Stephen King: Joining the kind of club that would have us as a member

Unlike most clubs, once you're in the eurozone, the keys are thrown away and there's no easy way out
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The Independent Online

It's a shame that Gordon Brown didn't publish the results of his five economic tests yesterday because then it would have been a little bit easier to fill up this column. Moreover, there's little point in my speculating over what might be contained within the five economic tests or in the 18 supplementary papers. Let's face it, by the time you get round to reading this column, the results will either be known or you will be pacing the room, chewing your nails, smoking another cigarette, nervously anticipating the arrival of the tablets of stone from the top of the Treasury's mountain of econometric equations.

So, instead, I am going to ask a very simple question. What sort of club is the eurozone? At first sight, this might seem rather obvious: it's a single currency with a single central bank and, hence, a single interest rate. All of this we already know. But I want to delve a little deeper. Is it a club where its members are happy? Or is it a club with rules that may need to be changed? Is it a club where new members obey the rules of the existing members? Or will the new members eventually force change on the club itself?

There are good reasons for asking these questions. After all, if the UK joins at some point, it will need to know precisely what sort of club it's signing up for. Unlike most clubs, once you're in the eurozone, the keys are thrown away and there's no easy way out. So it would be rather useful to know what the rules are and how easy they are to change.

One key issue is whether the eurozone, in its current form, can handle the economic problems that will come its way from time to time. Often, economists tend to think about this question with reference to so-called "shocks". If there's an oil shock, for example, would Europe's policy makers be able to act in the appropriate way and would Europe's economies be able to cope? Perhaps. In my view, however, this is too simplistic an approach. I would rather consider a different kind of economic problem, one that is associated with how economies evolve over time.

In the 1950s and early 1960s, the main challenge facing policy makers was unemployment. Emerging from the scars of the Second World War and with memories of the 1930s Depression fresh in people's minds, full employment seemed like an obvious objective to pursue. And policy makers had the tools to do so: Keynes and others had told us to manipulate monetary policy and, should that fail, fiddle around with fiscal policy as well to ensure jobs for all.

The trouble was, as the population began to understand how the policy worked, behaviour started to change. If governments really could guarantee full employment, it no longer mattered whether wage and price increases were modest or excessive. Why worry if every false move would be bailed out by macroeconomic policy? Once this thought entered the collective consciousness of a generation, inflation began its steady upward creep. And, with it, the game changed. Suddenly, full employment was no longer the main objective: instead, low inflation became the key measure of policy ambition and success.

My concern today is that we may be at another of these turning points, when behaviour within the private sector has changed precisely because we live in a world of low inflation. My generation was brought up in a climate of unwanted inflation and may now think that the arrival of price stability means that all economic problems are now solved. You can't really blame people for thinking this: after all, the goal of price stability is enshrined within the Maastricht Treaty and it's the only thing that matters for the European Central Bank.

However, I think there are some serious problems with this view. First, inflation is not the only macroeconomic problem: in my edition of Keynes' General Theory, there are only seven page references to inflation within the index, yet this is a book that is over 400 pages long. Are we to think that Keynes was wasting his time in writing the book? Second, the "inflation is the source of all woes" view of the world seems to assume that there is a unique rate of inflation that is desirable for all times: but it seems to me that the choice of inflation target - often made in a fairly arbitrary way - can have a sizeable impact on macroeconomic performance. Germany, for example, may be a little less content with the ECB's current inflation target than, say, Spain. Third, if inflation is the only macroeconomic problem, it makes sense to have a truly independent central bank for all times. But if other problems arise - problems that may require the co-ordination of monetary and fiscal policy - current economic arrangements within the eurozone "club" could prove unsatisfactory.

If these observations are in any way accurate, they suggest that the rules of the eurozone will evolve over time. In other words, the club that the UK might be thinking about joining could be a very different club a few years down the road.

Some of the possible changes need not be particularly controversial and should cause little concern for the UK. One such change would be to ensure that the inflation target should be able to adjust for the range of members within the eurozone and their differing stages of economic development, a point I made in this column on 27 May. Although this might lead to a lack of clarity about the ECB's underlying economic objectives, it really should not be too much of a problem: after all, the Federal Reserve has a better reputation than the ECB within financial markets, yet has no inflation target whatsoever.

The more difficult area lies within the field of monetary and fiscal policy co-ordination. If you believe that monetary policy should be aimed at stabilising the macro economy whilst fiscal policy should be aimed at microeconomic supply-side reforms, then the case for co-ordination would appear not to be that great. However, if we enter a world of liquidity traps, helped along by excess private sector debt, the case for a co-ordinated macroeconomic response becomes a lot stronger. Yet, under current arrangements, it is difficult to see how the eurozone could achieve the necessary degree of co-ordination. Monetary policy decisions are taken at the eurozone level, whereas fiscal policy decisions are taken at the national level and are constrained by a set of euro-wide rules in the form of the Stability and Growth Pact.

If the need for monetary and fiscal policy co-ordination increases, there are only two realistic ways forward. Either monetary decisions are devolved to the national level or fiscal decisions are centralised at the eurozone level. In other words, either the eurozone breaks up or it evolves into a much more federal system. In contrast, the current system may not be a steady state when faced with new economic challenges.

Now, I'm not going to take a view as to which of these two directions is the more likely. Suffice to say that if monetary and fiscal decisions eventually need to be co-ordinated, the current eurozone economic arrangements may not last. Something will have to give. It will be interesting to see whether the Chancellor will have anything to say, either now or in the future, about how the eurozone's policy arrangements are likely to evolve, with or without UK membership.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com

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