Even before it is born, the European Central Bank (ECB) may be a
victim of its own weight. There is little appreciation of the
considerable risks that Europe will face if it continues to ignore, as
the Maastricht Treaty does, the need to establish the relationship
between the Ins and the Outs on safe ground.
This is not a temporary arrangement: some countries may elect to
remain out for a long time; and new EU members will not always be able
to join the monetary union upon accession. Exchange rate stability is
intimately linked with Europe’s economic integration, and is one of
the pre-conditions for entry into EMU. Hence the euro must be part of an
EMS 2. Leaving to each ‘periphery’ country the responsibility to
position its currency against the euro will not be enough.
The reasonable solution is to keep the EMS ‘house’ open. Yet
three main lessons must be drawn from the experience of EMS 1:
- Exchange rate adjustments should not be delayed when they are
needed.
- The bands must be wide enough to avoid jumps at the time of
realignments.
- Interventions are needed to organize realignments but may have to
be massive given free capital mobility.
There seems to be little disagreement about the two first lessons,
but the third remains widely overlooked. Conventional wisdom has it that
‘proper policies deliver stable exchange rates’. This simplistic
view ignores the distinction between past policies and uncertainty about
the future.
Potential economic, social or political difficulties occasionally
cause markets to sell currencies that otherwise have sound
‘fundamentals’. With floating exchange rates, this results in wide
and long-lasting cycles. With fixed exchange rates, the outcome is a
speculative attack.
EMS 1 dealt with this risk by requesting unlimited support from all
concerned central banks. But experience has shown what reason should
have known: commitments cannot be unlimited. Yet the arrangement was
realistic in one aspect: only unlimited interventions can preserve the
system from collapse in the face of apparently unwarranted attacks. How
can we square this circle?
There is a simple solution: make interventions unlimited but
conditional. The arrangement would be limited to countries with a
declared intention of joining the monetary union within two years.
During this period of transition, they must in any case adopt a
programme of convergence. This programme could be the basis of a
contract with the ECB: as long as a country satisfies the convergence
criteria (which can be monitored on a quarterly or even monthly basis),
it would benefit from unlimited support in the face of a speculative
attack.
On the other side, the ECB would not be committed to support a
currency when the country is failing to meet the terms of the contract.
Such an arrangement has many merits:
- Unlimited support would be used only in cases where an attack is
clearly unjustified but where, should speculation win, the
well-behaving country’s chance of joining EMU would be ruined.
- The markets would know that they face unlimited interventions by
the ECB and probably retreat quickly.
- The contract would greatly enhance a country’s incentives to
respect the convergence programme as it involves both adequate
carrots (unlimited support) and sticks (conditionality).
- It does not require that all EMU countries participate in a tight
EMS 2. There can be wide band membership implying minimal restraint
along with narrower convergence bands leading to EMU membership.
- It is limited in time, clearly designed to encourage convergence.
The main advantage of this arrangement is the lack of reasonable
alternatives. One approach is to reject any form of exchange rate
commitment. Yet free floating is known to be conducive to large swings
that corrupt the game of international competitiveness. The answer then
is to adopt inflation targets and presume that success in meeting these
targets will automatically deliver a stable exchange rate against the
euro. There is no evidence that this has ever worked and heavy
suspicions that it will not.
Another approach considers that the first task is to protect the ECB.
In its first years of operation, the ECB is often described as a weak
untested institution, which will have to establish its reputation.
Viewed this way, any binding commitment is seen as a major threat which
must be ruled out.
But there are serious reasons to believe that the fledgling ECB will
be recognized by the markets as an independent and powerful institution.
Of course Goliath might be tempted to smash David to establish his
manhood. Yet Europe’s long-run stability stands to lose much more from
repeated attacks at the periphery of EMU, leading to permanent division
between the Ins and the Outs, than some slight doubts about the ECB’s
reputation.
Charles Wyplosz Wyplosz is Professor of Economics at the Graduate
Institute of International Studies in Geneva, a member of INSEAD in
Paris and a Research Fellow in CEPR’s International Macroeconomics
programme. This article summarizes ‘An EMS for both Ins and Outs: The
contractual and conditional approach’.