However, trade integration also leads to regional concentration. For example finance in London or car production in Germany. Therefore, a demand shock that is sector specific could become country specific.
On the other hand, there is no reason why these regional concentrations would not transgress borders. Therefore, national economic measures are less effective. Furthermore, there is still the option of fiscal measures, which can be directed towards specific industries. Foreign exchange intervention and interest rate policies will become less relevant if industry clusters cross borders. Frankel and Rose (1998) have found empirical evidence that supports the view of the European Commission. European business cycles have converged with integration. We come back to this later under the test for convergence.
Britain is more likely to experience asymmetric shocks than the others for 2 reasons. Britain is an oil exporter and does a lot more trade with the rest of the world, particularly the US and Japan. However, Britain’s oil exporting days are numbered. Today Britain produces half of European oil produce. Production reached a peak in 1999. Estimates are that production will have decreased by 60% in 10 years.
GRAPH 1
Fortunately, the UK is better placed than many European countries to react to asymmetric shocks. Our labour markets are more flexible and our public borrowing is not as high as countries like France and Germany.
The Services Economy
Another point is that European business is moving away from manufacturing to the service sector. In many European countries the service sector makes up 70% of GDP (De Grauwe). In the service sector, economies of scale are not as important, and therefore regional concentration will not happen as much. The OECD recently found that in the USA regional concentration has started to decline after years of increasing concentration. This makes asymmetric shocks less likely.
Tax Harmonisation
The European Commission is of the view that differences in national fiscal policies could result in shocks that affect countries differently. Harmonising taxes would also make competition fairer. In reality, the harmonisation of VAT is the only proposal on the table for European harmonisation.
Personally I believe that until there is a substantial fiscal redistributive fund, the governments of Europe must retain the right to their own fiscal policies.
Barry Eichengreen wrote a paper called ‘Saving Europe’s Automatic Stabilisers’. In it he claims that fiscal policy adjustments have little cross border repercussions.
‘On the one hand, the direct expenditure effect of a tax cut or public spending increase boosts the demand for foreign as well as domestic goods. On the other, increased government borrowing drives up interest rates, crowding out investment and depressing spending abroad. While the two effects need not offset one another exactly, by working in opposing directions they tend to minimise the cross-border repercussions of fiscal policies, in turn limiting the gains from coordinating those policies.’
In other words, while fiscal policies affect the domestic economy, foreign fiscal policy will have little effect on the home country. Therefore the harmonisation of taxes will do little to act against asymmetric shocks because foreign fiscal policy has little affect at home. Europe needs to be ready to counter asymmetric shocks, and should not be embarking on a crusade to prevent them, which seems impossible. Minford believes there is a political agenda behind these proposals.
‘What protagonists of harmonisation probably have in mind is the aim of building up central federal institutions that would ultimately have the revenues and the power’ (Minford 2002 p.50)
Personally I believe a fiscal redistribution fund would help far more to cushion a Short Term shock.
Fiscal Redistribution
What is a fiscal redistributive fund? In the example above, we can tax the German consumer to reduce demand there, and use the revenues to stimulate demand in Britain. This is something that Germany already does across its ‘Lander’. However, in a Europe of sovereign states, this would be difficult for any politician to introduce. Countries like Britain already have automatic stabilisers that redistribute fiscal funds, for example to areas like Scotland and Northern Ireland because of their high unemployment and less healthy lifestyle, but these are not enough. A good start would be switching the money from the CAP to helping those nations that lag behind. Almost half the EU budget (only 1.22% of EU GDP) is spent on agriculture (0.56% of EU GDP).
Even if measures were introduced Europe wide, ‘Fiscal transfers are only suited to dealing with temporary shocks in Aggregate Demand…when the demand shock is a permanent one, price and wage adjustments are necessary to deal with the problem’ (De Grauwe p.10).
The differences between European countries
Differences in labour Market Institutions
We talked earlier about the importance of a flexible labour market. So what are the differences between European countries on this issue?
Centralisation
Some labour unions are highly centralised, such as in Germany. The UK, on the other hand, has very de-centralised labour unions. In theory, wages and prices may develop differently in these two countries when faced with a supply side shock such as the oil hikes of 1979/80.
‘When wage bargaining is centralised, labour unions take into account the inflationary effect of wage increases. They will have no incentive to make excessive wage claims…but in a decentralised system, the wage claims will have a direct effect on the competitiveness of the firm, and therefore on the employment prospects of individual union members’ (De Grauwe p.14).
With only slightly centralised bargaining, as with the UK in the late 70s, there is a free-riding problem, so no one takes the initiative to not increase wages. Therefore, countries with different labour market institutions may find it costly to form a currency union without harmonising this aspect of their economies. However, while the UK and Germany are on opposite sides of the spectrum, their reactions to shocks are likely to be similar.
Inflation and Unemployment Preferences
In Figure 3 and 4 we see 2 countries that have differing priorities in the short-term trade-off between inflation and unemployment. A has low inflation and low employment. B has higher inflation and higher employment.
One problem posed by European Monetary Union is that different countries have different preferences or expectations of inflation and unemployment. The best example is of Italy versus Germany. Italians are used to higher inflation, just as Germans are used to higher unemployment. In EMU, one would think that these two countries would have to compromise. However, it has been necessary for the ECB to inherit some of the reputation of the Bundesbank in order to maintain the value of the euro in the short term. This has meant the pursuit of very low inflation setting a target for the euro area of below 2% (HICP), to be maintained over the medium term.
The tables below merely show a snapshot of European inflation and unemployment. It is worth noting here that figures such as these tend not to tell the whole picture due to the different ways in which the data is collected and counted. For example in Britain there is a high number of people who collect disability benefit and therefore do not fall under the category of unemployed.
TABLE 2
Britain
Germany
Italy
Economic theory suggests that in the Short Term there is a trade-off between unemployment and inflation. Taking this at face value one might conclude that Germany has high unemployment due to its preference for low inflation, and vice versa. The table shows 6 years, and in every year Germany had higher unemployment and in only one year did Italy have lower inflation.
However, the monetarist critique says that if a country chooses too high an inflation rate (and has to devalue a lot) it will find that its Phillips curve shifts upwards. In the long run the Phillips curve is vertical and unemployment is independent of inflation. Unemployment is at a natural rate that is best changed through structural reforms such as better education and training. This means that there is nothing to be gained from Italy and Germany having two different inflation rates, and thus there is no cost of EMU in this regard.
How does this concern the UK? Since 1997 we have experienced low inflation and low unemployment. However, historically Britain has had its fair share of economic problems in the post-war era. In my opinion it is fair to say that EMU would lock in some stability, as long as the convergence criteria are met. Therefore in terms of inflation and unemployment preferences, Britain has little to fear from joining the Euro.
Foreign Exchange Intervention
The Aggregate Demand and Supply Model
Although devaluation does not have a permanent effect on competitiveness and output, its dynamics will be different from the alternative policy. This loss of a policy instrument will be a cost of EMU. Foreign Exchange Intervention ensures there is less cost in terms of unemployment. Here are the main points of the Aggregate Demand and Supply Model.
Today we have the power to solve the dilemma of disequilibrium by devaluing the pound against the euro. This reduces demand in Germany and increases competitiveness in Britain. It is a policy, which the US has recently pursued, and it has stimulated growth there. While the Bank of England does not actively pursue devaluations, it is possible for the government to change the inflation target in a time of crisis, for example in a Japan style recession. If Germany had monetary autonomy right now, it would certainly ease the pain of this crippling recession it is experiencing.
‘If demand shifts from the products of country B to the products of Country A, a depreciation by country B or an appreciation by country A would correct the external imbalance and also relieve unemployment in country B and restrain inflation in country A. This is the most favourable case for flexible exchange rates based on national currencies.’ (Mundell 1961 p.510-11)
Of course, the effects of devaluation are only temporary, but then the effects of an economic shock may only be temporary. Foreign exchange intervention is a useful tool to save jobs. At the same time its use must be limited to protect the integrity of the currency. Therefore there is a trade-off between currency value and employment, the same as the trade off between inflation and unemployment.
Nominal and Real Depreciations of the Currency
How effective is exchange intervention at correcting for differences in demand? Can nominal exchange rate changes permanently alter the real exchange rate of the country?
Let’s take a simple example of a shift in demand from France to Germany. Figure 5 shows the effect of a shift in demand from France to Germany. Figure 6 shows how devaluation will shift demand back to D1 in France. However, the devaluation has directly affected import prices. This makes it more expensive to produce from foreign inputs. In the medium term the result is that the Supply curve shifts to the left. Nominal prices are raised further, but total output returns to Q2. So we can confirm that devaluations only have a short-term impact on output.
FIGURE 5
FIGURE 6
FRANCE
In reality, will the favourable effects disappear completely? De Grauwe looks at the case for the European countries.
‘This depends on the openness of the economy, on the degree to which wage earners will adjust their wage claims to correct for the loss of purchasing power. There is a lot of evidence that for most of the European countries this withering away … will be strong.’ (De Grauwe P.35)
Too much devaluation may in fact be detrimental. Essentially the incentive to devalue is an incentive to cheat. If a country cheats too many times it reduces the credibility of that currency, further devaluing the currency, and forcing interest rates up. Therefore foreign exchange intervention is not a flexible instrument that can be used frequently. More often, exchange rates are a source of demand shocks.
Essentially money is a medium of exchange or a store of value. If there is a lack of productivity or a demand shock, the problem is better dealt with directly than simply lowering interest rates, which will not solve the long-term problem.
Trade Account Equilibrium
Trade account equilibrium is defined as equality between the value of domestic output and the value of spending by domestic residents. This is sometimes also known as absorption. Trade account equilibrium can be shown as follows.
Pd Y = Pa A
Therefore if domestic prices increase, the value of output increases relative to absorption and there is a trade surplus (assuming constant government spending and interest rate), or an improvement in the terms of trade. The home country can reduce output and still maintain equilibrium in the trade account.
The Effects of Devaluation
In Figure 7 the country has been hit by a negative demand shock. Output moves to E and there is a trade account deficit. Devaluation would shift the demand curve to D1. Output is now at F1. As we showed in Figure 6, the increase in import prices shifts the supply curve to the left. More importantly the terms of trade shifts to T1 (the price of imports has gone up). This shows that devaluation does not improve the terms of trade.
Improving the Terms of Trade
A government can reduce absorption by reducing government spending. However this reduces demand. De Grauwe argues that a combination of devaluation and expenditure reducing policies can bring the economy to point G shown in Figure 7. This solution provides relief in the Short Term while at the same time going some way towards addressing the long-term deficit in the terms of trade.
This next part is an important argument against EMU. If we lose the ability to devalue in order to correct for a demand shock. What is the alternative government remedy, and what are the effects of this?
FIGURE 7 The Effects of Devaluation
The Alternative to Devaluation
FIGURE 8
At the initial equilibrium point of E there is a trade deficit, which needs to be corrected. As part of EMU the only option is to introduce deflationary fiscal policies, which will shift T to T1. The side effect of this is that there is a reduction in demand for the domestic goods in the economy and unemployment ensues. If there is sufficient wage and price flexibility in the economy, wages will decrease and this will induce the supply curve to shift to the right. The economy is back at equilibrium at point G1.
This looks fine on paper but it is difficult for governments implement because of the cost in terms of employment and the income of voters. With devaluation the economy suffers inflation, but the electorate will accept inflation more easily than unemployment. This brings us back to the question of preference over inflation or unemployment. In EMU, unemployment is the only option, and that is the cost of EMU in terms of losing the power to devalue. Therefore the more flexibility there is in the economy the easier the adjustment process will be. Britain is well placed as the labour markets here are among the most flexible in Europe.
Growth, Productivity and Inflation in a Monetary Union
Up till now we have talked about inflation levels converging across the Eurozone. This does not mean that inflation rates will be equal across the union. Even in a currency zone as small as Britain there are inflation differentials. While there is increased competition in tradable goods across the Eurozone, services do not generally compete across distances. This is one source of price differences.
De Grauwe argues that differences in inflation rates are necessary where there are differences in productivity. In a monetary union the rate of change in productivity must equal the rate of change of wages.
∆ German wages – ∆ Irish wages = ∆German output – ∆ Irish output
These changes are the result of the equilibrating mechanism. For example in Ireland productivity is catching up with most of Europe and therefore wages must increase in the same way. This keeps the competitive position of tradable goods in both countries unchanged. Therefore inflation in a country that is catching up is not a fear for the ECB and it should not react to it by raising interest rates. This will be the case for the Central and Eastern European countries that join EMU.
However, this does not mean that all differences in inflation are due to equilibrating mechanisms. Most European countries today have similar levels of productivity. The countries that join this year fall behind but if their growth rates continue in the same way they will catch up.
Do Differences in Growth Rates Matter?
Some suggestion has been made that the different growth rates of EMU will hamper the ECB in trying to find an interest rate to suit all. In the case of a difference in growth rates among countries with similar productivity levels, the associated inflation of a high growth country then makes this economy less competitive, and this consequently holds back growth. So we could say that differing growth rates are not of a major concern, as Dornbusch explains, the labour market will bring the economy back to equilibrium.
‘By abandoning exchange rate adjustments it transfers to the labour market the task of adjusting for competitiveness and relative prices…Forcing adjustment into the labour market…Competitive labour markets is the answer, but that is a dirty word in social – welfare Europe.’ (Dornbusch Transatlantic Perspectives on the Euro p.7)
The only potential cost is that of short-term unemployment. However, there is an assumption here that there will be differences in growth rates. If the convergence criteria are satisfied, Britain has nothing to fear in this regard.
The Inclusion of Central European Countries
The Countries of Eastern Europe that join this year have the biggest differences in productivity and growth from the rest of the EMU. Joining the EU will certainly help their convergence with the EU economy. In fact already their economic cycles run closer to the EU average than the Scandinavian countries. Their trade structure is as close to the EU 12 average as Ireland or Denmark (De Grauwe and Lavrac 1999).
‘Except for Slovenia, the gaps (in productivity) are so large that an average geometric growth rate of over 10% per year is required for all CE 10 countries to close the gap in 20 years’ (De Grauwe and Lavrac 1999 p.59).
In terms of debt to GDP ratio of 60% required by Maastricht, the CE’s have done better than the EU 12, and they are already experiencing higher growth than the EU average.
However, some countries like the Czech Republic rely on Germany to sustain their growth, and have therefore suffered in the last few years. Furthermore, CE countries are more likely to suffer demand shocks from the Russian economy. Could this affect Britain?
Rose 2000 explains that the level of trade between two countries depends upon their national income and distance.
‘The gravity model explains the flow of international trade between a pair of countries as being proportional to their economic ‘mass’ (national income) and inversely proportional to the distance between them’ (Rose 200 p.13)
As the CE countries have quite a small GDP total and are geographically at the other side of Europe, this would suggest that trade between them and the UK will not be significantly large.
Chapter 3
Gordon Brown’s Tests
At the end of 2003 Gordon Brown produced the long awaited assessment of his 5 tests for entry to the Euro. In this chapter I will look at the 5 tests and take evidence from his assessment as well as others to judge the specific questions that they pose.
Test 1: Is there sufficient flexibility in the UK economy to respond to shocks if it joined EMU?
The markets of the UK may be more flexible but the UK has more chance of facing an asymmetric shock. HM Treasury (1997, p.7) deemed that UK labour markets had ‘not yet achieved sufficient flexibility to meet the challenges of EMU membership’.
Bush (2001) finds that the stability and growth pact would actually constrain the UK in its efforts to make the economy more stable. We go in to the SGP in further detail later on.
In terms of employment, the UK has performed the best out of the EU big 4, being the only one to have reduced unemployment from the 1973 levels when the oil hikes produced inflation and unemployment at the same time.
Ardy Begg and Hodson studied flexibility in the UK.
‘The UK product market enjoys higher regulation than that of the US but greater liberalisation that the EU states. This makes the UK a very competitive economic environment. The UK labour market has moved closest to the US in terms of flexible employment conditions, hiring and firing costs are very low, and the rules of eligibility for unemployment benefit have been tightened.’ (Begg et al p.29)
Ardy, Begg and Hodson go on to show how the UK has benefited from this flexibility. The first point is that since 1993 the UK has broken the traditional trade-off between employment and inflation by keeping inflation low and reducing unemployment. This means that GDP was increased without greatly increasing wages, which also suggests more inequality in the economy.
FIGURE 9
So we have established that the UK has flexible product markets. How does this help?
How Does Flexibility Help Our Economy?
This diagram shows how flexibility works in order to keep employment high, and thus sustain growth.
FLOWCHART 1
(Source: HM Treasury Euro Report)
Inside the Euro the difference is the loss of exchange rate policy, but whether inside or not, inflexible economies experience unemployment.
Inside EMU, the prices of tradable goods across Euroland will act as an anchor to prices here. What this means is that any period of high inflation would have to be followed by a period of low inflation, with detrimental consequences to growth and employment. Inside EMU, the adjustment process is more cyclical and protracted.
‘The responses of inflation and output to shocks are more protracted and volatile with adverse consequences for growth and employment.’ (HM Treasury Euro Report p.88)
The Treasury displays this with some helpful graphs. Below we see the effects of a positive demand shock to the UK economy, over 4 years.
FIGURE 10
FIGURE 11
FIGURE 12
Barrell and Dury found in 2000 that inflation volatility would fall 44% under EMU. However, this was based on the exchange rate shocks of the 90s.
Minford 2001 looks at exchange rate volatility over a longer time period finding that inflation volatility would increase by 880%. Minford 2002 says that the Euro’s volatility against the Dollar would increase our inflation volatility, as has recently happened in Ireland.
Even Barrell and Dury agree that output volatility would be increased as part of EMU.
Is the Eurozone flexible?
Up to now we have highlighted the flexibility in the UK by comparing ourselves with the Eurozone countries. However, the fact that the economies of Europe are not flexible is not good for Britain.
Germany is prime example of how a rigid economy can lead to problems. The strong Euro has made life difficult for German exporters, but the wages in Germany have not come down to help the situation and as a result unemployment is not coming down. Germany is still in recession while we are beginning growth again on the tails of the US.
‘Structural rigidities impede the proper functioning of markets and greater competition and flexibility will be needed in the face of economic disturbances.’(Ardy et al p.33)
HM Treasury looks at the different outcomes for differing levels of flexibility. If the UK and Europe maintain a rigid employment and price structure,
‘Output and inflation would tend to suffer from long drawn out responses in the face of shocks – with sustained periods of output and employment below potential’.
(HM Treasury p.91)
If things remain as they are with the UK having more flexibility than the rest then output and growth stability would be much improved, but at the cost of inflation volatility. European reforms should move forward together as much as possible. Rigidities are one place spill over to affect the performance of others.
HM Treasury Euro report agrees with this.
‘If prices were highly flexible in both the UK and the euro area, this would represent the best outcome. Now, output volatility would be lower and inflation would be well controlled at target levels. Inflation differentials between the UK and the rest of the euro area would only emerge when relative price changes were warranted, and they would take place promptly.’ (HMT p.91)
Again HM Treasury Euro Report uses graphs to compare the three situations.
FIGURE 13
The good news is that the reforms are happening. Ardy et al had this to say about it.
‘Layard et al. (2000) note that recent labour market reforms in the Netherlands boosted the employment rate from 58% in 1985 to 68% in 1998 and the reform of the Spanish labour market has helped to create two million new jobs since the mid-1990s. Indeed, since the launch of the euro, employment growth in France (5.3%) has been double the rate in the UK (2.6%). In summary, therefore, UK labour markets are well placed for entry to EMU, while the reform of euro zone labour markets is progressing steadily.’
Fiscal Policy Flexibility
Under EMU fiscal policy becomes more important for 2 reasons. Firstly, without the monetary policy instrument of setting interest rates, governments will have to use fiscal policy to stabilise the economy. Governments outside EMU already do this, but the use of fiscal policy will increase in significance, so we must have room for flexibility in this regard.
Secondly, as convergence increases under EMU, the economies of Europe are more interdependent, and the fiscal policies of our neighbours will affect us. The Stability and Growth pact was meant to ensure that all governments kept government spending at sensible levels. Unfortunately its rules also promoted volatility in the business cycle. Now it has been suspended, but it may well be re-instated, and countries that have broken the rules may still be fined.
The Stability and Growth Pact
SGP set out a guideline that no government should run a budget deficit over 3% of GDP. Failure to adhere to this rule would result in a warning from the other members of the EU, and could ultimately lead to fines.
Placing a limit of 3% all the way through the business cycle meant that instead of encouraging stability it encouraged cyclical business cycles. The pact began in 1997 during a time of economic prosperity and budgetary discipline. It shows the short sightedness of policy makers that they would even suggest a limit of 3% given that just 5 years previously many of the 15 governments were borrowing 5% of GDP.
Governments within the Euro need to adjust their ideas of what is an acceptable level of debt given that fiscal policy is now the only policy tool left for governments to use.
‘The determination of whether a country’s fiscal-financial programme is sustainable, or whether a particular sequence of current and anticipated future deficits is excessive, cannot be reduced to a mechanical test, but will involve judgement, discussion and potential disagreement.’ (Patching up the Pact P.6)
It seems to be the broad consensus that a committee rather than a set of rules should decide whether or not a country’s policies are irresponsible, especially since there are 10 countries joining this year that will further diversify the structure of economies within the EU.
This kind of solution to the SGP can only be good for Britain. The UK faces different challenges from the rest of Europe, and a more flexible and expert ‘disciplinary panel’ would take into consideration our specific needs
Test 2: Is Britain converging with the Eurozone economies?
As we have explained, the greater the diversity between states will bring costs to monetary union. If preferences for inflation and unemployment and taxes etc. converge, the costs of the union will be lower.
Convergence has been a feature of the EU for at least the last 10 years, and is paramount to the success of EMU.
‘Even the least disciplined among EMU members have enacted rigorous anti-inflationary and fiscal reform policies. Hence the costs of EMU will be quite moderate.’(TPE, p.70)
However, there are various methods of calculating correlation.
‘There is no consensus on how convergence between time series in general,
and business cycles in particular, should be gauged’ (Massman and Mitchell 2003 p.2)
Frankel and Rose (1998) quote Artis and Zhang (1995) for finding that
‘most European countries’ incomes were more highly correlated with the US during the 1961-79, but (with the exception of the United Kingdom) have become more correlated with Germany since the ERM’ (Frankel and Rose 1998 p.1015).
However, Britain’s increasing trade with Europe will bring correlation in the future. Furthermore, the act of joining itself will increase trade and convergence (see page 44).
Massman and Mitchell 2003 looked at eurozone business cycles.
‘Although further data are required to corroborate the story, there is also evidence to suggest that the Eurozone has entered a period of convergence after the clear period of divergence in the early 1990s in the aftermath of German unification and at the time of the currency crises in Europe.’ (Massman and Mitchell 2003, p.16)
So although Britain, like the rest of Europe, had problems with convergence in the early 90s, this would not necessarily happen again.
TABLE 3 INFLATION CORRELATION
Source: Hall and Yhap 2003
Hall and Yhap conducted a study in 2003 to examine the correlation between the big 4 countries of the EU. Above we see the correlation coefficient for inflation. Germany correlates the least, around 0.59 for all three countries. Italy and France, however, correlate 0.9, which is quite high. Britain is tied in at about half way with 0.74 for Italy and France. Germany’s variation on inflation can be attributed to the Bundesbank’s hostility to inflation.
However, when we look at GDP there appears to be a lot less convergence.
TABLE 4 OUTPUT CORRELATION
Source: Hall and Yhap 2003
Here the correlation between France and Italy is again very high while that between
Germany and the other three countries is much lower. The UK lies somewhere between with a very low correlation with Italy but slightly higher with France and Germany. So there is clearly much more diversity in growth rates than inflation rates over the whole period.
Hall and Yhap explain that they calculated the tables using the Orthogonal GARCH method.
They conclude that it is Germany, more than the UK, that would find it difficult as part of the currency union. TPE backs this up on p.90
‘Germany is the only country for which export elasticity is statistically significant as far as employment is concerned’.
In 2003 Germany experienced its first full year recession for a decade (The Times Business Jan 16th 2004). Output declined by 0.1% over the whole year. However it does not appear that this is due to an ECB interest rate far too high for Germany.
TABLE 5
However, because Germany’s exports are highly elastic to price changes, in the long run exchange rate stability of EMU is an advantage. Furthermore, the 10 countries that join this year will help Germany’s position. As Mundell said, the larger the monetary union the less exchange rate matters.
What does the future hold for convergence?
We have established that a good currency area requires a high level of integrated trade and close convergence. Earlier on we established that EMU would greatly increase the level of trade amongst EMU nations. Could EMU also induce convergence?
In 1998 Frankel and Rose produced an important paper that looked at the effect that increased trade has on convergence. While the European Commission is of the view that increased trade will bring convergence, some authors disagree because of the specialisation that accompanies increased trade. Specialisation across EMU could mean that industry specific shocks become country specific shocks. So we have two conflicting views, but which one carries the more weight?
The difference is simple. If most trade is inter-industry, i.e. between different industries, it will result in greater specialisation. If most trade is within industries, or intra-industry, then the specialisation effect is minimal. So what is the verdict for EMU?
‘Intra industry trade…is commonly considered to account for a major share of international trade’ (Frankel and Rose 1998 p.1014).
This suggests that trade does lead to correlation. Frankel and Rose looked at empirical findings to back this up.
Empirical results show that the ‘effect of greater intensity of international trade on the correlation of economic activity is strongly positive and statistically significant…A closer trade linkage between two countries is strongly and consistently associated with more tightly correlated economic activity between the two countries’
(Frankel and Rose 1998 p.1020)
Therefore if Frankel and Rose are right, the introduction of EMU should induce the increase in trade necessary to further correlate the business cycles of the participating countries.
‘A country is more likely to satisfy the criteria for entry into a currency union ex post than ex ante’ (Frankel and Rose 1998 p.1024).
Test 3: How Will EMU Affect Investment in the UK?
EMU Good for Manufacturing in the UK
While we have already argued that the increased stability with Europe will be offset by increased volatility with the rest of the world, manufacturing is different. A large part of FDI by the US and Japan is in manufacturing. By and large the goods that are manufactured here are exported to Europe. Therefore joining EMU would be of value to both domestic manufacturers and foreign companies that manufacture here, of which there are many.
‘The fact that U.S. and Japanese firms in the UK export a large proportion of their output to Europe may explain why these firms are particularly keen on UK membership of EMU’ (Pain, 2002 p.105).
Bush 2001 argues that the record levels of FDI in the UK in 1999 and 2000 are proof that the UK is better off outside the Euro. However, this is a Europe wide trend and the UK has already lost its place as No.1 in Europe for FDI to Germany in 2000. This could decline further the longer we stay out of EMU.
‘On the basis of this evidence it seems unlikely that joining EMU and reducing currency volatility would have very large effects on inward FDI in the UK, but that it may encourage more manufacturing investment’ (Ardy et al 2002 p.30).
INWARD FOREIGN DIRECT INVESTMENT
TABLE 6
It is worth noting that the entry exchange rate for the UK is extremely important because if we enter too high the adjustment process would take a long time and the effects may last for a long time too. There is another reason why flexibility is important.
While we have seen that the savings of transactions costs for most industries is minimal, the deregulation of capital markets that looks likely to follow the Euro (Financial Services Action Plan) would be of great benefit to the UK financial markets. Competition in the financial services sector would be good for the UK as we have some of the biggest banks in the world. A Europe wide capital market would mean far greater potential for growth for these companies, lower prices for the consumer and far greater cross border investment. Therefore, joining the Euro would directly affect FDI in this country.
‘Overall, exchange rate volatility acts as a barrier to cross-border investment. EMU entry on the basis of sustainable and durable convergence, including at a sterling-euro exchange rate consistent with longer-term sustainability, would allow the UK to participate in a more active cross-border investment market, prompting greater foreign direct investment (FDI) flows into the UK from the euro area and greater outflows from the UK to the euro area.’ (HMT p.137)
Test 4: Would the City of London Benefit from being in or out of EMU?
The financial services sector is the UK’s biggest export, and in 2000 it accounted for 4.4% of all UK exports (IFSL 2001).
‘In 2001, financial services accounted for 5.2 per cent of UK output, compared to 5.6 per cent of output in 1997.’ (HMT p.162)
London’s position in Europe is under no immediate threat outside of the Eurozone. However, as part of EMU could London set in stone its position as the financial centre of the World?
EMU Benefits to the City
Economies of Scale
While we have seen that the savings of transactions costs for most industries is minimal, the deregulation of capital markets that looks likely to follow the Euro (Financial Services Action Plan) would be of great benefit to the UK financial markets. Competition in the financial services sector would be good for the UK as we have some of the biggest banks in the world.
‘Where they have not done so, financial firms may continue to harness the potential of technology, gather operations at one site and offer their services widely from a single location. This reduces costs and allows internal scale economies to be captured.’(HMT p.165)
Cross Border Investment
A Europe wide capital market would mean greater potential for growth for banks, lower prices for the consumer and far greater cross border investment. Therefore, joining the Euro would directly affect investment in this country.
‘Overall, exchange rate volatility acts as a barrier to cross-border investment. EMU entry on the basis of sustainable and durable convergence, including at a sterling-euro exchange rate consistent with longer-term sustainability, would allow the UK to participate in a more active cross-border investment market, prompting greater foreign direct investment (FDI) flows into the UK from the euro area and greater outflows from the UK to the euro area.’ (HMT p.137)
European Market Capitalisation
One important consideration is the changing face of equities within Europe. One of the engines behind the success of the markets during the 90s was the movement to equity financing seen in Europe. The downturn of 2000 has put this revolution on hold, for the mean time. However it is just a question of confidence returning before investors start putting their money in equities again.
Private Pension Growth
The ageing populations of Europe are going to rely much more on private pensions in the future, providing growth for the financial services sector. This is an area where Edinburgh too would benefit. Scotland has the sixth largest financial sector in Europe, and specialises in mutual funds. The question we have to ask is whether or not Britain’s opt out of the Euro will discourage investors from British banks.
The Bond Markets
Joining EMU would open the door to insurance companies wishing to invest in the ‘Pfandbriefe’, the bonds market, without facing a currency risk.
Mergers and Acquisitions
The banks on the continent are quite small compared to the UK. One could say that the potential for M & A’s in Britain is almost saturated. As part of EMU Britain would have the opportunity to expand quickly into European markets through M & A’s. Without EMU, retail banks may find it difficult to merge on the continent.
However, HMT p.172 states ‘that the business case for cross-border branch networks and M&A activity among retail banks is weak.’
‘The evidence from the US banking and insurance sectors (shows) that regional differences can still persist in a monetary union even in the very long run.’
(HMT p.174)
However this is based on past conditions. Recently UK banks have been looking to merge with US banks. As European regulation becomes more liberalised, the case for Mergers in Europe is likely to become stronger. When this happens, the UK would ideally already be part of EMU.
The Euro Doesn’t Make a Difference to the City
Today’s technology means that Banks in London can trade just as easily on Euro’s as pounds. If a German investor wants to invest in France he can do it just as easily from London as Paris. This kind of technology encourages finance companies to locate in one place where they conduct all their operations, regardless of the domestic currency. London is the most obvious choice in Europe.
TABLE 7
(ISFL latest data)
London is the Financial Centre of the World
There is evidence to suggest that wholesale financial activities are not related to the domestic currency. One of the most interesting figures of Table 4 is that 31% of all currency exchanges go through London. For this reason, London has taken the Euro conversion in its stride.
‘The competitive position of London in international wholesale financial services activity has been largely decoupled from the issue of domestic currency. London’s strength and development is independent of sterling’...’ Evidence suggests that membership of the single currency has not been an important issue in determining the location of wholesale financial services activity’ (HMT p.167).
The international nature of the city means that convergence is not as necessary as for other parts of the economy such as manufacturing. Furthermore, the changeover costs would be minimal given the experience that many companies have from 1999 and 2002.
Shaping The Financial Future
Before the introduction of the Euro there was a fear that Britain would get left out of shaping the financial future of the EU. Those fears have not been realised. The B of E has significant influence in the Financial Services Authority as well as security regulation. There is a joint UK German initiative to extend the Lamfalussy process to banking and securities, and this has not been affected by staying out of the Euro.
The 10 new entrants of this year will increase the number of EU members not participating in EMU, although these nations are required to join EMU when they meet the criteria.
What about the Challenge from Paris and Frankfurt?
Paris and Frankfurt are trying to catch up on London’s dominance of finance. They are modernising their trading systems and France is relaxing its tax laws. They have a strategy of using the Euro as a springboard for change. Also, the recent scandals in London may weaken the reputation of the city.
However, London does not have to worry too much. The economies of scale in finance are such that the ‘reinforcing virtuous circles are likely to prove just too strong’ (Curie 1997).
Test 5: How will the euro affect UK unemployment and prosperity?
This question summarises the points of the other 4.
Unemployment and prosperity is under threat from 2 areas; the need to be flexible and the possibility of asymmetric shocks. We’ve already seen how our economy is more flexible than those on the continent. Ideally we want a flexible Britain and a flexible Europe. This is slowly taking place, but a flexible workforce is a dirty word in social welfare Europe.
As our economy continues to converge with the EU, and as our oil reserves become low, the likelihood of an asymmetric shock is reduced. Again, flexibility is the key to combating asymmetry. Minford (2001) finds that volatility would greatly increase within EMU. Barrell, however, finds that variable output would be outweighed by more stable inflation.
In my opinion, the stability in prices we see in Britain today would continue under the stewardship of the Bank of England, given that their prime objective is to stabilise inflation. Inflation would be more volatile under the ECB. However I believe that the lower interest rates, and increased investment helping to close the productivity gap, would make slightly more inflation volatility worthwhile.
If the UK responds to shocks quickly and appropriately to shocks, unemployment should not be affected by much in the long term. We’ve also looked at how the Prosperity would not suffer greatly outside EMU. But inside EMU Britain could play a leading role. FDI would increase and the role of the City of London would be boosted.
Chapter 4
Other Points to Consider
The Transmission Mechanism
The Transmission mechanism is included under much of the literature on Optimum Currency Areas. However, I have included it here because I believe it to be a crucial part of OCA that is particularly significant to the UK and therefore deserves special attention.
Differences in Legal Systems
The transmission mechanism is the effect that interest rate changes have on a country. This mechanism works differently because of legal and cultural differences. Here are some examples.
Bonds
Different legal systems leave us open to asymmetric shocks. The differences that do exist are for mainly legislative reasons, but not all. Some have arisen from differing monetary policies. For example, historically higher inflation in Italy means that investors in Italy don’t buy long-term bonds. Italy has high short-term bond debt and Germany has high long term bond debt. However this has been due to the history of high inflation in Italy and low inflation in Germany. Over time the Euro will eliminate differences like these.
TABLE 8
Maturity Distribution of Government Bonds (% of total) (De Grauwe p.31)
Mortgage Markets
‘In some countries the law protects the banks extending mortgage loans better than in other countries…therefore mortgages are very different products with differing degrees of risk from one country to another’ (De Grauwe p.31).
Some countries require 100% collateral backing. This makes it difficult to get a mortgage unless you are very wealthy. Also, some countries don’t allow floating mortgages. This is an important point because it means that a change in interest rates will affect consumers differently in different countries. Furthermore, the different conditions in the European countries mean that there are differing levels of ownership of housing. This too means that interest rates affect people differently across the EU.
‘Amongst the four large European economies the GDP effect of a temporary interest rate change would be largest in Germany. This can be broken down into an ‘average’ effect on consumption (as a contribution to GDP) but a much stronger contribution to GDP from investment. Part of this is due to the larger share of investment in GDP in Germany than in the other large countries.’…‘Consumption in the UK was more effected than elsewhere, but the impact on investment was much smaller.’
(Barrell and Weale 2003 P.19)
There are two more reasons for the differences. Firstly, consumption in Britain is more sensitive due to the higher level of home ownership and also floating mortgage rates. Secondly, investment in Germany is more sensitive because business there has a tendency to finance investment through bank loans rather than equity. The UK, on the other hand, has the highest market capitalisation in Europe. This helps explain why London is the financial centre of Europe, and some say the world.
Should attempts be made to promote convergence of monetary transmission mechanisms? We could encourage migration from floating-rate mortgages to fixed-rate mortgages, which are typical in continental Europe?
This graph was taken from the Miles report 2003.
GRAPH 2
GRAPH 3
Owner occupation is an important issue because a high degree of ownership equals high consumer sensitivity to interest rate changes. As you can see from the graphs, the differences across Europe are distinct, from Germany at 42% to Spain at 80%. Britain’s home ownership is near the middle, but more importantly, it is higher than the big 3, which make up around 75% of Eurozone GDP. Germany and France in particular have low home ownership.
GRAPH 4
When examining the transmission mechanism we also have to take into account the stock market capitalisation of the UK. One could say that this opposite cancels out the opposite of fixed mortgage versus flexible.
Dornbusch, Favero and Giavazzi studied EU transmission during the early 90s.They analysed the elasticity of output after interest rate changes.
They find that the impact in the United Kingdom is similar to that in France and Germany, somewhat larger than in Spain, but significantly smaller than in Italy and Sweden. The effect after two years is smaller in the United Kingdom than elsewhere, which the authors attribute partly to the fact that UK activity is less strongly related to the European business cycle. However, UK activity is also more open to transatlantic influences, and this may be a source of asymmetric shocks.
In table 5 we see the standard deviations of output and short-term interest rates relative to their 21-quarter moving averages for the United States and the major European countries over the 1980s, the 1990s and over the period from 1980 to 2002. (Barrell and Weale)
Table 9: Standard deviations of output and short-term interest rates relative to their 21-quarter moving averages
Looking at the period as a whole, the United Kingdom shows median interest rate sensitivity, and Germany appears to be the most sensitive.
It has been suggested that the UK consumer leaves itself vulnerable to interest rate changes because of the high levels of debt we incur as a nation. However we must remember that for every borrower there is a lender. Put another way, savings equals investments and thus there are also many assets held in the UK, which of course benefit from interest rate rises just as borrowers suffer from them.
The Bank of England report “A view from next door” points out that British preferences to floating mortgage rates are due to the inflation volatility of the 70s.
GRAPH 5
Today in Britain floating mortgages are still more popular than fixed. Hence the government has made clear its intention to encourage stability in the housing market, possibly starting with a stamp duty on house sales. However, as prices remain stable, in the long term the consumer should see the value of fixed rates, helping to bring our transmission mechanism into line with the rest of Europe, at least in terms of consumption. As for investment, in France and Germany businesses are increasingly using equity to finance investment, which will bring them closer to the UK. This is why it is important that Britain encourage fixed mortgages and controls the record high level of consumer debt before joining the Euro, or we could find ourselves much more vulnerable to interest rate changes. In the short term, however, it is safe to conclude that joining the Euro would not be jeopardised by stark differences in the transmission mechanism.
Lessons From History
The Exchange Rate Mechanism
The disaster of the ERM in Britain does not mean the Euro would go the same way. The policy Trilemma helps to explain why the ERM did not work.
The theory of the Trilemma argues that in a world of high capital mobility it is not possible to have simultaneously pegged exchange rates, freedom from controls, and independent monetary policy.
FIGURE 14
Governments have to pick one side of the triangle in order to have long-term stability. Ignoring this rule, the governments of Europe left themselves open to speculative attack.
Ultimately it was an asymmetric shock that sent Britain flying out if the ERM. In 1992 while Germany was on a post unification boom, Britain was suffering a deep recession due to its closer ties with the US and the rest of the world. Inevitably the Bundesbank looked after German interests first. Furthermore, the Pound had entered the ERM at too high an exchange rate and the BOE was finding it difficult to prop up the Pound under increasing speculative pressure. The most important lesson of the ERM is to join at the right exchange rate. Thirdly, the bandwidth of movement was too narrow, and eventually the other major nations of Europe fell out of the ERM.
The Euro, however, is not vulnerable to this kind of speculation. There are no domestic currencies any more, but more importantly, the ECB has prioritised strength of the Euro above all else.
Bordo and Jonung identify 5 major lessons to learn from the history of Monetary Unions.
1: Successful monetary unions have been associated with political union. Therefore the members must have close political co-operation and co-ordination.
2: The collapse of a monetary union is usually messy, but Czechoslovakia is an exception. EMU is a multi-national union, and therefore if EMU were to break up it wouldn’t be so traumatic.
3: EMU is on a fiat standard with the ECB promoting stability, but the national governments must follow complementary policies. Therefore we need political integration.
4: Monetary unions are always dominated by a few powers at the centre; New York in the USA, the UK in the Gold Standard and the US in Breton Woods. So we can expect the same from Germany and France in EMU, and possibly the UK if we join.
5: Monetary union is an evolutionary process. A successful plan from the start is not possible. The Fed took 40 years to become effective. Similarly EMU will develop over time.
Conclusions
The Euro has quickly established itself as an important world currency. Therefore Britain should have no fears about giving up the pound for a weaker currency. The increase in trade that will arise from the Euro will be of great benefit. Right now it just seems like a question of by how much.
Moving monetary policy from the BOE to the ECB will lower our interest rates, which will boost growth but will encourage inflation volatility. There is also the possibility of asymmetric shocks, but as our economies converge and become more flexible that becomes less likely. While we will lose the economic tool of foreign exchange intervention, this was only ever a short-term tool, and does not affect long-term problems.
Differences in growth rates across Europe will still be accompanied by inflation differentials, therefore our terms of trade are safe. The addition of Central and Eastern European nations will serve to strengthen not weaken Britain’s position economically, as well as politically.
The five tests may not yet be met but are close, and will most likely be met ex post rather than ex ante.
The transmission mechanism is widely touted as a barrier and rightly so. The government will have to work hard to control consumer debt and rising house prices. It is paramount that Britain has the ability to cope with interest rates that will be slightly out of sync with our needs.
The lessons from history tell us that we must see political integration along with economic integration if the Euro is to succeed. This could be difficult in today’s climate, but I believe the criteria for a successful single currency will be met, albeit after the introduction rather than before. I therefore conclude that Britain should join the Euro, as long as we want to be part of an eventual European nation.
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CONTENTS
1. INTRODUCTION ………………………………………………………..P.1
2.CHAPTER ONE: THE BENEFITS OF EMU …………………………..P.2
Risk-Sharing……………………………………………..P.3
The Euro as a World Currency ………………………….P.4
EMU will increase our levels of international trade……..P.6
3.CHAPTER TWO: THE THEORY OF OPTIMUM CURRENCY
AREAS AND HOW IT APPLIES TO THE EURO…P.9
Higher interest rates outside of a monetary union ………P.10
What are the effects of asymmetric shocks?…………… P.11
How likely is a demand shock?………………………….P.13
The Services Economy…………………………………..P.14
Tax Harmonisation ………………………………………P.15
Fiscal Redistribution.……………………………………..P.16
The Differences Between European Countries…………..P.16
Foreign Exchange Intervention…………………………..P.20
Growth Productivity and Inflation in EMU……………...P.27
4. CHAPTER THREE: GORDON BROWN’S 5 TESTS………………….P.30
TEST 1: Is there sufficient flexibility in the UK economy to
respond to shocks if it joined EMU……………………………P.30
TEST 2: Is Britain converging with the Eurozone economies?………….P.38
TEST 3: How will EMU affect investment in the UK?………………….P.43
TEST 4: Would the City of London Benefit from Being Inside
or out of EMU?………………………………………………….P.45
TEST 5: How will the Euro Affect UK unemployment and prosperity….P.50
5. CHAPTER FOUR: OTHER POINTS TO CONSIDER…………..……..P.51
The Transmission Mechanism……………………………P.51
Lessons From History…………………………………….P.57
6. CONCLUSION……………………………………………………………..P.60
7. BIBLIOGRAPHY…………………………………………………………..P.61
ABSTRACT
This paper examines the economic case for Britain joining EMU. We begin by looking at the ways in which we can benefit joining. We then look at the theory, largely based on Mundell’s Theory of Optimum Currency Areas. This takes into account a wide range of theoretical possibilities. It enables us to look at how best we can prepare for monetary union. Then we go on to examine the 5 tests that have been proposed as an indicator of Britain’s readiness for EMU. The most important of these is the convergence test. Here we look at the conclusions of 3 different reports by Frankel and Rose, Barrell, and Massman and Mitchell. We go on by paying special attention to the transmission mechanism, particularly the housing market which many fear is a bubble waiting to burst. Finally we look at some of the lessons that can be learned from monetary unions of the past.
Acknowledgements
I’d like to thank Professor Jacques Melitz for encouraging me not to presume that the ECB interest rates will be out of synch for Britain. Special mention must go to the mice in my flat who encouraged me to leave the flat and go to the library where I found I could work 3 times as fast. Many thanks to my flat mates who made me feel guilty when I wasn’t doing any work. Furthermore I’d like to thank my French tutors for putting up with me missing class to get this done. Finally I’d like to thank the academy for continuing to award such terrible films as the English Patient, it gives us all hope that we are smarter than the people on television.
Figures
1: The difference in interest rates, inside and outside EMU……………………..P.4
2: The effects of a demand shift from Britain to Germany………………………P.11
3: A country that chooses low inflation and low employment…………………...P.17
4: A country that chooses high inflation and high employment………………….P.18
5: A currency depreciation of the Franc against the Deutsch Mark………………P.21
6: The Long Run effects of a currency depreciation………………………..……P.22
7: The Effects of Devaluation on the terms of trade………………………..……P.25
8: The alternative to devaluation and the effects……………………………..…..P.26
9: UK inflation unemployment trade-off……………………………………..…..P.31
10: The effects of a positive UK demand shock on inflation………………..……P.33
11: The effects of a positive UK demand shock on output…………………..…...P.33
12: The effects of a positive UK demand shock on real interest rates………..…..P.34
13: The effects of 3 scenarios of flexibility…………………………………...…..P.36
14: The policy trilemma…………………………………………………………...P.58
Tables
1: The interest rates set by all the major central banks……………………….P.10
2: Inflation and employment 1997-2001……………………………………..P.19
3: Inflation correlation amongst the big 4…………………………………….P.40
4: Output correlation amongst the big 4……………………………………....P.40
5: ECB interest rates compared with national rates needed…………………..P.41
6: Inward Foreign Direct Investment………………………………………….P.44
7: Percentage of Financial Services per nation………………………………...P.48
8: Distribution of Government Bonds…………………………………………P.52
9: Standard deviations of output and short-term interest rates relative
to their 21-quarter moving averages…….…………………………………..P.55