Is Europe Ready for EMU? Theory, Evidence and Consequences
Over the last 20 years, economists have studied the potential impact of
monetary union between countries under the rubric of optimum currency area
theory. It concludes that a single currency boosts participants' living
standards when they possess similar economic structures and international
trading patterns, but proves detrimental where these diverge. In view of the
potentially devastating impact of locking a country's currency within an
international regime ill-suited to meeting domestic and external economic
goals, as witnessed under the Gold Standard of the 1930s, it is surprising
that the need for prior and sustainable real convergence between economies is
paid relatively scant attention.
Indeed, the so-called Economic and Monetary Union (EMU) 'convergence
criteria' are more concerned with examining transitory cyclical
movements in financial indicators, rather than concentrating upon fundamental
structural convergence in the real economy. Perhaps this is not entirely
surprising, as the EMU project was designed by central bankers! However, not
only it is a matter of grave concern that that EMU proposes to proceed upon
such a flimsy theoretical base, but this is magnified by the fact that this
approach is untried without historical precedent. There has never been a
monetary union which existed independently of political union and no
independent country has ever unilaterally abandoned its own currency
(Goodhart, 1995). EMU is therefore a 'leap in the dark' which has potentially
destructive implications if its participants are not sufficiently converged
prior to its establishment (Eichengreen, 1992 and 1993).
The October 1997 statement by the Chancellor of the Exchequer sought to
clarify the Government's approach to EMU, with the detailed argument laid out
in the accompanying Treasury document: UK Membership of the Single
Currency: An Assessment of the Five Economic Tests (HM Treasury, 1997).
However, both the speech and the report are ambiguous. The latter is designed
to provide an objective assessment of the advantages and disadvantages of
joining a single currency, but it frequently displays a bias in favour of
participation unsupported by its own research. A recurrent assertion is that
'participation in EMU will be beneficial', although little evidence is
produced, with the balance often implying the reverse.
Therefore the Treasury document is an uneasy blend of assumptions and
analysis, prompting doubts concerning the five economic tests created as the
guidelines for UK entry into a single currency. Furthermore, their choice is
neither explained nor related to contemporary economic theory. Hence, this
pamphlet seeks to examine the criteria and tests advanced to support EMU
membership, together with analysing the potential impact upon the UK following
the adoption of a single currency by other EU member states.
The determination of which individual European Union (EU) member states are
suitable candidates for a single currency is supposedly achieved by their
attainment of the five Maastricht convergence criteria (MCC) established in
the Maastricht Treaty (EC, 1992):
- each country's rate of inflation must be no more than 1.5% above the
average of the lowest three inflation rates in the EMS;
- its long-term interest rates must be within 2% of the same three
countries chosen for the previous condition;
- it must have been a member of the narrow band of fluctuation of the ERM
for at least two years without a realignment;
- its budget deficit must not be regarded as 'excessive' by the European
Council, with 'excessive' defined to be where deficits are greater than 3% of
GDP for reasons other than those of a 'temporary' or 'exceptional'
- its national debt must not be 'excessive', defined as where it is above
60% of GDP and is not declining at a 'satisfactory' pace.
Although the initial two criteria have a clear rationale with respect to
the establishment of a single currency area based upon the achievement of
prior cyclical convergence, the latter three have fostered both theoretical
and empirical controversy. With respect to the third indicator, the 'normal'
fluctuation bands cited in the Maastricht Treaty were interpreted until 1992
as the narrow margins of 2.25% around the central parity. However, following
the 1992-93 exchange rate crises, these bands widened to +/-15% for an
indefinite period whilst Italy and the UK withdrew from the ERM. Consequently,
the EU member states initially accepted these wider margins as the exchange
rate regime most likely to prevail until the initial wave of countries enter
EMU (Aglietta and Uctum, 1996). However, at their June 1996 meeting EU Finance
Ministers agreed to ignore the ERM membership precondition since few countries
would meet the condition. In the process, they abandoned their earlier policy
of successively reducing the level of exchange rate fluctuations and
preventing realignments prior to the establishment of a single currency in
order to minimise adjustment costs.
The inclusion of the final two indicators as means to establish the
compatibility of potential participants within a monetary union is highly
questionable. The prominent justifications for their use are, first, that they
would result in a stable debt ratio in a steady-state economy with 2 %
inflation and 3% real growth (TUC, 1993 ); and second, through advocacy of the
'golden-rule' that current government expenditure and revenue should be
equated, together with the estimate that EU public investment approximately
averaged 3% over the period 1974-91 (Buiter et al. , 1993) .The first
justification is problematic since the fiscal reference values are compatible
with any combination of inflation and growth which summate to 5% per
annum. Furthermore, there is no evidence that attainment of these criteria
would result in a steady-state economy (Arestis and Sawyer, 1996). With
respect to the second justification, the operation of such fiscal rules
requires the unlikely situation of zero inflation, otherwise inflation
accounting must be undertaken. Additionally, the 60% national debt criterion
is problematical as it is largely a consequence of the prior
accretion of debt, reflecting past fiscal activities rather than current
policy (Goodhart, 1992).
Despite the problematic nature of the MCC, it is nevertheless the case that
the architects of EMU believed that their attainment would indicate the
compatibility of potential participants, together with providing a guide to
their subsequent maintenance in both favourable and unfavourable economic
conditions (Baimbridge, 1997). Indeed, the prerequisite of prior convergence
should be equally significant over each part of the economic cycle, if EMU is
to prove robust against symmetric and asymmetric shocks (Eichengreen, 1992;
Bayoumi and Eichengreen, 1993). However, examining the extent to which EU
member states have actually met the MCC during the past 8 years, a period
including both a recession and boom, makes disappointing reading for
supporters of European monetary integration. Only in 1997, the crucial year
prior to the choice of initial EMU members, does compliance with the MCC begin
to approach that necessary for a sustainable monetary union. Although only two
EU member states achieve all five MCC based upon strict adherence to their
Table1: EU Member States' Status on MCC
|Country ||1990 ||1991 ||1992 ||1993
||1994 ||1995 ||1996 ||1997 ||Average|
|Luxembourg ||5 ||5 ||5 ||4 ||5 ||5 ||5 ||5 ||5|
|Denmark ||5 ||4 ||4 ||3 ||3 ||4 ||4 ||4 ||4|
|France ||5 ||5 ||4 ||4 ||4 ||4 ||4 ||5 ||4|
|Germany ||5 ||4 ||4 ||3 ||5 ||4 ||3 ||4 ||4|
|Ireland ||4 ||4 ||4 ||3 ||3 ||4 ||4 ||4 ||4|
|Austria ||4 ||4 ||3 ||2 ||3 ||3 ||3 ||4 ||3|
|Belgium ||2 ||3 ||3 ||3 ||3 ||3 ||3 ||4 ||3|
|Netherlands ||3 ||4 ||3 ||3 ||3 ||3 ||4 ||4 ||3|
|UK ||3 ||3 ||2 ||2 ||3 ||3 ||2 ||4 ||3|
|Finland ||2 ||2 ||1 ||1 ||2 ||2 ||3 ||4 ||2|
|Sweden ||2 ||3 ||2 ||1 ||1 ||1 ||2 ||3 ||2|
|Spain ||1 ||1 ||1 ||1 ||1 ||1 ||1 ||4 ||1|
|Portugal ||0 ||0 ||0 ||0 ||0 ||0 ||1 ||4 ||1|
|Greece ||0 ||0 ||0 ||0 ||0 ||0 ||0 ||0 ||0|
|Italy ||0 ||0 ||0 ||0 ||0 ||0 ||0 ||3 ||0|
|Number Meeting all MCC ||4 ||2 ||1 ||0 ||2 ||1 ||1 ||2 ||2|
Table 1 shows that the achievement of all five criteria was fulfilled on
only 13 from a possible 120 occasions. Such a record in the period preceding
EMU, when member states retained considerable control over their economies, is
highly significant. Indeed, it is only Luxembourg, a country atypical of the
other EU members' economies, which appears able to consistently meet the 5
criteria, whilst of the remaining fourteen nations only three have ever
secured total compliance with the convergence indicators: France (1990, 1991
and 1997), Germany (1990, 1994 and 1997) and Denmark (1990).
Furthermore, if we take the average number of criteria met to provide an
indication of the 'fitness' of a given EU member state to participate in EMU,
it would appear that only Luxembourg, Denmark, France, Germany and Ireland
come close to satisfying the convergence indicators permanently. Even for
these countries, their inconsistency is problematic. Thus, the available
evidence provides little support for the ability of member states to both
achieve and maintain the stipulated convergence criteria for more than
momentary periods. This situation is likely to result in the operation of a
single EU currency becoming unsustainable in the medium - to long-term.
In view of the rather limited and theoretically suspect set of indicators
established by the Maastricht Treaty, the British Government adopted five
supplementary tests which are claimed to be criteria for the decision whether
EMU membership would be beneficial for Britain. These are:
(i) Whether there can be sustainable convergence between Britain
and the economies of a single currency - in a dynamic global economy,
it appears increasingly unlikely that the economies of countries can converge.
Even if they did, differential productivity, technology and demand changes,
together with the discovery of new process and commodities, will inevitably
re-establish 'divergence'. Another difficulty is that the Treasury document
slips between, and never precisely defines, two different interpretations of
convergence. First cyclical, the belief that a single currency is
only beneficial when the trade cycles of its members are synchronised, and
second structural, the belief that a single currency is only
beneficial when the national participants possess homogenous economic
structures and international trading patterns. Although the two are
inter-related, a determined government could potentially achieve 'cyclical
convergence' over consecutive five-year parliaments through appropriate fiscal
and monetary policy changes. In contrast, the more fundamental 'structural
convergence' would require a focused longer-term strategy, potentially over
generations (Burkitt et al., 1992). No government, nor the EU
Commission, has ever devised, let alone implemented, such a complex programme
and none appears to be immediately forthcoming. Moreover, if all EU economies
achieved the easier target of synchronising the business cycle, the effect may
be destabilising by its inducement of world inflations and recessions on a
greater magnitude than previously experienced.
(ii) Whether there is sufficient flexibility to cope with economic
change - a single currency cedes control over exchange rates and
monetary policy. Therefore, without flexibility, future economic shocks are
likely to impact negatively upon employment. Whilst the Treasury paper
addresses significant dimensions of flexibility capable of national solutions,
such as skills and long-term unemployment, it fails to confront directly the
crucial issues for a single currency, i.e. labour mobility and
price-wage flexibility across the EMU zone. It is precisely the absence of
significant international labour mobility, restricted by language and cultural
factors, together with the risk that wage differential transparency, enhanced
by a single currency, will give rise to demands for wage equalisation between
countries irrespective of productivity, thereby increasing wage
(iii) The effect on investment & (v) whether it is
good for employment - for both of these tests the Treasury argues
that the single currency possesses the potential to enhance investment,
employment and growth, but these benefits would only accrue if sufficient
convergence and flexibility exist. However, the argument ignores the crucial
role of British overseas investment, approximately 80% of whose destination is
outside the EU (Jamieson, 1995), the potentially deflationary impact of the
Maastricht convergence criteria and subsequent adherence to the Growth and
Stability Pact (Pennant-Rea, 1997), together with the establishment of
price stability as the sole legal objective of the European Central Bank
(ECB). Indeed, Bill Martin of United Bank Securities estimated that already
'EMU aspirants' suffered a deflation around 4.5% of GDP during the 1990s by
pursuing the Maastricht criteria. Moreover, it appears that the Treasury fails
to appreciate the enormity of any effective convergence and flexibility
strategy. Tables 1.1 and 1.2 in the document show that the British and German
economies have in fact steadily diverged; indeed since 1981 a negative
correlation exists between their growth rates.
(iv) The impact on our financial services industry - a
frequently cited danger for Britain remaining outside EMU is that posed to the
City of London which is one of three major world financial centres.
International financial services in Britain employ around 150,000 people,
generating £10-£15 billion in annual invisible exports (Taylor, 1995). It is
often asserted that, if the UK exercises its opt-out, London could lose its
pre-eminence to Frankfurt or Paris, because Euro trading will be focused in
the EMU area. However, international business within each time zone tends to
gravitate towards a single location, this centralisation being propelled by a
preference for deep, liquid markets, accommodating legal and tax frameworks,
skilled labour and a cluster of supporting services including accountancy,
law, software and telecommunications. The City possesses all these attributes,
which any EU competitor would find hard to emulate. Hence, providing that
complacency is avoided, the existence of such advantages should ensure the
City's dominance even if Britain remains outside EMU.
When analysing EMU's consequences for the City of London, it is crucial to
distinguish between its role as the premier European financial centre and its
position in the world financial markets. The immediate effect of EMU will be a
loss of intra-EU foreign exchange transactions, which can be compensated by an
increased volume of Euro dealing that will concentrate in London just as
French franc-US dollar business does currently. It would also be offset by
greater dollar and yen trading against the Euro. A greater threat arises from
the official bond market that will inevitably emerge from EMU, which the
relevant authority will seek to retain inside the single currency area.
However, without effective exchange controls, it will prove impossible to
prevent global trading, so that a bond market will inevitably develop in
London. Thus, so long as the City retains its competitive advantage, its
European pre-eminence will remain even with Britain outside the EMU. Indeed,
this constitutes an attraction as London falls outside the potentially
restrictive arrangements required to sustain the Euro. Moreover, the City's
international position in global markets, where business is growing fastest,
would be jeopardised if EMU led to fiscal and political union, since it would
become subject to greater regulation leading to its diminution to the benefit
of New York and Tokyo. The conclusion therefore appears to be that a Britain
outside EMU can provide a bridge between the USA and Europe so that the City
of London's status, where the dollar and the Euro financial systems have their
interface, is preserved (Baimbridge et al., 1997).
In summary, the five tests selected by the UK Government undoubtedly extend
the rather limited usefulness of the Maastricht convergence criteria and
highlight a number of important issue for further analysis. However, they
ultimately fail to meet the same requirements, namely the absence of a
justification for reliance upon this specific set of indicators and the
rejection of others (Baimbridge et al., 1998). Moreover, the 'vague'
nature of judging compliance with the 'five tests' impairs the clear and
unambiguous establishment that a country is either well suited for EMU
membership, or alternatively that its inclusion would weaken the union and
hamper the effectiveness of its stabilisation policy mechanism. Consequently,
a more extensive set of criteria is required in order to establish whether EU
member states are ready to join EMU.
The debate surrounding the prospects for a single EU currency has begun to
focus upon the prior necessity for broad economic convergence, which is wider
than simply meeting the Maastricht conditions or the Treasury 'tests'. Indeed,
many economists argue that there exists a parallel or even superior set of
requirements for convergence. The theory of optimum currency areas indicates a
number of characteristics that determine the likely consequences of monetary
(i) Degree of factor mobility - countries between which
there is a high degree of factor mobility are viewed as better candidates for
monetary integration, since factor mobility provides a substitute for exchange
rate flexibility in promoting external adjustment (Mundell, 1961; Ingram,
1962). However, in practice it is unlikely that the EU, with its different
cultures, languages and traditions across member states, displays sufficient
inter-regional labour mobility to act as a mechanism for payments adjustment.
Available evidence suggests that labour mobility within European nation states
is one-third the level found in the USA, despite the existence of greater
regional inequality and unemployment in Europe (OECD, 1986; Eichengreen,
(ii) Degree of commodities' market integration - a further
criterion is that countries possess similar production structures. Economies
exhibiting such similarity are deemed to be more welfare-efficient candidates
for currency area participation than those whose production structures are
markedly different (Mundell, 1961). Compared to most EU members, Britain
possess a relatively small agricultural and large energy, financial and media
sectors; has a greater reliance upon high technology exports; and a large
proportion of owner-occupiers who are subject to variable interest rates
(Weber, 1991; Taylor, 1995; Bank for International Settlements, 1996; Burkitt
et al., 1996; Eltis, 1996).
(iii) Openness and size of the economy - open economies
tend to prefer fixed exchange rates, because exchange rate changes in such
economies are unlikely to be accompanied by significant effects on real
competitiveness. Moreover, in open economies frequent exchange rate
adjustments diminish the liquidity property of money, since the overall price
index varies more than in relatively closed economies (McKinnon, 1963). Most
small - or medium-sized industrialised nations fulfil this condition.
(iv) Degree of commodity diversification - highly
diversified economies are better candidates for currency areas than less
diversified economies, since their diversification provides some insulation
against a variety of shocks thereby forestalling the need for frequent changes
in the exchange rate (Kenen, 1969). However, economic and monetary union is
likely to generate a degree of specialisation that undermines such insulation.
Virtually all industrialised member states will fulfil this particular
(v) Fiscal integration and inter-region transfers - the
higher the level of fiscal harmonisation, the greater is their ability to
smooth out divergent shocks through transfers from low to high unemployment
regions. If the previously analysed features that assist the smooth
functioning of currency unions are not present to a sufficient extent,
budgetary policy can be an important tool to cushion individual countries from
shocks, given the absence of exchange rate changes. Such fiscal flexibility
may involve the discretionary strategies associated with 'fine tuning', but
can also arise from the operation of automatic stabilisers (Kenen, 1969).
However, the current size of the EU budget, at only 1.24% of total EU GDP,
precludes the development of any significant inter-regional fiscal transfer
system for the foreseeable future (MacDougall, 1992). Moreover, its cost may
effectively defer meaningful consideration of this potential mechanism to
stabilise EMU in the medium - and long-term (Burkitt et al., 1997;
(vi) Degree of policy integration - similarity of monetary
and fiscal policies between member countries can create equilibria whatever
the characteristics of the currency area, thus generating an efficient outcome
(Ingram, 1969; Haberler, 1970; Tower and Willett, 1970). The necessity for
'economic' as well as monetary union is recognised by the Maastricht Treaty,
but its only practical applications thus far have been the continuation of EMS
membership until monetary union and the unduly restrictive Growth and
Stability Pact. The urgent need for greater macroeconomic policy
co-ordination is no closer to being met.
(vii) Similarity of inflation rates - this criterion
focuses upon divergent trends in national inflation rates as the principal
source of payments imbalance, due to structural developments resulting, for
instance, from differences in trade union aggressiveness or national monetary
policies. Therefore it diverts attention from microeconomic disturbances in
demand and supply conditions to macroeconomic phenomena (Haberler, 1970;
Fleming, 1971; Magnifico, 1973). The available evidence here is more
favourable, since ERM membership has caused most EU member states to adapt
their economic strategies to achieve similar inflation rates at the cost of
persistently high unemployment across most of Continental Europe. However,
non-ERM countries, such as the UK, are less likely to meet this criteria
unless they reduce growth rates and operate tighter fiscal and monetary
(viii) Price and wage flexibility - when prices and wages
are flexible between, or among, regions, adjustment is less likely to be
associated with unemployment in one region and inflation in another. Hence,
the need for exchange rate changes is diminished (Friedman, 1953). The
evidence here is that significant wage-price rigidity persists across Europe,
so that market flexibility is unlikely to prevent the generation of areas
blighted by high and persistent unemployment (Bruno and Sachs, 1985; Carlin
and Soskice, 1990; Drťze and Bean, 1990; Eichengreen, 1990, 1993; Layard
et al., 1991; Bini-Smaghi and Vori, 1992; Blanchard and Katz, 1992;
Kenen, 1995; Goodhart, 1995).
(ix) The need for real exchange rate variability - the
smallness of countries' real exchange rate movements is a crucial
characteristic for determining currency area optimality, since real exchange
rate changes are clearly measurable and automatically give the appropriate
weights to the economic forces of which they are the result (Vaubel, 1976 and
1978). Given that real exchange rate variability depends upon the absence of
real wage rigidity, the comments made for (viii) equally apply in this
These criteria for the efficient operation of a single currency are clearly
more extensive than either the MCC or the UK Treasury 'tests', both of which
constitute an inadequate guide on which to base the decision whether
the UK should participate in EMU.
The UK economy is significantly different from the majority of nations who
have indicated their desire to join the single currency. This can be
established in terms of the development of financial markets, occupational
structure, percentage of home ownership and so forth. Consequently, the
five-year adjustment period suggested by the Chancellor is far too short to
effect the scale of structural changes necessary to make Britain a suitable
candidate for EMU. Moreover, such a monumental transformation should only be
attempted if its benefits can be conclusively established and their magnitude
substantially outweighs the likely costs. It is to such an evaluation we now
Compared to most EU members, Britain possesses the following
characteristics: a lower level of unfunded pensions; a greater volume of high
technology exports; a business structure more orientated to services; an
economy where income from overseas investment is greater than from
manufacturing exports; a relatively small agricultural, and a relatively large
gas and oil sector; a system of variable-rate finance that makes
owner-occupiers uniquely sensitive to interest rate changes; a currency linked
by foreign exchange markets more closely to the US dollar than to any EU
currency; and a comparatively sizeable financial sector related to Wall Street
and Tokyo rather than to Frankfurt or Paris. These differences are profound,
indicating that EMU is unlikely to foster British prosperity (Burkitt et
al., 1996, 1997).
If EMU proceeds with UK participation, Britain's economy and capacity for
democratic self-government will be irretrievably affected for four principal
reasons. First, the impact of meeting the Maastricht convergence criteria for
joining a single currency will be deflationary. An estimate for the UK is that
cuts in public expenditure and/or increases in taxation of approximately £42
billion are required in order to meet the 3% budget deficit Maastricht
criterion at all points of the economic cycle (Burkitt et al., 1997).
A diminution in purchasing power of this magnitude will generate a loss of
jobs and a fall in living standards. Holland (1995) calculated that, if the
then twelve member states met the criteria by 1999, EU-wide unemployment may
increase by 10 million, thereby exacerbating the existing situation of
approximately 20 million unemployed persons across the EU.
Second, because the potential participants in a single EU currency posses
divergent economies, they respond differently to the changes inevitable in a
dynamic environment. Consequently, convergence between countries can only be
transitory, requiring an equilibrating mechanism to ensure the long-term
survival of a single currency zone. Given that EMU prevents the exchange rate
from performing this role, the primary alternative is the adoption of a
redistributive federal fiscal structure. MacDougall (1992) demonstrated that
such an approach requires an EU budget substantially in excess of the present
1.24% of EU GDP to provide adequate fiscal compensation. However, even
MacDougall's recommendation of 5-7% of EU GDP is likely to be insufficient in
comparison to the 20-25% of GDP that federal systems usually necessitate.
Moreover, language and cultural barriers will continue to inhibit labour
mobility on the scale required to act as an equilibrator between rich and poor
areas (Eichengreen, 1992; Dyson, 1994). Thus, the only remaining alternative
is higher unemployment, which will rise, not only during preparations for a
single currency, but also after its inauguration as existing differences
become exacerbated through cumulative causation (Myrdal, 1957) with serious
consequences for political and social cohesion (Baimbridge et al.,
Third, given divergent structures, an EU-wide monetary policy cannot meet
individual national requirements, but will widen the economic performance
between member states (Panic, 1992). A uniform policy for a variegated EU
creates economic instability since convergence is difficult to achieve and can
persist for merely a brief period. The Maastricht provisions alone are
therefore insufficient as they do not refer to the fundamental prerequisites
for convergence, instead focusing upon monetary variables only partially
related to it.
Fourth, EMU will inevitably affect fiscal policy by limiting budgetary
independence both directly through the Maastricht convergence criteria and
potentially via the Growth and Stability Pact. Consequently, citizens
lose the ability to influence democratically the measures that determine their
living standards. This power is instead exercised by unaccountable EU bankers
and bureaucrats, as the scope for national self-government is reduced
(Baimbridge and Burkitt, 1995a&b). The ECB is governed by bankers independent
of national governments and the electoral process. They are prohibited by the
Maastricht Treaty from consulting, or being advised by, politicians when
framing EU-wide monetary measures. The ECB would return Britain to the
situation of the 1920s when Montagu Norman, the unaccountable Governor of the
Bank of England, followed policies that fostered mass unemployment (Kitson and
The launching of an EU single currency on the basis of the Maastricht
conditions, is therefore likely to be both economically inefficient by
generating historically high levels of unemployment and undemocratic in
reducing the status of national parliaments. EMU will divide Europe because no
mechanism exists for achieving real convergence between national economies;
its occurrence due to a temporary configuration of influences would be
unsustainable in the long-run. Moreover, EMU is particularly inappropriate for
Britain's pattern of international trade which depends upon transactions in a
global market rather than being over concentrated in the low growth EU-area.
For example, UK exports to the Far East grew almost twice as quickly as those
to EU members after 1987, whilst over the last decade the EU's share of world
trade fell by one-quarter (Burkitt et al., 1996).
If some configuration of EU member states press ahead with EMU, the crucial
issue becomes, what 'dangers' would Britain face outside? One frequently cited
argument contends that countries not participating in the single currency will
experience higher interest rates because foreign exchange markets will exact a
risk premium against the possibility of devaluation. Such an outcome cannot,
however, be predicted with the certainty that is currently fashionable. First,
the inclusion of inflation-prone EU members such as Italy in an attempt to
maximise the number of participants has led to the Maastricht convergence
criteria becoming fudged to facilitate their accommodation. Second, long-term
currency strength is primarily determined by relative economic competitiveness
which will be enhanced if Britain remains outside the constraints of the
convergence criteria and the overall consequences of EMU.
These considerations imply that the Euro may prove weak, so that opted-out
currencies will appreciate against it. Indeed, such a view is substantiated by
the 40% rise in sterling's value against the deutschmark since 1995, which is
partly attributable to the UK opt-out giving the pound an EMU 'safe-haven'
status. Moreover, the ECB, for an initial period at least, would lack the
credibility gained by the Bundesbank thereby reversing the prevailing interest
rate hypothesis (Kenen, 1995). Consequently, interest rates may be higher or
lower outside EMU depending upon economic strength and productivity gains
which are more likely to be achievable away from its constraints.
A second argument claims that British non-participation in a single
currency might divert inward investment to EMU countries. This appears to be a
remote possibility given the lack of significant transactions cost savings or
benefits from eliminating exchange rate variability. Indeed the evidence to
date is unequivocal in dismissing this argument, as Britain enjoyed high rates
of inward investment in the 1980s when functioning outside the ERM, whilst it
remains the largest EU recipient of inward funds, receiving £7.6 billion of
direct investment in 1992 equivalent to 43.6% of the EU total, after its
opt-out had been negotiated. Moreover, investment from the rest of the EU
accounted for £37.5 billion, or 31% of total inward investment into Britain in
1995. Thus, the suggestion that foreign direct investment comes to the UK
merely to gain access to the EU market is unsubstantiated.
Various influences other than exchange rate stability account for Britain's
success, including a plentiful supply of skilled labour, access to all
European markets, a competitive exchange rate, use of the English language,
competitive telecommunications, superior international air services and
efficient low cost road transport (Hindley and Howe, 1996). Indeed persuasive
reasons exist to believe that inward investment may be threatened by EMU
participation. First, the consequent increase in economic instability will
reduce the UK's attractiveness as a destination for capital flows, and second,
British involvement in EMU would impose the higher non-wage labour costs
prevalent in the EU onto business, impairing competitiveness and hence the
ability to attract capital flows. Indeed, overseas investors are frequently
not attracted by the UK's convergence with the EU but by its divergence.
Further integration would undermine the profitable conditions which has
brought a disproportionate volume of overseas investment to Britain.
Two key passages from the Chancellor's October 1997 statement were:
"the potential benefits of a single currency are
obvious; in terms of trade, transparency of costs and currency stability. Of
course, I stress it must be soundly based. But if it works economically, it
is, in our view, worth doing."
... "if a single currency would be good for British
jobs, business and future prosperity, it is right, in principle to
This approach is dependent upon the existence of a theoretically sound,
comprehensive set of criteria which unambiguously indicate that the UK is
sufficiently similar to other participating nations that we would not suffer
from the application of common exchange and monetary policies unsuitable to
the needs of the British economy. Unfortunately, as we have demonstrated,
neither the Maastricht criteria nor the Government's 'five tests' perform this
role. Moreover, using the better guide of optimum currency area theory, it
becomes clear that the UK is not an obvious candidate for monetary union
without changes which are not justified for any other reason other than a
misguided desire to 'be at the heart of Europe' whatever the costs.
Our analysis further indicates that the 'favourable circumstances' implied
in the Chancellor's statement are unlikely to prevail, because Britain's very
different economic structure and international trading pattern simply do not
fulfil the conditions for a single EU currency to operate efficiently.
Therefore, if the UK loses control over its monetary policy, it will possess a
greatly reduced ability to adapt to an inevitably changing environment.
Moreover, our concerns about EMU relate not only to the adventure itself; for
instance, the EU possesses neither the labour mobility nor the US-style
federal budget needed to compensate for the loss of the exchange rate as a
means of economic adjustment. They also focus upon the deflationary policies
to which the Maastricht Treaty committed the EU. Hence, the danger exists that
the five Treasury 'tests' may divert attention away from fundamental
difficulties which surround the establishment of a single EU currency.
We therefore believe that, even if other EU members sign up for a single
currency, Britain should not. Prioritising sustainable growth and full
employment necessitates the rejection of EMU. Moreover, non-participation
gleans many benefits and imposes no substantial costs. The advantages of low
inflation and high employment can be obtained by pursuing coherent domestic
economic policies, whilst arguments that the City of London and the UK's
attractiveness for inward investment would be endangered outside the single
currency evaporate under scrutiny. Indeed European co-operation may be
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governed through inflexible rules than by the UK and other countries,
opting-out. Hence, through an independent yet global strategy, freed from
over-concentration on the European continent to the detriment of economic
relations with the rest of the world, the UK could achieve an economic
performance the envy of EMU participants. Consequently, the single currency
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