3 Responses to “Britain is better off outside the euro”

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1. Willem Buiter: The case for the UK shedding sterling and adopting the euro has never been clearer.

   From a conventional macro­economic perspective, there is no reasonable argument for a small, highly open economy such as Britain’s to retain monetary independence. For economies with a high degree of international financial integration, the exchange rate does not act as a buffer against asymmetric shocks, permitting an easier adjustment of international relative prices than under an irrevocably fixed exchange rate. Instead it becomes a source of unnecessary noise and volatility.

   The best way to deal with asymmetric shocks is to smooth national consumption by increased portfolio diversification and cross-border labour mobility. International portfolio diversification is aided by the reduced exchange rate risk that comes with membership of the euro area. Joining Schengen, the European border-free travel area, would boost the ability of labour to adjust to economic shocks.

   There is another powerful argument for adopting the euro. The UK has a large financial and banking sector, which conducts much of its activity buying and selling financial instruments denominated in foreign currencies, not in sterling. The UK has massive gross external liabilities and assets – well over 400 per cent of annual gross domestic product each – compared with less than 100 per cent for the US and 700 per cent for Iceland.

   It is not much of an exaggeration to describe the UK as a giant hedge fund, a highly leveraged entity borrowing shorter than it lends and invests. It has a lot of short-maturity foreign-currency-denominated foreign liabilities and illiquid, non-sterling denominated foreign assets. It is 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 at the onset of the credit crisis in August 2007) now performs this role effectively.

   The Bank, however, cannot print euros, dollars, Swiss francs or yen. That means it cannot be an effective lender of last resort, or market-maker of last resort, if UK banks find themselves unable to roll over their non-sterling-denominated short-term liabilities or unable to sell their foreign-currency-denominated assets in illiquid international wholesale markets. To deal with either problem, the Bank would be dependent on the goodwill of other central banks, through swaps and credit lines in foreign currencies. They would have to be willing to buy sterling when the markets are yelling: “sell it”. This would be possible, but an (unnecessary) risk.

   The main question is whether the UK is more like the US and euro area or like Iceland. I would argue that it is more like Iceland. Only the US and the euro area have serious global reserve currencies, with about 63 per cent and 27 per cent of the global stock of reserves respectively. Sterling, with about 5 per cent, no longer plays with the big boys and girls. Countries that want a large, internationally active banking sector and financial system need a serious global reserve currency to provide the lender of last resort and market-maker of last resort services required to limit the risk of a bank run or liquidity crunch bringing down their banking system. It is possible to run a large financial sector with a local currency such as sterling or the Icelandic krona, but it involves taking an unnecessary and costly risk. Sooner or later that risk will be reflected in the cost of capital and render the country uncompetitive. If London wants to remain the world’s financial capital, there is only one choice for the UK: adopt the euro now and wonder why it did not do so in 1999.

   Finally, there are political arguments for joining the euro area. The future of Europe is federal. The euro is a symbolic step towards deeper political integration. The UK can continue acting as it has since the European Union (or its predecessor institutions) was created: stand on the sidelines, snipe, join late and reluctantly and then moan about how things are turning out. Or it could be at the heart of Europe, shaping its institutions. The UK punches below its weight because it is not a full member of the EU: if you are not in the euro group, you do not count.

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

   Posted by: Willem Buiter | June 4th, 2008 at 12:59 pm | Report this comment
   

2. Andrew Smithers: I described the UK as the “World’s Largest Hedge Fund” in 2000 and pointed out the risks that this posed for the management of our economy. But I am far from agreeing with Willem Buiter that this problem makes it desirable for the UK to join the Euro.

   The UK’s dependence on the export of finance and other services means that real incomes are vulnerable to changes in the terms of trade. We have benefitted over many years from the relative rise in services compared with goods. It seems likely we are now seeing the start of a long-term reversal of this trend, due to the high marginal demand for food, other goods and their raw material inputs arsing from the shift in world growth rates towards emerging economies. Even if output growth is unchanged, this will reduce the growth of real incomes and increase the need for occasional declines in real wages. Such declines are much easier to achieve through changes in real exchange rates, via nominal declines, that by changes in nominal incomes. (A point I recall Willem making in an article he wrote for the FT a decade or so ago.)

   It follows that I am dubious of Willem’s claim that “….the exchange rate does not act as a buffer against asymmetric shocks…” at least if one includes deterioration in the terms of trade, possibly extending over a long period, as a shock. Nominal exchange rate flexibility will also ease, rather than impede, external asset imbalances, as well as current account adjustments. It seems that the UK is a large gross sterling debtor and gross creditor in other currencies; devaluation of sterling will thus tend to improve the net investment balance, both in terms of capital and income flows. Labour mobility within the European Community is already high and joining Schengen is a nugatory consideration.

   As a hedge fund which has borrowed short and lent long, the profits from this activity are vulnerable to a rise in the price of liquidity. But the UK entities exposed to this are in the private sector and, as current account data show, are largely foreign owned. The current account deficit fell from 5.5% of GDP in Q3 2007 to 2.4% in Q4 2007. According to the ONS, “Earnings on direct investment abroad rose £1.4 billion to £22.2 billion, while earnings on direct investment in the UK fell £10.1 billion to £4.1 billion. The significantly lower earnings on direct investment in the UK were due to the losses incurred by foreign-owned banks operating in the UK as a result of the recent turmoil in the financial markets.”

   The UK does not need to act as lender of last resort to bail out banks which are foreign-owned and does not appear to be suffering from the short-term shocks of “turmoil in financial markets”.

   Posted by: Andrew Smithers | June 4th, 2008 at 2:38 pm | Report this comment
   

3. Martin Wolf: I am a great admirer of Willem Buiter. He adds greatly to our understanding of the world. But even Homer nods and, in the case of British membership of the eurozone, Willem does so. Below I will deal with his arguments in reverse order.

   First, Willem is a European federalist. I am not. 30 years ago I was a devout federalist, too. But I have grown out of it: I now see most of the benefits of scale as being outweighed by the loss of national autonomy.

   The logical argument for a federation is that there are economies of scale in certain areas: defense and foreign policy are obvious examples. I accept that. But this leaves at least two questions: first, whether the European Union is an optimal level at which to deliver these benefits; and, second, whether the EU is sufficiently politically legitimate to act in these areas as a federation. I have doubts about both.

   To put it bluntly, is it more important for the British people to be close to the Americans or, say, the Bulgarians, if they are to enhance their security? Equally, would decisions taken at the European level by an elected European government be deemed legitimate by the British people? Again, I strongly doubt this.

   For these reasons, I do not expect a true federation to emerge in the foreseeable future. The fact that every referendum held on the Constitutional Treaty and then the (essentially identical) Lisbon Treaty led to its rejection suggests these suspicions are widely shared. The reasons for the rejection vary. But the common element is suspicion of what is seen, for understandable reasons, as an inherently remote and technocratic level of government.

   I am surprised that Willem, of all people, should resort to weary metaphors about being “at the heart of Europe”. The UK, he says, “punches below its weight because it is not a full member of the EU.” What is the concrete evidence for this in areas where this matters to the citizens of the UK?

   My view is that there is a trade-off between allowing countries to decide things for themselves, while also having less influence on the policies of others, and not allowing them to decide things for themselves, while having more influence on the policies of others. In many areas, including monetary policy, I would prefer the former. I would rather that the UK could decide its own migration, fiscal, monetary and labour market policies, while accepting that it also has less influence on the policies of its neighbours. If this is “punching below one’s weight” so be it.

   The second argument is that the UK cannot have a global financial centre without having a reserve currency. I believe this argument is entirely mistaken.

   London is an entrepot. Most of the business there is conducted by foreign financial institutions in foreign currencies. They are located in London, despite the UK’s position outside the eurozone, because it offers them the right labour market and the right institutional environment for their businesses.

   Should any of these institutions find themselves short of dollars, euros, yen or any other currency or find themselves unable to roll over their liabilities or sell their assets in these currencies, they will have to seek relief from the issuing central banks. Any British owned financial institution that operates in these currencies will need to set up its business in such a way that it, too, has access to the relevant central banks. That is exactly what global banks, such as HSBC, have done. But the fate of such “British” institutions is, in any case, far less important for the fate of the London financial centre than Willem seems to think.

   Interestingly, the institutions that have most found themselves in currency difficulties in this crisis seem to have been European banks that invested heavily in US-dollar denominated asset-backed paper. For this reason, the European Central Bank has made make large dollar-swap arrangements with the Federal Reserve.

   This shows that even the most important central banks may find themselves having to rely on swap arrangements with others. Obviously, it is possible that the US would help the ECB and refuse help to the Bank of England, in a crisis. Does Willem really find that plausible, given the historic links between the UK and US? Similarly, the ECB may help the Fed and refuse help to the Bank, even though the UK is a member of the EU. But does he really find that plausible either?

   The really big issue is not about the lender-of-last-resort function of central banks, but fiscal. The question is which fiscal authority would bail out a bank that made huge losses in foreign markets.

   Interestingly, this point of vulnerability is in no way unique to European countries not in the eurozone. Fiscal authorities remain national. If a Dutch or an Italian bank that did most of its business outside the home base made such huge losses that it had to be bailed out it would, presumably have to turn to its domestic taxpayers. It would be interesting to watch the debate over the proposed bail-out of an institution that has lost vast amounts of money abroad. In any case, a troubled Dutch or Italian bank would be in exactly the same situation as a British bank, if this happened.

   What has all this to do with Iceland? Nothing. Iceland is not an international financial centre, though it does have some banks whose business has extended far beyond their small home base. Willem imagines a situation in which the aggregate of financial institutions operating in the UK (most of them foreign) have fallen into severe difficulties. That would be disruptive for the British economy, of course, because the financial sector is so important to it. It is even possible that the UK’s net earnings will turn negative. But why does this mean that the London markets need a British lender of last resort?

   So I strongly agree with Andrew Smithers that there is no reason why a lender of last resort in the domestic currency is needed to support London’s financial centre. To me this looks like yet another in a long line of mistaken arguments that remaining outside the eurozone would kill off London’s role as a financial centre. Far more dangerous to London are attempts by the EU to over-regulate financial activities or harmonise taxes. Equally dangerous are bad policies by the British government.

   The third argument is that the exchange rate serves no purpose as a safety valve and, more broadly, that domestic monetary autonomy is worthless. Again, I strongly disagree. Willem recommends portfolio diversification and labour mobility instead and argues, specifically, that the UK join the Schengen area to improve labour mobility.

   It is true that labour mobility makes adjustment to shocks easier. In the UK case, a large housing-related recession would, no doubt, persuade many central and eastern Europeans to leave. UK membership of the Schengen area would have been irrelevant to that, however, since members have refused to allow these people to enter their labour markets. Not being in the Schengen area creates no significant obstacle to the ability of British people to move to other EU member states, beyond five minutes in a passport queue.

   What about Willem’s other points? Portfolio diversification is good, of course, but as he himself has pointed out in other contexts, the most important asset for most people is themselves. Diversifying ownership of oneself is impossible (except via the tax-levying power of the state and the welfare state, which remain strictly national). This is why the state of labour markets to which one has easy access is so important. In practice, the obstacles to easy movement of labour across the EU are – and will remain - high, because of linguistic and cultural factors. Most people are bound to national or even sub-national labour markets. Not everybody is a Willem Buiter.

   I do not accept Willem’s proposition that “the exchange rate does not act as a buffer against asymmetric shocks”. Indeed, it is doing so for the UK right now, as Andrew Smithers notes. I agree that a floating currency can be a source of instability. But a fixed exchange rate can be a source of even greater instability.

   While international shocks are important, more important, to my mind, are differences in domestic macroeconomic cycles. So long as nominal wage cuts are extremely hard to achieve, it remains useful to adjust the exchange rate. So long as countries experience very different cycles, it remains useful to run one’s own monetary policy. Cyclical instability matters, because it is hard for people to insure themselves against such risks.

   The UK’s rates of interest have been consistently higher than in the eurozone, even though its inflation performance has been better. This reflects the extraordinary elasticity of credit in the midst of a huge housing boom. If the UK had been in the eurozone, that boom would have been even bigger. Some will deny this. They will argue that the very fact of joining the eurozone would somehow have stopped this. Why? I agree rates of interest in the eurozone would have been a little higher with British membership, but they would still have been substantially lower than actual UK rates. I suggest they stop dreaming and start looking at Ireland or Spain.

   The UK’s boom would have been even bigger than it was and so the subsequent bust would have also been even bigger. This would, I believe, have inflicted a long period of recession and even outright deflation on the economy, with little possibility of an offsetting expansion of exports, in response to a devaluation. Meanwhile, British politicians would have had to explain to their people that these grim conditions were the price they pay for their engagement in the heroic European cause. That would have gone down well, wouldn’t it?

   Finally, let me make a slightly irritated comment on Willem’s use of the adjective “small” to describe the UK. The UK is the world’s fifth largest economy, after the US, the eurozone, Japan and China. There are about 200 countries in the world. So the UK is not small. It is merely not one of the giants.

   In all, Willem is letting his enthusiasm for European federalism overwhelm his normally high levels of economic analysis. The UK can survive outside the eurozone, provided policymakers understand the disciplines this entails. That is what they should do.

   Posted by: Martin Wolf | June 22nd, 2008 at 10:56 pm | Report this comment
   

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