Euro not an optimal currency zone
Within Euro-Zone countries there is geographical immobility of labour and there is insufficient wage flexibility inside European labour markets to cope with external economic shocks
Member economies have not converged fully in a real or structural sense. Although there has been a substantial amount of nominal economic convergence during the run up to the establishment of the Euro, there are still huge differences in the economic performance of member nations. And, at some stage in the future, there is a risk that excessively high interest rates will be set across the Euro Area because of an inflationary fear in one part of the zone that is unsuited to another area.
Loss of monetary policy autonomy
Joining a single currency reduces the UK's monetary policy autonomy. It might be better off if it retains the flexibility to set interest rates to meet her own economic objectives.
Member countries have signed up to the fiscal stability pact that means there is little scope for fiscal policy to cushion the effects of economic shocks affecting different countries in different ways. The stability and growth pact limits national budget deficits to 3%. And the EU budget is not big enough for international transfers to take the strain instead. Britain is more sensitive to interest rate changes than other EU countries - in part because of the high scale of owner-occupation on variable-rate mortgages. Joining a currency union with little monetary flexibility requires the UK to have more flexibility in labour markets and in the housing market.
Demand for European Fiscal Transfers
Substantial fiscal transfers will be needed to aid poorer countries within the EU along with a more activist European Regional Policy to reduce structural economic inequalities. The UK might not feel able to afford such large-scale intra-European transfers. The change over process to the introduction of the Euro will involve substantial menu costs for businesses and banks. Europe's labour and product markets are too inflexible to deal with the economic strains that EMU will put on them. If interest rates, exchange rates and fiscal transfers cannot be called on to deal with economic shocks such as a burst of imported inflation, then wages and prices will have to do the job.
- The UK is currently enjoying a period of sustained economic growth and stability, which has been achieved by being able to adopt the economic policies appropriate to its circumstances. By joining the single currency Britain would lose the ability to set interest rates and in future could have to endure rates quite inappropriate to the phase in its economic cycle (too high in times of recession or too low in times of boom). The constraints placed on euro-zone countries by the one-size-fits-all interest rate policy and the requirement of complying with the stability and growth pact will remove their freedom to react to changes in economic circumstances at a national level.
- Since the responsibility for setting interest rates in the UK now rests in the hand of the Bank of England and not the government, the setting of rates is now dictated by long-term economic goals, and not for political gain.
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There are inherent differences between the British and euro-zone economies, which suggest that closer integration with other euro countries is neither advisable nor practicable.
- The British economy is invariably out of phase with other European countries, entering recession and recovery at different times to that of most of her EU partners.
- The British economy has a higher sensitivity to interest rate changes because of Britain's high proportion of mortgage owners, in particular those with variable rate mortgages.
- Britain's rates of unemployment, public sector spending and taxation levels are markedly lower than most euro countries.
- Britain's high overseas investment levels are testimony to the economic ties, which she enjoys with the world beyond Europe.
- High levels of pension fund assets mean that Britain is less exposed to the high levels of pension liabilities, which face many other EU countries in the years to come.
The “separate cycles” argument, which points out that the UK economy, is almost always out of sync with the French, German and other EU economies. After all, the UK pattern of trade is far more externalised than for most Euro-land countries. The UK produces oil. It is one of the world’s largest global investor and is much less dependent on manufacturing; there is also a much greater dependence on short-term interest rates for mortgages and corporate debt. So, when an interest rate cut would be good for the UK, it is often the case that an interest rate rise would be good for Germany and France and some other members of Euro-land, or vice versa.
Instability and uncertainty
The Euro lost almost 15% of its value against the US Dollar in its first ten months of trading. Is it really going to provide stability and certainty? More than half of UK exports and three-quarters of its international investments are outside Euro-land, so the Dollar rate seems to matters more.
Efficiency Gains: CASE AGAINST
The EU is imperfect. External trade, state aids, and single market rules seemed individually desirable, but were mutually harmful. Is this now true with the currency?
Regionalism
- If monetary union is inappropriate for Europe, then this argument could also be applied to parts of the UK, East Anglia and Northern Ireland for example. Britain's economy as a whole is more closely aligned with the European average than Northern Ireland is with Britain; regional variations within countries can be just as great as those between countries.
- European economies are slowly becoming ever more naturally integrated with each other, mainly through the activities of international corporations.
Trade Patterns
- Modern trade is more about trade among businesses in the same industry. Thus the structure of developing economies, particularly Europe, is becoming more integrated, more similar, and less prone to shocks. Any change in consumer tastes is likely to affect Euro-land equally, as with cars for example.
Nature of Debt
- In the UK the highest consumer debt is mortgages, which are highly sensitive to interest rates - but there are more savers than borrowers. The move to EMU is likely to provide incentives to people to borrow at fixed interest rates for longer periods.
Exchange Rate Flexibility and Devaluation
Devaluations only work if they lead to a fall in the cost of production after allowing for subsequent price rises. Most devaluation in the UK has only worked in the short term. What you gain by devaluation is lost on the inflationary swing.
Social Costs
- The single currency alone will not make Europe prosperous. France and Germany are inflexible; both have high indirect social taxes, which threaten growth, such as the working time directive.
- Higher payroll taxes are inevitable to finance the irresponsible social policies of France and Germany. European factionalism may eventually destroy EMU.
- Some of the UK's advantages - labour market flexibility and low wage costs - have been eroded by government adoption of the social chapter, working time directive, and the national minimum wage.
- The euros benefits are not automatic, and can only come about if countries shift from social job protection, high benefits that discourage mobility, and wage inflexibility.
4. EMU AND ECONOMIC REFORM
I believe that economic stability, encouraging work and raising productivity are key areas for the European Union. The single currency will provide a competitive base to European business. Firms and consumers stand to benefit from price transparency, reduction of transaction costs and less exchange rate uncertainty. For these benefits to be realised in full the single currency must be based on solid foundations. More progress is required in two areas, fiscal discipline and economic reform. In particular:
- For labour markets, the key is to increase employability. With a single currency, it will be even more important for Europe to have a well-trained, adaptable and motivated labour force, able to adjust to changes in economic circumstances;
- For better functioning markets for products and services, Europe needs to build on the single market, promote entrepreneurship and improve access to finance. Within the single market this means liberalising markets and promoting better public procurement; and
- For deeper, more competitive and more integrated capital markets, the single market in financial services must be implemented effectively.
5. Conclusion:
Before I can conclude the economic pros and cons of the UK joining the EMU, one needs to mention the convergence criteria delineated in the Maastricht Treaty, which determines which countries can enter the European common currency. The five criteria to which all countries must adhere in order to join the EMU include macroeconomic variables such as price stability, government budget deficits, total government debt, interest rates and exchange rates. These have to be met even if the UK decides to join the EMU.
A clear alternative
The UK faces a clear choice. Opt for ever-closer integration in a Europe, which is over-governed, over-regulated, overtaxed, over-borrowed and a Europe, which is protectionist, inward looking, corporatist plus even federalist. A Europe which is a continental social model that destroys jobs and the capacity for wealth-creation and that drives businesses out of the EU altogether.
Or, we can play to our strengths as a global trading nation. Of course we want to develop trade and prosperity in Europe. Of course we want to cooperate with our European partners. But we also want to nurture our traditional links with the USA, Asia and the Commonwealth. We want to be a focus for enterprise, investment, productivity, growth, wealth-creation and high employment.
There is more than one reason for doubting possible benefits of the EMU. It has become obvious that the union is politically driven rather than economically. It will be put into existence even if, as it is clear now, almost all countries will miss one or more criteria. As countries are not able to meet the figures set forth in the Maastricht treaty the necessity of such figures has even been doubted. Furthermore, the success of the EMU is still very unsure. Important political and economic means to balance economies will not be available any longer. Means such as exchange rates are used to absorb local economic shocks. Thus, in the future regional economic failure will have a larger impact on other countries. Also, governments will have less political autonomy. Authorities such as the European Central Bank replace their local counterparts and there will be a need for a much closer political co-ordination. Whether possible advantages outweigh rather imminent threats is a question that remains unanswered. At this point it is certain that economic success of the EMU cannot be insured just by a single currency. However, economic ties between European countries are evident and in the long run a single currency can be an advantage in the global market. The UK will have to decide whether it is important to have considerable influence on the future or whether they would rather stay out of it.
The power to print money, inflate, and boost exports by devaluation, is now being created in the most powerful way possible - by treaty. But the European Currency Board's (1991) single aim - price stability - independent of political interference, cannot bail out profligate governments.
The independence of the European Central Bank replaces ultimately national reserve banks, and is not accountable to the people. Most worryingly, however, the EMU deprives national governments of the ability to use national fiscal policy to counteract recessions - this is not lost altogether, but restrained.
There is a danger that in the event of a sharp recession there will be a political reaction against the EU.
What next? A successful euro would give a big impulse to political union. Full union, as in the USA, is unlikely, but some form of federalism is more likely, with differing degrees of countries opting in or out. Perversely, could this be seen as the true success of the euro?
The euro zone is much further from being an optimum currency area than the USA. Price disparity is greater, after allowing for exchange rate fluctuations. Labour is not so mobile. The euro will encourage greater economic integration, but there are barriers of language and culture. A perverse consequence of the implementation of the euro is that it will promote a greater level of specialisation, thus increasing the chance of asymmetric shocks.
The live question is whether the diminution if national sovereignty is worth the gains of labour and market flexibility, and low interest rates. Political momentum can dominate good economics, but political ideology should not override economic sense.
The Case for the Single Currency (Source: The Case for the Euro, Britain in Europe (2000))
- A large single market benefits everyone - international trade - economies of scale
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The single market requires a single currency
- exchange rate uncertainty
- Exchange rate volatility will continue and may increase;
- technology in the global capital markets
- UK increased dependence on international trade
- Our European competitors no longer face this exchange rate uncertainty
- Foreign Direct Investment
- Political and Economic Influence
- The European Central Bank
The Case against the Single Currency
- Gordon Brown’s Five Economic tests:
- Are business cycles and economic structures compatible so that we and others could live comfortably with euro interest rates on a permanent basis?
- If problems emerge is there sufficient flexibility to deal with them?
- Would joining the EMU create better conditions for firms making long-term decisions to invest in Britain?
- What impact would entry into EMU have on the competitive position of the UK’s financial services industry, particularly the City’s wholesale markets?
- In summary will joining EMU promote higher growth stability and a lasting increase in jobs?
- The Maastricht Convergence Criteria
- Inflation rate of all Euro countries has to be within 1.5% of the average of the three best performing economies
- Long-term interest rates (10 yr rates) has to be within 2% of the average of the best performing three.
- Budget Deficits have to be below 3% of GDP
- The ratio of public (Government) debt to GDP has ot be below 60%.
Arguments Against the Euro
- One Size does not fit all - the interest rate issue - is fiscal policy sufficient to offset asymmetric shocks?
- Britain’s financial system is different - e.g. mortgage arrangements
- Europe’s unfunded pension liabilities - a constraint on fiscal policy
- The European Labour market is not flexible enough.
- Can individual member states coordinate policy? (see below).
Fixed exchange rates: Fiscal policy is (very) effective
The world interest rate is exogenous – you might discuss Perfect Capital Mobility (PCM) with them first. The income tax reduction results in a shift to the right of the IS curve, and this puts upward pressure on the domestic interest rate. However, as soon as domestic interest rate exceeds the world interest rate international investors will start to demand domestic assets, and therefore demand domestic currency. The monetary authority is obliged to supply the currency at the fixed exchange rate, which results in an increase in the money supply. Given a particular shift in the IS curve, the LM curve will shift to intersect the new IS curve at world interest rates. Under fixed exchange rates the money supply is effectively endogenous.
3. Suppose that the European Central Bank decides to tighten its monetary policy.
This implies that the European interest rate has increased.
a) How would this affect output and the exchange rate in those countries not joining the monetary union (Denmark, Greece, Sweden and the UK)?
Their interest rates will below that in the monetary union. Demand for their currencies will fall, leading to a depreciation of their respective currencies (assuming they do not fix their respective exchange rates against the euro). Net exports increase and this leads to higher levels of output in the non-member countries.
b) What could the authorities in the non-member countries do to stabilise output?
Given that their exchange rates are floating against the euro, only monetary policy has any effect (again assuming
PCM). If they wanted to stabilise output (perhaps it was already at potential output) they would have to also reduce their money supplies.
c) How would your answers to a) and b) change if the non-member countries had fixed their currencies to the Euro?
As in the ERM…
a) Demand for their currencies would fall (and supply increase), as investors move their wealth into Euro bonds. The non-member central banks would then be obliged to buy the relevant domestic currency at the agreed exchange rate. Taking this currency out of the market means that the domestic LM curve has shifted to the left (recall LM curves are endogenous under fixed exchange rates). Output will therefore fall.
b)Under fixed exchange rates they might use expansionary fiscal effects which would shift the IS curve to the right.