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Monetary Stability in Europe
The European Monetary Union (EMU) was created to overcome the economic
difficulties that Europe experienced in the last part of the twentieth century. Like the
European Community itself, EMU reflects the fact that European countries have learned
that they have much to gain by working together as a whole.
EMU, however, is also a challenge to economic theory. Its success will depend on
how it is managed, yet, the full economic and political ramifications of the monetary
union cannot be predicted. A large number of theoretical models and empirical facts have
been scrutinised by economists, yet, inevitably explaining why past policy actions or
institutions have failed and how the future could be improved sometimes requires
questioning of well-established, familiar principles. Too often, new facts are interpreted
in the light of conventional wisdom.
In this book, the author presents fresh perspectives on the theories surrounding EMU.
Urging the reader to examine conventional ideas from new viewpoints, he discusses the
events which led to EMU, analysing the current situation, and projecting possible futures.
Essential reading for academics and professionals concerned with the background and
implications of EMU, this book will also be of considerable interest to scholars in the
fields of European studies, monetary economics, international economics and economic
history.
Stefan Collignon is Professor of European Political Economy at the London School
of Economics and Political Science (LSE). Previously, he served as Deputy Director
General for Europe in the Federal Ministry of Finance, Berlin; he also teaches at the
College d’Europe (Bruge).
Routledge International Studies in Money
and Banking
1 Private Banking in Europe
Lynn Bicker
2 Bank Deregulation and Monetary Order

George Selgin
3 Money in Islam
A study in Islamic political economy
Masudul Alam Choudhury
4 The Future of European Financial Centres

Kirsten Bindemann
5 Payment Systems in Global Perspective

Maxwell J.Fry, Isaak Kilato, Sandra Roger, Krzysztof Senderoiwicz,
David Sheppard, Francisco Solis and JohnTrundle
6 What Is Money?
John Smithin
7 Finance
A characteristics approach
Edited by David Blake
8 Organisational Change and Retail Finance

An ethnographic perspective
Richard Harfier, Dave Randall and Mark Rouncefield
9 The History of the Bundesbank

Lessons for the European Central Bank
Jakob de Haan
10 The Euro
A challenge and opportunity for financial markets
Published on behalf of Société Universitaire Européenne de Recherches Financières
(SUERF)
Edited by Michael Artis, Axel Weber and Elizabeth Hennessy
11 Central Banking in Eastern Europe
Nigel Healey
12 Money, Credit and Prices Stability

Paul Dalziel
13 Monetary Policy, Capital Flows and Exchange Rates

Essays in memory of Maxwell Fry
Edited by William Allen and David Dickinson
14 Adapting to Financial Globalisation

Edited by Morten Balling, Eduard H.Hochreiter and Elizabeth Hennessy
15 Monetary Macroeconomics
A new approach
Alvaro Cencini
16 Monetary Stability in Europe

Stefan Collignon
Monetary Stability in Europe
Stefan Collignon
London and New York

First published 2002 by Routledge 11 New Fetter Lane, London EC4P 4EE
Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, NewYork,
NY10001
Routledge is an imprint of the Taylor & Francis Group

This edition published in the Taylor & Francis e-Library, 2005.
“To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of
thousands of eBooks please go to http://www.ebookstore.tandf.co.uk/.”
© 2002 Stefan Collignon
All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or
by any electronic, mechanical, or other means, now known or hereafter invented, including
photocopying and recording, or in any information storage or retrieval system, without permission
in writing from the publishers.
British Library Cataloguing in Publication Data A cataloguc record for this book is available
from the British Library
Library of Congress Cataloging in Publication Data Collignon, Stefan, 1951– Monetary stability
in Europe—Stefan Collignon. p. cm. Includes bibliographical references and index. 1. Economic
and Monetary Union. 2. Monetary policy—European Union Countries. I. Title
HG925.C656 2002
332.4′494–dc21 2001048668
ISBN 0-203-16592-6 Master e-book ISBN
ISBN 0-203-27081-9 (Adobe e-Reader Format)

ISBN 0-415-26732-3 (Print Edition)
Contents
List of illustrations vii

Preface xii
1 Why stable money matters or ‘the loss of paradise’ 1

2 After Bretton Woods: the world of bloc floating 26
3 International consequences of bloc floating 55
4 The instability of the bloc floating regime 75
5 A fresh look at Optimum Currency Area theory 94
6 Is EMU sustainable? 113
7 Sustaining price stability 129
8 Monetary policy and structural unemployment 143
Notes 196
Bibliography 215
Index 229
Illustrations
Figures
1.1 The structure of collective intentionality 5
1.2 Unit labour cost 14
1.3 Misery index: (a) inflation+unemployment rates; (b) 17

inflation−growth rate
1.4 (a) US inflation rate; (b) inflation differential to USA 24
2.1 Interest rates (a) USA; (b) Germany; (c) France 29
2.2 (a) Real short-term interest rate; (b) real interest rates on 30
government bonds
2.3 Variation of foreign exchange reserve 34
2.4 (a) Share of currency zones in world exports; (b) export share 36
of currency zones as per cent of world exports
2.5 Investment decision under risk 48
2.6 Risk premia and portfolio shares 50
2.7 (a) France’s marginal q; (b) Germany’s marginal q 53
3.1 Fundamental equilibrium 62
3.2 US dollar/DM exchange rate 69
3.3 NEERs 70
3.4 NEER volatility (USA versus Germany) 70

3.5 NEER Germany 71
3.6 REER Germany 71
5.1 Temporary and permanent shocks 101
5.2 Size and import share 107
5.3 Net benefit of a single currency for country i 109
6.1 Marginal cost-benefit analysis of EMU 116
6.2 Country contribution to aggregate net benefit from EMU 117
6.3 Total net benefits in a Benthamite OCA 117
6.4 Voting weights in the EU 118
7.1 Convergence of inflation rates 132
7.2 Convergence of interest rates 132
7.3 Optimal conservativeness before and after EMU 141
8.1 (a) Unemployment rates; (b) employment rates 145
8.2 Job creating growth in (a) Europe; (b) USA; (c) Japan 156
8.3 (a) Total factor productivity; (b) total factor productivity 160
change
8.4 (a) Capital intensity; (b) annual variation in capital intensity 161
8.5 (a) Real wage position; (b) profitability; (c) real wage pressure 167
8.6 Convergence of capital intensity 168
8.7 Investment share and unemployment rate: (a) EU 15; (b) Spain; 170
(c) Portugal
8.8 NAIRU as labour market equilibrium 177

8.9 The effect of an interest rate increase in a contract economy 179
8.A1 Wage pressure and cap intensity: (a) EU 15; (b) Germany; (c) 194
USA
Tables
1.1 European growth, 1890–1992 8
1.2 Nominal unit labour costs relative to 19 industrialised countries 10
2.1 Exchange rate regimes of the IMF-members 35
2.2 Exchange rate management and orientation of trade in 1991 37
2.3 Volatility under bloc floating and basket pegs 47
2.4 Risk premia under different pegging regimes 47
3.1 Trade matrix in a three-country world 57
3.2 Import shares and change of slope 59
3.3 Volatility of German NEER 72
4.1 Response of monetary variables to shocks 89
4.2 Growth of macroeconomic variables with respect to Germany 91
5.1 Size and degree of openness of European Union member 97

states–1997
5.2 Weight in Euro-GDP 99
8.1 Aggregate growth rate 146–152

8.2 A comparison of NAIRU estimates from cross-country studies 152
8.3 Economic growth and unemployment 155
8.4 Ratio of number of years with positive to negative output gaps 169
8.A1 Unit root tests 192

8.A2 Unit root test in presence of a structural break in 1989 193
8.A3 Regression results 195

Preface
This book describes a vision of Europe’s history and future and of economic theory. The
twentieth century has seen the best and worst of humankind. The advances of science,
knowledge and education, as well as material progress, have been unparalleled. People
are richer, healthier and are living longer at the beginning of this century than at the
beginning of the last one. Karl Marx never saw an airplane, but his great-grandchildren
fly to the Seychelles for a holiday communicate by e-mail in the Global Village and
watch a football match or a Royal funeral with three billion other people via satellite TV
While the nineteenth century seemed to be a period of almost unbroken material,
intellectual and moral progress, this century was without doubt the most murderous by
scale, frequency and length of warfare, famine and genocide in history (Hobsbawm
1994).
For Europe, the contrast is also stunning: convinced of its centrality as the cradle of
(western) civilization, it was the centre of two world wars, lost its power to the United
States and saw the share of its population dwindle to 6.5 per cent in the world. In the
eighteenth century Europeans formulated fundamental human values like Liberté,
Egalité, Fraternité. In the twentieth century the spirit of human kindness was represented
by leaders such as Mahatma Gandhi, Martin Luther King, Jr. or the Dalai Lama while
Europeans were ruled by Stalin, Hitler and Chamberlain. The World War I was followed
by the Age of Catastrophe (Hobsbawm 1994), a world economic crisis of unprecedented
depth, hyperinflation, and mass unemployment. After the World War II, the western part
of Europe lived through an unprecedented Golden Age, based on institutional stability
and political and economic cooperation under American hegemony. However, once US
power had passed its zenith and the international monetary system of Bretton Woods had
been abolished, the old strains of capitalism—low growth, severe cyclical slumps, mass
unemployment, and social inequality—that seemed to have disappeared during the
Golden Age returned.
European Monetary Union (EMU) is the attempt to overcome some of the difficulties
that Europe has experienced during the last quarter of the century. Like the European
Community itself, EMU reflects the lesson learned that Europe has had much to gain by
working together as a whole. This cooperation went far beyond the diplomatic games of
the nineteenth or the first part of the twentieth century. As Jean Monnet put it: ‘Nous ne
coalisons pas les Etats, nous unissons des hommes.1 Given the evidence of volatile
human volitions, European integration after the Second World War proceeded by creating
cooperative institutions which tried to preserve the more precious part of the European
heritage. A whole generation of Europeans must have felt what Keynes has lucidly
described: ‘…that civilisation was a thin and precarious crust erected by the personality
and the will of a very few, and only maintained by rules and conventions skilfully put
across and guilefully preserved.’ (Keynes 1938). Obviously, abolishing all national
currencies and replacing them with the euro did not happen without resistance, but there
were a few which had the will and the personality to push EMU through.
The next step is to ensure that EMU will help to preserve the thin and precarious crust
of civilisation in Europe. In view of past experience, this requires, more than anything,
the return of full employment and the preservation of certain standards of social safety.
For nothing is more likely to excite the beast in humans than insecurity and threats to
their livelihood.
EMU’s success will depend on how it is managed. But action without understanding
cannot produce desired results. ‘Practical men’, wrote Keynes, ‘who believe themselves
to be quite exempt from any intellectual influences, are usually the slaves of some
defunct economist’ (1936:383). Today, Keynes is himself a defunct economist, but our
practical men and women seem to have fallen for the intellectual answers of the 1920s,
draped in the fashionable cloth of New Classical Economics and styled in the language of
mathematics and econometrics. Karaoke-economists keep singing the old song that
wages are too high, social services too generous, and that government spending needs to
be cut to balance budgets. Not surprisingly similar causes produce similar effects and the
thin crust of civilisation becomes brittle. Not only is public enthusiasm for European
integration receding, but the consent to the system of liberal democracy is questioned as
extreme right wing parties emerge.
The parallel to the 1920s is striking. Analysing the disintegration of the Weimar
Republic, Childers (1982:414) wrote:
The political importance of the inflation has, of course, been readily

acknowledged in most studies of electoral realignment in pre-Hitler
Germany. Contemporary analyses were quick to point out the profound
social, economic, and psychological dislocations associated with the
inflation, and subsequent treatments have concluded that the inflation
certainly contributed to the radicalization of important elements in the
middle class electorate. Yet, while the political ramifications of the
inflation have drawn comment, surprisingly little attention has been
focused on the politically disruptive effects of stabilisation. This is
particularly striking since the manner in which the Reich government
liquidated the inflation in late 1923
1 Jean Monnet, Discours Washington (30 April 1952); in Monnet (1996).
and early 1924 shaped the contours of public debate on economic

issues until the onset of the depression. Indeed, it was the government’s
stabilization program that provoked the most persistent and programmatic
political response of the pre-depression period.
In a similar manner, the Great Inflation of the 1970s was followed in the 1980s and 1990s
by stabilisation policies which have fundamentally structured the economic and political
debate in Europe.
This is why EMU is also a challenge to economic theory. A new age needs new ideas.
Discussing EMU has become a growth industry for economists. A large number of
theoretical models and empirical facts have been scrutinised. Inevitably explaining why
past policy actions or institutions have failed, and how the future could be improved, may
require at times to question well-established, familiar principles. In my view, this is what
economic theory building is about. However, only too often, new facts are interpreted in
the light of conventional wisdom. If every reader of this book, after working his way to
the end, looks at least at one previously held idea from a new perspective, I will have
fulfilled my task. This preface is not scientific: that starts at Chapter 1. But intellectual
integrity commands that I reveal the normative context in which the theoretical ideas of
the following chapters evolve.
This book grew out of my work at the Association for the Monetary Union during the
1990s. I have benefited from the wisdom of Europe’s leading industrialists and from the
frequent dialogue with political decision-makers and over 15,000 citizens I have met to
discuss EMU in big cities and small villages all over Europe. Of course, the views
presented here are mine alone, and so are all possible errors. But I would like to express
my gratitude for stimulating discussions with Bertrand de Maigret, Hajo Riese, Manfred
Nitsch, Charles Goodhart, Jean Pisani-Ferry Peter Bofinger, Heiner Flassbeck, Hans-
Peter Fröhlich, Niels Tygesen, Martin Weale, Andrew Hughes-Hallet, Pier-Carlo Padoan,
Angel Torres, Willem Buiter, Hans-Jürgen Krupp, Reimut Jochimsen, Pierre Jaillet,
Francesco Papadia, Marc-Olivier Strauss-Kahn, Ludwing Schubert, Christa Randzio-
Plath, Karl Lamers (who inadvertently inspired Chapter 4), David Croughan, Agnes
Bénassy-Quéré, Andreas Worms, Julian von Landesberger, Franco Modigliani, Rudi
Dombusch, Allan Meltzer and many more. This book would not have been possible
without the total support, critical feedback and permanent dialogue with Susanne
Mundschenk and the devoted secretarial backup by Menuka Scetbon-Didi. Sebastian
Dullien saved me from some embarrassing mistakes and Allison Zinder checked my
English. Finally, the greatest burden was on my wife, Judith, who saw less of me than she
deserved. I only hope that the sacrifice was not in vain.
Stefan Collignon
Paris 2001
1
Why stable money matters or ‘the loss of
paradise’
Europe has a new currency, the euro. It has been the fruit of a long evolution of European
monetary co-operation. But despite this apparently irresistible historic process, many
observers have been puzzled: was it inevitable or merely an arbitrary political decision
without economic foundation? Was there no alternative to old nations of Europe giving
up the symbol of national sovereignty? In Europe, changes in monetary arrangements
have usually reflected the chaotic ups and downs of its history. This is nowhere more
obvious than in Austria which, by the end of the twentieth century has had its sixth
currency in less than 100 years. Thus, even such a fundamental institution as money can
be short-lived and volatile. Will the adventure of European Monetary Union (EMU)
succeed—or will it disappear as many other regimes in the past? Of course,
impermanence is the essence of the world. Even though nothing lasts forever, some
things last longer than others. How long will the euro last?
As far as the Treaty on European Union (TEU) is concerned, the single currency will
last forever. In the public debate Eurosceptic warnings about impending disaster (e.g.
Feldstein 1997; Congdon 1997) were not infrequent, but few (Lascelles 1997) have spelt
out how EMU could become undone. Others, like the Bundesbank (Tietmeyer 1995;
Jochimsen 1998), have insisted that ‘ultimately a monetary union is an undisolvable
community of solidarity’ and, therefore, only countries with a sufficient degree of
convergence ought to join. This argument implicitly assumes that joining EMU without
sufficient convergence could create difficulties for premature qualified members, and that
they would have to be bailed out by the others. But what would happen if this solidarity
and loyalty to each other did not exist? Would countries wish to leave? Ultimately,
EMU’s sustainability begs the question: Why do some international monetary regimes
fail while others succeed? Which domestic or international conditions bind nations
together in economic agreements, and which break them apart? (McNamara 1998).
For the neoclassical economic theorist, the question of the sustainability of monetary
institutions is odd: Why should it matter? If economic agents were free of money illusion,
they would distinguish monetary from real magnitudes, at least in the long term.
Economic value is derived from utility. In general equilibrium, markets would determine
relative prices, that is, the ratios at which goods are exchanged, in proportion to their
respective utilities. The money market would determine the stock of money and money
prices (Grandmont1983).Yet this implies that the value of money in relation to goods is
zero. Thus, it cannot serve a purpose at all (Duffie 1990). Consequently, why would one
bother with making money last? This question is related to a second one: how can money
an intrinsically worthless means of exchange, acquire value? Traditional explanations
centred around the functions of money, such as means of exchange, payment, unit of
Monetary stability in Europe 2
account or store of value. In overlapping generations models, money has value if it either
facilitates existing trades or allows for new ones. But as Blanchard and Fischer
(1989:159) show, trust in the value of money is necessary for money to have value. If at a
period zero the young do not believe that money will be valued at time 1, they will not
buy money, and money will never be valued. Modem theories emphasise the role of
money under conditions of uncertainty and asymmetric information (Goodhart 1989;
Brunner and Meltzer 1971). For Riese (1986a, 1990, 1995) the value of money derives
from the fact that it serves as a means of payment—and not just a means of exchange—
and this requires that money is kept ‘scarce’ by the central bank. We will return to this
argument in Chapter 8. What matters here, is that we can assign utility to the use of
money which is derived from the functions it serves. If for some reason, money does not
fulfil these functions correctly its functions are transferred to different carriers or assets
and money loses its value and ultimately becomes ‘useless’. In an international context
this process is explained by currency substitution models (Mizen and Pentecost 1996) or
by models of monetary hierarchy (Nitsch 1995; Herr 1992). What all these explanations
have in common is that for money to be used, it needs to have a positive value. Therefore,
sustaining money as an institution requires maintaining this value.
Over the course of history money has taken all kinds of forms, from metal coins
(copper, silver, gold) to bank notes and deposits, although the unit of accounts (pound,
franc, dollar…) have normally covered longer periods than their material support. For
centuries, economists have sought to explain the origin of money (Menger 1892). Early
theories linked it to a commodity. A modern look reveals it to be a more effusive concept
with a variety of assets and means of payment covering a range of instruments from bank
notes to electronic transfers and credit cards (Collignon 1998). Money’s characteristics as
an asset became apparent at the end of the eighteenth century, when money was related to
the monopoly of note issue by the central bank and no longer to the coinage of precious
metals. Ever since, monetary management has been a matter of credibility. Money has
become a promise to pay—if it ever has been anything else. Trust in honouring the
promise is essential for the sustainability of money as an institution.
However, it is not only the institution of money itself that is of uncertain durability but
also the organisations that manage it. Sweden is the country with the longest tradition
(since1668) of central banking; the Bank of England was founded in 1694; the Banque de
France in 1800 and the Deutsche Reichbank in 1875. But the Bundesbank only appeared
in 1957. On an international level, the Bretton Woods Agreement in 1944 set up an
international monetary system with rules which were abolished in 1971, but IMF as an
organisation continued to exist with new objectives. With the birth of a new currency the
euro and the European System of Central Banks (ESCB) as its organisation, one may ask
how long this newcomer is going to last. In fact the question has even been raised
whether central banks are a necessary institution at all (Smith 1936). I will not discuss
these arguments here. Instead, I will show in the next section that money is an institution
that matters and, therefore, deserves to be sustained. In the rest of the chapter, we will
then look at the historical background against which we can explain not only the
emergence of EMU, but also the expectations that it implicitly raises.
Why stable money matters or ‘the loss of paradise’ 3
Money as an institution
The human mind is of a fickle nature—a fact well known to philosophers and literary
artists, but less to economists. Usually, economic theory works with utility maximising
economic agents who have fairly constant preference structures or tastes.This might be a
perfectly justified assumption—over the short run. However, over time, preferences are
not stable. For example, public consensus on international monetary arrangements has
shifted five times in one century. From the Gold Standard the world moved to flexible
exchange rates after World War I; from the Bretton Woods fixed system again to a
flexible rate regime in the 1970s; and now EMU reverts to monetary stability in Europe.
These oscillations are puzzling. Each time flexible exchange rate regimes have been
coincidental with macroeconomic instability and low growth, and fixed rates with welfare
improvements. Does every generation have to learn the same lessons anew? It might well
be that the Golden Age only appears golden after it is over. We live, after all, as
Hirschman put it,
…in a world in which men think they want one thing and then upon
getting it, find out to their dismay that they don’t want it nearly as much
as they thought or don’t want it at all and that something else, of which
they were hardly aware, is what they really want…
(Hirschman 1982:21)
It may also be that once we have experienced disappointment, the ‘rebound effect’ makes
for an exaggeration of the benefits and an underestimate of the costs of the action that
provides a counterpoint to what has been done previously. We will deal with volatile
policy preferences in the case of EMU in Chapter 6. Yet, the history of monetary
arrangements of Europe in the twentieth century implicitly poses a normative question:
are fixed rates preferable over flexible ones or is it the other way round? And if
preferences are not stable, then why may social phenomena have any durability at all?
A short philosophical digression on institutional norms

Part of the answer is that society consists of more than a set of utility maximising
individuals with given preferences. Of course, individuals have preferences, however,
they also share mutual beliefs. Methodological individualism, the philosophical tenet of
economics, usually abstracts from these shared values and thereby reduces collective
intentionality to individual intentionality.1 However, the reproductive processes of
society are determined by individuals as much as by institutions and organisations that fix
patterns of human actions, supply information to other agents and enable regular and
predictable behaviour in an uncertain, highly complex world with limited information.
Thus, institutions are constraints that structure human interaction in order to reduce
uncertainty. Society is held together by contracts that oblige or bind individual players to
some correlated strategy. The content of these contracts is determined by institutions, that
is, rules of the game, and by organisations which are the players (North 1993).2
We will call the institution of EMU the set of rules, fixed by the Maastricht Treaty
(TEU), that are designed to structure monetary relations in the Union and give sense and
purpose to monetary policy. Similarly, the Stability and Growth Pact is an institution to
guide and direct fiscal policy in EMU. However, these rules are all derived from the
primary norm of maintaining price stability.3 On the other hand, the ESCB, the Euro
group, the European Commission or national governments are the players of the game;
they are organisations. A functional society requires that contracts, whether explicit or
implicit, reflect a credible commitment by the players. When creating a new currency like
the euro, ex ovo, the interesting question is how such a social contract comes into being
and what sustains it. The question is not how Maastricht was negotiated 4 or what games
individual players played, but rather what the consensual foundations are which make
such a treaty possible.
Money is one of the most fundamental institutions in a liberal society with a market
economy (Collignon 1995). This is because money is assigned its status by collective
intentionality. Money thereby acquires a normative character, and this fact structures the
whole of society. A long-standing philosophical tradition, going back to Hume (1740),
maintains that normative statements cannot be derived from objective, scientific
statements. Some economists have drawn the conclusion from this axiom, that ‘positive
economics is in principle independent of any particular ethical position or normative
judgements…’ (Friedman 1953). This implies that once the economist has described
economic facts, any evaluation is still left absolutely open. Against this view, Searle
(1969:263) has argued that ‘in the case of certain institutional facts, the evaluations
involving obligations, commitments and responsibilities are no longer left completely
open because the statement of the institutional fact involves these notions.’ Consequently
when we are dealing with the institutional fact of money we cannot dissociate our
analysis from the normative context which gives money its legitimacy, that is, that which
creates the belief in its validity. For example, it would be senseless to argue that it is a
fact that one of the functions of money is to have purchasing power, but the objective of
maintaining price stability is a normative value judgement independent of this fact.
Therefore, when we analyse the sustainability of institutions like EMU, we have to do
two things: we need to state the rules of the ‘social contract’ which sets up the institution
of money (constitutive rules) and then assess the likelihood that the related organisations
will behave in such a way that the credibility (legitimate validity) of the institution will
be maintained.
Searle (1995:43–5) has shown with respect to the evolution of paper money how
constitutive rules create institutional facts. There is, as he put it,‘an element of magic, a
conjuring trick, a sleigh of hand in the creation of institutional facts’. It results from the
collective intentionality assigning a new status to some phenomenon which cannot be
performed solely by virtue of its intrinsic physical features. For example, the material
support of money, such as coins, paper, electronic data, is intrinsically rather worthless,
but it obtains value because society uses it with a commonly shared, collective
intentionality. Without some underlying norms, or constitutional rules, individuals would
not be able to communicate their intentions, nor could they behave accordingly. This
explains why the persistence and sustainability of institutions is so dependent on credible
commitments, for they alone will keep the collective agreement alive and the institution
legitimate. Nowhere is this more obvious than in the field of monetary policy in a large
sense. Sustaining EMU means maintaining the credibility and legitimacy of monetary
institutions of Europe.
North (1993) distinguishes between motivational and imperative credibility.
Motivational credibility applies, if the players want to continue to honour their
commitment at the time of performance (i.e. time consistent behaviour). In this case,
institutions are self-enforcing and the success of the institutions sustains their success.
Alternatively, the credibility is ‘imperative’ when the performance of the players (i.e. the
application of the constitutive rule by the related organisations) is coerced or at least
discretion is disabled. This requires regulative rules (Searle 1995:27). However, both
forms of credibility derive naturally from the normative status of constitutive rules, for
any rule implies the possibility of abuse. Therefore, imperative credibility is necessary to
protect motivational credibility. Regulative rules, which can only work on the
background of the related constitutive rules, are necessary to maintain the ‘imperative
credibility’ of the institutions. Figure 1.1
Figure 1.1 The structure of collective

intentionality.
shows the inter-relatedness of norms, rules and motivations as the structure of collective
intentionality (arrows indicate the direction of influence).
This model of social institutions could explain why the political process towards
EMU, notably during the negotiations of the Maastricht Treaty (see Bini-Smaghi et al.
1994), has focused on institutional ‘stability conditions’ as the normative constitutive
rules. The norm of maintaining price stability is at the core of the collective European
monetary agreement. Once EMU had started, monetary policy rules, such as targeting the
growth of money supply aggregates or the level of inflation rates became regulative rules
to serve the Treaty objectives.
Collective intentionality is necessary to create the institutional fact of money. But if it

requires a norm, such as maintaining the purchasing power of money to make the system
functional, this is not a one-way street. If the constitutional rules that establish money are
credible, then they also create an environment of certainty which will feed back into the
anticipations and behaviour of the players. This creates a degree of moral cohesiveness in
society5 and gives rise to very different behaviours than if the legitimacy of the monetary
system is under doubt.
This interdependence between constitutive and regulative rules has been a central
preoccupation in the theories of the German ordo-liberals who laid the intellectual
foundations of Germany’s post-war economic model (Bernholz 1989). Röpke made the
point that
a sophisticated economic system which involves a widely developed

division of labour and hence a considerable mutual dependence of the
individuals concerned, can only be developed and maintained if an
important assumption is made. This is that those who have entered this
kind of dependence must feel safe enough in their moral, legal and
institutional surroundings to continue to accept the risks involved in such
interaction.
(Röpke 1951)
To achieve this, two prerequisites are required, according to this school of thought: ‘a
free, stable and internationally convertible currency’ and a’stable legal order’. One does
not have to share all aspects of ‘ordo-liberalism’ to see that the monetary constitution
influences the daily economic process (Eucken 1989:122). Clearly, money matters for
these thinkers.
Sustaining institutions
According to our analysis, institutions are necessary to make human behaviour
predictable in the social realm, that is, when actions are not determined by the physical
characteristics or utility of objects. But, this does not exclude that institutions may change
when new skills and knowledge lead to revised evaluations of opportunities.
Organisations can gradually modify informal constraints and formally alter the rules on
which the institutions are based. However, shifts in individual preferences are not enough
to change institutions. Institutions oblige individuals to act occasionally (even frequently)
against their individual, volatile preferences. From an individual point of view this may
appear annoying, but the obligation is an indispensable feature in making society
sustainable. This does not mean that institutions can prevail or be sustained against the
collective intentionality. It means that personal preferences may occasionally be at odds
with collective ones. But in the long run, many individual preferences are shaped and
structured by institutions. European integration since World War II has effectively been
based on such a conception of institutions.6
Our approach to institutions and money is quite different from the neoclassical
postulate of ‘instrumental rationality’ where institutions are unnecessary, ideas and
ideologies do not matter and markets are efficient. Neoclassical economics operates in
the framework of individual intentionality, which is justified when we can assume that
the collectively shared set of values is constant. However, even with given tastes but
bounded or ‘intended’ rationality when actors have incomplete information and limited
mental capacity, institutions are critical for the long-run performance of economies and
policies and their duration will depend on their credibility (North 1993). If however, the
sustainability of monetary institutions is the object of our research, we have to include the
wider framework of shared convictions and values7 and allow for the possibility that even
collective intentionality may be volatile. As an institution, money may stabilise
individual preferences. But in order to fulfil this function, it needs to be sustained. Thus,
money matters in the long-run. It can not be neutral.This claim is not to be confused with
the familiar Phillips curve trade-off: my thesis is that the stability of money has long-run
effects on output and on society as a whole.
There is plenty of evidence that monetary institutions matter. One does not have to go
back as far as to German hyperinflation which obliterated the life savings of millions and
pushed hundreds of thousands into poverty (Hughes 1982).8 It is enough to look at the
international monetary system of Bretton Woods which was a foundation of keeping
nations together in peaceful economic co-operation. Bretton Woods was an institution
that established monetary and economic rules for the (westen) world. As we will see in
the next section, it was grounded in the collective intentionality so well described by
Nurkse (1944). The system broke down when the US, as a principal player, persistently
violated the regulative rules by which the dollar served as the system’s anchor and was
supposed to be kept convertible into gold. With rising inflation and doubtful gold
convertibility the anchor currency lost its motivational credibility. Collective
intentionality in the world and national policy motivations changed. The norm of a
‘stable’ monetary system was replaced by a ‘flexible’ system.
EMU is, to use the language developed by North, a new institution (a set of rules)
which will be run by an organisation (the ESCB) in concert with other organisations (the
European Commission, national governments, etc.). Each organisation has its particular,
independent task. The sustainability of the new monetary institution will be determined
by the perceived effectiveness of the organisations that run it, for this is an important
element in the durability of the collective intentionality. If EMU were perceived as
ineffective, then the support for the institutional structure of the European Union (EU)
would weaken and wane. Thus, the sustainability of EMU—just as any other previous
monetary regime in Europe—will depend on what people expect and the ability of the
organisations to provide it. Consequently, the organisations of the new institutions will
also have to communicate the sense and purpose of their policy actions. In doing so, they
also change peoples’ expectations and transform the relations among the people and
peoples of Europe. This, at least, is the motive that underlies the collective intentions
behind the EMU-agreement.9
This book will trace the logic behind the shifts in collective intentionality that led to
the creation of the euro, and it will assess the likelihood that EMU can deliver. However,
before we analyse specific features in this arrangement, it is useful to recall the economic
context which has shaped the experiences and expectations of the European people as
they will shape the actions of the new European institutional players. In this context,
three questions emerge: Why did pre-EMU monetary arrangements not survive? Under
what conditions will EMU be sustainable? What can be done to improve the euro’s
chances of becoming a lasting currency? We will focus in our analysis on the medium to
long-term perspectives of European Monetary Integration (EMI).
The search for European monetary stability
Monetary Union is Europe’s response to the lessons of the twentieth century. The
interwar period with hyperinflation, unsustainable public finances and mass
unemployment was at the root of the political instability in the first half of the century
which was marked by wars, revolutions and dictatorships, culminating in the
concentration camps of Auschwitz. The second half saw a period of unknown prosperity
peace and renewed co-operation, despite the underlying tensions of the cold war and
increasing difficulties after the early 1970s. Western Europe experienced a Golden Age
for a quarter of a century that represents for many today a Paradise Lost (Eichengreen
1993, 1996, 1997a). Table 1.1 shows the average annual growth performance over a
long-time horizon.
Real GDP per capita grew 1.9 per cent over the long-term period 1890–1992, but the
subperiods diverged significantly from this trend. The Dark Age between (and including)
the two world wars is not surprisingly a time of stagnation, while the Golden Age (1950–
73) is characterised by exceptional growth rates for GDP and productivity. Post-1973
growth appears low in light of expectations created
Table 1.1 European growth, 1890–1992
Real GDP Population Real GDP per capita Real GDP per person-hour
1890–1913 2.6 0.8 1.7 1.6
1913–1950 1.4 0.5 1.0 1.9
1950–1973 4.6 0.7 3.8 4.7
1973–1992 2.0 0.3 1.7 2.7
1890–1992 2.5 0.6 1.9 2.6
Source: N.Crafts and G.Toniolo (1996).
during the previous quarter of a century, but when compared with the long-run trends, per
capita output is still close to average, and productivity is even higher. Nevertheless, real
GDP growth after 1973 is clearly closer to the period of stagnation than the Golden Age
and this explains a part of Europe’s high unemployment (see Chapter 8). In addition to
growth, the subperiods are also marked by distinct monetary characteristics. The Golden
Age was an era of great monetary and macroeconomic stability. Inflation was low and
exchange rates stable. The Dark Age was marked by monetary instability and fluctuating
exchange rate arrangements. The 1920s were the years of high inflation (in Germany and
Austria even of hyperinflation). The imposition of deflationary policies in pursuit of
financial orthodoxy and the return of leading economies to the gold standard forced
world trade into a vicious downward spiral leading to the Great Depression. Real wages
increased (except in Germany) and unemployment rose. Although very different in their
quantitative extent (Feinstein et al. 1997), these features are not without qualitative
resemblance to the period following the Golden Age after 1973.
The Bretton Woods Agreement for monetary stability

The architects of the Bretton Woods Agreement of 1944 had tried to draw the lessons
from the dramatic instability in interwar monetary relations. This was resumed by Nurkse
(1944) who saw ‘free and flexible exchange rates’ as important culprits in the economic
crisis in the Dark Age between the wars. They increased risk and discouraged trade,
created unemployment and invited speculative capital flows. In many ways his analysis is
reminiscent of the monetary experience after the collapse of the Bretton Woods System
and the public debate which preceded the creation of EMU:
Freely fluctuating exchanges involve three serious disadvantages. In the

first place, they create an element of risk which tends to discourage
international trade. The risk may be covered by ‘hedging’ operations
where a forward exchange market exists; but such insurance, if obtainable
at all, is obtainable only at a price and therefore generally adds to the cost
of trading…
Secondly, as a means of adjusting the balance of payments, exchange
fluctuations involve constant shifts of labour and other resources between
production for the home market and production for export. Such shifts
may be costly and disturbing; they tend to create frictional unemployment,
and are obviously wasteful if the exchange-market conditions that call for
them are temporary…
Thirdly experience has shown that fluctuating exchanges cannot
always be relied upon to promote adjustment. Any considerable or
continuous movement of the exchange rate is liable to generate
anticipations of a further movement in the same direction, thus giving rise
to speculative capital transfer of disequilibrating kind… Self-aggravating
movements of this kind, instead of promoting adjustment in the balance of
payments, are apt to intensify any initial disequilibrium and to produce
what may be called ‘explosive conditions of instability’.
(Nurkse 1944:210–11)
The monetary system of Bretton Woods was the answer to the lessons learned from the
Dark Age interwar experience. It created new international institutions, but its principal
achievement was the maintenance of a stable macroeconomic environment.The post-war
economic institutions were to a large extent influenced by Keynes’s General Theory or
rather, by how the theory was interpreted (Kenen 1985). Their purpose was to maintain
internal (full employment) and external (current account) equilibrium. By manipulating
the fiscal-monetary mix, discretionary policy actions were to prevent unemployment
from exceeding certain target levels or excess demand from overheating the economy,
and to develop inflationary pressures which would show up in balance of payment
difficulties.
The Bretton Woods System worked effectively as a gold—dollar exchange standard.

The US-currency served as the system’s anchor. Other countries would declare the par
value of their currencies either in terms of dollar or gold alone, but the value of the dollar
was exclusively fixed in terms of gold at $35 an ounce. This solved the n–1 country
problem which meant that in a system of n currencies there exist only n–1 degrees of
freedom. Once n–1 countries have adopted policies to determine their payment position,
the payment outcome in the nth country is determined as a residual (Williamson 1983).
Since the US as the nth country pegged to gold as a reserve asset, it was the only country
obliged to hold its reserves in gold. This exerted domestic discipline against excessive
money creation and kept inflation down (Gilbert 1997). The other countries could only
keep their exchange rates fixed as long as they possessed sufficient foreign exchange
reserves. When monetary gold reserves would not grow rapidly enough to keep up with
the accelerated growth in the Golden Age, the reserve deficiency in the rest of the world
was filled by US dollars. This implied a balance of payment deficit for the US and a
surplus in the rest of the world. At first, the dollar gap was closed by a mix of capital
exports from the US (aid and the Marshall Plan) and dramatic devaluations of most
currencies against the dollar in 1949 (Bordo 1993). Once the effects of these measures
had worn off, the constraints of the system became more apparent. Table 1.2 shows,
however, that the degree of undervaluation of European currencies was corrected only
very slowly before the regime of fixed rates came to an end. Once nominal exchange
rates had been allowed to float, the dollar depreciated rapidly and by 1980 many
European currencies were actually overvalued.
Nevertheless, for most of the 1950s and 1960s the dollar maintained a position of
structural overvaluation (Friedman and Schwartz 1982:290–3) which also contributed to
keeping domestic US-inflation under control. Together with the gold link, the strong
dollar helped to stabilise the domestic purchasing power in the world’s anchor currency
in the early years of the Golden Age. Given the fixed exchange rate, this stability
extended to the rest of the world. But when prices increased more rapidly in the periphery
due to the differential impact of productivity increases in catch-up growth (Balassa
effect), the dollar overvaluation slowly eroded and the current account balance became a
permanent concern outside the USA (Obstfeld 1993). Fast growing countries were hitting
the exchange reserve constraint. Cooper (1968) records that in 1962 all major industrial
countries were simultaneously wishing to increase their current account surpluses,
Table 1.2 Nominal unit labour costs relative to 19
industrialised countries
Index 1991=100 In per cent of USA
1960 1970 1980 1990 1960 1970 1980 1990
B 111.0 104.7 117.2 98.9 66.5 64.7 117.9 97.7
DK 82.4 84.9 105.6 105.4 49.4 52.5 106.2 104.2
D 91.6 98.6 112.5 103.0 54.9 60.9 113.2 101.8
EL 178.4 161.8 101.8 108.7 107.0 100.0 102.4 107.4
E 66.6 64.9 99.2 98.4 39.9 40.1 99.8 97.2
F 127.7 128.9 123.9 103.8 76.6 79.7 124.6 102.6

IRL 106.2 105.1 111.2 104.3 63.7 65.0 111.9 103.1
I 81.0 77.7 76.0 98.4 48.6 48.0 76.5 97.2
NL 83.7 88.1 126.8 102.0 50.2 54.4 127.6 100.8
A 82.9 83.9 92.1 100.5 49.7 51.9 92.7 99.3
P 102.5 99.9 83.3 86.8 61.5 61.7 83.8 85.8
FIN 87.3 85.2 78.9 101.6 52.3 52.7 79.4 100.4
S 101.3 100.1 102.4 98.8 60.7 61.9 103.0 97.6
UK 99.2 100.6 100.3 96.8 59.5 62.2 100.9 95.7
EUR 15+ 88.6 92.6 118.3 103.1 53.1 57.2 119.0 101.9
USA 166.8 161.8 99.4 101.2 100.0 100.0 100.0 100.0
JAP 54.4 54.3 80.3 93.9 32.6 33.6 80.8 92.8
Source: Huropean Economy 63 (1997) and own calculations.
or decrease their deficits (Williamson 1983:383–4). Thus, either internal or external

balance had to be sacrificed, unless an additional policy tool could be found to solve the
inconsistency. In the policy debates of the 1960s, Germany insisted on price stability as
the primary objective of its economic policy and it was more readily prepared to abandon
full employment. Most other countries, under Keynesian influence, focused more on the
external balance aspects. The search for new policy tools produced two findings: income
policies and more flexible exchange rates.
One important tenet in the General Theory was that ‘a stable general level of money-
wages is, on balance of considerations, the most advisable policy for a closed system’
(Keynes 1936:270). The emerging economies after World War II were essentially closed,
domestic economies. The autarkic policies of the 1930s and the controls on trade and
capital movements imposed during the war left countries less exposed to international
flows than in the 1920s. At the end of World War II, western economies were even less
open than before World War I (Eichengreen and Kenen 1994). Thus, the idea of stable
money wages corresponded to some degree with the structural reality of post-war Europe.
However, the success of economic development in Europe was going to undermine this
structure gradually. With stable money wages and fixed exchange rates, adjustment to
achieve external balance was not possible. The Bretton Woods Agreement recognised
this fact by allowing the adjustment of exchange rates in cases of a ‘fundamental
disequilibrium’. The impact of flexible exchange rates on wages was not explicitly
mentioned by Keynes (1936). With respect to stable money wages in an open economy
he simply stated, ‘…the same conclusion will hold good for an open system, provided
that equilibrium with the rest of the world can be secured by the means of fluctuating
exchanges’ (1936:270). The post-Keynesian approach in the post-war period always
emphasised the adjustment aspect of exchange rates and not the fluctuation aspect. This
led economists to become forgetful about the lessons learned by Nurske. The collective
intentionality changed. As we will see, this one-sidedness also overshadowed later the
debate on the utility of EMU in the context of optimum currency area theory.
From an adjustment point of view, nominal wage flexibility was necessary to operate a
successful gold-standard mechanism. If prices remained stable in terms of gold,
adjustment required a reduction in nominal wages. If both prices and money-wages were
stable, the exchange rate had to be adjusted in order to re-establish a fundamental
equilibrium after a disturbance. With stable money wages, as Keynes had claimed, this
meant that prices would increase, and real wages would fall. Therefore, fluctuating
exchange rates required real wage flexibility as Meade pointed out (1951, quoted in
Kenen 1985). Even Friedman’s famous ‘Case for Flexible Exchange Rates’ was founded
on the assumption that
wage rates tend to be among the less flexible prices. In consequence, an

incipient deficit that is countered by a policy permitting or forcing prices
to decline is likely to produce unemployment rather than, or in addition to,
wage decreases. […] This is clearly an inefficient method of adjusting to
external changes.
(Friedman 1953a:467)
We will see in Chapter 8, Table 8.1 that, at least for Europe and Japan, the assumption
that wages are less volatile than good prices is not in accordance with the facts. What was
missing from theory in those years was a rational micro-foundation of nominal or real
wage rigidity. Most importantly the adjustment theory of exchange rates assumed ‘money
illusion’, whereby money wages were divorced from the cost of living. This might have
appeared reasonable, as long as general price stability was taken for granted and inflation
was a surprise. But with flexible (in particular with depreciating) exchange rates and
increasingly open economies, prices will not stay stable.10 Once inflationary expectations
were integrated into wage bargaining, money illusion became itself an illusion. Nominal
wages had become upward flexible and downward sticky. With fluctuating exchange
rates the price level also had to become more volatile, particularly for small countries.
We will return to this argument in later chapters. As we will see, it meant also that
flexible exchange rates led to the development of nominal inertia in a way that was not
anticipated by the ‘adjustment’ theory. Consequently, the fundamental pillar of the
successful post-war growth performance, namely stable money wages, was no longer
sustainable when and after the Bretton Woods stable exchange rate regime broke down.
Golden Age versus Dark Age: lessons to be learned
The extraordinary performance of the post-war period requires an explanation. Crafts and
Toniolo (1996) have shown that war damage and reconstruction can account for only a
part of the rapid growth in the Golden Age, since most of the recovery was already
completed by 1950. There may have been some scope for catch-up growth with the US
thereafter, but the essential characteristics emphasised by these authors are:
1 High per capita income growth was a distinctly European phenomenon.
2 High growth rates characterised almost all European economies, regardless of their
social, political and economic institutions.
3 Initially poorer countries tended to grow faster than richer ones, so that by the early
1970s, the dispersion in levels of per capita income was much less pronounced than in
1950 (catch-up growth).
4 Full employment prevailed, cyclical fluctuations were mild, and inflation rates were at
socially acceptable low levels.
Explaining the causes for the high growth performance between 1950 and 1973 requires a
book on its own. However, there is one dominating feature: investment. Neoclassical
growth accounting reveals capital accumulation and total factor productivity as principal
sources of European growth (see Chapter 8). Levine and Renelt (1992) report evidence
whereby the acceleration in growth in the Golden Age came from increased investment in
both physical and human capital.11 Eichengreen (1996) reckons that net investment rates
in Europe were nearly twice as high in the 1950s and 1960s than before or since, rising
from 9.6 per cent in 1920–38 to 16.8 per cent in 1950–70. In most countries investment
rates after World War II exceeded by 50 per cent those between 1914 and 1945
(Eichengreen and Kenen 1994:22). Eichengreen (1996) also suggests that increasing the
gross investment share of GDP from 20 to 30 per cent may have raised the growth rate by
as much as 2 percentage points. As we will see, this has had important consequences for
European employment.
Yet, investment was not the only factor. The high rate of European growth can best be
explained by the triptych of high investment, high exports and considerable wage
moderation (i.e. the real world equivalent of Keynes’s stable money-wages). In several
European countries wage demands were linked to productivity increases. In the 1950s,
they were even at times lagging behind in return for an agreement by industry to
modernise and expand productive capacity. This applied in particular to Germany,
Austria, Benelux and Norway. The UK, Ireland, France and Italy were less successful in
building such social consensus (Eichengreen 1996). In the early 1960s, nominal unit
labour cost increased in the European aggregate more than in the US, but real wages still
lagged behind the rapid productivity increases, so that the profit share increased. (See
Figure 1.2 and Figure 8.6 (a) and (b).)12
Together with fixed exchange rates under the Bretton Woods Agreement, relative
wage moderation allowed the reaping of efficiency and productivity gains from
international trade, and in particular from intra-European trade, by specialising on
comparative advantages. The volume of exports expanded by more than 8 per cent per
annum in Europe, compared to 5.3 per cent in the US and 16.5 per cent in Japan.
Figure 1.2 Unit labour cost (annual

variation in per cent).
Source: AMECO (1999).
This rapid export growth concentrated investment in sectors with high productivity
growth and this facilitated the relative stability of unit labour costs. The exceptional
performance was helped by the institutional framework of the Bretton Woods era: stable
exchange rates and trade liberalisation under GATT in the world economy; Marshall Plan
and European integration on the old continent.Wage restraint, however, was crucial for
this strategy. The stability of money-wages was supported by stable exchange rates. We
will show in Chapter 3 that the abolition of fixed exchange rates in 1971–3 created large
distributional conflicts which were exacerbated by the oil price shock. During the Golden
Age, however, wage moderation reduced the danger that excessive inflation would create
competitiveness problems large enough to call into question the exchange rate peg
(Eichengreen 1997). However, most European countries also started from a position of
undervaluation relative to the US dollar which allowed them some leeway with unit
labour cost increases.13 Nominal unit labour costs in the 1960s relative to 19
industrialised countries were significantly lower than in the US, as Table 1.2 shows.
After the war, Europe developed institutions (commitment mechanisms) that bound
capitalists to invest profits and workers to exercise wage restraint. These institutions
solved commitment and co-ordination problems. Without them neither wage moderation
nor the expansion of international trade could have taken place (Eichengreen 1996:41).
These domestic institutions have become the basis for what may be called the European
social model (Bercusson et al. 1996). It was based on three pillars:
1 private property rights and a market price system;
2 a distributional settlement between capital and labour that included tax and transfer
payments and more or less balanced budgets;
3 achievement of full employment and development of the welfare state as a foundation

for political stability (Eichengreen and Kenen 1994).
Only the first pillar survived the Bretton Woods System.
One should add a fourth element that was indispensable to the maintenance of this
domestic consensus: price stability. Only if workers were confident about the future
purchasing power of their money-wages would they be willing to agree to wage
settlements not in excess of general productivity increases. Only then would relative
income shares stay roughly constant. It is doubtful that the domestic institutions of wage
moderation on which the European model was built could have worked without the
regime of fixed exchange rates.
The breakdown of Bretton Woods

If support for flexible exchange rates grew over time, it was partially due to some other
disenchantment with the Bretton Woods regime (Kenen 1985). In fact, the decision to
adjust exchange rates was eminently political and the way the system worked was rightly
described as ‘government-led’ (Padoa-Schioppa and Saccomanni 1994). Governments
would often attempt to postpone an inevitable devaluation for fear of losing face.
Possibly more important was the need to achieve current account convertibility for local
currencies in order to facilitate trade and cross-border investment. But with the increasing
mobility of capital, sustaining a system of pegged exchange rates became increasingly
difficult. At the first sign of an impending devaluation, investors would withdraw their
capital in order to avoid capital losses. This could quickly exhaust a country’s foreign
exchange reserves, if it attempted to defend its peg. For Friedman (1953a:476) the
advantage of flexible rates was that they offered ‘no definite sticking point’ for
speculators and this idea became a tempting option for policy makers.
In the mid-1960s, the value of US short-term liabilities started to exceed the value of
US gold holdings. Holders of dollar assets became alarmed, the ‘confidence premium’ on
dollar interest rates disappeared, and after 1967 speculation against the dollar
increasingly sought the Deutschmark as an alternative reserve asset. The DM was one of
the few currencies which showed good economic fundamentals and was free of
restrictions on capital flows. High interest rates also added to its attractiveness at the
time. Furthermore, traditional key currencies like pound sterling and the French franc had
already lost their reputation after the sterling devaluation of 15 per cent in November
1967, and the franc devaluation (11.1 per cent) in August 1969. At the same time,
Germany had acquired a solid surplus on current account, adding quickly to its external
net asset position. This situation attracted a massive flow of speculative funds from
abroad into the DM. In May 1971, the DM and the Dutch guilder were allowed to float
temporarily, after the French and Italian authorities had rejected a joint float because of
concerns about competitiveness. In August 1971 President Nixon announced unilaterally
the suspension of dollar—gold convertibility. The Smithsonian Agreement of December
1971 finally tripled the margins of all participating currencies fluctuating, vis-à-vis the
dollar to 2.25 per cent.
This new monetary rule urgently required a mechanism for reducing intra-EC
exchange rate fluctuations, otherwise any two EC currencies could have moved by up to
9 per cent against each other. Consequently the Basle Agreement of April 1973 between
the six founding EC countries, joined by Denmark, the UK and Ireland, halved their
margins of fluctuation later to 4.5 per cent (±2.25 on either side). This arrangement was
called the ‘snake in the tunnel’. When the Smithsonian Agreement broke down in 1973,
‘the snake left the tunnel’, and floated freely against all other currencies. It was the
beginning of a long and twisted march to EMU.
The New Dark Age

The end of the Golden Age is normally assumed to coincide with the first oil shock in
1973. But it might be more appropriate to take as the decisive point the 1971 decision to
abandon the gold peg of the US dollar, even if the general free float only followed in
1973. The persistent balance of payment deficit of the US, that had allowed to fill the
‘dollar gap’, had raised the ratio of foreign-held dollars to US gold reserves over time.
The gold convertibility of the dollar became increasingly doubtful and ultimately a run on
US gold did occur, which forced the suspension of the gold link of the US currency
(Little et al. 1993). This was a violation of the system’s constitutive rule and led to the
loss of motivational credibility. After that, prices no longer had a nominal anchor and
monetary discipline ceased until it was regained painfully in the early 1980s. Price shocks
from raw material markets now had permanent effects on the price level. This was a
structural change compared to previous incidents like the raw material boom after the
Korean war (Friedman and Schwartz 1982:569–72).
The 25 years that followed were marked by significantly lower economic growth.
Although productivity growth only fell to its secular trend, per capita income grew only
at the rate of the pre-World War I belle époque when technological progress and
productivity improvements were much lower. Most importantly European real GDP
growth more than halved in comparison to the previous era (see also Table 8.1). These
developments parallelled with high inflation in the 1970s, dramatic disinflation in the
1980s, persistent lower investment, rising structural unemployment and increasing public
indebtedness. Real convergence in income levels also slowed, while the variance of
output and unanticipated monetary aggregates increased. In short, the Golden Age was
followed by a period of macroeconomic instability which we might well call the New
Dark Age. This is apparent from a look at the two misery indices in Figure 1.3: The first
index (a) shows the sum of inflation and unemployment. It was low in the 1960s and shot
up after the first and second oil price shocks. Although it decreased rather rapidly in
Japan and in the 1980s in the USA, the index remained persistently high in Europe
reflecting high and rising levels of unemployment. The second index (b) calculates
misery as the difference between inflation and economic growth. Again, the 1960s reflect
a relatively blissful period, although less in Europe than in Japan and the US.
After the two oil shocks, it took Europe much longer to eliminate misery—and it did
so only for a short time. Europe seems to have much greater difficulties in keeping
economic growth above inflation than the two other leading world economies. Not
surprisingly, a sense of crisis (‘Eurosclerosis’) started to prevail. I will argue in Chapter 8
Figure 1.3 Misery index: (a)

inflation+unemployment rates; (b)
inflation−growth rate.
Source: AMECO (1999) and own calculations.
that the described developments—high inflation, low growth and high
unemployment—are intrinsically linked. Europe’s answer has been twofold: with the
completion of the Single Market Programme by 1992, it had sought to re-invigour its
industrial strength and competitiveness (Economie Européenne 1994); with the creation
of economic and monetary union, it has returned to the basic lesson that monetary
stability is a necessary condition for economic growth.
The case for price stability

What has caused the decline of the Golden Age? Many theories have been asserted. For
some it is just a return to normal, ‘the explanadum in post-war European history being
not the slowdown of the 1970s but the growth spurt of the previous two decades’ (Crafts
and Toniolo 1996:25). Olson (1996) explains Eurosclerosis by the development of
special-interest legislation and monopolistic practices that make an economy less
productive. However, both labour productivity and total factor productivity have
remained consistently higher in Europe than in the USA (see Table 8.1). Eichengreen
(1996) suggests that the increasingly prominent role of governments and welfare state
programmes were not able to adjust efficiently and rapidly to the new circumstances after
the catch-up phase of economic growth had passed. This is the labour market rigidity
argument with which we will deal more comprehensively in Chapter 8.
However, even if these explanations are able to explain partial aspects of European
post-war development, they remain unsatisfying as they either abstract from an extremely
complex and diverse economic, social and political reality or assume a metaphysical
force or law that consumes itself over time. This is particularly evident in the hypothesis
of ‘the end of catch-up’. For example, the regressions by Levine and Renelt (1992),
reported by Crafts and Toniolo (1996),14 can be interpreted as ‘reflecting lower scope for
catch-up’; but the fact that the negative coefficient for the initial per capita GDP in the
regressions explaining growth of output per head increased from the period 1950–73 to
1973–89 could also mean that rich countries were simply harder hit by the growth
reduction than others.15 We will deal with this argument more extensively in Chapters 4
and 8.
What could be the unifying event that explains Europe’s disappointing performance
after the end of Bretton Woods? Two answers spring to mind: the oil shock and flexible
exchange rates. As Eichengreen (1996) points out, the former worsened the inter-
temporal terms of trade for workers offering wage moderation in return for higher
investment. The latter removed the exchange rate as a nominal anchor, so that Keynesian
stabilisation policy lost its powers. However, the problem with both of these explanations
is timing: European wage explosion had taken place already before the oil price shock at
the end of 1960. In fact it might be argued that the dramatic increase in raw materials in
the early 1970s was a response to an earlier deterioration of purchasing power in dollar
terms by the oil suppliers (James 1996).16 Similarly, the change in labour market
behaviour seems to have been the consequence, rather than the cause of the breakdown of
the Bretton Woods Agreement on fixed exchange rates. Thus, it is likely that the end of
the Golden Age and the failure of Bretton Woods have the same roots.
The collapse of Bretton Woods has been attributed to flaws in the structure of the
system and to policy mistakes. It is certainly true that a system that cannot deal with
policy imbalances is doomed. But one has to be careful not to make what Ryle (1990)
called a’category mistake’. Such a mistake mixes logical categories. For example, the
statement: ‘the glass broke because a stone hit it’attributes falsely a cause to an event.
The proper statement is, ‘the glass broke when a stone hit it, because the glass was
brittle’. The increasingly inflationary monetary policy in the US was the event which
violated the regulative rules of the Bretton Woods System and undermined the legitimacy
and, ultimately the constitutive rules of the system. But the structure of fixed exchange
rate regimes always has a ‘brittleness’ which makes it vulnerable, as we will show in
Chapter 4. A monetary union with a single currency is more robust. However, it is
possible that Bretton Woods could have been sustained as long as the anchor country
would have continued to play by the rules.
Once the inflationary spirit was out of the bottle, disintegration followed rapidly.With
a drifting anchor, the normative foundations of money were shaken. Thus, my
explanation for the end of the Golden Age is that inflation destabilised the economic
system. This argument concentrates on the long-run relationship between inflation and
growth and not the short-term Phillips curve trade-off.17 In fact, empirical evidence points
strongly to a predominantly negative long-term relationship between growth and inflation
(Fischer 1993, 1994). Under this hypothesis, the Golden Age came to an end because of
the inflationary pressures that developed in the US from the mid-1960s on as a
consequence of the monetary expansion associated with the Vietnam War. Bordo (1993)
has shown that US authorities were expanding domestic credit at a rapid rate through
most of the 1960s and early 1970s. Inflation began accelerating in 1964 and exceeded
that of the GNP-weighted inflation rate in the G7 (excluding US) in 1968. Eichengreen
(1993) compares US-aggregates with other industrial countries and argues that the US
expansion had stronger inflationary effects because the US was growing more slowly
than Europe or Japan. Inflation was exported from the anchor currency in the Bretton
Woods System via fixed exchange rates into the rest of the international monetary
system. This then undermined the commitment mechanisms of wage restraint on which
the system was based. Inflation led to compensating wage demands. The resulting
misalignment in real exchange rates caused the break-up of the fixed exchange rate
system and removed the stable nominal anchor for the international monetary system.
From that moment on, the effects of shocks persisted, nominal inertia became a dominant
feature, and monetary policy had to take a quasi-permanent restrictive stance. The
virtuous circle which had allowed high investment, high returns and high productivity
growth with low unemployment in the previous decade was destroyed. We will return to
the mechanisms behind these developments in subsequent chapters. Here, I wish to
emphasise the disruptive effect of inflation on the wage moderation consensus.
The fundamental thesis underlying all chapters of this book is that Europe’s Golden
Age was destroyed by the Great Inflation of the 1970s. High real interest rates, rising
unemployment and deteriorating public finance in the 1980s and 1990s were unavoidable
side effects of the inevitable disinflation policies required to restore price stability. The
creation of the European Monetary System (EMS) in 1979 was the attempt to return to
monetary stability. But for structural reasons, discussed in the following chapters,
currency blocs with regional exchange rate pegging were not able to re-ignite the
previous growth dynamics. If EMU succeeds in eradicating inflationary expectations, it
will contribute to an economic environment that will stimulate growth, create
employment and reduce public debt ratios.
A formal model
The logic of our argument that inflation undermined the stable wage consensus in Europe
can be demonstrated by a simple model. Let us assume that the rate of inflation evolves
as a random walk, so that the current rate is equal to last period’s plus a white noise term.
In this case, the rate of inflation is expected to remain constant:
πt=πt–1+εt,
(1.1)
where π is the rate of inflation and ε the white noise term. The model could be augmented
by a drift and a moving average error term, but this would not add much to our argument.
For reasons that will become obvious in Chapter 8, Equation (1.1) may be overly
pessimistic. More realistic models, like Alogoskoufis and Smith (1991), show Equation
(1.1) as an AR(1) process, so that:
πt=π*(1−θ)+θπt−1+εt.
(1.1a)
Here π* is the steady state inflation rate and θ is the autoregressive coefficient or the
indicator for inflation persistence. Obstfeld (1993) estimates a similar coefficient that can
be derived from a sluggish (log) price level. π* is then a forward-looking equilibrium rate
of inflation that depends exclusively on exogenous fundamentals. In this case θ measures
the degree of persistence of price equilibria and θ=0 corresponds to perfect price
flexibility, that is, inflation is always in long-run equilibrium. Equation (1.1a) can also be
interpreted in terms of our model of institutional credibility. A low θ would reflect high
motivational credibility of the monetary institutions. A low value for π* is implied by
imperative credibility.
Alogoskoufis and Smith (1991) present evidence, supported by Eichengreen (1993)
that θ is regime-dependent and increases when the commitment of authorities to maintain
price stability is low. This is not surprising for Equation (1.1a) explains current expected
inflation as a weighted average of steady state inflation and the past realised rate. If θ
rises, price setters give less weight to a steady state inflation rate that they do not expect
to prevail much longer. Obstfeld (1993) has estimated price equations for G7-countries
and shows that his parameters for nominal price flexibility have been close to 1 in the
period 1952–71 for most countries except France (0.232), Japan (0.327) and UK (1.363).
Eichengreen (1993) has estimated coefficients for lagged price inflation that are less than
1, but they are larger after World War II, and they also show a tendency for inflation
persistence to rise between 1970 and 1973. Thus the assumption that θ=1 can be justified
by uncertain inflationary expectations and low imperative credibility of monetary
institutions and this assumption does not remove generality from our argument. For the
illustrative logic of our argument here it is acceptable to assume that inflation follows a
random walk.
The general solution to the first-order difference Equation (1.1) is
(1.2)
where π0 is the initial rate of inflation. Next we assume that wages are set in nominal
terms, but workers seek to protect their living standards. Hence, the wage equation is:
(1.3)
is the rate of nominal wage increase, ξ1 is a coefficient for the degree of nominal wage
indexation. If ξ1=0, we have no indexation or perfect nominal wage rigidity that is,
perfectly stable money wages. If ξ1=1 nominal wages are perfectly indexed and flexible.
Wage increases will then completely compensate for the loss of purchasing power and
the rate of wage growth becomes a random walk plus noise process. Nominal inertia
arises from staggered wage and price setting, from the cost of changing wages and prices,
and from adaptive expectations. However, adaptive expectations imply that wage earners
are consistently proved wrong in their expectations. With rational expectations, workers
would use all available information including the expected rate of inflation and, therefore,
ξ1=1 with respect to E(πt). Under rational expectations E(π)=π*(1−θ)+θπt−1 because of
Equation (1.1a), so that Equation (1.3) is transformed into:
(1.3′)
The difference between Equation (1.3) and Equation (1.3′) is εt which is white noise.
With low confidence in price stability θ=1 we can assume that wages are perfectly
indexed on past inflation. But with high motivational and imperative credibility (θ is low
and π* are low) wages remain stable—just as Keynes had claimed.
Another way to describe ξ1 is simply to call it the elasticity or flexibility by which
nominal wages respond to price changes. Wages are rigid or price-inelastic when ξ1=0
and perfectly elastic or flexible when ξ1=1. The concept of nominal wage flexibility is
related, but not identical with, real wage resistance. Nominal wage flexibility in our sense
describes the degree by which workers seek recompensation for an erosion in their real
wages by higher money wages. Real wage rigidity arises when the real wage responds to
factors other than changes in the price level. In Equation (1.3), xt is a vector of labour
market factors, which may have influence on the wage bargaining process and ξ2 is a
related structural coefficient vector for real wage rigidity. One of these factors may be
short-term Phillips curve dynamics so that ξ2 reflects the response of real wages to
unemployment.18 As will be discussed in Chapter 8, ξ2=0 implies perfect real wage
rigidity, that is, wages do not respond to factors other than inflation. We will make this
assumption here to show that even under extreme conditions of labour market rigidity the
extent of wage inflation depends more on price shocks than on labour market conditions.
ηt is a white noise process.
By inserting Equation (1.2) into Equation (1.3) and assuming that prices and wages in
period zero are stable, we get
(1.4)
The rate of wage increases has a stochastic trend because the inflation rate follows a
random walk. In other words, successive inflation shocks have permanent
effects on the rate of wage increases. High inflation shocks raise the rate of wage
increases permanently; negative shocks lower it. Thus, if inflationary shocks are imported
from the world anchor currency as it was the case in the late 1960s, then wage increases
in Europe have become permanently higher. If the European growth model was based on
wage moderation, imported inflation has undermined it.
Why did negative price shocks not make the system return to stability? Equation (1.4)
can also be written as the rate of change of wage inflation:
(1.5)
This shows that the rate of wage increases will stay constant only if ξ1εt=−∆ηt, where ηt is
the irregular (white noise) term in the wage equation. Non-acceleration in wage inflation
requires that in any given period inflationary impulses must be exactly compensated by a
negative variation in the wage-setting disturbance.This is rather unlikely, given that
workers will hardly be convinced to lower their pay increases when inflation is
accelerating. On the other hand, εt is the unanticipated variation in the inflation rate, and
ξ1εt is the mean of the wage acceleration, so that ∆ηt is the unanticipated or surprise
acceleration of wage inflation. If price deflation is not fully credible, then wage
reductions may be less than price surprises and Especially
in the early periods of disinflation, or when the mean inflation rate is still high, it is likely
that ∆ηt would exhibit a tendency to be positive. Thus, wage inflation would come down,
but only slowly.19 Furthermore, if ξ1 is not constant but rises with inflationary
expectations—as one would expect with Lucas (1973,1976)20—then nominal wages
become more volatile in periods of rising and falling inflation. This can be observed in
Europe during the 1970s and the 1980s—but less so in the USA (see Table 8.1). This is
not surprising in view of the fact that price stability in Europe was undermined by
flexible exchange rates and a large degree of openness (see section On the usefulness of
adjusting the nominal exchange rate in Chapter 5). On the other hand, if a regime of
stable prices prevails and imperative credibility of the institutions is high, ε and ∆η are
likely to be small, as well as ξ1 Wage moderation is then sustainable, even if stractural
parameters are very rigid.21 What this demonstrates is that the rate of inflation is decisive
for wage increases, and not the structural parameters which affect wage bargaining only
marginally.22
Alogskoufis and Smith (1991) show price and wage equations for the UK and the
USA to be very similar to Equations (1.1) and (1.2). They find that the hypothesis cannot
be rejected that consumer price inflation in both countries follows on AR(1) process and
that the log of the price level has a unit root. Their equivalent of our coefficient ξ1 is
0.947 (with s.e. 0.066) for the UK and 0.636 (s.e. 0.084) for the USA. The unemployment
level is insignificant and its rate of change enters in the first lag with a coefficient (ξ2) –
0.695 (0.189) and –0.954 (0.144) respectively (second lags are –0.149 (0.106) and –0.018
(0.084)). We may take this as evidence that our assumptions are not too far removed from
reality, although reality is less rigid. However, Alogoskoufis and Smith produce
important evidence that there are dramatic shifts in the degree of persistence of consumer
price inflation (θ). These shifts are related in their timing to fundamental monetary policy
regime changes in the international monetary system: the end of the classical gold
standard after World War I and the end of the dollar—gold standard with the break-down
of Bretton Woods. They explain the observed parameter change by the incorporation of
the monetary policy regime into price and wage setting. The nature of the regime depends
on whether authorities are willing to accommodate inflationary demand for money or not.
Accommodation implies higher expected future wages than otherwise, and these higher
future wages are partly reflected in the path of prices from today onward, with the net
result of higher inflation persistence. Similarly, the authors find that flexible exchange
rate regimes will result in more persistent inflation differentials between countries than in
fixed exchange rate regimes. We will find in subsequent chapters that this is highly
plausible and relevant for Europe, given the differences in the degree of openness of
European economies. They, therefore, conclude: ‘What is required for low inflation
persistence is credible lack of accommodation’.
This explanation would allow the conclusion that Europe’s Golden Age was not so much
terminated by insufficient labour market flexibility due to the European social model, but
rather by the Great Inflation of the 1970s. In fact, econometric evidence indicates that
structural rigidities in European wage equations (other than inflation persistence) have
been relatively stable except for the price expectations process (Artis and Ormerod 1994).
This is not to deny that more ‘flexible’, that is, higher structural coefficients ξ2 would
have helped to prevent the persistence of the great inflation.23 But it would not
necessarily have eased disinflation. Thus, changing structures in labour markets are not
only a difficult and long-winded task, but also have uncertain outcomes. More important
is our conclusion that price stability matters: if inflation is credibly low, wage moderation
is likely to hold.24 Money-wages will remain stable, just as Keynes had postulated. Figure
1.4(a, b) shows some support for our hypothesis that inflation in the international anchor
currency caused the subsequent inflationary pressures in other economies.
It shows the inflation rate in the US and the relative inflation differential for some
major industrial countries. From the mid-1950s to the mid-1960s the US inflation rate
remained stable around 2.5 per cent and the price increases in Europe remained close to
this rate. Although slightly higher in the first half of the 1960s, this phenomenon might
be explained by the Balassa-effect. This is what one would expect in a fixed exchange
rate system. By 1965/6, inflation accelerated in the USA, while inflation remained behind
in the partner countries: the European inflation differential became negative. However,
given their fixed peg, European inflation was pulled up: the negative inflation differential
of maximal 2.5 per cent was less than the US-inflation rate of 5 per cent.25 That ignited a
catch-up wage inflation in the late 1960s that could only be contained in Germany—not
least because the DM was revalued in 1969 and again after 1971 and 1973. From 1972
until 1991, with the minor exception of 1986, inflation was lower in Germany than in the
US. Under these circumstances it is not surprising to have seen the DM emerge as the
new nominal anchor for the European economy.26
In the next chapter we will analyse why smaller European countries pegged their
currency to the Deutschmark. But one lesson can already be anticipated: if Europe’s
exceptional growth performance after the war was based on stable exchange rates,
moderate wage increases, high investment and exports, and if imported inflation has
destroyed it, then it was tempting to fix exchange rates to a European currency with
stable prices. We will see in Chapter 4, however, that this was not the optimal solution to
Europe’s difficulties after 1973. Ultimately a more promising route was an EMU with a
strong commitment to price stability. This could then possibly pave the way to a mode of
development based on wage moderation and high investment that has proven so
successful in the Golden Age.
Figure 1.4 (a) US inflation rate; (b)

inflation differential to USA.
Source: European Commission.
Summary and conclusion
This analysis leads us to a number of conclusions and open questions. First, it has been
made clear that the sustainability of any monetary institution will depend on the
application and credibility of certain constitutive rules. With respect to money this
fundamental norm is the preservation of purchasing power, that is, price stability. This
constitutive rule is of particular importance because the norms of a monetary economy
matter for the whole of a market economy. Second, monetary regimes have changed
several times during this century. The Golden Age after World War II was the most
successful period with respect to economic growth, employment and monetary stability.
It ended when the leading anchor currency gave up its commitment to price stability.
Inflationary shocks then had persistent effects on wage bargaining. This led to the
collapse of the social model on which the European post-war period was built and
became a major cause of high unemployment in the 1980s and 1990s.
From these two propositions one may draw the conclusion that monetary stability and
more specifically price stability are necessary conditions for the sustainability of a
monetary regime. We will further specify this claim in Chapter 6. EMU, Europe’s newest
monetary regime, makes price stability explicitly the ‘primary objective’ of monetary
policy. In Chapters 7 and 8 we will analyse the conditions necessary for maintaining the
credibility of the stability commitment. However, before looking at these issues, two
questions still remain open:
1 Why is it that the regime of floating exchange rates has only lasted for a short time in
Europe?
2 Why is it that the regime of fixed, but adjustable exchange rates that prevailed under
EMS did not last either ?
In short, what was the inner logic that pushed Europe to the complete unification of its
monetary institutions?
2
After Bretton Woods
The world of bloc floating
In the years after 1973, the world economy went through a period of turbulence before it
started to restructure in the 1980s. Under the impact of the two oil shocks of 1973 and
1979, volatility of exchange rates increased markedly. This was partly a result of
diverging policies in response to shocks and partly due to instability following the
development of international financial markets, which outgrew the real economy. In the
general climate of uncertainty smaller countries sought to better control their
environment by pegging their exchange rate to some larger currency or to a basket. A
consequence was the emergence of monetary blocs around regional anchor currencies.
This chapter will look at the underlying causes of increased exchange-rate volatility,
show the emergence of regional currency blocs and formulate a model, which explains
exchange rate pegging as a rational policy option.
The unstable regime of flexible exchange rates
It is commonly believed that the collapse of Bretton Woods meant a regime shift from
fixed (but adjustable) exchange rates to generally floating exchange rates in 1973. But
this is not entirely correct. A variety of exchange rate regimes were adopted by countries
at different times (Argy 1990). It is true that officially the world passed to a regime of
generalised floating exchange rates in 1973 when simple adjustments of exchange rates
within the framework of the Smithonian Agreement of 1971 were no longer sustainable.
During the transition, foreign exchange markets had only little confidence in the
pegging commitment during 1971–3. Free floating looked attractive because it was
supposed to insulate domestic economies and particularly monetary policies from
external shocks. By 1973, the regime changed: the original Bretton Woods System was
terminated when the dollar lost its anchor currency function by severing its fixed price
link to gold. The international monetary system then went adrift. In the words of
Eichengreen and Kenen (1994:36), ‘the nth country problem would henceforth be solved
by foreign exchange traders’. International monetary relations turned into a market-led
system (Padoa-Schioppa and Saccomanni 1994). In theory, this meant that the foreign
reserve constraint had disappeared. Under a fixed exchange rate system a country could
adopt only those economic and monetary policies that were consistent with maintaining
foreign exchange reserves sufficient for the stabilisation of exchange rates. Generally,
with a flexible arrangement, any domestic policy mix is possible because exchange rate
fluctuations adjust and reserves remain stable. However, this requires that monetary
authorities choose their own internal nominal anchor for monetary policy.
After Bretton Woods 27
A monetary anchor is a nominal variable that is the target for monetary policy (Flood
and Mussa 1994). Broadly three types of anchors can be distinguished.
1 Fixed nominal anchors or commodity standards consist of a fixed currency price for a
standardised metallic unit like gold. Such standards exhibit the tendency for the
nominal price level to remain stationary over time so that periods of inflation are
followed by periods of deflation.
2 With moving nominal anchors monetary authorities attempt to hit a moving nominal
target such as monetary aggregates, inflation or nominal income targets. They are
moving because they aim at the growth rate of a nominal variable which is based on a
determined past. Under these standards the inflation rate is stationary over time, and
the rates of change of other nominal variables return to some long-term baseline.
3 An exchange rate anchor exists when countries share a nominal anchor, which is
targeted by the anchor country, while other countries target the exchange rate to that
anchor currency. The nature of this peg can be fixed or moving (permanently fixed,
adjustable, crawling, etc.), just as the exchange anchor can itself follow a fixed
(Bretton Woods) or moving European Monetary System (EMS) nominal anchor.
We have seen in the previous chapter that Keynes emphasised stable purchasing power of
money-wages in his General Theory. This would assimilate his wage standard to a
commodity standard. But the Golden Age with its moderate wage claims was closer to a
moving wage standard where the rate of productivity growth was the benchmark. After
the break-up of Bretton Woods, monetarist policies targeting money supply aggregates
were intended to be the constraint on wage growth. As Friedman (1953a:479) put it: ‘A
general wage rise becomes possible only if the monetary authorities create the additional
money to finance the higher level of prices’. After 1973, Germany seems to have
operated a monetary policy, which worked as a de facto wage standard (Streeck 1994).1
In a fixed exchange rate regime, the stability of the anchor is crucial for the
sustainability of the system. A stable anchor, that is, a currency whose rate of inflation is
low or zero, exerts discipline on monetary policy in the pegging country. Thus, the
objective to bring down inflation can be an incentive to peg to a stable currency as we
have seen in Europe in the 1980s. Yet, a stable fixed nominal anchor can also become a
deflationary constraint, as we have learned from the Gold Standard. On the other hand,
when an anchor becomes unstable, the fixed exchange rate system unravels quite rapidly
as demonstrated by the experience of Bretton Woods or the EMS.
With the regime shift in 1971, the nominal anchor in the international monetary
system became indeterminate. International capital flows achieved proportions that were
unimaginable in the 1960s (Collignon 1994), external disequilibria persisted longer and
to a larger extent than the advocates of flexible rates had expected. Exchange rates
between major international currencies became highly volatile in the short run and
followed megaswings in the long run that were unprecedented in history. We will discuss
the evidence in the next chapter. However, large variations in real exchange rates had an
important impact on output and employment. Furthermore, inflation-fighting tactics
increasingly dominated domestic policies, and interest rates rose to very high nominal
and real levels.
Figure 2.1(a–c) show the evolution of interest rates for USA, Germany and France.
Nominal interest rates were low in the 1960s, and high throughout most of the 1970s, the
early 1980s and 1990s.
However, while the rise of interest rates in the 1970s can be explained by increasing
inflation, nominal rates remained high even after inflation had fallen, notably in France.
This is clear from Figure 2.2(a) and (b) which show real interest rates. Alternative stances
in monetary policy are expressed by real short-term interest rates (Bofinger et al.
1996:346). In the Golden Age real short-term interest rates were low, below 2 per cent. In
the early 1980s, they rose dramatically in order to stop inflation. However, while
American monetary policy became less restrictive with regained price stability, it
remained excessively tight in Europe. German real short-term rates fluctuated between 2
and 5 per cent between 1980 and 1995. In France price stability was achieved by 1987,
when the ‘Franc fort’ policy became dominant, but real short-term interest rates rose to
11 per cent. These development trends are also evident for real long-term rates, although
less pronounced. In the late 1960s, when Germany resisted US inflation, real government
bond yields reached 5 per cent. They hovered above 3 per cent through most of the
1980s, peaking twice above 6 per cent. Only in the late 1990s did real interest rate finally
come down. The 11-month centred moving average is generally higher in Germany after
1980, with the exception of the reunification years with relatively high inflation. Thus,
the post-Bretton Woods macroeconomic environment had changed significantly. After
the Great Inflation followed a period of severe monetary tightness. Both were inter-
related and related to the exchange rate regime.
Immediately after the breakdown of Bretton Woods, governments attempted
unsuccessfully to find new ways to return to exchange rate stability.This failure was in
part a consequence of the oil price shock. It aggravated inflationary divergences and
contributed to the emergence of internationally integrated capital markets that were
incompatible with the ‘insular’ post-war economies and the related capital controls.
The emerging global capital market

The decision by OPEC to raise oil prices from $3.70 to $11.65 a barrel, effective from 1
January 1974, was probably the largest shock the world economy has ever experienced.
More than 10 per cent of world payments for trade were redirected in a single quarter
(Little et al. 1993). This caused not only a sharp increase in inflation, but also a drastic
reduction in output. Some countries, especially Germany, the USA and to some degree
Japan, reacted by fighting inflation and adjusting fully to higher oil prices. Others
preferred to borrow in order to cover their increased import bills and to smoothen their
output losses over time. Not surprisingly, inflation rates diverged significantly between
countries and this required continued adjustments in exchange rates. In addition, the
borrowing requirements for cyclical smoothing contributed significantly to the
Figure 2.1 Interest rates (a) USA; (b)

Germany; (C) France.
Source: IMF (1999).
Figure 2.2 (a) Real short-term interest

rate; (b) real interest rates on
government bonds.
Source: IMF (1999).
emergence in the early 1970 of an integrated world money and capital market, as in the
1920s. The Eurodollar market had already started in the late 1950s in London and was
fuelled by US capital restrictions. In the 1970s it became necessary to recycle the bulging
current account surpluses by oil producing countries. This opened the gates for large
international capital flows. By the late 1960, Eurocurrency credits to developing
countries had reached a volume of about half a billion dollars a year; by 1981 they had
increased to $44 billion. The international bond market also rebounded (Little et al.
1993:14). These large capital flows increased the volatility in foreign exchange markets
and ultimately inhibited a return to the ‘fixed but adjustable’ exchange rate regime of the
post-war era.
The recession that followed the first oil price shock and the contractionary policies in
major industrial countries resulted in two key outcomes: it increased borrowing
requirements in developing countries that attempted to maintain economic growth; and it
laid the ground for the debt crisis in 1982. Thus, while balance of payment difficulties
during the fixed exchange rate era had imposed early adjustment and thereby avoided
major crisis, the new world of higher capital mobility with markets recycling petro-
dollars created a more flexible, yet more vulnerable, financial system. The multilateral
management of international reserves that had marked the government-led Bretton
Woods System became increasingly impossible. In conjunction with the communications
technology domestic and offshore financial markets were opened and integrated into a
single global market (Goldstein and Mussa 1993). Financial liberalisation, lower
transaction costs, and increasing speed of transferring funds worldwide also made other
currencies than the US dollar increasingly attractive. This led to a multi-currency reserve
system, where international liquidity expanded at a much more rapid pace than under the
previous Bretton Woods System. Consequently inflation remained high. But the
Eurocurrency market also enabled countries to sustain deficit positions, which were much
larger and more persistent than if countries had still been constrained to mobilise their
own reserves (Padoa-Schioppa and Saccomanni 1994). Once US monetary policy shifted
and interest rates rose to historic highs in the early 1980s, the adjustment was harsh and
took crisis proportions in many countries.
These developments also have had important consequences for the microstructure of
financial markets.
• The internationalisation of portfolios by investors looking for attractive short-term
investment opportunities has increased the volume of short-term capital movements.
• Institutionalised financial investment management has concentrated market activity in a
few financial institutions, which are operating simultaneously in foreign exchange,
money and bond markets, often with highly leveraged positions.
• Securitisation has reduced banks’ roles as intermediaries. The traditional exclusive
direct relationship between lenders and borrowers as a vehicle for transmitting
information has been increasingly replaced by price signals in financial markets.
• At the institutional level, the territorial correspondence between financial markets and
central banks’ jurisdiction has been weakened. Simultaneously, financial liberalisation
and innovation have blurred the distinction between banks and non-banks.
This new environment has transformed the framework for monetary policy. The
effectiveness of central banks in the conduct of monetary policy has increasingly been
eroded. Several factors have been at work. First, the rapid liquidity expansion fuelled
rising inflation in the 1970s and contributed, as we have seen in the last chapter, to rising
nominal inertia in price and wage setting. Second, exchange rate volatility increased
dramatically with the rising volumes and mobility in capital markets. The growing role of
financial markets meant that, in the short term, exchange rates were no longer determined
by fundamental data from the real economy: foreign exchange transactions related to
financial operations have outgrown trade transactions at the ratio 25:1 (Collignon 1994).
In today’s market-led international monetary system, exchange rates are determined as

asset prices that react to changes in expectations, news, and interest rate differentials. As
a consequence, they can deviate quite substantially from fundamental equilibria (De
Grauwe 1989). Thirdly, the high capital mobility allowed the financing of these
disequilibria and thereby contributed to their longer persistence. Fourthly, as we will see
in Chapter 3, the emerging structure of currency blocs in the world economy has made
fundamental equilibrium exchange rates themselves more volatile and, therefore, less
suited for policy orientations. As a consequence, exchange rate policies, and to some
degree also monetary policy, seemed to escape increasingly from the control of monetary
authorities.
A European response: the EMS

These developments were cause for concern in Europe, and they took place on a world
scale. Nevertheless, they affected Europe more than other countries. European economies
were more open and therefore more vulnerable to exchange rate variations (see Table
5.1). The uncoordinated approach to the revaluations and devaluations of European
currencies caused distortions in the common market and threatened the functioning of the
common agricultural policy. These considerations led to the creation of the EMS in 1979.
It established a fixed exchange rate system between participating countries with
institutional rules for realignments and the backing of finance facilities for exchange
market interventions. In theory the n−1 country problem was solved by the creation of the
ECU as a unit of account, but effectively the DM became the anchor currency in the
system (Giavazzi and Giovannini 1989; Collignon 1994). The reason for this is found in
the relative stability and size of the DM currency zone as a nominal anchor.
For Germany’s partners in the European Union (EU), the disappearance of the fixed
exchange rate system of Bretton Woods posed a dilemma: in principle, flexible exchange
rates increase the degree of autonomy in their conduct of monetary policy. However, in
an extremely open economy exchange rate variations affect all relative prices: not only
export competitiveness, but also the cost of imported production inputs, which become
volatile. Therefore, the information content of prices was blurred and the outcome of
investment decisions became more uncertain. This affected each producer and every
company as long as their production techniques were not identical. By adopting fully
flexible exchange rates and following strict monetary policies, European economies
should have improved domestic control of monetary aggregates. But they also would
have put the benefits from integration into jeopardy, for every exchange rate shock would
have distorted the relative price structure. Yet, fixing exchange rates to the DM meant
giving up the capacity to conduct autonomous monetary policies. Therefore, the EMS
tried to square this circle by leaving some margins of flexibility in the form of a ‘fixed,
but adjustable’ exchange rate system with narrow and large bands around central
parities.2 However, for reasons that we will analyse in the next two chapters, the system
proved unsustainable. Ultimately, the political choice was between full surrender to the
Bundesbank or sharing responsibility for monetary policy in European Monetary Union
(EMU).
The DM-bloc emerged only gradually, both in size and with respect to the fixity of
exchange rate commitments: small open economies like the Benelux, Austria and
Denmark preferred to stabilise their macroeconomic environment by adhering to a fairly

fixed currency peg with the DM as the nominal anchor. Larger countries with a lesser
degree of openness such as France, Italy and Spain also saw the need to reduce disturbing
currency volatility but at first they gave greater weight to the microeconomic aspects of
competitiveness over stability. Their DM peg, therefore, was adjusted more frequently
until it became increasingly clear in the mid-1980s that this prevented full
macroeconomic stabilisation. Only then did countries like France and others opt for a
‘hard currency’ policy. It is also true that capital controls at first maintained some
margins for national monetary policy (Giavazzi and Giovannini 1989; Eichengreen and
Wyplosz 1993). But the increasing international capital mobility did not stop at Europe’s
borders.
The growth and hardening of the EMS also made it more brittle. With the creation of
the internal market, financial liberalisation in Europe and the removal of all capital
controls, it was also evident that there existed an ‘inconsistent quartet’ (Padoa-Schioppa
1992) between the policy objectives of free trade, free movement of labour and capital,
fixed exchange rates and autonomous national monetary policies. Ultimately, the single
market required the EMU to act as an instrument to co-ordinate monetary policies.
Bloc floating as an international monetary system

Europe was not the only case where small countries pegged to an anchor currency. The
post-Bretton Woods world increasingly became one where only leading international
currencies floated freely against each other. Most smaller regional currencies linked their
currencies for macro- or microeconomic reasons to regional anchor currencies. They kept
the volatility with respect to the anchor in exchange rate movements as low as possible
and accepted exposure to the full impact of fluctuations from other currencies. This
stabilisation could be managed by more rigid systems of fixed (but adjustable) exchange
rates (like the EMS in the 1980s or East Asia to the dollar until the mid-1990s) or by
some kind of crawling peg (like Portugal in the early 1980s, Greece until 1998 and
Central Europe today). As a consequence, currency blocs have emerged that float as a
whole with respect to other blocs, while they maintain relatively high monetary and
exchange rate stability within each region.
Bloc floating became the dominant feature in the world economy during the 1980s. In
theory, flexible exchange rates imply that foreign exchange reserves become more stable
because exchange rates adjust to supply and demand in the foreign market. However, as
Figure 2.3 shows, no clear structural break is apparent in the reserve volatility of USA,
France or Germany.
As a rule, periods of exchange rate instability seem to be positively correlated to
periods of foreign reserve volatility. This contradicts the theory. But it is easily
understandable in light of bloc floating: if authorities attempt to reduce the volatility of
exchange rates, they have to intervene in the market and that creates reserve volatility.
After abandoning their link to the US dollar in the 1970s, an increasing number of
countries have pegged their exchange rates to regional anchor currencies. In 1992, only
26 currencies out of 178 followed a fixed exchange
Figure 2.3 Varition of foreign

exchange reserve.
Source: IMF (1998).
rate to the dollar (see Table 2.1). However, more important than the number of currencies
is a currency zone for international trade.
Empirical evidence for the emergence of monetary blocs has been provided by Frankel
and Wei (1992) and Bénassy-Quéré (1995, 1997 and 1999). A country is defined as
belonging to a currency bloc when the relative exchange rate variability is significantly
lower within a group of countries than across groups.3 This definition permits some
flexibility in the pegging rule but emphasises the reduction in exchange rate volatility.
The size of the currency bloc can be measured by the share of foreign trade between
countries belonging to the bloc compared to total world trade. It appears that the
dominant characteristic of the last twenty years was the emergence of the DM-bloc, while
Asia, with the exception of Japan, belongs to the dollar zone.
The share in world trade of countries without an exchange anchor has fallen from 27
per cent in 1978 to 6 per cent in 1992 (see Figure 2.4(a)). Over the same period, the DM-
zone has continuously expanded. While it covered only Germany Benelux and Denmark
in the 1970s, it has nearly doubled in weight, progressing from 26 per cent to 47 per cent
in world trade and linking most of (Western) Europe in the early 1990s. Only after the
ERM crisis in 1992–3 did it slightly lose ground (Figure 2.4(b)). The dollar-zone has lost
ground in Africa and the Middle East, but it increased in Asia, where it covered nearly all
countries with the exception of Japan until 1997. It keeps its share in world trade
Table 2.1 Exchange rate regimes of the IMF-

members
Number of countries 1978 1983 1988 1992
Fixity to a currency
US dollar 43 34 39 26
French franc 14 13 14 14
Pound Sterling 4 1 0 0
Rouble – – – 9
Deutschmark 0 0 0 2
Other currency 3 4 5 6
Fixity to a currency basket
SDR 15 13 8 3
ECU – 1 1 2
Other basket 21 26 30 26
Limited flexibility
Snake, then EMS 4 7 7 8
Other fixed exchange rates with narrow margins – 9 4 4
High flexibility
Crawling peg and managed float 7 29 27 30
Free floating 27 9 17 48
Total 138 146 152 178
Source: IMF, exchange arrangements and exchange restrictions, various numbers; in Bénassy-
Quéré (1995).
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CHAPTER XIV.
EARNEST ENDEAVOURS.
WHEN Tom told his mother the news brought by Jack,

and that Mr. Murray and the clergyman had both agreed
that he might try for this scholarship, she was quite
overcome. For she had begun to blame herself very bitterly
for moving so hastily, and thus depriving her children of
educational advantages she had scarcely thought of at their
true value, until she came here and found the difference in
the schools.
Tom had continued his attendance after the fight with

Bill Crane, but she felt sure it was rather to please her than
from any real interest he took in his work there.
In this, however, she was mistaken. Tom did not say

anything about it at home, but the fight with the
redoubtable Bill had certainly improved his position with his
school-mates. They talked of him among themselves as a
"jolly plucky chap," though he did come from "Lunnon,"
where no boy was supposed to know how to fight. In
school, this opinion of him gradually leavened and altered
their behaviour towards him, and they were ready to forgive
his fluent reading and better writing than their own, in
consideration of his being able to stand up to the village
bully, of whom every boy had been secretly afraid until Tom
braved him.
Without knowing exactly why or how it had come about,
Tom found his position at school far more tolerable as time
went on than it was at first; and he was gradually becoming
oblivious of the noise that disturbed him so much at first.
So that when he told his mother of the scholarship plan, he
made no complaint about not being able to learn lessons in
such a school.
Mrs. Winn had burst into tears when she first heard the
wonderful news, and that greatly disconcerted Tom.
"Don't cry, mother, don't cry," he said, putting his arm

round her neck and kissing her. "I really do mean to work
hard this time, and I daresay Mr. Murray will help me a bit
extra, if he sees I'm in downright earnest, for I think he was
rather pleased that we went to ask him about it, and he
likes Elsie, I know."
"Yes, yes, dear, you will try now, I am sure," said the
widow, trying to smile at Tom through her tears. "I am
afraid it will be harder work for you this time, than if you
had kept steadily on under Mr. Potter; but we must not
mind that. And Elsie and I will do all we can to help you."
"Yes, mother, don't be afraid, will you? I really will, for

your sake, work hard now. Elsie has got the books you
bought for her when she was swatting up for her exam.,
and I daresay they will help me. I'll take them to school on
Monday morning, and ask Mr. Murray to set me some extra
lessons in grammar and geography. Now, come and see
Jack, mother, before he goes; he is having a bit of bread
and cheese before he starts."
Mrs. Winn thanked the boy who was so anxious to make

amends for the mischief he had caused a few months
before, and Jack started home on his wonderful bicycle,
feeling happier than he had for many months past.
"I shall come again soon," he said, as he mounted his

iron horse and rode away in the warm dusk of the evening.
"Yes, do," called Tom, Elsie, and little Bobbie, in one

breath; and then they went in to talk over once more the
alteration in Tom's prospects.
"I will call and see Mr. Murray on Monday," said the
widow. And then she heaved a sigh, for she knew it would
be quite out of her power to pay for extra lessons for Tom,
and she must explain this to the schoolmaster at once,
though it should betray her poverty in a fashion that was
very painful to her.
There was, however, no help for it, and this news had
brought her some consolation that neither of her children
could understand, for they did not know how bitterly she
had been blaming herself for coming here. But now if it
should prove that Tom would be eligible for this scholarship,
then her self-reproaches would lose half their sting, and she
would feel that for Tom, at least, the move had brought
nothing but good.
The country air agreed with all the children, and they
were growing strong and vigorous as well as Tom, who
seemed to be better than he had ever been in his life
before. But it was the want of work that troubled her.
Mrs. Perceval was very pleased with the way she had
made her girl's dresses, and had since given her two of her
own to do, with which she was so fully satisfied, that she
promised to recommend her to other friends.
"But I am only the doctor's wife, you know," she said,
laughingly, "and not being a fashionable lady, some of them
may think I am not a competent judge of what is the latest
thing in dresses."
She did not forget her promise, but most of the ladies
she spoke to on Mrs. Winn's behalf always sent their
dresses to be made in London, and quite looked down upon
a village dressmaker, though she had just come from
London, and could easily get the latest fashions and
patterns from there.
Some of them recommended their servants to try the

new dressmaker who had come to live in Fairfield, and she
got a few servant's and children's dresses to make; but her
business did not increase as time wore on, as she hoped it
would, and sometimes a whole week passed and she would
not earn a penny.
This state of things made her very anxious, for although

their expenses were now very small, the children were in
splendid health, and had good appetites. Fortunately Tom's
vegetables served them for many a dinner, with the simple
addition of a slice of bread, otherwise they must often have
gone hungry. Indeed, she and Elsie often went with only
half a meal, in order that the little ones should not go short,
each of them pretending that they did not want any more.
Tom had not noticed this for some time; but after Jack's
visit, and he had time to think over everything that had
passed, he remembered the few words spoken just before
they got home after seeing Mr. Murray, and coupling this
with what he often heard Elsie say now, that she did not
want much dinner or tea, he came to the conclusion that
there must be some truth in Jack's surmise, and that Elsie
was eating as little as possible that they might not get into
debt here, and he resolved to do the same, and try to help
his mother that way. But Elsie was too sharp for him.
"No, no, Tom, it won't do for you to go with half a meal

when you are working so hard at your books, or in the
garden. I don't want so much now because I have so little
to do, but with you it is different. I know how hungry I used
to be when I was working for my scholarship; and so you
must eat, or we shall all be disappointed again when next
November comes, and another disappointment will almost
kill mother, I am afraid."
"Mr. Murray and Mr. Cotton will be disappointed too, I

believe," said Tom, "for I know they quite expect me to win;
and Mr. Murray told me to-day he would do all he could to
help me. You see, it will be quite an honour for this school if
I should get the scholarship. But I could not have gone in
for it, if I had had my own way, and not gone to school to
please mother—for I shall only have been just the qualifying
time when the examination takes place, and I had been at
school a month when Jack brought the news. Dear old Jack!
He is another who will be disappointed if I don't pass," said
Tom.
"But you must pass," insisted his sister; "and that is

why you must eat all you can, as well as learn all you can.
For mother and me it don't matter, of course, but don't let
mother hear you say you cannot eat, or she will think you
are going to be ill again, or that it does not suit you to sit
close at your books. Oh, Tom, I shall be proud of you, and
so will Jack, I know. He will come again soon, I expect, to
see how you are getting on."
This hope that Jack would soon pay them another visit
was not disappointed, but the lad had brought something
besides himself this time on his iron horse. A large parcel
was dangling from the front, and Jack took it to Mrs. Winn
as a present from his father.
The lady wondered why Jack's father should send her a

large ham, but the lad told her a rambling tale about Tom
helping him with the rabbit hutch, and his foreman wanted
to sell the ham. But Elsie had a keen suspicion that Jack's
own pocket-money had been spent in its purchase. But they
had a splendid tea of ham and eggs, such a meal as they
had not seen for months past. Jack said he had brought the
ham to help Tom on with his lessons now, because he had
spoiled his chances before through building the rabbit
hutch.
They all smiled, though they hardly knew what to make

of Jack's tales; still, they were glad to welcome him
whenever he came over on Saturday afternoon, which he
generally did about once a month after that first visit, which
seemed to change Tom's whole life and its outlook.
The fact was, Tom could never quite forget Jack's words
about his mother owing money at the shops. Until he heard
of this, he had not thought much about the expense his
illness must have been, or that he had through this spoiled
her business, and that there was no one able to earn a
penny all the time he was ill.
But he often thought of it after that talk with Jack, and

it made a great impression upon his mind and conduct too,
for he now tried to do all he could to spare his mother and
sister trouble and expense in every way possible, while his
schoolmaster could not say enough in praise of his
diligence, and the steady, patient way in which he worked,
both at his ordinary school tasks, and those that were set
him in addition, to be worked at when he was at home.
And he did not let the garden become weed-grown and
neglected through this application to his books. Betsy Gunn
had told him that he would never get a decent crop of peas,
beans, or anything else if he did not keep the ground free
from weeds; and so his garden was kept tidy, though Elsie
often spent an hour or two in this work that her brother
might not be hindered from his lessons.
So the weeks and months went on, and one day Mrs.
Perceval called late in the summer to know how Mrs. Winn
was prospering with her business.
"Not very well, ma'am," said Mrs. Winn, hardly able to

keep back the tears as she spoke, for she had no work, and
knew not when to expect any.
There was also another trouble. Elsie was looking pale,

and had lost her appetite the last few days. The rest were
well; and Tom seemed to be quite strong again, and was
growing very fond of gardening. But Elsie always shared her
mother's anxieties now, and she was afraid it was proving
too much for her.
Mrs. Perceval suggested that Elsie should come and stay

with her for a few days, for her boys were coming home for
their holidays, and she would be very useful, if Mrs. Winn
could spare her. For such a sensible girl would keep them
from mischief when they went out for a long ramble, and
there were many ways she could be useful, if she could be
spared.
Mrs. Winn was glad enough to accept the offer, for she
had no doubt that a week or two with other boys and girls
would do Elsie a great deal of good, and it was arranged
that the gig should be sent for her on the following Monday.
Elsie was loth to go away and leave her mother with no
one to help her; but Mrs. Winn could plead that she had no
work in the house just now, and Mrs. Perceval had been so
kind she would not like to disoblige her. And these
considerations had more weight with Elsie than her own
health, or the need there was that she should have some
change, and forget for a time the cares and troubles of the
home life.
It was the want of work that troubled her as well as her

mother; for she knew well enough, that unless her mother
could soon get a great deal more work than seemed at all
likely now, absolute starvation would stare them in the face.
And though she had never said a word of this to her mother,
the thought of it haunted her day and night now. If only
they could get work, this country life would be very
enjoyable, Elsie thought, for she did not know yet what life
in the country was like during the winter.
During her stay at Mrs. Perceval's, she almost forgot the

home troubles, and grew rosy, and was able to eat anything
and everything that was offered to her. For her kind hostess
took care that she should spend the greater part of every
day in the open air, if it was fine. And this was altogether a
new life to the girl, for although they had a garden of their
own at the cottage, Elsie did not spend much time in it,
there being so much to do to keep the children tidy now
their clothes were beginning to wear out, and there was no
money to spare to buy new ones.
A good deal of the washing and mending fell to Elsie

now, for if her mother was not at work, she was out seeking
it. As she said, it would never come to her if she sat at
home with her hands folded. And many a weary mile did
she walk, hoping for the success that never seemed likely to
come.
By the time the cold autumn rains set in, Mrs. Winn had
almost lost heart, and was ready to think that her coming to
Fairfield had been a grievous mistake, that could only end in
failure, after all her efforts.
She went to church on Sunday, and tried to listen to the

service, and believe that God still cared for the fatherless
and widow, as the Bible taught; but her thoughts would
drift away to wondering how the rent was to be paid, and
what the baker would say when she told him she had no
money to pay his bill.
Then as the weather grew colder, and they needed fires

more, they had to do with less; for when their present stock
of coals was burnt, they did not know how they were to get
any more. And they had to sit huddled over a scrap of fire
in the kitchen during the day, and go to bed soon after dusk
to save lights and fires.
The only bright spot in the dreary outlook was that Tom
might get a scholarship at the forthcoming examination;
and this, as Mrs. Winn had learned lately, would be even
more valuable than Elsie's, for it would afford Tom board
and lodging as well as education at the college.
For Tom's sake, therefore, that he might not be

hindered in his book-work, they were obliged to make the
best of things, and the change of season brought Mrs. Winn
one or two dresses to make.
Mrs. Perceval bought her girls winter dresses, and sent

them to the widow to make up at once; and the servants
she had worked for in the spring sent her their work again;
one lady's maid saying, that her dress was better made
than her mistress's, though she had paid three times as
much to have it made in London.
This encouraged Mrs. Winn to hope that in time she
might be able to get a good business together here in
Fairfield, but what was she and her children to do while she
was waiting. That was the problem that confronted her
continually, and to which she could find no solution, but the
practice of such rigid economy, as to make their life one of
continual privation. They did not let Tom or the children feel
this more than they could help, but upon Elsie and her
mother the burden daily grew harder and harder as the
weather grew colder, and their need of food and fire greater.
CHAPTER XV.
A NEW FRIEND FOR ELSIE.
IT must not be supposed that Elsie's life had been

wholly unhappy during this time. At first she missed her girl
friends very much, but Tom's memorable fight, which led to
her introduction to the schoolmaster's daughter, made a
great deal of difference to her in this respect.
She liked Mary at once, and after they got home, and
Tom was safely in bed, she said to her mother, "I believe
poor Mary would be better, if her mother did not make her
believe she was very ill."
"Very likely," said Mrs. Winn, but she spoke in an absent

manner, for she was troubled about Tom and this fight,
fearing it might lead to more trouble for them.
That Tom seemed quite well, and was willing to go to
school the next morning, was a great relief to her, and when
he brought a message home at dinner time, that Mary
would like to see Elsie in the afternoon, Mrs. Winn at once
urged her to go as soon as she had cleared the dinner
things away.
"I was afraid Mr. Murray might think Tom was to blame
for the fight yesterday," said the widow, "as it was begun
over something Tom said in school, and so I shall be very
glad for you to go and see this girl, for it may smooth
matters for Tom, you know."
"Yes, mother," said Elsie, who needed no second bidding

to go and see her new friend.
She reached the schoolmaster's house, just as Mrs.

Murray was leaving. "Don't talk to her too much. I like her
to sleep in the afternoon, because she rests so badly at
night," said Mrs. Murray as she went out.
"Poor, dear mother! I wish she did not worry so much

about me," said Mary, holding out both her thin white hands
to greet her friend. "I am so glad you have come, for I was
not at all sure that you would, after what mother told me."
"Why! What did she tell you?" asked Elsie, in some

surprise.
"Oh! Nothing to feel hurt about; I only wish I could be

mother's right hand as you are."
"I see you thought I should be busy. Well, mother is not

at all busy just now, and if she was, I could manage to
come and see you in the afternoon; because I could either
bring my work or baby with me."
"Do come, and bring the baby to-morrow," interrupted
Mary, eagerly. "You see the afternoons are the worst part of
the day for me; mother is at home in the morning, getting
the dinner ready and other things; but in the afternoon she
has to go to school to teach the girls needlework, and so I
am all alone."
"Poor Mary! It must be lonely for you, I may call you

Mary, may I not?" she said, kissing the invalid again, and
looking pityingly at the pale faded face.
An answering kiss, and a whispered, "Dear Elsie, I am

so glad you have come," sealed the girls' compact of
friendship.
"Do you never go out?" asked Elsie, after a pause.
"I have not been out for a long time. Mother is afraid I
should take cold, but father said the other day, he thought
he should carry me out in the garden, sometimes, when the
weather got warmer."
"Oh! But if you could have a ride in a bath chair, that

would do you more good than just sitting in the garden."
"But you see I have to lie down all the time, and even
then my back aches dreadfully sometimes."
"So would mine if I was always lying on it," said Elsie,

stoutly. "You were not lying down when I came in
yesterday; you were sitting in that easy-chair by the
window."
"Yes, my back ached so much that I persuaded mother

to let me sit up just for once. It was funny that I should
have that fancy, for if I had not been here, I should not
have seen the fight, and they might not have brought your
brother in, and then I should not have seen you, and that
would have been a pity. Don't you think it would?"
"Yes, I should have been sorry, for you see I have no

girl friend here; and though I love Tom very much, he is
only a boy, and can't be expected to understand things as a
girl can."
"That's just what I have told mother, sometimes," said

the invalid, fondling Elsie's rather rough red hands. "You see
I have the dearest, sweetest mother and father that ever
was, but then somehow I have wished I could know a girl
like myself. Can you keep a secret?" she suddenly asked.
"What sort of a secret is it?" said Elsie. "You see I got

into trouble once through that, for mother said I ought not
to have promised to keep secret what I did, as a good deal
of trouble might have been saved to other people, if I had
spoken in time."
"I don't think; I hope my secret will not cause anybody

trouble, and I do want to tell you so much," said Mary. "You
see it is this way, the doctors said I must lie on my back for
two years, and only one year has passed. I have not walked
all that time, for I am not heavy, and father carries me up
and down stairs, and I lie here all day. I hardly thought of
what I was doing, but when I saw Mr. Thompson pick your
brother up and bring him towards our gate, I remembered
that the street door was locked, and I just slipped off the
chair, and walked across the room and unlocked it, and then
came back again. Nobody thought to ask how he got in, and
I was afraid to tell mother, for she would have fretted so
much about it."
"But why should she if you are no worse?" interrupted

Elsie.
"You see the doctors said I was to lie still for two years."
"But if you are no worse for sitting up in the chair and

walking across the room, you—"
"Oh no, I am not worse, I slept better last night than I

have done for a long time, and that is why I am going to
ask you something, but you must keep it a secret. I want
you to let me lean on your arm and try to walk again, I
don't think I could do it by myself, for there is no one
wanting to get in to-day."
Elsie laughed and clapped her hands. "I see you want to
cheat the doctors if you can, and you would like me to help
you," she said.
Mary laughed too, and her pale cheek flushed with

pleasant excitement when she saw how heartily her new
friend could enter into her feelings. "Wouldn't it be
delightful to surprise my mother and father one day, by
going to meet them as they come out of school?" she said.
"We'll talk about that afterwards, but you shall have

your walk indoors if you like. Suppose we lock the street
door before we begin our secret mischief, and then you
must have a pair of slippers on, or you may catch cold."
"Slippers?" repeated Mary. "Don't you think these wool

ones would be enough? They are nice and warm." And Mary
put one foot from under the rug to assure Elsie on this
point.
Elsie was about to suggest that they should postpone

this trial trip until the next afternoon, but she saw that Mary
would be greatly disappointed, for she was all eagerness to
put her feet on the ground again. And so she said, "They
would do for a little trial, just once across the room and
back again, and then if you can do it, I will run home and
fetch a pair of mine or mother's, that would go over those
soft woollen boots and prevent you taking cold."
This was readily agreed upon, and Mary went so well

with the help of Elsie's arm, that she would have repeated
the experiment again and again, if Elsie had not insisted
that she should wait until she could run home for the shoes,
before crossing the room again.
"If I am to keep your secret, I must take care that no

harm happens through it," said Elsie, "and it would do you a
great deal of harm if you were to catch cold."
So Mary agreed to wait, and Elsie was not long before

she was back again, bringing with her a warm soft shawl to
wrap round the invalid, for she did not doubt but that she
would want to go into the kitchen, when the parlour had
been crossed several times.
She knew where to find a comfortable pair of old

slippers, and was soon back with Mary, and had put them
over the woollen boots she wore.
"Now then, you are dressed for the journey," she said,
as she wrapped the shawl about her and walked gently
round the room, Mary seeming to grow stronger and more
confident at every step.
"Do let me walk once round the kitchen now?" said the
invalid. "You don't know how nice and funny it feels to be on
your feet again."
So she walked once round the kitchen, and then Elsie

said she must not attempt any more walking for that day,
but she promised to bring the slippers and shawl the next
afternoon, that she might try again, if she was no worse for
this experiment.
Mary seemed to grow stronger every step.
A look of infinite content settled upon the invalid's face

as she lay back on her pillows after this experiment. "My
back don't ache a bit now," she said; "and when I have
rested a little while, you will help me to sit up in the chair,
won't you?"
"Not to-day, dear; I would not attempt too much at
once. To-morrow if you feel strong enough, and have slept
well, you shall try to sit in the chair, but you see if you do
too much, your mother may think I am leading you into
mischief."
"Yes, that she would," laughed Mary, "and that is why I

must keep it all a secret. I have heard her tell father I
should not put my foot to the ground until the two years
was up, and really I think I should die, if I had to lie here
two years longer doing nothing."
"But why don't you do something? You read of course—"
There was a gentle shake of the head on the pillow.

"Mother does not like me to read much," she said. "You see
the doctors said I must be kept very quiet, and I suppose it
was needful at first. But I am sure I am getting better,
faster than the doctors thought I should, and I get so
dreadfully tired lying here that I believe I am beginning to
be really ill, and shall get really worse, if I can't move about
and do something soon. There dear, now I have told you all
my secret, and I hope you will help me."
"Yes, that I will," said Elsie. "But don't you think you
could tell your father all about it, he might be able to help
you better than I can."
But Mary shook her head. "You see I am the only child,
and they love me too well," she said. "You ought to be very
thankful that you have brothers. I wish I had," she added,
with a sigh.
"But if they love you so much," began Elsie.
"They love me more than you or I can understand,"

answered the invalid, solemnly.
"I know just what would happen if I spoke to father; a
troubled look would come into his face and he would say,
'We must speak to mother about it; she knows best.'
"And then when he told her, she would say, 'The child is
fretting because she is left alone so much; we will get
another teacher for the needlework, and then I can stay at
home with her in the afternoon.'
"Now I don't want that; she is the dearest mother that

ever was, but when she sits with me, she always makes me
think I am ill, though she does not say a word about it. And
then I have a bad night, and I do feel ill the next day. It is
funny, but this has happened so often, that I dare not let
mother know just how I feel, for fear she should want to
stay at home with me, and make me worse."
"But she would let you read some books if I brought

them, and, oh! Could you dress a doll for a bazaar?" said
Elsie, quickly.
"I think I could, if you would show me how to do it, and

cut out the clothes," said Mary. "I should not be so dull if I
had things like that to do," she added. "That is what I want,
—something to do for other people, and not take all the
love and care for myself, without doing anything for
anybody else."
"Well, it would be a real help to me and to my friend, if

you could dress this doll for us. The bazaar is in aid of the
penny dinners for poor children in London; so you may feel
sure that you are helping to feed some hungry child while
you are doing it. Mother will cut out the frock and other
clothes, and I will bring you everything ready fixed."
"Oh! I can fix it, mother has let me help her sometimes
to place the work for the girls at school, but she won't bring
it home to do now, because I always want to help her. She
is afraid I shall get tired, when it would do me good to feel
tired sometimes."
So the girls talked on, until it was nearly time for Mrs.
Murray to come back from school, and then Elsie went
home, taking the shawl and slippers with her, and not even
telling her mother what she had wanted them for.
She went again the next afternoon, feeling somewhat

anxious lest she should find Mary worse from the previous
day's exertions, in which case she had made up her mind
that she would not help her to walk again, although she
might offend Mary, and sever the friendship that promised
to bring so much sweetness and change into her life.
But to her great satisfaction, Mary declared that she

was feeling better, and certainly she was looking better,
Elsie thought.
"Mother says she thinks now it may do me good to have

a young friend to see me sometimes," said Mary, laughing
with glee. "Have you brought the slippers?" she asked,
eagerly.
Elsie produced the slippers, and Mary had provided a

shawl for this afternoon's expedition, so the two girls,
laughing and chatting, went round the house again, Mary
sitting in every kitchen chair for a minute, just to feel what
it was like as she said.
Elsie let her have her way in this, but when she thought
she had been walking long enough, she insisted upon her
lying down to rest before she sat up again in the easy-chair
by the window.
She was sitting there comfortably wrapped in the shawl,
when her mother came back from school. In a moment,
Mrs. Murray had taken alarm; "Oh, my dear, you must not
do that," she said, looking reproachfully at Elsie, who was
just going home.
"Mother, I made her do it," said Mary, quickly, "and I

feel better for her coming. Good-bye, Elsie, and come to-
morrow if you possibly can."
It was Mary's way of dismissing her friend before her

mother could reproach her for what she had done, and she
spoke with so much energy, that Mrs. Murray could only
look at her in silence, until the click of the garden gate
warned her, that if she wanted to lay any charge upon Elsie,
as to what she might or might not do, she would have to
wait and see her the following afternoon.
But it so happened that Elsie could not leave home early

the next day; Mrs. Winn had some work come in, and so
Elsie was obliged to wash and dress baby and take him with
her, and so Mrs. Murray was compelled to go to school
before she got there.
Baby was a fresh source of amusement to the invalid,

for he could run about now and prattle in a fashion that was
highly amusing to Mary. She was willing to lie on the couch-
to-day, because baby could stand close to her, when he had
overcome his shyness, and amuse her with his quaint
chatter. And Mrs. Murray finding her still on the couch when
she came home, felt more satisfied with Elsie.
Thus the days and weeks went on, and by degrees Mrs.
Murray was won over to let Mary read the books that Elsie
brought, and do a little sewing for the doll's clothes. She
could not but admit, that as the summer advanced, Mary
seemed better and altogether stronger, and she said it was
because her father took her into the garden sometimes.
Mary admitted this, but she wanted Elsie to have her

share in the improvement acknowledged, and she tried hard
to persuade her father one day to let her walk a few steps,
wishing to give him an agreeable surprise as to her ability
to walk.
But Mr. Murray almost shuddered at the proposal. "My

dear, your mother would not hear of it," he said; "you are
getting a little better we can all see, and we must let well
alone. Your mother would think you were fretting again if
you asked such a thing, and she says Elsie Winn has cured
you of that a good deal."
Mary had been on the point of telling her father once or

twice that she could walk, and felt all the better for walking
round the house every day. But after this talk, the girls
agreed that they must keep their secret a little longer, and
find out some other plan for divulging it.
Elsie had convinced Mary that it would never do to give

her mother the surprise she intended, for to go and meet
her coming from school would probably give her such a
shock, that she would not recover from the effects of it for
some days, even if she was not seriously ill through it.
Things were in this condition, when Elsie went to stay

for a week or two with Mrs. Perceval, and before she came
home, she had told the secret to that lady, hoping she
would be able to find a way out of the difficulty for them, as
Mr. Perceval was Mary's doctor now.
CHAPTER XVI.
A FRIEND IN NEED.
DURING Elsie's stay with Mrs. Perceval, she contrived to

tell her all about the friendship that had sprung up between
herself and Mary, and that lady was quite glad to hear of it.
But she did not know what to say of the secret walks about
the house, which Mary had been indulging in for some time
past.
"I must talk to the doctor about it, and hear what he
says, for it was scarcely a wise thing to do, I am afraid."
"But you will not let Mrs. Murray know about it, will
you?" said Elsie, pleadingly. "If it had been my own secret, I
should have told my mother long ago, or if Mrs. Murray was
not frightened about everything for Mary; I mean, if she
was brave and wise, as my mother is, there would not have
been any need for it to be a secret," said Elsie, by way of
explanation.
"I will tell the doctor all about it, and he will manage
everything so as not to shock Mrs. Murray or get Mary into
trouble; and I hope no harm has been done by your rash
experiment."
When the doctor heard the story from his wife, he

laughed. "This explains a good deal that had puzzled me
about Miss Mary the last few weeks. But leave it to me, I
am going to Fairfield to-morrow, and I shall find out this
secret, you may rely upon it."
So the next morning, he walked into the schoolmaster's
house, and to Mrs. Murray's great astonishment, he said,
"Now, Mary, you have been looking so much better the last
week or two, I want to see if you cannot walk a few steps,
at least."
"Oh, doctor but how about the two years she was to lie
on her back? They are not at an end yet," said Mrs. Murray,
in a tone of alarm.
"Perhaps not; but she may have improved more rapidly

than was thought possible when the doctors decreed two
years for her on the couch; certainly she has been much
better the last few weeks," he said.
"She has slept better, and her appetite has been better,"
admitted Mrs. Murray.
"And she has had a little more company, I hear," said

Mr. Perceval, looking quizzically at Mary, who knew then
that Elsie had told the secret, as she said she should.
"I could walk round the garden, if mother would let

me," said Mary, desperately.
"We shall see about that afterwards. Let me see, now,

how you can walk across the room with my help," and the
doctor put his hand under her arm.
"Capital!" he exclaimed, as he led her back to the

couch. "Now, Mrs. Murray, she may go for a little walk every
day in the open air, say to the top of the garden and back,
when it is fine; if not, then a walk up and down the room
for a few minutes, and I will see her again in a day or two."
"Oh, thank you," exclaimed Mary; "and please tell Elsie

about it, for she has helped me to get better," she added.
"I don't doubt it," said the doctor, taking his hat and
gloves, and without waiting to hear all Mrs. Murray had to
say against his advice being followed, he jumped into his
gig and drove away.
"That girl has done my invalid at Fairfield a world of

good," he said to Mrs. Perceval, when he got home.
"I am glad their experiment has done Mary no harm,"

replied the lady, "and it will be a great relief to Elsie to hear
it too, for I was telling her this morning it would not be wise
to go against doctor's orders in that way, as a general rule."
"Well no, perhaps, it wouldn't, but I believe Mary had so

strong an impulse to walk again, that any doctor would
have sanctioned it, if they had known of it; and certainly
her mother would, if she had not grown so terribly nervous
about the girl. Now, I hope when Elsie goes home, she will
help her friend to walk out a little way, every day that it is
fine, and Mary will soon be as well and strong as Elsie
herself. By the way, she is looking a good deal better since
she came here," added the doctor.
"Yes, she does. She needed a change I felt sure, she is

so very anxious lest her brother should not get this
scholarship for the horticultural college. She says he is very
fond of gardening, so that it will be just the thing for him;
and Fairfield will be able to hold up its head, as the first
village in the neighbourhood that has been able to take
advantage of the bequest which was left for these
scholarships."
"Oh, I think the lad is pretty sure to get it," said the
doctor. "I was talking to Cotton the other day, and he says
the lad has been working splendidly all the summer, and
Murray is going to have him at his house in the evening
from now until November, that he may help him all he can;
so that I think he will pull it off all right. This girl who is
staying here won a scholarship for herself they tell me; it
seems a pity she could not have had it."
"Yes, it does seem a pity," said the lady, "though she

might not have been such a kind, thoughtful girl, if she had
had more book learning. I am sure she has been quite a
comfort to me these holidays, and added to everybody's
enjoyment, as well as enjoying herself, I hope."
There was little question but that Elsie was enjoying the
change of air, and scene, and society. And the thought that
here a slice of bread and butter—more or less—would make
no perceptible difference in the larder, gave zest to her
appetite, and she enjoyed her food with double relish.
It was with mingled feelings of regret and relief that she

went home, for she was afraid lest she should find her
mother almost worn out with the extra care and trouble
that would fall upon her while she was away; but she found
her looking much the same as when she left her.
"Dear, dear mother, I am glad to come back to you,"

said Elsie, "though I have had a splendid holiday, and
enjoyed myself so much."
"You are looking better, dear," said her mother, who

really was glad to see Elsie back once more, for she had
missed her sadly, both for the work she took off her
shoulders, and the companionship that Elsie alone could
give her now. Tom tried to do what he could, but he was not
Elsie, he could not share his mother's burden; for he, like
the children, must be sheltered from all trouble and anxiety,
and provided for somehow, or he would not be able to give
that undivided attention to his books and lessons, that was
an absolute necessity, if he was not to disappoint
everybody's hopes on his behalf.
Mrs. Winn was very grateful to the schoolmaster for

asking Tom to spend his evenings with him now. Whether
he guessed that there was not too much for him at home,
she did not know, she hoped he did not. But that he took
Tom home with him to tea two or three times a week was a
relief to her, and that he went away directly after tea, until
bedtime, enabled her and Elsie to practice several little
economies, without Tom's knowledge, that would have
troubled him, if he had known of them. This was likewise a
satisfaction to her.
So the summer passed away, and the wet dreary month

of November came in, the month that was to decide Tom's
fate, and about which Elsie grew nervously anxious as the
time went on.
She knew now that this examination was a more

difficult one than her own had been, for during her visits to
Mary she heard various items of news that Mary had
gleaned from her father, and Tom himself. Elsie did not
venture to tell her mother of this, lest she should make her
more despondent than she was.
But it was a great burden to the girl to think that her

brother might fail after all, and through no fault of his own
this time, for Mr. Murray had told her that Tom had got on
wonderfully since he had made up his mind to try for this
scholarship. If he failed it would be an honourable failure,
for which he could not be blamed, as the examination was
very difficult for a mere boy such as Tom was.
Tom, too, had his own private worry just now, and it
was one he saw no way of getting over at present. He did
not know until the end of October that the examination
would be held at the horticultural college, and would occupy
the greater part of a week, and during this time he would
be expected to provide his own board and lodging in the
town. How this additional expense was to be met, he did
not know.
Mr. Cotton had mentioned the matter one day when he

called at the school, and advised Tom to go over to the
neighbourhood of the college before the day of examination,
and look-out for lodgings.
"I think I might do that through a friend," said Tom. And

there the matter had ended, so far as the clergyman was
concerned; but to Tom it was a serious question, as to how
he was to pay for the lodgings when they were found.
At last he thought he would write, and confide his

trouble to his old friend. And, as he hoped, this brought
Jack over on the following Saturday.
"Look here, old fellow," he said, "I have heard that this
blessed examination will last a week, and you'll have to
look-out for a lodging, unless you will put your pride in your
pocket, and come and stay with me. My mother will do the
best she can to make you comfortable, because of that
rabbit hutch; but we are working people, you know, and
rough it a bit sometimes."
Mrs. Winn looked anxiously at Tom, for it was the first

time she had heard of the examination lasting a week, and
she said, rather sharply, "Did you know of this, Tom?"
"Not until last week, mother. Mr. Cotton told me then

that I should have to look-out for a lodging, and I thought if
Jack should happen to come over, I would ask him about it."
"Bless you, I don't believe you would get a lodging for
love or money nearer the college than we are. They tell me
lots of chaps come for this, and it'll be a rare honour for
Tom and the school, and all the lot of you, if he gets this
scholarship. But he must have a place to live in while he is
there, so why shouldn't you let me have a share in the
honour, as well as the rest of you. We're a bit roughish as I
said, but my father's getting on: he's in business for
himself. Got a board as big as that wall. 'John Bond,
Carpenter and Builder,' writ on it, as large as you please. So
you see, Mrs. Winn, you need not mind him coming to us,"
concluded Jack.
Mrs. Winn did not know what to think, or what to say.

She did not like being indebted to strangers for Tom's
accommodation, and yet what could she do, she had no
means to spare for this, and she seemed almost bewildered
as to what she ought to do.
"We are very much obliged to you for your kind

invitation," she said, "but I am afraid it will be giving your
mother a great deal of trouble."
"Not a bit of it," said Jack. "Let me see, the examination

begins next Monday week, I shall come over next Saturday
and fetch Tom, so mind he is all ready, Mrs. Winn, for we
shall have to start early, because I want to show Tom about
the town a bit."
Mrs. Winn had no better plan to offer in opposition to

this, and so the matter was settled, and a great weight of
anxiety was lifted from Tom's mind, for now he was able to
devote his whole attention to his lessons during this last
week.
Betsy Gunn had heard about this college, and was
determined to have some hand in sending Tom there if she
could, and so she came in after Jack had gone, and gave
him some practical lessons in grafting and pruning, which
she said would be sure to come in useful.
Tom had learned to like the gossiping old woman, or he

would not have paid any attention to what she had to show
him. But as it was, he watched how she used her knife, and
then tried to imitate her method in a way that quite
delighted the woman.
He little thought, as he went on practising Betsy's

lesson, how much would depend upon his compliant civility
to the old woman, and how large a share Betsy Gunn would
have in securing his success.
Jack fetched him the following Saturday, and he took

with him quite a pile of books, which he studied every spare
minute, between one examination and the other. But each
in turn proved so difficult, that he almost lost heart after
the first day, and it was not until the examination in
practical gardening came on, that he began to hope again.
Part of what he had to do was in practical pruning and

grafting, and he remembered Betsy's lesson so well, that
for this he was awarded full marks, and attracted the notice
of the examiner, who reported in most favourable terms on
his skill and dexterity in using the pruning knife.
He knew he had done well in this examination, and

went home on the Friday somewhat cheered; but still
feeling very far from confident that he had passed.
Elsie saw him coming, and went out to the gate to meet
him, and to hear the news. But he shook his head sadly,
and walked so slowly, as though he had left all hope behind
him, that a chill feeling of despair crept over the girl, and
she shivered as though the cold had struck her inwardly.
"Oh, Tom, what is it?" she asked, when her brother

reached the gate.
"I cannot tell yet, of course; but I am afraid to hope,

Elsie. You see the examination was much stiffer than I
expected it would be, and I had so little time to work up for
it. I did all I could of the papers set, but I know I have not
done well in some. The best I did was the one Betsy Gunn
coached me in."
"Oh, Tom," gasped Elsie, holding on to the gate for

support.
Tom put his arm round her and led her indoors. But
either it was the cold, or the shock of his depressing news,
or both together, added to the privation she was enduring,
that quite overcame her, for she had no sooner sat down on
the chair than she fainted, and would have fallen upon the
floor, if her mother had not caught her in her arms.
"She is overtired, I am afraid, Tom; help me to carry

her up to her own room, and she shall go to bed at once."
Mrs. Winn chafed her hands, while Tom filled a bottle

with hot water to put to her feet; but alas, there was not
much in the way of restoratives they could give her, except
a cup of tea, and Tom made this while his mother helped
Elsie to undress.
When she had had her tea, and was somewhat revived,
Tom went to tell Mr. Murray that he feared he had failed,
and should not bring the honour to Fairfield Village School
that he had hoped to do.

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5 Payment Systems in Global Perspective

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List of illustrations vii

1 Why stable money matters or ‘the loss of paradise’ 1

1.1 The structure of collective intentionality 5

1.2 Unit labour cost 14

1.3 Misery index: (a) inflation+unemployment rates; (b) 17

1.4 (a) US inflation rate; (b) inflation differential to USA 24

2.1 Interest rates (a) USA; (b) Germany; (c) France 29

2.3 Variation of foreign exchange reserve 34

2.5 Investment decision under risk 48

2.6 Risk premia and portfolio shares 50

2.7 (a) France’s marginal q; (b) Germany’s marginal q 53

3.1 Fundamental equilibrium 62

3.2 US dollar/DM exchange rate 69

3.4 NEER volatility (USA versus Germany) 70

3.6 REER Germany 71

5.1 Temporary and permanent shocks 101

5.2 Size and import share 107

5.3 Net benefit of a single currency for country i 109

6.1 Marginal cost-benefit analysis of EMU 116

6.2 Country contribution to aggregate net benefit from EMU 117

6.3 Total net benefits in a Benthamite OCA 117

6.4 Voting weights in the EU 118

7.1 Convergence of inflation rates 132

7.2 Convergence of interest rates 132

7.3 Optimal conservativeness before and after EMU 141

8.1 (a) Unemployment rates; (b) employment rates 145

8.6 Convergence of capital intensity 168

8.8 NAIRU as labour market equilibrium 177

1.1 European growth, 1890–1992 8

1.2 Nominal unit labour costs relative to 19 industrialised countries 10

2.1 Exchange rate regimes of the IMF-members 35

2.2 Exchange rate management and orientation of trade in 1991 37

2.3 Volatility under bloc floating and basket pegs 47

2.4 Risk premia under different pegging regimes 47

3.1 Trade matrix in a three-country world 57