EMU demands awareness of the big picture

EMU now looks almost certain to go ahead on schedule, bringing changes to almost every area of economic life. Perhaps the greatest impact of a single currency will be experienced in the capital markets. Currently, Europe lags far behind the United States in terms of the depth and quality of its securities markets. EMU will permit the development of a large, liquid integrated financial market in a range of euro-denominated assets that will improve access to credit for firms and enable both households and corporations to better manage risk.

Moreover, although currency risk can be hedged by large firms over short horizons, hedging is not feasible at the horizons that matter for long-term savers and investors. In dynamic terms, the net result of a consolidated European capital market and elimination of currency risk will be a higher sustainable long-term growth rate for the euro-area economies and greater stability in income flows for investors.

Will Ireland be out of step with the rest of the proposed euro area? It is likely that enhanced trade flows within the euro area will over time bind the member countries more closely together, bringing the phase of the business cycle into alignment across the participating economies.

Moreover, a single currency will in itself eliminate an important source of asymmetry in business cycles, namely national central banks taking different approaches in monetary policies (for instance, mistakes in monetary policy have been an important factor in explaining the UK boom-bust cycle).

However, as a precaution, investors wishing to hedge the risk that Ireland falls into recession while the rest of the euro area is doing well would be wise to allocate a larger fraction of their portfolios to the securities of those countries.

The elimination of the devaluation option will also stimulate reforms in labour and product markets, in the direction of improving flexibility in the face of macroeconomic shocks. This restructuring of the euro-area economies will be the next major item on the policy agenda, once EMU is implemented.

Although the Irish economy is not as heavily regulated as continental economies, this new phase of market liberalisation will still constitute a major challenge. It is expected to raise the level of tension among the social partners, threatening the future of the national agreements. With respect to the future evolution of macroeconomic policies, we might expect to see a more active deployment of monetary policy by the new ECB, without compromising the long-term goal of price stability. Monetary policy is an ineffective tool for small economies, such as the individual European countries, since local demand conditions are relatively unimportant (compared to external factors) for countries that are heavily reliant on international trade. In contrast, the euro area will rival the United States in terms of its economic size and will be sufficiently large that ECB monetary policy can have a real impact in stabilising the economies of the euro area in the face of common macroeconomic disturbances.

In terms of fiscal policy, the Stability Pact provides welcome long-term discipline by raising the political costs of excessive budget deficits. But, in order to retain cyclical flexibility in the future, the government should be running substantial budget surpluses during the current boom to provide room for fiscal relaxation during the inevitable next downturn. The government should also press for the Stability Pact to be interpreted on the basis of current budget deficits, in order not to constrain the implementation of the public investment projects that are required to relieve the infrastructural congestion generated by Ireland's current high rate of economic growth.

Finally, turning to the question of the appropriate entry rate, the long-term prospect for Ireland is for trend real appreciation if we continue to grow more quickly than the rest of the prospective euro area, since economic expansion places upward pressure on prices in the non-traded sector.

In the absence of nominal exchange rate appreciation, which would generate an offsetting decline in import prices, an rising price level for non-traded goods translates into an increase in the aggregate inflation rate. The European Commission has recently estimated that this could lead to an inflation rate in Ireland inside EMU that is one percentage point higher than the euro-area average.

For instance, if the ECB delivers an average two percent inflation rate and a six percent nominal interest rate, the euro-area average real (inflation-adjusted) interest rate will be four percent but the Irish inflation rate will be three percent (i.e. 1.5 times the EMU average) and the Irish real interest rate will also be just three percent, hurting savers and contributing to yet further upward pressure on housing prices. Revaluation now can help to mitigate these future adverse effects of real appreciation inside EMU.

Philip Lane is an economist at Trinity College Dublin