(The City of London is, of course, already a full participant in the European financial markets – indeed it is the major contribution that we can make at this stage in the development of the new currency.) These are very considerable potential economic benefits which will lead to more efficient resource allocation across the euro area. The potential downside is the risk that at times the single European monetary policy will not meet the domestic monetary policy needs in all the individual participating countries – in other words that there will be problems of sectoral and regional divergence which are very familiar in larger economies at the national level, but on a larger, regional European, scale. The jury is still out on this question. Based on our experience it seems clear, as I say, that there is no clear best solution, applicable at all times for all currencies, to reconciling the inherent problem of potential conflict between the needs of domestic and external stability. The choice depends very much upon the country’s particular circumstances. Floating may be more attractive to a country which has a small tradeable sector relative to the size of its domestic economy, but in that case it will need an effective nominal domestic anchor, such as a money supply or inflation target; and it will need an institutional structure – typically an independent central bank – to reinforce the credibility of the commitment to that nominal anchor.
Each option has its pros and cons. Let me start with floating. At first blush the idea of allowing the exchange rate to take the strain, as a kind of buffer, insulating the domestic economy from shocks emanating abroad appears very attractive. Unfortunately it does not necessarily work like that. A floating exchange rate may move erratically in response to market news, causing unwarranted movements in the real exchange rate. That, of course, may be an important influence on domestic costs and prices; it may affect the relative competitiveness of domestically and foreign-produced goods and services leading to changes in the net external trade position, affecting aggregate demand in the domestic economy. So the insulation provided by a floating exchange rate may prove to be more apparent than real. The UK has been floating since 1992. For some years we experienced very little tension between our domestic and external policy needs. But then, from the autumn of 1996 we saw a sudden appreciation of some 20-25% in our Effective Exchange Rate against the core European currencies, and seemingly, largely related to uncertainties about the future characteristics of the European single currency. Whatever the reason the strengthening of the exchange rate had a dampening effect on the domestic price level, and a subsequent deterioration of our trade balance (accentuated over the past year or so by the global economic slowdown) reduced aggregate demand in the economy. Monetary policy accordingly needed to be less restrictive than would otherwise have been appropriate to offset these effects on domestic demand.