Eddie George, Governor of the Bank of England, outlines an economic, rather than political, approach to the challenges of monetary union

Steps towards monetary union should be debated on their economic merits, and the economic issues should not be lost sight of in the heat of the broader political debate. If we ask why we should be contemplating a move to monetary union, the economic - as distinct from the possibly political - answer would have to be that the permanent elimination of exchange rate fluctuations between the member states would promote economic prosperity within Europe by increasing further the benefits to be derived from the single European market. But there are equally economic risks in seeking to go too far or too fast.

But let me first define more precisely what I mean by monetary union in this context. Most people think immediately of monetary union and a single currency in terms of the replacement of their familiar bank notes and coinage by common European bank notes and coins. This is understandable, but it seems to me unfortunate because, like so many aspects of the European debate, it immediately arouses political and popular sensitivities that tend to obscure the more fundamental economic issues. The practicalities certainly need to be properly explored, but it is important that the debate about monetary union should not become bogged down in the technicalities of a single currency at the expense of the more fundamental issue of whether irrevocably to fix exchange rates in the first place. It would be a classic case of the tail wagging the dog!

What then are the potential benefits and the possible risks of monetary union in this more fundamental sense? I would not question the view that sustained monetary and exchange rate stability within the European Union is wholly desirable and would substantially increase the benefits of the single market by improving the efficiency of resource allocation within Europe. Monetary stability is desirable in itself - whether regionally or nationally - as a necessary condition for sustainable growth and to reduce the risks of long-term investment. And it contributes to real exchange rate stability, encouraging investment to be located where, within the European Union, it is most productive.

How far monetary union would contribute to this is a matter of degree. Countries individually have a strong national interest in pursuing monetary stability quite independently of the European dimension. I doubt whether we could be contemplating monetary union at all if it were not for the strength of the consensus that has emerged over the past decade or more - within Europe but also much more widely - on the crucial importance of monetary stability to economic prosperity. And if we were all individually successful in pursuing domestic monetary stability then that would help to produce some measure of exchange rate stability. In other words, some of the undoubted advantage of monetary and exchange rate stability could be achieved, in principle, without formal monetary union.

The economic argument for monetary union is that it would deliver greater EU-wide stability in practice and, importantly, that it would carry greater conviction with investors that intra-European stability would be maintained into the medium and longer term. Given past experience of both domestic and exchange rate instability within the countries of Europe, I am inclined to agree that there is substance in this.

The single monetary policy would anyway be beyond the reach of national governments if they were tempted to seek a short-run increase in output at the expense of higher inflation. And the Maastricht Treaty logically imposes continuing constraints on excessive overall fiscal deficits, although within those constraints overall fiscal policy, as well as decisions on taxation and expenditure separately, are matters for national governments. Given this, and given that monetary union removes the safety valve of exchange rate realignment within Europe so that this escape route would no longer be available, persistent relative inflationary pressures in one part of the monetary union would tend to be punished by falling economic activity and rising unemployment. That realisation ought to make inflationary price or wage behaviour in the private sector too less likely than hitherto.

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Even so, monetary stability within Europe would not be guaranteed. It would depend upon how successfully the independent European central bank pursued its mandate to maintain price stability within the monetary union as a whole. But there is no reason to suppose that it would be less successful than European countries generally have been in the past in pursuing price stability through independent national policies - rather the reverse.

Some people argue that even if, as a matter of degree, monetary union did make for greater monetary stability within Europe than would otherwise be achieved, national acceptance of such a strong external discipline would be a high price to pay. That, of course, is intrinsically a political judgement. But it would be a mistake to imagine that the discipline of monetary stability could be avoided without monetary union. If anything, that discipline would be more important for countries that did not participate because they would have to demonstrate that remaining outside monetary union was not simply seen as a soft option. Otherwise they would be likely to suffer in terms of both financial and physical investment, and their economies would remain vulnerable to disruptive intra-European capital flows.

While European monetary stability can in principle be achieved without monetary union, and while this could deliver de facto relative exchange rate stability, this would not provide the business community with certainty about intra-European exchange rates over the medium and long term. That would be a unique advantage of monetary union. Options nevertheless differ on just how great an advantage it would be, given that market mechanisms for eliminating the exchange risks are available - at a price.

Similarly monetary union - even without a single currency - would yield some benefits in terms of intra-area transaction costs. But while this is undoubtedly a factor on the plus side it is certainly not significant enough on its own to be decisive.

What then is the economic case on the other side?

Essentially, the argument is that there are, and could continue to be, significant economic differences between the member countries of the EU that could cause tensions between them that would be difficult to relieve without the continuing possibility of exchange rate adjustment between the member currencies. In that case, in monetary union the monetary policy appropriate in some countries would be inappropriate in others, leaving the European central bank in a dilemma as to what (single) monetary policy to pursue.

People point to the problems that arose within the ERM as a result of the economic 'shock' of German reunification as an example of the sort of tensions that could arise. It is certainly true that that did produce a situation in which the appropriate monetary policy in Germany was excessively tight for the conditions prevailing elsewhere in Europe - and while the circumstances in that case were, of course, quite exceptional, it is possible to envisage other shocks which could have similar assymetrical effects.

The possibility of inadequate convergence is explicitly recognised in the Maastricht Treaty, which lays down more or less precise criteria designed to ensure that conjectural convergence, at least, is achieved before any move to the irrevocable locking of exchange rates. Those criteria relate to relative rates of inflation, to exchange rate stability, and to relative long-term interest rates - all observed over a qualifying period - as well as to fiscal deficits and public debt ratios. The Treaty also contains ongoing provisions to prevent the subsequent emergence of excessive national fiscal deficits.
There is a concern that the Maastricht convergence criteria are not in themselves sufficient. The worry is that it may be possible for a country to meet the Maastricht criteria - which relate to nominal values - at a particular point in time but with no assurance that such convergence could be sustained into the medium and longer term. What matters fundamentally for the successful functioning of monetary union is that economic convergence is capable of being sustained. We should be confident that convergence is real and that it is sustainable before moving forward. It is in no one's interests for that decision to be fudged.

If it were to be fudged, the costs could be substantial. The European central bank is, quite rightly, required by its statute to set the single monetary policy so as to maintain price stability in the monetary union as a whole. In that case, and if inadequate sustainable convergence were not to result in long-term stagnation and unemployment in some parts of the union, there are only two possible adjustment mechanisms - neither of which on present evidence looks likely to be particularly effective.

First, there is the possibility of migration from areas of high unemployment to areas of lower unemployment. Secondly, there could be pressure for larger fiscal transfers from countries with lower unemployment to countries where unemployment was higher.

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Neither of these possibilities is particularly attractive. Either long-term stagnation in some countries or the rapid expansion of these adjustment mechanisms could become a source of political as well as economic disharmony within Europe, rather than monetary union acting as something that brings us closer together.

I have no doubt at all that the single market brings huge economic benefits to Europe as a whole and to its individual member states. There may be advantages in extending it into other policy areas - though proposals in this sense need to be examined very carefully on their economic merits and not pursued simply for their own sake. The same applies to monetary union. There are potential economic advantages in monetary union to the extent that it would increase economic and monetary stability in Europe and make the single market more effective. But there are also potential economic risks in moving ahead before sustainable convergence is assured. It would be an enormous step. A decision to take that step is, quite rightly of course, a decision that has to be taken through the political process. But it must be in the interests of the EU as a whole that that decision is informed by a careful and dispassionate assessment of the economic arguments.

It is not a decision that can or should be taken now. We all have our work cut out to achieve economic and monetary stability, and to address the problem of structural employment in Europe, through our independent national efforts and through European co-operation. And we have a great deal still to do in continuing to explore both the economic and technical conditions that would need to be met before any decision could be made. The important thing is that we all carry forward this work patiently and with an open mind.

This article is an edited extract of a speech delivered by Eddie George at the Fondation J P Pescatore, Luxembourg, in February 1995.

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©Kensington Publications 1996