British Monetary Policy vis--vis Euro-Zone - Term Paper Example

Running Head: British Monetary Policy vis-à-vis Euro-Zone British Monetary Policy vis-à-vis Euro-Zone s Britain’s Monetary Background A long history of a national currency, for an extensive period well managed, created a tendency to consider change as superfluous. For this reason ‘Britain remained detached from the 1867 International Monetary Conference’s bid for a world currency’ (Cottrell, 1992). In contrast, a decade ago the most recent half-century looked very much less laudable. The pound sterling that would be abandoned with euro membership, created as a definite weight of silver of a specified fineness, possibly as early as the 8th century, and indeed by the 11th. In the 19th century peak British currency was actually defined in terms of gold. Giving up the precious metal link after 1945 relaxed the constraint on monetary policy and the floating sterling exchange rate that followed provided even less discipline. With the discarding of any precious metal support, dependence in sterling and monetary policy after the Second World War was reflected in the foreign exchange value, which fell from $4.03 to $1.70 by 1976, while inflation climaxed at an annual rate of 26.9%. Different tactics to create monetary stability have been tried since 1945, including shadow the Deutschmark and monetary targeting. Paradoxically one of the greater political dishonours for sterling, being forced out of the European Exchange Rate Mechanism in 1992, marked the beginning of the present union of the British economy to a stable non-inflationary growth path. The turn around in post war British economic policy began with Margaret Thatcher’s government, elected in 1979. In addition to a series of monetary policy experiments, a variety of structural reforms in the economy were begun, including privatisation and steps to increase labour market flexibility. Inflation receded along with unemployment and economic development resumed. Election of the ‘New Labour’ government of 1997 saw no break in the principles of national economic management. It created an independent Monetary Policy Committee instructed to follow a uniform inflation rule and to report their deliberations. These arrangements eventually are usually judged to provide best practice monetary policy. For example synchronization between independent monetary and fiscal policies is far easier for Britain under the present arrangements than for Euro-zone with its many national taxing and spending policies. Not only is the monetary policy strategy and inflation target of the European Central Bank (ECB) censured for being poor and possibly damaging to the ECBs credibility. For the better management of the nation’s finances the Chancellor of the Exchequer introduced the long belated distinction between capital and current account spending. Borrowing to improve the nation’s useful capital was acceptable, as was temporary borrowing to stabilise the economy in the face of shocks. To ensure government debt increases were restricted to these two purposes, he accepted two obligations on government policy; that existing account spending should balance tax receipts over the cycle and that the government debt to national income ratio should not exceed 40 %. These improvements in the British macroeconomic management structure are important and definitely superior to the present equivalent institutions of the euro-zone, the European Central Bank and the Growth and Stability Pact. The government now needs to make comparable progress in the fields of the health service, education and transport, about which there is general displeasure among the electorate. In these services there is much to be learned from other European countries nevertheless joining the euro and possible resulting closer political integration with Europe do not guarantee to deal with British concerns. European Integration What Britain has in fact wanted from the rest of Europe is simply free trade, not imported institutions intended to manage continental problems. The first institution of the present phase of European integration was the European Iron and Steel Community. This proved a useful method of depoliticising conflict over iron ore and coal deposits that had employed France and Germany over the last seventy years. Nevertheless it was just unrelated to the British coal and steel industries that were quite independent of the industrial belt of the Ruhr, Belgium and Northern France. Economic geography ensured that there was no economic case for British participation in laying this particular historical ghost (For example Foreman-Peck and Federico, 1999). British trade connections and investment were considerably intercontinental in the nineteenth century; Britain’s largest trading partners were the United States and India in the 1850s, and by the end of the century the majority of British emigrants were heading for Australasia. These loyalties formed by these relationships almost certainly created difficulties for Britain in accepting the higher trade barrier consequences of the common external tariff agenda favored by the 1955 Spaak Committee. Britain logically supported a free trade area that would not have these effects, rather than a customs union. So she did not sign up to the Treaty of Rome in 1957, and formed instead the European Free Trade Area, with Sweden among others, as an interim institution. The Common Agricultural Policy (CAP), another legacy of history at the heart of the European Union, for some time proved objectionable to Britain. Britain industrialized earlier than the rest of Europe, became greatly urbanized by the middle of the nineteenth century and committed to free trade liberalism. As a result the agricultural sector was allowed to contract, in striking contrast to France and Germany. These countries resisted the invasion of cheap ‘New World’ produce with higher tariff barriers (For example Tracy, 1989). Britain had a small highly resourceful agricultural sector by the 1950s. France and Germany still engaged large numbers of people in low productivity agriculture. The CAP, intended to keep up food prices to protect the agricultural sector, would be particularly expensive for Britain as a net food importer. Reform, announced in June 2003, did not cut the financial cost of the policy although merely reduce the damage both in terms of unwanted production and to the rest of the world, by way of preparation for the forthcoming World Trade Organization negotiations. The Politics of European Monetary Union Monetary union is an answer to a Franco-German political problem rather than a selfless device for promoting the economic interests of Europe as a whole. The euro is only one means of achieving the greater exchange rate stability sought by those concerned to advance European integration. Greater harmonization within the Exchange Rate Mechanism framework could have delivered the same, and was in fact considered for this purpose. ‘Monetary union was chosen instead as part of a Franco-German deal over German re-unification. The Deutschmark was traded in for a unified state. This large, united Germany needed to be acceptable to France, and monetary union was the price charged by the French government’ (Levitt and Lord, 2000). Basically the French felt they had been obliged to comply the Bundesbank’s monetary policies. However they lacked any influence over the Bundesbank’s constitution or behaviour, directed mainly to domestic German objectives. Monetary union would bring to an end German leadership in a major area of policy and give France more control. Despite Bundesbank and popular opposition, the German government was prepared to make this concession since the Franco-German relationship was a top priority. France also wanted a wide monetary union to provide counterweights to the Germans. Since politics led economics, ‘optimum currency area’ arguments that suggested a smaller zone- of the type originally favored by the Bundesbank, consisting of France, West Germany and Benelux- were disregarded. Pressure that would be applied by monetary union for fiscal coordination and greater European fiscal powers was welcome. Such extension of economic powers would need more European government. As far as France was concerned, political union was also necessary for one of her major concerns i.e. German foreign policy transparency. Again, European economics was a tool of European politics. Britain’s in fact less than categorical historical commitment to European integration then should not be understood as mere obstruction. The hand dealt by economic history is different for Britain than for the core countries. Where monetary union is concerned this is also true. Besides the monetary institutions established recently, financial development over centuries has made Britain notably different from France and Germany and to overlook the legacy of history would be both costly and superfluous. Almost certainly such national or regional differences will be relevant to some other European countries too. Britain Joining Euro-Zone: An Introduction The biggest question now facing Britain is whether or not to join the euro. Many people say they would like more information before making up their minds. Moreover the Government itself, though in support of joining, has still to decide on when to propose entry. Therefore the aim of this paper is to elucidate the economic issues to articulate what really matters and what matters less or not at all. As in all decisions, there are pros and cons, and this paper try to set them out clearly. It is true that joining the euro-zone would increase British incomes and thus her standard of living. In 1956 Britain decided not to join the European Common Market. In the following years those in France and Germany overtook her living standards as they gained from the extra efficiencies derived from their access to a larger market. Those countries have now got the same output per hour worked as in the United States, and that is why they can afford hospitals, railways and schools that Britain can only aspire to. However finally in 1973 she too joined the European Common Market and soon after that her relative waning stopped. Nevertheless, in spite of 20 years of economic reform, Britain has failed to reduce the productivity gap with France and Germany. Furthermore now the countries of Europe have taken one more step towards making a really unified market, using only one currency. If again Britain delay joining, she again risks losing further. Britain could no longer set her own currency rates, which means that she would have to depend more on the budget to cushion her economy against economic shocks. Opponents have set out their case in a lengthy pamphlet and Britain shall deal seriously. (Bush, 2001). Before turning to the arguments opponents outline at the moment, Britain cannot desist from one general comment on the arguments they have used in the past. At each stage the opponents of the euro have forecast disasters which have actually never happened and which always looked most improbable. First, they predicted the euro would never get off the ground (Congdon, 1996; Wolf, 1993). Nevertheless it was wrong assumption. Then they predict a major exchange rate predicament in the run-up to January 1999 when the euro was due to begin. However there was no crisis, despite massive turbulence in other world financial markets in autumn 1998. Then they claimed the euro would rapidly break up (Healey, 1999; Eltis, 1998) and that there would be disorder and popular revolt when the notes and coins were introduced in January 2002 (Daily Mail, 28 December 2001. Nevertheless there was no failure and no chaos. Furthermore, directly applicable to the present British debate, they forecast disaster in Ireland, Netherlands and Portugal on the grounds that an inappropriate currency rate would produce intolerable overheating. In 2000 for instance, Patrick Minford, one of the most well-known economists opposed to the euro, forecast that “in Ireland prices could rise 10% a year for two or three years”(Minford, 2000.) However in 2001 inflation in Ireland was 4%. In other words the Euro-skeptics frequently misjudged the competency of the Europeans and their ability to organize things properly (Layard et al, 2002). However, wrong predictions in the past cannot be the main method of measuring current arguments about the future. Now this paper shall for that reason consider the arguments with the pros and cons. Britain Joining Euro-zone: An Analysis The Pros of Joining To improve living standards Britain needs to belong to a large unified market, such as exists in the United States. This will enable business to sell more far and wide and to realize the massive economies of scale enjoyed in the US. It will also enable families and businesses to buy from a wider, and hence cheaper, range of suppliers. That is why Britain first joined the Common Market, which abolished tariffs on trade, and why then under Mrs Thatcher Britain helped to create the European Single Market, in which other, non-tariff trade barriers are prohibited. Europe by far Britain’s Largest Market Europe takes half Britain’s trade, compared to only 16% with the US. Nevertheless Europe is only now becoming a ‘single’ unified market such as exists in the US. The European Single Market program, pushed by Margaret Thatcher, has helped to remove non-tariff barriers between European countries. However until recently there remained separate currencies, which acted as a major obstacle to trade. A single market needs to have a single currency Presently any British company exporting to the Continent has no initiative what the sterling/euro exchange rate will be in the future. Consequently it cannot tell at all precisely what profits or losses might result from expanding its trading activities in Europe. This ‘exchange-rate risk’ is a major deterrent to trade and invest for the purpose of exporting to the Continent. In this regard Britain is now in a worse situation than it was before 1999. Up to the start of the euro any company outside say, Germany that wanted to sell into Germany faced an exchange rate risk - whether it was located in Britain, France or Italy. At present companies in France and Italy face no exchange rate risk when they trade with Germany although those in Britain do. Therefore since 1998 companies wanting to sell into the huge continental market have ever more invested inside the euro-zone since they can thus build up their costs and revenues in the same currency. Since then trade between countries in the euro-zone has increased 20% faster than GDP, while trade between Britain and the Continent has been inoperative compared with GDP. Britain’s thus to avoid this loss of business is to join the euro. Damaging fluctuations in exchange rates increase Britain has already seen the effect of this in the strength of the pound from 1998-2002, which harms many exporting and import-competing companies. A separate currency will become increasing difficulties for a medium-sized country such as Britain, which is too reliant on international trade to be able to disregard its exchange rate in the way the US can. Thus Britain caught between two large currency blocs, the only predictable thing about sterling is that it is likely to head off in unpredictable directions. Thus by joining the euro Britain protects itself against the dangers of these damaging fluctuations. The issue of Influence Joining the Euro does not imply tax harmonization, and will not increase the powers of the European Union to pass laws affecting Britain. Such powers already exist whether or not Britain joins the euro-zone. However Britain will be better able to influence how those powers are used if she is represented at the regular meetings of ministers from the euro-countries. Representation in the European Central Bank will also give Britain more influence over the European business cycle, which is so important to British affluence and well being. By joining the euro and so becoming a full member of the European club, Britain’s influence outside Europe would also be greater. Cons of Joining One possible argument against joining the euro would be if it were a noticeably unstable currency, so that Britain terms of trade would become unstable by joining it than by staying clear. The No campaign argues that Britain would actually increase her currency risk by joining the euro. They say this is because the euro will still be floating against the dollar and the yen, and earlier experience shows that the Deutschmark (DM) often fluctuated quite sharply against the dollar. To make their point, the No campaign compare the fluctuations in British trade-weighted exchange rate with the fluctuations in the dollar value of the DM. According to them it “shows very clearly that we have been able to enjoy less volatility in our overall exchange rate by tying to neither of the two big regional currencies”(Bush, p.21). The No campaign sometimes argues, focus on the currency in which the trade is invoiced rather than the currency of the country where Britain is selling. Some 44% of British trade is invoiced in sterling, 32% in dollars and only 20% in euros. Therefore, the argument goes, if Britain wants to reduce exchange risk, she should join the dollar. Finally, the No campaign argues that Britain is more outward looking than the rest of Europe. This is wrong to suggest. There are wide disparities within Europe, and six euro-zone countries, including Germany, trade more of their GDP outside the EU than Britain does. Conclusions Thus for Britain the euro poses both an opportunity and a threat. It is crucial to consider the question of British entry in the “real world” context, where Britain now lives next door to a large and expanding euro-zone bloc. Too much of the debate is devoted to static analysis, or to hankering after an old status quo in which the euro had not been invented. That option is no longer on offer. The euro exists, and Britain has to live inside it or outside it. Either is risky; but the superficially “safer” route of staying outside until the arguments for joining are beyond dispute is the riskier of the two. By joining, Britain can have higher productivity and better living standards. If we stay out, the dangers of falling further behind the core of Europe will steadily increase. Bibliography Bush, J (ed) 2001, The Economic Case against the Euro, New Europe Research Trust. Congdon, T 1996, Retailing Supermarketing, 8 November. Cottrell, PL 1992, ‘Silver Gold and the International Monetary Order 1851-96’ In S N Broadberry and NFR Crafts Ed Britain in the International Economy 1870-1939 Cambridge. Daily Mail, “Holidaymakers will face chaos when they go to the Continent as shops and businesses battle to get used to the Euro from January 1st”. 28 December 2001. Eltis, W 1998, International Risk Management, 2 September. Foreman-Peck, J and Federico, G (eds) 1999, European Industrial Policy: The Twentieth Century Experience, Oxford, ch 15. Healey, D 1999, Daily Telegraph, 1 March. Layard, R, Buiter, W, Huhne, C, Hutton, W, Kenen, P & Turner, Adair 2002, Why Britain Should Join The Euro, RL334D. Levitt, M and Lord, C 2000, The Political Economy of European Monetary Union, Macmillan. Minford, P. Daily Telegraph, 21 August 2000. Tracy, M 1989, Government and Agriculture in Western Europe 1880-1988, Harvester. Wolf, M 1993, Financial Times, 25 August. Read More