Review & Outlook
With Britain's new Labor Government sending up a trial balloon about joining
the impending unified European currency, and with London financial markets
emphatically endorsing the idea, the whole enterprise of the Euro is worth
another look. Without Britain, the Euro would mostly formalize the deutsche
mark bloc. But with Britain, it would become a world-class financial innovation.
The Euro, Another Look
These columns have been exponents of fixed exchange rates, taking note
of the golden era of world economic growth under the Bretton Woods monetary
arrangements and under the gold standard prior to World War I. Stable exchange
rates let the price system work its magic, signaling production here and
investment there, advancing the division of labor and comparative advantage
and all the good things Adam Smith wrote about. Exchange rate fluctuations
distort this mechanism just as trade barriers do, and a common currency
area carries the same kind--and probably a similar magnitude--of economic
efficiencies as a common market.
Fixed exchange rates often fail, as some of the Southeast Asian tigers
are currently discovering. But they fail only because governments refuse
to adjust their internal policies. Indeed, the dirty little secret of central
bankers is "sterilized intervention," the standard practice of offsetting
foreign exchange interventions to leave domestic liquidity or money supply
unchanged. Rates can always be defended if foreign exchange transactions
automatically change domestic liquidity, as they did under the old gold
standard and do with currency boards in Hong Kong and Argentina,
A common currency is the ultimate in stable exchange rates because it
shortcuts all of this. Within the currency bloc there are no foreign exchange
transactions and no sterilization. Everyone lives with the same measure
of liquidity. The Federal Reserve sets one monetary policy for the whole
dollar bloc. The new European Central Bank will set monetary policy for
the Euro after January 1, 1999.
These large theoretical advantages of course have to be implemented
in practice, and we can understand why so many of our Tory friends became
Euro-skeptics. Unquestionably the transition to a common currency is bedeviled
by technical difficulties. Most fundamentally there is the matter of finding
the right rate, for the wrong one could set off a wrenching adjustment
of either inflation or recession that would make the enterprise politically
unsustainable. Twice in recent years Britain has had this experience trying
to tie itself to the mark.
Too, monetary union looks like the biggest step yet toward a European
political union linking, and saddling, Britain with the continental welfare
states. Why should the world's oldest parliament, we have heard Lady Thatcher
herself ask, yield to a batch of unelected and fundamentally unaccountable
bureaucrats in Brussels? Prime Minister Tony Blair has promised a referendum
before joining, and these sentiments would have to be overcome. No one
expects Britain to join until after the 1999 launch.
The European partners, for their part, did themselves no big favor with
their Maastricht criteria. They ignored the one number that does encapsulate
the European economic problem, the percentage of output that passes through
the hands of government--which is half or more in most continental nations.
Instead the criteria focused on the deficit, which is an invitation to
further tax increases and a barrier to needed tax cuts. Now the major nations
will not meet the criteria anyway except by outrageous fudging; they are
sacrificing credibility after years of distracting debate.
Yet in fact, the whole Maastricht idea of "convergence" has it backward.
You don't do convergence to fix currency rates, you fix the rates to get
the convergence. Indeed, because the Eurobank would not be obligated to
fund the deficits of individual governments, it would exert a rather direct
discipline. A government with a big debt or deficit would have to pay for
it with higher interest rates in the credit markets. Over time this might
force the welfare states to bring spending in line, forcing the European
nations to compete on industrial development and tax rates the way states
do in the common currency area administered by the Federal Reserve.
In this competition, Britain would do exceedingly well. Its deficit
and debt is the lowest of the major European Union nations. Its governmental
obligations are dramatically lower if you include unfunded pension obligations,
as you certainly should. It is the most entrepreneurial of the European
nations, and of course has Europe's financial capital. In any event it
will have to fend off the Brussels bureaucrats on regulatory and tax policies,
but from a common currency itself it has little to fear beyond a symbolic
loss of monetary sovereignty that in the long run it doesn't have anyway.
Whatever the Euro does for Britain, Britain would be good for the Euro.
The world can only profit from movement back toward exchange rate stability,
and if Britain joins this prospect becomes far more serious. Serious enough,
indeed, that we could hope over the long run it would reach the shores
of not only Britain but Japan and the United States.
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