Philipp M Hildebrand: Inside Europe, outside EMU - lessons and outlook
Speech by Dr Philipp M Hildebrand, Member of the Governing Board of the Swiss National Bank, at
the British Swiss Chamber of Commerce, Geneva, 23 April 2004.
* * *
My long-standing personal attachments to the United Kingdom make it a special privilege to be here
this morning to speak about Europe and its significance to our two countries. Geneva is one of
Europe's truly international cities and provides a fitting platform for a discussion on some of the salient
characteristics about the relations of the United Kingdom and Switzerland toward Europe.
The United Kingdom and Switzerland are both undeniably European nations. Nonetheless, they both
firmly remain outside of the European Monetary Union (EMU). Institutionally, the links of the two
countries with Europe differ, of course. The United Kingdom is in EU Europe while Switzerland is only
in Europe, despite the fact that until the EU welcomes ten new Member States next week, we Swiss
can be forgiven to think of ourselves as representing the "heart" of Europe. Culturally, our two
countries are rooted in different European traditions: Anglo-Saxon on the one hand and Continental
European on the other hand, notwithstanding the fact the historical roots of the Saxons are, of course,
on the continent.
During the remainder of my time with you today, I will sketch more fully a number of salient common
features and differences between the United Kingdom and Switzerland. Based on these
commonalities and differences, I will then draw some tentative economic, financial and political
conclusions about the respective experiences and relations of our two countries with Europe and more
specifically with EMU.
UK and Switzerland: Common features and differences:
It seems to me that even a perfunctory comparison of our two countries' relations to Europe and EMU
needs to touch upon law, politics and recent economic history.
Law and politics
There is a fundamental judicial divide between the common law tradition of Anglo-Saxon countries and
the civil law tradition of Continental Europe. Over the centuries, this divide has undoubtedly spread
into culture and minds. The custom and case-based common law was institutionalized in 1154 by
Henry II through elevating local custom to a unified system of law "common" to the country. It may be
unwritten, as it was at the outset, or captured in statutes and codes. This judicial history is reflected by
the absence of a written constitution in the United Kingdom. Civil law in Continental Europe, on the
other hand, has its roots in the Corpus Juris Civilis of Emperor Justinian. It constitutes broad legal
principles and doctrinal writings and is explicitly written law. This explicit and written tradition is
reflected in the "acquis communautaire" of the European Union with nearly 100'000 pages and some
20'000 laws, decisions and regulations. In light of our two countries' legal roots, the legal
consequences of relations with the European Union are undoubtedly of greater concern to the people
of the United Kingdom than to Continental Switzerland.
More importantly, in my view, the political systems of the U.K. and Switzerland differ in fundamental
ways. The United Kingdom is one of the oldest representative parliamentary democracies. Its electoral
system tends to yield clear-cut political majorities. The ruling party - Tory or Labour - is elected for
typically four years and can manage the country quite independently as it is assured quasi-autonomy
to alter existing legislative acts or enact new ones. Switzerland has an equally proud democratic
tradition. It is, however, deeply rooted in direct participation by the sovereign. A vote by the people is
possible on nearly everything. Indeed, it is often compulsory. The Swiss parliament is elected every
four years. Due to the proportional voting system, no political party can expect to achieve an absolute
majority. Thus, the parliament elects the government as a collegiate body which traditionally
encompasses all four main political parties. Consequently, legislative decisions tend to be deeply
rooted in compromise, not least to overcome the potential referendum hurdle.
The mechanics of a particular political system affects the ability of legislative bodies to pass politically
contentious reforms to a country's underlying economic structure. In parliamentary systems with a
clear majority the speed of structural adjustment - once initiated - tends to be higher. On the other
hand, policies are possibly more short-term oriented and large policy errors more likely. Investors may
therefore demand a higher risk premium. In direct democracies, the speed of reform is typically slower.
Grid-locks are possible through referenda and therefore more common. On the other hand, political
stability in direct democracies tends to be higher and economic policies typically have a more
long-term orientation. As policy changes take more time to be introduced, the risk of large policy errors
tends to be smaller. Over the long-term, investors appear to be willing to pay a premium for higher
stability.
Beyond differing parliamentary systems, our two countries' political structures are organized along
different principles. Whereas the political process in the United Kingdom can be broadly characterized
as top down, Switzerland's federalist structure implies a bottom-up political process with a great deal
of political autonomy for our nearly 3000 communes and 26 cantons. It is interesting to note that there
are at least some tentative signs of converging trends: In the United Kingdom, Tony Blair's
government has initiated constitutional reforms by establishing the Scottish Parliament and the Welsh
Assembly in 1998 and by advancing the Regional Assemblies in England. In Switzerland, a number of
centralization proposals are debated such as directly enhancing the power of the federal government
or alternatively, merging a number of cantons with the aim of ending up with larger and fewer regional
authorities. These trends illustrate that Switzerland and the U.K. both face a trade-off between
increasing economic efficiency on the one hand and retaining long-standing political and historical
traditions on the other hand. Under pressure from rapidly evolving global economic forces and the
need to adjust to them, both countries will need to continue to identify respective strategies to
maximize economic welfare and optimize political structures.
Recent economic history
Let me now turn to some recent economic history. History shapes memory and experience. The work
of Nobel Laureate Daniel Kahnemann demonstrates that experience constitutes a reference point for
human beings by which current and expected welfare are evaluated against.1
The United Kingdom has experienced profound economic crisis relatively recently. In 1976, the pound
sterling collapsed. The Labour government under Prime Minister Callaghan faced a near bail-out by
the International Monetary Fund.2 The crisis left deep scars in the real economy. As some of you will
remember, power failures were a common phenomenon in those days in London. The experience of a
severe economic crisis commonly shared by the British people undoubtedly played a role in paving the
ground for the ultimate acceptance of the far-reaching and rapid economic reform agenda under the
leadership of Margaret Thatcher which boosted economic growth in the United Kingdom.
In contrast, Switzerland has no recent memory of a comparable economic crisis. On the whole,
economic reforms progress only gradually and fail to cover the economy as a whole. Fortunately, in
some areas, liberalization has advanced rapidly. A positive example is the Swiss labor market.
Unencumbered by a history of pervasive unionization, Swiss labor market flexibility has continuously
been strengthened. Today, it is comparable to Anglo-Saxon standards.
Against the backdrop of our two countries' differing legal, political and economic traditions, let me now
turn to what strike me as significant lessons with regard to our respective relations with Europe and,
more specifically, with EMU.
Structural reform and EMU
The United Kingdom is currently harvesting the fruits of its growth-boosting liberalization policies
implemented during the past 20 years. A dynamic market economy yields strong and stable output
with low unemployment and monetary stability. This stands in contrast to the current situation in the
European Monetary Union. Its large member states in particular suffer from endemic growth problems,
structural weaknesses and high unemployment. In light of this comparison, it is not surprising that any
proposal for the UK to join EMU at this stage is widely regarded as economically disadvantageous,
quite apart from deeper cultural-historical misgivings in the UK about further European integration.
Moreover, correlations suggest that the US business cycle is no less important for the British economy
than the degree of activity in the EU (Chart 1).
In many ways, the lessons for Switzerland are more complicated. Unlike the UK, Switzerland has had
to endure a protracted period of very low economic growth. Indeed since 1980 and on an accumulated
basis, Switzerland has had the poorest growth performance amongst the advanced economies
(Chart 3).3 As a result, a widespread and welcome political and media debate about how to boost our
country's growth performance has emerged. At the same time, the absence of a deep economic crisis
experience, the mix of proportional representation, direct democracy, strong federalism and the
resulting consensus-oriented political process has so far prevented the implementation of a genuine
wide-ranging liberalization program.
As a result, there is a latent belief embedded in many economic debates in Switzerland that the only
way successfully to complete the necessary structural reform program is to join the European Union.
Given that an opt-out clause for Switzerland would be unlikely, joining the European Union would in
fact be tantamount to joining EMU. In other words, many of those who propose EMU membership
accept the need aggressively to push on with economic reforms but reject the notion that it can be
done independently. The responsibility for introducing reforms is in effect delegated to the European
Union.
This line of reasoning is flawed and must be dismissed. It is true that the obvious appeal of such a
strategy is the ability to blame the European Union for having to introduce unpopular reforms and
ultimately transfer the political costs of reforms to Brussels. Nonetheless, as the examples of several
member states demonstrate, EMU membership does not guarantee successful reforms. First of all, the
European Union, let alone the European Monetary Union were not primarily designed to be vessels to
accommodate liberalization efforts. Moreover, in the cases where membership does require legislative
adjustments which amount to economic reform steps, EU law only prescribes the formal legislative
change. Implementation responsibility typically remains with local authorities on the basis of the
subsidiarity principle.
This point is reinforced when considered from a macro-economic perspective. Far-reaching domestic
reforms often constitute painful macro-economic adjustment processes. With EMU membership, a
country loses its monetary policy and at least to some extent its fiscal policy lever. With these
important macroeconomic compensating mechanisms no longer available, the cost of domestic
economic reform is in fact likely to rise. Necessary real exchange rate adjustments will have to occur
via wage and price changes while the ability for fiscal policy to reduce the cost of higher
unemployment is curtailed. At the same time, labor mobility that could absorb some of the costs
remains limited in Europe. Arguably, therefore, far-reaching economic reforms become in fact more
difficult to implement once a country loses its independent monetary and fiscal policy inside EMU. This
is particularly true for countries with rigid labor markets. The recent electoral results in Germany and
France illustrate this dilemma.
It is of utmost importance for the Swiss political authorities not to fall into the trap of the kind of 'help us
from ourselves' line of reasoning that I tried to outline. There may well be political reasons to have a
long-term EMU accession strategy in place. But it is a mistake to link the question of domestic
economic reform to EMU accession. As I pointed out earlier, in light of Switzerland's legal, political and
historical context, far-reaching reforms will be a formidable challenge, despite the extraordinary asset
of a highly flexible labor market. Nonetheless, there is no alternative to tackling independently and
directly the domestic economic restructuring process and its consequences if Switzerland is serious to
boost its growth potential and thereby safeguard its tradition of broad social and welfare programs.
Monetary policy and EMU
Accession to a monetary union transfers the power over monetary policy from the national to the union
level. There are costs and benefits to such an abdication of monetary sovereignty. Nominal interest
rates are equalized throughout a monetary union and the nominal exchange rate is no longer available
as a tool for alleviating the impact of asymmetric shocks. Necessary economic adjustments between
different countries of a monetary union must therefore occur through various price and factor
movements. As I have already suggested, imposing real wage adjustments in particular can be
politically costly. In the case of both the UK and Switzerland, these potential costs of EMU
membership are mitigated by virtue of flexible labor markets in both countries.
In the case of Switzerland, EMU accession would also lead to the loss of an interest rate bonus our
country has traditionally enjoyed. At least partly, this bonus is rooted in the credibility of the Swiss
National Bank, acquired over a long period of independent and successful monetary policy (Chart 2).
One benefit of EMU membership for Switzerland as a trading nation would be lower transaction costs
derived from the use of a single currency and the disappearance of a considerable part of exchange
rate risk for our exporters. Interestingly, with the Swiss Franc's recent stability vis-à-vis the Euro,
Swiss Euro oriented exporters have of late enjoyed both the interest rate bonus and considerable
currency stability. This, of course, does not apply to our dollar-oriented exporters who have to manage
a substantially higher exchange rate risk. When we observe Switzerland's business cycle and its
degree of relative synchronization with that of the Euro-zone, there is little evidence that the two
business cycles would be fundamentally incompatible in the context of a monetary union. Not
surprisingly in light of our trade links, our business cycle is relatively closely correlated with that of
Germany. Nonetheless, it is worth pointing out that in terms of annual real GDP, Switzerland has
outperformed Germany in ten out of the last 24 years (Chart 4). There seems to be an increasing
synchronization of national business cycles inside the Euro-zone, though this pattern can also be
observed for economies that were outside EMU such as the UK, Switzerland and Sweden (Chart 5).
Higher business cycle synchronization may simply reflect the fact that with growing globalization, the
overwhelming economic trends are global rather than intra-regional. In the context of benefits for
Switzerland, I have already discussed why the argument that EMU membership would induce the
Swiss political authorities to embark upon a necessary and otherwise impossible economic reform
program should be dismissed.
For the United Kingdom, the economic cost-benefit assessment of EMU membership is a different
one. Analogous to the Swiss case, the UK would lose monetary policy as a flexible instrument to
respond to asymmetric domestic shocks such as the current steep rise in domestic house prices
(Chart 6). However, unlike Switzerland, the UK would gain from lower interest rates. In this context, it
must be remembered that the Bank of England's post-monetary independence highly successful
monetary policy under an inflation targeting regime follows a long period of stop-and-go monetary
policy and relatively high inflation (Chart 7). The argument that EMU would somehow induce further
structural reforms is equally irrelevant for the UK as it is for Switzerland though partly for different
reasons. As I outlined earlier, initiated by the economic shock experience of the late 1970s, the United
Kingdom has independently and autonomously embarked upon a long-standing and far-reaching
economic liberalization course. The current nature of the relative business cycles between the UK and
the Euro-zone points to higher economic costs of UK membership in EMU than for continental
European countries. This is illustrated by the different interest rates settings of the ECB and the Bank
of England in recent times.
To join or not to join
To join or not to join EMU is a complex and multi-faceted decision for any sovereign nation. By
definition, it amounts to a long-term commitment to an uncertain process subject to unpredictable
influences. The long-term costs and benefits of such a decision are therefore not easily evaluated. In
addition, the cost-benefit analysis must take place at many different levels. Economics constitutes only
one layer of analysis and by no means the only relevant one. Switzerland and the United Kingdom are
both nations with long-standing traditions of global integration and free trade. Both nations rely
fundamentally on multilateral contractual frameworks such as the one offered by the World Trade
Organization (WTO). Our nations and our peoples live in and benefit from a global and open world.
Europe is and must remain part of that world. Surely an open multilateral global economy must be our
primary long-term commitment. The decision to join a regional agreement such as the European
Monetary Union must be evaluated against this global backdrop. I have tried to provide you with a brief
sketch of some of the salient macro-economic issues related to such an evaluation. Beyond
economics, both of our nations have a proud political history. Ultimately, the decision to surrender
national sovereignty - be it monetary or otherwise - will always be a political one. Central bankers may
have views as private citizens which they would presumably express at the ballot box. In the public
domain, however, their responsibility should be to illustrate potential economic consequences of the
ultimately political decision to join or not to join the European Monetary Union.
Conclusion
Ladies and Gentlemen, the decision formally to join EMU does not appear to be a policy issue of
imminent concern in either of our two countries. In the United Kingdom, the issue was indefinitely
pushed back in time in June of last year. Here in Switzerland, it is the ratification of the second
package of bilateral treaties with the European Union that dominates our current external political
agenda. Since this contractual arrangement with our European partners was designed from the outset
as a multi-issue legal document with costs and benefits spread over multiple issues, the Swiss
government is to be commended for insisting on negotiating the agreement as a comprehensive
package and not break it down into multiple single issues.
Meanwhile, globalization is set to proceed. With the rapid integration of China and India into the global
economy and the subsequent reorganization of production processes, global competition is rapidly
increasing with changes in relative prices that become increasingly a function of global demand and
supply. Needless to say, the globalization path will neither be linear nor smooth. There are risks,
perhaps none less so than the temptation of governments to resort to protectionism in a misguided
effort to respond to the costs associated with global economic integration.
In Europe, integration is also proceeding. In less than a week, ten countries will join the European
Union. They will add twenty-five percent to Europe's population, twenty-three percent to Europe's land
mass and nine percent to European GDP on a purchasing power parity basis. Average GDP per
capita in Europe will therefore decline by thirteen percent to a level slightly above sixty percent of that
of the United States. Fifteen years after the fall of the Iron Curtain, the new member states are keen to
compete on the internal market. The adjustment process will entail important challenges to both
newcomers and old-timers. On balance, I remain confident that in the longer term, the growth
contribution to the European Union will be a positive one.
In a world of rapid change and integration, countries with a long history of open economies and
societies are well positioned to reap economic and social benefits. Both of our countries doubtlessly fit
into that category. Note that in a recent global survey, Switzerland was voted the third most open
country in the world. The challenge will be to maintain our ability to adapt to changing external
conditions. On the important issue of domestic structural reform, Switzerland would be misguided to
consider EMU membership as a strategy for curing domestic problems. Instead, we have much to
learn from our friends across the English Channel on how to reform a domestic economy on the basis
of domestic needs.
Thank you.
Chart 1
Correlations of UK GDP Growth with US and EU
1.0
0.8
0.6
0.4
0.2
UK-US UK-EU15
0.0
10 Years Rolling Correlation
-0.2
1970 1975 1980 1985 1990 1995 2000
Chart 2
Long Term Interest Rates in the UK, Germany and Switzerland in percent
18
16
14
12
10
8
6
4
2
Germany U.K. Switzerland
0
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan
Korea
Singapore
Taiwan Province of China
Hong Kong SAR
Ireland
Cyprus
Luxembourg
Israel
Australia
United States
Norway
Canada
Spain
New Zealand
Iceland
Japan
Portugal
Belgium
Finland
United Kingdom
Netherlands
Greece
Sweden
Austria
Denmark
France
Germany
Italy
Switzerland
Chart 4
Annual GDP Growth in the UK, Germany and Switzerland in percent
7
6
5
4
3
2
1
0
-1
Germany
Switzerland
-2
U.K.
-3
1980 1985 1990 1995 2000
Chart 5
Correlations with Germany's GDP Growth
1.2
1
0.8
0.6
0.4
0.2
0
AUT BEL CHE DNK E15 ESP FIN FRA GBR ITA SWE
1990.1-1998.4 1999.1-2003.4
Chart 6
12 Months Growth of the Halifax House Price Index
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
Apr 90 Apr 92 Apr 94 Apr 96 Apr 98 Apr 00 Apr 02
Chart 7
Annual CPI Inflation in the UK
25%
20%
15%
10%
5%
0%