Does EMU need political union?

Must Emu lead to greater political integration? Emu does not necessarily entail more centralisation but could be a catalyst for reform of Europe's institutions
June 19, 1998

The Brussels summit at the start of May confirmed what had been evident for some time: Emu will be launched on 1st January 1999 with 11 participating countries. This confounds the sceptics, who have been forced to switch from saying that Emu will not happen, to arguing that it will not work; and vindicates those of us who have been predicting for several years a full soccer team participation. Now the task for everyone-governments, people, companies -is to understand the implications of Emu. How will it work? How will it influence the future development of the EU? In particular, will Emu lead towards a United States of Europe, the federated Europe that British citizens and politicians find so unappealing?

Much has been written about the advantages of Emu and its potential problems. The euro will eliminate currency risk and the need for currency conversion, easing the task of those who trade in Europe. Consumers, tourists and businesses will benefit, irrespective of nationality: thus Europeans, but also Americans, Asians and other non-Europeans will reap the benefits. The elimination of currency risk is especially important for companies making long-term location decisions, the outcome of which can be disrupted by currency misalignments which cannot sensibly be hedged. The euro will bring greater transparency to trading across national boundaries, resulting in more competition and greater efficiency, to the benefit of consumers. It will also permit further development of the single market, which goes beyond the level of integration envisaged in Nafta, Asean or Apec. Without the elimination of currency risk, such deep integration would be impossible. The independent European Central Bank (ECB) offers the prospect of low and stable inflation in the euro-zone, a benefit for the many countries, including potentially Britain, whose national central banks have not delivered this guarantee in the past.

On the negative side there is the question of how well Europe will cope with a "one interest rate fits all" arrangement, particularly in the face of economic disturbances which have a differential impact on countries in the euro-zone. The worry is that, without exchange rate flexibility, such disturbances will result in high and persistent unemployment in some disadvantaged countries, creating political strains within Emu. Other concerns focus on the possibility of undue political influence over the ECB-worries underlined by the ugly row over the appointment of the ECB president at the May summit and the scope for conflict between the ECB and EuroX, the committee of finance ministers, resulting in mismatches between monetary and fiscal policy. Large government liabilities arising from unfunded pension schemes in several European countries could add to the pressures on fiscal policy.

all to play for on emu

A rational consideration of these issues should recognise that Emu has both advantages and disadvantages; and reasonable people can differ on whether the former outweigh the latter. But all too often the debate has been polarised, with Emu seen as a glorious venture or an unmitigated disaster. A key point, seldom acknowledged, is that the success or failure of Emu is not yet determined; it will depend on policy decisions and actions not yet taken: all is to play for.

Critics paint a pessimistic scenario in which euro monetary and fiscal policy will be mismanaged, resulting in a volatile macro-economic environment in which governments fail to make their labour and product markets more flexible. Such an outcome could threaten the future of the EU. But you can also paint an optimistic (and, in my view, more likely) picture in which monetary and fiscal policy is managed well and the issue of labour and product market flexibility is addressed, so that the EU exhibits dynamism and cohesion. Much will depend on policy decisions made by national and European policy-makers over the next few years.

But these economic considerations are only part of the debate. Critics as well as supporters see Emu as part of a much broader process of integration which will transform the perception of the EU both within and outside Europe, for better or worse. How can we see through the mist of emotion and prejudice which has all too often surrounded discussion of these wider issues?

An important starting point is to recognise that the euro will be a crucial symbol of the European project. If it works well, it will increase awareness of Europe. The British who become accustomed to using the euro on holidays and in Oxford Street (whether or not Britain joins) will become much more aware of the EU. Americans travelling in Europe will see Europe as much more like the US, and perceive a greater economic and political cohesiveness, albeit combined with cultural diversity. The effectiveness of this symbol will depend on how well the euro performs. But the perception of the EU will be changed forever. It is even conceivable that the euro might bring home to ordinary people the relevance of European institutions.

In business, companies operating in Europe will have a much more integrated approach to managing their operations. The old criticism-that US managers saw Europe as a whole, and did not understand the differences between countries-will become praise. Companies concerned that their interests be represented in the public policy process will look increasingly to the EU, not to national governments.

At the government level, the US, Japan and other countries will also look increasingly to the EU as the focus of influence in Europe. To an extent, this has already happened. The EU has played a key role in the recent World Trade Organisation (WTO) agreements on telecoms and financial services; before that, the European Business Forum was important in the debate over the Uruguay Round, which led to the creation of the WTO. More recently, the EU has been proactive in the European/American dialogue on removing impediments to trade, around the idea of an "Atlantic marketplace." Fears of a "fortress Europe" have proved groundless; the EU has proved a crucial force for trade liberalisation. These trends will be accentuated by the euro.

The big uncertainty is how European institutions will evolve. Three separate questions arise. First, will Emu develop centrifugal tendencies, leading to the centralisation of macroeconomic policy-making? Second, how will the euro affect relations between Europe and the rest of the world, notably the US? Third, will the logic of euro decision-making hasten a two-tier Europe?

The launch of the euro represents a significant expansion of central powers within the euro-zone. Participating countries will hand over their monetary independence to the ECB. Their power to regain monetary independence will be limited, both politically and practically. Emu also brings constraints on the conduct of fiscal policy. The Maastricht treaty, supplemented by a growth and stability pact, forces national fiscal policy not to exceed deficits of more than 3 per cent of GDP, except in case of severe recession. Critics of Emu argue that with one arm of policy chopped off by the loss of independent monetary action to combat recession, the other arm will be tied down by limiting the scope for national fiscal policy. This argument is flawed. To provide fiscal room to manoeuvre at a national level within the constraints of the stability pact, governments need only aim for low deficits, between 0 per cent and 1 per cent of GDP. This will leave them with an adequate margin for fiscal flexibility in the face of mild recessions. In the event of severe recessions, the stability pact provides for an override.

You might object that this imposes the constraint of near-balance on fiscal policy. This is true, but it is desirable. Just as the Maastricht process encouraged the desirable move from excessive deficits to moderate deficits, so the stability pact will encourage the move to near-balance. As Gordon Brown has argued, prudence in fiscal policy offers the best prospect for stability and growth. Low average deficits result in lower interest rates, to the benefit of investment, and a competitive exchange rate, boosting exports without inflation. This is equally true of the euro-zone as it is of national economies.

fiscal harmonisation required?

Will these spending constraints be the sole limits on national policy-making, or will other constraints develop over time? The euro could lead to a single fiscal policy, with harmonised tax systems across the different countries. This would correspond to the single currency federation, created in the last century, that is now Germany. But there is an alternative model, of which the US is an example. This combines autonomous fiscal policy at the level of the individual states with a federal system of taxes, spending and transfers. The euro-zone is still a long way from both these models. But does this mean that it will necessarily embrace them both, moving first towards the US model and then on to the German one, as critics of Emu fear?

No doubt there will be pressures towards a common fiscal policy. By eliminating currency risk, the euro will make it easier to exploit differences in national tax rates, leading to pressures for tax harmonisation. This is of particular concern to countries such as Britain with relatively low tax rates. Moreover, differences between economies could lead to pressure for fiscal transfers from those countries within Emu in boom to those in slump. Big external disturbances which affect Europe as a whole, such as oil price hikes or the Asian crisis, may also lead to calls for a common fiscal policy. National responses which take into account only the direct impact of such disturbances, and not the policy responses of other European governments, could lead to a sub-optimal response.

The case for fiscal harmonisation can be overstated. The introduction of the euro may increase the pressure for convergence of certain tax rates, especially on those factors-notably capital-which are highly mobile. But no such pressure applies to immobile factors. A common criticism of the euro-zone is that, in contrast to the US, it lacks labour mobility, and will therefore respond poorly to differential shocks. But critics often fail to appreciate the corollary: this lack of mobility means that harmonisation of taxation on labour incomes is not necessary.

Even if convergence of tax rates were required, it could take two forms. One is top-down, a Bismarckian or Napoleonic process of central decision-making, laying down what national governments should or should not do. The other is a Jeffersonian process of market pressure, where national governments respond to market pressures in setting tax rates. The latter opens the prospect of a race to the bottom, but this need not be so. If governments can use national tax revenue to good effect (by raising the labour skills and encouraging investment and R&D) a regime of higher taxes could prove superior to one of lower taxes; and therefore sustainable in the face of international tax competition and the absence of European-wide coordination.

Similar points apply to the response of fiscal policy in the face of external disturbances, such as an oil shock. With sufficient exchange of information between national governments within the euro-zone, the need for EU-wide coordination is not evident. Emu may be able to work well with no more fiscal coordination than that laid down in the Maastricht treaty and the stability pact.

Whatever the pros and cons of these arguments, a crucial point for Britain is that they are likely to be debated within the EuroX or Euro-11, in which Britain has no voice. It may be that the formal decisions have to be made in Ecofin. But voting arithmetic determines that decisions made in EuroX will carry the day in Ecofin. Britain's enforced absence from EuroX is likely to favour the advocates of greater fiscal centralisation.

The Euro and international economics

The launch of the euro will alter international perceptions of the EU. Unless it goes badly wrong, the euro will be adopted as a vehicle currency for international trade and will partially replace the dollar as an international reserve currency. Companies around the world will choose to raise equity or debt finance denominated in euros, to take advantage of the deep and liquid financial markets which Emu will bring. International institutions such as the World Bank and the EBRD will increasingly raise and lend money in euros, as the recipient countries come to see the euro as a convenient currency for borrowing. And the growing use of the euro by the rest of the world will raise international awareness of Europe as an entity.

International institutions such as the IMF, World Bank and the G7/G8 are also bound to evolve. At present, European countries are over-represented in these institutions. It is hard to justify an arrangement in which four European countries (France, Germany, Italy and Britain) are members of the G7. The shifting balance of the world economy will lead to pressures to include broader interests, such as those of Asian countries outside Japan.

The euro will accelerate this trend. An important focus of the G7 summits is the conduct of monetary and fiscal policy at an international level. With European monetary policy controlled by the ECB, there will be little justification to include in the G7 process those national central banks which are part of Emu. There is a strong case for moving towards a G3 arrangement (US, Japan and the EU) to consider the international coordination of monetary and fiscal policy, with an implied demotion of Canada and the individual European economies.

But there is a problem with the rationalisation of these institutions: who will represent European fiscal policy in the G3 or other international forums? Euro monetary policy will be determined by the ECB, and will be represented by the president of the ECB. By contrast, euro fiscal policy will be determined by the aggregation of the national fiscal policies set by the 11 governments participating in Emu. It seems likely that this gap will provide another drive for change. The country which chairs the EuroX subcommittee of Ecofin may emerge as the representative of euro-fiscal policy, alongside the president of the ECB. But such a development is likely to be resisted by national governments which currently enjoy the over-representation.

how will The EU institutions Evolve?

The institutional arrangements designed for the original six founder members are barely adequate for the current 15 countries and will gridlock with expansion to 25 or more. Emu might be a catalyst for institutional change.

Emu represents a shift in the development of the EU. It is the first EU project to envisage from the outset two tiers-them and us-and to embody this distinction in treaty form. This distinction is drawn in two ways: first, by allowing two countries (Denmark and Britain) an explicit opt-out from the main Emu arrangements; second, by laying down explicit criteria for participation which could, in principle, indefinitely prevent certain countries from joining. Previous initiatives, such as the common agricultural policy, the early tariff harmonisation process and the later single market, allowed laggards in the process of implementation, as well as some individual tailoring of provisions, but not exemption altogether. The 1990 Schengen agreement, which provided for early abolition of passport checks within a subset of EU countries (Benelux, France and Germany, since joined by all except Britain and Ireland), was a non-EU initiative, but it was perhaps a harbinger of the deal over the Maastricht treaty which followed. Some argue that the Maastricht treaty represents a shift away from a "table d'h?te" EU to an "?  la carte" union-sometimes described as "variable geometry." Such arrangements allow each member to choose those elements of the EU which suit it best.

At the same time a different trend is at work. The increase in qualified majority voting, as opposed to voting by unanimity, makes it harder for individual states to choose the parts of the EU they prefer. As a result of the Emu process, we see the growth of Emu-"ins" institutions: the ECB is an obvious example; another is the EuroX subcommittee.

Other Emu-"ins" institutions may develop. This could lead to an inner and outer division within the EU, not just with respect to Emu. This could help to solve the problem of EU governance which will arise from enlargement of the EU to the east and south. If the current trend continues, the EU could move towards an inner core of "ins" and an outer periphery of "outs." The "outs" would not have to assume all the requirements of membership: they could pick and choose from the ?  la carte menu; but they would have less decision-making power as a result. The "ins" would have to swallow the table d'h?te menu whole, but would also have greater powers to influence EU directions.

Critics point out that a move to a core/ periphery structure within the EU would represent a fundamental change. It would therefore require a treaty amendment which any member state could veto, thus making it unlikely. This does make development of the EU in this direction difficult. But if the deficiencies of current decision-making become more apparent, it may not be easy for member states which oppose further integration to stand in the way of those who favour it. If they try to, the inner core could, in the extreme, go its own way and sign a new treaty.

We do not know what the future direction of the EU will be. It could be a decade or more before these issues are worked out. At stake are two visions of how cooperation between sovereign states should develop. On the one hand, the ?  la carte approach suggests that bargains should be struck between member states on an issue-by-issue basis, with countries deciding whether or not to join in, based on whether the proposed bargain is judged to be in their interests. The table d'h?te approach, by contrast, requires commitment by countries to all agendas. Each country will participate if it derives benefit overall from the net impact of all the agreed policies, even though some individual policies may work against its interests.

At first sight, the ?  la carte approach seems more attractive. By choosing only the advantageous elements of the policies on offer, countries can maximise benefits. But this may not be so. By linking different agendas, the table d'h?te approach allows, at least in principle, for a wider range of bargains to be struck, with countries making concessions on one agenda to derive beneficial policies on another, thus generating deeper cooperation.

This will not suit some countries; it is a trend which could lead to a unitary European state. But it is not clear that those countries which oppose such a route need to or should stand in the way of those wishing to follow it. It is right for Britain to argue for EU enlargement as a policy priority, and to suggest that deepening should not stand in its way. But it is also right to acknowledge that this requires a change in EU decision-making processes, to ensure that enlargement does not lead to paralysis and does not stand in the way of further deepening.

the lessons of history

Does Emu necessarily entail much greater European centralisation and the move towards a United States of Europe? Some historical lessons can be drawn from the experience of regions which have successfully moved to a single currency in the past century or so. There are four examples: Germany, which came together in political and economic union in the 1860s under Bismarck; Italy, which formed a looser political and economic union in the 1860s and 1870s; the US, which forged its federation from the civil war; and Switzerland, whose separate cantons came together from the 1850s onwards, adopting a common currency in 1870. A feature common to these cases is that monetary union took place in the context of the gold standard, which gave little autonomy to national governments anyway. Today's European states will, by contrast, be giving up real powers of independent monetary policy.

Nevertheless, some lessons can be learned from these past experiences. First, monetary union operated for a considerable period without significant fiscal transfers through a central budget. This is not surprising, given that governments in the 19th century and well into the 20th century were small, and taxes were low. This gives support to those who argue that Emu can operate without significant fiscal transfers between member states.

Second, the countries in our examples varied enormously in the extent to which political union preceded or followed monetary union. In the US, political union came first, and the national currency was introduced swiftly by the victorious north as a symbol of the new political federation. In Germany, too, Prussian power was the primary force for integration, and economic and monetary union followed behind. But in Italy, the political forces for integration were weak (a fact which persists to the present day), and economic and monetary union ran ahead of political union. And in Switzerland, the political powers at the centre of the federation were weak at the outset and have remained so; while the centre has gradually acquired more powers, substantial powers have remained with cantons, the second tier of Swiss government between the federal level and the local (commune) level. This suggests two things: monetary union can precede political centralisation, and the degree of political centralisation required can be limited.

Third, in some of these countries the move to monetary union was not at all smooth. Although the US Federal Reserve system works very effectively today, its evolution was far from smooth. For much of the 19th century, US banking lacked any form of central control or regulation and bank failures were rife. The evolution of the Federal Reserve system to its present form took several decades and was characterised by struggles for influence by the emerging reserve banks of the key states. In Italy, too, evolution of efficient techniques of monetary control and the resolution of conflicts between different parts of the union took time. The modern Emu venture may experience similar instabilities, although the detailed plans being worked out from the Maastricht blueprint by the EMI, followed by the ECB, should avoid the worst of these.

In a sense the EU is already a loose federation. It has seen a progressive strengthening of the powers of the centre relative to member states; first with the Treaty of Rome, signed in 1957; then with the Single European Act of 1986; and most recently with the Maastricht treaty of 1992. Many of the additional powers passed to the federal level in the Maastricht treaty have little to do with Emu: they have to do with the additional powers of the European parliament, increased areas to which qualified majority voting applies, and new policy "pillars" such as foreign policy.


It is appropriate for those who argue that Britain should leave the EU to inveigh against the evils of European federalism. For the rest of us, the relevant debate concerns the form of federation that we want, not whether we want one. A strict application of the principle of subsidiarity (taking decisions at the lowest appropriate level) would imply that Brussels and the centre get involved in those areas of policy that can only be effectively handled at the centre, and let go of the others. This could be a slim, decentralised federation, along Swiss lines. Or Europe could go in a highly centralised direction, moving closer to the model offered by nation states such as Britain and France.

The debate on Emu, and the EU more generally, is not helped by using the term "federal" as an absolute term. The choice for Europe is not between a federation and a non-federation, but rather the appropriate degree of federalism. For the foreseeable future, the only realistic possibility is some adjustment of the loose confederation which already exists. In the longer term, unless this embryonic federation grows into a tighter, more cohesive federation, it might unravel. But the key question concerns the domain over which coordination is required. Those in Britain who are not euro-sceptic must argue for a limited, Swiss-style centralisation, leaving to national governments the maximum range of powers consistent with the effective working of the euro-zone.

Does Emu represent a challenge to such limited centralism? The answer is: no. The euro will bring in its wake forces for convergence, but these may be tackled by national responses, not necessarily by much greater centralised EU-level coordination.

This skates over the politics of the issue. With Britain voluntarily outside the euro-zone, its influence on policy developments will inevitably be diminished. In so far as other countries favour a more federal structure, Britain's power to negotiate for a more decentralised system will be weakened.