Road to Monetary Union in Europe Proving Bumpy

Britain, France and Germany have fixed their exchange rates--the values of their currencies--as a step toward monetary union. The benefits of the union, if achieved, lie in the future. The costs must be paid now. The costs are higher for France and Britain because of recent events in Germany, notably the German unification and Germany’s policy: Reaganomics on the Rhine.

At the beginning of February, short-term interest rates were 9% in Germany, 10% in France and 13.7% in Britain. Consumer prices in Britain rose by more than 9% in 1990, 6% more than in Germany and France. Wages and other costs of production reflect these differences in domestic inflation. And the differences in inflation broadly reflect the differences in average rates of money growth for the past several years--faster in Britain, slower (and approximately equal) in France and Germany.

Unemployment rates in the three countries differ also. British unemployment is 6.5% and rising. Germany reports 6.4%, while France remains stuck at about 9% unemployment.

The near-term costs of monetary union depend on how the differences in unemployment, interest rates and inflation in these three countries are resolved. If the unemployment rate in Britain rises toward the French rate, as many predict, the British will have to choose between their commitment to a fixed exchange rate with the German mark and the other European currencies or a prolonged period of unemployment.

Rates of unemployment in Britain are a direct consequence of their recent policy changes--the decision to join the European system in October, 1990.

France’s high and persistent unemployment is a consequence of exchange rate policy also, but the French problem is different. They have been members of the European system for more than a decade, so their problems tell us more about some costs of membership.

Although the problems in Britain and France have a common element, there are differences as well.

In 1979, France and West Germany took the lead in establishing a system of fixed but adjustable exchange rates for their currencies. Several other countries joined them. Members of the group, popularly known as the European Monetary System, agreed to buy or sell, at a fixed price, all the currency that anyone offered or demanded. Governments or their central banks became the buyers or sellers of last resort. Countries adjusted exchange rates from time to time to reflect past or expected inflation and other changes.

At first, countries followed rather different economic policies. France was more inflationary than West Germany, so France’s consumer prices rose more than twice as fast as West Germany’s from 1979 to 1985. The French franc devalued against the West German mark repeatedly. Other countries adjusted their exchange rates also. West Germany and Holland, with the lowest rates of inflation, revalued. France, Italy and Belgium, with higher inflation, devalued.

By the late 1980s, countries had adopted similar policies. Inflation rates converged toward the lower rate in West Germany. Exchange rate adjustments became smaller and less frequent. Member countries decided to take another step toward a single monetary system for Europe. The members agreed to remove all remaining overt controls and restrictions that prevented people from moving money from one country to another. And they expressed their intention of avoiding further adjustments in currency values by maintaining similar policies.

At about the time this new step was to be taken, the East German government collapsed. West Germany faced a new economic situation, one that was not imagined at the time of the agreement--the union of East and West Germany. Suddenly West German marks became German marks. The demand for West German goods rose, and a new supply of workers came pouring over the former border to help meet the increased demand.

Although the triggering events were very different, the union of the two Germanys has had effects similar to the Reagan policies of the early 1980s, so I have called these changes Reaganomics on the Rhine.

As in the United States in the early 1980s, productivity in Germany was expected to rise; in response, the anticipated return to investment in Germany spiked up. Interest rates rose, reflecting these higher anticipated real returns. Foreign capital flowed toward Germany to share in the higher returns on investment.

To invest in Germany, foreigners had to buy marks, so the price of marks rose against the dollar and the Japanese yen, pulling along all the currencies tied to the mark by the European system of fixed exchange rates. Large (and growing) government spending to build housing and infrastructure to support the former East German population and to slow immigration to the west added to spending and the budget deficit. The spending put additional upward pressure on interest rates. Restrictive monetary policy kept money growth and inflation low.

Appreciation of the mark against the dollar makes U.S. exports less expensive in Germany. Because the French franc, the British pound and other European currencies are tied to the mark, U.S. exports become cheaper in these countries also. U.S. exports also gain a competitive edge against the members of the European Monetary System in sales to third countries. All this has helped to make the current U.S. recession milder.

French investors want to get the higher returns from investment in Germany also. Since the French government has chosen to keep the exchange rate fixed, France cannot lower its costs of producing exports by letting its currency depreciate as the United States has done.

Instead, French exporters must reduce their relative costs of production in the only available way--by holding increases in wages and other production costs below the German increases. Until relative production costs are equal, France will remain far from full employment. With similar policies, small differences in interest rates and similar rates of increase in wages and prices, France stagnates while Germany booms.

Britain faces the same problem as France and its own bigger problem too. Britain flirted with the European fixed exchange rate system for a time in 1986 and 1987, but Britain didn’t join the system until October, 1990. Britain has a much higher rate of inflation, bigger wage increases and higher interest rates than Germany or France.

Wishful thinking by government ministers, bankers and financial journalists was that a fixed exchange rate would lower the costs of disinflation. The argument was that Britain would import the credible, low inflation policy of the Bundesbank. Inflation was supposed to fall without a recession, lowering interest rates.

It hasn’t happened. I think the British erred. As unemployment rises, the British government will be faced with a choice: Devaluate the pound to reflect higher British inflation or accept enough unemployment to cut the inflation rate.

Like France (and the other members of the European monetary system), Britain must compete against the higher returns to investment and the expected increase in productivity as the retrained and re-equipped East German workers go back to work during the next few years. Unless Britain’s costs and prices become competitive with those of its partners in the monetary system, unemployment will rise or remain high.

In 1925, Britain returned to a fixed exchange rate (against gold), with production costs higher than competing countries. Unemployment remained at about 10% until the 1930s Depression began. Finally, Britain devalued.

Usually people don’t repeat their mistakes; they make new ones. Those bankers and journalists in Britain who urged a fixed exchange rate as a less painful solution to Britain’s problems are reminiscent of their grandfathers who made similar arguments.

The British government again faces a difficult choice, this time made more difficult by the productivity surge expected from the merger of the two Germanys. They can hold on to the exchange rate and let unemployment rise until production costs are forced down. Or they can devalue and try again at a more competitive exchange rate. Or they can adopt a fluctuating exchange rate with monetary restraint to reduce inflation--the package that worked so well in the early 1980s.

The moral: The road to monetary union is bumpy.