National Institute Economic Review

As has been noted by other commentators, the economy is at a state in the cycle at which policy mistakes have often been made in the past. The need to correct these mistakes may have been a factor leading to subsequent recessions. It would be prudent both to restrict the growth in demand and take steps to improve the budgetary position. Budgetary tightening would achieve both these goals.

The transition to monetary union in Europe, which began formally when Stage 2 started in January 1993, is now well over half way to completion, according to the deadlines set in the Maastricht Treaty. The first decisions on Stage 3 are approaching fast, yet the prospects for its commencement are still very unclear, and many important practical and policy issues are still in doubt. This article provides an overview of the EMU debate, covering the latest developments on convergence (Section 1), the main institu tional matters still to be resolved before Stage 3 begins (Section 2), the key problems awaiting policy-makers in Stage 3 (Section 3), and finally the controversy about the economic rationale of EMU (Section 4). It concludes that the UK Government was wise to defer a decision on whether to participate in Stage 3 until the implications became clearer, but that it would be unwise to abandon the option, which it presently risks doing, by design or default.

This article considers the role of fiscal policy within a European Monetary Union. There are two quite different issues. The first is the medium-term problem of deficits and debt. The Maastricht fiscal convergence criteria are usually seen as an imperfect response to the need to contain potentially 'irresponsible' fiscal authorities. It is argued here that they should be seen as reflecting a coordinated response to the generalised objective of fiscal consolidation and restraint in Europe: similar rules are likely to be a feature of Stage 3. There is a danger that governments are underestimating the difficulties of fiscal consolidation in a large area such as Europe. In practice, success would require a sustained rise in private sector investment and growth (or reduced private savings). The monetary coordination to go with generalised fiscal restraint appears to be lacking and we suggest a preemptive cut in interest rates. A more complete view of the causes of rising debt stocks in Europe is needed, and we suggest that a reframing of the problem of deficits and debt in terms of the needed (counterpart) private sector responses would be helpful in highlighting the coordination problems and avoiding adverse dynamic reactions. The medium-term problems interract unfavourably with the second set of issues-the need for fiscal policy to be used more actively for short-term stabilisation in a future common currency area. Fiscal offsets are an appropriate response to domestic demand shocks, but not to others, such as those requiring a change in the real exchange rate. Contrary to the 'fiscal federalist' position, such stabilisation need not involve centralisation. But there are serious difficulties. Without care, needed stabilisation will be prevented by the Maastricht criteria or the rules likely to follow them. And without coordination, independent stabilisation of common shocks will tend towards too little fiscal activism rather than too much.

The external shocks emphasised by the standard Optimum Currency Area approach (i.e. shocks to exports) have surpris ingly little influence on employment and unemployment in most member countries of the European Union (EU) whether or not exchange rates are fixed. Short-run exchange-rate variability (but not the level of the exchange rate) seems to have a negative impact on employment.

It is often claimed that a high degree of international labour mobility is a condition for a monetary union. However, what matters for the Optimum Currency Area approach is the difference between inter-regional and inter-national labour mobil ity and not the level of the latter. Recent data show that international labour mobility in Europe is of the same order of magnitude as inter-regional labour mobility within member countries and that, the latter seems to be influenced by the housing market. EMU is thus unlikely to significantly worsen the problems that arise through the low mobility of labour in Europe.