Chicago take on the euro issue

Much current thinking on key economic issues is hidden away in learned journals and specialist books. Increasingly, however, professional economists who contribute to popular publications are publishing collections of articles that expound their thinking on issues of popular interest. Such books can make for rewarding reading.

Rudi Dornbusch is Ford professor of economics and international management at the Massachusetts Institute of Technology and an authority on international monetary economics. He has also been a frequent contributor to newspapers such as The Wall Street Journal and Financial Times , as well as magazines such as Business Week . This book brings together pieces he has written for these publications on a range of subjects, from free trade to the East Asian crisis. Dornbusch is a member of the Chicago School with its commitment to free markets and scepticism of government attempts to interfere with market forces, and this is reflected in many of the solutions he proposes.

Thus, he is a strong advocate of free trade, an opponent of most forms of capital controls, a believer in the efficacy of exchange rates and sceptical with regard to the European "social market" model of capitalism. Yet, in the light of the East Asian financial crisis and along with many other supporters of free markets, Dornbusch is prepared to entertain the possibility of controls on capital inflows as having some merit in discouraging excessive short-term borrowing and thereby altering the maturity structure of foreign debt. The example of Chile shows that under certain circumstances a so-called Tobin tax on short-term inflows can work.

However, no system of capital controls is likely to work in preventing the kind of speculative outflow that brought about the crisis in East Asia in 1997-98. Better to improve the system of supervision at national and international level and prevent such a crisis arising in the first place.

Although Dornbusch describes his underlying economic ideology as "unabashedly Chicago", his views on inflation are refreshingly different from those of the more conservative, rational-expectations school that followed in the wake of Friedmanite monetarism. Although inflation is never good for an economy, reducing inflation should not always be the dominating obsession of governments. Extreme inflation (20, 30 or 40 per cent a month) must be stopped whatever the cost, but a different approach is required when confronted with more moderate inflation (15 per cent a year). Too severe a restriction can cause a collapse, through a recession, super-high interest rates, banking problems and currency overvaluation. In the past ten years the experience of Chile, which tolerated moderate inflation rather than sacrificing growth, may be contrasted with that of Mexico, which provoked a currency crisis by over-correction. It is wrong to regard moderate inflation as necessarily detrimental to growth, and wrong to think that the only stable inflation rate is zero.

Faced with extreme inflation, Dornbusch is an advocate of a currency board or even complete dollarisation. In a period of rapid inflation a country becomes automatically dollarised as dollars replace domestic currency as the de facto medium of exchange and store of value. A currency board, such as has been operated successfully in countries such as Argentina and Hong Kong, works by changing the rules of central banking. Money creation, which is always the cause of extreme inflation, is now tied to foreign exchange inflows and outflows. An alternative is to go all the way, as Argentina has recently done, and replace local currency with dollars. The less radical option of pegging the exchange rate to a strong currency has proved unworkable for any length of time because of the opportunity it creates for holders of short-term funds to launch a speculative attack on the currency. On the other hand, the experience of Argentina, whose economy has been badly damaged by the rise of the dollar, illustrates the dangers that dollarisation can bring under more normal conditions.

On the subject of the euro, Dornbusch expresses the same scepticism as other North American academics. European monetary union is a bad idea but one that is certain to come about. The latter prediction has proved correct, although the euro has yet to replace national currencies and not all member states have chosen to join. However, much of the doom-mongering about the euro emanating from American onlookers has surely proved false, even if the weakness of the euro has taken all by surprise.

For Dornbusch, the main problem with having a common currency is the lack of wage-rate flexibility in the euro zone. If exchange rates cannot adjust in response to external shocks that do not affect all member states in the same way, then wage rates must instead bear the brunt of the adjustment. If they do not, output and employment will be depressed in countries or regions affected.

All this might not matter if there were clear and significant offsetting benefits from the common currency. Dornbusch sees none. Nearly three years down the road, however, very few of these transatlantic apprehensions have proved justified. Nevertheless, the need for Europe to press ahead with measures to reform the labour market and increase wage-rate flexibility is underlined.

This is a useful volume of short essays that students of international monetary economics and anyone with an interest in contemporary international economic affairs will find thought-provoking reading.

Nigel Grimwade is head of economics and finance, South Bank University Business School.