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Copyright © 1998, MCB UP Limited
Building a successful EMU
Building a successful EMU
Adair TurnerDirector-General of the Confederation of British Industry
It is now highly probable that the EMU project will go ahead on the 1 January 1999, and that it will be considerably wider in scope (with either ten or 11 participants) than seemed likely even a year ago. As someone who believes that the project can, under the right conditions, make economic sense, but who feels that Europe is perhaps proceeding faster than optimal and in less than ideal conditions, the prospect leaves me with mixed feelings. And the extraordinary lack of debate throughout much of Europe of the economic pros and cons of the project, and of EMU's true economic implications and the parallel policies therefore required for success, should leave us concerned about a process of European policy development which can result in such a huge step being so little considered.
But it is now very likely to occur, and the short-term economic context of returning European growth makes it likely, moreover, that outright opponents will be disappointed in their predictions of early collapse or even of severe tensions in the initial years.
Against that background, however, it still remains important to explore the arguments for and against EMU, both as the basis for deciding Britain's subsequent policy, and because a clear understanding of those arguments, and in particular of the arguments against, is the necessary basis for the design of policies most likely to make EMU a success. For if severe tensions in the earliest years are now seen for cyclical reasons as less likely, there remain real risks to the project which can and must be mitigated via the policies pursued in parallel over the next several years. And it is vital that Europe goes ahead with EMU with a clear understanding of those risks, and indeed with a clear understanding that while EMU will have benefits, there are vital problems facing Europe which EMU will not fix, and indeed which it could make worse.
The economic case for a single currency does not rest on savings on transaction costs (just as the serious case against does not rest on the one-off transition costs of investment in new ATMs and tills). Instead the case in favour rests on four key arguments:
(1) A single currency will create a more complete single market of transparent prices which will in turn lead to more intense competition across Europe, delivering the direct benefit of lower prices to consumers and making European companies more successful competitors in world markets.
(2) It will also eliminate intra-European exchange rate risk from trade and investment, providing a sounder basis for long-term investment, and, as with factor (1), creating a more openly competitive European market.
(3) Similarly it will facilitate the creation of a single European capital market, for debt and more importantly for corporate equity, with savings pursuing the highest return investment opportunities across Europe. This, plus the likely parallel development of a more active pan-European market for corporate control, will in turn spur economic efficiency and productivity.
(4) Finally, it will remove from the European economy, at least in respect to intra-European exchange rates, the harmful real economic volatility which is produced by the tendency of exchange rate movements to overshoot and indeed sometimes to move inversely to the corrections required to offset relative inflation rates and shifts in competitiveness.
Together these factors can establish a strong case for EMU under the right conditions. Together they could deliver a potentially beneficial stimulus to European economic development. But it is vitally important to understand the precise nature of that beneficial stimulus what it helps achieve, and what it does not. The essential impact of the Euro is to create a more open and competitive market. That should mean enhanced productivity growth, an enhanced ability in Europe to achieve faster economic growth than the USA and to close the gap of productivity and prosperity which now exists versus the USA.
Believers in the efficiency of free markets should welcome such developments, confident that the long-term impact of more open markets is beneficial. But equally, policy makers need to recognise that the impact of more intense competition in either product or capital markets will probably be restructuring and job shedding, and that therefore the first order impact of EMU on unemployment is more likely to be adverse than positive. EMU should have a clear positive impact on productivity growth: but there is no fundamental reason to believe that it will be positive for employment, and it will only be neutral for employment (as against negative) if accompanied by parallel policies to increase the flexibility of labour markets and to improve Europe's pace of new business creation and new product and service innovation.
The need for greater labour market flexibility and new business creation follows from the fact that EMU will intensify competition and productivity growth. Greater labour market flexibility will also become more important still because of the loss through EMU of other levers of macro-economic adjustment exchange rate flexibility and nationally differentiated interest rate variation. Of these the latter, the interest rate effect, is I believe by far the most important.
The loss of exchange rate flexibility is often cited by opponents of EMU as a key argument against, but it may prove to be less significant than often supposed. In theory exchange rates can move to offset differences in national inflation rates, on other shifts in the relative competitiveness of the traded sectors of two economies, and in theory they can do this more easily than movements in nominal wage rates. But in practice, exchange rate movements are often far less benign. When inflation rates in different countries are relatively low and similar, the actual medium-term movement (e.g. up to five years) of exchange rates bears almost no relationship to purchasing power parity theory, with bilateral exchange rates either massively overshooting necessary adjustment or moving perversely in precisely the opposite direction required for adjustment. As a result they as often in these conditions increase the need for nominal exchange rate flexibility as obviate it. And while it is true that if one country has an inflation rate significantly higher than a trading partner it will over time need to devalue its exchange rate, the history of those cases shows the dangers of an inflationary spiral in which devaluation generates more inflation and thus a need for greater devaluation.
While we would be wise to seek to increase wage-setting flexibility in the traded sectors of European economies to reflect the fact that the ultimate escape route of exchange rate flexibility has been removed, the overall impact of removing that flexibility is far more likely to be positive than negative.
It is instead the removal of national ability to vary interest rates to suit national economic circumstances which is the most worrying feature of EMU. For it means that there will be times when the pan-European interest rate will be severely sub-optimal for specific regions of Europe. Regional asset price booms will proceed for longer than would have been the case if national interest rates could have been raised, and more destructive busts will as a result occur. And regional recessions may last for longer with governments and national central banks no longer able to lower their specific interest rate to stimulate the economy. This risk is inherent to a large single currency area there have for instance been times in the last 20 years when the pan-US$ interest rate has been seriously sub-optimal for, say, Texas or California. It is not a knockout factor against EMU. But it does suggest that three sets of conditions are essential for EMU's success. These are:
(1) monetary convergence, similar and low inflation and interest rates, so that EMU does not start in conditions where the single pan-European interest rate is significantly sub-optimal for specific regions because of differences in inflationary expectations.
(2) sound fiscal positions in all member countries, and in particular levels of accumulated government debt which are low enough to allowing counter-cyclical movements in public finances to occur without raising concerns about fundamental credit-worthiness. In the absence of national interest rate variation, the automatic stabiliser effect the tendency of public deficits to rise in recessions and to fall in booms will become ever more important. But it will be constrained by fears of deteriorating creditworthiness if countries" structural fiscal position (their deficit/surplus at mid-point in the cycle) and their accumulated government debt are too high at the start of EMU. This is the fundamental economic logic of the Maastricht fiscal criteria;
(3) labour market flexibility, and in particular flexibility in real wage determination.
Of these sets of conditions, the first, monetary convergence, is met to a much greater extent and in more countries than seemed likely only five years ago. But fiscal positions are not as much improved as was, quite correctly, required by Maastricht, and the fact that Europe has largely stopped talking about the 60 per cent accumulated debt criteria simply because few countries will meet it, is a clear indication of the triumph of political will over economic criteria in the choice of EMU's launch date.
As for Europe's labour markets, the fact that they are inefficiently flexible today, before EMU, to deliver high employment, does not engender confidence that they will be able to deal with the challenge of a still more rapid pace of structural and productivity change in Europe, and with the increased demands placed on labour market adjustment by the absence of exchange rate flexibility and interest rate differentiation.
Both the benefits and the risks of EMU therefore point us to the conditions required for success. The fact that the benefits essentially lie in a more rapid pace of structural change and of productivity growth, in greater competitive intensity, clearly mean that greater labour market flexibility and a faster pace of new business creation and product and service innovation will be essential if the benefits of productivity are not to be lost through the further growth of under-utilised resources. And the loss of interest rate differentiation makes it vital to achieve sound public finances and provides a further (though secondary) argument for labour market flexibility. The absence of necessary conditions for success is why, is an ideal world, Europe should consider delaying EMU, or proceed now only with an inner core membership of the most converged and fiscally sound countries.
The world, however, is not ideal and EMU will proceed earlier and wider than is perhaps economically rational.
In these circumstances it is essential that governments across Europe pursue in the early years of EMU the parallel policies required to make EMU a success, using the good fortune of the likely European growth spurt to get fiscal positions in better order, and taking measures to increase the flexibility of their labour markets and to remove barriers to and increase incentives for new business creation.