Although proponents of a monetary union recognize that countries can benefit from a common currency that retains its internal and external value, the European Monetary Union as currently envisioned is too small to realize most of those benefits. A much more desirable outcome would be a largely voluntary, decentralized arrangement covering more of the world's trade.

In less than two years, proponents of the European Monetary Union will be forced to choose among three undesirable outcomes. They can postpone the date for beginning the European System of Central Banks and move back the date on which they plan a single currency. Or they can accept that all countries will not be members, at least not at first. Or they can weaken or waive the criteria for membership in the monetary union so that most of the countries can enter.

None of those choices is attractive. Skepticism about monetary union has increased as unemployment has mounted and budget deficits in principal countries, including Germany and France, have remained above the Maastricht criterion, a maximum of 3 percent of gross domestic product. Delaying the starting date inevitably increases doubts about whether monetary union will ever occur.

The second alternative, excluding some countries at the start, although formerly declared unacceptable, is now considered the most likely outcome. The hope is that the excluded countries will take the necessary actions to become members, but that seems unlikely. One of the requirements for membership is a government debt to GDP ratio not greater than 60 percent. Italy is not likely to meet that standard within the lifetime of any living person. Belgium is doubtful also.

The principal economic benefit of monetary union comes from the reduction in the volatility of prices of internationally traded goods and resources. That benefit depends on the number of countries in the union. If intraunion trade is a small part of total trade, a country will be free of uncertainty about exchange rates on only a small part of its trade and investment. In a monetary union including all fifteen countries in the European Union, the share of exports to member countries would be 50-75 percent in all member countries. But if the monetary union includes only the current deutsche mark bloc, nearly two-thirds of exports from Denmark, France, and Germany would be with countries outside the monetary union. So limiting the scope of the union would seriously undercut its economic rationale.

The third alternative would waive the criteria for some countries. That seems the least desirable alternative because it relaxes fiscal discipline from the start. If countries are not required to follow the fiscal rules to gain admission, how likely are fiscal rules to be enforced after countries become members? Is Germany likely to expel France if France has a large budget deficit? How can rules be applied to any country if they do not apply to every country?

Flaws of the Maastricht Plan

Questions such as these lay bare two of the three major flaws in the Maastricht plan. The rules can be waived, and the enforcement mechanisms are vague or nonexistent. Vague enforcement mechanisms heighten uncertainty about how the system would work in practice.

Much of the reason for the uncertainty lies in the different economic objectives that principal countries seek to achieve with monetary union. The Germans want to extend German rules for fiscal and monetary policy to the rest of Europe. They expect that, if their rules are adopted, currencies will be more stable and they will not be required to finance their neighbors' budget deficits. The French want to increase their influence over monetary policy. They chafe under rules made by the Bundesbank.

The second major flaw is that Germany and France have chosen an economic arrangement mainly to solve a perceived political problem. The problem is, of course, Franco-German relations. Lenders on both sides see value in establishing common institutions that will unite the two countries and replace disparate ends with common purposes. They are unable to get agreement on a federal structure, so they hope to move by steps toward monetary union.

As Dr. Otmar Issing, a director of the Bundesbank, has pointed out, they have reversed the usual process. Usually, political union precedes monetary union, and for good reason. Control of government spending and budget finance is critical for effective monetary control over the long term. The current vague criteria for admission and weak enforcement of rules for budget discipline cannot substitute for a political mechanism. In the case of monetary union, the absence of a political arrangement to control deficits is particularly important because monetary union will increase pressures for regional transfers within Europe. The concern is that, in some future fiscal crisis, a country will bargain for a bailout by the central bank in exchange for an increase in domestic taxation or a cut in government spending. Agreements of that kind are familiar from International Monetary Fund and World Bank adjustment programs. Uncertainty about how such issues will be resolved in practice adds to uncertainty about the properties of a European currency.

The third major flaw is the elimination of exchange rate changes as a means of adjusting for differences in regional experience. Countries experience differences in growth rates or differences in economic responses to important external and internal events; exchange rate changes between currencies work to adjust economies to such changes. The oil price changes of the 1970s are an example of an external change; an example of an internal change is the appreciation of the British pound after the discovery of oil in the North Sea.

If exchange rates are fixed, as in a monetary union, some other means of adjustment must be found. The alternatives are: (1) workers move from declining regions to expanding regions; (2) wages rise in the expanding region and fall in the declining region; or (3) the expanding regions make fiscal transfers to the declining regions.

Language and other cultural barriers severely reduce mobility between European countries for all but menial jobs. Social welfare policies limit the downward adjustment of wages. Unemployed workers have chosen social benefits and continued unemployment to wage reduction. They seem likely to continue to do so.

This leaves only two remaining choices for Europe if there is a single currency--budget transfers and continued unemployment. Failure to reach political agreement and vague rules for fiscal discipline expose Europe to repeated conflicts about the size and sustainability of transfers from rich to poor regions and from expanding to declining regions.

An additional source of conflict arises from the opportunity for exchange-rate adjustment by countries that do not join the monetary union. Those countries retain an adjustment mechanism that countries within the union forgo. When, inevitably, economic developments produce exchange-rate adjustments, member countries will complain that nonmembers are using their exchange rates to "export unemployment." There are already many complaints of that kind by French and German producers against British and Italian producers. Opportunities for friction and conflict will increase mightily if part of Europe goes to monetary union and the rest opts out or is excluded. A partial monetary union would test not only the fabric of monetary union but also the rules for open trade and other relations among nations in the current European Union.

The prospect that the quest for monetary union might produce greater conflict, rather than greater harmony, is ironic in light of the political goals that animate many advocates of union. The enormous costs and hardships of repeated European wars in the nineteenth and twentieth centuries, and the gains made during the relatively peaceful fifty years following the Second World War, suggest that the proponents of a federal Europe are right to worry about the prospects of resurgent, post-cold war nationalism. When it comes to monetary union, however, they err in not thinking more rigorously about how a single currency--or adamant efforts to achieve it in the face of economic realities--could exacerbate rather than dampen excessive nationalism. After all, many nations, such as the United States and Canada, have managed to live peacefully for long periods of time without merging their currencies. And there are better ways of achieving the strictly economic goals of monetary union.

A Better Alternative

The proponents of monetary union recognize correctly that countries can benefit from a common currency that retains its internal and external value. No country acting alone can achieve both price stability and exchange-rate stability. There are gains to each country and to all from a cooperative monetary arrangement.

The benefits of price and exchange-rate stability are too large to be ignored, but the European Monetary Union is too small to realize most of those benefits--especially if it is limited to a few countries in northern Europe. A much more desirable outcome for Europe and the world would be a largely voluntary, nonbureaucratic, decentralized arrangement covering more of the world's trade. Countries would be free to join or remain outside.

There are three types of countries to consider. The largest countries--the United States, Germany, and Japan--would follow a common monetary rule to maintain zero inflation in each of those countries. All three are now close to zero inflation, so the adjustment would be small. Bilateral exchange rates for those countries would fluctuate freely so that exchange rates could adjust to real shocks and cyclical changes. Since expected inflation would be zero in each country, monetary effects on exchange rates would be small or nonexistent; hence, volatility of exchange rates would be much lower than under current arrangements. All other countries could fix their exchange rates to one of the major currencies. They would have the benefit of a zero or lower inflation rate on average and a fixed exchange rate over a large trading area.

The central bank of a very small country can do much harm but has little prospect of improving on a fixed-exchange-rate, low-inflation solution. Very small countries should eliminate the monetary operations of their central banks by establishing a currency board or a permanently fixed exchange rate, and to enforce their commitment those countries should permit their citizens to use a noninflating foreign currency as a medium of exchange or parallel currency.

Midsized countries can choose between the advantages of a fixed exchange rate in a world of zero inflation or an independent monetary policy to prevent domestic inflation. Any other choice would fail to provide the benefits that countries can expect to gain from a stable world monetary order and more effective monetary policies. It is up to each country to decide whether it is small or medium-sized and whether it wishes to join the club of stability or undertake its own policy actions. Although others may choose to do so, only the three largest countries should be restricted by a common commitment to a rule that maintains zero expected inflation and provides public benefits for them and for any country that accepts the requisite monetary discipline.

The three large countries would gain from zero expected inflation and from the opportunity to trade at fixed exchange rates with countries that accept the rule-based arrangement. Coordination would not require international action. Each of the three countries would announce the procedures or rules it intended to follow. Actions would be monitored by markets around the world. Departures from the rule that produced excessive money growth would be recognized promptly. Traders would cause the currency to depreciate and interest rates and prices to rise, so any advantage would be modest and short-lived. Market action would encourage the large countries to follow consistent policies of low inflation. A fixed-exchange-rate policy would bind other countries. Efforts to cheat would be punished by traders and speculators.

The proponents of the European Monetary Union are correct in seeing the opportunities for improvement in the monetary system. They are wrong to believe that a single currency for the existing nations of Europe--too disparate in some respects, too limited in others--is the best approach. A much better solution for Europe, and for the rest of the world, can be realized by voluntary arrangements that benefit all countries without fiscal transfers or a world or regional central bank.

Allan H. Meltzer is a visiting scholar at the American Enterprise Institute.