The UK and the Euro:

An Evaluation of the Five Economic Tests

Brian Ardy, Iain Begg and Dermot Hodson

South Bank University

June 2002

Table of Contents

Table of Contents...........................................................................................................2

Executive Summary.......................................................................................................4

1. Introduction............................................................................................................8

2. The Five Economic Tests.....................................................................................10

Test 1. Sustainable convergence ..........................................................................10

2.1 Previous Studies ......................................................................................102.2 Growth and Inflation...............................................................................112.4 The Synchronisation of UK and Euro Zone Business Cycles.................122.5 A Sustainable and Stable Exchange Rate................................................162.6 UK trade and the exchange rate ..............................................................192.7 Suitability of euro zone economic policy for the UK .............................212.8 UK and euro zone macroeconomic policy..............................................242.9 Sustainable convergence most probable scenario ...................................272.10 Sustainable convergence the worst case scenario ...................................27

Test 2. Flexibility................................................................................................27

2.11 Previous Studies ......................................................................................272.12 Is the UK Labour Market Sufficiently Flexible for EMU?.....................282.13 Is the Euro Zone Labour Market Sufficiently Flexible for EMU?..........322.14 Is UK Fiscal Policy Prepared for EMU?.................................................332.15 Flexibility most probable scenario ..........................................................342.16 Flexibility worst case scenario ................................................................34

Test 3. Investment ...............................................................................................35

2.17 Previous Studies ......................................................................................352.18 Domestic Investment ...............................................................................362.19 Foreign Direct Investment.......................................................................372.20 Investment most probable scenario.........................................................382.21 Investment worst case scenario...............................................................39

Test 4 . Financial Services and the City of London.............................................39

2.22 Previous Studies ......................................................................................392.23 Financial Services and the UK................................................................392.24 Financial services most probable scenario..............................................412.25 Financial services worst case scenario....................................................41

Test 5. Employment and growth..........................................................................41

2.26 Previous Studies ......................................................................................412.27 The Outlook for the UK Economy..........................................................422.28 Employment and Growth: Most Probable Scenario................................432.29 Employment and Growth: Worst Case Scenario.....................................43

3. Conclusion................................................................................................................44

References ....................................................................................................................47

Executive Summary

The Chancellor’s five economic tests are designed to ensure that the UK economy is

well prepared for entry to the third and final stage of EMU. In this sense, the tests

share a common objective with the Maastricht Treaty’s convergence criteria. When it

comes to matters of form however, the two standards are fundamentally different. The

convergence criteria, which relate to five financial variables, are precisely defined and

measured over a fixed period of time. The five tests are imprecisely defined and

relate to general economic performance over an unspecified interval. Unlike the

Maastricht convergence criteria, which set precise quantitative limits, some

judgement is therefore required in assessing them.

In a study conducted by HM Treasury in 1997, the UK economy was deemed to have

failed the five economic tests but to be capable of achieving a more favourable result

at some future date. A study in 2001 that was commissioned by the ‘No Campaign’

reiterated HM Treasury’ s findings but rejected its predictions, suggesting that the UK

would continue to diverge from the euro zone economy. More recently, the UK

scored highly on all five economic tests in an appraisal by Barrell (2002).

This report offers a reappraisal of the five economic tests in reaction to previous

research and on the basis of fresh empirical evidence. It concludes that, on balance,

the UK economy clearly meets all five of the Chancellor’s tests. The UK in other

words, is in a good position to maximise the benefits and minimise the costs of entry

to the euro zone.

Cyclical convergence

Over the last four years, the UK economy has gradually attained cyclical convergence

with the euro zone. The question remains, however, as to whether this convergence

will persist. The answer will crucially depend on three factors. The first concerns

the sustainability of the exchange rate at which sterling enters the euro zone. An

overvalued rate could stunt economic growth in the UK, while an undervalued rate

could generate inflationary pressures. Although much has been made about the

‘overvaluation’ of sterling being a barrier to EMU entry, a gradual depreciation in

recent months has taken sterling to the verge of the ‘sustainable’ entry rate, as defined

by Barrell (2002), of 1.55 to 1.50 euro to the pound. Taking past movements in the

euro-sterling exchange rate as a guide, sterling is capable of reaching this target in

little over three months. The second factor concerns the effect of monetary

unification on trade integration and macroeconomic convergence. Rose (2000) finds

evidence to suggest that a common currency is a powerful catalyst for trade. The

results of Frankel and Rose (1998) suggest that trade integration, in turn, leads to a

closer synchronisation of business cycles and, by implication, a lower incidence of

asymmetric shocks. The third factor focuses on the compatibility of UK and euro

zone macroeconomic policy. In joining the euro zone the UK would adopt a monetary

policy which shares the same objective as the Bank of England i.e. price stability.

EMU’s fiscal framework differs in emphasis from the UK’s Code for Fiscal Stability

but the two share broadly similar goals. The EU has gradually come to realise that

fulfilment of Code for Fiscal Stability will allow the UK to meet the constraints of the

Stability and Growth Pact, whilst increasing investment in public services. In short,

membership of EMU under conditions of convergence would pose no threat to the

goal of macroeconomic stability in the UK. It would, moreover, bring permanent

nominal exchange rate stability vis-à-vis the euro zone, creating a more certain

macroeconomic environment and more credible macroeconomic policies.

Most probable scenario: UK entry to the euro zone will consolidate the recent

convergence with the euro zone and promote greater macroeconomic stability over

the long run.

Flexibility

The recent economic performance of the UK economy indicates a step change in

flexibility. Thus it has been possible to simultaneously achieve the lowest rates of

unemployment and inflation for a generation. This enhanced flexibility means that the

UK is well placed to adjust to asymmetric shocks within the constraints of ECB

monetary policy and a fixed exchange rate vis-à-vis the euro.

Concerns have been raised that inflexible euro zone labour markets will leave the UK

vulnerable to the effects of asymmetric economic disturbances arising elsewhere in

the euro zone. There can be little doubt that the UK economy is considerably more

liberal in character than its euro zone peers but this does not mean that these peers are

considerably less flexible. The wage bargaining systems of the existing member

states delivered highly competitive wage rates in the run up to EMU and the initial

evidence suggests that they continue, by and large, to act as important shocks

absorbers against asymmetric shocks (Soskice and Hancké, 2002). The member

states have recognised the need for greater flexibility in factor and product markets

and have duly implemented a coordinated approach to reform in both the European

Employment Pact and the Lisbon Strategy.

Concerns that the Stability and Growth Pact limits flexibility rest on too narrow an

interpretation of the pact for a number of reasons. First, member states that experience

severe recessions are exempt from the Excessive Deficit Procedure. Second, the

requirement for a medium term budgetary position of close to balance or in surplus

provides sufficient room for automatic stabilisers to operate in an economic slow

down, without breaching the 3% deficit ceiling. Thus whether member states have

reached their medium-term budgetary requirement becomes the crucial determinant of

fiscal flexibility. The UK with its healthy public finances, low level of national debt,

and low benefit rates is unlikely to encounter problems in meeting the terms of the

pact.

Most probable scenario : Economic convergence and macroeconomic stability are

likely to reduce the incidence of asymmetric shocks that affect the UK economy. In

the event that an asymmetric shock does arise, however, labour and product markets

on one hand and automatic fiscal stabilisers on the other will insulate the UK

economy to a significant degree.

Investment

Although the link between reduced currency volatility and foreign direct investment is

not a simple one, the evidence is that investors prefer a stable macroeconomic

framework. Thus, even though the UK has enjoyed greater macroeconomic stability

in recent years, currency volatility has been a problem. In this respect, being part of

EMU would add to the UK’s appeal in terms of stability. Joining the euro is unlikely

to deter either domestic or foreign firms from investing in the UK and may become

more helpful in the medium-term.

Most probable scenario: EMU will be compatible with high levels of indigenous and

foreign investment in the UK.

Financial Services and the City

There is no convincing evidence that joining the euro zone will harm the UK’s

financial services sector. Indeed, to the extent that a single currency promotes further

competition within the financial services sector, membership of EMU will provide the

City of London with the opportunity to exploit is competitive advantage in financial

services yet further.

Most probable scenario: Entry to EMU reinforces the City’s position as Europe’s

leading financial centre, resulting in a further agglomeration of financial services.

Employment and growth

Macroeconomic policies have undoubtedly contributed towards the UK’s strong

economic performance in the 1990s. However, the 1990s has also seen a build up in

consumer debt, rapid house price inflation, exchange rate volatility and, more

recently, recession in significant parts of the traded manufacturing sector. EMU will

bring greater exchange rate stability to complement the current macroeconomic policy

framework in the UK, which will contribute towards economic growth, and job

creation over the long term.

Most probable scenario: EMU membership enhances the stability of the UK economy

as a result of reduced exchange rate uncertainty. Investment is encouraged,

productivity is boosted, trade linkages are strengthened, and competition is increased.

The net result is a higher rate of economic growth and job creation.

1. Introduction

The UK government is committed, in principle, to full participation in Economic and

Monetary Union (EMU). For participation to become a reality, however, the UK

must meet three sets of requirements. First, HM Treasury must decide that the

economy passes the Chancellor of the Exchequer’s five economic tests for entry to

EMU. Then, the UK electorate must express its support for EMU in a referendum.

Thirdly, the EU’s Council of Economics and Finance Ministers (ECOFIN) must

formally decide that the UK has passed the Maastricht convergence criteria for entry

to EMU. If, and only if, these requirements are met, will the exchange rate of sterling

vis-à-vis the euro be irrevocably fixed, monetary sovereignty be transferred from the

Bank of England to the Eurosystem of Central Banks and euro notes and coins be

adopted as the UK’s sole legal tender.

The five economic tests, which the Chancellor presented before Parliament in 1997,

are designed to ensure that the UK economy is in a position to maximise the net

benefits of joining EMU. The objective is to minimise the costs associated with EMU

as well as maximising the benefits. Beginning with the former, the first test requires

that there is sustainable convergence between Britain and the economies of a single

currency. Sustainable convergence, according to HM Treasury (1997), requires

compatibility between UK and euro zone business cycles and economic structures.

This will, it is argued, ensure that euro zone interest rates are well suited to economic

conditions in the UK, on a permanent basis. In the event of an asymmetric economic

shock, the UK could no longer rely under EMU on the exchange rate as an instrument

of adjustment. The second economic test thus, requires, that the UK economy have

sufficient flexibility to cope with economic change through other means. Flexibility

refers here to the ability of factor and product markets to absorb the effects of an

asymmetric shock through, for example, changes in relative wages and prices and to

the effectiveness of fiscal policy as an instrument of counter cyclical stabilisation.

The third and fourth tests concentrate on the benefit-side of the analysis, ensuring that

the positive effects of EMU on investment in the UK and the financial services

industry are duly realised. With regard to the former, the third test requires that EMU

makes the UK a more attractive location for long-term investment. The fourth test

guarantees that EMU will have no detrimental effects on the competitive position of

the UK's financial services industry. Particular emphasis is placed here on the City of

London’s wholesale financial markets. The fifth economic test draws together the

preceding cost and benefit analyses to ensure that EMU promotes higher growth,

stability and a lasting increase in jobs for the UK. It is essentially a summary test, the

result of which will be positive once the four preceding tests are passed.

In 1997, HM Treasury published the first report on the UK economy’s position in

relation to the five economic tests. The report concluded that EMU ‘has the potential

to enhance growth and employment prospects’ in the UK (HM Treasury, 1997, p8).

However, before such benefits could be realised, further convergence between UK

and euro zone business cycles and greater flexibility within the UK economy were

deemed to be necessary. In 2001, the ‘No Campaign’ commissioned a study of EMU,

which agreed with the findings of HM Treasury (1997) that the UK economy was

insufficiently synchronised with the euro zone but was less optimistic about the

prospects for future convergence. This position was echoed in a study by Oxford

Economic Forecasting (2002), which suggested that the UK economy would be more

vulnerable to the effects of asymmetric shocks as a member of the euro zone than if it

retained independent control over monetary policy. In 2002, Barrell (2002) published

the most positive assessment to date of the UK’s readiness for entry to EMU. EMU,

it was argued, would install a more credible and stability-oriented macroeconomic

regime in the UK, which would bring greater convergence with the euro zone

economy and lay the foundations for higher growth, investment and job creation.

This report offers a fresh appraisal of the five economic tests in reaction to previous

studies and in the light of fresh evidence. A number of findings emerge. First, there

is evidence of a substantial convergence between the UK and euro zone economy

over the last five years. Second, UK factor and product markets are sufficiently

flexible and public finances sufficiently healthy to minimise the effects on the

economy of an asymmetric shock. Thirdly, EMU is likely to have a positive impact

on investment into the UK and will allow the City of London to exploit its advantage

in financial services yet further. All of this suggests that EMU would contribute

towards higher growth and increased job creation in the UK over the long term. In

the short to medium run, the outstanding issue with regard to UK entry concerns the

appropriate rate at which to fix sterling against the euro. Two main points are stressed

here. First, joining the euro zone at an inappropriate exchange rate will delay the long

run benefits of EMU, and could cause macroeconomic instability in the short run.

Second, the task of reaching a sustainable entry rate for EMU may be crucial but it is

by no means insurmountable. Indeed, taking a rate of between 1.50 and 1.55 euro to

the pound (Barrell, 2002) as a benchmark and past movement of sterling against the

euro as our guide, sterling has already reached a broadly sustainable exchange rate.

Thus, in short, the UK currently meets all five of the Chancellor’s Five Economic

Tests and is, in consequence, well prepared for a successful entry to EMU.

2. The Five Economic Tests

Test 1 Sustainable convergence

2.1 Previous Studies

HM Treasury (1997) and Bush (2001) suggest that the UK and euro zone economies

are not, or at least were not at the time of writing, convergent. Both studies agree that

divergence is driven in part by structural differences between the UK and euro zone

economies and that EMU is unlikely to alter this picture. Differences in trade

linkages, the oil industry, company finances and the housing market, it is argued,

leave the UK more vulnerable than many of its EU peers to the effects of asymmetric

shocks. HM Treasury (1997) places greater emphasis than Bush (2001) on cyclical

sources of divergence. The former argues that cyclical convergence will increase

with the advent of a more stability-oriented approach to macroeconomic policy in the

EU. They recommend that “[a] period of stability, through continuing to aim for low

inflation and sound public finances ... to ensure that convergence was sustainable and

durable, and to provide a basis for successful membership of the single currency”

(HM Treasury, 1997; p.6). A recent assessment of the first economic test by Barrell

(2002) reaches a more sanguine conclusion. UK membership of EMU, it is argued,

will install a more credible macroeconomic regime with lower and less volatile

inflation and, in consequence, higher rates of investment and growth. The UK’s

output gap is currently in the middle of the euro zone range, suggesting that the two

economies have converged. The durability of this convergence will depend on

developments in monetary policy, the incidence of asymmetric shocks and the

exchange rate at which the UK would enter the euro zone. Barrell (2002) finds that

sterling has been overvalued against the euro during the last three and a half years

against the euro but his findings suggest that the extent of this overvaluation should

not be exaggerated. He estimates that a sustainable rate of entry to EMU lies at a rate

of between 1.50 and 1.55 euro to the pound sterling. Following the rise in the euro

since Easter 2002, which has seen the pound drift downwards, sterling is on the upper

boundary of this range. There are undeniable differences between the structure of the

UK and euro zone economies much like there are undeniable structural differences

between the North East and South East of England, between the North and South of

Italy or between Bavaria and Eastern Germany. Nevertheless, the impact of such

regional and structural disparities should not be overstated. Bush (2001) notes that

the euro zone is a more important market for other EU member states than it is for the

UK. This fact notwithstanding, the euro zone remains the UK’s largest trading

partner by far, accounting for over half of the UK’s trade in goods over the last

decade. Exchange rate stability vis-à-vis the euro zone should thus be no less

important to UK than it is to other member states. In a similar vein, Bush (2001)

suggests that the UK economy is more sensitive to interest rate changes because of the

large amounts of variable interest debt borrowed by households and the dependence

of companies on short term bank overdrafts and loans. Notwithstanding differences

in housing markets and company finance, Byrne and Davis (2002) and Suardi (2001)

find little evidence to suggest that the UK economy is more sensitive to changes in the

interest rate than the euro zone economies. Turning finally to the significance of the

oil industry, although the UK remains a net exporter of energy, net exports of oil

products represented only 1.3% of total exports of goods and services in 2001. In

consequence, the vulnerability of the UK economy to developments in the oil industry

should not be overestimated.

2.2 Growth and Inflation

Sustainable convergence implies that the UK economy should follow a similar path to

the euro zone. Since their obvious divergence in the early 1990s, UK and euro zone

economic cycles have converged (Figure 1). The narrowing of differences in output

gaps also indicates convergence over the economic cycle. Macroeconomic stability in

the UK since the mid-1990s contrasts with the instability of previous periods

(Kontolemis and Samiei, 2000; Barrell, 2002). From 1971 to 2001 the UK had a

lower and more volatile rate of GDP growth and a higher and more volatile rate of

inflation on average than the euro zone member states as a whole. Since 1992 there

has been a remarkable transformation, with the UK enjoying higher rates of growth

and lower rates of inflation than both Germany and the euro zone. The variability of

economic growth remains the same for the UK but the variability of inflation has

diminished (Table 1).

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Per

cent

age

Cha

nge

in R

eal

GD

P

United Kingdom Euro area United States

Figure 1GDP growth in the Euro area, the UK and the USA

Table 1: Stability of GDP growth and inflation 1997-2001% annual change

1971-2001 1992-2001Average Standard deviation Average Standard deviationGDP growth

UK 2.3 2.1 2.7 1.2Germanya 2.7 1.8 1.6 1.2EMU 12 2.7 1.6 2.0 1.2

InflationUK 7.4 5.9 2.0 1.0Germanya 3.3 2.0 2.2 1.5EMU 12 5.1 2.7 2.5 1.1Source: European Commission, 2001; 2002a.

2.4 The Synchronisation of UK and Euro Zone Business Cycles

The correlation between output fluctuations in the UK and the EU, provides an

alternative measure of the degree of synchronicity between euro zone and UK

business cycles (Commission, 2002b).

Output movements, as reflected by cyclical changes in Gross Domestic Product

(GDP), in the UK are compared with Germany and the EU. The business cycle for the

EU as a whole provides a good proxy for an enlarged euro zone, which includes the

UK. Germany is the largest member state in EMU, producing roughly one-third of

euro zone GDP, and thus has the largest impact on the euro zone’s overall economic

performance. The data are quarterly, seasonally adjusted real GDP and the sample

period ranges from 1991 to 2001. GDP is measured in the home currency to abstract

from the effect of significant fluctuations in sterling exchange rates during the 1990s.

As can be seen in Figure 2, the UK experienced divergent economic conditions vis-à-

vis the EU and Germany in the early 1990s. At the beginning of the period the EU’s

annualised rate of growth was 2.1% but the UK economy shrunk by 0.4%. Economic

recovery in the UK began just as the EU and Germany entered a down turn, with the

result that the German growth rate was -1.5% in 1993Q3 as the UK growth rate

reached +1.5%. The picture at the turn of the century is quite different. The UK, the

EU and Germany reached the peak of their business cycles in 2000Q2, followed by a

pronounced downturn.

Figure 2: GDP Growth in the UK, Germany and EU, 1991-2001

-3 . 0

-2 . 0

-1 . 0

0 . 0

1 . 0

2 . 0

3 . 0

4 . 0

5 . 0

6 . 0

U K G e r m a n y EU

Econometric methods can be used to assess the extent to which two business cycles

have become more closely synchronised. The first step is to remove the trend

component from GDP growth. The trend is derived here with the aid of a

conventional Hodrick-Prescott (HP) filter and the result is subtracted from the original

figure to leave behind an estimate of the cyclical component in GDP growth or output

fluctuation as it might also be called. Figure 3 illustrates the deviation of GDP (UK,

Germany and EU) around its trend (hpUK, hpGermany and hpEU).

Figure 3: GDP and the Hodrick Prescott Filter

DM bn

€ bn

£ mn

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

175000

200000

UK hpUK

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

850

900

950

1000Germany hpGermany

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

1600

1700

1800

1900 EU hpEU

The next step in the analysis is to measure the degree of correlation between output

fluctuations in the UK and those in the EU and Germany. The correlation coefficient

for each period is calculated on the basis of the preceding twelve quarters. The results

are presented in Figure 4.

The correlation coefficient between the UK and the EU is low (0.59) in the twelve

quarters preceding 1993Q4. This situation is even worse with respect to Germany,

where the correlation coefficient over the same period is just (0.31). Greater

synchronisation is evident over the two proceeding years, with the correlation

coefficient rising to a high of 0.92 for the EU and 0.87 for the case of Germany. The

correlation weakens in the mid-1990s as the UK economy enjoys strong economic

growth at a time when EU growth slows and the German economy is stagnating.

Thus by 1998 the UK and Germany are actually moving in opposite directions as

reflected in a correlation coefficient of –0.1 in the twelve quarters preceding 1998Q3.

The correlation strengthens at the end of the decade as the EU and German economies

first emulate the UK’s economic growth and then follow it into an economic

slowdown. The correlation coefficient for this period rises to 0.90 for the EU and

0.87 for the case of Germany, indicating a strong degree of synchronisation with the

UK business cycle.

Figure 4: Output Correlation in the UK as compared with Germany and the EU

-0 . 2

0

0 . 2

0 . 4

0 . 6

0 . 8

1

Germany EU

This analysis provides evidence of a growing synchronisation between UK and

European business cycles. The UK and the EU began the 1990s in a state of

economic misalignment, which was driven not least by the effects of German

unification. This trend was reversed over the course of the decade, with a close

alignment between the UK and European economies evident in the prelude to and

aftermath of the US economic slowdown. Without the instability of the German

economy as a result of unification it is probable that the correlation of cycles between

the euro zone and the UK would have been higher. This indicates a potentially large

degree of synchronicity in the absence of the very large asymmetric shock of German

unification.

A number of caveats must accompany this analysis, however. First, these results are

contingent on a measure of cyclical fluctuations, which – like its alternatives – is

imperfect at best. Second, it is difficult to distinguish in practice between greater

synchronisation between two business cycles and a general trend in macroeconomic

policy towards greater stability. Macroeconomic policy reform in the EU has

produced a broad consensus over economic objectives with the result that the

incidence of policy conflict between member states has gradually been reduced. The

result could be a greater stability amongst national business cycles even if structural

differences persist between national economies. Finally, the results clearly show that

synchronisation between business cycles is a reversible process, as reflected in the

period between 1996 and 1998. The more salient question then is not whether the UK

has converged towards the European Business cycle but whether these business cycles

will remain convergent in the face of economic disturbances.

2.5 A Sustainable and Stable Exchange Rate

Although the preceding evidence points towards a growing convergence between the

UK and euro zone economies, this provides no guarantee that such convergence is

sustainable. The sustainability of convergence depends in part on whether EMU will

deliver exchange rate stability to the UK and whether sterling will enter the euro zone

at a sustainable rate.

In recent memory, sterling has been among the more unstable of the major European

currencies. This is shown clearly by large swings and periods of over and under

valuation in the UK’s Real Effective Exchange Rate Index (REER) (Figure 5). It is

equally evident from the standard deviation of the REER for the period as a whole as

well as for sub-periods (Table 2.). Even in the 1990s the new regime may have

improved the performance of the UK economy but it has not stabilised the exchange

rate. After the traumatic exit from the ERM in October 1992, sterling weakened until

1996 but has since rebounded strongly. Exchange rates that were unsustainable in the

ERM have been achieved and maintained since the end of 1999. Thus, stability of

growth and inflation has been achieved but only with imbalances between

manufacturing and services output, with a growing deficit on the current account of

the balance of payments and consumption fuelled by consumer debt. Long term

macroeconomic stability, in this sense, has yet to be secured.

Table 2: Standard deviation of the Real Effective Exchange Rates

SD of the monthly REER

72-02 72-81 82-81 92-01

UK 12.1 13.5 6.8 12.6

Germany 5.4 4.8 2.7 4.7

France 4.4 3.4 2.7 3.6

Italy 9.9 8.0 7.5 7.2

Source: OECD, 2002a

Figure 5Real Effective Exchange Rates

80

90

100

110

120

130

140

1972-1 1976-1 1980-1 1984-1 1988-1 1992-1 1996-1 2000-1

Source: OECD, 2002

Inde

x: 1

995

=100

GermanyFranceUK

Italy

Since 1998 the Real Effective Exchange Rate of the pound has been some 26% above

its 1993-95 average and 14% stronger than its long run average (OECD, 2002b; pp.

155-158). This raises three important issues with regard to EMU membership: what

would be an appropriate entry rate, what would be the implications of entry at an

inappropriate rate and would UK convergence with the euro zone be sustainable?

Estimates of the pound’s ‘equilibrium’ value against the euro vary widely (OECD,

2002, p.158), ranging from the 1.04-1.27 euro of Wren-Lewis and Driver (1998) to

the 1.50-1.55 euro of Barrell (2002). Estimates are derived in different ways, with

1 Based on a broad sample of partner countries and on consumer prices.

those based on more recent and forward-looking assessments generally providing

higher estimates. The appreciation of the euro over Easter 2002 has brought sterling

to the upper limit of Barrell’s range. Further depreciation to reach the lower limit

would have only a marginal impact on the UK economy. It would increase inflation

slightly not least because there has been a reduction in the extent to which companies

pass through increases in costs in general, and exchange rate depreciation in

particular, to consumer prices (Taylor, 2000). It would, moreover, represent a mild

boost to demand through net exports, which may be appropriate given that the

expansion of debt consumer spending cannot continue indefinitely to sustain

economic activity.

There are three potential problems with this scenario: the difficulties of estimating the

correct entry rate, the problems associated with entering EMU at the wrong rate and

the difficulty of engineering entry at a devalued rate. The inevitable problems of

estimating exchange rates are complicated by the fact that the UK is contemplating

fixing its exchange rate against one currency, albeit its most important trading partner.

This means that the estimation of the correct rate depends not only upon the pound

euro rate, but also upon the euro’s future exchange rates, especially against the US

dollar.

If UK entry to EMU took place at too high a rate, then the early years of membership

could see restrained economic growth and dampened inflationary pressures. Entry at

the current rate is predicted to have a mild effect on inflation and output but a rate of

1.73 euro to the pound would reduce output by around 1.5% and inflation by just over

1% below the current 2.5% target in the first five years of membership 3. UK entry at

too low a rate would lead to an acceleration of output and inflation during the initial

phase of membership. An entry rate of 1.43 is estimated to lead to 1.5% additional

output over capacity and just over 1% additional inflation 4 (Barrell, 2002; p.68).

2 Inflation is estimated to increase by around 0.25% and GDP by 1% over five years if the UK enteredat a rate of 1.53 euros to the pound (Barrell, 2002; p.68).

3 Oxford Economic Forecasting (2002) estimates for a 10% overvaluation are somewhat greaterparticularly for inflation GDP by -2.4% and inflation -3.8%.

4 Oxford Economic Forecasting (2002) estimates for a 10% undervaluation are greater GDP +2.6% andinflation +5.6%. These estimated effects for inflation seem particularly large.

Effects of the entry on investment, particularly on FDI, because of the potential path

dependence of growth may have permanent effects on living standards (Darby et al,

1999). Thus the decision over the entry rate of sterling is crucial but, as recent UK

experience has shown, remaining outside EMU does not avoid the potential problem

of long lived misalignments of the exchange rate.

Engineering the right entry rate for EMU will not be easy as the exchange rate is the

one Maastricht convergence requirement that the UK does not currently satisfy. All

current members maintained fixed exchange rates in the ERM before the examination

of the convergence criteria, and this central rate became the permanently fixed rate

against the euro. Finland, Italy and later Greece joined the ERM in order to participate

in EMU. In the case of Finland and Italy the central rates chosen against the ECU

were close to the current exchange i.e. within 2% of the average for the previous year.

Greece’s central rate represented a devaluation of 15.4%. So with the approval of the

Council, it is possible to devalue, to set an appropriate exchange rate for EMU entry.

Once in the ERM the UK would have to maintain the exchange rate without

devaluation or other significant tensions for a period of up to 2 years. Thus,

negotiating for the entry of sterling into EMU presents formidable challenges at the

EU level in addition to those faced in the UK.

A rough estimate for the ‘usual’ speed of adjustment of the sterling-euro exchange

rate can be derived by taking the average absolute three-month change in the

exchange rate between January 1999 and May 2002. The result reveals that in a given

three-month period, sterling has the potential to change by an average of 5 cent

against the euro. At the rate prevailing in the first half of June 2002 of around 1.56

sterling is at the upper boundary of a sustainable rate of entry, as defined by Barrell

(2000). On the evidence of previous exchange rate movements sterling could easily

adjust to Barrell’s lower boundary in a three month period.

2.6 UK trade and the exchange rate

5 The minimum so far has been Italy for 15 months before the examination, all current members havecompleted two years in the ERM before becoming full members of EMU.

The irrevocable fixing of sterling against the euro will not entirely eliminate exchange

rate variability in the UK. Real effective exchange rates (REER) can change within

the euro zone as a result of differences in inflation rates. The external value of the

euro can also fluctuate but since only the part of UK trade outside the euro zone is

affected, the overall REER would be more stable after joining EMU. This is contested

by Bootle (2001) who argues that the rest of the world is more important for the UK

than is the euro zone when it comes to international transactions and that joining the

euro would not increase stability for our foreign trade.

Whether fixing the exchange rate of sterling against the euro will stabilise the

exchange rate for items sensitive to its movement will depend upon three factors: First

the sensitivity of the transactions to exchange rate movements; second the proportion

of sensitive transactions with the euro zone; third the difference between euro and

sterling variability against non-euro zone currencies. It will also depend upon the

nature of exchange rate variability, which consists of volatility and misalignments.

Volatility is shown by random fluctuations around the long run trend. Misalignments

by contrast, are large movements away from long run trends with real exchange rates

becoming over or undervalued for extended periods. Volatility can largely be dealt

with (albeit at a cost) but sustained misalignments can have more profound effects.

Table 3 UK Current Account by region debits and credits 1992-99 average

Total Goods Services G+S Incomea Transfersb

Eurozone 45.1 52.8 37.3 49.3 33.6 56.3 + Rest of EU 48.4 56.7 40.3 53.0 36.7 57.3 + Rest of Europe 57.8 64.0 49.8 60.8 50.5 61.5USA 17.0 12.4 22.2 14.6 22.8 14.1Asia 15.9 16.3 16.3 16.3 16.2 9.6Other 9.2 7.2 11.7 8.3 10.5 14.71999£bn 725.0 358.1 116.4 474.5 209.9 40.7

a. Income includes investment income and compensation of employeesb. The figure for transfers and total transactions with the Eurozone are higher than those of Bootle because payments to andreceipts from the EU institutions have been included as Eurozone transactions, because they are denominated in euros.Source: Bootle (2001)

Trade in goods is obviously sensitive to changes in the exchange rate and the euro

zone accounted for 52.8% of UK trade in goods in the 1992-99 period. Some services

such as transport and travel are more sensitive to exchange rate movements and others

6 Volatility also makes it more difficult to recognise misalignment.

such as financial and business services are less so. The euro zone is a less significant

partner for services than for goods, accounting for 37.3% of the total value of services

transactions. Overall the euro zone accounted for 45.1% of transactions in goods and

services and in all likelihood a majority of the more exchange rate sensitive

transactions. Nearly two thirds of investment income is outside the euro zone but the

effect of fluctuations in exchange rates here is not clear. Obviously the sterling value

of investment income is affected but the market response to exchange rate volatility is

ambiguous. There can be no demand response and the supply response will affect the

volume and direction of portfolio and foreign direct investment (FDI). As a source of

uncertainty, exchange rate volatility may discourage foreign investors but by the same

token it may encourage diversification of both portfolios and foreign direct

investment. Thus, the inclusion of investment income in an assessment of exchange

rate sensitive transactions is questionable.

Two other issues are raised by Bootle (2001). The first concerns long run

developments in UK trade, while the second touches upon the issue of dollar

invoicing and pricing. Whilst population and growth projections might suggest an

increasing importance of non-euro zone trade to the UK in the future, there are other

factors that will work in the opposite direction, such as the enlargement of euro zone

and the subsequent increase in euro zone trade. It is also suggested by Bootle (2001)

that the trade figures overstate the importance of the euro because of its lesser role in

invoicing and the role of dollar transactions. The currency of invoicing is something

of a red herring, however, because of the weak linkage between invoicing and pricing.

In any case 63% of UK imports and 72% of UK exports were invoiced in either EMU

currencies or sterling in 1999 (Bootle, 2001; p. 17). It is also true that a number of

goods have their international prices set in US dollars and that allowing for this effect

may marginally reduce the significance of the euro in UK current account

transactions. The crucial point here is that the current situation does not allow the UK

to stabilise the value of sterling. Fixing the exchange rate against the euro would

eliminate a significant amount of the existing exchange rate instability in the UK.

2.7 Suitability of euro zone economic policy for the UK

The sustainability of convergence between the UK and the rest of the euro zone would

also depend on the suitability of euro zone monetary policy to the UK business cycle.

At present euro zone interest rates are marginally lower than they are in the UK but

the market expectation is that they will converge over the next three years. A switch

to euro zone interest rates at this time would thus be unlikely to have any immediate

impact on the UK economy (Barrell, 2002; p. 65). The question remains, however, as

to whether euro monetary policy will always be suitable for the UK. Bush (2001) and

Leach (2001) foresee three potential problems. First, the common monetary policy

might have different effects on the UK, in particular the UK might be more sensitive

to interest rate changes. Second, the UK could be subject to different shocks from

other euro zone countries so that the common monetary policy would be ill suited to

economic conditions in the former. Third, joining requires the UK to give up an

efficient system of macroeconomic policy making for a less efficient one.

It is possible that the sensitivity of output to interest rate changes differs between

member states. However, existing studies of asymmetries in monetary policy

transmission have failed to provide consistent and robust estimates of cross-country

differences (Kieler and Saarenheimo, 1998; Guiso et al, 1999). There are undoubtedly

differences between EU countries which could affect the transmission of monetary

policy to output, such as structure of banking, interest sensitivity of output, household

debt, size and composition of household assets, openness to trade, bank finance to

business and the structure of firms. Suardi (2001) finds only tentative evidence to

suggest that the UK and Sweden are more sensitive than their EU peers to interest rate

changes. Recent work by Byrne and Davis (2002) suggests that differences between

UK and continental financial systems may have been exaggerated. The UK is found to

have much in common with the continental countries, especially France and there is

some evidence of convergence towards a more market-oriented system even in

traditionally bank-oriented countries such as Germany.

If euro zone monetary policy is to be well-suited to the UK economy then the

incidence and magnitude of asymmetric shocks hitting the UK should be low. A

substantial body of studies have analysed shocks in the EU (OECD, 1999; pp. 93-97).

One of the chief questions considered by this literature, is the extent to which there is

a core group of countries with a high degree of commonality in their economic cycles.

Vector Auto Regressive (VAR) models have been used to make this assessment.

Bayoumi and Eichengreen (1992) in a notable paper established that there was a core

of European countries with closely related economic cycles and that the UK was not

part of this core. These results have largely been confirmed by other studies (Helg et

al, 1995; Artis and Zhang, 1999; Kontomlemis and Samiei, 2000).

The link between trade and monetary integration is a much debated topic amongst

economists. Some would argue that the effect on trade of reducing exchange rate

volatility is relatively small (Fitz Gerald and Honohan, 1997; Anderton and Skuldeny,

2001). A recent study on the Irish economy suggests that the Irish punt’s break from

its long standing parity with sterling in 1979 had a negligible impact on Anglo-Irish

trade. There is a difference, however, between a fixed exchange rate regime which

lacks credibility and a monetary union that installs a single currency. Rose (2000),

who employed a cross-sectional study of 186 countries, found that on average

monetary unification increased trade between countries by a factor of three. This

result has been challenged because of the small number of same currency

observations, most involving small underdeveloped countries, often colonial/post-

colonial monetary unions associated with many other changes affecting trade

(Honohan, 2001). The data used by Rose (2000) also contains very few examples of

currency switching i.e. adopting or abandoning a common currency. In a recent article

(Glick and Rose, 2002) extend their time period increasing the number of currency

switching observations and permitting the use of a fixed effects estimator that

provides a better statistical description of the data. Although it is reduced, the

currency effects still remains very substantial suggesting that adopting a common

currency doubles the level of trade. Further support for the proposition that common

currencies support trade is provided by studies of the home bias on trade. McCallum

(1995) found that the level of trade between Canadian provinces is ten to twenty times

greater than it is between the Canadian provinces and US states, when allowance is

made for other factors affecting trade. Of course as (Bush, 2001) indicates there are

many institutional and other differences that encourage internal rather than external

trade. The EU has eliminated many of these differences but trade between regions is

still ten times higher than it is to partner countries (Nitsch, 2000). Thus it seems likely

that a large developed country like the UK joining EMU will lead to increased trade

but that the effects will be modest in magnitude.

Krugman (1993) for one would see increased trade integration as a potential source of

divergence as national economies pursue different areas of specialisation, leaving

them more vulnerable to the effects of sector specific shocks. The higher incidence of

trade within countries can be partially explained by differences in regional

specialisation. EU Member States showed more overlap and diversification in their

output than US states (Helg et al., 1995, Braunerhjelm et al, 2000), although closer

analysis reveals that the differences are not too wide (Aiginger and Leitner, 2001).

Increasing integration has been associated with increasing specialisation but the

process has been uneven across sectors and relatively slow (Midelfart-Knarvik et al,

2000). However, Frankel and Rose (1998) find evidence of a significant and positive

relationship between the intensity of bilateral trade relations and the correlation of

business cycles. According to this logic, monetary unification in the euro zone will

promote deeper and deeper trade integration amongst its members and (by

implication), a greater synchronisation of business cycles and hence a lower incidence

of asymmetric shocks in the UK.

2.8 UK and euro zone macroeconomic policy: substitutes or complements?

Since 1992 the UK economy has experienced sustained economic growth, moderate

inflation and falling unemployment. Much of the recent success is attributed to

reforms in the UK’s macroeconomic policy architecture. The Bank of England was

granted operational independence in 1997. UK interest rates are now set by the

Bank’s Monetary Policy Committee in accordance with a symmetrically defined

inflation target, which has been set in advance by the government at a rate of 2.5%.

Fiscal policy was also placed on a more stable footing with the advent of multi-annual

expenditure planning, along with the government’s Fiscal Code of Conduct. The

former means that expenditure decisions are now formulated over a five year time

horizon, thus bringing greater transparency and continuity to policy making. The

latter enforces the goal of economic stability by ensuring that the government borrows

only to finance public investment (the golden rule) and that net government debt

remains at a stable and prudent level (the sustainable investment rule).

The euro zone policy architecture has been portrayed in certain quarters as a poor

alternative to the current UK system (Bush, 2001). In practice, the UK and euro zone

approaches to macroeconomic policy have much in common.

First, price stability is, in both cases, the primary objective of monetary policy. The

ECB favours an approach to monetary policy that targets changes in the money

supply in contrast to the Bank of England’s more direct inflation target. Despite the

controversy that persists over which of these approaches is superior, each offers a

relatively efficient means of maintaining a common objective i.e. price stability. The

inflation measure targeted by the ECB, the HICP, has consistently been under the UK

target RPIX measure, thus over the period 1999-2001 RPIX inflation in the UK

averaged 1.9% (ONS, 2002a) but the measured HICP inflation was only 1.1%

(Eurostat, 2002). These discrepancies are the result of differences in classification,

coverage and construction of the HICP (Baran, 2001) and are thus likely to persist.

The ECB regime is modelled on that of the Bundesbank, which has a strong track

record in controlling inflation over the past 40 years. Since 1992 UK inflation has

averaged 2.21%, which is marginally below the average for the euro zone 12 but

above that of Germany (1.86%) (Barrell, 2002; p. 59).

Second, fiscal policies in both the UK and euro zone are founded on common

principles. In each case, the consistency of fiscal policy with the objectives of

monetary policy is paramount. In essence, this requires a commitment to maintain

government debt at a level where there is no risk of default and, consequently, no

pressure on the monetary authority to bail the government out. In the UK this takes

the form of the sustainable investment rule, while in the euro zone it is embodied in

the Stability and Growth Pact, which requires governments not only to respect the

Maastricht debt limit of 60% of GDP but to reduce it over time. Similarly, there is a

commitment to economic stability in the exercise of fiscal policy. The golden rule

prohibits borrowing to pay for current government expenditure. The Stability and

Growth Pact requires member states to run a medium term budgetary position of close

to balance or in surplus and to maintain short term budget deficits within 3% of GDP.

The UK with its healthy public finances, low level of national debt, private pension

system and low benefit rates is unlikely to have a problem meeting the Stability and

Growth Pact’s deficit requirement. Controversy has emerged, however, over the

compatibility of the pact’s medium-term requirement with the government's Code for

Fiscal Stability. Government debt levels in the UK have fallen well below the

Maastricht threshold, while the government has maintained a budget surplus for a

number of years. In this sense, the Fiscal Code of Conduct has successfully allowed

the UK to keep its commitment to the Stability and Growth Pact. A threat of conflict

looms on the horizon, however, as future increases in public expenditure and

investment, consistent with the Code, are predicted to lead to the budget deficit rising

to 1.2% in 2003/4 and 1.4% in 2005/6 (HM Treasury, 2002a). In the Broad Economic

Policy Guidelines (BEPG) 2001, the Commission interpreted this measure as

potentially bringing the UK within breach of the Stability and Growth Pact, by

creating a budget deficit in the medium term. In response the UK stressed the need to

pay due attention to all cyclical factors when measuring the medium term budgetary

position and the importance of investment in the country's public services. The BEPG

2002 have attached greater weight to the UK’s position calling on the government to

be alive to deterioration in public finances but recognising the need to increase the

level of investment in public services. This subtle policy shift illustrates that the EU’s

understanding of fiscal policy is not set in stone and suggests that the Stability and

Growth Pact can evolve over time as member states learn more and more about the

effects of national fiscal policies within the euro zone.

The crucial distinction between the UK and euro zone macroeconomic regimes comes

when we consider the external dimension of the economy. Macroeconomic policies

have undoubtedly contributed towards the UK’s strong economic performance in the

1990s. However, the 1990s has also seen a build up in consumer debt, soaring house

price inflation, exchange rate volatility and, more recently, recession in significant

parts of the traded manufacturing sector. Economic growth, price stability and job

creation in other words has not precluded a degree of macroeconomic instability.

Providing that the UK economy has converged with the other euro zone economies,

membership of EMU offers an approach to monetary and fiscal policy, which is

largely consistent within its own, plus the added value of greater exchange rate

stability vis-à-vis its largest trading partner, the euro zone. In this sense, the euro zone

approach to macroeconomic policy should be seen not so much as a substitute for the

UK’s current economic framework but as a complement to it. The econometric

simulations of Barrel and Dury (2000) and Barrell (2002) confirm this point,

suggesting that EMU will have a positive impact on UK macroeconomic policy,

bringing exchange rate stability, greater credibility to monetary policy and more

stable prices.

2.9 Sustainable convergence most probable scenario

With the more stable macroeconomic policy environment in the second half of the

1990s, the UK and euro zone economies have gradually converged. Entry to the euro

zone is likely to sustain and consolidate convergence and stability. Convergence will

be reinforced by a reduction in exchange rate volatility, a common monetary policy

and enhanced fiscal policy coordination, as well as increasing levels of trade. The

common euro zone monetary policy is likely under these conditions to further

stabilise inflation in the UK and this should enhance economic performance over the

long run.

2.10 Sustainable convergence the worst case scenario

The UK enters the euro zone at an overvalued exchange rate and remains exposed to

occasional asymmetric shocks. In the event of a negative asymmetric demand shock,

for example, the fixing of the exchange would mean that adjustment would have to

take place through an adjustment in relative prices and wages, rather than through

exchange rate depreciation. The UK economy has proven its ability to live with a high

exchange rate, although the shock is likely to cause some loss in output and

employment in the short run. Output and employment effects are likely to be

minimised however with the aid of automatic budgetary stabilisers and flexible wages

and prices.

Test 2. Flexibility

2.11 Previous Studies

A key tenet of Robert Mundell’s (1961) Theory of Optimum Currency Areas is that

monetary unification between regions which face asymmetric economic shocks

necessitates greater flexibility in both factor and product markets and/or effective

instruments of fiscal stabilisation. In the event of such shocks, regions must respond

with a combination of relative wage and price adjustment, labour migration, capital

flows and counter-cyclical fiscal policy since unilateral exchange rate adjustment is

no longer an option. This raises three questions, with respect to the UK economy.

First, are UK factor and product markets sufficiently flexible to cope with the

constraints of a one-size-fits-all euro zone monetary policy? Second, is there a risk

that the inflexibility of euro zone factor and product markets could destabilise the UK

economy in the event of EMU membership? Third, is UK fiscal policy sufficiently

flexible to act as an adjustment mechanism within the constraints of the Stability and

Growth Pact?

HM Treasury (1997, p7) deemed that UK labour markets had ‘not yet achieved

sufficient flexibility to meet the challenges of EMU membership’. Bush (2001)

concludes that neither the euro zone nor the UK are any more flexible than they were

in 1997. Moreover, Bush (2001) argues that the Stability and Growth Pact would

unduly constrain UK fiscal policy as an instrument of adjustment against asymmetric

shocks and that it is in direct conflict with Gordon Brown’s Fiscal Code of Conduct.

Barrell (2002) is more optimistic in his assessment, suggesting that progress has been

made with regard to the reform of UK and euro zone labour markets. In his view, the

Stability and Growth Pact leaves room for automatic stabilisers to work, thus

bolstering the effectiveness of fiscal policy as an adjustment mechanism.

2.12 Is the UK Labour Market Sufficiently Flexible for EMU?

UK factor markets are highly liberalised and product markets are subject to a

relatively light degree of regulation. According to the OECD (2000b; p.103), the UK

product market enjoys higher regulation than that of the US but greater liberalisation

that any other EU member state. This makes the UK a very competitive economic

environment. The UK labour market has moved closest to the US in terms of flexible

employment conditions, hiring and firing costs are very low, replacement rates in the

social security system are low, and the rules of eligibility for unemployment benefit

have been tightened (OECD, 2000b; p. 98).

The UK economy was traditionally faced with real wage rigidity in the face of high

unemployment, combined with rapidly accelerating wage inflation as unemployment

fell. Margaret Thatcher’s governments in the 1980s fundamentally changed the UK

labour market, through a series of reforms. The reduction of employment protection

levels made it easier to hire workers, as well as to lay them off (Nicoletti et al., 2000;

p.51). The end result is a highly flexible labour market that is well placed to adjust to

asymmetric shocks (Fabiani and Rodriguez-Palenzuela, 2001).

Figure 6UK Inflation Unemployment Trade-Off 1973-1991

0

5

10

15

20

25

30

0 2 4 6 8 10 12 14

Unemployment Rate %Source: OECD (2002)

% a

nn

ual

ch

ang

e in

GD

P d

efla

tor

19731991

Recent performance suggests that the UK economy has reaped the benefits of labour

and product market reform. Since 1993, the UK has achieved stable growth, falling

unemployment and rising employment with low wage and price inflation. This seems

to represent a decisive break with the past. The evolution of the trade-off between

inflation and unemployment 1973-1991 is shown in Figure 6. The low rates of

unemployment are in the earlier part of the period, with the oil price increase showing

clearly as an inflation spike. Then there is a long period while unemployment rises to

squeeze the inflation pressures out of the system, so that it is not until unemployment

reaches nearly 12% that inflation falls below 5%. Subsequent reductions in

unemployment below 11% led to inflation rising above 5%. When unemployment

started to rise again towards the end of the period it had very little effect on inflation.

Thus throughout this period inflation remained relatively high even when

unemployment was high. Since 1992 there has been break with this past experience,

inflation fell to around 2.5% and has remained there despite rapidly decreasing

unemployment (Figure 7). This improvement in the UK’s performance in relation to

inflation and unemployment suggest that the UK’s non-accelerating inflation rate of

unemployment (NAIRU) has been substantially reduced (Wadhwani, 1999; Nickell

and Quintini, 2001). Thus there is downward trend in estimates of the NAIRU in the

1990s (McMorrow and Roeger, 2000, p.14), which is estimated to have fallen from

9.3% in 1990 to 6.8% in 1999.

Figure 7UK Inflation unemployment trade-off 1992-2000

0

5

10

15

20

25

30

0 2 4 6 8 10 12 14

Unemployment rate %Source: OECD (2001)

% a

nn

ual

ch

ang

e in

GD

P d

efla

tor

1992

2000

A further indicator of increased labour market flexibility is the increase in wage

inequality since the 1970s (IMF, 2001; pp. 8-10), which has been associated with an

increase in the employment intensity of growth. Between 1973 and 1991 there is a

positive relationship between GDP and employment growth (see Figure 8). There

were some unsustainable increases in employment in the late 1980s, associated with

the Lawson boom, but generally even high rates of growth in the period 1973-91 led

to only a moderate growth of employment. There are also a number of periods when

positive GDP growth was associated with losses of employment. From 1992 onwards

even modest rates of growth of GDP were associated with employment growth, which

was maintained despite shrinking unemployment (see Figure 9). Between 1973 and

1991 the ratio of GDP to employment growth averaged out at 3.75:1. The same

figure for the period 1992-2000 stood at 1.1:1. Part of this change in the employment

intensity of growth can be attributed to the fact that despite tight labour market

conditions, total hours and overtime have declined moderately since 1995 (IMF,

2001; p.11), again indicative of a change in the behaviour of the labour

market.

Figure 8 UK Relationship between employment and GDP growth 1973-91

-4

-2

0

2

4

6

8

10

-4 -3 -2 -1 0 1 2 3 4 5 6% annual increase in employment

Source: ONS(2001)

% a

nnua

l inc

reas

e in

GD

P

Figure 9UK employment and GDP growth 1992-2000

-4

-2

0

2

4

6

8

10

-4 -3 -2 -1 0 1 2 3 4 5 6

% annual change in employment

Source: ONS (2001)

% a

nn

ual

ch

ang

e in

GD

P l

agg

ed 6

mo

nth

s

7 Except Ireland and the Netherlands

The combination of the improved employment intensity of growth and the long period

of positive GDP growth have added up to an impressive level of employment

creation. Between 1993 and the end of 2000 nearly 2.5 million jobs were created in

the UK. The UK has one of the highest employment rates in the EU and it has been

one of the few countries to raise employment rates since the 1970s. All regions in the

UK have benefited to a greater or lesser extent from the reduction in unemployment.

Substantial inroads have also been made into the problem of long-term

unemployment, the proportion of the unemployed who have been out of work for

more than a year has fallen from 38.3% in the first quarter of 1996 to only 21.7% in

the final quarter of 2000. The comparatively strong employment performance of the

UK economy persisted during the recent global economic slow down

2.13 Is the Euro Zone Labour Market Sufficiently Flexible for EMU?

The primary concern for the UK is that is own labour market is sufficiently flexible to

adjust to EMU. Of secondary importance is the adjustment capabilities of its

neighbours since inflexible labour markets in the larger euro zone member states

could leave the UK vulnerable to economic instability abroad. The question remains,

therefore, as to whether the euro zone product and factor markets are well placed to

adjust to asymmetric shocks, which might arise under EMU. The answer will depend

on member states’ progress in the field of structural reform. There can be little doubt

that the UK economy is considerably more liberal in character than its EU peers but

this does not necessarily mean that these peers are considerably less flexible. Other

EU member states have approached the adjustment challenge with a combination of

competitively minded-wage bargains and structural reform in factor and product

markets (Calmfors, 2001).

The process of economic reform in the EU has been criticised in some quarters. A

recent study by Oxford Economic Forecasting (2002) finds that the UK would be

more vulnerable to the effects of asymmetric shocks inside rather than outside EMU,

even if euro zone labour markets are reformed ‘to bring then closer to the Anglo-

Saxon model’. The key assumption in this study is that labour market reform in the

EU is targeted ‘not on the dynamic adjustment to the euro zone economy to different

shocks, but on the long-run equilibrium unemployment rate’ (OEF, 2002, p.14).

Although the report is correct in pointing out that different strands of economic

reform will have different effects on the adjustment capabilities of the euro zone

economy, it is misleading to suggest that EU economic reform is concerned only with

lowering the equilibrium rate of unemployment. High unemployment levels were a

motivating factor behind the launch of the Employment Strategy but so too was the

need to boost the ‘shock absorbency’ of labour markets in the face of asymmetric

shocks (Dyson, 2000). At the heart of the Cardiff Process is the recognition that

structural rigidities impede the proper functioning of markets and that greater

competition and flexibility will be needed in the face of economic disturbances.

In its recent White Paper on Economic Reform in Europe, HM Treasury (2002b) was

positive about factor and product market reform in the Union. Five million new jobs,

have been created in the EU since March 2000, the telecommunications market has

been fully liberalised, postal services have been further liberalised and €1 billion in

venture capital support has been offered by the European Investment Bank to Small

and Medium Sized Enterprises. Lisbon is, of course, a 10-year strategy and further

reform is necessary. HM Treasury calls in this regard for ‘lighter and more targeted

regulation’, the liberalisation of financial markets in general and risk capital markets

in particular and the development of Union wide networks in public utilities. Layard

et al. (2000) note that recent labour market reforms in the Netherlands boosted the

employment rate from 58% in 1985 to 68% in 1998 and the reform of the Spanish

labour market has helped to create two million new jobs since the mid-1990s. Indeed,

since the launch of the euro, employment growth in France (5.3%) has been double

the rate in the UK (2.6%). In summary, therefore, UK labour markets are well placed

for entry to EMU, while the reform of euro zone labour markets is progressing

steadily.

2.14 Is UK Fiscal Policy Prepared for EMU?

EMU gives rise to a two-fold source of tension for fiscal policy. First, in the absence

of autonomous control over monetary policy, fiscal policy becomes a more important

policy instrument for national governments. Second, monetary unification increases

the interdependence between national economies. The effects of national fiscal policy

are quickly transmitted to the rest of the euro zone through, amongst other channels,

the newly created common interest rate. Hence, EMU brings with it the risk of greater

fiscal activism, increased fiscal spill over and increased fiscal conflict. The national

governments responded to this risk by adopting the Stability and Growth Pact, which

limits budget deficits to 3% of GDP i.e. within bounds where they pose no threat to

economic stability in the euro zone. A breach of this limit will trigger an excessive

deficit procedure, which begins with censure from the Council of Ministers and can

end up with the imposition of a fine on the member state in question.

The Stability and Growth Pact may secure a more coordinated fiscal policy for the

euro zone but it has been perceived by some commentators as limiting fiscal

flexibility and demand management at the national level (Bush, 2001, p54). This

criticism rests on too narrow an interpretation of the pact for a number of reasons.

First, the excessive deficit procedure will not be launched against a member state that

is confronted by an exceptionally severe recession. Second, and more importantly, the

deficit rule is accompanied in the pact by a medium-term rule, which calls on member

states to run a medium term budgetary position of close to balance or in surplus. So

long as a member state meets the latter requirement then its automatic budgetary

stabilisers will have sustained room for manoeuvre in the event of an economic slow

down, without breaching the 3% deficit ceiling. Thus, the more salient question in this

debate is not whether the Stability and Growth Pact limits fiscal flexibility but rather

whether member states have reached their medium-term budgetary requirement.

Providing that this is the case, euro zone fiscal policy will be flexible enough.

2.15 Flexibility most probable scenario

Economic convergence and macroeconomic stability are likely to reduce the

incidence of asymmetric shocks that affect the UK economy. In the event that an

asymmetric shock does arise, however, labour and product markets on one hand and

automatic fiscal stabilisers on the other will insulate the UK economy and the rest of

the euro zone to a significant degree.

2.16 Flexibility worst case scenario

Assuming that the UK economy does not become any less flexible under EMU, the

worst case scenario is that the existing members of the euro zone fail to increase the

flexibility of their product and factor markets. First, economic stability in Continental

Europe represents a problem for the UK whether it joins the euro zone or not.

Second, such instability is likely to harm inflexible parts of the euro zone itself more

than it harms the UK. This provides strong incentives on the former to reform factor

and product markets as witnessed in the implementation of the European Employment

Pact and Lisbon Strategy.

Test 3. Investment

2.17 Previous Studies

According to HM Treasury (2002), membership of EMU would be beneficial for

investment as a result of macroeconomic stability, competition and new opportunities

but only when the UK and euro zone economies are sufficiently convergent. In

contrast, high levels of indigenous and foreign direct investment are seen by Bush

(2001) as a vindication of the success of UK macroeconomic policy outside EMU,

indicating that there is no reason to change. The evidence to support this position

relates to business investment and foreign direct investment. In 2000 business

investment in the UK as a percentage of GDP was higher than at any time since 1965.

In absolute terms, though, the rate of gross capital investment as a percentage of GDP

(at current market prices) was lower in the UK (18.5) than it is in France (19.7) and

Germany (21.4)8. Business investment fell in 2001 (ONS, 2002a) as a result of the

telecommunications slump and capital formation overall has been falling since 1998

(ONS, 2002b). In addition business investment and investment overall is being driven

by investment in other services, which has recently accounted for around 60% of

business investment compared with only 16% for manufacturing. From 1998-2001

investment in other services rose by 24% while that in manufacturing fell by 18%.

The UK enjoyed record levels of inward investment in 2000, which was related to

exceptionally high overall levels of FDI (UNCTAD, 2001). Nonetheless, Germany

overtook the UK as the EU’s most popular destination for FDI in the same year

(UNCTAD, 2001, p291). The proportion of manufacturing projects also seems to be

declining (Ernst and Young, 2002). Thus the UK’s position in relation to foreign

8 European Commission (2001 p.150-151).

direct investment outside the euro zone is by no means as secure as suggested by

Bush (2001). The balance of evidence suggests that membership of EMU would

enhance stability, this is particularly important in relation to exchange rates and

inward manufacturing investment.

Layard et al. (2000) argue that fluctuations in the external value of sterling since the

1970s have caused destabilising fluctuations in the UK’s exporters ability to compete

on world markets. The 25% increase in the value of sterling against the (synthetic)

euro between 1996 and early 2000, they argue significantly damaged the UK’s

competitiveness vis-à-vis the euro zone.

Barrell (2002) is less sure about the effects of EMU on investment. The potentially

greater stability of inflation, interest rates and the exchange rate in EMU should

encourage higher investment, productivity and growth in the UK. There is no clear

view on the impact of EMU membership on FDI, however, because there are

contradictory effects both on inward and outward FDI.

2.18 Domestic Investment

There are two principal ways in which EMU may affect the volume of investment in

the UK: first by its impact on macroeconomic stability; and second by the effects of

further integration. Macroeconomic instability and exchange variability in particular

add to uncertainty and may adversely affect investment in the UK by domestic and

foreign firms. UK nominal and real exchange rates have been subject to high levels of

both forms of variability.

Where investment is irreversible and future economic conditions are uncertain

postponing investment can be a sensible strategy (Dixit and Pindyck, 1994). This

relates to the timing of investment not its long run equilibrium level. In fact

uncertainty has contradictory incentives that may encourage or discourage investment,

with simulations suggesting that the disincentive effect only dominates when

uncertainty becomes large relative to the expected growth rate (Abel and Eberly,

1999).

The empirical literature suggests that uncertainty measured in various ways reduces

long run fixed capital investment (Carruth et al, 2000) but also that the effect varies

across industries and types of capital goods. Exchange rate volatility has been found

to have had a negative long run effect on investment in France, Germany and the US

but only temporary effects in the UK and Italy (Darby et al, 1999). Sustained

exchange rate misalignment is, however, found to have a negative effect on long run

investment in the UK, France and USA. There may, however, be an aggregation

problem because not all investment is sensitive to the effect of the exchange rate. In

more disaggregated studies the real exchange rate is shown to have an important

impact on export performance (Carlin et al, 2001; pp.140). For individual firms, the

impact of exchange rate fluctuations is likely to be greater in more competitive

markets. Product market reform in the UK government could thus raise the

sensitivity of UK investment to the exchange rate.

2.19 Foreign Direct Investment

The Single Market Programme has had clear effects on the level of inward investment

into the UK (Arrowsmith et al, 1997; Pain, 1997; Dunning, 1997). The UK has been

an attractive location with a welcoming business environment and comparatively low

labour cost per unit of output with guaranteed access to the EU market. Outside EMU

the UK faces barriers compared to those inside the euro zone and uncertain costs of

production. The effect of exchange rate uncertainty effects on FDI is, however,

unclear. Exchange variability adds additional uncertainty to returns from investment

overseas and so may discourage it. There are, however, gains from production

flexibility and from diversifying risk, which may encourage FDI in the presence of

exchange rate volatility (Aizenman, 1992; Goldberg and Kolstad, 1995). Operating

several plants in different currency zones makes it possible to move production in

response to the effect of exchange rates on costs. Producing within a currency zone

ensures that the revenue and costs are denominated in the same currency, thus

avoiding a large element of exchange rate uncertainty.

Empirical studies differ as to the relationship between exchange rate volatility and

investment. Volatility is found to reduce FDI into the US (Campa, 1993) but to

increase it by Goldberg and Kolstad (1995) and De Ménil, (1999). These

contradictory results may be due to the effect of exchange rate volatility varying with

the type of investment and the size of the economy. The fact that US and Japanese

firms in the UK export a large proportion of their output to Europe may explain why

these firms are particularly keen on UK membership of EMU (Pain, 2002; p.105).

Thus, although the UK has held on to its share of inward investment (Table 4) the

proportion of manufacturing projects is declining (Ernst and Young, 2002). On the

basis of this evidence it seems unlikely that joining EMU and reducing currency

volatility would have very large effects on inward FDI in the UK, but that it may

encourage more manufacturing investment.

Table 4 Inward Foreign Direct Investment

1985-94 1995 1996 1997 1998 1999 2000Billion of US $

UK 19.2 20.0 24.4 33.2 70.6 82.9 130.4Germany 3.4 12.0 6.6 12.2 24.3 55.9 176.1EU 76.6 113.5 109.6 127.6 261.1 467.2 617.3

% of EU totalUK 25.1 17.6 22.3 26.0 27.0 17.7 21.1Germany 4.4 10.6 6.0 9.6 9.3 12.0 28.5Source: UNCTAD (2001)

There is, however, clear evidence that location decisions by foreign companies are

significantly influenced by the relative cost of production (Pain, 1997). Thus the rate

at which sterling enters EMU will have an impact on FDI. So entry to EMU at an

exchange rate that is near to its long run equilibrium level would encourage FDI.

Entry at too high a level could, by the same logic, depress FDI. Since it will take a

considerable time for changes in relative prices to correct any misalignment and since

the effects could be long lived, this underlines once more the importance for the UK

of entering the euro zone at a sustainable exchange rate.

2.20 Investment most probable scenario

10 In larger countries investment to produce for the indigenous market may be encouraged but for theexport market discouraged.

EMU will be compatible with high levels of indigenous and foreign investment in the

UK. A more stable macroeconomic policy environment and greater certainty over the

exchange rate under EMU will encourage higher levels of indigenous and foreign

investment in the UK.

2.21 Investment worst case scenario

There is little convincing evidence to suggest that EMU could be harmful to

investment in the UK. The worst case scenario is that exchange rate certainty fails to

spur domestic investment or attract foreign investors by the expected degree. The

status quo persists here, meaning that the UK continues to be one of the most

attractive locations for investment within the European Union.

Test 4 Financial Services and the City of London

2.22 Previous Studies

In the view of HM Treasury (1997), the City will prosper irrespective of whether the

UK joins EMU, although new opportunities would be easier to exploit inside rather

than outside the euro zone. Barrell (2002) presents a stronger case in favour of EMU,

suggesting that the City would benefit from access to a large and liquid euro zone

financial market. Whilst the UK remains outside the euro zone, however, the

economies of scale associated with this market integration could shift the balance of

competitive advantage in financial services from London to Frankfurt (Barrell, 2002).

Even now the rest of the EU poses stiff competition for the UK when it comes to

financial services. Levin (2001) finds that the total market capitalisation of firms

listed on the London Stock Exchange has doubled since 1993. Although it has clearly

started from a lower level, the total market capitalisation of firms listed on the Paris

Stock Exchange has tripled over this period. A note of caution is sounded in this

debate by Lascelles (2001) who warns that EMU membership could lead to creeping

harmonisation in the regulation of financial services. Financial regulation is of course

a matter for the Internal Market rather than EMU and as a such the UK must address

the issue whether it joins the euro zone or not (Levin, 2002).

2.23 Financial Services and the UK

The City of London is the financial centre of Europe and a vital industry for the UK

with its international orientation it is also important to the Balance of Payments,

accounting for 4.4 per cent of total exports in 2000. (IFSL, 2001) The importance of

the sector and the fact that it is subject to rapid change means that the impact of EMU

on UK financial services is a legitimate cause for concern.

EMU is expected to enhance cross-border competition significantly within the

financial services sector and this is already to be seen in wholesale banking and

securities markets. There has been a substantial growth in the use of stock and euro

bond issues as sources of European company finance. Investment policies have

become more diversified with a shift from national to euro wide investment, as shown

by the increasing use of European rather than national benchmark indices. Financial

institutions are also the subject of mergers although this has been in investment

banking and insurance rather than retail banking. (IFSL, 2001). Intra euro area foreign

exchange dealing has disappeared but this has had a limited impact on London whose

business is concentrated on extra euro zone foreign exchange.

London’s competitive advantage in financial services is based upon a combination of

factors favouring agglomeration. There are substantial externalities in the pooling of

information across the markets for financial products. The volume of transactions in

the large market provides liquidity ensuring that prices reflect the value of assets

more accurately and that the market is deep and wide. London has developed a critical

mass of financial markets, related business and support services. The size of London’s

financial services industry in addition provides a large, skilled and English speaking

workforce, with flexible employment conditions.

These factors have enabled London to compete effectively, even with the UK outside

the euro area. London is the world’s largest centre for cross-border bank lending,

equities trading, foreign exchange dealing, marine and aviation insurance, as well as

having an important role in fund management and corporate finance (IFSL, 2001a,

p.2). There is no convincing evidence that remaining outside the euro zone has

harmed the financial services industry in the UK. UK based banks have had access to

the euro payment system TARGET, indeed recently London has accounted for 19 per

cent of cross border payments, up from 15 per cent at the launch of the euro

(Clementi, 2001). Loopholes in Single Market legislation have not been used to block

UK access to Euro markets. In the longer term the location of the European Central

Bank, could encourage a gravitation of markets to the city with best local information.

As the case of the US shows, however, this need not correspond to the location of the

monetary authority. New York remains the financial centre of the US despite the

Federal Reserve being in Washington. Most US money market operations are,

however, carried out in New York by the local Federal Reserve Bank. EMU would

help London to consolidate its position as the EU’s financial centre. It would be the

natural location for the ECB to carry out most of its open market operations. With a

monetary union there would be strong incentives to concentrate financial services in

one centre both for ‘domestic’ and international operations.

2.24 Financial services most probable scenario

Entry to EMU reinforces the City’s position as Europe’s leading financial centre,

resulting in a further agglomeration of financial services.

2.25 Financial services worst case scenario

Since there are no convincing reasons as to why membership of EMU should harm

London’s position as a financial centre, the worst case scenario is that the status quo

prevails. The UK continues to successfully compete, in other words, with the likes of

Frankfurt and Paris.

Test 5 Employment and growth

2.26 Previous Studies

The fifth and final economic test will hold true if and only if the four preceding tests

have been passed. Using the Liverpool Econometric Model, Minford (2001)

demonstrates that output, employment, unemployment, real interest rates and inflation

would be much more unstable if the UK economy joined the euro zone, rather than

pursuing current policies with a floating exchange rate. This result arises because

under the floating exchange rate scenario interest rates in the UK are assumed to

change in response to economic shocks, but within EMU it is assumed that euro zone

interest rates do not. In a similar vein, Oxford Economic Forecasting (2002) use their

Global Macroeconomic Model to evaluate UK membership of EMU under five

scenarios. They find that the response of the UK economy to asymmetric shocks is

more pronounced within the euro zone and that these results hold true even if the ECB

adopted policies similar to that of the Bank of England and labour markets were made

more flexible. Barrell and Dury (2000) and Barrell (2002) reach a rather different

conclusion by using the National Institutes, NIGEM model to examine the effects of

shocks that are similar in nature to those which were faced by the UK economy

between 1991 and 1997. The difference in the variability of output, the price level

and inflation are then evaluated for the UK before and after it joins the euro zone.

The results suggest that output is more variable for the UK when it joins EMU,

although this is more than compensated for by large reductions in the variability of the

price level and inflation. It is important to note, however, that although there is a risk

that output volatility might increase, the key finding from the Barrell study is that the

trend of output growth will be higher. This finding is not contradicted in either the

OEF or Minford studies.

2.27 The Outlook for the UK Economy

UK macroeconomic policy has become gradually more stability-oriented in recent

times but fundamental instabilities remain, not least because of periodic and severe

fluctuations in sterling. This has taken its toll on employment and output, most

notably on the manufacturing industry. ECB monetary policy will be appropriate for

the UK if it is cyclically convergent with the euro zone. It is incorrect to assume, as

Minford (2001) and OEF (2002) do, that the exposure of the UK to asymmetric

shocks is independent of the macroeconomic regime. The analysis of OEF (2002)

considers the response of the UK economy to simulated asymmetric shocks both

inside and outside EMU. It provides little evidence however, to suggest that

asymmetric shocks will be more prevalent under EMU. Minford (2001, p70) assumes

that the UK economy that joins the euro zone will face shocks that are similar to those

witnessed in the late 1980s and the 1990s. The convergence process has thus far

brought greater stability to UK and euro zone economies and increased the correlation

between their respective business cycles. This trend would be enhanced by EMU

membership itself, with pro-competitive effects leading to deeper economic

integration within the euro zone, a lower incidence of asymmetric shocks and an ECB

monetary policy that is more suited to economic conditions within the UK economy.

The late 1980s and 1990s, in other words, are not very representative of the economic

conditions that the UK would face as a member of EMU.

No degree of economic integration will completely eradicate the occurrence of

asymmetric shocks. UK factor and product markets on one hand and fiscal policy

must be prepared to bear the brunt of adjustment against such shocks so as to

minimise their effect on employment and economic growth. As discussed in the

previous section, the UK’s flexible wages and prices and orderly public finances are

well-placed to meet this challenge.

Over the long term, membership of EMU would make a positive contribution towards

economic growth and job creation in the UK (Barrell, 2002). In this sense, monetary

unification is just the next step in a process of trade integration, which began with

accession to the EEC in 1973 and which has promoted intra-EU trade and contributed

towards economic growth (Coe and Moghadam, 1993; Ben-David, 1993; 1996).

EMU is expected to engender the kind of pro-competitive effects on UK economic

growth, which accompanied the Single Market Programme (Allen et al, 1998;

Griffith, 2001) and the effects of EMU should be similar (O’Mahony, 2002).

2.28 Employment and Growth: Most Probable Scenario.

EMU membership enhances the stability of the UK economy as a result of the

improved macroeconomic policy environment and reduced exchange rate uncertainty.

Investment is encouraged, productivity is boosted, trade linkages are strengthened and

competition is increased. The net result is higher economic growth and job creation.

2.29 Employment and Growth: Worst Case Scenario

Once it is a member of the euro zone, the UK is faced with asymmetric economic

shocks. These shocks will have an impact on investment, growth and employment

but the effect will be minimised by the flexibility of factor and product markets and

the operation of the automatic budgetary stabilisers.

3. Conclusion

The preceding analysis suggests that, in its current state, the UK economy has passed

the Chancellor’s Five Economic Tests for entry to EMU. This does not mean that

entry to EMU would be a costless exercise for the UK. It implies rather that the

conditions are in place to ensure that such costs will be outweighed by the benefits

that EMU membership would bring to the UK in the form of exchange rate stability,

macroeconomic certainty, increased competition, economic growth and job creation.

Analyses of this kind are always difficult and are never definitive but there are

particular problems in this case because the adoption of the euro is a major regime

change and thus the past is an unreliable guide to the future. The salience of such a

regime change is that it can lead to rapid and substantial change in the behaviour of

economic agents and thus in key economic relationships. A powerful illustration is the

adaptation in Italy and Spain, both of which have seen a shift in labour market

behaviour that has meant that their propensity to high levels of inflation has been

over-turned.

Attempts by the ‘No Campaign’ to evaluate the Five Tests (Bush, 2001) and the

effects on the UK economy of EMU membership (Oxford Economic Forecasting,

2002) are open to the criticism that they fail to recognise the effects of this regime

change. Thus a permanently fixed exchange rate with the euro and a common

monetary policy and the coordination of fiscal policy will lead to greater convergence

of economic performance between the UK economy and the other euro zone

countries. The relevant question is whether this benefit to stability will be more than

offset by the reduced ability to tailor macroeconomic policy to national

circumstances.

The UK economy is currently convergent with the euro zone on a range of criteria

such as output gaps, GDP growth, interest rates and inflation. This convergence is

likely to be maintained within EMU because the ECB monetary policy is likely to

prove more credible and stable than the current UK policy regime. A frequent cause

of past shocks will be avoided by installing a credible monetary policy, a fixed

exchange rate and stable fiscal policy. The UK is unlikely to have particular problems

from asymmetric shocks; the differences in its trade, financial structures and oil

production are insufficient to lead to large divergences in economic performance. The

current UK economic system may have delivered improved performance but

macroeconomic instabilities persist. Whilst the 1990s have witnessed stable and high

growth, growing employment and falling unemployment, this has been accompanied

by a stagnating manufacturing sector, a growing current account deficit and

ballooning consumer debt.

Both measures of product and labour market flexibility and actual performance

suggest that the UK is flexible enough to adjust to shocks without resorting to the

exchange rate and in the absence of national monetary policy. There is also evidence

that the euro zone is becoming more flexible as a result of structural reform as well as

through competitively-minded wage bargains. The Stability and Growth Pact does

provide for the possibility of both euro zone and national differentiated fiscal policy

to augment monetary policy. Although this is limited largely to automatic stabilisers,

this is in line with current thinking on the correct use and role of fiscal policy.

Greater stability, particularly of inflation, should be helpful in encouraging higher

levels of investment particularly in manufacturing. The avoidance of misalignments

of exchange rates will be another feature acting positively upon investment. The

impact of EMU membership on Foreign Direct Investment is uncertain but there are

no reasons to suppose that the effects would be dramatic. So, overall full EMU

membership should be positive for investment.

The City of London and the Financial Services Industry generally have prospered

outside of EMU. There are no strong arguments for expecting that membership would

harm the industry. In addition membership would ensure that the City was able to take

advantage of any concentration of economic activity within the euro zone.

With full EMU membership achieving stability and convergence, with flexibility to

adjust to shocks, increased investment and the position of the City secured, UK

growth and employment should be enhanced. Additional trade and competition within

the euro zone should augment this positive effect. Growth and employment could

suffer if the fixed exchange rate for sterling against the euro was too high. Although

the UK economy would adjust this would be costly in growth and jobs with

potentially long lasting results. Unfortunately standing aloof from EMU does not

prevent this problem, as witnessed by exchange rate instability in the UK over the last

five years. Past experience suggests that any realignment is likely to be excessive

triggering yet another round in the instability that has plagued the UK economy in the

floating exchange rate era. Full membership of EMU holds out the hope of

establishing the stable macroeconomic environment that has so long proved a chimera

for the UK.

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