HealthInvestor, 1st October 2004
The old cliché that all predictions are difficult, particularly about the future, seems especially feeble when the discussion is about Europe. We can be confident that Britain will vote “No” in the promised referendum, that this will lead to demands on both sides of the Channel that we should leave the European Union, and that many will claim that Britain would then face ruin.
The fundamental case for Europe is and should be a matter of politics rather than economics. Those writing about Europe should therefore declare their political stance. I am a pro-European romantic. The founding aim, to end forever Europe’s disastrous civil wars, was a high and worthy ambition. Its great success is taken for granted, and would probably have occurred anyway. But this was not obvious 50 years ago. Even if its success in Western Europe is discounted, the wish to join the Union has strengthened the forces for democracy in Eastern Europe. I would be sorry if Britain were to leave the Union, though I regret the weakness of its democratic legitimacy and its opposition to liberal economics.
The economic issues have, however, little to do with the political ones. They fall into three groups. First, are the benefits of scale and information, which come from free trade. Second, is the ability to adjust to shocks. Third, is the competence or follies of economic management.
Britain derives great benefits from international trade, but these come from our own openness, rather than from our membership of the European Union. Jagdish Bhagwati, who is probably the world’s premier authority on the matter, has argued that free trade areas are actually harmful as they tend to raise rather than lower barriers generally. But the key point is that these benefits are open to any country which chooses to avoid import taxes and restrictions. The famous economists Adam Smith and David Ricardo argued that it is in a country’s interests to follow free trade, regardless of what others did. Martin Wolf points to the success of Hong Kong and Singapore, which have clearly not been members of large trade associations, as evidence that this is valid today.(**)
The European Union’s trade stance provides powerful support for Professor Bhagwati’s viewpoint. In international trade negotiations it has probably been the most obstructive of any developed economy. If Britain were to leave the European Union we would no longer suffer from its trade restrictions, notably the idiocies of the Common Agricultural Policy.
Agriculture is an activity where we have a comparative disadvantage. Without the burdens of the Common Agricultural Policy we could, if we wished, have far lower food prices, which would produce a sharp increase in our living standards. We might fritter some of these away by introducing our own agricultural subsidies. But the question at issue would not be the loss of a benefit from Euro membership, but the benefit from ending it, which we would of course be free to retain or throw away.
There are benefits from membership of a wide currency union, which reduces information and currency transmission costs leading to greater economies of scale than free trade on its own can achieve. If we swapped pounds for euros, we could grasp these advantages, but the disadvantage would be that we would become less able to adjust to economic shocks. Such shocks often require falls in real wages and these are much more easily achieved through adjusting exchange rates than through reductions in nominal wages.
There is a better case for Britain joining a currency union than for being a member of the European Union, but it has drawbacks as well as advantages. Entry at the wrong exchange rate would be a major shock. As it is easier to increase nominal wages than to cut them, this means that there is an asymmetry about the risks of entry. It is much less risky to enter with an under- than with an overvalued currency. It would therefore be risky to join the euro unless sterling were clearly undervalued. But, as entry is unlikely, neither the benefits nor the risks are at issue today.
The problem of shocks could of course arise if Britain left the European Union. But this would only be a problem if Britain had a large manufacturing industry, with high short distance transport costs, where we could suffer a sharp deterioration in our terms of trade if European import taxes rose against us. However, Britain’s comparative advantage lies clearly in services rather than goods. It is only manufacturing that requires large amounts of capital to be sunk into assets which have little alternative use value and where such shocks can thus be important.
Britain clearly has a comparative advantage in finance and other services and our future prospects might be less rosy if barriers rose against us in Europe. Services, though, are not generally subject to import tariffs but to other kinds of restrictions, which have yet to be removed. We might lose a potential benefit from liberalisations yet to be introduced, but the fear of financial domination by the City of London and cultural domination by the English language have kept many barriers in place and prevented free competition in services.
(**) “Why Globalization Works” by Martin Wolf, published by Yale University Press 2004, provides a splendidly complete, authoritative and clear exposition of several of the issues which are only touched on briefly in this article.