The negotiation of an asymmetrical european monetary system and the decision of high inflation countries to join the system
- Autores: Anna Solé del Barrio
- Directores de la Tesis: María del Pilar Nogués Marco (dir. tes.), Fernando Guirao Piñeyro (codir. tes.)
- Lectura: En la Universitat Pompeu Fabra ( España ) en 2020
- Idioma: español
- Tribunal Calificador de la Tesis: Emmanuel Mourlon Druol (presid.), Albert Carreras i Odriozola (secret.), Patricia García-Durán Huet (voc.)
- Programa de doctorado: Programa de Doctorado en Historia por la Universidad Pompeu Fabra
- Materias:
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- Resumen
CHAPTER 1. THE NEGOTIATION OF THE EUROPEAN MONETARY SYSTEM: THE DEBATE ABOUT SYMMETRY Extended abstract Historically, the objective of stabilization of exchange rates has led to the creation of a series of fixed exchange rate agreements. These agreements have differed in what regards to the election of the numéraire of the system and the definition of fluctuation bands, as well as in the mechanisms to defend parities. The definition and the eventual functioning of monetary arrangements are the result of the particular historical frameworks in which these systems have been created and have operated. The European Monetary System (EMS) was created in the historical context of the dreadful monetary circumstances of the period of floating exchange rates of the 1970s, which was characterized by a very high inflation and high volatility of the exchange rates. After the collapse of the Bretton Woods system, European countries created the Snake, with the objective of letting all their currencies float together with respect to the dollar. However, some European countries (the United Kingdom, France, Italy and Ireland) were forced to abandon this system as a result of their inability to control inflation and maintain the value of their currencies within the fluctuation bands. These governments blamed the asymmetry of the Snake, which they claimed it operated as a Deutsche mark area and hence forced all the participants to adjust to the German inflation level, for their inability to maintain the peg of their currencies.
The negotiations of the EMS were highly influenced by the operation of the Snake (the system in force during the talks to define the new system) and symmetry became the main controversial point. Those countries that were forced to leave the Snake requested a more symmetrical system, while Snake countries, in particular Germany, were not willing to loss monetary autonomy and preferred a system which maintained the main features of the Snake. The main objective of this chapter is to analyse the debate on the symmetry of the EMS in order to establish whether it was a symmetrical or an asymmetrical system. In order to address this question, I will first explain the design of the system on the basis of what was approved in the Brussels European Council and, secondly, I will make the key distinction between the design and the actual functioning of the system, since there were several aspects which were not clearly defined in the agreement, or ended up operating differently to what was agreed.
This chapter starts with a review of the literature on EMS symmetry and the different approaches to the issue of symmetry, highlighting not only different authors’ stances on EMS asymmetry, but also the alleged reasons for asymmetry and the different methodologies to measure it. Most scholars state that the EMS was an asymmetrical system. There are two main explanations for this asymmetry: Some attribute it to the anti-inflationary role of the EMS and the desire of high inflation countries to import the Bundesbank’s reputation, which required the election of the Deutsche mark as the standard. To other authors, asymmetry is related to the German bargaining power, which allowed this country to impose it preferred option. Other scholars, however, state that the system was symmetrical. The debate about EMS symmetry has concentrated mostly in the assessment of the functioning of the system with the objective of determining whether it operated under the influence of the German monetary policy or not.
My approach to analyse this question is that it is important to distinguish between design and functioning of the system. Actually, some crucial aspects were not clearly defined in the final agreement (the most important were the use of capital controls and the definition of the criteria for realignments), and some mechanisms actually ended up working much differently to what negotiators anticipated at the moment of launching the system (mainly the creation of a European Monetary Fund or the divergence indicator). Furthermore, symmetry and asymmetry may not be considered as absolute categories, so that it is possible to establish different degrees of symmetry. Thus, the question I will address is not whether the system was symmetrical or asymmetrical, but whether it could have been more symmetrical. I will relate this issue to the demands of the countries which participated in the negotiations. In order to examine the negotiations, it is important to take into account that they did not start from zero, but the starting point was the Snake. The discussions on the EMS consisted basically in debating the proposals of non-Snake countries’ to create a system substantially different to the Snake concerning the aspects that determined the degree of symmetry. In order to analyse the degree of symmetry of the EMS compared to the Snake, I will examine the alternative designs for the new system contained in these proposals, and I will establish to what extent these suggestions to make the EMS more symmetrical than the Snake were successful. The sources I will use are the proposals of countries at the negotiations, the minutes of the European meetings and the resolutions of the European Council.
During the bilateral meetings between European leaders and in the meetings of the European Council, two alternative options to define the EMS fluctuation margins and intervention obligations were discussed: one was based on the European Currency Unit (ECU), a basket of currencies, and the other was based on a parity grid of bilateral exchange rates. The first option was expected to attain a more symmetrical functioning of the EMS, since it would oblige Germany to intervene frequently to correct the predictable appreciation of the mark. In the second case (the same as in the Snake), there were always two currencies forced to intervene and the burden of adjustment was expected to fall mainly onto the weak currency, due to the pressure that these countries would suffer in their balances of payments. The French, the Italian and the British governments strongly supported the first option, and believed that it would correct the asymmetry of the Snake. However, the German government opposed the use of the ECU to define intervention rules. Once the option of the ECU was discarded, other possibilities to correct the asymmetry of the Snake were proposed, mainly the creation of a pool of reserves through the extension of the responsibilities of the European Monetary Cooperation Fund, the construction of a divergence indicator based on the ECU and the enlargement of credit facilities. Eventually, these proposals were not endorsed or had very small impact on the degree of symmetry of the system, so the EMS ended up being very similar to the Snake.
From the analysis of the different proposals made during the negotiations and the eventual design approved in the Brussels European Council, my conclusion is that the design of the EMS was not asymmetrical, since there was no explicit election of the Deutsche mark as the numéraire of the system. However, the lack of concretization of some elements and the existence of a certain degree of discretion in interventions, together with the control of credit facilities by the Bundesbank (the central bank of the country with largest surplus), due to the decision of not creating any multilateral credit mechanism, eventually led to an asymmetrical functioning of the EMS. Actually it would have been possible to introduce features to the design to foster a more symmetrical functioning of the system. A system in which the fluctuation bands and the intervention obligations were defined in ECUs would have imposed Germany a more symmetrical pattern of interventions and would have eliminated some discretion in the system. Multilateral mechanisms to finance interventions would have also eroded the centrality of the Bundesbank in the system. Summing up, the asymmetry in the functioning of the EMS was the result of the inability of high inflation countries to convince other countries, in particular Germany, to introduce elements in the system able to impose a more symmetrical operation.
CHAPTER 2. THE SOURCES OF THE GERMAN BARGAINING POWER Extended abstract The negotiations leading to the launching of the EMS were controlled by the French and the German governments. Although decisions were endorsed at the European level, in the framework or the European institutions, the major advances in the process of bargaining to define the rules of the new monetary arrangement were made in Franco-German bilateral meetings. These two countries had different preferences regarding the definition of the EMS. The French government requested a more symmetrical system that was substantially different to the Snake. French leaders supported therefore the option of using the ECU to define intervention rules, or at least, to create a divergence indicator entailing compulsory actions, the enlargement of credit facilities, and the creation of a multilateral institution to manage credit. On the opposite side, the German government was not willing to make concessions that could affect negatively its monetary autonomy and rejected accordingly any proposal to use the ECU to define intervention rules, or any other feature which involved compulsory measures, and the creation of multilateral credit instruments. However, Germany was more disposed to accept concessions in matters that did not threaten its monetary autonomy, such as larger fluctuation bands, the possibility of realignments or the extension of credit lines between central banks.
The main purpose of this chapter is to analyse the negotiations between these two countries at the European level, as well as their domestic debates, in order to determine which country was more capable to influence the outcome of the negotiations and obtained a final design closer to its preferences. Using a bargaining theory approach (Muthoo 1999), I will also examine what are the factors that explain each country’s bargaining capacity in the case of the EMS discussions. In order to approach these two questions, I will use European documentation and the proposals that countries took to the negotiations, as well as the resolutions of the European Council. Since, I will argue, the domestic debate between the German Federal government and the Bundesbank was crucial to determine the negotiation stance of the German government, I will also use the Bundesbank’s minutes of the meetings of the Bundesbank Council and with the Federal Chancellor. The relationship of the German government and the central bank was, at that time, unique in Europe. In order to understand this very particular status of the Bundesbank, which I believe was crucial during the EMS negotiation, I will compare the legal and effective independence of the Bundesbank to that of the Banque de France, the central bank of the other main actor in the negotiations. Finally, I will assess to what extent the final design of the system ended up being more advantageous for the country with a bigger bargaining power.
The analysis of the negotiations leads to the conclusion that Germany was able to impose its stance in the majority of aspects deemed crucial in the design of the EMS, this is, the aspects which determined the degree of symmetry in the functioning of the system. For the German leaders, the preservation of domestic monetary autonomy was a non-negotiable condition, and this request was incompatible with the French demand of a symmetrical system. The German ability of imposing its stance regarding aspects affecting symmetry reveals a bigger bargaining capacity. Following a bargaining theory approach, I will explain that the factors that explain this bigger bargaining power are three: the existence of better inside and outside options, a lower cost of breaking up the negotiations than for France and the capacity of the German government of not assuming that whole cost, and the commitment of the German Federal government with a precise bargaining stance, which was determined by the restrictions imposed by the Bundesbank.
Regarding the inside and outside option, Germany was already participating in a monetary arrangement, the Snake, which would continue to be in force in the case of failure of the EMS negotiations. Although the Snake started suffering tensions during the second half of the 1970s, the German performance in the framework of this arrangement were much better than that of France, Italy, the United Kingdom or Ireland, who were forced to abandon the Snake and obtained awful results in terms of price stability and exchange rate volatility. Therefore, for these countries reaching a European solution for monetary cooperation was much more compelling than for Germany. With respect to the cost of breaking up the negotiations, the French government placed great importance to the creation of the EMS as a mechanism to achieve domestic economic policy goals, and took the initiative in the negotiations. Consequently, failing to reach an agreement would have political costs for the French government. In the case of Germany, not only the cost of breaking up the negotiations was smaller, but also the Bundesbank would assume the main part of this cost, since the Federal government was much more willing to make concessions to other governments than the Bundesbank. Finally, the Bundesbank imposed certain restrictions to the Federal government regarding the agreements it could reach with other countries. These restrictions acted as a previous commitment for the government, which compelled it to a concrete bargaining strategy.
Consequently, the Bundesbank had a decisive role in obtaining an agreement that was particularly beneficial for Germany. The Bundesbank played two important functions: it would assume the cost of breaking up the negotiations and committed the Federal government to a specific stance during the negotiations. The Bundesbank was able to undertake both roles thanks to its high degree of formal and real independence and the reputation it enjoyed among the German society. In particular, the conditions that the Bundesbank imposed to the German Federal government were: intervention rules should be defined on the basis of the bilateral exchange rates, the Bundesbank should be allowed to stop interventions if the objective of price stability was at risk, the divergence indicator (based on the ECU) should not entail any obligation, and no multilateral credit instruments should be created. With the only exception of the possibility of stopping interventions, the final design of the EMS met totally the Bundesbank conditions. With respect to the only requisite not included in the agreement, the Bundesbank obtained a “secret” guarantee from the Federal government that the bank could stop interventions if considered that domestic price stability was threatened. Hence, the Federal government allowed the Bank to “violate” the aspect of the agreement that infringed its restrictions.
To sum up, the different institutional designs of monetary policy and, in particular, the status of the central bank, affected decisively the bargaining power of their respective governments during the negotiations and, hence, the final outcome. As a result of this bigger negotiation power, the final design ended being very advantageous for Germany in terms of gains of competitiveness, with a minor cost in terms of intervention obligations, risk of inflationary tensions or loss of autonomy of monetary policy. On the other hand, France was forced to introduce severe reforms in order to make the peg sustainable.
CHAPTER 3. THE ITALIAN DECISION OF JOINING THE EMS: EXCHANGE RATE COMMITMENT AS A POLITICAL ARGUMENT IN FAVOUR OF INSTITUTIONAL REFORMS Extended abstract The agreement of the European Monetary System was signed the 5 December 1978, with only six of the nine EEC countries. The United Kingdom decided to stay out and Italy and Ireland requested some additional time to take their final decisions. Shortly after, both countries joined the agreement. The reason for the Italian government not to sign the agreement immediately was that the final design did not meet the conditions it considered essential to ensure a sustainable participation. Initially, the stance of the Italian government was that Italy would not join the system unless it was substantially different from the Snake (which they were forced to abandon), it entailed a symmetrical distribution of the burden of adjustment and included mechanisms of financial aid and cooperation. The Italian government played a minor role during the negotiations and the final design failed to meet Italian requests. However, even if the system design was very similar to the Snake, the government changed its position and decided to join it.
The objective of this chapter is to examine the decision of the Italian government to join the EMS. I will analyse Italy’s stance during the negotiations and examine why its demands were not met. A monetary arrangement that had met the government conditions would have had general acceptance among Italian political parties and social groups. However, after the Brussels European Council, once it became evident that the new system would not satisfy the Italian demands, there was a very intense debate on the convenience of joining the system. In order to analyse the position of the Italian government in the negotiations I will review European documentation, the resolutions of the European Council and the interventions of members of the Italian government in the Parliament and in the press. To examine the domestic debate, the sources used are the Parliament records, government documentation, the publications of the Banca d’Italia, and the main Italian newspaper, Il Corriere della Sera.
Most literature has explained the Italian decision to adhere the EMS as an attempt to fight inflation and import reputation from the Bundesbank, using the EMS as a mechanism to reduce the cost of disinflation (for example, Giavazzi and Giovannini 1989, McNamara 1998), or as the result of the confrontation of interests groups (Frieden 2001, Bearce 2003). I will argue that the Italian decision of joining the EMS was related to other domestic debates on economic policy and institutional reforms, which were connected to the national macroeconomic situation, as well as economic theoretical changes. During the second half of the 1970s, in the framework of the generalization of floating exchange rates and the dreadful inflation rates and volatility of the lira, there was an intense theoretical debate in Italy on the causes of inflation and the use of monetary instruments to tackle it. This led to the emergence of an academic and political elite that supported the need for a shift in the approach to the management of monetary policy. However, this new elite lacked the necessary political and social support to implement these new policies, and found in the EMS a strong argument to back the reforms they proposed.
In particular, the EMS debate was highly connected to the debate on the need of revoking or reviewing two reforms that were introduced in 1975 and that, by the end of the 1970s, were aggravating inflation: the reform of the scala mobile (the system of wage indexation), which unified the compensations received by all workers to counteract the effects of inflation, leading to an indexation of wages of more than 100%; and the reform of the Ordinary Treasury Bonds, which compelled the Banca d’Italia to purchase all Treasury bonds that were not sold in ordinary issuances. Amendments to these measures did not require a fixed exchange rate to be implemented; however, EMS membership was used by some economists and policymakers as an argument to justify and enforce these decisions in a framework in which there was not enough political and social support.
In the case of the scala mobile, any reform of the mechanism of wage indexation, which had important redistributive effects, generated intense conflicts. The adoption of a fixed exchange rate and the subsequent loss of competitiveness led to rising tensions in the balance of payments and forced continuous devaluations of the lira during the first years of operation of the EMS. This situation made evident the need for a shift in the direction of the economic policy. Entering the EMS made the reform of the scala mobile mandatory, and the only way to avoid it was leaving the system. Consequently, the cost of not carrying out this reform became much higher than it would have been if Italy had never joined the system. EMS membership ended being a powerful argument for those willing to amend the wage indexation mechanism.
The other big reform affected the relationship between the Treasury and the Banca d’Italia. As a result of the obligation of the Banca d’Italia to purchase the Treasury bonds unsold in ordinary issuances, monetary policy was totally subordinated to fiscal policy and there was a large monetization of the public deficit. The revocation of this obligation, known as the “Divorce”, was carried out through a “private” agreement between the Minister of the Treasury and the governor of the Banca d’Italia. This decision was taken unilaterally, without any intervention of the Cabinet or the Parliament, since both the Minister and the governor of the Bank were perfectly aware of the opposition of the rest of the government and the Parliament to that reform. Although the “Divorce” did not trigger major debates when it was implemented, once its effects (an increase in the cost of government’s debt and in interest rates) became noticeable, some voices raised to demand its repeal. The EMS was used as a strong argument to maintain, and later expand, the autonomy of the central bank. In an environment in which most policymakers still accepted the primacy of fiscal policy over monetary policy and hence measures aimed to introduce more autonomy for the central bank lacked the necessary support, the Minister of the Treasury and the governor of the Bank expected that this decision would be easier to maintain once implemented than to endorse it for the first time. These two officials were strong supporters of the EMS and EMS membership increased the cost of repealing the decision.
Summing up, at a moment of transition in the management of economic policies, characterized by an intense debate on the use of monetary instruments, some Italian economists and policymakers used the fixed exchange rate commitment and, more generally, European obligations, as a mechanism to introduce institutional reforms which they deemed crucial for stabilization, but lacked the necessary support. They used the EMS to bind unpopular institutional reforms, since EMS membership increased the cost of not endorsing or repealing those unpopular reforms.
CHAPTER 4. IRELAND IN THE EMS NEGOTIATIONS: BETWEEN THE BEGGING BOWL STRATEGY AND THE BREAK WITH THE STERLING POUND Extended abstract After the Brussels European Council, Ireland, like Italy, also requested a period for reflection to take a final decision about entering the EMS. Unlike in the Italian case, the reason for not signing the agreement immediately was not dissatisfaction with the final design of the system, but discontentment with the amount of financial aid that Ireland was going to receive in exchange for its participation in the system. Eventually, although the amount of transfers agreed with its European partners was far from the Irish requests, the Irish government decided to join the system. Joining the EMS had serious implications for the Irish economy. EMS participation entailed a very high probability of breaking up the one-to-one exchange rate with the sterling, which provided several advantages to the Irish economy. Besides, as one of the highest inflation countries in the agreement, Ireland would be forced to implement drastic measures to make peg sustainable. In spite of all these difficulties that the EMS implied, technical aspects such as the symmetry of the system, the definition of intervention obligations, credit facilities or the width of the fluctuation band, which defined how the new system was going to operate and the costs for Ireland of joining, had a negligible weight in the Irish government stance at the negotiations. Similarly, the domestic political debate concentrated in the amount of transfers that Ireland would receive in exchange for participation and the negotiation strategy of the government.
The government’s lack of attention to technical aspects is even more surprising when this negotiation strategy is compared to the official stance on the future relationship of the punt with the sterling. The Irish government affirmed that even if the United Kingdom decided not to join the system, the peg to the sterling would be maintained. This official position was consistent with the preferences of social and economic groups, which expressed an almost unanimous preference for the preservation of the fixed exchange rate with the sterling. However, regarding the definition of the system, the Irish government supported or endorsed options which made less probable the British participation in the system and the maintenance of the peg. Although it was evident that the EMS was incompatible with keeping the peg to the sterling, in particular if the United Kingdom did not take part in it, the Irish government stated that the peg to the sterling would be kept and held this position until the day in which the breakup with the sterling occurred, just a couple of weeks after the launching of the system.
The objective of this chapter is to explore the Irish decision on EMS membership and analyse both the government position during the negotiations and the domestic political debate. The sources I will use are the records of the European debates and the resolutions of the European Council, the debates in the Dáil Éireann, the lower house of the Oireachtas (the Irish Parliament), government documentation, and the generalist main Irish newspaper The Irish Times. I will conclude that the Irish decision to join the EMS cannot be explained on the grounds of the traditional literature on interest groups. From the perspective of the benefits of fixed exchange rate agreements, there were strong incentives to try to keep some kind of relationship with the sterling, perhaps not necessarily the one-to-one peg, but at least the EMS fluctuation band. There was an almost unanimous preference among economic actors and social groups, from trade unions and agricultural associations to business associations and the banking sector, in favour of the maintenance of the peg to the sterling. Additionally, the size of compensations obtained in exchange for EMS membership seems not to be enough to justify the government’s decision, since the final amount granted was far from the government’s initial request.
The contrast of the Irish government position during the European talks, in the Irish Parliament and in public declarations with the decisions eventually endorsed reveals important contradictions regarding the British participation in the EMS and the likelihood of breaking up with the sterling. The members of the Cabinet stated in many occasions that they preferred the United Kingdom to take part of the EMS and that one of their priorities was not to break the peg to the sterling or, at least, maintain it as long as possible. However, the options supported during the negotiations about the definition of the system and the particular conditions of the Irish participation in it were the opposed to those that could have facilitated these objectives. First, with respect to the definition of intervention rules, the Irish government did not support a symmetrical system and the basket of currencies and supported instead the option of the parity grid. This option not only had a bigger deflationary bias, which forced Ireland, a high inflation country, to carry out a more severe adjustment, but also made much less probable the British incorporation into the system. Second, the decision of not joining the wider fluctuation band allowed to non-Snake countries (and not even actively support during the negotiations the introduction of the possibility of a wider in the agreement) was also inconsistent with the announced desire of preserving the link to the sterling as long as possible. The wider band would have allowed the Irish government to maintain the peg to the sterling longer than the narrow band because, in this last case, the probability of the sterling (and thus the Irish punt) to reach the limit of the band with any EMS currency was much higher. In any case, even in the wider band, eventually Ireland would have been forced to break up the peg at some point. The justifications of both elections were too weak or even grounded on false assumptions.
The decisions taken show incoherence with the government’s stances. The analysis of the domestic debate reveals that the government, and also some other political agents, were much more favourable to end the peg to the sterling than most economic agents. The political debate on the peg to the sterling focused on the political and nationalistic aspects of the decision, mainly, the impact for the future relationship with the Ulster and the possibilities of reunification of the island, instead of the economic consequences, which were the reason why economic agents did not want the breakup to occur. The members of the Cabinet were quite convinced that the EMS and the breakup with the sterling, which in their opinion would improve the economic prospects and living conditions in Ireland while the British would experiment a decline, would be a driving force of the reunification of Ireland. This convincement led policymakers to be much more favourable to the end of the peg than the majority of economic agents. The EMS provided them an excuse to take this decision. Consequently, my conclusions are that the Irish government decision to join the EMS was mainly motivated by political reasons, as they expected the EMS and the financial aid obtained to be determinant in the development of the country and the detachment from United Kingdom, a crucial factor to encourage reunification. Eventually, the first years of the EMS membership refuted these aspirations. Ireland’s inflation rate was higher than the British and most EMS countries, the Irish punt was devalued in some occasions and unemployment soared. This poor economic performance forced the government to impose severe austerity measures during the 1980s.
