Punts, Pounds and Euros: In Search an Optimum Currency Area

Article excerpt

J. Peter Neary and D. Rodney Thom*

"What is the appropriate domain of a currency area's It might seem at first sight that the question is purely academic since it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favour of any other arrangement." Robert A. Mundell ( 1961

Introduction.

Recent statements by the British Government make it clear that the UK will not participate in the first wave of European Monetary Union (EMU) and that sterling will remain outside any proposed exchange rate system between the "ins" and "outs". In contrast, the Irish Government appears totally committed to first-wave membership when Stage III starts on I January 1999. Hence,just as in 1979, Ireland seems destined to participate in a major monetary reform which excludes its most important trading partner. Given these facts, this paper is primarily concerned with the economic implications of Irish membership in a scenario which excludes the UK.

In order to focus our analysis, it may be useful to start by disposing of several preliminary, and hopefully uncontroversial, issues. First, we draw a distinction between the desirability of EMU per.se and the wisdom of Irish participation without the UK. We contend that these questions are logically distinct. It is perfectly consistent to advocate the principle of monetary union but to argue for the, at least initial, exclusion of certain countries on the grounds that their participation would benefit neither their own domestic economies nor the union as a whole.' Put another way, the train may be leaving the station but we do not have to jump on. Before we purchase the ticket it may be prudent to enquire where the train is going, how much the ticket costs and how we might integrate with our fellow passengers.

Second, sacrificing policy autonomy by participating in EMU would be of little consequence if labour and commodity markets were characterised by a high degree of wage-price flexibility. In this scenario exogenous shocks would be absorbed by appropriate adjustments to nominal wages and prices leaving real exchange rates, or competitiveness, unaffected and the case for EMU would then hinge on the issue of potential benefits. On the other hand if, as the evidence suggests, labour markets are relatively inflexible then sacrificing policy autonomy may impose significant adjustment costs on participating economies. Once we accept that monetary and exchange rate policies may have real effects on domestic output and employment then the decision on EMU participation requires a full recognition of the costs as well as the benefits.

Third. decisions on whether to proceed with EMU and whether Ireland should participate will be driven by political as much as by economic considerations. In particular, EMU may be more generally perceived as a further step towards full political integration with obvious implications for national independence, foreign policy and, in the case of Ireland, neutrality. Unfortunately political decisions can have adverse economic implications and. while we recognise that EMU may be too important for decisions to be left to economists. we also contend that the latter have a professional obligation to offer an objective and independent analysis of the consequences, both beneficial and detrimental, of Irish participation. As in many areas of decision making, economics cannot offer definitive answers and the quote from Robert Mundell at the beginning of this paper suggests that economists might be wise to refrain from political forecasts. Nevertheless, economists can usefully explain the consequences to the policy maker and trust that the outcome will not require us to pick up the economic pieces of a badly judged political decision.

Fourth, if the UK decides to join EMU we shall take it as given that Ireland will also participate. Hence, we explicitly assume that:

At least Germany, France and a group of smaller 'satellite' economies will proceed towards EMU when Stage III of the Maastricht timetable commences in 1999. …