At the start of Emu on January 1 1999, the exchange rates of the participating currencies will have to be fixed irrevocably in terms of the new currency, the euro. From then on, the national currencies will simply be particular denominations of the euro, until they are phased out at the start of 2002. How should the conversion rates be selected?
Politicians who signed the 1992 Maastricht Treaty (and who took decisions at the Madrid Summit meeting of 1995) have already given an answer to this question but, in doing so, they have created new problems. The answer is that the conversion rates that will be applied on January 1 will be equal to the Ecu market rates of the previous day at closing time. Thus if on December 31 1998 the Ecu/Deutschmark rate reaches 1.96842, this will be the fixed rate at which the Deutschmark converts into euro from January 1 1999.
This looks like a simple rule. Yet politicians seem to have delegated to the market the arduous task of choosing the conversion rates that will be irrevocably fixed. That looks like an oversight - politicians usually do not like the market to take these difficult decisions, although this time one might think they are right to do so. The market may generally be the best possible mechanism for deciding what the exchange rate should be. Yet paradoxically, in the case of selecting irrevocably fixed conversion rates, the market will have great difficulty making up its mind. Behind this is what economists call an indeterminacy problem.
In general when deciding about the appropriate level of, say, the dollar/Deutschmark rate the market makes forecasts about the future fundamentals (for example, interest rates and inflation rates) that drive the dollar/ Deutschmark rate. As new information reaches the market, these forecasts are updated and, as a result, the dollar/Deutschmark rate moves up or down. It is quite possible that sometimes speculative frenzy drives the market rate away from its fundamental value. Agents know, however, that in such cases of misalignment economic forces will tend to bring the exchange rate back to its fundamental value.
Can one rely on this market mechanism to select the conversion rates? It is here that the indeterminacy problem pops up. Market participants know that on January 1 1999 the exchange markets of the currencies participating in Emu will end. This is like the end of the world for these markets. In addition, participants in them know that the conversion rate which will apply from January 1 1997 will be the market rate reached just before the end of the world. This creates the following problem. As we move closer to the end of the world, forecasting fundamentals becomes less and less important because they will cease to have any relevance in the new world. For example, after January 1 1998 the French franc/ Deutschmark market will cease to exist. As a result, any fundamental influencing the French franc/Deutschmark rate today will be irrelevant. In contrast, forecasting the conversion rate becomes more and more important as we come closer to that moment. This is all the more true because the forecasts about this "last exchange rate" are 100% self-fulfilling. Whatever that number turns out to be, it will forever be fixed. Thus as we approach January 1 1999 expectations that the Ecu/Deutschmark rate will be, say, 2.1 will drive the exchange rate to that level and at the same time force the conversion rate to be 2.1.
Such a situation is likely to create much turbulence. It also opens the door to manipulations by large investors capable of driving the exchange rate in a particular direction and profiting from this. The profits are almost a sure thing since the authorities will validate whatever level these large investors have chosen to drive the exchange rate to.
It is clear that a solution must be found to this problem, lest the Emu start in an environment of extreme turbulence. But how?
To give an answer, it is useful to rephrase the indeterminacy problem. The market knows that the decision to fix a conversion rate on January 1 1999 is essentially a political decision, as any fixing of exchange rates is. So the market has to forecast what that decision will be. At the same time the politicians tell the market participants that they will base their decision on what the market believes this conversion rate will be. A hot potato will be thrown back and forth between the market and the politicians. The market will lack an anchor on which to base its forecasts.
The previous discussion now makes clear how this problem should be solved. The authorities have to provide such an anchor. This means that soon after the decision on Emu membership (May 1998), the authorities should announce these conversion rates (or a band within which they will fall).
Several new problems arise with that solution but they can be solved. First, the authorities will not be able to announce the euro conversion rates of the participating currencies in advance. This is because the Ecu, which will become the euro after January 1 1999 (at a one-to-one conversion rate) is a basket currency. As a result, its market value will also be influenced by the movements of the currencies in the basket that do not participate in Emu (for example, sterling). Thus, announcing a fixed euro/Deutschmark conversion rate would imply that the sterling/Deutschmark rate is also fixed. It is not clear whether this can be done.
The authorities can alleviate the problem by announcing the bilateral conversion rates between the participating currencies. This will provide an anchor in the markets that really matter. However, it will still leave the euro rates of these currencies indeterminate. This indeterminacy problem can be reduced in intensity if the authorities are prepared to intervene when the outside currencies (for example, sterling) fluctuate too much.
A second problem is one of credibility. Announcing fixed conversion rates in advance is one thing. Making these announcements credible is another. This problem should not be exaggerated. After all, when the conversion rates are announced, the most difficult decision the one about membership of the single-currency system will have been taken. The whole Emu project will experience a credibility boost because the uncertainty about which states will be in and which out will have been resolved. The authorities can enhance the credibility of the announced conversion rates by some "institutional front-loading", that is, by starting the process of intense monetary cooperation before the actual start of Emu. For example, instead of the Bundesbank deciding alone about the interest rates, the participating central banks could already start deciding about this jointly. In doing so, they would give a strong credibility message to the markets. If the credibility is strong, the market exchange rates will automatically converge to the announced conversion rates.
Contrary to what is often believed, the conversion rates decision cannot be left to the market. It is a part of the authorities' responsibilities to take it. To guarantee a smooth transition towards Emu, the authorities will have to give clear signals about their intentions. Failure to do so will lead to major upheavals. Fortunately, once the decision about membership is taken, it will be relatively easy to give these clear signals.
Paul De Grauwe is economics professor at the Catholic University of Louvain, Belgium