorted out completely. This much is clear-a parting of ways is occurring on how to interpret the role of the deutsche mark as the anchor currency for monetary integration in Europe. German officials think that managing an anchor currency heightens their obligation to pursue an extremely tight monetary policy. If other European countries cannot follow the German lead any longer, then they should revalue their currencies within the European Monetary System and give up hopes of joining Germany in a monetary union any time soon. If monetary union is to happen by the end of the century (as the Maastricht timetable foresees), then it will have to be a "two-speed union." Germany, Belgium, the Netherlands, Luxembourg, and France (possibly together with such prospective members of the European Community as Austria, Switzerland, and some Scandinavian countries) could join in a core of monetary union, but the weak currency countries of southern Europe will have to wait. Many of Germany's EC partners see things differently. They would like Germany to ease up on its tight monetary policy for the sake of interest rate relief in Europe as a whole. They want the Bundesbank to stop running monetary policy for Germany alone and to acknowledge that it has become a kind of European central bank. They want Germany not only to set a tough example for other countries, but to take these other countries' special economic problems into account. Over the next several years we can expect the countries of the European Community to fight over which interpretation of the deutsche mark zone should prevail.
Jeremiah Riemer is Adjunct Professor of European Studies at the School for Advanced International Studies of The Johns Hopkins University in Washington, D.C., and a specialist in German studies.