Derailed

Wynne Godley on the ERM

I am in favour of Britain having much closer ties with other European countries, provided that appropriate institutions are created and the whole thing is brought under effective political control. But I have never been able to understand what it is that those who support the Maastricht Treaty think they are going to get out of it. Maastricht supporters are keen on ‘not being left out’. But left out of what exactly? How can people be so sure that a united Europe is something they want to be part of – particularly with the expensive, destructive and corrupt monstrosity called the Common Agricultural Policy sitting there as the single most important achievement of the EC so far? Matters were not helped by the frantic procedural manoeuvring in Parliament over ratification, and by the rather uncritical support which Maastricht has received from the opposition parties. The substantial questions have not yet been debated or criticised with any penetration, although the British people are deeply suspicious and would almost certainly have voted against ratification if there had been a referendum. Platitudes are not good enough. John Major thinks it means something to say that he wants us to be ‘at the heart of Europe’ but he must do far better than that to convince me. I suspect that his purpose is destructive, that all he really wants is to be inside the tent, pissing all over the shop.

What, in particular, were people supposed to make of the proposal, which until last weekend was central to the Maastricht process, that Europe should establish a common currency? I was recently circularised by our local MEP with a brief on this subject. He must have had the immense resources of the Brussels bureaucracy behind him and it was reasonable to expect a clear, balanced and simple statement of what the issues were and why, on a balance of considerations, a common currency would be advantageous. No such luck. The tract made only two points: that a single currency would remove the instability caused by fluctuating exchange rates, thereby enabling business to plan more reliably, and that international traders would no longer incur ‘transaction costs’ in the form of the small margin they now have to pay dealers when they buy and sell foreign exchange. It was as simple as that! The brief contained no reference whatever to the obvious fact that by joining a currency union, member countries would be giving up powers of independent action which at present they possess. It follows a fortiori that the document said nothing about who those powers would be given up to, and how the new authorities would exercise them.

Let me go back for a moment and recall the conventional view of the conduct of economic policy during the first twenty-five years after the war when growth was rapid and stable, and when inflation and unemployment were both negligible. The generally accepted view at that time was that individual countries could, by using the instruments of macroeconomic policy, mitigate the effect of external and internal shocks which might otherwise cause damaging economic fluctuations as well as endemic inflation and unemployment. The instruments in question included the setting of tax rates, the authorisation of public expenditure projects, the determination of interest and exchange rates and the regulation of flows of credit to the personal and business sectors. It is the use of these instruments that individual governments have to give up when they join a currency union. If there is only one money there can only be one monetary policy. And if an individual country cannot issue its own money, it has no more power to conduct an independent fiscal policy than has a local authority, say, or an erstwhile colony in an imperial system.

That these powers of independent action would be given up by members of a European currency union is, of course, recognised in the rules for ‘convergence’ which were adumbrated in the Delors report and given greater substance in the Maastricht Treaty itself. Budgetary policy is no longer to be discretionary but governed by very simple rules with deficits and national debts held within preordained limits. Monetary policy, once a common currency was established, would be conducted by an independent central bank in a way which would ensure, as the overriding objective, that inflation was kept to an absolute minimum.

There is only one theoretical position which would make sense of such a programme: one which, in sharp contrast with the post-war orthodoxy I have outlined, holds that any attempt to conduct positive macro-economic policy would, except in the very short term, only add to inflation and, in the end, make unemployment even worse than it otherwise would have been.

The astonishing and distressing thing about the period of British membership of the ERM was that this same view came to be held by the whole Establishment. I remember a feature which appeared in the Financial Times only a few months ago which replied to an imaginary schoolboy as though it was a matter of fact, first, that devaluation is always completely ineffective because it quickly results in a fully offsetting addition to inflation and, second, that since another devaluation would then be expected, it was erroneous to suppose lower interest rates would follow. On the contrary, the expectation that there would be a further devaluation means that interest rates would have to be raised. And this was the view firmly taken before last September by all our main conjuncture institutes as well as by virtually all our most respected economic commentators. Indeed, it became embarrassing to say anything else, and I was made to feel very foolish for believing that devaluation would be effective when the course of events had, so it was thought, simply proved that it wasn’t.

But Black Wednesday proved the Establishment view wrong. We had a large devaluation, which has had the effect of greatly improving our international competitiveness and the profitability of exports; there has been no detectable addition to inflation which has, on the contrary, continued to decline to levels not seen for decades; and to most people’s immense relief interest rates have been substantially reduced as well. All the things which we had so emphatically been told turned out to be completely wrong. And none of those advantages could have been won had we been members of a currency union.

What happened to the ERM countries last weekend was very similar to what happened in the UK last September and provides important further evidence that the former Establishment position was wrong. Structural differences, arising in particular because the Germans had so badly mismanaged their reunification, were far too great for market forces to resolve them, and the French and others found themselves crucified on intolerably high interest rates over which, within the system as it was, they had no control.

There are conclusions of enormous importance to be drawn from these events. It should be recognised, for a start, that market forces alone are not going to be sufficient to ensure that the European Community does not get locked into a state of endemic recession. The internationalisation of finance and industry has already emasculated, though not, in my opinion, destroyed the power of individual governments to pursue independent macroeconomic policies. But to the extent that national governments can no longer be effective, this points to a pressing need for some supranational authority, call it a federal government, to carry out these functions.

It seems clear that the Maastricht criteria for the establishment of ‘convergence’ were far too narrowly conceived. To fulfil the conditions necessary for a successful currency union it is not nearly enough that member countries agree to follow simple rules on budgetary policy and achieve some minimum period of low inflation and currency stability. They need to reach a degree of structural homogeneity such that shocks to the system as a whole do not normally affect component regions in drastically different ways. Moreover, arrangements should be made which ensure that when substantial changes of a structural kind do turn up the federal authority is equipped to share out any burden which ensues. It would be wrong to suppose that there exist well-defined ‘fault lines’ which can be cured once and for all. Structural changes are always going to be taking place as a consequence of political earthquakes, or for other reasons, and the Community must have some way of dealing with them.

It is a weird coincidence that the day on which Britain ratified the Maastricht Treaty, after months of bitter controversy and extraordinarily little comprehension on the part of the British people, should also be the day on which the ERM train which was carrying the rest of Europe towards a single currency should get completely derailed.

It is a good moment to start again. I think the Maastricht enterprise was built on a premise that has turned out to be completely mistaken: namely, that there can exist some kind of union between countries which is much more than a community of independent nations with special trading arrangements but much less than a full-blown political union. Maastricht is a half-baked half-way house and, with the CAP always at the back of my mind, I cannot agree that it is right to support it on the grounds that it is the only route ahead, the full nature of which will only be revealed in due course. Going forward should now mean that we explicitly hand over the main instruments of independent policy-making to some properly constituted body under appropriate political control. If this is not what Britain wants, is it completely out of the question that we now deliberately go backwards?