The events of August 1993 need not hurt integration within Europe--but they may. The outcome will depend on the resolve of governments to continue the process of real-economy integration through the Single Market programme and related measures, despite greater instability in currencies. It is perfectly feasible to reduce trade barriers under flexible exchange rates provided you want to, as the British government has maintained through most of the approach to "1992". What might change is the wanting to.

For the moment, Europe is having to cope not only with the economic difficulties caused by bigger fluctuations in exchange rates, but also with the suspicion and ill-feeling that the summer's ERM crisis have left behind. Because of that legacy, the chances of failure in the Uruguay Round of trade talks have increased. Recessions lead governments to turn inwards and to concentrate on their domestic problems; political and economic crises (the collapse of the ERM was both) reinforce this tendency. This is perhaps the biggest economic danger that Europe faces just now.

Over the past year EC governments have found it ever more disturbing to contemplate the adjustments that a successful Uruguay Round will require. Nonetheless, after the Blair House accord of November 1992, which outlined an EC-US agreement in agriculture, governments were quietly confident that a good result would be achieved. Except in France, that is. The French made clear their opposition to the accord from the start, questioned the right of the European Commission to agree to it and hinted that they might use their veto. Germany and Britain persuaded them to wait and see how the overall deal looked--evidently hoping that, in the end, the French would subordinate their (real or imagined) interest in agriculture to bigger EC-wide benefits in manufacturing and services. Then came the ERM crisis. The French believe that the Bundesbank set them up by refusing to lower interest rates, while the Anglo-Saxons stabbed them in the back by speculating against the franc. What price Blair House now?

Political friction aside, freer trade in European farming is especially difficult to achieve under floating currencies. EC farm prices are fixed in ECUs. A devaluation of the franc against the Deutschmark, for instance, increases returns to French farmers (in francs) and reduces payments to Germany. These effects were so strong after earlier realignments that the Community invented Monetary Compensatory Amounts (MCAs): in effect, tariffs and subsidies on intra-EC farm trade. (In this illustration, the MCA system would tax French exports to Germany.) MCAs are clearly inconsistent with the Single Market. They imply price differences across the EC and make it necessary to check goods at borders. The Community was dismantling the system gradually, but this could easily be reversed if governments, especially Germany's, fail to stand up to their farmers.

Turning to trade in manufactures and services, surveys suggest that businessmen find fluctuating exchange rates burdensome because they cause uncertainty. This is not an argument about the transaction costs of changing currencies: these existed before August 1993, although margins may widen slightly under the wider bands. Rather, fluctuating exchange rates make it more difficult to compare markets, and are another source of shocks. If people dislike uncertainty--and they do--fluctuating rates are likely to cause changes in behaviour. Contrary to the popular view, however, they need not reduce international trade. For example, an exporter which has to raise #1 million a year to service its debts would have to sell more units abroad as their sterling price became more variable if it was to maintain, say, a fixed probability of 1% of missing its target.

In any case, fluctuating exchange rates probably have a bigger effect on investment and entrepreneurship than on trade. Whether trade expands or contracts, the welfare of workers and shareholders goes down as uncertainty increases. The result is that, at the margin, resources will be shifted to less risky, but less productive, uses. For example, fluctuating exchange rates increase the probability that a firm will suffer a major loss of competitiveness in an export market. Realising this, the firm will invest less in developing its markets abroad, competition in EC markets will be reduced.

Wider bands could also affect economic policy. One danger is competitive devaluation, as members seek to stimulate their economies by boosting exports. Devaluation has certainly eased Britain's way out of recession. The government has come very close to claiming credit for this, and crowing over its ERM-bound neighbours. But most other EC countries have more anti-inflationary credibility to lose than the UK had, and most realise that their mutual trade is sufficiently great that the effect of widespread devaluation will be much smaller than that of any individual devaluation. Competitive devaluation is therefore unlikely--so long as countries are not seen to be competing "unfairly". If state aids are not tightly controlled, or if Britain's rhetoric about avoiding the costs of the social chapter becomes too strident, some countries could see devaluation as a legitimate weapon.

It is more likely that member governments will no longer try as hard to remove intra-EC trade barriers under the Single Market programme. Some of these reforms threaten major interest groups and may seem arcane and unimportant. It will be asked: "Why suffer the political and economic costs of removing a barrier that is equivalent to a 3% tariff, when the exchange rate can change relative prices by 5% in a week?" The right answer is: "The 3% is for ever whereas the 5% will most likely be undone next month or next year." Unfortunately, getting that message across is politically difficult. Unless governments make it a priority to remove the remaining trade barriers, progress towards the full integration of markets is likely to slow.

A further danger lies in trade policy with respect to non-EC countries. The Community uses anti-dumping duties to protect its firms from strong competitive pressure. Fluctuating exchange rates make it more likely that firms in some countries will feel such pressure (if currencies are fluctuating, some must be appreciating). Although the Commission is supposed to consider the Community as a whole in setting duties or import restrictions, there is a strong bias towards acting to help countries that are under particular strain. Czech exports of steel pipes to Germany and Italy attracted anti-dumping duties in mid-1992. In this way, too, the Community may drift towards greater protectionism.

The extra uncertainty suffered by firms as a result of wider exchange-rate bands may curtail economic activity, but this is not the main danger. The greater threat is that wider bands will undermine policy-making for the real economy. Governments may seek to revive the system of agricultural MCAs and/or raise the EC's external trade barriers. Slower progress in removing internal barriers also seems quite likely. The remedy is explicit commitments by member governments not to let setbacks in monetary co-operation undermine progress towards an efficient and integrated "real" economy for the EC.

Winters is Professor of Economics at the University of Birmingham and Co-Director of CEPR's International Trade programme.

Paul de Grauwe "Exchange rate variability and the slow down of international trade" IMF Staff Papers, 1987.

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