BRITAIN, THE EURO AND THE EU
Speech by the British High Commissioner, Mr Alex Allan,
at the University of New South Wales, 27 October 1998
I should like to start this evening with a quote from an editorial in The Economist magazine:
"If we do nothing, what then? Why we shall be left out in the cold. Before long, all Europe, save England, will have one money, and England will be left standing with another money."
That was not, as you might think, written by a recent editor of The Economist. It was written by Walter Bagehot over 130 years ago. He was referring to the Latin Monetary Union, made up of France, Belgium, Italy, Greece and - somewhat improbably - Bulgaria.
The Latin Monetary Union of the 1860s was not a great success, and Britain was right not to join. Should we adopt the same attitude to the new single currency the Euro? Will it be more successful?
Those are the topics I want to address tonight. I propose to start with a little of the history of how the single currency came about, and then to address the economic advantages and disadvantages, both for Europe and for Britain.
My own involvement with exchange rate policy goes back quite a long way. My first exposure was in November 1976, on my very first day in the Treasury. I arrived there to find my new boss hidden behind the largest pile of Top Secret files I've ever seen, before or since. We were in the middle of very tense negotiations with the IMF, and the Treasury was worried they might fail. So my boss was doing contingency planning on freezing overseas holdings of sterling. Thankfully, we did reach agreement with the IMF and sterling soon recovered.
I continued to work on exchange rate policy in the Treasury and I made my mark by a novel piece on economic research. I proved I could out-perform the Treasury's economic model in predicting exchange rates by using not relative inflation rates or monetary growth but instead England's performance at cricket. So I advanced what may have been one of the first of what have since become known as "convergence criteria": that Britain should not join a European exchange rate system until the Germans learnt to play cricket.
All through this time there was continuing debate within Britain and Europe about what could be done to avoid future exchange rate crises, and what new system could be set up to replace the ill-fated "snake" which Britain had joined briefly in 1972. By 1978, the French in particular were pushing for the creation of a European Monetary System, involving new agreements on short-term borrowings coupled with a new Exchange Rate Mechanism.
In the event, the British Government decided not to lock its currency into the Exchange Rate Mechanism, though it did join the wider Monetary System. The debate whether or not to join the ERM itself was to drag on for the next 12 years.
The advent of the Conservative Government in 1979 saw sterling strengthen markedly against the dollar and European currencies, causing great problems for exporters. But Mrs Thatcher had no love of fixed or pegged exchange rate, and was instinctively opposed to joining a European system. This put her at odds with two successive Chancellors of the Exchequer, Geoffrey Howe and Nigel Lawson. I went to work for Nigel Lawson in 1986, and saw at close hand the battles with Margaret Thatcher that eventually led to his resignation. It was a sorry lesson in how easy it is for pressures from the media and the markets to drive wedges between Prime Ministers and Chancellors.
Nigel Lawson was succeeded as Chancellor by John Major. He took over at a time when inflation was getting out of control and when the various measures of the money supply had all proved unreliable guides. So he too became convinced that a fixed exchange rate against the Deutschmark was the best way to give credibility to our determination to get inflation back down to German levels.
By then, Margaret Thatcher's resistance was wearing down - she could hardly afford to lose another Chancellor. So she reluctantly agreed to our joining the ERM in 1990.
Our ERM membership did indeed prove successful in defeating inflation, which fell from over 10% to under 4%. And just as important, wages growth fell back too, so the inflationary pressures in the economy eased markedly. The downside was that Britain - along with most of the rest of the world - went through a severe recession in 1990 and 1991.
While Britain had been debating whether or not to join the ERM, events in Europe had moved on. Even though the ERM had been relatively stable for some years, there was continual pressure, from France in particular, to go further and set up a single currency for Europe. Mrs Thatcher was, for once, outmanoeuvred at a European Council meeting and agreed to the setting up of a group under the then President of the European Commission, Jacques Delors.
The Delors Report, as it became known, recommended a system essentially the same as that now being introduced some 10 years later. Mrs Thatcher - and indeed Nigel Lawson - were strongly opposed, but the momentum made it almost unstoppable, and it was put forward as part of the Maastricht Treaty.
In the meantime, Margaret Thatcher herself had resigned, largely as a result of the poll tax - which is another story! She had been succeeded by John Major, and I moved across from the Treasury to work for him as Principal Private Secretary in early 1992. It was a traumatic period. Sterling was beginning to come under pressure in the ERM and the markets came to believe that devaluation was inevitable. The Government fought this for as long it could, but the pressures increased.
The beginning of the end came when the Italians devalued. We got the news on a Sunday, when the Prime Minister was at Balmoral for his annual weekend with The Queen. I remember going down to the Castle on the Sunday to arrange for the John Major to 'phone the Italian Prime Minister, made more difficult by the Scottish piper playing his bagpipes very loudly on the lawn outside.
The next week we hit what has become known as Black Wednesday, when literally billions of dollars were thrown against sterling. Downing Street was out of action because of building work to replace windows damaged by the IRA mortar. We were all camping at Admiralty House, where a hastily-convened meeting agreed that interest rates should be raised by 2%, from 10% to 12%. That didn't work. By the afternoon we were still losing billions of dollars of reserve. Interest rates were put up again, to 15%, but it was clear we were going to have to leave the ERM, which we did as soon as the markets closed. Interest rates were dropped back to 10% again and the pound fell by about 15% against the DM.
This was more or less the first time that hedge funds hit the public attention, as George Soros made large profits betting against sterling. Perhaps we should have abandoned the defence of the rate earlier, but it was a huge decision and we had legal obligations to deal at the agreed rate while markets were open.
In retrospect, the timing of our exit from the ERM worked well. We were able to cut interest rates further, eventually getting them down to 6%. And the fall in the exchange rate made British exports very competitive. But it was a huge political blow. John Major thought of resigning at the time. And it destroyed the Conservative Government's reputation for economic competence, something from which it never recovered.
The French themselves squeaked through and just avoided having to devalue when their referendum on the Maastricht Treaty passed by a couple of percentage points. All this only heightened their conviction and that of many other European countries that a single currency was the only way to avoid endless crises.
In Britain, however, the trauma of leaving the ERM left a legacy of suspicion - particularly in the Conservative Party - about joining any further European currency system. John Major had already secured an opt-out for Britain when the Maastricht Treaty was being negotiated. But that didn't stop Parliamentary opposition to ratifying the Treaty. The debate in the House of Commons dragged on endlessly, at further cost to John Major's government, though the Bill was eventually passed when he made it an issue of confidence.
Even then, the question of whether Britain might join the single currency continued to dog the Conservative Party, right through the last Election - and indeed since then. The new Labour Government has found it rather easier to agree on its policy, something I shall describe in more detail a little later.
The Present Position
So let me take stock of where things now stand.
The single currency will start on 1 January 1999. Eleven countries will join from the outset: Germany, France, Italy, Spain, Portugal, the Netherlands, Belgium, Luxembourg, Ireland, Austria and Finland. Four countries will not join for the time being: Britain, Sweden and Denmark, who all have opt-outs; and Greece which has not yet met the criteria on budget deficits and inflation.
In practice, the eleven countries have already locked their exchange rates together - and the markets seem to accept that: there has been no significant pressure on the bilateral rates since the final decision to go ahead was taken earlier this year. From 1 January, control will pass from the individual central banks to the new European Central Bank, based in Frankfurt. Individual currencies will remain in circulation initially, but the euro will increasingly be used in commercial transactions: Governments will borrow in euros and many firms will express their accounts in Euros.
In January 2002, notes and coins in each of the countries will be issued in Euros and six months later individual national currencies will disappear.
What does all this mean? I want to argue three particular points tonight.
I turn first to the economic benefits of a single currency. It is a significant further step towards making Europe a genuinely single market. There will be advantages for businesses in not having to cope with multiple currencies. And there will be advantages for consumers: most obviously for those who travel in different countries and will no longer have to change money; but also for those who will now be able to see readily if goods in their own country are being priced artificially high relative to those elsewhere. The converse of this benefit to consumers is of course a disbenefit to manufacturers and retailers who have made profits from segmenting markets and charging higher prices in one than another.
But I wouldn't exaggerate the scale of these benefits. Businesses have got used to dealing with multiple currencies, by taking out forward cover or by matching assets and liabilities. There are costs involved in doing so, for small firms in particular, but they are only one among a number of costs in doing business across national borders. And the significant transitional costs in switching from national currencies to the Euro also need to be weighed against those benefits.
Another economic argument advanced in favour of a single currency is that there will be benefits in setting up an international currency to rival the dollar. The French in particular have sometimes put forward this view. I am sceptical about this argument. There are some benefits from seigneurage if others choose to use your currency widely in international transactions. But they are unlikely to be large. And there are dangers from viewing one's currency as a sort of international virility symbol.
This brings me to another related argument, that a single currency is the only way to prevent national currencies being attacked by international speculators. Recent events both in Asia and in the losses sustained by hedge funds might be thought to lend weight to that. Certainly I would not want to minimise the harm that can be done by wild swings in exchange rates. But Germany and France, for example, have been successful in keeping their currencies stable against each other even before the single currency. And eliminating fluctuations between European currencies will not reduce fluctuations between the Euro and the US dollar or the yen, which are just as significant to European businesses.
A single currency should help economic convergence between different European countries - getting rid of the endemic problems some countries have had with inflation, and assisting development in the poorer regions. But this convergence has in practice largely taken place already as countries have prepared for the Euro, and taken what have often been difficult and painful decisions to get inflation down and to cut budget deficits. It is remarkable - and praiseworthy that countries such as Italy, Spain and Portugal have got inflation down near to German levels, and have greatly reduced government borrowing and debt. But that means that the scope for further benefits from convergence is limited.
So I feel some of the economic benefits are exaggerated. But I feel the same about some of the alleged economic costs too. Some of these attribute all sorts of disasters to the Euro: it wouldn't surprise me to see The Sun newspaper in Britain claiming that the single currency is responsible for everything from global warming to Sydney's water problems. But there are some genuine concerns.
The first is over the loss of monetary - and to some extent fiscal - sovereignty that a single currency will produce. Some argue that the ability to issue your own currency is the essence of national sovereignty: giving that up is a huge step towards creating a European government. Critics of a single currency argue that successful monetary unions have normally followed political union. I can understand these concerns. Britain - unlike many other European countries - has retained the same currency for centuries, even if the Queen's head has only featured on our banknotes since 1961. But the development of the European Union has inevitably demanded some pooling of sovereignty: there is no simple dividing line between what is essential to retaining national identity and what is not. I cannot, for example, see the French losing their identity just because they use the Euro as their currency rather than the franc.
Perhaps more important is how much it matters to a country if it loses its ability to adjust interest rates to meet its own domestic economic conditions. Here too, I believe the concerns are exaggerated. It is years since we believed that printing money offered a way out of economic difficulties - at best it offered only a temporary breathing space. And countries have increasingly had to take account of international market pressures in framing their domestic policies. If a Government is committed to low inflation, as all are nowadays, the scope for running independent monetary policies is very limited even without a single currency.
Much the same arguments apply to fiscal policy. While national fiscal policies have a role, there is no belief that running large budget deficits can generate sustainable growth. Indeed, the thinking behind the stability part has been very different: a concern that with a single currency a country could run an imprudent fiscal policy and pass the burden on to others. This has been countered in two ways. First and most important by a strict no-bail-out policy so that if a country starts to borrow more it will find its credit rating is reduced. And second by placing limits on budget deficits directly. This is to counter the concern that a country with a good credit rating might be able to borrow more without turning the market against it, and that others would feel the impact through higher interest rates right across the single currency area. So countries have agreed strict rules on the size of budget deficits.
Nonetheless, there are concerns whether the system is too rigid. Whether it will be flexible enough to cope with economic shocks that may affect different countries differently. In individual countries, people are free to move from one region to another in search of jobs; and governments use their tax and benefits systems to transfer resources from richer regions to poorer ones. What sort of mechanisms will exist within Europe? At present, if a country becomes uncompetitive, it can - at least in theory - devalue and reduce its real wage costs in that way. How will it cope if it is part of a single currency area?
As I have said, I do not believe in practice that devaluation offers anything other than a temporary solution. Nor am I persuaded of the need for a new system of fiscal transfers within the European Union. It is true that, in the US, the Federal tax and social security systems can produce substantial transfers between regions growing strongly and those that are depressed. But even if a new mechanism were introduced in Europe, there must be doubts how effective it would be. The issue would inevitably get widened from dealing just with temporary cyclical differences to trying to deal with underlying income differentials across Europe. And there is no political will for that - indeed the richer countries are trying to reduce their contributions to the EU budget.
It is also doubtful whether economic shocks are in practice likely to affect countries as a whole all that differently. Most such shocks tend to affect regions within countries, or industries across Europe, rather than one country compared with another - or at least not to a great extent. We expect a single monetary policy to deal with shocks that affect one region of Britain as against another - just as we do in Germany or in Australia.
The real concern within Europe is, I believe, the inflexibility of labour markets. Not so much the lack of mobility between countries, but the kinds of rules and regulations, and taxes and other charges, that have meant net job growth in continental Europe has been depressingly low, and unemployment remains far too high.
The Potential of the Single Currency
That brings me on to my next point. Although I feel the economic costs and benefits are often exaggerated, I do believe the single currency has the potential to bring about significant change within Europe, including in particular in labour market reforms.
The launch of the Euro has been helped by the benign economic conditions of the past few years, when we have seen several years of good growth right across Europe. But how will the system cope when things get tougher? As indeed we may be seeing at the moment.
I believe there are both opportunities and risks. The risk is that any increase in unemployment will get blamed on the European Central Bank. Governments will never want to admit to failings in domestic policies and will find it all too easy to blame bureaucrats in Frankfurt. The system has, however, been set up in a way that makes the ECB independent of political pressures. Its remit is focussed tightly on maintaining price stability, and I cannot see it compromising on that. So the Euro will be a hard, rather than a soft currency, even if that may be uncomfortable at times for businesses and for governments. What needs to be guarded against is pressure instead for protectionist policies - something which Britain would certainly resist.
The opportunity provided by the single currency is to force the changes in labour markets that are so badly needed. There is - rightly - concern in Australia about unemployment seeming stuck at 8%. But it is 11% in Germany, 12% in France and Italy and 19% in Spain. Europe has created very few jobs over the past 30 years. The contrast with the US is stark. Those in work in the EU have done well: their real wages have risen. But this has been at the expense of increasing numbers who can't find jobs. In the US, real wages have risen only a little, but there have been enough new jobs created to see unemployment under 5%.
When Britain held the EU presidency earlier this year, the Government put jobs and employment at the top of its agenda. Europe needs a new emphasis on education and training. It needs a new focus on reducing regulations that cost jobs. It needs a new push to help people off welfare and into work. Those are the policies Britain will continue to promote.
The optimistic view for the future of Europe is that the single currency will help push through the sorts of labour market reforms we should have seen years ago - just as it has already helped push through economic policies that have cut inflation and Government debt.
Before I leave the issue of structural change, one area that will certainly be affected is the financial markets. We will see - indeed are already seeing - a big expansion in the market for Euro-denominated bonds, to a size that will rival the US. And we will see strong competitive pressures within European banking. At present, there is very little cross-border shopping for loans or for deposits. A single currency will make it far easier for business and consumers to see where they can get the cheapest loans or the best return on their savings. This may well lead to more bank mergers - Europe looks very over-banked by comparison with elsewhere.
That leads me naturally to my next topic, which is the impact of the single currency on Britain, including in particular the City of London.
I am very confident that the Euro can be a boost to the City, not a threat, whether or not Britain joins. London's strength as a financial centre has come from its international focus. Its post-war growth came as a result of offshore dealing in dollars in the so-called Euromarkets. It is well placed to be a centre for dealing in Euros. And it should be able to take a large share of the bond market - London already handles three quarters of the secondary market trading in international bonds.
The British Government and the Bank of England have been working with the City for some time now to make sure all necessary preparations are made so that London is fully ready for the introduction of the Euro next year.
That brings me to the British Government's position on whether and when Britain should join the single currency. I believe that the Government's policy is both sensible and correct.
It would clearly be wrong for Britain to join now. There has not been the convergence between the economic cycles in Britain and the rest of Europe that would make that safe. Britain has enjoyed several years of above-trend growth, to the extent that inflationary pressures were beginning to emerge. By contrast, France and Germany have been much slower to emerge from recession. We can see this in the levels of interest rates. In Britain, they were raised to 7½% last year to curtail inflationary pressures, and have only recently been cut to 7¼%. In France and Germany they have been steady at 3½%. This led to sterling strengthening markedly to over 3DM, though it has fallen back in recent weeks.
One of the new Government's tests for joining the Euro is whether business cycles and economic structures are sufficiently compatible. It is clear they are not at present. It would be foolish to lock exchange rates and interest rates at a time when there can be no certainty that that would not produce severe disruption, at least in the short term.
But at the same time the Government has made sure that all necessary preparatory work has been put in place. This means that if in the future - almost certainly after the next election - the Government decided that it was in Britain's economic interests to join, we could do so without undue delay.
I have discussed the impact of the Euro on the European Union as a whole, and on Britain. What about the impact on Australia?
In the first instance, companies will need to adjust to another currency. There will be short-term costs, but then benefits as eleven currencies are replaced with one. There will be a sharper focus on the European single market of 340 million people, with enormous opportunities for Australia. Opportunities that can, I believe, be well exploited from Britain whatever our decision on joining.
In the longer run, what really matters for Australia, just as for Britain, is that the single currency is a success, and leads to a growing, outward-looking Europe that will play a dynamic role in the world economy.
As I have made clear, I am not a starry-eyed idealist when it comes to the Euro. I don't believe it is a magic formula that will transform Europe overnight.
But I do believe it is a significant step, and one that can be of great benefit if it is properly run. It has the potential to be the precursor of more far-reaching structural reforms, particularly to the labour market in Europe. If that can be achieved, and if we can maintain a strong, outward-looking focus, that will benefit Europe, and the world, including of course Australia. It is in everyone's interests that it is a success.
|Home|Journal Index|Photo Index|Speech Index|