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Review & Outlook
The Euro, Another Look

These columns have been exponents of fixed exchange rates, taking note of the golden era of world economic growth under the Bretton Woods monetary arrangements and under the gold standard prior to World War I. Stable exchange rates let the price system work its magic, signaling production here and investment there, advancing the division of labor and comparative advantage and all the good things Adam Smith wrote about. Exchange rate fluctuations distort this mechanism just as trade barriers do, and a common currency area carries the same kind--and probably a similar magnitude--of economic efficiencies as a common market. 

Fixed exchange rates often fail, as some of the Southeast Asian tigers are currently discovering. But they fail only because governments refuse to adjust their internal policies. Indeed, the dirty little secret of central bankers is "sterilized intervention," the standard practice of offsetting foreign exchange interventions to leave domestic liquidity or money supply unchanged. Rates can always be defended if foreign exchange transactions automatically change domestic liquidity, as they did under the old gold standard and do with currency boards in Hong Kong and Argentina, 

A common currency is the ultimate in stable exchange rates because it shortcuts all of this. Within the currency bloc there are no foreign exchange transactions and no sterilization. Everyone lives with the same measure of liquidity. The Federal Reserve sets one monetary policy for the whole dollar bloc. The new European Central Bank will set monetary policy for the Euro after January 1, 1999. 

These large theoretical advantages of course have to be implemented in practice, and we can understand why so many of our Tory friends became Euro-skeptics. Unquestionably the transition to a common currency is bedeviled by technical difficulties. Most fundamentally there is the matter of finding the right rate, for the wrong one could set off a wrenching adjustment of either inflation or recession that would make the enterprise politically unsustainable. Twice in recent years Britain has had this experience trying to tie itself to the mark. 

Too, monetary union looks like the biggest step yet toward a European political union linking, and saddling, Britain with the continental welfare states. Why should the world's oldest parliament, we have heard Lady Thatcher herself ask, yield to a batch of unelected and fundamentally unaccountable bureaucrats in Brussels? Prime Minister Tony Blair has promised a referendum before joining, and these sentiments would have to be overcome. No one expects Britain to join until after the 1999 launch. 

The European partners, for their part, did themselves no big favor with their Maastricht criteria. They ignored the one number that does encapsulate the European economic problem, the percentage of output that passes through the hands of government--which is half or more in most continental nations. Instead the criteria focused on the deficit, which is an invitation to further tax increases and a barrier to needed tax cuts. Now the major nations will not meet the criteria anyway except by outrageous fudging; they are sacrificing credibility after years of distracting debate. 

Yet in fact, the whole Maastricht idea of "convergence" has it backward. You don't do convergence to fix currency rates, you fix the rates to get the convergence. Indeed, because the Eurobank would not be obligated to fund the deficits of individual governments, it would exert a rather direct discipline. A government with a big debt or deficit would have to pay for it with higher interest rates in the credit markets. Over time this might force the welfare states to bring spending in line, forcing the European nations to compete on industrial development and tax rates the way states do in the common currency area administered by the Federal Reserve. 

In this competition, Britain would do exceedingly well. Its deficit and debt is the lowest of the major European Union nations. Its governmental obligations are dramatically lower if you include unfunded pension obligations, as you certainly should. It is the most entrepreneurial of the European nations, and of course has Europe's financial capital. In any event it will have to fend off the Brussels bureaucrats on regulatory and tax policies, but from a common currency itself it has little to fear beyond a symbolic loss of monetary sovereignty that in the long run it doesn't have anyway. 

Whatever the Euro does for Britain, Britain would be good for the Euro. The world can only profit from movement back toward exchange rate stability, and if Britain joins this prospect becomes far more serious. Serious enough, indeed, that we could hope over the long run it would reach the shores of not only Britain but Japan and the United States.