When will the UK wake up and join the Euro Area?

The case for the UK shedding sterling and adopting the euro has never been clearer.

From a conventional macroeconomic perspective (asymmetric shocks, cyclical convergence, the 39 tests or whatever), there is no reasonable argument for a small, highly open economy like Britain to retain monetary independence. The belief that an independent national monetary policy allows you greater greater scope for effective macroeconomic stabilisation is an example of the monetary fine-tuning fallacy. With a high degree of international financial integration, the exchange rate does not function as a buffer against asymmetric shocks, permitting a less costly adjustment of international relative costs and prices than would have been possible at an irrevocably fixed nominal exchange rate. Instead it becomes a source of extraneous, uncessessary noice and volatility and of at times persistent misalignment.

The best way to deal with asymmetric shocks is to smooth national consumption through international insurance: increased portfolio diversification and increased cross-border labour mobility. International portfolio diversification is encouraged by the reduction in exchange rate risk that comes with membership in the Euro Area. Joining Schengen and eliminating the other remaining administrative obstacles to labour mobility (including the temporary restrictions imposed on migration from some of the new member states) would boost the diversification of human capital.

There is another powerful argument for the UK to adopt the euro yesterday. The UK has a very large financial and banking sector, which conducts much of its activity by buying and selling financial instruments denominated in foreign currencies rather than in sterling. As a country, the UK has massive gross external liabilities and assets. These are well over 400 percent of annual GDP each, as compared with under 100% of annual GDP for the USA and around 700% of annual GDP for Iceland. It is not much of an exaggeration to describe the UK as a hedge fund, a highly leveraged entity, borrowing shorter than in lends and invests. It has a lot of short-maturity foreign-currency-denominated foreign liabilities and quite a lot of illiquid, non-sterling denominated foreign assets

It’s not a bad way to make a living, but it means the country needs a lender of last resort and market maker of last resort. It has one for sterling-denominated financial instruments. The Bank of England, after malfunctioning temporarily following the onset of the crisis in August 2007, now performs this function effectively. The Bank of England, however, cannot print euros, dollars, Swiss francs or yen. That means the Bank of England cannot be an effective lender of last resort or market maker of last resort if UK banks find themselves unable to roll over their foreign-currency-denominated short-term liabilities or if they find themselves unable to sell their foreign currency-denominated assets in international wholesale markets that have become illiquid.

To deal with a run on the non-sterling short-term liabilities of the UK banking sector or with a ‘strike’ in the wholesale non-sterling markets, the Bank of England would be dependent on the goodwill of other central banks, through swaps and credit lines in foreign currency. They would have to be willing to go long sterling when the markets are yelling: ‘go short’. Possible, but an (uncessary) risk.

The key question is: is the UK more like the USA and the Euro Area or more like Iceland? I would argue that, from the point of view of being able to act as an effective, credible lender of last resort and market maker of last resort in financial instruments that are not denominated in the national currency, the UK is more like Iceland than like the Euro Area and the USA. Only the USA and the Euro Area are serious global reserve currencies, with around 60 percent and 26 percent of the global stock of reserves respectively. Sterling, with around 4 percent, no longer plays with the big boys and girls.

To have a large, internationally active banking sector and financial system, your currency has to be a serious global reserve currency if you are to be able to provide the lender of last resort and market maker of last resort services required to minimize the risk of a bank run or market liquidity crunch bringing down large chunks of your banking system. You can decide to take the risk of running a large globally active financial sector with a local currency like sterling or the Icelandic krona, but you will be taking an unnecessary and costly risk. Sooner or later that risk will be reflected in your cost of capital and make you uncompetitive.

So, if the UK wants to remain the seat of the world’s financial capital, there is only one choice: adopt the euro now, and wonder why you did not do so in 1999.

Finally, there are the political arguments for joining the Euro Area. The future of Europe is a federal one. The euro is an important symbolic step towards deeper political integration. The UK can continue acting the way it has since the EU (or its predecessor institutions) were first created: stand on the sidelines, snipe, join late and relucantly and then moan about things not turning out the way they should have. Or the UK could be at the heart of Europe and help shape the debate and the future development of its proto-federal institutions. The UK now punches below its weight in the EU and globally, because it is not a full member of the EU – its opt out from stage three of the monetary union makes it a bit player at best. If you are not in the Euro Group, you don’t count.

So macroeconomic stability, the defence of London’s status as a global financial center and the political logic of deeper European integration all call for the dumping of sterling and the adoption of the euro. Just do it.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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