By Ted W. Hall*Wall Street Journal
April 11, 2006
For years, the U.K. has played Hamlet without the Prince, debating whether to abandon the pound sterling for the euro as though this was the only choice. Alan Greenspan's recent appointment as an adviser to Gordon Brown, chancellor of the exchequer, positions him to ask -- no pun intended -- two million-dollar questions: Why choose from so limited an option set? Why not also consider the U.S. dollar as Britain's future currency?
First things first: Adhering to sterling is not the U.K.'s best option. National financial systems cannot merely intermediate deposits and enable payments domestically. Their objective is to lower the cost of capital for issuers of financial claims by effectively aggregating and deploying capital. Individual capital markets are engaged in competition to create regimes that provide the lowest total cost, and compete for the continued loyalty of self-interested firms and savers.
In this contest, small national systems are cost-disadvantaged because they are subscale and relatively illiquid: the U.K.'s $8 trillion sterling-denominated financial stock is merely a quarter of the euro zone's $32 trillion and a sixth of the U.S.'s $48 trillion. With this relative lack of depth in sterling comes deadweight loss. If the U.K. is not to deploy its domestic capital relatively unproductively in the short run -- and witness an exodus of domestic firms to more attractive regimes in the longer term -- the sterling must go.
But why treat the euro as the alternative? True, the U.K. holds a greater share of foreign assets in the euro zone than in the U.S.: $650 billion of British-held debt and equity are in the euro zone, vs. $420 billion in the U.S. Yet from other perspectives, the dollar is emerging as a viable contender for British adoption. First, unlike its assets, the U.K.'s foreign-held liabilities are balanced across the U.S. and the euro zone at $660 billion each. Second, 44% of all equity outstanding worldwide is dollar-denominated (versus 16% for the euro), making this the world's preferred capital regime. Third, the dollar is on one side of 89% of all forex transactions world-wide (as against 37% for the euro), making it the global denomination of choice.
The U.K. loses monetary-policy control whether it adopts the euro or the dollar. The euro's very existence shows that even old Europe does not dispute that a unified, larger capital market is more advantageous than domestically controlled monetary policy. Moreover, the adage "when America sneezes, Europe catches a cold" is even truer of the U.K. Formalizing the existing U.S.-U.K. synchronization will only increase both governments' ability to act in tandem to manage cyclicality. And lower labor mobility across the U.S.-U.K. border relative to that within Europe is unlikely to be a major issue because sparking across the economic power grid only occurs if the voltages on the two ends are very different (think U.S.-Mexico).
There is much at stake in the U.K.'s choice. Adoption of the dollar would eliminate exchange rate risk, improving risk-adjusted returns for all asset classes. More venture capital would stay in the U.K. (and flow to it from the U.S.), stemming brain drain and fostering a more innovation-friendly environment in the U.K. The cost disadvantage and illiquidity premium associated with participating in a $40 trillion pool (euro zone plus the U.K.) will be significant compared to participating in a 40% larger $56 trillion pool (U.S. plus the U.K.). This is especially true because the U.S. already has thriving primary and secondary markets in the broadest range of financial instruments, especially longer tenure debt and niche products. The bad news is that both sides of the Atlantic have been nonchalant to date about which way the U.K. goes. The good news is that it isn't too late.
Like competition among computer operating systems, very few regimes will emerge as successful. Advantages from absolute scale and increasing returns created as additional participants join will define the winners. In this battle for scale, the U.K. has the enviable position of casting the $8-trillion swing vote. The euro needs it desperately. But for the U.K., the dollar may be more attractive, not least because of regulatory, legal, accounting, cultural and linguistic commonalities. The U.K. will likely find it easier to fashion a coordinated monetary policy with one compatible counterparty than with 15 countries with whom it agrees on wine but not on beef or Iraq.
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