A new argument is being made in favour of Britain joining the euro. It starts by making a surprising comparison between this country and Iceland. Following the battering that Iceland has received from the financial storms in which we are all enveloped, opinion there has swung sharply round in favour of ending the country's isolation and getting into the European Union and then into its inner ring, the euro zone, as fast as possible. The question is asked whether Britain's situation isn't more similar to Iceland's than we might suppose, and whether we would also do well to reconsider our opposition.
So, apart from both of us being islands, what else is similar? Professor Willem Buiter, a former member of the Bank of England committee that sets interest rates, suggests that there are three ways in which we resemble each other.
Each of us has a large, international banking sector, a currency that falls far short of the strength of the dollar or the euro, and a government that is at the limits of its ability to tax, to borrow and to spend. You can estimate the significance of a country's banking sector by adding together the balance sheets of its banks and comparing the total with the size of its economy. Iceland's came to nine times the value of the annual output of its economy before everything collapsed. The UK's ratio is four-and-a-half times and, by way of comparison, Switzerland has a multiple of six-and-a-half times. This overstretch poses a problem that hasn't been well understood until recently.
It is this. Whereas the governments and central banks in the three countries listed above can guarantee the value of domestic deposits (if only because they can always print more Icelandic krona, pounds sterling or Swiss francs if necessary), they cannot so easily guarantee the foreign currency deposits which their international banks take in large quantities.
If the Bank of England, for instance, wished to stand behind, say, the dollar deposits that are held with Lloyds Bank, then the Old Lady would have to borrow US currency to do so. Moreover, in such circumstances the creditworthiness of the British Government itself might be strained if it had already assumed the liabilities of a large part of its domestic banking system.
You can see where this analysis is leading. The next step in the argument is to observe that only the authorities of the two big currency blocs, the US Federal Reserve and the European Central Bank, are strong enough to borrow virtually unlimited amounts of foreign currency to put behind any stressed international banks within their fiefdoms. And thus the conclusion follows is that, lacking this facility, the City of London needs the protection that only the European Central Bank could provide. Ergo, Britain should enter the euro currency system.
We can say about this line of reasoning at least this: it is completely fresh. In a recent paper, Professor Buiter ruefully admits it. The reason the costly handicap of a minor-league currency does not appear to have harmed the UK in the past is the same as the reason why I have not made the argument in the past. Before the current financial crisis, no one could conceive of a world in which a financial crisis would start in the global financial heartland.?
Powerful and original though Professor Buiter's analysis is, it still doesn't persuade me that we should join the euro. As it happens, the current circumstances provide a good illustration of the benefits of not belonging. For countries that join the euro give up two important instruments of economic policy. They can no longer set their own interest rates but must accept whatever the European Central Bank decrees is good for the euro zone as a whole. Similarly they cannot let their own currency depreciate or appreciate according to circumstances, because they no longer have a currency of their own.
At present, for instance, Germany's strong exporters would like to have a weaker euro but that is denied to them. And France would like lower interest rates, but despite M. Sarkozy's huffing and puffing, it cannot obtain them.
In contrast, non-membership has allowed Britain to make unprecedented cuts in interest rates to meet an unprecedented crisis. Sterling has freely fallen a long way, but that in turn may provide a valuable boost to economic activity as exporters begin to find that their prices are very competitive. No more than Professor Buiter did I foresee the nature of the present crisis before it was upon us, but I draw the opposite conclusion. Recovery will be harder inside the euro zone than outside it. Nor, come to think of it, do I consider that Iceland and Britain do have all that much in common.Reuse content