ECB's record illustrates that one interest rate may be better for all

Two arguments have dominated the economic case against Britain joining the euro. One is that a common interest rate ("one size fits all") for such a large and economically diverse region is inappropriate; eurosceptics would argue that the same applies to a common exchange rate, or more precisely a frozen internal rate and a common external rate.

I am going to argue that, in truth, "one size may be better for all", and that if the market exchange rates between the pound and the euro and between the euro and the US dollar continue in the directions they are going, it may soon be possible for the UK to enter the euro at an economically competitive rate without the need for a special devaluation.

Let me start with two observations from others. According to Business for Scotland, interest rates set by the European Central Bank are far more attuned to the needs of the Scottish economy than those set by the Bank of England. Writing in The Political Economy Review, a Dulwich College publication, Tarik Soliman, a pupil at Dulwich College, says:

"Opponents of British entry to the euro inevitably return to the issue of monetary policy. They seem outraged at the thought of a non-elected bureaucratic body, the European Central Bank, setting short-term interest rates that will directly affect UK industry. They seem to forget that this already happens; our own non-elected body, the Bank of England sets UK rates.... Yet the UK itself has substantially different economic circumstances facing various parts of the country and they [the Eurosceptics] hardly propose to operate British monetary policy on a regional basis."

Well, England isn't Scotland or Ireland. We all know where England is. Somewhere between St Paul's and Aldgate, west to east, and Moorgate and Monument, north to south. In other words, the City of London. The idea that a common interest regime will inevitably damage "England" is wrong in every particular.

How successful have the Bank of England's Monetary Policy Committee (MPC) and the European Central Bank been in practice? The case for the MPC, goes something like this: From 1997 to 2001 the UK real economy grew at a satisfactory rate and held up well during the global slowdown at the end of the period; unemployment continued to decline and inflation was always at or below the target of 2.5 per cent.

Average nominal interest rates were about 6 per cent, implying real rates of about 4 per cent. The nominal rate rise of 1997-98 was justified by signs that the economy was "overheating", such as fast real growth, falling unemployment and accelerating earnings. There were few signs of domestic overheating in 2000-2001, but a rate rise could be justified by the rising oil price (see chart one).

The case against the MPC runs like this: Neither rate rise was justified and the high 4 per cent real rate has been bad for long-term growth. In 1997-98, MPC members allowed themselves to be misled in four different ways, namely fear of potential inflationary effects from a fall in the sterling exchange rate, misinterpretation of the earnings statistics and an under-estimation of productivity growth.

Each rate rise depressed the real growth rate. Over the whole period the average real growth rate has been reduced by between a half and a whole point. This downward bias in the MPC's approach is analysed in a careful statistical study by Christopher Martin and Costas Millas, of the Economics Department, Brunel University (Modelling Monetary Policy available from Christopher. Martin@brunel.ac.uk.)

Now the case for the ECB. See chart two, which is similar to chart 1 except that earnings are omitted and a track of oil prices included. Over the three years 1999-2001 the eurozone economy grew at 2.6 per cent per annum compared with 2.4 per cent in the UK, 3.1 per cent in the US and 2.2 per cent in the eurozone in 1996-98.

In terms of growth, the ECB has performed better than the MPC, better than the economy of the pre-euro eurozone, and comparably with the US late-1990s "tiger". Unemployment fell from 10 per cent in 1999 to 9.3 per cent in 2001. Inflation was half a point below target in 1999, on target in 2000 and half a point above it in 2001. In 2001, if the lagged effect of oil prices were removed, the eurozone would probably have appeared on target in that year also. The ECB has also maintained real interest rates at a lower level than in either the US or the UK.

In fairness, I should also argue the case against the ECB. The main case for criticising the ECB lies in the interest rate increases of the year 2000, which could be held responsible for some of the eurozone growth slowdown of 2001 and the historically unique collapse of German economic growth (see table four) that occurred in the last quarter of 2000. The explanation for what happened is not difficult. By attempting completely to forestall an oil price increase from affecting the domestic price level, the ECB also deflated the real economy. The correct procedure would have been to let domestic prices rise to some extent.

In the event, eurozone inflation did rise by half a point in 2001, but since real growth fell by no less than two points, one can say with certain hindsight that the eurozone nominal interest rate was too high by at least a point, if not more.

In summary, the performance of both the ECB and MPC showed strengths and weaknesses and both seemed somewhat biased against real growth. However, the facts do not support the view that the MPC has been a better manager of monetary policy for the British economy than the ECB has been for the eurozone.

On to the exchange rate. I have called my pamphlet We can go in now, but actually the exchange rate still needs to fall a bit before we can safely join. If it has not done so by the time a referendum is held, the Government should make clear in the question asked that it would not enter until a satisfactory entry rate had been made possible.

The ideal rate for UK entry lies between €1.40 to the pound (72 pence to the euro) and a little higher. That is the rate which would equalise the average cost of goods over the whole gross domestic product of the UK and the eurozone. It is also a rate which would help correct the current UK trade deficit with the eurozone. My calculation is supported by the OECD (Main Economic Indicators, May 2002, page 273, and The Pound's Fair Value in the Economic Survey of the UK 2001). The same conclusion was also reached in the recent Ernst and Young Item forecasting club report UK Economic Prospects Winter 2002.

Today's rate is €1.59. Recently it was a low as €1.54. So it is not true that we are "almost there". But it is certainly true that we are well on the way.

The writer is Professor Emeritus, Department of Economics, Birkbeck College, London. Robin Marris's pamphlet, 'We can go in now', goes into circulation this week. For a free download of the text, write to:

euromarris@btinternet.com