An Economic and Monetary 'Experiment' Gone Too Far?

This paper explores the monetary foundations of the European Union (EU) and argues that the legacy of the Bretton Woods system has resulted in a setup that is skewed toward the exchange rate (and price stability) rather than overall macroeconomic policies. This is evident in the design of the currency union which revolves around the exchange rate mechanism, ensuring that members of Europe's custom union and single market do not gain unfair advantages through competitive devaluations. However, it is also evident that the EU's monetary foundations leave open the question of the relative competitive positions of member states, as well as the EU's relative competitive position vis-à-vis the rest of the world. This, as the article argues, can be traced back to the features of the Bretton Woods system that was fundamentally a monetary setup designed to avoid competitive devaluations and 'beggar your neighbour' policy outcomes. By locking in exchange rates and constraining capital movements, the Bretton Woods system kept a lid on the deep underlying question of the relative competitive position of individual countries. But when Bretton Woods came to an end in the early 1970s and capital movements began to be liberalised, trade and financial imbalances began to re-emerge. To contain such imbalances among the EU member states – and remove the option of using the exchange rate to gain competitive advantages – a series of monetary arrangements were introduced that eventually resulted in the European Economic Monetary Union (EMU). The issue of the relative competitive position of individual countries and the macroeconomic setup appropriate for a currency union is still outstanding.