Should the United Kingdom Join the Single Currency?

Introduction

This project will concentrate on analysing the arguments put forth in favour of adopting the Euro as our currency, as well as those against it. A conclusion will then be drawn that weighs both the pros and cons and decides whether it would be beneficial to the UK economy if we adopted the Euro or continued to opt-out.

Theory

The major economic theories that will be used are the following:

Macroeconomic objectives.
Governmental macroeconomic policies.

Analysis

Arguments for the Euro

The arguments put forth for membership of the "Euro zone" (countries that have adopted the Euro as their currency) are split into two groups: political and economic. A move towards a Federal Europe (Churchill's ideal of a "United States of Europe") that is governed in a similar way as that of the U.S.A. is the primary political argument. A Federal Europe would be governed as a whole with member countries retaining a few powers but losing almost all political sovereignty. It is argued that this reason is one of the driving reasons for the setting up of the Single European Currency. France and Germany in particular want to integrate the core European economies more closely and move towards a single European Economy. The economic arguments are further sub-divided into three groups: transaction costs, trade competition and investment. Ultimately, if the United Kingdom does not adopt the Euro higher costs will be incurred as far as transaction costs are concerned. The commissions involved in buying the Euro when trading with European countries will remain and the uncertainty arising from a floating exchange rate will also continue to be apparent. Whilst this is unlikely to make a significant difference for UK businesses buying continental European exports, it could well affect the number of UK exports being purchased by continental European companies. Basically, UK exports will be more expensive to Euro zone countries compared to exports of other Euro zone countries due to the changing cost of buying the pound. The UK's membership in the Euro zone would eliminate these costs. Trade competition refers to the fact that if exports from Euro zone countries are all priced in the same currency then it is easier for companies to see price differences between companies across borders, ultimately increasing competition between companies. In effect, with the lack of tariffs or quotas for import and export between Euro zone countries, it is almost like an integrated single European Economy as buying from a company in a fellow Euro zone country is exactly the same as buying from a company in your own country. This is called price transparency: it will become far easier to compare prices across the markets of the Euro zone. This has the advantage of creating competition between countries (which leads to prices levelling out), perhaps even providing competition for existing monopolies. For example, with borders being opened up between Euro zone countries, the traditional telecom monopolies that plague most European countries could be opened up to include foreign competition as networks expand across borders.

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The Single European Currency goes one big step further to the completion of the Single European Market, by opening up the markets of each member and linking them with one currency. Labour markets are also linked and the economies of the Euro zone can become more synchronized, lending themselves to full-on integration. The completion of a Single European Market has one major advantage - there will finally be a major competitor to the U.S.A. in the global economy. Economists predict that the U.S.A. and Euro zone Europe will become the two major players with Japan as a junior partner in the world economy. This has particular relevance now, since many economies at the moment, particularly our own, hinge on the US economy. If it slows down, like it is about to, then those other countries are likely to do the same. With another competitor to the US, the global economy can become much more balanced and with it brings more stability.

Obviously a key factor in Britain's decision to join the Euro would be whether or not it would help reduce unemployment. Unemployment is currently falling within the United Kingdom as can be seen from appendices fig 1.1, and figures from the Euro Zone can be seen in fig 1.2. As you can see from figures 1.1 and 1.2, unemployment within the Euro zone is currently higher than that within Britain. However, if the downward trend in figure 1 continues then it should be at UK levels within a couple of years.

In theory, once at these levels, unemployment should stay low since there will be a far wider labour market where workers can seek employment. Also, demand should increase due to the competition created by lower transaction costs, so output will be higher. This should create more jobs and thus lower unemployment or at least keep it low.

Arguments against the Euro

The arguments against the UK's membership in the Euro zone are also split into political and economic arguments. Political arguments include the loss of Britain's individuality as a separate country, as well as the loss of nearly all control over the UK economy. Furthermore, adopting the Euro more or less ties Britain into any future plans of a Federal Europe. It would be hard to back out of such plans with so much integration already set in motion. This, of course, would mean the loss of political sovereignty for Britain. It is the economic arguments against the Euro that are the most important and in many ways the most compelling. Economic theory states that the macro objectives for a government are as follows:

Low unemployment
Low inflation
Economic growth
Balance of Pay Equilibrium

In order to succeed in these objectives, governments use policies to control various aspects of the economy:

Monetary Policy
Fiscal Policy
Supply-side Policies
Exchange Rate Policies

In the analysis that follows, it will be shown that three of these policies would be rendered unusable to control the UK economy:

1. Monetary Policy

Monetary policy involves the raising and lowering of the base rate to control aggregate demand. For example, if aggregate demand is rising too quickly and raising prices (demand-pull inflation):

In this situation, the government could increase the base rate. This would have the effect of lowering consumer expenditure since there would be a higher incentive to save and a higher cost of borrowing. The introduction of the Euro in the UK would make this policy unusable because interest rates for Euro zone members are set by the European Central Bank (ECB) and is the same for all member countries. Of course, the ECB is able to operate Monetary Policy over the whole Euro zone, but an increase or decrease in aggregate demand might have a positive effect on one economy but a negative one on another. Economists argue whether the economies of the Euro zone are suitably synchronized to allow policies such as this to be used universally.

2. Fiscal Policy

Fiscal policy is closely linked to monetary policy and is also used to control aggregate demand. However, it does so by controlling the amount of government spending and taxation. Increasing government spending will increase aggregate demand:

AD = C + G + I + X - M

Increasing taxation means that incomes are lowered, which causes consumer expenditure to go down which means that aggregate demand, goes down (see above). Of course, both can be applied vice versa as well.

Fiscal policy becomes more or less useless with the adoption of the Euro, since one of the convergence criteria for joining the Euro zone is a low government debt. This means that the government cannot increase government spending to increase aggregate demand.

3. Exchange Rate Policy

Exchange Rate Policy is the devaluation and revaluation of a currency in order to deal with a balance of payments deficit. Little needs to be said here, since obviously with membership of the single currency this will be out of the control of the British government and in the hands of the ECB.

This leaves only Supply-Side Policies, which are rather limited in their applications. They involve deregulation to lower costs of production for businesses, and increasing labour productivity to increase growth rate (by promoting competition, privatisation, reducing strikes, etc.)

The main reason behind setting the Euro in the first place is to promote economic growth within Euro zone countries.

Conclusion

Having analysed both the pros and cons of membership in the Euro zone, I conclude that at this time it probably is not beneficial to join. This is for two main reasons.

Firstly, the UK economy is at its strongest at the moment and has still has prospects despite opting-out of the Euro for the moment. Capital inflow is likely to continue even if we stay out of the single currency and the UK still has attractive supply-side factors in both product and labour markets for foreign investors. Particularly, the UK will remain attractive for Far Eastern countries such as Japan and the so-called tiger economies.

Secondly, I think that currently the risks outweigh the advantages that would be gained. As mentioned before, the UK economy is at its peak and is doing considerably better than other Euro zone members. If the UK joined the Euro then it is highly possible that the less fortunate countries will drag the UK down with them, as it were. Furthermore, the ECB will likely have to take relatively drastic action to keep some of the poorer economies in the Euro zone in check. This could have adverse effects on the otherwise sound economy of Britain. The problem is that the economies of the Euro zone are not suitably synchronised to allow economic control to be universal over all of them. Universal measures are the only option with a single currency. If Britain opts-out for the time being until the single currency has had a chance to both synchronise and improve the economies of the Euro zone, then it might be in a better position to offer advantages that outweigh the risks. On the other hand, if the Euro fails miserably and its economies go into recession, then we will be suitably distant from it to avoid unnecessary damage to our own economy.

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Appendices Fig 1.1

Appendices Fig 1.2

Bibliography