Stability of the eurozone adds to the attractions of the single currency

The case is proven for EMU now, argues the National Institute of Economic and Social Research
Click to follow
The Independent Online

As economists it is difficult to have a decisive view on the question of the UK's membership in the European Monetary Union. Economics can only play a part in the final decision, which must ultimately be a political one. But it is important that the economic input into the political decision is of the highest quality. One important aspect of the economic effects of EMU membership is the way that volatility may change if we join EMU. By volatility we simply mean the unforeseen fluctuations that affect economic decision makers. It is a strange contradiction that while it is often very hard to measure volatility, in many ways the only sure thing about EMU membership is that certain aspects of volatility will be removed. So in the euro area there will be no volatility in the sterling-euro exchange rate nor between UK and European interest rates.

As economists it is difficult to have a decisive view on the question of the UK's membership in the European Monetary Union. Economics can only play a part in the final decision, which must ultimately be a political one. But it is important that the economic input into the political decision is of the highest quality. One important aspect of the economic effects of EMU membership is the way that volatility may change if we join EMU. By volatility we simply mean the unforeseen fluctuations that affect economic decision makers. It is a strange contradiction that while it is often very hard to measure volatility, in many ways the only sure thing about EMU membership is that certain aspects of volatility will be removed. So in the euro area there will be no volatility in the sterling-euro exchange rate nor between UK and European interest rates.

Over the last year the National Institute of Economic and Social Research has studied the likely effects of these volatility changes. The first thing, which is common to all our work, is that the measure of volatility must be a sophisticated one. This is because we are making a decision about the future. Most simple measures of volatility are averages in one form or another over the past. They are relevant to decisions regarding the future only if we expect the future to be similar to the past. This will generally not be the case when we are considering the question of EMU membership. So we must use quite sophisticated techniques to measure the changing patterns of volatility.

To our surprise the relationship between the shocks affecting output and inflation in the UK and those of euro area countries has changed considerably over time.

This is important because one of the key criteria for a successful monetary union is that the shocks, which hit the member countries, should be similar. If they are, then policy can respond in an effective way even if the union constrains policy to be the same across the whole union.

If we consider a historical average correlation for these shocks then clearly the UK has not been a good candidate for membership. But when we realize that this average is overlaid with a steady rise in the correlation to the point where we are now in a very similar position to France or Italy the picture looks very different.

The conclusion of this work is that the UK is in a very similar position to the rest of Europe now in terms of the symmetry of economic shocks. In fact the European economy that is most dissimilar from the others is Germany.

The second broad issue to consider is, what will be the effect of removing the volatility in the sterling-euro exchange rate. This is after all one of the only sure effects of EMU entry. Here again we have come across some quite surprising results. Some people argue that growth and flexibility is greater in the UK than in the rest of Europe and that we should not join EMU until the rest of Europe has reached our level. However, evidence of our recent work throws doubt on this argument. Our studies do not dispute the point that the UK is more flexible and has been growing faster recently.

The question they pose is, if the UK is growing faster and is more flexible why should an investor (say from America) choose to invest elsewhere in Europe. The answer is quite straightforward; most investors wish to maximize their returns but also minimize their risks. The UK may be a good place to invest but while the sterling-euro exchange rate is uncertain there is an incentive for an investor to diversify risk by spreading some of his investment across Europe even if the expected return is lower there.

So the conclusion is that even if the UK economy may be performing well relative to the rest of Europe we would actually gain by removing the volatility in our exchange rate with the euro as this would remove the incentive for investors to diversify away from the UK.

In separate work, the Institute researchers have found significant evidence for this effect in general foreign direct investment into the UK, in the foreign direct investment in research and development and with respect to overall domestic investment. This suggests that there would be considerable benefits to UK investment from EMU membership, which would ultimately have important long-term supply side effects producing stronger growth. In effect, this evidence suggests that the strong regions of a monetary union tend increasingly to prosper and that there is absolutely no need to wait until all regions are equally efficient before joining.

What other benefits might we expect from the changing volatility patterns? One definite consequence of membership is that our interest rates will be fixed with respect to general euro area rates. Whether this will lead to higher or lower interest rates in the future is unclear. In the recent past, UK rates have been higher than European rates but this may not continue indefinitely. What we almost certainly can predict, however, is that the volatility of UK interest rates is likely to be lower if we join. This again is likely to have widespread benefits to investors and businessmen who have to plan for the future. It may also have an important impact on the housing market. Over the past 30 years one of the biggest problems facing policy makers has been the dramatic fluctuations that have taken place in the housing market. House prices relative to income have risen dramatically on three separate occasions over a prolonged period and then collapsed back to their original level.

Our interpretation of house price movements is that they are classic examples of an asset price bubble. The question is what starts the bubble? Our argument is that one possible trigger is interest rate volatility. Interest rates fall in an unexpected way, mortgages become cheap (at least in nominal terms) this causes a temporary rise in the demand for houses, house prices begin to rise and the bubble begins as people buy in expectation of further price rises. If the volatility in interest rates were reduced this would reduce the chances of bubbles starting in this way. The Chancellor recognized the problem posed by the housing market in his last budget speech and has suggested reform of the housing market should be considered. We argue that EMU membership is one important way of reducing the risk of future bubbles.

In our view one of the most important aspects of EMU membership from an economic perspective is the positive impact it has on the volatility effects outlined above. Joining the euro area will provide a more stable environment and one in which the UK should be able to compete effectively with the other European economies.

Martin Weale is a director of the National Institute of Economic and Social Research. This article describes work led by Ray Barrell and Stephen Hall at the NIESR.

Comments