EMU is still achievable, provided Europe builds the right sort of ERMThe so-called New ERM--the attempt to maintain narrow exchange-rate bands around fixed parities without capital controls--is gone. Have the prospects for EMU vanished with it? Not at all. A path can now be cleared toward a monetary arrangement that better meets the three requirements of the transition to EMU: flexibility, a credible commitment to stable prices, and Community-wide co-ordination of monetary policy. What the EC needs now is a Two-Tier ERM.

The ERM that failed called for all its members to pursue the same monetary policy at all times. When different members needed different policies, it could not cope, and was therefore doomed. With multiple currencies and highly-mobile capital, this outcome was inevitable. (German unification greatly increased the pressures on the system, but the underlying defect was there in any case.) Capital controls (as argued by Barry Eichengreen and Charles Wyplosz in the previous article) might have helped to sustain the system, at least for a time--but at the cost of undermining not only Europe's commitment to free mobility of factors but also whatever popular support may remain for EMU. In the event, the collapse of the ERM caused political frictions which seem to make EMU all the more remote. The ERM that was to have been a springboard to broader union had become a barrier.

The idea that the path to EMU requires a gradual tightening of the ERM was probably the biggest mistake in the Maastricht Treaty. It was wrong in economic logic, and now it stands refuted as a matter of fact. But was a one-size-fits-all, narrow-band ERM desirable on its own merits? No. Some fear that greater exchange-rate volatility may now hinder cross-border trade and investment in the EC. But the fact is that intra-ERM trade fell relative to trade of the ERM with all industrialised countries after 1979, and especially after 1987. More sophisticated econometric analysis has failed to show that exchange-rate volatility significantly affects trade.

Even accepting the conventional view that volatility impairs trade, it does not follow that a narrow-band ERM makes sense. Speculative attacks on currencies occur only in the presence of unsustainable exchange-rate constraints--that is, only in fixed-rate systems. It may be that the volatility associated with speculative attacks is more harmful than the volatility associated with floating rates. Similarly, the risk that misalignments (as opposed to volatility) of flexible exchange rates may distort trade and investment does not imply that a narrow-band system is preferable. This would be so only if governments knew the appropriate parities and were free to enforce them. The fate of the ERM suggests that neither is true.

Some fear that the ERM's new, wider bands will invite competitive devaluations. Perhaps not. The best protection against them is the Single Market itself. With a large volume of intra-industry trade, every devaluation causes a cost-push that offsets the desired gain in competitiveness. As a result, the incentive for competitive devaluations disappears.

In sum, there is no good reason to return to a narrow-band ERM. Many commentators would agree with that--and then argue that Europe should press on quickly to full EMU. But this too is a mistake. Monetary unions need their members to be in accord over basic principles of economic policy. This is the only convergence criterion that matters: will be met if it does not. In fact, there is no such accord. Governments all say that monetary policy should aim at price stability, but evidently not all of them mean it. Above all, fundamental disagreements remain over the proper role of government in the economy. Examples are the row over GATT (which touches on how open the EC should be to world trade) and the debate over the principle of subsidiarity (which involves the size and power of the EC's central administration).

Until recently, such fundamental disputes were covered up. When disagreement surfaced, the Community simply adopted plans for more ambitious integration. External threats (the military one from the East and the economic one from the United States) demanded EC solidarity; non-tariff barriers to trade sheltered markets from EC competition even within the customs union. Both these things made it possible for governments to suppress or forget their underlying disagreements.

Post-Maastricht, the policy environment is entirely different. External threats have receded and the Single Market is doing away with the remaining internal barriers to trade. As a result, international competition--not merely in trade, but among different approaches to economic policy--will be more intense. By choosing among goods, investment opportunities and places to live and work, consumers, investors, and workers will decide for themselves which politico-economic system they prefer. Governments will have to adjust to the public's demands. The ensuing changes in labour markets, patterns of tax and subsidy, regulation, and social policies will cause income, wealth and relative prices to shift across the EC. In this way. the Single Market is going to amplify shocks of the very kind that fixed exchange rates are ill-suited to deal with.

A monetary arrangement for the EC in the 1990s therefore requires the flexibility of the new, wide exchange-rate bands. Three other conditions concerning the role of the national monetary authorities are also necessary. First, central banks must be independent of government (and therefore free from short-term political pressures). Second, they must be held accountable by means of a clear mandate to achieve price stability;. Third, they must be vested with responsibility for exchange-rate policy. This formula provides the foundation of a credible commitment to price stability in the EC.

The role of the central bank in conducting exchange-rate policy is crucial. The ERM's new wide bands provide sufficient protection against large exchange-rate shocks. Within them, however, each central bank should be free to define narrower, non-binding bands with other currencies. Given this option, stability-oriented central banks will choose narrow bands only with other stability-oriented central banks. Since there will be no obligation to defend the margins, the narrow bands will not be exposed to speculative attacks. The resulting two-tier ERM could serve as a framework for flexible co-ordination of policy. If a currency left its narrow band for more than a short time consultations at the European Monetary Institute would follow. The EMI would publish a statement to inform the public and explain its decisions. Changes in the narrow bands, as indeed in the wide bands, would not pose credibility problems: the public would regard them simply as responses to asymmetric shocks. The EMI would also discuss and report regularly on European monetary trends and central-bank independence.

With time, competition among economic policies would lead some or all EC members to converge on similar policies and institutions. These countries would find that policy-induced, asymmetric shocks would peter out, and that changes in their reciprocal narrow bands would become increasingly rare. The two-tier ERM would thus be a self-selection mechanism for monetary union, achieving that goal through a smooth transition of flexible co-operation. An EMU built that way might even be worth having.

 Jürgen von Hagen

Von Hagen is Professor of Economics at Universität Mannheim and a Research Fellow in CEPR's International Macroeconomics programme.

Michele Fratianni, Jürgen von Hagen and Christopher Waller, The Maastricht Way to EMU, Essays in International Finance 187, Princeton, (1992).CEPR, The Monetary Future of Europe, 1993.

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