AS ECONOMISTS it is difficult to have a decisive view on the question of the UK's membership in the European Monetary Union. Economics can only play a part in the final decision, which must ultimately be a political one. But it is important that the economic input into the political decision is of the highest quality. One important aspect of the economic effects of EMU membership is the way that volatility may change if we join EMU. By volatility we simply mean the unforeseen fluctuations that affect economic decision makers. It is a strange contradiction that while it is often very hard to measure volatility, in many ways the only sure thing about EMU membership is that certain aspects of volatility will be removed. So in the euro area there will be no volatility in the sterling-euro exchange rate nor between UK and European interest rates.
Over the last year the National Institute of Economic and Social Research has studied the likely effects of these volatility changes. The first thing, which is common to all our work, is that the measure of volatility must be a sophisticated one. This is because we are making a decision about the future. Most simple measures of volatility are averages in one form or another over the past. They are relevant to decisions regarding the future only if we expect the future to be similar to the past. This will generally not be the case when we are considering the question of EMU membership. So we must use quite sophisticated techniques to measure the changing patterns of volatility.
To our surprise the relationship between the shocks affecting output and inflation in the UK and those of euro area countries has changed considerably over time.
This is important because one of the key criteria for a successful monetary union is that the shocks, which hit the member countries, should be similar. If they are, then policy can respond in an effective way even if the union constrains policy to be the same across the whole union.
If we consider a historical average correlation for these shocks then clearly the UK has not been a good candidate for membership. But when we realize that this average is overlaid with a steady rise in the correlation to the point where we are now in a very similar position to France or Italy the picture looks very different.
The conclusion of this work is that the UK is in a very similar position to the rest of Europe now in terms of the symmetry of economic shocks. In fact the European economy that is most dissimilar from the others is Germany.
The second broad issue to consider is, what will be the effect of removing the volatility in the sterling-euro exchange rate. This is after all one of the only sure effects of EMU entry. Here again we have come across some quite surprising results. Some people argue that growth and flexibility is greater in the UK than in the rest of Europe and that we should not join EMU until the rest of Europe has reached our level. However, evidence of our recent work throws doubt on this argument. Our studies do not dispute the point that the UK is more flexible and has been growing faster recently.
The question they pose is, if the UK is growing faster and is more flexible why should an investor (say from America) choose to invest elsewhere in Europe. The answer is quite straightforward; most investors wish to maximize their returns but also minimize their risks. The UK may be a good place to invest but while the sterling-euro exchange rate is uncertain there is an incentive for an investor to diversify risk by spreading some of his investment across Europe even if the expected return is lower there. …