EMU must go further

The EMU project is set for success in the short term, despite the financial crisis, but in the long run its prosperity depends on greater co-ordination between member states to undertake essential structural reform.

The economic backdrop to the launch of the single currency changed substantially in 1998. Market confidence, rattled by economic collapse in Asia over a year ago, plummeted following Russia's dramatic devaluation and debt default in August. By the end of September the IMF was expecting the world economy to grow by only 2% in 1998, significantly below trend and less than half the rate it had predicted a year earlier.

At the same time, the European Central Bank has brought down its expectation of EU growth in 1999 from 3% to around 2.5%, with some major euro-zone economies expecting significantly lower growth.

The changed economic environment has given the sceptics a field day. Surely, they argue, it will be impossible to make a success of the single currency in the face of such market turmoil? How can an untried and untested central bank, they claim, respond to the challenges that the EU currently faces?

Yet it is precisely the mechanism of a single European currency, and the greater co-ordination of economic policy which that will require, which gives the European economies their best chance of riding the current storm.

For a start, if the launch of the euro had not been on the horizon, it is likely that the damage in Europe would have been greater. Weak currencies worldwide have been especially vulnerable in 1998. In the absence of the sure-fire knowledge that the exchange rates of the euro-11 would soon be irrevocably fixed, it is unlikely that EU currencies such as the lira and the markka would have escaped a devaluation.

The preparation for EMU has also forced the euro-zone countries to strengthen their underlying economic position. OECD figures show that average budget deficits across the EU fell from 6.6% of GDP in 1993 to 2.5% in 1997, as countries strove to meet the Maastricht convergence criteria. The anticipation of joining the single currency has reduced inflationary expectations, particularly in countries such as Italy and Spain, which lacked price stability in the recent past.

Lower budget deficits and lower inflation, combined with the lower average interest rates which EMU will bring, have set the stage for more sustainable economic growth in EU countries, bucking the trend of a slowdown elsewhere in the world.

Critics of the single currency project also argue that it will prevent an individual countries responding to asymmetric shocks. This argument is flawed for a number of reasons, not least that EU countries share far more similarities than they have differences, but it is also irrelevant in the current circumstances.

What the emerging market crisis has done is confront the euro-zone instead with a symmetric shock: financial market instability combined with lower world growth. All countries are affected through similar channels; it is a common co-ordinated response that is therefore the most appropriate.

The framework for a co-ordinated response was laid down years ago in the Maastricht treaty. It gave member states a legitimate interest in the economic policies of their euro-zone neighbours and gave Ecofin, the council of EU finance ministers, the power to formulate broad guidelines for the economic policies of member states. A new principle of "multilateral surveillance" was also established, allowing individual countries to have their economic performance monitored by their peers.

This framework was then fleshed out by the Stability and Growth pact of December 1996, which allows harsh fines to be imposed on countries which run budget deficits above 3 per cent of GDP, unless that country is suffering a severe recession.

However the narrowness with which a number of the euro-zone countries, including France and Germany, met the Maastricht criteria, combined with a perceived political need to boost spending in the face of lower growth forecasts, is already leading to pressure on Ecofin to seek ways of circumventing this restriction.

(Ironically it is Britain, for now outside the euro-zone, that is best placed to meet the budget criteria with projected deficits for the next few years of under 1% of GDP, comfortably within the 3% limit.)

Yet the Stability pact will still be a force for the co-ordination of policy. The need for Ecofin to reach a consensus on how the pact is interpreted makes it unlikely that one country alone will be permitted a greater budget deficit unless it faces a severe recession. In practice a liberal interpretation of the pact would apply to all countries together. The pact will therefore provide a spur for a co-ordinated approach to fiscal policy, even if it does not bring down budget deficit levels as far as some would have wished.

But the euro-11 countries could and should reach higher in their response to the changed global picture. The new co-operation mechanisms provide an opportunity for member states to commit to the broad structural reforms that are needed to ensure the competitiveness of the euro-zone in the longer-term, particularly in labour market and pension reform.

Structural unemployment across the euro-11 is high, partly as a result of the high costs to employers of taking on staff. At the same time, demographic changes will early in the next century start to place unbearable burdens on governments' ability to deliver state pensions without greater institutional reform towards fully-funded schemes.

The policies needed to address these problems are unpopular and the temptation to postpone progress will be large. It is for this reason they should be flagged as a priority right from the start, when the political determination to make the euro project work is particularly strong.

A clear statement of intention from euro-11 countries to address labour market and pension reform would be welcome to the financial markets in a time of uncertainty. It would also provide the substance for the development of efficient mechanisms of peer review between member states. And in the longer term, it would ensure the continued prosperity of the euro-zone, regardless of the situation elsewhere in the world.