“Thank god that’s over” is the only possible verdict on the European component of the election campaign. In mid-contest the Conservatives seemed poised to benefit from a rich vein of electoral xenophobia, and the only reason they were unable to tap it more successfully was that they dragged Labour disconcertingly far in the same direction. Let us hope this was nothing more than an electoral spasm, and that sanity can now be restored.
Not only sanity, but bravery too. One of Tony Blair’s key pledges, one by which he has asked to be judged, is that under his premiership strong leadership will replace political drift. Europe will be his prime testing ground, and the single currency its most menacing element. Sometime this summer the camouflage of the “wait-and-see” policy, solely designed to get the main parties past 1 May intact, will have to bite the dust. But what can or should replace it?
A few months ago there were some in the Labour Party who still believed that first-round membership of the single currency might be the best option. They warned for the manifesto to contain warm words about the desirability of European monetary union as an ultimate objective, thus allowing Labour to claim subsequently that the “electoral test” for the single currency had been achieved. But the watershed on this question was passed when Tony Blair and Gordon Brown agreed last November that it was too dangerous to fight the election without a clear-cut referendum commitment. Even the most convinced European must acknowledge that their political judgement was vindicated in spades during the campaign.
Sad but true, an accommodating attitude towards Jacques Santer and his associates would have been one of the few ways that Labour could have risked its command of the 1997 election. Now the existence of the Blair “triple lock” on EMU membership – cabinet, parliament and the electorate must all approve before it can occur – presumably rules out membership in 1999, and it may only be a matter of time before this is accepted by Her Majesty’s new team of ministers.
Probably, though not certainly, a core group of European countries will nevertheless proceed to monetary union on time. This inevitably proposes the acutely awkward question of how Britain, for the first time genuinely semi-detached from the European core, can co-exist with the single currency group, possibly for many years, if not forever.
Where does the balance of economic advantage lie in such circumstances? Should we seek to join if others press ahead? The debate on the economics of the single currency has, until now, concentrated mainly on whether it would be a “good thing” in the abstract, without reference to the new situation that would be created if other countries proceed without the UK. The traditional discussion therefore focuses on the absolute costs and benefits of Britain joining the single currency, comparing a situation in which we are a member with another situation in which the currency does not exist.
However, in any sensible discussion of the present situation, we need to consider not only the absolute costs and benefits of membership, but also the relative costs and benefits that arise if the UK stays out while others move ahead.
There are three states of the world that could in principle exist. First, EMU might disappear altogether. Second, EMU might go ahead without the UK. And third, the UK might join. It is perfectly possible that EMU membership could be a bad thing in absolute terms, but less bad than the alternative of remaining outside a club which the rest of the EU is bent on creating. In other words, the first alternative might be the very best for the UK; but, failing that, the third might be preferable to the second.
To make more sense of this, consider the two tables, which try to summaries the absolute and relative arguments involved. The absolute benefits of joining a single currency are by now fairly familiar. Transactions costs on foreign business would fall, and exchange rates would be less volatile. This would be helpful on the margin for the creation of a genuine single market in the EU. But it is certainly not essential.
Other advantages usually claimed for EMU are that inflation would be lower than the UK could manage on its own, and that real interest rates would be lower, as the inflation risk premium on gilts begins to shrink. This would encourage higher investment, a larger stock of plant and machinery, and eventually higher economic growth. But none of this is inevitable. It is perfectly possible for the UK to create monetary institutions of its own – an independent Bank of England, for example – which could keep inflation under control outside emu. After a while, the risk premium on gilts would disappear, though this might take longer than it would under EMU membership.
Compared with these relatively modest absolute advantages for EMU, there are several disadvantages which could prove to be very large under certain circumstances. First, Britain would lose its monetary independence, so could not change base rates in response to an economic shock that hits this country alone. Many people argue that we have already lost monetary sovereignty and that UK interest rates are anyway determined by world conditions. This is nothing more than arrant nonsense: just look at how much base rates have varied, relative to German and American interest rates, in the past five years. Others argue that “monetary independence” is simply a more respectable term for devaluing the pound. Again, this is garbage. There is a huge difference between acquiescing in a continuing devaluation – which no one with any sense would support – and allowing the exchange rate to vary up and down as interest rates are adjusted to smooth the cycle.
Imagine the situation if we had been locked into a single currency in the recession of 1992: the long-term damage to the fabric of the economy might have been very large indeed. Or imagine what would happen if we were in a single currency now – base rates would be about 3-4 per cent, and the boom in the housing market would know no bounds. Such situations might not arise very often, but when they do they would be potentially disastrous. In addition, under the terms of the proposed EU Stability Pact for emu members, fiscal policy might not be able to adjust fully to such a situation, either. And the final disadvantage, which could also be large, is that the exchange rate would not be available to smooth out fundamental misalignments in production costs in different countries. As a result of all this, the only way out of an economic crisis would be to force declines in UK prices and wages, which could take aeons to effect, and would certainly be extraordinarily painful.
Of course, none of these costs or benefits is easy to measure, so sensible people can come out on either side of the debate. But our own conclusion is that with the present structure of the EU and UK economies, there is a significant risk that the absolute costs of membership could exceed the benefits. In other words, at least for the time being, and until further economic integration occurs, the best option for the UK is that the single currency does not exist.
But, sadly, that option in itself probably does not exist, so we need to move on to consider the relative costs and benefits of joining a single currency that others insist on creating. To start with one negative but important point, we do not argue for early entry on the grounds, often mentioned by politicians, that the UK should seek to influence the design of the system from the inside. In fact, there are very few important decisions yet to be taken, and there might actually be advantages in allowing other countries to incur the start-up costs of learning to make the new system work. In particular, if Britain were on the outside, it could avoid the dangers inherent in tightening fiscal policy to hit the Stability Pact targets, while the new European Central Bank is simultaneously keeping interest rates high to earn credibility. This policy mix could cause a recession which it would be just as well to miss.
More positively, early membership would insulate us from the potentially severe political costs of isolation from the EU core. These cannot be predicted with any clarity in advance, but it is easy to envisage a situation in which other EU members begin to view us as a “free rider”, attempting to take advantage of the single market without accepting any of the obligations that membership of the single currency would bring. The risk of outright economic warfare would be most acute in recessionary times, especially if we allowed sterling to decline at such times.
Who knows what would happen next? Would we be excluded from aspects of the single market? Would we simply find it more difficult to win concessions in unrelated areas (such as the beef war)? Would Eurosceptics in the UK use this potential schism to ask for a referendum on the whole question of EU membership? All these are obvious dangers, and a slow drift away from the core of the EU, followed eventually by divorce, would be a perfectly plausible scenario. In the long-term interests of the British economy, this is a risk that must not be run.
We are therefore left with the following situation, which is depicted in the graph. On the absolute arguments we have considered, there may be a permanent net cost to monetary union, the largest component of which is the loss of monetary independence. However, on the relative arguments we have listed, there is probably a net benefit from joining, the prime component of which is avoiding the political cost of becoming semi-detached from the EU core. For the time being the net absolute costs probably exceed the net relative benefits, so the UK should stay out. However, in the graph we have suggested that the net relative benefits from membership might increase over time, possibly at an accelerating rate, so that at some point in the future – our guess would be in about a decade – the two lines will cross. That is the optimal moment for the UK to join the single currency.
It must be clear by now that none of this is simple, straightforward or provable and that any attempt to strike out in a new direction by the Blair/Brown combo is fraught with danger, in fact the greater danger of allowing Eurosceptics in the Tory party to make the running unopposed, with the likelihood that Britain’s centre of gravity will shift further away from the EU over the next five years. A new more positive stance on Europe goes against the grain of the political mood of the moment, but unless we start to combat that mood now it will become ever more difficult in the future. The new approach requires the following elements.
First, it should be frankly admitted that sterling cannot be taken into the first round of the single currency, not just for logistical reasons, but because there are severe doubts about whether the UK economy is yet sufficiently integrated with the rest of the EU to make this desirable.
Second, however, it should be firmly stated that the principle of the single currency is acceptable to the new government, and that the long-run objective is to join, once integration between the UK and the Continent has been increased. No timetable should be set for this but some basic criteria that will guide the decision should be set out. It should be made clear that eventual membership would be subject to approval by referendum, for the excellent practical reason that it would be absurd, and ultimately self-defeating, to make such a profound change without the full-hearted consent of the electorate.
Third, the government should state that it will actively take measures to quicken the speed of integration, provided that the necessary measures make sense from the perspective of the government’s wider objectives. This should be a two-way process, involving some action by the UK and some by the rest of the EU. And we should make it clear that we are talking here about genuine and permanent integration of an economic structure, not simply temporary adherence with the botched “convergence” criteria that appear for a few nominal variables in the Maastricht treaty.
Fortunately it is quite easy to think of measures that would fit this requirement. The overall thrust should be to minimise the costs of giving up monetary independence, which we have identified as the main potential cost of emu, and that means thinking about reforms which would make the UK less susceptible to different economic shocks from those that apply elsewhere in the EU.
By far the most important of these is to change the system of housing finance in Britain, which is the prime source of differential demand shocks. Our system of variable rate finance sits uneasily with the practice in the rest of Europe, where long-term fixed-rate finance is overwhelmingly dominant. One idea for consideration would be to offer mortgage tax relief only on fixed-rate mortgages in future.
Also important is the much greater role for equities compared to bonds in the UK system of corporate finance and house-hold savings, which leaves us more vulnerable to global or local equity market shocks. This can be addressed by taking active steps to complete the EU single market in financial services, especially in the areas of corporate finance and fund management. This could lead to a gradual convergence in debt/equity ratios around the EU.
In addition we need to adopt measures that would speed the process of economic adjustment if differential shocks still occur. Essentially, greater flexibility in both wages and prices is needed to replace fluctuations in the exchange rate as the main shock absorber in the economy.
Fortunately all the key measures here are desirable in and of themselves. In the labour market long-term employment needs to be attacked, both through the suggested windfall tax measures and through further benefit reforms. The employment placement service needs further restructuring, with yet more tightening of the “work test”. In-work benefits, such as family credit, need to be amended and increased in scope so that the effective marginal tax rates on low-income households are sharply reduced.
Free child care for those in work would also be a big step forward for low-income single-parent families. In the area of making prices more flexible, there are many possible reforms, including the introduction of legal prohibitions for abuse of market power, with accompanying large fines and the possibility of enforcement through private action against dominant firms.
These are only examples of the kinds of thing that the new government should be doing anyway, but which would, over time, reduce the costs of joining emu. The idea would be actively to put the UK on a glide path towards the single currency, since the alternative would risk removing Britain from the EU altogether. Only when genuine integration had been achieved, and when the full-hearted consent of the electorate becomes feasible, would the question be put to a referendum. It may take a decade – but the government’s long-term strategy would never be in doubt.
One final decision is needed. Should the UK rejoin the ERM? At present, the cyclical differences between the UK and the rest of the EU make this ill-advised, and probably will continue to do so for at least a couple more years. But in the longer term it will be important to give the EU a clear indication of the bona fides of Britain’s eventual goal to join the single currency, which is where the ERM could come into play.
It is crucial to recognise that the current system has virtually no connection to the old ERM: for example. If sterling joined at a central rate equivalent to 2.50 against the mark, the fluctuation bands would be 2.15 to 2.90, which encompass the entire range of sterling’s movements since 1992. A commitment to a stable central rate over time would reassure our partners that we had no intention of pursuing a policy of devaluation, while the wide bands would allow the UK to employ monetary independence from the European Central Bank when absolutely necessary.
For the time being, memories of 1992 understandably rule out this option, and no one would recommend rejoining a system similar to the one we left that year. But it is impossible to move the Blair express from its current resting place to the single currency without passing through a stop marked “ERM2”. If the new government can win acceptance of this during its first term, then maybe Britain will begin moving away from the bleak dead end marked “Eurosceptic junction” towards which we have been hurtling these past six weeks.
This article is part of the New Statesman’s 1997 election archive, New Dawn. Click here for the full collection.
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