Son of ERM can stave off a shotgun wedding
`Higher public borrowing by our European neighbours will increase the level of real interest rates throughout the single EU capital market, whether or not that market is bound together by fixed exchange rates. We cannot declare independence from these effects'
Monday 09 December 1996
For example, there is our attitude to Stability Pact, a budgetary arrangement that will be probably be agreed in principle at the Dublin summit next weekend. The Germans have been asking for a "pact with teeth" but sadly, according to one government official this week, the outcome is likely to be a "pact with dentures". This means that the teeth in the mechanism will be removable by the user at will, ie that the enforcement mechanism needed to avoid excessive budget deficits inside the single currency will not be as tough as the Germans originally proposed. Even so, we should recognise that this "pact with dentures" is in the interests of all low- debt economies like the UK, whether or not we join the single currency.
This particular penny has not yet dropped in the minds of the Euro-sceptics, who seem hostile to the pact as a generality, and not just as it would apply to the UK if we ever joined EMU. The point is that higher public borrowing by our European neighbours will increase the level of real interest rates throughout the single EU capital market, whether or not that market is bound together by fixed exchange rates. We cannot declare independence from these effects.
Martin Brookes of Goldman Sachs has recently estimated that a successful Stability Pact will eventually reduce the level of European real interest rates by up to a full percentage point (admittedly over 25 years). The UK has a very strong vested interest in encouraging this to take place. Not only will it save the government about pounds 4bn a year in interest payments, but it will also boost the level of capital investment, and the rate of sustainable GDP growth. Why anyone should imagine that it is in our interests to encourage the Italians to run huge budget deficits - which by implication is what the Euro-sceptics are arguing - is most unclear.
Another question which will be raised by the Dublin summit is whether the UK should consider rejoining the new ERM system. Obviously, this is not an imminent question, since the initials E-R-M are too horrible to mention in the presence of the Conservative Party. However, if we imagine the quite likely circumstances of a change of government, followed by a decision by a Blair administration to stand aside from the first round of EMU itself, things would suddenly look very different. A large element of the Labour cabinet would want the UK at minimum to adopt the status of a "pre-in", rather than a permanent "out", and a crucial litmus test of Labour's sincerity in this regard will be membership of ERM2.
Memories of our last experience with the ERM are so painful that any suggestion that we should rejoin is likely to be met with much derision. However, after the single currency has been launched, the risks of the UK simply drifting away from our closest neighbours are intense. Their main political attention will be on making EMU work, and they are likely to become resentful about the UK acting as a "free rider", taking advantage of the single market without accepting the obligations of membership of the single currency. If we intend to place ourselves nearer the heart of Europe, as a Labour government presumably will, we can hardly do this while standing completely aside from monetary integration. By committing ourselves to ERM2, we would be reassuring other EU members that we had no intention of indulging in competitive devaluations against them, and indeed that we intend to enter the single currency when our economy is sufficiently integrated with theirs.
Some people would argue that if we are to rejoin ERM2, then we might as well go the whole hog and join the single currency itself. But this is quite wrong. The unique disadvantages of the single currency are first that we would be giving up the ability to vary domestic monetary policy in response to domestic economic shocks, and second that there would be no viable exit route for the UK in the extreme circumstance where things go very wrong. It seems doubtful the UK economy is yet sufficiently integrated with the core EU countries to justify taking these risks. Under ERM2, we would not have to.
The ERM2 proposal is that a central rate should be set for sterling against the euro, but that the intervention bands should be wide, probably of the order of 15 per cent either side of the central rate. Later, these bands could be narrowed as the process of integration proceeds. For illustration, the graph shows what this might have involved if sterling had joined such a mechanism early this year, though for familiarity we express the entry rate against the German mark, rather than against the (non-existent) euro. This does not change the substance of the argument.
The central rate chosen on the graph is DM2.55. Recall that sterling originally joined the ERM in November 1990 at a rate of DM2.95, but in retrospect most observers appear to believe that this rate was set too high, and that a rate of (say) DM2.80 would have been more appropriate.
If we update this DM2.80 rate from 1990 to the present, using relative price inflation in the two countries over the relevant period, we find that the central rate implied by this process is around DM2.55, which happens to be very close to today's actual rate. This is also confirmed by recent econometric analysis by Jim O'Neill and Stephen Hull of Goldman Sachs, which concludes that the equilibrium for the exchange rate on various estimates is between DM2.42 and 2.76.
If we rejoined the ERM at a central rate of DM2.55, then the limits of the bands would be DM2.95 and DM2.15. This encompasses virtually the whole of sterling's actual fluctuations since the ERM broke up in 1992, which implies that we would be left with all of the freedom we need to vary domestic monetary policy, and to allow sterling to oscillate up and down with interest rates.
But these temporary fluctuations would be very different from accepting a trend devaluation in sterling over long periods, which we would actively seek to avoid. This would be a perfectly good compromise until the UK felt that it was sufficiently integrated with other EU economies to justify full membership of EMU. In the choice between being semi-detached from the EU, and wholly detached from it, ERM2 and the Stability Pact have important roles to play, and it would be sad if false analogies with ERM1 were to prevent this from being properly considered.
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