Sterling at €1.34 is a threat: Britain, the EU and the price of independence

At the heart of the British argument against closer ties with Europe has always been many UK citizens’ fear of losing control over the country’s affairs in general and in economics in particular.

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This article originally appeared on OMFIF’s website here

At the heart of the British argument against closer ties with Europe has always been many UK citizens’ fear of losing control over the country’s affairs in general and in economics in particular. For many in Britain, the euro project is not a basket of former independent currencies, rather a basket case. Doubts about the wisdom of so-called ‘German-backed austerity policies’ or about the ability of Greece and others to stay in the single currency have strengthened this belief in many British minds.

The ‘in-out’ referendum on Britain’s membership of the European Union which could take place in 2017, depending on the outcome of the May general election, will further focus attention on this point. Latest opinion polls indicate a majority in favour of departing.

The big question for a relatively small country like Britain is what ‘independence’ means in a globalised world. Being on your own, in monetary affairs as well as politically, can be damaging. Against its €1.04 low point in 2009, sterling has appreciated by 30% to around €1.34. This may be good news for Britons holidaying abroad, but the pound’s rise will hammer British manufacturing exports.

Switzerland, which has just abandoned its currency peg against the euro, has a current account surplus and high-value manufacturing goods, helping the Swiss absorb the shock of the latest 20% Swiss franc revaluation. Britain, on the other hand, has a large and growing current account deficit. It desperately needs to rebalance its economy away from services to manufacturing.

Although the UK’s coalition government has declared it wishes to further the ‘march of the manufacturers’, it has made little progress. Britain’s external performance will get worse. All this spells future trouble for sterling, especially if an inconclusive May election result brings political uncertainty.

Against this sobering background, Britain’s power over monetary and fiscal policy – setting interest rates, deciding quantitative easing and calibrating fiscal expansion or contraction – is well short of being an unmitigated benefit.

Germany has been doing well within the euro area because it benefits from the weak euro for its non-European exports, and even more from the stability, or lack of volatility, that emanates from membership of a large club. Germany still runs a substantial trade surplus with the rest of the euro area, but it has fallen sharply in recent years, making up less than 25% of Germany’s overall external surplus, against 40% in 2011.

If Britain wants to be serious about rebalancing the economy, it has to give its manufacturers a solid base, particularly in foreign trade. Currency hedging is expensive, the more so when volatility is high. The euro bloc encompasses most of the UK’s largest trade partners. Every transaction to another currency – whether one is buying or selling – costs money.

With so much of British industry in foreign ownership, there is an additional danger. When the foreign owners see developments they don’t like, they will first stop investing and then look elsewhere. At the German-British Chamber of Commerce and Industry we hear many worried comments from the over 1200 German-owned companies in the UK. The grumbling is getting louder.

And it’s not confined to the Germans. British business is overwhelmingly in favour of the UK staying in the EU, as a recent poll by the EEF manufacturers association showed. Britain can hardly be expected to join the euro in the foreseeable future. But as the election approaches, the issue of UK EU membership will start increasingly to occupy business people’s minds. Some might even support Labour as a potential party of government that will not brook a referendum on the matter – and could bring a weaker currency as well.

OMFIF

The Official Monetary and Financial Institutions Forum is an independent research and advisory group and a platform for confidential exchanges of views between official institutions and private sector counterparties.

The overriding aim is to enable the private and public sector to learn from each other in different ways, promoting better understanding of the world economy and higher across-the-board standards.

All developments regarding OMFIF can be followed at www.omfif.org and www.twitter.com/OMFIF.

Bob Bischof is a member of the OMFIF Advisory Board.

Maastricht Criteria Did Not Do The Job

Following German reunification, Germany’s European partners, particularly France, were getting increasingly keen on making progress along the road to a common European currency. For France this was a way of wrestling power away from the almighty Bundesbank and getting a handle on the levers of economic power through a new European Central Bank.

German central bankers were reluctant about losing power – and were also seriously concerned whether a common European currency would be as stable as the hard D-Mark. Similar concerns were felt by a number of politicians as well as the great mass of the German public, for whom inflation had remained a red rag.

To pacify them, the German government insisted that all countries which wished to join the Euro club should give guarantees on inflation and the causes of inflation, which were believed – as so often in the past – to be in the arena of excessive public spending.

The result was a ceiling on total public debt of 60 per cent of GDP over time and an annual government deficit limit of 3 per cent of GDP. These plus some inflation targets were eventually agreed as the main entry criteria for members of the Euro area. They became known as the Maastricht criteria.

This article was first published on the German-British Forum in May 2009

Following German reunification, Germany’s European partners, particularly France, were getting increasingly keen on making progress along the road to a common European currency. For France this was a way of wrestling power away from the almighty Bundesbank and getting a handle on the levers of economic power through a new European Central Bank.

German central bankers were reluctant about losing power – and were also seriously concerned whether a common European currency would be as stable as the hard D-Mark. Similar concerns were felt by a number of politicians as well as the great mass of the German public, for whom inflation had remained a red rag.

To pacify them, the German government insisted that all countries which wished to join the Euro club should give guarantees on inflation and the causes of inflation, which were believed – as so often in the past – to be in the arena of excessive public spending.

The result was a ceiling on total public debt of 60 per cent of GDP over time and an annual government deficit limit of 3 per cent of GDP. These plus some inflation targets were eventually agreed as the main entry criteria for members of the Euro area. They became known as the Maastricht criteria.

However since their inception the world has changed dramatically. Inflation was comprehensively beaten as a result of globalisation. The fall of the Iron Curtain and the world-wide GATT free trade agreements, leading to the entry on to world markets of products made with cheap labour forces, resulted in national demand being dwarfed by global supply – causing persistent downward pressure on prices and wages. Simultaneous deregulation of the financial services sector allowed a worldwide credit boom and asset appreciation – particularly in the Anglo-Saxon world, where house prices in particular went through the roof. Corporate and consumer credit took over from public debt as the main drivers of economic expansion.

Central banks meanwhile followed the prevailing wisdom of gearing their monetary policies to fulfilling narrow inflation targets. Governments and central banks alike congratulated themselves on achieving non-inflationary growth for more than a decade – and averted their collective eyes from other sources of disequilibrium and eventual turmoil that were building up in the world economy.

They became Gordon Brown-like “no more boom and bust” legends in their own lunchtime. Take Britain for example. If, in pre-globalisation times, the UK had experienced the public spending of the last decade, together with the accompanying corporate and private household debt increases, the country would have had suffered inflation. Instead, Britain, like the US, was able to finance massive imports, experienced a huge deterioration in its current account deficit and got its economy totally out of balance.

The same thing happened, only the other way around, in the leading “saving and exporting” countries, Japan, China and Germany. Instead of spending and importing, Germany reduced public debt (and domestic demand) by raising VAT at the beginning of 2007. Very laudable: unfortunately Spain and Ireland – which were experiencing massive deteriorations in their current account deficits as a result of debt-fuelled economic expansion prompted by the European Central Bank’s “one size fits all” interest rate policies – should have done it instead, to damp down their own excessive domestic demand.

It is fashionable to blame commercial bankers and investment bankers for the malaise of the global financial system. But central bankers and governments are also responsible, in some ways culpably so. They have to accept their share of the blame – have to start thinking of amending and re-prioritising some of their key indicators.

The causes for inflation and imbalances are more diverse and international than ever. The way forward is to adopt the aggregate of public and private debt as percentage of GDP as the main criteria for stability, rather than just public debt. If Italy has a low private household debt, it can be allowed more public debt during times of getting the imbalances under control.

If Britain’s private households are now rebuilding their balance sheets by starting to save and by reducing their borrowings, then higher public debt could be allowed for a certain period – to achieve macro re-balancing of the economy. Similar calculations must be made for any new countries aspiring to join the Euro and for all existing members. The European Central Bank needs to be given broader targets and new parameters for gauging stability in the future, rather than maintaining its narrow focus on inflation. The same goes for the Bank of England.