Europe's Lycra monetary policy fits all
Even for a medium sized economy, monetary sovereignty is increasingly a chimera
Tuesday 31 August 1999
Monetary policy, on this view, is an essential adjunct of sovereign nationhood, since it generally helps the national economy to adjust to external shocks (such as rises in oil prices). Interest rates and exchange rates are seamlessly set by clever policy makers to optimise inflation, growth and the external accounts of a country. Living standards, output and employment are thereby higher than they would otherwise be.
This is a dream world which, if it ever existed, certainly does not now. In fact, British policy makers have a somewhat mixed record when it comes to competence. Our consumer spending and gross domestic product (GDP) have been more volatile than any other leading industrial country precisely because of policy errors like the Maudling, Barber and Lawson booms. This is why the Institute of Directors' insistence, in its recent paper on the economic tests for British euro-membership, that our GDP growth should move in line with Europe's for at least ten years is so odd.
Our GDP growth has moved out of line with Europe's over the past twenty years mainly because of our own policy mistakes. The swoop and crash of British economic activity was not a natural economic development. It was the result of mistaken monetary targeting, aggravation of sterling overvaluation, secret exchange rate targeting, ERM entry at the wrong rate without consultation, poorly sequenced liberalisation of markets starting with financial services and so forth.
Even if we assume that our new policy regime, with an independent central bank, avoids generating similar errors and shocks of its own accord - and, on present performance, it is doing well - this does not imply that an independent monetary policy will usually deliver helpful overall results. After all, there is now abundant evidence that the foreign exchange market is a source of shocks in its own right.
The overvaluation of the Swiss franc in the late Seventies, sterling in the early Eighties, the dollar in the mid Eighties and sterling again now are all proof that the free market can and does fundamentally misalign exchange rates for long periods of time. This has large costs for the tradable sector of the economy.
Just look at the figures. For those eurosceptics who like to pretend that the pound has been stable against the dollar, the graphic may prove a surprise. Taking end-month figures, sterling peaked at $2.62 in March 1972, troughed at $1.08 in February 1985, was back to $2 in 1992, and has fluctuated around its present range since then. Over the vast majority of this period, the pound was allowed to float freely (or muddily, depending on the interventionist instincts of the Chancellor) against other currencies.
It is difficult to argue that this result of the free play of market forces was in any sense optimal for the development of the British economy. Certainly, there have been some felicitous periods, such as the decline in the pound after our exit from the exchange rate mechanism in 1992. But they have been more than outweighed by other instances of substantial costs imposed on the economy, particularly during the overvaluation up to 1981 which wiped out swathes of manufacturers which might otherwise have survived to sell, produce and employ during the recovery.
Nor did British Chancellors generally feel that their fate was in the hands of a stern but nevertheless rational judge: the markets looked much less predictable than that. Lord Lawson peppers his memoirs with talk of sterling crises, not all of them down to his Fleet Street training in hyperbole. He says that Margaret Thatcher was in a "panic when it looked as if the pound might actually fall to below parity against the then mighty dollar in the wake of the Ingham crisis of January 1985". The Ingham crisis, you may remember, was set off by no more than a few ill-judged words from the Downing Street press spokesman.
Lawson himself was more concerned with the fall against the German mark in 1986. In The View from No 11, he says: "I was deeply worried that the slide of sterling might turn into a rout.We rapidly reached the conclusion that interest rates should be raised by a full percentage point, from 11.5 per cent to 12.5 per cent, forthwith. I was in no illusion about Margaret's likely reaction. It would be the first rise in interest rates for almost a year, the first since I had hoisted them to 14 per cent in the aftermath of the crisis of January 1985."
So British interest rates have certainly not been set according to the needs of the domestic economy: often, they have had to react to the ebb and flow of fickle foreign confidence. Far from being a way of helpfully adjusting to problems, an independent monetary policy in a relatively small country is usually an anarchic source of unpleasant surprises. It is hard to think back to all our sterling crises with a nostalgic glow.
Indeed, look at what is happening now, where the pound is almost universally regarded as being seriously overvalued. British farming is facing one of its worst crises since the Thirties, with the rise in the pound since 1995 a major factor as it has reduced sterling farm prices. Manufacturers are hit too. Mr John Cushnaghan, the managing director of Nissan UK, pointed out a fortnight ago that "the exchange rate is a serious threat to the competitiveness of industry. The Government keeps saying that productivity is important but we are the most productive plant in Europe and we can't produce our way out of this. If early entry to the euro will tackle the relative strength of the pound, then we should look at it". This - the most efficient car-maker in Europe - has now put in a request for government subsidies.
Small countries long ago realised the substantial constraints on their monetary sovereignty, which is why Ireland had no trouble being in monetary union with the pound from 1921 to 1979, and then had no trouble linking with the mark and joining EMU. Far from undermining broader Irish sovereignty, nationhood, or national identity, the link with sterling was gloriously irrelevant to any of them. It remained in place during a period when Eamonn de Valera was elected President, jettisoned Dominion-style status, instituted a Republic, and maintained implacable neutrality in a war in which the use of western Irish bases could have saved thousands of British lives. Nor, on balance, do my Irish friends seem any less Irish for the experience of sharing a currency with others for so many years.
The big, bad world of volatile international capital flows can do much more harm - and an independent monetary policy can do much less good - than the Sixties' textbooks used to tell us. Even for a medium sized economy, monetary sovereignty is increasingly a chimera. The British euro-debate should stop hankering after better yesterdays, and tackle the things that governments can affect, like education and business taxation and regulation. At least that way we can protect our companies and their staff from unnecessary financial storms, and get on with the business of getting richer.
Christopher Huhne is a Liberal Democrat member of the European Parliament's Economic and Monetary Affairs Committee, and author of "Both sides of the coin: the case for the euro and european monetary union", in which James Forder wrote the case against (Profile, pounds 8.99)
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