Feeling the Effects of the Financial Crisis
An issue for lots of people and which needs to be dealt with is exactly how then should the United Kingdom decide on the Euro? A growing number of leading figures such as Peter Sutherland believe the issue needs re-examining to assess the benefits that joining the Euro Zone may bring. The public will still need to be convinced that the net effect on the real economy will be favourable. However, the five tests were always imprecise and arriving at the ‘clear and unambiguous’ result that Brown hoped for by setting up the tests was always going to be a matter of opinion to a certain degree as well as empirical economics. Even in today’s current economic climate, an evaluation of the tests could go either way depending on assumptions made and, let’s be blunt, the political result that is wanted. What should, though, become more instrumental in judging whether it is now in the United Kindoms interest to join the Euro is the likely impact on financial stability and whether the new risks the economy faces can be adequately managed while the UK stands alone.
Larger and more diversified economies have many advantages in dealing with financial risks and economic turmoil. When times are good, Iceland benefited from the activities of its banks in external markets, but when the crisis hit it rapidly became apparent that it was not just the banks, but the country as a whole that was in default. By contrast, Luxembourg or Ireland (both of which have become relatively specialised in financial services), have the rest of the euro area as a source of liquidity.
This begs the question do financial stability and economic governance considerations replace the optimal currency area reasoning behind the five separate economic tests? Some commentators, such as the distinguished Financial Times columnist Martin Wolf, have posited the argument that the United Kingdom needs exchange rate and interest rate flexibility more than we ever have done in the past to deal with the fallout from the credit crunch. However a potent counter-argument is that the realsolution will come from co-ordinated international action to shore up bank balance sheets and sustain the desired level of aggregate demand. A country such as the UK may gain temporary respite by devaluation, but only by what is in effective a protectionist device to gain market share and by risking longer-term inflation. Moreover, it is not through devaluation that the health of the banking system will be restored, but by policies that assure an appropriate balance between risk and solidity.
An obvious conclusion to draw is that the old approaches to assessing Euro membership arelong since out-dated. By these latter criteria, the case for the UK to think afresh looks different and stronger than it has in the past.
