The European Monetary Union argument: Click here for the previous section
However, before we endorse the case for monetary union without further ado the serious arguments that have been raised against the idea must be addressed. Seven main objections to the project have been deployed:

1 It is said that the concept would be a denial of national or Parliamentary sovereignty. That argument has often been refuted. We are not today nationally sovereign in our monetary policy - nor can we be in a world of no exchange controls and free capital movements. A decision by the American or German authorities to adjust significantly their interest rates will have an immediate impact on the sterling parity and/or on sterling interest rates. So powerful would be the likely influence of a single currency that if sterling remained outside he project it might without exaggeration be said that the German or French (or even Luxemburg) Central Bank Governors who determined monetary policy in the European Central Bank would have more influence in the determination of British monetary policy than our own Chancellor or Governor. That would be a particularly absurd position for us to arrive at ostensibly in pursuit of a policy of national sovereignty. This is clearly a case where sovereignty is to be pooled, not sacrificed - and where the leverage on events we would acquire would be greater than we could hope to enjoy on the basis of purely national policies.

2 But there is a further source of perceived threats to national sovereingty in the EMU project. The fear is often expressed that monetary union would constrain the fiscal (taxing, public spending, and borrowing) policies of its member states, and that this would necessarily lead to fiscal uniformity and to a "federal" state. The first of these assertions is one third true - but the rest are not true at all.

A zone of monetary union, if it is to remain stable, must indeed imply some mechanism for ensuring a measure of discipline in the matter of public debt. The reason for this is simple. When the same authority - the national Government - is responsible for both fiscal and monetary policy then, if that authority borrows more money that its tax-payers are subsequently willing to repay, it can "monetise" its outstanding debt - in other words reduce its real value through inflation. It is no secret that, whether by accident or by design, that was precisely the process whereby the real burden of the public debt accumulated by the UK in the 1970s was considerably reduced (in other times and places the technique has of course been practised with even greater ruthlessness - and with more drastic effects on investor confidence and social stability).

Once governments lose their ability to monetise their own debt, however, their only possible reaction to loss of investor confidence and insolvency is default. And default by a government will generate a crisis in the whole financial and economic system, and especially in the other parts of the system sharing the same currency, as banks, insurance companies, pension funds, businesses and individuals who hold that debt find themselves having to write off a significant portion of their assets. By definition all parts of the system thus impacted suffer - however responsible and sound the fiscal policies of their own governments may have been. It might be therefore that in such circumstances the offending government could blackmail its partners into coming to its rescue - at the expense of the latters' tax-payers. If that happened the prodigal would have been rewarded at the expense of the virtuous - and an incentive for fiscal irresponsibility would be created of awesome proportions.

For this reason, every monetary union must have effective measures in place to prevent excessive government borrowing. The pre-1914 Gold Standard addressed this problem very effectively through the mechanism of gold convertibility - anyone accumulating claims on a government could convert them readily into gold. The excess deficits procedure of the Maastricht Treaty, with its provision for interest-free deposits, replicates the essence of that discipline for EMU. But EMU implies no restriction whatever on what member state governments can spend - provided only that they raise the required current revenue to finance it (or borrow within the limits of the rules). Some may welcome such a discipline both as a valuable reinforcement of democratic accountability, and as an economic gain for Europe as a whole. Others may see it as a cost of monetary union. But, in either event, it will not constrain governments or parliaments in their essential decisions either on the levels, or on the distribution, of taxation and spending. Nor is it easy to see it as a threat to national sovereignty. Whatever may be said of the Europe of 1914, in which government borrowing was so effectively constrained, insufficient national sovereignty was not one of of its more obvious shortcomings.

3 Among the economic objections to EMU the most obvious one is that we should not give up the weapon of devaluation. Devaluation as a means of accommodating (and therefore nurturing) permanent high inflation or permanent productivity failure in an economy (very much the model of the British economy in the 1960s and 1970s - and in a more extreme form of many Latin American countries for much of this century) is not a policy formula which should appeal to any Conservative. But there are two other arguments which deserve to be examined at slightly greater length, and which are somewhat more sophisticated variations of the same theme.

4 Those sceptical of monetary union often claim that while secular or repetitive devaluation may be very damaging, occasional devaluations or revaluations may be necessary to compensate for unexpected events which alter the demand for, or the supply of, a country's exports in a different direction to those of other areas in the single currency zone (in the technical jargon 'asymetric shocks'). The argument is theoretically sustainable. But does it do more than describe a theoretical special case?

It is not in fact easy to envisage a genuine shock from outside whose impact would be very asymetric between the likely initial members of currency union - say in the first instance France, Germany, Austria, Benelux (the "hard core"), and perhaps ourselves and Denmark. The most asymetric influences on countries' economies have in practice proved to be divergences between government economic policies - sometimes the result of different economic philosophies, these days in Europe more often simply the reflection of different electoral cycles. The asymetric effects of the two shocks of recent European history were both very substantially the result of policy decisions. That was the case both with the the 1973 and 1979 oil crises and with German reunification.

All West European countries except Norway were largely equivalently impacted by the oil crises - even in Great Britain oil never accounted for more than 4% of GDP. What was starkly different were the policy responses of governments. Britain and France loosened fiscal and monetary policy to accommodate higher oil prices, thus inducing inflation and fiscal crises (deeper and more prolonged in Britain than in France), while Germany and Switzerland held monetary and fiscal policies steady. Under EMU, of course, monetary policy would by definition be common, and fiscal policy would be subject to the constraints described above. No great divergences would therefore have arisen. The asymetric shock of German reunification was actually made possible by the absence of monetary union - had monetary union then applied the German Government would have had to finance reunification largely through tax increases from the start, a response which everyone would now agree in retrospect would have been the correct one, and which would have avoided the substantial rise in interest rates, and pressure on others' parities, which occured. The experience of these cases actually reinforces rather than otherwise the case for EMU.

Even if for the sake of argument we take the theoretical case of shocks which are not policy- induced, and are the product of uncontrollable events in the world, or for example, natural disasters at home, such events are probably more likely to be asymetric between regions within member states (where devaluation would not be a possible response anyway since regions do not have their own currencies, and European currency union would therefore be irrelevant). Moreover, given that there is considerably less economic specialisation between member states of the EU, and especially between the "hard core" member states, than exists between the states of the USA (in other words, the economies of individual EU member states are more diversified) any intenrnational shock would in principle be less likely to impact asymetrically on the participants in a European monetary union than on the USA. Since the latter have enjoyed a very successful monetary union for a long time, the chances of such an asymetric shock threatening monetary union in Europe may therefore reasonably be regarded, on historical experience, as not being very high. The argument is often made that in the US there is greater scope for fiscal adjustment in such circumstances. But that argument is not as valid as is generally assumed. Comparisons between EU and US fiscal transfers at the union level are set out in Section 5 below. They do not support this assertion. Furthermore, since almost all American states have balanced budget laws, whereas the Maastricht rules do provide for some fiscal flexibility for individual EU member states, there is actually greater fiscal adjustment potential at the member state level in Europe.

Let us, however, at least for the sake of theoretical completeness, assume that the classic asymetric shock beloved of opponents of monetary union did arise. For devaluation to be the appropriate response two additional conditions would need to be satisfied.

Firstly, demand for the exports of the country concerned would have to be sufficiently sensitive to price changes (in technical terms their price elasticity of demand would have to be high). Otherwise, real price adjustment through devaluation would prove futile in increasing demand for its exports and inflation would simply be added to the country's woes without any compensating increases in output or in employment. And the evidence is that in sophisticated economies the demand for their exports is not highly price sensitive. If it were, Germany and France (and Japan) would surely now be in substantial deficit and not in surplus on their trade accounts following those countries' massive revaluations in recent years, and the UK would perhaps be in substantial surplus and not still in deficit following our own devaluation.

Secondly, even in the limited case where demand for a country's exports is sufficiently sensitive to real price changes, devaluation will only bring such a change about if those setting prices domestically, including very importantly wage rates, do not attempt to compensate themselves for the fact of devaluation by increasing domestic prices. Modern experience - as much as modern rational expectations theory - indicates that such passivity is unlikely to occur, except perhaps temporarily in a recession. Domestic firms do increase their prices if the local price of competing imports rises. And wage bargainers are not easily, or for long, taken in by the illusion that "the pound in your pocket has not been devalued", and real wages - not "nominal" or cash wages as in the original Keynesian theory - generally prove to be "sticky" over the longer term. In such circumstances devaluation is certainly worse than useless - no new employment is generated and the economy, investment and future job prospects are instead simply undermined by inflation.

Finally, the "devaluation in response to asymetric shocks" argument assumes - mistakenly - that foreign exchange markets are always rational and that their response to a shock is necessarily proportionate to its impact. Experience shows the reverse. Anyone familiar with the foreign exchange markets - or with other financial markets - knows that they always over- swing or over-react. A recent British example well illustrates the point. In the UK under floating rates the foreign exchange markets reacted to the doubling of the dollar price of oil in 1979 and to the accompanying though perhaps coincidental change in fiscal and monetary policy introduced by the Thatcher government, by lifting the sterling parity by 30% in 2 years. By 1985 the sterling parity had returned to its 1979 level though a swathe of UK manufacturing capacity had meantime been wiped out - unable to compete or to adapt in the face of such a precipitous rise in the exchange rate. By the time the exchange rate fell back to its 1979 level of course it was too late. Currency union would surely have been a better option!

To sum up, whatever may be the position in developing countries, devaluation between the prospective members of European monetary union who have achieved the level of convergence required by the Maastricht criteria is likely to make sense only in a doubly special version of a rather unlikely event, and even then would probably only do more good than harm on some fairly heroic assumptions about the rationality of the foreign exchange markets. If there are strong reasons, on stability, trade or other grounds for sacrificing the devaluation weapon the asymetric shock argument is not likely to weigh very heavily against them.

5 A further, and very influential version of the "need for devaluation" argument is that the high levels of unemployment presently suffered by all countries of the EU (varying from 7% to 24% of the workforce) make currency union impracticable. The implication is that these levels of unemployment are a result of over-valued exchange rates, or that, more generally, they are a reflection of insufficient demand which can only be cured by a degree of monetary or fiscal expansion that would be inconsistent with monetary union. In fact the evidence points entirely in the opposite direction. All the countries likely to form the first echelon of monetary union (the "hard core" listed above) have recently been enjoying growth rates of around 2.5% per annum, and all have their current accounts in balance or in slight surplus. Those facts are not consistent either, respectively, with demand insuffiency or with an over-valued exchange rate. Moreover, Spain, the country which has undergone the greatest measure of devaluation since 1992, currently suffers by far the highest unemployment level (24%). The Continental countries whose parities have appreciated most have among the lowest unemployment rates (Germany 8.5%, Netherlands 7%).

The sad truth is that the high core level of unemployment, which ought indeed to be a matter of very considerable political concern, is largely policy-induced. It is the direct result of political action. It is also essentially a supply-side problem. Social insurance premia have created a growing gap between the cost to employers of taking on workers, and the return to the workforce for their labour. Still more significant, welfare payments and other benefits to those out of work (in this country in the form of Income Support, housing benefit or mortgage interest, Council Tax relief, free prescriptions and school meals, help with VAT on domestic fuel etc) are at such a level in relation to the net return available from un-skilled or semi- skilled jobs as to offer a less than sufficient inducement to many people to return to work. Such policies - generous and well-intentioned as the motives which prompted them undoubtedly are - could never have been reasonably expected to do otherwise than increase the core level of unemployment. Some countries (Spain and France are the most obvious) have excessively regulated labour markets, and high minimum wages - measures again surely guaranteed to reduce the demand for labour and to increase core unemployment. Britain and Portugal at the other end of the scale of regulation have much lower unemployment rates (8.5% and 7% respectively). There are , of course, other major deficiencies on the supply side of the labour market throughout Europe - skills mismatches, and the rigidities existing in both the public and owner-occupied sectors of the housing market among them. One thing, however, is quite certain. It would be not merely illogical but deeply damaging to treat supply side problems of this kind with a dose of devaluation or demand reflation. The result would be higher inflation, current account deficits, and economic crisis, for no increase in employment. And over the longer term a considerable sacrifice in the number of jobs available, as investment confidence and growth rates declined.

6 It is sometimes alleged that in the absence of devaluation there will be great pressure from lower income and lower productivity countries for transfers from the more prosperous areas, and that those could only be at the expense of taxpayers in the latter (the "fiscal transfers" argument). This argument is based on a double ignorance of the facts. Firstly, productivity and per capita incomes are remarkably close in the prospective "hard core" of countries likely to accede in the first instance to monetary union and net fiscal transfers between them are minimal. It is true that there are at the present time (and in the absence of monetary union) very significant transfers under the Structural and Cohesion funds from these countries to the Mediterranean members of the Union and to the Republic of Ireland which in the case of three of the Cohesion countries (Portugal, Greece, and Ireland) amount to 4-6% of each of these countries' GDP - a level equivalent to the contribution of Federal Grants in Aid to the poorer states of the USA. But it is unlikely that the Cohesion countries will meet the convergence criteria in the Maastricht Treaty and accede to monetary union this century. If and when they did so their economies would no doubt in any event be less reliant on such transfers - though in fact a mechanism providing for them is already in place! In short, monetary union on the Treaty's terms and timetable both in respect of the "hard core" and of the rest of the EU need in this field change nothing.

There is a rather delicious irony in the "fiscal transfers" argument, which does not always appear to have been appreciated by those who advance it. After all, the only way in which the UK could suffer under it by joining monetary union in the first wave would be if our economy turned out to be so successful and prosperous by the standards of Germany, France, and Benelux, that we found ourselves under pressure to subsidise the latter. Since these countries currently have a GDP per capita 30-50% higher than our own, the premise to the argument if it were realised would surely be an even greater source of satisfaction than the very uncertain threat of net transfer outflows would be a cause of anxiety. In any event, one thing must surely be quite clear. No one can simultaneously argue that the British economy will be so weak in relation to a single currency area that it will be unable to forego devaluation, and that it will be so strong that it will be the natural source of fiscal transfers to other members!

7 It is frequently claimed that monetary union is impractical since the British financial system is very different to that prevailing on the Continent, particularly in the very large proportion of households who have floating rate mortgages, and of small businesses which depend on floating rate overdrafts, whereas in the "hardcore" countries on the Continent most mortgages and business loans are advanced for long periods at a fixed rate. The description is accurate, and the contrast correct. But this phenomenon is itself merely another manifestation of the relative lack of monetary credibility we have been able to achieve in the UK. Depositors and other savers will not so easily take the risk of placing their money at a fixed rate for extended periods for fear of inflation reviving in the future. The cure for such lack of monetary credibility is of course monetary union itself. In that circumstance, exactly the same financial products would be available here as on the Continent, and both households and businesses would be able to enjoy the security of readily and relatively cheaply funding their debt at long-term fixed rates of interest. The "different financial structures" argument takes as a reason for rejecting monetary union what is in fact one of its salient advantages.

Monetary union, and especially monetary union on the Maastricht terms, is an idea which ought to appeal instinctively to all Conservatives. It combines the insights of monetarist and rational expectations economics with the traditional Conservative recognition of original sin - and the need to construct solid institutions to guard against it. Which Conservative does not believe in sound money and financial stability? Which Conservative does not believe in eliminating as far as is humanly possible all barriers and frictional costs to trade? And which Conservative would not consider it a historic achievement to find an effective way of removing from governments the temptation to manipulate the money supply for political purposes or to borrow excessive amounts of money?

Europe lived very successfully under such disciplines during the half century before 1914, on the Gold Standard. That was a period of exemplary stability, and, largely in consequence, of unprecedented growth in international trade, international investment, and in prosperity. A simple return to the Gold Standard is an impractical absurdity, but EMU replicates, on a still sounder basis, its most essential attractions. Of course, the creation of monetary union is far from certain. Economic recession or political crisis may yet delay it, or abort it altogether. Nor is it certain - though it seems increasingly likely - that the Maastricht criteria can be protected from dilution. The Prime Minister was quite right in these circumstances to negotiate an option for Britain. Given that option there is no need to take a decision now. Indeed it would be crazy to do so. But it is surprising that there should be those in the Conservative Party who believe that the UK should remain outside a zone of monetary stability in Europe, even if one were to be effectively created on the soundest financial principles.

Moreover, in the latter event the costs to us of rejecting monetary union would no longer be theoretical opportunity costs, but a practical competititive handicap to our economy. Some of the resultant difficulties can be anticipated unambiguously in advance. Our traders, for instance, would be at a disadvantage in the Single Market - they would be dealing in a foreign currency with all the costs and risks that that would entail; their competitors would be dealing in their own. It is difficult to see how we could avoid some deflection of investment, since industrial capacity designed to address the single currency area would naturally tend to be located within that area to avoid foreign exchange uncertainty and transactional costs (theoretically, other factors might outweigh those - higher investment subsidies for example, or lower wages - but such compensation would be at considerable cost to our people). Of course, if there were any fears in the minds of investors - British or overseas - that our declining to join monetary union might presage some future decoupling of Britain from full membership of the Single Market (though there is no constitutional or legal basis for this to take place) that displacement of investment could readily reach very alarming proportions.

Worst of all, there would be great difficulties in managing sterling. The Euro, together with the dollar and the yen, would be one of the world's reserve currencies - and even more of the world's trade might come to be denominated in it than in the other two since the EU is already responsible for the largest individual share of world trade. International investors would no doubt readily hold their assets in all of those three currencies. But they would require a special reason or inducement to hold them in other denominations - in short, a higher yield. In the case of sterling, with our reputation for devaluation (and especially if, untypically in the modern world, politicians rather than the central bank remain responsible for monetary policy) that yield premium might have to be high. In other words, real interest rates would always need to be significantly higher here than on the Continent, the cost of capital to British business and industry would be greater, and investment and our growth potential correspondingly less. And that at least is surely a price that no responsible Government could placidly contemplate for very long.

The Way Forward

British policy towards the European Union has long been veined with contradictions. We aspire in the Prime Minister's phrase to be "at the heart of Europe", and yet we regularly find ourselves in a minority of one in its deliberations. We are inclined to complain vociferously about the Union's lack of effectiveness in foreign policy and other fields, but we instinctively reject any proposals that are made to strengthen it. When asked what we consider the main priority for the 1996 IGC we unhesitatingly respond "enlargement". But we are unwilling to face up either to its likely constitutional implications, including the need to develop a more cohesive voting and decision-making system (is the whole Union to be vetoed by Latvia, or Malta?) or to its budgetary consequences. Nor is it adequate to say that enlargement can be financed simply by CAP or Structural Fund reform - that would mean that the price would be paid almost entirely by the Cohesion states, and by other Mediterranean countries including France, who are themselves much less politically commited to enlargement than are Germany and the UK, and thus much less inclined to pay any price at all.

The same lack of coherence appears in our approach to constitutional issues. It is a standard cliche of British political debate to denounce the Commission as undemocratic and unelected. But we have strenuously resisted suggestions that the Commission should be elected, or even that its members' nominations be individually confirmed, by the European Parliament. Perhaps we mean that the Commission, or the President of the Commission, should be directly elected by universal suffrage? Such a suggestion would cause apoplexy in certain circles in London. We routinely say that we aspire to give national parliaments a greater role in decision-making. But we have made no proposals to this effect, and the European Standing Committee of our own House of Commons is so constitutionally emasculated that its resolutions quite simply have no effect at all - they do not even trigger a debate and vote on the floor of the House, let alone alter the line which ministers take on behalf of the UK in the Council of Ministers.

All these contradictions, and others like them, will need to be resolved, imperatively over the medium term and ideally sooner if we wish our contribution to the determination of the Union's future policies, in the IGC and in other fora, to carry the weight which our country's importance deserves. For we must have the clarity to define our interests before we can hope effectively to defend or to promote them - otherwise any such efforts are likely to be ineffectual, or even perverse. And no Conservative could be content with that. This task will require a great deal of new thinking, of courageous challenges to cherished and comforting prejudices, of traumatic adjustment to new but unalterable facts. And it will also require the application of two venerable Conservative virtues: determined devotion to our people's interests; and pragmatism and therefore an open mind in their pursuit.

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