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Liberalization and Foreign Policy, by Miles Kahler, editor
8. Economic Liberalization and the Politics of European Monetary Integration
Jeffry A. Frieden
The European Union (EU) has gradually liberalized economic activity among its member states. 1 From the inception of the EU, trade liberalization has been a central goal. In more recent years, there have been initiatives to reduce or eliminate restrictions on the free movement of capital, people, and services, culminating in the completion of the single European market in the early 1990s.
Perhaps the most ambitious attempt to unite the European economies is monetary integration (MI), understood to include measures ranging from fixing exchange rates to adopting a common currency. The EU's current policy agenda, indeed, projects the full adoption of a single currency by 2002, although there is some doubt about whether this goal will be accomplished.
Monetary integration, and especially full currency union, is difficult and controversial. While many developed countries have liberalized cross-border economic flows among themselves, very few have actually given up their monetary independence, and even fewer have merged their currencies. In Europe, MI has a checkered history. It failed quite miserably in the 1970s and early 1980s. In the mid-1980s, however, the plan for monetary union associated with the European Monetary System (EMS) and its exchange rate mechanism (ERM) seemed to achieve a great deal of success. Yet in 1992-1993 the EMS was hit by a major currency crisis, and it has survived only in modified form. Today, the future of MI is uncertain. On the one hand, several members of the EU appear thoroughly committed to currency union. On the other hand, confidence in the ability of several other EU members to maintain their fixed exchange rate commitment has eroded substantially, and some EU members remain entirely outside the EMS.
This essay argues that the liberalization of European trade and investment had a profound impact on subsequent policies toward monetary integration. This is a special case of the broader argument that prior experiences of economic liberalization affect subsequent economic policy making, including policies to further reduce barriers to international economic activity. The essay argues for the importance of economic liberalization as a force pushing toward monetary integration, both in general and in the case of the EU. 2
First I develop an analytical framework to understand how previous levels of economic liberalization affect European monetary politics. There follows a description of the relatively unsuccessful attempts at European monetary integration before 1979 and a summary of the more positive experience of the EMS since then. Next I present several factors important in explaining European monetary politics, emphasizing how levels of intra-EU flows of goods, finance, and direct investment over time and across countries are correlated with variation in the course of European monetary integration. I conclude with some observations about the implications of this analysis for the future of monetary plans in the EU.
Economic Liberalization and Monetary Integration
The current goal of European monetary integration is the creation of a single EU currency and central bank. The starting point was a series of attempts, serious discussion of which began in the late 1960s, to tie the currencies of EU members together in a relatively fixed exchange rate system. These attempts had limited success until the late 1970s, with the founding of the European Monetary System (EMS) and its exchange rate mechanism (ERM). By the late 1980s there was pressure for additional movement toward full economic and monetary union (EMU).
There are both theoretical and empirical reasons to believe that previous progress in liberalizing European economic exchange, espe cially trade and investment, had a substantial impact on the course of monetary integration. It hardly seems controversial that countries whose trade, financial markets, and investments are more closely tied to each other are more likely to fix their exchange rates and, at most, move toward currency union. This vague observation can, however, be given more logical rigor and analytical specificity on the basis of several interrelated theoretical perspectives.
A large literature in economics analyzes the circumstances under which national welfare is improved by a fixed exchange rate and at the limit by a monetary union. 3 As regards the choice of fixed or floating exchange rates, the crucial observation is that as an economy becomes more financially integrated with the rest of the world, the government is faced with a choice between monetary independence and exchange rate stability. In a financially open economy, interest rates are constrained to world levels. 4 In such an economy, monetary policy operates as much or more by way of the exchange rate than the interest rate: monetary expansion leads people to sell the currency, drives the exchange rate down, makes local goods cheaper in comparison to imports, and stimulates demand for domestically produced tradable goods. Fixing the exchange rate forgoes this instrument, foreclosing the possibility of independent monetary policy.
Higher levels of financial integration, then, lead to a trade-off between national monetary policy independence and exchange rate stability: either a financially integrated country allows its currency to fluctuate or it accepts the loss of monetary policy as an instrument. Put differently, as countries become more financially integrated, the effectiveness of national monetary policy declines. The efficiency of a fixed exchange rate--the social welfare gains to be had from a fixed rate--tends to rise along with financial integration. 5
Monetary union can be regarded as a particularly binding form of fixed exchange rate regime. The literature on optimal currency areas argues that currency union makes economic sense for regions among which factors are mobile and economic shocks are correlated. 6 If two regions are so economically integrated that market conditions are closely linked between them, having a common monetary policy is efficient (and having separate monetary policies may be impossible). Labor and capital move relatively freely within the United States, which is why it makes sense for there to be one currency--given the mobility of factors and the integration of state economies, it would be difficult or impossible for Nevada, for example, to have a separate monetary policy from Arizona's even if the two states did have different currencies. 7
Here, too, economic integration plays a crucial role. The more integrated economies are among themselves, the better off a monetary union will make them. This is true of short-term financial flows, longer-term investment and migration, and trade: greater integration raises the desirability of currency union. The economic analysis is therefore quite clear: the more economically integrated two countries are, the greater the attractiveness of fixed exchange rates and of currency union.
Such social welfare criteria are probably insufficient to explain European monetary politics, however, for two reasons. First, there is substantial evidence that Europe in the 1970s and early 1980s did not meet the criteria by which fixed exchange rates would improve social welfare and that today there is no unambiguous social welfare argument for EMU. 8 Before the late 1980s, the EU was not very integrated financially--capital controls were common. 9 Factors are not very mobile among the members of the EU, and EU economies are not so integrated that they share common macroeconomic conditions.
Economically, then, neither fixed exchange rates nor currency union is clearly welfare-improving at this stage within the EU. Put differently, even if one believes that governments are driven toward efficient economic policies, that could not explain the movement toward monetary integration in the EU, for neither fixed rates nor currency union is the most efficient set of monetary policies available to EU members. Certainly, as the EU has become more integrated over time, the economic desirability of fixed rates, and eventually of a single currency, has risen. But this simply means that the EMS and the EMU are somewhat more economically defensible than they once were, not that some set of welfare or efficiency-based economic principles can be evinced to explain the EMS or the EMU.
Second, even if such policies were unambiguously welfare-improving, we would have little understanding of the mechanism by which governments might be driven to pursue policies favorable to monetary integration: plenty of efficient policies are never adopted. This leads me to explore the implications of the trends discussed here at the domestic political level.
Just as higher levels of economic integration raise the social benefits of exchange rate stability, so do they increase the size and strength of domestic socioeconomic groups interested in predictable exchange rates. Currency arrangements have a differential effect on firms and individuals, which can be expected to translate into crosscutting political pressures on national policy makers. Such arrangements are controversial on two dimensions--the exchange rate regime, especially whether the currency should be fixed in value, and its level, especially whether it should be strong (appreciated) or weak (depreciated).
The crucial political issue typically has to do with how important currency predictability is, relative to the ability of national monetary authorities to depreciate the exchange rate to increase the competitiveness of national producers. It is also important to keep in mind that eliminating the ability to devalue for high-inflation countries typically leads to a transitional (inertial) real appreciation of the exchange rate. This is especially troublesome for producers of tradable goods that compete primarily on price, as fixing the exchange rate in conditions of inflation above the EU average makes tradables producers less able to compete with other EU producers.
On the other hand, firms with strong international ties support MI's reduction in the vagaries of currency fluctuations. These effects are especially important to banks and corporations with investments throughout the EU. In addition, tradable producers with EU-wide markets, and for whom price competition is relatively less important--those whose appeal is based primarily on quality or technological prowess--may be less concerned about ability to devalue than about currency stability.
As countries liberalize their trade, finance, and investment, more of their citizens develop cross-border economic interests. Those involved in cross-border investment, traders, and exporters of specialized manufactured products tend to favor exchange rate stability to reduce the risk associated with their business interests in other countries. In this way, whatever the effects of economic integration on efficiency considerations associated with monetary union, it is likely to increase domestic political pressures for MI. 10
My conclusion is straightforward: economic liberalization should increase the likelihood of initiatives to stabilize exchange rates. Financial integration heightens the trade-off between exchange rate stability and monetary independence. Integration of trade and investment makes the region in question more likely to meet the criteria for an optimal currency area. Whatever the social welfare impli cations of these trends, at a more concrete domestic political level, economic integration swells and strengthens the ranks of those who favor currency stability, thus MI.
This positive relationship between economic integration and the economic and political desirability of monetary integration should hold over time and across countries. That is, as countries in the EU become progressively more integrated on current and capital account, I expect interest in MI to grow. By the same token, I expect support for MI to be stronger in those countries with higher levels of intra-EU trade and investment. In the following discussion I first present a synoptic analysis of the course of European MI from the late 1960s to the present; then I present evidence about the relationship between this course and the level of economic integration within the EU.
The Werner Report, the Snake, and the EMS: From Qualified Failure Through Skepticism to Qualified Success
Discussions within the EU over the possibility of stabilizing exchange rates began only a few months after the signing of the Treaty of Rome. 11 As fissures appeared in the Bretton Woods system, these talks accelerated, culminating in the 1969 Werner Report, which recommended the beginning of a process of monetary union among EU members. Within a few weeks of its adoption, however, the Werner Report's recommendations were overtaken by the collapse of Bretton Woods.
In the confused months after the August 1971 American decision to go off gold, EU member states resolved to hold their currencies within a 2.25 percent band against each other and to allow this band to move within a 4.5 percent band against the U.S. dollar. This arrangement was known as the "snake in the tunnel," as EU currencies would wriggle within a circumscribed range vis-á-vis the dollar. In addition to the Six, Great Britain, Ireland, and Denmark joined the snake on May 1, 1972, to prepare for their entry into the union eight months later. Britain and Ireland, however, left the snake in June 1972; the Danes left shortly thereafter but rejoined in October.
The collapse of attempts to salvage an international fixed rate monetary regime in 1973 ended the "tunnel" aspects of the snake. From then on, the EU's goal was to achieve a joint float of member currencies against the dollar, without targeting how they would move relative to it. In other words, the only consideration from 1973 on was intra-EU exchange rates.
Even this more limited goal was difficult to achieve. 12 As already indicated, Britain and Ireland left the snake within weeks of joining, and in February 1973 Italy followed suit. In addition, throughout 1973 only a series of parity changes allowed the system to hold together, and even then France chose to exit in January 1974. The French returned in July 1975, only to leave for good eight months later.
Within three years of its founding, then, the only EU members still in the snake were Germany, the Benelux countries, and Denmark. Even within this narrowed arrangement, realignments were frequent, typically to devalue the Danish krone and/or revalue the deutsche mark. Although by 1978 the EU began moving toward the EMS, nothing in the previous snake experience gave much cause for hope that the nine EU members could fix their exchange rates in any meaningful way.
It is not hard to explain in a discursive way why four EU members (Germany and Benelux) were able to maintain fixed exchange rates among themselves, while five others (Denmark, Britain, Ireland, France, and Italy) were not, in varying degrees (I attempt a more systematic explanation below). The ease with which the Germany-Benelux link held is largely attributable to the fact that monetary and financial conditions in the Benelux countries were so tied to those in Germany. As for Denmark, despite the formal link to the snake, the krone was so frequently devalued against the unit of account that the ties were hardly binding. In addition, Danish membership in the snake was facilitated by the fact that two Scandinavian countries with which Denmark is closely tied economically and politically were also members: Norway from May 1972 to December 1978, Sweden from March 1973 to August 1977.
As for those incapable of staying in the snake, Britain and Ireland were new members of the EU, Britain's Labour government was in a state of economic policy turmoil, and North Sea oil complicated matters still further. Ireland's close economic links to Britain made it difficult to break from the pound, and, indeed, the Irish had tied their currency to sterling at a one-to-one no-margins parity since independence.
As for France and Italy, since the late 1960s they had had consistently higher inflation than Germany, and during the 1970s they showed little real interest in monetary union, preoccupied as they were with domestic macroeconomic difficulties. Their attempt to commit to MI was consistently blocked by domestic political opposition to the measures necessary to make this commitment possible. The importance of these two countries makes it useful to discuss their problems in more detail.
Italy went through a series of payments crises in the middle 1970s, all related to chronic inflation. 13 In 1974, consumer price inflation approached 25 percent, with a public sector borrowing requirement (PSBR) of 7.9 percent of GDP. In that year the government signed a standby agreement with the International Monetary Fund (IMF), which met with only moderate success. Although inflation declined to 11 percent in 1975, Italy plunged into its most serious postwar recession (GDP declined 3.6 percent), and the PSBR rose to 11.4 percent of GDP. Under union pressure, the employers' association agreed to a wage indexation scheme (the scala mobile, or escalator) that embedded past inflation in wages and thus production costs. In this context, the exchange rate was allowed to depreciate continually to maintain competitiveness.
A new IMF program in 1977 again attempted to restrain demand. The government tried in vain to get the trade unions and businessmen to renegotiate the scala mobile and reduce indexation, finally decreeing a loosening of the mechanism. Inflation bottomed out at 11.6 percent in 1978, but the PSBR was 14.3 percent of GDP in that year and stayed above 10 percent of GDP through 1980, by which time consumer price inflation (CPI) was again rising at 21 percent a year. The country appeared to be in a vicious circle of massive budget deficits, inflation, indexed wage increases, and continual lira depreciation. It was hardly surprising that Italy showed no particular interest, other than verbal, in monetary union through the 1970s; no informed observer regarded a commitment to a stable lira as remotely credible.
France was doing only slightly better. 14 When Valéry Giscard d'Estaing became president in 1974, consumer price inflation was running at nearly 14 percent. With the franc out of the snake, the government of Jacques Chirac first tried monetary stringency, which reduced inflation a couple of percentage points but brought growth to a halt. In 1975, Chirac attempted to stimulate the economy with a fiscal policy that was relatively lax by French standards (a PSBR of about 3 percent of GDP, compared to the traditional near-balance). France rejoined the snake in July 1975, but by early 1976 unemployment was still high and the current account deficit was growing. In March 1976, after the left did very well in regional elections, Chirac took the franc out of the snake; a few months later, Giscard dismissed Chirac and appointed Raymond Barre to the premiership.
For almost five years after his appointment, Prime Minister Barre implemented austerity programs. Yet inflation was stubbornly high, nearly 11 percent for the period; unemployment rose continually even as real wages stagnated; and the current account remained in deficit. The government apparently attempted to shadow other European currencies, 15 but domestic conditions drove it to continual franc depreciation to maintain competitiveness. By 1980 inflation was still 13.5 percent, unemployment was 6.3 percent (triple 1973 levels), and five years of austerity seemed to have accomplished little except pave the way for a Socialist Party electoral victory of March 1981. In this context, French assurances about the desirability of monetary union were no more plausible than those of Italy.
The experience of the 1970s held out few hopes for success in the 1980s. The EU's two major high-inflation countries, France and Italy, had been unable to fix their exchange rates with other EU members. Resistance to austerity measures, and pressures from tradables producers to maintain international price competitiveness, led to continual rounds of franc and lira depreciations against the deutsche mark. Therefore, for the first several years of the ERM's existence, almost no informed observer believed that it would hold. Nonetheless, by the mid-1980s, the EMS had achieved quite substantialsuccess.
Renewed discussions of EU monetary union began to gather momentum in October 1977, when Roy Jenkins, president of the European Commission, made a prominent public appeal for MI. In April 1978, French president Giscard d'Estaing and German chancellor Helmut Schmidt proposed a new European monetary system, and in December 1978 the EMS was approved by the European Council. Its implementation was delayed by wrangling over implications for the EU's Common Agricultural Policy (CAP), but in March 1979 the EMS and its exchange rate mechanism went into effect. All EU members except the United Kingdom affiliated with the ERM, which allowed a 2.25 percent band among currencies (6 percent for the lira). 16
The prevailing opinion at the time was that French and Italian inflation rates were too high and intractable to allow the EMS to operate as planned. Indeed, in the first four years of its operation there were seven realignments of EMS currency values. During this period, deutsche mark revaluations and lira and franc devaluations reduced the DM value of the two problem currencies by 27 and 25 percent, respectively--hardly a sign of commitment to fixed rates.
Over the following four years, however, between April 1983 and January 1987, there were only four more realignments, generally smaller than the previous changes. Over the second four years, the lira and the franc were brought down 13 and 9 percent against the mark, respectively. Indeed, after 1983 exchange rate variability within the EMS declined substantially, while monetary policies converged on virtually every dimension. 17 From January 1987 until September 1992 there were no realignments within the ERM, while Spain, the United Kingdom, and Portugal joined the mechanism and Finland, Sweden, and Norway explicitly linked their currencies to the European Currency Unit (ECU).
Perhaps most important in this process was the unexpected turnaround in French policy in the early 1980s. In this case, a newly elected Socialist government, torn between its expansionary macroeconomic policies and its commitment to the EMS, chose the latter. Analyses of these events abound, and I will not go into them in detail. 18
In the aftermath of the French shift and less dramatic changes in Ireland, Denmark, and Italy, European integration more generally picked up speed. Over the course of 1985 and 1986, EU members discussed and adopted the Single European Act, which called for the full mobility of goods, capital, and people within the EU by January 1, 1993. 19 From then on, national barriers began falling. Most capital controls were gone by 1991, and the prospect of a unified market for goods defined much of the economic and political activity of the Union in the run-up to 1993. Indeed, as economic integration advanced and the EMS appeared to be stable, EU members devised plans for full monetary union and incorporated them into the 1991 Maastricht Treaty. Afterward, of course, these plans were derailed by German unification and the 1992-1993 currency crisis, a point to which I return below.
For present purposes, I focus on the period between 1973 and 1990. The principal developments that need to be explained are twofold. At the EU level, it is puzzling that MI was relatively unsuccessful in the 1970s but relatively successful in the middle and late 1980s. Within the EU, the variation in national willingness and ability to abide by the strictures of MI demands explanation. In the next section I turn to an evaluation of some of the factors that contributed to the unanticipated success of the EMS and that have affected national attitudes toward MI.
Explaining the Course of European Monetary Integration
European monetary integration is a complex phenomenon involving developments at the international, regional, and national levels, in both political and economic spheres. I do not pretend to present a full explanation of the process, only to outline some factors I regard as crucial and to highlight the importance of economic integration for MI. This is not, in other words, a rigorous test of the hypothesized relationship between economic integration and pressure for MI, nor is it an argument that this variable is the only one that matters. It is simply a demonstration of the posited correlation.
First, however, it is important to mention several factors that were undoubtedly also crucial in spurring MI within the European Union. One such factor was the CAP. 20 In the context of major agricultural subsidies, the EU sets union-wide food prices. When a currency is devalued, the EU reference price would normally be raised in the devaluing country to counterbalance the devaluation--thus "passing through" the exchange rate change to food prices. The inflationary impact of this pass-through would mitigate the devaluation's attempt to restore price competitiveness in the nonagricultural sectors. For this reason, the EU devised a series of compensatory arrangements and accounting exchange rates. For our purposes, what is important is that exchange rate fluctuations complicate union agricultural policy by changing compensatory farm payments in ways that could disrupt the delicate balance within the EU on farm policy. This was indeed one of the original reasons for early moves toward MI, and it remained important through the adoption of the EMS. However, the CAP is a constant, and while it explains the persistence of EU attempts at MI, it cannot explain variation in their success. The importance of the CAP might vary by country, thus explaining variation in commitment to MI, but there is no evidence that national support for MI is related to reliance on the CAP.
One reason why the EMS was more successful than the snake is the major increase in the amount of money available to EMS members for short- and long-term financing of payments deficits. Very short-term financing arrangements were extended from thirty to forty-five days. The capacity for short-term financing was expanded from 6 billion to 14 billion ECU. Medium-term financing commitment ceilings were raised from 5.45 billion to 14.1 billion ECU. Finally, 5 billion ECU in concessionary development loans over a five-year period were made available, essentially to Ireland and Italy, as a side payment to the two countries with the largest adjustment burden. 21 All told, the resources committed to the EMS were about three times those committed to the snake, which made affiliation with the system that much more attractive to potential members. There is little evidence, however, that the funds involved were particularly important to the process--Italy did not even use its concessionary finance, and the other funds were rarely central to EMS developments. And again, with the exception of the concessionary funds to Ireland, this factor cannot explain variation among EU members.
A third, somewhat less tangible but nonetheless crucial, change between the snake and the EMS was the relationship between them and broader EU participation. There was never any sense that the snake was an essential component of the EU; neither national politicians nor union leaders had staked much political capital on the arrangement. The EMS was different. The French and German heads of state launched the attempt with great publicity, and the European Commission regarded the EMS as of paramount importance. EMS success was publicly related to other aspects of European integration in ways that implied that a country unable to stay in the ERM would become a second-tier member of the European Union.
This linkage of the EMS with the broader program of EU integration was indeed decisive. In the early 1980s, with the European economies beset by stagnation and unemployment, many segments of society began to look upon an intensification of European economic integration as the last best hope for the region. 22 The process culminated in the Single European Act, and as the pace of European integration quickened, MI came to be viewed as a near-essential component of a broader process.
Linking MI with EU integration affected the domestic political lineup in many member nations. Previously, it had been possible to oppose national policies necessary to sustain a fixed exchange rate, while evincing great enthusiasm for the EU generally. With the 1992 program tied to the success of MI, such a division of the question was less feasible. To take one example, many national labor movements had resisted the austerity measures necessary to reduce national inflation to German levels, while supporting European integration; commitment to the EMS was separable from commitment to the EU. With the two no longer divisible, labor movements had to decide whether their opposition to austerity outweighed their support for the EU, or vice versa. This linking of the two agenda items was crucial to the eventual success of the EMS commitment in France, Italy, and Ireland; to British, Spanish, and Portuguese accession to the ERM; and to the Nordic countries' link to the ECU in preparation for their application for full EU membership. So this was clearly an important factor, one that has been dealt with in detail elsewhere. 23
All these factors are important for explaining the course of European monetary union. I focus, however, on the influence of economic integration. I believe that liberalization of intra-European trade and capital flows played a major role in leading EU members toward MI. I also believe that those EU members whose economies were more integrated with that of Germany, the monetary leader of the union, were more likely to pursue MI.
To analyze the relationship between economic integration and exchange rate policy, it is useful first to present some summary measures of the currency movements observed in the period in question. Two measures of exchange rate variations are presented in table 8.1. Panel A indicates the degree to which each currency in the EU depreciated in nominal terms against the deutsche mark (DM) during the snake (1973-1978), the EMS (1979-1990), and over the two periods combined (1973-1990). Panel B presents the coefficient of variation (a measure of variability) of each EU currency against the DM during the snake, the EMS, and the two periods combined. For ease of exposition, and in line with common distinctions drawn by observers, the countries are divided into three groups. Hard-currency countries are those that stayed in both the snake and the EMS. Soft-currency countries are those that left or never joined the snake and whose participation in the EMS has been limited or troubled. The two intermediate countries, France and Ireland, left the snake but have been relatively stable members of the EMS.
The division between hard, soft, and intermediate currencies is largely borne out by the statistical measures used. In addition, a gen eral trend toward reduced exchange rate variability can be noted between the snake and the EMS, as is to be expected. It should be noted that the absolute depreciation figures are not comparable, as the EMS period is more than twice as long as the snake. The only slightly anomalous case is that of sterling, which appears more stable against the DM than most accounts would have it. This is largely because North Sea oil and the Thatcher administration led to a significant appreciation of the pound in the early 1980s, which was reversed with a vengeance in the middle and late 1980s (and with even more of a vengeance after September 1992). In any event, the evidence in table 8.1 is meant simply to indicate that statistical data reinforce the more discursive story told above. This is particularly worth doing because in the statistical evaluations that follow, the coefficient of variation figures are used as the dependent variable. The reader should easily be satisfied that this figure both makes sense economically and accurately reflects real trends in the variability ofcurrencies.
The first step is to try to explain increased interest in MI within the EU. Here again I argue that higher levels of commercial, financial, and investment flows within the union should strengthen the position of those most interested in stabilizing currency values. And the statistical record does indeed indicate a significant increase in the importance of intra-EU trade and payments over the 1970s and 1980s.
By far the most reliable intra-EU economic figures are those having to do with trade. Table 8.2 shows the relationship between manufactured exports within subgroups of EU members, on the one hand, and their combined GDP, on the other. Manufactured exports are the relevant consideration for my purposes: agricultural trade is mostly controlled by the Common Agricultural Policy (CAP), and other nonmanufactured trade is relatively unimportant. More generally, as explained above, it is exporters of relatively specialized manufactured products (rather than standardized commodities) whom I expect to care about currency stability.
As table 8.2 indicates, intra-EU manufactured exports have become increasingly important since the early 1970s. This is true whether one looks at the founding members of the union or at its expanded size. The increase is continuous, and although the several percentage points in question might seem to be a small increment, they are in fact quite significant by most standards, and as trends. For example, if the rate of change in intra-EU 12 trade as a share of total GDP were to be sustained, by the year 2000 the EU 12 would be exporting manufactured goods equal to about 22 percent of their total GDP among themselves. This can be compared to total American manufactured exports, which are typically below 7 percent of American GDP.
Unfortunately, data on financial and investment flows within the EU are far less readily available than those on trade. The best available analysis is that by Jeffrey Frankel and his colleagues. 24 In an attempt to measure the level of financial integration within the union, they looked at levels and trends of covered interest rate differentials with Germany. This approach incorporates both interest rate differences and market expectations of exchange rate movements; the remaining differential is presumably the result of country risk, capital controls, and other forms of incomplete market integration. Data are available only after about 1980 (the relevant forward currency markets largely did not exist before then) and are thus not satisfactory for my purposes. They nonetheless help to indicate characteristics of intra-EU financial integration.
The analysis by Frankel and his colleagues shows that financial markets in Benelux, the United Kingdom, and Ireland were very closely tied to those of Germany. This is probably as expected, for Benelux finances have long gravitated toward Germany, while the UK and Ireland have very open financial systems. Financial conditions in France, Denmark, Italy, Spain, Portugal, and Greece were much less strongly tied to those of Germany, as most of these countries had relatively closed financial systems and capital controls. Denmark is a bit of a puzzle but is probably best explained by the link between financial conditions there and in neighboring Scandinavian countries. In all these last cases, however, financial conditions in the EU were converging rapidly, particularly in the countries least tied to Germany. By the late 1980s and early 1990s, indeed, most observers believed that financial markets within the EU were very closely linked.
A third dimension of economic integration has to do with foreign direct investment (FDI). Analysts have long believed that multinational corporations with pan-European investments are a major force supporting European integration, including monetary integration. It is regrettable that reliable data on intra-EU FDI are available only from about 1980 on. Table 8.3 presents a synopsis of these data, which indicate the importance of stocks of intra-EU FDI as a share of GDP in the early and later 1980s. The data are for a scattered set of years, and quite a few observations are missing. There are far better data available on both stocks and flows of FDI after the late 1980s, but this is too late to play any part in explaining monetary integration. Despite their shortcomings, the data in table 8.3 are both indicative and the best available.
As far as change over time goes, table 8.3 demonstrates the dramatic increase in intra-EU direct investment over the course of the 1980s (I evaluate intercountry differences below). It is in fact striking how rapidly FDI stocks grew in some countries. For example, Danish direct investment in the EU, and in the DM zone (defined as Germany and Benelux combined), as a share of GDP grew by a factor of more than four times in just eight years; EU investment in Spain and Portugal as a share of their GDPs grew more than threefold in just six and eight years, respectively. It can also be noted that in virtually every case, EU and DM zone direct investments grew as a share of each country's total direct investments as well. In other words, over the course of the 1980s all EU members experienced significant increases in the importance of intra-EU direct investment, and their direct investments became more concentrated in the EU.
With some exceptions, however, these data are of little assistance in evaluating the impact of changing levels of intra-EU FDI over time on incentives for EU monetary integration, for the simple reason that to a great extent the FDI in question was responding to existing currency arrangements. The potential exceptions are for those countries that were members of the EU but not the EMS during the 1980s. In these cases--the soft-currency countries in table 8.3--increased lev els of FDI presumably responded to considerations not directly related to currency variability. Undoubtedly the most important factor here was the gathering pace of European integration more generally. British firms invested very heavily in the EU as the United Kingdom was drawn more fully into the European market, and EU firms invested at unprecedented levels in Spain and Portugal as these two countries joined the union. It might well be the case that the important increases in intra-EU direct investments to and from these countries raised the costs of currency fluctuations for them and contributed to a strengthening of pro-MI sentiment in them. It is, however, impossible to assess this possibility with the data currentlyavailable.
Because the statistical record concerning FDI is somewhat spotty, it can be supplemented with more general figures. The increased level of international capital movements between the early 1970s and the early 1980s is well known. This was a global phenomenon, but capital flows increased significantly to and from the European Union. Between 1975 and 1979, long-term investment flows into and out of major EU countries (both among themselves and elsewhere) averaged $35.1 billion a year; in the 1980-1984 period, despite a major recession, they averaged $64.2 billion a year. Short-term net bank flows rose from $9.3 to $19.4 billion a year between the two periods. 25
The higher levels of international goods and capital market integration within the EU had two effects. First, increased financial integration raised the probability that divergent macroeconomic policies would lead to countervailing trends on capital and currency markets. This is simply another illustration of what was discussed above: higher levels of capital mobility made independent monetary policy inconsistent with a fixed exchange rate. Greater financial-market integration within Europe tended to quicken the rate at which divergent national monetary policies led to substantial capital flows and eventually currency crises. Financial integration made the resolution of the conflict between national monetary autonomy and exchange rate stability pressing.
The second impact of higher levels of economic integration within Europe, again as discussed above, was on the interests of domestic economic actors. As trade and capital flows within the EU grew, ever larger segments of EU business communities developed more important markets and investments in other EU nations. The growth of intra-EU trade and investment, therefore, increased the real or potential support base for economic policies that would facilitate and defend such economic activities. Stabilizing exchange rates within the EU was a prominent example of a policy that benefited the growing ranks of economic actors with cross-border intra-EU economic interests, whether these were export markets or investment sites.
The expectation that the level of interest in MI in the EU as a whole be correlated with the level of intra-EU trade and investment appears to be supported by the data. The next question is whether differing degrees of national support for MI are correlated with different levels of integration in EU goods and capital movements. To evaluate this, I present data on cross-national variation in trade and investment within the EU.
Table 8.4 shows the importance of intra-EU trade for members of the union. Manufactured exports as a share of national GDP are used, for the reasons discussed above. Two figures are shown, one indicating the importance of trade with the EU as a whole (i.e., the current twelve members), one the importance of trade with the deutsche mark zone, defined as Germany and Benelux. This latter figure should be the principal focus for an analysis of interest in MI, as such policies have since the start implied tying the national currency to that of Germany (and thus of the DM zone). In other words, this segment of my argument is that domestic political support for linking the national currency to the DM will be a function of the importance of a country's trade with the DM zone. Data are presented for two time periods, the early 1970s before the advent of the snake, and 1979-1982, during the early years of the EMS.
Several features of the trade data are striking. First is the extremely high level of Benelux trade with the DM zone: the three countries' manufactured exports to the area are a major share of their GDP. Second, the importance of intra-EU, and DM zone, trade has risen in every country (with the minor exception of Belgium). The Luxembourg DM zone trade, which was already at extraordinarily high levels). The increase has been quite remarkable in some cases, notably that of Ireland. Third, the importance of DM zone trade appears to be strongly related to willingness to tie national currencies to the DM. The only ambiguous cases are those of Denmark and Italy. Danish manufactured trade with the EU and the DM zone is important, but not sufficiently important to explain fully its strong commitment to MI. Italy's inability to commit to MI is a bit out of line with its relatively important DM zone trade ties. But both cases are borderline, and there are indeed special circumstances that help explain each. 26
A similar cross-national comparison can be carried out for foreign direct investment, using the data in table 8.3. These data, despite all their shortcomings, do show that, very generally, intra-EU and DM zone foreign direct investment was more important for those countries that went on to tie their currencies to the DM than for other EU members. To reiterate, one cannot read too much into these data, both because there are too many gaps (especially for FDI in the DM zone) and because the time period is in the middle rather than at the beginning of attempts at monetary integration. For example, it is quite plausible that the very high levels of Benelux investment in and from Germany are attributable at least in part to the fact that their currencies were stable against the DM during the snake, before a large part of the stocks measured in the table were accumulated. Nonetheless, there is a general trend in the expected direction. Anomalies persist, however: most prominently, Denmark has far "less" FDI than might be expected.
At this point it is worthwhile to raise the problem of simultaneity in these data. It is well known that stabilizing exchange rates among countries tends to increase trade and payments among them. In this case, it might be argued that the correlation between levels of trade, financial, and investment flows and currency stability is picking up the reverse causal mechanism: it is not that economic integration is increasing the political support for monetary integration but that policies for currency stability adopted for other reasons are speeding economic integration.
There is no doubt that economic integration is indeed encouraged by currency stability. Two points should be made. First, I have tried here (and will do so below) to use levels of economic integration before the monetary agreements to explain policy and performance during them. At the limit, if the pattern of economic integration in the early 1970s, before any serious monetary initiatives, can explain currency policy between 1973 and 1990, I am on relatively solid ground. Unfortunately, data for the early 1970s are available only for trade and not for FDI and financial flows.
Second, there is in fact no necessary contradiction between my argument and its reverse. In fact, the reason EU-oriented economic agents, in my analysis, support monetary integration is precisely that they expect it to increase the level of intra-EU trade and payments. Put somewhat differently, my framework leads me to expect that high levels of trade and payments will be correlated with currency stability both because economic integration increases political support for monetary integration, and vice versa. Of course, I would like to be able to disentangle cause and effect, especially chronologically, but data limitations make this difficult. In any case, it should be kept in mind that monetary, financial, and investment integration probably feed back to increase each other, and that where early 1970s data are not available I have trouble breaking into this feedback process.
Nonetheless, I can present some more evidence to bolster my argument. Rather than simply relying on casual inspection of the data, I try more systematic methods to show correlation between the importance of a country's trade and investment with the DM zone and its willingness to stabilize its currency against the DM. The easiest way to accomplish this is to run a series of regressions in which the dependent variable is the variability of the national exchange rate against the DM (as discussed above), and the independent variables measure the importance of DM zone trade and investment for the country. I present the results in tables 8.5, 8.6, and 8.7.
In table 8.5, I measure the impact of the importance of a country's manufactured exports to the DM zone to its economy at the outset of the snake and the EMS, on the variability of the country's currency against the DM during the snake and EMS periods. 27 The results indicate quite clearly that the higher the country's DM zone trade as a share of its GDP before the currency agreement, the less likely its currency was to fluctuate against the DM. The results are statistically significant, and the coefficients are quite large. 28
Perhaps the most striking result is that contained in table 8.6. The regression results in columns 1 and 3 look at the impact of trade with the DM zone and the EU in the early 1970s on national currency variability from 1973 until 1990. Although obviously a great deal went on over the two decades, it is quite remarkable (especially in light of the preceding discussion of simultaneity) that the results remain quite robust: trade patterns before 1973 had a strong and systematic impact on the likelihood that countries would tie their currencies to the DM after 1973. 29
The data on financial integration do not allow for a similar test, for the simple reason that the measures of financial market integration available are for the core period of the EMS rather than at its start. Here the simultaneity problems are insurmountable. Nonetheless, as the discussion above indicates, there does seem to be some relationship between financial integration and interest in monetary integration. The Benelux countries and Ireland are strongly linked to German financial markets, and they have been enthusiastic about MI. Countries less closely linked have been less enthusiastic, but the relationship is not so strong.
Given the somewhat better--but still unsatisfactory--data available on intra-EU direct investment, regression results on this dimension are presented in table 8.7. It can be seen that levels of intra-EU direct investment in the early 1980s are strongly correlated with currency stability between 1979 and 1990. Results are similar for direct investment to and from the DM zone, although they do not quite reach conventional levels of statistical significance (and there are very few observations). 30 With all the warnings already expressed about the data on FDI, and the unavailability of information on the independent variable before the currency arrangements (because of the absence of FDI data from before 1973), these results should be regarded with wariness. Nonetheless, they do tend to confirm my argument about the impact of intraregional investment on the incentives to fix regional currency values.
These data appear to support the contention that higher levels of economic integration have increased political pressures for exchange rate stability within the EU. 31 The growing ranks of integrated and export-oriented EU producers saw continued currency unpredictability as a major cost to them. As policy makers faced an ever starker choice between giving up monetary independence to maintain a fixed exchange rate, on the one hand, and floating away from the EMS, on the other, the rising importance of intra-EU trade, finance, and investment helped tip them toward the EMS.
The relative success of European monetary integration in the 1980s, then, was attributable to several factors. I have emphasized how increased economic integration increased the immediacy of resolving the conflict between national monetary policy autonomy and currency stability, even as it increased the support for a resolu tion that would stabilize exchange rates. It is also the case that member states invested far more money in the EMS than they had in the snake, and these funds were a significant incentive to governments for whom the EMS commitment implied difficult domestic economic-policy decisions. Finally, the linkage between MI and EU integration more generally increased the overall level of support for MI, by gaining the political support of groups that had been hostile or indifferent to MI until it became clear that monetary and broader economic union were practically indivisible.
Implications for the Future of European Monetary Integration
My assertion that the liberalization of international economic activities has systematic effects on pressures for monetary union, both over time and across countries, has clear implications for the future of MI in Europe. As is well known, even as plans for forward movement toward a full currency union gathered speed in 1992, a major currency crisis called even the less ambitious EMS into question.
Changes in the level of economic integration over time cannot explain the 1992-1993 crisis of the EMS. The members of the ERM were certainly more integrated in 1992 than they had been a decade earlier, yet the system did not hold together. Other factors, widely commented on in the literature, were undoubtedly central to the crisis. 32 Problems began with German unification, which led the Bundesbank to fear inflation and raise interest rates. The resultant European recession put EMS member governments under substantial political pressure to pursue more expansionary monetary policies. The only ways to do so were either to leave the ERM or to convince the Bundesbank to loosen its monetary policy. The Bundesbank would not budge, which left national governments with the difficult choice of either following Germany into even more recessionary policies or breaking the link to the ERM.
This development threw the crisis back into the realm of domestic politics. A rise in British interest rates to defend sterling, for example, would have been passed on by mortgage lenders, and many within the ruling Conservative Party worried about the objections of property owners. For its part, the Italian government might have enacted drastic fiscal measures to make its commitment to lower inflation more credible, but in the midst of a deep political crisis this was difficult to achieve over the objections of public employees and others who feared that their positions would be threatened. The German authorities might have loosened monetary policy but for the Bundesbank's traditional concern about inflation, which was reinforced by strong anti-inflationary constituencies in the German body politic.
The problems were exacerbated by growing political conflict over European integration as a whole. In the aftermath of the June 1992 failure of the first Danish referendum on the Maastricht Treaty, and with the results of the September 1992 French referendum in doubt, serious questions were raised about the future of the Maastricht process. The prospect of "de-linking" MI from European integration more generally--which was eventually realized--served to weaken the credibility of EMS members' commitments to the system.
In any event, in September 1992 the British and Italian governments took their currencies out of the ERM and allowed them to float. In subsequent months, the currencies of Spain, Portugal, and Ireland were devalued, although they remained in the mechanism. In summer 1993, with the system again under attack on currency markets, remaining ERM members agreed to widen fluctuation bands to 15 percent (the Dutch guilder remained in a 2.25 percent band). While the reduced ERM has been stable, questions persist about the future of monetary integration.
Although the causes of the 1992-1993 crisis were only partly related to the theme of this essay, three observations can be made. The first is that the economic objections to MI in Europe were amply borne out by the crisis. German unification subjected Europe to an economic shock, and this shock was asymmetric--it affected Germany but almost no other country. Germany's subsequent attempt to counteract expansionary fiscal measures with tight money only proved that a monetary policy appropriate for Germany could be inappropriate for its EMS partners. This indicates the truth of the assertions, reported above, that the EU is far from being an optimal currency area.
Second, the higher levels of financial integration obtaining in the Europe of 1992 clearly did, as anticipated above, heighten the conflict between monetary independence and exchange rate stability. Germany's EMS partners found themselves with the starkest of choices: either follow Germany's very restrictive monetary policy into recession or leave the ERM and allow their currencies to depreciate.
Third, given this stark choice, the responses to the crisis were roughly in line with the cross-national expectations indicated above. The EMS members most fully integrated into EU trade and payments--France, Belgium, the Netherlands, and Luxembourg--held fast. Those at the lower end of trade and investment integration--the United Kingdom and Italy--dropped out. Spain, Portugal, and Ireland, with relatively high levels of integration, were forced to devalue (under tremendous economic pressure) but made major efforts to stay in the ERM at their new parities. Denmark is something of an anomaly, as it is relatively less integrated than the other northern European EMS members but was able to avoid a devaluation; Danish ambivalence about the EU presumably expressed itself in other ways. In any case, and in a rough manner, the crisis appears to bear out most of my expectations: the level of sacrifice undertaken to sustain the fixed exchange rate was roughly proportional to the level of economic integration with the rest of the EU, and especially the deutsche mark zone.
In any event, given my analytical framework and the experience of twenty-five years of European MI, we can ask what the future of European monetary politics is likely to bring. EMU is unlikely to be implemented as originally designed at Maastricht. My analysis leads, however, to a series of predictions that imply that some form of monetary integration is likely to proceed.
The general level of intra-European trade and investment is very high and growing. Indeed, the completion of the single market will only spur economic integration within the EU. I thus believe that the general pressures for MI within the EU will continue to increase over time. If the link I posit between economic integration on the one hand and broad economic and domestic political pressure for MI on the other is present, we should see a continuation--in fact, an increase--in interest in MI.
There is no doubt, however, that interest in monetary integration varies across countries. Those most tied to the EU--and especially to its economic and financial anchor, Germany--should be most enthusiastic about moving forward with plans for monetary union. As indicated above, if interest in MI varies with level of general economic integration with the EU, France, Germany, and Benelux should be its strongest supporters; Denmark, Ireland, Spain, and Portugal should be less enthusiastic but still favorable; and Italy, Greece, and the United Kingdom should be least favorable of all. It is interesting to note that new EU member Austria is undoubtedly in the first group, while new members Sweden and Finland are closer to the second. Thus any future MI is almost certain to include Austria, and likely to include Sweden and Finland.
This implies that a "two-tier" EMU process is likely to ensue. Those countries that are most closely integrated on current and capital account are likely to proceed toward monetary union. Those that are least integrated are likely to remain behind. This leaves, of course, great room for variation and discretion. The southern European countries may decide to undertake the massive sacrifices necessary to ensure that they are not left out of MI efforts; Germany itself may shy away from further monetary union. What I expect is a tendency in this direction; specifics will be determined by a combination of domestic political developments within EU members and strategic interaction among them.
Previous liberalization of intra-European trade, finance, and investment has been crucial to the course of European monetary integration. I expect this effect to persist, and to be important for the future in two ways. First, the high and growing level of goods and capital movements within the union will increase the likelihood of some sort of monetary union. Second, variations in national reliance on EU markets and investments will affect national political debates over monetary union. In these ways, past decisions on economic liberalization will have a strong impact on policy toward monetary union in the European Union.
The author acknowledges support for this research from the Social Science Research Council's Program in Foreign Policy Studies, the German Marshall Fund, the UCLA Institute for Industrial Relations, and the UCLA Center for International Business Education and Research. He also acknowledges research assistance from Roland Stephen and comments from Barry Eichengreen, John Goodman, Miles Kahler, Peter Lange, and other participants in the Social Science Research Council Liberalization and Foreign Policy project. A substantially different version of this essay appeared in Comparative Political Studies.
Note 1: Throughout this essay, I refer to the organization that has variously been known as the European Economic Community, the European Communities, and the European Union with this last (currently preferred) name. This designation may be somewhat misleading at times, especially in reference to historical developments, but it has the attraction of consistency. Back.
Note 2: There are, of course, other potential explanations for the course of monetary integration. For a general survey, see Barry Eichengreen and Jeffry Frieden, "The Political Economy of European Monetary Integration: An Analytical Introduction," Economics and Politics 5, no. 2 (July 1993), as well as the other articles in this special issue of Economics and Politics dedicated to the topic. Back.
Note 3: For a more detailed discussion of these issues, see Jeffry A. Frieden, "Invested Interests: The Politics of National Economic Policies in a World of Global Finance," International Organization 45, no. 4 (Autumn 1991). Back.
Note 4: To be precise, it is covered (exchange rate-adjusted) interest rates that are constrained to be equal. The insight is that of the famous Mundell-Fleming approach, which originated with Robert A. Mundell, "The Appropriate Use of Monetary and Fiscal Policy Under Fixed Exchange Rates," IMF Staff Papers 9 (March 1962): 70-77; see also his "Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates," Canadian Journal of Economics and Political Science 29, no. 4 (November 1963): 475-485. The basic model can be found in any good textbook discussion of open-economy macroeconomics; a useful survey is W. M. Corden, Inflation, Exchange Rates, and the World Economy, 3d ed. (Chicago: University of Chicago Press, 1986). Back.
Note 5: This is a bit oversimplified and assumes that exchange rate stability is desirable in and of itself. There is no question, however, that the trade-off between exchange rate stability and monetary autonomy, absent or weak in a financially closed economy, grows in importance as the economy becomes more financially open. Back.
Note 6: The approach is set forth in Robert Mundell, "A Theory of Optimum Currency Areas," American Economic Review 51 (1961): 657-665; and Ronald McKinnon, "Optimum Currency Areas," American Economic Review 53 (1963): 717-725. Back.
Note 7: Of course, economic integration and currency union can interact: having one currency makes it easier for factors to move within a region. On such interactive effects in international monetary relations, see Jeffry Frieden, "The Dynamics of International Monetary Systems: International and Domestic Factors in the Rise, Reign, and Demise of the Classical Gold Standard," in Robert Jervis and Jack Snyder, eds., Coping with Complexity in the International System (Boulder: Westview Press, 1993). Back.
Note 8: Barry Eichengreen, "One Money for Europe?" Economic Policy (April 1990): 118-87. Back.
Note 9: Since the middle 1980s capital controls have been removed, and the EC has become more integrated financially. This, however, does not explain the course of the EMS before financial integration. Back.
Note 10: Again, the nuances are important. Most developing countries are quite trade-open, but exporters typically do not favor a fixed exchange rate. This is normally because the exports in question are either commodities or standardized manufactured products, for which price competitiveness is paramount. The ability to maintain or restore competitiveness by way of devaluation, in these circumstances, tends to outweigh whatever advantage exchange rate predictability may hold. In the EC, however, almost all exports are of specialized manufactured products. Back.
Note 11: On early monetary plans and developments, see Loukas Tsoukalis, The Politics and Economics of European Monetary Integration (London: George Allen and Unwin, 1977), esp. pp. 51-111; and Jacques van Ypersele, The European Monetary System: Origins, Operation, and Outlook (Brussels: Commission of the European Communities, 1985), pp. 31-45. Back.
Note 12: Tsoukalis, Politics and Economics, pp. 112-168; Peter Ludlow, The Making of the European Monetary System (London: Butterworth, 1982), pp. 1-36; Peter Coffey, The European Monetary System--Past, Present, and Future (Amsterdam: Kluwer, 1987), pp. 6-16. A useful chronology of the "snake" is found on pp. 123-125 of Coffey's book. Back.
Note 13: On this period, see Antonio Fazio, "La political monetaria in Italia dal 1947 al 1978," Moneta e Credito (September 1979): 269-319; Cesare Caranza and Antonio Fazio, "L'evoluzione dei metodi di controllo monetario in Italia, 1974-1983," Bancaria (September 1983): 819-833. A summary in English is in Why Economic Policies Change Course (Paris: OECD, 1988), pp. 74-82; a more analytical survey is Paolo Guerrieri and Pier Carlo Padoan, "Two-Level Games and Structural Adjustment: The Italian Case," International Spectator 24, nos. 3-4 (July-December 1989): 128-140. Back.
Note 14: Two good surveys are Gilles Oudiz and Henri Sterdyniak, "Inflation, Employment, and External Constraints: An Overview of the French Economy During the Seventies," in Jacques Melitz and Charles Wyplosz, eds., The French Economy: Theory and Policy (Boulder: Westview Press, 1985), pp. 9-50; and Volkmar Lauber, The Political Economy of France: From Pompidou to Mitterrand (New York: Praeger, 1983), pp. 81-158. See also D. Besnard and M. Redon, La monnaie: Politique et institutions (Paris: Dunod, 1985), pp. 178-198. Back.
Note 15: This is at least what Oudiz and Sterdyniak argue ("Inflation, Employment, and External Constraints," pp. 32-35). Back.
Note 16: Ludlow is especially detailed on the negotiations and early operation of the EMS; see also Ypersele, The European Monetary System, pp. 71-95; and Horst Ungerer, The European Monetary System: The Experience, 1979-82, IMF Occasional Paper 19 (Washington, D.C.: IMF, 1983). Excellent surveys of the EMS experience more generally are Francesco Giavazzi and Alberto Giovannini, Limiting Exchange Rate Flexibility: The European Monetary System (Cambridge: MIT Press, 1989); Michele Fratianni and Jurgen von Hagen, The European Monetary System and European Monetary Union (Boulder: Westview Press, 1991); and John Goodman, Monetary Sovereignty: The Politics of Central Banking in Western Europe (Ithaca: Cornell University Press, 1992). Back.
Note 17: Relative parity changes calculated from Policy Coordination in the European Monetary System, IMF Occasional Paper 61 (Washington, D.C.: IMF, 1988), p. 19; information on exchange rate variability is provided on pp. 20-34. Back.
Note 18: See especially Jeffrey Sachs and Charles Wyplosz, "The Economic Consequences of President Mitterrand," Economic Policy 2 (April 1986): 262-322; David Cameron, "The Franc, the EMS, Rigueur, and 'l'Autre Politique': The Regime-Defining Choices of the Mitterrand Presidency," (mimeographed, New Haven, 1992); Pierre Favier and Michel Martin-Roland, La décennie Mitterrand 1. Les ruptures, 1981-1984 (Paris: Seuil, 1990); Philippe Bauchard, La guerre des deux roses: Du rêve ˆ la réalité, 1981-1985 (Paris: Bernard Grasset, 1986); and Serge July, Les années Mitterrand (Paris: Bernard Grasset, 1986). Back.
Note 19: On which, two analyses are Wayne Sandholtz and John Zysman, "1992: Recasting the European Bargain," World Politics 42 (October 1989); and Andrew Moravcsik, "Negotiating the Single Act: National Interests and Conventional Statecraft in the European Community," International Organization 45 (Winter 1991). Back.
Note 20: On the connection, see Kathleen McNamara, "Common Markets, Uncommon Currencies: Systems Effects and the European Community," in Robert Jervis and Jack Snyder, eds., Coping with Complexity in the International System (Boulder: Westview Press, 1993). Back.
Note 21: Ypersele, The European Monetary System, pp. 61-64. The subsidy component of the concessional loans was a billion ECU. Back.
Note 22: For one among many possible interpretations of this trend, see Louka Katseli, "The Political Economy of European Integration: From Euro-Sclerosis to Euro-Pessimism," International Spectator 24, no. 3/4 (July-December 1989): 186-195. Back.
Note 23: See, for example, Geoffrey Garrett, "The Politics of the Maastricht Treaty," and Lisa Martin, "International and Domestic Institutions in the EMU Process," both in Economics and Politics 5, no. 2 (July 1993). Back.
Note 24: Jeffrey Frankel, Steven Phillips, and Menzie Chinn, "Financial and Currency Integration in the European Monetary System: The Statistical Record," in Francisco Torres and Francesco Giavazzi, eds., Adjustment and Growth in the European Monetary Union (Cambridge: Cambridge University Press, 1993), pp. 270-306. Back.
Note 25: Long-term flows include FDI, bonds, and equities. Calculated from Philip Turner, Capital Flows in the 1980s: A Survey of Major Trends, BIS Economic Papers, no. 30 (Basle: BIS, 1991), pp. 42-75. Back.
Note 26: Denmark, for example, has important nonmanufactured exports to the EC. And its willingness to link to the DM is related, as mentioned above, to its close ties to the other Nordic countries, all of which in one way or another have also indicated a desire to link their currencies to the DM. Italy, of course, has faced severe domestic difficulties in reducing inflation to German levels. Perhaps more important from the standpoint of this essay, its trade ties with the DM zone have grown more slowly than those of any EC member outside the zone, and its intra-EC FDI (as shown below) remains relatively small. Back.
Note 27: It might be objected that the 1979-1982 trade data are from the first years of the EMS and it is thus wrong to treat them as exogenously determined. This course was taken, however, because earlier trade data would have been during the snake and thus conceivably determined by it. It might also be pointed out that currencies varied a great deal during the first few years of the EMS. In any case, when the regression is recalculated using 1976-1978 trade data as the explanatory variable, the results are essentially identical to those reported. In this context it is especially important to point out how strong the impact of 1970-1973 trade patterns is on subsequent currency policies (see below). This is a powerful argument against the endogeneity of trade patterns. Back.
Note 28: The removal of Spain, Portugal, and Greece, which were not EC members in the 1970s and which are outliers on both dimensions in both periods, does not affect the results. If intra-EC (rather than DM zone) trade is used, the coefficients are predictably smaller and significance levels somewhat lower, but the results remain strong and statistically significant. Back.
Note 29: It might be argued that early 1970s trade patterns were themselves a result of pre-1970 differences in currency variations. This is empirically incorrect. There were few currency movements between 1960 and 1969--it was the heyday of the Bretton Woods system--and those that there were ran largely in the opposite direction of explaining early 1970s trade. For example, in the 1960s the currencies of Italy, Greece, and Portugal varied less against the DM than did those of all other EC currencies except the Dutch florin. Back.
Note 30: Omitting observations for Greece and Ireland, for which data are incomplete, does not affect the results. Attempts to use both intra-EC trade and FDI as explanatory variables in a multivariate regression are complicated by the fact that the two are very strongly collinear. For example, when 1979-1982 DM zone trade is regressed on early 1980s DM zone FDI for the countries for which data are available, the resulting coefficients are large, the r squared is 0.744, and the t- statistic is 3.82. In the absence of more detailed statistical sources, more complex multivariate regressions are impossible. Back.
Note 31: This conclusion is complementary to one finding of Russell Dalton and Richard Eichenberg in "Europeans and the European Community: The Dynamics of Public Support for European Integration," International Organization 47 (1993). They show that differences in national public support of European integration are very closely related to the country's level of intra-EC trade. Indeed, this is found to be the most important economic factor in their model: the inflation rate has a strong negative effect, but when the two are comparably scaled, intra-EC trade is far more powerful. Back.
Note 32: For an excellent survey, see Barry Eichengreen and Charles Wyplosz, "The Unstable EMS," Brookings Papers on Economic Activity 1 (1993). Back.
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