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Number 92-23, June 5, 1992

EMU and the ECB
The accord reached at Maastricht in southern
Holland last December moved the European
Community significantly closer to the creation of
a European Monetary Union (EMU) and a common European Central Bank (ECB). When the
EMU is established, exchange rates among participating countries will be permanently fixed,
resulting in essentially a single currency for Europe, and participating countries will surrender
control of monetary policy to a common European monetary authority.The movement towards
the establishment of a common currency and a
single European central bank represents one of
the most important developments in Western
Europe in the postwar era.
In this Weekly Letter, the proposed stages in the
process leading to monetary union are described,
the nature of the proposed common European
central bank is discussed, and some of the criticisms that have been made of the transition to
monetary union are evaluated.
1989: The Delors Report
The Delors Report in 1989 established the goal of
a European Monetary Union that would include
complete convertibility of all member currencies,
full liberalization and integration of capital markets, and the permanent fixing of exchange rate
parities. In order to maintain the credibility of
permanently fixed exchange rates, the Report
also envisioned a Europe in which the authority
for the conduct of monetary policy resided not
in the central banks of the individual member
countries, but in a common European central
bank. Without a single monetary policy, member
countries could have different inflation rates. The
combination of fixed nominal exchange rates
and different inflation rates would lead to real
exchange rate movements that would diminish
the relative competitiveness of the countries with
higher than average inflation. Such a situation
would eventually force a realignment of exchange
rates, so the claim that exchange rates would be
permanently fixed would not be credible.

The transition from a system of separate currencies and central banks to a single currency
economy was to proceed in gradual stages.
While realignments of exchange rates would be
allowed during the transition, the maintenance of
fixed exchange rates became an important political symbol of each nation's commitment to the
whole process leading to EMU. Only in the final
stage, however, would exchange rates among the
member countries become "irrevocably locked:'
In that stage, monetary policy authority would be
transferred from the national central banks to the
ECB, and member countries would be subject to
constraints on the conduct of fiscal policy, such
as binding limits on budget deficits in the individual countries.
This transition process has been criticized for its
emphasis on fixing exchange rates even though
policy convergence would not be achieved until
the final stages of monetary union. Maintenance
of fixed exchange rates in the absence of inflation convergence may require that capital controls be reintroduced. In that case, interest rates
could continue to incorporate a risk premium to
compensate for the eventuality of controls. As a
result, interest rates could differ across countries,
leading to economic inefficiencies (Giovannini
1990; Fratianni, von Hagen/and Waller 1992).
1991: The Maastricht Accord
The agreement reached at Maastricht in December 1991 accepted the Delors Committee's strategy of a gradual approach to monetary union,
but altered the stages by which EMU is to be
achieved. Most importantly, capital and exchange
controls were no longer viewed as acceptable
tools of national policy. In order to prevent the
potential instability that would arise with fixed
exchange rates and no capital controls, the
Maastricht agreement calls for early convergence
by the individual countries in achieving price
stability and fiscal balance, specifically by January 1, 1994. Unlike the strategy outlined in the
Delors Report, therefore, the Maastricht Accord

envisions the achievement of financial and economic integration, including the permanent
elimination of capital controls, before monetary
union is established, with greater convergence
required to ensure exchange rate stability during
the process.
To facilitate the necessary policy coordination,
the Maastricht Accord establishes a new European Monetary Institute designed to coordinate
national monetary policies and prepare the way
for the ECB. Finally, the Accord sets a timetable
for monetary union and establishes four requirements for countries to enter the union. First, a
country's inflation rate must be no more than 1.5
percentage poi nts above the average rate of the
three EC countries with the lowest rates of inflation. Second, its long-term government bond
interest rate must not exceed by more than 2
percentage points the rates of the three lowest
inflation countries. Third, the total government
deficit must be 3 percent or less of GOP. Fourth,
outstanding government debt must be no more
than 60 percent of GOP. These preconditions for
entry require inflation convergence, capital market integration, and fiscal budgetary control.
The Maastricht Accord calls for final monetary
union no later than January 1, 1999 and as early
as the end of 1996 if seven EC members (that is,
a majority) have met the entry conditions. Currently, only Germany, France, Denmark, and
Luxembourg qualify, and the only other country
that seems likely to qualify by 1996 is the Netherlands. Consequently, monetary union probably
will be delayed until 1999 and, even then, will
include only a minority of EC countries.

process of economic and financial integration,
at which point policy coordination could be
enforced, followed by the complete fixing of
exchange rates. In this scenario, the gains of
economic integration could be realized even if
individual countries were still following inconsistent inflation policies. Exchange rates would
be allowed to adjust to reflect differing inflation
rates or regional economic disturbances.
As an example of the costs of making fixed parities a symbol of commitment to the process of
eventual monetary union, EC countries were
forced to raise interest rates in line with the rise
in German interest rates that occurred at the time
of German unification, leading to a widespread
slowdown in economic activity. The alternative
of allowing the OM to appreciate relative to
other European currencies would have helped
to cushion the impact of German unification on
the economies of the other European countries.
Some economists have argued that a more satisfactory way to gain credibility for a low inflation
policy, while not losing the ability to adjust exchange rates if necessary during the transition to
EMU, would be to increase the independence
from political control of the individual national
central banks (Fratianni, von Hagen, and Waller

The Accord continues the strategy of the Delors
Report in using exchange rate policy as a signal
of commitment to the EMU and to policies of
price stability. In fact, the current exchange rate
system in the EC has been described as " .
arrangement for France and Italy to purchase
a commitment to low inflation by accepting
German monetary policy" (Giavazzi and
Giovannini, 1989, p. 85).

This argument is based on the observation that
countries with legally independent central banks
tend, on average, to experience lower inflation
(see Weekly Letter Dec. 13, 1991). Independent
central banks are believed to be less likely to
sacrifice long-term price stability than are elected
governments who might try to use monetary policy to achieve short-term economic expansions
for political reasons. While a government's decision to realign its exchange rate might call into
question its commitment to low inflation and
eventual monetary union, such a realignment
made while monetary policy is conducted by an
independent central bank would be less likely
to raise doubts about the commitment to low

According to one view, however, this strategy is
both unnecessary and costly. An alternative approach to monetary union could allow exchange
rates to remain flexible while completing the

The Maastricht Accord calls on EC countries to
modify their centra! banking legislation to ensure
their own central banks have a degree of independence consistent with that proposed for the

ECB. This requirement need only be met, however, by the time complete monetary union
actually begins.

ernments or from EC institutions. Members of the
ECB's Board will be appointed for eight-year nonrenewable terms in order to ensure their political

The ECB: Another Bundesbank?
Membership in the EMU requires participating
countries to surrender control over monetary
policy. Once monetary union is established, with
exchange rates of the participating countries permanently locked, monetary policy authority will
be vested in the new ECB; countries in the EMU
will no longer be free to set their own monetary
policies. The explicit policy objective of the ECB
is to be price stability, so it is not surprising that
the ECB is being closely modeled on the European
central bank that has been most successful in
achieving low inflation, Germany's Bundesbank.
Like the Bundesbank, the ECB will have an
Executive Board (appointed by the European
Council in consultation with the ECB Council
and the European Parliament) that will carry out
the policy guidelines established by a central
bank Council in which regional interests are represented. The ECB Council will consist of the six
members of the ECB Executive Board plus the
central bank Governors from those countries that
have met the requirements for entry into the EMU.
Fratianni, von Hagen and Waller (1992) argue
that the Governors from the national central
banks will be stronger supporters of price stability than the members of the Executive Board
who will represent EC-wide political interests.
This is similar to the argument that regional Federal Reserve Bank presidents are more disposed
towards low inflation policy than are members of
the Board of Governors. Tootell (1991), however,
finds no discernable difference in voting behavior
by Federal Reserve Bank Presidents and the Board
of Governors, suggesting that the inclusion of regional representation on the ECB Council may
make little difference.
To maintain the ECB's independence, its statute
says that neither the ECB nor the national central
banks are to take instructions from member gov-

Political and legal independence of the ECB is
unlikely to shield its decisions from political
controversy. If individual countries evaluate the
short-run tradeoff between unemployment and
inflation differentiy, there will be conflict over the
policy theECB should follow in the face of economic disturbances that have differential impacts
on the nations in the union. The unification of
Germany provides a vivid example in which the
"independent" Bundesbank was forced to accede
to decisions reached by the government that had
monetary implications. Such developments are
likely to test the true independence of the future
ECB and its ability to sustain price stability as the
sole objective of monetary policy.

Carl W. Walsh
Professor of Economics
Univ. of California, Santa Cruz
Visiting Scholar
Federal Reserve Bank of
San Francisco

Fratianni, Michele, Jurgen von Hagen and Christopher
Waller, "The Maastricht Way to EMU:' mimeo,
March 1992.
Giavazzi, F. and A. Giovannini, Limiting Exchange
Rate Flexibility: The European Monetary System,
Cambridge, Mass., MIT Press, 1989.
Ciovannini, Alberto, The Transition to European Monetary Union, Essays in International Finance No.
178, Nov. 1990, Princeton University.
Tootell, Geoffrey M.B., "Are District Presidents More
Conservative Than the Board Governors?", New
England Economic Review, Federal Reserve Bank
of Boston, Sept/Oct. 1991, 3-12.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
Printed on recycled paper .~ .:).
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Index to Recent Issues of FRBSF Weekly Letter





Taxpayer Risk in Mortgage Policy
The Problem of Weak Credit Markets
Risk-Based Capital Standards and Bank Portfol ios
Investment Decisions in a Water Market
Red ,Ink
Presidential Popularity, Presidential Policies
Progress in Retail Payments
Services: A Future of Low Productivity Growth?
District Agricultural Outlook
The Product Life Cycle and the Electronic Components Industry
japan's Recessions
Will the Real "Real GDP" Please Stand Up?
Foreign Direct Investment: Gift Horse or Trojan Horse?
U.s. International Trade and Competitiveness
Utah Bucks the Recession
Monetary Announcements: The Bank of japan and the Fed
Causes and Effects of Consumer Sentiment
California Banks' Problems Continue
Is a Bad Bank Always Bad?
An Unprecedented Slowdown?
Agricultural Production's Share of the Western Economy
Can Paradise Be Affordable?
The Silicon Valley Economy

Marti n/Pozdena
Schm idt/Cannon

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.