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Can devaluation save Europe?

Europe- by which I mean the continent- is facing the exciting problem of living with the Euro in less than nine months time. As things stand it will start off with about 12% unemployment and 2% inflation. On top of this it has the longer-term issue of state finances. Deficits are running at over the 3% of national income stipulated by the Maastricht Treaty, discounting one-off and other massage effects. The average tax take from national income is around 50%; and state pensions are in substantial prospective deficit, requiring another 10% rise in the tax take within two decades. How will the average European react to the realisation of all this? He has been brought up on the idea that superior European economic performance will guarantee a good private standard of living, plus generous public services, and job security. The reality is now turning out to be very different. I am currently visiting Humboldt University in former East Berlin; after huge investments in post-wall Berlin on the basis of optimistic projections of growth, the state government of Berlin has announced large cutbacks, not least in the city's three universities. All is flux: high wages and benefits have spelt high unemployment and low growth, which in turn have destroyed the federal and state finances. And into this mess steps in January next the European Central Bank (ECB)- on paper an all-powerful body above politics, but in practice a convenient political whipping boy with no allies.

It is all too easy to tell - as I have before- a variety of tales of woe about what may happen; protectionism, yet more cuts in working hours, tax and benefit harmonisation, and so on. But this week let us ask whether there is a golden scenario too.

European politicians have been desperately racking their brains for a route into such a scenario. They are realistic about cuts in social provision (including pensions) and rises in tax rates; the people are not (yet, at least) in a mood to wear them. They can hardly tamper with the virtue of their central banks, given their preparations for merging them in the mighty ECB. They cannot deregulate the labour market; what would the all-powerful unions say? Like Houdini they are all tied up in a dozen ropes and a hundred impossible knots. But can they too free themselves in one bound?

Well, our politicians have one instrument left: their exchange rates. True: after January they will lose control not just of these, but also of the Euro- though Maastricht technically allows them a say in exchange rate policy, in practice, without any instrument of control, this is a meaningless concession to them. After January it is very likely that a stern ECB, determined to prove its tough credentials for the inflation fight, will resist any weakening of the currency in case it threatens a rise in inflation. But that leaves a crucial window of opportunity for today's politicians: they can devalue massively in the run-up to the Euro, leaving the ECB to manage it from there.

This has in fact already been happening for over two years. The DM in 1995 was around 1.40 to the dollar; it is now over 1.80. The other continental currencies have followed suit because of their policy of linking closely to the DM. So Euro currencies have devalued some 25% in two years. That partly accounts for their current trade-led expansion. But it is not enough to make much dent in unemployment. One can see this from labour costs: it still costs 40% more to hire an ordinary German than the equivalent American. America is a model of a mature economy with good growth and full employment. So we might guess that other mature economies would need similar wage costs, if they are not to frighten off mobile but vital international capital. Certainly Japan found itself similarly overvalued in 1995 with 80 Yen to the dollar and wage costs 40% above US ones; it has since devalued by that percentage and brought its wage costs to parity. It must therefore be tempting for German politicians to drive the DM down another notch to wage parity with the US. This would mean the DM going to around 2.60 to the dollar.

Engineering such a devaluation is not too difficult. There is plenty of nervous foreign money fleeing Europe for a safe haven- away from the threats of warm-blooded central bankers from Italy and Greece or of popular uprisings against unemployment and rising taxes. A few more rumours whispering how concerned the Bundesbank, the European Monetary Institute, or the IMF are about all this, would help the process on its way. None of these rumours should be difficult to arrange- all these institutions are worried stiff and have issued veiled statements of this sort already. Just encourage them a bit.

This strategy would be likely to have quite strong and successful short-term pay-offs. Unemployment could fall and growth rise quite sharply. Inflation would not rise much provided there was wage restraint. We saw that in the UK after we left the ERM; inflation merely reflected some 'passing-through' of the higher prices of imports because there never was the wage explosion so feared by officialdom. But then in the UK we have had twenty years of supply-side policy reform, freeing up the labour market in particular. On the continent, labour markets are as rigid as ever, and strong unions hold sway across all sectors. How long will it be before these unions and other pressure groups press for compensation for devaluation of their wages and benefits by the lower DM? So far so good, but by the time the DM reaches 2.60 the cumulative devaluation will have reached 50%; true, only against non-Euro currencies but non-Euro imports are still nearly 20% of their national income so such a devaluation would imply a fall in living standards of nearly 10%.

There have been miracles of trade union restraint before- the famous post-war German economic miracle occurred with full union cooperation. Then of course there was growth to go with it and German unions were able to persuade their members of the virtues of capitalism. In the past twenty years those unions' attitudes have changed. They have pushed aggressively for both wage rises and cuts in hours even though unemployment has been rising; and it is more difficult for unions to cooperate with capitalist adjustment when their members are suffering. To ask continental unions to save the unemployed and permit Anglo-Saxon labour market flexibility when their members' real wages are falling is to ask for a miracle indeed.

So the chances are the early years of the Euro could look good on the back of a massive pre-Euro devaluation. But only expect it to last if you believe in miracles.

Patrick Minford is professor of economics at Cardiff Business School and visiting professor at Liverpool University.
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