Euro-sclerosis need not be catching

LAST WEEK, this column discussed the question of UK membership of EMU, and concluded there was no case for the Government to abandon its "wait and see" stance before the next election. This conclusion dismayed many of my pro-European friends, so I would like to reassure them that I have lost none of my enthusiasm for closer UK integration with the European Union, which looks as desirable as it is inevitable. Eventually, this will probably mean that Britain will become a full member of EMU.

But I just do not understand the case for rushing into this decision now. Integration needs to proceed further before we should give up monetary sovereignty, since idiosyncratic shocks to the UK economy remain all too likely.

This week, however, I shall turn to an increasingly fashionable, but nevertheless dubious, argument for staying out indefinitely - which is that the UK would catch a dose of "Europe sclerosis" if it were to become a member of EMU. The pro-European, but anti-EMU, group led by David Owen seems to believe that this might be the case, and even the Prime Minister is clearly worried about the issue.

The main loophole he has left himself for staying outside EMU over the long term is that our continental European neighbours might not introduce sufficient market-friendly reforms in their economies, in which case they might be plagued by low GDP growth and high unemployment forever.

So would the UK catch Euro-sclerosis if it joined EMU?

Probably the most crucial point to make is that most of the key areas of policy concerning labour and product market flexibility are subject to European Union rules already, and they would be (at least in theory) unaffected by EMU membership. On the face of it, it is difficult to think of any relevant policy area - certainly not labour market reform, product market flexibility, industrial policy, merger control or social security - which would be affected one way or the other by joining EMU. A clear example of this is the implementation of the Social Chapter, which was undertaken voluntarily by the UK, and will in future operate in this country irrespective of membership of the single currency. Similarly, the minimum wage.

Euro-sceptics reply that this may be all very well in theory, but that in practice things would work out very differently. Once inside EMU, they contend, Britain would be forced to adopt a pan-European macro and micro- economic programme that would be highly sclerotic in nature. The idea here is that the EMU bloc will inevitably gravitate towards a genuine single economy, and most probably towards full political union as well. Once that happens, Britain's option of remaining an island of market flexibility in a sea of European regulation could be eliminated.

Anything is feasible in the long term, but this really does seem to be an unlikely nightmare. The only policy areas that do appear likely to be affected by EMU membership (other than the obvious ones of monetary and exchange-rate policy) are the macro-economic aspects of fiscal policy. Sooner or later, it will become apparent that national fiscal policies will need to be co-ordinated in order to produce a coherent out-turn for the fiscal/monetary mix, and that will require further budgetary integration on top of the provisions of the Stability Pact. This could also lead to some further steps towards tax harmonisation. But all this will be subject to unanimous voting and, in any case, it is not crucial to the supply side issue of product and labour market flexibility. A more comprehensive political union seems fantasy at this stage.

From the supply side point of view, therefore, we seem reasonably safe. But what about the demand side? Observing the recent behaviour of the EMU bloc, it seems quite plausible to argue that a continuing conflict between the politicians and the European Central Bank will produce a combination of recession and an overvalued exchange rate in continental Europe. Some Euro-sceptics are obviously concerned that, inside EMU, Britain would not be able to declare independence from endemic Euro-recession. Hence we would be better off outside, where we would retain the flexibility to boost UK demand by cutting domestic interest rates if necessary.

There are two key points to make about this line of argument. First, assuming that the EU is prone to continuing recessionary problems, UK exports to Europe will be adversely affected whether we are inside or outside EMU. The freedom to cut interest rates outside EMU might initially protect us from recession, but it would also worsen the UK trade deficit and lead to a depreciation in the exchange rate. If this process were repeated for a few years in succession, the UK would soon be accused of pursuing a devaluationist strategy within the European single market. Before too long, ailing EMU members would start thinking about expelling the UK from the single market on the grounds that it was following a strategy of unfair competition through a weak exchange rate. In other words, it would be increasingly problematic to stay within the EU while staying independent from monetary union.

Second, would life for the UK really be so bad if we climbed into bed with a sclerotic EMU-bloc? Expansionary fiscal policy would still be available in the short term to avoid a domestic recession as European demand growth slumped. More important, in the longer term, supply-side flexibility would come to our rescue and would enable us to take an increasing share of European markets as our greater competitiveness took effect. Whereas inflation in continental Europe would remain stubbornly high during economic downturns, there would be more downward flexibility in both prices and wages in the UK. This would result in a decline in the real exchange rate, but it would be achieved in the "good" way (that is, lower inflation) instead of in the "bad" way (a lower sterling exchange rate).

Unlike in the case of sterling devaluation, it would be quite impossible for other members of EMU to complain about an increase in UK competitiveness achieved through lower price inflation. In fact, instead of attempting to freeze the UK out of the single market, other EMU members would eventually be forced to adopt more flexible economic practices themselves in order to compete with the success of flexi-Britain.

Is this just a Europhile's pipedream? Consider the experience of Holland in the past two decades. Twenty years ago Holland was the most extreme example of the sclerotic European model - stratospheric levels of tax and spend, vast pools of structural unemployment, mind-numbing regulation in product markets, the lot. But during the 1980s, in a series of patient and painstaking reforms, the Dutch took a large dose of Anglo-Saxon reformist medicine (along with a parallel dose of centralised wage moderation). The result, as the graph shows, has been that Holland has become one of the success stories of the 1990s, despite the chronic failure of its giant neighbour Germany, with whom it has had a monetary union for over 15 years.

The Dutch example proves that a fear of catching Euro-sclerosis is an unconvincing reason for the UK to stay outside EMU. Other factors may counsel delay, but this one does not.