The Pound, the Euro and
Report of a seminar held in Paris
15 March 2007
Christopher Johnson is an economist former chairman of the British section of the Franco-British Council.
16-18 Strutton Ground
London SW1P 2HP
Telephone: 020 7976 8380
Fax: 020 7976 8131
© Franco-British Council British Section 2007
cover design by Henry Paker
printed in Britain by TKO Print
Currency market shares and exchange notes 4
Central Bank differences and similarities 5
The fiscal-monetary policy mix 6
Structural reforms 7
UK membership of the euro 7
i British Participants 9
ii French Participants 10
iii Agenda 11
THE POUND, THE EURO AND THE DOLLAR
The participants from the two countries were welcomed by Jean Guéguinou, President of the French section of the Council. Lord Radice, Chairman of the British section, and Professor Christian de Boissieu, were co-chairmen of the seminar. The main themes covered were the present state of play as regards the currency market shares and exchange rates of the three major currencies; the monetary experiences of the UK and the euro area in terms of a comparison of central bank differences and similarities; and the economic policies behind the pound and the euro, covering the fiscal-economic policy mix and structural reforms. The question of UK membership of the euro was touched upon more to explain why it was off the agenda than to expound its potential benefits.
Currency market shares and exchange rates
In the opening session, Professor Agnès Bénassy-Quéré outlined the market shares of the three currencies in international finance, to show that we were in a tripolar world. The euro has overtaken the dollar in the international bond market, with 47% against 37% of bonds outstanding at end-September 2006. The two currencies are nearly equal in cross-border bank assets, with the euro accounting for 38% and the dollar for 40% at end-June 2006. The dominance of the dollar still prevails in the market for official reserves, which were 66% in dollars and 24% in euros at end-2005, and in the foreign exchange market, where 44% of transactions were in dollars and 19% in euros in April 2004. Meanwhile, the pound has overtaken the yen to become the third most important currency, with 8% of the international bonds, 6% of cross-border bank loans, and 4% of official reserves. Only in the foreign exchange markets does the yen still lead the pound, with 20% against 17%. The importance of financial flows between the City of London and the euro area has become dominant in the global financial system since the euro was created.
She argued that the euro’s rise as an international currency would allow it to share some of the advantages of the dollar. The US can make an exchange rate gain by borrowing in its own currency and investing in stronger currencies; it can get seignorage by the use of its own banknotes outside its territory, it can avoid exchange risk by invoicing in its own currency, and it can play a bigger role in the architecture of the international monetary system. William Keegan recalled the debate over the sterling balances in the 1960s to show that there were also disadvantages in having an international currency if its holders lost confidence in it.
Agnès Bénassy Quéré showed that exchange rates between the euro and the dollar have been misaligned, and much of the movement between them had been due to interest rate differentials. The euro had been weak when it should have been strong, and was now strong when it should be weak. French politicians were excessively nervous about the exchange rate, and were too ready to blame the European Central Bank, making it a scapegoat for poor economic performance, as another participant put it. The pound had risen because of its higher interest rate, but had for some time had a stable relationship with the euro. Professor Marcus Miller proposed a gigantic $500bn swap agreement between the dollar and the euro to stabilise their relationship. Thierry Walrafen pointed out that one of the merits of the euro had been the avoidance of exchange rate crises within the area, which had been one of the main motives in setting it up.
The UK’s economic performance had been better than that of the euro area, argued Professor Iain Begg. It was pointed out that this was one reason for the loss of British interest in joining the euro. The UK benefited from having a higher employment rate than France, which counteracted its lower productivity, and from having more Information and Communications Technology investments, thanks to lighter product market regulation. But the minimum wage was higher in Britain than in France, and spending on social protection was similar in the two countries. British unit labour costs were rising, while they were static in France. The UK had a big current account deficit; the euro area was in broad external balance, but this concealed a wide variety of performances, with Germany in surplus and France, and even more, Spain in deficit. It was harder for Italy to increase productivity than it had been for Germany, argued Simon Tilford, but the Netherlands had shown that competitiveness could be regained by an increase in productivity.
Central bank differences and similarities
The discussion focussed on the role of the three central banks in managing the three currencies. Marian Bell, a former member of the UK Monetary Policy Committee, thought there were more similarities of the monetary frameworks than differences. Price stability was the main goal for the Bank of England and the European Central Bank, while the Federal Reserve had the two other goals of economic growth and employment. Both central banks tried to be transparent, accountable and credible in such a way as to anchor inflation expectations. The members of the UK Monetary Policy Committee were individually accountable, which could lead to surprises in the decisions reached, and their votes became public, while the ECB Council members reached decisions by consensus, and were more political (excessively so, in Derek Scott’s view), in that most of them represented their own countries. This difference led to differences in methods of communication. The Bank of England did not send out signals in advance of its decisions, while the ECB tried to do so. It was no longer clear that the Bank of England’s Monetary Policy Committee gave greater transparency compared with the ECB, with early Press conferences, and the Federal Reserve, with a statement and members’ votes published at the same time as interest rate decisions.
The differences between the Bank of England and the ECB were brought out by Jean-Pierre Landau, Deputy Governor of the Banque de France. The ECB had a policy based on two pillars, of which the monetary aggregates were one. In the UK, the Chancellor of the Exchequer set the inflation target, whereas the ECB set its own target. The methods of communication were also different. The policy interaction between the Bank of England and the Treasury was relatively close and easy, because of the one-to-one relationship.
Christian de Boissieu drew attention to the importance of asset prices in the thinking of central banks. He questioned whether there needed to be a monetary pillar (it was generally conceded that monetary aggregates were a good source of information, without necessarily being a target) and thought that accountability would be improved if the discussions of the MPC and ECB Council were published.
The fiscal-monetary policy mix
This survey of the central banks led naturally to one of the main themes of the seminar, the policy mix between monetary and fiscal policies. Christopher Allsopp, also a former member of the MPC, pointed out that the policy mix was bound to be different as between the UK and the euro area, because the UK had a one-to-one relationship between central bank and Treasury, while in the euro area the ECB had a multiplicity of governments to deal with. The UK was thus not a good model. The Treasury set fiscal policy taking into account the likely monetary policy reaction of the Bank of England. Fiscal policy did not matter very much for macroeconomic management, because it had become internal to a system controlled by the Bank of England’s interest rate. In the euro area, governments had each to devise their own fiscal policy against a common monetary policy over which they had no control. This led to instability in that national fiscal policies might not be compatible with each other. The ECB had in fact been more active against unemployment than against inflation, conforming to a “Taylor rule” based on both output and prices, such as could be used to explain in the behaviour of the US Federal Reserve. The main objective of fiscal policy should not be so much the deficit or the debt, as the real exchange rate, which had to be controlled by working on comparative labour costs, given no possibility of changing nominal exchange rates. This could be done through incomes policy in smaller countries where it was easier to implement, such as Ireland or the Netherlands.
The policy mix in the euro area was sub-optimal, according to Christian de Boissieu. There was mistrust between the monetary and fiscal policy authorities, which had been a feature of the French presidential election campaign, with candidates calling for changes in the ECB’s remit. The ECB could have had lower interest rates if governments had had tougher fiscal policies, although the cost of credit had not constrained the French economy. There should be more powers for the Eurogroup, as the fiscal policy counterpart to the ECB. At present, the Eurogroup discussed everything and decided nothing. The Stability and Growth Pact to control public debts and deficits was a guarantee of sustainability of fiscal policies, but it was not in itself a sufficient fiscal policy. There was a case for exempting public sector investment from the fiscal deficit rules, on the lines of the British “golden rule”, which aims at balance over the cycle in the current budget, but allows for a deficit to finance public investment for the future. The Lisbon targets on domestic policies such as increasing employment were more important than the fiscal-monetary policy mix. It was pointed out in the discussion that the ECB had acted in a counter-cyclical manner, with low interest rates when the economic cycle was low, but governments had acted pro-cyclically, allowing deficits to increase as the cycle had turned upwards, instead of using better performance of the economy to carry out structural reforms and curb deficits. Government fiscal policies in the euro area, unlike the UK, got no feedback from monetary policy, which did not change in response to a single country’s behaviour. The feedback had to be from the real economy, in particular from the real exchange rate, based on relative unit labour costs.
The ECB had an impossible task in setting an interest rate suitable for all countries, according to Derek Scott, who put forward the “Walters critique”, named after a former economic adviser to Mrs Thatcher. The ECB interest rate was too low for high growth countries and too high for low growth countries. If the high growth countries also had high inflation, their real interest rate would be even lower, and if the low growth countries also had low inflation, their real interest rate would be even higher. He predicted a crisis in the euro within the next five years because of this. Neil O’Brien pointed to Italy as a country which needed higher interest rates, but had been a free rider on the back of lower rates set by the needs of Germany and other countries. He called for stronger market mechanisms to force a tighter fiscal policy on Italy through higher bond rates.
Senator Philippe Marini argued that there was no guarantee that the euro was sustainable, and there was a question mark over its credibility. It provided illusory comfort behind a protective shield, but what were the members doing behind the shield? There needed to be more integration of producer prices, and more harmonisation of indirect tax to create a single market corresponding to the single currency. Germany had done best in lowering its real exchange rate by domestic fiscal and economic measures, but this had left France, Italy and Belgium less competitive because they had not yet taken similar measures.
The real exchange rate within the euro area, and against the dollar and the pound, was widely recognised as the main policy objective for member governments. Structural reforms were needed in the wake of Germany’s success, with Portugal being the worst case, with low growth and lagging productivity. France was somewhere in the middle, with structural reform made more difficult because the country was neither in rapid growth making it possible, nor in an outright crisis making it necessary. Reforms were not necessarily harder on the lower socio-economic groups, pointed out Simon Tilford, because they might remove some of the privileges of the “insiders” to the advantage of the “outsiders”. Reforms were judged more acceptable in the UK than in France; the Rover car factory had been easier to close down than a car factory in France would have been.
The inadequacy of structural reform was highlighted by Iain Begg, when he argued that the euro area itself would not pass the five tests laid down by the British Treasury for the UK to join the euro. There was not enough convergence, either in growth rates or in external deficits. Flexibility was lacking in labour markets, particularly in France. Investment in the public sector was made more difficult by the terms of the Stability and Growth Pact. The euro had been good for the City of London, but this was an advantage to a non-member rather than to the members of the euro. The euro might be good for growth and jobs, but this was a future possibility rather than a present fact.
UK membership of the euro
The French seemed more interested than the British participants in whether or when the UK would join the euro. Lord Radice, in his introduction, said that British entry was still theoretically on the table, but no British Government was likely to want to join for several years, because it would not want to risk its reputation in a referendum. The UK had continued to prosper, while the economic performance of the euro area had been sluggish. This perception was one reason for the lack of interest in the UK in joining the euro, Christopher Johnson argued. He cited a recent study by Richard Baldwin showing the euro had brought about a modest increase in trade among its members, and almost as big an increase with non-members such as the UK, because firms which had invested resources in building up exports were using them to export to both the euro and the non-euro countries in the EU. He also drew attention to a recent poll showing that a majority of Europeans thought that the euro had been bad for their own country, but not so bad for other euro countries – an example of the “grass is greener on the other side” syndrome. The French say that the euro became unpopular after its introduction in 2002 because shoppers noticed that frequently purchased small items were rounded up in the new euro prices, but were not so aware that infrequently purchased large items had become cheaper. He concluded that if in several years’ time all the new members of the EU eventually joined the euro, it would be politically difficult for the UK to stay outside. The UK might just slip into the euro when no one was looking.
Rt Hon Lord Radice
Chairman, Franco-British Council
Chairman, House of Lords
Christopher Allsopp, CBE
New College, Oxford and Director, Oxford Institute for Energy Studies
Former member of the Bank of England Monetary Committee
First Secretary, Economics and Finance, British Embassy
Visiting Professor, European Institute, London School of Economics
Independent Economic Consultant
Former member of the Bank of England Monetary Committee
Economic consultant and writer
Former Chairman, FBC
Director, Open Europe
Professor of Economics and Associate-Director of ESRC, Warwick University
Sir Peter Petrie
Former Advisor to the Governor of the Bank of England, Former Chair, FBC
Former Ambassador to Belgium
Former Economics advisor to Tony Blair
Deputy Chairman, Open Europe
Head of the Business Unit, Centre for European Reform
Economist, Macro Policy Projects, HM Treasury
Christian de BOISSIEU
Président délégué du Conseil d’Analyse économique
Directeur des études économiques
Directrice du CEPII
Inspecteur général des finances honoraire
Vice-Président et Trésorier de la Section française du Conseil franco-britannique
Professeur agrégé de sciences économiques à l’Université de Paris-Dauphine
Inspecteur général des finances honoraire
Sous-directrice de la Section française du Conseil franco-britannique
Docteur en histoire de l’Université Paris-Sorbonne
Banque de financement et d’investissement,
Guy CARRON DE LA CARRIERE
Professeur à l’Institut Catholique de Paris
Membre du Comité de rédaction de la « Revue politique et parlementaire »
Rédactrice en chef international
Directeur général adjoint
Société Générale Asset Management
Grand Reporter, Le Figaro
Ambassadeur de France
Président de la Section française du Conseil franco-britannique
Sous-Gouverneur de la Banque de France
Jean-Marie LE BRETON
Vice-Président de la Section française du Conseil franco-britannique
Directeur des études économiques
Sénateur de l’Oise
Rapporteur général de la Commission des Finances du Sénat
Ancien Président de l’AFP
Président des Editions ILISSOS
Conseiller du Président d’EURONEXT
Secrétaire général de la Section française du Conseil franco-britannique
Inspecteur général des Finances
Ministère de l’Economie, des Finances et de l’Industrie