Some parts of Europe will be stuck with the wrong interest rates

Hamish McRae ON the last chance for fine-tuning currencies

TIDYING UP or a taste of the problems and pressures to come?

You could say that the exchange rate mechanism (ERM) currency realignment at the weekend was simply a bit of fine-tuning ahead of the supposedly irrevocable decision on the currencies of the candidates for Economic and Monetary Union in May. Taken in isolation the realignment was a straightforward bit of common sense. The Greek drachma would have needed to be devalued if it were to become a credible member of the ERM club, given its weak record as a currency over the last couple of decades. So once the decision to join the ERM had been taken, the only way of establishing a central rate which would stick was to give it a bit of margin over the current market view and the 15 per cent devaluation seemed plausible enough.

In the case of the Irish pound, all that was done was to validate the market's view - the new central rate in the ERM, a revaluation of 3 per cent, is much closer to the rate the markets had independently deemed appropriate. It fits in, too, with the need to find some way of checking the booming Irish economy.

Of course in the short term it doesn't actually change anything to change a central rate within the ERM if the currency is already within the boundaries of the system. But if the market rate were well adrift of the central rate come May, when the euro conversion rates are to be determined, the conversion rate would have had to have been completely different from the central rate, or there would have had to be a devaluation of the Irish pound. Given the boom, that would have been completely inappropriate.

Just how inappropriate you can see from the top graph, which shows how domestic demand in Ireland has been rising at above 6 per cent since 1994 - higher even that Britain, which in turn has been growing faster than France or Germany every year since then. True, there was plenty of slack in the economy then (and there is still slack in the labour market now), but if there had been a devaluation there would have had to have been either an offsetting tightening of fiscal policy or higher interest rates.

The first would have faced obvious political objections, and the latter would have been impossible in the one-size-fits-all European interest rates that are the integral part of the single currency. In practice members of the euro-club will not be able to have different interest rates after May - in fact they cannot really have them now.

Apply the four-to-one rule of thumb that is sometimes applied to the UK (four percentage points on the effective exchange rate are equivalent to one point on interest rates) to Ireland. The rise in the Irish exchange rate that the markets have imposed and which has now been validated has therefore been equivalent to a 0.75 rise in interest rates - not enough, but a move in the right direction.

But this is the second last time that it is going to be possible to make this sort of adjustment. The final opportunity will come in May - and I would, incidentally, expect another revaluation of the Irish pound then. But once conversion rate are fixed, that is it. Obvious, yes, but astonishingly the policy-makers have only just started to think about the consequences of this, for it has become completely clear that parts of Europe are going to have a prolonged period during which they will have the "wrong" interest rates. Slightly over-simplifying, the fringe will have rates that are too loose and the core will have rates that are too tight.

Think about it. We know that countries are going to have the wrong interest rates. In what ways will this matter?

I suppose the starting point would be to say that we have had situations when countries have had the wrong rates in the past, either because governments (which used to fix short-term interest rates in those not-at-all-distant days when they told central banks what to do) made mistakes.

Here in Britain we had too low rates in 1986 and 1987 (see bottom graph) when we were shadowing the mark; then too high in 1990-91 when sterling was part of the ERM. With hindsight it was pretty stoopid to have lower rates in the late 1980s boom than in the early 1990s recession but there you are.

It is also true that you can have wrong rates for different parts of the country and even for different parts of the economy. At the moment we have interest rates that are more-or-less appropriate for the South of England but are too high for the North. We probably have too low rates for parts of the services sector, which is booming, and too high for manufacturing, where output is currently falling.

So even if you do run your own monetary policy you have no guarantee you will get it right. The problem, I suppose is that if someone else runs it (ie the European Central Bank in Frankfurt) you are guaranteed to have the wrong policy at various times. Members of the euro club will find that sometimes monetary policy will be too tight; sometimes too loose. And there will be nothing they can do about it.

The result will be that other policies will have to carry much more of the burden. To some extent economies are self-adjusting: people move to better job opportunities; those who are left gradually accept lower wages; costs in booming areas rise and start to choke off the excess demand. Expect over the next four or five years the fringes of Europe to boom and the core to decline, an interesting reversal of the trends for most of the European Union's history.

But there are limits to self-adjustment, particularly within Europe where cross-border migration is still quite limited. Much of the burden will in practice fall on fiscal policy - or so it is fashionable among economists to claim.

I have a problem here. I'm not sure that fiscal policy works very well any more. Governments cut taxes but instead of spending the money voters save it, as in Japan. Governments raise taxes, as they have done here, but we bound on regardless. We ran an enormous fiscal deficit in the early 1990s but the recovery did not come till they cut interest rates and let the currency go. The one-size-fits-all monetary policy puts an additional burden on fiscal policy just at the time when it appears to have become much less effective.

Teeth should be brushed twice a day to prevent tooth decay
Bryan Cranston as Walter White, in the acclaimed series 'Breaking Bad'
footballChelsea 6 Maribor 0: Blues warm up for Premier League showdown with stroll in Champions League - but Mourinho is short of strikers
Those who were encouraged to walk in a happy manner remembered less negative words
Arts and Entertainment
Princess Olga in 'You Can't Get the Staff'
tvReview: The anachronistic aristocrats, it seemed, were just happy to have some attention
Renee Zellweger as Bridget Jones
ebooksAn unforgettable anthology of contemporary reportage
Life and Style

Board creates magnetic field to achieve lift

There have been various incidents of social media users inadvertently flouting the law

Life and Style
Stack ‘em high?: quantity doesn’t always trump quality, as Friends of the Earth can testify
techThe proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?
Bourgogne wine maker Laboure-Roi vice president Thibault Garin (L) offers the company's 2013 Beaujolais Nouveau wine to the guest in the wine spa at the Hakone Yunessun spa resort facilities in Hakone town, Kanagawa prefecture, some 100-kilometre west of Tokyo
CSKA Moscow celebrate after equalising with a late penalty
footballCSKA Moscow 2 Manchester City 2: Premier League champions let two goal lead slip in Russia
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Helpdesk Analyst

£23000 per annum + pension and 22 days holiday: Ashdown Group: An established ...

Senior Helpdesk Analyst / Service Desk Co-ordinator

£27000 per annum + pension, 22 days holiday: Ashdown Group: An established ind...

Senior Pensions Administrator

£23000 - £26000 Per Annum: Clearwater People Solutions Ltd: Our client is curr...

Corporate Actions Administrator / Operations Administrator

£25 - 30k: Guru Careers: A Corporate Actions Administrator / Operations Admini...

Day In a Page

Indiana serial killer? Man arrested for murdering teenage prostitute confesses to six other murders - and police fear there could be many more

A new American serial killer?

Police fear man arrested for murder of teen prostitute could be responsible for killing spree dating back 20 years
Sweetie, the fake 10-year-old girl designed to catch online predators, claims her first scalp

Sting to trap paedophiles may not carry weight in UK courts

Computer image of ‘Sweetie’ represented entrapment, experts say
Fukushima nuclear crisis: Evacuees still stuck in cramped emergency housing three years on - and may never return home

Return to Fukushima – a land they will never call home again

Evacuees still stuck in cramped emergency housing three years on from nuclear disaster
Wildlife Photographer of the Year: Intimate image of resting lions claims top prize

Wildlife Photographer of the Year

Intimate image of resting lions claims top prize
Online petitions: Sign here to change the world

Want to change the world? Just sign here

The proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?
Ed Sheeran hits back after being labelled too boring to headline festivals

'You need me, I don’t need you'

Ed Sheeran hits back after being labelled too boring to headline festivals
How to Get Away with Murder: Shonda Rhimes reinvents the legal drama

How to Get Away with Murder

Shonda Rhimes reinvents the legal drama
A cup of tea is every worker's right

Hard to swallow

Three hospitals in Leicester have banned their staff from drinking tea and coffee in public areas. Christopher Hirst explains why he thinks that a cuppa is every worker's right
Which animals are nearly extinct?

Which animals are nearly extinct?

Conservationists in Kenya are in mourning after the death of a white northern rhino, which has left the species with a single male. These are the other species on the brink
12 best children's shoes

Perfect for leaf-kicking: 12 best children's shoes

Find footwear perfect to keep kids' feet protected this autumn
Anderlecht vs Arsenal: Gunners' ray of light Aaron Ramsey shines again

Arsenal’s ray of light ready to shine again

Aaron Ramsey’s injury record has prompted a club investigation. For now, the midfielder is just happy to be fit to face Anderlecht in the Champions League
Comment: David Moyes' show of sensitivity thrown back in his face by former Manchester United manager Sir Alex Ferguson

Moyes’ show of sensitivity thrown back in his face... by Ferguson

Manchester United legend tramples on successor who resisted criticising his inheritance
Two super-sized ships have cruised into British waters, but how big can these behemoths get?

Super-sized ships: How big can they get?

Two of the largest vessels in the world cruised into UK waters last week
British doctors on brink of 'cure' for paralysis with spinal cord treatment

British doctors on brink of cure for paralysis

Sufferers can now be offered the possibility of cure thanks to a revolutionary implant of regenerative cells
Ranked seventh in world’s best tourist cities - not London, or Edinburgh, but Salisbury

Lonely Planet’s Best in Travel 2015

UK city beats Vienna, Paris and New York to be ranked seventh in world’s best tourist destinations - but it's not London