Over the last four months, I have been a member of a panel of economists and business people (several of whom have extensive public sector experience) who have met regularly to focus on a rather different aspect of EMU than the one about which most noise is heard. The panel, set up under the auspices of the Centre for Economic Policy Research and chaired by Rupert Pennant- Rea was asked to consider what the practical economic policy issues were of following various strategies towards the single currency. The issue was not whether the UK should be in or out. Had that been the question, writing a report (a task which fell to me) to which all members of the panel could put their names, would have been impossible. But, in fact, there was a surprising amount of agreement on what the policy implications of foll- owing different strategies were.
Our starting point was the observation that whatever course the Government eventually takes, there will be big changes in the economic environment, and these changes require policy responses. Some were widely recognised: for example, a decision to join EMU would require that the Bank of England should have more than operational independence over monetary policy. But other implications of joining have not been analysed so carefully. For instance, being in a monetary union would be less problematic for Britain if its sensitivity to interest rates were more like that of other EMU members. Could that be engineered and, if so, how? Any such policies would take time to implement and bear fruit, which therefore affects dates when it would be sensible to join EMU.
Our analysis was based on the view that the UK Government has four possible strategies for EMU:
Join at the start;
Decide to join at a later stage;
Wait and see. The pragmatic agnostic's position: if EMU works, then join up at some unspecified date;
Decide in principle not to join.
Joining at the start would require:
A fully independent central bank by the end of 1998. The Government would therefore have to attach high priority to drafting and passing a new Bank of England Act that was, in important respects, different from that outlined by Gordon Brown, when he gave the Bank operational independence.
A significant tightening in macro-economic policy before the UK was subject to an interest rate that would probably be much lower than it needs for its current cyclical state. Interest rates in EMU's first-wave candidates are now 3 per cent below UK rates, and the gap might be wider in a year's time.
A lower exchange rate.
Enhancing automatic fiscal stabilisers, to compensate for the loss of autonomy over monetary policy.
Reducing the tax incentive to use debt. This will help make the transmission mechanism of UK monetary policy more like that in other EMU candidates.
A decision to delay entry by, say, three or four years would ease or eliminate the practical problems of trying to achieve these things in time for the start of EMU. It will not be imperative to make the Bank of England fully independent by the end of 1998, though legislation should not be delayed for long. It will also be desirable to bring in legislative measures to enhance the fiscal stabilisers; they will then have a chance to start working.
But the bigger advantages of delay relate to conjunctural and exchange rate concerns. By 2001 or 2002 the EMU interest rate may well be broadly what the UK economy needs in the cyclical circumstances it will then find itself.
A wait and see strategy has the obvious advantage that some of the uncertainty about EMU - on the operation of monetary policy, on the demand for, and value of, the euro, on the strains generated by a single short-term interest rate for all the "ins" - will be reduced. But in order to keep open the option of joining EMU some way down the road it would still be desirable to reduce the fiscal deficit and remove tax incentives to use debt. It would also be sensible to draft the amendments to the Bank of England Act in a way which allowed it to operate as part of the European System of Central Banks should the UK join EMU.
If the UK was to stay out of a monetary union how the value of sterling fluctuated against the euro would be of great significance. The sterling- euro exchange rate would be more important for UK business than any bilateral rate now is. Sharp fluctuations would be more damaging than a similar fluctuation in a bilateral rate today. And because countries inside the single currency area could not independently do much to alter competitiveness against the UK they are likely to be more sensitive to the exchange rate implications of UK policy.
The surest way for the UK to minimise discrimination against British- based firms is to participate actively in the development of the single market. If the UK stays out of EMU, this will be even more important - and perhaps more difficult too. Much will depend on attitude. If the UK is seen as a constructive agnostic on EMU, it will be listened to on subjects such as competition policy. If it comes across as a whinging outsider, it won't.
Our key message is that time lags are crucial. It takes time to change tax rates, or to change the Bank of England's status, or to increase the role of fiscal stabilisers, or to move into fiscal surplus. It takes even longer for the impact of changes in taxes or regulations to feed through. Without a clear picture of the time lags it is hard to set priorities and make decisions on entry.
David Miles is Professor of Finance at Imperial College, University of London, and an Economic Consultant at Merrill Lynch. Hamish McRae is away.
'The Ostrich and The EMU: Policy Choices Facing the UK' is pub-lished by CEPR with support from the Esmee Fairbairn Charitable Trust. Tel: 0171 878 2900; Fax: 0171 878 2999.