European Monetary Union
Sterling's entry

When he was UK Chancellor of the Exchequer, Nigel Lawson decided upon full membership of the EMS as an attractive alternative for combating inflation, but he was unable to persuade the then Prime Minister of this view. He resigned when she refused to disown the view of her personal economic adviser, Sir Alan Walters, that the EMS is a `half-baked' system which would not survive the removal of capital controls. According to the `Walters critique', an inflationary economy entering the EMS without capital controls will be forced by financial arbitrage to reduce nominal interest rates, which in turn will reduce real interest rates, stimulate the economy and exacerbate inflation, so the system is potentially unstable. Only if the peg is not credible, according to Walters, will this tendency for inflation to diverge be checked. Therefore, paradoxically, the system can only survive if financial markets do not believe in it!

In Discussion No. 480, Programme Director Marcus Miller and alan Sutherland test Walters's argument using a macroeconomic model in which exchange rate expectations play explicit roles in wage setting and in determining interest rates. They find that the effects predicted by Walters will not occur when financial and labour markets have common beliefs about the permanence of the exchange rate peg, since the nominal interest rate and the inflation rate move by the same amount. Contrary to Walters, as the beliefs of agents in both markets in the credibility of the peg increases, inflation decreases. The `perverse' real interest rate effects will obtain, however, if financial markets view the peg as credible while labour markets do not, although inflation will only diverge `on impact' if the difference in credibility in the two markets is large. The Walters critique therefore depends on `expectational inconsistency'.

Miller and Sutherland argue further that even if inflation <MI>does<D> diverge on impact, two powerful stabilizing mechanisms remain. First, since the exchange rate is pegged to a non-inflationary hard currency, rising prices lead to real exchange rate appreciation which checks inflation, so the latter converges to zero. Second, if there are <MI>no<D> realignments, a `learning process' must result in a convergence to full credibility of the peg in both markets, which will again reduce inflation to zero. Hence, even if expectational inconsistency generates the short-run effects Walters predicts, it will not lead to instability in the longer run. The authors' analysis contradicts Walters's claim to have identified a fatal flaw in the EMS. It implies further that if the UK's entry into the ERM produces the perverse effects he predicts in the short run, the appropriate remedy would not be to reduce the credibility of the peg in financial markets but rather to increase its credibility among wage-setters.

The `Walters Critique' of the EMS: A Case of Inconsistent Expectations
Marcus Miller and Alan Sutherland

Discussion Paper No. 480, November 1990 (IM)