Misplaced fears over competitive devaluations
COMMENT: `Any suggestion that the outs should be forced to fix their currencies within narrow bands against the euro, with punishments for those who fail to comply, is simply outrageous'
Monday 15 April 1996
Never has this risk been clearer than at the weekend, when finance ministers in Verona started to grapple with the problem of the ``ins and out''. The future EMU ins (notably France but also Germany) apparently agreed to impose a regime on the future outs (notably the UK, but also Italy, Spain and Scandinavia) that Britain sees as unnecessary, authoritarian and unworkable.
This problem was not foreseen when the Maastricht Treaty was drafted, since the belief then was that most countries would be in from the start, or at least that they would mostly be on a smooth glide path to imminent entry. The idea that the outs may be a semi-permanent club, representing at least half of the EU's GDP, only began to dawn last year, and even then the problem would have been largely ignored were it not for the fact that the economic performance of the outs was temporarily rather better than that of the ins. The ins decided that this must be stopped.
Their thinking is this. Membership of the single economic space confers huge advantages in terms of market access, free trade and potential economies of scale. But it also requires certain obligations to be accepted by all. These obligations, according to the ins, involve not only a common regulatory framework and free capital movements,but extend also to the behaviour of the exchange rate. The outs must not be allowed to indulge in ``competitive devaluations'' which bring them an ``unfair'' advantage in the single market.
This means that a new ERM mechanism (``ERM 2'') must be agreed, with the outs accepting that their exchange rates must be directly linked to the euro. There is talk of imposing fines or exclusions from the single market on countries which fail to comply with this obligation. Furthermore, according to Bundesbank president Hans Tietmeyer, the onus for keeping the exchange rates within their new bands against the euro should rest explicitly on the outs, since otherwise the new European Central Bank would have to accept a duty to prop up weak currencies, which could prove inflationary for the ins. In addition, he suggested that the initiation of changes in central parities should come not from the governments concerned, but from a ``supranational authority'', namely the head of the ECB.
Quite apart from inflaming British concerns about national sovereignty, there have been questions about whether any of this is legal. The UK has argued that access to the single market is an inalienable right of all member states, regardless of exchange rate relationships. But the French and others have pointed out that Article 109m of the Maastricht Treaty states that ``each member state shall treat its exchange rate policy as a matter of common interest'', and they claim that this gives legitimacy to their calls for an ERM 2.
The British are surely right about this, but in any case this is not a matter which can be settled in the law courts.The key questions are whether the ins have an economic case, and whether they are strong enough politically to impose their wishes on the outs. On both counts, the outs are on strong ground.
To start with the economics, there is something very odd about the position being adopted by the ins. Here is a group of countries, which conspicuously failed to make ERM 1 work in 1992/93, now seeking to impose ERM 2 on a completely different set of countries. What is more, the ins are simultaneously managing to argue that it is in their own vital interests to give up the right to devalue their currencies, while also maintaining that other countries will secure great national advantage by ``competitively'' devaluing against them. Surely both cannot be true.
Admittedly, this line of argument has been encouraged by the tide of events following the break-up of ERM 1 in 1992. Since then, competitiveness changes triggered by exchange rate devaluations have ``stuck'' for much longer than usual, in the sense that they have not been simply washed away by higher inflation in devaluing countries like the UK and Italy.
This is very unusual by past historical standards, but it will probably prove to be either temporary or an unrepeatable fluke. We have already seen a large rise in the lira this year, eroding much of Italy's earlier competitive gains, while sterling never moved far out of line with its fundamental equilibrium, at least as estimated by Goldman Sachs (see graph). So the old rule that changes in nominal exchange rates within Europe cannot bring about permanent changes in real competitiveness probably still applies.
And in any case, the outs are not staying out because they want to retain the right to devalue. Most will be committed to joining the single currency as soon as they attain the convergence criteria and are allowed in. Competitive devaluations will be the last thing on the minds of these countries.
Britain is in a different situation since, at least under the Tories, this country could well become a permanent out. But the important reason for staying out is not to enjoy the right to devalue the currency on a continuous basis. Instead, it is to maintain the right to adjust monetary policy independently of that being followed on the Continent. Certainly, this may involve the exchange rate going up or down for short periods as interest rates vary in response to economic shocks, but that is very different from seeking a permanent competitive gain from devaluation, even if it were possible.
There is no recent instance of a large nation, never mind the UK, deliberately engaging in a competitive devaluation in order steal export orders from its neighbours. Nor would the suggested ERM 2, at least with narrow bands, be at all likely to work in practice. Unlike ERM 1, where there was in principle a commitment from all countries to intervene as necessary to maintain the bands, the idea now is for the entire onus to be placed on the outs. Since it is obvious from the outset that the UK, among others, does not have the political will to maintain the bands, such a system would be a sitting duck for the currency speculators.
Perhaps something like the present ERM - with theoretical 15 per cent bands that nobody takes very seriously - would be just about an acceptable, though cynical, compromise to keep the ins happy. But any suggestion that the outs should be forced to fix their currencies within narrow bands against the euro, with punishments for those which fail to comply, and with no support from the ins, is simply outrageous. For once, the British government would be fully justified in using its veto to stop this.
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