Britain Should Join The Eurozone

Written by Chris Huhne MEP and published in the Wall Street Journal on Fri 6th Jun 2003

Britain's europhobes are nothing if not inventive. When their argument flags, they are quite up to adding a little ginger and spice. Not only -- they argue -- would the euro be bad for Britain, but Britain would be bad for the euro. Neither proposition is right, which is why Chancellor of the Exchequer Gordon Brown should announce next Monday that Britain is better off joining the euro.

The essential europhobic contention is that one interest rate cannot be appropriate for all the euro-area economies. If Britain were to join -- requiring higher interest rates to handle the inflationary tendencies of its housing market -- then the overall interest rate in the euro-area would rise. And that would be even more damaging for Germany, which clearly needs lower interest rates.

The argument is logical, but wrong. Its premises are flawed. First, the independent setting of British interest rates has failed to forestall three house price booms since the beginning of the 1970s. The only solution to the volatility of U.K. housing lies in root and branch reform on the supply side of the market.

The reason why asset markets explode in price is because they are different from normal markets, where suppliers of goods and services are encouraged to provide more when the price rises. In asset markets, owners are often encouraged to supply less because they think the price will rise further. Expectations are crucial.

The issue is how to encourage supply during the price upturn, and the most likely solution is to increase the cost of holding onto land. A number of countries apply a tax to land whether it is developed or not. Independent of the wisdom of adding yet another tax, it does give the developer a greater incentive to develop to the maximum permissible.

A second flaw in the europhobic argument is the bizarre high-school notion that medium-sized economies can set their interest rates to optimise domestic economic conditions. Try telling this to successive British Chancellors of the exchequer who know that the main word associated with "sterling" is "crisis."

It was not just irresponsible socialist governments that suffered (though they did in the 1967 devaluation and the 1976 International Monetary Fund crisis). Even one of Margaret Thatcher's chancellors, Nigel Lawson, fell victim. Here is how the now Lord Lawson tells it in his memoirs:

"The thought of the pound dropping below one dollar had put the fear of God into (Margaret Thatcher). The sterling-dollar rate touched a new low of $1.10 in the Far East before the London markets opened; and the Bank literally unveiled a 1.5% rise in Minimum Lending Rate to 12%."

At the cost of higher interest rates, Lord Lawson staunched the flow. But nearly a year later in December 1985, sterling was under attack again. "I was deeply worried" writes Lord Lawson "that the slide of sterling might turn into a rout.... We rapidly reached the conclusion that interest rates should be raised by a full percentage point from 11.5% to 12.5% forthwith."

In other words, the freedom to set interest rates merely according to domestic needs is a cruel mirage. For exactly the same reason, it is simplistic to suggest that monetary conditions would be looser in Germany if it were able to resuscitate the German mark.

In fact, real interest rates -- after allowing for inflation -- are lower in Germany today than at any time since the late 1970s. If Germans had the mark, it would almost certainly be higher on a trade-weighted basis than the euro, further squeezing the trading sector.

Even if we make the wild assumption that medium-sized economies are able to set interest rates purely for domestic circumstances, interest rates in the euro-area look reasonable. Applying an independent monetary rule -- the well-known Taylor rule that relates rates to inflation and spare capacity -- finds that rates are less than one percentage point away from what would be suggested on average for each euro-area country.

Given the compromises that exist even within an economy like Britain's -- where the southeast region has grown by 80% over 10 years compared with growth of a half in the northeast -- this is a small price to pay. The benefits of the euro are the extra competition unleashed by ending transaction costs, increasing price transparency and removing the volatility that traps low profit margin businesses within their domestic markets.

Every economic study of the trade impact of the euro since its launch in 1999 has found positive effects ranging from 12% (in a study by economists at the Inter-American Development Bank) to 30% (in the recent report from a commission chaired by Professor David Begg). Business investment is higher in the euro-area than Britain, and Britain's share of inward foreign direct investment has collapsed.

Four countries within the euro-area have lower unemployment than Britain, and the average growth rate of the euro-area since the euro's launch in 1999 has been exactly the same as Britain's. Within the euro-area, two economies -- Ireland and Finland -- are growing more rapidly than Britain's. With Britain's advantages of labour market flexibility, there is every reason to expect that it could draw the benefits of the euro to boost investment, productivity and growth.

Mr. Huhne is economic spokesman of the European Liberal Democrats at the European Parliament and co-author of "Both sides of the coin: the case for and against the euro" (Profile £8.99).