Alexandre Lamfalussy: Founding Father and Wise Man behind the Euro

Ivo Maes
Senior Advisor for Historical Studies, Research Department, National Bank of Belgium. Member of Robert Triffin International

In 1949, a young Hungarian immigrant arrived in Belgium. He had just a few dollars in his

pocket, but he was armed with strong willpower to build a new life. Almost fifty years later, Alexandre Lamfalussy was unveiling the first designs of banknotes in euro, now the world’s second major currency.

As the first President of the European Monetary Institute, the forerunner of the European Central Bank, Alexandre Lamfalussy was clearly one of the “founding fathers” of the euro. However, as the book by Christophe Lamfalussy, Ivo Maes and Sabine Péters argues, Lamfalussy was more than just one of the founding fathers of the euro. He was “The wise man behind the euro”.

Alexandre Lamfalussy was a committed European federalist. Moreover, as an economist, he had a deep conviction that a common market can only survive with a common currency.

Lamfalussy also had clear ideas about the nature of a future Economic and Monetary Union. They were largely based on his deep scepticism about the functioning of financial markets. He was a strong advocate of a symmetric EMU, not just with a strong monetary pillar, but also a solid economic pillar, “an economic government”. He was one of the first proponents of a banking union, with a role for the European Central Bank of micro-prudential supervision of financial institutions. Basically, Lamfalussy had always had a profound belief that a central bank has a crucial role to play in safeguarding financial stability.

Alexandre Lamfalussy was born on 26 April 1929 in Kapuvár, in Hungary. He had a happy childhood, brought up in a cultivated entourage. But the Second World War ushered in a painful time for the young Alexandre. After the war, he got a place in a university that was renowned for shaping the nation’s elites. But he soon realised that the communist regime would not allow him to retain his freedom of thought and speech.

In January 1949, he fled Hungary and took refuge in Belgium, where he continued his studies at the Catholic University of Louvain. At the time, Louvain was one of the leading places for economics in the French-speaking world. The dominant figure was Léon-H. Dupriez, an eminent specialist in business cycle analysis.

During his student days in Louvain, Lamfalussy joined the Cercle Européen, along with some of his friends. For them, European integration was a very profound conviction, which had a special dimension for Lamfalussy, who had just crossed the Iron Curtain. These men were convinced that it was necessary to break down the barriers which divided Europe. Quite apart from the important economic motive, there was also a clear cultural dimension, a feeling of belonging to a common cultural heritage.

Lamfalussy gained his doctorate at Oxford, under the supervision of Philip Andrews and Sir John Hicks, one of the first winners of the Nobel Prize for Economics. In Investment and Growth in Mature Economies. The Case of Belgium, Lamfalussy focused on the weak investment and growth performance of Belgian industry. His analysis became a classic.

Lamfalussy then returned to Belgium and started a career as a banker at the Banque de Bruxelles, the second biggest Belgian commercial bank. At just over forty, he became Chairman of the Board there. In the early 1960s, he was involved in the creation of mutual funds and played a role in international investment banking. However, during Lamfalussy’s time at the helm of the Banque de Bruxelles, some traders took important open foreign exchange positions, triggering heavy losses. It became Lamfalussy’s first exercise in financial crisis management. After that, he took political responsibility for the losses and resigned.

During his time at the Banque de Bruxelles, Lamfalussy’s interest shifted to monetary and financial issues, both national and international. He took part in meetings of several groups on the reform of the international monetary system, one of the most famous being the Bellagio group, whose members included Sir Roy Harrod, Robert Mundell, Jacques Rueff and Robert Triffin.

In 1976, Lamfalussy joined the world of central banking. He was selected by the Bank for International Settlements for the key post of Economic Adviser. He later became General Manager. During this period, Lamfalussy was to take up a central position in all the major debates going on in the economic and financial world: the exchange rate mechanism, the excessive growth of international bank lending, the impact of financial innovation and Europe’s efforts to establish a zone of monetary stability. Alexandre Lamfalussy had spoken out clearly about all these themes and, in doing so, he often took a controversial stand. As Jacques de Larosière observed, “In the light of subsequent events, we are compelled to acknowledge that his assessments were generally correct and far-sighted”.

At the BIS, Lamfalussy was in a first-rate position to observe the international and European monetary system. He took part in the meetings of the G10 governors, including the informal dinners, where the most open and confidential discussions between the world’s central bankers were held. Lamfalussy also attended the meetings of the European Community’s Committee of Governors. He turned out to be “the professor” among the central bankers.

The sharp appreciation of the US dollar at the beginning of the 1980s was to have a profound effect on Lamfalussy. He saw good reasons for no longer relying on flexible exchange rates to correct external imbalances. And events at the time pointed up the risks these imbalances carried, especially in the form of strong protectionist threats, a theme that is still very relevant today.

 Lamfalussy also warned about the debt build-up in Latin America. Moreover, he pointed out the relationship between the United States’ lax monetary policies and its balance of payments deficit. He later played a significant role in the management of the Latin American debt crisis.

Lamfalussy quickly came to take a sceptical attitude to financial innovations. The big financial innovation of the 1970s were the so-called “floating rate notes”: long-term bonds, but with frequent interest rate adjustments, depending on movements in short-term rates. This appealed to the banks, since they mainly relied on short-term funding. It was also appealing for borrowers because the short-term interest rate was lower than the long-term rate. Some Latin American countries, which had large balance of payments deficits, took on substantial loans. With the sharp rise in commodity prices, real interest rates were strongly negative for these countries. However, when American monetary policy was tightened sharply in 1979, the situation changed completely. Nominal interest rates soared, while the recession lead to plummeting commodity prices. Real interest rates shot up dramatically. As Lamfalussy observed:

 “Innovation allowed banks to transform margin risk into capital risk which, in this case, was probably a greater threat to the stability of the international banking system – not to mention its rather disastrous effects on the borrowers themselves”.

So, Lamfalussy made a major contribution to creating a ”BIS atmosphere”, namely, the need to keep an eye on imbalances, to debt build-ups and bubbles. Lamfalussy thus became the principal architect of the “macro-prudential” approach adopted by the BIS in the area of financial stability, marked by concern for the financial system to be considered as a whole.

During his time at the BIS, Lamfalussy was also a member of the Delors Committee, which was to play a pivotal role in the process of European monetary union. As the meetings of the Delors Committee took place at the BIS in Basel, Lamfalussy was de facto its host. Lamfalussy played an intellectually stimulating role in the Committee, continuing in his role of professor among central bankers. With the help of his colleagues at the BIS, he compiled three research papers: a description of the functioning of the ECU banking market, a study on monetary policy operations in stage two of EMU, and an analysis of fiscal policy coordination.

In Lamfalussy’s view, fiscal policy coordination is a vital component of any European economic and monetary union. He saw two main reasons for that. The first one closely reflected his preoccupations with the policy mix on the international monetary scene: “the determination of a global fiscal policy in a way that is sufficiently responsive to evolving domestic and international requirements”. The second reason foreshadowed the “binding rules on budgetary policy” in the Delors Report itself, namely, the need “to avoid tensions arising from excessive differences between public sector borrowing requirements of individual member countries”. With his experience of the Latin American debt crisis, Lamfalussy did not believe in market discipline.

On 1 January 1994, Lamfalussy, at that time nearly 65 year old, became the first President of the European Monetary Institute. Lamfalussy had mixed feelings. As retirement beckoned, he was offered his dream job. His sense of duty won over.

 These were turbulent times for the EMU process, with the financial markets still in turmoil after the European Monetary System crisis and the laborious Maastricht Treaty ratification process. However, the second stage of EMU started on 1 January 1994. The Institute’s tasks fell into two broad categories: on the one hand, strengthening the coordination of the monetary policies of the EU Member States and, on the other hand, organising preparations for the final stage of EMU, especially the conduct of the single monetary policy and the introduction of the single currency.

One of the main issues unresolved at the time concerned the concrete scenario for the changeover to the single currency.  This was a very complex and delicate issue, as it affected the banking system, financial markets, enterprises and the public at large.  The European Monetary Institute’s scenario would be adopted by the European Council in Madrid in December 1995. The scenario strengthened confidence in the EMU process and marked the moment from which the international financial community started to take EMU seriously.

In a series of speeches and articles, Lamfalussy also tackled the benefits and costs of EMU. In his view, EMU would lead to major benefits, although he acknowledged that this also implied costs. He emphasised that, in order to ensure these “large and lasting net benefits”, countries had to ensure sustainable macroeconomic convergence before joining EMU. One area that needed to be tackled was fiscal policy. But for Lamfalussy, the greatest challenge concerned the labour market, “wage and price flexibility is essential to facilitate economic adjustment to various kinds of shocks ...  With or without EMU, employment policies have to be in the forefront of attention of European policy-makers”.

In 2000, Alexandre Lamfalussy became also the Chairman of the Committee of Wise Men, which developed a new approach for the regulation of European financial markets. The Committee’s work significantly speeded up changes in regulation and increased the transparency of the regulatory process. Lamfalussy was to lay the foundations for the prudential Supervisory Authorities, which were later set up in the wake of the financial crisis and the de Larosière Report.

During these years, financial stability would become, more and more, Lamfalussy’s main preoccupation. In 2004, he focused on the organisation of prudential supervision in the European Union, which he described as a “mind-boggling patchwork”. He pointed out that central banks had a crucial role in the management of financial crises, especially in “preventing a potential crisis from turning into a real one... In such a situation, they should provide liquidity to the system, so as to avoid liquidity shortages pushing otherwise solvent banks into bankruptcy”. Lamfalussy added that the timely provision of liquidity was very much a matter of judgment, which implied that central banks had to be intimately familiar with financial institutions: “they must possess direct information on banks risk-assessment methods and capabilities, on their decision-making processes and control mechanisms and, not least, on their expertise and skills in using innovative financial instruments. Such information cannot be acquired by reading second-hand reports, however lucid and transparent such reports may be”.

For Lamfalussy the crucial issue was whether one should give a responsibility to the ECB in the supervision of the large, systemically important, banks. This was obviously an early anticipation of the 2012 debates on whether to set up a banking union.

The financial crisis confirmed Lamfalussy’s beliefs: “whether they like it or not, central banks are in the front line when it comes to keeping crisis manifestations under control”.

Given the severity of the crisis, central banks reacted with a variety of “non-standard” measures. This led not only to a spectacular expansion of their balance sheets, but also to a change in the composition of their assets, with more risky assets: “As a result central banks have started navigating in uncharted waters, in terms of both operational techniques and their relations with governments”. Lamfalussy said he did not expect a quick end to the crisis. So, financial stability should remain an objective for central banks, in just the same way as price stability.

Lamfalussy’s advocacy of European monetary integration had its origin in two main sources: a profound European conviction, marked by the devastations of the Second World War and the Iron Curtain, and his mistrust of floating exchange rates systems. As observed by Wim Duisenberg: “You have never believed that a true single market is in the long run compatible with a quasi-floating exchange rate system”.

Bibliography

Alexandre Lamfalussy. The Wise Man of the Euro. A conversation with Christophe Lamfalussy, Ivo Maes and Sabine Péters, Preface by Jacques de Larosière, Leuven: LannooCampus, February 2014.

Alexandre Lamfalussy – Selected Essays, Ivo Maes (Editor), Forewords by J. Smets and G. Matolcsy, Budapest: Magyar Nemzeti Bank and National Bank of Belgium, January 2017.