(Reprinted from HKCER Letters, Vol. 3, July 1990)
The European Monetary System,
the European Monetary Unit
and the United Kingdom
Michael J. Artis
Previous U.K. View of the EMS
When the European Monetary System (EMS) began in 1979, the British position was one of skepticism. Most British economists believed that this system was not going to make a difference to anything and that it was unlikely to survive.
The outgoing Labour government of Mr. Callaghan thought that the system would tend to freeze nominal exchange rates, thus appreciating the real exchange rate, and Britain would be threatened with a possible loss of competitiveness.
The incoming administration of Mrs. Thatcher took a different view. They wanted to beat inflation by the standard kind of Friedmanian monetarist policy of reducing the rate of monetary growth. They argued that it was not possible to both have an independent monetary policy and belong to a system which was fixing nominal exchange rates.
Success of the EMS
It turned out that the EMS did survive and was quite successful. First of all, the system has been effective in stabilizing nominal and even real exchange rates among its members. It seems to have slowed down the tendency for real exchange rates to depart from equilibrium, relative to what appears to happen to the yen, the sterling, the dollar, currencies which are outside the system.
Secondly, countries within the system seemed to be able to reduce inflation in a relatively less costly way. What they did was to fix their exchange rates more or less within the bounds vis-a-vis the Deutsche mark. Since historically Germany has a very sound counter-inflationary record, a country which commits itself to targeting the Deutsche mark carries with it some additional credibility in fighting inflation.
Skeptics of the EMS would argue that the system has survived only on the basis of using exchange controls of capital flows, and that is not a tolerable position for the United Kingdom to adopt. These controls allowed the non-German members of the countries an extra degree of freedom, not always to have to follow the lead of the Bundesbank. They also protected the process of realigning the official rates of exchange between countries from destructive speculation. Under the provision of the Single Market Act in 1992 these exchange controls are to be abolished. This suggests that, failing additional cooperation, countries may have to follow the German lead more closely than before.
British Experiences outside the EMS
In the meantime, in the United Kingdom, we did have an independent monetary policy geared towards reducing inflation by monetary targeting, but it was a particularly unfortunate choice of economic strategy. Inflation did fall but in a very costly manner. The exchange rate appreciated substantially in the early 1980s, sharply lowering the competitiveness of industries. The recovery from that did involve the government backtracking on its commitment to monetary targets and taking the exchange rate seriously. Indeed, under Mr. Lawson in the period 1987 to 1988, monetary policy appeared to be to target the sterling at 3 Deutsche mark.
Nevertheless, I must say that Mr. Lawson's policy turned out to be a very bad experiment. It meant that nominal interest rates in the United Kingdom had to fall towards the levels prevailing in the continent of Europe. In retrospect, it seemed more appropriate to increase interest rates because inflation in the United Kingdom was not really as low as on the continent.
Pros and Cons of Joining the EMS
The two strongest points in favor of joining the system are, first of all, it does seem to provide a framework for inflation control, at least over the long run. The second point is the exchange rate stability which has been exemplified, and this is something which the British industry at large seems to desire.
On the other hand, there are two major arguments running in the other direction. First, in the short run there is the risk of actually increasing inflation. British membership in the EMS means that British interest rates should reduce towards the continental European levels and this may be inappropriate if the inflation rate is higher than in the continent.
I think this does not really matter that much. If interest rates are dedicated to the exchange rate target, then one must have another instrument to devote to inflation, and it could be fiscal policy. The current British government has made it a practice to unnecessarily divorce fiscal policy from current short-run economic management. I think they have overdone it, and if it were to join the EMS, it would have to have a more flexible fiscal policy than it has now.
The second thing which the current government will regard as a problem is that the way which the EMS is evolving now seems to be leading rather directly to the European Monetary Unit (EMU). In order to maintain fixed exchange rates and free trade after the removal of exchange controls, either all the members must follow the leader or they must increase the degree of cooperation. The problem for the United Kingdom is that moving to EMU means that she does not have any monetary policy of her own. There is, at best, shared monetary sovereignty. The current government is thinking of ways of joining the EMS without being committed to the EMU.
At What Rate to Join?
If a country joins at the current exchange rates with an inflation rate which is higher than those of the other countries, then it seems all too likely that two or three years later, the exchange rates will have to be realigned. Realignment very soon will be incredible. On the other hand, it would also be incredible to join the system on the basis of devaluing shortly before it. One solution that people used to offer was to join with a wide band, wider than the members currently have. A country would join at the top of the band on the basis that it can float down within the band while its inflation is in excess of the others. It does not have to realign, so there is no loss of credibility.
If we decided to join, we should join at a wider band partly for another reason. The sterling is more widely held than the French franc and the lira and so forth, and is more likely to be used as a speculative vehicle. There is some danger that speculation between sterling and the Deutsche mark could be bigger and more substantial than between the French franc and the Deutsche mark. For that reason a wider band would allow the exchange rate some adjustment without changing the interest rate, which is the main alternative.
The EMU Issue
The British government has argued that the logic does not require the EMS to move to an EMU. Indeed, centralizing the preferences of all the member countries in EMU is actually going to dilute the counter-inflationary bias of the system which it had in the past. It is going to weight the Bundesbank low inflation preference with some somewhat higher inflation preferences in France, Italy and Greece etc. Consequently, the inflation rate that could emerge from the EMU is going to be higher than the inflation rate that would emerge from a system dominated by the Bundesbank.
A little while ago that seemed to me a purely political construct with merely the purpose of delaying or scraping the EMU. However, since the unification of Germany issue has come up, people are now questioning whether the German leadership, based on low inflation, is going to survive. In that case, there is the question of who would be a credible leader. So one problem about the EMU now is how to slot into it the German unification. The French argument is that German unification is an argument for EMU, not the contrary. They do not wish Germany to become an even larger and more dominant economic power in Europe than it is now. They want to tie Germany down to the institutions of Western Europe.
Nonetheless, there are all sorts of other arguments for EMU. There is good evidence that monetary and financial unions increase the efficiency of resource allocation, investment and saving, and so forth. All of these add to the gains from 1992, which themselves are now thought to be quite large.
Professor Michael J. Artis teaches economics at the University of Manchester and is an associate editor of the Economic Journal published by the Royal Economic Society. The above was a talk he gave when he visited the Centre.