Question

There are several economic costs associated with the imposition of European Band of Currency Fluctuations and the European Monetary System (EMS). Briefly discuss the outcome of the Delors Report (Commission, 1989), which has been outlined by the Maastricth Treaty (1992).

Answer 1

The European Monetary System (EMS) was an arrangement between European countries to link their currencies.

The goal was to stabilize inflation and stop large exchange rate fluctuations between these neighboring nations, making it easy for them to trade goods with each other.

The most important component of the EMS was the ERM. Most EC member countries agreed to keep their exchange rates within a band of ±2.25% (or a total of 4.5%) of central values. This was a much wider band than the total fluctuation of 2% allowed in the Bretton Woods system. Furthermore, under the latter system, only the central bank of the weak currency country was obligated to intervene in the foreign exchange market and correct the exchange misalignment. This was carried out by simply having the central bank buy back its own currency.

Under the EMS, both central banks were required to intervene in the foreign exchange market to correct the misalignment of the exchange rate. The country of the weak currency had to buy back its own currency and the country of the strong currency had to buy the weak currency using its own currency. In this way, the deviating exchange rate was brought back to its par value much faster. It is, therefore, evident that the EMS was a regime that had more exchange rate flexibility than the Bretton Woods system. It is also correct that the EMS, by design, was a symmetric system whereas the Bretton Woods was asymmetric in terms of the way exchange rate misalignments were corrected.

The cause(s) of the 1992–1993 ERM crisis are found in deficiencies in the design of the EMS system and on structural changes that occurred in the EC member countries’ economies before and during the crisis. In every fixed exchange regime, out of “n” number of currencies, one of the currencies will have to evolve as the anchor or reserve currency. The reserve country must be willing to make its currency available to the rest of the countries when necessary to support the remaining “n − 1” currencies so they can remain within the band. In the case of the EMS, no currency was officially chosen as anchor or reserve currency, but the cur-rency that evolved to become the anchor was the German mark.

The ERM crisis was triggered when EMS countries experienced an asymmetric shock that affected the anchor country, Germany, differently from the other members. Immediately after the collapse of the Berlin wall in 1989, Germany launched a very expansionary fiscal policy in order to finance the reconstruction of the former East Germany. To finance its deficits, the German government issued bonds to the public; this reduced the money supply of the country and increased German interest rates. A European central bank could have kept the interest rates unchanged by increasing the money supply by equal amounts with the increase in the German government deficit, but the Bundesbank, which was cautious of igniting inflation, refused to do so, i.e., it refused to monetize the new public debt. But high interest rates were detrimental to the EMS partners because most of these countries were undergoing a severe recession during the same time period.

The Delors Report is structured in three chapters. The first chapter analyses past experiences and current developments in economic and monetary integration in the EC and spells out the economic rationale to move towards EMU.

The second chapter constitutes the bulk of the report. It examines the principal features and implications of creating an Economic and monetary union, and the transfers of sovereignty which it would entail.

Finally, the third chapter proposes the realisation of economic and monetary union in three stages.

While not making a clear-cut case for the absolute necessity of EMU, the Report sees the move towards an economic and monetary union as a “natural consequence of the commitment to create a market without frontiers”.“Economic union” in the Report is defined in terms of four basic elements:

(1) the single market,

(2) competition policies and other measures aimed at strengthening market mechanisms,

(3) common regional and structural policies and

(4) macroeconomic policy co-ordination, “including binding rules for budgetary policies”

It emphasizes the need to implement them in parallel, as “the process of achieving monetary union is only conceivable if a high degree of economic convergence is attained”. In particular, the completion of the single market programme and the reduction of existing disparities “through programmes of budgetary consolidation to those countries concerned and more effective structural and regional policies” are seen as necessary conditions to move from stage 1 to stage 2 in the road to EMU.

At the third stage of EMU, a well-functioning economic pillar is considered essential to limit the scope for divergences and permit the determination of an overall policy stance for the Community as a whole. In the absence of the exchange rate instrument, the Report emphasizes the importance of labour mobility, together with wage and price flexibility at the national level, to prevent and correct economic imbalances.

Apart from completing the single market and introducing national wage and price flexibility measures, the Report considers essential to set a framework for macro-economic policy co-ordination in the last stage of EMU.

On the precise institutional arrangements, a lot of attention is devoted to describe the mandate, functions and principles that should govern the new central monetary authority. In particular, the Report recommends the creation of a rather “federal” structure (the European System of Central Banks – “ESCB”), consisting of a central institution and the national central banks.

The Report considers that the European Parliament has to be involved.The Report emphasizes the need to guarantee the ESCB’s political independence while at the same time calling for its democratic accountability vis-à-vis the European Parliament and the European Council.

Thus, The Delors Commission gave a new momentum to the process of European integration. They 'completed' the internal market and laid the foundations for the single European currency. European Economic and Monetary Union was based on the three stage plan drawn up by a committee headed by Delors (the Delors Report). Delors and his Commissioners are considered the "founding fathers" of the euro. The groundwork and political persuasion was achieved through the work of the Commissioners leading to the signature of the Single European Act (SEA) in February 1986 and the Treaty of Maastricht in 1992.

Finally, the third chapter of the Report proposes a three-step approach to move towards EMU.