The lessons of the ERM for Britain and the euro
The ERM Crisis: not just a British crisis
There were benefits from the ERM
Mistakes at the time of ERM entry
Was DM2.95 too high?
The dangerous illusion of Exchange Rate stability
The euro: are there any precedents? Monetary unions without political union usually fail
The performance of the ECB: failure to meet inflation targets
Growth: the Euro has stalled the German locomotive
Germany’s currency errors
There is no inevitability about the euro
The dangers of a monetary union with countries less flexible than oneself
The most important test: the Chancellor should be congratulated
Points to applaud
The huge problem of the housing market and the Euro
There is no real convergence
The convergence test cannot be satisfied
The PM cannot mean what he says
I am delighted to be here in Dublin, a great city and a capital of a country that has much to teach the rest of Europe about the great economic success you have enjoyed.
I imagine that the fact I have been invited to give this speech tonight on this particular date is not a coincidence. This week marked the tenth anniversary of Britain’s exit from the Exchange Rate Mechanism on September 16th l992. I have spent many hours on TV and radio this week reliving that day.
The ERM Crisis: not just a British crisis
This audience knows better than a British audience that the currency crisis of the autumn of 1992 did not just affect Britain but Ireland and many other countries. In Britain the event is known as Britain’s “departure from the ERM”. It might be more appropriate to talk about the break-up of the ERM since after summer l993 the governments of the ERM countries decided to move to a system of broad bands, more or less the equivalent of floating. At the same time that Britain was experiencing the currency crisis in l992 similar events were happening in Italy, Spain, Portugal, Sweden, Norway, Finland, France ten months later, and of course Ireland. All these countries lost huge amounts of foreign exchange reserves, all were forced to devalue or to float their currencies. In all of them, during that time, interest rates rocketed up and down. One noted TV commentator, Adam Boulton, said to me this week that no other countries had tried to defend their country in September l992 with increases in interest rates. When I pointed out to him that may countries had done so and Sweden had increased overnight rates to 100% he looked at me disbelievingly. Of course I was wrong, the real figure was 500%.
It is interesting that the date of the currency crisis of l992 is remembered in Britain but not in other European countries. There are two reasons why memories of that crisis are more vivid in Britain. The first is that the recession was particularly painful in Britain. We experienced quite a severe recession even though it was not as deep as that of the early l980s. The ERM prolonged it, although it did not cause it.
The second reason is that the ERM has become a battleground between Europhiles and Eurosceptics. The former see seek to argue the ERM was very different from the single currency. The Eurosceptics argue that there is a direct read across from the ERM to the euro.
I would like to address precisely that issue. What lessons can be drawn about the euro from our membership of the ERM.
There were benefits from the ERM
Despite the continuing passion of the debate I was pleasantly surprised to discover in Britain many analyses of the ERM were reasonably balanced especially in the business pages. Commentators recognised that the ERM did provide a framework for Britain to get its inflation dramatically down. At the time that we joined the ERM, just before I became Chancellor, in the autumn of l990, inflation was in excess of 10%. Just over two years later at the end of 1992 it was around 3.5% but heading down. Shortly after that reached 2.5%. I was the only British Chancellor of the Exchequer of modern times who was ever able to boast that UK inflation was lower than Germany’s. Clearly the deceleration in inflation was a significant gain to the British economy from which it has benefited ever since.
At the same time it was obvious that the policy became increasingly too tight, and that it would have been better if we could have lowered interest rates as inflation came down. Sir Edward George, the Governor of the Bank of England, has argued that Britain got the best of all worlds. We got the discipline of the ERM, we got inflation down and then the system broke down giving us the opportunity to design a new framework for monetary policy. ERM was a tool that broke in my hands when it had accomplished all that it could usefully do.
Mistakes at the time of ERM entry
I am not aware of the precise background to Britain’s decision to join the ERM in l990 since I was not Chancellor of the Exchequer at that time. But it seems to me, with hindsight, that certain factors may have been inadequately considered.
Firstly Britain chose to ignore its own Madrid condition for joining the ERM, namely that our inflation rate should have converged with Europe’s. Inflation in the autumn of l990 was considerably above the average for other ERM countries. That was bound to make the maintaining the pound in the ERM more difficult since the real exchange rate was appreciating.
Second, Britain and other countries too gave insufficient attention to the effect of the abolition of exchange controls. The ERM had existed for over a decade. But it had done so with capital controls in many countries like France and Italy. These controls were gradually dismantled as part of the push to monetary union. With hindsight it is clear that their abolition made operation of a system of fixed exchange rates more difficult. I am not, of course, arguing that these controls should not have been abolished merely that their abolition made the ERM more vulnerable.
Was DM2.95 too high?
Then there is the question of the level of the pound at which Britain joined and whether DM2.95 was too high. Again I have no first hand knowledge. According to many reports the German Government did think the rate too high. They argued that Britain would create another “peseta paradox”. Their fear was that because of our high inflation and therefore high interest rates, the pound, like the peseta, would be a magnet for capital flows forcing the currency to the top of its band and thus forcing the Bundasbank to intervene. On this precise point they were mistaken.
I have also read that M. Delors said that he didn’t care what Britain’s entry rate was, as long as it wasn’t the rate Britain wanted!
Looking back at the behaviour of the pound over the decade since l992 the chosen rate of DM2.95 does not look out of line. While the pound fell sharply after 1992, it appreciated from l995 onwards and for much of the last seven years has been above DM3 and significantly above the level at which we joined the ERM.
DM2.95 may have been the right rate for a whole decade. It does not mean it would not have been valuable in 1991-92 to have had the flexibility of an adjustable exchange rate and so have been able to lower interest rates.
For reasons I will explain, devaluation was never a viable option for Britain. However, a revaluation of the deutschmark might have helped, particularly if it could have been accompanied by a reduction in German interest rates. I would certainly have supported that. Indeed I did do so, but M. Beregevoy, the French Prime Minister made it quite clear to me that a German revaluation was unacceptable to France. They feared that this would be seen as a franc devaluation, an abandonment of the “franc fort”, and that they would loose the Maastricht Referendum due to be held on September 20th.
The biggest problem for Britain was not the level of the exchange rate but the level of interest rates. The recession of l990-92 was different from that of the early 80s. It was concentrated more on the South East of the country and particularly affected the services sector, financial services, and most importantly of all the property sector for which interest rates were crucial.
The problem was interest rates. No country in the ERM including Britain could get its interest rates below those of the deutschmark the anchor of the system.
A devaluation would not have helped this and indeed would have made the problem worse. The worst possible outcome would have been a small devaluation – say 5% to 6% and a large devaluation would not have been accepted by other countries. A small devaluation would have led to an increase in interest rates as the markets would have expected it to be followed by another. This was the experience of Spain and Portugal who did devalue and remain within the system. For Britain, with its recession, it would have been a disastrous outcome.
The dangerous illusion of Exchange Rate stability
One of the claims made for the euro is that it will give British exporters currency stability. This is a shallow claim negated by the ERM experience. The exchange rate against the dollar also matters to Britain and is heavily influenced by the pattern of our trade which is different from other European countries. Very roughly around half our trade is with countries either on or closely linked to the dollar which is the currency most of the world outside Europe uses either in a formal or informal way.
The euro dollar exchange rate has been highly volatile for a long period. If the UK were to join the euro we would increase our exchange rate risk against the dollar as the euro rose and fell against it. This is well illustrated by Britain’s experience in the ERM. We had currency stability for Europe but because the DM was appreciating massively against the dollar so also did sterling. I well remember that in the summer of 1992 the rate of the dollar to the pound reached $2. By contrast Britain has enjoyed relative stability in her overall exchange rate since we left the ERM precisely because we have been tied to neither the dollar nor the euro.
This point has been well made by Professor Patrick Minford in his recent pamphlet “Should we join the Euro”. I quote “Our large dollar exposure means that currency stability in EMU is a myth. With the pound free to move as now against both the euro and the dollar we manage somehow while these two currencies gyrate endlessly against each other. Like a child on a seesaw we sit in the middle while the ends rush up and down. But linked to neither, and even though we stabilise ourselves at one end, we are dreadfully destabilised at the other.”
I digress because the basic problem was one, which is very relevant to the question of Britain’s membership of the euro. The basic problem for Britain in the ERM was the contrasting needs of the British and German economies. The latter was experiencing a post reunification boom and needed higher rates. Britain, in recession needed lower rates. Today this is what would be called the absence of convergence. Clearly this is an issue, which has to be considered again today.
The Euro: are there any precedents? Monetary unions without political union usually fail
The creation of the euro has no precise precedent in history. It is true that there have been monetary unions across different countries. There have been several: the Latin monetary union of l865, the Scandinavian monetary union of l873, the de facto monetary union of the British pound and the Irish punt and the various unions associated with colonial Empires, for example the CFA franc zone and the East Caribbean currency area.
But the motivation for the various monetary unions of the l9th century was very different from those for the euro. They were mainly concerned with the complications resulting from the circulation of numerous coins of varying denominations and purity.
The occasion of the break-up of the Latin monetary union was the First World War. But in reality it had long ceased to provide the majority of money before then. Its central coin was the 5 franc silver piece and when the price of silver fell in the 1870s, the face value of the coin soon exceeded its silver content.
The monetary unions of the past that failed did so for essentially two reasons. Either, as with the Latin and Scandinavian monetary unions they had different Central Banks with the authority to print money, or politics drove the countries apart.
The only monetary unions that have become permanent are those that have been accompanied by a political union. There are no examples in history of lasting monetary unions that have not been accompanied by political union. The successful monetary unions became unified nation states themselves, like Britain, the United States, Switzerland, Italy and Germany.
EMU is a multi-national currency union that for the moment has no overriding political authority. But in other ways it is more like a national monetary union in that there is a single Central Bank – the ECB which runs the currency.
The performance of the ECB: failure to meet inflation targets
How has the ECB being doing and how has the Euro zone prospered under its regime?
On inflation the European Central Bank, has to my surprise, regularly missed its inflation target – a year on year increase in the HICP for the Euro zone of below 2%. By contrast the Bank of England has consistently met its inflation target and the UK’s inflation performance has at least for the last few years been consistently better than that of the ECB. Still an overall rate of inflation for the Euro zone of 2.5% can be hardly be dubbed a disaster.
But one interesting point about European inflation which is relevant and which I see as a long-term threat to the euro, is the extent to which inflation among the members of the Euro zone has already begun to diverge.
One year before the Euro was introduced inflation rates in the twelve member states varied by less than 1.5%. This was a requirement of the Maastricht Treaty. France, the lowest was 0.6% and Italy and Spain at 1.9% were the highest. For the next eighteen months relative positions remained largely unaltered. However, from the autumn of l999 inflation rates rose in most countries including Germany and France. In particular inflation doubled in Spain and as you know trebled in Ireland. Six months later similar increases were recorded by Portugal and The Netherlands. By the end of 2001 the range of inflation rates from top to bottom had increased from the 1.3% percentage points in l998 to about 3.5 percentage points. A number of countries in the euro today would fail to qualify for membership of the euro, by the criteria of the Maastricht Treaty.
This is not much of a surprise, but underlines the validity of one of the main criticisms of the euro, namely that the one size fit all interest rate can cause problems. Indeed here in Ireland under the impact of the boom brought about by the fall in interest rates to euro levels of 3% inflation rose to a peak of nearly 7% and is still running a 4% to 5%. This is surprising from a country where productivity growth in tradable goods is faster than in non tradable.
What has happened in Ireland is a matter of great relevance to the UK debate. It is not just the close trading relationship between our two economies, but also because of the similarities between us. If the UK had joined the euro on the lst January 1999 probably we too would have experienced very similar problems.
Growth: the Euro has stalled the German locomotive
Turning to growth in Europe, the rate of growth of the Euro zone and of Britain has been broadly similar. From l997 to the middle of 2002 growth for the UK averaged 1.8% p.a. and for the Euro zone 1.7% p.a. However, the UK clearly did much better than Germany that averaged at only 1.1% p.a. during the same period. Germany has become the stalling locomotive. German growth has trailed behind the rest of Euroland for some time but since the euro came into being the underperformance of Europe’s largest economy has worsened. At least part of this lack lustre showing must lie with the inappropriate interest rates that the ECB has set for Germany.
There is little that can be done about it. While Germany accounts for almost one third of Euro zone GDP the actual political arithmetic of the ECB is against them. It has only two representatives on the seventeen member governing council.
Germany’s currency errors
Germany has made two great currency mistakes in the last ten years. The first was the one for one conversion of the East and West German marks which condemned the country to a long period, not yet over, of double-digit unemployment. The second was giving up the Mark, probably at the wrong rate. In the past the German economy has been strong enough to offset an overvalued currency. Germany is cutting costs today but domestic politics and the sluggish growth of the euro have prevented a really convincing reform of an inflexible labour market.
Most of Germany’s trade is with other Euro zone partners. Without the help of flexible exchange rates or interest rates and with limited use of taxes Germany has not managed to adjust to the single currency with depressing effects on its economy. GDP grew by only 0.6% last year. Even this poor performance would have been worse had it not been for an increase in exports which in turn was boosted by the euro’s weakness.
There is no inevitability about the euro
It does not seem to me, there is any evidence that Britain has suffered from being left outside the Euro zone. Britain has prospered pretty well. So much so that the inevitability argument looks distinctly weaker and will I suspect continue to grow even more so.
Nevertheless the British Government decided in l997 that in principle it would like to join the euro. The Government has put forward its famous five tests that need to be satisfied before the Government would recommend membership.
These tests cover convergence of business cycles, flexibility, higher growth, long-term investment in Britain, the position of the City, and economic structures. These tests have been criticised as being too vague and therefore easy to fudge. I want to concentrate on the first two tests because I think they are the most important and because they most closely relate to my theme tonight.
The dangers of a monetary union with countries less flexible than oneself
Let me deal first with the second test, flexibility: “if problems emerge is there sufficient flexibility to deal with them?”
Flexibility can be defined in different ways. It might include the flexibility of the exchange rate, which is an important safety valve. In times of recession exchange rates tend to go down and in times of strong growth they tend to appreciate thus curbing inflation. We certainly found in l990-92, as Germany is finding today, that this type of flexibility can be very valuable.
The Government’s paper on flexibility revolves largely around labour markets. This is important for the whole future of the Euro zone and whether the euro can operate successfully. Mobility of labour is important in ensuring that people can find jobs where they need them. Mobility between Britain and other EU countries is not particularly high especially when compared with the different states of the United States. Only 1.5% of the population of the EU live outside the country of their birth. In 2000 only 1% of the EU population moved between countries and 1.2% moved between regions of one country for the purpose of work. This compares with the 5.9% rate within the US. Ottmar Issing of the ECB has described this phenomenon as “an almost lethal threat to the euro in the medium term.”
Britain and Ireland are regarded as having flexible labour markets. But progress on labour market reform in Europe, particularly in Germany, has been disappointing. Even Tony Blair wasn’t able to hide his disappointment after the Barcelona Summit.
The purpose of highlighting Britain and Ireland’s flexible labour market is not to indulge in self congratulation. It is to highlight the distinct dangers in joining a monetary union whose markets are less flexible than your own. To do so is to risk ending up making all the necessary adjustments not just for yourself but other less flexible countries as well. It would be an error if the British Government claimed the flexibility test had been passed because the British economy itself was flexible. The flexibility that matters most is that of the others.
The most important test: the Chancellor should be congratulated
The most important test is the first test, that of cyclical convergence: “are the business cycles and economic structures compatible so that we (the UK) and others could live comfortably with euro interest rates on a permanent basis?”
I have to say the document published by The Treasury in October 1997 is formidable and impressive in dealing with the issue of convergence. So much so I would defy anyone to read it and still be in favour of Britain joining the euro. The Chancellor and his officials are to be congratulated. The case against in the Government’s document, even if the Prime Minister doesn’t realise it, is huge. The Chancellor is clearly mindful of the difficulties Britain had in the past in the ERM and the risks for the future.
The document describes in considerable detail the cyclical differences in the past between the UK, the US, France and Germany, and it does not understate the difficulty. As it says “a view of the future must depend on an analysis of the past”. The past may be inadequate but it is best guide we have. The document details the structural differences between the UK and other European economies and makes the point that these differences are important not simply because they make the UK more likely to suffer from different types of “shocks” but also because they affect how the UK responds to “shocks”. Even if the UK is affected by the same shocks, but then responds differently the UK economy could diverge from other countries. One example of this is the proportion of UK trade with other EU member states. In the UK’s case it is below the EU average so the UK is more vulnerable to changes in demand in non-European Union countries than are other member states.
Membership of the euro might increase the trade between the UK and other EU countries, and this could reduce the chances of “shocks” affecting the UK differently from other EU countries. On the other hand if increased integration led to greater regional specialisation of economic activity within the EU then regions of the EU could become more susceptible to industry specific “shocks”.
Points to applaud
Let we quote verbatim some of the points made in the document and add my applause to them because they are astonishingly telling.
Para 1.4: “Lack of exchange rate freedom could make the UK cycle more volatile”.
Para 1.5: “It is not safe to assume that the act of joining monetary union would automatically trigger convergence. That depends, for example, on whether the lack of convergence arises from different monetary policies or other factors.”
Para 1.8: “The cyclical divergence is expected to narrow……but is unlikely to disappear”.
Para 1.9: “Output gaps may initially be converging, but this could be temporary”.
Para 1.9: “It is not sufficient for economic conditions to coincide for a short time. It must be clear and demonstrable that our economies can remain sustainably converged.” And then it even adds “we can ask what lessons history provides.”
It then provides the answer to the question:
Para 1.12: “The correlation co-efficients…….show that the timing of the UK economic cycle has been closer to that in the US. For all periods, the US and the UK record high correlation co-efficients, consistent with relatively synchronised economic cycles, while in both the latest UK and international cycles there was little or no correlation between UK and German growth.”
These observations from the Government’s own document amount to massive obstacles to joining the euro. They strongly make the case that judged by the past the UK economy has usually behaved strikingly differently from other European economies.
The huge problem of the housing market and the Euro
If all this were not enough the marked differences between the UK housing market and the housing market in Europe ought to be sufficient to stop all talk of Britain joining the single currency. This is not necessarily so for all time but it certainly is so now.
The mortgage market in Britain is among the largest in Europe as a percentage of GDP, far higher than in countries like Italy or France. In addition, of course, far more people in Britain own their homes than in many European countries. But the important difference is that only 7% of UK mortgages are fixed for longer than five years. UK borrowers overwhelmingly favour variable rate mortgages whereas fixed rate mortgages are the norm in Europe.
The important consequence of Britain’s reliance on variable rate mortgages is that the UK economy is far more sensitive to changes in interest rates than other European countries. Simply put interest rate movements in the UK feed directly into take home pay.
In l997 a committee under the chairmanship of Rupert Pennant-Rae, the former Deputy Governor of the Bank of England, concluded that the UK economy was consequently four times as sensitive to changes in interest rates as the average for European countries. Professor Walter Eltis of Oxford University calculated that two fifths of the entire responses to changes in interest rates by the ECB would be borne by the UK. This is similar to my earlier point about the dangers of joining a labour market with less flexibility than your own. If you are the only flexible economy you are the one who makes the harmful adjustments.
In its l997 assessment the Treasury held out the prospect that a period of low inflation could lead to a shift in borrowing patterns and therefore a move to fixed rate mortgages. All one can say is that after a decade plus of low inflation this has not happened. About 70% of new loans taken out last year were taken out on a traditional variable rate basis.
It would be folly to expect the ECB to dampen down the UK housing market if it were threatening to get out of control. Imagine the problem for the ECB today: British house prices are rising today, German ones are falling. The UK would be one country among thirteen with a GDP weight of about one fifth. Euro interest rates can only be set to deal with euro averages. The risk is that ECB interest rates instead of stabilising the UK would become another source of shocks for the UK.
There is no real convergence
Nevertheless a number of academic institutions such as the South Bank University and the National Institute for Economic and Social Research (NIESR) have made half-hearted attempts to argue that the convergence test has been passed.
The evidence seems profoundly superficial. It is true inflation rates are not far apart as admittedly has been the case for sometime, and the gap between euro and UK interest rates has now come down to only 0.75%. Growth rates are fairly similar but this is largely a case of everyone slowing down and slowing down is not a case of convergence. The gap between unemployment rates remains large.
The UK economy may look more stable but would it continue to be stable if it were to hand over monetary policy to the European Central Bank? Would the exchange rate stability within the EU, although not for other trading partners, come at a price of more volatility in employment growth and inflation, and house prices.
If the UK has come to look more like European economies, that surface convergence has been achieved by strikingly divergent means, particularly by consistently higher interest rates. Britain has often required higher short-term interest rates because of the way in which the UK economy responds to changes in circumstances is different.
People say there is unlikely to be a major economic shock to the UK on the scale of German reunification or financial deregulation. I wonder. History is the continuous story of exceptional events or as Trotsky more sharply put it “History is the natural selection of accidents.”
Who can know on the basis of past experience whether recent developments are permanent or temporary? Will they continue or will they reverse? Is the UK leading or lagging? What we do know is that the structure of the housing market and short-term borrowing has not changed and therefore the much higher sensitivity of the UK to interest rate changes whether from Threadneedle Street or Frankfurt remains as it always has been.
The convergence test cannot be satisfied
It is impossible to see how the Government’s own test of cyclical convergence could ever be “unambiguously” satisfied. I do not myself go as far as Mervyn King, the Deputy Governor of the Bank of England who said that it would take two or three hundred years to offer “any certainty”.
Two or three hundred years would be a tall order. But you surely cannot judge convergence over just one cycle let alone part of a cycle.
“Certainty” may also appear an unreal standard for an issue of this kind. Sometimes one has to take risks on imperfect information. But it is the Government, which, by its words, has committed itself to certainty. The Prime Minister himself and the Chancellor again and again have said they will only recommend entry if the economic evidence is “clear and unambiguous”.
The PM cannot mean what he says
One is driven to the conclusion that the PM cannot possibly mean what he has said. Jack Straw gave a very different version of the five test on Newsnight on the 21st February when he said “If the choice is a very tricky one and there is ambiguity in it, then you will spend time, and of course there is a point where there has to be a political decision. But it is a decision informed by an economic assessment.” That is very different – that is not “clear and unambiguous”. This time it is not the voice of some Treasury civil servant who can be disowned. This is the Foreign Secretary who has blurted out the truth.
Clearly there are huge risks for Britain in joining the euro, and there is no way the evidence in the near future can be “clear and unambiguous”.
The Prime Minister has said it would be folly to refuse to join the euro for political reasons. It would be a much greater folly to do the reverse and for political reasons join the euro regardless of the risks. Many of the political arguments now advanced in favour of British membership of the euro were wheeled out at the time of the ERM, and the economic reasons were seen as less important than the political price to be paid if Britain stayed out. That is where history may be repeating itself. Mr. Blair seems determined to ignore both his own five tests and the lessons of the past.