What the New Europe Needs: Adjustable Exchange Rates, Open Markets

The movement toward a European Monetary Union and a single currency for Europe reversed this summer. The core of EMU was a fixed exchange rate between French francs and German marks that was supposed to lead to a single currency for France, Germany and, at the very least, the smaller countries of northern Europe: Belgium, Denmark, the Netherlands and Luxembourg.

The more ambitious plan for EMU, a single currency for the 12 countries of the European Community, always seemed more a distant vision than a practical plan. But several countries were committed to monetary union no later than the end of this decade.

The plans for EMU began to crumble last fall, when Britain and Italy left the fixed exchange rate system and Ireland, Portugal and Spain devalued their currencies. The sledgehammer blow fell as France was forced to let the franc fall below 0.29 German marks, the bottom of the fixed exchange rate bond.

As always, governments complained about speculators. In fact, the speculators did the governments a favor. Unemployment rates in several European countries border on rates last seen during the Depression of the 1930s--more than 16% in Spain, 11.5% in France and between 10% and 11% in Britain and Italy.

High unemployment and sluggish growth or recession were results of holding exchange rates fixed so as to achieve monetary union. Now that exchange rates are free to fluctuate within very wide bands, countries are free to pursue more expansive policies. Several countries that devalued or left the system last fall have ended their recessions.

There are other reasons to regard the end of monetary union as desirable, if it should happen. European governments have been transfixed for years by the prospects of political unity in Western Europe. Politicians were preoccupied with building a European federation that would have common laws in many areas. Monetary union--a single currency--was to be the first big step toward political unity.

The vision of an integrated Western Europe made more sense before communism collapsed. That vision is now much less appropriate.

The current challenge for Europe is to bring the new market economies of Central and Eastern Europe into the European trading system as full participants. The vision of Europe’s future should shift from Europe in the small to Europe in the large. An enlarged Europe with markets open to the Czechs, Hungarians, Poles and other formerly communist societies should be the goal.

U.S. assistance under the Marshall Plan helped Europe recover from the destruction of World War II. The plan’s more lasting contribution was to break down trade barriers within Western Europe. Under the General Agreement on Tariffs and Trade, barriers between Western Europe and North America also fell. Competition in open markets within a decade or a generation raised living standards beyond the hopes of the most optimistic observers.

Europe, the United States and Japan must offer the same opportunity to the formerly communist countries. Lowered trade barriers and open markets will raise living standards for both sellers and buyers. These open markets will allow the new market economies to buy as well as sell. Everyone gains if Western countries develop a concept of an enlarged Europe--eventually, Charles de Gaulle’s vision of a Europe stretching from the Atlantic to the Urals.

An enlarged, prosperous Europe contributes to the peaceful development of the Continent. Market competition and improved opportunities absorb energies and resources that might otherwise be used to renew ancient disagreements.

A Western European monetary union works against this vision of peaceful development and prosperity. It is far more difficult for Western Europe to absorb Eastern European exports if exchange rates are rigidly fixed. Exportation of agricultural products, steel, textiles and other manufactured goods will require major changes in prices of individual products that are incompatible with fixed exchange rates and high employment in Western Europe. Exchange rate changes ease the adjusting of domestic prices and output to new competition.

Although Europeans would gain from renouncing the idea of monetary union, I do not think they will, at least not yet. There is likely to be at least one more attempt to lock in exchange rates within a narrow band.

There are two main reasons: First, European governments are unable or unwilling to give up their very costly Common Agricultural Policy. This policy restricts imports, subsidizes output, produces huge surpluses, encourages inefficient production and raises prices. About half of the European budget is spent on this program.

The Common Agricultural Policy relies on a fixed exchange rate system to set prices and subsidies. Monetary union makes this inefficient system workable. An expanded Europe would bring into the EC countries with large agricultural sectors. Western Europe would have to change its agricultural policy--a desirable but politically difficult task.

Second, European governments do not trust their trading partners not to devalue their currencies in order to gain trade advantages. It is argued that some countries would use devaluation to make exports cheaper and imports more expensive. Other countries would retaliate by imposing tariffs and quotas. If this were true, the advantage of a single European market would be eroded or lost.

I am skeptical of this argument. The world’s largest bilateral trading partnership--between Canada and the United States--has operated with flexible exchange rates for 30 years, and there have been few if any claims that either side pursues competitive devaluation. Canada and the United States have moved toward a common market with falling trade barriers.

European governments do not think they will have the self-discipline to follow this example. It will take at least one more failure before France, Germany and others will look for an alternative.