Weak analysis and complacency among policy-makers nearly led to the train to European economic and monetary union (EMU) being derailed by the avoidable crises of the exchange rate mechanism (ERM) in 1992–3. Once again, those wishing closer monetary integration in Europe are being poorly served by official strategy and academic analysis.

That is the conclusion of the latest CEPR report in the Monitoring European Integration series. Its authors argue that if the ‘Ins’ of EMU are not merely to be betrothed in Spring 1998 but successfully wed on 1 January 1999, the strategy for transition needs to be amended quickly.

This transition, always likely to be fragile, has been complicated by three commitments: first, the Maastricht Treaty declares that conversion rates between the Euro and the national currencies of the first Ins will be decided at the start of EMU; second, the Treaty adds, the value of the Ecu must not change at this time; and third, as agreed at the Madrid summit, the Euro, being the legal continuation of the Ecu, should convert initially at one for one with the Ecu.

These decisions may seem technical but have important implications: first, conversion rates for the Ins cannot differ from those implied by market rates on 31 December 1998; and second, the conversion rate between the Euro and the currency of any In cannot be specified in advance. What could be specified in advance, however, are bilateral conversion rates between the Ins.

Markets will worry whether and how such problems will be overcome. Any coherent proposal for transition must deal with two difficulties: beliefs about eventual conversion rates may be self-fulfilling; and Ins may be tempted to relax their previous austerity once the selection for EMU is irreversible.

Most proposals for the transition fail to confront these challenges. Floating into EMUand adopting as conversion rates the exchange rates prevailing on 31 December 1998, offers too little guidance to market expectations, too little discipline on the Ins, and too great an opportunity for strategic manipulation of conversion rates.

The Report argues that other proposals are equally flawed. Narrowing the bands during the transition, for example, may diminish uncertainty and constrain competitive devaluation – but narrow bands might not survive speculative attacks. The use of conversion rates based on historical averages of actual exchange rates has also been proposed, but such conversion rates could still be manipulated and speculative pressures might simply be brought forward.

The Report offers a simple alternative proposal to avoid such pitfalls: pre-announce bilateral conversion rates for the Ins and then rely on floating to proceed to those fixed end points. Provided the conversion rates are credible, market rates will steadily converge on the pre-announced rates without any need for intervention while EMU is still some way off.

Complete credibility of bilateral conversion rates requires, if necessary, the prospect of substantial intervention on the final day to enforce these rates. But any monetary effects of intervention can, the Report argues, automatically be undone as the first act of the new European Central Bank. A national central bank will not have to take chances with inflation to bail out other currencies: there will not be time for its economy to be affected before policies are reversed. And in any case, being credible, such intervention is unlikely to be required.

The proposal goes further: pre-announced conversion rates between Ins should be based on the central parities ruling when Ins are first confirmed. The Report shows that rates based on current parities pose surprisingly few problems for the competitiveness of potential EMU members.

This in turn suggests a natural way to handle EU members not in the first wave of EMU: they should be required to join at exchange rates, relative to the Euro, based on central parities at the time their EMU membership is accepted. The Maastricht requirement of no devaluation for two years prior to EMU entry would remain in force.

This solution maintains the principle of equal treatment, reduces avoidable uncertainty about future admission, yet recognises the reality that countries deemed to have converged insufficiently may then face huge pressures for immediate depreciation. Requiring eventual entry based on 1997 parities would impose years of deflation and lack credibility. The proposal does not preclude devaluation by ‘pre-Ins’ provided the Maastricht requirement is still observed.

Speculative crises typically do not wait for policy decisions to be made. The Report concludes by arguing that the entire procedure for the transition should be announced as soon as possible. One important consequence of the proposal would be to reassure markets that current exchange rates might remain viable.

Leonardo Bartolini and Alessandro Prati, ‘Soft versus Hard Rules for Exchange Rate Targeting’, Economic Policy 24 (April 1997)

Barry Eichengreen, Andrew Rose and Charles Wyplosz, ‘Exchange Market Mayhem: The Antecedents and Aftermath of Speculative Attacks’, Economic Policy 21 (October 1995)

David Begg et al, The Making of Monetary Union: Monitoring European Integration 2, CEPR (1991)