III. Costs and Benefits of Joining the EMU


III. Costs and Benefits of Joining the EMU


  • III. Costs and Benefits of Joining the EMU

    • A. Introduction

    • B. The Theory of Optimal Currency Areas: Framework for Analyzing the Costs and Benefits of Joining EMU

    • C. Limitations of the TOCA

    • D. The Microeconomic Bases of the Potential Gains from Joining EMU

    • E. The Overall Level of Integration Between the United Kingdom and EMU Economies

    • F. Cyclical Convergence and Symmetry of Economic Disturbances

    • G. Flexibility and Factor Mobility

    • H. Conclusions

    • References

  • III. 1. Trade Direction in the United Kingdom and Selected EMU Economies

  • 2. Foreign Direct Investment and Assets

  • 3. Business Cycle Correlations

  • 4. Shock Correlations with Germany. 1960-1995

III. Costs and Benefits of Joining the EMU1

A. Introduction

1. The policy of the United Kingdom towards EMU membership was stated by the Chancellor in his October 1997 speech and has remained substantially unchanged since then.2 Under this policy, the key factor for the United Kingdom to join the single currency is that the economic case for membership be “clear and unambiguous”—as further laid out by five economic tests. Once the Government decides to join on that basis, the decision would need to be approved by referendum. At the time, the Government did not envisage that the five tests would be met during the current Parliament and opted to remain out of the EMU, while aiming for a reassessment of the decision on EMU membership early in the next Parliament. (The next parliamentary general elections are expected in 2001.)

2. The five entry tests, as stated by the Chancellor, can be summarized as follows. First, the U.K. economic cycle must have sustainably converged with the cycle of the euro area. Synchronization of the economic cycle is deemed essential to maintain the stability and growth prospects of the U.K. economy under a common monetary policy, and hence convergence must be likely to be sustained. The authorities’ assessment coincides with the broadly held view that, until now, the U.K. economic cycle has not been synchronized with that of the main euro area economies for long periods of time. This convergence test is considered the most critical, as meeting many of the other tests hinges on convergence. Second, there must be sufficient flexibility to cope with asymmetries among the euro economies—such as asymmetric shocks and transmission mechanisms—as well as increased competition. Flexibility in labor markets is considered necessary since otherwise, absorption of economic shocks in the absence of monetary policy and exchange rate buffers could result in unacceptable levels of unemployment. Third, joining the single currency should enhance the prospects for increased investment. Increased long-term investment would result from macroeconomic stability and deeper and more competitive markets offering new opportunities for private investment—hence, the prospects of higher investment are considered contingent on the likelihood of these outcomes. Fourth, joining the EMU should be judged beneficial for the financial services industry, particularly the City’s wholesale markets. This industry could be expected to be most directly affected by the replacement of the national currency by the euro and all preparations for this change should be in place. And fifth, joining the euro should have a positive effect on employment and growth. This positive effect would, in turn, require sufficient convergence and market flexibility.

3. These five tests have been criticized for being vague and insufficiently clear-cut to provide, as intended, a “clear and unambiguous” signal for joining the euro. It is apparent, however, that it would be impossible (and arguably, even ill advised) to define and precommit to a set of black and white tests that would mechanistically trigger EMU entry. Thus, the five tests are considered here as policy guidelines or criteria specifying the factors that, in the Government’s view, should be the focus of analysis and discussion in order to make a decision regarding EMU entry. The Government’s approach, epitomized by the five tests, explicitly circumscribes the relevant factors for this decision to the economic area. This stems from the authorities’ view that there are no overriding obstacles to U.K. membership from a constitutional standpoint and that if the single currency is successful, and the economic case is clear and unambiguous, then the United Kingdom should be part of it. This Government’s approach has also been disputed—from what could be considered the converse viewpoint of the previous criticism—for being too narrow and specific, since it abstracts from the political dimensions of joining EMU. This political aspect of the EMU undertaking has played a central role in the debate in many of the countries currently in EMU and has been emphasized in the United Kingdom by many sides in this debate (including those opposing U.K. membership). The discussion in this paper will be confined to the economic advantages and disadvantages of EMU membership, without prejudging the relative importance of these economic considerations vis-á-vis the political dimension.

4. This paper is organized as follows. Section B discusses the main analytical framework to assess the gains and losses associated with joining the EMU: the theory of optimal currency areas (TOCA), which indicates that the net benefits from joining are directly correlated with the level of economic integration of the United Kingdom with the EMU. Some limitations of this framework for assessing U.K. membership in the EMU are presented in Section C. Section D discusses the microeconomic basis of the potential gains from joining the EMU. The level of integration between the U.K. economy and the euro area is discussed in Section E and Section F devotes specific attention to the synchronization of fluctuations in economic activity between the United Kingdom and the EMU. Section G discusses other considerations suggested by the TOCA: wage and price flexibility, and factor mobility. Finally, the last section draws some conclusions.

B. The Theory of Optimal Currency Areas: A Framework for Analyzing the Costs and Benefits of Joining EMU

5. The analysis of the cost and benefits associated with joining a monetary union is typically cast in relation to the TOCA, which aims to identify the factors that minimize the costs and maximize the benefits of creating or joining a common currency area.3 In summary, the TOCA suggests that joining a monetary union is beneficial if the gains stemming from lower transaction costs and exchange risk, and greater price transparency exceed the additional costs of adjusting to asymmetric shocks and asynchronous business cycles incurred by the loss of monetary and exchange rate policy instruments. The more an economy is integrated with the intended currency area, the higher are the benefits of joining and the lower are the costs.

6. Microeconomic savings in transaction costs and risk premium will increase with the significance of trade among members of the currency area (see section D below). Although the traditional formulations of the TOCA place most of the weight on trade patterns, intense intra-area capital flows also increase the benefits of a common currency. The costs of joining a common currency area result from the loss of an independent domestic monetary policy and a flexible exchange rate as instruments of macroeconomic management. Entry into the EMU would imply the loss of an independent monetary policy geared toward the specific circumstances of the U.K. economy. Although, of course, the United Kingdom would be appropriately represented in the EMU decision-making institutions, the monetary policy stance would be tailored to the circumstances of the euro area as a whole. In particular, interest rates would follow those in the euro area (except for the country-specific risk premium) and there would be no independent exchange rate, which would be fixed with respect to the EMU economies. This could result in output losses when the domestic monetary policy stance and exchange rate are inappropriate to the circumstances of the U.K. economy. The lack of a flexible exchange rate would place the burden of absorbing eventual terms of trade shocks on the adjustment of domestic wages and prices—if the latter move sluggishly, the economy could undergo episodes of unemployment and excess capacity that might have been avoided through a flexible exchange rate.4

7. The magnitude of these costs is inversely related to the level of integration with the common currency area. Close integration implies that shocks to one economy will spread quickly to other economies in the currency area making it likely that the common policy stance will be simultaneously appropriate for all of them. At the same time, when the volume of trade and capital flows among a set of economies is large relative to their size, a monetary policy pursued independently by a single country is less likely to be effective as its impact would be diluted by spillovers through the balance of payments—thus, the opportunity cost associated to losing the instruments of an independent monetary policy would be lower. The degree of synchronization of output fluctuations between the United Kingdom and the EMU is, in this context, a particularly relevant aspect of economic integration: asynchronous business cycles and asymmetric shocks would magnify the costs of losing a flexible exchange rate and being subject a common monetary policy.

8. On the basis of the TOCA the main traditional criteria for a region to constitute an optimal currency area are openness and regional interdependence, production diversification within the individual countries, factor mobility, and wage and price flexibility (Masson and Taylor (1992)). Some of these criteria measure economic integration and aim to ensure that asymmetric or unsynchronized movements in economic activity, demanding differential monetary policy stances, are unlikely to develop. Other criteria point to the existence of sufficient flexibility to adapt to asymmetric developments, should these occur, without exchange rate adjustments or differentials in interest rates. The considerations suggested by the TOCA can be recognized in the “five tests” formulated by the Chancellor—particularly those regarding the synchronization of the U.K. business cycle with the euro area and the need for flexible markets to absorb asymmetric shocks.

C. Limitations of the TOCA

9. The TOCA does not cover all the potentially relevant criteria for U.K. membership, even on purely economic grounds. This theory is typically formulated under strong assumptions of exogeneity of behavioral parameters which, in fact, can be expected to change as a reaction to policies and the institutional environment—including the decision to join the euro.5 More fundamentally, Buiter (1997, 1999a, and 1999b) argues that the TOCA fails to distinguish consistently between (typically short-term) nominal rigidities and long-term real rigidities or structural distortions. As a result, it exaggerates the costs of relinquishing an independent monetary policy—which cannot palliate the negative consequences of the latter type of rigidities. Thus, for example, a nominal depreciation is often assumed to translate into a real depreciation, not only in the short run when nominal rigidities may be expected to be present, but even in the long run—hence, magnifying the stabilization value of monetary policy and therefore, the cost of joining a monetary union.6

10. Further, as Buiter points out, the TOCA abstracts from capital mobility and capital account openness—arguably, more important factors than trade in determining short term movements in exchange rates—which could turn an independent currency into a source of disruptions rather than an instrument of stability. Flexible exchange rates are preferable, from the standpoint of macroeconomic stability, to cushion the effect of idiosyncratic supply shocks and non-monetary demand shocks. In contrast, a common currency is preferable to fence off monetary and financial market shocks—many of which would not even arise in a common currency area. Canzoneri et al. (1996) analyze how much of the variation in relative national outputs among potential EMU participants can be explained by monetary and financial shocks (as opposed to supply and real demand shocks) and whether the variations in nominal exchange rates are correlated with the shocks that explain output variations. Their empirical results show that while most of the variation in relative national outputs can be explained by aggregate supply and non-monetary, non-financial demand shocks, these shocks play a very limited role in explaining movements in nominal exchange rates. They conclude that, since nominal exchange rates are relatively unresponsive to the shocks that cause real macroeconomic imbalances, the cost to macroeconomic stability of relinquishing a floating exchange rate is possibly exaggerated by the traditional TOCA analysis. Specifically, starting with a hypothetical currency union among Germany, the Netherlands, and Austria, they find that the stability of output in France, Spain, and the United Kingdom would not be much affected by joining that union.7

11. Finally, the TOCA abstracts from credibility issues associated with monetary policy. Whether the loss of an independent domestic monetary policy would be a cost depends in part on the credibility of monetary policy in an individual country relative to that in the common currency area. In the early stages of EMU, much weight was placed on the gains for countries such as the United Kingdom from enhanced credibility of monetary policy and lower inflation expectations.8 These gains, however, are not necessarily associated with joining the euro, but rather, with the consistently good conduct of monetary policy. With the increased credibility of the U.K. monetary policy framework following the adoption of inflation targeting and the granting of operational independence to the Bank of England, inflation expectations and the inflation premium in long-term U.K. interest rates have declined to levels comparable to those of the euro area.9 Thus, this credibility factor may not play an important role in the future for the United Kingdom, although for some other prospective members the gains in monetary policy credibility may more than offset the loss of an independent monetary policy.

D. The Microeconomic Bases of the Potential Gains from Joining EMU

12. The gains postulated by the TOCA that would stem from greater integration are mostly based on microeconomic externalities associated with the wider use of a common currency. Money, as a medium of exchange and store of value, is subject to network externalities: the more extended is the use of a given currency, the more likely it is to be accepted as payment by other economic agents in return for real goods and services. In fact, fiat money—as opposed to real money, such as gold—derives its value exclusively from these network externalities.10 In the case of a hypothetical U.K. entry in the EMU, these gains would take the form of deeper markets and elimination of transaction costs and exchange risk. Although it is impossible to estimate with any precision the potential savings from these factors, the direct transaction costs associated with maintaining independent national currencies were estimated by the EC Commission (1990) at 0.5 percent of GDP per year for the EU as a whole. This estimate only included the bid-offer spreads and bank commissions on foreign currency transactions, as well as some “in-house” costs incurred by nonbanks. A comprehensive estimate would have to include also, as a minimum, the costs associated with taking foreign currency positions in euros through nonbank instruments, such as euro-denominated bonds and other financial instruments, and the costs of hedging positions in euros. On the other hand, the EC commission estimate may overestimate the savings to the United Kingdom from joining the euro since it was based on a hypothetical scenario in which the 12 currencies of the members at the time were abolished simultaneously: some of the costs previously associated with holding positions in the 11 euro currencies may have already been eliminated by the consolidation of these currencies into a single one.

13. The elimination of exchange rate risk and transaction costs can be expected to increase the net rate of return to investment and, with it, the underlying growth rate of the economy, at least in the medium term. The EC Commission (1990) study considers an increase of ½ percentage point in the rate of return due to the elimination of exchange rate risk as moderate, and estimates that such an increase would lift GDP by 5 percent over the long run (the estimate corresponds to the EU as a whole).11 It could be argued that in the case of the United Kingdom, this positive impact on growth via higher investment is likely to be larger than in other EU countries due to the key role that investment, and in particular foreign direct investment, plays in economy-wide productivity improvements. Low levels of capital stock are among the main causes of comparatively low productivity in the United Kingdom; and foreign direct investment has played a crucial positive role in increasing labor and total factor productivity.12 Although foreign direct investment was strong in 1999 despite the U.K. decision to remain out of the EMU, inward investment could suffer if this position were seen as permanent. The gains from joining the EMU could be greater for small- and medium-size businesses, which currently may find barriers, due to their size, to engage in foreign currency transactions and that after joining EMU could tap larger product and financial markets.

14. Additional microeconomic gains from joining the euro would result from enhanced market transparency and competition. Consumers and other market participants—as well as consumer protection and competition authorities—would be able to compare more easily domestic prices with prices in foreign markets for similar products. As a consequence, discriminatory pricing practices that exploit cross-country differentials in monopolistic power would be hindered or, at least, would become easier to identify.13 Some cross-border price differentials (particularly in final consumer prices) would remain, however, as a result of differentials in the price of nontradable inputs and other domestic cost components in the prices of tradables.

15. Another source of potential gain (or loss) would be the net effect on seigniorage revenue. If the United Kingdom joined the euro, it would lose the seigniorage revenue derived from the issuance of pounds, but would receive transfers from the ECB corresponding to its share in the seigniorage from the issuance of euros.14 Although seigniorage is currently a minor source of fiscal revenue in most advanced economies and arguably should not be a substantial factor in the decision to join the euro, it is generally estimated that the United Kingdom would gain from the switch in currencies. The U.K. contribution to the assets of the ECB would be roughly proportional to its share in the joint (EU-11 plus the United Kingdom) monetary base, while the U.K. share of the ECB profits would be determined by its share in the ECB capital, which in turn is determined on the basis of GDP and population. The former share is lower than the latter as the U.K. monetary base represents a relatively small proportion of GDP—estimated by Buiter (1999a) at about 3 percent of GDP—due, inter alia, to highly developed payments and banking systems and minimal reserve requirements. Sinn and Feist (1997) estimate that the U.K. contribution to ECB assets would be roughly about 9 percent of total assets, while the United Kingdom would receive about 14.7 percent of the ECB income derived from its assets, as well as from new assets associated with the future expansion of the euro monetary base.15

E. The Overall Level of Integration Between the United Kingdom and EMU Economies

16. As part of the EU, the U.K. economy is highly integrated with the economies of the EMU. Nevertheless, the U.K. economy also has closer links to the North American economies than most other European economies—partly due to historical and institutional factors such as a common language and similar legal frameworks. As Table 1 shows, the trade links with North America are significantly higher for the United Kingdom than for other economies in EMU and trade with the euro area is lower. This mismatch in the relative weight of trade partners has been recognized as a potential obstacle to integration in the EMU, since it makes it possible for trade shocks to have an asymmetric impact in the United Kingdom relative to the euro area.16 A similar opportunity for idiosyncratic shocks arises from the importance of the oil-producing sector in the United Kingdom.

Table 1.

Trade Direction in the United Kingdom and Selected EMU Economies. 1998 1/

(In percent of GDP)
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Sources: Direction of Trade Statistics (IMF); and International Financial Statistics (IMF).

Goods exports plus goods imports for each country as percent of the country’s GDP.

17. The special significance of the economic links with North America are also apparent in the area of foreign direct investment (see Table 2). For example, the value of outward and inward investment flows with North America was four and ten times higher, respectively, than with the euro area. Thus, the evidence would indicate that U.K. foreign investment, and a fortiori the U.K. economy, could be more sensitive to investment shocks originating in the North American economic area than to those originating in the EMU. It should be noted, however, that the implication for an eventual U.K. entry into EMU from the evidence on inward foreign direct investment is not unequivocal. Although according to the TOCA, the relatively stronger link with North America would indicate a misalignment of fundamentals for the purposes of EMU entry, it could also point in the opposite direction. In particular, there is some evidence that some foreign investors may consider the United Kingdom, at least partly, as a bridgehead into the EU markets—most of which are part of the euro area. To the extent that this is the case, foreign investment could be negatively affected by a U.K. decision to stay out of the EMU for an extended period—the prospect of reduced transaction and exchange risk costs might divert some of this investment away from the U.K. economy.

Table 2.

United Kingdom: Foreign Direct Investment and Assets. 1998

(In percent of GDP)
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Source: Office for National Statistics (ONS).

18. An additional potential source of asymmetry between the U.K. economy and its EMU counterparts is the transmission mechanism of monetary policy. Even if the U.K. economy were hit only by EMU-wide common shocks and its fundamentals were in line with other EMU economies, a common monetary policy could have asymmetric effects in the United Kingdom and in the EMU economies due to different lags and sources of output response to a common monetary stance. HM Treasury (1997) and Bean (1999) find evidence of dissimilar transmission mechanisms between the U.K. and EMU economies. Although the econometric evidence on the speed and magnitude of the impact of monetary policy is inconclusive,17 there is some consensus that the transmission mechanism in the United Kingdom has probably a shorter lag and a larger impact than in most EMU economies. This opinion is mainly based on the relatively higher weight of variable-rate financing in both the household and corporate sectors. Owner-occupied housing is higher in the United Kingdom than in the EMU, as is household indebtedness (partly due to mortgages).18 Interest payments on most of this debt in the United Kingdom is closely linked to short-term rates, while in most EMU economies, household debt at fixed rates is more prevalent. U.K. corporations rely more on bond and equity finance than in the EMU economies where bank financing at relatively stable—if not completely fixed—rates is more common. Recent developments, however, indicate that this gap might be closing as fixed-rate mortgages are expanding in the United Kingdom owing to stable inflation expectations and EMU corporations are increasingly resorting to securities markets for their financing.

19. Trade patterns, financial links, and the overall level of integration of the U.K. economy with the EMU, however, are dynamic features susceptible to change over time, particularly after an eventual entry into EMU (see Frankel and Rose (1998)). Entry into the common currency area could significantly raise international trade and financial linkages with the EMU and, in turn, these tighter ties may increase the symmetry of economic shocks and strengthen co-movements in economic activity. In theory, the effect of strengthening trade ties (and a fortiori of EMU membership) is ambiguous: If the increase in cross-country trade leads to more specialized economies, the opportunities for idiosyncratic or asymmetric shocks, dissimilar transmission mechanisms, and out-of-step business cycles could all widen.19 On the other hand, if intra-industry trade, financial links, and demand shocks dominate, cross-country economic coherence can be expected to strengthen in a currency union. Most of the empirical evidence appears to back unambiguously (at least for OECD countries) the hypothesis that higher levels of bilateral trade lead to closer business cycle integration. Frankel and Rose (1997 and 1998) review this issue and find a strong positive relationship between these two developments. Angeloni and Dedola (1999) also report evidence of closer correlation of industrial production and GDP in recent times with the EMU as a whole for France, Spain, and the United Kingdom—even though the latter stayed out of the EMU. The analysis performed in OECD (1999) finds closer integration of actual and potential EMU economies, including the United Kingdom, in recent years—closer, in fact, for the United Kingdom than for some EMU participants.20 The authors report that “the results support the view that the creation of the single market and the conditions for participation in EMU have led to higher convergence in economic performance across EU countries in recent years.” Artis (1999), using industrial production—proxying for tradable output—finds that the VAR analysis of demand and supply shocks buttresses the conclusions of Frankel and Rose (1997 and 1998) of closer integration owing to stronger trade links for most EMU countries, but not for the United Kingdom. Tradable-based demand shocks in the United Kingdom appear much more correlated with those of the EMU, while supply shocks place the United Kingdom farther away from the EMU core.

F. Cyclical Convergence and Symmetry of Economic Disturbances

20. There is a growing body of literature aiming to test empirically the degree of synchronicity of the fluctuations in economic activity among actual or potential member countries of the EMU. This body of literature can be classified into three broad categories. First, countries can be divided in clusters that are defined to maximize the degree of compliance with TOCA criteria within each cluster on the basis of a set of observable variables such as bilateral trade, inflation differentials, market flexibility, etc. Second, crosscountry cyclical co-movements in output can be measured directly aiming to identify the cyclical affiliation of each country and, possibly, the existence and country composition of a common European economic cycle. And third, the cross-country symmetry of the underlying demand and supply disturbances experienced by the economies can be investigated using structural VAR models.

21. On the whole, the empirical studies tend to conclude that the United Kingdom is among the less likely countries to be part of a core optimal currency area centered around the EMU. Thus, as part of a review of this research, Artis (1999) concluded that “overall assessments of the optimality of EMU for its potential members virtually always place the United Kingdom in an ‘outsider’ category.” Typically, the U.K. economy appears in a peripheral group with some Nordic countries. Nevertheless, it should be emphasized that these statistical analyses measure the degree of commonalties between the United Kingdom (or other countries) and a conventionally defined EMU center (typically the German economy). They do not provide a pass-fail grade but a relative ranking based on past evidence. In particular, the United Kingdom appears often in the same group as some of the countries that have joined the EMU.

22. The first set of studies mentioned above applies the TOCA criteria to a set of European and other countries in order to construct an optimal currency area index, summarizing the information contained in those criteria. In the analysis of Bayoumi and Eichengreen (1997), the proposed index measures the agreement with TOCA criteria versus Germany—which is considered the center of the optimal currency area—in three different years: 1987, 1991, and 1995. They conclude that the countries analyzed fall in three broad groups: prime candidates for EMU (Austria, Belgium, the Netherlands, Ireland, and Switzerland), countries gradually converging toward EMU (Sweden, Italy, Greece, Portugal, and Spain), and countries exhibiting little convergence (the United Kingdom,21 Denmark, Finland, Norway, and France22). In another contribution to this literature, Artis and Zhang (1998b) apply cluster analysis to a set of variables suggested by the TOCA for actual and prospective member countries of EMU.23 They conclude24 that the countries analyzed cluster around three groups: the core (Germany, France, Austria, Belgium, and the Netherlands), a Northern periphery (Denmark, Ireland, the United Kingdom, Switzerland, Sweden, Norway, and Finland), and a Southern periphery (Italy, Spain, Portugal, and Greece).25 OECD (1999) also applies cluster analysis to the set of member countries of the EU to assess their degree of convergence over time. The analysis is performed independently for a sequence of years in the period 1980-1996 on the basis of output growth, current account balance as a percent of GDP, private-sector employment growth, long-term interest rates, government budget balance as a percent of GDP, and inflation. The results indicate that, from 1994 to 1996, there is a group of six countries (Germany, France, Austria, Belgium, Netherlands, and Sweden) which always fall in one of two closely related clusters, with the additional frequent inclusion of the United Kingdom, Italy and Finland in specific years. Spain and Portugal approach these clusters over the time period of the sample.

23. The second approach attempts to measure directly the degree of coincidence of output fluctuations in a set of potential members of an optimal currency area: ultimately, whether output fluctuations in the United Kingdom have been synchronized with those in the EMU—independently of whether other TOCA criteria are met—is an empirical question susceptible of direct measurement and can be addressed separately. Research along these lines reported in Kontolemis and Samiei (1999) found that the U.K. economic cycle had been more correlated with those of the United States and Canada than with those of Germany, France, Italy, or the euro area as a whole.26 These results were the same under two methodologies, based on cross-correlations of detrended output and business cycle turning points, respectively. Lumsdaine and Prasad (1999) find evidence of both a world-wide and a European business cycle, but conclude that France and the United Kingdom show higher correlations with the world common component than with the European common component. Artis (1999) and Artis, Krolzig, and Toro (1999), building on earlier work, employ a variety of statistical techniques to identify co-movements in the business cycles. They find evidence of an increasingly coherent European business cycle, although the affiliation of the U.K. business cycle to both the European and U.S. business cycles diminishes during the ERM period (see Table 3). Still, in the two sample periods, the U.K. business cycle shows higher correlation with the U.S. cycle than with the German cycle.

Table 3.

Business Cycle Correlations

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Source: Artis(1999).

The pre-ERM and ERM periods are defined to cover 1965-1979 and 1980-1997, respectively.

24. Finally, the third methodological variant attempts to estimate the correlation among the underlying shocks across economies, rather than the correlations among levels of economic activity themselves. This is because output (or other indicators) are endogenous variables and their profile may reflect—in addition to the fundamental structure of the economy—the behavioral response of economic agents, policies, and policy transmission mechanisms. All of these factors are likely to change as a result of membership in a common currency area. Under this methodology, the initiating disturbances are identified separately from the transmission process which, incorporating the public and private policy responses, mediates the passage of the shock through the economy. Typically, the shocks are identified as belonging to the demand side (occasionally distinguishing those stemming from monetary policy) or to the supply side and estimated for each country separately by means of a structural VAR model. This requires the a priori imposition of structural restrictions, which have been subject to some criticism.27 This line of research was initiated by Bayoumi and Eichengreen (1993) and, in an update of their results, Artis (1999) concludes that an EMU core and a periphery can be identified—the former comprises Germany (defined as the center), France, Denmark, Austria, Belgium, and Luxembourg, as well as perhaps the Netherlands and Italy; the latter includes the United Kingdom (see Table 4). These results are, however, inconclusive as to how much of an obstacle to monetary union is the asymmetry of shocks. The analysis conducted in Kontolemis and Samiei (1999) indicated that an important source of shocks in the U.K. economy was monetary policy itself and shocks to the exchange rate. An eventual entry into EMU would eliminate asymmetry in these two sources of disturbances with respect to other EMU economies.

Table 4.

Shock Correlations with Germany. 1960-1995.

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Source: Artis (1999).

G. Flexibility and Factor Mobility

25. Some market rigidities can exacerbate the negative consequences of joining a currency area. The main advantage of having an independent exchange rate is that it provides a flexible instrument capable of moving relative prices between currency areas in the short term. To the extent that an independent monetary policy acts as a cushion of economic disturbances, joining a currency area, and therefore losing that policy instrument, requires sufficient market flexibility to respond to fluctuations in activity and economic shocks without an unacceptable level of unemployment and output losses. These considerations apply most directly to economic disturbances that are country specific. Nevertheless they may also apply to disturbances affecting simultaneously the whole currency area if different economies have different transmission mechanisms. Most of the early versions of the TOCA were developed under the assumption that wages and domestic prices were fixed.28 Under these assumptions, the value of the exchange rate for restoring internal and external balance can be overstated as nominal exchange rate changes translate immediately into a permanent change of the real exchange rate. In assessing their relevance for the purposes of joining a currency area, it is important to distinguish between two types of price and wage rigidities: nominal and real. Real rigidities (as in the case of wide-spread wage indexation or structural distortions) may impair the stability and growth prospects of the economy, but they will be equally crippling under a currency union as under an independent monetary policy.29 Thus, the relevant issue for EMU membership is the existence of (typically short-term) nominal stickiness in either wages or output prices or both. The existence of nominal rigidities in wages and prices increases the value for a country of an independent and flexible exchange rate and, correspondingly, the cost of joining the EMU. Under a single currency, nominal wage stickiness would prevent or delay the adjustment of real wages or the real exchange rate to an economic shock, with adverse consequences for employment and output. Whatever the exchange rate regime, adjustment costs would, of course, be greater if structural distortions made real wages unresponsive to the increase of unemployment.

26. Unfortunately, evidence on cross-country market flexibility is scarce or inconclusive. The relative paucity of empirical evidence on this issue is compounded by the difficulties in measuring the specific phenomenon of relevance for EMU membership. Staff analysis of wage flexibility in the United Kingdom concludes that the institutional changes that have taken place in its labor markets during the last two decades have significantly increased the responsiveness of nominal and real wages to changes in economic conditions—as evidenced by the current low unemployment and high participation rates.30 Also, Bayoumi and Eichengreen (1996) report evidence indicating that wage behavior might be contingent on the exchange rate regime, showing a higher degree of flexibility when the exchange rate regime is more rigid. Studies on the flexibility of retail and product prices typically find that, on balance, price flexibility in the EU, and specifically in the United Kingdom, is in the middle range among industrialized countries and well below the typical relative price flexibility observed within a country. Masson and Taylor (1992) and Bayoumi and Eichengreen (1996) report that the dispersion of CPIs (measured in a common currency) across European countries is significantly higher than across cities or regions within a country, which is interpreted as evidence that European countries need flexible exchange rates. The evidence, however, could also be interpreted as indicating that the nominal exchange rate has not in fact responded to real exchange rate misalignments and, consequently, flexible exchange rates have not been effective instruments to avoid misalignments in cross-country relative prices. A related argument is presented by Buiter (1997, 1999a, and 1999b) who posits that nominal exchange rate flexibility causes financial and nominal shocks to result in misalignments of international relative prices rather than contribute to their stabilization in line with fundamentals.

27. Under the TOCA, factor mobility is considered a precondition for currency unions as a mechanism for adjusting to shocks unmitigated by an independent monetary policy and flexible prices. The attention has generally focused on labor mobility, as capital is highly mobile within the EU. Bayoumi and Eichengreen (1996) report that regional labor mobility in the United States plays a more important role in adjustment to shocks than wage flexibility or labor force participation. Much of the literature on this area finds that international labor mobility in Europe is significantly lower than within the United States or individual European countries and cross-country labor mobility is higher in Northern Europe than in the South.31 This evidence is interpreted as indicating an obstacle to the success of EMU and to U.K. membership. The relevance of labor mobility, however, is highly debatable as a shock-absorber in lieu of a flexible exchange rate or an independent monetary policy. The empirical evidence indicates that in Europe, even within national boundaries where legal barriers are absent, labor migration starts taking place only about four years after a shock has occurred—moreover, casual observation indicates that, in addition, the shock has to be perceived as permanent to trigger significant labor migration. This implies that labor migration, however valuable as a long-term adjustment mechanism, cannot be a means for short-term countercyclical stabilization.32 That is, even when labor mobility is unrestricted, such as within country, it cannot be counted upon to stabilize in any significant extent the type of economic fluctuations that are relevant to monetary policy.

H. Conclusions

28. This paper has reviewed the recent literature and empirical evidence on the main economic considerations influencing possible U.K. entry into EMU. The current state of economic analysis and empirical evidence on this area do not provide grounds for an overriding case in favor or against U.K. membership at this time. The main gains from joining EMU would be savings in the transaction costs and risk premium associated to exchange rate variability, as well as enhanced market transparency, with positive effects on investment, productivity, and growth. Although these gains are difficult to measure, they could be significant, particularly in the medium term.

29. On the negative side, joining the EMU would imply relinquishing an independent monetary policy and a flexible exchange rate. Thus, the main costs of joining the EMU would be associated with the possibility of monetary conditions that may not always be optimally tailored to the economic conditions in the United Kingdom. Since monetary policy in the EMU is tuned to the euro area as a whole, the likelihood that monetary conditions will be out of step with the U.K. economy, and the severity of the consequences, depends on the level of integration of the U.K. economy with the euro area. The balance of empirical evidence suggests that, currently, although the economic integration of the United Kingdom with the euro area is high, it is significantly lower than that of other countries in the EMU. Also, the level of integration with the North-American economic area is higher for the United Kingdom than for the euro area. As a result, output fluctuations in the United Kingdom are less correlated with the common euro area cycle than they are in the case of most EMU economies.

30. The five tests established by the authorities as criteria for taking a decision to join the EMU are broadly consistent with the main issues that are at the center of the debate in the economic literature. Particularly, the objective of achieving a higher degree of cyclical convergence and integration with the EMU economies on a sustained basis is well founded. As mentioned, the fluctuations in U.K. economic activity are not fully synchronized at present with those of the main EMU economies—although this is the case for some EMU members as well. Looking forward, there are indications of a trend to closer synchronization among European economies, including the United Kingdom—the dynamic patterns of co-movements in economic activity appear to be evolving, not the least because the creation of the EMU itself. Staff analysis also suggests that wage flexibility has increased in the 1990s. While many of the uncertainties regarding factors influencing EMU entry are likely to lessen over time, more evidence will be required before an overriding case for or against entry can be made on economic grounds.


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Prepared by Julio Escolano.


See “Statement on EMU by the Chancellor of the Exchequer” to the House of Commons (27 October 1997), and the associated publication HM Treasury (1997).


See Krugman (1990), Masson and Taylor (1992), and Bayoumi and Eichengreen (1996 and 1997).


For a discussion of wage flexibility in the United Kingdom, see the Selected Issues paper on “Wage Flexibility and EMU” in this volume.


See, for instance, paragraphs 19 and 24 below.


These issues are discussed further in paragraphs in Section G below.


Canzoneri et al. (1996) take 1970:Q1 to 1985:Q4 as the sample period (the period between the end of the Bretton Woods System and the beginning of the hardening of the ERM), in order to observe a regime of reasonably flexible exchange rates.


For example, Currie (1997) singles out this argument as one of the most significant in the view of many EMU proponents.


See “United Kingdom—Staff Report for the 1999 Article IV Consultation,” and the Selected Issues paper “Issues Relating to Inflation Targeting and the Bank of England’s Framework” in this volume.


Buiter (1997) compares the network externality associated with the use of a common currency to the externalities from adopting a common language, measurement system, or compatible software.


The increase in the net rate of return to investment would result from both increased gross return to business activities and lower borrowing rates, due to the elimination of transaction costs and the risk premium associated to exchange rate variability and other risks.


Discriminatory pricing of some products (e.g., cars) between the United Kingdom and other EU countries has recently raised concerns among consumer organizations and the authorities in the United Kingdom.


Buiter (1999a) estimates seigniorage revenue in the United Kingdom—defined as either the value of the annual increase in base money or the notional annual interest foregone on the stock of base money—at about 0.2 percent of GDP per annum. This estimate of both the average annual increase in the monetary base and the interest bill foregone corresponds to the average of the period 1994-1998.


Updated estimates based only on the EU-11 countries plus the United Kingdom indicate that the U.K. monetary base also represents about 9 percent of the joint amount and that the U.K. capital share in the ECB would be 15.7 of its joint capital.


HM Treasury (1997) draws similar conclusions based on 1995 data. Weaker trade integration with EMU also diminishes the potential gains from lower transaction costs and exchange rate variability.


Bean (1999).


In 1995, 66 percent of U.K. households owned their own homes compared to an EU average of 56 percent; mortgage debt in the United Kingdom was 57 percent of GDP compared to an EU average of 33 percent of GDP (HM Treasury (1997)).


For a discussion of this possible outcome of a currency union, see Krugman (1993).


This study is discussed below in greater detail.


In the last sample year (1995), the United Kingdom shows the lowest level of agreement with the TOCA criteria among the European economies.


Bayoumi and Eichengreen (1997) explain away the surprising and counter-intuitive result for France on the grounds that this country is large and relatively close by European standards, with trade representing a comparatively low share of its GDP.


In Artis and Zhang (1998b), this implies defining for each country a “distance” from Germany (or dissimilarity coefficient) measuring the degree by which their bilateral economic relation with Germany deviates from the TOCA criteria. The variables used to proxy the TOCA criteria are correlation in business cycle, volatility of bilateral exchange rate, correlation in interest rate cycle, bilateral trade (as percent of total trade), inflation differential, and labor market flexibility (measured by the relative ranking of a country’s employment protection legislation).


Artis, M. and W. Zhang (1998a) reaches very similar conclusions using fuzzy clustering analysis—a related, but different methodology.


Artis and Zhang (1998b) also finds evidence of two other non-European clusters in their sample: one comprises the United States and Canada, and the other only Japan.


In this study, the sample period for quarterly output data was 1960:1-1997:4 and the countries and economic areas considered were the United Kingdom, United States, Canada, France, Germany, Italy, the euro area, and North America.


See Bayoumi and Eichengreen (1996) and Buiter (1997). The latter, for example, points out that the standard identifying restriction that demand shocks have no long-run effects only makes sense for monetary policy shocks and not for (permanent) fiscal policy shocks. OECD (1999) also contains a discussion of VAR methods used in connection with defining criteria for EMU membership.


See Masson and Taylor (1992).


See Buiter (1999b) and Bayoumi and Eichengreen (1996).


See the Selected Issues paper “Wage Flexibility and EMU” in this volume.


See Bayoumi and Eichengreen (1996) and Masson and Taylor (1992).


A similar conclusion is presented in Bean (1992) and Buiter (1997).