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Carlo Cottarelli is Deputy Director in the IMF’s European Department; Julio Escolano is Deputy Division Chief in the same department. Petya Koeva prepared Appendix I. We would like to thank her and the participants in a seminar held at the U.K. Treasury for extremely useful comments on an earlier draft of this paper.
HM Treasury (2003b). The impressive range of topics covered by the studies is indicated by their titles: “The five tests framework; Analysis of European and UK business cycles and shocks”; “Estimates of equilibrium exchange rates for sterling against the euro”; “Housing, consumption and EMU”; “EMU and the monetary transmission mechanism”; “Modelling the transition to EMU”; “Modelling shocks and adjustment mechanisms in EMU”; “EMU and labour market flexibility”; “The exchange rate and macroeconomic adjustment”; “EMU and the cost of capital”; “EMU and business sectors”; “The location of financial activity and the euro”; “EMU and trade”; “Prices and EMU”; “The United States as a monetary union”; “Policy frameworks in the UK and EMU”; “Submissions on EMU from leading academics; “Fiscal stabilisation and EMU—a discussion paper”. These studies, prepared by academics, researchers, and treasury staff, survey the growing academic literature on these topics and constitute in their own right a valuable addition to this literature.
Note, however, that the last test is presented as a summary tests (“In summary, …”), which makes it difficult to see it as a separate test.
See ¶ 18–44 in the introduction to the Assessment.
This disregards, for simplicity, the inevitable lags between the entry decision and the actual entry. The duration of this lag is difficult to assess, as it does not depend only on the political process in the United Kingdom (including a referendum), but also on euro-areas procedures.
This assumes that the time discount rate r is higher than the economy’s growth rate g.
This assumes that monetary policy in the United Kingdom is adequately managed. Of course, an independent monetary policy does not help if it is mismanaged, in which case a country can always benefit from entry.
However, as discussed in the Assessment (¶ 2.31, in particular), more price and wage flexibility, while reducing output volatility, would increase inflation volatility.
The return curve illustrates the volatility of output with respect to a baseline where output volatility is expected to be minimized reflecting the use of an independent monetary policy. In principle, one should assess whether the increased volatility arising from the entry decision should really be added to the residual volatility of the baseline, or whether it could possibly offset it.
For example, one can argue that the complexity of the problem is such that maximizing the NPV is a futile exercise and one should be happy simply with being confident that the NPV is positive.
For example ¶5.92 argues that “additional volatility and uncertainty resulting from EMU membership in the absence of sustainable and durable convergence could have a negative impact on the actual level of UK output in the long term.”
One key argument in the Assessment is that the current idiosyncrasy of the UK cyclical position will lower significantly the potential benefits from entry. This could be a sufficient reason to delay entry to a more favorable cyclical juncture, if the criterion for entry is NPV maximization. But the argument is less credible if the criterion adopted is that the NPV should be positive, as the long term gains from entry are quite high (as discussed below). Arguing that these gains are more than offset by the short term costs of entering now is a more challenging task, that would require strong evidence that lack of current convergence also lowers significantly the long-term gains.
Indeed, one could argue that the effect of entry on investment and financial services is relevant only in so far as the latter affect income levels, and that it would have been sufficient to assess whether the fifth test was met. However, the material discussed under the financial services and investment tests are also relevant to assess the effect on output.
For example, the dynamic panel estimates in Micco, Stein, and Ordoñez (2003) suggest that more than ¼ of the long-run trade gains take place during the first year, and that the already realized gains in 2002 amounted to 4—10 percent of the estimated long-run gain of 34 percent.
The European Commission (1990) estimated the reduction in transaction costs at 0.4 percent of GDP if all EU countries adopted the euro. Savings, however, were thought to be smaller for large countries (with lower cross-border transactions-to-output ratios) and for currencies that were already traded in deep and efficient markets.
Growth is assumed to be 2½ percent through 2012, and then as in HM Treasury, November 2003 PBR: “Long-Term Public Finance Report: Fiscal Sustainability with an Aging Population.”
The Assessment, however, concludes that also the long-term benefits would not materialize in the absence of sustainable convergence (¶5.82). See discussion of issue 7.
The Executive Summary states that: “The assessment addresses… the risks and costs from delaying the benefits of joining” (page 4).” Later (page 6), it notes that the case for entry is not yet established, “despite the risks and costs from delaying the benefits of joining.”
The reference in ¶3.93 to a “risk” is unfortunate. It is certain, indeed tautological, that the longer membership is postponed, the longer the potential gains from entry are postponed.
Note that this applies also to the fiscal framework. As a non-euro EU area member, the United Kingdom is now expected to endeavor to avoid deficits exceeding 3 percent of GDP, while, in principle, would be obliged to avoid breaching that ceiling once in the euro area (as highlighted in ¶5.36).
As discussed above, ¶3.93 does note that the longer entry is delayed, the longer the potential gains in terms of FDI are postponed. But this is not the cost we are referring to here. With respect to the analytical framework used here, ¶3.93 focuses on the cost of shifting the return curve to the right (Issue 3 above), not to the change in the shape of the return curve (Issue 4).
See “Analysis of European and UK business cycles and shocks”; “Housing, consumption and EMU”; “EMU and the monetary transmission mechanism”; “Modelling the transition to EMU”; “Modelling shocks and adjustment mechanisms in EMU”; “EMU and labour market flexibility”; “The exchange rate and macroeconomic adjustment”; “The United States as a monetary union”; “Submissions on EMU from leading academics”; “Fiscal stabilisation and EMU”—a discussion paper in Treasury (2003b). For an earlier discussion see IMF (2000).
Discussing the risks to convergence posed by structural differences, the Assessment states that “differences in the UK and euro area housing markets are high risk, differences in investment linkages and financial structures are low to medium risk and sectoral and trade differences are lower risk.” (¶1.112).
This lower elasticity is usually explained by the higher resort to long-term capital markets financing—as opposed to bank lending—by UK firms and by higher external financing.
A section of the assessment (¶2.29-2.33) is titled: “How much flexibility is needed in principle?” However, it primarily deals with the effect that increased flexibility would have on inflation volatility, and with implications for macroeconomic management of different degrees of flexibility between the United Kingdom and euro-area members.
As to indirect approaches, the “what if” simulations presented in the Assessment regarding the effect of euro-entry in 1999 do show that entry at that time would have increased output volatility, which could imply that flexibility was not yet sufficient to compensate for the loss of monetary independence. But those simulations are necessarily based on models estimated on historical data and, thus, cannot evaluate the effect of the increased flexibility and convergence of the UK economy since 1997. The same argument can be made with respect to the discussion in ¶2.34–2.40, which takes a similar model-based approach.
In particular, the assessment takes the view that the benefits arising from increased trade would accrue only in the presence of sustainable convergence: Without the maintenance of continued stability, the trade benefits of joining EMU would be negligible. (¶5.82)
For example, ¶5.2 notes that one of the pillars of the UK government’s strategy to increase output and productivity has been “maintaining macroeconomic stability”. Indeed, stability “helps individuals and business to plan for the longer term, improving the quality and quantity of investment in the economy, and helping to raise productivity and the sustainable rates of growth and employment” (¶5.12).
Cross-country evidence of the detrimental effect of volatility on growth is presented, for example, in Ramey and Ramey (1995). The latter finds that volatility has a strong negative effect on growth. However, it does not focus on whether the effect of volatility on the level of output is permanent or temporary. The relation between volatility and growth in the context of the UK EMU decision is discussed in Barrell (2002) and Pain (2002). Barrell indicates that volatility in nominal macroeconomic variables has had a larger effect on UK growth than real volatility. Both types of volatility, however, have been closely correlated in recent times making it difficult to discriminate between their specific effects.
See, for example, the article by Ed Crooks, Economic Editor of the Financial Times, in the Financial Times of June 11, 2003 (A year may be a short time in five-test politics)
In principle, significant costs would also arise in case entry occurred when the exchange rate is being hit by a strong shock (that is, when it is far away from equilibrium, assuming that entry could not occur at a rate that is too different from the market rate). Indeed, as recalled in ¶1.134, in one of the EMU studies Professor Mundell notes that: “The issue of timing is important. If Britain enters when its economy is in a strong boom compared to Europe, the pound would be high against the euro, and that might in the long run put Britain at a competitive disadvantage.” The weakening of sterling since early 2003 has reduced the practical relevance of this issue for the moment. Thus, while the Assessment pays quite a lot of attention to it (¶ 1.133-1.151), the discussion of the transition costs primarily focuses on the implications of lowering interest rates at a time when a housing and households debt boom is in progress.
¶1.117 notes that the mechanism of endogenous convergence that can reduce the costs from entry over time would not alleviate the costs related to the immediate “shock of entry.”
Box 1.8 in the Assessment provides an estimate of the reduction in government spending that might be necessary. Also, one of the background studies includes a detailed estimate of the percentage cut in government spending (about 6 percent) that would be required to offset the relaxation of monetary conditions caused by EMU entry (see Wren-Lewis, S. (2003)).
See Financial Times, “Euro rows to go on as Brown puts off verdict,” June 10, 2003.
An investment project is partially or completely irreversible if its initial cost is at least partially sunk, i.e., “you cannot recover it all should you change your mind” (Dixit and Pindyck (p. 3, 1994)).
The existence of a “sunk cost”—something that needs to be sustained by member countries at the moment of entry and cannot be recovered in case of exit—is introduced in the model to mimic the irreversibility of the entry decision. The higher the sunk cost, the more “irreversible” is the decision. Actual sunk costs in the case of EMU-entry are low (e.g., the cost of the change-over), unless one also includes those that may arise from entering when cyclical conditions are not appropriate.
See Part II of Dixit and Pindyck (1994) for detailed discussion of the mathematical tools used in this annex.
This is analyzed in the background study The Exchange Rate and Macroeconomic Adjustment (HM Treasury 2003b). EMU entry, while eliminating the volatility with respect to the euro, might increase the volatility with respect to the U.S. dollar.