6 November 1998

Prosperity or doom in the euro-zone?

THE debate on the single European currency in this country rages on. Yet, in a couple of months, the euro will be established as the currency of choice in 11 out of the 15 EU member states.

Critics say that by signing up to the euro the UK would be throwing away its national sovereignty. Others believe Economic and Monetary Union (EMU)is doomed to failure.

But history has shown that all the worlds successful currencies are managed by central banks, independent of their national governments. The Federal Reserve Bank (the Fed) in the US and the Bundesbank of Germany both have outstanding records of maintaining monetary stability while ignoring the vagaries of domestic politics.

If the point that the European Central Bank (ECB) will also be truly independent is accepted, it really does not matter whether it is physically located in Frankfurt, Paris or London. Neither does it matter whether its president is Dutch, French or Austrian.

The important thing is that the ECB should provide sound price stability in the euro-zone. This in turn will give the euro credibility in global markets so that it can compete against the US$ as the major currency for foreign exchange dealings.

As the government has already given the Bank of England full independence, there would be no loss of sovereignty in joining the euro.

The UK voter and the UK government are not able to influence the monetary policy committee at the Bank of England. They would lose nothing by not being able to influence the board of governors at the ECB.

The real issue of concern, therefore, is whether the EU can operate as a single currency area, or not.

In simple terms, can it be right that the same interest rate applies in economies as different as Finland and Portugal, or Ireland and Germany? Have those economies converged enough to make a uniform monetary policy effective in all the regions of the EU?

These questions are not new to the UK. Only last month, Bank of England governor Eddie George was forced to admit that UK interest rates are designed to deal with strong growth in the south of England, a policy which has resulted in unemployment in the north-east.

And there has always been a particular problem in Northern Ireland, which has suffered an interest rate set in London when it would be more suited to the Republic of Irelands economic cycle and monetary policy.

The EU will have the same problems. It will need improved labour mobility to overcome the loss of local interest rates and exchange rates so as to be able to buffer regional differences.

For example, if Spain moves into recession while Germany booms, would Spaniards move to Germany to find jobs or would they go on the dole? The latter seems more likely. In that case, Germany and the other growing areas of the EU would have to move money (fiscal transfers) into Spain and the other regions of recession to pump prime their economies.

Budget deficits would increase and foreign exchange reserves would fall. That is not a recipe for success for the euro, nor for a harmonious euro-zone.

There are also justifiable concerns about whether the convergence criteria, used to judge the suitability of a member state for joining the single currency, have been applied strictly enough. Only Greece has been found unsuitable.

So what happens if it all goes pear shaped?

It will not be anything like the collapse of the Exchange Rate Mechanism (ERM), with which it is often confused. The ERM was a half-fixed, half-floating, half-baked agreement between EU governments to keep their exchange rates within a certain band.

When the economic fundamentals changed in Europe, as they did when the Berlin Wall fell and Germany had to bear the costs of reunification, the currency markets were at odds with the exchange rates within the ERMs narrow bands. Instead of realigning, governments chose to fight the markets and lost.

With EMU, exchange rates will be irrevocably fixed at the end of this year. From Jan 1, 1999 the currencies of the 11 participating member states will not be traded on foreign exchange markets. Although those currencies will still be used for internal transactions for the next couple of years, they will be gradually replaced in notes and coins by the euro and will be phased out totally in 2001.

In the event that EMU exacerbates regional economic differences, rather than forcing convergence, there could be political pressure for EMU abandonment.

But that is unlikely to happen. Despite the teething problems that are bound to occur, the euro should turn out to be a successful global currency by the time the UK joins around 2002. The economic advantages that will emerge from increased trade, greater price transparency and savings on currency conversions costs should ensure this.

The big question is, when the UK does eventually join, will it have enough say in managing the new currency, or will it have lost its chance to have a real bearing on the rules of the new system?

Robert Gooch believes the euro will emerge as a successful, vibrant currency.

Pros

&#8226 Lower inflation and interest rates.

&#8226 End to exchange rate risk.

&#8226 Reduced currency transaction costs.

&#8226 Greater price stability.

&#8226 No green rates for agriculture.

&#8226 Increased trade within euro-zone.

Cons

&#8226 Loss of flexible interest rates and exchange rates to suit each economy.

&#8226 More cash transfers between regions to compensate.

&#8226 Stronger demands for labour mobility.

&#8226 Inevitable pressure for political control of central bank.