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Interstate Cooperation and the Hidden Face of Power: The Case of European Money
Lloyd Gruber Assistant Professor The University of Chicago Irving B. Harris Graduate School of Public Policy Studies 1155 East 60th Street Chicago, IL 60637 tel: 773-702-3245 fax: 773-702-0926 email:
[email protected]
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September 13, 1999
For thoughtful comments and suggestions on earlier drafts of this paper, I am grateful to Delia Boylan, Jeffry Frieden, Geoffrey Garrett, Richard Locke, Lisa Martin, Thomas Oatley, Kenneth Oye, Duncan Snidal, and the participants of the University of Chicago’s Program on International Politics, Economics, and Security (PIPES) workshop.
-- Abstract -Why do highly-institutionalized international regimes like the EU, NAFTA, and the WTO exist?
The conventional wisdom says it is because they provide positive-sum benefits,
facilitating collectively desirable equilibria that their member states could never hope to obtain – at least not as efficiently – on the basis of unstructured intergovernmental bargaining and negotiation.
Focusing on the politically turbulent history of the European
Monetary System (EMS), this article points the way toward a more balanced, albeit less sanguine, theoretical perspective.
Although most scholars see international institutions as
efficient, Pareto-improving responses to collective-action problems, this is not, the EMS experience suggests, the only logical possibility.
Here, for example, we have a regime
with two signatories – Italy and the United Kingdom – that joined because (and only because) their neighbors – France and Germany – were in a position to create their own monetary system and “go it alone.” Recognizing that the pre-EMS floating exchange rate status quo was no longer a viable alternative, authorities in Italy and the UK decided they were better off cooperating with their French and German partners, the EMS regime’s ultimate beneficiaries, than not cooperating. But while the prospect of mutual gain is what drove their partners to cooperate, they – the Italians and the British – cooperated simply to avoid being left behind. Although the EMS is widely regarded as a paradigmatic case of states working together to achieve collective gains, the article thus makes a case that at least two EMS entrants would have preferred the original “non-cooperative” status quo, and so would never have joined (at least not voluntarily) had it remained a feasible option. What is needed, the article concludes, is a broader, more nuanced way of thinking about the relationship between state power and voluntary cooperation.
“The strong do what they can; the weak suffer what they must.” -- Thucydides, c. 400 BC
Introduction As the dust left behind by a collapsing Soviet empire settles and world leaders set about the task of fashioning a new global economic and security order, the work of analyzing international institutions – of understanding their distinctive origins, purposes, and consequences – has taken on special significance.
To this point, however, the
analytical apparatus that has framed scholarly discussion of the European Union, the WTO, and other such arrangements has left out an important part of the theoretical story. While there are many different themes running throughout the international political economy literature, the dominant lines of argument all share one fundamental premise:
all presuppose that international institutions, and regional and multilateral
“regimes” more generally, are structures of mutual advantage, their rules, norms, and procedures facilitating collectively desirable outcomes that their member states could never hope to obtain – at least not as efficiently – on the basis of unstructured intergovernmental bargaining and negotiation.
As for why new EU- and WTO-like structures are
proliferating more rapidly today than in the past, that’s because we are moving into an era of ever-increasing “globalization” in which the benefits of maintaining cooperative interstate relations are perceived to be higher (and the anticipated gains from unilateral action lower) than was the case in earlier years. wisdom on such things, surely this is it.
Inasmuch as there is a conventional
And yet, if one looks closely at the global
system’s emerging institutional landscape, one cannot help but be struck by the gulf
1
2
separating the IPE literature’s avowedly positive-sum analytical orientation from the murkier, more ambiguous institutional reality. Take the recent “contagion” of regional trade institutions, for instance.
Why are
political leaders throughout Europe and the Americas actively seeking accession into the EU and NAFTA – or, when their requests for admission are denied, forging ahead with similar (albeit smaller-scale) regional trade regimes of their own? The economic argument for eliminating protectionist trade barriers is predicated on the assumption that the domestic beneficiaries of economic liberalization compensate the domestic losers.
In
many countries, however, the prospect of higher taxes and lessened competitiveness discourages politicians from erecting the kinds of domestic economic and political institutions necessary to ensure that the benefits of free trade and economic liberalization are in fact widely shared.1 And because governments are unwilling to support large social safety nets, the increase in cross-border flows of goods, services, and capital has been accompanied in many free-trading societies by rising income inequality, a development which has fueled considerable resentment among those individuals and groups whose livelihoods are most directly threatened by rapid market integration (and who in a number of societies constitute a substantial proportion of the population).
In short, trade
cooperation – the reciprocal elimination of protectionist trade barriers – may be conducive to economic liberalization, but economic liberalization is by no means a universal or unmitigated good. Focusing on the politically turbulent history of the European Monetary System (EMS), this article makes a similar point about the “good” obtained through regional
1
Cf. Rodrik, 1997; see also Garrett, 1998a.
3
monetary cooperation – namely, a stable exchange rate. While stable currencies and low inflation may be viewed favorably by some states (or, more precisely, by the individuals who govern them), the loss of devaluation as a tool of macroeconomic policy can lead to political turmoil in countries lacking alternative means of adjustment during periods of temporary downturn.
And yet, over the past few decades, the international monetary
system has seen a remarkable proliferation of formalized EMS-like currency links.2
If
these arrangements do not actually facilitate collective gains, why do governments persist in creating (and sustaining) them? This sort of thing should not be happening – or at least our current institutionalist theories would appear ill-equipped to explain it. In this article, I want to suggest why I think institutionalist theory is capable of explaining it.
The problem is simply that, until now, the theory’s underlying rational-
choice logic has been pursued in only one direction – toward that holy grail of institutionalist research known as the Pareto frontier.
There has never been a very good
reason for this, for while most scholars see international institutions as efficient, Paretoimproving responses to collective-action problems, that is not the only logical possibility. Europe’s recent experience with monetary integration is, I will argue, a case in point. That the inauguration of the EMS regime in 1979 was a major step along the road to monetary union is indisputable.
Less clear, however, is whether that step – the establishment of a
highly elaborate pegged exchange rate system centered around the German mark – was a “good thing” in the eyes of that system’s participating governments.
In fact, domestic
authorities in Italy and the United Kingdom, two of the regime’s largest and most
2
See, e.g., Cottarelli and Giannini, 1997.
4
prominent signatories, would have been only too happy to return to the pre-EMS world of freely floating exchange rates. So what, then, prompted the Italians (in 1979) and the British (in 1990) to relinquish their monetary autonomy? The answer, in a word, is power – specifically, as I elaborate below, the “go-it-alone power” exercised by the EMS regime’s French and German beneficiaries. To be sure, my rendering of the EMS story is not the standard one; while the distributional conflicts engendered by the regime have been widely noted and discussed, the consensus of scholarly opinion – at least among political scientists – is that the EMS represented an unambiguous Pareto-improvement over the non-cooperative monetary status quo it supplanted.3 Concentrating on the entry decisions of the Italian and British governments, this article presents a different view. Before turning to the evidence, I want to make it clear that while my substantive focus here is on the dynamics and utility consequences of European monetary integration, the theoretical implications of my analysis are potentially much broader, touching as they do upon the more basic (and still unsettled) question of why and how states cooperate in general. In addition, the idea that some actors may be able to impose their will on others by virtue of their ability to “shift the status quo” unilaterally and not, at least not necessarily, because of their greater capacity to engage in coercive diplomacy (i.e., bullying) may also have relevance for how we think about cooperation and institution
3
See, for example, the recent study by Oatley (1997), who is most explicit on this point. The EMS, he writes (p. 49), was “a Pareto-improving bargain; weak-currency policymakers gave the Bundesbank control of the system’s single monetary policy instrument in exchange for the right to use the exchange rate to draw on the Bundesbank’s commitment to price stability and facilitate disinflation at home.” A similar view is implicit in Moravcsik’s (1998: 501) description of the European Community, of which the EMS was an integral part, as “the most successful international institution of modern times.”
5
building at the domestic level. This last issue strikes me as a particularly promising avenue for future research.
In much of what follows, however, I deliberately set aside these
generalizability concerns so as to keep the analysis as clear and simple as possible. Rethinking European Monetary Integration Formally inaugurated in March 1979, the EMS was the longest-lasting, most encompassing exchange rate arrangement among the advanced democracies since the collapse of the Bretton Woods regime in the early 1970s. While exchange rate agreements were not new to Western Europe, previous efforts to create a common exchange rate policy had enjoyed little success. A Little Background While many observers interpreted the failure of these earlier initiatives as a sign that progress toward monetary integration in Europe would have to await the creation of a European common market, others disagreed, maintaining that the introduction of a single European currency would promote – because its day-to-day operation would necessitate – the further dismantling of trade restrictions and, ultimately, the establishment of an integrated European market.
Foremost among these dissenters was the president of the
European Commission, Roy Jenkins.
During a visit to Italy in October of 1977, Jenkins
delivered a speech exhorting European heads of state to renew their earlier commitment to monetary integration precisely as a way of accelerating the process of trade integration. Six months later, these European leaders took his advice, embracing a bold (albeit initially rather vague) proposal for a new, exclusively European “zone of monetary stability.” The
6
next eleven months – from April until December of 1978 – were spent filling in the details.4 While the monetary arrangement that emerged from this process incorporated a broader set of agreements, its centerpiece was the so-called exchange rate mechanism, or ERM.
When a country joined the ERM, it was assigned a central exchange rate, or
“parity,” denominated in a common unit of account known as a European Currency Unit (ECU). The ERM signatory then promised to adjust its interest rates, buy and sell reserves in the currency markets, or take whatever other measures might be necessary to keep the value of its currency within a given range – either 2¼ or 6 percent – of this central rate. Eight countries – France, Germany, Italy, Denmark, Ireland, the Netherlands, Belgium, and Luxembourg – agreed to these rules from the outset. These eight were subsequently joined by Spain (1989), the United Kingdom (1990), and Portugal (1992). In 1992, less than two years after the United Kingdom had become a full member of the system, a tidal wave of speculation forced the British government to withdraw the pound from the ERM. The European currency crises of September 1992 and August 1993 also saw the departure of the Italian lira, devaluations of the Portuguese escudo, Spanish peseta, and Irish punt, and a dramatic widening of all ERM bands (except the one between the German D-mark and the Dutch guilder) to plus or minus 15 percent. At the time, the European Monetary System seemed to be in disarray.
In retrospect, however, the crisis
was but a temporary setback, as 1999 saw France, Germany, and Italy (although not,
4
The EMS proposal was first announced on April 7, 1978, at a European Council summit meeting in Copenhagen. A more detailed version of this proposal was approved at a second European Council summit held three months later in the German city of Bremen. Negotiations came to a close with the ratification of a formal resolution shortly after the conclusion of yet another summit – this one in Brussels – on December 15, 1978.
7
significantly, Great Britain) completely abandon their separate currencies in favor of the “euro,” the new appellation for the EMS regime’s ECU. 5 There is of course no guarantee that Europe’s newly minted single currency will endure.
Even if things do go awry,
however, the fact remains that the EMS, whether or not it ever gives way to a (sustainable) monetary union, has already altered the course of events in Western Europe, profoundly influencing the economic and political trajectories of countries throughout the region. Few would dispute that these EMS-induced effects worked to the benefit of the French and German officials who held office during the years in which the regime’s terms were being ironed out, and without whose initiative and support it would never have become a reality. 6 But what about these officials’ counterparts in Italy and the UK? Did the Italian and British governments enjoy utility gains as well? Addressing the Counterfactual Problem At first glance, one might think that the question of whether Italy and the UK were EMS “losers” could be resolved by simply evaluating how each of their governments fared politically during the years in question.
Yet the fact that the political fortunes of both
countries’ governments declined after their EMS entries – in Italy’s case quite precipitously – does not mean that governing elites in these countries would have preferred a world in which the EMS did not exist. For even if the Italian and British governments did fare worse after joining the EMS than before, no one would claim that the EMS
5
The larger theoretical significance of Europe’s transition from the EMS to a full-fledged monetary union (EMU) is discussed below. 6
On the politics surrounding the creation and early years of the EMS, see De Cecco, 1989; Frieden, 1994; Heisenberg, 1999; McNamara, 1998; Moravcsik, 1998; Oatley, 1997; and especially Ludlow, 1982, which remains the definitive work.
8
deserves all of the blame for this pre- versus post-entry differential. And in any case, what we want to know is not whether things would have been better for the Italians and British if (counterfactually) the EMS regime had never come into existence; it’s whether the members of the Italian and British political establishments believed that things would have been better. Now, one might suppose that because we are more interested in what these countries’ political leaders were thinking at the time they decided to join the regime than in what actually came to pass, one could simply go out and interview the protagonists. But, once again, matters are not so simple.
There are well-known reasons why one cannot
always infer the truth from politicians’ retrospective renderings of their motivations and thought processes. In this case, moreover, the policy decisions at issue were taken many years ago.
Although many of the protagonists no longer hold official positions and so
should be less inclined to dissemble for political purposes, the passage of time can also make it more difficult for the relevant parties to recollect why, years earlier, they made the choices they did.
Then, too, there is the problem that a number of the principals –
including the Italian prime minister who took the lira into the EMS in 1979 (see below) – have since been found guilty on charges of political corruption, thus casting considerable doubt on their trustworthiness, to put it mildly. For all of these reasons, it is important to use caution when gathering information from (or assessing first-person accounts written by) the individuals who were directly involved. In the end, however, I would submit that my description of Italy and the United Kingdom as absolute (not just relative) losers holds up despite these methodological and practical hurdles. Demonstrating this requires showing that the elected leaders responsible for introducing the Italian lira and British pound into the new regime would actually have
9
preferred the initial, pre-EMS status quo – that, in other words, these leaders would have breathed an enormous sigh of relief if France and Germany’s EMS initiative had gone nowhere. Let’s begin with the case of Italy. Why Did Italian Authorities Give Up Control of the Lira? It was not until April 7, 1978, several weeks after French president Valéry Giscard d’Estaing and his German counterpart, Chancellor Helmut Schmidt, had begun formulating the specifics of their monetary proposal, that the Italian prime minister Giulio Andreotti learned of its existence.
The first-hand accounts cited by Ludlow (1982: 91-92) suggest
that when Giscard and Schmidt finally broached the issue – the occasion was an informal after-dinner gathering of European heads of state at a European Council summit meeting in Copenhagen – Andreotti was caught completely off guard.
In time, however, the Italian
prime minister became a strong proponent for introducing the lira into the regime, a move he hoped to undertake (the vagaries of Italian domestic politics permitting) at the same time that France and Germany introduced their own currencies.
Contemporary accounts
suggest that deciding to give up control of the lira was not at all difficult for the Italian leader. Why was Andreotti’s decision such an easy one? Credibility One possibility is that Andreotti believed Italy’s entry into an exchange rate arrangement centered around the German mark would lend credibility to his government’s recently enacted program of fiscal and monetary retrenchment, thereby accelerating the downward adjustment of wages.7
7
Initiated at the beginning of 1978, the Pandolfi Plan –
See, e.g., Giavazzi and Pagano, 1988.
10
named after the minister of the Italian Treasury – combined monetary contraction and fiscal consolidation with calls for greater wage restraint on the part of Italian workers. The “disciplinary” rationale for Andreotti’s decision will be discussed at greater length below. For now, suffice it to say that Italy’s historic entry into the EMS occurred during a period in which the Italian Communist party (PCI), although denied ministerial portfolios in the Italian government itself, was nonetheless a crucial component of Andreotti’s governing coalition.
Why does this matter?
It matters because there is no
evidence that the leaders of the PCI believed Italy’s participation in an exchange rate regime anchored on the D-mark would work to the advantage of their party’s predominantly working-class supporters.
To the contrary, the view within Italian
Communist circles at the time was that “the government would ‘use’ the EMS as an excuse to push through domestic policies that would be deflationary and therefore damaging to the interests that they represented.”8 Despite its belief that Italy’s entry into the EMS would lead to higher unemployment and a lower standard of living for its constituencies, the Italian Communist party ended up going along with Andreotti’s decision.9 My contention below is that the PCI did so because it feared a “no” vote would lead to an (even) worse outcome. By the spring of 1978 it was clear that the French government was going to peg the franc to the Dmark irrespective of Italy’s decision. As a result, the status quo that the Communists (and even perhaps Andreotti’s own Christian Democratic party) would have preferred – a de
8 9
Ludlow, 1982: 212; see also Sassoon, 1981.
Although the PCI refused to vote in favor of the EMS, its leaders worked out an arrangement whereby the Italian Socialist party would abstain, thus ensuring that Andreotti would have enough votes to introduce the lira into the ERM and averting an all-out government crisis.
11
facto laissez-faire system in which Italy, France, Germany, and the UK each set their monetary policies more or less independently – had ceased to be a viable option. Had it not been for this dramatic change in Italy’s external environment, Italian domestic politics would have strongly militated against placing the lira in the new monetary regime, and the notion that preserving the value of the lira was about to become the touchstone of Italian policy would have struck most observers as too farfetched to merit serious consideration. The Costs of Exclusion This puts the explanatory emphasis where it belongs – on the decision by governing officials in France and Germany to establish an explicit link between their two currencies. While the Italian government could still have chosen to retain its monetary independence, this non-cooperative strategy would have entailed (or so, at the time, nearly everyone believed) extraordinarily high costs. Indeed, over the course of the previous three decades, the idea that Italy had to maintain its European “credentials” in order to prosper economically had come to be accepted as an article of faith by both the left and right of Italy’s political establishment.10
While one can fairly question the rational basis for this
view, the fact remains that politicians across the Italian political spectrum put a premium on their country’s European connection. That being the case, it is not hard to understand why they would have been reluctant to exclude themselves from the new Franco-German regime. By directly undermining Italy’s claim to being an integral part of Europe, a refusal to join this regime would have cast a shadow over a government that was not, as we shall see, all that stable to begin with.11
10
See, e.g., Spaventa, 1980; Frieden, 1994.
11
Ludlow, 1982: 147-50; see also De Cecco, 1989: 90.
12
In short, the announcement made by the French and German heads of state at the Copenhagen summit served to limit the range of possibilities for Italy.
Once President
Giscard and Chancellor Schmidt had resolved to link their currencies, public officials in Italy concluded that the price of exclusion – Italy’s being relegated to the European periphery, with all of the symbolic and economic costs that this implied – would have been even greater than the price of entry. This is not to say that Italy’s political leadership welcomed the new arrangement. What Giscard and Schmidt did, in effect, was to raise the definitional threshold for being considered a good European. Up until that point it had sufficed for a country to participate as a member in good standing of the EC, a standard that Italy could maintain without great difficulty.12 Now, however, Italy was being asked to meet a higher standard. In order to maintain its European connection, Italy would now have to accelerate its disinflationary trajectory to a degree that was neither economically nor, from the point of view of the center-left majority governing Italy at that time, politically optimal. The anxieties created by all of this were intertwined with a pervasive sense of resignation, a mixture nicely captured at the time by the official spokesman for Italian industry, Guido Carli. A former governor of the Banca d’Italia, Carli observed: “If Italy is too weak to participate in the EMS, it is also true that she is too weak not to participate.”13 A Victim of Coercive Pressure? Too weak, yes; coerced, no. At no point did the French and German beneficiaries of the EMS use force or intimidation to “bully” Italy into joining. Nor, for that matter, did
12
When Andreotti pledged to join the EMS in 1978, the Single European Act and the broader “1992” agenda were still many years away. 13
Quoted in Ludlow, 1982: 210.
13
Giscard and Schmidt resort to subtler, indirect forms of coercive pressure – promising, for example, to exclude non-signatories from the benefits of cooperation in other areas. One version of this latter coercion-through-linkage argument holds that Italian political elites consented to the terms of the EMS only because the arrangement’s French and German sponsors had been threatening to shut Italy out of the larger process of EC integration.14
That Italian politicians did not wish to be perceived as having “missed the
European train” is certainly true. The question is whether this train’s departure was part a deliberate strategy on the part of the new monetary regime’s French and German beneficiaries to manipulate Italy’s decision-making calculus.
In fact, President Giscard
and Chancellor Schmidt seemed relatively unconcerned with whether or not Italy opted out of “their” regime – perhaps because in 1978 Italy’s economy was less than two-thirds the size of France’s and less than half that of West Germany, and trade with Italy represented a fairly small proportion of both countries’ total trade.
Further belying the “strategic issue-
linkage” explanation is the fact that Giscard and Schmidt let the United Kingdom opt out of the EMS without demanding that it give up its affiliation with the EC.15 British Prime Minister Jim Callaghan’s request for special status, which was made at an early stage in the negotiations and the granting of which was never in doubt, made it highly unlikely that Italy would be singled out for punishment in the event that it, too, were to opt out of the EMS framework.
14 15
See esp. Frieden, 1994.
Technically speaking, the UK had been a member of the EMS from the very beginning. Prior to 1990, however, that membership was essentially meaningless, as the British government had steadfastly refused to introduce the pound into the regime’s all-important exchange rate mechanism, or ERM.
14
Britain versus Italy: A Natural Experiment What, exactly, did members of the Italian political establishment stand to lose by Italy’s being relegated to the European periphery?
If the argument I have been making
thus far is correct, their desire to avoid severing Italy’s European connection was motivated, at least in part, by their expectations about how the financial markets would react to such an occurrence.16
Once the envisaged “zone of monetary stability” had
become a reality, the expectation was that EC members located outside this zone would find themselves at a relative – and growing – disadvantage in attracting foreign capital. Underlying this prediction were three basic assumptions:
first, that the explicit link
between their own currencies and the D-mark would afford EMS member states greater protection against future inflation; second, that countries lacking this protection (e.g., the non-participating “laggards”) would face the specter of massive capital outflows; and third, that this would translate into higher interest rates, and ultimately slower growth and higher unemployment, in the non-EMS countries than in their EMS-participating neighbors. But did all of these assumptions really make sense? How can we know what Italy’s interest rate premia would have been if Andreotti had refused to introduce the lira into the ERM? The short answer is we cannot know, at least not for certain. But while there is no sure-fire method for determining how Italy would have fared economically as an EMS
16
As sensitive as he was to Italy’s reputation within the global financial community, Andreotti was also motivated, as noted earlier, by a separate, more diffuse set of concerns: by opting out of the ERM, Italy would have been relegating itself to the sidelines of “Europe.” Even if this opt-out option had had no financial implications whatsoever, its negative symbolic implications – the notion that Italy had somehow been left behind – would probably have been enough to tip the scales in favor of entry. As we will see, this was not the case in the UK.
15
outsider, all is not lost: in this case history has conspired to provide an appropriate point of reference – the United Kingdom. British authorities might well have entered the pound into the exchange rate mechanism (ERM) of the new regime at its inception in 1979. Their country was, after all, a longstanding member of the European Community.
For a variety of idiosyncratic
reasons, however, the British government delayed becoming a full-fledged participant in the system until 1990. The Italian case thus invites comparisons with Britain’s experience as an EMS non-signatory, making it a logical choice for further investigation. The EU’s Most Reluctant Regionalist Numerous considerations entered into Britain’s decision to remain on the sidelines of the EMS throughout the 1980s.17
Part of its hesitation had to do with the inherent
incompatibilities between the targeting of monetary aggregates, the centerpiece of Thatcher’s macroeconomic agenda during her first term in office, and the targeting of the exchange rate necessitated by full membership in the EMS.18 Complications such as these certainly played an important role in the Conservative government’s (initially) tepid response toward the regime.
Of even greater importance, however, were the perceived
symbolic costs of British entry.
Had Thatcher relinquished control of the pound upon
17
My discussion of British behavior draws on Dennis and Nellis, 1986; Lawson, 1992; Miller and Sutherland, 1992; Moravcsik, 1998; and Smith, 1993. 18
Upon taking office in 1979, the new Conservative prime minister announced that her government would strictly adhere to a set of previously announced five-year projections of the rate of growth of the money supply. It would not waver from these targets, Thatcher insisted, even if it meant sharply raising taxes in the midst of an economic recession. The underlying rationale was the credibility or “tying-hands” argument we encountered earlier. Proponents of this argument believed that Thatcher’s uncompromising adherence to preannounced monetary targets would encourage wages to adjust quickly, if not instantaneously, to the new, low-inflation reality. And if for some reason they did not quickly adjust, the resulting increase in unemployment would still have the beneficial effect (from Thatcher’s standpoint) of weakening the British labor movement.
16
taking office – or if Callaghan, her Labour predecessor, had done so when the EMS entered into force in 1979 – a large segment of the British electorate would have regarded the act as a blatant and wholly unwarranted encroachment on their country’s long tradition of political independence. Whatever the precise motivation, the fact that Britain’s leaders delayed introducing the pound into the ERM enables us to conduct a natural experiment.19 Did Britain pay a price for its self-imposed isolation – a price that Italy, too, would have had to bear had it chosen not to participate? Let’s begin by looking at the interest rate differentials displayed in Figure 1. -- Figure 1 about here -If attention is restricted to the first part of the 1980s, Britain’s relatively low interest rates might seem to belie the claim that the UK suffered a credibility loss as a result of its non-participation in the EMS. Between 1980 and 1985, British interest rates were typically lower, not higher, than those of other EMS member states. The absence of a persistent interest rate differential over this period comes as little surprise, however, given that – initially, at least – the Thatcher government seemed intent on wringing every last drop of inflation out of the British economy, even if that meant presiding over several straight years of double-digit rates of unemployment.
That being the case, the financial
community had reason to be confident that Britain’s inflation gap with France and Germany would continue to decline even if the Tories were to insist on maintaining exclusive control over the value of the pound.
In short, any misgivings the financial
markets might have had about the UK’s refusal to submit to the anti-inflation discipline of
19
See King, Keohane, and Verba, 1994, chap. 4.
17
Figure 1 UK-ERM Interest Rate Differentials, 1979-1993 Source : IMF, International Financial Statistics ; OECD, Historical Statistics
15%
UK 10%
ERM Avg. 5%
0%
-5%
Interest Rate Differential
Shaded bars show UK's Annual Rate of Growth (% change in real GDP)
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
-10%
1979
Money Market Rates (monthly)
20%
18
the EMS would appear to have been offset – perhaps more than offset – by Thatcher’s unparalleled, and seemingly unflappable, commitment to price stability. As the 1980s wore on, however, officials within the Thatcher cabinet (everyone, it seemed, but the prime minister herself) began to see Britain’s self-imposed monetary isolation as a major political and economic liability. By the start of Thatcher’s third term in 1987, there were few illusions that the presence of a fiscal conservative at the helm of British politics would be sufficient, given lingering rigidities in the British labor market and an unprecedented expansion of consumer credit, to induce a rapid, much less an instantaneous, decline in domestic inflationary pressures.
Though Thatcher had been able
to hold the line against inflation during her first two terms, she had been forced to do it the old-fashioned way – by swelling the ranks of the unemployed – and it had not been easy. To be sure, large-scale unemployment was not as great a political liability for the Tories as it would have been for a Labour government. If they voted at all, unemployed workers were highly unlikely to vote Conservative.
But that did not mean that
unemployment was politically unproblematic for the government. On the contrary, though they themselves may not have been at risk, most British voters nonetheless rated unemployment “the major problem facing the country.”20
Nor, by the start of its third
term, did the Conservative government have the luxury of using North Sea oil or privatization revenues to cover the costs of unemployment compensation.
Finally, and
perhaps most importantly, the opposition Labour party, though still greatly outnumbered in the House of Commons, had moved aggressively to the center of British politics, divesting itself of its militant faction (the “loony left”) in an effort to gain credibility among the
20
Garrett, 1993: 538.
19
broader electorate. For the first time since coming to power, the Tories’ once-formidable lock on power appeared to be dissipating. The Economic Consequences of Britain’s Self-Imposed Isolation As her government’s earlier willingness to bear the brunt of double-digit rates of unemployment began to decline, Thatcher found herself facing a predicament not unlike the one that had confronted Italian policymakers in 1978. As much as she disliked the idea of relinquishing control of the pound, she recognized that there was simply no other way – short of continuing to drive up Britain’s already high rate of unemployment – of demonstrating her government’s anti-inflation resolve. Even so, the prime minister refused to give in until October 5, 1990.
In the
meantime, and as Thatcher’s highly regarded Chancellor of the Exchequer, Nigel Lawson, never tired of pointing out, Britain’s special status as the only major EC member not to participate in the EMS caused the risk premium attached to sterling-denominated investments to increase relative to the premium on investments denominated in other European currencies.
In turn, this rising differential translated into higher interest rates –
and thus a slower rate of growth – than might have been necessary if Thatcher had followed Lawson’s advice in favor of immediate entry.21 Indeed, Lawson had been urging the prime minister to give up control of the pound since 1985. By the time Thatcher took Lawson’s his advice, Britain had endured nearly six straight years in which money market rates in the UK exceeded those of its EMSparticipating neighbors. Nor are we talking here about trivial differences: during the two years between September 1988 and September 1990 – a period characterized, not
21
See Lawson, 1992: 111.
20
coincidentally, by a dramatic slowdown in Britain’s overall rate of growth – interest rates in the UK were consistently more than four points higher than those found in EMS member states (Figure 1).22 Britain’s exclusion from the EMS was certainly not the only reason for these disparities.
Nevertheless, the view was widespread that British entry into the EMS, by
calming investors’ fears about an imminent rise in inflation, would go a long way toward alleviating the problem.
And indeed, when Thatcher did finally acquiesce (after countless
hours of lobbying by Lawson and others), the result was a dramatic, overnight decline in British interest rates. By the summer of 1992, interest rates in the UK were running more than four points lower than those in other EMS countries, suggesting that British entry did in fact lower the perceived risk to international lenders of holding sterling-denominated securities. The lesson to draw here, then, is not that Britain’s exclusion from the EMS had no adverse credibility effects. Quite the contrary, its exclusion came at a price so high that, in the end, not even the Iron Lady herself was willing to pay it. Were the EMS Losers Really Worse Off? Even if I am right that defensive considerations are what induced the Italians and, eventually, the British to take a seat on the pegged exchange rate bandwagon, it does not follow that their participation in the new monetary regime was a bad thing. Is it really the
22
It was because of Thatcher’s firm opposition to British entry during the early 1980s that Lawson began unofficially “shadowing” the D-mark in 1987. Insofar as this surreptitious policy restored (somewhat) the confidence of private investors, Lawson’s interventions may have temporarily diffused upward pressure on British interest rates. In the absence of a tacit currency link, it’s likely that the risk premia on British investments, and hence the output and unemployment costs of deflation, would have been even higher than they were.
21
case that the Italian and British governments would have preferred the pre-EMS world of freely floating currencies? The answer isn’t obvious. Consider Italy. Although it may be true that (1) France and Germany’s go-it-alone initiative removed the ex ante floating-rate status quo and (2) this in turn “forced” Andreotti to do something he would not otherwise have done, it does not necessarily follow that (3) Andreotti’s decision undermined his government’s economic or political welfare. The current conventional wisdom is that Andreotti’s decision to surrender control of the lira actually improved his government’s utility, though, to be sure, the fact that Italy’s political establishment secretly delighted in their monetary “predicament” was not something they wished to broadcast to the Italian public. As it happens, this view is in keeping with a well-established – though muchcriticized23 – body of economic theory according to which membership in a pegged or fixed exchange rate regime makes it possible for countries to reduce their rates of inflation without at the same time increasing their rates of unemployment. If this had been the case, the Italian officials who introduced the lira into the EMS would have had nothing to worry about. But it was not the case, and here’s why. Italy’s Preference for the Pre-EMS Status Quo Proponents of the positive-sum interpretation make two critical assumptions.
The
first is that membership in the EMS acted as a kind of low-inflation commitment device.24 This is reasonable enough, since high-inflation countries could remain in the system only by working aggressively to reduce their inflation differentials with Germany, the regime’s
23
See, e.g., Dornbusch, 1989.
24
Giavazzi and Pagano, 1988.
22
low-inflation anchor. Less plausible is the second assumption – namely, that wage-setters in a high-inflation country like Italy, anticipating their government’s new, harder-line disinflationary stance, would moderate their wage demands in advance, thus obviating the “need” for high unemployment during the country’s post-entry adjustment period. Concerns About the Prospect of EMS-Driven Unemployment At the time that Andreotti made his decision, the expectation of most observers was that Italian labor markets would in fact be quite slow to adjust to the new, post-EMS (i.e., deflationary) reality.
This expectation was well-justified.
Not only does the disciplinary
argument presume that Italian wage-setters trusted their government to stay in the system (i.e., not to resort to unwarranted depreciations); it also requires that the institutional framework governing the wage-setting process be free of major distortions, allowing labor contracts to be quickly and easily renegotiated in response to sudden changes in inflationary expectations. Over time, however, Italy’s labor market had in fact grown more, not less, distorted and inflexible.25
In 1975, for example, though Italy was in the middle of its deepest
recession since the end of World War II, Italian labor unions nonetheless succeeded in getting the employers’ association to accept an automatic wage indexation scheme. Known as the scala mobile, this scheme was intended to keep workers’ wages from being eroded by future inflation.
Although the government announced its opposition to the
scheme in 1977, the combination of double-digit rates of inflation and strong labor support for indexation severely undermined the short-term prospects for wage moderation.
25
Flanagan et al., 1983: 555-61.
23
To Andreotti, the fact that Italy’s EMS-induced wage adjustment was likely to occur relatively slowly, with Italian workers experiencing considerable economic upheaval during a lengthy post-entry transition period, was a serious cause for concern. 26 While the prospect of higher short-term unemployment would have struck fear within any Italian government, it was particularly alarming to Andreotti’s government, beholden as it was to the Communist party. Not that everyone in Italy was fearful of the EMS: for those on the right, and for banks and corporations heavily engaged in international transactions in particular, the appearance of the regime was like manna from heaven.27 Be that as it may, the officials who held positions within Italy’s government did not rely exclusively upon Italian banks and multinationals for their electoral, or even for their financial, support. Far from being the handmaiden of any one constituency, the dominant member of Andreotti’s governing coalition – the prime minister’s own Christian Democratic party (DC) – was in fact highly factionalized, its divisions revealed in heated internal debates during the course of the EMS negotiations in 1977 and 1978.28 Moreover, about half of the DC’s electoral support came from rural voters, many of whom lived in southern Italy, a much poorer region than the thriving, more cosmopolitan north.29
Finally, even if the interests of Italy’s
internationally oriented businesses had held sway within the Christian Democratic party, Italy’s multiparty system made it impossible for the Christian Democrats to govern except as part of a broad center-left coalition. And as noted earlier, Italy’s decision to join the
26
For evidence that Italy’s “sacrifice ratio” during the 1980s was consistently higher than that of many other OECD countries, see Dornbusch, 1989, and De Grauwe, 1990. 27
Cf. Frieden, 1991.
28
Ludlow, 1982: 205-17.
29
Spotts and Wieser, 1986: 34.
24
EMS occurred at a time when the domestic balance of power was shifting toward the left, not the right. A Note on Side-Payments At their July 1978 gathering in Bremen, the European heads of state resolved to undertake measures “to strengthen the economies of the less prosperous [EMS] member countries.” From that point on, it was clear that some sort of financial aid package would be incorporated into the new monetary agreement. The question, of course, was what sort of package:
How much aid would the regime’s wealthier participants be willing to
sacrifice for the benefit of their poorer partners? The answer was soon made apparent when, in a statement leaked to the press, Giscard declared: “France cannot upset her own financial arrangements in order to ensure the adhesion of those for whom membership ought to be an act of political will rather than a question of cash.”30
Although Andreotti had reportedly asked for assistance totaling
approximately 360 billion lira, to be divided roughly equally between grants spread out over three years and interest rate subsidies, he was granted only 73 billion lira worth of subsidies per year.31 Deeply disappointed, Andreotti joined with Ireland’s prime minister, Jack Lynch, in requesting a “pause for reflection.” Less than two weeks later, however, both countries accepted these offers – with some slight modifications in the Irish case – and jumped on the EMS bandwagon. In the end, therefore, though some analysts have emphasized the role of sidepayments in reducing Italy’s burden of austerity, the amount of financial assistance the
30 31
Quoted in Ludlow, 1982: 264-65.
Ludlow, 1982: 266-67. Roughly a fifth of what Italy had been seeking, this sum was equivalent to less than 0.03 percent of Italy’s GDP in 1978 (author’s own calculations).
25
EMS regime’s wealthier member governments were ultimately willing to make available for the purposes of equalization did not come close to compensating for the wrenching economic dislocations that a country like Italy, which had previously relied upon currency depreciation to create jobs and stimulate growth, seemed likely to endure.32 In reality, the offer of financial assistance was little more than a symbolic gesture.
Not only was the
amount of concessionary finance pitifully small, but its provision was also contingent on each would-be recipient’s ability to do the necessary paperwork ahead of time – a task that turned out to be beyond the administrative capacities of many of the Italian provincial authorities who qualified for (but never actually received) financial assistance. In short, while some have speculated that Italian authorities took secret delight in joining the EMS – and, by inference, in relinquishing direct control over their country’s monetary policy – it is unclear why members of Italy’s governing majority would have taken this view.
In fact, the political fallout generated by Italy’s entry into the system
paints a rather sobering picture, one with which neither the centrist Christian Democrats nor, certainly, the left-wing Communists could have been particularly delighted.33
32 33
Taylor, 1980: 381-83. Compare Grieco, 1990: 222-23.
The PCI experienced a severe setback in the Italian parliamentary election of 1979, suffering a 4 percentage point decline in its share of the vote – enormous by Italian standards and the party’s first such drop since 1953. After having its previous electoral gains wiped out virtually overnight, it was to take the PCI another seventeen years to regain the trust of the Italian electorate. The election results were also a blow to the Christian Democratic party, though it emerged from the 1979 election with the same number of seats it had controlled since 1976. More troubling than the decline in the DC’s vote share was the discrediting of the PCI, strange though that may seem to readers unfamiliar with Italy’s distinctive brand of partisan politics. In addition to drawing strong support from women, rural residents, and churchgoers, the Christian Democratic party had also drawn support from citizens who saw it as a counterbalance to the Communists. After 1979, however, those citizens felt free to shift their allegiance to other parties. Although other factors were also at work – the decline of the DC’s near monopoly on patronage, for example – it is revealing that in the parliamentary election of 1983 the party’s vote declined from 38.3 percent to 32.9 percent. The Christian Democrats subsequently surrendered the prime ministership and invited Socialist leader Bettino Craxi to form the next government.
26
Short-Term Losses for the Sake of Longer-Term Gains? In response, it might be argued that the Italian officials who came out in favor of the EMS were simply taking the long view, putting their country’s long-term economic interests ahead of their own, more immediate political aspirations.
Italy’s entry into the
EMS was, in this view, a case of short-term political sacrifice – higher unemployment and slower growth during the initial adjustment phase, declining support (at least temporarily) for members of Italy’s political establishment, and so on – for the sake of longer-term gains. But was this really the case? In fact, neither the Christian Democrats nor, least of all, the Communists enjoyed the kind of short-term electoral security that this sort of argument requires. And even if these parties had been preoccupied with advancing Italy’s long-term economic interests, it is doubtful that they would have chosen the path they did (surrendering control of the lira) had it not been for the go-it-alone “threat” posed by France and Germany. For while the inauguration of the EMS did promise certain long-term economic benefits for Italy – the stabilization of the lira-mark exchange rate, the end to double-digit rates of inflation, etc. – it was not at all clear that these benefits would be worth the long-term economic costs. What were these costs? Once Italy joined the EMS, officials in the government lost the ability to cushion Italian industry and agriculture from temporary economic disturbances, known in the literature as supply and demand “shocks.” Ever since the first OPEC shock in 1973, Italian authorities had been using lira depreciation as part of a deliberate strategy to compensate for Italy’s uniquely vulnerable position (prior to OPEC Italy had been among Europe’s largest importers of foreign oil). economist Marcello De Cecco recalls:
As the Italian political
“The Italian monetary authorities had ... been
piloting the lira close to the wind, with the aim of gaining on the dollar and losing on the
27
D-mark. This policy had been crowned by remarkable success. Italian exports, which had previously moved towards the American market, had invaded the northern European markets. Reserves had been rebuilt in a very short time and an attack was being launched on public debt and inflation.”34 In 1979, Italy’s entry into the EMS forced the government to abandon this devaluation-centered adjustment strategy, successful though it had proved to be during earlier years.
Henceforth, any effort by Italian monetary authorities to compensate for
“Italy-specific” shocks by temporarily driving down the value of the lira would have required the permission of the European Monetary Committee, any one of whose delegates, including the representative from the German Bundesbank, could withhold his consent. To be sure, the fact that EMS signatories could not readily alter their exchange rates to address country-specific shocks – except, as noted earlier, within certain predetermined and relatively narrow margins – did not much trouble the regime’s French and German co-founders.
By the late 1970s, the French economy had already become
closely linked to that of West Germany, whose economic ties with Belgium and the Netherlands, among other smaller European countries, were even more highly developed. Given the similarity in the underlying industrial structures of France and Germany, an external disturbance that injured French producers could also be expected to injure producers in Germany, and vice versa. Consequently, the chances were good that if France ever faced a legitimate need for a short-term exchange rate stimulus (to alleviate the burden imposed by a temporary downturn), so, too, would Germany.
34
De Cecco, 1989: 90; see also Giavazzi and Spaventa, 1989.
28
As recent research has shown, however, economic disturbances originating outside the EC, whether produced by sudden swings in the fiscal and monetary priorities of the United States or by fluctuations in the world price of oil, do not influence all EC members in the same way.35 By most accounts, Italy was indeed in a unique position. One reason – the Italian economy’s greater reliance upon foreign sources of oil – has already been noted. But the structural differences between Italy’s economy and those of countries located inside the EMS “core” ran much deeper.
A revealing, albeit crude, indication of the
distinctiveness of Italy’s industrial structure is the symmetry ranking presented in Table 1: Germany’s annual rates of GDP growth between 1965 and 1979 were less correlated with Italy’s growth rates than with those of any other West European country except Sweden and Ireland. -- Table 1 about here -It is true that if Italy had had an effective substitute for currency depreciation, its vulnerability to Italy-specific macroeconomic disturbances would not have been especially problematic. If, in other words, Italy’s leaders had possessed some other means (other than devaluation) of temporarily restoring demand for Italian goods and services, the country could have continued to honor its ERM commitments without experiencing a protracted period of slow growth and high unemployment. In fact, however, Italy’s economy was anything but resilient. perhaps the most visible substitute for devaluation: outward migration.
Consider what is In the United
States, region-specific downturns have historically been followed by a major outflow of unemployed workers from the low-growth region (e.g., the rust belt) toward states located
35
See esp. Bayoumi and Eichengreen, 1993.
26
Table 1 The Symmetry of Business Cycles in the European Community, 1965-1979 (Correlations between Annual GDP Growth Rates in Germany and Other European Countries)
Country
Correlation
Symmetry Rank
Germany
--
1
Denmark
0.77
2
France
0.71
3
Netherlands
0.67
4
Belgium
0.66
5
[Greece]
0.59
6
United Kingdom
0.58
7
[Austria]
0.56
8
[Finland]
0.53
9
[Portugal]
0.49
10
[Spain]
0.468
11
Italy
0.467
12
[Sweden]
0.29
13
Ireland
0.16
14
Sources: Garrett 1998b, table 3; OECD, Historical Statistics, various years; and OECD, Economic Outlook 59 (1996): A4. Note: Countries in brackets were not members of the EC during the time period in question.
27
in higher-growth regions (e.g., the sun belt).
This outflow serves as a kind of “natural”
cushioning device, reducing the depressed region’s need for the temporary stimulus that currency depreciations can provide. In Europe, by contrast, even if a “region” (e.g., Italy) were to experience a prolonged period of stagnant growth, that region’s newly-unemployed workers could not be counted upon to pick up and move to other, more prosperous regions (e.g., West Germany). By comparison with the United States, the mobility of labor within the EC remains quite low, a fact readily explained by the EC’s greater cultural and linguistic diversity. And if labor mobility is low today, after the “1992” agenda’s removal of all barriers to the free flow of persons, it was even lower when Italy first joined the EMS in the late 1970s. Outward mobility was not, of course, the only substitute for lira depreciation. If at some point after joining the EMS Italy were to suffer a sudden loss of competitiveness visà-vis the European core, Italy’s leaders could have offset the burden facing unemployed Italian workers by undertaking a fiscal expansion – which is to say, by spending more money.
That, at any rate, is the theory.
In practice, Italy’s potential for adjustment via
fiscal policy was severely constrained by the public debt that successive Italian governments had run up over the course of the 1970s.
If investors proved reluctant to
purchase government debt (or were willing to do so only at very high interest rates), policies designed to artificially pump up demand were as likely to exacerbate Italy’s unemployment problems as to alleviate them.36
36
For analysis of why the loss of devaluation entailed in pegging their currencies to the Dmark was likely to be particularly painful for high-debt countries, see Dornbusch, 1989.
28
To be sure, things might have been different if, instead of having to spend its own way out of recession, Italy could have counted on major financial contributions from its European neighbors.
In the United States, fiscal federalism provides an effective short-
term palliative in emergency situations, cushioning region-specific shocks that cannot be dealt with through depreciation (since each U.S. region shares the same currency) and yet whose effects may be only partially offset by outward migration and deficit spending. In Europe, however, the structure of the EC’s federal funding mechanism – specifically, its inelasticity to temporary disturbances – does not facilitate its use as a stabilizing device.37 If devaluation, outward migration, deficit spending, and fiscal federalism are all ruled out, that still leaves adjustment through wages. But for wages to adjust rapidly to sudden swings in aggregate supply and demand, labor markets must be free of “structural rigidities” – which Italy’s were most certainly not.
To the contrary, when Andreotti
decided to join the EMS in 1979, the institutional framework governing the setting of Italian wages was among Europe’s most distorted, ossified, and inflexible. Compared with its ERM partners, then, Italy was both (1) more vulnerable to idiosyncratic, countryspecific downturns and (2) less well equipped to respond to such shocks were they to occur. A prolonged period of lira overvaluation seemed inevitable. In the event, Italy’s participation in the regime did coincide with a marked real appreciation of the lira. Most damaging was Italy’s loss of competitiveness with respect to West Germany, its major trading partner.
Between 1979 and 1990, the lira appreciated
against the D-mark by some 42 percent -- and that was after controlling for Italy’s higher
37
See Eichengreen, 1994.
29
rates of inflation.38 Findings like these do not sit comfortably with the view of the EMS as an unmitigated long-term “good” for the Italian economy, least of all for Italy’s exportproducing firms and their employees.
While Germany’s export sector grew rapidly over
the 1980s, the 1980s saw no such growth in Italy.39 Does this mean that the EMS was solely responsible for the economic fortunes that befell Italy after the lira was introduced into the regime? Not at all. Although Italy’s rate of unemployment did increase sharply over the course of the 1980s, rising from 7.7 percent in 1979 to a high of 12 percent in 1987 and 1988, macroeconomic aggregates like unemployment and inflation are rarely “caused” by any one factor.
In any case, the
methodologically appropriate question here is not whether Italy’s economic performance was better after 1979 than before, but whether its performance was better after 1979 than it would have been if the pre-EMS status quo had never been disrupted. Although I have suggested a number of reasons for thinking that Italian economic performance would indeed have been better – not only in the short term but also, quite possibly, in the long term as well – the reality is that the pre-EMS status quo was disrupted, making it impossible for me (or, presumably, anyone else) to construct a definitive test. But while it
38
Fratianni and von Hagen, 1992: 29, table 2.4. Bilateral real exchange rates are not, of course, the only indicators of “competitiveness.” Alternatively, one could look for EMS-induced effects on the lira’s real effective exchange rate. Because a currency’s real effective exchange rate (RER) is a trade-weighted average of each of its bilateral rates (controlling for inflation), an increase in the RER ratio between the lira and the D-mark would indicate a worsening of the Italian economy’s overall competitiveness vis-à-vis Germany. In surveying this data, the economists Giavazzi and Giovannini (1989: 89) find that the RER ratio between the lira and mark did show an increase over the course of the 1980s, with Italy suffering about a 10 percent cumulative decline in its overall competitiveness. 39
Exports comprised 21.9 percent of Italian GDP at the beginning of the decade and 21.0 percent at the end. In Germany, by contrast, the contribution of exports to total output rose from 26.4 percent in 1980 to 32.0 percent in 1990 (OECD, 1992).
30
might not be possible to disprove the conventional positive-sum account of Italian entry, the evidence considered here does, I think, cast serious doubt upon this interpretation. Would Italy’s “utility” have been lower if the EMS had never made it off the ground – if, in other words, the non-system of freely floating exchange rates that began to emerge in the early 1970s had continued without interruption through the 1980s and 1990s? Granting that we may never know for certain, there is ample justification for thinking that just the opposite is true. Coming to Terms: The View from Thatcher’s Britain The same goes for the UK: it too would have been better off – or so one might plausibly argue – in a “non-cooperative” world of freely floating exchange rates.40 Although Thatcher eventually agreed to admit the pound into the ERM, she did so with little enthusiasm, viewing Britain’s participation in the EMS, and in Europe more generally, as a serious threat to British sovereignty.41 The EMS also ran contrary to the Tories’ interest in eliminating government interference from private markets, including the market for foreign exchange.
But while Thatcher may have been more vocal in her
opposition to the EMS, the truth is that British authorities had been critical of the regime from its very inception.
More than simply a product of “Thatcherism,” their reservations
40
By concentrating here on Italy and Britain, I do not mean to suggest that they were the only two EMS losers. A more complete analysis would also have to include a discussion of Ireland, a country whose EMS-induced disinflation coincided with very high unemployment, massive emigration, and a rising public debt. See, e.g., Bradley and Whelan, 1992, and Dornbusch, 1989. 41
As deep-seated as it was, Thatcher’s antipathy toward the EMS did not stop her from signing the Single European Act in 1986. In so doing, Thatcher agreed to accept qualified-majority rule in the European Council, albeit only on matters pertaining to the operation of the Internal Market. For analysis of this earlier decision, see esp. Moravcsik, 1998, chap. 5.
31
reflected legitimate concerns about the differing structures of the British and West German economies. This mismatch was immediately recognized by Thatcher’s predecessor, Labour Prime Minister Jim Callaghan, who refused to introduce the pound into the ERM for fear that it would force Britain to adhere to Germany’s contractionary policies even when they were not appropriate to economic conditions in the UK. Ken Couzen, the Treasury official who was Britain’s delegate to the earliest round of talks on the EMS, left little doubt as to the Labour government’s position on the issue:
“There is,” he confessed, “considerable
anger at the way in which the proposal was ‘sprung’ on the rest of the Community.” As for the terms of the “Franco-German scheme,” they were, in his words, “vague and often confused,” whence came the British government’s “deep suspicion that the system is little more than a means of holding down the D-mark and imposing restrictive policies on Germany’s partners.”42 Couzen voiced these suspicions in 1978. began extracting oil from the North Sea.
One year later, British oil companies
With the prospect of huge windfalls from the
second OPEC shock, the market’s demand for assets denominated in sterling grew rapidly despite Britain’s underlying economic problems.
The pound thus took on many of the
attributes of a petro-currency, rising sharply in value against the currencies of Britain’s European partners and depressing external demand for Britain’s non-oil-related exports. By driving the British and German economies even further out of alignment, these developments lent support to the argument, made by Labourites and Tories alike, that British entry into the ERM would serve merely to exacerbate the continuing
42
Quoted in Ludlow, 1982: 112-13.
32
“deindustrialization” of the British economy.
By the mid-1980s, the price of oil had
dropped by half, eliminating what had earlier been an idiosyncratic source of upward pressure on the pound. Even then, however, economic conditions in the UK continued to be out of sync with those on the continent (see Figure 2). -- Figure 2 about here -Over and above its deleterious economic effects and symbolic associations, the birth of the EMS also precipitated years of internal bickering and controversy within the UK’s Conservative movement.
While the question of whether Britain should actively
engage itself in European affairs had long been a contentious issue among British Conservatives, the inauguration of the EMS thrust the Tories’ internal divisions into the public eye, creating the impression of a government in disarray.43 Throughout the 1980s, media reports of protracted and often acrimonious debates between ministers were frequent, as were cabinet reshufflings. The most important of these came in the summer of 1989 when Thatcher demoted the two members of her cabinet who had been most outspoken in support for British entry, Lawson and Foreign Secretary Geoffrey Howe. By the time the pound officially entered the system in October 1990, public opinion polls were giving the opposition Labour party a ten-point lead over the Tories. One month later, the Conservative party’s political standing received a near-fatal blow when, speaking before the House of Commons, Howe delivered a resignation speech that riveted the country’s attention.44
43
Sharply critical of Thatcher’s European policy, Howe declared at
Among those pushing for immediate entry was Thatcher’s own Chancellor of the Exchequer, Nigel Lawson, who had in fact been urging Britain to become a full-fledged member of the EMS since 1985 (Lawson, 1992: 111). Thatcher herself, however, remained dead set against the EMS until some time shortly before the Madrid Economic Council summit in June 1989. 44
Howe, 1990.
33
Figure 2 A Comparison of Growth Rates in Germany and the United Kingdom, 1978-1990
6% 5% 4% 3% 2% 1% 0%
UK Germany ERM Average
-1% -2%
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
-3%
1978
Year-to-year percentage change in real GDP
Source : OECD, Economic Outlook--Historical Statistics, 1992
34
one point: “It is now, alas, impossible to resist the conclusion that today’s higher rates of inflation could well have been avoided had the question of ERM membership been properly considered and resolved at a much earlier stage.”
These words echoed the
sentiment expressed in another well-publicized speech to Parliament, this one delivered just a few weeks earlier by Thatcher’s erstwhile Chancellor of the Exchequer. In Lawson’s words, “the real tragedy is that we did not join the ERM at least five years ago. It was not for want of trying, as a number of my then colleagues can testify.”45 While Lawson and Howe may well have been correct that Britain was better off joining the ERM than maintaining its earlier policy of monetary isolation, the months following British entry were certainly no bed of roses for Thatcher’s successor, John Major.
Prior to reasserting control over the pound in 1992, Major’s tenure was
characterized by abysmal public approval ratings. Not all of the blame rests with the EMS, of course; the British economy was mired in recession throughout much of this period. Nevertheless, Germany’s restrictive monetary policies, combined with EMS-induced deflation in France and Italy, imposed an economic straitjacket on Britain, precluding its newly-elected government from cutting interest rates as drastically as the country’s recessionary conditions warranted. Looking Ahead: The New “Enthusiasm” for Monetary Union Whatever its impact on the political fortunes of the governments that presided over Italy and Britain during the 1980s and early 1990s, the EMS was a virtually unmitigated success from the perspective of the center-right Franco-German coalition that conceived
45
Lawson, 1990.
35
and designed the regime in the late 1970s.
As for whether this “success story” will
continue beyond the 1990s, the answer is much less clear.
What follows is a brief
discussion of European monetary relations in the run-up to the 21st century. My own view is that the pattern of developments during these years accords quite closely with this article’s larger theoretical analysis, although any assessment drawn from such recent events should be considered somewhat speculative. From Anarchy to Organization – and Back to Anarchy? Examination of this period properly begins with the abrupt withdrawals of the Italian lira and British pound from the ERM in September of 1992.46
In analyzing the
larger theoretical significance of these withdrawals, it is important to appreciate that the Italian and British governments were both extraordinarily reluctant to abandon the system. In the end, of course, both did drop out. But that was only after a tidal wave of speculation in the foreign exchange markets had thoroughly depleted the reserves of their two central banks. The Italians and British pulled out, in other words, because (and only because) they simply could no longer continue paying the huge sums necessary to maintain the value of their currencies.
46
In neither country did public officials think that devaluing would
The events leading up to this crisis, which culminated in the widening of most remaining members’ currency fluctuation bands from 2¼ to 15 percent, have been well chronicled elsewhere. Suffice it to say that the impetus for the departures of the lira and pound, and for much of the turmoil that characterized the ensuing eleven months, was the Bundesbank’s post-unification offensive against the inflationary policies being pursued at that time by Chancellor Helmut Kohl’s center-right government. With German interest rates climbing skyward, European countries whose currencies were tied to the deutsche mark were forced to raise their interest rates as well. This would not have been a problem if Italy and the UK had been experiencing their own postunification inflationary shocks. In fact, their governments were at that time struggling with high unemployment and stagnant (in Britain’s case, declining) growth, and so were desperate for a relaxation of monetary policy. Both Italy and Britain responded to these added deflationary pressures by withdrawing from the EMS on “Black Wednesday,” September 16, 1992.
36
somehow translate into lower interest rates. Quite the contrary, in both Italy and the UK, most officials took the view that while it was unfair that their constituents be asked to bear the costs of German unification, the alternative – cutting loose from the ERM – would only make matters worse.47 Notwithstanding
the
extraordinary
turbulence
that
characterized
European
monetary relations during 1992 and 1993, it would appear that Europe’s monetary bandwagon has now regained much of its earlier momentum.
Indeed, the closing of the
devaluation option aside, the EMU bandwagon of the late 1990s bears a striking resemblance to the EMS bandwagon of the 1970s and 1980s. Technically, the Maastricht treaty would have permitted the formation of a monetary union with as few as seven European Union member states.
But while the possibility of a two-track or multispeed
Europe was explicitly recognized by the agreement, most European governments were intent on adopting the euro at the earliest possible juncture. Most, but not all.
In the UK, the current Labour government is in no particular
hurry to abolish the pound, and has in any event promised to submit the matter to a national referendum. But Britain too will find it difficult – over time, increasingly so – to
47
That the financial catastrophe predicted by Lamont and others never materialized came as a great relief to Britain’s Conservative government, which was able to relax its monetary policy and speed the country’s economic recovery. As for Italy, the economic and political fallout produced by its EMS defection was more serious, but here, too, life on the outside, if not exactly carefree and easy (see below), was at least manageable. To what, exactly, did the two EMS dropouts owe their good fortune? In retrospect, three political-economic developments deserve much of the credit: first, the easing of German monetary policy in the wake of the 1992-93 crisis; second, a political corruption scandal in Italy (which paved the way for a series of previously unthinkable deflationary measures); and third, a fundamental, albeit temporary, shift in market expectations. Over time, the global financial markets came to appreciate that the newly-unified Germany was undergoing an unprecedented “country-specific” economic shock and that, under the circumstances, it was simply unrealistic to expect other EMS countries to honor their earlier commitments.
37
remain outside the continent’s new monetary union.
The Labour party, which scored a
resounding victory over the Tories on May 1, 1997, has seen what the UK’s earlier delay in joining the EMS did to British interest rates under the Conservative governments of the 1980s. For this reason, few observers view Britain’s relegation to the EMU periphery as a permanent condition.
And yet, even if the country’s increasingly euro-friendly prime
minister, Tony Blair, does go ahead and adopt the euro, the abolition of the British pound is not a change that most British citizens welcome. In Italy, the feeling is much the same – a sense of regret that France and Germany, rather than embracing the pre-EMS floating-rate status quo, have instead taken the opposite tack, embracing a full-blown common currency. But what if, in the wake of the 1992-93 currency crisis, France and Germany had in fact followed Italy and the UK into the floating-rate wilderness?
Would Italian citizens really have been better off with a
return to the “non-cooperative” politics that characterized European monetary relations during the 1970s? Prospects for the Euro: Can One Size Fit All? There is ample reason to think so.
While abolishing the lira made eminent sense
given Italy’s limited range of options – its limited “choice set” – the adoption of the euro seems more likely to exacerbate Italy’s economic and political woes than it does to alleviate them.
Even if the country’s business cycles are today somewhat more in sync
with those of Europe’s “hard money” core than they were during the 1970s and 1980s, it is still the case that (1) Italy’s rates of labor mobility are lower than those of France and Germany, (2) its wage-setting system is more ossified, and (3) an EU-wide system of fiscal
38
transfers remains a far-off prospect.48
Making matters worse, the institutional structure of
the new monetary union is even less accommodating than that of the EMS, which permitted members experiencing temporary balance-of-payments difficulties to ask for (if not always to obtain) fairly substantial exchange rate devaluations.
Finally, whatever the
long-term repercussions of Italy’s participation in a common currency may turn out to be, the stringent budgetary measures necessitated by Maastricht’s convergence criteria proved to be a hard sell politically. Former prime minister Romano Prodi’s 1997 budget, which called for a one-time levy (labeled a Eurotax) on middle- and upper-level incomes, was intensely debated, and the current conventional wisdom is that it has been highly damaging to his party’s left-wing constituencies. In Britain, too, the loss of an independent monetary policy is destined to produce a great deal of economic and political turmoil.
Business cycles in Germany continue to be
out of line with those in the UK, and Britain’s distinct strain of Euro-skepticism is as virulent as ever.
In this regard, it is worth noting that John Major’s policy toward
monetary union – his preference for taking a wait-and-see approach rather than rejecting the euro outright – prompted two-hundred Euro-skeptics within the Tory party to break ranks with Major during the last couple of weeks of the 1997 election campaign, a defection that certainly did not help the Tories’ cause. In truth, however, the Labour party is no more unified on the issue, suggesting that if Britain ever does adopt the euro, a political backlash of major proportions lies in store.
48
See, among many others, Bayoumi and Eichengreen, 1993; de Luca and Bruni, 1993; and Garrett, 1998b.
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Conclusion: A Call for Theoretical Reorientation The idea that a cooperative multilateral arrangement, even one as far-reaching and long-lived as the European Monetary System, could end up imposing absolute utility losses on some of its signatories would not be particularly surprising, let alone controversial, were it not for the scholarly literature’s continuing preoccupation with the mutual-gains side of the “cooperation under anarchy” story. In fact, though, rather than making things better, the good provided by the EMS – the stabilization of intra-European exchange rates – would appear to have undermined (and arguably, in Italy’s case, decimated) the political prospects of certain EMS-participating governments. It did so, moreover, despite the fact that participation in the regime was entirely voluntary.
At no point did the French and
German leaders who benefited from the system force their counterparts in Italy or the UK to take part.
Nor, owing to their go-it-alone power, did the regime’s Franco-German
enactors have any need to apply coercive pressure.
For though the Italians and British
might have liked to engineer a return to the pre-EMS world of freely floating exchange rates, they were, in each case, confronted with a fait accompli. France and Germany’s go-it-alone power has thus had an enormous – and quite possibly decisive – impact on Western Europe’s monetary trajectory over the past two decades.
That this is so raises the possibility that “power politics,” though frequently
hidden from view, may also be fueling much of the economic regionalism we have recently been seeing within Europe, North America, and the developing world with respect to trade. To the extent that go-it-alone power is the driving force behind these diverse set of developments, the existing theoretical wisdom on why and how states cooperate risks
40
obscuring more than it reveals. What is needed, in short, is a broader, more nuanced way of thinking about the relationship between state power and voluntary cooperation. To reach this goal, it seems clear that we will first have to move beyond our existing positive-sum theories.
The truth, however, is that while the world around them
may be undergoing extraordinary change, most scholars remain quite content with the theoretical status quo.
In their view, what is needed is not a full-scale theoretical
reorientation; it is a synthesis of the (rational choice) theories we already have.49 As one widely-cited review of the literature concludes, “The efficiency considerations that are the economist’s bread and butter, the self-interested political behavior whose analysis comes naturally to the political scientist, and the institutional approach that has gained increasing favor under the banner of ‘the new institutionalism’ need to be blended to provide a balanced picture of the integration process.”50 This blending is already well underway.
Indeed, for all the acrimony between
neoliberals and realists, members of the two dominant schools of IR theory have spent the last several years laying the foundations for an elegant, higher-order synthesis, one that takes the diverse strands of a larger rational choice literature on cooperation and institutions and fashions them into a single analytical framework.51 And yet, are we really any closer to providing the “balanced picture” everyone claims to want?
49
Of course, not everyone is convinced that the mainstream theoretical literature is moving in the right direction. See, e.g., Wendt, 1999.
15-32.
50
Eichengreen et al., 1995: 6.
51
The result is what might be termed the “collective-action paradigm.” See Gruber 2000:
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The problem with current research is not, Europe’s recent experience with monetary integration would suggest, that our theories are too disparate. The real stumbling block is that these theories have been put to use in understanding only one side of the cooperation and political integration story – the side having to do with collective action, efficiency, and mutual gains. If we want to understand the other side – the one concerning winners and losers, zero-sum conflict, and the struggle to achieve and maintain power – we must first discard the analytical biases that have led international relations theorists to consistently overlook it.
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