Nailing down the arguments in the euro debate

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Britain is one of agroup of countries that hasto compete particularlyhard on price

Britain is one of agroup of countries that hasto compete particularlyhard on price

We have come a long way from the 1960s, when (at least in political legend) a bad set of trade figures could lose you a general election campaign. Today, Britain's external deficit causes barely a ripple on the smooth surface of satisfaction with our economic performance. So long as output is rising and unemployment and inflation are low, who cares if we consume more than we produce?

Steady on. That deficit does carry important signals, over and beyond the sudden misery of closing manufacturing plants. It is highly relevant to what is (or should be) the most important issue of this upcoming general election, which is whether Britain should abandon its own currency in favour of monetary union with its continental neighbours. Whatever Ministers say, this is not only or even primarily an economic question - how people want to be governed cannot be captured entirely on a profit and loss account. But given that the Government is determined to position the debate on economic ground, the economic argument certainly matters.

We can forget, or at least set aside, the Chancellor's "tests", which are too general to serve as anything more than a have-ready justification for whichever way he wants to lean. Rather more has been learnt from the light of experience with EMU, which has demonstrated that a single monetary policy can indeed cause trouble where different histories and institutional arrangements result in very different levels of inflation. However, work reported in the latest Economic Journal, by Wendy Carlin, Andrew Glyn and John Van Reenen, sheds interesting light on the other side of the same coin - the role of the exchange rate in our economic performance.

By joining the euro, what we would be giving up would be the national setting of interest rates in which (with the success of an independent Bank of England) we are currently taking so much pride. But what we would actually be abolishing would be the very idea of an exchange rate between our economy and our main competitors'. In the seesaw years since fixed exchange rates broke down at the end of the 1960s, two remarkably contradictory arguments in favour of fixed exchange rates have found supporters.

One is that currency movements have no long-term effects on competitiveness, and so exchange rates are just a useless and disruptive feature of economic life. The other is that currency movements are only too effective in enabling countries to steal competitive advantage from each other, so that the existence of exchange rates is destructive of the very idea of a single market and a permanent temptation to beggar-my-neighbour policies. (Neither of these arguments, incidentally, were relevant to the European Exchange-Rate Mechanism, a "moveable peg" whose advantage to the UK was that it provided an anti-inflationary discipline where domestic monetary disciplines had failed.)

The EJ authors have taken a long look at a group of developed countries, to see what explanations of their export performance stand the test of time. The period chosen - the 1970s to the 1990s - is one in which the pound was more or less floating for most of the time and exports more or less declining. At the end of the period analysed, Britain had a brief burst of sunshine, when exports rose following a sharp depreciation of sterling. But, as the first chart shows, things then went cloudy: at a time when world trade has been growing very rapidly, Britain's exports have done relatively badly, and the OECD expects them to continue to lag behind.

Since economic development brings more and more countries into the competitive frame, one would however expect any "old" economy's share of the global marketplace to shrink over time. However, the measure used in the EJ study avoids this difficulty, by focusing on the share of total exports by 14 developed countries only. And it is notable that, as the second chart shows, between the 1970s and the 1990s, Britain's share of the market for manufactured goods declined more sharply than the shares of any of its main competitors except Australia.

The really important question, however, is how much of this performance is explained by what was happening to costs, and how much to other factors, such as technological advance or other "quality" aspects. Export prices contain a bundle of different cost elements, which may be moving in different directions: namely, productivity, the price of labour and the exchange rate. All of these are captured within the measure of "relative unit labour costs" (RULCs). And the authors find that movements in RULCs do indeed explain a good deal of what has been happening to most countries' market shares - but by no means all.

This leads the authors into another paradox, which is the impact of technological change. Increased global competition is supposed to have made markets much more price-sensitive, and the EJ study finds clear evidence of this effect, particularly from the mid-1980s onwards. But at the same time, hi-tech industries seem to be much less price-sensitive, enabling their leaders to gain or maintain market share even while losing cost competitiveness in the global marketplace.

But the differences are important not merely between industries, but also between countries as a whole. Over the period under review, the outstanding example was of course Germany, which managed to gain market share even while its relative costs were rising. That is to say, the rise in the D-mark was not being offset either by wage restraint or by productivity gains. Germany's ability to surf ahead of its strengthening exchange rate has been frequently cited in Britain over the past few years, but there seems little evidence that we are capable of doing the same. Indeed, the EJ study suggests that Britain is one of a group of countries whose export performance is particularly cost-sensitive: in other words, that it has to compete particularly hard on price. Significantly, the authors point out, this group includes another notably eurosceptic - Sweden. In contrast, it finds that the core monetary union economies are all much less cost-sensitive.

The problem this raises is set out as follows. Much of the debate on monetary union has focused on the fact that members which cannot achieve "convergence" in the rate of growth of RULCs will suffer from higher unemployment, having lost the ability to correct these costs through a decline in the exchange rate. But if there are differing underlying trends in export performance, even such convergence may not save a member country from an increase in the dole queue. A weak export performer, particularly reliant on cost competitiveness, will need slower growth in wages than in other regions.

This is not, of course, an argument for a return to the bad old days in which Britain came to rely on a falling exchange rate to protect industry from the effects of its inflationary behaviour. Nor, indeed, even for an exchange rate "policy", explicitly absent from our current monetary arrangements. What it does suggest is that abolishing the ability of foreign exchange markets to contribute, however abruptly, belatedly or erratically, to the process of adjustment, would be a more dangerous step for the UK to take than it was for the core group of monetary union countries. Of course, this is not the end of the story. The nature and quality of our export performance changes all the time, and will certainly have changed since the early 1990s. But EMU is not, like the ERM, an adjustable peg. This study makes it look uncomfortably like a bed of nails.

Sarah Hogg is chairman ofFrontier Economics

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