COMMENTARY.

Barrell, Ray ; Weale, Martin ; Young, Garry 等

The debate over the euro

The main macroeconomic debate over the past few months has concerned the euro and the question whether and when Britain should join the European Monetary Union. Related to this is the concern people feel over the current level of the exchange rate. We present a summary of a meeting that the National Institute held on this important issue on page 8 of this Review.

Inevitably the debate on monetary union focuses on the five questions drawn up by the Government in October 1997. The five questions are [1]

1. Would joining EMU create better conditions for firms making long-term decisions to invest in the United Kingdom?

2. How would adopting the single currency affect our financial services?

3. Are business cycles and economic structures compatible so that we and others in Europe could live comfortably with euro interest rates on a permanent basis?

4. If problems do emerge, is there sufficient flexibility to deal with them?

5. Will joining EMU help to promote higher growth, stability and a lasting increase in jobs?

and the Government has said that it intends to hold a referendum on membership of the monetary union once it is clear that the five questions can be answered favourably.

There is an obvious difficulty with these questions. While the government is looking for affirmative answers to questions 1, 3, 4 and 5 and an answer of 'favourably' to question 2, it says neither how it proposes to answer the questions nor what degree of confidence it requires in its answers. To accept answers on a balance of probabilities could lead to membership in a fairly short time, while to require positive answers beyond all reasonable doubt would be a recipe for never joining. The absence of any real information on the basis for reaching a decision means, in turn, that it is difficult for commentators to assess how close the questions are to receiving the answers needed for membership. However, the nature of economic research and its capacity to answer questions means that, if the questions are to be of any use, then the answers have to be accepted on the balance of probabilities. The following discussion should be read with that in mind.

Investment decisions

The first question can be read with particular reference to foreign investment but also in the context of the overall business environment. A range of studies by the National Institute suggests that the answer to the first question is yes, in that a part of the foreign investment in Britain appears to take place because Britain offers a gateway to the European Union. If the United Kingdom remains outside the monetary union, then other countries are likely to offer a more attractive gateway. The profitability of foreign investment in Britain will be affected by changes to the value of the euro altering costs set in sterling relative to sales prices fixed in euros; this may deter foreign investment in Britain. These findings are not contradicted by the fact that foreign investment in Britain reached an all-time peak last year. When those investment plans were struck there were certainly many people who believed that Britain would be a late entrant rather than a permanent non-participant.

The more general question concerns the overall business environment. A recent study from the National Institute (Barrell and Dury, 2000) suggests that, inside the monetary union, Britain will face an inflation rate which is less volatile and a level of output which is more volatile than those we have at present. We expect such circumstances to be more favourable for firms investing in the UK because inflation volatility leads to prices becoming increasingly uncertain in the indefinite future while output uncertainty has only short-term effects. We are not at present able to quantify the importance of such effects but they provide a focus for the discussion which should also take into account the fact that an active fiscal policy could be used to mitigate the increased volatility of output.

Financial services

The second question is usually interpreted as how would joining affect our financial services industry rather than the nature of financial services supplied to end users. One can think of all sorts of reasons why, if the UK decides not to join the monetary union, the financial services industry will gradually ebb away to the continent. There is only one obvious reason why membership would have an adverse effect on our financial services industry. That would be if the monetary union imposed uniform regulations, such as minimum reserve requirements, on all banking operations in the union. Such arrangements amount to a tax on the banking system and, whatever the fiscal equity of these arrangements, they would lead to banking moving to places where there are no reserve requirements. The skill with which Mr Brown fought off similarly damaging proposals for a witholding tax on interest payments suggests it would also be possible to resist this, at least if Britain seems likely to join the monetary union at an early stage. Obviously it would be much harder if Britain were to join after minimum reserve requirements were already in place. But without such a system, it is difficult to see why membership should worsen the position of the financial services industry. In terms of financial services themselves, it is to be hoped that eventually it will be possible to pay in a cheque drawn on a German bank in London as easily as that can already be done with a cheque drawn on a Scottish bank; this is unlikely to happen if Britain stays outside the monetary union.

Cyclical compatibility and the entry rate

The remaining questions are rather harder to address precisely. Much has been made of a recent report by OECD (2000) suggesting that next year Britain's 'output gap', the difference between actual output and long-term sustainable output, will be close to that of the Euro Area as a whole and less that than of some of the existing members of the Euro Area. On this basis then, Britain's economic cycle has converged with that of the Euro Area. One can reasonably ask what will happen beyond next year, but the truth is that, given the uncertainty associated with economic forecasts for two years ahead, it is very difficult to say. There is no basis for saying that Britain is bound to diverge again (like two ships passing in opposite directions) any more than there is any reason to say that Britain's cycle will remain coordinated with that of the Euro Area. In any case, the degree of cyclical cohesion of the Euro Area has increased over the last five years or so, and one would expect that, if Britain joins the moneta ry union, that in itself will promote cyclical cohesion.

A much greater worry is the fact that the convergence observed by OECD has been achieved with short-term interest rates which are much higher than those of the Euro Area and with an exchange rate many people regard as high. One ground for concern about the exchange rate (Barrell and Pain, 1998) lies outside the scope of our existing economic models. The current level of the exchange rate may have the effect of discouraging the inflow of foreign investment over and above the effects of exchange rate volatility discussed earlier. There is no reason why this should affect employment, but, because foreign investment has been a factor helping productivity growth, it may, in the end, lead to a lower level of productivity and thus a lower income level than might otherwise be achieved.

This aside, one can ask whether there are any more traditional signs of an overvaluation. Conventionally it would be argued that a high real exchange rate would be associated with either a depressed economy or one that was propped up by a large budget deficit. A budget deficit would be associated with a balance of payments deficit. Neither of these would be sustainable in the long run, because an increasing deficit results in increasing interest payments. In the end, without some corrective action, the consequences of cumulated interest payments would create a situation where there was no obvious means of servicing external or public debt.

The British economy does not show these characteristics. It is not depressed and, far from there being a budget deficit, there is a large budget surplus. There is, it is true, an external deficit but, at about 1 1/4 per cent of GDP it is not likely to become unsustainable for many years. In the light of this, why might one believe that the exchange rate is too high?

We can identify two concerns. First of all, the effects of the exchange rate may be larger and take longer to appear than our model suggests. If this is the case the exchange rate will start to have an undesirably depressing effect on the economy. Secondly we note that high exchange rates may be associated with and can be caused by low levels of saving. Private sector gross saving has fallen from 18 per cent of GDP in 1997 to 13.4 per cent of GDP last year, although the rise in public saving means that the fall in national saving from 17.7 per cent to 16.2 per cent of GDP is much smaller. A full recovery of private saving, rather than the more modest rise we expect, would be likely at today's exchange rate to lead to a budget deficit and a period of slow growth. Thus, in either of these cases, it could turn out that the exchange rate is much too high, as it seemed to be in the early 1990s.

There is, however, an important difference from the situation in the early 1990s. Then the high exchange rate was combined with high interest rates, while now the Euro Area has low interest rates. This means that, if Britain were to join the euro today at the current exchange rate, the result would be an expansionary stimulus. The effect would be all the greater if we were to join at a lower exchange rate. This expansion might well lead to renewed inflation which would drive the real exchange up.

Our forecast draws attention to another factor in addition to the level of interest rates which leads us to think the exchange rate is not badly overvalued. Productivity growth has been slow since 1995, although manufacturing productivity growth accelerated last year. We regard this low productivity growth as a counterpart of the rise in employment; people with low productivity were taken into the labour force, depressing the overall rate of productivity growth. In the nature of things, as the newly employed gain experience of work, their productivity is likely to rise. We expect the British economy to start to benefit from this process in the years ahead. This will generate, for the next five years or so, productivity growth rates which are closer to 3 per cent per annum than to the traditional 2 per cent per annum and will go some way to restoring the competitiveness of the British economy. This small-scale productivity miracle makes it possible to consider joining the Euro Area at the exchange rate of [pou nd]1 = [epsilon]1.55, as set out in our forecast, despite the fact that this seems high compared with past experience.

Flexibility

The question whether the monetary union will be able to cope with problems as they arise cannot easily be answered by direct observation if the country wants to be able to join in reasonable time. But perhaps it is reasonable to observe that most members of the monetary union have, for the last forty years, done better than the United Kingdom at coping with economic problems. To the extent that the question amounts to whether the UK is able to deal with shocks which affect mainly the UK it becomes necessary to ask what arrangements HM Treasury is making. A part of the flexibility required to deal with shocks can be provided by the sort of flexible fiscal policy to which we have alluded earlier. This might be needed if, for example, UK labour markets are more responsive to changes in the economic environment than are those elsewhere. There are many instruments available to the Chancellor for this purpose. For example, the 1961 Finance Act allows him to adjust some taxes in the same way that the Monetary Policy Committee now adjusts the interest rate.

Growth, stability and jobs

The last question suggests an air of confusion. The level of employment is determined by the working of the labour market and its interaction with the social security system. A lasting increase in jobs requires a lasting increase in incentives to work or permanent removal of obstacles to employing new staff. One might construct an argument that long-run employment would be adversely affected by very rapid inflation, or inflation volatility and in that sense the matter is related to the question of stability. The latter cannot be answered without raising the question stability of what?

We have already noted that we expect EMU membership to lead to a more stable inflation rate and that fiscal policy could be used to deal with the greater output volatility which might emerge. The favourable impact we expect this to have on investment is also more likely to be helpful than unhelpful for economic growth. Insofar as the question can be answered, our analysis suggests that EMU membership will be favourable for the economy, but it would be foolish to argue that it is bound to lead to a further reduction of unemployment or increase in economic growth.

The fiscal position and the Comprehensive Spending Review

Looking at more immediate issues, the Government recently announced its spending plans in a new Comprehensive Spending Review. The overall totals have not changed very much since those announced in the Budget, although it has become apparent that spending was lower than planned last year, and a part of this is to be 'made up' by increasing the spending this year and next year. However, within the total managed expenditure debt interest is expected to be lower, mainly because the government has received [pound]22 billion from auctioning the broad band spectrum. This is to be used to repay debt, saving [pound]1 billion per year of interest payments. There have been a number of other minor reallocations, with the result that, within the overall figures for total managed expenditure, expenditure on goods and services will rise at the expense of interest and transfer payments.

The Spending Review does not discuss tax revenues. These, however, continue to be buoyant. If oil prices stay close to current levels and if revenues from other taxes remain high, then the fiscal position is likely to be more favourable than the Government's budget projection suggested. Our own projection is still more favourable because we expect growth to be faster than the rate of 2 1/4 per cent assumed in the Government's calculations, resulting in still higher tax receipts. We expect the public sector current balance to remain at about [pound]20 billion, with rising levels of net investment reducing public sector financial saving from around [pound]10 billion in the current year to close to zero in 2003-4 with small deficits emerging beyond then. The precise figures for public borrowing depend on the way in which the proceeds from the broad band auction are described. The appropriate accounting treatment of this is discussed on page 40. It is worth noting here that, because the licences are valid for onl y twenty years rather than for ever, the overall impact on income is considerably larger than the saving on interest payments alone.

The economic outlook

In large part because of the prospective favourable productivity growth mentioned above, our forecast suggests that the British economy is set for a period of stable and relatively rapid growth. We expect growth at over 3 per cent per annum both this year and next. Although earnings growth is likely to accelerate, the faster productivity growth makes this consistent with the in-flation target. We see an interest rate peak of 6 1/2 per cent per annum reached next year to be followed by gradual convergence with Euro Area rates. Our interpretation (see page 13) of financial market prices is that markets are now expecting the UK to join the euro at around [pound]1 = [epsilon]1.55 with the rate stable from 2002 as a prelude to entry; as noted above, we have used this in our projection. If this increase in productivity growth does not materialise, then the economy will face more acute problems (see page 15). In particular, the rise in productivity is important in restraining unit labour costs while the exchange rat e falls modestly from current levels. If productivity does not grow as hoped, we expect inflationary pressures to be greater, resulting in a further increase in interest rates.

The favourable outlook is, however, conditional on a second important factor in addition to an improvement in productivity. We forecast a gradual recovery of the household savings ratio from the low value of 3.8 per cent of income in the first quarter of this year to an average of 6 per cent in 2002. This in turn im-plies that consumption growth will be relatively restrained. If the savings ratio does not recover, then the inflationary pressures in the economy will become more acute and the Monetary Policy Committee will be likely to raise interest rates above the 6 1/2 per cent per annum we have assumed. Similarly, of course, if productivity does not rise as fast as we forecast, then interest rates will have to be higher than we project. These observations mean that inflation is likely to remain firmly under control with the inflation rate excluding mortgage payments ending the current year at just under 2 per cent per annum and then rising very slightly looking further ahead.

Note

(1.) http://www.euro.gov.uk/will/govt.html

References

Barrell, R. and Dury, K. (2000), 'Choosing the regime: macroeconomic effects of UK entry into EMU', National Institute Discussion Paper No. 168.

Barrell, R. and Pain, N. (1998), 'Real exchange rates, agglomerations and irreversibilities: macroeconomic policy and FDI', Oxford Review of Economic Policy, 14, 3.

OECD (2000), EMU one year on, Paris, OECD.