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Global View: Europe the guinea-pig

By IAN CAMPBELL, UPI Chief Economics Correspondent

QUERETARO, Mexico, May 24 (UPI) -- Europeans do not fully realize that they are guinea-pigs, the subject of an experiment. The experiment is not unprecedented.

The Romans, for one, tried it. (There was a sovereignty issue those days, too, dealt with militarily.) But, now that the single European currency, the euro, is here, seemingly to stay, the simple question is not asked often enough. Will Europe's single currency and monetary policy work? Will it survive the passage of the years?

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What might go wrong? Let us begin with the present, troubles that might be deemed short-term and likely to go away -- just teething troubles -- or harbingers of serious problems in years to come.

The European Central Bank, the new creation which since 1999 has decided monetary policy for 11 European countries (with the United Kingdom the only major European economy to remain out), appears to face a policy dilemma.

In recent weeks its senior officials seemed to speak more hawkishly on inflation, which in three of the 11 countries that now share the single currency is higher than the ECB's key interest rate of 3.25 percent. The European interest rate might be raised, analysts said.

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But in the past week Germany's GDP number, showing just 0.2 percent growth in the first quarter compared with the fourth quarter of 2001, must have given the ECB pause for thought. Can it afford to raise rates when its biggest economy, Germany, has contracted for two of the past three quarters?

Economic performance across the euro-zone differs widely. At present Germany is the laggard in growth, Ireland the star. Meanwhile, in slow-growing Germany, inflation, at 1.6 percent, is a third Ireland's 4.8 percent rate. The ECB, setting one interest rate to cover 11 different countries, must take account of performance in both, and in all the other countries.

It is a difficult task, perhaps an impossible one.

For there can be little question that if Ireland had its own currency and monetary policy, it would have had a much higher interest rate in the past three years, and its inflation rate would be much lower -- though, so, too, of course, would be its growth rate.

But will the disparities in growth and inflation between countries persist? And do they matter much at all?

Professor Philip Lane of Trinity College Dublin in Ireland would argue not. Undoubtedly, he says, with Irish inflation at 4.8 percent, the interest rate would be much higher, probably between 8 and 9 percent, if Ireland were setting its own monetary policy. But "the fact that Ireland may not have the perfect monetary policy does not mean the euro is a bad idea."

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Small wonder that one of the intellectual authors of monetarism, Milton Friedman, rejected the idea of the euro in an interview with United Press International two years ago and imagines that the experiment will end badly.

But monetary policy, Lane feels, is not the key determinant of growth. Japan, with its close to zero interest rate, and even Germany, which has had the same interest rate as other European economies since 1999, he says, would appear to demonstrate that.

Moreover Lane points to the benefits for Ireland of the single currency and monetary policy. The Irish pound was a marginal currency. The government needed to pay holders of its debt a "liquidity premium' to hold it. That is gone. Ireland issues debt now much more cheaply. This is "a clear gain," Lane says. Other countries, especially the smaller ones, also share in that fiscal gain.

Another gain, he would argue, and not just for Ireland, is in international policy coordination. The 2001 economic slowdown occurred across the industrialized world. "A coordinated response is ideal," Lane says. The ECB provided it, bringing down rates for the bulk of continental Europe. "There was no need for inter-governmental meetings," Lane says.

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And, of course, there was no question of beggar-my-neighbour competitive devaluations in single currency Europe.

But will inflation in Ireland and other countries, such as The Netherlands and Spain, in all of which inflation exceeds the ECB's interest rate of 3.25 percent, come down while interest rates remain low? And will undynamic Germany, the biggest economy, achieve growth with a short-term interest rate that is 86 percent higher than the 1.75 percent of the United States? And might not new and wider disparities emerge over time, pressures that eventually drive the currency union apart?

Charles Jenkins, principal West European economist at The Economist Intelligence Unit in London, believes there is a limit to any inflation disparity over time because "prices in one country must bear some relation to prices in the rest of the area."

He does not find it so surprising that inflation in Ireland is higher than in other countries in the euro-zone. Ireland is a poorer country that is catching up. Jenkins' view, then, is similar to that of the Canadian Nobel prize-winning economist, Robert Mundell, seen as an intellectual author of the euro, who judges inflation in Ireland as "not inflation at all" but something "transitional."

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Lane, meanwhile, argues that even if Germany grows slowly, crisis will not ensue since "it would still be a very rich country." Yet would not rising unemployment in Germany push even a wealthy country towards crisis?

Simon Tilford, a consultant and an expert in the German economy, takes a less optimistic view than Lane or Jenkins. He "would like to see monetary union succeed" but is "skeptical about its sustainability." And it is for Germany that his fears are greatest.

"Productivity growth has stagnated in Germany, unit labor costs are picking up, and the D-mark was overvalued against the country's euro-area partners at the point of fixing," he says.

Tilford believes "substantive reform of the labour market and liberalisation of the business operating environment look a long way off," and so "the outlook doesn't look good."

Notwithstanding its poor growth performance, Germany has been helped in the past two years by the weakness of the euro. Against its European partners it can no longer devalue but Jenkins points out that even within Europe, Germany's exports have fared well.

He does not see export competitiveness as the problem. Nor does he believe that growth disparities would necessarily blow the monetary union apart. "Growth is different between Camberwell (a working class part of London) and Chelsea (a wealthier part)," Jenkins says, but it doesn't mean that London or Britain break apart.

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It is an argument that Mundell has put using the example of California. Its economy is thousands of miles distant from that of the American east coast, but would a separate currency and monetary policy have helped its development? On the contrary, Mundell argues that California is the rich place it is today partly because it shares a common currency with the United States. For his own country, Canada, Mundell recommends adoption of the U.S. dollar.

But to the argument that a common currency has served the vast United States, there is also a rejoinder. Though there are some differences in taxes and laws and other policies between states, the United States has a common language and shared customs and economic policies, and workers can move freely about the country in search of work. A depressed region of the United States gradually exports labor; a dynamic one imports it. Socially, this is a safety valve; economically, a means of transferring resources to where they can best be employed.

European workers enjoy the right to move freely but different languages, different customs and cultural ties stand in their way. Though the multi-lingual and adaptable Dutch and Scandinavians might find it easy to find work in a variety of countries, the average European will not.

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The arguments for and against European Monetary Union are complex. With a single currency and exchange rate, Europeans can now travel, sell, buy and invest more easily in neighbouring countries. The European capital market is far bigger than before, and would become much bigger still were Britain to enter the union. Further integration of the markets for goods and services should bring additional gains. And as Europe trades together more, the gaps in economic performance between countries should reduce.

Some Europeans argue still more coordination is needed. Romano Prodi, the former Italian prime minister and now the president of the European Union Commission, wants the commission to decide economic policy, such as tax policy, in the member states, as well as foreign policy and defence.

Both Lane and Jenkins judge this an unnecessary step. Lane favors a "competition of ideas." Let different countries handle their economic policies (other than monetary policy) differently. They will also perform differently but Lane does not judge that destructive.

But for Lane there is a question that Ireland faces within Europe. Does it "want to be like Boston or Berlin?" In other words does Ireland want the mid-Atlantic economy that the United Kingdom has achieved since Thatcher's reforms in the 1980s, with freer labor markets, lower unemployment, lower taxes and more entrepreneurship, or the more socially oriented European model?

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Lane's personal choice is for Boston. Indeed he would welcome British adoption of the euro because it would help to drive Europe in that westerly direction. But an important question is whether the choice of mid-Atlantic might be compromised by membership of the European club.

Separate countries; a sense of European identity, but not a United States of Europe, not further loss of sovereignty: for both Lane and Jenkins that would appear to be the ideal. Is it possible?

Will the separate countries of Europe work harmoniously together with their shared interest rate and shared currency, or will tensions eventually destroy the relationship?

These are countries with different languages, different customs, different propensities to consume, between the free-spending Latins and Irish and the savings-oriented Germans.

The Netherlands, small and dynamic, has reformed its labor markets. Germany has not. And if France wins soccer's World Cup, the French will go and celebrate while depression falls upon Germany. Is Jenkins' view right, that this matters no more than victory by Chelsea against (the unknown team of) Camberwell?

Is Lane right to be optimistic that a country that lags behind will not enter a crisis that will force its leaders to pull it out of the union?

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As years go by, can countries that do reform share the same currency and interest rate as those that do not?

The gold standard, the fixed exchange rates of the 1970s, the semi-fixed exchange rates of Mexico, Asia, Russia, Brazil and Argentina, Britain's own ill-fated and brief entry into the European Monetary System a decade ago: history is littered with currency fixes that have come apart. But the past cannot tell us for certain what will happen now. The experiment is a new one, a currency fix in which the old currencies were thrown away, thereby eliminating some of the pressures that have proven decisive in the past.

It is an experiment with no exact precedents. This writer is a skeptical observer. He may be short-sighted, failing to see the many benefits monetary union brings in a world economy that is integrating and globalizing. Perhaps one day even Mundell's dream of a single world currency will come about and prove successful.

But, for now, we know only that Europe's leaders have embarked on an experiment, an experiment for which they have volunteered their populations, largely avoiding giving them a chance to decide. It will be many years before we know whether the experiment will work.

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(Global View is a weekly column in which our economics correspondent reflects on issues of importance for the global economy. Comments to icampbell@upi.com)

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