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ECONOMY -Exchanging jobs for single currency?

Is the UK’s apparent antipathy towards European Monetary Union (EMU) an irrational, xenophobic response to a positive and logical change in Europe’s economic configuration or, are the concerns based on legitimate worries about the impact EMU might have on the economic and social structure of the European Union?

Unfortunately, our understanding of exchange rates is more limited than we might expect. Hence, currencies backed by high interest rates can depreciate, despite what we are taught at school and university. Exchange rates are the manifestation of a complex web of international transactions and capital flows, a mix about which we have only a poor understanding. Before we abandon the tried, if not trusted, system of floating currencies and take a step into the economic unknown, we must be sure we understand why currencies do what they do, when they do.

In essence, the main criticism of floating currencies is that they undermine other economic objectives. As a result, they are viewed as a hindrance to trade flows, destabilising and preventing governments from taking policy action that might otherwise be deemed appropriate. But these objections fail to recognise their key role as the primary adjustment mechanism in the international economy.

There is no doubt that periodically currencies do act as a constraint on macro-economic policy but, it is seldom the case that currencies, on their own, are a cause of economic distress. The discipline exerted through currency markets works only in as much as a government believes it should respond to movements in bilateral exchange rates or in that a government has an explicit exchange rate objective. More often than not, governments that allow themselves to be distracted by currency objectives make inappropriate policy decisions (as happened in the UK between 1987 and 1989); those that see currencies as a reflection of policy decisions taken to achieve internal economic objectives tend to be more successful (as has been the UK’s experience since its exit from the ERM).

The main argument in favour of a single currency is that it will encourage greater trade volumes. But the emergence of higher levels of intra-European trade will not, as the European Comission claims, in itself, boost growth in total. Indeed, improving volumes of both imports and exports will prove a zero-sum game. Only if higher trade leads to higher final demand will growth increase.

The Commission’s argument is that lower production costs brought about by greater specialisation will enhance economic performance, thereby increasing the EU’s ability to export outside its borders – a process that would act to stimulate final demand. However, it is doubtful the comparative advantage gained through more specialisation would have a measurable impact on competitiveness. In addition, a less diverse and more concentrated production base also has a potential economic cost through the associated increase in vulnerability to changes in demand patterns and economic circumstances.

The Commission is trying to persuade us that floating currencies are the cause of a misallocation or under-utilisation of productive resources within Europe. In effect, it is denying the free market system works in the best interests of member states. In terms of prevailing economic thought, to assert that a free market does not work has immense ramifications.

It is all the more worrying when the statement is made by politicians who believe they have identified a system superior to the free market.

Of course, if there were a perfectly free market in economic resources and all economies had similar economic characteristics, it is very likely that currencies would stablilise of their own accord. Given the existing rigidities, however, it is almost certainly the case that currencies help rather than hinder the operation of the European economy.

Clearly, floating currencies create risk. This risk can be neutralised, but at a cost. While currency risk may be mildly detrimental to trade flows, it also has an impact on cross-border capital flows. The impact here is to reduce the mobility of capital, an effect that tends to help economic stability. Were capital to move around at ease, without risk, it is likely that individual areas within the common currency block would find themselves starved of investment capital. This would necessitate capital transfers by the EU through a regional fund – transfers that would almost certainly have an arbitrary nature and result in further misallocation of resources.

As well as introducing risk into the economic system, currencies introduce a measure of self-correction. This can prove particularly useful when individual countries do not participate fully in the economic game. Thus, an economy that relies too heavily on export growth without generating sufficient domestic demand tends to see its currency appreciate as its trade surplus accumulates.

A crucial role performed by currencies is to allow countries at different stages of the economic cycle to coexist without the emergence of too much friction. If a common currency is to be successful, it is crucial advocates are able to show either that cyclical management can be carried out using other mechanisms of policy or that the institution of a common currency will force economies to follow similar cyclical paths.

If its adoption does not force cycles into phase, EMU will cause acute problems for cyclical management. These will be most obvious in the UK, an economy that tends to be at the leading edge of the world economic cycle, a year ahead of Germany and France.

In the end, we have to decide whether economic policy should be determined according to an arbitrary set of international standards or according to the requirements of a relatively homogeneous economic area. If Europe does move towards EMU, abandoning the currency adjustment mechanism between economies, the labour market will be forced to take the strain. Because wages are inflexible, adjustment will occur through employment and the cost of EMU will be counted through the length of the unemployment queues.

Richard Jeffrey is group economist at Charterhouse.

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