In this section we look at European Monetary Union (EMU). We focus on the question of whether the UK would benefit from joining EMU. We concentrate here on the economic arguments, although many of us believe the key issues concerning EMU are political, rather than economic. Also we briefly set out some of the main features of the blueprint for monetary union that is given in the Maastricht Treaty (see box).
Discussion is made more difficult because many important features of EMU are highly uncertain, including the starting date and the membership. Below we set out some working assumptions on some of these issues, which provide the framework for our subsequent discussion. In particular, we emphasise the desirability in the context of EMU of a high degree of economic integration between member states; and we discuss the inadequate treatment of fiscal policy in the Maastricht Treaty. As usual, we would refer readers to our separate submissions for a fuller statement of our individual views.
We all agree that no countries are likely to proceed to EMU in 1997, but we are divided over whether the EU will be in a position to move forward to EMU even by 1999. Under the terms of the Maastricht Treaty, if no date has been set by the end of 1997, the third stage will start on 1 January 1999 with those member states who are deemed to meet the criteria whether or not they constitute a majority. However, the start date itself could be set for well into the next century. Moreover, it seems quite possible that the political will to proceed by 1999 may begin to fade in Germany and France. If this occurs, the whole project could once again be substantially delayed. Indeed, Congdon does not believe that anything important will come of the current plans for EMU. Britton and Currie believe that it is likely a core group will go ahead in 1999.
For the purposes of focusing the present discussion, we assume that the third stage of EMU will begin in 1999 and that its membership comprises a "hard core" of Germany, France, Belgium, Netherlands, Luxembourg and Austria. One or two other countries may also join, but we assume throughout that those countries joining EMU all satisfy the Maastricht convergence criteria, defined reasonably strictly with the exception of Belgium whose very high debt ratio we expect would be overlooked to allow entry along with Luxembourg. We do not consider the case in which non-convergent countries are allowed to join for essentially political reasons. If they were to do so, the economic arguments against the UK joining would be greatly strengthened. We think it is unlikely that Greece, Italy, Portugal or Spain could achieve sufficient convergence by 1999. None of us would want the UK to join a monetary union which included several non-convergent members.
We would emphasise the difference between monetary union, which involves a single currency and a single monetary policy, and other forms of fixed exchange rate systems. The Bretton Woods system persisted for some time, but it remained an exchange rate system with separate currencies and separate monetary policies. One step closer to monetary union might be an exchange rate union, in which national currencies are effectively interchangeable and can be used throughout the union. While in some respects this is similar to stage 3A of EMU, it is still some way short of the full monetary union that is proposed in the Maastricht Treaty.
Most other monetary unions, including the US, Germany, Italy and Switzerland, have evolved into federal systems; and there are no large monetary unions today that are not federal systems. There are, however, historical examples of monetary union which were originally formed between sovereign states but evolved later into federal systems. Such an evolution would entail a large degree of political power passing to the centre, and perhaps eventually a degree of political union where countries would have similar powers as are currently held by individual states in the United States.
Some of us do not consider these historical examples offer any substantive insight into the character of monetary union in a modern world with fiat currencies, and they emphasise the difference between federal systems and EMU as set out in the Maastricht Treaty. Others of us argue that the Maastricht blueprint is not very different from how other monetary unions have started. Currie believes that EMU will, in time, lead to greater political integration, though the powers that need to be transferred to the centre could be limited.
In our assumed scenario, the UK would face a choice of (i) joining EMU from the start; (ii) remaining outside initially but consider joining at a later date; or (iii) ruling out membership for the foreseeable future. Although the immediate consequences of (ii) and (iii) might be very similar, there could be quite different implications for our relations with the new monetary union. If the decision were not to join immediately, the UK would be free to continue its present monetary arrangements or to make further changes. These might include granting a greater degree of independence to the central bank or some form of exchange rate link with the monetary union. However, we would not favour any formal exchange rate link if the UK had ruled out joining EMU for some time because an ERM-type link would be vulnerable to speculative attack by the foreign exchange markets.
THE EMU PROCESSThe Maastricht Treaty specifies the process of moving to a single currency.Procedure for moving to Stage 3 of Economic and Monetary Union (EMU) The Commission and the European Monetary Institute (EMI) provide reports to the Council of Ministers (ECOFIN) on progress made by member states regarding achievement of EMU. The coverage of these reports is explained in Article 109j of the Treaty. The reports will consider the following criteria a) the achievement of high degree of price stability - which is interpreted as inflation not more than 1½ percentage points of, "at most, the three best performing Member States" (Article 1 of Protocol to 109); b) the sustainability of each government's financial position -interpreted to mean "no excessive deficit", which in turn means (i) a deficit/GDP ratio below 3% unless declining to close to 3%, or the excess is "exceptional and temporary" and remains near 3% and (ii) a debt/GDP ratio below 60% or, if above, it must be "sufficiently diminishing and approaching the reference value at a satisfactory pace" (Article 104c); c) the observance of the normal fluctuation margins provided for by the Exchange Rate Mechanism for at least two years without devaluing on its own initiative against the currency of any other Member State; d) the durability of convergence, which is measured by whether nominal long term interest rates are no more than 2 percentage points of, at most, the three best performing Member States in terms of price stability. The reports will also assess the independence of Member States' central banks, the integration of markets, the development of the ecu, current account balances, unit labour cost and other price indices. On the basis of these reports, ECOFIN, acting by qualified majority on a recommendation from the Commission, will assess whether each Member State fulfils the necessary conditions and whether a majority meet them. ECOFIN will then make recommendations to the Council meeting as Heads of State or Government. The European Parliament will provide its opinion. The Heads are separately to decide, by qualified majority vote, whether a majority of Member States meet the necessary conditions, whether it is appropriate for the Community to enter the third stage and, if so, on what date. These decisions have to be taken by the end of 1996. If by the end of the 1977 no date has been set, the third stage will start on 1 January 1999. It will go ahead with those Member States who are deemed to have met the criteria whether or not they constitute a majority. Under its protocol, the UK will notify the Council whether it intends to move to Stage 3. Denmark has already announced that it will not take part in Stage 3. Practical Steps Following a decision to proceed to monetary union, the following sequence of steps would take place I) Interim Period - this is the time between the decision to go ahead and the beginning of Stage 3 with the irrevocable locking of parities; ii) Stage 3a - this is the period from the irrevocable locking of currencies until the move to using only the single currency. It is generally envisaged that the single currency and the relevant national currencies would be used in parallel during 3a, but they would be freely exchangeable in unlimited quantities at the locked parities; iii) Stage 3b starts when the single currency is used more widely and in the form of notes and coins. |
The credibility of a fixed exchange rate system would be greatly enhanced by the introduction of a single, union-wide, monetary policy in stage 3A. There may, nonetheless, remain some small perceived risk that a country could still withdraw from the monetary union before stage 3B. The continued circulation of national currencies in stage 3A would make it more reversible and therefore less credible than stage 3B, where the introduction of the single currency would increase the difficulty for any country leaving the union, although it would not make it entirely impossible. The slight risk that a country could still withdraw during stage 3A could be reflected in risk premia remaining for some currencies, and the possibility of (probably very small) divergences in long term interest rates despite the operation of a single monetary policy.
The move to a single monetary policy might also require stricter supervision of the banking system, because monetary policy in an individual country could no longer be adjusted to cope with problems affecting its own banking system. This applies to any fixed exchange rate system, but is given added strength with the pooling of monetary sovereignty in stage 3A and the introduction of the single currency in stage 3B.
A move to stage 3, and eventually to a single European currency, would have profound implications for the financial systems of participating countries. There are many outstanding questions about how the ECB will operate in setting monetary policy. These include the roles of reserve requirements; capital asset ratio requirements; and lender of last resort. Other issues to be resolved include the financing of government debt; the treatment of contracts specified in national currencies; and relations between national central banks and the ECB. The European Monetary Institute (EMI) will be making proposals on such issues; the options chosen could significantly affect the character of the financial system in EMU. There are also issues to be resolved with respect to exchange rate policy. The ECB will be in charge of intervention in the single currency but overall exchange rate policy will probably be decided by ECOFIN. In the absence of clear guidelines there is the potential for conflict between ECOFIN and the ECB.
If countries in a monetary union have diverse industrial structures, or very different degrees of labour and product market flexibility, they will tend to respond in different ways to common shocks and may be more subject to differing shocks. This might lead to significant differences in macroeconomic performance. All large countries have regions or industries which do markedly better or worse than the country as a whole; we do not argue that such differences need to be eliminated in a monetary union. Nevertheless, sharp divergences in performance are not desirable and a particularly bad experience might lead to pressures in the affected countries for a relaxation in fiscal policy, or even leaving the union altogether.
Greater economic integration would facilitate the operation of monetary union. A monetary union between economies that are not well integrated could be subject to severe pressures in the face of divergent economic shocks, with large differences in members' economic situations posing problems for the authorities trying to set a single monetary policy. We highlight several different aspects of integration:
The rest of us think a significantly greater degree of economic integration between member states would be necessary before we could consider any move to monetary union, and are less sanguine about the extent to which the necessary degree of integration would occur within monetary union. Although there is probably greater integration between members of the "hard core" than between those countries and the UK, some increase in integration even for them would still be highly desirable before any EMU.
Most of us believe a successful EMU would require a way of coming to agreement on the appropriate level of government borrowing overall and its broad division between member states. Within EMU, national governments would retain freedom in setting fiscal policy subject to market constraints. Their individual and uncoordinated actions could make a very large difference to the fiscal stance for the union as a whole. We do not believe the union ought to be indifferent to its overall fiscal stance; monetary and fiscal policy ought to be determined at the same, super-national, level, although not necessarily by the same bodies. Although the ECB can take account of the overall fiscal stance when setting monetary policy, without effective management of the union's fiscal stance it would be very much a second-best approach and might at times lead to a very unsatisfactory policy mix. Some of us think, however, that the alternative of the UK maintaining monetary independence with floating exchange rates may also suffer from problems: the determination of monetary and fiscal policy at a national level in an uncoordinated way can easily generate an unsatisfactory policy mix for Europe as a whole. Indeed, for this reason Currie believes the proper comparison, ie between monetary union and the present position, can favour EMU.
Congdon and Godley believe the lack of a union-wide fiscal policy to complement the single monetary policy is a fatal flaw in present plans for EMU. They think it would be impossible to proceed to monetary union without provision for a union-wide fiscal policy, which includes a federal budget, run according to principles which were agreed and under the appropriate administrative and political control.
We are doubtful whether the "excessive deficits" procedure will prove sufficiently rigorous to prevent anything but the most extreme abuses of fiscal policy. We do not think it would be powerful enough to counteract the change to fiscal policymakers' incentives that arise from a move to a single currency while national governments retain control over their individual fiscal policies. Monetary union removes the possibility of exchange rate pressure arising as financial markets lose confidence, at least until the situation becomes so bad that it affects markets' perceptions of the whole union. By removing one of the first penalties to fiscal recklessness, monetary union skews the incentives in an unwelcome direction.
Although there is scope for variations between long-term interest rates on national government debt, we cannot be confident that this will provide a sufficient or a timely discipline on errant governments. In practice, financial markets are likely to doubt that member states of a monetary union would refuse to "bail out" another member that was not able to meet debt repayments or servicing. Thus the onus is on the excessive deficits procedure, but it is not at all clear how effective a deterrent this will be. Whilst it is clearly important in the approach to monetary union, because of the convergence criteria, it is much less clear how large a role the procedure will play for countries which have already moved to stage 3. In particular, there does not appear to be any significant effective sanction on a country in the monetary union which is judged to have an excessive deficit. The present situation, however, is by no means perfect, as is apparent from the very high levels of debt and deficits in many EU countries.
Congdon draws attention to a possible source of conflict between the ESCB and national governments. The ESCB would be concerned about, and would need to have some control over, the maturity pattern of sales of national government debt: if too many Treasury bills or short-dated government bonds were issued they might be purchased by commercial banks or even by the ESCB itself in the secondary market and the result would be an increase in the money supply, with potentially inflationary consequences. But the national governments would also want to have some control over the maturity pattern of government debt, because Treasury bills and short-dated bonds usually pay a lower interest rate than long-dated bonds. The Maastricht Treaty does not say whether the power to decide the maturity profile of national governments' new debt issues lies with the ESCB, the Council of Ministers, national governments or some other body. Congdon sees the lack of a union-wide agency to determine the maturity profile of government debt as similar to the lack of a union-wide agency to determine fiscal policy. He emphasises particularly the danger of centralising monetary policy while control over fiscal policy is still, to a large degree, dispersed between them. Some of us judge that this is a largely technical issue that needs to be resolved by the EMI and the ECB as fuller operating procedures for a common monetary policy are defined.
Historically, EMU as outlined in the Maastricht Treaty would not be alone in the lack of significant fiscal transfers: other monetary unions, such as the US, Germany, Italy and Switzerland, were formed without significant fiscal transfers at the start. But such examples suggest that an increase in fiscal transfers between federated states tends to follow a move to a single currency, although increases in the size of the federal budget may occur only slowly. However, these are examples of monetary unions leading eventually to a federal system, which is not what we would expect to happen in EMU unless it was desired by national governments. Moreover, some of us do not think historical precedent is necessarily a good guide to today's very different economic and political world.
In view of these problems with the specification of fiscal policy in the Maastricht Treaty, if EMU goes ahead we might expect fiscal arrangements to develop further. But such development might be seen as a further loss of national sovereignty, which might not be acceptable to some governments.
However, Britton and Currie would regard the loss of monetary independence as bringing benefits, not just costs, because they believe it would lead to a firmer and a more consistent commitment to price stability. They also believe that international financial markets already reduce considerably the scope for countries to operate truly independent monetary policies and that the sharing of monetary powers is a great potential gain from EMU.
The effect of giving up monetary independence is difficult to quantify and, amongst other things, it will depend on: the frequency and severity of asymmetric shocks, the extent of different reactions to common shocks or to changes in monetary policy. Even in the most favourable scenario, where all members of the union were subject to the same external shocks and the same monetary and fiscal policies, differences in economic structure and integration could lead to somewhat different reactions to common shocks and policy changes. Differences between national financial and housing markets could be particularly important here.
Some empirical research (described in Minford's submission), based on estimated macroeconomic models and specific assumptions as to how monetary policy operates, has suggested that output and price variability could be significantly higher under EMU than under floating exchange rates. These calculations would only apply over long periods of time. The costs of ceding monetary independence could turn out to be much higher if an economy were to face a large shock that would normally be met by a monetary policy response and an exchange rate movement (for instance the fall in the exchange rate and reduction in interest rates on the UK's exit from the ERM in 1992). Such large shocks might be very rare, but the consequences could potentially be very much more serious if an affected country were unable to use monetary policy to respond. It is the capacity for this sort of response to large shocks that is associated with the debate on "sovereignty".
This sort of extreme shock might be very rare but it is one to which opponents of EMU attach great significance. It is an important risk associated with moving rapidly to EMU beforethe necessary integration in product, labour, financial and housing markets has been put in place. The reforms to bring about this integration might be politically very difficult to achieve, and might not be acceptable to most national governments who would be concerned about infringements on national sovereignty.
However, not all of us agree about the significance of the results described in Minford's submission and Currie in particular has obtained very different conclusions using other models. The calculations discussed in paragraph 32 are in some cases based on optimal monetary policy for each regime and they may therefore give too pessimistic a view of EMU: monetary policy in practice can be rather different from the optimal setting, and can itself be an important source of economic shocks. Indeed, Britton and Currie see the fixing of exchange rates in stage 3A and the move to a single currency in stage 3B as an important discipline on monetary policy that may well reduce shocks emanating from policy itself.
Congdon and Godley would put much more weight on the loss of political independence from EMU, rather than the loss of monetary independence. They believe the temporary costs of adjusting to a shock without the power to change the exchange rate would be secondary compared with the constitutional and political changes required.
The elimination of exchange rate uncertainty offers another potential gain, but one that is very much more difficult to quantify. Most of us think it would increase cross-border trade and investment. Although hedging can reduce exchange rate risks, it can only cover a limited range and cannot guarantee the longer-term stability that would be helpful to companies contemplating overseas investment. The effect of EMU on exchange rates with countries outside the union is less clear. Minford in particular argues above that prices and output in EMU might be more variable than under floating exchange rates. If this is so, the elimination of nominal exchange rate risk within the union could be offset partially by an increase in exchange rate risk against major countries outside of the union and an increase in real exchange rate risk within the union. Currie, by contrast, argues that price and output fluctuations may be less under EMU than under current arrangements, and therefore sees no reason for additional fluctuations in the extra-Union risk premium; indeed this may fall. He therefore sees EMU as helpful in this respect.
Some of us think a move to EMU would increase the credibility of monetary policy compared with the present arrangements in the UK. However, there is no certainty that a single currency would necessarily have a better inflation record than some of the major EU countries, and it is still rather early to assess the new monetary policy regime in the UK. Moreover, it is by no means certain that a move to a single currency would lead to a significant gain in credibility of UK monetary policy over what would be achievable outside of EMU: the potential advantage of EMU would be significantly reduced, and perhaps eliminated, in comparison with alternative ways of improving monetary policy, such as, some would argue, a fully independent Bank of England.
Britton and Currie believe that there is a further major advantage from EMU because a single currency will be needed to realise the full benefits of the single European market. This is because national governments will be reluctant to integrate fully (by dismantling trade barriers, harmonising regulations, opening up procurement etc) as long as they are exposed to the risk of competitive devaluations by their neighbours; and compliance with existing single market directives may well be more limited without a single currency. They also argue that exchange rate variability will limit the responsiveness of cross-border investment and limit the benefits of scale possible from the single market.
Congdon and Minford do not believe foreign investment has been deterred by the UK's hesitant approach towards both the ERM and monetary union. They argue that the most important requirement is that the UK should remain a competitive location for business. In their view, this is best achieved by not joining the EMU and certainly by continuing to opt out of the social chapter. Furthermore, there is no guarantee that real exchange rate variability, or the variability of output and prices, would be any less in a monetary union than outside. These will be important factors for both indigenous and foreign companies contemplating investment in the UK. Britton and Currie, however, think the UK would be seen as having a less central role in Europe and less influence on key decisions if it did not participate in EMU, and this could well deter foreign investment.
The balance of advantage would also be affected significantly by the regulatory regime within EMU. For example, the ECB might decide to impose a reserve requirement on commercial banks remunerated at below market rates. This would give a competitive advantage to those banks outside the union with lower reserve requirements (or none, particularly for offshore banking). More generally, financial institutions in non-participating member states would be at a competitive advantage if the ECB were to impose burdensome regulations in participating member states.