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Julian D. A. Wiseman
Publication history: my aunt explained to me that EMU was a great idea, because she wouldn’t have to change money when visiting France. I explained why EMU was (and still is) such a stupid plan. Having finished my explanation, my aunt asked “why doesn’t anyone tell us this?”, and requested that I set the reasoning down in writing for her friends. What follows is the text of the resulting ‘Dear Aunty’ letter. This was dated March 1997, and until now, December 1999, has been only been circulated privately. Usual disclaimer and copyright terms apply.
7th March 1997
Dear Aunty,
You said that you thought that European Monetary Union was a good idea because it eliminated the need for changing notes and coins when travelling to Paris. This is true, but there are much stronger reasons why any European Monetary Union is a bad idea, why this particular EMU is worse, and why it is worst for Britain. Allow me to explain.
Countries economic performance varies. This is inevitable because technology changes, and so the world economy is always subject to random little jostlings. For example, consider the economic effect of a health scare that affected beer rather than wine, or wine rather than vodka, or vodka rather than whisky. If countries have substantially different industries (small leather goods in Italy, whisky and gin and financial services and telecoms and airlines in Britain, subsidised agriculture in France) then a change in demand for or the technology of any of these industries will affect countries unequally.
What is therefore needed is a stabilisation mechanism. It is not enough for countries to have “converged” before Monetary Union, there must be a stabilisation mechanism that maintains convergence during Union: a mechanism that ends recessions and slows booms.
There are three such mechanism that are, in principle, available.
First, is fiscal transfer. Governments can tax the wealthy regions and give the money — often in the form of welfare — to the poorer regions. Will this work in Europe? Currently fiscal transfers between American states are twice the size of those between EU nations, so current intra-EU transfers are insufficient. But if the European fiscal transfers are to be increased, then who is to pay the bills? The French are already rioting about Juppé’s attempts to economise, the Germans have had enough of their 7.5% income tax surcharge to pay for the Union of 1989, and the Dutch and the Austrians are too small. It might be that the British are willing to foot the bill, but a minimum requirement is that the electorate should be warned of this prior to a referendum.
The second possible stabilisation mechanism is labour mobility. When there are no jobs in Alabama the native Alabamans (or is that Alabamois?) pack their possessions, rent a small truck and drive to Illinois or New York or California, and work there instead. But this fails miserably in Europe: of course the Irish will continue to work in the UK, but language barriers hinder the movement of labour between the English-, French-, Spanish- and German-speaking blocks. Language is not a total barrier, but is a high enough barrier enough to allow enormous wealth disparity.
There is a third mechanism: exchange rate movements. If the British economy slows, then the pound weakens. This is why the currency markets forced the UK out of the ERM in 1992 — we were in a deep recession. The weaker currency means that a dollar or a Deutschmark buys more British pence, and hence buys more British goods. Exports are sold in higher volumes or at higher sterling prices, and the increase in exports helps the economy to recover. After some years the economy has fully recovered, and the currency strengthens again — this is what we see now. Clearly a Monetary Union destroys this stabilising mechanism.
Of course, many years ago Europe did have a common currency: gold. There was no stabilisation mechanism, for the reasons outlined above, and the absence of a stabilisation mechanism ensured that recessions were much deeper and longer-lasting. It is not by accident that the gold standard was scrapped.
Not only is European Monetary Union a bad idea, but this particular EMU has been thrown together very poorly. There are five conditions for entry, two of which are of interest to us here: the government debt must be below 60% of GDP, and 1997 government deficit must be below 3% of GDP. Most of the continent’s governments have been cheating at both of these, by hiding borrowing and debt elsewhere (such as in de facto state-guaranteed mortgage banks in German, pension fiddles with state-owned companies in France, creative accounting in Belgium, and refundable taxes in Italy). On top of these constraints is the stability pact, which prohibits excessive borrowing after EMU (except in the event of a recession) with over-spending states being fined. The end result will inevitably be that governments continue to borrow in a manner that is not recognised by Brussels’ accountants as “borrowing”. Hence governments will accumulate hidden liabilities — debts by any other name.
The Maastricht treaty contains a very interesting clause, designed to deter the accumulation of debts; a clause which nobody believes. This is the “no bail-out rule”, which explicitly states that if a national government defaults on its debts, others will not bail it out. This rule is intended to give financial markets an incentive not to lend money to poor credits (ie., governments that borrow too much), or at least to charge an appropriately punitive interest rate. Let’s name names: will Germany allow Belgium to default on its huge debts? Think of the chaos that a default would cause to Europe’s financial markets and economies. Belgium pensioners have much of their money invested in Belgium bonds: will these pensioners be allowed to starve? Obviously not, even if only to prevent huge and sudden population migrations. If the US felt obliged to bail out Mexico, so Germany and France (and Britain) will be compelled to bail out Belgium.
The financial markets can see this bail-out coming, and are hence willing to lend money to Belgium at almost the same rates they lend money to Germany. What incentive does this give Belgium? If Belgium had its own free-floating currency, then the currency would weaken as the government’s borrowing increased. But several countries share this currency: it is easy to envisage an intra-EMU conference, at which all the governments agree to cut spending, after which the politicians each go home and cut their forecasts of spending rather than cut their actual spending — after all, they do have national elections to worry about. Belgium’s incentive is to repeatedly promise to cut that part of government spending that is not measured by the Eurocrats, and then to fail to deliver on that promise.
In general, if more than one country shares a fiat currency (a currency the value of which relies on confidence rather than being backed by a physical asset such as gold), then each has an incentive to debauch the currency whilst asking the others to tighten their belts.
But there is a bonus piece of bad news for the British. All large EU countries bar one (the UK) have a huge unfunded pension liability. The French government has promised pensions to French truckers et al, starting in many cases at the age of 55, but has not saved enough to pay for these pensions. Indeed, over half of all Europe’s pension savings are British: yes, we have more pension savings than the Germans French Italians Spanish Dutch Belgiums Swedes Austrians Danes Finns Irish and Portuguese put together. Europe’s population is ageing: for the moment continental governments can make do by giving directly to the retired the pension contributions from today’s workers (and thus saving nothing). But in thirty years there will be too many pensioners per worker for this to be viable — unless pensions are massively slashed in value, and the French have shown themselves willing to strike and riot to prevent pension cuts. When this European pension explosion starts to hurt (the OECD expects the German and French national debts to triple by 2030), then the fiscal transfers will all be out of the UK and into the hands of French train drivers who have retired nine years before their hard-working British equivalents.
Common currencies are not always unwise: the existence of a single currency in the US does reduce transactions costs and inconvenience, and so makes the economy more efficient. But the US has stabilising mechanisms: political willingness to engage in fiscal transfer, and a common language allowing labour mobility.
If two or more economies are similar, then there is less chance that external shocks will affect just one country; and if there is a common language and also the political closeness that permits one country to financially help another, then a common currency is a good idea. In these circumstances a common currency will reduce transaction costs and thus increase efficiency. So I heartily endorse an Austro-German currency union, and the Dutch language is sufficiently close to German for the Netherlands to join the party. The language barrier between Germany and France will hamper a monetary union between these two; and the British economy is so different to both of these that we would be better advised to have a monetary union with the Americans than with the Europeans.
In one sentence: monetary union between the right countries can be a good, but Europe has too many languages, and its governments are so indebted that they cannot afford the required tax transfers.
With love from your nephew in the City of London.
| Written March 1997; published on the web December 1999. Also see the postscript dated March 2000. |
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