One size cannot fit all in the new euro-zone

Monetary policy will inevitably be wrong for some parts of the European economy
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The Independent Online
IF THE GREAT dilemma of British economic policy is the need to cope with the two-tier economy - services still racing ahead and manufacturing in recession - could not that become a wider dilemma for policymakers everywhere? Does, for example, the new European Central Bank set interest rates to suit the countries which have relatively large manufacturing sectors or those which have relatively small ones? Is it possible to make a choice, anyway?

The starting point is to see just how different apparently similar economies are. The balance between agriculture, services and industry in the G7 countries is shown in graph - but showing percentage of employment rather than proportion of GDP. So it is looking at jobs rather than at economic activity. The figures are all heading in the same direction, for services dominate everywhere. Nevertheless the differences are still surprisingly large. In the US and Canada services are over 73 per cent of total employment, whereas in Germany and Italy they are still under 60 per cent. Industry still employs nearly 38 per cent of Germans, but under 23 per cent of Canadians and just 24 per cent of Americans.

Is this already affecting policy? I can't prove it, but I think to some extent it does. In the US monetary policy is set without explicit reference to the needs of industry, and interest rate decisions are not subject to pressure from industry lobby groups. The sort of response that greets any change in interest rates here, with the CBI welcoming falls in rates and criticising rises, is almost entirely absent in the US. Instead rates are set with general reference to inflationary pressures, including pressure in the labour market. What happens to the dollar is a factor, but not one which seems to figure large in the equation.

So I suppose one could say that the US Fed seeks to push interest rates in a direction that suits the service-oriented nature of the US economy, and the structural changes that take place in industry are seen as beyond the Fed's proper control. If a high dollar means jobs go to Mexico, so be it.

By contrast, in Germany the exchange rate is very important in Bundesbank decisions. The main guideline remains the growth of money supply, but the exchange rate is an important secondary factor. When the mark is weak its importance lies largely in its impact on inflation: the Bundesbank does not like an over-weak mark because of the way in which higher import prices feed through to domestic inflation. When the mark is over-strong, the Bundesbank does take the needs of German industry into some account. True, many German companies believe it does not pay them enough attention, but their problems are certainly taken on board and figure in the discussion.

Here, they figure very much in the discussion, even though the proportion of employment in industry is much closer to North American levels than it is to German. Indeed I think it is now pretty clear that excessive attention to the supposed needs of industry by the previous Chancellor held down interest rates for too long and therefore exacerbated the dilemma now. Had Kenneth Clarke sanctioned an earlier rise in rates this would have shaved the top off the service boom and so lessened the need to raise rates this spring. By going for the short-term interest of manufacturing we ended up damaging the long-term one.

But if we have a dilemma here, the new euro-zone will have a much greater one. A single monetary policy will have to encompass the needs of the Netherlands (23 per cent of employment in industry), Ireland and Belgium (28 per cent) and Finland (27 per cent), as well as those of Germany's 38 per cent. It so happens that these high-service, low-industry nations tend to be booming while the economies of the high-industry ones like Germany and Italy seem relatively slack.

We see the problem of the "one-size-fits-all" monetary policy in terms of countries being at a different stage of the economic cycle - a core/fringe problem - but it is also a function of countries having a different balance between manufacturing and services. Manufacturing will always be more affected by external shocks, in particular the rate of growth of world trade, than services, where demand tends to be internally determined.

This leads, however, to a further complication, in that the service sector is a great catch-all, some parts of which are directly and immediately affected by changes in interest rates and the exchange rate, and other parts of which are relatively immune. For example, the French service sector is skewed towards tourism, an industry which is notoriously sensitive to exchange rates. The UK's is affected by our large surplus on foreign interest and dividends, which vary immediately and directly in sterling terms in response to exchange rate changes but do not vary much in dollar terms.

The UK is not in Emu so that does not matter for the time being, but Belgium is, and Belgium has a large service sector (just under 70 per cent of employment) which is relatively immune to exchange rate changes because much of it is in the public sector. So measures appropriate to, say, the Dutch service sector, will not necessarily be right for the neighbouring Belgian one.

So a new European Central Bank will not only have to cope with countries at a different stage of the economic cycle - that will presumably decrease over time as the cycles are brought into sync. It will have the continuing problem of some industry-dependent countries and some service-dependent ones. And it will have to recognise that the service-dependent countries are all different.

Or at least it ought to. Will it? I cannot see how it can. The European economy is so diverse that monetary policy will inevitably be wrong for some parts of it. I suspect that even though the European Central Bank is located in Frankfurt, it will set its policies to fit the dominant service side of the European economy rather than the still-important manufacturing one. Policy will have to fit in with the big numbers of demand and that will inevitably be dominated by services. The result of that will be continuing and growing frustration by manufacturers that they are getting the "wrong" policies. In other words the sort of frustration vented here by the Confederation of British Industry will become much more widespread across Europe.

If this is right, the current British dilemma will become a recurring European dilemma. We are getting a glimpse of things to come.