“What would happen if we leave the European Union?” was not one of Gordon Brown’s five tests – the criteria which the then-chancellor and his special adviser, Ed Balls, dreamt up to determine the conditions under which the UK would have joined the euro.
Brown’s critics grudgingly concede the role of those tests in convincing Tony Blair not to ditch sterling. Ever since, those who did suggest Britain might want to share a currency with its largest trading partner have been unable to forget. “Wrong then, wrong now” was a powerful mantra for the winning side in last year’s referendum.
Nevertheless, with Britain about to embark on its most arduous negotiating mission in a generation, maybe being wrong back then would have made things a little easier right now.
For if Britain had opted to go for the euro – in the late 90s’, early 00s’ or even at the height of the financial crisis – the torturous Article 50 process might go a little smoother.
Of course, Britain – and Europe’s – recent histories could have been very different had we taken that route. The financial capital of Europe and another strong, prosperous northern economy being inside the Eurozone might have helped shore up the currency’s shaky adolescence. Perhaps a common debt crisis would have bound us closer to our euro-bearing peers and stoked European solidarity on this side of the Channel. Or, scared of being dragged into endless bailouts and unwilling to commit to the Eurozone’s budget rules (the UK hasn’t met the 3% budget deficit cap in any of the last eight years), David Cameron would have triumphantly campaigned to Leave and won the referendum with a landslide.
However, if, for whatever reason, the UK had joined and we arrived in largely the same place that we now find ourselves, Theresa May might be quietly raising a glass to Messrs Brown and Blair.
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Britain would, of course, be ditching the euro and returning to sterling. Despite protestations from the likes of Mario Draghi that the decision to join the euro is irreversible, he would quickly accept that to be outside both the rigid institutional architecture of the EU and the woolly political format of the Eurozone, but remain inside the monetary union, would be an impossible set of circumstances.
In that case, Britain would face the option of using a third-party currency for the first time in its history, or cobbling together a plan to shift the world’s fifth largest economy back to sterling. The Eurozone would be about to lose its second-largest member, largest financial centre, and one of its strongest advocates of fiscal responsibility. An economy 14 times the size of Greece being cleaved off in a matter of 24 months would ring alarm bells not only in Brussels, but in Frankfurt, Athens, Rome, Dublin – anywhere with even a passing interest in financial stability.
Moreover, for Britain, or any country, to leave the Eurozone, it would need to settle its accounts at the European Central Bank (ECB) as part of establishing a new currency. Due to the architectural quirks of the euro, this would have created more than a few headaches. It could, however, have helped Britain secure a decent exit deal.
It all comes down to the role national banks still play in the ECB system, and how Frankfurt manages to balance its books through the Target2 model.
National banks – the Bundesbank or Bank of Greece – are still the institutions that hold accounts with commercial banks in their countries. When money transfers from one bank to another, everything acts as it would within any other system: German bank A lends to German bank B and the Bundesbank changes some numbers on its spreadsheet.
But when it comes to cross-border transactions, the ECB needs to get involved. When a bank in Spain wires euros to one in Italy, the Banco de Espana deletes a few euros from the account of whichever bank sent the money. On the other side, the Bank of Italy adds that same amount to the account of the receiving bank. But central banks can’t just create and destroy money in that way. Enter Target 2, the ECB’s middle-man payments system. Target 2 logs all these cross-border deals, keeping track of which countries have been dishing out the most, and those that have been sucking it up – a de facto list of creditors and debtors. When a spanish bank sends €1 million to an Italian one, it puts the Banco de Espana €1 million in the red.
The whole structure is basically an accounting trick to square the circle of monetary union without economic, fiscal or political homogeneity and, in textbook cases should function behind the scenes, garnering little attention and more or less balancing itself. The overall numbers cause little concern. Central banks pay – or receive – interest on their account, but the debt is never called in.
However, in times of strain, it doesn’t exactly work out like that. Instead of a niche piece of accounting, Target 2 balances can – and have already – become highly political.
During the debt crisis, German economists started to pay close attention, realising just how much they were on the hook for should Greece or Ireland crash out of the single currency. From imbalances of just a few billion before the crisis, the numbers ballooned. As of January 2017 the Bundesbank is “owed” €795 billion by all the other national banks in the Eurozone. In the mid-2000s it was €5 billion.
On the other side of the ledger, Banco de Espana, Spain’s central bank, has an outstanding Target 2 balance of €350 billion. In other words, Spanish citizens, businesses and banks have sent €350 billion more to the rest of the Eurozone than they have secured in loans and transfers from the other 18 members. That amounts to one-quarter of the Spanish economy, and similar in proportion to the amount of cash which was pumped into the UK economy under the first tranche of quantitative easing.
It is likely that, were Britain in the Eurozone, the Bank of England would be in a similar position to Germany. Cash has tended to drift from south to north, from weaker economies with fragile financial sectors to the stronger ones, while the loans going the other way have dried up in the face of Greek, Italian, Spanish, Portuguese and Irish banking crises.
In a threat to those countries with big liabilities Mario Draghi recently said he would present any country that leaves the euro with a bill for its full Target 2 balance – putting a hefty price tag on €xit in a bid to discourage talk of breaking up the union.
The reverse, that in-credit €xit-ers could demand a cheque, also holds, putting a euro-issuing Bank of England in line for a multi-billion windfall as part of Brexit.
With Britain potentially stepping out of the picture, the idea of sharing even more of the burden for profligate southern neighbours is an unpleasant one for the likes of Germany and the Netherlands. But asking those in debt to cough up and cover the bill would put serious pressure on the entire system. The mere prospect of settling the UK’s claims would be a political spectacle and economic nightmare.
Faced with such a prospect, that €60 billion divorce bill – among other bones of contention, from the passporting/equivalence debate to a new free trade deal – might not loom so large in the bureaucrats’ thinking – especially at a time when every central banker across the Eurozone would be pleading with the Bank of England not to call in its debts.
From an economic perspective, history has decisively vindicated Gordon Brown and the anti-euro crowd. Politically, however, had the euro-backers won the day, Britain might be heading for a slightly more benign Brexit.