Joining euro would be no panacea

Flexibility in economic and monetary policy is of inestimable value

By David Marsh - published on 24/11/08 in Financial News 

At a dinner in London in July 2007, I asked Axel Weber, president of the German Bundesbank, whether Britain was a secret member of Economic and Monetary Union. The reason was that the pound had remained for several years at the stable rate of about  1.48 – exceedingly close to the old pre-EMU rate of DM2.95 at which sterling was pegged for 23 months in the Exchange Rate Mechanism before it was forced to leave in disastrous circumstances in September 1992. Weber replied that, if the UK was a clandestine member, then it really must be a big secret because nobody had told him about it.

Sterling’s long, sharp fall from grace over the past year – against both the dollar and the euro – has exposed to the world Britain’s dirty little secret. The decline of about 22% on a trade-weighted basis since the beginning of the credit crisis in August 2007 is one of the most significant on record.

The exchange rate stability in the early part of the decade has turned out to be an illusion. The pound was massively overvalued – illustrated by the strikingly large UK current account deficit – and the fall over the past year has returned sterling to more sustainable levels.

In view of the size of the decline, and the general economic turbulence in which the UK finds itself, it is not surprising that some old questions have been gradually rising to the surface of public consciousness. After 10 years of abstinence from EMU, should the UK start seriously thinking about joining the euro club?

Especially in view of the European Central Bank’s improved reputation as a crisis manager in the wake of the US-originated financial crisis, could EMU represent a haven for the UK economy? Would it be wise for Britain to lash itself to the life raft of the euro, along with the other 15 large and small members, to avoid the perils of drifting alone on a storm-tossed open sea? All these are big questions. The answer to all three is a forthright “No”.

Membership of the euro area would not solve Britain’s economic problems – and could make them worse. I have never believed the UK should exclude itself for all time from the euro. In the early 2000s, in the wake of the terrorist attacks on the US, I believed that the UK had an opportunity to negotiate an entry to the euro, above all with the German Government, in a way that would improve the openness and flexibility of the European economy, help British competitiveness, and shore up European solidarity at a testing time for international political cohesion.

That opportunity has been lost, above all because the UK and German economies moved in different directions after 2001 and because the two countries fell out in their response to the Iraq war.

The 16 years since the UK left the ERM have on the whole been a positive period for the UK economy, because Britain has benefited from flexibility of exchange and interest rates.

If Britain had joined the euro when it started in 1999, interest rates in the UK would have been lower than they have been, and hence the credit-fuelled housing and spending boom – and the eventual correction – would have been even worse than they have turned out to be.

Britain is traversing one of the most difficult economic periods of the past 100 years, but so are members of the euro club such as Italy, Spain and Ireland which have suffered the adverse consequences of living too long with interest rates and exchange rates unsuited to national economic conditions.

Unlike the members of EMU, Britain is able to align its monetary policies with its own economic position, and this should prove a benefit in the coming testing 18 months to two years of painful adjustment. I am therefore sticking to my view that – despite turbulence – it is highly unlikely, for both political and economic reasons, that Britain will join the euro area before 2025.

Over this period, the euro area is likely to be subject to change, and could break up as the policy inconsistencies at its heart become increasingly apparent. So the question of UK membership – although something that successive governments will have to keep under

review – will look quite different in 15 years than it does now.

Critics of Gordon Brown’s Government policy argue that sterling’s weakness, unless checked, could continue unabated, with ruinous consequences for the British economy. Joining the euro, they allege, would put a floor under the exchange rate, allowing the Treasury and the Bank of England to defend the currency with lower interest rates than would otherwise be the case.

This argument is, however, not valid. In contrast to previous foreign exchange market turbulence in the 1960s or the 1970s, the pound’s sharp fall will not lead to inflation, but is a vital means of adjusting the excessive current account deficit. The British recession will be sharp – but thanks to the pound’s decline it may turn out to be short compared with the pain faced by some continental economies.

Bank of England interest rate cuts will continue in coming weeks, at a more aggressive pace than those of the European Central Bank, and this again should be positive for economic adjustment. If international investors were worried about Britain’s absence from EMU, they would be selling gilts and buying Bunds; in fact, the interest differential between 10-year UK and German government bonds has narrowed sinceAugust 2007 to about 50 basis points – while for most euro member economies it has widened (to 140 points for Greece, 100 for Italy, 95 for Ireland, 70 for Portugal, 60 for Belgium, 50 for Spain and Austria, and 30 for France and the Netherlands).

Embedded into the folk memory of the Treasury and Bank of England is a lesson that the UK learnt when it rejoined the pre-First World War Gold Standard in 1925 and had to leave again in 1931: especially in times of crisis, economic and monetary policy flexibility is of inestimable value. Throwing it overboard by joining the euro is not in Britain’s interest – neither now nor in the foreseeable future.

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