Eurozone membership is still no answer for UK

By Martin Wolf

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Is this the time for the British to swallow their pride, admit they made a mistake and beg to enter the eurozone? A growing number of people argue it is. They are wrong.

The reason for having a floating exchange rate is that it should float. In an uncertain world, an economy needs mechanisms of adjustment. The exchange rate is the most powerful such mechanism. Only exceptionally flexible or exceptionally open economies cope well with big shocks without any exchange rate flexibility.

The UK is now suffering relatively severely (and so “asymmetrically”) from six large negative shocks.

First, the UK is experiencing a rapid fall in house prices that seems likely to continue for a long time.

Second, UK households have high levels of indebtedness. According to the European Commission, only Denmark and Ireland have higher levels of indebtedness relative to gross household disposable income, inside the European Union, though Spain, Portugal and Sweden come close.

Third, the credit crisis has damaged the financial sector and so credit supply extremely severely.

Fourth, the UK relies heavily on the now contracting financial sector for supply of well-paid jobs.

Fifth, the UK also relied on financial activity to finance a trade deficit of 6.4 per cent of gross domestic product in 2007. With much higher earnings on foreign assets than payments on liabilities, the UK even looked like a huge hedge fund.

Finally, the UK has moved from being a large net exporter of oil and gas to a large net importer: in this decade the swing in net trade in oil has been roughly 1 per cent of GDP.

Against this dire background, the UK must ultimately save more and the current account must go into surplus. If these are to be achieved, a big real depreciation of the exchange rate must occur. This can be secured either by a long period of falling nominal wages and prices of non-tradeable goods and services or by a fall in sterling. Fortunately, the latter has delivered what is needed.

The fall in the pound is not the problem; it is the solution. The question is only whether it has gone too far. I would strongly argue it has not. Last month, the real exchange rate calculated by JPMorgan was at the bottom of the trading range of the past three decades. It must now be slightly below it. Yet it is still well above levels reached before the UK became a large oil producer (see chart below). Sterling’s fall is inconvenient for many who believed the value of the pound between 1997 and 2007 was “normal”. It never looked sustainable.

The argument against this position, advanced by Willem Buiter in his blog on FT.com, is that there might be a calamitous run on the pound. It might even prove impossible to exchange sterling against any other currency. If we have learnt anything in the past 15 months it is that almost anything is possible. In 1997, the Indonesian rupiah even fell 84 per cent against the US dollar. But this would surely only occur if the solvency of the state were in question.

My colleague Wolfgang Munchau, in his column of November 17, adds that eurozone members might repatriate financial activities and launch policymaking summits from which the UK would be excluded.

Let me grant that the position of the City of London might be harmed by regulatory developments, even though similar prognostications have proved consistently false before. Yet even if this were true, why would membership of the eurozone prevent this shift and, more important, why should the British care that much? A decision as fundamental as that of the currency regime must not be made on the basis of the interests of the financial sector, which generates only about 8 per cent of UK GDP (with the City contributing just 3 per cent). As for eurozone summits, let them go ahead and make Gordon Brown’s day.

This leaves two big arguments, both stressed by Prof Buiter. The first is that the Bank of England cannot act reliably as a lender of last resort to the City. I believe he is confusing the City as an entrepot for offshore activities with the global activities of UK-based institutions. Foreign institutions operating in London can resort to their domestic central banks. British-based banks have also been able to take advantage of lender-of-last resort activities of other central banks or of swap lines advanced to the Bank of England. In practice, therefore, this argument does not look very telling.

The fiscal implications of explicit and implicit guarantees offered to the British banks with aggregate balance sheets of about five times GDP do look far more important. Yet membership of the eurozone would do nothing to limit the risks of a sovereign default consequent upon a collapse of the British-based banking system. The eurozone is, after all, explicitly not a fiscal union. That is why signs of declining fiscal creditworthiness are now evident in a number of eurozone member states. Indeed, Greece, Italy, Ireland, Portugal and Spain all have higher interest rate spreads over German 10-year bunds than the UK. The latter’s spread has even narrowed since the crisis began. Again, while prices of credit default swaps have indeed risen on UK gilts, the same is even truer for several eurozone members. The real interest rate on index-linked gilts is also still only 1.5 per cent. If, as some argue, the UK is going to have to pay an interest rate premium because of exchange-rate uncertainty, it is nigh on invisible so far.

My conclusion is that today’s extreme circumstances have made the case for retaining exchange-rate flexibility, as a lubricant for adjustment, not weaker, but stronger. I am delighted the UK’s government will not have to tell the people that a decade of stagnation might be needed to grind costs down to levels now needed for external competitiveness.

Yet I agree that the fiscal solvency of the UK can no longer be taken for granted. Two steps are now essential.

First, the British authorities must move swiftly and brutally to separate the UK-based banking system into a domestic utility they guarantee and an international component they do not. It is particularly important to put all activities that generate exposure to large international risks firmly outside the guaranteed utility.

Second, something must be done about the horrible fiscal position that Mr Brown allowed to develop when chancellor of the exchequer. This was risky and, in today’s circumstances, dangerous. This is not an overriding argument against a short-term fiscal boost. But I will judge the pre-Budget report out next week by how far it sets out a credible path back towards declining indebtedness relative to GDP. The UK is vastly more fiscally exposed than it should be. Eurozone membership would not help. That merely means it has to rescue itself.

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