The unshocking truth about EMU

Written by Charles Grant [1], 01 July 1998

It is the commonest of all the economic arguments against EMU, but also the most specious: that any country in the euro-zone which suffered an economic crisis that did not affect its neighbours (an "asymmetric shock"), deprived of the freedom to devalue, would be condemned to a massive rise in unemployment.

Look at the United States, say the euro's critics. When the oil price falls, and Texas enters recession, both transfer payments from the federal government and emigration from the state help Texas to adjust. Since the European Union has neither significant transfer payments nor much labour mobility, any EMU member in similar straits would be unable to cushion the blow.

But the EU's members are much less economically specialised than America's states. The structures of the European economies have converged over the past 20 years, making them less vulnerable to asymmetric shocks. Britain, for example, is no longer an oil economy, while Spain, Portugal and Greece are developing broadly based manufacturing and service sectors, making them less dependent on agriculture.

Economic shocks affecting only one EU country are now extremely rare. Most shocks affect groups of countries or regions within countries. Thus the current Asian crisis has had a similar impact on the EU's major economies and therefore has not affected exchange rates between them. Only twice in the past 15 years have European countries suffered serious solo shocks which could be said to have an external cause: West Germany's absorption of East Germany led to inflation and the high interest rates which provoked the early 1990s recession. Finland also suffered in the early 1990s, when the collapse of the Soviet Union destroyed its principal export market. (Britain's slump in the early 1990's was internally-generated: the extravagances of the Lawson boom begat an unusually deep recession.)

Let us suppose, however, that some dreadful event damages one EU economy and not the others. Without the freedom to devalue, EU transfer payments or labour mobility, how could one avert the mass unemployment that might threaten the political foundations of EMU? The answer is to use national fiscal policy. Each government remains free to increase its budget deficit to stimulate demand.

But surely the "Growth and Stability Pact" of 1996 removes that freedom? The pact says that budget deficits should be kept to 3% of GDP, and raises the prospect of fines for governments which transgress. The thinking behind the pact makes sense: if a country runs a deficit as high as 3% during an economic boom, it has little spare room to expand demand in recession. The useful part of the pact is that it establishes the procedures for finance ministers to discuss each others' budgets: peer-group pressure will discourage governments from embarking on unwise spending sprees. But the provisions which allow governments to be fined - if they run a deficit of over 3%, outside a recession - were unwise, for they make the pact appear much more draconian than in practice it will be. A close reading of its wording makes it clear that EU finance ministers have complete freedom whether or not to apply fines. The finance ministry officials charged with making the pact work say that it is inconceivable that governments would actually fine each other.

Provided that governments are free to alter their fiscal stances, the EU can cope with asymmetric shocks, or indeed economic cycles that are out of sync (economies that are subject to a single monetary policy will in any case tend to follow similar cycles). As David Currie notes in "Will the euro work?" (EIU, 1998): "Many countries in Europe have lived for years without fiscal federalism [significant EU transfer payments] and with a locked exchange rate against the D-mark; life in EMU will not seem very different."

Nor is labour mobility a precondition of a successful EMU - so long as labour markets are flexible (mobility should not be confused with flexibility, which is about reducing the non-wage costs of employment, moderating the bureaucratic hurdles to taking on or laying off staff and ensuring that wage structures are not too rigid). The general trend on the continent is for more flexible labour markets. Certainly some of the continental economies will have to move further in that direction if they want to reduce unemployment. But that is the case whether or not they are in EMU.