Should Britain dump the pound for the euro?

By Associate Editor David Stevenson Jun 02, 2008

David Stevenson

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The news on the UK economy just keeps getting worse.

Last week’s news was unremittingly glum - from falling house prices to income squeezes, most of us are quite a bit worse off than we were a year ago. And with inflation soaring, we can’t expect the Bank of England to cut interest rates this week to try to alleviate any of the pain.

To add insult to injury, the pound, our national virility symbol, has plunged against the euro, so we can’t even afford to go away from it all on holiday on the Continent. And we came last in Eurovision… again. We seem to be becoming the sick men of Europe.

If you can’t beat them, they say, join them. So has the time finally come to dump the poor old pound and plump for the euro?

Why Europe could be in as much trouble as the UK

With the euro now among the world’s strongest currencies, you might assume that the eurozone was in a much better state than Britain. But take a closer look and you soon see that plenty of problems have been cropping up on the other side of the Channel, as well as across the Irish sea.

Take housing. Last week’s Nationwide house prices survey showed that prices were down 4.4% year-on-year in May, the biggest fall since the early 1990s. That’s pretty grim.

But in Spain house prices have already fallen 15% across the board since September, according to the developers' association (APCE). And in Ireland, house prices were down nearly 10% year-on-year up to the end of March.

Of course, the UK property market is set to get a lot worse. But the same could be said for Spain and Ireland.

Then there’s consumer confidence. In Britain this has crumpled, according to the latest GfK indicator, to its lowest point since Margaret Thatcher was ousted from office. Again, pretty grim. But the eurozone isn’t immune either - French consumer confidence has now fallen to its lowest level in 20 years.

And as for inflation, despite the European Central Bank’s (ECB) reputation as a hard-nosed inflation fighter, Europe’s having trouble with rising prices too. Last Friday’s figure turned out worse than expected, coming in with an annual rate of 3.6%, adding to what ECB president Jean-Claude Trichet has called policy makers’ “biggest challenge”. Despite the strong currency, that’s 0.6% higher than in the UK. Indeed, the pressure’s now building on the ECB for the next move in interest rates to be up.

And the broader picture for the euro isn’t looking a lot brighter than for the pound, either. Because long-term private investors are pulling their cash out of the eurozone at the fastest rate since the creation of the single currency, says a report by BNP Paribas.

Foreign direct investment in plant and factories has swung down over the past year to a negative €149bn (£117bn), including a drop to minus €19bn in March alone as the surging euro drove up relative labour costs in southern Europe. Add in a $280bn withdrawal of private funds from eurozone equities and bonds, and total outflows have exceeded €400bn over the last twelve months.

The euro is now suffering from the “reserve currency curse”, says Ambrose Evans-Pritchard in The Telegraph, as central banks in Asia, Russia, and the Middle East use it as an alternative to the dollar. “While Asian funding has helped ease the credit crisis in Europe, it has also pushed the exchange rate to damaging levels. The eurozone has gained financial flows, but has lost industrial and investment flows.”

BNP’s currency strategist Hans Redeke sees mounting signs of stress. “There are lots of ugly surprises in store as deleveraging finally hits Europe. Investors are going to stop treating the eurozone as if it were just Germany. We will discover in this downturn whether the eurozone is really an 'optimal currency area'. This is the test”.

So, on reflection, maybe this isn’t the time for the Treasury’s great and good to contemplate dumping the pound. And if you’re still unconvinced, here’s what the FT’s Martin Wolf has to say. He’s such a staunch opponent of such a move, he’s even just criticised his europhile peers in print: “the Lex column argued last week that the UK was close to meeting the economic tests for joining. Lex is wrong.

Three reasons why our currency should be left alone

We’ve not been hurt historically by being out of the euro, says Mr Wolf. Between the first quarter of 1999 and the first quarter of 2008, Britain’s economy expanded by 28% compared with 21% in the eurozone as a whole and 16% in Germany. Nor has London's position as a financial centre been hurt.

In fact, had the UK been a recent eurozone member, our present situation could be even worse. Our credit bubble would have inflated more, because euro interest rates have been lower. On top of that, now that the domestic spending boom is over, there’d have been no offsetting benefit from the recently plummeting pound.

Inflation may well now rise faster in the UK than in the eurozone, but at least we have some hope of controlling this. The Bank of England can set interest rates to suit Britain alone, rather than relying on the ECB, which is arguably far more concerned with how suitable interest rates are for Germany. If the BoE sticks firmly to its 2% inflation target, Britain will almost certainly veer into recession, but then so will the eurozone countries.

So forget the euro - our currency should just be left alone, to find its own level. Which of course, looks like it could well be considerably lower than it is now.

Turning to the wider markets…

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UK shares had another quiet day with the FTSE 100 index slipping 15 points to 6,053. Retailers enjoyed a slightly better time as one or two brokers became more bullish, with DSG adding 3% and Home Retail 2.4%. British Airways soared 8% after the demise of business class carrier Silverjet, and was further helped by the weaker oil price which knocked back energy stock prices. European markets were again firmer, with the German Xetra Dax climbing 0.6% to 7097 and the French CAC 40 gaining 0.8% to 5014.

US stocks slipped into negative territory in late trading, with the Dow Jones Industrial Average ticking down 0.1% at 12638. The wider S&P 500 flipped up 0.1% to 1400, while the tech-heavy Nasdaq Composite advanced 0.6% to 2523.

Overnight the Japanese market continued to flourish, with the Nikkei 225 climbing 0.7 to close over 100 points better at 14440, while in Hong Kong, the Hang Seng added 1.2% to 248173.

Commodity prices were generally firmer. Brent spot was trading this morning at $126.5, while spot gold was at $883. Silver was trading at $16.77 and Platinum was at $1991.

In the forex markets, sterling was weaker against both the US dollar at 1.9648 and the euro at 1.2655. The dollar was trading at 0.6438 against the euro and 104.17 against the Japanese yen.

Big news over the weekend - private equity firm Texas Pacific Group has spent £179m on a 23% stake in Bradford & Bingley, which has also announced a profit warning this morning.

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