By OLIVIER BLANCHARD, RUDI DORNBUSCH, STAN FISCHER, PAUL KRUGMAN, FRANCO MODIGLIANI, PAUL SAMUELSON and ROBERT SOLOW
In the straitjacket of the exchange rate mechanism, the European economy in 1993 was lost to recession and 1994 was unlikely to see recovery. European unemployment, already at 22m, was expected to rise in 1994 to an all-time high. The demise of the narrow ERM now opens the door to far better performance in most economies.
It is wrong to believe that something precious was lost last weekend; on the contrary, the liberation of currencies previously trapped in the ERM offers a significant opportunity to recapture the buoyant spirit that animated Europe in the run-up to 1992.
The decision to loosen exchange margins was inevitable; central banks could postpone, within limits and at escalating cost, the time of crisis, but not the ultimate occurrence. The markets understood the basic dilemma: the Bundesbank had made clear its unwillingness to cut interest rates to preserve the existing exchange rates. Whatever the rhetoric, Denmark, Spain, Belgium and ultimately France lacked the reserves and the resolve to sustain exchange rates at the price of visibly and rapidly rising unemployment. Uncertainty about the timing and extent of German interest rate cuts and the urgent need for relief in the distressed partner countries opened up a credibility gap. Such a situation is a standing invitation for speculators who understand which way rates must move. Sometimes currency speculation may deserve the bad name it has; by prematurely hardening exchange rates, the central bankers and finance ministers of Europe gave speculators the proverbial one-way bet. Even so, in this case the speculators were the best friend of the unemployed, and - even though we will not hear that admission - of the monetary officials who had assumed unsustainable commitments.
There has undoubtedly been some loss of face for policymakers who proclaimed that they would never devalue, but it would be wrong to dwell on that. Rather than look back and dream of punishing speculators, officials need now to exploit the newfound freedom to fight unemployment, of course paying due respect to inflation risks.
The decision to maintain the format of the ERM - exchange rate margins, but 15 per cent - is sound and pragmatic. The European Monetary System was a good convergence device for quite a while, but it hardened prematurely with the insistence that further realignments would destroy the accumulated gain in credibility. With limited margins and no realignments, the room for divergent interest rate developments vanished, just at the time when high German inflation made far more flexibility highly desirable. The wide margins adopted in the present form can accommodate big divergences in interest rates without the prospect of creating yet another crisis - at least in the near future.
What strategies should countries pursue to use enlarged scope for interest rates and currency movements? There is no common and simple answer for each of the countries gaining freedom of maneuver.
All must be concerned to avoid a recurrence of inflation, a task easier for some than for others. But they also must give urgent priority to expansion, because that is the only way to bring down unemployment. Low interest rates are the fastest affordable way, given actual or imagined constraints to fiscal action, to get there. Finally, they all must look beyond recovery to give more emphasis to the supply side; more room for incentives, more flexibility, less status quo. But beyond these general common targets, the differences in constraints and opportunities deserve spelling out.
France enjoys a privileged position for action. With moderate inflation, it can go hard for growth and will succeed. France should cut interest rates rapidly to reach a level of 4 to 5 per cent in just a few months. There is no reason to hold off. In fact, given the long lags of monetary policy in stimulating recovery - particularly when unaided by fiscal stimulus, as the US demonstrates so clearly - there is no place for complacency. Even with immediate action, it will take at least until the beginning of 1994 to see results in terms of growth.
In the case of Belgium the need for moderate interest rates is even more imperative. The extraordinarily high debt ratio - perhaps the highest in the world - makes the country hypersensitive to even the appearance of unsustainable strategies. The country has a good reputation now, but it can lose it in no time if interest rates stay high.
Spain faces far more serious constraints. Inflation is not moderate and the instinctive response to a weakening of the currency is a resurgence of inflation. Of course, keeping the tight money lid on does not solve the problem. Lower interest rates are essential; growth is paramount; the status quo of pervasive corporatism, lack of competition and mounting unemployment needs a co-operative frontal attack.
That there is another way is demonstrated by Switzerland, Italy and the UK. Switzerland has interest rates of less than 5 per cent, far below Germany's. The UK when it was pushed out of the ERM last autumn opted for growth and is well on the way, without signs of strain or loss of financial stability. Italy's demise at the hands of speculators became the foundation for growth and for far-reaching domestic reform. Italy demonstrates that unions can be far-sighted and willing to co-operate in a growth strategy that does not translate into inflation.
Interest rate cuts cannot be accomplished without some depreciation of currencies. Only with the expectation of an appreciation relative to the D-Mark can a currency have lower interest rates than Germany. The practical question then is how much the French franc, say, must decline to support moderate interest rates. Our view is that the necessary depreciation is very limited, perhaps 5-7 per cent. After all, France is just moving ahead of German rate cuts by six to 12 months or so, and that hardly warrants big swings. Much the same argument applies to Belgium and Denmark. Thus the extent of depreciation need not be large and stabilizing speculation can be counted on to limit the fall.
There is, of course, a strong argument for limiting unnecessary volatility and uncertainty by broadly and informally coordinating the strategy among the floaters. For the most part, they should be able to cut interest rates in line with one another, and that will limit excess volatility. Where they part company will depend on their attitude towards unemployment, their performance on inflation, and their success in reducing rates without overly large depreciation.
If interest rate targeting takes advantage of the new room for letting exchange rates move and growth resume, there is also the question of when to tighten the margins and return to the EMU project.
The immediate priority is flexibility and that precludes formal commitments to unsustainable exchange rate targets. There is no reason, however, to rule out pragmatic trading ranges around newly found levels of the exchange rates, once interest rates have been cut. Thus we do not expect extreme volatility, just because the margins are wide. Ultimately, 18 months or two years from now, Europeans can re-examine whether the preconditions for stable rates or even monetary union are in place, how to remedy shortcomings, how to assure better co-ordination, and how to proceed.
Whether ultimately there is a common money or not, a common Europe has already shown its worth in the establishment of a market where goods and services flow freely. The good name of Europe will be all the better if further integration yields prosperity and not mass unemployment.
Originally published, 8.6.93