EUROPES SINGLE CURRENCY
Ready or not, here comes EMU
B R U S S E L S
The question is no longer whether or when EMU will happen. The question is whether Europe is prepared for the euro it now seems almost certain to get
EUROPES leaders settled on their plan for monetary union in the treaty they signed at Maastricht nearly six years ago. This is the European Union, so it would have been rash to count on the plans being implemented just because governments had promised it would beand for most of the six years an air of unreality surrounded the venture. It was widely assumed (especially in Britain, but not just there) that somehow it would never happen. Even this summer there was talk of postponement; flutters of anxiety were detected in Germanys government, whose determination to see the thing through is essential if the project is to go ahead. Now, all this has changed. Almost everyone accepts that EMU will start on time on January 1st 1999.
Nothing in life is certain, least of all plans as bold as this. Why then has the mood changed so sharply? Perhaps that earlier hesitation was seen as the last opportunitypainful as seizing it would have beento postpone or cancel. As it turned out, Chancellor Kohl never wavered. When the EUs finance ministers met last month they did not even discuss the possibility of delay. On the contrary, they sealed their determination to press on by actually accelerating the timetable: they agreed that they would announce next May the parities which will be locked for all time when their currencies are merged at the beginning of 1999. And that was that.
The only remaining question, it appears, is exactly which countries will take partand in particular whether Italy will be among them. Next week the European Commission will unveil its economic forecasts for 1997 and 1998. They are likely to say that all EU countries bar Greece and probably Italy will hit the Maastricht treatys 3% target for budget deficits in 1997 and 1998. The commissions figures matter: they will form the basis of recommendations next March on candidates for the single currency. At a summit in early May, heads of government will then vote by qualified majority on those recommendations. If the commission fails to recommend a country, it cannot be overruled.
Greece will fail by a wide margin to satisfy the criteria. Denmark has opted out. Britain has the right to do the same, and is expected to exercise it by the end of 1997though the new Labour government is warmer towards EMU than its predecessor, and has hinted lately at its willingness to join soon after 1999. Sweden lacks a formal opt-out but has decided not to join. Italy badly wants to be a founder-member, but its economy will test the edges of the Maastrict criterias credibility, with or without the proposed austerity measures that plunged its government once more into crisis this week. Yet the chances are that Italy will get inpartly in recognition of the enormous efforts it has already made to improve its public finances, and partly because such ardent euro-enthusiasm can hardly go unrewarded.
No time to think
It would be wrong to say that Europes governments have set at naught their doubts about the principle of the single currency. To set something at naught you first have to recognise itand doubts about the euro, it seems, have simply failed to register with most EU leaders. Many politicians say that the time for debate has now passed. In fact it never came, and apparently it isnt going tothat is, not until the single currency is up and running and Europe can see what its leaders have created.
Despite this lack of scrutinyall the more remarkable, when you consider the scale of what is proposedthis creation could yet turn out to be a good thing. One great prize should be low inflation, assured by a central bank that will be among the worlds most independent. (That it should indeed be independent is something that even the French, who have been pushing all year for some political counterweight to it, now seem to have accepted.) The euro should create more certainty for trans-European business and mean lower costs, perhaps worth 1/2% of the unions GDP, a tidy sum. Less certainly, the euro may foster growth and attract foreign investment, partly by guaranteeing low inflation and partly by cementing in place Europes single market.
Yet the euros chances of success will be smaller than they should have been. In a variety of ways, big and small, Europe is ill-prepared. Perhaps for fear of seeming cool towards the larger goal, its governments have been dilatory in addressing these difficulties. The result is a needlessly greater risk that the project will go wrong.
To begin with mundane matters (but no less important for that), far more preparation is needed by banks, companies and, hardest of all, public administrations. This may cost a lot, although the commission is insouciant about banks: it says computers need upgrading anyway, so the arrival of the euro may not mean genuine extra costs. Many companies, especially small ones, seem utterly unready. One recent survey for the commission found that only 12% of small companies across Europe had begun to think about the euro; another found that even most multinationals are not yet ready.
More broadly, if EMU is to prove a success, its economies will have to adjust smoothly to economic disturbances without recourse to currency devaluations. The United States is a single-currency area, and doubtless reaps great benefits as a result. But it is also a very open economy with substantial mobility of labour, flexible local markets for its goods and workers, and a federal budget that takes resources from booming states and gives them to depressed ones. In all these respects, America is well equipped to deal with economic stress. The EU is not.
Europe is beset by structural problemsincluding extensive state ownership, excessive subsidy, overly generous welfare and pension systems and too much regulation. The mobility of labour is restricted by strong ties of culture and language, and national labour markets are notoriously rigid. As yet, there is no machinery for transferring income from countries where demand is high to countries where it is weak.
What makes these facts of more than theoretical interest is the EUs starting position: high unemployment. The risk of imposing a one-size-fits-all monetary policy together with the stability pact (the EU leaders agreement to constrain public borrowing not just up to but beyond the euros arrival) is clear. Unless governments undertake structural reform of their economies, this policy regime could lead to still higher unemployment and slower growth.
Governments would then come under intense political pressure to explain why the traditional tools of national monetary policy, fiscal stimulus and exchange-rate depreciation are no longer available. If an economic shock hit one euro member harder than others, it would make things even worse. To many, the nightmare already has concrete form: it is eastern Germany, a permanently depressed region yoked to too strong an exchange rate.
Yet this is too gloomynot least about the prospects for eastern Germany. Commission economists argue that the present conditions strongly favour the euro, and what they say is plausible: not only is inflation low, but the next few years should see the fastest growth that most of Europe has experienced this decade. Unemployment is tumbling in countries such as Spain, Finland and Ireland. The euro may help by trimming short-term interest rates. The risk of nation-specific shocks is falling as EU economies become more integrated. A bigger problem is the lack of stabilising transfers of resources; but in practice the main source of such transfers will be, as now, within countries not between them (eg, as from northern to southern Italy).
The opening circumstances may be favourable, but structural reforms are still going to be needed. So a crucial question is whether EMU will improve or set back the prospects for securing them. Doubtless it would have been better to carry out the reforms first. On the other hand, it beggars belief to claim that if the euro were now abandoned, Europes governments would suddenly adopt the measures they have shrunk from for decades.
Perhaps the euros discipline will force governments (and voters) at last to accept the need for reform. As one official puts it, it is flexibility in the exchange rate, not the reverse, that makes inflexibility in labour and product markets possible. Yves-Thibault de Silguy, the commissioner in charge of the euro, says that people who hope that the euro means the end of Thatcherism in Europe have got it precisely backwards.
The fact remains that measures that would help EMU to succeed are not yet in place. And the list of questions as yet unanswered goes on. What about the outsor, as they tend to be called in Brussels, the pre-ins? Enthusiasts reckon that 14 of the 15 EU members could be in the euro by 2002, with only the Danes determinedly aloof. Yet it is possible that there will be three or four outs for some years to come. New arrivals from Central and Eastern Europe are also sure to stay out of EMU for a while. An ERM-2 is to be set up for the outs, but membership will be voluntary.
All hail, Denmark
What remains unclearand by now should not beis whether it will be possible in the long run to remain in the EU and its single market without adopting the euro. Legally and in economic terms, there is no reason why not. Yet the politics will be awkward. Would-be euro members, who mutter about the threat of competitive devaluations, may cut up rough. Acceding countries are unlikely to be offered permanent opt-outs like Britains and Denmarks. The relationship between ins and outs may prove tricky, the more so if outs stay out for many years.
However, the biggest gap of all in the Unions preparations for monetary union is not economic but political. Throughout, to put it mildly, there has been little popular enthusiasm for a single currency. The tortuous ratification of the Maastricht treatya Danish No followed by a guarded Yes a year later, a knife-edge French referendum, a string of narrow votes in the British parliament, a court challenge in Germanybears witness to this. Even now, polls suggest that in several countries, including Germany, the balance of public opinion is against the euro.
Three related developments have accentuated these negative feelingsand made the probable birth of the euro more traumatic. First came a wrenching recession. Unemployment across the European Union rose from 13.6m (8.2%) in 1991 to 18.5m (11.1%) in 1994, and plenty of people blamed the approach of EMU. Second, opinion in Germany, as ever the central country in the project, failed to warm to the ideaespecially when it became clear that moves to political union, which the Germans had pressed for as the price for sacrificing the D-mark, added up to little. Third came increased awareness of the perverse effects of the Maastricht criteria.
To remind, the criteria call for: price stability (defined as inflation within 11/2 percentage points of the average of the three best performers); low long-term interest rates (meaning within two points of a similar average); stable exchange rates (defined as having observed normal fluctuation margins inside the ERM for two years); and sound public finances (a budget deficit no bigger than 3% of GDP and public debt no bigger than 60% of GDP). At the time of the treaty, these seemed easily achievable for most countries other than Italy, Greece and perhaps Spain and Portugal: the rules were designed, indeed, with excluding the Club Med countries uppermost in mind. But the recession changed things.
With respect to inflation and interest rates, the only criteria that make much economic sense, the recession actually helped. The exchange-rate test has become moot since the ERM fell apart (though it is still often cited as a reason why Britain and Sweden cannot qualify). The real problem has been on public financeswhich was much the daftest of the rules to begin with.
The deficit criterion is not just unnecessary but counter-productive, requiring governments to tighten fiscal policy during recessions. Voters tend to disapprove, and rightly. The stability pact, which will apply the 3% ceiling to budget deficits after the euro has begun, on pain of fines, seems even more ill-advised. It neutralises fiscal policy just as monetary policy has been surrendered to the European central bank. In the event of a nation-specific shock, this will place an even larger burden of adjustment on changes in relative prices and wages.
Are ins really pre-outs?
Given all these worries and uncertainties, one wonders whether the euro can endure. When it comes to currencies, confidence is everything: much will therefore depend on the credibility of the European Central Bank. Its design, and governments assurances that it will be independent, are encouraging. But credibility can take years to acquire. Markets know that this is by no means the first time that European countries have tried to lock currencies. One of the best-known efforts was the Latin Monetary Union of the 19th century, which embraced a motley set of countriesFrance, Belgium, Switzerland, Italy, Bulgaria and Greece. It collapsed.
More recent efforts at currency-building have also been somewhat discouraging. The 1971 Werner report, unanimously approved by heads of government, recommended moving to a single currency in 1980. Shortly afterwards the snake in the tunnel, an attempt to band Europes currencies together, slithered forth. In the late 1970s the European Monetary System was set up. Many hoped all along that its exchange-rate mechanism, which linked currencies in a semi-fixed grid, would be transformed into a full monetary unionas indeed the Maastricht treaty eventually decreed. But none of these intermediate schemes had an untroubled existence.
The Werner deadline came and went. Several currencies were spat out by the snake, often more than once. There were frequent large devaluations inside the ERM, which did not include the pound at all until 1990. Worse was to come: a mere seven months after Maastricht, both the pound and the Italian lira were ejected from the ERM altogether. A year later the markets demolished what was left of the system, leaving currencies free to fluctuate by the huge margin of 15% on each side of their central rates.
Defenders of the euro have a good reply: the ERM debacle proves that, following full liberalisation of European capital movements in 1990, no exchange-rate regime short of full EMU can work. However, many in Brussels go further: the euro will be not just much safer than the ERM but quite impregnable. They say there will be no way for speculators to home in on a possible break-up of the euro in the way they destroyed the ERM. Also, the economies of euro members will be less vulnerable externally than they are now, since the share of trade in the euro zones collective GDP will be far smaller than it is now for individual EU members. As for the politics, Mr de Silguy observes that it will be impossible for Europe ever to go backwardsthat is, no country will in practice be able to leave the euro (or indeed the European Union).
It is unsettling that such ridiculous arguments are being relied upon. European governments will still be sovereign. Unless Mr de Silguy knows of new and as yet undisclosed military arrangements, there will be nothing to prevent the government of Spain, say, or France deciding to withdraw from the euro zone if it calculates such a move to be in the national interest. And however much EMU has going for it, the fact remains that almost every monetary union in history that extended across national borders has in the end broken down.
True, the euro will be invulnerable by definition to the kind of speculative attack that wrecked the ERM. But it is not difficult to imagine circumstances in which a run on the euro confronts the central bank with a horrible dilemma. Either accept both the depreciation of the euro (against the dollar and the yen) and the inflationary consequences of that depreciation, or else raise interest ratespossibly forcing one or more euro countries deeper into recession, and conceivably out of the monetary union.
In such a scenario, it would be more accurate to talk of the markets betting on the preservation of the euro rather than on its break-up (selling the euro would be a bet that the central bank would cave in and not raise interest rates). Paradoxically, though, if they pressed the bet too far, and the central bank called their bluff, the break-up of the euro could be the result.
As long as governments are sovereign, EMU will be capable of breaking up. In its early days, especially, the system may be more susceptible to that fate, despite the fact that economic conditions seem likely to be favourable. The reason is that between 1999 and 2002 the plan is to leave national currencies in circulation, albeit with irrevocably fixed parities. During this period, the markets will be watching for signs of faint-heartednessto see whether, for instance, the German authorities are willing to see Italian lire converted to D-marks without limit on demand.
If the euro, once established, did break up, the implications for the single market and for the EUs other great achievements would be dire. All the more reason why governments failure to convince their electorates of the case for EMU is so hazardous. The decision to stick with the regime in difficult times will be a political one. That is, it will turn on politicians calculations of how much their voters will put up with. So far, efforts to convince voters that this bold innovation is worth any sacrifice at all have been entirely lacking. Most governments prefer not to talk about the euro at all.
The commission last week announced that it would spend 18m ecus on communication campaigns next year. No amount of money is likely to be enough unless political leaders put their full weight behind justifying what they are about to do. It may be unrealistic to hope that in the next 450 days Europes leaders will think hard about whether Europe really needs the euro. But is it also too much to ask that they should do all they can to ensure that their great adventure does not end in disaster?
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