EMU could be a Trojan horse carrying reform into Europe
Diane Coyle on the likely impact of the single currency
Thursday 26 February 1998
As Britain's presidency of the EU during the crucial six months for the decisions on EMU gets into its stride, it is clear that nothing short of a cataclysm is going to derail the single currency now. There will be intense scrutiny of the detailed convergence reports due at the end of next month, and much jockeying over the presidency of the European Central Bank and the Euro-X council, and copious amounts of market analysis of the conversion exchange rates. But too much political capital has been sunk, and too many businesses in Europe have spent real money on preparing for the launch on 1 January 1999, for it not to happen.
So the time has come for serious economists to stop pontificating about whether or not they think EMU is a good thing - heaven knows, there has been enough of this since 1992 - and turn instead to what impact it is going to have. After all, this is one of the biggest leaps policy-makers have ever taken, an economic experiment on a continental scale. Even the most apocalyptic pessimists must admit that it is fascinating.
The list of pros and cons the Europhile and Europhobic camps have put forward during the period of polemic is a good place to start with the analysis, however. Start with the benefits. As one of two new papers* from Merrill Lynch, the investment bank, points out, there is a powerful economic force driving the EMU project, namely the discovery among close trading partners that the cost of varying exchange rates has threatened the benefits of free movement of goods and capital.
Author David Miles, professor of economics at Imperial College and an adviser on EMU to the Treasury Select Committee, notes that many European governments have already given up independent control of their interest rates for this reason. Forming a single currency will further reduce the barriers to trade between members.
And what gains will this bring? Essentially, two. One is that the most efficient companies in Europe will be able to do more business, boosting economic efficiency in the EU as a whole. The other is that companies will be better able to exploit economies of scale. There is convincing evidence that the smaller scale of output in Europe explains a large part of the productivity gap between Europe and the US, as I described in a recent column.
One implication is that in the short term, EMU would provoke more consolidation and restructuring, with consequent pains of adjustment - a point also picked up in a recent UBS strategy circular to clients**. But in the medium term the scope for improved prosperity (because higher productivity means higher real wages) is immense.
Professor Miles says it is not the grandiose political goals such as making a European war forever impossible that are driving the single currency forward, but rather economic conditions. "They make a single currency for many European countries the best system," he writes.
The anti-EMU forces accept the scope for gains from increased trade and a genuine single market in principle, but argue that the benefits are likely to be swamped by the disadvantages of losing an independent interest rate policy. It is probably true that in many or most member countries the level of rates will be less suited to local economic conditions than before. This is why noted doubters like Eddie George, Governor of the Bank of England, would like to see more convergence in the underlying economic structures of the potential members before EMU goes ahead.
This argument usually fuels the view that the disparate behaviour of member economies struggling under the yoke of a common interest rate would lead to either the inexorable development of a federal Europe, with big tax and subsidy transfers between member countries, possible pressure for protectionism to defend Euroland against the outside world and ultimately the political union of Fortress Europe.
But the second of the Merrill Lynch documents notes that there is an alternative: that EMU will act as a Trojan horse for supply-side reforms that will make the member economies more similar. Richard Bronk, its author, argues that there is no political impetus behind this supposed process. Nobody in Europe has a big appetite for increasing the EU budget - rather, the reverse, as the prospect of admitting new entrants in central Europe draws closer.
Yet the EMU zone will lack the flexibility to adjust to shocks when exchange rates are irrevocably fixed. Governments, companies and employees would try to adjust in other ways. If competitive devaluation is ruled out, governments will have to try competitive structural reforms to make their industry more dynamic, their workforces more flexible. "EMU might represent a Trojan horse containing the forces of supply-side reform and deregulation."
This is, increasingly, the view of many economists and politicians in the continental European countries. They argue that Eddie George-style worries about structural differences between member countries are overdone because EMU itself will be the catalyst for convergence.
Excellent news, then, for those who believe that if Britain errs on the side of inequality and unfairness, then the Continent errs on the side of over-regulation and lack of competition. They will be clambering aboard the single currency Trojan horse. But this is not to say that it will be a painless process. In some countries there will be resistance to enforced flexibility, perhaps on the streets.
Just as with the other potential EMU benefit of increased productivity, there will be losers as well as gainers, even if the European economy as a whole stands to benefit. What's more, the start of the single currency will in itself constitute a big economic shock - just think of the fall- out from German unification, or from the shock-therapy of deregulation in Britain during the Thatcher years.
It might well be that eventual convergence will only follow a period of diverging performance by the member economies, depending on how much adjustment they have to make. This certainly does not mean the Eurosceptics are right, even if they are irrelevant. Sometimes long-term gains are worth short-term pain.
* Fundamental Economic Implications of EMU by David Miles, 17 February, and EMU: A Trojan Horse by Richard Bronk, February.
** Europe: The Big Picture by Mark Howdle, January 1998.
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