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Summary and appraisal.


In this issue we devote special attention to the proposals for economic and monetary union in Europe. First we summarise our forecasts for domestic and world economy prospects; both have been constructed on the assumption that European economic and monetary union will be completed by the beginning of 1997-although an earlier date than that is possible.

The outlook for the UK economy

The short-term prospects for the UK economy have deteriorated since our last issue both with respect to the rate of inflation and with respect to the balance of payments. For growth the prospect has changed little for the immediate future, but the recovery next year could be sharper than we have suggested before.

The twelve month increase in the retail prices index reached 9.4 per cent in April (7.9 per cent excluding mortgage interest payments). The high level at which the poll tax was set is the main reason for the most recent acceleration, but the faster growth of wage costs-to which we referred in our last Appraisal-has also contributed. The annual rate of rise in the deflator for gross domestic product at factor cost is a useful measure of inflation as it excludes taxes and subsidies as well as interest-rate changes. We expect an increase of 6.3 per cent this year, followed by 6.9 per cent in 1991.

The path of the 'headline figure' for the increase in the RPI however will be very different. It should peak at about 9 1/2 per cent (possibly 10 per cent for a month or two) before easing down to 8 1/2 to 9 per cent by the end of the year-assuming that mortgage rates are unchanged. Next year we expect interest rates to come down steeply, with bank base rates falling to 14 per cent in the first quarter and to 11 per cent by the fourth. If this is right, the increase in the RPI is expected to be below 5 per cent by the end of that year.

One reason why inflation is lower in this cycle than in previous ones is that much of the excess demand has been taken up by imports. The trade figures for the first quarter of the year showed a surprisingly large deficit; together with the revisions to the invisible balance they contribute to a significant increase in our forecast of the current account deficit for this year. We now forecast a deficit of 15 1/2 billion [pounds], as against an optimistic figure of 11 1/2 billion [pounds] in the February Review. We still expect, nevertheless, that the balance will be getting smaller from now on; our forecast for 1991 is hardly changed at just under 10 billion [pounds].

It is likely that the level of output has fallen in the first half of this year, compared with the latter half of 1989. Capacity utilisation in manufacturing industry has fallen sharply, and the unemployment figures have levelled off. From now on we expect to see output recovering especially next year as interest rates are reduced.

Our medium- and long-term projections for the UK economy illustrate the possible implications of closer integration with the rest of Europe. As in previous issues of the Review, we take full EMS membership as our main assumption. We now put the date for its implementation in the first half of next year, the earliest date when it could be claimed that our inflation rate is converging towards that of other European countries. We take 1997 as the date for full economic and monetary union. Prior to that sterling depreciates in line with the weaker EMS currencies and a significant gap between UK and German interest rates remain. (Even after monetary union is complete the gap is not exactly closed, since the rates paid by British borrowers on average may not be exactly the same as those paid by German borrowers even when all are using a common European currency.)

Our forecasts highlight the potential importance of lower interest rates for the UK economy. Even though we assume that fiscal policy is very tight, there is a revival of consumer spending and of housing investment. The personal sector, having crossed over briefly into financial surplus in our forecasts for 1991, runs a large and continuing deficit in the longer term. in a variant forecast we look at the implications of a higher rate of savings.)

As a consequence of lower interest rates the current account of the balance of payments is in considerable deficit in our forecasts for the whole of the decade, albeit at a reduced rate at the end. It is possible that the financing of such a deficit would be easier once a monetary union is formed. Nevertheless we would assume that it must, by one means or another, eventually be corrected.

The outlook for the world economy

Our forecasts for the growth in the major industrial economies this year and next are little changed from the February Review, but we have revised up our forecasts of inflation. This higher rate of inflation seems to be the consequence of higher demand pressure within the industrial countries themselves; world markets for commodities have shown little reaction-in sharp contrast to earlier cycles of activity at the world level. We now expect consumer price increases of over 5 per cent in the United States this year, and of 2 1/2 to 3 per cent in Japan, Germany and France.

The rise in world inflation, which had already triggered a rise in short-term interest rates, has more recently caused the yield on longer-term bonds to rise as well. These increases are already slowing down the rate of growth of economic activity, especially in the United States, but we do not expect as sharp a slowdown in any other major country as in the UK. By next year growth should be recovering in both the United States and Germany, although it will be slowing down in Japan.

The economy of West Germany prepares for union with its eastern partner with the pressure of demand already moderately high, and with inflation still relatively low, but rising. The process of unification will add to spending in the West: some of the savings of the East, benefitting from a surprisingly generous rate of exchange, will be spent on goods which were previously not available; demand for investment goods will rise sharply as industry in the East is modernised. The main effects on output in the West will be felt in 1991, rather than in 1990. Our forecasts are 3.1 per cent this year, rising to 3.9 per cent next year.

The influx of labour into the West will put downward pressure on wages and German import prices will be held down by the recent appreciation of the D-Mark. For those reasons we expect the threat of inflation in Germany to recede next year and by then interest rates could be gradually reduced.

Whilst the D-Mark has been rising, the Yen has been falling. This may seem inappropriate since the Japanese current account is in surplus, but it seems that the underlying capital outflow from Japan has become even larger. We are not forecasting further exchange-rate changes between the United States, Germany and Japan except for the gradual movements implied by the open arbitrage condition and the current levels of relative short-term interest rates.

The assumed date for economic and monetary union in Europe is the beginning of 1997. Up to that point, we apply the same rules to exchange rates in Europe as elsewhere. Since interest rates are higher in France and italy than in Germany, we assume (after deducting our guess at the underlying risk premia) a slight depreciation of the Franc and the Lira against the D-Mark. (The same assumption is applied to the Pound Sterling, see above. Since realignments within the EMS are now rare and discontinuous events, these assumptions are not presented as the most likely scenario, but as the mean outcome of a range of possibilities.)

As the date for economic and monetary union approaches, interest rates in Europe will come more closely into line. At present we estimate that a risk premium of 1/2 per cent against the D-Mark is included in the French short-term interest rate; by 1997 it should be eliminated. For italy we now estimate a risk premium of 2 per cent on the Lira against the D-Mark. Because of the scale of public sector debt and continued borrowing in Italy that premium may not be entirely eliminated even after a common European currency has been introduced.


The proposals for economic and monetary union in Europe (EMU) are taking shape and it now seems that the timescale for its implementation may be relatively short. The EC Commission has prepared a note (1) intended `to clarify the main issues, to deepen the analysis and to take a position on some of the options.' It it hoped that agreement will be reached during a conference beginning this year, and ratified by the end of 1992. We first consider the proposals as they now stand from the point of view of the Community as a whole; we then consider how they may affect Britain in particular.

The EMU proposals

The Commission has come out in favour of a new institution, the European System of Central Banks, or EuroFed, to direct a common monetary policy. It would be independent of national governments and of other Community bodies, but accountable to the European Council and the European Parliament. This proposal involves a very different division of responsibility between governments and central bankers from that familiar to most European countries other than Germany. The absence of political control can be justified on the grounds that independent central bankers are more likely than governments to acquire the reputation for firmness and consistency which is one of the requirements of a successful monetary policy. Central bankers have, moreover, demonstrated their ability to cooperate with one another closely and continuously. There is, in any case, no governmental institution of the Community dealing with financial policy that has sufficient standing to control the actions of the EuroFed. it is all the more important that the constitution of the EuroFed should be drawn up well, and that it should be given the right terms of reference.

The proposal is that the EuroFed should be `legally committed to price stability'. This is a good principle to start out from, but on its own it may be too imprecise. No institution can actually promise zero inflation every year, but no mention has been made of the extent of variation in inflation over time which would be tolerated. Zero inflation on average over time would seem an unnecessarily strict interpretation; it is more important to ensure that the top end of the range of variation is acceptably low. Similarly no mention has been made of the range of variation in inflation across countries (which would prevail to some extent even with a common currency). Zero inflation for the Community as a whole would typically mean prices falling in some countries and will be too strict an interpretation of the policy objective. Under a monetary union the rate of interest would be the same in all countries, but it might be possible to devise some means by which the EuroFed could exert more severe downward pressure on inflation in some countries than in others. Its responsibilities relative to those of national central banks need clarification. These are issues which should be faced when the EuroFed is set up, not left to emerge subsequently as reasons for discord.

It has also to be recognised that no central bank has ever pursued price stability to the exclusion of all other considerations. The stability of interest rates, of the external exchange rate and of the level of economic activity in Europe are all criteria by which the performance of the EuroFed will in fact be judged, whatever its constitution may say. In practice the Board of the EuroFed must be given considerable discretion to interpret its own obligations in the light of experience. This means that democratic accountability to the Parliament needs to be firmly maintained.

The Commission note proposes `a regular dialogue between the EuroFed and those responsible for economic policy in the Community, in order to promote the coherence of internal monetary policy with external exchange-rate policy and coordinated economic policies'. This does not sound a satisfactory arrangement at all. The drafting may be deliberately ambiguous in relation to the external exchange rate, but this is a very important issue on which clear proposals are needed. International capital is so mobile between Europe, America and Japan that there is no way in which the determination of exchange rates between these countries can be separated from the determination of relative rates of interest. it would seem only logical that the EuroFed should be made responsible for the external as well as the internal monetary policy of the Community. The dialogue' mentioned in the Commission note would be difficult to conduct if, as seems likely, responsibility for economic policy within the Community is itself diffuse. Conflicts often do arise between the aims of internal and external monetary policy; it would be better if they were resolved within the EuroFed, rather than becoming the occasion for conflicts between institutions.

The Commission's note favours the use of a single currency, the ecu, to replace the existing national currencies. The merits of this proposal have been considered in a recent report prepared by the Institute. (2) A single currency would provide the most efficient medium for transactions within Europe, and also give maximum assurance that the monetary union was irreversible. (A common currency used in addition to domestic currencies would actually increase the costs of transactions for much of the population.) We see the move to a single currency as a logical, and highly desirable, consequence of monetary union in Europe.

If the ecu is indeed to become the single currency of Europe in the not-too-distant-future, there would be advantages in announcing this decision as soon as possible. In the absence of a clear lead, international business in Europe may increasingly be denominated in D-marks. From the point of view of eventual monetary union this would be at best an irrelevant digression, at worst an irreversible move in the wrong direction. The aim now should be to expand the private use of the ecu in international business, in anticipation of its role as the single currency of Europe.

The Commission note devotes some attention to the tricky subject of fiscal policy, and its coordination between member states. It is difficult to arrive at an altogether satisfactory proposal. Analogies with fiscal policy at national and local level within one country are useful, but if pressed too far could be misleading, since EMU will not transform Europe into a single country for all the purposes of macroeconomic policymaking. National governments will still be concerned about inflationary pressures at the national level, about industrial competitiveness, about national income and wealth and about national levels of unemployment. We would argue that member states will need, even after EMU is completed, to use fiscal policy to influence the level of demand in each country and possibly their balance of payments positions as well. Some arrangements will clearly be needed, nevertheless, to ensure the compatibility of the fiscal policies of member states with one another and with the monetary policies of the EuroFed.

No system will work unless the member states cooperate, and in general a cooperative approach to fiscal policy will produce a better outcome for the Community as a whole than could be achieved by the independent action of member countries. The danger is that individual countries might seek to exploit the others, for example by excessive government borrowing in one country which drove up the interest rates in all countries. (3) The Commission note proposes that binding procedures' on fiscal policy should be written into the treaty which establishes EMU, and that 'rules or guidelines' for public sector borrowing should be incorporated into national law. This seems to us too legalistic and inflexible an approach.

What is needed is a sanction that will enforce cooperation, a sanction which might never actually be invoked. Perhaps the EuroFed, in conjunction with the European Council or Parliament, might be given the authority to censure member states if their fiscal policies are deemed to be irresponsible or disruptive. Some financial or administrative penalties might be available to back up this rebuke. This should suffice as a deterrent, in combination with the provisions, now generally accepted, that borrowing by governments will not be monetised by the EuroFed and that there will be no Community guarantee of members states' debts.

On the timescale for the completion of EMU, the note makes no precise proposal. It draws attention, however, to the danger of monetary instability during the transition and says `it is to be recommended that the Community prepare for a relatively rapid passage from the beginning of Stage 1 to the definitive EMU, including a single currency'. We suspect that the dangers of financial instability are exaggerated, and we would emphasize that the timescale should reflect the degree of convergence which can be expected between member states over the next few years, especially with respect to inflation rates and interest rates. The inherent tendency of the economies to spring apart must be largely overcome before the attempt is made finally to lock them together.

Some estimates are presented in a note in this issue (4) of the implications of an immediate fixing of exchange rates in Europe. These implications could be troublesome, especially for italy and the UK. It would seem that a more realistic date for the completion of EMU must be in the latter half of the decade, assuming that all twelve members of the EC are to participate fully from the beginning. The timescale is considered in a recent institute Discussion Paper (5). The momentum of the 1992 programme has been maintained partly because it has been focused on a particular year as the target date for its completion. In the same way EMU needs a clear timetable so that the private sector of the economy can prepare for the major changes which it will involve.

The implications for the UK

The issue facing the UK now is not the longstanding one of whether we should participate fully in the European Monetary System as it now is. The issue now is whether the UK should participate in the proposed monetary union. When we argued in the Review last August that there was a good chance of a single currency in Europe by the end of the decade we were in advance of public opinion in this country. The UK government has been exceptionally slow in reacting to the pace of change in Europe. It is unlikely that the UK government can greatly influence the way that EMU is designed; neither can it prevent its taking place without our membership. The fate of the Treasury's alternative approach (6) illustrates the futility of arguing against the political consensus.

The case against the UK joining the EMU rests on the advantages of exchange-rate flexibility. It has never been demonstrated that the 12 countries of the EC would constitute an optimal currency area. A note in this Review (7) illustrates the role that exchangerate changes within Europe can play in response to external shocks such as changes in US fiscal policy or in world commodity prices. For the UK the case of an oil price shock is especially relevant since the implications for the UK economy are quite different to those for the rest of Europe. The appropriate adjustments of relative prices will in the long run take place whether the UK is in a monetary union or not, but exchange-rate changes may in some circumstances make for a quicker or easier adjustment. More generally it could be argued that the the extra degree of freedom afforded by exchange-rate flexibility should, if it is used wisely, improve the outcome attainable by the optimum choice of policies.

The case for the UK to give up this degree of freedom rests on two premises: that the gains from cooperation and collective precommittment more than offset the loss of flexibility; and that in practice the use made of independent monetary policy in this country would be far from optimal.

The record of monetary policy in the UK is not good. Since the 1970s, if not earlier, the monetary authorities have been seeking to reconcile a competitive banking system with effective monetary control. it does not seem that a satisfactory solution has even now been found. The UK's poor record on inflation is not due only to a lack of political will, but also to the problems of definition and control which have bedevilled monetary policy for the last two decades. It is possible that the EuroFed, if it were given overall responsibility for monetary policy in Europe, would seek to implement a different approach to control of the banking system in this country drawing on experience elsewhere in Europe.

The use made by the UK monetary authorities of exchange-rate flexibility is also open to criticism. it seems that it may not have been consistent in its policy aims: sometimes the authorities seem to have favoured a rising Pound to curb inflation, at other times a falling Pound to preserve competitiveness. Whatever the objectives of policies, the result has been additional turbulence and uncertainty. Moreover the Sterling exchange rate has been subject to sometimes violent swings of sentiment in international markets, which the authorities have been unable or unwilling to damp down. It would be too sanguine to assume that an independent UK monetary policy in the future would be free of problems given the experience of the past. On these grounds Britain might have more to gain than to lose from joining the proposed monetary union.

The other elements in the case for joining the EMU rest on industrial or microeconomic arguments rather than arguments about the conduct of macroeconomic policy. Although the UK is fully committed to the 1992 reforms, and is making good progress towards implementing them, their full benefit might not be felt unless they were accompanied by EMU. If the UK stays outside the EMU, we would be on the fringe of the European market, not at its centre. Consider, for example, the choice of location by an American or Japanese producer entering the European market. The prospect of exchange-rate uncertainty would be a deterrent so far as location in the UK was concerned.

A similar argument applies to the location of service activity, especially financial services and the City of London. The economies of transactions in financial markets arise from the use of a single currency. British banks, for example, would be at a disadvantage in Europe if their domestic business was transacted in Pounds rather than in ecus. (Conversely they might find it easier to preserve a local monopoly in the UK.) Foreign banks might also find it troublesome to locate their main European activities at a financial centre where the local costs were not predictable in terms of the ecu. The future of the City as a centre would be at risk as well as the market share of British owned institutions.

Assuming, then, that the aim is for the UK to join the EMU when it is formed, there are immediate implications for the conduct of policy in this country. The sooner the UK announces its intention to join the ERM the better, if only as a demonstration of our wish to cooperate with the move to closer union, rather than to obstruct it.

The options for exchange-rate policy in that context are discussed in a recent Institute Discussion Paper. (8) It must be recognised both that the initial impetus of inflation is higher in the UK than in the rest of Europe and that our real exchange rate is too high for balance of payments equilibrium. It would be a mistake therefore to attempt to raise the exchange rate prior to entering the ERM. On the contrary even if we enter at broadly the present rate, it is likely that Sterling will have to realign downwards some time between entering the ERM and the final fixing of exchange rates when EMU is complete. Alternatively Sterling could join the ERM initially with bands of 6 per cent rather than 2 1/4 per cent.

Once we are full members of the EMS, and especially if we make an explicit commitment to EMU, the interest rate on Sterling will tend to fall. The extent of the fall will reflect the perceived commitment to exchange-rate stability as well as the development of savings and investment in this country. To offset the fall in interest rates fiscal policy will probably have to be tightened further. This is a good illustration of the need for an independent and country-specific fiscal policy mentioned above. We should not enter into any binding commitments about the stance of fiscal policy or the size of the budget balance until we know how well the British economy can cope with the new international environment, and the transfer of monetary policy to the EuroFed.

Because the UK has a relatively high rate of inflation and a serious problem of trade imbalance, the time period required for convergence with the rest of Europe may be longer than for any other major economy. A really rapid move to EMU would create more difficulties for this country than for most others. The other member states seem on balance to want the UK to participate, but there must be a limit to how long they are prepared to wait.


(1) EC Commission `Economic and Monetary Union:The Economic Rationale and Design of the System'. Document dated 20th March 1990.

(2) `A strategy for the ECU', published by Kogan Page for Ernst and Young and the NIESR, price 19.50 [pounds]. See also `Obstacles to the use of the Ecu' by A. Britton and D. Mayes forthcoming in the Economic Journal.

(3) The effect of fiscal policy in one country on the economies of the other countries was discussed in Annex II to the World Economy Chapter of the Review for August 1989.

(4) R. Barrell, 'European currency union and the EMS', see page 59 below.

(5) R. Barrell, A. Britton, and D. Mayes, `Macroeconomic obstacles to the wider use of the ECU', National Institute Discussion Paper No. 180.

(6) HM Treasury, `An evolutionary approach to economic and monetary union', November 1989.

(7) R. Barrell, 'European currency union and the EMS', see page 59 below.

(8) S. Wren-Lewis, P. Westaway, S. Soteri and R. Barrell, `Choosing the rate, an analysis of the optimum level of entry for sterling into the ERM', National Institute Discussion Paper No. 171.
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Title Annotation:British economy, economic and monetary union in Europe
Publication:National Institute Economic Review
Date:May 1, 1990
Previous Article:Comparative properties of models of the UK economy.
Next Article:Chapter I. The home economy.

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