Back in 2003 when Gordon Brown's five tests were being discussed, an excellent pamphlet by David Begg, Olivier Blanchard et al (2003) noted that sooner or later the pound would be squeezed between the mighty ‘tectonic plates' of the euro and the dollar. With sterling dropping through the €1 psychological barrier, it appears that the moment has come.

So let's examine once again some of the main arguments for and against eurozone membership. I shall spare the reader any discussion of the five tests since they have now all been met.

Currency Stability
The main argument in favour of joining is to gain currency stability---as Icelanders and others have discovered.

In 2001, Iceland returned a strongly free-market centre-right government which promptly denationalised the banks, deregulated finance and shunned the euro. The result was to turn the country into a giant hedge fund, with overseas indebtedness many times the size of the country's GDP. When the country's banking system began looking suspiciously overstretched earlier this year, the currency plummeted with devastating effects on ordinary people's jobs and standard of living.

Nor is it only in Iceland that there is growing enthusiasm for joining the euro; Denmark and Sweden are also showing renewed interest.

Some economists rightly point out that membership of the euro did not prevent the Irish banking panic or the Spanish property collapse. But this argument misses the salient point: if the punt and the peseta (and for that matter the lira and the drachma) still existed, there is little doubt that traders would have driven these currencies mercilessly to ground.

But Britain - it will be argued - is not Iceland or Greece. We are a large(ish) economy and our pound has a proud history stretching back to King Offa of Mercia. The pound is the world's fourth most important reserve currency. Yes, but much the same could be said of Germany, France and others when they gave up their national currencies in favour of the euro nearly a decade ago.

The euro brings stability in part because it is such an important currency, and in part because of the industrial strength of the main eurozone economies. At present, about more than a quarter of the world's reserves are held in euros. Germany is the world's leading manufacturing exporter, and although several of the core eurozone countries may be in recession at the moment, their economies are likely to recover sooner than Britain's. The euro is simply too strong for speculators to attack successfully.

Exchange Rate Flexibility
This brings us to a second line of argument about exchange rate flexibility. Consider the view of the Guardian's Larry Elliot who, while rightly admiring the German economy, thinks our flexible pound will help us rebalance the economy, thus moving towards rebuilding our industry.

There are two points to be made here. First, if you want to rebuild industry, you need a long term industrial policy which stresses the need to modernise infrastructure and you need a highly educated workforce; Britain has neither. Secondly, while gradual exchange rate adjustment might help Britain, extreme currency fluctuations do not. A plummeting pound is more likely to undermine industrial confidence than to strengthen it, just as it will weaken consumer confidence in general, ultimately reducing aggregate demand.

That's the problem with a fully flexible exchange rate system---it breeds instability. In the absence of the sort of international financial regulation Keynes favoured at Bretton Woods in 1944, it's better to have your Central Bank manage the exchange rate. Unfortunately, our government has made it clear that the Bank of England's mandate does not extend to exchange rate management of any form

However, because of the two-year waiting period imposed by Maastricht, if Britain wanted to join the euro, it could only do so at the end of the current recession---assuming we do not go into a slump. To do so, it would need to target an exchange rate which, while stronger than the present one, maintains our industrial competitiveness. So the argument that euro membership fosters currency stability in particular (and economic stability in general) is about long term strategy rather than short term tactics.

One-size-fits-all interest rate

The third argument about the euro has to do with interest rates. Were Britain in the euro, it would have to accept one-size-fits-all monetary policy. Mervyn King may have dithered, but in the end he bit the bullet (and doubtless will bite it again soon). UK interest rates have been slashed to fight recession. By contrast, the ECB continues to cut eurozone rates very slowly.

There's substance in this argument. The ECB has the dubious honour of being the world's most conservative central bank, in part because of German folk-memories of inflation, but mainly because bankers value ‘sound money' above all else. The bankers of Frankfurt believe that the euro's ‘credibility' depends on maintaining their image as relentless anti-inflation warriors. But inflation has not been a serious threat for over a decade, and today the real risk is that the general price level may start to fall, triggering Japanese-style deflationary expectations.

In any event, how important are interest rates in a recession? It is quite true that low interest rates alone will not get either the UK or the Eurozone out of recession (what economists call the ‘liquidity trap' problem), but it's equally true that Keynes insisted that loosening monetary policy should precede fiscal pump priming. Even Milton Friedman argued that if the general price level started to fall, the Central Bank should print money and dump it from helicopters.

Fiscal Policy

That brings us to a crucial point about fiscal policy; would Britain lose its fiscal independence in joining the euro? I have argued in Regaining Europe that the eurozone's Stability and Growth Pact (SGP) was always a very clumsy instrument for controlling national indebtedness, in particular, constraining public spending while leaving the private sector untouched.

That such a state of affairs favours the interests of finance capital is all too obvious. The financiers are happy to manage the nation's pensions, to spur its spending by distributing billions of unsolicited credit cards and to back deregulated labour markets. The irony is that all this has already happened in Britain without having had to join the euro.

If neo-liberal economics rules the roost in Brussels and Frankfurt, it is because it was first pioneered in the Anglo-Saxon world of Thatcher and Reagan. And while the Maastricht Treaty restricted public indebtedness to an arbitrary 60% of GDP, Mr Brown was even more prudent, capping it at 40%. For years, Britain has lectured the major EU countries on the merits of supply side economics, flexible labour markets and the rest.

Would Britain in the eurozone seek to scrap the SGP or back a larger EU budget which could be used to counter recession? I'd like to hope so, just like I'd like to hope that opposition to the euro from two most powerful institutions concerned with economic policy---the Treasury and the Bank of England---would melt away. Neither big beast will relinquish even a scrap of power without a fight.

The German dispute

While Peer Steinbruch correctly reminds us that Brown's conversion to ‘crude' Keynesianism is quite recent, it is regrettably true to say that Germany too has hardly been very progressive in its macroeconomic policy. True, it has the world's strongest manufacturing export base, outstanding infrastructure and a highly educated workforce. But Germany's Keynesian tradition is thin.

In the prewar period, Germany's pump-priming was associated with re-armament while over most of the wirtschaftwunder years, the then federal finance Minister, Fritz Schaffer, explicitly rejected Keynesian deficit spending. In the past two decades, consumer demand has remained constrained by the priority given to export production. In place of ‘demand management', German economists prefer to speak of using ‘automatic fiscal stabilisers', citing the merits of rules-driven policy over ‘policy discretion'. Unfortunately, automatic stabilisers alone cannot prevent recession, nor can they protect the economy from the danger that a prolonged recession could turn into a world-wide slump.

At the same time, it is important to recall---as Larry Elliot has done--- that Germany has run up a substantial national debt in order to finance reunification, and that its recent stimulus package, although somewhat smaller than Britain as a share of GDP, has emphasised higher child benefits, lower contribution rates for unemployment insurance, and measures to modernise public transport infrastructure and energy efficiency.

A Monetary Giant but a Fiscal Dwarf

The centre-left in Britain remains deeply divided about the euro, as exemplified by (say) the respective positions of Will Hutton and Larry Elliot. This disagreement persists even if many socialists and social democrats have a strong distaste for the neo-liberal precepts and financiers' mythology about ‘wealth creation' which has infected the new Labour project for so long.

The eurozone is a very imperfect construct, and its ‘financial architecture' is particularly vulnerable to an economic downturn. With monetary policy centralised and democratically unaccountable and with a small, rigid and ill-targeted budget, the Eurozone is a ‘monetary giant but a fiscal dwarf'.

Nevertheless, we live in a world where economic stability requires either joining a currency bloc or managing the exchange rate. The arguments against the euro are largely based on free-market orthodoxy. Blind faith in the market leads to instability, and those who suffer most from economic shocks are always the least well-off.

Crucially, the argument about the eurozone has always been more about politics than economics. As the PES Congress in Madrid showed recently, what Europe can offer is a model which values social protection and ecological sustainability above the unrestrained pursuit of greed. Only Tory diehards (and a few members of the current cabinet) still believe that Britain can be rebuilt on the basis of light-touch regulation and City bonuses.

Sooner or later, democratic socialists must recognise that it is preferable to fight for reform from within the eurozone than to deride it from the outside.

George Irvin, SOAS