EU: Economic truths - A yardstick for monetary union.

EU: Economic truths - A yardstick for monetary union. - Economic truths - A yardstick for monetary union - Europe falls well short of optimal conditions for a single currency zone as spelled out 40 years ago in a seminal book and exemplified today in Ame

by DAVID SMITH.
Last Updated: 31 Aug 2010

Economic truths - A yardstick for monetary union - Europe falls well short of optimal conditions for a single currency zone as spelled out 40 years ago in a seminal book and exemplified today in America.

Lewis Carroll once wrote that it was possible to believe six impossible things before breakfast. However, he might have had trouble dreaming up the three things that have befallen Europe in recent weeks, which, if not impossible, were at least highly unlikely. I refer to the weakness of the euro, the shock departure of Oskar Lafontaine and the resignation en masse of the European Commission.

At times like this you begin to realise it will be events, as much as arguments, that will settle Britain's little euro conundrum

- whether to join, and when?

None of the above seems to me to do much for either side. The euro's short-term weakness tells us little about its likely long-term performance.

Lafontaine, depending on the point of view, was either the one European politician prepared to tell the truth about the ultimate political aim of economic and monetary union, or a loose cannon who should never have held high office. As for Jacques Santer and his team, their fate was political high drama but had nothing directly to do with the euro.

Amid the drama, I have been working on one of the central arguments about economic and monetary union, not least to get the issues clearer in my own mind. The results are contained in a new book, Will Europe Work? (Profile Books, £8.99).

The starting point was a pioneering work almost 40 years ago by Robert Mundell, who defined the conditions required for a successful monetary union. He called the zones which met these conditions optimum currency areas. The question is, does Europe - either the 11 Emu countries or a grouping of 15 or more including Britain - meet the Mundell conditions?

To answer, we need only to look at the living example of a large and successful single currency area, the United States.

America clearly satisfies the first condition - geographical mobility of labour. Travel on a US interstate highway and you see U-Haul vans transporting people from state to state. When California's defence industry contracted in the early 1990s, hundreds of thousands moved. Americans move to find work.

The US also meets the second condition - wage flexibility. Whether it is the work ethic or the harshness of the benefits system, Americans will accept lower paid jobs as an alternative to unemployment - they have to.

This has not been tested much in the recent booming job market of the 1990s, but it is there.

The US also meets the third condition, a central budget large enough to offset economic shocks that hurt some regions more than others. We think of the US as a 'small government' country, which it is, but a significant part of the 30% of GDP it devotes to public spending is directed from Washington and can be used as Mundell envisaged. Some economists say if the first two Mundell conditions are working, properly, the third - transfer of resources between states - would not be needed.

So how does Europe fare? On the first condition, geographical mobility of labour, very poorly. A manual worker in the US is 18 times more likely to uproot for employment reasons than his UK equivalent. Mobility within European countries is a quarter of that in the US. Mobility between countries, which is the relevant measure in respect of the single currency, is lower still.

The single market provides for free movement of labour but it is rarely exercised, for familiar reasons, including language and cultural differences and lack of recognition of job qualifications obtained elsewhere.

Europe also fails on the second count, wage flexibility, and for good reasons. Benefits in Europe provide a floor below which wages cannot fall.

More important, they are open-ended. Some EU states in Scandinavia pay higher benefits the longer someone is out of work. Europe cannot claim wage flexibility

Mundell's third test, a large enough central budget to cope with economic shocks, is also failed - by an EU budget just 1.27% of the combined GDP of its members, with most going to the Common Agricultural Policy.

What happens if the three tests are not met? The short answer is that very high levels of unemployment will be 'locked in' to certain regions without the means to do anything about it, which is politically dangerous and economically wasteful.

Are there adjustments Europe can make to be an optimum currency area?

One popular argument is that capital mobility will, within a single-market single-currency Europe, bypass the need for labour mobility. So it could, but only if Mundell's second condition, wage flexibility, is met. Capital is not going to move without a powerful signal in the form of lower labour costs.

If Europe has existed up to now with wide variations in unemployment, why should it not continue to do so under a single currency?

None of this means Emu is doomed. What it does mean, as Tony Blair has realised, is that Europe needs to reform to make a success of the single currency. The pity is Europe has decided to have the single currency first and is at best lukewarm about the need for reform later.

David Smith is economics editor of the Sunday Times.

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