The message is clear: the UK should wait and see

The UK should not rush into European Monetary Union. As I see it there are at least seven reasons why it is beneficial for the UK to wait and see.

First, there is no guarantee Emu will be a success as the Maastricht treaty has led to a minimal degree of convergence and it is not clear if it is sustainable. Even though a broad-based Emu now looks certain to begin in January 1999 there is still a strong possibility it will subsequently fail.

A large number of starter currencies lends Emu a certain political attraction – but this will be at the expense of economic problems that could eventually undermine the system. The Maastricht criteria have not resulted in economic convergence among all the likely starters. This is because the criteria are arbitrary, being narrowly focused on a small number of mainly financial variables. As important as these variables are, at best they can only achieve a minimum degree of economic convergence. By not focusing on growth and employment there is no guarantee countries have converged sufficiently to survive within the system if there is an external shock or if difficult economic conditions prevail.

Second, one European interest rate will bring back memories of the problem of the ERM and the clash between domestic and external needs. A single European monetary policy will not be appropriate for each country. As the Bank of England governor Eddie George said in September: “The one-size fits-all interest rate could result in economic weakness and unemployment in some areas if the European Central Bank pursued a firm monetary policy, or unwanted inflation in others if it were more accommodating”.

Third, there is a lack of flexibility in the system. To see this, compare Emu with America. Unlike the US Federal Reserve, the European Central Bank is not accountable, and its terms of reference are narrower, being entrusted solely with achieving low inflation. The Federal Reserve aims for low inflation and stable employment conditions.

In America, when there are regional economic imbalances people migrate from the depressed area to a more prosperous region. For instance, an average 7.7 million people move from one US state to another in any year, providing an enormous amount of adjustment for local economies. By contrast, throughout much of Continental Europe labour markets are not flexible.

Just as important is the need for fiscal flexibility and budgetary transfers from central government to poor regions, or areas suffering difficult economic adjustment. In America an indication of such fiscal stabilisers is that between 1991 and 1994, California’s tax bill was reduced by $350 for every man, woman and child – or 15% of personal tax collections. By contrast, the stability pact will remove the scope for fiscal flexibility once Emu goes ahead.

There will be minimal monetary, labour and fiscal flexibility in Emu.

This is likely to result in depressed regions, with pockets of high unemployment throughout Europe. Such an environment could feed the nationalist tendencies which the architects of Emu hoped to avoid.

Fourth, what happens after Emu? This question is often ignored by those who argue for early entry. Eventually there will have to be a loss of fiscal sovereignty, as Emu will need a single fiscal policy with central control of tax and spending powers.

Initially there will be a “free-rider” problem, where a profligate government could run a loose fiscal policy. If this happened the European Central Bank could respond by tightening, but all countries within the monetary union will pay the interest rate price, not just the country whose government is overspending. To offset this free-rider problem there is the fiscal stability pact. This is aimed at ensuring fiscal restraint after Emu begins.

But in order to address one problem this fiscal stability pact creates another, more immediate one. It will result in a deflationary bias in the system.

Fifth, Emu is not an optimal currency area. Academic theory backs up the empirical evidence on the need to be cautious, through the concept of an optimal currency area. This is a problem for a medium-sized open economy such as the UK. If we belong to Emu while having major trading and financial links with countries elsewhere, outside Emu, we could come under pressure unless the countries outside Emu pursue policies compatible with those of the Union. Emu will remove currency risk within Europe, but the danger is greater volatility against the dollar and other currencies outside the system.

Sixth, the experience of monetary unions elsewhere suggests the need to wait. The evidence of a union involving more than one major sovereign state surviving is limited. Of course, some monetary unions are still in existence, such as Germany’s after Unification, the Belgium-Luxembourg Economic Union and the US Federal Reserve system has survived since the Fed’s establishment in 1913.

But there have been some spectacular failures of monetary unions involving large sovereign states. The collapse of the gold standard in 1931 is probably the best example but also around that time a Latin Monetary Union and a Scandinavian Monetary Union folded. It is also interesting to note when they failed – at a time of a major external shock, as the world economy suffered from deflationary pressures. Emu’s success will be influenced by what happens in the rest of the world.

Seventh, the current state of the UK economic cycle does not favour early Emu entry. Short-term official interest rates among likely Emu participants will have to converge. This has already started, following the Bundesbank’s tightening on 9 October, when the repo rate rose from 3% to 3.3%. If the UK were to enter Emu soon, British monetary policy would have to be relaxed more than is justified by domestic needs, with official rates falling.

The pound would also need to fall to a sustainable and sensible rate, nearer DM2.50.

The UK should wait, not just until economic cycles are in synchronisation, but until Emu has proved it can be a success.

Dr Gerard Lyons is chief economist of Dai-Ichi Kangyo Bank (DKB) International.