Sterling and the EMS In for a penny

Sterling and the EMS
In for a penny …

Britain should join the EMS now, Jacques Melitz told a lunchtime meeting on 14 September. He presented evidence which suggested that membership would help stabilize the real effective exchange rate of sterling and the UK terms of trade. Melitz dismissed the arguments against UK entry: there would be no real loss of monetary policy independence, since the authorities had already largely abandoned monetary control, and the persistent misalignments of the 1980s could be avoided in the EMS, despite the pound's petrocurrency status. The importance of sterling in international portfolios could cause problems with EMS membership, but Melitz believed these could be managed.

Jacques Melitz is a member of the Research Unit at the Institut National de la Statistique et des Etudes Economiques (INSEE) in Paris and a Research Fellow in the Centre's International Macroeconomics programme. Some of his research on the EMS is reported in CEPR Discussion Paper Nos. 96 , 97 and 178 . The meeting at which Melitz spoke was one of a series sponsored by the German Marshall Fund of the United States, focusing on the international economy. The views he expressed were his own, however, and not those of the German Marshall Fund or CEPR, which takes no institutional policy positions.

It was often argued that EMS membership was undesirable because it would limit the range of monetary policy choices for Britain. Melitz conceded that this point had some force, but the unpredictability of monetary growth rates appeared already to have forced Britain to abandon monetary in favour of exchange rate targets. In one sense then, the United Kingdom has no monetary policy independence to lose: only its freedom to choose an exchange rate target. Since realignments do occur within the EMS, however, some independence in exchange rate policy would remain.

Other objections to UK membership have focused on the importance of the dollar to British trade, arguing that the pound-ECU rate is not the appropriate exchange rate to stabilize. But the EMS currencies were as important for the UK as for Germany and France: the EMS member nations represented 58% of the weights in the effective exchange rate of the pound, compared to 63% for the Deutschmark and 62% for the franc.

Melitz also presented evidence suggesting that entry into the EMS might stabilize the real effective exchange rate of sterling. Both before and after the establishment of the EMS in 1979, the pound and the EMS currencies have displayed similar variability relative to non-EMS currencies. Significantly, since the creation of the EMS the pound has varied much more relative to the EMS currencies than have the EMS currencies relative to one another. As a result, given the importance of trade with EMS members, the real effective exchange rate of sterling has fluctuated much more against all other currencies than have the EMS currencies. This suggested that UK entry into the EMS would stabilize the real effective exchange rate of the pound relative to the EMS currencies, without destabilizing it relative to other currencies. This overall gain in stability would be very difficult to match outside the System, Melitz argued.

The petrocurrency status of the pound had also been cited in arguments against UK entry. But this was actually one of the strongest reasons in favour of entry, according to Melitz. If the British government stays out of the EMS in order to determine its own response to a possible oil shock, this tells the market that the government will let sterling adjust in response to an unforeseen change in the price of oil. The persistent sterling misalignments of the 1980s might thus be repeated. The other members of the EMS, on the other hand, are likely to consent only to realignments based on economic fundamentals, i.e. current and prospective movements in UK competitiveness and trade, and Melitz argued that the EMS had a good record of avoiding the tendency of fixed exchange rate systems to 'underadjust'. He cited as evidence the large number of corrections to EMS parities, some of them small, which have resulted in large adjustments over several years. Melitz concluded that the EMS was capable of managing the strains the pound would put on the System, without overshooting or misalignment. Sterling's vulnerability to oil-price shocks may therefore be an excellent reason to join the EMS.

Melitz conceded, however, that sterling's importance in international portfolios could cause problems: EMS membership would make sterling and the Deutschmark closer substitutes and thus increase swings between them. In that event, however, smaller adjustments in interest rate differentials between London and Frankfurt would suffice to dampen such capital movements, Melitz suggested, although the spread between British and German interest rates would need to be reduced as well. Although policy-makers would have less room for manoeuvre, UK macroeconomic policies appeared to be close to those of Germany already. Britain might even benefit from the extra monetary discipline it would gain from tying the pound to the Deutschmark, even though the most important benefit of entry would be the extra stability of the UK terms of trade.

Melitz concluded by dismissing the argument that the time is not ripe for UK entry. Successive reports of the House of Lords and House of Commons in 1983 and 1985 had argued that the overvaluation of the pound was an obstacle to entry. Since then the index of the effective exchange rate of sterling had fallen from 78 to around 72-73, and the pound had fallen from around 3.5 DM to 2.8-2.9 DM. If timing of entry was still really the problem, Melitz argued, the time would never come.