There has been widespread discussion on whether Britain should enter the exchange rate mechanism of the European Monetary System. The House of Commons Treasury and Civil Service Committee published a report on the EMS on Tuesday, 19th November, and Research Fellow Patrick Minford discussed the EMS and the Committee's report at a CEPR lunchtime talk that day. Minford argued that it would be a disaster for Britain to join the EMS and that the Select Committee had been right to recommend against membership, which would bring few clear benefits and some important disadvantages. He said that the EMS has encouraged the growth of distortionary barriers to capital mobility and to free trade. It has also led to increased monetary volatility in member countries. Minford argued that current UK monetary policy is performing reasonably well and that there is no reason to change course.

Patrick Minford is Professor of Economics at the University of Liverpool and a Research Fellow in the Centre's International Macroeconomics programme. Minford's talk was one of a series in which CEPR Research Fellows discuss policy-relevant research; financial support for this meeting was provided by a grant from the German Marshall Fund of the United States. Research Fellows may advance specific views on policy at these meetings, but these views are their own and not those of the German Marshall Fund nor of the Centre, which takes no institutional policy positions.

Minford observed that the EMS is a system of 'fixed-but- adjustable' parities between a number of European countries, each pursuing independent monetary policies. The key currency in the EMS is the Deutschmark (DM), and the monetary policy of the Bundesbank plays a key role in the behaviour of the EMS. There have inevitably been shifts of member currency parities against the DM, notably the Belgian and the French francs and the Italian lira. These parity shifts are generally foreseen well in advance, even if their timing is uncertain. They create a 'one- way option' in the devaluing currency, of the kind familiar in the later years of the Bretton Woods agreement. The exchange market becomes unstable, and during these crises capital flows must be stemmed by means of exchange controls and abrupt shifts in monetary policy. A period of quiescence usually follows the devaluation, but the initial instability recurs unless domestic monetary policy is aligned with that of the Bundesbank. Hence, Minford argued, exchange controls become institutionalized, either through two-tier markets or physical controls. Controls on trade in services such as tourism and insurance also become necessary, because these are a potential route for avoiding capital controls; even barriers to trade in goods may be encouraged for the same reason. Monetary policy also becomes much more volatile.

The EMS is often defended as a means of reducing fluctuations in intra-European price competitiveness, but Minford suggested that evidence for this is weak and informal. The earlier pattern of random fluctuations has been replaced under the EMS by occasional sharp swings. The result may be exchange rates which are less volatile (i.e., they have a lower variance) but which display a more skewed distribution. It was not clear that this was preferable, Minford observed.

Minford drew attention to the disadvantages of the EMS. One cost is the tendency of the EMS to encourage barriers to capital mobility and to free trade. The distortions caused by these barriers are well-known and likely to be important, driving a wedge between investment returns in the world and in the protected markets. Minford estimated that if exchange controls caused real returns in the UK to fall 1% below a world rate of 5%, this would inflict over time a loss equivalent to 15% of GNP.

A second cost of the EMS is the increased monetary volatility it causes in member countries. Such volatility leads markets to add a risk premium to bond yields, pushing interest rates up and so creating another market distortion. Increased monetary volatility also contributes to greater volatility in the real economy, Minford added.

These problems are compounded for Britain, because she is an oil exporter and one of the major world financial centres. One object of the government's Medium Term Financial Strategy (MTFS) was to create monetary stability. Minford argued that Sterling M3 had been rightly abandoned (informally) as a major indicator some four and a half years ago, because it yielded a distorted picture in the more competitive financial environment which has arisen since 1979. Since 1981 M0 has assumed an informal role as an indicator of monetary conditions and has performed relatively well. Minford hoped that the Treasury was not flirting with membership of the EMS or with exchange rate targetting. The correct policy for the UK, he said, involves continued emphasis on M0, preferably in a slow evolution towards Monetary Base Control. Policy should respond to the exchange rate only if it displays sharp and sustained movements, which threaten to destabilise monetary conditions. Such a policy has worked well hitherto, and Minford viewed this as perhaps the most decisive argument against the EMS. Why embark upon a sea of unknown troubles when present policies serve us reasonably well?