Markets all at sea over monetary union

Whether it is the calm after the storm or the brief period of respite at the eye of the hurricane, 36 hours of relative quiet in the currency markets have given survivors time to ponder whether there is a future for the single European currency.

There are two views about the post-crisis prospects for European monetary union. One is that the forced devaluations of the peseta and escudo and 6.5 per cent appreciation of the mark since 1 January mean plans for EMU are dead in the water.

The other is that the currency markets have done the architects of EMU a huge favour, clearing the ground for a swift move to a currency union of the most closely linked economies in the Community.

In the markets the preferred interpretation is that those red-braced, white-socked dealers have destroyed the single currency by putting the differences between the strong and weak European economies under the spotlight. Paul Chertkow, head of currency research at UBS, says: "This episode has made a nonsense of monetary union."

Of course, the exchange rate fluctuations have been over-dramatic, but if even the French franc can move so far against the mark it indicates the pressures that would have to bubble up somewhere else under EMU. The markets have passed their verdict: there is not enough economic convergence between European countries.

Those who share the opposite view, and think the past week's turmoil strengthens the case for EMU, include Jacques Santer, president of the European Commission. Yesterday he said the lesson of the crisis was the need for a single currency to avoid new episodes of instability - especially as the tension between European exchange rates was due to the dollar's weakness rather than their own.

Others agree that the case for taking the plunge has been reinforced. David Miles, an economist at Merrill Lynch, said: "The exchange rate turbulence has not changed the analysis about the desirability of monetary union, but it suggests they might as well get on with it."

So far, that analysis has focused on the convergence criteria set out in the Maastricht Treaty. There are four: countries must have similar inflation rates; long-term interest rates that do not vary too widely from the average; a government deficit equivalent to less than 3 per cent of national output and a debt ratio of 60 per cent or less; and the currency should have remained within normal ERM bands without devaluing for two years.

Eddie George, Governor of the Bank of England, introduced the idea of "real" as opposed to "monetary" convergence criteria into the debate in a speech last month. Britain is one of the few countries that meets all the Maastricht requirements, but Mr George raised the question of whether those were enough.

It was possible, he said, that countries could meet those four criteria at a given moment without eliminating tensions between them that could not be resolved without exchange rate adjustments. The tensions show up in widely different unemployment rates, ranging from 6 per cent in western Germany to 23 per cent in Spain.

These differences reflect structural features of each country's labour market, which show no signs of converging over time. Demographic trends, productivity growth rates, welfare systems differ enormously.

A single currency would lock in high unemployment rates in some countries. With extremely low mobility of the population within and between European countries, there would be no obvious means of relieving the tension caused by running a single monetary policy for all of them.

The easy answer would be to transfer tax revenues from low-unemployment countries to high unemployment ones. But pressure for a pan-European budget would be resisted by most members - except, perhaps, those on the receiving end of hand-outs.

There are two problems with the introduction of the need for real convergence: re-opening the Maastricht Treaty to include them would be politically impossible; and the countries likely to meet the existing Maastricht criteria also have similar growth and joblessness rates.

The new criteria do not add extra hurdles, according to recent research by Goldman Sachs.

Whichever way you look at it, Germany, France, the Netherlands, Luxembourg, Austria, Britain, Denmark and perhaps Belgium can probably pass both kinds of convergence test by 1997; Italy, Spain, Portugal, Greece and Finland cannot.

The debate about convergence is a red herring, anyway. In terms of economic analysis, what determines whether countries should join a single currency - "an optimal currency area" - is not the value of particular indicators for a year or two, but whether the economies tend to suffer the same upheavals and react to them in a similar way.

In other words, do growth and inflation in Germany and Italy, say, tend to change in similar ways even if the rates are very different? David Miles at Merrill Lynch has calculated the links between changes in inflation rates, growth rates and trade balances between the EU countries.

For a small group of countries the links are all strong. These include Germany, the Netherlands, Belgium, Austria, Luxembourg and France. Britain and Denmark would be second-rank candidates. The southern fringe economies behave in a totally divergent way. Spain might have brought its inflation rate down, but it is no Germany yet.

Paul Mortimer-Lee, chief economist at Paribas, says: "The markets have cleared the decks for monetary union." The markets in the past week have played out the politics of EMU. They have dashed the hopes of the Mediterranean economies, given another excuse to ditherers like Britain, and left the way clear for countries that want to go ahead with the boldest experiment in monetary policy for more than two centuries.