Euro-monetarism: how Britain was ensnared and how it should escape

Extract from Fabian Society pamphlet - 1992

By Ed Balls

"In short, monetary union, in the manner and timetable envisaged in the treaty, is an economically and politically misconceived project."

A rapid move to monetary union would be destabilising

A radical option for Labour would be to push for an early move to a monetary union in Europe. This would buy domestic monetary credibility effectively by abolishing national monetary policies altogether. Labour is, in any case, currently committed to the Maastricht timetable which envisages a single European currency in 1997 at the earliest and 1999 at the latest.

Yet there would also be costs to Emu; and these costs - in terms of unemployment and slow growth - would be prohibitively high.

Emu means that no country can run a different monetary policy and have a different interest rate from that set by the European Central Bank. All well and good, proponents say, because this will free policy from the electorally motivated manipulations of national politicians.

Yet there are times when individual countries gain from running a different monetary policy from their trading partners' independent monetary policy: if, for example, that country is in a deepening recession while its partners are experiencing wage inflation.

Emu implies a trade-off between the gains from low inflation and no exchange risk and the costs from losing the flexibility to change the currency and interest rates. If all countries suffer the same economic events at the same time, there is no loss in giving up the power to vary the exchange rate.

But if countries are affected differently by an economic event - such as an oil shock or German unification - then the desired policy response will not be the same. Tying countries together under these circumstances means large and persistent regional problems - slow growth and high unemployment in different European countries, precisely what has occurred in Europe since German unification.

What does the evidence suggest about the costs and benefits of this trade-off? One test is to compare individual European countries with states of America. The US has survived for a very long time with a fixed exchange rate between its states. But the US is more integrated than Europe, both in economics and politics.

Economics matters.

The US is not free from regional problems. Swings in the fortunes of particular industries and commodities, combined with a high degree of regional industrial specialisation, mean that individual states regularly suffer slow growth and high unemployment. But there tends to be much more variation in economic growth rates across European countries than US states. Region-specific economic shocks are more common in Europe than in the US, as the chart shows (see Appendix). They tend to mean larger swings in output and employment across countries.

This pattern does not hold for all combinations of European countries. Excluding the peripheral European countries makes the European 'core' (Germany, France, Denmark and the Benelux) look like the US. It is the peripheral European countries - southern Europe and also the UK - that are most likely to suffer regional output shocks that differ from those of the European core.

But Maastricht implies that all European countries should first link their exchange rates and monetary policies together, eschewing devaluation, and then join the single currency when they meet the convergence criteria. The result is that the southern, poorer countries are likely to suffer more frequent swings in output and employment in Emu.

But politics matters more

A relatively low level of European economic integration, by US standards at least, does not rule out a monetary union in Europe. To be sustainable, the gains from a single currency must outweigh the pain; and the pains - higher unemployment and slow growth in certain regions and countries - must be small enough and temporary enough to be politically acceptable.

These tests are met in the US - there is no pressure for Texas or Massachusetts to form an independent currency in pursuit of lower interest rates or a devaluation. But there are two socio-political reasons why the US is a poor model for Europe:

Inter-state migration - US state unemployment rates do not stay high for very long - the US does not have persistent high or low unemployment regions. But the main reason why this is so is the very high level of migration between US states according to a recent study by Larry Katz and Olivier Blanchard. They show that if employment in particular state falls by 1000 in any year, then, on average, 300 workers stay unemployed, five drop out of the labour force and 650 leave the state. Eventually out-migration erases the effect on unemployment and participation rates.

Europe does not yet have anything like the degree of social, cultural and political integration which would be needed for migration on a US scale to work. European workers are unlikely to be able or willing to travel to other countries in search of work on the necessary scale, given the differences in language and culture. There is, in fact, both more migration and wage flexibility between US states than between British regions, let alone European countries.

A Federal fiscal policy - The US has a second important advantage: the federal tax and transfer system acts as a large insurance system to soften the blow for troubled regions. On average, more than a third of the fall in regional pre-tax income per head is offset, largely because the badly affected state pays less taxes into the central pool of revenue which finances the federal government activities. Because the system works through the tax system, it works quickly and automatically.

The 'peripheral' European countries cannot count on a similar federal European insurance scheme. The logic of European political integration, as envisaged in a very modest form in the Maastricht treaty, may eventually require a federal European income or value-added tax in order to fund much more pooled spending, for example to finance a common European defence policy. But that is a very long way from becoming a reality.

For now, the necessary degree of social and political cohesion needed to run a federal tax and transfer system does not exist. The German government has faced enormous difficulties persuading west German citizens to pay more taxes to support the unemployed in east Germany, never mind the unemployed in Spain or Portugal.

Nor are the EC cohesion funds an adequate substitute. They are tiny compared to the US federal budget and act as a means for discretionary redistribution rather than automatic stabilisation. Until a system of taxes and transfers exists, there is little scope for counter-cyclical fiscal policy at the European level.

Moreover, the strict fiscal rules embodied in the Maastricht treaty would severely restrict individual countries' ability to use fiscal policy to stabilise incomes by borrowing when times are bad. Britain's current budget deficit is already twice that allowed in the treaty.

In short, monetary union, in the manner and timetable envisaged in the treaty, is an economically and politically misconceived project. Imposing the same monetary policy on the whole of Europe, without automatic fiscal stabilisers, would mean persistent regional growth and unemployment differentials within the Community, with all the political and social dislocation that brings. Already, Europe is plagued by right-wing nationalism and opposition to the European project as a result of the slow growth and high unemployment that the inflexible version of the ERM has brought.

The mistake is to let economic schemes run ahead of political realities. The goal of a single European currency, like an ever close union, is not inherently misconceived. But to work, it requires a much closer degree of social and political cohesion and integration than Europe is likely to achieve in this decade or probably the next too.

This is the flaw in the Maastricht treaty: the timetable is rigid and overtly ambitious while the treaty's inflation and fiscal convergence criteria are likely to impose slow growth and high unemployment, especially on those countries outside of Germany and its immediate northern European neighbours.

The risk is that Emu, anytime soon, would risk destroying rather than cementing European political ties and undermining rather than propelling European economic and political integration. It would deliver low inflation, at least for a while. But it would not deliver the stability, growth and full employment that Britain and Europe need.

Copyright: The Fabian Society, 1992