Why the British Citizen should reconsider joining European Monetary Union.

 

 

The financial crisis is far from over and the United Kingdom has - and is - paying a heavy price for dealing with the situation. The coalition Government has implemented an austerity program, unparalleled in peace time, to control government expenditure and the excessive borrowing requirement aggravated by the bailing out of an overextended banking system. The impact of this “courageous” program has yet to be fully felt by the population which faces an extended period of stagflation, the political and social consequences of which should not be underestimated.

 

In the first phases of the crisis, the brunt of the adjustment was absorbed by the exchange rate letting, from 2007 onwards, Sterling fall 25% against the € but sustaining for a while economic activity. During this period, the UK benefitted fully from the EU single market free trade rules but happily ignored its corresponding “responsibilities” which should recognize that “exchange rates” between Member States currencies are a matter of mutual interest. The benign attitude adopted by Eurozone Members can be attributed to the significant shift towards intergovernmental decision making in dealing with the financial crisis, leading to the marginalisation of the Commission and its role of Guardian of the Treaties.  

 

With the passage of time, the EU has, nevertheless, made significant progress towards market integration in the fields of financial regulation (in parallel with the US), of crisis management (with the establishment of the EFSF and the proposed EMS) and of “economic coordination” (with the implementation of the European Semester and the reinforcement of the Stability and Growth Pact). These welcome developments remain unfortunately firmly anchored in an intergovernmental framework as demonstrated by the still largely “nationally” based character of financial regulation and supervision, the absence of an EU wide bankruptcy procedure as well as the convoluted operational rules suggested for the EMS. Unless further efforts are made to remedy these weaknesses, it is unlikely that the reforms will prove sufficiently robust to deal with future crisis.

 

Within this context, EU Member States that remain outside of EMU find themselves more and more marginalised. Nowhere has this been more felt than in the UK, where after taking an initial “hands off” attitude towards decisions affecting the Eurozone - on the understanding that the UK would retain, unhindered, its full monetary sovereignty – the Prime Minister seems to have come around to understand that the UK has vital interests in the orientation of EMU policies. Indeed, the Eurozone is the UK’s largest export market and London – for the time being – remains the centre of the Euro “capital market”.

 

If the UK wishes to play a constructive role in shaping future Eurozone policies, be it on the political, economic or regulatory front, it must accept that this privilege comes with a series of obligations that, by definition, must give equal rights to EMU authorities to exercise influence over UK policies.

 

Joining EMU would of course be the simplest and most effective answer, presenting significant advantages for both sides.

 

The EU would benefit from the further strengthening of the economic foundation supporting the single currency. It would also improve significantly the anchoring of the € as a credible alternative to the US Dollar reducing the pressure for “inventing” yet another unnecessary “multilateral” global “reserve asset”.  The power of the Eurozone in international forums (IMF, IBRD, G20, WTO, etc.) would be enhanced by the progressive replacement of weak national representations by a strong consolidated EU one. Necessary reforms of the global financial system should no longer be implemented exclusively at the expense of individual European countries (as was the case in the amendments to IMF quotas and voting rights).

 

Joining EMU, would tie definitively the UK’s currency to that of its most significant trading partners allowing for the deployment of an effective “free trade area”, so dear to the British, in which the distorting weapon of competitive devaluation would have been eliminated. EMU would benefit significantly from participation of the UK in shaping a single regulatory framework for the Eurozone, accelerating its integration into an effective “single market” for financial services. Furthermore, once the UK joins (to be followed rapidly by remaining EU Members), the EU could undertake more flexible monetary and economic policies adding to the toolkit of policy options a pro active management of the external value of the €. Thus, le exchange rate of the € would no longer be set exclusively by the actions of authorities who have no particular vested interest in EU policy priorities. 

 

The UK would exercise a significant and welcome influence on EU economic policies. As I have already suggested previously, the Bank of England could be charged by the ECB with the management of the external value of the € (on the model of the NY FRB), giving the Eurozone the benefit of its knowhow in managing a “reserve currency”.

 

While the arguments developed here above are not particularly new, recent developments, and in particular the publication of the “interim” Vickers Report add important new elements that justify reconsidering EMU membership. Indeed, at the centre of the debate around the Report, lies the degree of separation (ring fencing) between traditional “commercial banking” and “investment banking/own account trading” activities and the levels of “own funds” required to support these activities.

 

An often overlooked element is not so much the absolute “size” of financial institutions (too big to fail) but rather their size relative to that of their respective supporting economies. It is indeed apparent that the size of the banking sector was an important factor in spreading the financial crisis in Greece, Ireland, Belgium, Spain, Switzerland and the UK when it became clear that the size of the balance sheets of major financial institutions – regulated domestically – exceeded very considerably the GNP of their respective home country. The “bail outs” of the banking system led to the rapid deterioration in levels of Sovereign debt including in countries that had low levels prior to the crisis (Ireland, UK, and Spain). It precludes the possibility of any further large scale bank rescue operations which is why the implementation of new and more severe prudential regulation is of the highest order of priority.

 

Ireland, Greece, Spain (and Belgium temporarily in the fall of 2008) all EMU Members, have been able to avoid - so far - default/restructuring through the flexible and unlimited access to funding provided by the ECB.

 

It is worth noting that the rapid recovery in the US can be attributed in part to the smaller size of the banking sector relative to the economy in general (and to the existence of a more effective resolution mechanism). This justifies relatively lower capital ratios due to the reduced “systemic” risk associated with the sector. It also explains the reticence of the US to adopt the more stringent “global” standards of Basel II and III and some of those being discussed within the G20.

 

A contrary example is furnished by Switzerland that has imposed on its two “systemic” universal banks significantly higher capital ratios than those called for by the Basel III rules. These two banks manage balance sheets that exceed Swiss GNP by such a multiple that their failure could not be managed by Swiss authorities.

 

It is in this light that one should consider the preliminary findings of the Vickers Report. If the UK remains out of EMU, the authorities will have to choose between two unpleasant alternatives: either to impose on banks sufficient capital requirements to insure against the necessity of future rescue operations, either to limit the size of banks and/or scope of operations to a level compatible with the overall capacity of the domestic economy. Though there is a clear necessity in political terms to protect the citizen from future taxpayer financed rescue operations, neither option is appealing to the UK banking industry which has enjoyed the secular privileged status of dominant financial centre in the European time zone, and, in some specific areas, remains today the “global market” reference. If high capital requirements are imposed, the sector’s ability to compete with major international financial institutions will be constrained. This fear is already evidenced by the debate on EU “passporting”, possibly giving an unfair competitive edge to EU regulated banks operating “branches” in the UK; alternatively, implementing size and activity limitations would impinge on profitability, leading in turn to a competitive handicap and to the downsizing of the London financial market to “provincial” proportions.

 

Membership of EMU would largely obviate these drawbacks, creating an EU/EMU wide level playing field in which the City of London could deploy unhindered its competitive advantages founded on its unrivalled financial expertise. Indeed, the size of the Eurozone economy and the existence of a fully empowered European Central Bank as lender of last resort, create the necessary conditions to allow for the deployment of financial institutions of a size that exceeds the capacity of any of its single Members to entertain. Thus, Belgian, Luxemburg or Dutch banks will be able to compete fairly with their German, French or UK counterparts both on a European and world scale.

 

In addition to the economic and financial arguments put forward here above, there are additional “political” arguments that militate for a reconsideration of the UK’s position towards EMU. It will have escaped no one that the financial crisis has severely strained European solidarity. The voice of Germany in orienting debates has become overwhelming, fuelling a resurgence of populist and nationalist sentiment as evidenced by the success in the Finnish elections of a party opposing financial assistance to Portugal or the recent breakthrough of the French National Front advocating the withdrawal of France from the Euro. In this debate, the marginal role played by the UK, as a non EMU participant, is highly damaging as it deprives weaker peripheral countries from achieving a more equitable “burden sharing” in the efforts needed to restore confidence and financial sustainability. Additional strains have appeared on the geopolitical front with Germany’s spectacular abstention in the UN Security Council vote on Libya and its refusal to join its British and French partners in subsequent military operations.

 

These developments have created, for the first time, serious uncertainty in financial markets concerning the survival capacity of EMU (and of the EU). It would be foolish to overlook the disenchantment, in particular of the unemployed and most vulnerable segments of society who are becoming increasingly hostile to the ever growing gap between the sacrifices required from them in the face of the ever increasing wealth of a “happy few”. After financial turmoil, social unrest could be just around the corner!

 

This trend is confirmed by a most unwelcome shift in Germany’s position: the 1989 commitment of Chancellor Kohl ensuring that Germany would be firmly “European” (as a quid pro quo for EU support of German reunification), is progressively moving towards the not so subtle imposition of a “German” EU.

 

It is in the interest of all Member States that a more balanced equilibrium of power be re-established within the EU. This implies the full implication of the United Kingdom; EMU membership would be the most powerful symbol of such a move. Only then can the EU - and each of its Members – reap the full advantages of its wealth, its superior level of education, and its human, economic and social values in order to defend its position in the concert of world powers.

 

Joining EMU and exercising its rightful position and influence within the EU is a dramatic adjustment for the only European country that has not known “foreign occupation” for the last thousand years. It would, nevertheless, demonstrate the UK’s ability to adapt to the new world globalised order and prove to be its best option for the prosperous survival of its future generations.

 

It is at such time when all concerned parties can show demonstrably that they need each other that the best outcomes are most likely. Now is the time to grasp the nettle and make a new decisive step towards European integration and put to rest any fears of resurgence of nationalistic and populist doctrines that have brought twice Europe to its knees in the course of the XXth. century. In its own best interests, the UK citizen should seriously reconsider the advantages of joining EMU now.

 

Lorgues, 25th April 2011

 

Paul N. Goldschmidt

Director, European Commission (ret); Member of the Thomas More Institute.

 

 

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