Verona heralds arrival of new monetary order

Date: 18/04/1996

A LONG chapter in the history of European monetary policy came to an end in Verona last weekend.

Far from heralding the revival of the currency control systems of the past - Bretton Woods, the Snake or the kind of Exchange Rate Mechanism that collapsed three years ago - EU finance ministers and central bank governors laid them to rest in this small northern Italian town.

True, there will be a new ERM, but it bears about as much resemblance to the old system as ski-pants do to flared trousers.

In all the fuss about whether the UK or Sweden will be forced into a revamped ERM, one major fact has been over-looked: a sea change has occurred in European thinking about how to keep the external value of their currencies stable.

The idea that the nominal exchange rate of a currency can be bound, albeit in a narrow range, and that this will feed through into tight control of price inflation and budgetary rectitude, is dead.

The truth is that the agenda of the German establishment has been bought.

In the words of Sir Nigel Wicks, president of the EU's powerful monetary committee, “all my colleagues would agree that what matters if you want a stable exchange rate is not interventions in the market, but the fundamental policies to do with interest rates and budgetary policy”.

The German government, and the Bundesbank in particular, never really trusted the way the old ERM was used. This so-called 'symmetric' system, which demanded as much commitment from the strong as from the weak, never suited the EU's hardest-currency country.

Too often, the Bundesbank felt, governments expected the unlimited aid of the deutschemark to dig them out of their own mess.

Their currencies came under market bombardment because their budgets were out of control, their inflation too high or their parity simply unsustainable.

Under the old system, if a government was determined to keep its parity, then the Bundesbank was obliged to intervene in the markets, selling marks for pesetas or lira or pounds, theoretically until they ran out.

Frankfurt never liked it, but it was the terrifying experience of the currency crises of 1992-93 which convinced them this could never be allowed to happen again.

In September 1992, the then Bundesbank President Helmut Schlesinger revealed the enormous commitment his institution had been forced to make in support of the lira and the pound. In one month, intervention had swollen the German monetary base by 13 billion ecu. The Bundesbank, bound by its constitution to pursue price stability, could not risk this kind of expansion of the money supply.

When finance ministers agreed in August 1993 to widen the ERM's trading bands from 2.25&percent; (or 6&percent; for Spain and Portugal) to 15&percent;, they did it on the understanding that it would be temporary. It was not. Central bankers fell in love with the new 15&percent; bands.

Suddenly, the tail had stopped wagging the dog. European economies could now be made to 'converge' by reductions in current public spending and reforms in labour and product markets. The crushing weight of adjustment no longer sat on the daily use of interest rates and intervention in the currency markets.

It is this that was enshrined in Verona. Never again will the Bundesbank have to fork out billions to save the face of errant governments.

A report from the European Monetary Institute rules out intervention “if this entails actions that enter into conflict with its primary objective of maintaining price stability in the Euro area”.

The new ERM will, in general, have wide fluctuation bands so that the financial markets have no realistic targets to aim for. Interventions will be selective and limited, and the president of the European Central Bank will be given new powers to persuade non-EU members to devalue their currencies.

The system will be even more flexible than that. When everyone else's bands were widened to 15&percent;, the Bundesbank kept a special narrow-band bilateral deal with the Dutch. For Denmark - with low inflation, a stable currency and a narrowing budget deficit - a sweetheart deal à la hollandaise could well be on the cards. But Greece should not hold its breath, and nor should those countries at the front of the queue for EU membership.

While operational details are still highly tentative, it is very possible that applicant countries such as Poland, Hungary or the Czech Republic could be given central parities to target but without fluctuation bands.

Forget all the talk about punishments for wicked governments who deliberately devalue their currencies to steal export markets from the virtuous Euro bloc.

How do you identify such delinquents? Who would argue that the Italian, Spanish, Portuguese or Irish governments deliberately devalued their currencies?

The Swedes only gave up the defence of their krona peg against the Ecu in 1992 after a Herculean effort involving a rise in short-term interest rates to 500&percent;.

Only in the UK could it be argued that the government took no account of its partners, particularly those in Dublin, when it hacked away at interest rates in early 1993 and allowed sterling to find its own level. But even that was after a struggle and political humiliation which still haunts John Major's government today.

The French government, which is pushing the idea of sanctions for competitive devaluations, has given the European Commission the task of beefing up its so-called 'multilateral surveillance' techniques.

One idea being discussed is to set subsidies to farmers in national currencies rather than in euro so that devaluation would avoid an increase in farming incomes in weak currency states.

But even this is not clear-cut. While it is true that UK agricultural incomes rose by more than 15&percent; last year after slower growth in 1993 and 1994, Italian incomes shrank by 8&percent; in 1993 and 5&percent; in 1994 before rising by 5&percent; in 1995.

Talk of invoking trade safeguards to defend the Euro bloc against cheap Italian, Spanish or British cars is, quite simply, bizarre.

Giving the Commission a mandate to assess all the issues involved should give Paris just enough time to backtrack.

The whole thrust of Verona had nothing to do with exchange rate systems and punishment for wanton devaluationists, but everything to do with convergence of macro-economic performance.

At the heart of this is German Finance Minister Theo Waigel and his plan for a 'stability pact' to enforce the Maastricht Treaty's rules on fiscal discipline inside a monetary union.

Never mind that it will not be the child he originally foresaw, boasting automatic fines for missed budget-cutting targets and an institutional structure to impose them.

In fact, the man who oversaw a rise in the German budget deficit from 0.5&percent; of gross domestic product to 5&percent; can be happy that his stability message has been swallowed whole across the EU - right from the 'ins' to the 'outest of the outs'.

Again, to quote Sir Nigel Wicks: “The essence of the proposals is very much in tune with the spirit of the age. If you look around the world outside Europe, there is a consensus that budget deficits should be low and, indeed in some countries, there should be budget balance.”

The job of the Commission over the coming months is to put communautaire flesh on the bones of the stability pact and the ERM II - two sides of the same coin.

The Commission will work on the basis of the existing convergence programmes, but ensure that targets and detailed measures on how to meet them are drawn up at least partly at Union level.

If countries outside the Euro bloc - whether in the ERM II or not - achieve price stability and tight budgetary control, this will instil the kind of international investor confidence needed to stabilise their exchange rates.

At first glance, Verona agreed nothing. But a second look reveals it augurs a new monetary order.