EMU outsiders will not be free agents
Sunday 14 April 1996
As a result, this has become an important weekend for the future financial system of Europe. The meeting of European Union finance ministers and central bankers taking place in Verona is supposedly "informal" but there is some serious thinking to be done about the relationship between the currencies that do take part in a single currency and those that do not.
However justified British scepticism of the project might be and however distant the possibility of even a handful of European nations meeting the Maastricht convergence criteria, the fact remains that the plan- ning for a single currency is proceeding apace. Both the institution which is supposed eventually to become Europe's central bank, the European Monetary Institute, and the commercial banks across the Continent are busy working out not just the constitutional arrangements under which the central bank will operate, but also the practical details of timetables, re-programming computers, minting the currency and so on.
But as this great tide of preparation rolls on for the insiders, there has been very little thought about what will happen - if anything - to the outsiders. We assume here that ourselves and the Danes will probably exercise our opt-outs, and that however far the criteria are bent, countries like Italy, Spain and Greece, will not qualify. So there will be a large number of outsiders. But we also assume that we will be able to carry on as we do at the present, with membership of the ERM suspended, and therefore absolutely no external political control over our interest rates and exchange rate. (One has to emphasise the word political because there is, of course, substantial practical control over both from the financial markets, but this is driven by economics.)
This comfortable assumption, that nothing need change for us, is almost certainly wrong. Some kind of mechanism, call it surveillance, call it monitoring, call it just co-operation, will have to be put in place to co-ordinate the economic and monetary policy of the insiders and the outsiders. This does not necessarily mean a return to the old ERM, but it does, in all probability, mean less freedom than at present.
There is a range of views of what "less freedom" might in practice mean. At one extreme is the British one. This would mean some kind of loose co-ordination of monetary policy, with agreement perhaps on inflation targets, but allowing the different countries to meet those targets in whatever way they thought best. At the other extreme would be a series of trade sanctions imposed on EU countries which used competitive devaluation as a trade weapon, by allowing their exchange rate to depreciate and so boost their exports and employment at the expense of other EU members.
In practice some kind of compromise will have to be struck between these two extremes. Inflation targets would hardly be sufficient to ensure currency stability, particularly if there were no way of making sure that countries actually met them, while trade sanctions would be a more draconian measure than anything that has been suggested even for insiders. At the moment, countries which plan to be part of the common currency would be subject to fines if their fiscal policies diverged too far from the straight and narrow, but no-one has put forward ideas which would in effect lead to the break-up of Europe as a free-trade area. The fact that trade sanctions should even be talked about shows how concerned some people are about the danger of competitive devaluations.
Here in Britain this may seem hard to understand. Though we have been beneficiaries of the depreciation of sterling which has taken place since Black Wednesday, achieving faster growth and lower unemployment than any large European country and doing so without serious inflationary consequences, the ejection of the pound from the ERM was not a political choice. It was dictated by the financial markets against the government's wishes. Similarly the ejection of the Italian lira, which has helped Italian growth at the expense of French and German, was market-driven and contrary to Italian policy.
But if the effect in the UK (and to a lesser extent in Italy) has been to convince the business community that exchange-rate freedom is vital to national self-interest, the effect in France and Germany has been to increase the fear among business people of competition from low-exchange rate countries. I was told by the German plant-and-machinery manufacturers' association, VEBA, in Frankfurt ten days ago, that the greatest competition for German companies came not from Japan, the US or Korea but from Italy. Italian companies produced similar "bespoke" machinery and had gained ground sharply as a result of the depreciation of the lira. Actually the lira is now at its strongest level against the mark for 18 months, but the scars (and the competitiveness) remain. France would like to lock the lira back into the ERM at a rather higher level than at present, a view apparently accepted by the Italian government.
The key point here is that while neither the UK nor Italy has deliberately tried to depreciate its currency to gain competitive advantage, in practice both countries have been able to do so, and this has put enormous pressure on German and French industry. It is quite difficult for anyone sitting in Britain to understand the real fear now running through both Germany and France as both countries teeter on the brink of renewed recession. If things seem slowish here on the periphery of Europe, they are vastly worse at the core.
So what will happen? As far as one can judge at this stage - the Verona meeting does not end until lunch-time today - the finance ministers and central banks have agreed to disagree. There has to be some co-ordination of policy, but how rigid that will be is for the future. Just getting inflation rates more in line would be very helpful. The graph on the left shows how while average inflation in the EU countries is back to the level of the late 1960s, the dispersion of these levels is still higher than it was then. If you are worried about exchange-rate pressures, the dispersion is arguably more important than the actual level of inflation, for if everyone is inflating at the same rate, however high that rate is, there should be less pressure for shifts in exchange rates.
Setting targets for inflation, though, cannot be enough, for there is no point in having targets if the underlying policies are out of kilter. Here the Maastricht criteria for fiscal policy are a great help for they do set a bench-mark for the deficit; 3 per cent of GDP may be too high, but at least it is better than any large EU country at present achieves.
Contrary to popular opinion, however, fiscal laxity is not a peculiarly European problem. If you project government fiscal policies forward, and make the admittedly unrealistic assumption of no change in policies after the year 2000, Germany and France both face a more healthy fiscal future than the US and Japan (see right hand graph). The UK is a model of restraint.
One of the oddities of the Maastricht criteria is that they are only supposed to apply to countries at the moment of joining the single currency - just what they might do once they were inside has been rather glossed over. So a second useful way forward would be to set up some kind of Europe- wide mechanism for requiring both insiders and outsiders to run responsible fiscal policies - not just to qualify for EMU, but as a good thing in its own right.
If that sort of approach is developed in the months following this meeting, then we will look back on Verona as a turning point in European financial affairs. But if the trade-sanction advocates start winning the argument, then Verona will have been the start of an unravelling of free trade in Europe, maybe even an unravelling of the EU itself.
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