Disorder, page 15
Only their common dollar problems could push the EC monetarily back together. But, necessarily, the price was institutionalizing West Germany’s intra-European monetary privileges. A prolonged bout of dollar weakness in 1977–78 exasperated Schmidt. For Schmidt, West Germany could not simultaneously adjust to more Asian trade competition, buy US Treasuries to finance American deficits, absorb more Deutsche Mark appreciation against the dollar and the non-Snake European currencies, and control domestic monetary conditions while the Eurodollar markets provided offshore credit. Although there was nothing in the short term that could be done on the dollar side, France and Germany could not, he told the Bundesbank in 1978, continue in ‘two different monetary areas’ if in the medium term the impact of the dollar on European economies was to be diminished.40
Schmidt pushed for a European Monetary System (EMS), with an Exchange Rate Mechanism (ERM) as its centrepiece. He found an ally, albeit a somewhat nervous one, in the French president, Valéry Giscard d’Estaing. Giscard perceived the choice for France to be between allowing ever-higher inflation and accepting German-led monetary discipline, and he chose the latter. All parties to the new European fixed exchange rate system tried to disguise the monetary power structure it entailed, pegging currencies against an artificial currency, the ECU, which financial historian Charles Kindleberger called ‘the Deutsche Mark with a French name41.’
As it would later do in the euro’s creation, Italy’s position revealed that little had changed around the European monetary hierarchy since the last years of Bretton Woods. The ERM had to allow for singular arrangements for Italy, so the lira could fluctuate within wider margins around its central parity than the other currencies. The West German, French, and Italian governments all wanted to treat Italy’s membership principally as a matter of EC unity. If the EC was to become a single monetary area, Italy had to be inside. If it were not, the EC would have tiers of membership.
* * *
Whatever the aspirations to EC commonality, the ERM did not include Britain. From the start, Britain became detached from EC monetary cooperation. This was not because the Heath government, which took Britain into the EC, had a strong political objection to future European monetary union. Indeed, Heath and his chancellor talked during the March 1973 crisis as if this was the desired future.42 But the economic and domestic political costs of defending any sterling parity with the Deutsche Mark were near insurmountable.
From the first British application to join the EEC, Britain’s Sterling Area had proved an impediment to membership. Originating in the 1930s, the Sterling Area was a monetary and exchange rate arrangement whereby former British colonies and states closely associated with Britain pegged their currencies to sterling, maintained large sterling balances as reserves, and aligned their capital controls to Britain’s. Believing that sterling’s international use made Britain’s interests within Bretton Woods more akin to those of the United States than the West European countries and fearing that in any currency crisis the sterling balances would become an EEC problem, de Gaulle had not wanted the Sterling Area inside the EEC. Indeed, it was Wilson’s 1967 decision to devalue sterling that pushed de Gaulle into his second veto. On this occasion, de Gaulle said that ‘the state of sterling would not allow it at present to become part of the solid, interdependent, and assured society in which the franc, the mark, the lira, the Belgian franc, and the guilder are joined43.’ In order to pre-empt the issue derailing the third application, Heath gave an assurance to Giscard that the sterling balances would be gradually eliminated as the states that held them turned to dollars.44 But ending the Sterling Area was likely to cause severe capital outflows. Allied to the fact that Britain’s rate of inflation was more akin to Italy’s than Germany’s, this made the prospect of defending any new currency parity with interest rate increases electorally unappealing, even to a government like Heath’s that wished to preserve Britain’s Community credentials.
Although Heath did place sterling in the Snake in the Tunnel in May 1972, he took it back out again the next month at the first sign of difficulty. During the discussions in March 1973 about the Snake, Heath, well aware that the French had told the Germans that they were only willing to move to a joint float with all nine EC states on board, did endeavour to return to a European approach.45 But once it became clear that the burden of maintaining sterling inside the Snake would fall on British politicians, not the Bundesbank, and that the French government would not tolerate a unilateral German float, Heath was left with a choice that would largely haunt British governments for the next two decades: the macro-economic and domestic political price for joining a European monetary arrangement was too high to contemplate, but staying out cost Britain political influence inside the EC. When Schmidt began to push his ERM plan, the Labour prime minister, James Callaghan, hoped the French reluctance would leave the two EC monetary areas in place, with Britain and France on the same side. But after Giscard decided that France should accept more monetary discipline, the costs on the EC side of exclusion increased. With Italy and Ireland deciding to join, Britain was left in a monetary group of one.46
The Volcker Shock
If the ERM represented an attempt to protect the EC from the dollar’s weakness, the source of European fear was American inflation. But, as the ERM began, the Fed was already beginning to worry about how far and for how long this inflation could be accommodated. After Carter appointed Paul Volcker to lead the Fed, American monetary policy took a radical turn. In October 1979, Volcker reconceptualized it towards systematically eliminating inflation by restricting the money supply.47 The ensuing high interest rates, which remained for the most part in double digits until autumn 1984, produced a much stronger dollar between 1981 and spring 1985.
The Volcker shock caused the EC states many problems. Even after dollar oil prices gradually fell from the second oil price shock of 1979–80, the strong dollar made oil imports more expensive. Jacques Delors, who served as French finance minister from 1981 to 1984, termed the years between 1981 and 1985 the third oil shock.48 High American interest rates, meanwhile, created conditions for capital flight at the same time as several European states, led by Britain and West Germany, were removing their capital controls.
Again, American monetary decisions reverberated divisively. In 1981, the Bundesbank tightened interest rates, and pushed for a wage freeze. By preventing Schmidt’s government opening up a credit line from Saudi Arabia, the German central bank played a big part in ending the Social Democratic–Free Democratic coalition government without an election taking place.49 This coalition switch by the Free Democrats brought the Christian Democrats back to power where they remained for sixteen years.
In France, by contrast, there was no independent central bank that could force a monetary response on politicians. Under any political conditions, this demarcation would have strained the ERM. But when François Mitterrand won the 1981 presidential election, and then the Socialists won a majority in the National Assembly—the first political victories for the Socialists in the Fifth Republic—it risked breaking up the mechanism entirely. Even without the Bundesbank’s monetary tightening, Mitterrand and his ministers would have baulked at the constraints Giscard had agreed to institutionalize. But Mitterrand became president when ERM membership required particularly high interest rates. After devaluing the franc several times, he was confronted in March 1983 with a moment of decision. Either his government accommodated itself to tracking the Deutsche Mark, and in so doing accepting that it was the Bundesbank that determined how to manage the dollar constraint, or it decisively broke monetarily with West Germany. After toying with both options, Mitterrand chose to retain ERM membership. His new franc fort (strong franc) approach subordinated the entirety of French macro-economic policy to maintaining the franc-Deutsche Mark parity. Henceforth, French politicians had to support the Banque de France’s monetary alignment with the Bundesbank, achieve wage discipline in the export sector, and aim for a current account surplus.
Being outside the ERM, Britain was in a different position when the Volcker shock hit. Indeed, the Thatcher government had already moved to a monetary policy rather like Volcker’s. In the same month Volcker prioritized inflation, the Thatcher government removed capital controls, amplifying the fallout for Britain of Thatcher and Volcker’s policies. Consequently, in the period between 1979 and 1981 before the dollar’s general rise accelerated, sterling sharply appreciated. As in the United States, high interest rates and a strong currency had a devastating effect on manufacturing and employment. For much of 1981, as the Bundesbank pushed the ERM states to higher interest rates, the Thatcher government was wrestling with how to steer sterling down without reigniting inflation.
But since dollar appreciation was now gathering speed, this strategy only moved Britain closer towards the ERM states’ dollar-generated currency problems. From autumn 1981, the Thatcher government had to keep raising interest rates to try to abate sterling’s decline. This imperative occasioned the first serious debate within the Thatcher government about ERM membership. From 1985, the debate became an incredibly acrimonious dispute between Thatcher and her senior colleagues, right up to the point when Britain joined in 1990.50 But neither in 1981 nor in 1985 did anyone in Thatcher’s Cabinet particularly see the issue as a matter of Britain’s position within the EC. In good part, this reflected the sheer difficulty that fiat money and exchange rates under conditions of open capital flows generated. When economic conditions eased from 1986, and the European issue did resurface, the Thatcher government used its macro-economic flexibility to differentiate the British economy further from the ERM states. Consequently, a geopolitical argument and a macro-economic argument for Britain joining never realigned.
A Not Quite German Single Currency
The end of the Volcker monetary shock and the second Reagan administration’s concerns with the impact of a strong dollar on American exports provided a temporary monetary respite for the EC. Just as Nixon had ultimately chosen dollar devaluation over tariffs, so Reagan decided to approach the burgeoning American trade deficit first and foremost as a monetary matter, albeit in the face of a Congress—controlled in both houses after the 1986 mid-term elections by the Democrats—that legislated for some protectionism.51 In aiming to depreciate the dollar, the Reagan administration sought cooperation from West Germany, Britain, France, and Japan. In the 1985 Plaza Accord, these five governments agreed to act collectively to bring the dollar steadily down. Adding Canada to their group, they followed Plaza with the 1987 Louvre accord to put an effective floor under the dollar’s depreciation.52
But Louvre reopened the American-German monetary divergence. The American trade deficit benefited little from the dollar’s fall. If this deficit was to be dealt with as a monetary problem, US treasury secretary James Baker believed, other governments and central banks would have to pursue policies that would encourage higher domestic consumption to create demand for American exports. While the Japanese government could agree a monetary accommodation to which the Japanese central bank would adhere—one that had disastrous consequences for the Japanese economy—the West German government could not bind the Bundesbank to any Atlantic assurances. Since the Bundesbank was unwilling to loosen monetary policy—indeed in October 1987 the Bundesbank raised interest rates—the Plaza–Louvre period of exchange rate cooperation broke down.
This turbulence then reignited the Franco-German monetary disagreement at a time of rapidly falling oil prices. The reverse oil price shock in 1986 was in part, but only in part—see chapter two—a product of dollar depreciation.53 Whatever its complex causes, it was a structural force driving inflation down. For the Bundesbank, it allowed for zero inflation. For the French, by contrast, this should have been an opportunity to lower interest rates to support higher growth, particularly since the Fed’s monetary policy was so much more accommodating than it had been earlier in the decade. But the ERM ensured the Banque de France had to follow the Bundesbank.
From a French perspective, the German-shaped constraints inside the ERM were now remorseless. In late 1987, Mitterrand persuaded the West German chancellor, Helmut Kohl, to accept a Franco-German Council to coordinate macro-economic policy, including monetary matters. But, once it realized what Kohl had surrendered, the Bundesbank rendered the agreement redundant. The French finance minister, Edouard Balladur, then took a proposal for monetary union to an EC finance ministers’ meeting in January 1988, setting in motion a path that would eventually lead to the Maastricht Treaty and the euro.54 This French push for a single currency marked a departure from previous European monetary moves. The Werner Report and the ERM had been responses to the problem the dollar caused European states. By contrast, Balladur’s case was a response to the internal European problem posed by the Bundesbank.55
That monetary union was conceived as a move to end the Bundesbank’s monetary power and required West Germans to relinquish the Deutsche Mark ensured there was plenty of opposition in Germany to the project. Helmut Kohl’s government decided to focus on the advantages of a single currency, which were primarily the prospect of an end to competitive devaluations by other ERM states and an opportunity to repurpose and reform the EC. Even after German reunification could have provided a pretext for retreat, Kohl persisted with that choice.56 Nonetheless, given the sacrifice, there was no possibility that the German government would ever allow a monetary union that did not meet fundamental German concerns.
In straight monetary policy terms, this meant that the proposed ECB had to be another version of the Bundesbank, legally committed by a European Union (EU) treaty to price stability as the sole purpose of monetary policy, and free from any democratic political control. Whether the ECB could in practice be like the Bundesbank would, of course, be another matter. The Bundesbank’s de facto political authority to set interest rates for Germany came from a strong domestic political consensus that price stability should prevail in monetary policy.57 A similar consensus was not in evidence in the EU by the time the Maastricht Treaty establishing the ECB was ratified. Indeed, had there been a European consensus behind a Bundesbank-like monetary policy, there would not have been a political demand for monetary union in the first place. When monetary union did begin, the dissensus was soon made apparent by attacks on the ECB’s treaty-guaranteed independence.58
Although this judgement could not be made explicit, the German government, to all intents and purposes, also insisted that monetary union could not include every member of the EC. To this end, the Maastricht Treaty, agreed in 1991, included strict convergence criteria—on inflation, exchange rate stability, budget deficits, and state debt—for states to qualify for the single currency.59 Drawing lines to establish ins and outs took Germany to a position quite different from that adopted by Brandt and Schmidt. When the push for monetary union began in 1988, of the then Southern EC states, only Italy was in the ERM, and it still used the wide bands with which it entered the system. It would have seemed implausible then to think that Italy, let alone the others, could maintain a permanently fixed exchange rate with West Germany without disastrous economic consequences.60 In contrast to 1978–79, any case for treating Italy as if it were France would appear to have required either significant support from the ECB for Italy’s debt, or a fiscal union that redistributed revenues to Italy, both of which were political non-starters in West Germany. Accordingly, the German path to monetary union set out in the Maastricht Treaty appeared to offer a two-tier EU.
In practice, the Maastricht convergence criteria could not resolve the question of ins and outs. Initially, there was no uniformity of opinion between the German government and the Bundesbank about who the convergence criteria might exclude. The smallest monetary union possible might have suited the Bundesbank’s overriding anti-inflationary concerns. But it risked German exporters facing ongoing devaluations from those outside the single currency.61 Meanwhile, the convergence criteria could not straightforwardly be directed against the Southern European states. If the budget deficit criterion had been applied in 1991, Belgium would have been out, and, although it might have seemed that there was no chance of Italy qualifying, the same could not be said for Spain. In the treaty, the German government looked to have the advantage over the Bundesbank via a clause whereby the European Council could exercise a ‘flexible’ interpretation as to whether a state had met the conditions or not.62 But since ERM membership without a devaluation for two years was a convergence condition, the Bundesbank had the means to push out the Southern European states.
Indeed, nine days after the Maastricht summit ended, the Bundesbank raised interest rates in response to the inflationary effects of German reunification. This move led to eighteen months of turbulence within the ERM, during which Britain permanently left, Italy made a temporary exit, the Spanish, Portuguese, and Irish currencies were devalued, and, in July 1993, all currency bands except those between Germany and the Netherlands were suspended. For a while it seemed as if monetary union would not happen. Then it appeared as if a select group of states would go ahead, dividing the EU into a core and the rest. Instead, the Eurozone began in 1999 missing only those with legal opt-outs—Britain and Denmark—and temporarily Greece.
This large monetary union lacked broad political support in Germany. Opposition to it first appeared in a set of legal challenges to the Maastricht Treaty in the Federal Constitutional Court. In 1993, the Court, in ruling that the treaty’s ratification was constitutional, also asserted, among other things, that it was for the German Parliament to decide whether a state had qualified to join. This left monetary union’s size to be contested within German democratic politics. The Social Democrats fought the 1994 German federal elections on a platform to shut out Southern European states from the single currency, and for some time it looked like they would win.63 In trying to rescue that election, Kohl turned monetary union into something it had hitherto not been: a symbolic issue of European unity. The following year he went further, saying that monetary union was a matter of ‘war and peace in the twenty-first century’.64 Although the Christian Democrat–Free Democratic coalition did retain power in 1994, the election did not settle the euro’s composition. In 1995, Kohl’s finance minister, Theo Waigel, declared that Italy would not meet the convergence criteria. This belief that Italy did not belong in a monetary union persisted inside the German government well into 1997.65 But Waigel and the Bundesbank lacked the means to impose their will since Germany’s own fiscal difficulties, caused by reunification, ensured that the convergence criteria on state debt and budget deficits could not strictly be enforced. So long as there was no clean technical way of determining exclusions from the single currency, Kohl’s argument that what mattered was European unity had a force it would not otherwise have possessed.
