Britain and the EMS
Fit to be tied

UK firms will find it difficult to compete in the single European market of 1992 unless sterling participates fully in the European Monetary System, argued Mark Taylor at an April lunchtime meeting. British industry, no matter how well it has prepared for 1992, will be handicapped without a substantial shift in UK government policy. Without full participation in the EMS, invoices in sterling will remain a relatively risky prospect for European importers, despite the existence of well developed forward and options markets. Conventional arguments against EMS membership were not convincing, according to Taylor. Membership would lead to a loss of monetary autonomy to the German authorities, but he argued that it was better to tie the hands of UK policy-makers through EMS membership than to tie the hands of British firms competing in Europe in 1992.
Mark Taylor is Robert Fleming Professor of Finance and Investment at the University of Dundee and a CEPR Research Fellow. He based his talk on joint research with Michael Artis, reported in CEPR Discussion Paper No. 250, `Exchange Rates and the EMS: Assessing the Track Record'. Financial support for the meeting was provided by the German Marshall Fund of the United States.
Taylor began by discussing two common arguments against full UK participation in the EMS the `monetary autonomy' argument and the `volatility transfer' argument, both of which he found unconvincing. The `monetary autonomy' argument is straightforward: each country should choose its monetary policy to achieve its desired level of unemployment, accept whatever level of inflation the Phillips curve implies and allow its exchange rate to fluctuate in order to keep industry competitive. The difficulty with this argument, Taylor observed, was that for years there has been no stable relationship between inflation and unemployment to be found in the UK or elsewhere. This realization was absorbed into economic theory by Milton Friedman in the late 1960s and forms a central plank of the monetarist ideology underlying the present government's Medium-Term Financial Strategy.
Taylor conceded that linking the nominal sterling exchange rate to what is essentially a Deutschmark zone is tantamount to allowing UK monetary policy to be set in Bonn or Frankfurt rather than Whitehall. Comparisons of relative track records on monetary control suggest that this probably wouldn't be such a bad thing, he argued. EMS membership might also counter two worrying developments in the UK economy, which have persisted despite Britain's impressive performance in reducing inflation. One is the continued high growth of the monetary aggregates, while the other is the relatively high growth of UK wages. If full EMS membership led to a credible exchange rate policy, this would address both concerns, first by imposing monetary stringency and second by indicating to British industry that com petitiveness lost in conceding high wage increases would not be accommodated by movements in the exchange rate.
The `volatility transfer' argument rests on the supposition that advanced macroeconomic systems naturally generate a `lump of uncertainty' which, even if suppressed in one area of the economy, will inevitably emerge in another. According to this argument, reducing the volatility of exchange rates against other EMS member currencies will only lead to a rise either in the volatility of exchange rates against non-EMS members or in the volatility of interest rates. In their Discussion Paper, Artis and Taylor report evidence which casts doubt on this argument. Although there is some evidence of an increase since 1979 in the volatility of nominal and real bilateral exchange rates between EMS and non-EMS currencies, this is completely swamped by reductions in exchange rate volatility within the EMS. Since 1979 the EMS countries have seen a reduction in the volatility of their real effective exchange rates (i.e. real exchange rates against a basket of currencies which reflects the importance of trade patterns). In contrast, the volatility of the real effective dollar and sterling exchange rates appears, if anything, to have risen over the same period.
Taylor maintained that this reduced volatility has not&nbspbeen transferred to interest rates. The evidence examined in the Discussion Paper suggests that full EMS participants have actually enjoyed a reduction in the volatility of short-term onshore rates over the past nine years. Taylor argued that common sense could explain this result. Membership enhances the credibility of a country's exchange rate policy: this should reduce speculative attacks on the exchange rate and the volatility of short-term interest rates. This is the advantage of the credible precommitment implied by EMS membership, or of `tying one's hands'. A shadow EMS policy cannot achieve this because markets know that, in the last analysis, the Chancellor will quietly let the exchange rate target slip under sustained market pressure.
The econometric study by Artis and Taylor also highlights two other issues. The EMS has not, apparently, been successful in rendering its member currencies perfect substitutes. Thus a wave of sentiment against the dollar still tends to appreciate the Deutschmark strongly and the lira and the franc to a much lesser degree, thereby worsening intra-EMS German competitiveness. Second, judging by the size and variation in the differentials between offshore and onshore interest rates, the smooth running of the EMS has at times relied on the deployment of substantial capital controls by France and Italy. This has led some economists to argue against full EMS membership for Britain because it would involve the reinstatement of capital controls. Whether or not the EMS could operate in the complete absence of capital controls remains uncertain, in Taylor's view. But in any case, these two findings are not in themselves arguments against the EMS, but rather in favour of a European currency.
On balance, the research on the EMS suggests that the System functions effectively. Taylor argued that there are clear advantages to tying the hands of UK policy-makers through EMS membership. Otherwise British firms competing in Europe might find their hands tied in 1992.