In a paper written for the European Policy Forum in July, Giles Keating uses the lessons from the last two decades of policy making in formulating a radical new proposal for UK policy post EMU entry. He suggests that today's independent Monetary Policy Committee should be succeeded by an independent Fiscal Commission, with powers for limited variation of tax rates to counter asymmetric impulses to UK inflation, up or down, after EMU entry.

Citing episodic monetary policy mistakes and fiscal policy errors which led to bouts of inflation from the late seventies to the last general election allied to the existing UK institutional structure, he believes that although erstwhile politically sensitive decisions are now the domain of an independent monetary policy committee "The shift to (Bank of England) independence has removed this effect but has not removed the risk of technical errors which figure in at least two of these inflation episodes (...) and the risk now is that a very tight policy will be necessary, leading to a hard landing for the economy (especially given the deflationary impulses emanating from Asia).

On the impact of EMU he writes "A much larger issue is the impact of EMU entry, which is now looking more and more likely for early in the new millennium. In the run-up to entry, care will have to be taken to ensure a smooth switch to an exchange rate objective to replace the current inflation target.

There are two opposite kinds of danger from making the switch too early. One is that scepticism about UK's likelihood of entry forces too high an interest rate level, depressing the economy unnecessarily. The second (and more likely once a referendum had approved entry) is that UK entry becomes "too credible", forcing too low a level of rates and a bout of inflation. The potential dangers of the latter will be minimised if either the UK economic cycle is roughly in line with the other participants' in the run-up to entry, and/or if the incumbents agree that a very tight band for sterling-euro need be observed for only a short period (less than a year). A broad band, so wide that it had little monetary impact, could be applied for the balance of the two-year period required by the letter of the Maastricht Treaty.

Once the UK enters EMU, it will benefit from (hopefully) an established independent central bank with strong credibility. Balanced against this will be the problems inherent in centrally-set policy in a large single currency area. By its nature this tends to produce significant regional gyrations in inflation rates and unemployment, as happened for example in the Northeastern boom-slump in the US in 1988-9. There are two. The first is because of "asymmetric shocks", that is external events which affect one part of the currency union more than others. The second is the difference in responsiveness to interest rate changes.

The UK, compared to other EMU participants, still has a higher proportion of its trade and investment links with the "dollar bloc" (both the US and other counties whose currencies are linked to the dollar or tend to move with it). It is thus vulnerable to an asymmetric effect from a weak dollar (which would damage competitiveness in the UK more than in the rest of the EMU zone) or a strong dollar (which would cause the UK to overheat faster). Another source of a possible asymmetric external shock comes from oil prices, given the residual importance of oil in the UK economy.

On interest rate sensitivity, there is some (imperfect) evidence to suggest that the UK consumer is more sensitive, at least in the short term, to interest rate movements, reflecting the more developed consumer credit market and the remaining importance of variable rate mortgages. This might suggest that the UK would be over-stimulated and thus experience higher inflation during phases of monetary easing by the European Central Bank, with the reverse applying in periods of tightening. However, the corporate sector is subject to more complex influences, with much debt finance at fixed rates and a much higher reliance on equity finance than in most other European countries.

In addition to these problems, there is the risk that fiscal policy will be inappropriate in the UK, with the prospect of an election causing governments to expand at a time when inflationary pressures are already building (although there is no reason to suppose the UK is more prone to this than any other European country).

In concluding, he proposes"There is a possible radical route to counter these problems. This is to establish an independent Fiscal Commission, not with power over all fiscal matters (which of course has to remain in mainstream politics) but with carefully defined powers to make limited variations in taxation. For example, it might be allowed to make certain adjustments (up to say 3 percent) in the basic rates of income tax and of VAT. Over the course of a full economic cycle, the Fiscal Commission would be expected to broadly balance its books and to on average impose tax increases for as long as it allowed tax cuts.

These changes would be designed to minimise the deviation of UK inflation (and hence unemployment) from the (presumably well-behaved) European average, and would be made according to clearly defined assessments of expected deviations in output from potential. One particularly neat mechanism would be for the government to replace a significant part of its current debt with unhedged dollar borrowings. A weak dollar would reduce the cost to the UK of servicing this debt, and the saving could be used by the fiscal commission to cut taxes. This would be desirable because the UK, relative to the rest of the euro area, would suffer more from the weak dollar. The reverse would apply when the dollar was strong.

A proposal of this type may sound far-fetched, but the notion of giving the Bank of England independent policy-making power seemed distant as recently as eighteen months ago. Entering EMU is itself a radical step, and there are important differences between the UK and the rest of the EMU countries. This proposal would address those."

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