My Lords, I believe that one lesson of the credit crunch is that we should look again at the case for joining the eurozone. It is not an issue that has been raised in this debate, although it was raised in today's Financial Times. The arguments today are different from those of 10 years ago, because circumstances have changed, but they are very relevant to our present condition.
First, we now face a crisis of stability and credibility. To avoid heavy unemployment, we need low interest rates and higher government borrowing, whether by way of tax cuts or further spending. Both of those will threaten sterling, which is now a highly vulnerable currency. If there were a collapse of sterling, with the threat of high inflation, it would cause the mother and father of all economic crises, especially since we have such a very high level of personal indebtedness; 53 per cent of all credit card debt in the European Union is in Britain. Membership of the eurozone would give us a certain security.
The second argument concerns the future of the City as a world financial centre. That is mainly what I want to speak about. The question that we have to face is whether we can today successfully maintain the City's role as a world financial centre if we are not part of a major reserve currency area and do not have a central bank that can act as a lender or market-maker of last resort. The issue has been the subject of a fascinating dispute between two economists who I greatly admire; Martin Wolf and Willem Buiter. I find Buiter's arguments impressive and persuasive.
Why did Iceland's banks collapse? They collapsed not necessarily because they were insolvent or badly managed, but because, like so many banks, they were overwhelmed by the unexpected liquidity crisis in all the world's wholesale financial markets. Iceland is a very small country that has a very large financial sector; it is huge in relation to its GDP. It is internationally active and internationally exposed. That need not have proved fatal, except that Iceland has its own currency.
All banks are, in a sense, risky businesses, because they borrow short and lend or invest long. If all their depositors suddenly want their money back, they cannot pay, even if they are not fundamentally insolvent, since their long term assets normally exceed their liabilities. In the case of domestic banks, the central bank can act as a lender of last resort to tide them over, since it has the security of the value of their long-term assets. The central bank can rescue a perfectly sound domestic bank if there is, as at present, a crisis of liquidity. If necessary, it can print more money.
However, a central bank can intervene as saviour only if it can lend in the currency in which liabilities have to be met. It cannot print foreign money. Iceland's banks borrowed and invested abroad in foreign currencies and incurred foreign liabilities on a massive scale, amounting to about 800 per cent of Iceland's GDP. Its central bank could not act as a lender of last resort in foreign currencies. The story would have been different if that country had been a part of the eurozone. The case of Iceland was not altogether unique. It is very likely that Ireland would have gone the way of Iceland if it had not been part of the eurozone.
What about the UK? Financial services also form an important part of our economy, although not on anything like the scale in Iceland. Our financial institutions, too, have borrowed and lent or invested in foreign currencies on a massive scale, amounting to well over 400 per cent of our GDP. That compares with a figure of some 100 per cent in the United States and some 30 per cent in the eurozone. The Bank of England is not able to act as lender or market maker of last resort if UK banks cannot sell their foreign currency-denominated assets to meet their short-term foreign currency-denominated liabilities. They may not be able to do that because they cannot roll over their liabilities or because of the shortage of liquidity in international wholesale markets.
The UK finds itself somewhere in the middle between Iceland and the reserve-currency countries—the United States and the eurozone. It can be plausibly argued that we are closer to Iceland because sterling is not a major global currency to speak of. We are very minor players on the global scene. On the other hand, we have far more credibility than Iceland, and, because of that, the Bank of England can get over the problem by arranging swaps and credit lines with other central banks. However, the cost of that is considerable. Having to rely on such arrangements will place the City of London at a competitive disadvantage. Is it a loss of competitiveness that the City can afford? What would happen if we lost credibility because of a collapse of sterling?
Other countries which thought that they should preserve their economic independence, like Denmark and Sweden, are now seriously reconsidering membership of the eurozone. We now have to face the question: can we maintain a successful world financial centre without being a member of a major reserve currency area? If not, the only choice for us is the eurozone. Euros are likely to be a lot safer and more stable than pounds.