The crisis: a reason to join the euro?

Is Britain running the risk of a sterling crisis by staying out of the euro? Or would it have been in an even bigger financial mess had it already joined?
February 28, 2009
YES:Willem Buiter

NO: Derek Scott

Dear Derek
11th January 2009

This year the euro celebrates its tenth anniversary. Since the global financial system is in tatters, the case for Britain going in is now stronger than ever.

Britain's business cycle is synchronised closely enough with Europe's that we look like a Frankfurt suburb. This suggests that "asymmetric shocks"—events like oil price hikes that might affect Britain differently from the rest of Europe—are unlikely to be a real problem in making the currency work. Yet, even if they were, flexible exchange rates wouldn't actually help much. For a small open economy facing highly integrated financial markets such as Britain's does, the exchange rate is something that happens to you, not an instrument you can manipulate. Sterling's exchange rate has indeed fallen handsomely of late. It is now close to levels that give our internationally exposed sectors a fair chance to compete. But that same exchange rate also gave us 15 years of overvaluation. It wasn't a buffer, but rather a source of excessive volatility.

In any case, Britain's flexible economy can cope with asymmetric shocks. Better labour mobility—Polish plumbers arrive when the economy booms and leave when it tanks—has certainly helped.

Outside the euro Britain risks a perfect storm caused by four factors: a small open economy, a large, internationally exposed banking sector, a currency that is not a global reserve currency and limited fiscal capacity. Joining the euro will not solve Britain's fiscal problems, but it will eliminate the risk of a sterling crisis, like that which George Osborne predicted in late 2008. By keeping sterling, Britain looks more like Iceland than one of the eurozone countries.

Britain is also losing political influence. Ecofin, the EU council of the finance ministers, has become a rubber stamp group, playing second fiddle to ministers from the group of 16 euro members.

This will only get worse as more countries sign up. Denmark and Sweden will join in soon, while Iceland is applying for EU membership to gain the security of the euro. Countries from eastern Europe are all scrambling to join as soon as they can. Soon, Britain will stand alone, stuck outside the eurozone's haven of relative financial stability.

Indeed, a collapse of the UK monetary union—following Alex Salmond's abandonment of his pledge to keep sterling in an independent Scotland—is more likely than a collapse of the eurozone. It is true that the secessionist tendency in Scotland was dealt a bloody nose when the government bailed out the Royal Bank of Scotland in 2008. (An independent Scotland could not have afforded it.) But it is not clear that the British state itself can support a banking system that is worth more than 400 per cent of GDP. People still argue that if the UK adopted the euro, its sovereignty would be threatened. Ironically, it is more likely to save the union.

Certainly, further European integration is needed if the UK is to remain the world's leading financial centre. Membership will not lead to a European super state, but instead add to a new form of federalism "lite." Britain has a choice. It can join the eurozone and engage fully in further political and economic integration. Or it can join late and reluctantly, as it has done on every previous occasion of European integration, and then complain bitterly that arrangements are not as they ought to be. Now that Ken Clarke and Peter Mandelson are back at the helm, there has never been a better moment to get on the front foot.

Yours ever

article body image

Dear Willem
13th January 2009

You claim that the economic and political case for Britain adopting the euro is stronger than ever. The opposite is nearer the mark: economic and monetary union has been a malign force both for its members and the wider international economy. Had Britain joined at the start, we would now be in an even bigger mess.

The notion that integrated capital markets render separate currencies redundant—the core of your case—is wrong. In economic terms, the euro might have worked better in the 1950s and 1960s when there were no private sector capital flows and corporatism was rife. The last decade is more like the 1920s and the 1930s, when large-scale private sector capital flows could seek out the highest returns across international frontiers.

This began again only in the mid-1980s, but in many ways transformed economics, in particular putting a premium on monetary policy and accentuating the repercussions of monetary policy mistakes.

Economists of the Austrian school, such as Friedrich von Hayek, highlighted the danger of inappropriately low interest rates creating "inter-temporal" problems: stimulating too much spending by households and business today, meaning there is less tomorrow. Any attempt to get interest rates back to normal levels tips economies over the cliff because of the debt and borrowing built up when rates were too low. Many of the world's economies are now suffering from this problem. Of course, the present crisis has seen greed and indebtedness—from the boardroom to consumers. But monetary policy mistakes have been critical too.

Two huge monetary mistakes were made in the late 1990s. First, Alan Greenspan kept US interest rates too low, despite his warnings of "irrational exuberance." Secondly, the euro imposed another asset price bubble on top of anything made in the US.

Even Europhiles recognise that one interest rate cannot be appropriate for all countries. For a long time after the start of the European Monetary Union, the European Central Bank (ECB) focused on a weak Germany economy, and as a result Spain, Ireland, and others live today with the consequences of excessively low interest rates. Boom has led to bust.

The European Monetary Union (EMU) has also created difficulties for Britain. The ECB's low interest rate policy reinforced a weak euro, and thus a strong pound. The Bank of England could not raise interest rates—the strong pound was helping the bank meet its inflation target—although Mervyn King, in particular, warned of the dangers of accelerating asset prices.

Of course, being outside EMU has not prevented Britain getting into a mess. I defer to no one in my criticism of Gordon Brown's period as chancellor, particularly his handling of the public finances and his flawed framework for banking supervision. But had Britain been inside EMU interest rates would have been even lower—the boom would have been bigger and the bust even more spectacular. Also, we would have abandoned one important policy tool that could help us out of the hole: the ability to run an appropriate monetary policy. The fiscal cost of offering guarantees several times larger than GDP to British banks could not be reduced inside EMU since it is not (yet) a debt union.

Several countries trapped in EMU face even more serious problems than Britain. The abandonment of individual currencies simply means that the pressures are felt elsewhere in the economy. If some of the patients are sick, throwing the thermometer away doesn't constitute a cure. Spain, Portugal, Greece and Ireland now face depression rather than recession, similar to those countries that stayed on the gold standard after 1931.

You have been more honest than most in arguing that the euro requires political union. But most people, and not just in Britain, don't want that, and it can't be imposed. You are too sanguine in believing that the final outcome will be a "new form of federalism lite" (whatever that is). History points the other way—once Brussels gains power, it never gives it up.

The biggest threat to stability and tolerance comes when a nation finds itself without a real voice in a political structure that is unaccountable. The EU erodes national identity without replacing it. This is dangerous.

Yours ever

Dear Derek
16th January 2009

I don't just argue that integrated capital markets make separate national currencies redundant—they make separate national currencies a dangerous, unaffordable luxury. The logic of financial integration requires a common currency. A monetary union joining all of Europe, the US, Canada and Japan would be ideal. Sadly, it is politically unfeasible. So a common European currency is the best feasible solution for European nation states, including Britain.

Second, monetary policy is not an instrument for fine-tuning the business cycle or for responding to shocks in specific countries. Indeed, the exchange rate is not an instrument at all. (Try to manage it and interest rates become the plaything of international capital markets. Ask Norman Lamont.)

The only feasible exchange rate regimes under unrestricted capital mobility are a free floating exchange rate or a common currency. A freely floating rate, such as we have now, makes the exchange rate a persistent threat to financial stability—the potentially catastrophic risk of the City of London becoming Reykjavik-on-Thames. That risk would be greatly reduced by adopting the world's second reserve currency. Asset price and credit bubbles should be fixed by regulation, not by the Bank of England or the ECB.

But here is the more important point. Monetary union both requires, and is a step towards, deeper political union. The political traditions of Britain and other European states have much to offer each other. The low countries and Scandinavia have democratic roots at least as deep as Britain's. The younger democracies in Iberia and eastern Europe embody a vibrant sense of precious, hard-won freedom that is absent from more blasé established democracies like Britain.

The demise of the House of Lords, combined with Britain's first-past-the-post electoral system, has created a political system close to an elective dictatorship. But Britain, like a number of previously unitary nation states in Europe, has devolved significant powers during the past decade. Likewise, EU members have also transferred power up. This has not always been sensible, for instance the working time directive. But, in areas of defence, foreign policy, immigration, financial regulation and monetary policy, the economic logic for a supranational approach is overwhelming. It will happen. The only question is when.

Yours ever

Dear Willem
17th January 2009

You favour a monetary union covering Europe, the US, Canada and Japan. But you recognise that this is politically unfeasible. Why, then, if a monetary union "is a step towards political union" is a common European currency the best system for the EU?

This put things the wrong way round. Monetary union is an objective of those favouring further European integration; but this was always regarded (particularly in Germany) as the last piece in the jigsaw. When the Berlin wall fell, President Mitterrand, fearful of the potential power of a united Germany, persuaded Chancellor Kohl to go with the euro long before other forms of integration had been completed.

For much of its history the US might have been better off, in purely economic terms, with more than one currency. But its political settlement determined otherwise. Political union in the EU would require citizens in Germany, France, Italy or Britain to see themselves as people do in New York or California. That is not going to happen.

This is but one reason why much of the economic literature on optimum currency areas (OCA) is a waste of time. Is Britain an OCA? Is Western Australia, or Quebec? What matters in all of these cases is political viability. Without political union, monetary union brings only instability, as is happening in the EU today. An independent monetary policy is still the best option for a nation state. This is not just a matter of fine-tuning the business cycle. As I mentioned, the growth of private capital flows since the mid-1980s has changed the nature of economic policymaking. The freedom of exchange rates to float is the best way of combining economic dynamism with overall stability.

You are disparaging about British democracy, and there is reason for concern. But parliament's authority has been undermined in part because powers have been handed to an unaccountable political system in Brussels—without the consent of the British people. This has corroded politics and made us more vulnerable in the current financial crisis.

Yours ever

Dear Derek
18th January 2009

I share your view that most OCA theory is rubbish. But you implicitly appeal to old Keynesian theories when you argue that the US should have had many currencies. Why? Because you still see exchange rates as a tool for countering shocks in a specific country, like an asset bubble or oil price hike. This view assumes persistent, even permanent, inflexibilities in wages and prices and no capital mobility. It also assumes a central bank run by omniscient, benevolent geniuses. None of these three factors is remotely realistic. Foreign exchange markets, in particular, are driven by mood swings, while central bankers are all too fallible.

As regards the politics, anyone who cares about democracy must be concerned by the further erosion of checks and balances that an overly powerful executive, a toothless parliament and an irrelevant judiciary have produced over the last decade. The main guarantors of British freedom are now the wonderful bloody-mindedness of the British people and the European court of justice.

It is a canard to say there have been transfers of sovereignty to the EU without the consent of the people. There were two referendums on EU membership. I support a referendum on the Lisbon treaty. Like the previous two, this one would be won. In any case, the European parliament is a more effective check on the EU executive than the British parliament is on the British executive.

Yours ever

Dear Willem
20th January 2009

My observation on America was based on the simple observation that although, until relatively recently, the US did not have a single economy, the long-term isolation of the south's labour market didn't end until after the second world war. And the US did have an established political identity. The EU has neither. The notion that the euro provides stability, let alone safety, defies belief in the face of what is happening—not in textbooks but on the ground.

Any rational economic framework should reinforce good policies and provide an exit for (inevitable) mistakes. The euro does the opposite. Within EMU, any government that embarks on economic reform and manages to raise productivity and real incomes, as Ireland did, is penalised: the new dynamism attracts capital inflows, but boom is followed by bust because the interest rates set by the ECB are too low. Recovery from the bust is stymied because an independent monetary policy has been abandoned, so that attempts to put the public finances back in order will add to recession. And so the remedy for lost competitiveness is depression!

Allowing currencies to appreciate and depreciate remains the best way to maintain stability within and between countries. Of course, countries that pursue rash policies will get into difficulties. But they are better able to get out of them with independent monetary policies. There is no reason to believe that economic dynamism cannot be combined with overall stability in Germany, France, Britain and many other countries in the EU, provided central banks can set appropriate interest rates on their own.

Of course nothing is perfect. But you imply that currency volatility is induced simply by the existence of exchange markets; speculation runs rife so the markets for separate currencies should be shut down. But the same logic would suggest banning stock markets too!

There is insufficient space to cover your political points, save to say that there has been only one referendum on membership (not two), when the proponents of entry deliberately denied the implications for the country's sovereignty—as many of them have subsequently acknowledged. This lack of democracy is a reason to stay out, even if the economics did suggest going in.

Kind regards