Policy in the event of a "no" referendum on EMU

Citation

Taylor, C. (2002), "Policy in the event of a "no" referendum on EMU", European Business Review, Vol. 14 No. 4. https://doi.org/10.1108/ebr.2002.05414dab.004

Policy in the event of a "no" referendum on EMU

Christopher Taylor

Keywords: European monetary union, United Kingdom

Although popular support in this country for joining the euro may be growing slightly, the outcome of the promised referendum, if it comes, remains highly uncertain. It would therefore be advisable to give some thought to the consequences of a "no" vote – or of the Government simply shelving the question. In any case, sensible decisions on the substantive issue require a proper understanding of the alternatives.

The prospect of life outside EMU is less daunting now than it was ten years ago. For many chastened by the inflationary excesses of the 1970s and 1980s, a key attraction of monetary union was its offer of better inflation control by an independent central bank committed to price stability. However, the remarkable improvement in UK inflation performance in the past decade, and New Labour's bold step of passing responsibility for monetary policy to an independent Bank of England, make it hard to see what the UK now has to gain in price stability from embracing the euro.

Most other risks from being outside EMU have appeared less threatening, and seem even less so now. Currency conversion costs per se were never seen as a serious burden, except perhaps by tourists. Large firms with substantial EU business and good credit standing in Europe's financial centres routinely minimise their conversion costs by skilful treasury management, and margins on wholesale transactions are narrowed by scale economies and "netting" procedures operated by commercial banks. For the independent traveller, wider use of credit and cash cards greatly reduces the inconvenience of having to change currencies. Payments processing costs, which arise from different legal, tax and institutional arrangements across Europe, were seen by practitioners as a more significant problem, but they are now much ameliorated for large-value payments, thanks to the TARGET system introduced with the euro. Processing of smaller payments across the single market remains relatively costly and time-consuming, but help is on the way through standardisation of payments media and better interlinking of national retail payments systems. UK participation in this progress does not depend on being in the euro zone.

Lack of price transparency in the single market was a worry for some consumers, but the advent of the "retail" euro must have removed much of it. Price discrimination persists in cars and other durables but that is a matter for competition policy, not monetary union.

There were concerns that "the City" would lose from being outside the euro area, but London's financial institutions have thrived for years despite being offshore the major global currency areas; indeed they have made a virtue of it. After three years of the wholesale euro there are few signs that they are suffering. Frankfurt and Paris are gaining share in some markets, but that owes more to financial liberalisation rather than the euro.

Exchange-rate volatility

It is thus arguable that the only major economic risk nowadays from eschewing the euro lies with exchange-rate volatility. Joining the euro zone would of course remove all possibility of exchange-rate variation against our euro partners. This would be an important benefit for industry, though not quite as large as some commentators imply. One should not overlook that EMU participants are still subject to exchange variability against the rest of the world. This would matter more for the UK than for others because more than half of UK external payments are outside the EU (about 52 per cent), a higher proportion than for goods trade (about 45 per cent). Moreover the euro is likely to be more volatile than sterling against other major currencies. As Table I shows, the $/DM rate has been more volatile than the $/£ rate since sterling left the ERM (in September 1992), mainly because of the DM-euro's relatively high volatility since EMU began in 1999. If the euro emulates the D-mark over the longer run, which seems plausible, and if sterling's behaviour since "Black Wednesday" is representative of its future (if it has one), it can be calculated that UK effective-rate volatility inside EMU would be between a third to a half of what it would be outside.

Nevertheless, sterling instability would remain a serious problem outside EMU, and it could get worse if the dollar-euro rate became more volatile in time, as might happen if, as some economists fear, further "polarisation" occurs between the two global currencies. A big disappointment of the past decade is that, successful as the international campaign for internal price stability has been, it has not delivered stable exchange rates between floating currencies, as the table shows, at least for short-period ("high-frequency") volatility.

Real exchange rate instability

Admittedly, "low-frequency" instability in real exchange rates (adjusted for relative national inflation) is probably more damaging for industry. Figure 1 shows how unstable the UK real effective exchange rate (a measure of competitiveness) has been over nearly three decades, as indicated by percentage deviations from its long-term trend. Real-rate instability has not been as violent in the past decade as it was in the oil-shock era (1974-1984), but it has clearly not gone away.

Economists disagree about the present extent of sterling overvaluation and its implications, but few would disagree that huge and persistent swings in sterling's real rate are bad for business, perhaps as much for tradable services as for goods production. An idea of the damage is given by the whole-economy unemployment rate (see Figure 1), which when brought forward three years (to reflect the average time taken for changes in competitiveness to work through the economy), appears positively correlated with the real exchange rate. So far, the upswing in sterling's real rate since 1996 does not appear to have raised whole-economy unemployment, but this may simply reflect that many firms are delaying cuts to their UK operations in the hope that joining EMU will bring a more competitive rate, one way or another.

Figure 1 Sterling real effective exchange rate (% deviations from trend) and UK unemployment rate (%), 1974-2001

Policymakers contemplating life outside EMU must be prepared to cope with the threat of sterling instability and the damaging uncertainty that it brings for industry. The challenge would be to find a way of stabilising the pound without weakening inflation control. Several options are worth considering, but most must be rejected for one reason or another.

Policy options

The most obvious course would be to rejoin the ERM or, more accurately, put sterling into the scheme for linking candidate currencies to the euro, introduced with EMU. This approach works for others, notably Denmark. It would be tantamount to joining EMU by stealth, accepting the ECB's inflation target and monetary policy, but without a seat on the Governing Council or at euro ministers' meetings. Moreover, it would leave the UK economy susceptible to euro instability against the dollar. It would also doubtless be seen as weakening the UK commitment to price stability, given our history of baling out of the ERM. On these grounds it would not be an economic starter, even if it were so politically, which the Government continues to deny.

A second, more adventurous, course would be to peg unilaterally to the dollar, seeking price stability on the strength of the USA's low inflation record. As it would also offer exchange stability for about 50 per cent of UK external payments, this approach would be almost as logical economically as joining the euro. However, it would leave the economy susceptible to dollar-euro instability on the other half of its payments (and 55 per cent of its trade), and it would expose the UK price-stability commitment to the risk of a lapse in US inflation performance (the Fed being formally less committed to price stability than the ECB). Last but not least, it would seem politically unthinkable for a country that sees its future in Europe. As such, it must also be judged a non-starter.

A third option would be to stabilise the real effective exchange rate in a policy framework that sought to retain and make explicit much of the existing commitment to price stability. For an economist, this option is especially interesting in that it would provide scope for "policy optimisation", giving specific weights to different policy objectives and using formal techniques to select policies that minimised the total costs of departing from them. Conceivably the Government might specify the weights as well as the goals but, more practically, discretion to pursue them would be given to the Bank of England's Monetary Policy Committee. The approach is attractive in that it focuses on the version of the exchange rate (the real rate) that matters most. And it might have political appeal in that it recognises that economic policy has more than one goal. However, inclusion of a "real" variable as an objective would almost certainly be seen as a clear dilution of the price-stability commitment, which would be a fatal objection for many. Also the approach would complicate the MPC's policy task and propel it further into the political limelight. For these reasons, it must regretfully be judged too risky at the present juncture, given the UK's chequered inflation history.

The best option

The fourth and best option would be to stabilise sterling's nominal effective rate as part of a firm and clear inflation-targeting strategy. The approach would work as follows. The Government would set the inflation target as now, except that it would be re-cast as a medium-term target, not necessarily to be hit each year. The Chancellor would then instruct the Bank to adopt the sterling effective rate index (£ERI) as its intermediate target for achieving the inflation target. The target level (or path) for the £ERI would be set by the MPC, subject to confirmation by the Chancellor, who could object only on the ground that it would not adequately achieve the inflation target; and it could be suspended or altered by the MPC in consultation with the Chancellor, though only on that ground. The Bank would announce and monitor the £ERI target as part of its counter-inflation routine.

One technical but not trivial innovation would be needed to make the approach work. The existing £ERI index weights its component currencies (effectively ten since the arrival of the euro) in accordance with their importance for UK manufacturing trade, but it is arguable that these weights are no longer appropriate for the UK economy, given the structural decline of manufacturing in the past 30 years. For inflation control purposes, the index should be revamped and simplified to give the euro and dollar a weight of 50 per cent each, so eliminating the smaller currencies. In practice this would not be an enormous change – the index thus recalculated does not diverge dramatically from its published path over the past 30 years – but it would reflect better the importance of the euro and dollar in UK external payments.

The advantages from this option would be compelling. By focusing on the two currencies that really matter for the UK economy, the index would gain greatly in transparency and market relevance. It should provide a good nominal anchor, promoting price stability in the medium term, so long as euro-zone and US inflation remained close to the UK inflation target. A nominal anchor works well for many small/medium-sized open economies, and should do so for the UK. If the USA succumbed to a bout of inflation, the intermediate target could be adjusted (upwards) accordingly. It would cope particularly well with instability between the euro and dollar. Moreover with low inflation in the main economies, stabilising the £ERI would come close to stabilising sterling's real effective rate, thereby offering industry stable external competitive conditions.

There would of course be objections. No modification in the established, apparently successful, machinery of inflation control would be entirely risk-free. The Government's inclination would probably be to "leave well alone", and the markets would need convincing about the new approach. But clinging to the policy status quo would mean badly underestimating the damage that exchange-rate instability has done to the real economy over a generation, and the greater damage it could do if the door to EMU were closed. Many industrialists might see such an event as the last straw and vote with their feet. If so, the Government would need more than spin to stop the exodus.