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CEPR and the single currency - EMU and the ostrich
CEPR and the single currency EMU and the ostrich
European Monetary Union involving a transfer from national currencies to a single European currency; the euro is a highly complex subject with many sides to it. It is not in any way comparable to the original question of joining the Common Market. One cannot simply talk about being "out in the cold" if we are not in it. There is a range of options and appropriate adjustment to be made to whatever choice is made. Nevertheless, the British Government is committed to putting either/or type questions to the British public in a referendum.
It is vital that the ramification of this new phase of European integration should be first debated carefully by the experts they do sometimes count! and explained to a wide public who are ready to try and get their minds round this difficult subject which they know to be vital. In turn they should influence the wider public and warn them of some of the consequences. If this is not done, people will react to the immediate difficulties in a way that might damage the whole project and endanger the process of European integration.
This journal has devoted a great deal of space to the subject of monetary integration and will go on doing so for sometime to come but it is important to draw attention to the work of other journals and organisations who are concentrating on this topic and moving it into the area of public debate.
The most important work of all in my opinion is that going on in the Centre for Economic Policy Research. The best brains dealing with the subjects come not just from Britain or from the rest of the European Union but also from Zurich and the wider Europe as well as from the USA.
The first paper EMU and the Ostrich emphasises that the single European currency has important policy implications for the UK whether it decides to join or not. It is not an option for the UK to bury its head in the sand:
The great British debate over the single currency has focused almost exclusively on whether or not to join. Barely any attention has been paid to the crucial questions of how economic policy must change if the UK is to participate in economic and monetary union (EMU) or how policy must adapt if the country decides to stay outside. In or out, the UK will be affected by EMU and its policy machine must react. Doing nothing is not an option.
A new CEPR Report takes up these issues, presenting an assessment of the implications of EMU rather than its desirability. The authors, an independent panel of experts, recognise that the UK government has four possible strategies for EMU:
(1) Join at the start.
(2) Decide to join, but do so later.
(3) "Wait and see", the pragmatic agnostic's position: if EMU works, then join at some unspecified date.
(4) Decide in principle not to join.
The first option, joining at the start, now looks highly unlikely. But even if circumstances changed dramatically, joining in the first wave would require a fully independent central bank by the end of 1998. The government would therefore have to put a high priority on drafting and passing a new Bank of England Act. In important respects, this legislation would have to be different from that outlined by the Chancellor, Gordon Brown, when, on 6 May 1997, he announced his plans to give the Bank operational independence.
Joining at the start would also require: a lower exchange rate; enhancing automatic fiscal stabilisers to compensate for the loss of autonomy over monetary policy; and reducing the tax incentive for companies and households to use debt. This last requirement would be necessary in order to help make the transmission mechanism of UK monetary policy more like that in other EMU candidates.
Interest rates in EMU's "first wave" candidates are now 3 per cent below UK rates, and that gap may well widen. There would need to be significant tightening in macroeconomic policy before UK interest rates could be allowed to fall by such a large amount; rates this low would not be appropriate. given the UK's current position in the business cycle.
Option two, a decision to delay entry by, say, four or five years would make it easier to achieve these things in time for the start of EMU. It would not be imperative to make the Bank of England fully independent by the end of 1998, though legislation should not be delayed for long. It would also be desirable to bring in legislative measures to enhance the fiscal stabilisers: they would then have a chance to start working.
But, the Report argues, the bigger advantages of delay relate to timing and exchange rate concerns. By 2001 or 2002, the EMU interest rate may well be broadly what the UK economy needs at the stage of the cycle it will then be in.
A "wait and see" strategy, the third option, has the obvious advantage that some of the uncertainty about EMU on the operation of monetary policy; on the demand for and value of the euro; and on the strains generated by a single short-term interest rate for all the "ins" will be reduced.
But in order to keep open the option of joining EMU sometime in the future, it would still be desirable to reduce the fiscal deficit and remove tax incentives to use debt. It would also be sensible to draft the amendments to the Bank of England Act (required under the plans to grant it operational independence) in a way that allowed the Bank to operate as part of the European System of Central Banks should the UK join EMU.
Under option four, where the UK decides in principle to stay out of a monetary union, the issue of greatest significance would be how the value of sterling fluctuated against the euro. The sterling-euro exchange rate would be much more important for UK business than any current bilateral rate now. Sharp fluctuations in the rate would be more damaging than a similar fluctuation in a bilateral rate today.
What's more, because countries inside the single currency area could not independently do much to alter their competitiveness against the UK, they would be likely to be more sensitive to the exchange rate implications of UK policy. The Report concludes that the surest way for the UK to minimise discrimination against UK-based firms is to participate actively in the development of the single market.
If the UK stays out of EMU, this participation will be even more important and perhaps more difficult too. Much will depend on attitude. If the UK is seen as a constructive agnostic on EMU, it will be listened to on subjects such as competition policy. If it comes across as a whinging outsider, it won't.
The second important set of papers is covered under the title Miscalculations?.
How to extract market expectations from asset prices is a question of great interest to both market participants and central bankers. In a recent CEPR Discussion Paper, Carlo Favero, Francesco Giavazzi, Fabrizio Iacone and Guido Tabellini examine a specific example: how the term structure of interest rates can be used to estimate the probability the market attaches to a particular country in this case, Italy joining the EMU on a given date.
The researchers observe that there are striking differences between the surveys regularly conducted among market participants (such as Reuters Survey) and the probabilities estimated by financial houses (such as JP Morgan) using the term structure. For example, in the early months of 1997, the probability that Italy would join EMU on 1 January 1999 ranged between 7-17 per cent, according to the Reuters Survey. During the same period, the JP Morgan "EMU calculator", which is published regularly in the Financial Times, assigned Italy probabilities ranging between 51-70 per cent. Favero et al. investigate the source of these large discrepancies. They find that the probabilities computed by EMU calculators are "upward biased". This is because the calculations are based on averages rather than instantaneous forward rates.
In the next section Professor Paul De Grauwe of the Catholic University of Leuven argues that the Maastricht criteria are creating uncertainty and that "convergence victory" should be declared now.
The prospective launch of EMU in 1999 remains uncertain. It is still not clear which countries will be members; and expected political conflicts over the "first wave" membership of the monetary union raise doubts about whether it will actually begin on time."
Such doubts about the timely start of EMU certainly don't arise from a lack of convergence. Anyone who reads the Maastricht Treaty objectively must conclude that all EU members wishing to join (with the possible exception of Greece) now satisfy the convergence criteria.
For example, the harmonised inflation figures issued by the European Commission show that all EU members (except Greece) satisfy the inflation condition. The same is true of the long-term interest rates condition.
What is more, a careful reading of the Treaty indicates that the budget deficit criterion too is satisfied everywhere except Greece. According to the Treaty, the budget deficit should be no more that 3 per cent of GDP, "unless either the ratio has declined substantially and continuously and reached a level that comes close to 3 per cent; or alternatively, the excess over the reference value is only exceptional.
There is no question that if the political will exists, the movements in government deficits since 1993 (the low point of the European recession and the high point for deficits) can be interpreted to have "declined substantially and continuously and reached a level that comes close to 3 per cent.
Only a blatant misinterpretation of the Treaty allows some governments to maintain that the deficit criterion is not satisfied in 1997.
With public debt, however, a little benevolence may be needed in the interpretation of the Treaty's text, particularly for countries like Belgium. At the same time, the political consensus, recently reiterated by the German finance minister, is that not much importance should be attached to the debt criterion. If there is sufficient consensus to stretch the Treaty's wording on the debt criterion, why is it that such consensus cannot be reached on the deficit criterion, despite the fact it can be done without real stretching?
Since virtually all the EU's members satisfied the conditions for adopting a singly currency in 1997, it is possible, with the Treaty in hand, to make the decision on membership today. The Treaty says that the decision on who qualifies will be taken by the European Council before 1 July 1998. This means that the Council does not have to wait until that date. It could do it today.
Why is this not done? The answer is to be found exclusively in German soul-searching about the desirability of EMU. Germany's doubts have two dimensions:
(1) A large part of the German public distrusts the whole project: EMU is identified as a monetary regime that will produce inflation and instability, especially if southern European countries like Italy join in.
(2) The German political establishment has treated the project in a fundamentally ambiguous manner.
The economic benefits of EMU for Germany will be realised mainly if the union includes the southern countries. A large EMU would finally rid Germany of the chronic overvaluations of the Deutschemark against the southern currencies and the ensuing loss of industrial competitiveness. But while, in economic terms, only a large EMU makes sense for Germany, politically this is the worst possible solution given the latent hostility of the German public to the project.
Germany's political establishment has surrounded this issue in ambiguity. It has sold EMU to the German public by stressing the economic benefits of the project, which can only be achieved in a maxi-EMU. Yet its tough stance on interpretation of the Maastricht convergence criteria is an implicit promise of a mini-EMU (without Italy and other "unreliable" countries), which cannot provide these benefits.
It has become clear that this game plan is backfiring. Contrary to German expectations, in terms of convergence, the southern Europeans are now performing as well as France and Germany, the twin pillars of a future EMU.
This unexpected development has created a new political situation in Germany. The option of a small EMU is effectively gone. Hence Germany can only choose between a large EMU and postponement of the whole project, an uncomfortable choice. Whether the postponement option is taken depends on the political entrepreneurship of those politicians in Germany aiming to wrestle power from Chancellor Helmut Kohl.
Professor Philippe Martin looks at the volatility of the euro against other major currencies:
Will the emergence of the euro lead to greater or less international monetary stability? And will the euro's exchange rate against other major currencies be more or less stable than the current rates of European currencies against the dollar? In the short term, as portfolio adjustments take place, many economists argue that there may be a lot of instability. This is illustrated by current uncertainties about the future dollar-euro exchange rate.
But what about the longer term, when the portfolio adjustments have taken place? Will the internal exchange rate volatility eliminated by EMU be transferred to the euro exchange rate? Or will the creation of a large euro zone make both monetary policies and the exchange rate itself more stable? Recent CEPR research addresses these questions.
One way to analyse the euro's likely volatility is to start from a known fact: the "size effect" of EMU. The size of the zone created by EMU will be bigger (far bigger in the case of the full EU-15) than any individual member. This means that from a macroeconomic perspective, the EMU zone will be less open. If EMU included all EU member states from the start, the zone's degree of openness would be similar to that of the US and Japan. 12 per cent for the EU-15, compared to 10.5 per cent for the US and 9.5 per cent for Japan.
This size effect will certainly lead the European Central Bank (ECB) to attach less importance to the euro's exchange rate against the dollar. Since exchange rate changes have a smaller impact on the domestic price level in a large country, the ECB will probably follow a policy of "benign neglect" rather like the current policy of the Federal Reserve. The Bank may also care less about the trade and output consequences of changes in the exchange rate.
Daniel Cohen uses this mechanism to argue that the euro will be more volatile than existing European currencies (Cohen, 1997). To illustrate his argument, one can compare the reactions of the Fed and the central banks of Europe to the recession of the early 1990s. Whereas in the US the Fed did not hesitate to lower interest rates aggressively, the European central banks reacted much less strongly, in part because of their fear of the consequences both for bilateral exchange rates and for the exchange rate with the dollar.
Cohen argues that since such concerns will be eliminated or at least reduced with EMU, monetary policy and fiscal policy may be more reactive to domestic shocks and therefore more unstable. With perfect capital mobility, this in turn will lead to more unstable exchange rates.
On the other hand, as I argue (Martin, 1997), a large country has less incentive to use its monetary policy strategically to stabilise its economy than a small country. Again, this is because output of the former depends less on the exchange rate that the output of the latter. Reduced use of the exchange rate as a strategic instrument should lead to a more stable exchange rate. From that point of view, the euro should be a more stable currency.
It is clear that theoretical arguments can be used to substantiate scenarios of both higher and lower euro volatility. An examination of existing relationships between country size and exchange rate variability for OECD countries may help clarify the matter.
In my recent paper, I find a strong positive relationship between size and volatility for relatively small countries. But the relationship is non-linear and appears to be reversed for large countries. In other words, the larger a large country, the less volatile its currency. Since EMU will entail the creation of a very large monetary zone, my empirical model actually predicts a small decrease in nominal exchange rate variability. This decrease should be more significant the larger the monetary union.
Cohen's paper approaches the problem rather differently, focusing on real exchange rates and simulating the reaction of the ECB to different shocks. Under a scenario where monetary policy is bolder because the Bank is less concerned about trade imbalances, he finds an increase in the volatility of the real exchange rate.
Even though researchers disagree on the impact of the euro on exchange rate volatility, they are united on the welfare implications. With a weaker exchange rate constraint, large countries are able to focus more on domestic stabilisation of output and inflation. If EMU generates increased exchange rate variability because of "benign neglect", this would only reflect the fact that monetary policies will react more, and more optimally, to domestic shocks.
So from a purely macroeconomic point of view, the scenario of increased exchange rate volatility under EMU should not be of great concern. The microeconomic consequences, however, may be less welcome, obliging European industries to reinforce their hedging strategies, either through financial engineering or relocation.
Two books in which Professor David Begg has a major editing role EMU:Getting the End Game Right (which is reviewed in this issue) and New EMU Prospects and Challenges for the Euro with outstanding American and European contributors will be reviewed in the next issue of New European.
Meanwhile, books and discussion papers can be obtained from the CEPR, 90-98 Goswell Road, London EC1V 7DB. Tel : (44 171) 878 2900 Fax: (44 171) 878 2999.