Mr. George discusses the prospects for the euro and the attitude towards the
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 Europe
It's a great pleasure to be here in the beautiful city of Bruges, and I am honored to
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 - eleven
European countries will take the long-awaited, truly historic, step of merging their national
currencies into a single "euro". The United Kingdom will not be among them, but we have a vital
interest in the euro's success. I should like to explain to you this evening Britain's attitude to the
euro, and then say something about the prospects for the new single currency as an element of
stability in today's turbulent global financial and economic environment.
Let me make clear at the outset that, of course, I recognise that monetary union is
fundamentally a political issue. It necessarily involves some deliberate further pooling of national
sovereignty over important issues of public policy - monetary policy and overall fiscal policy - just
as the single market involved the pooling of sovereignty over aspects of trade and competition policy
and so on.
As a central banker I have nothing to say about the politics of monetary union. But it
is also, of course, about economics, and the economics of monetary union could go either way. I can
see that if it goes well it will contribute to a broader cohesion within Europe; but equally if the
economics were to go wrong, then that could blow back on the politics of Europe and give rise to
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 United
Kingdom and the arguments are now reasonably well defined, even though different opinions
inevitably attach different weights to them.
On the positive side, the crucial and unique economic advantage of monetary union is
nominal exchange rate certainty within the euro area - not just the reasonable de facto stability that
might result from each EU member state individually pursuing disciplined macro-economic policies
in parallel - but nominal exchange rate certainty for the indefinite future. And that is a very real
economic advantage as any UK exporter who has suffered from the exaggerated strength of sterling
over the past two years or so will readily tell you! One can argue that such exchange rate certainty is
not an essential complement to the European single market - any more than exchange rate fixity is
essential to achieving benefits from free trade more generally. But it brings very material benefits
through increased competition as a result of greater transparency of prices and lower transactions
costs, through broader and more liquid financial markets, and through the associated improvement in
economic resource allocation. And there is no doubt that intra-European exchange rate certainty in
particular will enhance the benefits to be derived from the European single market. Whether or not it
is essential, therefore, most people would, I think, agree that, other things equal, the nominal
exchange rate certainty that comes with the move to the single European currency is very desirable
in this context.
What then are the economic arguments against it? Essentially they can be
summarised as the risk that the single monetary policy - the single, one-size-fits-all, short-term
interest rate within the euro area, which is a necessary corollary of the single currency - will not in
the event prove to be appropriate to the domestic needs of each of the euro-member countries. There
is no doubt that such risk exists. It may result from cyclical divergence within the euro area, with
some participating countries needing to stimulate domestic demand while others are already
operating close to capacity. It may arise from differences in fiscal positions even though these are to
be constrained through the Stability and Growth Pact. Or it may result from economic shocks of
some sort that have a bigger impact on some countries than on others. The rise in oil prices in the
early 1970s or German reunification are classic examples.
So the risk of divergent monetary policy needs within the euro area is real. And if
there were a material divergence of monetary policy needs, that could lead to serious tensions,
because alternative adjustment mechanisms, such as labour migration or fiscal redistribution, that
exist within individual countries, and which help to alleviate familiar regional disparities when they
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 convergence
criteria were specifically designed as a means of reducing the risk to manageable proportions by
requiring that, before joining the euro club, countries should have achieved at least a minimum
degree of macro-economic convergence - thereby demonstrating their commitment to
macro-economic discipline both through fiscal consolidation, and through monetary policy
consistently directed at effective price, and exchange rate, stability. And all member countries of the
European Union have certainly made great progress towards macro-economic stability over the past
few years.
This has, of course, been a matter of national economic self-interest. But there is no
doubt that the goal of monetary union, and the Maastricht criteria, provided a very powerful external
incentive for many countries - indeed it is barely conceivable that anything like so much progress
would have been achieved across the Continent without this incentive. It is a remarkable
demonstration of political commitment that the eleven participating countries - against all the odds
as seen only a couple of years ago - could reasonably have been judged to have met the criteria,
enabling the Heads of Government to agree to the launch of a broadly based monetary union at their
meeting in Brussels in May.
But the risk of divergent domestic policy needs - or of potential regional tensions
within the single currency area - did not simply disappear during that momentous weekend in
Brussels.
Remaining cyclical differences are reflected in the persistence of interest rate
differentials among the first eleven, which will, of course, have to be eliminated by the end of the
year. It may then prove necessary in some countries for fiscal policy to be tighter than would
otherwise be necessary in order to offset the easing of monetary policy as a result of the move to a
single interest rate.
Even without that, a number of Euroland countries enter monetary union with very
high ratios of public debt to GDP. And virtually all - to varying degrees - face the prospective burden
on their public finances of ageing populations. All of this means that there will be a continuing need
for rigorous fiscal discipline throughout the area well into the future - as was very clearly recognised
in the EMI's Convergence Report. That indeed is very much the purpose of the Stability and Growth
Pact.
And the potential for external shocks, with asymmetrical effects on different
Euroland countries, of course remains.
A particular worry is that macro-economic stability - vitally necessary though it is
will not, on its own, be sufficient to prevent the persistence of unacceptably high levels of
unemployment in a number of the major Continental European economies. Unemployment has been
for some considerable time, and remains, much the most urgent and important economic issue
confronting us in Europe. I do not suggest for a moment that the right answer would be to abandon
macro-economic discipline and revert to old-fashioned demand management policies. In anything
other than the very short term that would be likely to make matters worse. I share the broad
consensus view that Europe's unemployment problems originate essentially in rigidities on the
supply-side of the economy. The point is that unless we are all more successful in bringing down this
structural unemployment, through micro-economic policies designed to improve structural,
supplyside flexibility, then some countries could find it difficult to continue to live with a common
macroeconomic discipline without significant tensions. The nagging doubt is whether the necessary
commitment to fiscal discipline, alongside monetary stability, will prove - in the terms of the
Maastricht Treaty - to be sustainable.
Some people who basically recognise this concern are inclined to argue that if a
europarticipating country were to find itself in this situation - and given that it would have no
macroeconomic way out, for example, through exchange rate adjustment, or monetary relaxation, or fiscal
stimulus beyond the limits of the Stability and Growth Pact - then it would have an overwhelming
incentive to take the sort of supply-side measures which have proved so difficult to implement
hitherto. As one of my colleagues once put it to me "when we have exhausted all other possible
policy options, we will finally be forced to do what we know to be the right thing!" And the
populations in those countries would it is true have a similar incentive to accept structural change. I
am not sure how far one can rely upon that. But it does in any event serve to emphasise that
supply-side flexibility will be more crucially important than ever in the context of monetary union.
I should emphasise at this point, Mr. Chairman, that I am not predicting that there
will necessarily be serious tensions within the single currency area. There will no doubt be policy
challenges - there always are, with or without monetary union. But it is difficult for anyone to predict
how serious the problems will in fact turn out to be. I am simply describing the sort of economic
risks which might occur, and which have been identified in the debate about monetary union in the
United Kingdom as the potential downside to be set against the potential benefits of nominal
exchange rate certainty which I touched upon earlier. You here in Belgium may think that these risks
are sometimes exaggerated - you have after all been effectively in de facto monetary union with
Germany for some considerable time. But I don't think one can reasonably argue, certainly in the
case of a larger country, that the risks can be ignored.
It was against the background of this kind of economic debate that the Chancellor of
the Exchequer announced a year ago that the United Kingdom would exercise its opt-out and not
participate in the first wave of euro membership. That was a disappointment to some of our
European partners. But it was a considerable relief to others, because UK participation from the
outset would undoubtedly have complicated the project - not least because of the substantial cyclical
divergence between ourselves and the major countries on the Continent.
But the Chancellor also made it clear that the present British Government is not
opposed to euro membership as a matter of principle; it will make its decision on pragmatic
grounds - the test being whether membership would be in our economic interests; and it would
submit that decision to Parliament and to the British people in a referendum. The Chancellor
recognised that - barring some fundamental and unforeseen change in economic circumstances - it
was unrealistic to think that a decision could be made during the lifetime of the present Parliament
and that could extend to May 2002. But he stressed that in the meantime the United Kingdom should
prepare - both for the euro's introduction on the Continent on 1 January 1999 and for our own
eventual participation.
This statement was the first by a British Government to accept the principle of
monetary union. It implied that the United Kingdom is to be regarded effectively as a "Pre-In". It
recognised that the single currency will affect us whether we are in or out of it, and that it is clearly
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, positive and
constructive relationship between the United Kingdom and other EU member states, including those
participating in the first wave of the euro. And that must be in the interest of both sides: just as we
benefit from a stable and prosperous Europe, so too the Continental European interest lies in a stable
and prosperous Britain - and that mutual interest above all is the thing we must all hold on to. To
allow the euro to become a divisive factor in the broader relationship between European Union
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', to the
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 fiscal
discipline alongside the euro-area countries. The Government is committed to that course as a matter
of national economic self-interest, but it reflects the same philosophy as that which underlies the
Maastricht Treaty.
One of its very first acts in Government, for example, was to give operational
independence for the conduct of monetary policy to the Bank of England, and we have been set the
objective of delivering, consistently, underlying retail price inflation of 21⁄2%. That objective appears
to be compatible with the ECB's target for the European Harmonised Index of Consumer Prices of
less than 2% - in fact while we are, on the most recent data, precisely on track in terms of our own
target measure, our inflation rate in terms of the harmonised index is down to 1.3%. And on the
fiscal side the Government has committed itself both to maintaining the debt to GDP ratio at a stable
and prudent level over the economic cycle and to the "golden rule" (under which public sector
borrowing is limited to the financing of investment). These fiscal rules, too, are broadly consistent
with those established for euro-member countries under the Stability and Growth Pact, and will
ensure that we continue to comply with the Maastricht Treaty fiscal criteria.
These macro-economic policies - together with continuing structural reforms to
improve supply-side flexibility - are calculated to make the United Kingdom a more prosperous
trading partner and to ensure that we do not disrupt the policies and the economy of the rest of
Europe. More than that they are calculated to encourage sustainable economic convergence with the
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 the
development of the euro through the City of London's financial markets. To take its place alongside
the dollar, the euro needs well developed, pan-European, financial markets. And providing liquid,
transparent, competitive and innovative, but well-regulated, financial markets is one of the things
that the City of London does particularly well.
The City's strength derives from being a uniquely international financial centre, in
which the strongest financial businesses from all parts of the world - including from all parts of the
European Union - are represented. There are more banks in the City incorporated abroad, for
example, than domestic banks. And more than half the total deposit base (over £1 trillion equivalent)
of the UK banking system is denominated in foreign currencies. And while the current global
financial turbulence is taking its toll on employment in some financial services activities in London
as elsewhere, the longer-term trend is for the foreign presence - including that from European partner
countries - to continue to increase.
The Bank of England has been working intensively with the City for the past few
years to ensure that it is as thoroughly prepared for the start of the euro next year as the financial
centres in any of the participating countries. We will be ready to provide financial services
denominated in euro to all those that want them from day one. And we are already taking the
initiative with our European partners in creating regional market structures, as you see, for example,
in the talks between the London Stock Exchange and the Deutsche Börse, which are designed to lay
the foundations for an inclusive, pan-European, equity market. You will be able to account, trade
and settle in euro-denominated assets in London just as you can now in Deutsche Mark or French
francs or dollars or yen. The financial markets of the City are our wedding present to the euro
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 City as
something of a mixed blessing - perhaps even a threat rather than a promise. There is a view that the
euro should somehow 'belong' exclusively to the participating countries and that its introduction
should be used as an opportunity to confer competitive advantage on national financial centres
within the euro area. If that view were to prevail the main effect would be to inhibit the development
of the euro as an international trading and portfolio currency, reducing one of the single currency's
major benefits to both investors and borrowers within the euro area itself.
In practice in today's world of globally integrated markets and liberalised capital
flows there is very little prospect of being able to impose artificial constraints on the international
use of the euro. There will inevitably be active euro markets in all the major financial centres,
including London. And it is in the interest of financial activity right across Europe that there should
be. Like trade in goods, trade in financial services is a positive sum game, so that London's success
is not a threat to other European financial centres. As a major interface between Europe and the rest
of the world I have little doubt that euro-activity in London will mean more rather than less euro
activity in other European financial centres like Frankfurt, Paris, Milan, Amsterdam or Brussels. And
conversely I have little doubt either that what is good for those centres will be good too for the City.
I hope, Mr. Chairman, that I have said enough to persuade at least some of you that
British hesitations about participating in the euro from the outset are not just plain obstinacy! Out of
the first wave we may be - indeed we are - but we remain very much an active and, I would hope, a
constructive partner in the process of European monetary integration in a wider sense, and we clearly
want the euro to succeed. That is why I prefer to think of Britain in Europe which I took as the title
for my talk.
Let me conclude, Mr. Chairman, with just a few remarks on the prospects for the
euro in the current climate of global financial turmoil.
For much of the past two years or so financial markets have shown a degree of
scepticism about the future character of the euro. The sense, from about the autumn of 1996,
appeared to be that the process was being driven by the politics of Europe with less emphasis on the
importance of economic convergence; expectations therefore increasingly focused upon the prospect
of a broadly-based rather than a narrower euro; and the inference was drawn that this would mean a
weaker rather than a strong euro. Together with comparatively subdued economic activity on the
Continent, this perception - or misperception - meant that the core European currencies were for a
time relatively weak against the dollar, and against sterling.
That situation has more recently begun to change. Market scepticism has diminished
with the growing realization that the European Central Bank will in fact be rigorous in pursuit of its
mandate of maintaining effective price stability throughout the euro area as a whole - that the euro
will in fact be soundly managed. And at the same time domestic demand growth and economic
activity have started to pick up in the core European countries, causing the euro-currencies
collectively to strengthen in the foreign exchange market and helpfully easing some of the cyclical
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 economy
from Asia, from Russia, and most recently from the need to rescue Long-Term Capital Management
Fund (LTCM).
In practice the euro currencies have been remarkably stable in relation to each other
in the face of these shocks - demonstrating the market's total conviction, in the words of one market
participant recently that "the euro is a done deal". The euro area has in fact been a zone of stability
in turbulent currency markets - and that performance puts in proper perspective earlier excited talk
about spectators waiting to rip the euro apart. That never was in my view a serious issue, given the
political commitment to the process - the economic issue has, as I say, been about the sort of
regional tensions that might subsequently emerge.
The big questions now - for all of us, not just for the euro countries - are, first, and
most immediately whether we can avoid new financial shocks; and, secondly, how we should
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 the Yen
has brought welcome relief to much of the rest of Asia. United States Congressional approval of the
IMF quota increase and of the New Arrangements to Borrow (NAB) has paved the way to a vitally
necessary increase in IMF resources. Brazil - which has been widely seen as the next potential
emerging market domino - is clearly committed to taking strong corrective domestic policy action,
which would command broad international support. And while there evidently has been a sharp
contraction of wholesale market lending, within the financial sector in particular, in the United
States, and suggestions there of a possible wider credit crunch, no new problems on anything like the
scale of LTCM have in fact been uncovered. We are certainly not yet out of the wood, but the
financial situation looks rather better than might have been expected two or three weeks ago.
If we can avoid a new financial shock - and I am hopeful that we will - we still have
to manage the global economic slowdown already underway. In that context there has been a good
deal of talk about concerted interest rate cuts in Europe and the United States to stimulate domestic
demand and offset the effects of recession elsewhere. And it is true that those effects - both lower
world commodity prices and falling external demand - do mean that interest rates in the industrial
countries generally can be lower than they would otherwise be, which in turn will help to sustain
global demand. But we do not all start from the same point. Rates have in fact been cut in the United
States and the United Kingdom, where underlying domestic demand growth also shows signs of
slowing. In Continental Europe, on the other hand, domestic demand growth has, as I say, been
picking up. But even here interest rates have already come down in some of the smaller countries
and are likely to be generally lower than they would have been in the absence of the global
slowdown. Markets are, in fact, now expecting rates to converge by the end of the year on German
rates, where only a couple of months ago, they expected convergence at significantly higher rates.
None of this, Mr. Chairman, it seems to me need affect the prospect for the euro - if
anything it may reinforce the more recent firmer tone of the euro currencies. It would only add to
potential tensions within the euro area if the global economic weakness had a disproportionate
impact on some member countries as against others. Although, therefore, the present international
climate is less than ideal for the euro's introduction, that does not alter my conclusion that the new
currency will indeed prove to be a stable element in an uncertain world, and that continuing growth
of the European economy will help to ensure that the present slowdown does not develop into global
recession. And that is clearly in everyone's interest.