FAILURE to achieve monetary union could severely affect the future of Europe, a director of the International Monetary Fund said yesterday.

Dr Stanley Fisher, a director of the IMF and former chief economist at the World Bank, also warned that the current bout of Euro optimism could be replaced by Euro pessimism within the next year.

Nevertheless, he said, it is becoming inevitable that European exchange rates will be irrevocably locked 113 weeks from today.

Speaking at the ESRI banking conference in Dublin yesterday, Dr Fisher said monetary union will change the way people think and change economies more deeply than many people think.

"It is extremely important that the project succeed because the Europeans have created a situation where they cannot fail to continue or the whole project will have to be rethought," he said.

Dr Fisher also stressed the importance of a fiscal package which would bail out any state which was hit by an external shock. In the US, he pointed out, there is a very powerful fiscal compensation mechanism to allow states to adjust to shocks. In the US, if a state loses the Federal Government will compensate it to the tune of 30 to 40 cents.

However, he added, a far more important factor in the US is labour flows. It is the lack of adjustment of labour in Europe which could cause problems.

"The flow of people in the US is way, way larger than in Europe," he said. In addition, in the US specific industries get hit and labour moves, whereas in Europe the reallocation takes place entirely in the state.

He added that fiscal policies being followed by European central banks to qualify for the single currency have reduced growth somewhat, as has the adherence to low inflation. But he also stressed that the European experience of slow growth with high unemployment could be due to the lack of flexibility in the labour market. "It does not mean we should give up on EMU," he said.

Dr Fisher also predicted that wage and price flexibility will be implemented in Europe over the next five to 10 years. European countries are already beginning to implement structural changes. The only problem could be that the European Central Bank will be too ambitious on inflation. He suggested that an inflation target of 2 to 3 per cent would be appropriate, whereas a zero rate target could be dangerous.

Overall, according to Dr Fisher, monetary union has far more than economic implications. If the future of Europe depends on having half a per cent more or less on a country's GDP, then it is certainly worth it, he suggested.

He admitted that the loss of control over the exchange rate could occasionally be expensive but pointed out that exchange rate realignments are often used as a medicine for bad monetary policies. He also said that the detailed penalties being proposed for countries which fail to keep their budget deficits within strict limits are cumbersome.

He suggested that the capital markets would be a better enforcement mechanism than the so called "stability pact". He pointed out that the difference between interest rates in US states has been above 1 per cent at times. If Europe were to go down the same route, the markets would punish any transgressing nation by simply increasing the margin on their interest rates, he said.