Flexibility – Is there sufficient flexibility in the UK economy to respond to shocks if it joined the Euro-zone?
With control over interest rates being handed over to the European Central Bank (ECB) 7 it is important that the UK economy can respond to economic shocks. The burden of adjustment in the Euro is on the labour markets and fiscal policy. The UK excels against its European counterparts in terms of flexible labour markets with one of the most flexible in Europe. To say whether this will be enough or not is conjecture, personally I am doubtful about one size fits all monetary policy especially with the growth and stability pact restricting government spending.
Investment – What will be the effect of the euro on investment in the UK be?
This test is about whether entry into the euro will encourage foreign investment. Since numerous companies have stated they will pull investment in the UK if there is no sign of joining the Euro, the fact that the Euro-zone has lower interest rates (the cost of borrowing to invest), and the reduced transaction costs and increased convenience of a single currency lead me to conclude overwhelmingly in favour of this test being passed. Gordon Brown has said himself that the UK could gain billions of pounds by joining the Euro-zone.2 However I think it is important to note that joining without sufficient convergence and flexibility would damage the economy and investment.
Financial services – What will be the effect of the euro on the UK financial services industry be?
This test primarily concerns the city of London, if the effects of joining the Euro are good for the city the test will be passed. The key issue is whether Frankfurt will overtake London as Europe’s top financial centre.1 This was the only test passed in 1997, it is intuitive to me the benefits of cost reduction and convenience of the Euro mean this test would be passed now as well, though there has been little evidence to conclude London’s position as a leading financial centre has been damaged by opting out of the Euro.
Jobs and growth – How will the euro affect UK unemployment and prosperity?
This test is about whether and how economically beneficial it would be to join the euro, whether it would promote growth and employment. The increased trade and competition due to reduced transaction costs and greater price transparency would in theory lead to higher employment and faster economic growth in the UK. However if the UK joins at the wrong time the economy could go into recession or worse. I would say this is more of a sub-test as if the UK is convergent, flexible enough to deal with economic shocks, and the euro would have a positive impact on investment and the city, it seems intuitive that this test would automatically pass.
Conclusion
My analysis of the issue leads me to conclude that the economic problem that would represent the great hurdle for the UK prior to potential entry into the Euro is flexibility. Can the UK ever be truly flexible enough to cope with a severe economic shock with no direct control over interest rates? Fiscal policy can be used but Governments face strict spending restrictions. I think Fiscal rules in the Euro-zone are far too rigid they force government to cut spending in a downturn, precisely when it is needed. This is the problem in Germany at the moment, their hands are tied to get out of recession, and they must have considered themselves able to deal with such eventualities when they joined or they would have opted out like the UK did. Also the UK has flexible labour markets but the Euro-zone doesn’t, I think the Euro-zone need to reform before this test could be passed its labour markets (especially in countries like Spain and Germany) are far too rigid.
The UK also needs to reform its housing market as it is highly sensitive to interest changes, so much so that they could be a source of economic shock in themselves. With control of interest rates being handed to the ECB, the UK needs to be able to cope with a ‘wrong’ interest rate. For example Euro-zone rate are at 2% at the moment, the UK’s have just gone up to 3.75% to cool off the housing market. Joining the Euro-zone now would cause house prices to soar leading to a boom and bust that would be destabilising to the whole economy. This illustrates why reforms are necessary, the UK needs to be less dependent on variable interest rates before this test could be passed. I would say this is also linked to the convergence test, the UK housing market needs to be more like the German one where only 40% of households are homeowners compared with 70% in the UK.6
In summary the fact that the Euro-zone labour markets are highly inflexible, and the rigidity of Euro-zone fiscal rules makes the flexibility test the hardest to pass. Though both are undergoing reform and look likely to become similar to the UK’s rules5, which is a step in the right direction.
