Three Reasons Why The UK Can Never Join The Euro

Mar 7 2014, 11:02pm CST | by

Three Reasons Why The UK Can Never Join The Euro
Photo Credit: Forbes Business

There are three reasons why the UK can never join the Euro. They are Ireland, Cyprus and Iceland.

Ireland

The Irish financial crisis saw the near-failure of its entire banking sector. Ireland bailed out its banks, partly at the behest of the European Union, which was concerned that Irish bank failures would destabilize the European banking system. The bailout wrecked the Irish economy and forced the Irish government to accept assistance from the combined European Union and IMF, the price for which has been five years of tax hikes and spending cuts exceeded in severity only by those in Greece. Ireland has now left the EU/IMF “program”, although fiscal austerity continues. But its economy remains depressed, and despite substantial emigration it still has nearly 12% unemployment. And both its banks and its sovereign are still highly indebted and vulnerable to further shocks.

As this paper from the Irish central bank comments (my emphasis),

“Although Ireland has experienced a very traditional banking crisis, in that it was preceded by a credit and asset price boom, it also occurred in the context of a significant global shock. Also, given its membership of the European Monetary Union (EMU), Ireland did not suffer a currency crisis, experiencing instead an internal devaluation. As previously noted, the scale of state support required to deal with the systemic banking crisis, combined with the severe correction in the real economy, eroded confidence in the Irish sovereign. This latter fact differentiates Ireland from the majority of that group of crisis episodes in advanced economies where property played a key role in the propagation of the crisis.”

The UK’s banks were at least as badly damaged as Ireland’s in the financial crisis. But the UK had its own currency and a functioning central bank.  The currency acted as a shock absorber, falling in value as the central bank cut interest rates to historic lows and used extraordinary measures to reflate the economy in the aftermath of the crisis. The UK’s economy still suffered – it has had a very long, slow recovery. But had it been a Euro member, the damage would have been far, far worse. It would have gone down the same road as Ireland – unaffordable bank bailouts, economic collapse, sovereign default and an EU/IMF “program” accompanied by brutal austerity measures.

Cyprus

In April 2013, the two biggest banks in Cyprus collapsed.  Cyprus is a tiny country with – at the time – a financial sector whose assets were 8 times its gdp. The sovereign was too small to bail out its banks, so one bank was allowed to fail with loss of all deposits above the deposit insurance limit, while in the other one a proportion of deposits above the deposit insurance limit were converted to equity – the so-called “haircut”. Cyprus imposed capital controls to prevent depositors removing their money to avoid the haircut: these controls still remain in place nearly a year later, although they are gradually being reduced.

The financial sector was Cyprus’s largest industry, and its collapse ripped the heart out of the economy. Cyprus’s use of capital controls created an implied currency devaluation that protected the economy to some extent, but as with Ireland, membership of the Euro meant there was no functioning central bank that could reflate the economy. Cyprus’s economy shrank by 5.4% in less than a year: the damage was felt directly by Cypriot businesses, households and ultimately by the sovereign because of falling tax revenues. Cyprus was forced to restructure its domestic sovereign debt in 2013 – the second sovereign default in the Euro area (the first was Greece

But Cyprus is actually doing considerably better than the IMF’s prediction of 8% gdp contraction, and far better than Ireland, Greece, Portugal or Spain.  This is no doubt because it forced bank creditors to take losses and used capital controls to protect its economy from damaging capital flight. But although forcing bank creditors to take losses will now form part of the European Bank Resolution Directive, capital controls remain exceptional and – arguably – contrary to the spirit if not the letter of the Lisbon Treaty. It is by no means clear that a Euro member the size and significance of the UK would have been allowed to use capital controls to create an implied devaluation as Cyprus has done. Small countries don’t benefit from the tolerance that, say, Spain has experienced – Spain’s banking system is still teetering on the brink five years after its crisis – but they also get away with actions that larger countries cannot. They simply do not have the same systemic importance.

Iceland

Prior to the financial crisis of 2008, Iceland’s banks dominated its economy. At the time of their collapse the financial sector’s liabilities were about 9 times Iceland’s gdp, most of it foreign-denominated. And therein lay the problem. Iceland wasn’t a member of the Euro: it had its own currency and its own central bank. But its banks’ foreign liabilities far exceeded the country’s foreign currency reserves. It couldn’t bail them out. In essence, it was in the same position as Ireland or Cyprus – its banking sector had extensive liabilities in a currency it could not control.

But Iceland’s government had a big advantage over Ireland and Cyprus. It had its own currency and full control of monetary and fiscal policy. It could protect its economy. It allowed its banks to fail and refused to honor foreign liabilities: there was legal action against it, of course, but it won. It allowed its currency to devalue by 50% and imposed capital controls, most of which are still in place. And it provided fiscal support to businesses and households. Six years later, Iceland’s economy has recovered fully from its crisis and is expected to grow at a rate of 2.5% over the next year.

Lessons for the UK

Iceland, Ireland and Cyprus were all small open economies with very dominant financial sectors. The UK is much larger than any of them, but it is still a relatively small open economy with a dominant financial sector: despite a 10% contraction in the last six years, the liabilities of the UK’s financial sector still stand at about twice UK gdp. Were the UK to join the Euro, this would have to be significantly reduced. The UK simply could not afford to take the risk that such a dominant financial sector would pose to the economy in the event of another crisis without the protection of its own currency and central bank.

Whether the UK could, or should, cut its financial sector further – and what the economic cost of doing so would be – is an open question. Diversification of the UK economy is desirable, but the financial sector is an important contributor to gdp and an area where the UK has comparative advantage. So far, the government seems keen for the financial sector to retain its global significance.

But the global importance of the financial sector is not the only reason why the UK can never join the Euro. The other reason is the high level of household debt due to residential mortgages, coupled with the relatively high level of sovereign debt and stubborn primary deficit. Even if the UK stopped being a market leader in global finance, it would still be enormously at risk in a financial crisis. It’s worth remembering that although many UK banks were bailed out in the financial crisis, capital markets activity was a significant factor in only one – RBS. The rest were all damaged by excessive risk in residential and commercial property lending. This is also what happened in Ireland and Spain. Both have suffered terrible economic contraction due to being in the Euro straitjacket.

While the UK remains a highly indebted property-owning economy with a large and dominant financial sector, it can never join the Euro.

Source: Forbes Business

 
 

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