This is no time for us to join euro

Anthony Hilton
16 Dec 2008

People seem to be getting quite worked up over the idea that the British Government might be thinking once again about joining the euro. Several London-based economists suggested that the collapse in sterling made it look an opportune time to apply, and EU President José Manuel Barroso really set the hare running with a few well-timed comments. Plus the fact that, with a global financial crisis raging, it may seem like a good time to find shelter in a larger currency bloc.

But, as often happens, the debate seems to be all about the wrong issue. Whether or not you think Britain should be part of the single currency in the longer term, this is not the time to apply. Britain is likely to be among the worst-affected economies in the current downturn because of the importance of a very troubled, and likely to be much-diminished, banking sector in our economy and because of the high level of personal indebtedness.

The rapid fall in sterling is one of the good things to happen in that it speeds up the process of re-adjustment, in effect making us poorer in relation to the rest of the world but better able to rebuild our economy through what are now much cheaper exports. Members of the euro do not have the freedom to use the exchange rate to facilitate re-adjustment - witness the current difficulties of Spain and Italy.

The real debate about the euro is not whether we should be joining but whether it can hold together through this crisis. There is an intrinsic contradiction in having a monetary union without a political union - and indeed logically and economically the political union should come first. The absence of political union does not matter particularly in good times because each member country can grow more prosperous but it comes to the fore in bad times when one nation is seen to be suffering much more than another, and when the readjustment through deflation and unemployment seems to fall more heavily on one or two nations rather than across the bloc. Thus it has always been said that the real test of the euro would come in bad times.

This is the first really bad time. There was one after the bursting of the dot-com bubble in 2001, but it hit Germany much harder than anyone else and, as Germany is the arch-supporter of the euro and the strongest member nation, it was not an issue.

This time though, it is different. There is a major north-south split in the eurozone with Spain, Italy and Greece with economies that are in trouble and badly in need of lower interest and exchange rates. Spain, after 40 years as a European outcast under Franco, is probably politically committed to staying within the euro bloc regardless of the cost, but one does have to wonder if this is also the case with Italy.

If it still had its own currency, outside economists reckon the necessary devaluation would be of the order of 30%. The alternative process of adjustment, given that devaluation is not an option, is massive internal deflation. One has to wonder whether the Italian state, with its deepening north-south divide, could take the strain. It may be a more politically attractive (and economically literate) option to quit the euro. Prime Minister Silvio Berlusconi is the sort of politician who might just make that kind of call.

This is not likely - but the chances of Italy leaving seem every bit as high as the chances of the UK joining, and that certainly would be the way to bet but for one thing. Having sold our gold reserves at the bottom of the market, timing would appear not to be the Prime Minister's strong suit. It would be typically British to apply to join the club just when the others are thinking of leaving.

Grim logic of the new Gresham's

Gresham's Law, formulated by Sir Thomas Gresham not far off 500 years ago, postulates that bad money drives out good. He lived in an age where the coin of the realm actually was made of silver to the face value of the coin concerned. It was vulnerable to clipping, where people would shave off some of the silver but still try to pass off the coin as genuine. As a practice it gradually became so widespread there were no unclipped coins left — the bad money had driven out the good.

Much the same is happening today.

Banks withdraw support from sound companies because they need to conserve their capital to shore up their losses elsewhere. Hedge funds sell their good investments in liquid markets and drive those prices much lower because they cannot get anyone to take their rubbish. Property funds sell their choice properties at a discount because nothing else will sell at all. Investors in emerging markets find Russia closed so sell Brazil instead, thereby undermining that country.
Unfortunately, the logic is that this continues until there is no good money left — only then does the “bad money” find its fair value.