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Meeting the Maastricht targets.

Article Excerpt
BACKGROUND

Ever since the 1950s, the democratic nations of Europe have proceeded toward increasing politico-economic integration. From integrating the coal and steel industries they moved on to the joint development of the peaceful use of nuclear energy and the establishment of a customs union. Gradually they have created a "Single European Market" with few barriers left to free trade among an increasing number (presently 15) of participants in the European Union.

However, the proponents of full economic integration realized early on that a true internal market, like that of the fifty states of the U.S., would also require a common European currency. Only such a monetary union would eliminate market distortions emanating particularly from currency exchange fees, exchange-rate fluctuations, and a lack of international price transparency.

As early as the 1970s, steps were taken to come to grips with this problem, most importantly the introduction of the European Monetary System (EMS), which established among the participants an exchange-rate mechanism, not unlike that of Bretton Woods. Participating currencies had to keep their exchange rates to the newly created "ecu," a weighted basket currency used for accounting purposes, within a narrow range. Stronger currencies were given a 2.25 percent band of variation; weaker currencies were allowed to vary six percent from the set rate. It was the obligation of central banks to hold their currencies within this range through market intervention. It seemed like a good idea to let the European currencies converge gradually. Even Britain was participating for a while. But several rate adjustments and outright defections indicated real trouble.

To begin with, any responsible monetary policy has to reconcile competing international and domestic demands. The former call for exchange rate stability and conformity with market forces; the latter require the option to inflate the economy to increase growth and employment.

The economic fundamentals in member nations had simply been too different for a system of relatively inflexible exchange rates to succeed. The failure to fully establish the planned European Monetary Fund to help out currencies under stress contributed to the disappointments. Without systemic remedies, the accumulated effects of differences in inflation rates, unemployment levels, money supplies, budget situations, taxation, and balance-of-payments positions made the loosening of the relatively rigid exchange-rate mechanism unavoidable.

THE MAASTRICHT TARGETS

Nevertheless, the architects of the next effort to bring about monetary union in Europe had learned important lessons. When their plans took shape in preparation for a 1991 summit of the European Union in the Dutch city of Maastricht, they included "convergence criteria" to be met by those countries who wanted to join the newly conceived European Monetary Union (EMU). A commitment to economic stability and sound budgetary policy had to be demonstrated by meeting a number of requirements for fiscal year 1997:

1. Inflation rates were not to exceed the average of the three best performing members by more than 1.5 percentage points.

2. Long-term interest rates were to be kept within two percentage points of the average rate of the three countries with the lowest interest rates.

3. Annual budgetary deficits were not to exceed three percent of GDP and overall national debt was to be kept under 60 percent of GDP.

4. National currencies were not to have been devalued for at least two years, remaining within the band of permissible fluctuation under EMS rules.

To appreciate the formidable task ahead for prospective EMU members, Table 1 gives a partial view of the situation at the time of the initial review of the Maastricht Treaty.

The numbers showed that only little Luxembourg met all requirements, while all others failed in one category or the other. As time advanced, the national debt target was interpreted more and more loosely, while the budget deficit limit of three percent was gradually elevated to a fetish.

Most economic experts, regardless of their nationality or ideological conviction, had serious reservations about all of this. Some warned of asymmetric shocks (Martin Feldstein) which would pull the diverse economies of Euroland apart. Others lamented the unenforceable rules and feared a lack of financial discipline among certain members. Still others on the left worried about a possible competitive "race to the bottom" that would sacrifice all the progressive accomplishments of Europe's "social market economies."

The politicians and EU officials, on the other hand, advertised the common currency as part of the larger project of European integration. It made perfect sense as another example of the "disequilibrium dynamics" (Emerson, 1999). As with riding a bicycle, you need to move forward to keep from falling. Thus, after establishing the Single Market, a common currency was the next logical move to keep going toward a united Europe. As specific economic benefits they usually listed:

1) A larger market, serving 290 million...