European Central Bank and EU at a crossroads?

In 1971, the Bretton Woods Gold-Dollar exchange rate system broke down, bringing in an era of floating exchange rates with all their uncertainty. Governments, especially the USA's and UK's may have been relieved of defending a particular parity by having to take deflationary action but this simply passed the burden on to trade and industry. As rates of exchange might vary at any time, both exporters and importers feared exchange rate losses, so increasing risk and uncertainty in the business community. Many firms, especially smaller ones, would choose to remain strictly domestic.

The American dollar however, remained the main world reserve currency and the one which most third-party countries' debts were settled in, but after the first oil shock in 1974/1975 the dollar continued to weaken, especially against the German mark. This increased tensions between Washington and a more and more confident Bonn government under the urbane and pragmatic Chancellor Helmut Schmidt. France too, wanted the USA to do more to defend the dollar, even demanding that it return to the Gold-Dollar system, forgetting a main reason of its demise had been France's insistence that its dues be always settled in gold - others could have the paper currency.

In 1975 an economic summit took place between the USA, UK, Japan, Canada, Italy, France and Germany, a forerunner of future G7 summits. Little was agreed and the USA made it clear that there would not be a Bretton Woods, Mark II. What did emerge was a proposal by Helmut Schmidt and Valery Giscard d'Estaing, the French President, that the EEC set up a European Monetary System, a currency scheme independent of dollar fluctuations. With only a lukewarm response from the UK (what a surprise), the Schmidt-Giscard d'Estaing partnership would put Germany and France at the heart of the EEC and be a real driving force for further integration. The foundations of the eurozone had been laid.

By the mid 70s, Germany had transformed over a period of 30 years into Europe's biggest economy accounting for nearly 10 per cent of world GDP, its monetary policy largely controlled by an independent-from-government central bank, the Bundesbank, with headquarters in Frankfurt am Main. Under the German constitution, the Bundesbank has always been tasked with controlling inflation and maintaining the currency's real value and German governments do all in their power not to upset the bank which is held in high esteem by the populace.

Asked by a colleague in 1997 whether or not Britain should join the euro, I answered in favour as doing so would reduce transaction costs and encourage trade, and knowing that the European Central Bank (ECB) was to be sited in Frankfurt, thought it would be a clone of the Bundesbank. My colleague was against as he felt that the then proposed countries joining, formed too large an optimal currency area and couldn't see how one set interest rate could fit all. I took his point but that argument had in the past been applied to the USA, anyway, my view was shared by a comfortable majority.

There was also the Maastricht Treaty's joining criteria, as laid down in Article 109j and the Protocol on Convergence:

"...where these are not met by a country, the country's economic performance will be deemed to be out of line with that of other members and the country will be ineligible to join EMU [the euro]. This is because either membership would produce unacceptable adjustment costs in that country (eg unemployment) or because it would undermine EMU itself."

Two of the more important convergence criteria:

"High degree of price stability" - average rate of price inflation in the previous year no more than 1.5 per cent above the best three performing states.

"Sustainability of the government financial position" - government net borrowing of no more than three per cent of GDP and a ratio of gross government debt to GDP of no more than 60 per cent.

Undoubtedly the British Government did not join the Eurozone for political reasons, "When the time is right", was never. The main reason is probably because both main parties were and remain unwilling to cede direct control over macro-economic policy implied by the establishment of the ECB with further indirect implications for fiscal policy. If, as likely, the ECB followed a Bundesbank approach, there could be a strong deflationary bias in solving economic problems.

It is obvious since the Greek crisis unfolded nine months ago, that the rules put into place to protect all members were flagrantly disregarded and this has resulted in the humiliation of the EU and its institutions and member states, whether in the Eurozone or not. Asians and Americans rubbish any idea of the Euro being treated as a reserve currency and, it follows, a currency of debt settlement - so that just leaves us with the Dollar. Indeed, for the past nine months US bonds and the dollar are seen as "safe havens" despite a $1.4 trillion Federal Budget Deficit and near trillion dollar deficits projected for the rest of the decade. Such "safety" should read "scary". Although off its low against the dollar, the euro's rate is only 1.2282 (14 June 2010).

There is no perfect financial system and the euro was such a bold step that it was bound to have its share of flaws and problems. Its very success, speculative construction booms in Ireland and Spain aside, hid or papered over its flaws but this is not a proper excuse for the lack of rigour and control any Central Bank and regulatory authority is tasked with a duty of care to exercise. The rule breaking was hardly a secret as the 2009 Deficit to GDP percentage figures illustrate:

Germany 3.3 per cent

France 7.5 per cent

Italy 5.3 per cent

Portugal 9.4 per cent

Greece 13.6 per cent

Spain 11.2 per cent

Ireland 14.0 per cent

Although the governments of most of the above states were claiming that these deficits were exceptional and falling and that national debt to GDP figures were well below "permitted" norms, the money markets had started scrutinising the trend increases anyway and had lost all confidence that Europe could put its house in order. This was made worse by German dithering over the 750 billion euro EU/IMF rescue package, 440 billion euros from EU governments.

The Times editorial "Will the Euro Survive?" pointed out that : "The euro is a union between the very different economies of Europe's rich north and poorer south.....The euro was always more of a political romance than an economic project." With hindsight, this is true but it is also what it was allowed to become by political leaders inviting the unready governments and the unready governments accepting. Some of those accepting had very honourable motives like ex Prime Minister of Italy, Romano Prodi, who wrote in the FT last month that he pushed hard to get Italy into the eurozone "...to give his country the discipline it needed to end the string of currency devaluations that had left its economy fragile and undermined its public finances."

Can the Euro and Eurozone survive? Frau Merkel for one is determined they both will and despite differences with Mr Sarkozy and his Finance Minister, Christine Lagarde on broadening the ECB's remit to include job creation and such like, France is solidly behind the euro too. The Benelux will follow where these two lead and I can't see Italy being left behind. Gosh, the original Six! The answer must be a resounding "Yes". Intact?

Provided the EU/ECB/IMF rescue package works, and it should be given every chance to do so, then yes, but reforms within the system are most definitely needed.

Supporters of UKIP and anti-EU Conservatives need read no further and can look away now.

What is most obviously lacking in the Eurozone and ECB is a Central Treasury, the task of which would be to examine member states' budgets before announcement to the members' parliamentary bodies and, like the Bundesbank, would be unable to veto, but would constitutionally allowed to voice dissent to the parliamentary body and public of any "offending" state. This will enable all to see the transfer of funds to poorer regions if needs be because all currency areas experience such flows. The Central Bank must have teeth. Loss of sovereignty - oh yes, but that's the quid pro quo for joining the club and always was. This idea has no appeal? Well, remember that saying, he who pays the piper calls the tune. The tune is likely to have a very German melody and if any state does not like it, Germany's response is likely to be - auf Wiedersehen!