Academic journal article National Institute Economic Review


Academic journal article National Institute Economic Review


Article excerpt

The debate over the euro

The main macroeconomic debate over the past few months has concerned the euro and the question whether and when Britain should join the European Monetary Union. Related to this is the concern people feel over the current level of the exchange rate. We present a summary of a meeting that the National Institute held on this important issue on page 8 of this Review.

Inevitably the debate on monetary union focuses on the five questions drawn up by the Government in October 1997. The five questions are [1]

1. Would joining EMU create better conditions for firms making long-term decisions to invest in the United Kingdom?

2. How would adopting the single currency affect our financial services?

3. Are business cycles and economic structures compatible so that we and others in Europe could live comfortably with euro interest rates on a permanent basis?

4. If problems do emerge, is there sufficient flexibility to deal with them?

5. Will joining EMU help to promote higher growth, stability and a lasting increase in jobs?

and the Government has said that it intends to hold a referendum on membership of the monetary union once it is clear that the five questions can be answered favourably.

There is an obvious difficulty with these questions. While the government is looking for affirmative answers to questions 1, 3, 4 and 5 and an answer of 'favourably' to question 2, it says neither how it proposes to answer the questions nor what degree of confidence it requires in its answers. To accept answers on a balance of probabilities could lead to membership in a fairly short time, while to require positive answers beyond all reasonable doubt would be a recipe for never joining. The absence of any real information on the basis for reaching a decision means, in turn, that it is difficult for commentators to assess how close the questions are to receiving the answers needed for membership. However, the nature of economic research and its capacity to answer questions means that, if the questions are to be of any use, then the answers have to be accepted on the balance of probabilities. The following discussion should be read with that in mind.

Investment decisions

The first question can be read with particular reference to foreign investment but also in the context of the overall business environment. A range of studies by the National Institute suggests that the answer to the first question is yes, in that a part of the foreign investment in Britain appears to take place because Britain offers a gateway to the European Union. If the United Kingdom remains outside the monetary union, then other countries are likely to offer a more attractive gateway. The profitability of foreign investment in Britain will be affected by changes to the value of the euro altering costs set in sterling relative to sales prices fixed in euros; this may deter foreign investment in Britain. These findings are not contradicted by the fact that foreign investment in Britain reached an all-time peak last year. When those investment plans were struck there were certainly many people who believed that Britain would be a late entrant rather than a permanent non-participant.

The more general question concerns the overall business environment. A recent study from the National Institute (Barrell and Dury, 2000) suggests that, inside the monetary union, Britain will face an inflation rate which is less volatile and a level of output which is more volatile than those we have at present. We expect such circumstances to be more favourable for firms investing in the UK because inflation volatility leads to prices becoming increasingly uncertain in the indefinite future while output uncertainty has only short-term effects. We are not at present able to quantify the importance of such effects but they provide a focus for the discussion which should also take into account the fact that an active fiscal policy could be used to mitigate the increased volatility of output. …

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