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European Monetary Union

by Michael Newland

Britain's main political parties are placing increasing pressure on the electorate to accept entry into the group of European countries which are currently abolishing local monies and introducing a single currency.

Despite such a move being the greatest political and economic decision taken in generations, most members of the public have only the haziest idea what is involved. There are two reasons for this, one good and one bad. The bad reason is that the main parties would rather the public did not look at the matter from a too well-informed position. The good reason is that the economic side of the matter is complex, and even professional economists cannot agree on the outcome. The purpose of this article is to lay out the basics.


The political aspect of the single currency issue may rapidly be disposed of.

At the Messina Conference of 1955, European nations agreed formally to embark on a project of political and economic unification, which had been planned since shortly after the war.

It was well understood by the founding fathers of the project, Robert Schuman, the French Foreign Minister, and Jean Monnet, that this would mean, eventually, an almost total loss of national sovereignty - something which would be unacceptable to Europe's peoples.

Thus a strategy was discreetly formulated of making the erosion of sovereignty a gradual process. Most steps in that direction would be so small that - it could be argued - only the churlish would object. Overall, the strategy was denial of the objective - witness Sir Edward Heath during the 1970s.. The technique relied partly on 'directives' under which participant countries would be required to alter their laws at the behest of the union, rather than having regulations directly imposed on them. Thus, a certain illusion of being in control of events could remain with individual countries.

One day the nation states would awake to find that their self-determination had gone. The process has been compared to tying down Gulliver. Each thread could individually be easily broken, but, once sufficient threads had been tied the victim would find himself immobile. There is even a technical term for it in Eurospeak - 'neo-functionalism'. No wonder the Europhile Michael Heseltine said that government cannot tell the truth about the project! The claimed economic advantages are routinely talked-up to distract attention from the main objective.


One step in the process could not be carried out in minute stages however - the introduction of a single currency. The process could certainly be broken down into stages, but they would individually be major in themselves. The Maastricht Treaty of 1991 proposed the fixing of exchange rates, before the single currency itself would be introduced. It is the necessity for major steps to be made at one fell swoop which has pushed the whole affair into the forefront of political debate. Europe was regarded by voters as something of a yawn until recently.

The reaction to the problem of gaining public acceptance, when advancement to integration could no longer be undertaken by stealth, was met by politicians in two ways, until about 1994. The first was to claim that a single currency would have little effect upon everyman beyond removal of the inconvenience of changing monies at Dover. The second was to suggest that the affair was of such complexity that it was best left to experts. 'Just leave it all to us' said the surgeons before lopping off the wrong leg! Indeed, information on the pros and cons was hard to come by - no accident the conspiratorially minded will say. At the time of Maastricht it was difficult even to come by the text of the treaty!

The single currency project, like most economic policy making, involves weighing up the positive and adverse effects of the policy and deciding whether advantage outweighs disadvantage.

For example, if government tries to bring down unemployment it may have to face excessive wage claims which necessitate bringing the experiment to a shuddering end. The advantages of a single currency are essentially two - removing the costs and inconvenience of changing monies when trading across national borders, or travelling abroad, and avoiding uncertainty about how much one's goods will fetch or cost if one imports or exports products. The disadvantage is inability to alter exchange rates or 'parities' as they are often termed.


In 1944, the leading countries covenanted to establish a system of broadly fixed exchange rates between their monies known as the Bretton Woods system after the place in New Hampshire where the agreement was made. However, separate currencies were retained by the various countries involved - the pound, dollar and so on - and if a country's exchange rate became permanently out of line with the relative costs of its goods relative to other nations - the big disadvantage of fixed exchange rates or indeed a single currency - then an adjustment to the exchange rate was permitted. That is what happened in 1967, when Britain substantially devalued the pound.

The then Prime Minister, Harold Wilson, made at the time his famous remark about 'the pound in your pocket' remaining the same in value. This was a proposition economical with the truth to say the least since the pound would no longer buy so much in terms of imported goods - more than a quarter of what we consume.

The intention of the Bretton Woods system was to make investors and traders confident about trading and investing abroad without the disadvantage of a single currency, in that any adjustment to exchange rates becomes impossible - the best, in fact, of both the worlds of fixed and constantly variable exchange rates.

The Bretton Woods system collapsed during the early 1970s, partly as a result of the US having persistently taken advantage of its position by issuing a currency everyone wanted - the dollar. The US could acquire goods simply by printing money, but at the expense of inflation in other countries! It was thought at the time that abandoning fixed exchange rates between currencies - termed 'floating' in economist's jargon - might mean constant small adjustments automatically made by market pressures which would avoid having to make the occasional large adjustments which took place under Bretton Woods.

Unfortunately, at around the same time, controls on speculative movements of money were abandoned, and exchange rates began often to move around wildly, spreading distress far and wide. The view taken in Europe became that it was impossible to return to reasonable stability of exchange rates unless different monies were abolished. The alternative of blocking movements of money not directly involved in trade was rejected as a barrier to investment, although debate about this issue has been regenerated by the collapse in Far Eastern economies towards the end of 1998.


Thus, impetus was given to a scheme for European countries to form a single currency - European Monetary Union or EMU. The argument put forward is that the advantages of removing gyrations in the exchange rate outweigh the problems when a country's costs and prices becoming sufficiently different to its trading partners for its trade to be unbalanced - either buying more than it sells or the reverse. If advantage outweighs disadvantage among a group of countries the area is termed by economists an 'optimum currency area'. The big question for Europe, at which we now arrive, is whether the countries of the European Union, and in particular Britain, constitute an 'optimum currency area'.

In a perfect world, the price level of wages and the cost of goods and services would be completely flexible. If a country were purchasing more goods from abroad than it imported then, by simple supply and demand, the price level in the country whose sales were disappointing in quantity would fall until a balance was achieved. In practice that does not happen to the degree required. Workers are reluctant to reduce their wages since their standard of living will fall.

That is what happened when Britain restored a system of fixed exchange rates during the 1920s at much too high a rate. In such circumstances, trade can only be made to balance by imposing a recession. If unemployment increases then less goods will be bought from abroad, while sales will be largely unaffected. The same thing happened when we joined the European Exchange Rate System (ERM) in 1990 at too high a rate. The cheers soon turned to tears, and, within two years, the project was abandoned and the economy began to recover.

The position of a country with too an high exchange rate is known as the 'Meade Dilemma', after Britain's Nobel Prize-winning economist James Meade. If government tries to increase employment then the trade balance worsens. If it improves the trade balance then unemployment worsens. That is one of the major reasons why fixed exchange rate systems have a history of collapsing. The political pressures on governments faced with a contest between meeting the terms of external agreements and dealing with a society where mass unemployment may eventually bring their downfall are intense.

Of course, the problem can initially, and in theory, be avoided by choosing the right exchange rate at which to join up to a fixed exchange rate system. Unhappily, the other countries involved may not agree. Some may wish to force agreement on a rate of exchange which gives them an advantage in selling their goods. Japan is an example of a country which has tried to maintain a low exchange rate, outside any fixed exchange rate system, to ensure booming exports which will compensate for a low level of demand at home. The choice of exchange rates between the world's countries has a strong political dimension.

Even if agreement can be reached on the perfect exchange rate that is not the end of the matter. It is very likely that different levels of inflation in different countries, or changes in the level of demand for goods which a particular country specialises in producing, will, before long, need a change in exchange rates impossible in a single currency system. Britain, internally, has a single currency and whole areas of the North of England have suffered prolonged decline as a result, for example, of a shift in demand for coal relative to other products and services produced elsewhere. Another example is Italy, which, after a century and a half of the lire, is almost two countries economically to an extent that there is a separatist movement in the more successful northern half.


There are two ways in which such adjustment problems can at least be partially dealt with within a single currency, and therefore by definition fixed exchange rate system. One is for workers in the high unemployment areas to move to successful regions. That is difficult enough within a single country with the same language, although some nations to a greater degree than others accept migration as a part of the pattern of working life. The United States is such a country. Mass movements of population around Europe are far more difficult owing to the language barrier. Jobs increasingly require skills involving verbal and written communication, and few of us are multi-lingual.

The second method is simply for the more successful areas to subsidise the weaker areas as, for example, occurs via the tax system within the United Kingdom. The unemployed draw benefits paid for by those working in other areas. The European Union's MacDougall Report suggested that all of us would have to contribute 10% or more of our incomes to a central fund to make a single currency tolerable. At the moment, the EU budget amounts to not much more than 1% of what we produce as a continent. Enlarging such a fund to the degree needed would meet considerable political and taxpayer resistance! There is also the difficulty that poorer areas become dependent on handouts and fail ever to restore their local economies. Under a single currency smaller and weaker countries or regions may drift into this position. Southern Italy is an example.


There is an argument that the outcome of economic processes cannot be altered by monetary means. The doctrine, known as 'monetarism' regards money as merely a veil on economic activity.

Monetarists will say that the ability to alter the exchange rate is largely worthless. Prices will rapidly adjust to restore the original relative values of goods and labour. A country which devalues its currency to sell more will simply provoke inflation and end in much the same position. Such a prediction was much offered after the UK left the ERM in 1992 - and proved false. During a massive recession people will accept a small loss of earning power if more jobs are available. Practical experience suggests that devaluations may not be a permanent answer to the problem of balancing trade, but they do at least provide a window of opportunity during which investment is encouraged in new plant, which will allow a better trade-off between unemployment and paying foreign debt. Economists call such changes 'structural'. A single currency, by definition, would not allow this escape route.


Those who say that countries can live with permanently fixed exchange rates will sometimes point to the existence of such a system during most of the latter part of the 19th century and up until the First World War. The arrangement was called the 'Gold Standard', and fixed the values of all currencies in terms of gold, which has historically tended to retain its value over long periods, thus giving confidence in paper money. The system only broke down as a result of the First World War. We mentioned earlier the attempt by Britain to go back to the old system during the 1920s.

If the Gold Standard could work for a long period then why not take the extra step of abolishing separate currencies? The question is then did it really work and if so how? The answer is that, until after the First World War, unemployment was not a primary political concern. It was generally believed that joblessness could only occur if workers demanded too high wages - what economists call 'classical unemployment'. The jobless were generally seen as the feckless poor. The system also vigorously dealt with trade imbalances by one of today's big economic no-noes - tariffs on imports.


Our discussion so far has focused largely on the problem of balancing trade to avoid a level of foreign debt which eventually becomes unsustainable (this outcome is likely to hit the US at some point owing to its trade deficit). There is a second difficulty within a single currency area.

In the 'Meade Dilemma' situation, a country did, in theory, have some leverage over the level of demand and thus unemployment. The two main ways in which government can regulate demand is to alter the rate of interest at which the central bank will lend money, and to borrow and spend. Adjusting the central interest rate tends to affect the general level of interest rates like, for instance, overdraft charges, with consequent effects on spending. Government borrowing and spending directly affects the level of demand, and has particular advantages in that it can be directed away from imported goods and, often, towards desirable investment rather than consumption.

In a European single currency the interest rate will be set by a single central bank. If different countries do not have their economic cycles synchronised then, for example, the interest rate may be set to dampen demand in a booming country or group of countries, leaving those in recession stuck without one major means of stimulating demand. Even more perverse, if one country's inflation rate is higher than another, and its economy is running out of control, then the interest rate, after allowing for inflation, will fall making the situation worse. The reverse will apply to a country in recession. Britain's economic cycle is not synchronised with those of France or Germany, for example - both were about to enter an upturn, until the late 1998 world shock, while Britain is set for a downturn after the miniboom in some areas during the last year or two.

That leaves government borrowing and spending, or 'fiscal policy' as it is known, as the remaining instrument usable when a single country suffers recession. Under the Maastricht agreement, governments are barred from using fiscal policy to more than a very moderate extent. The reason is a fear that any particular country which makes use of the fiscal weapon will force up interest rates generally throughout the EC, to the disadvantage of other members. A country in severe recession will be stuck!


The principal purpose of the single currency is political, but it has also profound economic effects. Ability to alter a country's exchange rates provides a means of altering relative prices across countries without relying on individuals within the countries making those adjustments. This second line of defence allows countries which cannot keep trade with their neighbours in balance a means of making the necessary changes over a period with the minimum pain. Complete inability to adjust exchange rates, as in a single currency, is likely to spell prolonged recession for some areas, and probably permanent decline. This can be partly obviated by mass movements of population, and massive transfers of tax revenues away from the more successful areas. There are advantages in a single currency - certainty about prices when trading and the removal of the costs of changing monies.

There is no very simple manner of presenting the maze of economic complexities involved in a single European currency, and it this fact which has eased the path of those who wish to introduce it. A bored public - if not media - will feel less disinterested in the economic counundrums when the results begin to come through in years to come.

Drama lies ahead.

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