Members of the European Union (EU)have long attempted to unify their monetary policies, whether by fixing exchange rates or moving toward a single currency.The success of these attempts has varied over time,and among EU member states.This article argues that the degree to which a country is integrated into EU trade and finance has a major impact on its willingness to make the sacrifices necessary to pursue monetary integration,especially stability against Europe's anchor currency,the Deutsche Mark(DM).Higher levels of intra-European trade and investment increase the desirability of stabilizing exchange rates between European countries. Statistical evidence indicates that greater integration of goods and capital markets is associated with greater success in fixing national exchange rates against the DM.This implies that pressures for monetary integration will continue but will vary among countries,along with the degree to which they are economically linked to European trade and investment. THE IMPACT OF GOODS AND CAPITAL MARKET INTEGRATION ON EUROPEAN MONETARY POLITICS JEFFRY A.FRIEDEN Harvard University Union Hv empeincneary ce ered history.They failed quite miserably from their inception in the early 1960s through the early 1980s.During the 1980s,however,the European AUTHOR'S NOTE:The author acknowledges support for this research from the Institute on Global Conflict and Cooperation.He also acknowledges research assistance from Roland Stephen and Michael Harrington and comments from Barry Eichengreen,John Goodman,Miles Kahler Peter Lange,Lisa Martin,Kathleen McNamara,George Tsebelis,and Guy Whitten.An earlier,and substantially different,version of this article was prepared for an SSRC project on Liberalization and Foreign Policy. 1.Throughout this article,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 may be somewhat misleading at times,especially in reference to historical developments,but it has the attraction of consistency. COMPARATIVE POLITICAL STUDIES,Vol.29 No.2,April 1996 193-222 1996 Sage Publications,Ine. 193
194 COMPARATIVE POLITICAL STUDIES April 1996 Monetary System(EMS)and its exchange rate mechanism(ERM)began to resemble a binding fixed-rate regime.Today,the future of the process is very much in doubt.On the one hand,several members of the EMS appear committed to continued monetary integration,leading eventually to a single European currency.On the other hand,especially in the wake of the 1992- 1993 currency crisis,there is little confidence in the ability of other EMS and EU members even to maintain stable exchange rates,let alone to move toward a single currency.A wide variety of alternative futures for European monetary integration have been discussed,from abandonment through a two-stage union to a single currency. Monetary integration,as used here,refers to a range of policies to achieve convergence among national monetary conditions.It includes measures to stabilize exchange rates,through formal fixed exchange-rate regimes (such as the Bretton Woods system or the EMS)to a single currency.At whatever level,monetary integration is difficult because stabilizing exchangerates,and at the limit adopting a single currency,can require national governments to implement politically unpopular economic policies in the interests of macro- economic convergence.It is not surprising that the willingness and ability of national governments to take the measures necessary to reduce exchange-rate fluctuations vary a great deal and that the policies of particular countries have varied over time. To understand the prospects for European monetary integration,it is important to understand its past trajectory.One way of doing so,particularly important for looking toward the future,is to examine the degree to which different European countries have been able and willing to take the steps necessary to hold their exchange rates constant against one another.This is of special importance because all plans for further monetary integration in Europe involve some degree of exchange rate stabilization,ranging from target zones through a single currency.Although the possible outcomes differ widely,they can all be seen as points on a continuum that measures the degree of permanence and rigidity of the fixed exchange-rate agreement. In this light,this article argues that a major determinant of national propensities to fix exchange rates is the degree to which the country in question is integrated into EU trade and finance.?The more important are a country's trade and investment ties with the EU,especially with the DM bloc around Germany,the more costly are fluctuations of its currency against the DM,and the more likely the government is to stabilize the exchange rate. 2.There are,of course,other potential explanations for the course of monetary integration. For a general survey,see Eichengreen and Frieden (1994a)
Frieden/IMPACT OF GOODS 195 Higher levels of capital mobility and intra-EU trade increase economic and political pressures for monetary integration.Closer links among EU financial markets heighten the trade-off between national monetary policy independence and exchange rate stability,forcing countries to choose be- tween them.More cross-border trade and investment within the EU expose more economic agents to currency risk and increase the demand to stabilize exchange rates.This effect is evident both over time and across country.As the EU has become more integrated,the demand for stable exchange rates has grown;and national support for monetary integration is correlated with national reliance on intra-EU trade and payments.The argument presented here grows out of,and is broadly consonant with,the economics literature on optimal currency areas and related macroeconomic policies. In section 1,I describe the history of attempts at European monetary integration.In section 2,I present various factors important in explaining European monetary politics,then develop my argument that the level of trade and capital market integration is a crucial determinant of currency policy.In section 3,I show how changes in the levels of intra-EU flows of goods,finance,and direct investment over time and across countries are correlated with Union-wide and national measures to reduce exchange rate variability.I conclude with some observations about the implications of this analysis for the future of monetary plans in the EU. 1.THE DIFFICULT COURSE OF EUROPEAN MONETARY INTEGRATION:FROM THE WERNER REPORT THROUGH THE EMS Fixing exchange rates between countries with different social,political,and economic conditions can be difficult.Although the determinants of exchange rates are still hotly debated among economists,there is little doubt that for the value of the currency of one country to be stable against that of another, the two countries'macroeconomic conditions cannot be too divergent.This is true,with varying degrees of stringency,whether the monetary integration in question involves simply stabilizing national currencies,or a more formal fixed exchange-rate system,or a single currency.In the case of the EU,in which the monetary anchor has long been Germany and the DM,monetary integration requires that other nations bring their macroeconomic conditions into line with those of Germany.This has typically meant reducing inflation, and-again,without entering the debates about this issuethe policies necessary to do so often have costs,typically involving recessionary mea- sures that increase unemployment and reduce real wages and consumption
196 COMPARATIVE POLITICAL STUDIES /April 1996 Although virtually everyone in the EU,then,gives lip service to the desirability of stable currency values,only in some countries and only at some times has rhetoric been backed up by the national sacrifices necessary to implement a stable exchange rate against the DM.The course of European monetary politics since the late 1960s illustrates this fact. Although stable exchange rates were a goal of the EU from its beginning, serious discussion of the matter began only once fissures appeared in the Bretton Woods system.Early talks led to the 1969 Werner Report,which recommended beginning a process of monetary union among EU members (Tsoukalis,1977,pp.51-111;van Ypersele,1985,pp.31-45).These recom- mendations were superseded by the end of the Bretton Woods regime.Over the course of the year that followed the August 1971 American decision to go off gold,EU member states established the snake,an arrangement to hold their currencies within a 2.25%band against each other.In addition to the original six,Great Britain,Ireland,and Denmark joined the snake on May 1, 1972,to prepare for their entry into the European Community 8 months later. Yet the goal of stabilizing EU currencies proved impossible to achieve.3 Britain and Ireland left the snake in June 1972,just weeks after joining;the Danes left shortly thereafter but rejoined in October.In February 1973,Italy withdrew from the arrangement.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 8 months later. Within 3 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 DM.Norway affiliated with the snake from May 1972 until December 1978,and Sweden from March 1973 to August 1977,even though the two were not EU members.Austria and Switzerland, also not EU members,had their currencies shadow the DM informally but did not join the snake. In the late 1970s,discussions of EU monetary integration began to gather momentum again,and in March 1979,the EMS and its exchange rate mech- anism went into effect.All EU members except the United Kingdom acceded to the ERM,which allowed a 2.25%band among currencies(6%for the lira). 3.Tsoukalis(197),p.112168:Ludlow(1982),pp.1-36:Coffey(1987),pp.616.A useful chronology of the snake is in Coffey,pp.123-125. 4.Ludlow (1982)is especially detailed on the negotiations and early operation of the EMS; see also van Ypersele (1985),pp.71-95;and Ungerer (1983).Excellent surveys of the EMS experience more generally are Giavazzi and Giovannini(1989);Fratianni and von Hagen(1991); Goodman(1992);and the articles in Eichengreen and Frieden (1994b)
Frieden IMPACT OF GOODS 197 The experience of the 1970s held out few hopes for success in the 1980s. The Union'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 to maintain international competitiveness led to continual rounds of franc and lira depreciations against the DM. Therefore,for the first several years of its existence,almost no informed observer believed that the ERM would hold.Indeed,in the first 4 years of its operation,there were seven realignments of EMS currency values. However,after 1983,exchange-rate variability within the EMS declined substantially,whereas monetary policies converged on virtually every dimen- sion.Between April 1983 and January 1987,there were only four realign- ments,generally smaller than previous changes,and from January 1987 until September 1992,there were no realignments within the ERM.3 Meanwhile, Spain,the United Kingdom,and Portugal joined the mechanism and Finland, Sweden,and Norway linked their currencies to the European Currency Unit (ECU).In 1981,the Austrian government announced a unilateral peg to the DM,to which it held firmly. In the wake of the EMS's apparent success,European integration more generally picked up speed.In 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 Union by January 1,1993(Moravcsik,1991; Sandholtz Zysman,1989).Most capital controls were gone by 1991,and barriers to the movements of goods were reduced continually in the run-up to 1993.The 1991 Maastricht Treaty included plans for full monetary union. But as preparations for currency union gathered force,the 1992-1993 cur- rency crisis called even the less ambitious EMS into question(Eichengreen Wyplosz,1993).The German government's massive fiscal effort to finance unification led the Bundesbank to raise interest rates to counter potential inflation.EMS member governments faced the choice of either following tight German monetary policies,in an environment of already high unem- ployment,or leaving the ERM.Uncertainty about the future course of European integration was exacerbated by the June 1992 failure of the first Danish referendum on the Maastricht Treaty and by the closeness of the September 1992 French referendum.Faced with runs on their currencies, in September 1992,the British and Italian governments took sterling and the lira,respectively,out of the ERM and allowed them to float.In subsequent months,the currencies of Spain,Portugal,and Ireland were devalued,al- though they remained in the mechanism.In Summer 1993,with the system 5.Relative parity changes are reported in International Monetary Fund (1988),p.19; information on exchange rate variability is provided on pp.20-34