The UK Treasury's growing reservations about the wisdom of fixing exchange rates have been revealed in a little-noticed supporting document published with this week's pre-Budget report. Treasury officials have said that the paper has been prepared for the New Delhi meeting of the Group of 20 rich and poor countries a week ago, and was written with developing countries in mind. Nevertheless it probably provides a good test of the temperature of the water being written in what might be called "Treasury-speak" (stealing yet another Roachian expression).
Officially the assessment of the five economic tests for the decision on the euro, due by next June, has not begun, you would however have to be blind not to see some of what is going on in Brussels and Frankfurt, and not, in good British style to raise the proverbial eyebrow. The language in the paper, 'Macroeconomic Frameworks in the New Global Economy, is the strongest yet heard from the Treasury about the potential risks of joining a monetary union. It warns, for example, that if a country wants to establish "a rigidly fixed regime, for example through monetary union", then "the conditions which must be met to minimise the risk of destabilising shocks are specific and demanding". Among those conditions are that "the economy must be very open, with a high share of trade with the country to which it is pegged, the economy and financial system must already extensively rely on its partner's currency, and the shocks it faces must be similar".Much of the evidence continues to raise doubts over whether Britain would or could meet those "demanding" conditions.
The paper also offers an interesting review of thinking behind current UK monetary and fiscal policy. Interestingly enough Britain has become, it seems, the land of the middle way. Contrasting the Schylla and Charybdis of complete discretion (read Greenspan and the US Fed) with fixed rules (read Duisenberg and the ECB) Britain's system is, we are informed, one of constrained discretion (this means that while you may be able to get your hand into the till, you can only take so much out at a time). The first real hint that not everyone is happy with the way things are going in Euroland comes with the following reservations expressed about the problem with fixed rule regimes:
the relationships on which such rules are based tend to break down in the face of financial deregulation, changing technology and widening consumer choice;
rigid rules do not allow any flexibility to respond to economic shocks, leading to substantial costs of adjustment and, at the extreme, irresistible pressure on the rule itself. If a fixed rule becomes too costly to maintain, it will tend to undermine credibility, rather than support it. For example, a rigid fiscal policy rule which requires offsetting adjustments irrespective of an economy’s cyclical position could exacerbate the cycle and undermine public support for the policy.
Obviously someone is thinking about the problems with the stability pact. These problems are not, however, insuperable in principle. This weeks proposals from Pedro Solbes - which would in fact give the UK (but not France, Germany, Italy and Spain) considerable leeway with defecit management - can be seen as going some way towards calming British anxiety here. In another little aside they also indicate that they are not as blind as Frankfurt seems to be to the real problems of the moment:
Shifting the policy focus towards sustainable long-term goals requires governments to set realistic and appropriate objectives for macroeconomic policy which are clearly defined, and against which performance can be judged. For example, the UK has introduced a clear, single, symmetric inflation target. The symmetry of the target means it is clear that inflationary and deflationary pressures will be resisted equally, and there is no dual targeting of inflation and the short-term exchange rate.
In treasury-speak this means that the deflation watch is on. On the subject of monetary union and other forms of fixed-peg system the document contains the following:
The exchange rate can provide an alternative nominal anchor for monetary policy. Countries have put in place a variety of different exchange rate regimes, ranging from a rigidly fixed regime (e.g. through monetary union or a currency board), to regimes that peg the exchange rate to a greater or lesser degree. At the other extreme, a freely floating rate requires domestic monetary policy to provide the nominal anchor.
A fixed exchange rate does not allow any scope for ‘constrained discretion’ in response to shocks. Since it sets a rigid rule, shocks have to be absorbed elsewhere in the
economy, if stability is to be maintained.
If a country wants to establish a fixed exchange rate as part of a longer term policy framework, the conditions which must be met to minimise the risk of destabilising shocks are specific and demanding: the economy must be very open, with a high share of trade with the country to which it is pegged, the economy and financial system must already extensively rely on its partner’s currency, and the shocks it faces must be similar. It must also be willing to give up monetary independence for its partner’s monetary credibility; this means that its fiscal policy must be flexible and sustainable, and it must have flexible labour and product markets to cope with shocks when the exchange rate can’t adjust. The real credibility of any peg thus does not come from the peg itself, but from putting in place the wider institutional arrangements that support the regime and which facilitate adjustment. Experience suggests that a peg in itself cannot be relied upon to be the driver for the essential, wider-ranging reforms.
Some have argued that in a world of international capital mobility, it is not credible for countries which are open to capital flows to run intermediate forms of exchange rate regime in the long-term. This is because they do not have the institutional backing provided by more rigid regimes, such as currency boards, so lack sufficient credibility and strength to withstand speculative attacks. Thus only the extreme ends of the spectrum, (of freely floating or very rigid regimes such as monetary union or a currency board) are feasible. But even with a very rigid fixed exchange rate regime, such as a currency board, the same conditions apply, i.e. monetary and fiscal policy have to operate in a way consistent with it. A fixed exchange rate regime cannot be expected to solve a country’s economic problems if the appropriate macroeconomic framework is not in place. Argentina’s recent experience demonstrates the difficulties of sustaining a fixed exchange rate regime, even where a currency board is used.
Obviously the force of these comments is directed towards the problems of more fragile economies of the newly developing countries type. It should not however escape our notice that the UK economy has a very different form of 'openness' to that of the main Euro economies, an openness to international finance, and rapid capital movements (remember 1992 and the EMU exit). The UK economy may experience shock whichs differ fundamentally from those to which the other Euro economies are susceptible. It should also be noted that while the weaknesses of the fixed rate regime type are identified (and even Argentina is mentioned) the document is strangely silent on the problems of a free-floating regime (which, of course, are enormous for a developing economy, but seem not to be extreme in the context of the UK's current needs).