Economic and Monetary Union - learning by doing?

When the European Union set course for economic and monetary union (EMU) in the early 1990s there was extensive debate in Ireland and elsewhere on whether it was a wise initiative. The governments of most EU member states concluded it would be beneficial for their individual economies and EMU went ahead. However, some countries, such as Sweden, Denmark and the United Kingdom, did not share this view and today continue to use their own currencies.

It has certainly been a bumpy ride in EMU over the last seven years as things did not turn out as expected – but then things never turn out as expected. While many would blame EMU for the ills of the great recession, that is to ignore the fact that the crisis also seriously affected non-EMU members, such as Estonia, Latvia, the UK and the United States. The financial crisis had global origins and global effects.

It is instructive to look back at some of the key issues in the debate which took place in the mid-1990s on the benefits and costs of EMU. An important argument put forward for joining EMU was that it would reduce the cost of borrowing in countries such as Ireland and Spain. In the 20 years prior to 1998, borrowers here – allowing for changes in the exchange rate – on average paid 2 per cent more than their German counterparts, and this in turn hampered investment.

From the beginning of EMU in 1999, Ireland did benefit from lower interest rates, as expected. However, as we now know, our policymakers failed to manage this advantage. To prevent a bubble developing, they should have regulated the banks effectively and tightened fiscal policy. The fault for this policy failure lies primarily at the door of government. Many non-EMU countries such as the US, the UK, Estonia and Latvia also experienced low interest rates at this time. The failure to manage the benefits of low interest rates also led to a huge property bubble in non-EMU Latvia and Estonia. On the other hand Finland, which was an EMU member, having learned lessons from an economic crisis in the early 1990s, avoided the emergence of a post-EMU property bubble through running a large surplus.

In the run-up to EMU one of the most prominent arguments against joining was that, without an independent exchange rate, an economy would be vulnerable if an economic crisis affected an individual EMU member. Experience had suggested that, when an economy encountered a major shock to output, being able to devalue and rapidly improve competitiveness hastened adjustment to the new situation, reducing the period of high unemployment.

Competitiveness One of the features of recent experience in EMU that

has surprised many observers is the extent to which countries in serious trouble have improved their labour-cost competitiveness through cuts in wage rates or wage moderation, making up for the absence of an independent exchange rate with what is sometimes termed “internal devaluation”.

The graph above shows the movement in wage rates over the last 25 years in Spain, Portugal and Ireland relative to the average for the EU 15. Having lost competitiveness heavily in the run-up to the crisis, all three countries have seen a major turnaround since 2008. In the case of Ireland this happened very rapidly, with average earnings even falling by a small amount in 2009 and 2010. The result of the restoration of competitiveness has been a major turnaround in employment growth in Ireland since 2012, and in Spain over the last year.

While an independent exchange rate might have allowed a more rapid cut in real wages (through higher inflation), it is not clear it would have made a difference to the subsequent adjustment of the economy, especially that of the labour market. It would appear that economies are behaving differently as EMU members in times of crisis, making up for the loss of an independent exchange rate by greater labour market flexibility.

False starts

One area of EMU policy which has developed under the pressures of the crisis is the provision of liquidity to member states facing major problems. This was a case of learning by doing: it took a lot of time and some false starts to establish the European Stability Mechanism (ESM), which is now in place to lend money to EMU members with temporary liquidity problems. It still has many defects, not least the decision-making on accessing the funding. However, if it had been in place in 2008 it might have made things easier for Ireland and Portugal.

Whatever the defects of the lending provided by the EU, the experience of Ireland and Portugal in EMU contrasts with that of Latvia and Estonia, which were not EMU members when the crisis began. The Baltic states had to rely on the IMF alone and they had to make dramatic cuts in their public finances to access this funding. While the experience of Portugal and Ireland has also been very difficult, the availability of EU money has allowed a much less harsh adjustment process.

It is certainly true that EMU membership provided more opportunities for unwise policies in Ireland and Spain in the last decade. However, membership of EMU, and the access to finance which flowed from it, has made the handling of the crisis somewhat easier than would otherwise have been the case.