BLAIR’S BRITAIN, 1997–2007
Page 32
central banking, and possibly to improve monetary policy processes and
decisions.
There are also counter-arguments. Unifying currencies across some,
but not all countries, will divert trade, very probably wastefully, from
excluded countries. Exchange rate uncertainties can often be hedged
against at very modest marginal cost. Your country’s optimum inflation
16 Some influential indirect evidence supporting this claim includes J. McCallum, ‘National
Borders Matter: Canada–US Regional Trade Patterns’, American Economic Review, 85,
1995: 615–23 and A. Rose, ‘One Money, One Market: Estimating the Effect of Common
Currencies on Trade, Economic Policy, 30, 2000: 7–45.
17 This would indeed happen in any number of endogenous growth models. See R. E. Lucas,
‘Supply Side Economics: An Analytical Review’, Oxford Economic Papers, 42, 1990:
293–316; P. Romer, ‘Endogenous Technological Change’, Journal of Political Economy, 98,
1990: S71–102; and P. Aghion and P. Howitt, Endogenous Growth Theory (Cambridge,
MA: MIT Press, 1998).
trend may differ from your monetary union partners’. Asymmetric
shocks (which have quite different impacts on you and your union partners) must mean that both you, and they, are constrained to follow a
second-best, common reaction. ‘One size fits all’ probably implies a
perfect fit for no one. Currency union requires you to surrender the
option to set interest rates independently, and the option to enact or
permit changes in your exchange rate. Those two options may have far
from negligible domestic value.8
Furthermore, in Britain’s case, there were the luckless dummy runs.
Sterling joined the ‘snake-in-the-tunnel’ in 1972. Later, in October 1990,
it entered the ERM. But both of these commitments – however unfortunately timed – were to prove unsustainable. Further possible complications include: wrangles about how to fix entry exchange rates for legacy
currencies (the partners will have conflicting interests here, and there is
no easy or agreed way of quantifying a ‘fundamental equilibrium’
exchange rate9); how to make a supranational central bank democratically accountable; how to ensure that national fiscal policies do not
undermine the common currency, in the way that, for example, spending
and deficits of Argentina’s provincial authorities helped to destroy the
country’s currency board in 2001–2;10 and seignorage allocation disputes.
From 1997 to 2003, the government’s official position was ‘prepare and
decide’. Despite its hint of activity and resolve, only a skilled semiologist
could discern much real difference between this phrase and the Major
government’s policy of ‘wait and see’. Public opinion on the issue bobbed
up and down, but showed a consistently negative majority (and no
overall trend). May 1998 saw it at its smallest in the MORI opinion poll –
34% in favour, and 48% against. There was a record majority against in
November 2000 (18% in favour, 71% against). Typically there were about
18 With its independent currency, France could devalue its way out of the wage hikes, agreed
between (then) premier Pompidou and trade union leaders, that ended its national strike
in 1968. But if events ever repeated themselves under the euro, France would be doomed
to suffer a haemorrhage of its external competitiveness and jobs.
19 As explored recently, for example, by R. Driver and P. Westaway, ‘Concepts of Equilibrium
Exchange Rates’, in R. Driver, P. Sinclair and C. Thoenissen (eds.), Exchange Rates, Capital
Flows and Policy (London: Routledge, 2005).
10 See A. Powell, ‘The Argentine Crisis: Bad Luck, Bad Management, Bad Policies, Bad
Advice’, Brookings Trade Forum (Washington DC: Brookings Institution Press, 2003); and
F. S. Mishkin, The Next Great Globalization: How Disadvantaged Countries Can Harness
their Financial Systems to Get Rich (Princeton, NJ: Princeton University Press, 2006) for
more on this.
twice as many against as in favour throughout the period from 1992 to
2003. Opposition was on the whole rather stronger among women,
over thirty-fives, lower-income groups and those inclined to vote
Conservative. The Conservative Party made its hostility to abandoning
sterling a central plank in its 2001 general election campaign, and subsequently attributed its drubbing to undue emphasis on the issue.
Nonetheless, the fact that winning a referendum on euro entry looked a
hopeless prospect was clearly critical in reconciling Blair to staying out, at
least for a while. It may also have helped to strengthen Brown’s doubts
about the wisdom of entry.
In June 2003, Brown announced his verdict to the House of Commons:
‘A clear and unambiguous case for UK membership of the EMU has not
at the present time been made and a decision to join now would not be in
the national economic interest.’ The accompanying Treasury document11
stated that ‘we cannot . . . conclude that there is sustainable and durable
convergence or sufficient flexibility to cope with any potential difficulties
within the euro area’. On a more positive note, Brown did announce that
the country’s inflation target (2.5% per year increase in the Retail Price
Index, definition RPIX) would switch to one based on the Consumer
Price Index (which was easier to compare with the ‘harmonized index of
consumer prices’ watched by European Central Bank). He also declared
that steps would be taken to modify Britain’s housing and mortgage
markets, in line with the recommendations of the Barker12 and Miles13
reports that he had commissioned.
Was Brown right to say no (or not yet) to the euro? It is interesting to
speculate on what would have happened had (a) sterling joined at the
inception (1999, with notes and coins debuting in 2002), or (b) Brown
announced that his tests had been met, and (improbably) that ratification
11 It was buttressed by an eighteen-volume research document, HM Treasury, ‘UK
Membership of the Single Currency: EMU Studies’, 2003, www.hm-treasury.gov.uk/documents/international_issues/the_euro/assessment/studies.
12 K. Barker, Delivering Stability: Securing Our Future Housing Needs, Final Report (London:
HMSO, 2004). House prices were increasing strongly in the UK – and also in some euro
area economies with faster growth, such as Ireland and Spain – to much larger multiples of
income than in France, Germany and Italy, raising concerns about overall monetary
stability in the short run and financial stability in the longer run.
13 D. Miles, The UK Mortgage Market: Taking a Longer-Term View, Final Report and
Recommendations (London: HMSO, 2004). Unlike much of the rest of the EU, Britain’s
mortgages were typically at variable interest rates, not rates fixed for several years. This
raised worries that the transmission mechanism of monetary policy could be more violent
in Britain, a special concern if interest rates were to be set with reference to euro-areawide, rather than UK, economic conditions.
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by parliament and people been followed swiftly in 2004. In either case,
adding UK data to the aggregate euro area statistics would probably have
led the ECB into a slightly more hawkish stance for the time profile of its
policy rate. This is because UK unemployment, unlike Germany’s,
France’s and Italy’s, has been low by historical standards. But, for the same
reason, the policy rate would surely have been set at lower rates than the
UK’s.
There is a curious (and in the author’s view, needlessly restrictive)
convention that policy rate changes are normally limited to twenty-five
basis points (one quarter of one per cent) or multiples thereof. Partly
because of this, but principally because the UK would have formed
barely one-sixth of the hypothetically enlarged euro area (EA+, call it),
our counterfactual thought experiment would have EA+ rates set very
much closer to the ECB’s than the Bank of England’s actual rates. This
suggests that euro participation could actually have served to overcook
the UK’s already relatively overheated economy. EA+ rates would also, to
some degree, have deepened the doldrums for the three large euro area
economies: any rise in interest rates would have intensified their problems of sluggishness in production, investment and employment
growth. Lower policy rates would probably also have inflamed the UK
housing market, either, as in Ireland, by pushing up prices strongly in
2000–2 when they were still rather quiet (had the UK joined early on), or
(with entry in 2004) by intensifying the 2003–6 giddy house price boom.
And an enlarged euro would probably have seen its external value fall less
than it did in 2000, and recover more slowly in 2004–6. Although the
UK’s mild 2000–3 downswing could have been softened somewhat by
the consequences of early euro entry, the major effects would, on
balance, probably have been to destabilise GDP (and inflation) in the UK
and also in the euro area core. The first technical, scholarly attempt to
gauge the effects of euro entry-at-inception on the UK and Sweden
reaches not dissimilar conclusions.14 Future research may of course
point to a different conclusion. Or we might see some evidence of sharp
increases in intra-euro area trade and in growth rates that advocates of
the euro project once prophesied.15 But there is precious little evidence
of this to date.
14 H. Pesaran, V. Smith and R. Smith, ‘What if the UK or Sweden Had Joined the Euro in
1999? An Empirical Evaluation Using a Global VAR’, International Journal of Finance and
Economics, 12, 2007: 55–87.
15 See, for example, M. Emerson, D. Gros and A. Italiener, One Market, One Money (Oxford:
Oxford University Press, 1992).
Furthermore, there have been asymmetric shocks that have affected
EU countries in different ways. Instances include the big 2004–6 jump in
oil prices (relatively bullish for sterling), major differences in immigration patterns, and sharp increases in Chinese exports (neutral to favourable for some EU countries, but especially damaging for Italy, given its
greater similarity in export patterns). And perhaps the biggest argument
for keeping sterling out of the euro area for a while was another asymmetry. Postponing entry would allow experts to quantify actual effects and
see how things worked out (‘the value of waiting’). Importantly it would
also preserve options. Entry, an all but irreversible commitment, could
only close them.
Other financial and monetary issues
If the Blair–Brown economic policy record is crowned by its essentially
negative – and judicious – decision to stand aside from the euro area, there
are some positive radical changes that it introduced as well. Foremost
here were granting operational independence to the Bank of England,
and the creation of the Financial Services Authority to combine the
supervising roles of numerous bodies, the Bank included. Both changes
were announced in early May 1997, in the first days of Blair’s government.
They had been prefigured in some earlier Labour policy pronouncements. But the Bank independence decision astonished observers with
the speed and manner of its execution. The key idea is that politicians are
inherently short-sighted – fixated by impending elections – and therefore
tempted to do things that bring short-term gain at long-term cost.
Among these, Barro and Gordon argued,16 were policy decisions that
affected inflation. An unexpected rise in inflation would bring extra
output, profits and jobs for a while; so politicians that declared a promise
to keep inflation low, the right policy for the long run, would soon misbehave and lose credibility. The output gains would be fleeting, but the
extra inflation would do harm. Better, therefore, to pass monetary policy
decisions to a ‘conservative’ central banker who made low inflation his
sole priority17 – or set the central bank a widely published, transparent,
low inflation commitment (a ‘target’) and let it get on with it, with no
political interference. Perhaps it was no accident that the astonishingly
16 R. Barro and D. Gordon, ‘Rules, Discretion and Reputation in a Model of Monetary
Policy’, Journal of Monetary Economics, 12, 1983: 101–21.
17 K. Rogoff, ‘The Optimal Degree of Commitment to an Intermediate Monetary Target’,
Quarterly Journal of Economics, 100, 1985: 1169–89.
rapid inflation rates in all the world’s democracies during the second half
of the twentieth century – so much higher than the approximately zero
rates seen in the eighteenth and nineteenth centuries – owed much to
lagged effects of franchise extensions, and the Keynesian revolution that
encouraged politicians to seize the levers of monetary policy and use
them to try to defend and create jobs.
Brown’s move was indeed a radical departure. It accorded with the
grain of the times, and followed most of the best recent academic thinking on the issue. It was welcomed by the financial markets, which
promptly lowered nominal interest rates on longer-term (sterlingdenominated) UK government debt sharply, demonstrating a belief that
British inflation would be substantially lower as a result. But just how
novel was it? In some ways, the new arrangements represented a step back
to the years before 1939, or 1914, when policy interest rate decisions were
taken by the Governor of the Bank of England, not the Chancellor. In
others, it was a logical extension of Norman Lamont’s decision in 1992 to
replace the broken anchor of British monetary policy – the link to the
German Mark – with a new monetary framework, inflation-targeting,
which New Zealand had initiated barely three years before. And before
that Nigel Lawson had wanted to grant the Bank operational independence. The fact that Lawson could not tells us how subordinate most
Chancellors are, in some key issues, to 10 Downing Street. But where
Thatcher forbade, Blair was to delegate, at least to the Chancellor if not to
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br /> other ministerial colleagues. Perhaps Blair just preferred to involve
himself in foreign affairs, in education, in health, in Ulster, and saw that
his time was limited and his talents and interests better confined to those
spheres. Perhaps he and Brown agreed from the start that Brown should
have an untrammelled say in all matters economic. And perhaps Blair
recalled how Thatcher never really recovered from Lawson’s angry resignation, and determined not to repeat that error. There is probably some
truth in all three of these statements.
In the new system, a Monetary Policy Committee (MPC) would meet
at the Bank each month to set the UK’s short-term policy rate,18 by
majority vote. The MPC consisted of the Governor and two Deputy
Governors of the Bank (all crown appointees on renewable five-year
terms), two other Bank officials, and four external members, chosen by
the Chancellor, serving three-year renewable terms. A tenth non-voting
member would be a Treasury official. So the sense in which the Bank
18 Known as Bank Rate from 2006.
of England gained independence in 1997 was strongly nuanced.
Furthermore, it lacked goal independence. The MPC would be charged
by the Chancellor with aiming at a specific number for the rate of inflation (2.5% RPIX, later changed to 2% CPI).19 Other objectives, such as
sustaining employment and growth, were to be secondary to that. If inflation over a year strayed by more than 1% from the target, the Governor
would write an open letter to the Chancellor explaining why the target
had been missed, and what action might be taken to attain it later. In the
ten years of Blair’s premiership, coterminous with the first ten years of the
MPC, just one letter had to be written, right at the end. Until March 2007,
annual inflation was never more than 1% off target. The upper limit was
touched in January 2007, then breached two months later, largely as a
result of oil price movements.
You must have a nominal anchor. To see that, look at the huge jump in
Britain’s annual inflation rate, to 26% in 1975, which followed her pilotless exit from the snake-in-the-tunnel in 1972. But which? Monetary
targets – but for which monetary aggregate, and why an indirect one