D[~I1~JULY/AUGUSt 1995

Patricia S. Pollard is on economist at the Federal Reserve Bank of St. Louis. Jerram C. Betts provided research assistance.

EMU: Will It Fly?

Patricia S. Paftard

• n December 1991, the leaders of themember states of the European Union

~ met in Maastricht, the Netherlands, toconclude the negotiations on a Treaty onEuropean Union. The Maastricht Treaty as itis commonly known, encompasses a widerange of issues, from foreign affairs and secu-rity policy to citizenship, health and tourism.Primarily, however, the Maastricht Treaty isknown for formalizing the intentions of themember states of the European Union to cre-ate an economic and monetary union (EMU)by the end of this century. The main featuresof EMU are the creation of a single monetarypolicymaking body and a single currency forthe European Union.

While EMU seemed certain in December1991, within a year the outlook had turnedmuch bleaker. In a referendum injune1992, Danish voters rejected the treaty Thiswas followed by a series of exchange ratecrises affecting the European Union in 1992and 1993. Despite these setbacks, theMaastricht Treaty was ultimately approvedby all member states (a second referendumpassed in Denmark in 1993) and the treatyentered into force on November 1. 1993.In accordance with the treaty the EuropeanUnion is laying the groundwork for monetaryunion: creating the institutions and studyingthe technical details necessary to meld asmany as 14 independent monetary policy-making bodies into one cohesive systetn)Furthermore, to make themselves eligible forentry into EMU, countries are undertakingpolicies aimed at achieving economic con-vergence across the European Union.

This economic conversion is seen as anintegral part of the process toward monetaryunion. Indeed, the Maastricht Treaty isbased on the idea that economic convergenceis a prerequisite for monetary union. The

treaty creates a series of criteria which coun-tries mnst meet to join the monetary union.These criteria are designed to ensure thatpotential entrants share a commitment tothat union.

Much has been written critiquingthe usefulness of economic convergenceprior to monetary union.2 Some papers,such as Dc Grauwe (1994), focus onwhether the convergence indicators detailedin the treaty are the proper indicators toensure a well-functioning monetary union.This article does not enter this discussion;rather, given the criteria established by theMaastricht Treaty, it assesses the progressof the members of the European Unionin meeting these criteria. After illustratingthe lack of progress of the EU in tneetingthem, I consider the two main alternativesavailable to the member states that hope toachieve monetary union in the near future.One is to allow latitude in the applicationof the convergence criteria and the other isto view the starting date for monetary unionas flexible.

BACKGROUNDSerious discussion in Europe of a

move to monetary union began in 1988with the decision of the European Councilto create a Committee for the Study ofEconomic and Monetary Union. Thiscommittee was chaired hyJacc1uesDelors, the president of the EuropeanCommission,’ The Delors Coanmittee,as it was commonly known, was given amandate to examine the issue of EMUand to develop a program aimed at its inuple-mentation. In 1989, the committee issued areport stating:

“Economic and monetary unionin Europe would imply completefreedom of movement for persons.goods, services and capital, as wellas irrevocably fixed exchange ratesbetween national currencies and

Belgium nod l1100rrb000g aloud9operate in u monetary 30(00.

See, for example, Do Groowe

(1992) and Potter (19931.

°See tie shaded insert, “Institutionsof the European Unior’ onpage 2 for on erpionofon of the

institutonol structure of thelampoon Union.

FEOSRAL RISERYS SANK OF St. LOUES

3

llF~’I[WJUlY/AUGUST p995

INSTITUTIONS OF THE EUROPEAN UNION

The European Commessnon is the executixebranch of the European Union government.The president of the commission, who serves atwo-year renewable tenn, is chosen by theEuropean Council. The other 19 commissionersare appointed by their national governments forfour-year renewable tenns. France, GermanyItaly and the United Kingdom each appoint twocomunisstoners and the rematnmg 11 EU countrues each appoint one commissioner Althoughthe president of the commtssuon has no controlover the selection of commissnoners he doescontrol the selection of the portfohos assugnedto each commissioner During their term unoffice the commtssuoners are expected to repre-sent the unterests of the European Union notthose of their home countries

The Council of Ministers consists of therepresentatives of the national governmentsThe composution of the Council of Munistersdepends on the ussue beung considered Forexample issues related to the CommonAgricultural Policy are addressed by the agri-cultural munisters of the member states where-as finance matters are addressed by the financeministers. Within the Council of Ministers,each country is allocated a number of votesbased loosely on the size of its population.France, Germany, Italy and the UnitedKingdom have 10 votes each. Spain has eight.Belgium, Greece, the Netherlands, Portugal and

FEDERAL RESERVE SANK Of ST. LOUES

Sweden have five votes each. The remainingcountries, Austria, Denmark, Finland andIreland, have three voteseach. In sum, thereare 85 votes. To pass by qualified majority ameasure must receive at least 61 votes. Thus,two large states and two small states can form ablockingcoalition.

The European Council consists of the headsof state or government of the member coun-tries. The president of the EuropeanCommission is a non-voting member of theEuropean Council. The presidency of theEuropean Council rotates among the memberstates on a six-month basis. The EuropeanCouncil holds a meeting at the endof thesix-month period (in December and June).

The European Parliament is the legislativebranch of the European Union. The 626members of Parliament are elected in nationalelections and serve renewable five-year terms.In the Parliament, members are groupedaccording to their party affiliation, not theirnationality The European Parliament is theweakest institution within the EuropeanUnion, having mainly consultative powers.The exception to this weakness is in budgetaryissues, over which it has considerable control.The European Parliament may dismissthe European Commission en masse, hutcannot dismiss individual members ofthe Commission.

In the plan suggested by the DelorsReport, and incorporated in the MaastrichtTreaty EMU was to be achieved in threestages. Broadly speaking, stage one wouldemphasize economic convergence and stagetwo would emphasize institutional conver-gence. The final steps to full EMU wouldoccur during stage three.

During stage one, which began in July1990, the member countries of the EuropeanUnion were to achieve greater convergencein economic performance through increasedpolicy coordination. Stage one was also tobe characterized by the completion of thesingle internal market and removal of all

finally a single currency This, in turn,would imply a common monetary policyand require a high degree of compatibilityof economic policies and consistencyin a number of other policy areas,particularly the fiscal field. These poli-cies should be geared to price stabilitybalanced growth, converging standardsof living, high eonployment and externalequilibrium” (Committee for theStudy of Economic and MonetaryUnion, 1989, p. 17).

The recommendations of the DelorsCommittee formed the basis for the negotia-tions on EMU in the Maastricht Treaty

4

llF~IF~JULY/AUGUSt 1995

capital controls. in addition, all currencieswould be linked in the Exchange RateMechanism (ERM), and ptocedures wouldbe established for budgetary policy coordina-tion.5 The goals for the completion of stageone have yet to be met because the currenciesof five countries do not participate in the ERM.

In accordance with the MaastrichtTreaty stage two began onJanuau-y- 1, 1994.During this stage, the member states are tomake their central banks independent. Aspart of the steps toward independence, centralbanks are prohibited from providing overdraftfacilities to their governments and fromdirectly financing the government debt.The European Monetary Institute (EMI)began operations at the start of stage two.It is charged with ensuring cooperationbetween national central banks and strength-ening the coordination of national monetarypolicies. The ENI is also to begin prepara-tions for a single currency and the conductof a single monetary policy Perhaps mostimportantly in this regard, it is to createthe instruments and procedures necessaryfor the operation of a single Europeanmonetary policy Also, during stage two,countries are to achieve further economicconvergence, as detailed by the criteria inthe Maastricht Treaty

The most important role of the EMI isto ensure that the technical barriers to EMUare removed prior to the start of stage three.These barriers include cross-country differ-ences in the conduct of monetary policyfinancial regulations, payments systems andcurrencies. The EMI is studying issues relatedto the conduct of monetary policy Forexample, should the future European CentralBank target the money supply as the GermanBundeshank does, or should it target infla-tion, as the Bank of England does? Anotherissue being studied by the EMI is the designand implementation of the single currencysystem. This is a politically volatile issuebecause each country has an interest in hav-ing the new currency resemble its own,

Stage three will mark the final transitionto a full-fledged monetary union. At thestart of stage three, exchange rates betweenmennber countries will be permanently fixed.The governments of the member countries of

the monetary union, acting in consultationwith the European Commission and theEuropean Central Bank, will determine theexchange rates at which currencies are to befixed. The determination of these fixedexchange rates requires the unanimous con-sent of the member states, As the final stepto EMU, individual currencies will be replacedwith a common currency Monetary policydecisions will he made by the independent,supranational European Central Bank,According to the Maastricht Treaty stagethree must start byJanuary 1, 1999,

The exact starting date will be deter-mined as follows. By December 1996, aninter-governmental conference comprised ofthe leaders of the European Union countriesmust meet to determine if EMU is ready tocommence. Prior to this meeting, theEuropean Commission and the EMI areto issue reports detailing the progressmade by each country in meeting theconvergence criteria. These reports willbe sent to the Council of Ministers, TheCouncil of Ministers will use these reportsto determine:

• whether each member statefulfills the necessary conditionsfor the adoption of a singlecurrency; and

• whether a majority of themember states fulfill the necessaryconditions for the adoption ofa single currency (Treaty onEuropean Union, Article 109j.2).

The decisions of the Council of Ministerswill be made on the basis of a “qualified”majority vote. The determinations ofthe Council of Ministers will be forwardedto the European Parliament, which willmake its own recommendation on thereadiness of the member states to move tothe final stage of monetary union,

Taking into account the decisionsof the Council of Ministers and theEuropean Parliaunent, the EuropeanCouncil at the inter-governmentalconference must then decide, again byqualified majority:

In accordance with the Moastnichttreaty, Greece was olluwed tomaintain cupitul controls until theend of June 1994.

The Eochnnge Rnte Mechuuiscn,crented in 1979, set narrowmargins for exchange note fuctua’tons hetween member countries,Normally, enrch currency wasallowed to fluctuate by±2.25 percentage paints againstany other member currency. Sowncurrencies, iaweuer, were giontwiden nsntgins of flucteuton(±6percentage paints) to smooththeir transition upon enteing theElM.

FEDERAL RESERVE SANK OF St. LOUIS

S

II FYIJULY/AUGUST 1995

Re~ium

Denmark

FretucifGermanyGreeceIrelandItalyLuxembourg

NetherlandsPortugal

SpainUnited ltmgdant

AustriarmlaSSweden

Number meetIng aiteria

See Protocol on t/re CaoovnrgerxceOntario referred to in Article /09/tithe Panty Estnblislnitg theEuropean Caaroncwity (1992) und

Protocol on the Excessive DeficitProcedure tt9921.

Number of Criterig Met1990 1991 1992 1993 1994

2 3 3 35 4 4 3 35 5 4 4 45 4 4 3o 0 0 0 04 4 4 3 3o o o o o5 5 5 4 53 4 3 3 3o o 0 0 01 1 1 1 03 3 2 2 3

4 4 3 2 32 2 1 1 22 3 2 1

4 2 1 0 2

• whether a majority of the memberstates meet the necessary conditionsfor monetary union;

* whether it is appropriate ... toenter the third stage; and if so,

• set the date for the beginning ofthe third stage (Treaty on EuropeanUnion, Article lO9j.3).

If no date for the start of monetaryunion has been set by the end of 1997,the treaty obligates the leaders of theEuropean Union countries to meet by July 1,1998, to determine, based on the sameprocedure outlined above, which metnherstates fulfill the conditions for monetaryunion. These states are then to enter thethird stage on January 1, 1999. For mone-tary’ union to begin prior to 1999, a majorityof countries nnust meet the criteria establishedby the Maastricht Treaty However, in 1999,

according to the treaty EMU will commencefor those countries (however few) that meetthe entry conditions.

The countries that do not uneet the entryconditions and are excluded from EMU will,according to the Treaty be referred to as“member states with a derogation” (Treaty onEuropean Union, Article 109k.2). This exclu-sion, however, need not be permanent. Atleast once every two years, following theguidelines outlined above, the EuropeanCouncil will decide by qualified majoritywhich unember states with a derogation havefulfilled the entry criteria and admit them tothe ononetary union,

CONVE’RGINCE CRIT.EAJ.AAs noted above, entry into EMU is

dependent upon the fulfillment of whatthe Maastricht Treaty calls “necessary condi-tions.” What are these conditions? First, tofacilitate the common monetary policy eachmember must guarantee the independence ofits central bank and pass national legislationin accordance with the protocol establishingthe European Central Bank. Second, in mak-ing their reports on the progress of countriesin meeting the necessary conditions, theEuropean Comnussion and the EMI are to

consider the progress made in developing a

comunon currency, “the results of the integra-tion of markets, the situation and developmentof the balances of payments ou account andan examination of the development of unit

labour costs and other price indices” (Treatyon European Undon, Article 109j.1).

Most attention, however, has been focused

on the conditions that the Maastricht Treaty

says are designed to ensure “the achievement

of a high degree of sustainable convergence”

(Treaty on European Union, Article 109j.1).

Convergence must he achieved in exchange

rates, inflation rates, long-term interest ratesand government finances, The treaty and twoseparate protocols detail these convergencecriteria as follows:6

• The currency of each niemberstate must have reunainecl withinthe normal fluctuation marginsof the ERM for a least two years prior

FEDERAL RESERVE BANK OF ST. LOUIS

Progress in Meeting Convergence Criteria

6

DFYIF~JULY/AUGUST 1995

to the examination. Specificallya member state may not havedevalued its currency againstany other currency within the ERMon its own initiative,

• The average inflation rate forany member state during the yearprior to the examination by theEuropean Commission must havebeen no more than 1.5 percentagepoints above the average rate ofinflation in the three best-performingcountries during this same period.

• The long-term interest rate(on government bonds orcomparable securities) of any memberstate during the year prior to theexamination by the EuropeanComtnission must have been nomore than 2 percentage points abovethe average long-term interest rateof the three countries with thelowest inflation rates during thissame period.

• The governnnent budget deficitof any member state may notexceed 3 percent of that country’sGDP at the time of the examination.

• The government debt of anymember state may not exceed60 percent of the country’s GDPat the time of the examination.7

Table 1 sunnanarizes the performanceof each current EU member state in fulfillingthe convergence criteria during the years1990-94, As this table shows, the pathtoward convergence has not been smooth.On the basis of these five criteria, morecountries met tine eligibility requirement in1990, the year before the treaty was conclud-ed, than in any subsequent year. Denunark,France, Gernnany and Luxennbourg met allfive convergence criteria in 1990,~Thenumber of countries fulfilling the criteriadeclined in each following year, reaching alow of zero in 1993, In 1994, the perfor-mance of the meunhers of the European

Union improved slightly with Germany andLuxembourg meeting all five criteria.

As the performance of the countries in1990 and 1994 is compared, only Belgiumimproved its overall performance on the cri-teria. In contrast, six countries met fewercriteria in 1994 than they met in 1990, Thisworsening performance reflects the crises inthe ERM and a deterioration in the publicfinances of many countries,

Exchange Rate Cr.iten’anAlthough the ERM had functioned

smoothly since 1987, it was beset by a seriesof crises during 1992 and 1.993. These crisesresulted in the September 1992 withdrawalof the British pound and the Italian lira fromthe ERM, and the February 1993 devaluationof the Irish pound. The Portuguese escudoand the Spanish peseta were devalued severaltimes throughout 1992 and 1993. As a resultof these crises, fewer countries met theexchange rate convergence criterion in 1994than in 1990 (see Table 2).

The exchange rate crises ended inAugust 1993 with the expansion of the bilat-eral bands from ±2,25percent to ~15 percenl.for all pairs of currencies with the exceptionof the Dutch krona/Deutsche unark, Theconsensus within the European Union is thatthese wider hands have reduced currencyspeculation and thus have lessened theprospects for exchange rate crises withinthe ERM. Thus, no return to the narrow’tnargins is likely The maintenance of theexpanded margins presents no problem forthe fulfillment of the convergence criteria aslong as the European Commission and theEuropean Council agree that the treaty’s ref-erence 1.0 “normal fluctuating margins”

means margins of ±15percent.In March 1995, the currencies within the

ERM again experienced sharp fluctuations.The movement in the exchange marketsaway from dollars and into Deutsche markscaused problems for weaker currencies withinthe ERM. As a result of this turbulence, theescudo and the peseta were both devalued.In the absence of any further devaluations,only eight of the 15 member countries of theEuropean Union would meet the exchange

‘As discussed in the Protocol an theExcessive Deficit Procedure, thedeficit and debt natos are bused antgenerol gaoernnieat budgets, thatis, the ceutrul ganernment, regionalor local gouernments nod socialsecuity futtds. Commercial opera’tions of the public sector areexcluded. The deficit is defined asnet borrowing by the ganaramunt.Net banrawirg eucltdas any pot/utof the deficit that is used for “theocqtisitian of loans on other llama’ciai ussens by the govummunt.thus, for enomple, the funds bar’rowed b1 the German gaournntenttthat were in turn lane to agencies ineastern Germany do not shaw up inthese deficit fgures ICallignon andothers, 1994). tinatixatian pro’ceuds canaan leased to reduce thedeficit, although some counties oretrying to change this pwv)sian.Whereas the deicit rota is basedat ten bacrawing, the debt rota isbased an gross debt,

IfAustia had been a member ofthe Euaupaan Uuion, it eon wouldhaue met all flue canuergence crite’ia ir 1990. Although it was natomember of tie Ft/el, its currencyhas shadowed the Deutsche mark.

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7

DFYIF~JULY/AUOURT 1995

BelgiumDenmark

France

GermanyGreeceIreland

Italy

LuxembourgNetherlands

Portugal

Spain

United Kingdom

Austria

Frniand

Sweden

Number meeting criterion

1990 1991 1992 1993 1994

yes yes yes yes yes

ys yes yes yes yes

yes yes yes y ye

yes yes yes yes yes

am nm. ann ann nra

y yes ye no no

no no an ann. nan

yes yes yes yes yes

yes yes yes ye yes

ama nra no no no

no no no no nono no no nan. nra

nan n.m nra nan nra

nan nan nra. nan n.m

nan n.m nra. nan nra

7 7 7 6 6

rate criterion at the end of 1996. The

currencies of five countries — Finland, Greece,Italy Sweden and the United Kingdom—are

not participating in the ERM and therefore

will not meet the two-year rule by the end of1996. As a result of the recent devaluations

of their currencies, Portugal and Spain will

not meet the criterion by the end of 1996.

Inflation CriterionComparing 1990 to 1994, the perfor-

mance of the EU countries with regard tothe inflation criterion has improved. As

shown in Table 3, seven of the present 15 EU

countries met the inflation criterion in 1990.

This number fell to five in 1993, but

rebounded strongly with 11 countries meet-ing the criterion in 1994. Greece, ItalyPortugal and Spain were the countries with

inflation rates exceeding the criterion in

1994. Although these four countries have

not men the criterion in any year, each

country has made progress in lowering its

inflation rate over the period in question.

The economic recovery currently under

way in Europe is expected to lead to a slight

increase in inflation in anost member cotmntries

by 1996. Because the criterion is based on

the performance of the three countries with

the lowest inflation, a general increase in the

rate of inflation will not affect the overall

performance of countries. As shown in

Table 3, the increase in the inflation forecast

for 1996 is not expected to reduce the num-ber of countries satisfying the inflationcriterion. Moreover, the inflation perfor-mance of the countries not currently meetingthe criterion is expected to improve over the

next two years.

Interest Rate Cr.iterionThe interest rate criterion has been the

one thar countries have usually found easiest

to meet. Furthermore, the member coun-tries showed stead)’ icnproveanent over theperiod 1990-94. In 1990, as shown in Table

4, nine countries had long-term interest rateswithin the hunit set forth in the Maastricht

Treaty This number rose to lOin 1991 and

increased to II in 1993. In 1994, however,the number of countries meeting the interest

rate criterion slipped back to 10. In 1994,

Greece, Italy Portugal, Spain and Sweden didnot meet this criterion. The formner four havenever met the criterion.

Public Finance CriteriaThe two public finance criteria have

caused the biggest problems for countries in

their quest to join the EMU. In 1990, nine

of the current 15 EU countries met the

deficit criterion while only three met, it in

1994. Similarly nine countries met the gov-ernment debt criterion in 1990 but only four

FEDERAL RESERVE RANK OF ST. LOUIS

.

Convergence Indicators: Exchange Rate

Notes: n.m. indicates that the county was not a memberof the ElM during any pant of therelevant year

the Irish pound was devalued by 10 percent in February 1993.the Italian finn was detalued by 3.7 percent in January 1990 when it was incorporated

into the narrow (2.25 percent) bands. The lieu left the ElM Ia September1992.the Pantuguese escudo was devalued by 6 percent Ia November 1992 and by 6.5

percent in May1993.The Spanish peseta was devalued by 5 percent in September 1992, by 6 percent in

Navembee 1992 and by 8 percent in May1993.

8

D1\’I[~JULY/AUGUST ‘995

Convergence Indicators: InflationPercent

9 2.423 27

19 21

23 2596 8.929 2.752 4523 251.8

45 45

49 45

3.0 30

28 2917

32 3.2

33 37

11 11

Notes: Paioa to 1992, data for Germany is for western Germany only.Data for 1995 and 1996 are forecastsConvergence criterion is based on data for the 12 member states prior to 1995 and the 15 states thereafter.

SOURCE: European Eronomy (April/May 1995, Supplement A, Table 10)

did in 1994. Much of this decline can beattributed to the expansionary nature of

fiscal policies in reaction to the recession ofthe early 1990s, from which Europe is just

beginning to recover. The effect of the reces-sion on public finances can be seen byconsidering the exacuple of Finland, Output

growth in Finland fell from 5.7 percent in

1989 to -7.1 percent in 1991. Consequently

Finlandts government budget balance

declined from 5.4 percent of GDP in 1990 to

a low of -7.8 percent in 1993. The govern-ment budget deficit shrank in 1994 as itseconomy moved out of recession.

The economic recovery currently under

way in Europe is expected to lead to a grad-ual improvement in the budget balances ofthe EU countries. Nevertheless, only six of

the 15 countries are expected to meet the

budget deficit criterion in 1996. The recovery

is expected to have less of an effect on

countries’ performance with respect to the

debt criterion. The ratio of debt to GDPis expected to increase through 1996 in

most countries.

The criterion limiting the governmentdebt to 60 percent of GDP has been the

most difficult for countries to meet. Only

Luxembourg has a debt ratio well below’ thatlevel, The other three countries that met

this criterion in 1994 (France, Germany andthe United Kingdom) all have debt-co-GDP

ratios close to 50 percent. Among those

countries not meeting the criterion, somehave debt ratios so high that they would

have to run substantial budget surpluses for

a number of years to meet it. For example,

Buiter, Cosetti and Roubini (1993) calculat-ed that based on the 1991 debt levels andassuming a 5 percent nominal GDP growth

FEDRRAL RERERVE BANK OF ST. LOUIR

1990 1991 1992 1993 1994 1995 1996

BelgiumDenmarkFranceGermanyGreeceIrelandItalyLuxembourgNetherlandsPorlugalSpainUnited Kingdom

AustriaFinlandSweden

convergence criterionNumber meefing criterion

3.7 25 21 26 2.427 24 LB 0 17

28 32 Z4 22 182.8 4.0 4.7 3.8 27192 188 5.1 136 10914 25 28 16 30

59 69 52 SI 4.736 29 28 36 22

22 3.2 0 2.1 22117 12.5 10.0 79 5165 64 64 5.6 51

55 74 47 34 25

31 34 39 35 3360 56 41 39 1696 102 22 58 30

3.6 40 36 31 347 8 7 5 11

9

DF~I[~JULY/AUGUST 1995

BelgiumDenmarkFranceGermanyGreeceIrelandItalyLuxembourgNetherlandsPartugalSpainUnited Kingdom

AustriaFinlaadSweden

Convergence criterionNumber meeting criterion

Percent1990 1991 1992 1993 1994

101 93 8.6 72 7.811.0 10.1 101 82 L51OA 9.5 90 7.0 7.589 8.6 8.0 6.3 6.7185 188 177 182 na.101 92 91 77 81134 13.0 13.7 11.3 10.68.6 82 7.9 6.9 6490 8.7 Li 6.7 7.2

16.8 18.3 ISA 123 10.014.7 12.4 12.2 10.2 9.711.8 99 91 78 82

8.7 86 8.3 66 67

132 119 121 82 BA136 109 10.4 85 93

12.0 115 11.2 91 9A9 10 10 11 10

rate, Belgium needs a government surplus ofmore than 9 percent of GDP a year for eachyear through 1996 to meet the convergencecriteria, To meet the criteria by the end of1998, Belgium would need an annual gov-ernment surplus greater than 5 percent ofGDP

Sununary- on S’onver~e:nceTo summarize, the data indicate that

inflation and interest rate convergence aretaking place in the European Union, Theoutlook for the next two years anticipatesfurther convergence with respect to thesetwo criteria, In contrast, the public financesof the EU members have worsened since theestablishment of the convergence criteria.Although the government budget balances of

most member states are expected to improvethrough 1996, the debt ratios are unlikely toshow significant improvement. Turning tothe exchange rate criterion, five countries arenot members of the ERM and thus do notmeet, the convergence criterion. For theremaining 10 counties, although the widerbands eliminated tensions within the ERMbetween August 1993 and March 1995, thereis now evidence that even these bands can-not prevent pressure from accumulating onweak currencies.

PROSPECTS ppq~tEMPFor the 1996 inter-governmental confer-

ence to set a date for monetary union, eightcountries must fulfill all of the convergencecriteria. If there are no further devaluationswithin the ERM, eight countries—Austria,Belgium, Denmark, France, GermanyIreland, Luxembourg and the Netherlands—will fulfill the exchange rate criterion in1996. Thus, if EMU is to get off the groundprior to 1999, all eight of these countriesmust meet the other four convergence crite-ria. However, the dehtJGDP ratios of fourof these countries—Belgium, Denmark,Ireland and the Netherlands—are notexpected to he close to the 60 percent refer-ence value by the end of 1996.

Thus, based on the five convergencecriteria, it is almost certain that a majorityof the EU countries will not be ready formonetary union when the inter-governmentalconference is held in 1996. If EMU ispostponed, the next issue is: How manycountries will be eligible at the start of1999, the last possible date for monetaryunion in accordance with the treaty? Barringunforeseen economic shocks, Germanyand Luxembourg should both be eligiblefor monetary union. The eligibility of theremaining 13 countries is less certain, evenleaving aside the uncertain future of theERM. Austria and France are the most likelyadditional candidates. Both, however, couldrun into problems meeting the governmentbudget requirement, and Austria is notexpected to meet the debt criterion.

Belgium and Italy have public debtstotaling more than 100 percent of their

FEDERAL RRSSEVE BANK OF ST. LOUIS

Convergence Indicators: Long-TermInterest Rates

SOURCES: European Economy (1995, Number 59, table 54)and OECD Economic Outlook (June 1995, Number 57, Annex Table 36)

10

H F~ILWJElLY/AUGUST 1995

respective GDPs. It will be many yearsbefore these debt ratios come close tomeeting the 60 percent limit, Denmark,Finland, Ireland, the Netherlands andSweden also have high debt ratios unlikelyto fall within the target range by the end ofthe century The Dutch central bank lastyear calculated that if the Netherlandslimited its annual public sector deficit topercent of GDp, and achieved an averagenominal GDP growth of 4 percent a year, itwould still rake 10 years to reach the 60 per-cent public debt target (Financial Times,January 17, 1995), While 4 percent was theaverage nominal GDP growth for theNetherlands during 1985-94, its averageyearly budget deficit has been more thandouble 1 percent of GDP over the last10 years.°

Portugal and Spain are likely to havedifficulty meeting several of the criteria.Although they both have substantially low-ered their inflation rates in recent years. the5.1 percent Portuguese and Spanish inflationrates remain outside the ceiling. The debtratios of both countries also have grownrecently and thai of Spain is likely to reunaina problem as long as it maintains its highunemployment rate (estimated at more than22 percent in 1994). No one expects thatGreece will be a candidate for monetaryunioti for many years to come, It aloneamong ahe EU countries still has double-digit inflation.

The remaining country the UnitedKingdom, is a good candidate for meetingall of the eligibility requirements formonetary union, except the exchange ratecriterion. The United Kingdom is unlikelyto rejoin the ERM in the next few years.Even ignoring this problem, oppositionto EMU is strong within the British govern-ment and Britain is one of two EuropeanUnion countries that have the right torefuse entry into the monetary union)0

A change in the government from theruling Conservative party to the oppositionLabour party is likely to increase theprospects for Brirain joining EMUsimply because the latter is much moreamenable to the idea of monetary unionthan the former,

Respon.ses to the Lock of Prograss inMeeting the Convergence Criterio

The reality that a majority of countrieswill not meet the convergence criteria in1996, and that most, including some key-countries, are unlikely to meet the criteria in1998, has generated three responses withinthe European Union. One reaction hasbeen to label the idea of monetary unionimpractical. A second suggests that the pub-lic finance criteria for monetary union can beand should he interpreted with some leewayA third reply suggests that the timetable formonetary union should be interpreted withsome flexibility

Abandoning EMUl’hose who have reacted to the difficulty

in meeting the convergence criteria by label-ing EMU impractical are basically opposed tothe idea of monetary union, They see thelack of progress in meeting the criteria as ameans to gain support for the idea of aban-doning the treaty. Proponents of this vieuçmost notably some members of the BritishParliament, have reacted to each crisis withinthe ERM with predictions of the deanise ofunonetary union. For example, British PrimeMinister John Major responded to the August1993 widening of the bands of the ERM withthe statemena that the Maastricht timetablefor monetary union was now totally unrealis-tic.” The reaction of Norman 1_amont, theformer chancellor of nbc exchequer inBritain, was even more pointed. He claitnedthat the crisis in the ERM meant ‘the end ofmonetary union in Europe” (Financial Times,August 3, 1993). In practice, this group sup-ports strict adherence to the convergencecriteria, since this will delay the starting datefor monetary union,

Flexibility in Interpreting theConvergence Criteria

In opposition to this group are thosewho not only support EMU hum believe thatthe earlier the starting date the better, Thislatter group favors a liberal interpretation ofthe convergence criteria. One reason for

A meductiam in pmbhc debt can occurthroogh several means besides agovernment surplus. Bath nominalGOP growth and a reduction ininterest rates an gnvernrnerrt debtwill reduce the debt/GOP ratio.Nominal GOP growth way beachieved thrmegh growth in aetyntor iefatian. This might lead are tothink thou inflating away nbc debtwould bea compelling opine.Such a strategy, hawever, will onlywork iv the short nun. An increasein inflator raises the interest noneon wInch the government most ban’raw to finance its debt, the shorterthe maturity of the outstandingdebt, the shorten the period of tinebefore which the engineered irtlla’tiny will olfect the interest rate anthe debt. Furtherware, any suchattempt by the government tomeet the debt convergence cnitenionthnongh inflation is likely to havelang’term nepenmussians fan theinterest rate at which the govern-ment bannows by reducing thegovernment’s credibility.

ruIn Maasnnicht, the United Kinrgdaw

refused to conclude negoniatnas anthe treaty aeless it was given thenight ta aptaut at FMU. Denmarkis the ether cauntry with the rightto apt.oun of maeeuary unlay, Itnegotoned this night fallowing thenelectan of a referendum an thetreaty. After secetag the opt’outprevision, u new referendumapproved the treaty.

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Deing the Maasanicht negotiaions,several countries proposed adaptaga concept of cyclically udlusteddeficits. The prapasal was relectadbecause of measurement problemslfini’Swoghi and others, 19941.

supporting a quick move to monetary unionis the belief that a long transition period mayitself be the source of instability A proponentof this view is Portes (1993). In additionto arguing that a long transition periodcreates instability Portes contends thatthe convergence criteria are unnecessarybecause “monetary union will deliverconvergence—at least the extent required tomaintain it.” Dc Grauwe (1994) takes thisargument one step further by claiming thatthe convergence criteria cannot he met priorto EMU.

Although support for a quick move tomonetaty union is generally tied to the beliefthat convergence is not a necessary prerequi-site for EMU, support for a flexible approachto the criteria is based on addhthonal reasons,One is to provide a wide participation inEMU. Another is the fear among countriesthat have little chance of meeting therequirements that non-participation in EMUwill be costly both politically and economni-cafly In the political sphere, countries areafraid that remaining outside EMU willreduce their political power within the EU,particularly as the inner core of countries(the mnembers of EM.U) become more inter-dependent. In economic terms, countries areconcerned that exclusion from EMU may beviewed as a mnark against them, and result ina higher interest rate premiutn and a weak-ness in their currencies.

Supporters of a flexible approach to theconvergence criteria make reference to theMaastricht Treaty to holster their case, ‘l’hetreaty provides an opening for a relaxation ofboth the deficit and the debt criteria, The 3percent deficit/GDP ratio and the 60 percentdebtIGDP ratio are referred to in the treaty asreference values, not fixed limits as are thecriteria for inflation and interest rates. Thetreaty says that these reference values musthe met unless, in the case of the deficit:

• either the ratio has declinedsubstantially and continuouslyand reached a level that comesclose to the reference value; or

• alternatively the excess over thereference value is only exceptional

and temporary and the ratio remainsclose to the reference value (Treatyon European Union, Article 104c.2.a),

In addition, in preparing its report onwhether an excessive deficit exists, theCommission is to take into account:

• whether the government deficitexceeds government investmentexpenditure (gross fixed capitalformation); and

• all other relevant factors, includingthe medium-term economic andbudgetary position of the MemberState (Treaty on European Union,

Article 104c,3).

These clauses provide the commission ameans by which to relax the deficit require-ment. As noted by Collignon and others(1994), the treaty could he interpreted asapplying the deficit criteriorn to only the partof the deficit not accounted for by govern-ment investment, and only requiring the 3percent ratio to be met “when the economywas near full capacity” Looking at the datain Table 5, one could argue that Austria,Denmark and the Netherlands all meet thedeficit criterion since their budget deficitsremain close to the reference level, and thatthe elevated levels are merely temporary —

caused by the recession,maWith respect to the debt criterion, the

Maastricht Treaty states that the referencelevel (60 percent dehtJGDP) is binding“unless the ratio is sufficiently diminishingand approaching the reference value at asatisfactory pace” (Treaty on European Union,Article 104c.2.b).

‘F he debt levels of all the countries, withthe exception of Ireland and the Netherlands,have increased between 1990 and 1994, asshown in Table 6. In Ireland’s case, substan-tial progress has been made in reducing itsdebt ratio. Ireland has met the deficit con-vergence criterion in every year and hasreduced its debt ratio fromn 97 percent ofGDP in 1990 to 90 percent in 1994. In thefall of 1994, the European Council, assessingthe progress of countries toward the

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it (ii rat

130.8 130.1 131 1 137.2 1361

596 646 69.0 80.3 756354 357 39.6 458 483438 41.5 441 482 50182.6 86J 923 1152 114196.8 96.9 94.2 97_u 89 8979 1013 1084 1194 1254

54 4,9 5.7 69 7278.8 789 79.9 814 78.168.6 69.3 617 66.6 692

451 45.8 483 599 62335.0 35.7 41.9 485 501

583 587 584 628 645145 230 415 571 60143 530 671 762 791

60.0 600 6~0 60.0 60.09 8 7 6 4

Notes: Data for the United Kingdom in 1990 are based on DECO calculations of general government gross financialliabilities. All other data are bused on the Maastricht Ireaty’s definition of public debt.Prior to 1991 the data for Germany are for western Germany only.Data far 1995 and 1996 are forecasts.

SOURCES: Europeon Economy (April/May 1995, Supplement A, table 22) andOECO Economic Otilfook (June 1995, Number 57, Table 34).

convergence criteria he treated with flexibilityare those who believe that the 1999 deadlineshould be viewed as flexible. The propo-nents of a flexible timetable believe thatstrict adherence to the convergence criteria isa necessary condition for a well-functioningmonetary union. Thus, rather than relaxingthe criteria to guarantee that an optimalnumber of countries will participate in EMU,they suggest that the date for monetaryunion he delayed if the criteria are not metby a sufficient number of countries. GermanChancellor Flelmut Kohl was the first leaderto publicly address this issne. In 1993,he stated that strict adherence to theconvergence criteria might delay mnonetaryunion beyond 1999.

The October 1993 ruling of the GermanConstitutional Court supported those who

argue that the timetable for monetary unionis more flexible than the criteria. Thecourt, in ruling on the constitutionalityof the Maastricht Treaty wrote that strictadherence to the convergence criteria wasessential to Germany~participation in EMU.In other words, the criteria could not heweakened without the consent of theGerman parliament.

The German central bank, theBundesbank, has been perhaps the mostvocal advocate of a strict application of theconvergence criteria. Both Hans Tietmeyer,the current president of the hank, and hispredecessor, Helmut Schlesinger, have madestatements on several occasions favoring astrict interpretation of the Maastricht criteriawhile claiming that the criteria are them-selves not strict enough. For example, the

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Convergence Indicators: Government DebtPercent of GDP

1990 1991 1992 1993 1994 1995 1996

ReigtumDenmarkFranceGermanyGre aIrelandltofjLuxernbou §NetherlandsPortugalSpainUnrted Kingdom

AustriaErolandSweden

Convergence criterionNumber me ting crKerion

1343 132.3761 754512 52.8582 58

1153 1162846 86.8

124.9 12447.6 7.8

781 77~i70.5 70.7646 652513 513

66.2 67.464.4 64.684.6 857

60.0 6004 4

II [~iF~JULY/AUGUST 1995

Bundesbank has favored an absolute limit oninflation rather than a relative one, the latterbased on the behavior of other countries.The reason for this is to ensure not simplyconvergence in inflation rates, but also acommitment to price stability TheBundesbank has also attacked the deficit cri-terion as setting too high a ceiling.Specifically Mr. Tietmeyer has stated that theceiling for the deficit ratio is at least doublewhat it should be. He also has emphasizedthat the deficit criterion should be metthroughout the business cycle (FinancialTimes, November 5, 1994)’~This statementcontrasts with a study prepared for theEuropean Parliament that suggests that “Itwould be keeping ~ch the spirit of theTreaty, if 3 percent were taken as the ‘fullemployment’ deficit during periods ofeconomic expansion” (Collignon andothers, 1994, p. 76).

As noted above, the emphasis on a strictinterpretation of the convergence criteria isbased on the belief that adherence to them isnecessary for a well-functioning monetamyunion. The proponents of strict criteriaargue that for EMU to succeed, the memberstates must show a prior commitment toprice stability and follow sound governmentbudgetary policies. Specifically the empha-sis on a strict interpretation of the deficitcriterion is based on the idea that “a soundbudget position is an indispensable precon-dition for a successful anti-inflationarymonetary policy~HThere is a concern thatwithin a monetary union, expansionarynational fiscal policies (as evidenced by bud-get deficits in excess of 3 percent of GDP)could conflict with the monetary policy ofthe supranational central bank. Such a con-flict would not only create difficulties for thecentral bank in its effort to maintain pricestability but also could cause tension amongthe participants in the monetary union.Would the participants of a monetary unionbe willing to accept a recession broughtabout by the anti-inflationary polices of thecentral bank in an effort to combat the fiscallaxity of other members? Furthermore,although the Maastricht Treaty prohibits thecentral hank from extending credit to, ordirectly purchasing the debt of, member

states (Protocol on the Statue of the EuropeanSystem of Central Banks and the European

Central Bank, Article 21), and declares thatneither the central bank nor other countriesshall be liable for or assume the financialcommitments of any member states (TI’reatyon European Union, Article 104b.1), there arethose who believe there would be pressureon the central bank to bail out countriesexperiencing financial difflculties”~

CONCLUSION

Despite the many setbacks that haveoccurred since the December 1991 conclusionof the Maastricht Treaty most of the countriesof the European Union remain committedto monetary union. This commitment, how-ever, has not been enough to produce theeconomic convergence prescribed by thetreaty Many countries have made progressin reducing their inflation rates, and thedivergence in long-term nominal interestrates is declining. On the fiscal side, however,the number of countries meeting the conver-gence criteria has declined. The recentrecession in Europe resulted in a deteriorationin the fiscal balances of most countries. Inaddition, the 1992-93 exchange rate crisesresulted in a reduction in the membershipof the ERM. Thus, the European Union isfurther away from a fulfillment of theconvergence criteria today than it was inthe year prior to the negotiation of theMaastricht Treaty

By the end of 1996, the member states ofthe European Union must decide if a majorityof countries are ready to proceed to EMUin 1997. As detailed above, it is implausiblethat a majority of countries will have fulfilledthe convergence criteria by the end of 1996.EMU will most certainly he delayed beyondits earliest possible starting date. TheMaastricht Treaty states that the final stage ofEMU must begin by,January 1, 1999, withthe membership decided by July 1998, Evenby this date, few countries are hkely to satisfythe convergence criteria.

Given the lack of progress in meetingthe convergence criteria, the EuropeanUnion faces two options if it is to continue topursue EMU: Relax the criteria or relax the

Others have claimed that even a

aevernmeet then has e hrlancedbudget during upnurns cauld have abudget deficit eeceediag theMaestricht limitdurina a recession.See, for example, Eicheegreer(1992) cod Keneo (1992).fichengreen argues that it may

ever he optimal far disciplined guy’

erenrents to accasiorrlty havedeficits exceeding 3 percent of GOt(p. 50).

~ lietreeyem (September 9, 1994).

H Support for this view is giuer by

Frotarri, voe Hageo end Wailer(1992) and Cmig (19941.

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In is ieteresfng to note then in therogotutuns ur the MrustrimhtTreaty, Germany resisted settinghued dune fur the commencementof moretery Orion. It believed thatfixing a dune would resale ir a looseapplicatan of the convergence crite-Cu (The Econoais( September14,1991).

~° The other membersof thiscure group urn France, Gormunyred luxembourg.

timetable for monetary union. Which optionit chooses will likely not be decided until theJuly 1998 deadline for determining the mem-bership of EMU. The choice taken by theEU will undoubtedly he influenced by thetwo countries without whose participationEMU will not occur: France and Germany

Germany has strongly opposed a relax-ation of the convergence criteria.tm’ If itmaintains this position, few countries arelikely to meet the membership requirementsfor EMU by the end of the decade. Moreimportantly two countries considered amongthe core group of EU countries — Belgiumand the Netherlands — are not expected tomeet the criteria.tm5 Without the participationof the core group, monetary union may notbe feasible. Thus, it is likely that EMU, likeits avban namesake, will remain grounded.

RIFI!R:ENCES

Barber, lionel. ‘Santer staers middle course far EU,” Financial Times(January 18,1995).

Bin’~Smaghi,larenzo, lommoso Padoo’Schioppo and Francesco Papadia.“The Transition ta EMU in the Maasticht Treaty,” Essays inInternational Finance (Number 194, November1994),Princeton University.

Buiter, Willem, Giancarlo Corsetti and Nouriel Roubini. “EecessiveDeficits: Sense and Nonsense in the Treaty of Moastricht,” EconomicPolicy (April 1993), pp. 57~100.

Collignon, Stefan with Peter Bofingur, Christopher Johnson andBertrand de Maigret. Europe’s Monetary Future. PrinterPublishers, 1994.

Committee for the Stady of Economic and Monetary Union.Report on Economic and Monetary Union in the European Community.Office for Official Publications of the European Communities, 1989.

Council of the European Communities, Commission of theEuropean Communities. Protocol on the ConvergenceCriteria Referred to in ArIn’cle 109/of the Treaty Establishing theEuropean Community. Office for Official Publications of theEuropean Communities, 1992.

___________ Protocol on the Excessive Deficit Procedure, Office forOfficial Publications of the European Communities, 1992.

___________ Protocol on the Statue of the European System of CentralBooks ond of the European Central Bonk. Office for OfficialPublications of the European Communities, 1992.

_________ Treotyon European Union, Office far Official Publicationsof the Eurapean Communities, 1992.

Craig, R. Sean. “Who Will Join EMU? Impact of the MaaslrichtCunvergunce Criteria on Economic Policy Choice and Performance,’Board of Governors of the Federal Reserve System InternotionolFinance Discussion Papers No. 480 (September 1994).

De Grauwe, Paul. “Towards European Monetary Union Without theEMS,’ Economic Policy (April 1994), pp. 1 47~85,

__________ The Economics of Monetory Integration. Oxford UniversityPress, 1992.

The Economist. “The Unpopularity of Two-Speed Europe”(September 14, 1991).

Eichengreen, Barry. “Should the Maastricht Treaty Be Saved?”Princeton Studies in Intemoionol Finance (December 1992).

Fratianni, Michele, Jurgen von Hagen and Christopher Woller, “TheMaastricht Way to EMU,” Essays in International Finance(June 1992).

Gawith, Philip. “Tietmeyer Sets Out Tough line an EMU ConvergenceCriteria,” Financial l7mes (November 5, 1994).

Marsh, Oavid, “Emu Strain Begins ta Show.” Financial Times(January 17, 1995).

Owen, David. “Malor Says Timetable for Monetary UnionUnrealistic,” Financial Times (August 3, 1993).

Partes, Richard. 1993. “EMS and ENU After the Fall,” The WorldEconomy (No, 1, 1993) pp. 1-16.

Tietmeyer, Hans. Speech at flue Association for the Monetary Union ofEurope in Frankfurt/Main, September 9, 1994. Printed in Bank forIntarnafianal Settlements, B/S Review (October 14, 1994).

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