SHOULD THE UK JOIN EMU?

Artis, Michael

Michael Artis [*]

The Review is pleased to give hospitality to CLARE Group articles, but is not necessarily in agreement with the views expressed. Members of the CLARE Group are M.J. Artis, T. Besley, A.J.C. Britton, W.J. Carlin, J.S. Flemming, C.A.E. Goodhart, J.A. Kay, R.C.O. Matthews, D.K. Miles, M.H. Miller, P.M. Oppenheimer, M.V. Posner, W.B. Reddaway, J.R. Sargent, M.Fg. Scott, P. Seabright, Z.A. Silberston, S. Wadhwani and M. Weale. Drafts of this article have been discussed among members of the Group, but responsibility for the views expressed rests with the author alone.

This article considers the economic case for UK membership of EMU. Traditional optimum currency area (OCA) analysis provides only a weak case for membership: the UK is located among the periphery and not in the core. Considerations of the possible costs of isolation (the risks of trade discrimination and the dangers of a volatile currency) together with some pertinent qualifications of OCA analysis (the possible endogeneity of the OCA criteria) serve to strengthen the case for joining. Whilst it is not overwhelming, the final verdict is positive.

Introduction

The European Monetary Union (EMU) is up and running. The choice the UK faces is whether to join and, if so, when. Public opinion, business opinion and professional economists are divided on this issue, as are the main political parties. It is clear that the decision is a political one and that political arguments are critically important in this debate. Monetary unions are usually, after all, preceded or accompanied by political union. Nevertheless, monetary union is an economic issue and economic analysis is vital.

In this article we attempt to set out such an analysis. The next section begins with some factual background; what would have to be done if the decision were taken that the UK should join; what the constitutional situation is; what the state of public and business opinion is; what the government's 'five tests' are; and so on. Economic analysis offers 'optimal currency area' (OCA) theory as a framework for the discussion of the pros and cons of monetary union. So, in the next section, we go on to discuss what optimal currency theory suggests. Finding, as we do, that the verdict to be obtained from OCA theory is somewhat lukewarm, we proceed to probe its possible weaknesses. This helps to reduce the negative quality of traditional analysis -- but without, in our view, transforming the picture completely. So we seem to be left with a balance sheet of economic costs and benefits that is more or less neutral. But of course it is one thing to evaluate the proposition for EMU, so to speak in the abstract, and anothe r to evaluate the case for joining (or not) an already existing organisation. It is the latter that is now the relevant question. So, to complete the analysis, it is necessary to investigate the pros and cons of a decision to stay out of EMU -- what we can term 'the Canada solution'. We do not find such a solution to be in any way an infeasible nor clearly undesirable solution on economic grounds -- as the title we have given it of course implies. Yet there seem to be some risks in such a solution that help tip the balance of advantage a little further towards joining. Something depends on whether non-participation in EMU places the UK's participation in the Single Market at risk. And a great deal depends, all round, on whether exchange rate flexibility and monetary independence provide insurance from external shocks or simply provide an additional route through which destabilising forces can exert themselves. For large developed countries, with well-managed financial systems, the balance of advantage on this score is not obvious.

The background

The European Monetary Union came into being on 1 January 1999, with an initial complement of 11 out of the 15 EU countries. Eligibility for participation depended on satisfying a set of criteria laid out in the Treaty of European Union (more commonly known as the Treaty of Maastricht).

These criteria require that:

* the national central bank of the country concerned should be independent;

* the country's currency should have participated in the Exchange Rate Mechanism (ERM) for at least two years, without stress;

* the country's inflation rate should have been below a reference value given by a range of 1 1/2 percentage points above that of the best three inflation performers;

* its long-term interest rate should have been within 2 percentage points of that of the three best inflation performers;

* the ratio of the budget deficit to GDP should not exceed 3 per cent and its debt-to-GDP ratio should not exceed 60 per cent (with exceptions that require infringements of the deficit criterion to be "only exceptional and temporary" or where the ratio "has declined substantially and continuously" whilst infringements of the debt-to-GDP ratio are permitted only if "the ratio is sufficiently diminishing ..."). [1]

In the event, one of these criteria -- that pertaining to the level of the ratio of government debt to GDP -- was effectively ignored, whilst neither Finland nor Italy fulfilled the letter of the criterion pertaining to exchange rate performance. Greece failed to meet the criteria, whilst the UK and Denmark exercised the opt-outs negotiated in the Maastricht Treaty. Sweden, not yet a member of the EU at the time of the Maastricht negotiations, was also judged to have failed the criteria. Both Greece and Denmark are generally recognised as 'prein' countries, that is as countries simply waiting to join the EMU (but in Denmark's case needing an affirmative referendum result to do so), whilst the position of the UK, as that of Sweden, is seen as less enthusiastic about making further progress towards joining.

The British government's position is that UK membership depends on a positive referendum result in the next parliament (thus most probably after 2001) and upon its five tests being satisfied (see HM Treasury 1997). Those tests comprise the following:

* "whether there can be sustainable convergence between Britain and the countries of the single currency;

* whether there is sufficient flexibility to cope with economic change;

* the effect on investment;

* the impact on our financial services industry;

* (and) whether it is good for employment".

It has been remarked of all of these tests that they will be satisfied when the government says so. Certainly they all require some interpretation. The first two of the tests effectively coincide with the concerns of OCA theory, which we discuss further below. The others, by contrast, do not 'belong' to any particular framework of economic analysis. The fourth, indeed, seems to be the reflection of the power of a particular interest group, the City of London. It is hard to see how an effect on investment can be verified before the event, and much the same comment might apply to the employment 'test', though this could be related to a concern about the exchange rate at which entry occurs. Of these tests, the first and second are ones that correspond to the concerns of OCA theory.

It seems clear that, at present, EMU is not an overwhelmingly popular option. The Survey of British Social Attitudes has consistently reported that less than a fifth of those polled since 1993 would "replace the pound by a single currency", a result confirmed in the latest (1999) release. [2] In response to related questions in other surveys, some more favourable figures have been returned, but it is clear that public opinion has some way to go before being convinced about participation in the EMU. Of course it can be argued that the balance of opinion could be significantly swayed by decisive action on the part of government. It has also been argued that public opinion could be favourably influenced by revelations of pro-EMU business sentiment.

However, a recent survey of business opinion found business sentiment to be very evenly divided on the issue. In a MORI poll of 1000 UK companies, conducted for the Financial Times and published in the issue of that paper for 1 November, 1999, just 49 per cent (when weighted by employment) expressed themselves in favour of joining the euro. A recent survey of professional economists' opinions, reported in The Economist of 17 April 1999 found 64 per cent of those who returned the questionnaire to be in favour of switching from the pound to the euro. The survey was aimed at academic economists and specifically at professors in leading universities rather than those working in business or finance. Among those professors declaring themselves as macroeconomists, the proportion in favour was a little higher than average, at 67 per cent; monetary economists polled two-to-one against.

What would the UK need to do to participate in EMU? At the formal level it would have to be seen to comply with the Maastricht Treaty criteria. In 1998, when the composition of the present Euro-zone was decided, the UK would have complied with nearly all of these criteria, and still would do so today.[3] The exceptions were (and remain) the criteria relating to Central Bank independence and to exchange rate performance. The former can be easily satisfied. Participation in EMU would of course imply in any case an end to the Bank of England's new monetary policy-setting procedures, since responsibility for such decisions would pass to the ECB.

The exchange rate criterion could pose more severe problems. The Maastricht Treaty's formal requirement on exchange rate performance involves membership of the ERM "within the normal fluctuation margins . . . without severe tensions for at least the last two years and "In particular, the Member State shall not have devalued its currency's bilateral rate against any other Member State's currency on its own initiative for the same period". The "normal fluctuation margins" referred to of course meant at the time of the Maastricht negotiations the [plus or minus] 2 1/2 per cent margins, but by the time of the 1998 review the ERM had been substantially changed with the adoption of [plus or minus] 15 per cent margins after the 1993 crisis. In the 1998 review the Commission looked for exchange rate stability defined as fluctuation within [plus or minus] 2 1/2 per cent of the median currency in the ERM grid over the period March 1996--February 1998. As already mentioned, neither Italy's nor Finland's membership of th e ERM prior to the May 1998 examination satisfied the 'two years' requirement (the Finnish markka joined the ERM for the first time in October 1996 and the Italian lira re-entered in the following month), but emphasis was placed on the stability of the lira and markka exchange rates rather than on the need for continuous formal membership for the two-year period. What would the UK position be? The British government has insisted so far that membership of an 'ERM II' is not an option the UK would accept, and that the change in the ERM arrangements following the 1993 crisis makes something of a nonsense of the Treaty's formal requirements. The UK's prospective partners could probably accept this, but would reasonably require some assurances about the rate at which the UK would join the EMU (which would indeed have to be agreed); and would probably feel compelled to insist that the UK should demonstrate a period of exchange rate stability. In any case, there would almost certainly be a period of transition betwe en the point at which participation was agreed and the formal date of entry. In the case of the existing Euro-zone countries there was a transition period of some seven months, between the decision on participation in May 1998 and the formal start of EMU on 1 January 1999. This period was remarkable for its stability; the pre-announced cross rates of exchange between the participating currencies were not seriously questioned by the markets and none of the defence lines was tested. This reflected, inter alia, that there was no serious threat of withdrawal by any member country; whilst the commitments remained firm, speculation seemed pointless -- changing French francs for Deutschmarks would have been like swapping pounds for pennies. The same assurance might not be so readily available in the UK case, where the recollection of the crisis of 1992 might cause the markets to question the arrangements arrived at, especially if political conditions within the UK could be seen as falling well short of consensus. Th e ultimate defence line would be a promise of unlimited intervention in the foreign exchange markets on the part of the ECB, but such a promise could not reasonably be expected if there were substantial political uncertainty. This suggests that three things will be particularly important for a successful transition to UK membership of EMU: agreement with our potential partners on an entry rate that is widely seen as sensible and so enlists market support; technical defence lines involving conditional foreign exchange market intervention on a large scale if necessary; a reasonably solid domestic consensus; and, given the above, a short period of transition. [4] In contrast to the other conditions of entry, this one could be difficult.

Optimal currency area theory

The traditional economic analysis of monetary unions, optimal currency area theory, was shaped by the pioneering contributions of Mundell (1961) and McKinnon (1963). Numerous subsequent contributions have been made within the same framework. A recent review that incorporates insights derived from different frameworks is available in Tavlas (1993). OCA theory was created in the period of 'fix price' macroeconomics and thus emphasises demand shocks as key, whilst identifying nominal with real exchange rate changes -- reasonable in the short run, not so in a longer run. Then the central argument of OCA theory is that the costs of monetary union consist in resigning the possibility of using an independent monetary policy, and appropriate exchange rate changes, to deal with shocks that are asymmetric between the potential partner countries. This cost can be mitigated if the partners agree on a federal fiscal arrangement that cushions asymmetric shocks, if labour mobility between the partners is sufficiently high, or indeed if internal labour market flexibility is great enough.

It is generally agreed that EMU will not feature any federal fiscal arrangements (such as do exist in the United States) for the foreseeable future, [5] and it is also quite clear that intra-Union labour mobility is rather low, again as compared to the United States. [6] Stimulating internal labour market flexibility remains, however, a realistic policy option for the European countries. Capital market integration may also assist the process of adjusting for asymmetric shocks in so far as it helps promote risk-sharing. One of the aims of EMU is to realise a more integrated European Financial Area. Recent studies (Sorensen and Yosha, 1998) have shown that there is considerably more risk-sharing through private capital and credit markets within the United States than there is within Europe. This feature is presumably linked -- but not exclusively so -- to the presence of a single currency in the former case and its absence in the second. The benefits of monetary union are primarily to be identified with the rem oval of transactions costs in the exchange of one currency for another. It is popular to argue nowadays that a single currency, through the transparency it lends to the practice of discriminating monopoly, also helps to increase effective competition. Krugman (1990) suggested that the OCA arguments could be represented in a cost-benefit framework, with a corresponding diagrammatic expression such as that in Chart 1.

The chart depicts the position of a country contemplating participation in a monetary union with another country or group of countries. Costs and benefits (say, as a proportion of GDP) are measured on the vertical axis, and trade integration with the prospective partner country or group of countries, along the horizontal. This might be measured, in standard fashion, as {[M.sub.i] + [X.sub.i]}/[2Y.sub.i] where [M.sub.i] is country i's imports from its potential partner, [X.sub.i] its exports to the potential partner and [Y.sub.i] is GDP.

In the chart, the benefits schedule (BB) is drawn as upward sloping. This expresses the idea that the greater the degree of trade integration the greater is the benefit of the removal of transactions costs in the exchange of currencies between the potential partners. The cost schedule (CC) is drawn as downward-sloping, expressing the idea that the greater the degree of integration the less effective will be a nominal exchange rate change in inducing a change in the real exchange rate. In a group of economies which are highly integrated, a large proportion of consumers' expenditure in any one of them will consist of goods imported from the others. Hence a devaluation of its currency against theirs, and the ensuing rise in import prices, will have a relatively large impact on the domestic price level, thus generating money wage increases and nullifying the intended 'real' effects of the devaluation. To the right of the point E, where the BB and CC schedules intersect, benefits exceed costs and monetary union is worthwhile for the country under consideration. The schedule C'C' indicates that costs will be higher for a country that is especially prone to asymmetric shocks. For a country that has a similar experience of shocks to the partner it wishes to join, the costs of foregoing an independent monetary policy will be less and a lower cost schedule -- like C''C'' -- would prevail.

The chart is a useful summary of some of the leading issues here. It suggests, for example, that as integration proceeds, monetary union will become more desirable. It is also easy to appreciate that smaller countries are likely to find monetary union more compelling than larger ones (integration is likely to be higher). At the same time, the cost--benefit framework used in the diagram is a reminder that there may be non-economic costs and benefits that could indicate a decision to join (or not) at an economic cost.

The diagram also suggests, however, what is not generally feasible and that is that OCA theory can be operationalised in such a way as to yield a clear calculation of net cost or benefit. Whilst such a calculation cannot be carried out, it is nevertheless possible to get an impression that for some countries monetary union is 'more obvious' (trade integration is higher, the frequency of asymmetric shocks lower) than for others. In the discussion of the shape of EMU, it has indeed become popular to distinguish between a 'core' group and one or more 'peripheries'. For the core group monetary union seems more compelling, or less undesirable than for the peripheral groups. In most such exercises the UK appears to rank among the peripheral countries. We now turn to explain what kinds of calculation can be made that lead to such a conclusion.

Operationalising OCA theory

The benefits of joining a monetary union can be proxied by the amount of trade carried out with the countries with which a union is under consideration. Table 1 conveys some basic data in this regard.

The table shows, on the left-hand side, for each of the EU-15 member countries, the amount of intra-EU trade as a percentage of GDP ('EU trade integration'), and the ratio of intra-EU to total trade (EU trade intensity). [7] On the right-hand side of the table are shown as ratios to total exports and imports of goods of each country, the portion due to trade with Germany. As will be seen, in many of the extant exercises in operationalising OCA theory in the EMU context, Germany has been taken as the anchor or reference country. Clearly, some conclusions which are reached on this basis might not hold as strongly for an extended exercise in which the EU as a whole or the Euro-zone sub-set of 11 EU countries is taken as the referent. The relative figures shown for Ireland in Table 1, for example, are somewhat different between the two alternative referents, due to the still large dependence of Ireland on the UK in its trade. As far as these figures go, it is important to note that the UK is not wildly out of lin e with other EU countries. Among the larger countries its integration is actually a little higher than most; its EU trade intensity is only a fraction lower. On the Germany-centred data, likewise, the UK position is not exceptional.

More difficult to illustrate, perhaps, have been the costs of EMU membership, represented by the frequency of asymmetric shocks. Ideally, what is required is an estimate of the asymmetry in shocks that a country will experience in future compared with those that will impact its prospective partner Ideally, one would like to have estimates of the 'no policy' shocks, since it is one of the tasks of policy precisely to offset them. In practice, economists have had recourse to two alternative approaches to get an estimate of the asymmetry of shocks. One, following Bayoumi and Eichengreen (1993), isolates the shocks as the error terms in an estimate of a two-variable (output and prices) vector autoregression on which some simple identification restrictions have been imposed. These restrictions serve to identify supply and demand shocks separately, where demand shocks are estimated subject to the restriction that they have no long-run effect on output, but only on prices, whilst supply shocks may have such an effec t. In the table (Table 2) we show the correlations of the demand shocks identified this way with those of Germany. These seem worth more emphasis than the correlations of supply shocks in that monetary policy is more obviously capable of addressing them than it is of addressing supply shocks. The table shows estimates for two periods: 1960-88 and 1960-95. A core-periphery distinction seems discernible in both estimates, though the composition of the two groups is not fully robust to the extension of the data period. In any event, the UK seems to belong to the periphery and not the core, even though its correlation noticeably strengthens with the addition of the later data.

The alternative approach has been to identify asymmetries in business cycle phase as a signal of asymmetric shocks in the relevant sense. Artis and Zhang (1997) reported that using this method, implemented by measuring the cross-correlations of detrended output series, gave an impression that the UK was more closely attached to the US cycle than to the German one and that the ERM period had served to strengthen the appearance of a 'European' business cycle affiliation in the case of most other countries. The lengthier data samples used in the estimates shown in Table 3 support these hypotheses, albeit in slightly more muted form than in the original study. It remains true that the UK'S affiliation seems stronger with respect to the US than the German cycle; and it is true with only one exception that ERM countries' 'German' affiliations strengthened relatively to their US affiliation between the pre-ERM and the ERM periods. However, on the more extended 'ERM' data sample employed here, the German cross-correl ations of the ERM countries do not all rise in absolute terms between the two periods.

Overall assessment

What do overall assessments, that seek to combine both benefits and costs, look like? Bayoumi and Eichengreen (1997) offered one such evaluation. They computed an OCA index based on the contribution of various factors to the determination of bilateral exchange rates. These included: a measure of business cycle synchronisation; a measure of export composition; and measures of country size and output-weighted trade intensity. On this basis they classified one group of countries as "convergent", another as "converging" and a third as showing little sign of convergence. This identification and the composition of the three groups resembles quite strongly an identification based on the use of cluster analysis by Artis and Zhang (1998a, b), which we discuss below. [8]

Cluster analysis is based on the recognition of similarities between data sets. The variables provided in the studies by Artis and Zhang are inspired by OCA theory. They are centred on Germany, which is taken as the anchor country and include the following six variables: a country's bilateral trade intensity with Germany; the flexibility of a country's labour market with respect to Germany's (measured by the relative ranking of its employment protection legislation); the synchronisation of a country's monetary policy (measured by the real interest rate) with that of Germany; the synchronisation of a country's business cycle with Germany's; the volatility of its real DM exchange rate; and its inflation rate relative to Germany's. The inclusion of the last of these measures is a proxy for counter-inflationary commitment, a variable suggested by later additions to OCA theory.

Tables 4 and 5 give the results of, respectively, hard and 'fuzzy' clustering analysis when applied to the six variables mentioned above. The sample period for the data construction is April 1979 to Autumn 1995. Hard clustering operates on a step-wise basis, forming an initial cluster based on the two countries having the least distance between their respective vectors of characterisations, then proceeding to form the next cluster on the same minimum distance criterion between another pair of countries (or one of the countries and the initial cluster formed) and so on. [9] Given the way that the variables are constructed in this particular exercise, clusters are formed on the basis of countries' similarity in respect of vectors of characteristics which, in some sense, measure similarity to Germany. In the case of Table 4, the set of countries includes all EU-15 members (except for Luxembourg, not separately distinguished) together with the US, Canada, Japan and Norway. The first cluster formed in the sequence described is that between the US and Canada (alike, in effect, in being distant from Germany), followed by a Southern Periphery Group, a core group and a Northern Periphery Group. Japan is the last single country to enter a cluster. Chart 2 illustrates the sequential process of the clustering in a tree-diagram. The procedure of hard clustering can be carried out in any one of several slightly different ways. In the study referred to the principal results are robust to differences in the way in which clusters are represented (the results quoted here are for 'group average' clustering) and to the introduction of a weighting scheme that groups together the 'cost' items among the six variables. In this last case bilateral trade and the inflation differential were each assigned a weight of 0.33 whilst the cyclical and monetary policy correlations, relative labour market performance and exchange rate volatility were assigned a weight of 0.33/4 = 0.08 each.

The procedure of hard clustering can be claimed to be wasteful of information, however. It requires that a country should be classified to one or other cluster. This means that borderline cases may be misrepresented. Fuzzy clustering, by contrast, assigns a 'membership coefficient' to each country, where these coefficients add to 100 per cent. In this way the borderline cases are clearly identified. Table 5 shows the results of fuzzy clustering applied to the EU-15 countries, using the same six variables as listed earlier. This confirms the existence of a similar set of three groups -- with a core and two peripheral groups. The UK is identified here as a solid member of the Northern Periphery group, with rather little inclination to belong to the core.

Carlin et al. (1999) provide evidence on another issue that helps distinguish a core and a periphery. This is the sensitivity of a country's trade to exchange rate changes. Carlin et al. find that peripheral countries, especially the UK and Sweden, experience considerably more sensitivity to unit labour costs in their export performances than do the core countries. This could provide a reason for scepticism about the merits of participation in EMU for the peripheral countries in so far as the loss of an independent exchange rate is the more costly for them.

The upshot of this review so far, then, is that according to OCA principles the UK is a marginal candidate for EMU. At least, it is a peripheral rather than a core country. This does not mean that the UK should not participate in EMU; aside from other more frankly political considerations, a number of weaknesses in the OCA analysis should be emphasised. Some of these may be seen as tending to deliver a more positive edge to the economic case for UK membership of EMU; but not all. In the next sub-section we investigate some of these suggestions.

Making for a more positive verdict?

There are a number of reasons for questioning the verdict rendered by OCA theory. It is convenient to group these under two heads: first, there is a group of considerations which can be understood within the framework of OCA theory itself. Then there are some considerations that come from outside that framework.

Among the first group, an important issue is that of the endogeneity of the OCA criteria themselves. This issue has been raised directly by Frankel and Rose (1997, 1998); they argue, on the basis of an extensive statistical examination of the issue that, as a matter of fact, bilateral trade intensity and business cycle symmetry are highly correlated. Thus, if monetary union creates further trade integration, as seems likely, this will in itself promote greater cyclical symmetry. Ex post, monetary union will seem easier to recommend than ex ante. It is not clear, however, that the type of trade created by monetary union will necessarily have this effect. One of the effects of monetary union that studies have looked for is an effect on the location of industry; with more complete certainty about relative costs, it is argued, plant no longer needs to be scattered across the Union as an exchange-rate hedge. Location decisions can more freely exploit economies of scale. The resultant pattern of production, being m ore specialised, is liable to promote greater asymmetry of shocks rather than the reverse. Krugman (1993) has emphasised this possibility, pointing to the more geographically specialised location of industry in the US as support. Frankel and Rose's econometric evidence does not contradict this possibility since the evidence is limited to the relationship between bilateral trade and symmetry and does not touch the issue of the particular quality of trade promoted by monetary union, which is at the heart of the specialisation argument. It is worth noting that the distinction involved goes beyond that of whether the trade created is intra-industry trade or inter-industry trade. Even the former type of trade may have asymmetry implications if the intra-trade in question is in varieties (e.g. the exchange of high-grade motor cars for low-grade motor cars rather than the exchange of, say, transmissions for engines). [10] Another reason why the criteria might prove endogenous lies in the notion that policy itself (o r the foreign exchange market) is a prime source of shocks; then the adoption of a common policy and the elimination of a foreign exchange market will ipso facto reduce the evidence of asymmetric shocks. A suggestion to this effect might be imputed to the evidence brought forward by Artis and Zhang (1997, 1999) where ERM countries seem to have moved to a more common business cycle than those outside. Here the UK evidence is awkward; the UK's inability to stay within the ERM in the 1992 crisis can reasonably be related to the fact that her business cycle was out of phase with that of her partners. It was this that gave substance to the speculators' insight that a raid should be successful. Thus the line of causation is not clear. Being successful in the ERM may reflect prior or coincident convergence as much as convergence reflects the experience of the ERM.

It has also been argued that, because national monetary policy transmissions differ, a common policy will necessarily produce shocks which, if not asymmetrically signed, will be of quite different size. Dornbusch et al. (1998) regard this as a problem, but the evidence is mixed (see for example Ehrmann, 2000) and many of the differences currently existing seem likely to be arbitraged away over a period of time. Another line of argument is this, however: OCA theory imputes to real exchange rate fluctuations the role of buffering asymmetric shocks. Evidence that real exchange rate fluctuations effect this role, however, is not overwhelming. [11] Further, it may be argued that the foreign exchange market is an independent source of shocks. Buiter (1999b) argues strongly in this direction. A calculation by IMF researchers (Samiei et al., 1999) supports the view that the abnormally large fluctuations in output in the UK are traceable to shocks arising independently in the foreign exchange market and by implication in poor monetary policy-making. Currently, of course, there is more generalised scepticism abroad about the stabilising properties of foreign exchange markets, due to the crises in South East Asia. However, it is not clear that much of that scepticism should apply to the market for sterling, at least in the presence of well-conducted policies. There is positive evidence that exchange rate changes promoted in the presence of sensible complementary policies can have desirable effects: some of it is discussed in de Grauwe (1997).

A final issue that should be discussed is in fact that of the policy-making institutions. The 'new' literature on monetary unions (as summarised in Tavlas, 1993, for example) stresses that the counter-inflationary commitment of the Union's Central Bank should be of prime concern to participants. The leadership of the Bundesbank proved a positive feature for the 'apprentice' monetary union of the ERM; and its statutes provided a model for the constitution of the European Central Bank. The overhaul of the monetary policymaking machinery in the UK, its currently low inflation rate and the concomitant reform of fiscal policy are widely regarded as reassuring in this regard. Indeed, if anything, the consolidation of these reforms might be contrasted with the 'under construction' notices still applicable to parts of the European design, especially, perhaps, to the fiscal policy component. Nevertheless, there is no doubting the proper intent of the European design nor the credentials and successful achievements so f ar of its managers.

The 'Canada solution'

The impression is sometimes given that entry into EMU is, if not exactly desirable, an inevitable 'pis aller'. The example of Canada, however, suggests that it is feasible to maintain monetary independence and to belong to a free trade area with a very large partner country. The Canadian dollar/US dollar exchange rate is, moreover, very much more stable than any bilateral DM exchange rate has been inside the European Union over the past two decades. Since the UK is roughly twice as big, in relative GDP terms, compared to the Euro-zone as is Canada in relation to the United States, it would seem that what Canada can do the UK could also expect to do. And, whilst there has been some re-awakening of interest in Canada in the possibility of a monetary union with the United States (for leading references see Courchene and Harris, 1999, Laidler and Poschmann, 1998), much of that awakening interest paradoxically is a reflection of what has been happening in Europe. [12]

Free trade requires fixed exchange rates

The Canadian example serves to blunt, though not entirely to negate, the force of some of the arguments that can be used to suggest that the UK 'must' join the Euro-zone. One of these - an important one - is that sustained membership of the Single Market requires a means of stabilising competitiveness and insuring against deviations due to shocks in the nominal exchange rate. In general terms, it can be argued that a Single Market or free trade arrangement cannot survive without some stability in nominal exchange rates between the partners. Where competitiveness is subject to sudden and capricious change, affected partner countries will demand the reinstatement of protective devices. Thus the achievements of liberalisation stand to be unravelled in the absence of a parallel agreement on exchange-rate stability. Some evidence in favour of this conception can be sought in the complaints brought against the UK, in the aftermath of the 1992 ERM crisis, that sterling had been the object of "competitive devaluation ". Whilst this argument has a strong logic, it is possible to overemphasise it: the North American Free Trade Agreement (NAFTA) -- to which Canada belongs (along with the US and Mexico) is not paralleled by any explicit measures to maintain exchange-rate stability. Further, the UK market is a large one for Euro-zone producers to sell into; it follows that their interests would not necessarily be well served by demanding protection against temporary movements in nominal exchange rates. Nevertheless, exposure to some kind of risk of discrimination is a feature of the isolationism that the Canada solution implies, at least if that isolationism involves erratic exchange rate changes.

Ensuring exchange rate stability

This brings us to another important argument. This is that membership of the Euro-zone is the only way to provide British producers with a desirable degree of exchange rate stability. The alternative -- that of adopting a 'go-it-alone' exchange-rate targeting policy -- is not credible. Recent events in the world have increasingly been read as implying that there is no stopping place between monetary union (and closely equivalent arrangements) and completely free floating. And the latter, even with a background of transparent and well-directed monetary policy, is likely to imply some unwonted volatility in exchange rates. Some of the force of this argument derives from experience in economies that are unlike the UK's (e.g. the South East Asian and Latin American crises), but it seems clear that there is a residual risk of undue exchange rate volatility for a UK which is outside the Euro-zone. [13]

Wait and see?

To some outsiders the present position of the UK could look like the reflection of a rational decision to 'wait and see'. By not joining immediately the UK has the opportunity to learn from the experience of others and to assure itself on aspects of the Euro-zone construction about which there are or were legitimate doubts. This is an argument for the temporary and conditional adoption of the 'Canada solution'. What are its merits? One aspect of the operation of the Euro-zone about which legitimate doubts have been expressed is of course the core-periphery question. For some countries, the adoption of the single monetary policy seemed wholly inappropriate at the time. Ireland is a notable case in point, where a relative boom has been sustained by a laxer monetary policy and a more expansive fiscal stance. The costs of 'upside' deviation are not as obvious as those of a 'downside' deviation; and it is arguable that small countries have some advantages in economic policy not available to larger economies like t he UK's. Small countries can adopt tripartite policies and internalise adjustment strategies in a manner not open to the UK. [14] They can also expect side-payments and a degree of tolerance for exceptional behaviour from the rest of the EU which a larger country cannot expect. For these reasons the UK cannot learn much from the experience of small countries; it also cannot learn much, as yet, from the experience of the larger economies in the Euro-zone. These, by reason of their size, have pretty much the monetary policy they would have given themselves independently and, so far at least, share a somewhat similar conjunctural experience. Elsewhere -- where the UK by standing outside might hope to learn something useful -- the news is probably reassuring, even if the time elapsed so far is comparatively short: the ECB has progressed considerably in clarifying its monetary strategy and it has created a high degree of transparency for its actions. The Stability Pact has also clearly gained credibility and survi ved the first of its critical early years. But there is a cost to standing aside temporarily. This is the cost of not being part of the institutional framework, not participating in the setting-up of the basic rules of operation. Whilst no potential damage is evident yet from this exclusion, it is clearly a danger.

In sum, the example of Canada serves to reduce the force of some arguments that are used to suggest the need for UK participation in EMU. But there is a residual truth in these arguments, that remains.

Conclusions

EMU comes in a line of European opportunities for the UK which can be typified as involving a cycle of disdain, obstruction and, finally, reluctant consent on the British side. [15] First, the project is viewed with disdain, as not in the British interest and probably not workable; then, as the project seems to move ahead there is an attempt to stop or divert it; finally, finding that the project is up and running the UK eventually joins in. By leaving it late the UK may have lost something. Switching attitudes from disdain to opposition to acquiescence is psychologically and politically difficult. [16] The analysis appropriate to the first stage -- viewing the project as a hypothesis -- is not the one appropriate in the final stage.

In the present case, it is reasonably clear that, viewed as a hypothetical project, EMU would not be a UK priority. But EMU is up and running. Analysis must take account of the fact that the choice is to be in EMU or out of it, not to decide whether it was a good idea in the first place. This does tend to imply that some of the arguments for joining in have a negative quality (being 'the costs of isolation') which tends to blunt enthusiasm. Nevertheless, in the present case, and on balance, the economic arguments do point in the direction of a positive decision.

Joining almost certainly means being prepared to accept some transitory cost, since the business cycle divergence is not likely to disappear at all quickly. It also means being prepared to invest in some policy research into tools that can be used in the worst cases to substitute for the loss of an independent monetary policy. We have in mind particularly refinements of fiscal and regional policy calculated to relieve the worst of the deficiency that would be left by the delegation of monetary policy to Frankfurt.

* European University Institute, Manchester University and CEPR.

Notes

(1.) Kenen (1995) provides the definitive account of the criteria and much else of significance in the EMU enterprise.

(2.) In 1992, the percentage in favour of this option reached its record, at 21 per cent. Curtice (1999) reviews this and other surveys of public opinion.

(3.) The 1998 review (see the issue of The European Economy, no. 65) employed data through 1997 as the basis for the decisions made; then, the UK's rate of inflation (measured by the Harmonised Index of Consumer Prices) was below the reference value of 2.7 per cent; its long-term interest rate, at 7.1 per cent, was below the reference value of 7.8 per cent and the UK's deficit/GDP and debt/GDP ratios, at 1.9 and 54.3 per cent, were comfortably below the respective 3 and 60 per cent reference values.

(4.) Genberg (1999), in a review of the analogous transitional problem that could face Sweden, comes to very similar conclusions.

(5.) Estimates of the smoothing effect of the US Federal tax-and-expenditure system on intra-area shocks within the United States have been progressively revised downwards. Initial estimates (e.g. Sala-i-Martin and Sachs, 1992) suggested that the system buffered "40 cents in the dollar" of primary income shocks. Later estimates of the buffering effect have fallen as low as 10 cents (e.g. Von Hagen, 1992).

(6.) See, e.g., Bayoumi and Prasad (1998).

(7.) Trade is imports plus exports, so in the calculations in which GDP appears as the denominator it has been multiplied by 2. Direction of trade data exist only for shipments of goods, so the data in Table 1 refer only to visible trade. In principle it would be desirable to include also trade in services.

(8.) There are also a number of useful and informal studies available -- a good example is Taylor (1995) -- which distinguish similar categories.

(9.) In the exercise referred to, the variables are first normalised with zero mean and unit variance before an unweighted root mean square summation of the differences between countries is performed.

(10.) See Fontagne and Freudenberg (1999).

(11.) Canzoneri et al. (1996) examine the issue directly. The conclusions they draw do not support the idea that real exchange rates respond "correctly" to the appropriate stimuli.

(12.) As one Canadian colleague put it to me, "the European experiment made Canadians worry whether they were missing something". It is more than a little important, of course, to note that monetary union for Canada with the US is not available on the same terms as is monetary union with Europe for the UK. The best that Canada might hope to do is to 'dollarise' itself completely. Buiter (1999a) argues that this is a decisive reason for Canada to continue with its present arrangements.

(13.) Of course it is a theoretical possibility that stabilising the euro exchange rate for UK producers comes at the cost of destabilising other exchange rates or passing on the erstwhile volatility in the exchange rate to other parts of the economy (e.g. to interest rates). ERM experience does not lend these 'volatility transfer' ideas any support, however.

(14.) Ireland has such a tripartite policy.

(15.) Young (1998) provides a good account of British European policy, from which this caricature is drawn.

(16.) The polls of public and business opinion which report lukewarm attitudes towards the euro also report majorities that believe that the UK will nonetheless join. This seems to suggest that the EMU decision will be a part of this same cycle.

References

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 Trade integration and trade intensity in the EU
 EU trade EU trade
 Integration (%) [a,d] Intensity (%) [a,f]
Belgium/Luxembourg 41.35 73.06
Denmark 16.45 63.15
Germany 11.80 56.73
Greece 10.90 68.55
Spain 12.95 68.52
France 11.40 62.81
Ireland 36.75 62.77
Italy 10.50 56.91
Netherlands 28.50 66.82
Austria 17.95 76.87
Portugal 22.45 77.68
Finland 15.60 55.03
Sweden 17.70 61.03
UK 13.05 55.18
EU-15 14.35 61.19
 German trade intensity
 Exports (%) [b,f] Imports (%) [b,f]
Belgium/Luxembourg 20.8 18.9
Denmark 23.0 21.8
Germany -- --
Greece 21.1 16.4
Spain 13.4 15.3
France 17.7 20.4
Ireland 14.1 7.0
Italy 19.0 19.2
Netherlands 28.6 20.9
Austria n.a. n.a.
Portugal 18.7 14.0
Finland n.a. n.a.
Sweden n.a. n.a.
UK 12.9 14.2
EU-15 13.6 [c] 13.4 [c]
Note: the data refer only to trade in goods.
(a.)Data are for 1996.
(b.)Data are for 1994.
(c.)Data are for EU-12.
(d.)Trade integration is measured as {[M.sub.i] + [X.sub.i]}/2[Y.sub.1]
-- see text.
(f.)Trade intensity is measured as the share of total trade (exports, imports)
performed with the EU (Germany).
 Core and periphery: demand shock correlations w.r.t. Germany
 1960-88 1960-95
EU-15 0-32 0-57
Germany 1.00 1.00
France 0.28 0.28
Denmark 0.30 0.25
UK 0.07 0.14
Italy 0.14 0.29
Netherlands 0.17 0.18
Belgium 0.38 0.28
Austria 0.30 0.32
Spain -0.07 -0.03
Portugal 0.20 0.16
Greece 0.18 0.09
US -0.21 -0.22
Canada -0.05 0.03
Norway 0.28 0.22
Sweden 0.07 0.19
Finland 0.16 0.02
Source: Artis (2000).
 Business cyclecross-correlations with Germany and the US [a]
 Germany US
 Pre-ERM [b] ERM [b] Pre-ERM [b] ERM [b]
France 0.65 0.69 0.72 0.34
Italy 0.37 0.43 0.58 0.30
Netherlands 0.79 0.48 0.43 0.31
Austria 0.63 0.73 0.44 0.22
Belgium 0.69 0.56 0.63 0.18
Spain 0.48 0.38 0.64 0.17
Portugal 0.41 0.30 0.52 -0.18
UK 0.64 0.16 0.75 0.35

Source: Artis (2000)

Notes:

(a.)The cross correlations are between the cyclical components of monthly industrial production figures, after filtering (with [gamma] = 50,000) through the Hodrick-Prescott filter.

(b.)'Pre-ERM' is 1965:5-1979:3 'ERM' is 1979:3-1997:6.

 Clusters detected under hard clustering
1. Core group: (France. Netherlands, RMS: 0.56
 Belgium, Austria)
2. Northern periphery: (Denmark, Ireland, RMS: 0.81
 Switzerland, Sweden,
 Norway, Finland, UK)
3. Southern periphery: (Italy, Spain, Portugal, RMS: 0.47
 Greece)
4. North America: (US, Canada) RMS: 0.18
5. Japan (Japan)
Source: Artis and Zhang (1998a).
 Fuzzy clustering: membership coefficients
 Group I Group II Group III
 (Core) (Northern) (Southern)
France 62.7 19.9 17.4
Italy 11.6 18.5 69.9
Netherlands 87.3 7.0 5.7
Belgium 87.9 6.1 6.0
Denmark 22.8 58.7 18.5
Austria 66.7 16.2 17.1
Ireland 8.4 75.8 15.8
Spain 8.1 28.7 63.2
Portugal 2.1 4.9 93.0
Sweden 3.2 86.8 10.0
Finland 6.1 82.5 11.4
Greece 8.1 15.5 76.4
UK 5.3 82.9 11.8
Source: Artis and Zhang (1998b)