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RESEARCH
PA PE R
EURO PE AND THE MAASTRICHT CHALLENGE
by Michel Aglietta and Merih Uctum
Federal Reserve Bank of New York
Research Paper #9616
~EMN. t~
~ , . FED ERA L RESERVE
~ i BANK OF NEW YORK
~1fD~ ~
EUROPE AND THE MAASTRICHT CHALLE NGE
by
Michel Aglietta* and Merih Uctum**
Revised June 1996
* Universite de Paris X and CEPII
**Federal Reserve Bank of New York
We would like to thank two anonymous referees whose comments considerably improved the
paper. erhe views expressed in this paper are ours and do not necessarily represent those of the
Federal Reserve Bank of New York or the Federal Reserve System.
Abstract
The uncertainty caused by the exchange rate crises of 1992-1993 led to two questions: Is
monetary union still feasible? What strategies are best for achieving convergence according to the
Maastricht criteria? This article addresses these questions by examining the progress made by the
five major European Union countries in satisfying the Maastricht criteria and the two crucial
impediments facing these countries --disparities in real exchange rate convergence and fiscal
imbalances-- and alternative strategies to deal with these impediments.
Overall, our analysis suggests that the prospects for monetary union are less gloomy than
many analysts believe. We show that wide bands have been useful in limiting competitive
disparities. We also argue for more general fiscal criteria set forth in the Maastricht treaty.
Under these more general criteria, countries that reversed the path of debt accumulation and
achieved a sustainable deficit would be admitted to the monetary union. Finally, under a multispeed transition a small group of countries will form the initial core of the monetary union, and
other countries will join over time.
Key words: European monetary union, Maastricht criteria, real convergence and fiscal imbalances.
2
When the European monetary system (EMS) was founded in 1979, one of its general
goals was the promotion of monetary stability among its members. The Delors report in 1989
made this goal more explicit by establishing a blueprint for the creation of a European monetary
union (EMU) with a common currency. Three years later, the Maastricht Treaty set specific
criteria that members were required to meet in order to achieve a monetary union by the end of
the century. Progress toward monetary union was soon interrupted, however, by the exchange
rate crises of 1992-93. The ensuing uncertainty has raised two questions: Is monetary union still
feasible? What strategies are best for achieving convergence according to the Maastricht criteria?
To address these questions, this article examines the progress made by the five major
European Union countries in satisfying the Maastricht criteria. We then examine two crucial
impediments facing these countries --disparities in real exchange rate convergence and fiscal
imbalances-- and alternative strategies to deal with these impediments.
MEETING THE MAASTRICHT CRITERIA: WHERE DO THE EUROPEAN UNION
COUNTRIES STAND?
The Maastricht Treaty, signed on February 7, 1992, establishes four economic
convergence criteria that must be satisfied before the scheduled completion of EMU in 1999.
These criteria, detailed in the exposition of Article 104c of the treaty, are as follows: (I) the
inflation rate, measured by the consumer price index, cannot exceed by more than 1.5 percent that
of the three economies with the lowest inflation rates; (2) long-term interest rates may not exceed
by more than 2 percent the average comparable interest rates in the three countries with the
3
lowest inflation rates; (3) the general government budget deficit cannot exceed 3 percent of GDP,
and the gross government debt must be less than 60 percent of GDP; and (4) currencies must
remain within normal fluctuation margins without realignments for two years before monetary
union.
The four convergence criteria set forth in the treaty have presented different degrees of
difficulty for the countries seeking monetary union. Chart 1 displays the time paths of the
inflation rates, interest rates, debt, and deficits of the five largest countries --Germany, France,
Italy, the United Kingdom, and Spain-- from 1979, the year the EMS was founded, through 1995.
Clearly, most countries have made substantial progress in satisfying the inflation and
interest rate criteria since the early 1980s. Despite recent depreciation in the Italian lira and
Spanish peseta, the inflation criterion is close to being met, even.in traditionally high-inflation
economies (Chart I, Panel A). By 1993, most countries were in compliance with the interest rate
criterion, although over the last year, Italy and Spain have strayed somewhat from the specified
standard (Panel B ). The evidence in Chart I also suggests that the European Union countries are
willing and able to take the necessary policy steps to meet these criteria. While some analysts
have argued that the progress toward satisfying the interest rate criterion is an accidental outcome
of Europe's recent recession, panels A and B make it clear that the dramatic decline in interest
rates and inflation had begun as early as the mid-1980s, when the European Union nations
adopteu disinflationary policies.
By contrast, fiscal criteria depict a more troubling picture. After 1990, both the debt and
the deficit ratios worsened for almost all countries (Panels C and D). This development is
explored in detail in the second half of this article. First, however, we look at the problems that
4
arose with the fourth Maastricht criterion, the requirement that the exchange rates remain within
"normal" fluctuation limits.
EXCHANGE RA TES AND COMPETITIVENESS
Until 1992, the "normal" fluctuation bands cited in the Maastricht Treaty were interpreted
as narrow bands (±2.25 percent around the central parity). Member countries sought to stabilize
their exchange rates within these narrow bands in order to reach nominal convergence. However,
nominal exchange rate stability triggered short-term capital flows into high interest rate countries,
and monetary authorities were not able to restrain prices (Giavazzi and Spaventa 1990).
Distortions of competitiveness ensued, reflected in the real appreciation of the exchange rate in
Italy, Spain, and the United Kingdom. Competitiveness problems culminated in the 1992-93
exchange rate crises: the currencies of these three countries and others came under heavy attack
by investors and speculators and were subsequently devalued sharply.
What was learned from the events of 1992-93? First, it became apparent that equating
normal bands with narrow bands had precipitated many of the problems that led to the exchange
rate crisis. Taking corrective action, the European countries widened the bands to ±15 percent
for an indefinite period. Italy and England chose to withdraw from the Exchange Rate
Mechanism (ERM) altogether and allowed their currencies to float. Second, France's efforts to
peg its currency to the German mark and stick to the long-term goal of realizing monetary union
enabled it to weather the crisis better than other countries. We consider these points in more
detail below.
5
Wide bands in the transition to monetary union
Although the fluctuation bands were temporarily widened to ±15 percent in the aftermath
of the 1992-93 exchange rate crisis, the European countries have never formally adopted the wide
bands as the normal fluctuation margins stipulated in the Maastricht Treaty. However, because of
the many advantages they offer over narrow bands, wide bands will be the exchange rate regime
most likely to prevail until the first group of countries form the monetary union in January 1999.
When wide bands were first introduced in 1993, they were met with scepticism and were
associated with the collapse of the EMU. Since then, the markets have come to accept wide
bands because a strong argument can be made in their favor. One indicator of the effectiveness of
a particular regime is its performance in limiting the volatility of exchange rates. A comparison of
post- and pre-crisis periods shows that under the wide-margin regime, the stability of real
exchange rates has improved remarkably, despite an inci;ease in volatility of nominal exchange
rates (Table I). Wide bands have also alleviated the disparities in competitiveness that arose after
1993. As we have seen, the currencies ofltaly, Spain, and the United Kingdom were devalued
following the crisis. By contrast, France and Germany have seen their currencies appreciate since
1993 (Chart 2, panel 2c). These differences in real exchange rates gave countries with
depreciating currencies a clear competitive advantage. Adoption of wide bands has helped to
contain these differences by reducing volatility and limiting the depreciation of currencies.
The wide-band regime is a transitory arrangement, and it has proven to be a successful
transition tool to EMU. The flexibility of this regime allows economies of different convergence
rates to coexist, and to absorb nonfundamental and temporary shocks without affecting each
other's convergence process. Chart 3 shows that since 1992 the European currencies can be
6
divided into two distinct groups. One group consists of core countries of the ERM such as
France, Belgium, Denmark, the Netherlands. The other group includes weaker currencies that
either were in the wide bands (Portugal, Spain) or floating (Italy and the United Kingdom).
Despite the 1992-93 foreign exchange crises, the core countries were successful in maintaining
stable and moderately volatile bilateral rates with the Deutsche mark. Helped by intra-marginal
interventions, the regime has worked as a de facto soft margin narrow band within the larger
official bands, and enabled the core countries to impose a two-way risk to speculators.
In contrast, weaker currencies experienced higher volatility and systematic depreciation
against the Deutsche mark. Although the wide-band currencies on average depreciated less and
had lower volatility than the floating currencies, they still need relative price flexibility to adjust to
real shocks because their convergence process is not yet complete.
Thus, the need for relative price flexibility justifies maintaining wide bands for weaker
currencies during their transition to the monetary union. Since the wide-band regime turned out
to be a good compromise, most observers agree that all countries that are candidates for monetary
union would benefit from entering the ERM with wide margins, which alleviate market disorders
and convert the progress in real convergence into higher exchange rate stability (Bayoumi and
Thomas 1994).
Strength of the Franco-German Link.
The second lesson that emerged from the 1992-93 exchange rate crisis is the value of the
French-German exchange rate link. Many think that this link is likely to be the prerequisite for the
achievement of the EMU. Panel 2a in Chart 3 shows that the nominal French franc-German mark
7
exchange rate has remained remarkably stable since September 1987. The decline in consumer
price inflation (Chart I, Panel I a) reveals that exchange rate stability in France has been based on
competitive disinflation. France conducted a consistent monetary policy by pegging to the
German mark and sticking to the long-term goal of realizing the monetary union (Blanchard and
Muet 1993). At the same time, the interest differential with Germany, and therefore the risk
premium associated with the French franc, has been declining (Chart I, Panel lb), suggesting that
the French policy has been slowly validated by financial markets despite the 1992-93 exchange
rate crisis. The robustness of the Franco-German link in nominal exchange rate extends to the
real exchange rate depicted in Panel lb of Chart 3. Its modest variation since 1987 stands in
contrast with the huge real fluctuations of the other currencies against the German mark,
reflecting the integration of both economies.
FISCAL CONSOLIDATION IN PUBLIC FINANCE
Since differences in real exchange rates and competitiveness are eased by the continued
use of wide margins, the fiscal criteria cited in the Maastricht Treaty are now the main impediment
to monetary union. One drawback of these criteria is that they are rigidly fixed and do not take
into account cyclical factors that may adversely affect public finances and government
indebtedness during a recession. A better measure of fiscal stands would incorporate the growth
potential of the economies. In this section we discuss some alternatives to the current debt and
deficit criteria that are flexible but still provide sound fiscal discipline. Interestingly, while these
alternatives depart from the specific numerical standards set forth in the Maastricht Treaty's
exposition of Article 104c, they are consistent with the more general language found in other
8
parts of the document.
For public debts, countries might benefit from adopting the standard articulated in broad
terms in the treaty's Article 104c. This standard holds that a country's debt-to-GDP ratio must be
"sufficiently diminishing and approaching the reference level at a satisfactory pace" before the
country can qualify for membership in the monetary union. Thus, a country that has been
successful in reversing the path of debt accumulation would satisfy the debt criterion.
A shift to this more general criterion would expand monetary union eligibility. The top
panel of Table 2 presents annual growth in government debt ratios averaged over five-year
periods. The last two columns display the OECD estimates and forecasts of debt ratios for the
years 1995 and 2000 based on the assumption of fiscal restraint by governments. According to
the 60 percent rule, Italy and Spain would still not qualify for membership in the year 2000 despite
fiscal restraint (column 5). However, if the standard of declining debt is applied, Italy might join
1
the countries satisfying the debt criterion in the year 2000 (column 3). Spain's situation,
however, is unclear. Although the rate of increase in government debt is substantially slower, it
does not reverse its positive path.
For public deficits, a criterion based on the sustainability of fiscal policy could be used in
conjunction with the numerical criterion. A sustainable policy can be defined simply as a policy
leading to a stable debt-to-GDP ratio. To see the relation between the debt-GDP ratio, the GDP
growth rate, and inflation, consider the following nominal government budget constraint:
(1)
The negative number for Italy in the subperiod 1995-2000 is obtained from a decline in the debt ratio for three
consecutive years.
1
9
where G and T are government spending and taxes, i is the yield on government debt, B is the
stock of outstanding debt at time t, and .1.B represents the change in debt to finance the deficit.
Since it is more convenient to write the government budget constraint as a proportion to GDP,
we can divide both sides of equation (I) by nominal GDP and obtain the following expression:
(2)
where small-cap letters represent the same variables as before as a proportion of GDP. The only
difference now is that the yield on government debt is adjusted for inflation and growth. Equation
(2) can also be expressed in terms of the total financial deficit-GDP ratio, cl,, which is equal to
the sum of the primary deficit (gc-i;J and interest payments i,b,. 1:
2
(3)
If government stops accumulating debt, it satisfies the sustainability criterion in the long
run, and the budget constraint becomes:
(4)
Equation (4) says that a country would satisfy this criterion if its deficit-GDP ratio equaled
the rate of growth of nominal GDP multiplied by the debt-to-GDP ratio. 3 In other words, a
country could roll over its debt without paying it back as long as the deficit is consistent with the
'If the deficit is partially financed by money creation then dis interpreted as the deficit adjusted for money creation
and seignorage revenues that arise from it.
'See Blanchard et al. 1990, Aglietta and Uctum 1995, Uctum and Wickens 1996 for a dynamic analysis of
sustainable fiscal policy in European countries.
10
long-run growth potential of the economy.
However, despite being sustainable, the policy of setting the deficit-GDP ratio at a rate
that keeps the debt-GDP ratio constant is not compatible with the declining debt criterion
required by the Maastricht Treaty. Thus, a fiscal rule that would be consistent with the joint
requirement of declining debt and a sustainable deficit is that the deficit-GDP ratio should be
below the debt-GDP ratio adjusted for nominal GDP growth:
(5)
The condition expressed in (5) would not only satisfy the sustainability criterion but also the
declining debt requirement. The debt-reducing sustainable deficit criterion operates much like
wide bands in providing the economy the flexibility it needs during crises. It gives room to
maneuver to the economy, while a 3 percent rule chokes off the recovery, as has recently
happened in most European countries. It provides an upper and a lower bound to the deficit
depending on where the economy is in the cycle. If economic activity is slowing, the government
can use the upper bound and let the deficit be equal to the growth-adjusted debt-GDP ratio (debt
stabilizing policy). When the recovery takes off, the government can bring the deficit below the
debt-GDP ratio and satisfy the lower bound (debt reducing policy).
The new deficit criterion is intuitive yet rigorous. It puts an upper limit on the government
deficit consistent with the economic cycle. This requirement, in tum, ensures that the government
will not crowd out private investment by absorbing private savings. If investment and saving are
roughly equal, the government deficit does not put upward pressure on interest rates.
11
The new deficit/debt requirement would fulfill the spirit, if not the letter, of the Maastricht
Treaty. In Article 109j, the treaty requires "achieving a sustainable financial position" while
effecting convergence in long rates. In Article 104c, paragraph 3, the treaty specifies that should
a country not fulfill the numerical criterion, "other relevant factors" will be taken into account
(including the country's medium-term economic and budgetary position) in evaluating the
sustainability of a country's financial status. In addition, since the sustainability rule excludes
seignorage revenues (or inflation tax), it does not allow monetization of the debt and is, therefore,
consistent with the inflation criterion of the treaty.
Thus, the concept of the sustainable deficit In conjunction with a declining debt ratio is not
less strict than the 60 percent rule but consistent with a growth path that leads to an equilibrium
of saving and investment at a given interest rate. It is also compatible with the German position
that (i) countries' fiscal policy should have no negative effect on interest rates, and that (ii) the
credibility of the future European Central Bank should not be affected by governments' solvency
problems.
The new rule requires the deficit and the debt ratios to be related by a proportion equal to
or less than the growth rate of nominal output. The lower panel in Table 2 compares the deficit
performances of the five countries in 1995 and 2000, using both the 3 percent rule and the new
rule. The calculations for 2000 are based on OECD forecasts of inflation, growth, debt-to-GDP
ratios,
ai1d
deficit-to-GDP ratios, under the assumption that these countries conduct policies in
line with the convergence criteria.
In 1995, the sustainable deficit is about 3 percent for Germany and the United Kingdom,
above 4 percent for Italy and Spain, and less than 3 percent for France (column 2). The diversity
12
in these numbers is explained by cross-country differences between nominal GDP growth rates,
the debt-GDP ratios and the underlying primary balances. For example, Italy's substantial
sustainable deficit-GDP ratio is due to its high debt-GDP ratio (126 percent) which is supported
4
by an equally high nominal GDP growth (7 percent).
All countries except Germany violate the 3 percent rule (column 1). However, Italy joins
Germany in satisfying the sustainable deficit rule. Moreover, since both countries' total deficitGDP ratios are below their respective sustainable deficit-GDP ratios, their debt-GDP ratios are
declining, thus fulfilling the debt criterion as well. The other countries' total deficit-GDP ratios
are above the sustainable levels, suggesting that they must impose fiscal discipline on government
finances for the next five years if they are to qualify for membership in EMU.
Assuming that all countries follow tight policies, under the 3 percent rule Italy will still not
be entitled to membership for the monetary union by 2000 (column 3). Under the new criterion,
however, all five countries qualify to enter the monetary union this year, including Italy. All
deficit-GDP ratios in the year 2000 are expected to be less than the sustainable deficit-GDP ratios
(column 4), which means that the debt-GDP ratios are declining as well.
The two alternative fiscal criteria analyzed above allow candidate countries a more
realistic fiscal discipline without penalizing those with an initial high indebtedness and/or those
adversely affected by cyclical conditions.
'Italy has been running primary surpluses throughout the 1990s and is expected to continue doing so to the year
2000. These surpluses will lead to a cumulated 12 percent decline in the debt-GDP ratio between 1995 and 2000.
13
CONCLUSION
We have argued that wide bands have been useful in limiting competitive disparities. They
are likely to reduce fluctuations in the floating currencies and prevent the stable currencies from
being hurt by competitive devaluation of the floating currencies. Most policymakers believe that
the wide bands will prevail throughout the transition. Officially adopting the wide bands as
normal and reintegrating floating currencies into the ERM would benefit the system overall. For
this reason, both the European Monetary Institute Council and the European Union Council have
advised maintaining the wide bands.
We have also argued that the more general.fiscal criteria set forth in Article 104c of the
Maastricht Treaty should be used in conjunction with the numerical criteria outlined elsewhere in
the document. Under these more general criteria, countries that reversed the path of debt
accumulation and achieved a sustainable deficit would be admitted to the monetary union.
Clearly, such a change would allow more countries to qualify for acceptance.
A third strategy for achieving monetary union, a multispeed transition, has now been
widely accepted. Under a multispeed transition, a small group of countries will form the initial
core of the monetary union, and other countries will join over time. We have seen that France has
succeeded in keeping its cmTency closely linked to the German model. Based on the exchange
rate criterion, France is likely to be among the countries in the core group.
Overall, our analysis suggests that the prospects for monetary union are less gloomy than
many analysts believe. Although policymakers in most countries must continue their efforts to
strengthen convergence, the formal acceptance of wide exchange rate bands, more general fiscal
criteria, and a multispeed transition could ease the achievement of monetary integration.
14
REFERENCES
Aglietta, M. and M. Uctum (1995) "Fiscal consolidation", forthcoming Economie Internationale.
Bayoumi, T. and A. Thomas (1994) "Relative prices and economic adjustment in the U.S. and the
E.U.: a real story about EMU", IMF Working Paper, No. 94/65.
Blackbum, K. and M. Ravn (1992) "Business cycles in the U.K.: facts and fictions, Economica,
vol.59, pp. 338-401.
Blanchard 0., J.C. Chouraqui, R.P. Hagemann, N. Sartor (1990), "The sustainability of fiscal
policy: new answers to an old question", OECD Economic Studies, No. IS, pp. 7-36.
Blanchard, 0. and P.A. Muet (1993) "Competitiveness through disinflation: an assessment of the
French macroeconomic strategy", Economic Policy, April, pp.12-56.
Connoly, B. and J. Kroger (1993) "Economic convergence in the European economy and the role
of economic policies", Recherches Economiques de Louvain, vol. 59, pp.37-63.
Giavazzi, F. and L. Spaventa (1990) "The new EMS", CEPR Discussion Paper, No. 369.
Uctum, M. and M.R. Wickens (1996), "Debt and deficit ceilings and sustainability of fiscal poliy:
an intertemporal framework", FRBNYWorking Paper.
Table 1: Volatility of Exchange Rates against OM
(Period Standard Deviation)
Feb. 73Dec. 79
Jan. 80Mar.83
Apr. 83Sep.87
Oct. 87June 92
July 92Aug. 93
Sep. 93May95
France
10.2
8.6
4.9
0.8
1.3
1.6
Italy
17.9
8.8
9.2
2.0
14.2
11.8
U.K.
16.4
6.5
13.7
5.7
8.2
5.1
Spain
17.3
11.2
13.3
4.6
12.5
6.6
France
5.1
3.5
2.5
0.9
1.3
0.8
Italy
5.9
3.1
2.0
2.8
6.6
2.0
U.K.
6.8
6.7
7.5
4.2
6.0
2.1
Spain
9.1
4.3
4.6
6.1
6.1
0.7
Nominal
Rates
Real
Rates
* Real rates end in Jan.95.
Source: Bank of International Settlements, and authors' calculations.
Table 2: Fiscal Criteria
Government Debt-GDP Ratio
Level
Growth Rate
(Percentage change over previous year, period
average)
1980-1990
1991-1994
1995-2000
1995
2000
Germany
3.2
3.9
2.3
62.5
56.9
France
2.3
8.7
1.7
59.5
53.5
Italy
4.6
5.7
-2.0
122.1
111.1
U.K.
-4.1
14.2
-0.8
53.4
47.4
Spain
10.3
9.3
1.8
66.5
70.1
Actual/Forecasted Deficit Ratio and Sustainable Deficit Ratio
Deficit in 1995
Sustainable deficit
in 1995
Deficit in 2000
Sustainable deficit
in 2000
Germany
2.3
3.0
1.9
3.1
France
5.0
2.4
1.6
2.7
Italy
7.8
8.8
3.5
8.3
U.K.
4.2
2.8
0.1
2.7
Spain
6.2
4.7
2.9
4.9
Source: OECD Economic Outlook, 56, December 1994, 58, December 1995, and authors' calculations.
·
ria
Chart 1: Maastricht Convergence Crite1b)
Long Term Interest Rates**
1a) Consumer Price Inflation*
Percentage Change
25,..---------------
Percentage Change
20
1s~··-•·-·•
-·--·····--.'. .-..
France
10
France
20
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20
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1980
1983
1986
1989
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5
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percent
* Shaded band represents average of three Maastricht members with lowest inflation rates, plus 1.5
plus 2.0 percent
rates,
inflation
** Shaded band represents average interest rate of three Maastricht members with lowest
1d) Government Deficit****
1c) Government Debt** *
140r ----= ----- ----- ----- ----- ,
Percentage of GDP
120
P~e~rc ~e~n~t a~g~e~ o~f~G~ D~P---- --------- --~
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100
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60
40
20
1980
1983
1986
1989
1992
1995
1980
1983
1986
1989
1992
represents 60 percent Maastricht debt limt
***Prior to 1990, standard national account definition, 1990-1994 figures use Maastricht definition. Shaded area
****Shaded area represents the 3 percent Maastricht deficit limit.
1995
Chart 2: Exchange Rates
2a) Nominal exchange rates against DM
300
---
2b)
rates
against
,.,,..,
~Real
- -exchange
-----~
- - -DM- - - - - - - - ,
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91
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* Exchange rates deflated by CPI of EC countries (weighted by the same GDP shares)
"
_______
"
"
I
93
"
_.
Chart 3: Volatility and Depreciation of
Nominal Exchange Rates against DM
July 1992 - May 1996
(percentage change over previous month, period average)
Volatility
3.5 ~ - - - - , . - - - - - - - - - - - - - - - - ,
3 UK
•
2.5 -
2
-
•
•
Spain
Ireland
1.5 >-
•
Portugal
f•
1Denmark
1
~
'
Belgium
0.5
l
~
•
0
-0.2
France
I
Netherlands
i
'
'
'
0
0.2
0.4
0.6
Rate of Depreciation
0.8
@FedFRASER