Britain: Well Done, Gordon Brown!

In June 2003, as Britain was contemplating adoption of the euro, I published an article on The Globalist. It was entitled “Britain and the Euro – Just Say No?” In fact, I recommended that the UK opt out – as it actually did six days later – because of what I considered the fundamental defects of the eurozone.

It is not unreasonable to ask 12 years later whether Britain really is better off with the pound sterling.

It would be too easy to answer this question in the affirmative by pointing to the seemingly never-ending debt crises in several European countries that decided to adopt the single currency.

Let us look at some relevant performance numbers. Between 2003 and 2014, the eurozone reported annual average growth of 1.0%. The UK, on the other hand, had an annual average growth rate of 1.6% during that time period.

Other countries outside of the eurozone did even better or equally as well, Sweden and Switzerland at 2.0% per annum and Norway came in at the UK level, 1.6%.

How does this compare to individual eurozone countries? Germany – the self-appointed poster child of economic correctness – only accounted for an annual economic growth rate of 1.1%. France grew just a little less, at 1.0% per year. And Italy’s economy has contracted for twelve years at an average annual rate of 0.24% (all data from the IMF).

It wasn’t easy for the UK

Some will say that the UK growth performance was “inflated” by excessive reliance on fiscal spending. The economic performance of the UK was especially strong during the first six years of this century. As of 2006, the fiscal deficit stood at 2.9% of GDP — just below the 3.0% Maastricht Treaty’s eurozone entry criterion.

After the crisis, this UK deficit swelled due to hefty stimulus packages and loss of revenues. It stood at 10.3% in 2010, when the Tories took over.

In the eyes of conservatives, austerity is the preferred path to economic recovery. Following that mantra, the Tories immediately cut spending, although the British economy had not yet recovered.

That reduced the deficit, but only mildly so, because it also retarded economic growth post-2010 – and hence reduced the government’s intake from taxes.

It was only in 2014 that the UK economy began to grow again more closely to its projected potential. As a consequence, government revenues grew. Current projections for the 2015 fiscal deficit stand at 4.6%, not stellar but on the way down.

In spite of initial policy mistakes caused by Tory Party austerity, the British economy grew at an annual average of 1.7% between 2012 and 2014.

This compares to Germany’s 0.7%. This is especially remarkable as German exporters have benefited from a rapid depreciation of the euro, while British exporters – operating outside the euro — had to contend with the opposite.

Much better off out than in

In spite of the burden of a strong pound for exporters, Britain would likely have been much worse off inside the eurozone. The growth pattern of all major economies in the eurozone, including Germany, is evidence of that.

Part of the reason is that a chronically weak euro, while a boon to exporters, also lowers an economy’s growth potential. This is because capital imports from outside of the eurozone and dollar-denominated commodities become more expensive.

Another challenge for the UK economy is that the value of a country’s currency affects its trade and current account position.

The strong pound has led to a spike in Britain’s current account deficit. The eurozone, on the other hand, is experiencing a high current account surplus.

What are the implications of that contrast? First, it should be re-emphasized that, from an economic perspective, neither a current account surplus nor a deficit is inherently “good” or “bad.”

Secret behind eurozone’s current account surplus

In the case of the eurozone, which claims to be in good shape because it operates on the basis of a current account surplus, it is important to note that this current account surplus is largely a function of the extraordinary surplus accrued by Germany (7.6% of the country’s GDP).

Many other countries have generated only small surpluses, or even deficits, often as the result of import compression. This term describes a situation when a nation’s imports shrink because they are too expensive.

In the case of the UK, the strong pound evidently has the opposite effect. It dampens the country’s export potential, while making imports cheaper.

The British economy, growing at 2.8% in 2014, also increased its need for imports.

Finally, how about those famous transaction costs? One of the key reasons for the introduction of the euro was that it would eliminate exchange rate uncertainties between and among its member countries.

Therefore, an exporter would always know how much they would receive for their product. Likewise, importers would know how much they had to pay.

Removing such exchange rate related uncertainties, it was argued, would be a boon for business, helping economies to grow.

There is no doubt that such costs exist in any regime of multiple exchange rates. But what often gets overlooked is that the true magnitude of these costs has shrunk drastically.

Transaction costs, a big deal?

The reason for this is simple: The foreign exchange market is by far the deepest and most liquid market in the world. Daily turnover amounts to an approximate $5 trillion.

During the financial crisis, settlement of forex contracts amounted to over $10 trillion in one single day.

As a result of this depth and liquidity, the market also has developed very sophisticated instruments to hedge against exchange rate risk. Among the largest currencies, these instruments are also very cheap.

In other words, transaction costs are no longer a major factor when deciding whether to maintain a single currency.

In conclusion, my 2003 recommendation stands. The United Kingdom has maintained fiscal and monetary independence, which is especially critical in managing economic downturns. Its annual GDP growth rate has outperformed that of the eurozone, including Germany.

In addition, the UK’s current account and fiscal imbalances have shown to be self-correcting and the sophistication of currency markets has significantly reduced transaction costs.

Well done, Gordon Brown!

In that vein, one final thought: The continued independence of the British pound might be critical in keeping the British electorate from voting in favor of a foolish exit by the UK from the European Union in the forthcoming referendum.