By Willem Buiter

The case for the UK shedding sterling and adopting the euro has never been clearer.

From a conventional macro-economic perspective, there is no reasonable argument for a small, highly open economy such as Britain's to retain monetary independence. For economies with a high degree of international financial integration, the exchange rate does not act as a buffer against asymmetric shocks, permitting an easier adjustment of international relative prices than under an irrevocably fixed exchange rate. Instead it becomes a source of unnecessary noise and volatility.

The best way to deal with asymmetric shocks is to smooth national consumption by increased portfolio diversification and cross-border labour mobility. International portfolio diversification is aided by the reduced exchange rate risk that comes with membership of the euro area. Joining Schengen, the European border-free travel area, would boost the ability of labour to adjust to economic shocks.

There is another powerful argument for adopting the euro. The UK has a large financial and banking sector, which conducts much of its activity buying and selling financial instruments denominated in foreign currencies, not in sterling. The UK has massive gross external liabilities and assets - well over 400 per cent of annual gross domestic product each - compared with less than 100 per cent for the US and 700 per cent for Iceland.

It is not much of an exaggeration to describe the UK as a giant hedge fund, a highly leveraged entity borrowing shorter than it lends and invests. It has a lot of short-maturity foreigncurrency-denominated foreign liabilities and illiquid, non-sterling denominated foreign assets. It is not a bad way to make a living, but it means the country needs a lender of last resort and -market-maker of last resort. It has one for sterling-denominated financial instruments. The Bank of England (after malfunctioning at the onset of the credit crisis in August 2007) now performs this role effectively.

The Bank, however, cannot print euros, dollars, Swiss francs or yen. That means it cannot be an effective lender of last resort, or market-maker of last resort, if UK banks find themselves unable to roll over their non-sterling-denominated short-term liabilities or unable to sell their foreigncurrency-denominated assets in illiquid international wholesale markets. To deal with either problem, the Bank would be dependent on the goodwill of other central banks, through swaps and credit lines in foreign currencies. They would have to be willing to buy sterling when the markets are yelling: "sell it". This would be possible, but an (unnecessary) risk.

The main question is whether the UK is more like the US and euro area or like Iceland. I would argue that it is more like Iceland. Only the US and the euro area have serious global reserve currencies, with about 63 per cent and 27 per cent of the global stock of re-serves respectively. Sterling, with about 5 per cent, no longer plays with the big boys and girls. Countries that want a large, internationally active banking sector and financial system need a serious global reserve currency to provide the lender of last resort and market-maker of last resort services required to limit the risk of a bank run or liquidity crunch bringing down their banking system. It is possible to run a large financial sector with a local currency such as sterling or the Icelandic krona, but it involves taking an unnecessary and costly risk. Sooner or later that risk will be reflected in the cost of capital and render the country uncompetitive. If London wants to remain the world's financial capital, there is only one choice for the UK: adopt the euro now and wonder why it did not do so in 1999.

Finally, there are political arguments for joining the euro area. The future of Europe is federal. The euro is a symbolic step towards deeper political integration. The UK can continue acting as it has since the European Union (or its predecessor institutions) was created: stand on the sidelines, snipe, join late and reluctantly and then moan about how things are turning out. Or it could be at the heart of Europe, shaping its institutions. The UK punches below its weight because it is not a full member of the EU: if you are not in the euro group, you do not count.

So macroeconomic stability, the defence of London's status as a global financial centre and the political logic of deeper European integration all call for the dumping of sterling and adoption of the euro. Just do it.

The writer is professor of European political economy at the London School of Economics and Political Science

Copyright The Financial Times Limited 2008