During a recent speech at Louvain University in Belgium, Germany's chancellor Helmut Kohl warned that the debate about Europe's economic and political future was nothing short of a "question of war and peace in the 21st century". He told his audience that "if there is no momentum for continued integration, this will not only lead to standstill but also to retrogression. Nationalism has brought great suffering to our continent; just think of the first 50 years of this century."

The chancellor has held these views for many years and they have provided the touchstone for the policy initiatives of the European Union's (EU) most powerful economic power during Kohl's 15 years in office. By restating them in such apocalyptic terms, he was demonstrating his determination that his vision of Europe would be the one to prevail.

But he will not win without a fight. Although a substantial majority of Europe's governments are in favour of further political and economic integration, the case for federalism has yet to be accepted by voters, and some governments remain reluctant to subordinate national interests to those of the EU as a whole.

Kohl will try to force the pace in coming months as decisions are taken which will determine the structure of the union for the early years of the next century. The results are likely to be a further step towards the chancellor's blueprint for an EU extended to eastern European states, a single currency, a common foreign policy and enhanced powers for its institutions, including the European Court and the Parliament.

The precise direction and speed of the changes are harder to predict. The next three months will be critical as the deadline approaches for crucial decisions which have to be taken on the single currency and ministers start to hammer out an agreement on a new Maastricht treaty.

Monetary union has effectively become a battle between political will and economic reality. In the past year it has become clear that, Luxembourg aside, few if any countries feel confident of meeting the convergence criteria for the single currency in time. To do so, governments would have to impose tough economic medicine by removing social benefits that are regarded as an inalienable right in much of the community and by cutting state spending, which could jeopardize Europe's fragile economic recovery from recession. The issue has been further complicated by the Bundesbank's public insistence that it would resist any attempt to ease the entry conditions for monetary union.

Supporters of full monetary union took some comfort from the May assessment of the European Commission - the most optimistic for some time - which predicted that Europe's economy would recover sufficiently for seven countries (Germany, France, Ireland, Luxembourg, The Netherlands and Finland, plus Denmark if it chose to opt in) to meet the criteria.

There will be a political price to pay, though. In Germany, there have been a series of public sector strikes in reaction to attempts to keep the lid on wage settlements and France has been brought to a standstill several times in recent months as workers protested against cuts in social security and health budgets.

Only a minority will lock their exchange rates and establish a central bank with sole control over monetary policy by the start of 1999. The failure of other states to meet the economic conditions has not diminished their determination to be in the second wave.

Italy, under a new left-of-centre prime minister Romano Prodi; Spain, under a new right-of-centre prime minister José-María Aznar; and Belgium, under their long-serving arch federalist Jean-Luc Dehaene, have proposed measures to make substantial budget cuts in the face of considerable unpopularity and threats of industrial action. Even Britain, which has an opt out, is close enough to the targets to be able to join early next century if it wishes. Other states argue that once a majority of states has achieved monetary union, Britain will be forced to follow suit.

This more flexible approach to European integration is likely to be one of the principal elements to emerge from the intergovernmental conference (IGC) on the next stages forward for the Union. Europe's leaders have spent several months trying to find a way around Britain's growing intransigence on EU matters and ensuring that, in Kohl's words, "the convoy does not go at the speed of the slowest ship".

The idea would be that an inner EU bloc of federalist states could be established. Alongside them, a second group, possibly consisting of Euro-sceptic states such as Britain, less efficient economies such as Italy and Spain, and new members such as Poland and Hungary, could co-exist with the federalist core.

One of the key battlegrounds of the IGC is likely to be the extent of the national veto. Germany and France want to extend the number of issues decided by qualified majority voting - a weighted system that enables a minority in certain circumstances to block decisions that have majority support. There will also be calls to bring justice and home affairs under the community umbrella: at present they are decided intergovernmentally. And there will be argument over whether the power of the European Court should be extended or constrained.

One of the most contentious battles will be over proposals to extend the role of the European Parliament in the way it monitors the activities of both the Commission and the Council of Ministers. Germany, as the strongest proponent of a united Europe, and itself a federal country, wants to extend the supranational control of the parliament. Britain and France argue that national parliaments should be the real focus of power.

The EU also has to reform the way it conducts its business. It has to adapt its institutions - initially designed for a community of six - so they can cope with a membership of more than 20. For example, if the present system of revolving six-month presidencies were to remain, each state would hold the post only once every decade.

Policies need to be reformed as well. The Common Agricultural Policy (CAP) already takes the lion's share of the EU's budget. Unless substantial cuts are made in the way it operates, the CAP would be put under an intolerable burden if it had to fund the agricultural economies of eastern Europe. That will be difficult to achieve as the farm lobby, although an increasingly small element of the European economy, has been extremely vocal in protecting its interests and financial support.

There is no doubt that the community will have more members early in the next century. Cyprus and Malta can be absorbed relatively easily. The problems come with Turkey and other countries with association agreements.

Turkey, which has upgraded its relationship to a customs union, is unlikely to be offered full membership for at least 20 years. Its parlous economic state, large population, dispute with Greece and the European view of its human rights record ensure considerable opposition to a membership application.

There have also been membership applications from eastern European states including the four Visigrad states - Hungary, Poland, the Czech Republic and the Slovak Republic - and other former communist states such as Bulgaria, Romania, Slovenia, Estonia, Latvia and Lithuania. These states have already negotiated association agreements with the EU but negotiations for membership will not start until some unspecified time after the completion of the IGC and, even then, will take some years.

The strongest support for widening the EU to include eastern Europe comes from Germany. Its proximity to the former communist bloc has made it very conscious of the need to bind these states into western democratic structures. But, if these states joined the EU, which has included Austria, Finland and Sweden as members since the start of last year, the focus of the union would change dramatically. The geographical centre, which in the community of 12 states was Paris, would be moved irrevocably to Berlin.

This has alarmed France and the other southern European countries which see not only a shift in political focus but also competition for funds redistributed from the rich member states to the poorer ones. This fear is behind the desire to boost links between the EU and the Mediterranean states, which is reflected in the partnership agreement reached in Barcelona last November.

After two days of negotiations between the EU states, 11 Mediterranean countries (Algeria, Morocco, Tunisia, Egypt, Israel, Jordan, Lebanon, Syria, Turkey, Cyprus and Malta) and the Palestinian Authority, agreement was reached on developing economic, political and social cooperation.

A free trade area between the 27 states will be completed by the year 2010. Tariff and non-tariff barriers on manufactured goods will be gradually removed, and trade in farm products and services will be steadily liberalized.

The case for the fast track

I write as an unashamed pro-European. I am deeply and personally convinced of the need to press forward towards ever greater political and economic union within Europe. What is more, I believe that further integration is very much in Britain's interest and Britain's positive involvement is also in the European Union's interest.

My starting point is that the European Union (EU) and the institutions which preceded it - the European Coal and Steel Community in 1961 and subsequently, the EEC - have made an unimaginably positive contribution to the well-being, security and prosperity of Europe's people. Europe, throughout history a cockpit of conflict between warring states, has enjoyed decades of unprecedented peace and prosperity. This is not in spite of the EU's institutions - but in significant measure because of them.

The EU is now the longest-established and the most successful of the world's growing number of free trade areas. Britain has played a central role in promulgating this reality. The EU's exports to the rest of the world are growing rapidly and the growth in the EU's trade in goods is being matched by a powerful surge in services, especially financial services. It is simply inaccurate to present the European economy as being in serious decline or as a stagnating failure - although, of course, some significant adjustments to social welfare systems and to labour flexibility are required.

The EU has evolved to the position it enjoys today precisely because individual nation states have been prepared to share sovereignty. Shared sovereignty was what the European Community was all about from its inception and European countries' willingness to share sovereignty has invariably paid dividends for Europe as a whole. Look at the impotence of the EU where its members have not created the mechanisms for it to speak with one voice. Europe has proved itself utterly incapable of dealing with the horrors of war in former Yugoslavia.

By contrast, the recent Uruguay trade round could not have been concluded successfully if Europe had not spoken with one voice throughout the protracted negotiations. The EU, represented exclusively by the Commission, acted as a vital counterweight to the US and other powerful trading blocs. The resulting agreement will give a major fillip to world trade: in primary goods alone, the boost to world trade is likely to be in the region of $500 billion on an annual basis from the year 2000.

Increasing trade is one sign of an international political economy in a state of flux. The collapse of the iron curtain has added some 3.5 billion people to what I would broadly define as a free market economy system. Technology is accelerating the process. Money moves at the flick of a switch across continents, not merely countries. Companies are no longer defined by where they have their head offices: today half of all equity raised by European companies is raised outside their countries of origin. Just as company managers have to pursue strategies which reflect the reality of global markets, governments cannot afford to conduct their economic policy in splendid isolation from the rest of the world. For example, the effects of the markets place constraints on fiscal and monetary policy today which make a nonsense of arguments about maintaining national sovereignty in absolute terms.

So much change packed into so short a time is, of course, unnerving, especially for political elites which everywhere find their traditional powers eroded. But the reaction to all this change should not be to hark back nostalgically to comforting but outdated models of the nation state - or to protectionism, the economic concomitant of nationalism. The way forward is to recognize the realities of increasing interdependence in political and economic affairs, and to develop the institutional framework accordingly.

For Europe, this means greater political and economic integration. In the political sphere, we need to ensure that the powers of the supranational institutions of the EU work effectively, rather than seek to undermine them. We need to have more majority voting within the Council on a wider range of issues - particularly in view of the fact that there are 12 countries queuing to join the EU.

On the economic front, we must pursue a single currency within the time-frame envisaged by the Maastricht Treaty.

Of course, there are risks associated with this project, but I believe it is essential to take an imaginative and positive leap forward.

... and against

The monetary Cassandras have got it wrong. An important part of the case for enacting economic and monetary union in 1999 rests on the argument that a postponement beyond the date planned in the Maastricht treaty would lead to chaos. However, a delay to the Emu timetable, provided it were still accompanied by credible policies to restore economic growth and rein back budget deficits, would have a salutary effect. It would provide Europe with a greater chance of genuine economic convergence and relative exchange rate stability than if the present timetable were maintained. And it would raise the credibility of Emu by making the Maastricht targets more feasible for the weaker EU states which could join a modified form of monetary union in the early years of the next century.

Those in favour of sticking to the timetable, of course, argue along different lines. Pro-Emu politicians and bankers state that postponement would plunge Europe into political instability. Chancellor Helmut Kohl has even hinted that an end to the Maastricht process could cause war. On the economic front, there are fears that postponement could set off currency turbulence and recession, and reverse the drive towards a single market. However sincerely some people may hold these beliefs, constant repetition of such over-dramatized anxieties represents little more than propaganda.

Admittedly, the political momentum towards Emu in 1999 has lately picked up as the result of Germany's desire for stable exchange rates to combat unemployment. At the same time, worries about German jobs have led to a watering down of previous German insistence for significant progress towards political union as a condition for monetary union. As a way of railroading through Emu on time, Germany also seems to be moving towards interpreting the fiscal convergence criteria (targets for budget deficits and government debts) far more generously than seemed likely at the end of last year. Yet launching the euro in 1999 on the basis of significantly softened convergence criteria risks confronting Europe with the worst of all worlds.

If the criteria are bent, through the exercise of Franco-German political will, the new European currency will lose credibility in the eyes of financial markets. This would confront the European Central Bank with the unenviable prospect of either a weak euro or higher interest rates - or possibly both - during the ECB's first year of existence. A hastily-conceived euro would not even guarantee German companies the exchange rate stability they so desire. A significant number of larger EU countries - almost certainly including the UK as well as Italy and Spain - would stay outside Emu during its initial phase, so that European currencies, in reality, would be only a little more stable than they are at present in the core group of the admittedly imperfect exchange rate mechanism.

The arguments against postponing Emu, on careful analysis, are less water-tight than they often appear. It is sometimes alleged that delay could cause the complete collapse of Maastricht. There is clearly a risk that this could happen, especially if postponement caused the entire treaty to be renegotiated. However, an orderly retreat - say, sometime next year - would have more credibility than one conducted under the pressure of financial market panic. Another assertion is that Emu delay could cause governments to pursue fiscally irresponsible policies. In fact, to avoid the opprobrium of financial markets, governments will continue to show self-interest in pursuing budget deficit reductions. They will have a better chance if, through relaxing the time constraints on reaching the Maastricht fiscal targets, EU growth can be improved after a fall in average annual GDP expansion from 3.3% during the period 1986 to 1990 to 1.5% during the period 1991 to 1995.

Another view often heard is that an Emu postponement would send more speculative funds into the Deutschmark adding to downward pressure on domestic German investment and jobs. In fact, even after the recent correction to last year's over-valuation of the Deutschmark, the economic justification for a further run into the currency looks very slender. Emu delay would pave the way for a more sensible valuation of the Deutschmark by allowing markets to assess, in a more orderly way, the prospects for the French franc and other seemingly vulnerable currencies.

By stretching the timetable for monetary union, governments would increase the prospects of securing both jobs and stable money in the new millennium.

The key to a single market

The capital markets appear to have decided that Emu will start on schedule and will endure - judging by current prices in large and active bond markets. The spread between three-month French and German interest rates in January 1999 should be a good indicator of market expectations of the Emu start date, because the spread should be minimal when Emu commences. Derived from today's yield curve, that forward spread fell to zero in March 1996.

Moreover, the 10-year bond yield spread for these two countries has now disappeared - implying that the market does not expect any particular shift in the exchange rate between the French franc and Deutschmark during the next decade.

Even so, the convergence of the French and German yield curves does not, by itself, prove that investors believe Emu is certain. But many investors expect Emu to start on schedule because politicians are taking actions which back up their strong statements of commitment. However, and remarkably, few investors believe that 1997 budget deficits, for example in France, will hit the Maastricht Treaty reference value of 3%. Instead, recognizing the economic slowdown, investors have demonstrated that they believe that a robust Emu can start with deficits above 3%. After all, the EU's aggregate budget deficit peaked in 1993 at 6.2% of GNP and has only fallen to about 4.5% this year. Yet inflation has declined steadily from 4.1% in 1993 to about 2.5% this year, despite these deficits.

It is a natural and legitimate function of these markets to avoid risk and investors' power to discipline errant governments has been demonstrated several times in recent years. The build-up of financial assets, and thus the size of markets, was driven in part by the need for citizens to save for retirement. An ageing population, combined with the pressure on public pension systems, makes it certain that the scale of retirement savings will increase enormously in the years ahead. Such savers - whether individually or via financial institutions - are keen to preserve the value of their financial assets and are likely to use the new economic freedoms of the Single European Market to move their capital anywhere within - or outside - the European Union.

Mature funded pension systems, together with individual long-term savings, can exceed 100% of GNP. So the EU - with a current GNP close to Ecu7 trillion - can eventually look forward to a colossal pool of liquid financial assets.

Emu preparations are now urgent: in just 30 months' time participants must have completed the construction of the euro capital market. The scale of this new market may surprise some investors. As at April 1996, tradeable US treasury bonds stood at Ecu1.6 trillion - an EU-wide Emu would have about Ecu2.1 trillion of bonds outstanding. However, it is not clear yet whether EU governments will convert the stock of public debt - as the French government has said it will - or merely issue new debt in euros.

Government debt managers have a clear incentive to be at the leading edge of market developments so that there are no artificial barriers to establishing the lowest credit spreads versus other EU governments. Once such perceptions are formed they are hard to shift.

The establishment of the lowest possible European benchmark yields to serve as the reference rate for credit spreads is crucial. The rapid creation of a highly-liquid capital market should appeal to global investors and help debt managers achieve their key objective of reducing their funding costs.

This process will give a further twist to the veto power of the markets over an unsound Emu. Once Ecu2 trillion of highly-liquid government bonds are distributed among global investors, potential capital flows may be large relative to the foreign exchange reserves of EU central banks if investors become nervous about the direction of fiscal policy. Central bank reserves stand at Ecu400 billion but, in Emu, more than Ecu100 billion will cease to be foreign exchange. Once Emu has started, a particular Emu member state that chooses to move away from fiscal rectitude could find the markets automatically extract a substantial penalty in interest charges, if those unsound policies are sustained and the no-bail-out rule proves credible.

Bringing in the East

At its 1993 Copenhagen summit the European Union (EU) committed itself, in principal, to enlarging to the east. Although no clear timetable has been set, integrating the former communist countries of central and eastern Europe into the capitalist west has already raised important questions over the structure of the EU.

Negotiations for entry of the most advanced eastern and central European countries are likely to begin after the conclusion of the intergovernmental conference. Poland, the Czech Republic, Hungary, and perhaps the Slovak Republic, can expect to join early in the next decade, although transition periods will be long and financial transfers will be much smaller than those that accompanied the southern expansion of the European Communiy in the 1980s.

Transfer payments for agricultural and regional support already account for 80% of the EU's annual budget. Without cuts, enlargement to the east will dramatically raise the cost of integration. If entitlements are reduced, today's main recipients - the EU's southern members and Ireland - would bear most of the financial loss. Moreover, transfer payments strongly distort market forces. Pressure from consumers, international trade partners and cash-strapped finance ministries will reinforce the drive to reform these subsidies. Fiscal solidarity of the richer EU countries will be limited by their own employment problems and budget constraints.

Despite incomplete liberalization of central and eastern Europe's economies, trade with the EU has expanded significantly. Between 1989 and 1994, total trade grew by almost 26% per year. Nevertheless, trade with central Europe remains a small fraction of the EU's overall trade (about 2.5% in 1994) and is still less than its trade with the Middle East (see chart 1).

The EU has already replaced Russia as the most important trading partner for reforming eastern nations. The EU's share of the combined trade of the largest prospective members - Poland, Hungary, and the Czech and Slovak Republics - increased from 26% in 1988 to 60% by 1995.

But gains from liberalizing trade and market integration are likely to be unevenly distributed within the EU. Germany, Italy, France and Austria now account for three-quarters of EU trade with the east; Germany alone accounts for nearly half of the total (see chart 2). Machinery, transport and telecommunications equipment are the most important EU exports to the east, while imports consist mainly of raw materials, semi-finished goods and components for further manufacturing.

Economic relations between the EU and the east have developed beyond mere trade. Direct investments by western firms in eastern industry are helping to build an integrated production structure. By 1995, foreign-owned companies already accounted for 70% of all Hungarian exports.

But southern European countries do not share the complementary economic structures enjoyed between the more developed northern member states and reforming eastern countries. Industry in Greece, Spain and Portugal remains strongest in traditional, labour-intensive sectors. Thus industries in southern and eastern Europe tend to rival rather than complement each other.

Furthermore, the east has lower labour costs and therefore an edge in attracting investment capital. Industrial wage costs in Hungary, the highest in the east in 1994, amounted to only 58% of those in Portugal, which has the lowest overall wages in the EU (see chart 3).

The crucial question that EU expansion poses for less developed southern member states is whether they can restructure their industry towards more capital- and technology-intensive products quickly enough to avoid serious and long-lasting economic disruption from eastern competitors. Income redistribution from richer to poorer EU countries could help compensate potential losers but risks introducing costly distortions.

Integration into western Europe's market will also pose problems for eastern economies. Abolishing tariffs and quotas in the west will give eastern producers access to a market of 370 million consumers but, in turn, will expose them to stronger competition (from western companies) in their own back yard.

Western firms have abundant capital, technology and marketing know-how to succeed in competitive markets, while many newly-privatized and newly-formed eastern companies do not. But how well these companies can compete will depend more on their own governments' policies to promote internal competition in labour, capital and output markets than on the size of transfer payments from Brussels.

A key objective of the Maastricht Treaty was to bridge the gap between rich and poor member states. But eastern enlargement will require serious reforms to the redistribution mechanisms. The present scheme rests on two pillars: the Common Agricultural Policy (CAP) and the structural funds. Including central and eastern European countries in both mechanisms would require substantial income transfers, which taxpayers in existing member states are not likely to accept.

Most eastern economies are more agricultural than today's EU members: 25% of Poland's labour force, for example, is still employed in agriculture. To extend agricultural price supports under present CAP criteria would encourage expanded farm output and strain the present system to breaking point. Conservative cost estimates for a CAP extension to Hungary, the Slovak Republic, the Czech Republic and Poland would, by the year 2000, add nearly 20% to the agricultural support budget planned for that year. Not surprisingly, western European farm lobbies are among the most outspoken critics of eastward expansion.

Even greater problems would arise from extending the present regional development policy to the east. Under current practices, new member states would receive large net structural and regional assistance funds.

The regional development system allows a region to claim subsidies if its GDP per capita is less than 75% of the EU average. In 1994, eastern European countries' average GDP per capita was less than 25% of the EU's average (see chart 4). It is unlikely that these gaps will be closed quickly. Even based on the optimistic forecast that eastern nations will grow three percentage points faster than the EU average, they would need between 25 and 50 years to reach 75% of the average income for the rest of the Union (see chart 5).

Under present rules and practices, the total annual costs of EU enlargement to Poland, the Czech Republic, the Slovak Republic and Hungary alone could reach more than $65 billion a year by the year 2000 - most of it from structural funds. This implies a 60% increase in the EU budget, and suggests that the enlargement must focus less on transferring income to the east and more on improving market access for eastern goods and services.

The EU is entering rough waters. Eastward expansion is just one of the daunting challenges it faces. The intergovernmental conference is likely to result in further internal reforms but will fall short of fully resolving the problems.

The cost of inaction or rigidity would be large, and the very diversity and complexity of the political issues at stake make compromise possible. Even in politics, trade is not a zero-sum game.

Difficulties reforming agricultural and regional development policies are likely to leave eastern applicants facing lengthy transitions before they can participate fully in these schemes. Most importantly, more EU decisions will be made by qualified majorities.

This will produce an EU with a variable geometry that allows groups of member states to proceed at different speeds. One club - the Schengen group - will have their borders fully open to each other, while a core Emu group will be the first to introduce the single currency. Other groups will pursue closer defence cooperation or participate in particular police actions outside the community.

Economic and political integration will continue well beyond the year 2000, even if the all-or-nothing pattern of integration since the 1950s is abandoned.

William Gasser and Armin Guhl are senior economists at the Union Bank of Switzerland, economic research department in Zurich. This article is based on "Toward a Broader and Deeper Europe", featured in the summer issue of ubs International Finance.

Creating a central bank for Europe

If European monetary union (Emu) goes ahead as planned on January 1 1999, the countries in the euro currency area will irrevocably lock their exchange rates and the euro will become the sole medium for settling wholesale transactions.

The European Central Bank (ECB) will formulate a unified monetary policy which independent national central banks will implement. The role played by these central banks will change dramatically. Those that are, to varying extents, under the thumb of national governments will gain a formal independence they did not formerly enjoy. Those that are now independent will effectively lose authority to a Europe-wide collective decision-making process. Europe's retail and investment banks will face severe costs and challenges in adapting to Emu. These changes will affect all countries in Europe, whether they enter into currency union or not.

The ECB will be fully independent in its decision-making, which means it will not be answerable to any EU institution, legislative body or national government. Indeed, unlike many other independent central banks, it will not be obliged to follow targets set by democratically-elected bodies and its key personnel will be dismissable only on grounds of extreme personal incapacity or misdemeanour.

The ECB's decision-making body, the governing council, will be made up of the heads of the national central banks and an executive board. The executive board will consist of a president, vice-president and four directors, appointed for (non-renewable) eight-year terms by agreement of the national governments in the same way EU commissioners are appointed. The heads of the national central banks will be appointed for five-year terms.

It is too early to predict who will be proposed for these crucial posts, but as Emu draws nearer, this will be a matter of great debate. Representation of national central bank governors will enable countries' individual views to be expressed. Indeed, because decisions in the governing council will be taken on a simple majority basis, without weighted voting, the larger European countries have argued that smaller countries will be afforded disproportionate power.

In fact it is far more likely that the executive board will usually have the whip hand since it is the most natural substantial power bloc on the governing council. This will be particularly the case if only a few countries qualify for Emu. The ECB executive board members will be the six most powerful economic policy decision-makers in Europe, with power to affect the economies of countries both inside and outside Emu.

The decision-making structure of the ECB is effectively identical to that of the Bundesbank, where executive power is held by central appointees and regional central bank governors play a lesser role. This approach has clearly worked for Germany's relatively homogeneous economy, but there is no guarantee that it would be as successful for a Europe-wide monetary union covering a far more diverse economic environment.

One of the major issues at stake here is the tension between the promise of stable low inflation if executive board members have tight control, and the possibility of severe structural unemployment in depressed countries and regions of the monetary union if national central bank governors' powers are reduced to such an extent that they are not able to institute effective countermeasures.

The prime objective of the system of central banks (the ECB plus the national central banks) will be the maintenance of low inflation. This goal is not in dispute, but intermediate targets and the instruments used to achieve low inflation are a different matter because different policy tools are used in different EU member states.

One bone of contention is over whether or not targeting money supply should be the prime control method, as it has been in Germany. The disagreement among leading European nations over this issue has not yet been resolved, and so the ECB's statutes currently allow for money supply and more direct approaches to inflation control. The European Monetary Institute (EMI), set up to create the ECB and headed by Alexandre Lamfalussy, announced last month that further analysis of different monetary policy strategies was required and that it intends to carry this out this year.

The specific monetary policy instruments to be used to achieve low inflation are also still under discussion. Minimum reserve requirements are an aspect of this that could profoundly affect the competitiveness of Europe's commercial banks. European heads of state have given their consent to a central bank that may conduct open market operations, may stipulate that banks hold minimum reserves with itself or with national central banks, and may use other instruments of monetary control.

Minimum reserve requirements have long been used by European countries where markets for treasury bills and other debt instruments are less deep and liquid than in sophisticated centres, to assist central banks in managing short-term interest rates. Since reserves held at the central bank usually pay no interest or interest below market rates, there is an incentive for banks to raise their lending rates if their business expands faster than the central bank wishes and this puts a brake on monetary growth. Minimum reserve requirements are in force in nine EU states, including France, Germany, Italy and Spain, so there has been strong support for their use by the ECB.

The UK does not use minimum reserve requirements to control liquidity in the banking sector since they amount to a differential tax burden on banks, which distorts the market. And this fact has been recognized elsewhere in Europe, as witnessed by the progressive lowering of rates in other EU countries. If reserve requirements are not harmonized across Emu countries, banks in countries with the lowest rates will be at a competitive advantage. Indeed a recent report by the British Bankers Association noted that if the UK were not in Emu "this could be to the City's advantage and the knowledge of this should act as a moderating influence on thinking within the EMI".

The Maastricht Treaty decrees that open market operations - the method by which the central bank sets the interest rate through the banking sector - will be conducted through repurchase tenders only. This is the method currently used by the Bundesbank, but is not the exclusive method used by other central banks such as the Bank of England.

While the Maastricht Treaty rests control over monetary policy with the ECB (and independent national central banks), there are no provisions in the ECB statutes for control over fiscal policy, implying that it will continue to rest with governments. The Delors Report recommended binding rules for the conduct of fiscal policy and penalties on nations which break them. This has been followed by the proposal of the Waigel stability pact which argues for the imposition of automatic penalties on countries whose budget deficits exceed 3% of GDP.

Economists often argue in favour of an element of fiscal harmonization under Emu in order to avoid the danger that some countries will seek to free-ride with expansionary Keynesian policies on the back of a steady exchange rate and interest rates which reflect others' caution. But the Maastricht Treaty specifically states that Emu countries should stick to fiscal restraints, but that it is acceptable for targets to be missed in exceptional and temporary cases. In any event, strict restrictions on national autonomy could cause a backlash against the European project in depressed countries and regions.

Central to this debate is Germany's desire to ensure that its economy is not dragged down by less inflation-averse partners, as against the desire of less robust economies to retain the means to deal with shocks to their economies.

Although the Maastricht Treaty does not specify that Europe's central banks should have control over fiscal policy, it is possible that in practice the independent and empowered central banks will play more of a role in this. This would mean a delegation of the power to tax from elected to non-elected bodies.

This shift would be significant both practically and conceptually. Independent central banks currently withhold interest rate cuts until they are satisfied that prudent fiscal policies are in place. An extension of these sorts of powers will vary from country to country. If, for example, the UK were in Emu, the UK government would probably resist transferring any control over fiscal policy to the Bank of England - but it might be pressured to do so if the credibility of its economic policy was under question.

Arrangements for prudential supervision and the lender-of-last-resort role are important for all banks. No specific objective of sustaining the health and effective functioning of the banking and financial systems is stated in the statute of the European system of central banks. Nor is the ECB pinpointed as a lender of last resort, although it is not specifically ruled out either. It is likely, though, that this role can be maintained by national central banks, but with the European central bank having the power to overrule if a two-thirds majority of the governing council votes that a national central bank's actions are interfering with the objectives and tasks of the European system of central banks.

How this is likely to work in practice is not at all clear and its importance to Europe's banking community means that it is an issue that needs to be resolved. The delegation of this role to national central banks is supported by an odd alliance. The Bundesbank believes a lender-of-last-resort function for the ECB could entail moral hazard and might encourage inflation. Heads of EU governments who are Euro-sceptics are equally opposed to it, but because they wish to maximize subsidiarity.

The Maastricht Treaty has left open the possibility that the ECB will be involved in supervision of banks and other credit institutions. But as it has not set down any rules by which it would operate this supervision, it is likely that national central banks will continue to undertake this function, on an increasingly passported basis, following the Second Banking Coordination Directive and the Investment Services Directive. Once a bank or other credit institution is licensed to operate and carry out a range of functions in one EU country, it has the right to set up an operation in any other EU country. Again, supporters of delegation include the more Euro-sceptic nations on grounds of subsidiarity - this time in alliance with banks labouring under relatively costly regulatory regimes which seek a level playing field. In any event, this delegation of responsibility to national central banks might change if the ECB were to take on the function of the lender of last resort.

Europe's central banks also have to prepare for managing exchange rate policy in a multi-speed Europe. On the assumption that not all EU countries will advance to monetary union at the same time, the central banks and governments of states yet to accede to Emu will have to decide on an exchange rate policy - whether or not to peg to the euro.

Some countries, principally Germany, argue that the outs would have to peg to the euro. The more sceptical countries, which are likely to be out, among them the UK, argue in favour of flexibility for national economies. The governor of the Bank of England, Eddie George, has publicly argued for this on many occasions, in direct opposition to the views of Bundesbank president Hans Tietmeyer.

It is probable that resolution of the debate for each country will be influenced by whether it wanted to join but did not meet the convergence criteria (wannabes) or met the criteria but did not want to join (don't wannabes). The result could be a tripartite Europe with some countries engaged in full monetary union - most likely Germany, France, Benelux, and possibly Ireland and Portugal; the wannabes attempting to peg to the euro in an ERM2 - most likely the southern European countries plus Sweden; and the don't wannabes leaving themselves free to float - most likely the UK and Denmark. Although the fear, on the part of the ins, of competitive devaluations by the outs might lead them to blackmail the outs to enter an ERM2 on pain of being excluded from the single market. The new east European EU members will be an unknown quantity.

Tessa Read worked until recently at the Bank of England. The opinions expressed are her own.

When it comes to attracting overseas investors, most of Europe's diverse business communities seem to rely on the same main selling point. Almost every region between Birmingham and Bologna claims to be located at the heart of Europe.

Yet the regional development industry admits that it is not location, nor even cost, that sways companies from the Americas and from Asia to set up shop in a particular part of Europe. If price were all that mattered, labour-intensive producers like Goodyear would scarcely have considered manufacturing in Luxembourg, one of the most expensive business locations in Europe in terms of labour costs and taxation.

The US-based tyre manufacturer has recently extended the production of truck tyres at its Luxembourg factory, thanks to a legal change that allowed Sunday working for the first time. Likewise, TDK of Japan has decided to begin manufacturing CDRs - a new type of compact disc - at its Luxembourg plant.

Like most European investment locations, Luxembourg will never be able to compete with Asia or most of the Americas in terms of costs, deregulation or flexibility. Romain Foarges, a commercial attache at the Luxembourg Board of Economic Development, says that it lobbies overseas companies only when they have already decided to invest in Europe. So Luxembourg is competing with France, Germany and Belgium, but not with Taiwan, Hong Kong or Mexico.

Inward investment for many European governments is a priority. The figures suggest, however, that the battle may already have been lost, as more domestic companies decide to invest overseas where costs are lower and business regulations more flexible.

Recent figures from the German ministry of economics show that in 1995 German companies invested Dm48 billion abroad, while less than Dm14 billion was pumped into the German economy by foreign companies. The deficit would have been even greater if investment in Germany's medium-cost neighbours - Hungary, Poland, the Czech Republic and others - had been as substantial as economists predicted in 1989.

Attracting foreign investors is so difficult that most development corporations rely on repeat investments. Jean-Daniel Tordjman, France's ambassador for international investment, says that the Japanese automotive manufacturers' huge investments in Britain are an accepted fact which cannot now be reversed. Nevertheless France still has the chance to establish itself as a manufacturing location for automotive components and has seen several large investments recently by General Motors, Ford and Mitsubishi.

Most countries use tax breaks to market themselves - but that may be an illusion. According to Jeannot Erpelding, a strategist at TDK in Luxembourg, local tax breaks and investment incentives have made scarcely any difference to the company's latest venture.

In fact, Luxembourg was chosen because it was predictable. "It's an enormous advantage that the lines of communication are very short in Luxembourg. If there's a problem we can solve it quickly," Erpelding explains. "We just go straight to the minister."

That suggests inward investment is even more difficult for large countries. The UK, which attracts one-third of all world investment in European Union countries, is beginning to stress its competitiveness in terms of labour costs. The largest foreign investment in Britain this year, in terms of jobs, involves labour-intensive manufacture of electronics components. The venture by Chunghwa Picture Tubes of Taiwan has created over 3,000 jobs in Scotland.

Yet future overseas investors who make their choice on the basis of cost will be dealing with slimmer differences as wage costs converge. In theory, that means that nations with highly-skilled workforces (such as Germany or Ireland) have most to gain, but economies which are still developing (such as Poland and Hungary) run the risk of deterring foreign investors if wage costs rise too quickly.

"Of course, the emerging economies of eastern Europe are bound to attract investment in years to come. However, people should be very cautious of ascribing a competitive advantage to low labour costs. Other issues, particularly skills and infrastructure, are also critically important," says Andrew Fraser, chief executive of the Invest in Britain Bureau.

Fraser does not believe that investors have been deterred by the uncertainty over Britain and Europe, and whether the UK will adopt the single currency: "In many ways the UK has led the EU in the development of the single market agenda on behalf of business interests. For example, in terms of deregulation and privatization, the rest of Europe is having to catch up with the considerable lead the UK has established in areas such as telecomms, utilities, steel and airlines."

But it is only in the financial services industry that Britain's lead is undisputed. Banks, brokers and investors have settled in London or Edinburgh regardless of location, costs, an uncertain future in the EU or any other factors. They have relocated to join the rest of their market and that is probably the strongest card which Europe has to play in attracting investment beyond the year 2000, whether in high-tech manufacturing, services or finance. By Laura Covill