Thomas Mayer is Senior Fellow at the Center of Financial Studies at Goethe University Frankfurt and Senior Advisor to Deutsche Bank’s management and key clients. From 2010 to 2012 he was Chief Economist of Deutsche Bank Group and Head of Deutsche Bank Research. He has previously held positions at Goldman Sachs and the International Monetary Fund.

Europe’s Unfinished Currency

The Political Economics of the Euro

By Thomas Mayer

Wimbledon Publishing Company

Copyright © 2012 Thomas Mayer
All rights reserved.
ISBN: 978-0-85728-548-5

Contents

List of Charts, Tables and Textboxes,
Introduction,
A Question of War and Peace,
No Longer a Question of War and Peace,
A History of Failures,
The Euro’s Happy Childhood and Its Abrupt End,
A Crisis of Legitimacy,
A (Hidden) Balance-of-Payments Crisis,
Forward or Backward?,
In Search of a Lender of Last Resort,
The Politics of Euro Rescue,
Why Europe Needs the Euro,
A New Foundation for EMU,
Summary and Conclusions,
Acknowledgements,

CHAPTER 1

A QUESTION OF WAR AND PEACE

‘Europe cannot be made in one stroke, nor can it be made through simple aggregation: it will emerge through concrete facts, which at first will create solidarity of deeds. The unification of European nations requires that the century-old adversity between France and Germany will be eliminated. The work under way in the first place has to affect Germany and France.’

— Robert Shuman, French foreign minister, 9 May 1950

Already towards the end of World War II, visionary French politicians, such as Jean Monnet and Robert Marjolin, concluded that a defeated Germany would have to be bound into a European structure in order to avoid a repeat of the experience after World War I. At that time, France, led by Prime Minister Georges Clemenceau, had insisted on a peace treaty that was not only to keep Germany powerless but also prevent its economy from recovering from the war for a long time. Mired in nineteenth-century thinking, the victorious European powers had expected that Germany would not only pay for her own reconstruction but also finance their war debt and economic recovery from the destruction experienced in 1914–18. The Inter-Allied Reparations Commission in 1921 initially put the reparations at 269 billion German gold marks or 64 billion US gold standard dollars (equivalent to USD 785 billion in 2011 prices). But soon it became clear that this demand was impossible to fulfil. As Germany had difficulties making the payments, they were reduced to 226 billion gold marks in the Dawes Plan of 1924, and then, as Germany defaulted again, reduced further to 112 billion gold marks under the Young Plan of 1929. The latter envisaged payments over a period of 59 years, with the last instalment due in 1988.

The harsh conditions dictated in the Treaty of Versailles led to deep-seated German resentment and helped pave the way to German revanchism and eventually to Nazi Germany. When Hitler came to power in 1933 and ended all war reparations, Germany had paid only 20 billion gold marks. At the time, very few people recognized the dangers of the harsh treatment of Germany. One of them was John Maynard Keynes, who in June 1919 resigned from the British Treasury in protest over the size of the reparations. In his famous treatise ‘The Economic Consequences of the Peace’ published in the same year, he wrote:

Europe, if she is to survive her troubles, will need so much magnanimity from America, that she must herself practise it. It is useless for the Allies, hot from stripping Germany and one another, to turn for help to the United States to put the States of Europe, including Germany, on to their feet again.

Mindful of the developments in the 1920s and 30s, Robert Marjolin, an economic adviser to the exiled de Gaulle government and later head of the Organisattion for European Economic Cooperation (the predecessor of the Organisation for Economic Co-operation and Development) and a commissioner of the European Economic Community (EEC), in a memorandum to Jean Monnet in 1944 argued for the construction of a unified Europe. In his memoirs, he recalls: ‘A grandiose conception, I wrote, extremely difficult to implement, but representing the only hope of salvation for our western civilization in Europe. The first stage would be to form a federation comprising Britain, France, Benelux, and Germany.’ He quotes from his 1944 paper:

In the economic sphere, the unification of Europe would be marked by a progressive dismantlement of all barriers to the free circulation of goods, persons, and capital, by a rational division of labour among the different regions, by a progressive equalisation of living standards across the continent (though it will never be possible to achieve complete equalization …) The European economy as a whole would receive an extraordinarily powerful impetus from unification of the European market.

Under the leadership of their French colleagues, politicians on the Continent set the stage for the creation of the ECSC, where industries important for the conduct of war were brought under a European umbrella. But European integration was not supposed to end there. Ever-closer economic integration was seen to drive forward political integration. Already in 1950, German chancellor Adenauer in an interview with International News Service proposed a political union between Germany and France:

A union between France and Germany would give new life and new impetus to a very sick Europe. It would be of great influence both psychologically and materially and would unleash forces that surely would rescue Europe. I believe this is the only way to achieve the unification of Europe.

The goal of political union was pursued by making concrete steps forward at the economic level, including over time the move to the EEC, the creation of the European Union and the Single European Market and eventually the establishment of EMU (see textbox below for a short history of European integration). The most fervent advocates of integration saw the process as a ‘chain reaction’. According to Walter Hallstein, a close collaborator of Adenauer and a president of the Commission of the EEC from 1958 to 1967, the ‘inner logic of integration’ would lead from the ECSC to customs union, a common agricultural and commercial policy and eventually political union: the United States of Europe. However, the vision of a European federation was quite controversial. Against the federalist model popular in Germany and the smaller European states stood the concept of Europe as a union of sovereign nation states. This view was most strongly held in France. As Marjolin put it:

Between maintenance of national sovereignties in toto and dismantlement of the latter, there is a middle way. For me, this middle way represented the reality, the hypothetical extremes – full maintenance of sovereignties or their dismantlement – being mental constructs. The middle way was a treaty whereby the signatory states would pledge themselves to one another indefinitely and undertake to carry out certain acts by specified dates, such as the progressive abolition of customs duties and import quotas, the gradual derestriction of movements of labour and capital, the organisation of agricultural markets, and so on. After a transition period, which might vary according to the circumstances, the result would be a Europe which, if perhaps not wholly unified economically, would nevertheless present a degree of unity unachieved hitherto.

The history of economic integration in Europe: Timeline of major events

1951 ECSC ->(1) Preferential Zone

1957 Treaties of Rome:

• EEC ->(2) Free Trade Area

• European Atomic Energy Community (EURATOM)

• ECSC

1960 European Free Trade Area (EFTA): founding members were the ‘Outer Seven’ (Austria, Denmark, Norway, Portugal, Sweden, Switzerland, UK)

(1965) Merger Treaty: ECSC, EURATOM and EEC merged into European Community (EC)

1967 ->(3) Customs Union

1972 Exchange Rate Mechanism (ERM): European currency snake

1973 Northern enlargement 1: accession of Denmark, UK and Ireland

1979 European Monetary System (EMS), including ECU as a basket currency

1981 Southern enlargement 1: accession of Greece

1985 Southern enlargement 2: accession of Spain and Portugal

1985 Schengen Treaty signed. Schengen area came into existence 10 years later in 1995

(1986) Single European Act

1987

• First major treaty revision since 1957

• Agreement on full removal of all tariff and nontariff barriers in the European Single Market (ESM) until 1992

(1992) Maastricht Treaty: ->(4) Common Market

1993 Treaty reform — three pillars:

• EC (supranational)

• Common Foreign and Security Policy (CFSP, intergovernmental)

• Justice and Home Affairs (JHA, intergovernmental)

Agreement on 3 stages to EMU:

1. 1990: Free capital movement

2. 1994: Convergence of macro policies

3. 1999: Launch of the euro

(1993) European Economic Area: EFTA plus EU-12 minus Switzerland

1994

1995 Northern enlargement 2: Finland, Sweden, Austria

1996 Broad Economic Policy Guidelines as a means for economic policy coordination ->(5)

Economic Union

1997 Stability and Growth Pact

(1997) Amsterdam Treaty

1999

• More power for European Parliament, strengthening the rights of citizens

1999 Third Stage of EMU: European Central Bank; launch of the euro as accounting unit ->(6)

Currency Union

2002 Euro notes and coins replace national currency

(2001) Treaty of Nice: amendment of majority rules in the council. Strengthening the principle of

2003 qualified majority; weighing population

2004 Eastern enlargement 1: Cyprus, Czech Republic, Estonia, Hungaria, Latvia, Lithuania, Malta, Poland, Slovak Republic, Slovenia

2007 Eastern enlargement 2: Romania, Bulgaria

2009 Lisbon Treaty: institutional reforms, more qualified majority voting, closer economic coordination between EMU member states, EU becomes legal personality

2010 Euro Crisis: EMU countries agree on support programmes for Greece (2 May) and other EMU countries (9 May). Founding of EFSM and EFSF

2011 Signing of ESM Treaty

2012 Signing of Fiscal Treaty

The close relationship between France and Germany as the engine for European integration was reflected in the close personal relationship between the political leaders of the two nations. President de Gaulle and Chancellor Adenauer started the tradition that was carried on by, among others, Valéry Giscard d’Estaing and Helmut Schmidt, and François Mitterrand and Helmut Kohl. During most of the post–World War II period, this was not an equal partnership. There was a clear hierarchy: France was in the political lead and Germany followed, often backing the European project with its renewed financial power. But the relationship benefited both partners: Germany was able to influence the international political debate by having France speak for her as well as for herself and France could leverage her political weight via German economic power. The process of European integration was driven forward by the political elites in both countries. The general public retained more or less sceptical attitudes towards the European project and had to be pulled along by its political leaders.

Early on, the creation of a common currency was seen as being of particular importance for European unification. According to the ‘inner logic of European integration’, currency union would inevitably drive Europe towards political union. Already in 1949, Jacques Rueff, a famous French economist and government adviser, had predicted that ‘Europe will be created through its money or not at all’. Money has of course always played an eminently political role. As the anthropologist David Graeber has pointed out, in early societies coins were often issued first to soldiers. Requiring the civilian population to pay their taxes with coins created demand for them. Thus, rulers used money to measure the tax obligations of their subjects and fund a standing army. Rueff’s call for monetary integration must also be seen against the background of the disparate conditions of European countries immediately after World War II. Currencies were not convertible and trade was conducted under bilateral agreements, without the possibility of balancing the deficit of one trading partner with the surplus of another. When the bilateral credit lines granted in 1946 and 1947 had been exhausted, the result was a complete jam in the intra-European payment system. This led eventually to the creation of the European Payments Union (EPU) in 1950, which allowed the netting out of all deficits and surpluses of a country vis-à-vis the EPU on a monthly basis. Monthly net positions were cumulated over time and settled periodically. Up to a certain ‘quota’ (based on trade turnover), countries could settle imbalances with the EPU in credit, but when the imbalance exceeded a certain threshold, payment had to be made in gold. Given the scarcity of countries’ gold holdings at the time, debtor countries were hard pressed to adjust when imbalances exceeded the size that could be settled with credit.

In a telling prelude to the developments of 2010–12, when a country accumulated a deficit larger than its quota and lacked the gold to settle it, the EPU gave financial assistance, provided that the country committed itself to pursuing an economic adjustment programme. The first country receiving such assistance was Germany, which in 1950 developed a large current account deficit in excess of its quota. Germany’s EPU-funded adjustment programme was successful and the country achieved a current account surplus in 1951, the first of many more in the following years and decades. However, the EPU became redundant and was officially dissolved in 1958, when European countries had accumulated sufficient gold reserves to make their currencies convertible. Only with currency convertibility achieved did the Bretton Woods exchange rate system eventually become fully operational in Europe.

Concern about the implications of a revaluation of the D-Mark and the Dutch guilder in 1961 for support prices in the context of the Common Agricultural Policy (CAP) prompted the EEC Commission to argue for a permanent fixing of EEC exchange rates. In October 1964, Marjolin, in his function as a commissioner, told central bank governors of the EEC to prepare for monetary unification. In 1965, he declared that monetary union was ‘an inevitable obligation’. However, his call fell on deaf ears, especially at the Bundesbank and the Dutch central bank, which thought that the preconditions for a monetary union as spelt out in the economic literature in the early 1960s by Robert Mundell and Peter Kenen were far from fulfilled. This episode highlights a dispute over European monetary integration that has been going on virtually ever since the beginning of the process. One camp, dubbed ‘monetarists’, has argued that monetary integration must drive economic and political integration.

Monetarists were in favour of a common currency early on, expecting the conditions for a smooth-functioning EMU to come into place in due course. Present-day monetarists would take the EMU crisis of 2010–12 in their stride, seeing it as a necessary catalyst for the fortification of the currency union and a driver towards further political integration. The other camp, dubbed ‘economists’, has argued that the economic and fiscal conditions for monetary union must be established first before EMU can begin. Consequently, economists today would interpret the most recent crisis as proof that the necessary conditions of EMU had not been fulfilled at its start. They would in present circumstances probably be more sceptical about the future of EMU than monetarists.

Despite the controversy over EMU in the mid-60s, the first serious attempt at creating a common European currency was made in 1970. The initiative came primarily from German chancellor Willy Brandt and was turned into an action plan by Luxembourg’s prime minister Pierre Werner. The so-called ‘Werner Plan’ envisaged the creation of a monetary union in several stages, to be completed in 1980. Compared to the later Maastricht Treaty, the Werner Plan was relatively short with regard to the creation of the central bank, only recommending a community system of central banks along the lines of the US Federal Reserve System, but it was fairly specific with regard to the need for joint economic policies. Thus, it envisaged a ‘centre of decision for economic policy’, politically responsible to the European Parliament, exerting decisive influence over countries’ economic policies, including fiscal policy:

The essential features of the whole of the public budgets, and in particular variations in their volume, the size of balances and the methods of financing them or utilising them, will be decided at the Community level; regional and structural policies will no longer be exclusively within the jurisdiction of the member countries; a systematic and continuous consultation between the social partners will be ensured at the Community level.

To avoid regional and structural disequilibria despite increased capital and labour mobility, there would have to be public financial transfers.

(Continues…)Excerpted from Europe’s Unfinished Currency by Thomas Mayer. Copyright © 2012 Thomas Mayer. Excerpted by permission of Wimbledon Publishing Company.
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