The European Payments Union : History and Implications for the
Evolution of the International Financial Architecture *
University of California, Berkeley
Jorge Braga de Macedo
OECD Development Centre, Paris
The European Payments Union (or EPU) functioned successfully for nearly eight years, from its establishment on 1 July, 1950 to its dissolution on 27 December, 1958, when current account convertibility was restored by the participating states. This experience inspired several proposals for an EPU-like arrangement following the fall of the Berlin Wall and the collapse of the Soviet Union. In retrospect, these proposals were misguided: whereas the nations of Western Europe were seeking to draw together after World War II into an economic community, the successor states of the Soviet Union were seeking to loosen their regional ties in favor of stronger links with the rest of the world. Be this as it may, these recent invocations of the EPU leave no doubt that Europe’s experience in the 1950s continues to cast a long shadow.
The EPU was one of several postwar institutions of European economic cooperation that can trace their origins to the Marshall Plan (Bielet 1956, Carli 1981). The U.S. saw the Marshall Plan as a device for fostering the integration of Europe and required as a condition for the disbursal of aid not only the dismantling of intra-European trade restrictions and the coordination of national recovery plans but also agreement on the part of the recipients on how to allocate the payments. The venue in which this was to be achieved was the Organisation of European Economic Cooperation (the OEEC, which evolved into today’s OECD). Despite U.S. participation as associate member of the OEEC, the EPU and the OEEC were essentially European entities. They were mechanisms for European countries to exert peer pressure not unlike the one that is at the heart of the multilateral surveillance procedures of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). Insofar as Europe’s monetary union (EMU) is a descendent of the EMS, it can be said that the lessons of the EPU continue to be practiced today.
In this paper we relate the structure and operation of EPU to the ongoing debate on reforming the international financial architecture. The text is organized into five sections. Section 1 reviews the structure and operation of EPU. Section 2 evaluates its contribution to Europe's post-war recovery and growth. Section 3 then describes how the EPU provided a precedent for the ERM code of conduct and for policy coordination in EMU. In section 4 we describe how these developments were challenged but ultimately solidified by the financial crises that battered Europe in the 1990s. And Europe’s experience with crises helped to inform the debate about how to strengthen the international financial architecture (as we describe in Section 5). The implication is that regional organizations and arrangements along the lines of EPU and EMU may become increasingly attractive to countries in other parts of the world as they aspire to create comparable zones of monetary and financial stability.
1. The operation of EPU
The EPU was a mechanism for multilateralizing the bilateral agreements upon which intra-European trade had been restarted after World War II. At the end of each month, each EPU country's net balances with each other country were reported to the Bank for International Settlements, the EPU's financial agent, which cancelled offsetting claims. Remaining balances were consolidated, leaving each country with claims on or liabilities to not individual countries but the union as a whole. From the perspective of any one country's assets and liabilities in foreign currencies, it thus made no difference with which other European country it traded. Only the overall balance in European currencies mattered at the end of the day.
Net debts could be financed initially with credits, but eventually these liabilities had to be settled in dollars and gold. Each country received a quota equal to 15 percent of its total trade with EPU area in 1949. So long as its liability to EPU remained less than 20 percent of its quota, it was financed entirely by credit. The net position was carried on the books of EPU without requiring any payment. After the liability reached 20 percent of the quota, settlement had to be 20 percent in gold. Debts in the amount of 40, 60, and 80 percent of quota required settlement in 40, 60, and 80 percent gold or dollars. Cumulative surpluses were settled in similar fashion, albeit with different percentages. Once the quota was exceeded, settlement with the union had to be made entirely in gold, although under exceptional circumstances additional credits were extended by EPU's Managing Board. Thus, trade was multilateralized and its volume was stimulated by the availability of EPU credit lines.
Accumulated claims could be converted into commodities or hard currency only partially and with delay. Until its quota was exceeded, a surplus country would receive gold amounting to only 40 percent of its cumulative net exports to other EPU countries. For debtor countries securing loans and relieved of the need to settle bilaterally, the attraction of this system was obvious. But what was the attraction to a creditor like Belgium in persistent surplus with the union?
The answer comes in three parts. First, a lower proportion of gold payments was initially required of debtors than was extended to creditors. This increased the likelihood that surplus countries, which would otherwise be trading their exports for inconvertible claims, would wish to participate. Giving creditor countries more gold than was contributed by debtors required working capital: this the US contributed in the form of a grant of $350 million of Marshall Plan money to EPU.
Second, financial assistance came with conditionality minimizing the scope for exploitation of creditors by debtors. When a member exhausted its quota, EPU Managing Board, comprised of independent financial experts reporting to the Council of the OEEC, met to advise it and compel the adoption of corrective policies. Thus, the creditors had reason to anticipate that the debtors would be forced to adjust.
Third, EPU membership required the liberalization of trade. Countries, when joining, pledged to eliminate discrimination against other participants based on balance of payments considerations. A Code of Liberalization formalized this commitment. By February 1951, less than a year after EPU came into operation, all existing trade measures were to be applied equally to imports from all member countries. Participants were required to reduce trade barriers by a given percentage of their pre-existing level, initially one half and then escalating to 60 and 75 percent. The most internationally competitive European countries, such as Belgium, stood to gain disproportionately from such liberalization.
Intra-European trade expanded vigorously under EPU, from $10 billion in 1950 to $23 billion in 1959. Imports from North America grew more slowly, from $4 billion to $6 billion. Although both intra-European trade and trade with the rest of the world expanded more quickly than European production in the EPU years, the spurt in European trade was coincident with the inauguration of the EPU. All this suggests that its liberalizing effect was considerable. Despite the relatively slow expansion of trade with the United States, Europe's strengthening dollar balance more than doubled its dollar holdings between the end of 1949 and mid 1956. As dollars grew less scarce, the need to discriminate against the US became less pressing. The terms of EPU settlements were hardened, and the removal of quantitative controls on intra-European trade accelerated.
To what extent did EPU credit fuel this trade? Participating countries had $46 billion of surpluses and deficits against one another during EPU years. Nearly half ($20 billion) was canceled multilaterally. Another quarter ($12.6 billion) was canceled intertemporally, as countries ran deficits in one month, financing them wholly or partially with credit, and ran offsetting surpluses in subsequent months, canceling their previous position. Settlement in gold and dollars was limited to most of the remaining quarter ($10.7 billion). Thus, EPU reduced settlement in gold and dollars by more than 75 percent compared to what would have been required under strict bilateralism.
2. The role of the EPU in Europe's post-war growth
Was this payments union scheme the only way of organizing Europe’s postwar trade and payments, or were there alternatives such as current account convertibility?
For political more than economic reasons we think not. As argued in Maier (1987), post-World War II Western European growth was based on a distinctive social pact. A repeat of the debilitating struggle over income distribution that had characterized the post-World War I period was successfully averted. Workers agreed to moderate wage demands if management agreed to reinvest the profits they thereby accrued in productivity-enhancing plant and equipment. Each side agreed to trade short-term gains for long-term benefits so long as the other side agreed to do the same.
In the Netherlands, for example, labor unions explicitly agreed that the fruits of all productivity increases in the first half of the 1950s should be used to finance investment. In Germany, they observed significant wage restraint throughout the 1950s. In Austria, German-style wage moderation and investment were secured through consultation between representatives of labor, management, and government. Even in Britain, not renowned for labor-management harmony, the Trades Union Congress cooperated with management and with the Conservative governments that ruled from 1951 by moderating wage demands.
Management, for its part, raised investment rates to nearly twice the levels that prevailed before the war and, to higher levels than after 1972 when the post-war settlement began to unravel. In Britain, not one of Europe's high investment countries, management agreed to restrain the payout of dividends and to reinvest profits instead. British economic growth is subject to criticism, but growth rates in the 1950s were impressive compared to preceding and subsequent periods.
Reaching this settlement required minimizing the ratio of short-term sacrifices to long-term gains, especially since discount rates were high in the post-war years. By strengthening Europe's terms of trade, the EPU moderated the requisite sacrifices. Devaluation implied a worsening of the terms of trade, reducing the size of the pie to be shared out among competing interest groups. For devaluation followed by convertibility to balance the external accounts, residents of other continents had to be coaxed into purchasing more European exports and Europeans had to be induced to purchase fewer imports. A decline in the relative price of European goods would have been needed to bring this about.
In contrast, a payments union that restricted imports from extra-European sources relative to how they would have been treated under convertibility had the same effect as a tariff. Europe maintained payments equilibrium vis-à-vis the rest of the world not by altering relative prices so as to export more but by limiting purchases of non-European goods through the use of import licensing, foreign exchange rationing, and the other administrative devices associated with inconvertible currencies. By reducing the European demand for US goods, this shifted relative prices in Europe's favor. Stronger terms of trade meant that fewer exports could command more imports from countries like the United States. As an implicit tax on imported goods, inconvertibility raised the level of European incomes consistent with payments equilibrium vis-à-vis the rest of the world.
Pursuing convertibility would have shrunk European incomes by 1 to 2 percent, an effect comparable to that of eliminating the Marshall Plan. This could have threatened the fragile agreements between labor and capital over distribution in post-war Europe. Opting for the EPU averted this danger. The post-war settlement, once struck, still had to be enforced. Workers had to be convinced to trade lower current compensation for higher future living standards, despite uncertainty over whether management would keep its part of the bargain to reinvest the profits that accrued tomorrow as a result of labor's sacrifices today. Awareness of this problem rendered labor hesitant to agree. Governments reassured it by adopting policies and programs that acted as "bonds" which would be lost in the event of reneging. They agreed to limit rates of profit taxation in return for capitalists plowing back earnings into investment. They provided limited forms of industrial support (selective investment subsidies, price-maintenance schemes, orderly marketing agreements) to sectors that would have otherwise experienced competitive difficulties. Workers were extended public programs of maintenance for the unemployed, the ill, and the elderly. This web of interlocking agreements - what might be called the mixed economy for short - functioned as an institutional exit barrier. It increased the cost of reneging on the sequence of concessions and positive actions that comprised the post-war settlement.
The EPU was a concomitant of these arrangements. Without import licensing and foreign exchange rationing, which provided limited insulation from international markets, intervention in the operation of domestic markets would have been more difficult. More intense trade competition would have increased the budgetary cost of selective industrial subsidies. It would have made the wage compression across sectors sought by solidaristic trade unions more costly to achieve. Social programs would have been threatened by pressure to minimize labor costs. The web of arrangements that provided the institutional barrier to exit would have been that much more difficult to spin. In the worst-case scenario, the domestic settlement might have broken down.
The other element of the post-war growth recipe was trade expansion in the context of European integration. Rather than reverting to the pattern of the 1930s, post-World War II Europe exploited trade as an engine of growth. National economies were allowed to pursue their comparative advantages and to exploit economies of scale and scope.
This was accomplished in the first instance through the liberalization of intra-European trade. Quantitative restrictions on intra-European trade were removed more rapidly than those affecting transactions with other continents. European nations were natural trading partners for reasons of proximity and history. To say that Germany was a traditional exporter of capital goods and other European countries of consumer goods is to generalize excessively but to convey the essential point. Without a rapid expansion of trade to permit this pattern of comparative advantage to be exploited, it is doubtful that productivity and incomes could have risen as they did. And, for reasons described above, slower growth emanating from the international sector would have increased the sacrifices in living standards entailed in the domestic settlement, threatening stability there as well.
Restructuring along export-oriented lines was costly. Before undertaking it, policymakers had to be convinced that Europe's commitment to free trade was permanent. Reallocating resources along lines of comparative advantage entailed sunk costs; sinking them would be a costly mistake if any of the major European trading nations reneged on its commitment to free trade.
With memories of trade conflict in the 1930s still fresh, European policymakers had to be convinced that the countries concerned - especially Germany - would make benign use of their productive capacity. Two wars had heightened skepticism about whether Germany could be trusted to use its industrial power benevolently. But permanently dismantling German industry, as advocated by some in the US government, would have left a hole at the center of the European economy. A depressed Germany would drag down the demand for the exports of other European countries. Eliminating the Continents principal supplier of capital goods would raise the cost of investment, worsen the dollar shortage, and force other countries to divert resources toward the production of capital goods.
For Germany, recovery required consent on the part of the occupying powers that controls on the level of production should be removed. In return, the Allies required that Germany be integrated into the European economy and that mechanisms be developed to prevent that commitment from being reversed. Germany, for its part, needed reassurance that its access to raw materials, industrial intermediates, and foodstuffs produced abroad was guaranteed, given the prominence the Nazis had lent to Germany's dependence on foreign supplies.
For those concerned to construct institutional barriers to exit, the EPU and the arrangements in which it was embedded were preferable to unilateral convertibility. A payments union required institutions capable of monitoring compliance and imposing sanctions. EPU membership was linked to trade liberalization: member countries committed under the terms of the agreement to "the maintenance of desirable forms of specialization . . . while facilitating a return to full multilateral trade . . ." They adopted a Code of Liberalization mandating a schedule of subsequent liberalizations. Countries failing to comply with this code or employing policies to manipulate the terms or volume of trade in undesirable ways could expect to be denied access to EPU credits.
The Economic Cooperation Administration, which administered the Marshall Plan, supported the EPU. Hence, the leverage the US enjoyed as a result of the Marshall Plan buttressed the credibility of European countries' commitment to trade.
3. From EPU to EMU
The EPU was dissolved at the end of 1958 when it became feasible to restore the convertibility of currencies on current account. But full convertibility (on capital as well as current accounts) was not achieved until the 1980s or even the early1990s. In the meantime, European countries sought to establish a zone of monetary and financial stability by creating the ERM. The single financial market, established in 1993, and the euro, established in 1999, were made possible by the operation of the ERM code of conduct. At one time or another, all of the EU member states participated in this gradual acceptance of stability-oriented policies, supported by the peer pressure applied through EU institutions. But where the U.S. had encouraged acceptance of the EPU code of conduct through a system of rewards and sanctions administered by the OEEC, the success of EMU depends on the members of the EU alone.
Their commitment to European integration was reinforced by the emergence of a more volatile economic and financial environment. There were three waves of financial crises in the 1990s: the first erupted in September 1992 in Europe and was resolved in the summer of 1993 when the fluctuation bands of the ERM were widened from 2 1/4 to 15 per cent; the second followed the attack on the Mexican peso in December 1994 and had ripple effects in South America and Central Europe; and the third and most serious erupted in Asia in 1997, lasting two years and ending around the time of the launch of the euro.
Each of these crises had a strong regional component (Glick and Rose 1999). Reflecting what were described as "geographic fundamentals," the escudo and the punt suffered attacks based on what was happening to the peseta and sterling. While those attacks were short-lived, they nevertheless forced Ireland to request a realignment of the punt in January 1993 and Portugal to realign the peseta. Perhaps because their regime change was quite recent (1987 for Ireland, 1989 for Spain and 1992 for Portugal), these countries’ financial reputations remained imperfectly established, allowing conditions in neighboring countries to have a particularly powerful impact. Perhaps market participants were particularly badly informed about conditions in these countries: rightly or wrongly, they believed that firms in Spain and Portugal sold many of the same products into world markets, placing them in close competition, so that devaluation by Spain would put irresistible pressure on Portugal.
Except for the Deutschmark, which was the anchor of the ERM, most European currencies could neither float comfortably nor fix credibly. Resolving this dilemma has required the creation of an institutional framework for mutual surveillance, comprised of the Monetary Committee, the Ecofin Council, the European System of Central Banks and the mutual surveillance procedures of the Maastricht Treaty. The Bank of England and the Swedish Riksbank have taken a different approach to this problem by attempting to substitute a well defined, alternative monetary-policy operating strategy – inflation targeting – for their abandoned ERM pegs. How successful this alternative will be only time will tell; so far, the krona, if not sterling, has been stable against the euro and inflation in both countries has been subdued.
The ERM was therefore an instrument of convergence towards the single currency, to the extent that it was flanked by other instruments specified in the Maastricht Treaty and the Stability and Growth Pact. These other instruments include a timetable, specific procedures of multilateral surveillance, convergence programs, and the excessive deficit procedure. In addition, progress was made in many countries to strengthen the independence of the national central bank. The European Monetary Institute was established to contribute to the realization of the conditions necessary for the transition to stage three of EMU and the creation of the European Central Bank also proceeded on schedule. The fact that the single European currency was delayed from 1997 until 1999 may actually have helped prevent and excessively fast politicization of monetary policy. The politicization would increase the temptation to soften the excessive deficit procedure, raising fears that some governments will expect to be bailed out by the union, in contradiction to Article 104b of the Treaty. Once again, an effective multilateral surveillance is required, supported by all member states, whose effectiveness is decisive for medium term policy credibility at national and union level. Indeed it may provide a model for the global surveillance performed by the IMF. Properly used, all of these instruments and procedures effectively delivered convergence and cohesion in EMU.
In addition, political stability and social consensus were decisive for achieving convergence. Social consensus presupposes that social partners and public opinion understand and accept the medium term stance of economic policy. In particular, trade unions must recognize the perverse interaction between price and wage increases, which hurts the poor and unemployed disproportionately. With the feedback of wages into prices in operation, price stability will not be durable without wage moderation. The social acceptance of these norms can be turned into a factor of national cohesion if the government takes the leadership in wage negotiations for the public sector employees. This is actually what happened in the 1950s, as mentioned in section 2.
4. Financial crises in emerging markets
As more emerging-market currencies became convertible on capital account in the second half of the 1990s, financial interdependence was no longer confined to advanced industrial democracies. National financial policies came under increased scrutiny from investors and rating agencies. In periods when the international system was flush with liquidity, interest rate spreads for emerging markets narrowed. But there were also sudden reversals in investor sentiment, typically associated with periods of illiquidity, which led to massive capital outflows and dramatically widening of spreads.
The most recent wave of crises in emerging markets was foreshadowed in the spring of 1997, when a minor attack on the Czech koruna led to that currency’s devaluation. Later that spring, Malaysia, Indonesia and the Philippines experienced moderate to intense pressure on their currencies. The transforming event was the attack on the Thai baht in July, which forced that country to abandon its implicit dollar peg. Almost immediately, currency and banking crises spread to other Asian economies. The Republic of Korea, a recent member of the OECD (like the Czech Republic), suffered a combined currency, banking and debt crisis. South Africa was infected when Russia floated the ruble and defaulted on its domestic debt in August of 1998. Brazil desperately defended its dollar peg in the face of a series of severe attacks starting in September on the eve of a crucial presidential election. Only China, which had moved only part way down the road of domestic and international financial liberalization, remained immune from these pressures.
All this took place against the backdrop of the "all but failure" of Long-Term Capital Management, a Connecticut-based hedge fund that had bet aggressively on declining spreads and, following the flight to quality precipitated by Russia’s default, had to be rescued by its creditors. This rescue, orchestrated by the Federal Reserve Bank of New York, was followed by the lowering of interest rates by the Federal Reserve Board. While there was further contagion to Latin America, as well as to Hong-Kong and China, U.S. interest rate cuts (followed by various European central banks) did much to sooth the markets. Eventually (in January 1999) Brazil did devalue the real but, against this more benign backdrop, managed to avert serious economic damage.
5. The International Financial Architecture
One legacy of this experience is discussion and debate over how governments and multilaterals should respond to such instability.
5.1. The role of global and regional initiatives
For the last quarter century, the leaders of the seven richest economies (G-7) have met regularly and their financial discussions have provided a crucial conduit, along with OECD peer reviews, for US influence on European and Japanese policy. But with the advent of the euro area and the progressive solidification of the EU, there is a growing feeling that policy coordination efforts will be organized around three economic blocs centered on the U.S., the EU and Japan.
Emerging markets naturally prefer having these coordination functions carried out in venues where they are represented. One such venue is the IMF, although its lack of independence from its principal shareholders (the one and the same G-7 countries) makes it less than an honest broker in the view of some developing countries. In addition, the most recent wave of financial crises revealed an unusual depth of disagreement within the Bretton Woods institutions. Without a reasonable degree of consensus, the IMF and World Bank may not be capable of influencing the architecture of the international economy. While competition between the two Bretton Woods institutions can be helpful, it does not enhance the credibility of the advice. The World Trade Organization (WTO), which played an essential role in preventing the 1997-99 financial crises from disrupting the world trading system, is another entity with global reach now that China is becoming a member. But the WTO has no mandate in the financial and macroeconomic areas that are at the center of the crisis problem.
Regional arrangements are the obvious alternative. They are viable in Europe because of the singular depth of commitment to political and well as economic integration that has sustained the development of European institutions of mutual surveillance over the last half century. However, the way the European Commission probes the budgetary procedures, competition policies, and corporate governance standards of EU member states would not be acceptable to the U.S. or Japanese governments were the latter to contemplate establishing comparable arrangements with other countries in their respective spheres of influence.
5.2. Crises as triggers for reform
While financial crises have caused hardship in individual countries, the process of globalization continues. Any tendency to draw back from world financial markets, as in Malaysia, has been isolated and temporary.
The problem is rather how to tailor macroeconomic and financial arrangements to the imperatives of globalization and in particular to limit the vulnerability of the domestic economy to the crisis problem. The complexity of this problem is evident in the exchange rate dilemma. It has become clear that exchange rate systems involving fixed but adjustable rates, bands and crawls are crisis prone. The alternatives are to float more freely, as such Latin American countries as Chile, Colombia and Brazil and such Asian countries as the Philippines, Korea and Thailand have begun to do, or to adopt a hard currency peg, as in Argentina and Hong Kong. The launch of the euro emphasizes that with global financial markets there must be fewer currencies. This has stimulated discussion of dollarization as a mechanism for installing hard pegs in Mexico and various Central American countries.
Radical reforms of the international architecture are not in the cards; the existing architecture is deeply embedded in dense networks of market and political relationships. But there have been useful steps in the direction of strengthening the architecture, such as the creation of the Financial Stability Forum and the G-20, which have been investigating highly leveraged institutions, offshore centres and short-term capital flows. They have tabled a variety of recommendations aimed at improving capital-flow statistics and strengthening prudential standards in both lending and borrowing countries. It may be, then, that the crisis encouraged responses that would not have been possible in calmer periods and in this sense provided a trigger for reform.
The immediate effect of the crisis is to underscore a lesson from the inter-war period: liberalization and globalization must managed in order to prevent protectionist pressures at bay. This threat could conceivably spread from the tariff escalation to non-tariff barriers like exchange controls. Therefore, containing financial instability means avoiding a relapse of protectionism while fostering reform in the international system. This will allow for a more effective regional and global response to threats of contagion of national crises.
In any event, liberalization and globalization must be better managed to avoid a protectionist backlash.
The EPU was critical to the post-World War II reconstruction of the Western European economy. By greasing the wheels of intra-European trade, it allowed the participating nations to specialize in the production of goods in which they had a comparative advantage, enhancing the efficiency of resource allocation. By strengthening Europe's terms of trade and reconciling the mixed economy with expanding international trade, it helped to solidify the pact between capital and labor upon which the post-war generation of rapid economic growth was based.
The EPU succeeded because it minimized distortions. Trade distortions were minimized by the program of multilateral trade liberalization to which the European participants committed themselves as a condition for the receipt of the $350 million of American credits which provided working capital for the payments union's operation (not to mention other forms of American aid). Price distortions were minimized by intra-European trade, especially since some European industries were already competitive on world markets, and by Marshall-Plan-financed imports, which limited the market power of European producers. Finally, obstacles to borrowing from the United States were attenuated by a US program to guarantee American foreign investments against the risk of inability to transfer funds.
The EPU, the EMS and now EMU have all relied on shared economic and societal values, a fact with obvious implications for any attempt to design this structure to other parts of the world. In other words, Europe’s institutional solutions to the problem of monetary and financial instability may be difficult to adapt to the rather different circumstances of other parts of the world.
In this regard, there have been proposals for regional fora, which could help the IMF improve its performance when exchange rate and banking issues are difficult to disentangle, as is more and more frequently the case. While this is certainly true, institutions of global governance such as the WTO have been essential in preventing the 1997-99 financial crises in emerging markets from becoming a 1930's style global depression. For regional initiatives to play a positive role in containing financial instability, they thus need to be embedded in the relevant institutions of global surveillance. The architecture of the world economy of the new millennium can thus benefit from Robert Triffin's vision of Europe fifty years ago.
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