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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO AUGUST 1993 NUMBER 72 Chicago Fed Letter Europe at the crossroads I sh a ll be tellin g th is w ith a sigh Som ewhere ages a n d ages hence: T w o roads diverged in a w ood, a n d / — / took the one less traveled In;, A n d th a t h as m ade a ll the difference. —Robert Frost, ‘The Road Not Taken" Economic and political integration in Western Europe has been more suc cessful than could have been imagined at the end o f World War II. It is per haps a symptom o f our frenetic times that this success could he viewed as in serious trouble after hitting a few bumps in die road during the past year. Prior to World War II, unity in Europe was usually the result o f con quest or the creation o f alliances in an attempt to fend o ff conquest. PostWorld War II Western European integration, on the other hand, has been based on the voluntary accord o f the participants. Yet, in some sense this integration harkens hack to yester year, because its impetus was largely based on the post-war reaction o f the Western allies to that war and to the emergence o f the Sov iet bloc threat. The receding o f the Soviet threat has left the nations o f Europe much freer to deline and follow their own desti nies, but it has also stripped the Euro pean integration process o f a powerful unifying force. The most recent milestone in the Euro pean Community’s (EC) integration process— the Maastricht treaty— has become a major focus o f debate within Western Europe. The breadth o f this 1991 agreement has magnified issues o f national, poliucal, and economic sovereignty and generated widespread concern about the future o f a united Europe. This meaty is designed to push the envelope o f the integration process, moving the European Com munity toward increased economic and political integration by setting a schedule for the adoption o f com mon policies on foreign affairs and defense issues and common policies on social issues, such as working condi tions in labor markets. It also expands the powers o f the elected European Parliament over environmental, educa tional, and consumer issues. Most controversial among the provisions o f the agreement, however, is the ambi tious schedule for establishing mone tary union— a unified EC cenu al bank and a common Community curren cy— by 1999. Vigorous opposition to the Maastricht treaty from many quarters has made the future o f European integration uncertain— at least so far as monetary unification and a common currency are concerned. But such arguments tend to oversimplify the complexity o f the unification arrangements and interdependencies that have evolved within Europe during the last 40 years and ignore an important, but often missed factor in the European integra tion process— the Soviet bloc. As this Fed \jet Ur article will argue, the recent concern about EC viability is a mistake o f focus and perspective. The current difficulties grow out o f a few specific, albeit controversial, provisions o f one treaty'. Unquestionably, there are difficult choices to be made that will have important long-term conse quences for Europe, as well as the rest o f the world. But the members o f the EC, and the EC as an entity, have expe rienced an extensive political, social, and economic evolution during the past three decades. When placed in the broad context o f this historical development, today’s problems, as they relate to Maastricht, are more like wavelets in a pond during a summer storm than rough seas whipped up by a North Atlantic gale. Western Europe comes together The devastation from World War II in a Europe barely recovered from the trau ma o f World War I made it imperative that former opponents come together in a cooperative structure to facilitate the reconstruction process. In part, the need for cooperation among the West ern European states reflected the Allies’ desire to see Europe reconstituted in such a way that Germany would not dominate the region again. But, in addition, another threat arose almost immediately after the war’s end— the dominant influence o f the USSR in Central Europe. As the first step in this process o f coop eration, the Organization for European Economic Cooperation was established in 1948, now known as the Organiza tion for Economic Cooperation and Development(OECD), to implement the U.S. inspired Marshall Plan recon struction. In 1949. the North Atlantic Treatv Organization (NATO) was orga nized as a mutual defense pact among most o f the Western European nations and the United States and Canada. Then in 1951. Belgium, France. West Germany, Italy, Luxembourg, and the Netherlands signed a treaty' implement ing a plan, inspired by French Foreign Minister Robert Schuman, to pool the resources o f the French and German coal and steel industries to form a “common market” in those industries. This was a first tentative step in Eu rope’s experiment with economic integration— the European Coal and Steel Community. In 1957, the six members o f the Coal and Steel Com munity' broadened the common market concept in the Treaty o f Rome, which created the European Community. Not only did formation o f the EC result in a reduction in restrictions on trade between members, it began the process o f setting com m on trade restrictions a g a in st nonmembers. In other words, participat ing members gave up their sovereign rights to impose external tariffs— a key step forward in the process o f econom ic and poliucal integration. During the ensuing years the integra tion process continued. The adoption o f an agricultural policy that was com mon across borders rather than nation ally unique was a significant step toward integrauon o f the member economies. The participation o f the EC as a single entity representing its member states in the multinational GATT tariff negotia tions was another important step in the integration process. In 1973, members lied their currencies’ exchange rates together in a “joint float” against the dollar. And in 1973, Denmark, Ire land, and the United Kingdom joined the EC. In 1981, Greece joined. Then in 1987, Spain and Portugal became members, bringing the current mem bership to 12. In 1992, Austria, Fin land, Norway, and Sweden applied for membership and negotiations toward that end are progressing. In 1985, the Community laid out a major blueprint for future integration. The EC Commission issued a “white paper” setting forth goals aimed at shaping the F.C for the twenty-first century. Members ofthe EC envision: 1) economic integration o f their economies by making the EC a “single market,” from a commercial as well as a legal perspective; 2) the integration o f financial markets; 3) a common Euro pean citizenship; and 4) unified mone tary and fiscal policies, including the creation o f a common currency. Most o f these goals are scheduled to be met by the year 2000. Impressively, many o f the goals associated with the creation o f a single EC market and the integration o f commercial, financial, and cross-border markets were met with the implementation ofthe EC’s “Europe 1992” plan, which went into effect at the beginning o f this year. Losing a helpful prod Anodier economic and political force was also at play at the same time that Western Europe was moving toward economic and political integration. That force— the Soviet bloc— critically influenced the face o f Europe during the last four decades. Moreover, the degree o f that influence has been accentuated by virtue o f its recent demise. In 1949, under the auspices o f the USSR, the Committee on Mutual Eco nomic Cooperation (COMECON— an Eastern/Central European trading bloc) was established. This was fol lowed in 1955 by the formation ofthe Warsaw Pact— a mutual defense ar rangement for the Eastern/Central European Soviet bloc that paralleled the West’s NATO. Although COME CON was never a serious economic competitor with Western Europe, the political and military threat ofthe Warsaw Pact casi a long shadow over Western Europe. The drive toward integration in West ern Europe was fueled, importantly, by fear o f the political and military strength o f the Soviet bloc. The com mon threat o f the Soviet bloc served to unify the EC during the first 30 years o f its existence. By the same token, the recent disintegration o f that bloc has diffused the focus o f Western Europe in several ways. First, the common external threat now seems much reduced. Second, West Germany has played a major role in the process o f European integration, but with the unexpectedly difficult and expensive reunification o f West and East Germany, that role has been diluted as its attention has been divert ed inward. Third, some Europeans, already apprehensive about German dominance o f a unified Europe, are even more apprehensive o f a larger and potentially more powerful unified Germany. Finally, the historic issue o f national sovereignty in Central and Eastern Europe, suppressed dur ing the USSR’s domination o f that area, was rekindled with the dissolu tion o f the Soviet bloc. In a parallel development, important for the pro cess o f European integration, long dormant issues o f national sovereignty were also reopened for many Western Europeans in the absence ofthe Soviet threat. The rush to monetary union While the fragmentation o f Central and Eastern Europe has complicated the integration process, most o f the concern about the future o f European integration centers on older issues, most specifically monetary integration. Arguments alluding to the “falling apart o f EC integration” have focused heavily on whether the Maastricht goals that center on monetary integra tion will be reached on schedule. Ar guably this is one o f the most difficult components o f the integration process, even though Western Europe has been moving toward monetary integration since the introduction in 1973 ofthe European Monetary System. During the early years o f the EC, inter national currency markets operated under post-World War II Bretton Woods Agreement. The exchange value o f a counuy’s currency was “fixed” in terms o f the U.S. dollar. In August 1971, this fixed exchange rate system began to break down and by March 1973 the U.S. dollar link with gold was severed and the exchange rate value o f the dollar was set “afloat.” At that time the EC made a significant decision. Six o f its nine members formed the European Monetary' Sys tem (EMS)— a joint float against the dollar'— holding their currencies in a fixed relationship with each other while allowing their “bundle” to float against the dollar. Mere was the kernel o f a common monetary policy. Almost 20 years after the creadon o f the EMS, a significant component o f the Maastricht agreement look mone tary integradon a giant step farther. This provision contained an explicit time table for the creation o f a unified centr al bank and the adoption o f a common EC currency. Initially, attain ment o f these goals, even ahead ofthe 1999 scheduled date, seemed a real possibility. But iir mid-1992, the Dan ish electorate rejected the Maastricht agreement in a popular referendum. This resulted in the negouadon o f a much watered down version, as it ap plied to Denmark, which was accepted in May o f this year. In September 1992, the French electorate accepted Maastricht, but only by a slim margin. At this writing, the German govern ment faces a constitutional court chal lenge to its acceptance o f the Maas tricht accord (over the specific issue o f the abrogation o f German sovereignty if national functions, e.g., monetary poli cy, are allowed to be ruled by an out side body, i.e., the EC). The U.K. de ferred its final vote on Maastr icht until after Denmark’s second referendum vote. Although Maastricht appears likely to survive, it no longer possesses the life or the stature o f early 1992. Monetary union identifies for Europe ans, more dearly than any other issue to date, the implications o f suprana tional versus national power. It defines where the ultimate political and eco nomic power resides— “foreigners” making decisions that affect home prices, employment, output, and the like. National sovereignty issues have long been a major stumbling bloc that has thwarted European attempts at cooperation, to say nothing o f unity. In the absence o f the external pressures exerted by the Soviet bloc, the subjuga tion o f national policy to a supranation al authority has become an even more poignant issue for the EC. Even without a formal unified mone tary system Europeans are getting a taste o f what losing monetary autonomy means under the existingjoint float mechanism. Since the East/West unifi cation, Germany, with the dominant currency in the EC, has pursued a tight monetary policy in an attempt to hold in check inflationary pressures associat ed with the domestic monetary aspects o f its unification. In order for other European currencies to remain tied in a fixed exchange rate relationship to the German mark the other govern ments have been forced to run tight monetary policies. The result? Not only is the German economy in serious recession, virtually all o f Europe is in recession. In the attempt to break free from the restrictive German policy, the U.K. temporarily opted out o f tying its exchange rate to the mark last fall, as did Italy. Spain and Portugal have had multiple devaluations o f their curren cies since die fall o f 1992, and EC aspir ants Finland and Sweden broke the link with the mark. Not only is the German economy paying the price o f its unifi cation policies, but so is the rest o f Eu rope— the price o f a common mone tary' policy, explicit or' not. In recent years many Europeans have looked to the Federal Reserve System as a model for a European Central Bank. Interest has centered on the District orientation o f the Federal Reserve and an implicit question: Can individual countries (regions) maintain sufficient autonomy to conduct monetary policy within the framework o f a unified cen tral bank? (Again, the issue o f regional sovereignty.) In fact, regions can not follow monetary policies independent o f national policy'. In a unified mone tary system, be it the United States or a united Europe, a tight monetary policy nationally is a tight monetary policy regionally. There may be different economic consequences, depending upon the different structures o f the regional economies, but there is only one policy. Monetary integration implies relin quishing regional sovereignty. A weak housing market in the U.K., for exam ple, might benefit from lower interest rates initiated by a cenu al European monetary authority, but the monetary authority (possibly dominated by conti nental members) might view rising prices as a more serious threat for ihe Community overall, and consequently raise interest rates, a negative to the British housing industry. After centu ries o f building and defending their national identities, to lose this kind o f sovereignty is a hard pill to swallow' for many Europeans. In this regard, it is instructive to remember that the Unit ed States did not have a successful cen tral bank until 1914, nearly 140 years after becoming one nation, and that numerous currencies circulated in the U.S. during the late 1700s and through out most o f the 1800s. A look to the future To some, the possibility o f a unified Europe may seem to be a pipe dream. But over the last three decades the EC has made great strides in integrating the economies o f its members. Re duced barriers to trade, the elimination o f border controls, relaxed restrictions on capital movements, acceptance o f other member’s product and testing standards, are developments that, among others, are relatively east' to implement without individual coun tries having to give up large chunks o f autonomy. In short, much o f die real sector and financial market integration leading to a united Europe has been accomplished or is well on its way to ward being put in place. After centu ries o f trying, an extensive degree o f European integration is a reality. The recent hesitance to move rapidly onward in the advanced stages o f the integration process reflects the reality that the easy parts o f the iniegradon process are largely completed and that the external motivation to move forward— the Soviet bloc— has largely dissipated. The next major, and per haps the most difficult, stage in the process will require the giving up o f big chunks o f nadonal sovereignty by submitting national economies to an increasingly powerful supranational authority. In an environment now lacking the external prod o f the Soviet bloc and facing the sU'uctural changes taking place in Eastern and Central Europe and in Germany, the early rush to EC monetary union was faster than could reasonably be sustained. Progress toward that end will surely be more cautious during the next few years. That more cautious approach should not be cause for concern. —Jack I.. Hervey Karl A. Sc held. Senior Vice President and Director o f Research: David R. Allard ice. Vice President and Assistant Director o f Research; Janice Weiss, Editor. Chicago Fed Letter is published monthly by the Research Department o f the Federal Reserv e Bank o f Chicago. The views expressed are the authors’ and are not necessarily those o f the Federal Reserve Bank o f Chicago or the Federal Reserve System. Articles may be reprinted if the source is credited and the Research Department is provided with copies o f the reprints. Chicago Led letter is available without charge from the Public Information Center. Federal Reserve Bank o f Chicago, P.O. Box 834, Chicago. Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Manufacturing activity in the Midwest declined 0.7% in May, the first decline since September 1992. Nationally, manufacturing activity continued to expand, although durable goods manufacturing increased by only 0.1 % during die month. However, purchasing managers’ surveys— both in the Disuict and the nation— continue to indicate expanding activity. Sources o f weakness in the MMI were widely distributed among durable and non durable goods industries. Transportation equipment, fabricated metals, and food processing industries were the major contributors to the overall decline in May. The weakness in the transportation equipment industry follows a decline in auto assemblies in the second quarter o f this year. Recent production plans indicate that this trend should turn around in die third quarter. SOURCES: The Midwest Manufacturing Index (MMI) is a composite index o f 15 industries, based on monthly hours worked and kilowatt hours. IP represents the FRBB industrial pro duction index for the l .S. manufacturing sec tor. Autos and light trucks are measured in an nualized physical units, using seasonal adjust ments developed by the Federal Reserve Board. The PMA index for the U.S. is the production components from the NPMA survey and for the Midwest is a weighted average o f the produc tion components from the Chicago. Detroit, and Milwaukee PMA survey, with assistance from Bishop Associates and Comerica. ine-sss (r,u;) 1’S80U6909 smutlll oStiJup h;k x»a od joui.y) uopuiujoju | ojiqtij O 9V 0IH 3JO M N V H 3A tf 3S3tf IV>T3a33 \ p O J O .o to lip )
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