More going for EMU than against
The benefits of a single currency in Europe are likely to outweigh the disadvantages, argues Richard Freeman
Sunday 06 October 1996
An important speech in July by Howard Davies on the economic implications of the single currency went almost unreported in the press, for example. Economics is, after all, much less interesting than politics even though a little more edifying!
While there are aspects of European Monetary Union that are hotly disputed by economists both in the UK and in the rest of Europe, there is a growing consensus about some of the most important costs and benefits. There is still some way to go, however, on getting a consensus on where the balance lies.
Starting with the benefits of the single currency, there is little dispute among the experts that the elimination of transactions costs within Europe will be of considerable benefit for business. Tourists will also gain. It is easy to quibble about the size of the benefit, but it will undoubtedly be of considerable advantage to insiders. A gain of only 1 per cent of turnover is not to be sneezed at, and it is likely to be larger than that.
The second benefit is that the single currency will make prices more transparent across borders. That should promote competition and further economic integration in Europe. As a result, economic efficiency is likely to be improved.
Thirdly, the single currency, by getting rid of nominal exchange-rate variability, will reduce uncertainty. Businessmen dislike exchange-rate variability. Without it, trade should receive a boost providing an incentive particularly for small and medium-sized companies, which are currently discouraged from exporting by currency risks and high hedging costs.
The removal of exchange-rate variability is linked to the fourth potential benefit, an increased incentive to invest. Many surveys among businessmen have shown that uncertainty about exchange rates makes planning and investment decisions difficult. A single currency would remove that uncertainty.
It is argued that many firms include exchange-rate risk premiums in their hurdle rates of return for investment projects. With the removal of exchange risks, there would be an inducement to higher investment. There should also be lower nominal interest rates in the euro area than outside with the elimination exchange-rate premiums.
There is also a possibility that real interest rates in Europe will fall over time to provide a boost to investment. This potential fifth benefit comes from the greater price stability that is widely expected as a result of the conduct of economic policy.
Monetary policy in the euro area will undoubtedly be conducted Bundesbank- style, aimed at ensuring sustained low inflation. Over time, this should result in greater price stability than in the past in some European countries from the start. While outsiders can and do pursue similar monetary policies, the policies in the euro area are likely to have greater market credibility for some time ahead.
The management of fiscal deficits should also be beneficial to stability. Already a number of countries are attempting to put their fiscal houses in order. When they have done so, the Stability Pact, when agreed, should ensure that public-sector deficits do not get out of hand and endanger price stability.
The final potential benefit of the euro is that it could be widely used as a reserve currency. This would act to reduce further exchange-rate risks for countries in the currency's area and there would be income to the central bank from its holdings of euro.
What then of the potential economic costs of the single currency? On these, there is also considerable agreement among experts, but not on their size.
The most important economic cost is the loss of the exchange rate as a means of adjustment to the economy. There will almost certainly be disruptions in future that have different impacts in different countries. To offset the effects on employment and output, countries in the euro area will need to rely more on fiscal policies than in the past, which may be difficult. Greater flexibility in fiscal policies than now envisaged could be essential.
The other costs are mainly transitional. Of these, the costs associated with the Maastricht criteria, particularly the public deficit and debt criteria, are important. In terms of slow growth and unemployment, the costs have been sizeable.
The other transitional costs relate to the technical aspects for governments and companies in switching to the euro. While significant in the short- term, they are not a serious argument against the single currency.
Where does the balance lie between economic costs and benefits? lt is impossible to quantify, but my view is that the balance is in favour of the benefits.
Richard Freeman is corporate chief economist at ICI
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