BRITAIN AND THE EURO
SPEECH TO THE EUROPE-ASIA INSTITUTE CONFERENCE ON EUROPEAN MONETARY UNION, VICTORIA UNIVERSITY, MELBOURNE
FRIDAY 19 MARCH 1999
If you’ve been watching what’s been happening in Europe since all the hype surrounding the launch of the Euro on 1 January this year, some of you may be asking "What's the big deal?"
It hasn't so far proved to be new strong currency rivalling US dollar.
If you’re travelling to Europe, you can't go to shops and use Euro notes or coins – indeed you won’t be able to do so until 2002.
On top of this, first the German Finance Minister resigned, and now the whole of the EU Commission has resigned too. Isn’t it all a bit of a shambles?
Having started like that, some of you may be saying, wait a moment: isn’t this a very Euro-sceptic line? Isn’t the Blair Government now in favour of joining the Euro?
Well you’d be wrong to think I’m a Eurosceptic. I fully support the British Government position in favour of joining a successful single currency provided the Government’s economic conditions are met.
What I am sceptical about is some of the more exaggerated claims made for the Euro, which can obscure what a significant step it really is. What I am sceptical about is some of the over-simplified economic arguments, which can obscure the really big structural changes the Euro is capable of bringing about.
I thought I might start by explaining some of my own background, since that lies behind my interest in this subject.
I come from the Treasury not the Diplomatic Service. My first day in Treasury was in 1976, when I arrived to find my new boss hidden behind the biggest pile of Top Secret files I’ve ever seen, before or since. Sterling was plunging and we were in the middle of tense negotiations with the IMF. The group I was working in was doing contingency plans in case the negotiations failed and we had to introduce import controls and block overseas holdings of sterling.
I got very interested in exchange rate policy, but rather frustrated over the inability of the Treasury economists to predict what was going to happen. So I decided to take them on, and proved I could produce a better model of sterling’s exchange rate. I did this using not relative inflation rates or relative rates of monetary growth, but England’s performance at cricket. In the light of England’s performance over the past few years, it’s probably just as well that - like most economic models – this one broke down soon after I had discovered it!
I later became Nigel Lawson’s Principal Private Secretary when he was Chancellor of the Exchequer. There, I witnessed heroic efforts to stop the pound going down against the Deutchemark. And then heroic battles to stop the pound going up against the Deutchemark.
This led to a new burst of interest in exchange rate stability. Both in Europe, where the Delors Committee was set up and produced a blue-print for monetary union that was to be the one followed, more or less, through to the birth of the Euro. And in Britain, where Nigel Lawson and Margaret Thatcher were united in their opposition to a single currency but deeply divided over whether sterling should be linked to the Deutchemark and other European currencies by joining the European Exchange Rate Mechanism. A divide that was eventually to lead to Nigel Lawson’s resignation.
I subsequently became John Major’s Principal Private Secretary in Downing Street in 1992. Not long after I arrived we were into the currency turmoil that eventually led to sterling’s exit from the ERM. As with all such crises there were moments of high tension and moments of light relief. I remember John Major trying to take a phone call from the Italian Prime Minister while staying at Balmoral with the Queen, and finding it difficult to make himself heard against the sound of a Scottish piper playing loudly on the lawn outside.
Then I witnessed the Parliamentary battles over the Maastricht Treaty that implemented the single currency – battles that brought out the deep divisions within the Conservative Party on this subject, and must have contributed to John Major’s defeat at the Election in 1997.
I stayed on at Number 10 after the Election. The new Government moved with remarkable speed on one aspect of monetary policy, making the Bank of England independent. They took office on Friday and made the announcement on Monday. This was done to increase transparency in the way interest rate decisions are taken, though it is also in line with the pre-conditions necessary for joining the single currency.
Tony Blair was keen to take a more positive approach in Europe – and had to negotiate the new Treaty, the successor to Maastricht, at a Council meeting in Amsterdam less than six weeks after he took office. He held firm on some issues that the Government saw as vital British interests, including border controls for example. But on other areas, where the Government did not see vital interests at stake, he indicated willingness to compromise. We then saw how other countries had often found it convenient to hide behind the British veto, without revealing their own difficulties with particular proposals. When the UK indicated it could accept them, suddenly other hands went up round the table putting in reservations.
The Labour Government also adopted a new policy towards membership of the single currency, something I will come on to later.
But first start with arguments sometimes advanced for the Euro that I do not believe really stand up or are exaggerated.
First, the argument that Europe needed to have a currency that could stand up to the US dollar in world markets. A sort of currency machismo. A reaction to the US view of the dollar that it's "my currency, your problem"
There was a feeling in some continental European countries that Europe lost out on international financial scene by not having its own currency. They pointed to the fact that 50% of world trade is invoiced in US dollars even though the US share of world trade is a tiny portion of that. They pointed to the fact that 56% of foreign exchange reserves are held in US dollars as against 28% in EU currencies.
I think the importance of this is greatly exaggerated. The direct benefits from ‘seignorage’—from other people using your currency in trading or as a store of value—are nowadays small. A sophisticated banking system ensures that.
Equally there are no great benefits from having your currency widely held in other countries’ foreign exchange reserves. That may in theory make it easier to finance a current account deficit, but that was hardly a problem anyway for the members of Euroland.
Indeed, it was rather odd to see the way some in Europe positively welcomed the idea that the Euro might appreciate sharply as international investors switched portfolios so as to increase their weighting of Euros. That may yet happen, though so far the weakness of the Euro, even if linked to political events, suggests it’s not a significant factor. But if the Euro did appreciate because of those sort of flows, it would hardly be good news for European business competitiveness.
If the Euro does start to rival the dollar as a numeraire, business will see some benefits from being able to invoice goods in their own currency or being able to buy commodities denominated in their own currency. That would eliminate the exchange risk from such transactions. But most firms are well able nowadays to cope with exchange risks and to hedge against them where necessary – and there would still be a need to hedge against changes in the underlying prices of commodities.
And I think the wider argument about the economic power of a single currency is a bit of a red herring. What matters in international economic negotiations, in the G7 or elsewhere, is not whether you have one currency or several; but the economic weight you wield and—crucially—whether you speak with one voice or several. The single currency may help provide a more united voice for Europe—a point I will come back to—but that has certainly not been a feature of developments since 1 Jan!
Not having to cope with multiple currencies in Europe
The second issue widely promoted at the launch of the Euro was the benefits for businesses and consumers in having to deal with one currency rather than 11.
There are undoubtedly benefits here, particularly for smaller firms. But we shouldn’t overplay them. It will make it easier for firms who sell into more than one market – they will see their transaction costs reduced from not having to hedge against currency movements between European currencies. It will make it easier for travellers who will not have to carry pocket-fulls of different notes and coins. And I fully agree that having a single currency does mark a further step towards a genuinely single market in Europe. But the cost savings will not be huge. For exporters from Australia, for example, the biggest exposure is to fluctuations between the Australian dollar and European currencies, not to fluctuations between individual European currencies.
And for international travellers and tourists, most have been making increasing use of credit cards, debit cards and maybe soon stored value smart cards. Very few carry large amounts of foreign currency cash.
What then are the benefits?
Having argued that some of the widely perceived benefits may be not be as large as they are sometimes made out to be, what then do I think are the most important implications of the Euro, and the real benefits?
Much has already happened
First of all, we must not overlook the huge changes that have already taken place as countries have prepared themselves to join the Euro. Only a couple of years ago, there was great scepticism whether more than a handful of countries could meet the Maastricht criterion: people said Italy would never get its budget deficit down; that Spain and Portugal would never get their inflation down; even that Germany was in danger of overshooting on its fiscal deficit.
In practice, all except Greece got themselves into a position where they could join on 1 January 1999. 11 chose to join and Britain, Sweden and Denmark stood aside for the time being. Even Greece is moving to a position where it may be able to join soon. All this has required some significant adjustments in many of these countries. Preparing for the Euro has enabled countries to take necessary steps they might otherwise have found politically impossible. Decisions to cut profligate spending programmes. Decisions to grant independence to central banks and eschew the political control of interest rates that had often been far too tempting. Their economies will be the stronger for this.
But it is a second impact that I believe will be of even greater significance. This is way the Euro will increase competition within Europe, and the structural changes that will in turn be brought about. At present, it is relatively easy for firms to segment markets within Europe and to charge different prices in different markets. People—whether final consumers or firms buying supplies—may in theory be able to identify that a company is charging much more, say, in Deutchemarks in Germany than it does in Pesetas in Spain or Lira in Italy. In practice, it is not as easy as that, there is a cost to getting the information, and people may just be lazy.
But once the Euro is fully introduced, we will see much more questioning of why prices differ, and much more willingness to shop around—companies in Italy buying German goods in France if they are being sold cheaper there. Developments in information technology will reinforce this trend. We will see the common market becoming a reality. And provided Europe remains open and outward-looking – as it must - this will in turn help make European companies more competitive internationally.
Of course for some firms, and perhaps for some countries, this will be painful. Forcing through structural changes may be good for the long term but will cause short-term problems. Some firms that now manufacture in many locations throughout Europe may start to concentrate their production in fewer locations. This may accelerate trends already under way in the car industry for example.
The effect will be marked too in the financial sector. There has been relatively little cross-border competition in loans or mortgages within Europe, except for the bigger firms. But it will become increasingly easy for a borrower in Italy to see whether loan rates are cheaper in Germany. This will have big structural implications for the banking industry—indeed we are already seeing more merger activity than at any time in the recent past.
This increased competition also has the potential to force through changes in an area where it is badly needed: the labour market. Let us not forget that the real problem facing Europe is not unstable currencies but jobs. There are 18 million people unemployed in Europe, roughly equal to the entire population of Australia. Britain has been relatively successful in getting unemployment down, to around 6%, compared to just over 7% in Australia. But unemployment is 10˝% in Germany, 11˝% in France, over 12% in Belgium and Italy and over 18% in Spain. Increased competition brought about by the Euro should provide the impetus to get through much-needed reforms, something the British Government is pushing hard.
In the long run, this could be one of the most significant indirect benefits of the Euro.
Let me turn now to the constitutional implications of the Euro, something that has excited much attention in Britain, and indeed in the rest of Europe, though from a rather different perspective. Take first the independence of the European Central Bank.
That’s a pretty significant step. Yes, most countries had already made their central banks independent. But those countries that have joined the Euro have now handed over responsibility for interest rates to a body over which they have no control, the European Central Bank. They have no power to intervene or over-ride decisions on interest rates. The constitution of the ECB specifically enjoins it to ignore pressure from Governments and to deal solely with their remit to keep inflation low.
That places a lot of responsibility on the shoulders of the ECB. We have seen the importance of monetary policy illustrated very well in the actions taken by the Reserve Bank of Australia. The Reserve Bank did not panic when the Australian dollar floated down last year, correctly judging that the depreciation was a necessary offset to the fall in commodity prices facing many exporters and that there was little inflationary pressure. So the Reserve Bank resisted market pressure to raise interest rates, and has been vindicated by the remarkable performance of the Australian economy over the past year. Other central banks acted in a more mechanical way to increase interest rates when their currencies came under pressure and have seen growth falter.
There has been a body of opinion in Britain has been very concerned about the loss of sovereignty that would be involved in joining the Euro, and ceding decisions on monetary policy to the European Central Bank. It is linked into more visceral concerns about giving up the pound, about having strange Euro images on our banknotes instead of the Queen’s head—though that second point rather falls away when you realise we have only had the Queen’s head on British banknotes since 1961. Isn’t issuing your own currency the essence of national sovereignty?
I do understand these concerns. But I don’t believe the issue of sovereignty is marked by simple dividing lines. The development of the European Union has inevitably demanded some pooling of sovereignty along the way. And there is no way that the French for example will lose their national identity just because they’ve given up the French franc.
Nor in reality does giving control over interest rates to the ECB make much difference in practice—provided the ECB does its job well. Countries have increasingly had to take account of what is happening internationally in framing their domestic policies. If a Government is committed to low inflation, the scope for running an independent monetary policy is very limited even without a single currency.
The handover of responsibility to the ECB has, however, created a more subtle concern, over the accountability of the ECB. Accountability is an elusive concept. There are real advantages in not having a central bank subject to political pressures and political control. But in a democracy, there does need to be a sense that institutions are ultimately subject to some accountability. For the ECB, who is this to be?
This is a live issue in Europe at present, given the turmoil in the European Commission, even though that has nothing to do with the Euro. The European Parliament has identified areas where fraud or dubious practices have been going on, without being able to get anyone to accept responsibility for what has happened. The arrogance of some Commissioners at being called to account by the Parliament has illustrated the problem. Governments are going to have to use the opportunities created by the mass resignation of the Commissioners to introduce some changes in accountability. And that may in time have implications for the ECB too.
The other area where we see concerns about sovereignty, again particularly in Britain, is over fiscal policy. Will we see a creep towards centralisation of decisions on budget deficits, or harmonisation of tax rates? Witness the fuss in Britain over pressure from Oscar Lafontaine for more harmonisation of business taxes—and the undisguised glee in the Euro-sceptic press when he resigned last week.
The pressure for harmonisation of tax rates is not much to do with the Euro, except indirectly. It stems from a fear of the effects of competition within Europe. If some countries are "unfairly" keeping tax rates low, that will distort business decisions within Europe. This is often an argument used to avoid structural reforms that may be far more important to business competitiveness. As I have indicated, the British Government wants to see more business competition within Europe and will be pushing for structural reforms to improve business competitiveness. Of course we are ready to join together to reduce genuinely distortionary tax competition—some specifically targeted tax subsidies for example. But the new British Government, like its predecessor, believes in low tax rates and is not going to see those eroded by pressure for harmonisation.
On fiscal policy more generally, countries in Europe have already voluntarily limited their scope to increase fiscal deficits, as part of the so-called stability pact. This was to deal with the concern that with a single currency a country could run an imprudent fiscal policy and pass the burden on to others. A strict no-bail-out policy has been introduced so that if a country starts to borrow more it will find its credit rating is reduced. And the stability pact introduces direct limits on budget deficits. 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
Recent concerns in Europe have been over whether these rules are too rigid. Some of these have been a disguised attack on the European Central Bank, in an attempt to pressure it into cutting interest rates. But there are deeper concerns. Will the system 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?
There is no sign, at least yet, that these are practical rather than theoretical problems. Few people believed that currency realignments between countries in Europe with relatively similar economies offered anything other than a very temporary solution. Nor is there any appetite for a new system of fiscal transfers within the European Union, which would risk getting widened from dealing just with temporary cyclical differences to trying to deal with underlying income differentials across Europe. Countries like Germany are in any case now trying to reduce their contributions to the EU budget.
It is also doubtful whether economic shocks are in practice likely to affect countries within Europe 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 already look to a single monetary policy to deal with shocks that affect one region of Britain – or indeed Australia - as against another.
Given that my title is Britain and the Euro, you may think I have spent rather too long dealing with general issues and not enough dealing specifically with British policy. But I believe the background is crucial to explaining how the debate in Britain has evolved.
But let me now set out the Government’s position. Back in October 1987 the Chancellor, Gordon Brown, made clear the Government’s view that membership of a successful Euro would bring benefits to Britain in terms of jobs, investment and trade. The Prime Minister, in his most recent statement, spelled this out again: Britain should join a successful single currency provided the economic conditions are met.
It is strongly in Britain’s interests that the Euro should be a success. 50% of our trade is with the Eurozone. It represents 20% of world income, as big as the US. We want and need the Eurozone to be a dynamic and successful economy, especially given the time it will take countries affected by the economic turmoil in Asia and elsewhere to rebuild.
But it would be a mistake for Britain to join unless the conditions are right. First there needs to be sustainable convergence between the UK and the Eurozone, and second there needs to be sufficient flexibility in Britain and in continental Europe so that joining the single currency would be good for investment and for employment.
The first of these conditions is crucial to explaining why we have not joined from the outset. Britain is still at a different stage of the economic cycle from Europe. A year or so ago, our interest rates were over 7% whereas those in Germany and France were close to 3%. It would clearly have been wrong to join the Euro when we still needed high interest rates near the top of our cycle to make sure we kept inflation under control, while France and Germany were still struggling to get beyond the early stages of their upturn. But that gap is narrowing. British interest rates are now 5˝% compared to 3% in Euroland, and the difference in long-term rates is now down to around ˝%. So that condition may be met before too long.
The second of the Government conditions relates to flexibility, and the impact on investment and jobs, something I have spelled out earlier. We hope and believe that the changes brought about by the Euro and taking place anyway will lead to necessary economic reforms in Europe, and that that will lead to a strong and prosperous Eurozone. But we have retained the right not to join if experience were to show that the Eurozone was turning inwards, away from the necessary reforms. It is right that a key test for joining is whether it is in Britain’s economic interests.
Assuming, though, that the Eurozone is a success, Tony Blair has set out the potential timetable for Britain to join:
In the meantime, all the necessary preparations are being put in place.
But what are the implications while Britain remains outside? Will companies—including Australian companies—feel they should invest in Euroland rather than Britain so as to secure the benefits of the single currency and just in case Britain doesn’t join? That prospect was raised at the time the Euro was introduced, but I’m glad to say it hasn’t been born out in practice. It is clear that there are many reasons why firms invest in Britain as a centre for their European operations, and that currency considerations play only a very small part. Much more important are factors such as: a favourable environment for business; flexible labour laws; low taxes and so on.
There is in any case, no reason why firms operating in Britain should not use Euros if that is in their commercial interests—indeed many are already doing so. They can open Euro bank accounts, pay suppliers in Euros, prepare their accounts in Euros—even pay taxes in Euros soon.
Last year—when it was clear the Euro would start from 1999 and Britain would not be a member—we still attracted over a third of all foreign direct investment in the EU, and all the signs are that this is continuing in 1999.
City of London
Equally, all the signs are that the City of London is making a success of the Euro, and will continue to do so even if the UK remains outside the Eurozone.
John Hewson, who is speaking later on, may not remember this, but we met in the 1970s when I was in the Treasury and he was at the IMF doing research on the development of the Euromarkets. Those Euromarkets were nothing to do with the single currency, but reflected the way offshore business was being done in US dollars, particularly in Europe. London was the leading market for that, and showed by its explosive growth how well it was able to cope with dealing in other people’s currencies. So I have no fear about any perceived threats to the City from the Euro, whatever Britain’s decision on joining.
As one of our Treasury Ministers put it: the UK may be out but the City of London is in.
The statistics make this abundantly clear. Of business done this year in euro-denominated bonds, 90% has involved a London counter-party.
London remains the largest centre for foreign exchange dealing. It’s turnover is 6 times that of Frankfurt. It is as big as New York, Tokyo and Singapore combined.
So I have every confidence in success of City.
I’d like to end with another episode from my time in the Prime Minister’s office in 10 Downing Street. It occurred in the summer of 1993, when the ERM had still not settled down from the turmoil of the previous year, and the French franc was under some pressure. We were having a meeting in the Cabinet Room with President Chirac and his team.
In the middle of the meeting, the big baize door at the end opened, and a clerk walked in quietly but purposefully. He handed John Major a folded slip of paper. John Major looked at it and frowned. He handed it to the Cabinet Secretary, who looked at it and frowned. The Cabinet Secretary passed it on …
Finally, President Chirac had had enough. "What is the news, John? Is there renewed crisis in the foreign exchanges?"
"Much worse than that" John Major replied. "England are 5-75 at lunch!"
So, as all good Aussies and Poms will know, while currencies are undoubtedly important, there are some things that matter even more.
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