- Observer.co.uk,
- Sunday May 11 2003
In what was almost an admission of defeat, the pro-euro camp this week published the outcome of its own deliberations into the consequences of staying outside the single currency. Professor David Begg's report gave warning of the opportunities for trade with our European partners that will be forgone. And to the damage that staying out has, and will continue to do, to our attractiveness as a place for foreigners to invest. But these arguments are well worn. They will do little to convince a sceptical British public that the status quo is not a viable alternative. And in case there were some who were wavering, the Treasury's 2,000-page study into British economic interests stands ready to reassure.
But the greatest danger from saying "no" to euro entry now is an immediate and menacing one. And it is one which the Treasury is highly unlikely to have considered in its otherwise comprehensive assessment. It is the growing likelihood of a sterling crisis. Over the past three months sterling has shed more value than at any time since its ejection from the ERM. And just this week, it hit a six-year low against a trade-weighted basket of currencies and a four-year low against the euro. It even failed to keep pace with the struggling dollar.
These developments in the foreign exchanges have nothing to do with the up-coming five tests announcement. Instead, they reflect a growing belief in markets that all is not well in the economies of the Anglo-Saxon world. However much the assessment seeks to highlight the well-known difficulties of the eurozone economies, the former darlings of the foreign exchanges are now increasingly being seen as having major problems of their own - not in terms of structural policies but in terms of macroeconomic imbalances. Where the US is seen as suffering from a chronic current account deficit, it is feared that the UK is on the brink of a major correction in its inflated housing market that will send consumers into a tailspin. So, caught between the two main currency blocks of the dollar and the euro, sterling is reeling from a collapsing dollar and its own home-grown problems.
How these domestic problems work themselves out will determine whether the current rout on the foreign exchanges turns into a full-blown crisis. The omens are not good. According to the Royal Institution of Chartered Surveyors, in the first three months of this year, the London housing market, a lead indicator of the national market, posted a 20% fall in prices at an annualised rate. At the same time consumer spending, long the lynchpin of the fast-growing UK economy, is now growing at its most frugal pace since the third quarter of 1997.
This combination of a weakening domestic economy but a rapidly depreciating currency confronted the Bank of England with a tough decision on interest rates last week. Why? Because although the housing market and the consumer look frail the rapid fall in sterling is threatening to give an unwelcome boost to inflation. When many had expected an interest rate cut, the Bank opted to keep them steady, largely in response to sterling's fall. The exchange rate, we are thus reminded, is as much a source of shocks to the economy as it is a buffer.
Past experience suggests that if sterling were to continue falling there would be little that the government could do to halt it. However, a decision to join the euro would offer a unique escape route from this historical experience. For markets would immediately put sterling on a path consistent with the eventual entry rate. This rate is probably a little weaker than currently, but not much more. It would therefore rule out a crisis. Without such a commitment, little stands in the way of a sterling crisis which would boost inflation and stand in the way of interest rate cuts. It could even lead to higher interest rates. Negative equity in the housing market and loss of the "feel good" factor could easily result.
John Maynard Keynes once argued "our power of prediction is so slight, it is seldom wise to sacrifice a present evil for a doubtful advantage in the future". It is with cruelly ironic timing, therefore, that, just as the Treasury publishes a work of excruciating detail examining the long-term consequences of euro entry, the spectre of another sterling crisis has raised its ugly head. An even richer irony is that the implication of the assessment is almost certain to be that the economic arguments are finely balanced, if slightly tilted towards the status quo. This being the case, can it be reasonable to sacrifice the present danger of a sterling crisis for the doubtful advantage of remaining outside the euro? The announcement the chancellor is about to make is momentous. But his decision is already made. It may well his nemesis.
· Michael Hume is Director and Senior Europe Economist at Lehman Brothers
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