Monetary Politics: Exchange Rate Cooperation in the European Union

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Figures 1. Distributive Outcomes along the Pareto Frontier 2. Coalition Bargaining over Price Stability 3. Coalition Bargaining over European Integration 4. Coalition Bargaining along Two Dimensions 5. Real Wage Growth, 1967–87 6. Profitability of Fixed Capital, 1967–87 7. Adjusted Wage Share, 1967–87 8. Factional Bargaining over Price Stability and European Integration

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Tables 1. Hypothetical Franco-German Monetary Policy Externality 2. Hypotheses Linking Domestic Monetary Politics to Exchange Rate Institutions 3. Inflation, Growth in Productivity, and “Gap” Calculations: Italy, France, Germany, and the United Kingdom, Selected Periods, 1961–78 4. Coefficients of Variation of Bilateral Nominal Exchange Rates, 1974–89 5. GDP Deflators, annual percentage change 6. The Domestic Politics of Inflation: France, Germany, Italy, and the United Kingdom, 1971–91 7. The Domestic Politics of Inflation in Western Europe, 1968–90 8. The Domestic Politics of Inflation in the European Community, 1972–87 9. Onshore-Offshore Interest Rate Differentials 10. Index of Profitability of Fixed Capital Stock: France and Italy, 1971–86 11. Electoral Performance, 1958–87 12. Percentage of Vote for Regional, Provincial, and Municipal Elections, 1975–85 13. Government Stability, 1948–87 14. Italian Public Sector Deficit Targets and Outcomes 15. Unemployment in the European Community, 1979–87 16. Real Interest Rates in the European Community, 1960–90 17. Budget Deficits in the European Union (percentage of GDP) 18. General Government Gross Debt (percentage of GDP)

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Acknowledgments Portions of this research were supported by a Fulbright-Hays European Communities Dissertation Fellowship, by a grant from the Department of Political Science at Emory University, and by a Junior Faculty Development Grant from the University of North Carolina at Chapel Hill. In researching this project, I contracted many debts of gratitude, most of which can never be adequately repaid. I thank all who gave graciously of their time to answer my questions about monetary politics in Europe. I thank the Royal Institute of International Affairs in London for accommodating me during the fall of 1992 and the Commission of the European Communities for providing office space and access to EC officials during the spring of 1993. This book would not have been possible without this support. I would also like to thank the many people who have read and commented on various aspects of this manuscript. Peter Van Doren, Jeffry Frieden, Richard Doner, and two anonymous reviewers at the University of Michigan Press read earlier versions of the entire manuscript and provided invaluable suggestions for improvement. Timothy McKeown, Michael Munger, William Keech, Barry Eichengreen, C. Randall Henning, and Gary Marks have all read and commented on earlier versions of chapters or articles that have since been integrated into chapters. I thank them all for having taken the time to do so. Thanks are also due to Robert Nabors, Paul Presler, and Brooks Blake, for help with data collection, and to John Stephens and Leonard Ray, who graciously shared some of their data.

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CHAPTER 1 Explaining Exchange Rate Cooperation in the European Union In December 1991 European Community policymakers signed the Maastricht Treaty, an ambitious plan to achieve, among other things, full economic and monetary union by 1999. Under the terms of this treaty EC policymakers committed themselves to trade their national currencies for a common European currency and to give up their ability to pursue independent monetary policies by subordinating their national central banks to the authority of a newly created European central bank. The economic and monetary union envisaged in the Maastricht Treaty evolved out of an existing exchange rate institution, the European monetary system (EMS), which Community policymakers had constructed in 1978 and which had proved remarkably successful in stabilizing intra-Community nominal exchange rates during the 1980s. The EMS, in turn, followed upon one earlier attempt to stabilize intra-Community nominal exchange rates, the “snake,” implemented in the early 1970s. How do we explain the creation and evolution of these European Community exchange rate institutions? In spite of the existence of elaborate exchange rate institutions, European policymakers have shown considerable variation in their ability to stabilize nominal exchange rates. Their attempt to do so during the 1970s was a general failure, as policymakers in France, Italy, and the United Kingdom all proved incapable of keeping their currencies inside the exchange rate system. The European monetary system was initiated in 1978, and within this framework European policymakers achieved a high degree of nominal exchange rate stability for thirteen years. Nominal exchange rate stability eroded, however, in the early 1990s. Inconsistent monetary policies in 1992–93 forced British and Italian Page 2 →policymakers to take their currencies out of the EMS, forced others to devalue their currencies within the system, and eventually forced Community policymakers to expand considerably the system’s flexibility. How do we explain this variation in EC policymakers’ ability to stabilize nominal exchange rates? This book provides answers to these two questions. To do so, I develop a model of monetary and exchange rate cooperation. The model consists of two components: a domestic model of monetary politics and a domestic institution-based model of bargaining power. It suggests that variations in the intensity of monetary policy conflict have driven the creation and evolution of EC institutions. The more intense this conflict, the less stable are Community exchange rate institutions. Given stable exchange rate institutions, the model suggests that monetary policy conflict in the domestic arena drives variation in nominal exchange rate stability. The more conflictual are domestic monetary politics, the less policymakers can stabilize their exchange rate. In short, this book argues that variation in European Community exchange rate cooperation is endogenous to domestic political-economic objectives. In this chapter I show why two bodies of literature—one on international cooperation, “neoliberal institutionalism, ” and the other specific to European exchange rate cooperation, the “capital mobility hypothesis”—need models of domestic politics and bargaining power. I highlight how each body of literature treats the problem of exchange rate cooperation, point out inadequacies, and show why rectifying these inadequacies requires domestic politicsbased models of preference formation and models of bargaining power. I then outline the approach developed here.

A. Explaining Exchange Rate Cooperation in the European Community: Neoliberal Institutionalism and the Capital Mobility Hypothesis How do we explain the creation and evolution of EC exchange rate institutions, and how do we explain variation in EC policymakers’ ability to stabilize exchange rates within the institutions they create? Two literatures provide useful points of departure. Neoliberal institutionalism focuses on the general problem of international cooperation, examining how the structure of the international system constrains policymakers’ ability to enter mutually

beneficial agreements and how international institutions, by mitigating these systemic constraints, facilitate policymakers’ ability to achieve cooperative outcomes. Within this framework improvements in monetary and exchange rate Page 3 →institutions increase policymakers’ ability to stabilize exchange rates cooperatively. The capital mobility hypothesis offers an issue-specific explanation within which financial integration has driven EC exchange rate cooperation and economic and increasing monetary union. While neoliberal institutionalism and the capital mobility hypothesis both provide insights into the dynamics of EC exchange rate cooperation, they provide, at best, incomplete explanations of both the processes driving institutional creation and variation in policymakers’ ability to stabilize exchange rates within these institutions. Neoliberal institutionalism can explain neither why policymakers initiated exchange rate cooperation nor why they created the specific institutions they create. The capital mobility hypothesis can explain neither policymakers’ choice between exchange rate stability and monetary policy autonomy nor why EC monetary policies converged around the Bundesbank’s price stability standard rather than around some alternative standard. The weaknesses in both literatures point us in the same direction: explaining the creation and evolution of exchange rate institutions and variation in policymakers’ ability to stabilize exchange rates within these institutions requires domestic politics-based models of monetary policy and models of bargaining power. 1. Neoliberal Institutionalism Neoliberal institutionalism frames the problem of international cooperation as one of market failure. As Keohane explains, “in situations of market failure, economic activities uncoordinated by hierarchical authority lead to inefficient results, rather than to the efficient outcomes expected under conditions of perfect competition” (1982: 335). Market failures arise not from deficiencies of the actors themselves but from the structure of the system and the institutions, or lack thereof, that characterize it. Specific attributes of the system impose transaction costs (including information costs) that create barriers to effective cooperation among the actors. Thus, institutional defects are responsible for failures of coordination. (Keohane 1984: 83) For Keohane, and for neoliberal institutionalism more generally, the market failure literature captures the central problem of international cooperation. “Like imperfect markets, world politics is characterized by institutional deficiencies that inhibit mutually advantageous coordination” (Keohane 1984: Page 4 →85). This literature uses two market failure analogies to highlight the institutional deficiencies that inhibit policymakers’ ability to reach mutually beneficial agreements: an externality analogy highlights how high transaction costs and imperfect information pose obstacles to ex ante bargaining; a contracting problem analogy highlights how the lack of effective enforcement mechanisms makes policymakers reluctant to enter agreements. Keohane draws on externalities and the Coase theorem to highlight how, in the absence of international institutions, a lack of property rights, high transaction costs, and imperfect information make it difficult for policymakers’ to identify and reach mutually beneficial agreements. Externalities occur “when the consumption or production activity of one individual or firm has an unintended impact on the utility or production function of another individual or firm” (Mueller 1989: 25). The classic example is that of a train traveling along tracks through a farmer’s field emitting sparks that damage the farmer’s crops. The train is engaging in its normal behavior, but one unintended consequence of this behavior is the reduction of the farmer’s profits. Because the train operator is not forced to bear the full costs of his activity, the two are stuck at an inefficient outcome: train sparks will destroy more crops than if the train operator were forced to incorporate these costs into his profit function (Landes and Posner 1987). A stylized example of Franco-German monetary interaction can illustrate how the externality analogy frames the problem of international cooperation. In this example Bundesbank interest rate increases, by reducing the value of the franc against the mark, impose an externality on French policymakers in the form of a real income loss.1 Let R(x) be the utility Bundesbank policymakers gain from an increase in interest rates, and let Rx be their marginal utility from each additional one-point increase in interest rates. Bundesbank policymakers’ utility is depicted in

table 1 by using a utility function of the form R(x) = 4x-(½)x 2 (where Rx = 4 - x). Initial utility from interest rate increases is positive, but it declines and eventually becomes negative the more interest rates increase; the Bundesbank maximizes utility by increasing interest rates by four points. Let D(x) represent the total loss of French income that results from Bundesbank interest rate increases, and let D represent the marginal loss to French income from each additional point increase. The assumption made here is that both total loss and marginal loss increases as German interest rates go up. Finally, assume that D(x) can be written as (½)x 2, and thus marginal damage, D, equals x. Table 1 illustrates the resulting marginal utility and loss schedules, showing that, the more German policymakers increase interest rates, the greater the income loss imposed on French policymakers. Page 5 →Given this depiction of the interdependence between French and German utility, what kind of outcome should we expect? Because they have no reason to incorporate French costs into their utility function, we expect Bundesbank policymakers to maximize their utility and push interest rates up by four points. This interest rate increase yields a utility of eight to the Bundesbank and imposes a loss of eight onto French policymakers. The resulting joint utility—the difference between the Bundesbank’s benefits and French costs—from this behavior is zero. This outcome is suboptimal. If the Bundesbank takes into account the costs to French policymakers in setting monetary policy, i.e., if French and German authorities maximize joint utility, they can do better. To maximize joint utility they maximize the difference between the gains from interest rate increases and the costs of these increases, or p(x) = R(x)-D(x). This maximization reduces to Rx = Dx. In words joint utility is maximized by the interest rate that equates the marginal benefits that German policymakers realize from interest rate increases to the marginal costs these increases impose on French policymakers. In terms of the functions developed here, this means setting 4 - x (the marginal benefit to Germany of a one-point increase in interest rates) equal to x (the marginal cost suffered by France from a one-point increase). This equation yields an optimal interest rate increase of two points. With this two-point increase German policymakers realize utility of six—a two-point reduction from their maximum—but French policymakers realize costs of only two—a six-point reduction in costs compared with the previous outcome. Thus, maximizing joint utility and raising interest rates by only two points yields an outcome at which the resulting benefits are four points greater than the resulting costs, R(x) - D(x). In other words, by pushing interest rates up by two points rather than by four points, French and German policymakers realize a four-point improvement in joint utility. TABLE I. Hypothetical Franco-German Monetary Policy Externality Page 6 →The problem however, is that, though German and French policymakers can realize higher utility, Bundesbank policymakers have no incentive to incorporate the costs they impose onto French policymakers into their utility function. As a result, they will maximize their individual utility and push interest rates up by four points. Given this inefficiency, Coase asks the following question: without an overarching authority, can French and German policymakers achieve the efficient outcome? The answer he supplies, known as the Coase theorem, is that, if transaction costs are zero and if property rights over the externality are specified, then French and German policymakers will bargain from the inefficient four-point increase to the efficient two-point increase. If Germany holds property rights and transaction costs are zero, French policymakers can offer the Bundesbank up to six “units of utility” (the difference between French utility with a four-point increase and French utility with a two-point increase in German rates) to induce German policymakers to increase interest rates by only two points. In doing so, French policymakers will still realize utility somewhere between two and eight, an improvement over the utility they realize from a four-point increase. If the French make this offer, German policymakers have the opportunity to realize utility somewhere between eight and twelve (the six points of utility they realize from the

two-point interest rate increase, plus the two points or more of the utility French policymakers pay them not to raise rates further). Thus, German policymakers would realize at least as much utility by accepting this offer as they would by increasing interest rates by four points. Thus, if the conditions of the Coase theorem hold, French and German policymakers can bargain their way to an efficient outcome.2 Keohane inverts the Coase theorem to point out that, in the absence of international institutions, the conditions Coase identifies as necessary to bargain to the efficient outcome are absent. Without international institutions French and German policymakers confront one another under conditions of imperfect and asymmetric information and thus lack reliable information upon which to base an agreement: the transaction costs associated with making the agreement are greater than zero. Because an international system characterized by institutional deficiencies does not meet Coase’s conditions, Keohane argues, the Bundesbank will raise interest rates by four points, and the French Page 7 →will suffer income losses from the franc’s depreciation; French and German policymakers will not identify and reach the efficient outcome. Thus, according to Keohane, the Coase theorem shows how information problems and transaction costs make it difficult for policymakers to identify and conclude Paretoimproving agreements. A second strand of neoliberal institutionalism treats cooperation as a contracting problem, focusing upon how ex post enforcement problems make policymakers reluctant to enter Pareto-improving agreements.3 The standard contracting problem involves a ship owner and a railroad. The shipper would like the railroad to build a spur to the dock and promises the railroad a price per ton that makes the spur profitable. Once they build the spur, however, the shipper can renegotiate the initial contract, offering the railroad a lower rate per ton. The railroad can hardly refuse; having already made the investment required to build the spur, some return is better than no return. Because the railroad recognizes that the shipper has incentive for ex post opportunism, it will be reluctant to enter the agreement ex ante. Thus, a potential welfare-improving transaction goes unrealized. As in the externality analogy developed by Keohane, the central problem highlighted by contracting problems is that, even in situations in which mutually beneficial cooperation is possible, institutional deficiencies prevent policymakers from realizing Pareto improvements (Keohane and Axelrod 1986: 231). The particular institutional deficiencies stressed by contracting problems differ from those identified by Keohane’s externality analogy, however, focusing more on how ex post enforcement problems make policymakers reluctant to enter mutually beneficial agreements. To return to the Franco-German example, even if French and German policymakers could costlessly identify and bargain to the efficient outcome, they would refrain from entering into the agreement. The French would be reluctant to strike an agreement that obligated them to pay German policymakers not to raise interest rates, because they could not prevent German policymakers from taking the payment and raising rates by four points anyway. Thus, even if transaction costs were zero and property rights were assigned, the lack of a mechanism to enforce ex post compliance would make French and German policymakers reluctant to enter an agreement that internalized the monetary externality. Thus, in framing the problem of international cooperation, neoliberal institutionalism has focused primarily upon the efficiency consequences of the institutional deficiencies present in the international system. Two arguments have been developed within this literature. The first draws on externalities, focusing upon how policymakers confront severe information problems and Page 8 →high transaction costs that prevent them from internalizing existing externalities. A second draws on the contracting problem, focusing upon how, in the absence of ex post enforcement mechanisms, Pareto improvements are unrealized. b. The Efficiency-Enhancing Properties of International Institutions

International institutions, according to neoliberal institutionalism, mitigate information problems, reduce transaction costs, and facilitate enforcement and, by doing so, help policymakers reach mutually beneficial agreements. We can highlight how international institutions perform these functions by seeing how they might make a difference in the internalization of the German monetary policy externality. First, international institutions help policymakers resolve problems that plague ex ante bargaining by reducing the transaction costs associated with bargaining and by mitigating information asymmetries. International institutions reduce transaction costs in a

number of ways. First, by centralizing the collection and distribution of information and by providing other infrastructure, international institutions reduce the costs to French and German policymakers of bargaining over monetary policy. The European Community provides an easily accessible forum that serves to reduce the costs to French and German policymakers as they meet and discuss the monetary externality. Institutions reduce transaction costs in other, more important ways as well. International institutions can generate economies of scale: “Once a regime has been established, the marginal cost of dealing with an additional issue will be lower than it would be without a regime” (Keohane 1984: 90). For French and German policymakers the existence of the European Community means that, rather than creating a brand new institution, they only need to extend the EC’s competence into a new policy domain. Moreover, the overarching framework provided by the European Community, a framework within which French and German policymakers manage a broad range of substantive issues, facilitates the kinds of issue linkages and side payments that might be necessary to arrange the compensation necessary to internalize the externality (Keohane 1982: 339–41; 1984: 79). These transaction cost reducing functions of EC institutions mean that French and German policymakers will confront fewer costs in bargaining over the monetary policy externality and are therefore more likely to seek a mutually beneficial agreement. International institutions also mitigate the information problems that can plague ex ante bargaining. Because information about governments’ reputations is distributed asymmetrically, some states may be disinclined to enter potentially beneficial agreements from fear that these agreements will place Page 9 →them at a significant disadvantage. Without Community institutions, French and German policymakers would lack reliable information about one another’s reputations and, out of concern that the resulting bargain would be highly disadvantageous, would refrain from entering into an initial agreement. The European Community, by collecting and disseminating unbiased information about French and German reputations, can mitigate these information asymmetries. In doing so, French and German policymakers would have greater confidence that any deal they struck would provide benefits, and they would thus be more likely to enter an agreement. As Keohane notes: “by reducing asymmetries of information through a process of upgrading the general level of available information, international regimes reduce uncertainty. . . . Mutually beneficial agreements are more likely to be made” (1984: 94). Thus, by reducing transactions costs and mitigating asymmetric information, institutions facilitate ex ante bargaining between French and German policymakers, increasing the probability that they can identify and reach a mutually beneficial agreement over German monetary policy. International institutions also help resolve the ex post enforcement problems that make cooperation difficult. As Axelrod and Keohane note, institutions “provide information about actors’ compliance; they facilitate the development and maintenance of reputations . . . and they may even apportion responsibility for decentralized enforcement of rules” (1986: 237). Here again problems arise from shortages of high-quality information. The first problem French and German policymakers confront is trying to convince the other that they are committed to cooperation. EC membership can be seen as a mechanism for making a credible commitment to cooperation. Constructing the EC represents a considerable investment by both French and German policymakers, thus providing concrete evidence of a commitment that each intends to continue to interact with the other for an extended (indefinite) period. In other words, the construction of the European Community iterates the FrancoGerman relationship, and, as a result, French and German policymakers both have longer shadows of the future than they would have otherwise. They begin to care as much about future payoffs as they do about current payoffs, and the more players care about future relative to current benefits, the less likely they are to defect in the present (Axelrod 1984; Axelrod and Keohane 1986). Even with credible commitments, an iterated game, and a lengthening shadow of the future, however, French and German policymakers still must be able to detect opportunistic behavior. As Oye notes, “If defection cannot be reliably detected, the effect of present cooperation on possible future reprisals will erode” (1986: 16). The European Community facilitates monitoring by Page 10 →reducing the information costs of detecting uncooperative behavior. On the one hand, Community rules provide unambiguous standards that make behavior transparent (Keohane 1984: 94; Axelrod and Keohane 1986; Oye 1986: 17). Such detailed rules, in turn, reduce the difficulties associated with assessing whether specific actions undertaken by French or German policymakers

are consistent with the terms of any agreement they reach. This, in turn, reduces the information necessary to monitor effectively policymakers’ ex post behavior. Finally, by iterating the game and by facilitating French and German policymakers’ ability to monitor the extent to which each complies with the terms of the agreement, international institutions help policymakers use strategies of reciprocity to enforce agreements. As work by Axelrod (1984) has shown, in iterated prisoners’ dilemmas strategies of reciprocity like tit-for-tat provide effective decentralized enforcement mechanisms. As Keohane notes in the context of international cooperation, with well-developed institutions “governments may comply with rules because if they fail to do so, other governments will observe their behavior, evaluate it negatively, and perhaps take retaliatory action” (1984: 103). Thus, were French policymakers to observe that the Germans were cheating on the terms of the agreement, they would be able to defect from the agreement in turn, in an attempt to encourage the Germans to return to full compliance. Thus, international institutions facilitate ex post enforcement, increasing the probability that French and German policymakers will have sufficient confidence to conclude the agreement. Thus, by reducing transaction costs and mitigating problems of information asymmetries, international institutions can facilitate French and German policymakers’ ability to bargain toward the efficient outcome. Moreover, because international institutions help to iterate Franco-German interaction, make ex post monitoring of agreements a bit easier, and facilitate the use of tit-for-tat strategies to enforce compliance with the agreement, French and German policymakers are more likely to enter, and ultimately abide by, an agreement that takes them to the efficient outcome. Thus, international institutions, by mitigating the deficiencies inherent in the international system, help policymakers reach mutually beneficial outcomes. c. Neoliberal Institutionalism and the Creation and Evolution of International Institutions

Neoliberal institutionalism has provided some important insights. It highlights how the structure of the international system inhibits cooperative outcomes and how international institutions can help policymakers overcome these Page 11 →obstacles. In EC exchange rate cooperation it forces us to recognize that, without Community institutions, European policymakers would likely have found it difficult to realize Pareto improvements in monetary and exchange rate policy and would not be contemplating full economic and monetary union. Thus, EC institutions, and the network of relationships that have developed within these institutions, were necessary conditions for exchange rate cooperation. Neoliberal institutionalism provides little leverage, however, with which to explain the creation and evolution of international institutions. The approach relies upon a strong functionalist logic to explain creation and evolution. According to Keohane, “Institutions . . . are formed as ways to overcome the deficiencies that make it impossible to consummate even mutually beneficial agreements. Their anticipated effects—whether these are welfare gains resulting from the sale of used cars by a reliable dealer or benefits accruing to governments from being able to concert their actions in the world political economy—explain their causes” (1984: 83). Relying upon a functionalist logic to explain why policymakers create new and alter existing international institutions is unsatisfactory because market failures are not sufficient to explain the creation of international institutions. The presence of market failure is not sufficient to explain international institutions, because market failures rarely point to unique solutions. The strategic form presentation of the prisoners’ dilemma depicts the problem of institutional creation as a dichotomous choice between one inefficient outcome (mutual defection) and one efficient outcome (mutual cooperation). Policymakers, however, rarely face simple dichotomous choices (Garrett 1992; Knight 1992; Sebenius 1992; Krasner 1991; Van Doren 1989). Instead, as figure 1 illustrates, policymakers must move from a status quo inside the Pareto frontier—represented here by point F—to a point along the Pareto frontier—the arc bounded by points B and D. Thus, in creating institutions, policymakers are not just moving to the Pareto frontier but are moving to one of a potentially infinite number of points along this frontier. Each point carries an alternative distribution of the resulting gains from trade. Fully explaining the creation of an international institution requires us to explain why policymakers chose one of these infinite number of possible institutions rather than one of the others. Neoliberal institutionalism gives no means to do so.

Given this indeterminacy, Krasner (1991) argues that power determines institutional outcomes and that, because cooperation has this strong distributive flavor, a focus on distribution and power should supplant the focus on efficiency that dominates theories of cooperation. Embarking upon an efficiency versus distribution debate, however, would be largely unproductive for two reasons. First, distribution and efficiency are inseparable. Every cooperative outcome will both yield efficiency improvements and carry distributive implications. As Sebenius notes, “competitive and cooperative elements are inextricably entwined . . . There is a central inescapable tension between cooperative moves to create value jointly and competitive moves to gain individual advantage” (1992: 330). Page 12 → Fig. I. Distributive outcomes along the Pareto frontier The creation of the EMS nicely illustrates this point. In any exchange rate system the number of bilateral exchange rates is always one less than the number of member countries (Mundell 1968). Thus, every exchange rat system contains one monetary policy that can be set independent of the exchange rate constraint. Policymakers who control this monetary policy will enjoy the benefits of exchange rate stability without sacrificing monetary autonomy. Everyone else must sacrifice monetary autonomy to stabilize exchange rates. Thus, exchange rate systems have distributive implications toward which policymakers are not indifferent. In creating the EMS, policymakers each proposed institutions that gave them control over the single monetary policy. The Bundesbank “won” the negotiations and created rules that gave it control over the system’s single monetary policy. Yet, even given this distributive outcome, exchange rate stability still provided utility improvements for many Community policymakers. So, while the EMS contained a particular distributive outcome, it also represented a Pareto improvement compared with the status quo Page 13 →ante. Thus, while Krasner is right in noting that we need to focus more on power than does neoliberal institutionalism, arguing about whether institution building is primarily efficiency or primarily distributional misses the point—it’s both.4 The introduction of distributive considerations into theories of cooperation increases our information requirements in two ways. First, we must model the power-based bargaining that determines institutional outcomes and the resulting distribution of the gains from trade. This requires us to pay much greater attention to models of bargaining power than does the existing theory of cooperation. Second, distributive considerations mean that it is no longer sufficient to say that a policymaker proposes an institution because it offers joint gains. Even if we accept the claim that policymakers propose only Pareto-improving exchange rate institutions, there are a large number of paths to exchange rate stability. Thus, we need to explain why a particular policymaker proposes a specific path. This requires us to explain why policymakers hold particular monetary policy preferences, how these preferences map onto the exchange rate institutions they propose, and how the processes through which these preferences are created shape decisions about membership in the exchange rate systems that are created. In short, we need to make exchange rate institutions endogenous to policymakers’ domestic monetary objectives. 2. The Capital Mobility Hypothesis The capital mobility hypothesis offers a narrower, issue-specific explanation of the stabilization of nominal exchange rates in the European Community. The capital mobility hypothesis draws on the basic insight of Mundell-Fleming open economy models, the so-called unholy trinity (see, e.g., Webb 1995; Andrews 1994a, 1994b; Goodman and Pauly 1993). According to the unholy trinity, policymakers face three objectives—capital mobility, fixed exchange rates, and monetary policy autonomy—but can simultaneously achieve only two. In a world of perfect capital mobility policymakers who fix their nominal exchange rate will be subject to the interest parity condition: domestic interest rates must equal foreign interest rates. Any deviation from world interest rates will generate capital flows that place pressure on the exchange rate. Policymakers will be forced to intervene in the foreign exchange markets to support the currency. This intervention, if unsterilized, will reverse the domestic monetary operations that led to the interest rate change, pushing the domestic interest rate back to the world interest rate. The point here is simple: if policymakers want to adopt domestic interest rates that depart from the world interest rate, Page 14 →i.e., if they want to pursue an independent monetary policy, they must either control capital movements or accept nominal exchange rate flexibility.

The unholy trinity has led proponents of the capital mobility hypothesis to suggest that, “when capital mobility is high, the sustainable macroeconomic policy options available to states are systematically circumscribed. International financial integration . . . has raised the costs associated with pursuing monetary policies that diverge from regional or international trends” (Andrews 1994: 193). Moreover, in response to the diminished effectiveness of domestic monetary policies, policymakers are likely to pursue international strategies of coordination. As Webb notes, “when short-term capital flows easily across national borders, governments face powerful incentives to coordinate their macroeconomic policies internationally in order to achieve their domestic objectives” (1995: 35). An appreciation of the distributional implications of this coordination accompanies the focus on the increased need to coordinate macroeconomic policies. Andrews points out that, though capital mobility forces greater convergence among monetary policies, the costs of this convergence are not distributed symmetrically across countries (1994: 211). Webb echoes this point, noting that “the key issue in international negotiations has been determining how burdens of adjustment to international macroeconomic disequilibria will be distributed among countries, not overcoming obstacles to cooperation posed by the fear of cheating in an anarchic world” (1995: 46–47). In short, the monetary coordination generated by capital mobility carries distributive implications. Explaining these outcomes implies that “an understanding of the international political structure, especially the distribution of the power among states, is crucial for understanding the distribution of the burden of adjustment among countries” (Webb 1995: 46). To explain exchange rate stability the capital mobility hypothesis relies upon two additional assumptions. First, this literature assumes international financial integration and capital mobility is an exogenously given constraint. As Webb notes, although the creation of integrated international financial markets was the result of conscious policy choices, governments are unable to reverse the process short of a major economic crisis such as the Great Depression (Webb 1995; see also Goodman and Pauly 1993; Andrews 1994). Second, the capital mobility hypothesis assumes that policymakers have fixed preferences for nominal exchange rate stability. As Webb notes, “In practice . . . governments are not willing to tolerate the drastic exchange rate fluctuations that would accompany monetary policy choices based solely on domestic conditions” (1995: 31). Andrews states simply that “Western European governments have for many years regarded exchange rate stability as a very high priority” Page 15 →(1994: 209).5 With these assumptions the unholy trinity yields a very neat prediction: as capital mobility has increased, policymakers have lost their ability to conduct independent monetary policies, and we have thus seen the increasing convergence of monetary policies. When applied to the European Community, the capital mobility hypothesis provides a very parsimonious account of monetary convergence and the resulting stabilization of nominal exchange rates. Andrews (1994a; 1994b) notes that European policymakers have for many years had a strong preference for nominal exchange rate stability. A distributive element is grafted onto the capital mobility hypothesis by the recognition that Germany was a regional hegemon who “played a notably passive role in this multilateral stabilization of European exchange rates” (Andrews 1994a: 429). With preferences for exchange rate stability given, and with Germany serving as the regional hegemon, increasing capital mobility in the late 1970s and 1980s raised the costs of pursuing monetary policies that diverged from the Bundesbank, and “all the advanced industrial states of western Europe eventually accommodated German policy.” This conclusion is echoed by Walsh, who argues that, in spite of significant cross-national differences in the timing of the implementation of convergent monetary policies, “the original forces for policy change have been the constraints on economic policy imposed by greater international capital mobility and the need to respond to changes in monetary and exchange rate policies adopted by other states” (Walsh 1994: 257). While parsimonious, the capital mobility hypothesis contains two important indeterminacies that render it much less satisfying as an explanation of exchange rate stabilization. First, the Mundell-Fleming framework tells us only that monetary policies must converge; it tells us nothing about how the monetary standard around which monetary policies will actually converge is selected. In his work on G-7 macroeconomic policy coordination Webb (1995) constructs a model of power with which to resolve this indeterminacy. Andrews (1994a), however, fails to provide a similar model, noting only that Germany played a “notably passive role” in the stabilization of Community exchange rates. Thus, while the capital mobility hypothesis highlights the importance of distributive considerations and models of power, it does not provide one appropriate to the Community context.

Second, the Mundell-Fleming framework tells us that policymakers face a menu that includes capital mobility, monetary policy autonomy, and exchange rate stability, from which they must choose two, but tells us nothing about which two selections they will make. Even if we treat a high level of capital mobility as exogenously given, we are still left with the need to explain which of Page 16 →the remaining two will be chosen. Andrews resolves this indeterminacy by drawing upon the high degree of trade openness experienced by EC members, in conjunction with theories of optimal currency areas, to assert that European policymakers have strong and stable preferences for nominal exchange rate stability.6 Unfortunately, these imputed preferences do not stand up well against the empirical record. A comparison of the 1970s and 1980s is particularly troublesome. Because capital mobility was lower during the 1970s than it was in the 1980s, policymakers had to sacrifice less monetary policy autonomy to stabilize nominal exchange rates during the 1970s than they did during the 1980s. Exchange rate stability was cheaper in the 1970s than in the 1980s. Why were EC policymakers willing to pay higher costs to stabilize rates in the 1980s, but unwilling to pay lower costs to stabilize nominal exchange rates in the 1970s?7 This suggests that an explanation based upon changes in policymakers’ monetary and exchange rate policy preferences across the two periods might provide a more compelling explanation of this variation than an explanation based on imputed and fixed preferences for exchange rate stability. Frieden’s work (1996; 1991b) points in this direction by drawing a tight relationship between economic integration and policymakers’ tradeoff between monetary policy autonomy and exchange rate stability. Frieden offers a model in which economic actors’ exchange rate preferences are determined by their sectoral interest. Distinguishing broadly between tradable and nontradable sectors, and then further between service and manufacturing activities within the tradable sectors, Frieden’s central claim is that, as economies become more open on current and capital account, more economic agents develops crossborder trade and investment interests. Those involved in cross-border investment, traders, and exporters of specialized manufactured products all 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 monetary integration. (Frieden 1996: 203) Thus, according to Frieden, economic agents’ desire for stable exchange rate relationships as the EC became more tightly integrated has driven exchange rate stability during the 1980s and the push toward EMU in the 1990s. Frieden’s approach is not without problems. First, Frieden fails to tell us how competing demands over exchange rate stability and monetary autonomy are reconciled. A stylized example can help make this point. The franc-mark Page 17 →exchange rate is endogenous to the interaction of monetary conditions in France and Germany. Suppose Germany experiences a negative supply shock—an increase in wage costs, e.g.—while France does not. German policymakers will either respond with monetary restriction, in which case capital inflows will cause both the real and the nominal exchange rates to appreciate, or they will accommodate the shock, in which case inflation, at a fixed nominal exchange rate, will cause a real appreciation. Exchange rate stability, in such a case, requires French policymakers to tighten monetary policy if Germany tightens, even though it has no inflationary pressure, or to loosen monetary policy if Germany accommodates, to create an equivalent amount of inflation. Thus, exchange rate stability in the wake of an asymmetric shock requires French policymakers to adopt a monetary policy that bears no relation to domestic monetary conditions. Frieden’s argument thus amounts to the claim that economic actors engaged in international transactions are willing to sacrifice the domestic economy for the sake of exchange rate stability. While commercial banks and MNCs might be indifferent to domestic economic conditions, it is not at all obvious that politicians can afford to be. Politicians remain accountable at the national level, where they are judged by voters. A clear losing strategy in any election is “run the economy into recession.” Thus, Frieden’s model has a large gap between the preferences he derives and the policy outcomes to which he links them. How, and why, did the internationally oriented sector win the competition over exchange rate and monetary policy? Thus, at a minimum Frieden’s approach needs to be accompanied by a model of how the political process reconciles competing actors’ exchange rate stability and monetary autonomy demands. Moreover, it is not clear that economic actors hold the exchange rate preferences Frieden derives.8 According to Frieden, banks and large corporations involved extensively in international transactions are likely to be the

strongest supporters of exchange rate stability. While this appears intuitive, as those most engaged in international trade and payments are most exposed to foreign exchange risk, Frieden overlooks an important aspect of international financial markets. Economic actors engaged in international transactions are exposed to foreign exchange risk only in the absence of insurance markets. Financial markets do provide insurance, however, through forward currency markets. Forward markets enable firms to hedge against currency movements, allowing them to eliminate most of the risk involved in foreign currency transactions. Thus, while banks and MNCs might not want excessive exchange rate volatility, it does not follow that they have strong preferences for fixed exchange rates. Frieden also states that tradable goods producers prefer weak and depreciating Page 18 →currencies. While this makes sense in an economy in which tradable producers rely primarily upon domestically produced intermediate goods, it becomes less reasonable in a highly open economy in which tradables producers import many of their intermediate inputs. Once producers import inputs, they have more interest in having an overvalued exchange rate that reduces input costs than in having a weak exchange rate that cannot reduce the foreign price of the goods they produce because it raises the price of their inputs. The way to square competing import-export interests, and, as we will see in chapters 4–6, the way they were squared in the EC during the 1980s, is to embrace an overvalued nominal exchange rate to reduce input costs and push down labor costs to regain export competitiveness at this exchange rate. This, in turn, points us away from Frieden’s sectoral approach and toward a class-based, wagebargaining approach. In sum, while the capital mobility hypothesis rightly points our attention to both the importance of international economic constraints and the distributive aspects of monetary cooperation, indeterminacies inherent in the hypothesis point to the same conclusion reached in the discussion of neoliberal institutionalism. Explaining variation in policymakers’ ability to stabilize nominal exchange rates requires models of bargaining power that explain why EC policymakers converged around the Bundesbank rather than an alternative standard and models of monetary policy preference formation that explain variation in EC policymakers’ willingness to converge around the Bundesbank.

B. Explaining Exchange Rate Cooperation: A Model of Monetary and Exchange Rate Politics In the chapters that follow I develop and test a public choice approach to exchange rate cooperation that fills in the gaps in neoliberal institutionalism and the capital mobility hypothesis. The model is based on three components. A model of exchange rate determination, purchasing power parity, links changes in bilateral nominal exchange rates to cross-national inflation differentials. A political model links inflation to partisan preferences, domestic institutions, and capital-labor conflict over the distribution of income. A model of bargaining power based on Schelling’s notion of “power as credible commitment” resolves the indeterminacy about the rate of inflation around which policymakers must converge to stabilize exchange rates. I then use this model to derive hypotheses about why policymakers create exchange rate institutions, about why policymakers exhibit variation in their willingness and ability to stabilize exchange rates within these institutions, and Page 19 →about why existing exchange rate institutions evolve. Like neoliberal institutionalism, the model expects policymakers to create exchange rate institutions when exchange rate stability offers mutual benefits. The model locates the motivation for these benefits in domestic politics. Policymakers propose and create fixed exchange rate systems in order to achieve politically determined domestic monetary objectives they cannot achieve otherwise. The distributive outcome—i.e., who controls the system’s single degree of monetary policy freedom—will be determined by bargaining power. Variation in policymakers’ willingness and ability to stabilize exchange rates within an exchange rate institution is a function of the symmetry of monetary responses to shocks. Monetary responses, broadly conceived as accommodating or nonaccommodating, that diverge in the wake of shocks will tend to yield exchange rate instability. Monetary responses are, in turn, a function of partisan preferences, the organization of labor, and central bank institutions. Exchange rate outcomes are not fully determined by domestic politics. Policymakers with a preference for the monetary policy required for exchange rate stability, but who are constrained by domestic institutions from implementing the necessary monetary policy, can use exchange rate institutions to loosen these constraints and implement their preferred policies. At the

international level policymakers can use exchange rate institutions to relax the exchange rate constraint by imparting flexibility to the system through periodic realignments, to reduce the costs of, and shift the blame for, the monetary policy necessary to stabilize the exchange rate and to construct domestic coalitions in support of their desired monetary policy stance. Finally, unlike neoliberal institutionalism, the model expects exchange rate institutions to evolve, either toward a more flexible arrangement or toward a currency union, when the existing system ceases to offer joint gains, i.e., when at least one policymaker is unable to achieve their domestic monetary objectives within the existing system. I then assess these hypotheses against twenty years of EC exchange rate cooperation. Chapter 3 examines the creation of the EMS. Neoliberal institutionalism and the model developed here offer explanations that converge on the recognition that the EU policymakers created the EMS because it offered mutual benefits. Because my model fills in the gaps in the neoliberal explanation, however, it provides a more compelling explanation. The chapter shows how the motivation for the system’s proposal lay in policymakers’ politically defined domestic objectives. Helmut Schmidt proposed, and French and Italian policymakers joined, in order to achieve domestic monetary objectives they could not achieve within the confines of domestic institutions. For Schmidt, under pressure from his party and German labor unions to deliver a more Page 20 →dynamic economic environment, this was a matter of escaping coalition constraints to engineer a fiscal expansion and escaping central bank constraints to engineer a monetary expansion. The EMS, by obligating the Bundesbank to intervene in the foreign exchange markets in support of weak currencies, would produce a looser monetary policy and, at a minimum, slow the mark’s appreciation against Germany’s major trading partners to reduce unemployment and downward pressure on wages. French and Italian policymakers, each striving to stabilize their economies but constrained by strong labor, coalition governments, and lacking independent central banks, saw the EMS as a useful external nominal anchor that would help them achieve this objective. The system’s distributive outcome was determined by Bundesbank power. The German central bank committed to price stability and shaped the institutional framework to gain full control over the system’s single monetary policy. The resulting outcome was one in which EC policymakers gave the Bundesbank control of Community monetary policy in exchange for the ability to use a fixed exchange rate to help them achieve price stability at home. With the Bundesbank in control of the EMS’ single monetary policy instrument, nominal exchange rate stability depended upon other policymakers’ willingness and ability to implement monetary policies that converged on the Bundesbank’s price stability standard. Between 1983 and 1990 EC policymakers proved both willing and able to do so, and, as a result, nominal exchange rates stabilized. Chapters 4 and 5 investigate whether capital mobility or domestic politics drove this nominal convergence. In chapter 4 I present the results of statistical analysis of two data sets covering the period 1971–90. The evidence provides little support for the capital mobility hypothesis and strong support for the domestic politics hypothesis. With only two exceptions variation in policymakers’ responses to wage and other shocks drove variation in inflation rates. Even in Italy and France, where policymakers whom we would not expect to implement monetary restriction did so, capital mobility does not appear to have caused the shift. In both countries the acceptance of the exchange rate constraint and the elimination of capital controls followed rather than led the policy shift. Thus, chapter 4 suggests two conclusions: the nominal convergence upon which the stabilization of nominal exchange rates was based was largely driven by the emergence of a Community-wide consensus on price stability, but France and Italy stand as exceptions to the model’s expectations. In chapter 5 I present case studies of the French and Italian experiences to try to understand why, and how, policymakers whom we would expect to be neither willing nor able to implement monetary restriction did so. A similar picture emerges in both countries, one in which a minority group of policymakers Page 21 →committed to price stability used EMS institutions to help them win distributive struggles over monetary policy. In both countries policymakers used realignments to reconcile inflationary monetary policies with EMS membership. Keeping their currencies inside the EMS gave policymakers both the time and the opportunity to use EMS institutions to help them construct domestic support for price stability. In France the social democratic wing of the Socialist Party used the EMS to link price stability to European integration more broadly cast to gain majority support for monetary restriction. In Italy center-right governments confronting acute coalition instability used the

EMS to hand the conduct of monetary policy over to the Italian central bank, which used the exchange rate to adopt a much more restrictive monetary policy than would have been possible otherwise. Thus, the French and Italian cases deviate from the model’s expectations, because French and Italian policymakers who wanted price stability used EMS institutions to help them achieve it. EMS institutions began to evolve in the mid-1980s. Neoliberal institutionalism and the model of exchange rate cooperation developed here offer divergent expectations about the factors driving this process. Neoliberal institutionalism expects the EMU process to be driven by a quest for the additional welfare improvements offered by a single currency, while the model developed here expects this process to be driven by efforts to redistribute the costs and benefits provided by the existing system. Chapter 6 assesses these divergent expectations. I provide two types of evidence. First, I show that EMU does not offer welfare improvements to the EU as a whole and that a joint gains approach based on the core-periphery distinction does not correspond well with patterns of support for EMU. Peripheral policymakers, who this approach would predict would suffer costs in EMU, have been among its most ardent supporters, while some core policymakers, who by this approach could expect to realize benefits, have been most reticent about, and in some cases opposed to, EMU. The absence of clear joint gains from full EMU and the inconsistencies between patterns of support and expected costs and benefits make a neoliberal account difficult to sustain. I then provide evidence in support of the redistributive hypothesis. I show how the EMS had hardened into a quasi-currency union by the mid-1980. This hardening had two implications. First, the EMS as a quasi-currency union, like full EMU, was costly. At least one policymaker had to sacrifice his domestic economic objectives to sustain exchange rate stability. Second, therefore, while the welfare differences between EMS and EMU were small, the distributive differences were potentially quite large. I then show how French policymakers initiated EMU in an attempt to redistribute the costs of exchange rate stability and Page 22 →how Bundesbank resistance to these efforts led first to a conditional EMU then to greater exchange rate flexibility and to what now looks like a variegated institutional framework that combines monetary union with exchange rate flexibility. Thus, the EMU process suggests that neoliberal institutionalism not only offers an incomplete explanation of institutions but also, at times, a misleading one. In chapter 7 I summarize the book’s findings and highlight what I think they imply for future research on international cooperation.

C. Conclusion How do we explain the creation and evolution of Community exchange rate institutions and the variation in policymakers’ ability to stabilize nominal exchange rates within these institutions? Existing literatures that address these questions are inadequate for the task. Because it relies upon a functional logic, neoliberal institutionalism fails to offer a compelling explanation for the creation and evolution of exchange rate institutions. Because it contains indeterminacies about the standard toward which monetary policies will converge and, given this standard, about policymakers’ choice between monetary policy autonomy and exchange rate fixity, the capital mobility hypothesis fails to offer a compelling explanation of the variation in policymakers’ ability to stabilize nominal exchange rates. Explaining both the creation and evolution of exchange rate institutions and the variation of nominal exchange rates within these institutions requires us to develop theories of preferences and a model of bargaining power. This book develops a public choice approach to monetary politics and uses it to explain EC exchange rate cooperation. Based on model of exchange rate determination, a political model of inflation, and a domestic institution-based model of power, the model of exchange rate cooperation yields hypotheses about the creation and evolution of exchange rate institutions and about variation in policymakers’ willingness and ability to stabilize nominal exchange rates within these institutions. The empirical findings suggest that the European monetary system was stable during the first half of the 1980s because it was an efficient institution; i.e., with all members committed to domestic stabilization, an exchange rate tied to the Bundesbank provided utility gains for all members. The evolution of the EMS has been driven by policymakers’ responses to the erosion of mutual benefits within the EMS.

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CHAPTER 2 A Model of Nominal Exchange Rate Cooperation How do we explain the creation and evolution of European Community exchange rate institutions, and how do we explain the variation in European policymakers’ ability to stabilize nominal exchange rates within these institutions? This chapter develops a public choice approach to exchange rate cooperation in order to answer these questions. The model of monetary politics has two components: an economic model of exchange rate determination that links nominal exchange rate stability to cross-national inflation differentials; and a political model that treats inflation as a product of labor-capital conflict over the distribution of national income mediated by the political process. The model provides the basic condition for nominal exchange rate stability: nominal exchange rate stability requires policymakers to adopt and implement monetary policies that force inflation rates to converge. The indeterminacy about the rate of inflation toward which policymakers must converge is related to the degrees of freedom problem, shown to have distributive implications, and resolved by a model of bargaining power based upon cross-national differences in central banking institutions. The resulting model depicts the creation and evolution of exchange rate institutions as endogenous products of policymakers’ domestic monetary objectives. Policymakers representing constituents harmed by nominal exchange rate instability propose exchange rate institutions to improve their constituents’ welfare. Policymakers create exchange rate institutions if the monetary policies they want to adopt at home converge on the monetary policy adopted by the actor who controls the system’s single monetary policy instrument. Exchange rate systems evolve as the costs of exchange rate stability rise above the benefits, i.e., when policymakers want to adopt monetary policies Page 24 →that diverge from the monetary policy adopted by the actor who controls the system’s single monetary policy instrument. Policymakers facing rising costs will either drop out of the system or try to renegotiate the terms of the initial bargain. Thus, both the creation and the evolution of exchange rate institutions are endogenous products of policymakers’ domestic monetary objectives. The model depicts variation in policymakers’ ability to stabilize nominal exchange rates as an endogenous product of the interaction between domestic monetary politics and exchange rate institutions. While policymakers who have monetary objectives that diverge from those held by the center country can either exit the system or seek reform, policymakers who prefer the monetary policy required to stabilize their exchange rate, but face domestic constraints on their ability to implement this policy, can use exchange rate institutions to relax these constraints. Policymakers can use exchange rate institutions in three distinct ways. Realignments reconcile monetary divergences with membership in the exchange rate system; exchange rate institutions can reduce, and deflect the blame for, the costs that the monetary policy required by membership do impose; and exchange rate institutions can facilitate the construction of domestic coalitions in support of the required monetary policy.

A. The Politics of Nominal Exchange Rate Stability The model of nominal exchange rate stability consists of three components: a model of exchange rate determination, purchasing power parity, that links nominal exchange rate stability to cross-national inflation differentials; a political model in which the rate of inflation is caused by the interaction between labor-capital conflict over the distribution of national income and the political institutions within which this conflict is mediated; and a model of bargaining power that determines the rate of inflation toward which the countries must converge. The resulting model provides the conditions for nominal exchange rate stability, yields explanations of the creation and evolution of exchange rate institutions, and explains variation in policymakers’ ability to stabilize nominal exchange rates within these institutions. 1. The Model of Exchange Rate Determination

Purchasing power parity (PPP) provides the model of exchange rate determination. While PPP models are not without their critics, they provide a simple base upon which to construct a political model of nominal exchange rate cooperation Page 25 →in which inflation differentials is the primary dependent variable.1 PPP models of nominal exchange rate determination start from the “law of one price.” The law of one price states, quite simply, that in well-integrated markets, and in the absence of transportation costs and barriers to trade, “identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency” (Krugman and Obstfeld 1994: 399). Purchasing power parity extends the law of one price from single commodities to aggregate price levels, claiming that a given bilateral nominal exchange rate will equal the ratio of two countries’ price levels:

Thus, according to the PPP model, the mark-franc exchange rate is equal to the ratio of German and French prices. The absolute version of PPP in turn yields a relative purchasing power parity model in which changes in nominal exchange rates are equal to the differences in the changes in each countries’ price level, or change in nominal exchange rates equals the inflation differential: or, more simply, If, for example, during one year French inflation was at 10 percent and German inflation was at 3 percent, relative PPP would expect the franc to depreciate against the mark by seven percentage points. In sum PPP models suggest that the ratio between two countries’ price levels determine nominal exchange rates, while changes in these countries’ relative price levels determine changes in their nominal exchange rate. Within the monetarist framework upon which PPP models are based, the interaction between the supply of and the demand for money determines prices. In the equations that follow let Ms represent money supply, set exogenously by the monetary authorities, and let L represent the demand for money, which is a decreasing function of the interest rate (R) and an increasing function of real output (Y). Page 26 → Equations 3 and 4 tell us that the total money supply divided by total money demand determines price levels in Germany and France. With money supply held constant an increase in the demand for money will yield a reduction in the price level, while a decrease in the demand for money will yield an increase in the price level. In conjunction with the PPP equation (1 ) these equations tell us that the relative supply of and the relative demand for francs and marks will fully determine the bilateral franc-mark exchange rate in the long run. Moreover, equations 2, 3, and 4 tell us that relative changes in money supply or money demand will determine changes in the franc-mark bilateral nominal exchange rate. An increase in the French money supply not accompanied by an increase in the demand for francs will generate an increase in French prices. If in Germany, money supply and money demand remain constant, the French franc will depreciate against the mark. In sum PPP models and the monetarist approach more generally tell us that, if policymakers wish to affect their nominal exchange rate, they need to alter the ratio of domestic to foreign prices, and to affect this ratio they need to alter either money supply, money demand, or both. The PPP model highlights three points relevant to the political model of nominal exchange rate cooperation developed here. First, in a fixed exchange rate system the domestic price level and the rate of inflation become endogenous to a given, and fixed, nominal exchange rate. Fixing an exchange rate is, in effect, a commitment to prevent changes in the nominal exchange rate. The necessary condition for achieving zero change in nominal exchange rates, according to relative purchasing power parity (eq. 2) is the convergence of French and German inflation rates:

Thus, within the relative PPP model stabilizing nominal exchange rates requires French and German policymakers to converge toward a single rate of inflation.2 Second, the monetarist approach highlights the instruments policymakers must manipulate to achieve convergent rates of inflation. Since inflation results from the interaction of money supply and money demand (eqs. 4 and 5), and because it is difficult for policymakers to manipulate directly the demand for money, policymakers’ ability to stabilize nominal exchange Page 27 →rates becomes dependent upon their ability and their willingness to alter the money supply. In other words, if policymakers want to stabilize nominal exchange rates, they need to adopt monetary policies that lead to convergent rates of inflation. Third, and finally, equation 6 leaves open the rate of inflation toward which policymakers must converge to stabilize nominal exchange rates. It tells us that countries’ inflation rates must converge, but this convergence can occur at a low rate of inflation, a moderate level of inflation, or a high level of inflation. Thus, PPP points out two necessary political components: we need to explain how domestic politics shape inflation, and we need to explain the choice of the inflation rate toward which policymakers must converge to stabilize nominal exchange rates. 2. The Domestic Politics of Monetary Policy and Inflation The domestic political model depicts inflation as the result of a struggle between labor and capital, in both the economic and the political arenas, over the distribution of income.3 The model contains two basic components. First, it contains a simple description of how labor-capital conflicts over the distribution of income can generate inflationary pressure. Second, it contains a political model that explains the extent to which labor-capital conflict generates inflation. This model has three components. First, wage-bargaining institutions determine the degree to which economies are exposed to labor market shocks. Second, a class-based partisan model of monetary policy preference formation tells us how policymakers are likely to respond to inflationary shocks. Third, two political institutions, regime type—single-party majority versus coalition governments—and central bank independence, shape policymakers’ ability to respond to inflationary shocks in their desired manner. a. Labor Markets, Supply Shocks, and Inflation

Inflation results from the interaction between labor and capital’s struggle over the division of income and policymakers’ monetary policy response to this distributive struggle.4 In the purest case of inflation generated by labor-capital struggle over the distribution of income, prices rise because of an autonomous wage shock—a onetime increase in the real wage without a corresponding increase in productivity.5 As labor becomes better organized and more powerful, it attempts to capture a larger share of national income by imposing real wage increases onto capital. If, in response to this shock, the monetary authorities are passive and hold money supply constant, producers will pass on the higher wage costs as higher prices, and output will fall. If the price level rises, Page 28 →labor finds that its initial attempt to realize real wage gains has failed and responds by pressuring for additional nominal wage increases. If labor gains a second nominal wage increase, industry must either swallow the full costs of the wage shock, i.e., capital’s earnings will fall, or push prices up again, imposing another real wage loss on labor. Labor’s response will likely be the same as in the first round of price increases, and so the cycle continues. Thus, the struggle between capital and labor over the distribution of income sets off a wage-price spiral that drives inflation upward. Autonomous wage shocks are not the only source of labor market-induced inflation. Other negative supply shocks, anything that increases the costs of producers’ inputs, such as an increase in oil prices or exchange rate depreciations that drive up the domestic currency costs of imported inputs, can also set off a distributive struggle over which, capital or labor, will bear the costs of adjusting to this shock. Capital is likely to respond to exogenous shocks as it would respond to autonomous wage shocks—by passing the higher costs on as higher prices. Labor will respond by seeking nominal wage increases that compensate for these price rises, and the wage-price spiral begins. b. Labor Market Organization and Supply Shocks

While labor markets can be a source of inflationary pressure, the extent to which they generate inflation depends in part upon the institutional framework governing labor-capital relations. These institutions, by structuring labor-

capital bargaining over real wages, will shape both the extent to which a given economy will experience autonomous wage shocks and the extent to which labor markets transform other exogenous supply shocks into wage-price spirals. We can identify three distinct institutional frameworks: corporatism, market based, and decentralized union-industry bargaining.6 Corporatist institutions reduce the frequency of autonomous wage shocks and are less likely than alternative institutions to transform other exogenous shocks into inflation (Layard, Nickell, and Jackman 1991). Under corporatism real wages are set through highly centralized bargaining between peak associations. In Scandinavia, for example, the most corporatist region of the OECD, national level bargains between trade union and employers’ federations set wages, industry and firm-level agreements supplement these bargains.7 Within such a framework labor moderates real wage demands in return for an industry commitment to reinvest a significant share of its retained earnings (Eichengreen 1995). As a result, labor is less likely to believe that it has been systematically under compensated in an earlier period and, thus, less likely to press for large Page 29 →settlements that redress perceived imbalances. Thus, countries that manage labor-capital relations in corporatist institutions are less likely to experience autonomous wage shocks. Moreover, because corporatist institutions enable labor and capital to develop a degree of trust, they are likely to facilitate the apportionment of the costs of adjustment in the wake of other exogenous supply shocks. As a result, rather than an oil price increase causing a wage-price spiral, labor and capital will be more easily able to negotiate an agreement in which they share the costs of the adjustment. Thus, corporatist institutions are also unlikely to transform nonwage supply shocks into wage-price spirals and inflation. Market-based institutions are also less likely to experience nominal wage shocks and more likely to prevent other exogenous shocks from being transformed into inflation but for reasons quite different from corporatism. Within market-based institutions union coverage is low, labor is poorly organized, and wage setting takes place at the firm level. Though labor in such a system may find real wage growth unsatisfactory, without unions to coordinate responses to employer behavior, labor is unable to use large wage campaigns to redress the imbalance. Thus, widespread autonomous wage shocks are unlikely to occur in such systems. Moreover, in the wake of other exogenous supply shocks, capital faces few constraints on its ability to increase prices without offering compensating nominal wage increases. Thus, market-based institutions are also less likely to transform exogenous shocks into wage-price spirals. An institutional framework characterized by decentralized union-industry bargaining possesses none of the advantages of corporatism nor the obvious power imbalance of market-based institutions. As a result, decentralized union-industry bargaining is more likely both to generate autonomous wage shocks and to transform other supply shocks into wage-price spirals. Under decentralized bargaining labor is well organized, wage bargaining takes place at the industry level and is supplemented by firm-level agreements, but there is little coordination between union confederations. Thus, labor is sufficiently organized to launch strong wage campaigns, but wage bargaining is too decentralized to prompt the types of cooperative bargaining found under corporatism.8 Wage settlements under such institutions are likely to reflect shifts in bargaining power between labor and capital. When capital is ascendant, real wage growth should slow, and, as labor gains ascendancy, it should strive for real wage settlements that compensate for what they perceive to have been prior shortfalls. Thus, decentralized union-industry bargaining institutions are more likely to generate autonomous wage shocks that prompt inflationary pressure. Moreover, because power-based bargaining characterizes industrial relations Page 30 →within these institutions, the institutions are more likely than other systems to transform other supply shocks into wage-price spirals as each side tries to force the other to bear the full costs of the shock. In cases in which labor is sufficiently powerful its desired share of national income can become locked in through institutions. Two such institutions are important—wage indexation mechanisms and labor market regulations. Wage indexation mechanisms link increases in nominal wages to increases in a price index, protecting real wages against inflation. Thus, a good strategy for labor is to achieve a one-shot increase in its real wage and then gain a wage indexation mechanism that prevents capital from escaping this increase by raising prices. Capital’s response to wage indexation is likely to be layoffs: as the real wage exceeds the marginal product of labor, industry will reduce employment. If labor can gain labor market regulations that constrain industry’s ability to shed labor, however, capital is stuck with more labor than it can profitably use at the given real wage and is likely to respond

by searching for some political means to undo these institutions.

c. Responding to Exogenous Shocks: Monetary Policy Preferences, Regime Type, and Central Bank Independence

While wage bargaining institutions are likely to have an important influence on an economy’s exposure to wageprice spirals, the probability that a given economy will face wage-price spirals also depends on policymakers’ monetary policy responses to wage shocks and labor and capital’s expectations about these responses. Put simply, if policymakers refuse to accommodate shocks, then, regardless of the institutions governing labor-capital relations, they will push the economy into recession, generating unemployment and reducing upward pressure on wages. Thus, to know whether exogenous shocks yield inflation, we need to know how policymakers are likely to respond to these shocks. Policymakers’ responses to exogenous shocks depend on three factors: the degree of central bank independence, policymakers’ monetary policy preferences, and the regime type within which they are trying to respond. i. Central Bank Independence

The institutional structure of central banking can have a powerful impact on the extent to which exogenous shocks yield inflation.9 The central issue at stake is the extent to which a country’s central bank possesses a high degree of political and economic independence from the political decision-making process. Central banks range along a spectrum of political and economic independence from positions of full subordination to the political process, in which the government Page 31 →determines monetary policy, to full independence from the political process, in which the central bank determines monetary policy.10 The factors that determine a given central bank’s degree of independence include the appointment of the bank’s decision-making board, the decision-making board’s ability to define the monetary policy objective autonomously, how the central bank and the executive branch resolve conflict over monetary policy, and the central bank’s ability to control the process of money creation to meet the objectives it sets. In fully independent central banks governments appoint board members but are not able to dismiss them before the end of their term, the central bank alone determines monetary policy objectives, conflict over monetary policy between the central bank and the executive is resolved in favor of the former, and the central bank alone controls the process of money creation (Cukierman 1992: 372). Cross-national variation in central bank institutions will contribute to cross-national variation in policymakers’ response to exogenous supply shocks. Because independent central banks are charged with maintaining the value of the domestic currency, they are likely to adopt nonaccommodating monetary policies in the wake of wage or other exogenous supply shocks. This is likely to have two effects on such shocks. The first effect operates directly on monetary policy outcomes: the inflationary impact of supply shocks are likely to be choked off quickly. The second effect operates on expectations. Because central banks will not accommodate inflationary shocks, they develop a credible commitment to price stability that reduces the incidence of autonomous wage shocks. Organized labor recognizes that the central bank authorities are committed to price stability and will respond to wage and other supply shocks with monetary contraction, i.e., with a policy stance that generates unemployment rather than real wage increases. Labor thus has a strong incentive to practice wage moderation.11 Thus, we should expect fewer wage shocks, and less wage pressure in the wake of other exogenous supply shocks, in countries with autonomous central banks. ii. Monetary Policy Preferences and Monetary Policy Outcomes

If a country does not have an independent central bank, then the political system determines the response to the exogenous shock. Policymakers’ responses to shocks depend upon two distinct processes: how policymakers form monetary policy preferences; and how they transform these policy preferences into monetary policy outcomes. Labor-capital conflict over the distribution of income enters the political arena as conflicting monetary policy preferences. In the European context Page 32 →party systems have historically mirrored class divisions, with labor interests represented by parties, such as the British Labour Party and the Italian Community Party, with strong ties to the trades unions movement and with capital’s interests represented by parties, such as the British

Conservative Party and the Italian Christian Democrat Party, with strong, though often informal, ties to producers groups. Politicians who wish to rise to positions of power within a party must convince its supporting coalition that they are willing to represent the interests of this coalition once in power. This implies the need to proclaim a commitment to, and demonstrate a willingness to implement, sets of policies that enhance the utility of the party’s supporting coalition. Thus, the tight relationship between classes and political parties creates strong incentives for policymakers to prefer the monetary policies preferred by their support coalition. Not surprisingly, labor and capital have divergent monetary policy interests. Labor has an interest in monetary policies that keep labor markets tight, to increase its bargaining power against capital, and that accommodate exogenous shocks. Capital prefers monetary policies that generate slack in labor markets, to limit labor’s bargaining power, and that do not accommodate supply shocks. Politicians’ tight link to their underlying classbased coalitions transforms these competing monetary policy interests into monetary policy preferences. Parties of the Left are likely to prefer monetary policies that avoid generating higher unemployment, while parties of the Right are likely to prefer monetary policies that generate unemployment and preserve domestic price stability.12 Mapping these policy preferences onto monetary policy outcomes is complicated by the recognition that different countries have different electoral and party systems and, as a result, different types of government. The basic distinction is between proportional representation (PR) and single-member district plurality electoral systems. As Duverger (1963) pointed out, single-member district plurality systems tend to weaken all but the two strongest parties. Because third parties are underrepresented in parliament relative to their share of the national vote, voters become increasingly unwilling to waste their vote on third parties and vote, instead, for whichever of the two strongest parties falls closest to their ideal point. As a result, single-member district plurality systems tend to yield two-party systems and single-party governments in which a single party holds political power. In two-party systems elections resolve the distributive conflict over monetary policy. Elections resolve this conflict in two ways. First, by determining the ruling party, elections determine who wins the conflict. In addition, however, the electoral process mitigates the severity of this distributive conflict. For, while politicians must implement policies that increase the utility of their Page 33 →respective constituencies, they must also experience electoral success before they can implement any set of policies. Thus, in addition to their efforts to improve their constituents’ utility, rational policymakers must also be motivated by a desire to win elections (Downs 1958; Alesina 1988b; Alesina and Rosenthal 1994). As the policies that fully represent the interests of one segment of society are likely to be too narrow to gain the votes necessary to win a national election, politicians must moderate the extent to which the policies they advocate impose costs on their opponents. Such moderation, in turn, reduces the severity of the distributive conflicts inherent in political competition. Thus, parties of the Left are most likely to adopt monetary policies that both accommodate exogenous supply shocks and generate demand-pull inflation. Parties of the Right are least likely both to accommodate exogenous supply shocks and to try to push the economy above its natural rate of output. Thus, in two-party systems policymakers’ response to exogenous shocks, and their tendency to create demand-pull inflation, will depend on which party happens to be in power at the time of the shock. Proportional representation (PR) systems have no systematic bias against weaker parties. As a result, PR systems tend to yield multiparty political systems and coalition governments under which a group of parties shares political power. Mapping monetary policy preferences onto monetary policy outcomes is more difficult in multiparty systems, because coalition governments will find enacting redistributive policies much more difficult than will single-party majority governments. A simple spatial model can help make this point. Consider a threeparty system considering a single issue (fig. 2). Each party has its individual ideal point, depicted here by A, B, and C, and no party holds a parliamentary majority. Thus, it requires two parties to adopt any policy. This model highlights two points. First, coalition governments are formed of policymakers from distinct political parties representing distinct constituencies that have distinct ideal points. Thus, rather than being unified on most policy issues, coalition governments constitute distinct, and often contradictory, policy preferences. Second, median parties determine outcomes; any attempt to move away from the median party’s ideal point will cause this party to defect from the coalition and join the alternative coalition. More generally, in coalition governments each party, by threatening to withdraw from the coalition, has the power to block movement away from the status quo. Thus,

coalition governments will not only find it more difficult to construct a coherent policy position than will singleparty majority governments; they will also find it difficult to implement policies that represent decisive movement away from the status quo. Page 34 → Fig. 2. Coalition bargaining over price stability If we impose a short-term Phillips curve on the coalition dimension, we can see the impact of coalition government on monetary policy. Assume that points A, B, and C correspond to each party’s ideal inflation /unemployment combination. What is the likely monetary policy response to an exogenous shock? It does not matter whether the coalition contains parties of the Left and the Center or parties of the Right and the Center; in both cases the government will find it very difficult to alter monetary policy in response to the shock. Movement from the status quo either to tighten or to relax monetary policy will prompt defection by the median party. In effect, coalition government biases the outcome in favor of labor: no change in monetary policy represents accommodation. Policymakers wishing to respond to supply shocks with a nonaccommodating monetary policy will find it difficult to do so. Moreover, coalition governments are also likely to generate demand-pull inflation. This derives from coalition governments’ tendency to run larger budget deficits than single-party majorities. Because, as the spatial model illustrated, coalition governments find it difficult to make decisions that redistribute income, they will tend to increase government spending rather than make hard choices between spending priorities (Sachs and Roubini 1989). Without strict constraints on central bank financing of government expenditures, governments are more likely to monetize budget deficits, translating deficits into money creation and inflation. Moreover, the same elements of the political system that constrain the government’s ability to control budget growth also constrain coalition governments’ ability to reduce the size of the budget deficit and the recourse to central bank financing. Thus, coalition governments are likely to have an expansionary monetary policy and are unlikely to be able to implement the budgetary cuts that can facilitate the monetary restriction necessary to stabilize the domestic monetary environment. In sum policymakers’ response to exogenous shocks depends on the monetary policy preferences they hold and the political institutions within which they operate. We expect parties of the Left to accommodate exogenous shocks Page 35 →and generate demand-pull inflation, while we expect parties of the Right to react to shocks with monetary restriction and resist demand-pull inflation. The ability of these different parties to achieve their monetary policy objectives depends upon whether they are operating within a single-party majority or a coalition government. Policymakers in a single party majority government will be more able to adopt their preferred monetary policy response than will policymakers in coalition governments. 3. The Political Economy of Nominal Exchange Rate Stability: A First Cut The model of exchange rate determination and the domestic model of monetary policy and inflation provide the basic hypothesis about nominal exchange rate stability. Returning to our model of exchange rate determination (eq. 6), I asserted that the condition for nominal exchange rate stability in a given dyad was the convergence of inflation rates within the dyad: or, more simply, Inflation in each country is a function of policymakers’ monetary policy preferences and domestic institutions, Substituting equation 8 into equation 7 yields the political conditions for nominal exchange rate stability: In words, we expect nominal exchange rates in dyad ij to stabilize when monetary policy preferences and institutions in country i and in country j yield the same rates of inflation. This condition for nominal exchange rate

stability yields the basic hypothesis tested in this study: variation in nominal exchange rate stability in a given dyad is negatively related to political-institutional asymmetries Page 36 →within that dyad. The more symmetric are preferences and institutions across the dyad, the more likely are inflation rates to converge, and the more likely is nominal exchange rate stability. 4. Resolving the Indeterminacy: Central Bank Institutions and Bargaining Power The basic model contains a central indeterminacy: it tells us inflation rates must converge but tells us nothing about the rate toward which they must converge. In other words, the model provides no solution to the “N-1 “ problem. As Von Hagen and Fratianni explain, “An exchange rate [system] among N countries predetermines N-l central parities and leaves only one degree of freedom to choose the [system’s] common monetary policy” (1992: 43). Thus, exchange rate systems contain one redundant monetary policy. In the short run this monetary policy determines the system’s response to exogenous shocks, and in the long run it determines the system’s rate of inflation. The actor who controls the single degree of monetary policy freedom determines the rate of inflation toward which policymakers must converge and, as a result, will sacrifice no monetary autonomy to stabilize its nominal exchange rate. Thus, the solution to the N-1 problem has strong distributive implications. Suppose, for example, that price stability-oriented policymakers control the single degree of freedom. If high inflation policymakers want to stabilize their exchange rate, they must adopt monetary restriction. Monetary restriction will redistribute income in the high-inflation economy away from labor and toward capital as real wages fall to restore competitiveness. Thus, monetary restriction pushes the high-inflation policymaker toward the right end of the price stability dimension, yielding greater utility to supporters of the Right and less to supporters of the Left. Whether this redistribution is welcome or unwelcome depends upon the characteristics of the government in power, but, because the resolution of the N-l problem has distributive consequences, policymakers cannot be indifferent toward it; in fact, we must expect it to be the central issue in bargaining over the construction of any exchange rate system. Relative bargaining power determines the solution to the degrees of freedom problem. While much of the literature on the EC relies upon a relative economic size model of power, the model of bargaining power relied upon in this study draws on Schelling’s idea of power as credible commitment: “The essence [of bargaining power] . . . is some voluntary but irreversible sacrifice of freedom of choice . . . [T]he power to constrain an adversary may rest on the power to bind oneself” (1973: 22). In exchange rate politics the relative advantage Page 37 →in making a credible commitment lies with independent central banks. Reputational considerations, embodied in Schelling’s “principles and precedents,” are central to any actor’s ability to make a credible commitment. As Schelling notes, “To be convincing, commitments usually have to be qualitative rather than quantitative and to rest on some rationale.” In bargaining over the single degree of freedom, a reputational commitment by an independent central bank to a particular rate of inflation might not represent a credible commitment, but a [reputational] commitment to [the] principle [of price stability] . . . may provide a foothold for [a credible] commitment. Furthermore, one may create something of a [credible] commitment by putting the principles and precedents themselves in jeopardy. If in the past one has successfully maintained the principle of, say [price stability] and elects to nail his demands to that principle in the present negotiation, he not only adduces precedent behind his claim but risks the principle itself. Having pledged it, he may persuade his adversary that he would accept stalemate rather than capitulate and discredit the principle. (Schelling 1973: 34) Thus, an independent central bank with a reputation for price stability can credibly commit to a position that ensures that any exchange rate system does not constrain its ability to achieve price stability at home. Within Schelling’s framework this ability to make a credible commitment, in turn, yields bargaining power to this bank in both tacit and explicit bargaining over the N-l problem, allowing it to gain control over the exchange rate system’s single monetary policy and to achieve a domestic level of inflation close to its ideal point.

Within the context of EC monetary politics this model implies that the relative power advantage lies with the Bundesbank. Such an approach corresponds well with much of the literature on European Union politics, which claims that Germany, by virtue of its relative economic size, is the most powerful state within Europe.13 Basing the model on the notion of credible commitment rather than economic size, however, forces us to recognize that “Germany” is not a unitary actor, a claim with particular validity for monetary and exchange rate issues. In Germany two centers of monetary authority exist: the government, which has legal control over exchange rate policy, and the Bundesbank, which has legal control over monetary policy. As we will see, Bundesbank and government policymakers have not always agreed about the “German” position toward exchange rate and monetary cooperation. Thus, while the exchange rate outcome at the Community level will be shaped by German Page 38 →power, the Community outcome “Germany” wants depends upon whether the Bundesbank or the German government is the more powerful actor within Germany. In other words, who “wins” bargaining processes in both the German and the Community arenas determines Community exchange rate outcomes. The power as credible commitment model suggests that, more often than not, the Bundesbank will win at both levels. The model of bargaining power allows us to eliminate the indeterminacy inherent in the basic hypothesis. Whereas earlier I hypothesized that variation in nominal exchange rate stability would be negatively related to cross-national asymmetries in political-institutionally determined responses to shocks, we now hypothesize that in Community exchange rate systems variation in nominal exchange rate stability will be negatively related to policymakers’ willingness and ability to adopt price stability-oriented monetary policies.

B. Exchange Rate Institutions and Domestic Monetary Outcomes Two tasks remain. The first is to link the model to exchange rate institutions, i.e., to make exchange rate institutions endogenous products of monetary politics. I do this by deriving hypotheses about the conditions under which policymakers have incentives to propose new or try to alter existing exchange rate institutions. The second task is to link domestic monetary outcomes to the exchange rate institutions that policymakers create. This I do by examining how policymakers who prefer the monetary policy required for exchange rate stability can use exchange rate institutions to help them implement their desired policy. 1. The Creation and Evolution of Exchange Rate Institutions: Domestic Monetary Objectives and Institutional Outcomes Policymakers will propose an institution to stabilize nominal exchange rates because they believe that nominal exchange rate stability can yield a welfare improvement over floating rates. Thus, we expect a proposal to stabilize nominal exchange rates to be put forward by policymakers facing high costs from floating exchange rates. Two conditions seem necessary to yield such costs. First, domestic monetary policy must diverge from the monetary policies pursued by the country’s main trading partners, yielding a persistent change of the domestic currency’s value against the currencies of its major trading partners. Second, the policymaker must represent a constituency being harmed by this Page 39 →exchange rate change. Two configurations of domestic preferences and institutions seem most likely to meet these conditions. First, the conjunction of a leftist government and an independent central bank can yield an appreciating currency that places downward pressure on employment and wages as industry strives to maintain competitiveness. Exchange rate stability, by reducing downward pressure on wages, yields benefits to this policymaker. Second, a rightist policymaker working within a coalition government and facing a decentralized wage-bargaining regime might confront a wage-price spiral and be unable to adopt a nonaccommodating monetary policy. The resulting currency depreciation will aggravate the wage-price spiral. Exchange rate stability, by eliminating increases in the cost of inputs, can represent one step toward stabilizing domestic prices.14 Thus, we hypothesize that an exchange rate system is most likely to be proposed by either a leftist government with an independent central bank or by a rightist policymaker in a coalition government facing decentralized wage bargaining, the former to reduce downward pressure on wages, the latter to increase downward pressure on wages. Whether policymakers translate a proposed exchange rate system into a concrete reality depends upon the interaction between two factors. First, it depends in part upon the resolution of the N-l problem. The exchange rate institutions that policymakers construct will reflect and enforce a particular solution of the degrees of freedom

problem. Exchange rate institutions elaborate the rules apportioning responsibility for foreign exchange market intervention to support nominal exchange rates, determine the amount of short-term finance available for intervention purposes and the amount of medium-term balance of payments support, and specify the conditions governing access to these finance mechanisms. These rules, in turn, will reflect the monetary policy preferences of the policymakers who gain control of the system’s single monetary policy. If the policymakers prefer price stability, these rules will place primary responsibility for intervention on weak-currency policymakers, will provide limited financial mechanisms, and will impose stringent conditions of access to these mechanisms. Such rules will ensure that the exchange rate system does not become an additional source of money creation and inflation. An individual policymaker’s decision about membership in the system depends upon the balance of costs and benefits of exchange rate stability given the institutional outcome. In other words, does the sacrifice of monetary policy autonomy implied by pegging monetary policy to the anchor prevent policymakers from achieving their domestic monetary policy objectives? We should expect leftist policymakers not to join an exchange rate system in which a rightist Page 40 →policymaker or an independent central bank controls the single degree of monetary policy freedom, and the converse. If no policymaker believes costs to be greater than benefits, then the resulting exchange rate system provides joint gains. Exchange rate systems evolve when they cease to provide joint gains, which occurs when monetary policy preferences in the anchor country and in at least one pegging country diverge. In these cases the fixed exchange rate prevents policymakers from achieving their preferred monetary policies. In other words, the exchange rate constraint becomes costly. In such cases policymakers face two options: they can exit the system, or they can try to alter the exchange rate institution. To be more specific, the policymaker can try to restructure the institutional framework governing the exchange rate system to gain control of the single degree of monetary policy freedom. The severity of the divergence of monetary policy preferences will shape the choice between exchange rate flexibility and institutional reform. If short-term factors drive the divergence, such as the need to adopt differing responses to an asymmetric shock, policymakers are more likely to resort to exchange rate flexibility and less likely to seek institutional reform. If more deep-seated disagreements over the long-term conduct of monetary policy drive the divergence, such as the existing room for noninflationary monetary expansion, policymakers will be more likely to seek institutional reform. In sum, the system will evolve when at least one policymaker believes the costs of the system are greater than the benefits. While we cannot hypothesize in advance what strategies policymakers will adopt to restructure exchange rate institutions, we can state two basic expectations. First, in an existing exchange rate system in which an independent central bank controls monetary policy, the model expects a leftist policymaker confronting high unemployment to initiate institutional evolution. Moreover, he or she will aim these efforts at gaining control over the system’s monetary policy. Because reforms will be distributionally disadvantageous to at least one actor, successful institutional reform requires a shift in bargaining power away from those policymakers who structured the initial institutions and toward those policymakers seeking reform. 2. Exchange Rate Institutions and Domestic Monetary Policy Outcomes The basic model of exchange rate cooperation conflates two distinct types of monetary divergence: those driven primarily by divergent preferences; and those driven primarily by differing domestic institutions. When policymakers Page 41 →prefer the monetary policy stance consistent with nominal exchange rate stability but, because of domestic institutions, cannot implement this policy, the basic model predicts that policymakers will float their currencies. Yet, because these policymakers have a strong incentive to win the distributional struggle over domestic monetary policy, we should not expect them to accept the exit option easily. Instead, we should expect them to use exchange rate institutions to try to attract the necessary support. Exchange rate institutions, by reducing constraints on monetary politics at both the domestic and the Community levels, can play an important role in helping policymakers gain domestic support. At the international level exchange rate institutions can provide exchange rate flexibility by allowing policymakers to realign their exchange

rates. Flexibility enables policymakers to reconcile inflationary monetary policies with EMS membership, giving them time to use the exchange rate institution to construct a domestic coalition in support of price stability. Continued membership in the exchange rate system can help policymakers construct a support coalition by reducing two domestic constraints on disinflation. First, the exchange rate system, by providing a credible commitment to price stability and by providing a scapegoat, can reduce the economic and political costs of disinflation.15 The “EMS as commitment mechanism” argument rests on the logic of time inconsistency and credible commitments in the conduct of monetary policy. Time inconsistency problems, the recognition that a policy that is optimal ex ante may not be optimal ex post, arise in the presence of nominal wage rigidity. When nominal wages are rigid, monetary authorities have a strong incentive to impose an unanticipated monetary expansion that reduces the real wage and boosts output and employment in the short run. Because labor recognizes that monetary authorities face this incentive, wage demands are ratcheted upward in anticipation of inflation. Over the long run the economy moves to a highinflation equilibrium. Policymakers can escape the high-inflation equilibrium if they can make a binding commitment not to impose an inflationary surprise. Credible commitments can be made by creating institutions that set the determination of monetary policy outside the political process. Central bank autonomy, if accompanied by a constitutional obligation to prioritize price stability, puts the control of monetary policy in the hands of authorities insulated from the political processes that generate the incentives to impose monetary surprises. Fixed exchange rate institutions might also enable policymakers to make credible commitments (Giavazzi and Giovannini 1989; Giavazzi and Pagano 1988). When there exists a large credibility gap between the domestic and the foreign Page 42 →monetary authorities (i.e., if the foreign central bank is independent and has a much stronger reputation for price stability than does the domestic monetary authority), then a fixed exchange rate regime puts the determination of domestic monetary policy in the hands of monetary authorities (the foreign central bank) insulated from the domestic political processes that generate the incentive to impose monetary surprises (Giavazzi and Giovannini 1989: 102). As in central bank autonomy, substituting a price stability rule for discretion over monetary policy reduces inflationary expectations. Reduced expectations, in turn, reduce the rate of unemployment necessary to drive down wage demands and stabilize domestic prices. Because a fixed exchange rate might reduce the output and employment costs of disinflation, the political costs of monetary restriction will be reduced, making it easier for policymakers to attract domestic support for monetary restriction. Policymakers can also use exchange rate institutions to deflect the blame for those costs they do incur. That is, policymakers can use exchange rate institutions as “scapegoats” for the redistributive policies they must implement. As Andrews notes, scapegoating is a useful strategy in situations where the coalition of elites (having reached agreement on the general direction policy ought to take) find themselves insufficiently powerful to press these demands in the face of organized opposition, yet powerful enough to influence the shape of the political agenda. (1993: 10) Scapegoating allows policymakers who want to implement a policy that will impose costs on one of the coalition’s supporting groups to externalize the blame for these costs. As Vaubel points out, an international decision-making body allows domestic policymakers to “shirk domestic responsibility for unpopular policies” and to “sell such policies as part of an international bargain” (1991: 33). Thus, the exchange rate system, by reducing and externalizing costs, can make it more likely that policymakers who want to implement the required monetary policy can attract the necessary domestic support. Second, exchange rate institutions might facilitate the construction of a domestic coalition in support of price stability. A return to the stylized coalition government developed earlier can help make this point. If the solution to the degrees of freedom problem yields control of the single degree of monetary policy to a policymaker pursuing price stability, the pegging country must implement a restrictive monetary policy. Assume that the pegging country has a three-party system in which each party occupies one-third of the parliament. Page 43

→Since no single party controls a majority, a coalition of at least two parties is necessary to implement the required monetary policy. The three parties are arrayed along a single price stability dimension, with leftist parties preferring a low degree of price stability and rightist parties preferring a high degree of price stability (fig. 2). As we have seen, the median party determines the outcome. Thus, we have one party—the rightist—who is willing to adopt the monetary policy consistent with nominal exchange rate stability but, because of the coalition, cannot do so. If the rightist party acts strategically, however, it can link price stability to a second issue, such as European integration, and achieve a higher degree of price stability. Assume that on the European integration dimension the centrist party values European integration more than both the leftist and the rightist parties do (fig. 3). If European integration is considered as a single-dimensional issue, then the median party, here the rightist party, determines the level of integration. If the two dimensions are linked, the status quo is point E—the median party outcome on each dimension considered independently (fig. 4). From E, however, the rightist and centrist parties can both move onto higher indifference curves by moving in a southeast direction toward line AB. Thus, if the rightist party acts strategically and links nominal exchange rate stability to European integration, it can gain coalition support for the adoption of a monetary policy consistent with nominal exchange rate stability. Thus, the exchange rate system might reduce the coalition constraint on stability-oriented monetary policies. To summarize, policymakers who prefer the monetary policy stance consistent with nominal exchange rate stability but, because of domestic institutions, cannot implement this policy can use exchange rate institutions to relax important constraints in both the domestic and the Community arenas. In the Community arena they reduce the severity of the fixed exchange rate constraint, enabling policymakers to reconcile inflationary monetary policy with exchange rate system membership. By keeping their currencies inside the system, policymakers gain the ability to draw on these institutions to help reduce two constraints in the domestic arena. First, they can reduce the costs, both economic and political, of the monetary policies required for exchange rate stability, thereby expanding the range of the political spectrum from which they can attract support. Second, by using exchange rate institutions to link monetary policy objectives to European integration, they can reduce the constraint imposed by coalition politics. In short, exchange rate institutions give policymakers time to build coalition support for monetary policies and provide a useful instrument with which policymakers can construct this support. Page 44 → Fig. 3. Coalition bargaining over European integration Fig. 4. Coalition bargaining along two dimensions The hypotheses derived from the model and previously discussed are summarized in table 2. The basic model of exchange rate stability is based upon two hypotheses: cross-national inflation differentials determine variation in nominal exchange rates; the interaction between wage shocks and the politically determined monetary policy responses to these shocks determine inflation rates. The model yields hypotheses that link policymakers’ domestic monetary policy objectives to the exchange rate institutions they create. Policymakers will create a new exchange rate system because they believe they can better achieve their domestic objectives with the proposed system than without, and both leftist and rightist policymakers can have an incentive to propose an exchange rate system. Relative bargaining power determines the distributive outcome inherent in the exchange rate system. Policymakers will initiate institutional reform when they are no longer able to achieve their domestic monetary objectives Page 45 →within the confines of the existing system. If the divergence is of a short-run nature, policymakers are likely to seek a short-run solution, such as a realignment or a temporary float. If the divergence is more fundamental, then the policymaker is likely to seek more extensive institutional reforms. Finally, policymakers who prefer the monetary policy required for exchange rate stability, but whose ability to implement this policy is constrained by domestic politics, can use exchange rate institutions to relax these constraints. Exchange rate institutions can provide flexibility, reduce and help policymakers deflect the blame for the costs of monetary restriction, and facilitate the construction of domestic support coalitions. In short, exchange rate institutions are shaped by policymakers’ domestic monetary objectives, and policymakers use these institutions to help them achieve their desired domestic monetary outcomes.

C. Conclusion

Exchange rate stability is a function of cross-national inflation differentials. When cross-national differentials widen, nominal exchange rates become unstable, and, as differentials narrow, exchange rates are more likely to stabilize.

H1:

TABLE 2. Hypotheses Linking Domestic Monetary Politics to Exchange Rate Institutions Variation in nominal exchange rates is determined by cross-national inflation differentials.

National inflation rates are caused by the interaction between wage shocks and politically determined monetary policy responses to wage shocks. Policymakers propose exchange rate systems to achieve domestic monetary objectives they cannot achieve H3: otherwise. H3a: Leftist policymakers confronting an independent central bank will propose an exchange rate system. H3b: Rightist policymakers confronting a wage-price spiral will propose an exchange rate system. H2:

Policymakers will initiate exchange rate institution reform when the monetary policy they want to H4: implement at home is inconsistent with the monetary policy required by membership in the existing exchange rate system. H4a: Policymakers confronting asymmetric exogenous shocks will seek greater exchange rate flexibility. Disputes between anchor country policymakers and pegging country policymakers about the room for H4b: noninflationary monetary expansion will cause pegging country policymakers to seek institutional reform. Policymakers who have a preference for the monetary policy required by the exchange rate system but H5: whose ability to implement this policy is constrained by domestic political processes will use the exchange rate system to relax constraints on monetary policy. Page 46 → National inflation rates are determined by the severity of class conflict. Labor-capital wage bargaining and wage bargaining institutions determine both the frequency of autonomous wage shocks and the extent to which other exogenous shocks translated into wage-price spirals. Monetary policy responses to these shocks, responses that are determined by politicians’ constituent bases, government type, and central bank institutions, determine the extent to which class conflict generates inflation. Within this framework nominal exchange rate instability can be caused either by an asymmetric shock or by cross-national differences in monetary policy responses to a symmetric shock. Policymakers try to create new, or alter existing, exchange rate institutions to achieve domestic monetary objectives. Policymakers who confront an asymmetric shock, or who are constrained by domestic political institutions to adopt a differentiated monetary response to a symmetric shock, and who represent constituents harmed by this monetary policy response, have incentives to propose exchange rate institutions that force domestic monetary policy to correspond to their objectives. In other words, policymakers propose new exchange rate institutions, or try to reform existing ones, to achieve domestic monetary objectives that they cannot achieve otherwise. Domestic monetary policy outcomes can be, in turn, partially determined by existing exchange rate institutions. Policymakers who prefer the monetary policy required by the system but, because of domestic constraints, are unable to implement this policy, can use exchange rate institutions to build support coalitions.

Page 47 →

CHAPTER 3 Explaining the Creation of the European Monetary System German Chancellor Helmut Schmidt proposed the EMS at the April 1978 European Council in Copenhagen. Between April and December European Community policymakers bargained over the proposed system’s institutional framework, creating an exchange rate system based on a bilateral parity grid, centered around the Bundesbank and supported by restrictive financial mechanisms that asymmetrically placed the costs of exchange rate stability upon weak-currency policymakers. The system began operation in March 1979, but only two of the four largest Community countries, France and Germany, were full members. Italy entered the system with the lira fluctuating in extra-wide margins, while Britain refused to enter the exchange rate mechanism. Neoliberal institutionalism provides a correct but incomplete explanation of the creation of the EMS. It tells us that EC policymakers saw mutual benefits from exchange rate stability and moved to institutionalize exchange rate relations. A neoliberal explanation provides no insight into why Schmidt rather than another EC policymaker proposed exchange rate cooperation, nor why he did so in 1978 rather than a year earlier or later. Nor does neoliberal institutionalism offer insight into why EMS institutions distributed the costs of exchange rate stability asymmetrically to the disadvantage of weak-currency policymakers rather than distribute them more evenly across members. Finally, neoliberal institutionalism offers no insight into why some EC policymakers joined the EMS, others joined only with additional flexibility, and others opted out. Thus, while the EMS might have provided mutual benefits, a joint gains-based explanation tells us very little about the factors that motivated policymakers to propose the EMS or about the characteristics of the institutional outcome. Page 48 →The model developed in chapter 2 provides an explanation of the creation of the EMS that is consistent with, but offers two advantages over, a neoliberal account. The model hypothesized that policymakers will propose a fixed exchange rate system to help them achieve domestic monetary objectives they could not achieve otherwise. Schmidt’s proposal is consistent with this hypothesis. As a leftist politician, Schmidt was being pressured by labor to increase employment, but constrained by coalition government and an independent Bundesbank committed to price stability. He was facing an appreciating currency and downward pressure on wages and employment. A community exchange rate system, by stabilizing the mark, and perhaps also forcing the Bundesbank to adopt a less restrictive monetary policy, could help Schmidt meet labor’s demands. Thus, Schmidt proposed the EMS to try to achieve domestic objectives he could not achieve otherwise. Once proposed, bargaining power would determine the institution’s distributive outcome, and here we expected the advantage to lie with the politically independent Bundesbank. The Bundesbank would be better able than other policymakers credibly to commit to a bargaining position. The case study also supports this hypothesis. Though Schmidt proposed, and most Community policymakers preferred, exchange rate institutions that promoted a symmetric distribution of the costs of exchange rate stability, the Bundesbank vetoed all institutions that constrained its ability to control monetary conditions in Germany. As a result, the Bundesbank gained control of the system’s single degree of monetary policy freedom. The resulting exchange rate institutions exempted the Bundesbank from using monetary policy to support the exchange rate and placed the costs of exchange rate stability fully upon weak-currency policymakers. Finally, the model hypothesized that policymakers’ assessments of the costs and benefits of the monetary policy required to stabilize the exchange rate given the distributive outcome embodied in the system’s institutions would determine membership decisions. This hypothesis is also supported. With the Bundesbank in control of the system’s single degree of monetary policy freedom, exchange rate stability required weak-currency policymakers to implement price stability-oriented monetary policies. French policymakers joined the EMS because monetary restriction was fully consistent with Giscard’s domestic monetary policy objectives. Italian policymakers wanted to adopt monetary restriction but, fearing that a tight link to the mark would cause too sharp a drop in economic

activity, joined only with greater flexibility. The British Labour Party wanted to adopt a growth-oriented monetary policy and, being aware that the EMS would prevent it from doing so, opted out. Page 49 →Thus, the model developed here offers an explanation of the creation of the EMS that both fleshes out the account of the creation of the EMS offered by neoliberal institutionalism and, in doing so, provides a novel insight into how policymakers use international institutions. The EMS was proposed and created by weakcurrency policymakers wanting to use exchange rate stability to facilitate disinflation at home and a strong currency policymaker wanting to use exchange rate stability to reduce wage pressures at home. That is, policymakers created an international institution to help them achieve substantive domestic policy objectives. The system’s distributive outcome was structured by Bundesbank power and placed the costs of exchange rate stability squarely upon the shoulders of weak-currency policymakers. Those policymakers for whom this distribution provided benefits joined the system, while those for whom the system imposed costs sought additional flexibility or opted out. The resulting exchange rate was a Pareto-improving bargain; weak-currency policymakers gave the Bundesbank control of the system’s single monetary policy instrument in exchange for the right to use the exchange rate to draw on the Bundesbank’s commitment to price stability and facilitate disinflation at home.

A. The Proposal for Multilateral Exchange Rate Stability German Chancellor Helmut Schmidt proposed the European monetary system at the April 1978 European Council in Copenhagen. After meeting privately with French President Valery Giscard D’Estaing and eliciting his support for the venture, Schmidt proposed not only the stabilization of intra-Community exchange rates, a development that an extension of the existing “snake” to the other Community members could have achieved, but also an expansion of the financial institutions supporting exchange rates. Policymakers would create a new European monetary fund to take over the responsibilities of existing financial institutions and manage the financial arrangements that supported the snake. In addition, Schmidt proposed that Community members pool between 15 percent and 20 percent of their foreign exchange reserves and that the European unit of account take on a more important role as both a means of settlement between central banks and, eventually, as a new reserve asset (Ludlow 1982:92). The Schmidt-Giscard proposal emerged from a unique convergence of interests. Each believed a stable franc-mark relationship would enable them to achieve domestic economic objectives they could not achieve otherwise. The domestic objective each hoped to achieve, in turn, derived from the macroeconomic consequences of their respective political systems’ responses to the wage Page 50 →and oil shocks of the early 1970s. Thus, to understand why Schmidt and Giscard proposed exchange rate stabilization, it is necessary to look at their responses to these exogenous shocks and at the problems each was facing in 1978 because of these responses. 1. Exchange Rate Stability and German Labor Schmidt proposed exchange rate stability because he thought it would enable him to preserve the gains labor had achieved during the first half of the 1970s. German labor had imposed two wage shocks on the German economy during this period. The first came in 1968, 1969, and 1970, as German labor gained real wage settlements that outstripped growth in productivity (see table 3). The second shock arose in the wake of the oil price increase in the fall of 1973. Questioning the Bundesbank’s ability to restrain inflation in the wake of the oil shock, labor pressed for nominal wage increases to offset the anticipated increase in the cost of living. In January 1974 the German public sector employees’ union took the lead in wage bargaining, gaining nominal wage increases of 15 to 20 percent, “twice the level of inflation forecast by the government” (Goodman 1992: 71). TABLE 3. Inflation, Growth in Productivity, and “Gap” Calculations: Italy, France, Germany, and United Kingdom, Selected Periods, 1961–78 Page 51 →The operation of the Bretton Woods system had constrained the Bundesbank’s ability to tighten monetary policy in response to the wage shocks of the early 1970s (see Emminger 1977). Upon exiting the Bretton Woods system in March 1973, however, the Bundesbank regained its ability to conduct monetary policy

unconstrained by exchange rate considerations and used this autonomy to begin an aggressive defense of price stability (Deutsche Bundesbank 1974). While the Bundesbank’s commitment to price stability was not novel, Bundesbank policy following the exit from Bretton Woods marked a new approach to macroeconomic policy in Germany. This “new assignment” of monetary policy absolved the Bundesbank of responsibility for unemployment. The Bundesbank would use monetary policy to set the rate of inflation, and unions and industry would maintain full employment by setting wages at rates consistent with this level of price increases (Deutsche Bundesbank 1975). Within this framework the Bundesbank responded to the 1974 oil and wage shocks by refusing to accommodate real wage increases, declaring that it would hold inflation below 10 percent despite the costs in terms of unemployment (Goodman 1992: 71). Monetary policy was kept tight, inflation in 1975 never rose above 7 percent, and, as a result, industry was unable to translate these increased real wages into increased prices, and unemployment increased. The wage shocks had two significant effects on the German economy. First, they enabled labor to achieve a significant redistribution of income, raising labor’s share of German income from 70 percent in 1968 to 74.6 percent in 1974.1 Second, with real wages increasing faster than productivity, industry profitability fell, and investment fell from an average annual rate of increase of 4.4 percent in the 1960s to an average annual rate of decrease of 3.1 percent between 1972 and 1975 (table 3). The question confronting German labor in 1977–78 was whether it could sustain the gains it had made. The situation did not look encouraging. Though output had picked up since 1975, employment remained high, having increased from 2.2 percent in 1974 to 4.8 percent in 1975, and was coming down very slowly. Industry claimed that high real wages that caused a decline in profitability and a corresponding decline in investment caused unemployment Page 52 →(Flanagan et al. 1983: 270). Moreover, the mark’s steady appreciation accentuated industry’s wage-induced profit squeeze. The combination of restrictive monetary policy in Germany and looser stances elsewhere, in particular in the United States, led to considerable turmoil in the foreign exchange markets. The mark rose not only against the dollar, however, but, because of its role as a substitute for the dollar, it appreciated against other European currencies as well. Between 1975 and 1978 the mark’s nominal effective exchange rate, a measure that weights the mark against nineteen other industrialized countries based on German trading patterns, appreciated by almost 20 percent (Commission of the European Communities). This nominal appreciation further squeezed German industry’s profits, creating additional incentives for industry to push real wages down to compensate. These were the problems that occupied much of Schmidt’s attention as he headed into 1978. Schmidt was coming under increasing pressure from the left-wing of the SPD and from the main trade union confederation, the DGB, and was also beginning to feel the pressure of the approaching 1980 elections. The union federations had exercised considerable wage restraint after 1974, with annual real wage increases averaging only 2 percent between 1975 and 1978. With inflation down, they were looking for a quid pro quo in the form of increased employment (Flanagan et al. 1983: 270–71). By 1977 the SPD and the DGB were arguing that price stability had come at the expense of labor; wage restraint, they argued, had facilitated investment in labor-saving production techniques rather than improving employment prospects (Goodman 1992: 79). In an internal memo Schmidt’s advisors pressured him to adopt an expansionary policy, arguing that, with inflation below 4 percent and unemployment high, the German economy had room for growth. Expansion would not only be economically beneficial, the memo noted, but would also serve Schmidt’s “domestic political needs, including the need to plan for adequate growth in the approach to the 1980 elections” (quoted in Putnam and Bayne 1984: 87). By early 1978 Schmidt was responding to these pressures. In response to the pressure from the SPD and DGB, he proposed a DM 16 billion medium-term investment package in early 1978 and an additional expansionary package in conjunction with the coordinated expansion agreed at the G-7 summit at Bonn that summer (Goodman 1992: 79; OECD 1979). Schmidt’s efforts to preserve labor’s gains were frustrated, however, by the Bundesbank’s independent control of monetary policy. Unless the Bundesbank believed the German economy had room for noninflationary growth, it would be unwilling to loosen monetary policy. Unless the Bundesbank loosened monetary policy, the mark Page 53 →would continue to appreciate, unemployment would continue to rise, and real wages would continue to fall. Moreover, the Bundesbank’s policy-making council believed the German

economy to be operating very close to capacity in 1978. In the run-up to the 1978 Bonn Summit, Emminger did everything he could to dissuade Schmidt from undertaking further stimulus, going as far as to ask then chairman of the United States Federal Reserve, Arthur Burns, to convince Schmidt that fiscal expansion was unnecessary (Putnam and Bayne 1984). Within this context Schmidt decided in January or February of 1978 to propose a new Community exchange rate system (Ludlow 1982: 63). Stabilizing the mark against other EC currencies would slow the mark’s appreciation and help German industry retain competitiveness without real wage cuts. Fixed exchange rate rates might also solve Schmidt’s second problem. With the right institutions Schmidt could get what he could not get within the German political system—a looser monetary policy (Vaubel 1991: 35). If the exchange rate system could obligate the Bundesbank to engage in foreign exchange intervention to stabilize the mark against the franc, the lira, and the pound, then Germany would have a much looser monetary policy than it would have without an exchange rate system. The institutions Schmidt proposed at the Copenhagen Council—in particular, the reserve pool and the transformation of the EUA into a new reserve asset—were designed to provide a new source of liquidity and thus reduce the Bundesbank’s control of German monetary policy. As he said in a June interview, he was “thinking of [an exchange rate system] which goes a little beyond the present snake. . . . It might mean . . . that we have to expand our money supply somewhat more rapidly than we have done until now” (Business Week, June 26, 1978). 2. Exchange Rate Stability and Disinflation in France Schmidt enlisted French support for his initiative in a meeting at Rambouillet the week before the Copenhagen Council (Ludlow 1982: 63). For Giscard, who had presided over the French economy throughout the 1970s, first as minister of finance and then as president, exchange rate stability promised quite a different set of advantages. To understand what these advantages were we need to retrace Giscard’s efforts to cope with the wage-price spiral set off by the wage shocks that began in May 1968 and by the oil shock in 1973. French wage bargaining during the postwar period has been highly decentralized, tending toward a market-based regime. As Flanagan, Soskice, and Ulman note, the Page 54 →French labor market did not function, however, like a market-based system but was, instead, characterized by periodic instability (1983: 567–68). Periods of labor weakness brought rising unemployment and slow growth in real wages, and these in turn fueled labor grievances, widespread strikes, and large real wage shocks. The labor ascendant phase of such a cycle came in 1968, as labor responded to a four-year period of unemployment and real wage restraint with a massive wave of strikes and demands for large nominal wage increases (Flanagan et al. 1983:593–606). The settlement to the May strike, the Grenelle agreement, yielded a 14 percent nominal wage increase, which caused a significant increase in real wages and a consequent reduction in profitability (Flanagan et al. 1983: 606–7). In the wake of the Grenelle agreement the French government gave priority to rebuilding industry profitability and adopted a four-pronged strategy to do so. First, it reflated domestic demand to try to induce industry to improve productivity. Second, it transferred part of the employers’ social security contributions to the state to reduce unit labor costs. Third, it tried to inflate away the wage increases through subsequent price increases (Flanagan et al. 1983: 610). Fourth, the government tried to institutionalize wage bargaining to moderate future wage demands. In trying to inflate away the wage shock, the government gambled that the institutionalization of wage bargaining would keep labor from gaining corresponding increases in nominal wages. This gamble proved mistaken, however, as the unions used the attempt to institutionalize industrial relations to preserve real wage gains. Through negotiations with the government the main union federation, the CGT, gained government agreement to measures that rigidified labor markets and kept upward pressure on real wages. Thus, instead of real wages falling in response to the government’s reflation, they continued to rise, averaging increases of 4.04 percent per year between 1970 and 1974 (table 3), while safeguard clauses protected these increases from future inflation (Flanagan et al. 1983: 618). Thus, rather than inflating away the initial wage shock, the French government found itself caught in an inflationary spiral that was given an additional boost by the 1973 oil shock. As it became clear that labor’s real wage gains could not be inflated away, the only remaining available option

was monetary restriction. This option was ruled out, however, as politically risky. In October 1972 the French Communist Party and the French Socialists signed the programme commune, a nationally binding second-ballot electoral pact. By moderating the more radical elements of the Communist platform and giving the Socialists access to a larger constituency, Page 55 →the union of the Left provided a feasible alternative to the Center-Right for the first time in the Fifth Republic, and public opinion polls suggested that French voters were willing to bring the left to power (Jaffre 1980). The challenge from the Left led to a government economic strategy designed to minimize the probability of a left-wing victory in the 1978 parliamentary elections. Believing that measures that increased unemployment would redound to the Left’s political benefit, Giscard and his prime minister, Jacques Chirac, rejected confrontation with the unions and, instead, exhibited a willingness to maintain real wage increases and employment in the primary sector (Flanagan et al. 1983: 629). Such a strategy necessarily precluded the use of monetary restriction designed to push the economy into recession.2 There were three direct results of this wage campaign. First, French labor’s share of national income increased from 71.4 percent of French GDP in 1967 to 75.8 percent by 1976. Because growth in real wages outstripped growth in productivity (table 3), industry profitability shrank, and investment declined from annual increases averaging 7.8 percent during the 1960s to annual increases averaging only 2.3 percent during the 1970s (Commission of the European Communities). Third, the conflict between French labor and capital over national income, and the government’s accommodation of this conflict, produced a wage-price spiral that pushed up inflation: between 1974 and 1976 the annual rate of inflation averaged more than 12 percent. In 1976 Giscard moved to end the inflationary spiral and reverse labor’s wage gains. As the Socialist-Communist cooperation showed signs of strain during 1976 and 1977, the government ceased accommodating labor and gave priority to the restoration of industry profitability. In August 1976 Giscard D’Estaing appointed Raymond Barre as prime minister, and, in the year and a half preceding the 1978 parliamentary elections, Barre cautiously attacked the real wage structure. Relying primarily upon wage and price controls and measures to constrain the growth of domestic demand, Barre slowed the growth of nominal wages from 18.8 percent increases in 1975 to average increases of 13.7 percent in the two-year period. He was less successful in stabilizing the growth of prices, and thus real unit labor costs stabilized, and industry rebuilt a bit of profitability (Flanagan et al. 1983). In the wake of 1978 parliamentary elections in which Giscard retained a slim majority, Barre adopted a more radical policy in which price stability based on monetary targeting was the central macroeconomic pillar.3 Behind Barre’s shift to monetary targeting was an analysis of the cause of inflation in France and an analysis of how monetary policy could address these factors. For Page 56 →Barre inflation in France resulted from the high level of conflict between social groups in their struggle to distribute the national income and from defective market organization that constrained competition (Banque de France 1978: 2). Monetary policy could play an important role in eliminating both causes of inflation. Against distributive conflict, monetary policy would not arbitrate between labor and industry but would “lead . . . economic agents—state, firms, and individuals—by [the] global constraint that it imposes, to bring about a less inflationary environment gradually” (Banque de France 1978: 6). Publicly announced and restrictive targets for monetary growth would influence the expectations of unions and industry in wage bargaining and price setting and restore profitability to French producers, enabling them to compete in domestic markets against foreign goods and increase their share of the world market (Goodman 1992: 119–21; Albert 1985; Banque de France 1978: 6). Giscard’s interest in exchange rate stability derived from his effort to stabilize the French economy. For, in addition to monetary targeting, Barre and Giscard were also seeking to impose competitive pressure on French industry by exposing them to world prices (Flanagan et al. 1983: 640). Confronted with international competition, industry would be unable to pass on cost increases and would have strong incentive to slow the growth of real wages. Successful liberalization, however, depended upon nominal exchange rate stability, or, more precisely, upon a credible commitment to a fixed exchange rate. Without exchange rate stability industry could pass on real wage increases through higher prices, and the world price constraint could be escaped by exchange rate depreciation. Stabilization of the franc, even at an overvalued exchange rate, would thus prevent French industry from easily translating cost increases into higher prices and create strong incentives to resist real wage increases (Spivey 1982: 88). Thus, for Giscard and Barre exchange rate stability could play an important role in addressing

the problems created by Giscard’s earlier response to wage and energy shocks. In sum Schmidt and Giscard proposed the stabilization of intra-Community exchange rates because each believed nominal exchange rate stability would help achieve domestic objectives not otherwise attainable. For Schmidt nominal exchange rate stability promised to stabilize the mark’s appreciation and, with the right institutions, force the Bundesbank to accept a less restrictive monetary stance. Both outcomes would help him meet demands from his party and its labor constituency for policies that preserved the gains labor had made in the 1970s. For Giscard exchange rate stability provided an external anchor that would force industry to make labor accept growth in real wages consistent with productivity improvements. Page 57 →

B. Creating EMS Institutions: Bundesbank Power and the Distribution of the Costs of Exchange Rate Stability While exchange rate stability would yield benefits to Schmidt and Giscard, the question after the Copenhagen Council was whether the initiative would also provide benefits to British, Italian, and Bundesbank policymakers. The initial answer appeared to be no. In preparing his April proposal, Schmidt had encountered little but skepticism from Bundesbank officials, who had opposed all of the institutional elements embodied in Schmidt’s Copenhagen proposals because they would lead to higher German inflation. From the Bundesbank Schmidt later said, “one could expect not only criticism but carefully orchestrated resistance” (quoted in Henning 1994: 186). Anticipating Bundesbank resistance during negotiations within the Community’s Monetary Committee, the normal channel for the negotiations, Schmidt moved the negotiations into a back channel that excluded the central bank. Thus, after the Copenhagen Council Schmidt, Giscard D’Estaing, and British Prime Minister James Callaghan appointed special representatives, the “gang of three,” who then met secretly, insulated from other government officials, to elaborate upon Schmidt’s initiative.4 The British position within the gang of three discussions was determined by Labour Prime Minister James Callaghan’s desire to return to a growth-oriented monetary policy after having stabilized the British economy. The United Kingdom had also experienced twin shocks in the second half of the 1960s and the early 1970s. Postwar wage bargaining in Britain was decentralized. Fairly strong unions organized workers, but pay and work conditions were subject to negotiation either at the shop level, during the 1950s, or at the plant level, during the 1960s. Real wage growth in such an institutional framework varied with the relative strength of capital and labor, and during the 1960s British unions grew increasingly militant. Labor militancy caused real wage increases above improvements in productivity (see table 3). These real wage increases came in two waves: a 3.6 percent real increase in 1968, a further 5.6 percent increase in 1970, and then 4.6 and 5.6 percent increases in 1972 and 1973, respectively. Thus, as the British economy moved toward the oil shock, it was already under severe pressure from increased costs. The Conservative government adopted a two-pronged response to the initial wage shock: an attempt to scale down the rate of growth of real wages by slowing the rate of growth in public sector wage settlements and encouraging the private sector to follow their lead; and a deflationary monetary and fiscal package to generate labor market slack to convince labor to moderate their Page 58 →demands (Flanagan et al. 1983: 398–401). As it became clear that the government’s strategy was not affecting real wages, the government changed tack, adopting an active incomes policy that combined wage moderation from labor with an industry commitment to limit price increases. The government’s quid pro quo came in the form of expansive monetary and fiscal policy. Though this strategy failed to achieve either wage or price moderation, monetary policy was relaxed, fiscal policy was set on an expansionary course, and the exchange rate was allowed to float, adding yet another source of inflationary pressure. This expansion was given additional thrust when, in the wake of the 1974 Labour victory in the general election, the new chancellor of the exchequer, Denis Healey, responded to the oil shock with further demand stimulus. The British labor campaign, and the government’s response to it, had three consequences. First, British labor

redistributed a considerable amount of income away from British capital. Real wages grew at an annual average rate of 4.22 percent between 1970 and 1974, pushing labor’s share of national income from 72.3 percent in 1968 to 78 percent by 1974. Second, because productivity failed to keep pace with the growth of real wages, industry profitability was squeezed, and investment fell off dramatically. Whereas gross fixed capital formation had increased at an average annual rate of 5.2 percent during the 1960s, during the 1970s it barely increased at all, averaging an annual rate of increase of only 0.4 percent (Commission of the European Communities). Third, because of the British governments’ accommodation of these wage increases, and industry’s consequent ability to pass these cost increases on, British inflation rose sharply, peaking at an annual rate above 27 percent in 1975. While the Labour government’s initial response to the oil shock had added to the inflationary pressure, Callaghan reversed course in 1975. Monetary policy was placed on a restrictive footing, the government prepared two years’ worth of budget cuts, and TUC support was gained in moderating wage increases. In an attempt to restore industrial competitiveness in international markets, the Treasury and the Bank of England engineered a devaluation of the pound in March 1976 that caused sterling to collapse—between March and October it depreciated by an average 10 cents per month—and led the Labour government to the International Monetary Fund in search of a stand-by arrangement and the accompanying stabilization package (Burk and Cairn-cross 1992). Wage restraint was an important component of IMF stabilization, and the large increases labor had gained in the early 1970s were partially undone; 1976 and 1977 brought real wage decreases averaging 1.6 percent and a fall in labor’s share of national income to just less than 72 percent. On the Page 59 →back of these stabilization measures inflation came down to just above 11 percent by 1978. By 1978 the Callaghan government was facing pressures similar to those confronting Schmidt. Elections were due by the spring of 1979 at the latest, and this made Callaghan both inclined to ease monetary policy and unwilling to act against the demands of the Labour Party and the Trades Union Congress (pers. comm. with former cabinet minister). The TUC was demanding an expansionary course. The TUC had accepted wage restraint in 1975 and 1976, conditioned upon the stipulation that the government would refrain from deflationary measures and resume expansion as soon as such a course was possible; dissatisfaction with government policy only strengthened in the wake of the 1976 IMF letter of intent. As the TUC’s National Economic Development Council told Healey, the government was asking that the unions accept wage restraint with little chance that improvement in the economy would head off a further deterioration of purchasing power or the threat of further unemployment. Once inflation had come down in 1978, the TUC was determined to recoup the losses of the previous three years (Dorfman 1979: chap. 4). In early 1978 the TUC requested the government to prioritize the fight against unemployment. According to the TUC, growth at levels of between 5 and 6 percent over the next three years would be necessary to have any significant impact on unemployment, and the body called for a budget that injected 3.8 billion pounds into the economy “to move the economy onto a 5–6% growth path . . . to reduce unemployment.” In addition, the TUC indicated an unwillingness to continue wage restraint, arguing that the “government appeared to under-rate both the difficulties arising from continued pay restraint and factors which could create a climate favorable to constructive negotiations” (Trades Union Congress 1978: 283, 289). The Callaghan government proved receptive to these pressures. As a former cabinet minister indicated, Callaghan was unwilling to risk alienating TUC support so close to the election by adopting policies that contradicted TUC preferences (pers. comm. with former cabinet minister). Thus, in the second half of 1977 the government shifted macroeconomic policy onto an expansionary path. It allowed higher-than-agreed pay settlements in August, and late in the year increases in personal tax allowances were brought forward by five months. The budget for 1978–79, introduced in April 1978, provided additional tax relief and a series of measures to expand public expenditure. Callaghan’s attitudes toward nominal exchange rate stability derived from these domestic objectives. While not hostile to the prospect of a Community Page 60 →endeavor to stabilize nominal exchange rates, Callaghan was unwilling to allow such an initiative to constrain his ability to adopt a more active monetary policy stance. In spite of this skepticism Callaghan’s representative worked with the French and German representatives,

developing the Bremen proposal. The resulting institutional framework, presented to the other Community policymakers at the Bremen Summit in July, further developed the ideas Schmidt had presented in April. Under this so-called ECU-centered system, currencies’ parities would be defined in relation to the ECU, bands would be placed around central rates, and intervention obligations would be based on a currency’s position relative to the ECU. Expanded finance mechanisms, and a new European Monetary Fund (EMF), would facilitate foreign exchange intervention. Within the ECU-centered system policymakers could maintain a parity simply by keeping monetary policy in line with a weighted average of monetary policies in all other Community countries. A Bank of England paper submitted to the Monetary Committee gives a general impression of what this was expected to mean in practice (Ludlow 1982: 162). The European Monetary Fund would set up two types of accounts, one for creditors and one for debtors. If either of these accounts became excessively large for a period of six months or more, the country concerned would be obligated to review economic policy in conjunction with the EMF. As excessive credits would be an indication that the creditor country’s monetary policy was too tight relative to monetary policies in the rest of the Community, correction would require monetary loosening in the creditor country. Since it was widely expected that Germany would be a persistent creditor, the ECU-centered system gave the other members some control over German monetary policy. Thus, the system of consultation and policy adjustment embodied in the ECU-centered system would represent joint control of the single degree of monetary policy freedom within the exchange rate system and would promote nominal convergence toward the Community’s average rate of inflation. While the process through which Schmidt, Giscard, and Callaghan had developed the Bremen proposal put off other Community members, they agreed that the plan would serve as the basis for further bargaining (Ludlow 1982). The Bremen agreement suffered from one basic weakness: Schmidt had purposely excluded the Bundesbank from its development. In the wake of the Bremen Summit negotiations moved into the Monetary Committee and could no longer exclude the Bundesbank. In this forum Bundesbank officials placed an alternative exchange rate institution onto the bargaining table, the bilateral parity grid, that represented a de facto (if not a de jure) assignment of the single Page 61 →degree of monetary policy freedom to the central bank with the strongest currency, i.e., to the Bundesbank. In the bilateral parity grid each currency would be assigned a central parity rate against the ECU, and cross-rates would be calculated for each currency’s bilateral parities against all other currencies within the system. Margins of fluctuation would then be imposed around these bilateral rates, and policymakers would be obligated to defend their bilateral rates within these margins. Because currencies would be defined in relation to each other, two currencies would always reach the outer limits of their margins at the same time—one at the top of the band and one at the bottom. Movement to the outer limits of the band, in turn, would force the central banks in both countries to take measures to support the bilateral rate. As long as the credit mechanisms supporting intervention were limited, strong- and weak-currency countries’ ability to support the bilateral rate without altering monetary policy would be asymmetrical. Because a weakcurrency country’s foreign exchange reserves are limited, while a strong-currency country’s ability to engage in sterilized intervention is, in theory, unlimited, the weak-currency country will be forced to raise interest rates to support the exchange rate once its reserves are depleted. The strong-currency country, facing no reserve constraint and able to sterilize most of its foreign exchange market intervention, would not face symmetrical pressures to loosen monetary policy. Thus, the distributive implication of a bilateral parity grid in the European Community context was one in which Germany would be under no obligation to use monetary policy to stabilize the mark against other members of the EMS. The Bundesbank would target monetary policy toward domestic objectives, and weak-currency policymakers would adopt restrictive monetary policies to defend the bilateral exchange rate. Which of these two institutions, and what distribution of the costs of exchange rate stability, would emerge from the bargaining process depended upon policymakers’ relative bargaining power. Bargaining power, in turn, rested upon policymakers’ ability to commit credibly to their most preferred outcome. Bundesbank officials had three advantages relative to other policymakers in committing to their bargaining position. First, they could draw upon monetarist theory to provide principled support for their commitment to price stability. According to monetarism, monetary policy has no long-run effect on the real economy. Thus, using monetary policy for any purpose other than maintaining price stability was both futile and costly, and constructing an exchange rate system that

promoted anything other than price stability would be sheer folly. Second, Bundesbank officials could point to two episodes in the 1970s to provide precedent for their commitment to price stability. In both Page 62 →their exit from the Bretton Woods system in 1973 and in their response to wage and oil shocks, the Bundesbank had given clear priority to price stability at the expense of nominal exchange rate stability and employment. Third, the Bundesbank enjoyed a structural advantage; it was fighting a defensive battle. Bundesbank officials needed only veto exchange rate institutions that would constrain their monetary independence; the other members would be forced to develop alternative institutions that the Bundesbank would not veto. Given these advantages, Bundesbank officials needed only state their commitment to price stability early and often and wait for the others to concede. Bundesbank officials wasted no time in committing to this position in the German and Community arenas. Bundesbank president Ottmar Emminger recognized that “the general effect of [an ECU-centered] system would be to push the Federal Republic toward accepting inflation rates at or near the Community average” (Ludlow 1982: 162). This was unacceptable to Emminger, and he stated the Bundesbank’s bargaining position quite succinctly: “We will not accept rules of the game that carry . . . anything more than a tolerable rate of price increase,” a rate he put at between 1 and 3 percent a year (Banker, September 7, 1978). Emminger transmitted the Bundesbank’s three conditions for the EMS to Schmidt the week after the Bremen Summit: there could be no return to a fixed exchange rate system like Bretton Woods; thus, the system must provide simple processes for parity adjustments; there could be no increase in international liquidity, either through expanded credit arrangements or through reserve pooling; because much of the intervention within the system would be conducted in marks, the system must limit intervention obligations (Ludlow 1982: 137–38). Emminger’s initial response was followed by an effort to convince Schmidt that a commitment to price stability be made a condition for entry into the exchange rate system. The French were okay, but it would perhaps be better if transitional arrangements could be found for Britain and Italy (Ludlow 1982: 181–82). In the Community arena Bundesbank officials working within the Monetary Committee invoked their commitment to price stability to veto the symmetrical obligations inherent in the ECU-centered system. As one member of the Monetary Committee recalled: the idea [of an exchange rate system] to bring Community pressure to bear on spendthrift or “inflationary” members of the Community to mend their ways and conform to the . . . antiinflationary policies of the Bundesbank [was fairly well accepted by the weak-currency countries]. But it was at this point that I asked the obvious question. Does it not follow that if the Page 63 →grid discloses that one particular currency (for example the D-Mark) is discernibly responsible for disruption of the grid by diverging from all the rest by moving towards the ceiling of the grid, the authorities of that currency would be expected to take similar opposite action, i.e., lower interest rates, expand public expenditure, intervene in the markets to sell its currency, etc. The authorities responsible for the D-mark greeted this with pitying smiles. It would surely be ridiculous, would it not, [they said], to devise a set of regulations which specifically provided for promotion of inflationary policies, in certain circumstances, whatever those might be (Pers. comm.) To demonstrate the degree of their commitment to price stability, Bundesbank officials even suggested that, because the ECU-centered system forced convergence toward the EC average level of inflation, policymakers committed to low inflation had incentive to adopt severe monetary policies aimed at zero inflation in their economy to bring the Community average to as low a level as possible, an implicit threat about the power the Bundesbank had to wreck the system should the other members continue to push for it (pers. comm. with central bank official).5 The Bundesbank’s commitment to price stability pushed the weak-currency countries to a fall-back position based upon a bilateral grid with symmetrical obligations. Under this Belgian proposal policymakers would define central rates in relation to the ECU, while a bilateral grid based on cross-rates would determine margins and intervention obligations. Symmetry of obligations would be imposed, however, by using the ECU as a divergence indicator, with the burden of intervention and monetary policy adjustment placed on the country whose currency the

indicator highlighted (Ludlow 1982: 165). Emminger refused to accept any such obligations. Because the indicator was imprecise, he argued, it would encourage rumors in the foreign exchange markets, fuel speculation against currencies, and require excessive intervention. The most Emminger was willing to accept was an obligation to consult with other members of the system if a currency crossed the divergence threshold (Ludlow 1982: 233). Thus, by late summer Bundesbank officials had vetoed the exchange rate mechanism embodied in the ECU-centered system, forcing the other policymakers to replace it with a bilateral parity grid without binding symmetrical obligations. The Bundesbank was also able to limit the credit mechanisms that would support the exchange rate system. Emminger noted in mid-July that the way to prevent the EMS from having negative consequences on German inflation was Page 64 →to limit the system’s available credit (Financial Times, July 15, 1978). Two elements embodied in the Bremen proposals, however, would act with the opposite effect. The creation of a European Monetary Fund to manage pooled reserves and create ECUs against member country reserve deposits would create a source of liquidity in the system outside direct Bundesbank control. Second, the Bremen proposals called for expanded short- and medium-term assistance, with “due account . . . given to the need for substantial shortterm facilities (up to one year),” and unlimited assistance through the very short-term financing mechanism. The Bundesbank succeeded in postponing and ultimately eliminating the EMF. Its officials simply refused to transfer any portion of German reserves to the fund, arguing that such a transfer would require constitutional change. Further discussion of the EMF was deferred until 1981, a move that resulted in its death. As one EC official recalled, in the 1981 discussions over reserve pooling, Bundesbank officials simply said no, and that was the end to the pooling of reserves and the expansion of the European Monetary Fund (pers. comm. with EC official). While less successful in blocking expansion of very short-term financing, the Bundesbank acceded to an expansion of these credits only after reaffirming with the Schmidt government its right to deny requests for financing under this mechanism if the bank’s policy-making council thought such credits were inconsistent with its monetary policy objectives.6 Thus, though a clear majority of Community policymakers preferred the symmetrical ECU-centered institutions, the institutional framework that emerged from intra-Community bargaining in the late fall of 1978 was based on a bilateral parity grid, all but very short-term credits to support currencies within this system would be quite limited, and the Bundesbank retained the right to refuse credits under the very short-term mechanism. The inherent asymmetry within the system was redressed only by a weak obligation to consult if the divergence indicator were tripped. As Karl Otto Pohl, who followed Emminger as president of the Bundesbank’s Central Bank Council, would later brag, the Bundesbank had taken the original conception of a system aimed at reducing D-mark dominance and turned it on its head to create a system based on D-mark dominance (Marsh 1992). In short, Bundesbank officials had committed themselves to a position based on price stability and convinced the other Community policymakers that they could either grant the Bundesbank de facto control over the single degree of monetary policy freedom and use their own monetary policies to stabilize nominal exchange rates or continue to allow nominal exchange rates to float. Page 65 →

C. The Decisions to Join With the distribution of the costs of exchange rate stability determined by the bargaining outcome, decisions to join, and the special arrangements sought in joining, were based on the consistency between policymakers’ domestic monetary policy objectives and the monetary policy required to stay inside the Bundesbank-dominated system. 1. France Opts In While tying the franc to the mark would likely impose short-run employment and output costs while expectations adjusted, the French government believed that such a policy would not bring long-run costs. To the contrary, a

reduction in inflation, by restoring competitiveness and by allowing interest rates to come down, would create the basis for strong growth. Thus, as the Bundesbank pushed the EMS negotiations toward the bilateral parity grid, the French willingly followed. The formal decision to accept the Bundesbank-designed system was taken by Schmidt and Giscard at a mid-September Franco-German summit in Aachen ([London] Times, September 15, 1978). The Schmidt-Giscard d’Estaing statement announcing their agreement reflected the Bundesbank’s victory: “a precondition of the durability of the new system [is] the convergence of member states’ economies, which the system itself would naturally encourage, but which would be ensured above all by the commitment of all concerned to anti-inflationary policies” (Ludlow 1982: 183). 2. Italy Opts for a Flexible Association The Italian decision to seek a more flexible association with the EMS was based on the interaction between Italian policymakers’ desire to reduce labor’s share of national income and their belief that doing so would be a protracted and difficult affair. As in France and Britain, Italian wages had been set through decentralized bargaining, in which the size of increases reflected fluctuations in the relative power of labor and industry (Flanagan et a1. 1983). As in France and Britain, the end of the 1960s saw labor power on the rise. In the fall of 1969 labor initiated a wave of strikes that led to real wage increases averaging 8 percent. This wage shock set off an escalating wage-price spiral that Italian policymakers were still trying to contain in 1978. The government responded to the wage shocks from a very fragile coalitional Page 66 →base. Disagreement among the major parties constrained the Center-Right coalition’s ability to respond with monetary restriction over economic policy, a disagreement that spilled over into disagreement over the coalition formula. While the Socialists had participated in Center-Left coalitions with the Christian Democrats during the 1960s, electoral losses in 1969 forced them to conclude that this strategy was losing them votes to the Communist Party. As a result, the Socialist Party moved toward greater cooperation with the Communist Party and the unions and conditioned its participation in a Center-Left government on formal or informal PCI participation in the coalition (Salvati 1980: 35–36). The Socialist demand was supported by the Christian Democrat Left, which also refused to participate in the government and conditioned its parliamentary support for the government on evidence of a restrained response to the wage increases. The resulting Center-Right government had very little room for maneuver and accommodated the wage shocks. In the wake of general elections held in 1972 the Socialists, encouraged by the PCI, which feared that failure to resolve the economic crisis would yield a right-wing backlash, returned to the coalition (Flanagan et al. 1983: 540). A Center-Left coalition was constructed that constituted the Christian Democrat Left, under pressure from industry to gain wage moderation, and the Socialists, who, with Communist help, might be able to deliver such moderation. Government policy sought to meet labor demands for economic expansion and institutional reform in exchange for wage moderation. While the union confederations were predisposed to use their influence to seek moderation in wage demands, the industrial unions proved both less inclined and less able to do so. As a result, wage increases continued to outstrip productivity improvements (Flanagan et a1. 1983:540). The wage campaign, and the government’s monetary accommodation, had three effects on the Italian economy. First, it yielded a significant redistribution of income away from capital and toward labor. Real wages grew at an average annual rate of 4.88 percent between 1970 and 1974 (table 3), yielding a large net transfer of income to Italian labor. Whereas labor claimed only 69.6 percent of Italian GDP in 1969, by 1975 it had increased its share to 75.7 percent. Because growth in productivity was much slower than the real wage increases, profitability was squeezed (table 3), and investment declined. Gross fixed capital formation, which had increased at an average annual rate of 5.1 percent during the 1960s, fell to annual average rates of increase just above 2 percent during the 1970s (Commission of the European Communities). Third, the wage increases, industry’s efforts to pass these increases on, and the government’s accommodation generated a wage-price spiral that pushed inflation up Page 67 →to postwar highs; between 1973 and 1975 the annual rate of inflation averaged 16.5 percent. Inflation yielded current account deficits and exchange rate depreciation. The Italian government was forced to the International Monetary Fund, once in early 1974 and then again in the second half of 1976, for standby agreements and stabilization plans (Spaventa 1983). While the stabilization packages did not stop the growth of labor costs, they

did prompt a change in the government’s response to the inflationary spiral, convincing the Center-Left coalition that the Italian economy could no longer afford real wage increases that outstripped productivity gains. From the mid-1970s on the government began to seek support for the income-reducing measures that stabilization would require. A broad-based, multiparty consensus on the need to stabilize the Italian economy had begun to emerge by 1976. At the base of this consensus was the PCI’s “historic compromise,” through which the Communists sought political legitimacy by seeking a power-sharing arrangement with the Christian Democrats, by trading support for monetary restriction, and the use of its organization to help gain wage moderation, for formal participation in government (Flanagan et a1. 1983: 547; Regini 1982; LaPalombara 1981). PCI moderation was accompanied by a similar shift in the unions, which, by 1977, were restraining wage demands at the plant level. Tacit union support for austerity was transformed into explicit union policy in January 1978, when the CGIL-CISL-UIL confederation adopted the EUR program that, for the first time, recognized that wage increases were a major contributory factor to the Italian inflation and accepted the need for a policy of sacrifices and austerity. Union support for austerity, however, was not easily translated into control over wage bargaining at lower levels, and real wage growth continued to outstrip productivity (table 3). It was within this context that the Italian government approached the decision about EMS membership. The government’s position was not without ambiguity. On the one hand, the European monetary system offered a useful linkage between European integration and domestic stabilization that could strengthen coalition support for the latter. While it might prove difficult to sustain the Center-Left’s support for the distributional implications of stabilization, it would be easier to do so if stabilization could be linked to the broader benefits the Italian economy derived from European integration. A stabilization package developed in 1978, the Pandalfi Plan, presented just such a linkage. Staying in the center of Europe, the Pandalfi Plan indicated, was central to the future growth of the Italian economy. To “stay with Europe,” it argued, “it will be necessary to reduce the differential in the growth in prices and labor Page 68 →costs between [Italy] and the other countries of the Community.” The plan continued: The Community is beginning to work toward stricter monetary discipline. . . . The road forward is a difficult one, but we are now beyond the point of no return. . . . The road that leads us toward Europe is the same one that leads us toward the objectives of growth on the basis of stability: it is the same in other words as the one proposed in the strategy outlined in this document. (Pandalfi Plan, Corriere della Sera, September 1, 1978: paras. 60, 58) Thus, the EMS enabled stability-oriented policymakers to link price stability to the objective of keeping the Italian economy at the center of the European integration process and, by doing so, sustain coalition support for stabilization. On the other hand, there was little conviction that strict monetary restriction and a rigid nominal exchange rate were the appropriate solutions to Italian inflation. As Banca d’Italia Governor Baffi noted: management of the money stock aimed exclusively at stabilizing its value used to set off a process of adjustment that would last a known time and spread throughout the economy as a vast number of individual adjustments were made; in this process the temporary costs of stabilization were economically, socially and politically acceptable because they were very widely distributed. Today they would be concentrated in those parts of the economy whose resistance had finally been overcome, perhaps for ever, bringing unemployment to vast areas and broad sections of society and causing the disruption of whole industries . . . Opposing more concentrated and inflexible processes of price determination by applying the monetary monopoly more rigorously without the assent and confidence of those who operate in the economy would mean pursuing monetary stability by compulsion. “In the conditions prevailing today,” Baffi continued, “monetary policy cannot replace the exercise of discipline in the decisions and behavior of the whole of society; when [monetary policy] has been successful it has guided and

confirmed the decisions that have been reached on the basis of reason and experience” (Banca d’Italia 1979: 159–61). This interpretation led to an analysis of the exchange rate that differed Page 69 →quite dramatically from the one the central bank would advance in the years to follow. Fixing the nominal exchange rate and allowing the lira to appreciate in real terms against other EC currencies to reinforce domestic stabilization was, according to the Banca d’ltalia, of limited utility. Italian industry was intent on improving profit margins and, thus, would not pass on the cheaper domestic prices resulting from reduced import prices (Banca d’ltalia 1979: 146). Thus, the Banca d’Italia did not orient exchange rate policy in 1978 toward reinforcing stabilization, but toward improving the current account surplus to relax the constraints on growth (145). In short, while the central bank recognized the contribution exchange rate policy could make to disinflation, it believed that it was “an illusion . . . to think that exchange rate management alone could lead to the achievement of the prime objective of eliminating inflation” (147). The political parties reflected this ambiguity about EMS membership. The PRI suggested that Italy could survive in the system only if domestic economic policies were appropriate, but, because the policies were not appropriate, remaining inside the system would be difficult (Ludlow 1982: 208). The PSI was suspicious of the system, viewing it as a way for the Right to pursue deflationary policies, while the PCI became increasingly opposed to membership, arguing that the system could only bring deflation, unemployment, and economic weakness (L’Unita, November 5, 1978). While the DC promoted membership, even Pandalfi expressed concern about the deflationary tendencies of the system (Pandalfi 1978: 2). As Baffi summarized, Italy wanted to take advantage of the rigor a fixed exchange rate system would impart to the Pandalfi Plan but needed to ensure that the system realistically took into account the scale of the divergences between the Italian economy and the healthier economies of northern Europe (Baffi 1978: 11). The desire to use the EMS as a reinforcement of the stability orientation, and the fear that full membership would be too costly, led the Andreotti government to negotiate as much flexibility within the system as possible. Wider margins for the lira to offset the anticipated costs of the tie to the mark were of critical importance (pers. comm. with Banca d’ltalia official). Andreotti, Pandalfi, and Baffi met with Schmidt in Siena, requesting a widening of the system’s margins from 2.25 percent to plus or minus 8 percent for the lira. While failing to reach agreement—Schmidt offered only a 4.5 percent band—the principle of special concessions to Italy was accepted. Schmidt and Giscard d’Estaing, meeting a few days later, agreed to margins of plus or minus 6 percent for the lira (Ludlow 1982: 238–39). Having gained wider margins, Andreotti placed the lira in the EMS (pers. comm. with Banca d’ltalia official). Page 70 → 3. The United Kingdom Opts Out The Callaghan government’s decision to opt out of the EMS flowed from its estimates of the costs of membership. As one senior Treasury official stated, there was a deep-seated belief in the Treasury that fixed exchange rate systems were deflationary (pers. comm. with senior Treasury official). The EMS, Treasury analysis estimated, would cost the British economy somewhere between 3.5 and 9.5 percentage points of lost GDP growth and between 1 and 2.7 percentage points of additional unemployment (pers. comm. with senior Treasury official; Times, November 4, 1978).7 None of the scenarios estimated by the Treasury suggested that the British economy would perform better, in output and employment terms, inside the EMS than outside. As the government’s Green Paper on the EMS suggested, the EMS would have a “tendency to encourage deflationary policies overall” (Great Britain 1978a: 5). More important, however, and in stark contrast to the situations in France and Italy, no constituency for disinflation existed in the Labour Party. In fact, all important forces were pushing Callaghan in the opposite direction. In early September the TUC rejected continued pay restraint, stating its intention to return to unrestrained bargaining in an attempt to recoup some of its losses during the previous three years (TUC 1978).

The TUC rejection was picked up by a Labour MP, Eric Heffer, who in late September proposed an emergency resolution rejecting the government’s proposed wage guidelines. In early October the Labour Party Conference voted against wage restraint by a margin of two to one. The TUC also made clear its opposition to membership in the EMS. A TUC paper submitted to the House of Commons’ Expenditure Committee argued: The parity grid system [at the base of the proposed EMS] is exactly the same as that which obtains among members of the European “snake.” . . . On past evidence, it appears that snake-type arrangements have been too rigid and inflexible, tending principally to benefit those participating countries with stronger currencies. The TUC had no illusions that Britain could be classified as a strong-currency country: “It is evident . . . that far from encouraging recovery an ill-devised EMS could produce the opposite effect. Employment and growth in the UK could be adversely affected” (Great Britain 1978b). The Labour Party Conference echoed the TUC’s rejection of the EMS: Page 71 →The economies of the EC countries differ widely. . . . Any attempt to tie their exchange rates together by artificial devices . . . is fraught with the gravest of dangers. It could force Britain back into deflationary policies which would set back our economic recovery and could also damage the world economy. It would jeopardize the great progress which has been made under the Labour Government to strengthen Britain’s economy after all the sacrifices of recent years Conference therefore declares its opposition to British participation in the proposed system. (Times, October 16, 1978) Opposition was also strong within the parliamentary Labour Party, in which back-benchers threatened to revolt if the government joined the EMS and passed a resolution opposing the EMS and requesting the government to veto any EEC regulation to bring the system into effect (Times, November 28, 1978). Opposition from the Labour Party and the TUC was fully reflected within the cabinet, in which by November only two members—Harold Lever and Shirley Williams—advocated EMS membership. Confronted with such overwhelming opposition, Callaghan faced two options. He could either challenge the entire structure upon which his position rested or accept the fact that opposition to membership was too strong to bring Britain into the EMS. Callaghan opted out. Epilogue: TheTories Opt In

The British Conservatives placed sterling in the EMS in October 1990. British entry resulted from a lengthy, and often acrimonious, debate within the Conservative Party that then Chancellor of the Exchequer Nigel Lawson had initiated in the early 1980s. Lawson had become disillusioned with the existing monetary targeting framework shortly after being appointed chancellor and had requested that his Treasury staff review monetary policy. The source of his disillusion was not intellectual—like most members of Thatcher’s team, Lawson was both committed to price stability and convinced of the lack of any trade-off between employment and inflation. Lawson’s disillusion resulted from the difficulties involved in implementing the targeting strategy. In particular, efforts to establish a reliable indicator of monetary conditions were proving difficult. While the Treasury tried a number of different definitions of money supply—M3, M1, MO, M4—all were subject to a high degree of volatility (Lawson 1992: 76–87). As one Treasury official indicated in a memo to Lawson in mid-1983: Page 72 →Probably the main change that has happened since your time8 has been the way policy has degenerated into “looking at all possible indicators of monetary conditions.” On occasions there is more than a hint of muddling through. Maybe this is inevitable given the failure of the target measure of money always to give a reliable indication of the degree of financial laxity or tightness. . . . But it does leave the City unclear about what our intermediate targets really are: they suspect it is too easy for us to find a post hoc justification for anything we want to do.

The Treasury review summed up the issue succinctly: there was a general dissatisfaction with M3, but there existed no clear alternative (Lawson 1992: 450, 451–52). As his dissatisfaction with the operational role of monetary aggregates grew, Lawson increasingly began to look to the exchange rate as a guide in setting monetary policy. He indicates that by early 1981 he had become “persuaded of the case for making the discipline of the ERM rather than targets for domestic monetary aggregates, the prime determinant of monetary policy” (Lawson 1992: 111).9 By late 1984 the exchange rate was playing an important role. No explicit target had been set, but the Treasury saw that exchange rate movements provided an important piece of information. During 1985 Lawson sought to make the exchange rate the cornerstone of the government’s monetary policy by placing the pound in the EMS. Lawson held the first serious meeting with his Treasury staff to discuss the possibility of placing sterling inside the EMS in January 1985. Lawson believed that joining the EMS would reinforce the government’s anti-inflation policy in two ways. First, an explicit exchange rate linked to the D-mark would facilitate the operational aspects of monetary policy; rather than having to look to volatile monetary aggregates, they could adjust monetary policy based on sterling’s movement against the mark. And, as the exchange rate was already playing an important role in the formulation of monetary policy, EMS membership would be seen as a “natural development.” Second, Lawson believed that an explicit commitment to the mark would simplify the presentation of monetary policy; “it would undoubtedly strengthen our strategy in the eyes of the markets, it would make it clear to industry that they could not look to exchange rate depreciation to solve their difficulties, and it would create a helpful context for the Government’s public expenditure decisions” (Lawson 1992: 495). Thus, rather than having to explain the difficulties inherent in controlling monetary aggregates every time monetary growth overshot their stated target, Lawson could simply tell the city and industry that the government intended to set monetary policy on a course that Page 73 →stabilized the bilateral rate with the mark. Inasmuch as the Bundesbank remained a price stability anchor, then this signal would indicate the government’s commitment to a stability-oriented monetary policy. While most Treasury officials initially opposed ERM membership, in the course of the year Lawson managed to convince them of the attractiveness of the move and gained the support of Geoffrey Howe, at the Foreign Office. What remained was to convince Thatcher that this was the correct move. Lawson gained Thatcher’s assent to two meetings devoted to ERM membership—one in February and a second in the fall—but failed to convince her of the wisdom of joining. Thatcher’s opposition was based on a strong commitment to allowing the market to set the exchange rate. As she tirelessly pointed out, either one could control domestic monetary developments, or one could try to peg the exchange rate. One could not do both. She saw “no particular reason to allow British monetary policy to be determined largely by the Bundesbank rather than by the British Treasury, unless [the Government] had no confidence in [its] ability to control inflation.” She “was extremely skeptical about whether the industrial lobby which was pressing [them] so hard to join the ERM would maintain its enthusiasm once they came to see that it was making their goods uncompetitive” (Thatcher 1992: 696). While Thatcher was in the minority opposing membership, she managed to force an outcome in which government policy was “to join when the moment was right” (Lawson 1992: 488–92; Thatcher 1993: 693–98). Thus, by 1985 the chancellor of the exchequer had concluded that EMS membership was not only fully consistent with the government’s monetary policy objectives but would also solve many of the operational problems plaguing monetary policy implementation. He had failed, however, to gain Thatcher’s support for the move. While ERM membership was put to the side for the time being, Lawson continued to rely heavily upon the exchange rate in formulating monetary policy and in 1987 began to shadow the D-mark. The disagreement over exchange rate policy and the underlying disagreement over monetary policy led, ultimately, to Lawson’s resignation in late 1989. British EMS membership was achieved by Lawson’s replacement at the Treasury, John Major. Major was quickly converted to a pro-ERM stance by Douglas Hurd at the Foreign Office (Watkins 1991: 132). Whether he was convinced by the merits of the economic case for membership or by the recognition that ERM membership might be a more effective means for Britain to gain support in negotiations over EMU is unclear. In discussions with Thatcher over the governments’ EMU stance, he seemed to suggest the latter. In these discussions Major indicated relative unease with the government’s position, a position Page 74 →he believed would isolate Britain from the

rest of the Community. In such a context a show of support for monetary cooperation by a concrete commitment to full participation in stage 1 of EMU, one requirement of which was ERM membership, could perhaps give the British a better chance of gaining support.10 In any event Major began to work on Thatcher, and in June 1990 she finally assented to membership. She did so, she later claimed, because in the face of fairly broad-based support for membership from the cabinet, from the parliamentary party, from the “industrial lobby,” and from the press, she “had too few allies to continue to resist and win the day. . . . By this stage all my advisers were telling me—though on political rather than on economic grounds—that I should have sterling enter” (Thatcher 1993: 721). Thus, on October 5, 1990, the British announced that they would place sterling inside the ERM.

D. Conclusion The model developed here thus provides an explanation of the creation of the EMS that, while not inconsistent with, offers two advantages over, a neoliberal account: it explains more of the process than does neoliberal institutionalism, and it provides evidence of a novel insight into how policymakers use international institutions. Neoliberal institutionalism’s central claim—namely, that seeing that exchange rate stability offered joint gains—EC policymakers created institutions that would enable them to realize these gains, was supported by this chapter. This chapter also highlights, however, that a neoliberal account of the creation of the EMS is incomplete. Neoliberal institutionalism provides no leverage with which to explain the characteristics of the institutional outcome, i.e., why did EMS institutions promote an asymmetric distribution of the costs of exchange rate stability and why did Italian policymakers join the EMS on special terms, while British policymakers opted not to join at all? Moreover, an explanation based on neoliberal institutionalism overlooks the fact that the driving motivation behind the creation of the EMS lay less in the information problems of international politics and more in the institutional problems of domestic politics. The model’s expectation that the motivation for the proposal of the EMS would lie in domestic politics was supported by the evidence. Schmidt proposed and Giscard and Andreotti joined the EMS because each saw exchange rate institutions as a means of achieving a substantive domestic economic policy objective that he could not achieve otherwise. For Schmidt this objective was the reduction of the downward pressure on wages and employment caused by the strong mark. Constrained by coalition politics and Bundesbank independence, Page 75 →there was little Schmidt could do within the German arena to implement policies that would meet his constituents’ demands along these dimensions. For Giscard and Andreotti the domestic objective concerned the ending of wage-price spirals that were driven by oil and wage shocks and could not be easily ended in the context of coalition governments, dependent central banks, and uncooperative labor-industry relations. For each the EMS appeared a means to achieve the desired objective. For Schmidt the EMS would stabilize the mark and perhaps also force the Bundesbank into a less restrictive monetary policy. For Giscard and Andreotti exchange rate stability within the EMS offered a nominal anchor against which to moor stabilization. Thus, the primary motivation for the creation of the EMS was a desire to use the exchange rate system to achieve substantive domestic economic objectives. The model’s expectation that the distributive outcome would be shaped by Bundesbank power was also supported by the evidence. Unwilling to accept institutionalized obligations that might force them to subordinate domestic price stability to exchange rate stability, Bundesbank policymakers committed to an institutional framework that gave them de facto control over the system’s single degree of monetary policy freedom. Even though a large majority of EC policymakers supported the ECU-centered system, Bundesbank policymakers were able to use their commitment to price stability to veto all institutions that would impose inflation onto Germany. The institutions structured by the Bundesbank performed a slightly nuanced version of the monitoring and enforcement role emphasized by neoliberal institutionalism. EMS institutions structured, monitored, and enforced a particular distribution of the costs of exchange rate stability. The bilateral parity grid, the rules concerning the role the divergence indicator would play, or rather not play, in assigning adjustment burdens, and the restrictive financial mechanisms that would support the system structured a distribution of the costs of exchange rate cooperation to the benefit of the Bundesbank and to the detriment of weak-currency policymakers. Bundesbank policymakers thus structured the choice the other EC policymakers had to make as one between the status quo and the bilateral parity grid.

Policymakers’ choices between these two options were a function of their assessments of the costs and benefits of each. French policymakers, committed to stabilizing the French economy and seeing a clear advantage in an external nominal anchor upon which to moor this policy, joined the EMS as full members. Italian policymakers, desiring a more stable economy but confronting acute political instability and fearful that a tight link to the mark would generate steep adjustment costs that would accentuate this instability, sought a more flexible association. They placed the lira in the EMS but only after having Page 76 →gained extra-wide margins. British policymakers, facing an impending election and desiring a more expansionary monetary policy, believed that a link to the mark would prevent them from pursuing this objective. They therefore opted to keep sterling outside the system. In sum neoliberal institutionalism and the model of exchange rate cooperation provide largely convergent explanations of the creation of the EMS. The EMS was created because those policymakers who joined believed they were better off with the exchange rate system than without it. The model of exchange rate cooperation provides a fuller explanation than does neoliberal institutionalism, however, accounting for both the distributive outcome and the pattern of membership, and providing one novel insight into why policymakers create international institutions. Institutions do help manage the information problems that make cooperation difficult, but institutions also help policymakers achieve substantive domestic political objectives they cannot achieve otherwise. This is an insight to which we will return in chapter 5.

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CHAPTER 4 Explaining Variation in Nominal Exchange Rate Stability: The Domestic Politics and Capital Mobility Hypotheses Working within the institutional framework established in 1978, EC policymakers achieved a high degree of nominal exchange rate stability in the 1980s. Nominal exchange rates between EMS members exhibited much less variation during that decade than they had exhibited during the 1970s, an improvement in stability not enjoyed by European countries that did not participate in the EMS. The stabilization of nominal exchange rates was based upon the adoption and implementation of monetary policies that yielded a high degree of nominal convergence within the EMS. Whereas monetary policies and inflation rates within the Community diverged dramatically during the 1970s and the early 1980s, the adoption of price stability-oriented monetary policies and the gradual achievement of a high degree of nominal convergence characterized the second half of the 1980s. How do we explain this pattern of monetary divergence-convergence and nominal exchange rate stability? This chapter examines two hypotheses—a domestic politics hypothesis and the capital mobility hypothesis—to offer an initial explanation of the variation in intra-Community nominal exchange rate stability. I test both hypotheses with statistical analysis of two pooled cross-sectional data sets. One data set consists of quarterly data for Britain, Germany, France, and Italy between 1971 and 1992, and the second one consists of annual data for ten European countries for roughly the same period. The Page 78 →analysis suggests two things. First, the domestic political model explains a large amount of the cross-national and longitudinal variation in inflation in this period, a finding consistent with the claim that domestic politics drove much of the variation in nominal exchange rate stability. Thus, rather than being forced to adopt monetary restriction by capital mobility, Community policymakers adopted stability-oriented monetary policies because they preferred price stability and had an institutional context within which to implement it. Second, the analysis does not fully explain convergence in France and Italy. While the domestic model explains much of the inflation in these two countries before 1983, it fails to account for French and Italian policymakers’ adoption of monetary restriction after 1983. Thus, France and Italy stand out as exceptions to this general pattern, a finding that suggests that capital mobility may have played an important role in the French and Italian disinflation. To explore the capital mobility hypothesis in the French and Italian cases, I examine evidence on the effect of French and Italian capital controls on onshore-offshore interest rate differentials and the degree of exchange rate fixity within the EMS. This evidence suggests that capital mobility did not cause the French and Italian shifts. By periodically realigning their exchange rates, and by using capital controls to limit reserve losses in the run-up to these realignments, French and Italian policymakers retained a degree of monetary independence until the late 1980s. Thus, while capital mobility was clearly a constraint on monetary policy, it does not appear that international capital markets forced French and Italian policymakers to adopt restrictive monetary policies after 1983. Thus, this chapter concludes with a bit of a puzzle. We gain a comprehensive understanding of how the European monetary system worked. The picture is one in which the Bundesbank prevented the EMS from constraining its ability to control monetary developments in Germany, and, as a result, exchange rate stability became a function of other European policymakers’ willingness and ability to adopt monetary policies that brought about nominal convergence. For most Community policymakers the adoption and implementation of stability-oriented monetary policies was fully consistent with their political predilections; thus, domestic politics drove much of the nominal convergence upon which nominal exchange rate stability was based. French and Italian policymakers also proved willing to adopt monetary restriction, but, in contrast to the other countries, neither domestic politics nor capital mobility appear to have driven this development. Page 79 →

A. Nominal Exchange Rate Stability and Nominal Convergence in the European Community According to our model of exchange rate determination, PPP, changes in nominal exchange rates should be tightly linked to cross-national inflation differentials. Nominal exchange rate stability requires the convergence of inflation rates. The direction of this convergence is undetermined by the model—why do policymakers converge around one standard rather than another? This section provides evidence on both aspects of EC exchange rate stability. Descriptive data highlight the connection between exchange rate stability and nominal convergence in the 1970s and 1980s, showing that during the 1980s EC policymakers converged around the Bundesbank’s price stability standard. Analytical evidence of Bundesbank behavior suggests that the selection of the price stability standard was determined by the Bundesbank’s ability to maintain monetary independence within the EMS. With the Bundesbank in control of the single degree of monetary policy freedom, intra-Community nominal exchange rate stability required other EC policymakers to be both willing and able to adopt monetary policies that converged on German rates of inflation. European Community policymakers achieved a high degree of nominal exchange rate stability during the 1980s, in comparison to both the degree of nominal exchange rate stability they had experienced in the previous decade and exchange rate developments in non-EMS countries during the 1980s. Ungerer et al. (1990) provide coefficients of variation of bilateral nominal exchange rates for two periods, 1974–78 and 1979–89, which help make these comparisons (table 4). Coefficients of variation of bilateral nominal exchange rates show that for ERM members as a whole—and for Italy, France, and Germany individually—variation in bilateral exchange rates dropped dramatically in the 1980s compared with the 1970s. For the EMS as a whole the degree of nominal exchange rate variation in the 1980s was reduced by one-half compared with the 1970s. While EMS policymakers did achieve a higher degree of nominal exchange rate stability throughout the 1980s in comparison to what they had achieved during the 1970s, this process of exchange rate stabilization was spread unevenly across the decade. While the absence of coefficients of variation for the first eight years of the system’s operation make the identification of cross-period differentials a little complicated, a decomposition of the coefficient of variation for the entire 1979–89 period does provide some insight into this question. Over the whole period EMS bilateral nominal exchange rates yielded Page 80 →a coefficient of variation of 12.7. Yet, in three of the four years for which Ungerer et al. provide annual coefficients, bilateral nominal exchange rates exhibited either more than half as much or close to half as much variation for the entire period. This suggests that intra-EMS nominal bilateral exchange rates exhibited greater variability before 1986 than they did between 1986 and 1989. This increased stability of intra-Community bilateral nominal exchange rates cannot be attributed to a general stabilization of the international monetary system. Two comparisons from the Ungerer coefficients help make this point. First, a comparison of EMS members with non-EMS members in the 1970s and 1980s shows that non-EMS members failed to realize an equivalent improvement in nominal exchange rate stability; the coefficients for nonEMS members remain quite high during the 1980s, while the coefficients for EMS members fall quite dramatically. Even if we restrict our focus to the set of European countries outside the EMS, and we thus exclude the large swing in the dollar and the yen that occurred in the 1980s, EMS members still experienced a much higher degree of nominal bilateral exchange rate stability during the 1980s than did non-EMS members. While non-EMS European currencies were more stable during the 1980s than they had been in the 1970s, the extent of this improvement does not approach that realized by EMS members. Second, a comparison of the variation of EMS member currencies’ against other EMS currencies with the variation of EMS currencies against non-EMS members suggests that EMS members achieved a higher degree of nominal exchange rate stability only with other members of the EMS; in fact, variation in bilateral nominal exchange rates against non-EMS members increased in the 1980s compared with the 1970s. In short, EMS policymakers achieved a high degree of nominal exchange rate stability in the 1980s. The improvement appears to have been only moderate in the early years of the EMS but became much more pronounced as the decade progressed. This improvement appears not to have been attributable to a more general stabilization of the international monetary system. TABLE 4. Coefficients of Variation of Bilateral Nominal Exchange Rates, 1974–89

Page 81 →The stabilization of intra-EMS nominal exchange rates was based upon nominal convergence among EMS members. Intra-Community rates of inflation, which had diverged so dramatically during the 1970s, began to converge during the 1980s (table 5). GDP deflators for EMS members show that, for the EMS as a whole, both the gap between the highest and the lowest rates of inflation and the standard deviation of inflation were smaller during the 1980s than during the 1970s. The average rate of inflation for EMS members between 1975 and 1978 was just less than 11 percent, with a gap between the highest and lowest rates of almost thirteen points (Italy and Germany) and a standard deviation of 4.3. By 1989 the average rate of inflation for EMS members had fallen to 3.6, the gap between the highest and lowest had been reduced to 3.9 points, and the standard deviation had fallen to 1.3 points. Thus, as the PPP model led us to expect, the stabilization of intra-Community nominal exchange rates was achieved on the basis of a high degree of nominal convergence. The 1980s thus brought a narrowing of the intra-EMS inflation differential and the consequent stabilization of intra-EMS nominal exchange rates. Not only did inflation rates increasingly converge, but they clearly converged around a price stability standard based on German rates of inflation. Why did EMS policymakers converge toward German levels of inflation rather than toward a Community average? The answer lies in the Bundesbank’s ability to retain monetary independence inside the EMS. As we saw in the previous chapter, Bundesbank officials had guided negotiations over the EMS toward an institutional framework that they believed would impose few constraints on their ability to control monetary conditions in Germany. The operation of the EMS between 1979 and 1987 suggests that Bundesbank officials were largely correct in their anticipations, as the stabilization of intra-Community nominal exchange rates imposed few constraints on their ability to manage domestic Page 82 →monetary conditions in Germany (Russo and Tullio 1988; Mastropasqua et al. 1988; Von Hagen and Fratianni 1992). Two types of evidence bear on the question of Bundesbank independence in the EMS: evidence on the impact of foreign exchange intervention undertaken in connection with the EMS on German money supply; and evidence on monetary interactions within the EMS. Mastropasqua et al. (1988) provide an analysis of foreign exchange intervention. They examined the relative importance of domestic and foreign channels in monetary base creation by estimating an equation of the following form: Where: da = Π = g = fa =

change in domestic monetary base inflation output change in foreign component of monetary base.

As Mastropasqua et al. explain: to the extent that monetary base growth is determined in the light of domestic objectives, changes in the foreign component must be offset by equal and opposite changes in the domestic component; the coefficient d must therefore approach a value of -1. Smaller absolute values of d can be taken to mean that monetary policy objectives are modified in response to developments in the balance of payments and official reserves. (1988: 274) TABLE 5. GDP Deflators, Annual Percentage Change Page 83 →In estimating this equation for Germany for the period 1979/1 through 1986/4, Mastropasqua et al. found a coefficient on d of -0.82 and not statistically different from -1, a finding suggesting that Bundesbank officials reversed the impact of foreign exchange intervention on German money supply almost completely. Other countries tested in this study (France, Italy, and Belgium) yielded much smaller negative coefficients, with France offsetting just less than 0.31 of its intervention, Italy about 0.28, and Belgium 0.31—coefficients that suggest that, in setting monetary policy, policymakers in these countries were much more responsive to developments in the

external account than were Bundesbank officials. Thus, not only did Bundesbank officials prevent most EMSrelated intervention from having an impact on German monetary conditions; they managed to do so at a much higher level than other members of the system. In a more elaborate examination of monetary interaction within the EMS, Von Hagen and Fratianni (1992: 75–98) estimated a series of models that tested the extent to which the growth of EMS members’ monetary base, the levels of EMS members’ money market rates, and changes in EMS members’ money market rates were a function of monetary growth rates, interest rates, and interest rate innovations in other EMS countries. The results of their analysis suggest two things. French and Italian policymakers retained a fair degree of short-run monetary independence, a finding that stands in contrast to the capital mobility hypothesis. Second, and directly relevant to the question of Bundesbank independence, Von Hagen and Fratianni find considerable evidence that confirms the hypothesis that the Bundesbank enjoyed a high degree of monetary independence within the EMS: All EMS members except Denmark show significant and lasting reactions to German monetary policy, to other EMS members, or to the rest of the world, but German responses to the rest of the EMS and the rest of the world vanish after several quarters. One may conclude that in the long run, the Bundesbank pursues its own policy independently, showing no lasting response to the monetary policies of other EMS members. (1992: 82) Page 84 →In sum EC inflation converged around price stability rather than an alternative standard because the EMS imposed few constraints on Bundesbank policymakers’ ability to control monetary developments in Germany, and the Bundesbank used its monetary independence to maintain price stability in Germany. This is not to claim that the Bundesbank dominated EC monetary policy, somehow forcing other Community policymakers to adopt price stability-oriented monetary policies. Bundesbank control of the single degree of monetary policy freedom structured the choice other EC policymakers faced: if they wanted exchange rate stability, they had to adopt monetary policies oriented toward price stability. This choice was not automatic, as the willingness and ability of other EC policymakers to adopt stability-oriented monetary policies varied across the decade (table 5). In the wake of the second oil shock many EC policymakers were either unwilling or unable to adopt monetary policies that converged on the German standard. Although the average rate of inflation fell, the gap between the highest and lowest rates of inflation increased, and the standard deviation of intra-EMS inflation rose by 0.6 points compared with the late 1970s. As a result, intra-EMS inflation differentials widened, and nominal exchange rates became unstable. This increasing divergence peaked in 1983, however, and throughout the remaining years of the decade Community policymakers reduced the system’s average rate of inflation, narrowed the high-inflation/low-inflation gap, and reduced the standard deviation. Thus, while European Community policymakers achieved a high degree of nominal convergence during the 1980s, they achieved it primarily between 1983 and 1987. Thus, nominal exchange rate stability and the process of nominal convergence within the European Community went hand in hand. As Community policymakers achieved a higher degree of nominal convergence, nominal exchange rates became progressively more stable. The direction of this process of convergence was determined by the Bundesbank’s ability to prevent the operation of the EMS from imposing constraints on its ability to control monetary developments in Germany. With the Bundesbank able to maintain a high degree of monetary independence, nominal exchange rate stability depended upon the extent to which other EC policymakers were willing to adopt and able to implement monetary policies that brought about a reduction in their rates of inflation. Their willingness and ability to adopt such policies, in turn, was quite weak in the period prior to 1983 and grew progressively stronger in the latter part of the decade. Page 85 →

B. Explaining Divergence and Convergence: Domestic Politics and Capital Mobility Variation in nominal exchange rate stability was strongly related to variation in policymakers’ willingness to

adopt and ability to implement monetary policies that converged around the Bundesbank standard. What explains this pattern of monetary divergence and convergence? Two hypotheses have direct relevance: the domestic politics hypothesis and the capital mobility hypothesis. This section uses statistical analysis to test both explanations. The political model of inflation hypothesized that policymakers’ responses to exogenous supply shocks determine the inflation rate. Supply shocks emanate from labor markets and other sources, creating inflationary pressure. Whether a given shock is transformed into an inflationary wage-price spiral depends upon how governments respond to the shock. The model suggested that leftist governments and coalitions would tend to accommodate inflationary shocks, while rightist, single-party majority governments, and independent central banks would tend to respond with monetary restriction. Thus, according to the domestic politics hypothesis, monetary policy is endogenous to domestic processes. The capital mobility hypothesis suggests that in a world of highly mobile capital policymakers are unable to pursue independent monetary policies. Therefore, according to the capital mobility hypothesis, monetary policy is determined by factors—the world interest rate—outside the domestic arena. We can take advantage of the endogenous-exogenous dichotomy of the domestic politics and capital mobility hypotheses to use statistical analysis of the political model of inflation to test both hypotheses. The logic of the test is as follows. If the political model explains a large amount of cross-national and longitudinal variation in inflation, accounting for both the increase in inflation in the 1970s and its decrease in the 1980s, then we have strong support for a domestic politics explanation of the divergence-convergence pattern identified earlier and little evidence of capital mobility-induced convergence. If, however, by using time period interactive dummy variables and F-tests, we can identify statistically significant differences in the explanatory power of the variables included in the political model, and these tests suggest that the political variables that caused inflation during the 1970s were not significantly related to disinflation during the 1980s, then we have found evidence that something exogenous to the political system, such as capital mobility, played an important role in fostering nominal convergence. Page 86 → 1. The Domestic Politics of Inflation in the Big Four The political model is tested first against the four largest Community countries—Germany, France, Italy, and the United Kingdom. These countries, because they are less open than the small community members (Belgium, the Netherlands, Denmark), would be the least likely to exhibit outcomes consistent with the capital mobility hypothesis. The data set is a pooled cross-section of quarterly data for the four largest EC countries (Italy, France, Germany, and the United Kingdom), for the period 1971–87. The general form of the estimated equation is: INFj,t is the rate of inflation as measured by the GDP deflator, where i and t refer to the country and the time period of the observation. POL represents the set of exogenous political variables consisting of PARTISAN, the percentage of cabinet seats occupied by ministers from leftist parties; STABILITY, the stability of the ruling coalition as measured by the duration of each government; LABOR, labor-capital relations as measured by strike data; and CBI, a measure of central bank independence.1 All political variables are lagged one or more periods. DUMMY is a set of country and time period dummy variables. While these variables constitute the basic model, the pooled design generates estimation problems that are resolved through the inclusion of interactive variables—COUNTRY*POL and EMS*POL. Pooled designs assume that parameter estimates are stable both across the units and across the entire time period. This implies that, in pooling data, one is making the assumption that the underlying political model is exactly the same in all countries included in the sample and that the effects of these political variables are constant over time. Such an assumption is an inappropriate starting point for any pooled analysis, for, if the true political processes are in fact different, either across units or over time, then the parameter estimates one gets by not allowing for these differences will be biased (Stimson 1985).

Thus, rather than start from the assumption that the four countries are the same, I start from the assumption that each country is different and test the extent to which this is in fact the case. To achieve this I estimated an unconstrained form of the model. The unconstrained form includes the exogenous political variables plus COUNTRY*POL, which is a set of N-1 interactive variables between the exogenous political variables (POL) and country dummy Page 87 →variables. Including all country interactive terms into an initial estimation of the model allows the parameter estimates for each political variable for each country to vary from those for the excluded country. Estimates are thus not forced to the mean of the entire sample but, instead, are allowed to be larger in those countries in which the effects are larger and smaller in those countries in which the effects are smaller. Each country’s set of interactive variables are then tested jointly, using an F-test, to determine whether allowing for this cross-unit parameter instability improves the overall fit of the model. Those countries’ interactive terms for which we cannot reject the null hypothesis—the difference in the parameter estimate between a given country and the excluded country is zero—are then excluded, and this constrained model is re-estimated and interpreted. While perhaps a bit messier than alternative estimation techniques, this procedure gives us a high level of confidence that the resulting parameters are in fact good estimates of the underlying causal relationships. The results of these tests indicated that the countries pool, and, therefore, the reported model was estimated in unconstrained form. I adopt the same logic to test for longitudinal parameter instability. EMS*POL represents sets of interactive terms between the exogenous political variables and time break dummy variables. As in the case of cross-unit parameter stability, the model is estimated in unconstrained form, and F-tests are used to determine whether allowing the parameters for the exogenous political variables to vary across selected time breaks improves the overall fit of the model. The results of the analysis are presented in table 6 and yield generally strong support for the model of the domestic politics of inflation developed in chapter 2, but with one important qualification. Each of the four political variables was statistically significant and correctly signed. First, both of the sources of exogenous supply shocks—oil and wage shocks—were significantly related to inflation. Both variables yielded positive and statistically significant parameters. In particular, controlling for the other political variables, the hypotheses developed about labor markets fare quite well; the higher the degree of labor-capital conflict in a given countryquarter, the higher was inflation in subsequent quarters. The political and institutional factors shaping policymakers’ responses to these supply shocks also perform quite well. First, the impact of central bank independence is positive and highly significant: countries with independent central banks were on average significantly less inflationary than countries with central banks subordinate to the government. Controlling for central bank structure, the other two variables determining policymakers’ responses to supply shocks also perform well. First, the PARTISAN variable Page 88 →hypothesized that leftist governments, because of their strong links to labor, would be more inclined to accommodate wage and other supply shocks than would rightist governments with links to capital. This hypothesis is supported by the analysis, as leftist governments tended to be more inflationary than did rightist governments. Second, the government stability variable, our measure of regime type, is also strongly related to inflation. It was hypothesized that coalition governments would be more unstable and thus less able to adopt a nonaccommodating stance to wage shocks and more inclined to run inflationary deficits. The analysis supports this hypothesis as well, as unstable governments tended on average to be more inflationary than more stable governments. While the model fits the data quite well, tests for longitudinal parameter instability yielded a significant time break at 1983 quarter 2, a finding that forces us to modify our conclusions about the role domestic politics played in the process of nominal convergence. The 1983 time break interactive terms are significant as a group, suggesting quite strongly that the domestic politics of monetary policy and inflation changed across the two periods.2 Moreover, the signs on all of the interactive terms, with one exception, are the reverse of the signs on the variables themselves, suggesting that each of these variables explains less of the longitudinal and cross-national variation in inflation after 1983/2 than they did before. The LABOR variable had a smaller effect on inflation after 1983/2 than it had in the previous period, a finding that suggests that after this time governments were much less inclined to accommodate wage shocks. The STABILITY variable also had a smaller effect on inflation after the 1983/2 time break, a finding that suggests coalition instability was less of a constraint on policymakers’ ability to adopt nonaccommodating responses to exogenous supply shocks. The sign on the PARTISAN variable is also reversed,

suggesting that leftist governments were less willing to accommodate supply shocks after 1983/2 than they had been before this period. The one exception to this general pattern is the CBI variable; here the interactive term suggests that cross-national variation in central bank independence explains more of the cross-national variation of inflation after 1983/2 than it did in the previous period. These findings are consistent with the capital mobility hypothesis: the exchange rate appears to have been endogenous to monetary policy preferences in both France and Italy until the middle of 1983, at which point domestic monetary developments became endogenous to the exchange rate. Page 89 →TABLE 6. The Domestic Politics of Inflation; France, Germany, Italy, and the United Kingdom, 1971–91 Variable Name Parameter Estimate LAGGED INFLATION

OIL

LABOR

F-test for joint significance of labor lags CBI LEFT STABILITY

0.53*** (13.37) 0.10*** (8.67) 0.000002** (2.18) 0.000002*** (2.73) 0.000002** (2.17) F value 12.31 P>F0.0001 -0.07*** (4.73) 0.012*** (2.60) -0.002*** (6.08)

-0.000005 (1.26) -0.000005 E2LABOR (1.40) -0.000004 (0.05) -0.02* E2CBI (1.88) -0.16* E2LEFT (1.93) 0.002*** E2STABILITY (3.12) -0.009 EMS2 (0.64) F-test for joint significance of EMS2 F value 4.56 variables p> F 0.0001

Adjusted R-squared

0.86

N

287

Note: Dependent variable is GDP deflator. Method of estimation is OLS. All data are annual. * indicates significance at .10 level ** indicates significance at .05 level *** indicates significance at .01 level Page 90 → 2. Expanding the Analysis To assess whether the time break identified in the previous analysis was restricted to these four countries or was a more general phenomenon of European monetary policies, I tested the political model against a second data set constituting a larger sample of countries. I extended the cross-section to include six additional European countries (Austria, Belgium, Denmark, the Netherlands, Norway, and Sweden), three of which were not members of the European Community at the time.3 The LABOR variable is two standard measures of labor organization, union density and union centralization, taken from Cameron (1984) and Visser (1991; 1990; 1989). The specification relied upon here is one in which the interaction between union centralization and union density is expected to be associated with wage moderation and fewer wage shocks. PARTY is coded on a five-point scale, with right-wingdominated governments coded as 1 and left-wing dominated governments coded as 5; we should thus expect a positive relationship between this variable and inflation. Government stability is measured as type, with singleparty majority coded 1 and caretaker governments coded as 6, and we again expect a positive relationship between government type and inflation. Both the PARTY and the STABILITY Variables come from Woldendorp, Keman, and Budge (1993). Finally, CBI is the same Cukierman index relied upon in the previous analysis. All data are annual and cover the period 1968–90. As in the previous data set, I estimated the model in unconstrained form using OLS and F-tests to test for pooling. The F-tests suggested two things: first, at standard levels of significance the countries pooled. Second, France and Italy were marginal poolers, with F-tests suggesting an improvement of fit at the .10 level of significance if the parameters for the political variables in both countries are allowed to vary from the pool. This suggests that processes in France and Italy were different from those prevailing in the rest of the sample, a finding consistent with the findings of the previous model, but not sufficiently different to prevent a pooled analysis.4 The results are presented in table 7. The analysis suggests two things. First, the domestic political variables perform quite well in this estimation. With only one exception, central bank independence, the political variables are statistically significant and correctly signed. The CBI variable, while correctly signed, failed to return a t statistic sufficiently large to reject the null hypothesis. This may reflect problems with the indicator (Oatley forthcoming). Comparisons of realized and predicted inflation rates suggested that the model overpredicts inflation for three countries—Germany, the Netherlands, and Denmark—all of which have relatively independent central banks, if the CBI parameter is omitted. Including the CBI Page 91 →parameter in the predicted inflation equation for these countries removes the systematic overprediction. Second, while the EMS dummy suggests that EMS membership had a negative and statistically significant impact on inflation, the political variables displayed no evidence of a significant time break. Testing for a time break in the larger sample was done in the same way as in the first model. Time break interactive terms, in which time break dummies interacted with the political variables, were placed in the model and F-tests were used to determine whether these improved the fit of the model. The dummies were coded as zero for all countries for all years up until a given year and then coded 1 in the following years for those countries that were members of the EMS; thus, the time breaks exclude those countries that were not formal members of the EMS.5 Four time breaks were tested—one in 1979 at the start of the EMS, one in 1983; the year at which the smaller sample yielded a significant break; and one on either side of this year (1982 and 1984). None of these

interactive time breaks was significant. The absence of significant time breaks in the large sample, in conjunction with the recognition that France and Italy were marginal poolers with the other members of the larger sample, suggests that the time break found in the smaller sample shows up in the larger sample as relatively high F values on the French and Italian interactive terms. TABLE 7. The Domestic Politics of Inflation in Western Europe, 1968–90 Variable Name Parameter Estimate UNIONCNT*UNIOND -0.009 (1.60) UNIONCNT 0.01 (0.04) UNIOND 0.08 (2.08) F-test for Labor Variables F Value: 2.90 Prob > F 0.04 PARTISAN 1.04*** (3.07) STABILITY 1.34** (2.08) CBI -2.01 (1.34) EMS -0.91* (1.92) R- Squared Adjusted R-Squared N

.61 .59 209

Note: Dependent variable is GDP deflator. Method of estimation is OLS. All data are annual. * indicates significance at .10 level ** indicates significance at .05 level *** indicates significance at .01 level Page 92 →Thus, while inflation was lower, on average, under the EMS than it had been during the 1970s, the relationship between domestic political-institutional variables and inflation did not change across the two periods. Thus, we can qualify the findings from the first model; as will be further elaborated, domestic politics drove much of the cross-national and longitudinal variation in European inflation during the 1970s and 1980s. Only in France and Italy does the relationship between domestic political-institutional variables and inflation that caused high inflation in the 1970s and early 1980s weaken. That is, only in France and Italy do we find evidence consistent with the capital mobility hypothesis. 3. The Domestic Politics of Inflation and Nominal Exchange Rate Stability The statistical analyses enable us to develop a reasonably comprehensive portrait of the political processes that drove nominal divergence and convergence within the Community between the late 1960s and the late 1980s. In the early part of the 1970s Community countries experienced dramatically similar wage and oil shocks. Labor

markets were the first source of shocks, as real wages increased sharply at the end of the 1960s and continued to register large annual increases in the early 1970s (fig. 5). The oil shock in 1973–74 gave the downward pressure on profitability that had begun with wage shocks’ greater force. The combination of wage and energy price increases had a dramatic effect on industry profitability, which began to fall in the early 1970s and then fell even more sharply in the wake of the first oil shock and the wage reactions to this shock (fig. 6). These shocks transferred a large portion of national income to labor: the adjusted wage share drifted up in the first half of the decade (fig. 7). While all countries experienced similar shocks, the extent to which they were translated into persistent inflation varied both across countries and across time in accordance with variation in political-institutional factors (table 8). In Germany any desire by the Socialist government to accommodate these shocks was counteracted by the Bundesbank’s refusal to accept the inflationary implications of the wage and energy shocks. Thus, in Germany, while the shocks created inflationary pressure, it was quickly brought under control, real wage growth slowed, and profitability recovered relatively quickly. Given the German response, nominal exchange rate stability within the Community depended upon the willingness and ability of other policymakers’ to respond in a similar fashion. Only in the Netherlands did this occur. In the Netherlands a centrist coalition government could draw on wellorganized labor markets and a relatively high degree of central bank independence to prevent the shocks from creating persistent inflationary pressure. While Dutch inflation did not subside as quickly as did German inflation, it came down more quickly than in the other countries, and the guilder/D-mark rate was quite stable. Page 93 → Fig. 5. Real wage growth, 1967–87 Page 94 → Fig. 6. Profitability of fixed capital, 1967–87 Page 95 → Fig. 7. Adjusted wage share, 1967–87 Page 96 →Policymakers in Denmark appear to have tried to steer a middle course—neither full accommodation nor full restriction. This response was shaped by a strongly leftist government that fluctuated between single-party majority and minimum winning coalition status, a high degree of corporatist organization that largely prevented real wage increases in the wake of the first oil shock, and a relatively high degree of central bank independence. The leftist government appears to have traded a commitment to avoid a strongly restrictive monetary policy in exchange for a labor commitment to wage moderation. As a result, real wage growth slowed and profitability recovered quickly. The nominal exchange rate was the victim of this response, however, as the persistent DanishGerman inflation differential required a continual devaluation of the Kroner. The halfway response to the shocks was reversed beginning in 1982–83, as a single-party majority rightist government replaced the leftist government. With a government both committed to price stability and lacking coalitional constraints on its ability to implement monetary restriction, real wages continued to grow very slowly, inflation came down quickly after 1982, industry profitability began to recover, and the nominal exchange rate stabilized. Policymakers in Belgium, France, and Italy fully accommodated the shocks. In all three countries labor kept upward pressure on real wages throughout the 1970s, and policymakers, working in coalition governments and lacking independent central banks, simply lacked the ability to respond to this pressure with monetary restriction. As a result, real wages continued to grow throughout the decade, there was a larger transfer of national income to labor than in the other countries (except in Italy), and profitability dropped much more sharply than in the other countries. With industry seeking to restore profit margins, labor trying to defend its gains, and policymakers being accommodating to avoid unemployment, wage-price spirals emerged. The severity of these cycles varied across the three countries, with Italy experiencing the most severe problems, Belgium the least severe, and France a middle position. In all three countries the resulting persistent inflation differentials with Germany were dealt with through continual devaluation. Page 97 →TABLE 8. The Domestic Politics of Inflation in the European Community, 1972–87 Page 98 →Policymakers in all three countries embarked upon disinflation in the early 1980s. The Belgian adoption of monetary restriction paralleled developments in Denmark: the centrist coalition that had governed during most of the 1970s was replaced by a rightist single-party majority government in 1982. Preferring price stability and facing few coalition constraints on its implementation, Belgian policymakers slowed real wage

growth, thereby allowing industry to restore profitability and inflation to come down. As inflation came down, the inflation gap with Germany narrowed, and the Belgian franc stabilized against the mark. Policymakers in the two remaining high-inflation countries, France and Italy, also achieved disinflation in the 1980s. Real wage growth slowed, industry profitability recovered, income was redistributed away from labor toward industry, the inflation gap with Germany narrowed, and the nominal exchange rate stabilized. Unlike Belgium and Denmark, however, and as highlighted by the statistical analysis, there are no clear domestic political explanations for these developments. In France the political changes point in the direction of higher, not lower, inflation. The rightist government was replaced by a leftist government in 1981, while the other political and institutional variables remained unchanged. Thus, in France we would expect a widening of the inflation gap rather than a narrowing. In Italy the rightist government was replaced by a Right-Center coalition, but no other political institutional variables change to a degree sufficient to explain the disinflation. Thus, while much of the stabilization of nominal exchange rates during the 1980s was driven by domestic politics, monetary policies in France and Italy are exceptions to this pattern. In sum the pattern of inflation generally conformed to the model developed in chapter 2. Labor market organization was important in generating wage shocks and in translating exogenous shocks into inflationary pressures. In addition, policymakers’ domestic monetary objectives conformed to the models’ expectations; leftist policymakers and coalition governments accommodated wage and energy shocks, while rightist policymakers and independent central banks responded to these shocks with monetary restriction. Moreover, the nominal convergence upon which nominal exchange rate stability was based was driven by pro-industry governments that were using monetary restriction to reverse the distributional consequences of the wage and energy shocks of the 1970s. For these policymakers nominal exchange rate stability imposed few costs, because a peg to the deutsche mark provided a stable nominal anchor to guide the process of disinflation and was thus fully consistent with policymakers’ domestic objectives. Potential benefits would derive from Page 99 →policymakers’ ability to make a credible commitment to the exchange rate (Giavazzi and Pagano 1987; Giavazzi and Giovannini 1989). If labor and capital viewed policymakers’ commitment to the exchange rate as credible, then industry would have much less incentive to concede large real wage increases, as they would no longer be devalued away, while labor, seeing that large real wage increases would translate into higher unemployment, would have much more incentive to practice wage moderation. Thus, a fixed exchange rate with the Bundesbank would not only provide a useful guide to disinflation, but it could also reduce inflationary expectations and thus reduce the output and employment costs of disinflation. In sum monetary policy outcomes remained highly responsive to domestic politics. This suggests that capital mobility did not drive the process of nominal convergence. At most, capital mobility reinforced preexisting commitments to price stability. France and Italy, however, stand out as exceptions to this pattern. The relationships between domestic political processes and monetary policy outcomes that characterized monetary policy in France and Italy during the 1970s and early 1980s either ceased to exist or were significantly reduced after 1983. Thus, while the domestic politics hypothesis explains much of the monetary convergence within the Community during the 1980s, policymakers in France and Italy stopped treating the exchange rate as endogenous to their politically determined monetary policy objectives and, instead, set domestic monetary developments endogenous to the exchange rate constraint. The remainder of this chapter, and the entire next chapter, seek to assess why, and how, they did so.

C. Nominal Convergence in France and Italy: A Closer Look at the Capital Mobility Hypothesis Was the shift in French and Italian monetary policies in 1983 caused by capital mobility? The capital mobility hypothesis states that, with a fixed exchange rate and perfect capital mobility, the domestic interest rate, and thus monetary policy, is fully determined by the world interest rate. According to this hypothesis, the French and Italian shift to monetary convergence after 1983 resulted from the inability of French and Italian policymakers to pursue monetary policies that diverged from the Bundesbank. To assess this hypothesis I examine two types of evidence: evidence on exchange rate fixity within the EMS; and evidence on the effect of capital controls on French and Italian onshore-offshore interest rate differentials. This evidence does not provide strong support for

the capital mobility hypothesis, suggesting that the shift to exchange Page 100 →rate fixity and capital mobility in both countries followed rather than led nominal convergence. Evidence on exchange rate fixity within the EMS suggests that French and Italian policymakers shifted to a “fixed” exchange rate system only in the late 1980s, i.e., only after they had achieved a substantial degree of nominal convergence. Between the implementation of the EMS in March 1979 and January 1990 EC policymakers realigned the exchange rate mechanism eleven times, an average of once per year. These realignments, however, were not spread evenly across this period. Between February 1979 and March 1983, the period in which intra-Community inflation differentials widened, the EMS was realigned seven times, an average of just fewer than two realignments per year. Between April 1983 and January 1987 the period during which policymakers achieved much of the nominal convergence, the exchange rate mechanism was realigned four times, an average of one realignment per year. Finally, between February 1987 and the end of the decade, the period in which nominal convergence was consolidated, the exchange rate mechanism was never realigned.6 Thus, rather than leading the process of nominal convergence, as the capital mobility hypothesis would suggest, exchange rate fixity followed the convergence process: in periods when economies were diverging, policymakers relied upon realignments to offset the real appreciation of their currencies caused by inflation differentials; policymakers accepted a higher degree of exchange rate fixity only as nominal convergence progressed. Exchange rate flexibility implied that the capital mobility constraint was lessthan-fully binding and that French and Italian policymakers retained a degree of monetary autonomy. According to theories of balance-of-payments crises, policymakers should not have been able to realign the exchange rate mechanism (Krugman 1979; Obstfeld 1984). As Wyplosz notes, the two main results of the balance-of-payments crisis literature is that a foreign exchange crisis will take place in anticipation of a given currency’s devaluation, and, because the crisis will exhaust a central bank’s foreign exchange reserves, it will be followed by a period of floating (1986: 168). The logic behind these results lies in the operation of the financial markets. When a currency is devalued, those who hold assets denominated in that currency experience a capital loss. Since financial agents are endowed with rational expectations, they will sell all assets denominated in a given currency as soon as they expect that currency to be devalued. These massive sales create an exchange market crisis, and, if sales of assets denominated in the devaluing currency are unlimited, the country’s central bank will lose all of its Page 101 →reserves and be driven out of the foreign exchange markets. The currency must be allowed to float (Wyplosz 1986). In short, in the presence of monetary divergences and perfect capital mobility a system of fixed-but-adjustable exchange rates cannot be sustained through periodic realignments. French and Italian policymakers were able to escape this problem and devalue their currencies inside the EMS rather than float outside because they relied extensively on capital controls until the late 1980s (see Giavazzi and Gio-vaninni 1989; Wyplosz 1986, 1988; Ungerer et al. 1990). In both countries a process of cautious liberalization of the capital account that had begun in the 1960s was reversed in the early 1970s. In Italy portfolio investment was effectively prohibited by the introduction of a “zero-interest deposit requirement equal to fifty percent of the value of [the] foreign investment. This regulation lasted until 1987 and made it virtually impossible for an Italian resident to acquire foreign assets” (Giavazzi and Giovannini 1989: 165–66). Italian authorities also prohibited lending by residents to nonresidents, and between July 1984 and December 1985 they also prohibited foreign borrowing by domestic banks. The Italian authorities also imposed controls on trade finance. As Giavazzi and Giovannini explain, “with portfolio investment . . . ruled out, the only way for domestic residents to trade in foreign assets [was] through the financing of trade. By extending or shortening the maturity of trade credits, exporters and importers can increase or reduce their holdings of foreign assets” (1989: 165). To limit outflows of capital through this channel the Italian government limited the length of trade credits and used forced financing of trade credits. These controls were removed only beginning in 1988 in conjunction with the creation of an integrated European financial market, and it was not until 1990 that Italy abolished all capital controls and exchange restrictions (Ungerer et al. 1990:35). French policymakers also relied quite extensively on controls on both portfolio investment and trade finance. Throughout much of the postwar period French citizens could purchase foreign assets only from other French citizens (the devise titre system), a control that effectively capped the stock of foreign assets held in France. While

removed in 1971, the devise titre was reintroduced by the Socialist government in 1981. In addition, French residents were prohibited from lending to nonresidents, and their ability to borrow from abroad was also subject to regulation. In addition to controls on portfolio movements, the French government also controlled trade finance; the maturity of export credits was limited and quite short, while importers were limited in the amount of credit they could offer foreign suppliers (Giavazzi and Giovannini Page 102 →1989: 165). Like the Italians, the French liberalized the capital account only in the late 1980s. French and Italian capital controls did not prevent capital outflows but, instead, placed an “upper bound” on how much capital could leave in times of crisis. That capital controls conserved reserves in times of expected devaluation is evident in data on interest rates. Table 9 presents evidence on onshore-off-shore interest rate differentials for France, Italy, and the Netherlands, a country that did not rely on capital controls, taken directly from Giavazzi and Giovannini (1989). Using weekly data for the period November 1980 through December 1987, Giavazzi and Giovannini measured the extent to which exchange controls created arbitrage opportunities—either an opportunity for borrowing in the domestic market and buying a deposit in the euromarket, an opportunity that arises when domestic rates are lower than euromarket rates, or an opportunity for borrowing in the euromarkets and investing in the domestic market, an opportunity that occurs when domestic rates are higher than euromarket rates. If the French and Italian domestic capital markets had been fully open, arbitrage operations would have eliminated any possibility for profit from borrowing in one market and lending in another, and rates of return would have been equalized. In the French case, however, we observe a positive differential in favor of the euromarkets in over 80 percent of the cases, an advantage for domestic markets in 5 percent of the cases, and no difference between the two in 15 percent of the cases. Findings for the Italian case are quite similar; there is an incentive for arbitrage, either outward or inward, in 50 percent of the cases, and the incentive was more often in favor of outward movement (30 percent) than for inward movement (20 percent). Contrasted with the Netherlands, these differentials are quite large: in the Dutch case opportunities for arbitrage occurred in less than 1 percent of the entire sample, a finding that suggests that “in the absence of exchange controls, uncovered interest parity between the onshore and offshore rates always holds” (Giavazzi and Giovannini 1989: 176). Giavazzi and Giovannini also divided their sample into two periods to assess the role of exchange controls in times of realignment. Their first subsample covers the period between October 1983 and March 1983—a period in which both the franc and the lira were under considerable pressure in the markets. Their second subsample covers April 1983 through November 1985, a more stable period in which there were no realignments of either the lira or franc. These subsamples suggest how important capital controls were during pre-realignment periods. In the first period exchange controls enabled the French authorities to hold domestic interest rates below euromarket rates by an average of 7.2 points throughout the entire period and enabled Italian authorities to keep their domestic interest rates below euromarket rates by an average of 3.2 points in more than 90 percent of the period. In the period of relative calm the percentage of cases in which arbitrage opportunities were absent was much larger, rising to just less than 60 percent of the weeks in the Italian case and to just less than 20 percent of the weeks in the French case. Again, the Netherlands stands in stark contrast to both France and Italy, as arbitrage opportunities were consistently lacking in both periods.7 Page 103 →TABLE 9. Onshore-Offshore Interest Rate Differentials (November 1980–December 1987) Page 104 →Capital controls that “bit” during speculative attacks were fundamentally important (Wyplosz 1988; Giavazzi and Giovannini 1989). While these controls did not prevent capital outflows, they did reduce the size of capital outflows relative to the amount of capital that would have exited, given the monetary stance, without controls. This upper bound, in turn, gave policymakers time to organize exchange rate realignments and allowed French and Italian central banks to conserve the reserves needed to defend their currencies’ new parities. Thus, as Von Hagen and Fratianni (1992) found, French and Italian policymakers enjoyed a large degree of monetary independence inside the EMS. The use of capital controls to facilitate realignments, and the use of realignments to restore competitiveness in the face of persistent inflation differentials, imparted medium-term monetary independence to French and Italian policymakers. Thus, the capital mobility hypothesis appears not to explain the sharp change in French and Italian monetary

policies previously identified. The two elements of the Mundell-Fleming trilogy that would strip French and Italian policymakers of monetary autonomy, capital mobility and exchange rate fixity, were themselves treated as choice variables by French and Italian policymakers. Until mid-1983 French and Italian policymakers treated nominal exchange rates as endogenous to domestic monetary objectives, and inconsistencies between these domestic objectives and German monetary policy were reconciled by adjustments of the exchange rate mechanism. Realignments, in turn, were facilitated by reliance on capital controls that reduced reserve losses from speculative attacks. The resulting exchange rate flexibility provided French and Italian policymakers a degree of monetary autonomy with which to pursue their domestic monetary objectives. French and Italian policymakers reduced their reliance on both mechanisms only after the 1983 monetary shift brought about a relatively high degree of convergence. In short the two aspects central to the capital mobility hypothesis—exchange rate fixity and capital mobility—followed, Page 105 →rather than led, the adoption of convergent monetary policies and therefore cannot be offered as an explanation for this convergence.

D. Conclusion We thus conclude this chapter with a bit of a puzzle. We have established a comprehensive picture of how Community policymakers stabilized nominal exchange rates within the framework established by the European monetary system. The operation of the EMS was based on the interaction of two factors. First, Bundesbank policymakers managed to translate the institutions they shaped in 1978 into an exchange rate system that imposed few constraints on their ability to manage monetary conditions in Germany. As a result, the stabilization of intraCommunity exchange rates depended upon the willingness and ability of other Community policymakers to adopt and implement monetary policies that converged toward German monetary conditions. Second, domestic political considerations drove the willingness and ability of Community policymakers to adopt and implement convergent monetary policies. Throughout much of the Community policymakers for whom price stability was consistent with their monetary policy preferences rose to power in the early 1980s. The emergence of this “price stability” consensus yielded monetary policies that, over the course of the decade, both reduced the average level of inflation within the Community and narrowed the gap between the best and the worst performer. In short the stabilization of nominal exchange rates within the EMS was based on the emergence of a widely shared political consensus on the merits of price stability. French and Italian policymakers, however, stood out as exceptions to this general pattern. In the late 1970s and early 1980s domestic political processes in France and Italy yielded configurations that made policymakers either unwilling to adopt or unable to implement stability-oriented monetary policies. As a result, inflation rates between Italy and France on the one hand and the Community on the other diverged, and the franc and lira were relatively weak within the EMS. After mid-1983, however, the domestic political processes that had shaped monetary developments in France and Italy during the previous eleven years, and which continued to shape monetary developments throughout the rest of the Community, ceased to determine French and Italian monetary policies. The evidence on the capital mobility hypothesis suggested that capital mobility was not the primary cause of this shift; French and Italian policymakers relied quite extensively on capital controls and exchange rate realignments Page 106 →to preserve monetary autonomy. Thus, while French and Italian policymakers joined the price stability consensus in 1983, we lack an explanation for why and how they managed to do so. Appendix A: Variable Codings and Data Sources Data Set 1

LABOR. Most studies of labor market organization have relied upon measurements of institutional characteristics, in particular union density and the degree of union centralization. While such an approach is appropriate for large cross-sectional analysis, and perhaps even for time series analysis that looks at period averages, this study’s more limited cross-section and quarterly data require an alternative approach that provides a bit more variation. I rely, instead, upon a behavioral indicator of labor-capital conflict: strike data. The assumption here is that the more labor and capital conflict over real wages, the greater will be the number of strikes, and we thus expect a positive sign on this coefficient. Strikes are measured as thousand person hours lost per quarter as a result of work

stoppages, and the data are taken from OECD historical statistics series. PARTISAN. The partisan variable is measured here as it has been measured in many other studies—the percentage of cabinet seats held by leftist parties. Placement of parties on the Left-Right dimension was based on Laver and Schofield 1990. Governments in which leftist parties held a larger number of cabinet seats receive a higher score on this measure, and thus we expect a positive sign on the coefficient. Data on cabinet composition was compiled from Keesings Contemporary Archives. STABILITY. As in measuring labor-capital conflict, the basic choice in measuring government stability is between an institutional measure, either electoral systems or single-party majority versus multiparty coalitions, or a behavioral measure. While an institutional approach might be appropriate for a study with a large cross-section, this study’s primary focus on longitudinal variation necessitated a behavioral measure of government stability. The approach adopted here is a measure of government duration aimed at capturing the extent to which an existing government did or did not possess a coherent policy objective. Based on the assumption that government longevity is endogenous to the government itself, short-lived governments are likely to be those in which coalition partners held opposing preferences, and these opposing Page 107 →policy preferences are what led the government to collapse. Conversely, long-lived governments are likely to be those in which there is a fairly stable consensus within the ruling group, be this a single party or multiple parties, on the direction of policy. Thus, coding each government quarter as the number of quarters the government survived captures that government’s underlying ability to adopt and implement a specific monetary policies. We should expect a negative sign on the coefficient of this variable—longer-lived governments should be associated with lower inflation. In any measure of government duration one needs to adopt a standard by which to assess whether there has been a change in government. I used the following rules: the longest possible tenure for any government was the maximum length of the parliamentary term (i.e., twenty quarters), and the postelection government was coded as a new government, even if it was exactly the same as the government in the preelection period. For governments that lasted less than a full parliamentary term a government change was considered to have occurred any time that an existing government was dissolved and negotiations over the creation of a new government ensued. The second condition differs from that adopted by other studies that have coded a new government only if the government that is formed after the existing coalition is dissolved is led by a new prime minister or composed of a large number of new cabinet ministers. While this may be a better measure of change in government, it is not as good a measure of government stability, because ignoring the collapse of coalitions that are ultimately reformed because of the absence of feasible alternatives will overstate the extent to which the existing coalition is able to work together. Data on government changes was compiled from Keesings Contemporary Archives. CBI. Central bank independence is measured with an index created by Cukierman (1991). While other indices exist, the Cukierman index is the most comprehensive. It is based on fourteen attributes taken from four broad categories of central bank institutions: the chief executive officer, the process of policy formulation, the determination of the bank’s final objectives, and legal constraints on the bank’s lending. The index itself is based on each central bank’s average score on each of these fourteen attributes. High index numbers indicate a high level of central bank independence, and, thus, we expect a negative sign on this coefficient. INF. GDP deflator. Data from the International Monetary Fund’s International Financial Statistics. OIL. National indices of energy prices. Data from OECD historical statistics. Page 108 → Data Set 2

Union Centralization. Cameron’s (1984) measure of union centralization Union Density. Visser’s (1991; 1990; 1989) measure of union membership as a percentage of total labor force. TYPE. Number of parties participating in government and their parliamentary status. Taken from Woldendorp,

Keman, and Budge 1993.

1 = Single-Party Majority 2 = Minimal Winning Coalition 3 = Surplus Coalitions 4 = Single-Party Minority 5 = Multiparty Minority 6 = Caretaker Government PARTISAN. Ideological complexion of government that accounts for relative strength of parties in government with reference to a five point Left-Right scale in which the proportional shares of the Left, Center, and Right are transformed into scores (1 to 5) representing the degree of dominance of either party both in parliament and government. Taken from Woldendorp, Keman, and Budge 1993. 1 = right-wing dominance (share of seats in government and party support in parliament larger than 66.6 percent) Right-Center complexion (share of seats of Center and Right parties in government and in parliament 2= between 33.3 percent and 66.6 percent) balanced situation (share of Center larger than 50 percent in government and in parliament or, if Left and 3= Right, form a government together not dominated by one side or the other) Left-Center complexion (share of seats of Left and Center in government and in parliament between 33.3 4= percent and 66.6 percent) 5 = left-wing dominance (share of seats in government and parliament greater than 66.6 percent). Other variables as in data set 1.

Page 109 →

CHAPTER 5 Exploring French and Italian “Exceptionalism”: Implementing Monetary Restriction in the EMS European monetary policies have followed an identifiable pattern: monetary responses to exogenous shocks have been shaped by partisan preferences and domestic institutions. Leftist governments and coalitions accommodated shocks while rightist single-party majority governments and independent central banks adopted nonaccommodating responses. Thus, domestic politics largely drove the stabilization of nominal exchange rates during the 1980s. Italy and France stood out as exceptions to this general pattern, however, as the traditional patterns of monetary policy weakened in both countries after 1983. In France the Socialist government adopted and implemented a price stability orientation in March 1983, while in Italy a government committed to price stability, but beset by uncooperative labor relations, unstable coalitions, and a politically subordinate central bank, also implemented a stability-oriented monetary policy. Thus, monetary restriction in France and Italy poses a puzzle: why, and how, did governments that we would not expect to have either the willingness or the ability to implement stability-oriented monetary policies do so? While the capital mobility hypothesis is an obvious candidate explanation of this shift, further examination of this hypothesis in the case studies confirms the conclusions drawn in chapter 4. Capital mobility imposed an important constraint on French and Italian policymakers’ ability to conduct independent monetary policies only to the extent that they embraced the fixed exchange rate commitment embodied in the European monetary system. Yet policymakers in both countries relied on capital controls and exchange rate realignments to Page 110 →gain a substantial degree of monetary autonomy, and the monetary policies they adopted in the early 1980s varied considerably from those pursued in Germany. Full acceptance of the external constraint came only after each had shifted to restrictive monetary policies and after each had achieved a substantial degree of nominal convergence. Thus, neither French nor Italian policymakers were forced by capital mobility to adopt monetary restriction; they chose to do so. Monetary restriction was adopted by French and Italian policymakers who had a preference for price stability. These policymakers saw price stability as part of the solution to the investment problem confronting their respective economies. The increase in real wages during the 1970s, in conjunction with the twin oil shocks, caused a decline in industry profitability, and, as profits fell, investment dropped off, and unemployment increased. The solution to the investment problem, according to an important subset of policymakers in both countries, lay in reducing industry’s unit labor costs. Driving down unit labor costs required a combination of real wage stabilization and productivity improvements, but, since productivity improvements depended upon investment, initial steps had to focus on real wages. Thus, monetary restriction was advocated as a global constraint upon labor-capital wage bargaining. A commitment to price stability forced industry to recognize that large real wage increases would further erode profits and force labor to recognize the linkage between excessive real wage settlements and unemployment. The result would be the stabilization of real wages, a reduction of inflationary pressure, and, it was hoped, an increase in productive investment. While French and Italian policymakers chose to adopt and implement stability-oriented monetary policies, they used EMS institutions to do so. It was hypothesized in chapter 2 that EMS institutions could help stabilityoriented policymakers achieve their desired monetary policy outcomes by relaxing constraints at both the Community and domestic levels. At the Community level EMS institutions, by providing exchange rate flexibility through realignments, could allow policymakers to reconcile inflationary monetary policies with EMS membership. This flexibility would give stability-oriented policymakers time to construct domestic coalitions in support of price stability without forcing them to lose the benefits of EMS membership while they did so. At the domestic level EMS institutions could remove two important political constraints on disinflation and thus help

policymakers build support coalitions. First, by linking the issues of price stability and European integration, the EMS could facilitate the construction of domestic coalitions in support of price stability that would not have been possible without this linkage. Thus, the EMS could relax Page 111 →the constraint on disinflation imposed by domestic coalition politics. Second, the EMS provided a convenient scapegoat to blame for the costs of disinflation. Scapegoating would enable policymakers to avoid facing the full political consequences of adopting monetary policies that cut against their constituency’s short-term interest. Thus, the EMS could relax the political constraint imposed by the costs of disinflation. French and Italian policymakers used EMS institutions in the manner these hypotheses suggest they would. They realigned their exchange rates frequently, escaping the need to choose between exiting the system and adopting monetary policies for which they lacked political support. In addition, the French price stability faction relied heavily upon the EMS to link choices about monetary policy to choices about European integration to construct a majority coalition at home and try to deflect blame for the resulting monetary restriction onto both the Bundesbank and the general demands of EC membership. External strategies were less effective in the Italian case, but the exchange rate constraint embodied in the EMS did enable the Banca d’Italia to exercise greater control over monetary developments than it could have without the commitment and provided a justification for monetary restriction. In sum stability-oriented policymakers in France and Italy used the EMS to adopt and implement monetary policies that they would not have been able to adopt otherwise.

A. The French Socialists, the EMS, and the Battle for Monetary Policy The Socialist about-face is by now a familiar story (Muet 1985; Cameron 1988; Loriaux 1991; Goodman 1992). Following the 1981 elections the Socialists launched a classic Keynesian expansion within a recessionary international economy. The combination of expansion at home and recession abroad led to balance-of-payments problems, and, in response to these developments, the Socialists adopted a fairly classic package of austerity measures. Thus, the generally accepted story argues, the constraints imposed by international interdependence forced the Socialists to drop the set of policies to which they were ideologically committed and fall in line with the policies being pursued in the rest of the industrialized world. While such a depiction is descriptively accurate, it is ultimately unsatisfactory as an explanation for this aboutface; it assumes that the constraint imposed by the international economy was exogenously imposed rather than endogenously chosen. Yet, as we saw in chapter 4, and as we will see here, the Page 112 →Socialists relied upon capital controls and exchange rate realignments to gain monetary autonomy between 1981 and March 1983, and there was considerable Socialist support for an alternative response to the balance-of-payments problem: withdrawing the franc from the EMS to facilitate exports and introducing protectionist measures to reduce imports. It was not until the week of the March 1983 franc devaluation that Mitterrand decided to reject this approach. Thus, to understand the about-face we need to explain why and how the Socialists chose to embrace the international “constraint” rather than seeking to reduce it. 1. The Expansionists in Power The Socialist Party that came to power in May 1981 faced an acute crisis in the French economy. The oil and wage shocks that hit French industry in the late 1960s and throughout the 1970s had a dramatic impact on industry profitability, which by 1980 stood at postwar lows, both in the economy as a whole and in the private sector (table 10). The dramatic fall in industry profitability had led to a sharp contraction of productive investment in the French economy, which during the 1970s had increased at an annual average rate of only 2.3 percent, compared with an average annual rate of increase of 7.8 percent during the 1960s.1 Decreasing investment was, in turn, affecting French competitiveness and French employment. As the French industrial plant aged, French industry was losing its ability to compete against foreign industry in both the home and external markets. As competitiveness declined, French unemployment began to increase, marking a steady growth throughout the 1970s. If the Socialists were to improve the performance of the French economy and bring unemployment down, they would have to increase investment.

While the Socialist Party was unified on the need to take steps to increase investment, its members were far from united on the strategy to adopt to achieve this objective. Born in the early 1970s from the remnants of the declining SFIO, the Socialist Party had sought to be as inclusive of leftist currents as possible to present a strong challenge to Gaullist dominance (Lewis and Sferza 1988). Two factions defined the extremes of the Socialist Party. On the left was the CERES (Centre d’Etudes de Recherches et d’Education Socialistes) group, led by JeanPierre Chevènement. The CERES faction believed that the international economy was undergoing two fundamental transformations: increasing integration dominated by the capitalist mode of production; and a crisis of capitalism caused by the surplus accumulation of capital. The emerging global division of labor was yielding intensified competition that only the fittest firms Page 113 →would survive. Governments that participated in this global division of labor would be forced to give priority to only the most promising industries and accept the decline and eventual loss of weaker industries (Hanley 1983: 106–7). CERES policy prescriptions aimed to prevent the loss of traditional heavy industry by recapturing the French domestic market, by nationalizing the banking sector and the large French industrial groups, and by using state control of banking and industry to direct investment toward the modernization of uncompetitive domestic industries. Such an economic strategy necessarily conflicted with European integration; CERES saw the European monetary system as a constraint that forced France to follow the German monetary policy line and spoke of the need to renegotiate the Rome Treaty to allow France to regain national sovereignty (Hanley 1983: 110). The “second left” (le deuxième gauche) defined the right end of the Socialist dimension. Made up of the social democrats, led by Michel Rocard, who had defected from the PSU (Unified Socialist Party) to the Socialist Party in 1974, and Jacques Delors and his supporters, the second left promoted a very different solution to the investment problem. The second left was much more market oriented than was the CERES group. Drawing on the Scandinavian model as an example, the Rocard faction wanted to use selective intervention and cautious reforms to both modernize and energize the French economy while protecting the weakest members of society, an approach criticized by the CERES group as a leftist Barrism (Bauchard 1986: 11–19; Bell 1983: 51). While not a member of any of the Socialist currents, and perhaps best categorized as belonging to the Christian Left, Delors would prove to be the most vocal member of the party’s right wing. Having worked in the foreign exchange department of the Banque de France for the first seventeen years of his professional life, and having briefly taught economics at the University level, Delors believed markets to be indispensable for the allocation of resources. Yet, as he saw it: TABLE 10. Index of Profitability of Fixed Capital Stock: France and Italy, 1971–86 Page 114 →the market by itself could not . . . guarantee equity, a moralized social order, or full economic success. These things depended upon “dialogue” among different groups—employers and labor in particular—to reach clear understandings of mutual needs about what had to be done and what could be shared. Labor had a stake in economic success and thus good reasons to accept certain responsibilities. Employers had an interest in the predictability that labor’s acceptance of these responsibilities would bring. “Dynamic compromise” based on persistent discussion between different groups would be the secret of success It was not the state’s job to decide for others, but to facilitate negotiations among social partners. (Ross 1995: 18) Delors thus wanted the state to construct mechanisms that enabled labor and capital to reach sustainable wage agreements—agreements that, over the long run, ensured that real wages grew in line with productivity improvements and, in the short run, effectively stopped the growth of real wages to allow industry to rebuild profitability.2 For the second left the European Community was not a problem but, instead, part of the solution to French economic difficulties; as Rocard told Socialist Party delegates to the Metz Congress in February 1979, “the necessary line of resistance to American imperialism is to be found today at the continental level” (Hanley 1983: 109). Pierre Mauroy’s faction played a mediatory role between the CERES and second left factions (Bell 1983: 54). On economic policy Mauroy and his supporters shared the CERES group’s beliefs in the need for a radical break from the capitalist mode of production, a positive role for state intervention, and skepticism of market-based solutions. At the same, however, the Mauroy faction, like the social democrats, was supportive of the general line of French

external relations as they had developed in the postwar period and, in particular, advocated continued European integration. Thus, the Mauroy faction stood somewhat uneasily between the two wings of the party, trying to integrate the two factions in the interest of Socialist Party unity. Page 115 →While both wings were represented in the Mitterrand entourage in the run-up to the 1981 elections, it was the CERES group, supported by Mauroy’s faction, that enjoyed preeminence. The social democrats were in disfavor—Rocard because he had challenged Mitterrand for the Socialist Party’s support as presidential candidate in the wake of the 1978 parliamentary elections, while Delors, having played an important role in Jacques Chaban-Delmas’s government in the early 1970s, was not trusted by CERES (Maris 1993). As a result, the Socialist electoral program was worked out in early 1981 by a group led by Pierre Bérégovoy and Jacques Attali and was heavily influenced by CERES thinking. The result of this work, the 110 Points, painted a clear picture of the measures the government would take upon coming to power. At the center was a concern for growth, a classic Keynesian expansion, and a dramatic restructuring of the French economy—rapid nationalizations and social reforms. In spite of consistent pressure on the franc in the foreign exchange markets throughout the late winter and early spring of 1981, the 110 Points were quiet about the EMS. As one member of this group indicated later, the group was thinking primarily about growth, about the defense of employment, and about structural reforms. Defense of the currency was only of secondary importance (Bauchard 1986: 17–18). Thus, Socialist economic policy in the preelection period was formulated essentially along a single dimension—how much expansionary thrust should be injected into the French economy—and the outcome reflected the economic priorities of the CERES and Mauroy coalition. Upon coming to power in May 1981, the Socialists moved quickly to implement the 110 Points. The first act taken by the new government, however, was a tightening of capital controls in an attempt to slow the outflow of capital prompted by the Socialist victory (Mauroy 1983; Bauchard 1986). By August the Socialists had developed and implemented a supplementary budget and were developing the expansionary budget for the 1982 fiscal year. The expansion was oriented around three sets of measures (Muet and Fontenau 1990). First, operating on the belief that an increase in domestic consumption would cause an increase in investment, the Socialists raised the minimum wage by 10 percent. Second, in an attempt to keep many of its electoral campaign promises, the Socialists increased a wide range of welfare payments; the family allowance, pension payments, and transfers to offset rent payments were all increased. Finally, the Socialists relied upon an expansive fiscal policy; created a large number of public sector jobs; enacted training schemes; made a renewed commitment to the financing of research and development; and gave large capital grants to the nationalized sector. The expansion was financed by an increase in revenue through a new wealth tax and new taxes on the credit and energy Page 116 →sectors’ “windfall” profits, and about a third of the budget was financed by the Banque de France (Sachs and Wyplosz 1986: 271). The expansion hit the French economy as a negative exogenous supply shock and as a positive demand shock. Real wages increased by 5.2 percent between April 1981 and July 1982 (Sachs and Wyplosz 1986). Consequently, labor’s share of French income increased by approximately half a percentage point, to a postwar high of 77.3 percent by 1982 (Commission of the European Communities). Real wage increases, the increased costs imposed on industry by the government, and the rise in import prices caused by the appreciation of the dollar further cut industry profit margins (table 10), and investment fell sharply. Gross fixed capital formation fell from 23 percent of GDP in 1980 to 20.2 percent in 1983; in each of the Socialist’s first three years in power investment fell by an average of 2.13 percentage points (Commission of the European Communities). Cost increases were passed on as higher prices and, with extensive wage indexation, into further nominal wage increases; the wage-price spiral pushed inflation up to 12 percent by 1982. The decline in French competitiveness, in conjunction with the surge in demand, hit the current account, which fell from a deficit equal to 0.8 percent of GDP in 1981 to a deficit equal to 2.1 percent of GDP in 1982. The deterioration of the current account, the macroeconomic policy stance that contributed to it, and concern about the impending nationalizations generated capital flight, placing steady downward pressure on the franc within the European monetary system. In September capital controls were further tightened (Financial Times, September 21, 1981), and on October 5, 1981, the Socialists devalued the franc by 8.5 percent against the D-mark (Ungerer et al.

1990: 55). 2. The Challenge from the Second Left As the expansion caused pressure on the franc, the second left, and in particular Jacques Delors, moved to wrest control of economic policy from the party’s left wing. While both Delors and Rocard had indicated their reservations about the 110 Points to Mitterrand before the May election, the second left had remained essentially isolated in the first months of the Socialist administration. Economic policy was made by a very tight circle that did not include the minister of finance (Bauchard 1986: 43–44). Delors ended his silence at a cabinet meeting in October 1981, following the devaluation of the franc, saying that devaluation gave an opportunity to constrain some of the more ambitious elements of the Socialist expansion, and he presented a series of measures designed to cut the public sector deficit and reduce wage costs. Delors’s call for Page 117 →a slowdown was not well received. Laurent Fabius, asserting his position as minister for the budget, challenged Delors’s right to propose spending changes. Both Mitterrand and Mauroy rejected a reversal of course but acceded to Delors’s demand to cut the budget deficit by Ffr 15 billion and accepted a broad-based voluntary wage campaign in an attempt to get unions to accept wage increases no greater than the rate of inflation.3 Having been unsuccessful within the government, Delors turned to the media, and in a November interview issued a very public call for a “pause,” a phrase that evoked memories of the failure of Leon Blum in the 1930s (Bauchard 1986: 62). While Delors initially stood alone in the pursuit of stabilization, the franc’s weakness in the European monetary system created a linkage that would ultimately enable him to wrest control of economic policy from the CERES faction. While macroeconomic policy had been treated as a single-dimensional issue, the franc’s weakness forged a linkage to a second dimension: European integration. It was becoming increasingly clear that the Socialists would have to choose between pushing forward with the CERES line, a choice that would entail exiting the EMS and retreating from the Common Market or staying inside the EMS and adopting the social democratic approach—moderation on reforms and a dose of austerity. Figure 8 depicts the linkage between the two dimensions, along with factions’ ideal points. The horizontal axis represents degrees of price stability, with high inflation outcomes at the left and zero inflation at the far right, while the vertical axis represents degrees of European integration, with full integration at the top and zero integration at the bottom. The CERES group’s ideal points on these two issues were at the bottom left-hand corner: expansionary monetary policy and a low level of European integration. Delors’s position was at the top right-hand corner: a high degree of European integration and a high degree of price stability. Given the linkage between the two issues, Mauroy’s position was critical. Mauroy’s ideal point was located at the top left-hand corner of the figure: support for the CERES economic strategy but committed also to European integration. The linkage of the two dimensions transformed Mauroy’s choice between the social democratic and CERES economic policies. As long as macroeconomic policy could be considered independent of European integration, as it was in the formation of Socialist policy in 1980 and 1981, Mauroy would support the CERES line. Once choices about macroeconomic policy became linked to choices about European integration, however, the CERES approach was no longer Mauroy’s best option. Mauroy could do better, i.e., he could reach an indifference curve closer to his ideal point, by supporting the social democrat economic strategy (price stability) and European integration than he could do by supporting the CERES line. Thus, by linking Socialist monetary policy to European integration, the EMS created the possibility for a shift in the Socialist coalition that would take control of economic policy from the CERES line and vest it with the social democrats. Page 118 → Fig. 8. Factional bargaining over price stability and European integration Two things would have to happen for this shift to occur: Mauroy would have to perceive the linkage and defect from the CERES line; and Mitterrand would have to accede to the coalition shift and the accompanying shift in economic policy. Mauroy’s defection occurred in early 1982. Due in part to weekly meetings devoted to international finance organized by his economic advisors, Mauroy was converted to the stability faction in the early months of 1982 (Favier and Martin-Roland 1990: 412). By early May it appeared that Delors and Mauroy were gaining control of monetary policy. In April Mauroy’s advisors had warned that a second devaluation was

necessary, and a forty-page stabilization plan to accompany the devaluation was developed. Delors indicated that the government was seeking a gentle disinflation (désinflation en douceur) in which the emphasis of government policy would change from a battle against unemployment to one of controlling inflation without prompting a further increase in unemployment (Le Monde, May 21, 1982). Mauroy also Page 119 →indicated that a “leveling out” in the speed of social reform was made necessary by the “widening gap between our inflation rate and that of our neighbors” (Guardian, May 25, 1982). Mauroy and Delors presented the stabilization package to Mitterrand on the eve of the Versailles G-7 Summit and managed to convince him of its necessity (Favier and Martin-Roland 1990). While Mitterrand accepted the need for a dose of austerity, the open question was how to gain support from the full cabinet: would this package represent a permanent shift in policy or simply a temporary measure? Mitterrand, Mauroy, and Delors remained in disagreement on this point, with Mitterrand preferring to treat the package as a temporary pause, and the three appear to have decided to use the Community to sell the policy to the expansionist faction (Favier and MartinRoland 1990: 418–19). Meeting German officials on the sidelines of the Versailles summit they indicated the intended shift in policy and requested that it occur in the context of an EMS realignment (Financial Times, June 14, 1982). The realignment took place the following weekend. The franc was devalued by 10 percent against the D-mark (Ungerer et al. 1990: 55), and, even though the stabilization plans had already been developed by the time EMS members met in Brussels, the realignment bargaining process was depicted by the principals as a conflictual affair in which fiscally conservative Germany had forced the fiscally lax Socialists to tighten their belts (pers. comm. with Monetary Committee official; Attali 1993), and the stabilization measures were presented to the French public as Community obligations (see, e.g., Le Monde, June 15, 1982). The austerity package sought to hold the budget deficit to 3 percent of GNP for 1982. Additional revenue was sought through an increase in the top tax bracket from 60 to 65 percent, and the exceptional tax on wealth was maintained, although reduced from 10 percent to 7 percent (Le Monde, September 3, 1982; Financial Times, September 2, 1982). Finally, 1983 would bring an effort to slow monetary growth, with M2 allowed to rise by 10 percent, compared with the 1982 growth of 13 percent. The implementation of budgetary stringency was accompanied by direct action on prices and wages in an attempt to break the price-wage spiral (Muet and Fonteneau 1990: 250). Wages in France had achieved almost 100 percent indexation by 1982. To counter the inflationary impact of this indexation, Delors and Mauroy introduced two measures in 1982. First, they instituted a freeze on both prices and wages during the second half of the year. Second, a new wage regime would manage the transition from the wage and price freeze. In place of the backward-looking indexation mechanism, Delors and Mauroy instituted a forward-looking system in which nominal wage increases would be Page 120 →based on the government’s inflation targets—8 percent in 1983, 5 percent in 1984, and 4.5 percent in 1985—rather than on realized inflation. If the government overshot its inflation target, adjustments could be made, but the extent of any adjustments would depend upon conditions in the industry in question (Muet and Fonteneau 1990: 251). The two measures combined to effectively de-index wages and prices, and inflation began to come down. Thus, by June 1982 Delors had managed to gain some control over Socialist macroeconomic policy. He had used the EMS to convince Mauroy to defect from the CERES coalition and appears to have used the June devaluation to cultivate German pressure as a scapegoat for the stabilization measures he and his faction wished to implement, thereby reducing resistance by the CERES faction. What remained open was the permanency of this policy shift; Mitterrand had accepted a dose of austerity but had not yet acknowledged a fundamental shift in Socialist economic policy. 3. Expanding and Consolidating the Coalition Shift The Delors-Mauroy coalition was expanded and consolidated over the next nine months and finally accepted by Mitterrand in March 1983. The dose of austerity failed to end the franc’s weakness, and by late 1982 it was clear that the government would have to choose between a tightening of austerity and exiting the EMS, adopting

protection, and continuing with the CERES strategy. The recognition of the need for such a fundamental choice fueled factional conflict within the government. Delors and Mauroy, supported by the Finance Ministry and the Banque de France, continued to push for a reinforcement of the stability orientation, while Chevènement, Bérégovoy, and Fabius, along with representatives of industry, most notably Jean Riboud of the French multinational Schlumberger, were pushing for a withdrawal from the EMS and the introduction of protectionist measures to recapture the domestic market. Both sides were in essential agreement about the main problem: insufficient investment and an aging capital stock. And both were in essential agreement about the solution: they required measures to promote investment. Where they disagreed was in the path to take to achieve this. Throughout the fall of 1982 and the first months of 1983 Mitterrand received a stream of visitors—the “visiteurs du soir,” as Mauroy dubbed them—who lobbied for one or the other of the possible strategies (Bauchard 1986). Riboud, probably the most prominent of these visitors, argued that French industry was suffering from the high interest rates necessary to defend the franc. Under previous governments industry had survived only by inflation: Page 121 →inflation allowed them to repay their debts in devalued money. This was no longer an option, and, thus, France had to break out of the indebtedness-inflation-devaluation cycle. Riboud’s suggestion was for a temporary withdrawal from the EC and the EMS and provision of state credits to industry to help the country shed its debt. With debt reduced, investment would pick up, industry would modernize, and France could reintegrate itself into the Community. This general line was supported in the government by Chevènement and Bérégovoy, who both thought that the government’s ability to modernize French industry was too heavily constrained by the peg to the mark and, within the Elysée, by Charles Salzmann and Alain Boublil (Favier and Martin-Roland 1990: 439–44). The other possibility was a reinforcement of austerity, as promoted by Delors, Mauroy, and the French financial bureaucracy. For proponents of this strategy the problem of investment lay in a general disequilibrium in the French economy. Of the total import bill in 1982 only 45 percent could be replaced by French products—thus, protecting the French market would do little to restore French production (McKormick 1985: 55). Without new investment and industrial restructuring, demand stimulus would only draw in imports. The solution lay in a tightening of the state’s finances, not in undertaking further commitments to reduce industrial debt, and an accentuation of the pressures of market competition, both domestic and international, not in a withdrawal from the EC, and in slowing the growth of, if not reducing labor costs—both wages and social payments. Mitterrand listened to both sides of the debate. He had decided in late 1982 to devalue the franc after the March 1983 cantonal elections, hoping to make it “appear as though it was taken by the pressure of events,” but the choice of the economic policy to follow in the wake of the devaluation would be made only after the elections could be interpreted (Attali 1993: 404). Meeting with Mauroy on the Monday morning following the first round of voting, voting that suggested that the Socialists were likely to suffer heavy losses, Mitterrand indicated that he had opted for the Riboud-Chevènement line; the franc would be withdrawn from the EMS (Bauchard 1986). Mitterrand instructed Mauroy to construct a government to implement this new policy. Mauroy refused to do so, telling Mitterrand that such a course would be a disaster; he preferred to resign than to lead a government down that road. Mitterrand encouraged his prime minister to take the day to think about his decision and to meet with him again that evening. In the evening discussions with Mitterrand, Mauroy held to his original position and convinced Mitterrand to adopt a strategy in which they would Page 122 →seek as good a deal from Germany within the EMS as possible (see Favier and Martin-Roland 1990: 467–68). If the conditions for a devaluation within the EMS framework proved acceptable, then the franc would stay inside. If, on the other hand, the Germans presented overly stringent demands, then the franc could be floated. The solution to the franc problem would in turn shape the postdevaluation government: if the franc were floated, the party’s Left would dominate the new government, while, if the franc remained inside the system, then the stability faction would be strengthened. In short, the March realignment would represent the decisive battle for control over monetary policy. The faction that won would not only gain control of monetary policy but also would form a government insulated from the opposing faction. To win this battle Delors and Mauroy devoted their attention to two objectives, one at home and one abroad. At

home Delors and Mauroy employed Mitterrand’s advisors and the financial bureaucracy to convince Mitterrand and as many members of the expansionist faction as possible that floating would be costly. Mitterrand’s advisors sent a barrage of memos to the president, urging him to keep the franc inside the EMS. A memo written by Elisabeth Guigou in late February is indicative of the general theme. Floating the franc, Guigou argued, would bring an immediate depreciation of between 10 and 15 percent against the dollar, worsening the balance of payments deficit by Ffr 2 billion per month. Having already borrowed Ffr 90 billion in 1982, there was little hope that the government would be able to raise additional money from the financial markets to finance this deficit. The only alternative would be loans from the EC or from the IMF, both of which would impose conditions on economic policy. The message was summarized by Bianco on the bottom of the memo: “Monsieur le President, leaving the EMS will place us at the IMF” (Favier and Martin-Roland 1990:461). Seeking independent confirmation of these conclusions, Mitterrand asked Budget Minister Laurent Fabius to get precise information on the state of the French reserves from Michel Camdessus, the Directeur du Tresor. Camdessus responded by drawing stark conclusions about the float. According to the information supplied to Fabius, a float would lead to a 20 percent depreciation of the franc, to an equivalent increase in the external debt, already at Ffr 330 billion, to a complete cessation of intervention support from the EMS members, and to a likely increase in domestic interest rates to a range of 20 to 21 percent. Hearing these details, Fabius drew the conclusion that “leaving the EMS was impossible” and defected to the stability faction (Bauchard 1986: 144–45). While meeting with some success in raising the expansionist faction’s perceptions of the costs of floating, Delors was also striving to reduce the costs of Page 123 →staying inside the EMS. Meeting with German Finance Minister Hans Stoltenberg in the week preceding the realignment, Delors argued that too large a franc devaluation and too stringent an austerity package would be rejected by Mitterrand and force the franc from the EMS. If Stoltenberg could offer a revaluation of the D-mark in conjunction with a small franc devaluation and a moderate set of stabilization measures, Delors could keep the franc in the EMS and solidify the stability orientation over the medium run. Delors’s request put the Germans in a difficult position. German unemployment was itself hovering around 2.5 million, and an upward revaluation of the mark against all EMS currencies would increase downward pressure to the economy. Moreover, German officials confronted an important information asymmetry: was Delors truthfully characterizing the consequences of a harsh stabilization plan, or was he seeking to exploit German uncertainty about Socialist factional conflict to free-ride on the Kohl government’s desire to prevent the French from turning away from the European Community? If the former, then pushing too hard would push the French out of the EMS and possibly out of the European Community as well. As one German official indicated, the impending realignment was not primarily about changes in parities (Financial Times, March 15, 1983). If Delors was exploiting the information asymmetry, however, then accepting Delors’s request for a D-mark revaluation and lenient austerity measures would set an undesirable precedent for future realignments. The week of informal meetings preceding the realignment enabled German authorities to reduce the uncertainty a bit and conclude that, while Delors was probably overstating how little austerity he could accept, it was also clear that pushing too hard would push the franc out of the EMS. As one German cabinet member expressed at the time, while the Kohl government hoped the French would continue their anti-inflation policy, they recognized that there were significant opponents in the government who believed that EMS membership was imposing unbearable costs on France (Financial Times, March 15, 1983). These comments were echoed by a Bundesbank official, who noted that, “since Delors is the man most likely to follow the policies based on achieving convergence, our preference is for his position in Paris to be strengthened” (Financial Times, March 30, 1983). Thus, the weekend realignment focused on a single question: how far could German officials push the Socialists without pushing them out of the EMS? Kohl accepted the need for a D-mark revaluation, but there would be a limit to its size, and there would have to be a reciprocal tightening of the screws in French stabilization. As the negotiations shifted from back channels to the Brussels arena, Page 124 →Delors took advantage of the publicity to use the Bundesbank as a scapegoat, threatening to withdraw from the EMS unless the French position was accepted (Financial Times, March 22, 1983). These threats were largely disregarded by other Community

members; as one Bundesbank official commented, “we realized [these comments] were mainly for home consumption” [Financial Times, March 30, 1983; pers. comm. with Monetary Committee officials). Behind the privacy of the Commission’s doors the atmosphere was much more businesslike. Delors and Stoltenberg pushed toward agreement centered around a realignment of the franc-D-mark parity of between 7 and 8 percent and a series of stabilization measures for the French economy, including an increase in wage earners’ social insurance contributions, a compulsory loan on taxpayers, and a Ffr 20 billion cut in expenditures. In return, the French would gain a 4 billion ECU medium-term loan to rebuild their reserves. The remaining question was whether Delors could credibly deliver a promise to implement the stabilization package. With the composition of the French government contingent upon the outcome of the bargaining in Brussels, the answer to this question remained unclear. The EMS was suspended for one day to allow Delors to return to Paris to get Mitterrand’s response. Mitterrand, confronted with a growing coalition in support of staying inside the EMS, accepted the realignment package. Control over monetary policy was turned over to the stabilization faction and a new government was formed. The new government contained only fifteen members and excluded the strongest representatives of expansion, Chevènement in particular. While the expansionists were weakened, the key members of the stability faction—Mauroy and Delors—remained in office, with Delors adding the budget portfolio to his responsibilities at the finance ministry. The new government tightened the austerity program. The austerity package aimed to restore the balance in French finances over a two-year period and, by doing so, reduce pressure on the balance of payments. The package had four sets of measures. First, taxes and other payments were increased. A 10 percent enforced loan was imposed on households paying more than five thousand francs per month in tax, and an additional 1 percent surcharge was imposed on all taxable income. In addition, the government imposed tax increases on spirits and petroleum products, while charges for state-provided services (electricity, rail fares, telephone) were increased by 8 percent (Muet and Fonteneau 1990: 160–61). Second, the government sought to limit the public sector deficit to 3 percent of GDP, and, given the rising costs of servicing the public debt, this required reductions in government spending. Cuts were made in grants to the nationalized sectors, spending that had been scheduled for 1983 was deferred until 1984, and the rate of Page 125 →growth of social welfare payments, particularly retirement pensions and unemployment benefits, was constrained below the rate of growth of prices (Muet and Fonteneau 1990: 171–72). Third, the government enacted a range of measures designed to increase savings. Finally, the Socialists further tightened capital controls, placing a two thousand franc limit on foreign exchange transactions undertaken for travel. The combination of the wage regime instituted in June 1982 and the reduction of domestic demand brought French inflation down. As Muet and Fonteneau note, the process of disinflation in conjunction with the stabilization of real wage growth allowed industry to restore profitability (1990: 261). Between 1978 and 1982 French industry had experienced an annual decrease in profits of 0.2 percent, due largely to real wage growth that outstripped productivity gains. In 1983 and 1984 the relationship between productivity and real wage growth was reversed: real wages grew only by only 0.5 percent, while productivity increased by 4.25 percent. The result was a strong improvement in industry profitability, which began to recover (table 10) (Muet and Fonteneau 1990: 261). The adjusted wage share also began a dramatic reversal: whereas the share of national income going to labor had consistently increased since 1973, reaching a peak of just more than 77 percent in 1982, beginning in 1982 this share began to fall, reaching 74.6 percent in 1985, the last year of the Socialist government (Commission of the European Communities). 4. Domestic Politics and the European Monetary System: Explaining the Socialist Disinflation Capital mobility did not force the Socialist about-face. Between May 1981 and March 1983 the government pursued a monetary policy at considerable variance to the policy being followed in Germany and remained a full member of the European monetary system. The Socialists were able to do so by relying on the combination of capital controls and periodic realignments of the exchange rate mechanism. The high degree of flexibility within the EMS between 1981 and 1983, a flexibility that granted the Socialists an average devaluation of just less than 9 percent every six months, imparted a high degree of monetary policy autonomy to the French Socialists.

The shift in monetary policy from expansion to restriction resulted from the outcome of intraparty factional conflict over the government’s economic strategy. Two groups with distinctly different economic strategies competed against each other for control of economic policy. The CERES group was initially dominant but found itself increasingly challenged by the party’s social Page 126 →democratic wing. While capital mobility and the exchange rate constraint did not force the Socialist turnaround, the existence of an explicit exchange rate commitment, by linking two policy dimensions—monetary policy and European integration—that would not have been linked otherwise, did help the stability faction prevail in this factional conflict. While the franc would have depreciated without the EMS, speculation against the French currency might well have been much less intense (no explicit target against which to bet), and continual depreciation would not have required an explicit decision to reduce French linkages with the European Community. Thus, the EMS effectively linked choices about macroeconomic policy to choices about European integration, creating the possibility for a shift in the coalition that dominated the Socialist government. Mauroy, facing a choice between insulated expansion and integrated austerity, opted for the latter and defected from the CERES group. The consolidation of this coalition shift was facilitated by Delors’s use of exchange rate realignments. Realignments enabled Delors to place monetary stabilization on the Socialist agenda, to gain an initial pause in the Socialist expansion without requiring the entire government to accept a fundamental reorientation of economic policy, and to construct a transnational coalition with Germany in support of a stabilization package that reduced the costs of staying inside the system compared with the costs of exit. These processes enabled the rigeuristes to wrest control of the monetary policy from the expansionist faction.

B. Italian Institutions, the EMS, and Monetary Restriction The late 1970s brought a wide-based consensus between Italian political parties and unions on the need to stabilize the Italian economy to restore industry profitability and induce investment. Initial successes of this strategy in the late 1970s were reversed in the early 1980s, however, under the weight of exogenous shocks and a shifting political landscape. In the early years of the decade policymakers lacked the institutional context within which to achieve price stability. Achieving disinflation required the Italian government to convince the unions to abandon the existing wage indexation regime, and this, in turn, hinged on its ability to make a credible commitment to price stability. Doing so required a stable governing coalition that could reduce the budget deficit, an independent central bank, or a combination of both. Policymakers proved incapable of doing either, and between 1980 and 1983 the Italian-EC inflation differential widened, and the lira was kept inside the EMS only by virtue of capital controls and frequent devaluations. Page 127 →Success came slowly during this period, facilitated by both external and internal developments. The European monetary system provided an explicit means of justifying a tight monetary policy, helping the Banca d’Italia to assert its control over monetary policy. Institutional change that granted the central bank a bit more independence reinforced this control. The central bank used the additional independence to pursue monetary restriction and force Italian industry to begin restructuring. In addition, a mid-1983 agreement committing the governing parties to a multiyear coalition enabled the government to begin budget reduction, reinforcing the commitment to price stability. On the basis of these two changes the wage indexation system was reformed, policymakers made less recourse to central bank financing, and inflation was brought under control. 1. Coalition Instability, the Scala Mobile, and Italian ln>ation As in France, the central economic problem confronting the Italian economy was the need to stabilize real wages, restore industry profitability, and induce investment. The initial measures undertaken in the late 1970s had proven quite successful. The unions’ mid-1970s agreement to wage moderation slowed real wage growth to a 2.3 percent annual average between 1977 and 1980. As it slowed, industry profitability recovered, reaching levels in the private sector last seen before the first oil shock (table 10). As industry profitability recovered, investment increased, growing by 5.7 percent in 1979 and by an additional 8.7 percent in 1980 (Commission of the European Communities). Thus, as the Italian economy moved into the 1980s, it appeared as though the government had successfully gained union cooperation to engineer an investment-led recovery of the Italian economy.4

These initial successes were reversed, however, in 1980. While the unions had shown a willingness to moderate wage demands in the late 1970s, the second oil price increase and the dollar appreciation imposed two new exogenous shocks on the Italian economy, giving renewed push to the distributive struggle between capital and labor. Industry profitability fell, real wages increased, and investment dropped off sharply. Implementing monetary restriction within this environment would prove anything but straightforward. Central to the problem was a set of tightly knotted institutional constraints: the wage indexation regime, the coalitional nature of Italian politics, and the lack of political independence enjoyed by the Banca d’Italia. The wage indexation mechanism, the scala mobile, had been instituted in 1975 at the height of union power and provided almost 100 percent protection of real wages. Because it rigidified real Page 128 →wages, the scala prevented relative price adjustment in the wake of exogenous shocks. An index basket consisting of import items translated exogenous shocks directly into nominal wage increases that fueled inflation. Disinflation would require reform of wage indexation practices. In the early 1980s the balance of industrial power appeared to support wage reform. The high level of cooperation achieved by the three main trade union organizations during the 1970s broke down in the early 1980s, membership declined, and, with growing political polarization, strong linkages between unions and parties reemerged. Active union membership declined by 15.5 percent during the 1980s. The decline in membership was reflected in a decrease in union density, which fell from 48.4 percent in 1980 to 39.5 percent in 1986 in the entire economy and from 44.3 percent to, 36.6 percent by 1986 in the nonagricultural sector. This general decline was evenly spread between the industrial and service sectors: the industrial sector saw a 6.5 percent decrease in unionization in the first half of the 1980s, while the service sector, both public and private, saw a drop of 7 percent (Negrelli and Santi 1990). As union power ebbed, industry moved to regain control over real wages. Confindustria, the main industrial confederation, threatened to abrogate the scala unilaterally in June 1981, but Giovanni Spadolini, then council president, persuaded the organization that his government could push the unions toward agreement (Financial Times, June 4, 1982; Golden 1988: 82). The agreement toward which the government was pushing would change the way that points for quarterly nominal wage increases were determined. Under the existing scala points were determined by changes in the prices of the basket of goods constituting the index. Spadolini proposed, instead, to determine quarterly increases from the government’s preannounced inflation target that, as stabilization was implemented over the next several years, would be below the rate of inflation prevailing at the time of the target’s announcement. Spadolini faced two problems in trying to gain union agreement to this reform. First, in trying to undo the scala, he was asking the unions to accept the real wage costs of exogenous shocks. Gaining union ascent to this request would require some form of quid pro quo. The unions were requesting the Italian government to take a series of measures to create employment. Second, Spadolini was asking the unions to believe that the government could provide real wage stability in the absence of exogenous shocks. This required the government first to stabilize and then to reduce government spending, or at least reduce the portion of government spending financed by the Banca d’Italia. Given existing coalition instability, the union confederations had legitimate concerns about whether the government could in fact deliver on this Page 129 →commitment. The 1979 national elections had provided evidence that the Italian electorate was moving away from the dominant Italian political parties, the Communists (PCI) and the Christian Democrats (table 11). Elections at the regional, provincial, and municipal levels showed the same diminution of support for the Christian Democrats, a strong fall in support for the Communists, and an increase in Socialist electoral support (table 12). These changing electoral fortunes pushed the parties to reevaluate their coalition strategies. The Socialist Party, led by Bettino Craxi, was on the offensive, striving to claim the presidency of the council. Craxi’s ambition was to transform the Socialist Party into a realistic alternative holder of power in Italian politics. According to Craxi, the Christian Democrats would continue to exercise dominance over Italian politics as long as the Communist Party exercised hegemony over the left (Di Scala 1988). Upon assuming the leadership of the Socialist Party in 1976, Craxi had initiated modernizing reforms, adopting an essentially social democratic outlook

on economic questions that stressed private enterprise, innovation, and efficiency—a strong break from the Communist Party’s Marxist orthodoxy. For Craxi’s PSI private enterprise was fully consistent with socialism, while nationalization projects that created “bureaucratic collectivism” would serve only to threaten efficiency and innovation (Nilsson 1987: 81–82). The hope was that these reforms would attract the “managerial elite” and the “electronic youth” into PSI ranks. The similarities between Craxi’s strategy and Mitterrand’s hardly need to be pointed out. Craxi’s political strategy was two pronged: first, the PSI would have to reject cooperation with the PCI and keep the PCI out of government; second, the PSI would have to cooperate with the Christian Democrats in Center-Left coalitions but limit the effectiveness of these governments to provide the basis for improved performance under a Socialist-led government (Di Scala 1988). TABLE 11. Electoral Performance, 1958–87 TABLE 12. Percentage of Vote for Regional, Provincial and Municipal Election Results, 1975–85 Page 130 →For the Communists the decline in electoral fortunes translated into a reassessment of the strategy embodied in the “historic compromise” (LaPalom-bara 1981). The PCI widely interpreted its declining electoral fortunes to be a result of its cooperation with the Christian Democrats in the 1970s. Cooperation had led the PCI to moderate its views in an attempt to gain legitimacy within the Italian system, and, to shore up its declining support, it returned to a policy of intransigence, pursuing a strategy of obstructionism within parliament to reaffirm that the country was governable only with the acquiescence of the PCI, and a militant strategy within the trade unions to reaffirm their claim to be the only true representative of the working class. The Christian Democrats also drew conclusions from the 1979 elections and returned to a policy of noncooperation with the Communists. The right wing of the Christian Democrat Party had never fully accepted Communist inclusion in the governing coalition, and the 1979 election campaign intensified the tension between the left wing of the party, supporting cooperation with the PCI, and the party’s right wing, advocating a return to cooperation with the PSI—even if this required offering the prime minister to the Socialists (Wertman 1981). Tensions between the left and right wings did not lessen in the wake of the election. At the party’s national congress the party voted to drop the Moro strategy and give renewed emphasis to cooperation with the PSI and the small parties (Wertman 1987). These shifting electoral fortunes and the party strategies to which they gave rise pushed coalition stability to postwar lows in the early 1980s (table 13). Coalition instability, in turn, blocked successive governments’ efforts to control the public sector deficit. A stabilization package developed in the spring of 1980 failed to gain parliamentary approval, as the PCI and the Christian Democrat left-wing cooperated to block its passage. This obstructionist tack, designed to illustrate that Italy could be governed only with the PCI’s assent, led Cossiga to resign and opened the door to the Christian Democrat left wing. A new government was formed on a Center-Left coalition led by Forlani. Page 131 →Budgetary restriction proved no easier to implement under succeeding governments, however, as conflict between the Christian Democrats and the Socialists replaced Christian Democrat-PCI conflict. The Forlani government fell victim to this conflict when revelations of a Masonic Lodge, the P2, involved in criminal activities linking close to one thousand of the Italian elite, including government ministers, led the PSI to withdraw from the government.5 Forming a new government was difficult in the wake of the P-2 affair, however, as Craxi demanded the council presidency as the condition for Socialist participation, and the PCI refused to support a Christian Democrat-led government. Unable to construct a government based on a Christian Democrat presidency, Republican Party leader Giovanni Spadolini was asked to form a government. Spadolini’s government, however, had no greater success implementing stabilization than had Christian Democrat-led governments. Over the next year Craxi continued to push hard to bring down the Spadolini government and force early elections. Thus, although the Spadolini government sought to continue the stabilization orientation begun under Cossiga, little coherence could be found. Tension between the PSI and the DC led the PSI to resign from the government in early August. While the occasion for the resignation was the DC’s failure to support an important PSI bill in the Chamber, the motive behind the move was largely electoral. In

the negotiations following the collapse Craxi refused to reenter the government, demanding early elections in the hope that this would enhance the PSI’s position and yield the premiership. President Pertini refused to allow Craxi’s political ambitions to set the timing of elections, and the PSI reentered the governing coalition (Keesings Contemporary Archives 1981, 31046.A). The second Spadolini government was an exact copy of the first.6 TABLE 13. Government Stability, 1948–87 Page 132 →Because the second Spadolini government contained the same people as the first, the tensions that had prevented the first Spadolini government from taking effective action affected its second incarnation, and it collapsed in early November. Craxi’s demand for early elections and PSI pressure to modify the austerity package blocked the formation of a new government. With Spadolini unable to form a new government, Pertini handed the job to Fanfani, with an agreement that Fanfani would act as a caretaker until the next election, which would be held in 1983 (Financial Times, November 26, November 29, December 2, 1982). As interparty competition prevented successive governments from implementing stabilization packages, the public sector borrowing requirement rose steadily throughout the period (table 14). Though each government presented programs that promised cuts in public expenditure, the PSBR. increased, while the authorities’ ability to limit the borrowing requirement to its predetermined target deteriorated. Moreover, the growing borrowing requirement was monetized as the Banca d’Italia was obligated, until the middle of 1981, to purchase Treasury bills not taken by the markets, transmitting budget deficits into monetary growth. The inability of the government to reduce the government budget or significantly reduce the extent to which the budget was monetized, in conjunction with the failure of the attempts to reform the scala, had a negative impact on the Italian economy. Real wages increased in 1981 by 3.4 percent and then remained steady over the ensuing two years.7 These increases, in conjunction with rising input costs due to the appreciation of the dollar and the second oil shock, were pushed through into higher prices, generating a wage-price spiral that pushed inflation up to an average rate of just less than 17 percent. With industry caught by rising input costs, the improvements in profitability realized in the late 1970s were reversed (table 10), and investment dropped off, declining at an annual average rate of 4.2 percent in 1981 and 1982 and by a further 0.9 percent in 1983. A surge in domestic demand accentuated these basic problems in 1981, causing the current account deficit to increase to 2.2 percent of GDP. TABLE 14. Italian Public Sector Deficit Targets and Outcomes Page 133 →As Italian inflation increased, the lira was kept inside the EMS only through heavy reliance on capital controls and four devaluations. The capital control regime was one in which any outward movement of capital by resident-owned capital for the purposes of direct investment, portfolio investment, real estate purchases, or movements of personal capital were subject to a non-interest-bearing lira deposit with either the bank conducting the transfer or, beginning in 1982, with the Banca d’Italia. These deposits would be released only when, and to the extent that, disinvestment occurred and only with the approval of the Banca d’Italia. Until 1983 this compulsory deposit was to be 50 percent of the amount of the transfer, an amount that they reduced to between 30 and 50 percent in 1984 and to 25 percent in 1985. This basic regime was tightened at the end of May 1981, as the Banca d’Italia instituted compulsory, non-interest-bearing four-month deposits equal to 30 percent of import value for all imports except oil and grain. Besides relying heavily on capital controls, the Italian government devalued the lira four times, by an average amount of 7.4 percent each time, between March 1981 and March 1983.8 These devaluations offset much of the competitiveness Italian industry had lost due to the inflation differential. While Italian competitiveness deteriorated by 6.4 percent between 1979 and the beginning of 1981—a period that saw no devaluations of the lira—Italian competitiveness deteriorated by less than 1 percent between March 1981 and the end of 1982, in spite of the widening of the inflation differential between Italy and the rest of the Community.9 Unlike the French Socialists, however, Italian policymakers were subject to only mild pressure to adopt stabilization packages in conjunction with devaluations. This is not to say that pressure was altogether absent. The lira’s devaluation in March 1981 prompted the Council of Ministers to recommend wage indexation reform, and a Monetary

Committee report presented in November concluded that the recourse to indexation presents drawbacks for the conduct of economic policy faced with the need for adjustment…. It is therefore of the opinion that no additional indexation procedures should be introduced and that the scope of the present systems should not be extended. Where such systems Page 134 →exist, it would be desirable that, by a combined action of the public authorities and the two sides of industry, their scope be reduced so that they may no longer undermine the effectiveness of certain economic policy instruments. (Commission of the European Communities 1982b: 15) Moreover, the Banca d’Italia’s resort to import deposits in May 1981 led to a commission report that urged Italian policymakers to tighten public spending and take steps to limit the Banca d’Italia’s purchases of Treasury bills (Commission of the European Communities 1981: 153–55). The lira devaluation in June 1982 was also accompanied by a stabilization package aimed at cutting public spending. Yet external pressure had little visible impact on the Italian authorities’ ability to implement stabilization and seemed more pro forma than anything else. The contrast between the pressure brought to bear against the French and that brought against Italian policymakers is striking, and even more so when one considers that three of the four lira devaluations occurred in the very sessions in which the franc was devalued. How do we explain such divergent treatment? One possibility is that the focus on the Franco-German conflict during these sessions allowed Italian policymakers to slip past unnoticed, taking advantage of the realignments prompted by the French Socialists to treat the EMS more as a crawling peg than as a fixed exchange rate system. In short the Italians free-rode on the French Socialists. An alternative explanation, however, would suggest that the members of the exchange rate system recognized that the prime source of the Italian problem—wage indexation and the coalition’s inability to offer a credible deal to reform this mechanism—was not amenable to external pressure. It could be solved only through trilateral bargaining and then only once the Italian coalition stabilized. As long as Italian authorities did not abuse the exchange rate system and were willing to devalue when requested to do so (as they were in October 1981), then the other members appeared willing to refrain from placing strong pressure on Italian policymakers until they were capable of implementing stabilization packages (pers. comm. with central bank officials). 2. The Banca d’Italia, Coalition Stabilization, and a Credible Commitment to Price Stability Given the polarized and unstable political environment, there was little reason for the union confederations to believe the government could achieve price stability. As a result, bargaining over scala reform dragged on for more than three Page 135 →years, as the unions sought evidence that the government could stabilize the domestic environment. The government earned the necessary credibility in two ways: first, it used the EMS to turn over as much control of monetary policy as was possible to the Banca d’Italia, and it reformed central banking institutions to grant the bank a bit of independence. Second, after the 1983 parliamentary elections the main parties committed themselves to a three-year coalition government that prioritized reductions in the public sector deficit. The Banca d’Italia played one central role: by using the EMS to reassert its control of monetary policy, the bank went far to show the authorities’ commitment to domestic stabilization. As inflation in 1979 and 1980 eroded Italian competitiveness, a significant portion of Italian small and medium-sized businesses began complaining of an overvalued lira that was squeezing profit margins.10 According to Confindustria president Guido Carli, Italy’s participation in the EMS was being seriously questioned (Financial Times, May 7, 1980). Industry pressure grew stronger in the summer of 1980, led by Umberto Agnelli, chief executive of Fiat. The overvalued lira had hit Fiat hard, and the automaker had placed seventy-eight thousand workers on short-time as a result of the export slump. Agnelli told the Banca d’Italia that the gap between Italian inflation and inflation in the rest of the EC made devaluation essential (Financial Times, June 24, 1980). Agnelli’s demand gained wider support from Confindustria, which in July demanded both a cut in production costs and a devaluation of the lira (Goodman 1992: 165). Neither the Banca d’Italia nor the government was willing to accommodate industry’s demands. Ciampi told Agnelli that Fiat’s troubles had less to do with the lira and more to do with the company’s inability to control its

production costs. The government also took a hard line, with Budget Minister Andreatta justifying the government’s refusal to devalue by arguing that “competitiveness should be frustrated by the exchange rate, so that production is pushed toward greater innovation, efficiency, and quality” (Goodman 1992: 165). The authorities’ refusal to consider a devaluation was given greater credibility when the Banca d’Italia managed to resist strong pressure from the financial markets in June and July (Ciampi 1985: 13). The Banca d’Italia’s refusal to accede to industry demands for devaluation prompted Fiat to accelerate plans to improve productivity, and in midsummer the company announced fourteen thousand layoffs. Union resistance to Fiat’s restructuring led to a three-week shutdown of Fiat’s plants in Turin. The dispute was resolved only after the so-called march of 40,000 in October indicated that the union rank and file were willing to accept some costs of industrial adjustment. While the processes at Fiat were the most dramatic representation Page 136 →of this process, Fiat’s victory over the union confederations set off a widespread process of industrial adjustment (Golden 1988: 79). Thus, by refusing to accommodate the demands of industry and labor and devalue, the Banca d’Italia had forced industry to adjust. The exchange rate constraint embodied in the European monetary system was central to the Banca d’Italia’s ability to force this restructuring. The central bank used the exchange rate to force industry to push down wage demands and increase productivity, and a multilateral exchange rate system made this process easier than it would have been otherwise. As one central bank official indicated, had the bank been targeting an internally determined exchange rate, then it would have had little reason to resist devaluation. With an explicit exchange rate constraint the Banca d’Italia could use its Community obligation to justify its reluctance to devalue the lira as a means of regaining competitiveness and, instead, press industry to restructure. Moreover, defending the exchange rate provided strong justification for interest rate levels that the government would otherwise have resisted and perhaps vetoed. In 1980–81 the Banca d’Italia pushed the discount rate up to almost 20 percent, justifying the move as necessary to defend the lira’s value in the EMS. Without the exchange rate commitment the bank would probably not have pushed rates up so high (pers. comm. with Banca d’Italia official). By giving the Banca d’Italia an external constraint upon which to draw, the EMS helped Italian policymakers commit to a stability orientation. The government’s increasing reliance on the Banca d’Italia was reinforced by institutional reforms in the summer of 1981 designed to give the central bank a bit more independence. Acting outside the coalition, Spadolini, Treasury Minister Nina Andreatta, and the Banca d’Italia negotiated an agreement that reduced the bank’s legal obligation to buy Treasury bills not taken by the private markets (Goodman 1992; Epstein and Schor 1989). This “divorce” of the Banca d’Italia from the Italian Treasury, while a clear step toward greater independence, could only have a partial impact on the Italian economic environment. While domestic demand was slowed and the process of industrial adjustment begun, the high interest rates it took to do so raised the costs of investment and slowed the process of industrial restructuring. Nor did the removal of the obligation to buy Treasury bills restrict the amount of funds available to the government, as it was able to take advantage of the international capital markets (pers. comm. with former Banca d’Italia official). The percentage of the borrowing requirement provided by the Banca d’Italia did fall in the years following the divorce, but the increase in the absolute value of the public sector deficit implied that the amount of money created through the budgetary Page 137 →process remained relatively stable (table 14). In short reform of central bank institutions could only go part of the way: as the bank had argued in 1978, control of government spending had to come from the government itself; the bank could not provide the lead. What the central bank’s actions did do, however, was convince the union confederations that the government could achieve price stability. This impression was strengthened in mid-1983 in the wake of national elections. The 1983 elections ushered in one of the most stable periods of government in Italy’s postwar history as the interparty competition that had blocked stable governments in the early 1980s gave way to broad-based acceptance of a Socialist-led government. The Socialists were the one clear victor in the elections, while both the PCI and the Christian Democrats saw their share of the vote fall (table 11). With the Christian Democrats and the PCI suffering losses in the polls and the PSI and the other small parties making gains, the council presidency was given to Craxi on the basis of a three-year term in which to address the country’s economic problems (Nilsson 1987: 87).

Craxi’s rise to prime minister effected two important changes in the Italian political system that facilitated stabilization. First, it removed the central cause of coalition instability that had frustrated previous efforts. No longer would the Socialist Party threaten to withdraw from the coalition in an attempt to gain political advantage. Second, the five-party agreement on a three-year tenure extended the policy-making horizon, giving policymakers the opportunity to take a longer-term perspective on economic policy. As a result, coalition stability in the wake of the 1983 elections reached postwar highs, with the average government life lengthened to an unprecedented two years. From this relatively stable coalition the Craxi government began to scale back the public sector deficit. Working with the Christian Democrats and the Republicans, Craxi developed an austerity package aimed at reducing inflation to 10 percent by the end of 1984. This would be achieved by constraining wage growth to the stated inflation target and by holding the public sector deficit to Lit 90,000 billion for 1983 and 1984—a target that would require savings or new revenue of Lit 40,000 over the following eighteen months (Financial Times, August 10, 1983). The Craxi government came close to both objectives. Inflation fell to 11 percent in 1984, while the public sector deficit target was achieved in 1983 and was overshot by only 2 percent in 1984. The temporary solution to the political instability, and the government’s ability to make some progress scaling back the budget deficit, in turn, lent greater credibility to its commitment to stabilization and facilitated bargaining with the union confederations over the scala. Negotiations during 1982 had Page 138 →managed to achieve partial wage indexation reform. An agreement signed in January 1983 included three broad lines of action. First, ceilings on wage increases and revised cost-of-living allowances were set, bringing a 15 percent reduction in the scala’s coverage; second, the flexibility of the labor market was enhanced; finally, measures were agreed upon to reduce the level of conflict at the shop floor (Italy 1988; Golden 1988: 82–84). While the January reforms marked a first step in reigning in the scala mobile, they did not bring union acceptance of the inflation target as the basis for quarterly increases, and in the first months of his government Craxi moved to gain union support for this shift. The government’s proposal called for a limitation of the number of points paid each year. Rather than allow nominal wages to increase to recoup all losses due to inflation, nominal wages would increase by a predetermined number of points each quarter, and 8 percent for the full year, regardless of actual inflation (Golden 1988: 85). To demonstrate that the proposal offered substantial benefits to the unions, the government presented data showing how lower inflation and reduced fiscal drag would translate into as much protection of real wages as the current system. Moreover, the government committed itself to make up real wage losses because of overshooting through fiscal incentives in 1985 (Lange 1986: 32–33). The proposed changes split the union confederations. The CISL and the UIL, whose primary interest was in trading the scala mobile for greater freedom in wage bargaining to reestablish wage differentials eroded by indexation and a government commitment to job creation, supported Craxi’s proposal. The CGIL, representing predominantly low-wage earners, rejected the package; modifications that carried possible real wage cuts were unwelcome, while reestablishing wage differentials held little appeal (Golden 1988: 85). The CGIL’s refusal to support the government’s proposal led, in turn, to a split within the CGIL, with its Socialist wing voting in favor and the Communist wing voting against. The dispute came to a head in February 1984. Meeting with Confindustria, the CISL, the UIL, and the CGIL, Craxi gave them forty-eight hours to reach agreement on a position. When they failed to do so, Craxi, acting with the formal approval of the Confindustria, the CISL, the UIL, and the cabinet, imposed the reform measures by decree (Financial Times, February 16, 1984; Golden 1988).11 3. Disinflation in Italy Capital mobility did not force Italian policymakers to adopt monetary restriction. The Italian case makes this point strongly, for, rather than being a preference-dominated Page 139 →reversal, as in France, Italian inflation came only as domestic institutional constraints were gradually removed. Because they faced institutional constraints, Italian governments pursued a monetary policy that diverged considerably from that pursued in Germany between early 1980 and the middle of 1983. Italian policymakers kept the lira in the EMS by relying upon capital controls and periodic realignments. EMS flexibility granted the Italians a devaluation of about 7.5 percent approximately

every six months and, thus, a fairly high degree of monetary autonomy. The adoption of monetary restriction resulted from the government’s ability to loosen a set of tightly knotted institutional constraints, which became tightened by distributive struggles that reemerged in the wake of the second oil shock and the dollar appreciation. Restoring industry profitability required wage indexation reform, and this required a stabilization of coalition politics to stem the monetization of the budget deficit. The stabilization of coalition politics, in turn, required the resolution of intraparty competition created by the shifting political landscape. Unable to resolve the underlying political competition, Italian governments turned to the central bank, allowing it to use the exchange rate constraint to justify a tight monetary policy. The Banca d’Italia’s use of the exchange rate constraint helped set off a process of industrial restructuring that forced unions to accept the linkage between real wage settlements and employment. This external strategy could be of only limited effectiveness, however; monetary restriction could be achieved only through budget reductions and the reform of wage indexation. It was only in 1983, after Craxi had been given the presidency of the council on the basis of a threeyear agreement, that progress on these two fronts was achieved.

C. Conclusion Capital mobility did not cause the adoption of monetary restriction in France and Italy. Until the middle of 1983 policymakers in France and Italy relied upon capital controls and exchange rate realignments to maintain monetary policy autonomy. Policymakers could have continued to pursue this strategy. French and Italian policymakers willingly adopted monetary restriction as part of medium-term strategies aimed at constraining the growth of real wages, rebuilding industry profitability, and inducing investment. In other words, they adopted monetary restriction to redistribute income away from labor and toward capital. The path to monetary restriction in both countries was remarkably similar, both in the way important changes in domestic politics narrowed the gap Page 140 →between partisan monetary policy preferences and in the way stability-oriented policymakers tried to use the EMS to implement monetary restriction. Within the domestic arena the French and Italian Left underwent significant change in the 1970s and early 1980s, as the Communist Parties and the “union of the left” factions within the Socialist Parties were increasingly marginalized by leftist politicians with more social democratic philosophies and who were more reliant upon market-based solutions to the economic crisis than those of the traditional Left. They were more willing to reform wage bargaining practices to restore industry profitability by modifying wage mechanisms from backward-to forward-looking systems, more willing to use monetary restriction to impose a global constraint on wage bargaining, and more willing to use the exchange rate to demonstrate a commitment to price stability. Thus, as social democratic politicians came to dominate the Left in France and Italy, the difference between leftist and rightist monetary policy preferences narrowed, yielding a cross-party consensus that excessive real wage growth was a central element of the economic crisis and that monetary restriction to slow the growth of real wages was a necessary part of the solution. The early 1980s saw the consolidation and implementation of this consensus, and here the two countries exhibited considerable differences. In France variation in monetary policy preferences of the faction that dominated the government caused variation in monetary policy. The “Barrism” that had been the basis for French membership in the EMS was overturned by the Socialist victory in May 1981, and the traditional Left attempted to engineer a Keynesian solution to the crisis. This reversal proved only temporary, however, as the Socialist’s “second left” shifted the balance of power within the Socialist Party, gained control of economic policy, and returned monetary policy to a Barrist stance. In Italy variation in monetary policy was caused less by divergent preferences and more by domestic institutional constraints, and in particular by the tight interaction between coalition politics, monetary policy, and institutional reform. Lacking a government strong enough to force a change in the scala mobile, and lacking sufficient stability to offer a credible commitment to price stability that would enable them to reform the scala through negotiation, the Italian government muddled through until the stabilization of coalition politics enabled Craxi to force a revision of wage indexation practices. In spite of confronting very different domestic problems, price stability-oriented policymakers in both countries hit upon similar strategies to help them overcome domestic opposition to monetary restriction: both sought to use

the European monetary system to help them implement monetary restriction, although with varying degrees of success. While the EMS did not Page 141 →Page 142 →determine the outcome in either country, it did provide an external lever upon which stability-oriented policymakers could draw to help them achieve their domestic objectives. In France, where institutional obstacles to the implementation of monetary restriction were low, the EMS linked monetary policy to European integration and created the possibility for a shift in the Socialist coalition. Delors drew on the exchange rate system to exploit this possibility, using a realignment to place austerity on the Socialist agenda, using the EC and the Bundesbank as scapegoats for initial austerity measures, and creating a transnational coalition with German policymakers and a domestic coalition with the party’s centrist faction to shift the center of gravity within the Socialist Party. In Italy, where institutional obstacles to implementation predominated, the Banca d’Italia used the EMS to gain a degree of independence from the underlying coalition instability and imparted a bit of credibility to the government’s commitment to price stability. External strategies contributed to the implementation of monetary restriction in Italy only at the margin. An external strategy could not stabilize coalition dynamics nor fully grant the Banca d’Italia independence. In the face of such institutional constraints Community institutions played a much smaller role in the implementation of monetary restriction in Italy. In sum monetary restriction was adopted and implemented by French and Italian policymakers who had a preference for monetary restriction. These policymakers believed that resolving the economic crisis required a redistribution of income away from labor and toward capital to induce productive investment. Monetary restriction was seen to be a necessary component of a medium-term strategy in achieving this objective. These policymakers, with varying success, drew on the EMS to help them implement monetary restriction. Thus, French and Italian policymakers were not forced by capital mobility to adopt monetary restriction. Instead, they embraced exchange rate fixity and capital mobility after they had adopted monetary restriction.

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CHAPTER 6 Explaining the Evolution of the European Monetary System The EMS has evolved along three distinct tracks since 1987. Between 1987 and 1991 EMS institutions evolved toward greater exchange rate stability. The achievement of a high degree of nominal convergence, the integration of financial markets in conjunction with the Single European Act, and reforms that placed less emphasis on exchange rate realignments and more emphasis on interest rate coordination to manage the system (the BaselNyborg reforms) combined to push the EMS first toward a more rigid exchange rate system and then toward economic and monetary union (EMU). Between 1992 and 1995 the EMS evolved in the opposite direction. The crisis that drove many currencies from the EMS in 1992 continued into 1993, leading finally to a widening of the system’s bands to 15 percent. Finally, since 1995 EU policymakers have moved toward variegated monetary institutions and are constructing a system that combines monetary union among a select group of EU members with exchange rate flexibility for the others. How do we explain this evolution? In contrast to chapter 3, in which neoliberal institutionalism and the model of exchange rate cooperation offered convergent explanations of the creation of the EMS that differed primarily in the fullness of account, here the two approaches offer divergent expectations about the factors driving institutional evolution. Neoliberal institutionalism argues that the evolution of the EMS has been driven by a quest for the additional joint gains offered by a single currency. As European integration deepened in the wake of the Single Act, EU policymakers initiated EMU to realize the efficiency gains that would result from a single currency. In the absence of exchange rate uncertainty, increased cross-border trade and investment would promote a more efficient allocation of resources that would yield welfare improvements. Page 144 →Even if correct in its basic expectation, neoliberal institutionalism offers no insight into two central elements of this process. First, as in the creation of the EMS, it provides little leverage with which to explain the characteristics of institutional outcomes, either those embodied in the Maastricht Treaty or those embodied in the hybrid system now emerging. Second, neoliberal institutionalism struggles to explain the shift to greater exchange rate flexibility in 1992–93. Why, if a single currency promised additional benefits, did EU policymakers prove unwilling to sustain the less-demanding fixed exchange rate system less than one year after having committed to monetary union? More problematic, neoliberal expectations that monetary union has been driven by a quest for joint gains struggles with the fact that EMU does not offer welfare improvements relative to the EMS. Therefore, a neoliberal explanation of EMU is not only incomplete but also misleading. The model of exchange rate cooperation developed here suggests that the evolution of the EMS has been driven by a redistributive logic rather than by a quest for joint gains. The model hypothesized that exchange rate institutions would evolve as the mutual benefits they once provided disappear. Policymakers no longer gaining benefits from the existing exchange rate system could either embrace fixed exchange rates and push for new institutions that would force the system’s monetary policy to meet their preferences, or they could opt for greater exchange rate flexibility. Which option they ultimately choose, and the ultimate institutional outcome, depends upon bargaining power. In EU monetary politics we expect the Bundesbank’s relative power advantage to make institutional reform that yields less restrictive monetary policies difficult to achieve. This model, by filling in the gaps in a neoliberal account, provides a more compelling explanation of the evolution of EU exchange rate institutions in which institutional evolution has been driven by a redistribution of the existing costs and benefits of exchange rate stability rather than by a quest for further welfare improvements. During the mid-1980s the EMS hardened into a “quasi-currency union,” i.e., a rigid fixed exchange rate system with a single, unionwide monetary policy. As a result of this hardening, the welfare differences between the EMS and EMU were likely to be small. The distributive differences were potentially quite large, however, for this quasi-currency union was costly: either the Bundesbank or the weak-currency policymakers would have to sacrifice their

economic objectives to maintain exchange rate stability. As the mutual benefits from the EMS began to erode, French policymakers initiated institutional reform to try to force the Bundesbank to accept a portion of these costs. The distributive struggle between weak-currency and Bundesbank Page 145 →policymakers led first to efforts to redistribute the costs of exchange rate stability through EMU and then, as the Bundesbank fought to limit the inflationary consequences of institutional reform, to greater exchange rate flexibility in the 1992–93 crisis. This struggle now appears to be leading to variegated monetary and exchange rate institutions that combine monetary union with exchange rate flexibility. The emerging outcome reflects the Bundesbank’s continuing ability to shape institutional outcomes.

A. The EU as a Suboptimal Currency Area A compelling neoliberal explanation of EMU must, at minimum, be based on evidence that monetary union offers a welfare improvement relative to the EMS. Theories of optimal currency areas offer the best way to assess whether or not EMU offered such gains.1 Theories of OCA look at two sides of the monetary union coin. On one side lie the benefits from monetary union. Benefits from monetary union arise through two basic channels. The first concerns the dynamic efficiency gains that derive from the introduction of a single currency. As exchange rate uncertainty is eliminated, economic actors engaged in cross-border trade and investment face a less risky environment. As risk from international transactions falls, one would expect cross-border flows of goods and capital to increase, and these increases will yield a more efficient allocation of resources. A more efficient allocation of resources in turn yields welfare improvements. The magnitude of these benefits relative to the premonetary union world will be reduced to the extent that forward markets that allow economic actors to hedge exchange rate risk exist. The second channel operates through expectations. As a single currency eliminates exchange rate devaluations, governments with reputations for devaluation will likely face reduced interest rate premiums. A single currency might therefore also yield lower real interest rates. These benefits will be reduced by the uncertainty generated by the creation of a central bank with no reputation for maintaining price stability. Reduced expectations about devaluation might be replaced by increased expectations of inflation. On the other side of the coin lie the costs of monetary union. The costs of a single currency arise from implications of sacrificing independent monetary and exchange rate policies. In a currency union prices across the union will converge to a single level. Given this nominal convergence, currency unions are costly if regions within the union need to adopt divergent monetary policies in the wake of exogenous shocks. Whether some regions need divergent monetary policies in the wake of shocks depends upon whether exogenous shocks are Page 146 →symmetric, i.e., whether all regions within the monetary union are hit by the same shocks. If shocks are symmetric, then all regions will require the same monetary response and independent monetary policies are redundant. If shocks are asymmetric, then a single monetary response to a shock will either cause some regions to suffer falling output and rising unemployment or other regions to suffer rising inflation. A single monetary policy in such a monetary union is therefore costly. As we will see, the adjustment process is more complex and operates through labor markets. Here it is sufficient to note that the degree of symmetry of shocks is the central determinant of costs within a monetary union. The EU does not constitute an OCA. While a single currency will deliver dynamic efficiency and credibility benefits, it will also impose costs that are likely to outweigh these gains. Work by Bayoumi and Eichengreen (1993) investigated the symmetry of shocks within the EU and found that, compared to the United States, regions within the EU tend to be exposed to more asymmetric shocks than are regions within the United States. Thus, monetary union for the EU as a whole does not represent a welfare improvement relative to the EMS. Some group of countries would be forced to accept greater costs than the benefits they would receive from a single currency. The conclusion that one draws from this evidence can be best provided by Eichengreen himself: “Uncertainty about the empirical magnitude of every one of these benefits and costs suggests the absence of a clear economic case in favor of EMU” (Eichengreen and Frieden 1994: 92). Bayoumi and Eichengreen’s conclusion was nuanced by the recognition that a core group of EU countries displays a higher degree of symmetry than does the EU as a whole. This group, consisting of Germany, the Benelux countries, and Denmark, appears to qualify as an OCA. For these countries monetary union would offer more

benefits than costs. France stands on the cusp of the two groups, more integrated with the core than the peripheral countries but not as tightly integrated with Germany as the other core members. One might therefore sustain a neoliberal explanation on the basis of this core-periphery distinction (Frieden 1996). This distinction allows one to suggest that EMU has been driven by core country policymakers’ quest for the efficiency gains promised by a single currency. While the core-periphery distinction resolves the economic problem, it encounters a political problem: the expectation that core policymakers would support EMU while peripheral policymakers would be less enthusiastic supporters, or perhaps even opponents of EMU, does not correspond well with EMU bargaining positions. Peripheral policymakers from Italy, Spain, and Portugal have been strong proponents of EMU, while some Page 147 →core policymakers, in particular the Germans, have been skeptical of, and in some cases opposed to, monetary union. Why would policymakers who would be worse off in EMU support this process, and why would those who supposedly benefit be so reticent? A neoliberal institutionalist explanation of EMU therefore confronts two central problems: a lack of evidence that monetary union represents a welfare improvement relative to the EMS; and a poor fit between the costs and benefits of monetary union, on the one hand, and the pattern of support for monetary union, on the other. The neoliberal account confronts these problems because it overlooks two aspects of EMU. First, the distinction between a fixed exchange rate system and monetary union is one of degree rather than of kind. The distinction is a matter of the degree of exchange rate fixity and the degree of monetary autonomy policymakers enjoy within the system. The more rigid are exchange rates and the less monetary policies are autonomous, the closer the system approximates a monetary union. By the mid-1980s the EMS came very close to monetary union, having hardened into what I call a quasi-currency union. By this I mean that the EMS gained two central characteristics of a currency union: rigid fixed exchange rates and a single, unionwide monetary policy. Only two things distinguished the EMS from a full currency union: irrevocable commitments to these fixed exchange rates; and the elimination of margins around them (Dornbusch 1991). Three interactive developments drove the EMS toward a quasi-currency union. The first, and because it established the necessary condition for the other two, most important was the achievement of a high degree of nominal convergence. Disinflation had set as its medium-term aim the moderation of real wage growth and the stabilization of price levels. EU policymakers proved remarkably successful achieving these objectives; real wage growth for the EC 12, which had averaged an annual rate of 4.6 percent during the 1960s and 3.0 percent during the 1970s, grew by an average annual rate of only 1.1 percent between 1981 and 1990. As real wages stabilized, so too did inflation, which, among the EC 12, had fallen to less than 5 percent by 1987. By the mid-1980s EU members enjoyed the highest degree of nominal convergence that they had seen since the late 1960s. Nominal convergence provided the conditions for two other developments that pushed the EMS toward a quasicurrency union. First, nominal convergence allowed policymakers to reduce the exchange rate flexibility that had been central to the management of the EMS. It did so for two reasons. As inflation differentials narrowed, real exchange rate appreciations within the system became less severe, and, therefore, policymakers had less need to offset Page 148 →competitive losses through devaluation. In addition, policymakers increasingly began to attach costs to devaluations. Costs of devaluations derived from the emergence of a Community-wide focus on the credibility gains provided by the EMS (see Giavazzi and Pagano 1988; Giavazzi and Giovannini 1989). By the mid-1980s policymakers became convinced that a credible exchange rate link to a currency issued by a central bank with a reputation for price stability would reduce the output and employment costs of disinflation by provoking a reduction in inflationary expectations and would reduce interest rate premiums by provoking a reduction of exchange rate devaluation expectations. As a result, policymakers increasingly associated exchange rate realignments with a loss of credibility that would increase inflationary expectations and interest rate premiums. Realignments became costly. Nominal convergence also allowed policymakers to move forward with the financial component of the single market. Whereas the creation of an integrated European financial market had been a stated objective since the signing of the Rome Treaty, concrete steps toward its realization required a higher degree of nominal convergence than had been achieved prior to the mid-1980s. As policymakers strengthened nominal convergence within the EMS, it became possible to translate the goal of a single financial market into a reality. While the success of the

EMS thus spilled over into the single market project, financial integration “spilled back” into the EMS. The decision to liberalize national financial markets, eliminate capital controls, and create a single European financial market made it less feasible for policymakers to rely upon exchange rate realignments. As we saw in chapter 4, fixed-but-adjustable exchange rate systems and a high degree of capital mobility rest uneasily together. Because financial markets have every incentive to anticipate devaluations, signals by monetary authorities of an intention to realign exchange rates generate speculative attacks that erode a weak-currency central bank’s reserve holdings, forcing policymakers to float. Thus, the elimination of capital controls reinforced policymakers’ reluctance to seek realignments. Less need, less willingness, and less ability to realign the system’s exchange rate mechanism pushed the EMS toward a quasi-currency union. Whereas prior to 1986 the EMS had been realigned every six months to a year, between January 1987 and September 1992 the system was not realigned a single time.2 With fixed exchange rates and a high degree of capital mobility, the interest parity condition, which had heretofore been held at bay by capital controls and periodic realignments, began to bite. As a result, the monetary policy independence policymakers had enjoyed in the first half of the decade disappeared. The EMS thus took on two of the defining elements of currency unions: exchange Page 149 →rate fixity; and a single, unionwide monetary policy. The EMS had become a quasi-currency union and, therefore, the welfare differences between full EMU and the hard EMS were likely to be small. The second aspect of the EMU process that a neoliberal account overlooks is that, because the difference between fixed exchange rates and monetary unions is one of degree rather than of kind, the recognition that the EU does not constitute an optimal currency area applies as much to the EMS as a quasi-currency union as it does to EMU. In other words, just as full EMU would impose costs on some group of EU policymakers, the EMS cum quasicurrency union also imposed costs on some group of policymakers. As we saw earlier, currency unions impose costs if nominal convergence cannot be achieved without either increasing unemployment rates in one subset of countries or increasing inflation in another subset. We need to complicate the analysis a bit with the recognition that the critical issue is the way labor markets react to exogenous shocks. In currency unions in which the constituent regions are exposed to asymmetric exogenous shocks, adjustment will occur through labor markets: unemployment will increase, and wages will fall or labor will migrate in response to the shock. If labor market institutions are either rigid throughout the union or differentially rigid across the union’s members, then currency unions become costly. If, for example the union adopts a restrictive monetary policy in response to a supply shock in one region, those regions not affected by the shock will experience rising unemployment unless there is a high degree of wage flexibility, a high degree of interregional labor mobility, or both. Cross-national variation in labor market institutions can cause real divergences even in the wake of symmetric shocks. If, e.g., an oil shock hit the union, and if the union responded with a restrictive monetary policy, regions with less labor market flexibility would experience more unemployment than those regions with greater labor market flexibility (Heylen and Van Poeck 1995). EU labor markets tend toward rigidity: sacrifice ratios are significantly larger than in the United States and Japan, indicating that a higher level of unemployment is necessary to induce wage moderation in Europe than in the United States and Japan, while labor mobility remains below interregional labor mobility within the United States.3 Moreover, EU members display considerable variation in labor market institutions. German labor markets are much less rigid than are labor markets in France, Italy, and the peripheral countries (Heylen and Van Poeck 1995). In such an environment, adjusting to the 1979 oil shock and the asymmetric wage and currency depreciation shocks that followed in its wake, by importing German monetary policy through the EMS, increased real divergences within the EC. Page 150 →The French experience illustrates the general problem. Under the exchange rate constraint French real wage growth slowed dramatically, averaging just less than 0.5 percent per year between 1983 and 1987 (Commission of the European Communities). As real wages stabilized, profitability recovered quickly and, by 1987, stood at levels not seen since before the first oil shock. The drop in real wages and the improvement in profitability pushed inflation down to 2.9 percent by 1987. While successful in disinflating, real wage stabilization was achieved primarily through increased unemployment (Collignon 1994; Fitoussi et al. 1993), which grew

continuously between 1983 and 1987, peaking at 10.4 percent. Thus, adjustment was transferred to labor markets and, in the context of labor market rigidities and low labor mobility, yielded rising unemployment. The French experience was not unique. Although policymakers hoped for credibility effects from EMS membership, evidence suggests that, rather than operate through the expectations channel, the exchange rate constraint forced adjustment primarily through the “punishment” channel (Collignon 1994: 125). That is, adjustment to a disequilibria can be achieved through price or quantity adjustments. In the absence of a significant shift in expectations leading to price adjustments, adjustment will come through quantity adjustments, i.e., a fall in output and an increase in unemployment. While unemployment had been on an upward trend during the 1970s, the 1980s saw a further accentuation of this trend (table 15). The German experience was quite different. In Germany unemployment rose sharply following the second oil shock but never reached the levels prevailing in the weak-currency countries and began to recover in the middle of the decade (table 15). In short, adoption of a unified monetary response to the oil and wage shocks increased real divergences within the Community. Unemployment rose throughout the EC but by much larger amounts in the weak-currency countries than in Germany. By the mid-1980s weak-currency policymakers confronted a choice between two strategies. On the one hand, they could continue with disinflation, hoping that wage moderation would eventually reduce the equilibrium rate of unemployment. Assuming constant technology, this strategy would push down wages and drive down domestic prices. Price reductions would encourage a demand shift toward domestic goods, output would recover, and the equilibrium level of unemployment would fall. Given labor market rigidities, however, it would cost two points of additional unemployment for every one point of wage moderation (Collignon 1994: 126–34). Because Germany had less rigid labor markets and slower wage growth, the level of unemployment needed to cause the required demand shift made disinflation a costly strategy.4 An alternative Page 151 →strategy would combine the logic of disinflation with investment-induced increases in productivity.5 With productivity increasing and wage growth held below growth in productivity, unit labor costs and domestic prices would fall. Demand would shift toward domestic goods, output would increase, and the equilibrium rate of unemployment would fall. The second strategy, because it centered on investment-induced rather than wage-induced reductions of unit labor costs, would be less costly in terms of employment. Its success, however, hinged on increasing investment. Yet investment was not recovering. Investment is positively related to income, so that faster growth in income generally yields greater investment, and it is negatively related to interest rates, so that the lower are interest rates, the higher is investment. Both variables were unconducive to investment. GDP growth had stagnated as monetary restriction depressed economic activity. The EC as a whole grew at an average rate of only 1.9 percent between 1981 and 1987, while industrial production grew at an annual average rate of only 1.3 percent in the same period. Real interest rates were high in historical terms (table 16). For the EC as a whole long-term interest rates were twice the average level prevailing in the 1960s and almost eight times higher than the rates that had prevailed in the 1970s. Short-term rates displayed a similar pattern, with the difference between rates in the 1970s and 1980s even more extreme. The combination of very slow GDP growth and historically high real interest rates was hardly an environment likely to induce large amounts of investment. Investment throughout the Community as a whole increased by an average annual rate of 0.8 percent between 1980 and 1987. The investment problem could be resolved by a reduction of interest rates, but the rigid EMS and elimination of capital controls made unilateral interest rate reductions impossible. Cutting domestic rates would generate capital outflows that would force policymakers either to abandon the exchange rate commitment or to increase interest rates back to initial levels. Thus, interest rate reductions would have to be coordinated and system wide. With Bundesbank policymakers in effective control of the system’s single degree of monetary policy freedom, weakcurrency policymakers’ ability to reduce interest rates and meet their domestic objectives hinged upon their ability to draw the Bundesbank into monetary cooperation.6 Drawing the Bundesbank into monetary cooperation would require the German central bank to give priority to an objective other than price stability, and this could impose inflation onto the German economy. Either the Bundesbank or the weak-currency policymakers would have to sacrifice their domestic objectives to sustain exchange rate stability. TABLE 15. Unemployment in the European Community, 1979–87

Page 152 →In sum a neoliberal account of the evolution of the EMS toward EMU confronts two problems. First, monetary union does not offer welfare improvements relative to more flexible exchange rate arrangements. At least one EU policymaker will be worse off in monetary union than he or she was within a fixed-but-adjustable exchange rate system. Second, even an application restricted to the core fails to correspond with patterns of support: peripheral policymakers have been the most ardent supporters of, and some core policymakers have been the most reluctant participants in, EMU. A neoliberal account confronts these problems because it overlooks two important aspects of the EMS process. First, the difference between exchange rate fixity and monetary union is a matter of degree, and by the mid-1980s the EMS had hardened into a quasi-currency union. Thus, the welfare differences between EMU and the hard EMS were small. Second, the quasi-currency union, like full EMU, was costly. At least one policymaker would have to sacrifice his or her domestic objective in order to sustain stable exchange rates. Thus, while the welfare differences between the hard EMS and full EMU were likely to be small, the distributive differences between the EMS and EMU could potentially be quite large. TABLE 16. Real Interest Rates in the European Community, 1960–90 Page 153 →

B. Bargaining over the Costs of Exchange Rate Stability, 1986–1996 The evolution of the EMS into a costly quasi-currency union generated a basic distributive question: did exchange rate stability require weak-currency policymakers to accept high unemployment, or could they instead force Bundesbank policymakers to accept higher inflation? Efforts to resolve this distributive question have driven the evolution of EU exchange rate institutions since 1986. Distributive bargaining has played out in four distinct phases, and the emerging outcome has been strongly shaped by Bundesbank power. Between 1986 and early 1988 French policymakers tried, and failed, to engage the Bundesbank in monetary cooperation through a series of increasingly ambitious institutional reforms. Having failed with limited attempts, French policymakers sought through EMU an immediate transfer of authority over monetary policy to EU institutions. This attempt also failed. While the French gained a conditional commitment to adjustment symmetry, Bundesbank policymakers ensured that the transfer of monetary authority to the EU arena would coincide with rather than precede the introduction of a single currency. Until then EMS rules would apply. Phase 3 reflects the implications of this failure. As the costs of exchange rate stability increased in the wake of German unification, the Bundesbank forced the costs of exchange rate stability onto the weak-currency policymakers. Unwilling to accept these costs, weak-currency policymakers opted for greater exchange rate flexibility. Phase 4, which continues as this book goes to press, has seen the emergence of variegated monetary institutions that combine monetary union for policymakers with a demonstrated commitment to price stability with exchange rate flexibility for policymakers with no such commitment. Page 154 → 1. Toward EMU: Ad Hoc Cooperation and Limited Institutional Reform Between 1986 and 1988 French policymakers initiated an increasingly ambitious series of attempts to force the Bundesbank to accept a portion of the costs of exchange rate stability. The Bundesbank, unwilling to accept the inflationary implications of monetary cooperation, blocked each of these initiatives. The French tried first to engage the Bundesbank in ad hoc monetary coordination in the context of G-7 macroeconomic policy coordination. As one French policymaker indicated: Germany was absolutely the determinant of our economic policy and yet it was sometimes difficult to work with them, especially . . . the Bundesbank . . . [The push toward macroeconomic policy coordination] was a good way for us to put pressure on Germany so that they would accept more growth, a more dynamic fiscal policy, reduction of interest rates. (Funabashi 1988: 125–26) Working within the Community and the G-7, French Prime Minister Jacques Chirac and his minister of finance, Pierre Balladur, tried to convince Helmut Kohl and his finance minister, Hans Stoltenberg, to pressure the Bundesbank to reduce interest rates (Funabashi 1988). Combined pressure from the Reagan administration and the

French government did not affect Bundesbank policymakers, however, who refused to make the requested interest rate cuts until domestic monetary conditions warranted them. A crisis within the EMS transformed ad hoc efforts to gain an interest rate reduction into efforts to achieve an institutional solution to Bundesbank dominance. The appreciation of the D-mark against the dollar during 1986 in connection with the Plaza Accord led to exchange rate tensions in the EMS and a conflictual realignment in January 1987. The January realignment differed from previous realignments in that, with French inflation below 3 percent and the French current account in balance, and zero inflation and a current account surplus above 4 percent of GNP in Germany, French policymakers appeared justified in blaming exchange rate tensions on an overly restrictive German policy rather than on an excessively loose one in France. As exchange rate tensions grew, the French stopped intervention and allowed the franc to fall to the bottom of its bands, forcing the Bundesbank to intervene. Facing massive capital inflows, the Bundesbank initiated a realignment. Rather than realigning, French policymakers believed the January crisis Page 155 →should have been resolved by the Bundesbank loosening monetary policy and stepping into line with conditions in the rest of the EU, just as the French Socialists had been obliged to do in 1982–83. French concern about the Bundesbank’s unwillingness to accept adjustment obligations was shared by other EU members. Jacques Delors, in his role as Commission president, summarized this concern in commenting that, given the extent to which economic conditions within the Community had converged since 1982, it “was necessary to move from [an exchange rate] system in which weakcurrency countries adopt adjustments in reference to the German model to a more symmetric system” in which the strong-currency countries carry a larger share of the adjustment burden (Le Monde, April 1, 1987). During 1987 French policymakers tried two strategies to force the Bundesbank to carry this larger share. In February Balladur proposed a system of macroeconomic surveillance that would “set up a more efficient procedure for examining the compatibility of economic policies in the different EC member states.”7 Bahadur’s central concern was the asymmetrical operation of the EMS. “The [January] crisis . . . reveal[ed] . . . a flaw in the working of the EMS, which does not spontaneously lead to an appropriate sharing of adjustment efforts.” Imparting symmetry through the surveillance indicators was seen to be of greatest importance: while “the exchange rate mechanism is a good warning signal . . . it does not provide an analysis of the causes of tension. France proposes organizing surveillance and analysis on the basis of a small number of indicators, focusing in particular on economic and financial interactions between our economies” (Financial Times, June 17, 1987). Surveillance would highlight the source of tension within the EMS and, if coupled with automatic obligations to correct the underlying cause of the tension, could push the Bundesbank onto a less restrictive path. The Bundesbank proved as able at blocking automatic obligations in these discussions as they had been in resisting U.S. pressure to lower interest rates. Whereas the French had placed great emphasis on imposing automatic obligations onto the Bundesbank that would force it to adopt a less restrictive monetary policy, the Bundesbank avoided any such constraints (pers. comm., Central Bank Official), and the report that emerged from the Committee of Governors of the Central Banks in early September was far from Bahadur’s proposals. The primary outcome of the Basel-Nyborg accord, as these reforms were called, was an agreement to rely less on realignments and more on interest rate adjustments to manage exchange rate tensions. While the plan emphasized interest rate coordination and included a call for macroeconomic surveillance to reveal inconsistencies in the policies of EMS members, it made no Page 156 →mention of any obligations that would arise from these surveillance procedures (Commission of the European Communities 1988b). The French also sought a bilateral solution that would give them a direct voice in Bundesbank policy. At the Franco-German summit in November 1987 the French proposed a Franco-German Economic Policy Council. The council would be composed of French and German finance and economic ministers and central bank presidents, who would meet quarterly to develop coordinated medium-term policy objectives that would be binding on both countries. Again, however, the French effort was frustrated by the Bundesbank’s refusal to allow non-German concerns influence German monetary policy. The Bundesbank had been informed of the general nature of the proposed council in November but had been excluded from subsequent negotiations of the treaty, learning of its contents only three days before its being made public at the official signing in Paris in mid-January. Fearing a

French “monetary trojan horse,” the Bundesbank quickly prepared a legal analysis of the treaty that argued that the council contradicted the Bundesbank law: harmonization of economic policy between France and Germany would erode the Bundesbank’s monetary autonomy (Kennedy 1991: 94–95). Absent binding authority, the Franco-German Economic Policy Council offered little of benefit to French policymakers. Having been blocked by the Bundesbank on less ambitious reforms, Balladur proposed a European central bank in January 1988. 2. The Maastricht Treaty French policymakers sought to use the EMU process to bring about an immediate transfer of monetary authority from the national to the EU arena. Balladur’s proposal led EU policymakers to create a committee, chaired by commission president Jacques Delors and consisting of Community central bank governors and outside experts, to examine the feasibility of, and outline the transition to, EMU. The committee’s report was published in April 1989 and adopted by the European Council in June 1989 as the basis for the transition to EMU. The Delors Report proposed a three-stage transition to economic and monetary union. Stage 1 would strengthen the “convergence of economic performance through strengthening of economic and monetary policy coordination within the existing institutional framework.” Steps would be taken to establish a process of multilateral surveillance on the basis of an agreed set of indicators—the parallels with the G-7 process here are clear—and “where performances were judged inadequate to commonly set objectives . . . recommendations would take place . . . with a view to promoting the necessary corrections Page 157 →in national policies.” In the monetary domain the Committee of Governors of Central Banks would “formulate [majority] opinions on the overall orientation of monetary and exchange rate policy. . . . In particular, the Committee would normally be consulted in advance of national decisions on the course of monetary policy, such as the setting of annual domestic monetary and credit targets,” and would express opinions to individual members on “policies that could affect the internal and external monetary situation in the Community, especially the functioning of the EMS (Commission of the European Communities 1989: 34–35). In the first stage, however, these opinions would not be binding. Finally, the Delors Report advocated the establishment of a European Reserve Fund that would, among other things, manage pooled reserves and intervene in foreign exchange markets. While stage 1 would bring about a more concerted effort at policy coordination at the Community level, stage 2, which would begin as soon as the treaty was implemented, marked the critical turning point in the Delors Report vision of EMU. Stage 2 would create EMU’s institutional framework, and, in particular, a European system of central banks (ESCB) that would gradually transfer monetary operations to the Community level. A “mediumterm framework for economic objectives aimed at achieving stable growth” would be established, and the functions of the ESCB in the formulation and operation of a common monetary policy would gradually evolve as experience was gained. . . . While the ultimate responsibility for monetary policy decisions would remain with national authorities, the operational framework necessary for deciding and implementing a common monetary policy would be created and experimented with. (Commission of the European Communities 1989: 38–39) Foreign exchange intervention operations would also begin, creating an alternative source of liquidity. Stage 3 would bring the irrevocable fixing of parities, the elimination of margins around them, the full transfer of monetary policy authority to the ESCB, and a single currency. The Delors Report thus reflected the objectives French policymakers had been seeking since 1986. The report’s call for stronger macroeconomic policy coordination guided by Community-level institutions during the first stage, and its strengthening in stage 2, echoed French demands made in the G-7 process, the Basel-Nyborg reforms, and the Franco-German Economic Policy Council and gave weak-currency policymakers greater input into the formulation Page 158 →of Bundesbank policy objectives. The evolutionary logic of the second stage would erode the Bundesbank’s operational autonomy, weakening its ability to implement monetary policies that diverged from those promoted through Community-level macroeconomic surveillance. Finally, reserve pooling and foreign exchange intervention by the ESCB would create an alternative source of liquidity in the system that would erode Bundesbank control of German monetary conditions.

Bundesbank bargaining strategy, as it had been during the earlier French initiatives, was defensive and aimed at achieving three objectives: preventing the early transfer of monetary authority to the Community embodied in the Delors Report; creating institutionalized obligations that would make it difficult for EU members to qualify for the transition to the third stage of EMU and ensure that this transition would be based on price stability; and creating monetary institutions that would limit the inflationary consequences of any EMU that was eventually created. Bundesbank officials were successful in achieving all three objectives. While the early and evolutionary transfer of monetary policy central to the Delors Report had gained the support of the European Council in both Madrid and Rome, Bundesbank officials, supported quite strongly by the Dutch, “refused to contemplate even partial surrender of sovereignty before the transition to the final stage,” arguing that granting the ESCB any responsibilities in stage 2 would create confusion and uncertainty about ultimate responsibility for monetary policy and weaken the institution’s credibility (Bini-Smaghi et al. 1993: 14). The final outcome reflected the Bundesbank position. The Maastricht Treaty created two separate institutions; the European Monetary Institute would come into existence at the beginning of stage 2 and perform a primarily technical and preparatory role in the transition to EMU (Bini-Smaghi et al. 1993: 21). There would be no evolutionary transfer of monetary policy authority to the EMI in this stage. Instead, monetary policy would remain the exclusive, and undisputed, responsibility of national authorities. A transfer of authority would occur only at the beginning of stage 3, when the EMI would be dissolved and a European Central Bank (ECB) vested with full operational authority over monetary policy would be created. In short, Bundesbank officials managed to prevent the early transfer of monetary authority to the Community. The ability to prevent the early transfer of monetary policy authority to the Community level facilitated the Bundesbank’s ability to achieve its second objective: including in the treaty a set of conditions that would make the transition to the third stage of EMU difficult to achieve. These institutionalized Page 159 →obligations—the convergence criteria—created conditions for membership that would reduce EMU’s policy domain. Bundesbank officials stressed the need to achieve nominal convergence from the beginning of the EMU discussions: A particularly important point in the Bundesbank’s eyes is that the transition to another stage (no matter whether this is a transitional stage or the final stage) should be made solely on the fulfillment of previously defined economic and economic policy conditions, rather than on specific timetables. (Bini-Smaghi et al. 1993: 24) During the negotiations Bundesbank officials stressed that the convergence criteria must be stringent and applied in an objective fashion. Community members who did not qualify on the basis of the criteria must be excluded from EMU. The fact that few countries would qualify for EMU based on their proposed criteria was not an indication that the criteria were too strict, Bundesbank officials argued, but, rather, that the Community was not yet ready for a single currency. Moreover, Bundesbank policymakers insisted that the criteria be part of the treaty, thus ensuring that their modification would require unanimity, rather than allowing them to be established by supporting legislation, which would enable modification of the criteria through majority vote of the Council of Ministers (Bini-Smaghi et al. 1993: 33). The convergence criteria written into the Maastricht Treaty reflected Bundesbank concerns. Community members who wish to join EMU must fulfill four criteria. First, members qualify for entry into EMU if their inflation rate (CPI) over the last twelve months is no more than 1.5 percentage points above the average rate of the three lowestinflation members. Nominal exchange rate stability is the second criteria: prospective members’ exchange rate must be kept inside the EMS without being devalued on the initiative of the issuing country for the two years preceding the adoption of the single currency. Third, long-term interest rates over the year preceding adoption of the single currency must be no more than two points above rates in the three lowest-inflation countries. The inclusion of the interest rate criteria was controversial, pushed by the Bundesbank against opposition from French and Italian policymakers, as a way to assess the extent to which financial markets believed a given policymaker’s commitment to price stability (Bini-Smaghi et al. 1993: 35). Finally, prospective members must have achieved a sustainable fiscal position, defined as a budget deficit no greater than 3 percent of GDP and a total public debt no greater than 60 percent of GDP. If a majority of Community members fulfill Page 160 →these criteria in 1997, then the third stage of monetary union—the formal vesting of monetary policy in the ECB—would begin, and

those members who meet the convergence criteria would adopt a single currency. Two elements about the convergence criteria are worth emphasizing. First, it is important to note the interaction between Bundesbank’s insistence on no transfer of monetary authority until stage 3 and no transition to stage 3 until sufficient members meet the convergence criteria. Because two of the criteria, price stability and long-term interest rates, will be determined by average levels, the degree of Community control over national monetary policies would shape the ease of transition to stage 3. A high degree of Community control could yield a permissive monetary environment, making it easier for more countries to meet the convergence criteria: the average rate of inflation of the three best performers would likely be higher, and the gap between members’ longterm interest rates would likely be smaller. Thus, there was a necessary connection between the Bundesbank’s insistence on convergence criteria and its unwillingness to allow the transfer of monetary authority to the Community level until these criteria were met. Second, the convergence criteria perform an important information revealing role. By providing a mutually agreed set of unambiguous economic indicators, the convergence criteria allow Bundesbank policymakers to assess other policymakers’ commitment to price stability. As Eichengreen notes: The economic rationale for these fiscal criteria is not clear. Possibly they can be justified on the grounds that there exist two types of governments—those possessing and those lacking fiscal discipline—and that a smoothly functioning monetary union requires the exclusion of governments lacking discipline, the identity of which the Maastricht Treaty criteria are sufficient to recognize. (1992: 48–49) The convergence criteria thus prevent cheap talk; weak-currency policymakers are unable to claim a commitment to price stability; they must demonstrate it. Moreover, discriminating between governments with and without fiscal discipline on the basis of mutually agreed rules provides the opportunity to exclude the latter from monetary union. This, in turn, reduces the probability that the ECB will be confronted with a situation in which different regions of the EU will require dramatically different monetary policies, thereby reducing the probability that monetary union will impose costs onto Bundesbank policymakers. Finally, the Bundesbank shaped the ECB’s institutional framework to Page 161 →restrict the number and type of policymakers who will have a voice in determining monetary policy in the EU and in national arenas. In the EU arena the European central bank was designed to be independent of both the primary Community decision-making body, the Council of Ministers, and national governments. The bank’s Executive Board will be selected by the Council of Minsters for eight year terms, while the Governing Council will include the Executive Board and representatives of the members’ central banks, all of whom must serve a minimum of five years. Members of the Council of Ministers cannot serve on the Executive Board, while members of the Governing Council are prohibited from receiving instructions from their national governments. Moreover, the ECB will be prohibited from advancing lines of credit to Community members (Eichengreen 1992: 41). The net effect of these provisions will be to make the ECB as politically independent as the Bundesbank (Alesina and Grilli 1991). At the domestic level the Maastricht Treaty obligates Community members to reform domestic central banking laws to grant full political independence to national central banks. This will remove partisan and electoral concerns from the determination of national monetary policy objectives, reducing the extent to which these considerations are represented in the ECB. The rules governing the ECB and the reforms of central banking practices required at the domestic level together will restrict the number of policymakers whose preferences will have a direct impact on the determination of the ECB’s monetary policy stance and will likely restrict the type of policymaker to active central bank officials. Besides ensuring, to the extent possible, a central bank committed to price stability once created, Bundesbank insistence on the reform of domestic central banking practices was also driven by a desire to develop an additional indicator of policymakers’ commitment to price stability. The logic is simple: if a country’s politicians were incapable of implementing the legislation necessary to grant their central banks greater independence, they would be unlikely willingly to pursue a stability-oriented monetary policy once inside EMU (pers. comm., Bundesbank official).

While the Bundesbank shaped the Maastricht Treaty to minimize the probability that it would find itself trapped in an inflationary monetary union, the treaty did give French policymakers part of what they had been seeking: the Bundesbank conditionally accepted more symmetric monetary relations. French policymakers, failed, however, to achieve an immediate transfer of authority over monetary policy to the EU arena. The French push for macroeconomic policy coordination and ECB foreign exchange intervention in the second stage were blocked by Bundesbank-designed institutions that ensured Page 162 →that the transfer of monetary authority would coincide with rather than precede the introduction of the single currency. Until then EMS rules would prevail. 3. Choosing Greater Exchange Rate Fiexibility: The 1992–93 EMS Crisis While monetary union offered one institutional solution to the problem of a costly quasi-currency union, exchange rate flexibility offered another, and one that the weak-currency policymakers selected in 1992–93. Thus, one of the implications of the failure of weak-currency policymakers to impart symmetry to exchange rate relations was a shift to exchange rate flexibility. The shift was precipitated by a sharp increase in the costs of the EMS in the wake of German unification. Rather than arrange a cooperative solution to the crisis, weak-currency policymakers and the Bundesbank both committed to their positions in the broader struggle over the distribution of the costs of exchange rate stability. The Bundesbank refused to use monetary policy to sustain the exchange rate system, while the weak-currency policymakers refused to bear the full costs of the German shock. With neither willing to bear the costs necessary to stabilize exchange rates, the EMS moved in the direction of exchange rate flexibility. Problems in EU exchange rate politics emerged quickly in the wake of the Maastricht Treaty, as the shock imposed by German unification sharply raised the costs of participation in the EMS. Kohl had responded to the collapse of the Berlin Wall by promising to bring the eastern Lander into the Federal Republic at very little cost to East German standard of living and savings. Thus, rather than set an exchange rate for currency union that reflected underlying productivity differentials, Kohl established a rate that enabled east Germans to buy D-mark at a 1:2 rate. To address the problems this exchange rate would create for east German industry, he relied on massive transfers financed through an expanding deficit. The effect of unification was an initial demand shock that created inflationary pressures, followed by a wage shock in the Federal Republic that added to these pressures. By 1990 German inflation had risen above 4 percent. Behind the leadership of Helmut Schlesinger, who had replaced Pohl in mid-1991, the Bundesbank began an aggressive defense of price stability. Interest rates began to move up in August 1991, and by July 1992 they stood at levels not seen since September 1931. As interest rates moved up in Germany, central banks in other EMS countries were forced to follow. The July 1991 rate increase was followed by increases in the Netherlands, Belgium, and Denmark. Page 163 →The Bundesbank’s rate increase in December was followed by increases in the Netherlands, Denmark, Belgium, and Austria, all of whom immediately raised their discount rates by 0.5 points. France, who had briefly cut its rate in the fall only to have to reverse the move with a half-point increase in November, followed a few days later, raising its key intervention rate from 9.25 percent to 9.6 percent and its repurchase rate by a half-point. Italy also moved up, increasing its discount rate from 11.5 percent to 12 percent. Only the United Kingdom failed to move up (Financial Times, August 16, 1991). The final Bundesbank rate increase in July 1992 provoked an increase only in Italy, which increased its discount rate to 13.75 percent, the highest level since 1986. As interest rates moved up, financial markets began to question whether weak-currency policymakers would be willing to sustain interest rates so far out of line with prevailing economic conditions, and speculative pressures emerged as dealers began to bet on the eventuality of a D-mark revaluation (Eichengreen and Wyplosz 1993). These pressures were accentuated in June by the Danish no in a referendum on the Maastricht Treaty and further accentuated in August by opinion polls that indicated France was also likely to vote against the treaty. By late August pressure had turned into crisis; the mark was threatening to break through the top of the EMS, and all other currencies were bouncing along the bottom. The crisis raised the issue of cost sharing in starker terms than ever before: who should bear the costs required by a unified monetary response to an asymmetric shock? Tensions could have been reduced in one of three ways. Weak-currency policymakers could have agreed to a realignment, an outcome in which they would bear the costs

of adjustment. Alternatively, the Bundesbank could have agreed to an interest rate cut, in which case it would bear the costs of adjustment. Finally, the solution could have been based on a combined realignment and interest rate adjustment, in which case the costs would be shared. In approaching the crisis, however, policymakers could not treat the solution independent from their respective interests in the EMU process. Instead, weak-currency policymakers and the Bundesbank committed to the objectives each sought, or resisted, in EMU. Who would bear the costs of the single monetary response would hinge upon who could make the most credible commitment. Realignment had been on the Community agenda since the early summer of 1992. Policymakers in the weakcurrency countries, however, were unwilling to realign. The reasons for this reluctance were straightforward. Devaluing within the EMS would be costly for the weak-currency countries; they would lose the benefits of a credible commitment and face higher inflation and interest Page 164 →rates as a result. Moreover, paying these costs did not appear to be justified. Since German monetary policy caused the exchange rate tensions, why should the weak-currency countries bear the costs? The appropriate solution required the country causing the tensions to take the measures necessary to correct them. This, after all, is what the French had been seeking since January 1987 and what they believed Maastricht had achieved. Thus, as pressures built, British chancellor of the exchequer, Norman Lamont, serving in the role of president of the Council of Economic and Finance Ministers (ECOFIN), responded to the speculative pressure by consulting the other members of ECOFIN and releasing a statement on August 28 avowing that “a change in the present structure of central rates would not be an appropriate response to the current tensions” (Financial Times, August 29, 1992). They reiterated this stance at the Bath ECOFIN meeting ten days later, where Lamont and French Minister of Finance Michel Sapin refused the German request for a general realignment. Rather than realign, British, French, and Italian policymakers pressured the Bundesbank to cut interest rates. During nine hours of discussions at the Bath ECOFIN, the Bundesbank came “under colossal pressure to cut rates . . . far more than [many had] ever experienced from the British delegation, supported by France, Italy, Denmark and Ireland” (Financial Times, September 7, 1992). Schlesinger became so annoyed with Lamont that at one point he began to walk out of the meeting and was convinced to remain only through Waigel’s intervention. An interest rate cut in response to pressure from other EC policymakers, however, ran counter to the Bundesbank’s commitment to price stability, a commitment that was reinforced by two incentives generated by the EMU process. First, pressure from other EC policymakes to cut interest rates in response to developments in the EMS sounded strikingly similar to the early and evolutionary transfer of monetary policy authority to the Community arena embodied in the Delors Report. Having institutionalized the commitment to transfer authority only at the beginning of stage 3, the Bundesbank was unwilling to set a precedent that cut in the opposite direction. As one Bundesbank official said, “an interest-rate cut in isolation would have indicated the Bundesbank was giving in” (Financial Times, September 15, 1992). This incentive was reinforced by other incentives generated by the convergence criteria. With transition to the third stage of EMU scheduled to take place as early as 1997, every extra point of inflation in Germany would raise the average inflation of the three best performers. Thus, if the Bundesbank cut interest rates, EMU would be more likely to happen early and more likely to include high-inflation countries. By keeping interest rates high, German inflation Page 165 →would come down, and the Bundesbank could lower the best performer average (pers. comm. with Bundesbank official).8 Lowering the best performer average would make the transition to EMU more difficult and, if not stop EMU, at least prevent the entrance of chronic high-inflation states. Thus, the possibility of relinquishing monetary policy in the future reinforced the Bundesbank’s commitment to a low-inflation stance in the present and made it even less willing to set a precedent that could be interpreted as Bundesbank accession to an early and evolutionary transfer of monetary policy authority to the Community. As a result, the Bundesbank committed to the position that, if German interest rates were placing strains on the EMS, the other members should realign (Financial Times, July 11, 1992). With weak-currency policymakers committed to a cut in German interest rates and the Bundesbank committed to a realignment, apportionment of the costs of adjustment would depend upon who blinked first. The weak-currency policymakers were at a considerable disadvantage, for the Bundesbank was the only actor with an incentive compatible strategy—its position on the EMS required no sacrifice of its domestic monetary objectives—and thus

the Bundesbank needed only wait for the costs of the weak-currency policymakers’ position to become untenable. This threshold was reached quickly for British and Italian policymakers: unwilling to sustain the level of interest rates required to peg the mark, the British and Italians were forced out of the EMS in early September 1992. With two of the weak currencies gone, the financial markets focused on the franc, which was kept inside only by extensive coordinated intervention by the Banque de France and the Bundesbank. By November the franc looked as though it had survived the market pressure. Pressure returned in late July 1993, however, following a Bundesbank decision not to reduce the discount rate. The Bundesbank prompted Kohl and Waigel to call a weekend meeting of the Monetary Committee to arrange a solution to the crisis. Like in the previous summer, however, the French opposed a devaluation and demanded an interest rate cut. The Bundesbank, for the same reasons as the year before, adamantly opposed an interest rate cut. The French then demanded that the mark be taken out of the EMS, allowing the franc to serve as the system’s anchor currency. This proposal failed to gain the support of the Dutch, the Danes, or the Belgians, all of whom stated that they would stay with the mark rather than go with the franc (Andrews 1995: 169). With the Bundesbank unwilling to concede a rate cut and the French unwilling to concede a realignment, they opted for the only remaining alternative: exchange rate flexibility. The system’s margins were widened from plus or minus 2.25 percent to plus or minus 15 percent.9 Page 166 →The 1992–93 crisis, and the manner in which it was resolved, reinforces the central messages of this chapter. First, the crisis demonstrated that the European Community, even in the core, is not an optimal currency area; it remains exposed to asymmetric shocks. Asymmetric shocks imply that a single monetary policy, a single currency, is costly. Second, the 1992–93 crisis posed the same distributive question that had motivated French policymakers to propose EMU: who will bear the costs of exchange rate stability? The first time the question was posed yielded ambitious institutional reforms that tried to force the Bundesbank to bear some of these costs. When it was posed in more concrete form in 1992–93, however, the Bundesbank again forced weak-currency policymakers to bear the costs of exchange rate stability. They opted, instead, for greater exchange rate flexibility. 4. The Endgame:Transition to EMU? While the first two phases were depicted as binary choices between EMU and exchange rate flexibility, the third phase has brought a system that combines monetary union and exchange rate flexibility. Bargaining in this phase has seen weak-currency policymakers striving to meet the convergence criteria and qualify for EMU and the Bundesbank striving to use the convergence criteria, and more recently the stability pact, to partition EU policymakers into two groups—those who are committed to price stability and those who are not—in order to craft a noninflationary EMU. While the outcome is not yet fully clear and what follows is speculative in part, it now appears that members who have demonstrated a commitment to price stability will move forward with EMU, while the others will either float their currencies or link to the single currency (the euro) through the EMS. To prevent inflation from entering EMU through the core-periphery exchange rate relations, Bundesbank policymakers have worked to limit the ECB’s exchange rate obligations vis-à-vis the peripheral countries. The combination of monetary union and exchange rate flexibility brings EMU much closer to the EMS status quo than was envisaged at Maastricht and will impose few costs on the Bundesbank. As we have seen, the convergence criteria performed an important informational role for Bundesbank policymakers. By forcing policymakers to engage in painful economic cuts, the criteria eliminated cheap talk and allowed Bundesbank authorities to identify governments committed to price stability and exclude from EMU those who were not. Since 1995 weak-currency policymakers have made a determined effort to meet the Maastricht Treaty’s criteria. This effort strengthened as French President Jacques Chirac’s commitment to EMU Page 167 →in 1995 removed the uncertainty that had surrounded EMU as a consequence of the 1992–93 EMS crisis and the ambivalence Chirac had demonstrated toward EMU during the French presidential campaign. Deficit reduction has been the central focus in these efforts, and politicians have shown tremendous courage in cutting subsidies, transfers, and social welfare policies in the face of considerable, and at times organized, public opposition. The results of these efforts to date have been meager (tables 17 and 18). In 1993 five countries—the Netherlands, Luxembourg, Ireland, Finland, and Denmark—had budget deficits that met the convergence criteria, and the EU

average was a full two points above the Maastricht criteria. Although the EU average fell by three-quarters of a point between 1993 and 1996, only three of the original five countries met the deficit criteria in 1996. Recessionary economic conditions had caused Finland and the Netherlands to fall behind and prevented other members from achieving the necessary cuts. Projections for 1997 deficits indicate that somewhere between four and nine EU members will meet the deficit criteria. EU projections are more optimistic than are those provided by the OECD, but even EU projections indicate that only nine countries will meet the deficit criteria in 1997, the year in which the EU will make decisions about membership in EMU. Five of these nine satisfied the criteria in 1993. Two of the other four, Germany and Austria, have traditions of fiscal conservatism and were pushed to larger deficits as a result of an extreme shock or from economic stagnation. The other two countries had more work to do. The Swedish government cut its deficit by two-thirds, while the French pared two percentage points off theirs. According to the more pessimistic OECD projections, only the five members that satisfied the 3 percent cutoff in 1993 will meet the deficit criteria in 1997.10 The situation for government debt is no more encouraging. Of the five members who satisfied the debt criteria in 1993 (France, Germany, Luxembourg, Finland, and the United Kingdom), two had ceased to do so by 1996 and are not projected to do so in 1997 (Germany and Finland). In the German case this again reflects the costs of German unification. EU and OECD projections both indicate that none of the other EU members will come close to Maastricht’s debt requirement. Finally, only one EU member, Luxembourg, meets both the deficit and the debt criteria. Thus, in spite of considerable effort, EU policymakers will not meet the Maastricht Treaty’s convergence criteria. Bundesbank strategy appears to have been quite effective. If the convergence criteria are strictly adhered to, EMU will not be created by 1999. With the Chirac and the Kohl governments both committed to EMU, however, EU policymakers have been moving away from a strict interpretation of the Maastricht criteria. It appears that some form of EMU will be created, and the criteria will be relaxed to do so. How far will they be relaxed? A good working assumption is that they will be relaxed just enough to allow the French inside. Because it would be difficult to allow France in and then exclude other members whose budget deficits are equal to or smaller than the French deficit, then based on the OECD projections, we can use a budget deficit of 3.7 percent of GDP as the cutoff. This cutoff partitions the EU into two groups. One group contains those with no history of fiscal conservatism: Spain, Portugal, Greece, and Italy. The second group contains the more conservative members, Austria, Denmark, Finland, Germany, Netherlands, Sweden, and those members who have been able to bring spending under control, France, Belgium, the United Kingdom, and Ireland. If we also require countries to have a public debt of 75 percent or less of GDP, we eliminate one more country from the list, Belgium. If we go one step further and strike from the remaining members those who are uncertain about wanting to join (United Kingdom, Denmark, and Sweden), we are left with only six countries that will form EMU: Germany, Austria, the Netherlands, France, Finland, and Ireland. Thus, even if the criteria are relaxed, the gap between the core and the periphery is sufficient to sustain the partition the Bundesbank has sought. Page 168 →TABLE 17. Budget Deficits in the European Union (percentage of GDP) TABLE 18. General Government Gross Debt (percentage of GDP) Page 169 →Two problems threaten to unravel this partition. The first is the Belgian problem. The Belgian economy is so tightly integrated with Germany, the Netherlands, and Luxembourg (in fact, Belgium forms a currency union with Luxembourg) that, on the basis of the criteria one would use to assess optimal currency areas, Belgium belongs in EMU. Fiscal policy, however, places Belgium far from qualifying for monetary union. Belgian public debt is higher than any other EU member, and even EU projections of the Belgian budget deficit place it well above the Maastricht criteria. Granting an exception to Belgium generates problems. If Belgium can be admitted with debt and deficits far above the Maastricht criteria, what possible legitimate justification can be found to deny membership to Portugal, Spain, and Italy, all of which have debt lower than Belgium? The Belgian problem threatens to disrupt the neat partition the Bundesbank has crafted. Second, the partition can be disrupted by budget gimmicks. The French government plans to use seven billion dollars that it will earn from the privatization of French Telecomm as revenue for the 1997–98 fiscal year. Italian policymakers are planning to impose a one-year EMU tax in order to bring the budget deficit very close to the Maastricht criteria. While such on-off revenue measures will bring deficits down in 1997 and enable governments

to meet the convergence criteria in this critical decision year, they will do nothing to correct underlying budget problems. Bundesbank policymakers have been particularly Page 170 →concerned that Portugal and Spain will copy this practice. The Portuguese and Spanish both fall under the 80 percent debt margin, and, on the basis of EU projections, each must shave only 0.7 points off their 1997 budgets to fall comfortably within the expanded criteria. Bundesbank policymakers have little faith, however, that the Spaniards and Portuguese are committed to conservative fiscal and monetary policies but see them, instead, acting strategically in order to qualify for EMU. Once in, old spending habits will return, with inflationary consequences for monetary union. In an attempt to prevent this strategic behavior, the Bundesbank and the German finance ministry have recently introduced additional conditions upon membership. Embodied in the stability pact, these conditions focus on future rather than current behavior. Under the German proposal governments that enter EMU would commit to maintaining budget deficits no larger than 3 percent of GDP except in the event of recession. The German definition of recession is quite stringent: four consecutive quarters of negative GDP growth that accumulates to at least a 2 percent reduction in GDP. Weak-currency policymakers consider the German demand much too stringent. As French Minister of Finance Jean Arthuis has noted, “since the Liberation, France has never had such a recession” (Reuters News Service, November 14, 1996). French concern is shared by Italian, Spanish, and Portuguese officials, all of whom are pressing for a less-stringent qualitative definition, a position that does little to reassure German policymakers. The Bundesbank’s use of the convergence criteria and the stability pact to partition EU members into two groups has pushed EU monetary relations toward a variegated institutional framework. Those member governments that have demonstrated a commitment to price stability will move forward with economic and monetary union in 1999. Member governments who have not sufficiently demonstrated such a commitment will be left outside the monetary union. For governments left outside, exchange rate stability will be achieved through the EMS. Thus, the emerging system combines elements of monetary union and exchange rate flexibility. These developments are consistent with the expectations of our model of bargaining power. Forming monetary union with only those policymakers who have demonstrated a commitment to price stability will significantly reduce the probability that a single currency will impose inflation onto Germany. Variegated monetary institutions do not fully prevent EMU from imposing inflation onto Germany, as coreperiphery exchange rate relations could bring inflation into EMU through the back door. Depreciating currencies in those countries now floating outside the EMS create opportunities for crossborder Page 171 →commodity arbitrage. In the winter of 1996, for example, French and German residents were able to purchase French and German cars more cheaply in Italy and Spain than at home. French and German dealerships, losing sales to Italian and Spanish dealers, in turn pressured domestic automakers to limit sales to Italian and Spanish dealers (New York Times, January 17, 1996). The French government has responded to peripheral depreciation by trying to require periphery governments to maintain a rigid fixed exchange rate against the euro (Financial Times April 13–14, 1996). Two interpretations of French motivations are possible. On the one hand, one can accept French concerns about exchange rate depreciation and the accompanying competitive losses French producers will confront at face value. An alternative interpretation, however, is that the French exchange rate argument is strategic. Just as Schmidt sought to use the EMS to force the Bundesbank to adopt a less restrictive monetary policy, so might the French see exchange rate relationships with the periphery as a way to force the ECB to adopt a less restrictive monetary stance within the core. Both interpretations point us back to the point developed in the first half of this chapter: the distinction between currency union and exchange rate fixity is one of degree rather than of kind. Depending upon the rules governing the euro-periphery relationship, the monetary implications of an EMU among the hard core linked to the periphery through rigid exchange rates could be identical to the monetary implications of an EMU among the entire EU. Rigid euro-periphery exchange rates could force the ECB to accept inflation as a result of foreign exchange intervention and interest rate coordination in support of weak currencies. The Bundesbank has responded by limiting the rigidity of euro-periphery exchange rates, by trying to impose strict limits on the ECB’s foreign exchange intervention obligations, and by trying to grant the ECB president fairly broad powers concerning the management of the EMS. The French proposal for mandatory participation in the EMS was ultimately vetoed based on opposition from the British, the Swedish, and the Bundesbank. Most

periphery currencies will be placed in the EMS voluntarily, however, and the Bundesbank has pursued two remedies to prevent these currencies from imposing inflation onto the core. First, the Bundesbank has pressed for rules that would ensure that the reformed system would work like the EMS worked during the 1980s, only with the ECB rather than the Bundesbank providing the nominal anchor. Within this system the primary burden of adjustment will lay with the peripheral countries. As Tietmeyer has noted, “it is not right to expect the euro-area to stay stable, while sacrificing this stability on the altar of a particular exchange rate” (quoted in Financial Times, April 4, 1996). On the other hand, the Bundesbank Page 172 →has pressed to give the ECB president fairly broad powers to determine the appropriateness of existing parities. Again in Tietmeyer’s words, the ECB president should be “a supra-national figure with a supra-national role,” in charge of a system of surveillance that he could use to trigger realignments of peripheral countries’ currencies. By imposing the burden of adjustment onto the periphery, and by allowing the ECB to determine realignments, the Bundesbank reduces the extent to which ECB policy will be directed toward exchange rate targets. As a result, monetary policy within EMU can be dedicated to maintaining price stability.

C. Conclusion Neoliberal institutionalism and the model of exchange rate cooperation offer divergent expectations about the factors driving the evolution of the EMS. Neoliberal institutionalism argues that the evolution of EU exchange rate institutions has been driven by a quest for joint gains. As European economic integration deepened, EU policymakers sought through EMU to realize the additional welfare gains a single currency would deliver. The model of exchange rate cooperation suggested that the evolution of the EMS has been driven by the redistribution of existing gains rather than by a quest for additional welfare improvements. The model hypothesized that exchange rate institutions would evolve as they ceased to provide mutual benefits. As monetary policy preferences within the exchange rate system diverged, those policymakers bearing costs would initiate institutional reforms to redistribute the costs of exchange rate stability. Whether they achieved institutional reform that redistributed these costs or were forced, instead, to opt for exchange rate flexibility depended upon relative power. As in the creation of the EMS, we would expect this outcome to be shaped by the Bundesbank’s ability to limit the inflationary implications of institutional reform. The neoliberal explanation is both incomplete and confronted by one important puzzle. First, even if correct in its central expectation, it is incomplete. It provides no explanation for the institutional characteristics embodied in the Maastricht Treaty or for the variegated institutional framework now emerging. Nor does a neoliberal account offer insight into why EU policymakers shifted to exchange rate flexibility in 1992–93. Second, monetary union is not a Pareto improvement relative to the EMS for the EU as a whole, and even a neoliberal explanation restricted to the core countries must wrestle with one large puzzle: why have some core policymakers, in particular in Germany, been extremely reticent about EMU, while many peripheral policymakers have been Page 173 →among its strongest supporters? A neoliberal explanation is therefore not only incomplete, but the absence of clear joint gains from EMU and the apparently contradictory bargaining positions held by policymakers in this process pose a significant puzzle for a neoliberal explanation. The model of exchange rate cooperation offers a more compelling account that not only fill in the gaps in the neoliberal account but also resolves this central puzzle. The achievement of a high degree of nominal convergence in the mid-1980s, the emergence of the credibility consensus, and financial integration pushed the EMS toward a quasi-currency union. Mutual benefits within this quasi-currency union eroded as inflation subsided and weakcurrency policymakers turned their attention to the problem of unemployment. Weak-currency policymakers’ ability to address employment was dependent upon their ability to draw the Bundesbank into monetary cooperation. Monetary cooperation, however, threatened the Bundesbank with higher inflation. Just as full monetary union did not represent a welfare improvement relative to more flexible exchange rate relations, the quasi-currency union was costly: either weak-currency or Bundesbank policymakers would have to sacrifice domestic monetary objectives to sustain exchange rate stability. The evolution of EU exchange rate institutions has been driven by a struggle over the distribution of these costs, and institutional outcomes along the way have been shaped by the Bundesbank’s refusal to allow institutional

reform yield higher inflation. As joint gains inside the EMS eroded, French policymakers initiated a series of increasingly ambitious institutional reforms, G-7 macroeconomic policy coordination, limited EMS reforms, and the bilateral Franco-German economic council, to gain influence over German monetary policy and force the Bundesbank to subordinate its domestic objectives to the exchange rate. As these less ambitious attempts were blocked by the Bundesbank, the French proposed a European central bank. By transferring monetary policy authority from the national to the EU level as soon as the Maastricht Treaty was ratified, and by granting the ECB the power to formulate coordinated EU-wide monetary objectives and engage in foreign exchange intervention, the French hoped EMU would bring about an immediate redistribution of the costs of exchange rate stability. Again, they failed. While they did gain the Bundesbank’s conditional acceptance of monetary symmetry, Bundesbank policymakers ensured that the transfer of monetary authority would coincide with rather than precede the introduction of the single currency. Moreover, Bundesbank policymakers were able to insert into the Maastricht Treaty a set of conditions governing the transition to the third stage of monetary union and structure the central banking institutions that would operate monetary policy Page 174 →within the currency union. Both achievements will significantly reduce the inflationary implications of a single currency. Whereas between 1986 and 1991 the distributive struggle led to institutional reforms in the direction of greater exchange rate stability, in 1992–93 this struggle yielded greater exchange rate flexibility. The 1992–93 EMS crisis posed the issue of cost sharing in a more acute form than ever before. As the Bundesbank pushed up German interest rates in the wake of German unification, weak-currency policymakers were forced to follow in order to sustain their EMS parities. As financial markets began to bet that weak-currency policymakers would be unwilling to push their economies into recession to support their exchange rates, the system was pushed into crisis. Rather than resolve the crisis cooperatively, weak-currency policymakers and the Bundesbank each became more committed to their respective positions in the broader distributive struggle. Weak-currency policymakers demanded that the Bundesbank bear the costs of exchange rate stability by relaxing monetary policy. The Bundesbank, unwilling to accept the inflationary implications of supporting the mark’s parity, refused to cut interest rates unless the weak-currency policymakers accepted a realignment. With neither side willing to pay the costs exchange rate stability required, the only available option was a movement toward greater exchange rate flexibility. For some governments this was achieved by exiting the EMS, while for others it was achieved through a face-saving widening of the system’s margins. Since the 1992–93 crisis Bundesbank policymakers have used the Maastricht Treaty’s convergence criteria and the recently introduced stability pact to try to partition EU countries into two groups, one including the northern European governments that have demonstrated a commitment to price stability and a second made up of those members who have failed to demonstrate such a commitment. These two groups form the basis for a variegated approach to exchange rate stability. The price stability core, composed of five or six countries, will likely move forward with monetary union in 1999. Peripheral members will be shut out of monetary union and, if they desire exchange rate stability, will be forced to achieve it within an EMS that will enjoy very little active support from the ECB. A monetary union created along these lines will have only minimal impact on the Bundesbank’s ability to maintain price stability in Germany. This distributive battle thus resolves the central puzzle for neoliberal explanations of EMU: why would countries expected to suffer costs from EMU be its most enthusiastic supporters, while those expected to benefit be its most reluctant participants? The periphery have promoted and the Germans have Page 175 →Page 176 →resisted EMU because the primary difference between the hard EMS and full EMU lies not in the welfare effects of the two institutions but, rather, in the distributive implications of the two institutions. Weak-currency and peripheral policymakers have been the strongest supporters of and German policymakers have been the most reluctant participants in EMU, because EMU was the vehicle through which the weak-currency governments have tried to force German policymakers to accept a share of the costs of exchange rate stability. Thus, whereas a neoliberal explanation of the creation of the EMS was merely incomplete, a neoliberal explanation of the evolution of the EMS is both incomplete and incorrect. Neoliberal institutionalism’s exclusive focus on efficiency rules out redistribution as a cause of institutional change and forces us to offer an explanation based on the assumption that institution building can only be undertaken in order to realize joint gains. In this case this assumption appears to

be mistaken. We will return to the broader implications of this mistake in the conclusion.

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CHAPTER 7 Exchange Rate Cooperation in the European Union This book has explored two questions about European exchange rate cooperation: how do we explain the creation and evolution of EU exchange rate institutions, and how do we explain the considerable cross-national and longitudinal variation in EU policymakers’ ability to stabilize nominal exchange rates within these institutions? Existing theories provide incomplete, and in one case misleading, answers to these questions. Neoliberal institutionalism, which one would expect to have relevance to questions of institutional creation and evolution, provides little leverage with which to examine either the motives driving the creation and evolution of exchange rate institutions or the distributive elements embodied in institutional outcomes. The capital mobility hypothesis, which others have offered as an explanation for the stabilization of European exchange rates during the 1980s, provides no explanation of why policymakers chose fixed exchange rates rather than monetary autonomy nor for why policymakers converged around the Bundesbank standard rather than another. This book developed a model of exchange rate cooperation to fill in these gaps and tested it against evidence drawn from more than twenty years of EU exchange rate cooperation. This chapter summarizes the answers to questions that have been developed in the previous chapters and discusses what I believe these answers imply for future research on institutionalized cooperation.

A. Explaining the Creation and Evolution of Exchange Rate Institutions How do we explain the creation and evolution of exchange rate institutions? Neoliberal institutionalism provides incomplete, and at times misleading, Page 178 →explanations of the creation and evolution of international institutions. Neoliberal institutionalism places most of its explanatory burden on policy-makers’s efforts to realize joint gains. Because information asymmetries and transactions costs make ex ante identification and ex post monitoring and enforcement of international agreements difficult, policymakers are reluctant to enter into what would be mutually beneficial agreements. Relying upon an explicitly functional explanatory logic, neoliberal institutionalism argues that the desire to realize these joint gains causes policymakers to construct international institutions with which to mitigate the information and transactions costs problems. Neoliberal institutionalism provides no means, however, with which to explain the distributive outcome embodied in all institutional outcomes or to determine policymakers’ positions along this distributive dimension. Thus, while neoliberal institutionalism offers compelling insights, at best it provides only incomplete explanations of the creation and evolution of international institutions. This book constructed a model that filled in the gaps in neoliberal institutionalism. The model provided an alternative rationale for the creation of international institutions based in domestic politics, provided a model of power with which to explain distributive outcomes, and offered an explanation for the evolution of existing institutions at variance with neoliberal expectations. The model hypothesized that policymakers would propose exchange rate institutions to achieve domestic monetary objectives they cannot achieve otherwise. Leftist governments facing an appreciating currency and whose control over monetary policy is constrained by independent central banks have an incentive to propose a fixed exchange rate system to induce the central bank to adopt a less restrictive monetary policy. Rightist governments facing wage-price spirals and constrained from stabilizing the economy by coalition governments and uncooperative labor-industry relations have an incentive to propose a fixed exchange rate to achieve monetary restriction. Once proposed, distributive bargaining would yield an outcome that determined control of the system’s single monetary policy, and rules would be written to institutionalize this outcome. Here we expected the Bundesbank would be best able to make a credible commitment to its bargaining position and push the institutional outcome to one in which it controlled the system’s single degree of monetary policy freedom. Whereas neoliberal institutionalism expects institutional evolution to be driven by a quest for additional joint

gains, my model expected exchange rate institutions to evolve as joint benefits within existing institutions erode. The erosion of benefits would be a function of policymakers’ ability to achieve their Page 179 →politically defined monetary objectives within the confines of the existing exchange rate system. As benefits erode, policymakers will face a choice between floating their currency and initiating institutional change through which to redistribute the costs of exchange rate cooperation. Which option they choose will be determined by relative bargaining power. Given the institutional determinants of bargaining power in European exchange rate relations, it will prove difficult to redistribute the costs of exchange rate stability. Applied to the EMS, neoliberal institutionalism and the model of exchange rate cooperation offered convergent explanations that differed primarily in their degree of completeness. Both accounts suggest that EU policymakers created the EMS to realize joint gains. The model of exchange rate cooperation offered a more complete account than did neoliberal institutionalism, however, and offered evidence in support of the hypothesis that policymakers create international institutions to achieve substantive domestic objectives. The EMS was proposed by Helmut Schmidt, and supported by Giscard and Andreotti, because it provided an instrument with which to achieve domestic economic objectives they could not achieve otherwise. Schmidt was a leftist politician facing stagnant wages, relatively high unemployment, and an appreciating mark. Schmidt’s ability to use fiscal and monetary policies to improve these conditions was constrained by the coalition structure of the German government and by the Bundesbank’s independence. Unable to achieve his economic objectives within the domestic arena, Schmidt proposed the EMS, hoping that the system’s intervention obligations would force the Bundesbank to adopt a less restrictive monetary policy. Even if the Bundesbank refused to alter monetary policy to support the weak currencies, a fixed exchange rate would at least ease the pressure on wages and employment caused by the mark’s appreciation. For Schmidt, then, the EMS offered a means of achieving domestic economic objectives he could not achieve within domestic institutions. Schmidt’s proposal found strong support from French policymakers because a fixed exchange rate would help them achieve their domestic objectives. Giscard D’Estaing and Barre were trying to control the wage and oil shock-induced wage-price spiral and needed a mechanism with which to convince French industry that the government was no longer willing to accommodate nominal wage increases through exchange rate depreciation. Lacking corporatist institutions with which to negotiate a solution, and working within a coalition environment that constrained their ability to reform central bank institutions, the French government looked to EC institutions. A fixed exchange rate would impose a global constraint that would make producers less willing to pass cost increases on in the form of higher prices. This in turn would Page 180 →create incentives to resist labor demands for large nominal wage increases, and these twin developments would end the wage-price spiral that had characterized the French economy. Perceiving potential joint gains from a fixed exchange rate system, Schmidt and Giscard proposed the ECUcentered system: a set of exchange rate institutions that would promote a symmetric distribution of the costs of exchange rate stability. By linking parities to the ECU rather than directly to one another, by pooling reserves, and by expanding the finance mechanism that supported the system, the ECU-centered system would promote convergence around an EU average rate of inflation, rather than around the level of the best performer. In operation this system would force the high-inflation policymakers to accept a little bit lower inflation and force the Bundesbank to accept a little bit higher inflation. Yet, in spite of broad EU support for the ECU-centered system, the EMS that emerged from the Monetary Committee was based on a bilateral parity grid that placed the costs of exchange rate stability asymmetrically upon weak-currency policymakers. This institutional outcome was determined by the Bundesbank’s commitment to price stability in Germany and its ability to use this commitment to influence negotiations within the Monetary Committee. By committing to a position in which EU exchange rate stability could in no way constrain its ability to control monetary developments in Germany, and threatening to engage in extreme behavior if EU policymakers pushed forward with the ECU-centered system, the Bundesbank forced other EU policymakers to choose between a continuation of the status quo and exchange rate stability based on the bilateral parity grid. As the distributive outcome clarified, EU policymakers made decisions about membership. For Schmidt and Giscard the bilateral parity grid offered clear benefits. For Schmidt stabilizing the mark, regardless of how this

was achieved, promised to reduce pressure on the German labor market. For Giscard a link to the mark, even if asymmetric in cost, would provide the desired nominal anchor. Schmidt and Giscard thus became full members of the EMS. Benefits were less clear for Italian and British policymakers. Italian policymakers faced an accentuated version of the problems faced by their counterparts in France: a severe wage-price spiral fed by noncooperative labor-industry relations, acute coalition instability, and a politically dependent central bank. Like the French government, Italian policymakers wanted to implement a policy of stabilization, lacked the domestic capacity to do so, and saw the EMS as providing a useful external anchor upon which to moor stabilization. Unlike the French, however, Italian policymakers were concerned that a tight link to the mark would generate steep adjustment costs, which would accentuate political Page 181 →instability. Wanting to stabilize, but fearful of the costs of full EMS membership, Italian policymakers sought a more flexible association. A tight link to the mark was inconsistent with the Callaghan government’s economic objectives. Having just completed two years of stabilization under IMF guidance, Callaghan’s Labour government was facing pressure from the TUC and the Labour Party to use macroeconomic policy to boost economic growth and employment. Because a tight link to the mark would constrain Callaghan’s ability to dedicate monetary policy to domestic objectives, he kept sterling outside of the EMS. Britain’s entry into the system would have to wait twelve years. When it came, it was engineered by a Conservative government committed to price stability as chancellor of the exchequer Nigel Lawson grew increasingly disenchanted with domestic monetary aggregates as monetary targets. Committed to price stability, and increasingly dissatisfied with his ability to achieve this objective at home, Lawson became increasingly attracted to an exchange rate target as the best means of stabilizing prices in the United Kingdom. Seeing benefits from EMS membership, Major placed sterling in the system. In short, neoliberal institutionalism and the model of exchange rate cooperation offered convergent explanations of the creation of the EMS. Both suggested that EU policymakers had constructed the EMS because exchange rate stability offered mutual benefits. The model of exchange rate cooperation, however, offered a fuller account of this process. It provided insight into how domestic political and economic objectives motivated Schmidt to propose, Giscard and Andreotti to join, and Callaghan to opt out of the EMS. The model of bargaining power provided an explanation for the distributive outcome embodied in EMS institutions. While the two explanations converge on an explanation in which the EMS was created because it offered joint gains, the model of exchange rate cooperation provides a much fuller explanation than does neoliberal institutionalism. Neoliberal institutionalism and the model of exchange rate cooperation offered divergent expectations about the factors driving the evolution of the EMS. Neoliberal institutionalism expects institutional change to be driven by a quest for the additional welfare improvements offered by a single currency. The model of exchange rate cooperation expects institutional change to be driven by the redistribution of existing benefits as joint gains from the EMS eroded. Evidence on the EMU process suggested two conclusions that combine to suggest that neoliberal institutionalism offers an incomplete and misleading explanation of EMU. First, full EMU does not represent a welfare improvement relative to the EMS. The EU does not constitute an optimal currency union, and Page 182 →therefore at least one policymaker will be worse off in monetary union than in a flexible EMS. Moreover, a neoliberal account based on the recognition that, while the EU as a whole does not constitute an optimal currency area, core countries come close, is confounded by policymakers’ positions on EMU. Policymakers from those countries that this approach expects will suffer costs in EMU have been among the project’s most ardent supporters, while policymakers from countries this approach expects to benefit have been the most reluctant participants. In short, the lack of joint gains from full EMU and the failure of bargaining positions to correspond well with what theories of OCAs tell us about the costs and benefits of EMU restricted to the EU core make it difficult to sustain a neoliberal explanation. Second, the evidence did suggest that the evolution of the EMS has been driven by a distributive struggle over the costs of exchange rate stability. In the mid-1980s the EMS hardened into a quasi-currency union. The exchange rate flexibility that had characterized the system in the early 1980s disappeared as governments achieved nominal convergence, became less willing to accept the credibility costs of realignment, and liberalized capital accounts. As rigid exchange rates and financial market integration tightened the Mundell-Fleming constraint, the interestparity condition began to bite; exchange rate stability required weak-currency policymakers to maintain a tight

relationship between domestic and German monetary developments. As inflation receded, governments began to direct increasing attention to the problem of employment. Locked into the EMS, however, and forced to offer an interest rate premium to maintain the fixed exchange rate vis-à-vis the mark, weak-currency policymakers’ ability to improve employment by either increasing aggregate demand or inducing investment depended upon Bundesbank policymakers’ willingness to accept a less restrictive monetary policy. The hardening of the EMS into a quasi-currency union thus raised a basic distributive question: would weak-currency policymakers have to accept higher unemployment as the price of exchange rate stability, or would the Bundesbank now have to bear a portion of the adjustment costs? By the mid-1980s, therefore, the key distinction between full EMU and the hard EMS lay not in the two systems’ welfare effects but, instead, in their distributive implications. The hard EMS distributed the costs of exchange rate stability asymmetrically upon weak-currency policymakers. The evolution of the EMS has been driven by weakcurrency policymakers’ efforts to force the Bundesbank to bear a larger share of these costs. As joint gains inside the EMS eroded, French policymakers initiated a series of increasingly ambitious institutional reforms, G-7 macroeconomic policy coordination, limited EMS Page 183 →reforms, and the bilateral Franco-German economic council, to gain influence over German monetary policy and force the Bundesbank to subordinate its domestic objectives to the exchange rate. As these less ambitious attempts were blocked by the Bundesbank, the French proposed a European central bank. By transferring monetary policy authority from the national to the EU level as soon as the Maastricht Treaty was ratified, and by granting the ECB the power to formulate coordinated EU-wide monetary objectives and engage in foreign exchange intervention, the French hoped that the EMU would yield an immediate redistribution of the costs of exchange rate stability. The French were no more successful in these efforts than in their earlier attempts. While they did gain the Bundesbank’s conditional acceptance of monetary symmetry, Bundesbank policymakers ensured that the transfer of monetary authority would coincide with rather than precede the introduction of the single currency. Moreover, Bundesbank policymakers were able to insert into the Maastricht Treaty a set of conditions governing the transition to the third stage of monetary union and to structure the central banking institutions that would operate monetary policy within the currency union. Both achievements will significantly reduce the inflationary implications of a single currency. Whereas between 1986 and 1991 the distributive struggle led to institutional reforms in the direction of greater exchange rate stability, in 1992–93 this struggle yielded greater exchange rate flexibility. The 1992–93 EMS crisis posed the issue of cost sharing in a more acute form than ever before. As the Bundesbank pushed up German interest rates in the wake of German unification, weak-currency policymakers were forced to follow in order to sustain their EMS parities. As financial markets began to bet that weak-currency policymakers would be unwilling to push their economies into recession to support their exchange rates, the system was pushed into crisis. Rather than resolve the crisis cooperatively, weak-currency policymakers and the Bundesbank each became more committed to their respective positions in the broader distributive struggle. Weak-currency policymakers demanded that the Bundesbank bear the costs of exchange rate stability by relaxing monetary policy. The Bundesbank, unwilling to accept the inflationary implications of supporting the mark’s parity, refused to cut interest rates unless the weak-currency policymakers accepted a realignment. With neither side willing to pay the costs that exchange rate stability required, the only available option was a movement toward greater exchange rate flexibility. For some governments this was achieved by exiting the EMS, while for others it was achieved through a face-saving widening of the system’s margins. Since the 1992–93 crisis Bundesbank policymakers have used the Maastricht Page 184 →Treaty’s convergence criteria and the recently introduced stability pact to try to partition EU countries into two groups, one constituting the northern European governments that have demonstrated a commitment to price stability and a second constituting those members who have failed to demonstrate such a commitment. These two groups form the basis for a variegated approach to exchange rate stability. The price stability core, composed of of five or six countries, will likely move forward with monetary union in 1999. Peripheral members will be shut out of monetary union and, if they desire exchange rate stability, will be forced to achieve it within an EMS that will enjoy very little active support from the ECB. A monetary union created along these lines will have only minimal impact on the Bundesbank’s ability to maintain price stability in Germany.

In sum, the lack of evidence of joint gains from EMU, bargaining positions that fail to correspond with what theories of OCAs tell us about the costs and benefits of a single European currency, and the substantial evidence of a redistributive logic in the evolution of the EMS combine to suggest that a neoliberal account is not only incomplete but also misleading. It is misleading because it neglects the distributive element of institutionalized cooperation. The central difference between EMU and the hard EMS lies not in the two systems’ welfare effects but in their distributive implications. Weak currency policymakers have promoted EMU, and some core policymakers have been reticent, because EMU is the institutional vehicle through which the weak-currency policymakers have sought to redistribute the costs of exchange rate stability. The redistribution of existing gains, not a quest for additional welfare improvements, has driven the evolution of the EMS. I will return to what I believe this implies for future research in the final section of the conclusion.

B. Explaining Variation in Exchange Rate Stability How do we explain variation in European policymakers’ ability to stabilize exchange rates? The capital mobility hypothesis suggested that exchange rate stabilization during the 1980s was driven by international financial integration. Unable to stem cross-border flows of capital, European policymakers were increasingly forced to pursue convergent monetary policies. The capital mobility hypothesis is indeterminate, however, along two important dimensions. First, the CMH predicts that monetary policies will converge but tells us nothing about why European policymakers converged around the Bundesbank standard rather than an alternative one. Second, even given a standard, the CMH does not explain why European policymakers chose fixed exchange rates Page 185 →and convergent monetary policies rather than flexible exchange rates and monetary policy autonomy. I constructed a model that would resolve these two indeterminacies. Based on purchasing power parity theories of exchange rates, the model hypothesized that exchange rate stability required nominal convergence. The level of inflation around which members of the exchange rate system would converge would be determined by the solution to the degrees of freedom problem, and this outcome would be determined by relative bargaining power. Here I argued that independent central banks would be best able to credibly commit to a bargaining position and would therefore be most likely to gain control of the system’s single monetary policy instrument. Nominal convergence would depend upon policymakers’ willingness to adopt and ability to implement the monetary policy necessary to converge on this standard, and this would be a function of partisan preferences and domestic institutions. Governments led by rightist parties would have incentive to adopt restrictive monetary policies, while governments led by leftist parties would have incentive to pursue accommodating policies. The ability of parties to implement their desired policies was constrained by domestic institutions. Government type, whether multiparty coalitions or single-party majority, labor-industry relations, and central bank institutions constrained governments’ ability to implement their preferred monetary policies. As the model predicted, the EMS monetary standard was provided by the Bundesbank. Recognizing that an exchange rate system that demanded the use of foreign exchange market intervention and interest rates to support weak European currencies would reduce their ability to control German monetary developments, Bundesbank policymakers used their institutional control over German monetary policy to commit credibly to a bargaining position and gain control over the system’s single degree of freedom. During the EMS negotiations Bundesbank policymakers vetoed Schmidt’s ambitious efforts to give EC institutions a high profile through the ECU-centered system, reserve pooling, and extensive credit arrangements. In their place the Bundesbank instituted a bilateral parity grid supported by limited credit arrangements and periodic realignments. Moreover, Bundesbank policymakers retained the right to cease intervention in support of weak currencies if such operations contradicted monetary objectives at home. In short, Bundesbank policymakers structured EMS institutions to gain control of the system’s single degree of monetary policy freedom. Given this Bundesbank standard, intra-European Community exchange rate stability required other EU policymakers to implement monetary policies Page 186 →that converged on the Bundesbank. Throughout most of the 1980s policymakers proved both willing and able to do so, and, as a result, intra-EU exchange rates stabilized. Was this convergence driven by capital mobility or by domestic politics? Empirical evidence did not yield strong support for the capital mobility hypothesis and did support the domestic politics hypothesis. Rather than the sharp break in the historical relationship between partisan preferences and domestic institutions, on the one hand, and

monetary policy outcomes, on the other, which we would expect if governments were being forced to adopt convergent monetary policies by mobile capital, statistical analysis revealed stable relationships between domestic political variables and monetary policy outcomes throughout the entire period. The empirical evidence suggested a broad shift in domestic political factors from conditions that generated wageprice spirals, leftist and unstable coalition governments, uncooperative labor-industry relations, and dependent central banks to domestic political conditions conducive to price stability. The late 1970s and early 1980s brought Center-Right governments to power. These governments were committed to ending the wage-price spirals that had characterized their economies during the 1970s and reversing a portion of the income gains labor had realized during that decade. Moreover, domestic institutional obstacles that had frustrated previous stabilization efforts, in particular coalition instability, were significantly reduced. Domestic political processes thus yielded governments for which monetary policies that converged on the Bundesbank standard were fully consistent with domestic economic policy objectives as well as political environments in which the implementation of monetary restriction was possible. Thus, statistical evidence suggested that domestic politics rather than capital mobility drove the monetary convergence upon which intra-European exchange rate stability was based. Italy and France, however, were exceptions to this pattern. In both countries policymakers that the model led us to expect to be either unwilling or unable to implement monetary restriction did so. Here again, however, the capital mobility hypothesis failed to gain strong support. Policymakers in both countries relied upon capital controls and exchange rate flexibility to escape the capital mobility constraint. While capital controls did not prevent capital flight, they did reduce capital outflows below what they would be in the absence of capital controls, allowing governments to conserve foreign exchange reserves. French and Italian policymakers used the resulting breathing room to realign exchange rates within the EMS, a process that in the early years of the system’s operation transformed the exchange rate constraint into little more than a crawling peg. The shift to monetary restriction, the embracing of the fixed Page 187 →exchange rate, and the liberalization of capital flows in both countries followed the resolution of acute political conflicts over economic policy. In France the conflict pitted the traditional Left against the social democratic Left, and the reversal of economic policy came only after Delors’s decisive victory in March 1983. In Italy the conflict pitted labor and the Communist Party against Craxi’s social democratic Left and the Center-Right parties. The shift to monetary restriction in both countries came only after the factions that preferred price stability won these political conflicts and gained control of monetary policy. The French and Italian outcomes were not fully determined by domestic politics. Price stability-oriented policymakers in both countries used EMS institutions to help win this conflict. Delors used the EMS to entice Mauroy to defect from the CERES line, thereby giving him enough support within the Socialist Party to reverse the CERES expansion. While Italian governments’ ability to use the EMS to construct coalition support was less effective, they did use the EMS to give the Banca d’Italia the freedom of action it needed to pursue monetary restriction and to impose a constraint with which to convince labor that reforming the scala would not yield sharp reductions in real wages. Thus, rather than being forced to adopt monetary restriction by mobile capital, price stability-oriented French and Italian policymakers used the EMS to relax the Mundell-Fleming constraint and maintain monetary autonomy until they were able to prevail in the domestic conflict over monetary policy. Once having won the battle, French and Italian policymakers directed monetary policy at price stability, embraced fixed exchange rates, and abandoned capital controls. In short, variation in intra-European exchange rate stability was driven by domestic politics rather than by capital mobility. With the monetary standard determined by Bundesbank policymakers’ ability to gain control of the single degree of freedom within the EMS, exchange rates stabilized when other European governments were willing to adopt and able to implement monetary policies that converged around the Bundesbank standard. That most policymakers were both willing and able to do so was the result of domestic political processes and not driven by mobile capital.

C. Implications for the Study of International Institutions Let me conclude by briefly tracing a research path that I believe this book suggests. The book has offered one

novel insight into why policymakers create, and how they use, international institutions: governments create these institutions to help them achieve substantive domestic political objectives. To make this point, the book based its analysis on a model of political competition. Politicians Page 188 →are engaged in competition with other political actors, and winning this competition requires them to satisfy constituent demands. The need to satisfy these demands shapes the policy objectives that governments seek. In other words, politicians produce policy to satisfy the demands of those domestic actors who keep them in power. Providing the policy outputs necessary to retain power is sometimes not possible within the domestic arena, and policymakers thus sometimes construct new international institutions, or exploit or reform existing ones, in order to do so. Thus, in addition to managing international informational and transactions costs problems, international institutions are also instruments of domestic politics. The specific hypothesis developed and examined here—that policymakers created and used exchange rate institutions to reduce the political and economic costs of, and relax coalition constraints on, the implementation of monetary restriction—represents only one manifestation of this logic. If an important determinant of governments’ efforts to create international institutions is the need to satisfy constituent demands, then it is not obvious that politicians will restrict the international institutions they propose to the set of institutions that offer mutual benefits. Politicians might also often propose, and sometimes even create, international institutions that redistribute wealth (or utility). The functional logic upon which neoliberal explanations are based argues that policymakers create institutions to realize joint gains; redistributive institutions are ruled out by assumption. The implications of this assumption were evident in the EMU process, in which an explanation based on the joint gains assumption was misleading. If policymakers propose and sometimes create redistributive international institutions, then we need to move away from neoliberal institutionalism and begin to develop models that allow for both Pareto-improving and redistributive institutions. To do so, we need to move away from neoliberal institutionalism while being careful not to violate the Pareto criterion that distinguishes cooperation from coercion. Two different research strategies can be suggested. One approach would be to drop the complete information assumption upon which neoliberal institutionalist analysis has been based and move in the direction of incomplete information models. Within an incomplete information model policymakers propose but do not create redistributive international institutions. Dropping the assumption of complete information means that preferences become private information with strategic value (Morrow 1994; Kennan and Wilson 1993). While this literature has made important inroads into theories of deterrence and crisis behavior (e.g., Fearon 1994), it has yet to be incorporated into the IPE literature. The logic of an incomplete information Page 189 →approach applied to international economic institutions would be roughly as follows. A policymaker striving to satisfy the demands of domestic constituents proposes an international institution that would redistribute wealth (or utility) from foreign to domestic actors. Because preferences are private information, however, neither side knows a priori that the institution is redistributive. Two outcomes are possible. As the bargaining process reveals information about actors’ preferences, either the actors fail to reach agreement as it becomes clear to both that the proposal is purely redistributive, or the proposal’s redistributive elements are whittled away and the two reach a Pareto-improving agreement. Such an approach is broadly consistent with the Bundesbank’s use of the convergence criteria in the EMU process to force weak-currency policymakers to reveal information about their true preferences for price stability and fiscal rectitude (see Oatley 1996). Moving in this direction would allow our theories to account for instances of failed institution building that are ruled out by assumption from the joint gains-based neoliberal institutionalism. An alternative approach would be to maintain the claim that politicians propose international institutions to satisfy the demands of domestic constituents, remain in a complete information world, and examine the conditions under which international redistribution is possible. Within this approach politicians propose and create redistributive international institutions. Pursuing this strategy requires us to work out the conditions under which governments would voluntarily agree to join institutions that make them worse off. At least two possibilities exist (see Oatley and Nabors forthcoming). First, we can maintain the focus on Pareto-improving agreements by exploiting coalitional models of domestic political competition. A coalitional model allows us to distinguish between the redistribution of wealth and income and the redistribution of politicians’ utility and explore the possibility that an international institution that redistributes wealth need not diminish a given politician’s utility. Suppose, for

example, that there are two countries, Britain and Germany.1 Britain produces “dirty cars” that do not have catalytic converters, and Germany produces “clean cars” that do have catalytic converters. Both sell their cars in the European market, in which emissions regulation allows dirty cars, and both cars sell for about the same price. Suppose that the German government, under pressure from the German auto industry, proposes a tightening of European emissions regulation as a means of taking market share from British producers. By driving up the cost of British cars, this regulation would transfer income from Britain to Germany as the cost of making a clean car raises the price of British cars. Even in the absence of compensating side payments, need this redistribution of income from British to German producers necessarily Page 190 →make the British politician worse off? If the British auto industry is an important constituent, then the income transfer will reduce the politician’s utility. If the auto industry supports another party, however, the income transfer from British to German producers need have no negative effect on the British politician’s utility. Thus, once we move from a focus on the “state” to a focus on the coalitional basis of domestic politics, we can distinguish the wealth and income implications from the utility implications of international transfers and reconcile international redistribution with the Pareto criterion. The second possibility is one in which an international agreement represents a transfer of both wealth and utility, i.e., at least one policymaker realizes a decrease in utility from a wealth-redistributing international agreement. This type of redistribution does appear to be ruled out by the Pareto condition. Such “cooperative” international redistribution is impossible, however, only if two stringent conditions are met: unanimity is the choice rule, and actors are equally powerful. If either condition fails to obtain, then politicians can use international regulation to transfer wealth. The implication of moving from unanimity to majority rule is obvious; the majority redistributes wealth from the minority. While majority rule is not the dominant decision rule in international politics, it does characterize some organizations—the IMF and World Bank, e.g., take decisions by weighted majority, as does the European Union on many issues. Thus, the politics of institution building in these bodies can be redistributive. Less obvious, however, is the recognition that if one actor can define the choice set—the set of alternatives from which the outcome is selected—then redistribution is possible even under unanimity rule. The logic is similar to agenda-setting power in the public choice literature, in which “an individual who can control the agenda of pairwise votes can lead the committee to any outcome in the issue space he desires” (Mueller 1989: 88). The essence of agenda-setting power lies in the fact that the outcome is sensitive to the way in which the committee chair frames the choices others must make, and this logic is fully applicable to unanimity rule situations. Under unanimity rule an actor can define the choice set by excluding the status quo from among the feasible alternatives and including two redistributive outcomes among them: the desired redistributive regulation and an outcome that is even more costly for foreign politicians. With the status quo no longer a relevant choice, foreign politicians must choose between two costly outcomes and will choose the least costly of the two—the powerful actor’s desired regulation—even though it entails a negative wealth transfer. Thus, by having the power to define choice Page 191 →Page 192 →sets, politicians can use international institutions to transfer wealth from foreign to domestic actors. In summary, I believe that incorporating domestic politics into theories of international cooperation requires us to rethink the way we model international cooperation. By providing an alternative incentive to create international institutions based on substantive domestic policy objectives, rather than international information and transaction costs problems, we are forced to ask whether policymakers propose, and sometimes even create, redistributive international institutions. Because it assumes that all international institutions are Pareto improving, and thus eliminates redistributive institutions by assumption, neoliberal institutionalism offers us no leverage with which to assess this question. Modeling the redistributive element therefore requires us to embed neoliberal insights in a framework that allows for the possibility of redistributive institutions.

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Notes Chapter I 1. The utility functions and the numbers used in this example, as well as some of the description of both, are taken directly from Landes and Posner 1987 (31–33). 2. It does not matter who holds the property rights to the externality in question. As long as property rights are specified and transactions costs are zero, French and German policymakers will reach the Pareto efficient agreement under which one side compensates the other and German interest rates go up by only 2 points. It is important to note, however, that, while no efficiency consequences result from the initial allocation of property rights, the initial allocation does yield significant wealth effects: the initial allocation will determine if the French will be compensated for the loss in income they suffer on account of Bundesbank monetary policy, or if they will instead have to pay the Bundesbank to stabilize the exchange rate. In other words, the solution to the externality has distributional consequences. 3. The contracting literature, strongly influenced by the publication of Robert Axelrod’s The Evolution of Cooperation, substitutes the prisoners’ dilemma for Keohane’s reliance on externalities and the Coase theorem (see, e.g., Oye 1986; Axelrod and Keohane 1986; Martin 1993). The prisoners’ dilemma is a mixed-motive game in which cooperation on the part of all players yields Pareto improvements relative to uncooperative behavior. In a one-shot play of the prisoners’ dilemma, however, defection is each player’s dominant strategy, i.e., defection is the best choice regardless of what the other player does. Because defection is the dominant strategy, the only stable outcome in a one-shot play of the prisoners dilemma is an inefficient Nash equilibrium. It should be noted that contracting problems are also inherent in the resolution of externalities. I discuss them separately to indicate that, even in the absence of externalities or public goods problems, institutional deficiencies can prevent Pareto-improving bargains. 4. Martin (1992) suggests that Pareto-improving distributive games, like the battle of the sexes, do not require institutions to enforce outcomes. A battle of the sexes game has the following character: suppose a husband most enjoys classical music, while the wife Page 194 →most prefers hockey games, and these events take place on the same evening. Both, however, prefer going to one of the two events together to going to their favorite event alone or staying home. The game has two Pareto-optimal Nash equilibria: either the two go to the hockey game, and the wife gains more utility than the husband, or they go to the symphony, and the husband gets more utility than the wife. Martin argues that, since both of these outcomes are Nash equilibria, institutional enforcement is not necessary. While this makes sense in a one-shot play of a game, it is not clear that it applies to iterated play. In iterated play we would expect the actor who fared relatively less well in the previous round to appeal to considerations of equity, i.e., “I did what you wanted last time, so it is only fair that you do what I want this time.” Thus, in iterated play each actor has strong incentive to commit the couple to their respective most preferred outcomes. Thus, we might expect the husband to buy season tickets to the symphony and the wife to buy season tickets to the Rangers. In the context of international politics building an institution commits the actors to one particular distributive outcome in iterated play of the battle of the sexes in order to prevent efforts to renegotiate the initial outcome by appealing to considerations of equity. 5. This assumption is questionable on a number of grounds and will be examined in more detail. Here it is sufficient to note that both the United States and Germany have very long histories of paying little attention to the exchange rate. In the United States the Carter administration acted as though it were studiously indifferent to the impact of monetary policy on the dollar’s external value, while the first Reagan administration so neglected the impact of macroeconomic policy on the dollar’s exchange rate that its exchange rate policy was called a policy of benign neglect. In Germany the Bundesbank has consistently prevented the mark’s external value from interfering with the operation of German monetary policy (Henning 1994; Emminger 1977). 6. According to theories of optimal currency areas, if national economies’ goods markets are sufficiently well integrated, and if policymakers in different national economies have the same monetary policy

preferences, then no costs arise from forgoing monetary policy autonomy. The logic of the argument rests on the recognition that, in well-integrated markets, exogenous shocks will hit different national economies symmetrically, and thus the countries within the currency areas require the same monetary policy response. Hence, independent monetary policies are redundant. If shocks hit the various regions asymmetrically, however, then the different regions require different monetary policy responses, and the absence of independent monetary policies within the currency area will be costly. See chapter 6 for an extensive discussion of the European Community as an optimal currency area. 7. One could suggest that the 1973 oil shock was the primary factor behind European policymakers’ failure to stabilize nominal exchange rates during the 1970s. The collapse of the “snake,” however, predated the oil shock; Britain pulled out in May 1972, Italy pulled out in February of 1973, and France pulled out in January 1974, before it felt the inflationary impact of the oil shock. 8. Nor do Frieden’s data appear to support the trade integration hypothesis. While Page 195 →Frieden (1996) reports a statistically significant parameter when the trade integration variable is regressed against exchange rate variability against the mark, he does so on the basis of a model that fails to control for fixed effects. I reestimated Frieden’s pool, consisting of fourteen countries (Belgium/Luxembourg, Netherlands, Denmark, France, Ireland, Spain, Portugal, Britain, Austria, Norway, Sweden, Finland, Greece, and Italy) and three time periods (1973–78, 1979–89, and 1990–93), including thirteen country dummy variables and two time dummy variables, and the trade integration variable ceases to achieve standard levels of statistical significance. Thus, once we control for country-specific and time-specific effects, the level of EC trade integration has had no statistically discernible effect on the level of EC exchange rate variability in the period 1973–93. These results are not presented here but are available from the author.

Chapter 2 1. While certainly not appropriate to explain spot rates, this study focuses on policymakers’ ability to achieve a high degree of nominal exchange rate stability between 1979 and 1992, rather than on an exchange rate’s spot rate on a given day. This make a PPP-based model much less problematic. Moreover, the primary criticism of PPP models, that they tend not to be well-supported by empirical evidence, has to be qualified by the recognition that PPP models perform relatively well under fixed exchange rate systems and relatively poorly under floating regimes. Since this book focuses on fixed-but-adjustable exchange rate systems, the empirical problems with PPP are less severe (Genberg 1978; Krugman 1978; Frenkel 1981; and Mussa 1986). 2. What happens if they do not converge toward a single rate of inflation? If France has a rate of inflation above the German rate, then the French will experience a real appreciation of their exchange rate, i.e., French goods will become more expensive relative to German goods. As a consequence, demand for French goods will fall, and this will cause a reduction in the demand for francs. Moreover, because the expected return on investment in France is reduced, we should see a fall in the demand for francs for investment purposes as well. Thus, a persistent positive inflation differential should yield a fall in the demand for francs and downward pressure on the franc in the foreign exchange market. If committed to the fixed nominal exchange rate, French authorities must intervene in the foreign exchange markets to buy excess francs, an operation that, if not sterilized, will contract French money supply and, with demand for money held constant, cause a reduction in the rate of growth of prices that will restore PPP. 3. See Simmons (1994) for a similar approach to exchange rate determination during the interwar period. 4. Not all labor markets will in fact yield such wage shocks. The characteristics of labor market organization that make them both more and less likely to do so are discussed in the next section. For a good text on labor market economics, see Sapsford and Tzannatos 1993, upon which the following discussion draws. 5. Page 196 →Although the account that follows focuses on supply shocks, the logic of the story is equally applicable to policy-induced inflation, such as that which occurs when policymakers use monetary or fiscal policy to push the economy above its natural rate of output. As Layard, Nickell, and Jackman (1994b: 11 ) write: “when buoyant demand reduces employment, inflationary pressure develops. . . . If the inflationary pressure is too great, inflation starts spiraling upwards; higher wage rises lead to higher price rises, leading to still higher wage rises, and so on.”

6. The following discussion draws on the empirical evidence in support of the “hump-shaped hypothesis” about labor market organization (Calmfors and Driffill 1988). 7. For a useful summary of wage-bargaining systems in OECD countries, see Layard, Nickell, and Jackman 1991. For a more intensive examination of cross-national differences in union organization, see Golden and Wallerstein 1994. 8. Layard, Nickell, and Jackman (1991: chap. 3) argue that the key difference between corporatist and decentralized regimes lies in the extent to which labor takes employment into consideration in real wage bargaining. Under corporatist arrangements the union federation, because it represents all employees, must care about the employment consequences of real wage increases and is thus more likely to moderate its demands. Under decentralized bargaining industry-specific unions need not care about the employment consequences of real wage settlements in their sector and are thus less likely to moderate their real wage demands. 9. The literature on central bank independence is voluminous. In particular, see Cukierman 1992. See Goodman 1992, for a good history of postwar central banking in three western European countries. 10. The degree of political independence is determined by the central bank’s ability to choose the objective of monetary policy, while economic independence is the ability to select the instruments used to pursue this objective. Economic independence is determined by the “influence of the government in determining how much to borrow from the central bank . . . and [by] the nature of the monetary instruments under the control of the central bank.” See Grilli, Masciandaro and Tabellini 1991: 366–70; Eijffinger and Schaling 1993. 11. The credibility role of central bank independence links to much of the macroeconomic literature on the European monetary system, which has investigated the extent to which a fixed exchange rate can substitute for central bank independence as a credible commitment. See, in particular, Giavazzi and Giovannini 1989. We return to this point later. 12. For empirical evidence in support of this claim, see Hibbs 1977, 1987; Alesina 1988b, 1989. 13. Smith and Sandholtz (1995) also offer an institution-based model of bargaining power over monetary issues. Their model is based on institutional access: the German government has greater access to Community institutions than does the Bundesbank, and thus is more powerful in Community-level monetary bargaining, but the Bundesbank Page 197 →has exclusive institutional access to monetary policy in the German domestic arena and is thus more powerful in the day-to-day operation of monetary policy. While this approach appears consistent with the Maastricht Treaty negotiations (as we will see in chaps. 3–6), Bundesbank officials used their access to EU bargaining to shape powerfully both the EMS and the Maastricht Treaty. 14. A rightist government with an independent central bank is likely to welcome the downward pressure on wages resulting from currency appreciation, while a leftist government facing decentralized wage bargaining is unlikely to welcome a mechanism designed to suppress real wage growth. Thus, neither of these configurations is likely to propose a fixed exchange rate system. 15. The strongest argument in favor of this interpretation can be found in Giavazzi and Pagano 1988; and Giavazzi and Giovannini 1989. For a critique of this interpretation of the EMS, see Fratianni and Von Hagen 1992.

Chapter 3 1. All wage share data in this chapter refer to adjusted wage share—compensation of employees adjusted for self-employed as a percentage of gross domestic product (Commission of the European Communities). 2. Giscard, and his first finance minister, Jean-Pierre Fourcade, did adopt a restrictive monetary policy in the months following the 1974 presidential elections. This policy was loosened in the summer of 1975, however, as its employment consequences became increasingly clear. On this episode, see Goodman 1992: 115–17. 3. For a full account of the “Barre Plan,” see Spivey 1982. 4. On the history of the gang of three discussions, see Ludlow 1982. 5. It is interesting to note that the inflation convergence criteria embodied in the Maastricht Treaty is based on averages of the three best performers in each category and thus creates the same incentives. This aspect

of the Maastricht criteria, pointed out to me by a Bundesbank official in an interview, leads to an interesting interpretation of Bundesbank behavior in the period immediately preceding the 1992 EMS crisis. For more on this point, see chapter 6. 6. See the letter from Emminger to the government, in Eichengreen and Wyplosz 1993:57–58. 7. This paper was never made public but was leaked to the Times on November 4, 1978. 8. Prior to being appointed to the Cabinet in September 1981, Lawson had been the financial secretary at the Treasury, for Geoffrey Howe. 9. The British press and government officials refer to the EMS by the name of the system’s exchange rate mechanism, perhaps to maintain the halfway position established by Callaghan in 1978—members of the EMS but not members of the ERM. 10. See Thatcher 1993 (719–26), for discussions between Thatcher and Major on EMU. Page 198 →

Chapter 4 1. A full description of variable codings is provided in the appendix. 2. In coding the time break dummies, the United Kingdom, which joined the system only in 1990, was coded as zero throughout the 1980s. Thus, the interactive terms are relevant to only France, Italy, and Germany. 3. The model was also estimated on a third data set that included four additional OECD countries (the United States, Australia, Canada, and Japan) with only minor changes in the results reported below. 4. F-tests on the second iteration, one with only France and Italy interactives included, indicated that these two countries pooled. 5. The exclusion of the non-EC countries from the time break analysis is justified on the basis of MundellFleming; capital mobility determines monetary policy only given a fixed exchange rate. Since the non-EC countries were not members of the EMS, there is no reason to expect capital mobility to have determined monetary policy in these countries. 6. In the first period realignments took place on September 24, 1979, November 30, 1979, March 23, 1981, October 5, 1981, February 22, 1982, June 14, 1982, and March 21, 1983. In the second period realignments took place on July 20, 1985, April 6, 1986, August 2, 1986, and January 12, 1987. One further realignment occurred on January 8, 1990, when the lira was moved from the wide to the narrow band (Ungerer et al.: table 2). 7. Other interest rate evidence that indicates the same wedge between domestic and offshore rates is presented in Mastropasqua, Micossi, and Rinaldi 1988.

Chapter 5 1. A study by the Commission of the European Communities found that about three-quarters of the variation in fixed capital formation in EC countries during the period 1960–90 is explained by variation in industry profitability. See Commission of the European Communities 1991c. Investment data from Commission of the European Communities. 2. Working in Gaullist governments during the late 1960s and early 1970s, Delors twice had the opportunity to put his ideas into practice, developing and implementing a politique contractuelle in which labor-capital bargaining was oriented toward keeping the growth of real wages at rates supportable by productivity improvements and investment needs (Ross 1995: 18). 3. The wage campaign amounted to three proposals: the moderation of wage demands and the maintenance of purchasing power; efforts to reduce inequalities; and a new method of setting wages in the public sector. The unions, while not willing to accept real wage cuts, were willing to accept the need for wage moderation, so long as wages were allowed to increase in line with inflation. Even the CGT accepted the need Page 199 →for moderation, as long as the package preserved purchasing power (Financial Times, October 8, 1981; Le Monde, October 9, 1981). 4. See Giavazzi and Spaventa 1989, for an analysis of the Italian disinflation strategy of the late 1970s.

5. Among those named on the list discovered at the Tuscany villa of P-2 leader Lucio Gelli were two cabinet members—Enrico Manca, PSI minister of trade, and Franco Forschi, DC minister of labor. In addition, the DC minister of justice, Adolfo Sarti, whose name did not appear on the list, resigned after widespread rumors alleged that he had applied for membership (Keesings Contemporary Archives, 31046.A, 1981). 6. With the exception of one, which was occasioned by the death of the former minister. 7. All data from the Commission of the European Communities. 8. The lira was devalued by 6 percent on March 23, 1981, by 8.5 percent on October 5, 1981, by 7 percent on June 14, 1982, and by 8 percent on March 21, 1983 (Ungerer et al. 1990: 55). 9. Author’s calculations based on the Competitiveness Indicator in Banca d’Italia (1985: 184); and the Effective Exchange Rate index in Banca d’Italia (1988: 200). 10. On the basis of the effective exchange rate index, Italian competitiveness had fallen by 8 percent by mid-1980 (Banca d’Italia 1982). 11. The PCI challenged the legality of Craxi’s decree and managed to gain a referendum on the question of wage indexation in July 1985; it lost.

Chapter 6 1. The standard works for optimal currency areas are Mundell 1961; and McKinnon 1963. 2. The only parity change came in 1989 in connection with the lira’s move from the wide band to the narrow band. 3. See the general discussion in Collignon 1994 (142–50). For evidence on wage rigidity and labor mobility, see Englander and Egebo 1993; DeGrauwe 1994; and Sachs and Bruno 1985. The unemployment costs of sacrificing monetary autonomy can be offset through fiscal transfers. Wealth from dynamic regions is simply transferred to declining regions in an attempt to offset the social consequences of the rising levels of unemployment. The success of such a solution, however, is dependent upon the existence of a supraregional system of transfers, that is, a significant EC fiscal capacity. The European Community fails to provide such a mechanism, however; the Community budget is only about 1 percent of community GDP. 4. Between 1981 and 1990 real wage increases in Germany averaged only 0.6 percent per year, compared to 1.0 percent in France and 1.5 percent in Italy. 5. Productivity did increase in weak-currency countries during the 1980s, but much of these gains resulted from labor shedding (Collignon et al. 1994: 146–48). 6. As Dornbusch (1991: 310) notes, “If success is measured by how close one can Page 200 →come to the German inflation rate, then raising Germanys’ rate is just as successful a strategy as is lowering one’s own. And since the former is less painful it must be the common ambition of most EMS members.” 7. See the proposal in the Financial Times, 12 February 1987. 8. It is interesting to recall in this regard the Bundesbank’s assessment of the ECU-centered system during the negotiations over the EMS in 1978. Recall that Bundesbank officials contended then that establishing a process of nominal convergence based on an average, rather than on the basis of the best performer, yielded an incentive structure that drove actors toward extremes in order to influence the average rate of inflation. 9. The Netherlands retained the narrow band around the Guilder’s D-mark rate. 10. The OECD provides no projection for Luxembourg. I assume that the discrepancy between the EU and OECD projections are not sufficiently large to push Luxembourg beyond the 3 percent target.

Chapter 7 1. This example is inspired by Stephen 1995.

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Interviews A total of twenty-seven interviews were conducted from 1992 to 1993 with officials at the ministries and organizations listed here. A commitment to maintain the confidentiality of the interviewee prevents me from providing names. Banca d’Italia, Rome, June 1993. Bank of England, London, November 1992. Banque de France, Paris, February 1993 (interview conducted in Brussels). Cabinet Minister, London, November 1992. Commission of the European Communities, Directorate General II (Economics and Finance), Brussels, JanuaryMay 1993. Confindustria, Rome, June 1993

Deutsche Bundesbank, Frankfurt, March 1993. HM Treasury, London, September-December 1992. Monetary Committee of the European Communities, Brussels, February 1993; Rome, Italy, June 1993; London, October 1992. Secretariat of the Monetary Committee of the European Communities, Brussels, January and February 1993.

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Index Agnelli, Umberto, 135 Albert, Michel, 56 Alesina, Alberto, 33, 161, 196n.12 Andreatta, Nino, 35, 136 Andreotti, Giulio, 69, 74–75, 179, 181 See also Italy Andrews, David M., 13, 14, 15, 16, 42, 165 Arthuis, Jean, 170 Attali, Jacques, 115, 119, 121 See also France Australia, 198n.3 Austria, 90, 163, 167–69 Axelrod, Robert, 7, 9, 10 Baffi, Paolo, 68–69 Balladur, Pierre, 154–55 Banca d’Italia, 68–69, 127–28, 132–36, 139, 141, 187, 199nn.9, 10 Bank of England, 58 Banque de France, 56, 114, 116, 120, 165 Barre, Raymond, 55–56, 114, 140, 179 See also France “Barrism.” See Raymond Barre Basel-Nyborg reforms, 143, 155, 157 “battle of the sexes” game, 193n.4 Bauchard, Philippe, 114, 115, 116, 117, 120, 121, 122 Bayne, Nicholas, 52, 53 Bayoumi, Tamim, 146 Belgium, 63, 83, 86, 90, 96, 98, 146, 162–63, 165, 169

Bell, David, 114 Bérégovoy, Pierre, 115, 120–21 See also France Bini-Smaghi, Lorenzo, 158, 159 Blum, Leon, 117 Boublil, Alain, 121 Bretton Woods system, 51, 62 Britain. See United Kingdom Bruno, M., 199n.3 Budge, Ian, 90, 108 Bundesbank, 3–6, 15, 18, 20, 22, 37, 51, 92, 99, 111, 124, 144–45, 178–80, 182–87, 189, 194n.5 and EMS, 47–53, 56, 57, 60–65, 73–75, 79, 81–85, 105, 140, 152 and EMU, 153–66, 170–74 See also Germany Burk, Kathleen, 58 Burns, Arthur, 53 See also United States Federal Reserve Cairncross, Alec, 58 Callaghan, James, 57–60, 70–71, 181, 197n.9 Camdessus, Michel, 122 Cameron, David, 90, 108, 111 Canada, 198n.3 capital mobility hypothesis (CMH), 2–3, 13–18, 22, 77–108 Carli, Guido, 135 See also Confindustria Page 218 →central bank independence, 27, 30–31, 37, 107 Centre d’Etudes de Recherches et d’Education Socialistes (CERES), 112–20, 126, 187 CGIL, 67, 138 Chaban-Delmas, Jacques, 115

Chevènement, Jean-Pierre, 112, 120–21, 124 See also France Chirac, Jacques, 55, 154, 166–67 See also France Ciampi, Carlo A., 135 See also Banco d’Italia. CISL, 67, 138 CMH. See capital mobility hypothesis coalition governments. See regimes Coase theorem, 4, 6–7 Collignon, Stefan, 150, 199nn.3, 5 Commission of the European Communities, 50, 52, 58, 66, 116, 127, 134, 150, 156, 197n.1, 198n.1 Committee for the Study of Economic and Monetary Union, 157 Monetary Committee of the European Communities, 57, 60, 62–63, 133–34, 165, 180 Communist Party France (PCF), 54–55 Italy (PCI), 32, 66–67, 69, 129–31, 137–38, 140, 187 Confindustria, 128, 135, 138 convergence criteria, 159–60, 164, 166–72, 174, 184, 189 See also EMU corporatism. See labor market institutions Council of Ministers, 133, 159, 161 See also European Community; European Council; European Union Craxi, Bettino, 129, 131–32, 137–40, 187 See also Socialist Party, Italy (PSI) Cukierman, Alex, 31, 90, 107, 196n.9 currency union. See EMU; optimal currency areas DC. See Italy, Christian Democrat Party De Grauwe, Paul, 199n.3

Delors, Jacques, 114–26, 141, 187 as EC Commission President, 155–58 Delors Report, 156–58, 164 Denmark, 83, 86, 90, 96, 98, 146, 162–65, 167–69 Deutsche Bundesbank. See Bundesbank devise titre. See France Di Scala, Spencer, 129, 130 Dorfman, Gerald A., 59 Dornbusch, Rudiger, 147, 199n.6 Downs, Anthony, 33 Duverger, Maurice, 32 ECB. See European Central Bank Economic and Monetary Union (EMU), 16, 21–22, 73–74, 143–62, 166–76, 181–84 ECU. See European Currency Unit Egebo, T., 199n.3 Eichengreen, Barry, 28, 146, 160, 161, 197n.6 Eijffinger, Sylvester, 196n.10 EMF. See European Monetary Fund EMI. See European Monetary Institute Emminger, Otmar, 51, 53, 62–63, 194n.5, 197n.6 EMS. See European monetary system EMU. See Economic and Monetary Union Englander, S., 199n.3 Epstein, Gerald A., 136 ERF. See European Reserve Fund ERM. See exchange rate mechanism ESCB. See European system of central banks EU. See European Union EUR program, 67

euro, the. See EMU European Central Bank (ECB), 156, 158, 160–61, 166, 171–74, 183 European Commission. See Commission of the European Communities European Community, 1, 8, 9, 12, 13, 15, 16, 36, 38, 43, 47, 62, 84 Page 219 →See also Council of Ministers; EMS; EMU; European Commission; European Union exchange rate institutions, 2, 19, 22, 23, 61 European Council, 47, 49, 53, 57, 156, 158 European Currency Unit (ECU), 60–64, 75 European Monetary Fund (EMF), 60, 64 European Monetary Institute (EMI), 158 European monetary system (EMS), 47, 49, 53, 57, 61–76, 77–84, 99–105, 179–82 evolution of, 143–75 monetary restriction in, 109–42 origins, 47, 49, 53, 58 European Reserve Fund (ERF), 157 See also Delors Report; EMU European system of central banks (ESCB), 157–58 See also Delors Report; EMU European Union (EU), 47, 49, 53, 59 See also Council of Ministers; EMS; EMU; European Commission; European Community exchange rate institutions, 1, 13, 38–46 exchange rate mechanism (ERM), 72–74, 79, 100, 104 Fabius, Laurent, 117, 120, 122 See also France Favier, Pierre, 118, 119, 121, 122 Fearon, James, 188 Fiat, 135–36 Finland, 167–69 Fitoussi, J. P., 150 Flanagan, Robert J., 50, 52–55, 58, 65, 66, 67

Fontenau, Alain, 111, 115, 119, 120, 124, 125 Fourcade, Jean-Pierre, 197n.2 See also France France, 1, 8, 17, 19, 20–21, 25–26, 77, 86, 88, 92, 96, 98–99, 186–87 CGT, 54 cooperation with Germany, 4–6, 9, 49, 65, 156 devise titre, 101 and EMS, 47, 49, 53–56, 60, 62, 65–66, 70, 75, 78–79, 83, 99–106, 109–26, 139–41, 144 and EMU, 146, 150, 153–56, 159, 161, 163–71, 173 “exceptionalism,” 109–42 Fifth Republic, 55 franc, 16, 25–26, 49, 119–23 Unified Socialist Party (PSU), 113 Franco-German Economic Policy Council, 156–57, 183 Fratianni, Michele, 36, 82, 83, 104, 197n.15 Frenkel, Jacob A., 195n.1 Frieden, Jeffry, 16–17, 146, 194–95n.8 Funabashi, Yoichi, 154 G-7. See Group of Seven “gang of three,” 57–58 See also James Callaghan; Valéry Giscard d’Estaing; Helmut Schmidt Garrett, Geoffrey, 11 Genberg, Hans, 195n.1 Germany, 8, 15, 19–20, 25–26, 77, 86, 92, 96, 98, 113, 119, 194n.5 cooperation with France, 4–6, 9, 17, 49, 65, 141, 156 DGB, 52 and EMS, 47, 49, 60–61, 75, 78–84, 104, 105, 141 and EMU, 146, 150, 167–74 and the European Union, 37–38

mark, 16, 25–26, 49, 52, 64, 72–73, 116, 119, 122–23, 154, 162 SPD, 52, 92 unification, 153, 162, 174 Giavazzi, Francesco, 41, 42, 99, 101, 102, 104, 148, 196n.11, 197n.15, 199n.4 Giovannini, Alberto, 41, 42, 99, 101, 102, 104, 148, 196n.11, 197n.15 Giscard d’Estaing, Valéry, 47, 49, 53–57, 60, 65, 74, 75, 179–81 Golden, Miriam, 128, 136, 138, 196n.7 Page 220 →Goodman, John B., 13, 14, 51, 52, 56, 111, 135, 136, 196n.9, 197n.2 Great Britain, 70 Greece, 169 Grenelle agreement, 54 Grilli, Vittorio, 161, 196n.10 Group of Seven (G-7), 52, 119, 154, 157, 182 Guigou, Elisabeth, 122 Hanley, David, 113, 114 Healey, Denis, 58–59 See also James Callaghan; United Kingdom Heffer, Eric, 70 See also United Kingdom, Labour Party Henning, C. Randall, 57, 194n.5 Heylen, Freddy, 149 Hibbs, Douglas A., Jr., 196n.12 Howe, Geoffrey, 73, 197n.8 Hurd, Douglas, 73 See also United Kingdom IMF. See International Monetary Fund International Monetary Fund (IMF), 58, 107, 181 Ireland, 164, 167–69 Italy, 1, 19, 20–21, 77, 86, 88, 96, 98–99, 138, 180, 186–87

Christian Democrat Party (DC), 32, 66, 69, 129–31, 137 and EMS, 47–48, 57, 62, 65–70, 78–79, 81, 83, 99–106, 109–11, 126–41 and EMU, 146, 159, 163–65, 169–70 inflation in, 50, 126–27, 132–33, 135, 137–38 productivity in, 50, 66 Republican Party (PRI), 69, 131, 137 scala mobile, 127–28, 132, 134–35, 137–38, 140, 187 unions in, 127–28, 135–36, 138 wages in, 50, 65–67, 126–28 Jackman, Richard, 28, 196nn.5, 7, 8 Jaffré, Jerôme,55 Japan, 149, 198n.3 Keman, Hans, 90, 108 Kennan, John, 188 Kennedy, Ellen, 156 Keohane, Robert, 3, 7, 8, 9, 10 Knight, Jack, 11 Kohl, Helmut, 123, 154, 162, 165, 167 See also Germany Krasner, Stephen, 11, 13 Krugman, Paul, 25, 100, 195n.1 labor-capital conflict, 18, 24, 25, 31–32 labor market institutions, 28–30 Lamont, Norman, 164 See also United Kingdom Landes, William M., 4 Lange, Peter, 138 LaPalombara, Joseph, 67, 130 Laver, Michael, 106

law of one price, the, 25 Lawson, Nigel, 71–73, 181 See also United Kingdom Layard, Richard, 28, 196nn.5, 7, 8 Lever, Harold, 71 Loriaux, Michael, 111 Ludlow, Bernard, 49, 53, 60, 62, 63, 65, 69, 197n.4 Luxembourg, 146, 167–69 Maastricht Treaty, 1, 144, 158, 160–64, 166–69, 172–74, 183–84 See also Treaty on European Union Major, John, 73, 181, 197n.10 See also United Kingdom Marsh, David, 64 Martin, Lisa, 193n.3, 193–94n.4 Martin-Roland, Michel, 118, 119, 121, 122 Masciandaro, Donato, 196n.10 Mastropasqua, Cristina, 82, 198n.7 Mauroy, Pierre, 114–15, 117–24, 187 McKinnon, Ronald, 199n.1 McKormick, Janice, 121 Micossi, Stefano, 82, 198n.7 Mitterrand, François, 112, 115–24, 130 Monetary Committee of the European Communities. See European Commission Page 221 →Morrow, James, 188 Mueller, Dennis, 4, 190 Muet, Pierre-Alain, 111, 115, 119, 120, 124, 125 Mundell, Robert, 12, 199n.1 Mundell-Fleming open economy models, 13, 15, 104, 182, 187, 199n.1 Mussa, Michael, 195n.1

Nabors, Robert, 189 Nash equilibrium, 193–94n.4 Negrelli, Serafino, 128 neoliberal institutionalism, 2–13, 18, 19, 21, 22, 47–48, 74, 143–53, 172–73, 175, 177–82, 188–89, 191 Netherlands, 86, 90, 96, 102, 146, 158, 162–63, 165, 167–69 Nickell, Stephen, 28, 196nn.5, 7, 8 Nilsson, K. Robert, 130, 137 nominal exchange rates cooperation, 23–46 stability, 24–38 Norway, 90 Oatley, Thomas, 90, 189 Obstfeld, Maurice, 25, 100 OECD. See Organization for Cooperation and Development oil shocks, 50–51, 92, 110, 112, 150 optimal currency areas, 145–53, 166, 182, 184, 194n.6 See also suboptimal currency areas Organization for Economic Cooperation and Development (OECD), 28, 52, 106, 107 Oye, Kenneth A., 9, 10, 193n.3 Pagano, Marco, 41, 99, 148, 197n.15 Pandalfi Plan, 67–69 See also EMS; Italy Pauly, Louis W., 13, 14 PCF. See Communist Party, France PCI. See Communist Party, Italy Plaza Accord, 154 plurality electoral systems. See regimes Pohl, Karl Otto, 64 See also Bundesbank; Germany

Portugal, 146, 169–70 Posner, Richard A., 4 PPP. See purchasing power parity prisoners’ dilemma, 11, 193n.3 property rights, 4, 6–7 proportional representation systems. See regimes PSBR. See public sector borrowing requirement PSF. See Socialist Party, France PSI. See Socialist Party, Italy public sector borrowing requirement (PSBR), 132 purchasing power parity (PPP), 18, 24–25, 79, 185 Putnam, Robert D., 52, 53 regimes, impact of, on monetary system, 27, 30, 31–35 Regini, Marino, 67 Riboud, Jean, 120–21 Rinaldi, Robert, 82, 198n.7 Rocard, Michel, 113–16 See also France Rome Treaty. See Treaty of Rome Rosenthal, Howard, 33 Ross, George, 114 Roubini, Nouriel, 34 Russo, Massino, 82 Sachs, Jeffrey, 34, 116, 199n.3 Salvati, Michele, 66 Salzmann, Charles, 121 Sandholz, Wayne, 196n.13 Santi, Ettore, 128 Sapin, Michel, 164

Sapsford, David, 195n.4 Scandinavia, 28 scapegoating, 42 Schaling, Eric, 196n.10 Schelling, Thomas, 18, 36–37 Schlesinger, Helmut, 162, 164 See also Bundesbank Schmidt, Helmut, 19 and the EMS, 47–53, 59–60, 64–65, 69, 74–75, 171, 179–81, 185 See also Germany Page 222 →Schofield, Norman, 106 Schor, Juliet B., 136 SEA. See Single European Act Sebenius, James K., 11, 12 SFIO, 112 Simmons, Beth, 195n.3 single currency. See EMU Single European Act (SEA), 143 Smith, Michael, 196–97n.13 snake, the, 1, 49 Socialist Party France (PSF), 54–55, 101, 109, 111–26, 133–34, 140–41, 155, 187 Italy (PSI), 66, 69, 129–32, 137–38, 140 Soskice, David, 50, 52–55, 58 Spadolini, Giovanni, 128, 132, 136 See also Italy, Republican Party Spain, 146, 169–71 spatial model of political parties, 33–34 Spaventa, Luigi, 67, 199n.4

Spivey, W. Allen, 197n.3 Stephen, Roland, 200n.1 Stimson, James, 86 Stoltenberg, Hans, 123, 124, 154 suboptimal currency areas. See optimal currency areas Sweden, 90, 167–69, 171 Tabellini, Guido, 196n.10 Thatcher, Margaret, 71–75, 197n.10 Tietmeyer, Hans, 171–72 See also Bundesbank Trades Union Congress, 58–59, 70, 181 See also United Kingdom Treaty of Rome, 113, 148 Treaty on European Union. See Maastricht Treaty Tullio, Giuseppe, 82 Tzannatos, Zafiris, 195n.4 UIL, 67, 138 Ulman, Lloyd, 50, 52–55, 58 Ungerer, Horst, 79–80, 101, 116, 119, 199n.8 United Kingdom, 1, 77, 86, 180 Bank of England, 58, 60 Conservative Party, 32, 57–58, 71–73, 181 and EMS, 47–48, 57, 62, 65, 70–75, 78 and EMU, 163–65, 167–69, 171 Labour Party, 32, 48, 57–59, 70–71, 181 Treasury, 59 United States, 52, 146, 149, 194n.5, 198n.3 dollar, 52 Federal Reserve, 53

Van Doran, Peter, 11 Van Poeck, Andre, 149 Vaubel, Roland, 42, 53 Visser, Jelle, 90, 108 Von Hagen, Jurgen, 36, 82, 83, 104, 197n.15 wage shocks, 28–31, 44, 50–51, 65–66, 92, 112 Waigel, Theo, 164–65 Wallerstein, Michael, 196n.7 Walsh, James I., 15 Webb, Michael C, 13, 14, 15 Wertman, Douglas A., 130 Williams, Shirley, 71 Wilson, Robert, 188 Woldendorp, Jaap, 90, 108 Wyplosz, Charles, 100, 101, 104, 116, 197n.6