Mr. George discusses the prospects for the euro and the attitude towards the single currency in the United Kingdom  (Central Bank Articles and Speeches, 21 Oct 98)
Central bank: boe | Type: speech | Date: 1998-10-21

Mr. George discusses the prospects for the euro and the attitude towards th single currency in the United Kingdom Speech by the Governor of the Bank of England, Mr. E.A.J.

George, given to the Financial Forum of West Flanders in Bruges on 21/10/98.

## Britain in EuropeIt's a great pleasure to be here in the beautiful city of Bruges, and I am h have this opportunity to address the Financial Forum here in West Flanders.Mr. Chairman, in just 50 business days' time - on 1st January next year European

countries will take the long-awaited, truly historic, step of merging thei currencies into a single 'euro'.

The United Kingdom will not be among them, but we have interest in the euro's success.

I should like to explain to you this evening Britain's euro, and then say something about the prospects for the new single currency as an ele stability in today's turbulent global financial and economic environment.Let me make clear at the outset that, of course, I recognise that monetary fundamentally a political issue.

It necessarily involves some deliberate further pooling sovereignty over important issues of public policy - monetary policy and overall fiscal p as the single market involved the pooling of sovereignty over aspects of trade and competit and so on.As a central banker I have nothing to say about the politics of monetary union is also, of course, about economics, and the economics of monetary union could go either w see that if it goes well it will contribute to a broader cohesion within Europe; but e economics were to go wrong, then that could blow back on the politics of Europe and give tensions.

I shall concentrate my remarks this evening on the economics of monetary union.The economic pros and cons have in fact been exhaustively debated in the Un Kingdom and the arguments are now reasonably well defined, even though different opin inevitably attach different weights to them.On the positive side, the crucial and unique economic advantage of monetary un nominal exchange rate certainty within the euro area - not just the reasonable de facto s might result from each EU member state individually pursuing disciplined macro-economic po in parallel - but nominal exchange rate certainty for the indefinite future.

And that i economic advantage as any UK exporter who has suffered from the exaggerated strength of st over the past two years or so will readily tell you!

One can argue that such exchange rate not an essential complement to the European single market - any more than exchange rate essential to achieving benefits from free trade more generally.

But it brings very materi through increased competition as a result of greater transparency of prices and lower tr costs, through broader and more liquid financial markets, and through the associated improv economic resource allocation.

And there is no doubt that intra-European exchange rate cer particular will enhance the benefits to be derived from the European single market.

Whether is essential, therefore, most people would, I think, agree that, other things equal, exchange rate certainty that comes with the move to the single European currency is very in this context.What then are the economic arguments against it?

Essentially they can summarised as the risk that the single monetary policy - the single, one-size-fits-allinterest rate within the euro area, which is a necessary corollary of the single currency the event prove to be appropriate to the domestic needs of each of the euro-member countri is no doubt that such risk exists.

It may result from cyclical divergence within the eur some participating countries needing to stimulate domestic demand while others are operating close to capacity.

It may arise from differences in fiscal positions even though be constrained through the Stability and Growth Pact.

Or it may result from economic sh some sort that have a bigger impact on some countries than on others.

The rise in oil pr early 1970s or German reunification are classic examples.So the risk of divergent monetary policy needs within the euro area is real. there were a material divergence of monetary policy needs, that could lead to serious because alternative adjustment mechanisms, such as labour migration or fiscal redistribu exist within individual countries, and which help to alleviate familiar regional dispariti arise at the national level, are simply not well-developed at the pan-European level.The Maastricht Treaty, of course, recognised this risk.

The famous converg criteria were specifically designed as a means of reducing the risk to manageable propo requiring that, before joining the euro club, countries should have achieved at least degree of macro-economic convergence -thereby demonstrating their commitment macro-economic discipline both through fiscal consolidation, and through monetary p consistently directed at effective price, and exchange rate, stability.

And all member cou European Union have certainly made great progress towards macro-economic stability over th few years.This has, of course, been a matter of national economic self-interest.

But th doubt that the goal of monetary union, and the Maastricht criteria, provided a very powerf incentive for many countries - indeed it is barely conceivable that anything like so muc would have been achieved across the Continent without this incentive.

It is a rem demonstration of political commitment that the eleven participating countries - against a as seen only a couple of years ago - could reasonably have been judged to have met the enabling the Heads of Government to agree to the launch of a broadly based monetary union meeting in Brussels in May.But the risk of divergent domestic policy needs - or of potential regional within the single currency area - did not simply disappear during that momentous week Brussels.Remaining cyclical differences are reflected in the persistence of inter differentials among the first eleven, which will, of course, have to be eliminated by th year.

It may then prove necessary in some countries for fiscal policy to be tighter otherwise be necessary in order to offset the easing of monetary policy as a result of th single interest rate.Even without that, a number of Euroland countries enter monetary union with high ratios of public debt to GDP.

And virtually all - to varying degrees - face the prospe on their public finances of ageing populations.

All of this means that there will be a con for rigorous fiscal discipline throughout the area well into the future - as was very clea in the EMI's Convergence Report.

That indeed is very much the purpose of the Stability and Pact.And the potential for external shocks, with asymmetrical effects on dif Euroland countries, of course remains.A particular worry is that macro-economic stability - vitally necessary thoug will not, on its own, be sufficient to prevent the persistence of unacceptably high unemployment in a number of the major Continental European economies.

Unemployment has bee for some considerable time, and remains, much the most urgent and important economic confronting us in Europe.

I do not suggest for a moment that the right answer would be to macro-economic discipline and revert to old-fashioned demand management policies.

In any other than the very short term that would be likely to make matters worse.

I share consensus view that Europe's unemployment problems originate essentially in rigidities supply-side of the economy.

The point is that unless we are all more successful in bringing structural unemployment, through micro-economic policies designed to improve structural, side flexibility, then some countries could find it difficult to continue to live with a c economic discipline without significant tensions.

The nagging doubt is whether the ne commitment to fiscal discipline, alongside monetary stability, will prove - in the te Maastricht Treaty - to be sustainable.Some people who basically recognise this concern are inclined to argue that if participating country were to find itself in this situation - and given that it would ha economic way out, for example, through exchange rate adjustment, or monetary relaxation, o stimulus beyond the limits of the Stability and Growth Pact - then it would have an over incentive to take the sort of supply-side measures which have proved so difficult to hitherto.

As one of my colleagues once put it to me 'when we have exhausted all other policy options, we will finally be forced to do what we know to be the right thing!' populations in those countries would it is true have a similar incentive to accept structu am not sure how far one can rely upon that.

But it does in any event serve to emphas supply-side flexibility will be more crucially important than ever in the context of monetaI should emphasise at this point, Mr. Chairman, that I am not predicting tha will necessarily be serious tensions within the single currency area.

There will no doub challenges - there always are, with or without monetary union.

But it is difficult for anyo how serious the problems will in fact turn out to be.

I am simply describing the sort o risks which might occur, and which have been identified in the debate about monetary unio United Kingdom as the potential downside to be set against the potential benefits of exchange rate certainty which I touched upon earlier.

You here in Belgium may think that th are sometimes exaggerated - you have after all been effectively in de facto monetary un Germany for some considerable time.

But I don't think one can reasonably argue, certainl case of a larger country, that the risks can be ignored.It was against the background of this kind of economic debate that the Chancel the Exchequer announced a year ago that the United Kingdom would exercise its opt-out an participate in the first wave of euro membership.

That was a disappointment to some European partners.

But it was a considerable relief to others, because UK participation outset would undoubtedly have complicated the project - not least because of the substanti divergence between ourselves and the major countries on the Continent.But the Chancellor also made it clear that the present British Government opposed to euro membership as a matter of principle; it will make its decision on p grounds - the test being whether membership would be in our economic interests; and itsubmit that decision to Parliament and to the British people in a referendum.

The Ch recognised that - barring some fundamental and unforeseen change in economic circumstance was unrealistic to think that a decision could be made during the lifetime of the present and that could extend to May 2002.

But he stressed that in the meantime the United Kingdom prepare - both for the euro's introduction on the Continent on 1 January 1999 and for eventual participation.This statement was the first by a British Government to accept the princi monetary union.

It implied that the United Kingdom is to be regarded effectively as a 'P recognised that the single currency will affect us whether we are in or out of it, and th in our national interest to do all that we can to help ensure that the euro is successful.This, in my view, provides a solid foundation for a continuing, positiv constructive relationship between the United Kingdom and other EU member states, including participating in the first wave of the euro.

And that must be in the interest of both sid benefit from a stable and prosperous Europe, so too the Continental European interest lies and prosperous Britain - and that mutual interest above all is the thing we must all hol allow the euro to become a divisive factor in the broader relationship between Europea member states would be to cut off our collective nose to spite our collective face!What then can the United Kingdom bring, initially as an 'out', or 'pre-in', European party, in terms of contributing to the euro's success?There are, I think, two things in particular.First, we can continue to pursue macro-economic - both monetary and fisca discipline alongside the euro-area countries.

The Government is committed to that course as of national economic self-interest, but it reflects the same philosophy as that which u Maastricht Treaty.One of its very first acts in Government, for example, was to give opera independence for the conduct of monetary policy to the Bank of England, and we have been objective of delivering, consistently, underlying retail price inflation of 2½%.

That objec to be compatible with the ECB's target for the European Harmonised Index of Consumer Pric less than 2% - in fact while we are, on the most recent data, precisely on track in terms target measure, our inflation rate in terms of the harmonised index is down to 1.3%.

An fiscal side the Government has committed itself both to maintaining the debt to GDP ratio and prudent level over the economic cycle and to the 'golden rule' (under which public borrowing is limited to the financing of investment).

These fiscal rules, too, are broadl with those established for euro-member countries under the Stability and Growth Pact, a ensure that we continue to comply with the Maastricht Treaty fiscal criteria.These macro-economic policies - together with continuing structural reform improve supply-side flexibility - are calculated to make the United Kingdom a more pro trading partner and to ensure that we do not disrupt the policies and the economy of t Europe.

More than that they are calculated to encourage sustainable economic convergence w rest of Europe as a necessary precursor to our eventual adherence of the euro club.Secondly, Mr.

Chairman, the United Kingdom can contribute directly to t development of the euro through the City of London's financial markets.

To take its placethe dollar, the euro needs well developed, pan-European, financial markets.

And providin transparent, competitive and innovative, but well-regulated, financial markets is one of that the City of London does particularly well.The City's strength derives from being a uniquely international financial ce which the strongest financial businesses from all parts of the world - including from all European Union - are represented.

There are more banks in the City incorporated abroa example, than domestic banks.

And more than half the total deposit base (over £1 trillion e of the UK banking system is denominated in foreign currencies.

And while the current financial turbulence is taking its toll on employment in some financial services activitie as elsewhere, the longer-term trend is for the foreign presence - including that from Europ countries - to continue to increase.The Bank of England has been working intensively with the City for the past years to ensure that it is as thoroughly prepared for the start of the euro next year as centres in any of the participating countries.

We will be ready to provide financia denominated in euro to all those that want them from day one.

And we are already tak initiative with our European partners in creating regional market structures, as you see, in the talks between the London Stock Exchange and the Deutsche Börse, which are designed the foundations for an inclusive, pan-European, equity market.

You will be able to accou and settle in euro-denominated assets in London just as you can now in Deutsche Mark or francs or dollars or yen.

The financial markets of the City are our wedding present to marriage partners.

They are not just a national - but a European - asset.There are, of course, some here on the Continent who regard this role of the something of a mixed blessing - perhaps even a threat rather than a promise.

There is a vi euro should somehow 'belong' exclusively to the participating countries and that its in should be used as an opportunity to confer competitive advantage on national financial within the euro area.

If that view were to prevail the main effect would be to inhibit the of the euro as an international trading and portfolio currency, reducing one of the singl major benefits to both investors and borrowers within the euro area itself.In practice in today's world of globally integrated markets and liberalised flows there is very little prospect of being able to impose artificial constraints on th use of the euro.

There will inevitably be active euro markets in all the major financ including London.

And it is in the interest of financial activity right across Europe that be.

Like trade in goods, trade in financial services is a positive sum game, so that Lond is not a threat to other European financial centres.

As a major interface between Europe a of the world I have little doubt that euro-activity in London will mean more rather tha activity in other European financial centres like Frankfurt, Paris, Milan, Amsterdam or Bru conversely I have little doubt either that what is good for those centres will be good tooI hope, Mr. Chairman, that I have said enough to persuade at least some of yo British hesitations about participating in the euro from the outset are not just plain obs the first wave we may be - indeed we are - but we remain very much an active and, I would constructive partner in the process of European monetary integration in a wider sense, and want the euro to succeed.

That is why I prefer to think of Britain in Europe which I took for my talk.Let me conclude, Mr. Chairman, with just a few remarks on the prospects for euro in the current climate of global financial turmoil.For much of the past two years or so financial markets have shown a degre scepticism about the future character of the euro.

The sense, from about the autumn appeared to be that the process was being driven by the politics of Europe with less empha importance of economic convergence; expectations therefore increasingly focused upon the p of a broadly-based rather than a narrower euro; and the inference was drawn that this woul weaker rather than a strong euro.

Together with comparatively subdued economic activity Continent, this perception - or misperception - meant that the core European currencies w time relatively weak against the dollar, and against sterling.That situation has more recently begun to change.

Market scepticism has dimini with the growing realization that the European Central Bank will in fact be rigorous in pu mandate of maintaining effective price stability throughout the euro area as a whole - th will in fact be soundly managed.

And at the same time domestic demand growth and econo activity have started to pick up in the core European countries, causing the eurocollectively to strengthen in the foreign exchange market and helpfully easing some of th tensions that might otherwise have complicated the move to a single monetary policy.All this is now overlaid by the successive financial shocks to the global e from Asia, from Russia, and most recently from the need to rescue Long-Term Capital Manage Fund (LTCM).In practice the euro currencies have been remarkably stable in relation to ea in the face of these shocks - demonstrating the market's total conviction, in the words of participant recently that 'the euro is a done deal'.

The euro area has in fact been a zon in turbulent currency markets - and that performance puts in proper perspective earlier e about spectators waiting to rip the euro apart.

That never was in my view a serious issue political commitment to the process - the economic issue has, as I say, been about th regional tensions that might subsequently emerge.The big questions now - for all of us, not just for the euro countries - are most immediately whether we can avoid new financial shocks; and, secondly, how we sho manage the economic fall out from the financial shocks that have already occurred.Developments since the IMF/IBRD meetings in Washington have in my view been quite encouraging.

The Japanese financial package is reassuring, and the strengthening of has brought welcome relief to much of the rest of Asia.

United States Congressional approv IMF quota increase and of the New Arrangements to Borrow (NAB) has paved the way to a vit necessary increase in IMF resources.

Brazil - which has been widely seen as the next emerging market domino - is clearly committed to taking strong corrective domestic policy which would command broad international support.

And while there evidently has been a contraction of wholesale market lending, within the financial sector in particular, in States, and suggestions there of a possible wider credit crunch, no new problems on anythin scale of LTCM have in fact been uncovered.

We are certainly not yet out of the wood, financial situation looks rather better than might have been expected two or three weeks agIf we can avoid a new financial shock - and I am hopeful that we will - we st to manage the global economic slowdown already underway.

In that context there has been adeal of talk about concerted interest rate cuts in Europe and the United States to stimul demand and offset the effects of recession elsewhere.

And it is true that those effects world commodity prices and falling external demand - do mean that interest rates in the countries generally can be lower than they would otherwise be, which in turn will help global demand.

But we do not all start from the same point.

Rates have in fact been cut in States and the United Kingdom, where underlying domestic demand growth also shows signs slowing.

In Continental Europe, on the other hand, domestic demand growth has, as I sa picking up.

But even here interest rates have already come down in some of the smaller c and are likely to be generally lower than they would have been in the absence of th slowdown.

Markets are, in fact, now expecting rates to converge by the end of the year on rates, where only a couple of months ago, they expected convergence at significantly higherNone of this, Mr. Chairman, it seems to me need affect the prospect for the e anything it may reinforce the more recent firmer tone of the euro currencies.

It would o potential tensions within the euro area if the global economic weakness had a disprop impact on some member countries as against others.

Although, therefore, the present inte climate is less than ideal for the euro's introduction, that does not alter my conclusion currency will indeed prove to be a stable element in an uncertain world, and that continu of the European economy will help to ensure that the present slowdown does not develop int recession.

And that is clearly in everyone's interest.