For nearly 50 years, Europe has been on a course of ever-widening and -deepening integration. For just as long, Germany has been building a reputation as the global champion of hard money to which the deutsche mark stands as its monument. The proposed monetary union to create a common currency in Europe joins these two strands: Europe gets German monetary integrity, and Germany blends into Europe.

The Maastricht Treaty, concluded in December 1991, is the pre nuptial agreement for this marriage. However, on the way to union doubts loom larger than joy. Still in question are the benefits to be derived, the suitability of the partners, and relations with outside parties. These questions are particularly acrimonious because the tight timetable (see p. 112) for converting to a common currency destroys illusions, as does Europe's poor economic performance. Europe has 18 million unemployed, and no one knows what to do with them. German Chancellor Helmut Kohl, German industry, and German banks all agree that the common currency, provided under the European Monetary Union (EMU) is a must. Promoters of "social union" are equally eager; they see integration as a way to ameliorate an economic system that they regard as having too much competition and too little social justice.

Those who question the drive toward a common European currency include monetary hawks, that is, most of Germany's population and its central Bundesbank; excluded bystanders, such as Central European countries; and benevolent spectators in the United States. The prospective partners in EMU who financially live from hand to mouth -- France, Italy, Spain -- are cheering monetary union. They still believe it is a miracle cure for rotten public finance and generations of debased currency, but they are also wincing as they are weighed in for the race to the Maastricht goal. Meanwhile, Britain is searching its soul. The Labour party wisely is favorably inclined toward the monetary union -- a safe and pragmatic strategy with which to tear the Conservatives apart.

Achievement of a common currency is being touted as Europe's event of the century even as its real impact is in doubt. EMU could create a powerful and vigorous Europe, politically and economically cohesive and financially strong enough to dwarf the United States and the dollar. Or it might turn out to be a nonevent. Then again, financial markets might blow it away before it even starts, or bureaucratic bean counters might strangle it by rigid application of the Maastricht tests (see p. 112), thus ruling the partners unfit to consummate the union. The most likely scenario is that EMU will occur but will neither end Europe's currency troubles nor solve its prosperity problem. Euro-fantasies envision EMU as a panacea, or at least a pivotal step toward making Europe wonderful -- politically, culturally, economically, socially, financially. Do not hold your breath.


In the past few months, the probability of a European Monetary Union has increased. The turning point was undoubtedly the French government's success in facing down labor opposition and pushing through the bulk of the government's budget cuts. The French also pushed their interest rates below German levels, demonstrating that in the EMU context France could be a hard-currency country. The performance impressed Kohl and gave him confidence that Germany and France could pursue monetary union together.

So EMU has gone from being an improbable and bad idea to a bad idea that is about to come true. High unemployment, low growth, discomfort with a welfare state that is no longer affordable -- all these issues have found new hope of resolution in a desperate bid for a common money, as if that could address the real problems of Europe. On the contrary, the hard work of attaining a common currency, meeting the demanding Maastricht criteria for admission to EMU is adding to the burden of an already mismanaged Europe. The struggle to achieve monetary union under the Maastricht formula may be remembered as one of the more useless battles in European history. The costs of getting there are large, the economic benefits minimal, and the prospects for disappointment major.

At the outset, European integration was a historic move to bring Germany and France together and thus avoid the recurrent wars that have plagued this century. Then European integrationists developed bigger ambitions -- the creation of a common market with no obstacles to trade in goods and services or the movement of people. Monetary union was seen as the next step on the way to full union. Even as that agenda is being implemented, the circle of candidates for inclusion in the European Union (EU) widens, public disenchantment grows, and the contradictions between enlarging the circle and deepening the integration of members become more apparent. Kohl has recognized that unless he pushes hard for EMU, the concept will fall by the wayside, and he is not alone. The French, too, want EMU. Their reason is surely not to build bridges that avoid future conflict -- Germany and France by now are as tight as the United States and Canada. The reason is that no French minister of finance dares go to bed not knowing where the franc will be in the morning. Monetary union will allow them a good night's sleep, the first in a decade. And then there are all the other candidates who are trying to get a bit of credibility for budgetary policies and currency rates that do not quite make it without membership: Ireland, Belgium, Scandinavian countries, Italy, and Spain.

By April 1998 the key membership decisions will be made; by 1999 currencies will be pegged to each other; by 2002 there will be only the new currency, the Euro. But that won't be the end of the story. Frustrating relations between the included and the excluded countries will jeopardize much of the gain from adopting a common money.


There is virtually no country, including Germany and France, whose budget today meets the Maastricht criteria. As a result, all Europe is simultaneously plunging into budget-cutting and will likely suffer an economic slowdown. These reductions are appropriate even without emu, but their timing and size will add to its ultimate cost, stunt growth, and raise unemployment. Monetary authorities in these countries have shown no inclination to accommodate these consequences. They have their own agenda of holding tightly to the criteria until the last moment on the timetable, thus shaping the "right" attitude for the new central European bank. The combination of overly tight monetary policy and determined budget-cutting suggests a tough time ahead for Europe.

An even more important issue is what happens to those who cannot or do not want to be part of the monetary union. Britain has shown an aversion to full inclusion. British pragmatism stops at the proposal of inflation-targeting as the common bond. Joining the monetary cult is too much.

Italy, with its undervalued currency, poses another problem. France wants Italy to be in so that further competitive depreciation becomes impossible. But once Italy is in, with an appreciated currency, the country will soon be back on the ropes, just as in 1992, when the currency came under attack. The matter of the "outs" comes down to a simple question: What can be offered to Britain and Italy to induce them to join the emu club? Germany's unlimited, unconditional defense of their currencies is enough of a reward for Italy. Predictably, Germany is utterly unwilling to take that offer, leaving France sulking in the wings. Everybody is waiting and hoping that Italy and Britain, the soft currencies when the Maastricht Treaty was enacted in 1992, will make it a point of pride to show that they are European, they are willing to be hard-currency countries, and they will do the pushups necessary to join. Do not wait for Britain; the Labour government has as much trouble at home with the proposed Social Charter as with the European Central Bank.

Assuming emu is a foregone conclusion, vital questions remain about whether inclusion is the right choice for various parties, the potential for economic benefits, the expected role of the European Central Bank, and the amount of sovereignty emu members will give up.


Without Germany and France, of course, there will be no emu. For Germany, emu is a political step reflecting the deeply held belief that domestic stability requires an unbreakable link with France; nothing else matters in this context. Few north European advocates of emu lose sleep over the exclusion of Greece, Portugal, even Italy or Spain. Assuming France and Germany are founders, how will they structure the debate about fulfilling the Maastricht criteria? Where will they draw the line between the "ins" and "outs"?

The present financial condition of most European countries suggests that a narrow reading of the Maastricht criteria sets too-high ratios of debt to GDP and deficit to GDP. Moreover, undue optimism about the strength of a 1997 economic recovery is pervasive. Without a solid recovery, everybody's deficit numbers will look far worse, and prospects will be dim for meeting the Maastricht requirement of a deficit below three percent of GDP. Politicians may not be able to afford to let the market toss around these questions for the next two years. A more likely and practical scenario is that an assumption will be made that France, Germany, and a small group of nations are progressing toward monetary union. They will lay out a demanding three-year program of fiscal adjustment that puts them below the Maastricht targets by 1998. That will serve as a justification for fudging a bit by these countries on the strict criteria for emu entry.

Which other countries will also be allowed to fudge? Belgium cannot pass even a fudged test unless its debt is written off; it now has twice the maximum indebtedness allowable under the Maastricht Treaty. There is an interesting precedent in the country's 1926 overindebtedness and funding crisis. In a forced consolidation, Belgium gave the national railways to bondholders, an approach that Belgium's plentiful supply of public enterprises would allow today. Belgium is a northern European darling and hard-money partner, which ought to call for some special concessions.

Italy is surely off the list for immediate consideration, even though German and French industry want to put Italian competition on a short leash by excluding competitive currency depreciation. The fact is that they cannot; Italy has such high debt and deficit levels that it could not be cleaned up enough to pass German scrutiny for first-wave entry into emu.

There is an overriding issue in the "ins" versus "outs" debate. Monetary union is like marriage between partners of very unequal assets. Prenuptial arrangements are naturally the rule and must be followed closely. But when the passion is gone, the agreements endure. In forging the agreement, German bondholders, who have the most to lose, rule supreme. While France has oscillated between hard and soft money, Germany has built a strong, consistent coalition of bondholders and the Bundesbank. Kohl would make a big mistake if he threatened the bondholders, who are savers and who fear, if not remember, debased currency. For that reason, Italy will not be a first-wave entrant, since German bondholders view it (rightly or wrongly) as the incarnation of monetary delinquency. A credible case for fudging with the Maastricht timetable can be made for Germany and France, but not for countries with bad fiscal reputations.

If there are "ins" and "outs," which is it better to be? For Italy, out is clearly better initially. Because the French are tied in knots over Italian competitiveness and fear another round of competitive depreciation, they are willing to make deals to help Italy come on board. For Italy, the key to making exchange rate commitments will be an offer from Germany of "unconditional, unlimited intervention" in support of the lira. Hell will freeze over before that comes about. Yet Italy could gain from professing interest in emu membership; doing so would help in the country's inevitable fight over its own budget. More important, a public request for membership is a signal to investors of Italy's economic intentions, which helps bring down interest rates and improve the budget.

If Germany and France do initiate emu as expected, a structured process to incorporate the "outs" would follow. But because Germany will not offer exchange rate guarantees, much of the burden would fall on the "outs" who will have to lay out their convergence programs and do the work. Italy will be urged to consolidate its public finance. London will feel pressured by the prospect of losing large amounts of financial business to Frankfurt. As emu gets under way, the pressure on the "outs" will increase because including them is essential to ultimate emu success. For stragglers like Britain, who are indifferent or picky, the strategy will be to raise the ante. For financially tainted, would-be mem bers like Italy, it will be to push harder.

The emu is a particularly difficult issue for Eastern European countries. They are on a slow course of incorporation into the European Union but remain financially weak. Were emu an integrating mechanism, early inclusion would be critical. But this aspect of emu is overdone. An option for "out" countries like the Czech Republic and Poland would be the adoption of the euro as their national currency, just as Argentina has effectively done with the dollar. Such a move would help with financial stability, but it would come at the cost of losing the exchange rate as an adjustment tool.


Whatever persuaded European leaders in 1991 to single out money as the key vehicle of political integration, it is a poor choice. Money at its best is apolitical, and the European central bank will accomplish that. Leaving aside the political benefits, if any, from integrating currencies, can economic gains be reaped? emu is unlike the all-important customs union and the brilliant scheme of completing the internal market. Those dramatic initiatives carried incentives to make the European market, desperately uncompetitive and segmented as it was, into one large unit. The imagination was captured by the vast and highly competitive U.S. market, and the initiative was both bold and worthy. emu has little of that.

Currency integration will bring two benefits in two ways. First, the elimination of cumbersome money-changing will make transactions more convenient and reduce the costs of making payments. Second, exchange-rate volatility will be reduced, to zero in fact, and businesses will be better able to trade and invest across intra-European borders. But by itself a single market does not mean integration of the means of payment. The value of a euro in Barcelona will not necessarily be computed the same in Berlin until and unless a transfer system, akin to the U.S. Federal Reserve's inter-bank wires, is accompanied by a requirement to clear all checks at par. Such a requirement, which would protect against stiff and varying charges by oligopolistic banks, is vitally important to business.

Minor gains in the stability of the deutsche mark-franc rates could be more than offset by the increased volatility of rates to outside markets and investors. Were that so, trade integration would be captured by the "ins" at the expense of Europe's "outs" and the rest of the world, from Eastern Europe to the United States. However, there is little evidence that currency volatility, low as it has been, is an impediment to trade. As a result, reduced volatility between the "ins" will not change the landscape of trade and investment in Europe much. In the meantime, it can be used to pressure countries like Britain to be in or really out.

Will Europe, governed by one money, do fundamentally better? The French view is emphatically positive: if Italy cannot devalue anymore, it cannot steal French jobs. Thus for France, one money is great. But its enthusiasm is based on a fallacy, because what is at issue is the real rate of exchange adjusted for costs. If the nominal exchange rate cannot change, for equilibrium the real rate must change. Expect wages and prices to do the work. The French may be right to believe that it is far more difficult to make adjustments by deflation than by devaluation. But that is small comfort.

In countries with highly flexible wages, the exchange-rate regime makes little difference. In countries with rigid labor markets, like most of those in Europe, flexible exchange rates are all-important. The most serious criticism of emu is that by abandoning exchange rate adjustments it transfers to the labor market the task of adjusting for competitiveness and relative prices. Without wage flexibility, the adjustment process is frustrated; losses in output and employment (and pressure on the European central bank to inflate) will predominate. The overriding cost of an integrated monetary area is that nominal exchange rates disappear as an adjustment mechanism. If a region goes into decline, say, because its exports become obsolete, deflation has to take the place of devaluation. If a region experiences a boom, say, because it has superior research, education, and trade performance, inflation takes the place of ap preci ation.

Exchange rates as an adjustment tool have a good history, Mexico and Latin America notwithstanding. Forcing adjustment into the labor market, the European market with the poorest performance, is bound to fail. In backward regions unemployment will rise, as will social problems and complaints about integration. If exchange rates are abandoned as an economic tool, something else must take their place. Maastricht promoters have carefully avoided spelling out just what that might be. Competitive labor markets is the answer, but that is a dirty word in social-welfare Europe.


The creation of a European monetary union is not a natural part of the process of trimming sovereignty in favor of a more integrated Europe. It is not a first step, with foreign policy and defense naturally following soon. On the contrary, depoliticized money is the ambition around the world. Creating an independent central bank in New Zealand or Chile is mostly the same as creating a European central bank. The intent is to transfer the regulation of money from short-sighted and politically vulnerable legislators to conservative managers who have long time horizons and are accountable only for what they achieve.

In a European central bank, money management would be removed from national authorities. Even if money management were already institutionalized in an appropriate way, as in Germany, it would simply be moved up one layer to a Europe-wide level. For many European countries, that would be the only way to liberate their central banks from political influence -- literally to move them into a single out-of-town house. For others, it would be merely a lateral move, from an independent body shadowing Germany to one subsuming it. The point is: good central banking is apolitical, and the more apolitical the better. That is what a European Central Bank is all about. And that is why emu is not a transfer of sovereignty over money but a Europe-wide abdication.

Money management by a central bank, of course, is unlike defense and foreign policies, which are intrinsically political. In defense and foreign policies, citizens broadly want peace (most of the time), but that is where agreement ends. The task is reconciling conflicting national objectives, views, traditions, or cultures. In money management, everyone wants the same thing -- stable money. So in defense and foreign policies, the transfer of sovereignty means giving up something real and precious. Giving up nationally managed money is just kicking a bad habit! The difference could not be greater.


Italians dream that the European central bank will make their life easier than the Bundesbank does now. For Germans the prospect is a nightmare. Their fears are unjustified. The new central bank is certain to establish itself at the outset as a direct continuation of the German central bank, the current pillar of European monetary orthodoxy. This result is assured by the narrow rules of the game but even more by other factors. Those selected for the board of a central bank, in the spotlight of public attention, immediately turn conservative, as has routinely happened at the U.S. Federal Reserve. As member nations will also want their representatives to be influential, the European central bank is likely to be composed of prestigious conservatives. Of prime importance will be the board chairman, who will chart the bank's course with no precedents in place. If, as now seems likely, Willem Duisenberg of the Netherlands central bank heads the European central bank, the assurance of hard money is carved in stone. After all, Duisenberg has on occasion expressed the fear that Germany could turn soft!

It is obvious the European central bank will be off to a good start, if that is measured by keeping interest rates high and inflation low. The trouble is that Europe by then may be in deep trouble: accelerated budget-cutting combined with tough central banking led by the Bundesbank spells trouble. Unfortunately, central banking in Europe does not buy into the concept that budget-cutting requires accommodating monetary policy. That means Europe between now and 2000 cannot expect much growth. Europe's new currency, far from creating prosperity, may in the end be blamed for a period of poor performance. If the current national central banks accommodate by easing monetary policy, growth can go on harmoniously and unimpeded. If central banks misread their role, deficit-cutting will wind up as a recessionary debacle, and emu will be blamed for it.


In setting up the Maastricht criteria, policymakers focused on avoiding pollution of the central bank's objectives by member countries' weak fiscal positions. High debt and deficits, from this perspective, are an invitation to monetization and "inflating away" of fiscal problems. At the extreme, treasury departments go straight to central banks to be accommodated. The separation of the two institutions is entirely appropriate. So is the current emphasis on smaller deficits, if only because of the vast unfunded pension liabilities on the horizon. But it is also true that the reasoning that screens out high-debt and high-deficit countries as threats to the integrity of a European central bank can be used against high-unemployment countries. In these countries, plausibly, policymakers will turn to a central bank to seek help -- a bit more money, a few more jobs. The incentive to inflate is just the same as in accommodation of jobs; inflating away debt is just as easy as inflating away unemployment. Neither may work, but the attempt or the expectation of an attempt will be counterproductive.

The implication is that emu should include an outright unemployment ceiling. Countries with more than, say, six percent structural unemployment should not be members. They should be required to undertake the structural and macroeconomic policies (including loosening economic regulations, reducing excessive benefits, etc.) that bring unemployment down to levels that are not a threat to the European central bank. If the Maastricht requirements were structured that way, they would initiate a supply-side revolution. Countries would be falling all over themselves to create jobs by deregulation instead of destroying jobs by taxation. Unfortunately, although the logic is impeccable, Europe's good economics have yet to reach the labor market.

Experimenting with a new money is a bad idea at a time when Europe must face the tough realities of abolishing the welfare state, reintegrating millions of unemployed into a normal working life, deregulating statist-corporatist economies, cultivating the supply side of its economy, and integrating Central Europe. The new money creates insignificant benefits at best while frustrating adjustment and restricting pragmatic cooperation. From outside Europe, a common money and the efforts necessary to get it are viewed as deeply misdirected and ill-timed steps that will make Europe a weak link in the world economy.

Although approving of the evolution of a European common market, the United States is fearful about emu. The first was seen as contributing to prosperity and thus political stability. The second is seen as carrying a high risk of contributing to recession and thus to political trouble, which has always been expensive for the world. Europeans, with their rose-tinted Euro-glasses, do not see that prospect. The U.S. skepticism comes from the belief that tying up currencies forces the adjustment elsewhere, resulting in high interest rates and high unemployment. Having lived through that when the dollar was overvalued in the 1960s, the United States has never been a fan of fixed rates. Watching the recurrent currency crises in Europe in the 1980s has reinforced that opinion. The United States has substantial flexibility in both wages and labor market institutions. With such arrangements it could conceivably enter a regime of fixed exchange rates. Europe has neither flexible wages nor functioning labor markets, but already has mass unemployment. Emu will add to it, both on the way there and once the system is trapped in fixed rates across vastly divergent countries. If there was ever a bad idea, emu is it.

You are reading a free article.

Subscribe to Foreign Affairs to get unlimited access.

  • Paywall-free reading of new articles and a century of archives
  • Unlock access to iOS/Android apps to save editions for offline reading
  • Six issues a year in print, online, and audio editions
Subscribe Now
  • Rudi Dornbusch is Ford Professor of Economics and International Management at the Massachusetts Institute of Technology.
  • More By Rudiger Dornbusch