Britain stands aside ... and events pass us by

We can join EMU late but all the big decisions will have been taken, warns Francesco Giavazzi
Click to follow
The Independent Online
Now Chancellor Kohl has decided to stand for office once again in 1998, the odds that EMU will go ahead as planned have significantly shortened.

Mr Kohl has stated that Europe will be a central plank in his election manifesto, and that by the time Germany goes to the polls the single currency will be a fait accompli. This is no surprise: the German elections will take place in October, just five months after the decision on EMU. If Mr Kohl had accepted a postponement of EMU, he would have implicitly admitted that his entire European strategy had failed, and that his critics (who keep repeating that EMU represents a serious danger to German stability) were right.

On the contrary, what we shall see in the coming year is a resolute Chancellor who will attack the opposition head-on and accuse those critics - if ever they indulge in Euro-scepticism - of being myopic and failing to understand the big issues in history. He may not be right, but he will certainly be very difficult to resist.

The scenario the new UK government will face on the eve of 1 May is thus one in which the single currency train is firmly on track. Mr Kohl is in the driving seat, a few passengers (notably French, German, Dutch, Belgian, Irish and Austrian) are comfortably ensconced, while others (notably those from the Club-Med countries) are struggling to get on. Whether to watch the train go by, or try to jump on it, will be the first big decision facing the new team at 10 Downing Street.

If the UK decides to wait, catching the train further down the line will certainly be possible (as it was with the European Community in the 1970s and with the ERM in 1990), but by that time every important decision will have been taken, and the UK will not be in a position to exercise much influence.

Among these decisions, one of the most crucial concerns the exchange rates to be used to convert individual currencies into Euros. Bilateral rates among the currencies that join EMU will be irrevocably fixed on 1 January 1999, but which exchange rate should be used on that day remains an open issue - and possibly a controversial one since this will be the last chance to use the rate to gain a competitive edge.

One idea currently being touted suggests that conversion rates should be left to the markets to decide. Governments and central banks should adopt a hands-off strategy, and let the markets freely determine the conversion rate to be used on the last day (31 December, This seems crazy: markets price a currency today based on their expectation of the value of that currency tomorrow. On the day before francs and deutschmarks disappear, the markets will lose any anchor - they will be unable to price the stuff. But precisely because markets will lose this anchor, central banks will be infinitely powerful: they will be able to drive the exchange rates wherever they wish. All of this means a lot of uncertainty and volatility - hardly the best conditions for managing a smooth transition into the new single currency.

Is there a better solution? In a new report, EMU: Getting the End-Game Right (published by the London-based Centre for Economic Policy Research), we set out a consistent proposal: an early announcement of bilateral conversion rates based on existing ERM parities. This would reduce uncertainty about conversion rates and the temptation to manipulate them in order to obtain a competitive edge. There would also then be no need for narrow bands during the interim period, thus avoiding the accompanying risk of speculative attacks in the very fragile period between May and December 1998. This solution avoids the pitfalls of other plans currently under discussion, such as letting the markets decide.

The proposal set out is as follows:

Pre-announce bilateral rates and use floating bands (or, failing that, very wide bands) to proceed to the pre-announced fixed-end points. Provided conversion rates are credible, market exchange rates will smoothly converge on conversion rates without any need for intervention while EMU is still some way off.

Complete credibility of bilateral conversion rates requires, if necessary, the prospect of substantial intervention on 31 December to enforce these rates. But any monetary effects of such interventions will automatically be undone by the first act of the new European Central Bank. In other words, a national central bank does not have to take chances with inflation to bail out other currencies. There will not be time for its economy to be affected before policies are reversed. Moreover, and more importantly, being credible, such intervention is unlikely to be required.

The proposal also specifies how pre-announced conversion rates should be determined: they should be based on current ERM central parities. Currently, such rates pose surprisingly few problems for the competitiveness of EU members.

This in turn suggests a natural way in which to handle the latecomers. These countries should be required to join at exchange rates, relative to the Euro, based on central parities at the time their EMU membership is accepted. The Maastricht requirement of no devaluation for two years prior to EMU entry would remain in force.

This maintains the principle of equal treatment, reduces avoidable uncertainty about future rules for admission, but recognises the reality that countries deemed to have failed adequately to converge may then face huge pressure for immediate depreciation. Requiring their eventual entry at rates based on 1997 parities would impose years of deflation and would therefore lack credibility.

When the "new" EMS was set up a year ago (the arrangement linking the Euro and the currencies of those countries that will not join the EMU), the UK monetary authorities lost an important chance to convince Europe that a generalised system of inflation targets (such as those operated by the Bank of England) would be superior to exchange rate bands.

On that occasion the UK position on EMU was instrumental in reducing its bargaining power.

In the next few months a large number of important decisions will be taken that will shape the future of EMU - from Europe's payment system to the way in which the ECB will run monetary policy.

The later the UK changes its attitude towards EMU, the more it will face a system that has been shaped without its contribution. This will not only be a loss for Europe, but a significant loss for the UK.

Francesco Giavazzi is Professor of Economics at Bocconi University, Milan and a co-Programme Director of CEPR's international Macroeconomics programme. He is the co-author (with Professors David Begg, Jurgen can Hagen and Charles Wyploosz) of 'EMU: Getting the End-Game Right', published by CEPR. Telephone 0171 878 2900; fax 0171 878 2991.