EMS -
IS THE HONEYMOON OVER?

The European Monetary System has experienced success to date, but will face greater difficulties in the future, according to CEPR Research Fellow Charles Wyplosz. Research Fellow David Begg accepted that EMS membership would be advantageous for the UK but maintained that it did not represent an easy solution to current problems. Membership would be no help in dealing with the problem of the dollar while the US, Europe and Japan pursued divergent economic policies. Should the UK join the EMS with sterling at its present level? Begg argued that this problem of the "right rate' had been overemphasized in recent discussions of EMS membership. Begg and Wyplosz, joint managing editors of the new European journal Economic Policy, spoke at an April 22 lunchtime meeting devoted to the EMS.

Since 1979, exchange rate variability has been reduced for intra- EMS parities, at a time when the exchange rates of non-EMS countries have shown increased volatility. There is also evidence that economic policies have converged. Inflation in the EMS countries decreased between 1979-84 with some reduction of inflation differentials, while unemployment rose uniformly, with no widening differences.

This performance was not due entirely to the merits of the EMS itself, but to other favourable circumstances, according to Wyplosz. First, the EMS was created at the peak of inflation. Members were resolved to fight inflation and accept the consequences in terms of unemployment. Second, restrictions on capital movements in devaluation-prone countries may have been instrumental in easing realignment problems, even though the EMS was expected to contribute to a further integration of financial markets. Third, while the EMS has been seen sometimes as a threat to the US dollar, the strength of the dollar turned out to be the best ally of the EMS, as it kept the DM relatively weak.

The EMS may now face harder times, Wyplosz predicted. With inflation under control, member countries may now give more emphasis to a reduction in unemployment. This may exacerbate tensions as the EMS countries adopt divergent policies to cure unemployment.

One of the most encouraging features of the EMS, he argued, was the success of the ECU as a private "currency'. Why should the monetary authorities, which created the ECU, actually trail behind private markets? They should build upon the success of the ECU and move quickly toward a monetary union. The loss of independence in monetary policy is likely to be more symbolic than real, given the current consensus in favour of less activist monetary policy and the deregulation of financial markets. Fiscal policy would be more effective under the fixed exchange rates of a monetary union and could provide some scope for policy independence. Monetary union would reduce the volatility of interest rates, lessen uncertainty and encourage the pursuit of less "chauvinist' policies by member states.

Begg emphasized that EMS membership was not an easy solution to UK problems, especially for a government committed to independent domestic monetary targets. He noted that freely floating exchange rates allow autonomous domestic policies, but can lead not only to volatile but also persistently misaligned exchange rates. This can be avoided by sacrificing autonomy over domestic policy and pursuing international policy harmonisation. UK membership would mean that the EMS contained two large and open capital markets, Germany and the UK, and this would necessitate policy coordination between their governments. Since intervention in the foreign exchange markets is unlikely to have substantial and persistent effects, speculative pressures could cause serious problems unless markets were convinced that such policy harmonisation would be effective. In this sense, the EMS may be a form of policy precommitment, the advantages of which have been stressed in recent analyses of rules versus discretionary economic policies. But how far would the UK wish to follow the German medium-term financial strategy?

Begg argued that the gains from EMS membership could also be attained outside the EMS by an appropriate choice of policies. He thought the government unlikely to adopt such policies, however, while remaining outside the EMS. EMS membership might be advantageous if it induced the government to pay more attention to the exchange rate.

Begg noted that EMS membership had been advocated as a means of reducing nominal exchange rate volatility. There was little evidence, however, that such volatility has seriously impeded world trade. Volatility in the foreign exchange market may be less costly than volatility elsewhere in the economy, Begg argued, since forward markets allowed foreign exchange traders to "insure' against the risk of volatile exchange rates.

Misalignment - a persistent departure of the exchange rate from its competitive level - was a more serious problem, according to Begg. Such misalignment seemed to persist in the UK for up to 5 years after an exchange rate shock. Misalignment affected aggregate demand and led to resource misallocation by providing the wrong price signals to the domestic economy. He argued that these costs are more important than those due to volatility.

The recent behaviour of the dollar has been a source of uncertainty, both for the UK and the EMS currencies. Begg thought it unlikely that UK membership would significantly affect this. Only greater policy coordination could prevent the wilder swings of international competitiveness and the threats of protection to which they give rise. Begg asserted that believing that exchange rate stabilisation can be achieved by institutional means, without reference to the fundamentals of domestic monetary and fiscal policies is even less sensible than believing incomes policy alone can fight inflation, regardless of the monetary policy in force.
What effect would UK membership have on the EMS and on the UK itself? Faced with a potential loss of autonomy over domestic policy, the government might look much more seriously than before at the "second-best' alternative of interest equalisation taxes. EMS membership might force the government to implement interest equalization taxes where it would not otherwise have done so, Begg argued.


The effect of oil on UK government revenues has led the pound to react sharply to oil prices, more than has seemed necessary to maintain the UK current account position. Future oil price shocks would have an asymmetric effect on the UK and other EMS members. Begg argued that the UK should not join the EMS without a credible policy commitment to realign currencies in the event of such an oil shock. Such an agreement would mean, however, that EMS membership would then do little to protect the UK from exchange rate variability induced by oil effects.


Should the UK join the EMS with sterling at its present level? Begg argued that the problems of determining the "right rate' at which to join are overstated. The initial sterling parities are not the most important consideration in assessing the desirability of EMS membership. Remaining outside the EMS has not been a guarantee that misalignment will be avoided. Begg argued that EMS membership would at least oblige the government to form a view on a desirable exchange rate "band' and would rule out the option of neglecting the exchange rate. Whether or not the UK joins at the most advantageous rate, misalignment is unlikely to be worse than that experienced in the first half of the 1980s.