EMU or Ostrich? A contribution to the assessment of the economic issues relevant to UK membership of the European single currency

EMU or Ostrich? A contribution to the assessment of the economic issues relevant to UK membership of the European single currency
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  EMU or Ostrich? A contribution to the assessment of the economic issues relevant to UK membership of the European single currency 02-02-2003 Willem H. Buiter  ∗  and Clemens Grafe ∗∗   ∗  Chief Economist European Bank for Reconstruction and Development, NBER and CEPR. ∗∗  Birkbeck College, University of London. © Willem H. Buiter and Clemens Grafe, 2003 The views and opinions expressed are those of the authors. They do not necessarily represent the views and opinions of the European Bank for Reconstruction and Development. This note was written as a contribution to the UK Treasury’s assessment of the economics issues relevant to membership of the European single currency.   1 Introduction It is too early to attempt a definitive judgement about the costs and benefits of  participation in the Euro-zone for EMU members, or about the costs and benefits for the UK of remaining outside EMU. 1  The ‘irrevocable’ locking together of the EMU currencies became effective on January 1, 1999, and the introduction of Euro notes and coin is barely a year old. Unfortunately, we cannot ask for a twenty year moratorium on our judgement. A decision on whether the UK should join EMU could  be imminent. From a technical point of view, the birth of the Euro has been a great success. There had been concerns (even confident predictions) that the fixing of the conversion rates would be precluded by massive last-minute speculative attacks. There were even  benighted commentators who predicted a collapse, through a speculative shift out of lira and into the D-mark, between January 1, 1999 and the introduction of Euro coin and notes on January 1, 2002. Since January 1, 1999, the lira and the D-mark were  just non-integer and therefore somewhat inconvenient denominations of the Euro. This channel for the collapse of EMU was therefore about as likely as a collapse of the UK monetary standard through a speculative shift out of £5 notes into £10 notes. The technical costs of the Euro’s introduction appear to have been exaggerated to an extent similar to the non-event of Y2K. Clearing and settlement systems have worked virtually flawlessly. The introduction of the Euro notes and coins, possibly Europe’s greatest peace-time logistic challenge, was an unqualified success. The Euro corporate debt markets have grown spectacularly. Monetary growth in the Euro area, which has consistently outstripped the forecasts of the ECB, is driven by strong demand for the currency. However, the fact that the birth of the Euro was painless is no pointer to the odds that the Euro will have a long and successful life. While it is clear that of the fifteen current EU members, the ten smaller ones cannot individually be optimal currency areas, the issue is perhaps not as self-evident for Germany, the UK, France, Italy and Spain. In this note we look at the recent experience of the EU countries, both the 12 EMU members and the three EMU outsiders - the UK, Sweden and Denmark - to find  patterns that may inform a preliminary judgement. With the short run of data, just over 4 years, on the full EMU experience, it is particularly difficult to disentangle transitional and long-term effects. We shall focus on the implications of EMU membership for macroeconomic stability, leaving aside the microeconomic transaction cost savings and the benefits from increased competition, greater price transparency and financial market-deepening. EMU is not just the adoption of a common currency. It comes with a wide range of other economic and political measures, practices and arrangements that will affect the economic performance of the Euro area and its constituent member states. Especially relevant for our purposes is the fact that the common currency comes bundled with the Stability and Growth Pact. The fiscal rules of this Pact are arbitrary and rigid in design as well as highly politicised in their implementation. They are therefore not 1  We refer to the UK being outside EMU or the UK not being a member of EMU as shorthand for the UK not having proceeded to the third and final phase of Economic and Monetary Union.   2 credible. 2  While this is regrettable, we believe that the Pact will evolve from its poor  beginnings into something that will enhance rather than hamper EMU-wide macroeconomic stability. Note also that, even outside EMU and without striving to meet the EMU membership conditions, the UK is subject to some of the key clauses of the Pact, notably the requirement that the general government budget be close to  balance or in surplus over the medium term. The only way for the UK to escape all direct effects of the Pact would be to leave the European Union. The likelihood and speed of reform of the Pact towards something more robust, credible and stability-enhancing will be greater with the UK inside the EMU tent than outside it. The legal framework governing monetary policy in the UK and the operating  procedures of the Monetary Policy Committee (MPC) are, in most respects and on  balance, superior to those of the European Central bank (ECB). The key distinctions concern first, the division of labour between the elected political authorities and the technocrats to whom monetary policy implementation has been delegated, and second, the openness, transparency and accountability of the two monetary authorities (see Buiter [1999a, b, c], Buiter and Sibert [2000] and Issing [1999]). These weaknesses of the ECB arrangements should not, however, present an insurmountable  barrier to UK membership. In the four years since the birth of EMU, the ECB has shown itself willing and able to change its modus operandi  when its shortcomings  became apparent. Again, the UK will have a greater influence on the outcome of these Treaty revisions if it is viewed as ‘pre-in’ rather than ‘out’. 1. Independent Monetary Policy Need Not Imply Higher Short-Term Exchange Rate Volatility Have the Euro countries experienced a reduction in short-term exchange rate volatility relative to that experienced by the UK? If yes, is this a benefit from the Euro? The second question is pertinent, because a reduction in volatility is not a plus if observed volatility reflects the appropriate response of the exchange rate to news about fundamentals. We believe that much of the short-term exchange rate volatility we observe does not represent optimal responses to fundamental shocks. The same also holds for more  persistent, medium-term exchange rate misalignments. This belief is firmly based on research which has consistently shown that only a fraction of observed exchange rate volatility (even at frequencies as low as 1 year) can be explained by movements in fundamentals such as money supply shocks, productivity shocks etc. (e.g. Clarida and Gali [1994], Faust and Rogers [1999]). Socially costly movements of the exchange rate (or failures of the exchange rate to move when it should) could reflect flaws elsewhere in the economy, e.g. in product or labour markets. They also could be due to flaws in the operation of the foreign exchange markets themselves, e.g. herding  behaviour, bandwagon effects, irrational exuberance and pathological despondence or  panic. Even asset prices that efficiently aggregate all information held by market 2  In an interview with Le Monde on 18 October 2002, EU Commission President Romano Prodi said that the rules which govern the euro – the Stability and Growth Pact - are “stupid”. His exact words were: “I know very well that the Stability Pact is stupid, like all decisions that are rigid.” That same week, EU Trade Commissioner Pascal Lamy described the Pact as “medieval” and praised the economic framework that the United Kingdom has established.   3  participants do not provide the appropriate allocative signals for savers and investors if much of the information is rumour, tittle-tattle or complete nonsense ( vide  the tech  boom of the second half of the 1990s). Monetary union is likely to reduce not only excessive high-frequency volatility of the exchange rate, but also to reduce medium-term misalignments due to attempts by  policy makers to manipulate the exchange rate, such as competitive devaluations. The relevant summary measure of exchange rate volatility is the volatility of the effective exchange rate, which aggregates bilateral exchange rates using weights reflecting the size of the trade flows between countries. Table 1 shows the volatility of the nominal effective exchange rate for the Euro-area member countries and the three outsiders. The US is included as another reference point. Table 1 here . Volatility of Nominal Effective Exchange Rates The volatility of the nominal effective exchange rate for Euro-area countries has decreased and is now at a relatively low level, significantly below that for the United States, Denmark and Sweden, and moderately below that for the UK. 3  However, the largest decline in volatility is registered by the UK. As EMU is not a monetary union containing all countries in the world other than the UK, it is not certain that joining EMU union will lower the volatility of the (global) effective exchange rate of sterling. If the covariance between the Sterling-Euro exchange rate and the effective exchange rate of Sterling vis-à-vis the world excluding EMU is negative and sufficiently large in magnitude, the volatility of Sterling’s global effective exchange rate could in  principle increase as a result of the UK joining EMU. 4   Table 2 here Volatility of Nominal USD Exchange Rates   Table 3 here Volatility of Nominal ECU/Euro Exchange Rates 3  Germany’s volatility, on our measure, was actually slightly higher than the UK’s in 1999-2002. 4  Let e  denote the global effective exchange rate of sterling, 1 e  the exchange rate of sterling with the Euro and 2 e  the effective exchange rate of sterling with the non-EMU world, the USD rate, for simplicity. The weight of the Euro in the global effective exchange rate of Sterling is α . Var denotes the variance and Cov  the covariance. Then 221212 ()()(1)()2(1)(,) VareVareVareCovee α α α α = + − + − . If Sterling joins EMU, 112 ()()0 VareCovee = = . Sterling’s global effective exchange rate will be more variable after joining EMU if and only if 2122 (1)(,)()2(1) CoveeVare αα α −− >− .   4 As shown in Tables 2 and 3, the decline in the volatility of the nominal effective exchange rate for both Euro area members and Euro area outsiders is driven by a decline in volatility in the national exchange rate vis-à-vis the Euro despite increased volatility against the USD. While this is hardly surprising for the Euro area members, it is somewhat of a puzzle that the steepest decline in volatility against the Euro/Ecu is registered by the UK. Any reduction in the volatility of nominal variables is unlikely to be of economic significance if it is not mirrored in comparable changes in the behaviour of real variables. The decline in volatility of the real exchange rate (we use the IMF’s measure that adjusts the nominal effective rate for developments in relative unit labour costs), shown in Table 4, shows a similar pattern to that of the nominal exchange rate. At high frequencies, this is hardly surprising as it is well known that labour cost series are rather stable compared to exchange rate series. The magnitude of the decline in real exchange rate volatility is, however, somewhat larger that the decline in nominal exchange rate volatility both for the Euro area countries and for the three outsiders. The decline in the volatility of the real exchange rate observed for the EU is not a world-wide phenomenon, vide  the rise in the volatility of the real exchange rate of the US over the period. Table 4 here Volatility of Real Effective Exchange Rates High frequency exchange rate volatility, while of vital interest to those making a living trading in the foreign exchange markets and in the forex derivatives markets, does not appear to be of great significance to the behaviour of the real economy - trade flows, capital formation or consumption. In part this is because hedging instruments for short-term foreign exchange exposure are widely available and relatively cheap. The same cannot be said for medium-and long-term fluctuations in nominal exchange rates. The persistent misalignment of Sterling between 1997 and the middle of 2002 has caused costly imbalances in the real economy. 2. EMU Membership Does Not Produce Immediate Trade Performance Miracles A common argument in favour of adopting the Euro is that the adoption of a common currency will lead to increased trade intensity (see Rose [1999, 2002], Frankel and Rose [2002] and Glick and Rose [2002]). The evidence on this issue for the Euro area (just three years of annual data) is mixed and, on balance, uninformative. 5   5  The estimates of very large effects, produced by Rose using data on other monetary unions, are not credible (Rose [1999, 2002], Frankel and Rose [2002], Glick and Rose [2002]). There is a key ‘omitted variables’ problem in these studies. Countries that belong to a currency union are also likely to have harmonized laws and regulations pertaining to cross-border transactions within the union.. How is one to distinguish the effects on the progressive completion of the single market through the implementation of the Single European Act from that of adopting the Euro?
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