why britain should join the euro

Concern over the financial sit-uation of Greece and othersouthern European coun-tries has led to renewedprophesies that the eurozone

is close to collapsing. Action certainly needsto be taken, particularly by Greece, Spainand Portugal. Britain with its massive fiscaland balance of payments deficits is, howev-er, in no position to be over-critical and thesubstantial decline of sterling against theeuro since the financial crisis began is areflection of weakness rather than strength.Running away from the battle by devaluingis hardly a sign of confidence in our abilityto meet the challenges of an increasinglyglobalised world.

Britain’s continued rejection of the euro isendorsed by most sections of the British polit-ical, media and financial scene. However,staying out of the euro is having a major effecton Britain’s declining manufacturing baseand other areas where long-term investmentis required.

Britain�and�manufacturing�Britain has moved from being the ‘work-shop of the world’ to very much an also-ranin manufacturing. There are remainingpowerful manufacturers, such as Rolls-Royce and BAE Systems but they are fewin number. Manufacturing’s share of the

economy and the country’s share of worldmerchandise exports have declined signifi-cantly. Some reduction was to be expectedbut the deterioration has been far greaterthan in two of our major competitors – seeTable 1.

This table shows the substantial currentaccount differences between Germany andJapan, which have retained their manufac-turing base, and the UK and United States,which have not.

The decline in British manufacturing hasunbalanced the economy and society withsignificant adverse effects. First, the increasedfocus on financial services, house buildingand the retail and state sectors to provideemployment and tax revenue meant thefinancial crisis, the collapse of the banks andconstruction industry and public sector cutsare – and will continue – to take a severe toll.

Increased concentration of the econo-my in London at the expense of theregions has led to overcrowding and traf-fic congestion in the South East. Well-paidand well-regarded jobs in areas outsideLondon, which were available to thosewith less intellectual skills, have been lost,causing greater inequality and a break-down of society in certain deprived areas.

Manufacturing has become unattractive touniversity graduates who see better prospectsin banking and the professions. This furtherweakens the ability of manufacturers to

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Why�Britain�shouldjoin�the�euroBritain�turned�down�the�initial�opportunity�to�participatein�the�euro�project�and�has�continued�to�reject�the�eurodespite�it�being�embraced�by�nearly�all�other�members�ofthe�European�Union.�PPeetteerr��HHoowwaarrdd��argues�that�this�stanceis�damaging�to�the�country,�economically�and�socially�–particularly�because�it�is�contributing�heavily�to�the�declineof�British�manufacturing.

compete internationally. And substantialdeficits on the external current accountresulting in high borrowing from overseasare contributing significantly to the currentcredit crisis and the government’s inabilityto resolve the position.

Manufacturing�declineSince the Second World War internationaltrade has grown more strongly than globaloutput. In Britain’s case Europe hasreplaced the national market as the mostimportant area of economic activity and isnow the market for nearly 60 per cent ofBritain’s exports. It is the area whereBritain must sell most of its products andin which it must compete with other sup-pliers. Within this market consistent levelsof pricing and quality of products andservices are forced on competing firms.While innovation provides opportunitiesto achieve premium pricing, these oppor-tunities are usually short lived. The majori-ty of economic activity is carried on inconditions of extreme price competitionwith relatively harmonised costs andreturns on capital dictating the prices thatcan be obtained. This benefits Europe’scitizens through lower prices and betterquality but it is uncomfortable for thefirms concerned.

Long-term economic success in suchcircumstances depends on investment – inequipment, R&D and skills. Such investmentwill only be made when there is confidence

of obtaining satisfactory returns, based onprojections of sales and costs. The two keyparameters in the final decision on theinvestment are the return envisaged and theconfidence with which that return can beexpected to materialise. The more uncer-tainty can be removed, the greater theprospect of long-term investment and thebenefits that flow from it.

Once lost, investments in facilities, equip-ment and skills are extremely difficult toreplace. Those who believe that the recentweakness of sterling will enable the manu-facturing sector to recover are fooling them-selves; it will provide temporary respite atbest. The facilities, equipment and skills arenot in place to exploit the lower pound andwould take years and, in the case of skills,decades to create.

Another factor that instils the confidenceto invest is position relative to the competi-tion with respect to costs and selling prices. Ifa firm knows that it is unlikely to lose itscompetitive edge through factors beyond itscontrol – that its competitors will be subjectto the same cost and price pressures and sim-ilar constraints and government action – itwill have more confidence to invest.

The countries that formed the EU did sopartly in recognition of the benefits of amuch larger market. Without such a market,companies would have much greater difficul-ty in competing, particularly against their UScounterparts with their huge domestic mar-ket and against Japanese companies withtheir big protected market. Those member ©

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Table�1:�Manufacturing’s�share�of�the�economy,�1996–2006,�in�the�UK,�US,�Germanyand�Japan

Manufacturing’s�share Current�account�pastof�the�economy five�years

1996�� 2006 Total Per�capitaUS$bn US$

UK 21% 13% -313 -5,200

US 18% 14% -3,576 -11,500

Germany 22% 23% 869 10,500

Japan 22% 21% 845 6,600

Source:�Percentages�taken�from�The�Economist,�10�January�2009

countries that created the common currencyof the euro then recognised a second truth –that investment requires confidence and thatthis was not available when exchange ratefluctuations could destroy the competitive-ness of firms in different member countries.

To understand the advantages thisbrings, consider the example of a Britishfirm operating outside the euro area andinterested in making a substantial invest-ment to produce widgets. Assume thatthese widgets will be supplied 30 per centinto the British market, 40 per cent into theEuropean market and 30 per cent to therest of the world. The main competitors areEurope-based. The investment will be one-third financed with debt, it has a 10-yearlife, and projections show that it is expectedto provide a lifetime return on equity of 18per cent assuming constant exchange rates.Domestic cost inputs such as materials andlabour amount to 70 per cent of sales andimported costs are 20 per cent of sales.

The project appears attractive until some-one asks ‘What happens if sterling appreci-ates by 20 per cent?’ The answer is prices,which are set by European-based competi-tive pressures and cannot be increased ineuro terms, have to be cut in sterling terms.As a result, the margin turns negative andthe project produces a negative return of 11per cent. The decision to go ahead with theinvestment, therefore, becomes a gamble onthe future strength of sterling. Responsibleboards of directors do not like gambling andtherefore another otherwise attractive invest-ment is lost to the country.

A movement of 20 per cent in theexchange rate must not be regarded asextreme. The sterling/euro rate weakenedby 22 per cent between its high of 2000 andits low of 2003, then strengthened by 11 percent to the high of 2007 and has subse-quently weakened by 33 per cent. Over thenine years from 2000 through 2009 theeuro/£ rate averaged 1.45 but rangedbetween 1.76 and 1.01. Who knows whatpaths this exchange rate will follow over thenext 10 to 20 years when projects embarkedon and skill development initiated todaywill be required to bear fruit.

Consider by contrast the position of theeurozone-based manufacturer. If sterlingweakens, his British competitor will be morecompetitive but will not have the capacity totake more than a small slice of the global mar-ket. The euro-based manufacturer will also beunder a continuous but not overwhelmingpressure to lower costs and improve qualityand service. He will be seeking annual pro-ductivity improvements in contrast with thealternating cost cuts or relaxations of a Britishmanufacturer facing a fluctuating pound. Theeuro-based business will tend to invest withmore confidence and with greater focus onthe long term than will its Britain-based com-petitor. British prosperity will lag behind thatof the continent and British incomes will fallrelative to European incomes.

The two countries that have been mostsuccessful in recent years at exporting havebeen China and Germany. Both clearlyunderstand the significance of exchangerate stability: China by locking its rate tothe US dollar where its main market lies,and Germany by locking itself into theeurozone where its main market is situated.

It is not just traditional manufacturingindustry that is affected: any business activityrequiring investment in skills, equipment andfacilities which can only be recouped throughearning an adequate profit over the long termand where there is international competitioncould find itself in the same position. Thedecision on joining the euro therefore hasprofound implications for a very wide rangeof businesses competing in Europe.

The uncertainties created by possiblefuture moves in exchange rates can lead torisk aversion, which will have a very signifi-cant effect on business decisions. Its applica-tion can result in sub-optimal decisionsimposing large costs. The British manufac-turer faced with a decision to invest wherethe resulting income flows can vary massive-ly depending on the exchange rate is likely tobe much more reluctant than his Germancompetitor, whose exchange rate risk ismuch lower, to make such investment. Thisconsideration also applies where a US orJapanese company is looking to invest in theEuropean region. Clearly exchange rate


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volatility is only one aspect, with others suchas labour productivity and ease of doingbusiness playing an important role, but itdoes mean that Britain has to run muchharder in these areas than its eurozone com-petitors to retain its investment attractiveness.

Arguments�against�the�euroOpponents of the euro in Britain point to thefive economic tests, conducted by theTreasury in 2003, which contributed to thedecision to reject membership. However, thesetests are obsessed with interest rates whileignoring much more important issues. The teston investment, for example, devotes 98 percent of its content to the impact of interest rateswhich might comprise 4 per cent of the costsof a properly capitalised manufacturer, whileignoring the impact of changes in exchangerates on the other 96 per cent of costs.

That the great majority of the publicundoubtedly oppose euro membership atthe present time is hardly surprising giventhe misguided and at times malicious positionof much of the media. Yet where the facts areclearly explained public opinion can bechanged in favour of the euro. Unfortunately,through ignorance or intention, the pointsmade in this paper are rarely if ever raisedeven in the more responsible newspapers orother parts of the media. An example is thethree-page debate between Willem Buiterand Derek Scott entitled ‘The Crisis: a rea-son to join the euro?’ in the February 2009edition of Prospect. This debate did notonce mention the effect of the euro decisionon manufacturing or investment.

In comparison with the lack of understand-ing of the importance of exchange rate volatili-ty, great focus is placed on the perceived sig-nificance to manufacturing of changes in inter-est rates. The effect of such changes on the costbase is, however, miniscule compared with thehavoc caused by exchange rates.

Manufacturers base their decisions toinvest on a comparison of the return to beearned from the investment and the cost ofcapital to finance that investment, but it is anillusion that the return and the costs are veryclose, and that a saving of, say, 1 per cent inthe cost of capital is extremely significant. Infact the return from almost any investment ishighly uncertain because it relies on assump-tions regarding the size of the market, thetrend of costs, and most importantly theactions of competitors. None of these can bepredicted with great confidence and compa-nies therefore tend to have benchmarkreturns for investments which are significantlyhigher than the expected cost of capital. It isnot a case of comparing a return of say 11 percent with a cost of making the investment of10 per cent but rather one of comparing arange of possible returns say between 0 and25 per cent with different weights against thecost of capital. This is true even where theinvestment is entirely focused on the domesticmarket and the exchange rate is not an issue.The introduction into the equation of a possi-ble 20 per cent variation in the exchange ratewill inevitably raise the range from 0 per centto 25 per cent to -25 per cent to +40 per cent.

The cause of this illusion possibly lies inthe banking mentality, where it is possibleto know the return from a specific invest-ment with some degree of certainty and thecost of the funds invested is a much moresignificant factor. In banking, small marginscan be predicted with confidence and canbe multiplied with gearing – though withdisastrous consequences when there is a sys-temic collapse, as we have recently experi-enced. In manufacturing, the range of possi-ble outcomes is very wide while the cost ofcapital is known with reasonable certainty.The problem with the UK government’sfive tests is that they have been driven by abanking rather than industrial mindset. ©

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That�the�great�majority�of�thepublic�undoubtedly�opposeeuro�membership�at�thepresent�time�is�hardlysurprising�given�the�misguidedand�at�times�malicious�positionof�much�of�the�media�

Testing the effect of an additional 3 percent interest charge on the borrowingsof 14 large non-financial companiesshowed a 5 per cent reduction in theirvalue – serious but not the disastrousimpact often claimed. The average debt-to-equity ratio for the 14 companies was 170per cent, indicating an over-reliance ondebt, contrary to the view expressed in themarket that British companies are ‘well fund-ed’. In practice these companies obtainedmost of their funds through medium to long-term bonds and were largely immune to theimpact of fluctuations in the bank rate. Thehigh levels of debt are, however, largely areaction to the low cost of interest and this istrue of the economy and society as a whole.

Greece�and�the�euro�crisisBritish politicians and the British publichave congratulated themselves on being outof the euro during the financial crisissparked by the problems in Greece whichhave led to concern over Spain, Portugal,Italy and Ireland. But Britain is – hopefully –

not Greece and should instead compareitself with the northern European countrieswhich in many respects have coped betterthan Britain with the financial crisis. Table 2gives food for thought. Except for Denmark,Sweden and the UK, these countries are allmembers of the euro area and are ranked interms of their current account balances.

The euro area as a whole had positivebalances on both current account and tradein 2007 and over the five years to 2009 wasin reasonable balance. The following pointsdeserve comment.

The figures show that the northerncountry members of the eurozone, and notonly Germany as is usually suggested, havebenefited from the euro but the southerncountries have suffered. This reflects thegreater industriousness of the north and theinability of the southern countries to remaincompetitive by devaluing their currencies.

Denmark and Sweden have been includedand show up well despite not being membersof the euro. They have, however, understoodthe significance of exchange rate stability andhave tied their currencies closely to the euro.


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Table�2:�Balances�on�trade�account�and�current�account�per�capita,�selectedEuropean�countries,�2007

Country Region Balance�per�capita�(US$,�2007)

Trade Current�a/c

Sweden North 2,000 4,220

Netherlands North 3,348 3,634

Germany North 3,370 3,058

Finland North 2,264 1,906

Austria North 220 1,463

Belgium North 162 686

Denmark North -73 436

France Central -901 -514

Italy South 72 -876

UK North -2,978 -1,313

Portugal South -2,274 -2,019

Ireland North 7,279 -2,953

Spain South -2,833 -3,335

Greece South -5,098 -3,982

Source:�The�Economist,�10�January�2009

The worst performing countries are allin southern Europe apart from the UKand Ireland. France falls in the middle asbefits its geographical and politicalambivalence. The current problems withGreece1 were clearly predictable andshould have been reflected in much higheryields on the country’s debt. The situa-tions of Spain and Portugal are perilous,with Spain averaging a deficit on currentaccount over the past five years of $2,600per capita per year. Unless these countriesmake major structural adjustments theyface similar situations to that currentlybeing experienced by Greece.

The UK’s position is not good althoughinvisible inflows partly compensated for apoor performance on trade. Over the fiveyears to 2009 the per capita deficits on cur-rent account and on trade averaged $1,000and $2,400 respectively. The problem lies inthe level of visible exports which, on a percapita basis at $7,400 in 2007, are the lowestof the major European countries and lessthan half the level of Germany.

ConclusionThe decision to join or not join the eurohas implications which go well beyondpurely financial issues and into those suchas the type of society we wish to create, toreducing inequality and to halting theconcentration of activity in the South Eastof England. In summary the argumentgoes as follows:

� The independence of the pound leavesBritish manufacturers outside the eurocurrency area in which most of theirproducts have to be sold.

� Britain is unable to maintain the stabilityof the pound against the euro.

� This creates great uncertainty in theminds of manufacturers (and othercompanies that might make long-terminvestments) about their ability tomatch their prices against those of theircompetitors who mainly come from theeuro area.

� Such uncertainty creates a reluctance toinvest which leads to a decline in manu-facturing capacity and ability.

� This is problematic given the generallyheld view that a healthy manufactur-ing sector is critical to the long-termhealth and balance of the UK economyand society.

Rejection of the euro therefore is funda-mentally negative for our long-term exis-tence as a significant and prosperouscountry. Reviving our economy and socie-ty and restoring a position where we areable to earn and pay our way rather thanliving on borrowed money will be a diffi-cult task under any circumstances. It willbe made considerably more difficult if wepersist in remaining outside the commonmonetary area.

Joining the euro will not be easy. It willinvolve swallowing our pride and some cur-rent members of the eurozone will beunwelcoming. Others, however, will recog-nise the strength which Britain would addto the eurozone.

Remaining outside of the euro would bea sign that we regard ourselves as beingunable to compete with the northernEuropean countries and having more incommon with the southern countries,whose culture has been described as one of‘corporatism, corruption, labour-marketrigidities and overbearing public sectorunions’ (Joffe 2010).

A final plea is that we should reduce ourobsession with interest rates. They areimportant but not to the extent assumed bythe Government and most commentators.A degree of certainty about the exchangerate is much more important.

Peter Howard is a retired chartered accountantwith 30 years’ experience as finance and executivedirector of a number of large manufacturing andmining companies in several countries.

Economist, The (2009) Pocket World in Figures 2010, London:Profile Books

Joffe J (2010) ‘Germany won’t let the euro train be derailed’,The Times, 18 June

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why britain should join the euro

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