Keep floating, stop worrying

The real case for an independent pound has nothing to do with ultra-nationalism or hostility to Europe, writes Samuel Brittan

Published: March 27 2002 20:54 | Last Updated: March 27 2002 21:06

The opponents of Britain's joining the euro at an early date are in danger of shooting themselves in the foot by their generalised hostility to continental Europe. The case I wish to make is is a positive one, not against the euro - still less against the European Union - but in favour of a floating exchange rate, which the UK now enjoys and could not have inside the euro.

A fixed rate of exchange produces two problems. The first is the threat of a balance of payments crisis and runs on the currency. It should in all fairness be said that this threat is removed either by a floating exchange rate or by membership of the European Monetary Union. There cannot be a run on the pound if it no longer exists.

But there is a second problem, which would not be removed by joining the euro. That is the possibility of unemployment owing to money wages that make British goods uncompetitive compared with those of other countries. An exchange rate adjustment to reduce them is no more possible in the eurozone than it would be now for Yorkshire or Lancashire.

The foreign exchange crises that bedevilled British economic management throughout the 1940s, 50s, 60s and 70s are legendary. The last of the sterling crises, the "IMF" one of 1976, took place when sterling was already floating. In retrospect, this was an unnecessary crisis, owing to the fact that policymakers had insufficient experience of floating rates.

Today the wide divergence of views, both on whether the dollar is overvalued and on the rate at which Britain could safely enter the euro, shows how unsure we are of the correct exchange rate. Many of the business people who say they want Britain to join the euro really mean that they want a lower sterling exchange rate. Euro-enthusiasts hope that the announcement of an early euro referendum would soon bring down sterling with a bang. But supposing that it does not? Voters would have to decide on the basis of an entry rate still to be negotiated with Britain's European partners.

The matter is worse than this. Suppose that Britain were able to negotiate a euro entry rate 5 or 10 per cent below the present market one. There is a common belief that the euro is undervalued. What if the euro itself subsequently staged a vigorous recovery against the dollar? The result could be a net appreciation of sterling.

The only way of restoring the competitive position of British industry would then be several years of near-zero increases in nominal wages in the trading sector. There is of course no way of avoiding necessary adjustments in real wages. But there is all the difference in the world between reducing them indirectly via the exchange rate backdoor and reducing money wages - as Winston Churchill discovered in the 1926 General Strike.

A floating exchange rate was one of the first causes that I espoused as an economic journalist. Why then did I suspend my belief? The answer is of general and not just autobiographical interest. It began in the 1980s when the Thatcher government was trying to follow a monetary approach to reducing inflation but was thrown off course by divergent movements of different measures of money, none of which appeared to reflect underlying conditions. It then seemed tempting to hitch sterling to the D-Mark via the Exchange Rate Mechanism and thus to borrow the Bundesbank's credibility. This was a strategy that was already being used by France.

At the time the only contending policy targets were for the money supply and the exchange rate. The inflation target had not been invented. It was introduced in New Zealand in 1990 and in Britain only when the country was forced out of the ERM at the end of 1992. It turned out more successful than many of us thought it would be. Although I still do not think it is the last word, it has so far beaten all contenders.

Even after 1992 there was a remaining attraction in joining the looming euro: it seemed the only feasible route to an independent central bank. The surprise establishment and subsequent success of the Bank of England's monetary policy committee by the incoming Labour government deprived me of the second argument; and since then I have drifted back into the floating exchange rate camp.

This was brought home to me by the recent Venice press seminar organised every year by the Italian embassy in London with corporate support. There was a session on the subject of left-right differences. The advent of Silvio Berlusconi spared us the routine denunciations of Margaret Thatcher and Ronald Reagan; and several of us argued that the terms now mainly stood for rival tribes. But at this point there was a revolt by some British journalists who insisted that there was still a leftwing agenda to be enacted in terms of public spending, union rights and so on.

Some of those who spoke regretted that globalisation ruled out an old left agenda. This was wrong. Globalisation is an excuse. A country inside the euro, such as Italy, has indeed to be careful about anything that risks increasing labour costs further. But there is nothing to stop a country such as Britain, which is still outside, from taking these risks, knowing that sterling can take the strain. The argument against the old left agenda is that the electorate will not wear it or that in practice it has proved counterproductive. The issue should not be pre-empted by arbitrary currency mechanisms.

The argument does not apply only to the left. There are various ideas on the centre and right, such as a payroll tax to pay for an expanded health service. Two weeks ago I argued for an earmarked value added tax instead. But there is still no reason why the payroll alternative should be ruled out. Or suppose that there were a serious move to tax energy. Such policies should not be made impossible by the exchange rate regime.

Most of those who spoke for the left in Venice pinned their hopes on a European federal structure that could promote their desired social model across the continent. But this is many moons away; and any policy experiment would be hazardous without the exchange rate safety valve.

There has been an inconclusive debate on what is an optimum currency area. The practical answer is that it is the area covered by whatever political authority is responsible for decisions affecting costs and profitability. This is still individual governments. By all means let the British government encourage people to use the euro as a parallel currency - but there is no early benefit in throwing away the advantages of the floating pound and MPC regime.