From devaluation to fiscal transfers
Thursday 06 July 1995
The fact that EMU has become the most divisive issue in British politics is bizarre. With the possible exception of Germany, the gamut of attitudes in other potential members of the single currency runs from broadly to hugely enthusiastic.
The explanation is unlikely to be merely cultural. It has nothing to do with the Mediterranean diet, although the kind of Britons who like to sip San Pellegrino and munch rocket salad are indeed those emotionally most likely to favour a common European currency.
So why do other countries with weak economies not worry about whether removing the chance to devalue will condemn them to perpetual high unemployment and slow growth? Take Italy, for example. Italians are on average a bit richer than Britons but the performance of their economy has in many ways been worse. It has stubbornly higher unemployment, higher inflation and a far bigger government deficit and debt.
But do Italian policy makers worry about achieving real economic convergence before entering a monetary union, as they sip their after-dinner sambucas? They do not. Instead, they embrace EMU as the only hope of escape from the unremitting decline of the lira and intermittent speculative attacks on the currency.
The Governor of the Bank of England would presumably regard this as Latin frivolity. In his Churchill Memorial Lecture in February, Eddie George worried that the longer-term problem of unemployment ranging from 6 per cent in western Germany to 23 per cent in Spain, reflecting structural features of the jobs market in different countries, would become more difficult to resolve within a monetary union. One method of adjustment - an exchange rate change - would have been removed.
The Governor concluded: "The important thing is that we should be confident that convergence is real and that it is sustainable before moving forward." His speech has been cited ever since by those who feel lukewarm about EMU but want to appear enthusiastic, or vice versa.
According to Professor Willem Buiter of Cambridge University, "The Governor's recent Churchill lecture shows he knows as much about economics as Churchill did."
In a new working paper, Professor Buiter says the notion of real convergence is a complete red herring. A flexible exchange rate can never help a country compensate for structural disadvantages such as a rapidly greying population, high non-wage labour costs or chronically low productivity.
He agrees that the possibility of devaluation would help adjustment to certain kinds of economic shocks. Allowing the exchange rate to fall would be more palatable than the alternative of lower wages and higher unemployment when an improvement in competitiveness is required.
However, flexible exchange rates make matters worse after other types of disturbance - think of the pound's over-appreciation after Margaret Thatcher decided to tighten monetary policy in the early 1980s.
With free capital movements, too, a floating exchange rate creates what Professor Buiter calls "a happy hunting ground for Mr Soros, who takes the world's most unsuccessful speculators, the central banks, to the cleaners on a regular basis". The excess currency volatility caused by hot money flows can certainly harm the economy.
Even in the limited number of cases where a fall in the exchange rate could ease the pain of adjustment, it is unlikely to have any long-term, lasting benefits for productivity or wealth.
The British experience confirms this. There has been only one devaluation in modern British economic history that has not been offset by higher inflation within a couple of years, and that was the pound's unceremonious plunge out of the exchange rate mechanism in September 1992. In all other cases higher inflation, brought about through rising import prices and transmitted to domestic prices and wages, has taken the real value of the exchange rate back to its earlier level in pretty short order.
Removing the possibility of devaluation as a safety valve in the cases where it would help could be offset by introducing alternative adjustment mechanisms. Labour mobility - famously recommended to northerners by Norman Tebbit during the early 1980s recession - is often cited as one possibility. This is unrealistic. Even within the US it does not attain the scale and reversibility that make it sensible to think getting workers on their bikes is a solution to regional recessions.
The realistic prospect is the use of fiscal transfers between member states. These might have to be fairly large but would not represent another permanent transfer of European Union funds to the high unemployment economies like Italy and Spain. They would be temporary, just as increases in domestic government budget deficits are a temporary response to a downturn in the business cycle.
The fact that transfers of cash between member countries are recognised as the most likely replacement for exchange rate adjustments offers the best clue as to why national attitudes to EMU differ so much. The chart below shows net payments to or receipts from the EU budget for individual countries and explains why the British might not be confident about relying on fiscal transfers as a substitute for the odd devaluation.
Despite having only the fourth-biggest economy, Britain is the second- biggest net contributor to the EU's budget, coughing up three times more than France gets away with. Italy hands over only half as much as us, and the other "peripheral" economies like Spain and Portugal are net recipients.
In particular, Britain is far less effective than its partners at getting handouts from the regional and social funds, which mainly go to high unemployment areas. No wonder other EU countries have more faith in fiscal adjustment. Britain's chattering classes are doubtless busy booking their summer holidays in Tuscany (cheaper than the Dordogne as the pound has climbed back at last to the level it held against the lira in 1985). They should chat to their Italian counterparts about how to turn the EU fiscal taps on. It might prove more enlightening than the domestic debate on a single currency.
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