Some parts of Europe will be stuck with the wrong interest rates
Hamish McRae ON the last chance for fine-tuning currencies
Tuesday 17 March 1998
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.
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