Out in the Cold?
By Luigi Spaventa

The Maastricht Treaty implies the existence of an exchange rate arrangement for the euro with outside Union currencies: the observance of normal fluctuation margins around a recognized parity is a condition for later admission. But with the single currency, the EMS will cease to exist. The Treaty is silent on a plausible alternative. What’s more, it is legally difficult to establish one since exchange rate arrangements in Article 109m are considered only in relation to non-EU currencies. Conflicting interests make a solution difficult. Potential insiders want outsiders’ exchange rates under control to deter competitive devaluations. But they fear that an arrangement with weaker currencies would pollute the purity and endanger the reputation of the newly-created European Central Bank (ECB).

For the UK, for which non-entry is a voluntary choice allowed by the opt-out clause and not the result of exclusion, participating in a system devised for countries with a derogation would blur its status. Non-participation may just be one opt-out too many. For the outsider wishing to enter but unable to do so because it does not fulfil the required conditions, the economic and political costs of exclusion are heavy: higher exchange rate volatility, greater exposure to external shocks, higher interest rates, and diminished weight in EU decision-making. A link with the euro is desirable because it would alleviate those costs.

The basic choice is between doing without an exchange rate arrangement altogether or finding a successor to the EMS. In the British (or Anglo-Scandinavian) view, a formal arrangement is neither necessary nor desirable: mandatory and coordinated inflation targeting for all members is thought a better and more effective way to achieve stability and convergence. But this solution has severe drawbacks. Inflation targeting is a medium-term exercise, better suited perhaps to ensuring peaceful coexistence with currencies accepting indefinite outsider status, but less relevant to a country seeking later admission at a certain date. Its exchange rate stabilizing effects are uncertain, especially in the presence of external shocks.

The Treaty conditions for admission include both an inflation target and an exchange rate condition. Hence the UK position implies that one of the Treaty provisions should be disregarded. But why only that one and not others that are equally questionable? The majority of participants in the Verona Council opted for an EMS 2. The known argument against the revival of a system of ‘fixed but adjustable parities’ (the oxymoron that defines the EMS) is that it cannot be both credible and stable since unlimited and unconstrained interventions, preventing speculative attacks from being self-fulfilling, conflict with a central bank’s commitment to price stability.

The 1992 crisis is invoked as conclusive evidence. This is not fully convincing. After a remarkably tranquil life, the EMS suffered from excessive inflexibility in the presence of a powerful shock and growing misalignments. Fundamentals are far more aligned now than they were in 1992. More importantly, a reconstructed EMS should not be a permanent arrangement. Rather, it should be conceived as a bridge to the single currency: each country’s degree of convergence to the conditions required for admission should become a crucial determinant of the credibility of its membership. For that to happen, the system should be based explicitly on conditionality.

In Verona, agreement was reached on a few broad guidelines: the system will be flexible, anchored to the euro and with a band around central parities; it will be asymmetric, with the burden of adjustment falling on the outsider; and there will be compulsory bilateral interventions at the margin, but the ECB can invoke a suspension clause when its control over monetary stability is at risk, and it will have the power to trigger realignments.

The risk of an unsatisfactory outcome is far from remote as many problems are as yet unsolved: Hub and spokes would be more compatible with a flexible setting of the band widths than a grid of parities; Conditionality tailored to the situation of each outsider would be better served by bands of different widths, according to each country’s progress towards convergence; Unless the Treaty is changed, membership should be compulsory for a country seeking later admission. No country should be denied membership,but if its track record is bad, its currency can be assigned to the widest band, with no support unless that record improves.

Conditionality is the key issue. The ECB decision to invoke the suspension clause for interventions cannot be left to unmotivated discretion, but should be made, and known to be, contingent upon precise conditions. Withdrawal of support if and when the ECB judges that it conflicts with its ability to control the money supply is a sure recipe for trouble. As speculative pressure can always be brought to whatever point the ECB considers to be the limit beyond which further support would cause loss of control over monetary conditions, markets will always win the day. Pre-set conditionality based on an IMF-type programme for the extent and speed of convergence is the desirable alternative: compliance with the programme would entitle the outsider to unlimited support; lack of it would sanction unjustified underperformance. This rule protects the performing outsider against unwarranted speculative shocks. At the same time, it allows the ECB to intervene less, as there would be no support for the underperformers, while the performing currency would not be attacked once markets are aware that support is unlimited.

A conditionality rule raises an institutional problem. The Treaty does not allow a repetition of the procedure that gave birth to the EMS, with a Council resolution defining all the features of the system and an agreement between the participating central banks merely laying down the operating details. Following a lead by the Council, the essence of the arrangement will now find its place in an agreement between central banks. But the definition of conditionality and the assessment of performance properly belongs to the Council and other Union bodies and not to an independent (and unaccountable) central bank. Thus a conditionality rule may require an extension of the provisions of Article 109m to Union currencies.

The difficult task ahead is to reconcile two seemingly conflicting requirements: providing the deserving outsider with a safe route to joining the single currency; and preserving the ECB’s freedom in the pursuit of price stability. By providing a transparent benchmark, a conditionality rule represents a sensible and acceptable compromise. Attempts to tilt the balance towards the second requirement, by leaving the decision on interventions contingent upon the ECB’s discretionary judgement about their effects on monetary conditions, would produce an intrinsically unstable system. It would also offer no benefit in terms of the size of interventions and could cause irretrievable damage to deserving outsiders.

Luigi Spaventa is Professor of Economics at the Università di Roma ‘La Sapienza’, a Research Fellow in CEPR’s International Macroeconomics programme, a former Minister of the Budget in the Italian government and a member of the Board of Banca Nazionale del Lavoro.