Should Britain Join the Euro?
Robert Skidelsky
Atlantic College Lecture | Friday, November 20, 1998

I have tried hard to find a humorous way of introducing this subject. I have failed. The Euro does not lend itself to jest. But at least I hope to talk clearly about it and avoid technicalities.
In about six weeks the first Euro notes and coins will become legal tender in eleven EU member states. They will circulate alongside existing national currencies at a fixed rate of exchange before becoming the sole means of payment in those countries in July 2002.
What will they look like? I don’t have any specimens to show you. Not much different I expect from the coins and notes you are all used to, only they will be called euros, not francs, deutschmarks or liras, and will carry uplifting European, rather than national, emblems.
Britain will not be in the first wave of those adopting the euro. It is exercising its option, negotiated at the Treaty of Maastricht in 1992, to delay switching to the euro for an indefinite period. When you go to the Continent you will still have to change your pounds into euros. But once there, you will be able to use the euros in all eleven joining countries. No further queus or losses at money changers. The same euros will buy you a meal in Paris, Milan,or Amsterdam.
The debate here is about whether Britain should join this currency union later or never. The present government says (probably) a little later. The Conservatives say (maybe) a lot later. The Eurosceptics say ‘never’.
I want to talk about both the economic and political implications of joining. But before that let me sketch in a bit of historical background.
I want to start with a proposition which you may find surprising. Two thousand years ago the idea that political frontiers were relevant to trade flows would have seemed absurd. Trade started as global trade. For thousands of years long-distance exchange of goods coexisted with subsistence agriculture and purely local markets.
This was natural. Trade arises from differences in natural advantages. All the things which the rich wanted could not be produced in their own areas, so they bought them from afar with the produce of their own localities. Before the railway age overland transport was very expensive. So the main trade routes exploited cheap river and sea transport, spreading across political jurisdictions, while domestic markets remained localised.
And this had a further surprising consequence: global money came before national money. Global money consisted of gold and silver minted into coins whose value was determined by their weight. Rulers certified the weight of these coins by stamping their heads on them. The rates at which these ‘national’ coins exchanged against each other was determined by their gold or silver content. So when the English merchant sold goods in Venice, receiving gold coins in exchange, he knew exactly how much they would buy him on any point along the trade route. Of course, rulers and merchants cheated by ‘debasing’ –or reducing the gold content –of their coins. So some coins came to be preferred to others for long-distance trade. The most successful international currency of all time was the ‘byzant’, the coins issued by the Byzantine Emperors, which retained their gold content for six centuries, and circulated all over Europe.
Side by side with global money, a multitude of local currencies circulated, accepted as legal tender in local markets. Copper coins are the main example, but anything scarce and durable could serve.
‘National’ currencies only began to circulate widely in the modern era when national markets were unified by political design. What enabled this to happen was the dramatic fall in overland transport costs. But over much of Europe the unification of local currencies into national currencies occurred quite late in the day. It was only in 1850, for example, that Germany achieved a national currency, following on from the Zollverein, or customs union, in 1834. This was part of a sequence –customs union, single currency, political unification, which alarms British eurosceptics today.
Up to the first world war, when the main countries were on the international gold standard, national money simply meant gold and silver coins in domestic circulation, or paper equivalents, which could be converted into gold or silver at a price set by the national mints. The separation of national from international money came only after the first world war, when citizens of Britain and other European countries lost their right to convert paper money into gold. Thereafter national currencies became simply bits of paper or token coins. As their costs of production were negligible, governments could issue as many of them as it wanted.
Till 1971, the issue of national paper currencies was still limited by the agreement of leading nations to keep the exchange values of their paper currencies fixed. A British trader selling goods to France would get paid in francs which he could change into pounds at a fixed rate, so he would know exactly how much domestic currency he would get. He could then tell whether the trade was profitable.
This certainty collapsed when national currencies started to float against each other in the 1970s. Uncertainty about exchange rate movements reduced the attractiveness of selling to foreign markets rather than domestic markets, since firms would not be able to calculate their proceeds.This in turn reduced what economists call allocative efficiency.
The abolition of international money and the inability of governments to restrain the issue of their domestic currencies not only brought about inflationary conditions, but greatly increased the risks of international trade. What was the remedy? Ideally, the solution to both problems might seem to be to abolish national moneys altogether, substituting for them a single global currency which could only be issued by a super central bank freed from political control. But as that was not possible, why not start with a continental-wide money in the European Economic Community, replicating the historical experience of the Zollverein? This was the economic logic leading to the European Monetary Union.
However, it would be wrong to imply that the drive to EMU was simply, or even mainly, an economic project. It may be, as I shall argue later, possible to have a single currency without a political union. But it is impossible –in the modern world – to have a political union without a single currency.
The drive to unify Europe politically dates from after the first world war. It became a concrete project after the second world war; and the first major step towards it was the Treaty of Rome signed in 1957, which looked forward to ‘political union’, of which monetary union was an essential building block. The inspiration behind the project was noble: to banish the possibility of war which had plagued the member states for centuries, most explosively in this century. France and Germany which had fought three wars since 1870 took the lead. The United States, a federal union itself, which had been drawn into both from its comfortable position of isolation, gave the project its backing and was, indeed, anxious that Britain should join from the start. In fact, Britain only signed the Treaty of Rome in 1971.
It is the inter-relation between the economic and political aspects of European Union which gives rise to particular difficulty in this country –much more so than on the Continent. Britain accepts the single market or customs union, but many see a single currency as leading inevitably to a single state, which few people in this country want.
Let me say a brief word about the institutions agreed at the Maastricht Treaty. Monetary policy in the Euro-area will be conducted by a Central Bank (ECB) whose goal is price stability. It will set interest rates for the whole area and decide exchange policy. Fiscal policy remains the prerogative of national governments, within the confines of the ‘stability pact’ which allows a maximum budget deficit of 3% of GDP and sets a target national debt to GDP ratio of 60%.
The task of coordinating national economic policies and keeping the ECB accountable is given to ECOFIN, the Council of Economic and Finance ministers of the member countries, itself accountable to the Council of Ministers.
What are the economic advantages of such a system? It would bring about greater transparency of price differentials within the currency union, thus revealing opportunities for profitable trade. It would remove the huge cost of hedging against exchange risk. This would bring about static and dynamic gains. Prices would fall increasing real income (the static gain). The greater competition in the EU would force force firms to become more innovative in order to survive, thereby increasing long run economic growth (the dynamic gains). And of course to these advantages must be added the benefits to ordinary citizens of not being robbed of their money as they travel round the continent.
If the gains from abolishing national currencies are so great, why do the British still cling so obstinately to their pound? The answer is twofold. First, we are very reluctant to give up what we call monetary sovereignty, the right to issue as much of our own money as domestic circumstances require. Notice that this was not regarded as an aspect of svereignty under the gold standard. Governments or central banks of countries on the gold standard did not claim the freedom to issue as much domestic money as they wanted, since the amount of money they could issue was a fixed proportion of their gold stocks. This was necessary to preserve the convertibility of domestic currency into global currency (gold). Under the gold standard there was no ‘transfer’ of monetary sovereignty from a national to a supranational central bank. Rather all countries agreed on a rule to limit the issue of domestic money. You may say they chose not to exercise sovereignty in the monetary sphere. Britain, the most powerful nation in the world in 1900, did not ‘control’ its monetary policy. But no one else did either. This is a big difference from the European ‘single’ currency which will be issued by a European Central Bank.
National monetary sovereignty started to be emphasised after the first world war when the conflict between external balance under the gold standard and domestic social policy came into prominence. Today national monetary independence is seen as part of national economic management- the ability, for example, to pursue full employment policies even if no one else does, or to ‘choose’ a rate of inflation which suits our institutions. This requires that we should have the freedom to set our own interest and exchange rates –something we would be denied if we became part of the single currency zone.
The second reason is political: many people in Britain regard the single currency as a stalking horse for political union –setting up a European federal state, with its own President and government. This prospect does not appal many Europeans whose own constitutions have been changed many times, which have experienced all kinds of federal arrangements going back to the Holy Roman Empire, and many of whose own nation states are recent creations with a less than glorious history. Britain is not only an exceptionally ancient nation state, but one whose constitution is built on the notion of parliamentary sovereignty.
Let me consider the economic and political aspects of euro-building in turn. The fundamental economic argument for retaining economic sovereignty within a political jurisdiction is based on the notion that different countries may suffer different shocks at different times, and must therefore retain freedom to use national instruments to overcome them. For example, it is often claimed that our business cycle is ‘out of phase’ with that of the Continent, so that we boom while they bust, and vice versa. The same monetary treatment of these different diseases would be like a doctor using the same medicine to treat fevers and chills.
This problem of ‘single country shocks’ has given rise to a huge literature on ‘optimal currency areas’ – roughly, areas in which the existence of a single currency would not impose intolerable strains on any of the participant regions or countries. The main conclusion of this literature is that the benefits of having a single currency dominate the costs if the following three conditions are satisfied:
*Trade shocks which affect all countries in the single currency area predominate over those which affect countries separately –in the jargon if they are symmetrical across countries.
*Labour markets are flexible and/or labour mobility throughout the common area is high.
*There is an established and accepted system of fiscal transfers, which can stimulate demand in countries affected by trade shocks.
Notice that a currency union may work reasonably well if any one of these conditions applies, but not if all three are absent. For example if wages and prices are perfectly flexible throughout the union you don’t need fiscal transfers. Alternatively, if all shocks were perfectly symmetrical you don’t need labour mobility, and so on.
Is Britain part of an Optimal Currency Area? The answer is ‘probably not’. Its share of trade with the United States and dependence on oil and financial services for exports is disproportionately large, so its business cycle tends not to be closely synchronised with that of the core euro countries, who trade much more with each other. Secondly, even after decades of labour market reforms, UK labour mobility is low and nominal wages still relatively inflexible. Finally, the present EU budget is certainly not large enough to support demand-stimulating fiscal transfers in response to country-specific shocks.
However, this may not matter that much. Typically, single currency areas (eg nation states) have large central government budgets capable of redistributing expenditure internally. The crucial difference between the EMU and the USA is that the member states will continue to raise practically all of their revenue domestically. There is no fiscal transfer mechanism across the union; but by the same token individual states will have ample scope for fiscal stimulation, even within the restrictive terms of the Maastricht Treaty. If member state governments run budget surpluses of 3% of GDP a year in good years, they will have room for a 6% injection of demand in downturns –which is a great deal.
A further point worth noting is that the single currency itself will tend to promote convergence of consumer tastes and production patterns across the currency area thus actually creating an optimal currency area over time. For example, the United States was probably not an optimal currency area when the country first came into being.
The other side of the coin is that the monetary independence which Britain will preserve by staying out is largely illusory. Since Britain conducts most of its trade with the Euro area, and capital is mobile , it could be subject to highly destabilising hot money flows, if interest rates between the two currency areas diverged.
If Britain deliberately depreciated the pound against the euro in order to gain a competitive advantage, it would be risking a first class row with the EMU, whose consequences would be difficult to predict. One might be long-term exclusion from the EMU. The Commission has made it clear that it expects currencies of member states which remain outside the euro zone to have fixed rates of exchange with the euro. So the likelihood is that the pound would closely shadow the euro throughout the period in which Britain remains outside.
If Britain is constrained to run the same interest rate policy as that of the euro zone and fix the sterling-euro rate, the national sovereignty arguments for not joining the single currency become much weaker.
On balance then the economic arguments for Britain joing the EMU, taken in isolation, seem strong. We gain no obvious advantages by staying out; and we gain considerable benefits by going in. The political implications of going in are rather more worrying.
A frequently used argument against Britain ever joining is that monetary union necessarily leads to political union. Since this is not what most people in Britain want, then it should never join. However, two points need to be made.
The connection between currency union and political union is not a necessary one, since there is no logical contradiction between the ECB running a monetary policy while leaving all other policy choices to national governments, within the constraints of Maastricht. It is wrong to argue, as eurosceptics do, that monetary union cannot work without political union. The history of the gold standard gives the lie to this proposition.
But it is also true that the move to a single currency will increase the political pressure for political union. The main reason is the so-called ‘democratic deficit’. The ECB derives its price stability mandate from the states which signed the Maastricht Treaty.It cannot be removed except by a new treaty. That mandate reflected the view, more common in the early 1990s than perhaps it is today, that central banks should be independent of political control. But in the modern world such independence is bound to be qualified. But there exists no European polity which can, when the occasion arises, override the independence of the central bank – as say the German government did when the Bundesbank disagreed with it about the economic arrangements for reunification.Already there is a move by the centre-left governments of France and Germany to weaken the Bank’s mandate by adding full employment to the its price stability objective. But the ECB is under no obligation to comply. So, the argument goes, there must be a popularly elected European government which can, if necessary, give orders to the ECB.
Apart from the single currency, other pressures are driving the European Union towards political unification. At present the Union has a civil service (the Commission), an independent central bank, a weak, indirectly elected Parliament and a Council of Ministers which, apart from qualified majority voting in certain areas, remains an intergovernmental institution. The Brussels bureaucracy is the main source of what is felt to be increasingly intrusive social and economic directives The demand for a supranational top tier to control bureaucratic logic will almost certainly gather momentum.
It will be very hard for Britain to resist this. After all it is widely accepted that the Council of Ministers and European Parliament cannot exercise ‘democratic’ supervision over the Brussels officials. Britain –as indeed other member states – are left with their veto powers. But for how long will a nation be able to live in a Community in which it constantly has to use its veto to prevent things from happening which most other members wish to happen? For how long will other members tolerate its presence? At one time Britain was thought to be essential to European Union. I doubt whether this feeling is nearly as widely shared today.
I have reached the frontier of a debate which is much wider than that concerning future currency arrangements taken in isolation. The two fundamental questions which need to be answered are: does Britain want to be part of a Union which is heading inexorably, as it seems, towards political unification? And if not, can arrangements be worked out whereby it would retain its membership of the single market –which may include joining the euro zone –while avoiding having to commit itself to a European state? At this point the debate becomes a historic one, and here I will leave it.