A single life after the ERM: Quentin Davies rejects the 'hard' ecu, but sees monetary union as inevitable

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THE headline 'ERM crisis - the end of monetary union' seems to be the almost universal verdict in this country on the foreign exchange crisis of the past two weeks. Two very different conclusions are drawn. Eurosceptics declare with glee that the 'dream' of Maastricht is 'dead' and a new era of floating exchange rates in Europe is about to dawn. Euro-enthusiasts try to salvage something from the wreckage by relaunching the concept of the hard ecu.

The hard ecu differs from the current 'basket' ecu in being a new currency. While the present ecu is a weighted average of the various European currencies, the hard ecu is fixed to the strongest currency of the time. So the hard ecu is the 'best' European currency, not the average one. It can only go up against other EC currencies. Its anti-inflationary credentials are impeccable, and it could be a very effective additional discipline for European central banks, and a useful adjunct to the Maastricht criteria for convergence within the EC.

But precisely because it is so 'hard', the ecu is unlikely to be much used in commercial transactions or prove in any way a substitute for monetary union. Every supplier would love to have his contracts denominated in a currency that can only appreciate against his own between the time he quotes and the day he is paid - a one-way bet to additional profit. But equally no customer would willingly accept a one-way bet to unquantifiable loss. And the trouble is that in any normal deal in competitive markets it is the customer who specifies the currency in which he will deal. If the existing 'basket' ecu has been little used in cross-border trade, its 'hard' cousin will be even less so.

In any case, the basic assumption behind both British reactions is seriously flawed. The 'dream' of Maastricht is far from 'dead'. The crisis may actually strengthen the determination of our Continental partners (and Ireland) to create a single currency. There are three reasons why.

Firstly, the great irony of the ERM is that there is no reason on fundamentals (the essential fundamentals being inflation rates, inflationary expectations and productivity levels) why Germany, France and the three Benelux countries should not form a single currency tomorrow morning. There is equally no reason on fundamentals why they should not be joined on the same day by Denmark, if it so wished, by the first-wave applicant countries to join the EC - Norway, Sweden, Finland and Austria - and by Switzerland.

Foreign exchange crises are costly - invariably financially (because of the costs of intervention), certainly economically (because of the risks and costs they impose on business) and probably politically. This crisis could have been avoided by monetary union.

Second, the ERM crisis has highlighted the absurdity of the Bundesbank's position. Because of its great monetary credibility it has become de facto the central bank for the whole Community, establishing a floor for interest rates throughout Europe. Yet this de facto central bank, whose decisions have so direct an impact on the lives of all Europeans, remains de jure a purely German institution, permitted by its statute to take account only of conditions in Germany.

The obvious remedy is to create an institution on the model of the Bundesbank but with explicit responsibility for the Community as a whole. This is another important element in the Maastricht treaty - and one arguably made more, not less, relevant and urgent by recent expensive crises and recriminations.

Third, we have to ask about alternatives to monetary union and a single currency. If the hard ecu is not a serious runner, there is only free floating or some halfway house between the two. Neither is remotely satisfactory.

Free floating is an attractive idea - at least in theory. The trouble is that to remain attractive two elements of reality have to be abstracted from the model. First, no business involved in cross-border trade can entirely hedge its exposure to foreign currency risk, and such risks will always deter a significant amount of trade and investment. Output, employment and wealth will be foregone. Moreover, hedging, even if never entirely effective, is costly. And transactional costs remain - the margin taken by banks in converting currency, the costs of clearing foreign currency cheques and so forth. All these amount to a tax imposed by the banking system on every foreign currency transaction. Again, trade, output and wealth are sacrificed.

Second, governments in practice never have allowed free floating - and never will. The intolerable risks and burdens that foreign exchange volatility imposes on businesses mean that no government can ever be disinterested in the parity of its own currency for very long. And if an individual government did so, its currency would fall victim to other governments' proactive intervention policies - hardly an acceptable position for any responsible government to take.

So we are left with the halfway house. The managed floating of the Seventies, the flexible ERM of the Eighties which we did not join, Nigel Lawson's informal exchange rate policy of the late Eighties, the fixed ERM of the Nineties, were all halfway houses of a kind. Such expedients have always ended in tears. They always will. The relative values of separate currencies will, by definition, always at some time diverge. If their parities were genuinely fixed 'irrevocably' they would in fact have become a single currency. Any attempt to 'manage' a parity, or foreign exchange markets as a whole, whether informally, formally, or otherwise, will always end in the classic foreign exchange crisis.

The only other option, establishing a single currency in Europe, or in a part of it, is not a venture to be undertaken lightly. It requires careful groundwork, and difficult issues have to be resolved. No one would guess it from last week's media, but much progress has already been made in resolving them.

The costs of exchange rate volatility are very great and it is no accident that the periods when international trade and prosperity have grown fastest have been those of greatest currency stability - the era of the gold standard, and again in the Fifties and Sixties. But the economic costs of government policies designed to stabilise their currency's parity are probably incalculable - apart from losses on intervention, an unnecessary inflation or recession can be induced which may last for years. Are we condemned to go on relearning these same expensive lessons for ever?

There is a better way - at least for countries in a single market that have achieved a high degree of real convergence of their economies. It will probably not be long before it is taken.

The writer is Conservative MP for Stamford and Spalding and a former head of European Corporate Finance at Morgan Grenfell. He is secretary of the Conservative Backbench Finance Committee, and a member of the Commons Treasury Select Committee. He writes in a personal capacity.

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