The looming Euro crisis and how to defuse it

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John Major is perfectly right. There, I knew that would get your attention. Britain's much-pummeled Prime Minister was once again on the wrong end of a mauling in Madrid. He raised issues created by the highly probable two-tier European monetary system. All he got for his pains was to be called a "pessimist" by Helmut Kohl. Yet the concerns he expressed were real and justified. Indeed, assorted politicians and Eurocrats acknowledged as much in private.

The reason that he still got short shrift was twofold. First, his motives are suspect: warnings from a friend are one thing; the nitpickings of an opponent are another. Second, as someone said, "the trouble is that he isn't offering any solutions".

Of course, poor Mr Major cannot offer solutions. He has to keep the warring wings of the Tory party in suspended animation. Any particular solution is likely to trigger an uproar from someone. We can do better, however. Let's look at the problems that Mr Major correctly foresees and see whether any solutions suggest themselves.

The European Union and its plans for monetary union are drifting into an acknowledged crisis. The original Maastricht Treaty was insistent that the Union had to move in a convoy to monetary union. This plan has foundered and is giving way to a "variable geometry" or "a la carte" Europe with different states in and out of various circles of co-operation, including monetary union.

The original conception of Maastricht foundered on two rocks. One was the barely-suppressed hysteria of the German public at giving up the mark, the symbol of their post-war economic miracle. In an effort to assuage these feelings, German politicians have been insisting on tighter and tighter interpretation of the so-called convergence conditions for a country to take part in EMU.

The idea is that only states in very good order need apply because this new money has to be firmer than the mark. The conditions are now in a fair way to exclude all but a handful of countries.

The second rock was Germany's insistence (backed up by Britain in the role of trouble-maker) on admitting more countries from eastern Europe. Since those countries had no chance of qualifying for Maastricht, on any interpretation, the essential unity of the EU was sure to be lost.

Why should the Germans damage so seriously the Europe they love with these two demands? The first demand they cannot help. Public opinion is in revolt. The second demand was pure muddle-headedness.

European politicians have been intoning for so long that widening and deepening are not contradictory that they forgot it was nonsense. Of course it is. Only the British government acknowledged that clearly, but was happy to go along with widening because it does not want deepening, anyway.

The upshot will be a two-tier monetary system with some states in a common currency area and many outside. Now, suppose unemployment stays high in Europe. Suppose further that there is a shock to the system and many of the fringe currencies devalue.

Neither supposition takes much imagination. The French (who must be in the inner circle) get annoyed about "competitive devaluation" and slap quotes on Spanish and Italian farm imports. The Italians, already angry about being excluded from the inner circle, retaliate. The whole single market shivers to destruction.

Far-fetched? Not very. Historical patterns have a way of repeating themselves. Come the 2010s, Europe might look much as it did in the 1950s with a hard- core EU of five or six states and a free-trade Efta-ish fringe around.

It is not even clear that the French, for example, would care. They would have what they want: Germany tied into a West-European grouping with France.

If nobody else wants that, however, what to do? Mr Major implies monetary union must be postponed until everyone who wants to go in is "ready". But French and German politicians are afraid they will miss the tide for ever if they delay. Oh, dear. It sounds as if we need a fixed exchange rate system for countries left outside EMU.

The merest suggestion provokes howls of scorn: what about black Wednesday? Didn't ERM prove that adjustable peg systems are unstable with free capital markets? Maybe, but what's the alternative?

Moreover, ERM, like Bretton Woods before it, lasted about 13 years before cracking up. That might be enough to get the Germans over their DM-fixation.

What's needed is a bit of salesmanship. The inner core, the Euro currency area will be using the Euro. Everyone else will be on a Euro standard. As under the old gold standard, the other currencies will be backed by a reserve asset - then gold, now Euros.

In order to retain that backing, each country must respect certain "rules of the game". In effect its central bank would ensure that its liabilities were balanced by Euro assets and it would surrender its monetary policy to the European Central Bank. However, it would retain its own currency and, at the limit, the power to devalue - just as countries were always able to change the gold price of their currency.

If a currency came under pressure, domestic interest rates could rise very high, since the local central bank could not bail out the money market. The only alternative would be for the European Central Bank to tackle the speculation head-on by buying large amounts of the currency for Euros.

This it would do, so long as the country in question was meeting certain conditions. If the country's inflation was low, its foreign balance not too far in the red and the economy was not hopelessly depressed, the ECB should be ready to shoot the moon in defence of the fixed peg.

Since the ECB can supply as many Euros as the market may desire, that should be good enough. The point is the countries themselves are responsible for their own good behaviour; the ECB then shields them from de-stabilising speculation. What's the catch? Simply this. In effect, the ECB would be running monetary policy not just for the Euro currency area but for Europe, the Euro-backed zone, as a whole. That means it must look at indicators for the whole Euro zone, not just the ECA.

If it has a money supply rule it must be one for the whole Euro zone. Suppose, for example, the ECA money supply were growing fast but the weighted average money supplies of other Euro-based currencies were growing slowly, the ECB would have to smile and not tighten policy. Speculative movements out of sterling, peseta and lira into Euros would have just that effect, after all.

So the Germans cannot disembarrass themselves of neighbours such as the Italians by excluding them from the ECA. If Europe is to survive they must embrace them, anyway.

This does not mean that the Euro has to be weakened. But it must be run sensitively in the interests of the whole area and in discussion with associated central banks. The only alternative is free floating and a bust-up sooner or later.

You don't believe that German and French bankers will have the wisdom and breadth of vision to do that? I am not sure they have myself, which is why I used the word crisis.

The writer is director of the IPPR