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The Bruges Group spearheaded the intellectual battle to win a vote to leave the European Union and, above all, against the emergence of a centralised EU state.
The Bruges Group spearheaded the intellectual battle to win a vote to leave the European Union and, above all, against the emergence of a centralised EU state.

Is Europe Ready for EMU? Theory, Evidence and Consequences

Paper No. 31

Mark Baimbridge
Brian Burkitt
Philip Whyman

1st June 1998


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.


Attainment of Maastricht Convergence Criteria

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' nature;
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 interpretation.

Table1: EU Member States' Status on MCC indicators 1990-97

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.

The five UK Treasury tests
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 rigidities.

(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.

EMU and optimum currency area theory
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 union:

(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, 1992).

(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 criteria.

(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; Whyman, 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 policies.

(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; Dréze 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 instance.

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 turn.

The detrimental effect of an EU Single Currency
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., 1994, 1995).

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 Michie, 1994).

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).

The UK opt-out if others go ahead
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 join."

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 undermined more effectively by increasing national divergences within an EMU 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 'Emperor' is without clothes!

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