2 From the origins to Maastricht

THE EUROPEAN PROJECT was a consequence of the second world war and the cold war. How to tame the German problem that had led to two world wars? How to harness its economic power to rebuild Europe? And how to reconstitute the German army to help fend off the Soviet threat? The answer to these conundrums was to fuse the German economy within a common European system, and to embed its armed forces within a transatlantic military alliance.

Already in 1946, just a year after the war had ended, Churchill called in his Zurich speech for the creation of a “kind of United States of Europe”, to be built on the basis of a partnership between France and Germany:1

At present there is a breathing-space. The cannon have ceased firing. The fighting has stopped; but the dangers have not stopped. If we are to form the United States of Europe or whatever name or form it may take, we must begin now.

Four years later, with a strong nudge from the United States, the French foreign minister, Robert Schuman, produced a plan to integrate the coal and steel industries of France, Germany and anyone else who would want to join the project. This led directly to the creation of the European Coal and Steel Community (ECSC) in 1951.²

The solidarity in production thus established will make it plain that any war between France and Germany becomes not merely unthinkable, but materially impossible. The setting up of this powerful productive unit, open to all countries willing to take part and bound ultimately to provide all the member countries with the basic elements of industrial production on the same terms, will lay a true foundation for their economic unification.

This was the germ of the idea of European economic integration. Today the anniversary of the speech (May 9th) is celebrated as a holiday by the European institutions (known as Schuman Day). The ECSC encompassed not only France and Germany, but also Italy and the three Benelux countries, Belgium, the Netherlands and Luxembourg. Jean Monnet, a French civil servant and scion of a cognac-trading family, who was in many ways the éminence grise behind the entire European project, acted as the first president of its high authority.3

Schuman and Monnet followed the successful establishment of the ECSC with an attempt to set up a pan-European army, the European Defence Community. But this was a step too far for France. The plan was blocked by a vote in the French National Assembly in August 1954. Henceforth NATO would provide the necessary security umbrella, while European integration would focus on economic matters.

The Messina conference of 1955 prepared the ground for the signing in 1957 of the Treaty of Rome, under which the six European countries that had joined the ECSC established a European Economic Community (EEC), which proclaimed the objective of an “ever closer union”. The treaty established a customs union and envisaged the progressive creation of a large unified economic area based on the “four freedoms” of movement – of people, services, goods and capital. The EEC is the direct forerunner of today’s European Union.

Despite Churchill’s ringing call in 1946, the UK, always a sceptic about European political integration, had stood aside from the process. Indeed, Churchill himself was clear that the UK would encourage but not join European integration. The British Labour government refused to sign up to Schuman’s plan, with the then home secretary (and grandfather to a later European commissioner, Peter Mandelson), Herbert Morrison, declaring bluntly that “it’s no good: the Durham miners won’t wear it”.⁴ A later Tory government sent only a junior official to Messina, with clear instructions not to sign up to anything. Yet by 1961, only four years after the Treaty of Rome, the Macmillan government lodged an application for membership, only to see it blocked by Charles de Gaulle’s veto in January 1963.

Currency roots

The notion of a single currency was present at the very creation of the European project. Jacques Rueff, a French economist, wrote in the 1950s that “Europe will be made through the currency, or it will not be made”.5 The idea of a common currency has even earlier roots. Various exchange-rate regimes emerged in 19th-century Europe, including the Zollverein (customs union) and the gold standard. The Latin Monetary Union, set up in 1866, embraced a particularly unlikely sounding group: France, Italy, Belgium, Switzerland, Spain, Greece, Romania and Bulgaria (even more bizarrely, Venezuela later joined it). When it started Walter Bagehot, editor of The Economist, delivered a warning that has a curious echo today:⁶

If we do nothing, what then? Why, we shall be left out in the cold … Before long, all Europe, save England, will have one money, and England be left standing with another money.

In the event, the Latin Monetary Union fell apart when it was hit by the disaster of the first world war.

The 1930s was another period of currency instability in Europe – and the world. The UK and the Scandinavian countries all chose to do the unthinkable in 1931 by leaving the gold standard and devaluing. A rival “gold block” led by France and including Italy, the Netherlands and Switzerland, chose to stay on the gold standard until 1935–36. As Nicholas Crafts showed in a 2013 paper for Chatham House, the early leavers did much better in terms of GDP and employment than the stayers – and France, which suffered a lot from clinging so long to gold, played a role equivalent to today’s Germany by hoarding the stuff and also insisting on running large current-account surpluses.⁷

Although the desire for currency stability carried through into the early years of the European project, the global system of fixed exchange rates linked to the dollar (and thus to gold) set up after the 1944 Bretton Woods conference that established the International Monetary Fund (IMF) and the World Bank seemed sufficient for most countries. But over time, and especially in France, the perception was growing that this system gave the Americans some sort of exorbitant privilege. This was one reason why the European Commission first formally proposed a single European currency in 1962. By the end of the decade, the revaluation of Germany’s Deutschmark against the French franc in 1969 created fresh trauma in both countries, which turned into renewed worries when the United States formally abandoned its link to gold two years later.

As the difficulty of living with a dominant but devaluing dollar increased, Willy Brandt, then German chancellor, revived plans for a currency union in Europe. His plan was taken up in the 1971 Werner report, named after a Luxembourgish prime minister, which argued for the adoption of a single currency by 1980. The report was endorsed in 1972 by all European heads of government, including those from the three countries that planned to join the club in 1973: Denmark, Ireland and the UK. Indeed, at a summit meeting of heads of government in Paris in December 1972, all nine national leaders, including the UK’s Edward Heath, signed up blithely not only to monetary union but also to political union by 1980. A last-minute attempt by the Danish prime minister to ask his colleagues exactly what was meant by political union was ignored by the French president, Georges Pompidou, who was in the chair.8

It was the final collapse of Bretton Woods, followed by the Arab-Israeli war and oil shock and then by the global recession of 1974–75, that upset most of these ambitious plans. Yet by then West Germany, always on the look-out for greater currency stability, had already set up a system linking most of Europe’s currencies to the Deutschmark, swiftly dubbed the “snake in the tunnel”. The idea was to set limits to bilateral currency fluctuations, enforced by central-bank intervention. However, it turned out that the snake had only a fitful and unsatisfactory life. The UK signed up in mid-1972, only to be forced out by the financial markets six weeks later. Both France and Italy joined and left the snake twice. Devaluations within the system were distressingly frequent.

By 1978 there was still no sign of a general return to the Bretton Woods system of fixed exchange rates. So Europe’s political leaders came up with the idea of creating a grander version of the snake in the form of a European Monetary System (EMS). The EMS was mainly the brainchild of the French president, Valéry Giscard d’Estaing, and the German chancellor, Helmut Schmidt, although the president of the European Commission, Roy Jenkins, acted as midwife. In March 1979, the EMS came into being. Its main provision was an exchange-rate mechanism that limited European currency fluctuations to 2¼% either side of a central rate (or to 6% for those with wider bands). All nine members of the European Community joined the system – except, as so often, the UK (this meant, incidentally, that the EMS broke up one of Europe’s few existing monetary unions, that between the UK and Ireland).

Yet for all its ambitions, the EMS proved only a little more permanent and solid than the snake. Italy was at best a fitful and wobbly member. And the election in 1981 of François Mitterrand as France’s first Socialist president of the Fifth Republic led to repeated devaluations of the franc – until the president, under the guidance of his new finance minister, Jacques Delors, and his most senior treasury official, Jean-Claude Trichet, adopted a new policy of le franc fort. When a year or two later Delors arrived in Brussels as the new president of the European Commission, he was quick once again to dust down the old plans for a European single currency.

Enter Delors

The result was the Delors report, commissioned by European leaders in June 1988, which advocated a three-stage move towards European economic and monetary union (EMU). First, complete the single market, including the free movement of capital. Second, prepare for the creation of the European Central Bank and ensure economic convergence. Third, fix exchange rates and launch the euro, first as a currency of reckoning and then as notes and coins. The Delors report went on to form the basis of the Maastricht treaty, negotiated over 18 months and finally agreed on, with much fanfare, in the eponymous Dutch city in December 1991. The treaty was formally signed only in February 1992. Maastricht laid the foundations for a new ECB and a single European currency, to be brought in either in 1997 or (at the latest) 1999. It also promised to make progress towards the parallel objective of political union; and it symbolically renamed the European Community the European Union.

The new treaty reflected above all the changed political situation in Europe after the fall of the Berlin Wall in November 1989 and the subsequent collapse of the Soviet empire. Mitterrand, in particular, was minded to accept German unification after the fall of the wall only if France could secure some control of the Deutschmark, which he feared would otherwise become Europe’s de facto currency. In effect, he had no wish to replace the dominance of the dollar with the dominance of the Deutschmark. Hence the underlying Franco-German deal at Maastricht.

The French had long favoured a new single currency, over which they hoped (vainly, as it turned out) to exert greater influence, in large part to offset the growing might of a newly powerful united Germany. In his turn, the German chancellor, Helmut Kohl, accepted the idea of giving up the Deutschmark, which many German voters as well as the Bundesbank were against, as a price for unification and as a giant step towards building a political union in Europe. Other countries signed up to this with more or less enthusiasm. As usual, the British concern was mainly to be allowed to opt out if they wanted, an objective that was easily secured by John Major, the prime minister, who told the press that the result was “game, set and match” to the UK.9

Besides a general (especially German) desire for currency stability and a wish to contain the power of a united Germany, two other forces were important in driving Europe along the road towards Maastricht and the decision to adopt a single currency. One was theoretical: the literature on shared currencies that began with Robert Mundell’s 1961 article outlining a theory of “optimum currency areas”. Mundell, a Canadian economics professor, posited that substantial welfare gains were to be had if a group of countries shared a currency – because of more transparent prices, lower transaction costs, enhanced competition and greater economies of scale for businesses and investors. But these gains needed to be weighed against the possible costs from losing both monetary and exchange-rate independence.¹⁰

Such costs, according to optimal currency-area theory, risked being especially high if the countries concerned suffered from internal labour- or product-market rigidities, had very different economic structures or were likely to be subject to asymmetric shocks. The theory went on to look at how groups of countries that did not meet these conditions could be changed to make them more suitable. The obvious remedies were more flexibility, notably in labour and product markets; greater labour mobility, so that workers who lost jobs in one country could move freely to countries with more job opportunities; and a substantial central budget that could transfer resources to countries that got into trouble. The 1977 MacDougall report had argued that, in the early stages of a European federal union, a central budget would have to be at least 5–7% of Europe-wide GDP, excluding defence (that is, 5–7 times the size of the existing European budget), if it was to be effective.11

The second force driving monetary union was a more practical one: the move towards a full single market that was being pushed forward by the Delors Commission, most notably by the British commissioner of the time, Arthur Cockfield. The Single European Act, approved and ratified in 1986–87, had paved the way for much greater use of qualified-majority voting (that is, a system of weighted majority as opposed to unanimity) on most directives and regulations. This was crucial to the adoption of the 1992 programme for completing the single market. With this step, what was about to become the European Union at last embraced, more or less in full, the four freedoms that had supposedly underpinned the project from its very beginnings: free movement of goods, services, labour and capital (the last remaining capital controls were abolished in 1990).¹²

The link between the single market and the single currency is not always clear, especially to Eurosceptics, who tend to prefer the first to the second. The reason it exists lies mostly in the fourth of the four freedoms: movement of capital. It is best summed up by the notion of the “impossible trinity” that became popular in the economics literature in the 1980s: the combination of free movement of capital, wholly national monetary policies and independent control of exchange rates was declared to be unworkable or even impossible because the three were likely to contradict each other. The solution, it was held both in the literature and by Europe’s political leaders, was not to revert to constraints on capital flows, still less to unpick the single market, but instead to press forward to a single currency.

Yet Mundell’s work also showed quite clearly that, outside a limited central group, Europe was a long way from being an optimal currency area. Labour and product markets were inflexible and overregulated. Workers’ mobility was limited, not just for obvious linguistic and cultural reasons between countries but even within them. Asymmetric shocks, far from being rare, were worryingly common: German unification was itself an example of one, as was the collapse of Finland’s trade with Russia in 1990 and the bursting of various property bubbles in the 1980s. And countries’ economies varied widely: Germany was strong in manufacturing but weak in services, whereas the UK was the reverse, for example, while national housing and mortgage markets differed hugely in their structure, operation, importance and sensitivity to interest-rate changes. The Maastricht negotiators were well aware of such problems, although many were swift to point out that the United States had a single currency without really being an optimal currency area either. But there were crucial differences between the American system and the euro zone.

Perhaps ironically, it was the UK’s David Cameron, prime minister of a country that will probably never join the single currency, who best summed up these defects, speaking 12 years after the euro was launched at a Davos World Economic Forum. As he then put it:13

There are a number of features common to all successful currency unions: a central bank that can comprehensively stand behind the currency and financial system; the deepest possible economic integration with the flexibility to deal with economic shocks; and a system of fiscal transfers and collective debt issuance that can deal with the tensions and imbalances between different countries and regions within the union. Currently it’s not that the euro zone doesn’t have all of these; it’s that it doesn’t really have any of these.

Instead of creating such structures, the creators of the euro limited themselves to devising a set of “convergence criteria” that national governments would be required to meet in order to qualify for membership of the European single currency. Yet, as many argued even at the time, they quite irresponsibly chose ones that had little to do with transforming Europe into something that might have more closely resembled an optimal currency area.

The right debate at Maastricht would have been about how best to push forward structural reforms to labour and product markets, how to improve countries’ competitiveness and current-account positions, how to create a backstop system of transfers or insurance and how to make sure that the putative European Central Bank could act properly as a lender of last resort. Plenty of commentators, including many from the United States and the UK, made such observations. One example was an article in The Economist in October 1998, which concluded:14

The current set-up looks unsatisfactory. The ECB should be recognised as lender of last resort. It could also be given central responsibility for financial-sector supervision.

In the event, the five criteria chosen for the Maastricht treaty were: low inflation and low long-term interest rates; two years’ membership of the exchange-rate mechanism of the EMS; and, most controversially of all, ceilings on public debt of 60% of GDP and on budget deficits of 3% of GDP. Why were these last two tests chosen? The leaders of more prudent countries (that is, Germany and the Netherlands) argued that, if the single currency were to pass muster with sceptical financial markets and public opinion, limits would have to be set on potentially profligate public borrowers (by which they chiefly meant Italy and the Mediterranean countries).

But the truth was a lot more political. German voters were still hostile to the idea of giving up the Deutschmark. One reason was a widespread fear that Germany might end up having to bail out Europe’s most indebted countries, especially the most indebted of all: Italy. Thus the debt and deficit criteria were devised not so much on their economic merits, but rather in the expectation that they would keep Italy (and presumably also Spain, Portugal and Greece) out of the single currency, as these countries were expected to find it all but impossible to pass the two fiscal tests. The hope, in short, was that EMU would begin smoothly but with a small core group, essentially the Deutschmark zone plus (almost certainly) France.

Ready, steady, go

Two big events overturned this tidy plan. The first, which coincided ominously with the negotiation and signature of the Maastricht treaty, was yet another bout of financial-market jitters. Throughout the trauma of German unification, the EMS and its exchange-rate mechanism had continued to operate. Indeed, the UK chose to join in mid-1990, after a long and politically controversial experiment by the then chancellor of the exchequer, Nigel Lawson, to “shadow” the Deutschmark without informing his prime minister, Margaret Thatcher. The strain of keeping up with a strong Deutschmark soon began to tell, and it was considerably increased in November 1990 by the ousting of Thatcher, largely over the issue of the UK’s attitude to plans for the new European treaty that later became Maastricht.

But it was the aftermath of German unification in that same month that really got the markets going. This asymmetric shock may have cost West Germany a lot of treasure and required massive new investment, but its effect in the marketplace was to increase demand for the German currency. That sent the Deutschmark soaring, hitting German competitiveness at a time when much of Europe was on the verge of recession or actually in it. The markets became even more jittery when, in a June 1992 referendum, the Danes narrowly said no to the recently signed Maastricht treaty. In early September French voters said yes, but by the thinnest possible majority. By then the strains on the UK, Italy and France itself of supporting their exchange rates to keep up with the Deutschmark had grown intolerable. In a dramatic week in mid-September, first Italy and then the UK were forced out of the EMS’s exchange-rate mechanism. And the German Bundesbank had to intervene heavily to keep France in (a trick it repeated in late 1993, when the permissible bands in the exchange-rate mechanism were widened to 15%).

Those involved in what the British later came to call “Black Wednesday” drew very different conclusions from it. France became convinced that a single currency, over which it still hoped to exert some political control, was more essential than ever, for without it the Bundesbank would remain paramount. The UK concluded that a currency straitjacket was a bad idea and that it could never rely on German support, so Black Wednesday came to be seen as another reason to stay out of a single currency, if one ever came into being (it is worth recalling that a young Cameron was a political adviser to the chancellor of the exchequer, Norman Lamont, at the time of Black Wednesday). Italy, Spain and other Mediterranean countries drew a different lesson still: they decided that, while a single currency might well impose pain on them, it would be better to do whatever they could to hop on board from the beginning rather than risk falling further behind.

Hence also the second big development in the 1990s: the response of the Mediterranean countries, most of which the Germans still wanted to keep out. The test case was Italy. In the early 1990s its budget deficit and, even more obviously, its public debt were way above the Maastricht targets. Yet there was bound to be some flexibility in the system, not least because Belgium, which as the seat of the European institutions and part of the Benelux trio was seen by all as an essential founder member of EMU, also had a public debt in excess of 100% of GDP. In 1996 Romano Prodi, who had become Italian prime minister just over a year earlier, spoke to his Spanish counterpart, José Maria Aznar, about the possibility of jointly standing aside from the third stage of EMU when it came. But Aznar replied that he, at least, was determined to join from the start. That drove Prodi not only to rejoin the EMS but also to redouble his efforts to cut Italy’s budget deficit to below 3% of GDP. Given the Belgian position, it was always going to be hard to exclude Italy on the grounds of its public debt alone. This became truer still when France and to some extent Germany itself had to massage their budget numbers to get below the 3% ceiling in 1997 and 1998.

As the likelihood that Italy would be a founder member of the single currency became ever more obvious, the German finance minister, Theo Waigel, started to press harder for a formalisation and tightening of the rules limiting budget deficits and debts after EMU had started, as well as before. The Maastricht treaty had laid down an excessive deficits procedure, but Waigel felt that it was too flexible. Instead, he demanded a new “stability pact” that would automatically impose swingeing fines on any country that ran a budget deficit above 3% of GDP. Most other countries, led by France, naturally resisted any automatic sanctions.

Eventually Waigel was forced to give ground: the fines would be imposed only with the approval of a “qualified majority” of member governments (excluding the miscreant). When in France a new Socialist government was formed after the party won the parliamentary election of June 1997, he even had to concede a change of name to turn it into a “stability and growth pact”. Ironically enough, his own boss, Helmut Kohl, lost his job just over a year later to his Social Democratic challenger. This meant that the two original champions of the euro – Kohl and Mitterrand – had both left office by the time it actually began (and the two countries also had nominally centre-left governments in 1999). Their successors as German and French leaders, Gerhard Schröder and Jacques Chirac, felt less committed either to the euro in general or to the stability and growth pact in particular. Indeed, they were to become the first to breach its terms, in late 2003.

By late 1997, then, it was clear that all EU countries except Denmark, Sweden and the UK, all of which had opted out in one way or another, and Greece, which was miles from meeting any of the criteria, would join the euro when it began life in 1999. Physical notes and coins followed only in 2002, partly because of the time said to be needed to print and mint them in sufficient quantities. In the meantime Greece quietly slipped in to join the single currency at the start of 2001, at a time when few people were looking. Perhaps worryingly, this echoed the story of Greece’s entry into the EEC in 1981. The Commission had given a negative opinion on Greece’s application, but it was overruled by national governments largely on the basis that, as France’s classically minded president, Valéry Giscard d’Estaing, put it, “one does not say no to Plato”.15 It also helped that Greece’s prime minister in 2001, Costas Simitis, was both Germanophile and German-speaking. After Greece joined, the fun really began.