Review & Outlook
The Euro, Another Look
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
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
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.