The UK and the uro: Background and Prospects

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The UK and the uro Background and Prospects

• Roger Vickerman
• Department of Economics
• University of Kent, Canterbury, UK
•  
• Lecture at University of Western Bohemia, Pilsen,
  April 2007

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The Euro, EMU and EU integration

• Is monetary integration the ultimate goal or a
  means to an end?
• What about the E in EMU?
• Currency and sovereignty power and
  responsibility
• Subsidiarity in a globalised world
• Economic size and the one-size fits all problem
• Why should the UK always be different (and
  difficult)?
• Is this about economics or politics?
• Is it a technical question or a fundamental
  question about rights?

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Overview

• Optimal Currency Area Theory
• Is the EU an OCA?
• EU Convergence Criteria and OCA
• The UK question
• The 5 tests
• Assessing UK against the 5 tests
• UK economic performance outside the Eurozone
• Stability and Growth Pact and the Lisbon Agenda
• Some thoughts on the implications for new member
  states

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Optimal Currency Area Theory

• Basic question is about exchange rates
• Flexible exchange rates
• adjust to cope with asymmetric shocks
• Fixed exchange rates
• exchange rates cannot adjust to deal with
  asymmetric shocks/ productivity
  differentials/inflation differentials
• adjustment has to come through other markets
• require common monetary policy
• thus output/employment adjusts
• but adjustment less if certain criteria are met

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Optimal Currency Area Theory

• Six criteria for an OCA
• Labour mobility (Mundell)
• Labour needs to move freely to reduce stickiness
  of wages and remove unemployment differentials
• Product diversification (Kenen)
• Where production and exports are diversified and
  of similar structure, asymmetric shocks are less
  likely
• Openness (McKinnon)
• Countries which are very open to trade and trade
  heavily with each other will have similar prices
  for goods. Need to distinguish between traded and
  non-traded goods.
• Fiscal transfers
• Can act as an insurance that mitigates the costs
  of an asymmetric shock. Distinguish Implicit
  transfers (automatic stabilisers) and explicit
  transfers.
• Homogeneity of preferences
• Prevents asymmetric responses to symmetric shocks
  and an understanding of partner countrys actions
  
• Solidarity
• Acceptance of short-term costs of partners
  adjustments in interests of long-term goals

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Is the EU an OCA?

• The criteria scoresheet
• Labour mobility NO
• Trade openness YES
• Product diversification YES
• Fiscal transfers NO
• Homogeneity of preferences MAYBE
• Commonality of destiny - ???
• Insiders and outsiders
• the converged, the converging and the unconverged
  
• i.e. the EU may not be an EU, but is a subset of
  the EU an OCA does this imply that some should
  go it alone (a multi-speed union), and does this
  matter?

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EU Convergence Criteria

• The European Council decides whether the
  necessary conditions for EMU entry have been
  met on the basis of progress against the EC
  Treaty convergence criteria
• the achievement of price stability a low rate
  of inflation close to the best performing states
  (defined as being within 1½ per cent of the
  average of the three lowest)
• sustainability of the government financial
  position the government should not run a
  financial deficit greater than 3 per cent of GDP,
  and gross general government debt should be less
  than 60 per cent of GDP
• exchange rate stability apparent by the
  observance of the normal fluctuation margins
  provided by the Exchange Rate Mechanism, for at
  least two years and
• durability of convergence convergence of
  long-term interest rates (defined as being within
  2 per cent of the average long-term interest rate
  of the three lowest inflation states).
• Note how these monetary criteria differ from
  the real criteria of OCA theory

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The UK question

• UK satisfies most convergence criteria not
  strict interpretation of exchange rate
• Two economic sources of UK hesitation to join
• That UK may not form an optimal currency union
  with the rest of the EU asymmetry in the cycle
• The pound may be overvalued relative to the euro.
  Thus, if the UK enters the euro-zone at too high
  an exchange rate it might be saddled with low
  competitiveness for years to come, putting
  downward pressure on economic growth in the UK.
  Fears of the ERM experience revisited
• But possible large costs to not joining
• Transactions costs
• Trade costs
• Of course the main objection is political
• The so-called loss of sovereignty
• Economic decisions taken remotely
• The current UK Government is committed to a
  referendum when it decides the time is right to
  join (on the basis of the 5 tests) public
  opinion suggests that such a referendum would not
  support joining
• The opposition would rule out membership ever

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The 5 tests

• Convergence
• Are business cycles and economic structures
  compatible so that we and others could live
  comfortably with euro interest rates on a
  permanent basis?
• Flexibility
• If problems emerge is there sufficient
  flexibility to deal with them?
• Investment
• Would joining EMU create better conditions for
  firms making long-term decisions to invest in
  Britain?
• Financial services
• What impact would entry into EMU have on the
  competitive position of the UKs financial
  services industry, particularly the Citys
  wholesale markets?
• Growth, stability and employment
• In summary, will joining EMU promote higher
  growth, stability and a lasting increase in jobs?
• The 2003 conclusion
• Tests 1 and 2 not met, 3 and 4 met 5 could only
  be met when 1 and 2 met

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The UK question

• On standard OCA criteria, UK is open though
  towards the lower end of openness
• But shows high product diversity (index measures
  similarity of trade structure to that of Germany)

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The UK question

• UK has considerable openness in terms of labour
  mobility
• internal mobility is higher than any other EU
  country
• UK labour markets most open to workers from new
  member states
• Perhaps the real test is whether MU induces
  convergence in trade terms at least this looks
  likely

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But is the UK really free?

• Exchange rate flexibility only nominal
• Real exchange rate
• Defined as ? EP/P
• PPP concept says changes in E offset by changes
  in P/P
• So ? constant
• Limitations
• Speed of offset
• Balassa-Samuelson effect (real exchange rate may
  rise with productivity/inflation)
• Evidence
• Real exchange rate much less flexible
• Any advantage is only short term

Nominal and real exchange rates Germany vs UK
(DM index 1951100)
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UK economic performance outside the Eurozone

• Look at UK economy in more detail
• Exchange rate movements
• stability?
• Price movements
• on target relative to ECB?
• role of Monetary Policy Committee
• Employment and unemployment
• better performance than Euro zone
• Government debt and deficits
• better performance than large Eurozone countries
• Fiscal rules and the Stability and Growth Pact
• a difference of opinion about time scales and
  cycles
• investment and golden rules

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UK View of the SGP

• The UK Government advocates a prudent
  interpretation of the SGP which takes into
  account
• the economic cycle by allowing the automatic
  stabilisers to operate fully and symmetrically
  over the cycle, fiscal policy can support
  monetary policy in smoothing the path of the
  economy, so providing the flexibility to take the
  right decisions over the cycle
• sustainability taking into account that low
  debt levels enhance the sustainability of the
  public finances, allowing greater room for the
  automatic stabilisers to operate, and providing a
  sound basis for investment in public services.
  Assessment of sustainability should also take
  into account the long-term budgetary impact of
  ageing populations and
• public investment recognising that public
  investment contributes to the provision of
  high-quality public services and can help to
  underpin a flexible, high productivity economy.

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The Lisbon Agenda

• UK major advocate of Lisbon Agenda
• Purpose Europe must become the most competitive
  and dynamic knowledge-based economy in the world
  capable of sustainable economic growth with more
  and better jobs and greater social cohesion
  (Lisbon Council, March 2000)
• Method
• Emphasis on removing barriers to market
  efficiency especially in labour markets
• Action mainly at the national level with
  reporting and monitoring at EU level
• Role of benchmarking, targets, and monitoring
• Problems
• Legislative activity may mislead on actual
  effects
• Should EU be rule-maker, policymaker, regulator,
  supervisor or facilitator?
• Confusion and tension due to complexity and
  diversity of roles
• Gaps between ends and means?

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Lessons from UK experience

• There are benefits, but also costs, to being
  outside the Eurozone - if outside should stay
  right outside?
• Fixing an entry date helps to secure convergence
  of both monetary and real indicators
  (expectations matter)
• Monetary convergence may be better determinant of
  real convergence than vice versa
• Life inside the Eurozone can be hard, but that is
  the reason why ERM could not go on for ever
• The Euro is about more than the ECB, but linking
  monetary policy, fiscal policy and economic
  efficiency requires better coordination of
  economic policy
• Is the Euro a success, and by what criteria?
• Should the ECB (and the European social model)
  learn from recent UK experience (and vice versa)?

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