The City of London can no longer afford the expensive luxury of sterling

It’s time to revisit the ‘Five Tests’, to declare them passed and, subject to the UK being deemed, by our EU partners, to meet the Maastricht criteria, for the UK to adopt the euro.

Remember the ‘Five Tests’ designed at the behest of then Chancellor Gordon Brown (whatever happened to him)? Passing these economic tests was presented as a necessary condition for the UK to apply for full membership in the Economic and Monetary Union (EMU).

For those who have a life and therefore don’t remember what the Five Tests were, here they are again:

  1. Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
  2. If problems emerge is there sufficient flexibility to deal with them?
  3. Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?
  4. What impact would entry into EMU have on the competitive position of the UK’s financial services industry, particularly the City’s wholesale markets?
  5. In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?

The UK Treasury was given the task of assessing the tests – independently and without any regard to the political preferences of the political leadership, of course. The first assessement was in October 1997.  The Treasury concluded that the UK economy was neither sufficiently converged with that of the rest of the EU, nor sufficiently flexible to apply for membership.

The second and thus far last assessment was published in 2003.  The verdict of the Treasury was: closer but no cigar.  Specifically:

  • There had been significant progress on cyclical convergence since 1997, but significant structural differences remained, especially in the housing market.
  • UK flexibility had improved (it had to, after six years of New Labour).  The Treasury could not be certain, however, that the improvement had been sufficient.
  • Investment would increase as a result of euro area membership if and only if there had been sufficient convergence and flexibility.
  • The City of London (accounting for roughtly four percent of UK GDP, out of a total financial services sector of around 9 percent of GDP) would benefit from euro area membership
  • As regards growth, stability and employment, see the third bullet point.

I have decided to save the Treasury (who have more urgent albeit no more important things on their mind right now) the time and effort of making another assessment by doing it myself.  Here it is.

(1) Convergence

  • Cyclical.  The UK business cycle is now so synchronised with that of the euro area that the country looks like a suburb of Frankfurt.  For those to whom a picture speaks more clearly than a thousand words, the chart below shows the growth rates of real GDP for the UK and the euro area.  The synchronicity is very very very high indeed.  Test met.
  • cyclical-convergence_7897_image001.gif

  • Structural, especially as regards the housing market and housing finance.  The UK model of housing finance is broken – kaput.  New mortgage financing has collapsed and the construction sector is teetering on the brink of disaster.  Higher UK interest rates did not prevent the out-of-control housing finance boom and house price bubble that preceded the crash.  The culprit was faulty UK regulation not just of residential mortgage finance but of household borrowing and of the financial sector generally.  As a result the UK household sector is the most leveraged in the developed world.  Its financial debt and deficit are unsustainable.  In the euro area there are countries that, like the UK, have disfunctional household finances and discredited regulatory regimes for the financial sector.  Ireland is one example.  But there are also examples of superior financial systems and better regulation, including Germany and the Netherlands.  The UK should abandon its light-touch approach to financial regulation, which turned out to be soft-touch regulation.  To describe the British regulatory system as principles-based and risk-based is laughable.  It was an invitation to the unprincipled to take excessive risks. Test met because the UK should adopt one of the working, superior contintental models of housing finance and of financial regulation in general.
  • (2) Flexibility.  It’s oozing out of the country’s pores.  How could it be otherwise after more than 11 years of New Labour?  The main further improvement since the last test has been large-scale equilibrating flows of labour between the new EU member states in Eastern and Central Europe and the UK. They came in their hundreds of thousands when the economy was booming.  They are leaving in their hundreds of thousands now that the economy is tanking.  Test passed.
    (3) Investment.  No-brainer. Test passed.
    (4) The City.  The euro was always going to be good for the City. We did not realise until the present crisis just how bad an independent currency is for financial stability in general, for the City in particular and for the wholesale markets most specifically.

    That having an independent currency means increased financial instability for the UK  does not stand or fall with the fact that the Bank of England has been the most inept of the leading central banks at liquidity management -the art of providing illiquid financial enterprises and illiquid markets with funding liquidity and market liquidity, respectively.  After a dreadful start in August 2007, when the Bank insisted on following what amounted to a ‘Treasuries’ only collateral policy at its discount window (the standing lending facility) and in its repos, there had been signs of real progress since the late autumn of 2007, culminating in the creation of the Special Liquidity Scheme (SLS).

    Since then, it has all been downhill again, however.  The SLS was restricted to asset-backed securities and covered bonds backed by ‘old’ mortgages and other underlying assets only – assets orginated before December 31, 2007.  This did nothing to revive the securitisation markets for new mortgages.

    Instead of extending the SLS to new originations, the Bank announced last summer that it would close the existing SLS to new business by October 21, 2007.  This created a beautiful focal point for those wishing to short bank equity or to cut off credit lines to those suspected of having significant amounts of SLS-type assets on their balance sheets.

    The Bank recognised the error of its ways during the height of the banking panic of the past two weeks and extended the SLS.  It still specified a specific date for the end of new business, however: the end of January 2009.  Once again, the Bank of England has created a perfect focal point for speculative attacks on banks holding (or suspected of holding) large amounts of illiquid assets.  It cannot be that hard to see that a scheme like the SLS is to be kept in place until the conditions necessitating its existence have vanished.  Unless the Bank of England has perfect foresight, the exact date on which the SLS will become redundant cannot be predicted.

    Although it is, regrettably, true that the Bank of England has become part of the problem in the financial markets rather than part of the solution, that in itself is not the main reason why it would be desirable to get rid of sterling.  The financial stability case against sterling and for the euro would exist even if the Bank’s liquidity management and market support were of the very highest quality.

    In a nutshell, the argument goes as follows.  There is no such thing as a safe bank, even if the bank is sound in the sense that, if it could hold its existing assets to maturity, it would be able to meet all its contractual obligations.  More generally, there is no such thing as a safe highly leveraged institution that borrows short and lends/invests long and illiquid.  Government guarantees/support are required to make private financial institutions with leverage and asset-liability mismatch sustainable.  Such support is provided in the first instance by the central bank acting as lender of last resort and market maker of last resort.

    When the short-term liabilities of the banks are denominated in domestic currency,  there is no limit to the amount of appropriate liquidity the central bank can create – costlessly and instantaneously.  It can simply print the stuff.  The only constraints on its willingness to provide liquidity would be fear of moral hazard and fear of the inflation it might create.  Moral hazard can be dealt with by pricing the liquidity support appropriately and by imposing regulatory requirements on entities borrowing from the central bank.  The threat of inflation can be eliminated by the Treasury transferring resources to the central bank (recapitalising the central bank).

    When a significant share of the short-term liabilities of the banking system (broadly defined to include the AIGs of this world) is denominated in foreign currency, there are limits to the foreign currency liquidity support the central bank can provide.  Foreign exchange reserves, credit lines and swaps are small outside a small number of emerging markets.  For the UK they are negligible.  So to act as a lender of last resort or market maker of last resort in foreign currency, the Bank of England would, in short order, have to approach the central banks of the only two countries/regions that have serious global reserve currencies: the USA (the US dollar makes up around 64 percent of global reserves) and the euro area (the euro accounts for around 24 percent).  No doubt it would be possible for the Bank of England to arrange swaps with the Fed and the ECB (if the UK Treasury were to back such a request), but there would be a cost.  This insurance premium for foreign exchange liquidity risk would make the City of London uncompetitive compared to institutions operating in the jurisdictions of the Fed and the ECB.

    Other countries are more vulnerable than the UK to a run on the foreign currency deposits of their banks or to a locking up of foreign currency wholesale markets.  Iceland (where gross financial assets and liabilities reached almost 800 percent of GDP at their peak in early 2007) is an example.  Switzerland is another one, aggravated by the fact that Switzerland is a Confederation where the central fiscal authority has very limited revenue raising powers.  Unless a strong and solvent fiscal authority backs up the central bank, the central bank cannot hope to access a signicant amount of foreign currency liquidity when an emergency strikes.

    The UK is more like Iceland than like the US or the euro area when we consider the size of its financial sector and especially the size of its external balance sheet.  With gross foreign assets and gross foreign liabilities both close to 450 per cent of annual GDP, and with much of these assets and liabilities denominated in foreign currency, the UK is a highly leveraged entity – a hedge fund – and therefore vulnerable.  In contrast, gross external liabilities of the US are around 100 per cent of GDP.  And the US dollar is one of two serious global reserve currencies.  Sterling, with 4.7 per cent of the stock of global reserves is a minor-league legacy reserve currency.

    It is true that London has prospered mightily with sterling in the past, even after sterling lost its world reserve currency status.  But that was then – then being before the current global financial crisis. No-one had even considered the possibility that all systemically important financial wholesale markets would seize up at the same time, making lender of last resort and market maker of last resort support from the central bank essential for the very survival of banks and a whole range of highly leveraged financial institutions.

    The Bank of England can, at best, be an effective lender of last resort and market maker of last resort in foreign currency at a cost – a cost that will undermine the competitive advantage of the City.  At worst, if the fiscal credibility of the UK authorities were to be in doubt also (not an inconceivable event, given years of procyclical budgetary policy), the Bank of England would not be able to operate at all as a foreign currency lender of last resort and market maker of last resort.

    There are just three conceivable ways to handle this problem.  The first is to run down the international financial activities of the City.  The second is to become the 51st state of the USA.  The third is to adopt the euro.  Only the third one is reasonable; the first is a waste of a potential comparative advantage and the second is infeasible.  Adopting the euro happens to be an excellent choice for other reasons as well.

    (5) The sum of all previous tests: growth, stability and employment are hurt by the UK hanging onto sterling.  Test passed.

    All that remains is for the UK to apply for membership.  Save the City – dump the pound. 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