Repost: 5th August 2000

Some notes on the controversy regarding Britain's potential membership of the European Single Currency.

The main argument of those currently in favour of Britain joining the Euro group is that it would have prevented the difficulties caused to many British businesses by the recent fall in value of the Euro against Sterling.  (Some seem to claim that joining now would remove these difficulties, but it is difficult to see how they expect this to happen)

This was not an argument put forward in advance of the Euro being launched - in fact the opposite was widely claimed, that Sterling would fall in value against the Euro with consequent damage to those importing raw materials or finished goods, or servicing foreign-currency debts.

This is in itself a partial answer to critics of the policy of remaining out of the Euro zone.  A high or a low exchange rate is not a good thing in itself, but helps some and disadvantages others within the national economy.

The common reply to this is that the unpredictability of exchange rates makes commercial planning difficult, and is thus a bad thing for everyone, even if fluctuations give temporary advantage to some.  A fixed exchange rate removes uncertainty and allows all businesses to make investments with greater confidence.

This argument has more merit, but I believe it to be flawed.  Movement in exchange rates is not random, nor are the markets independent of the companies and consumers that make up the world economy.  Exchange rate variations reflect real changes in economic conditions between currency areas.  If these changes cannot feed through exchange rates, they will exhibit themselves in different ways, and the real arguments over currency integration centre on the different effects and costs of these different chains of events.

More concretely, the recent fall in value of the Euro against other major currencies is the result of a recession in mainland Europe. High unemployment in the largest Euro-zone countries has led to low interest rates, so finance has moved out of the Euro into currencies that give higher returns, including the Pound, the US Dollar and the Yen.  This has produced the fall in the Euro's value, with the effects of making costs lower in Euroland in international terms, making exports from Euroland cheaper and imports into Euroland more expensive.  This should have the longer-term effect of helping the economies of the Euro members recover from the present recession.  It also has the effect of making the workers of these countries poorer, in that prices increase in Euro terms, reducing the standard of living.

If Britain was inside the Euro zone, interest rates would be lower in Britain than they now are.  This would encourage borrowing and investment in industry, driving up wages and prices.  Imports of goods from outside the EU would become more expensive, driving up prices further.  Overall, this inflation would cause an increase in the standard of living (just as has happened as a result of the strong pound), and would make British labour and goods more expensive relative to the rest of Europe (just as has happened as a result of the strong pound).  Businesses that export to Europe would therefore be hurt (as is happening now), while businesses that buy from Europe to sell outside the EU or in the booming domestic economy would do well (as they are doing now).

In other words, the real economic effects of the Mainland European recession on Britain would be fundamentally the same whether they are felt through a high pound or domestic price and wage inflation.  It is a real-world fact that Germany, France, Italy and the Netherlands are having to cut their prices to stimulate sluggish demand, and that this will divert industrial investment into those countries from countries like the UK where economic growth is making standards of living higher and business more expensive.

That is not to say that the results are entirely identical, and that there is nothing at all to choose between being in the Euro and being outside.  There is one obvious advantage of being in, which is the simplicity of being able to spend the same money in a dozen countries instead of one, without the overhead of currency trading.

The disadvantage of being in is more subtle.  It is that exchange rates can and do change extremely quickly, based on the judgement of those dealing in the currencies concerning the economic situation and the likely future economic situation.  Prices and wages, however, change much more slowly, as it is awkward and expensive for businesses to alter them.  Wages increases are delayed until it is clear that staff cannot be recruited or retained without them, and decreases are strongly resisted.

To see the effects of this, look back fifteen years to the Britain of the mid-eighties.  In a similar economic situation to that of the last few years (European recession, British growth), the government adopted the policy of keeping the exchange rate between the Pound and the Deutschmark approximately constant by decreasing interest rates.  The result of this has become known as the "Lawson Boom", as cheap borrowing stimulated an already buoyant economy into a spiral of industrial growth and inflation, notably of property prices.  This is the only policy that at that time would have prevented the prevailing economic conditions from causing problems for those sectors of the economy that were dependent on European markets, or vulnerable to European competition.  The result, however, was the spectacular crash of 1987 once it became clear that inflation would have to be controlled.  It is widely recognised that this would not have happened if the economy had not been artificially stimulated by low interest rates over a long period under the policy of "shadowing the Deutschmark".

This is the real advantage of not being in the Euro.  The flexibility of an independent currency means that businesses will face economic pressures to adapt to changing conditions instantly, and are forced to take appropriate measures, rather than being insulated from outside developments until the dam bursts.

Even those who instigated and set up the Economic and Monetary Union project recognised this.  That is why the Maastricht Treaty made one of the preconditions of the Single Currency coming into effect a certain degree of "convergence" between the member nations.  The theory underlying this was that the free movement of goods and capital between EU member states would, after a period, put an end to the variations of economic conditions between countries that independent currencies are needed to deal with.

Whether this can happen is arguable, but so far it certainly has not. Within Britain, for example, if one region becomes economically depressed relative to another, workers tend to move from the poorer regions to the richer ones, thus easing the differences.  Whether this is really a good thing is another discussion entirely, but obviously there comes a point where adding more different currencies produces costs and inconveniences out of proportion to the benefits.  I might argue for an independent currency for Scotland, but not for Durham.

However, despite being given the legal rights, people are much less keen to move from Belgium to England to find work than to move from Scotland to England.  The long term aim of the European Union project is for the attitudes behind this to change, but that I would contend is a distant goal.

The other mechanism intended to produce the neccessary economic convergence is the so-called "cohesion fund".  This is a cross-subsidy intended to stimulate depressed regions at the expense of prosperous ones, thereby decreasing the regional differences that cause problems in a single-currency area.  It, however, suffers the same kind of barrier that the idea of migration faces, that taxpayers are much less willing to subsidise the economies of other countries than depressed areas of their own country.  Pumping funds into the North-East or South Wales is one thing, but supporting Greece or Portugal is quite another.

It should be clear that I am not attempting to argue that Britain should stay out of the Euro simply on the grounds that Britain's economy is doing well and Euroland's badly.  I have dwelt on current conditions, but they obviously are not set in stone.  In fact, my argument is that an independent Pound is as much in France or Germany's interest as Britain's (as those in Britain suffering from competition from Euro-priced imports are only too keen to point out). Similarly, if conditions were reversed (as they were, for instance, for most of the 1970s), the argument regarding the advantages of currency flexibility would be equally strong.  In fact, the only events that would really indicate that Britain ought to join the Euro would be if the exchange rate remained roughly constant for a long period, and looked like continuing to do so.  Under such circumstances, an independent Pound would contribute nothing to economic flexibility, and be merely a pointless and expensive administative overhead.  If Gordon Brown is waiting for this to happen, however, he may be in for a long wait.

Real evidence is hard to come by, but the above can be used to make predictions.  A useful "guinea pig" is the Republic of Ireland. Ireland, though independent for decades, only had an independent currency from the 1970s.  Since that time, and with the help of EU subsidies, the Republic has become a modern and prosperous economy. It seems to be at a similar stage in the economic cycle to the UK. However, unlike the UK, the Republic of Ireland joined the Euro. Therefore, at present, where the UK economy is being restrained by relatively high interest rates, Ireland has the same cheap borrowing as the other Euro countries.  This puts them in the same position described for Britain during the Lawson boom.  Building projects are everywhere (remember Loadsamoney?), property prices are spiralling upwards.  Under prevailing economic theories, these are effects of incorrect monetary policy.  However, European monetary policy is not set for Ireland, which is a small economy compared with the stagnating economies of mainland Europe.  The prediction is that within a few years, the Republic of Ireland will face a sudden and traumatic deflation, while any simultaneous change in Britain will start earlier, be more gradual and of less magnitude.