Would a single currency be a good idea? The collapse of the narrow bands of the exchange rate mechanism last year amply demonstrated one large disadvantage, which is that exchange rate changes could no longer be used as a tool of stabilisation policy. Even if exchange rates are at their appropriate long-term levels, it can be useful to allow them to fluctuate for short periods to dampen booms and slumps when economic cycles in different European economies get out of synchronisation. For example, it would have been useful for the mark to have floated up against other European currencies in 1990-92 in order to have dampened the unification boom in Germany, and to have allowed larger interest rate cuts elsewhere in Europe.
After monetary union, such changes in exchange rates will be out of the question and monetary policy will be restricted to dealing only with the stabilisation of the entire European economy. This is a genuine disadvantage that cannot be denied by the Euro-enthusiasts. But it is not beyond the wit of mankind to design other means of stabilising different countries within the European Union - fiscal policy, for example - so this objection is not necessarily decisive.
Moving from cyclical to secular issues, many opponents of monetary union have argued that exchange rate changes are also important in helping economies to adjust to long-term real shocks. Of this, I am much less certain. The argument here dates back to a classic article on 'optimal currency areas' written by Robert Mundell in 1961. Mundell describes a situation in which two economies each produce a single commodity - cars and wheat, for example.
He then postulates that the global demand for wheat declines while the demand for cars increases. If prices and wages are not fully flexible in both economies, there will be unemployment in the wheat economy, and an inflationary boom in the car economy. Both of these shocks could be avoided by allowing the exchange rate to rise for the car economy.
Although this appears to constitute a strong argument in favour of flexible exchange rates, it in fact rests on two very restrictive assumptions. (The German economist Peter Bofinger has recently spelled this out in a perceptive research paper for the Centre for Economic Policy Research in London.) First, Mundell's result requires that the change in the exchange rate between car and wheat producers - which raises the world price of cars, and cuts that of wheat, thus correcting the demand imbalance - will not be washed away by price changes in the domestic economies. In other words, it requires that changes in the nominal exchange rate will stick in real terms.
But this is not what seems to happen within the EU. A recent study by the Bundesbank (published in its monthly report last November) shows conclusively that real exchange rates between European countries are in fact very stable over time. Changes in exchange rates are entirely offset by changes in relative inflation rates, and vice versa. So one assumption in Mundell's model fails to hold.
The second crucial assumption, which is that each economy produces only one good, is of course ludicrous. In fact, the large European economies are highly differentiated in product mix, and it is difficult to imagine how any shock could cleanly hit one particular economy while leaving others unscathed. What is much more likely is that a demand shock might, for example, hit the British Midlands, northern Germany and the Milan/Turin belt in Italy. Quite how these regional shocks are supposed to be cured by exchange rate adjustments between countries is a mystery.
Not only are these 'real adjustment' arguments against EMU rather weak, but there are a clutch of monetary arguments that seem to favour monetary union. Supporters of the single currency have tended to focus on the extra convenience that this would entail and on the problems to trade flows that currency fluctuations involve. However, the best evidence available on these issues suggests that the benefits of a common currency in making the single market more efficient, and in encouraging trade between EU members, are rather small, possibly less than 0.5 per cent of GDP. If this is the case, it scarcely seems worth the trouble.
Potentially much more significant is the impact on national monetary policy of the integration of capital markets and banking services across the union. For the first time in recent European history, controls over the movement of money inside the EU have not only been abolished, but have been permanently removed by international treaty. Firms and individuals can hold their money wherever they like, and can (in theory) borrow from banks in any currency.
This will have several effects. One is that there will be a rapid spread of new monetary instruments into countries where retail banking services have been relatively primitive, including Germany. This will render the relationship between old-style monetary instruments (German M3, for instance) and other economic variables, such as inflation, increasingly unstable. This will apply across the whole union, but it will be especially annoying in countries that have not so far experienced the problems for monetary policy that can follow a revolution in the financial markets.
Even more irritating for the national central banks is the fact that the money stock of any individual economy will be subject to considerable disruption as people shift funds between different currencies to take advantage of small changes in interest rates and foreign exchange rates. This will mean that national monetary data will become devoid of importance as the private sector switches its money holdings between union members.
There is plenty of evidence that this is happening already. Recent studies have established quite clearly that the relationships between money growth and national income have broken down within many individual countries, but have survived quite well for the EU as a whole.
This would suggest that currency substitution between member states may already be having important effects. It is, for example, conceivable that the recent strength of M3 growth in Germany may have occurred because the private sector across Europe has switched into marks following the widening of ERM bands last year. If so, it may be right for the Bundesbank to ignore at least part of the monetary overshoot.
All this suggests that close integration of monetary policy, possibly even monetary union, may be a necessary corollary of the single market in financial services. How ironic it would be if the Bundesbank found that it could in future implement its preferred methods of monetary control only in a European context.Reuse content