One way of illustrating what a single currency might mean for the UK is simply to ask what would have happened in the recent past if we had been inside EMU. This procedure is subject to many caveats but it is interesting none the less. Let us assume that the single currency had been in existence when Britain decided to join the ERM in 1989. What would have happened if we had joined a single currency instead, with an entry rate for sterling of DM2.95 (the actual ERM entry rate)?
First, monetary policy would have been very different. The graph compares the actual behaviour of UK short-term interest rates with what might have happened to UK rates if they had instead been set by a European central bank. In order to guess what the latter might have done, we simply take a weighted average of the rates that were set by the central banks of the core ERM countries plus the UK - we deem this to be the stance of policy that would have been set by an independent central bank for the whole of the single currency area.
Initially, in 1989/91, interest rates in the UK would have collapsed from around 15 per cent to around 10-11 per cent. With the benefit of hindsight, this might have been a good thing, since it might have dampened the recession in 1991/92. But after 1992, the opposite would have happened. British rates would not have been able to drop as fast as they did, and sterling would have been permanently stuck at DM2.95, instead of being devalued to under DM2.20. This would undoubtedly have greatly prolonged the recession, and slowed the recovery.
By now, a different phase might have been developing. If we were inside a single currency, UK base rates would now be about 3.5-4 per cent, mortgage rates would be at 40-year lows, and the consumer would no doubt be embarking on a vibrant boom. But remember that the "exchange rate" (by now only a hypothetical concept, admittedly) would still be fixed at DM2.95, so this consumer boom would be hugely fuelling the growth of imports. Although we would no longer have to worry much about a balance of payments deficit, our economy would be very unbalanced, with consumer demand bursting ahead of manufacturing output - and there would be not a thing that policymakers could do about it.
The lesson to be drawn from this rather artificial hypothetical exercise is that the optimal policy set for the single currency area might easily differ by a lot from that which the UK might wish to set on its own. Over time, it would be astonishing if this mis-match did not involve serious costs, though it is just conceivable that these might be worth bearing for the other economic or political advantages of the single currency (such as the boost it would give to the single market).
Next, let us look at budgetary policy. The key here is to realise that the panoply of budgetary controls which will accompany a single currency will include a so-called "stability pact", the terms of which have still not been fully agreed. However, the initial German proposals for this pact have been quite well received, and would involve fining countries if they allowed their budget deficits to exceed 3 per cent of gross domestic product in any given year. The fines would be large - 0.25 per cent of GDP for every 1 per cent of GDP by which the budget deficit exceeded the limit. Initially, the money would be parked in Brussels interest-free, but it would be permanently forfeited if the budget deficit remained above the limit for more than two years.
Of course, we do not know whether the existence of these fines would have altered the course of budgetary policy in the past few years. But it would certainly have been difficult, in the context of an exchange rate fixed at quite a high level, and with interest rates falling only slowly from 1992 onwards, to have avoided a run of very high budget deficits. Perhaps they would have been even higher than they have actually been, since the Lamont/Clarke tax increases would have been difficult to impose.
On the pattern of budget deficits which we have seen, Britain would have incurred some huge fines under the current proposals for the stability pact, and virtually all of them would have proved permanent. These fines would have cumulated to 4 per cent of GDP since 1992, equivalent to pounds 30bn in today's money. Even if all of this had been added to the debt burden, rather than financed by higher taxes at the time, the extra cost of the debt service alone would require an increase in the basic rate of income tax of 1p in perpetuity. These extra costs to the Exchequer would hardly be welcome under any circumstances, and certainly not during a prolonged recession.
Some people might regard these figures as too bad to be true, and in one respect they are. Most discussions of the stability pact stop the story when the fines are paid, but of course the EU would not simply sit on the money. One way or another, they would find a way of recycling the funds back to the member states, though almost certainly not in the same year, or to the same states that pay the fines.
What would matter, therefore, is whether the UK were incurring the fines alone, or whether all countries were in recession together. In the latter case, refunds would probably cancel out the fines. But if a single country were to miss the targets through having a recession in isolation from the rest of the EU, the stability pact would increase the budget problem at precisely the moment this could be least afforded, and the fines would subsequently be distributed to other EU members which were not in recession.
If any of that had happened in the recession of 1992, the demands for Britain to withdraw not only from the single currency, but from the EU itself, might well have become unstoppable.