Tuesday, November 23, 2010

Britain and the Euro

If political circumstances had been different, the UK could have joined the Euro in 1999. How would the British economy be different now?

Bigger Boom and Lower Interest Rates.

Between 2003-2005, ECB interest rates were 2% (ECB Rates), UK interest rates were above 4% (UK rates). Many suggested that lower interest rates would have been good (cheaper mortgages e.t.c). But, with hindsight, those years were a period of unsustainable bank lending and an unsustainable asset bubble. If the UK had been in the Euro, there would have been an even bigger boom and bust in house prices. If we had ECB rates, Bank lending would have been even greater, exposing banks to more bad debts. (like Ireland experience).

In other words, ECB interest rates were too low for the UK at that stage in the cycle. In hindsight, the MPC should have had higher interest rates to dampen the housing and asset bubble, not lower.

Response To Recession.

When the economy appeared to be heading towards recession, the Bank of England cut interest rates quickly and sharply. The ECB followed the B of E in cutting interest rates. The ECB were slightly more cautious in cutting rates, I don't think it would have made a huge difference as the Bank of England rate cut struggled to stimulate bank lending because of the nature of the credit and financial crisis.

No Quantitative Easing.

The recession hit the UK more than any other country. This was because our economy was heavily reliant on the banking and financial sector. The credit crisis hit the UK economy more than other Euro members. In response to the unprecedented downturn in the economy, the MPC embarked on an unprecedented round of quantitative easing. (creating £150bn of money). This was necessary because even interest rates of 0.5% weren't helping economy. The quantitative easing led to a depreciation in the value of the pound - a 25% depreciation.

Even with zero interest rates, quantitative easing, fiscal stimulus, bank bailouts and large depreciation the British economy struggled to get out of recession. This indicates how much the economy was affected by the financial crisis and balance sheet nature of recession. If we had less options to stimulate economy and if the asset boom and bust had been bigger, we would have faced a deeper recession.

The depreciation in the exchange rate helped make UK exports more competitive, it also made UK assets like London house prices appear more competitive to foreigners.

Though exports were slow to grow, it did reduce the size of the downturn.

The greater attraction of UK assets (due to depreciation) helped prevent house price falls of 20% becoming more like 30% or 40% like in Spain and Ireland. Though the main reason the UK property collapse was less than in other Euro countries was the fact that in the boom we didn't build many houses (due to planning restrictions). The UK doesn't have a surplus of housing stock driving prices down like in US, Spain and Ireland.

Inflation. There are people in UK worrying that inflation is slightly above the government's target. But, we are lucky to have positive inflation and are avoiding the debt deflation which gives the likes of Ireland and Greece and unenviable situation.

The great dilemma for Greece and Ireland is that they have to cut their budget deficit, but, they don't have any alternatives for boosting growth. It is this combination of austerity plus lack of economic growth that makes bond investors take fright at prospect for debt to GDP ratio.

UK Debt

If the UK had been in the Euro, there would have been a much greater chance of debt default. I doubt we would be having bond yields of less than 3%.

In 2007, Ireland had public sector debt of only 25% of GDP, the UK had debt of 40% of GDP. In 2009, the UK had one of the largest annual debts.
  • Firstly, the boom and bust would have been bigger.
  • Secondly, we would have less potential to boost economic recovery through independent monetary policy.
This would have led to a sharp rise in government borrowing costs and debt to GDP ratio.

Given constraints of being in Euro, bond markets would have placed much greater pressure to cut budget quicker and earlier,


No comments: