Memorandum submitted by Professor Iain
Begg and Mr Brian Ardy, South Bank University
INTRODUCTION
Despite the fall in the euro, the beginning
of stage 3 of EMU has been relatively trouble-free. The institutions,
particularly the ECB, have carried out their roles satisfactorily,
although inevitably there have been some problems. The economic
performance of the euro-area has been good with accelerating economic
growth, falling unemployment and low inflation. Even the fall
in the external value of the euro has been a mixed blessing, encouraging
growth but undermining market and public confidence. For the UK
the experience of being outside has been rather uncomfortable
especially as the euro has continued to fall.
This memorandum is written in response to the
invitation circulated by the Treasury Committee to submit written
evidence to the inquiry into economic and monetary union announced
on 16 March 2000. Following the terms of reference, it covers
the conduct of monetary policy in the euro area and the prospects
for its economy, the UK position and the possible implications
for the euro of enlargement. We do not feel competent to discuss
the national changeover plan.
SUMMARY OF
MAIN POINTS
— Euro area macroeconomic policy has
been well judged over the last 18 months and has contributed to
a favourable economic performance.
— The fall in the euro has been steep
but is not unprecedented.
— The euro is now significantly undervalued
and seems to be undergoing a correction.
— The rise in the value of Sterling
against the euro has made it more difficult to satisfy the exchange
rate stability criterion for the EMU entry, but the UK meets the
other Maastricht convergence criteria.
— The UK is now much more convergent
with the euro area than when the five economic tests were set.
— The risk for the future is that non-convergence
could become self-fulfilling so long as the UK stays out of the
single currency.
— There is unlikely to be any pronounced
or immediate impact of enlargement on the euro.
OVERALL ASSESSMENT
Seen from the UK or from City dealing rooms,
the euro has had a rocky start. Its loss of value against other
major currencies and the apparent inability of the members of
the Governing Council of the European Central Bank (ECB) to sing
from the same hymn-sheet, notably in commenting on the external
value of the currency, have been seized upon by the euro's detractors
as evidence that the whole enterprise is mis-conceived. But viewed
from within the "euro area", the picture is much more
rosy. Growth is picking up, unemployment is edging downwards and
there is no sign of a resurgence of price inflation despite the
fall in the value of the currency. On the whole, the economic
management of the euro area has been sensible and fears of either
an overly restrictive or a cavalier monetary policy have proved
to be unfounded. Certainly, unemployment remains high, especially
in the euro area's four largest economies (France, Germany, Italy
and Spain), but the trend is manifestly in the right direction,
although there is wide recognition that the pace of supply-side
reform needs to be accelerated.
The latest forecasts from the OECD, published
in late May 2000, confirm those published by the European Commission
in April in projecting that the EU economy will continue to grow
at a healthy but sustainable rate this year and next. The OECD
forecasts that the euro area's growth rate in 2001 will, at 3.3
per cent, be higher than the US, Japan and the UK. Moreover, inflation
is expected to remain under 2 per cent and the current account
balance is in growing surplus. Consequently, there is no obvious
reason for the euro area economy to slow down. The OECD does forecast
some further increase in the euro area interest rate, but expects
rates to remain below those in the US and the UK. The gap between
the UK and euro rates is, however, expected to narrow.
The implication of all this is that euro area
macroeconomic policy has, on the whole, been well-judged and that
the ECB seems to have fulfilled its mandate to assure price stability
while having regard to general economic conditions. There was
undoubtedly a fear in advance of stage 3 that the ECB would implement
an overly muscular monetary policy that would hamper recovery,
but thus far monetary conditions seem to have been appropriate.
In fact the early cuts in interest rates effected by the ECB in
late 1998 and early 1999 suggest a greater willingness to ease
than the Bundesbank showed a few years earlier.
THE FALL
IN THE
EURO
What, then, of the fall in the euro? Although
something of an embarrassment to those who expected or wanted
the euro to be a rival to the dollar, it has not obviously damaged
the euro area economy. Any devaluation has to be judged on whether
the boost it gives to net export demand is offset by inflationary
pressures emanating from higher import costs. The evidence on
inflation, growth and trade performance suggests that this trade-off
has, thus far, been favourable. This is not altogether surprising:
the euro area (in common with the US and Japan) is a relatively
closed economy which means that the shift in the currency has
relatively little impact on consumer prices through imports, but
that net exports are boosted.
A more subtle question is whether the fall in
the euro poses a longer-term threat. To answer this, it is useful,
first, to consider what caused the fall, bearing in mind the widespread
agreement that "fundamentals" point to a strong euro.
Four reasons can be put forward:
— First, the difference in interest
rates between the euro and the dollar has provided an incentive
to hold the latter (and the pound). Plainly, though, this does
not hold for the yen.
— Second, the boom in, especially,
high-tech stocks across the pond drew capital from Europe, creating
a demand for dollars and selling pressure on the euro.
— Third, the discordant voices from
Frankfurt and elsewhere speaking on behalf of the euro have sown
uncertainty that the markets have been quick to exploit. This
reinforced worries about a new and untried currency.
— Fourth, the perceived slow pace of
structural reform in the larger EU economies coupled with the
relatively slow recovery from recession seemed to signal an underlying
economic weakness compared with a dynamic US economy.
It also has to be recognised that the fall in
the euro between January 1999 and April 2000, though steep, is
not unprecedented. The fall in the dollar in the mid-1980s was
much greater, while the collapse of the pound between 1980 and
1985, and again in 1992, is too easily forgotten.
Foreign exchange rates are notoriously unstable
and difficult to predict, so it would be a mistake to read too
much into the weakness of the euro over the last 18 months. The
values of euro-area currencies have been lower than this before:
in a previous period of dollar strength in 1985 the DM fell to
a rate of 3.5 to the dollar compared to the current implicit rate
of 2.2 to the dollar. By contrast, between 1996 and the end of
1998, the dollar languished at under 2 DM to the dollar.
Today, there is, nevertheless, a general agreement
that the euro is substantially undervalued. The ECB estimates
that in terms of purchasing power parity the euro has lost 12.5
per cent of its value since its launch[1].
Even before the euro's slide began it was estimated that it was
7.4 per cent undervalued against the dollar and 15.5 per cent
undervalued against sterling.[2]
A rebound in the value of the euro is, therefore, likely and the
recent fall in the value of sterling and the rise in the euro
above $0.90 may indicate the start of this process.
THE MAASTRICHT
CRITERIA
The UK meets four of the five Maastricht criteria,
but plainly cannot satisfy the exchange rate stability criterion
embodied in the requirement that an aspirant to stage 3 should
have participated in the ERM without parity change for two years.
The degree of independence of the Bank of England also falls short
of what is expected. However, neither of these is likely to be
an obstacle to UK participation in stage 3 and a political fix
would almost certainly be found if the UK wanted it.
THE FIVE
ECONOMIC TESTS
The first of the Chancellor's tests—cyclical
convergence—is the one deemed by the Treasury to be most
important and the one that has seemed most difficult to pass.
It can, however, be argued that in the light of macroeconomic
developments across the EU in the last 30 months, cyclical convergence
is no longer the problem it was in 1997. After the slowdown in
1999, the UK is roughly in the middle of the EU league tables
for growth and inflation, though still better than average for
unemployment.
Measures of "output gap" also suggest
that the British economy is now much closer to the rest of the
EU in cyclical performance. In 1997, according to the OECD, the
UK economy was operating at 1.1 per cent above full capacity as
measured by the difference between actual and potential output,
whereas the euro area had a negative gap of 1.6 per cent, a difference
of 2.7 percentage points. Projections are that the difference
between the UK and euro area output gaps will narrow to 1.1 per
cent this year and to 0.1 per cent in 2001. Although there are
methodological problems in measuring and interpreting output gaps
(European Commission estimates show a similar difference between
the UK and the euro area in 1997 and 2000, but based on differing
values), the steady narrowing of the gap is significant.
In any case, total convergence within any monetary
union would be exceptional and it is undeniable that there is
continuing macroeconomic divergence in the euro area. Germany
and Italy, in particular, have been laggards, whereas several
of the smaller EU economies have been booming. But there is little
sign that this is undermining the conduct of policy. Tensions
are bound to increase as some of the euro area economies become
more over-heated, but it is important to recognise that all sides
are adapting progressively to the new monetary regime. A few years
ago, it would have been inconceivable that Ireland, Portugal or
Spain could have sustained their current growth rates without
stoking inflation. Indeed one of the consequences of monetary
union that has received too little attention is that it must be
expected to alter the behaviour of economic agents, notably those
in the labour market, by transforming expectations.
The significance of such change is that it bears
on how convergent economies are and thus on the suitability of
a one-size-fits-all monetary policy for different parts of the
economy. The Governor of the Bank of England found himself in
hot water in the North of England for his admission that UK monetary
policy is weighted towards the over-heating South East. Leaving
aside the irony that current euro interest rates would be just
about right for the North of England, though not for the South,
the degree to which convergence occurs as a result of euro
membership is a critical part of the UK decision on the five economic
tests.
The rise in the pound since 1996 does not appear
to have much adverse effect on the UK growth rate and has probably
helped to keep inflation low. But the volatility of the currency
creates problems for the planning of investment and production.
Anecdotal evidence suggests that UK manufacturing industry was
badly hit by the appreciation of sterling against the euro, with
the most obvious examples being the travails at Rover and the
planned ending of car manufacturing at Dagenham by Ford. The risk
for the future is that excessive sterling volatility will become
a cause of further cycles of boom and bust. Non-convergence could,
therefore, become self-fulfilling so long as the UK stays out
of the single currency.
Of the other four economic tests, one (the impact
on the UK financial services industry) seems to us to point only
one way, while the others are vague enough to be open to be adjudged
either positively or negatively on the basis of the same circumstances.
— Flexibility: Some of the UK
weaknesses noted by the Treasury in 1997 such as skill levels
and workless households remain. The continuing reduction in unemployment
coupled with the impact policy initiatives has helped to alleviate
long-term unemployment. Unemployment is also falling in the euro
area, although the pace of structural reforms (as noted above)
has been subject to criticism. Whether the fall is a cyclical
phenomenon or more permanent it is still early to tell. However
with the increasing willingness across the EU to confront structural
problems, it can be argued that flexibility is less of a problem
today than it was in 1997.
— Investment: Greater macroeconomic
stability in recent years has favoured investment, but many foreign
investors complain that exchange rate instability outside EMU
may discourage investment. Government figures (including mergers
and acquisitions as well as new investment) show that the UK has
continued to attract high inflows of inward investment, reaching
a record figure in 1999, up 26 per cent on 1998. But a study by
Ernst & Young (reported in the Financial Times, 30
May 2000) suggests that UK's share of new projects in the EU in
1999 dropped from 28 per cent to 24 per cent while euro-area countries
France, Spain, Germany, The Netherlands, Ireland and Italy all
recorded big investment increases. It is too early to ascribe
any impact directly to the euro, but given the lags in the investment
process, the likelihood is that the UK will be penalised by staying
out of EMU.
— Impact on UK financial services
particularly the City: Thus far the creation of EMU does not
seem to have had much impact on the City and UK Financial Services.
Consolidation has been taking place but this has primarily remained
within national boundaries. Nevertheless, it is hard to see how
British participation in stage 3 of EMU could damage the interests
of the financial sector, whereas staying out could be a slippery
slope. Hence for us this "test" can be interpreted only
to favour membership.
— Employment and growth: It
still remains the case that: "membership of EMU has the potential
to enhance both growth and employment prospects."[3]
With the euro area economy forecast to lead, rather than follow1
the "Anglo-Saxon" world in economic performance in the
next couple of years, the immediate prospects are promising. Perhaps
more important, the gradual coming together of economic management
in the EU through the Luxembourg, Cardiff and Cologne processes
should lead to more coherent economic management.
IMPLICATIONS OF
ENLARGEMENT
On the most optimistic scenario, enlargement
of the EU to bring in some of the central and eastern European
countries is three to four years away and much can happen in the
foreign exchange markets over a period of this length. Even then,
it is by no means certain that the new entrants would be allowed
to join the single currency and might have to wait for some time
before being eligible. If the five front runners were to join
the EU, they would increase its population by about a sixth, but
boost real GDP by less than half that proportion if measured in
purchasing power parities and by about 3 per cent if measured
in euros. To put the possible change in perspective, it would
be the equivalent of adding a country of the economic weight of
the Netherlands to the euro area. Since the mandate of the ECB
is to set policy for the euro area as a whole, and thus to weight
decisions according to the economic significance of different
parts of the union, enlargement would not make much of a difference
to this averaging process. There might conceivably be some adverse
market sentiment based on a concern that the Central Bank Governors
from new members would be less willing to favour price stability,
but such a fear is likely to be proved unfounded for three main
reasons:
— First, to join the euro, new members
will have to fulfil the convergence criteria and to have put in
place policies and legislation consistent with the acquis communautaire.
Some of the candidates already do and the others aspire to,
so that the risk of bringing in divergent economies is low.
— Second, central bankers tend to have
common values which include a preference for price stability.
— Third, the Treaty provisions militate
against individual members of the ECB Governing Council steering
policy towards the needs of their countries.
In short, any impact of enlargement will only
manifest itself after a period of years and cannot be expected
to be great even when it does.
CONCLUDING COMMENTS
The implementation of stage 3 of EMU has, on
balance, gone fairly smoothly, although the new institutional
set-up is inevitably experiencing some teething troubles. The
performance of the euro-area economies has been improving and
looks to be soundly based. Although the fall in the euro presents
the ECB with public relations and credibility problems, its impact
on the euro area economy has been largely beneficial by enhancing
growth without fuelling inflation.
For the UK, the argument that the economic cycle
is out of "synch" with the euro area looks much less
convincing than it did two years ago. The slowdown in the UK economy
in 1999 seems to have allowed the euro area to catch up and, with
the difference between the two in output gaps set to fall away
over the next 18 months, convergence from the perspective of monetary
policy seems much closer.
In the light of these conclusions, our view
is that it is now time to assess the five tests and to move towards
a decision on membership of the single currency.
NOTE
The authors of this memorandum thank the ESRC
for financial support under research project number L213252034.
This project forms part of the "One Europe or Several?"
Research Programme directed by Professor Helen Wallace.
June 2000
1 ECB European Central Bank (2000) Monthly Bulletin,
May. Back
2
Alberola, E, Cervero, SG, Lopez, H and Ubide, A (1999) "Global
Equilibrium Exchange Rates: Euro, Dollar, "Ins," "Outs,"
and Other Major Currencies in a Panel Conitegration Framework",
IMF Working Paper, WP/99/175. Back
3
HM Treasury (1997) "UK Membership of the Single Currency:
An Assessment of the Five Economic Tests" London: The
Stationery Office. Back
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