The EMU Illusion

Fraser Hosford~Senior Freshman


The biggest economic event on the European Union's immediate horizon is unquestionably the proposed Economic and Monetary Union. Ireland as a small open economy must carefully evaluate the potential costs and benefits of joining such a union. In this piece, Fraser Hosford systematically discusses possible gains and losses from an EMU and concludes in a way which will be like a red rag to Irish Europhiles.


The quest for a United Europe has stepped into a new dimension. The final stage of an economic and monetary union (EMU), 'the irrevocable fixing of exchange rates' to form a single and stable currency across the European Union is progressively getting closer. This concept forms the backbone of Chancellor Kohl's idea of a federal union. Does this mean that economic reasoning has been overlooked or is the EMU, as often implied, an economic utopia?

Economists generally refer to the EMU as an economic trade off between perceived costs and benefits of joining. There is strong and sometimes emotional disagreement on the extent of these costs and benefits, and therefore, ultimately on the decision whether to participate or not. This short paper aims to outline the economic reasons for monetary union before analysing the main objections to the concept.

Benefits of a Monetary Union

The main perceived advantages are a reduction in transaction costs, consolidation of the Single Market, an end to destabilising currency shifts within Europe, price convergence and price stability (assuming a 'hard-nosed' European Central Bank). An estimated $30 billion a year is spent on foreign exchange transactions and exchange rate hedging. The elimination of these costs will be particularly relevant to a country like Ireland which exports a considerable amount of its output to the European Union. It will also be especially helpful to small and medium sized enterprises which may not be able to reap sizeable economies of scale. Furthermore, the consolidation of the Single Market is important in itself. It will increase efficiency in production because of increased specialisation and economies of scale, thus increasing the European Union's level of GDP.

Assuming the EMU delivered the end of currency shifts, this would bring increased certainty to business. This should result in foreign multinationals being more willing to set up in Europe. There will also be savings to national monetary authorities through the lowering of international reserves. This may result in the lowering of Irish interest rates, thereby encouraging more investment and reducing the cost of national debt service, ultimately increasing national income. The reason behind this is that interest rate premia compensate investors for the possibility of devaluation, which is why Irish interest rates are above Germany's.

A single currency highlights price differentials. The subsequent enhancement of competition will increase economic efficiency and should cause price convergence, thus ending any market discrimination. A European monetary policy will aim for, and largely succeed in, price stability assuming there is no politicisation of the European Central Bank. This will mainly be due to the influence of the Bundesbank upon the new European Central Bank. The Bundesbank's 'loathe' for inflation and success in limiting it, makes the German Central Bank an ideal role model for a low inflation regime.

Further advantages as regards free trade should emerge. At the 1996 Inter Governmental Conference discussions regarding further trade liberalisation with the USA will be held. Also recently an agreement between the EU and the four countries of the Latin America free trade zone was signed establishing summits every two years and closer trade links between the two blocs. Monetary union will give the EU increased bargaining power in such negotiations because a common position could be put forward. Some observers also predict dynamic benefits as the credibility and visibility of a single currency lead agents to modify their wage and price setting in a more disciplined way. This will increase business confidence, investment and the rate of economic growth in the community.

Costs of a Monetary Union

The strongest economic argument against monetary union is the obvious diversity of the economies involved. Problems will emerge when economies with different fundamental economic structures, levels of efficiency, productivity and inflation are integrated under a single currency. If all economies were the same and had similar objectives they would possibly adopt the same policies and respond in the same way to changing circumstances, thus eliminating many of the advantages of fixed exchange rates. The main rationale behind fixing exchange rates is because economies are not all the same and it is necessary to constrain national monetary authorities from short term political aims for the sake of overall efficiency gain.

The Maastricht criteria were drawn up in an effort to bring convergence to the participating economies. However, this was an optimistic objective and does not really account for the costs a loss in sovereign monetary policy can entail. Economic policy would become very rigid within an EMU as governments lose the option of devaluation, and monetary policy would be set by a supranational European Central Bank in Frankfurt. In the event of a detrimental asymmetric shock that puts the economy in recession, the government would be very limited in its policy response options in a EMU. It could not devalue to restore competitiveness or decrease interest rates, and fiscal policy is also likely to be severely restricted especially in the light of Theo Waigel's proposed stability pact which would limit the yearly budget deficits of the EMU countries to an average of 1% of GDP. Basically the government would only be left with microeconomic options to boost the economy which may help to increase employment and output in the long run but would do little in the short run during a recession. This problem would be exaggerated in Ireland because of the long time period associated with the 'short run' due to the inflexibility of prices and wages and the rigidity of the labour market in general.

Sir Alan Walters, economic adviser to Margaret Thatcher in the 1980's, was particularly concerned with this problem. He observed that a high inflation regime might be burdened with centrally dictated low interest rates thus exacerbating its economic problems. Conversely, countries with high unemployment may be unable to reduce interest rates. This dilemma surfaced in 1992 when the German authorities employed restrictive monetary policy to combat inflation after reunification, while Britain was experiencing a recession and pursuing expansionary monetary policy. If the EMU was in place then, the existing British recession may have been exacerbated given an absence of monetary policy flexibility. However, it could be argued that the Bundesbank already has a certain level of control over European interest rates, so national monetary policies are controlled anyway.


It has been proposed that integration among the European economies will lead to convergence and therefore make asymmetric shocks less likely to occur. However, according to classical trade theory integration entails more specialisation due to comparative advantage and thus core economies may benefit at the expense of less efficient peripheral ones.

Is it really worth sacrificing independence on policy making for advantages which are hypothetical at best? The benefits are difficult to quantify and might not even accrue. As Alan McCarthy, chief executive of Bord Trachtala said 'competitiveness is the key to winning more business.'

With the consolidation of the Single Market and the resultant economies of scale, many firms will have to increase in size to compete. Such large firms are likely to locate in the core of the EU, near the main markets and with sound infrastructure, advantages not present in peripheral regions. Firms in the peripheral region not gaining the same efficiencies may become less competitive and probably go out of business or be forced to relocate to the core. The ultimate result being decreased national income and increased unemployment in the peripheral economies.

To conclude this author believes the present format for proposed monetary integration is flawed. Having said that however, the author asserts that if the larger economies participate in the EMU, Ireland will be left with little option but to follow as its economy is so dependent on exports to such countries. If the UK utilises its 'opt-out' clause and retains its sovereignty then Ireland faces a dilemma with regard to joining the EMU, as an estimated 50% of Irish employment is dependent on British trade. Ultimately the author cannot accept the loss of devaluation as a policy option, or the concept of a European monetary policy aimed at price stability. Foreign policy makers are not in a position to govern Irish monetary policy. Every government is entitled to make its own value judgement as regards policy objectives and each government is best positioned to dictate the needs of its national economy.


El-Agraa, Ali (1994) The Economies of the European Community, Harvester Wheatsheaf, London

O'Hagan, J.W. (Ed) (1995) The Economy of Ireland, Gill & Macmillan, London