Information about Western Hemisphere Hemisferio Occidental

4. Monetary Integration in Europe

Jacob Frenkel, and Morris Goldstein
Published Date:
September 1991
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Andrew Crockett

Economic and monetary union is now in the forefront of the European agenda. An intergovernmental conference, aimed at proposing the necessary amendments to the Treaty of Rome, was formally opened in mid-December 1990. It is expected to complete its work during the course of 1991, so that the proposed Treaty amendments can be ratified by national parliaments during 1992.

There remains, however, much to discuss. While most countries are agreed that a single currency managed by an independent central bank should be the objective from the outset, the United Kingdom has proposed an evolutionary approach. This would involve the creation of a common (not single) currency, which could eventually develop into a single currency “if peoples and governments so choose.”1

Beyond the disagreement about whether it is wise to specify the exact nature of an eventual monetary union at the present time, there is also a range of views concerning the speed of progress toward union and the nature of transitional arrangements. Some favor the continuation of broadly the current arrangements (i.e., the exchange rate mechanism (ERM), anchored by the deutsche mark) for an extended period, until the European Community is ready to move to a single currency. Others support the creation of a new institution at a relatively early stage. Some favor the creation of deadlines as a means of stimulating progress, while others believe there should be strict conditions before any move is made from one stage to the next.

The current discussions are not, of course, the first time that the European Community has addressed the issue of monetary union. In 1970, the Werner Report proposed a plan for moving to irrevocably fixed currencies within ten years.2 This plan effectively foundered with the breakdown of the Bretton Woods system and the onset of the exchange rate volatility that characterized the 1970s. Thereafter, monetary authorities revised their aims to the less ambitious goal of creating “a zone of monetary stability” based on the stable but adjustable parities of the ERM.3

How have circumstances changed in the twenty or so years since the Werner Report? And are the chances of success greater now than they were then? The purpose of this paper is to re-examine these issues in the light of the debate initiated by the publication of the Delors Report.4 The substantive analysis begins (Section I) with an assessment of the underlying case for monetary union, from an economic standpoint. Many of the arguments involved are familiar from the optimum currency area literature, but recent contributions5 have extended this analysis in several directions.

Section II addresses itself to transitional issues. The Delors Report was rather skimpy on transitional issues. The assumption was that in the process of monetary union there could be a gradual transfer of functions and responsibilities from national central banks to a central institution. Subsequent analysis, however, has suggested that the gradual transfer of monetary functions is not really very practical.

Section III of the paper analyzes in some more detail the “Hard ECU” proposal of the U.K. authorities. This proposal has received a rather bruising reception in certain quarters, in part because the U.K. Government has been isolated in not wishing to commit itself to the ultimate achievement of single currency. Section IV therefore examines some of the criticisms that have been made of the Hard ECU. The conclusion is that the Hard ECU proposal is indeed technically feasible and can be used to address some of the transitional problems that have so far been inadequately dealt with in other proposals.

I. The Costs and Benefits of Monetary Union

The traditional optimum currency area literature6 identified the elimination of transactions costs and the trade-creating effects of lower exchange rate variability as being the principal benefits of extending the domain of a single currency. The cost, of course, is the loss of the exchange rate instrument as a means of responding to disturbances that affect different regions differently.

In an exceptionally thorough and professional study of the consequences of monetary union,7 the Commission of the European Communities has attempted to quantify these costs and benefits and has also identified other ways in which monetary union can have an impact on national economies. The Commission study identifies 16 different mechanisms by which economic and monetary union can affect economic performance. These mechanisms are grouped under five main headings, shown in Table 1.8 The Commission wisely does not attempt to arrive at a “bottom line” that provides a quantified balance of benefits versus costs. The tone of the report, however, is that the benefits are greater than the earlier literature has suggested, and the costs much smaller and transitory. Moreover, since many benefits accrue at the conclusion of the transition process, the advantages of rapid progress are overwhelming.

Without necessarily denying that the advantages of a single currency could eventually come to outweigh the costs, it is possible to be skeptical about some of the hyperbole in the Commission paper. The following analysis considers in turn the various mechanisms that the paper identifies. (The sections that follow correspond to the groupings of mechanisms shown in Table 1.)

Table 1.Economic Mechanisms Generating Benefits and Costs, by Stages of EMU, as in the Delors Committee Report
Stage IStage IIIa


Exchange Rates)
Stage IIIb


Efficiency and growth
Exchange rate variability and uncertainty++ ++ +
Exchange transaction costs++ +
Extending 1992 to economic union++
Dynamic gains++ +
Price stability
Price discipline++ ++ +
Institutions conducive to stability-oriented
monetary policy++ +
Transitional costs of disinflation- ---
Public finance
Autonomy, discipline, and coordination-/ +-/ +-/ +
Lower interest-rate costs (less
seigniorage losses)-/ +++ +
Public sector efficiency+++
Adjustment without exchange rate changes
Loss of nominal exchange rate instrument-- -- -
Adjustment of real wage levels-/ +-/ +-/ +
Lesser country-specific shocks++ ++ +
Removal of external constraints++ +
International system
ECU as international currency++ +
Improved international coordination++ +
Note: + = benefit; - = costs; and • = insignificant or uncertain. The comparisons are between the stages and a baseline case that assumes completion of the single market and membership of the European Monetary System’s exchange rate mechanism.Source: Commission of the European Communities. “One Market. One Money: An Evaluation of the Potential Benefits and Costs of Forming an Economic and Monetary Union,” European Economy (Luxembourg), No. 44 (October 1990). p. 26.
Note: + = benefit; - = costs; and • = insignificant or uncertain. The comparisons are between the stages and a baseline case that assumes completion of the single market and membership of the European Monetary System’s exchange rate mechanism.Source: Commission of the European Communities. “One Market. One Money: An Evaluation of the Potential Benefits and Costs of Forming an Economic and Monetary Union,” European Economy (Luxembourg), No. 44 (October 1990). p. 26.

Efficiency and Growth

Four mechanisms contributing to higher efficiency and growth are distinguished. The first is the reduction in exchange rate variability and uncertainty, which is considered to generate strong benefits. The basis of this claim is the observation that, during the period 1987–89, nominal exchange rate variability among ERM participants averaged 0.7 percent monthly, while among non-ERM participants it averaged 1.9 percent. Fully fixed exchange rates would eliminate this variability and hence, it is implied, remove a costly source of uncertainty in economic activity.

Econometric evidence on the damage exchange rate variability does to trade is pretty inconclusive.9 But even if it is accepted that wide swings in exchange rates (such as those that occurred in the 1980s between the U.S. dollar, the yen, and the deutsche mark) have adverse effects on resource allocation, it is much more debatable whether the relatively minor movements within the narrow bands of the ERM have the same consequences. It is these fluctuations that the move from present arrangements to full monetary union will eliminate. Such small and short-term fluctuations can be hedged against at relatively minor cost.

There are, in addition, a number of further considerations that should make one cautious about concluding that eliminating nominal exchange rate flexibility within the Community is an unambiguous source of benefit. First, as the Commission paper itself concedes, nominal exchange rate variability is not the same as real exchange rate variability. It is the latter that is the more relevant for purposes of competitiveness and resource allocation. Second, reduction of exchange rate variability vis-à-vis partner countries within the Community is not the same thing as reduction in overall exchange rate variability (i.e., including third currencies such as the U.S. dollar and the Japanese yen). Third, and most importantly, a reduction in exchange rate uncertainty is only welfare-enhancing if it is associated with a reduction in the overall level of uncertainty facing economic agents. If the elimination of exchange rate movements means that exogenous or policy-induced disturbances give rise to additional fluctuations in other variables (inflation or employment, say) then welfare will not necessarily be improved. It is not impossible, indeed, that welfare will decline, if exchange rate movements are a lower-cost method of adjustment to the sorts of disturbances to which the economies concerned are prone.

The second source of efficiency gains from monetary union is to be found in the elimination of transactions costs. How great these costs are has proved difficult to measure. The Commission’s study is easily the most careful so far, and produces an estimate of cost savings of approximately ½ of 1 percent of Community gross domestic product (GDP). (This appears to be an upward rounding, as the estimate presented at the conclusion of the Commission’s quantitative analysis is in the range of 0.3–0.4 percent of GDP.)10 Although the Commission considers its estimates “conservative,” and they are certainly lower than in other published studies,11 they nevertheless contain some sources of potential overestimation. Some of the costs related to currency exchange (e.g., the holding of zero-yielding balances in foreign exchange) are private costs but not social costs. The expenses borne by the private sector are offset by seigniorage income to issuing central banks. And the estimate of in-house costs of currency exchange is derived from a questionnaire returned by only six companies. The small size of the sample, combined with the unexplained divergence in individual responses, make the use of this data very suspect.

It is also worth noting that the Commission’s estimates suggest that, for large member states, the reduction of transactions costs from moving from ERM membership to a single currency is likely to fall in the range of 0.1–0.2 percent of GDP. Such savings are worth having, but they are small in comparison with the potential costs and benefits from other mechanisms.

The next two efficiency-enhancing mechanisms in the Commission’s paper are the effects of extending the 1992 program and the dynamic gains from higher economic efficiency. The first of these is of course a highly important aspect of economic integration in Europe. It is likely to have substantial beneficial effects in the long term (although it is possible to quibble with the Commission’s unquestioning acceptance of the proposition that “greater Community involvement” in fields such as education, environment, and commercial policy can be expected to “yield considerable net benefits”). The consequences of measures toward greater economic integration are, however, outside the scope of the current analysis, which is concerned only with the direct implications of monetary union.

The assessment of dynamic gains from greater economic efficiency, the last of the four mechanisms under the genera! heading of efficiency, should probably be characterized as a pure guess. For example, “estimates show that if EMU reduced the risk premium in the required rate of return by a moderate amount (0,5 percentage points) there could be a substantial growth offered [sic] over the long run, accumulating to perhaps 5% of GDP.”12 This argument is in fact an extension to the dynamic level of the proposition that a reduction in exchange rate variability can be considered to offer a reduction in the overall risk premium in the required rate of return. To the extent that it does so, it is reasonable to suppose that benefits will be felt in dynamic efficiency and a higher rate of capital accumulation, as well as in improved static efficiency.

The central question, however, is whether alternative adjustment mechanisms can work sufficiently smoothly to ensure that eliminating exchange rate movements will indeed lead to a reduction in uncertainty. As was suggested earlier, there is no necessaryreason why a reduction in uncertainty should result. It can be argued that where risks and uncertainties are inherent in the economy, the suppression of exchange rate variability will simply cause these uncertainties to be reflected in other markets.

Monetary Union and Price Stability

The next set of mechanisms that the Commission considers is related to price stability. Put briefly, the argument is that (1) price stability is a benefit; (2) monetary union produces a more conducive environment for the pursuit of price stability; and (3) the transitional costs of disinflation will be less under monetary union.

Most economists would probably no longer challenge the view that price stability provides a conducive environment for sustainable growth. (This is not in itself a mechanism to affect economic performance, but a statement of the premise on the basis of which monetary arrangements could affect performance.) The mechanism itself is of a political economy nature. It is argued that a new European central bank would be designed in such a way (i.e., with greater political independence) as to make it less susceptible to political pressures for monetary accommodation. This may or may not be true. To the extent that it is true, it is not an argument for monetary union; it is an argument for independent central banks. Only if the desired degree of central bank independence is itself constrained by the absence of monetary union would it be necessary to abandon national currencies to get the benefits of price stability.

As to the proposition that monetary union lessens the transitional costs of reducing inflation, this seems to rest on the argument that a new Community central bank would have greater credibility, and would thus contribute to better price stability than a continuation of current arrangements based on the ERM. This proposition is certainly not incontrovertible. The current ERM is based on the anti-inflationary credibility of the Deutsche Bundesbank, and the demonstrated willingness of other countries to peg to a deutsche mark anchor. It is to be hoped that a new central monetary institution would in time acquire the credibility of the Bundesbank; but it seems fanciful to assume that it would begin life with such credibility.

Monetary Union and Public Finance

The next set of arguments falls in the area of public finance. It is argued, first, that the absence of independent monetary policies will require a greater weight to be placed on national budgetary policies for stabilization and adjustment purposes. This in turn will require greater policy coordination and surveillance. The Commission considers that this could be accounted either a benefit or a cost. A more neutral assessment would surely put it in the “costs” column; to the extent that policy coordination produces benefits, it can be achieved with or without monetary union; to the extent that it is required to make monetary union effective, it implies what fiscal adjustments have to be introduced that were not considered necessary on their own merits.

Further budgetary consequences will ensue if monetary union leads to a lower general level of inflation. Governments will lose access to some of the seigniorage revenues generated by inflation, but will gain through the lower inflation premiums they have to borrow. The Commission paper concludes (rightly, in my view) that the gains of lower interest rates will outweigh the losses of seigniorage. Note, however, that these gains are the result of lower inflation, rather than of monetary union per se. The argument for a positive effect of monetary union therefore depends upon the assertion that price stability will have a higher priority in a monetary union than under alternative monetary arrangements.

Lastly, in the area of public finance, it is argued that public authorities will come under increased pressure to harmonize those taxes and expenditures that fall on potentially mobile factors of production. This effect is due to the removal of barriers to factor mobility following the completion of the single market. It does not depend at all on monetary union. Moreover, it is difficult to see why it should be considered an unambiguous benefit, as the Commission does, given the well-known risk that public goods may be underprovided in such competitive circumstances.13

The Effects of Monetary Union on Adjustment Costs

The next broad way in which monetary union can affect economic performance is through the elimination of the exchange rate as a mechanism of adjustment. This has previously been assumed to be the main source of costs in widening a currency area. Much of the literature on optimal currency areas concentrates on identifying the factors that determine the extent of these costs.14

Generally speaking, adjustment costs will be greater in the absence of the exchange rate instrument (1) if economies are subject to country-specific real economic disturbances, and (2) if other adjustment mechanisms, such as factor mobility and factor price flexibility, are deficient. Countries can find themselves subject to country-specific shocks requiring different adjustment responses either if the composition of their output and trade differs, or if the response of domestic costs and prices to common stimuli is different (e.g., if there are differences in inflation proneness). If the exchange rate is not available to play a role in adjusting to such disturbances, other mechanisms have to be called into play, chiefly greater factor price flexibility and increased factor mobility. If these mechanisms are insufficiently effective, the response will have to be felt through variations in the level of output and employment.

The Commission argues that the loss of the exchange rate instrument, though a significant cost, should not be exaggerated. They note that nominal exchange rate adjustments have already been limited under the ERM. Moreover, competitiveness adjustments will remain possible through differential rates of cost inflation, and the completion of the single market will both reduce the incidence of country-specific shocks and make them easier to adjust to.

The Commission is undoubtedly right to say that active use of the exchange rate instrument is unlikely to be effective in securing improved economic performance. What is at issue, however, is whether the residual likelihood of competitiveness divergence is great enough to warrant the retention, at least for the time being, of the safety valve of exchange rate adjustment.

Over time, the completion of the single market should play an important role in integrating economic structures, harmonizing wage bargaining, and increasing factor mobility. But these changes will not be complete on January 1, 1993. Cultural and linguistic considerations suggest that it will take many years for the legislative program of 1992 to have its full effect on economic behavior. And the economic impact of German unification—although no doubt itself a unique event—is a useful reminder that unexpected country-specific disturbances remain a distinct possibility.

It cannot be excluded, therefore, that exogenous developments will have differential impacts, of significant size, on individual countries. Nor can it be excluded that costs and prices may diverge in a way that would be very costly to correct through the mechanism of variations in levels of real economic activity. If economic activity has to be maintained at suboptimal levels for extended periods to enable the fixed exchange rate to be maintained, the costs could easily exceed the efficiency gains resulting from a single currency.

What all this suggests is that it would be prudent to allow the process of integration to proceed further before finally abandoning the instrument of the exchange rate. At the very least, it would seem essential to wait until the full effects of the 1992 program have been felt, and a complete cycle of successful experience with ERM (i.e., a cycle without forced realignments) has occurred before moving to a single currency.

International Effects

The final mechanism identified in the Commission paper is the advantage to the Community of having a single currency in the international arena. To the extent that the single currency is used more widely outside the Community than individual national currencies are used currently, seigniorage gains will be reaped. And the greater weight of the Community in international affairs will enable discussions in the Group of Seven to be conducted among a smaller number of players. These effects are hard to quantify, but would seem unlikely to give rise to a major change in Community welfare.

All in all, therefore, a more skeptical assessment of the potential costs and benefits of monetary union leads to a less eupeptic judgment than that reached by the Commission. Despite the multiplicity of mechanisms by which European monetary union (EMU) is said to affect economic performance, the key costs and benefits of moving to a single currency boil down to, on the one hand, the reduction of exchange rate uncertainty and, on the other, the potential costs of the nonavailability of the exchange rate as an instrument of adjustment. It has been argued above that these costs are inversely related to the degree of economic integration and convergence. This suggests that the issues of transition—how to move from 12 currencies to 1, and how fast to do so, are of particular importance. To these issues we now turn.

II. Transitional Issues

There are two main transitional issues. First, at what speed is it appropriate to make progress toward monetary union? Second, what intermediate steps are possible to ease the transition to the eventual goal of a single monetary policy conducted by a single monetary authority? (Left aside for the moment is the question of whether one should define the ultimate goal at the outset, as desired by 11 countries, or whether one should focus only on the next step in an evolutionary process without commitment to a predetermined end-point, as in the British preference.)

Concerning speed, some participants in the debate have favored rapid progress to full monetary union. For example, the European Commission, in its paper of August 21, 1990,15 suggested that Stage II of monetary union should begin on January 1, 1993, and that after a brief “training period” for the new European central bank, Stage III with the single monetary policy, should begin “shortly there-after.” More recently, the summit at Rome in October 1990 recorded that 11 countries favored beginning Stage II on January 1, 1994, and taking a decision to move to Stage III within three years after that date.

The argument in favor of this means of progress is that by imposing institutional constraints and deadlines, countries will be obliged to achieve the necessary degree of convergence in order to be able to meet the discipline of a single currency and a single monetary policy.

There are, however, potential risks in such a rapid progression. Monetary union implies an irrevocable fixing of exchange rates (and eventually a single currency) with a single rate of interest throughout the Community. If monetary union were to take place before competitiveness had been broadly harmonized, or before underlying inflation rates had converged, then the necessary convergence would have to be obtained through shifts in the level of economic activity. Consider a country that enters a monetary union with a weak competitiveness position and an underlying inflation rate above that of its partners. After union, it will be unable to have a nominal interest rate different from that of the rest of the union, so that the real interest rate will initially be lower than elsewhere. Lower real interest rates will stimulate economic activity and help keep inflation above the Community average until the cumulative loss of competitiveness causes unemployment to rise. Thereafter, of course, activity will have to be kept sufficiently depressed to bring inflation below the Community average for as long as it takes to restore full-employment competitiveness. Most historical experience suggests this would be a long process, particularly if the Community average inflation rate is as low as is to be hoped.

The costs of conjunctural adjustment would be significantly reduced if, by the time exchange rates were locked, substantial convergence had already been achieved in key economic variables such as inflation rates, interest rates, external competitiveness, relative cyclical positions, and budget balances. It can be argued, therefore, that a better priority than fixing a date for transition from stage to stage of monetary union would be to design an agenda for achieving and maintaining convergence. Convergence would then lead to additional steps to union, rather than union enforcing a possibly costly path to convergence.

A further reason for moving cautiously in abandoning the possibility of exchange rate adjustment lies in the fact that the European Community does not have income transfer mechanisms to cushion the effects of divergent economic developments. In most cases where a single currency is used, there is also a single government, or at least a large federal budget. This enables redistributive mechanisms, operating through social security provisions and the progressive income tax, to be called into play. It is not likely that such mechanisms will be created at the European level, and more overt means of income transfer from one national authority to another, beyond those already in place, would certainly encounter political resistance. (Such resistance is perhaps not surprising, since experience suggests that such direct income transfers can impede, as well as assist, necessary adjustments.)

Quite apart from cyclical or conjunctural differences among European economies, there is still a significant lack of convergence in underlying economic structure. Europe is, in this respect, some distance from becoming an optimum currency area. For one thing, the countries comprising the Community are at very different stages of economic development: the disparity in income levels between Community members is much greater than that between, say, individual states of the United States.16 Moreover, the mobility of factors of production between member states still falls short of that prevailing in other single currency areas. While it is true that the single European act will remove all formal barriers to the movement of goods, services, labor, and capital, barriers of custom and tradition, to say nothing of language, will for some time continue to inhibit labor mobility. And capital movements may continue to be limited by portfolio preferences and institutional rigidities.17 This means that factor mobility cannot be relied upon as a means of cushioning differential economic shocks in quite the same way as would be possible for other single currency areas.

In addition, there is still apparently a significant difference in the inflation proneness of different European countries. Even among members of the narrow band of the ERM, retail price inflation in 1990 ranged from around 2½ percent (Netherlands, Germany) to over 6 percent (Italy). In countries that are not members of the narrow band, inflation rates were generally even higher. Until these underlying divergences are eliminated (and it is not unreasonable to suppose that, with time, they will be) there may be significant costs in arrangements that in effect suppress the manifestation of such divergences.

What all this adds up to is the fact that the Community is still in a situation where the costs of giving up the possibility of using monetary and exchange rate policies to adjust to differences in economic situations are potentially significant. Over time such costs should diminish as the effects of the single market work themselves through, increasing the level of basic economic integration, and as divergences in the economic cycle and in underlying fiscal positions are reduced.

How far these trends would have to go before the benefits of a single currency would outweigh the costs of forgoing independent monetary policies is, of course, a matter of judgment. But a good case can be made for proceeding cautiously, and not making an irrevocable jump until the integrating impulse of current trends, in particular the 1992 program, has more chance to make itself felt.

A second danger in a rapid progression to a single currency, without an intermediate transitional stage, is that a known and trusted system—that of the exchange rate mechanism based on the anchor of the deutsche mark—would be abandoned in favor of an untried system—that of a new European System of Central Banks. This is not a change that should be undertaken lightly. Monetary stability is sufficiently important that confidence in the strength of any new institutional arrangement should be established before the existing one is abandoned.

It may be asked why a new institution cannot simply be designed in the Bundesbank mold, with effective political and operational autonomy. This would allow it to produce the same degree of price stability that the Bundesbank has achieved. This view falls into the trap of assuming that legislative arrangements can produce operational credibility. This is surely a simplistic interpretation of how a central bank achieves a reputation for anti-inflationary monetary policy. No central bank, however independent it is in a formal sense, can be impervious to the pressures of public opinion. The Bundesbank has acquired its credibility not simply through the independence conferred on it by statute but following a long period of exercising that independence in skillful monetary management. During this period, the aversion of the German people to inflation (born of historical experience) has been augmented by a realization that price stability provides the best basis for sustained and stable economic growth.

A new institution would start with no such inherited legitimacy. If, in addition, it began its life in circumstances where there were significant divergences among member countries in inflation performance and budget deficits, as well as in underlying living standards, it might face substantial political pressures. As noted above, persistent divergences in inflation could lead to corresponding divergences in competitiveness, and eventually to growing unemployment in the less competitive regions. If unemployment were high in large parts of the Community, and if, in addition, these were regions where average income levels were already below those elsewhere, political pressures could become very great indeed.

There is a point beyond which a central bank, however independent in formal terms, cannot ignore such pressures if it is to retain its political legitimacy (and, indeed, its formal independence). It would be unfortunate (at best) and disastrous (at worst) if a new European central bank began its life in circumstances where there was a major economic and political tug-of-war going on between parts of the Community seeking monetary easing to avoid politically damaging unemployment and regions seeking tight money to assure price stability.

The conclusions of the foregoing are twofold. First, it is desirable to allow steps toward monetary union to take place in an evolutionary and pragmatic way. The locking of currencies on the basis of a predetermined schedule, without regard to the extent of underlying economic integration, would carry significant risks. Second, it would be desirable to provide for a period in which any new institution that was expected to be responsible for monetary policy in a monetary union could acquire operational experience and market credibility beforebeing given sole powers.

III. The Hard ECU Proposals

The U.K. Hard ECU proposals are intended to address these difficulties. They are designed to achieve a number of objectives. First, they acknowledge the desire of many Community countries to maintain the momentum of institutional development by establishing, at a relatively early date, a Community monetary institution with meaningful powers. Second, they seek to avoid the risk that premature locking of parities would occur before adequate convergence in economic performance had been achieved. Third, they are designed to promote further convergence in economic performance beyond the end of Stage I. Fourth, they allow the establishment of a new Community currency, while avoiding a confusion of responsibilities between national and Community monetary authorities. Fifth, they give the Community the opportunity to gain experience in joint management of a common money, without abandoning or undermining the tested system of the ERM, and its anchor, the deutsche mark.

These objectives are to be achieved by the creation of a new common currency, the Hard ECU (henceforward HECU) that would be issued and managed by a new Community institution in such a way as to provide both a firm anti-inflationary anchor and a Community currency. This new currency could gradually acquire market standing and eventually displace national currencies.

The following paragraphs describe some of the key features of the proposal. In Section IV some of the objections that have been raised are examined.

The Nature of the New Currency

The U.K. proposal involves redefining the ECU as a new currency, rather than a currency basket as in the present definition. There are, in principle, several ways in which a new currency might be given the anti-inflationary credentials it would need to be a satisfactory focal point for Community monetary policy. One would be simply to give the managers of the HECU the mandate to pursue price stability, and the necessary instruments and autonomy to pursue that objective. This approach has a number of attractions, but its drawback is that it does not provide any security (beyond the basic mandate) that operations would in fact be conducted in the desired way. Hence, the HECU managed in this way might take additional time to establish its role.

Another possibility would be to define the HECU in terms of a commodity basket or, more ambitiously, in terms of a purchasing power index.18 This would be a direct means of achieving the fundamental objective of any monetary standard, that of preserving price stability. However, it also has a number of well-known practical disadvantages.

The U.K. proposal therefore suggests that the HECU be defined so that it could never be devalued against any other ERM currency. In other words, its central rate, which could be changed only as part of a more general realignment, would always move up in step with whichever happened to be the strongest currency. The HECU would be subject to the same (narrow) margins of variation as the other ERM currencies, whose central rates would over time become increasingly fixed, though not irrevocably so.

The Issuing Institution

The HECU would require an institution to issue and manage it. Under the U.K. proposals this institution is illustratively named the European monetary fund (EMF) and is owned and controlled by participating national central banks as shareholders. Participating central banks would subscribe capital in agreed proportions reflecting their relative economic weight. (Capital or guarantees would be needed because the EMF would incur financial risks as a result of its market activities. It is to be expected, however, that the EMF would make profits over time. In this case, capital subscriptions would provide the “key” for determining the distribution of net income.)

If absolute credibility were to attach to the commitment to maintain the value of the HECU, such a commitment would need to be unlimited. It would be the task of the management of the EMF to limit the extent of possible loss, balancing that risk against the requirements of creating a competitive and durable new currency. The EMF would essentially be a deposit-taking and currency-switching institution.19 Its business would consist of receiving deposits in national currencies (probably, but not necessarily, channeled through commercial banks) out of which it would acquire a portfolio of claims denominated in national currencies; in return it would issue liabilities denominated in HECU. The EMF would be free to accept and convert national currencies on demand at an exchange rate determined in the market. It would however have an obligation to buy HECU for national currencies at an intervention point set at the HECU’s lower margin of variation against national currencies. It would also have an obligation to acquire national currencies against HECU at the upper end of the range.

The EMF would need to offer interest on its HECU liabilities, in order that the demand for them would be sufficient to keep the HECU within its prescribed margins of fluctuation against other ERM currencies. Initially, it seems likely that HECU interest rates would need to be administratively set. There could be different rates for a range of maturities, adjusted as necessary to keep the HECU at the desired point in the ERM band. At a more mature stage in the HECU’s development, and probably only when it had been complemented by the provision of a central clearing and settlement system for commercial banks participating in HECU-denominated business, a more significant demand might emerge for non-interest-bearing, operational deposits. In time, numbers of commercial banks might hold operational balances in HECU at the EMF. If and when this occurred, these balances would be a means whereby the new institution could exert increasing influence on monetary conditions throughout the system.

Managing the EMF’s Portfolio

The management of the EMF’s portfolio of liabilities would be relatively straightforward and would be constrained by the need to keep the exchange value of the HECU within its ERM margins. The management of the EMF’s asset portfolio poses more difficult questions. One objective would be to contain the risk of loss arising from a mismatch—by currency, maturity, or interest rate—with the liabilities described above. A second objective would be to exert appropriate pressure for policy action on the issuing central bank(s) of the currency(ies) that were offered for conversion to the EMF. The objective would be to ensure that the combined effect of the EMF’s own money creation—through the generation of HECU monetary liabilities—and the influence it exerted on the money creation by national central banks was consistent with the anti-inflationary objectives of the Community as a whole.

To give the EMF the necessary power to influence the money creation of national central banks, it is envisaged that it would be empowered to require issuing central banks to repurchase, against hard currency, balances in their currency which the EMF acquired, and possibly also to provide a maintenance of value guarantee in terms of HECU. In effect, central banks would be required to support their respective currencies within their ERM bands by spending hard-currency reserves. This would both safeguard the EMF against loss and provide leverage on the policies of national central banks. The mechanism by which pressure would be exerted on national central banks to correct any tendency to laxity in monetary policy is broadly similar to the one that operates under present ERM arrangements. Policy weakness leads to a decline in the exchange rate and a loss of net reserves when the currency concerned reaches the bottom of its margin of fluctuation.

There remains, however, a range of options over how the EMF’s power to require national currencies to be repurchased might be exercised. At one extreme, full discretion might be left to the EMF’s management regarding the amounts of national currency that the institution might hold (and therefore the amounts that would need to be presented to national banks for repurchase); as well as regarding the currencies that would be acceptable to it in the event of repurchase. Alternatively, or in addition, maintenance of value guarantees might in some cases be deemed sufficient protection for its national currency holdings up to a certain point, perhaps in association with monetary policy undertakings by the relevant national bank. In another variant, the obligation to redeem national currency balances might be automatic.

The obligation on national central banks to repurchase their currencies would, as just noted, exert monetary discipline through the familiar mechanism of reserve loss. National authorities would be obliged to spend their own reserves or to purchase reserves with their own currency (in both cases extinguishing an equivalent amount of domestic base money), or borrow reserves in the market. To limit or reverse such reserve loss, a national central bank would have to raise its interest rates. This would tend to depress national currency creation, and thereby restore the appropriate Community-wide stance of monetary policy. The harder the monetary discipline to be exerted on individual countries of issue, the greater the need to insist on immediate and full redemption in external assets.

If the EMF were to manage the HECU in a passive way (e.g., by simply matching interest rates on the hardest ERM currency), this would, as noted above, replicate the mechanisms of current arrangements. A more proactive monetary role for the EMF would envisage the possibility of outbidding equivalent interest rates on national currencies. This would enable the EMF to exert upward pressure on Community-wide interest rates. At the same time, it would involve greater exposure to risk of loss. The trade-off between monetary leverage and exposure to loss would depend on the degree of maturity of development and acceptability of the HECU.

Interest Rate Policy

The immediate purpose of managing HECU interest rates would be to influence the exchange rate of the HECU against other currencies. A range of possibilities would be available. At one extreme, the EMF could pursue an entirely passive or nonmanaged approach, in which it would set HECU interest rates close to those on corresponding maturities of the strongest of other ERM currencies. In that case, the rate of growth of the HECU would depend purely on the market’s view of (1) the EMF’s commitment to maintaining its exchange value, as reflected in the credibility of the guarantees provided by its shareholders; (2) the usefulness of the new currency as a payments medium, which would depend in part on the rate at which an associated clearing and settlement system developed; and (3) the value of the option that the new currency would in effect provide for its holders in the event of a realignment. If its reputation were at least on a par with that of the central bank with the strongest currency, the EMF might, by virtue of the option afforded by the HECU, find that it could set the HECU deposit rate below that on the strongest national currency and still see some substitution of HECU for other deposits. The greater any expectation of a forthcoming devaluation of the hitherto strongest currency, the larger would be the margin by which HECU interest rates could diverge below those on that currency.

In a more managed approach, it would be open to the EMF to raise the interest rate on HECU relative to rates on national currencies. It would do this either by raising the rate offered on HECU deposits or by raising the rate at which it lent HECU to relieve market shortages created by its sales of HECU. In the early stages, a higher interest rate on HECU would be the only available means of provoking additional demand for HECU assets, other things being equal. The EMF, which would be called upon to satisfy the additional demand, might well face the choice between, on the one hand, selling increasing amounts of its own HECU liabilities, to maintain its desired level of rates, and, on the other hand, allowing market interest rates on HECU assets to fall away from the desired level.

The stronger the EMF’s resolve to keep HECU interest rates up, the greater would be its ability to sell HECU assets or issue HECU liabilities, and the greater would be the pressure on national central banks to move their interest rates up in parallel. The strength of this pressure would also depend on how widely the HECU was used in commercial transactions.

Admittedly an operation of this sort would expose the EMF to some financial risk. This might in practice imply some limitation on its willingness to act for long in this kind of way. In the longer run, the key means of enhancing the new currency’s role would be to secure its reputation as a currency subject to low inflation expectations, backed up by an efficient clearing and settlement system. This should enable a negative risk premium to be established against even the strongest currency. That, in turn, would permit low HECU lending rates, which would enhance its appeal for borrowers.

IV. Criticisms of the HECU Proposal

As noted earlier, the HECU proposals have attracted a number of criticisms, on political as well as economic grounds. This section surveys a number of the main reservations that have been expressed.

A first criticism is that the proposals provide no clear link with, or commitment to, the ultimate objective of Stage III of EMU. It is, of course, true that in putting forward its proposal, the U.K. Government has not accepted the goal of a single currency. But, while the plan does not itself involve an eventual move to a single currency, it certainly does not preclude such a move. Indeed, insofar as it promotes disciplined monetary policies throughout the Community and the progressive attainment of price stability, it helps provide an essential precondition for any move to a single currency.

A second criticism is that the operations of the EMF and the constraints and obligations it would impose on national monetary authorities would represent an undesirable loss of national sovereignty. It is certainly true that participation in the EMF would constrain national central banks to accept the disciplines set by the EMF in managing the HECU. But this would not be fundamentally different from the current situation, since national authorities have to take account of external market pressures in formulating policy. Each national authority would continue to have the option to manage its own currency, subject to the constraints imposed by membership of the ERM. In extreme circumstances, it would retain the right to request a change in its central rate or even to withdraw from the mechanism altogether.

Third, at a more technical level, it is argued that the HECU would not develop without artificial incentives. Its relative strength and stability would not be sufficient to compensate for its unfamiliarity as a transactions medium. This argument is based on a strand of literature that points out that an established national currency has a considerable power to resist replacement by an outside currency, even when the intrinsic properties of the latter are clearly superior. Thus, even in countries with very high inflation (Brazil, Argentina) the national currency remains the principal circulating medium.

This argument clearly has a strong basis in observed experience, but cannot necessarily be extrapolated to the European case. If a common currency were given equality to compete with national currency (through the removal of legal impediments and the provision of effective cross-Community payment and settlement systems) it might well perform better. Conferring legal tender status on the HECU could provide a useful additional incentive to its use, though the importance of this step should not be exaggerated. A growing recognition that the new currency was a potential future single currency might further enhance its acceptability.

Nevertheless, it is perhaps unlikely that a new currency such as the HECU would quickly find its way into everyday retail use. This does not, however, undermine the case for the HECU. Its primary importance in the early stages of development would lie in its role as a noninflationary standard for the ERM and as a wholesale instrument in financial markets.

Fourth, it is argued that to encourage holding of HECU, rates would have to be set above those on other strong currencies, thus imparting upward pressure to interest rate costs across the Community. This seems to misunderstand the character of the HECU. From the outset the new currency would have an appeal as a store of value that was devaluation proof relative to national currencies within the Community. The required interest return could therefore be correspondingly low. At the same time, the low rate of interest payable would compensate borrowers of HECU whose income or assets were still largely denominated in national currencies for the currency risk that they would be undertaking.

It is not possible to predict exactly where rates would need to be set to ensure the EMF met its primary obligation that the HECU should never be devalued and progressively to attract savers and borrowers to use the new medium. But over time short-term HECU rates should settle below even the interest rates for comparable assets denominated in the strongest of national currencies.

A fifth objection is that the HECU would not have the hedging characteristics of the basket ECU, since it would not be composed of the national currencies of member states. But the HECU would be a different product, satisfying a different market need, namely stability as a store of value and low interest rates; in this sense what it would be offering is a hedge against inflation. It would have additional appeal of being a common currency for the Community as a whole, whose management and development would be the responsibility of a Community body, the EMF. At the same time, the private markets would not be deprived of the means of hedging against movements in Community currencies and interest rates. Positions could still be taken in baskets of Community currencies, either synthesized to a standard formula or tailored to a particular need.

A sixth objection that has been advanced to the U.K. proposal is that competition between the HECU and the basket ECU would be harmful to the development of a common currency. This is because of the confusion that might be created by the coexistence of two different types of ECU. It has to be recognized, of course, that there would be an initial period in which instruments in both HECU and basket ECU would exist alongside one another. But this presents no particular difficulties. Unless the contracting parties in the private ECU markets agreed otherwise, existing contracts in basket ECUs could be worked out on the basis of their original contractual terms. But from its inception the HECU would be expected to become the main vehicle for new contracts.

A seventh question concerns the inflationary potential of the HECU. It is argued that the primary objective of the EMF would be exchange rate stability rather than price stability, and that the introduction of the HECU as a parallel currency would provide an additional source of credit creation that would complicate the management of monetary policy within the Community. Although this criticism has gained some currency, it is neither the intention nor the likely outcome of the proposal that exchange rate stability should be given primacy over price stability. The premise of the proposal is that any arrangements for moving beyond Stage I should ensure, to the maximum degree possible, anti-inflationary pressure and convergence toward stable prices.

The HECU proposal is designed to provide strong safeguards against the concerns expressed in the Delors Report about the inflationary potential of parallel currencies. In the first place, the creation of HECU can only come about when national currencies are surrendered to the EMF in exchange for HECU claims. Therefore, at the point of creation of HECUs there would be an equivalent extinction of national currency. In addition, further safeguards are provided. The responsibility of the EMF to ensure that the HECU could not be devalued against other national currencies provides an assurance that the EMF would operate the policy instruments at its disposal to maintain sufficiently tight monetary conditions in the Community as a whole. This would be reinforced by the repurchase obligation (possibly backed up by a maintenance of value guarantee by member states). To the extent that the EMF received national currencies, it would always have the right to put these currencies back to national central banks in exchange for “hard” assets. Thus, if a national monetary authority was running an excessively loose monetary policy, and this was resulting in the national currency concerned being exchanged for HECU-denominated deposits, the national central bank would find itself either losing reserves, or having to underwrite the HECU value of the national currency holdings of the EMF.

Lastly, there is the objection that the existence of a common currency would result in confusion over the ultimate responsibility for monetary policy. In fact, the HECU proposal is designed to eliminate ambiguity in this regard. Each national monetary authority would remain responsible for its own monetary policy, while the EMF would have responsibility for the maintenance of value of the HECU. There would similarly be no ambiguity about the objective of the EMF as the managing authority for the HECU. It would be to maintain the value of the HECU in terms of the strongest currency and to ensure that continuous downward pressure on inflation was maintained.

The views expressed in this paper are those of the author and not necessarily of the Bank of England.


Speech by John Major, then the Chancellor of the Exchequer, to the German Industry Forum on June 20, 1990, “Economic and Monetary Union: Beyond Stage One.”


Commission of the European Communities, Report to the Council and the Commission on the Realization by Stages of Economic and Monetary Union in the Community (Werner Report), Supplement to Bulletin 11 of the European Community (Luxembourg, 1970).


Resolution of the European Council of December 5, 1978 on the establishment of the European Monetary System (introduction, paragraph 1); see Commission of the European Communities, European Economy (Luxembourg), No. 3 (July 1979), pp. 95–97.


Committee for the Study of Economic and Monetary Union (Delors Committee), Report on Economic and Monetary Union in the European Community (Luxembourg, 1989).


Richard E. Baldwin, “On the Microeconomics of the European Monetary Union,” in The Economics of EMU, Special Edition No. 1 to European Economy, Commission of the European Communities (Luxembourg, 1991),


Yoshide Ishiyama, “The Theory of Optimum Currency Areas: A Survey,” Staff Papers, International Monetary Fund (Washington), Vol. 22 (July 1975), pp. 344–83.


“One Market, One Money: An Evaluation of the Potential Benefits and Costs of Forming an Economic and Monetary Union,” European Economy, Commission of the European Communities (Luxembourg), No. 44 (October 1990).


Ibid., p. 26.


Exchange Rate Volatility and World Trade: A Study by the Research Department of the International Monetary Fund, IMF Occasional Paper No. 28 (Washington: International Monetary Fund, 1984).


“One Market, One Money” (see footnote 7), p. 68.


Alex Cukierman, “Fixed Parities versus a Commonly Managed Currency and the Case Against ‘Stage I’,” Ministry of Finance (Paris, June 21, 1990).


“One Market, One Money” (see footnote 7), p. 21.


Frederick van der Ploeg, “Macroeconomic Policy Coordination Issues During the Various Phases of Economic and Monetary Integration in Europe,” in The Economics of EMU, Special Edition No. 1 to European Economy, Commission of the European Communities (Luxembourg, 1991).


See, for example, Peter B. Kenen, “The Theory of Optimum Currency Areas: An Eclectic View,” in Monetary Problems of the International Economy, ed. by Robert A. Mundell and Alexander K, Swoboda (Chicago: University of Chicago Press, 1969).


Commission of the European Communities, “Economic and Monetary Union” (Brussels, August 21, 1990).


In the United States, the highest per capita income state (Connecticut) had a per capita income in 1987 2.1 times greater than that of the state with the lowest income level (Mississippi). In Europe, the comparable multiple is 5.0 (Denmark: Portugal). See U.S. Bureau of the Census, Statistical Abstract of the United States: 1990 (110th edition, Washington, 1990); and Organization for Economic Cooperation and Development (1988).


Martin Feldstein and Charles Horioka, “Domestic Saving and International Capital Flows,” Economic Journal (London), Vol. 90 (June 1980), pp. 314–29.


A.A. Walters, Sterling in Danger: The Economic Consequences of Pegged Exchange Rates, Chapter 7 (London: Fontana/Collins, 1990).


Joe Grice, “The U.K. Proposals for a European Monetary Fund and a ‘Hard ECU’: Making Progress Towards Economic and Monetary Union in Europe,” Treasury Bulletin (London), Autumn 1990, pp. 1–9.

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