The Italian elites knew all along that the Eurozone would be a disaster

There is often a discussion about whether politicians and government officials introduce policy changes that end up being damaging to the well-being of the people are ignorant or wilful. It is sometimes hard to discern what the agendas are and who knows or understands what. The release of the US Central Intelligence Agency’s declassified report – Economic Intelligence Weekly Review 9 November 1978 – tells us a lot about the deliberate deception that goes on where the citizens are kept in the dark and the politicians deliberately make decisions that they know are not in the best interests of the nation. The questions then are why do they do that and what can citizens do about it? In the case of Italy – and the decision to enter the European Monetary System (EMS) in 1978, which was the precursor to the Eurozone, the motivations are fairly apparent. They knew that the EMS would not be in the best interests of Italy from an economic standpoint but were lured by the ‘European dream’. This is the idea that ‘Europe’ (by which we mean the formal European Union) is a representation of political stability and sophistication. The southern European states never felt part of ‘Europe’ and considered that their own political stability and oversight of corrupt politicians would improve if they went along with any idea proposed by the European Union. Italy had been a foundation state but still doubted their own legitimacy. The neo-liberals that were taking over the European integration process by the late 1970s sold this line to subtlety coerce these nations into joining up. It worked. But the polity and the technocrats knew all along that entry into the EMS and later the Eurozone was not in Italy’s best economic interests.

Under the Freedom of Information Act, the US Central Intelligence Agency regularly releases archival material that lets us know what was going on some time in the past.

On July 28, 2004, the CIA declassified a 10-page document – Economic Intelligence Weekly Review 9 November 1978 – which was part of their weekly information sharing series among CIA officers.

It is here they muse about various things such as the the upheaval in the Iranian economy and how Moscow (still the USSR) “have allayed former Western concern about Moscow’s creditworthiness” and the like.

In the November 9, 1978 weekly briefing they also discussed “Italy: Debate over EMS”. The briefing is of great historical interest because it tells us that the Italian government elites (Central bank, Ministry of Finance, Foreign Ministry and the polity) were well informed of the negative consequences that would follow Italy’s entry into the new European Monetary System at the time.

Some background first …

When President Nixon suspended the US gold convertibility in August 15, 1971 it effectively ended the Bretton Woods system of fixed exchange rates that had been in place since the advanced nations signed an accord on July 22, 1944 in the US town of Bretton Woods.

Nixon’s decision meant that national currencies no longer had any gold backing. This was the only way to resolve the unsustainable tensions within international monetary markets at the time.

The US dollar quickly devalued against gold and most of the other major currencies were revalued.

The Bretton Woods system was formally abandoned in February 1973 after further major US dollar devaluation. This historic shift established the modern era of fiat currencies, which provide no guaranteed convertibility into any other commodity (such as gold).

These currencies are given legal status by dint of a legislative fiat at the imprimatur of the national government. The world of economics had changed and governments were no longer financially constrained in their spending.

Various currency arrangements followed the formal abandonment of Bretton Woods.

Most nations freely floated their currencies, which meant that the forces of supply and demand in foreign exchange markets determined their values against other currencies. That situation persists today.

Other nations opted to peg their currency to another currency or perhaps to a basket of other currencies, while others adopted a foreign currency outright (for example, nations that ‘dollarised’ by accepting the US dollar as their domestic currency).

Against all logic and evidence, the Europeans chose to press on with a fixed exchange rate system.

The lesson that the Europeans should have learned from the chaos of the Bretton Woods system was that nations with very different economies and export strengths will always find it difficult tying their exchange rates together in any fixed arrangement, and jointly prosper in the process.

There was never going to be a way that nations such as Italy, France and Germany could prosper jointly if their currencies were pegged.

The might of the German export machine and the uncooperative nature of the Deutsche Bundesbank, obsessed with even the slightest sniff of price acceleration, made sure of that.

The unilateral action by the US gave the other nations in the Bretton Woods system three options:

(a) fully float their currencies against the US dollar and all other currencies;

(b) jointly float against the US dollar, that is, maintain fixed parities between themselves but allow for flexibility against the dollar;

(c) continue to peg to the now non convertible US dollar.

During the mark crisis in May 1971, the Germans had proposed that the EEC Member States arrange a joint float against the US dollar but the French rejected the plan.

They were steadfast in their desire to maintain the peg (between European currencies), and used capital controls to reduce the currency fluctuations.

The French saw danger in anything resembling a float because it would threaten the subsidies they enjoyed from Germany under the Common Agricultural Policy (CAP).

The decision in 1962 to introduce the CAP (the first major initiative of the newly formed EEC), should have taught the European nations that entering a currency union would be a fraught exercise.

France wanted to protect French farmers and Germany wanted to expand its industrial export market.

To achieve their goals, the Germans agreed to provide subsidies through the CAP to French farmers: a gnawing tension that remains today.

But the administrative viability of the CAP required a very stable exchange rate environment because a multitude of agricultural prices had to be supported across the Community.

Once the Member States locked in the CAP they were also trapped into pursuing the impossible task of maintaining fixed exchange rates.

The German mark became the strongest currency in the 1960s as Germany’s export strength grew, which put France and Italy under constant pressure of devaluation and domestic stagnation and undermined the CAP.

The various agreements to maintain fixed parities between the European currencies all largely failed because of the different export strengths of the Member States.

But instead of taking the sensible option and abandoning the desire for fixed exchange rates, the European political leaders accelerated the move to a common currency when the Bretton Woods system collapsed in 1971. The lessons from the Bretton Woods fiasco were not learned.

In a sense, the decision to create the CAP locked the European nations into a one-way street towards monetary union to overcome the impossibility of maintaining stable exchange rates.

What was not fully articulated in the Maastricht process of the late 1980s and early 1990s was, that by abandoning their separate exchange rates (and giving up their currencies) the Member States were not going to simultaneously overcome the forces that had created the currency instability throughout the post World War 2 period.

All they were doing was formalising the need for the domestic economy to bear the brunt of the trading imblances. Under Bretton Woods, external deficit nations were forced to depress domestic demand and create high unemployment to suppress import expenditure and attract foreign capital.

Under the common currency, this becomes formalised under the rubric of ‘internal devaluation’. It is clear that domestic adjustment is much more painful and uncertain to the well-being of citizens than is exchange rate adjustment.

In the wake of the collapse of Bretton Woods, the French were adamant that they wanted to maintain the fixed parity system in some form even without the US participation (and role as anchor).

French President Valéry Giscard d’Estaing was very vocal at the time. The French clearly were sticking to the hope that they could somehow make some progress towards a monetary union, which would see stable exchange rates and a funding mechanism for the CAP. Their heads were firmly buried in sand!

An attempt was made to revive the Bretton Woods system under the guise of the so-called Smithsonian Agreement, which was signed on December 18, 1971 by the G10 nations. It was effectively a system of pegs against the US dollar. By early 1972, it was clear the currency instability would continue and the system became unviable.

Enter ‘Le Serpent á l’intérieur du Tunnel’ (the Snake in the Tunnel), a peculiarly European scheme to maintain fixed exchange rates as the Smithsonian parities collapsed under the weight of currency speculation.

On December 13, 1971, the Committee of Governors of the Central Banks of the European Member States established a ‘group of experts’ presided over by M. Théron.

Their report, submitted on February 2, 1972, set out a system that formally became known as the ‘snake in the tunnel’ system, which represented the first European specific attempt to maintain fixed exchange rates between the currencies.

Essentially, from July 1, 1972, the fluctuations between currencies of the Member States would not exceed 2.25 per cent, which was a rather skinnier snake than the 3 per cent recommended by the Théron Report but still consistent with the hope of returning to stable exchange rates.

The band established in the Smithsonian Agreement whereby no currencies could fluctuate more than 4.5 per cent against the US was retained.

On April 10, 1972, the Committee of Governors of the Central Banks of the Member States met in Basel and formalised the Basel Accord, which defined the operations of the snake system.

The central bankers agreed to intervene in foreign exchange markets if their currencies were in danger of breaching the new more restricted ‘snake’. To facilitate cooperation in this intervention, they agreed to swap their currencies to ensure that they had sufficient funds to sustain this commitment.

But, alas, the snake started slithering out of control a few months after the Basel Accord.

The British floated the pound and withdrew from the arrangement in June 1972, following a period of massive instability in international currency markets.

It was generally considered that the US dollar remained overvalued even though it had been devalued by 7.9 per cent against gold, and other nations had revalued as part of the Smithsonian Agreement. This was in the context of the ongoing US balance of payments deficits and the unwillingness of the US government to drive unemployment up through domestic monetary and fiscal restraint.

The speculative activity saw significant fund movements out of the US dollar into marks, the Benelux currencies and the yen.

In the case of the European currencies, the upward pressure pushed them to the upper limits renegotiated as part of the Smithsonian process and forced their respective central banks to sell their currencies and buy US dollars to soak up the strong demand.

The Basel Accord, in fact, worsened things, because the central bank intervention by France, Belgium and Germany (selling their currencies to buy the pound) had contained the slide of the pound against the US dollar, but weakened their own currencies.

In Italy’s case, they were forced in January 1973 to partially float the lira (segmenting commercial transactions from the rest) to stem the capital outflow.

A full float came on February 14, 1973 – but the decision to partially float meant Italy had to quit the ‘snake’.

Foreign exchange markets were repeatedly being forced to close to stop the wild gyrations in exchange rates as speculators had lost all confidence in the fixed parity system.

It came to a head on March 19, 1973, when the US abandoned the Smithsonian rule that it had to maintain a stable value against gold. The US abandoned the fixed exchange rate system and floated the dollar.

The Bretton Woods system of fixed exchange rates had finally been terminated despite the efforts to salvage it under the Smithsonian Agreement.

But Europe was not for change.

The remaining Basel Accord partners (Benelux, Denmark, France, Germany and the Netherlands), however, chose to ignore the ‘sword of Damocles’, such was their fear of floating exchange rates.

On March 12, 1973, they announced they would jointly float against the US dollar, effectively keeping the ‘snake’ (Basel Accord) but abandoning the ‘tunnel’ (the Smithsonian Agreement).

There were a series of ad hoc decisions taken to control capital flows and to realign currencies (for example, the mark was revalued by 3 per cent immediately and then by 5.5 per cent in June 1973) as part of this decision.

But the trouble was far from over. The underlying economic fundamentals in Europe meant that the currency pressures were unstable.

Germany faced continual upward pressure on its currency and France the opposite. This meant that the Bundesbank continually had to purchase the ‘snake’ currencies and the other central banks were continuing to intervene on a significant scale to stabilise currency movements.

Then came the OPEC oil shocks, which saw the US dollar appreciate sharply, the European currencies fall sharply, France exiting the ‘snake’ because it was running out of foreign exchange reserves to maintain the value of the franc.

At this stage, the ‘snake’ was looking decidedly Germanic by this stage leading commentators to refer to the residual ‘snake’ system as a mark zone.

France, foolishly re-entered the ‘snake’ in July 1975, but lasted less than a year (exiting again in March 1976). The system was unviable. The mark was going through the roof and was revalued by a further 2 per cent in October 1976 as it became difficult for the Bundesbank to keep the currency within the agreed limits.

Less than six months later (April 1977), most of the remaining members of the ‘snake’ devalued against the mark, further revealing the unviable nature of the arrangement.

Then we get to the European Monetary Sytem (EMS)

As the ‘snake’ was falling apart, the President of the Commission of European Communities, Roy Jenkins, delivered the first Jean Monnet lecture in Florence on October 27, 1977.

He claimed that Europe had to move ahead with monetary union and that eliminating currency fluctuations within Europe would improve economic welfare.

His understanding of history was rather weak to say the least. The attempts at eliminating currency fluctuations had caused nothing but human misery.

The economic situation across the ‘snake’ membership was disparate.

The withdrawal of the French franc in March 1976 exemplified the problem facing the non-German membership: either they had to continually devalue their currencies or create high domestic unemployment to reduce imports.

Neither option was politically tenable. Even after the revaluation of the mark in October 1976, the remaining currencies were under pressure.

The European nations response to the OPEC oil shocks were also disparate.

Europe was divided between low inflation nations (Benelux, Germany), the mid inflation nations (Denmark and France), and the high inflation nations (Ireland, Italy and the United Kingdom).

The widening fluctuations in the latter half of the 1970s reflected the different struggles the nations had in dealing with the oil price rises.

The low inflation nations had strong trade positions and continually faced upward pressure on their currencies, particularly Germany.

The rest of the nations had weak trade positions and faced the opposite pressures in foreign exchange markets. These disparities made it virtually impossible for the fixed parities embedded in the ‘snake’ arrangement to be maintained.

Further, the CAP was causing further tensions, particularly in France. Stability of the fixed agricultural price system across the membership thus depended on the stability of national currencies because if one currency depreciated, the fixed prices would yield a competitive advantage to that nation’s farmers and vice versa.

In my book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale – I discuss how the Europeans further complicated the matter by creating a shadow system of exchange rates to overcome the continual instability in official rates.

The Italians certainly knew the system was damaging their prospects. In 1976, they introduced the Italian import deposit (which required importers to place funds in advance with the Italian Foreign Exchange Office), ostensibly in response to its balance of payments problems caused by the oil price rises.

This was seen as a basic challenge to the concept of freedom of movement of goods and services, a foundation stone of the customs union.

The policy caused consternation among its European exporters and raised accusations of a return to the ‘beggar thy neighbour’ strategies that haunted world trade during the Great Depression.

Unilateral imposts such as the deposit scheme were self-defeating if all nations followed suit. The global result would be a decline in overall trade and no change in the capacity of the nation to deal with the deficits caused by the need to pay higher prices for oil.

The matter led to Commission v Italy (Case 95/81, 1982) in the European Court where Italy argued the deposit scheme was in fact ‘part of monetary policy’ (p. 2191) and therefore legal under Article 104 of the Treaty.

The Italians also argued it was allowable under ‘the concept of public policy’ (Article 36) (p. 2192), which related to the government’s right to protect its currency sovereignty.

The French government supported Italy in its claim that a nation ‘must be able to combat’ speculative attacks on its currency using methods such as the deposit scheme in question (p. 2194).

While the Italian government lost the case, the general point was that the currency instability was undermining the legal framework of the European Project, in this case the customs union.

The two big leaders Germany’s Helmut Schmidt and France’s Valéry Giscard d’Estaing met in relative secrecy in early 1978 to develop a joint strategy to replace the ineffectual ‘snake’ with a more integrated level of monetary cooperation.

In April 1978, they unveiled their plan for a renewed attempt to introduce a European Monetary System (EMS) and the European Council supported the creation of the EMS in July 1979.

The system would be like the ‘snake’ but unilateral realignments were prohibited.

Further, all central banks were obliged to intervene in a symmetric fashion to maintain parities, which as I noted in this recent blog – Mario Draghi uses TARGET2 to cower Italy into staying within the Eurozone – led to Germany reneging almost immediately.

The CIA view on Italy’s entry into the EMS

The declassified CIA document is very interesting as it was written at the time that Italy was toying with the idea of entering the EMS as the ‘snake’ was collapsing.

The CIA observed that:

A sharp debate over participation in the proposed European Monetary System (EMS) is dividing Italian policymakers. High-ranking politicians, led by Prime Minister Giulio Andreotti, charge that failure to join in so widesweeping and enterprise as EMS could consign Italy forever to the sellers of Europe. Technocrats, taking aim from the bastions of the Bank of Italy, argue that exchange-rate rigidity is a sure formula for economic disaster given Italy’s high inflation rate …

West German insistence on a parity-grid system for regulating exchange rates had sparked a technocratic revolt. Voices from every quarter were being raised against Italian participation in what would allegedly be a reconstituted snake. Once passive observers of the fray, the Communists and Socialists were remonstrating against an EMS built to West German specifications … Some private economists are warning that if the West Germans had their way, Italy’s entry would have to be postponed for at least several years.

So, really the dividing lines described in that entry characterised the entire history of the European integration debate. Germany had lost the War but won the economic battle.

It so dominated the European economy that it was nigh on impossible for any other nation to prosper if it linked it exchange rate to the mark.

Nothing has changed since – just the type of adjustments that this dominance requires on the weaker nations.

The Germans have been very aware of its history (the inflation, the War etc) but has continually created situations where other nations are encouraged to ignore history.

To lure the Italians into the EMS, it was proposed to create a “two-tier system” where “allowable margins of fluctuation” would be “much wider than those for current snake members”.

So the lira would have been allowed to wider fluctuations against the mark than say the guilder.

The CIA briefing identifies the crux of the problem:

Italians have long hoped that through participation in a united Europe they could attain the stability, both political and economic, which they’d been unable to achieve on their own. All the major political parties applaud the principle of European integration; a greater proportion of population supports the European Community than in any other West European country. Italians recognise, however that their position in the EC has deteriorated in the 1970s. Sharp depreciation of the lira, soaring prices and wages, low investment, and the political shift to the left have generated anxiety that Italy is being gradually forced from the European mainstream. Fears of isolation and underdevelopment other driving forces behind the Italian desire to enter EMS. Many are convinced that if Italy cannot join EMS, it will be forever condemned to second-class status in Europe.

The same argument is common in Spain, Greece and Portugal. It is a belief that Europe is commensurate with stability and sophistication.

It is an expression of a deep national paranoia among these nations – a lack of confidence in their own capacities, and, a recognition that the political systems that have emerged were open to corruption and worse.

The military coup in Greece and the days of Franco were strong motivations for this idea.

The problem was that the idea of Europe became corrupted by the desire to extend it into monetary union (with the EMS being the penultimate step in that shift).

And, the final push to monetary integration became poisoned by the advent and rising dominance of Monetarism with Milton Friedman and his gang pushing nonsensical economic policies onto nations in the name of science and progress.

It was only the uptake of those neo-liberal ideas that allowed France and Germany to channel their enmity and historical rivalry into a joint process that would end up in Maastricht and the disastrous Eurozone.

The CIA document notes that while the politicians were keen to join the EMS:

The monetary authorities, however, have always viewed life under the proposed EMS is particularly difficult. Central Bank Governor Paolo Baffi has repeatedly stressed that continual devaluations of the lira would be required to maintain export competitiveness with inflation still at the 14-percent level and no relief from rising labor costs insight.

The Italian central bank required a phase in plan with more flexible parities and “a gradual realignment of the Italian economy with the rest of Western Europe” before they would support participation.

The Italian Treasury Minister (Filippo Pandolfi) also supported the central bank position.

He is described by the CIA as being “adamantly opposed to a reemergence of an expanded snake”. Importantly, apart from flexible parities, he wanted “A generous credit facility to ward off speculative attacks” and “Structural investment and resource transfer programs to benefit the poorer EC regions” as a price for participation.

That looks remarkably like the established of some European-level fiscal capacity of the type that had been recommended by the Werner Report (1970) but disregarded by the European Council.

The Italian Trade Minister upped the ante even further. The CIA said he wanted “a major overhaul of the EC’s Common Agricultural Policy as a price for entry”.

You see that these politicians and officials fully understood that the CAP was only viable if exchange rates were fairly inflexible among the Member States but that such a system of parities was unworkable.

They wanted more flexible parities and a major retrenchment of the CAP whereas France and Germany wanted more rigidity.

Even the Italian business lobby realised the dangers of entering the EMS.

The CIA refers to Guido Carli (a former Banco d’Italia governor) who at the time was “president of the national manufacturers association” coming “down squarely against the Franco-German design”:

Echoing business fears that tying the lira too closely to the deutsche mark would spell export disaster, Carli has insisted that the government resist West German efforts to impose the parity grid. He has repeated the complaint often heard in Italian business circles the tying European currencies tightly together would accentuate imbalances with the dollar area and exacerbate the boom-and-bust cycle to which Italian industry is subject.

On December 5, 1978, the Prime Minister Giulio Andreotti was quoted in the Italian centre-left daily newspaper Republicca as saying:

The operation is not without risk, but what would happen if the system is set up without us has to be taken into account. If Italy misses this historic opportunity it would also miss some decisive steps.

Andreotti was playing the European statesman, swanning around to meetings with Schmidt and Giscard but knowing that there was broad opposition to an Italian EMS entry.

The CIA realised that:

Clearly-political pressure is being exerted at the highest European levels to ensure Italian entry into EMS … Andreotti, however, faces greater obstacles in setting economic policy than Schmidt or Giscard. His minority government faces a host of contentious economic policy issues in the coming months, including wage contract renewals, budget cuts, and pension reform …

we estimate that the odds in favor of acceptance are now slightly above 50-50.

History tells us that Andreotti got his way.

The Italians joined although delayed entry by one week (December 12, 1978 instead of December 4-5 when the European Council met in Brussels).

The political imperatives gave Italy a wider margin for fluctuation (a 6 per cent band) and there were some “parallel measures” (loans for some development projects).

At the time, Italy’s inflation rate was high and the lira had been continually devalued throughout the 1970s.

It was almost inconceivable on economic grounds that the Italians would have agreed to enter – just as its continued membership of the Eurozone is beyond economic logic.

The fact is that the Italian polity equated the EMS with ‘Europe’ despite the fact that the design of the system was German-dominated.

The Bundesbank clearly forced the design of the system to ensure it would not compromise its price stability obsession.

Although in principle symmetry was proposed in terms of central bank intervention, the system forced the costs of adjustment onto the countries with external deficits (who were facing downward pressure on their exchange rates).

Just like the Bretton Woods system and the ‘snake’ that it gone before and failed categorically.

The only way the Italians were able to operate within the EMS after that was due to their use of capital controls. These were phased out after the Single Market Act later in the 1980s that meant the fixed parities were unviable.

Conclusion

History is good to study.

It provides for deeper understandings of where things are at today.

This CIA document makes it clear that at the time the decision-making parties were clear that entry into the EMS would not work for Italy.

But the ‘European’ dream – a sort of sop to hide the creeping neo-liberalism that would evolve into Maastricht and the Eurozone – was built up to blur good economic sense.

And the Italians are paying the price. As are other Eurozone nations.

That is enough for today!

(c) Copyright 2017 William Mitchell. All Rights Reserved.