A Hypothetical History: Had Britain Entered EMU
Essay prepared for publication in the Sutherland report on British membership of the euro
Suppose that Britain had entered the euro when it was founded at the beginning of 1999, instead of spending ten years inventing reasons as to why entry would be a bad idea. It is commonly assumed that this would have been a terrible mistake, and that loss of the exchange-rate instrument would have imposed a catastrophic cost on the economy. The intent of this paper is to examine this contention.
I do not intend for one moment to disparage the importance of having a roughly right exchange rate for achieving sensible macroeconomic outcomes. Far from it: My argument is that Britain would have had an exchange rate consistently closer to its real needs if it had been in the euro than it had with an independently floating pound. Of course, that depends upon the entry rate being roughly right and the real rate not being carried somewhere greatly different, e.g., by differential inflation. Both of these conditions were, in my view, likely to have been satisfied. It also requires the condition that there be no important shock that would have required a substantially different real rate.
The Entry Rate
It is common knowledge that Britain could not have entered the euro at a rate greatly different from one the Bundesbank regarded as sound. One could not enter at a rate so undervalued that the Bundesbank feared it would give rise to an inflationary impulse in the euro area or threaten Germany’s trading interest, nor at a rate so overvalued that the Bundesbank expected to be presented with bailout bills. It is true that German officials commonly mouthed at G-7 meetings the same sort of platitudes as most of their peers about the impossibility of making sensible judgments about whether or not currencies were close to their fair value. But the Bundesbank acted far more intelligently than German officials spoke: Look, for example, at its opposition to the overvalued rate at which Nigel Lawson had put the pound in the ERM in1989, and its consequential refusal to rescue the pound in 1992. Discomfort at the depths the pound plumbed after 1992 doubtless made the Bundesbank unhappy too, though there is no public record of its misgivings comparable to the one that emerged after the ERM crisis.