Martin Wolf, Financial Times
The Risks and Rewards of EMU

EMU: Small reward
Martin Wolf, FT, May 26, 1999

The UK would not benefit that much from joining the euro-zone, largely because currency instability would not be eliminated

Tony Blair wants the UK to be "a leading player" in Europe. If the prime minister is to achieve his aim, he must first persuade his people to lose their ambivalence about European economic and monetary union.

This is his biggest challenge. But he faces a serious obstacle: it is not self-evidently in the economic interests of his country to join. This does not mean there is no case. It is merely a weak one.

The best way of considering the economics of membership is in terms of rewards and risks. The rewards are modest and the risks large. In this column, I intend to assess the former; next week I hope to examine the latter.

The economic rewards of membership can be divided into the positive and the negative - the benefits of being in and the costs of being out.

The first group consists of elimination of exchange rate risk and a superior monetary policy; the second consists of the threat to inward foreign direct investment (FDI), the danger to the City of London financial centre, and the possibility of hostility towards British business within the single market.

The one obvious and inescapable consequence of Emu membership is the elimination of exchange risk within the zone (provided Emu is irrevocable). But it is wrong to conclude that foreign exchange risk will be eliminated for British business. The UK received just 43 per cent of its total credits on the current account from members of the euro-zone in 1997 (see chart). It follows that membership of the euro-zone cannot eliminate currency instability. It could even deliver more instability. This depends on what happens to the euro itself.

The euro may well fluctuate more against the dollar and other outside currencies than the D-Mark used to do. Christopher Huhne, managing director of Fitch-IBCA, an international rating agency, and a strong proponent of British entry, makes the case particularly effectively. "The volatility of the exchange rate between the euro and the dollar is likely to be much greater than it is at present," he argues, "because the European Central Bank is likely to care much less about movements in the external value of the currency, as imports will be a comparatively small share of the euro area."*

If the euro is to be highly unstable against outside currencies, a country that obtains more than half its current account receipts from outside the area will not necessarily enjoy greater overall currency stability. It may not be better off with absolute stability on half of its external transactions and still greater instability on the other half than with a certain amount of instability on all external transactions.

Yet there is also some reason to question the extent of the gains from currency stability. The reduced cost of currency transactions would probably not be more than half a per cent of gross domestic product for a country as big as the UK - and probably far less. As for reduced exchange-rate volatility, there is little cogent evidence that this would bring very large economic benefits.

Turn then to the other argument in favour of membership: superior monetary policy and lower interest rates. The UK now enjoys a monetary arrangement at least as soundly constructed as that of the ECB. Moreover, this has been rewarded. Since the Bank of England was made operationally independent, the gap between yields on German and British 10-year bonds has shrunk by a percentage point, to about 0.75 per cent. British bonds are even yielding 0.8 percentage points less than their US equivalents.

The difference between British and German long-term interest rates is entirely explained by higher British short-term rates. Expected short rates (derived from long rates) converge seven years from now. But these differences in short-term rates largely reflect the different cyclical positions of the two economies.

The Organisation for Economic Co-operation and Development estimates that the UK will be operating at its potential GDP level this year, while Germany is 1.6 per cent below it. Sterling also looks likely to fall against the euro, in the medium term.

Nor is there any reason why UK monetary performance should be worse: on the harmonised index of consumer prices, British inflation is well within the ECB's target range, at 1.5 per cent in the year to April. The ratio of gross public debt to GDP is forecast by the OECD at 46 per cent next year. Within the euro-area only Finland, Ireland and Luxembourg have lower debt ratios than the UK. Given sound public finances, low inflation and sensible policy arrangements, there is no reason why the UK should not enjoy a monetary policy as good as that on offer inside the euro-zone.

Turn then to the three economic reasons for not joining: the threat to foreign direct investment; the danger to the City; and the risk to British business. In 1997, when it was clear the UK would not be joining Emu, it received 34 per cent of all FDI into the European Union. It was the third-largest recipient in the world, after the US and China. The UK was also host to 23 per cent of all FDI within the EU, in spite of having remained outside the European exchange rate mechanism for all but two years of its existence. This does not suggest currency instability is decisive for inward FDI.

No less unjustified are fears for the City. The issue here is not whether there is going to be increased competition: there will be. The question is what difference it would make to London's future to be inside or outside the euro-zone. The answer is: very little.

London is the world's largest international financial centre and the dominant centre in the European time zone. It is so because it has an unrivalled concentration of skilled people, a supportive regulatory environment and adequate infrastructure. As David Lascelles, co-director of the Centre for the Study of Financial Innovation, argues in a cogent pamphlet, markets are dematerialising.** What matters is where the people doing the trading are located, which depends on "cost, convenience and congeniality". London may fail to survive as a first-rate financial sector, but not because it is outside the euro-zone.

Finally, discrimination against the UK within the single market is possible, but unlikely. It would be a violation of the legal basis of the EU, hardly a persuasive argument for closer involvement. It would also be against the interests of members of the euro-zone. Remember that the UK is the euro-zone's largest external trading partner.

The overall conclusion is straightforward.

Yes, membership of the euro-zone offers the elimination of exchange rate uncertainty with the UK's most important set of trading partners. That is a benefit. But it cannot eliminate exchange-rate uncertainty overall. Moreover, the arguments that the UK must enter to enjoy lower interest rates and avoid serious threats to inward FDI, the City or treatment within the single market are feeble.

The UK has the fifth- (or sixth-) largest economy in the world and the fourth-largest currency area. It is hardly surprising that the potential economic gains from the euro are modest.

But if the potential rewards are modest, the risks are not, as I will show next week.

*Both Sides of the Coin: the Arguments for the Euro, Christopher Huhne (Profile Books, 1999)

**Confidence in the City outside the euro, David Lascelles, New Europe, 1999

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The risks of Emu
Martin Wolf, FT, June 2 1999

There is no politically palatable way for the government to ensure the economy's smooth entry into monetary union

In judging whether and when to join the European single currency, the UK needs to assess not just potential benefits, but also risks. Last week I argued that the benefits are modest. But the risks are not. These risks are created by the need to manage entry and then live safely within economic and monetary union.

The government states that its decision on entry will rest on an assessment of five economic tests. Of these, "sustainable and durable convergence is the touchstone . . .

It means that the British economy: has converged with Europe; can demonstrably be shown to have converged; that this convergence is capable of being sustained; and that there is sufficient flexibility to adapt to change and unexpected economic events."*

A cynic might conclude that these tests were designed never to be met. Yet suppose that the government wanted to achieve these aims. How might it go about it?

"With difficulty" is the answer. In the year to April, the UK's rate of inflation, as measured by the European Union's harmonised index of consumer prices, was 1.5 per cent, not far from the euro-zone's average of 1.1 per cent. But short-term interest rates are 2.75 percentage points higher than the euro-zone's, while the real exchange rate is some 20 per cent above its average of the past 25 years.

A less risky exchange rate on entry would seem to be around DM2.5, as against today's DM3. The UK might be able to push the exchange rate down by lowering interest rates, but this would threaten a rapid expansion in demand, probably driven by a surge in house prices. This, in turn, would create economic instability and, as inflation rose, a decline in competitiveness. The chancellor could mandate the lower interest rates, but he would then be subverting both the objectives and the institutions of the monetary regime in whose creation he takes justified pride.

Instead, the UK has to end up naturally with the same interest rates as the euro-zone, a more sensible exchange rate and sustainable convergence of inflation. Only two possibilities suggest themselves. The first would be a vigorous recovery in the euro-zone, generating both higher short-term interest rates and a stronger euro. The second would be fiscal tightening in the UK. The former would be a favourable act of God. The latter would be an unpopular act of government.

Why would it be so unpopular? The answer is that to offset the demand- and inflation-boosting impact of lower interest rates and depreciation, the fiscal tightening would have to be large. According to Sir Alan Budd, former member of the Bank of England's monetary policy committee, it might need to be £20bn, or 2½ per cent of gross domestic product.

The UK chancellor would then be introducing what amounts to a "euro-tax". It would not be designed to meet the Maastricht fiscal criteria, since the UK already does so, but rather to constrain demand with a view to offsetting a domestically unwarranted reduction in interest rates. This fiscal tightening would also generate an unnecessarily large fiscal surplus. If the government wanted to lose a referendum campaign on the euro, one could not imagine a surer way of doing so.

There is no politically palatable way of ensuring sustainable convergence prior to entry into Emu within a few years. The alternative would be merely to hope that the exchange rate falls spontaneously to a level tolerable to the UK and bearable to its partners. But this might still leave the UK with excessively high short-term interest rates. It would then be necessary to run a large fiscal surplus, once interest rates fell upon entry. No government is likely to manage this.

Trying to secure entry successfully is only the beginning of the risks the UK runs.

There is also the second big challenge: fitting into the monetary union in the long run. How well, in particular, could the UK cope with the irrevocably fixed exchange rate and the same monetary policy as the rest of the euro-zone?

On the exchange rate, the answer must be that a valuable safety valve would be lost.

Exchange rate movements can facilitate adjustment. They can bring about helpful changes in relative prices and wages, provided nominal (or money) prices are relatively rigid, but real prices less so. This sort of real price flexibility is useful if shocks hit one region more powerfully than another. As specialisation develops within the single market, vulnerability to such shocks could increase rather than fall.

Turn then to monetary policy. The chart shows inflationary pressure, measured by the "output gap", against the monetary stance, measured by short-term real interest rates. Normally, one would expect real interest rates to be higher the greater the inflationary pressure. The euro-zone's single interest rate means, however, that today the reverse is often the case. Ireland, for example, is operating more than 3 per cent above sustainable output levels, but has a short-term real rate of interest of only 0.4 per cent.

One size does not fit all

Meanwhile, Germany is operating 1.6 per cent below its sustainable output, but with a real rate of interest of 2 per cent.

Ireland could tighten its fiscal policy, but it already has a general government surplus of more than 2 per cent of GDP. Germany could relax its fiscal policy, but its deficit is already forecast to be close to 2 per cent of GDP this year. For Germany to loosen fiscal policy appreciably would be to make a nonsense of the stability and growth pact's 3 per cent limit.

The challenge of coping with a domestically inappropriate monetary policy could be particularly severe for the UK, since its financial structure is different from - and more interest-rate sensitive than - those of other euro-zone countries.

The UK has, for example, the highest ratio of outstanding mortgage debt to GDP and the highest proportion of short-term variable rate debt within total mortgage debt. The price of eliminating the exchange-rate instability that directly affects only 14 per cent of UK gross domestic product (the ratio to 1997 GDP of exports of goods and services to the EU) could therefore be a monetary policy that destabilises the economy as a whole.

Since the UK would account for only about 15 per cent of total euro-zone output, such a divergence between the actual and ideal monetary policies for the UK must be likely.

The conclusion is obvious. Entry is risky. So is living without monetary autonomy. And this is to ignore many other questions raised by Emu's design. Is the European Central Bank sufficiently transparent and accountable? Is there a satisfactory procedure for setting a euro-zone wide fiscal stance? Does the stability and growth pact embody a sensible marriage between member state discipline and flexibility? The answer to all these questions seems to be no.

As Eddie George, governor of the Bank of England, has pointed out, entry into Emu is a leap of faith. These risks might, however, be worth running to achieve the wider political goal of full UK participation in the EU. What that might mean will be the subject of next week's final column on the challenges of entry into the single currency.

* UK Membership of the Single Currency: an Assessment of the Five Economic Tests, HM Treasury, October 1997.

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German handicap
Martin Wolf, Financial Times, March 31, 1999

Few have realised the most dangerous feature of Emu: it has locked Germany into a seriously uncompetitive real exchange rate

No, prime minister
Martin Wolf: TUESDAY SEPTEMBER 30 1997

The level of sterling and the UK's cyclical position mean it would be suicidal for Tony Blair to take Britain into Emu in the first wave Whether and when to join European economic and monetary union are by far the most important questions facing the British government. It is not just whether it would be wise to risk joining this irrevocable monetary marriage. The question has as much to do with when it would be wise to do so.

Everything suggests Emu will begin, on time, at the start of 1999. Moreover, it is likely to include 11 countries. That is every EU member except Greece, which will not qualify, and Denmark, Sweden and the UK, which are unlikely to choose to join then. In its latest World Economic Outlook, the International Monetary Fund forecasts the 1997 general government fiscal deficits of all EU member states - except Germany, France, Italy and Greece - at or below the Maastricht treaty target of 3 per cent of gross domestic product. But Germany's will only be 3.1 per cent and those of France and Italy 3.2 per cent. Effectively, all members, Greece apart, meet the deficit criterion.

The IMF also calculates that all members, except Greece, have cyclically adjusted fiscal deficits of well under 3 per cent of GDP, most of them below 2 per cent. The UK's actual deficit is forecast at 2 per cent. As growth proceeds, deficits elsewhere should converge on cyclically adjusted deficits, making even the 1 per cent deficit target in the growth and stability pact attainable. Against this background, the two big obstacles to a single currency - French unwillingness to undertake further fiscal austerity and German reluctance to embrace a broad Emu - are almost irrelevant.

The new government of Mr Lionel Jospin does not need to impose much austerity. German politicians may huff and puff over Italian membership. But the technocrats in the European Commission and the European Monetary Institute will surely conclude that all members - again with the exception of Greece - have met the criteria. A German refusal to join would be tantamount to an act of war on European integration. It is not going to happen.

As this reality dawns, the British government is rightly debating how to respond. Tony Blair must be asking whether to exercise his option of trying to join in the first wave, at the beginning of 1999. The answer he should be given is: "No, prime minister." Business opinion is moving in favour of joining as soon as possible. The fiercest opponents are the tattered remnants of the Tory party. Never is the political background likely to be more favourable, Mr Blair may reasonably conclude.

Unfortunately for his ambitions, the economic background is just the opposite. If Mr Blair tries to put sterling into Emu in 1999, things will almost certainly go seriously wrong. There are two linked reasons: the currency's level and the UK's cyclical position. Together, they make entry in 1999 suicidal. All measures of the real exchange rate suggest sterling is overvalued. The International Monetary Fund, for example, offers a measure of relative unit labour costs adjusted for the state of the economic cycle. At the end of July 1997, UK relative labour costs were higher than at any time since late 1983. Between July and the end of last week, sterling's trade-weighted nominal exchange rate depreciated 2 per cent. But this is not enough to change the picture. Merely to bring relative costs to the middle of the range in which they have moved since the end of the extraordinary appreciation of 1979-1982, sterling's nominal effective exchange rate needs to fall about 10 per cent. Given long-standing weaknesses in the production of tradeable goods and services, such a depreciation is the least one should hope for. A depreciation of 15 per cent would be safer. If the exchange rates of the UK's trading partners were to remain stable, this would imply a rate against the D-Mark of DM2.40. To lock sterling in at a rate very much higher than this would be quite mad. There is more. At present UK short-term interest rates are 4 percentage points higher than in Germany. This reflects the very different position in the economic cycle. In the UK, broad money is growing at an annual rate of close to 12 per cent, against 6 per cent in Germany. National estimates of unemployment in August are 5.3 per cent for the UK and 11.6 per cent for Germany. The UK's economy is expected to have expanded at a rate of 2.9 per cent a year between 1992 and 1997 and Germany's at only about 1.5 per cent. UK consumer price inflation is above Germany's, in spite of the 20 per cent effective appreciation of sterling since early 1996. Against this background, stabilisation of UK inflation will demand short-term interest rates well above those in most of Europe's core for a substantial period. Suppose then that rates started to fall in anticipation of entry into Emu next year. This might bring sterling down. But it would also stimulate a credit-driven surge in domestic demand. The combination of an initial sterling depreciation with lower interest rates and faster growth in domestic demand is likely to push underlying inflation well above its 2½ per cent target for some years. Suppose, for example, that inflation were to be a little over 3 percentage points higher than in the European core for three years, or 2 percentage points higher for five. Either would mean a real appreciation of roughly 10 per cent. Even an entry rate of DM2.50 would, within a few years, leave the UK as uncompetitive as it is today. The classic way to claw back such a real appreciation is a squeeze on the profitability of industries producing tradable goods and services. This would lead to a fall in their output and distort the structure of the economy. But it would also ultimately produce lower inflation. An extremely tough fiscal policy would help. But remember that annual inflation in the euro area is likely to be around 2 per cent. The UK would need five years of zero inflation to recover a real overvaluation of 10 per cent if its productivity growth were the same as in other member countries. Elsewhere, perhaps, political commitment to European integration might allow a government to survive such a long period of decline in manufacturing and semi-stagnation in the economy. In the UK, it would be a recipe for a nationalist upsurge against the EU. A government that put the country in such a mess would be doomed. Whatever Mr Blair might prefer, entry in 1999 is out of the question. But tight monetary and fiscal policy could perhaps make it possible by 2002. This date would have the advantage of coinciding with introduction of the new notes and coins. Should the early period of Emu be as turbulent and unstable as some fear, the UK could avoid it. The option of joining cannot safely be exercised next year. But that of later entry must be kept open. Whether it makes sense to risk a referendum on an option that will not be exercised for some years is a tactical matter. The timing of entry, however, is not tactical, but fundamental. Some wonder whether the time will ever be ripe to join Emu: what is certain is that it is not ripe now.

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Martin Wolf, Financial Times, March 31, 1999
Few have realised the most dangerous feature of Emu: it has locked Germany into a seriously uncompetitive real exchange rate

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Martin Wolf
i Financial Times 97-03-11

To anyone unfamiliar with the convoluted logic that accompanies Europe's plans for economic and monetary union (Emu), the notion that the launch of the single currency in January 1999 might have to be postponed because of Germany's growing unemployment will seem incredible. Yet that possibility is now widely canvassed.

Until recently, the focus for worries about the Emu timetable was France, struggling to reduce its fiscal deficit in the face of rising unemployment. But attention has switched to Germany since the seasonally adjusted increase in unemployment of 160,000 in January brought the country's unemployment rate to 11.3 per cent. This was then followed by another seasonally adjusted increase for February - albeit of only 5,000.

These figures confirm that Germany's labour market is not working. They also make it likely that - with unemployment already some 200,000 higher than the government assumed in its budget - the general government borrowing requirement will exceed the Maastricht target of 3 per cent of gross domestic product.

Yet bad though this news is, it hardly means Germany has become unsuited to participation in a stable euro zone - few would argue that lax monetary policy is to blame for the country's high unemployment. A more relevant conclusion would be that the economic convergence criteria, as currently interpreted, cannot draw an economically sensible line between countries that can live with monetary union and those that might be unable to do so.

In fact, the decision has apparently already been taken to pay little attention to the other fiscal convergence criterion in the Maastricht treaty - the requirement that public debt should not exceed 60 per cent of GDP. This the treaty would seem to allow, since it asks only that the public debt level be "sufficiently diminishing and approaching the reference value (60 per cent) at a satisfactory pace".

The willingness to tolerate high public debt ratios is explained by the fact that they take a long time to correct - so rigorous enforcement would exclude some member states from the single currency for decades. But a number of Germans, including Mr Theo Waigel, the finance minister, insist there can be no leeway on the 3 per cent target for fiscal deficits.

Insistence on a rigorous interpretation of the deficit criterion has three consequences. First, the judgment on whether a country is a suitable Emu entrant now seems likely to be taken on whether its cyclically unadjusted fiscal deficit happens to hit an arbitrary target in 1997. Second, Germany may fail to meet the criterion if its economy does not recover strongly. Third, precisely for this reason, some observers now expect EU leaders to agree to a postponement of the start of Emu from January 1999.

This is an absurd state of affairs. The rigidly applied fiscal deficit test does not make economic sense. Nor is it required by the treaty which states the deficit should be no more than 3 per cent of GDP "unless either the ratio has declined substantially and continuously and reached a level that comes close to 3 per cent; or, alternatively, the excess over the reference value is only exceptional".

Even a short postponement would undermine the credibility of monetary union, invite market speculation against weaker currencies and prolong the period of intense concentration on Emu that has afflicted the EU throughout the 1990s. Mr Helmut Kohl, the German chancellor, insists Emu is a matter of war and peace. It defies belief that a meaningless fiscal failure might be allowed to postpone so cherished a project.

When propositions so apparently irrational are advanced, there must be a hidden reason. In this case, it is Italy. Mr Kohl must convince worried German savers that the new euro will be as sound as the D-Mark. They have no problem about sharing their currency with the Dutch or the Austrians. The French have made an extraordinary effort to adopt Germanic monetary habits.

But Italy, with its history of high inflation and large fiscal deficits, may be too much to swallow. Even Mr Kohl, it is widely believed, could not sell Emu to his fellow Germans in the general election due in October 1998 if Italy were included.

Yet Italy - not to mention Spain and Portugal - has made heroic efforts to meet the Maastricht treaty criteria. It would be hard to exclude the southern countries if their deficits were to end up slightly above 3 per cent of GDP in 1997 unless Germany met the criteria cleanly. This is why Germany's economic performance this year has become so important.

Behind this fixation on arbitrary fiscal numbers therefore is something much more worrying: widespread German mistrust of the economic rectitude of some of their potential partners in the single currency. Since even senior Italian politicians agree it may be impossible to keep their country's public finances on the straight and narrow if it is not in the first wave of entrants, German suspicions are justified.

Indeed, Professor Ronald McKinnon of Stanford University argued in a paper to the American Economic Association at New Orleans in January that Emu's great achievement has been to force politicians in countries such as Italy to make necessary fiscal corrections. Quite reasonably, confidence in the continuation of such painful fiscal adjustment after monetary union may be small.

One solution is to start Emu with the small group of countries that have already achieved stability against the D-Mark over a long period and enlarge its membership a year or two later. In that way the German people would not confront southern European membership of the single currency immediately, but everyone who wanted to could be in before the switch to the new notes and coins in January 2002. If that proved impossible, the second-best alternative might indeed be delay, notwithstanding the many risks.

Yet the important difficulty is not the tactical one of timing the beginning of Emu to minimise the shock to the German people. Indeed it is not obvious why any of these all-too-transparent ruses would assuage their concerns. The big difficulty is strategic: Mr Kohl is trying to bind Germany into Europe with an arrangement that the majority of Germans dislikes. If they find the new euro unsatisfactory, they will end up less favourably inclined towards their neighbours, not more so. Monetary union would then drive Europe apart, not bring it together.

Emu's success - indeed survival - will depend on its legitimacy in every member state. When countries start off mistrusting one another such legitimacy is imperilled. But it will be still further endangered by the high unemployment that lies behind the concerns over Germany's fiscal prospects. The fiscal retrenchment demanded by Emu could too easily become the scapegoat for Europe's unemployment ills. Instead of being seen as a source of prosperity, the EU would be condemned as the cause of misery. That is a serious strategic risk. It could destroy Emu and gravely damage the Union.

Concern about precise fiscal deficits is indeed irrational. Worry about the consequences of launching Emu into a tide of mutual suspicion and economic failure is not.

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Martin Wolf ställer frågan: Vad är den Europeiska Unionens uppgift?
Källa: Financial Times 96-01-30

Artikeln utgår från en bok av Frank Vibert, Europe : a constitution for the millenium (Aldershot: Dartmouth, 1995). För de mest övertygade anhängarna (true believers) är Europa inte bara en mekanism utan en tro. Det är i god överensstämmelse med kontinentens historia.

Religion, revolution, socialism och nationalism har varit saker att leva, dö och döda för. Att bygga ett enat Europa är en annat storslagen uppgift (another grand cause). Men hur ädla motiven än må vara måste EU bedömas av hur den löser sin uppgift. Vad är då den Europeiska Unionens uppgift, frågar Martin Wolf, en av de ledande skribenterna på Financial Times.

De svar som lämnats har handlat om peace, prosperity and power. Frankrike och Tyskland kommer inte att gå krig med varandra ändå, tror dock Wolf, som påpekar att inward-looking liberalisations bring diminishing returns. Marschen mot den monetära unionen med den gemensamma valutan har lett till en serie valutakriser och en onödigt hård penningpolitik, men den viktiga frågan om Monetär Union handlar mycket mera om slutmålet än om vägen dit. EU kan skänka hopp om makt för Europa som helhet och framför allt för dess elit. Om EU skall välja ett federalt öde "it must at least develop a constitution (en författning). EU needs what it does not have - a fully articulated constitution".

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