EMU to emerge from egg rather lopsided

The recent, hysterical debate about tax harmonisation is a sign of things to come in the construction of what some have taken to calling "Euroland", a place of which we have still, on the very eve of its birth, but the sketchiest of visions.

The reason for this uncertainty is deceptively simple. In a project devised to create Economic and Monetary Union in Europe, only the monetary aspect has been properly developed and defined.

The "economics" aspect has been left to follow, with the result that EMU will emerge from the egg a rather lopsided bird.

An enormous amount of energy has been devoted to monetary policy in the 11 countries of the new euro zone. This will more or less be centralised at the European Central Bank (ECB) in Frankfurt. Fiscal policy, however, remains in the hands of 11 sovereign governments.

Euro-sceptics ask whether this can possibly work.

They are right to pose the question, but the answer is a conditional "yes". Such a lopsided arrangement can work but only if everybody sticks to the rules, especially the rules concerning fiscal deficits and government debt.

Will they? Europe's governments have turned out to be surprisingly rule-abiding in the last few years but this has been encouraged by the importance of qualifying for membership of the single currency club.

It is not clear whether the governments will continue to co-operate in the same spirit in the absence of such pressure.

Unless they do co-operate with each other and with the ECB, however, monetary and fiscal policy could easily move out of alignment. Europe would then be at risk of committing serious and persistent macro-economic policy errors that could ultimately force the euro zone economy out of control.

Even supporters of the single currency admit that the asynchronous structure of fiscal and monetary policy is the Achilles heel of the new system. But this very weakness could also act as a catalyst for European integration, a pattern repeatedly followed in the past. This is a point frequently misjudged by critics of European integration.

In fact, while EMU marks one of the momentous economic events of the 20th century - on par with the creation in 1944 of the Bretton Woods system of fixed exchange rates - it does not owe its existence primarily to economic considerations. EMU is in the first instance a political event, a leap in the long process of European political integration.

This much has become clear again in the tax harmonisation furore. The debate over whether to harmonise corporation and savings taxes appeared to have reopened old fault lines between the British government on the one side - supported by Ireland, among others and France and Germany on the other. But at the recent summit in Vienna, the 15 EU leaders presented a common front.

Further political compromise on the issue can ultimately be expected, with closer integration the result. For the rest of the world, however, the two most important features of the new regime are the new currency and the euro zone itself.

The euro zone is a new economy in its own right, an economic superpower roughly the size of the US. It has a slightly larger population than the US and a larger share of world trade, but a smaller gross domestic product.

The two are alike in at least one important respect. They are both large, closed economies with a relatively small foreign trade exposure that accounts for only about 10 per cent of economic activity. With the arrival of the euro zone, the world economy has become bi-polar.

In the old uni-polar world, the US economy has served as an anchor to the world economy. The US has been able to afford to run persistent current account deficits for decades. It has the largest and most liquid capital and stock markets and the dollar is the world's largest reserve currency.

From January 1st, there will be an alternative of equal size and strength. It is unlikely that investors will suddenly dump the US in favour of Europe but it is already becoming apparent that they may be re-balancing their investment portfolios.

Investors look at the euro zone as something more than the sum of its parts, just as the euro will be a bigger currency than its 11 constituent currencies combined.

The arrival of a bipolar economic system, however, is an event whose full ramifications are not yet entirely understood. Does it mean the US may no longer be able to run persistent current account deficits? Does it imply more or less volatility in currency markets? Does it require new forms of global macro-economic co-operation, perhaps through exchange-rate target zones?

And then there are unresolved institutional issues. Does it still make sense to co-ordinate macro-economic policy through the Group of Seven industrialised nations?

It is even conceivable that the euro may have more implications for the outside world than for Europe itself. The Europeans may turn an old US adage on its head, proclaiming, not without schadenfreude, that "the euro is our currency. But it is your problem."