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Europe: Economic Success Leads To Failure

  • Breffni O'Rourke

Prague, 4 August 1998 (RFE/RL) -- Modern economic theory can sometimes resemble a riddle. For instance, if an economist poses the question, when can things go badly", the answer is "when things go too well."

The transition countries of Central and Eastern Europe have had much experience in the last decade of the social costs associated with dramatically contracting economies. But so far only a few of them have felt the pains that go along with an overdose of success. In the west, Britain is in exactly that predicament.

Alarm is growing that Britain, which until recently had one of the most robust economies in West Europe, is heading for a recession. That's because the strength of the pound has increased so much that the export of British goods at competitive prices is now impossible. Since it began its rise some two years ago, the pound has soared by more than 25 per cent in value. And this at a time when the currencies of important competitors like Germany, Japan and the Southeast Asian countries have weakened and in some cases plummeted.

The result for Britain is now becoming clear. Joblessness is increasing as companies hit by falling exports lay off staff. Last week the Rover car company announced at least 1,500 job cuts as well as plans to manufacture spare parts in other countries. Another big company, Siemens, will spend almost $600 million to close a brand-new semiconductor plant in north England, with the loss of 1,100 jobs.

The Confederation of British Industry (CBI) reports confidence is falling among small and medium-size businesses, and company collapses are increasing. Export orders are declining at their fastest rate since the CBI began surveys nearly 20 years ago. Business leaders have called on the Bank of England, the country's central bank, to cut interest rates, and the bank's monetary committee will consider that appeal later this week. But few analysts hold out much hope that the bank will act.

What are the causes of the pound's rise? Adrian Schmidt, senior economist at Chase Manhattan Bank in London, explains there are several reasons: "It started to rise partially because of Britain's overall economic recovery, partially, yes, because interest rates came up, partially because people were worried about the introduction of the new euro currency, and about the fading of the historical strength of the D-mark.... the pound is to some extent a safe haven."

The perception that Britain and the British pound were safe environments in unsteady times attracted money from abroad. Crucially, British bank-interest rates were rising when continental European interest rates were declining and Asian economies were beginning to go unstable. The result of the inflows into Britain was a steep rise in the value of the pound.

The next question is, why were interest rates raised if that helped focus unwanted attention on the pound? The answer is: because the Bank of England has to control inflation, fueled by rapid expansion of the healthy economy. Chase Manhattans Schmidt says: "The Bank of England has only one objective, which is to maintain inflation near the target of 2.5 percent annually, and although they may be very sorry about people becoming unemployed and suffering, there really is very little alternative if they want to achieve that target."

The bank, which is independent of government control, does not concern itself with political aims such as full employment. As Schmidt explains, if inflation is allowed to rise above the target, ultimately the economy will be weakened in response to accelerating inflation. And then people will start to lose their jobs anyway. So, although the politicians may be upset in the short-term to see the impact of the bank's policy, the more far-seeing among them realize that some pain now is better than probably greater anguish later.

"That's the economic cycle. You start from periods where unemployment is high and generally the currency is low, and then the economy accelerates, more people get jobs and you have to be careful otherwise things start to overheat. The ideal situation is that you are always at a constant inflation rate and low unemployment, but it's very hard to achieve that."

This, then, is the dilemma posed by modern economic practice: to walk the narrow central path between inflation-producing growth on the one hand, and damaging disincentives on the other. Oscillations are costly in either direction.