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Three themes behind monetary shortcomings

Three themes behind monetary shortcomings

Economic and Monetary Union failings were foreseen
Lack of ECB supervisory role ‘a fundamental flaw’

by David Marsh

Fri 2 Nov 2012

A historical account of the saga of European monetary integration produces three great findings, all of them as fascinating as they are disturbing. First, almost everything that has gone wrong with economic and monetary union (EMU) since 2009 was a repeat of various episodes that already took place many years before. Second, a large number of the setbacks were predicted by central bankers and technocrats whom politicians charged with laying down the groundwork for the project. Third, some basic safeguards against negative developments were suggested in the past, but were not put in place – with the results that we see today.

All three of these strands become visible in Harold James’ meticulous book on monetary union.* James, a professor at Princeton University, and a member of the OMFIF Advisory Board, expertly chronicles how the job of building EMU was left unfinished.

One illustration of the first theme – the syndrome of ‘repeat performances’ – stems from the 1992-93 crisis in the European Monetary System (EMS), the precursor of EMU. As James writes, the tensions produced by fixed exchange rates in the EMS, leading to capital inflows, price and wage inflation and rapidly diminishing competitiveness in fringe countries, neatly anticipated the turmoil in EMU in 2010-12. ‘Like the later crisis, the institutional and political framework also produced an intense discussion as to where the policy mistakes had been made: at the periphery or in the core?’

The second theme is reflected in warnings by central bankers in advance of the EMS upsets, again aptly prefiguring setbacks in EMU. Alexandre Lamfalussy, the Belgian central banker who later became head of the European Monetary Institute (the embryonic European Central Bank), warned in January 1989: ‘I am extremely preoccupied about what might happen to the EMS…I do see basic imbalances in terms of current accounts …Things may happen within the EMS which need a very very careful handling, not excluding perhaps exchange rate changes etc.’ Lamfalussy put forward potential EMS vulnerability as a powerful reason for advancing quickly with EMU. This argument could not be presented in public because it might undermine confidence in the existing European monetary arrangements.

A still more prescient example of central banking foresight, which again like Lamfalussy’s was kept well out of public view, was the scepticism by Andrew Crockett of the Bank of England about the level at which sterling joined the EMS exchange rate mechanism in October 1990. In an internal note two months later, Crockett (who died in August 2012) spoke of a ‘significant danger’ of locking in the British exchange rate at too high a level and subsequently discovering ‘that the domestic economy was weakening by more than we anticipated, and our internal competitiveness was insufficient to permit exports to become the engine of renewed growth. If we did this, and subsequently kept the exchange rate unchanged, it could be a mistake of historic proportions.’

An extraordinary illustration of the third theme, non-applied safeguards, related to the issue of Europe-wide supervision of banks with cross-border activities – a question that in recent months has returned to the top of the political and central banking agenda in Europe. In a December 1988 memorandum on prudential supervision of European banks, Huib Muller of the Nederlandsche Bank identified how banks with ownership spread across more than one European country ‘are creating risks for banks and the financial system which pose challenging questions for the central banks.’ Wim Duisenberg, the Nederlandsche Bank president, stated powerfully that Europe-level banking supervision was needed, a view backed by Brian Quinn of the Bank of England. However, Germany opposed the move, based on a long-held belief that involvement in banking supervision would provide a moral hazard to the bank’s main business of controlling inflation.

The Bundesbank’s Hans Tietmeyer argued that banking supervision was a responsibility for finance ministries, not central banks. European central bankers’ draft statute for the ECB referred to the possibility that the ECB would take over supervisory and regulatory functions. But by the time this reached the Maastricht treaty, the clause was heavily hedged in with many provisos. As James writes, ‘The intrusion of politics had resulted in a fundamental flaw in the new European monetary order.’

*Making the European Monetary Union, Harvard University Press, November 2012

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