SYNOPSIS:

Only four months ago, people took it for granted that EMU -- European Monetary Union -- was a done deal. The details of the plan, which would create a single European currency, had been hammered out in the Dutch city of Maastricht, and all that remained was for the member nations of the European Community to formally approve the treaty.

That conventional wisdom looks foolish now. France's narrow vote in favor of the Maastricht treaty has saved EMU from immediate extinction, but the turmoil on European financial markets has revealed how poorly prepared the Continent really is for monetary union. Indeed, a new conventional wisdom is quietly taking shape: Maastricht will not become reality and there could be a progressive unraveling of the European Monetary System (EMS). So why did Europe's policy elite think it could go all the way to monetary union? The reason is that fixed exchange rates worked far better than anyone expected. The EMS was founded in 1979, and for the first few years it was relatively ineffective as its members changed their target exchange rates every few months. Soon, however, countries learned to live with fixed exchange rates. In retrospect, it is clear that the stability of the EMS was based on special circumstances. First, the good years of the EMS came at a time when most European countries were still struggling to control inflation. These nations needed a strong anchor, both to discipline themselves and to convince markets that fighting inflation was really their top priority. They found that anchor by pegging their currencies to the deutsche mark. In effect, they let Germany's central bank run their monetary policies in order to gain credibility.

Common problems. During the good years of the EMS, all countries were facing basically the same economic circumstances. From 1982 to 1986, everyone was preoccupied with inflation; and from 1986 until 1990, a recovery had most of Europe fairly satisfied with its economic performance. As long as everyone had the same problems, there was nothing wrong with letting Germany impose a common monetary policy.

But after the fall of the Berlin Wall, West Germany found itself faced with the massive task of rebuilding East Germany. Understandably, Germany chose to borrow most of the money rather than impose huge tax increases. This deficit financing threatened a revival of inflation. To combat this, Germany's central bank raised interest rates. But other European nations, obliged to match the German rate rise, found themselves pushed deeper into recession.

Consider the plight of Great Britain, suffering a severe downturn with no end in sight. If Europe had an American fiscal system, Britain's recession would be partly offset by automatic transfers from more-prosperous nations, like Germany. If workers moved freely between European nations, British workers would be migrating en masse to Germany. But as it is, Britain must either face the full burden of its joblessness alone or let its currency fall. And it was bound, sooner or later, to conclude that defending the pound wasn't worth the cost. Thus, when push came to shove, speculators did not believe that Chancellor of the Exchequer Norman Lamont would be willing to sacrifice the British economy on the altar of EMU. He tried to persuade markets otherwise by pushing interest rates from 10 to 15 percent, but it didn't work. The interest-rate hike was gone within a day and the pound right along with it.

It's likely that over the next few weeks European finance ministers will try to put their monetary Humpty Dumpty back together again. The EMS may be reconstituted at a new set of exchange rates, and this new system may hold together for a while. But it will be a weaker system than the EMS of a few months ago. Now that the markets know that governments will cave in under pressure, they will attack weak currencies even more readily than they have over the last few weeks.

The tragedy of all this is that the monetary debacle may overshadow the strides that Europeans have made toward economic union. Only a short time ago, Jacques Delors, creator of Europe 1992, was widely regarded as a hero of European unity. Now, history may judge him as the man who snatched defeat from the jaws of victory by pushing Europe toward a monetary union for which it was not ready.

Originally published, 10.5.92