One for all . . . or maybe not


Patrick Honohanreviews The Belknap Press of Harvard University Press, 592pp, £25, By Harold James, The Belknap Press of Harvard University Press, 592pp, £25

The “old and profound liberal insight” that increased commerce reduces tensions and removes the causes of war goes back to the 18th-century French thinker Montesquieu. Yet, by 1997, Martin Feldstein, a grandee on the Republican side of US economic policy, predicted that the soon-to-be-launched European monetary union, seen by others as a further step towards the growth of commerce within Europe, would bring “civil war as states fought about secession from an economically costly union”.

That is only the most extreme of the contradictions that have characterised the debate about monetary co-operation in Europe over the past half-century. This has been not simply a debate between creditor and debtor countries, between the profligate and the thrifty, nor a divide along left-right lines within countries, but a reflection of a genuine lack of certainty about the long-term consequences of institutional design choices in this far-reaching, albeit somewhat arcane field.

Harold James, an undisputed authority in the history of international financial diplomacy, throws unique new light on this debate, based on his full access to the archives of the Committee of EEC Central Bank Governors over three decades.

Commissioned before the crisis, this is the official prehistory of the euro. The euro was fashioned as a solution to several related problems with currency and exchange rates that had bedevilled economic co-operation in Europe. Thanks to this lucid, well-organised exposition of the historical record we can now understand more fully the lines of argument and the modes of thought of the officials and political leaders that created, by the late 1980s, an intellectual consensus in favour of the single currency that had not existed 25 years earlier. We can also see the origin of the overoptimism that meant some long-standing problems were not addressed in the early years of the euro but allowed to fester subcutaneously, only to erupt lethally when the global financial crisis hit. This applies, of course, in an extreme way to Ireland but also refers to divergent economic and policy developments in different parts of the euro area more widely.

The salience and value of this book are much greater now than could have been foreseen just a few years ago, with political scientists and economists reassessing the euro project and seeking to pinpoint what has gone wrong and what is needed for the euro 2.0 project to get back on track.

To be sure, the single currency has always had its critics. Many of these have been economists who, “irritated by the intellectual imperfections and flaws that often accompany the compromises implied by any big project”, have acted, in James’s view, as Cassandras. In contrast, he finds political scientists to be “more easygoing characters and tend to the Panglossian”. But the “flaws have a tendency to be exposed at precisely the least propitious moment”. Even within the German policy hierarchy, and even within the Bundesbank, there has often been division and ambiguity on monetary and exchange-rate matters. In 1971, for example, as the postwar dollar-based international system was falling apart, the Bundesbank vice-president Otmar Emminger sided with the Bonn government’s decision to float the Deutschmark, in opposition to his own boss’s wish to stick with a dollar peg.

Bundesbank’s secret opt-out

Fix or float? That question often lay at the heart of the central bankers’ exchange-rate discussions over the years. Expressed national positions sometimes shifted dramatically, depending on the changing circumstances, sometimes for tactical reasons. As early as 1980 the Bundesbank president Karl Otto Pöhl surprised his colleagues by expressing a preference for a common central-banking system in Europe, though James suggests that this “was not the first or last time a theoretically convincing case for an ambitious program was put forward as a way of blocking practical and realizable small-scale steps”.

Ultimately the dominant Bundesbank position became and remained stable and coherent. Germany should not tie itself into a global fixed-rate system, and its adherence to a European monetary regime was contingent on such a regime not posing a threat to price stability. When the EMS arrangement of fixed but adjustable exchange-rate bands began in 1979 (ending, for Ireland, the 150-year currency union with sterling), the Bundesbank secured a secret opt-out from the obligation to support the exchange rate of weak participating currencies if such support were to threaten German price stability. This opt-out, enshrined in what became known as the Emminger Letter, was revealed and acted on in the crisis of 1992-3, so shocking the Banca d’Italia governor Carlo Ciampi, whose currency would not now be supported by the Bundesbank, “that his face drained of its colour”. That crisis, peaking in Ireland with the tragicomic coincidence of the forced devaluation of the Irish pound on the very weekend of the Central Bank of Ireland’s golden-jubilee celebrations in January 1993, actually crystallised the view that mere co-operation between European central banks could not prevent recurrent disruptive exchange-rate crises in a managed regime. The only viable alternative to free-floating exchange rates would be the introduction of a nonstate currency, managed by a central bank created in the model of the Bundesbank, as had already been agreed in the Maastricht Treaty. Only then did the path to the euro become unobstructed.

Irish members of the committee make a few cameo appearances, most notably Maurice Doyle, in February 1993, bemoaning the lack of a collective approach for dealing with the EMS crisis of the time – an Irish complaint that was echoed some 15 years later in the next and biggest crisis.

If, as James suggests, using the words from Gilbert and Sullivan’s Iolanthe, central bank governors in the 1960s did “nothing in particular, and did it very well”, all changed in the 1980s and 1990s as they battled successfully to beat inflation, in the process forging “an intellectual consensus . . . that had not previously existed”. The “amazing and unprecedented achievement” of creating the euro seemed to promise an era of uninterrupted monetary tranquillity. But it was not to be so.

In a concluding chapter, James offers some interpretation of what was missing. His analysis here is surefooted and convincing.

One missing element was a sufficient institutional arrangement for dealing with financial-instability issues beyond price inflation. This neglect James sees as inherited from the limited mandate of the Bundesbank but also as reflecting the parallel emergence of international co-operation on bank supervision in the wider forum of the Basel Committee, which included the US and Japan. This lacuna is now, of course, being belatedly filled.

A deeper flaw lay in the unthinking confidence in the capacity and effectiveness of financial-market forces to act as a stabilising force by restraining banks and governments from overborrowing. One key figure who had already expressed concern about this in the late 1980s was Alexandre Lamfalussy, the far-sighted chief economist of the Bank for International Settlements – which provided the secretariat of the committee of governors throughout – but his pessimism seemed outmoded even then. Indeed, it was no less a personage than the president of the European Commission, Romano Prodi, who (echoing a widespread view among economists at the time) dismissed the fiscal rules of the stability and growth pact as “stupid”. Inadequate they surely were, as Ireland’s experience subsequently showed, but not because they were too restrictive; on the contrary, they were insufficiently constraining in good times.

In addition, labour-market institutions did not adapt, and divergent wage inflation persisted for years, without apparent financial-market reaction at first. Far from being corrective, “this modern version of an international economy without exchange rates turned out to be a mechanism to intensify imbalances.” Thus, rather than dissolving the financial pressure points in Europe by removing the sources of economic divergence, the euro at first worked to mask the fact that these long-lasting divergences were persisting and even widening. When the crisis hit, the policy fault lines were revealed as being deeper than ever.

The way forward

Understanding the origins of the euro is crucial to obtaining a broad political consensus on the steps needed to correct the malaise that has emerged in the current crisis. Already, as James points out, a rather unlikely lightning rod for the anti-globalisation movement, the euro has also become a bugbear for conservatives in the creditor countries who see it as a threat to the value of their national savings.

The only politically viable way forward for the monetary union is in the context of the four dimensions of further integration on which work is now under way: banking supervision and regulation; the budgetary framework; economic efficiency and competitiveness; and democratic legitimacy. The manner in which work towards these objectives is accomplished will, no doubt, be the topic of a sequel to be prepared by the next generation of historians. As James observes at the end of this absorbing volume, we have not yet reached the end of Europe’s long struggle over money.