Comments on “Real Convergence, Economic Dynamics, and the Adoption of the Euro in the New European Union Member States,” by Sue Owen
- Susan Schadler
- Published Date:
- April 2005
These comments draw both on the European Central Bank (ECB) paper by Christian Thimann and on the United Kingdom’s assessment of the five economic tests (convergence, flexibility, investment, financial services, and growth/stability/employment) for European Monetary Union (EMU) entry in order to draw insights for accession countries on their approach to the EMU.
We outline the U.K. approach in Table 2. The United Kingdom’s assessment of the five economic tests was based on 18 background studies. The approach was similar to the ECB’s, drawing on insights from optimal currency area theory. The convergence and flexibility tests focused on the costs of living with a single interest rate and the loss of the nominal exchange rate as an adjustment mechanism. The last three tests focused on the benefits, which are not considered in detail in the ECB paper. In the U.K. approach, macro-economic stability was the underlying metric; without stability via sufficient convergence and flexibility, it would not be possible to realize the potential benefits of EMU membership. One might then suggest that the “Accession 10” should focus on the same issues; however, they would not necessarily arrive at the same conclusions because the U.K. economy is very different from those of the accession countries (themselves, of course, also a heterogeneous group). Conclusions will vary according to the size of economy, the degree of integration with the euro area, the state of development of institutions, and the economic structures (e.g., the United Kingdom is more service-intensive like the euro area, while the accession countries are more industry based). The ECB paper focuses on structural supply-side differences; in our U.K. analysis we found structural demand-side differences relative to the euro area relatively more important as a factor inhibiting real convergence.
|Convergence: Are business cycles and economic structures compatible so that others and we could live comfortably with euro interest rates on a permanent basis?|
|Flexibility: If problems emerge, is there sufficient flexibility to deal with them?|
|Investment: financial services; growth, stability, and employment|
The ECB paper suggests that in a potentially enlarged euro area, “monetary policy would not be sufficiently counter cyclical for countries with higher fluctuations.” Figure 10 addresses this “one size fits all” question; in the U.K. analysis, we used macro models to help address this question by simulating the impact of entry had the United Kingdom joined the EMU along with the first wave, based on estimated relationships. In the U.K. case, this would have meant joining on January 1, 1999, at an exchange rate of €1.46 = £1 and would have implied a cut in short-term interest rates of 4 percent. Joining in 1999 would have generated a less stable business cycle, with greater risk to investment, employment, and output after an initial boom generated from the substantial cut in interest rates. Output growth would have been less stable: higher for the first three years, and lower for the next seven. It may, of course, be harder for the accession countries to run such similar exercises; they may have less reliable data going back less far, they have experienced major structural changes recently, and so on. Even so, such an exercise was useful in the U.K. context in showing the potential costs of entry without sufficient prior convergence. These results derive, of course, from only a hypothetical exercise, and the focus is on adjustment costs rather than potential benefits.
Figure 10.Why the Five Tests Matter: What If the United Kingdom Had Joined in 1999?
Cyclical convergence featured in both the ECB and the U.K. analyses. Indeed, according to the ECB paper, “Three important features stand out, all of which have a bearing on the choice of timing of euro area entry: growth rates have been persistently higher in the new member states, growth fluctuations (i.e., amplitudes of upswings and downturns) have been more pronounced in the new member states, and new member states’ business cycles have not always been closely synchronized with those of the euro area.” They found that the differentials between the new member states and the euro area had not diminished in the 1996–2002 period. In the United Kingdom, by contrast, as Figure 11 shows, we found that both the timing and amplitude of cycles relative to the euro area had improved since 1997. Business cycles become more convergent than in the past.
Figure 11.Business Cycles in the United Kingdom and the Euro Area
Sources: European Commission; and HM Treasury.
Note: Updated October 2004.
However, the United Kingdom managed to achieve this only against the background of much tighter monetary conditions than in the euro area—reflected both in interest rates relative to the euro area and in the exchange rate.
The ECB paper shows that interest rates are still well above the level of the euro area in most acceding countries. Figure 12 considers the United Kingdom/euro area interest rate differential; this has narrowed since 1998 but remains above 1 percent. For the United Kingdom this poses a transitional risk of closing the gap on EMU entry. We also examined the option of tightening policy in advance of entry, concluding that the degree of advance tightening needed would be substantial. The ECB paper also concludes: “Given the current policy interest rate spreads, most countries would have to enact a substantial cut of interest rates toward the euro area level within a time span of a few years, if they joined the euro area a few years after EU accession.”
Figure 12.Convergence Tests: Interest Rates
Sources: Bank of England; European Central Bank; UK Office of National Statistics; and Eurostat.
Note: Updated on October 4, 2004.
The need for relatively tight monetary conditions in the United Kingdom is also reflected in a strong exchange rate (Figure 13), which suggests that the exchange rate helped absorb the impact of relatively strong U.K. consumption demand.
Figure 13.Convergence Tests: Sterling-Euro Exchange Rate
Note: Updated October 2004.
But monetary union means that nominal exchange rates are no longer available to equilibrate supply and demand and to absorb shocks. This is of course reflected in the ECB paper: The issue to be considered is whether exchange rate fluctuations have been a useful adjustment tool to adverse shocks—in which case they would stabilize domestic output growth—or whether they have disrupted trade and financial relations and thereby possibly have magnified domestic output fluctuations. Obviously, in only the first case would the abandoning of the exchange rate tool prove costly. Background analysis on this particular issue suggests that the exchange rate has indeed played a role as a shock absorber, which has been larger in countries with flexible exchange rate regimes than in countries with tight exchange rate management. This question of flexibility in nominal exchange rate adjustment formed a major part of the U.K. assessment—particularly the three studies “Modelling Shocks and Adjustment Mechanisms in EMU,” “Estimates of Equilibrium Exchange Rates for Sterling Against the Euro,” and “The Exchange Rate and Macroeconomic Adjust-ment.”13 Our work suggested, as the ECB’s work has, that on balance the exchange rate helped act as a shock absorber. So in the years 2000 through the end of 2002 a relatively strong level of sterling (average €1.60 = £1) was probably warranted to help absorb the strength of demand, although it was of course unhelpful to some sectors of the economy. Since then, sterling has fallen to a rate closer to the range estimated by Simon Wren-Lewis (on the basis of fundamental equilibrium exchange rate analysis) as being a sustainable level for sterling out into the medium term (€1.37).
Moving beyond cyclical convergence, our U.K. work looked also at “endogenous” convergence, structural convergence, and transition issues. We wanted to look at the likelihood of the U.K. economy eventually diverging from that of the euro area. We were concerned about the possibility of not only asymmetric shocks but also asymmetric reactions to common shocks. The ECB paper covers many of these aspects too. The accession countries will have their own idiosyncratic structures that may limit convergence (Table 3).
For the United Kingdom, we found that structural supply factors, such as the United Kingdom’s greater propensity to trade with North America (i.e., more vulnerable to dollar shocks), its position as an oil producer (i.e., vulnerability to oil price shocks), different foreign direct investment patterns, and different financial market structures all posed only low to medium risks. We did, however, find that housing was a key structural demand factor that differentiated the United Kingdom significantly from the euro area. Two housing-market factors (high mortgage debt financed at predominantly variable rates, and inelastic housing supply combined with liberalized financial markets affording easy access to housing wealth) have combined to generate a very strong consumption element in demand growth and to make the U.K. economy relatively sensitive to interest rate changes. Through these factors, U.K. consumption has been running at double that of the euro area, so the economy has needed higher interest rates and an appreciating exchange rate to maintain an internal balance between supply and demand and to prevent inflation. This clearly posed a risk both to the process of transition to the EMU and to the prospect of life within the EMU, so the issue was not so much vulnerability to asymmetric shocks but rather a potentially asymmetric reaction to common shocks. The accession countries, however, seem more likely than the United Kingdom to suffer structural supply-side differences stemming from trade and sectoral differences in small, open economies with less developed capital markets.
Of course, the degree to which convergence matters and shocks can be absorbed depends on the degree of market flexibility. Figure 14 illustrates the different adjustment mechanisms that operate outside and inside the EMU. Outside the EMU, an economy potentially benefits from two sources of flexibility that would not be available inside the EMU: interest rates determined by national economic conditions rather than euro area economic conditions, and a flexible nominal exchange rate between the United Kingdom and the euro area. In the EMU, the loss of these sources of flexibility would mean that other mechanisms have to work much harder. In practice, much of the adjustment would take place through market mechanisms: adjustment of wages and prices, redeployment of labour and capital into new occupations or industries, and so on.
Figure 14.Flexibility Test
There may also be a supporting role for fiscal policy adjustment; outside the EMU, monetary policy responds to national economic conditions and is supported by fiscal flexibility in the form of the full operation of the automatic stabilizers. Inside the EMU, the ECB targets euro area conditions so fiscal policy may need to play a bigger role in circumstances where the monetary policy stance is not well suited to national conditions, either through stronger automatic stabilizers or, possibly, through more active discretionary fiscal policy used symmetrically to be explicitly countercyclical. For the accession countries, as the ECB paper notes, exchange rate questions are especially important given that their real exchange rates should appreciate over time. Within the EMU, this would need to be achieved by slightly higher inflation in accession countries than in the euro area as a whole. The issue then would be how to prevent inflation running ahead of its warranted rate, leading to a loss of competitiveness. Outside the EMU, the nominal exchange rate would be available to correct any loss of competitiveness. Inside the EMU, adjustment would come through domestic prices.
To perform well, particularly in a globalized world, an economy needs structural reform generating market flexibility. However, Figure 14 underlines the additional importance of such market adjustment mechanisms inside a monetary union. The ECB study spends some time looking at the performance of the accession countries in this respect. In the U.K. context, this was also done in the second, “flexibility,” test. We looked at flexibility in labour, product, and capital markets in terms of current U.K. performance relative to its own past, relative to that of other euro area member states, and relative to that of the United States (to get a measure of the flexibility operating in a successful monetary union). In general, we found that the United Kingdom had made great improvements both in relation to its own past and in comparison with many other EU countries (though with some notable areas where the United Kingdom remains weak) but still lagged well behind the performance recorded in the United States. We concluded that the U.K. economy was still not flexible enough to meet the additional challenges of life inside the EMU.
Table 4 shows some model-based analysis that provides insights into how belonging to the EMU might affect the United Kingdom’s macroeconomic volatility. As expected, the results anticipate additional price volatility inside the EMU. But they also suggest that current U.K. flexibility is not sufficient to avoid an increase in U.K. output volatility within the EMU. They confirm that improved price flexibility could reduce output volatility but would enhance inflation volatility marginally. More fiscal flexibility could help reduce the loss of output stability in the EMU. The results showed that, if a floating exchange rate acts as a shock absorber, the loss of nominal exchange rate does not necessarily produce higher volatility.
|Ratio of volatility|
|More U.K. price flexibility||1.41||1.09|
|Augmented fiscal policy in United Kingdom||1.11||0.92|
|Highly volatile nominal sterling-euro exchange rate||0.84||0.99|
The U.K. assessment, unlike the ECB paper, did spend some time addressing the benefits of monetary union for the United Kingdom. The Jeffrey Frankel paper (Chapter 2 in this volume) has already looked at a great deal of the evidence of the trade-generating impact of monetary union, and we covered much of this ground in the fifth test on the impact of the EMU on growth, stability, and employment (Figure 15).
Figure 15.Growth, Stability, and Employment: Trade, Competition, and Productivity
The EU is a major U.K. trading partner, and elimination of currency risk between the United Kingdom and the euro area should stimulate cross-border trade, facilitating production on a more efficient scale and raising productivity and competition. The problems of convergence and volatility need to be seen in the context of these expected gains to joining the EMU, which might clearly be forgone if there is further delay in joining. There is considerable academic debate about the extent to which monetary union may enhance trade and therefore productivity; the empirical research by Andrew Rose14 and others suggests that currency unions provide a very strong stimulus to trade, though others are more skeptical. In our analysis, we focused more on the research so far on the impact of the EMU itself—for example, the work by Micco, Stein, and Ordoñez,15 and that of Piscitelli16 in the United Kingdom. Our assessment was that in the very best case—namely, joining on the basis of sustainable and durable convergence—the impact on the United Kingdom could be between 5 and 50 percent of gross domestic product (GDP) over a 30-year period. The impact for small, open economies such as the accession countries could be larger, given their greater degree of openness and their existing and potential degree of integration with the euro area. Against that, of course, the risks of interindustry specialization may increase the accession countries’ susceptibility to asymmetric shocks.
Table 5 looks at fiscal issues discussed in the ECB paper. The ECB underlines the scale of the fiscal challenges to some accession countries. The United Kingdom’s approach to both its own and the EU’s fiscal framework emphasizes the following:
Solvency—the importance of debt and long-term sustainability issues in the face of aging populations.
The stabilizing role of fiscal policy—letting the automatic stabilizers work over the cycle and, possibly, play a greater role in the EMU.
Public investment—the importance of infrastructure and quality public investment as a complement to private investment.
While the 3 percent reference value for the government deficit seems reasonable for EMU members, accession countries may need to undertake important public investment for some time. This could be justified even under the stability pact, provided that debt was low. One important message, then, is that to the extent to which accession countries need to consolidate public finances, it might make sense to focus their effort on current, noncyclical expenditure. Transition issues will be important too; the ECB paper high-lighted the Irish case, where monetary easing in the runup to euro adoption resulted in strong inflationary pressures. Thus, the government imposed severe fiscal tightening in the form of large budget surpluses of around 4.7 percent of GDP in 2000 to dampen GDP growth.
The U.K. Treasury is working on ideas to make discretionary fiscal policy more effective for stabilization purposes than it has been. In particular, we are looking at institutional reforms to ensure that any such stabilization would operate symmetrically, credibly, and transparently.
This chapter reflects the presentation given at the International Monetary Fund conference in Prague in February 2004 and is based on the paper “The Acceding Countries’ Strategies Towards ERM II and the Adoption of the Euro: An Analytical Review,” prepared by a staff team led by Peter Backé and Christian Thimann and including Olga Arratibel, Oscar Calvo-Gonzalez, Arnaud Mehl, and Carolin Nerlich. The paper was published as ECB Occasional Paper No. 10. Comments by Peter Backé, Lance Domm, and Arnaud Mehl on this chapter are gratefully acknowledged. The views expressed are those of the author and do not necessarily represent those of the European Central Bank.
Income levels are highest in Cyprus, Slovenia, the Czech Republic, Malta, and Hungary, with income levels in PPP terms close to, or in some instances above, those in Portugal and/or Greece, while per capita GDP in most of the other new member states is about two-thirds this level. When they joined the euro area, Spain, Portugal, and Greece registered GDP per capita levels of 85 percent, 70 percent, and 67 percent, respectively, of the euro area average in PPP.
According to the optimal currency area argument, countries with similar economic structures are less affected by asymmetric shocks and respond to shocks in a similar way, so that business cycles are likely to be more harmonized and independent interest rate policy is less relevant for output stabilization (Corden, 1972; Tavlas, 1994). For an application to the Central and Eastern European countries see European Commission (2002) and De Grauwe and Aksoy (1999).
EBRD transition indicators do not exist for Cyprus and Malta.
However, the demographic structure of the Polish agriculture sector, where the average age is close to 60, might also imply a gradual decline in the high employment share over time.
In this section, the term new member states does not include Cyprus and Malta.
I am grateful to Ralph Süppel for having pointed out the applicability of the Theil framework to illustrate differences in economic dynamics between new and existing EU members. For more details of the quantitative analysis, see Backé and others (2004) or Süppel (2003).
See Pindyck and Rubinfeld (1997), pp. 210–11.
This part of the analysis excludes Ireland, since quarterly GDP data stretching back to 1996 are not available.
Estimated correlation coefficients for Greece, Ireland, and Portugal with the euro area may be positively biased given that these countries are euro area member states themselves. However, since they account for a small share of euro area GDP, this bias is unlikely to be large.
GDP series are detrended by subtracting a quasi-linear trend estimated by the Hodrick-Prescott filter with a smoothing parameter of 14,000.
Series are reduced by dividing them by their respective standard deviations.
All the above analyses have looked at the correlation of various measures of aggregate output. A popular alternative is to use time series of both GDP and the GDP deflator to distinguish and identify aggregate demand and supply shocks via a structural vector auto-regressive (VAR) model of the Blanchard-Quah type. See Backé and Thimann (2004) for the results.
HM Treasury, 2003, EMU Studies. Available via the Internet: http://www.hm-treasury.gov.uk/documents/the_euro/assessment/studies/euro_assess03_studindex.cfm.
Rose, A., 1999, “One Money, One Market: Estimating the Effects of Common Currencies on Trade,” NBER Working Paper No. 7432 (Cambridge, Massachusetts: National Bureau of Economic Research).
Micco, A., E. Stein, and G. Ordoñez, 2003, “The Currency Union Effect on Trade: Early Evidence from EMU,” Economic Policy, Vol. 18 (October), pp. 315—56.
Laura Piscitelli, 2003, “The Effects of EMU on Euro Area Trade—a Sensitivity Analysis” (London: HM Treasury).