Who will suffer for EMU's growing pains?

How quickly can Europe converge? On a visit to Brussels last week I found myself sitting next to a prominent Europhile, who explained something I had never understood before. Our conversation had, unsurprisingly, turned to European Monetary Union. I remarked how, given the rigidities of the European economy, it seemed a remarkably hazardous venture. Would it not be better to attack some of the rigidities and then prepare for monetary union at a time when it would be safer to do so?

"You don't understand," he replied. "It is precisely because it is politically so difficult to do anything about the rigidities in Europe that we have to have monetary union. We know that there are enormous changes which need to take place in the European economy to make it more competitive. Monetary union will force countries to do the things which they know they have to do, but which at the moment are politically impossible."

And of course this is the way Europe has operated. By setting an ambitious objective with firm deadlines, Europe has been able to force integration through much faster than would otherwise have been possible. This happened with the single market, the previous great leap forward, and already fiscal policy has converged with surprising speed. It happened with the fiscal side of the Maastricht agreement, for countries like Spain and Italy, which used to have particularly wide deficits, have cut their deficits fastest. The fiscal problems, if anything, are now with Germany and France.

So the reason for EMU is to force further European integration: the fact that there would (will?) need to be very big adjustments is an argument in favour of EMU, not against.

If you take that point of view, the period of pain which Europe will suffer as it tries to converge is a plus, not a minus. It is the necessary pain of forging a single economic system with not just a single monetary policy but also converging tax policies, a single labour market, a common legal system and so on.

None of this, however, diminishes the burden of adjustment, and if EMU does go ahead on time next year, the need for convergence will become the dominant economic story.

It is becoming possible to catch a feeling for what might happen, for there are several areas where convergence is needed. First, if you are going to have a common monetary policy, you need economic cycles to be in kilter. They are not. Look at the first graph. This shows how several countries on the fringe of Europe are enjoying buoyant consumer demand, while the mood of those in the centre is only just starting to catch up.

At the moment there is still some leeway for central banks to set different short-term interest rates. Once the currencies are locked together there won't be. Conversion rates will be announced next spring and fixed at the end of the year. So allowing for some months of adjustment, members of EMU could have the same monetary policy in the second half of 1998.

Already some countries probably have too tight a policy and some too weak a one. Determining what is too tight and too weak is, of course, arbitrary, but the market's judgement on the appropriateness or otherwise of monetary policy in several European countries is charted in the middle graph. There is already a problem, and with a single set of European interest rates, this will get worse.

Of course, within countries there is a single monetary policy and this leads to some areas having the "wrong" interest rate. You could argue that interest rates in Britain are too low in London and too high in the North-east. But people can and do move about a country in search of work, though they are even more willing to move in the US than they are in the UK. Labour market rigidities, in their many forms, are even more marked within countries in Continental Europe (see right-hand graph), so it is unsurprising that there is very little movement between countries.

So what will happen? There will be a series of first-round effects as Europe moves to the "one-size-fits-all" monetary policy. Some City firms have started to pick winners and losers. For example, James Capel reckons that there will be "overheaters" like Spain, Portugal, the Netherlands, Ireland and ultimately Italy, while France, Germany and Belgium will languish. The economic team at Kleinwort Benson pretty much agrees: "The periphery countries are likely to enjoy a major economic boom in the medium-term." In the Netherlands, Ireland, and Finland a "Euro-bubble" is already under way, they say.

You can see this as an investment opportunity, but it is also an economic threat. Kleinwort suggests investment in the fringe, and it is interesting to note that last week Goldman Sachs said it was advising clients to diversify investments away from Germany. At any rate, the plain fact is that some regions will have to learn to live with inappropriate levels of interest rates, which will encourage them to make other adjustments. As a rule of thumb, BZW suggests that the more flexible an economy, the more likely it is to cope with a lack of flexibility in exchange and interest rates. So EMU puts more of a premium on flexibility - pretty much the point made by my dinner companion in Brussels.

I suppose the real question is to what extent these forces become evident next year, because if they do, it would be astounding were there not to be more political opposition to EMU in Germany and France. James Capel audited the flexibility of Europe's economies, taking various measures. It added up the totals and asked: "Who can grow, who stagnates?" Ireland came top, just ahead of the UK; Portugal was third. Right at the bottom came France and Germany.

Could fiscal policy offset an inappropriate monetary policy? No, the link is the other way round, for too tight a monetary policy will lead to slow growth, making it impossible to correct the present fiscal deficit, let alone run a looser policy. So deficits in places such as Italy and Spain will continue to shrink; those in France and Germany will continue to grow.

If all this is right, the scale of the changes that the core countries of Europe will have to make appear enormous: more like those which Japan is having to make now, than the ones the UK made in the 1980s. Making structural change is much easier if the pain can be eased with a bit of decent growth. If you cannot get the growth, you are telling people they have to change without any obvious reward. It is all stick and no carrot.

Of course EMU can be done. Technically it is possible, and using the single currency to force more flexibility on the Continent is an effective, if brutal, way of doing so. But if the realisation that EMU was likely to condemn Germany to a decade of slow growth took hold, would the politicians really want to override popular opinion and do away with the mark? This one is Germany's call.