Sunday, December 14, 2008
Wrong time to reach for the euro lifeline
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Ever since Jose Manuel Barroso set the ball rolling earlier this month, it has been nagging away at me.

Could Gordon Brown, having abandoned his own fiscal rules, embraced bank nationalisation in a way that echoed the 1945-51 Labour government and announced a rise in the top rate of tax, produce the biggest u-turn of all? Could he, and you may want to sit down at this point, take Britain into the euro?

Euro entry is an issue that was once very hot but went into the deep freeze. In 2003 it was the biggest story in town, Brown and Tony Blair wrestling over whether to take Britain in. If it is of any comfort, the day will come when we look back on the credit crunch in a similar vein.

Until the European Commission president's remarks I had thought euro entry remained in the freezer. He said, to remind you, Britain was "closer than ever before" to joining, that "the people who matter" were thinking about it, and that those same people were also saying, "If we had the euro, we would have been better off".

It would be easy to dismiss this as simply reflecting a high-profile transfer from Brussels to London. Lord Mandelson has made no secret of his enthusiasm for sterling to take what he sees as its rightful place in the euro. He is close to Barroso, so you don't need to be a Maigret to work it out.

Last week's intervention by Peer Steinbrück, the German finance minister, will not have warmed anybody in government to Europe. There is plenty to criticise about UK policy and our soaring borrowing. But his attack, in an interview with Newsweek, was pretty lame.

The pre-budget report cut in Vat he attacked is trivial and temporary in the context of Britain's deteriorating public finances. For a finance minister to be asking whether people will buy a DVD player because it costs £39.10 rather than £39.90 shows he does not know how tax cuts work. Any cut, whether Vat, income tax or corporation tax, is small in its microeconomic impact but cumulatively can add up to a significant macro effect.

Steinbrück also misunderstands "supply-side" economics, which he said had been replaced by "crass Keynesianism". What he means, I think, is fiscal prudence. Such prudence, as we saw in Brown's early days, came alongside the higher taxes and red tape that harmed Britain's supply-side.

Actually, there is quite a lot of misinformation around, some of which has contributed to the pound's fall against the euro. Sterling traders in London don't need much excuse to sell the currency. For years it was their default position. Then the pound enjoyed a run of stability from 1996 to 2007, and the euro became the pariah currency. Now they are back in familiar territory.

There was, it should be said, a logical, credit-crisis-related reason for sterling to fall over the past year. Until summer 2007 capital flooded into Britain either because foreign companies were taking over UK firms or, more important, because some of the surplus savings from other parts of the world flowed into the City. Without these capital flows, the counterpart to which was a large current-account deficit, a lower pound has to be one of the routes to making the balance of payments balance.

As always, though, the markets take these adjustments too far. A caricature view is that Britain is worse off than the eurozone because of the importance of financial services to the UK economy.

But, as economists at Goldman Sachs point out, this importance is usually exaggerated. Financial services make up 8% of the UK economy, just over half the size of the manufacturing sector. It is bigger than the eurozone average of 5% but smaller than America (just over 8%) or Switzerland (nearly 9%).

Meanwhile, despite some awful UK manufacturing data last week, down 4.9% on a year ago, this was smaller than the eurozone's 5.3% fall. Germany's Ifo Institute predicts a 2.2% GDP fall for its economy next year, and a 0.2% drop in 2010.

Another bit of the caricature is that Britain's indebted households, government and company sector are in hock to the rest of the world, while Britain's banks have built up a reliance on international wholesale markets of Icelandic proportions.

The truth is that UK debt, whether owed by people, businesses or the chancellor, is overwhelmingly domestic. UK savers, directly or indirectly, lend the lion's share of money to UK borrowers.

UK-owned banks do have foreign current liabilities, but at £1,300 billion these are some 90% of gross domestic product, compared with about 220% of GDP in Switzerland and nearly 700% of GDP in Iceland.

Overall, since 1995 Britain has had net foreign liabilities — foreign-owned assets in Britain being worth more than UK assets abroad. Curiously, Britain still earns more income on those foreign assets than foreigners do on their UK holdings.

The latest figures for those net foreign liabilities, £309 billion, or about 20% of GDP, show a fall of about £100 billion over 12 months. This is not a huge imbalance. A side effect of the pound's fall, by increasing the sterling value of overseas assets, will be to reduce net liabilities further.

The oddest thing about the sterling story is that it stems from the idea that Britain will have a worse recession than the eurozone. Europe entered the recession with an over-strong currency and a central bank cautious about cutting rates. Britain has a weak currency and lower rates. I know which I prefer and it is why most economists think Britain will bounce back more quickly than euroland.

The recession, moreover, will expose divisions and disparities within the eurozone. Sterling will also bounce back — it is 11% below its 10 and 30-year averages against the dollar and about 15% below fair value against the euro — but for the moment its weakness is useful.

So what about that question of euro entry? Paul Mortimer-Lee, head of market economics at BNP Paribas, a French bank, has no eurosceptical axe to grind. He argues that, not only would Britain's problems have been worse had we been in the euro (think how much more powerful the housing boom would have been with interest rates significantly lower), but that this is just about the worst time to think about joining.

I agree. Britain tends to turn to Europe at times of trouble, with disastrous consequences. Entering the exchange-rate mechanism in 1990, as recession was under way, made a bad situation much worse. The same applies to the euro now.

For those who missed Brown's interview with Sir Alan Sugar in The Sun last week, the prime minister's response on the question of euro entry was "No, no, no" for "this year, next year and beyond". Euro entry should remain in the freezer. I suspect it will.

PS: It has been a statistical curiosity that until the third quarter of this year Britain had been through its longest continuous expansion on record, with GDP growing every quarter since the spring of 1992, 63 in all.

Now Andrew Sentance, a member of the Bank of England's monetary policy committee, has disputed that in a speech a few days ago. He has a more robust definition of recession, an outright fall in GDP one year to the next. On this basis, the "golden age", 1948-73, a 26-year expansion, was the longest. There were a few two-quarter "technical" recessions during that period but Sentance does not think they count.

So this beats what he describes as the 16-year expansion since 1992 (or should it be 17?), which will formally come to an end when GDP falls next year. Third longest, interestingly enough, was the upturn that began in 1932 and lasted until 1943, continuing through even the Battle of Britain and the Blitz.

From The Sunday Times, December 14 2008