The British government says it will only join a successful single currency. With three and a half years’ experience of the euro in operation, we can now make that judgment. On the issue of trade the answer is clear: Britain is paying a high price for keeping the pound.
Sterling always seems to be causing trouble – not least now. Exporters complain that its strength stunts their sales. Business and trade unions agree that it destroys jobs. The Bank of England worries that a currency collapse could spark inflation. Most economists believe the pound is overvalued. All the signs suggest so. Britain’s trade deficit swelled to £21.7bn in the year to June. Exports in the first half of 2002 were 4.5 per cent down on the same period last year.
This overvaluation is exacerbating the economy’s growing imbalances. The sheltered (predominantly service) sector is faring better than the internationally exposed (predominantly manufacturing) sector. Manufacturing output was 5.3 per cent lower in the second quarter than a year earlier. This fall is not entirely due to sterling’s strength. Manufacturing has long been in structural decline; weakening export demand has scarcely helped. But sterling is making the problem worse, not better.
Were the pound a helpful adjustment mechanism, it would be depreciating gradually, thus boosting the traded sector. In fact, sterling remains painfully strong. Its trade-weighted exchange rate was as high at the end of July this year as a year earlier.
Now that international capital flows freely, the whims and passions of foreign exchange dealers, not cross-border trade, drive currencies. Whereas world trade amounts to £4,000bn a year, nearly £1,000bn changes hands on currency markets each day. And since currency markets are essentially bets on an unknowable future, prices jump around erratically as traders’ expectations change. They are prone to bubbles. So sterling can – and does – deviate for long periods from a rate that would help balance trade.
The immediate costs of sterling’s volatility and misalignment are bad enough. But the long-term burden is even greater. Just as Britain’s accentuated boom-and-bust cycle has deterred long-term investment, so sterling’s ups and downs damp trade and economic growth. Next year, a pound might buy 10 per cent more euros – or 20 per cent fewer. Who knows what it will be worth in 2007?
This uncertainty greatly complicates planning for the future. It discourages British companies from seeking markets abroad and deters foreign ones from exporting to the UK. So Britain trades less than it ought to. Less trade means less competition, higher prices, less consumer choice, less specialisation in what Britain does best, fewer economies of scale and a slower spread of technologies. Less trade means economic growth is slower than it could be.
Contrary to conventional wisdom, companies cannot hedge all their exchange-rate risk at little cost. An uncertain stream of revenues that will arrive in uncertain amounts at uncertain times over several years cannot be hedged. Joining the euro would insulate half of Britain’s trade from currency moves. Adopting the US dollar – as some Europhobes suggest – would protect only 16 per cent.
One study estimates that the pound is akin to a 26 per cent tax on both imports and exports. Jeffrey Frankel of Harvard University and Andrew Rose of the University of California at Berkeley say joining the euro would increase Britain’s trade with the euro area by 62 per cent of gross domestic product, eventually raising British GDP by 20 per cent. Most of this would come within 20 years, allowing Britain’s economy to grow nearly 1 per cent a year faster.
There are already signs that the euro may be starting to work. Since the euro was introduced in January 1999, Germany’s trade with the EU (exports plus imports) has risen from 27.2 per cent of GDP in 1998 to 32.2 per cent in 2001, and France’s from 28.0 per cent to 32.2 per cent. If Mr Frankel and Mr Rose are right, the 5 percentage point rise in the share of its GDP that Germany trades with the EU has boosted its economy by 1 per cent. The 4 point rise in France has lifted GDP by 1 per cent. Britain’s trade with the EU has fallen from 23.4 per cent of GDP in 1998 to 22 per cent in 2001, shaving 0.5 per cent off GDP growth.
The trade benefits of joining the euro are clear. So Europhobes have to explain why, although they generally favour free trade with the EU, they want to deny Britain some of its benefits. Joining the euro would complete the single market to which Margaret Thatcher signed up. They also have to justify why, although they want Britain to compete on a level playing field, they want to handicap its trade with the euro area. They will find that very hard, because joining the euro is in Britain’s national interest.