The case for UK membership of the euro
Let me start with a disclaimer. I was never a strong advocate of British membership of Europe’s economic and monetary union, though I was, and still am, a big fan of Emu itself. I always felt the economic arguments made by euro advocates in the UK were vastly exaggerated and counterproductive. Judged from a narrow economic perspective, which is how the British looked at this, they were right to stay out during the euro’s first 10 years. The tangible economic benefits that came with an independent monetary policy outweighed the much less tangible economic benefits of membership.
But that was then and this is now. A financial crisis, a house price crash and a recession later, the arguments are still fundamentally the same, but the cost-benefit analysis produces a different result. The advantage of monetary independence, while somewhat greater than zero, will be more than compensated by the following four factors.
The first relates to long-term economic costs. In the good old times of financial exuberance, global real interest rates were low and successive bubbles kept the credit-devouring beast of the British economy going. Even assuming that financial balance sheets will be back in good shape in 2010 or 2011, I would not expect a return to the credit-binge era. We have probably entered a secular bear market in equities. There will be no immediate appetite for another housing bubble and the regulatory framework will be conservative, to put it mildly.
In such an environment I would expect smaller economies with free-floating currencies to be forced to pay higher risk premiums on their sovereign bonds. Real interest rates in the UK will rise by more than elsewhere and this will weigh on long-term economic performance. The real interest rate gap with the eurozone will rise. To be clear: this is an argument about long-run economic costs. This is not a variant of the short-sighted argument that mortgage rates would be lower in the eurozone. They may, or they may not.
The second point relates to the City of London. The City has managed to remain the eurozone’s financial centre, even though the UK is firmly outside. We should not take this situation for granted. The transaction-based system of financial capitalism suited London better than Frankfurt or Paris. Regulatory revenge will push offshore activities back onshore and the relative attractiveness of the City of London will be correspondingly reduced. The UK will at some point have to make a choice whether it wants to be in the eurozone or whether it wants to seek an alternative use for those rather tall buildings in the heart of London.
The third point is one of political economy. There will be more economic governance at eurozone level in the future. The French have always been pushing in that direction. The Germans resisted vigorously, but are slowly beginning to move in the same direction. The UK and other non-eurozone members will not like it. Frank-Walter Steinmeier, Germany’s foreign minister and Social Democrat candidate for chancellor at next year’s election, last week announced a policy shift that the SPD was now in favour of macroeconomic policy co-ordination at eurozone level. Even in the German government, which has hitherto rejected any notion of EU or eurozone-level banking supervision, there is now an acceptance that such supervision may eventually be necessary for the 44 large cross-border European banks. This is still not yet an official policy position, but there is now an openness to the idea that was previously absent. Expect to see a lot more eurozone summits in the future, and this means a lot more group photos without Gordon Brown, the British prime minister.
The fourth, and possibly most important point, is that the UK’s macroeconomic policy framework may simply not survive this crisis. There must now be a risk of a real sterling crisis at some point, something significantly more alarming than the tremors felt last week. As Willem Buiter of the London School of Economics noted in his Financial Times blog, the UK is in many respects comparable to Iceland. It is bigger of course, but still tiny in relation to the global economy, with a sick financial sector that accounts for several times gross domestic product.
This is an argument about macroeconomic risk management. The world’s two large reserve currencies, the dollar and the euro, offer more protection from speculative attack than a free-floating offshore currency unit. And when global investors repatriate money, or wind down their carry trades, or when a deep global recession drives government into competitive devaluations, expect currencies to move all over the place and then back again.
None of these arguments is new, but they now appear in a new light. I know that British euro membership faces large political hurdles. Mr Brown’s famous five tests would have to be judged accordingly. Newspaper editors would have to be bribed. Parliament would have to vote in favour. A referendum would have to be held, and won, and the polls tell us that this is not possible.
But remember that public opinion in eurosceptic Iceland shifted from hostile to enthusiastic within a short period, when people discovered to their horror that monetary independence comes at a crippling cost. When the facts changed, the people of Iceland changed their mind. I cannot see any reason why the British, dispassionate and pragmatic as ever, should react differently.
munchau(at)eurointelligence.com
© The Financial Times Limited 2008