Tug of war for control of the euro

Date: 27/03/1997

SIMMERING away under all the speculative froth about a single currency delay is a real power struggle between Europe's central bankers and elected politicians.

Struggle may sound a strong word. When monetary officials cross swords, the battlefield is a conference room and the casus belli merely textual interpretation.

Nevertheless, a power struggle this certainly is. Depending on who wins, it will determine whether the European Central Bank (ECB) or finance ministers will decide the external exchange rate of the euro.

The Maastricht Treaty handed huge, unencumbered powers to the ECB over the conduct of domestic monetary policy. Its president and all the members of its decision-making board will be entirely independent of political influence and they will have one objective only: to keep prices stable. They, and not the EU's finance ministries, will set interest rates and they will do this according to the rate of inflation and not according to political necessity.

Such a transfer of monetary powers was difficult for many member states but they agreed to it partly to win over the Bundesbank and partly because the postwar German experience suggests that an independent central bank does indeed work wonders.

However, when it came to negotiating international currency agreements, the politicians drew a line in the sand. The ECB could have a say in deciding at what level the euro should be pegged against the US dollar, the Japanese yen or anything else for that matter, but the final word would rest with finance ministers and their political masters.

After all, the foreign exchange rate of the euro will have a major impact upon general economic conditions - such as industry's ability to export, and import penetration - and that is still the responsibility of governments.

The outcome of these negotiations was Article 109 of the treaty - painful to negotiate and consequently excruciating to read.

The story is not over yet. It is in the nature of central bankers that they think they know best. Free of the burdens of seeking re-election or reporting to parliaments, they tend to get things done quickly and efficiently.

The European Monetary Institute, the Frankfurt-based precursor to the ECB, is rightly proud of its successes. After all, it was not finance ministers but the EMI council, which groups together the EU's central bank governors, which swiftly brokered agreements on how to manage the transition to the euro and then on how to bind the euro to Union currencies which stay outside the single currency zone in January 1999. Ministers simply rubber-stamped their proposals.

But, as governments are discovering daily, central bankers have to be watched like hawks. Give them a finger and they will take your hand.

Last December's EU summit in Dublin gave its blessing to a proposal from the EMI on how to reform the Exchange Rate Mechanism (ERM) so that it will bind 'out' currencies to the euro.

If member states outside the single currency zone choose to join the ERM, they will be given a central rate for their currency against the euro and it will be allowed to fluctuate (probably) as much as 15&percent; either side of this rate. The ECB will support these fluctuation margins so long as the authorities in the 'out' country pursue sound economic and monetary policies approved by their euro-bloc peers.

This will not be enough for some governments. For them, 15&percent; bands are as good as floating and do not reflect the differences in economic performance between, say, Denmark and Greece or - perhaps later - between the UK and Poland. These countries want recognition for their 'convergence' in the form of narrower trading bands for their currencies. Instead of 15&percent;, they want 1-2&percent; either side of the central rate.

This is the origin of the dispute. Since the Dublin summit, central bank and finance ministry officials in the EU's monetary committee have been putting the legal flesh on the bones of the agreement to establish an ERM II.

As negotiations have progressed, the central bankers have started to chance their arm.

At first, they tried to suggest that they should be given the powers to negotiate whether a narrow band was granted to an outsider. It was they, after all, who would have the responsibility of sustaining the bands by intervention in the markets to buy or sell currency.

Governments saw off this challenge to their treaty-enshrined authority. Now, the central bankers are trying another tack.

Narrowing an outsider's trading band can be done in two ways. On the one hand, there is the 'informal' German-Dutch model. When the bands of the ERM were widened to 15&percent; in August 1993, the Dutch and the Germans agreed that the guilder would be kept to 0.5&percent; bands with the help of central bank intervention and interest rate policy.

This could be emulated by the euro-bloc authorities and, for example, the Danes. Central banks would play the leading role in striking such a sweetheart deal, since they would choose the width of the bands and they would decide when and whether to defend them.

'Formal' narrow bands are another matter. These would be negotiated by the finance ministers and central banks of the euro-zone, the ECB itself and the minister and central bank governor of the 'out' state. Other 'out' authorities would be given a say in the economic and financial committee - the successor to the monetary committee once EMU begins - but would not be allowed a veto.

Ministry representatives are keener on the formal route because it maintains their role in foreign exchange policy - one of the few areas which they will still be allowed to determine.

The days of international agreements between the Group of Seven industrialised states, or even the old-style Bretton Woods system - where major currencies were fixed against each other and backed by gold - seem to be over.

But once the euro-area finds its feet, foreign exchange policy is likely to become increasingly important, as will interpretations of Article 109.

The US authorities have rarely had to worry about the impact of a falling dollar because the attractiveness of its huge and unified capital market has meant that investors have had nowhere else to go. A collapsing dollar does not necessarily spell higher interest rates in the US.

With the euro suddenly becoming an invoicing currency, and a single European share and bond market, the Americans are more likely to be drawn to the negotiating table to keep fluctuations to a minimum.

European politicians want to make sure that when Washington does this, it is they - rather than just representatives of the ECB - who are there to meet them.

The first part of Article 109 gives ministers the power to negotiate “formal agreements on an exchange rate system” on the basis of a recommendation from the ECB. This seems to refer only to a Bretton Woods-style regime.

Given that the euro-zone is likely to be a large and relatively closed trading area, a system whereby the euro is fixed against the dollar and yen should not be expected.

More probable is an informal agreement, along the lines of those concluded at the Plaza Hotel in New York in 1985 to push down the dollar, or at the Louvre two years later to stabilise exchange rates.

The remainder of Article 109 suggests that these types of accords would again be negotiated by ministers but that they should be “without prejudice to the primary objective” of the ECB - that is, price stability.

If the ECB chose to abandon an international agreement because its support for a foreign currency was undermining its ability to control domestic inflation, it is unclear whether this would land it in court.

Similarly, while these arrangements are meant to ensure that the euro-zone “expresses a single position”, monetary officials are the first to point out that the single voice of the common currency is not named.

The short history of the EMI suggests that this could be the central bank.