A case for currency freedom - Samuel Brittan: New Economy 06/03

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A case for currency freedom Samuel Brittan: New Economy 06/03 Politics versus Economics Many years ago when I was on the committee of the Cambridge University Labour Club, Brian Redhead - who subsequently became a well known British broadcaster - asked "Why is it that this one branch of policy, economics, is so dominated by obscure specialist studies which keep other people out of the discussion while everything else everything else is decided by common sense argument in which we can all take part?" This question has not been answered to this day. It has become all too topical in relation to possible British membership of the Euro. Many British leaders believe that the political case has been made; and the only question is whether boring economic obstacles should keep the UK outside for the time being. In fact the political case has not been made and should not be taken for granted. It is simply asserted by the current generation of Ministers and Foreign Office mandarins. For the fullest explanation one is usually referred to Tony Blair's speech to the Polish Stock Exchange on October 6, 2000. Most of the relevant section is a generalised statement of the case for Britain "being at the centre of influence in Europe". On the euro specifically the Prime Minister merely said: "The political case for Britain being part of the single currency is strong. I don't say political or constitutional issues aren't important. They are. But to my mind they are not an insuperable barrier. What does have to be overcome is the economic issue." What then would a true political assessment look like? The more I think about it, the less difference there is between the two kinds of assessment. The object of economic policy is surely to promote the welfare of the inhabitants of the United Kingdom, with some regard for the welfare of those outside especially in poorer countries. But is that not an equally good description of the goal of political activity? We get bemused because the intermediate objectives seem so different. On the one hand the famous five tests refer to specifics including growth, employment and even the prosperity of one particular part of the economy, namely the financial sector. On the other hand the political case, so far as it has ever made , centres around more nebulous matters, such as British influence in Europe or: who will be sitting at which top table? But surely all such specifics, whether on the so-called economic or political fronts, are intermediate objectives. Jobs and growth are only valuable to the extent to which they promote the welfare of inhabitants of these islands. Surely too British government influence in international institutions is important only to the extent that it promotes the well being of British citizens. Influence at European summits or even the ability to "speak for Europe" (this last, a rather remote goal) -- may be important for their own sake to prime ministers and top level diplomats; but for the rest of us they matter only in so far as they promote peace, security and prosperity. "Economic" Arguments So much has been written on the economic effects of euro membership that I will be selective and concentrate on those which seem to me most important. Readers who have had enough of this discussion can move straight to the last part of this article. Many of the supposed economic arguments both for and against euro membership are extremely unconvincing. A frequent objection is that the core euro countries, and especially Germany, are suffering from low growth and high unemployment due to an over rigid labour market and a bias against innovation. This has some truth. But why is it an argument against joining the euro? If other countries' economies are so rigid and ossified, this surely will give British business an opportunity to make gains at the expense of their competitors. The most successful single currency the world has known was the 19th century gold standard. Under this, countries had complete independence over the whole range of fiscal and social policies and were even occasionally at war with each other. There are indeed pressures from the European Union for making for over unionised and overregulated labour markets which could price workers out of jobs. But they do not come from the euro. They come from the Labour Government's decision to adopt the EU Social charter when it came to office in 1997. There are further threats from the Constitutional Convention which might well give Brussels institutions an increased role in business and labour market decisions. It is a mistake to suppose that every unwise EU policy is an argument against the single currency. I have never regarded the direct economic effects of euro membership as terribly important one way or the other. The main reason why I formerly supported it was that it seemed for many years the most likely way of establishing an operationally independent central bank. The independence of the European Central Bank was established by treaty on the lines of the Bundesbank in Germany and seemed pretty safely ensconced. But since the incoming Labour government took many people by surprise in 1997 by unilaterally establishing operational independence for the Bank of England - and still more because of the favourable track record of the new regime - that particular argument for the euro goes out of the window. The case I now wish to make is a positive one, not against the euro - still less against the European Union - but in favour of a floating exchange rate which the UK now enjoys and could not continue to have inside the euro. A floating exchange rate automatically balances a country's overseas payments - current and capital account taken together - without the need for cap-in-hand official overseas borrowing and without the need for inflationary or deflationary distortions of domestic policy. A fixed rate of exchange produces two problems. The first is the threat of a balance of payments crisis and runs on the currency. The recurring feature for decades or even centuries of British economic history has been the needless crises brought about by futile efforts to maintain a fixed exchange rate. When in 1931 a Conservative-dominated national government floated the pound which its Labour predecessor tried so hard to save, the former Labour minister Margaret Bondfield remarked: "Nobody told us we could do this." The foreign exchange crises which bedevilled British economic management through the 1940s, 50s, 60s and 70s are legendary. It would be foolish to argue that the UK has had a smooth ride since the pound floated in 1971. The last of the sterling crises, the "IMF"one of 1976, took place when sterling was already floating. In retrospect, this was quite an unnecessary crisis, due to the fact that policymakers had insufficient experience of market-determined exchange rates. There were all kinds of fears that the pound would "go through the floor", whatever that meant. But once the government had taken action to reduce the budget deficit and control money and credit, as it had largely done by the time of the IMF visit, the rest could have been left to the market, which indeed produced in 1977 a bigger "recovery " of sterling than anyone had bargained for. The then Chancellor, Denis Healey, actually used the IMF negotiations to gain support for policies that he in any case favoured. It should in all fairness be said that the balance of payments threat is largely removed either by a floating exchange rate or by membership of the European Monetary Union. There cannot be a run on the pound if sterling no longer exists. The only run can be on the euro as a whole, which is a pretty far fetched proposition - at least so long as the euro is managed by a cautious and independent European Central Bank. But there is a second problem which would not be removed by joining the euro. That is the possibility of unemployment due to money wages which make British goods uncompetitive compared with those of other countries. If the UK joins at too high an exchange rate many industries would become uncompetitive and unemployment would rise until wages were pushed down to a lower path than that of partner countries. An exchange rate adjustment to reduce them is no more possible in the euro area than it would be now for Yorkshire or Lancashire. The dangers of entering at too low an exchange rate are more subtle. Instead of unemployment and deflation, the proximate consequence would be overheating and inflation. A euro enthusiast could argue that these would be once-for-all; but while the adjustment was taking place Gordon Brown's inflation target, into which so much political effort has been put, would be exceeded; and it could be very costly to regain credibility. Ireland has avoided this fate because its overvaluation within the EMU coincided with a world slowdown which particularly affected Ireland's leading edge industries. This is not the kind of "luck" on which we can either count or should hope to achieve. Today, the wide divergence of views on the exchange rate at which Britain can safely enter the euro shows how unsure we are of the correct exchange rate. The real sterling exchange rate - that is the rate adjusted for international cost movements - looked very high by historical standards until this spring. Many of the businessmen who were campaigning to join the euro really meant that they wanted a sterling devaluation. A case can nevertheless be made for saying that the UK managed to live with a supposedly overvalued exchange rate for so long that it might have been a tenable rate after all. Suppose, however, that the optimists are wrong and the pessimistic businessmen are right. Then under a floating rate the market will ultimately bring about a sufficient depreciation. But joining the euro forecloses the options. If the UK is already locked into the euro, the equivalent adjustment can only be made by a lengthy period of depressed demand and downward pressure on wages. There is of course no way of avoiding necessary adjustments in real wages. But there is all the difference in the world between adjusting them indirectly via the exchange rate and a pitched battle to bear down on money wages - as Winston Churchill discovered in the 1926 General Strike. Some further advantages of a floating exchange rate were brought home to me at a recent international seminar. There was a session on the subject of left-right differences. Several of us argued that the terms had largely lost their meaning and mainly stood for rival tribes. But at this point there was a revolt by some British participants who insisted that there was still a left-wing agenda to be enacted in terms of public spending, union rights and so on. Some of those who spoke regretted that globalisation made an Old Left agenda impractical. This was wrong. Globalisation is an excuse. A country inside the euro such as Italy has indeed to be very careful about anything that risks raising labour costs further. But there is nothing to stop a country like Britain that is still outside from taking these risks, knowing that sterling can take the strain from any cost-push effects. The argument against the Old Left agenda is that the electorate will not wear it or that in practice it has proved counterproductive. The issue should not be pre-empted by arbitrary currency mechanisms. The embarrassments from locking in the exchange rate would not be confined to the Left. Any experimentation with higher payroll or indirect taxes which raised nominal costs would be ruled out of court - whether the purpose was to reduce income tax or to finance the Health Service, as sometimes advocated on the Centre and Right. Or suppose that there were a serious move to tax energy? Any kind of experimentation from any part of the political compass would be extremely risky without the safety valve of a flexible exchange rate. Some people will say that my exchange rate argument is too short term. It is not. There is nothing short-term about a floating exchange rate as a permanent adjustment mechanism. The more conventional "long term" analysis also turns on the exchange rate. It comes down to weighing the advantages of exchange rate stability for over half of British trade against the disadvantages of a "one size fits all" interest rate policy for the whole euro area.(1) It is difficult to become too excited about the issue. One is tempted to say that it is half a dozen of one and six of the other. 1 The argument for interest rate independence needs to be made with care. The trend of interest rates over several years must reflect the international real rate of interest plus an allowance for expected inflation. If we no longer believe that tolerating a high rate of inflation will bring faster growth then we might as well converge on some European inflation rate somewhere between the British 2½ per cent target and the ECB objective of "below two per cent". Once inflationary expectations are approximately the same then, inside or outside the eurozone, the UK does not have the ability to follow a completely different interest rate policy of its own, whether it is in EMU or outside it. What the Bank of England can do if it remains independent is to pursue a different short-term trend around a common long-term average. It can then temporarily lower interest rates in a recession, as the Bank did in the early 1990s, and raise them again the face of temporary overheating. If the right entry rate is unclear and the positive advantages of being in the ERM are not overwhelming it would surely be better to stay with a floating rate for the pound as a safety valve which has served the UK so well in recent decades. British Overseas Influence The "political" supporters of euro membership would say that this analysis ignores the increased influence it is supposed to bring for Britain. It would be foolish to deny that there might be a marginal increase in influence in some specialised areas. But would any such increase in influence carry over into less technical, but more important, issues such as British ability to pull France and Germany - the countries that Donald Rumsfeld has aptly called Old Europe - out of their negative anti-Americanism on the great issues of war, peace and terrorism? Or would it increase Britain's supposedly moderating influence on US gung-ho Republican US presidents? The line of causation is very tortuous. The europhiles would have to say that joining the Euro would be taken as a sign of positive involvement in EU affairs and thus help British spokesmen to "take the lead" in Europe. But can anyone really argue that if Britain belonged to the euro, Tony Blair would have been able to talk President Chirac out of his unforgivable decision to invite Mr Mugabe to Paris? Let alone his threat to veto any military action on Iraq. On transatlantic issues the argument is even more tenuous. The official British government line, from Vietnam onwards, has been to support the US in public, but privately to put its weight behind moderate State Department elements in their struggle with the "hawks". Whatever the pros and cons of this approach, is it conceivable that Chancellor Schroder and President Chirac would allow Tony Blair to speak for them too just because the UK had the same currency as other western European countries? The one plausible case is that British euro membership might be a step towards a European Federation in which there would only be one voice when the US president rang up (if he did) to enquire about European views. I do not dread a properly functioning European Federation based on limited government and effectively functioning markets. But a single currency is only a very small step in that direction. In any case we are many decades away; and for the foreseeable future we face a confusing confederation with at least two so called "presidents", not able to speak for governments when push comes to shove. Finally: how important is it for the ordinary non-political British citizen that the British government should have a marginal increase in overseas influence? Naturally if you are working in the Foreign Office or advising the Cabinet, you would think that this could be only for the good. But a more detached historian would see the picture as far more mixed. He might ask for instance if official British insistence on the so called independent nuclear deterrent has helped or hindered efforts to stop nuclear proliferation. The most important task for British governments is to avoid disastrously wrong decisions on matters such as peace, war and terrorism. The welfare of British citizens will also depend on their ability to provide a reasonably stable economic environment free from the excesses of depression, runaway inflation and boom and bust. Beyond this basic agenda, there is room for argument on how far the governments should go in income redistribution or the provision of public services in kind. In any case, people's welfare will hardly depend on whether the chancellor has to endure the boredom not merely of sitting on Ecofin but on the Eurozone council as well. At the most basic level of analysis the political and economic tests come to the same thing; and if there is no overwhelming economic case for British Euro membership, there is no political case either. The Case for Currency Choice Having said all this, I would find it difficult to voice any real enthusiasm for a No vote in a Euro referendum. The danger of euro rejection by the British electorate is that it would spill over into other areas. Much of the steam behind the anti-euro campaign comes from a jingoistic nationalism and impatience for any kind of international involvement in British affairs. To be quite specific: I fear that a No vote would strengthen the voices that can already be heard - and not only from the tabloids - calling for Britain to pull out of the Strasbourg Charter of Human Rights. This Charter has nothing to do with the EU and long pre-dates it. It has already had a humanising influence been influence in many areas of British life. A couple of years ago I suggested that Tony Blair should give the euro a rest for five years, as endless discussion had not achieved anything and merely distracted attention from more important issues. My main hope now is that the whole euro membership issue will be shelved for as long as possible. The Treasury assessment is likely to advocate further examination at a later date. The further ahead this is pushed the less the urgency of a No campaign. Meanwhile there are several things that could be done to show a friendly British attitude to the euro without actually abandoning the pound sterling. There is a lot to be said for the parallel currency route, that is through the creeping use of the euro in ordinary business - or as it is sometimes called "membership by osmosis". There is nothing in British law to prevent contracts being made in any medium to which the parties agree - whether sterling, dollars, euros or cowrie shells. Legal tender is a formality which only applies if the currency of the contract is not clearly stipulated. Why should not a euro-friendly government such as Tony Blair's, try to encourage the use of the euro? The most important single step would probably be to allow the euro to be used for settling tax bills. This would require a formula to establish the date at which the currency conversion would be made in each financial year. It might also make a symbolic difference if the euro were declared legal tender - or best of all if the whole concept of legal tender, which is an archaic survival, were abolished. Why not then shelve the euro issue indefinitely by declaring that British residents are free to use whatever currency they like and let the euro make its way on its own merits?
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