143. Memorandum From the Chairman of the Council of Economic Advisers (Schultze) to President Carter1


  • Assessment of Proposals for a New European Monetary System

You asked if I would prepare an assessment of the new European Monetary System. We labor under the disadvantage that the outline [Page 435] proposed at Bremen was very broad and general. Given that limitation, this memorandum (i) discusses the background for the proposal; (ii) outlines it; (iii) evaluates the likely impact of alternative formulations of the proposal on the United States’ and world economy; and (iv) states my view on what our reaction should be. Before the Summit, you will receive an interagency memorandum with further discussion and agreed-upon talking points.

I. Background for the New Proposal

The new European Monetary System (EMS) proposals must be seen in light of both a long history of the functioning and subsequent breakdown of the Bretton Woods system, and the current frustrations with economic policy in Europe today. A short history of postwar international monetary arrangements is given in an Appendix.2

Why are the European governments proposing EMS now? First, most high officials in Europe do not like floating exchange rates. Second, Europeans believe that U.S. “benign neglect” of exchange rates (our view that market-determined, floating rates are appropriate) reflects an enduring lack of concern about exchange market instability. They believe, therefore, that measures to achieve greater exchange rate stability must be taken without active U.S. participation.

Most important, I suspect that this is a brilliant ploy for deflecting criticism from the failure of European economic policy. The central need in Europe and most of the world today, outside the U.S., is to restore economic recovery. By taking the initiative on a dramatic and bold new action and focusing everyone’s attention on EMS, Schmidt may well remove the sting of German failure to promote adequate economic growth. It should be emphasized, however, that exchange rate instability cannot be reasonably counted as the central cause of economic weakness in Europe. The cause is basically failure to take appropriate monetary and fiscal policies.

Schmidt does genuinely believe that exchange rate instability has been a significant drag on economic growth, especially in Germany. In fact, there is little evidence to date that exchange rate appreciation has markedly dampened German exports (and therefore growth). Exchange rate instability is a symptom of fundamental disparities in economic conditions among countries. Moreover, attempts to impose ex [Page 436] change rate stability on countries with widely different inflation and external positions could well do more harm than good.

What are current views on fixed vs. floating rates?

• There is very little support in the United States for moving back to a fixed rate regime. Such a move would put a straitjacket on domestic economic policies. As in the late 1960s, we would have to weigh the balance-of-payments consequences of every major government transaction. (As Director of the Bureau of the Budget in the mid-1960s, I literally had two sets of books: one for dollars spent in the U.S., and another for dollars spent abroad.) Ultimately, we might be forced into raising unemployment to cure a trade deficit.

• The view from Europe is different. Countries that are smaller and more open than the United States, and have close economic ties with one another, have sound reasons for pursuing economic integration, including monetary unification. About one-fourth of the E.C. GNP moves in world trade, as compared with 7 percent of U.S. GNP. Moreover, half of E.C. trade is within the E.C. Unnecessary exchange rate fluctuations are disruptive of trade and investment. By joining together, these countries hope to reduce unnecessary fluctuations. (But inevitably this must involve harmonizing domestic policies as well as providing for monetary union.)

II. Proposals for a European Monetary System (EMS)

The heads of government in Bremen decided that competent E.C. groups would study the German-French “scheme” with an eye to adopting an EMS in December. It should be emphasized that no agreement was reached in Bremen on the substantive scheme. The main features of the German-French scheme are:

—Setting limits on movements of E.C. currencies relative to each other;

—The establishment of a pool of reserves, consisting of dollars, E.C. currencies, and gold to support these rates;

—There would be “conditionality” on borrowing of pooled reserves, i.e., countries in deficit would have to institute policies to eliminate their deficits. (Note: The Bremen scheme states that responsibilities apply to “deficit and surplus countries alike.” I am very skeptical whether surplus countries will be subject to effective pressures for adjustment.)

—The adoption of a European Currency Unit (ECU) whose value would be based on a basket of EC currencies as “the center of the system;”

—The ultimate establishment of a European Monetary Fund to hold the pooled reserves and oversee the system.

These arrangements would be phased in over two or more years beginning in early 1979. At least during the transitional period they would be superimposed on the existing Snake arrangements. Cur [Page 437] rencies not now in the Snake might initially have leeway for greater rate fluctuations than now exist among the Snake currencies, but it is envisioned that when fully implemented the new system would be at least as restrictive as the Snake.

As you know, the U.K. and Italy have serious reservations about such a plan, and did not endorse it at Bremen. Moreover, the features are all subject to change and negotiation.

III. Analysis of the Proposals

As the exact details will be unclear for weeks or months, we can only pose a series of potential problems that the EMS may hold for the U.S. and world economy.

1. Will EMS restrict the ability of the dollar to reflect underlying market forces? If the EMS only attempts to reduce fluctuations among European currencies, extreme fluctuations of the dollar against individual European currencies may be reduced. (For example, the dollar might depreciate less against the German mark and more against the French franc than it would have otherwise.) On average, the depreciation against European currencies might well be unaffected. There are some hints in the Bremen statement and from other reports, however, that the new system might be used to manage the value of the dollar against European currencies. If these operations went beyond efforts to counter disorderly markets, they could deprive us of needed exchange rate flexibility.

Comment. We must be assured unequivocably that the dollar will be free to adjust when fundamental economic conditions warrant. It must not be pegged.

2. Will the proposals destabilize the dollar? The discussion and development of these new proposals is itself likely to create nervousness and uncertainties in exchange markets—indeed, some has already occurred. This probably will be temporary and modest. Moreover, initially speculators will test the new set of intra-European exchange rates rather than focus on European/U.S. rates.

If the new system uses dollars to intervene when it is buying or selling currencies of its members, and if the transactions are not balanced between buying and selling, then the value of the dollar would be affected.

A more fundamental question arises as to whether the development of more stable rate relationships within Europe, and perhaps ultimately the emergence of a European currency, will make European currencies relatively more attractive compared to the dollar as international money. This may occur, but it is unlikely to occur overnight. Moreover, the dollar as the key currency is likely to face growing competition from the DM and the yen in any case.

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Comment. Although technical provisions need to be worked out, it is clear that the dollar may be subject to unnecessary pressures if the details are not carefully drafted. For example, the intra-European intervention arrangements should be generally neutral with respect to the dollar. Our technical people must be kept abreast of the details as they develop.

3. What effect will the new system have on growth in Europe? There will be a number of offsetting forces at work within the new system, that will affect economic growth. (i) Because countries in payments deficits will not be able to depreciate their currencies, they may have to adopt more restrictive internal policies to deal with their deficits. (ii) The provision of additional resources for loan to deficit countries will, on the other hand, help ease the pressure on them to take such restrictive policies. (iii) But, finally, the fact that the loans will be conditional on adopting “stabilization policies,” and the lack of any equivalent leverage on surplus countries, may create a contractionary bias in the system. This is the source of much of the Italian and British reluctance to participate.

Implementing the system at a time when large and stubborn differences in inflation rates exist among participating countries increases the likelihood that even with fairly large financing resources some countries will be forced to take sharply restrictive action or abandon the system.

Any overall contractionary bias in the system could be reduced (i) by allowing periodic adjustments in intra-European exchange rates; or (ii) imposing and enforcing symmetrical responsibilities on both surplus and deficit countries to adjust internal policies. Little has been said so far concerning the responsibilities of countries in surplus.

4. Will a New European Monetary System be viable? I have some doubts about whether EMS will succeed. A new system of fixed rates will be subjected to severe strains almost immediately:

—Significant current account imbalances exist within Europe.

—Large differentials in inflation rates will lead inexorably to the overvaluation of currencies where inflation is high and undervaluation of currencies where inflation is low.

—More fundamentally, a fixed exchange rate regime in Europe requires institutions to assure that Europe has a concerted fiscal and monetary policy; and that harmonization of inflation rates will occur. The EMS proposal puts the cart of exchange rate stability before the horse of economic harmonization.

Past experience with maintaining fixed rates under such conditions suggests that a system of fixed rates is not likely to last. Britain, France, and Italy have been in the Snake already, and have dropped [Page 439] out—France twice. As the respected German Handelsblatt wrote yesterday, “An old worn out dress has been ironed again.”3

IV. Recommended U.S. Reactions

1. At this stage, the Bremen agreement is very general; its implications for the U.S. and the world economy cannot be assessed until its further details are worked out.

2. Although there are some political disadvantages for the United States, we should not take a negative attitude on general principle, and indeed should support the broad objectives of European economic integrations, including monetary cooperation.

3. When this subject arises in meetings with your Summit counterparts, especially Schmidt, Giscard, and Callaghan, you should indicate: (i) we have historically supported moves toward European integration; (ii) we cannot render a final judgment on EMS until the specific features have been worked out; and (iii) we do have a major interest in seeing that certain broad principles are incorporated and certain dangers avoided.

A. We have an obvious interest in what the system implies for the relationship of the dollar to the basket of European currencies in the system. The system should not be designed or operated in ways that reduce the flexibility of the dollar.

B. Given the current depressed state of the European economy, we think that over the next several years it will be especially important that the system not exert a contractionary force.

C. The specific technical choices made in the design of the system will inevitably have important repercussions for the dollar and for U.S. economic interests. For that reason, you should urge that the United States be kept closely informed at all stages of the technical discussions, so that we can make our views known before arrangements are frozen.

4. Finally, it is critical that discussion of the Monetary System not distract us from recognizing the central requirement in Europe today: a concerted policy to expand the European economy especially in the strong countries like Germany, Switzerland, and Benelux. It would be a tragedy if EMS removed attention from the necessary expansionary measures which must be taken.

  1. Source: Carter Library, Staff Office Files, Council of Economic Advisers, Charles L. Schultze Subject Files, Box 53, Memos to President, 7/78–8/78. Confidential. Under cover of a July 11 memorandum, Owen forwarded to Carter a July 7 message from Schmidt that described the decisions on EMS taken by the EC Heads of Government at the July 6–7 meeting in Bremen. Owen noted that Treasury, State, and CEA would prepare “a memorandum analyzing the scheme.” Carter wrote at the top of Owen’s memorandum: “ZB—I have a good memo from CEA—will study before Bonn.” (Carter Library, National Security Affairs, Brzezinski Material, Brzezinski Office File, Country Chron File, Box 12, Europe: 1978) Under cover of a July 15 memorandum, Owen forwarded to Carter a July 15 memorandum from Blumenthal that provided more information on the EMS. (Carter Library, National Security Affairs, Brzezinski Material, Trip File, Box 13, President, Germany, 7/13–17/78: Economic Summit [II])
  2. Attached but not printed is an undated paper entitled “A Short History of Postwar International Monetary Arrangements.”
  3. Telegram 12607 from Bonn, July 10, reported on the Handelsblatt editorial with this statement. (National Archives, RG 59, Central Foreign Policy File, D780282–0589)